Friday, December 27, 2013

No Capital Investments?

The Economist wrote an article “More bricks, fewer bubbles” early December that said that no one is quite sure why monetary loosening (QE) has so little effect on investment.  The answer is simple: capital investment is partially for replacement and partially for growth. As long as industrial production is lower than the 2008 peak in industrial capacity, there is no need for investment in growth.
The considerations behind this are described in the Flostock Laws of Demand, which can be found on 

Stocks have a memory

Strange idea that a collection of goodies can have a memory. When you see pebbles on a beach, they don't look as if they have a memory. Yet I don't mean this in some sort of strange philosophical way: I believe stocks really have a memory, in the sense that a future change is already embedded in the stock before the future arrives. This can be the direction of the change, or the intensity, or the force.
Maybe this becomes more easy to understand if you include some thermo: When I did not know the answers to a thermodynamica question as a student, I just filled in: "because then the system moves tot the lowest energy level", and that is still the best answer to many questions about why things are happening.
The same is true for stocks with a memory: the stocks know there is a lower energy level and they would like to go there. A bucket full of marbles on a hill top that has just been toppled has a memory: the markbles "remember" that they will start rolling downhill. A bank account remembers it can deplete, so a credit card is burning in your pocket. When you start a holiday game with a full bank account, you know it is going to go down. A country full of youngsters knows it can expect revolution. A city full of hooligans knows it will see riots and drunkeness.
More practically, if you are the manager of a warehouse with a certain inventory and your boss wants you to increase the inventory towards a desired level, ordering new products and going to the desired inventory is like going to a lower energy level. In this sense the inventory had a memory of where it would want to be. If you have ordered a new gadget and it is being flown to your doorstep by a drone, the pipeline of goods in transit (also a stock) has a memory of where it is going.
An ocean full of warm water has a memory in the sense that the huricanes are already in the process of becoming. A class full of children has a memory of creating chaos. A chimney that has not been cleaned for a long time will ignite when the conditions are right. A car moving at a certain fixed speed has a memory in the sense that it will continue to do so untill it is stopped. So inertia is a form of memory. Kinetic energy is a memory property of a stock (e.g. the car).  Potential energy is a memory. And a banking account has potential energy. A warehouse has the potential to order replenishments. An empty stomage has the potential to be filled by eating.

Stocks have much more memory than flows. Flows stop flowing immediately when stopped. When eatign stops the flow stops. But the stomage can still be half-empty, so it remembers that more eating should be done.

So stocks have a memory.

Thursday, December 12, 2013

Bubbles are not bubbles

Economic bubbles are always compared with soap bubbles, but that introduces a misunderstanding, because economic bubbles are always flows, never stocks, while soap bubbles are objects, so more like stocks.  Soap bubbles "accumulate".

People probably use the analogy because they have no better way of picturing a flow. In general it is difficult to draw a flow, any flow. When you want to draw a river, normally you draw the banks, and the meandering. The trees next to it. When you want to draw the wind, you show clouds or leaves, floating in the wind. Or you show a giant cloud with a face that is blowing stripes of wind from his mouth.   In the same way it is difficult to picture a stream of goods or a flow of money. Movement is difficult to catch and difficult to picture. An inflated flow is also difficult to picture. The picture is static, the flow is dynamic.  The tulip mania and the south sea bubbles were not called bubbles in their time, because people did not look at them in a graph!

Is a price bubble a stock or a flow? Price has a flow character, I believe, much more than a stock character. It depends on transactions, on demand & supply, typical flows. What about a sentiment bubble like confidence (e.g. in bitcoins)? Yeah, that is a stock and indeed a bubble, filled with thin air. When punctured it will deflate fast.  But this is just the confidence behind the real bubble, which is price and transactions, so the real bubble that we talk about is a flow. Confidence itself is normally not depicted as a bubble.

Another point where this analogy goes wrong is when an economic bubble bursts. In reality it means that a flow reduces fast in size. The feeling we get from the soap bubble analogy is that some protective shield (like the membrane of the soap bubble) is punctured with as result that some pressure escapes and pieces of membrane spat on the floor. In economic bubbles there is no membrane, and there is no escaping pressure.

