Wednesday, 23 April 2014

Graph(s) of the week: Companies' cash holdings

According to numerous reports, it seems that the biggest world companies are sitting on record levels of cash holdings. If this is true, the question is why aren't they spending it?

According to Financial Times, in 2008 the biggest 1000 world companies held a total of $1.95tn in cash, however by the end of 2012 this level has jumped up to $3.2tn. This can be attributed solely to the credit slump and the consequential severe lack of confidence during the entire recovery period. 

However in 2013 the cash reserves kept on rising despite a rebound in the stock market and rising business confidence with still very low interest rates. All this should have encouraged more spending and investing from the business side, but cash reserves just kept on rising. 

Source: WSJ and US Federal Reserve 
Source: The Telegraph
However, it is obvious the distribution of these funds are uneven. The very fact that only the top companies are holding all this cash is biasing the estimate. The top 10 companies (Apple, Microsoft, Google, Verizon, Pfizer, Cisco, Oracle, Johnson&Johnson, GM and Intel) account for more than 10% of the total amount. The FT reports that companies with more than $2.5bn in cash holdings (really big companies) account for 82% of the total amount. 

On the other hand many smaller and medium-sized companies are in lack of proper funding, and have maintained this position ever since 2008. Companies outside the top 1000 are taking more debt as they are taking advantage of low interest rates and cheep borrowing. So there are basically two divergent scenarios; one for highly profitable firms which hardly face any financing issues but are still holding on to their cash, and the second for small and medium companies which, as always, lack funding and have to rely on loans.

So the question is why aren't the big firms spending more now that the market is rebounding? What makes them hold so much liquidity when the risks of losses are relatively lower. There are two main explanations:
"Fiscal policy affects cash holdings in two ways, both of which involve taxes. First, public firms are seeing their profits rise elsewhere in the world; if these firms were to bring these profits from overseas operations back to the U.S., the profits would be relatively heavily taxed. Second, uncertainty about future taxes is on the rise. 
Other explanations point to gradual changes in the nature of the operations of a firm. The leading hypothesis in this group relates the rise in cash holdings of U.S. corporations to the increasing predominance of research and development (R&D). Since R&D is an activity intrinsically connected with uncertainty, the association of R&D and cash holdings is a natural one. The rising importance of R&D in the overall economy is a long-term phenomenon that is due to the rapid growth of information technology firms."
The R&D hypothesis is a much more likely explanation in case of IT companies, whereas the tax uncertainty story relates more to other multinationals. So when should we expect a reversal of the trend? In terms of fiscal policy an approach designed at balancing the budget would definitely lower the tax uncertainty, but as for the R&D story this may well last for the next several years.

Friday, 18 April 2014

Assessing Abenomics

Japan has been such a perplexing country in terms of its economy for the past two decades. A country riven by a slow, government-driven recovery has tried everything: from massive monetary stimuli which has kept interest rates really low for the entire period, to massive fiscal stimuli which resulted in a >230% of Japanese debt to GDP (which is ok apparently since the majority of this debt is held by domestic entities - or is it?). It's hard to think of any country going through the same painful experience. Up until today that is. It seems that a similar scenario awaits the UK and Europe - stagnant economies at least for a decade if not longer, with rising debt levels and low productivity. 

However 20 years of no growth (the two lost decades) have finally taken its tolls and the idea was to replace them with something new and yet untried, so to speak. Abenomics, the set of economic policy measures applied by Japanese PM Shinzo Abe, appears to be just what the country needed - a mix of everything: fiscal stimuli, monetary stimuli and a long-term pledge for reforms. 

The three pillars of Abenomics; monetary easing, expansionary fiscal policy and a long-term growth strategy are designed to reinforce each other (he refers to them as the "three arrows", according to a 16th century tale from Japan where breaking one arrow in half is easy, but tying all three together and breaking them at the same time is impossible). So apparently that was the problem - these policies weren't being done simultaneously, which is why each of them has failed individually. 

