:LPE:

Some interesting economic data coming out in the past two days and two spins being put on it. Labour economists at CEPR are suggesting contraction in 2007 and something like a recession - two consecutive quarters contraction of GDP, in most definitions. However, the Federal Reserve and the BoC are concerned about wage inflation and maybe even general price inflation, and are signalling no rate cuts (no-one thinks they will hike rates - although the BoC didn’t rule them out), so the central bankers are still hoping for the ’soft landing’ as the housing markets cools. The OECD was overall bullish on global prospects, suggesting that slow-down in North America would be off-set by growth elsewhere, except Japan. The FT contained OECD reprts suggesting that rises in equity in houses had kept pace with rises in personal debt, so that overall, US consumers were no worse off and would be able to cope with increasing costs of borrowing.

So, one scenario is recession in US in 2007, another still suggests slowdown but no recession, and worries somewhat about wage levels increasing and household debt financing. One friend said he’d hear a figure quoted - 60% chance of recession in 2007. So, a little better than half, according to someone.

Yes, it’s true, we have no clear idea how recessions come, are triggered, and will last. The economy, like all human affairs, is an open system, and one so chaotic as to defy close prediction.

Recent posts have noted (FT, Globe, others) that in the world of buying and selling firms, transactions this year have been markedly (i) privatizations and (ii) debt and cash deals. I speculated about the use of the record corporate profits being retained - and now, to speculate about the source of the debt being loaned to finance these transactions. There is some indication it is coming from private equity houses, hedge funds and the investment banks, who are lending this money and then laying off the loan risk in credit derivatives (for which there is a booming market, as noted earlier in posts). So, three questions arise: what is the nature of the loan risk, who is ‘holding’ it, through these swaps, and are those that are holding it best equipped to manage it? That is, are they able to monitor the credit risk and take steps to manage any problems arising?

One wonders, and I don’t have data on the buyers and sellers of credit derivatives. So I don’t know who is holding the risk. However, if enough borrowers see their debt downgraded, or interest rates (i.e., financing rates) rise enough, this arrangement begins to unwind and someone takes a loss. The bankers seem to know its coming, and are making hay while the sun shines, and no-one is really sure which event or series will set off the process.

An interesting development: there is a push on to have standardized clauses in credit derivative instruments that permit early re-payment of debt that does not trigger event of default (the US model does not include these, the Euro model does).

A few cases to watch this week out of the US SC: will they over-turn a low threshold for ‘conspiracy’ set in an appeal court (Bell Atlantic v. Twombly), which will feature a group of economists arguing that litigation is a “tax” on US business, and what is “too obvious” to obtain a patent (KSR v. Teleflex), which features a well-known Standford professor and critic of the obviousness standard testifying in defence of the current standard, and finally, whether the EPA has the right to refuse to regulate greenhouse gas emissions, if you can believe it. More news as events warrant.

I wrote a paper this fall on the comparative experiences of hedge and pension funds, and one of the major points to discuss was the implications for hedges of the entry into the capital markets of too many new players and too much hot money or blind investment. Well, it turns out hedges, especially those with the best reputations for returns, have been turning away money.

This is just one reaction we might expect, as the players attempt to control their market, their competitive advantage, their investor base. It has even more interesting implications for the control of secondary markets in hedge fund investments (funds of funds and the like), which hedges apparently seem intent on stifling. Secondary markets require consistent and open disclosure to perform ‘efficiently’, and this is something that hedges cannot do. So we have an interesting moment here in the development of capital markets - large blind investment partnerships under pressure to standardize a secondary market in their investments and resisting it through tried and tested means: non-standard clauses, lock-up clauses, penalties for withdrawl, limited investors, etc. This is ripe for theorizing.

The FT reports that Spitzer (Governor elect in NY) has nixed Paulson’s suggestions that Sar Ox get watered down (mostly) - and interestingly, says US capital market’s performance have little to do with Us corporate performance. Spitzer used the example of GM’s woes, which were outlined clearly in the NYT last year: its major costs are franchise agreements it cannot breach cheaply, and these agreements were part of its old business model.

But this analysis - while I agree - misses the point that London and now Chinese-based stock markets have done more business in raising money than the NYSE. Four years ago, the NYSE accounted for 50% of the world-wide equity financing, this year, 33%. I don’t have data on total securities - the US bond market is likely to be much larger than the other two, and US capital markets may still be dominant. And this analysis fails to state the most obvious fact, and that is that on average Wall St. bankers fees are higher than anyone else’s in the world (something Paulson knows very well) and this year, a boom for M&A activity, they are going to be higher than ever.

