Helicopter Money (Part 3)

Money is never free.

Photo: Jon Cutrer. Source: Morguefile

Even if all you do is print more bills, you still need to pay the printers. That’s what Venezuela is finding out. Late last year, the government needed to satisfy a growing currency shortfall. In December Venezuelans throng to the banks to cash in their bonuses, and like everything (but oil) in their economy, bank notes have to be imported.

Instead of inviting printers to bid for the job, the central bank told several of them to produce as many notes as possible—to run their printing presses flat-out. The companies filled the order—but haven’t been paid yet. They want to be paid in hard currency, not Bolivars, and for the last year that has been in short supply. Last year Venzuela imported more than 10 billion bank notes, 30% more than the US—for an economy less than 3% of our size.

Source: Bloomberg

The result is the world’s highest inflation—currently 180%. Usually, when prices spiral like this, countries start adding zeros to their bank notes. Venezuela is going into uncharted waters by not printing larger bills while not paying its printers, either.

Now, people have to use wheelbarrows of cash to buy basic goods. We know where this ends. In 2005 Zimbabwe’s economy spontaneously dollarized after its hyperinflation. Maybe Venezuelans won’t trust the gringos with their money—there’s too much bad blood between our countries. But for everyday commerce to continue, they need some sort of hard currency.

Maybe Yen?

Douglas R. Tengdin, CFA

Chief Investment Officer

The Mosquito Coast

What if we found a way to eliminate malaria?

Photo: James Gathany. Source: Center for Disease Control

I hate mosquitoes. When I was growing up in Minnesota, we joked that it was the “Minnesota State Bird.” Mosquitoes suck your blood and make you itch. And they carry a lot of diseases, including Malaria.

Malaria kills half a million people every year, mostly children in tropical Africa. References to the disease have been found throughout history and around the world, from ancient China, to Greece and Rome, to 19th century Europe and America. It has been controlled by a combination of medicine and public health measures. It’s still a major problem in Africa.

Malaria Life Cycle. Source: NIH

But a new technology is being developed that has the potential to almost totally eradicate the disease. Using a form of genetic engineering, it sterilizes the mosquitoes that transmit the parasite to people. And it could help with other problems—saving Hawaii’s disappearing native birds, or stopping the spread of dengue fever and the Zika virus.

But it raises lots of issues: would removing some species of mosquito upset ecosystems? Is it ethical to eliminate an entire species? Could we risk a genetic epidemic if the altered DNA jumps to another insect? And could the technology be used by terrorists to create a designer plague? Some think the research ought to be classified, although it’s probably too late for that.

This is reminiscent of the questions that arose in the ‘70s when recombinant DNA first started to be used. At that time, scientists declared a voluntary moratorium on new research projects while professional and ethical guidelines were worked out. Since then, hundreds of different uses for the lab technique have been found—from synthetic human insulin to rennet-free cheese.

Our understanding is always advancing, and species continually adapt and compete with one another. Chances are, if we eradicate malaria-carrying mosquitoes, other mosquitoes will spread and take their place in the ecosystem. But eliminating malaria carries huge potential—on an economic as well as humanitarian basis.

Technology is what has made large populations possible. And large populations are what makes technology possible.

Douglas R. Tengdin, CFA

Chief Investment Officer

Helicopter Money (Part 2)

What’s wrong with helicopter money?

Photo: Eric Salard. Source: Wikimedia

“Helicopter money” is money created by the central bank so that the government can spend it. It typically happened during wartime: the government unmoors the currency from a gold or silver standard, and the central bank credits the government’s financing agency the funds. Governments do this when their very existence is threatened, when war or insurrection require them to raise a large army and buy a lot of material.

The result is always inflation: more money chases the same amount of goods, so the price of those goods has to rise. And that’s the whole point. In our slow-growth stuck-in-the-mud economy, prices are stuck, too. Inflation has been about 1%. Should the economy falter, they could start to fall. And deflation could be disastrous, threatening the financial system. The government needs to have a way to fight it.

