19/11/17: The Next Global Financial Crisis

My column for Cayman Financial Review on how the stage has been now set for the next Global Financial Crisis is available at http://www.caymanfinancialreview.com/2017/10/20/the-stage-has-been-set-for-the-next-global-financial-crisis/.

18/11/17: Say thanks BEPS, as Sweden Cuts Corporate Tax Rates Again...

Sweden, the tough-fighting 'socialist' haven of capitalism is cutting its corporate tax rates. Again.

Yes, that is right. Sweden used to have a decisively 'socialist' rate of corporate income tax (irony implied) of 28% until 2008. In 2009 this rate dropped to a relatively convincing 'socialist' rate of 26.3%, before falling to a sort-of-'socialist' softy 22%. It now plans a cut to 20%.

 h/t for the chart to @mattyglesias 

The announcement is made here: http://www.ey.com/gl/en/services/tax/international-tax/alert--sweden-proposes-major-corporate-income-tax-changes h/t to @tylercowen for the link. 

Note, extensive compliance changes proposed for Swedish tax code to bring it in line with the OECD's BEPS scheme. The scheme was designed, as defined by its objectives, to make it harder for the corporations to avoid taxes in the future. Which means, of course, that to maintain effective tax rates closer to where they were before the BEPS, Sweden, as other states, will need to offset BEPS-induced accounting changes with lower headline rates. 

Tax optimization, folks, just went mainstream in Europe and the U.S. Which is a good thing for transparency (reducing the disparity between the effective rates and the headline rates). But a bad news for personal income taxes. To offset the declines in corporate tax revenues that BEPS changes will inevitably engender, Governments from Sweden to Italy, from Canada to the U.S. will have to either cut spending or increase personal income tax rates. No medals for guessing what they will opt for.

18/11/17: North Korean Uncertainty and Market Impacts

S&P new post about the risks poised by North Korea is a neat summary of key actions and players involved (see the full note: https://marketintelligence.spglobal.com/blog/global-credit-risk-spikes-as-key-apac-countries-respond-to-the-north-korean-threat).

And it is very interesting to those of us, who study the links between geopolitical risks and financial markets.

Two pieces of evidence are presented in the S&P note worth pondering: first, the rising frequency of the North Korea threat signals:

The above shows that starting with 2016, acceleration in the North Korea threat signals has been posing a departure from the previous trend. Structurally, this suggests that we are entering a new regime in terms of potential market spillovers from North Korean risks to global financial markets.

Next, some evidence on changes in specific shares valuations timed close to the North Korean threat signals:

The evidence above suggests that, in line with our research findings in other instances, the uncertainty about North Korean threat evolution is feeding into the valuations of defence stocks. And that this effect is still ambiguous. Which is in line with our findings on the links between actual conflicts and defence stocks valuations revealed in my paper with Mulhair, Andrew, "Performance Analysis of U.S. Defense Stocks in Relation to Federal Budgets and Military Conflicts in the Post-Cold War Era" (April 2017). Available at SSRN: https://ssrn.com/abstract=2975368. Furthermore, the nature of North Korean policy-induced uncertainty is consistent with our findings relating to terrorism spillovers to financial markets as revealed in my paper with Corbet, Shaen and Meegan, Andrew, "Long-Term Stock Market Volatility and the Influence of Terrorist Attacks in Europe" (August 2017). Available at SSRN: https://ssrn.com/abstract=3033951. Note, the latter paper is now forthcoming in the Quarterly Review of Economics and Finance.

While explicit testing of spillovers from North Korean uncertainty to global financial markets is yet to be firmly established in empirical literature, it is worth noting that the indirect evidence (based on data similar to S&P blog post) suggests that North Korean threat is likely to have a significant VUCA-consistent effect on the markets.

18/11/17: ECB Induces Double Error in the EU Policy Markets

In economics, two key market asymmetries/biases lead to the severe reduction in markets efficiency often marking the departure from theoretical levels of efficiency (speed, with which markets incorporate new relevant information into pricing decisions of markets agents) and the practical outcomes. These asymmetries or biases are: information asymmetry and agency problem.

