What’s going on in China: An introduction to macro-economics

Before I begin, let’s start with a few basic macro-economic foundations. A country can either control its interest rates or its currency. It cannot control both at the same time. When you increase interest rates, you make investing in your country more appealing to foreigners and your currency rises.

China has a mostly fixed exchange rate with the U.S. This means that Chinese monetary policy is essentially decided by the Federal Reserve. The problem is that given its growth rate and where it stands in the business cycle, China needs much higher interest rates than it currently has. Given the current growth and inflation rates in China, the current rates are much too low and extremely expansionary – essentially akin to putting gas on a burning fire.

If you don’t control your monetary policy, there are still a few things you can do to slow down your economy. You can run a government budget surplus and if you happen to run large parts of the banking system (most Chinese banks are at least partly government owned), you can try to make lending more difficult – by introducing risk adjusted returns based lending systems as opposed to allowing lending based on political connections.

Announcements like the ones made yesterday are basically saying: we are going to push hard on the brakes because there is way too much liquidity in the economy. It makes perfect sense for the markets to have reacted the way they did in light of the announcement.

Whether or not the Chinese government succeeds in slowing down its economy is still up in the air. I am a bit skeptical. The central government in the end does not really influence bank lending policies, especially in the provinces far from Beijing and Shanghai. Moreover, facing some discontent by workers and farmers left behind by the growth on the coast, it’s unclear that the Chinese government will successfully reign in its spending.

The much simpler solution would be to increase short term rates, let the currency float and introduce more competition to the banking system to make sure lending was based on returns rather than political connections. Moreover, a rising currency would have a few benefits: it would make foreign goods cheaper and therefore hold down inflation and it would bring oil prices down as oil is still priced in US dollars.

In other words, China should take control of its monetary policy and let its currency float – not because some idiots in the US think that will solve the US current account deficit, it won’t – but because it’s in China’s best interest to do that. Given the inherent conservatism of the Chinese government, I bet it’s the direction they are moving in, but that they will just do it slowly over the course of a few years.

Brief non-sequitur: I am not saying that currency boards and fixed rate exchange rate systems are always bad. They have a time and place – especially if a country is facing hyper inflation or can’t be trusted not to keep the printing presses running (e.g.; Argentina in the early 1990s). The problem is that over time if the fixed exchange rate is too high relative to the real exchange rate, you can get massive speculative runs on the currency – which when the central bank runs out of foreign currency reserves – leads to a devaluation, a floating currency and often a recession (e.g.; Argentina 2000, UK ejected from the ERM in 1992). Conversely, if the fixed exchange rate is too low you get massive inflows of capital, over investment and asset price inflation (e.g.; China right now).

Macro Perspectives on Global Liquidity: How Chinese Farmers and Oil Sheiks are Subsidizing American Consumption and its Implications

If you were an economist arriving from Mars and looked at capital flows around the world, you would be very surprised by the patterns you observe. Ex-ante you would have expected the wealthiest countries to be exporters of capital as return on invested capital should be higher in developing countries than developed countries. The UK was a net exporter of capital when it was at the height of its power. However, a glance at actual capital flows shows that the US is an importer of capital with a current account deficit nearing $1 trillion dollars and 7% of GDP.

Where the flows are coming from and what assets they are invested in is just as interesting. US corporations are actually net exporters of capital. The current account deficit is caused by consumer and government consumption. Almost all of the deficit is with China and the Middle East, which to date have been investing in treasury bills. Chinese citizens have an extremely high savings rate, which when combined with the Chinese government’s desire not to let the Yuan appreciate against the dollar, means that China has been buying hundreds of billions of dollars of treasury bills. Similarly, the Middle East is awash in cash given the increase in the price of oil and the low extraction costs. As domestic consumption has not and probably cannot increase beyond certain levels without unleashing inflation or the money getting wasted as it was in the 1970s, most of that excess cash has also been invested in American treasury bills.

As American treasury bills are not yielding very much and as the Yuan and Middle Eastern currencies are reasonably expected to increase relative to the US dollar, you could expect them to make little or negative returns on their US investments. In other words American consumers’ and the American government’s consumption are being subsidized by Chinese citizens and oil sheiks!

If any country but the US had a 7% current account deficit, alarm bells would be going off at the IMF and elsewhere. Fortunately for the US as the dollar is the reserve currency of the world and its debt is denominated in dollars, it can print as much money as it needs to cover the debt. The issue is that being the reserve currency of the world is not a given and geopolitically depending for funding on countries whose loyalty is dubious at best is risky. Optimists will point out that China and Middle Eastern countries have to continue to buy treasury bills and cannot sell their holdings if only to prevent the dollar from collapsing and generating significant losses on their investments. This is not a good argument. For where it to happen, the US would undoubtedly have lost its reserve currency status.

