The Fed’s Policy Mechanics Retool for a Rise in Interest Rates

It’s easy to take for granted the Federal Reserve’s ability to raise interest rates. Even among the legions who doubt that Fed officials will pick the ideal moment to start increasing rates for the first time since 2008, few question the Fed’s technical competence. The central bank has a long history. The engine is known to work.

So it may come as a surprise to learn that the old engine is broken. When the Fed decides that it’s time to “lift off” — perhaps this week, but more likely later this year — it will be relying on a new system, assembled from spare parts, to make interest rates rise.

There is a general agreement among economists and market analysts that the Fed’s plans make sense in theory. A team led by Simon Potter, a former academic who now heads the Fed’s market desk in New York, has been testing and fine-tuning the details by moving billions of dollars around the financial system.

But markets have a long history of scrambling the best-laid plans.

“If something is going to go wrong, I haven’t been able to figure out what, but there’s a lot of reason for caution,” said Stephen G. Cecchetti, the former chief economist at the Bank for International Settlements. “We’ve never done this before.”

The stakes are huge. The Fed is in charge of keeping economic growth on an even keel: minimal unemployment, moderate inflation. It tends to operate conservatively and to change very slowly because when it errs, the nation suffers.

Yet the Fed has found itself forced to experiment. The immense stimulus campaign that it started in response to the 2008 financial crisis changed its relationship with the financial markets. It has pumped so many dollars into the system that it cannot easily drain enough money to discourage lending, its traditional approach. Instead, the Fed plans to throw more money at the problem, paying lenders not to make loans.

The Fed, embedded in the banking system, has also concluded that working through the banks is no longer sufficient to influence the broader economy. It plans to strengthen its hold by working directly with an expanded range of lenders.

Fed officials have repeatedly expressed confidence that the plan will work. “The committee is confident that it has the tools it needs to raise short-term interest rates when it becomes appropriate to do so,” Janet L. Yellen, the Fed’s chairwoman, told Congress earlier this year, referring to its policy-making body, the Federal Open Market Committee.

And if the new approach does not work at first, Mr. Potter said in a recent speech, then his team of monetary mechanics “stands ready to innovate” until it does.

Freezing, Not Draining

The markets desk at the New York Fed has put monetary policy into practice since the mid-1930s. In the decades before the Great Recession, the desk exercised its remarkable influence over the American economy through its control of an odd little marketplace in which banks could come to borrow money for a single night.

The Fed requires banks to set aside reserves in proportion to the deposits the banks accept from customers. The reserves can be kept in cash or held in an account at the Fed. Banks that need reserves at the end of a given day can borrow from banks that have a surplus. Before the crisis, the Fed controlled the interest rate on those loans by modulating the supply of reserves: It lowered interest rates by buying Treasury securities from banks and crediting their accounts, increasing the supply of reserves; it raised rates by selling Treasuries to banks and debiting their accounts.

As the crisis hit in 2008, the Fed pressed this machine to its limits. It bought enough securities and pumped enough reserves into the banking system to drive interest rates on short-term loans to nearly zero. The federal government now pays about a dime to borrow $1,000 for one month. Companies with good credit pay about a dollar to borrow $1,000 from money market funds and other investors.

But the Fed didn’t stop there. It kept buying Treasuries and mortgage bonds to eliminate safe havens, forcing money into riskier investments that might generate economic activity. As a byproduct, the Fed kept expanding the supply of reserves.

One result is a banking system almost comically awash in money. In June 2008, banks had about $10.1 billion in their Fed accounts. The total is now $2.6 trillion. Picture all of the money in June 2008 as a single brick; the Fed has added 256 bricks of the same size. On top of that first brick, there is now a stack five stories tall.

Bank of America, for example, had $388 million in its Fed account at the end of June 2008. Seven years later, at the end of June 2015, it had $107 billion. The bank could double in size and double again and still have more reserves than it needs.

To switch metaphors, the old monetary-policy machine sits at the bottom of a lake of excess reserves. The Fed would need to sell most of the securities it has accumulated before short-term rates would start to rise. Selling quickly could roil markets; selling slowly could allow the economy to overheat. So the Fed decided to find another way.

Instead of draining all that excess money, the Fed decided to freeze it.

