Archives for March 2014

Mankind’s Biggest Historical Blunders

evolution 1

Since the beginning of the human race, up until relatively recent decades physical strength —and/or military power— was a constant, and quite frequently, was the most determinant factor to rule any type of social organization, from the family to an entire empire. That’s a very sad and shameful fact, but it is also a true recollection of how mankind used to behave until relatively recent decades. Let’s go over some of the most relevant examples:

  • Reason finally begun to prevail, although still far from a full-fledge evolution in this regard. Developed nations already have arrived to the unequivocal conclusion that old-fashioned, anachronic military wars are an aberration, an insult to intelligence and human dignity, not to mention that, from a strictly pragmatic standpoint, wars are a lose-lose proposition for all parties involved; there are no long term winners.

In fact, the preservation of peace among member countries was the main idea behind the creation of the EU among the founding six nations, with its predecessor, the 1951 European Coal & Steel Agreement. The major objective was to establish a common bond so strong that would make it nearly impossible for member countries to declare war among one another. Since the end of WWII, that principle has been likewise observed by all developed nations, by all democracies.

Going back in history, the UN itself —at the end of WWII—, and its League of Nations forerunner —at the end of WWI— not coincidentally had the same purpose at its core, the preservation of peace in the world.

Thus, there is high hope and very good reasons to believe that the developed world has already left behind the bloody past of territorial and power-thirsty military aggressions amongst other nations. A late but indeed a most welcome step in mankind’s evolutionary path. There is still plenty to do in this most critical global aspect outside of the developed world. Nonetheless, it is no minor feat that the developed world has finally reached this stage of advancement. Moreover, it is an indispensable platform for the rest of the world to learn from.

  • Since the beginnings of time, wrongly so, women were considered to be inferior to men. Its origin, probably deriving from the difference in physical strength generally speaking. However, when widening the comparison scope to the intellectual, biological, emotional, and even spiritual realms, the situation dramatically changes, to such a degree to render irrelevant the physical strength advantage of men in relation to women.

Mankind’s evolution process slowly got the facts and the appropriate lessons right and, as a result, many rectifying changes have taken place in the last decades. At last, women have become eligible to fill almost any position and high posts previously reserved only for men, provided they have the right qualifications. Here are just a few of the many testimonials of this constructive social change during recent decades:

• President of the US’ Federal Reserve, Janet Yellen
• German Chancellor, Angela Merkel
• UK’s Prime Minister, the late Margaret Thatcher
• President of Brazil, Dilma Rousseff
• CEO of General Motors, Mary Barra
• CEOs of HP, Meg Whitman, and formerly Carly Fiorina
• CEO of Yahoo, Marissa Mayer

  • Racial discrimination —in western society, mainly, but not exclusively to blacks— is of a similar nature than the previous case. Combining the use of force with a perverse —and utterly false— principle whereby blacks —or any other ethnic group— were considered an inferior class of human beings, gave birth to the humiliating and most shameful millenary practice of slavery. Once slavery (in that form) was abolished in the XIX century, the day-to-day non-discriminatory spirit still took many more decades to achieve a pragmatic, functional level where, for instance, an African American could gain the presidency of the US —Barack Obama. There is still a lot of progress to be made in the race discrimination front; nonetheless, mankind seems to be solidly moving in the right direction in this foremost aspect of development.
  • Based on the ideas of Karl Marx and Frederick Engels, during a significant part of the XX century a good portion of the world’s population was governed under the grotesque principle than the state, and mostly the state, had the ultimate answers to mankind’s most pressing problems and aspirations. As well all know, the Soviet version of Communism imploded in the late 80s, and the Chinese version was profoundly transformed by Deng Xiaoping since the late 70s and onwards, to such an extent that the original program has been rendered obsolete and inapplicable.

EvolutionOrder, organization, discipline, and teamwork are concepts widely regarded, and rightly so, as pillars for progress and socioeconomic well being. With the benefit of hindsight, it is evident that the major drawback of communism was a very poor understanding of limits; they carried the antithesis of the uber-solid previous concepts beyond reasonable limits.

