Wednesday, September 27, 2006

I Wish That I Were This Smart

The Invisible Hand's Impressive Work
By Louis-Vincent Gave

We like to think of financial markets as a massive big puzzle whose pieces are scattered around the table. We also like to think that, if we concentrate hard enough, [...] then we should be able to somehow piece this puzzle together.

1- The First Piece of the Puzzle: Very Strong Profit Margins

[Shouldn't profit margins decrease rapidly, and soon]? After all, profits as a percentage of GDP have historically always returned to the mean (as they should-otherwise, given the laws of compounding, profits would end up being bigger than GDP).

The answer, as far as we are concerned is "yes". Profit margins as a percentage of GDP should come back down as our economies go through their mid-cycle slowdowns. After all, corporate profits have historically been one of the first variables of adjustments in our economic cycles.

But having said that, the "mean" to which profits revert to may be much higher than some expect. Indeed, while profits as a percentage of GDP cannot rise forever, we might have witnessed a structural shift higher in corporate profitability.

Let us take the US as an example. With ever-growing shareholder activism, and ever-improving management techniques, an increasing number of companies have become parsimonious with their capital spending. Capital is only deployed on projects which are deemed to bring returns over a certain threshold. Functions in which the company does not add value are either shut down, or spun off and sold to other investors better able to generate value. In the US, what matters first is profits and returns on invested capital. Employment then comes as a natural consequence of the companies' profit seeking activities.

Let us now take China as a second example. Thanks to a low cost of capital and a very low cost of labour, companies have sprung up all around the country and piled into new businesses. Because returns on invested capital are a distant consideration, most sectors are in overcapacity; and yet capital spending continues regardless. The country thus has over 300 auto producers, 3000 ball bearing manufacturers... In China, what matters first and foremost is employment; profits are not really even a consideration.

The US and China could of course each live as islands unto themselves [...]. But fortunately, the past twenty years have been characterized by ever greater improvements in communication technologies, port infrastructure, airplanes... Encouragingly, trade barriers and impediments to the movements of goods, and people, have been rapidly collapsing. [...]

As a result, we live in a world in which China and the US can increasingly talk to each other. And when they do talk, what do they say? China says "all I want is jobs" and the USA says "all I want is profits". And in that discussion a deal can rapidly be struck. Is it a coincidence that, just as we saw a widening of the US current account deficit, we also witnessed an explosion in the profitability of US corporations? [We would] argue "no".

Would it be a stretch to say that the impressive, and unprecedented, growth in US profits of the past few years is directly linked to Chinese companies' inability to hold on to any recurrent profitability? As the trade between the two economic giants keeps on growing, one question that investors should ask themselves is "who captures the profitability of the trade flows?" Is it Wal-Mart (or some other US distributor)? Or is it the Chinese goods manufacturer?

The answer to that question (i.e.: Wal-Mart), brings us back to the idea that profits need to return to the mean. This is undeniably true of a closed economy. But of course, few economies in the World today could be called "closed economies"; instead, companies are increasingly global, and thus their total profits should probably be compared to global GDP, instead of domestic GDP. Or to stay on the Wal-Mart example, maybe Wal-Mart's earnings as a percentage of US GDP are at the top of their band... But could the same be said of Wal-Mart's earnings relative to Chinese and US GDP. Most likely not! In other words, profits [will] probably return to the mean on a global basis; they may no longer return to the mean at a national level. [Emphasis added].

2- The Second Piece of the Puzzle: Income Disparity

This new world order (in which rich nations get the profits and poor nations get the jobs) immediately creates a quandary: massive income disparity. Indeed, in the "old days", people sitting at the bottom of the socio-economic ladder could get well-paid manufacturing jobs and ensure decent living standards for themselves and their families. The problem today is that, as the US-China trade of "we take the profits and you take the jobs" gets made, the people who were previously holding those jobs could be seen as losing out.

And, to be fair, one of the more obvious economic developments of the past decade has been the increase in income disparity across much of the Western World. The poor have not gotten poorer... but the rich have definitely gotten much wealthier. And for a simple reason; when we say "we will take the profits" the "we" is usually a somewhat concentrated smallish pool of rich people, i.e.: shareholders in Western companies.

This growing income disparity, one could fear, might lead to political problems and tensions. Are our societies sufficiently mature to cope with such income disparities? Some might be (US? Hong Kong? UK?...). Others, maybe less so (France? Italy? Germany?...). [...]