For capital flows to realign four things need to happen:

  • Consumer savings needs to increase in the US
  • Government savings needs to increase in the US
  • Consumption needs to increase in China
  • Consumption needs to increase in the Middle East

How fast this happens will determine the outcome. Historically, such adjustments were rapid and led to massive currency depreciations and recessions (think of the 1998 Asian currency crisis). A year ago, I was extremely bearish about the US economy as I felt we could be entering a perfect storm.

Specifically, I thought global liquidity would collapse as:

  • Short term interest rates rose in Japan ending the Japan carry trade were people would borrow in Yen at a 0% rate and invest in dollars and dollar denominated assets yielding much more than that
  • Short term interest rates rose in the US
  • As baby boomers started to prepare for retirement, I expected the American savings rate to start to increase
  • I expected US consumption to start declining as homeowners on variable rate mortgages faced higher bills leading both an increase in foreclosures, supply of houses, decline in prices and a further decrease in consumption

In addition, the yield curve was inverted, which was usually a harbinger of a recession to come.

I was wrong. Interest rates rose in Japan and the US. There was a real estate correction in the US. Yet throughout the period liquidity remained high. The world is still flush with cash.

Peter Thiel, a brilliant friend of mine who was founder of Paypal and now runs a macro hedge fund called Clarium thinks he knows why – and I agree with him. China also has a current account deficit with the Middle East so arguably all of the excess liquidity in the world is coming from the Middle East. As long as oil remains above $40 – and there are a lot of reasons to believe it will remain around $60 for years to come – the global liquidity glut is not about to disappear.

As both China and Middle Eastern countries seek higher returns on their investment you can expect even more money to flow into venture capital, private equity, hedge funds and real estate – despite the fact that returns have been declining and that people have been predicting a collapse for a long time.

This is why you are seeing frothy valuations for assets around the world:

  • Startups are raising money at high valuations
  • Ever larger private equity deals are happening
  • Hedge funds keep pooling ever larger sums of cash
  • Real estate prices are still increasing globally

So what does this all mean? If you are an entrepreneur trying to raise money – this is a very good time to do so! The fact that oil prices are likely to stay high suggests that the liquidity glut is likely to endure for quite some time, but you never know so take the money while it’s available! From an economic perspective, I think this explains cleanly why we have seen asset price inflation without seeing real core inflation. The last time this happened was in 1978-1979 during the last oil shock. Peter’s contrarian thinking is that this suggests that short term interest rates are not going to go down anytime soon. The asset price inflation and excess global liquidity suggest that central banks should probably have a more monetarist stance and if anything might have to increase short term interest rates. Before Volker the Fed was essentially saying: “Inflation is 10%, our interest rates are 10%, we are neutral.” Volker came in and essentially said “inflation is 10%, but asset and monetary inflation is so much higher that interest rates should be 20%.” He brought core and asset inflation under control at the cost of a severe recession that set the stage for the expansion that has essentially gone unabated ever since except for a few very mild recessions.

In other words, Peter’s contrarian stance is that the yield curve is going to become even more inverted as short term interest rates increase – at least in countries which are paying attention to liquidity growth like the UK and Japan – while long term interest rates remain low given the excess global liquidity. This story’s most likely outcome is a severe recession.

It’s interesting that while I am probably the most optimistic person I know in terms of life, humanity, geo-political outcomes and our long term success as a civilization, I am such a pessimist the US economic prospects in the short and medium run. For once, I really hope I am wrong!

A different perspective on global warming

Global warming seems to be on the mind of many these days. There is no denying that the earth has warmed up over the last century. There is also increasing evidence and a growing consensus among scientists that humanity is contributing to and is probably the main cause of global warming.

There are still many unknowns. There is clear evidence of extremely rapid changes in temperatures in the past. Sediments extracted from the Ross Ice Shelf in the Antarctic, the world’s largest ice shelf, show that it disappears and reappears in cycles. There seems to be a correlation with the solar cycle, yet changes in solar intensity seem too small to cause ice ages without some sort of amplification effect.

Nonetheless, there is a consensus that we should reduce man-made carbon emissions, which seem to be the main human driven cause of global warming. Unfortunately, it strikes me that many people are not doing cost benefit analysis when making their recommendations. The Kyoto protocol as it is designed, if fully implemented with its inflexible rules, would cost tens of billions of dollars with the only benefit of slowing down warming (not reducing temperatures, merely slowing down the increase) by maybe 10 years. Moreover, I rarely see discussions of the benefits of global warming. As most of the warming is happening and will continue to happen at higher latitudes, it will make life more enjoyable and productive for many.

There is also a real question of equity. World GDP has been growing at nearly 5% per year for the past few years, but even if was only 3%, with the power of compounding, the upcoming generations will be much richer – not to mention technically more advanced – than we are. From a question of equity, it’s not clear that we should bear a disproportionately large portion of the costs of fighting global warming.

