18/2/2014: Wages and Employment: Irish labour market plight

This is an unedited version of my Sunday Times column from February 9, 2014.


In recent months, Irish Government has gone into an overdrive, producing various reports, scorecards and papers on the Irish economy. Much of this activity is a welcome sign that various Departments are starting at last to engage with the world beyond the halls of civil service and political establishment.

The most recent report card on the Irish economy, courtesy of the Department of Finance, presents an interesting read. The document provides an insight into Official Ireland's view of the future, with forecasts covering 2015-2018 medium-term priorities for the Government, including: managing public finances, focusing on jobs, and restructuring the financial system.

To those of us inhabiting the real economy, removed from the MNCs and Government finances, of key importance here are the objectives of "reviving domestic demand" and "increasing employment". The Department’s overarching framework for achieving economic growth in the economy rests on the assumption that over 2014-2016, both total domestic demand (sum of public and private consumption of goods and services and investment) and exports will be positive contributors to growth. In fact, domestic demand is forecast to add, on average, 1.2 percentage points to economic growth annually, accounting for more than half of the GDP expansion in 2014 and 2015 and over 40 percent of growth in 2016.

The Department of Finance vision of the future is a positive one, especially for the financially battered Irish households. Alas, it also reflects some potential contradictions – a sign of the overall dilemma inherent in our economy’s structure. For all the talk about recovery and regaining of our economic independence, Ireland is still facing years of dealing with the debt crisis as well as sustained fiscal austerity. Growing out of this predicament can only be achieved by pushing up exports. But this, in turn, requires moderation in production costs and, thus, suppression of domestic demand. As the 1990s showed, you can’t have both, growth in exports and growth in the domestic economy, until we erase the debt overhang.


By definition, increases in domestic demand can only come from either public or households' consumption and investment uplifts or both.

Growth in Government spending on both current and capital goods and services is not on the cards. In 2014 and 2015 Irish fiscal tightening will continue to reduce domestic demand. In particular, fiscal consolidation, as planned, will take 1.8 percent of GDP in 2014 and 1.1 percent of GDP in 2015. Thereafter, we are still set to face the so-called 'preventative arm' of the EU’s Stability and Growth Pact (SGP). Under the 2011 Six-Pack legislation amending the SGP, a number of fiscal rules will apply to Ireland, including the requirement to continue reducing structural imbalances by at least 0.5 of GDP per annum, plus the debt break mechanism designed to draw debt to GDP ratio down toward 60 percent benchmark over time.

Which means the households are expected to fund the fiscal adjustments in 2014-2015, and fiscal maintenance in 2016 and beyond. All while delevaraging own debts and paying for the banks deleveraging their loan books, without dipping into deposits which will have to remain high to sustain core banking sector performance metrics.

Meanwhile, the Department of Finance forecasts that Ireland's unit labour costs adjustments over 2008-2015 will total 21 percent, relative to the Eurozone average. This projection, turn, underwrites the forecast growth in our exports.

Just how the households of Ireland can be expected to deliver on all of this is anyone's guess. An even bigger guess is required to explain as to how all of the above financial pressures on Irish households can be dealt with while increasing private investment and consumption, e.g. growing domestic demand.


The answer to the above questions rests with the outlook for the labour markets and wages.

In 2013, Irish economy seen the return of growth in employment - the only significant bright spark on otherwise bleak economic horizon. Based on the latest data we have, in 12 months through September 2013, numbers in employment rose in all sectors in Ireland, with exception of Transport and storage, Administrative and support services, Public administration, and Health and social work. Non-agricultural employment rose by 33,000 and the bulk of new employment was generated in the jobs with 35 and higher average weekly paid hours. In fact, in Q3 2013 compared to Q3 2012, the number of people in employment more than 35 hours per week rose 52,500.

This means that employment growth is now beginning to support domestic demand growth.

The problem is that this support is coming off extremely low levels. Between 2008 and 2013, number of jobs with weekly work hours in excess of 35 hours has fallen 242,500. And gains in employment so far are still fragile. At current rates of growth, it will take us some 13 years to get back to the same levels of full-time employment. Of all sectors, only three are currently registering larger number of jobs than in 2007-2008 period: Accommodation and food, Information and communication, and Health.

And the latest Live Register figures released this week show that controlling for State Training Programmes participation, declines in the numbers on the Live Register remained rather static over the last 4 months.

With employment rising off low levels the other source for growth in domestic demand can be found in earnings. And, aptly, in recent months, there has been resurgence in political chatter about the need to raise wages.

In part, these calls are driven by wages dynamics during the crisis. As of the end of September 2013, average weekly earnings in Ireland were down across all sectors by EUR16.40 compared to the same period in 2012 and down EUR31.37 compared to 2008 average. However, earnings were up significantly in Information and communication: rising EUR40.28 per week on Q3 2012 and up EUR64.28 on 2008 levels. This is a sector with employment that is predominantly capturing foreign workers into new jobs. In turn, these workers have only tenuous connection to the domestic economy: they rarely invest in Ireland, do not save here and are more likely to spend money abroad than the long-term residents. In almost all sectors of the economy linked more directly to Irish resident workforce, earnings are still declining.

So employment might be growing, but wages are declining or stagnant. Which does not bode well for household incomes and, in return, for domestic demand growth story.

More importantly, earnings deflation or stagnation must continue if the Government projections for exports growth were to materialise.

The maths are further stacked up against the theory of domestic demand growth fuelled by wages rises. Given changes to taxes over recent years, a euro increase in wages from current levels for an average household will yield less than 50 cents in the gains in the disposable income. When juxtaposed against the non-discretionary spending, such as funding mortgages, this means that wages increases are not exactly an efficient path to growing domestic demand. Based on Central Bank data, average mortgage in arrears today is EUR190,372. Per CSO, average household income is around EUR61,000pa, once we adjust for unemployment. Which means that at current tax rates, a 1.5 percent increase in income (corresponding to average weekly earnings rising by EUR10.13 on their Q3 2013 levels) is not enough to offset a 0.25 percent rise in mortgage interest.

This week, we have seen the publication of the research paper showing that some 100,000 households in Ireland are unable to pay their mortgages despite having regular income from employment. That is roughly 63 percent of all mortgages in arrears.

