Unpleasant Facts and Other Musings

The UK’s Ministry of Defense has a Strategic Trends Programme that made a report in 2008 called “Global Strategic Trends – Out to 2040”. If you skim through the report, there are some very enlightening charts.

-Page 28 lays out the population growth and aging forecasts for the different regions of the world.

-Page 42 has a very interesting chart of global infrastructure and resources.

-Page 67 contains a map highlighting the areas with the most potential for conflict driven by frontier disputes.

One of the most interesting charts is on page 69 of the report. It highlights areas where there will be an overlap of at least two of the following: demographic growth, water and food shortage and crop decline. The top chart looks at the current situation, which shows that current stress zones are correlated with conflicts containing greater than 8000 fatalities since 1997. The bottom chart uses forecasts to identify where the future stress zones will be in 2040.

The forecast of larger stress zones in China is particularly interesting. China is going to have water management issues that they will have to deal with as they try to keep their economy on course. Water treatment facilities are a large part of this solution, but since they require a lot of energy, this will add to China’s energy demand.

While debt levels in both Japan and the US got to comparable heights, it is interesting that it would be very difficult to pick out the US housing bubble from a chart of their relative nominal USD equity market returns.

Source: Palantir Finance

There are a few possible reasons as to why this might be the case.

1. A larger fraction of the profits in the United State’s bubble went directly to highly paid individuals rather than corporations.  This would be more likely if corporate profits didn’t reach 12% of GDP in 2006, levels not seen since the 1960’s.
2. The US housing bubble was focused on the leverage in housing, which was residential in nature. Japan’s financial bubble was also to a degree about the real estate, but a lot more of this real estate was owned by companies who were on a whole more directly involved in their bubble.
3. The technology bubble of the late 1990’s prevented the valuation of US equities from getting too disconnected from their earnings so soon after the last bubble.
4. The United States’ bubble drove equity markets all around the world while Japan’s bubble was focused on Japan.
5. Japan was benefiting from China driven growth the same time US assets were benefiting from the housing bubble.

Number 5 could be a coincidence or it could be seen as similar to #4 if the theory is that US consumers helped China’s exporters who created demand for Japanese imports.

In the United States, betting that government is going to grow is what some people might call a “positive carry trade”. A positive carry trade is a trade that makes money as long as things stay the way things are currently priced.  The growth of government under current conditions can easily be seen in data on projected spending levels from the CBO.

As spending levels increase, revenues are not at this time projected to rise to keep pace with earnings. There are a few ways that this extra revenue can be found.

1. More debt: The CBO currently projects that under current policies the US will have much higher debt levels in the future.

The trade based on these projections would be to sell short US government debt, as an increase in supply without a subsequent increase in demand should lower the price of an asset.

2. Inflating away the debt: A lot of people worry that the debt won’t be an attractive asset, so the government will have to raise money from seigniorage (issuing new government currency). The trades that make sense in this current situation are to buy gold and sell bonds. This scenario is what most people who worry about government spending often decide they need to focus on, so there is a question of whether there are too many people buying gold and selling bonds in the absence of any present fiscal crisis. However, if a fiscal crisis does occur it may be too late to put on any of these trades so it isn’t completely illogical for a person who thinks there is a higher probability of a fiscal crisis than other people admit to try and hedge their portfolio against the possibility.

3. Higher taxes: This is the least extreme case, though there are still investments that can be made if this occurs. Although the average US voter loves low taxes, they may decide that they like their entitlements more. The recent healthcare policy is a shift in the direction of more entitlements and higher taxes. This negatively impacts domestic growth while not having much of an international impact.  The fact that companies with more international exposure have outperformed companies with domestic exposure even when the dollar was strengthening could be attributed to the wave of new regulations in the US.

Source: Palantir Finance. For International/Domestic Index: GS International Growth Theme Index (68% of revenue from sales outside the US) divided by GS Domestic Sales Basket (less than 1% of its revenue from international sales)

4. Repeal of future entitlements: I’m not sure that this scenario is likely enough absent an inflationary shock to make it worth considering, but the basic scenario would make gold less attractive and while bonds might sell off due to higher future growth they would not be at risk of a major sell off.

1. Megan McArdle has some interesting predictions about what won’t happen after yesterday’s healthcare vote.

2. Arnold Kling discusses why Modigliani-Miller just doesn’t apply in the real world. It is interesting that many of the differences happen to favor leverage.

3. Eric Falkenstein highlights the difference between a popular account and an accurate account of the recent bubble. It is too bad that people are seemingly hardwired to prefer stories with heroes and villains.

4. Scott Sumner vs. Paul Krugman on US policy as it regards China and its currency.

5. Michael Pettis looks at the potential impacts of a revaluation of China’s RMB.

9. The authority to pay interest on reserves is likely to be an important component of the future operating framework for monetary policy. For example, one approach is for the Federal Reserve to bracket its target for the federal funds rate with the discount rate above and the interest rate on excess reserves below. Under this so-called corridor system, the ability of banks to borrow at the discount rate would tend to limit upward spikes in the federal funds rate, and the ability of banks to earn interest at the excess reserves rate would tend to contain downward movements. Other approaches are also possible. Given the very high level of reserve balances currently in the banking system, the Federal Reserve has ample time to consider the best long-run framework for policy implementation. The Federal Reserve believes it is possible that, ultimately, its operating framework will allow the elimination of minimum reserve requirements, which impose costs and distortions on the banking system.

In the last post I mentioned some interesting research about the psychological tendency to fixate on enemies, inflate their powers and imagine that they are behind most of our problems.

New research supports the notion that we fixate on enemies, and inflate their power, as a defense mechanism against generalized anxiety.

