Friday, 30 December 2011

Rail Subsidies

Last week I watched a nerdy documentary on steam trains in Wales and the Beeching cuts. Intrigued a read a bit more about the Beeching cuts which gives a good insight into the more recent history of British railways. Essentially since the second world war the railways have operated at a loss despite numerous schemes and ideas to make them more profitable.

 There was a typically simplified study this morning highlighted by the BBC which suggests that London commuting fares are 10x a similar Italian fare. I would highlight this is somewhat extreme and also misleading. For instance London in the financial capital of Britain and a place where wealth is highly concentrated due principally to a large financial sector. To compare prices with Rome and Berlin is misleading as these are political but not economic capitals and Berlin in particular is a poor city relative to other areas of Germany. However it is certainly true that British rail fares are the highest in Europe. 

The reason for Britain having such high fares is the lower level of subsidies provided to the railways. Since privatization in the 1990s the railways have been weaned off their subsidies at the expense of fare payers. This seems fair to some extent - why should all taxpayers subsidise transport for a slice of the commuting population. However the effect of compounded above inflation fare rises means that rail fares are becoming excessive. I believe the government target in the end is to end subsidies entirely. Currently the cost is around £6bn to fare payers and £5bn to the taxpayer so substantial further fare rises or greater cuts in costs are needed to balance the books. Cutting costs looks difficult given the woeful state of many of Britain's trains and track.

Arguably the policy of indexing fares to inflation + x% is a serious error. To index fares to the RPI rate and then add a further margin both compounds the on going rate of inflation in the index (albeit for a small constituent) thus maintaining and driving up RPI in the future. Additionally wages are rising at nothing like the RPI rate so for many rail commuters this means a squeeze on real income or at least that is the general argument.

Its important to remember that if my wages are £30k p.a I should earn around £1,900 a month. Now say my rail ticket is £300 a month. If my salary rises 1% I earn around £1,920 a month and if my rail fare rises 6% it also rises to £320 a month. So in reality one is really no worse off. Now obviously the lower your wage level and the higher your ticket price the more the squeeze on your income. For instance if my wages are £20k with a 1% pay rise would see a gain of just ~£10 a month whilst the aforementioned railfare rises £20 a month meaning a net squeeze on income of £120 a year. This means workers with lower wages who live further from London (or a given destination) become disincentivised to travel to work.

This to my mind is the crux of the issue. Realistically many workers can easily afford the fare rises on the railways however rail fares are effectively a tax on jobs. Most rail journeys are commutes and they are commutes which cannot be made by car due to distance/parking constraints etc. So effectively its a tax on commuting in much the same way as fuel duty. Therefore arguably one could say fuel duty on motorists subsidies rail fares for rail commuters.

However all of this ignores the social good of both railways and roads:

  • Road users forget that roads themselves like the railway are a public good. There is no road pricing system in the UK and so effectively roads are subsidised by the government just like the railways. This is an important distinction as motorways in Italy and France are toll roads which may help to subsidise and incetivise the use of railways.
  • As a public good railways provide intangible economic benefits beyond the simple calculation of ticket revenues against operating costs. Railways facilitate travel and without them London would literally be starved of workers due to the total incapacity of the road network to handle the volume of commuters. The loss of jobs and income from people being unable to travel to work would be so vast for the tax system that the cost of a rail subsidy pales into insignificance. Railways like roads are a public good and therefore the government needs to fund and subsidise them to encourage greater economic activity. Thus the payback is indirect via the taxation of rising personal income.
  • Railways are more environmentally friendly than cars and the environmental protection from lower emissions is impossible to quantify economically but has a clear benefit for the future economy due to reduced environmental degradation.
  • Government policy states that they wish to improve the usage of public transport and get people out of their cars. Making all modes of transport simply more expensive does not constitute a policy. Rail fare rises are rising above inflation, fuel duty increases continue and air passenger duty increases are coming in the spring. If the government wishes to have a policy it needs to decide where it wants to focus investment and subsidies.
Since rail fares are effectively a tax on commuting arguably the subsidy should be increased in order to benefit the less well of in society. This could be paralleled with a rise in the rate of income tax in the higher brackets. At the moment the rail fare acts as a poll tax with those earning the most paying the least proportion of their income and vice versa. Imagine theoretically that rail fares were tax deductible expenses; this would have approximately the same effect as increasing subsidies. Someone earning £60k could take a their £3k rail fare off their income as a deductible leaving a taxable income of £57k and someone earning £20k could do the same leaving £17k. This way people are not disincentivised to travel to work and seek productive employment by the rail system. The cheapest way for the government to implement such a system would be to make employer season ticket loan schemes tax deductible.

To my mind the current policy is wrongheaded as it assumes the railways can operate at a breakeven level without huge demand destruction. I could be wrong of course but given that no government has managed to operate the railways at a profit in over 60 years it might be high time to change course.

Monday, 19 December 2011

Investing for the end of the world

"-...well...i don't like the way the country's ran, don't you know,
and, erm...that's pretty much what i was expressing in my poem.
the government...the american government -
they're sneaky, they're very deceitful,
they're liers, they're cheats, they're rip-offs.
i mean, the american government is one systematic government that...that nobody can trust.
i don't trust them myself.

and how long have you been writing for?


how long have you been writing for?

-since i was four."

-Bill Bailey Finnegan III 
quoted on Slow Riot for new Zero Kanada EP

In the event of total meltdown many people seem to consider buying gold a good idea. However I would suggest that one needs to have the physical gold or some other from of non-financial asset if one really believes in Armageddon . This is because of course total Armageddon implies the loss of all banks and counterparties.