3- The Third Piece of the Puzzle: Discontinuous Inflation

[A]ssuming that we are right in our statement above that "the rich keep on getting richer", then it follows that whatever the rich buy should be going up in price much more rapidly than what poorer people buy (for there will be more competition for the goods/services that rich people buy). [...] The extent and persistence of the divergence between service and goods prices in the past decade also suggests a less obvious and more important story in three parts.

The first part of this story relates to China's entry into the global economy. By becoming the workshop of the world, China has pushed down the prices of all mass-produced manufactured goods. The virtually limitless supply of cheap labour and capital in China, and the chronic mis-allocations of capital will ensure that manufactured goods continue to get cheaper, not only in Britain but around the world.

But the relentless downward pressure on manufactured prices from China has resulted in a second effect which is less widely understood, even among economists: cheap imports from China have actually pushed up the prices of many goods and services which the Chinese cannot or do not produce - either because they lack the resources (for example, oil) or the legal infrastructure (financial services) or simply because some things cannot be traded (for example, housing, healthcare and education).

People who see China purely as a source of downward pressure on prices forget that overall inflation in any economy is essentially determined by the availability of money. If monetary policy is successfully run (as it is in Britain) to produce an overall inflation rate of 2%, [then if] the prices of manufactured goods are persistently falling by 3 or 4%, prices elsewhere in the economy must rise faster to maintain the 2% average inflation rate. [Emphasis added].

In this sense the ever-cheaper consumer goods from China have created more leeway for other prices in the world economy to go up. This effect has been particularly visible in the prices of goods and services which the Chinese are ravenously consuming but cannot produce themselves - for example oil, financial services and luxury property around the world.

Which brings us to the third, and most surprising, part of the inflation story. As the prices of services and luxury goods are driven persistently higher, service-producing countries such as Britain get richer relative to countries which specialize in manufacturing. And within Britain, the rich, who tend to work in high-end service industries which are relatively unaffected by competition from Asia, get richer, while the poor, who tend to work in industries more exposed to cheap-labour competition, get relatively poorer. [However], for the lucky bankers, lawyers and, yes, even economic analysts, who are benefiting from this seismic change in the structure of the global economy, [there is] a sting in the tail. While we are getting richer, the high-end services, most obviously housing, travel and private education - on which many of us spend a disproportionate share of our incomes - are becoming more expensive, because of the very same global trends which are making us relatively rich.

That is why, even as inflation remains almost nonexistent, the talk in London's bars and restaurants is of galloping prices. [...] Being rich has never [cost so much]. And staying rich is going to get more exorbitant by the day.

Reading the above, our friend David Scott wrote a great report where he stated that "while it has never been so expensive to be rich", it has also "never been so cheap to be poor". And, if we accept the crude simplification that poor people tend to spend more of their revenues on goods (which keep falling in price) while rich people spend more of their income on services (which seem to just keep on rising), then there might be a simple explanation to the impressive discontinuous inflation we have witnessed in recent years, [which has baffled us so]. [...]

4- The Fourth Piece of the Puzzle: A Confused & Confusing Fed

[H]ow should policy makers react to the odd inflationary environment which they now confront? [...] If policy makers take aim at the galloping service price inflation, they risk pushing the entire system into deflation.

However, given the recent tick higher in the inflation data, the question needs to be asked as to whether we have moved from an environment of: a) falling goods prices which allowed for rising service prices and an overall benign inflationary environment to b) an environment where the price of goods is no longer falling and service prices are still on the rise?

Now, as Churchill once said, most economists use statistics like drunks use lampposts: for support more than for light. And given that there are so many statistics on inflation one might be able to back-up nearly any kind of pre-conceived idea with scientific sounding data.

Unfortunately for the Fed, however, all the inflation data seems to be pointing in the same way: prices are creeping higher. The only question is whether this is a new trend? Or whether the rise in prices we have recently experienced is a short term phenomenon which will roll-over with the economic cycle? [...]

[U]ntil the mid 1990s, we lived in a world of oligopolies. When average costs went up, so did average prices. But as the recent spike in oil, copper, transportation prices has shown, this is simply not the case any more. Thanks to the combination of globalization, industry deregulation, technological progress, the spread of the Internet, and the emergence of the 'platform company model' (which feeds off all the above trends) we are moving towards a world with perfect information and perfect competition. In such a world, prices are made at the margin, and no longer on average.

The perfect examples of such pricing mechanisms can be found in the commodity markets where the information is at the same time available to most, and widely spread. As we all know, commodity prices are far from stable: if there is a shortage of one barrel of oil, the price shoots up; if we have an overcapacity of one barrel, its price collapses. The same can be said of the freight rate for oil tankers, for copper, or for any well published price determined at the margin.

