Europe: a house of cards

EUROPEAN leaders have tried to characterise the October writedown of Greek debt as “private-sector involvement”. While the writedown would appear to be a default in all but name, efforts to maintain investor confidence have so far been surprisingly successful. Yesterday, US stocks and Asian stocks rallied amid optimism that European leaders are taking steps to deal with the crisis.

Excessive optimism is nothing new.

Recent history provides plenty of examples of people systematically over-estimating the likelihood of positive outcomes.  In 2000, the dot-com bubble pushed the NASDAQ above 5,000 (it currently sits at around 2,500).  In 2004, Moody’s held its credit rating for Greece steady after the country admitted that its budget deficit had exceeded the EU’s ceiling of 3% of GDP every year for 8 consecutive years (source: NYT).  In 2007, median house prices in the US hit an all time high based on a widely held belief that “house prices always go up”.

Optimism will buy European leaders some much needed time. But it is difficult to see how Europe will managed to quickly or painlessly repay combined public debts which stand at more than €9 trillion.  Europe’s enormous debts might be thought of not as a mountain but as a towering house of cards.  It was fairly easy to build but now appears almost impossible to deconstruct without knocking the whole thing over.

A house of cards is a fragile arrangement, it will collapse, not only under the burden of one card too many, but by mere want of carefulness.

Beware of Greeks Bearing Bonds

THE MARKETS have been temporarily buoyed amid optimism that European leaders will find a solution to the debt crisis.  Unfortunately, the optimism is likely to be short lived because the problem with Greece is not just that they owe everyone a lot of money.  Greek debt is a symptom of a more endemic problem rooted in the Greek culture.

Michael Lewis, writer for Vanity Fair, revealed the story of how Greece meandered towards its current nadir: tax evasion the norm, bribery a way of life, and the Vatopaidi monks obtaining a gift of Greek commercial property worth over a $1 billion. 

His intriguing and insightful article, “Beware of Greeks Bearing Bonds“, uncovers the human story behind the Greek debt crisis. It is not a short piece, but if you have 15 minutes and are interested in the current affairs then it is well worth reading.

Helping the 99%

WITH the Occupy Wall Street movement still in full swing, we have to stop and think for a moment about the distribution of wealth in the world.

One of the slogans of the Occupy Wall Street movement is “we are the 99%”, which is a reference to the fact that the top 1% of households in the USA hold more than 40% of the wealth.

This sounds incredibly unfair. How could they be so selfish?

Well, as Milton Friedman pointed out, people are often selfish out of a concern for their families (albeit perhaps subconsciously). And this concern for family is the same for both the rich and the poor.

As you will see in the video, one solution that could be proposed to the income disparity is an inheritance tax.  People would be allowed to earn as much money as they want while here, but would be forced to give it all back to society (read: the government) when they check out.  This may sound reasonable, but as Friedman pointed out this would undermine one of the key incentives that encourage people to work hard and save for the future, a concern for family.

Clearly many poor families are hurting financially as a result of the ongoing financial crisis, and things look set to get worse before they get better. However, it is not clear that camping out in Zuccotti Park and vilifying the wealthy is a productive answer to the problem.

At the same time, those in the top 1% (or even the top 10%) hold a privileged position in society. The current sentiment of the Occupy Wall Street movement is that the wealthy have not held up their end of the societal bargain to justify their privileged position. While this may or may not be the case, it would seem incumbent,  or at least highly prudent, for wealthy families in the States and elsewhere to consider how they might use their privileged positions to create opportunities for those who have none.

Greek default in all but name

Whatever you say it is, it isn’t ~ Alfred Korzybski

IN OCTOBER 2011, private banks accepted a 50% writedown on Greek debt. European leaders negotiated the writedown to avoid a technical default.

It is surprising that ratings agencies did not classify the writedown as a default when you consider that S&P defines sovereign default as “the failure to meet interest or principal payments on the due date…contained in the original terms of the rated obligation when issued”.

In your author’s opinion, the writedown of Greek debt falls clearly within the S&P definition of sovereign default.

Undeterred however by rating agency definitions, European leaders have characterised the writedown as a voluntary “private-sector involvement” or PSI. This is clever politicking because a “private-sector involvement” sounds like a positive development. However, in reality, it means that private investors have lost 50% of their investment in Greek bonds.

European leaders are now using the same brand of financial wizardry which created the global financial crisis in the first place. Over the last few decades, countless risky financial products were sold to investors using harmless sounding terms like “credit default swap”, “mortgage backed security”, “special purpose vehicle” and “off-balance sheet financing”.

Characterising the writedown of Greek debt as “private sector involvement” is more of the same financial manipulation, but it is also shrewd politics. European leaders know that a Greek default could have devastating consequences for the Euro-zone.

Would a Bund by any other name smell as sweet?

