A Tale of Two Depressions – Charts & Analysis by Barry Eichengreen & Kevin O’Rourke

I came across the following charts and had to share them. They are the work of Barry Eichengreen and Kevin O’Rourke, and was published at voxEU.org on June 4th.

I suggest that you read their post and view their graphs in a quiet room and give yourself time to take them in.  They set the current discussion of “green shoots” in perspective and show that how bad things might seem today they can get worse. It is also worth noting that the first 50% correction of world stock markets took 27 months from the peak in 1929, whereas we achieved that in 10 months.  We are on the same path, but we are “smarter” now.  I hope.

When to Duck and When to Catch

After Google I/O, my wife and I visited my eldest, Rich, who is a graduate student at Stanford, and he suggested that we sit in on one of his lectures.  It was a treat, and not just because Professor Mehran Sahami throws candy to his students.  The class was on probability theory.  So here I was sitting at the back of a lecture hall, which I have not done for 27 years, being taught about “Modeling Uncertainty and Utility” – so, why was it such a treat?

Well, first of all, Sahami is a great teacher.  He keeps his students involved and awake, and not just from a sugar high.  He tied the subject back to the real world, talking about betting games, and micromorts, an idea core to life insurance.  It was his discussion of the behavioral aspects of utility that grabbed my attention.  Why would one person make a bet (or an investment) where the long-term average outcome (the “certain equivalent”)  makes it a “bad” bet.  Part of the answer lies in the relative amount of the bet vs. the person’s net worth and well being.  Sizing up/down the size of the bet changes the attractiveness of the bet in a way not immediately apparent from the numbers.  A billionaire is more willing than a multi-millionaire to bet $1mm for the fun of it, even if the odds do not make sense.  Psychology and Maslow’s Hierarchy need to be factored in.

The lecture made me think about the outcome of an investment in a private company.  Say that you invested $1mm 10 years ago at $1 per share and the company just had a successful IPO.  You also believe that it is capable of growing 50%  a year for next few years.  For sake of argument assume that there was no dilution and the company went public at $10 per share and traded to $15.  Assuming the market is rational (Okay, bad assumption) the stock could rise 75% a year for the next few years, if multiples do not contract.  You $1mm investment is worth $15mm today, $26mm in one year, $46mm in two year and $80mm in three years.  What is the utility value of profit?  When do you take money off the table?  Situations like this are are the subject of bar discussion by angel investors.

Sahami’s lecture helped me solve this problem.  It all depends how rich you are.  If you are just getting by, then $15mm today is very valuable to you, you can’t risk losing it (the market being irrational and all that) and so you probably sell a lot of it so that you can have money to live on.  If you are worth $100mm, you probably let it ride, not because you need it, but because of what a great story turning $1mm into $80mm would be.

This perspective helps solve another question I have been pondering as well.  If early stage venture capital and angel investor returns CAGR north of 15% (and there are a number of studies that support this view, but let’s just take it as a given) then why do more people not invest in this space?  Well, part of the answer is that if they did then the returns would not be as strong – which I wholly agree with, but part of the answer is that there is a small group of people to draw from that both have enough money to make such an investment and tie up their money for 3-8 years, but do not have so much money that the investment is too small to be worth their time.  Thus the space is left to a subset of rich angels and the handful of early stage venture capital firms such as ff Asset Management.

I was attentive throughout the class, and gained a lot from it.  We had a great weekend touring Alcatraz and walking amongst the sequoias at Muir Wood National Monument – some of these trees predate Christianity.  Both worthy uses of time, and good places to clear one’s head.  But the 50 minutes I spent listening to Professor Sahami and dodging candy was just as special.  Thanks, Rich.

Inflation, Deflation and Globalization Arbitrage

There is a debate raging amongst economists and market participants about whether the US is about to suffer inflation or deflation.  It is an area of great discussion and there is no clear consensus.  I think that, as with most areas of this dismal science, people are too short term focused here to see clearly what is going on.  We will get both.

My first problem is that when people address the subject they are generally talking about price levels reflected in changes to the Consumer Price Index (CPI).  The CPI is flawed, however, as a measure of price levels.  It does not measure inflation that real people suffer in part because it is an average of an average and in part because it is manipulated down (by reasonable adjustments) so that government payments that are indexed to it are lower than they would be else wise.   CPI will, therefore, tend to underestimate inflation and overestimate deflation.

