Thursday, 30 January 2014

The week links (2)

Continuing with the weekly overview of the "best of the rest", here's a couple of good ones you shouldn't miss: 

1. A few great posts on social mobility from at the Marginal Revoultion blog:

Cowen citing an interview with Gregory Clark: How much does social mobility ever change? - social mobility rates are apparently impervious to government intervention (upward mobility, that is). 

Cowen citing the new Chetty et al paper: Upward mobility in the US is not declining as many citizens think: a very good and disturbing piece of evidence that intergenerational mobility in the US hasn't changed for the past 20 years! I'll devote a separate post to this topic after I read the paper. 

Tabarrok: Why the worst get on top - Indian edition; ok, perhaps this is not on social mobility per se, but something is wrong in a country if 30% of its members of parliament have criminal cases pending against them. How do these people even get their votes? That's easy, they buy 'em! 

2. Steven Rattner: "The Myth of the Industrial Rebound", New York Times - makes a good case that there isn't any renaissance of manufacturing in the US, as many seem to claim. The obvious decline of manufacturing (see graph below from the text) is mostly due to the decline of the automotive industry, where wages have fallen dramatically. 

Source: NYT

Even more importantly he attributes some of the cheap talk on the rebound of manufacturing to heavy government subsidies: 
"Low wages are not the only price that America pays for its manufacturing “renaissance.” Hefty subsidies from federal, state and local government agencies often are required. Tennessee provided an estimated $577 million for Volkswagen — $288,500 per position! To get 1,000 Airbus jobs, Alabama assembled a benefits package of $158 million.
Now Boeing has just used the threat of moving to a nonunion, low-wage state to win both a record subsidy package — $8.7 billion from Washington State — and labor concessions."
All these efforts resulted in only half a million jobs created in manufacturing, merely a fraction of the 6 million lost from the beginning of the decade. He makes a couple of interesting proposals as to how to help manufacturing:
"Manufacturing would benefit from the same reforms that would help the broader economy: restructuring of our loophole-ridden corporate tax code, new policies to bring in skilled immigrants, added spending on infrastructure and, yes, more trade agreements to encourage foreign direct investment and help get closer to Mr. Obama’s seemingly unattainable goal of doubling our exports."
3. Paris and Wyplosz: The PADRE plan: Politically aceptable debt restructuring in Europe, Vox.EU - a controversial idea, least to say:
"The plan involves an agency that acquires at face value a share of existing public debts and swaps them into zero-interest perpetuities. In practice, therefore, the corresponding debts are wiped out. To that effect, the agency borrows on the financial markets the amount needed to acquire the debts. As it pays interest on its obligations and receives no interest on the perpetuities, the agency makes losses. As it rolls over its obligations, its losses are forever. This is where the costs of the debt restructuring are borne. Existing bondholders are fully protected, eliminating any risk of banking crisis. The agency best suited for the task is the ECB, for three main reasons. First, it is the only institution that can mobilise the required resources (in our main example, we assume that half of existing debts are bought and swapped, which amounts to some €4.5 billion). Second, because central banks do not have to worry about their capital, they have a unique credibility and can sustain large losses. Third, the ECB passes on its profits to Eurozone member countries. This applies to losses as well."
4. Noah Smith: What if preferences are unstable? on his Noahopinion blog citing the new experiment by David Eli from GMU:
"Experimental and field research has shown that individuals often exhibit time inconsistent preferences. Often this is in the direction of “hyperbolic” or quasi-hyperbolic discounting. That is, individuals have a steeper discount rate for a given delay length when that delay comes sooner. This paper presents an experiment that tests this hypothesis with a novel choice task. Instead of being asked how much money today makes them indifferent between some amount later, subjects are asked how long they would be willing to wait to be indifferent between some amount sooner and some larger amount later. In this new task, many subjects exhibit “hypobolic” discounting, the opposite of the standard finding. This result does not appear to be a consequence of payout risk. The result suggests that hyperbolic discounting may be subject to the framing of choices, and therefore not purely an aspect of preferences."
5. In the end a couple of interesting thoughts on economics - first Noah Smith in The Week: Why economists get such a bad rap?, attacking mainly macro:
"When people in the media say "economists," what they usually mean is "macroeconomists." Macroeconomists are the economists whose job is to study business cycles — booms and busts, unemployment, etc. "Macro," as we know it in the profession, is sort of the glamor division of econ — everyone wants to know whether the economy is going to do well or poorly. Macro was what Keynes wrote about, as did Milton Friedman and Friedrich Hayek.
The problem is that it's hard to get any usable results from macroeconomics. You can't put the macroeconomy in a laboratory and test it. You can't go back and run history again. You can try to compare different countries, but there are so many differences that it's hard to know which one matters. Because it's so hard to test out their theories, macroeconomists usually end up arguing back and forth and never reaching agreement."
So he claims micro is the right way to go as the only real way to justify economics as a science (as I also wrote back in October). He cites game theory, statistics, behavioral finance and even policy-oriented economics (labour economics, health economics, environmental, agricultural, developmental, etc.), whose research can actually be used to solve issues. 

