The Corporate Paradox: Communism inside a Capitalist Entity

I'm sure there is more extensive research on this out there but I was recently struck by a discussion I had with a colleague about the nature of capitalism and the players that act in it.  The crux of this post is that it is a strange dichotomy where the main players in our capitalist system - i.e. the corporations (especially the large institutionalised ones) work more like a communist economy internally while spouting the benefits of capitalism and free markets externally.

In several posts before I have identified as a 'realist capitalist'.  That is I know and appreciate the benefits of free markets and capitalism however I do not think they are perfect and we add enough distortions to the system which means that rational actors do things and act in ways which are perfectly rational from an economic standpoint (such as forming unions).  I think that accepting the rhetoric of capitalism and ignoring it's shortfalls are dangerous and leads to bad policy outcomes.  Besides which - it can be a fun thought exercise.

Corporate entities often work like communist economies

Most people would call me out for being ridiculous for suggesting that the bastion of free market capitalism - the corporation - is more like a communist government than the free market hero they position themselves at.  They may be a free market hero when they are operating as an entity as a whole but if you look through to how corporations (especially large institutionalised ones) actually work...they are remarkably like a communist economy.

You can take this analogy quite far however at a very high level:

• Like communist countries, corporations are centrally planned
• Corporations have a very strict hierarchy of control and the ability for any part of the corporation to act economically independently of another to maximise their own profitability or outcomes is squashed for the greater good of the corporation
• Like communist countries workers within a corporation rarely have an input into their job function
• There is an allocation of labour in corporations based on where the resources are needed and people find themselves often doing things that they originally didn't come on for because that is where they were needed...a system awfully like that of communism
• I'm not saying that you cannot leave the corporation...just that if you want to stay in it you need to play within these rules
• Ideas and independent initiative are subject to approval of those further up the chain 
• How often have you seen employees of a corporation come up with and implement independent ideas without the approval of their managers and how often can they quickly respond to a need or want without this approval?
• If a corporation acted like the free market bastion it claimed to be there would be a maximising out outcomes within the corporation through things like competition and innovation

You can keep going with this analogy for as long as you want - there is a centralised media strategy, only approved people are allowed to set strategy and to message this strategy to the outside world etc. etc. 

Yet corporations are often the most vocal proponents of capitalism

I find it incredibly ironic that probably the most centrally planned entities within our free market economy are the ones that are constantly calling for deregulation and an ability

Damn! No one seems to be over-reacting to the US Government Shut Down

About a week ago now the US government went into shut down after Democrats and Republicans could not pass a budget.  There are many causes of this - all political and I do not have a good enough understanding about US politics to understand how it is going to end or how long it is going to take.

Similarly, most people know that the likely economic effect will be bad if the shut down goes on for long enough but people do not know how bad or what the impact will be on confidence or markets generally.  There is much speculation and reporting out there on this very fact and it is not something I have a great deal of insight into so won't post about.

Why do I want people to over-react to the government shut down?

You may be wondering why then I am posting about it and why I seem disappointed (from the title of this article) that people are not over-reacting to the news.  The fact is that I am looking for a (personal) silver lining in the shut down.  Markets typically over-react to all news (good and bad alike) and this creates opportunities to buy or sell depending on which way the market goes.

I have posted recently on how the market had run so strongly and I was actually finding it hard to find places to invest.  I am not a short term investor nor am I in need of my invested money in the short term so I would be quite happy for the share market to tank temporarily (or even for a few months) which would give me the chance to invest some of the cash I have been building up.

Interest rates are so low at the moment that having this cash has been really inefficient however I have not found any value in the share market (other than some of my current holdings) so I have been sitting waiting for buying opportunities.

I want people to over-react.  Panic is good if you (as a rational individual) can control your own feelings and invest when others are panicking.

Unfortunately...people seem quite sensible about it this time around

I think one of the reasons that the markets are not over-reacting is that it very much seems like ground hog

The free market is not perfect: The case for unions

It has been a while but I thought I would return to one of my pet series of posts which attempts to provide a rational economic explanation for much of what we see around us.  Most people have a basic understanding of economics 101 however this is not enough.

There are those, especially on the political right who advocate the free market as the solution to all our problems.  The believe that market mechanisms are the most effective and efficient means of allocating resources and to the largest extent possible governments should keep out of this.  I believe this to be only partially true.  As I have posted about before, better outcomes often result if governments are around to enforce property rights and intellectual property rights which lead to innovation and better outcomes for society which would not result in a free market.

This time, I am going to stretch the bow a little further (and perhaps drive those free market advocates a little crazy).  I believe that unions are a product of the free market and rational actors and are a natural part of an economy where businesses are allowed to gain market power.

A union is a worker trying to improve their outcomes through scale

All of intuitively understand that the bigger an enterprise gets, the lower it's unit cost of production is.  This is one of the major benefits of scale.  However there are other benefits - if it is able to achieve some form of market power then it can influence pricing and extract monopoly rents from customers.