Paying Banks Not to Lend

For the last seven years, the Fed has encouraged financial risk-taking in the service of its campaign to increase employment and economic growth. By starting to raise interest rates, the Fed intends to gradually discourage risk-taking.

The straightforward part of the plan is persuading banks not to make loans.

In a serendipitous stroke, Congress passed a law shortly before the financial crisis that let the Fed pay interest on the reserves that banks kept at the Fed. Written as a sop to the banking industry, it has become the new linchpin of monetary policy.

Say the Fed wanted to raise short-term interest rates to 1 percent, meaning that it did not want banks to lend at lower rates. Because the glut of reserves is so great, the Fed could not easily raise rates by reducing the availability of money. Instead, the Fed plans to pre-empt the market, paying banks 1 percent interest on reserves in their Fed accounts, so banks have little reason to lend at lower rates. “Why would you lend to anyone else when you can lend to the Fed?” Kevin Logan, chief United States economist at HSBC, asked rhetorically.

This is not a cheap trick. Since the crisis, the Fed has paid banks a token annual rate of 0.25 percent on reserves. Last year alone, that cost $6.7 billion that the Fed would have otherwise handed over to the Treasury. Paying 1 percent interest would cost four times as much. The Fed has sent roughly $500 billion to the Treasury since 2008. As the Fed raises rates, some projections show that it may not transfer a single dollar in some years. Instead, the Fed will pay banks tens of billions of dollars not to use the trillions it paid them previously.

At first, Fed officials thought that paying interest to banks would establish a minimum rate for all short-term loans, exerting the same kind of broad influence as the old system. It soon became clear, however, that rates on most such loans remained lower than 0.25 percent. Even banks that needed overnight loans found they could borrow more cheaply. The average rate in July was 0.13 percent — about half of the Fed’s new benchmark rate.

The rest of the financial system is also awash in cash, and lenders — like money market mutual funds — put downward pressure on interest rates as they fight to attract borrowers.

And here’s where the Fed’s plans got a little less orthodox.

The Fed lacks the legal authority to pay these lenders a minimum interest rate on deposits, as it does to the banks. But two years ago, Lorie Logan, one of Mr. Potter’s top aides, suggested the Fed could achieve the same goal by borrowing from these companies at a minimum interest rate.

The resulting deals, known as overnight reverse repurchase agreements, signal a significant break from the Fed’s history of working through only the banking industry.

“We’re pushing more activity out of the regulated banking sector, and so monetary policy has to take account of the unregulated sector,” said Jon Faust, an economist at Johns Hopkins University who until recently served as an adviser to Ms. Yellen, and before that to her predecessor, Ben S. Bernanke. “The world is changing, and I think the bigger risk is not changing along with it.”

When liftoff arrives, however, the Fed plans to place this machinery inside the familiar language of the old system. It is likely to announce that it is raising the federal funds rate, the interest rate that banks pay to borrow reserves, from its current range of 0 to 0.25 percent to a new range of 0.25 to 0.5 percent. The Fed does not plan to emphasize that this rate is now a stage prop or that the real work of raising rates will be done outside the limelight by its new tools.

Mission Control

On weekdays at about 12:45 p.m., the New York Fed’s trading portal, known as FedTrade, plays three musical notes — F-E-D — signaling that Mr. Potter’s shop is open for business. So begins another day of training camp, another test of the Fed’s plans to borrow money from nonbank financial companies.

The Fed’s traders sit at terminals in a converted conference room. Along one wall are five chairs and five sets of computer monitors beneath five historical photographs of the trading desk: men answering phones, men writing bids in chalk on a long board and, in the most recent photograph, from the 1980s, a glimpse of a woman in the background. On another wall is a screen that links the room in New York by videoconference with a backup trading room at the Chicago Fed.

Potential lenders — a preapproved group of 168, including a bevy of money market funds and the housing finance companies Fannie Mae and Freddie Mac — have 30 minutes to offer the Fed up to $30 billion each. At 1:13 p.m., a warning message starts blinking red. At 1:15 p.m., the Fed closes the auction and accepts up to $300 billion in loans at an interest rate of 0.05 percent.

During two years of experiments, the Fed team has adjusted the rates it pays, the amounts it accepts and the time it enters the market, among other variables. Mr. Potter and his lieutenants have also held lunch meetings with investors on the other side of the portal to solicit advice and complaints.

