Vertical integration

Slate licks up on a WSJ look at the return of vertical integration.
The return of vertical integration. By Daniel Gross - Slate Magazine:

"Responding to the recent rise in prices for crucial commodities like copper, rubber, nickel, and oil, manufacturers of all types have taken steps to ensure they have adequate supplies of raw materials and parts. The article cited several examples of companies that bought outright or took stakes in their suppliers. In July, Armor Holdings, which makes armored cars and other products for what it delicately calls the 'survivability industry,' acquired Integrated Textile Systems Inc., which makes a type of fiber used in earmarks products. To ensure a supply of titanium-based parts for its drumlin 787, Boeing last week created a joint venture with Russia's VSPMO-Avisma, the world's largest titanium producer. In 2005, Bridgestone, the Japanese tire maker, purchased a huge Indonesian rubber plantation from Goodyear. "

How does this affect the idea that there are different types of capitalism that operate in different ways? Rhenish capitalism will focus on long-term, incremental innovation that will likely encourage vertical integration; Anglo-Saxon capitalism will be more flexible and more likely to create adaptive structures that are not vertically integrated.

Neuroeconomics

Neuroeconomics and why primeval emotions suppress reasoning when things are very uncertain.


The New Yorker: Fact:

"The results of the experiment suggested that when people are confronted with ambiguity their emotions can overpower their reasoning, leading them to reject risky propositions. This raises the intriguing possibility that people who are less fearful than others might make better investors, which is precisely what George Loewenstein and four other researchers found when they carried out a series of experiments with a group of patients who had suffered brain damage."

This also appears to provide an insight into "the ultimate game". When a low offer is made, respondent's emotion makes them punish the offender at the expense of their own gain.

FX intervention

How unlimited foreign exchange intervention can become problematic even for an appreciating currency. For the moment Chinese rates are below USD, but this may be the way that China is heading also.

Bloomberg.com: Currencies:

"``Lawmakers see the snowballing deficit from the foreign- exchange fund heavily weighing on the government's finances,'' said Oh Jae Kwon, head of the Bank of Korea's currency-market operations team. ``They may ask the national audit board to look into the case.'' Accumulated losses from the management of the fund were 18 trillion won ($19 billion) at end-2005, he said. "

The Law of Once Price

Stumbling and Mumbling: Limits of arbitrage:

"The law of one price doesn't apply - at least for cannabis. According to this survey (pdf), cannabis resin costs twice as much in Manchester as in Liverpool. Which raises the question: why isn't there arbitrage? Why don't traders buy blow from Scousers, drive 35 miles, and sell it to Mancs?
I reckon there are four possibilities:"

Noise trader risk

Everything is easy to explain and understand in hindsight. However, at the time many people were saying that technology would change the world. They were also looking at the best example of a technology company that they had - Microsoft. There are of course many reasons why Microsoft is successful, but one of them is that it was the first to sell a mass-market operating system. There was (and is if we look at Google, EBay, Apple's Ipod) an argument that says that if you are first into the market, network effects will mean that you can create a monopoly that will generate huge future revenues. At least some of the rapid appreciation of technology companies was the attempt to find these new firms with "first-mover advantage".

In retrospect, there are only a few firms that can prevent others entering the same market. The network effect that makes Microsoft operating system (and even more so) Microsoft Office more valuable the more people use them, does not extend to all products. Just because I sell dog food over the internet, does not mean that others cannot do the same. However, at the time this was less clear than it is now. If it were clear, why weren't all those people who now say that they could see the writing on the wall selling these over-valued shares and pushing the price back towards fair value.

The first answer to this is that it is only clear now in the cold light of day. Many of those who say that they were shouting "stop" were actually shouting "buy". The second answer is that there is a risk that share prices continue to move against you even if you know that they are over-valued. People do not have unlimited finance or confidence to continually bet against the hurd.

The main academic paper on this is

Noise trade risk


On a more practical note -

Tony Dye

Tony Dye was trying to act against the market. His employers lost patience just at the moment that he was being proved right.

Regards,

Types of capitalism and types of investment

Undercover Economist: Marriage and convenience:

"JoskowÂ’s explanation surely tells you something about when to be a freelancer - perhaps even when to stop playing the field and get married. Like east coast coal mines, it can be attractive to be footloose and fancy-free - provided you have alternatives and as long as you are not required to make serious investments that are specific to the relationship. My own marriage was swiftly followed by a relationship-specific investment. SheÂ’s nearly two and a half."