So what’s wrong with this approach? First, it would require close coordination of the central bank and the administration. That’s something we don’t want. Central banks need to be independent in order to be free to take the punch bowl away when the party gets too hot. Second, it’s unlikely that a one-off increase in spending would boost the economy very much. People aren’t stupid. They know that what the government gives, the government can take away, one way or another. We know what happened to the tax-rebate checks issued in 2008 and 200. Only about 20% of it was spent. That’s not much of an effect.

Finally, we’ve seen the end-game of money-financed spending. Countries running out of funds have resorted to printing more money, and the result is hyperinflation. Prices don’t just gently rise, they spiral up out of control. Examples are abundant: Peru in the ‘80s, Yugoslavia in the early ‘90s, Zimbabwe in the mid-2000s, Germany in the early 1920s. Prices increased by more than 50% per month. This happens because people know the money is unmoored from any notion of value. If the central bank thinks it can keep this genie in the bottle, it is mistaken.

Price of gold in Weimar Germany. Source: Wikipedia

Helicopter drops don’t work because if they don’t persist, the money is saved, and if they do, inflation gets too high. It’s always a temptation for technocrats to think that they can manage the process—that it’s different this time. But it’s never different this time.

Douglas R. Tengdin, CFA

Chief Investment Officer

Helicopter Money (Part 1)

What is helicopter money?

Photo: BegoBego. Source: Morguefile

“Helicopter money” is a concept first floated fifty years ago by Milton Friedman, where he proposed – theoretically – that the government fly over a community and drop thousands of dollars, financed by the central bank. What would that do to the economy, he wondered. This notion was revived by Ben Bernanke in 2002 when he gave a speech on preventing Japan-like deflation here in the United States. The speech earned him the nickname “Helicopter Ben.”

In a recent blog post, Bernanke revives the idea as a potential tool of the central bank. Obviously, he didn’t suggest fleets of Sikorskys flying over the country. But a money-financed tax cut or spending boost would be essentially the same thing. In technical terms, “helicopter money” is an expansionary fiscal policy financed by a permanent increase in the money stock. It’s an increase in public spending or a reduction in taxes financed by a permanent increase in the Fed’s balance sheet.

To effect this, the central bank would credit the U.S. Treasury’s “checking account,” and those funds would be used to pay for the spending. Alternatively, the Treasury could issue zero-coupon perpetual bonds, which the Fed could buy. This would have a number of effects:

First, households would have more money, either because there’s more employment on government projects or because after-tax pay goes up. The bigger the helicopter-drop, the bigger the impact on income. Second, inflation would pick up. When more dollars chase the same amount of goods and services, prices—the clearing mechanism—have to increase. You can’t repeal or suspend the law of supply and demand. Third, because the spending is financed by the Fed, there would be no expectation of future tax increases; there’s no way for them to shrink their balance sheet back down. All this is intended to boost the economy.

Bernanke concludes his piece by saying that helicopter drops aren’t very likely to be needed in the US. We still have a growing economy and moderate inflation. In fact, there are some signs that inflation is picking up. But this sort of thought-experiment is kind of like physicists thinking about trains and elevators moving near the speed of light. It helps us build our understanding of how things work.

But we know that light-speed trains are impossible. Helicopter drops—money-financed government spending—are quite possible and have been used many times throughout history. And the result is always the same: hyperinflation. It’s not pretty. Let’s hope we don’t go there.

Douglas R. Tengdin, CFA

Chief Investment Officer

Bootleggers and Bankers

Are banks out of control?

Photo: Nightscream. Source: Wikimedia

Many people are still hurting as a result the Financial Crisis. And there’s a lot to be upset about. By some measures upwards of $5 trillion in wealth was destroyed. The crisis triggered the Great Recession of 2008-9, and led to government bailouts and fiscal stimulus packages around the world.