Looks like Kramnik might have thrown a game against Deep Fritz today - I’m a crappy chess player, but it’s such an obvious mate that it is hard to believe he didn’t intend the result. For the summary,

http://www.spiegel.de/static/chessbase/client3.swf

Last week’s Globe reported that Skye’s attempt to sell itself to its largest shareholder, or other mining giant, failed when no-one turned up to buy it. Link.

This is pretty interesting given the red-hot market for Canadian mining companies: no-one was biting at all. It is hard to say why, but two reasons could be that it needs about a billion dollars to get the Guatemalan concessions up and running (something Inco decided not to do 30 years ago, and since decided to spin off). Nickel prices are at historic highs at the moment, so, one would think that if there was a way to get the stuff out of the ground, now would be the most promising time to do so. For the same reason, mining giants, with inflated balance sheets and retained earnings from the boom in commodity prices, are wandering around the globe looking for acquisitions. So, why the lack of interest?

One reason is may be that there is significant community opposition to the concession and the mine in Guatemala, a sort of risk that is hard to measure and price into your model.

So Skye is thinking of turning to the equity markets for the cash to develop its claim: in today’s market, the most expensive way to raise money. It is seeking $80M at first. Quite apart from the political risk I mention above, why anyone would buy these shares and warrants is beyond me, when the cheaper way was rejected by the most knowledgable investors in this business (other big players), and second, when $80M does not represent any real start. We know the mine is there, we know what is there, we know what the fixed costs to bring it online and processed are: there is no significant further exploration. What will $80M do aside from tide management over for another year or two, and dilute existing equity. The market seems to agree, as its shares have slid down a 30% slope for the past two weeks.

UPDATE: After rooting around on the listserves, a significant fact helps explain these developments: the Guate concession is nickel laterite, which has thus far proven to be very expensive and difficult to refine. Skye claims to have a new refining process, but to date most new refining processes have been marked by cost over-runs. Here’s the summary: (thanks, Andy.)

Many of you on the list may have noted that nickel laterite, rather than sulphide, production has been hit by big cost over-runs, nearly all of which have been down to experimental new forms of leaching. While HPAL (high pressure acid leaching) has been the main problem, and Murrin Murrin the most obvious example of where it has gone wrong, any company promising a new, patented production method to get at both the limonite & saprolite layers [is still speculative investment].

Last post noted record profits in corporate Canada, and asked where the money was going. Some evidence last week suggests a hypothesis: to finance the M&A binge. Last Monday was the largest day ever, globally, for M&A activity, with a total of $75 bn worth of transactions announced in 24 hours. The Financial Times interviewed the M&A bankers doing the deals, and they report that they are:

+ cash and debt deals, not equity deals
+ not IPOs (consequently), but are taking business private
+ private equity houses (purcahsers) are awash in cash looking for a place to spend
+ prices are soaring as a result

The Globe reported yesterday similar statistics in the Canadian context. M&A activity saw $90 bn of deals in the 3rd quarter, the highest in any quarter in history (higher than the dot.com era). The Globe’s reporting cited the same factors: cheap debt, cash deals, and in the Canadian context in particular, high commodity prices.

So, what do we have? Retained earnings and cheap debt being used to finance merger transactions at record paces. Whether there are underlying ‘fundamentals’ that make these efficient transactions - and therefore, worth the time and money they take - will not be clear for some time. The past 15 years record on M&As is mixed at best, and there is some evidence to suggest these types of deals do not increase long-term business valuations or derivatives of that, such as share prices. Equally as possible is that this represents another re-arrangement of ownership patterns among elite owners and managers, particularly because of the number of going-private transactions. Another troubling aspect of these deals - as has been written here before - is the role of credit in them: the cheap credit and the credit being provided by hedge funds and other private bodies is difficult to measure and track, and therefore, we do not know who is ‘holding the bag’, if adverse conditions hit particular, markets or there is a secular economic slow-down. For example, a larger percentage of corporate debt is being downgraded to below investor status (there is more ‘junk’ debt around), and it is still unclear whether these are mis-pricings (overly pessimistic) or an indicator of overall less creditworthy and less profitable corporate North America (if we can still use that geographic term). Although ’systemic risk’ is an inexact term that is very difficult to operationalize, it is never-the-less the term used by central bankers and other guardians of the financial system, and these market trends ought to be concerning them.

Stats Can quarterly measurement of profits shows the continuing increase in profits before taxes - aka retained earnings - of Canadian enterprises (which exclude public corporations). In short, as has been said here before, corporations are sitting on piles of cash. This is in part fuelling the M&A binge - more on this next post, as last Tuesday, there was a $75bn binge of deals in 24 hours world-wide - and in part was one of the justifications of the trust form, disgorging these profits to unitholders. Dividends have gone up, but sadly, we are not seeing wages or re-investment rise nearly as quickly…if at all. So, where does the money go? A good question. Graph from Stats Can.