Source: Richard Koo
Except this isn't really true. Bank of Japan (BOJ) has been performing easy monetary policy ever since the bubble burst in 1990, which has been steadily accompanied by higher government spending throughout the same period (to substitute for the lack of private spending) (see the graphs). By the ineffectiveness of these policies it was obvious that Japan was NOT and AD shock, but much more likely a deep structural (AS) shock, which is exactly why Japan cannot be characterized by any of the standard macroeconomic models (and why soon enough the same will apply to Europe as well).
Source: Richard Koo
However, perhaps the "third arrow" was missing all this time since there was never any real pledge to do long-run reforms. Perhaps that's why the stimuli failed? 

Was it successful?

The initial effects were surprisingly good. Since the start of the policies, the stock market soared (40% annual gain), the yen has depreciated which boosted exports (yes currency depreciation only works if you have massive production, i.e. if you have stuff to export), credit growth rebounded, asset prices started rising, consumption recovered, while the unemployment rate dropped down to 4%. Real GDP growth rebounded in the first half of 2013, even though it dropped back to low levels in the next quarter and has been gradually declining ever since. So the short-term effects have been really good. The question is for how long did they last?
Quarterly economic growth rates in Japan for 2013.
Source: Kunio Okina, WSJ
After such great initial results the critics have focused on Japanese potential output and the long-run set of policies that need to be introduced to overshoot that goal. Koichi Hamada, one of Abe's advisers, praises the short-term effects of the first two arrows, but is worried over the increasing role of government in picking industry winners. This is where Abe needs to be much more effective according to Hamada: "A more effective approach would entail achievable, concrete goals like relaxing labor- and financial-market regulations, reducing corporate income taxes, liberalizing trade by joining the Trans-Pacific Partnership, and perhaps easing immigration policy." He resents the power held by Japanese bureaucrats, which makes them very inefficient and wasteful. Which is no surprise as they've gotten used to this with two decades of failed fiscal stimuli, particularly at the local level

There were the negative effects as well. The current account deficit has reached a historical high, since Japan's economy is dependent on imports (food, oil, natural resources) and a depreciating yen has increased their prices. Despite the initial upsurge of GDP growth, it was really low in the final quarter, and on the yearly level it stood only at 0.7% (the expected was a 1% annual growth rate). This all comes before an increase of the sales tax from 5% to 8% which is expected to again hit consumption. Furthermore since real wages are still falling, don't expect any positive increases of consumption any time soon, despite the expected growth in employment. In addition, the debt levels are unsustainable and are still rising. This is another issue the government needs to quickly begin to address, as such high debt levels are certainly constraining economic growth

Source: Kunio Okina, WSJ
Finally, an interesting argument comes from Edward Hugh's blog, where he claims that Japan's economy is actually near its potential, as opposed to what many economists seem to think. Many are using the argument that not only Japan, but also the US, UK and Europe, are currently all operating far below their potential output. But what if this isn't true? What if all these economies are simply now facing a lower output path, a sort of a new, low equilibrium? I've made this argument many times in the cases of US and Europe, and it seems to be the correct portrayal of Japan as well. After all, they are all characterized by similar structural issues and were facing the same problems after a huge bubble burst - they falsely described an AS shock as an AD shock, which has led to a number of ineffective fiscal and monetary policy solutions. 

This is exactly why Japan doesn't fit the pattern of any macro model and why any conventional macroeconomic policy won't work there. Abe has made a nice try, but Japan is way too exposed for a short-term stimuli to be of any significant effect even for a single year. Abenomics is still using only the first two arrows, and yet again they are being broken. 