Put simply, from economy’s point of view, it is more effective to raise and extend mortgages interest relief than attempt fuelling wages inflation. With ECB’s policy firmly geared toward lower rates, one might be excused thinking that interest rates increases are for now a distant prospect, but in 2013, house loans rates for outstanding mortgages in Ireland went up 0.1 percent compared to the same period in 2012, while rates of outstanding consumer loans were up 0.34 percent. Overall, these increases, suggest that just to keep up with the cost of funding our immense household debt overhang, households need to see wages increases of some 2.2-2.4 percent per annum. Unless you work in ICT, this is not on the books, given supply-demand imbalances in skills and jobs in this economy.

Which leaves us with only one sector where realities of supply and demand have little to do with pay and employment and where wages increases can be imposed by the state: the public sector. This is precisely where pressures to raise wages are currently emerging, driven by political, not economic considerations. With local and European elections approaching, Labour wing of the current Government is trying desperately to force the reversal of their slide in electoral approval ratings. Labour's traditional support base - the Unions - are happy to oblige, in return for concessions of value to their members.

The problem with this, however, is that in order to keep labour costs competitive on the aggregate, wages hikes in the public sector will require more wages ‘moderation’ somewhere else in the economy. Furthermore, with fiscal policy breaks still in the hands of the EU, increases in the lower skilled wages in public sector are likely to benefit incumbent employees at the expense of the newcomers. And if productivity growth in private sectors does not compensate for labour cost increases in public sector, we will be heading for new layoffs, slower jobs creation and, thus, contracting domestic demand.


Our economy is between a rock and a hard place. We are living through the slowly unfolding nightmare of the exports-led recovery – a recovery during which households’ earnings and employment growth are unlikely to reignite domestic economy any time soon. The only way this dilemma of wages vs exports can be resolved is if it is accompanied by a rapid reduction in household debt. But, of course, you won’t find that featuring anywhere in the Official Ireland glossy presentations or in Labour Party’s exhortations about the need for wages growth.

Box-out:
This week, Irish Spirits Association published the latest statistics on our whiskey sector. According to the association data, Ireland had only 4 registered distillers delivering gross value added to the economy of EUR568 million for all spirits produced. This compares against 108 distillers of whiskey alone, pumping out value added of ca EUR3,630 million in Scotland. Total exports in Ireland stood at 6.2 million cases per annum. Scotch exports were fifteen times that number. The figures highlight both a massive potential for Irish whiskey growth and a huge gap between our sector output and that of our next-door neighbours. Looking at the Scottish model, it is clear that Ireland’s decades-old policy of industrialising production in the whiskey sector has failed spectacularly. We need a new policy approach focusing on stimulating independent distilleries, catering to higher value-added premium segment of the market, and delivering rapid innovation with focus on high quality. Marketing efforts of our trade facilitation agencies are not enough.

18/2/2014: Wither Irish manufacturing? Not so fast! Sunday Times, February 2

This is an unedited version of my Sunday Times  column from February 2, 2014


The news flow was mixed in recent days when it comes to covering Irish economy.

After a massive boost of consumer confidence and a maelstrom of media spin extolling the expected rebound in Christmas season sales, December retail sector statistics came in as a disappointment. Over the entire Q4 2013, core retail sales (excluding motors) were up just 1.1 percent year on year in terms of volume and down 0.5 percent in value. Profit margins in services sectors have shrunk once again in the third quarter and with them, non-financial services sectors activity also slumped in the five months through November 2013.

One bright spot, however, was the return to growth in industrial production. Based on 5 months data through November, in the second half of 2013 industrial output was up 1.2 percent year on year in Traditional sectors and up 3.3 percent in Modern sectors.


This latter bit of news highlights the potential for the sector to play a more active role in delivering long-term source of growth in Irish economy.

Over the second half of 2013, using data through November, Irish manufacturing activity rose 3 percent in volume and 0.1 percent in turnover terms. The improvement in output was largely driven by the MNCs-dominated modern sectors. However, it was also supported by positive performance in domestic sectors, such as food, basic and fabricated metals, and capital and core consumer goods. All in, H2 2013 marked a positive break in the previously negative trend across a number of manufacturing sectors. And this change was even more substantial when one takes out downward pressures exerted on the 2011-2013 figures by the pharmaceuticals, where patents cliff continues to cut into output and revenues of major MNCs operating from Ireland.

Adding to good news, capital goods sectors growth signaled the restart in domestic and international investment cycle. And this confirmed the earlier data on capital acquisitions in the industry.

The latest data is now starting to feed through to official forecasts. This week, the Central Bank upgraded 2014 and 2015 outlook for Irish economy. Specifically, the Central Bank is now projecting investment growth of 8.9 percent in 2014 against 0.1% estimated growth in 2013. Crucially, investment in machinery and equipment, having declined 10 percent in 2013 is now forecast to rise 7 percent in 2014.


The news of the quiet out-of-media-sight stabilisation in the Irish manufacturing is welcome because our exports and economy at large are still heavily dependent on industrial and manufacturing sectors activity.  This news is also positive because manufacturing sectors are responsible for high quality jobs creation and hold a significant potential for Ireland in developing a long-term sustainable economic growth model in the future.  In 2013, weekly earnings in industry were the third highest of all private sectors in Ireland and carried a premium of 33 percent on average private sector earnings.

Beyond the above reasons, there are two basic arguments as to why the latest manufacturing trends are encouraging in the context of sustainable economic development.

The first one is a push-factor, driving Ireland in the direction of the new manufacturing.

Worldwide, we are witnessing a new trend in manufacturing. In the commoditised manufacturing geared toward mass-market supply, global supply chains continue to drive down margins and costs, necessitating ever-increasing degree of automation and labour cost reductions. This trend covers a wide range of goods, such as generic consumer goods and intermediate goods production, ranging from textiles and clothing, to consumer electronics, and basic materials industries. Here, robots are increasingly displacing workers. For example, the McKinsey Global Institute study published this month projects that by 2025 up to 25 percent of the tasks performed by industrial workers in developed countries and up to 15 percent in developing countries will be at a risk of replacement by automated systems.

