Open Letter to Market Monetarists

Note: This is an open letter to all Market Monetarists, although it addresses the topics presented in Lars Christensen's paper. Since what is presented in the paper is a good gauge of the Market Monetarist beliefs I thought it would be better if I addressed it to all and not just Lars Christensen.

Dear Market Monetarists,

I have read Lars Christensen's paper on Market Monetarism recently, on my quest to educate myself on the different schools of thought on economics. After reading it I have acquired some questions and comments which I would like to put to you. I would like to note that I am not an advocate of no economic school of thought and these are just the products of my thoughts on your paper.

As you have elaborately explained in your paper, the main difference between Market Monetarism and Monetarism is that the former focuses on NDGP as its target. The suggestion in the paper (and in general as it is implied) is the introduction of NGDP-linked futures which would fluctuate with NGDP ups and downs thus (theoretically) adjusting the equilibrium for money, not allowing for excess demand or supply.

Nevertheless, although this may be quite easy to do when demand is higher than supply, just by increasing money supply, it would be rather tedious to do so when demand is lower than supply. Given that the money supply is not just created by the Central Bank but from commercial banks as well, how would it be possible to absorb the over-supply of money? One might argue that the Central Bank could increase the reserves rate, yet this will just create the incentive not to lend any more and not to decrease the existing money stock. For example, if we assume that we have 2bn of money created by the Central Bank and 6bn created by the Commercial banks how could the former reduce the money stock from the current level of 8bn to, say, 7.5bn? It cannot touch the amount of money already created by the banks through monetary policy, just their excess reserves. In addition, it cannot really retract the amount of money it has created without the use of fiscal policy (e.g. increased taxes, or other sort of levies). Open market operations are nothing but an asset swap between cash and Treasuries, which means that the amount of money in the system has not been increased or decreased after the transaction. In addition, these are money which were not usually employed in actual transactions in the economy thus they pose part of the demand equation. This becomes even more difficult to work with since we cannot know with certainty the values of the money multipliers given the large spectrum of a bank's potential loans. Thus, the feasibility of the plan is rather doubtful.

In addition, the point Scott Sumner makes about forecasters being able to determine the actual policy is rather odd if one considers all the previous examples of cartels in all fields of the economy. What I am basically trying to say here is that people may work together in a way to serve their own personal interests and not that of the general public. Thus, although I believe that not many would bother to do such a thing, could we leave the integrity and safety of our system to the hands of forecasters who have much to win or lose from their actions?

Another point I would like to make is that even if, for the sake of argument, the above-mentioned policy works, i.e. the Central Bank successfully manages to reduce the amount of money, wouldn't those reduced expectations in addition to the scarcity of money create the incentive for people to increase savings and reduce current spending, thus exacerbating the situation and leading to a deeper recession? If deflation sets foot on the economy then the incentive to invest or consume is diminished; this, in addition to reduced money supply, would make the state of the economy even worse than it was. How can the vicious cycle of falling NGDP expectations resulting in lower money stock and deflation resulting in lower investment and consumption thus assisting in the free fall of expectations be stopped? If this cycle initiates then the only thing which could stop it would be increased spending (via the printing machine) meaning an increase in the money supply. Yet, this would be contradictory to the NGDP futures idea which means that people would expect the Central Bank to take unorthodox measures every time a recession is created.

I would also like to note just a simple question: although I agree that the interest rate is the price of credit wouldn't this make the inflation rate the price of money?

Thank you for your time reading this letter and I hope that you will find some time to respond because I would appreciate your answers and clarifications on my questions and comments.

Best Regards,

Euronomist

Work Hours, Job Turnover and Aggregate Demand in the US

It has been said that our perception of the world economy has changed. We are no longer constrained by limited goods like we did in the early- and mid-20th century; in fact, we have more goods than we have ever had in the past. Our economic understanding has shifted from supply problems to demand issues (not all economists adhere to this, but the flat earth society still exists doesn't it?) and our view of crises has been exactly that: a sharp drop in demand causes an abundance of goods and services remaining unsold, resulting in losses for corporations which, given their worsening economic situation have to let go many employees, if not all. This vicious cycle can be easily seen in any economy where austerity has been defining policy in the past couple of years with politicians unfortunately still adhering to flat-earth remedies (an excellent review of this shifting of ideas can be found in Tom Streithorst's Post-Scarcity Economics).