Monday, 14 April 2014

Graph of the week: beware of stock market charts

Observe the following two graphs (HT: Business Insider):

Source: Business Insider
The first one depicts the S&P 500 index over the past 17 years where it seems to show remarkable patterns of volatility. The pattern is basically a series of sharp increases followed by a an even steeper decline. The market went up during the dot-com bubble in the 90-ies, only to see a sharp decline when the bubble burst (the 9-11 attacks didn't help either). The Fed then lowered the rates in fear of another recession and was encouraged to help fuel the housing bubble to offset this temporary market decline. Which it did as the market again underwent several years of high returns (which was actually another bubble). Then came the crisis of 08 and the market plummeted, only to recover in the later years, primarily thanks to massive QE done by the Fed. So if the pattern continues, we could be in for another correction right about now? Right?

Wrong. Even by looking at this graph alone that would be a false conclusion given the fact that we know what caused the market to slump in 2001 and 2008 (or at least we think we know). We don't expect any of the same bubbling adversities today, at least not until the money multiplier is still below 1 and the velocity of money is at its historical low as well. 

Source: Business Insider
Looking at the second graph the pattern is obviously much different. The past 17 years, in terms of the long run, seem to represent a stagnating trend, similar to the one after the Great Depression, or better yet to the one in the 70-ies. This could be indicative of a different type of shock that has hit the economy (a technological shock which didn't uncover the inefficiencies in the labour market until 07-09), but it could also not mean a thing. There is a good way to explain each of the downturns and surges in particular. Looking at just one historical segment of the curve can be more off-putting than helpful.  

Here is the lesson from this: If you wanna make money on the stock market, beware of making investment decisions just via technical analysis (predicting future movements based on historical trends).

Tuesday, 8 April 2014

Where do YOU think Ukraine is?

From Washington Post comes a very disturbing piece of information (HT: Business Insider). A couple of political scientists from Dartmouth, Harvard and Princeton did a survey of 2066 Americans (sampled in a usual way) and asked them what action they wanted the US to do in Ukraine. In addition, they've asked them to locate Ukraine on the map: 
"We wanted to see where Americans think Ukraine is and to learn if this knowledge (or lack thereof) is related to their foreign policy views. We found that only one out of six Americans can find Ukraine on a map, and that this lack of knowledge is related to preferences: The farther their guesses were from Ukraine’s actual location, the more they wanted the U.S. to intervene with military force."
Correlation doesn't imply causality, of course. However there is something to this - more ignorance implies further ignorance. I guess military interventions in Iraq can be justified the same way?  

But anyway, what surprised me is the variety of different answers people gave on Ukraine's location (see the map below). I mean some seem to think Ukraine is part of the US (Alaska, Kentucky, Kansas, Colorado, even Florida) - of course they would want a US military intervention - you have to protect your own turf, right?

Source: K. Dropp, J. Kertzer and T. Zeitzoff, Monkey Cage blog, WP
The red dots depict the closest guesses, while the blue ones depict those furthest away.
16% got it right. A bit more were close (opting for Eastern Europe), but some were just outright stupid. Australia? India? Canada!? Greenland!!? Seriously? A lot chose Kazakhstan, Pakistan and areas in the Middle East (you know - as long as we're around, we might as well intervene). 

They found that younger Americans are more precise (27% of those between 18-24 compared to 14% of those 65+), men did better than women (20% vs 13%), independents (29%) did better than both Democrats (14%) and Republicans (15%), members of military households did about the same as members of non-military households (16%), while collage graduates outperformed non-college graduates, even though 77% of those holding a college degree cannot place Ukraine on the map. Now that's disturbing. 

Let's go back to the correlation story. The authors said to have controlled for a series of demographic characteristics and foreign policy attitudes and have found the story viable (under a 5% significance level): the less the people know about the location of Ukraine, the more likely they would be to support US military intervention. I would have to read the paper to make a better judgment of this, but if the data holds that this is indeed a very troublesome finding. And this would be yet another case in point how a lack of information on a topic influences people's attitudes towards adverse government policies - just like protectionism in international trade. What's the answer? Improve education, I would say. The better educated population, the better decisions they make, and the stronger the informal institutions.