For those, uninitiated into econospeak, information asymmetry (sometimes referred to as information failure), is a situation, in which one party to an economic transaction possesses greater knowledge of facts, material or relevant to the decision, than the other party. For example, a seller may know hidden information about a car on offer that is not revealed to the buyer. In more extreme example, a seller might actively conceal such information from a buyer. This can happen when a seller 'prepares' the car for sale by cleaning the engine, thus removing leaks and accumulations of oil and / or coolant that can indicate the areas where the problems might be.

The agency problem, also referred to as principal-agent problem, arises when an agent, acting on behalf of the principal, has distinct set of incentives from the principal. The resulting risk is that the agent will act in self-interest to undermine the goals and objectives of the principal. An example here would be a real estate agent contracted by the seller, while taking a commission kickback from the buyer. Or vice versa.

Occasionally, both problems combine to produce an even more powerful distortionary result, pushing the markets further away from finding a 'true' (or fundamentals-justified) price point.

Today, we have an example of such interaction. As reported in Euractiv, the ECB has denied the EU Court of Auditors access to data on Greek bailout. (Full story here: http://www.euractiv.com/section/all/news/ecb-denies-eu-auditors-access-to-information-on-greek-bailouts/) The claimed justification: banking secrecy. The result:

1. There is now clearly an asymmetry in information between the EU, the Court of Auditors, and the ECB when it comes to assessing the ECB actions in the Greek bailout(s). The 'car salesman' (the ECB) has scrubbed out information about the 'vehicle' (the bailout(s)) when presenting it to the 'buyer' and is refusing to show any evidence on pre-scrubbed 'car'.
2. And there is an agency problem. The ECB is an agent for the EU (and thus an agent relative to the principal - the EU Court of Auditors, which represents the interest of the EU). As an agent, the ECB has a contractual obligation to act in the interest of the EU. But as a part of the Troika in the case of the Greek bailout(s), the ECB is also contracted into a set of incentives to act in concert with other players: the sub-set of the EU, namely the EU Commission and the EFSF/ESM funds, and the IMF. At least one of these agents, the IMF, has a strong incentives to avoid transparent discovery of information about the Greek bailout(s) because these bailout(s) have, potentially, violated the IMF by-laws in lending to distressed countries. Another agent, the EU Commission, has an incentive to conceal the truth about the same bailout(s) in order to sustain a claim that the Greek bailout(s) are(were) a success. The third set of the agents (various EU funds that backed the bailout(s)) has incentives to sustain the pretence that the Greek bailout(s) were within the funds' bylaws and did not constitute state aid to the insolvent government.

In simple terms, the ECB refusal to release information on Greek bailout(s) to the EU Court of Auditors is a fundamental violation of the entire concept of the common market principle that overrides any other consideration, including the consideration of monetary policy independence. This so because the action of the ECB induces two most basic, most fundamental failures into the market: the agency problem and the asymmetric information problem, which are (even when taken independently from each other) the core drivers for market failures.

7/11/17: 800 years of bond markets cycles

An interesting new working Paper from the BofE, titled “Eight centuries of the risk-free rate: bond market reversals from the Venetians to the ‘VaR shock’” (Bank of England, Staff Working Paper No. 686, October 2017) by Paul Schmelzing looks at new data for “the annual risk-free rate in both nominal  nd real terms going back to the 13th century.”

Such a long horizon allows the author to establish and define the existence of the long term “bond bull market”

Specifically, the author shows “that the global risk-free rate in July 2016 reached its lowest nominal level ever recorded. The current bond bull market in US Treasuries which originated in 1981 is currently the third longest on record, and the second most intense.”

