Hedge Funds and Global Liquidity

Oh dear it seems as if Bear Stearns may be in a little trouble as it coughs up $3.2bln to support one of its hedge funds exposed to the US subprime market.

This is not good news at all but the market has been through this before with the Long Term Capital meltdown in 1998 and of course the 1995 collapse of Barings Bank by Nick Leeson. So it won’t be in complete panic but this is a big move to Bear Stearns and perhaps just a taste of what can go wrong when the music stops.

Hedge funds are heavily leveraged and so when a big move goes against them the losses can be astronomical. In theory risk models are supposed to flash warning lights at set points but the reality is that these models are not foolproof (after all we designed them) and traders can often disguise bad positions. And from my experience all risk is underpriced since it is based on average volatility and not the heavy meltdowns that come with increasing regularity.

The last 10-15 years has seen a huge amount of money created by the worlds’ banks and much of that finds its way back into the financial markets to be invested or used as speculative margin. The numbers are so huge that the Fed in the US has decided it would rather not publish money supply numbers anymore.

So when the market goes into reverse it can cause major losses which have knock on effects around the whole system.  It will be interesting to see how this situation pans out but at some point there will be a serious contraction unless new demand can be conjured up.

RBNZ: Have They Lost the Plot?

There has been a lot of hand wringing over the recent Reserve Bank’s intervention in the currency market. So what’s the story here?

Well the RB has a clear mandate to keep inflation, as measured by the CPI, between 1-3% on an annual basis. According to them they also say that,

“The Bank is required to ensure that, throughout the economy, money works as well as possible as a mechanism for making transactions, storing value, and keeping account.”

So let’s say they are also responsible for price stability in a general sense i.e. no serious asset bubbles or major deflationary shocks.

So how are they doing?

Since 1998 the CPI has risen 20.7% to December 2006. So an average of 2.5% per annum which is within the prescribed band.

But the key worry, or so they keep repeating, has been the housing market which in the same period has risen 143%.

So what have they done about it?

From Mar 04 to Dec 06 they raised interest rates by 2%, from 5.25% to 7.25%. That doesn’t sound like a great deal by historical standards and clearly has not had any impact.

From Mar 04 to Mar 05 rates went up 1.5% as inflation took off towards 3%. However, they stopped when they should have kept going. When CPI hit 3.4% and stayed above, the bank should have got really serious and jacked rates up very quickly.

They didn’t. CPI was above 3% from Sep 2005 to Sep 2006 and they moved only 50bp. This was their big mistake. With house prices on the march as well they should have had rates up to 8% by June 06. They are a year behind the curve and that could cause some major problems.

Alan Bollard has been soft in his approach and this may well stem from the false comfort that low global rates has brought. The great inflation crush of the late 1990s has seen global rates fall into ranges not seen for many a year. Central bankers have been playing in a very small range and have been lulled into a false sense of security.

All around us we witness the asset price bubble caused by cheap global credit. The Japanese are still at it pumping out cheap yen that no one really wants. This is a major disaster waiting to happen. We’ve seen it before when USD/JPY fell to 79.65 back in 1995 on the back of US trade concerns and Asian Central banks dumping their US$. For now the flow out of the yen and into the kiwi continues with a rise of over 15% in the last 6 months.

Yesterday Winston Peters called for an amendment to the Reserve Bank Act asking that the Reserve Bank take a more rounded approach to managing monetary policy. I have to agree with him that a major review is needed and that simply using the OCR to control the economy is not working.

Submissions for the inquiry into a future monetary policy framework close on 19th July. I will post my submission up here in due course. It’s a great opportunity to throw open the arcane nature of our monetary system and make proposals that may lead to a more productive and stable economic system.

The Nature of Money

In a previous post Does Money Grow on Trees? I looked at how money comes into existence, but in a broad sense of the word.

In his paper, The Nature of Money, John Kutyn examines in detail what money is starting from the late 16th century. He explores the development of what we know as bank notes from their early days as accommodation bills and the establishment of the Bank of England as a way of funding a war against France.

He follows the development of money and banking primarily through the legal process andlooks at numerous cases in law of challenges to the meaning of money and the transactions it is used for.