And so today, we are in a situation where a growing number of prices are going up (hence the rise in median CPI) while the "heavy" prices (e.g.: rent) are still in check (explaining why the rise in the core CPI is more modest).

5- The Fifth Piece of the Puzzle: China's Export Prices

In the capitalist world, and barring the emergence of monopolies, competition always leads to the most efficient producer lowering prices in order to drive his output higher. The fall in prices is therefore inherent in capitalism, which is why Marx believed capitalism sowed the seeds of its own destruction. A claim to which Bastiat would answer: in economics there is always what you see, and what you don't see. You see the fall in prices, but you do not see the rise in disposable income, or the increase in sales triggered by the falling prices. [...]

We believe that [this natural capitalist tendency is still in effect today], if only because important parts of the world are clamouring to join the capitalist world, and in so doing, are using their excess savings (which are often large), to build excessive manufacturing capacity. This, of course, is nowhere more true than in China. A quick example will illustrate this.

As mentioned above, in China today, one can reportedly find over 300 car manufacturers. Unfortunately, the Chinese market is probably big enough for [perhaps only] ten car manufacturers. This means that 300 car manufacturing company CEOs wake up every morning and wonder: 'how do I get to be one of the ten survivors?' Being the most profitable is good, being technologically advanced is also a plus, as are political connections, but at the end of the day, one gets to survive by being the biggest; by employing so many people that, when the down phase of the cycle occurs, the government can not afford to fire hundreds of thousands of workers. One becomes 'too big to fail'.

This of course means that, when capital is offered up, all three hundred car manufacturers (following their 'too big to fail' business models) will grab it and spend it with both hands. Competing with each other for: a) raw materials, b) labour and c) allocations on the overstretched power and transportation grids.

In previous cycles, Chinese manufacturers would, in this way, end up with excess capacity that no-one would buy from them at any price. Today, the situation is very different. After the recent Chinese capital-spending boom (Chinese capital spending has grown from 32% of GDP to 45% in the past five years), most Chinese manufacturers now produce goods that are competitive on the international market not only on price, but also on quality.

This is a very important change, whose ramifications help explain China's continuous disinflationary impact. Because of the excess capital spending of recent years, Chinese producers have little choice but to export their overcapacity aggressively (hence the era of the US$5,000 Chinese car... despite rising steel, aluminum, rubber prices...). Chinese goods will attempt to gain market share by undercutting any other producer out there. Which, of course, then explains why goods prices have been under pressure in most economies in the past decade.

With that in mind, measuring China's propensity to export its excess production and put pressure on the prices of "goods" around the World becomes very important. And fortunately, there is a simple way to do this: studying the changes in Hong Kong's re-export prices. Indeed, Hong Kong is still an important port of transit for Chinese-made goods; and the data that the Hong Kong government compiles is trustworthy.

And this is where it gets interesting: according to Hong Kong re-export prices, China's deflationary impact seems to have been the greatest at the end of 2001 - beginning of 2002. It then took a little over a year for the world to really start to worry about deflation (and "the China price"). Of course, by that point, the deflation that China was exporting was already abating.

Then, for the first time in a decade, China's export prices started to rise meaningfully in 2004 and 2005. For a short while, China was exporting inflation; but once again, it took a year for the world to notice (and now people everywhere seem as concerned about inflation as they were about deflation three years ago). Today, Chinese re-export prices are back into negative territory. In other words, a year ago, Chinese companies had pricing power, [...] but this pricing power has now disappeared. China is back to exporting deflation.

6- Conclusion: The "Invisible Hand" at Work

At the risk of sounding Panglossian, we will admit that we are in awe at how Adam Smith's "invisible hand" works in strange and funny ways. If anyone had told us a decade ago that a "trade" would be put in place whereas China would say "give us all the jobs" and American companies would say "we'll take all the profits" and that this trade would lead to greater wealth, and greater social harmony in both countries, we most likely would have been very skeptical. Of course, we would have been wrong, for we would have forgotten to put our faith in Adam Smith's invisible hand which somehow has a way to make things work out in the end. [...]

To conclude, we would like to leave the reader with the following points:

(1) Inflation, at this stage, does not seem to us to be a viable threat. The current increase in prices we are witnessing reflects the past years' easy monetary policies and increases in China's export prices. These factors are now behind us. In front of us, we have the fact that China is once again exporting deflation, [...] and the tighter monetary policies of recent quarters.

(2) In a tighter liquidity environment such as the one we are now facing, owning the [company] that says "I'll take all the profits" makes a lot more sense to us than owning the [company] that says "I'll take all the jobs".


Blogger Bret said...