What has come to be an increasing worry is whether the US can really break out of the current secular trend of falling demand and continue on a path where demand is higher and more stable. In the case of the US, many appear to be pessimistic on whether this could be implemented. While others argue that the time of a permanent decrease in demand has come, others (like yours truly) believe that demand could actually be increased. Despite the camp the reader chooses to abide with the truth is that data are not so terrible as many present them. Job turnover has averaged about 3% per month, much lower than the early 2000's 4%, yet still quite high.

Job Turnover Rate. Source

In addition, real wages which had been falling ever since the 1970's, according to the Federal Reserve, show a clearly increasing trend since the mid-1990's, despite some ups and downs during the years.

Source: CPI and Wages

The unemployment rate has been decreasing since 2008 (although quite slowly) yet the most alarming issue is that the number of hours worked by the average American in the past years has been steadily increasing. While on average people were working 54.3 hours per week in 1979, in 2012 this has increased to 60.0. The trend seen in the next chart is more than obvious:

(Weekly compensation divided by Hourly compensation. Data can be found in the BLS website under codes LEU0208183700 and LEU0258178300 respectively.)

A most straightforward question which comes to mind is why do people feel like they need to increase their working hours if their real wages are increasing every year since 1996? The turning point in the graph was 2007. The reader will notice that between 1992 and 2007 working hours had fluctuated in the 56-57.4 interval without ever going past it. Yet, when the late-2007 crisis occurred, a jump in the graphs could be observed: between 2007 and 2009 people were working 1.5 hours more per week. In addition, labour productivity was also increasing in the 2007-2012 period which means that it wasn't that Americans were producing less than other periods in their history so they had to work longer to make up for it. Then, was this trend due to high turnover or high unemployment? Was it due to increased worry about what the future would bring or a willingness to save for debt repayment? My opinion is all of the above. It's not that easy to see everything around you shutter and not be willing to work some more in order to secure your job.

Source:BLS

This, however, comes at a cost. The more people are afraid, the more they are willing to postpone spending for the future, thus making the situation even worse. It is a sort of citizen-imposed austerity, with the same results as the state-imposed one. People work more, spend less, and watching unemployment rise and others around the world (e.g. Europe) facing difficulties makes them willing to live on a shoestring. As people get more and more afraid they fell victims to their employers' whims and requests as they are "willingly forced" to work longer hours out of uncertainty about their job stability and their future employment prospects; this uncertainty manifests as fear and spreads like wildfire through the economy.

Although the increasing trend in the number of hours worked is worrying there are remedies which can assist in making things better. Many still believe that even if people are finally persuaded to spend more, demand will never reach the heights of the pre-2008 era. I would respectfully disagree with them: data are not supportive of their claims and opportunities are still plenty. Unfortunately, they are still plenty because not all is good in the US.

Real personal consumption is increasing ever since the 1940's, despite the sharp drop during the recession. Yet, as commentators indicate, the crisis has taken its toll on the people: real household income had decreased by 4% in 2011 (data for 2012 are not yet available) and the poverty rate reached 15% or 46.5 million people in the same year, up from 14.3 in 2009 and 13.2% in 2008. Thus, there is plenty which can be done to boost demand, with most of it includes some sort of government intervention; either direct or indirect. Underprivileged members of the society could be given better education (in a country where some universities have endowments of over $1 billion, only 27% of the population has a bachelor degree) and more importantly a better chance to work somewhere that offers them the opportunity for personal and professional growth.

Many a policy (e.g. tax breaks for corporations hiring them, subsidies, scholarships, etc) could be implemented in order for the underprivileged to overcome their financial difficulties, yet these are beyond the scope of this article. What matters is that if income is increased by just $1000 a year on average then an additional $46.5 billion would be available for spending. This might not seem like much compared to the $9.5 trillion of total spending per year, yet the effect of these would be further increased over time with the increase in bank credit and accumulated jobs which would further stimulate the economy. In contrast to austerity's vicious cycle we would experience a virtuous cycle which would reduce the poverty level, increase real wages, decrease the total hours of work and in addition create more jobs and boost consumption, thus making the economy grow.

Those who fear that aggregate demand will fall in the future may be proven right if nothing is done to prevent such a turning of the events and the US will be one of the first countries to witness a permanent abundance of supply over demand, resulting in worsening economic circumstances. Regardless of whether we call it Keynesianism or Monetarism (which are in essence the same) the truth is that markest appreciate assistance in times of crises. I am not arguing that they would never get out of the crisis on their own, yet why should we force ourselves through the torment of a long-lasting depression when we know the doctrine which would help us overcoming the problems?

