Short-term solutions for a life-long problem

Just like a big playoff game, a forced shot in the last seconds has made it possible for the US Government to reach an agreement on raising the debt ceiling, see Reuters coverage. It has been, as basketball fans would call it, a buzzer beater.

However in this case, there is no real reason to high-five your teammates or to have even the smallest grin on your face. Because this is not a win, this has only been a disaster-avoiding move. Maybe the markets will see it differently during the first hours and recover some of the ground lost last week (gold is already down a little), but the situation is still critical, and the rating agencies' threat to slash USA's AAA rating is still there.

The last minute deal that has helped avoid the possibility of the US defaulting on its debt includes a 2.4$ trillion spending cuts package to be applied for the next ten years (no extra details are known yet about how and where they will be placed). However these cuts will not be introduced until at least 2013. The reason behind that? Sadly a partisan one, as 2012 is election year and neither Democrats nor Republicans want their chances of winning the presidential race altered because of something as ugly for voters as these spending cuts. Of course spending cuts are never popular or welcomed decisions, it is far easier to "buy" a vote by promising new social measures or tax reductions than by being responsible with your country's finances... but these cuts are sure needed and someone has to do them. Once again short-sighted and selfish political interests take the upper hand and put everyday's problems and the future of the economy to the background.

I must say something to justify Democrats and Republicans decision to delay the cuts until 2013 though, the US economic recovery is being quite weak and slow as of today, so applying extra spending cuts now could definitely stall said recovery. And the last thing the US needs now is an economic contraction, as it would be devastating, specially regarding unemployment. But once we have reached this point we can say that this is (once again) delaying the problem, not solving it. 

We are in a situation where people should already notice that a great part of the economic growth of the pre-2008 years was debt-based rather than real growth. Financial irresponsibility has been the most common behavior regarding government spending and debt issuing, not only in the US but elsewhere. Now the time to pay the bills has come, but nobody seems to be up for the challenge.

Lehman On My Mind

The US government still has not reached an agreement on raising the debt ceiling, the markets turn their backs on Spain and Italy, stocks worldwide erase all their recent month's earnings in two days, gold is near its historic high again... Everybody seems to be expecting another big hit to the economy sooner rather than later. We have already been there, we should know what to do. Quoting the great Ray Charles "No peace I find, just this old sweet song keeps Georgia on my mind". In this case the name may not be Georgia but Lehman Brothers, and the 'song' may not be sweet at all, but we should have it on our minds...

Because while preparing for this kind of impact, what people are not figuring out is that they are inadvertently paving the way for said impact to be much stronger. Nobody seems to trust anybody else these days, and this is bad, very bad for market stability. No matter how long you have traded or invested with a counter-party, no matter how strong and risk-averse you have been for years; in the eyes of others nobody seems safe against what is coming. 

Lehman Brothers' situation was really bad, but it was the mistrust from its clients, partners and rivals that put it into a corner and accelerated its demise. This mistrust seems to be the general rule in financial markets these days. Today everybody is hedging against everybody else, buying insurance and taking CDSs (Credit Default Swaps) through the roof. This mistrust has enough power to stall the global financial markets; and as we recently became aware of, a financial crisis can transform in a fully fledged economic crisis in the blink of an eye. If that was to happen we would find ourselves in the much feared double-dip recession. I do not want to even think about what another economic crisis would mean globally when we are still struggling to make our ways out of the first one. However there is something I can be totally sure of: if such a double-dip recession happened, a lot of players would be out of the game very soon. A lot of companies, and most importantly some countries, would be unable to dodge a second punch when they are still dizzy from the first one.

A skyrocketing euro for a deep diving Europe

Although it is not the first time I write about why I think the actual exchange rate of the euro against other currencies is wrong (see here and here), the latest developments on the Eurozone's life well deserve a revision of the subject. A quick look at the Eurozone lets one see some not very encouraging facts. The Greek tragedy has been quieted down in the last days but is far from over. In fact almost everybody with eyes in the matter is expecting a default sooner rather than later. The only uncertainty seems to rest in knowing if it would be an orderly default, basically a giant debt restructuring effort (hopefully...), or a messy one.

On the opposite side of Europe we have Portugal, but it seems to be in the opposite side only geographically speaking, because its bonds have also been kicked out of investment grade and are now officially  'junk' grade like Greece's. This will make Portugal financing efforts (even) more difficult, which in turn could end with Portugal asking Europe for more money soon. And to complete the domino effect, this troubles are putting extra pressure into Italy's and Spain's not-exactly-buoyant finances.

Credit: Yahoo! Finance

But the euro simply does not care. As seen in the graph above, the euro is rising against the US Dollar, the British Pound and the Chinese Renminbi, and it is doing so with a specially notable rally in the actual week despite all the bad news surrounding the Eurozone. The european currency is spiking also against special cases like the Japanese Yen and the Swiss Franc, although this is a totally different matter. The Yen has its own set of playing rules because of the Fukushima incident, and the Swiss Franc had been overtly growing uncomfortable with its strength against the euro affecting their exports competitiveness. The case with China's Renminbi is a difficult one to analyze, but what happens with the Dollar and the Sterling Pound?

Too public to fail? The moral hazard with public institutions.

Although it copes most of the headlines lately by being the most extreme case, the financial problems of Greece's public institutions are not one of a kind... If you have a quick look worldwide you will see cities, councils, regions... having similar problems to pay their bills. You can find near-bankrupt cities in the US (specially in California and Florida) Italy, Spain, Ireland, Portugal, Japan... Public management at its worst seems to be the common factor, with some institutions walking on the edge of default.

We are not talking about having trouble finding money for new investments or projects, as this would be a totally normal (although not desirable) situation in the actual environment. They are struggling even to pay the most basic of services, like electricity or waste disposal. This problem may not be totally evident to citizens because said services are still being provided, but it is serious enough for everyone to be concerned about it. 