And plotting real debt bull markets (shaded):

Finally, the extent of the current bond bull market (since 1981) relative to previous historical bull markets is reflected also in the extent of yield compression (annualized) that has been achieved during each bull market cycle:

While the rest of the paper goes through three specific case studies of bull markets corrections, it is the first section - the one based on historical long-term data series - that poses the starkest evidence of just how exceptional (and thus risk-loaded) the current markets environment is. Looking at historic averages, and potential for historical mean reversion for yields, the current yield on U.S. 10 year paper will have to double, effectively increasing long-term risk exposure to widening fiscal deficits by the tune of 2.5-2.75 percent of GDP. The cost of carrying this level of indebtedness, when yields run 1.5-1.7 times the upper envelope of the potential rate of economic growth is a function of simple arithmetic. Currently, this arithmetic suggests that the U.S. will either have to figure out how to live with above 5% annual deficits and ballooning debt, or how to live within its own means.

7/11/17: To Fine Gael or not: Employment Stats and Labour Force

Recently, Fine Gael party PR machine promoted as a core economic policy achievement since 2011 election the dramatic reduction in Ireland’s unemployment rate. And in fact, they are correct to both, highlight the strong performance of the Irish economy in this area and take (some) credit for it. The FG-led governments of the recent years have been quite positive in terms of their policies supporting (or at least not hampering) jobs creation by the MNCs. Of course, they deserve no accolades for jobs creation by the SMEs (which were effectively turned into cash cows for local and central governments in the absence of any government power over taxing MNCs), nor do they deserve any credit for the significant help in creating MNCs’ jobs that Ireland got from abroad.

Now, to briefly explain what I mean by it: several key external factors helped stimulate MNCs-led new jobs creation in Ireland. Let me name a few.

1. ECB. By unleashing a massive QE campaign, Mario Draghi effectively underwritten solvency of the Irish State overnight. Which means that Dublin could continue avoiding collecting taxes due from the MNCs. And better, Mr Draghi’s policies also created a massive carry trade pipeline for MNCs converting earnings into corporate debt in Euro area markets. The combined effect of the QE has been a boom in ‘investment’ into Ireland, and with it, a boom of jobs.
2. OECD. That’s right, by initiating the BEPS corporation tax reform process, the arch-nemesis of Irish tax optimisers turned out to be their arch blesser. OECD devised a system of taxation that at least partially, and at least in theory, assesses tax burdens due on individual corporations in relation physical tangible activities these corporations carry out in each OECD country. Tangible physical activity can involve physical capital investment (hence U.S. MNCs rapidly swallowing up new and old buildings in Ireland, that’s right - a new tax offset), an intangible Intellectual Property ‘capital’ (yep, all hail the Glorious Knowledge Development Box), and… err… employment (that is why Facebook et al are rushing to shift more young Spaniards and Portuguese, French and Dutch, Ukrainians and Italians, Poles and Swedes… into Dublin, despite the fact they have no where to live in the city).
3. EU. Not to be outdone by the aforementioned ‘academics’ from Parisian La Defence, the EU Commission helped. It waved in the utterly ridiculous, non-transparent, skin deep in fundamentals, Irish tax optimisation scheme that replaced the notorious Double-Irish Sandwich  - the scheme is the already mentioned above Knowledge Development Box. The EU Commission also aggressively pursued a handful of top MNCs trading from Ireland - Apple, Google, etc. This put more pressure on both the Irish Government and the MNCs to cough up some at least half-credible scheme that would show some sort of tangible business expansion and growth in Ireland.

So the result of all of the above has been a jobs boom in the MNCs-dominated sectors, a boom that soaked up quite a bit of the younger graduates from Irish Universities as well, but also helped to grow indigenous ICT sector in Ireland. The latter soaked up some more graduates. Unemployment fell. employment rose.

If this sounds like Nirvana, it ain’t. Because above the silver lining of the good and strong employment/unemployment numbers there is also a cloud of rather darker hues. That club is the Labour Force Participation Rate.

As Chart above shows, seasonally-adjusted LFP for Ireland stood at 59.8% in 2Q 2017 - matching the lowest recorded levels for the entire 16 years since the end of !Q 2001. And the lowest level in 13 consecutive quarters. Worse, as the chart above clearly shows, the dismal performance of the economy in terms of LFP has been in place since the Great Recession. In other words, all the recovery to-date has not been able to shift Irish participation rate.

