#71 Europe’s Unequal Siblings: Monetary Economics in Central Europe

The great experiment that is Europe still needs to overcome a number of obstacles until it truly becomes an economic entity. Especially when looking at the integration of new member states to the economic, political and cultural entity that Europe seeks to be. Central Europe can be seen as a collection of younger siblings in the family of European states. In many ways states such as Hungary, Poland, Slovakia and the Czech Republic are like restless teenagers on their way to adulthood.

Current president of the Czech Republic, Mr. Václav Klaus, is known to be a vivid enthusiast of Milton Friedman and his dogmatic free markets. You might therefore think it would only be natural for this liberal economic fervor to wash over to the lower political echelons. But this is not the case, because these badly needed fiscal reforms hurt those people in the economy who need government protection the most. Leftist and Populist parties make good use of this and find great support from the disadvantaged, disenfranchised and elderly sections of the electoral masses. In "old" Europe these type of factions do not enjoy the same level of support because the West has already gone through many of these transitions over the last several decades, albeit one small step at a time.

Europe’s Central European siblings want to take larger steps on the road to economic prosperity and future European economic integration. Fiscal discipline is an important prerequisite, but Central Europe's budget deficits are not heading in the direction of 2-3% of GDP. In fact, they are actually showing a widening trend. This, coupled with inflation, is not going to strengthen currencies and reduce the purchasing power parity gap. Yet, there are some unique forces at work. Skilled labor is much more mobile in Europe than unskilled labor. Wages of highly skilled laborers are even on a road to parity, while if they work abroad they are often already in parity. But for the majority of laborers in Central European countries such as Hungary, the Czech Republic, Poland and Slovakia, the question remains how long it will take until there is a true convergence of per capita income.

The good news is that there is actually downward wage pressure in countries such as Germany and Austria as a result of this imbalance between per capita income differentials. This is inherently a good thing because it makes the rest of Europe more competitive.

When visiting the capitals of Central Europe such as Budapest and Prague, one can definitely observe a boom. Low interest rates, economic vitality, wage growth and speculation are driving new real estate development and pushing property prices up. This boom is to a large extent a local driven phenomenon, at least when looking at the residential market. Most of residential housing stems from large Communist residential development; giant, dated and somewhat drab apartment complexes still form the mainstay of housing of Central European residents. But with a growing segment of the population being upwardly mobile and flush with cash, they are driving a residential building boom. People want to move out of their dated Socialist housing arrangements into new housing and apartments. An increase in interest rates could bring some much needed revaluation into the property market and blow off some steam.

This seems unlikely to happen in the short term as central banks are keen to keep the economy going. Inflation doesn’t appear to be at the forefront of their worries. Economists and central bankers should keep their eyes on the horizon because there are some worrisome circumstances. Some of the currencies such as the Hungarian Fórint have been quite volatile compared to the relative stability of the Euro and the Swiss Frank. Additionally, many Central European Economies have fallen behind in their fiscal reforms and will find pushing painful reforms through in the various parliaments a difficult task to say the least. Sure, bumps on the road to maturity are imminent and even unavoidable for the Central European teenagers. Some central bankers also argue that the type of inflation we are witnessing is completely natural and to a certain extent outside of their influence.

EU taxes on regulated goods such as alcohol and tobacco is an important inflationary presence, especially is Central Europe, where alcohol and tobacco consumption tends to be larger. My final worry lies in the close correlation between Central European currencies, which tend to move fairly together, even though political and economic circumstances are rather different between Poland, Hungary and Slovakia. There is the fear that we could be oversimplifying those dynamics, assuming too much and questioning far too little. Undeniably the dissimilarity of growth is as much an opportunity as it is a threat to the economic entity of Europe as a whole. Nonetheless, if Central European governments do manage to get their fiscal responsibilities together, there is little to fear besides a few bubble bumps on the road. Projected rate increases in Euroland should inspire the central banks in Central Europe to do the same.

#41 Making Money From Hot Air

Ever since the implementation of phase one of the Kyoto Protocol, the right to release CO2 into the air has become commodified. In Europe alone, there were 24 billion dollars worth of CO2 deals; indicating a booming trend.

Traditional banks and brokerages have been relatively quick to follow suit, albeit with mixed success. For one, the dynamics of the CO2 market are not as straightforward as they are in other markets. CO2 prices have been volatile, arguably for the reason that these markets are not by definition efficient and mature. One major factor in CO2 pricing is weather; when the cold sets in, energy consumption goes up, and with it the need for emission rights.