ON WEDNESDAY November 23rd, an auction of German government bonds (known as “Bunds”) managed to sell only €3.6 billion out of a total €6 billion worth of Bunds on offer (source: Economist).

Germany is one of the most financially stable countries in the Euro-zone, so its failure to sell all of its Bunds is worth examining. In the context of an ever worsening European sovereign debt crisis this could be cause for concern.  However, there are three reasons why the news does not raise concerns about Germany. Firstly, the German Debt Agency (Finanzagentur) normally retains part of any new Bund offer, so a partial sale of Bunds is pretty standard. Secondly, German Bunds are expensive. With a current 10-year Bund yield of only 2.26% it is no wonder that investors have a weak appetite for German debt.  Thirdly, European banks are currently focused on building their balance sheets not on lending. European banks have until the end of June 2012 to get their core capital ratios up to 9%.

While Bunds may still smell sweet, weak financial markets in Europe are a cause for concern.

Weak financial markets increase the risk that one or more European banks will fail. In fact, one already has.  Dexia fell victim to the Euro-zone debt crisis in October and was rescued by Belgium and France. This is particularly concerning because only a few months ago Dexia was rated 12th safest bank in Europe by European Union stress tests. How could Dexia fail? The short answer is, surprisingly easily. Dexia has around $700 billion on its balance sheet, but like many banks it requires access to short term funding.  With banks becoming increasingly nervous as a result of weak credit markets, Dexia simply failed to secure the short term funding it needed to stay afloat.  Dexia’s problems stemmed in part from its exposure to around $25 billion of Greek debt.

There is every likelihood that Greece and other countries may default on their debts. Greece and Italy both have a debt/GDP ratio exceeding 100%, but they are by no means the only countries that need to balance their books. Debt levels are worryingly high in Japan, the UK, USA, Portugal, Ireland and Belgium (among others). Greece represents less than 2% of the EU economy, but the effect of a Greek default could be worse than the sub-prime mortgage crisis. There are three reasons for this:

  1. Integrated financial markets: As we saw during the sub-prime crisis, credit markets are highly integrated. France alone is exposed to more than $56 billion of Greek debt (see graph below).  If Greece defaults then this could drive a number of European banks into bankruptcy;
  2. Nervous markets: As it is not clear which European banks may fail, nervous banks may stop lending money to each other. As a result, this would drive up interest rates or, in the worst case, may completely stop the flow of short term credit and put the viability of many banks and businesses in jeopardy;
  3. The Domino Effect: Greece is the first domino.  Following a Greek default, financial market vultures will turn their greedy attention to other beleaguered countries. Italy may be second in line.

The Hospital Bed Question

THE guesstimate question is a usual type of question that you can expect to be asked when interviewing for a position at a consulting firm.

Here is one to test your mettle.

The Hospital Bed Question

The question is this: How many hospital beds are required in New York city to provide for all of its pregnant women? 

You can assume that:

  1. pregnant women stay in hospital for one night only (American hospitals are very expensive); and
  2. hospital beds in New York are used exclusively by New York residents (no sharing).

If you are game to test your skills, then this is what you need to do.

Please respond in the comments below, covering the following in your answer:

  1. set out the steps that you would take to answer the question;
  2. note any additional assumptions that you would make at each step; and
  3. provide a final numerical guesstimate to the question.

To spice things up, I will be happy to send the best answer (as judged by me) a copy of an interesting book by Lawrence Weinstein (nuclear physicist) and John Adam (professor of mathematics). The book is called Guesstimation: Solving the World’s Problems on the Back of a Cocktail Napkin.

Note that the comments section remains open for 14 days only, so you have a limited time in which to respond…

Happy guesstimating.

Harvard students protest against Greg Mankiw

IN THE WAKE of the global financial crisis, there has been a backlash against the mainstream school of economic thought, of which Greg Mankiw is a proponent.

Mainstream economists did not predict the global financial crisis and notable commentators, including Steve Keen, single out the narrow minded and simplistic ideas put forward by mainstream economists as the source of the problems that the world economy now faces.

This backlash came to a head earlier in the month, November 2nd, when a large group of Professor Mankiw’s students, sympathisers with the Occupy Wall Street movement, boycotted one of his classes.

Commentator Steve Keen argues fairly persuasively that Professor Mankiw has based his popular mainstream economics textbook, Principles of Economics, on assumptions that are simplistic at best and, at worst, deeply and irreparably flawed.

What does this mean for mainstream economics as we know it?

What does this mean for Mankiw’s 10 Principles of Economics?

Mankiw’s 10 Principles of Economics

Economics is about decision making in situations of scarcity

ECONOMICS is the study of how individuals, firms and government make decisions to manage scarce resources.  What does this mean exactly?

