Given the debt crisis in Greece, I have been shocked to see no one in the media talking about the effects of currencies on a nation and how that fits into the idea of Grexit. So let’s fix that with a game of “what if”. There are a dozen reasons why economists avoid playing “what if” games but here I think it will help to explain the situation. With that said, give me a bit of leeway with the detail. What if Detroit seceded from the union in late 1960’s?

So in our alternative history, Detroit along with some of the adjoining area (specifically those including the MSA data area) leaves both the US and the State of Michigan in an organized manner starting in 1966 and finished their transition in 1968. They are on good terms with Canada and America helps with the transition to ensure everything happens smoothly. Detroit even launches their own currency, the Seger, named for the musician who plays at the bar where the open market committee meets. The Seger is pegged at 1 Dollar to 1 Seger during the transition. The Nation of Detroit continues to export cars to America and import, well, most other things.

This continues for a few years with the value of the Seger fluctuating from .9 to 1.1 of a Dollar but roughly staying near the original 1 to 1 rate. The people of Detroit will remain in roughly the same economic shape as Americans in neighboring areas. But in 1973 the oil crisis hits and things change. American customers start to favor smaller foreign vehicles, which are not built in Detroit. This lowers the demand for the larger style cars made in Detroit. With exports down, the value of the Seger drops to 1 Seger = 75 US cents. This has two effects. All those imports that Detroit buys just got a lot more expensive. This means the living standards of a Detroiter just got lowered. However this also makes all those heavy cars that are for export much cheaper for American buyers.

And this is where history really splits. This currency adjustment cushions the hit that automakers actual took in the mid 70’s, however it does so at the cost of a drop in buying power for everyone else in Detroit. Over the next decade, more factories stay open and less of the industrial base of Detroit is gutted, but each of these adjustments happens both via a drop in the value of the currency and in the buying power of those in the community. Economics is a double edged sword and with a floating currency there is a relationship between exports and currency value that acts as two steps backwards and one step forward in this crisis.

Of course this Detroit is a “what if” scenario. No massive currency adjustment happened and Detroit did lose a lot of its industrial base and the buying power of those living in Detroit is not fundamentally different from those elsewhere in the US. But for fun, let’s apply the same analysis to Greece.

There are many problems in the Greek economy, but let’s focus on of the core ones. The cost of labor is higher than the productivity of that labor. To those who do not study economics, please do not read this statement as a personal or racist insult to the Greek people. It is not. It is a calculation and that calculation is affected by many elements including technological sophistication, the maturity of the industrial base, the role of automation, and availability to capital to only name a few. It is not a critique of culture.

Now, if a country has its own currency and its labor to productivity rate is too expensive there are a few options. First, the nation can become more productive and thus worth the price that labor is charged. Second, the labor prices could drop to match their productivity levels. Third, and the focus of this blog post, is the value of the currency could drop. This last option would naturally happen over time if neither of the other two options happen. However Greece is not Greece, it is Europe and on the Euro. So does Europe’s labor price match its productivity? Yes, yes it does and thus a long term drop in the value of the Euro is not likely.

A quick note on scale and GDP: the US is $16.8 trillion and Detroit is currently $225 billion. The EU is $18.5 trillion and Greece is currently $242 billion. As you can see I did not pick Detroit at random. Much as we did not spin-off Detroit, a “Dexit” one would assume, neither was Greece forced out of the EU… thus far. But we also can’t expect the result to be much different. As Detroit suffered from their high labor costs as factories moved to the South or oversees, do not expect Greece to dodge that fate as long as their labor to productivity ratio remains high.

Would Detroit have been better as a spin-off nation of the US? In purely economic terms, it would have been a mixed result. Would Greece be better in or out of the EU? Once again there are no good answers and the result would be mixed…. but with one caveat: the transition.

In our “what if” the US helped Detroit transition. When Greece joined the Euro it did so via an orderly transition. The danger is not in the long term result, but in the short-term transition. Both enlightened experts and even the markets themselves can get this transition wrong, at least in the short term. Pegging the right price to a new currency will dramatically affect Greece. And yes, the Drachma will be a new currency even if it has an old name. In 2008, Greece exported $17 billion and imported $61 billion. By 2011, after the start of their crisis, those levels have adjusted to exports of $27 billion and imports of $48 billion. This means 31% of their economy is directly linked to trade and thus that currency evaluation rate. Another 18% of Greece GDP is based on travel and tourism, processes that are greatly simplified by a single currency.