Now I am not so sure that buying gold is a great idea in preparation for a world without money. Surely the main things people will want are food, fuel and shelter so a large cache of all three sounds a better bet. Aside from this how can one hedge one's exposure to a non catastrophic outcome? After all building a bunker and filling it with gold, food and fuel whilst liquidating all your financial assets might not be a sound idea if said apocalypse does not arrive. (I wonder what Harold Camping's asset composition looks like). 

So I would argue a good hedge is to liquidate all your observable financial assets by taking your money out of the bank/stockbroker etc. You could preserve this as physical cash or investment in previous metals (not diamonds due to their being a horrendous investment.) You can bury this in your garden or some other 'safe' place (or even your bunker should you already be so advanced).

Now should apocalypse not occur the taxman may wonder what you spent your cash on. You may even be out of a job having been so convinced of the oncoming collapse of the modern financial system. So I would suggest creating a plausible cover story for your spending. Likely outlets for the cash would by a drugs problem or strippers.

I would recommend stating you spent the cash on strippers rather than drugs due to (i) a lower social stigma (except with your spouse who is probably in on the scheme) (ii) you are less likely to find yourself referred to a treatment plan and (iii) you can make up great sounding war stories from your strip club blowouts to entertain your friends (you need these cover stories too in order to convince the taxman). Ensure that you have been to a couple of strip clubs during the run-up to your liqudiation to lend credibility to your argument. Take some friends as witnesses and ensure you are seen spending lavishly. This is also easier than pretending you spent the cash on drugs as you might actually need a bloody nose or some track marks to keep that line convincing. However clearly if you already have a drugs problem option two is more feasible.

Now this is the trick if there is no end of the financial world; with no observable assets you can survive on state benefits for as long as you need to since without the apocalyse the welfare state still exists. One can claim state welfare as one now has no assets, except perhaps a bunker where you live.

The gold/cash / food / physical metals you bought are still there and you can sell them off for cash in increments when you need it for top-ups and luxuries. There are plenty of dealers who buy metal for cash no questions asked. If you are really risk averse you could also hedge the price of the underlying gold etc as without an apolcalypse the price of gold could fall during your holding period. By buying a few put options on your assets you get some downside protection cheaply and its a win-win. If the banks collapse your hedge is worthless but your physical is probably worth more. If the banks dont collapse you have a nice put option to cover your potential capital losses.

Just an idea for all those doomsayers who read Roubini and post comments on the Telegraph.

Friday, 16 December 2011

UK Housing

“An Englishman’s home is his castle”
-Popular phrase

The UK in general has a strong attachment to its housing market. The apparent resilience of house prices in the UK since the financial crisis has been a source of much comment and analysis but I wanted to reconsider the broader issues in the market and look at potential remedies.

Clearly one of the key supports for house prices have been interest rates set by the Bank of England at just 0.5%. In the UK a large number of mortgages are indexed to the base rate plus or minus a number of basis points. Therefore for many homeowners interest payments on their mortgages are negligible. This has helped cushion the blow of rising unemployment and falling real incomes from driving a wave of repossessions. In fact the primary reason for the UK housing market remaining at such elevated levels is the distinct lack of repossessions.

The UK housing market has shown a distinctly different pattern from the US market where some areas have seen falls of more than 50% from their peak. I would suggest four primary reasons for this.
(i)                 More UK mortgages benefit from the extremely low BOE base rate. Many US subprime mortgages had punitively high fixed rates after the 2 year teaser rate expired. Most of UK mortgages are inherently more affordable.
(ii)               UK home loans are recourse loans. If you default on your mortgage the lender can pursue you for the difference between the outstanding balance and the realised price of the home. In many US states a mortgage is a non recourse loan. If your lender has recourse to chase you for your debt you are less likely to bail on the loan.
(iii)             Unemployment has risen more slowly and less drastically in the UK meaning more people can afford their mortgage payments by virtue of having an income. In the UK more workers found ways to move to part time or took a pay cut whereas it would appear in the US more workers simply were fired.
(iv)             Britons tend to have a greater psychological attachment to housing due to various historical and cultural factors. This is indicated by the composition of assets. People in the UK seldom own shares or other financial assets aside from funds held in pension plans as they have tended to view their homes as their primary asset leveraging up to buy the best home they can afford. Some of this makes sense as the UK has a scarcity of housing and tough laws on new development alongside a rising population. In the US far more families own equities and other financial assets so their personal wealth is more diversified.

A new factor is also starting to weigh on the market. A popular trend during the last decade was for a number of homeowners to acquire a second or third property as a buy-to-let investment. Often this was on the basis of potential capital gains i.e the tenant effectively finances the mortgage and the capital gains from rising house prices provide the owner with future investment gains. During the crisis buy-to-let homes saw a greater pickup in delinquencies as tenants lost their jobs and landlords looked to exit the properties having lost the hope of speculative capital gains. However this quickly abated. Now with rising rental yields, due to the shut down of mortgage finance to first time buyers meaning they are forced to rent, combined with potentially very low mortgage rates for landlords the rental yield now provides a spectacular income stream. This means that for both buy-to-let investors and forced mover home owners (those with a job offer abroad for instance) they no longer need to accept a potentially lower offer for their home than they paid for it – they can let it out instead. Market forces suggest over time the market will find equilibrium due to new supply of rental property coming to market but in the short term those renting are paying more.

