Today’s press announced that Germany’s industrial sector recorded a 12.1% increase on the previous year, outperforming most of the other Eurozone peers, and was boosted by another rise in business morale, as ZWE indicator of economic sentiment climbed 2.5 points in November.

Many countries, especially Ireland, Portugal, Greece, Italy, have particularly strong problems with their finances, facing difficulties raising money to fund their state budgets. Spain is currently in the news due to Moody’s, a rating agency, threatening to downgrade the country’s creditworthiness again (currently at Aa1). For Spain, the main trigger is to recapitalise its struggling banks and to coordinate cost cuttings with the regional governments (Spain being a federal state, the central government has not as much influence as it would wish for).

Nevertheless they start to take drastic measures to improve their own finances, cutting costs and dressing up for international investors. Huge efforts are on their way to bring their first fruits and as soon as the reforms are confirmed and the budgets back to normal the formerly falling countries will be back on a growth path.

The strong recent German economic performance supports German government but could lead to a phase of a slower path of reform. As the economy seems to outperform most of its peers, we are less likely to see any unpopular cost cutting measures. It is simply not in the blood of a politician to start painful measures when most of the population is doing well (unemployment being on the lowest level since years). And as the polls are currently rather gloomy for the current conservative government (forecast to lose their majority in parliament if there would be an election next Sunday), the chancellor will probably scale back some reforms in order to improve the negative image and gain some ground for the next elections.

One might think that the Euro is currently the biggest problem but as in any crisis of confidence, and I believe that it is only a crisis of confidence, as soon as reforms start to show their merits, and as soon as the panic calms down and investors get back to normal, the Euro will recover. Additionally, a weak Euro helps most of the Eurozone members to boost their exports and thus stimulate their economy artificially.

The real risk for Europe is that in a couple of years, Germany is the sick man of Europe again due to the lack of significant reforms and cost cutting measures undertaken by the federal government. As Europe’s largest economy, a struggling German would be another drawback for the Eurozone’s economy. It is therefore right to refuse the euro bond idea as it would increase refinancing costs for the German government, but refusing euro bond is one thing, necessary and painful reforms are another thing, yet to be undertaken.

The financial crisis seems to be over and many research institutes, like the Deutsche Bank think tank, even consider the crisis as one of the less expensive ones when solely looking at government spending. Most of the rescue funds have been used as a guarantee. Guarantees which finally weren’t needed to the extend governments initially feared. Thus, the crisis wasn't as disastrous as expected. The Economist in its July 10 issue even expects German GDP to rise by some 4% in the second quarter 2010. The unemployment rate is lower than in 2007 (The Economist - July 10 2010 - Lemon aid - The euro-area economy). The picture is gloomier elsewhere. The United States haven’t managed to keep unemployment low but here as well we see positive signs. Don't even talk about China, the seemingly almighty economic champion. Should we lean back and enjoy the recovery?

Well you might enjoy it for a certain time but the next crisis is already coming. The strong connection between countries and markets increases contagion. Any little bushfire in the most remote area might burn our house down at any time.

Best example is the last crisis which has been a local American housing problem but spread over to one of the most global crisis ever (I am just saying global, not the worst). The continuing globalization has its merits and should not be stopped – contributing to the development of each participant - , but we need to be aware that when markets can infect other, seemingly non-correlated, markets, we need official bodies that can govern and control the impact.

A G20 summit is not enough and the IMF has not enough power. The World Trade Organization has limited powers and struggles even to resolve the most basic topics such as the hidden – and illegal - support from the US and Europe to their big aerospace companies (Boeing and EADS).

You would think that Europe is a good example for an effective international co-operation. But when it comes to economics, Europe is deeply divided and has no apparent plan. Europe struggles as much as other countries to find a middle way between free markets and regulations. When it comes to monetary policy Europeans are hopelessly divided (especially France and Germany).

With such an “economic government” we will certainly see some more crisis and those crises will be even more severe. We probably need two or three deep recessions, which bring us close to a war, to change the international bodies, to implement effective regulation and supervision.

So lean back, but keep on growing your own food and buy a house, so that, during the next decades, you’ll have at least something to eat and a roof over your head.