I have heard many, many economists and politically savvy individuals point out that Greece should not Grexit and the recent bailout deal is wrong. Greece should instead focus on growing their economy via a Keynesian approach by increasing deficit spending to increase consumption and thus create economic growth. I understand that desire and I personally agree with large swaths of Keynesianism. However I do have a problem with it in this case. In the US from 1932 to 1936, the worst years of the Great Depression, budget deficits were equal to 4.8% of GDP on average. Since 2008, the start of the Greek Crisis, budget deficits have been equal to 10.2% of GDP on average. Greece is not running a New Deal, they are running two of them in terms of deficits and they have ran them for more than twice a long! I understand why some many have suggested this, but if this policy was going to have an effect it would have happen already.

There are some problems you can grow out of and there are some problems that just keep spawning more problems until something fundamentally changes. I’m afraid Greece is the second form in which case the reforms are still a poison pill but one correctly prescribed. The real question is if they go far enough. If they do, then and only then can I see some form of targeted deficit spending becoming a functional policy option. Until that day, deficit spending in Greece under the current conditions is just doing the same thing again and again expecting a different result.

Thanks for coming back! If you missed the first or second entry in the series you will want to read those first since I will be referencing them throughout this post.

Labor Markets

The Labor market is… messy. One share of stock is as good as another however no employee is exactly the same as another. Outcomes are unknown, can be effected by things unrelated to your company, and an interview/resume combo is far less informative then a stock’s disclosure report. Among salesmen, the top tier commonly sell twice the average. The bottom tier commonly sell only half the average. That is a 4 fold difference in outcome based on something that can’t be measured before they are hired.

While stocks and products don’t care what portfolio they are in or what shelf they sit on, people do care and care deeply what company they work for and what work they are doing. A loaf of bread does not care if it is sold for 75¢ or $3 dollars. To an employee there is a massive difference between making $25,000 a year to $100,000 a year. If my grocery store puts bread on sale, it is still the same bread and my sandwich tastes the same. If I cut an employee’s salary from $50,000 to $35,000 odds are their productivity will plummet.

These non-market factors also carryover to the distribution of labor. Financial assets are non-physical so can be transferred near instantly; Products can be shipped from one side of the country to the other although it may take a few days and cost a bit. Employees are very different. People can relocate, but slowly and with great difficulty. The effect of this is that many labor markets are localized, although this can vary by skill set. Higher skills sets tend to be more likely to move and companies are generally willing to pay more to get people to move. For lower tiers of skill the markets are more local.

In short, labor is a product that cares where it is thus limiting distribution, cares what it costs thus you have non-market forces effecting price, and the buyer has incomplete information about the quality of labor they are buying. Labor markets are messy.

Much like production technology and product development, companies invest in their human capital. There is a natural attrition rate for employees that the company will have to work against. Human capital can’t be mothballed and it takes a long time to develop good employees. Thus, companies don’t, nor should they, instantly optimize their long-term workforce to match only short-term needs.

If revenue has dipped then it may make sense to hold on to excess employees for the dip since you will need them when sales return to normal. Of course the problem with that statement is knowing if this is a short-term dip or a long-term shift. It’s also important to never forget that employees are people. Nobody wants to fire someone they like and who they know is working hard. While it is easy to see how larger companies can commoditize their labor, for smaller companies letting people go can be personally painful for the owner/operator. This can be a major market friction.

This pressure to hold a non-optimum amount of employees is one of two big sticking points in the division between GnS and the Labor Market. The second is the Keynesian notion of sticky wages, which we have already touched on in passing.

The connection between GnS and Labor

So what is the net effect of all of this? Expect the Labor market to lag behind the GnS market in terms of lowering total jobs vs. output. Expect employees to be unwilling to lower the price of their labor… at least in the short run. Note that both of these trends are the effect of a negative GnS on the labor market. Companies aren’t too hesitant to hire during a boom and employees will gladly accept a raise and accept it right now. Thus a positive GnS can interact very smoothly with the labor market while the effects of a negative GnS are commonly delayed and dissipated.