The question is, why are services still being provided if they are not being paid? Well, because public institutions enjoy preferential treatment from their suppliers and vendors. This preferential treatment is not precisely earned by being a good customer, but because of their size. The public sector represents a very big part of the total earnings for some of these suppliers and vendors, so they can not afford to stop providing them. They prefer the prospect of being paid ten months later (and this is not an exaggeration) than losing such a big client. They simply have no other option but to bear this load, specially when talking about local companies whose only client is the city council.

This creates a big problem though, as the inability of public institutions to pay their bills creates a highly destructive domino effect. Suppliers and vendors do not enjoy the same preferential treatment with their own business partners; they must pay on time as specified on their agreed terms or otherwise their partners will immediately stop serving them. As they do not get the money public institutions owe them, the disruption in their cash-flow creates a need for factoring or other ways of financing. And while this can be good for the financial sector, it is devastating for the companies being forced to use it. Some companies get strangled by those extra financial costs to the point their business is no longer profitable. In the end, this companies are forced to close or go bankrupt, leaving their employees jobless just because they had the worst client possible, a public institution.

The problem with subsidies

There has been much talk lately about whether the United States Government should stop subsidizing domestic oil companies like Exxon, Chevron or ConocoPhilips to name a few. Tax breaks to oil companies are an old time practice in the US and no government, either democrat or republican, has dared to eliminate them. The reason why these tax breaks still exist is not clear for me, as oil has always been a profitable industry, even through energy crisis like the ones in the 70's or the Gulf war crisis in 1990. However, recent talks about the need to eliminate those tax breaks and focus the money on alternate energy have spiked some heated debates across the US, mainly due to the already high prices of gas and the multi-billion benefits of oil companies worldwide. This has put the problem with subsidies back in the spotlight. 

People (and corporations) get used to subsidies really fast and once they are fully integrated in daily life they are just perceived as an acquired privilege, rather than what they really should be: a temporary boost to an ailing or complicated situation/sector. This is a big problem for two main reasons. The first one is that, after their initial effect on containing or lowering prices, the subsidized good or service generally goes up as if nothing had happened, thus rendering the subsidy useless. The second reason is, when government retires said subsidy, prices are expected to go up even more, so people will complain about it. And that people will complain is not an expectation but a true fact.

But despite energy subsidies having a distorting effect on the economy, the clearest and biggest examples of the danger of subsidies I can think of are the homeownership subsidies that caused the Irish and the Spanish housing bubbles. Yes, over-optimistic lending by numerous banks makes them guilty by association,  but they are businesses and they responded to the needs of a market. A market governments artificially created. Governments were the true enablers of said bubbles. I will never understand what (if any) is the noble idea behind subsidizing homeownership through mortgages. If said noble idea was giving access to a decent house to low-income citizens renting subsidies would have worked similarly well, yet they did not appear anywhere. Maybe the reason was that buying a house provides far more tax revenue for a government than renting one does... Whatever the reason was, for me homeownership is not a security but a limiting factor, as discussed in this article.

The only thing these housing subsidies have achieved in both of the examples given is a construction boom together with a price spike, and a quite heavy one. In a normal, not mortgage-subsidized market, even after assuming the natural demand increase caused by higher demographics in the period, the situation would have been very different. A housing and construction boom would have led to lower or stable house prices, never to sky-rocketing ones! Sky-rocketing prices that ended busting the bubble that we can easily trace to the drowning of Ireland and Spain economies in the past two years.

The supply and demand law is at the base of economic liberalism for a reason. It is a force powerful enough to shape any given economic sector with common sense. The market is wise enough to decide on the evolution of a sector. Subsidies should only be used in exceptional cases, or to protect distressed citizens from being excluded from the system (think health for example) but never on a generalized scale or on a long-term basis.

Blaming the coming 2.0 bubble on Facebook

Some time ago, a social network called Facebook raised 500$ million from Goldman Sachs (450 million) and Russian firm Digital Sky Technologies (50 million). This operation valuated Facebook at an astonishing 50$ billion. This is more than other well-established digital firms like eBay or Yahoo and double the market cap of Sony. Yes, I know Facebook has 600 million users or 'potential clients' (in business terms), but until now it has failed to monetize them. Its main source of revenue is advertising, and according to reports Facebook's success in it is far lower than the rest of the web. Its users have a clear objective in mind, communicating with friends, thus they do not pay attention to banners. Brands however, have found in Facebook the perfect channel to communicate with their clients; but Facebook itself is not seeing any money from this... In marketing, having a large audience and knowing a lot of information about said audience is key for success; but until know Facebook has been unable to use this at full power (conspiracy theories of Facebook selling user's personal data to other companies aside) so the 50$ billion market cap comes basically from estimations of the company's potential.

Valuating a company based just on its potential is a tricky thing to do, as subjectivity comes to play. In the example of Facebook, maybe it has the necessary ingredients to earn lots of money, but nobody is cooking them into an edible product as of now. This takes us to the point where some very risky bets are done based purely on instinct, not real-world results or prospections. But investors around the world, sad with the absence of  'bulls' to ride on the way to market recovery did not mind that. They began to salivate on the thought of being part of the rise of a new giant, the social internet companies (commonly called 2.0). As such, when the invitation to the party appeared in the form of the LinkedIn IPO, and later the Yandex (the leading search engine in Russia) IPO the market was all-in. 

Anti-nuclear movement, helping the German economy go wrong

This week we have witnessed the incredible announcement by German Chancellor Angela Merkel saying Germany will abandon nuclear power totally by 2022, when it will shut down the last 3 remaining nuclear plants that will be in service on that date. Germany has a total of 9 nuclear plants providing energy to the grid as of now, accounting for 23% of the energy mix. Merkel's bet is to replace nuclear power with renewable energies, a move that is expected to harm the German industry greatly by increasing its energy bill. In fact this will be the second most important factor to hit Germany's industrial competitiveness in a row, the first one being the actual exchange rate of the euro against its clients' currencies. 