Meanwhile, highly specialist, customised manufacturing, where the businesses processes are dominated by user-unique design and/or proximity to customers, are seeing development costs and time-to-build lags becoming the main points of competition between producers. Actual production in these sectors is based on high precision and skills flexibility and these drivers are pushing for on-shoring of these sectors to the economies with requisite skills and talent infrastructure. The examples of such manufacturing sub-sectors are also numerous, spanning customised precision equipment manufacturing, professional equipment design and production, medical devices, customised medical equipment, individualised or specialist medicines, technology-intensive and complex machinery, but also high value-added consumer goods. Ireland has some limited experience in this area, with companies such as Mincon and Mainstay Medical, Outsource Technical Concepts and others. And we are witnessing growth in design-rich consumer goods areas, such as homewares, personal accessories and higher value-added foods.

I covered these trends in my recent presentation at the TEDxDublin in September 2013 and over the last three months, major consultancies, such as McKinsey and the Institute for Business Value, IBM have written on the topic.


The second factor is the pull-factor of the opportunities presented by new manufacturing.

The crucial point for Ireland is that this trend offers smaller economies a comparative advantage over larger manufacturing centres, as long as the smaller economies can create, attract, retain and enable core human capital.

The competitive advantage of skills-intensive manufacturing is anchored to traditions of high quality specialist production in the country, and to the innovative and entrepreneurial capacity of the economies. Here, examples of Switzerland, Northern Italy, Germany, Holland, Sweden, Denmark and Finland offer a significant promise for countries like Ireland.

In fact, our immediate neighbours industrial policy platform is now firmly focused on enhancing the connection between industrial design, consumer innovation and manufacturing. This is well-anchored in the UK’s Design Council initiatives and in the Government programmes aiming to systemically increase the role of industrial design in the UK manufacturing. Most recently, Government report “Future of manufacturing: a new era of opportunity and challenge for the UK”, published in October 2013 stresses the importance of merging skills, design and technological innovation in driving the future industrial policy in the UK.


To deliver on this potential, our industrial policy needs to be enhanced further to stimulate growth in entrepreneurship in manufacturing. We also need policies that more closely align product, process and design innovation and R&D, especially within indigenous and traditional sectors.

Skills training in manufacturing should be boosted via a targeted apprenticeship programme that develops key expertise and provides support for training both in Ireland and abroad. Our supports for development of manufacturing clusters in traditional industries need to become more pro-active, providing shared sales and marketing platforms for smaller producers.

We can start by consolidating various promotional agencies under the cover of Enterprise Ireland in order to reduce trade and investment facilitation bureaucracy, while increasing resources available on the ground in the foreign markets. Aligning Enterprise Ireland’s pay and promotion systems with tangible longer-term outcomes for indigenous entrepreneurs and exporters should be considered. The overall thrust of reforms should be on reducing duplication and complexity of the system.

Recent report by the Entrepreneurship Forum, published earlier this month outlined a number of measures aimed at helping the unemployed and underemployed to transition into entrepreneurship. These include reducing the eligibility period for the Back to Work Enterprise allowances and creating an entrepreneurship internship programmes. Beyond this, focused incubation and co-working centres targeting manufacturing entrepreneurs can help develop new capabilities and generate new startups. Aligning these programmes with vertical market access accelerators set up in key cities can help enhancing growth potential of indigenous high value-added entrepreneurship. The above programmes can also stimulate inflow of key talent into the country from abroad, including entrepreneurial talent. One of the core benefits of high value-added manufacturing is that the jobs created and capital investment made in this sector are much better anchored in the economy than comparable outlays undertaken in services sectors.

To simultaneously enhance incentives to undertake entrepreneurial activities and to invest time, effort, talent and funding in such activities, employee stock ownership should be encouraged. Over the recent years, this column has repeatedly argued for a reform of tax codes applying to employee share ownership in startups and SMEs. The Entrepreneurship Forum report echoed these ideas.

Driving growth across the design-rich and R&D-intensive manufacturing will also require managerial talent. Looking across the sectors, Irish management skills are the strongest in the externally trading traditional industries, such as food, beverages, and building and construction services. Here, the pressures of global competition, coupled with the acute need to build exports bases have driven management to adopt lean and effective M&A and organic growth models. Management track record of companies such as CRH, Glanbia, Kerry Group and Ryanair presents the best practices in their sectors that can and should be brought to enterprises in much earlier stages of development.


The encouraging signals from Irish manufacturing suggest that we can put our indigenous economy on an evolutionary path toward ever-increasing reliance on radical technological innovation, design and creativity. This path is closely aligned with the need to develop new models of entrepreneurship that combine disruptive technologies with cultural, managerial and skills-rich talent. The key to success here will be in developing greater agility and flexibility of all systems: from crowdsourcing networks for new product development, to training and education, to data analytics for gauging new demand and to new market access platforms.

Box-out:

This Monday, in its monthly report, Germany's Bundesbank stated that in future crises, countries requiring international assistance should first impose a one-off capital tax on net assets of its own citizens, before any international assistance can be extended to them. In the view of the Bundesbank, a capital tax reflects the principle that "tax payers are responsible for their government's obligations before solidarity of other states is required". These latest musings about the need for a capital or wealth tax come on foot of October 2013 IMF report that estimated that reducing euro area's debt levels to 2007 levels will require a 10 percent tax on net wealth of the euro area residents. Neither the IMF, nor Bundesbank identify explicitly specific assets to which the tax should apply. Alas, past experience with Cyprus suggests that such a tax will most likely take the form of a levy on household deposits. Logically, all other assets held by the households are already either heavily taxed, or illiquid. Property taxes are in place in majority of countries and it is hard to imagine every household being able to come up with cash to cover 10 percent levy on their assets values without being forced to sell their homes. Equity and investment funds are de facto illiquid, as a large scale sell-off of these assets in a distressed economy will trigger a crisis hardly any better than the one the levy will be trying to cure. Business equity is notoriously illiquid. Which leaves deposits as the only readily available cash sitting on captive banks balancesheets. In short, Bundesbank and the IMF might be talking about 'capital levies' and solidarity, but all they really mean are deposits bail-ins and loading pain onto taxpayers. That's one way to underwrite inherently faulty and unstable common currency zone.