That is not to say that nothing should be done, quite the contrary, a lot can and should be done – but intelligently. The environment is not owned by anyone and thus no one charges for the right to damage it. This free access causes the “tragedy of the commons” as the resource is doomed to over-exploitation. As economists would put it, if you buy a product that pollutes and are not charged for it, you only bear the marginal private cost of the product and not the marginal social cost that you impose upon society by consuming your product. You will thus over-consume.

In other words, if you want to change consumer behavior to reduce carbon emissions, the easiest way is to tax carbon emissions. There are many ways to do this. To charge corporations, the most efficient way is to create a global carbon market and decrease the annual carbon emission allocations. This would allow factory owners to decide for themselves when it’s more effective to buy the credits or to change their production means. It also has the benefit of not tying their hands technologically. The market will find the most efficient means of decreasing their carbon emissions. I would not trust politicians to make decisions – especially given their tendency to pursue self-interested policies (e.g.; supporting ethanol in corn producing states).

It’s important to note that such markets need to be carefully regulated. The European Union created a trading scheme: the European Union Emissions Trading Scheme (EUETS), but some of the countries, especially France, were so shameful in giving out carbon allocations that price of carbon collapsed. Human ingenuity is very good at dealing with problems. When CFCs were essentially banned, it cost a lot less than expected to replace them. In this case I am sure there are low hanging fruits and we could probably reduce carbon emissions by 10-20% at very low cost.

At the consumer level, given that most of the carbon emissions are generated by fuel consumption for cars, the easiest way to make consumers bear the costs of their consumption is to tax gas. In the U.S. a $0.50 or $1 per gallon tax on gas would go a long way towards pushing consumers towards more fuel efficient cars. Unfortunately, no politician has had the courage to come out with this simple solution – most prefer to hand subsidies for alternative fuels.

It should also be noted that the tragedy of the commons affects not just carbon emissions, but essentially any market where producers or consumers do not bear the marginal social cost of their actions. We should also create carefully regulated global trading markets for other pollutants. On the consumer side congestion charges should also be introduced to decrease traffic and pollution. London successfully introduced such charges with minimal disruption and decreased traffic by 15% at peak times in central London and significantly increased average speeds.

Kite boarding and entrepreneurship

Entrepreneurs are often risk taking, adventurous individuals. Not surprisingly many of them try things like kite boarding, ice climbing, car racing, flying planes and heli-skiing.

According to Sean Tierney, a young entrepreneur and founder of Jumpbox, it’s not just that entrepreneurs are attracted to those sports, but entrepreneurs have a lot to learn from a sport like kite boarding. You can read his fun analysis at: http://www.scrollinondubs.com/2007/02/08/kite-surfing-startups-and-the-power-band/

Heli-skiing is divine!

I love skiing and have skied at lots of places: Snowbird, Alta, Jackson Hole, Tahoe, Chamonix, Val d’Isère, Courchevel… However, there is something very different about heli-skiing and especially heli-skiing with CMH (www.cmhski.com/ski).

Skiing a full week in untracked snow floating on powder as if they were champagne bubbles is quasi-spiritual! I just arrived at the CMH Gothics lodge for a week of heli-skiing and after one day of skiing was overcome by a near spiritual moment of joy!

I was overwhelmed by gratefulness – to life, to my dad for having introduced me to skiing and taken me heli-skiing so young, to my circumstances! I am happy!

There is so much in life for wonder and awe – it sometimes makes me wonder that people need religion at all!

Here are a few videos and pictures to provide a glimpse of this magical adventure:

I am really looking forward to the rest of the week!

Why I don’t work in the gaming industry

As a self avowed gamer and gaming enthusiast with a true passion for games and clear game design ideas, I often get asked why I don’t pursue that passion professionally.

The reason I am not in gaming is that economic dynamics don’t favor startups:

  • As Moore’s law and Metcalfe’s law continue unabated consumers expect ever richer gaming experiences. This leads to rapidly increasing game development costs in all segments – from low end online and mobile casual games to hard core games.
  • Gaming is inherently hit driven and a few hit games (for which there is no recipe) generate the bulk of the revenues in the industry.
  • Startups cannot easily raise the $100+ million necessary to develop some of today’s high end games – and even if they could they would have all their eggs in an incredibly risky basket. A large company like EA can easily finance multiple large projects knowing that even if most fail its hits will likely pay for the failures.
  • Very few game companies successfully transition from being low-end casual game makers to multi-billion gaming behemoths (though Netease and Shanda in China successfully made that transition).
  • In many ways what I describe above is reminiscent of Hollywood. The large studios are the only ones capable of bankrolling $100+ million movies hoping that the hits pay for the flops. The “startups” are the smaller independent movie studios which develop lower budget movies. The risks are lower but so are the rewards as they can’t create billion dollar revenue movies such as the Lord of the Rings trilogy or Titanic.

