China is slowing because the world economy is slowing

Sometimes I read what others think and just smack my head in amazement–why didn’t I think of that!

I had that feeling this last week in reading about a brief interview with Wells Fargo’s former CEO, Dick Kovacevich. Mr. Kovacevich said Tuesday that China’s economy has slowed because the rest of the world has decelerated.

This view is in contrast to what many are saying and thinking: that the world economy is slowing because China is slowing. When you think about it, Mr. Kovacevich’s interpretation makes more sense.

China’s economy has mostly been serving as the world’s workshop. Goods are manufactured there and sent to the rest of the world. The inputs that China uses to build all those products come from both inside and outside of China, but mostly outside (iron ore, coal, oil, copper, etc.).

If world growth slowed, that would cause China to slow down production in reaction, which would lead to a lower demand for inputs, which would cause commodity prices to tank–just what we’ve been seeing over the last year.

China isn’t driving demand or creating growth, it is reacting to growth outside China. Of course!

So, why then is the world economy slowing? The quick answer is bad policy. If you look at the Middle East or Russia over the last several years, you see gross government overreach leading to military incursion, loss of lives, destruction of property, misallocation of capital, etc. If you look, too, at places like Brazil, where a massive oil and gas find turned into massive government corruption, you see more bad policy (government ownership/control of oil/gas fields) leading to economic troubles. Then, if you look at Japan, Europe and the U.S., you see central banks trying to create economic growth by fiddling with interest rates and money supply. As Dr. Phil would as, “How’s that working for you?”

The world economy has slowed in reaction to bad policy, and that has turned, first, into significant declines in input prices (commodities), and then, second, into slowing and economic upheaval in China.

A reversal will require either a change from bad policy to good policy (through elections or changed policies due to the threat of elections/being ousted), or for the power free markets to overcome the dead weight of bad policy. Either solution will take time, though, so it wouldn’t surprise me to see markets continue their recent instability.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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China is slowing because the world economy is slowing

Savings, not consumption, grows the economy

It’s hard to believe, but in a country where thrift was once a virtue, it’s become a vice in the view of many.

The blame lies clearly with economists and politicians who try to reverse cause and effect.  Their attempt fails when confronting the facts.

Imagine yourself on an island in the Pacific Ocean without any outside contact.  Do you think you could grow your standard of living by eating more, or by storing food?

The answer is obvious.  You can’t consume what you haven’t produced.  You can’t live in the shelter you haven’t built, you can’t eat the fish you haven’t caught, and you can’t escape on the boat you haven’t constructed.

To have the time to build the shelter and boat, you’d have to put enough fish aside so you could build instead of fishing.  You can’t both build and go fishing, and without fish you’d starve.  To grow your standard of living, you have to forgo consumption by eating less, which then becomes savings.  The savings then allows you to build shelter and a boat.  Savings is what leads to growth, not consumption.

And, so it is in the world economy.  To get to the point where we have shelter, transportation, clothes, etc., we need to first save up enough food to have the time and resources to devote to building the other things we need.

Here’s another example.  Assume you want to open a store that sells clothes.  To rent the store, purchase inventory and pay employees, you need money.  You can’t use the sales revenue you haven’t gotten yet.  You need to use someone else’s savings.  Once those savings are used to rent the store, buy the inventory and pay employees, you can pay back the person you borrowed from.  But, you can’t borrow what’s been consumed–it must be saved first.  The lender has to save instead of consuming in order for the store, the jobs or the clothes to ever exist.

Once again, so it is with the world economy.  To create growth, hire new employees, etc., you need savings first.  Savings that are invested create growth.  Consumption can’t do it.

If you spend more than you produce, your standard of living will go down.  That’s just a fact.  You can’t spend your way to prosperity.  You have to save first.  But, to save, you need to spend less than you make.

Sometimes, savings doesn’t produce growth.  As illustration, suppose you put enough fish aside to build some shelter, but a storm comes along and blows it away.  Now, you have to save enough fish up, again, so you have enough to get by as you rebuild a new shelter.  Consumption won’t fix the problem, only more saving. 

Using my second example from above, suppose the clothes store fails–suppose buyers are not interested enough in the clothes to pay as much as the rent, employees and inventory cost?  Then you won’t have enough to pay back the person you borrowed from.  To build back to the point the lender started from, more savings will be required–which means the lender will have to consume less and save more.

Once again, so it is with the world or national economy.  Bad loans are solved by more saving, not consumption.  Destruction by mother nature requires more saving, not more spending. 

More spending than production leads to lower standards of living.  The solution, once again, is savings, not consumption.