Labor economists must look at the long term when discussing these numbers. Seasonal variations are strong, effects are delayed, and different labor types can be treated as either a short term cost or a long term asset depending on their skill sets and the company. While the links between the financial markets and GnS only apply to some firms, the links between Labor and GnS are all about a mix of short vs. long delays in effects and the natural frictions in hiring/firing. It is also critical to remember that while any company wanting finance has access to the same financial market, firms hiring employees may face dramatically different labor markets given there location. Skill sets and education are not highly fluid and thus these markets can be highly isolated.

I started with the statement that the labor market is messy. That is the best ways I know to end.

Final Notes on the 3 Economies

Now here is where we start to get blunt and maybe a little mean. I am not here to be a jerk but there is a point in time where things are simplified to the point of inaccuracy.

The debate between “Wall Street and Main Street” is nonsense. Not because of political ideology but because when people talk about “Main Street” they are general talking about the labor market which is highly disconnected to the financial markets. As you have seen both are connected via the GnS market but both have very imperfect connections to the GnS market itself much less each other. If it feels like the financial market and the labor market are completely unrelated it is because they largely are. A good policy for the financial market might have no bearing at all on the labor market. That is not the fault of the policy, those markets are naturally that far apart. The same goes for the effect of labor market policies on the financial market.

If a labor policy is good it is because of what it does to the labor markets, not the stock market. If a financial policy is good it is because of what it does to the investment world as a whole, not just the NYSE and definitely not a shift in the unemployment rate a week or two later.

Both labor costs and credit issues do effect the cost side of the GnS market; however, these effects can differ wildly per company and sector of the economy. Different companies within a sector have different exposures to the credit market, however all companies share that one credit market. Companies within a sector do share a labor market for much of their workers, but it is commonly limited to those within that sector. A glut of teacher does not counter act a shortage of nurses in the short run. Neither will a credit crunch.

That “nice one size fits all” analysis about how the jobs report boosted the moving average of the NYSE… bullshit. Just bullshit. Just retail stocks within the NYSE, ok that makes sense. I can get behind that story.

The Fed changing interest rates causes tech stocks to drop a half a percent. Bullshit. The Fed rate affecting banks… ok that makes sense. The connection is obvious. A report on the lack of graduates with computer science degrees causes tech stocks to drop half a percent. That might or might not be true but at least that makes senses, the details belong together. It is a story the reporters can tell and the pieces make sense.

There are these grand stories of interconnect pieces where the burden of proof is just not met. It is on the story teller to prove the connection. When facing these kinds of stories I make it a point of looking for the mechanism. What is the piece that causes X to change Y. How significant of an effect does X have on Y? What are the limits to that effect? What counters and substitutes for that effect?

The take away is this: there are simple stories and fundamental truths that do hold for parts of the US Economy, but when we start to simplify across complex systems and ignore major frictions and mechanisms between sectors we are simply lying to ourselves. If we are going to talk about complex systems, then let’s recognize that they are complex, treat them as such, and require a bit more proof.

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Thank you for joining me over the last 3 week. As always, I will have a new topic starting on the first Friday of each month. Next time I will be talking about the force structure questions the US Military faces, how foreign policy fits into these questions, and the pros and cons of different solutions.

Thanks for joining me again. If you missed last week’s blog you will want to read it before you read this one.

The Goods and Services Market

When Economists talk about “the Economy” this is the part they are generally talking about. This is (most of) GDP, products going to customers, and services being used. However this process is not instant, perfect, all knowing, or omnipresent. Even in the world of modern e-commerce where hundreds of intermediate sellers are presenting the same item, the results at check outs can vary and the item still has to be shipped. In cases where products are similar but not identical more research is need and sources may be good for popular items but will most likely be limited for more specialized items.

Different products and services can take on different market structures. As we move from identical or nearly identical products into items which are more complex, specialized or unique, the rules shift. The issues of understanding quality, getting clear pricing, and delivery/transaction costs can increase in complexity and increase dramatically. In these cases it is also common for market structures to shift from near prefect competition into more oligopoly like conditions.