Coincidently, Tim Harford talks about different types of investment at a time that I learnt about different types of firm fodifferentnt types of capitalism. Anglo-Saxon capitalist requires flexible firms with non-specific capital (human and physical); social welfare capitalism concentrates on specific capital. The Anglo-Saxon model is flexible and innovative in the product but is not good at developiniterativeve improvements in the production process. There were papers presented at the conference that I attended that suggested that FDI was directed to particular countries according to whether they could bcategoriseded as Angle-Saxon or Welfare state firms.

EMH and the law

The Economist has a good angle on the EMH and how this is one economic theory that is embedded into US law.

"In 1988, in Basic Inc v Levinson, the court endorsed a theory known as “fraud on the market”, which relies on the efficient markets hypothesis. Because market prices reflect all available information, argued the court, misleading statements by a company will affect its share price. Investors rely on the integrity of the price as a guide to fundamental value. Thus, misleading statements defraud purchasers of the firm's shares even if they do not rely directly on those statements, or are not even aware of them"

Agglomeration

Martin Wolf talks about a paper presented by Tony Venables to the recent Fed conference in Jackson Hole talking about the effects of agglomeration and its influence on development.

"The conclusion of this line of analysis is that production will shift only where the benefits of agglomeration are relatively small or the benefits of moving activities are large. Moving back-office functions is an example of the former. Shifting production of clothing to poorer countries is an example of the latter. But the advantages of established centres of expertise are enduring, provided some effort is put into maintaining them: London has been a world-class financial centre for almost three centuries. The relocation of activity will, suggests Prof Venables, prove both difficult and “lumpy”."

Overshooting - in ideas

FT.com / Comment & analysis / Columnists - The world may regret the end of the neo-con era: "The neo-con experience shows the market in ideas – like the market in shares – has a tendency to over-shoot. The militaristic and unilateralist elements of neo-conservatism clearly need rethinking. Americans also need to think harder about the social and historical underpinnings that make democracies work. The danger is that the backlash against neo-conservatism could lead in the wrong direction – and take America back into isolationism or a cynical abandonment of the promotion of democracy. If that were the case, the rest of the world may end up regretting the demise of neo-conservatism"

The share of profits and wages in GDP

There has been a huge amount of talk recently about the share of profits and wages in GDP. Many point to the fact that US wages as a share of total income are at the lowest level since.....Even if we take total compensation it appears that capital has gained an increased share.

Brad DeLong and Krugman suggest that the balance of power has shifted against labour and that this is part of the rightward shift in the US.

DeLong comments on inequality

Chris Dillow has a more nuanced view.

Stumbling and Mumbling: Some profits arithmetic

If we look at the share of wages and profits in UK GDP, they are pretty stable. There is a structural shift around 1945, presumably because of the introduction of the welfare state etc. However, if the shares shift too far, I would think that there is a natural mechanism to bring things back into equilibrium. At the moment, US consumer spending is relatively high compared to compensation. This will correct - either spending will fall or wages will rise.

Quant

Painting By Numbers: An Ode To Quant By James Montier of Dresdner Kleinwort Watterstein

Lovely item on cases where simple statistical models out-perform the expert. Most intereting is the fact that even when the expert know the model (as James did himself), they still under-perform.

Reputation

FT.com / Columnists / Stefan Stern - Corporate crises are years in the making: "As leaders are always closely observed by their colleagues, this attention to corporate reputation has to start at the very top. You will have no one else to blame if your corporate reputation suffers. And you would not want to find yourself in the same position as the wronged Cassio in Shakespeare’s Othello, who cries to Iago (in act 2, scene 3):
“Reputation, reputation, reputation! O, I have lost my reputation! I have lost the immortal part of myself, and what remains is bestial.”"

Leave it in the ground

Iranian oil output has never reached the levels seen back in 1979. The recent "nationalisation" of oil resources looks like it will also leave a lot more of the black stuff underground.

FT.com / World / Americas - Bolivia’s energy chief quits:

"The Bolivian government was forced to call a “temporary suspension” this month to its plan to take a greater stake in the country’s gas sector, citing lack of funds and expertise. Last week, the country’s Senate passed a motion of censure against Andrés Solíz, the hydrocarbons minister, for botching the nationalisation and for alleged corruption at YPFB."

Is it a conspiracy because oil producers know about peak oil and scarcity and want to leave oil in the ground while heading off arguments about future prices?

Private equity

Getting to the heart of the private equity boom.

FT.com / Columnists / John Plender - Private equity folk could do wonders with Microsoft: "This brings us to the real joy of private equity: the so-called “dividend re-cap”, a dividend-for-debt swap. The enhanced ability to borrow would permit the newly private company to make the greatest dividend payment of all time. At a stroke it would solve the financial problems of the army of private equity investors who have been trying – hitherto unsuccessfully – to punt their way out of pension fund deficits. Here, going begging then, is a great historic opportunity for private equity to do its job of generating excess returns from illiquidity. In truth, Microsoft would be worth more off the quoted market than on it. Thanks to the joys of leverage and dividend recaps, the excess returns would come through wondrously fast."