POWER STRUGGLE: First part

Nations seek for power and resources. Without the latter they cannot survive, their economical and social system would come to a halt. There used to be a time where these struggles were fought by armies and long wars. Today, things changed, there are still wars, but the struggle for power and resources is more subtle. States secure contracts allowing them to access certain resources of certain countries. Some help others to build up infrastructure with the ulterior motive to later use these infrastructures to extract and dispatch raw materials and finished goods. To open the newspaper means to read about the obvious power struggles. It is to see Iran seeking for nuclear weapons, China refusing to cut emissions to boost local economy and the US keeping interest rates low to help exports (what’s Europe doing??).

Bill Emmott, the former editor of The Economist, published a book in which he predicts that the power struggle between China, India and Japan will shape our next decade, more than an eventual conflict between China and the US. Most of the time, it is true, people tend to neglect the rivalry between those three countries and accordingly the potential geopolitical consequences. People talk of “Asia” and forget that the continent is far from being “united” in the way Europe is. We are talking about a continent where India, China and Japan seek for the first place in terms of economical and political power, but where Russia, Korea, Singapore and other states also wish to have a word…not to forget Australia and New Zealand that seek for greater influence in the region as well.

China won’t be able to keep growing without resistance from India and Japan. Neither of these countries will keep on watching without intervening. Ties to South-East Asian countries are in that logic especially important, because representing future markets and strategic positions, thus Japan finances, for instance, the construction of the Ho-Chi-Minh City subway (Vietnam). A defense agreement with Australia is also meant to strengthen Japan’s position within Asia. But is that really going to help? China is now crucial for the United States, who else would buy their government debt? In order to finance the recovery and two wars, the one in Afghanistan and the other on in Iraq, they need to raise funds. Without China that recovery would hardly be manageable. But of course, admitting that would be equal to political suicide.

The United States depend therefore to a certain degree on China. In case China would expand its political ties in a more violent manner, would the US intervene? Would they protect Taiwan for instance? Many would say “yes” and think “hopefully” but we can no longer be so sure. In order to intervene, they would need to raise more funds to pay for that defense. Tax payers would not like to see their money wasted in wars, thus raising taxes would be rather unpopular. If the US would still decide to intervene, China could sell of their foreign reserves thus creating oversupply of dollars on the markets which would eventually lead to a sharp decline of the dollar’s value. The USD would collapse and become worthless and no one would like to invest in USD denominated assets. Would the US risk such a thing? Investors would pure out of the country and invest their funds into more secure places, such as Europe. But Europe cannot stay neutral, probably…or can it? By staying neutral, Europe would encourage China to proceed with the aggressive extension. This cannot be in the interest of the European countries because next victim could easily be Europe itself. Thus, Europe needs to stand on the US side just to secure US support once China tries to tackle European territory.

The Japanese reliance on US help in case of a military conflict is declining which demonstrates the agreement with Australia. It is a move towards a more diversified defense pact and shows that Japan is aware of the fading American power. In 2005 and 06, the Bush administration also opened the door to a new partnership in Asia: with India. The new collaboration for civil nuclear energy with India proves that the US is aware of the threat that China might become too mighty and thus unpredictable.

China can, however, not afford to make an aggressive move because it does rely on the United States and Europe as a market for its own goods and it also needs the technology and know-how. Thus, a Chinese attack is not an issue. But the simple thought of the immense power it could potentially have might frighten and should lead us to consider whether our political system is prepared for those future conflicts. The Lisbon treaty is now enacted and Europe has a new political leadership with a permanent president and a person responsible for foreign relations. Europe, however, still speaks with 27 voices when it comes to foreign policy which is not suitable for the geopolitical conflicts of the 21^st century where only a strong union with clear and unchallenged leadership can pose as a real opposition to an emerging, power seeking, China. The transformation, from a loose federal construct to a strong federal state, might be the only solution to keep a high profile during the next decades.

The hope that China might anyways collapse due to potential social conflicts is a dangerous thought. The idea that only democracy survives is naïve due to the fact that China has never been a democracy, as most of Asian states in their history, and it never seemed to bother its population. As soon as the Chinese peasants were unhappy with their leadership, they replaced it using a revolution but only to implement a new kingdom, to set up a new dynasty. Thus, even though the dictatorship in China might not last forever, it will probably be replaced by something similar.