The key thing to remember here is the effect of these frictions. There is no factory, retail outlet, or service provider that is going to be as fluid as the financial markets. Prices will not change by the second, items are not delivered instantly, and disclosure rules are minimal (if at all) thus information is normally wrapped in marketing or opinions on review sites.

The market for goods and services (GnS) will adapt but it takes time and energy to produce products, liquidate excess inventory, restock, and for management to manually adjust prices. Most companies are doing all four of these tasks at all times to some extent or another. While different financial markets tend to be highly interconnect, goods and service can be surprisingly independent from each other at times. There have been many, many times where people say “the economy” is doing badly but a large number of sectors are very stable and growing year to year as if nothing has changed.

It is a well understood economic phenomena for some companies to be cyclical while a few are counter-cyclical, i.e. for some companies to perform well in tandem with “the economy” while others actually improve when the economy is down and struggle when the economy is doing well.

Yes, we live in an age where things have become more and more connected than ever before; however, we must be careful not to jump to grand conclusions and image connectivity where it simply is not, or where they may be an effect but it is minor at most. My challenge for anyone on this issues is simple. Before you think something is connected try to quantify how interconnected it is. Try to calculate that number. If the best you can muster is notions about how it is connected to “the economy” as a whole then they probably are not as connected as you think.

A shift in other sectors might change a company’s revenue from 52 million to 51 million. A million dollars is a lot of money, but note that 98% of the firm’s revenue has not changed. When was the last time 98% of your life was exactly the same from year to year?

The news media, politicians, and even we lowly economists like to talk about “the economy” as if it is a race horse bounding down the track. It makes for great TV and catchy news titles online but is commonly over stated. In reality it a jumbled mess lurching in all direction with the aggregate effect being a slight movement in one direction or the other. For most companies the actions of your competitors and middle managers are more important to your bottom line than the larger economic picture. I am not saying the effect isn’t there. I just want to place that effect in a more reasonable, empirically accurate context.

Not all Markets are Highly Competitive Open Markets

When people talk about economics they tend to assume an underlining structure of an open competitive market place with near perfect information, lots of sellers, and lots of buyers. However if you take a hard look at most market places the reality can be much less Marshallian than we imagine. Marketers work very hard to create price discrimination via ad campaigns and product differentiation. Branding has become a proxy for quality. Stores are stocked to provide options… but those are often limited to good-better-best sales pitches. Sales, coupons, and various point schemes cloud the true costs/savings of different bundles of goods.

For many industries, selection can be a real issue. It common to see a pair of heavy weight businesses going head to head with a more niche 3^rd tier competitor far behind. This has improved dramatically in recent times with e-commerce outlets bringing a range of smaller sellers to market places well beyond their normal geographical reach.

The connection between Financial Market and the Goods and Services Market

Before I dive too far into this connection I want everyone to take a second and just think through a question: If the NYSE drops 2% on Thursday does a car manufacturer in Alabama drop its production goal for Friday?

No… of course not.

The talking heads on the news love horse races and thus financial markets. They are always in flux thus have content to cover, regardless of if that content actually means anything. So the question quickly becomes how does the financial market effect firms? The answer to that question largely depends on the firm, but we will cover large archetypes here.

The first is a mix of long term and short term loans. Long term for when they can’t, or shouldn’t, self-fund expansions and retooling. The second is short term loans for covering various cash flow issues like seasonal variants in revenue or one time production costs both of which are common issues in business.

Note that these are fairly simple bank operations, not complex financial arrangement. Financial markets can lower the costs of these transaction or simply provide a skilled CFO a range of options beyond traditional banking, like issuing stock or corporate bonds. The results of lower costs will increase the rate at which companies retool or the easy with which they can address cash flow issues. Although these costs are lowered they still exist and of course not needing to pay any cost will always beat paying a low cost.

Improvements in the financial markets, lowing financing options, and providing flexibility to CFO’s who are facing complex financial challenge can all help to increase production in the GnS markets… but only among the firms facing those kinds of financial problems and then only for a fraction of those firms’ total production. These are marginal gains, not grand economics revolutions.

