Sunday, 20 May 2012

Greece will stay in the Euro

A few months ago mention of the Euro currency area breaking up, of countries going back to a national currency, was officially verboten. Today the impossible has become the inevitable: between the crushing depression era poverty, the silent-but-deadly run on Greek banks, the clueless indifference of EU élites and the voters' flight from mainstream parties everyone is now confident that it's only a matter of time before Greece reverts to the Drachma and the Euro dream is officially over.

I think they're wrong. Today I bet* a modest sum that Greece will still be in the Euro at the end of 2012 and that the Euro will still exist as a currency in 2015. 

I wrote last week that there are only 3 possible ways out of the Euro problem:

1. Richer Euro members make large annual payments to poorer members.

2. Richer Euro members guarantee poorer members' debts.

3. The Euro breaks up.

All 3 solutions have been ruled impossible, but eventually at least one of them must happen. It's an interesting problem.

Media opinion seems to be swinging behind the idea that we're heading for breakup, but the more I think about the practical details of that the more I doubt that it will be allowed to happen. The logistics of the thing are overwhelmingly difficult and in the short term it will make life in Greece even worse, and already it's pretty bloody grim.

The argument for breakup is that it will cause even more short term pain, but in the long term things will be better. However, that's not the kind of decision that the EU's leaders tend to take. They do not like to be brave. They do not tackle difficult choices head on. They do not take a bold position and risk being wrong. 

Instead, they like to hide, to shrink from controversy, to smother people with warm words and euro-babble until their goal has been achieved without anyone really noticing. Most of all, they like to make the European Union bigger, grander and more powerful. For these reasons, and especially the last, I think they will do absolutely everything to avoid Euro break-up.

So we're back to impossible option 1 or impossible option 2. I suspect we will see a combination of the two: 

- a clear expression of solidarity that the whole eurozone will stand behind each of its members' debts. This is necessary (and hopefully sufficient!) to prevent the run on Greek banks which is already happening. I suspect mutual guarantees rather than official eurobonds, because it's fudgier and the EU likes to fudge.

- large cash transfers (which will be described as a temporary measure) to ease the burden on the Greek people, who are genuinely suffering. Offering more loans would be easier to sell, politically, but I think (or at least, I hope) they will realise that the arithmetic of even more debt simply doesn't work.

But the quid pro quo will be an enormous degree of EU control over national budgets, taxes and economic reform. The Fiscal Pact is just the beginning. If northern Europeans agree to underwrite and subsidise the Club Med states to this extent, then having different pension arrangements, employment protection, closed shop economies and so forth will become politically untenable. The south will have to reform and I can't see the north just trusting that they'll do it by themselves: it will be managed from Brussels.

Germany has benefited greatly from being in the Euro: its export-driven economy has been able to relentlessly sell goods to most of the rest of Europe without its currency rising, which would have made its exports dearer to foreigners. This has been a windfall for German businesses and a burden on almost everyone else. The Germans are not keen to acknowledge this, preferring the "hard working Germany, lazy southern neighbours" narrative, but it's true nonetheless. I think that will provide the cover to sell the idea.

The other benefit is that it avoids any dramatic climax. Money will be quietly bled from one group and given to another, but the hope will be that no one really notices and there'll be no key moment to galvanise opposition. That's exactly how the EU likes to operate. 

Coincidentally, the plan involves the EU becoming even more powerful at the expense of member states, which is really the only thing that they care about.

That's why, for my money, the Euro will survive and Greece will probably stay in it.

* William Hill offer a market to bet on the euro, albeit intermittently. They were offering 3 markets earlier today: Greece to leave Euro in 2012, Euro to still exist in 2015, and which country will be the first to leave. But this evening they are no longer taking bets on any of those markets. There was no explanation given, but I assume they'll reappear at some point. I presume that volatility is the reason, or perhaps they're only willing to take so much exposure. Ladbrokes have sometimes offered a market on the euro, as well.