The author wrote: "But the relentless downward pressure on manufactured prices from China has resulted in a second effect which is less widely understood, even among economists: cheap imports from China have actually pushed up the prices of many goods and services which the Chinese cannot or do not produce - either because they lack the resources (for example, oil) or the legal infrastructure (financial services) or simply because some things cannot be traded (for example, housing, healthcare and education)."

I don't buy this incredibly zero-sum mentality. While it might well be true to say that services are getting more expensive relative to Chinese produced goods, services on an absolute scale are also getting less expensive. Which financial services does the author think is getting more expensive? Wiring money between banks? The cost of buying and selling stocks and other assets? Bookeeping services? Investment advice? Last I looked the long term trends of all these things were down, even relative to the CPI that is supposedly diluted by falling prices of Chinese goods. Perhaps the near term trend is up (I'm not sure), but I wouldn't make too much of that. Technology generally makes services cheaper as well, just at a slower rate.

Status goods, like high-end real-estate, are getting more expensive, but they almost have to be - otherwise, they wouldn't be status goods. The economy is not zero-sum, but status may be.

Mr. Gave seems to pontificating with great certainty. I think that much of what he says might possibly be true - but I wouldn't bet on it.

September 27, 2006 3:07 PM  
Blogger Harry Eagar said...

I don't think I truly understood all that, but one thing I get:

If China makes a crappy barbecue grill and sells it to Wal-Mart and Wal-Mart sells it to you, and China takes its -- evidently imaginary -- profits and buys US bonds because it doesn't need anything you produce, then two years from now, the grill will have rusted out and gone to the landfill, but somebody in China will be collecting money from your great-grandchildren forever.

China has had to deal with capital inflows for about 400 years now and has done a really bad job of it.

September 27, 2006 6:53 PM  
Blogger Oroborous said...

Bret: on an absolute scale are also getting less expensive.

The examples that you mentioned are well taken, but as the author mentioned in passing, the costs of healthcare and higher education are increasing far more rapidly than most other areas.

Status goods, like high-end real-estate, are getting more expensive...

Not just high-end real estate; in many markets, falling-down shacks became valued at several hundred thousand dollars, and decent homes required what were essentially multi-generational loans to allow middle class families to purchase them.

...but they almost have to be - otherwise, they wouldn't be status goods. The economy is not zero-sum, but status may be.

That strikes me as an excellent insight. Status is zero-sum.

I think that you did a post related to that on your blog, about how somebody had written that the rich actively enjoy oppressing the poor, that it increases their perceived happiness.


But the bond, and the money used to repay it, is imaginary as well, and extremely subject to fluctuations in value.

Our great-grandchildren will be paying off those bonds with what they'll perceive to be pocket change.

Which is not to say that there is no danger of overconsuming, and taking on enough debt to become burdensome, just that we're not there yet.

September 28, 2006 5:24 AM  
Blogger Duck said...

Which is not to say that there is no danger of overconsuming, and taking on enough debt to become burdensome, just that we're not there yet.

But are we getting there? Are we moving closer to that point or farther away? I don't think that there will be a sharp drop-off when we reach that point, but more like a parabolic curve downward, like a gravity well. The closer we get, the easier it will be to slide closer and the harder to climb away from it.

We shouldn't outsource all of our savings. I'm suspicious of any theory that tells me I shouldn't worry about that.

September 28, 2006 6:14 AM  
Blogger Harry Eagar said...

'with what they'll perceive to be pocket change.'

In that case, inflation is a problem.

Besides, even if the bond trades at $1, we still pay interest to the Chinese at par.

I was struck by the statement that Britain is successfully managing its inflation at 2%. That's very high and US inflation is even higher.

Just because we can remember a time when it was (briefly) a magnitude higher doesb't make 2 or 3% low.

My nominal income has doubled in 20 years, and my expenses would have way more than doubled except that I am still paying 1991 housing prices.

September 28, 2006 9:26 AM  
Blogger Bret said...


...the costs of healthcare ... are increasing far more rapidly than most other areas.

Yes, but I personally think that cheap goods from China is unrelated. Lawsuits, government regulation, insulation from market forces, monopoly rents by the AMA, etc. are, in my opinion, likely to be far more important explanations for rising health care costs.

Which is not to say that there is no danger of overconsuming ...

It may be harder than you think to overconsume. I'm not convinced that it's possible for a public who borrows only in its own government's fiat (e.g. non-gold backed) currency to overconsume itself into a really serious problem. It hasn't really ever happened.

On the other hand, underconsuming sustained the Great Depression for a decade.


We shouldn't outsource all of our savings.