Communist regimes gave the state a superlative commanding role, at the expense of the individual. We all now know for sure that this was a guaranteed recipe for disaster. The reason behind that spectacular failure is quite simple: order, organization, discipline and teamwork are superb concepts, as long as they do not interfere with individual creativity and innovation. That balance has to be kept as much as possible in the optimum level.

We now know with certainty that authoritarian governments are not a viable long-term solution for development and social well being since their permanent interference with liberties structurally hamper high levels of creativity and innovation.

The lessons to be drawn from the four big blunders of humanity previously outlined are uncontroversial and extremely valuable. Policymakers and society as a whole should strive to have these lessons crystal clear in their minds. There has been excessive misery and suffering throughout the ages by the lack of a proper understanding of the big truths behind the true nature of things. A well-informed, learned and demanding society is the best guarantee to avoid grotesque deviations from righteousness as the four previous historical cases illustrate.

Beautiful Deleveraging and the Robinson Crusoe Economy

There has been quite a bit of distress in some political, financial and business circles, regarding the unconventional measures taken by the Fed and some other central banks, most notably the ECB, to add liquidity to the system on a massive scale and to prop up the bond market. The era of unprecedented massive monetary stimulus has arrived.

This major concern is very legitimate, given that these kinds of measures are indeed unprecedented not only in scale, but also in many respects. The chief worry is that the aggregate of these measures might be planting the seeds for future high inflation, without ruling out the possibility of hyperinflation sometime in the not so distant future.

economic theory

Assuming everything else remains equal, a gargantuan injection of liquidity to any economy will, in due time, inevitably generate extremely powerful and very difficult to control inflationary pressures down the road. Of critical importance, the premise “assuming everything else remains equal” does not hold at all during the period when those extraordinary liquidity measures referred have been taking place.

On the opposite side of the ledger, however, the significant belt-tightening of government finances as a response to the subprime crisis as well as to the European debt crisis, have been simultaneously generating tremendous deflationary and contractionary pressures in their respective economies.

A deleveraging process is indispensable to put public finances on a strong foot again after a severe debt crisis. Belt-tightening, in turn, is also an indispensable ingredient of any deleveraging process. If left unattended, the contractionary and deflationary forces that substantial belt-tightening produce will certainly create a significantly higher pain to the economy and the job market, aggravating the recession and the unemployment picture even further, not to mention the possibility of ending up in a catastrophic  depression/deflation spiral. Granted, the solution has not been perfect; no human creation ever is. A well orchestrated deleveraging process will simply attenuate the otherwise more severe and painful outcomes.

With so many deep imbalances in the US economy when the subprime bubble burst, it would have been naive to have expected a quick full restoration to normality afterwards. Achieving high growth in any economy under a severe slashing of government spending, including paying off national debt, is a virtual impossibility. In addition, there is also a very powerful factor working against the resumption of vigorous growth, the shrinking labor force in the developed world.

To avoid the most pernicious vicious cycle that deleveraging implies, when appropriately done, it must be simultaneously accompanied by a parallel process of a relaxed —or  extremely relaxed, as conditions dictate— monetary policy, to compensate the contractionary and deflationary effects of deleveraging itself. Otherwise, a sharp contraction —recession— with high propensity to outright deflation develops. History has unequivocally shown that a deflationary recession quite easily morphs into depression, like in the 1930s in the US.

The balancing act, the optimum calibration is probably not as difficult to accomplish as it is normally perceived to be. The underlying strength of a recovering economy —mainly measured by the unemployment rate— coupled with the inflationary pressures —or their lack thereof— undoubtedly are the best indicators available to measure when a significant policy change is required. If appropriately acted upon, this duo of indicators should be constantly monitored, for at one point they will signal when it is time for the Fed to begin lifting the extremely lax monetary conditions.

For the time being, inflation is basically dead. There shouldn’t be so much confusion about it. The behavior of inflation is completely logical. In fact, this is a confirmation that the ultra-easy monetary policies are working, since they have not yet materialized in significant and generalized inflationary pressures. Likewise, the US economy —and  the EU’s more so— are far from  overheating.