He challenges the banking system to show that it is not acting fraudulently in law when it uses deposits as money and actually creates money via new loans. Of course only a Reserve Bank can create money or so the law states. So is true? Well i suggest you read his paper and draw your own conclusions but he makes a compelling case.

Not content with that he then moves on to looking at the economic impacts of the current system which has a built in imperative for growth resulting in continued boom bust cycles. He argues that this is down to the interest burden and that debt free money is the only way a stable economy can be achieved.

As we approach yet another global bust and possible depression it is worth relfecting on the themes in this paper.

Food Miles - Consciousness is Growing

Barely a week passes without a new campaign in the UK around the issue of food miles and NZ produce. Though this has been thoroughly debunked by the report from Lincoln University the story continues to rumble along.

This is just the beginning of a more serious debate on the issue of environmental costs otherwise known as externalities. Food miles is just a simple way of engaging the public and media just as the phrase “think global, buy local” has always done.

We all like to support our local farmers whether in NZ, UK, France, Japan or the US. However we all like to sell as much as our produce into markets where we can achieve a better price (even after taking account of transport costs). NZ is heavily geared towards exporting and with a large productive base and small local market it is more exposed than many other larger countries.

Stepping away from the hype and hysteria we can see that the Food Miles debate is both important and necessary. Consumers should be paying the full price for the goods they buy and that includes the basic inputs of energy and matter as well as ecosystem goods and services.

Whilst food miles comes across as a marketing ploy and is somewhat simplistic in its formulation, it can be seen as the start of a serious attempt to bring Trucost pricing into the mainstream economic system. Of course it makes sense to buy your veggies from the farmer down the road but the supermarket system is all pervasive and has driven costs down so far that they have been able to get away with an international supply chain as well as shipping domestic produce many miles further than necessary.

Pricing ecosystem services in at the primary level would see a vastly different pricing mechanism: one which included the price of nutrient and effluent run off, mining run off, soil depletion, air quality processing, clean water provision and the numerous other services which have enormous economic value.

If this happens then maybe we can relax a bit as the produce in our supermarkets and farmers markets will be priced on the same basis.

Only then will we really know which is really cheaper.

Sustainable Business - Costing the Earth

I wrote this article for a business paper here in NZ about 3 years ago. I don’t think alot has changed really though the issue of Food Miles and Carbon Pricing has reared its head. Pricing the ecosystem is an emotive subject but i believe we must recognise its value in monetary terms in order to enable true economic comparisons to be made.

We know in our hearts that we need to consume less and make better. We don’t do it because we are time constrained as we slave away in our jobs to pay off huge mortgages, large rents and all the bills we have incurred in our consumption binge. If we really knew the true cost of our goods and services we may change our behaviour with increased speed.

And yet see the seething anger when petrol prices go up……we may be in position to control and destroy the planet but it may well do that to us first. Anyway this may or may not resonate. See what you think:

March 2004.

‘Greens take us back to the Dark Ages’ screams the Business Round Table. ‘Business doesn’t care about anything apart from money’ whines the Green Party. Sound familiar? This is generally what passes for debate between the official representatives of the economy and the environment. It is reminiscent of a long running stand off between a teenager and parent. Will the environment and business ever resolve their disagreements live together in sustainable harmony?
To answer this question we need to explore how the economy and the environment interact. The word economics is derived from the Greek ‘Oikonomos’ meaning household steward or home economist in modern diction. In ancient times, the household was the central functioning unit of any economy and most economic activity took place within that framework. Now the household is a place where we live and sleep but rarely do we produce anything that is identified as part of the economy, reflected by GDP. Business is now the place where most economic activity takes place and it is now the steward of the environment.
Our technological capabilities have also moved on giving us DVD recorders, microwaves, mobile phones and other similar gadgets but they are still all built from materials taken from the same source as thousands of years ago. As, John Muir, the founder of the modern ecology movement, said “When we try to pick out anything by itself, we find it hitched to everything in the universe”. In simple terms, the economy is simply a subset of the environment, and economics a framework for understanding our transactions with the environment. They are one and the same, not distinct and separate entities as often portrayed in the media.
We have become expert in transforming natures’ goods into new products to satisfy our ever increasing desire for material consumption. At the same time, the waste products from manufacturing, some 90% of actual inputs, are becoming harder to absorb and process. Whilst nature provides obvious goods in the form of wood, minerals and fossil fuels, little attention is paid to the crucial services it provides in acting as a both a source and a sink for economic activity. These services include waste processing, climate regulation, water supply and regulation, soil formation, nutrient cycling, food production, erosion control, pollination and even recreation and cultural values.
The value of these services has been largely ignored by the mainstream economics profession rather like the value of unpaid labour in the economy. A mother who goes out to work and hires a nanny to look after her children suddenly finds out the monetary value of her work in the household. Previously no value was attributed to looking after children but as soon as someone is employed formally then the value is recognized. Of course anyone who has children knows too well the value of unpaid labour in the home.