Who's "we" exactly? Each person probably ought to save some for security and (unfortunately) retirement, but the US in aggregate doesn't need to save anything at all. Saving is not required for investment, yet investment creates savings.

Any dollar you don't spend is a dollar someone else may not get paid. Since the federal government can create an essentially infinite number of dollars for investment, your saved dollar has no value to anybody but you.

As a quick thought experiment: let's say everyone in the US, starting tomorrow, decided to be ultra frugal - move to a tiny apartment, walk or take mass transit to work, eat as cheaply and as little as possible, no gifts, no gadgets, etc. and we all saved all of the extra money. It's pretty simple to see, I think, that the economy would be in complete ruins in a matter of weeks. Massive layoffs would ensue (since nobody's needed to do anything since nobody's buying hardly anything), tax revenues would crater, demand for investment would crash, etc. Yet we would be awash in "savings" (at least temporarily).

So saving for the sake of saving isn't necessarily all that great.

Harry Eagar:

Just because we can remember a time when it was (briefly) a magnitude higher doesn't make 2 or 3% low.

A couple reasons why 3% is a fine inflation target. First, nobody really knows what the inflation rate is. Some thing it's substantially higher, some think it's substantially lower.

Second, the banking system (and the public) can easily deal with 3% inflation, but even a 1% deflation is much trickier. Generally, fed funds target rates are 0 to 2 percent above the inflation rate. At a 1% deflation rate, the Fed may need to drop the target rate below zero (which is impossible) in order to keep the banking system solvent (using the current mechanisms). Note that Japan has flirted with zero interest rates and has had a tough time of it.

September 28, 2006 5:06 PM  
Blogger Oroborous said...


Moving away, for now.
As long as a society maintains high productivity, adding debt isn't a problem.


Yes, inflation could be a problem, (and I expect that it will be a problem over the next fifty years, as governments world-wide try to use inflation to ease the burden of Boomer retirement), but I also expect increasing productivity as well - at least in America.
So today's debt will be future "pocket change" in both nominal and real terms, if I am correct about the trends.


I personally think that cheap goods from China is unrelated.

Your examples are on-target, but if the cost of goods is decreasing, and the money supply is growing, (as it has since at least '00), then it would be reasonable to suspect that some of the increased price of those services that have gone up is a function of a surplus of money, freed from purchasing goods, yes ?

It may be harder than you think to overconsume.

I'm pretty sure that Italy and Japan have managed to do so, among other societies. Time will tell.

September 28, 2006 6:23 PM  
Blogger Bret said...


...then it would be reasonable to suspect that some of the increased price of those services that have gone up is a function of a surplus of money, freed from purchasing goods, yes ?"

Yes, it is something to suspect. Let me just plant one little seed of doubt. One of the difficulties in actually measuring CPI is the problem of substitution bias. That is, as prices change, people buy different things. If the new choices are more expensive than the old, the question is it because of inflation, or is it because of increased value, or some mix? Many people thing that the CPI measurements don't weight changes in quality or value enough and so the CPI is overstated. If so, it's easily possibly that the overstatement is most severe in these high end products and services. If so, it's possible that everything is getting cheaper relative to the stated CPI and certainly relative to increases in GDP per capita.

On the other hand, certainly something must be getting pricier faster than CPI, so your assertion is certainly true at some level.

I'm pretty sure that Italy and Japan have managed to do so, among other societies.

Well, Italy now uses the Euro as its currency so it violates one of my premises (that it borrow in its own currency). In other words, California could get into deep financial straits, but I don't think the US can just as Italy can get in trouble but probably not the whole EU.

Japan is more interesting. Indeed, Japan has made me rethink the whole debt thing over the last few years, because according to my previous internal model, government debt at the level they have it was inherently catastrophic. Clearly my model was wrong, but I need to see what happens when interest rates rise significantly there before I know how to completely revise it. If interest rates never get very high (or at least not for many more yet), then I'll just have to make a stab at it. Right now my guess is that there is some inherent negative feedback loop that mitigates the effects of Japan's government debt. I just don't quite understand it yet (and I'm not sure all that many economists do either).

September 28, 2006 7:20 PM  
Blogger Duck said...

Have Italy and Japan overconsumed, or under-invested in human capital, ie. having babies?

September 29, 2006 10:21 AM  
Blogger Harry Eagar said...

Tonight's Google ad is from something called, which takes an apocalyptic view of foreign holdings of US securities and private assets.

What I found curious was a box on its home page listing the totals of US government debt held by foreigners.

It gives a total of $1.006 billion for Japan and China. The correct figure is about $1.8 billion.

You don't often find prophets underselling the amount of sin that much.

September 30, 2006 10:49 PM  

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