The mild winter resulted in lower energy consumption, which in turn resulted in both lower energy and CO2 emission prices. CO2 prices are actually fairly correlated to a basket of fuel indexes such as Coal, Oil, Gas, etc. The relationship between coal consumption and CO2 is one of the strongest, as it produces the most CO2, thus requiring more emission rights. With Kyoto in place, there is finally a financial incentive to move towards reducing CO2 emissions. Furthermore, with CO2 pricing, there is a benchmark that can be used to calculate returns on investing in alternatives that reduce the overall CO2 emissions exposure.

There remain some issues to be worked out; notably the pricing of emission contracts remains a tricky endeavor. Part of the problem lies in the fact that the CO2 trading platform remains a young market in its adolescence, meaning there remain considerable arbitrage opportunities. Academically and professionally there is no real simple uniform pricing model for CO2 emission in the way that the financial world has embraced the Black & Scholes option pricing model or the Capital Asset Pricing Model.

Other factors bringing uncertainty to the whole affair (excluding energy dynamics) are the different political organs and processes that determine the emission ceilings of different countries. When emission ceilings move arbitrarily - for the most part downward - this creates much volatility in the market. With CO2 allowances set to tighten in Europe as we move towards phase 2 of the Kyoto Protocol, it is expected that prices are set to rise once again. Looking at the future, there is definitively money to made from hot air and, in doing so, arguably stemming global warming.

Kyoto opponents, for whatever reason or motivation, may laugh at the whole "pseudo" CO2 market phenomenon. Nevertheless, its significance (aside from scientific debate on global warming) can by no means be ignored. Non-Kyoto signatory countries are going to face significant pressure in the near future. French President Chirac was already bold enough to suggest putting an import tax on countries that have not signed Kyoto. This sends a clear message to the U.S., Australia and China, who, even without signing and accepting environmental responsibility, will face a steep price to pay for their environmental desecration.

#19 Technology, Demographics and Lay Trading

After the boom and bust around the turn of the century, it seemed that small discount brokerages would be hard pressed to survive. Many professionals and amateurs alike got burned as the markets retreated after 9/11 and the bursting of the tech bubble. In recent years we are witnessing a clear uptrend in the use and popularity of discount brokerages. "Amateur" investors are once again rushing to the market place and there is some hefty wooing going on to attract those flushed with enough cash.

We are now witness to the rise of a new kind of investor. This new kind of investor is an active trader that has become known as a "day trader." These are mainly amateurs and semi-professionals who play the short term markets in various ways, be it by trading in commodities, currency markets, using leveraged products, futures or options. Often it is a retired professional with some knowledge of financial markets. Then there are also the "early" retirees (late 40's, early 50's) who are using day trading to supplement their income and financially secure their retirement. The new day trader community is a mixed bag of complete amateurs, gamblers and semi-professionals alike.

The recent upswing in US and Global markets has provided ample money making opportunities for this group of day traders, which has lead to an increasing number of amateurs joining their ranks. By sheer word of mouth, the success of Joe the neighbor, who sits at home making "easy" bucks, is a fairy tale concept that is capturing the imagination of many. We could coin a new term for this growing class, namely "lay traders." This is a play on the words "layman" and "trader," put together in the same way that the term "day trader" is. Lay traders are amateur traders who try their luck on short term market fluctuations.

It is true that even aspiring lay traders can make money in bullish markets. But what will happen to these traders when markets turn bearish? The democratization of trading is not going to be a blessing for everyone. In fact, there is a significant risk that these new lay traders could overexpose themselves to risks that their financial situation does not allow for. The smell of easy money is one that has the potential to blind even the most experienced and confident investors. The end of the tech bubble has shown the devastating effect that declining markets can have on traders. Significant financial damage was caused to countless traders who lost their entire savings, sometimes in a matter of months. The threat of losing all they own is a serious reality for today's bullish day traders.

Technology has been a critical aspect with respect to providing near professional real-time trading tools for the aspiring lay trader. The technology transfer from the professional market makers to the amateur trader has the same potential as what blogging offers traditional media. The paradigm in creation has the potential to create a small hurricane in the traditional brokerage and trading community.

