Some suffer the ultimate price

The crisis in the Eurozone has exacted the ultimate price for failure as a large number of small business owners have taken their own lives.  Recession in Italy, Greece, and elsewhere has battered the prospects of local businesses, and as a result, suicide rates have seen a dramatic increase with 400 owners of small businesses committing suicide in Italy in 2009 and 2010.  The suicides have become a big political issue in Italy where critics blame the reforms of the prime minister Mario Monti.

Suicides would seem a strange topic for an economist to write on but there are economic issues in play that would affect the choice of whether someone takes their own life.  One of these is the laws on bankruptcy.  Bankruptcy is a legal status of a person or business that cannot repay the money that it owes to others.  The laws regarding bankruptcy vary considerably depending on the culture of different countries. 

There are significant differences in the ease of bankruptcy procedures.  It is not a good idea to allow individuals and companies to run up a large amount of debt and then get away with not paying it back.  But, there are adverse effects for the economy if people are saddled with large amounts of debt from bad business decisions.  Not only do the individuals themselves suffer but money and time is spent on ventures that are not giving any return to their owners which are often referred to as zombie firms – kept alive despite being close to death.  Also, other entrepreneurs who may be thinking of setting up a business will not do so if they think the price of failure is high.  Small businesses play an important part in the economy and can grow into large companies with Google and Facebook as recent examples of this. 

The different approaches depend on the culture of a country.  In the US with its gung-ho approach to business, business failures are almost seen as a badge of honour and an important part of eventually being successful.  As such, the law allows for a simpler processing of bankruptcy so that individuals can move on and apply their energies elsewhere.  However, in Europe, there is a stigma against such failures and bankruptcies are a drawn out and costly process.  And Europe and its citizens suffer as a result.  So much so that some are even willing to take their own lives rather than deal with the consequences.   

And it is not only rules on bankruptcy but there are a whole range of other laws where bureaucracy can get in the way of business.  A lot can depend on how business is viewed in different countries.  Different cultural views can be reinforced through the laws and can have real effects on the lives of people – sometimes to a profound effect.

The King is Dead - Long Live the King

Your Neighbourhood Economist fondly remembers his first Walkman.  It was red.  And it was a Sony.  Like the Walkman in question, Sony was the pick of the bunch at the time but its best days seem to be well behind it.  Like other Japanese electronics manufacturers, the qualities that propelled it to global dominance have also prompted Sony’s fall from the top.  Sony recently announced that it expects to post a bigger loss, a record net loss of 520 billion yen (US$6.4 billion), for the financial year than ended in March 2012.  And it is not just the one year - Sony has lost money in each of the past four years.

The immediate cause of Sony’s malaise is its television manufacturing division.  Numerous firms churning out flat screen TVs has resulted in a rapid decline in prices for TVs and Sony (and other Japanese firms) has been unable to cut costs faster enough (but we as consumers benefit from cheaper TVs).  Japanese firms such as Sony are suffering the same fate that they inflicted on their US rivals in the 1980s when the small upstarts with lower wage costs managed to snap up a growing proportion of the market.  Now it is the turn of the rise of South Korean and Chinese firms to rise to dominance. 

Life at Sony was easy to begin with.  There was a clear goal – to copy and improve on the products of US firms.   It had a motivated and loyal workforce stemming from a consensus style of management and the group orientated nature of Japanese society.  Sony also benefitted from the government providing an environment which was good for exporters and with less of the rigours of competition which meant that Sony could apply itself to a different range of products.  So Sony pushed into a wide range of products and sacrificed profits while it built up a growing share of the market.  

But once Sony had risen to the top, it lost its way.  Japanese firms are good at playing follow the leader but struggle to innovate on their own.  This is because betting on new technologies at the cutting edge of electronics is difficult with a system of consensus management.  Its prior diversification proved to be a distraction to management who should have been focusing their and the firm’s efforts on core areas.  And discarding of unprofitable areas is not easy when you have amassed a large corporate family that had worked to the bone previously.  Sony still remains a scattered group of businesses with 6.4% of its 2011 sales coming from its music business, 8.3% from movies, and 11.1% from financial services. 

So Sony ended up losing its focus and has lost out to rivals in mobile phones and tablets (Apple and Samsung) and in game consoles (Nintendo – a much smaller firm which has shown that a few Japanese firms can innovate).  Further damage has been inflicted by a strong yen (which hurts Sony as an exporter from Japan) and weaker demand due to the global recession and the electronics giant is on the ropes.  A recent announcement by a new president that the firm would cut 10,000 or 6% of its global workforce will probably only help a bit considering the firm requires a major overhaul.

