Monday, 5 January 2009
Goodbye 2008 - Andy Xie
Many governments are trying to boost asset markets directly. The US suspended short-selling for a period. Pakistan and Russia closed stock markets from time to time. China cut stamp duties. These measures have had little effect for a good reason. Most of the reductions in asset prices are due to bubble bursting, i.e., the prices were too high before, not too low now. For example, the average price-book ratio for the US stock market for the past eight decades is 2. The current level is 1.7, not a big discount from the historical norm.
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Goodbye 2008
In economics, everything that could go wrong went wrong in 2008. 2009’s leaders will have a tough job.
By Andy Xie, board member of Rosetta Stone Advisors Limited
4 January 2009
Most people can’t wait for 2008 to end. I still remember grave apprehensions among my friends and acquaintances about the year that began with the snowstorm. All sorts of conjectures were popping up to predict a bad year. Indeed, apart from the spectacular Beijing Olympics and election of Barack Obama, nothing else has gone right. Why has 2008 gone so wrong? What can we look forward to in 2009? I’ll try my best to explain, speculate, and forecast.
First, let me talk about the good things in 2008. The election of Barack Obama is like a miracle. The last breakthrough in America’s presidential politics was the election of John Kennedy in 1960. He was Irish American and Catholic. The worry was if he would be loyal to the pope or the US Constitution. People now laugh at such concerns. Compared to the election of Obama, John Kennedy’s breakthrough was quite minor. Just think that the US never elected a president with the last name ending with a vowel, i.e., someone of non-Anglo-Saxon heritage. Mario Cuomo, governor of the state of New York in the 1980s and the best orator of the time, didn’t run for president partly due to his concerns that Americans wouldn’t vote for someone with an Italian heritage.
Only ten years ago, Obama’s name alone, let alone his skin colour, would have sunk his candidacy. It is difficult for Chinese people to imagine the barriers that he brought down. But, after digesting his win for two months, American people as well as the rest of the world breathe a sigh of relief: the best choice was made. Among all the candidates on the Republican and Democratic side, he is the best choice for handling the growing crisis that is engulfing the US and the world. He has picked heavyweights to join his administration. I am not worried about lack of talents in his administration. The challenge will come when these people disagree.
China winning the most gold medals at the Beijing Olympics was a big deal for the country. Chinese have a strong desire to see the country strong and powerful. From the late 19th century onwards, the number one goal among reformers or revolutionaries was to make the country strong. Getting rich was a distant second. It was a direct response to the humiliations that the country suffered at the European powers and late Japan. Despite revolutions and periods of turmoil, Chinese people have been absorbing technologies into the economic activities, and the country has been modernizing for over a century. The pace of the economic modernization has been particularly fast over the past three decades, thanks to the open-door policy, IT, and globalization.
Almost all the countries that rose to great power engaged in wars in order to win recognition and a favourable seat in the world affairs. Many foreigners are worried China will pursue the same path. China has espoused the ‘peaceful rise’ policy. This policy is the best in the current environment. Peace has given China the opportunity to grow over the past three decades. Both market access and availability of natural resources have been quite good. As long as the global economy remains open, peaceful development is the best choice for China.
China has plenty of other opportunities to reach psychological fulfilment. Winning the most gold metals at the Olympics is a big one. It’s like running the Marathon for an individual: once it is done, the need for a repeat is gone. China will probably feel more relaxed at future Games, i.e., not winning most gold metals is ok. Moving onto the next target, like landing on the moon, will bring more satisfaction. In a way China is trying to experience in half a century what other powers have in two centuries. However, there are better and nobler ways to grow up in the 21st century. Joining the UN peacekeeping forces is not only psychologically satisfying, and a way to earn international respect, but also a contribution to the global stability that benefits China’s economic development.
The good news in 2008 features China and the US. They also account for much of the bad news. The property collapse in the US has brought down the speculative positions in the financial system. The ensuing collapse of global trade has worsened China’s economic difficulties that began with the bursting of the stock-property bubble. In reaction, the two have committed the most among all the countries to fiscal stimulus. The two countries are the driving forces behind what have happened and what will happen.