I would say that in many ways buy-to-let has been very damaging to the UK economy and the housing market. In the past decade it drove up the price of housing across the board due to additional demand aside from normal household formation. Now buy-to-let is damaging the economy because it is creating a rentier class of private landlords. The charging of rent by what is generally an affluent older segment of the society against what is generally a younger generation who do not yet own homes is damaging to a consumer economy. This is because rising rents are another squeeze on real income. Further young people tend to spend more driving the economy by virtue of having young families and generating more activity. What we are seeing therefore is an accumulation of assets in the hands of one segment of society to the detriment of the wider society. Now I am not arguing that home ownership is a right for young people or a better alternative to renting. What I am saying is that this process is making society less equal and not from an equality of opportunity perspective. By this I mean even those with good jobs who have worked hard are finding the cost of accomodation in general prohibitive if they dont already own property whilst a number of older people are sitting on valuable assets, assets which they could not afford to buy again. This disincentivises productive employment and incentivises asset accumulation which is bad for economic growth.

Nepotism is on the rise and to my mind this is damaging for society. The so called ‘bank of mum and dad’ has become the primary option for young people today to stick up a deposit on a home or to buy one outright. So what we see is those families who are more affluent, who likely also hold more housing assets already, are able to buy or subsidise homes for their children. This is hardly the way one wants to see wealth being distributed in an economically liberal society. This is ironically in many ways a function of the economically liberal post-war society because it was probably those productive workers of the previous generation who were best able to afford housing and accumulate assets and who are now passing these down to their children. Any parent would want to provide for their children so this is understandable.
What troubles me most about the UK housing market is popular attitudes that I find when engaging people on the subject. For one thing the ‘recency effect’ means that people view ‘bricks and mortar’ as unequivocally the best investment they can make. This is because for a generation over the past 15-20 years house prices have risen steadily. I find it frankly absurd that young people are expressing anger that they are not being granted sufficient leverage to get on the housing ‘ladder.’ People should be considering why they should need such leverage in the first place. Government policy on this matter is highly contradictory with various shared ownership schemes designed to support the housing market by splitting said leverage between the first time buyer and government or local authorities. Surely the point is the housing is unaffordable? Why don’t people question why housing is unaffordable?

Further to this point I might add that George Osborne’s plan to sell up to 2 million social houses to tenants at up to a 50% discount is frankly *insane.* He claims the proceeds would be reinvested in new social housing but surely selling 2 social houses to build 1 more amounts to a massive depletion of social housing at a time when it is more in demand than ever. It is also a ridiculous gift of a discount to those lucky enough to have received social housing. But such a policy has a strong appeal to the British psyche and this highlights the strength of point (iv) above.

There is nothing wrong with renting per se however I should highlight the primary frustration of renters are two fold;
(i)                Rental protections in the UK are poor. Landlords can often evict tenants with as little as one to two months notice. Further tenants often cannot even paint the walls without the landlords say so. The issue is you cannot make you rented accommodation your home in the same fashion as you can if you buy it.
(ii)               The perception that renting is throwing money away paying someone else’s mortgage. This has some truth to it. With an amortising mortgage over time the payments become more capital and less interest and in the end one pays no more for their home. This especially makes sense when prices are rising as capital gains accrue to the borrower. However if prices are flat or falling then arguably the difference between renting and buying narrows (assuming payments are roughly equal). This is because when one rents a home one doesn’t pay for the maintenance, the new boiler, the new kitchen etc. All of these incidental costs add up over the tenure of a 25 year mortgage and beyond.

So this is the problem for the UK housing market. But what can be done?
(None of these ideas are my own in any sense, rather they are different arguments I have seen presented in various forums.)

A radical solution suggested would be a land tax of some form. In many ways this is actually a very intelligent idea. By shifting more of the tax base from income tax to asset taxes one can improve the utilisation of scarce assets and encourage more velocity of asset exchange. However I would argue that said tax should be levied on all property rather than being an obvious punitive ploy to play on resentment of the rich such as the Liberal Democrats' ‘mansion tax policy.’

If taxes were levied on housing and land based on size, value etc it would encourage more efficient use of housing. There would be a strong incentive for older people to downsize from large homes as their income from productivity reduces in retirement freeing up housing stock for larger, growing families. Similarly by reducing the tax burden on income one encourages greater productivity from workers and incentivises production and activity rather than asset hoarding and rent seeking behaviour. A limited version of this would be to raise marginal tax rates on rental income to disincentivise rent seeking.

 However I fear such a fundamental shift in the tax base as an asset tax would be highly unpopular. It would be highly unpopular because human nature suggests we would all like to accumulate enough assets to retire and seek rents from everybody else. Removing that option from people would make society fairer but I am not sure people want it to be fair – or rather they would probably rather have the chance to become a rentier than the certainty of living in a fairer society in aggregate.

At a more microeconomic level what the UK certainly needs is more housing stock. The lack of supply is one factor which has elevated prices and keeps them elevated. Strong incentives could be made through taxation/subsidy to encourage new developments of housing perhaps specifically for letting but built to a high standard. With many institutional investors (pension funds) looking to diversify away from financial assets due to high volatility, perceived counterparty risks and systematic risks investment into these kind of real assets could be attractive. This would have the added benefit of supporting the future pensions and pensionable income of those with defined contribution pensions or annuities by bringing stable cash flows to investors. This would have the added societal benefit of bringing rental income within a more regulated environment than private tenancies increasing social protections for tenants and income protections for landlords. Further institutional management would lower frictional costs through economies of scale.

