John Mauldin's Latest

A couple of items worth noting in John Mauldin's latest "Thoughts from the Frontline" weekly e-mail. The first relates to the effects of high frequency program trading on the markets. The second is about a topic we've wondered about here before (e.g., in this post), why Japan's government bond yields are so low despite that country's massive debt as a percentage of its GDP. Below are brief excerpts from Mauldin's column on both topics.

On program trading:

I want to direct the attention of those in the US finance industry to a white paper written by Themis Trading, called "Toxic Equity Trading Order Flow on Wall Street." Basically, they outline why volume and volatility have jumped so much since 2007; and it's not due to the credit crisis. They estimate that 70% of the volume in today's markets is from high-frequency program trading. They outline how large brokers and funds can buy and sell a stock for the same price and still make 0.5 cents. Do that a million times a day and the money adds up. Or maybe do it 8 billion times. It requires powerful computers, complicity of the exchanges (because the exchanges get paid a lot), and highly proximate computer connections. Literally, the need for speed is so important that to play this game you have to have your servers physically at the exchange. Across the river in New Jersey is too slow. Forget Texas or California. This is a game played out in microseconds.

The retail world doesn't get to play. This is a game only for big boys who can afford to pay for the "arms" needed to fight this war. But the rest of us pay for the game, as that half cent is like a tax on transactions, not to mention the increased daily volatility, which skews pricing. Think it doesn't affect you? That "tax" is paid by mutual funds, your pension fund, and every large institution.

Frankly, this is outrageous. The more I read the madder I got. And it is going to get worse as computers get faster and software more intelligent. We need rules to level the playing field. Themis suggests one simple one: just make it a rule that all bids have to be good for at least one second. That would cure a lot of problems. One lousy second! In a world of microseconds, that is an eternity.

Goldman Sachs went after an employee who stole some of their latest and greatest software this last week. The US assistant attorney general said in the courtroom that the software had the potential to manipulate the market. Imagine that. I am shocked. There is gambling going on in the back room? Gee, commissioner, I had no idea.

The comment that the stolen Goldman Sachs software "had the potential to manipulate the market" raises a fairly obvious question: did this software only have the potential to manipulate the market in the former employee/thief's hands (i.e., did it not have the same potential in the hands of Goldman Sachs employees?)? On to Mauldin's Japan comments.

"Land of the Setting Sun":

Japan's population is shrinking, and the number of workers per retiree is rising. Japan has the highest ratio of debt to GDP in the developed world. And that debt is growing by 7-8% a year, and does not include local debt. Interest rates cannot go lower. Savings are falling rapidly and will not be able to cover the need for new debt issuance, by a long shot. Within a few years, because of the aging of the population, savings will go negative. Social security payments are rising. GDP is shrinking, and export trade is off about 30-40%, depending on the industry. Machine tools are down 80%!

If rates were to go up by 1%, let alone 2%, over time Japan's percentage of tax revenue dedicated to interest payments would double to 18% and then to 40% and then just keep going up. It is conceivable that it will take 100% of tax revenues in less than ten years, at the current trajectory. Why? Because Japan is going to have to start to compete with the rest of the world to sell its bonds. Who but the Japanese would buy a Japanese bond at 1.3%? From a country that is rapidly going to 200% of debt-to-GDP? Doesn't really seem like a smart trade to me. And as the data shows, the ability of the Japanese consumer to buy more debt is rapidly waning.

The Japanese government is coming to a crossroads with no good exits.

Octopus Dough Balls

Cheryl and I had a late lunch at Mitsuwa today: soup with bean curd and soba noodles from Kayaba, followed by black sesame ice cream cones from one of the other stores. On the way over to the supermarket side to pick up a case of Asahi beer, we saw a rope line of customers that snaked around for about 100 feet. Curious, we walked over to see what everyone was waiting in such a long line for. Octopus dough balls, apparently, as the English-language sign at the store called them. Octopus fritters might be a better translation. Given their apparently huge popularity, I expected to find a description of these octopus fritters at Japanese Snack Reviews. No such luck, though.

The image above comes from the Chinatown Eats blog.

Quantitative Easing and Inflation in Japan

Apropos of a recent post ("Are Inflation Fears Overdone"), a lucid article by Owen F. Humpage and Michael Shenk of the Cleveland Fed last December on Japan's quantitative easing policy (straight forwardly titled, "Japan’s Quantitative Easing Policy") included the chart above, drawn from IMF data.