Unions are rational workers doing exactly the same thing.  They are achieving market power to deal with companies on a more even footing.  The negotiating position of an individual is minimal - you take what you are given (especially if you are replaceable), however the negotiating position of a workforce is formidable - a company cannot fire everybody if they want things made.  Just as the company would seek to extract monopoly rents if they are in a position to exercise market power, so are unions able to extract higher than market outcomes for their members if they have enough power in the system.

This is no better and no worse than the company making the money themselves.  There is often a rhetoric which suggests that it is good for companies to make large profits and it is bad for unions to demand a large share of the profitability of the company.  I do not view one outcome as

Why you should be wary of billionaire politicians

Super rich politicians are not a common feature of the Australian political landscape.  In fact when you talk about this phenomenon most Australians would refer you to the US where this is much more common.  However with the way that preferences are flowing in the 2013 election, it looks like Clive Palmer's Palmer United Party ('PUP') will pick up at least one seat in the lower house and  one seat in the upper house.

Why don't I like the idea of the super-rich being elected into government positions?

There are several reasons that having someone who is super rich in a position of power makes me uncomfortable.  Although there are no doubt exceptions to this the following common traits of the self made super rich make them unsuited to high political office in my opinion.

1. Their primary motivator has been self interest
• Self interest is what drives the capitalist model and all to often the best players in this model are those who are best able to advance their own self interest above the interests of others. 
• Elected officials are their to work for the people they represent.  Although it is possible, I am finding it hard to imagine a situation where a person who has worked for their own interests their entire lives, votes against these interests because it is better for their constituents
  
2. They are not used to being accountable
• When you have reached the levels that many of these super rich have reached, you are not used to be accountable to anyone, least of all a fickle public whose views you need to listen to if you are going to be an effective politician
  
3. I question their motives
• I could have been completely off the mark with my first point and self interest could have been replaced by a sense of civic duty
• If these billionaires cannot evidence this

Trickle down economics...separating self interest from good policy

I was on Facebook a few days ago when I noticed one of those annoying 'recommended pages' advertisements that look like your friends updates but are actually subtle advertising.  I was surprised to see Gina Rinehart posting a link to her website with what looked like a blog entry entitled "Gina Rinehart is our least controversial celebrity".

I questioned whether even Ms Rinehart would promote herself so blatantly and in such a crude fashion.  I think it is a fan site and I didn't bother reading it - I was much more interested in the comments under the post itself.  What genuinely surprised me was how much support there was for Ms Rinehart on the entries. There was actually far less trolling than I would have imagined and a rather lively debate on whether the policies and views she espouses were good or bad for Australia and how economic policy should work.

Although it was not clearly stated, I was reading a lay discussion about the relative merits of 'trickle down economics'

Trickle down economics is a term which is often used in a negative sense to refer to the idea that if you stimulate the top end of town - e.g. the wealthy and the business community through incentives, tax cuts and other financial means they will be incentivised to expand their business operations.  Although the immediate benefits in the short term go to business owners and those in the wealthier classes, the 'masses' also benefit as businesses are encouraged to hire people which results in job growth, wage growth and everyone benefits.

This is an argument that is seen much more in America than here in Australia and importantly - they have tried it.  During the Regan era policies designed around trickle down economics were introduced.  Here is a good summary from the Rachel Maddow show - the explanation starts around the 2 minute mark.

These sort of economic policies are promoted by conservatives all the time.  However, it is often hard to separate the truth from self interest and this is where my interest in the Gina Rinehart story came in.  A lot of her supporters were big believers in

Negative political advertisements about the economy have ALREADY started

I don't often watch television however happened to have very little to do a few days ago and so noticed something I wouldn't have ordinarily noticed.  The negative political advertisements about the economy have ALREADY started.  They have started before a general election has been called and, like most political advertising, is so biased an inaccurate as to be rather misleading.

For all my international readers, this post will be a complaint about the Australian electoral cycle however you may get some benefit when thinking about advertising in your home districts when you go through election cycles.

What sort of advertisements am I talking about?

I tried to find videos on YouTube which illustrated my point but appears that Australians do not bother enough to put their political advertising on YouTube and thankfully our politicians are not yet internet savvy enough to deploy the full gambit of internet advertising.  Alas, that means that I will need to describe for you the type of advertising I am talking about.

The particular advertisement that got to me was one in which the Liberal party pointed out that the Australian government was running up a deficit of $100m a day in 2009/2010 when Kevin Rudd was last leader of the Australian Labor party.   The implication of course being that with him now back in control, if you vote for him he is going to destroy the economy and pile on the national debt again.

It reminded me of an advertisement a few election cycles ago where the basic argument was that you could not trust the opposition party because every time they were in power interest rates rose, thus if you put them in power again, the interest rate that you pay on your home loan will go up again.

This happens at EVERY election cycle.  And both sides of politics play this game with different issues.  I am particularly concerned about economic policy and the Liberal party is typically the one that runs the advertisements about how the Labor party is going to ruin the economy and look at their past record.  The Labor party does it about other issues such as how the Liberal party cronies up the businesses and sticks it to the ordinary Australian worker.

Why do I hate these sort of advertisements?

