There are several publications that I read weekly, The Economist, Bloomberg Businessweek, TIME Magazine, and the occasional Foreign Affairs when I have time.  However, there is one website that I value dearly: The Motley Fool.  The reason I like the The Fool is because it stresses investing, not trading.  It is a fantastic resource for anyone looking to dabble in the stock market and retire with more wealth than you have now.  In addition to stock advice, the Fool has some amazing articles every so often that go largely unnoticed by the public at large.  Don’t worry TMF, this Fool noticed.  On April 24th, Morgan Housel penned an article called “Why It’s So Much Better Than the Great Depression” that articulated just how bad the Great Depression was compared to the Great Recession.  While the whole article is a must read, I found the explanation put forth by Ray Dalio extremely helpful in understanding where we are and what lies ahead. 

“Imagine someone who makes $100,000 a year and has a net worth of $100,000 with no debt. That person can safely borrow about $10,000 a year for several years, meaning they can spend $110,000 a year even though they only make $100,000. The flip side to all that spending is that someone else is earning$110,000 a year. “For an economy as a whole,” Dalio writes, “this increased spending leads to higher earnings, that supports stock valuations and other asset values, giving people higher incomes and more collateral to borrow more against, and so on.” That describes our economy from 2000 to 2007.

But it can only last so long. Eventually, debt service payments take up too much of income, and everything breaks apart. “The person spending $110,000 per year and earning $100,000 per year has to cut his spending to $90,000 for as many years as he spent $110,000,” to pay down the borrowing spree, says Dalio. That means some one else can now only earn $90,000. And it means the economy grinds to a halt, as it has since 2007.”

Now that you get the idea behind deleveraging, you understand where we are and where we are headed.  We are by no means out of the woods yet, and there is still a bunch of uncertainty in the market regarding QE3, the spending cliff of Jan 2013, and the upcoming elections in November.  But thus far, this financial crisis has been handled pretty well and policy makers are just waiting to see how the economy reacts.  Take a look at the chart below to see where we are compared to what could have happened.

Trade Wars

Forbidden City A long time ago in a galaxy far, far away…. no wait, that was Star Wars, what did I want to write about?  Oh yeah, Trade Wars!   Let’s try this again . . .Not so long ago, in a city just as dysfunctional as the late stages of the Galactic Republic, but centered in the US and called Washington D.C., a bill passed the Senate . . .

There is wide consensus that the Chinese yuan is considerably undervalued with some economists citing ranges between 20-40%.  While the renminbi is officially classified as a “managed floating exchange rate” whereby it is allowed to appreciate or depreciate within a narrow band against a basket of currencies, it sure feels like it is pegged to the dollar at a steep discount, dramatically lowering the cost of Chinese goods for export.  This also has the effect of a tax on US imports to China, making foreign goods seem more expensive on the Chinese market.  This has been a constant thorn in politicians’ sides over the past few years, especially those whose constituents reside in hard hit areas of the economy such as manufacturing that saw many jobs go overseas.  It is an old and familiar dance much like the hustle – politicians make noise about the undervalued currency, China reminds us that they want to get off the dollar as a reserve currency, a few months pass and just when it seems that the politicians want to implement protectionist policies, the value of the yuan magically increases and the calls for action fade.
Why this time is different
Unfortunately, this time seems different because just as the US is preparing for an election in 2012, China is ready for a political transition as well, and leaders on both sides of the Pacific want to look strong for their populace.  In this atmosphere, even minor disputes run the risk of being hyped-up.  Does anyone really want to see a trade war break out between the two largest economies in the world?  That spells doomsday for the global economy as a whole.
Mr. Greenbacks goes to Tiananmen SquareI had the pleasure of traveling to China earlier this year and one of the major lessons learned in dealing with Chinese is the concept of “face”.  I can hardly do this concept justice in just a few sentences, but hear me out.  “Face” is your reputation, but it is much more than that, it is your code of conduct in forming relationships – from new acquaintances to family elders.  I take it back, this is almost IMPOSSIBLE to explain in words.  Basically, it means not humiliating anyone in public – ever.  In the Chinese culture, it is acceptable to lie to a person in order to save face.  “No” is a very hurtful word and damaging to any relationship.  An example of this would be a street vendor selling souvenirs – while you might not want anything to do with this, you cannot simply say “No, get this crap out of my face” as we would here in New York.  In Beijing, you have to say, “It is very nice, but too expensive.”, or some form of lie to let the retailer “save face”.  This includes avoiding backing someone into a corner in an argument, you must always leave them a way out in order to preserve face.  Often the Chinese will lie directly to you, but their body language will tell you the real answer.  This is all done for the concept of “face” and to preserve the relationship.  It cannot be stressed how important this is in dealing with the Chinese culture.
Saber Rattling
So now the Senate passes this bill and calls China’s leaders out to the whole world, completely ignoring this concept of face.  Response – China lets the value of the yuan fall even further.  Now we have hard line politics being met with hard line resistance.  The problem with currency accusations is that they eventually morph into trade wars, add more fuel to the fire and trade wars become real wars.  As economist Frederic Bastiat once said, “When goods don’t cross borders, soldiers will.”  History tells us that China has never been an imperialist country, but they have, over the past few years, developed a blue water navy and began to exert their influence over an expanding area, from coastal protection to patrolling international waters that the US maintains shipping routes through.  Could more serious confrontation lie ahead?
Yuan Appreciation
The problem with the bill in the Senate is that it was a very public spectacle over a problem that has been solving itself.  From 2009 to early 2011, the analysis found, the yuan appreciated by just 4% in nominal terms, but by 17% in real terms, after accounting for inflation.  Other studies put the yuan appreciation at 30% between 2005 and today.  It should come as no surprise to China that they need to rebalance their economy from exports to domestic consumption in order to keep growing.  A floating yuan would give the government more flexibility in their domestic policies such as battling inflation as well as prove to other nations that China is committed to a level playing field.  Due to rising labor costs in the Middle Kingdom, manufacturers are already coming back to the US or moving their shops to other low cost Asian nations such as Vietnam.
Is the Measure Warranted?
Most economists will tell you that capitalism combined with free trade is the single biggest creator of wealth in history.  You will not find argument here, billions of people are now being lifted out of poverty due to the developed world’s appetite for cheap goods.  Even if one country is great at producing many goods, the concept of comparative advantage allows other countries to enter into the fray and begin to trade.  But while free trade is great for developing nations, what about America and other developed nations?  What we get in return is cheaper goods and soaring company profits, good for investors, bad for workers.  America has always been the creator, the inventor, and the producer.  We would then manufacture these new innovations on our shores (south and mid-west actually) for domestic consumption as well as export.  Now however, we have given up our manufacturing base.  We have outsourced and outsourced until the only possible play we have left is the service industries.  As education improves in developing nations, this advantage will become less and less.  New generations will have to compete with globally connected, highly skilled, low-wage workers.  So what is the answer for America?  How do we put America back to work?  That will have to be another post, so stay tuned.  One thing is sure, though, this bill is the wrong way to get results.  Not only would this bill fall apart in front of the WTO, but it also runs the risk of retaliation from other countries possibly convinced that the rounds of quantitative easing were a ploy to keep the value of the dollar low.  When countries stop trading, we all lose.  So instead of figuring out ways to build walls (pun intended . . . see photo below) to prevent trade, shouldn’t Congress worry more about optimizing the conditions for the next growth industry such as improved infrastructure, broadband or clean tech that will pull our country out of this funk?  After all, isn’t there an American jobs bill somewhere on their desks?Fordham MBA's on the Great Wall of China

