George Magnus on Boom and Bust

Fast forward to 4:00

George Magnus, former chief economist at UBS, in conversation with RT’s Erin Ade on the emerging markets sell off, the concern with China, the demographic challenges facing advanced economies as well as Russia and China, and an assessment of Ben Bernanke’s tenure as FED chairman.


When Obama said ‘income inequality’…

Via @NewYorker: “I propose a drinking game: each time Obama says ‘income inequality,’ let’s swig a glass of Clos de Vougeot Grand Cru ’88.”

…plutocrats got drunk?

For what its worth, Clos de Vougeot contains many different vineyards but the notable producers such as Domaine Leroy, Méo-Camuzet and René Engel (to name three) that make ‘Grand Cru‘ bottles have their 1988 vintages going for about GBP 800 (USA 1,318 or CAD 1,472)  a bottle based on today’s exchange rates.

Is the World Re-balancing?

As we witness the latest sell off of securities, concern ourselves with frothy valuations, and fret over FED ‘tapering’ –another nugget from Bernanke’s lexicon mine– we need to consider that rumours of global rebalancing and sustainable recovery are greatly exaggerated. Read the latest post by Yanis Varoufakis

Yanis Varoufakis

Before the Crash of 2008, the dominant view amongst the world’s policy-making elites was that global imbalances were not a problem. The great and the good in Washington and in London, in Paris and in Frankfurt, at Davos and on the golf courses where deals of note are struck, dismissed as economically-illiterate moaning-minnies all those who dared warn against large current account imbalances. Caught up in the soothing fiction of the ‘Great Moderation’, and the toxic fantasy that finance had invented ‘riskless risk’, the powers-that-be were adamant that we were living in a ‘new paradigm’.

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More thoughts on real estate and the nature of Canadian banking

(Disclaimer:  Opinons are my own and don’t reflect in any way those of my employer)

There is a very good post (“Real Estate: Are High Prices a Bubble or New Normal“) from December 2013 by my colleague David Wishart that I had overlooked. It concentrates on banking and the nature of why banks lend, why they prefer to lend a certain way and how they hedge their risks. Read the whole thing here

Here is an excerpt:

As the banking industry has consolidated over time after periodic recession induced bank failures, management decision making has become more centralized. The era of the small independent savings and loan institution depicted in the movie It’s A Wonderful Life is largely over. The average branch manager has far less autonomy to make loans to local businessmen than in the past and must defer the credit approval process to formal adjudication centers. These centers rely mostly on standardized credit policies rather than personal relationship management (the character C of credit). As a result of regulatory pressure, competitive pressure to manage costs, and additional compliance to handle increased operational risk in a larger organization, differentiated small business loans with their own unique features become less feasible. What banks need for lending purposes is consistent, homogeneous collateral like real estate or an automobile. When collateral is similar and subject to a more straightforward legal framework than a small business loan, it means that these mortgages and auto loans can be securitized more easily in to Mortgage Backed Securities (MBS), Asset Backed Securities (ABS) and then further tranched in to Collateralized Mortgage or Loan Obligations (CMO or CLO). This kind of securitization at least at present isn’t available for small business lending. A combination of a bank’s own ability to shoulder risk and BASEL regulatory requirements like the liquidity coverage ratio (LCR) or the capital ratio’s risk weighted assets treatment (RWA) means that the modern global bank isn’t able to make numerous dissimilar small business loans and is naturally steered towards lending for real estate purchases. This is further exacerbated by government guarantees on high ratio mortgage loans that protect banks from losses in the higher risk portions of the housing market.

From a risk management perspective, private banks have to do the best they can to line up their liability cash flows with their asset cash flows. What this means is that if the bank has a lot of long dated loans on its books and many short dated deposits, it can either securitize the loans and sell them for short dated bank reserves (cash) or it can sell long dated bonds to the market and stretch out the term structure of its liabilities. Mortgage and auto loans more easily facilitate this process on either side of the balance sheet, especially as covered bonds (a debt of a bank that is typically collateralized by mortgages) become more popular as a bank funding instrument. (bold emphasis added)

Related to this I have made the point in some previous posts that for the macroeconomy to grow better in the long run it may require that banks become ‘less’ profitable in the short run. Now, as a bank employee, this may sound counterintuitive and against my interests and those of the many banking employees that make a living working in the Canadian financial sector –I am not referring to investment banking “Master of the Universe” or prop trading types, I am referring to the legion of middle class employees that have benefits, a pension and work diligently day in and day out– but upon closer examination it isn’t.