18/2/2014: Gold Demand Trends 2013

The World Gold Council released its annual (2013) report on Gold Demand Trends (GDT). link: http://www.gold.org/investment/statistics/demand_and_supply_statistics/

Highlights are:

• Jewellery: 2013 saw the largest volume increase in jewellery demand for 16 years as consumers across the globe reacted to lower gold prices. Full year demand was 2,209.5t, 17% above 2012 and the highest level since the onset of the 2008 financial crisis.
• Investment: 2013 was a year of contrast between the different elements of gold investment. Demand for bars and coins surged to an all-time high of 1,654.1t as individual investors took advantage of lower prices, while large-scale selling of more tactical ETF positions by western investors generated outflows of 880.8t.
• Technology: Annual demand for gold used in technology stabilised at 404.8t, from 407.5t in 2012. The lower price environment and improved global economic outlook was supportive for gold used in a range of applications in the sector.
• Central Banks: Net purchases by central banks increased global official gold reserves by 368.6 tonnes. 2013 was the fourth consecutive year of net purchases, albeit at a slightly reduced pace due to the environment of heightened gold volatility and slower foreign reserve accumulation.
• Supply: In 2013 the supply of gold declined 2% to 4,339.9t as a drop in recycling activity (in response to lower gold prices) more than offset growth in mine production.

Total demand is 3,756.1 tonnes against 4,415.8 tonnes in 2012 down 14.9% y/y, of which ETFs and similar investment funds' purchases declines accounted for 880.8 tonnes in 2013 against a rise of 279.1 tonnes in 2012. Thus, the decline of 659.7 tonnes y/y was more than accounted for by the net swing in demand from ETFs of -1,159.9 tonnes.

Total bar and coin demand for investment purposes, however, rose from 1,289 tonnes in 2012 to 1,654.1 tonnes in 2013.

17/2/2014: Is Bitcoin a Real Currency?

Bitcoin has been a focal point of many debates and discussions. None as important as whether or not the digital currency is a real currency.

A new research paper, titled "IS BITCOIN A REAL CURRENCY?" by David Yermack (NBER Working Paper 19747: http://www.nber.org/papers/w19747, December 2013) attempts to answer this question.

"Late 2013 became an auspicious time for Bitcoin, a “virtual currency” launched five years earlier by computer hobbyists. During the month of November 2013, the U.S. Dollar exchange rate for one Bitcoin rose more than fivefold, and the value of one Bitcoin, which had begun trading at less than five cents in 2010, exceeded $1,200.00. Two days of hearings were held by the U.S. Senate Commitee on Homeland Security and Governmental Affairs, at which government regulators testified that virtual, stateless currencies like Bitcoin had the potential to play useful roles in the commercial payment system.

Stories appeared in the media about travelers subsisting for lengthy periods by spending only Bitcoin, and various businesses – including Richard Branson’s Virgin Galactic space travel startup – attracted publicity by agreeing to accept Bitcoin as payment. With approximately 12 million Bitcoins circulating, the worldwide value of the currency exceeded $14 billion, equal to the market capitalization of a mid-range S&P500 company."

Yermack argues that "Bitcoin does not behave like a currency at all. Instead it resembles a speculative investment similar to the Internet stocks of the late 1990s." In other words: not even a commodity...

Starting from the money as defined in economics: "having three characteristics: it functions as a medium of exchange, a unit of account, and a store of value. Bitcoin increasingly satisfies the first of these three criteria, because a growing number of merchants, especially in online markets, appear willing to accept it as a form of payment. However, …Bitcoin performs poorly as a unit of account and as a store of value."

Why?

Reason 1: excessive volatility: "The currency exhibits very high time series volatility (see chart below), which tends to undermine any useful role for Bitcoin as a unit of account. A currency should have only negligible volatility in order to be a reliable store of value."

Reason 2: no correlation with other currencies: "Bitcoin’s daily exchange rate with the U.S. Dollar has virtually zero correlation with the Dollar’s exchange rates against other prominent currencies such as the Euro, Yen, Swiss Franc, or British Pound. Therefore Bitcoin’s value is almost completely untethered to that of
other currencies, which makes its risk nearly impossible to hedge for businesses and customers and renders it more or less useless as a tool for risk management."

Reason 3: "Bitcoin lacks additional characteristics that are usually associated with currencies in modern economies." Which are:

• "Bitcoin cannot be deposited in a bank, and instead it must be possessed through a system of “digital wallets” that have proved vulnerable to hackers. 
• "No form of insurance has been developed for owners of Bitcoin comparable to the deposit insurance relied on consumers in most economies. 
• "No lenders use Bitcoin as the unit of account for standard consumer finance credit, auto loans, and mortgages, and no credit or debit cards have been denominated in Bitcoin. 
• "Bitcoin cannot be sold short, and financial derivatives such as forward contracts and swaps that are routine for other currencies do not exist for Bitcoin. The absence of these types of contracts seems to be the most straightforward explanation for the astronomical rise in Bitcoin’s value in November 2013. Since currency investors have no easy way to bet against Bitcoin’s appreciation, skeptics can only watch as optimists trade the currency among themselves at ever-rising prices."

About the only steadily-advanced argument for Bitcoin is that it is a private currency offering anonymity. Alas, it might be the former, but it does not offer the latter. "The benign attitude of U.S. regulators toward Bitcoin, as revealed in the November 2013 Senate hearings, may stem from the existence of a universal online audit trail for Bitcoin transactions. Although many services exist on the Internet that purport to cloak Bitcoin transfers in anonymity, confidence in the security of these protocols appears to be naive. The arrest of Silk Road’s operator in October 2013, which took place amid widespread publicity of online data monitoring by the U.S. National Security Agency, disabused many about the possibility of keeping any information anonymous on the Internet. Tax evasion, money laundering, purchases of contraband, and other illicit activities using online transfers become far more difficult when the use of a virtual currency like Bitcoin can be reconstructed by governments that have sufficient technical skills."

Ouch!

14/2/2014: BlackRock Institute Survey: N. America & W. Europe, February

BlackRock Investment Institute released its latest Economic Cycle Survey for EMEA region was covered here http://trueeconomics.blogspot.ie/2014/02/822014-blackrock-institute-survey-emea.html

Now, on to survey results for North America and Western Europe region. Emphasis is, as always, mine.

"This month’s North America and Western Europe Economic Cycle Survey presented a positive outlook on global growth, with a net of 65% of 110 economists expecting the world economy will get stronger over the next year, (18% lower than within January report).

The consensus of economists project mid-cycle expansion over the next 6 months for the global economy."

First, 12 months ahead outlook: "At the 12 month horizon, the positive theme continued with the consensus expecting all economies spanned by the survey to strengthen except Norway and Denmark, which are expected to remain the same."