Neckarwestheim nuclear plant

Even though Germany is the world's 4th biggest economy and Europe's number one, it is not bullet-proof. The last thing the German industrial sector needs is its energy bill rising non-stop or being unpredictable. Because let's face it, whether you are pro-nuclear or anti-nuclear you know shifting from nuclear power to any other source of energy is an expensive move. 

In the case of Germany, the shift will be made towards renewable energies, which are expected to add up to 35% of the total energy mix in 2022 (up from 13% today). In a country where the industrial sector takes more than 50% of the total energy used, the main problem with renewable energies will not be their price, but its unpredictability causing blackouts. The sun not shining, the wind not blowing or simply a specially cold winter day could cause a blackout on peak-hours. When renewable energies are used to cover domestic demand, this unpredictable behavior can be covered with some natural gas power plants, which are fast enough to be plugged into the grid when needed and disconnected shortly afterwards. But industrial demand is far bigger and more important, so that could mean said natural gas plants have to be on most of the day to avoid power disruptions, which would probably kill Merkel's objective of slashing carbon emissions by 40% in 2022, meaning she would have hurt German industry for nothing.

So what are the reasons for such a sudden rush in leaving nuclear energy behind?

Looking for a better life? There's an index to help you find it.

The Organization for Economic Co-operation and Development, better known as OECD, has created what they call a 'Better Life Index'. They have put together a great amount of data from member countries, organized it by topics, mixed and stirred the numbers and the result is a simple, 0-10 scale mark for each topic and country. Unsurprisingly, the 'popular students' have come out on top: Sweden, Norway, Switzerland, Canada, the Netherlands, Denmark, Luxembourg, Australia...

Life Satisfaction Index. Credit: OECD Better Life Initiative

Maslow's pyramid. Credit: wikipedia

The Better Life Index is born as a way to measure the progress of a country beyond the limitations GDP growth figures pose, specially for developed countries. Because let's face it, GDP can be booming in China but life is still way more comfortable in a cozy hut on the Swiss Alps. When you reach certain economic status and your needs are covered, GDP growth goes into the background and work-life balance, personal fulfillment, education... take the center stage. It is just another implication of the widely known Maslow's hierarchy of needs. Only when you have covered your basic physiological needs you can start worrying about the upper levels. The most useful feature of the Better Life index is that you can interact with it. So, independently of what Mr Maslow said, you can define the importance each of the eleven available topics have for you, overweighting the most important ones or simply avoiding others. 

Maybe you have kids and education is now far more important than income. Maybe you are retired so your only worries are now safety and health to be able to enjoy life. The possibilities and combinations are endless... But like it or not, what most of the people are now worried about is housing, and this is where the Better Life Index comes short, showing its biggest and more serious flaw. The housing topic takes into account two indicators to calculate its mark: average number of rooms per house and their access to basic facilities (plumbing, electricity and such). Seriously?? We are talking about arguably the 34 most developed and industrialized countries in the world and all you can think about to evaluate housing standards is having a faucet in the bathroom? A lot of better ideas come to mind when thinking about ways to evaluate housing in a country.

Recommended reading: The tragedy of the euro

Even though it is almost a year old, just yesterday I came across a book called "The tragedy of the euro" by professor Philipp Bagus from Universidad Rey Juan Carlos in Madrid. I have not had enough time to read it thoroughly, but what I saw in that short time span is more than enough for me to recommend it to everyone interested in knowing about the future (if any) of the European currency. You can find the full book here (PDF) thanks to the Mises Institute.

It is a story of good and noble ideas being badly applied or intentionally misunderstood. It is a story of how the fathers of what today is called the European Union tried to establish economic liberalism all across Europe, thinking of the possibilities, progress and growth an European-wide open marketplace could bring. But sadly, it is also a story of how some countries, specially France, managed to convert this great idea into a fully-fledged European super-state. A super-state with limiting regulations, the typical bureaucratic slowness and stiffness and inefficiency in general.

The book explains, with piercing clarity, the different motivations behind European countries to adopt a unified currency. Periferic countries like Greece, Ireland, Portugal, Spain and also France saw in the euro a great way to keep printing money and issuing debt (a necessary by-product of their deficit-prone economies). With an unified currency they would be able to hide the inflation caused by this objectionable tactics, as there would no longer be a Deutsche Mark to be compared against.

How did they convince Germany to be part of such an awful plan?

LinkedIn IPO craziness. A new giant? Or the start of a 2.0 bubble?

Yesterday's (19th of May) session at Wall Street was a much anticipated one. It was the day LinkedIn, dubbed the 'professional social network' went public. Initially valued at 43.5$ per title, which would have roughly added to a $4.1 billion valuation, it was already a high enough price for some. But the demand for the stock was overwhelming and it astonishingly skyrocketed during its first session, reaching a peak of +160% during the day, to finally end the session at almost +110%. That left LinkedIn valued at 94.25$ per share (NYSE:LNKD), or if you prefer it, a total market cap of $8.91 billion!

The behavior of the LinkedIn stock on its first session ever shows a renewed appetite for tech companies, which is good for the market, but honestly I find it to be a quite unrealistic performance. It says more about traders looking for some lonesome bulls in the middle of the last week's reigning uncertainty, than about the real short-term prospection of the company. But do not let the stock price fool you into thinking LinkedIn is a one-day flower, its future looks bright, with a first quarter 2011 revenue of $94 million, more than doubling the same period of 2010 ($44.7 million), and having surpassed the 100 million registered users milestone. 

LinkedIn has shown that social networks can truly be monetized, something Facebook and Twitter have been unable to do, and the main reason why both of them are not still publicly traded. Although you can count on them going public in a not-so-far away future... 

LinkedIn (LNKD) graph from 1st day on NYSE. Credit: Google Finance

They say knowledge is power, and there is no doubt that social networks have an enormous wealth in the form of personal information and other data, but there is no direct formula to turn this knowledge into money. LinkedIn, thanks to its professional incline, seems to have found the magic formula and just so you know it is the following: 33% revenue comes from advertising, 21% comes from selling premium subscriptions and the rest comes from services to companies and headhunters.