Currently, everything is structured towards pushing the banks toward areas such as residential mortgage lending as the David Wishart’s passage illustrates. This cannot continue indefinitely as the Canadian economy becomes less diversified and more concentrated in its reliance on resource extraction and real estate, there comes a time when the expanding balances sheets of Canadian households (driven by bigger liabilites of ever larger residential mortgages) meets the reality of stagnant incomes. To reprise the business analogy, it isn’t a great sign to have an ever larger balance sheet with no concomitant rise in income. Greater levearge entails less resilience.  This is what has been happening in Canada. Rather than a housing crash, which is in no one’s interest, we will arguably see slower growth as discretionary consumption by many is curtailed to support debt obligations. The low growth thesis also  relates to the cost of raising a child to adulthood which is reaching astonishing new heights according to Maclean’s magazine and means that the consumer, the driver of growth and the bastion of consumption, can only spend so much witout further access to credit in the absence of wage increases.

Back to the issue to bank lending and the supply of credit: clearly on the supply side we do need to refocus an emphasis on not only getting more lending to SMEs but also have policies that encourage those SMEs to become bigger and more productive. In financial parlance, this is termed credit for investment purposes rather then credit for speculative purposes (i.e. buyin a house, making cosmetic changes and then flipping it for substantially more after a few months). None of these problems have ready made solutions but we aren’t going to get there with speculative finance and hoping that real estate prices continue to skyrocket. Trees don’t grow to the sky and ultimatley the price of a place to call home has a limit.

BOC’s benchmark policy rate to continue flatlining

The Bank of Canada is set to release its interest rate announcement and Monetary Policy Report tomorrow morning at 10 AM (ET). There is an expectation of no policy rate change and the possibility of an easing bias by market participants. The former appears a good bet given the flow of economic data recently, from employment falling by 46,000 in December to  inflation remaining below the BOC’s 2% target yet remaining just within the central bank’s (1% to 3%) operating band.

 The chart below illustrates three metrics, 2 observable the other an estimate, that BOC watchers pay close attention to: core inflation (in dark blue), the BOC target (i.e. policy) rate (in teal), and the output gap (in brown measured against the right Y-axis). It is the latter that should be reason enough to believe that the BOC policy rate will continue to flatline for the short term (2 years) as the slack in Canada’s economy continues to widen despite a low nominal central bank policy rate, credit extension by the banking sector, and federal and provincial governments that are running budget deficits.  


My personal view is that there is no reason for the BOC policy rate to move up before the 2015 Federal elections. The Conservative government of Stephen Harper will be running, according to its Executive Director Dimitri Soudas,  on a platform of supposedly ‘strong, stable leadership’ (below).dimitri.soudas
Moreover, there is the determined effort on the part of the current Conservative Federal government to ‘balance the books’ and return Canada to the promised land of budget surpluses. For a graphic on how federal governments from the time of Lester B. Pearson’s Liberals to Stephen Harper’s Conservatives have fared in this endeavour, see this graphic from the CBC.

The idea of conflating the budget of a federal government with that of a household is attractive but it doesn’t work for Canada; it can for other nations, such as those under the monetary straitjacket of European Monetary Union, but it doesn’t make sense in the Canadian context. Every nation has a particular political economy to deal with that is the legacy of history and goepolitical relations. Moreover, the nature of a nation’s currency –is it sovereign or is it shared or pegged to global reserve currency– is worth considering as is the composition of that nation’s debt ownership.

Currently, the Canadian context is one where the household sector has taken on an increasing amount of debt –both residential mortgage and consumer– that will be serviced for the coming decades and at the same time the federal government has gone into deficit spending mode since the 2008 financial crisis.

Debt to income ratio in Canada

Debt to income ratio in Canada


The Bank of Canada understands this and has made the explicit assumption in previous Monetary Policy Reports that the business sector would drive growth in the economy through capital investment. That hasn’t happened.