The information policy of the country shows that its leaders are aware of this threat of “revolution” and it might lead to the conclusion that the leaders are not as much in control as they would wish to be. Official statistics can hardly be trusted, a UBS economist, tried to calculate the real GDP growth rates from 1980 till today and found a less attractive picture, corresponding more a rollercoaster ride. The so praised sharp GDP growth rate increase between 2005 and 2008 might, for instance, have been rather stable instead. Another interesting fact about the official GDP rate is the 2005 figure. Official growth rate was 10.4%. China is divided into 31 regions (22 provinces, 5 autonomous regions and 4 municipalities). Of these 31 regions, 29 reported higher growth rates than the national one, only two (Hainan and Yunnan) were below national average. Everyone above average?

This might make us laugh but can also be a serious threat. First of all these figures are not so much aimed at outsiders as they are aimed at their own population. Keeping good news in and bad news out of the newspapers is a measure to reduce the possibility of social unrest. The problem for outsiders is that we do not know for sure how big China really is. Probably smaller, probably bigger…

And while we hope that China will eventually fall over its own shoes, the Chinese are silently conquering Africa. They promise not to intervene in local conflicts and invest huge sums of money to secure natural resources. To a certain degree the African nations to benefit from such investments, some however don’t. But the leadership does most of the time benefit and what is more important to keep relations intact? Chinese leaders have understood that future geopolitical challenges cannot depend on moral and that those who insist too much on certain values will be the future losers. Some claim that China needs to be a more responsible player if it wishes to implement itself on a global basis. But that would mean that responsible means an alignment to western values or to a certain set of predefined values that might not be the ones China would defend. Certainly, it is important to safe human lives and to help poorer people, but the efforts of Western countries in Africa have been rather unsuccessful as well.

It is probably not the best solution to forget about those values and rush into Africa, as it happened during the colonization, to secure raw materials. But it is probably good to think about the future challenges and to determine where do we stand? How can we act and what should we do? There is no easy answer.

Where will Russia stand in the future? Having closer ties to Iran and neighbors it will probably expand its political influence in the Middle East and Eastern Europe. Closer ties with China might provide it with a big client for its natural gas. But China does not need Russia as much as Russia needs China. Thus, turning it’s solely attention to China would be a mistake from Russia. Closer ties to Western Europe, a friendlier relationship would be of more benefit but that is not going to happen in the near future. The Russian president has even offered a defense plan where Russia would have a veto right for new NATO members in Easter Europe. That offer will most certainly be declined by the NATO states but demonstrates that Russia is not aware of the potential benefits of a European-Russian partnership. The most likely scenario is therefore that Russia becomes a second league player, having some influence on regional issues but not being able to talk on a worldwide basis.

The most common discussion during a crisis is how to stimulate the economy in order to pass the recession or crisis. Even if economic theory considers a crisis as a necessary evil in order to readjust certain parts of the economy and to enable a fresh start, most of the people dislike these periods and politicians do their best to restore confidence.

However, most of the political action targets businesses. Thanks to subsidies governments ask companies to not lay-off part of their workforce and support those companies in international trades. Temporary tax cuts or cash-injections are part of that "treatment". The goal is to encourage companies to invest further.

But do these measures tackle the right problem? Where is the real problem during a slump? It is not quite the businesses that are the trouble makers here but consumers are. They lose their confidence and spend less. Consumption decreases due to their lack of confidence. Due to this, companies sell fewer goods and services. Selling fewer goods means that they need to cut their costs in order to stay profitable. This means that they will decrease the production volume (fewer orders to suppliers, lower energy consumption, need of fewer workers to produce goods...) and hold back any investment plans. This postponement hits some more suppliers (for instance construction companies or machinery suppliers).

Helping the companies is certainly a good thing to do and makes sense politically speaking because it is always good to know that the industry is happy with the current government. This will potentially safe jobs in the future and make re-election of the government more likely.

But still, it doesn't tackle the issue of consumer spending. How can a government influence consumer spending? You might think of taxes and it is surely the easiest way to influence the amount of money the taxpayer has in his or her pocket. Today, income tax is based on our income (seems logic). By simply lowering the income tax, we would add some incentives to spend more money. But this is not enough.