Trade Deficits and Current Accounts. Is Mercantilism Inevitable?

In the past few days, a substantial amount of articles has been aiming at either defending (or better semi-defending since most arguments do not really prove or disprove anything) or attacking mercantilism. Thus, I decided I'd give my (rather lengthy) view of the subject.

To begin with, mercantilism is "the economic doctrine that government control of foreign trade is of paramount importance for ensuring the military security of the country. In particular, it demands a positive balance of trade." The system flourished in the 16th-18th century in Europe, although lighter forms of it appeared after World War II in several countries, where tariffs and taxes were imposed. Mercantilism is obviously not a system which can be sustained if every country in the world assumes it since in order for one country to have a positive balance of trade other countries need to have a negative one (on aggregate, this is a zero-sum game). The system favours domestic corporations and puts barriers on foreign ones, although in lighter forms of mercantilism many foreign companies have managed to successfully establish their presence in a country. The economic rationale behind these policies is that trade deficits matter; not only do they matter but they are of great importance to a country's well-being. So, do they?

As usual, economists are divided on the subject. Monetarists, echoing the words of Milton Friedman and following the rationale of David Hume state that a country could not permanently gain from exports because the income from exports would make prices rise in the country, thus making exports less attractive and imports more attractive. On the aggregate and in the long-run, countries' trade balances would balance out. On the most extreme form, Frédéric Bastiat asked the following question: "If I send $50 of wine abroad, sell it for $70, buy coal from the foreign country at that price and import and sell it in mine for $90 imports would be higher than exports (Imports=$70, Exports=$50) yet the trader would be richer." Using reductio ad absurdum Bastiat pointed out that a trade deficit is an indicator of a successful economy not a deteriorating one. A similar thesis is held by most mainstream economists today, with Gregory Mankiw stating that "Trade Can Make Everyone Better Off" in his "10 Principles of Economics".

On the other end of the spectrum, Keynesians state that the balance of trade matters. This is why Keynes had proposed the International Clearing Union and the Bancor at the Bretton Woods Conference; in cases of severe crises occurring governments could control the flow of capital and trade to their best interest. Similar proposals have arisen ever since the 2008 crisis, notably by Zhou Xiaochuan the Governor of the People's Republic of China which prompted an IMF analysis on the subject. (For details on Keynes's proposal George Monbiot has an excellent article on the subject). The prevalent opinion amongst those who believe that deficits matter is that one country is indebted to another (or several others) when it continuously runs a trade deficit. 

Nevertheless, if trade deficits matter and nations have to do all in their power to keep them at a minimum, then they will in fact be forced to act under a mercantilistic system. The simple reason is that if a country has to make sure that its exports match its imports at the end of the day, then it has to either control for the one or the other. Since it cannot obviously control for exports (other countries drive demand even if production is increased) then all it can control for is imports. Thus, the only solution is to limit imports to the amount of exports. In addition, if deficits matter this will not just be a country's private knowledge. Every other nation in the planet would also like to balance its trade every year and thus they would begin to pay attention to how much they import. And what better way to do that than by providing incentives for growth to domestic companies and by imposing tariffs and taxes on imports?

What proves to be rather against the Keynesian treatise is explaining why a nation becomes a debtor when it continuously has trade balances: the only way a nation could be a debtor is if it is buying directly from another, i.e. if the public sector of the economy is buying products or services from abroad. This does not hold if the country is not using its currency reserves to buy these goods; in essence it does not hold when the private sector is causing the deficit. The private sector's imports can in fact raise output in the country; this dates back to Bastiat's explanation of the subject and can be shown in a simple model:

GDP=G+C+I-X+M

where X is exports, M is imports, C is consumption, G is government spending and I is investment. Assume that G, I,C and M are constant. Now suppose that in a given country increases its imports by amount V; this would mean that GDP would be decreased by V. However, why are goods imported if not to be consumed? Thus, the import of goods would mean that C would also rise. Even under the very reasonable assumption that not all imported goods are consumed during the same calendar year, they are added to I, which means that no matter how much imports they cannot have any negative effect on GDP. In fact, deriving from Bastiat again, since merchants want to gain some profit from the transactions, the final price (i.e. the one measured as C in GDP) would be higher than V, meaning that an increase in imports would essentially raise GDP by more.