Which brings us to the real point of the crisis: the current levels of LFP are much much worse than the comparable headline rates attained in 1999-2000. How? Simple.

• Unlike in 2000-2001, we have years of net outward emigration (and continued net outward emigration for Irish nationals). This should increase LFP, and yet it clearly does not.
• Unlike in 2000-2001, we have widening retirement age, not shrinking as was the case in 2000-2001. This too should have supported LFP to the upside. And again, it clearly is not happening.
• In contrast with the 2000-2001, we also have more students in the third level and above education today. Which, again, should have supported current LFP to the upside relative to the early 2000s. 

And so on… in simple terms, our starting conditions (post-crisis environment) and our demographics all suggest that current LFP is reflective of deeper structural problem than the same LFP reading back in 2000-2001 was.

So, yes, Fine Gael can claim some strong record of improvements in the economy that took place on its watch. But, no, this is not the time to enjoy the laurels. Until such time when more Irish people go back to search for jobs, train for jobs and the LFP rises to 63.2% range (2005-2008 average), it is way too early for us to declare a victory over the Great Recession.

Now, what does 3.4% increase in LFP mean? To keep current rate of unemployment fixed at 6%, that means adding 70,450 new jobs and adding roughly 4,500 new unemployed to the Live Register. What that would take in terms of time? Given the current rate of 17,150 new employment added per quarter over the last 4 quarters, this implies about roughly 13 months of jobs creation.

Of course, attracting the disillusioned folks back into labour force is not as easy. So the more important bit is not whether we can achieve it, but rather, what would it mean in terms of economic policies necessary to achieve it? I expect answers from the various FG departments and may be even some Ministers…

28/10/17: Trade vs Growth or Trade & Growth?

Much has been written down recently about the dramatic slowdown in growth in global trade flows. For example, after rebounding post-Global Financial Crisis (global trade volumes fell 10.46% in 2009) in 2010-2011 (rising 12.52% and 7.1% respectively), trade volumes growth slowed to below 4% per annum in 2012-2016, with 2017 now projected to be the first year of above 4% growth in trade (4.16%).

This has prompted many analysts and academics to define the current recovery as being, effectively, trade-less growth (see, for example https://www.bis.org/review/r161125c.pdf).

This is plainly false. In fact, growth in global trade volumes has outpaced growth in real GDP (based on market exchange rates) in every year since 2010, except for 2016. As the chart below clearly shows, the difference between the rate of trade volumes growth and the rate of real GDP growth remained positive in average terms:

Instead, what really happened to the two series that both real GDP growth and trade volumes growth have fallen significantly since 2011. Average growth in trade over 1980-2017 period stood 2.31 percentage points above growth in real GDP. The 2010-2017 period average gap between the two is 1.78 percentage points, the second lowest decade average after 1.48 percentage points gap recorded in the 1980s. However, these comparatives are somewhat distorted by influential outliers - years when post-recessions recoveries triggered significantly higher spikes in growth in both series, and years when trade recessions were substantially sharper than GDP growth slowdowns. Omitting these periods from decades averages, as the chart above illustrates, makes the current recovery (2010-2017 period) look much much worse than any previous decade on the record (green dashed lines).

Still, the above presents no evidence that trade weaknesses contrasted GDP growth trends. And there is no such evidence when we look at decades-based correlations between trade growth rates and GDP growth rates:

In fact, correlation between trade growth and GDP growth is currently (2010-2017 period) running at an extremely high levels of 96%, compared to historical correlation (1980-2017) of 87% and compared to pre-2010 average (1980-2009) of 88%.

So what has been happening, thus?

As the chart above clearly shows, there are significant differences in trends between the two series. Using indexing approach, setting 1979 = 100, we can compute index of real GDP activity and trade volumes activity based on annual rates of growth. The two series exhibit a diverging pattern, with divergence starting around the end of the 1980s, accelerating rapidly during 1993-2008 period and then de-accelerating since the onset of the post-GFC recovery. Notably, however, this de-acceleration simply slowed the expansion of the gap between the two series, and it did not reverse it or close it.