But as much as Your Neighbourhood Economist laments the decline of Sony, the rise and fall of different companies is a fundamental part of how the system of capitalism provides consumers with what they want.  Sony had its time as the favourite of consumers but firms like Samsung have managed to do a “Sony” on Sony and provide more attractive electronics at better prices.  And it means we can look forward with anticipation of what comes next after Apple and Samsung!

How to live with Globalization

Globalization for many people is a bad word.  For those in richer countries, there are positives such as cheaper goods and a wider variety of products which everyone benefits from.  However, it is the hardship caused by those who lose their jobs due to increased competition from countries where labour is cheap.  Governments in the western world are thus caught between promoting trading with other countries which has brought so much prosperity over the past decades or to start putting up walls to trade which would help save jobs in the short term but be harmful as a lack of competition hurts domestic industries. 

One key battleground for those wanting to protect jobs is car manufacturers.  Car makers in the US and Europe typically run squealing to politicians when they feel pressure from foreign competition and politicians get up in arms when these firms think of shifting production (and jobs) overseas.  The US government even bailed out General Motors in 2008 amid the financial crisis.  But the protection afforded to car manufacturers results in the industry as a whole being plagued by excess capacity as firms are not allowed to go bankrupt, and therefore, auto firms tend to go cap in hand to the government when times get bad. 

In this background, the British car industry is an interesting example of how a manufacturing industry can thrive in an increasingly integrated world.

The UK has for the past forty years run a “car trade deficit” which refers to that the value of the auto exports are less than that of imports. But, the car trade deficit was the lowest in 36 years in 2011 and may turn into a surplus in the near future.  Car manufacturers are prospering in an open market with five out of six cars made in the UK being exports and imports making up the same proportion of cars sold to locals. 

Auto firms have prospered despite (or due to) there not being any more large UK car makers.  UK firms that make cars have all been brought by overseas rivals.  But it is these car makers who have retained their brand that have found lots of buyers overseas.  Firms such as Rolls Royce and Mini (owned by BMW), Bentley (owned by Volkswagen), and Jaguar and Land Rover (owned by Tata Motors) have seen strong sales in countries such as China and Russia.  The rise of a new generation of wealthy in these countries and others has opened up new markets for these premium-brand car makers. 

But it is not only an older generation of British firms that are doing well making cars in the UK but also foreign firms as well.  Japanese car makers Nissan, Toyota, and Honda all have large operations in the UK for the European market and are looking to expand production there.  It is the flexibility of the British work force that makes the UK an attractive place to build cars.  Car makers can thus respond to sales trends in Europe faster than if they were making cars anywhere else which helps make up for labour being more expensive than elsewhere.  And the growing level of automation used to make cars means that labour costs are being a less important factor in the manufacturing costs.  Nissan’s factory in Sunderland made 271,000 cars with 4,600 people in 1999 but almost doubled its production to 480,500 while still only needing 5,500 people.

The tale of the story is that openness and flexibility can be the best way to create an environment where manufacturers can thrive thanks to rather than despite globalization.

Spain and the Long Hard Slog

Despite all the brouha over the bail out for Greece, the most pain from the Eurozone crisis is going to be felt elsewhere in the Mediterranean.  Spain doesn’t have the debt of Greece but it does have the highest unemployment and is set for the biggest cuts in government spending in the Eurozone.  And it is not going to be quick or easy with a weak economy made worse by fiscal cuts and trouble likely from its feckless regional government and agitation from a generation of youth out of work.

In terms of government debt, Spain looks like a model of virtue compared to many other countries in Europe.  Its government debt as a percentage of GDP was a mere 39.9% in 2008 before the Eurozone crisis and had only climbed up to 68.3% by 2011 which is lower than the supposedly virtuous Germans who have a government debt to GDP ratio of 82.6%. 

However, the budget deficit of the Spanish government has ballooned due to the effects of the global recession.  The initial effects on the Spanish economy was not as bad as elsewhere with a 3.7% decline in GDP in 2009 compared to the Eurozone average of a 4.3% drop.  But while 2010 saw a recovery in most European countries, the economy in Spain remained weak and GDP edged down by a further 0.1%.  Growth returned in 2011 but was limited to a 0.7% rise in GDP and all eyes had turned to Europe in the midst of its sovereign debt crisis.

What attracted the concern of investors to Spain was the combination of the sluggish economy and a rapidly expanding budget deficit.  The budget deficit hit 11.2% of GDP in 2009 and remained stubbornly high in the following years at 9.2% in 2010 and 8.5% in 2011.  Along with extra government spending for unemployment benefits and the like, government revenues dried up as two sectors which had benefitted from the boom before the crisis, construction and banking, fell into trouble. 