I am passionately against any sort of advertising that relies on the fact that your electorate is uninformed and which feeds them a simplistic

The free market is NOT perfect: Property rights improve efficiencies

As outlined in my last post on this topic - 'The free market is NOT perfect: Knowing Economics 101 is not enough' - I will be doing a series of posts rebutting the claims of free market advocates masquerading as 'libertarians' that we would all be better off if the government was not involved in the free market.  Indeed the only way to create a more efficient society where everyone is better off is if the government stopped getting involved.

These points of view have been gaining momentum in recent times, especially in the United States, although I have noticed more and more people starting to join libertarian type organisations here in Australia as well.  Indeed, in the lead up to an election, these voices tend to get significantly louder.  I will be rebutting many of their claims in the coming weeks - however I am by no means left-leaning in my preferred economic outlook.  I believe that market mechanisms are broadly the most efficient because they most closely play to the human condition.  However I believe that the market is NOT perfect and that regulation and intervention is needed to maximise efficiencies.

If you want a truly free market...give up property rights

Free market advocates and the libertarian strain of these in particular rail against rules, regulations and government intervention in the operations of the markets claiming that all this does is create inefficiencies.

Fine libertarians...if you don't like rules and regulations then the first thing I want you to give up is property rights and see what that does to market efficiency.

Property rights form no part of a true free market economy.  By property rights I mean the right to

• Intellectual property rights including
• Patents
• Trademarks
• Physical property rights

If you truly want a free market

Emissions Trading Schemes...why would a conservative party oppose it?

If you live in Australia you will know that the Prime Minister, Kevin Rudd, announced that he wanted to move from a carbon tax to an emissions trading scheme (ETS) next year.  What was baffling to me, was the response of the opposition leader, Tony Abbott who is looking (according to the polls) like almost certainly being Australia's next Prime Minister.

I suggest reading this article for a brief overview on the comments made by both parties and I will do a brief overview of why I think Mr Abbott is just playing politics and assuming the Australian voter is exceedingly dumb.

Emissions Trading Schemes internalise negative externalities

Negative externalities are those outcomes of the 'free market' which are bad, however which are generally not taken into account in the price of the good or service being produced.  In the case of energy for example, coal is the cheapest form of fuel in a private sense (i.e. to dig out of the ground and to burn) however there is a social and environmental cost to this which does not get included in the price of coal.  However there is a very real cost to this which is borne by society in terms of environmental effects which need to be fixed / cleaned up by future governments and taxpayers.  This is what is known as an externality.

Note that externalities can be both positive and negative however they both face the same problem in a market economy - the benefits of positive externalities and the costs of negative ones are not included in the price of that product.

The solution to externalities is to try and internalise the cost or benefit in order to reflect the true cost of the product.  This often has to be done via regulation (especially in the case of negative externalities) as profit seeking enterprises are never going to voluntarily give up the lower private cost / higher social cost item.

An emissions trading scheme is a market mechanism to internalise the cost of carbon for those who pollute and it also offers 'credits' for those who do not pollute (e.g. for those who use or create renewable energy).  It is the right-wing, market method of accounting for a cost where the market fails.  A left wing measure would have been to put a tax on the product which

The free market is NOT perfect: "Knowing" Economics 101 is not enough

I have been thinking about this topic for a while actually and have spent the last week writing down my thoughts on it on various scraps of paper because I thought that I could make it into a series of posts which outline why I am not, nor have I ever been, a believer in the free market.

This may seem strange coming from an ex-investment banker, turned investment professional and also as a person who writes a blog tracking their wealth journey and sharing what my goals and aspirations are.  However I should state up front that government control is a sliding scale - an economy is NOT either free market capitalist or planned socialist.  There is no pure free market capitalist economy in the world just as there are very very few remaining planned socialist countries in the world.

Why did I start thinking about this?

I was motivated to think about this issue when I was watching some clips about the Tea Party movement in the US.  The whole movement struck me as fundamentally odd...the people protesting and joining these movements looked like those who most benefited from government programmes and assistance.  I also wondered about the economic policies and catch phrases that right wing politicians and free market advocates often throw out there which are so simplistic that they are effectively wrong.

And then it struck me...most of the general public has some appreciate of basic economics - they can see, think about and visualise simple economic concepts in a very real way around them.  However I do not believe that most of this same public has an innate understanding of the assumptions that underlie these 'simple' principals nor the consequences of what they are asking for when they demand a free market economy.

As I was thinking about how I would approach this series of posts though, one of my economist friends sent me a link to this article which explains how and why Econ 101 is killing America.  It is one of the best and most succinct articles I have ever seen.  It busts many of the myths that the general public has in their mind.  I highly recommend reading it.

Why does it matter?

It matters because as these movements start to gain steam and momentum, politicians and policy makers start to take notice.  There are some who would

The share market has gone mad...when bad news is good news

The financial markets and the investment world generally has gone mad.   When bad news is good news in the stock market and I see headlines in the financial news saying that the stock market rallied on weaker than expected financial news or that it was weaker on better than expected news you know that the markets are not working in their proper way and that something out of the ordinary is happening.

