Theories of Investing

...or why every theory is a greater fool theory.

Imagine, dear reader, that you are currently thinking about purchasing a company's stock. What would your rationale for buying might be? Usual answers would be great potential for future growth, low P/E ratio, excellent management, stable growth over a period of time or a strong company record. Others may say that they have received a tip from a "good source" that the price might rise or that their charts tell them that there will be a "head-and-shoulders" recovery or their MACD combined with their 7- or 30-day average has indicated that they should do so. No matter what the approach might be, there really is just one simple reason people buy stock: they believe that the price will rise.

Some have longer horizons than others, some bet for a 1% return, some bet with high leverage; it does not really matter. Their purpose is simple and can be fully described in one word: profit. Why would any us bother to trade a stock if their was no potential of gaining something for it? There is no-one out there (I think!) who would be willing to buy a stock if he believed that the price would remain stable and he wouldn't be able to make a single cent of profit. Keeping his money in the bank, earning his meager but stable return would be a better alternative. The same holds if the stock-picker was certain he would face a loss in his investment.

I doubt that there is anyone who would disagree that people are into stocks for profits. There might also be other reasons for it, such us obsessive gambling behaviour, but this just an outcome. The only real reason everyone got involved with the stock market was profit. Note that before, my statement was "if one believed that there was no profit potential" he wouldn't bet in the market. Not if I (or any other) told John, Jack or Jill that the stock was going down and they had a different opinion; only if they believed it themselves, although someone might be able to influence them one way or another. Yet, any other person cannot trade with their money (unless they give it to him) which means that if he cannot influence them, they will continue to buy; at the same time I would prefer to sell. This is essentially what makes stock markets move up and down: differences of opinion. 

It does not really matter who is right and who is wrong when the market moves. You cannot even know who is. Just because the market has moved with you for a day does not make you right just as it does not make you wrong if the market moved against you for a day. What makes you right or wrong is whether the market moves with you or against you in the time-frame you have personally selected, no matter how big or small that might be. If your horizon is infinite, then you have less to worry about day-to-day movements, yet more to worry about longer-term ones. If it's a couple of days or hours then the opposite holds.

Then the question becomes: when do you sell? Is it just when the investment horizon hits or when the price hits a certain limit? Let's think about it. People tend to have some sort of price or return in their minds if their horizon isn't infinite (which usually isn't). Returning to the previous arguments, people always buy for a profit. But they want the profit to be substantial enough to cover their costs and gain some return on top of that. Thus, they have to at least know about the minimum price at which they will sell. How about the maximum then? If one uses more sophisticated techniques (value investing is an example that springs to mind) they can even calculate the exact price they expect the stock reach; after reaching that plateau, they will almost certainly sell it. If ones does not use any sophisticated technique then he will just sell it when his gut tells him to do so (this does not make the "gut" technique better or worse than the others).

In any case, deep down, there is only one reason for selling a security and that it that the investor believes that it has run its course, i.e. that it cannot provide him with any more profit at the time being. If an investor is asked, explanations offered may appear to be different but at the heart of every argument about the sale of a particular security is the simple notion that the investor does not expect it to provide any more profits at the time being. The stock may continue to rise or it may fall, yet this is of no meaning to the investor. He may purchase it again later if his forecast changes, but at the time of sale he is almost certain that the winning strike will no longer continue.*

Consequently, when the investor's beliefs are that the stock must be sold, it means that anyone suggesting that it will continue its course will not matter. At the time of selling, his belief dictates that doing anything else but selling would be irrational, given his knowledge and the interpretation of that knowledge at the time. Thus, for the investor, any other person acting against what he believes is nothing but a "fool". This might appear to be a rather broad generalization given that others might have better information or better understanding of the situation. Yet, the idea behind this is subjectivity. If I know something and keep on postponing my actions because I do not know what others know then I would be indefinitely postponing closing the position. This will mean that I will never capitalize on any gains which will mean that there is no point in ever opening the position. Under my subjective decision, I can only say that I am doing the best of what I can understand and have information of, which means that my decision is optimal based on what I know and understand at the time.

Thus, returning to the original argument, if an investor decides, using whatever technique or idea, that the position must be closed, any other way of acting would be foolish, including the person who buys the stocks he sells. Once again: the decision may be proven right or wrong in the future, but it does not matter. All that matter is that the investor believes it is the correct one at the time. Subsequently, when we are selling we are depending on finding a fool to buy the stock. We might have been foolish in buying the stock or we might have been clever, it does not matter. All that matters is that, when we decide to sell it, a greater fool than us will be willing to buy it. Maybe the buyer is not a fool and in the end proves to have better understanding or information. Yet, from our subjective point of view, the buyer is a greater fool since we are giving stock at a price we would consider ourselves a fool for buying.

Most critics will say that approaches like value investing are not like that. Let's think again: we have a firm with 1 million of profits selling for 9 million when we believe that the proper price would be 10 million. Thus, we buy at 9 and wait until it reaches 10 to sell. Would we have bought it at 10? No profit potential so I would assume the answer would be a clear no. Thus, for the value investor, anyone buying the stock at 10 or higher is a fool since he cannot possible get any profit from the transaction (unless information changes that is).