Now, the government has announced plans to implement savage austerity measures to lower the deficit to a target of 5.3% in 2012 and 3.0% in 2013.  While saving the country from a rise in the interest rates on government debt and the possibility of similar debt restructuring to Greece, the cuts to government spending will further weaken the economy and this may get Spain in even more trouble by creating a perverse spiral of government cutbacks and economic fallout.  Considering the lower level of government debt, a slower pace of budget cutting could be seen to be more appropriate but this is not something that the bond markets or Angela Merkel (among others) seem likely to allow.

Plans to cut the budget are also expected to run in trouble with protests already a common sight on Spanish streets.  Also, regional government controls a large part of government spending and won’t be happy to see spending cuts hit home on their turf.  So the stories in the papers have been whether the unprecedented 27 billion euros worth of budget cutting measures announced last month will be enough.  With a further 1.7% decline in GDP forecast for 2012, it is unclear whether the economy or the Spanish people can take much more.

Yen as weathervane for global economy

Recent previous postings in this blog had looked at where investors move their money in the good times and the bad.  The choice is not limited to just stocks and bonds but also to what currency to invest in.  One currency more than all others has seen its fortunes dominated by the global flow of money, the Japanese yen, and has sometimes had to pay the price.

In economic text books back when Your Neighbourhood Economist was at university, currencies were determined based on trade flows.  If a country exported more goods and services than it imported (a positive balance of trade), its currency would rise.  The higher currency would mean that the price of exports increased and imports decreased so that the balance of trade would head back toward zero. 

However, globalization has meant that the flow of goods between countries has been overwhelmed by a flood of cash and so it is this that dictates the value of a currency.  Investors now move their money into countries that were growing and as a result had high interest rates.  Cash inflows into a country would lift the currency and raise the value of any investments in that country giving investors a boost to their returns. 

With money becoming increasingly easy to come by, investors came up with a new trick – borrow money in a country with a low interest rate and move it somewhere with a higher interest rate.  This is what is known as the carry trade and is where the yen comes in.

The Japanese economy has been in the doldrums after the bursting of a massive investment bubble in the late 1980s.  Its interest rates have been close to zero for a long time so investors could borrow in yen and invest in bonds in other countries with relatively low risk.  The carry trade also resulted in the yen being weaker than it normally would have been, because investors would sell the yen that they had borrowed, despite a large balance of trade and other factors that should have been driving the yen higher. 

The yen thus became a gauge of the world economy.  As long as interest rates elsewhere remained high on the back of a buoyant global economy, the yen would stay weak.  On the other hand, an economic downturn would lower interest rates globally and prompt investors to buy yen to repay their borrowing which caused the yen to rise.  So there was a link established whereby the yen was the currency to hold if an investor was pessimistic about the global economy.  That interest rates in Japan were close to zero didn’t matter as interest rates would be low everywhere during a global downturn.  Thus, the yen became a safe haven where investors would park their money when the economy turned bad.

The result of this is that, despite the onset of a recession both globally and in Japan, the yen was rising.  This was a major blow to Japanese manufacturers which export lots of TVs and cars and are the mainstay of the Japanese economy.  Perhaps, most perversely of all, the tsunami that devastated the Japanese northeast prompted a further rise in the yen.  This was because the havoc caused by the tsunami was seen as being bad for the global economy due to its effect on Japanese business in the region which supplied parts to many international firms.

The yen reached peak of above 120 yen to the US dollar in mid 2007 to almost 75 yen to the US dollar early in 2012.  So a jump in the yen to near 85 yen to the US dollar in March sparked interest that the direction of the market was about to change.  The upturn in the yen was triggered by an announcement of further easing by the central bank in Japan which comes at a time where other central banks are winding down their efforts to prop up their economies.  But little respite is expected for the Japanese economy until the interest rates else where such as in the US rise further.  For now, Japan looks stuck with a currency which is more of a weathervane for the global economy than a currency that reflects its domestic economic climate.

Not All Investors in Bonds have Lost Money

While some countries such as Greece have been terrorized by the bond markets, the governments of other countries have seen the interest rates on their debts fall to record lows.  So while some bond investors have been losing money in Europe, there have been others who have raked in good returns.

There can be considered to be a large pool of money which moves around the global financial markets looking for the highest returns.  This pool of money is made up of pension funds, cash from wealthy individuals, as well as sovereign funds run by various countries.  The money typically follows a predictable pattern over the business cycle – to shares and other risky investments when times are good and to bonds and other safer investments during a downturn. 