To get a better understanding of the inflationary and deflationary pressures we are facing I think that we have to look at the drivers of price levels and see what thematic forces are at work here.  Deflation and inflation are the results of larger thematic forces at work.  As a long-term investor in private equity I have to be thematically driven, but I think that it also gives you a good framework for understanding shorter term phenomena.

The themes that I think are most relevant here are Moore’s Law, democracy/capitalism, and globalization:

• Moore’s Law for processors (and its sister Nielsen’s Law of Internet Bandwidth) point to us being able to do more for less resources, be it processing or communicating.  This is pushing communication costs to/near zero and allowing new disruptive business models to be built at ever lower costs.  If I have a business that sells or services widgets for $10, and someone comes along with a new service at $5, it it at its core deflationary.  Moore’s Law is a massive deflation driver, especially for businesses that involve end-to-end communication and can be disrupted by moving from analogue to digital foundations; think newspapers, music, finance, education, etc.
• Democracy and capitalism go hand in hand in many places in the world today.  It is possible to have capitalism without democracy (such as in China or Saudi Arabia), but I cannot think of an example where we have democracy without capitalism.  They are powerful interlinked forces and they are forces where the driver for change is decentralized to the people and not centrally controlled and conceived.  The result is that the best ideas can percolate to the top and they facilitate the adoption of new idea, disruptive ways of doing things and, like Moore’s Law, are inherently a deflationary enabler.
• Globalization is both deflationary and inflationary.  Simply put the Indian outsource model is a huge arbitrage of wages in the West vs. wages in India.  It keeps a lid on wage inflation as there is someone the other side of the world able and willing to do the same job for less.  Today I can hire a programmer in the US for $5,000 -$10,000 a month here or $1,000 a month in India.  Moore’s law has reduced the cost and technology barriers, democracy and capitalism has facilitated the formation of such industries in India and the reduced political and tariff barriers from globalization makes this all possible.  Thus for the West globalization is deflationary – we make these goods in China because the end result is cheaper goods.  For China, India and the service centers and factories of the wold it is inflationary, especially for wages.  I would say that this is a good thing; rising wages in developing nations has a trickle down effect for their economy, raising living standards, raising availability of health care and lifting people out of abject poverty.

There is another theme here that combines all three (and other) themes; rising expectations in the developing economies.  Though America receives a bad press around the world, everyone wants to live like an American.  Everyone would love to consume as an American; drive a car, live in a big house, be rich.  Now I know that is not how many live here, but the American Dream is the World’s Dream.  The problem is that it is not possible, not in the short term, and even if we approach it it will seem to be more of a nightmare than a dream.  The world is resource constrained.

The speed of the growth of expectations and realization of those expectations in the developing economy is unprecedented in world history.  Never before have so many people been lifted from utter poverty to mild poverty, mild poverty to working class, working class to middle class.  This is amazing, it is magnificent and it has significant repercussions.  Some of these are good and some are not.  I remember reading in 2006 that the number of obese people in the world now exceed the number malnourished.  Forbes in 2007 published a table with 88 countries that have over 50% of their population with a BMI over 25.   There is not enough basis materials and resources available to meet the expectations of the newly enabled people from the developing world.  Advances in technology will ultimately bring us new and novel solutions, but in the short term these demands will lead to shortages that are resolved through price.  Commodity prices are going higher, agricultural product prices are going higher.  This demand driven inflation is required to lower demand.  It is basic economics.

Thus my expectation is that we see commodity based inflation combined with services and manufacturing based deflation.  I expect both.  We can expect a relative wealth transfer from the West to emerging economies, especially those that have an abundance of resources or cheap labor.  The recent economic crisis has only exacerbated the deflation aspects here as the cheap money led to a build up of excess manufacturing capacity, and a desire to increase productivity in the downturn that will reduce the need for labor going forward.  It also has led to a fall in commodity prices that I expect will prove to be temporary.  The end game is that the globalization arbitrage will continue, that living standards will move closer between emerging and developed economies, but that they will meet more in the middle than either expects.

Shanghai Rising

I see this a a natural outcome of policies and processes that are in place, have momentum and are tough to dislodge.  This is not all bad for those in developed economies.  There will be an unprecedented increase in the ranks of the middle classes globally, and this will stimulate massive new markets that can be addressed with new products that will benefit all of mankind.  For example there will be more people willing to pay for drugs and therapies for diseases that today are too “rare” to have research funded.  This will not just be limited to healthcare but extend to investment in consumer products, entertainment, and all aspects of life.  There will be change and disruption, but overall we will all benefit from this brave new world.