People often present Germany as an excellent example of a society where people tend to rent as often as buy property. I would concur with this view but there are key structural differences in terms of rental protections for Germans vis-à-vis those available in the UK. In Germany one often rents a mere shell of a dwelling and brings all sorts of furniture and fittings to the home including the kitchen. This would be highly unusual in Britain where most rental properties are at least part furnished and it means that Germans can better customize their home to their preferences. It has some of the benefits of ownership with some of the benefits of renting. In addition German tenancies are usually longer (as you would expect when you just unpacked and fitted your kitchen) and better protected in terms of rights against eviction and intrusion. The UK would need a variety of structural reforms to move to this model.

What may change in the near term for UK housing?

A recession.

With the Eurozone slipping into one now and no end in sight to the austerity race to the bottom its hard to see the UK escaping a similar fate since the EU is our largest trading partner. With further rises in unemployment we may well see substantially lower costs of housing and renting in the UK. This could finally flush out much of the leverage in the system. But be careful what you wish for because such a scenario would likely bust the banks and sink the economy. It’s a sorry state I’m afraid and we are all in it together.

Thursday, 15 December 2011

The State of the Union

“The car is on fire, and there's no driver at the wheel
And the sewers are all muddied with a thousand lonely suicides
And a dark wind blows

The government is corrupt
And we're on so many drugs
With the radio on and the curtains drawn

We're trapped in the belly of this horrible machine
And the machine is bleeding to death

The sun has fallen down
And the billboards are all leering
And the flags are all dead at the top of their poles”

Dead Flag Blues’ – Godspeed you Black Emperor!

There is an excellent piece out today on inequality:

Personally I don’t see the 1% or the 0.1% as some form of the illuminati. Such conspiracy theories tend to overestimate the power of conscious intention. Rather these issues are functions of human nature. People want to pull up the ladder and close the door right after they get on board the ship of privilege.

Everyone agrees that social mobility is a good thing, but nobody wants their children to move down the ladder. Parents in the professions are hardly about to start getting their children work experience as taxi drivers and shop assistants.

This is why society needs balance with strong and open institutions and this was how the American political and education system was initially conceived with a trilogy of political institutions to bring checks and balances to the system of exercising political power and open access to education for all. The recent paralysis in US policymaking shows what happens when faith in the system has totally evaporated.

The problem is corruption and regulatory capture across the board by vested interested doing at a microeconomic level what is best for them. However this corruption lives within all of us. If you believe you don’t share this corruption at all you are likely the most corruptible of individuals. It takes an impeccable spirit to resist the impulses of corruption. The corruption has its seed in arrogance and the arrogance of the revolutionary is as great as the arrogance of the incumbent. As can be seen in the various revolutions of the 20th Century those who replaced the previous regimes arguably replaced them with something far worse and more murderous (Khmer Rouge, Stalinism, Maoism).

What is required now is a transcendence of existing arguments and factions towards something greater because at present US politics is a race to the bottom. As my mother would say “two wrongs don’t make a right.” One would do well to remember this when pointing the finger of blame.

The vague OWS objectives reflect the same issue with tired and fractious policies. They know what they don’t want but don’t know what they do want. Across the board we seem to have a society devoid of new ideas and creative impulses. The current system is literally tearing apart the institutions and civilization which has been built over the past few centuries.

One would have to side with Einstein on this one;

“You cannot solve a problem from the same consciousness that created it. You must learn to see the world anew.”

Wednesday, 14 December 2011

Why higher petrol prices are a good thing

"Adrian Tink, Senior Media Relations Manager / RAC Motoring Strategist said, ‘It’s a victory for common sense. With people paying in excess of £1300 per year just to go about their daily lives this needs to the first, not the last, step. This is welcome short term relief, but what is the Chancellor’s plan if prices keep going up next year’"

Like most people I have a car which fortunately I don’t drive regularly due the nature of metropolitan life. However with petrol in the UK now above £1.30 a litre there is continued pressure on the government, retailers and oil companies to reduce the price at the pumps. This has led to various short sighted policy responses such as the increase in taxes on North Sea oil producers (something done in such a cavalier fashion that it could have been promoted by PDVSA). I do however agree with a medium term freeze in duties but in general I support the duties and I disagree that fuel costs for consumers are ever a matter of ‘common sense.’

The reality of fuel prices at the pumps in the UK is that most of the cost goes to the government as the illustration from indicates:

When you fill up your government takes the lion’s share of the revenue via duty and they then slap VAT on top of the cost which includes their own duty! Now clearly with duty rises over the past few years alongside a substantial rise in oil prices from greater demand and tighter supply globally many decry the cost of fuel in the UK. I have a great deal of sympathy for those negatively affected by this which is basically; everyone.

I used to feel very strongly that the government tax take was something of a crime but now I feel quite the opposite. The reality is that taxes on fuel reduce demand for fuels in the short term and therefore promote all kinds of innovation in the medium to long term. Fuel efficiency of modern vehicles is astounding compared even to 10 years ago. The other substantial change we are seeing is in downsizing of engines. Where BMW expected the 530d to lead sales 10 years ago today it will be the 520d as customers seek cheaper fuel and tax. Even high powered cars are following the trend with Audi dropping its V10 and V8 powerplants for turbocharged V6 units in its RS cars.