However a response came last week from the Economist's Free Exchange blog saying that No, micro is not the good economics:
"What is true of all economics is that as soon as you wander into policy, you find the debate hijacked by policy advocates who write, report and promote research that reinforces their side of the debate while ignoring or disparaging the other. Do higher capital requirements reduce lending? (Yes: it raises the cost of capital! No: Modigliani-Miller tells us firms are indifferent to capital structure! Yes: banks aren’t like other firms!) Do higher marginal tax rates reduce the work effort and tax paid by the rich? (No: their labour supply is inelastic! Yes: They reclassify their income to avoid taxes!) Does Obamacare hurt part time employment? Does it lower labour supply? Do tougher emissions requirements cost jobs? Does net neutrality lead to more investment in technology? Or less?"
I agree with the distinction over policy, which is why I like to separate the science part of economics with the policy part, which often creates scope for many quacks and their ideologically-biased interpretation. The most important part of policy-oriented research is to leave ideology at the doorstep, and just focus on the facts. This is easier said than done. 

Friday, 24 January 2014

Corporate profits in the US: finance vs non-finance

I was looking for some data in the Economic Report of the President and I stumbled upon table B-91: Corporate profits by industry, 1964-2012.

Here's a graph I got from the data, comparing corporate profits of the finance industry vs the non-financial industries from 1964 to 2012.
Source: Economic Report of the President, Table B-91
Notice the divergence of profits of the non-financial (real) sector in the 90-ies, and particularly in the pre-crisis boom. The rise of profits in the real sector was immense compared to the financial sector at that time. In fact throughout the past 50 years the gap in total profits between finance and the real sector was widening (albeit a few episodes). This can be a good indicator of how one needs a strong financial industry to support the growth of the real economy. 

Notice another even more interesting fact. As real sector profits clearly declined by the end of the 1990s we don't recall those times of being characterized by a particularly strong recession. The dot-com boom and the September 11th attacks apparently didn't influence corporate profits that much at all. However the period immediately after September 11th, when the Fed was holding interest rates down at 1% up until 2004, we can see a huge rise in real sector profits (finance industry as well). 

Then comes the bust, caused by a series of interlinked instabilities, where the financial sector suffers first, and the real sector follows. This further emphasizes the point that a severe recession can only be triggered by a collapse of the financial sector, as we can see several slumps in the financial sector leading to a decline of profits in the real economy, but not the other way around. 

The story of corporate profits in finance tends to be linked with the issue of a huge rise of inequality from the 1980s till today (the Atkinson, Piketty and Saez papers show the rise in inequality starting by the end of the 1970s). However, simultaneously with the growth of financial sector profits and the wealth of the richest 1% and 10% of Americans, there was a massive growth of the real sector, in which period many major companies we know today have emerged. Particularly the IT companies like Microsoft, Dell, Oracle, Apple and the internet giants Google, Facebook, Amazon etc. Even giants such as Wall Mart (founded in 1962, became a national giant in the 1980s and the 1990s), not to mention the rapid rise of profits in the oil industry and the automotive industry. For more on this debate see my earlier texts on the 1% vs the 99% debate. 

Looking at the profits divided by industry the picture is slightly different:
Source: Economic Report of the President, Table B-91
Now we can see that individually, finance became the most profitable industry sometime around 1999 following the first apparent decline in manufacturing profits. As they both bounced back briefly until 2006 the pattern of the slump is again evident. (Notice also the dot-com bust that affected the IT sector in 2000, after which it recovered rather well.)

Particularly in the last decade we can notice the apparent correlation between the changes in corporate profits in the real sector to those of the finance industry, thus further confirming the importance of this industry in creating the scope for growth in the real economy.  

Finally, these graphs are far from proving anything, but they do point to an interesting direction. 

Tuesday, 21 January 2014

The week links

I've decided to start a weekly overview of some of the decent articles on the web, not always having the time to comment on each of them in detail, but still would like to share some of their ideas to my readers. This will be in addition to the "graph of the week" column, with a slightly more interesting play of words. (I wanted to call it "the best of the rest" but someone else had already used it). After all, a lot of economics bloggers apply this practice, so I'm gonna do the same.

Here they are for this week:

1. David Brooks, "The Inequality Problem", New York Times:
"If you have a primitive zero-sum mentality then you assume growing affluence for the rich must somehow be causing the immobility of the poor, but, in reality, the two sets of problems are different, and it does no good to lump them together and call them “inequality.” 
...If you think the problem is “income inequality,” then the natural response is to increase incomes at the bottom, by raising the minimum wage.  

But raising the minimum wage may not be an effective way to help those least well-off ... That’s because raises in the minimum wage are not targeted at the right people. Only 11 percent of the workers affected by such an increase come from poor households. Nearly two-thirds of such workers are the second or third earners living in households at twice the poverty line or above.
The primary problem for the poor is not that they are getting paid too little for the hours they work. It is that they are not working full time or at all. Raising the minimum wage is popular politics; it is not effective policy. 
...Some on the left have always tried to introduce a more class-conscious style of politics. These efforts never pan out. America has always done better, liberals have always done better, when we are all focused on opportunity and mobility, not inequality, on individual and family aspiration, not class-consciousness.
If we’re going to mobilize a policy revolution, we should focus on the real concrete issues: bad schools, no jobs for young men, broken families, neighborhoods without mediating institutions. We should not be focusing on a secondary issue and a statistical byproduct."
 The entire article is very intuitive. I recommend it.