Note that Ireland has moved closer to Eurozone average, away from 1st position in the chart it occupied in 2013.

Now, for 6 months outlook: "Eurozone is described to be in an expansionary phase of the cycle and expected to remain so over the next 2 quarters. Within the bloc, most respondents expect only Greece to remain in a recessionary phase at the 6 month horizon. Over the Atlantic, the consensus view is firmly that North America as a whole is in mid-cycle expansion and is to remain so over the next 6 months."

Note: Red dot denotes Austria, Norway and Switzerland.

Notable changes on previous: Greece position is much improved compared to 2013 when it occupied the North-Eastern most corner. Denmark is now in a weaker outlook position than Greece with higher expectations of a recessionary phase 6 months out. Ireland is bang-on on 10 percent assessing current state of economy as recessionary and same percentage of analysts expecting economy to be in a recession over the next 6 months. Coverage for Ireland is pretty solid in terms of number of analysts surveyed, so the above, in my opinion, shows that analysts consensus expects economy to strengthen over the next 6-12 months with strong support for a modest uplift.


Note: these views reflect opinions of survey respondents, not that of the BlackRock Investment Institute. Also note: cover of countries is relatively uneven, with some countries being assessed by a relatively small number of experts.

14/2/2014: Buffett's Alpha Demystified... or not?

Warren Buffett is probably the most legendary of all investors and his Berkshire Hathaway, despite numerous statements by Buffett explaining his investment philosophy, is still shrouded in a veil of mystery and magic.

The more you wonder about Buffett's fantastic historical track record, the more you ask whether the returns he amassed are a matter of luck, skill, unique strategy or all of the above.

"Buffett’s Alpha" by Andrea Frazzini, David Kabiller, and Lasse H. Pedersen (NBER Working Paper 19681 http://www.nber.org/papers/w19681, November 2013) shows that "looking at all U.S. stocks from 1926 to 2011 that have been traded for more than 30 years, …Berkshire Hathaway has the highest Sharpe ratio among all. Similarly, Buffett has a higher Sharpe ratio than all U.S. mutual funds that have been around for more than 30 years." In fact, for the period 1976-2011, Berkshire Hathaway realized Sharpe ratio stands at impressive 0.76, and "Berkshire has a significant alpha to traditional risk factors." According to the authors, "adjusting for the market exposure, Buffett’s information ratio is even lower, 0.66. This Sharpe ratio reflects high average returns, but also significant risk and periods of losses and significant drawdowns."

According to authors, this begs a question: "If his Sharpe ratio is very good but not super-human, then how did Buffett become among the richest in the world?"

The study looks at Buffett's performance and finds that "The answer is that Buffett has boosted his returns by using leverage, and that he has stuck to a good strategy for a very long time period, surviving rough periods where others might have been forced into a fire sale or a career shift. We estimate that Buffett applies a leverage of about 1.6-to-1, boosting both his risk and excess return in that proportion."

The conclusion is that "his many accomplishments include having the conviction, wherewithal, and skill to operate with leverage and significant risk over a number of decades."


But the above still leaves open a key question: "How does Buffett pick stocks to achieve this attractive return stream that can be leveraged?"

The authors "…identify several general features of his portfolio: He buys stocks that are
-- “safe” (with low beta and low volatility),
-- “cheap” (i.e., value stocks with low price-to-book ratios), and
-- high-quality (meaning stocks that profitable, stable, growing, and with high payout ratios).
This statistical finding is certainly consistent with Graham and Dodd (1934) and Buffett’s writings, e.g.: "Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down"  – Warren Buffett, Berkshire Hathaway Inc., Annual Report, 2008."


Of course, such a strategy is not novel and Ben Graham's original factors for selection are very much in line with it, let alone more sophisticated screening factors. Everyone knows (whether they act on this knowledge or not is a different matter altogether) that low risk, cheap, and high quality stocks "tend to perform well in general, not just the ones that Buffett buys. Hence, perhaps these characteristics can explain Buffett’s investment? Or, is his performance driven by an idiosyncratic Buffett skill that cannot be quantified?"

The authors look at these questions as well. "The standard academic factors that capture the market, size, value, and momentum premia cannot explain Buffett’s performance so his success has to date been a mystery (Martin and Puthenpurackal (2008)). Given Buffett’s tendency to buy stocks with low return risk and low fundamental risk, we further adjust his performance for the Betting-Against-Beta (BAB) factor of Frazzini and Pedersen (2013) and the Quality Minus Junk (QMJ) factor of Asness, Frazzini, and Pedersen (2013)."

And then 'Eureka!': "We find that accounting for these factors explains a large part of Buffett's performance. In other words, accounting for the general tendency of high-quality, safe, and cheap stocks to outperform can explain much of Buffett’s performance and controlling for these factors makes Buffett’s alpha statistically insignificant… Buffett’s genius thus appears to be at least partly in recognizing early on, implicitly or explicitly, that these factors work, applying leverage without ever having to fire sale, and sticking to his principles. Perhaps this is what he means by his modest comment: "Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results." – Warren Buffett, Berkshire Hathaway Inc., Annual Report, 1994."


There is more to be asked about Warren Buffett's investment style and strategy. "…we consider whether Buffett’s skill is due to his ability to buy the right stocks versus his ability as a CEO. Said differently, is Buffett mainly an investor or a manager?"

Authors oblige: "To address this, we decompose Berkshire’s returns into a part due to investments in publicly traded stocks and another part due to private companies run within Berkshire. The idea is that the return of the public stocks is mainly driven by Buffett’s stock selection skill, whereas the private companies could also have a larger element of management."

Another 'Eureka!' moment beckons: "We find that both public and private companies contribute to Buffett’s performance, but the portfolio of public stocks performs the best, suggesting that Buffett’s skill is mostly in stock selection. Why then does Buffett rely heavily on private companies as well, including insurance and reinsurance businesses? One reason might be that this structure provides a steady source of financing, allowing him to leverage his stock selection ability. Indeed, we find that 36% of Buffett’s liabilities consist of insurance float with an average cost below the T-Bill rate.


So core conclusions on Buffett's genius: "In summary, we find that Buffett has developed a unique access to leverage that he has invested in safe, high-quality, cheap stocks and that these key characteristics can largely explain his impressive performance. Buffett’s unique access to leverage is consistent with the idea that he can earn BAB returns driven by other investors’ leverage constraints. Further, both value and quality predict returns and both are needed to explain Buffett’s performance. Buffett’s performance appears not to be luck, but an expression that value and quality investing can be implemented in an actual portfolio (although, of course, not by all investors who must collectively hold the market)."