Taxation on transport is clearly a political issue and to my mind one of the most unfair and bizarre aspects of motoring taxation is the Vehicle Excise Duty. VED is a subsidy paid by all those who use their cars infrequenty to all those who use their cars substantially. This is because VED is levied on the emissions per mile of the vehicle regardless of the actual milage travelled per annum. Therefore one could be paying over £400 on VED for a Ferrari which they drive one thousand miles per annum whereas one could also pay £0 VED for a Fiat 500 Twinair which they drive 100,000 miles per annum. Arguably all taxation on motoring should be levied via fuel duties as this would capture actual consumption of fuel and align taxation incentives with environmental concerns to reduce CO2. As clearly the Ferrari owner with a thirsty V12 will produce a lot more CO2 and use a lot more fuel per mile than the Fiat owner. But he will also travel far fewer miles. The production of CO2 and the fuel consumption of an engine are obviously highly correlated and this would be the most fair system to tax motoring. However it is also politically unpopular because clearly people want owners of powerful cars to pay more than those of ordinary cars as its seen as something of a tax on wealth - since a Ferrari is only ever a status symbol and an indulgence.

There is no cure for high prices like high prices.

The popular sentiment appears to be that higher fuel prices are curtailing economic growth and reducing consumer spending and given that the government has substantial pricing power on fuels they should cushion the impact of higher fuel prices. This seems fair but it betrays the economic incentives created by higher fuel prices. Higher fuel prices incentivise investment in public transport (as well as making it comparatively cheaper – although to my mind its still as expensive as driving), they disincentivise wasted journeys and they drive innovation. Why should we have a right to cheaper fuel? Why should it be the case that people need to commute for tens of miles a day to workplace? We should be asking these questions about our use of fuel aside from demanding lower prices.

As an example compare European vehicles with those used in the United States. In Europe high taxes on fuel over the past two decades have driven innovation and promoted thrift. Most cars have four cylinders, engines less than 2litres in capacity and turbocharging alongside being (at least more recently) predominantly diesel. This results in high fuel efficiency and less waste which alongside the huge tax take as a percentage of the price of the fuel cushions the impact of oil price volatility on consumer spending. In Europe as a whole we now use less fuel than 10 years ago which is in contrast to every other region on the planet. 

Contrast this with the United States where taxes on fuel are extremely low. In the US most cars have at least 6 cylinders, the turbo is a rare sight and people drive replicas of an armoured vehicle. Now certainly part of the explanation of US driving habits is geography – distances are far greater and public transport links far weaker. But arguably with higher fuel prices the building of public transport links would become more economically viable creating long term infrastructure investment. The low hanging fruit of all Americans moving to European levels of motoring efficiency would have a massive depressing effect on the price of oil globally. This process is already happening as the twin oil price shocks of 2008 and 2011 have pushed US consumers to more economical vehicle choices especially after the period of moderate oil prices that prevailed between the gulf war and 2007 which caused all sorts of crazy auto buying of V8 SUVs.

The danger of pricing fuel at depressed levels is best illustrated by an extreme example; Argentina. Following the collapse of the economy in 2001 the Argentine government has supressed the price of fuel and natural gas paid by consumers using first their great internal resources of oil and gas and later in the decade fuel subsidies paid for by export taxes. In Argentina one can leave the air conditioning on at home all day, the heating on all winter and drive about in old and inefficient cars because prices are so bizarrely low. (In Argentina I saw cars like the Renault 9  which I haven’t seen in two decades in Europe!) This has meant that over the past 10 years the oil and gas resources of Argentina have collapsed as they have been pillaged by overuse resulting from supply priced at near marginal cost of production levels and of course no incentive to invest in new resources.

Now the Argentine scenario is an extreme case of the government subsidising fuel but I would say the European model of fuel taxes is more progressive for investment in alternative energy sources and in insulating consumers from the volatility of the global oil price. The Argentine system insulates consumers but it is now crippling government expenditures. Clearly the US tax neutral position still encourages good investment incentives but arguably it also leaves the US much more vulnerable to global swings in oil prices.

The reality for oil and fuel is that prices will remain high. Historically consumers adjust to the new high price level. The fuel protests in the UK in 2000 when fuel breached 80p a litre have never been repeated even with prices at £1.30 today. Consumers have adjusted consumption and bought more fuel efficient cars. They have also accepted what may be a reality that higher oil prices are here to stay as are the high taxes which governments rely on in times of austerity. In the short term one suffers but in the long term one adapts. Arguably the UK consumer should be thanking their government for insulating them against price volatility in oil so at least one knows what one is likely to spend on fuel in years to come. The answer is; more.

As a footnote I would also add that arguably a petrol car is a better investment today than a diesel one. The money saved on a diesel car in terms of fuel consumption is predicated on a relatively tight spread of diesel to gasoline. Historically this has been so with Europe net importing diesel and exporting gasoline and the US doing the opposite. However with most emerging markets growth being fuelled by diesel one could expect the spread to widen as diesel demand grows faster than gasoline demand in the future. This could potentially erode the gains of the extra miles per gallon of diesel. In addition your asthmatic children might thank you as petrol produces fewer harmful particulates than diesel (look at what comes out of diesel car when someone puts their foot down!). Diesel does produce less CO2 but in total it is certainly more polluting which is where various environmental groups seem to have missed a trick.

Tuesday, 13 December 2011

The politics of denial

“When people accept futility and the absurd as normal, the culture is decadent. The term is not a slur; it is a technical label.”

– Jacques Barzun ‘From Dawn to Decadence.’