My doubts do not come from LinkedIn's future, but from the reaction of the market to its IPO and the precedent it creates given the late eagerness to invest in internet firms like Twitter, Groupon, Baidu, Yandex, Facebook... regardless of them being viable companies economically or not.

When rescue packages are not enough, a Greek tragedy in the making.

The astonishingly beautiful deep blue waters of the Aegean sea must be starting to boil as of now, with the economic situation in Greece heating up even further. Debt-to-GDP ratio has reached 143%, Credit Default Swaps are at 1371 basis points, S&P downgraded (once more) Greek debt to B rating from BB-, taking it only two steps about the C rating, which effectively erases one from financing and flags you as someone waiting to default. To make matters worse, often-violent demonstrations are stopping the country's already ailing economy day after day. I truly can understand the frustration the situation causes, but halting economic activity is clearly the worst thing to do in the actual situation...

Another rescue package, combined from both the European Union and the IMF (with or without Dominique Strauss-Kahn), seems to be in the way but its effectiveness is already in doubt. A recent poll shows almost everybody thinks this would be artificial life support for Greek debt. Sooner or later a default or a painful debt restructuring process seems to be coming. Not being a debt restructuring expert, just based in common sense I can only say: make it sooner rather than later.

Extending this situation is bad for everybody, it is bad for Greece's future, bad for Portugal and Ireland debt prices and bad for the whole euro area's stability. Stop being stuck in the actual situation, a situation that slowly built the hole where you are now. Just change everything! 

First thing, go out and make the people understand why spending cuts and privatizations are basic, unavoidable and necessary to have a future. You can not afford to have your people burning policemen, destroying everything that comes close and shutting down air transport... Tourism is a keystone in Greece's actual economy, so flying stones and burnt buses are not the best of promotions for the country. In fact any company thinking of investing in Greece as of now would be held back but the situation on the streets.

Microsoft's impulse buy. Expect buyer's remorse soon...

The net is still shocked by Microsoft's buyout of Skype for $8.5 billion. The adjectives whopping, astonishing, unbelievable, incredible, crazy and stupid are among the most repeated when describing the price Microsoft paid for the VoIP company. People do not forget that when eBay purchased Skype in 2005 it did so for $2.5 billion. That price also seemed very high at that time, people were still remembering the excesses of the dotcom era. However back in 2005 when eBay bought it, Skype was still a promise, a young and innovative company with lots of room to grow and lots of potential for doing so. 

While Skype is still young and innovative it can not be considered a promise anymore, but a fully mature company. Its earning reports matter like any other company's and the last one showed a $7 million loss. It has a user base of more than 663 million but as of now, Skype is making a slender profit of approximately 1.30$ per user. These are some numbers that do not help justify the price Microsoft has paid.

But Microsoft knows this, its is impossible to justify the price paid based on the numbers, so they are focusing on the intangible instead. Microsoft talks about seamless integration with its Xbox360 network, about the synergies between Skype and Facebook (which was thought to be a bidder for Skype too and has a partnership with Microsoft) and about integrating it with its latest Windows Phone 7 mobile phone OS.

All of these look like legit reasons for Microsoft to buy Skype; but seriously: who does think these synergies are going to compensate the price paid? Not even in the long term... 

For me, the real reason for Microsoft to purchase Skype is mainly:

Misunderstanding the commodities plunge

Last week we witnessed the biggest plunge in commodity prices since the post-Lehman era (2008). Every commodity fell an average of 10% during the weak: wheat, cotton, soybeans, iron, zinc, silver, gold... even the mighty oil took a step down (and that is big news!). Part of this plunge was quickly erased as a rebound started right on last friday, but the situation is quite stable at the time I am writing this.

People started to reason that the recession was back, that the industrial sector was not growing as expected, that we are not producing enough or consuming enough of what we produce, that a dry spell could risk wheat crops in some parts of the world... According to these same people sometime during last week we stopped eating too, because food commodities also fell. These people are very wrong, we never were recovering strong enough to justify the never-ending rise of the last months neither we have suddenly stopped recovering now to justify the plunge. What are the real conclusions we can take away from last week's events? 

I see clear proof that speculators rule the commodities market.

Canada goes the cost reduction way

Canada had its general elections last Monday and while the winner, the actual Prime Minister Stephen Harper from the Conservative Party, was totally expected; the result boosted him to a majority government. With their hands untied from a minority government against the New Democratic Party, Mr Harper's Conservatives are now free to apply the keystone point in their electoral program, taxes and government spending reductions.

Stephen Harper celebrating victory

I have expressed my concerns on excessive government spending worldwide on previous posts, Canada was not an exception there, with 39.7% of GDP going to government expenses every year... Canadians have expressed their concerns with the matter too, strongly supporting the only party that promised to reduce said spending. With this move, Canada joins the trend of slashing government spending, a trend that started in Europe to fight troubled economies like Greece's, but that has gone mainstream since then on developed economies. Finally everybody begins to notice the weight of the state is unbearable as of now, recession has made this blatantly visible.

I will not analyze in detail the politics behind Mr Harper's party, but from a macroeconomic point of view Canada is in a far better position to boost recovery than for example European countries. Canada is one of the few net energy exporters (together with Norway) among developed countries and is also the world's second biggest uranium producer with 20.7% of production. Not only they are exporting energy abroad (which at actual prices is quite a good business) but they are energetically independent as they control the supply for their main energy source, nuclear energy.

This independence means their recovery plans will not be heavily altered by raising energy prices, or tensions in the Middle East for that matter... If the Conservative's deficit reduction plan works as planned and corporate tax reductions really help boost employment I would say it is quite possible for them to be able to beat IMF's expected GDP growth of 2.8% for 2011. I am confident on every economy that successfully covers its energy needs and Canada has been doing it for a long time.