Awesome study!

14/2/2014: Debt & Growth: New IMF Paper

An interesting working paper from the IMF, worth further digesting and blogging: "Debt and Growth: Is There a Magic Threshold?" by Andrea Pescatori, Damiano Sandri, and John Simon (IMF Working Paper WP/14/34, February 2014: http://www.imf.org/external/pubs/ft/wp/2014/wp1434.pdf)

Per abstract (emphasis is mine): "Using a novel empirical approach and an extensive dataset developed by the Fiscal Affairs Department of the IMF, we find no evidence of any particular debt threshold above which medium-term growth prospects are dramatically compromised."

"Furthermore, we find the debt trajectory can be as important as the debt level in understanding future growth prospects, since countries with high but declining debt appear to grow equally as fast as 
countries with lower debt."

"Notwithstanding this, we find some evidence that higher debt is associated with a higher degree of output volatility."

As I noted above: needs more reading and blogging. Generally, before dealing with the paper in details, this appears to contradict Reinhart & Rogoff (2010) paper and several subsequent papers (on slowdown in growth conclusions) and support a number of papers finding inconclusive evidence. Note another caveat: absence of evidence is not evidence of absence.

13/2/2014: Sticky Wages, Job Effort and Jobless Recoveries

In two posts earlier I discussed some new studies relating to the problem of a jobless recovery (http://trueeconomics.blogspot.ie/2014/02/1222014-jobless-recoveries-post.html) and the ICT-driven displacement of workers (http://trueeconomics.blogspot.ie/2014/02/1222014-ict-productivity-employment-in.html). Here is another recent study dealing with labour markets outcomes in the case of a recessionary shock.

Here is another paper on employment adjustments, this time looking at cyclical shocks and wages rigidity: "HOW STICKY WAGES IN EXISTING JOBS CAN AFFECT HIRING" by Mark Bils, Yongsung Chang, Sun-Bin Kim (NBER Working Paper 19821: http://www.nber.org/papers/w19821, January 2014).

There is much evidence that wages are sticky within employment matches, so that incumbent workers face wages that do not adjust significantly fast downward in the downturns, thus creating a wage mis-match with entry of new workers. "For instance, Barattieri, Basu, and Gottschalk (2014) estimate a quarterly frequency of nominal wage change, based on the Survey of Income and Program Participation (SIPP), of less than 0.2, implying an expected duration for nominal wages greater than a year."

"On the other hand, wages earned by new hires show considerably greater  flexibility. Pissarides (2009) cites eleven studies that distinguish between wage cyclicality for workers in continuing jobs versus those in new matches, seven based on U.S. data and four on European. All these studies find that wages for workers in new matches are more pro-cyclical than for those in continuing jobs."


"Consider a negative shock to aggregate productivity. If existing jobs exhibit sticky wages, then firms will ask more of these workers. In turn this lowers the marginal value of adding labor, lowering the rate of vacancy creation and new hires. Note this impact on hiring does not reflect the price of new hires, but is instead entirely a general equilibrium phenomenon. By moving the economy along a downward sloping aggregate labor demand schedule, the increased effort of current workers reduces the demand for new hires.

The result of this mechanism of adjustment is that "wage stickiness acts to raise productivity in a recession, relative to a flexible or standard sticky wage model. Thus it helps to understand why labor productivity shows so little pro-cyclicality, especially for the past 25 plus years (e.g., Van Zandweghe, 2010)."

The authors set up two versions of the model for such an adjustment.

First model allows firms "to require different effort levels across workers of all vintages… During a recession the efficient contract for new hires dictates low effort at a low wage, while matched workers, whose wages have not adjusted downward, work at an elevated pace."

In the scone variant of the model, authors "impose a technological constraint that workers of differing vintages must operate at a similar pace. For instance, it might not be plausible to have an assembly line that operates at different speeds for new versus older hires."

The study finds that the second model "generates considerable wage inertia and greater employment volatility." In other words, if contracts do not allow firms to impose greater effort requirement on new hires against incumbent workers, there will be more shocks to unemployment and stickier wages for incumbents. Or in other words, there will be a more jobless recovery.

The authors provide an example: "Again consider a negative shock to productivity, where the sticky wage prevents wage declines for past hires. The firm has the ability and incentive to require higher effort from its past hires, in lieu of any decline in their sticky wages. But, if new hires must work at
that same pace, this implies high effort for new hires as well. For reasonable parameter values we find that firms will choose to distort the contract for new hires, rather than give rents (high wages without high effort) to its current workers. This produces a great deal of aggregate wage stickiness. The sticky wage for past hires drives up their effort and thereby the effort of new hires. But, because high effort is required of new hires, their bargained wage, though flexible, will be higher as well. In subsequent periods this dynamic will continue. High effort for new hires drives up their wage, driving up their effort in subsequent periods, driving up effort and wages for the next cohort of new hires, and so forth. By generating (counter)cyclicality in effort, this model can make vacancies and new hires considerably more cyclical." (Or put differently, it creates more unemployment at the shock and retains more unemployment in the adjustment period.

Now onto empirical evidence: "There is only sparse direct evidence on cyclicality of worker effort. Anger (2011) studies paid and unpaid overtime hours in Germany for 1984 to 2004. She finds that unpaid overtime (extra) hours are highly countercyclical. This is in sharp contrast to cyclicality in
paid overtime hours. Quoting the paper: "Unpaid hours show behavior that is exactly the opposite of the movement of paid overtime." Lazear, Shaw, and Stanton (2012) examine data on productivity of individual workers at a large (20,000 workers) service company for the period June 2006 to May 2010, bracketing the Great Recession. At this company a computer keeps track of worker productivity. They find that effort is highly countercyclical, with an increase in the local unemployment rate of 5 percentage points associated with an increase in effort of 3.75%."

The authors use their model to "show that sticky wages for current matches exacerbates cyclicality of hiring when effort responds. In particular, for our benchmark calibration with common effort, the effort response markedly increases the relative cyclical response of unemployment to measured productivity. It does so by increasing the response of unemployment to productivity, but also by making measured productivity less cyclical than the underlying shock."