Even if you do not follow the financial markets closely you cannot have failed to notice the stock market tanking over the last month.  Indeed most major stock markets have lost the strong gains they have made since the start of the year.  One of the major causes of this was an announcement by Ben Bernanke of the US Federal Reserve that the economy was recovering to such an extent that they would consider starting to roll back QE3.

A recap on QE3

When QE3 was first announced I posted about it, what it was and why the share market reacted so strongly to it.

In brief QE3 was the US Federal Reserve printing money and buying back US Treasuries and mortgage backed securities to provide liquidity in the market

This was to force down interest rates and force lending to start as the yields on these products were depressed to levels so that people would have to invest elsewhere.

QE3 was only ever going to be a short term measure! 

You cannot continue printing money into infinity in order to provide liquidity in the market.  It was only going to be a short term measure to get the economy kick started again and guess what?  It worked.  The US economy started to recover strongly with economic growth rebounding and the share market reflecting this

So why did the market react so negatively towards the announcement that it would be scaled back?

I personally think that much of it has to do with how short term investment managers and profit makers are these days.  In the short term you would expect the share market to pull back as yields recover

How will the Australian 2013 - 2014 Federal Budget affect you?

The federal government's long anticipated 2013 - 2014 budget was released last night.  It was always going to see what the government did given:

• It is an election year and the Gillard Government is well behind in the polls
• Tax revenue and income to the government has fallen off a cliff with the slowing economic environment

I confess that although I am not particularly drawn to any political party, I have found the Gillard Government's fiscal policies to be frustrating and spineless.  This is probably a function of the hung parliament they have had to negotiate but it was nonetheless very frustrating.

From my point of view this budget surprised me - it was pragmatic, invests in Australia's future and does not do the pork barrelling and vote grabbing that most election year budgets do.  We are all going to be a little worse off but I do appreciate having a government that is willing to acknowledge that we are in a worse economic position now than we were a year ago and that does not spend just to grab votes.

So how will the 2013 - 2014 Australian Federal Budget affect you?

Like all things...it depends.  There isn't really something for everyone in this budget.  From an individual point of view there are not a great deal of positives and some negatives but it really has to do with how much you are already getting from the government (or not getting).

The benefits in the budget for individuals

• $14.3 billion in funding for the national disability insurance scheme
• If you have a disability this will definitely benefit you
• If you do not have a disability you may be disadvantaged through the increase in the medicare levy - see below
• Increased funding for public schools and education
• This will benefit the quality of educational institutions but there will be no hand outs to individuals like in the past
• I'm not against this at all - I think a good system is much better than giving people choice about where to spend their education dollars
• Note that this is for primary and secondary only...tertiary education did not get the same level of funding benefits
• Seniors funding
• $112.4m to help seniors who are downsizing their homes

The rest of the benefits do not really impact individuals at all - they are all about nation building.  It is about infrastructure (roads, rail) and other measures that only a government can fund.  If you're going to try and improve a country and an economy in the long run this is are the types of things that need to be funded.

Personally I got no real benefits from this budget but I'm just glad that we finally have a government that is thinking about the long term.

The downsides for individuals

• The baby bonus

Too Big to Fail by Andrew Ross Sorkin

Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System is an in depth look at the credit crunch from the time that Bear Sterns was bought by JP Morgan (it does not cover this in any great detail) to the introduction of the bail outs for the major US Banks.

This book is the most in depth look at the near collapse of the financial system in America (although it briefly touches on the impacts on the international financial system) and is the most in depth look at a financial crises since the 1990's classic Barbarians at the Gate which dealt with the takeover of RJR Nabisco.  It is written in a similar fashion as well - it looks at the crises from each individual bank CEO and senior management as well as regulators and investors. 

What Sorkin has attempted to do in this book, and does so amazingly effectively, is look at the financial crisis from every viewpoint so that we the reader understand what was going through the minds of decision makers when important decisions were being made (whether they were the right or wrong ones at the time).  It was a mammoth task and one that few books previously have emulated.

The necessary trade off for the amount of detail required is that this book takes a seriously long time to read if you are following all the detail.  I like to think that I am a rather quick reader however this book took me a very very long time to finish.  I enjoyed every moment of it. 

The beauty in a book like this is that most of us know the highlights - Lehman's fails, Morgan Stanley and Goldman Sachs become bank holding companies, AIG, Fannie Mae and Freddie Mac are effectively nationalised, the banks are bailed out etc etc.  Therefore we are not reading to see what happens but rather HOW it happens.  In this way the detail is not too much - we are reading for the detail, for the thought processes and for the insights that this book gives us into the way that CEO's, regulators and law makers think.

Because this book is not pushing one point of view or another, but rather going through a series of events, and these are from the view of the professionals involved in it it may seem like it is very much pro business and does not tackle the underlying flaws in the system.  But this book is not meant to preach - it is giving insights into what actually happened - not what should have happened.

Pros

• The level of information that author has been able to get from interviews etc is truly amazing - if you want the detail behind the effort to save Wall Street then this is the book for you
• It is not biased at all - you actually

Election Cycles: Voting is about self interest

In the midst of the US election cycle combined with the early shots fired in what is looking like being a very bitter and contentious Australian election cycle in 2014 I thought I would write a post on elections, voting and self interest. 

