Welcome to Finance and Fury, the Say What Wednesday edition. This week’s question is from Phuong.

“Hi Louis - With strikes happening at Sydney’s port recently and worker asking for pay rises, do you think that Robot will eventually replace human workers? And what are future job for younger generation, do you think?”

Thanks for the question – brings up a great point – in todays episode – look at the rise of the robots – does it pose a danger to the employment sector and what the future of employment may look like

To start with – look at the rise of robotic workers – in automation

1. study from Oxford Economics - Robots could take over 20 million manufacturing jobs around the world by 2030 – over the next decade – about 14 million of those were estimated to be in China alone
   1. Perspective – 7.8bn population – about 5.15bn aged from 15-65 – working age – 20m is about 0.4% of this working population – or about 0.04% of the population each year
   2. China has an economically active population – or in other words – employed individuals of 776m – so 14m being replaced over 10 years is about 1.8% - or 0.18% p.a.
   3. To give a comparison – say this was happening in Australia – which it isn’t at the same rate – due to the roles that robots will be replacing in the next decade – Oxford Economics also found the more repetitive the job, the greater the risk of its being wiped out – so these jobs are very limited in Aus – but lets say that we will have the same replacement rate of positions
   4. but in Aus it would be the equivalent of 22,700 jobs being lost each year – lots of jobs – but we have just had much larger job losses – ABS said that 594,300 people lost their jobs in April this year due to the shut downs - ABS estimated another 227,700 jobs were lost in May – people have gone back to work – but many jobs are still lost – greater number than would be replaced over the next decade by robots in two months still out of work
2. so over the next 10 years – does sound like a lot of people but perspective is important – wont be massively disruptive as this transition will be gradual –
   1. I don’t think this will be as large as disruption as people think – that is because we know about it as a likely possibility – when people are saying something will happen people can adapt – we are very adaptive –
   2. Technology changes and the resultant unemployment are a part of creative destruction within an economy – which is a part of the cycle – it is the unknown and massively disruptive technological shifts that create turmoil – even in employment – like a lockdown that puts people out of work
3. People may think that robots replacing jobs is going to be a huge issue – and it may be – I may be way off the mark – but I think it will have less of an impact in the long term – as people can truly adapt
   1. Technological change is an economic concept that includes the introduction of labour-saving "mechanical-muscle" machines or technology – automation that replaces the human’s role in production within the economy
4. That technological change can cause short-term job losses is widely accepted – but the view that it can lead to lasting increases in unemployment – structurally – the views are mixed - Participants in the technological unemployment debates can be broadly divided into two camps - the optimists and the pessimists
   1. Optimistsagree that innovation may be disruptive to jobs in the short term, yet hold that various compensation effects ensure there is never a long-term negative impact on jobs – with new technology there comes new employment  
   2. pessimistscontend that at least in some circumstances, new technologies can lead to a lasting decline in the total number of workers in employment. The phrase "technological unemployment" was popularised by John Maynard Keynes in the 1930s
      1. Should be noted that the Oxford Study comes from the pessimists of the group – some of the economics here think that half of human jobs will no longer exist in the future – which may be true – but they neglect that new jobs come up along the way
   3. Yet the issue of technology and machines displacing human labour has been discussed since at least Aristotle's time – he lived around 350BC – so this has been a long running concern – that is because there have been many technological shifts through our history – examples of changes to working conditions –
      1. Just as horses were gradually made obsolete by the automobile, humans' jobs have also been affected throughout modern history
      2. Historical examples include artisan weavers being replaced by the introduction of mechanized looms – but these jobs were replaced over time – and clothing over time because cheap and available – people only used to have one or two sets of clothing
      3. Before electricity - cities and streets were lit by gas and oil - in the early 19th century, gas lamps were first installed in the dark foggy streets of London and other cities and spread throughout the world – and someone had to light these gas lamps at night, then extinguish them in the morning - Thus the job of lamplighter was born – which was an increase in employment
         1. To give you some sense of the scope of the job, there were tens of thousands of these lamps in London alone. The largest gas lighting network in the world is that of Berlin - with about 37,000 lamps
         2. Each lamplighters were paid about $2 per day to care for 70 to 80 lamps – so in Berlin there were likely 500 – throughout the world – 10s of thousands of lamplighters – at this time the world population was about 1.2bn

• In the late-19th and 20th centuries, most cities with gas streetlights replaced them with new electric streetlights

1. On top of this – was the industry that supplied the lamplighter's equipment included whale blubber (for use as lamp oil), wick trimmers and a ladder

1. Similar story over the years in Farming – agriculture – back in the 1400s – between 60-75% of a countries population was involved in the production of food – ranges from 1-10% now – western countries being in the lower 1-4% ranges – most of the job losses occurred since the 1800s – so over a little over 200 years seen the number of people employed in the production of food drop massively –
   1. Assuming that in 1800 – 1.2bn population – at 55% - 660m – assuming everyone is working – lets assume that 66% are working – so 435m
   2. In 2020 – population of 7.8bn – 66% working and 4% in agriculture – a little over 200m people working in this area – so means there have been around a 1m p.a. reduction in employment in agriculture each year for 200 years – so is there a long-term unemployment issue here?
2. During World War II, Alan Turing's machine compressed and decoded thousands of man-years worth of encrypted data in a matter of hours. Then with the rise of computers – economists were worried about many jobs being replaced
3. A contemporary example of technological unemployment is the displacement of retail cashiers by self-service tills

1. That is where there has always been a split of views between the optimism party and the pessimism party –
   1. Prior to the 18th century both the elite and a lot of the common people would generally take the pessimistic view on technological unemployment, at least in cases where the issue arose.
      1. the 18th century fears over the impact of machinery on jobs intensified with the growth of mass unemployment, especially in Great Britain which was then at the forefront of the Industrial Revolution.
      2. Carl Marx – who was a pessimist – would organise the workers in factories to destroy machines as they were worried the machines would replace them – even though they were employed to operate the machines

• Yet some economic thinkers began to argue against these fears, claiming that overall innovation would not have negative effects on jobs. These arguments were formalised in the early 19th century by the classical economists- because it became increasingly apparent that technological progress was benefiting all sections of society, including the working class

1. Concerns over the negative impact of innovation diminished and the term "Luddite fallacy" was coined to describe the thinking that innovation would have lasting harmful effects on employment.

1. The view that technology is unlikely to lead to long term unemployment has been repeatedly challenged by a minority of economists. In the early 1800s these included Ricardo himself. There were dozens of economists warning about technological unemployment during brief intensifications of the debate that spiked in the 1930s and 1960s.
2. During the 20th century and the first decade of the 21st century, the dominant view among economists has been that belief in long term technological unemployment was indeed a fallacy. More recently, there has been increased support for the view that the benefits of automation are not equally distributed

1. However – now the views are changing in the main stream – back to that technology will be massively disruptive to the employment markets
   1. The actual evidence - Robots have come a long way already – but only about 1.7 million manufacturing jobs have already been replaced by robots since 2000 - including 400,000 in Europe, 260,000 in the US, and 550,000 in China – so in the past 20 years only 1.7m jobs have been replaced – but robots are getting better – so this may accelerate
2. What is going to expediate this replacement?
   1. As mentioned in the question – strikes and union action may incentivise employers to replace workers – strike that was referred to was organised by the Maritime Union of Australia (MUA) - caused an 11-day cargo backlog at the port, with a knock-on effect of container supply chain congestion spreading to Melbourne and Brisbane as vessels are diverted.
      1. Patrick said this week the action had seen terminal production cut by 40%, shipping schedules had slipped dramatically by nine days and delays were worsening by a half-day for every day the action continued.
      2. The terminal operator said MUA was demanding 6% annual pay rises for the next four years, and Patrick estimates the full list of claims will cost it around A$40m (US$29.2m) a year.
   2. Patrick CEO Michael Jovicic said: “I’m bewildered that the MUA would try this on during a pandemic, particularly when the average permanent employee is currently paid approximately A$155,000 a year, with top earners receiving more than $200,000.” – not sure if this is accurate – but

What is the next generation of employment – will people be fully replaced by robots? This may be what some economists are worried about – but they may be in a similar line to Carl Marx – who was a pessimist and his followers would go around destroying machinery

1. short term – there will be a displacement of workers – but as I said earlier – this is already known – and the replacement of jobs will be gradual – not in one go - anyone not currently in a job – younger generations – may escape the fate of losing jobs – as there will be new jobs that come out of this –
   1. Like machine operators – rather than doing the automated job – working with the robots
2. That is where while automation displaces workers, technological innovation creates more new industries and jobs on balance
   1. if robots are taking over jobs – there will be additional jobs for Mechanics, those who construct, build and install the machinery, or even additional software and IT employment opportunities
   2. Outside of this - jobs that require creativity or social intelligence are very unlikely to be replaced – so there are plenty of industries that wont be likely to be replaced for decades
3. But longer term – who knows – AI may replace workers – but again additional employment opportunities can come out of this – ones that people haven’t even dreamed of – it will come out of the additional supply of goods or services produced by AI and hence there will be a demand for additional employment opportunities – can speculate – but what employment will look like in 100 years is really anyone’s guess –
   1. But do I think that things like UBI will be needed to help give people incomes because robots/AI have replaced all employment opportunities? I don’t – as history has shown – more job opportunities comes out of additional technology – not less – we went from 55% to 2-4% in western nations working in Agriculture over 200 years – so a likely trend may occur with additional technology being implemented – but with this change – jobs will come
   2. Who would have though that that people would be driving a car in the form of a taxi or uber 200 years ago - would have thought that an electrician would be a job or that IT would be an industry – or anyone working with software – or that oil and gas would be an industry – this is less than 200 years old on a mass scale
   3. Or even the steel industry – which used to be very labor intensive and expensive – now it is everywhere
   4. As more automation occurs – there is likely to be more output of production which goes into other forms of employment
4. What would be a concern –if Governments get involved and regulate industries and innovation gets stifled – may see the job losses with no rebound
   1. For example - job creating effect of product innovation could only be observed in the United States, not as much in countries with massive levels of regulation and limited innovation like Italy
5. My hope is that this allows additional economic growth and people to grow with this

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/

https://ourworldindata.org/employment-in-agriculture

Welcome to Finance and Fury.

1. This episode – be looking at one of the simplest ways to potentially generate alpha and outperform the broader market
2. It’s been a decade since financial markets have become increasingly centrally-planned by central banks and with this - disconnected from fundamentals
   1. Hence – traditional analysis of shares based around their fundamentals may not provide outperformance – however – I think it is still important to understand which are good companies to buy into
   2. Looking at fundamentals and understanding these and their implications in the broader sense can be hard – takes many years to learn
   3. But what if there is an even simpler strategy to beat the market and generate alpha?
   4. That is where there is one interesting strategy from some quants – released an article called "Can quants make money by tracking the Fed books?"
      1. Runs through trading alongside the Fed's balance sheet – as this seems to be the dominant price setter in markets
      2. Been talking about this emergence in a few episodes recently – but interesting that some quant traders are now implementing this
   5. Looking at the influence the Fed has had on share prices -
      1. Monetary policy has the ability to influence asset prices – a lot of evidence that low interest rates and accompanying expansionary in monetary supply creates rallies in assets with risk - monetary contractions can create market retreats  
         1. been more obvious since the GFC - market reactions appear to have become increasingly aligned and dependent on central bank actions – especially that of the Fed
         2. This is in part due to policies such as QE – as well as forward guidance from CBs – with statements like to the effect of supporting markets by any means necessary – increasing speculation and the dive head first into those assets that will be supported
      2. In 2008 – the total assets on the Fed balance sheet have expanded from $2.3tn to about $7tn today – this is a growth rate of over 200%
         1. Over the same time - S&P 500 rose from 900 to about 3,300 -growth of about 270%
      3. Over the shorter term – this year specifically – From March the Fed was sitting on about $4.7tn and this has grown to the previously mentioned $7tn figure – a growth of about 48%
         1. the S&P 500 over the same period has returned about 42%
      4. There is definitely a correlation here – but there is likely a causal relationship as well due to the flow of money into the markets that comes with the Feds balance sheet expanding – injecting liquidity as they would call it
   6. But how predictable are asset returns based on prior Fed action and can this be used as a tool to outperform the market?
      1. Technically – Fed policies have to be transparent – hence they can be market-moving – if traders are paying attention – so there is likely a first mover advantage here –
   7. Looking at what the quants wrote as their trading strategy – or what they are looking at - simply following the Fed
      1. They first go through the observation of the correlated movements between markets and the balance sheet of the Fed – have many charts showing the relationship between the growth of the Fed balance sheet and a variety of risk assets
      2. They note that the sheer scale of unconventional monetary policy does seem to have also made asset returns more predictable, and performance appears increasingly contingent on central bank actions. This provides a potential opportunity for investors.
      3. Fed has committed to maintain its asset purchase programmes “at least at the current pace to sustain smooth market functioning”, and with ultra-low rates expected to at least until 2023, according to the Fed, it is clear these unconventional monetary policies are going to remain a key driver of markets for some time.
   8. The quants note introduces a simple tactical alpha strategy that uses the growth of the Fed balance sheet to measure the degree to which monetary expansion is supporting risk-asset rallies
      1. The strategy - implemented in the context of the classic long-only equity/cash decision (buying and selling shares) – “provides supportive evidence of market predictability and the potential to utilize measures of unconventional monetary policies in designing systematic strategies”
      2. This means that to outperform the market – you can follow the growth of the feds balance sheet – as they note based around their simulations – doing so “generates a sizable outperformance with a reasonable success rate"
      3. Important to point out that this model is illustrative - provides a framework to extend to analogous risk -on/-off
   9. They did run some observations on if the relationship between the Fed causal beyond what is correlated –
      1. presented the correlation of weekly growth in total Fed balance sheet assets with lagged and subsequent returns of the S&P 500 index – what they found:
         1. “The negative correlation between lagged stock market performance and current growth in Fed assets (left-hand chart) means that stock market declines increase the likelihood of Fed action in the form of balance sheet expansion. On the other hand, the positive correlation between subsequent stock market performance and current Fed asset growth means that Fed balance sheet expansion leads to positive stock market performance. The impact of Fed asset growth on equity markets lasts, on average, for the subsequent four weeks.”
         2. “Consistent with economic priors, balance sheet expansion leads to stronger positive market returns, and our analysis shows that this lasts for up to four weeks, following the policy change, with a peak observed at three weeks. On the other hand, and contrary to expectations, Fed balance sheet contractions are also followed, on average, by market rebounds, although the strength of these correlations were much weaker in the initial three weeks, with a stronger bounce on the four-week mark.”
      2. So there appears to be a small announcement effect initially – but then the market reaction appears gradual – peaking at the 4 week mark
         1. Could be for a number of reasons – information delay – through to it taking 4 weeks for the liquidity to hit equities – through the purchases being in the Fixed Interest markets and for those on the secondary market to turn around and use the funds to buy shares – or it could be the impact on the lowering costs of capital for companies pushing up the valuations – whatever the reason – there is a lag  
      3. Can these observations be traded – this isn’t advice – but general in nature – based around what the evidence shows
         1. The Quants design of investment strategy considers the distinctive lead-lag correlations between Fed expansion and Fed contraction – so they designed a weekly tactical alpha strategy based on Fed asset growth that aims to boost investment returns by selectively overweighting riskier assets during Fed monetary expansion regimes. To that end, the quants used weekly Fed balance sheet data over the period of 2009 and Sep. 2020 – a period of intensive use of unconventional monetary policy tools
         2. The strategy consists of using a classic equity-cash allocation with the goal of generating excess returns by systematically tilting towards risk opportunistically following expansionary monetary policy
         3. In the illustration – they used a long-only portfolio with a strategic allocation of 75/25 between equity and cash – their evidence showed that the impact of Fed asset growth lasts on average for four weeks with the lead-lag correlation to cumulative S&P returns peaking at around the fourth week. The input to the strategy is the weekly growth rate in the Fed total assets, and the strategy seeks to allocate more to equities (from safe asset holdings) during periods of monetary easing as reflected in the growth in Fed assets.
         4. the performance of this simple tactical tilting strategy shows that they would have been able to provide annualized excess returns of 2.5%
      4. So based around these models – it appears to work – can it continue working?
         1. If it is implemented correctly – and assuming that the causal relationship is due to the spill over effects from programs like QE or corporate bond purchases
         2. But there is no denying that the Feds movements do now move markets –
      5. the quant strategy implemented in the context of a long-only equity/cash portfolio provides some evidence of the potential to utilize the Fed as a partner in generating returns – if they are going to expand the money supply and this is going to flow into risk assets – like shares – why not follow?
         1. The Quant simulation generates a sizable outperformance with a reasonable success rate
         2. What else should we expect in the financial world where trillions of additional dollars from the expands of the Fed balance sheet have the ability to flow into shares once they are loosed into financial markets
      6. This being said - the Fed balance sheet-tracking strategy probably shouldn’t be the sole investment strategy that people use –
      7. Important to remember goals and look at your own risk tolerances and the point of investing
      8. But it could be useful as an overlay - given the massive numbers of other factors that affect markets and their performances - the Fed balance sheet strategy could also be blended with other trading decisions

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/

Welcome to Finance and Fury, the Furious Friday edition.

This episode – be looking at the weird combination between socialism and billionaires that is emerging – especially focusing on why billionaires are increasingly becoming in favour of socialism? Or additional government controls over economic function

1. Interesting development - Wouldn’t think that these two worlds would collide – the only time I could think of socialism being used in the same sentence is to take away the billionaires money – which is has been – but why would some billionaires be in favour of this? technically – if a country was truly socialist – they wouldn’t have any wealth – or would they?

In this episode – try to puzzle this out further to make sense of it and to see why they might be in favour of it -

To start with – look at the concept of Socialism for the rich and capitalism for the poor 

1. This is a classical political-economic argument which states that in advanced capitalist societies – the more advanced the country the more there is wealth – the more governments can exist – and with larger governments comes the ability of additional policies –
   1. Hence – these state policies can assure that more resources flow to certain sectors of the economy - in the form of transfer payments
2. One of the most commonly raised forms of criticism are build around the fact that the more political the economy becomes – the more it allows for the flow of resources to go towards certain large corporations
   1. This allows for the process of privatize profits and socialize losses - The argument has been raised and cited on many occasions.
   2. May have heard this from mostly individuals on the left – those
   3. But they take their anger out on the ‘rich’ – which is such a generic term – what is rich? We are all rich compared to someone living in the 3rd world – that is where movements like the occupy wall street movement was misdirected in their energy and efforts – they were pointed in the wrong direction – as their solutions would have caused more of the same – giving the government additional power over the economy – wanting redistribution to take from the top to give to the bottom
3. The concept of socialism goes on large spectrums –
   1. All the way – Government controls all means of production – which has never worked well
   2. Part of the way – what most people might think of – is social policies – like social security
   3. In either case – governments need more authority – either to control all of the means of production – or to have the ability to tax or raise funds through deficits to fund their policies
4. There are lots of criticisms of free market principles – but with Governments acting the way they do now – there is no free market – so calling a county capitalist when it has a socialist style monetary policy – where a semi-state or even private company in the case of the Fed control all of the money – isn’t truly a free market –
   1. I have plenty of criticisms of the current economic system – but I don’t blame the free market – I see that the free market got hijacked by the one entity that have greater control over it than the sum of individual choices in optimisation – that is Government – they create the rules in which the market has to operate – and the more rules – the less free
   2. But that is where people can use free-market rhetoric to go one of two ways – what is happening in a lot of politics is that it is being used to justify imposing greater economic risk upon the non-billionaire class – SME – through additional regulations – however – billionaires and large companies considered TBTF are being insulated from the rigours of the market by the political and economic advantages that such wealth affords
      1. These two things are not the same – and neither is technically free market
   3. This form of free market is socialism for the rich – where they have levels of state protection – that is part of why I believe that some of the billionaire class and politically powerful want to have a nanny state –
      1. But for the end result of when one is in trouble the taxpayer will bail them out – this is where the too big to fail scenarios of the past decade plus are a good example – seeing more of that now with the Fed buying back corporate debt off the market to further bail out the largest companies on earth – and over this time period whilst most individuals wealth and incomes have declines – select billionaires who have been the recipients of this have seen their wealth skyrocket

A lot of this comes back to the concept of Corporate welfare

1. The term corporate welfare is widely used to describe the bestowal of favourable treatment to big business by the government
   1. The definition of corporate welfare is sometimes restricted to direct government subsidies of major corporations – this doesn’t include tax loopholes and other forms of regulatory trade decisions - which in practice could be worth much more than any direct subsidies – but are indirect due to policy decisions
   2. Subsidies considered excessive, unwarranted, wasteful, unfair, inefficient, or bought by lobbying are often called corporate welfare. The label of corporate welfare is often used to decry projects advertised as benefiting the general welfare that spend a disproportionate amount of funds on large corporations, and often in uncompetitive, or anti-competitive ways.
   3. For instance agricultural subsidies are usually portrayed as helping independent farmers stay afloat - However, the majority of income gained from commodity support programs actually goes to large agribusiness corporations - as they own a considerably larger percentage of production – the same thing happens in the EU with quotas of production for things like the fishing industry where one large company can get 90% of the quota where the remaining independents having to fight over the scraps
2. In the US – estimates are that state and local governments provide $40–50 billion annually in economic development incentives to large companies which could be categorised as corporate welfare
3. the Cato Institute estimated that the US Federal government allocated approximately US$92 billion in the 2006 federal budget toward programs that the authors considered to be corporate welfare - estimated that number to be US$100 billion in the 2012 federal budget – who knows that it is now
   1. Comparison – that $770 billion on social security – which is still a large amount of money – but I’m guess a lot of people didn’t realise that well over $150bn was provided as a form of social security to multi-billion-dollar companies

Brings up important question – how did a lot of the largest companies get there? They provide good product yes – but along their climbs they have received a lot of government assistance – Examples – there are plenty – and too many to go through

1. Tesla – Tesla Motors Inc., SolarCity Corp. and SpaceX together have benefited from an estimated $4.9 billion in government support - data compiled by The Times as at 2015
   1. underscores a common theme running through these emerging empires: a public-private financing model underpinning long-shot start-ups – that investors and the market used to finance
   2. From subsidies at the national and state level, to federal tax credits for consumers buying electric cars and solar panels, to fuel efficiency standards that help bring millions in revenue for Tesla – selling carbon credits given to Tesla has helped them turn a small profit last quarter
2. Amazon - growing rapidly in part to its aggressive strategy for getting subsidies and tax breaks - been getting about 20 subsidy packages a year since 2012 for its warehouses and data centres - $2.8 billion and countingas of December 2019
   1. Amazon created an entire team just to seek out these subsidies, in a continuation of its strategy to work the tax code to its advantage—first by not collecting sales tax and offering an effective discount on every product, and more recently to lower the cost of building new shipping facilities
   2. I understand the benefit of trying to get economic development through additional employment by attracting Amazon to move to your city - If a city or state shells out millions of dollars to attract Amazon, the least it can do is ensure that the resulting jobs lift people out of poverty – average salary for the warehouse workers is about $30,000 per worker, barely above the $26,208 poverty line – 10% of employees are on food stamps
   3. This is another result from this form of socialism – if amazon is the only employer and not much competition – they don’t need to pay much in salaries
   4. But they also take up state resources with other tax payers need to covers - Bloomberg reported last year that emergency responders visit the Amazon warehouse in one County at least once a day for the month to attend to an injured worker
   5. The largesse bestowed on Amazon in Ohio is incredible. A deal for three Amazon data centres netted Amazon a 15-year exemption on property and sales taxes worth $77 million, a $4 million offset to payroll costs, and $1.4 million in cash
3. I’m for not regulating over regulating companies – but I am also not for then making the playing field unfair through providing hand outs to the companies that you choose –
   1. But Billionaires who have benefited from this – as their companies at the top are the recipients of these hand outs – so the individuals who own these companies wealth also grows– they don’t directly get the money in the form of welfare – but they indirectly get wealthier from it
   2. An extreme example of billionaires benefiting from Governments assisting them in creating monopolies is Carlos Slim– billionaire in Mexico – failed business ventures in US – didn’t have the right politicians to help his ventures along unlike what he had in Mexico

Important to point out that here I am not talking about rich – which could be the middle and upper middle class – not even against billionaires – but those that are wanting governments to have more power to help protect their monopolies and provide them corporate welfare – a lot of back scratching going on through lobbying – which is all part of a socialist state – people are still wealthy in socialism – those with political connections – as well as politicians themselves – it is you and I that get the poor end of the deal

1. We don’t have the same political connections to game the system – and when the system is set up to a point large companies need big governments to grow to the point they have – they want to continue that - So they push for bigger governments – like socialism does
2. Plus – even if the government plans to tax all of their wealth away – good luck – billionaires have access to many things that you and I don’t – such as mobility of ourselves and our money – look at the flight from NYC – if you are a billionaire – move your money elsewhere or live elsewhere – and have the best international accounting teams to help avoid paying any taxes – so billionaires can support all the tax payments in the world – cause they know they wont have to pay them – but the upper middle class will –
   1. Same with company taxes – large corporates get tax credits and can use complex accounting practices – through IP laws and R&D costs to conduct a tax shifting scheme through conduit and sink countries
   2. But again – the smaller or medium sized companies can’t operate in this way – even some larger companies can’t – but the new age of billionaires have different companies – especially in technology – which is borderless
3. But there is more to this I think -
4. Where I think this is all heading – with billionaires pushing for socialism and have the political power to direct changes – on top of informational influence – through platforms like Amazon, FB, Google – they are also in favour of concepts like UBI – so we will look at how if a more socialist state or things like MMT come to be – this will also benefit these large companies
5. But in summary for this episode – I think that most of the billionaire class are in favour of calling for socialism due to it giving governments more control over the economy – and hence
   1. Not true socialism – but a socialism lite version to help create additional barriers to entry and help monopolies the markets further
   2. More political power – greater ability for lobbyist to influence policy at the state and federal levels – hence additional benefits for the company

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/

Welcome to Finance and Fury, the Say What Wednesday edition.

This week’s question continuing on the from Raj in last two weeks episodes – interesting topic on how factors affect the real economy – which is us –

1. so this episode will to continue on a similar line –will focus on the remaining factors that can affect the real economy - fiscal deficits more and then the real inputs to the economy, like forex, oil prices and trade imbalances
2. All previous factors – like interest rates can affect our lives and hence affects the real economy – influencing the decisions we make – similar – the yield curve – whilst not directly affecting our lives - can indirectly affect it by decisions that banks make – such as what interest rates to charge or pay on fixed rate loans or term deposits respectively

Before we go on – important to remember that the real economy is the combination of our economic interactions – so it is almost impossible to forecast the degree to which one factor is affected by the other – but you can get an idea about in what direction they are affected -

Fiscal deficit – what does it mean – The government is spending more than it earns and gets into debt –

1. The actual effect on our lives - All depends where the money is spent –
   1. For the individual – public debt in the fiat economy is progressively becoming less relevant to our day to day lives –
      1. Back before fiat currencies – a public (Government) debt may have been a concern – as taxing the population was one of the only recourses to dig themselves out of that hole
      2. Today – every country is in debt – and they can just keep issuing more debt as all money is debt – so just have a CB create more money and use it to buy the debt of a government – hence lending them the money

• When the money comes due – then simply issue more debt to repay the principal – almost like a balance transfer for the individual on credit cards – but on a much larger scale and can be done essentially indefinitely – until confidence and CBs ability to print money ceases

1. So the major determinate on how deficits can affect the individuals in the economy and hence the real economy depends on where the money is spent – major spending areas:
   1. Infrastructure – can improve our lives and daily functions – helps to improve the economic function as well
      1. But the degree to which this has an affect is hard to measure – covered episodes on infrastructure – called “Can public infrastructure spending help to boost a depressed economy?” – mixed bag – and comes back to the same question on how well the funds are spent – white elephant projects – or dig a whole to fill a hole –
      2. Even at the moment – lots of talk that shovel ready projects need to be implemented to help the economy through additional employment – but how? Those out of work are predominately in the hospitality and service industry – everyone I talk to in engineering an infrastructure are already busy – so are people who work in hospo going to go out and all of a sudden go and start working on fixing roads?

• In theory it might sound good – but in reality, the transaction of the economy doesn’t function this way

1. Fiscal stimulus – additional welfare/social security payments -
   1. This comes back to demand side economics – the individual has additional money to spend in the economy – so growth is meant to materialise
   2. Also falls into MMT – that government should monopolise currency and control the flow of a lot of the capital to maximise economic conditions – but this is theoretical -

Other economic factors - some specific ones mentioned in Raj’s question - forex rates, oil prices and trade imbalances – which either directly or indirectly are determinates of the real economy -

1. Oil prices – this is an interesting one – for the individual it might not seem like there is much impact beyond what it costs to fill up the car each week – so look at this first
   1. Petrol bills are a component of a weekly spend for most households – but how much depends on how far you drive – but also the cost of the petrol
   2. The Australian Automobile Association's (AAA) March 2019 Transport Affordability Index reported the average two-car Australian household (two adults, two children) pays $68.99 for fuel every week – this is equal to about $3,500 per year for a family in fuel costs
      1. This is back when fuel was averaging between $1.3 to $1.4 per litre – equal to about 51 litres each week for the family
      2. so if petrol prices goes down to $1 – then at the same usage of 51 litres – this means the family is spending $51 on fuel for the week – or about an $18 savings per week (26% reduction) – or a savings of $935 p.a.

• So this in theory can go towards other spending within the economy – however – it could also go towards debt repayment

1. Especially when debt levels are very high – so people may consider that additional savings should go into debt repayment – which doesn’t boost the economic output –
2. Also – in the measurement of inflation – this lowering of price is deflationary – if it is persistent – and doesn’t increase – as well as individuals not spending the saved funds on other areas of products or services – then CBs may lower rates out of this – but it is unlikely – as fuel is a smaller part of the CPI basket

1. Beyond fuel for the individual – the costs of lowering fuel prices are passed on in the form of lowering costs of supply –
   1. This is part of economic theory – when think about how goods are transported – does make up a minor cost overall – so isn’t that impactful at the single good level – but as an aggregate it could help – in theory – how the theory goes:
   2. If your country is a major importer - the shipping costs for lots of goods are cheaper when fuel and hence transportation costs are lower – so the goods that you buy are now cheaper – which is good for the individual – is also deflationary
2. At the top level – oil companies and fuel producers are affected based around prices that they can charge for fuel versus their costs
   1. Incentives and profits – the costs for most producers are stagnant when compared to the volatility of prices
   2. The Middle East and North Africa are very low-cost producers – at around $20 per barrel down. Worldwide, conventional oil production typically costs between $30 to $40 a barrel

• So if the price of oil is $100 – there are large profits to be made – hence these companies can expand their search for oil and upgrade existing infrastructure – however – if oil prices are $10 – producers lose money – so they have to shut down supply – but this then raises supply – and the lower cost producers survive –

1. Where this impacts the individual in the economy is employment – when prices were high the oil industry worldwide was booming – good salaries and lots of employment opportunities

1. Next comes the currency exchange - Forex – which is a dichotomy between the individual and companies within a country – that is because what is good for one might not be good for the other
   1. For the individual - The costs of buying products from overseas may be better or worse – depending on where the exchange rate lies –
      1. for countries that are heavy importers
      2. For countries that are exporters –

• But the goods that are imported/consumed is really what matters for the individual – example with Australia –
  1. We do have a big export market – resources, tourism and education - a lot of what we purchase from a day to day was likely produced overseas – things like clothing –
  2. Say we are buying goods from China – and the Chinese Yuan (renminbi) goes from 7 to 5 to one AUD – assuming the cost of production don’t change in China (big assumption) – almost a 30% drop in purchasing power for Australia – so like for like – now goods would be 30% more expensive for us to purchase

1. In a similar way – travel costs change – Australians are big travellers – so when our currency is high compared to others – cheaper to travel – I remember going to America in 2011 – was great – things were dollar for dollar – going over to the states at the start of this year – was technically more expensive – whilst the costs of goods in USD hadn’t changed by as much – 30% more expensive –
   1. But if travel is incentivised outside of your country – technically less spent domestically – so there is a feedback loop here – where if it is too expensive to travel for currency reasons – then people may go on holidays domestically which boosts the economy
2. When your currency is high when compared to others – is good for the individual but not for companies if you are exporters – as the reverse is true where the goods are now more expensive

1. For a company – selling a good at $1 AUD is the same regardless of if you do it domestically – or that is your prices to sell to overseas purchases – that price is generally based around the domestic cost to produce – if you sell 1,000 widgets, you have made $1,000 in revenue
   1. But if overseas buyers can now buy two of your goods versus one – well your demand will increase – and with it your total revenue – take the reverse example of the previously mentioned individual scenarios –
   2. Say an Australian company is selling widgets to consumers in the US – or even US companies – and our exchange goes from $1 USD to $1 AUD to $1 USD to $1.43 AUD – or $1 AUD to $0.7 USD – then that is an increase of 30% in what can be purchased by an overseas buyer in the US –
      1. All else being equal – they can now buy 30% more and hence – the Australian company’s revenues will increase by 30% at the same time – this is a simple example – but illustrated that the demand for goods with a global economy changes with exchange rates – this is good for export nations – but the reverse is true for import nations – now it is more expensive for the nation as a whole – and those companies that make up the nation may have less impact on the overall economy

• so unlike the individual – for a company (and technically individuals through those who own the business or are employed by it) – the lower your currency relative to the countries buying your goods and services – the better

1. This is where there is pressure on major exporter nations to keep their currencies low – whether it be artificially like china through a peg – or through monetary policy or other economic factors – the lower the relative currency the better for companies

1. Coming back to the individual in the form of investors – the unhedged position of investments can help or hurt
   1. Smaller follow on point – but if you own apple or amazon shares – they have to be in USD – so if the AUD depreciates then your investment values actually increase – but the reverse is also true – whilst is doesn’t have a massive impact on the economy – does affect the individuals investment values and returns
2. Finally - Trade imbalances – more or less a summary of the previous activity – how much the country is importing versus exporting
   1. It can signify certain realities though – such as what country is an importer or exporter – as well as the direction of currency (forex markets) are likely to move
   2. If you are a major exporter country – you might be considered productive – lots of goods or services provided by your country – hence you have low levels of unemployment – but also potentially cheap labour such as countries like China – hence why you have low unemployment and are a major exporter – but it depends on what you export
      1. Whether it be a service or capital-intensive industry – versus a labour intensive one
      2. Not a consumption nation – unless the production levels can keep up with consumption levels and more
   3. Major importer – you might be less focused on the production of goods – but may be more focused more on domestic services –
      1. Countries like the US have a huge negative balance of trade – but they are still doing pretty well as an economy
   4. When it comes to trades imbalances – don’t have much of an effect on the economy – they are a representation on what type of economy a nation has – and how well the country performs economically comes back to how productive a country is more so than the imbalance in trade

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/

Welcome to Finance and Fury. This episode we’ll take a deeper look into the RBA property market models and how different inputs affect prices.

Potential models that give the ability forecast future growth of the market based around assumptions – from a study by the RBA - A Model of the Australian Housing Market

• Not set in stone – it is a best guess model – the accuracy is built around the assumptions – But the RBA built an empirical model of the Australian housing market that quantifies interrelationships between the factors that drive property price growth
• Looking back over the past 30 years - the Australian housing prices have increased on average by 7¼ per cent per year – since the inflation-targeting period since the mid-90s - by around 7 per cent per year - However, these averages mask three distinct phases:
  1. During the 1980s, annual housing price inflation was high, at nearly 10 per cent on average, but so too was general price inflation. In real terms, housing price inflation during the 1980s was relatively low, at 4 per cent per annum compared with 4.5 per cent during the period from 1990 to the mid 2000s,
  2. The 1990s until the mid 2000s were marked by quite high housing price inflation, of 7.2 per cent per annum, on average, in nominal terms – but 4.5% in real terms
  3. Since 2010 - Annual nominal housing price inflation over the past decade was lower than either of these periods, at a little over 5 per cent on average - and 2.5 per cent over the past decade in real terms
• So what are the major factors and how much do they have an effect on price

Wont go through the whole document or all the RBA papers – but give a summary

In this RBA model – the findings

• They find that low interest rates (partly reflecting lower world long-term rates) explain much of the rapid growth in housing prices and construction over the past few years.
• Another demand factor, high immigration, also helps explain the tight housing market and rapid growth in rents in the late 2000s. A large part of the effect of interest rates on dwelling investment, and hence GDP, works through housing prices.
• The Australian housing market shows strong relationships between interest rates, investment, rents and prices.
  1. The RBA paper combines these relationships in one – hopefully realistic – model. The model provides internally consistent projections for housing construction, prices and rents. It estimates responses to interest rates, allowing for feedback between quantities and prices.
• It helps explain historical developments and some of the key relationships that they found include:
  1. Interest rates, income and housing prices have strong and clear effects on residential construction.
  2. Dwelling completions and changes in population explain the rental vacancy rate.
  3. The vacancy rate has a strong and clear effect on rents.
  4. Interest rates, rents and momentum have large effects on housing prices.
  5. Housing prices and construction are mutually determined, so examining bivariate relationships in isolation can be misleading.
• Some of these observations are not new – but this paper examines these relationships

What are the model outcomes – responses to variables - bring the equations together

• Responses to Interest Rates – Shows that a cash rate change that is expected to be long-lasting feeds one-for-one into long-term interest rates and the user cost of housing - but the temporary change having much less effect.
  1. As interest rates drop – so does user costs - Changes in the user cost give rise to similar, but lagged, changes in the rental yield (lower the cost the higher the net income from property) - which involves substantial increases in housing prices
  2. The combination of lower interest rates, higher housing prices and higher income boost dwelling investments – which increases the number of dwelling stock as well as rental vacancy rate
     1. Rents initially rise due to the income boost from lower interest rates, but as extra supply builds, they begin to fall.
     2. The signs of the effects on vacancies and rents both vary with time and with the expected duration of the shock.
  3. Since 2011 - the cash rate has fallen from 4.75% to 1.5% (3.25% drop) – at the time of the report last year – since then obviously lower to 0.25% - the user cost has fallen from almost 5 per cent to around 3½ per cent (1.5%)
     1. The decline in the user cost reflects a fall in long-term real interest rates (only be half), which in turn reflects falls in global rates and expectations that the decline in rates will be persistent.
     2. The model estimates that the reduction in real interest rates accounts for most of the subsequent boom in dwelling prices and a large part of the boom in dwelling investment – increasing the supply of property
        • The increase in housing supply boosts the vacancy rate and reduces rents. However, these effects are offset by the effect of higher income, with neither the vacancy rate (bottom left) nor rents (bottom right) being much changed on net.

• Responses to Population Growth - Reflecting a surge in immigration, year-ended growth in the adult population (15 years and older) rose from 1.5 per cent in 2005 to 2.4 per cent in 2008.
  1. To assess the effects of this surge, RBA ran a simulation in which adult population growth continues to grow at its 2005 rate of 1.5 per cent.
     1. With per capita income unchanged by assumption- dwelling investment also increase by about 3.3 per cent. This raises housing supply slightly. However, the short-run boost to housing demand is much larger, leading to a fall in the rental vacancy rate to a near-record low of 1½ per cent in 2008 (3rd row, left).
     2. Rents, which were already growing quickly, accelerate to grow 4 percentage points faster than the overall rate of inflation. Without the extra population, our simulation suggests that real rents would have only grown by 2 per cent a year, as shown by the 3rd row, right panel. The cumulative result was that real rents were 9 per cent higher in 2018 than they would have been otherwise. The increase in rents gradually flows on to a similar increase in dwelling prices, although this effect is small relative to the effect of interest rates, discussed in the previous section.

• Responses to Completions - increase in construction as a deviation from baseline - assume that building approvals increases by 10 per cent for one year - represents about 21,400 extra approvals for new dwellings
  1. The extra ‘supply’ (as it is commonly termed) would increase the vacancy rate and hence lower rents and housing prices. The proportionate response of rents and prices (0.4 per cent) is 2.5 times as large as the increase in the number of dwellings (0.16 per cent). This ratio (2.5) represents the inverse of the elasticity of housing demand. It also applies to larger and more sustained shocks. As a rule of thumb, every 1 per cent increase in the number of dwellings (when driven by an increase in supply) lowers the cost of housing by 2½ per cent. Our estimate of the elasticity of housing demand lies well within the range of other estimates. Abelson et al (2005) estimate that a 1 per cent increase in the Australian housing stock per capita leads to an estimated decrease in real housing prices of 3.6 per cent in the long run. Girouard et al (2006) summarise ten international studies, which have an average estimate of 3.1. Two recent and arguably more thorough studies point to smaller effects. Albouy, Ehrlich and Liu (2016, Table 3) find that a 1 per cent increase in real housing expenditure in the United States is associated with less than a 2 percentage point reduction in price. Oxford Economics (2016) find that a 1 per cent increase in the number of houses in the United Kingdom would reduce house prices by 1.8 per cent and cite (their Figure 20) several other elasticities that range between 1.1 and 2.2.
• Responses to Changed Price Expectations and the User Cost - Our measure of the user cost assumes that home buyers expect real constant-quality housing prices to continue rising at their post-1955 average rate of 2½ per cent a year.
  1. This is a simple assumption that is consistent with some of the main features of the data. However, forecasts from RBA model imply that real housing prices (measured with a different quality adjustment) will grow at an annual average rate of 0.2 per cent over the next ten years.
     1. This scenario can also be interpreted as capturing the effect of an exogenous fall in housing prices if the model to be extended to include taxes on housing, this is an important channel through which they would operate. As shown in the top left panel, expected capital appreciation declines 2½ percentage points. The user cost (not shown) rises by the same amount. Housing prices (top right and middle left) then take a long time to adjust, falling gradually, but substantially, to be one-third lower after five years.
     2. housing bubbles do not ‘burst’, they gradually deflate. This scenario is extremely unlikely: nothing like it has happened in Australia before. However, in scale and duration, it resembles the largest housing collapses seen during the global financial crisis (Ireland, Spain, United States), so is relevant as a worst-case scenario to be guarded against. Falling house prices result in large falls in investment (middle right), which reduce vacancies (bottom left), boosting rents (bottom right).

• The decline in construction dampens the fall in prices. The limitations of this partial equilibrium exercise should be emphasised. In a more complicated model, falling house prices would reduce household wealth and hence consumption. The net worth of financial intermediaries would fall. Offsetting this, interest rates would fall, moderating the macroeconomic impact. That said, the housing market response would be an important part of the overall effect.

Their model quantifies some important developments:

1. The model suggests that much of the strength in housing prices and construction over the past few years can be explained by the fall in interest rates – some of this fall reflects lower world real interest rates and some is cyclical.
2. A large part of the effect of interest rates on dwelling investment (and hence real GDP) occurs through the channel of housing prices.
3. The model suggests that an increase in population growth will reduce rental vacancies, boost rents and housing prices, and increase construction. This helps to explain developments following the immigration surge of the mid 2000s.
4. The model is consistent with some important longer-run trends. Construction activity is approximately cointegrated (trends together) with income, although the housing stock is not. The rental yield is cointegrated with the user cost of housing. Rents tend to grow slightly faster than inflation but slower than income per capita

Conclusions –

• Looking ahead, it seems unlikely that there will be a return to the rather extreme conditions of the past few decades when significant increases in household debt supported high housing price growth. Nonetheless, protracted periods of changes in population growth that are not met by adjustments in dwelling supply could lead to periods of sizeable changes in housing price growth. One important factor for housing price growth is the ability of the supply of new dwellings to respond to changes in demand. The significance of this is made clear by the recent increases in higher-density housing and lower growth of those prices relative to prices of detached houses, whose supply has been less responsive.
• Varied bag – and before the recent economic downturn – But the major factors have been
  1. Interest rates declining – rates would need to continue to decline
• But not looking as good as the past 20 years worth of growth as a percentage – may become lower with either

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/

https://www.rba.gov.au/publications/bulletin/2015/sep/3.html

https://www.rba.gov.au/publications/rdp/2019/pdf/rdp2019-01.pdf

Welcome to Finance and Fury, the Furious Friday edition.

This episode is a little different – it is some of my commentary about the political division that is starting to emerge – especially in America – but also how to avoid it in your own lives and also prosper through it

1. Populations being divided It is a natural part of any cycle – and in a pretty natural occurrence in the world at large – there is nothing new to people thinking differently – but to what degree and the degree to which this gets played out in society in a physical manifestation does differ
   1. Covered cycles in the Fourth Turning episode as well as the K-wave theory episodes – and the political spectrum of society works in similar cycles – its almost like it is interwoven between the seems of each generational turning – going back to the 1920-30 – things were pretty crazy – then calmed down – before picking back up
   2. Started to see the emergence of everything in modern society being politicised - from race, sex, economics – even a virus
2. Very useful from a politician’s point of view as it is a natural progression for them to pander to a base – as the population becomes more divided – you shore up more of your voting base – picking sides if you will
   1. So politicians have nothing to actually incentivise them to focus on a reduction in the escalation of the tensions in the population – if anything – many would prefer to increase tensions – especially in the US where voting is not mandatory – you need to energize your base to get out and vote for you – nothing will energize someone like an us versus them mentality –
      1. But we see a lot of what happens in the US - so this mentality spreads here as well
   2. Look at the basic psychology of any cult – or cult like group – the first major step is painting a picture of an enemy – whether it be real or imagined – a group soon falls apart without this core aspect – hence division is important – for a cult it means that people will remain within the group and be afraid of those outside the group
3. But does it actually help us as a population?
   1. If anything – and what is fairly evident – it polarises us – divided us – and pits neighbour against neighbour – so in sort it doesn’t
   2. When everything that people pay attention to is politicised – or everything reported on in the media is politicised – is it any wonder that there is political division and hence division in the population – whether it is by design or just an acceleration of a political cycle doesn’t matter – it has the same outcome – that groups of the population are at one another’s throats
   3. Yuri Bezmenov – talks about subversion – KGB defector – the easiest way to destroy a country is not through military force – you let the country destroy itself – political subversion takes a generation or two – but through making people divided in a nation – through removing any long-term goals and focusing on one social issue after another – can easily have a country implode
4. Hence someone’s political leanings and with – their outlook on life can create a further division - especially in a society which is meant to pride itself on differences – such as multi-culturalism which would naturally bring with it differences
   1. I don’t know how many people have seen the irony here – the fact that we can all look different - but don’t you dare think anything different from one another otherwise you are the enemy – complete inversion
   2. The idea that if someone has a different idea about how something should be done is an enemy to the point that violence is the best response is ludicrous
5. But all of this stems from a deeper root – if there is anything emotional running through society which can be used for political gain – it will be
   1. Emotions are a very strong tool to control people – as you don’t need to actually do anything to control them on an ongoing basis
   2. You just instil an emotion and then train the response – pavlovian style – in a classical conditioning sense
   3. We are visual creatures – monkey see monkey do – if we see others acting in one way – we are influenced by this behaviour – especially in mobs – or what we see on a screen

I view politics today as the wings of a bird – whether it be the left or right wing – they are still part of the same bird –

1. This analogy flows through to the entity known as the Government – think of the government as the bird
2. And it either uses its wings to flap one direction or the other – this is a major issue of the two party system – create an us versus them mentality – without realising that no matter which wing we flock to – the bird is still flying higher – whilst our car windows get their splatter
3. Further divides in goals and outcomes that society can agree upon –
   1. Especially when everything being focused on is in the short term
4. One thing that China has going for it at the Government level – 100 year plans – can afford to do this as they know that the same party is likely to still be in power – hence why they have been able to economically beat most nations –
   1. Not saying this is a good thing – as any government that has absolute control is an awful system
   2. But when western Governments and societies are become more totalitarian in nature – if you have one with a plan compared to one without – well the one without will likely fall behind the former
   3. But a government with a plan can be a dangerous thing – depending on how much power it has –
5. If the people have the power and a plan for betterment – and the government helps the people form their own goals and plans at the individual level and follow through on these through allowing the equality of opportunity – society can flourish and grow
   1. But in the name of being progressive – people are tearing down communities at the moment – rioting and destroying the communities that they live in – based upon the perception that there is a lack of opportunity
   2. But when society is divided by the politicians that are meant to rule – we end up eating ourselves - like the ouroboros – snake eating its own tail
   3. But like the ouroboros - it represents the cyclical nature of the environment – and over time – like any cycle - the division between society occurs in trends –
6. Think about todays compared to the 1930s in most parts of the world – politically – things were pretty similar –
   1. Political ideologies stemming into violence on the streets
7. In Australia we have been fairly immune to most of the political violence when compared to what those in the US are facing
8. But the danger is being so wound up in politics that affects your outlook on society – that is your perception in reality can be changed – when compared to any fact or dialectic discourse – if individuals are based on the emotional representation on what the media is portraying – it can warp perceptions –
   1. The danger is treating perception as reality – which is what actually occurs for most people - to the point where reality is warped in order to make it comply with their pseudo-reality that they see through a TV or phone screen – rather than their own two eyes in their daily lives
      1. That is where our brains have the impossible task of distinguishing between what we see in person or on a screen – and with the ability to either manipulate what is seen through a screen – or show every occurrence of an event so our availability heuristics kick in and we think it is much more likely to occur in our daily lives – the perception takes over
      2. Hence this partisanship untethers the mind from objective reality – partisanship enslaves the rational mind, forcing it to create an alternative reality to justify one’s actions – be it shouting down someone as to not hear an opposing view or knocking them out to avoid those uncomfortable truths

• This partisan reality is so powerful it blocks out anything that contradicts or disconfirms the alternative reality.

1. Seeing the emergence of political murder – wont see the media reporting on this – but in the US there have been occurrences where a disagreement quickly moves to murder – or even someone wearing a trump hat - because in the individuals mind – they have created a reality in which anyone showing a sign of the triggers to their perception of reality – if they have their own firm convictions – killing someone else is acting in self-defence and in fact, they have to kill their opponents for the good of society – as they must be a Nazi – even with no evidence

1. The emotional level of drive – the division between groups – nothing can be achieved in this manner –
   1. And as the saying goes – when words fail – the only recourse left is violence
   2. This is a shame – in a civil society – words and the freedom of speech is the most important facets –
   3. However when words are now seen as hate – when a logical argument or individual opinion can be quickly shot down with cries of sexist, racist, misogynist, or any platitude – the logical debate no longer exists –
   4. Sunlight is the best disinfectant – in society to be able to say anything and then be corrected based around the dialectic in a public forum of debate – that has been how society as a whole has been able to progress through its thinking
      1. But when the minority has the strongest voice and the silent majority just wants to avoid the ire of the vocal minority – the public discourse of what is seen starts to close – hence perceptions change
   5. And as overtons window starts to close – the very topic of discussing police brutality is too much – it has to exist and if you don’t think it does – you need to be brutalised in return -
   6. At the moment – in Aus – plenty of videos going around especially from Melbourne that depict police brutality – they are doing their jobs – financial incentives are in play – they don’t wont to be fired and lose their incomes from not carrying these tasks out – so this cycle continues -
   7. But that is another trap – further division – as it is fear on both sides –
      1. Either fear that the stasi will come and kick your door down
      2. Fear by those carrying this out – that the population will turn on them – such as enforcement agencies such as the police
   8. Fear – it is a powerful tool – especially the fear of death – but people forget that beyond self inflicted deaths such as obesity – governments have been responsible for hundreds of millions of deaths in the past 100 years – but yet the cries for governments to take additional controls to solve our mortality issues grows even more

I try to look at the facts and evidence of the situation – I’m not perfect – can easily get things wrong – but I try to not base anything on a partisan or emotional response – through an us versus them mentality

1. But once fear has a grip on someone’s mind – any amount of evidence is hard to get them to change their minds
   1. Hence – if emotion is the root of the argument – and emotional arguments is no way to base a decision for the whole of society –
   2. Mainly due to emotions being a very powerful way to persuade – hence they can easily be manipulated and controlled – Especially without people knowing it
2. fear and with it anger can be used as a major tool in politics – I have been swept up into it in the past – fearing another party will come into power drives a motivation to vote – or being angry at events playing out – hence why the majority of political ads are negative to the opposition – we all know the type – ‘this party wants to do this, they must be stopped’
   1. Why I no longer support an induvial party – to avoid getting wrapped up into this –
   2. Sure I have a preference – but that is based around policy – but this being said – it is taking the best of the worst – most policies I don’t agree with – but it is a sum of the good versus the bad – more or less a pros and cons list
3. You need to put yourself in a position outside of fear or anger - Doesn’t mean I don’t vote – vote for who I think is best suited – but I no longer put my hopes in politics – I put my hopes in my community, my family and myself
   1. the emotional division created by the modern political environment and energy this drain – not good – we only have so much time and energy that can be given
   2. This doesn’t mean to not pay attention – being informed is important – but this can be a trap – as if your political information is coming from the media – this is a warping of perception
      1. Just not to get wrapped up in either fear or anger – paying attention to those emotions is important – know that you are experiencing them is the first step to controlling them
   3. but at the same time – some peoples lives are completely devoted to one political ideology
   4. to move above this – I try to aim my life in a direction where it doesn’t matter – to become self-sufficient – to be financially independent as well as independent in life – with sources of power, food and water
   5. If I was on welfare and needed the Government – would matter more – I would be out there in the streets shouting the government needs more power to fight the wealthy and provide additional welfare to myself
4. Aim to have your life outside of politics – I view politics as reality TV now – about as scripted and as trashy
   1. The way the media covers it now seems the exact same as any episode of any trash TV – very little facts and cherry picked/edited to the point of purveying the point of view that they want – not the actual information
   2. But this creates a situation with limited real information to base reality upon – and most of what people consume on TV is not reality – but our brains have a very hard time distinguishing this – so even a false reality becomes real in our subconscious
   3. TV – Social media and the news – compare what you see here to your day to day lives –
   4. Pay more attention to the day to day – not what you see on a screen – if you are feeling overwhelmed – switch the screens off
5. The major question we face in this current turning of the cycle is whether it is possible to maintain a civil society with an abundance of political division and the increased number of people embracing an alternative reality – based around the perception being fed to them through a screen –
   1. We’re being overrun by simulacrum - image or representation of something
   2. But once you realise this – you can start moving above it – and moving back to what is important in your own lives – focusing energy on your own community – helping your family, friends, neighbours and walking away from the system itself – as your build towards your own independence – building financial independence and being above the political division

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/

Welcome to Finance and Fury, the Say What Wednesday edition. This week’s question is continuing on the from Raj in last week’s episode.

“I would love to have an overview of how certain economic factors are interlinked and impact economies”

This episode look at Yield curves and bond prices and touch on fiscal deficits

Last week – looked at the other factors – mainly CB policies including interest rates, inflation and the monetary supply – but can’t talk about these without the flow on effects that they have on what is known as the yield curve

1. The yield curve for government bonds is an important indicator in financial markets - helps to determine how actual and expected changes in the policy interest rate (the cash rate), along with changes in other monetary policy tools, feed through to a broad range of interest rates in the economy – hence can have affects on the entities that comprise an economy

The basics for bonds -

1. A bond is a loan made by an investor to a borrower for a set period of time in return for regular interest payments
   1. Known as a debt instrument –
   2. The time from when the bond is issued to when the borrower has agreed to pay the loan back is called its ‘term to maturity’.
   3. When the Government is the borrower – it is a Gov bond
   4. The main difference between a bond and a regular loan is that, once issued, a bond can be traded with other investors in a financial market directly – in the secondary market - As a result - a bond has a market price.
      1. True that mortgages can be traded as well – but it is after they are packed up by a financial institution and traded in a product like a MBS – however – bonds don’t need this securitisation step
   5. Bond yields - is the return an investor expects to receive each year over the bonds term until it reaches the maturity date
      1. For the investor (who has purchased the bond) - the bond yield is a summary of the overall return that accounts for the remaining interest payments and principal they will receive, relative to the price of the bond
         1. Say that the bond is paying a coupon of 1% over a year – and the bond is maturing in 1 years time – the investor will get $100 back and the current price of the bond is $99 – the total yield will be close to 2%
      2. For the borrower (entity that issued the bond) - the bond yield reflects the annual cost of borrowing funds through issuing a new bond
         1. For example, if the yield on three-year Australian government bonds is 1% - means that it would cost the Australian government 1% each year for the next three years to borrow in the bond market
      3. So there is a difference when talking about the bond yields for the investor or borrower
   6. Relationship between a bond and its yield - The prices at which investors buy and sell bonds in the secondary market move in the opposite direction to the yields they expect to receive
      1. Once a bond is issued - it offers fixed interest payments to its owner over its term to maturity – say the coupon payments are going to be 1% p.a. and it is a 10-year bond – get 1% p.a. for 10 years
      2. However - interest rates change all the time = as a result, new bonds that are issued will offer different coupon payments to investors when compared existing bonds that were issued 5 or 10 years ago
         1. In the current economic environment – created a situation where as interest rates are falling – older bonds have become more valuable to investors due to the higher coupon payments – hence the price of existing bonds will rise when compared to newly issued bonds
         2. However, if a bond's price increases it is now more expensive for a potential new investor to buy – so the bond's yield will then fall because the return an investor expects from purchasing this bond is now lower –
      3. Example - consider a government bond issued in mid-2019 with a 10 year term - The principal of the bond is $100 – so on 30 June 2029 the government must repay $100 dollars to the bond's owner
         1. The bond has an annual coupon payment of 2% of the principal (i.e. $2 each year).
         2. Imagine that the cash rate falls – and so does the coupon on newly issued bonds – Governments are similar to households – if the cash rates go down – we want to be able to borrow at lower rates – only major difference is one does it from banks and the other from investors – however investors have little choice as cash returns also fall –

• If new bonds now pay coupon payments of 1% (or $1 p.a.) – However – the older bond still offers a $2 annual income – with basic maths this is $1 in excess of what new bonds will pay - As a result – investors will be willing to pay more than $100 to purchase the older bond – hence the price pay increase above the Face Value of $100 – with a 10 year maturity (now just under 9 years until maturity) - The price of the bond will actually be close to $109

1. But you can see in this example – that if you are paying more than the bond is worth – get back $100 in just under 9 years – but you are paying $109 for it – your yield is actually close to 1% - the additional $9 you get from the income will be negated by the additional $9 that you pay for the bond – so in essence – the price of the bond forms part of the yield curve

1. The yield curve - shows the yield on bonds over different terms to maturity – it is a way of plotting the expected return of a bond over the life of the bond in a visual way – in graph form with the yield on the y (or vertical) axis and the date (maturity) on the x-axis – or horizontally
   1. To graph the yield curve - the yield is calculated for all government bonds at each term to maturity remaining
      1. For example, the yield on all government bonds with one year remaining until maturity is calculated - this value is then plotted on the y-axis against the one-year term on the x-axis – then you do this for the yield on all bonds for two years, then 3 years, all the way up to 30 years or 50 years
      2. Now – the cash rate forms the beginning of the government yield curve – due to this interest rate having the shortest term in the economy (as it is overnight)

• So normally – the yield curve is upwards sloping – goes from a low cash rate to the longer term maturities

1. However – there can be different shapes to the curve based around the level and the slope of the curve
   1. The level refers to the cash rate – the higher the cash rate – as the first point on the curve – the higher the level of the yield curve will be – think of values along the y-axis of a chart – 0.25% compared to 5% - hence the cash rate is the anchor of the yield curve
      1. Due to being the anchor – changes in the cash rate affect the whole yield curve upwards and downwards due to the future influences on the starting point for yields
   2. The slope - reflects the difference between yields on short-term bonds (e.g. 1 year) and long-term bonds (e.g. 30 year) – however this slope reflects the expectations on the fact that the cash rates might differ between now and the future - which are uncertain – However these expectation by the market translate into actual outcomes based around the pricing on debt in the markets – Types:
      1. Normal yield curve - where short-term yields are lower than long-term yields - so the yield curve slopes upward - considered a normal shape for the yield curve because bonds that have a longer term are more exposed to the uncertainty that interest rates or inflation could rise at some point in the future (if this occurs, the price of a long-term bond will fall); this means investors usually demand a higher yield to own longer-term bonds – A normal yield curve is often observed in times of economic expansion, when economic growth and inflation are increasing. In an expansion there is a greater likelihood that future interest rates will be higher than current interest rates, because investors will expect the central bank to raise its policy interest rate in response to higher inflation
      2. Inverted yield curve - An ‘inverted’ shape for the yield curve is where short-term yields are higher than long-term yields - so the yield curve slopes downward – likely to be present when investors think it is more likely that the future policy interest rate will be lower than the current policy interest rate - an inverted yield curve has historically been associated with an anticipated economic contraction – mainly because the anticipated response of central banks reducing interest rates in response to lower economic growth and inflation, which investors may correctly anticipate will happen
      3. Flat yield curve - A ‘flat’ shape for the yield curve occurs when short-term yields are similar to long-term yields. A flat curve is often observed when the yield curve is transitioning between a normal and inverted shape, or vice versa. A flat yield curve has also been observed at low levels of interest rates or as a result of some types of unconventional monetary policy.

• Hence – the slope of the curve is use to help anticipate the health of an economy – if up – things are likely to improve due to rates likely increasing – if it is downwards sloping (inverted) – rates are expected to drop due to CB policy to help boost the economy

Why is the yield curve important – can it actually have an effect on the economy?

The yield curve receives a lot of attention from those who analyse the economy and financial markets. The yield curve is an important economic indicator because does provide information to participants in the market:

1. The yield curve for government bonds is also called the ‘risk free yield curve’ - The expression ‘risk free’ is used because governments are not expected to fail to pay back the borrowing, they have done by issuing bonds in their own currency – this is an important part of financial markets – pricing assets using the RF rate as a discount – so it can affect asset prices – not the curve itself – but the information it contains
2. YC is central to the transmission of monetary policy – in the form of interest rate movements in the economy
   1. When households, firms or governments borrow from a bank or from the market (by issuing a bond), their cost of borrowing will depend on the level and slope of the yield curve
      1. A bank would calculate the interest rate on their fixed rate mortgages by taking the relevant term on the risk-free yield curve – if they are offering 3-year fixed rates – they would look at the three-year term on the yield curve when calculating how much to charge
      2. So the yield curve influences the interest rate fixed rate loans but also on savings products with a fixed term, such as term deposits.
   2. Outside of individuals - Different terms of the yield curve are important for different sectors of the economy
      1. In the previous example – individuals may only be able to lock in their interest rate for 2–3 years, so this part of the yield curve is important for fixed mortgage rates.
      2. However - Many Australian households have mortgages with variable interest rates, so the cash rate is important for them today

• On the other hand, companies as well as the government often wish to borrow for a much longer term, say 5 or 10 years at a fixed rate - so this part of the yield curve is important for them

1. So the yield curve provides a source of information about investors' expectations for future interest rates, as well as economic growth and inflation
   1. In financial markets, the slope of the yield curve (e.g. normal, inverted, flat) provides an important signal of investors' expectations for future interest rates, and by extension their expectations for future economic growth and inflation – hence the slope of the yield curve is considered to be a ‘leading indicator’ of future economic growth and inflation – this is due to financial markets being a forward-looking environment – markets try to price in future data today to make profits
2. The curve can be a determinant of the profitability of banks – through both the level and slope of the yield curve
   1. In an ideal world - banks support the growth of credit (lent money) in the economy - which is an important factor for economic growth when used appropriately for investment (especially business)
      1. Think it is obvious that banks earn profits from lending funds at a higher interest rate than they pay cover the costs of funding their lending (tier 1 capital or paying depositors) – However - Banks usually lend for longer terms in the form of 30 year mortgages than what they are covering in the costs of the tier 1 capital - so part of this profit comes from the difference between long-term and short-term interest rates (i.e. the slope of the yield curve)
      2. If the yield curve is normal, all else equal, a steeper slope will mean a larger margin and higher profits for the banking system – this is a major consideration in countries like the US with long term fixed rates

• However - In Australia, the interest rate on many loans is based on the shorter-term end of the yield curve – due to variable rate mortgages - so the slope of the yield curve has less of an effect on bank profitability – hence why our banking system does better in the current economic environments

1. Fiscal deficits – do play a part – as these are funded through bonds – so if yield curve is inverted – means Govs can easily fund long term deficits and may prefer to wait before issuing bonds –
   1. However – who would want to buy bonds in this world when the curve starts to become inverted – well – welcome to the necessity of QE – have CBs buy back bonds off the markets – if you can create the money out of thin air and it is part of your monetary policy – doesn’t matter to them

In summary – whilst the yield curve doesn’t directly affect the economy – it is used as an indicator to base economic decisions around – so indirectly affects the economy based around the actions that individuals take due to the information portrayed

1. Comes in the form of valuation for assets using it as the risk free rate
2. Also shows the expectations of the markets on what the future has in store for economic growth and inflation – hence investors will make decision today based around what is expected in the future
3. Also shows the potential impact of the banking systems profitability as well as the incentives to raise funds now or later for governments through issuing bonds.

In next episode – finish up – focusing a bit on fiscal deficits more and then the real inputs to the economy, like forex, oil prices and trade imbalances

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/

Welcome to Finance and Fury. In this episode be looking at one piece of information in the share market – insider trading

There is a lot of information in the markets that can be looked at – can look at the fundamentals of an individual company – can also look at systematic information – economic indicators

In this episode – look at one specific bit of information which markets provide and that is the behaviours of insiders of the share markets – specifically directors or people working in management in companies (what are considered insiders) buying and selling shares and if this is a good indicator of the share price performance

1. When talking about insider trading in this episode – won’t be talking about the insider trader that most people might know – what you might see in a TV show or in media headlines about one trader being arrested - insider trading is actually a legal practice that despite the common misconception –
2. does exist and is perfectly legal as it is in a governed way – such as say Elon Musk, or Bezos or Buffet buying or selling their holdings in Tesla, Amazon or Berkshire – this is what we will be focusing on in this episode

To start – looking at the behaviour of investors in the market –

1. There is a theorised relationship on how information affects markets – it is either 100% responsible for market movements or at least contributes to the price movements somewhat –
   1. either way – information can be one of the key reasons buyers and sellers are willing to buy a share at a given price
   2. investors try to make perfect decisions with imperfect information all the time – but the overall demand for a share based around information can lead to the price movements
   3. Sometimes – people buy a share with no more information than that they know the company and have seen the price go up – so they get on the bandwagon
   4. But what about someone who has almost as near to perfect information as is possible? Such as an insider for a listed company – compared to you and I they would be much closer to having perfect information - so surely their decision making on purchasing shares would be better informed – the outcome of their performance on the shares should improve when compared to the average joe
   5. This is one major reason that when insiders are either buying or selling their shares – it is information for us –
      1. It might be encouraging for the market when insiders are buying more of their shares – as this may mean the price is lower than expected
      2. Or if an insider is selling – it might show that they think a company is overvalued
   6. However – it might just mean they have additional cash lying around or they are going through a divorce or buying a multimillion-dollar house and need some surplus cash
   7. But you can know this information – on a register – and can use sites like - Market Index
      1. can’t verify the accuracy or completeness of the information contained on their website - it does appear to offer a decent insight into the owners of shares on the ASX as well as the movements of share buys or sells by those individuals/trusts/companies

What can information can be gained from looking at insider trading

1. The concept comes down to these insides being the owners of these businesses, as well as having inside information but also – they also have some say in the companies direction -
   1. If someone is an owner of shares in the business they are running – they will probably have much stronger alignment with the interests of other shareholders – that is to make a positive return in the share price – why else buy a share?
      1. Compare this to non-owners – in the forms of executives without significant stakes in the company – if they are on the board
      2. On the other hand – some CEOs might run a pump and dump of a share in their tenure without actually making the company a good long term performer – that is where the incentives do need to be monitored closely – hence why with most share schemes for management they have a period in which they cant sell the shares for years after leaving the company – unlike in the past when this was more of a problem
   2. Another somewhat obvious point is that the smaller the company is - the more likely it is for founders and owners of the shares to exert more influence over the direction and success of the company
      1. Not only are they emotionally invested being the founders – but heavily financially invested - hence it further aligns the interest of the CEO to the shareholders
      2. This has been an interesting point when talking to fund managers – they pay close attention to small cap shares that have the founders/CEOs with large ownerships in the business

• However – the smaller the company – no matter how passionate a founder/CEO might be – their company may underperform

1. So, is there any evidence that following the insiders actually works?
2. Thankfully – others have done the work for this – there are plenty of studies over the years – both in the US markets and in Australia that have attempted to quantify the impact of returns out of following the flow of shares from insider dealings
   1. This topic does draw debate form both sides around its application when actually making a decision on buying or selling a share – but based around some studies – there is some evidence to support the notion of following insiders can lead to outperformance of the market
3. US markets
   1. Special information and insider trading – released in 1974 – so rather old and only looks at the years between 1962-1968 – it does show that there is an outperformance in the market of around 7% p.a. over those 6 years from either buying shares when the insiders are buying, or selling when they are selling
   2. Estimating the returns to insider trading: a performance-evaluation perspective – released in 2003 – went through the years of 1976-1996 – showed that there was a return of around 6% p.a. outperformance from following the insiders
4. Aus Markets
   1. Information trading by corporate insiders based on accounting accruals – study from 2006 – followed the years between 1996 to 2003 – showed a 4.3% outperformance level as an average
   2. Insiders profits in the Australian Equities Market – shows that outsiders incur loss if they follow insider’s purchase in all firms
      1. However - for large stocks - earn on average 1.02% 2 weeks, then up to 1.88% and 2.32 % (t-statistics=1.82) 3 and 6 months, respectively, after they purchase stocks.
      2. On the downside - The results for sale transactions across all stocks and size groups show that outsiders make profit over all window periods after they sell following public announcement of insider’s sale. However, the abnormal return after a year for small and medium size stocks is statistically insignificant.

• The results over all transactions (buy and sell) for small stocks show that there is a loss for outsiders after 3 and 12 months if they follow insider’s transactions in small firms. However, outsiders who follow insiders in large stocks earn an increasing abnormal return from 0.29% after a week up to 5.3% after one year following the insider report date.

1. In summary, outsiders can make profitable trades by following insider’s trades in large firms, but the abnormal returns of doing transactions following insiders in small and medium size firms are limited to insider’s sale trades.

1. This is not an exhaustive list of studies and it doesn’t include those that argue against following insider trading
   1. The issue with most of the studies for insider trading is they only follow a relatively short timeframe – the average is about 6 years’ worth of data and the older ones that do follow say 20 years of data were working under different market conditions
   2. Points to look out for – Following an insider’s lead may work in some cases – or they might work at all –
      1. It is almost impossible to know the motives behind the buying and selling decisions of an insider – however – lets look at some recent movements on the ASX and in global markets
      2. A2M – there were material share disposals in August 2020 by the Chairman, interim CEO, AsiaPac CEO and other Executives in the company
         1. Price was around $19 at this time – since then has declined to just above $16 – so either others in the market are paying attention or the outlook for the company might not be so great

• In the technology space – there have been recent accounts of many directors selling in a number of technology companies – this is one area of the market that is speculated to be in a bubble
  1. Even family members – like Kimbal Musk (Elon’s brother) sold36,375 Tesla shares at a weighted average price of about $482.59 around the 31st of Aug – netting $8m – this was right before the price drop – that had a bit of a rebound recently – but is still over 10% lower

1. Few key takeaway points -
   1. Directors buying might be better information than if a director is selling
      1. An insider might sell their shares for any number of reasons - but they are probably only going to buy them for one reason – they think it is undervalued and the price will go up
      2. This being said those - buying can sometimes be an action an insider may take to game the market – this would especially be the case in small cap markets where investors pay closer attention to this – smaller amounts of capital can raise the price by more than what it would in a CSL – could be in an effort to raise some additional capital from the markets
   2. The more involved the insider is the better - often act well in advance of any news
      1. A CEO buying and selling is a better signal than a non-executive director
      2. Pretty obvious point – but the higher the individual in the day to day management is – the better understanding they should have on the operations

• There are papers that have gone further – that the CFO trades are more profitable than CEO trades

1. Another obvious point - but the more directors are trading the stronger the signal – if it is a large portion of market cap or the individuals holdings – then that is a better signal
2. There can be many false flags

Summary

1. You probably should be out there running screens identifying trades purely around what the insiders do - but still at least pay attention –
2. If the company looks good – good fundamentals, good management and the price seems right – and insiders are buying – that might be a strong signal

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/

Welcome to Finance and Fury, the Furious Friday edition.

Today – discuss the topic of banking policy changes and how this opened the gates for the potential of never-ending money supply in the modern banking system

To start with – look at How does money get lent out in Australia?

1. Well – by a bank of course – you go to a bank to borrow money
2. but what are they allowed to lend around? Well in basic economics – banks are treated as a financial intermediary – their role in a traditional sense is to connect savers to borrowers – they act as the middleman
   1. So a saver with surplus cash will put it into the bank – the bank will then use this as a reserve and lend out based around this
   2. Under this situation – a banks ability to lend is limited by how much they have of their customers savings – which act as the deposits
      1. Because in order to lend more money – they need more depositors – no depositors – no loans
      2. However – this theory is based around what is known as fractional reserve banking – where a commercial bank has a set reserve requirement and will lend out at a multiple of those reserves

• The classification of reserves was expanded upon over time – in addition to depositors funds - had treasury bonds and deposits at the RBA – but depending on monetary policy – lending could be limited

1. As an example – say the reserve requirement is 10% - then the multiplier is 10 times – if the bank has $1m of deposits they can lend out $10m deposits -
2. But this concept is rather misleading in the modern era of banking – I mentioned in Weds episode that Australia does not have an official fractional reserve banking system

1. This was abolished when we brought in the Basel standards – ‘Basel I’ – which was implemented in 1988
   1. Central to the design of the Basel capital standards is the idea that a bank should hold capital in relation to its likelihood of incurring losses
   2. In the modern era - A bank's capital simply represents its ability to withstand losses without becoming insolvent
   3. Hence – a capital adequacy requirement is set – monitored and regulated by APRA based around guidelines set by the BIS using the Basel standards
2. I do see one reason why there was a need for this movement away from the reserve requirements – In the modern economy where deposit accounts are insured by governments – it is likely that banks would have found it tempting to take undue risks in their lending operations since the government insures deposit accounts
   1. So these regulatory capital requirements have at least removed this moral hazard
   2. But it has opened up the floodgates for lending – and skewed the traditional incentives of lending – so let’s look at it further

How does the Capital adequacy requirements work?

1. First – look at the capital that has replaced depositors’ funds as the reserve requirement – these are broken down into Tier 1 and Tier 2 capital – where the sum of these two make up the reserve requirements - net of any deductions on the banks balance sheets
   1. Tier 1 – Tier 1 capital consists of the funding sources to which a bank can most freely allocate losses without triggering bankruptcy – essentially - assets that can be liquidated (sold), written down or converted to cover losses quicky – hence it avoids a bankruptcy – includes:
      1. ordinary shares in the bank and retained earnings that the bank has on its balance sheet - makes up most of the Tier 1 capital held by Australian banks –
      2. But tier 1 capital also includes specific types of preference shares and convertible securities – such as capital notes –

• Convertible securities, for example, were included in the Basel II definition of Tier 1 capital on the premise that banks would exercise their option to convert them into common equity whenever additional capital was needed.

1. however - since it is more difficult for banks to allocate losses to these instruments - APRA set a limit of 25% of Tier 1 capital being allowed in this form
2. The APRA requirements set are 10.5% for the capital adequacy requirement – or 10.5% of its risk-weighted credit exposures – the loans that may not be able to be repaid

1. Tier 2 – considered to be less liquid or convertible than tier 1 - in many some cases they may only be effective at absorbing losses when a bank is being wound up
   1. provides depositors with an additional layer of loss protection after a bank's Tier 1 capital is exhausted - primarily consists of subordinated debt - though it also comes in other varieties
2. Both Tier 1 and Tier 2 capital are measured net of deductions
   1. This is an adjustments due to the way accounting measures are treated – sometimes the banks will have forms of equity used to balance their holdings of intangible assets – things like goodwill – so if a bank is going to go bankrupt – this loses all of its value
3. Secondly – have to measure the risks that this capital requirement is set against - For capital adequacy purposes, Australian banks are required to quantify their credit, market and operational risks
   1. most significant of these risks is credit default risk – or bad loans emerging from people defaulting on their loans – which is part of a banks traditional lending activities
   2. This credit risk is measured as the risk-weighted sum of a bank's individual credit exposures, which gives rise to a metric called ‘risk-weighted assets’
   3. Standardised approach for these risk weights are prescribed by APRA for smaller banks - based on the risks of default and other characteristics of each loan the bank is exposed to
   4. For example – take one residential mortgage – if it has a loan-to-valuation ratio of 70%, no mortgage insurance and the borrowers are managing to make repayments - APRA specifies a risk weight of 35% - so for every $100 of outstanding debt – the risk-weighted asset would be $35
   5. However –the risk weight for corporate (business) loans is 100% -
   6. For the big 4 – they use an alternative Internal Ratings-based approach whereby risk weights are derived from their own estimates of each exposure's probability of default – so the bank can set the limits for the risk weight against each loan

Where does the market currently stand –

1. Banks have been busy – the amount of capital held by the Australian banking system has been increasing – rather rapidly since 2014 – went from a capital adequacy ratio of 12% to 16.3% in June – this is a combination of Tier 1 and Tier 2 capital
   1. The rise in the banking system's Tier 1 capital mostly reflects a large amount of new equity in the form of share issuances as well as capital notes that have been issued to the market
   2. Covered this as part of the bail in topic a while back – but the banking system has been preparing for some downturn in loans for some time
   3. Over time – it was also through dividend reinvestment plans occurring over the years the banks Tier 1 capital has been growing – up until recently
   4. Also – with a lot of banks cutting back on dividends – their retained earnings have also boosted the Tier 1 capital more than the reinvestment of dividends normally would
2. Another major trend over the years – thanks to recommendations from the Basel Standard – lend more to households over businesses – that way your risk
   1. There has been a large shift in the composition of banks' loan portfolios towards housing lending - attracts much lower risk weights than business and personal lending
   2. Reversal in lending trends – Busines loans used to make up the lion share – in 1990s – Housing accounted for about 25% business loans about 65% - today these are reversing –
   3. It makes sense from a risk weighted asset point of view -
   4. As an example - The RBA released a paper back in 2010 - $3.9 trillion of lending by the banks with all kinds of loans – based around these risk weighted methodologies – there was $1.2 trillion in credit risk-weighted assets – then $2.7 trillion was unweighted assets
      1. Within the risk-weighted total, corporate exposures account for $370 billion, while residential mortgage exposures are lower at around $300 billion, reflecting their relatively lower risk weights
   5. To expand this example further – on the $1.2 trillion in RWA – banks would need about $126bn by todays standards in Tier 1 capital
3. Bit of a side note – but was interesting reading a paper from the RBA back in 2010 – was talking about the forthcoming regulatory developments that are now in place –
   1. Increase the quality, international consistency and transparency of the capital base - This includes enhancing a bank's capacity to absorb losses on a going concern basis, such that more of its Tier 1 capital is in the form of common shares and retained earnings – which has occurred with massive capital raisings in shares of the banks over the years
   2. Ensure that even if a failed or failing bank is rescued through a public-sector capital injection, all of its capital instruments are capable of absorbing losses. This includes a requirement that the contractual terms of capital instruments allow them to be written off or converted into common equity if a bank is unable to support itself in the private market – which has been achieved by the capital notes which are convertible and form part of the bail in legislation

So what really affects banks’ ability to lend?

1. if bank lending is not restricted by the reserve requirement then do banks face any constraint at all?
   1. As we have seen – it isn’t the reserve requirements – looking at the household debt to GDP over the years – back when it was constrained by deposits and central bank reserves – struggled to get over 40% of household debt to GDP – after these requirements were removed – started to rise by quite a bit – by 2008 was about 110% - today is about 120% - so it has slowed over the past 10 years – but still second highest in the world
2. But – they have to keep their capital adequacy in line with the minimum requirements – however this is rather subjective – in essence – banks are only constrained by three factors
   1. First – you have the demand for loans - banks base their lending decisions on their perception of the risk-return trade-offs – so as long as there are consumers out there with the deposit requirements (or existing equity in property) and the incomes needed to service the loans based around their lending standards- then the banks will lend
      1. There has been no shortage of demand – property markets have been a competitive environment – and with lowering interest rates – the amount people can afford by the borrower in the banks eyes (especially since the benchmark for the serving got dropped over a year ago) has goes up dramatically
   2. Second – the amount of Tier 1 capital they can raise –
      1. the sequence of how this works in practice is that it works in opposite direction of what most people would think – in reality - banks first make their lending decisions (lend the money out) and then go looking for the necessary capital through issuing it to the market to make sure they remain within the requirements
   3. Finally – the measurements of the risk weighted assets – which is a nominal establishment of how much per loan is consider risky – for example – 35% of a home loan
      1. And since the capital requirements are specified as a ratio whose denominator consists of risk-weighted assets (RWAs) – the level of capital that needs to be retained is dependent on how the risk is measured
      2. in turn – this level – say the 35% is dependent on the subjective nature of human judgment – and any subjective judgment from coming from regulators with close ties to those who work for the banks that they regulate – sometimes comes with the ever-increasing profit desire - which may lead the financial system down the road of underestimating the riskiness of their assets – especially in situation with bubbles in asset prices

In summary –

1. If bank lending is constrained by anything at all, it is how much tier 1 capital they can raise as well as how much the population can afford to borrow
2. But the changes from 1988 has created a situation where banks were adapting to the changes in the monetary systems around the world – lending in a fiat world
3. In reality – why wouldn’t the banking system do this? The reserve requirements were the foundation to banking under the gold standard – but under the fiat system where money can be created out of thin air – as long as there is somewhere to soak it up – such as the property market through additional mortgages – why wouldn’t the bank continue to lend as much as possible? Loans to them are assets – so the more they can lend – the more money they can make
4. But I hope this episode helps to explain how the modern banking system works

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/

Welcome to Finance and Fury, the Say What Wednesday edition. This week’s question is from Raj.

“I would love to have an overview of how certain economic factors are interlinked and impact economies: Inflation, Forex rates, Oil prices, Trade imbalances, Fiscal deficit, Money supply, Repo rates, Yield curves and bond prices, Lending rates and Central Bank monetary policy”

Big topic – every one of these factors is related in one way or another – both to the economy and to one another

1. The economy is complex – incredibly interconnected and unfortunately for any economist or policy maker – incredibly hard to accurately predict – or accurately theorise about
   1. You can have theories about if one factors moves in one direction – it will affect others in another matter
   2. But a lot of this is theoretical – purely to it making logical sense based around models that were conducted in an isolated environment –
      1. The world and economy isn’t an isolated environment – change one input and down the road it is anyone’s guess what the 10th order of effect may be
   3. That is the core issue of this sort of topic – any individual with specialised knowledge about the economy – whilst they will have more specialised knowledge than the average person – when compared to the economic decisions based around the individual’s self-interest – the expert will always fall short
   4. For example – I might know more economic knowledge than the next 1,000 people, but if the economy is made up of millions of people – well then their combined specialist knowledge in their own fields and the actions that they will take in turn due to this will result in any number of potential outcomes – ones that an expert cannot predict
2. And like with any complex system – which the economy is – it isn’t linear – so for one expert to say that adding $100bn into the economy through increasing the money supply will result in inflation of 1% might be what the theory says – technically isn’t possible to accurately predict – so it is anyone’s guess
3. For these episodes – we will take a different way of looking at this topic – when most people talk about the economy, they are talking about numbers and statistical measures – for example, how certain metrics affect GDP, or employment, or any range of numbers on a screen –
   1. But this isn’t the real economy – it is a statistical measurement which is cherry picked – did an episode on this three months ago – called “How accurate are economic statistics and do they really matter in our daily lives?”
      1. we are the economy – so to answer the question – will be focusing on the relation to these economic factors and the effect that they have to the individual in the economy
   2. Could go through the theory in relation to the economy – for example - that lower interest rates are meant to lead to GDP growth and inflation – but it is proving to not be the case – so looking at the individual level may be a better place to start
   3. Now – this is still going to be a generalisation – not every individual will act in the same way – but how they will be affected will be similar – depending on their situation
      1. For example - Think it goes without say that if interest rates go down and someone has debt – like a mortgage – their interest repayments will go down
      2. But what about someone without debt? That is either looking to get into the property market or has already retired and doesn’t have debt? Well – the outcome on them is worse – their savings aren’t earning anything and it is likely that the property market just got more expensive if they are trying to get into the market
   4. At the aggregate level – taking the sum of all individual decisions- you get the economic output – but each group of individuals will take different actions depending on their financial situation and what is best for them

This topic can be broken up into a few chunks –

1. Monetary and Fiscal side – how do things like inflation, money supply, lending rates – which are central banking monetary policy affect the individual in the economy which will be covered today -
   1. Then next week - how do things like the Yield curves and bond prices – then government spending as fiscal deficit affect the individual?
2. Real economy side – forex rates, oil prices and trade imbalances – made up of the daily economic interactions within the economy

To start with – on the monetary side

1. Inflation – this is one of the factors that affect individual choice – and in turn the economy
   1. How does the individual respond to inflation – generally – if it is low – not much of a concern
   2. In your own life, do you really notice if inflation of 1-2% is present each year? As long as your income growth or investment/asset growth goes up by more each year – do you really care?
      1. Inflation is one of those factors that if it is out of sight – it is out of mind – especially when it is in small increments that aren’t noticeable in the short term – obviously when you compare the prices of goods and services today to the 50s there is a massive erosion in the purchasing power of your money
      2. Inflation is like the concept of boiling a frog – someone times you don’t notice until it is too late
   3. Where inflation to the individual really matters is when hyperinflation – or at least higher levels of inflation materialise – as this starts to impact the individual’s behaviour
      1. We may start seeing inflation materialise in western nations – potentially on food – ill potentially cover this in another episode – as there are some interesting developments on the supply side – with food areas like rice and meats – need to do some more research on this
         1. If inflation kicks into the country – it may not be from the increase in the money supply to individuals solely – but a lack of supply
      2. When inflation of goods and services starts to rise – it creates further shortages – if you know that by the end of the week things may cost 10% more – you buy now – and stockpile
         1. This leads to a further shortage – and it starts to create a breakdown in the economy – as the nations medium of exchange is likely to lose its value – and when this happens – your economy’s function starts to slow or cease
         2. A barter system starts to emerge and there is a chronic shortage of goods – that creates black markets
         3. For instance – toilet paper – some have recently seen this be a rare commodity – well in countries with hyperinflation like Venezuela – it is an extreme luxury – better to use cash instead - roll of toilet paper costs 2,600,000 bolivars – which converted is about $1 Aud after the resent reset of the currency – as they keep knocking zeros off the denomination – first was 3 and then 5
      3. Thankfully we aren’t at this level of inflation - However – in western nations that are facing the opposite problem of potential deflation – inflation the statistic does affect our lives – due to the way monetary policy is conducted – through interest rate movements in response to inflation targeting
      4. How does a central bank control interest rates – money supply – this is what can reduce our purchasing power
         1. How does the creation of money occur - central bank creates central bank reserves for use by a commercial bank –
            1. The bank – and its shareholders have put up their own money which has been invested in government bonds – then the bank informs the CB that they would like some of the central banks reserves – it exchanges the collateral of the bonds for the cash – then it can lend based around a capital requirement ratio-
            2. Then additional cash is introduced into the economy through fractional reserve banking systems - involves banks accepting deposits from customers (on top of the injection of cash from CBs) and making loans to borrowers while holding in reserve an amount equal to only a fraction of the bank's deposit liabilities – technically Australia doesn’t even have this – we have a capital adequacy requirement – so we technically have no reserve requirements – Statutory reserve deposits abolished in 1988 - and in theory our banks can lend endlessly – in practice – APRA regulate them to have about 10.5% as capital – but this capital can be debt that these banks issue – so they issue more debt in capital notes then lend based around this
         2. Money supply – creation of money is also conducted through open market operations – the Central banks determine how much money is required in the economy for interest rates to be set at a determined level
            1. Interest rates are indirectly affected by open market operations (OMOs), the buying and selling of government securities in the public financial exchanges
            2. OMOs are tools in monetary policy that allow a central bank to control the money supply in an economy
               1. Under a contractionary policy, a central bank sells securities on the open market, which reduces the amount of money in circulation. 
               2. Expansionary monetary policy entails the purchase of securities and an increase in the money supply. Changes to the money supply affect the rates at which banks lend to one another, a reflection of the basic law of supply and demand.
            3. But how does a central bank – and by extension commercial banks create inflation in the economy – two ways – as remember – the definition of inflation is the price increase – I view it more as the devaluation in real terms of the purchasing power – but be that as it may – increasing newly created money to an economy has to flow somewhere – and when it does – it can have the effect of increasing prices -
               1. Price growth of assets – through CB policies like QE or OMO through banks’ lending money – the inflation of prices materialises in the growth of property and shares – what is considered hard assets
                  1. These asset classes can increase in prices outside of these monetary policies – however – they are accelerated when CBs get involved
               2. Then - Price growth in goods and services – this is what most people would be familiar with –
                  1. But IMO - these two prices increases – between property and goods and services can be counter initiatives

• You have a thing called thew wealth affect – the concept that if property or asset prices go up – people will spend more – as they feel wealthier –
  1. However – what about new entrants over time – they are just left with more debt – so might not feel that wealthy if they have $600k of debt

1. That is the difference in the intergenerational effects of these policies – my parents’ generation is probably very happy with these polices – buy a place back in 1990s to 2000s for $300k to $400k - now worth about $1.5m to $2m - that is a good return –these policies have helped them massively –
   1. This is part of the Australian economy – and why we are some of the wealthiest population on earth –
   2. But it has the potential to hamstring our economy moving forward – when the new generations have to take out $600k of debt to buy a standard house – that is a lot of debt that needs to be paid back
   3. Give me 15% interest rates when the average loan was about $80k in the early 90s compared to $600k of debt at 2.5% interest rates – 6 times less interest but more principal
   4. With $80k – repayments of $1,012 p.m. – total repaid of $365,160 – pay back the $80k with $284,160 of interest
   5. With $600k – repayments of $2,371 p.m. – Total repaid $853,461 – pay back $600k with interest of $253,461
   6. But the catch here – and important to remember – the high interest rates of 15% or 17% lasted about 2-3 years – dropped down to 10%, then 7% within a few years – so a drop of 10% in a matter of 5 years –
      1. But even if interest rates had stayed the same at 15% - I would take that over todays economic situation
      2. In real terms – with inflation compared to the 1990s to today - $1,012pm is $2,027 to today – or about $350 less p.m. than what you would have had to pay in the 90s
   7. This means less money in real terms to put towards the economy in spending
2. Inflation itself isn’t a great measure – talked about it plenty in the past – however it is what is used as the measure on which monetary policy is conducted
   1. Looking at the flow on effects of this – on A yield curve - which is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity
   2. Look more at this in the next SWW episode – as bonds and yield curves as a pretty complex topic and takes a while to unpack – as it incorporates interest rates as well

Thank you for listening to today's episode. If you want to get in contact you can do so here: http://financeandfury.com.au/contact/