Don’t be fooled by those who say the U.S., or China, or Europe, or Japan, or anyone else can create prosperity or growth by borrowing to consume.  Growth comes from savings, not consumption.  And borrowing to consume requires even more savings to get back to break even.

Next time you hear someone prattle on about how we need more consumption to get growth “going” (I don’t care if they have a Nobel prize in economics–that just means they should know better!), think about an island in the Pacific and that consuming fish doesn’t create shelter or boats.

It’s time to go back to our country’s roots, it’s time to tear down the over-worship of consumption and spending and replace it with a reverence for savings and investment. 

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Savings, not consumption, grows the economy

Economics rap

(If you’d like to skip my set-up to two amusing and excellent economics rap video’s, please zip to the bottom for the links)

After graduating from the Air Force Academy in 1992, I went on a knowledge-gathering binge.  I read philosophy, pop science, great quotes and great literature.  I was eager to put my 17 years of learning to work, but I realized I still had much more still to learn.

After graduating from pilot training, I got back to work in my knowledge-gathering project, this time filling huge gaps in my knowledge of history, politics and economics.  In that journey, I found out about the Austrian economists.

In college, I took Economics 101 and 201, which focused on micro-economics–the economics of supply and demand in individual markets–and macro-economics–economics at the aggregate level (national, regional, world). 

Little did I know that an intellectual battle had been fought long ago, and that the Austrian economists had been essentially stricken from the record of academia.  In almost any college in the nation, the focus of macro-economics courses was on Keynes and the Monetarists (Milton Friedman being the most prominent of the latter).

My problem, before reading the Austrians, was that Keynes and the Monetarists didn’t seem to very well describe reality as I saw it.  Keynes, a British economist, saw the government having an active roll in the economy, smoothing out the bumps of free markets.  But, my reading of history clearly showed this always ended in tears.  The Monetarists, based especially out of Chicago and MIT, constructed complex mathematical models based on assumptions that were clearly false, so they too seemed off the mark.

When I read the Austrian economists, especially Carl Menger, everything seemed to fall into place.  I felt like a physicist reading Newton for the first time–this was clearly a better description of reality.  So, I was stunned that my college classes never mentioned the Austrians and that they were basically relegated to the back-woods of academia (much like Aristotle during the Dark Ages).

As time went by (I first read the Austrians 16 years ago), I realized the Austrians weren’t and wouldn’t get a hearing any time soon.  The Austrians, including Hayek and Mises, were considered to be cranks and irrelevant (like those who believe in the gold standard–oh wait, that’s becoming fashionable again, too!).

The Austrians showed that economics was best left to individuals freely choosing their own economic destiny.  Interest rates, prices, quantities produced, etc. set by the free market would fluctuate, but this would be infinitely better than bureaucrats setting them more disastrously. 

In particular, they showed that bureaucrats setting interest rates would lead to gross mis-allocation of capital over time, leading to worse booms and busts than occur in free markets.

This discussion may seem academic, but it became clear to me that the Great Depression could be clearly understood in this framework.  The Federal Reserve was created in 1913 to prevent financial panics.  In the mid 1920’s, the Fed held interest rates artificially low so France and Britain could pay back their debts from World War I.  This led first to a real estate and then a stock market bubble that crashed (sound familiar?).

The mis-allocation of capital for years before 1929 had caused the Great Depression, not animal spirits (Keynes) or inadequate money supply (the Monetarists).  This seemed a more accurate description of reality than anything else I had read.

Not surprisingly, this meant the Austrians clearly saw the dot-com and housing bubbles building and bursting more recently–because they were focused on the mis-allocation of capital due to the Fed fiddling with interest rates!  Keynes and the monetarists were oblivious and even responsible for the busts! 

Despite all this supporting evidence, I still expected the Austrian economists to remain in the backwoods during my lifetime.  I didn’t think they’d get their hearing. 

I must admit, I was short-sighted and wrong.  The Austrian economists are coming back.  As proof, here are two links (Keynes and Hayek round 1, Keynes and Hayek round 2) to rap video’s featuring none other than Keynes and Hayek (not the real people–they are both dead–but actors playing economist rappers).

Perhaps the Austrians will get their hearing.  Perhaps people will start demanding economic policies that conform to the facts of reality and human nature.  I must admit, I would be all too happy to be wrong on this.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Economics rap

There’s no free lunch

One of the most succinct propositions in economics is that there’s no such thing as a free lunch.  Put more plainly, when you think you’re getting something for nothing, you’d best check your premises.