So are trade deficits totally innocent? Not really: if you remember, an increase in consumption means that demand is higher, thus prices will rise; an increase in prices means an increase in inflation (the way conventionally measured). Although the relationship is not very clear due to the lack of a longer data series, it can be seen in the following graphs: when the balance of trade is negative, inflation is higher in the US.

Even if the data series is relatively short, it is rather obvious that the inflation rate was lower during the times where the trade deficit was lower than other times. Yet this is not all there is to trade deficits. Enter the Current Account: "the sum of the balance of trade (i.e., net revenue on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors) and cash transfers." Using Bastiat's example in a simpler form, we assume that country A exports $50 worth of goods to country B and country B exports $70 worth of goods to country A. Then this would mean that the Current Account of country A CA(A) would be -$20 and CA(B) would be +$20 than it would have otherwise been. However, consumption in country A would be raised by $20+ε (ε designating the increase in price when the good would be sold) and in country B it would be  decreased by $20. 

The current account change indicates the flow of funds in the economy. Thus a negative current account balance would indicate that total money in the economy would be decreased (if nothing else changes) while a positive CA balance indicates a rise in the amount of money in the economy. Then, we are faced with the following the scenario: the net importer sees its money supply fall while its consumption increases and the net exporter sees its money supply increase and its consumption fall. What happens to inflation then the reader may inquire. If we assume that the change in money supply has equal effect to the level of prices as does the change in consumption, then on aggregate country A (the net importer) would have a positive change (20-20+ε=ε) thus a rise in inflation and the net exporter (country B) would have a zero aggregate change (20-20=0). Yet, since the change in the money stock is usually more powerful than the change in consumption (or at least it should be) then we would expect that in the real world, the net importer would witness an increase in the level of prices (i.e. a greater inflation rate than it would have otherwise been) while the net exporter would face a decrease in the inflation rate (disinflation).

The above can also be seen in a country which has a large export sector, Germany. When the balance of trade is positive, the inflation rate is lower than during other times; when the balance of trade is positive, yet less than what it used to be, inflation is again higher. (Note: private consumption is constantly rising in Germany over the the past 20 years. This does not mean that this case does not hold since consumption can rise for many reasons not just the balance of trade, e.g. population increase. For details on inflation read this)

Returning to our original question do trade deficits matter? It depends on whether one considers the inflation rate to matter. If an inflation rate of 2-3% does not matter then having a trade deficit when the rate is 1% will not mean anything. This changes when the inflation rate is increased to 10 or 15%. Thus, it depends both on the size of the deficit and its continuity. For example, even though the US has been experiencing trade deficits and current account deficits in the last 25 years it has not affected the economy's ability to grow and prosper.

An implicit subject in the whole above analysis is that every country has the ability to print its own money. This subject, which was taken for granted until the developments in the Eurozone nearly a decade ago, is anything but certain now. The Eurozone countries for example have to take much greater care with their finances than the US or the UK, since in the absence of new currency entering the market, the monetary outflows will decrease money in circulation if they experience large and prolonged current account deficits. This will lead to a situation where the amount of money in economy will become scarcer every year, leading to a deflationary state, with all the known consequences. After a country which does not issue currency reaches that level of deflation, imports would collapse since it cannot further sustain them and a period of lower consumption and lower GDP would take over.* The question posed is whether if the situation would remedy itself or if it will require an intervention of some sort; in addition what kind of monetary policy should the ECB pursue to avoid such issues.

The answer is that both are possible: the situation will eventually remedy itself but the period would be longer and the consequences direr than if the country could just print its own currency. In essence, the country would see its consumption fall, unemployment rise and witness a general slump in economic activity which would in time (although the length required to do depends on the economy's ability to adjust) decrease demand for foreign goods, decrease prices and force exports to rise. Nevertheless, this case means that the economy would have much larger variability than it would otherwise have; in order to avoid such a case, Eurozone countries should be extra careful with their finances, leading again to some sort of protectionism. While the ECB will lower the probability of this happening in the near future and possibly reducing the consequences by continuing its money mandate, I would not dare suggest that any proprietary measures would (or could) be taken for any nation which will face a current account problem. Given the current situation in the Eurozone it is very doubtful whether any ECB intervention (or increase in money supply for that matter) could be done to avoid or counter the occurrence of the problem. 