Friday, 18 May 2012

Facebook is overvalued

You may have heard in the news that Facebook gained a stock market listing today, trading at around $38 per share. That values the company at $104 billion which is 88 times its annual earnings, or an earnings yield of about 1.1%. 

Oh, hold on, my phone's ringing.

That was the 90s on the phone, they want their insane tech stock valuations back. Actually, that's not fair: Facebook is at least profitable and cash generative, so we are spared idiotic analysis about rates of cash burn.

Personally, I am inclined to value Facebook at between $6.30 and $8.60 per share. That would value the company at 15 to 20 times its earnings or an earnings yield of 5% to 6.7%. If you feel really optimistic, maybe go to $10 which would be just over 23 times its earnings or 4.3% earnings yield. But $38 is just batshit insane, it's hard to see how anyone buying at that price will make money, other than by selling it to someone even more stupid (the Greater Fool Theory of investment).

Many would call my valuations over-cautious, especially all those people today who've paid 5 times my suggested price to buy Facebook shares. They will argue that Facebook is growing rapidly, will continue to grow rapidly, its future profits will be immense and I am an idiot to pass up such an opportunity. Perhaps that's true.

I would argue that Facebook's profits must grow about 500% even to justify today's price, and once they've grown by that amount those profits would still need to show strong signs of future growth if you expect to make any money as a shareholder. There is a vast reservoir of optimism baked into that $104 billion price. Even if the company does grow, its shareholders could lose money if the growth isn't rapid enough. As the economy recovers I'd expect advertising revenue to pick up, even so Facebook is a long way from demonstrating that it can actually generate $5 or $6 billion in profits; currently it's earning about $1.1 billion from revenues of $4 billion. Assuming it maintains its 24% profit margin, its revenues need to reach about $25 billion to justify today's price, and would need to look like continuing to grow from there. Maybe they will, maybe they won't.

There is also the risk that 2, 4 or 10 years from now people are just kinda bored with Facebook and go somewhere else. Ten years is a long time away: no one can predict online social trends so far into the future, but Facebook's price says they can predict at least that far. 

As it happens, the snack and beverage group Pepsico is valued at about the same price as Facebook: $106 billion on today's share price of $68. Last year they had $67 billion in revenue and earned $6 billion in net profits. Which company looks like the stronger bet? What are the odds that people are still drinking Pepsi, 7up, Tropicana, Mountain Dew or Lipton, while eating Walkers, Doritos or Lay's, or Quaker oats 10 years from now, versus the odds that Facebook is still going and has revues and profits 10x today's?

Just for fun, I'll track the revenue, profits and valuation of Pepsico and Facebook to see how things pan out. Feel free to bookmark this post so you can pop back periodically to laugh in my face, comments will remain open :)

All financial data from Yahoo! finance, correct as far as I'm aware. I've not personally taken a financial position in either Pepsico or Facebook.

Thursday, 17 May 2012

Every major's terrible

I'm a big fan of the XKCD comic, but Randall has truly surpassed himself with this effort. Genius.

If you need a refresher on the original, or want to sing along with the new lyrics, try this:


Inevitably, YouTube is now full of people performing this! I vote for this one as the pick of the crop:

Monday, 14 May 2012

Greek arms spending

Enlightened Economist Diane Coyle blogs about a surprising and little-reported area of Greek government spending: weapons.

Greek flag

She points out that by 2008 Greece was the 5th largest arms importer in the world, and the 2nd and 3rd largest customer for German and French arms exporters, respectively. France and Germany are Europe's biggest arms exporters. (The UK is 3rd)

Last year Greece spent 3.2% of its GDP on arms, the highest in Europe. Apart from big military spenders UK and France (2.6% and 2.3%) most European nations spend around 1.5% of GDP on arms. As it battles a 9% deficit, why isn't there any debate about the very large 3.2% share of national income being spent on the Greek military? 