At the heart of the crisis was our overly complex banking system. Fundamentally, banking is pretty simple: move money from people who have it to people who need it. People need money for lots of reasons: buying a home or car, starting and running a business, financing large projects like roads, bridges, or fiber optic cables. People have money from their long-term savings, their transaction accounts, and from the “rainy day funds” they need to set aside

This is pretty basic, but it gets lost in the arcane world of mortgage-backed securities, venture capital funding, and collateralized debt obligations. Banks have always been regulated – after all, establishing sound money is an essential government function – but in our global financial system regulatory difference between countries encourage large financial institutions to game the system. And the more rules there are, the more gaming that takes place.

This is why smaller banks are almost always a lot simpler than big banks. The big banks have Caiman Island subsidiaries, Eurodollar deposits, and foreign exchange desks that small banks don’t. These are necessary to serve the needs of their clients, but they also become profit-centers in their own right. It’s easy to look at these operations and say that they’re too risky, full of moral hazard. And wasn’t it trading in sub-prime mortgages that led to the failures of AIG and Washington Mutual and Lehman?

Not really. The institutions that traded these toxic financial instruments only lost a few hundred million dollars. That’s a lot, but it’s not enough to take down the system. It was the banks that bought and held the products—you know, long-term investing, the kind that politicians and pundits are always praising but never seem to support with their policies—that collapsed.

Source: Wikipedia

In the aftermath, Congress passed the Dodd-Frank bill, many of the details of which are still being hashed out more than five years after its passage. The devil is in the details, though, and the lack of clear direction by Congress gives regulators some pretty wide-ranging authority. Currently, the regulators are floating a rule to control the compensation of senior bank managers as well as the bank’s traders—the ones who make markets in government bonds and foreign exchange.

There’s a “Bootleggers and Baptists” problem here, where it’s in the big banks’ interests to have the regulations as complex as possible. In the short-run, these rules cost them money. But they cost everyone money—and the largest institutions can afford the systems and risk-management staff and legal counsel to make sure they comply, while smaller firms struggle. So the system devolves into an oligopoly, and too-big-to-fail banks become bigger and bigger.

Source: St. Louis Fed

The answer isn’t having even more complex rules. It’s having clear, unambiguous legislation with more specific direction by Congress – leaving less to regulatory discretion – which often appears capricious and contradictory. You can’t regulate your way to simplicity. But you can make simplicity more profitable. And let the market make it less risky.

Douglas R. Tengdin, CFA

Chief Investment Officer

Clash of Civilizations

Clash of Civilizations

Are we doomed to an endless cycle of conflict and violence?

Clash of Civilizations Map. Artist: Kyle Cronan. Source: Wikipedia

Sometimes it feels like it. In 1992 Samuel Huntington outlined his thesis: there were nine major world civilizations in the world, and these would remain a major source of conflict. The early ‘90s was a heady time: the Berlin Wall had fallen; East and West Germany were reunifying; Operation Desert Storm had repelled Saddam Hussein’s invasion of Kuwait. Some political theorists opined that we had reached the end—or goal—of history, and that liberal democracy and free-market capitalism were the only reasonable way for societies to organize themselves. This was the “new world order.”

Huntington didn’t see it this way. He observed that there were still large cultural rifts in the world—and he outlined the major world civilizations: Western, Islamic, Russian, Chinese, Japanese, Hindu, Buddhist, Latin American, and African. The people in these groups are separated by history, language, culture, and most importantly, religion. The principal conflicts of the future, he thought, would occur along the cultural fault lines between these civilizations.

Source: Libya Diary and Huntington’s Clash of Civilizations

We certainly see a lot of conflict among the first four—China, Russia, Islam, and the West—and a lack of understanding. China sees itself as a formerly great civilization that was oppressed and is now assuming its proper place in the world. Vladimir Putin justifies his aggression as a defense of the Russian people, language, and culture from Western decadence. And Islamic jihadis believe there are only two regions of the word: the dar al-Islam and the dar al-harb—the house of Islam and the house of war.