A summation of the above analysis would be this:
1. Trade deficits matter with regards to inflation with net importers having greater inflation than if they were balanced and net exports lower than balanced.
2. They also matter with regards to money supply with net importers seeing a decrease in money supply and net exporters a rise.
3. Trade deficits and Current Account deficits do not matter much if they are not extremely large and if the country can produce its own currency. Yet, they matter a lot if they cannot.
4. If trade deficits (and subsequently current accounts) matter then countries should consequently either start paying attention to their imports and exports (which would lead to mercantilism/protectionism) or just let free trade be (and witness large ups and downs in the economy).

Free trade can and has worked in the world economy, being a stimulant over the past 30 years. Yet, what was once considered a burden, i.e. the existence of too many currencies, was what actually assisted to the development of trade. In an inflationary world, economies work much better than in a deflationary one, making the economic future of the Eurozone countries depend on their course of action regarding trade balances.

*Readers may (rightly) ask: "then why is this not happening to the US?" The US face a very similar situation with the Eurozone as their states are (economically speaking) tied the same way to the greater country. Nevertheless, after examining some of the existing data what makes the US different from the Eurozone lies in a sentence in page 11 of the .pdf file (or page 313 if you prefer) "Put another way, each state indirectly subsidizes or is being subsidized by the other states". This means that specific states would never run out of money as long as the whole nation is prospering (that is, its citizens will not witness deflationary pressure) since states are assisting one another. With this in mind, the Eurozone is inherently different: the ECB can never "print" new euros to support nations with current account problems thus the probability of EZ Member-States facing problems is (much) larger than the one for US states.

P.S. Given the recent publicity Keynes's plan with Bancor and the ICU has taken I would like to note that at the time when Keynes was proposing the plan was one where the world was leaving the gold standard behind and the process had just began. It was a time of managed currencies, tariffs and barriers to trade, with the world divided between communist and capitalist countries, with dire memories of the Great Depression and a World War, entering an era which lasted for almost 50 years. The circumstances at the moment are much different than the ones when Keynes proposed his plan. Although I am not against the IMF changing its agenda, it would be somehow pointless to promote a currency just for trade given that we do not wish to impose trade barriers or mercantilistic tactics and that fund transfers and done in fractions of a second. If a large crisis occurs, controlling capital and trade would be indeed beneficial to the country's economy; nevertheless, if all countries did that we would again end up in mercantilism. If Keynes was alive today I doubt whether his plan would have been the same as the one in the 1944. In his own words: "In my facts change, I change my conclusions. What do you do Sir?"

Ponzi Games, Pyramid Schemes and MLM's

It's easier to fool a man than to convince him that he has been fooled - Mark Twain

Ponzi games got their name from Charles Ponzi, who was the first to serve prison time after trying to profit from such a scheme in the early 20th century in the US (Such schemes existed in the past as well. In Charles Dicken's 1844 novel Martin Chuzzlewit and 1857 novel Little Dorrit similar schemes were described). The now notorious con-artist promised a 50% return to his investors by engaging in post stamp arbitrage. This proved to be much costlier than Ponzi expected thus he began to paying off older investor with the proceed he got from new ones. Although he was finally apprehended and served 10 years in jail, his idea had (unfortunately) caught on.

One of the most serious cases, and the largest to-date, has been Bernie Madoff's investment fund, with a life span of 48 years (was founded in 1960) and amounts ranging to approximately $65 billion, obtained from 4,800 clients. Madoff was sentenced in 2009 to 150 years of prison time and forfeiture of $18 billion. In another example of the size such schemes may reach, a pyramid scheme in Albania reached approximately 43% of the country's GDP.

Pyramid schemes are of similar characteristics with the Ponzi ones. Their two important differences is that in a pyramid scheme there exists a product which is supposedly sold to bring in the money and the pyramid participants have to recruit others to join the scheme if they wish to have a return on their "invested" capital. (In the Ponzi scheme, the initiator finds new investors on his own, in contrast to pyramids where participants are "obliged" to do so if they wish to make a profit. In a sense, participants of a pyramid scheme are co-conspirators and not innocent victims like most of the Ponzi scheme investors are) While it is obvious why Ponzi schemes are illegal (the con-artist is taking from Peter to give to Paul) many fail to see the reason why pyramid schemes are doomed to fail. The answer is simple mathematics: if the participant has to recruit 4 people under him then after 10 levels the amount of people who have to be recruited exceeds 1 million. At the 16th level, the number of those who have to be in the scheme is approximately the number of person alive in the world today (and we are also making the very bold and untrue assumption that everyone would be interested in participating)

Many also assume that they are one of the "first persons in" since they are being told so. According to the Federal Trade Committee (FTC) when a participant has to recruit 3 more people, a whooping 89% of total inductees end up in the red. If they have to recruit 4, then under the same regime the percentage of losers is almost 94% (the probability of losing grows with the number of new recruits a member has to get). In addition, the people on the top of the pyramid earn from each individual who enters the scheme after them; and these people never do really change.