2. Chris Giles, "Productivity crisis haunts the global economy", Financial Times.
The Conference Board said: “This stalling appears to be the result of slowing demand in recent years, which caused a drop in productive use of resources that is possibly related to a combination of market rigidities and stagnating innovation”.

The failure of overall efficiency – known to economists as total factor productivity – to grow in 2013 results from slower economic growth in emerging economies alongside continued rapid increases in capital used and labour inputs. Labour productivity growth also slowed for the third consecutive year. 
Mr van Ark said Europe’s problem in achieving more efficiency from its labour force stemmed from structural rigidities. “We really see the need for more people to move quickly from one company to another and where [innovative] firms do not see huge risks in taking on these people”. 
3. Acemoglu & Robinson: "Democracy's pains", Why Nations Fail blog
"Democracy will function better, and has a better chance of approximating our ideal “inclusive political institutions,” when complemented by non-electoral constraints, which includes not just the media but also the willingness of ordinary people to get up and protest in the streets.
Though the conundrum of patronage-based elections under imperfect institutions has no simple solution, a good case can be made that the way to increase the inclusivity of political institutions is not to ignore the ballot box, but to utilize it, together with protests when necessary. But so long as elites and a vocal minority refuse to accept electoral results they don’t like, the path to a healthy democracy and truly inclusive institutions will be long, arduous and perhaps blocked for a long time."
4. Robert Shiller: "The Rationality Debate, Simmering in Stockholm", New York Times - he asks whether people are rational in economic decision making, referring to the Nobel Prize lectures given by Fama, Hansen and himself in December: 
"The question is not simply whether people are rational. It’s about how best to describe their complex behavior. A broader notion of irrationality may someday be reconciled with one of rationality, and account for actual human behavior."
5. "Technology and jobs: Coming to an office near you", The Economist (arch theme of last week's issue)
"Although innovation kills some jobs, it creates new and better ones, as a more productive society becomes richer and its wealthier inhabitants demand more goods and services. A hundred years ago one in three American workers was employed on a farm. Today less than 2% of them produce far more food. The millions freed from the land were not consigned to joblessness, but found better-paid work as the economy grew more sophisticated. Today the pool of secretaries has shrunk, but there are ever more computer programmers and web designers."
I wrote about the impact of technology on jobs quite a lot over the last year (see here, here, here and here), and it's nice to see the Economist agreeing with me and even using some of the same arguments I used. 

Friday, 17 January 2014

The real problem with minimum wages

This week, the Economic Policy Institute, a liberal (left-wing) US think tank, has released an open letter to the US President Barack Obama and the leaders of Congress in which they urge the government to raise the minimum wage. In total 75 US economists have signed the letter, including Nobel laureates Joseph Stiglitz, Kenneth Arrow, Eric Maskin, Peter Diamond, Robert Solow, Michael Spence, Thomas Schelling and a number of other notable economists such as Larry Summers, Emmanuel Saez, Dani Rodrik, Daron Acemoglu, etc. These are some very respectful names in the field, and when a group such as this one signs a policy proposal, one should hear what they have to say. 

Their idea is the following: an increase in the minimum wage would benefit the economy as a whole, causing not only a direct increase of wages for 17 million workers, but also spillover effects to other workers as the employers would "adjust their internal wage ladders". Consequently this would boost their purchasing power and raise consumption and hence aggregate demand. Here are some excerpts from the letter [emphasis mine]:
"...We urge you to act now and enact a three-step raise of 95 cents a year for three years—which would mean a minimum wage of $10.10 by 2016—and then index it to protect against inflation. ... [this would imply an increase in every state = see map] The increase to $10.10 would mean that minimum-wage workers who work full time, full year would see a raise from their current salary of roughly $15,000 to roughly $21,000. ... 
...This policy would directly provide higher wages for close to 17 million workers by 2016. Furthermore, another 11 million workers whose wages are just above the new minimum would likely see a wage increase through “spillover” effects, as employers adjust their internal wage ladders. The vast majority of employees who would benefit are adults in working families, disproportionately women, who work at least 20 hours a week and depend on these earnings to make ends meet. ... 
And the most interesting part:
...In recent years there have been important developments in the academic literature on the effect of increases in the minimum wage on employment, with the weight of evidence now showing that increases in the minimum wage have had little or no negative effect on the employment of minimum-wage workers, even during times of weakness in the labor market. Research suggests that a minimum-wage increase could have a small stimulative effect on the economy as low-wage workers spend their additional earnings, raising demand and job growth, and providing some help on the jobs front."
I've already covered some of the research that suggests this new relationship (the Card and Krueger, 1994 paper is the often cited one) and have raised several concerns (see my earlier blog post, or my ASI text). Disregarding for the moment some technical econometric issues, the biggest problem I see is the shift in incentives for taking lower-paid jobs.