Summing up, it does not really matter why a person buys a stock; he wouldn't be doing it if there was no hope of profit. And if he does buy it then we assume he has to sell it at some point, whatever that point may be and no matter how many times the point is revised. When finally reaching it, the investor will sell; and from the investor's point of view, anyone else buying what he is selling, is a fool.

*It is straightforward to say that if the market turns against the investor and is forced to close his position then all of the above do not matter; leverage, willingness to hold the position despite worsening of the situation are what will define his ability to remain there.

What Natural Interest Rate?

Most of the times, the articles that inspire me to write leave a positive impression on me. Other times, I just feel that a subject needs to be clarified or that an issue has not been addressed properly. There times though, like this one, where articles I read do not seem to understand that the issues they address are so theoretical and so convoluted that they have very little use (if any) to either consumers or firms. Although I like theory and believe that especially in macroeconomics many more (useful) conclusions may be reached from theory than empirical work (although not dismissing the latter), I share a strong resentment towards theory which cannot really focus on reality and presents the world on how it could potentially be or how its author believes it should be. Without further ado will let you know that the article which sparked this response is Miles Kimball's Natural Interest Rates: Clearing Away the Confusion

Perhaps, in some way, Kimball has cleared away the confusion on what he feels is the natural rate of interest. Although he mentions that low output levels lower the short-run interest rate (which is true) and the deeper the recession the lower interest rates should be to counter it (which is partially true), it appears that Monetarism got the best of him. Nobody would argue that interest rates play an important role in recessions, yet they are not a panacea: they can be employed to assist but they cannot do all the work on their own. For example, he states that monetary policy supposedly determines the equilibrium interest rates in the market. Yet, this not only does not really hold as Central Banks are most of the times retroactive in their responses; it is not until commercial bank rates rise that Central Banks raise theirs, meaning that unless we are to employ the previous period's policy rates in our calculations, we wouldn't factor the effect of monetary policy in estimating the short-run interest rate.

In addition, what is my greatest disagreement with not only Kimball but many economists is what is presented as the "natural" interest rate. This, is nothing but a number which might (or might not since we cannot see it) be true if we had no wage stickiness, price-stickiness or, in general, if them people (and yes I do mean all of us) did not distort the idea world economists are trying to build. (Ironically, economists do not act like the ideal people of the ideal world...)

The essence of the disagreement is that he believes (as many other economists do to be fair) that we could have both a medium-run and a short-run interest rate. What most economists fail to see is that we cannot distinguish one from the other even if they exist. In fact, they are so convoluted that we can only see the result of this interaction, without being able to see the original inputs. According to his definitions, we have an ultra short run, a short run and a medium run which would appear like this:

(Click to Enlarge)

As anyone may observe, in the medium run we would be experiencing the results of 4 distinct short run periods and 16 (!) ultra short run periods. This means that when we are about to measure the medium-run interest rate of an economy we have to take into account the short run as well, as it defines it. Suppose that we were at #1 and now we are almost at #16. According to the calculations made at #1, we would be witnessing the results of the medium-run interest rate which, according those calculations would be, say 2%. Now suppose that a recession or a boom occurs at #15, meaning that the interest rate would either be at 1% or at 3%. These effects are not due to neither fiscal policy nor technology shocks which Kimball understands as affecting the rate. They are, in fact, outcomes of the whole business cycle, models which lie behind the sticky-price, sticky-wage models.

The claim is that this medium-run "natural" interest rate is not a constant. If it was, then debunking their thinking would be too easy. Nevertheless, even saying that the medium run interest rate is not a constant actually indicates that we have some knowledge about what it would look like and we can re-calculate it with every new piece of information we get.

The reader may inquire why I am bothered with this. Yes, the medium-run interest rate is never what we calculate it to be, not just because of stickiness but because such a medium run does not exist. Still, this is just the tip of the iceberg. Kimball's argument is that investment, as he understands it, occurs when the benefit relative to amount spent is more than the real interest rate plus the depreciation rate and the obsolescence rate. What Kimball is trying to say (I think) is that basically the return on the investment made should be higher than the cost. Yet, this does not really depend on just the real rate, or to be specific the firm does not really care about the real rate. It does care about its return though. As long as the estimated return from the project is higher than the estimated rate it has to pay then the project is valuable. The firm cannot really know about the interest rate, more so about inflation, even at the Ultra Short-Run. It can only estimate them. Now, these estimates may actually affect both the rate as well as inflation, yet they are neither constant nor precise. They are mere estimates, which, considering Kimball's arguments should affect the medium run. Yet, there can be no medium-run estimate and neither can there be a long-run one. The reason is that they both require the economy to remain stable and stability is something the economy has never done.

It's not just that the economy needs to be stable to have the medium-run interest rate come out like we estimate it. It's that we have to magically transport ourselves from 2013 to 2025, with the state of the economy being exactly as it were 12 years ago, the same short run interest rate and have the exact same conditions. But... oh wait, if we had that, then we wouldn't experience the medium-run interest rate but the short-run one. This, makes the medium run a state which we cannot ever experience, even in theory.