The feeling that everything is going wrong in 2008 is on the mark. Globalization and information technology have tightly integrated the world across industries, markets, and countries. The bubble lasted as long as it could spill into corners of the world. So many experts, including the IMF, the World Bank, and prominent scholars, called the global economy resilient over the past decade, as it bounced back quickly from every blow. The reason was that the bubble had a lot of room to grow into in an integrated global economy. From puer tea in China, property in Mumbai, oil from Saudi Arabia, soya from Brazil, and modern paintings at Christie’s auctions, there were so many assets to inflate, and central banks could keep pumping money. When the bubble burst, it brought everything down at the same time. The speed and scale of the collapse have bewildered governments, businesses, and scholars alike.
2008 is not the end of another cycle. It is the end of the 20-year super cycle. After the Berlin Wall fell, demand within the former Soviet block collapsed, and all the former planning economies tried to export in order to grow their economies. It led to oversupplies of natural resources and labour in the global economy. Concurrently, the IT revolution was improving corporate efficiency and facilitating trade of goods and services. For example, the OEM model could have never gone so far without IT. The good news in these factors was higher productivity growth, i.e., the global economy could expand faster without inflation.
The bad news was that the demand side was not structured to absorb the rising output. According to economic theory, when one factor of production rises quicker than others, its relative value declines. The factor in oversupply was labour. The theory proved to be true; the share of wage income in all the major economies kept declining. However, workers are also consumers. When their income share in the economy is declining, demand and supply could find a balance. Investment demand from businesses or governments could keep the balance only temporarily. Ultimately, consumption must rise in tandem with aggregate demand.
Alan Greenspan stumbled on the bubble equilibrium. He kept pumping liquidity to stimulate demand. It worked by creating asset bubbles, first the stock market and then in property and credit, to create demand. Essentially, workers whose income was declining relatively borrowed to support their consumption, believing that their rising home value justified higher spending. Their creditors thought that, even thought their income was insufficient to pay debts, rising asset prices could. Debt derivatives further blurred the vision of creditors: they no longer knew who they lent to and relied on ‘models’ to assess their risk exposure. The models, of course, didn’t take into account of the possibility of a credit bubble.
Looking back, what happened was obvious and almost farcical. From my conversations with investors over the past decade, only very few investors, usually old and experienced, understood what was happening. The common mistake they made was to go short too early, like in 2005. On the other hand, young hedge fund managers and traders on Wall Street stayed optimistic. The balance between the two is the reason that the bubble kept going for another two years. The later were attracting so much money that they overwhelmed the short trades by the former.
The bubbles were most prominent in Anglo-Saxon countries (Australia, the UK and the US). Their financial markets were more liberalized than elsewhere and could turn the Greenspan liquidity into bubbles quicker and more efficiently. That is the reason that they have run large trade deficits, i.e., their debt financed demand and kept the global economy running. The bubble burst when inflation came with the recovery of energy demand among ex-Soviet economies. I wrote in 2006 on the tension between the oil and property bubbles. The former could destroy the latter by sucking too much money away. When the property bubble burst, the declining demand caused the oil bubble to burst also.
The Bernard Madoff scam gave 2008 a fitting end. The Madoff scam is the biggest Ponzi or pyramid scheme in human history. A Ponzi scheme promises higher returns to investors on some plausible idea but actually pays old investors with the money of new investors. As long as there are enough new investors, it keeps going. Most Ponzi schemes suck people in with novel ideas that promise fat profits. For example, young traders will show a lot of math on arbitrage opportunities. After seeing such a presentation, you walk away thinking that, even though you didn’t understand it, they were probably geniuses and could make a lot of money for you. Some plausible idea and perceived scarcity are the core elements of a Ponzi game.