It also underlines the circular nature of some of the bailouts: if Greece had no bailouts it may be forced to slash arms spending and contemplate defaulting on the loans (presumably from French and German banks) which funded previous purchases. In which case, the benefit is really falling on the French and German arms exporters and banks rather than the Greek people.

The popular narrative that strong, prudent nothern Europeans are being asked to ride to the rescue of feckless Greeks is simplistic. The financial and trade relationships are complex: the ultimate beneficiaries much less obvious than it first appears.

Friday, 11 May 2012

Happy Birthday Mr Feynman

Richard Feynman was born on the 11th May 1918 in Queens, New York. Had he not died in 1988, today would be his 94th birthday.

Idolising people is not my style, but Feynman is one person whose attitude and approach to life I would be happy to follow. The importance of cutting through received wisdom to find the truth using experiment and evidence; the sense of fun and exploration of the world; valuing real accomplishments over honours, titles and pomposity; the playful intelligence that is at once toying with a problem and seeing through it with great insight; the humanity and compasson. Both genius and buffoon.

I offer some thoughts from the man himself.

"The first principle is that you must not fool yourself, and you are the easiest person to fool."

"We are at the very beginning of time for the human race. It is not unreasonable that we grapple with problems. But there are tens of thousands of years in the future. Our responsibility is to do what we can, learn what we can, improve the solutions, and pass them on."

"It doesn't seem to me that this fantastically marvellous universe, this tremendous range of time and space and different kinds of animals, and all the different planets, and all these atoms with all their motions, and so on, all this complicated thing can merely be a stage so that God can watch human beings struggle for good and evil — which is the view that religion has. The stage is too big for the drama."

"Looking back at the worst times, it always seems that they were times in which there were people who believed with absolute faith and absolute dogmatism in something. And they were so serious in this matter that they insisted that the rest of the world agree with them. And then they would do things that were directly inconsistent with their own beliefs in order to maintain that what they said was true."

"The real question of government versus private enterprise is argued on too philosophical and abstract a basis. Theoretically, planning may be good. But nobody has ever figured out the cause of government stupidity—and until they do (and find the cure), all ideal plans will fall into quicksand."

"For a successful technology, reality must take precedence over public relations, for nature cannot be fooled."

"It doesn’t matter how beautiful your theory is, it doesn’t matter how smart you are. If it doesn’t agree with experiment, it’s wrong."

"I can live with doubt, and uncertainty, and not knowing. I think it's much more interesting to live not knowing than to have answers which might be wrong. I have approximate answers, and possible beliefs, and different degrees of certainty about different things, but I’m not absolutely sure of anything, and in many things I don’t know anything about, such as whether it means anything to ask why we’re here, and what the question might mean. I might think about it a little, but if I can’t figure it out, then I go to something else. But I don’t have to know an answer. I don’t feel frightened by not knowing things, by being lost in a mysterious universe without having any purpose, which is the way it really is, as far as I can tell, possibly. It doesn’t frighten me."

"The first ... has to do with whether a man knows what he is talking about, whether what he says has some basis or not. And my trick that I use is very easy. If you ask him intelligent questions — then he quickly gets stuck. It is like a child asking naive questions. If you ask naive but relevant questions, then almost immediately the person doesn't know the answer, if he is an honest man."

Back in 1981 BBC Horizon interviewed Feynman at length: the entire programme was Feynman talking about his life, family, work, influences and ideas. It's been put on YouTube and I highly recommend watching it in full, not only for the fascinating interview but just to marvel that 30 years ago it was possible to make a TV science programme that treated its viewers as intelligent, thoughtful, and able to concentrate on something interesting for 50 minutes. Though it appears that even back then, cheesy computer graphics were de rigeur.

Feynman's BBC Horizon interview, 1981.

Liquidity or solvency problem?

It's rarely discussed in the media, but at the heart of the crisis in government borrowing is one question: is this a liquidity crisis or a solvency crisis?