Professor Greg Mankiw teaches economics at Harvard University and is the author of a popular economics text book called Principles of Economics which is used at many Ivy League schools. Mankiw’s status within the economics profession makes him uniquely well placed to help us understand the basic principles of economics.

Set out below are Mankiw’s 10 Principles of Economics:

How People Make Decisions

1. People face tradeoffs: To get one thing, you have to give up something else. You may have heard economists say “there is no such thing as a free lunch”. What they mean by this is that, for example, you might get a free bowl of soup at the student co-op, but the soup is not free because you have to give up 35-minutes waiting in line to be served.

2. The cost of something is what you give up to get it: Making a decision requires comparing the costs and benefits of alternative courses of action. The cost of one option is not how much it will cost in dollar terms, but rather the value of your second best alternative. For more explanation, see understanding the cost benefit analysis.

3. Rational people think at the margin: People make decisions by comparing the marginal benefit with the marginal cost. For example, you might buy one cup of coffee in the morning because it helps you start the day, but you might not buy a second cup because this gives you no extra benefit (and costs another $3).

4. People respond to incentives: Behaviour changes when costs or benefits change. For example, if your hourly wage increases then you are likely to work more (unless of course your income is already too high).

How People Interact

5. Trade can make everyone better off: Trade allows people to specialise in what they do best. By trading, each person can then buy a variety of goods or services. For example, you may be a skilled management consultant. Money you earn through your consulting work might be used to build a house even though you may not have the skills to build the house yourself.

6. Markets are usually a good way to organise economic activity: Individuals and firms that operate in a market economy respond to prices and thereby act as if guided by an “invisible hand” which leads the market to allocate resources efficiently. For example, if there is an oversupply of wheat on the world market then individual farmers will lower the price they charge until they can sell all of their wheat.  Lower wheat prices will also likely reduce the total quantity of wheat that farmers decide to produce. Market prices are able to adjust to equate supply and demand without the need for any central planning.

7. Governments can sometimes improve market outcomes: Sometimes a market may fail to allocate resources efficiently, and government regulation can be used to improve the outcome. Market failures can occur due to the existence of public goods, monopolies and externalities. For example, an electricity supplier might have a monopoly. Government regulation may be required to ensure that the supplier does not abuse its market power.

How the Economy Works

8. A country’s standard of living depends on its ability to produce goods and services: A country whose workers produce a large number of goods and services per unit of time will enjoy a high standard of living.

9. Prices rise when the government prints too much money: Printing money causes inflation. When a government prints money, the quantity of money increases and each unit of money therefore becomes less valuable. As a result, more money is required to buy goods and services. For more explanation, see quantitative easing.

10. Society faces a short-run tradeoff between inflation and unemployment: Reducing inflation often causes a temporary rise in unemployment. This tradeoff is the key to understanding the short-run effects of changes in taxes, government spending and monetary policy. For more explanation, see the Phillips curve.

Do you have an app?

Creating an app is not that hard, for a 12 year old

DO YOU have an app?  Well, do you?  … Many leading companies have already jumped on the app-store bandwagon (e.g. New York Times, Twitter and Facebook) but most businesses can still confidently answer this question in the negative: “no apps here.”

Given that the Mac App Store was only launched in January of this year, the lack of an app is perhaps understandable.  However, with 12 year olds now building apps in school yards, there is no longer an excuse to ignore the app-reality. The future is upon us, and you need to get moving.

Here are five ways that you, your business or your client’s business might benefit from creating an app:

  1. Pay per download – some apps cost money, so you might decide to charge users a fee to download your app.  Each download means money in your pocket. This is a particularly attractive model for indie rock artists who don’t have access to established record labels;
  2. Ad revenue – apps can act as an “advertising vehicle” where mobile marketers can place advertisments.  They can also be used to drive traffic to your website, where you can generate further ad revenue. The more popular your app becomes, the more you stand to make from advertising;
  3. Lead generation – apps can attract new business.  If you have an online store, or sell pretty much any kind of good or service, then a popular app can help you generate new leads. For example, if you own a restaurant, your app could allow customers to make online reservations;
  4. Promotion – apps can generate attention. Even if your app does not directly make you any money, a popular app could help you generate the attention you need to build your brand online. A stronger brand can help you raise prices without losing market share and attract more customers;
  5. Networking – creating an app demonstrates your area of interest, and allows you to reach out to other people who share that interest.  It also allows customers, employees and potential collaborators to connect with you more easily.

Apps are already a daily reality for our tech-savy youth. At the same time, apps represent an exciting and relatively new opportunity for businesses to build new revenue streams, promote their products and reach out to interested members of the online community.

Do you have an app?

The Road Not Taken

Which path are you following?