The US, Europe, and all the developed World are growing well below their economic potential. That’s one hundred percent compatible with the absence of inflationary pressures. We must always keep in mind that, most of the time, the economy must be close to overheating condition for inflationary pressures to become unbearable and truly dangerous if unattended.

In summary, through lax monetary policies, central banks must provide adequate liquidity and credit support for the economy in a deleveraging process, in order to:

  • Offset, as fully as possible, the contractionary and deflationary forces at work, while tight fiscal conditions and austerity prevails. In this way, the pain will be significantly lower, and above all, this is the only known way to…

  • Avoid falling into a depression within a pernicious deflationary environment.

Ray Dalio, the founder and principal of Bridgewater Associates, the prestigious hedge fund, has referred to a well implemented deleveraging process as a “beautiful deleveraging”. We couldn’t agree more with him in this regard. We highly recommend watching Dalio’s video How the Economic Machine Works, for  an excellent description of this process.

Ray Dalio very appropriately summarizes a beautiful deleveraging, when the following three conditions are met:

  • Positive growth in the economy,

  • Nominal GDP growing above nominal interest rates, so that…

  • A falling debt/income ratio is observed.

Wrapping up, although in many respects both the US and the EU are in uncharted territory, as long as outright deflation is avoided, even if the rate of growth is rather anemic, like the current case, the outcome is far better than the multi-mentioned unpalatable alternative. A more vigorous growth rate can be attained anywhere anytime through genuine structural reforms and deregulation to improve the ease of doing business status. Monetary policy alone can’t and shouldn’t be expected to do everything for any economy.

More on the inner workings of an economy in our post: John Maynard Keynes, Milton Friedman, and the Robinson Crusoe Economy

Putin, Russia, Ukraine, and the Globalized World

Putin Ukraine

When ordering the Russian Army to take control of key points of Ukraine’s Crimean Peninsula on the first weekend of March, it is highly unlikely that Vladimir Putin had appropriately contemplated the full financial and economic implications of such a decision.

Unsurprisingly, on Monday March 3, the global financial markets (currency, bonds, and stocks) reacted as expected and took a toll on the Russian market. That day, Russia’s main stock index, the MICEX, plunged 11% (wiping off an estimated US $58 billion of its market cap), the Ruble and the bond and money markets also experienced strong deterioration, forcing the Russian Central Bank to increase short-term interest rates (from 5.5% to 7%) and spending with about US $12 billion of its reserves in an effort to stop the drastic drop of the Ruble and counterbalance capital flight (currently, the market’s penalization has dipped even further). The European bourses also felt the pinch, given their proximity to both Ukraine and Russia, albeit to a substantially lower degree, with Germany’s DAX tumbling 3.4% and France’s CAC 40 dropping 2.7%. In the US the reaction was rather muted, with no major index dropping over 1%.

As previously stated, it is very likely that Putin did not have any idea of the adverse financial reaction that his belligerent political decision would cause. Why so? Two reasons:

  • First, Putin’s professional training was in the security and intelligence forces, serving as a Lieutenant Colonel in the KGB before joining politics in 1991. By the end of 1999 he became Russia’s PM. Since becoming the strong man of Russia, his actions have consistently denoted a mentality far apart from knowing the intricacies of the global society. Putin is anything, but an internationalist.

However painful it might be to him, Putin must realize that the ideological confrontation between communism (and essentially everything associated with it, like closed and rigid central planning with autocratic governments) and capitalism is over. Capitalism won. That outcome has been overwhelmingly clear since the late 80s.

  • Second, Putin’s immediate damage control reaction on Tuesday March 4, notoriously softening his belligerent stance, de-escalating both the rhetoric, as well as the general movement of Russia’s troops in Crimea. Yes, it could have been a tactical, temporary retreat. But there is a high chance that Putin was caught off guard by the severe and immediate market penalization towards his hostility. If this was so, this factor by itself (plus future similar possibilities) might weigh heavily in his mind and make him seriously reconsider his whole strategy.

ukraine-russia

Regardless of future events in this affair, it seems that Vladimir Putin and his inner circle received an unexpected harsh and painful lesson from the global financial markets.