Politics is something I find particularly interesting, however being neither particularly left-wing (due to my blue collar upbringing) nor right wing (due to my current job and position) I find myself often torn between the various political parties.  This post will not be about who I think should run different countries but rather is a collection of thoughts about why people vote the way they do and perhaps how you should think about voting.

Voting is all about self interest

I have this core belief that voting is purely about self interest.  People vote for whomever they think will give them the best possible outcome.  It is unsurprising therefore that lower income earners tend to vote for the left leaning parties and higher income earners tend to vote for the right leaning parties.

There are of course exceptions to this - a commonly used term for a high income person voting left is a 'champagne sipping leftie' being a person who votes left but would vote right if they were voting in what would be perceived to be their traditional roles.  These people are not, however, exceptions to the rule - I think they are also voting in their self interest - you just have to define self interest a little bit broader

Self interest is more than just economic self interest

If you define self interest in a purely economic sense then you are going to have outliers like the one I described above.  Self interest however, is broader than this.  I believe there is 'utility' associated with doing what one perceives as social good.  This is why we give to charity - because it makes us feel good.

A quote that sums this up best in a political sense was when Gracchus,  Roman Senator in the movie Gladiator says

I do not pretend to be a man of the people...but I do try and be a man for the people

I think that altruism hides self interest though.  If the

What is QE3 and why did the share market react so strongly to it?

If you follow the share market at all you will have noticed that there was a major spike towards the end of last week as the US Federal Reserve announced that it would undertake QE3.  This post is a quick background for all those who were wondering why the market spiked so much last week and what the impact of QE3 will be going forward.

QE3 actually stands for a form of unconventional monetary policy known as quantitative easing.  The quantitative easing announced on Thursday last week was the third time the Federal Reserve had announced this policy would be implemented (and hence the 3)

What is Quantitative Easing?

As mentioned above quantitative easing is a form of monetary policy.  Normally when an economy is slowing or inflation is well below central bank target levels, the central bank (or Federal Reserve in this case) will step into the market and reduce interest rates to help stimulate demand in the economy. 

The problem that the US Federal Reserve had was that it had already reduced interest rates to effectively zero which means that they could do nothing further on this front to help stimulate demand in the economy.  Given interest rates can be changed on very short notice the Fed had even tried to extend the period which they were committed to these low interest rates (currently they say they will keep them low out to 2015).  This still did not have the desired result and so interest rates are effectively useless now.

The US Fed then turned to quantitative easing.  The basic idea of quantitative easing is to print money and use that money to buy back US Treasuries and mortgage backed securities to provide liquidity in the market.  The basic hope is that with the excess of capital now in the market that investments will be made in 'real world' assets or on consumption and so stimulate growth and fix the economy.

Why does it involve buying US Treasuries and mortgage backed securities?

Using the money to purchase US Treasuries and mortgage backed securities is a function of the current financial crisis

• There has been a general 'flight to safety' where money has flowed to those assets deemed most safe in the markets.  If you have a look at the yield on US Treasuries it is clear that this is where a lot of the money has been flowing.  The Fed's aim was to move some of this money out of US Treasuries by buying these bonds back and hopefully people will allocate their funds elsewhere in the market
• The market for mortgage backed securities is still very weak and people do not want to be buying these assets.  By providing liquidity for these markets it is hoped that funding will return to these markets so and effective borrowing costs for homeowners will come down

Why did the share market react so strongly?

There are several reasons the share market reacted so strongly:

• It is a pure demand / supply outcome.  If you have billions of dollars flowing into the market which have been created out of thin air then this increases demand for the same supply of stocks thus increasing the general level in the market
• It provides confidence  in the market.  There are some who believe that this is the first step on the road to recovery.  That the inflow of funds will help right the state of the US economy and that things will return to normal.  I am less confident about this.  Given this is the third time that the US Fed is introducing quantitative easing it suggests that the strategy is not all it is cracked up to be.  There is a downside as well - market participants start to expect this level of involvement from the government and when and if it stops the market will return to 'normal levels'

The outcome from QE3 is far from certain.  Over the last week we have seen the dust settle after the furor created by the announcement and general market sentiment and share prices start to pull back.  Perhaps it will be this round of quantitative easing that works or perhaps the Fed has done nothing more than create inflation through the printing of money.

Why don't banks pass on the full rate cut to homeowners

Throughout the world, homeowners would have noticed the phenomenon that while the 'official interest rate' has been dropping dramatically (in the case of the US it has gone to virtually zero), home mortgage rates have not dropped as much.

I'm not sure about the rest of the world, but in Australia where banks are still making record profits and where they have not had the bad debt issues seen in the rest of the world, every time there is a rate decrease of 0.25% and banks decrease their rates by something like 0.20% (i.e. do not pass on the full official rate cut) there is uproar - particularly among the politicians and the media.

I think this comes about because there is a fundamental misunderstanding around how home loan rates are set, how banks are funded and therefore why your interest rate does not go down as much as the official cash rate

Some basic finance first - how does the official interest rate work?