Whist ecosystem services have always had value they have never been recognized in monetary terms and therefore incorporated into the economic framework. In 1997, a study, led by Robert Costanza at the University of Maryland, attempted to value global ecosystem services. The findings estimated very conservatively the value of ecosystem services to be in the region of 2-3 times global GNP. In 2000, a study into the external costs of UK agriculture by Jules Pretty at the University of Essex, showed a value of ₤2.3bln, based on actual financial costs incurred. This equated to ₤208 per hectare of arable and permanent pasture. Again this was a conservative estimate of all agriculture related externalities.
What these and other studies have shown is that there is a real and attributable value to these services previously taken for granted. If any business has any doubt about the relevance of these costs, they should have another look at their insurance bill. Munich Re, one of the world’s largest re-insurance companies, puts the annual global costs of climate change at US$300bln by 2050. Even the Pentagon, a normally conservative institution, is recognizing the potential security issues of serious environmental changes. One thing Greens need to recognize from their side is that without security, law and order, the issue of environmental damage is likely to be an irrelevance.
Actually incorporating external costs at the company level has proved difficult. However Trucost Plc, a London based but Christchurch born company has designed an external cost calculator and an environmental rating system, which incorporates the externalized costs of any organization into their actual accounts. Initially there was strong resistance from some in the environmental movement, concerned about placing a value on nature. However, now there is an understanding that if you don’t value something then it will be treated as if it has no value. It is an unashamedly anthropocentric view to place a monetary value on nature but one which in the long run will lead to a more sustainable economy. Mainstream economics needs to acknowledge the importance of externalities and not spend so much time pouring over inflation statistics. Economics is fundamental to how society organizes itself and surprisingly can be fun and understood by anyone, as demonstrated by Diane Coyle in her recent book, “Sex, Drugs and Economics”, which succinctly analyses everyday activities in simple language.

Whilst the economics profession needs to wake up, the environmentalists must also acknowledge that expecting society to make a wholesale change of consumption habits without strong financial incentives is naïve. The only way to make them change their current ‘unsustainable’ consumption patterns is for goods and services to properly reflect the externalized costs that make them unsustainable in the first place. The true sustainable business is one which internalizes all its costs, instead of passing them to the taxpayer to pick up at some future date. Therefore, in order to create a sustainable economy, we must recognize the value of the environment in real terms. Then maybe business and the greens can redirect their energies to work out smarter and cheaper ways of living well and enjoying life.

Incoherent System

Professor Peter Brown from McGill University in Canada is here in New Zealand speaking about our dysfunctional economic system.

He’s not wrong there. He was speaking on Radio NZ but the interview never really got going. He had enough time to talk about the incoherent nature of our economic system, how GDP measures income and consumption but not well being and how triple bottom line accounting was a waste of time. Agreed!

What we need is a better connection between our biophysical system and our economic frameworks like Trucost for example.

We also need to ask ourselves some basic questions such as

- what is our economy for? speculation or sustenance.

- what size should it be? as big as possible or big enough.

Simple questions but rarely asked. The mantra of economic growth at all costs is intellectually flimsy. Its lazy thinking……..the assumption that GDP growth is all that matters is quite clearly false.

What about crime, illness, pollution? What about the increasing gap between rich and poor.

As individuals we search for coherence but as a global economy we struggle to find that because there are no tools to do so. So perhaps by becoming more coherent ourselves we will aid and enable a global coherence.

As the Mahatma said “Be the change you wish to see”.

Let’s keep asking questions of our system.