Currently, global GDP growth is just above the long-term trend. But global trade growth has been running below its historical trade since 2014. Back in 2004-2008 period, rate of growth in global trade vastly exceeded its trend. Why? Because 2004-2008 period was the period of rapidly inflating real assets bubbles around the globe - the period of ample credit and ample demand for investment goods and raw materials. Similar logic applies to 1994-2000 period of  In other words, the glorious days of global trade expansion, the period of accelerated growth in trade.

In other words, past periods of exploding trade volumes growth are unlikely to reflect sustainable trends in the real economy. These were the periods of substantial misalignment between trade and growth much more than the current period of slower trade growth suggests. In other words, something is happening to both trade and growth, and that, most likely, is what we call a structural slowdown or a secular stagnation.

28/10/17: Supplies of Monetary Methadone: ECB's Recalibration

My take on ECB's latest policy announcements for the Sunday Business Post: https://www.businesspost.ie/opinion/supplies-monetary-methadone-will-continue-401179.

28/10/17: Income Inequality: Millennials vs Baby Boomers

OECD's recent report, "Preventing Ageing Unequally", has a wealth of data and analysis relating to old-age poverty and demographic dynamics in terms of poverty evolution. One striking chart from the report shows changes in income inequality across two key demographic cohorts: the Baby Boomers (born at the start of the second half of the 20th Century) and the Millennials (born in the last two decades of the 20th Century):

Source: http://www.oecd.org/employment/preventing-ageing-unequally-9789264279087-en.htm.

The differences between two generations, controlling for age, are striking. In my opinion, the dramatic increase in income inequality across two generations in the majority of OECD economies (caveats to Ireland and Greece dynamics, and a major outliers of Switzerland, France and the Netherlands aside) is one of the core drivers for changing perceptions of the legitimacy of the democratic ethics and values when it comes to public perceptions of democracy. 

You can read more on the latter set of issues in our recent paper, here: http://trueeconomics.blogspot.com/2017/09/7917-millennials-support-for-liberal.html.

The dynamics of income inequality for the Millennials do not appear to relate to unemployment, but rather to the job markets outcomes (which seemingly are becoming more polarized between high quality jobs/careers and low quality ones):

In other words, where as in the 1950s it was sufficient to have a job to gain a place on a social progression ladder, today younger workers need to have the job (at Google, or Goldman Sachs, or other 'star' employers) to achieve the same.

Thus, as low unemployment swept across the advanced economies in the post-Global Financial Crisis recovery, there has not been a symmetric amelioration of the youth poverty rates in a number of countries:

In 25 OECD countries out of 35, poverty rates for those aged 18-25 are today higher than for those of age 65-75. Across the OECD, statistically, poverty rates for the 18-25 year olds cohort are on par with those for of 76+ year olds cohort, and both are above 12 percent. 

There is a lot that is still missing in the above comparatives. For example, the above numbers do not adjust for differences between different age groups in terms of quality of health and education. Younger workers are also healthier, as a cohort, than older population groups. This means that their incomes should be expected to be higher than older workers, simply by virtue of better health.  Younger workers are also better educated than their older counterparts, especially if we consider the same age cohorts for current Millennials and the Baby Boomers. Which also implies that their incomes should be higher and their income inequality should be lower than that for the Baby Boomers.

In other words, simple comparatives under-estimate the extent of income inequality and poverty incidence and depth for the Millennials by excluding adjustments for health and education differences.

22/10/17: Italian North: another chip off Europe's Nirvana

Having just written about the Czech electoral pivot toward populism last night, today brings yet another  news headline from the politically-hit Europe.

In a non-binding referendums in two wealthiest Italian regions, Veneto and Lombardia, the voters have given local governments strong mandates to push for greater autonomy from Rome and the Federal Government. Both regions are dominated by the politics of Lega Nord, a conservative, autonomy-minded party with legacy of euro scepticism, strong anti-immigration sentiment and the past promotion of outright independence for the Northern Italy.