Energetic independence partly shields Canada from the never-ending commodities rally and thus gives it the most desirable ground for economic recovery and growth: a ground where it can focus on its own economic efficiency.

Oil prices shape the present and the future of the economy

Modern economies are oil-junkies, and they will still be for a long time. Every movement in the price of oil, no matter how small, reaches the furthermost endpoint of the economy. Without hesitation I can say that oil price is the key factor shaping (and limiting) the behavior of our day-to-day economy. An even more important factor than interest rates or currency exchange rates, which are predominant in the long term.

Actual oil prices are the result of a deadly combination of circumstances: political instabilities in oil producer countries, a low exchange rate of the US dollar (still the preferred currency when trading oil), rise on total demand due to developing economies and last but not least speculation. The extended duration of this situation is very worrying for both oil consumers and oil producers. Consumers, meaning developed and developing economies as a whole, have their GDP growths strongly linked to oil prices, as it has the power to increase the cost of production and distribution processes and also personal transport expenses; all of them key drivers for a healthy economy.

On the other side, oil producers fear that high oil prices can harm demand. Even though oil demand has historically been highly inflexible, as energy is a primary need, it also has its breaking point. This breaking point is that where more expensive energy sources (think alternative energies) become affordable when compared with oil.
Oil producers are aware of this breaking point and on the last days we have seen reactions from Saudi Arabia and Kuwait, biggest and 7h biggest oil exporters worldwide respectively, saying they do not endorse such insanely high oil prices. They are profiting largely from these high prices, but at the same time they show some much needed common sense by acknowledging high oil prices can brake or break economic growth. They need their clients' economies to grow, to need more and more of their precious oil.

The government, that drag on the economy.

In the previous post, on why economic recovery was being compromised by excessive and useless government spending I quickly illustrated my point with a table showcasing government expenditure in percentage of GDP and also average tax burden on percentage of GDP. I did not analyze the data from the table though, it deserved its own post. So let us have a look at how much money the governments need in some countries:

2011 data from The Heritage Foundation , The Wall Street Journal via Wikipedia

The highest percentages on government spending are found scattered across developed countries, specially in Europe. On Baltic countries (Denmark, Finland, Iceland, Norway and Sweden) we can see the percentage even goes over 50% of GDP . No surprises here, blame it on their splendid welfare systems everybody loves... The real problem is not welfare systems themselves, but the progression of the government spending in the latest years. People would agree with me than welfare systems and social measures have not increased during the last 5 years, in any case they have been reduced, but government expenditure on the other side has kept growing, as plotted in the following chart for the biggest economies in Europe.

Credit: Eurostat

The corrections on the growing trend seen in the 2010 data, as you may expect, are related to the austerity packages endorsed by the European Union to fight the financial and debt crisis. But these corrections have been too soft to correct the situation. Economists and traders everywhere (The Economist devoted an issue to this matter) see the situation as unbearable, which explains the rising concerns on sovereign solvency that has plagued the markets and has already blasted through Greece, Ireland and Portugal.

But if this has been this way for a long time, what can possibly have changed to make the situation so worrying for developed countries?

Losing ballast for a faster recovery: Slashing the government

Almost every developed country worldwide is nowadays fully immersed on its own fight for economic recovery. But this fight is made tougher by high unemployment rates, sovereign solvency doubts, inflation and financial speculation. The resultant situation is hard to tackle for governments: they need their economies to grow but they must ensure they are solvent and responsible, thus being a stable soil for said recovery to grow on. 

I am not going to discuss the measures for economic growth here, but the ones used to keep the state under control. These measures to try to lower government spending range from budget cuts, the end of some subsidies, establishment of debt ceilings, social services restrictions... to issuing (more) debt to be able to keep public spending at actual levels. Some of these moves are smart, some of them are insane, specially the debt issuing one... But all of them are late, very late.

2011 data from The Heritage Foundation , The Wall Street Journal via Wikipedia 

 

In the last decades we have grown accustomed to bigger and bigger states, with a never-ending growth in civil servants, entities, organizations, committees... Just have a look at the table above on the column for Government expenditure in percentage of GDP and you will see some unbearably high numbers (I will come back to analyze this table in a future post). This growth in size and cost was associated with the growing complexity of running a state in modern times, the never-ending appearance of new social measures and so on. Everybody let the parasite grow deep inside us, and when the ride was smooth nobody seemed to care about the extra weight that was being placed on the shoulders of the economy. But what now that we are on one of the bumpiest sections of this one-way road that is history? No matter how much horsepower your car has, if you start putting rocks in the trunk its performance will fall to the ground.

Stopping the government growth and its crazy spending is not enough, we must shrink its size and cost to reasonable levels. But how do you shrink a government without stopping its functions?

Get used to China's trade deficit

When the balance of trade for February 2011 was published a lot of people were genuinely shocked to see that China had a 7.3$ billion trade deficit, the first since March 2010. When those same people think of China, they think on an enormous factory and lots of container full of goods ready to be transported to the West. While this image is right to some extent, they seem to disregard China's soaring internal demand for non-Chinese goods (mostly luxury items) and the uncomfortable neighbor that rising commodity prices are.

China's main clients are Europe and the USA, and with both of them growing slowly in the first quarter of 2011, exports have obviously slowed down too. China knew this, and expected to offset this slowdown with increasing internal demand. However this internal demand had another idea, it has focused mostly on non-Chinese goods... China is starting to have an incipient middle-upper class, but more importantly it is creating lots of new millionaires every month. And this newly created wealth is mostly being used to buy western goods, specially luxury cars, high-end clothes and fine jewelery. Take as an example BMW and Mercedes, whose sales in China grew 76% last year. This can be the biggest example, but it is only one of many; luxury clothing brands keep opening flagship stores (mainly in Shanghai) to fill the never-ending Chinese appetite for foreign luxury.

How many containers full of light bulbs, ipod accesories or handkerchiefs do you need to compensate for a Chinese entrepreneur buying a fully-equipped BMW 7-series? There you have your trade deficit...