In many ways the present crisis in Europe is quite clearly as much a political as an economic crisis. The Eurozone for instance is not suffering from a solvency crisis but rather a balance of payments issue. It has all the tools to resolve questions of solvency in the ECB and a collective of wealthy nations with ripe assets and productive peoples. The issue rather is political and navigating a political course in order to unlock the tools within the Eurozone to start to resolve its imbalances.

Unfortunately what has been thrown up by the Eurozone crisis is the complete lack of political will to do the deed. Perhaps I am flattering the intelligence of the European leadership but I think they do understand all of the problems they face and they can foresee a solution. I disagree with the broader chorus in columns and blogs expressing frustration at the leaders’ ability to grasp the seriousness of the crisis. But what has been exposed to my mind (aside from the obvious difficulty of the lack of political coordination) is the utter contempt that the political leaders have for their people. It is either that or their people should be held in utter contempt.

Never forget the power of denial. Even if said leaders understand the intractable pain that is inevitable for the Eurozone they cannot tell their people perhaps because their people do not want to hear it. This need to play up domestic interests seems to be ensuring the worst of all possible outcomes for the Eurozone. Are the educated people of Europe so foolish that they cannot see that there are now no solutions which are not painful. So either it is the arrogance of the leaders who believe that the people (who are allegedly sovereign) will never be able to accept the truth or it is the denial of the people who want to blame another for their crisis.

In the end perhaps it is both, because one has the leader one deserves. Remember the Italian people voted for Berlusconi; they voted for an endless sideshow of tacky game shows and bimbos. The French voted for an egoist who wants to cavort on the world stage but is so insecure he poses on his tip-toes for official photographs. Even in the UK we have a leader who is a baby faced replicant (h/t Charlie Brooker) and appears as some form of inoffensive catch all dummy.

Perhaps we need either a trickster or a heroic Cassandra to drag as through these turbulent times. Growth is hard (and I don’t just mean economic growth). Challenges and crisis that arise must be stood up to with faith and an honest inventory of options. But as so many comments from the public suggest on so many blogs and news articles what we would rather do is blame others.

Until we can take responsibility for our collective failings we cannot move on from this present crisis. Blame is the name of the game certainly in the UK. First people blamed the bankers, now it’s the public sector pensions, next it will be the eurocrats. But where were ordinary ‘families’ complaining when their houses were going up 10% a year? Nobody asked any questions as to why they were getting richer? There was no suspicion. Well now we all have a responsibility and a need to make sacrifices. Until we face up to this we will continue to have the leaders we deserve. Spineless individuals whose sole skill seems to be twisting the reality (its called spin) to advocate what is convenient for the politics of the day. Frankly this sounds like all of us. We believe what is convenient for us to believe. We want our denial and we don’t want to face the truth and we will slaughter those who shatter our collective illusions.

This crisis will likely ferment a new leadership arising from the disenfranchised of today. Perhaps once again we will have leaders emerging with honest hearts and a new conception of the way we should proceed. But not until we change our own hearts too.

“And so, my fellow Americans: ask not what your country can do for you - ask what you can do for your country.

My fellow citizens of the world: ask not what America will do for you, but what together we can do for the freedom of man.

Finally, whether you are citizens of America or citizens of the world, ask of us the same high standards of strength and sacrifice which we ask of you. With a good conscience our only sure reward, with history the final judge of our deeds, let us go forth to lead the land we love

- John F Kennedy

Remeber; Nobody is innocent.

Monday, 12 December 2011

The UK and the EU

The headlines this week in the UK are all about Cameron’s ‘historic’ veto in the EU and how this will change the future of Britain in the European union. I don’t think it is particularly historic or particularly important.

In many ways Cameron was able to do what all the Eurozone leaders wish they could have done which was play a popular policy for his domestic audience. I will go out on a limb here and suggest that the majority of British people are for the single market and against the politicisation of the European union. Culturally and linguistically Britons have far more in common with their own commonwealth and the Americans than with the majority of Europeans (whatever they are) so for Cameron to play the 'Britain first' card was an easy score for popular support back home. It was also something Sarkozy and Merkel would love to do but for their common straightjacket called the Euro.

They really set Cameron up with the proposed Financial Transaction Tax which would have hit the UK (which isn’t in the EZ anyway) the hardest since it houses 75% of all the financial trades in the EU. Excellent political genius to Merkozy and Barroso but Cameron just fell right into the trap – he might’ve mentioned French agricultural subsidies or suggested an EU wide tax on manufactured exports instead (hello Germany).

In many ways Cameron missed out on the subtleties of European politics in this move and set himself up to be painted as a pariah by the other EU leaders. He could have gone more Hungarian and rejected the deal, then realised it will never pass 25 (27 EU states less Hungary and the UK?) other national parliaments so they might as well agree and be ‘good Europeans.’ In the end it doesn’t matter because the EU or at least the Eurozone is clearly a sinking ship – so speculation on the future of the UK and its financial sector in the EU may well prove to be a moot point.

However all this cant of not being good Europeans betrays the extremely fragile position the European Unions now finds itself. If they must appeal to such abstract notions as a european common good then the project really is on its last legs. As Lao Tzu might say;

“When the Tao is lost, there is goodness.
When goodness is lost, there is morality.
When morality is lost, there is ritual.
Ritual is the husk of true faith,
the beginning of chaos.”

I would say we are pretty deep in the EU into ritual now if you permit me a little poetic license.

Wednesday, 7 December 2011

Plastromancy and Economic Forecasting

Whilst observing our captive economist today prognosticating on growth for different economies across the globe I was struck by the remarkable similarities between this art form and that of general and ancient practices of divination.