You can't understand the problem without understanding that question. I think the media avoid it because it seems technical, and perhaps the people in the media don't understand it themselves, but the technical-sounding terms hide two very simple concepts which I shall now explain.

Scenario 1. You are on a night out but you've lost your wallet leaving you unable to pay for your taxi home. You have money in the bank, but at this precise moment you have no way of using it to pay the taxi driver. You have a liquidity problem: you have money but temporarily can't get to it.

Scenario 2. Your owe money, the bills are piling up, you have no savings, no assets to sell and therefore no realistic chance of paying those bills. Even if You borrowed money to cover the shortfall you are only delaying the inevitable. You have a solvency problem: you have run out of money.

In the beginning, the debt crisis was seen as a liquidity problem: struggling banks and countries were good for the money, but they needed a little help to get though a temporary tight patch. Rich countries agreed to lend them money to tide them over, on the assumption that they would get all the money back, plus interest. Everyone's a winner.

Over time the problem grew and people started to wonder whether this really was just a liquidity problem: could it be a solvency problem after all? Is it possible that the money may not be repaid? That is the stomach-churning thought that led the bond markets to flee at-risk countries and raise the interest rates of many others. Who wants to lend money to someone if they cannot pay it back? Is it even ethical to do so? As each successive bailout failed to solve the liquidity problem it was aimed at, the concern that this was really a solvency problem grew stronger.

But if the distinction is so simple, how could so many smart people confuse them? To see how it can be difficult in practice to distinguish the two, imagine scenario 3. It's 5 days until pay day, you are owed your wages by a reliable employer but you've had a difficult month with car repairs, have run out of money and need to borrow a few quid to buy food. This looks like a liquidity problem: in 5 days you will receive your salary, repay the loan and all will be well. A friend, relative or pay day loan company might well decide to lend you the money, confidently expecting to see it repaid.

But what if you return again with the same story the following month? And then the month after that? Your temporary difficulty, your exceptional expenditure, starts to look less exceptional and your financial difficulty seems less like a lack of liquidity and more like a flat-out lack of money: insolvency. Suddenly people start calculating that if they lend you money that'll be the last they see of it, and if you're going to go bankrupt it's better that you don't take their money down with you. But what if you really are just having a terrible run of luck and with help you will thrive and repay? If so, your creditors may be cutting you adrift and, if you're a country, creating enormous problems which could be avoided. That is the dilemma.

The dilemma is obscured in the maelstrom of daily discussion about other things: should you try to kick your expensive smoking habit? Pack in your gym membership and cable TV? Find ways to earn more money? Break away from a disastrous currency union which is preventing you from using monetary policy to ease the pressure on fiscal policy? But your overall strategy must always be guided by whether you are solvent but illiquid and therefore in need of bridging finance, or insolvent and destined for bankruptcy, in which case you may be better to grit your teeth and get on with it.

Specifically with Greece, it has now "restructured" some of its debt, which is the euphemism for telling its creditors that it is insolvent and making an agreement to repay a lower amount on extended terms. But most of the debt that remains is not owed to banks, who were strong-armed into agreeing to a restructuring, but to fellow European countries who lent money when Greece was already in difficulty with specific assurances that they would definitely be repaid. This borrowing was not "restructured" alongside the commercial loans, because doing so was considered politically impossible. I think it is also economically inevitable. Just one more part of the Euro problem in which political ambition will eventually be smashed on the unyielding rocks of economic arithmetic.

Quote of the day - euro complacency

From David Frum on Twitter:

"Weird punditry moment. I just taped a segment for Fareed Zakaria's weekend show in which 2 distinguished Europeans refused even to take notice of my suggestion that the employment crisis in southern Europe was attributable to the Euro. It was as if I'd committed some horrible social gaffe, from which decent people must avert their eyes.