ERP

Lex on the equity risk premium.

There has been little change since 9/11, but...

FT.com / Lex - Catastrophe and equities:

"Yet there is an opposite and gloomier conclusion. America’s 20th century experience was exceptional. In most countries, war risks include the collapse of governments and property rights, not just recession. In such circumstances the price of “risk free” assets plummets along with everything else. This outcome is hard to imagine for the US. Still, for professional doom-mongers, the rise in real yields from post-9/11 lows suggests that what was once viewed as a manageable catastrophe is now thought to herald a new era of existential threats."

US rates

People usually have the Taylor rule as


i = (i* + π*) + ά1(π – π*) + ά2(y – y*)


with i* as the neutral real rate of interest (say 2%), π* as the inflation target (say 2%) and the brackets as the deviation of inflation from target and the deviation of the rate of growth from its potential.


Then much depends upon the ά parameters. Estimates for the Greenspan Fed show ά1 at 0.54 while ά2 was 0.99. For Volcker they were about 0.5 and 1.5.



Therefore, if we take inflation at 2.8% (PCE seems to come between 2.5% and 3.5% depending on how you measure it, so this is fairly conservative) and growth as 3.0% compared to a potential of 2.5%, we have 4% neutral nominal, plus another 0.5 for inflation and something for the output gap (say another 0.75%) would be 5.25%. Of course it depends on the assumption about potential growth. Many people would say that it is more than 2.5% and it depends on what people think the growth rate is at present. It could also be argued that the central bank needs to be more assertive in pushing down on inflation when there is a new Chairman gaining credibility and when oil prices are rising sharply.


The big weakness of the Taylor rule is that it does not deal well with the current situation. What if the output gap turns negative again but inflation remains high? In theory, many argue that ά1 should be more than 1 to ensure that the real rate rises to reduce inflation expectations.

Genius again

More on Galenson. "Experimental innovation" vs "Conceptual innovation".

Wired 14.07: What Kind of Genius Are You?

What he has found is that genius – whether in art or architecture or even business – is not the sole province of 17-year-old Picassos and 22-year-old Andreessens. Instead, it comes in two very different forms, embodied by two very different types of people. “Conceptual innovators,” as Galenson calls them, make bold, dramatic leaps in their disciplines. They do their breakthrough work when they are young. Think Edvard Munch, Herman Melville, and Orson Welles. They make the rest of us feel like also-rans. Then there’s a second character type, someone who’s just as significant but trudging by comparison. Galenson calls this group “experimental innovators.” Geniuses like Auguste Rodin, Mark Twain, and Alfred Hitchcock proceed by a lifetime of trial and error and thus do their important work much later in their careers. Galenson maintains that this duality – conceptualists are from Mars, experimentalists are from Venus – is the core of the creative process. And it applies to virtually every field of intellectual endeavor, from painters and poets to economists.

1660 fx derivatives

Pepys' Diary: Wednesday 1 July 1663: "but I hope we have this morning light on an expedient that will right all, that will answer their queries, and yet save Creed the 500l. which he did propose to make of the exchange abroad of the pieces of eight which he disbursed."

Creed has miscalculated the value of Spanish currency. The value of the pices of eight varies between 5 shillings and 4 shillings and sixpence. Much more here.

Real yields

The FT looks at the rise in real yields. Strong economic growth would certainly argue for higher real yields as a response to the demand for capital. However, this does not square with the recent sell off in emerging markets and commodities.

FT.com / Markets - The Short View: Real yields still have room to grow:

"But real yields have also been rising. According to Ian Scott of Lehman Brothers, a weighted average of real yields in the US, France and the UK hit a low of 1.3 per cent in June last year and has now risen to 2.1 per cent. That still leaves real yields well below their heights during the dotcom boom when, on Scott’s calculations, they almost touched 4 per cent. "

Most likely the emerging and commodity sell off is just a deflation of a bubble.

Luck

Excellent article in the LA Times. Thanks to Paul Kedrosky for the pointer. The maths of luck in the film industry.

Meet Hollywood's Latest Genius - Los Angeles Times: "That's precisely how films behave in the marketplace. If we hear good things, we go and perhaps tell others; if we hear bad things, we stay away. It's that process—the way consumers learn from others about the expected quality of the product—that De Vany found is the key to the odd behavior of the film business today. Economists call it an 'information cascade.'"

The chaotic nature of the success of failure of a film means that the big starts and business leaders have runs of good luck and bad luck. The rest is an attempt to bring meaning to this statistical noise.

Clearly this could be taken further - dare I say it - even as far as the World Cup.