Reserve banks in different countries operate differently, however they fundamentally do the same thing.  They control one interest rate (typically a very short term one) and this interest rate influences all the other interest rates in the market.

The following description is from the Australian perspective.  Effectively what the RBA (Reserve Bank of Australia) does is control the overnight cash rate.  They do this by controlling the supply of funds available to banks in this overnight market (i.e. more funds mean a lower interest rate and vice versa).  A more in depth discussion of this is available at the RBA's official website - see link.

Because they control this interest rate they influence all the other interest rates in the economy.  This is because if this interest rate moved and none of the others didn't there would be an arbitrage opportunity.  Because of the constant work of traders at banks and other financial institutions such arbitrages don't exist.

So when the RBA decreases their interest rate, the market automatically moves the interest rates on all other interest bearing products.  While the banks theoretically could keep their interest rate the same and take the higher profit, what would happen would be that some other bank would try and gain market share and cut their cost.  As soon as they do this everyone else has to cut their mortgage costs as well.

OK so if official interest rates serve to move all interest rates - why aren't the cuts passed on in full?

This essentially comes down to how the banks are funded.  If I use the major Australian banks as an example.  Most of them are funded through a variety of sources but at the broadest level they have ~60% retail funding and 40% other (mostly wholesale) funding.

For Australia, most wholesale funding comes from international markets.  Therefore any changes to the official cash rate will only move the cost of funds for ~60% of their funding.  BUT where there is competition for deposits (such as term deposits) and banks are paying higher margins on these term deposits, much of the cost of debt will not get passed on.

In Australia over the last few years there have been several factors hitting the funding markets for banks.  Wholesale funding costs have been going up, as has the competition for retail deposits.  Against this the official cash interest rate has been coming down.  The result is that we definitely feel like we should be paying less.

The following diagram was one released by the Commonwealth Bank of Australia in their FY12 Results presentation in August 2012 and gives a great indication of why home loans have repriced in the way that they have (relative to the RBA cash rate) and the things that have been impacting them.



But doesn't that mean that when official interest rates are increasing the opposite should be true?

In short - yes.  However banks use this to recoup a lot of the losses they are forced to wear when interest rates are going down.  They also use this opportunity to 'profit gouge' to a large extent.  Therefore as consumers you should be more annoyed on the way up not on the way down because that is typically when you are actually getting screwed.

The Big Short by Michael Lewis

The Big Short by Michael Lewis, author of Liar’s Poker, is a well researched, although obviously biased, look at sub-prime debt crisis and the factors that led up to it.  The book has been on several best sellers lists and for good reason – it is the best book that I have read on the topic and is interesting even if you do not know anything about CDO’s, subprime debt, the US housing market and all the other factors that led to the crisis.

Although the book primarily focuses on the hedge funds (including a fund that was seeded by Joel Greenblatt, author of You Can Be a Stock Market Genius which was been previously reviewed on this site) that saw the crisis coming and made significant money out of it, Lewis also looks at the other players in the market including the buyers of the mortgage backed securities, the buyers of the credit default instruments, the investment banks that were pedalling the goods to everyone and the ratings agencies who were probably the reason that the whole thing came undone.

The strength in The Big Short is on Lewis’ ability to distil quite complex products and topics down to rather simple explanations of how they work and the relative pros and cons of either side of holding the product.  Also I liked how Lewis broadly arranged his books into time periods and then looked at that particular time period from every angle (i.e. pre-crisis when no one realised there was a problem, when people started to realise the issues, when the crisis became public knowledge etc)

As a last point of note, when I read this book I read it from the perspective of an investor (as that is what I do for a living).  However I was chatting about it to investment bankers who really focussed on the failings of their business model and incentives.  Again when chatting about it to those who have nothing to do with the financial industry the focus was on how the system failed.  There are so many different ways to interpret the lessons from this book and it all depends on the perspective you are reading it from.

Pros

Sector Allocations: Will stocks or bonds outperform?

When I posted my June 2012 expenditure tracker I mentioned that Iwas quite heavily weighted towards my share portfolio at the expense of my fixed income portfolio.  I also mentioned that I was quite happy for this to be the case in the foreseeable future because of the expected returns that the market was showing.  I shall expand on this second point here.

This post will go through the arguments in favour of allocating funds towards the share market instead of investing it in a fixed income portfolio.  Note that this does not take into account your financial position - if you are likely to need the funds within the next few years then it becomes a completely different story as they market may not have recovered yet.  For those, like myself, who have a long time to invest though I think the story is fairly compelling.

Identify the types of each investment that you would normally invest in

The first thing to do is to identify the types of stocks / bonds you would normally invest in and use this as the basis of your comparison.  Don't compare the returns of securities you know very little about or are unlikely to invest in because this will give you a distorted view of what your sector allocations should be.

For fixed income securities / bonds I am going to assume that the investor is looking at investment grade bonds in high yielding companies, probably through both unlisted and listed bond funds, government bonds, high interest savings accounts and using funds in offset accounts (which are effectively fixed interest securities).  A quick side note - those who have read my expenditure tracker posts would be used to me referring to my home loan offset account - I view this as a fixed income security because the interest I save is effectively a return on this money.