Another issue with regards to the interest rate ups and downs is why the interest rate is lower in recessions and higher in booms. The reason that rates are lower in recessions is not because the real rate is not high enough or that depreciation rates are higher than in other periods (in fact depreciation should be the same in recessions and in booms). The reason is that the expected return in a recession is lower than the one in a boom. These are based on scenarios given the state of the economy at the time. When a wide enough problem has occurred in the economy which keeps demand down, it makes sense to lower estimates about perspective demand (whether firms are correct in estimating that is another question which is beyond the scope of this article). This means that the expected return of the project will be lower. Thus, the firms will say no to high interest rates and will continue to say no until these rates are lowered. The same logic can also be applied to consumers. If rates remain high because of Central Bank inaction, it could seriously harm investment expenditure in the country (or region).

Obviously corporate finance experts take the possible duration of a recession into consideration when they make their scenarios, but as usual when times are bad, people tend to err to the side of caution. In Kimball's words, the firms choose whether to "rent" capital (i.e. rent buildings, etc) and treats buying capital distinctly (separating it into two companies). Yet, renting capital would be the same as buying it if one considers that buying the capital means that they have to pay a depreciation expense which those who rent it do not incur. This is not really mentioned in the article, and at a point I just get the feeling that we employ perplexity for the sake of perplexity.

In addition, he mentions that people who work in corporate finance are more eager to buy when business is good than when business is bad. In all fairness, this all depends on how good or how bad things are. If sales are down 5% because of a recession, then we would be more willing to buy capital at a cheaper price than when sales are up 5% because of a boom and capital costs more. More so, he mentions that since capital does not change fast increases in wages and total worker hours push the rental rate up. This is true but it's not the whole story: the rate does go up but it is only because demand has already gone up and the firm is better off producing more than it did. Why? Well because the firm, seeing its products have more demand wishes to produce more in order to have more profits. Yet, this means that their estimates concerning new projects has been re-evaluated upwards, making them more eager to get money at just a bit higher rates than the current ones.

Thus, the workers who actually see this from the inside and understand that since their firm is expanding, money is more plentiful now and the outlook is going to be better in the future (in addition to seeing their employers earn much more than before) they demand higher nominal wages. This, in addition to the already higher demand, makes the interest rate rise. Now, from what we have already learned, this means that demand will be further encouraged with rates increasing even further.

Yet, in this analysis we have left out the role of the banks: when banks have more liquidity that they want, they are more willing to give out that money as loans. Thus, even though the demand for funds is increased during booms which makes the interest rate rise, the bank's willingness to supply funds is also increased (this means lowering the interest rates). The first is much more powerful than the latter though, for the simple reason that those who want to get money are usually more than the amount of money the bank is willing to lend, thus, the interest rate does not skyrocket unless in extreme situations (too much inflation for example). Another reason the rate does not skyrocket is that investment projects do not really skyrocket themselves. Although firms would have enjoyed it, they cannot earn a 35% annual return on a project (unless in very extreme and unsustainable cases) putting an upper limit to the rates; no firm would borrow at 15% when the most it can make is 12%.

Concluding, the main topic to be extracted from the article is that the defining powers of interest rates are firms, consumers and banks. The lower limit in a recession is imposed by the Central Bank (in the sense that it will not allow for the rate to fall below some point, i.e. not become negative) and in booms by the expected return on investments. There is no such thing as a "natural" rate of interest since it would necessarily mean that there are "unnatural" ones. There is only the prevailing interest rate of the economy. In addition, there is no "medium-run" interest rate, nor is there any way of actually experiencing such a rate; even if we lived in an ideal world filled with "homo economicuses".

Counter-economics for the Japanese Economy: Interest Rates and Growth

Japan provides one of the most interesting cases of economic booms and bursts the world has ever experienced and provides a staggering example of how the real world is affected by the state of the economy. Since the Japanese real estate bubble of the late 1980's, the economy has gone through what has been dubbed as the Japanese lost decade(s). Strangely, although many indicators show that the economy has been growing and things should be doing much better, it does not really feel like this to most economists and certainly not to most residents. (Click to enlarge graphs; all data from tradingeconomics.com)

The above indicate that both government and consumer spending have been on the rise for the past 15 years, and although confidence has seen its ups and downs it nevertheless is approximately at the same levels as during the late 1980's boom, as it was during the mid-2000's. Thus why no growth? Population (which has been slowly declining) would matter in these data only if aggregate consumer spending was less than before. Yet, this does not appear to be the issue. In addition, increased government spending also adds to aggregate demand, thus making its rise even greater. Interest rates, both interbank and central bank, are at all-time lows, which means that people should have incentives to invest or spend. This should, theoretically boost the economy and take it out of the recessionary cycle. Right? Wrong.

Despite what prevalent economic theories proclaim, interest rates are not dictated by policy but by the market. Using, the basic supply and demand knowledge from Economics 101, it is easy to see that when supply of funds is greater the interest rate paid to keep those funds in the bank is lowered. Conversely, when the economy is booming and people tend to spend more than they save, demand for money is higher by the banks (since they need it to lend more and thus have more income), making rates higher. The graph below should further clarify the subject.

The line indicates the long-term trends in savings and as you may see it has been clearly rising over the past 15-18 years and has only recently shown signs of slowing. This should also make us understand why bank credit has also been falling since the mid-1990's, with a mild recovery in the mid-2000's. Since savings have been on the  rise for the last 15 years, then people had no incentives to invest, thus no incentive to borrow money.