Let's consider a completely new approach to income tax. Let us call it the savings tax. Instead of taking the tax from the disposable income, the government would base the tax on the income that has not been spent. That means, if a household has spent all of their income, they would not pay (saving or income) taxes. If they decide not to spend all of their money, the tax would be based on the amount that has not been spent. Does that mean that people have no longer the right to put money aside? No, of course not, they can put as much money aside as they wish, but they have to pay taxes on it.

A few things should be exempt from the savings tax though. Putting money aside for the retirement is a good thing and should be supported. Thus a special account will be created where each person can put as much money on as they wish. This money will not be taxed but can only be used for a special (and authorized) purpose, such as retirement. Certain kind of spending can also be supported. If a household spends a certain amount per month or year on education or culture, they have a lower tax on their savings. This encourages people to consider their spending and use more for child education.

The system does therefore not penalize savings that have been made for a legitimate purpose and encourages people to spend all their money. There are few incentives to save. The state would recover from the loss of the income tax revenue by collecting more money from corporate taxes (thanks to higher EBITs) and VAT.

Inflation vs deflation

We are currently facing a heated debate whether we have a risk of deflation or inflation. Not that this is a passionate subject for most of the people but it might well influence our future – especially our purchasing power. What do we know about these two? We know that deflation is that kind of thing which the Japanese have been facing for a decade or so already. Do they seem unhappy? When they travel around and block our inner cities with their tourist busses they all seem quite happy. What about inflation? That’s that kind of stuff which is going on in Zimbabwe: the government issued on January 16th a ZWD 100 trillion bill. You can be a millionaire so quickly!!

The problem is that, as a citizen of one of these countries or as a corporation, we do not really think that this is funny. Why? Because if we receive a bill of LCY[1] 100 and some days it is only worth 90 we are rather pissed. This is inflation. Inflation makes things more expensive and thus we can buy less with our 100. Deflation is more complicated. Consider that you are the head of XYZ Inc. and that you want to make an investment in Yokohama. Today that investment costs you JPY100, tomorrow probably JPY90. What will you do? Yeah right, you’d probably wait. But the thing is that once the investment would cost JPY90 today it would cost JPY80 tomorrow, so you keep on waiting. That’s pretty embarrassing for the country because suddenly no one is investing because prices are falling. It is a vicious circle because for prices to rise again, someone would need to invest. But because no one does so prices keep on falling.

So to keep it simple, inflation is caused because too many people are spending too much money and deflation is that too many people are not spending anything. Thanks to globalization all this becomes somewhat complicated. Investors can transfer funds from place A to place B quite easily. Inflation is low in Japan, the Central Bank lowered interest rates to 0 and thus investors enter the market to take on a credit and invest it in a country with a higher inflation such as the US a couple of years ago. The difference they made was their gain. The trade is called a carry trade. Normally the exchange rate is going to prevent that kind of trade from happening but exchange rates are not always free-floating which gives place to arbitrage opportunities.

Are we now facing deflation or inflation? What should the Central Banks policy be?

According to some inflation can only be caused when consumers are spending more nominal dollars. They argue that the state has so far been reluctant to pure money to consumers’ pockets and thus the risk of inflation is low. The state funds consist basically in guarantees meaning that there is most of the time no exchange of cash. Consequently, there can not be inflation. They argue that the bigger threat is deflation. Consumers stop spending, companies stop investing, employment rises and a downward pressure on prices is exerted.

If the crisis continues and recession deepens, deflation becomes a real threat. Drying liquidity causes deflation, money is hold back by consumers as well as lenders. Mr. Bernanke said in 2002 that a healthy banking system is the best defense against deflation. The banks now being in a shaky situation, the economy can no longer rely on that defense. Thus the risk of deflation increased significantly.
All also depends on the currency. If the LCY is getting stronger, import prices are decreasing which adds deflationary pressure on prices.