Manning and Harris have weighed in on freedom and prosperity in Canada, via a Fraser Institute working paper. There are so many problems with this report it is hard to take it seriously. It is firmly rooted in economic theory that has been disproved or cast in serious doubt by the past 15 years’ research, and few advocate it but a small fringe of the economists community that cling, for perhaps ideological reasons, to its central tenets. Some initial thoughts:

Claim: individuals lack the freedom to make economic decisions and this limits economic growth.

This is not merely an economic argument, but one of political economy and even political or legal philosophy. The final section of the report deals more comprehensively with this underlying reasoning behind the key term “economic freedom”. What does that mean? It is beyond this post to draft a full critique (ahh, another paper to write), but the authors say that less government and lower taxes is the same as more freedom, and individuals receiving more money is more freedom. Few can argue that more money is a good thing, but less government doesn not necessarily mean more money for individuals, and in fact it can mean less wealth for some individuals. Their claim is that individuals spend more efficiently or wisely than governments. This is just not true in many situations - not only ‘market failure’ situations, which typically justifies government intervention in economic relations - but also on other bases, including moral or social goals of a society. We know, for example, that people do not rationally measure costs and benefits over the long term, which justifies subsidized education and public health insurance and pensions among other things. But we also justify those on moral or social values, and both justify government intervention in those industries, and also, general taxation (in a neutral, equitable, progressive and administratively efficient manner) to pay for them. There are many other examples of these very justified interventions producing the kind of society we want. The euphemism about ‘right-sizing’ government is another way of saying ‘privatize’ or ‘end social programs’ and the like.

This is a massive debate, with many social and political dimensions, and this report, presenting it as a choice between more freedom and less freedom is barely worthy of consideration - my nine-year-old daughter could come up with a more nuanced and appropriate framework to discuss the complexities of these issues.

To support their conclusions about what the right meaning of ‘economic freedom’ is, the authors cite over 100 sources, stating that there is “clear” and “persuasive” evidence of their claims. Take a look at those sources: they do not represent the full cross-section of evidence available on these issues, are often drawn from sympathetic sources (e.g., other Fraser Institute reports), from academics with the same policy objectives, from sources which themselves have been critiqued. There is not consideration of contrary evidence or opinion, and a discussion of why their view is the better one. It is a little bit like saying “tax cuts are good” and pointing to the papers published by the Tax Cutds Are Good Society as incontrovertible evidence.

Added to this simple-minded policy choice and biased data-set is the very biased vocuabulary - as a research or academic policy paper, they ought to be embarrassed by this poor vocuabular - full of what Jeremy Bentham called “question-begging epithets”, such as “tax burdens” or “economic freedom” or “right-sizing” , which, by the very selection of terms, implies the conclusion that is to be reached in advance of debate and consideration of the evidence. This paper would fail most peer reviews.

As just one example of how this proposition about ‘economic freedom’ has been debunked, please see Milton Freidman’s work on this idea of the connection between free markets and democracy, which was at the time critiqued heavily, and which since then has been largely abandoned. It is rather sad to see Canadian policy-makers re-adopting the long-debunked policy prescriptions of a U.S. economist, after both theory and practice have abandoned them as unworkable. Keynes was right…

Finally, as just one counter-example: over 50 years ago there was a very lively debate about what ‘economic freedom’ meant in legal theory and philosophy, a debate continued in various forms in the US (CLS) schools and Continental (Frankfurt) schools, which early on discovered that ‘freedom’ was a very relative and blunt term, and that proper state intervention did much to ameliorate conditions of unfreedom for the vast majority of the citizens of any state. In other words, it is a more coimplicated picture than freedom versus serfdom, and the state’s role is often very positive in making things better. This is a series of arguments that these authors do not seem to be able to consider, even conceive.

Claim: Canada’s public sector is too large, and does not produce wealth, or not as much s the private
sector.

I’ll keep this short: there is plenty of economic evidence that public sector spending produces as much or more wealth than private sector spending. This contention is controversial and not supported by a majority of economists. In reality, public and private sectors are so intertwined that this a meaningless prescription. Or, if we took it very seriously, we would immediately cut all military spending, which is incredibly unproductive in these terms.

Claim: tax cuts cause economic growth, and pay for themselves. Once again, this argument has been disproved again and again since 1980, and most recently in the U.S. Yes, tax cuts cause some economic growth, but government spending almost always causes more for the same money spent, and moreover, tax cuts do not really pay for themselves (by increasing revenues on the new growth). The main reason is that tax cuts get spent by individuals or companies at their discretion, and the richer you are, the more you can save or spend overseas.

I could go on, but it hardly seems worth it…