Thus, not surprisingly, the increase in the M2 money measure (whose increase has also been slowed down since the early 1990's) was driven by the increase in the monetary base. When the M0 trend was slowing in the mid-2000's, the rise in private sector loans made up for that loss, thus keeping the M2 trend stable.

Where I am getting with this? Bear with me for a second. Up to now, economic thinking has taught us that the central bank dictates policy, lowering rates in times of recession so that people can borrow with greater ease thus boosting investment and consumption; raising rates in times of growth, to hold things from exploding. Nevertheless, this successful policy is not an issue Japan can be proud of. Deflation has set its game in the country over the past few years and is not about to leave any time soon. Whether you call the situation a liquidity trap or anything else it matters very little to the people. Then big question is how this can be changed.

You cannot have too much of good thing and QE in Japan is living proof for this. We cannot know what result Shinzo Abe's policies will have on the economy, but we can nevertheless be optimistic that they will continue to put an upwards pressure on prices. This should induce investment and growth in both the medium- and the long-run. We are forgetting though that QE is nothing more than an asset swap, supposedly forcing banks to lend more money since they have all that excess liquidity in their hands. What it does not say is how much banks will lend and how willing are customers to assume those loans.

As mentioned before, economists traditionally believed that monetary policy, as dictated by the Central Bank, was tantamount to countering crises and recessions. After years of education, finance practitioners have also grown accustomed to the "fact" that the interest rates are dictated by the almighty Central Banker. These are the gospels of monetary policy and, along with "unorthodox" measures like Quantitative Easing are supposedly the most important facets of the Central Bank's function.

This understanding of the world dates from the monetarist view of the 1950's. The previous understanding of how the world functions can be found in Keynes's "Tract on Monetary Reform", where it is stated that interest rates are mainly formed by the continuous interaction between banks and customers and not the Central Bank. When demand for money is higher (i.e. customers want to borrow) banks increase their interest rates both so that they can attract more funds (to loan out later) and as a response to the increase demand for their supply (if demand for a good is increased then, all else being equal, price would rise).

While it is true that increasing or decreasing the interest rate has some effect on the overall state of the economy, it is however also true that the trend is dictated by the economy and not by the central bank. Thus, in the case of Japan, although the interest rate has been kept at very low levels over the past decade we have seen no significant increase in bank lending (other than the slight increase in the mid-2000's) or investment. This can only lead to one conclusion: people are more prone to save than to spend or invest, thus keeping the interest rate down.

The question then becomes when do people tend to spend more. The answer is relatively obvious: when they have more money and feel wealthier, as Ben Bernanke states. Low interest rates should in theory boost lending but the fact is that lending is also high when interest rates are high. The rather counter-intuitive to economic thinking, conclusion we may reach is that if interest rates are increased then both consumption and investment can potentially rise. The reason is that higher interest rates also boost spending. The maths are really simple (formulas from Wikipedia)

The future value of an annuity depends on both the interest rate on money and the number of periods. If a person wishes to save €100,000 in the next 10 years at a 1% interest rate then he will have to save approximately €790 per month. Increasing the interest rate to 3% would mean that the amount he saves would be decreased to €720 per month. The difference between these amounts is the potential increase in private consumption. The intuition behind these calculations is that people wish to save for their future, keeping a specific number in mind.They save enough to reach that number, but when assisted by increased interest rates they can save less and also reach their goals. This has a three-fold advantage: it assists people reach their goals, makes uncertainty about the future fall, increases current spending making investment and inflation grow and subsequently rises asset and stock market prices fulfilling the "feeling wealthier" notion. 

Although the idea appears to be strange, eliminating uncertainty about the future which is what makes savings fall and consumption rise. Quoting Bernanke,

"To the extent that home prices begin to rise, consumers will feel wealthier, they’ll feel more disposed to spend. If house prices are rising people may be more willing to buy homes because they think that they will make a better return on that purchase. (...) The issue here is whether or not improving asset prices generally will make people more willing to spend. (...) If people feel that their financial situation is better because their 401(k) looks better for whatever reason, or their house is worth more, they are more willing to go out and provide the demand." 

In addition, while realizing that higher wages and lower unemployment would make 65% of people spend more as a recent poll suggests, we tend to forget that the only thing which could make wages increase is an increase in consumption and spending. Then why shouldn't we use this doctrine in the US or other countries a reader might inquire. For the simple reason that Japan is facing stagnation not for the past couple of years but for the last 2 decades. Risk aversion is now deeply rooted in the Japanese culture and only a strong shock would be able to bring them back to a more sustainable path.

Critics might argue that raising interest rates would mean more trouble in repaying existing loans or creating new ones. What is forgotten here is that with an increase in the price level means that the real value of the loans will be decreased, thus allowing them to repay them with more ease. In addition, the increase in the level of prices should increase investment and consumption, leading to higher nominal wages, again assisting with loan repayments.

What should not be forgotten here is that the aforementioned policy cannot go on indefinitely (although the program should not have a specific end date) because of crowding out effects. When the economy reaches (or is close to) full capacity, government spending should be significantly decreased to counter for the expansion in consumption and investment. This should (in theory at least) bring the country to a more stable growth path than the current one.