Today, the money-in-circulation is not so much of a problem because so far the consumers are careful and lenders are keeping their money. According to an article published in the Wall Street Journal, the M1 aggregate rose so far by 10%. The biggest problem comes from the bank reserves. Banks now have huge reserves enabling them to make new loans. The question is now how quickly do the banks make these loans? Consider that banks are hungry for new business and make loans quickly in order to have higher returns. Money-in-circulation skyrockets and creates inflation. The phenomenon is even intensified by the low demand – due to high unemployment and low investments - and high supply of money.

Some more factors do enter into the inflation figure: commodity prices. Commodities are the basic element of all products. If commodity prices rise – what they are doing again since May – product prices might follow. Why do commodity prices rise? So far analysts expect the Asian economies, especially China, to recover from the crisis. According to Chinese newspapers, Chinese industrial production rose by 8.9% in May. This is a sign that the economy is recovering but especially an indication that Chinese manufacturers are starting again to import raw materials which pushes up prices again.

Gold price which is usually considered as an indicator for inflation has been pretty volatile during the recent weeks probably indicating that investors are considering the risk of inflation. Inflation indexed bonds also start pricing in an increase of inflation. Especially the 10yr bonds are showing some sensitivity to that issue (they currently price in an inflation of 2%).
It is therefore probably safer to say that there will be inflation. Not now but in the next years and if the Central Banks do not take the necessary steps – such as reducing the money-in-circulation by increasing the reserve requirements for banks – we might see a strong and persistent inflation. This damages parts of our economy. For sure it would be unwise to say that deflation is not going to happen but the chances that we enter a deflationary cycle are pretty low. Finally everything depends on the
[1] LCY = Local Currency ; FCY = Foreign Currency

Mass hysteria

The world is suffering. The Western economies are slithering into a recession, maybe a severe depression and no one dares to question the apparent fact the everything is going to be worse. We read it every day, newspapers seem to predict the apparent death of capitalism, television shows us how badly we will suffer and radio is playing one requiem after another.

Chased by these messages, people start feeling shaky and they start fearing that the promised catastrophe will also affect them and their standard of living. They will all be laid off, will face dearth and everyone will have to move to new kind of slum. Slums for fallen stars.

However, we should have a more objective look on how things work. The financial crisis had its ruthless effects, billions were lost and the system suffered. But initially the shock remained something particular to the financial industry. Banks, insurances, funds and all other kind of investors got convinced by something wonderful. A security offering stable cash flows and a high yield. These securities were based on different kind of mortgages, some quite risky, others less. Investors could choose whether they would like to invest in a riskier part or if they would like to remain conservative.

In the meanwhile, hard working people would bring their money to banks in order to invest it. Their goal? Receive interests, put money to work. Banks offering lower interest rates suddenly saw their clients and potential clients walking away to other banks. These other banks offered higher interest rates, and consequently they needed to invest the money into higher return securities. Banks being under the pressure of offering higher returns to their clients, because clients asked for such returns, entered the field of seemingly safe securities. Lacking the necessary experience, however, to understand what factors influence the intrinsic value of these securities, these banks became a dangerous, because unconscious, player on the market.

When house prices started to collapse, some homeowners had difficulties to pay their interest rates and therefore the initially and apparently stable cash-flow started to become suddenly unstable and unpredictable. Unconscious players, instead of remaining calm, started to sell of all their securities, some other players, the very few smart ones knowing that a big slump was going to come, also sold of all their Mortgage Backed Securities (MBS). Facing this huge wave of sales, prices necessarily started to collapse and no one would dare to buy MBS, putting their price close to 0.

Does this mean that this money is lost? No. Does this mean that banks will go bankrupt? No. It simply meant that the stream of cash-flow is interrupted for a certain period of time. As soon as people are able to pay off their loan again, the cash flow will recover and the investor receives its money.

If this would be so, why are so many banks facing difficulties? Let us call it “mass hysteria”. People get scared when their bank is facing some troubles and they take back their savings, give these savings to another bank or keep it under the mattress. A bank, having only a very small proportion of the savings, in their account as available funds, faces difficulties paying back all the money. A bank usually receives money and lends it to other people. It cannot ask these people to pay back the loan right now, only because some others would like to have their money back. The bank therefore faces bankruptcy.
You might want to chip in with the fact that this only happened to a couple of banks, the others being untouched by the bank runs. Sure. But a bank run can take several forms and what we actually saw was not a mass bank run but a dying interbank market. Indeed, it was not the clients who took away their money, but it was the other banks that stopped lending their money.