Germany's biggest enemy: a strong euro.

Neither the (now certified) fall of Portugal nor increased debt pressures on other european peripheric countries have been enough to tumble down the never-ending rise of the euro exchange rate against other significant currencies. This should be very worrying for the heart and engine of the eurozone, Germany. I am sure Germany is already worried about that, what I mean is they should be worried enough to do something about it. 

A net exporter like Germany should not allow its currency to be its Achilles heel. Ok, the currency is not really German, but they are its founding fathers and the main reason why it exists... With this in mind, it becomes very difficult to understand why they allow 'their idea' to make their international trades more expensive and complicated. In the actual economic situation, competitiveness and efficiency are key to keep selling and Germany can lose their edge because of this. It is survival of the fittest.
The competitiveness indicators based on consumer prices published by the ECB show this trend clearly, see charts below (where 100% equals the index value in 1999 ) with an obviously sharp decline coincidental with the rise of the euro.

Harmonised competitiveness indicator for Germany. Credit: Deutsche Bundesbank

A strong euro is obviously good for debt issuing, for general borrowing and for imports but it can really hurt the muscle of Europe. Maybe you could think of it as eating everyday at McDonalds (no bashing here, just an example): it is cheap, it is easy and convenient as you can find one almost everywhere and it gets you through the day. But in the long-term fats are bad for your figure and, more importantly, bad for your most important muscle, the heart. The European Central Bank (ECB) is damaging the heart of Europe.

Reasons for an oil producer to go nuclear.

This same week I read at Bloomberg's Businessweek that Abu Dhabi, the 7th country in the world by estimated oil reserves, is building a civilian nuclear reactor to go-live on 2017. The article mainly focused on the assertiveness of the United Arab Emirates (UAE) going forward with their plans despite the ongoing events at Fukushima. Nothing exceptional here from my point of view, as there is nothing in common between the Fukushima plant and and what  the UAE is building in Braka together with Korea Electric Power Corporation (KEPCO).  What I am most interested about is the fact that one of the oil-richest countries in the world is going nuclear.

Illustration of the future, 4-reactor nuclear plant.

Internal energy demand is growing fast in Abu Dhabi, but it is still marginal compared with all the oil the UAE is exporting worldwide. We know Abu Dhabi, as every other producer, can have oil for cheap, so its domestic oil consumption would not justify the huge investment a nuclear energy facility demands. We could also consider Abu Dhabi not a front runner in climate preservation, and because of their small population density they do not have to be much worried about their fossil fuel emissions neither. 

So what could be the reasoning behind this ambitious nuclear plan started in 2008. Are their oil reserve estimates too optimistic? Do they prepare for a sooner-than-expected post-oil era? Or are they simply trying to keep their energy independence? Not being suspicious here, just trying to make some sense of such an expensive and (unfortunately) controversial decision.

Crazy or genius ideas: Individual Carbon Emissions Cap (II)

On the previous post I put on the table an idea to help control carbon emissions at an individual level while at the same time creating a way for citizens to monetize from their energy efficiency. I named it the Individual Carbon Emissions Cap (ICEC for short). After explaining its inner workings on the first post, now is the turn to explain why I think it could be highly beneficial for the economy.

Motivation

I am fed up of seeing the utility companies promoting energy saving and efficiency (even though one could think, on first instance, it goes against their business) but governments doing nothing but subsidize renewable energies producers. Renewable energies, as of today, are not capable of covering our whole energy consumption and they will not in the short term either, at least if we follow our historical trend of growing consumption. For renewable energies to really become alternative energies, efficiency measures must be applied to our daily life.

That is where ICEC kicks in, by setting a comprehensible limit on individual carbon emissions it promotes energy efficiency while at the same time boosting non fossil-based energies as they do not emit any CO2.

Prize efficient people, punish wasteful spenders = Prize the economy

I do not want anybody to think about the ICEC as a tax, because it is not. It could only become a tax for someone who is not capable of living without wasting a lot of energy by doing so. If that was the case, then tax him like you would with a normal business... The ICEC limit is high enough to not disrupt you usual life habits, but at the same time giving you an incentive to be efficient. For those who find the way to be efficient, the prize could not be more obvious: cash. Well, apart from the peace of mind of helping the environment and such... This cash could be forced to be for consumption only (if needed), then it would give a much needed boost to our weak economic recovery by increasing goods consumption. The best part? it would come at zero cost for the government, no need to raise taxes to the already tax-massacred citizens and, collaterally, it would mean increased earnings from VAT and other already existant taxes on consumption.

Crazy or genius ideas: Individual Carbon Emissions Cap (I)

This marks the start of a new series of posts that, from now on, will share the blog's spotlight together with the habitual posts analyzing the situation of the global economy. These series will be far more subjective than the economic analysis posts, I will just expose some ideas that cross my mind. That means I could incur in some inaccuracies from time to time, so take it with a grain of salt. 

When there is so much talk about carbon emissions, lowering carbon footprints, global warming, the problem with fossil fuels, etc. what if  we began helping by setting a yearly CO2 quantity that people are allowed to emit? I am talking about creating an "Individual Carbon Emissions Cap", similarly to what it is done with industrial emissions as stated by the Kyoto Protocol but taking it a step further by making citizens part of it. 

What does this mean? Every participant country would set an Individual Carbon Emissions Cap (from now on I will call this ICEC for clarity's sake) for its citizens; a defined number of kilograms of CO2 that one person was allowed to emit to the environment over a year. For some people ICEC would instantly become an asset, for others it would mean a new tax, but in any case a tax you have control over... People would be able to trade part of their ICEC on a newly-defined public market (obviously with fixed prices per year to avoid the speculating vultures from spoiling the idea) and they could also make their cap grow by planting trees, sharing cars, installing or buying energy efficient devices and similar tree-hugger 'activities'. 