Economic Stories: The Tale of Austerity

Joe was an average man. Medium build, medium weight, dark hair and eyes. Not married yet, but wanting to settle down. He had a steady job and a steady, average salary; he was a government employee at the Ministry of Finance. Joe liked doing what everyone of us does: have a pint of beer with his friends, enjoy a good meal and watch some TV at night. In fact, Joe was a creature of habit: he did the same things, with the same people over and over again and he enjoyed it. He had strict habits with regards to his personal finances as well: he always saved 10% of his salary for a rainy day, had 30% of his salary go to the loan installment for the small apartment he had recently purchased  and used the rest for his everyday needs.

Most of Joe's friends were also in the government sector. Mark was working as a mailman and was a father of two sons, Andrew was a newly-wed accountant in the same department as Joe and Susan was a single mother, a school secretary. All of them usually met at Bob's Bar, just down the road from where they were staying and they were Bob's most faithful customers. It was because of them and others like them that Bob could earn a decent living; for he had his expenses as well. Every month Bob had to pay a large amount of money on electricity, water and licenses for running the place, not to mention the 2 waiters he employed. In addition, although he possessed a small brewery in the back of the bar and produced his own beer, he had to pay for the wheat, barley and hops required for production. 

On that particular day, Joe and the others were waiting for Andrew when they started talking about the rumours that had been raging in the news. 

"You know", said Mark, "if what they claim is true, then we might face a 15% cut in our salaries. Things will get harder you know."

"That is true, yet it is not us that I fear for. We are still going to get some salary, and with or without difficulty, we are going to have to adjust ourselves to that. It is those who depend on us, like Bob for example." commented Joe as he ordered four beers.

"I heard my boss talking today, and he said that if this is true, that our country has a lot of debt accumulated, it cannot be taken lightly. A pay cut will only be the tip of the iceberg" said a fearful Susan "Who knows what might happen after?"

At that point Andrew came in. As he took his seat, he looked more upset than usual, and his fast talking proved that. "It is true. The pay cut is official. As of this month we will receive 15% less money than we have. I know this for sure because this is why I've been late. We had a meeting concerning these developments" and with an exasperated voice added "darn! I was hoping to get that down-payment for our house in a few months. What am I going to do now? My wife will be so upset that we will not be able to finally get a house."

Bob was getting them the beers himself and had overheard most of Andrew's monologue. With a shrewd smile he tried to joke around the subject "Don't worry about it Andrew. You guys were already getting too much money anyhow. It's not like you are going to be left on the streets you know"

"Even if that's correct Bob" argued Joe "which I assure you that its not since we are all making average salaries here, and" pointing to Andrew "he can confirm that, that is not what you should be worried about. It is the fact that now, less money will be in the economy than before. Which means that as people get worried about their finances, they will spend less. Thus, the income of every other person in the economy will also fall"

"Nah, I don't understand these things anyhow. I just sell my beer and hope people are having a good time"

"That's the point Bob. There will be much less beer going around after this"

"But look around you. Everyone is having such a good time. Why should they need less beer? You need more beer when things go bad anyhow!" he chuckled.

"Oh well, I guess we 'll have to wait to see about that"

"You kids enjoy your beer and don't think about anything else. Things will be good" said Bob with a reassuring smile.

Everybody put in an effort to talk about something else during their time there. Andrew was trying not to think about his new house, Joe and Mark were forcing themselves to forget about the loan installments and Susan put on her best show, trying not to show her fear that she and her son would not have enough to get by after paying the rent and every other bill next month.

As expected, all four of them started defining expenses as necessary and not-necessary, just after the announcement, and even before the reduction in their salaries occurred. Who could blame them? Two of them had children to take care of, one had taken a loan to buy his apartment and another was about to get one in order to move in a new house with his wife. Things were beginning to appear bleaker for them and thus they had to act in order to reduce the effects the cut would have in their lives. Obviously, the regular visit to Bob's Bar was deemed unnecessary for them and thus they reduced it to scarce gatherings. They were actually proud they had arranged that their gatherings could take place at someone's house in order to reduce expenses even more.

After a long time without visiting, the four friends decided to have a gathering a Bob's Bar, for old times' sake. The bar, which was usually crowded at that time, was only half full. When the owner approached their table he seemed more worried than any time before. 

"What happened Bob?" asked Andrew "did people stop liking your beer?"

"Nah, that's not it" sighed Bob "It's just that people are now more...erm, stingy, with their money. People who used to come here and order 4 beers now only get two because they are trying to save up. And its not just my idea. Many have told me. People are afraid that there will be more cuts soon and they try to prepare themselves for that"

"You do remember that I happened to warn you about this don't you?"Joe said.

"Yeah, and I thought about that too. But it looks like you got trapped there as well. Your visits here much less than before and you always leave after a short while. What happened?"

All four looked at themselves and all around trying to find something to say. Mark was the first to break the awkward silence

"I guess we were also caught up in this Bob. It's not something we really wanted. We all had fun coming here. I guess.. I don't know. We just fear that things will get worse and had to pull back from our habits"

"All of us have families and loans and we have to put them first" added Susan"We were out of options"

"You know, I am not the only one saying this. John and Mary who own the bakery just across the street have been telling me that even their customers have been much less than usual. These cuts did more damage to us than they did to government employees!" said Bob, sitting down with them.

"Let me take a guess here Bob. Has your income been down by more than 15%?" asked Joe

"Of course! I have only been working at three quarters of what I used to do. Maybe 80% if I get lucky. And I feel bad about Jonathan, my waiter. I cannot afford to keep him employed full time so I had to make his employment part-time" Bob sighed. "He's a student and I really feel bad about this. But what could I do? Janice, the other waitress, has a family and she has to support them. Terrible situation really."

All 5 looked at each other in silence again. Bob couldn't keep down any more as he finally found someone he could talk to and started talking again:

"You know this goes back too. Remember Frank, the farmer I buy the barley for the beer from? Well he is facing difficulties too. His clients stop ordering like they used to. It seems like if you guys get a 15% reduction, I get a 25% one and poor Frank loses even more than that. Things are not going well"

Joe looked at him and said "Well, it does make sense. Think about it this way: if you are depending on us, and we decrease our beer-drinking, then you face a 20% decrease; imagine what will happen to Frank who is depending on you, and other breweries to sell his goods. When they do not see enough clients it is sure that they will reduce their orders. Most of the times, since I am guessing that all of you have some sort of inventory in both beers and their raw materials, the reduction in orders from Frank will be much higher than what your reduction in sales has been." and after pausing for a second he continued "Sorry to be the bearer of bad news but this situation will not end up very well you know. You are an honest tax-payer I assume right?"

"Of course" roared Bob "been paying my taxes honestly for the past 30 years"

"Well you know that our country gets the money it needs from two ways: taxes from honest tax-payers like you and by loans" said Joe and looked at him. "And the taxes they receive are linked to what you earn. Do you see where I am going with this?"

"Don't tell me that...!"

"Exactly. If you earn less, then the government earns less. Thus if the government earns less, it has to get a loan to keep on paying those in its payroll and cover other expenses it may have such as rent for buildings or electricity bills and such"

"But who lends the government that money?"

"Basically banks" answered Andrew "but it's not their money they are lending. It's money they have sitting around. That means my deposits and yours"

"But isn't that illegal?"Bob asked somehow startled by this discovery.

"Not really because, you see, banks are actually playing around with odds. They know that everybody will not come at the same time asking for their money, thus it is to their best interest to lend out as much as they can. Then they lend money to to regular people like our friend Joe here, who wanted to buy an apartment and use the rest of that to lend the state. Always at an interest though"

"Yes but doesn't that mean that banks can lend our country whatever it needs based on our savings? We are all patriots right? We can lend our country if it needs the money"

"But banks and legislation does not work that way. Banks cannot simply give your money to anyone looking for a loan. This would be a recipe for disaster. The banks simply lend the state under the cause that the state will pay back and that the banks will get some interest from it. They are only allowed to lend the state because the state is considered as impossible to run out of money. "

"Yet, they have to be careful"Joe said, taking on from Andrew,"if they reach a point where the state cannot repay them then they will lose all that money."

"So they wouldn't be able to give me my money if I asked for it right?"Bob finished the sentence.

"Exactly. And how can the state earn more money?"

"By taxes"Susan replied "Or by paying less money to the people it employs"

"But if you pay less money to the people you employ then you are doomed to get less money as taxes" Bob gasped."Then how can they do it?"

Susan smiled dryly "I think it's all about timing. Had they done this a few years ago then trouble may not have been so big. Unfortunately they didn't. We are humans, and as such we refrain from thinking about bad things until they have reached the point of no return. Now, the solution, although it appears to be extraordinary strange is to actually increase spending, hope that tourists come to leave their money here, or that foreigners will start demanding more of our domestic goods so we can export them and have money from abroad come in. Otherwise we are lost"

"Tourists and foreigners? How can we depend on other people to save our country then?" asked  Mark after finishing his beer. "Isn't it better to rely in our own powers?"
"Yes, he is right" Bob hurried to agree.
"It is obviously better if we can do it ourselves", Joe interrupted "but who would be willing to say that when the state has been over-spending, the correct way to counter that would be by increasing spending and providing initiatives for investments and consumption?"

"What do you mean spending and are incentives for investments and consumption Joe?" asked a confused Mark.
"Well, you see, spending is actually what the government does when it is building new roads or buildings or when it is paying us who are in its payroll. And then you will have to ask where the government expects to find that money aren't you? Well, here's the trick: all it has to do is to temporarily spend more money and simultaneously increase taxes a while."
"Increase taxes?" Bob looked at him startled "But then we wouldn't have anything!"
"Hold your horses Bob, and let me explain. Let's have an example. Suppose that you were earning 1,000 per month before the cuts in our salary happened. Now, with a 20% decrease you would be earning 800 right?"
"True. Go on."
"Then, if the state charges you a 25% tax you would have to pay 250 at first and just 200 afterwards, leaving you with 750 and 600 after tax proceeds respectively. Now, if the state instead of decreasing what it spent, had increased them by 10% we can easily say that your income would be, say, 5% higher right?"
"Yes..."
"So you would be earning 1,050 before tax. Now let's say that the state increases taxes by 5% to 30%. You would be earning 1,050, paying 315 for taxes and earning 735, a bit less than before, but still much more than what you are making now!"
"But wait a minute. This isn't good for the state. It increases its spending by 10% and then receives 5% more for it. It's still 5% down. How can it make up for that 5% loss?" argued Mark.
"Ah, but you were not paying attention to the mathematics! Do you remember how much money the government was making from Bob before?"
"Yes, 250"
"And how about now?"
"315"
"So how much more is the government making now?"
"That would be 65"
"You know, that 65 is a 26% increase from 250. Thus, using this little trick, the government is actually making much more than it is spending, which can be used to reduce its existing debt."

