Category Archives: Economics

To borrow or not to borrow: Thoughts on US government debt

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A reputable investment bank approaches you and says they’ll lend you as much money as you want for a very low interest rate. The rate depends on how long you want to hang onto the cash:

  • 1 Month will cost you 0.01% APR interest
  • 6 months: 0.07%
  • 1 years: 0.11%
  • 5 years: 0.88%
  • 10 years: 2.02%

If you earn 3.5% on the money over 5 years which simply keeps pace with US inflation, when you pay back the principle you will be able to keep a 2.62% annual return on whatever you borrowed, based on the 5 year borrowing rate above. So if you borrow 1 million over 5 years you earn $138,046.62 in pure interest over 5 years (compounded annually).

Sounds like a pretty good deal right? $138K earned 5 years from now for nothing. I’d take it, assuming I could find somewhere to invest the money that would give me a 3.5% return, which shouldn’t be too hard.

However, if I’m fiscally irresponsible and rather than investing the cash I’m likely to spend it on hookers and blow, then it’s probably a bad idea for me to borrow as much as I can.

However, if I am that irresponsible and have a history of being a nut job, the interest rate that the investment bank charges me on my borrowings will reflect my lifestyle and will be more like 30% APR which is what many credit card companies charge once you’ve missed a payment.

The interest rates above are what America currently pays to borrow money. It’s the treasury yield curve rates. They are below inflation which means that the rest of the world pays the United States to store their money. And the United States makes money if they can get a very moderate return on any of that cash they invest. If the return simply keeps pace with inflation, they’re rolling in dough.

The interest rate the United States gets charged reflects how investment banks, sovereign wealth funds, companies and individuals feel about the United States “lifestyle” or fiscal and monetary level of responsibility.

So the question is: Can our country borrow trillions of dollars, put it to work in a responsible way and make out like a bandit? Or will it spend it all on hookers and blow and leave our grandkids in the hole struggling to pay off the principle?

Footnote: The answer to this question is usually along ideological lines. Keynsian economists like Paul Krugman who dominate the Democratic party will say Hell Yes! Government knows best and should borrow like there’s no tomorrow. Hayekian economists like Russ Roberts and economic conservatives on the other hand will tell you that the private sector knows best, government should limit it’s size and balance sheet and should never engage in massive borrowing no matter how low the interest rate or the potential return on investment, because it’s not government’s place to act like an investment bank.

Footnote2: I’m still feeling pretty good about my bull market prediction yesterday and am now long Apple (AAPL). I’m expecting it to churn during the next 6 months and have a 18 to 24 month price target of $550 (bought at $418).

Unemployment is lower? Bull.

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Last Friday and again today the DJIA got a nice bump from data showing unemployment has dropped from 9% to 8.6%. This number is known as U3 and only counts those actively looking for work. U4 is what the government should publish which counts U3 + those who have given up looking.

We “added 120,000 jobs in November” and have added over 100,000 jobs per month for the last 5 months.

I found the birth, death and marriage rate on the CDC website. For December 2009 we had 344,000 live births per month, 216,000 deaths per month and 138,000 marriages per month.

Our population is increasing by roughly 128,000 per month, which is 8000 more than the number of jobs we added. Looking at marriages per month gives you an indication of how many new couples are starting life and presumably expecting full employment. That’s 18,000 more than the maximum number of jobs we added per month in the last 5 months.

I don’t think we’re ever going to get the jobs we lost back because the financial crisis of 2008 was a trigger that caused companies that have become more efficient to cut a workforce that is no longer needed. That is why corporate revenue has not declined even though unemployment has increased. The grey marks the recession, click the graph to go to ycharts for a live version.

The only way to solve this is to bring our education syllabus up to date. The chinese have a few ideas how to do that: They’re cutting majors that produce unemployable graduates. 

Can you build a Big Business on Apple’s App Store?

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A good friend refers to the Apple App Store as the California Lottery. So I thought I’d do some rough numbers on how feasible it is to build a big software business creating apps for iPad and iPhone and selling them in Apple’s App Store.

The Apple App Store will still own three quarters of mobile app revenue by the end of 2011. It’s the place to be if you want to develop paid mobile applications.

According to Apple, they had paid out developers $2.5 billion since the creation of the app store until July this year. I’m including this as a sanity check on my numbers below.

According to this article, the combined revenue of all app stores will be $3.8B in 2011, with Apple owning 75% market share. That’s $2.85B total revenue for the app store in 2011 with 30% going to developers so total payout to devs will be approximately $1.995B for 2011 (which roughly gels with the total all time payout number above).