I am further going to assume that investors are not  looking at investing in distressed bonds.  If you know how to invest in distressed bonds and are comfortable investing in these then this may be the perfect market for you.  There are bonds within Europe that seem rediculously cheap however you need to be really good at evaluating and pricing the risks associated with this.  This is not an area I know well so I tend to steer well clear of it.

Similarly you need to identify what stocks you are most likely to invest in.  I am comfortable with both cyclical and defensive stocks so both of these form part of my investment portfolio.  I don't mind small cap though prefer to avoid micro cap stocks so this forms part of my investment comparison.

Look at the relative forecast returns of stocks vs bonds

Over the last few years (i.e. post the GFC) the bond market has had an unbelievable rally.  You only need to look at the prices of bond funds, espeically those relating to 'safe' government debt to see this.  This has been driven by low official interest rates especially in the US and Europe.  The price of German government debt is at virtually zero percent and you don't get a whole lot of return by investing in US treasuries either.  Savings accounts (the other major form of fixed interest for investors) are also offering very low returns as well.

The above low yield environment has given rise to P2P lending (such as the Lending Club) which offer more attractive yields but you get none of the safety associated with a bank and if you want diversification benefits then it is very time intensive for quite a poor return (relative to historical returns). 

Conversely the stock market has been jittery over almost the whole period.  Most markets had a partiuclarly good run at the start of 2012 but then gave up most of their gains in the following months.  Companies have (by and large) degeared from the heady days of the GFC and most are better run and leaner though are suffering because of a poor economy.  There are plenty of companies who have actually increased their distributions (I may put up a list of good ones sometime in the next week or two) but are being penalised because of general disenchantment with the economy and stock market.

Retail price differences across countries: economically sound...but very annoying

There has been a lot of press lately about the extent to which international congolomerates charge significantly different prices in different countries.  In fact it has become such a politically hot topic in Australia that the government launched an investigation into the issue and are holding parliamentary inquiries into the topic.  The Austrlaian Productivity Commission released a great report in 2011 which spelled out why there are pricing differences between different countries and it is definetely worth a read.

Retailers often try and explain the difference away by talking about higher minimum wage standards, the highest retail rent costs in the world, high costs to ship to Australia as well as high taxes.  Savvy consumers though have pointed out that even when you take these into account Australians still get significantly charged more for exactly the same product than overseas consumers do.  Actually the big issue is that (and this is spelled out pretty clearly in the Productivity Commission's report above) wholesale prices for Australian retailers are much higher than those incurred by retailers in other markets.  Thus it is the multinational manufacturers who are causing the significant price difference that Australian consumers face.

For anyone that has studied economics however the fact that companies that operate across countries charge different amounts for different products should not come as a suprise to anyone.  It all has to do with price discrimination which is charging different prices to different consumers to the same product.  This actually occurs all the time, you only have to look around you to see lots of examples such as:

• Discounts for seniors for the same products
• Concession rates for students
• Cheaper rates for those who choose to buy in bulk
• Cheaper prices on the same product but 'cheaper stores'

The common rebuttal to most of the above is that they get cheaper rates 'because they cannot afford to pay as much'.  Actually this is exactly the right answer - it all has to do with willingness to pay or what is also called elasticity of demand.  A full wage earner is willing to pay more for the same product for a senior or a student so if you as a seller can sell at one price to one consumer and one price to another you can maximise both demand for your product and the price you recieve (thus maximising your profits).

Thus companies that charge different prices to different countries of customers are doing exactly the same thing which as I mentioned above makes complete economic senese.  However the system only works as long as those who are paying the higher price have no way of buying the good for the lower price.  In traditional price discrimination companies use things like seniors / concessions cards / volume to seperate the lower paying customers from the higher ones. 

The current fly in the ointment for these companies though is parallel importers who make a profit by buying at the lower prices overseas and then selling over the internet into Australia.  Australian consumers are obviously loving this and helped by the exchange rate at record highs have been buying from overseas in larger and larger quantities.  Companies have responded by trying to ban their retailers from selling into Australia but have run up against competition issues (i.e. you run afoul of the competition laws in Australia because you essentially are forming an agreement to keep prices higher).

By doing this the companies have also put consumer offside.  Consumers now realise that they are being overcharged.  I think to some extent consumers are blaming the wrong people.  The people to blame are the multinationals not the Australian retailers.  It will be interesting to see where the issue ends up.  In the mean time I will continue to import my goods from overseas and avoid Australian retailers completeliy.

Next week I'm planning on doing a post seeing whether I can financial import a luxury car into Australia and save tens of thousands of dollars.  One of my friends sent me a spreadsheet which says it can be done but I'm going to test his assumptions to make sure.

Investing in shares: European Meltdown - Finding opportunities

In a previous post I outlined those areas which investors should probably avoid due to the uncertainty in the European investing environment.  In this post I will outline some areas where investors may find opportunities to get great value investments.