 "I have to two questions for you then. Why isn't it doing this all the time, and why isn't it doing this now?" Mark asked, after sipping another beer.
"Your first question is relatively simple: it cannot keep on doing this because, if everyone keeps getting more and more money then inflation will be huge. You know what inflation is right? It's when prices rise over time. Well this works as follows: if we all get 1,000, then the price of a beer is let's say 2. But if we suddenly all earn 2,000 then the price of the beer will rise to 4! You see where this is going right? If the government keeps raising our income then at a point you would need 1,000 to buy a bottle of beer, and yet that 1,000 will not essentially be worth more than the 2 we are paying now!"
"But the government will be taking some of that amount back!" said Mark
"True, but taxes cannot grow indefinitely. Imagine, who would be willing to work if the state takes 80% of your income? Not to mention that once you cannot pull that strategy off anymore, because you have reached a huge amount of taxation, your only other alternatives are to either keep on printing money and make a bottle of beer cost 100,000 or declare bankruptcy. In addition, this sort of strategy will not work indefinitely as it works just when interest rates are very low and not when the economy is doing well. Yet, the good thing about this strategy is that even though it may not increase consumption by that much (remember that in our example earlier we had gotten a 10% increase while Bob only got a 5% one?) it helps banks make loans because it increases people's savings. More savings mean that banks will be able to hand out more loans and thus increase consumption as well. Depending on the level of the interest rates, money in the economy can increase a lot."
"Oh, I see..."

"Then you ask why it is not doing this now. The reason for this is that to doing this requires money; something our country does not have. If a nation has its own sovereign currency then things are quite simpler. It can just print more money and try to implement the solution I described above (although I remind you this only works when the economy is doing really bad). But, if it does not have this opportunity, then the only alternative is to either increase taxes to get more money to repay its debts or to decrease the money it is paying. The first solution is relatively easier on the taxpayers but unfortunately politicians' views do not make this consistent. For example, if the president wants to look good for re-election, the government can just announce that tax rates will be reduced. This means that we cannot be sure that such policies will succeed. Yet, as you may notice the same holds for spending cuts as well. But, what makes the spending cuts look more favourable is that they have immediate effects in reducing government spending, while tax increases may be delay the influx of money. Unfortunately, as our friend Bob here has witnessed, these cuts also have a significant effect on everyone else in the economy, meaning less money for them too."

"Then why is our country not getting more money?"asked an eager Bob
"Remember what we talked about banks and lending a while ago?" replied Andrew. "Well, banks and other institutions only lend the state money when they believe that it is creditworthy and that it will repay them. Just like you and I would not be willing to lend someone 1,000 if we thought he wasn't good for them or just like the bank does when it gives money to Joe here in order to buy a house. So, if the banks do not think that the state will be able to repay them they choose not to lend it. The problem is that we are all as good as our state."
"Meaning that a single company cannot possibly be doing great if it is based in a country that is doing bad" continued Stacy. "Then, after the country does not look good, banks feel the effect fast: due to the cuts people like you and me do not earn as much as we did before and we start not being able to repay our loans. This also happens when times are good but can you imagine what it means when 10 or 15% of the bank's customers stop repaying their loans? The banks do not have enough money and they are close to failing as well."

"You see the banks are caught between a rock and a hard place: they either lend the state money, which they are afraid they will lose or they do not and watch their clients fall back on their loan installments"

"You remember a few years ago when things were going great?" Andrew continued "Well, everybody was seeing their businesses flourish, receiving high income and unemployment was really low. Everybody was spending like there was no tomorrow, and I do include ourselves in that. Banks encouraged that behaviour as well: account overdrafts, too much lending and at good interest rates, every person had to spend more, more and more. Yet, after the wheels turn and we are at the low part of the circle, what happens? We panic because we were not wise enough to think that this could not go on forever. Even those who were wise enough to put some money aside are still not feeling too good about this. Too much prosperity causes people not to think. Thus, our government kept spending more and more."and after pausing he added "but this is not the time or place for reminiscing. I just hope that this cut will be the final one, because as people will be financially wrecked if this continues. You can see how things will work out if we get another 10% decrease right Bob?"
"God knows I 'll have to fire a waiter for sure to keep up; and I am not even sure I will be able to continue having the bar. I hope those who run the country will be wise enough to wise know what they are doing to us..."

"I 'll drink to that hope Bob" said Joe raising his glass

Regional vs Local Stability in Investment

Note: This post is a continuation of the ideas presented in Horatiu Ferchiu's "Investment as localized panacea or growth opportunity?" article.

We learn from basic economic theory, often taught in first-year university students, that stability is a good thing. Without a stable political regime, a country cannot progress as people will be reluctant to invest if they believe that they might lose their money. What this theory does not directly tell us is that an investment opportunity can never be safer than the country it is in, if one has a look at the three ratings agencies. For example, the ECB (and the EFSM/ESM funds) now enjoys a AAA rating by Moody's Analytics. If this rating falls to AA then no country in the Eurozone should have a greater rating than that. 