Why was that so? It was so, because the cash-flow was interrupted. And no one knew when it would recover. But it would recover, right? Let’s look back to the functioning of the MBS. It is like a normal loan, only packaged and sold to a third person. Neither very unusual, nor very complicated to understand. However, our accounting rules force banks to declare the market value of the securities on their balance sheets. The balance sheets being the main reference for investors, banks were reluctant to put on the “losses” of their MBS on their sheets. Law being law, they needed to put these on and needed to write-down billions and billions of dollars.

That’s certainly unfair to everyone, because no one knows if these securities are really worthless. Most certainly they are not worthless. But that’s the rule.

But what about the real economy? How did it get into trouble? You might say because banks weren’t lending so much. Probably this is only a small reason for the slump we are currently facing. The main reason would be closer to this statement: because slump is fashion. That might sound weird but let me explain a few things.

All our system is, of course, based on human beings. Each of us has a mind and thinks independently. Consequently, economy is based on our psychology. There is no such thing as a purely rationale thinking person, everyone has feelings and therefore everyone is partly irrational and special in a certain way. However, thinking makes us feel tired. We love to listen to others and simply accept what they say. Those people are not questioning whether it is true or not what their speaker said, as soon as it sounds easy to understand, they accept it.

Now, let’s go back to the first paragraph of this article. We open the newspaper, we switch on television or radio, we go online and we will always see the same message. The message saying: recession, depression, slump, fear, stock prices falling. Having almost no one saying the opposite, people accept what they hear, read and see. People start getting angry at the system and they stop consuming, fearing that they might be part of the next wave of lay-offs. By doing so, by simply accepting the message, that everyone is going towards hell, and by getting feared, we actually create the slump.

We create the slump, because suddenly there is no more consumption. No one wants to buy cars and no one is ready to make an investment. Although we still have the money to do so. But because others do not spend their money, we better keep it as well. Newspapers write about the slump, because the others do so. We are in a vicious circle and this vicious circle leads directly into a recession. Recession based on a fashion still, but it remains a recession.

Politicians predict that 2009 will be a bad year. By saying so, citizens safe even more and spend even less. We are in the classic case of a self realizing anticipation. Because we anticipate the downturn, and because we react as if the crisis would already be with us, it will inevitably come. Let’s have an example for a self realizing anticipation: we own a stock, we anticipate the stock to lose value and sell it. Buy selling it, the price of the stock drops. Our action caused the drop and therefore our anticipation became true thanks or due to our acting.

It is safe to say that we are accompanying the downturn, that we are most certainly responsible as well. No one has wished it but everyone has a share of responsibility. Now we have to life with it.

Stayin’ Alive: A Guide for the Summer Analyst or Associate

Let’s say you actually care about whether you do well at your summer program. Then…

• Don’t complain about your projects. Get staffed on a shit job? Everyone has worked on a shitty project, including the people you are working for. The worst thing you can do is echo someone who is negative around you.
• Think of your internship as a 2-month long interview process. You wouldn’t tell the interviewer that you don’t like a certain part of the interview.
• Befriend the staffer.
• Show up earlier than the people you work for. If you’re a summer associate, show up earlier than the VPs or MDs.
• Face time does count. Don’t leave earlier than 8pm, and for weekends, do as others do.
• Don’t eat meat? Vegetarians don’t belong in finance. And if you want to say that you don’t drink, you might as well say that you don’t have sex.
• Socialize with your colleagues. As for going beyond formally planned activities and reaching out to other (non interns) — let them reach out to you. If someone asked me to go out for a drink — I wouldn’t think negatively of that person, I’d just think of a reason not to go.
• Expenses — just follow policy.
• People find out if you’re hooking up with another intern. It’s considered puerile, but happens all the time. It’s not like dating another ibanker is considered prestigious. If you’re hooking up with a model, on the other hand… And if you’re a girl, you’re writing yourself into the ’slut’ category.
• When it comes to dress, you definitely want to fit in, but on the upper end of fitting in. You should dress well for interviews, however.
• Lastly, you want to create bonds with people who are going to pull for you when it comes to hiring time. Think about that.