Even if it's true that an increase of the minimum wage would (temporarily) boost consumption and AD, I worry of the secondary effect it might have on the shift in incentives and the re-specialization of people with higher skills for currently low-paying and low-skilled jobs.

As I've mentioned before, the Card and Krueger (1994) paper looked at fast food restaurants, where increasing the minimum wage made this easily accessible job more attractive than the alternative of investing into gaining more skills and finding another, more demanding job. 

The result is a reshuffling of the labour market towards certain types of jobs, rendering some higher paying jobs a lack of skillful employees, while the net effect for lower-skilled workers is negative. It would be interesting to observe the total effect on all industries during the observed periods, not just on one, favourable industry, to prove the employment effect of minimum wages.

Furthermore, some of the research on the minimum wage increases too often suffers from the omitted variable bias problem, where it is hard to differentiate between what why the minimum wage hasn't decreased employment - it could well have happened during a favorable point in the business cycle. A good example is claiming that the 1999 introduction of the minimum wage in Britain resulted in an increase of employment. This is a typical reverse causality problem. Since its introduction Britain's economy experienced a boom decade with rising productivity and declining unemployment, coupled with an increase of labour costs and real wages. It is hard to believe the minimum wage was a cause of all this. If a student were to make this assumption in an econometrics class, he or she would have surely failed the course.

Contradictory research findings 

Plus there is a multitude of contradictory research out there, where some tend to find that the minimum wage increases unemployment, while others find no such effect. Neumark and Wauscher (2007) went through the literature and found that the majority of studies reported negative effects of the minimum wage on employment, particularly among low-skilled workers, as did a more recent paper by Baskaya and Rubinstein (2011) from LSE, where they used a time series from 1977 to 2007 and concluded that "a rise in the minimum wage has an instantaneous impact on wage rates and a corresponding negative impact on employment...minimum wage increases boost teenage wages and reduce teenage employment..."

On the other hand there is also a multitude of research claiming otherwise. They seem to have found no significant effect of the minimum wage hikes on employment (in accordance with the Card and Krueger, 1994 paper). Giuliano from Berkely looks at the effects of the 1996 minimum wage increase and finds no significant effects on employment while distinguishing between subgroups of low-paid workers. Dube et al find no effects either, while controlling for local economic conditions.

The point is the research on this topic is far from conclusive. It would be a mistake to use just one side of the argument and claim that the research favorable to this argument is the correct one. The topic is still subject to interpretation and bias, which is why no one can claim to have the correct answer to the question of "does the minimum wage hurt employment?".

All in all, when discussing the minimum wage I am far more concerned with its effects on occupational heterogeneity than on whether or not it hurts employment or boosts AD. If a multitude of research was to be done in this direction, then we could hope for a more precise answer of the total effect of a minimum wage increase. 

Tuesday, 14 January 2014

Graph of the week: gender gap in the labour market

In the recovering US labour market, it seems that women have overtaken the men in terms of job gains in the past few years. 

This trend was noticed in the last month's job report where the men gained zero net jobs, attributing the entire net job growth to women (75,000 jobs). Interestingly enough this apparent gender gap trend is characteristic for the entire recovery:
Source: FRED

Why is this? It's actually rather expected - the male-dominated sectors like construction or manufacturing have suffered a huge slump and are recovering slowly, while the women-dominated sectors like health care, retail or the public sector (teachers), have been less sensitive to the business cycle and have recovered more quickly (both can be seen in the graph - the drop in female employment has been less steeper than the drop in male employment, and while both were struggling to recover, by 2013 the women have made up the lost time and regained their pre-crisis employment levels).  

The employment gap is not so much gender-driven as it is sector-driven. This is obvious when looking at the numbers for manufacturing: 

Source: FRED
Not a particularly strong recovery in this sector, is it? Even before the crisis, the downturn was obvious due to the outsourcing trend. The same can be seen for employment in construction, meaning that the private sector job growth has obviously been captured more by women. In addition, looking at the E-P ratio for men, it seems many are still discouraged. However, despite all of this, the real gender gap is still there, as evident from the first graph above. I wouldn't say it was much different than from before the crisis. 

What about the young? The drop in male employment was even more steep than in the general population, which again makes sense, as the young workers were the first to get laid off in construction or manufacturing. The women however seem to have both suffered less and recovered even more robustly. Why didn't young women experience a drop in employment? This can be explained through college enrollment, where the latest trends have pointed out that women not only enter colleges at a higher pace than men, but also that around 60% of grad students were women. 

Source: FRED

This could be the best explanation of why in the age group 20-24 men were more sensitive to the business cycle, working predominantly in the industries that suffered the most, while the women of the same age group were mostly studying at the time. All in all, I believe this is a positive trend as I assume in the long run it will put pressure on closing the gender gap. Which is still very large. 

Saturday, 11 January 2014

'The man who broke the Bank of England'

My previous post on short-selling reminded me of another famous case study of this trading practice - the one that actually happened in the real world on a massive scale - the story of how George Soros, today a world famous philanthropist, broke the Bank of England back in 1992. Or more precisely, how speculators seized the opportunity of a poor British government economic policy decision to make a huge amount of money.