And now Portugal... But hunters already looking for their next prey

Here comes the latest member (it is almost there) to join the euro-bailout club: Portugal. This is not breaking news, as everybody was expecting this to happen sooner or later. It is not frightening either, as Portuguese contribution to the whole European GDP is relatively low; it is lower than that of the Irish and clearly the eurozone did not break because of Ireland's (or Greece's) bailout. Belgium is mentioned too, but that would not pose a much bigger problem than Portugalm, but what IS frightening economists worldwide is the possibility of Spain or Italy being next.

Portugal 10-year Bond. Credit: Bloomberg

The pattern on European bailouts is becoming worryingly clear. One country's economy begins showing signs of slowing down and continues with its excessive debt issuing. Rating agencies notice (thus making the yields go up), international investors notice (and ask for bigger yields on said sovereign bond) and last but not least speculators notice and try to take advantage of the situation. The death spiral has begun and everybody knows the results... The same moment this happens, the whole financial world locks in to their next target; the most suitable candidates being now Spain and Italy. The first expression that comes to mind when mixing the word 'bailout' and the name of Spain is 'too big too fail'. The expression is already familiar for American people but European people have not suffered it yet. The falls of Greece and Ireland were manageable for the European rescue fund, but a crash in Spain, or Italy, would pose an enormous problem to the whole eurozone. But disregarding what the hunters (speculators) want, is really Spain in need of a bailout? 

The tsunami reach on the global economy

On previous posts we have done a brief analysis on the devastating effects of the earthquake-tsunami combo on the Japanese economy. To have a more general and complete view of the events, one has to look at the other side of the story too, the collateral effects the damage suffered by Japan will have on the global economy. Over the last days we have heard words of relief from Japan's government and from analysts saying that the bite on Japanese GDP will not be as big as thought on first instance. But, no matter how fast the world's third biggest economy can recover from the disaster, the weight of said economy makes it impossible to dismiss the effects it  will have in the coming months (and is having as of now) on the march of the global economy.

Countries affected

The first wave to affect the global economy was a logic fund repatriation, specially from Japanese banks and insurance companies in need of liquidity to begin with reconstruction tasks at home. This initial repatriation made the yen go higher instead of immediately falling as expected, but this is not something to fear specially for the rest of the world. What some people are fearing is that Japanese mutual funds, hedge funds and instruments alike began to massively withdraw their positions over the rest of the world to take their money back home. If this movement is done gradually no significant damage would be done, Japanese money would simply be substituted by somebody else's money. But if this repatriation was to be done massively it would pose an important threat, specially for emerging markets. Emerging markets usually rely on bigger economies' capital to fund their growth, to the point where a runaway of Japanese money could partly derail short-term growth expectations for some emerging markets. I am not talking China, Russia or Brazil here which are exposed but big enough to not notice a heavy change. I am talking about smaller markets like South Korea, Singapore, Hong Kong, Taiwan, Malaysia, Thailand, South Africa or Chile.

Uphill battle for Japan. How can they fight it?

While the situation is extremely tense in Japan at the moment with all eyes set on the Fukushima Daiichi Nuclear Plant, the Japanese markets are open and the obvious, not ethic at all but expected nonetheless, has happened. The Nikkei plummeted more than 11% in the earthquake's aftermath just to regain more than 5% today. Japan is now officially the playground for avid speculators and this can do no good to the forthcoming Japan recovery. 

It is quite difficult to ask for stability in the markets when the country itself is still (literally) shaking, but investors and speculators should leave Japan some room to breath, for the greater good. Japan is still one of the biggest economies worldwide; playing against it just to make some easy money now is quite a stupid, short-sighted and naive thing to do and could have heavy consequences in the future. But we know human stupidity is second only to human greed, and that you cannot expect nothing good from the same people that invented subprime-mortgage-backed securities and thus brought the world economy to its knees... So let us analyze what Japan can do from here on.

Credit: Yahoo! Finance

Japan's instruments for recovery
Japan's economy is one of a kind, after booming heavily during the eighties, it entered a phase the Japanese call "The lost decade", stagflation after their asset bubble burst has plagued the economy since then. The global crisis we have been suffering since 2008 has not helped Japan totally get out of their slump at all, even though before said crisis Japan showed promising signs of recovery with GDP growths better than Europe or the US. Still, Japan is the world's third biggest economy after USA and China so it will not be bare-handed through its long, hard, recovery.

Japan's earthquake biggest replica: the economic one

First of all, my thoughts are with the Japanese people in these difficult moments. I am sure being such a hard-working, disciplined and respectful country they will have no (unmanageable) problems getting over it very soon. 

Earthquakes as big as the one that hit Japan last night are always followed by numerous replicas of different strength. These replicas can last for several days until the tectonic plates 'settle down' again. Well, we have begun to see what can be the biggest and more widespread replicas of said earthquake: the economic one. Few hours have passed since the disaster and we can already see the effects on the markets: oil prices, gold and stocks go steeply down and the german bond and the US dollar go up. Pure textbook reaction.

ECB raising interest rates. Damage control?

Take a quick look at the news an see how many times the expression 'raising tensions' appears on articles lately when talking about the situation in the Middle East. I am sure you do not have enough fingers to count them... Now take this same expression but exchange the word 'tensions' by 'interest rates' and see everybody panic and run for their lives. Although we have lived (and we are still living) one of history's longest period of low interest rates, people keep asking for more. Governments and enterprises around the world have grown so accustomed to debt issuing and uncontrolled spending thanks to cheap money that mentioning the slightest interest rate hike makes them shiver.

The key factors to justify a (slight) interest rates raise are all there though: we have growing core inflation, uncontrolled energy prices, excessive debt and severely depreciated currencies. On the other side we have a weak, mostly artificial recovery (already mentioned), that depends heavily on the availability of cheap money. Which side has a more important impact on the future status of the economy? It is clearly the first one, no hesitation. The Middle East turmoil is not coming to an end soon, and until it does the oil barrel price will keep rising, putting even more pressure on inflation control measures.