The important thing to remember about financial markets is that it is at the edges, not the core, of business finance. Although we saw major financing issues starting in 2009, specifically in housing and cars, most elements in the economy were unaffected. Groceries were still bought, doctors still cared for patients, and electronics were still developed/produced/sold. Firms that had financial issues before the financial crisis were the ones that suffered heavily during the credit crunch. The credit crunch was irrelevant to businesses that did not need credit.

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Next week I will be concluding this series with a discussion of the labor market and how it differs from and interacts with both the GnS and Financial Markets.

The 3 Economies

When talking about the US Economy there is a set of problems that I see people running into again and again. It is almost as if people are not talking about the same economy which in turn leads to economic arguments where we can’t even agree on basic facts much less begin to work towards a solution.

Instead of viewing the US economy as a single entity, I believe there is value in viewing it and discussing it as 3 different economies that are imperfectly connected to each other. Each of these economics follow slightly different rules. The 3 economies are: the financial market, the goods and services market, and the labor market.

The Financial Markets

The financial markets are hyper reactive. Things change on a dime. A new market price can be reached in a fraction of a second. Pricing information is largely open and readily available. Due to public disclosure laws, it is as close to perfect information as you can get for a product. Don’t misunderstand me, a skilled and unethical accountant can fudge the numbers to make a company look better than it is, but only to a point. In terms of information, you know far more about the stock you are buying then your next toaster.

Note that although the NYSE is critical, it is only part of a larger international financial market place. Other stock exchanges, various public and private bonds, venture capital, and private investment are all competing for the same resource, capital. Ups and downs in a specific subset may reflect a fundamental change in the financial markets… or may just be a rebalance between subsets. The old joke in Economics is that the NYSE has correctly predicted 9 of the last 5 recessions.

It is also critical to remember that the financial market is what statisticians call “noisy”. There is a lot of ups and downs that just happen. Over the last decade, on average the Dow Jones Industrial Average changed about .75% per day on trading days. If you look for dramatic changes then a guideline of two standard deviations (to cover about 95% of the data) comes out to be about a shift of 1.8%. In other words, a shift of greater than 1.8% in a single day happens about once a month. If someone tells you that something massively important happens and that the markets reacted to it, then look at the shift. If it was less than 1.8% shift then it was not that dramatic. If it is less than .75% then there was actually a less than average about of change on the market that day. If you take a hard look at most financial reporting, expect to see a lot of false drama over sexy issues used to explain tiny shifts that frankly are just noisy markets being noisy.

The big, powerful, fancy theory in Economics to explain the financial market is something called “Modern Portfolio Theory” (MPT). It is taught in most graduate schools and is largely regarded by both practitioners of the market and scholars as dysfunctional. Specific critiques center on false assumptions built into the underlining theory and a mismatch between forecasts made using MPT and actual market prices. In fact more recent graduate level text books open with a discussion on MPT not as a tool that should be used but as a pedagogical exercise.

I genuinely believe that MPT can and will be replaced, and fairly swiftly, once a better theory with more consistent predicting power enters the field. Traders and Economists have been watching for that theory since the mid 1970’s and it has not yet emerged. This theoretical gap is critical since those who turn a profit in the market are those who can “get in front” of the market. It is this desire that has in many ways forced traders to be overly sensitive to changes and information. This adds to the lean, aggressive trader and the quick changes in prices that we see in modern financial markets.

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Thank you for taking the time to read my blog. The entries for the next two weeks will be about twice as long. Next week I will be talking about the goods and services market as wells how it fundamentally differs from and interact with the financial market. In two weeks I will conclude this topic by using the same approach to discuss the labor market with a few final conclusions to wrap things up.

I have a massive beef with how we teach economic history today. 3 beefs to be exact:

• it normally starts around 1850 plus or minus 30 years
• it is European/American exclusive
• it normally deals with economic philosophy instead of economic quantification or structures

To be blunt, the difference in scope between world history and economic history is pathetic. However, in science there are times when you have very limited information so you have to make do with what you can find.

In today’s blog I will attempt to add a critical piece to the standard story of economic history. It is not as long reaching or global as I would like, but it is at least a minor improvement on what we have seen. Also, I will be completely ignoring economic philosophy. You’re welcome.