The Beast They Call Inflation

For anyone interested in monetary theory, the works of Milton Friedman are a must read. Based on his monetarist view, one would have expected to see inflation shoot up over the past two years with the dramatic increase in money supply that the Fed has undertaken. So why is inflation important? Inflation determines how much we pay for goods and services. Inflation risk premium is a component of interest rates and therefore affects personal and corporate investment, labor contracts and government fiscal policy. Inflation touches everyone – from retirees on fixed income to ibankers on Wall Street. When inflation is high, it acts as a hidden tax on goods because it reduces your buying power per unit of money.
So is inflation bad? Yes and No. Yes, inflation is bad because it erodes purchasing power, costs businesses more in terms of their inputs such as materials and labor (workers demand higher salary to keep up with increasing cost of living), and creates a climate of uncertainty. On the other hand, inflation allows companies to charge higher prices creating a smile for investors and allows large borrowers (governments) to repay debts with cheaper dollars. So, the answer to that question is small and controlled inflation of about 1% to 2% a year is good, high inflation or hyperinflation is a nation killer.
I just have to mention a quick something about deflation here. Deflation – or falling prices – is just as dangerous as inflation. While lower prices may sound good at first, this leads to lower profits for firms, layoffs for workers, higher unemployment, lower consumer spending, further price declines, lather, rinse, repeat. It is a nasty cycle of an economy in decline and much tougher to recover from. Think USA in 1929-1933 or Japan in the 1990’s.
So lets get back on track here, looking at the historic charts of CPI, it seems that historically the headline and core CPI move in tandem with each other, but have not followed that pattern since 2000. I can only explain this by the frequent price swings in grains and oil. Headline inflation is a measure of all goods in a proverbial ‘basket’ of about 80,000 goods such as beer, cereal, used cars or anything else you might want to buy and each category is assigned different weights inside the basket. Core CPI is the increase in price of that same basket of good minus food and energy. These two items account for approximately 25% of the basket and have a much more volatile price index than the other goods in the basket and thus can distort the true inflation picture. Back to the graphs. Core inflation appears to have bottomed in late 2010 and has been climbing steadily and rapidly ever since. Currently it sits at 1.95%, just a tad shy of the high end of the target rate.
In summary, following the financial crisis, I think Uncle Sam was extremely worried about the threat of deflation and played fast and loose with our monetary policy. So far, this policy seems to have guided us away from that black hole of deflation. However, the increase in the money supply may have triggered an uptick in inflation that is just now beginning to rear its ugly head. There is usually a two year lag time between cause and effect.
While we must keep a eye on this, I must admit that I expected inflation to be much higher by now. All this led me back to thinking about Friedman’s helicopter example in Money Mischief where money is dropped into a system to illustrate how more money chasing the same amount of goods causes inflation. So to revisit that example, lets say the same amount of money is dropped from the helicopter but only a few individuals stumble upon the money. Instead of spending more and unleashing the new found money into the system, they stash it away for a rainy day and pay down their debts. I have to assume that both businesses and individuals are paying down debts right now, thus explaining why the inflation level has been kept in check at least thus far.
One thing to make clear is that CPI is not a forward predictor of an economy. It is a lagging indicator and can merely indicate areas of inflation that could become potential problems down the road. Let’s wait and see what Helicopter Ben does now, but even more, let’s worry about what steps we can take should this turn into an even larger problem down the road.