The app store just passed 500,000 approved apps in May 2011. (Edit: fixed a typo. Apps, not developers)

In May of this year:

  • $3.64 was the average price for paid apps.
  • There were 244,720 paid apps.
  • There were 85,569 unique developers.
If those paid apps split Apple’s projected 2011 revenue to developers of $1.995B between them, they each earn $8152.17 per year. There will be more paid apps by the end of 2011 than there were in May, so the same calculation for 2010 revenue to developers gives us: $2.1 total sector revenue X 75% apple’s market share X 70% developer share gives us $1.1025B / 244,720 paid apps = $4505 per app in 2010.
I’ve calculated both 2010 and 2011 revenue per app because the only data I have on total paid apps is from May.
So total revenue per app now is roughly between $4K and $8K per year based on my back of the envelope calculations.
While app store revenue is increasing, so is the number of developers in the app store, exponentially:
Lets say you create a startup producing Apple App Store apps. You manage to completely dominate the app store in 2011 and capture 1% of the total 2011 app store revenue of around $2 billion that Apple will pay out to developers.  That’s $20 million in annual revenue. Remember, you’ve just owned 85,560 other unique developers and a quarter million other paid apps, which is not impossible.
To put this in perspective, here is the 2010 annual revenue from a collection of well known software companies, leaving out the eye watering revenue from companies like Oracle, Microsoft, Apple, Google and the like.
Sources:

Food for thought.

We are centrally planned and we are vulnerable

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John Robb writes an excellent post arguing that the concentration of wealth in the United States has resulted in a centrally planned economy. I wanted to expand on his writing.

After World War II, there was a widely held view that Nazi Germany was the result of failed capitalism. Economists and political scientists in the UK and across much of western Europe thought that Capitalism was a bad thing and the answer was socialism.

A now famous economist called Fredreich von Hayek argued in The Road to Serfdom, published in the early 1940′s, that Nazi Germany was actually the result of central planning. He suggested that a centrally planned government is destined to become fragile and is easily seized and taken over by those that might not play by the rules.

Hayek was based in England, but his book was far more popular in the United States and it may be the reason we ended up with a free market economy post WWII.

John Robb’s idea is a new and useful lens to examine our political and economic decline: Through capitalism gone wild, we may have ended up with all the trappings of socialism after all.

 

 

The world is now paying the US government more to store their money.

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I ran across this page on the Treasury’s website via Marc Cuban’s blog. It shows the yield on US government treasury bonds, adjusted for inflation. If the yield on a bond is 3% and inflation is 2.5%, the real yield is 0.5%.

So in inflation adjusted terms, anyone buying 5yr treasuries today is paying the US government 1.02% per year to store their money.

Curiously, after the downgrade, the world is paying the US government even more to store their money.

 

Treasury real yield curve

What does the S&P’s AAA to AA+ downgrade for the United States mean?

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If you haven’t heard the news, S&P just downgraded us from AAA to AA+ and gave us a negative outlook to add insult to injury. But it’s not like we didn’t deserve it. In a democracy, people deserve the government they get. Remember that “We the people…” document? Well we the people just got a AA+.

It’s the first time the US has been downgraded since we received a triple-A rating from Moody’s in 1917 and a AAA from S&P in 1941.

Obama says “S&P’s analysis of the United States economy is deeply flawed.”. I think his chances of reelection just got deeply f***ed.

Keep an eye on treasury bond yields on Monday morning. There’s a tension between interest rates going up since they’re now technically more risky and the reflex flight to risk causing treasury buying that drives their rates down. It’ll be interesting to see whether fear or common sense prevail.

So what will happen going forward?

  • Interest rates in this country are bound to rise long term because, what the government pays on debt is the base of all other interest rates in the country.
  • Mortgage rates rising won’t help the housing market “recovery”. Less people will buy houses with the cost of borrowing becoming more expensive.
  • With asset prices falling a few more banks will fail. Their debt to asset ratio will not meet the minimum requirements and the FDIC will show up on Friday afternoon and seize them.
  • Expect to hear about the FDIC fund running short on cash and there to be a vocal debate about how to replenish it. Technically it’s an insurance policy that the banks fund and in normal times the government might just top it up. But what will probably happen as the fund gets depleted is that they will need to raise the rates they charge banks, which may make banking in this country more expensive for consumers and businesses.
  • The latest budget debate made it very clear there will be no more trillion dollar bailouts. The good news is that at least this kills moral hazard (when bankers and execs are irresponsible because they know they’ll get bailed out.
  • It gives us a reasonable facsimile of a free market. Even if you’re going to have to dodge the falling bodies on Wall St….
  • The dollar will fall as foreign investors move to countries like the UK, Germany, France and Canada who all still have their AAA rating intact.
  • Companies that rely on cheap foreign labor or resources will have to radically restructure their supply chains to survive and some might not be able to pull it off.
So where are the opportunities? Well I’ve said it before and I’ll say it again: “Gold prices will hit $1800 in September/October and $2200 or more by year end.“
  • Companies that export US goods or services will earn more as the dollar falls.
  • Technology companies who are nimble, efficient and export services will do well.
  • New innovators will replace incumbents who can’t readjust.
  • We might get a new political party in the next half decade.
And for a laugh.. the Federal Reserve just announced that risk weightings for US government securities (how risky the government thinks it is) will remain unchanged:
For risk-based capital purposes, the risk weights for Treasury securities and other securities issued or guaranteed by the U.S. government, government agencies, and government-sponsored entities will not change. The treatment of Treasury securities and other securities issued or guaranteed by the U.S. government, government agencies, and government-sponsored entities under other federal banking agency regulations, including, for example, the Federal Reserve Board’s Regulation W, will also be unaffected.