One needs a source of divination. For the economist it helps to have a number of charts and usually plots of trends and potentials. All sorts of interesting terms are bandied about to nuance the viewpoint ‘output gap’, ‘trend growth’ or ‘inflation expectations’ but interestingly none of these are wildly different from present levels. All scenarios as merely extrapolations of the ‘known’ when what we are faced with is an unknown and dynamic notional system dubbed ‘the economy.’ I have no bones with the use of these charts to understand and explain economic activity but what I can’t understand is how an economy (being a giant description of a huge, interconnected system of trade) can have a trend growth rate? Or where one can physically observe the output gap?

This to my mind is akin to divination from the charts just as the sages of ancient China used turtle shells burned in fires to read the cracks in the charred shell and offer views on the future. I will take a bold step and suggest that actually the ancient sage’s method was appropriate for the world view at the time just as economic explanations for many modern systems help people make decisions and the future. That may in fact be where the value of economic forecasting lies. It’s never correct but it’s another tool to make sense of the world. Perhaps in the future the science of economic forecasting will be resigned to the scrapheap of obsolete description of the world such as the four temperaments or the celestial spheres.

For my forecast I am selecting the Bible and the Pharaohs dream of seven fat cattle and seven thin cattle. Using this estimate I foresee an upswing in recovery from 2015 assuming the 2001-2008 fat trends persists to the next cycle.

Tuesday, 6 December 2011

A defence of Active Investing?

Are active investors akin to Pilot Fish or are they more like Ticks?

The paradox of active vs passive investing is that the active investors drive efficiency in the market but on average lose as much as win (lose more after fees) and passive investors get to benefit from active (apparently rational) capital allocation decisions but will be the nature of the product *never* outperform a given index.

Therefore for the individual investor with no market experience it makes sense to buy the index but if we all did this the markets would be horribly inefficient simply moving stocks up and down by free floats / liquidity from flows in the index - in addition pure index investing could create a vicious cycle of weights driving liquidity and liquidity driving weights. I often wonder now and in the future about the myriad of investment opportunities for individuals that could open up with an increasingly indexed stock market. For instance if you look at real dividend income yields and the whole index is getting dumped by passive funds potentially you can pick up solid income generating stocks at bargain prices/ This is different from the past where active fund managers might have sold down their cyclicals in preference of their defensive cash flow plays in a downturn. With some much automaton money out there it must create opportunities where the return of a stock is defined by more than just its buy and sell flows i.e where it returns cash to investors.

Part of the problem to my mind is the use of indexes. An index is a synthetic thing which is difficult to beat often by virtue of its own construction - for instance just like hedge fund returns indexes have a huge amount of survivorship bias - a fund can get stuck with a stock it cant sell that gets dumped out the index and lose a lot of performance, further a fund can find a stock dumped out the index resulting in forced selling and equally a loss of performance. Other issues include; when a stock moves in and out of the index it doesn’t suffer frictional costs, funds always hold some cash for liquidity purposes and that funds may be forced out of positions by their own flows. Now of course one could still argue that the fund manager still has a great chance to outperform the index through simple stock selection and this is true. But my experience is that clients want to micromanage their fund managers and micromanage their risk so its dangerous from fund managers to do much but hug the index tightly and try and squeeze out a little alpha against the aforementioned frictional headwinds.

I think the issue of benchmark investing is anathema to individual investors. These investors just want to make money on a total return basis against cash or some target return with relatively low risk. The issue on the institutional side is that between asset managers and investors there is a layer of consultants whose job it is to be a go-between for assets and asset managers and provide as lot of allocation type advice. Therefore they advise 10% in UK equities, 15% in Gilts etc so they then start looking for a fund which beats the UK equities market or Gilts market consistently.

Now clearly part of the criticism of active management is the fees and the amount of money the industry pays itself. This is fair to my mind as 1% a year off a mutual fund over a 30 year timeline is a serious take in terms of value for investors – equally 2 & 20 is something of a crime – although my favourite is the private equity model where the manager charges the investors to borrow their money in the form of called down capital – that is an astonishing financial Jedi mind trick. But discussions on fees ignore the scalability of the industry. One can manage a $1m or a $1bn with a very similar sized team of individuals. Arguably funds have better performance when they are smaller as they can trade the market rather than move it. This means in some ways the funds are self limiting; when they become too big they lose performance, lose clients and therefore lose fees. However a much fairer model to my mind would be something along the lines of a performance fee against a nominal total return benchmark and then an imputed management fee based on a cost plus model for the fund manager. I read somewhere that Michael Burry ran his hedge fund somewhat along these lines.

Finally there is the issue of value destruction via fees and trading which would appear to rob the world of its wealth. My criticism is this simplistic view takes no account whatsoever of the impossible to quantify benefits of efficient capital allocation. When investors invest in IPOs they regularly lose money or sometimes make money (usually the former in my experience) but they also distribute capital. When investors favour one stock over another the preference helps drive relative returns in the market and lower the cost of capital for the presumably successful company again helping future economic growth by rewarding efficient and productive businesses with additional capital. You can’t quantify what the value of this is but the relationship between investors and wealth may well be at least as much symbiotic as parasitic if only investors weren't charging so much for the privilege.

Monday, 5 December 2011

Apparently The UK doesn’t make things any more

“And was Jerusalem builded here,
Among these dark Satanic Mills?”
-William Blake

So often you hear people decry the lack of manufacturing in the UK and the loss of our industries. Whilst I was perusing the offerings on the box last night I caught the end of Robert Peston pontificating in his usual irritating manner about the crisis in the UK. At one point a middle aged man was seen outside a factory in a high visibility jacket lamenting the loss of British industry. This was of course a lie! If one stayed tuned for the next show “how to build it” you would see the answer to the shift in British industry.