Soros was just one of the stock market speculators who earned a bundle from the infamous Black Wednesday in 1992. However, he profited the most. His hedge fund, the Quantum Fund, made a profit of $1.1 billion. The event turned him into one of the most feared figures in finance.

The ERM and Britain 

What happened on Black Wednesday? To understand that we must first go back in time to explain the 1992 European Monteray System crisis, and in particular the faulty policy applied by the British government.

The European Exchange Rate Mechanism (ERM) was introduced in 1979 as a part of the European Monetary System (EMS) with the goal of reducing exchange rate volatility in Europe, thus achieving higher monetary stability. This was basically a prelude to the introduction of the Eurozone in 2000. It was a fixed exchange rate system where exchange rates were allowed to fluctuate between pre-agreed boundaries (2.25% over and under the weighted average of the EMS countries' currencies).

The UK didn't enter the ERM until 1990, primarily because of strong opposition to the EMS by Thatcher's government. However in 1990 John Major made the decision of joining the ERM with a guarantee that the government will prevent the exchange rate from fluctuating by more than 6% against other members' currencies.

Britain entered the ERM with a highly overvalued pound, at 2.95 DEM (Deutsche mark) to GBP. This meant that its currency was worth less against the DEM than what the BoE was trying to hold on to. Much less than the upper bound on the exchange rate (the higher the absolute number of one currency to another, the lower its value). Furthermore, UK's inflation was much higher than the German inflation, implying that entering the ERM at such an overvalued pound rate was a bad idea. Under the relative purchasing power parity condition, higher inflation in one country has to be offset by a depreciating currency in that country. And in Britain, under an overvalued fixed exchange rate for the GBP, this wasn't allowed to happen. In other words, the currency was artificially being kept too high in value.

I'll borrow a graph from Manfred Gartner's excellent Macroeconomics textbook to explain this. Before the 1992 crisis, at point 1 in the graph, the upper bound the BoE guaranteed was deemed credible. As the ERM began losing credibility amid the Maastricht Treaty rejection by the Danish referendum voters, and amid the uncertainty around the French referendum, the value of the pound sterling hit its upper bound. The curve represents the exchange rate response line in an exchange rate target zone (basically depicts the reaction of the market forces on currency movements). The persistent loss of credibility by investors in the ERM moved the response line further upwards. Without allowing the exchange rate to adapt to a higher level (depreciate), the BoE had to support the pound by reducing its money supply downwards (from m1 to m3). BoE was lowering the money supply by selling its foreign exchange reserves, thus weakening its own position. This lasted for a few weeks during which Britain was under constant speculative attacks on its currency. It increased the interest rates by 5 percentage points in one day in an attempt to make the pound more attractive and stop the speculators from shorting it. Not until Britain admitted defeat and exited the ERM on September 16th (Black Wednesday) was the pound allowed to depreciate, turning the response line straight (point 4). The pound lost 20% of its value against the DEM withing a day after leaving the ERM.

Source: Gartner, M. (2006) Macroeconomics. Prentice Hall, 2nd edition.
Chapter 12: "The European Monetary System and Euroland at Work", Pg. 332. 
For more on the EMR crisis I recommend two great papers, one by Eichengreen and Wyplosz (1993) "The Unstable EMS", and the other by Eichengreen (2000) "The EMS crisis in retrospect"

Soros's $1 billion bet

Let's look at the whole story from the speculators' point of view. The Atlantic describes the process via an excerpt from Sebastian Mallaby's book "More Money Than God". I'll paraphrase the story. 

Amid problems caused by the German unification in which the Bundesbank raised interest rates causing other members of the EMS to suffer a fall in income, the biggest worry for the UK Chancellor at the time, Norman Lamont, was the interview given by the German Bundesbank president Helmut Schlesinger to the WSJ, where according to reports on his remarks (still unpublished) he stated that "there would have to be a broad realignment of Europe's currencies." In Britain this was perceived as a direct attack on the pound calling for its devaluation. Primarily because the investors perceived that as a clear signal that the pound was in fact overvalued. Even more so as Schlesinger's previous public statements triggered an assault on the Italian lira. 

Soros and his chief portfolio manager Stan Druckenmiller at the Quantum Fund saw these unpublished comments as an opportunity. It was obvious to them that the Bundesbank wasn't going to help the pound remain within its boundaries by cutting the German exchange rate. This meant that a pound depreciation was inevitable and that it was only a matter of time before Britain would exit the ERM. 

Now it was the time to do some short-selling. Upon receiving this news Soros was reported to say to his portfolio manager "Go for the jugular". And they did. They made a huge bet against the pound, being certain that it would drop. They began the first step of shorting: selling at a high price, limited by the upper bound held by the BoE. They expected Britain exiting the ERM which would allow the pound to depreciate. The rapid fall in value would be their profit margin. When the pound dropped following the depreciation after September 16th, they made the second step of short-selling - the buyback, where they bought back the pound at the lower value to zero their position. The tactic worked brilliantly. In October Soros said in the Times: "Our total position by Black Wednesday had to be worth almost $10 billion. We planned to sell more than that. In fact, when Norman Lamont said just before the devaluation that he would borrow nearly $15 billion to defend sterling, we were amused because that was about how much we wanted to sell."