And finally, lets hope that 500 point drop in the DOW this week was a leak that has now been fully priced into the market, or we’re in for an even bigger drop on Monday.

How sovereign debt becomes leverage – a lesson from history

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"America Looks at its Neighbors" (political cartoon, 1932).

"America Looks at its Neighbors" (political cartoon, 1932).

I grew up in South Africa and for a time my birth country was the only worthwhile stop on the long sea journey that spice traders would make from Europe to India and back. South Africa was colonized by Europeans for this reason. A guy called Jan Van Riebeeck was ordered to set up camp there by the Dutch East India Company.

In November, 1869 the 10 year construction project on The Highway to India, aka the Suez Canal, was completed and South Africa became just another colony. Since then the Suez has had a colorful history, but there’s one specific teachable moment in the history of the Suez the United States could learn from…

In July 1956 the president of Egypt, Gamal Nasser decided to nationalize the Suez Canal. This irked a few stakeholders and on October 29, 1956, Israel invaded Egypt. The next day Britain and France threw their hats into the ring and started bombing Cairo.

At this point in history, Britain was suffering under a mountain of debt. Here’s a historical graph of Britains debt to GDP ratio to give you some perspective:

British Public Debt from 1900 to 2010

British Public Debt from 1900 to 2010

The United States held much of the debt that Britain was in. Some of the bonds were owed to the US as part of Britains World War II debt to the US government, corporations and individuals and some of them were part of the Marshall Plan to help rebuild Europe post WWII.

The US used this debt to put tremendous pressure on Britain to halt the invasion. Eisenhower ordered Humphrey, secretary of the treasury to prepare to sell part of the US governments sterling bond holdings. His British counterpart advised his prime minister, Anthony Eden, that if the US did sell their bonds, the British pound would devalue to such an extent that they would no longer be able to import what they needed to sustain the islands. Eden announced a cease fire on November 6th.

The US is now at around 90% debt to GDP ratio with a total debt of just over 14 trillion. Around 4 trillion of that is held by other countries, China being our biggest “investor”.

Lets put it this way: It’s hard to not take the call when your single largest investor needs a favor.

Who created the debt crisis the United States is in?

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This is illuminating to say the least. The Washington Post is reporting on spending under Bush vs Obama. Keep in mind that the Post has been called “Pravda on the Potomac”, so it comes with a healthy pinch of liberal bias. My view is that the budget culture in Washington is broken because a new budget item becomes permanent by default, so spending can never decrease.

Spending under Bush vs Obama

 

Why burger stands, gas stations and politicians tend to cluster

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Presh Talwalkar has an elegant explanation on why competing entities in an environment where demand is linearly distributed (like two burger stands on a beach) tend to cluster in the center of demand.

The intuitive explanation is this: Imagine two burger stands on a straight beach a mile long with the beach crowd evenly distributed along its length. Customers will gravitate towards the closest stand. If one stand was a quarter mile from the left and the other was a quarter mile from the right, they would have an equal number of customers.

But if one of the stands moved slightly towards the center, it would gain more customers and the other stand would lose those same customers (a zero sum game). So the optimal position for both stands is dead center i.e. on top of each other. That gives them both 50/50 market share and prevents the other stand from gaining more market share.

…even though it causes people on the beach to have to walk further to get a burger.

Check out Presh’s blog entry for a full explanation and accompanying graphics. He relates this to why politicians tend to position themselves in the political center and why news channels all carry the same stories.

Bringing this back to the real world, I wonder about things like goodwill, brand loyalty, pricing power, brand cachet and so on. Positioning yourself in the center of the beach, in the center of the political spectrum or, if you’re a news channel, carrying the stories everyone else carries does not engender much love in your target market.

If a competitor were to come along and position themselves off-center, they may sacrifice a portion of the market, but develop fierce loyalty among their customers for being better and being different.

This brings to mind many famous brands who started with a cult following: