Friday, October 26, 2012

Imbalance Sheet

Situations that appear serene and balanced on the surface can hide a deep undercurrent of suppressed tension and imbalance. In most instances, the state of imbalance however doesn't emerge suddenly but develops over time. If we're conscious of the unfolding pattern, we'd have spotted the eventual outcome long before it transpires.

A losing business can continue operating provided it has enough cash or, more likely, credit to sustain itself. It's only when banks and creditors refuse to extend further credit that leads to its collapse. That usually occurs when its debt to capital leverage has reached a dangerous level. The root cause of the collapse however is not the extreme level of its indebtedness but its loss-making operation.

A glimpse of a firm's accounting balance sheet, that is, its statement of assets and liabilities, can reveal a distressing situation if most of its capital assets are financed by external short-term borrowings. Likewise, for a national economy, a similar account of its assets and liabilities can also disclose a worrying condition if the assets are held by a small, prosperous group that's totally detached from the bigger but wretched group bearing the liabilities.

Other types of imbalance also exist in a national economy. For example, the exchange rate can become too expensive leaving the populace unable to produce and dependent on imported goods. Also, the power of technology can hasten the decline in middle class income, leaving a small minority at the top able to afford spending. These imbalances are the reason why an economy stops producing. By the time an imbalance makes itself felt, the economy would've already been in serious trouble.

Politicians and policymakers are naively exhorting their countrymen to be more productive as if this economic crisis is all about failing to compete. Improving productivity is a slow process that's ill-suited as a crisis solution. Moreover, it usually calls for major investment that's unlikely to be forthcoming when investors are fleeing the country. Any turnaround effort must therefore first rectify the debt imbalance through debt write-offs. If the debts are owed between residents of the country, a high inflation rate performs the same function as debt write-offs. An exchange rate imbalance can be addressed through a currency devaluation. The last imbalance, the technological edge, has no fix except for a new Kondratieff wave that will obsolete the existing technology. Because of this, the first two imbalances will keep on recurring even after they have been snuffed out. It also explains why an economic depression is inevitable.

How do we spot an imbalance in a country's balance sheet? First, we need to understand the assets and liabilities that need to be monitored. What we mean by assets are financial assets, the numbers in virtual bits and bytes stored digitally on the servers of financial institutions. They are not the tangible, physical assets that can be touched and seen, the values of which are unimportant since they move in sync with the ups and downs in the credit quantity.

Liabilities, on the other hand, are always financial. In modern times, you don't owe others in terms of physical things. Even if you do, they'll be translated into financial terms. As assets and liabilities are just opposite sides of the same coin, we only need to monitor one, which in this case is liabilities, being the more convenient because the Fed publishes complete data on credit in its quarterly Flow of Funds Accounts.

If you recall the cash flow of a national economy in an earlier post, the cash flow is actually the debt movement of the economy. The balance sheet on the other hand is a snapshot status of liabilities and assets. As on the cash flow, we're interested only in debts on the balance sheet. So in effect, with the GDP — this being the economy's income statement — and the debt flow, you can assess the strength and portend the future of any economy. These are the speedometer and tachometer of the economy. Extending the car meter analogy further, you can add the house price index and the labour force participation rate (LFPR) charts to represent the temperature and fuel gauges. Unlike a car which breaks down from overheating, the global economy is grinding to a halt because of overcooling. The world economy doesn't have much problem with overheating because mankind's ingenuity will see to the expansion of capacity to meet any excess demand.

Let's bring on the latest charts to see how much further the world economy would have to struggle before succumbing to the forces of the economic depression. We begin with the US GDP which has just declared its third quarter figures for 2012. There's only one driver of growth: personal consumption. Both government spending and investment haven't shown any improvement. In fact, investment spending would have sagged had not residential investment, again incurred by consumers, risen. Regardless, home prices have much further to fall, despite the recent price uptick. In the lead to an economic depression, you'll come across many instances of the dead cat bounce.

The GDP growth since the 2009 recession also has been wriggling within a narrow band (blue line) with no sign of breaking out. With no more trillion dollar deficit in the pipeline, we can be sure where the GDP growth is headed in the coming quarters.

It appears from the first chart that the consumers are the driver of the GDP growth but the GDP components as computed aren't a true reflection of the real driver of growth because a significant proportion of government spending and business spending would end up as personal spending. In addition, the GDP records only spending and ignores any wealth destruction, such as loan write-offs — every time a loan is written-off, an equivalent amount of financial asset disappears.

To get the true picture, we need the debt chart, at left, updated only up to the second quarter 2012. A different picture now emerges. The government debt is on a relentless increase because of Obama deficits. But the household debt  is trending south together with that of the financials. Aside from the massive government spending, the major reason for the escalation of government debt is that it cannot be written off whereas household debt is still suffering from write-offs with much more expected in the future.

How do you explain the inconsistency between the household debt on the debt chart and personal consumption on the GDP chart? There can be only one plausible explanation: two groups of consumers are experiencing two diverging patterns, one flourishing from government spending spillovers and the other languishing under the burden of debts. Technological progress and globalisation also reward the former but assail the latter. Bloomberg has a revealing chart below that sums up the fortunes and misfortunes of the two groups. The pattern fits the 80:20 rule, the top 20% enjoying and the bottom 80% suffering. This pattern is spreading worldwide to any country that exposes itself to the ravages of globalisation.


























This increasingly lopsided sharing of wealth is reflected in the worsening Gini coefficient, a measure of inequality, as shown on the The Economist chart below. But more ominous is China's Gini coefficient which has deteriorated at the fastest pace since 1980. Heralded by many as the next engine of growth, doesn't China look more likely to be a drag on global economic growth?



Saturday, October 13, 2012

The view from the top

The maxim, "What gets measured gets done", is the root of many blinkered views in the business world. Only an enlightened maxim can trump this malign one. What better aphorism can you get than one from Einstein: "Not everything that can be counted counts, and not everything that counts can be counted."

In real life, there are many things that cannot be measured and of those that can be measured, the brain can only keep track of only a few. Take the analogy of driving a car. Of all the various gauges on the dashboard, only two are prominent — the speedometer and tachometer. Our eyes though should not be fixated on those meters but on the road ahead and the surrounding situation. Of course we can also use the analogy of the plane with its many gauges and the need to keep our eyes on them but if there were as many planes in the sky as cars on the road, flying would've been very frightening.

With the economy, we also need only a minimum of metrics. Our focus however should be on the unfolding situation which we can always glean by observing, and talking to people in business and on the street. That's why Jack Welch couldn't stomach the latest unemployment number because it doesn't jibe with the input that he's getting from other sources.

The metrics for an economy are quite similar to those of a business. We've gone through the cash flow. Now it's the turn of the income statement, to be followed in the next post by the balance sheet. How do you derive an economy's income? Actually we don't need to. When you're at the micro level, that is, at the level of business, you can't see what's happening outside your business boundaries. But as you go up, that is, at the level of the national economy, you'll find that the economy is a closed system. Certainly, foreign trade exists but for most countries, the net impact — export less import — is relatively small.

In a closed system, someone's income is another's expense. Or one's profit is another's loss. So there's no point in looking solely at profit as a bigger profit could mean a bigger loss elsewhere. But you hardly hear losses elsewhere because only businesses post profits or losses. Take the profits of the US corporate businesses (see chart at left from The Economist). They continue to register ever increasing profits in the midst of a depression. But this good fortune would soon peter out once Obama runs out of deficit fire power. Well, it turns out that they are about to report pessimistic third quarter results. We can thus dispense with business income or profits since this is indicative of only one sector of the economy.

For the economy, the GDP which really is the total output of the economy is the best indicator. We only need to dissect its components. For a typical country, that is, not a city-state, the relevant components are personal consumption, government spending and private domestic investment. The exports and imports, although each may be sizeable, are small when offset against each other. For example, the imports less exports of the US over the years tend to range between 3 and 6 percent of GDP. If the number sways beyond this range, the drop in exchange rate will set it back. The problem with the southern euro countries is that, with no possibility of currency devaluation, they have straitjacketed themselves into a progressively worsening situation with no avenue of redress.

The chart at left shows the three main components of the GDP in real terms using 2005 dollars. I've  used two vertical axes because personal consumption is several times the size of the other components, this being the result of a quirk in categorisation. By using two axes, we can place the three components close together and magnify their movements. Though both axes start at different amounts, their vertical increments are identical. I've also chosen 2001 as the beginning year since this is the beginning of the depression in the US with the dotcom bubble burst.

With this magnification, we can see clear patterns. The steep increases in both debt-financed personal consumption and investment prior to the subprime crisis were never sustainable. This led to the crash in 2009. Government spending took up the slack in 2009 but it has been on a gentle decline since 2010. Investment, of which only a quarter is undertaken by households on residential properties, the rest by businesses, appears to have stalled in 2012. Only personal consumption by households still mindlessly climbs upwards. But households eventually depend on income from government spending and business spending to drive personal consumption spending. Now, the quirk in GDP computation that I mentioned earlier is the non-inclusion of business non-investment spending, the bulk of which is on payroll, for reasons of double counting. But similar spending by the government is included. That's why the GDP component spending is disproportionately skewed towards personal consumption.

Be that as it is, we can infer from the investment spending, three quarters of which is by businesses, the pattern of business non-investment spending since both would have moved more or less in a similar fashion. As investment is now stalling, shouldn't non-investment spending also flag? The third quarter results of major US corporations which are expected to be subdued portend dark clouds on the horizon for business non-investment spending and, by extension, household income.

The relative size of the GDP components for the US economy is typical of most other mature economies. Developing economies however have a different component profile. Their investment spending is proportionately much higher. The US investment spending as a percentage of the GDP is usually in the teens.

Not so for China. I've included two pertinent graphics, the first from The Economist and the other its sister publication, The Financial Times, to demonstrate how insanely weird is China's economy. This concerns its investment spending. Never in the history of mankind has economic growth been powered primarily by investment spending that's now touching 50 percent of GDP. China is fuelling its growth by adding more capacity. In the early days of the Kondratieff Wave, this may have been acceptable though still excessive. But we are in its waning days in which capacity would be least needed. If this were a car tachometer, China is in the redline zone with the engine about to seize. It would've been safer for China to heed Keynes's advice that the government should instead pay people to dig holes in the ground and then fill them up. At least there won't be deserted apartments and malls, and underutilised roads and railway tracks that would've been costly to maintain or demolish.

China's relentless drive for growth at all costs is the price being paid for the mistake that Deng Xiaoping made more than 30 years ago. In an interview then, Deng was asked whether wealth accumulation  contradicted socialism's doctrine. Deng assured the interviewer that China's wealth accumulation was unique because its wealth would be shared by all. Deng might have been politically astute but economically he was a neophyte. Once you allow wealth accumulation, you must be prepared to live with extreme inequality. Probably only the Scandinavians have found a way to equalise wealth with massive government transfers.

Mao Zedong was thought to have been a madman for carrying out the bloody purges of the Cultural Revolution. But let us reflect on the wise words of Kenneth Boulding, an American economist who was cofounder of the General Systems Theory: "Anyone who believes exponential growth can go on forever in a finite world is either a madman or an economist." Now, Mao doesn't seem that mad after all.