It's a really interesting story of what happened behind the curtain. I encourage you to read it either from The Atlantic excerpt or from the book itself.

This short-selling story didn't include any insider information, and was therefore much more legit than the one covered earlier in the movie Trading Places. All it did include was a correct assessment of a bad policy decision from the British government, which was hopelessly trying to fight against the market forces. All you had to do is to be smart enough to recognize it and make a profit out of it. And that's exactly what Soros did. 

Monday, 6 January 2014

Short-selling explained (case study: movie "Trading Places")

After seeing the movie "Trading Places" (1983), starring Eddie Murphy and Dan Aykroyd, for the thousandth time during the holiday season, I decided to write a quick post explaining what happened at the end of this movie that gets so many people puzzled (including me for the first couple of times I've seen it).

This entertaining 80s comedy can actually teach you more about finance and trading than any other Hollywood movie (not counting documentaries), including the infamous "Wall Street" (1987), starring Michael Douglas as the ruthless Gordon Gecko, and especially the latest Scorsese film "The Wolf of Wall Street" (2013).

Anyway, we all know the story from Trading Places. Dan Aykroyd plays a snobbish investor Louis Winthorpe ("the Third"), while Eddie Murphy plays a street con artist Billy Ray Valentine whose lives get reversed as a result of a bet between two cruel millionaires, the Duke brothers. The Dukes own a commodities brokerage house and have young Winthorpe as their managing director. When they encounter a street hustler/con artist Billy Ray Valentine falsely accused of trying to rob Winthorpe they decide to conduct a social experiment in which they switch the social positions of these two men to determine which is more important: environment or heredity. Winthorpe is framed with drugs and ends up in jail, loosing his fiancee and his social status, while Valentine is being given Winthorpe's job and all possessions, including his house.

Needless to say, a lot of funny stuff happens on the way, but when Winthorpe and Valentine realize the deceit they want to get back at the Dukes, and the best way of doing so is by bankrupting them. And the best way of doing that is with a little short-selling.

What is short-selling?

Short-selling is basically the reverse of normal trading. In normal trading you buy low expecting the price of a security to rise in order to make a profit. When short-selling, you expect the prices to drop instead of rise and so you decide to sell high and buy low. It sounds puzzling at first, but it really isn't.

Source: EconMatters
Short-selling implies selling a security you do not own at a high price, with the obligation to buy it back later at a lower price. If the price drops, you made a profit, since the cost of repurchase of the security will be lower than what you got for it during the initial short sale. The higher the drop in price (high-low spread), the more money a short-seller gets. On the other hand if the price goes up, one can lose a huge amount of money. 

The graphic summarizes the whole story pretty well. Usually a short-seller will borrow shares to sell them, thus creating an obligation to return them. He bets against the shares selling them immediately at a high price. If the price goes down, he can make a profit the size of the spread (just like with normal, "long" trading). He waits for the stocks to plummet and then buys back the stocks he pre-sold at a lower price, since he still has an obligation to return these shares. The transaction also includes a fee to the broker who borrowed him the shares. You can do the same thing with futures contracts. Futures are perfect for short-selling: contracts one can sell when he doesn't yet own a commodity (or asset).  Making a sell of a 1000 pounds of a commodity (say oranges) at $2 per pound in March simply means that the seller is obliged to provide and the buyer is obliged to purchase the commodity at the specified future time and price (in this case three months from now, at $2 per pound). It doesn't matter how you get the commodity (or whatever you're selling) as long as you are able to provide it at the designated time. That's why the buy back is important - you still have an obligation to provide the stuff, and your buyers have an obligation to pay you at the high price (the agreed $2), even if in the mean time the price dropped to, say 50 cents.  

Why short-selling, or the cleaner "going short"? Because it's the opposite of the conventional trading practice of "going long" - when an investor expects a price of a stock to rise in order to make a profit. 

So how did they do it in Trading Places?

Going back to the movie, the question is how was it possible for Winthorpe and Valentine to make hundreds of millions in one hour on the trading floor, while simultaneously bankrupting Duke and Duke (the final scene)?

The answer: Short-selling. And of course: rigged insider information. This is the most important piece of the puzzle. Short-selling can only be fully efficient if you know the price will go down. Then you can scam everyone else easily.

The insider information I'm referring to is the Dept of Agriculture crop report for oranges (they're trading a commodity - frozen orange juice). The Dukes hired their secret agent Mr Beeks to get them the report before anyone else sees it. Unfortunately for them, Winthorpe and Valentine get their hands on the report before the Dukes do and feed them false information. The Dukes are led to believe that the weather was bad and so the harvest was less than normal. Therefore the Dukes are expecting high prices (low supply + high demand = high prices). However the actual report signals the opposite - the harvest was unaffected by the bad weather, and the supply will be plentiful. Hence the scope for short-selling, as Winthorpe and Valentine know that the price is likely to go down.

Trading floor. The Dukes tell their broker to buy as many frozen concentrated orange juice (F.C.O.J.) contracts as he can before the crop report is revealed to the public. They anticipate prices to rise high after the report is revealed so they are looking to make a good profit.