Ironically, there are many in the West who deny that there is a civilizational clash—that Iranians and Chinese and Russians are just like Westerners, only with different backgrounds. But that’s the whole point. Our different backgrounds lead to skirmishes that highlight our different cultures and values. We don’t all want the same thing. And the very self-criticism that characterizes Western culture has led many folks in other cultures to believe that the West is fundamentally flawed. Hence the belief that most of the world’s problems come from the blind assertion of Western power.

So we see conflict—hacking and cyber-war, guerilla war and terrorism, refugees, espionage, and other battles. We need to acknowledge this and be ready. To paraphrase Leon Trotsky—the Communist revolutionary—you may not be interested in the Clash of Civilizations, but the Clash of Civilizations is interested in you.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Tiger and the Dragon

The Tiger and the Dragon

Is India on-track to overtake China?

Photo: Jeff Kubina. Source: Animal Photos

China’s growth has slowed. We know this from innumerable reports. The reduction in aggregate demand resulting from China’s economic shift from manufacturing to services is at the heart of the bust in commodity prices. But what about India? They have over a billion people, most of whom are trying to emerge from poverty. And they have a competitive democratic system—rather than a Party-led autocracy—along with a free press. Why can’t they grow as fast or faster than China?

Part of the problem in India is optics. When people see pictures of China they see gleaming skyscrapers in Shanghai, or the political symbols in Beijing. The images of Mumbai aren’t so striking. Also, India’s crude infrastructure doesn’t inspire confidence. No one raves about Delhi’s polished international airport. India has less “curb appeal” for investors.

India and China Economic Growth. Source: Charles Schwab

But a bigger reason in India is something common to many developing nations: the pervasiveness of family control over the major institutions in the country. When institutional accountability is weak, families tend to run things. Different families have ways to reward or punish their members. But a family-run system tends to become deeply corrupt. Crony capitalism diverts money intended for development into family coffers. And there is little incentive to innovate or become more efficient.

As a result, India has a bloated government, primitive infrastructure, and a poor educational system, despite the fact that hundreds of millions of Indians want to escape poverty. There are certainly areas of growth—the states of Bihar and Gujurat come to mind—but the country as a whole never seems to live up to its promise.

It’s not enough to have a large, growing population. A country has to be able to put its people to productive work. India has yet to see significant numbers move from the countryside to the cities. In a corrupt system, farmers are reluctant to leave their land.

Still, the potential for growth is there. In a world of oversupply and falling commodity prices, resource-poor countries like China and India should do better. The true promise of both nations lies in developing their internal markets. After all, both countries are richly gifted with the ultimate natural resource: the human mind.

Douglas R. Tengdin, CFA

Chief Investment Officer

Transparently Foggy?

Are corporations becoming too transparent?

Photo: Chance Agrella. Source: Free Range Stock Photos

Goldman Sachs’s annual report was over 400 pages. GE’s 10-k contained over 100,000 words. Annual reports today are dense, filled with jargon, and longer than a Russian novel. Are these corporate leviathans trying to obscure what they’re doing—trying to hide the truth in plain sight?

Part of the reason annual reports have gotten so big has to do with the complexity of the businesses themselves. Goldman Sachs and GE are much more complicated entities than they were 25 years ago. They have wide-ranging global operations, significant off-balance-sheet activities, and diverse business strategies. Explaining all of these takes a lot of ink.

Second, regulations have multiplied around corporate disclosure. CEOs and CFOs now carry personal legal liability for what goes into their 10-k’s. And the accounting oversight board never seems to reduce the number of reports, schedules, and footnotes required. A kind of regulatory ratchet happens, where it’s always easier to require one more item. It’s like the number of pages in the Federal Register: it always seems to go up, and rarely ever comes down.