Friday, 4 April 2014

When states don't perform

One of the essential roles of the modern state is to solve market failures, i.e. provide goods on the market for which the demand is high, but the supply is inadequate. Or in other words provide goods and services when the markets for such goods don't exist (at least not enough to satisfy the demand), when the selection is adverse (e.g. health insurance market), when there is a lack information (e.g. used car market), or when there is a lack of competition (e.g. monopolies - even though we are aware that monopolies can only exist with the consent of the government). In some of these cases we can indeed find market solutions (reputation in case of asymmetric information - "fool me once, shame on you, fool me twice, shame on me", or venture capital funds to solve the adverse selection problem on the financial markets in loans to small businesses), however in certain cases we do need the government to at least provide the basic infrastructure.

In the past governments built roads, railways, telecommunication lines or pipelines, so one would expect all of these to be a public good. However, it's a completely different story when governments give a single company monopoly rights to use the infrastructure it has provided. That is an example of failed government intervention. The proper solution would be to enable many companies (even though it's usually a few) to use these goods and compete on the market for customers by doing so. The privatization of the British railways is one good example, the telecommunications industry worldwide is an even better one. Why should a single company bear the right to extract all the profits from what is essentially a public good? Particularly since such monopoly companies are overrun with inefficiency and rigidity. 

Government failure

But the real question is do the states always perform their role efficiently and fairly? Even when they do provide us with public goods or services, they often do it very costly and inefficiently. The reason for lack of efficiency and high costs is due to the lack of the profit motive that characterizes the private sector. On the other hand the lack of profit motive is precisely the reason why markets for certain goods don't exist. The free rider problem disables any entrepreneur from offering a certain good to the public since there would always be individuals who would use a good or service without paying its price - or in other words it is hard to exclude people from consumption of public goods (such as street lights, city roads, anti-missile defense system, etc.). Then there's also the justice system, protection of private property, safety (police, military), and even the use for public administration (to get permits, IDs, drivers licence etc.). However even when such goods and services are provided government intervention can result in failure.

The dichotomy between fairness and efficiency is important in the issue of justifying government intervention, but we so often see cases of governments that are neither fair (high inequality) nor efficient (governments that act extortionary). This is not limited to failed states in Africa, whose ethnic fractionalization and wars keep pushing out new dictators which only further perpetuate the iron law of oligarchy. No this can also be applied to many states of the developed (or developing) world, which carry only a fictional democracy, while in reality they are dominated by state capitalism and cronyism.

Why do states fail? There is a multitude of potential reasons, most of them well explained by Public choice theory. If market participants are modeled as being self-interested, there is no reason not to apply the same logic when it comes to politicians in power and bureaucrats in office. Even more so since the selfish behavior of market participants doesn't hurt anyone, whereas the self-interest of politicians can have huge negative ramifications upon the economy.

Furthermore, reasons for state failure stem from the very definition and assumptions of market failure. It is said that due to a lack of perfect (or full) information, markets fail. However, government bureaucrats and decision-makers arguably possess even less information than the private sector whose incentives they wish to correct. Because of this government intervention is, the least to say, also imperfect. The key is to distinguish between relative efficiency of both the market and the government. If there is a market failure that the government tries to solve but its solution causes a great deal of inefficiencies then it is best not to involve the government at all.  

Rampant and persistent government failures lead to vast differences in the perception the population has towards governments and it can sway public preferences in either direction. A highly efficient government operating in a stable and strong institutional environment (e.g. Scandinavia) has a population which favors and more easily justifies government intervention. On the other hand in countries with highly inefficient governments with a high public perception of corruption of government officials and the society in general, there is very likely to be a very negative perception of the government's role in the society. This depends first and foremost on the historical trails the country went through (social capital diminishes following a transition process), but generally in failed states people perceive the role of the government much differently than those in successful states.

The point is to opt for an efficient government, regardless of its size. The size will depend primarily of the preferences of a particular nation. But efficiency, transparency and accountability can be the end goals every voter desires from its government.