TWO ROADS diverged in a yellow wood,
And sorry I could not travel both
And be one traveler, long I stood
And looked down one as far as I could
To where it bent in the undergrowth;

Then took the other, as just as fair,
And having perhaps the better claim,
Because it was grassy and wanted wear;
Though as for that the passing there
Had worn them really about the same,

And both that morning equally lay
In leaves no step had trodden black.
Oh, I kept the first for another day!
Yet knowing how way leads on to way,
I doubted if I should ever come back.

I shall be telling this with a sigh
Somewhere ages and ages hence:
Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.

~ Robert Frost

Economies of Scope

Economies of scope exist where a firm can produce two products at a lower per unit cost than would be possible if it produced only the one

ECONOMIES OF SCOPE is an idea that was first explored by John Panzar and Robert Willig in an article published in 1977 in the Quarterly Journal of Economics entitled “Economies of Scale in Multi-Output Production”.

1. Relevance

The title of that landmark article may not sound very appealing, but it does make clear that economies of scope and economies of scale are closely related concepts.

Economies of scale is a fairly well known concept relevant to big producers like Intel, Boeing and Toyota.

In contrast, economies of scope is a lesser known concept particularly relevant to small and medium sized enterprises (SMEs) that may not have access to large markets or the ability to produce at scale. SMEs represent the overwhelming majority of global business activity, and are the world’s main source of job creation and economic growth. For example, SMEs currently account for more than 99% of businesses in Europe (Economist Intelligence Unit 2011).

With the Euro-zone at the brink of collapse, governments and business leaders may be well advised to revisit basic concepts like ‘economies of scope’.  If properly understood, economies of scope could be used by SMEs to drive profit growth and reduce the risk associated with product failure.

2. Importance

Economies of scope provide firms with two key benefits:

  1. Lower average costs: If a company diversifies its product offering it may be able to lower the average cost of production. For example, McDonalds offers a range of different products (e.g. burgers, fries, sundaes and salads). As a result, it can achieve lower per unit costs by spreading its large overhead costs across a broad range of products. Lower per unit costs allow a company to do one of three things: (1) enjoy higher profit margin on each unit sold; (2) lower the price it charges customers and thereby increase market share; or (3) a combination of 1 and 2.
  2. Diversified revenue streams: By producing multiple products, a firm can diversify its revenue sources, which reduces the risk associated with product failure.

3. Economies of Scope

Economies of scope exist where a firm can produce two products together (joint production) at a lower average per unit cost of production than would be possible if it produced only one of those products (OECD glossary). Economies of scope have been found to exist in a range of industries including banking, publishing, distribution, and telecommunications.

Economies of scope and economies of scale are related concepts. The distinction is that ‘economies of scale’ refers to where the average cost of producing a unit of output decreases as output increases, whereas ‘economies of scope’ refers to where the average cost of producing a unit of output decreases as the number of different products increases.

3.1 Sources of economies of scope

There are 7 potential sources of economies of scope:

  1. Common inputs – Using more of the same inputs will increase bargaining power with suppliers. For example, Kleenex manufactures a range of products which use the same raw materials: tissues, napkins, paper towels, facial tissues, incontinence products and Huggies nappies.
  2. Joint production facilities – Plant and equipment can be more fully utilised. For example, a dairy manufacturer may be able to use its existing dairy production facilities to produce a range of different dairy based products: e.g. milk, butter, cheese and yoghurt.
  3. Shared overhead costs –The cost of certain fixed overhead costs can be shared across products. For example, McDonalds can produce hamburgers, French fries and salads at a lower average cost than it would cost to produce any of these goods separately. Each product shares overhead costs such as food storage, preparation facilities, restaurant space, toilets, car parks and play equipment.
  4. Marketing – The cost of advertising can be shared across products. For example, Proctor & Gamble produces hundreds of products from Gillette razors to Old Spice aftershave, and can therefore afford to hire expensive graphic designers and marketing experts and spread that cost across a broad range of products.
  5. Sales – Selling products is easier when salesmen can provide customers with a range of value options, as well as upsell and cross promote … “Would you like fries with that?”
  6. Distribution – Shipping a range of products is more efficient than shipping a single product. For example, Amazon sells an extremely broad range of products. As a result, it can negotiate favourable deals with freight companies.
  7. Diversified revenue streams – A firm that sells multiple products will have lower revenue risk because it is less dependent on any one product to sustain sales. More stable cash flows are attractive for three reasons. Firstly, they can be used to negotiate more favourable credit terms with banks. Secondly, a strong cash position can also be used to extend credit to customers and thereby increase sales. Thirdly, more stable cash flows can allow a firm to be more innovative with new product launches because the failure of any one product will have less impact on total revenues.

4. Diseconomies of scope

A firm that offers too many products may actually incur an increase in average per unit costs when it offers additional products. Reasons for diseconomies of scope may include:

  1. diluted competitive focus;
  2. lack of management expertise;
  3. higher raw material costs due to bottlenecks or shortages; or
  4. increased overhead costs.