Enter Multi-Level Marketing (MLM). The difference between MLM's and both the above-mentioned schema is that MLM's do actually have and sell a real product to members of the general public without requiring the consumers to pay anything extra to join the MLM system. Notable, legitimate MLM's include Avon and Tupperware. Amway Corp is another famous example: the company was accused of being a pyramid scheme, yet the FTC decided that although Amway's earnings claims when recruiting new distributors were false and misleading) the company's selling plan was not an illegal pyramid scheme.

Two very important characteristics of the Amway Corp were the ones which tilted the case to it's favour: it required each distributor to sell at wholesale or retail at least 70% of its purchased inventory each month (known as the 70% rule) while it also required each sponsorship distributor to make at least one retail sale to 10 different customers each month (the 10-customer rule). In addition, Amway participants were not purchasing the right to earn profits unrelated to the sale of products to consumers by recruiting other participants, who themselves are interested in recruitment fees rather than the sale of products (known as the Koscot definition).

Nevertheless, the Amway rules are not definitive of non-pyramiding: Omnitrition had claimed to abide by these rules yet the court noted that they are meaningless if commissions are paid based on a distributor's wholesale sales (i.e. effectively on new recruits) and not based on actual retail sales. To this end, note the importance of David Einhorn's question in a Herbalife meeting(page 17)

"(...) first is how much of the sales that you make in terms of final sales are sold outside the network and how much are consumed within the distributor base?"

The reply Einhorn received was the 70% rule, yet on subsequent questioning the spokesman commented that the company had no such knowledge. A 2009 FTC publication mentions the following: "Do distributors sell more product to other distributors than they do to the public? Does the amount of money distributors make depend more on recruiting? Does the money made depend mostly on selling to other distributors than sales of the product to the public?" If the answer is yes, then you are looking a pyramid scheme. (In fact, Herbalife has already been deemed as a pyramid scheme by a court in Belgium in 2011. An appeal has been made to that end and the final decision is awaited eagerly by investors.)

Signs

The most important question in the Ponzi/Pyramid world is "how can I know if what I am about to do is a real, legitimate MLM and not some devious scheme?" The FTC document provides a list of potential red flags:

1. Beware of any plan that makes exaggerated earnings claims, especially when there seems to be no real underlying product sales or investment profits. 

2. Beware of any plan that offers commissions for recruiting new distributors, particularly when there is no product involved or when there is a separate, up-front membership fee.

3. If a plan purports to sell a product or service, check to see whether its price is inflated, whether new members must buy costly inventory, or whether members make most "sales" to other members rather than the general public.

4. Beware of any program that claims to have a secret plan, overseas connection or special relationship that is difficult to verify. 

5. Beware of any plan that delays meeting its commitments while asking members to "keep the faith." 

6. Finally, beware of programs that attempt to capitalize on the public's interest in hi-tech or newly deregulated markets. 

In addition, what an investor/distributor should do is have a look at the compensation plan. The more complicated, the more chance of scheme being either Ponzi or pyramid there is. As The Observer states, the World Ventures compensation plan runs approximately 26 pages. Even if you close your eyes to all the aforementioned guidance lines, there are two things which an investor should keep his eyes open to:

1. Recruitment fees

2. Promises of lavish returns/grand lifestyle to participants

The latter guideline is what investors should always be aware about any asset manager or business opportunity: there are no fast solutions, no get rich quick formulas. Even Warren Buffett did not get rich in a day. His returns exceed the S&P 500 by 10.3% on average yet even he has had years in which the S&P did materially better than him or faced losses (for details on how hard it is to be Warren Buffett have a look at Cullen Roche's interesting article here). Ken Fisher's must-read "How to Smell a Rat" points out some other important aspects and notably that "due diligence is your job and yours only. Don't be impressed by marbles, lavish parties, claims of exclusivity or anything that does not matter". Another issue is the investment strategy followed. If people can explain their strategy simply (or as stated before if their compensation plan is not easy to understand) then there is less chance of being a fraud.