In my opinion the safest way to make good investment returns in Europe in the current prevailing environment is not to try and predict the way the markets will go or what business sectors will recover etc but rather to invest in those areas which are already fundamentally sound but which are being hit due to the general malaise in Europe.  It is the perfect buying environment for people who do not get emotionally involved in their investments because you can take advantage of terrible market sentiment to make great profits.  Not living in Europe is also a big advantage as you are removed from constant negative news flow etc and can focus purely on your companies and investments.

Below I have outlined areas where great investments can be found

1. Companies listed in Europe which have no operations in Europe:  There are several Asian companies that listed in Europe over the last few years (presumably to get international exposure) which have no operations in Europe.  These companies are exposed to the highest growth economies in the world, have absolutely no exposure to Europe in a business sense but their share prices have been smashed along with the rest of the European share market.
2. Small Cap stocks in Europe that are performing fundamentally well: In a 'risk off' environment like the one that currently prevails in Europe people only want to own the biggest 'blue chip' stocks and will not touch small caps with a ten foot pole because of their perceived riskiness regardless of how the business is doing.  As long as these businesses do not need to tap the funding markets they are a great place to find bargain investments.
3. Companies listed and operating in 'strong' European countries like Germany:   The big uncertainty with Europe is whether the EU will stay together or whether countries like Greece, Spain, Portugal etc will leave the Euro.  The uncertainty is causing the Euro to remain depressed and is affecting companies and stocks in almost every market in Europe.  Countries like Germany are actually performing extremely well.  As soon as certainty returns to the market (regardless of the outcome) these stocks should perform well.  Even if the Euro collapses and Germany goes back to the Deutschmark this will be a much stronger currency than the Euro currently is (as the Euro is dragged down by the poorly performing countries) so as an investor you win either way.

One thing that should be noted with investments like this is that they will not come off straight away or even within one or two years.  As an investor you are waiting for the market to settle down and for investors to 'realise' that these companies that they have been shunning are actually really good investments which drive the price up.  You are waiting for market sentiment to return to normal (the business does not need to improve for you to get your return although this may provide an extra kicker).

Occasionally you can find stocks which conform to all the above criteria.  An example is Kinghero AG which is a stock I'm invested in - it is a small cap, German listed clothing manufacturer and retailer which only operates in China.  There are plenty of others out there - all you have to do is look for them.

Disclaimer: I'm long Kinghero AG.  Also make sure you do your own research and get advice relatign to your pesonal situation.  This is not meant to be investment advice and investors should do their own evaluations of opportunities and stocks.

The 2012 - 2013 Australian Federal Government budget: An exercise in class welfare

I normally try and avoid posts which are very specific to one country / region because in fact most of my readers are not from my home country (Australia) but are spread across the world.  However at the same time this is a blog which also tracks my personal finance issues and as such sometimes this is unavoidable so this will be one of those posts. 

Last night the Australian Federal Government released their 2012/2013 budget (see the full budget here) which I confess was not surprising although a little disappointing.  Australia currently has a Labor government which is geared towards lower income and working class voters.  This budget was reflective of that with nearly all of the benefits going to lower income and working families and the costs effectively being bourne by all the other sections of society.  Key benefits provided by this budget include

• An extra $300 per week in family payments (not something that affects me)
• An extra $350 per annum for low income individuals as a cost of living allowance (again not affected personally)
• A significant small business benefit in the form of a loss carry-back which allow losses to be offset against previous years profits to help businesses back to profit.  This is a significant allowance for small businesses (however does not benefit me at the moment)
• Tax free threshold increased from $6,000 to $18,200 which means that ever working person in Australia will pay less tax (thankfully myself included)
• An extension of the payments to parents of school children for educational expenses

Given the current political climate in Australia this is an unsurprising result.  I confess that I was actually surprised at where the cuts came from.  I had expected them to come from the high income earners who had no family to speak of (and so did not get any of the benefits).  As I am in that category I was a little apprehensive of this budget.  In fact the largest savings came from:

• A cancelling of the proposed cut to company tax rates.  With the introduction of the Mining Resource Tax this year, much of the benefits were supposed to flow to pay for a cut in the corporate tax rate from 30% to 28% over the next few years.  This has been cancelled.  Although I think this will impact my share portfolio valuations it should not be too extreme and may be a time to buy if the market over-reacts
• Massive cuts in defence spending over the next 5 years: I admit that I thought that defence was one area they would never touch but this is where some of the biggest cuts are happening.  I'm not too fussed about this because (other than wanting to be safe) I have no real affiliation with this sector
• Cuts in public sector spending:  Canberra is going to be affected quite significantly with the significant budget cuts to public sector jobs.  Again this does not affect me a great deal.

If you have a family or are a lower income earner this budget should benefit you significantly.  However if you are like me and are trying to build wealth it doesn't really do anything for you.  Going through the budget in detail helps you understand a lot of what the news articles are about so I recommend this to anyone who is interested to know how their position is likely to change over the next year.

In terms of investing in Australian companies - nothing in the budget should make too much of a difference.  Nearly all the provisions were already flagged well in advance (such as the mineral resource rent tax and the carbon tax) so these have already been priced into the equities.