However, discount brokerages always expand in boom times, only to sound a hasty retreat when markets go down. The same could very well happen to the growing "lay trading" community. On the other hand, when the market goes down, only the most able and skilled traders will remain, weeding out the amateurs and speculators blinded by easy money. Perhaps this is nothing more than a healthy, Darwinist example of "survival of the fittest." Either way, "laytraders" are here to stay, driven in part by demography, technology as well as a human hunger for more than it can safely devour.

#17 A Spoonful of Sugar Makes the Medicine Go Down

"A Spoonful of Sugar Makes the Medicine Go Down." If Mary Poppins were an economist, this is what she would be saying to the American Economy. She would also have said "do not be fooled by the temporary upswing of the dollar (rebounding back to 1.30 this Friday)." Unfortunately, even fundamentals such as employment cannot change the direction in which the American economy is heading in the long run. The spoonful of sugar is in fact the cheap money supply, which after moderate tightening is still plentiful to sustain investments that reap positive effects to American labor statistics.

Investors were desperate for good news and the results came as a mild surprise. It is even rumored that the fed may not decrease its short term rates. Is this a reason for celebration? No. The market often overreacts to both gloom and positive news. Investors have been warned of a forthcoming recession for many months. The signal by the economic weatherman is hardly a prediction of blue skies for the coming time period. The minute cheap oil is hampered by a cold surge or other disruptions from the world's incurable hot spots; the short honeymoon is surely to end with a migraine.

As economists, we are often trained to treat investor reactions to news with a certain degree of reservation if not pessimism. Economists like to focus on the analysis of indicators such as housing, trade imbalances, GDP, fiscal strength, growth et al. And economists are quite aware of the temporary emotional fickleness of investors who think that a patch of blue sky spells out summer.

I, however, am not afraid to stick out my neck and say that even though the forecasted rain is somewhat postponed, it is definitely not the time to plan a picnic just yet. Furthermore, your best investment right now is an umbrella such that your tasty dollar assets do not get watered down by the rain. The temporary rebound may be the perfect opportunity you need to strategically relocate that picnic basket of yours.

And yes, a spoonful of sugar does make the medicine go down.

#12 About Dollars, Euros and Uncertain Times

With the Dollar at yet another unprecedented low (1.32 Dollars to the Euro on January 2nd, 2006), we are living in uncertain times. This uncertainty is not necessarily a bad development and for economists it is a very interesting time indeed. For one, we are going back to more fundamental aspects of monetary policy, economic strength et al.

It is very possible that we are witnessing the end of an era known as the dollar era. As the American economy stutters, the rest of the world is feeling the pinch. And this pinch is fueling a growing demand for Euros and Euro based assets and derivatives.

The Dollar originates from the German coin the Thaler, or, according to the Dutch, the Daalder. While the US Dollar has a European heritage, it soon became hegemony when in the post-war world the American Economy blossomed, bloomed and spread over the world. In international trade the Dollar had become the main standard of trade across the world. Practically all commodities are today still traded based on dollars. This means that as people trade on the global market, a Dollar surplus or deficit is created based on trade. This dollar is then, if desired, traded back into a local currency or asset. However, when the basic exchange metric (the Dollar in this case) starts to rapidly depreciate, so does that what you are exchanging if the underlying goods do not equally appreciate.

In these circumstances a lot of activity and volatility quite naturally occur in the exchange and commodity markets. Furthermore, it creates a large demand for hedging for those firms, enterprises or countries with considerable exposure. This hedging activity explains the rise of Euro or Gold assets vis a vis the Dollar.

In the future we must consider several scenarios which include a possible change in the Dollar as the exchange metric. This would be very bad news for America and Dollar based economies, as the change could worsen the anticipated American Economic downturn, which in today’s global economy affects nearly everybody. US demand for foreign goods is set to decrease with further Dollar depreciation, which will also dampen global growth elsewhere.

American consumer markets are an essential motor for the global economy. China has long realized this and has been very willing to provide credit for American consumers. However, with so much excess foreign provided credit, the already “maxed” out credit card consumer is expected to dramatically cut consumption. The end of the American Dollar hegemony is going to be bitter pill not only for Americans but for all of us in the global economy.

As the economic axis begins to swing away from America towards a Eurasian (with the emphasis on Asian) powerhouse, we can expect a vastly different economic and political paradigm to unfold. Maybe it is not such a bad idea to learn Mandarin after all.