The authors then look at the data to see if their "model is consistent with wage productivity patterns across industries, especially the cyclical behavior of productivity in industries with more versus less flexible wages. We measure stickiness of wages by industry based on panels of workers from the Survey of Income and Program Participation for 1990 to 2011."

The study finds that 

• "productivity (TFP) is more procyclical in industries with more flexible wages"; and 
• "this impact is much greater for industries where labor is especially important as a factor of production. 
• "However, we do not see that wages are more procyclical for industries with flexible wages, suggesting that frequency of wage change may not capture wage flexibility particularly well."

12/2/2014: The Origins of Stock Market Fluctuations

An exceptionally ambitious paper on drivers of stock markets changes over long time horizon. A must-read for my students in MSc Finance and certainly going on syllabus next year. Big paper, big conclusions.


"The Origins of Stock Market Fluctuations" by Daniel L. Greenwald, Martin Lettau, and Sydney C. Ludvigson (NBER Working Paper No. 19818, January 2014, http://www.nber.org/papers/w19818).

"Three mutually uncorrelated economic shocks that we measure empirically explain 85% of the quarterly variation in real stock market wealth since 1952."

This is an unbelievably strong statement. Traditionally, little attention is given "to understanding the real (adjusted for inflation) level of the stock market, i.e., stock price variation, or the cumulation of returns over many decades. The profession spends a lot of time debating which risk factors drive expected excess returns, but little time investigating why real stock market wealth has evolved to its current level compared to 30 years ago. To understand the latter, it is necessary to probe beyond the role of stationary risk factors and short-run expected returns, to study the primitive economic shocks from which all stock market (and risk factor) fluctuations originate."

"Stock market wealth evolves over time in response to the cumulation of both transitory expected return and permanent cash flow shocks. The crucial unanswered questions are, what are the economic sources of these shocks? And what have been their relative roles in evolution of the stock market over time?"

The authors use "a model to show that they are the observable empirical counterparts to three latent primitive shocks: a total factor productivity shock, a risk aversion shock that is unrelated to aggregate consumption and labor income, and a factors share shock that shifts the rewards of production between workers and shareholders."

And the core conclusions are: "On a quarterly basis, risk aversion shocks explain roughly 75% of variation in the log difference of stock market wealth, but the near-permanent factors share shocks plays an increasingly important role as the time horizon extends. We find that more than 100% of the increase since 1980 in the deterministically detrended log real value of the stock market, or a rise of 65%, is attributable to the cumulative effects of the factors share shock, which persistently redistributed rewards away from workers and toward shareholders over this period."

This is a huge result. "Indeed, without these shocks, today's stock market would be about 10% lower than it was in 1980. By contrast, technological progress that rewards both workers and shareholders plays a smaller role in historical stock market fluctuations at all horizons."

And on the risk aversion shocks? Uncorrelated with consumption or its second moments, these shocks "largely explain the long-horizon predictability of excess stock market returns found in data."

"These findings are hard to reconcile with models in which time-varying risk premia arise from habits or stochastic consumption volatility."

Massively important paper.

12/2/2014: ICT, Productivity & Employment in the US Manufacturing

More recent research, to follow up on previous post (which dealt with jobless recoveries). This time around on the key issue of workers displacement by technology.

"RETURN OF THE SOLOW PARADOX? IT, PRODUCTIVITY, AND EMPLOYMENT IN U.S. MANUFACTURING" by Daron Acemoglu, David Autor, David Dorn, Gordon H. Hanson and Brendan Price (NBER Working Paper 19837, http://www.nber.org/papers/w19837 from January 2014) looks into the validity of the 'technological discontinuity' paradigm - the one that "suggests that IT-induced technological changes are rapidly raising productivity while making workers redundant."

Here's the justification of the tested thesis: "An increasingly influential “technological-discontinuity” paradigm suggests that IT-induced technological changes are rapidly raising productivity while making workers redundant. This paper explores the evidence for this view among the IT-using US manufacturing industries."

Basic argument here is that modern workplace is continuing to become more automated, transformed by the ICT capital. Two implications of this are:

"First, all sectors—but particularly IT-intensive sectors—are experiencing major increases in productivity. Thus, Solow’s paradox is long since resolved: computers are now everywhere in our productivity statistics."

"Second, IT-powered machines will increasingly replace workers, ultimately leading to a substantially smaller role for labor in the workplace of the future. Adding urgency to this argument, labor’s share of national income has fallen in numerous developed and developing countries over roughly the last three decades, a phenomenon that Karabarbounis and Neiman (forthcoming) attribute to IT-enabled declines in the relative prices of investment goods. And many scholars have pointed to the seeming “decoupling” between robust U.S. productivity growth and sclerotic or negligible growth rates of median U.S. worker compensation (Fleck, Glaser and Sprague 2011) as evidence that the “race against the machine” has already been run—and that workers have lost."


Top conclusion of the paper: "There is some limited support for more rapid productivity growth in IT-intensive industries depending on the exact measures, though not since the late 1990s."

But there are some serious nuances involved.

"We find, unexpectedly, that earlier “resolutions” of the Solow paradox may have neglected certain paradoxical features of IT-associated productivity increases, at least in U.S. manufacturing." Of these, the paper highlights two:

"First, focusing on IT-using (rather than IT-producing) industries, the evidence for faster productivity growth in more IT-intensive industries is somewhat mixed and depends on the measure of IT intensity used. There is also little evidence of faster productivity growth in IT-intensive industries after the late 1990s.

"Second and more importantly, to the extent that there is more rapid growth of labor productivity (ln(Y=L)) in IT-intensive industries, this is associated with declining output (ln Y ) and even more rapidly declining employment (lnL). If IT is indeed increasing productivity and reducing costs, at the very least it should also increase output in IT-intensive industries. As this does not appear to be the case, the current resolution of the Solow paradox does not appear to be what adherents of the technological-discontinuity view had in mind."

In other words: "Most challenging to this paradigm, and our expectations, is that output contracts in IT-intensive industries relative to the rest of manufacturing. Productivity increases, when detectable, result from the even faster declines in employment."

Goes some miles explaining the declining role of primary labour… 

12/2/2014: Jobless Recoveries post-Financial Crises: Solutions Menu?

Next few posts will be touching on some interesting new research papers in economics and finance… in no particular order. Please note, no endorsement or peer review analysis from me here.