"So what?", you might say.

This is relevant because the analogy sets us on the wrong foot: when we study an economic bubble, we have to see it as a flow, not as a stock. A stock responds to a pulse completely different from a flow. Most stocks are integrals of flows, that means they accumulate a flow or they bleed into a flow. Stocks are therefore much more inert and more stable over time than flows. This gives a false sense of stability to economic bubbles.
An economic flow is always going from one stock to another stock, based on decisions by people (or based on algorithms in computers programmed by people). If people decide to do nothing, the flows stop immediately, but the stocks remain stable.  When we would see economic flows as flows, people would easier understand that an economic bubble is always finite because the stock where the flow comes from is finite.

So bubble is the wrong word.

Is there an alternative? How should we call an inflated, a swollen stream?  A comparison with an overflowing river that rises above its dikes is maybe appropriate. Maybe a dike in which a small breach is broadened by the overflowing river and a small stream grows into a giant flow.

I don't know. Any of the readers maybe?

Thursday, December 5, 2013

How do you like your Gini?

The End of History
Since the fall of communism, now more than 20 years ago, history as a struggle has ended according to Francis Fukuyama in his ground breaking book The End of History and the Last Man. There are no serious people any more who claim that communism is a realistic alternative for free market, democratic capitalism. Since then a lot of commentators said that state capitalism, as practiced e.g. in Singapore and China, could be an alternative for democratic capitalism. This piece of History has not ended yet, so it is too early to tell which system will survive. But I don't believe in state capitalism.

Quatro Politica
There are too many wrong investments in state capitalism and not enough checks and balances. The Trias Politica should be expanded to a "Quatro Politica", and the fourth power, Business, should also be handled as a separate force. The other three forces are needed as a counter balance to the overwhelming forces of global Businesses. Think e,.g, of the military Industrial complex for which Eisenhower warned us, the lobying forces in "Supercapitalism" by Robert Reich, or -closer to home- the obscure funding behind some political parties in Holland.

All parties in the middle
Since the "end of history" in Europe, the fundamental differences between the old political parties are eroding. The importance of religion as a factor in politics had already been going down much longer. Now, communist parties are gone and traditional socialist parties have moved to the middel ground of the political spectrum.  As a result the old and comfortable left-right or communist - capitalist split is gone. All political parties have difficulty positioning themselves to keep their voters loyal.

How do you like your Gini?
The Gini curve (Italy,1912) can be used for measuring the spread of income in a population. The population is sorted on income, than accumulated into a graph, with vertical cumulative income and horizontal cumulative people. This is the Gini curve and it always runs from the left bottom corner to the right top corner. Depending on the spread of income the Gini curve is more round or more flat. When everyone has the same income, the theoretical communist ideal, the curve is a straight line. Needless to say that it was not achieved in communism: this was one of the reasons the system failed. When 90% of income is earned by 10% of the population, the curve goes almost vertical in the beginning, then makes a turn in the top left corner and goes almost horizontal to the top right corner. This was the shape in the dark ages, when absolute rulers were exploiting there population.
Economic discussion in parliaments everywhere is now dealing with the shape of this Gini curve. Representatives of lower income basically want a flatter curve, while free market adepts want a round Gini. Both try to argue that their view is best for society and for the economic growth as a whole. Venezuela and Cuba are trying hard to prove that a flat curve is wrong. A too round Gini has strong undesirable effects, such as extreme poverty and state debt. Ironically, recent American capitalism as well as the Russian oligarchy confirm this. The Gini-discussion is mixed with a debate about justice and equality, because there is probably not just one answer, but a reasonably large "sweet spot" for the ideal shape. Within that sweet spot the ethical discussion can be held.