In antiquity, we have seen the rise and fall of empires. With the rise of empires we see a crescendo of culture, literature, and wealth. As the empire falls we see a “dark age” and stories of poverty. In modern times we have large government bureaus that gather and construct a detailed economic picture for us and from time to time we find fragments of that from the ancient world. When analyzing antiquity our mathematics is far more back of the envelope. Nothing you are about to read is cite worthy and take all of it with a grain of salt. If there was better information I would bring it to you but it just isn’t there.

Most empires, large and small, were about 90% devoted to sustaining themselves and the remaining 10% was nobility, culture, religion, etc. Arts, culture, and religion all gain from economies of scale. By centralizing the excess 10% from across multiple cities/towns into a single city, an empire will gain more of those “high society” elements at a higher average then if they were independent of each other. This mandatory centralization of cultural actors was why cultural elements rose and fell in tandem with empires.

This is a trend that we see across history, around the world, until Britain in the 1200’s and other parts of Europe soon after. Here we see a series of minor agriculture reforms that completely change the structure of their economy. Before this lords ruled peasants, directed their activities, and provided them with tools and food. Both groups were directly attached to the land they ruled/worked.

Around 1200 this attachment to the land was weakened. Lords became more like landlords and peasants were able to move between lords to rent specific fields. From this simple change we see a mix of micro-revolutions happening. First off, peasants now provided their own tools. What we see in the archeological record is a massive increase in the number, range, and variations of tools. It appears that once lords stopped buy tools and the farmers themselves started to make the purchases it sparked a massive change in tools design and production.

Secondly, we see an increase in people moving between towns. The reputations of the farmlands began to become important. As farmers began to move away from unproductive farmland to more productive farmland, an informal system of field rotation was created via market frictions. Bad fields would stay unused until the lord dropped the price so low someone would rent it simply because even if it produced less food, they would get to keep most of that smaller amount.

Rent was generally paid in the crop itself. Pre-1200, let’s say a piece of land could produce about 100 units if the peasant put in a medium level of work. However, the peasant got the same amount of food and shelter regardless of their work load. If they put in a high level of work they could get 120 units while at a low level of work the field would only produce 80 units. The incentive for the peasant is to put in the lowest level of work to get the standard pay. Since the pay is standard, the lord’s only choice to get the higher level of production is via fear or by taking more land.

So now let’s say we change incentive structure. The rent is 60 crops and yes, paying 75% to the lord was not uncommon. But since the peasants turned tenant farmer now get to keep the remainder of their corps the work to keep ratio changes dramatically. Now if you put in a low level of work you get to keep 20 crops, if you put in a medium level of you get to keep 40 units, and if you really work hard and put in a high level of work the peasant gets to keep 60 units of crops… the same as the lord gets from this piece of land via rent!

So from this mix of incentive structure, tool ownership, and field rotation productivity shifted dramatically. Instead of needing 90% of the population to sustain the nation only 60% was now needed. That means that instead of 10% being devoted to culture, religion, and the arts 40% of the population can now be used.

From 1300 to 1400 we see a massive increase in the number of monasteries, libraries, and universities. The roots of Oxford University are laid in 1280’s. Cambridge was officially founded in 1208 but its first college was established in 1284. English monasteries already had libraries before this time, but we see case after case of those libraries expanding as well as massive Cathedrals being built, collapse, and then being rebuilt again but this time with a bit better understanding of architecture.

From here we see the start of the trend. Agricultural reforms led to an increase in those engaged in intellectual pursuits. Intellectual pursuits led to the scientific age. The scientific age created the engineering need for the industrial revolution… which is generally where others begin the discussion of economic history.

And this is where the problem lies with starting a history lesson in the 1800’s. There are a massive number of microeconomics and efficiently lessons to be learned from the 1200 to 1400. Lessons on incentive structures, technology/efficiency, and simply understanding how you are distributing man hours. What is particularly striking is how many of these empirical phenomena, not “economics principles” or ideas but regularly observed outcomes, are ignored in various economic philosophies. But, I promised to not talk about economic philosophies so we will end this for today.

I hope to see you all again next month.