To start with: NBER WP 19683 (http://www.nber.org/papers/w19683) by Calvo, G., Coricelli, F. and Ottonello, P. "JOBLESS RECOVERIES DURING FINANCIAL CRISES: IS INFLATION THE WAY OUT?" from November 2013.

The paper discusses 3  traditional policy tools to mitigate jobless recoveries during financial crises: 

• inflation
• real devaluation of the currency, and  
• credit-recovery policies. 

The nominal exchange rate devaluation tool not being available to the euro area economies independently of the ECB, we have by now heard a lot about inflation (the need for). At the same time, real devaluation tool includes fabled European cost-competitiveness measures. 

Here's the pre-cursor to the paper: "The slow rate of employment growth relative to that of output is a sticking point in the recovery from the financial crisis episode that started in 2008 in the US and Europe (a phenomenon labeled “jobless recovery”). The issue is a particularly burning one in Europe where some observers claim that problem economies (like Greece, Italy, Ireland, Spain, and Portugal) would be better off abandoning the euro and gaining competitiveness through steep devaluation. This would be a momentous decision for Europe and the rest of the world because, among other things, it may set off an era of competitive devaluation and tariff war."

Hypotheticals aside, the study starts by "digging more deeply into the relationship between inflation and jobless recovery, also considering the possible role of real currency depreciation and resource reallocation (between tradables and non-tradables)."

As authors note: "This discussion is particularly relevant for countries that, being in the Eurozone, cannot follow a nominal currency depreciation policy to mitigate high unemployment rates 

(e.g. Greece, Italy, Ireland, Spain, and Portugal)."

First finding is that there is "some evidence suggesting that large inflationary spikes (not a higher inflation plateau) help employment recovery. Even in high-inflation episodes, inflation typically returns to its pre-crisis levels…" so the effects of the induced inflation wear out quasi-automatically.

Second finding is that "(independent of inflation) financial crises are associated with real currency depreciation (i.e., the rise in the real exchange rate) from output peak to recovery. This shows that the relative price of non-tradables fails to recover along with output even if the real wage does not fall, as is the case in low-inflation financial crisis episodes. This implies that, contrary to widespread views, nominal currency depreciation may eliminate joblessness only if it generates enough inflation to create a contraction in real wages; real currency depreciation or sector reallocation might not be sufficient to avoid jobless recovery if all sectors are subject to binding credit 

constraints that put labor at a disadvantage with respect to capital." In other words, there goes Argentina's fabled hope for recovery via devaluations.

Third finding extends the second one to the case closer to euro area peripherals: "Similarly, for countries with fixed exchange rates, “internal” or fiscal devaluations during financial crises are likely to work more through reductions in labor costs than changes in relative prices and sectoral reallocation obtained through taxes and subsidies affecting differentially tradable and non-tradable sectors." In other words, internal devaluations work, and they work via cost competitiveness gains and exporting sector repricing relative to domestic.

Tricky thing, though: "However, neither nominal nor real wage flexibility can avoid the adverse effects of financial crises on labor markets, as wage flexibility determines the distribution of the burden of the adjustment between employment and real wages, but does not relieve the burden from wage earners." which means that a jobless recovery is more likely under internal devaluation scenario.

Fourth finding: "Our findings highlight the difficulty in simultaneously preventing jobless and wageless recoveries, and suggest that if the goal is to avoid jobless recovery, the first line of action should be an attempt to relax credit constraints." Oops… but credit constraints are not being relaxed in the case of collapsed financial systems and debt overhang-impacted households in the likes of Ireland.

More on this: "Only direct credit policies that tackle the root of the problem seem to be able to help unemployment and wages simultaneously. …common sense suggests the following conjectures. In advanced economies, quantitative easing operations, especially if they involve the purchase of “toxic” assets, can have an effect on increasing firms’ collateral and relaxing credit constraints that affect employment recovery." But, of course, in Ireland these measures failed to trigger such outcomes - Nama has been set up for two years now and credit restart is still missing. May be one might consider the fact that targeting of bad assets purchases is needed? May be buying up wasteful real estate assets was not a good idea and instead we should have pursued purchases and restructuring of mortgages? Sort of what Iceland (partially and with caveats) did?

Overall, tough conclusions all around. 

11/2/2014: Greek Bailout 3.0 or a Fix 1.4: Ifo Assessment

In light of Bloomberg report on new package of supports for Greece being planned (http://www.bloomberg.com/news/2014-02-05/eu-said-to-weigh-extending-greek-loans-to-50-years.html), German institute Ifo issued a neat summary note.

The core supports being discussed in the EU are: extending term of the loans to 50 years, and lowering the interest cost of loans by 50bps.

Here's a summary via Ifo:

• As of December 2013 "Greece had received 213.4 billion euros from two bailout packages."
• First package was May 2010 Greek Loan Facility (GLF) comprising a loan of ca 73 billion euros, disbursed in December 2011. "Of this sum 52.9 billion euros was loaned in the form of bilateral credit between Greece and the other countries of the Eurozone (excluding Slovakia, Estonia and Latvia), while a further 20.3 billion euros was provided by the International Monetary Fund (IMF)."
• Second package was extended in February 2012 in the form of credit from the European Financial Stability Facility (EFSF). "By December 2013 133.6 billion euros of this second package had been paid out. Moreover, the IMF also increased its financial assistance to Greece by 6.6 billion euros during this period."

In addition, Greece already restructured 52.9 billion euro of the GLF. Original loans were issued for 5 years term at an interest rate equivalent to the 3-month Euribor plus an interest rate margin of 3 percentage points for the first three years and 4 percentage points for the remaining years.

• "The term of all loans was subsequently extended to 7.5 years in June 2011 and the interest rate margin was reduced by 1 percentage point." 
• Subsequently, in February 2012 "the term was extended to 15 years and the margin was reduced to 1.5 percentage points for all further interest payments". 
• In November 2012 the GLF lenders "doubled the term of the loans to 30 years and reduced the interest rate margin to 0.5 percentage points. 

So in effect, Greece had: 2 Bailouts and 3 adjustments to-date.

By Ifo estimates, the above revisions reduced real debt under the GLF by 12 billion euros.
"The envisaged further relaxation of credit conditions for the 52.9 billion euros of the Greek Loan Facility - with an extension of the term to 50 years and a reduction of the margin to 0 percentage points would entail further losses of around 9 billion euros for European creditors."