Are Inflation Fears Overdone?

So say (separately) the editors of the Financial Times and New York Times columnist/Princeton economist Paul Krugman.

In an editorial yesterday ("US not in bondage") the FT editors wrote,

Shock, horror: US government bond rates are jumping. Soon, goes the story, long-term interest rates will leap, the Federal Reserve will monetise, inflation will soar and civilisation will end. Actually, no. What is happening is precisely the normalisation the Fed has sought. The government is not off the fiscal hook. But it does have at least some time.

[...]

What has happened, quite simply, is normalisation of inflation expectations

[...]

Does this mean nobody needs to worry? Certainly not. Desirable normalisation could yet become a panic over the massive prospective bond issuance. Now that the worst of the panic has passed, the administration and Congress need to agree a credible plan for elimination of the huge structural fiscal deficits. As the Congressional Budget Office’s forecasts demonstrate, President Barack Obama’s budget proposal is not such a plan: it leaves deficits of between 4 and 6 per cent of gross domestic product as far as the eye can see. This will need to change soon. But, right now, everybody needs to keep calm. Normalisation is a big success, not a danger.

In his New York Times column yesterday ("The Big Inflation Scare"), Dr. Krugman made a similar point: Inflation isn't a near-term concern, but we do

[H]ave a long-run budget problem, and we need to start laying the groundwork for a long-run solution.

Krugman also brought up the example of Japan, which has borrowed massively in recent years without driving up its interest rates or inflation. What many Americans fear -- our country losing its triple-A credit rating and having its government debt exceed 100% of its GDP -- has already happened in Japan (The CIA World Factbook says Japan's public debt exceeds 170% of its GDP). And yet, Japan's borrowing costs are significantly lower than ours. For example, according to Bloomberg, the current yield on 10-year U.S. Treasuries is 3.46%, versus 1.49% on the 10-year Japanese government bond.

I've wondered for some time about why Japan has so much lower borrowing costs than the U.S., despite having a lower sovereign debt rating and a much higher ratio of debt to GDP, but I haven't heard a convincing explanation yet. When I asked The Atlantic's Megan McCardle about this, she said the answer was Japan's Postal Savings System, but according to Wikipedia, prior to the beginning of its privatization in 2007, that system only held about 20% of Japan's government debt. Perhaps someone will leave a more convincing answer in the comment thread below.

Built to Last

My first exposure to the business guru Jim Collins came during a conference call in the late 1990s. I was sitting in a conference room in Northern New Jersey with several colleagues while our division head was on the speaker phone from his office in Southern California. The division head had announced two challenging new goals for us and one of my colleagues had apparently asked him which one should demand more of our attention. I wasn't listening too closely at that point. The division head's response caught my attention though, when I thought I heard him extol the "genius of the ant". "The genius of the ant," I thought, "what the hell is he talking about?". After another sentence or two it was clear that he was referring to one of the "myths" Jim Collins (pictured above, rock climbing) debunked on p.10 of his book, Built to Last: Successful Habits of Visionary Companies:

Visionary companies do not brutalize themselves with the "Tyranny of the Or" -- the purely rational view that says you can have either A or B, but not both.

[...]

Instead, they embrace the "Genius of the And" -- the paradoxical view that allows them to pursue both A and B at the same time.

At the time, I thought: another management guru serves his purpose, by letting a manager parrot him to rationalize why he set an unrealistic goal. I was scheduled to be interviewed by that division head for a promotion in a couple of weeks, so I decided to read the book before the interview. The book was better and more substantive than I had expected. In it, Collins compared companies he considered great with companies in the same industries he considered also-rans, and tried to explain what made the great ones great. One of the invidious comparisons in the book, Merck (great) v. Pfizer (also-ran) seemed questionable by the late 1990s, when Pfizer was raking in money from Viagra, but I was reminded of it a couple of weeks ago when Pfizer announced that it would start giving away Viagra, Lipitor, and a number of other drugs to current patients who lost their jobs during this recession.