The bottom line is that pyramid schemes, Ponzi games and other con plans which will be conceived in the future will not disappear. The main reason is greed: people want to believe that they can get rich in a very short period of time without having to work much. The truth is this is never true unless you are breaking the law. I do not wish to delve into the various psychological and societal dangers one will come to after being involved in such schemes (everybody is a potential client, people start to mistrust you thinking that you have a hidden agenda every time you talk to them, etc) as this is beyond the scope of this article. 

The final note to readers is what Ken Fisher says: do your homework and keep your eyes open. Many may try to persuade you, and they can be very persuasive with presentations and live "examples" of success. Yet, after lifting the veil of "pureness" and the promises of great life and riches, what is left is nothing but a simple scheme designed to part money from their owners and pass it on up the pyramid.

UPDATE: The Albania case has been very well described in this article by an IMF economist. Being the largest scheme ever (with regards to GDP) it makes this a must-read

Inside Information and Trading

The US has been the prominent pursuant of investors who, after having undisclosed information about a corporation try to exploit it by either buying or selling according it. The Wikipedia definition is "any individual who trades shares based on material non-public information in violation of some duty of trust", not limited to people who are part of the specific company but to all others who use such information to their benefit. The rationale for going after people who trade as such is simply that they are taking advantage of people with less information than their own.

The other side of the coin promotes that people with inside information should not be persecuted but instead, in the words of Milton Friedman "You want more insider trading, not less. You want to give the people most likely to have knowledge about deficiencies of the company an incentive to make the public aware of that." Others, argument that insider trading is a victimless act, meaning that those who were going to sell were going to sell anyhow, thus the fact that their counterpart has more information does not affect them. Nevertheless, this rather simplistic argument does not take into account that if a person is presented with more information he might change his mind from selling his current position. Thus, the seller is prevented from reaching a decision under full information. Obviously, those who argue that this kind of asymmetric information is legal in other practices such as real estate, are making the argument that if something bad is happening somewhere else then we should let it happen elsewhere even if we can control for it.

Friedman's argument brings to mind the theses of the Efficient Market Hypothesis (EMH) and the Noise Trader approach. The former, as already discussed, suggests that all available information (either past, present or future, public or private) has already been reflected in the stock price, thus making the market efficient and inappropriate for gaining from them. The latter states that in a stock market, there exist two types of agents: noise traders, who trade erratically and irrationally and rational ones. The noise traders, who even under erroneous beliefs can dominate the market and earn significantly higher returns than rational investors, are responsible for the stock market deviating from fundamental values and they are keeping arbitrageurs from correcting those values (the interested reader may have a look here, here and here for more details).

Returning to the argument, Friedman implicitly assumes that the markets are not efficient but if insiders with more information come to dominate the market then noise traders would diminish thus making markets fully efficient. If someone has information which is useful in estimating a company's future prospects (regardless of the way the estimation is done) then his knowledge would alter the company's stock price, even slightly, to his favour. No trader with new information is ever small, no matter how large the market is. The only difference is that if a trader has private information about a company and that information will never become public, then he stands no chance of ever winning in the stock market no matter how important his information is.

Although this is a rather strange thought, it is easy to understand: if I have information that a company faces trouble but no-one else has that information then I would sell the stock short in order to make a profit from its fall. However, this fall will not occur until the rest of the crowd finds out about it as well. The crowd has no incentive to sell the company if they do not have that information: for them, the company is doing as great as always and no news to the opposite have come to shutter that belief. In addition, the ends do not justify the means either: the public would be aware of that but the only way that insiders would ever disclose such information would be if they stand a chance of winning from it. Thus, they would not be doing it for the public's benefit and neither would the public be benefited from this new information. In fact, new information would increase the duration of the effect as it would start with the insiders' trading and finish when the stock market had assimilated the effect (to be fair it might decrease volatility in the market since prices would not have to adjust so rapidly; still that would depend on the state of the economy, the current trend in the market and so on).

Thus, any inside information trading is bound to disrupt the current market state; although readers may assume that this happens every time new information presents itself, I would like to remind you that this is not a collective action: the market shifts because of the action of some individuals who are in fact determining the price of a stock based on their beliefs and information. This is essentially the same as stock manipulation: the motive to earn a greater return than others, exploiting information others do not have (in the original case the public had no idea that someone was manipulating the stock while in this case they have no idea that new information exists).