What does this has to do with investing? Basically, it has everything to do as it encompasses both the regional and the local element. This can be viewed more clearly if one has a look at the United States: will an investor feel the same if he puts his money in bonds issued by the federal government than if he puts it in bonds issued by one of the states comprising it? The answer would be a definite no. How about if one was to choose between investing in New York and Kansas? Definitely not the same feeling is it? The same line of reasoning can be used to explain why Greece suffers from lack of investments and the Northern countries do not. 

The question of whether the EU can do something about this is ambiguous. As stated in Horatiu's article, the issue becomes whether the EU can (or should) interfere with the internal politics of each Member-State. Many may claim that this already occurs since EU laws have supra-national power. Yet, this is totally different. What makes a country stable is not the availability or passing of laws but their actual enforcement. At another level, corruption, ease of doing business and availability of funds and potential customers are also very important. The above all can be summarized in one word: mentality.

It is not that the people in Germany, Finland and Austria think that much differently than the people of Italy, Spain and Romania. They all think about their job, money, education, love affairs, food and so on. What makes the difference between a Dutch and a Cypriot though is the expectations they have on the conduct of business in their country. If the latter believes that finding cash, resources or potential customers is extremely difficult then this will be visible to any foreigner who wishes to invest in his/her country. Now the big question is: can we change this?

The answer is unfortunately not simple. What is more not all regions are equal even if all the aforementioned barriers have been overcome. For example, an area in Germany can be much less developed than another (the former East Germany comes to mind). Yet, this does not mean that things cannot be improved. It just means that inequalities will always exist between regions are they always exist between people (think about a different people's abilities in sports, arts or other subjects for example). Any effort for changing the current state of affairs will, as always, face the resistance of those who are unwilling to change. People do not change as fast as other factors of production.

The only chance to promote additional investment to under-performing areas is to make the returns to these investments more lucrative than elsewhere. To do that we have to make sure that investors know about this and do not see a chance that their money will be permanently lost; at the same time we should not forget that one investment usually brings more in. An increase in the projects funded by the European Investment Bank could probably help, yet with an increase in these projects some are bound to turn out to be unprofitable which would render the institution less willing to fund any more. Thus, the golden mean between no investment and enough investment to initiate an investment cycle should be found.

This is obviously a non-exhaustive proposal of possible things that may be done in our region in order to boost investment. The issue of growth is not one which can be taken lightly. Yet, as we emphasize in other issues now (austerity for example) this is unfortunately left behind.

What is GDP?

After several discussions and arguments recently, I discovered that although most people are bombarded with statements of the "GDP has retracted by 1%" or "the banks' assets are greater than the nation's GDP" kind, many do not have a clear image of what GDP is, or what it counts. To begin with, GDP is short for Gross Domestic Product, was developed by economist Simon Kouznets in a UN report in 1934, and has been the main measure of a country's economy since the Bretton Woods conference in 1944.

GDP is calculated as follows (based on the expenditure method, meaning that every good or service has a price and is therefore measurable):

GDP = Private Consumption (C) + Gross Investment (I) + Government Spending (G) + (Exports - Imports)

Now let's see what the components of GDP are (most of the definitions used here are from Wikipedia):

1. Private Consumption falls under one of the following categories: durable goods, non-durable goods, and services. Examples include food, rent, jewelry, gasoline, and medical expenses but do not include the purchase of new housing.

2. Investment includes, for instance, business investment in equipment, but does not include exchanges of existing assets. Examples include construction of a new mine, purchase of software, or purchase of machinery and equipment for a factory. Spending by households (not government) on new houses is also included in Investment. In lieu of the common use of investment, i.e. purchase of financial products, these are not considered as investment but as savings.

3. Government Spending is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. It does not include any transfer payments, such as social security or unemployment benefits.

4. Exports are gross exports within the year measured and Imports are the gross imports within the same year.

What some people believe is that GDP is some sort of state income, which is distributed to people in some way. This is far from true as GDP is merely a rough measure of the economy's ability to produce and not any sort of income, although it is measured on an annual basis. As economist note, the main driving force of the above equation is Private Consumption (C). If for example, due to a prolonged crisis, people are afraid to go out and shop, since they believe that they will need the money later on, or if their income has fallen, C will go down and drag GDP will it. Similarly, in a crisis, Investment usually falls, as less people are likely to buy new houses and less firms invest in new equipment. Imports usually fall as well since people, faced with less purchasing power than before due to their unwillingness to spend, or lack of income, are less eager to purchase foreign goods.

The only part of the equation which is really a matter of government is G (Government Spending). That is the reason why in most nations where budget cuts are implemented, in the form of wage reductions, GDP falls. However, as one may observe, transfers from the government to the people (e.g. social benefits, pensions) are not included in the definition for government spending. Nevertheless, this does not mean that it these will not affect GDP, since a reduction in pensions, such as the one currently occurring in Greece, affects GDP indirectly, as pensioners with fewer money will spend less and C will drop.

As a matter of fact, GDP is neither a measure of welfare as it can only measure what is measurable and lacks an ability to quantify quality. Although sometimes it is used as such, even Kuznets himself has separated the ability of GDP to measure an economy's production and its use as a measure of welfare:

"Distinctions must be kept in mind between quantity and quality of growth, between costs and returns, and between the short and long run. Goals for more growth should specify more growth of what and for what." (Kuznets, 1962)