Mr. Madoff didn’t have that. He is a plodder, not a sprinter in the cheating game. He began small and worked the country clubs in Florida to attract small amounts of money first. Through time, he built a ‘track record’ on consistent and high returns. When the pool of money was small, it was easy to pay for the ‘track record’. Words then spread, and more and more people wanted in. He then created ‘scarcity’ by demanding introduction for accepting money. Nothing gets people worked up like exclusivity. People suspend their rational senses when they try to get into an exclusive circle. Many have succeeded in fooling people that way. But, Mr. Madoff fooled so many prominent people for thirty years. He obviously possesses a special talent for winning people’s trust. In terms of size and longevity Mr. Madoff must be the Ponzi champion.
However, in terms of ending, Mr. Madoff may not fare as well as others who have taken less. Everyone knows he is a crook and must go to jail. He said so himself. ‘It’s all a lie’, he confessed about his scheme. Obviously, he has lived well for the past thirty years and is an old man now. He has lived enough, as Chinese would say. Further, he may have hidden enough for his descendants to live well. But, in comparison, the top people at big financial firms have walked away with hundreds of millions ‘legally’. If governments sue them, they have enough money to hire expensive lawyers to keep them out of jail for years. Most will never go to jail and will enjoy their lives with their ill-gotten gains, while Bernard Madoff will languish in jail until the end of his days.
The financial crisis is about the past. The revelations of the scandals tell us how deep of the hole the bubble has dug for the world. Asset markets have already corrected by over $50 trillion or 100 percent of global GDP. That is loss of paper wealth, not cash. The latter is needed to fill the losses from non-performing loans. My guesstimate is that the total would be about $10 trillion or 20 percent of global GDP.
The past is affecting the present. The global economy is contracting for the first time in half a century. The most important force is the negative wealth effect, about 5 percent of the wealth loss, or $2.5 trillion. The second most important is credit crunch or the unwillingness or inability of financial institutions to lend. The third effect is demand contraction from rising unemployment, as unprofitable businesses lay off workers. Faced with the one-two-three punch, governments around the world have reacted in an ad hoc fashion and have worsened the crisis by destroying market confidence.
Many governments are trying to boost asset markets directly. The US suspended short-selling for a period. Pakistan and Russia closed stock markets from time to time. China cut stamp duties. These measures have had little effect for a good reason. Most of the reductions in asset prices are due to bubble bursting, i.e., the prices were too high before, not too low now. For example, the average price-book ratio for the US stock market for the past eight decades is 2. The current level is 1.7, not a big discount from the historical norm.
To deal with the credit crunch, I haven’t seen a single government on the right path. All the governments have focused on bailing out financial institutions with capital injections, believing that, recapitalized, they could lend again. The main cause of the credit crunch is that potential borrowers are not credit worthy. Their collateral value and income have declined. Debt reductions, either through inflation or bankruptcy, may be necessary to get the credit system back on track. Pumping money into financial institutions won’t solve the problem.
Cutting interest rates is another tool almost all central banks are doing. I am not against cutting interest rate per se. However, when interest rates are close to zero, one must think of the inflationary consequences in the future. The reduction of interest rate boosts the economy by encouraging borrowing. But, too much borrowing has got the world into today’s trouble. Can more borrowing solve the problem? Again, back to the credit worthiness of the borrowers, lowering interest rates couldn’t increase credit supply like before; lenders wouldn’t lend to bankrupt businesses regardless of how cheap the funds they get from central banks are.
Fiscal stimulus is the only thing that will be effective. Through creating demand directly or boosting income, economies will improve, and borrowers will become more credit worthy. But, fiscal stimulus should be mainly in economies with trade surpluses. China is doing the right thing. I hope that China’s package could be bigger. The central government should issue RMB 1.5 trillion, three times the announced figure, to inject into the economy. The money should be mainly for transfers to households to support property purchases, not fixed investment. It is much better to give money to the people than government. China’s problem is giving too little money to the people, and too much to the government. Stimulus should try to reverse the trend.