What to vote?
What now? The result is that voters no longer know what to vote, because the Gini discussion is boring and technical and has a lot of unknowns and make-believes. Voters do not vote for the nuance of the sweet spot: they start to float and do not give the final call on what to do. The alternative is let history sort it out, but it takes years before the effects of a change in Gini become visible. History as a judge is ruthless, but slow. History convicted fascisme after 20 years, and needed more than 100 years to disprove communism. Now History is already taking 30 years to evaluate state capitalism.

Unwanted by effects
The result is that new parties come up around mono themes like age, animal rights, environment, euro- or xenofobia. Voters (who do not understand the Gini discussion and who no longer vote what the priest says) are shopping around for a nice face or a narrow interest or an underbelly feeling. Parliaments are no longer peopled by the best and the brightest, tried and tested in a long upward career of service to the country, but by opportunistic followers of populists who temporarily catch the limelight. This is not a good development, because it is making our democracy volatile. Maybe it is an unavoidable stage of development towards a true End of History.

Tuesday, August 20, 2013

Capital goods are the first derivative of consumer goods

When analyzing product demand, a distinction should be made between consumption goods,  like toys and clothes and capital goods, like machines and trucks.  Capital goods can be defined as goods that are used to manufacture consumption goods.  Demand for capital goods can again be split in demand for growth and demand for replacement. Demand for replacement of Capital Goods is not the issue here: we focus on Demand for Growth. Demand for growth means the production capacity needs expansion.  If the production capacity grows at a constant rate, growth-demand for capital goods is stable. If production capacity is constant, growth-demand of capital goods is zero. If there is overcapacity, growth-demand of capital goods is negative, and because you cannot return machinery, it is zero. This relation is equivalent to the mathematical expression that growth-demand for capital goods is “the first derivative”  of demand for consumption goods. This 4th Law of Flostock may seem trivial or overly mathematical, but it has important implications.

Growth demand for capital goods goes through a peak when the demand for consumer goods merely goes through its inflection point (i.e. the point where the curve goes from stronger and stronger growth to weaker and weaker growth). Since the inflection point is much earlier in the economic cycle than the peak of consumer goods, capital goods peak much earlier. So all companies that produce capital goods go through an earlier cycle than all companies that produce consumer goods.

Labor in this comparison is also a Capital Good and there is supply of labor (hiring) for Growth and supply of labor (hiring) for Replacement. When consumer goods go through their deflection point, supply of labor for growth goes through its peak and starts going down. Supply of labor for replacement continues to take place untill the consumer goods go through their peak, then becomes negative and people are fired. Temporary labor suppliers like Randstad always remind us that they are early-cyclic, therefore they are a leading indicator. This is true, but they are only a good indicator because it is easier to see a peak than to see an inflection point. For the rest temp labor is just the first derivative of the main cycle. 

China is another implication of the 4th law : China has grown strongly over the last 25 years, but mainly in capital goods for the own industry and export of consumer goods. When the export growth slows down (so it is still growing, only slower), Chinese production of capital goods will decline.  If China does not manage to get its population to increase their consumption fast, and it is unlikely that they will, the Chinese industry will decline. This has already started. If the export of consumer goods will reach its peak, so when export markets become saturated, growth demand for capital products will be zero (or negative). In addition, the Chinese industry is young, so there is not yet much demand for replacement. This means that both types of capital goods production will stop.

On the other hand (because I don't want to stop with the word 'stop'), if demand for consumer products starts growing again, as it may be doing in the USA, Japan and Europe, growth demand for capital goods will once again see a strong growth indeed.

Wednesday, June 5, 2013

The Hoarding Cycle

In an economy that grows year-on-year, for centuries, the total amount of possessions will grow too. There is however a physical limit to what our houses can contain,  so either we stop buying and start saving, or we throw away faster, or we miniaturize our possessions. The miniaturization then is especially the investment  per cubic meter, so we can hoard more cumulative income in the limited space of a house. An iPod takes up less space than a CD-collection, which is again smaller than the same amount of music in vinyl. An Xbox is smaller than a baseball, an e-reader is smaller than a book case, a flat screen takes up less space than a classical TV-set and 100 euros worth of jewelry in gold is smaller than 100 euros worth in silver. But at some point the house is full and we have to throw things away if we want to buy new stuff. Despite the miniaturization and throwing away, the result over the centuries is that the amount of possessions increases. Let’s call this the Hoarding Trend.  