Totally agree (obviously!) that countries like France have deep structural problems, need more flexible labor markets, etc. But Europe is like a patient with high blood pressure who has just been hit by a truck. Diet and exercise will only do so much..."!/davidfrum

In a nutshell, this captures the problem with the EU: a self-appointed elite is dogmatically pursuing its warped vision of European unity come what may, and no evidence or opinion which challenges that dogma is allowed to be taken seriously.

If half of Europe hadn't decided to band together in a single currency, today's problems would be serious but solvable. Instead, the Euro club has turned a difficult problem into a borderline unsolvable problem - the burning building with no exits, in Mr Hague's shrewd analogy. Meanwhile, the refusal to accept even the possibility that the Euro currency is part of the problem means that far from working towards a solution, the EU's cheerleaders continue to make things worse.

There are only 3 possible solutions to the problem:

1. Rich eurozone countries agree to large, permanent subsidies, called transfer payments, to the poorer countries. This would continue for ever, or until the poor countries become as rich as the rich countries (ie: for ever).

2. Rich eurozone countries guarantee to underwrite the credit risk of poorer countries, by issuing joint debt: so-called eurobonds. So euro countries wouldn't issue their own debt, it would be issued centrally and all of the countries would be jointly liable.

3. The eurozone breaks up.

Basically, option 1 means that rich countries give cash to the poor countries to cover their debts, option 2 allows weak countries to shelter under the strong credit rating of richer nations, option 3 means that poor countries gain a floating exchange rate to ease pressure on national finances (ie: devalue their currency) and are no longer in a position to drag richer countries under.

Anyone who talks about solving the European economic problem without doing one of those or a combination of them, is not actually talking about solving the European economic problems. There are no alternatives.

Option 1 is how Germany mainly dealt with reunification: the richer West Germany has so far spent about €1.4 trillion rebuilding East Germany's infrastructure and economy. Rapid catch-up growth and "a flowering" in the east were promised, but more than 2 decades later the former East German areas are still the poor relation, still needing transfer payments, still lagging far behind their western compatriots. Worse, the process seems to have stagnated. Hardly surprising that Germans suspect that if the same experiment were tried again, but this time with Greeks, Spaniards, Portuguese, etc, it would be even less successful. Throw in that some southern Europeans are retiring to a life of Mediterranean sunshine in their 50s while Germans would toil into their late 60s to pay for it, while still carrying former East Germany, and it's easy to see why Germans aren't rushing to sign up.

Germany has point blank refused option 2, which is sensible because it would be reckless to take on liability for another country's debts unless you control their spending. It would be like agreeing to become jointly liable for your over-spending cousin's credit cards: unless you can gain control of his overspending, he'll just drag you down with him. Interestingly, this is a big part of why Greece got itself into this difficulty in the first place: the presumed guarantee from creditworthy eurozone countries allowed Greece to borrow far more (and at far lower interest rates) than it could have as an independent nation. Chaos broke out when it became apparent that the presumed guarantee was not really there. So the eurobond plan is unlikely to fly unless eurozone countries give up most of their autonomy and become states within a federal EU with the bulk of spending and taxation policy decided at the EU level. The EU Fiscal Pact and associated budget monitoring powers are designed as a major step in that direction, but it's still a long way short, and already it is proving difficult to agree.

More to the point, the flurry of Euro summits over the last 12 months has proven that Germans in particular are unwilling to countenance either option 1 or option 2, and for sensible reasons. So that leaves option 3: breakup. But no one wants to talk about that either.

Instead people are sipping their wine, nibbling their canapés, making polite conversation about the weather and pretending that this is just a liquidity problem. One last heave on the Borrow & Bailout Plan, lads, I think it might work this time!

The problem behind all of this is the point made so often that it has become a cliché, but it is no less true for that: there can be no European democracy because there is no European demos.

When push comes to shove, Greeks, Germans, French and Portuguese will each vote in their own national interest, so even if national leaders agree on a way to face down a difficult problem, that agreement is always at risk of voters deciding to renege on their commitments and replace their leader. I predict that we will see that happening again and again in elections across Europe.