In both referendums, turnout was relatively strong by Italian standards (58% projected for Veneto and over 40% for Lombardia). And in both, exit polls suggest that some 95% of voters have opted for stronger regional autonomy.

The referendums were not about outright independence, but about wrestling more controls over fiscal and financial resources from Rome. Both regions are net contributors to the Italian State and are full of long run resentment over the alleged waste of these resources. Both regions want more money to stay local.

In reality, however, the vote is about a combination of factors, namely the EU policies toward Italy, the monetary conditions in the euro area, the long-term stagnation of the Italian economy and the centuries-old failure of Italian Federal State to reform the economy and the society of the Southern Italian regions. Italy today is saddled with stagnation, huge youth unemployment, lack of business dynamism, weak entrepreneurship, dysfunctional financial institutions, high taxes, failing and extremely heterogenous public services, collapsed demographics and centuries-old divisions. Some of these problems are european in nature. But majority are Italian.

Greater autonomy for wealthier regions, in my view, is a part of the solution to the long running problems, because it will create a set of new, stronger incentives for the Southern regions to reform. But in the end, it is hard to imagine the state like Italy sustaining its membership in the euro area without an outright federalization of the EU.

In the nutshell, within a span of few weeks, the dormant political volcano of the Europe has gone from stone cold to erupting. Spain, Austria, Czech, & Italy are in flames. Late-stage lava flows have been pouring across Poland, Hungary and the UK, Slovakia and parts of the Baltics for months and years. Tremors in Belgium, the Netherlands, Germany, (especially Eastern Germany) and Finland, as well as occasional flares of populist/extremist activity in other parts of the Paradise are ongoing. And, it is only a matter of time before populism resurges in France.

All of this with a background of stronger economic growth and booming markets. So wait till the next crisis/recession/market correction hits...

22/10/17: Robot builders future: It's all a game of Go...

This, perhaps, is the most important development in the AI (Artificial Intelligence) to-date: "DeepMind’s new self-taught Go-playing program is making moves that other players describe as “alien” and “from an alternate dimension”", as described in The Atlantic article, published this week (The AI That Has Nothing to Learn From Humans - The Atlantic
https://www.theatlantic.com/technology/archive/2017/10/alphago-zero-the-ai-that-taught-itself-go/543450/?utm_source=atltw).

The importance of the Google DeepMind's AlphaGo Zero AI program is not that it plays Go with frightening level of sophistication. Instead, it true importance is in self-sustaining nature of the program that can learn independently of external information inputs, by simply playing against itself. In other words, Google has finally cracked the self-replicating algorithm.

Yes, there is a 'new thinking' dimension to this as well. Again, quoting from The Atlantic: "A Go enthusiast named Jonathan Hop ...calls the AlphaGo-versus-AlphaGo face-offs “Go from an alternate dimension.” From all accounts, one gets the sense that an alien civilization has dropped a cryptic guidebook in our midst: a manual that’s brilliant—or at least, the parts of it we can understand."

But the real power of AlphaGo Zero version is its autonomous nature.

From the socio-economic perspective, this implies machines that can directly learn complex (extremely complex), non-linear and creative (with shifts of nodes) tasks. This, in turn, opens the AI to the prospect of writing own code, as well as executing tasks that to-date have been thought of as impossible for machines (e.g. combining referential thinking with creative thinking). The idea that coding skills of humans can ever keep up with this progression has now been debunked. Your coding and software engineering degree is not yet obsolete, but your kid's one will be obsolete, and very soon.

Welcome to the AphaHuman Zero, folks.  See yourself here?..

22/10/17: Framing Effects and S&P500 Performance

A great post highlighting the impact of framing on our perception of reality: https://fat-pitch.blogspot.com/2017/10/using-time-scaling-and-inflation-to.html.

Take two charts of the stock market performance over 85 odd years:

The chart on the left shows nominal index reading for S&P500. The one on the right shows the same, adjusted for inflation and using log scale to control for long term duration of the time series. In other words, both charts, effectively, contain the same information, but presented in a different format (frame).

Spot the vast difference in the way we react to these two charts...