I won’t bore you with the details save one can catch the show on Iplayer in its entirety but this fascinating insight into the extremes of modern manufacturing highlighted exactly the kind of economic strength that Britain has in manufacturing. The show followed the story and the assembly of the Rolls Royce Trent jet engine. What it highlighted is the staggering level of R&D, craftsmanship, use of advanced materials and complex logistics that go into the endeavour of creating efficient, modern jet engines. One could see highly trained and skilled welders, research engineers and logistics managers at work in the factories – the kind of jobs their parents would be proud of them having. And Rolls aren’t the only British business making cutting edge quality goods; Range Rover are opening a new factory to build their Evoque mini 4x4, JCB are still hard at it making diggers, EADS make the wings for the A380 in the UK and most of the Formula One industry is developed in the UK.

It seems to me that the popular sentiment is that Britain does not make anything anymore. It is not hard to see why with the closure of so many factories and the loss of many businesses (MG Rover being a recent example). But with all the textiles industry, coal mining, potteries and steel mills closing over the last few decades people decry the loss of UK manufacturing. However how many parents would want their children working in a pottery? Mining Coal? Shovelling cement into bags? I am sure that people want to see their Children grow up as skilled graduates or apprentices designing the next generation jet engine fan blade or welding the fuel piping system of an A380 wing. These jobs require skills and education such that one can take pride in one’s work. Do people really want to return to the dehumanization of the industrial age with its dirt, grime and monontonous assembly lines? In many ways the service economies growth in the last 30 years has been a process of rehumanization bringing us closer again to the totality of human potential.

People don’t see the shift in society in the last 30 years from an industrial to a service based economy. I ask you how many times a year do you buy capital goods such as a kettle, a television or even a car? Not very often. In the past this was the basis of the economy. Today our lives are more complex. We demand more and we achieve more; instead ask how many services you consume in a year? How often do you fly abroad? Go for a massage? Require childcare? Take a languages course? Read a website? Enjoy a television programme? These things are services and just because you can’t lay your hand on it it doesn’t mean it isn’t produced and usually, by virtue of the fact of it requiring interpersonal exchange, these services are made in the UK. In fact the UK exports a huge amount of services to the rest of the world whilst it imports capital goods. I see no harm in this for a globalised economy.

The great trial of our times seems rather on how to mobilise, retrain, re-educate those whose skills are barely above the common Chinese labourer and whose costs of livings are substantially higher. This is the dark side of globalisation; the economic dislocation of those who cannot compete in the globalised age. It is here that the government should be focussing their energies on employment and development ensuring that high skilled jobs and training continue to make the UK a global power in manufacturing of high value added and high worth goods. The idea that we should return to the labour intensive industries of the last century as some kind of golden age whilst decrying the ‘sweat shops’ of Bangladesh seems absurd!

Growth in of course a virtue for the economy bringing more opportunity and better living standards but as we all know from experience growth is also painful.

Friday, 2 December 2011


The 2000 Film “Almost Famous”;

                                      PENNY LANE
                       How old are you?


                                      PENNY LANE
                       Me too.
                       How old are we really?


                                      PENNY LANE
                       Me too.

                       Actually I'm 16.

                                      PENNY LANE
                       Me too.  Isn't it funny?  The truth
                       just sounds Different.

                       I'm 15.

I watched “breakfast” on BBC today for 2 mins before I could not take it anymore. This media furore about Jeremy Clarkson’s comments on the public sector strike is ridiculous. If you look at what he said before he said that the ‘striking civil servants should be shot’ it was quite moderate and simply pointed out London was very quiet on the day of the strike (true). Then the presenters expressed surprise at his lack of vitriol! They wanted Clarkson to be more, well, more Clarkson-like! So he threw in a clear joke that they should all be shot just to please the presenters. (In some ways this may indicate he is becoming a parody of himself but that is beside the point.)

The point is it was a joke, and not an especially tasteful one, that attacked nobody personally. However these union types queue up to demand he be fired from the BBC! I mean we live in a democratic country with freedom of speech (within bounds) this kind of lack of any sense of humor would fit in nicely in a totalitarian state but otherwise people should just chill out. Instead the media makes a big deal of it spinning it out for days analyzing and commenting on a comment. Clearly the union leaders are enjoying the chance to extend their PR beyond the November 30th strike by lining up to condemn said comments but how does everyone involved feel when they go home at night and look in the mirror.

What I find funny abstracting myself from this situation is that it all appears to be theatre. These union chaps have to step up and play their part which is the ‘indignant, righteous union leader,’ as a few thousand of viewers played their part “the public offended on behalf of some notional group of ‘hard working teachers and nurses.’” Then the presenters play their part in stirring up reaction and so on. Whilst I can accept that in our society we are all actors, or advocates if you will, for our given jobs, roles, professions and allegiances the real issue is to remember that *you are acting.* If you forget this you lose your sense of humour and your sense of irony. Unison seeking legal advice on whether Clarkson should be referred to police is a case in point.

The truth just sounds different because, well, it sounds true. This is not what the news sounds like. Lowering the tone of our social discourse seems to be the aim of most live news media and current affairs shows. We all continue to live in the shadow of human nature but let us remember the comedy of it all while luxuriating in the tragedy.