Take free Internet search.  Is that really free?  No, it’s paid for by advertising.  Free news from over-the-air broadcasters ABC, NBC and CBS?  Advertising.  Free advice from financial planners?  Commissions on mutual fund sales.  Free roads?  Check out the taxes you pay on fuel.  Free lunch from an insurance salesperson?  Commissions, too (an insurance salesperson once bragged to me that he only needed 1 out of 20 people to buy insurance at those events–so you should know right away the “product” is a rip-off!).

There’s no such thing as a free lunch. 

In no case should this be more obvious than government support of the economy.  Hey, if all it really took were the Federal Reserve printing money to promote prosperity, then Wiemar Germany and Zimbabwe would have been the most thriving economies in history.  They weren’t/aren’t (both disasters on scales that make earthquakes and hurricanes economically boring in comparison).

And so, when the Fed ends it’s quantitative easing program this summer, we should all be on the lookout for economic tremors.  We ate the lunch, now the bill’s coming due.

I’m actually quite surprised market participants have been short-sighted on this issue.  I naively thought the quantitative easing program hinted at last summer would be seen for what it was–quite costly.  Instead, the market started partying like it was 1999.

This attitude will, however, prove short-sighted.  Unfortunately, John Q. Public has joined the stampede.  As usual, he waited until the herd reached full speed, long after the lead steers saw the Fed’s policy as a license to speculate.  My guess is that he’ll leap off the cliff only to look back and see the lead steers observing the slaughter from the sidelines. 

So was it ever.

Perhaps we’ll get a third round of quantitative easing and the day of reckoning will be put off.  If so, that lunch will be no more free than the last several. 

It will be interesting to observe how the lead steers react, and how long it takes for John Q. Public to learn that there are no free lunches.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

There’s no free lunch

The most important concept in finance

I was going to write a blog about why I think China looks more like developing Japan (with the same dreadful destination) than developing America, but realized I just couldn’t get there without an intermediate step. 

That intervening step may seem like a minor point, but I believe it’s the most important concept in finance and one of the most important in economics: return on capital.

Okay, of the 10 people reading this blog, I just lost 80% with that last sentence, so thanks for sticking around remaining 2!

Return on capital probably seems like either a very mundane or overly abstract concept.  Everyone knows that for any financing to work, the financier must get his capital back and then some.  Otherwise, why bother, right?

But, it seems like people frequently drop this context when they discuss broader issues.

Take college loans for example.  If you lend someone more money than they could possibly repay to go to college, it’s not economic.  But, you’ve got to do the math to really grasp this concept. 

If you lend someone $100,000 to go to college, and they earn a degree that pays $20,000 a year, then it would take 20% of their pay ($4,000) for the rest of their life just to service a 4% interest rate–and that’s without paying any of the principal!

No intelligent financier would ever make such a loan, yet most people think the financier is being mean.  What they should recognize is that such a loan is bad for the borrower and society just as much as for the financier–such a loan saddles the borrower for life and reduces the productive capacity and standard of living for the whole economy.  It’s not mean, it’s just a plain stupid.

In 2006, I would have been laughed at for suggesting that many home loans were being done under the same uneconomic conditions.  I hope that 2007-2009 has convinced most people of the soundness of this logic.  If you can’t get a positive return on capital, it screws up the whole economy and wrecks the lives of those involved.  If you can’t get a positive return on capital, it’s not financial or economic, it’s charity.

Society does not grow and prosper by charity, it requires a positive return on capital.  For those who wish we were ants or that reality was other than it is, this may be a real downer, but that’s the way it is.

In order to meet our current and growing needs, we need to produce more this year than last, and the only way to do that is to get a positive return on capital.

What, exactly, does that term mean, anyway?  It means if you borrow $10 from someone, you need to be able to pay them back the $10 plus whatever makes it worth their time.  Or, more importantly, it means that you need to do something with that $10 that will generate $10 plus interest. 

Or, more fundamentally, it means that if you buy 10 pieces of wood for $10, you better be able to turn those 10 pieces of wood into something worth more than $10, or you’re wasting your time and someone else’s money.

Or, even more fundamentally, if you don’t produce something worth more than $10, then you’ve reduced the productive capital available and thus lowered everyone’s standard of living (please see Peter Schiff’s How an Economy Grows and Why It Crashes for an excellent, very readable, and more thorough illustration).

This is not a minor point, I hope you can see.  If you lend someone $10 and they can only pay back $9, it’s not just bad for you, it’s bad for them and for the rest of society.  Those 10 dollars were earned by your time, effort and resources, which you can never get back.  That $1 is done, gone, kaput!