The above, make the simple case that if private information was obtained by a person and used in such a manner as to secure a profit, it would only be illegal if that information was to reach the public at a point in the future; if the information was to remain private then no such case would hold. In fact, this also brings forth an issue of importance: it is not the information per se that matters but the timing of that information. As a recent experiment (whose link I was unfortunately unable to find) has shown, those investors who (on purpose) received information on the CPI publication minutes before the actual were published gained on average more than those who received it later. The information on the CPI would have been practically useless if they had received it 3 months prior to the actual publication as the stock market would have demolished their potential profits. In common parlance the investor would have been "too smart for his own good". (The same holds in experimental game theory as participants who understood the game before everyone else faced the problem of being right too soon, thus losing their bets.)

The main idea of all the above arguments can be put simply in just a sentence: insider trading is knowing information sooner than the public does but not too soon as volatility would destroy any potential for gain. In addition, you have to be certain that the public will find out that information and that it will subsequently act on it. Thus, instead on focusing on information which could potentially be used by insiders we should focus on the people who can get that information just minutes before everyone else does and act on it. Inside information is nothing more than timing and not new information.

Interest Rates on Sovereign Bonds: The Price of Debt

The aspect probably most sought after by the financial industry of both government and corporate bonds is yield. Yield indicates the yearly return a bond will give its owner based on the interest payments he will receive and the price the investor will acquire it for. Although at the time of issue a bond's yield equals its interest rate, the situation is soon altered as trading makes the two deviate. Yet, from the sovereign's point of view, the most important aspect of bond issuance should be the interest rate, for the simple reason that it reflects the price it has to pay for the credit received.

The rationale behind this idea is simple: when a nation has to pay more to get credit, its possibilities for growth are diminished as it is obliged to allocate more of the yearly budget to service existing debt, depriving resources from the economy both through decreased government spending as well as increased taxation or unnecessary money printing. In addition, funds employed to service the debt could have been used more effectively in promoting more growth, which in its turn would decrease the debt burden and the borrowing costs promoting a benevolent cycle. In the Eurozone, the situation is exacerbated by the fact that no nation has the liberty to use a sovereign currency, thus increased borrowing costs are a burden the taxpayer unavoidably has to assume.

On examining the current data on bond interest rates (one has to do some data mining to find what the average interest rate paid is) one of the most interesting aspects is that bond interest rates were increasing even before the crisis for some countries. The following is a graph of the interest rates on bonds of 9 Eurozone countries from 2001 to 2011 (data obtained from World Bank and Eurostat. Cyprus did not have any data at the World Bank database prior to 2007)

Not surprising, the lowest interest rate throughout the years has been the one of Germany, yet the Cyprus one is rather amazing. Historically, the island now notorious for setting a precedent on depositor bail-ins, had at a time been paying interest rates with a spread of approximately 7.5% from the German one. Yet, as it appears, the market caught up with what had been going on and in 2011 Italy, Ireland and Greece had taken her place as the leading interest payers in the region. Unfortunately, the World Bank database was not yet updated for 2012 data.

Nevertheless, although the numbers are not up-to-date, they indicate that the market has much predicting power, even in the case of sovereigns. Italy's interest rates have been on the rise since 2010 as have been Greece's and Portugal's although Italy has not yet requested any assistance, Portugal required assistance a year later and Greece did not file for help until mid-2010 and the aid received was for restructuring the debt. In addition, France has also seen interest rates rise in the last two years (2010-2011) as a result of increasing uncertainty about the state of her economy. One can safely assume that data for 2012 would indicate that interest rates in the troubled countries have further increased while in safer countries like Germany they have decreased.

This, is supposedly a problem the OMT should have addressed. When at the issuance of government bonds, the yield (which equals to the interest rate) in higher than a threshold (and importantly the country is still in the markets, i.e. not considered junk), the ECB has pledged to intervene and purchase the bonds itself. Yet, even at relatively lower interest rates than the threshold, a country's ability to service it's debt is severely affected if the interest due is high. For example, with debt at 108% of GDP in 2011, Portugal had to pay more than 5bn euros just for interest payments or approximately 10% of her revenues. The percentage for Greece was 17% of revenues while for Germany and France was just over 5%, making troubles for the Greeks even harder as they have to generate a large amount of money just to cover their interest expenses, without addressing any other problems.

Thus, if the problem of extracting large amounts of money from the population to cover increasing interest rates is not addressed, then recovery will almost certainly be delayed for even longer. As governments cannot print any new money, increased interest rates as a result of uncertainty and fear about the sovereigns' futures can only signify that more funds would be taken from the real economy and given to non-productive uses, creating a vicious cycle. This, will only add to the abundance of problems faced by the South while not promoting any solutions whatsoever.