In "Built to Last", Collins had written that one of the things that made Merck great was the company's idealism, and as an example he cited the company's decision to give away Mectizan, the cure it had developed for River Blindness, when it couldn't find a third party to pay for the drug. Collins also quoted then-Merck CEO Roy Vagelos on the decision:

Asked why Merck made the Mectizan decision, Vagelos pointed out that the failure to go forward with the project would have demoralized Merck scientists -- scientists working for a company that viewed itself as "in the business of preserving and improving human life." He also commented:

When I first went to Japan fifteen years ago, I was told by Japanese business people that it was Merck that brought streptomycin to Japan after World War II, to eliminate tuberculosis which was eating up their society. We did that. We didn't make any money. But it's no accident that Merck is the largest American pharmaceutical company in Japan today. The long-term consequences of [such actions] are not always clear, but somehow I think they always pay off.

Perhaps Pfizer CEO Jeffrey Kindler has read "Built to Last"? That thought went through my mind when I heard the Pfizer announcement a couple of weeks ago, but I didn't get around to blogging about it. I was reminded of it by the cover article on Jim Collins in this past Sunday's New York Times business section, "For this Guru, No Question is Too Big". The photo above, by Kevin Moloney, accompanied that article.

More on Japan

In yesterday's Financial Times, David Pilling wrote that many Japanese are pining for Japan's pre-industrial days, "Japan harks back to an age of innocence":

On a visit to Tokyo this week, on more than one occasion when I asked how Japan should tackle the economic crisis, my interlocutor turned with ninja-like alacrity to the topic of pre-Meiji Japan. The period before American warships forced the country open in the mid-19th century was regularly invoked as a prelapsarian idyll, a time when Japan did not have to deal with the grubby business of earning its crust in the world.

Eisuke Sakakibara, the former vice-finance minister indelibly branded Mr Yen, describes a country that was peaceful, orderly, unspoilt and friendly. “That was what pre-Meiji Japan was like. We should go back to that,” he says.

His invocation of a more innocent, pre-industrial age could easily be dismissed as idle chatter were it not for the fact that it keeps coming up.

[...]

There is now much talk of putting more emphasis on agriculture and de-emphasising the manufacturing industries on which postwar wealth was built. “Japan, having major strength in manufacturing, will probably suffer most,” says Mr Sakakibara, who argues that, even after this economic crisis subsides, the world will never return to previous levels of material consumption.

Japan’s farm industry is commonly regarded as heavily protected, but the Japanese worry that they only produce 40 per cent of their calorific requirements. Mr Sakakibara supports the DPJ’s proposals massively to increase subsidies to agriculture and to industrialise the family-run farming industry. He has been trying to persuade Toyota that cars are a dying industry and that it should turn its engineers on to farming efficiency instead. The era of just-in-time carrots could soon be upon us.

A Historical Perspective on China and Japan

Interesting letter to the editor in Wednesday's Financial Times:

Japan has been in the cold before, by the same rationale

Published: March 4 2009 02:00 | Last updated: March 4 2009 02:00

From Prof Arthur Waldron.

Sir, Japan’s allies have left it in the cold before (“A diplomatic feint that looks set to leave Japan in the cold”, Philip Stephens February 27), most notably after the Washington Conference of 1921-22, which saw the security treaty with Britain, fundamental to Japan, discarded, with a fine-sounding set of multilateral guarantees as substitute. The rationale then, as now, was the need to yield before the inevitable rise of China.

What happened? China entered an unexpected period of turbulence that threatened Japanese interests. Tokyo drifted for a while trying to work within the multilateral framework, but when it proved useless found a new compass in dictatorship at home and pre-emptive attack abroad, against China and eventually the US.

History does not repeat itself but it has lessons. One is never to sell short Japan, least of all as a power. Another is that all long positions on China should be carefully hedged.

Arthur Waldron,
Bryn Mawr, PA, US
Lauder Professor of International Relations,
University of Pennsylvania

The image above, of one of the Kongo Rikishi guardian statues at the Kofukuji temple in Nara, Japan, was pilfered from a Geocities site of what appears to be (judging by the flag) an Argentinian karate club.

A Local Business That Seems to be Doing Well

The NJ location of the Japanese Mitsuwa Marketplace (pictured above) features these specialty shops and restaurants, along with a Japanese supermarket. We stopped in last Saturday and picked up a six pack of Asahi beer, and then had lunch the next day in the food court (which offers a riverside view of Upper Manhattan). The Asahi beer was actually brewed in Canada by Molson, under Japanese supervision (according to the label), but many of the other products sold in the supermarket are imported from Japan. Mitsuwa was packed on both days, with customers queuing up for noodle bowls, black sesame ice cream (which is excellent, by the way) and hot Cream Yakis (also tasty) in different parts of the food court.