More inflation in the actual scenario we are facing would kill all recovery aspirations on the medium and long-term, even if it now seems detrimental for the short-term.

Do not get me wrong, as of now, a raise in interest rates will be hard to handle, specially for debt-burdened countries like Greece, Ireland or Portugal. It would be bad for Spain too even if its debt situation is marginally better, because all the semi-public savings banks (called 'Cajas de Ahorros') are now undergoing reforms to transform themselves into normal banks. A process that needs, and will need, a lot of funding and bond issuing on their part. For these troubled countries higher interest rates mean only one thing: more expensive financing, that is all they can think of when they hear these words.

The US Dollar not-so-free fall

When talking about international trading and investing everybody has grown accustomed to the same face, the US Dollar. It was at the core of any transaction, it denominated almost all the financial instruments you could think of and it was the shelter everybody looked for when things got ugly (this last one was shared with gold obviously). But this familiar face seems to be aging quickly for a number of reasons and, most importantly, it does not seem to care about it.

This omnipresence of the USD has always been key for the US economy, as it has allowed for the US to issue more and more debt at quite low prices independently of the markets situation. The perceived-risk of the US debt had always been very low (notice the past tense here). The US government of course knew this, and used it on its favor but they have been using the strategy for too long and too hard. As it happens with everything, if you overuse and stress something for long enough, it breaks...

EUR-USD exchange rate. Credit: Yahoo!

 

Tuning down inflation

Falling into deflation or stagflation has always been one of the greatest fear for politicians, economists and enterprises. A negative inflation rate theoretically means less money is available, in turn that means less credit and everybody knows what that means in a debt-dependent world like ours. Also deflation is correlated with lower prices, which people tend to associate with depressed economic growth. Whether one agrees with this affirmation or not, during last year's credit crunch it made some sense to be fearing deflation and its consequences,  thus no one worried about currency devaluation and general credit easiness to avoid it all costs.

Now, after the crunch is mostly forgotten and credit channels work again as normal, it begins to look like a flagrant excuse to keep interest rates at all-time lows and to support the worrying commodities rally. 

Strangely, some economists are still asking for a moderately higher inflation as a way to increase competitivity and as a way to cut salaries inadvertently (you cannot lower them without complaints, but you can make them effectively lower by increasing inflation) to boost employment. Everybody knows how to raise inflation, what is difficult is controlling its raise. Raising inflation when official levels are well under 4% would no be a problem by itself, the issue here is that official inflation levels are all wrong.

Davos tells the world to be optimistic, the world does not care.

The one-word conclusion one could take from the Davos' World Economic Forum (WEF) 2011 meeting from last week would be "Optimism" because that was what every big corporation CEO and every government leader were continuously saying, but everybody knows saying something a lot of times does not make it more real than saying it for the first time. 

For sure this optimism cannot be based on the Global Risks 2011 report that the World Economic Forum published because the data shown there is quite worrying. Let us have a quick look at this data.

Social Media, the ultimate WMD.

When George W. Bush decided to invade Iraq one of the main reasons (of the public and politically correct ones) was not only to free the Iraqis from the oppression of Saddam Hussein, but to stop the menace Saddam's Weapons of Mass Destruction (WMD for short) posed to the stability of the Gulf region. After months long of thorough search for said WMDs none was found. Maybe they were looking for the wrong WMD...

If you look at all the civil unrest happening across Arab countries in the last weeks you can clearly see that the ultimate WMD is neither a nerve gas nor a new virus, but Twitter, Facebook and social media in general.

Going underwater? Learn to swim

With the housing boom and bust of the last years a fairly new phenomenon has been born, I am talking about 'underwater mortgages'. People were blind and naive to think that the housing market will incessantly go up. Banks, mortgage intermediaries, real estate salesmen, governments and even some economists (that is the most unbelievable part) helped uninformed people think this was true and was going to be for ever after. Of course they all had their own interests in making this fallacy last as long as possible, making the mother of all bubbles grow forever. "Buy a house! It pays by itself" Can you already see the problem with this?

Debt death spiral

Issuing debt when you have problems is not the answer. It is not the answer for today's problems and obviously it will not be the answer for your forthcoming problems... In fact it creates more problems for the future. Take the case of a struggling household, what is the wise thing to do if your income was to decrease for some reason: Keeping your spending as usual by borrowing money? or trying to optimize it and reduce expendables? Everyone on its right mind will tell you the later is the only responsible and logic way to go. Well, everyone but European governments or so it seems.

The euro, evolved. Europe's way out?

As we discussed in an earlier post, one of the possible solutions to the problems the single currency is causing to some eurozone members would be to split said currency into two different ones. The main purpose of this would be to better focus on the members' vastly different and diversified needs and demands. However this move would not be free of charge... 

Let's do a quick analysis of what this currency split would mean. 

Europe. Opposed realities, same currency

When the euro was born in the late 90's everybody (except for the UK and Sweden) thought that adopting it was the best way to boost the European Union (EU), to establish it as a competing power to the supremacy of the United States and its reference currency, the US Dollar. It was expected to facilitate intra-EU commerce and tourism, ease the access to credit and financial instruments and making them more stable at the same time. Purchasing power and exports-imports from EU companies would benefit from having a better reference instrument to compare their money against the rest of the world currencies, lowering the risk introduced by exchange rates fluctuation worldwide. It really had all of those benefits, at least at the beginning... 

Economic policy new year resolutions

Each and every new year people make bold statements about changes (for the better) they are decided to apply to their lives from the very beginning of said year. Now replace the word 'people' with 'government' and 'lives' with 'countries'. Does this sound familiar? Yes, every government promises to change the country for better, but as it happens with people, most of them end up doing the same thing, committing the same errors over and over again.

This year should different though, numerous countries are in a situation where, if they keep doing the same, they will not stay the same, but they will go deep down. When the global outlook was (artificially) good, governments' mistakes were easily eclipsed by the housing boom, low unemployment rates, easy money and a ridiculously big government spending. Not anymore.