Trading begins at 102 cents per pound (at 15,000 pounds of F.C.O.J. per contract - size of a typical contract - the value of a single contract is $15,300). Once everyone realizes the Dukes are trying to 'corner the market' (it means getting sufficient control of a stock or commodity so that one can manipulate its price), they all try to get their hands on the contracts, driving the price up (high demand, typical bubble behaviour).

At the same time Winthorpe and Valentine are on the floor but are not selling yet. They have to wait for the price to go really high before they can start pushing it down. Have in mind they need to maximize the high-low price spread.

When the price reaches 142, that's when Winthorpe yells: "Sell [some quantity] in April at 142!" Now they are short-selling (step 1): selling futures contracts they don't hold. Yet. They are betting they will be able to buy the contracts later at a lower price and thus make a profit.

The other brokers are buying from them as they still think the price will go up, since the Dukes are applying the same strategy. However the price is going down. The reason is again simple supply and demand. New, fresh supply of future stocks decreases the prices of the contracts. Trading continues until the crop report is being revealed when everyone pauses to hear it. The price is back down to the initial 102.

The real crop report (read out by the Secretary of Agriculture) states that the harvest was good and that the supply of oranges is plentiful. The over-inflated price starts dropping significantly as everyone starts frantically selling to get rid of their contracts and at least zero their position before trading ends. The Dukes are in disbelief. Their broker is full of soon to be worthless contracts and is literary overcrowded by an army of traders quickly getting rid of their contracts.

When the price falls down to 46, Winthorpe and Valentine announce their second important move (step 2: the buyback): buy at 46! This is the spread they've been waiting for (142-46). They have to buy a lot of these worthless contracts to zero their position. They are basically the only buyers left on the floor. However it is important for them not to buy directly from the Dukes' broker. They want him to hold onto a lot of those contracts he bought at over-inflated prices.

When trading ends, the price is down to 29 cents per pound, and they've managed to deliver on all their short-sold contracts.

How much have they made? Let's see. In the movie Winthorpe says they've moved around 20,000 contracts. Assuming they've sold short at a constant pace from 142 down to 102, and that later they've bought them back while the price was falling from 46 down to 29, let's say that the average sell price was around 122 cents per pound, where the average buy-back price was 37.5 cents per pound. The spread is therefore 122 - 37.5 = 84.5 cents per pound profit. Per single contract this is 15,000 pounds * 84.5 cents per pound = $12,675 per contract. Multiply this by roughly 20,000 contracts and their total profit was: $253,500,000.

In just one hour on the trading floor. Impressive. That's what you can do with just a little bit of favorable insider info. 

On the other hand, the Dukes faced a margin call of $394,000,000 (they were left holding even more contracts), rendering them completely broke. Buying shares on margin means you are borrowing money to buy more shares than you have cash for. The Dukes have done this believing they have a sure bet based on their (albeit false) insider info. After a drop in prices, when the value of your asset becomes too low, the exchange announces a margin call, insisting you pay immediately. As they couldn't do this, they were bankrupt. 

However, since this is a movie, it suffers from several flaws. This wouldn't be possible to pull off in today's market. Or even in the one in the 80s. There are rules and regulations that prevent exactly the sort of thing that happened in the movie. The so-called 'circuit breakers' limit or stop trading when prices go up too high, and especially if they drop down too low. Also, the regulators recently actually came up with the "Eddie Murphy rule" that expanded insider trading laws with regular securities to the futures contract market. The goal was to prevent exactly the sort of insider trading that happened in the movie. This rule is actually a part of the Frank Dodd financial overhaul bill. How's that for a quick reaction from the regulators (27 years!). 

Thursday, 2 January 2014

2014: Recovery or bust?

Happy new year to all my readers!

Last year's first post, conveniently called "The day after", started off with an analysis of what happened in the final hours of 2012 in the negotiations between President Obama and the Republican-led Congress. The feared fiscal cliff has been averted, however the negotiation outcomes only set the stage for further disarray that would happen 9 months later. 

This year, thankfully, starts a bit better. A budget deal in the US was reached in December, decreasing the chances of another government shutdown in January. However the debt ceiling threat still looms, but with signs of good will from the Congressmen, perhaps we're facing a less uncertain new year. 

As I've summarized my last year's predictions in my previous post, it's time to make new ones at the start of the new calendar year. 

First off, the recovery.

As the title says, next year a stronger recovery should finally kick off in most of the Western world. Emerging markets will grow too, however less dynamically than before. Their slowdown trend is likely to continue in 2014 as well. In America the energy boom will reignite the recovery momentum, in absence of further political deadlocks of course. America's stronger growth will rub off on Europe as well, so we can finally expect to see the Eurozone with positive growth rates next year (around 1%). Japan too will continue with positive results, riding on Abenomics, although it will most likely fail to lift inflation to the targeted 2% next year. 

Central banks will keep rates low in 2014. The Fed made this pledge rather clearly, even though it will reduce its bond buying program. A lot of pressure will be on the shoulders of the new chairman Janet Yellen, who is expected to expand the Fed's forward guidance - setting out clear expectations of the Fed's policy moves. Inflation will most likely still remain to be below the 2% target in the US. The BoE, faced with declining British productivity and close to 1% growth rates, will also keep rates low, as will the ECB, coping with the Eurozone's fragile recovery. The ECB will be more focused on supervision of still-endangered Euro banks. 