Source: George Washington University

Finally, shareholder litigation is a much more serious issue toady. If something bad happens to the business and managers don’t immediately disclose it, shareholders will file a class-action suit. These lawsuits are so common now that there are multiple firms whose sole business is to manage the proceeds from these class-actions on behalf of smaller investors.

It’s easy to look at how complex financial statements have gotten and assume that managers are trying to fog up their disclosures—to make it more difficult to get at the reality behind the numbers. But that would be a mistake. Most managers are trying to do the right thing: to provide useful information to their investors, trading partners, and customers in a way that keeps the company out of trouble. But they’re like Gulliver, tied down by a host of Lilliputian rules.

The solution isn’t more regulation. You can’t add regulations about too much regulation to simplify regulatory disclosure. Only when investors reward simple businesses for their straightforward business plans will financial disclosure become easier to understand. Financial statements used to be communication tools, rather than compliance mechanisms. Let’s hope they can return to that role.

Douglas R. Tengdin, CFA

Chief Investment Officer

The Investor’s Enemy

Why is investing such hard work?

Photo: Alvimann. Source: Morguefile

Investing should be simple: spend less than you earn, and sock away the extra. But we have a host of habits that get in the way. First there’s the lure of excess spending. Our lifestyles are determined more by our peer-group rather than our financial goals. That’s why young athletes with seven-figure incomes end up bankrupt just a few years later. Then there’s predatory financial products: complex annuities, high-fee mutual funds, and so on. These con games are designed to turn our hard-earned savings into someone else’s income. Finally there’s contagion: we tend to chase performance and get sucked into markets just as they’re on their last legs, then panic and bail out at the bottom. We’re tempted to cycle between fear and greed at just the wrong time.

When it comes to investing, emotions are the enemy. Different strategies fall in and out of favor. The time to buy straw hats is in February, but people rarely do. It’s hard to look past the snow and the cold and realize that summer will come again with its heat and humidity. We like to be with other people, and when a crowd is running in one direction, it’s hard to go the opposite way, or even just stand still. But euphoria is the enemy of reason, and financial performance is a coldly rational business.

Source: Wikipedia

Warren Buffett says to be greedy when others are fearful and fearful when they’re greedy, but I’d settle for being emotionally stable. Neutrality is often the best policy.

Douglas R. Tengdin, CFA

Chief Investment Officer

Chinese Dreams

What’s going on in China?

Photo: SP. Source: Pixabay

Given the size of their economy, it’s an incredibly important question. The global economy totals about $78 trillion. The US is about 22% of that, Europe is 20%, and China is 13%. Together, our three economies make up 55% of the world’s commerce.

So it’s crucial to understand what’s happening. We knew that China couldn’t export its way to prosperity forever. Eventually, it became limited by the size of its trading partners. So China has been shifting to a more domestic, services-driven economy—like most of the developed world. Officially they’re growing at around 7% per year—which makes their economic growth double that of the US, in raw dollars, and triple that of the Euro-zone.

But there’s a lot of skepticism about these official numbers. Some folks have been looking at electricity consumption or other measurable items as proxies for government statistics. These indicate that national electricity consumption is running about 5% per year. And recently, with little fanfare, the official seasonally-adjusted GDP numbers were revised downwards.

Source: Stats China

Quarter-on-quarter growth their economy is growing 1.1%. This implies an annual growth rate of about 4.5%, not 7%. That’s a lot slower. Combine that with the implied growth rate of 5% that comes from utility consumption, and you have a much more somber view of China’s current activity.

When it comes to the global economy, the US, Europe, and China dominate the discussion—and for good reason. The rest of the world either trades with these economies or is affected by them in a major way. We have a pretty good idea what’s going on here and in Europe, but China’s a mystery. It’s hard to know what’s happening in a country with a billion people, where communication and other infrastructure is in a less developed state.

The Chinese sage Laozi said that the “Tao” that can be explained is not the true way. It seems that the Chinese economy that can be explained via statistics is not the true China, either.

Douglas R. Tengdin, CFA

Chief Investment Officer