Perhaps dollars is an inadequately concrete way to describe this point.  Suppose you had 10 pieces of wood and you destroyed one by fire without producing any product or service.  Nothing you can do will bring that piece of wood back.  That wood can’t be used for fuel, or be turned into furniture, or anything else ever again.  Time and effort would have to be expended to gain a new piece of wood–time and effort could have been used productively instead of simply bringing things back to the way they were before.

Return on capital isn’t just nice to have, it is a very concrete description of what is necessary to maintain and grow our standard of living.  We must use our resources wisely such that they produce more and more each year. 

It’s the bedrock upon which our world is built, and if taken too lightly, our foundation and prosperity will suffer.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The most important concept in finance

One clunker of an idea

I usually try to stay away from political commentary, but the “cash for clunkers” idea needs to be addressed from an economic standpoint.

If you haven’t heard about it, the “cash for clunkers” program gives cash to people who trade in their low mile per gallon vehicles to purchase newer, higher mile per gallon vehicles. From the way I understand it, you get $3,500 to $4,500 (depending on the mileage of the vehicle you purchase) for “cashing in” your “clunker.”

Now, let’s trace this idea from beginning to end and understand what’s going on. The government is paying people cash to throw away functioning cars. Where does the cash they are giving away come from? It comes from issuing government debt.

That means the government is raising money from someplace (China, Japan, Middle East, U.S. investors) that would otherwise have been invested in some other way, and using it to pay people to throw away functioning cars. Why?

(I’m sure it has nothing to do with the fact that the U.S. government has become a huge investor in Chrysler and GM. Note: I’m being sarcastic).

One reason is that most economists look at economic growth in terms of new things being sold instead of return on investment. Gross Domestic Product (GDP), which is the figure most economists and government employees watch, will show an increase because of the cash for clunkers program. GDP increases whenever things are sold, the government spends money, or we export more than we import.

Using this magical math, the economy grows any time consumers or the government spends, whether or not that’s positive return on investment spending.

But, let’s think further about this issue. Say you buy a car because of the cash for clunkers program. Because you are now making payments on a new car, and those payments are almost certainly higher than the payments on your clunker, then you have less money to spend on other things. In other words, spending has simply been taken from one place and put in another. GDP will show a spike because you spent a lot money today on a new car, but then you’ll have payments plus interest in the future which you can’t spend. Is that positive return on investment growth? Not likely.

Plus, the government has incurred debt to finance this spending. That won’t show up in GDP figures, so everything seems peachy. But, borrowed money needs to be paid back, with interest, and where will that money come from? It’s simply been borrowed from the future!

When I make an investment, the issue isn’t just: does growth occur? I must get a return on investment more than what was put into it.

Suppose I bought a company for $100,000 and had to put $10,000 into it in the first year. Suppose I only netted $5,000 in earnings. No one would consider that a wise investment. Suppose I put $15,000 into the business the next year and made $7,500. That would be growth, right, from $5,000 to $7,500, but I don’t think anyone would rejoice in putting in $25,000 and getting $$12,500 back over 2 years.

So, why would someone consider it a good investment to borrow money to pay people to buy something they don’t need? I don’t get it.

By such reasoning, it would make sense to burn down all the houses in my neighborhood so we could spend money to build new homes. If that’s considered economic growth by someone, then cash for clunkers makes sense.

But, to me, it doesn’t.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

“Reasoning correctly from erroneous premises”

The quote above is from John Locke, but I found it second hand from Nassim Taleb’s The Black Swan. Supposedly, it’s Locke’s definition of a madman.

In my opinion, this quote accurately describes the state of the art in academic finance and economics.

Although it may be hard to believe, the Nobel prize has been given out repeatedly to very smart people who are exemplars of the above quote.

As a result, the field of finance, economics and investing is populated with folks who seem to unquestioningly follow such teachings.

That’s why most people are over-diversified and think risk equals volatility. The result is that most investors are under-protected from low probability, high impact, negative events and over-protected from low probability, high impact, positive events.

When a couple of Nobel laureates who exemplify the quote above followed their own advice, they lost almost all of their investors’ money and nearly caused a temporary collapse in the world’s financial system (if you think I’m exaggerating, read When Genius Failed by Roger Lowenstein).

Despite this paradigm shifting result, most market participants go right on assuming that erroneous premises can be followed with rigorously correct reasoning (and lots of higher math and Greek symbols).

Which reminds me of an apt definition of insanity: “doing the same thing over and over again and expecting different results” (Albert Einstein).

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.