In June and July Brazil will host the 2014 FIFA World Cup, the most watched sporting event in the world. The favorites are the hosts Brazil (looking to win their record 6th tournament), the defending champions Spain (having won it all in the past 6 years: 2 Euro Cups and one World Cup), always dangerous Germany, last-time finalists Holland, Messi-powered Argentina, and the Suarez-powered Uruguay. I often make predictions of the World and Euro Cup winners just before the tournament, and I often come close. This time my call is Germany. But I'll go even further than this. The wild horse will be Belgium, which could reach the half-finals, where it will probably face Spain or Uruguay. In the other half-final, I see Germany and Brazil, where Brazil will crumble under pressure and lose, but will go on and win the third place playoff. 

Europe and the US

In Europe, the EU parliamentary elections in May will give rise to anti-EU parties (both far-left and far-right), mostly thanks to low turnout and discontent with economic recovery from the majority of the population. This could shake the very foundation of the European project. However, I believe this will be a clear sobering signal to the Eurozone leaders to be more focused on solving the Euro's problems. 

Despite all the problems, the Eurozone gets bigger as Latvia becomes its 18th member. This may actually contribute to lifting the Eurozone's average growth rate, since Latvia was growing at 4.5%. 

Latvia will once again be the fastest growing member at around 4% growth, while the largest negative growth will face Greece or Slovenia (around -1%). 

In the UK, growth will be better than last year, probably somewhere around 2%. It will mostly rest upon the housing recovery and an improving global environment. Next year's robust recovery may actually increase the chances of the Conservative-Lib Dem coalition in the 2015 election despite them falling short of the central goal of fixing the public finances (budget deficit is still around 6%). Another thing that will decisively shape Cameron's re-election chances will be the Scottish referendum, to be held in September. The Scots will vote no. The majority of the population is Scotland doesn't want independence, but rather more power for their country within the Union, in particular over the oil reserves in the North Sea. They will get this, but not next year. It will be interesting to see how the results of this referendum will reflect on the campaign calling for a British exit out of the European Union. This is to be decided on the 2017 referendum. 

In the United States, as mentioned above, a budget deal has been struck thus avoiding further government shutdowns. However, the deal has also avoided solving the difficult problems, such as the sustainability of Medicare, Medicaid and Social Security. The debt ceiling, which will be reached in February, is also left to be negotiated. An immigration reform is expected sometime next year, where the Republicans are supposed to cave in in an attempt to secure the Latino voters. Obamacare, the hot issue in America, will not be repealed. The individual mandate will be triggered in 2014, but despite this many will still stay uninsured. The health spending budget will rise even higher, currently around 18% of GDP (in comparison the OECD average is 9%). This will most likely hurt the Democrats in the November midterm Congressional elections, meaning that the power struggle in Washington will remain as it is. The recovery will continue steadily with the country growing at around 3%, led by a housing recovery and an energy boom.  


Chinese growth will drop down below 7%. Will next year be the year of the bubble burst in China? Possibly. As the FT reports: 
"Bad loans are piling up, the shadow financial system is in chaos and local governments are mired in debt. Overcapacity in almost every industry is crimping corporate profits. The costs of credit, electricity, water and other key inputs are all set to rise as Beijing pursues a new reform agenda. Housing bubbles in some parts of the country have already burst, while home prices scale giddy heights elsewhere."
What could help China is the anticipated rise in consumer spending. This is why many stay optimistic about China despite the malinvestment and the housing bubble burst. The population isn't cramped in debt as was the case in the West and Japan. 

India expects general elections in 2014, where Narendra Modi is expected to become the next PM. The economy will remain to be weak, suffering from high inflation, a large budget deficit, weak currency, rising debt and loss of international confidence. 

In Brazil all eyes will be on the aforementioned World Cup, where the President Dilma Rousseff will be hoping that a positive result in the June World Cup will translate into a positive result in the October presidential elections. I don't expect the mass protests that have happened last summer during the Confederations Cup to be repeated this summer. Rather, I expect the people to voice their anger at the presidential elections. I'm not sure Rousseff will hold onto power. 

Russia too stages a big sporting event - the 2014 winter Olympics in Sochi, the most expensive Olympic games ever, at a price tag of $50bn (by comparison the Beijing summer Olympics cost $40bn). It is expected to be a combination of extravagance, glamour, waste and corruption. But also it will be a new showcase of Putin's power to the rest of the world. Expect a lot of protest surrounding the games. Only a few months later Sochi will be the host of the G8 summit. Expect even more protests then. 

Altogether 2014 will be a year of reignited strength in the West and a continuing gradual slowdown in the emerging markets. The West could actually contribute more to global growth than the East for the first time since 2007/2008. This doesn't mean that its problems are over. Not by a long shot. The recovery is not happening because of the policies enacted by the politicians, it is happening despite them (like the housing and energy booms or the reemergence of international trade). It will be bad if the politicians take this good news lightly and halt the necessary reforms. Unfortunately, it seems that this is exactly what will happen.