So it has finally happened. After threatening for months that a credit rating down grade was probable for the USA, Standard & Poor’s finally took the ‘big step’ on Friday 5 August, after the major markets closed.
Will the markets and market participants see the down grade as an opportunity to play an FX gain game; or has the game fundamentally shifted and will the capital markets react by demanding a higher nominal or at least Real Return on US Treasury bills?
All pointers at the moment did not indicate a problem, but time will tell on whether a fundamental shift in attitude has occurred. Remember a credit rating is only a qualitative indicator, not a quantitative one, so on a technical call a few FX traders and investors might make a profit or two; but we are all waiting to see if the entire game has changed, or not.
Other factors that might come into play soon would be QE3 and attitude hardening by major T-Bill investors.
How the US Treasury and administration now react will be crucial.
In the previous article we posted, mention was made of the (0.72)% [negative 0.72%] real return US Treasury investors can currently expect on 5 Year Treasury Bills. The Nominal (quoted) Yield Curves and Real (Inflation adjusted) Yield Curves for two specific points in time, namely Friday 29 July 2011 and 30 July 2006 are listed below.
Yield Curve 1
What is interesting to note is the very flat nature of the Yield Curve for all T-Bills at the end of July 2006, at around a 5% Nominal Return for investors. Yet the most significant fact is that the Real Yield was around 2.37% on 5 Year Treasuries, versus today’s (0.72)% on 5 Year or (0.18)% 7 Year T-Bill yields. In order to generate a very small Real Return, you have to be looking at purchasing a 10 Year T-Bill to obtain a modest 0.38% Real Return in today’s market.
A cynic might make this remark:
“Not only do you pay your taxes, but with the negative Real Yields on both 5 & 7 Year T-Bills, you are paying the government to hold on to your cash too”
There is a conundrum here somewhere! As a libertarian leaning Think Tank organization and publication, we instinctively know that more government interference in the economy and bigger government per se is not a good thing. And so is sovereign debt and the servicing of that debt. Both are drains on the economy and economic potential of any sovereign nation, yet both are necessary evils too.
But where lies the ‘sweet spot’ between the size of government, fiscal policy, sovereign debt (if necessary)? The magic formula or ratio between the public and private sectors and their respective shares of the economic output pie?
These are questions the political and business leaders are struggling to understand and define in Europe and the USA at this point in time in order slowly and arduously drag their economies back to a ‘normal growth cycle’.
Part of the challenge we believe is the massive imbalance created by the shifting nature and sources of production, combined with the rapid uptake of technology and the disruptive influences of technology. Our planning cycles and hence levels of understanding and ability to adjust the factors of productions to keep up with these disruptive forces are being severely challenged. Or maybe our grasp of the theory underpinning our economic models just aren’t up to coping with the rapid nature of change and forces of change in the global economy.
As has been argued in previous articles, by its very nature the instruments we utilise to adjust economic activity and output in specific geographical locations, namely fiscal (tax) and monetary policy, are very blunt instruments and not as effective and able to cope with the speed of change in given economies. But are their any other mechanisms we can utilise to adjust unfavourable behaviours and activities in order to get back to equilibrium?
A further factor we believe is a lack of understanding of where exactly we are in the global economic adjustment life-cycle. There is no real comprehensive understanding and agreement at best of these influences. True mechanisms like the G8 now G20 have been created to address more global challenges, but there is hardly ever consensus and a collective will to act in unison to address the bottlenecks and imbalances in global economic activities.
With this introductory article we have laid out some of the areas to explore and bring back into the ‘light of scrutiny’ as part of a deeper understanding of the nature of our global economic state and status.
As it has been our most read article, we thought we might continue to build on the theme of Economic Friction Cost.
Williamson (1993) published some work on Transaction Cost Economics (TCE) in a book entitled The Economic Institutions of Capitalism’. TCE is an equilibrium theory and looked more closely at the firm level or micro-level analysis and at behavioural aspects of ‘rational choices’. Up until that point most economists had only considered production cost as part of profit maximisation assumptions, and not at transaction costs within the firm.
Transaction Cost Economics focuses predominantly on the governance of ongoing contractual relations (Williamson, 2007).
But what exactly, in practical terms are Friction Costs?