Arguably, businesses require signals from the consumer in order to have the confidence to enact capex. Say’s Law need not apply for most companies: supply does not create its own demand. The decision in favour of capex is demand driven. Absent that effective demand, businesses can propel growth via a combination of increasing efficieny or financial engineering. The former prescription has meant offshoring, outsourcing, and hiring more workers as temporary and, increasingly, the autommation of work that requires fewer and more specialized workers (if any as the graphic below concerning the decoupling of productiviy and employment illustrates).


The latter prescription has meant, at best, bringing leverage onto a company’s balance sheet as a catalyst to translate modest top line sales growth into robust bottom line profitability and, at worst, aggressive revenue recognition to make a balance sheet and income statement look better than it really is.

Fundamentally, the deficits of one sector emerge as the surpluses of another. If we consider the debt burden of most Canadian households in terms of the stock of liabilities divided by the flow of income, we recognize that the moribund income growth entails curtailing future discretionary consumption. Canadians have brought forth a lot of future consumption by taking on mortgage and consumer debt. This requires debt servicing. Furthermore, the demographic factors facing Canadian society are a challenge that this country’s policy makers are inadequately prepared for. As the dependency ratio increases, the growth trajectory decreases: older Canadians, many of whom have saved inadequately for retirement, won’t consume as they did during their working years.

The Bank of Canada will continue to cling to the hope that the sagging loonie will spur greater demand for Canadian exports and thus make their heretofore forecasts appear more credible. This is more faith and hope then scietific reasoning as the flipside to this is that it will make capital expenditures more expensive as that is invoiced in USD. The Canadian dollar remains a petrocurrency:

CAD remains a petrocurrency

CAD remains a petrocurrency

Head winds to growth:

  • Household deleveraging
  • Government deficit reduction
  • Aging demographics

Tail winds to growth

  • A depreciating currency
  • Credit expansion
  • Easy monetary policy

Market rates will continue to ebb and flow on the steady trickle of economic and financial data. Mortgage rates, in turn, will go up and down as a result based on the risk appetitite of the major banks. What won’t change is the policy rate: the Bank of Canada will be circumspect in articulating an easing bias as it won’t want to further inflame a housing market that is becoming expensive for most Canadians yet, in the face of the head winds facing the economy it is unlikely how the slack out of the economy will disappear over the coming years.

(Full disclosure: the author’s views are his own and he added allocation to XLB iShares in anticipation that 2014 would be a bounceback year for Canadian Long Bonds)

Development economics in the Vanuatu context: one size doesn’t fit all

Emergent Economics

The following is based on a talk I gave with Devpacific last Thursday in Vanuatu.

In a passage from his famous work The General Theory of Employment, Interest  and Money, John Maynard Keynes presented a novel theory of how share prices are determined. Normally economists like to think of stock prices settling at an equilibrium level where supply and demand meet. The cost of shares is a fundamental property based on the present discounted value of a company’s future worth.

But Keynes thought otherwise, likening stock market investment to a newspaper beauty competition in which the winner is the person who predicts the most popular woman in the contest. Players won’t win by saying who they think is the prettiest; if they’re rational they should try to predict others’ probable choices. Other entrants will, if behaving sensibly, do the same thing, basing their submissions on others’ likely entries.

In the…

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Easing Congressional Gridlock: A divorce mediator’s guide!

Yanis Varoufakis

Screen Shot 2014-01-18 at 12.26.43 PM

The United States is ungovernable.

Or at least it has been every time, post-Reagan, the White House has been controlled by a Democrat while Congress is in the clasps of a Tea Party infested Republican party.

An exasperated electorate is watching the gridlock. A playful, yet serious, manifestation of the resulting frustration is the pamphlet that my dear friend, Seattle divorce lawyer Carol Bailey, published recently and distributed to members of Congress in situ herself. It is, you guessed it, a divorce lawyer’s guide to easing congressional gridlock. (Click here for Carol’s appearance on CNN and here for a relevant article in Politico).

Carol’s pamphlet serves an important purpose that the cynic in me interprets thus:

Politicians pretend that they care about the nation, like parents care for their children. This is, of course, a fiction in most cases. Congress is in gridlock because a considerable number…

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