In contrast, the US’s stimulus will probably be too large. The US should decrease its trade deficit. The stimulus should cushion the downturn, not reverse it. The talked-about package could be $1 trillion. It would keep the US trade deficit close to its historical high, prolonging global imbalance. Maybe the Obama Administration wants to take advantage of the opportunity to fulfil its campaign promises as quickly as possible. A large stimulus package makes political sense. But it won’t make economic sense. A reasonable stimulus package should $300 billion, in my view.
Europe’s refusal of a sizable fiscal stimulus is the most frustrating part. It should and can afford $500 billion or more in fiscal stimulus. In particular, Germany should bear more responsibility for the global economy. It has been the largest export nation for many years. It is not right that Germany refuses to share any burden during the hour of need for the global economy. Japan is in a similar shape and should be held accountable. Both should cough up around 5 percent of GDP to support their economies.
Most countries are likely to join the fiscal stimulus wagon next year. The global economy will recover somewhat in the second half of 2009. Indeed, stock markets may rally in the second quarter. However, it would still be a bear market rally, not sustainable. The world must overcome two barriers for a new bull market to begin. First, the losses due to bad debts must be paid. That day comes when we see that bad debts are sold. So far, bad assets are not traded, and financial institutions give them arbitrary value. I think that the bad assets would become liquid before the end of 2009.
The second barrier is more difficult to overcome: how to grow the global economy vigorously again. As discussed above, the income distribution issue -- labour’s share declining during high growth -- is at the heart of a dysfunctional global economy. The obvious solution is income redistribution through taxation: increasing tax rates on high income earners, capital gains, and business profits, and spending the money on low income earners to boost their consumption power. Maybe tax policy is the only solution. But I think that anti-monopoly policy may even be more important. Mergers and acquisitions over the past two decades have reduced the number of players in many industries. When one checks around in any product market, the number of players is small and the same across the world. Monopoly profits have contributed to the problem of low labour wage and insufficient consumption.
During the Great Depression, many governments regulated finance and broke up monopolies. These were the right policies. The wrong policy was trade protectionism, which worsened the economic downturn and made the benefits of the right policies invisible then. Hopefully, the world would do the right thing this time.
China can actually get its economy going easily. Chinese consumption has declined consistently as a share of GDP in correspondence to the declining share of labour income in the GDP. On the other side, the government share in the economy has risen. The trend can be reversed if the government collects less and, of course, invests less. The economy can easily be balanced that way. Further, the Chinese government owns most of the shares listed in the stock market. If the shares are distributed among people equally, it could start a lasting consumption boom. How hard could it be for the government to give the shares to the people?
Obviously, 2009 won’t be easy. We just can’t see the light at the end of the tunnel. However, investors have been bearish to the max in the past six months. If things improve just a little, markets may bounce quite a bit. On the positive side, I think gold, energy, and infrastructure could do well. While deflation is a concern, inflation will come by the end of 2009. All that money printed could turn into inflation through commodity speculation or labour unions demanding wage increase.
Some beaten down assets may stage a comeback, especially if the economic environment improves around mid-year. Corporate credits, financial and manufacturing stocks have declined massively. Many financial institutions will survive. And most manufacturing companies will. When the picture clears up, the beaten down assets can bounce back. This is a rebound story, not a bull one.
I am bearish on the so-called “safe haven” assets in 2009. For example, consumer staples, healthcare, and utility stocks and government bonds have performed well during the crisis. Investors have been running into these relatively safe assets. Extreme risk aversion has created a bubble among safe haven assets. In particular, government bonds are grossly overvalued. Fiscal stimulus means the supplies would rise. Low interest rates will eventually lead to inflation. I think such assets will struggle in 2009.
Last and not least, the dollar will resume its bearish trend in 2009. The Fed has cut short-term interest rate to zero and is buying bonds to depress yield at the long end. Without being able to influence the yield curve, markets can only sell dollars to escape the low interest rate trap.
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