As stated in our previous article there is a large element of hidden costs implicit in Friction Costs. Friction Costs can be highlighted by analysing the end to end or life cycle costs of any product or service. A general rule of thumb that is applied to life-cycle costing is to take the visible ‘advertised’ cost and double it up. That exercise generally gets you very close to the full life-cycle cost of any product of service. This rule of thumb works with large capital projects, as well as estimating the full employment costs of hiring people.
But friction costs go further than this. You might call it the fourth dimension of costs as it incorporates time value and opportunity cost elements.
Time value has two specific meanings for us here:
Time value due to down time, loss of productivity, etc. This is more accurately referred to a value of time
Time value in terms of the diminishing purchasing power of money, due to factors like inflation and opportunity costs when money is not put to beneficial uses. This is the general use of the term Time Value of Money and ustilises Present Value techniques via a discount rate to work out the equivalent value of money in today’s purchasing power terms, whether we look into the past or into the future.
Thus, the two areas we have to focus on during the expansion of the Friction Cost exploration in the next article will be time value and opportunity cost elements, as part of our enquiry into delving into a better understanding of Friction Costs.
There has again been a short period of drift and volatility in ‘The Markets’ recently.
And yet again we have heard the old refrain:
“Markets hate uncertainty”.
This we assert is yet again a misused turn of phrase. It is not uncertainty that markets hate, because inherent within market processes and market operations is the principle of uncertainty. This is also known as – Information Asymmetry.
So, if it is not uncertainty that markets hate, then what is the missing ingredient that delivers these periods of volatility?
We believe what markets require above all else is:
Yes, structure and clear operating parameters, in other words a framework within which to operate is the key.
Whether that structure and framework is delivered via regulatory mechanisms or liquidity or a political landscape that sets the parameters in terms of policy guidelines and fiscal and monetary controls, it does not matters.
Remove the nebulous shifting and drifting borders and put in place a framework that sets the framework and outline of the playing fields and markets respond positively to these signals.
Refrain from doing the work of ‘framework establishment processes’ and markets and their participants become ‘restless souls’ aimlessly drifting within the ‘nebulous fog’ of uncertainty, clearly waiting and anticipating the regularity that structure delivers to the ‘Market’
We will interrupt our series of articles on ‘The Trouble with Innovation’ and begin to weave in between those conversations, a more fundamental argument to help enlighten the debate and understanding around the differences between ‘Monetary Economics’ and ‘Real Economics’.
The basic themes of this series of articles will be around growth and shrinking in the economy, value and money measurements.
This will be a layman’s guide to understanding the differences and principles of Monetary Economics. We realise that in casual conversations with finance and business professionals, there is a basic misunderstanding of what Monetary Economics is and how it impacts on the broader or ‘Real Economy’.
Our quick and ready definition of Monetary Economics is this: Money and currency is only a temporary measure of value.
Another definition is: “An economic theory, the proponents of which argue that economic variations, such as changes in prices and output, are primarily the result of changes in the money supply. (Thus, the Federal Reserve Board is the most important economic policymaker in the country.) Proponents of monetarism believe that changes in the money supply precede changes in other economic variables, including stock prices, and that a rational policy calls for moderate, steady increases in the money supply.” (See the link monetarism).
Now we can get bogged down in definitions and we realise the dangers of always taking the top two or three definitions offered by Google search at face value.
An example of a textbook definition of monetarism is: “a range of views which emphasise the role of money in the operation of the economy system”. At this point we need to mention that it is a contrast to Keynesian economics, which is being applied in various degrees in most Western governments at the moment, in order to support the Economic System as a whole.
However, Michael Foot, an ex Labour Opposition leader in 1983 made unhelpful comments such as: “monetarism is a worldwide disease” (The Economics of Taxation, Prentice Hall, 7th Edition, we linked to the 9th Edition).
Turning to an analysis of the Wikipedia definition we focus on the key phrases of ‘measure of value’, ‘store of value’ and ‘unit of account’.
Nowhere in this definition does it mention measurement of output or production, the key building block of the real economy.
Therefore, we conclude this first introductory article by making the clear distinction between money as a measurement tool and unit of account and real output or production being the building blocks of economic activity.
In the next instalment of this article we will define output, activity and production and then start making the stark contrasts between what monetary and real economics really are.
Let’s get the basics of economic language right and move on towards a better appreciation and understanding of the intricacies and interplays of economic discourse and activity.