There is a big destabilizing effect of this amassment of goods: people have so many possessions that buying many types of new goods is for a large part discretionary. When a crisis hits, people may  decide to postpone buying new things.  The notorious Men’s Underwear Index describes this phenomenon, but it also applies to many other material goods. Some collections of material goods (“fleets” in Flostock terminology) will age fast and  at some time will need replenishment, whether the crisis is over or not, either because of wear or because of fashion (which could also be seen as a kind of wear).  This applies to cars, underwear, clothing in general and maybe it applies to music as well. But it does not apply so much to furniture, home decorations, books, kitchen utensils, sporting equipment or gardening. For those categories of fleets of material goods fashion is not changing so fast and a little aging is not directly visible (at least not for a middle-aged guy like me J). So in these categories people can postpone the rejuvenation of their hoard, their fleet of possessions over a longer period.

So what is the point? Point is these material possessions are a stock that in a crisis may undergo aging without changing in size, but with a big change in flow. Example:  Suppose the maximum life of a couch was 10 years before the crisis, so the fleet of couches had an average age of 5 years. In the crisis people decide to wait longer with buying a new sofa and thus to let it age to e.g. an average of 6 years. In that case the furniture retailers see a 17% drop in sales.  Underwear sales dropped in the crisis, but you cannot postpone buying new shorts longer than a couple of years, so sales must have recovered by now. So a crisis drives delays in buying for stocks of possessions, which delays worsen the crisis. For goods with a potential long life the effects are biggest.

After the crisis, when consumer confidence returns, people want to go back to the average age of their hoard and buy a bit more for a while, creating an upturn in the economy and creating a new, young fleet of stuff, ready to be aged again in the next crisis. This we can call the Hoarding Cycle. The Hoarding Cycle waves around the Hoarding Trend. Question is whether the Hoarding Cycle is driven by the long term economic cycle or the other way around. And since the discretionary part of the possessions is getting bigger over time as the Hoarding Trend curve goes up, the amplitude of the Hoarding Cycle might be growing as well, predicting bigger crises in the future.

Monday, May 27, 2013

Lehman Wave explains price swings in the Commodity Super Cycle

The commodity super cycle, with a wavelength of  30 years, has passed its peak, according to several researchers including José Antonio Ocampo of Columbia University and the Worldbank. The peak was in 2007 and prices are now considerably lower. See e.g. FD of 25 May 2013. Expectation is that prices will continue to go down another 15 years. Interesting.

What puzzles most researchers is that the strong dip after the bankruptcy of Lehman Brothers in September 2008 was followed by a new pricing peak which lay for various commodities between 2010 and 2011. Most of the researchers do not have an explanation for this effect. Michael Camachof of J.P. Morgan believes the cycle is not going down and the intermediate peak is the beginning of another decade of price rises.

Maybe the following can help in this discussion: There has been a Lehman Wave that can explain the recent swings in the prices of the Commodity Super Cycle, both the extreme dip down and the rather strong recovery.

The Lehman Wave was first described by us in a Beta publication in 2009 and can be defined as a global destocking wave that went through the industrial supply chains after credit became scarce due to the panic after the bankruptcy of Lehman Brother (hence the name). In the Lehman Wave, companies wanted to reduce their inventory to free up cash: the so-called Active destocking. Based on anecdotical evidence and common sense I have estimated the desired destocking at 10%. For suppliers at the beginning of the supply chain (the "commodity suppliers") the cumulative effect of all this destocking was an unprecedented dip in volume of 50% or more, with on most cases the deepest point around March 2009. When it became clear a bit later that the end market had continued to consume goods at an almost normal level, the supply chain discovered that they had destocked too far and started re-stocking, creating an upward peak in 2009/2010/2011, which sometimes led to severe shortages and stock-outs.

From volume to price: obviously the supply/demand balance reversed between 2007 and early 2009 and reversed again mid 2010. Therefore I dare speculate that it is this upward volume peak of the Lehman Wave that created the intermediate price peak and I therefore propose to call it the Lehman Price Wave. Without the Lehman Price Wave the Commodity Super Cycle over the last 5 years cannot be understood.

Tuesday, April 23, 2013

Oysters are easier than rabbits

Recently scientists discovered that cooking pots dated some 15.000 year BCE, i.e. from the last Ice Age,  were used to cook fish.
Humans originated from Africa and spread all over the world, in various waves of interbreeding about which the scientists can endless debate. And my family spent many summers with the kids on the French Normandy coast. The connection is that it is easier to catch an oyster than it is to catch a rabbit.
While walking over the beaches and rocky stretches of the European coast line, it is possible to gather a lot of food with little effort, even for toddlers. Oysters, mussels, cockles, crab, fish, snails: they all live there in abundance and only need to be picked up. This is such an easy way of finding high value protein, that I dare say that our ancestors must have spread following the coastlines. People at that time did not have wasabi, lemons or soya sauce, but good fresh shell fish is tasty also without condiments.  The clay pot confirms the hypothesis: in the period when the world was being populated, people foraged the beaches and ate what they found.
I estimate, without any scientific proof, but based on many walks along the coats, that a group of hunter-gatherers consisting of a single family can find enough food along the European coast within a days’ walk. That means they cannot stay long at a single location, but have to keep moving. If I would have to do this I would walk north in spring and south in the fall, with the birds. European coasts have plenty of opportunity to do this. This must have stimulated a rapid spreading of humans over the fringes of the continent.  Only later the centers were populated, when hunting had been improved and people were able to catch rabbits, deer and wild pigs .
Interestingly, if we ignore some islands for a second, there is only one long European coast line: this must have been like a 2-way narrow Neolithic highway, on which bands of foragers constantly bumped into each other, trading, exchanging, fighting and intermarrying. The chance of meeting someone if you are both following the coast is 1000 times bigger than when you spread over the center of the continent. They all must have known each other... This could also be the reason that Neanderthalers were absorbed by incoming waves of new humans.
In stock and flow terms: the stock of humanity in Africa flowed into the Eurasian continent. The passage way were the coastal areas. The feeding capacity of the beaches determined their traveling speed. Bigger groups had to travel faster. Only when the beach highways became too crowded, and stocks of cockles, mussels and crab depleted, people had to move inland to forage.
According to the European committee, there is 89.000 km coastline in Europe.
Assuming a family eats 100 to 150 meter of coast line per day, and it takes 1 year to replenish the stock of crustaceans,  one family needs about 5 km coastline, permanent. This means that Pleistocene Europe could feed about 20.000 families, say 1 million people, on its beaches.

Monday, April 22, 2013

Target to create oscillation

In many industrial companies, December is a not a good month. The sales volume for these companies has an oscillating pattern over the whole year, with month-to-month differences that can be as big as 20%. Demand in December is the lowest of the year because of the Christmas holidays, and because in December demand is reduced by active de-stocking.
Managers have targets for running their business, and for many managers that includes a target  –strange enough if you look at it— to have a low level of working capital at the end of the year. The easiest way to achieve that target is to reduce the stocks.  The target is not to have a constant low working capital: it only needs to be low at the end of the year; This is obviously for reporting purposes: it looks good and tidy in the annual report.

A calculation example of the effect: If your customer on average has 60 days of stock, and the customer decides to reduce his working capital with ten percent,  in December he buys less product for the equivalent of 6 days' sales, creating an additional 20% (6 days divided by 30 days) dip in your already low December volume. 

As a result, in January stocks will be too low for normal operations and fast replenishments need to be ordered. This creates a hurried peak in January demand, often resulting again in lower February orders.  So the working capital target is responsible for a considerable part of the oscillating pattern: after a normal November, it creates a deep dip in December, a peak in January and again a dip in February.  The target thus contributes considerably to inefficiencies in the chain.  But you get what you ask: lower inventory.