This time around, the severity of the recession has heightened the sense of fear in the market and investors have become picker about where they park their money during the slump.  This coupled with the high level of debt that many governments (and companies) took on-board during the boom time has resulted in the sovereign bond market being split into winner and losers.  The previous post dealt with the losers. But if money is to be invested in bonds during the recession and some governments and many firms (considering all of the bankruptcies) are out of bounds, it has to go somewhere and it goes to the winners.  

And the winners have been the governments of the US and the UK among others.  The interest rates on 10-year government bonds for both countries have fallen below 2.0% to record lows.  Along with investors seeking safety, the reduction in interest rates has also been driven by the central banks buying large quantities of government debt as part of their efforts to lift the respective economies out of their slump. 

But the thing that investors are asking now is whether bonds will remain popular.  When the global economy starts to pick up again, investors will be willing to take more risks.  And the buying by the central banks is near an end.  The Federal Reserve in the US has not suggested that it will again buy more bonds issued by the US government even though the Bank of England has committed itself to buying more UK government debt.  Furthermore, not many investors will be happy with a return of 2.0% in comparison to recent strong gains made in the share market.  Rallies in both the share market and the bond market is a contradiction that cannot continue for too long and either the optimist buying shares or the pessimists sticking with their bonds will be proven wrong.

However, despite some signs of better prospects for the global economy, there are some who still think that interest rates for these bonds have further to fall.  If the economic recovery is weak, the factors that have been driving the rally will continue.  Then, a return of 2.0% and more gains in bond prices (interest rates and bond prices move in opposite directions – see the previous posting) may be a clever bet if things turn out for the worst.  This is where those bankers are supposed to (but don’t always) earn their exorbitant pay packets. 

Bond Markets Ain’t All Bad

The bond markets have caused havoc in Europe.  A rapid surge in interest rates on the debt of some European countries have forced governments to cut back on spending at a time when economic theory would argue for governments to spend more.  The results have been carnage.  There have been riots in Greece, protests in Spain, and the toppling of numerous governments in Europe.  Many people have pointed a finger at the bond market implying some notion of culpability for this.  The bond markets have something to answer for but not for the current situation.  To understand why, we must first however look at the role of the bond market in setting interest rates on debt.

Interest rates on bonds are set by the forces of demand and supply.  A large number of buyers will increase the price of a bond which will result in a lower interest rate.  This is a concept that even I struggled to come to terms with so I will provide a theoretical example to explain why bond prices and interest rates move in opposite directions.

For example, consider a government selling a fixed number of bonds where buyers pay $100 now and receive $150 in one year which is a return of 50%.  The high return attracts other investors who buy the bonds from the original buyers at a higher price and the price increases to $120 but the amount which is paid out at the end of the one year is still $150 so the return on the bond is now $150/$120 = 25%.  The government can now sell more bonds at the lower interest rate. 

But the opposite can also occur.  If investors do not think that the government can pay back $150, the original return of 50% will be seen as too low in relation to the risk that the government will default.  That means that if the original buyers want to sell, other investors will want a higher return to compensate for the riskiness of the bond and so the price of the bond will fall.  For example, investors may only offer to buy the bonds for $75 which means the interest rate on the bond is 100% (i.e. investors will double their money).  And if the government wants to sell more bonds, it will have to pay the higher interest rate.

The changes in the interest rates in this manner are an important part of the essential role of the bond markets.  In theory, the return on any investment must be enough to reward the investor for taking the risk of investing their money.  So interest rates provide an important signal on the risk that the government or the company that has issued the debt will not be able to pay back the money.  It also acts as a warning to governments that take on too much debt (or any other action that would be seen to hamper debt repayment) that they will be punished by higher interest rates.

So the problem is not the high interest rates that some governments in Europe are currently been forced to pay but that there was no warning from the bond market prior to the crisis.  Previously, investors had been happy with the same interest rates on all bonds from countries using the euro whether it was debt from Germany or Greece.  So Greece and the other counties have no notion that they would fall out of favour so quickly once investors realised that some government may struggle to pay their debt with the economic conditions having rapidly deteriorated.

Previously, the bond markets had been feared by any government who dared to spend too much.  One advisor for Bill Clinton was famously quoted as saying that if reincarnated, he would “want to come back as the bond market. You can intimidate everybody”.  But in the lead up to the recent financial crisis, bond investors had been caught napping.  The investors would have lost money as the prices of bonds of Greece and the other plunged but it is the citizens of Greece and elsewhere who pay the heavier price.