    That is not to say one cannot build a small successful gaming business – especially in the short and medium run. I know many companies such as Boonty or Jamdat who have become successful building online or mobile games. But despite those successes, I don’t like the long term dynamics of the business – even the supposedly low cost casual online and mobile game segments.

    In both of those markets, a few years ago it cost less than $50,000 to make a game. Licenses were cheap and most of the games made money. In many ways this was reminiscent of the PC gaming industry in the 1980s. However, as the devices grew in complexity and the market grew, licensing and development costs increased dramatically moving the market in a hit-driven direction. I am sure that by now several mobile games have cost over $1 million to make. That’s why it made so much sense for Jamdat to sell itself to EA to leverage its licenses and balance sheet.

    Conclusion: I love games, but for now I will remain a gamer on the sidelines of the gaming business.

It pays to be lucky – part 3

This time I am not blogging about how lucky I have been in the past but about how lucky others have been.

Paul Kedrosky, a venture capitalist, recently posted the shareholder information from the Youtube transaction on his blog.

Clearly Chad & Steve did extremely well for 18 months worth of work on Youtube. What is even more extraordinary is that they did not intend (at least as far as I can tell) to create an amazingly successful company to change the way people entertained themselves with video. They just wanted to create a simple way to upload their own videos on the web. It happened to take off and become incredibly popular.

When I look at some of the other mega-successes on the Internet over the past 10 years, most of them were not intended (again if the legends are real):

  • eBay: Pierre wanted to allow his wife to sell pez dispensers online
  • Yahoo: David & Jerry built a directory of the Internet for their personal use
  • Craigslist: Craig’s list was a list of fun parties and events for him and his friends to attend
  • Google: Larry & Sergei started Google as a Stanford PhD research project
  • MySpace: While Chris knows why MySpace took off (inherent virality and the early focus on music), he clearly did not expect it to have the success it ended up having

The only extremely successful consumer Internet company that seems to have been intended is Amazon. Jeff decided that his entry strategy would be the book market because of the long tail (to offer books bookstores could not). He located his company in Seattle to be near Ingram – the largest book distributor in the world. He already had designs on other product categories from the beginning. In other words, he intended to build the company he built.

While I have somewhat more respect for Jeff as I like to see intended successes (it would be depressing if outcomes were purely based on luck), I still tremendously respect the entrepreneurs who got lucky. They might have gotten lucky, but they did so by trying to solve a problem that they – and as it turned out the entire world – faced and they fully used their skill and intelligence to capitalize on their luck.

In a famous 2001 meeting between investment bankers who will rename unnamed and Larry, Sergei and the newly arrived Eric Schmidt, the bankers were excitedly telling Google that Overture (or Goto) had successfully raised money and that its business model was becoming very successful as a means of monetizing search. Larry, Sergei and Eric went on to reply that they would never put ads on Google because:

  • The quality of their algorithmic search results was so good no one would ever click on paid search results
  • They did not want to interfere with the purity of their search results

They went on to produce a 55 page Powerpoint (that my banker friend still has saved for historical purposes) to explain that they were going to make money by selling their search services to enterprises to help them sort through all the data they collected and mostly did not use. If anyone needs 55 pages to tell you how they are going to make money it’s a very bad sign! Today this accounts for less than 1% of Google’s revenues.

Clearly, they had the strength and intelligence to recognize the error of their analysis and then went on to copy and then greatly improve upon Overture’s model – displaying the highest revenue generating ads on top, not the ads with the highest CPC – and the rest is history… All the “lucky” upstarts mentioned previously probably had such forks in the road where they could have gone down another path. Hats off to them for successfully managing growth and getting to where they are today!

On a related topic, Joel Cutler, a great venture capitalist at General Catalyst and friend of mine, pointed out to me yesterday that the companies that got lucky and grew extremely rapidly with little capital in the past few years had at least one of two things going for them: they were inherently viral, had great search engine optimization or both. Wikipedia clearly benefits from the fact that its millions of articles are indexed in Google. MySpace and Youtube truly succeeded because of the viral nature of their services.

As my companies are not inherently viral, I will just have to slug it out for a few years and see what happens. As for you, if something is nagging you about your online experience – go fix it – it may actually be something that’s nagging everyone else too! If whatever it is you are fixing is viral and produces lots of content – preferably created for free by users – all the better! Maybe you can get lucky too 🙂

The thinker versus the doer

“Having gone though two university departments, I was fairly cultivated, thanks also to my long inertia, which I consider highly educational. He, on the contrary, was a great businessman, ignorant and active. But from his ignorance he drew strength and peace of mind, and I, spellbound, would observe him and envy him.”

Zeno’s Conscience