As previously mentioned, the immediate penalization to Russia’s economy by the severe setback of the financial markets on March 3 was in the tens of billions of USD. The devaluation of the Ruble was an immediate blow to Russian society’s purchasing power, particularly towards imported goods and services. Fortunately for Russia, the penalization damage can eventually dissipated. For this to happen though, the lesson has to be well learned. This means no further significant misbehavior from the Russian government elite in the coming weeks and months, as well as settling the Crimea-Ukraine-Russia dispute through diplomatic channels, with the mediation of the EU, the US, and possibly the UN’s International Court of Justice (ICJ) as well.

Russia, much like the world, has handsomely benefited from globalization. Namely, Russia has been an active actor in world trade (in both directions) and in the financial markets. Understandably, every business and financial transaction implies rights and obligations. To a very large degree, the whole world is ruled by financial markets. There is no single country that can subtract itself from that influence, more so when dealing with a country essentially open to the world, at least from the financial standpoint.

When the extinct USSR invaded Czechoslovakia in 1968, the Russian markets didn’t blink, because there were no open financial markets. The USSR was then a Communist country, an essentially closed society to the outside world. Russia in 2014 is very different from its predecessor in this regard.

No one can have it both ways. By opening up its financial markets (and to some degree its economy), Russia did agree to play according to the global rules of the game, which were already established. That inherent responsibility was perhaps not assumed with full awareness. Nonetheless, the cause/effect relationships in the financial markets are universal and permanent, with no exceptions allowed. The global financial system resembles a somewhat democratic society where the voice of a very powerful and representative segment of society is manifested not by vote, but by instant and unambiguous money flows.

Russia is a newcomer to the financial markets. The Moscow Exchange was established on December 19, 2011, by the merger of the Moscow Interbank Currency Exchange and the Russian Trading System. The Moscow Exchange operates all financial assets across the board: equities, bonds, derivatives, currencies, money markets, and precious metals; in addition, the Moscow Exchange also operates Russia’s Central Securities Depositary and the country’s largest clearing service provider.

To a great degree, the financial markets achieved (very quickly and effectively) what diplomatic and political pressure couldn’t; it remains to be seen if the financial pressure will be sufficient. At the very least, some of the potential losses and costs for Russia derived from its actions were rapidly visible to Putin. That’s why, in most likelihood, he was forced to step back and resort to damage control techniques right away.

Russia’s might is essentially military, as well as cultural —within its immediate geographic circle— not economic. Russia is a middle-of-the-table country (see table below), with a current per capita GDP of around US $18,100, almost half of the EU’s $34,500, with rampant corruption and extreme income disparities between the haves and the have nots, abundant ethnic conflicts, with decreasing personal income (after several years of growth), with an economy that’s barely growing, way below the levels of affluence of the first world. Russia is extremely dependent on the export of raw materials, basically oil, gas and related products; in this respect, Russia has a third-world-country-like economic structure.

By far, Russia’s reliance on the EU and the world is much greater than viceversa.

Energy exports accounts for roughly 70% of Russian exports.

Russia vs US and EU

SOURCE: CIA World Factbook

On the other hand, Putin has dreams of grandeur for his nation, however far Russia is from achieving them. Putin has openly stated that the greatest geopolitical catastrophe of the XXth Century was the collapse of the USSR. It appears like Putin’s golden dream is to recover Russia’s power and lost might (in his eyes, probably stolen). Evidently, Putin has been having a lot of difficulty in understanding the rules of the game of the global society, especially among the first world countries.

It must be very difficult for Putin to renounce to his aspiration of Russia one day becoming a first world nation. Russia became an odd member of the now G8 group in 1998. Because of Russia’s development afterwards, the decision to include Russia into the G7 and make it a G8 is  increasingly looking like a weird geopolitical miscalculation of whoever sponsored the enlargement initiative among the G7 nations. In no way does Russia resemble any of the other seven members of the group: Canada, France, Germany, Italy, Japan, the UK, and the US, all of them developed countries and full-fledged democracies—Russia is in an entirely different playing field. It is obvious that the high level of affinity, and relative integration among the former G7 is not shared with Russia, and viceversa.

On a related topic, beyond the bravado attitudes of China towards Japan in regard to the disputed sovereignty over the Diaoyu-Senkaku islands, China has recently shown a great dose of prudence and wisdom when dealing with Taiwan. The multi-mentioned Russian/Ukrainian experience should serve as a very useful confirmation of China’s intelligent recent approach towards Taiwan, in great contrast with the attitude of Putin towards Ukraine.

The history of the world is full of plundering and invasion wars among nations. That is a horrible truth, yet an undisputed shameful historical precedent of mankind. Most fortunately, this abominable traditional behavior among nations seems to have been eradicated from the developed nations’ mentality since the end of WWII.

All developed nations, without exception, seem to have learned that most painful lesson: military territorial annexation is a thing of the past. Besides the overwhelming moral considerations against it, in today’s globalized world true leadership implies other attributes, more related with know-how, science, technology, brands, intellectual capital, and the population’s well-being. Large territorial extensions are not that closely associated with world leadership among nations any longer. Ironically, Russia is the best example of this. Russia is the country with the largest landmass in the world, it also boasts a sizable population (10th in the world), yet, it is very far from being a wealthy and prosperous nation.

The close, permanent, and irreversible interconnectedness among all different nations in the planet is unquestionable. It is all around us, omnipresent, permanent, and essentially irreversible (read more on What is Globalization?). World leaders need to learn how to adjust and reap the most benefits from globalization, as a myriad corporations from different corners in the world have already successfully done. There is no other way.

Russia is a very rigid, antiquated economy, in urgent need of modernization and virtuous structural change. Thus, Russia essentially is in a fragile and precarious economic condition, lacking the financial resources to effectively confront the EU and the US. Nonetheless, despite of how powerful this truth is, is not sufficient by itself to guarantee the success of the good cause. In addition, it is indispensable that both the US and the EU stand together in as much unity as possible in confronting and containing Russia, if the need arises.

If stability and reasonable normality is not quickly achieved in Ukraine after Russia’s meddling, the EU and the US should exert strong pressure (economic, political, and diplomatic) on Russia to do things right. There is a lot at stake for the world at large. China must be paying extremely close attention to how things unfold.

It would be a terrible mistake not to punish Russia’s belligerence and unlawfulness, if and when the time comes. The present world order will be severely damaged if the need arises and the duo EU/EU do not rise to the occasion.

If Putin persists in his primitive territorial ambitions and is not stopped on its tracks, an ominous precedent will be established, with potentially devastating consequences for the whole world. The wellbeing of the new world order is a constant work in progress, with the permanent need of leadership from the great powers, particularly at crucial historical junctures. If required, the right precedent has to be established, with the EU and the US punishing Russia financially, politically,  and diplomatically, for the rest of the world to see and learn from it.

 

Does Protectionism Protect?

ProtectionismA couple of recent events have made evident that the cause/effect relationship between protectionism and its ominous consequences is still often painfully misunderstood, or what’s even worse, forgotten. The cumulative, collective knowledge process is the universally known pattern of how we humans advance our knowledge through time. However universal and unequivocal this concept is, there are no shortage of examples showing a relatively frequent utter lack of an understanding of basic, fundamental historical lessons as to merit comment and analysis.

After the US markets’ closing bell on February 19, Facebook announced its agreement with WhatsApp to acquire it for a staggering US $19 billion. The price tag will be the largest-ever paid for a venture-backed startup company (WhatsApp was founded in 2009, still an unlisted company). The transaction is subject to regulatory approval.

By far, WhatsApp is the leading instant messaging system on earth, recently boasting 450 million subscribers worldwide, with new subscribers piling up at about one million per day. WhatsApp is also the world leader in transmitting images between users, above Facebook and Instagram combined.

Beyond the merits of the transaction, it is both appropriate and timely to make a quick recap of the evolution of the text message industry in recent years, in order to remind us of a great historical lesson that should have been fully in command of key players, but wasn’t.  

In addition to the typical service provided by all mobile carriers throughout the world (known as SMS), up to now there have been only a couple of memorable experiences of specialized companies in this utmost important market. Up until about late 2011 the Blackberry Messenger (bbm) was comfortably the clear market leader. A combination of becoming a lagging brand in innovation plus the fact that back then bbm was a service provided exclusively to blackberry users, caused the loss of leadership of Blackberry’s bbm, in favor of the then emerging WhatsApp. The precipitous loss of market leadership in favor of WhatsApp eventually forced Blackberry to rectify, opening up its service to all mobile platforms. Recent statistics place WhatsApp in the #1 spot with the 450 million registered users previously mentioned; Blackberry is a distant second with about 80 million users.

Protectionism1

It is evident that Blackberry’s top management did not have an adequate idea about the great value of its leadership —namely opportunities and risks inherent to that leadership— in the short messages market, when they had it. Or, to put it in another way, Blackberry’s management naively thought that the best way to preserve their market leadership was by going solo, keeping the exclusivity of their service to blackberry users. Otherwise, Blackberry would have opened its service to all mobile platforms early in its extraordinary success, a few years ago. Unfortunately, Blackberry didn’t realize it in time. When Blackberry  finally reacted to correct its major blunder it was too late, since WhatsApp was already the worldwide leader, miles ahead of Blackberry.

WhatsApp was born out of an evident desire to replicate the great success bbm had had within the blackberry ecosystem, targeting the immense market vacuum left by Blackberry’s closed system. WhatsApp originally targeted the iPhone market with great success. Immediately after that, WhatsApp went after the Android market. The rest is history.

Nature abhors vacuums. Hence, the marked propensity for vacuums to be filled. This is more so, when dealing with a market vacuum with great appeal, a potential market worth millions —or in this case, billions— of dollars.

In retrospect, it is very easy to perceive the great fault of Blackberry’s management: blindness in regard to the rest of the market. So, the million dollar question —or in this case $19 billion— to ask is… If Blackberry had such a great product and sat on the throne as market leader, why in the world didn’t they open bbm to the rest of the mobile operating systems in time? It is a classic case of not learning from others. With the benefit of hindsight, that mistake has an approximate present value of US $19 billions.

Going back in history, Blackberry’s management committed the same mistake that Apple made in the early 80s by not licensing its operating system to other platforms, before Microsoft took off. The WhatsApp/Blackberry case is a virtual carbon copy of the Apple/Microsoft experience —with the difference that Apple was not only able to bounce back after that, but by 2012 it became the company with the largest market cap in the world. A few years earlier, Sony had made exactly the same mistake with Betamax, in favor of the VHS video-home system format.

Anyway we approach the previous failed business strategy cases, the major objective behind it is to protect a very valuable asset with the intention to preserve leadership in the long-run. Thus, the main intention is protection. The key element here is a functional definition of protection within this context.

Ironically, quite often the best way to protect a valuable product, or a nation’s wellbeing, is by opening up, not by closing down.

Although, in principle a traditional protectionist strategy —closing up the market to other formats— makes intuitive sense, that  strategy has proved to be deeply flawed, since it ironically yields exactly the opposite results. History shows it in an unmistakable way, case after case, with no exceptions, be it at the individual, organizational, or national level. The lessons are there  to be learned, as a cumulative, collective knowledge of mankind.

Unsurprisingly, the same cause/effect relationship also applies to nations. In fact, the protectionism cases are amply documented regarding nations. A case in point is the recent result of the Swiss referendum of February 9th on immigration policy (The Limitations of Democracy).

As previously stated, the cause/effect relationship between protectionism and its ominous consequences is still often painfully misunderstood, and sometimes even forgotten. The examples cited from the business world are an unobjectable evidence in this direction.

In summary, there is no way to overstate the importance of truly learning from others as an indispensable way of avoiding making monumental mistakes, as the corporate cases mentioned clearly demonstrate.

History shows that national —or regional— protectionism yield exactly the same results for similar reasons. Logically, this isn’t a coincidence, but the manifestation of the same nature of things at different levels of the human experience —individual, organizational, national.

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