This provides another interpretation for why some people believed that Japan in the late 1980's and early 1990’s might take over the world.

A research team led by social psychologist Daniel Sullivan of the University of Kansas reports on four studies that suggest people are “motivated to create and/or perpetually maintain clear enemies to avoid psychological confrontations with an even more threatening chaotic environment.”

Without the threat of the Soviet Union, the American public had to focus on something to take its place.  After Japan’s spent two decades without significant economic growth, growing government debt and an aging population they are no longer much of a bogeyman. The next bogeyman is China, as people now believe that China is going to eventually take over the world.  China’s growing economy is competing with America’s economy on numerous levels, but the areas where the US is struggling are caused more by structural problems inherent in the US economy than the emergence of China’s economy from poverty.  If there is a tendency is to inflate the enemy's power, that would explain why a large fraction of people are apparently blind to the unsustainable high levels of government driven investment fueling China's current growth. They just figure that China has a long term plan that they will have no trouble bringing about. The article elaborates on the conditions causing this tendency.

Those who were forced to contemplate their lack of control over significant life events “reported a stronger belief in opponent-led conspiracies,” the researchers report.

This can explain why protectionism with regards to China might get more popular the worse unemployment becomes.  If it is seen as a way to thwart China’s plans, it can very easily become popular with an American population worried about keeping their jobs.

In our third study, we showed that if people perceived the broader social system as ordered, they were more likely to respond to a threat to personal control by boosting their faith in the government, rather than by attributing more influence to an enemy.

So if the government solution to a perceived problem is protectionism, this will solve the problem for both types of people worried about their personal control.  Too bad this won't solve any of our real problems and will make the economic situation even worse. 

HT: Marginal Revolution

Considering the implications of the last post, I thought some data would be helpful. Remember, the government doesn’t see gold as an investment but as a collectible.

Source: Tax Foundation

When capital gains taxes were cut for most financial assets other than gold, gold underperformed the market, although the subsequent maneuverings of the twelve to 18 month capital gains tax rate had less clear effects:

The effects of the next relative tax cut for the market and gold is unclear, as it happened during a time period when central bankers were still mildly worried about deflation. Bernanke’s helicopter speech was only 6 months before. The dollar had been falling for a year, and would continuing falling for a year and half more. In an environment like that even an increasing tax disadvantage can get overwhelmed pretty quickly.

In general, it is rather difficult for a casual look back to accurately the determine market impact. There is a lot of noise preventing the market watcher from knowing what is being priced in at any one moment. Looking at past news stories, unless the story is about a specific announcement, would only help in the rare cases where the financial journalist knows what they were talking about.  In these cases, falling back on theory is probably the best approach.  When the opportunity cost of holding an investment has decreased, then when all other things are held constant it becomes a more attractive investment.  Whether this is already priced in and whether this signal is greater than the general noise of the market are the next two questions.

It is important to note that gold isn’t going to be impacted by the upcoming change in the capital gains tax rate. Gold is already taxed more than other assets because under current tax law gold is a collectible. The capital gains tax on collectibles is 28%, 13% higher than the current tax rate of other assets. With a hike in the capital gains tax rate from 15% to 20% at the end of 2010 this spread decreases to 8%.  If the healthcare bill passes the senate and the house in its currently proposed form then this spread will be reduced even further at the end of 2011.

Gold has always been one of the closest things to an anti-investment; people invest more in gold when they aren’t sure that other investments are a good way to preserve their capital. The current trend in policy of taxing other forms of investment more while not taxing collectibles at a higher rate is only going to make the anti-investment look relatively more attractive.

This Gold/S&P 500 chart helps put the relative performance of gold and equities (unadjusted for dividends) in historical context. Gold’s best relative performance occurred during the deflationary crash of 1929 and the inflationary scare of the 1970’s.

Source: Palantir Finance

In my last post, I mentioned that the lack of children might be a signal that society isn’t looking forward to the future.  There are a few problems with this, mainly that as societies become richer they naturally have more children. This inclination isn’t because people aren’t focused on the future, but because wealthier societies have children that are more likely to survive they don’t need to have that many. On top of that, each child requires greater investment in education so in an advanced society increased investment in fewer children looks like a better strategy than less investment in more children.  With birth control, families are able to make that choice.  So less children per household wouldn’t be a signal of a hyper-present oriented society, but less children overall would still be suggestive.  If less people have children then the pleas to “think of the children” will be more likely to fall of deaf ears.  Data from the U.S. Census Bureau is helpful in digging deeper into these questions.

As mentioned above, the people per household and family have shrunk over time.

Looking at the breakdown of household sizes, this gradual decrease is due to the disappearance of large families and the emergence of the single person household.

In order to determine whether the one person households have been increasing purely due to an aging population, the breakdown in one person households by gender is informative.  If the trend is age driven, single female households should be increasing at a rate much higher than single male households due to the greater female life expectancy.  This is not actually the case, so the increase in single person households is likely preference driven.

The preference for single households increases the nonfamily households as a percent of total households.

Non-family households have increased even faster than the percent of one person households.  This may be due to an increased preference of cohabitation over marriage or due to a rising economic necessity for people to have roommates.

It isn’t just nonfamily households that are saving money on rent, a larger percentage of married households than before do not have their own household. These households are most likely living in the house of one of their parents. In bad economic times, this trend is likely to continue.

Even though household sizes have remained relatively constant, families with young children have also decreased as a percent of the total. This is due to both to the aging of the population as well as a decrease in the propensity of the average couple to have children.

Overall, it does look like the decrease in children in our society is due both the decrease in family size and the increasing prevalence of one person households.  The decrease in family size may be a reallocation of investment, but the decision not to have children is more likely to be both a cause and a symptom of present oriented behavior.