The size of the program poses the most obvious risk. Fed officials limited daily borrowing to $300 billion because they didn’t want to freeze more money than necessary. They also worry about exacerbating market downturns by giving investors a new place to flee. These concerns were heightened by reports that some investment companies were interested in creating money market funds that would be advertised as the safest place to park money — because the money would be parked at the Fed.

Last year, at the end of September, shortly after the cap was imposed, lenders offered the Fed $407 billion on a single day. Demand was so high that instead of asking for interest, some lenders offered to pay the Fed to take the money. The Fed ended up borrowing at zero percent and turning away $107 billion in loans.

A cardinal rule of central banking is that you don’t starve financial markets during panics, and the Fed has been leaning in the direction of doing more. It has already announced that it is willing to borrow at least $200 billion through a parallel program at the end of September this year, for a total of $500 billion. It has also suggested that it may raise the cap during liftoff. “My sense is we’re better off making sure we can maintain control,” James Bullard, president of the St. Louis Fed, said in a recent interview.

Unpredictable Reactions

“This is where the nutty people on the bond-trading desks have control,” joked Alan Blinder, a former Fed vice chairman, when asked if the Fed’s plan would work.

Mr. Blinder’s point was that markets ultimately determined the cost of borrowing money, particularly for longer-term loans like mortgages and corporate bonds. The Fed can be precise in its planning, but the market is unpredictable in its reactions.

Fed officials have emphasized that they do not want the liftoff to surprise investors. “This has probably been the most telegraphed 25-point rate hike in history,” said Wayne Schmidt, chief investment officer at Gradient Investments in Arden Hills, Minn. “I think when they actually do something, it will be more of a nonevent.”

But there are at least three reasons markets are becoming less predictable.

The rise of an interconnected global financial system has weakened the Fed’s influence over interest rates. When the Fed last raised short-term rates, beginning in 2004, officials were surprised that long-term rates failed to rise because foreign money was pouring into the housing market and other domestic investments. This time, there are plenty of warnings that the weaknesses of other developed economies could once again make it harder for the Fed to raise domestic interest rates.

“Financial market conditions have come to depend increasingly not only on developments at home but also on developments abroad,” William C. Dudley, the president of the Federal Reserve Bank of New York, said in a February speech in which he cautioned the Fed’s control over those conditions had been “loosened.”

The Fed’s audience also increasingly consists of computer programs that will start buying and selling securities before people have time to read the first words of the Fed’s policy statement, creating the potential for new kinds of chaos.

On Oct. 15, for example, automated trading programs drove up the price of 10-year Treasuries in a burst of buying so intense that a government report later found the machines bought more than 10 percent of the securities from their own firms. Then, just as quickly, the computers turned around and drove prices back down.

The 12-minute spree was among the largest price movements ever seen in one of the world’s most liquid markets, yet the government report found no clear cause.

Finally, investors say regulatory changes are keeping some large traders on the sidelines, making it harder to buy and sell, even in the highly liquid market for Treasuries. That can exacerbate market movements because when people are in a hurry to buy or sell, they tend to chase the best available offers. “The depth of the market is not what it used to be,” said Tad Rivelle, chief investment officer for fixed income at TCW, a Los Angeles investment firm that manages some of the world’s largest bond funds. “You can get the same trades done, but it takes more time.”

Other observers, however, urge a broader perspective.

“People are very concerned about those 12 minutes last year,” said Mr. Cecchetti, now a professor of finance at the Brandeis International Business School. “I’m very reassured by the fact that there were only 12 minutes.”

Moreover, Mr. Cecchetti said that removing some liquidity was a good thing because much of that liquidity was a result of public subsidies for the banking system that had encouraged undue risk-taking.

“Does it mean that there’s going to be more high-frequency volatility? Sure,” he said. “It means the Simon Potters of the world are going to have to be much more careful about what they’re doing. But that seems to me to be kind of O.K.”

Volcker’s Messy Lesson

Mr. Potter has worked at the New York Fed since the late 1990s, but he spent most of his career there in the research department before taking over the markets desk in 2012. He became more involved in the practical side of the Fed’s work during the financial crisis. In a 2012 speech at New York University, Mr. Potter said the experience — particularly during a four-week period at the peak of the crisis — had impressed upon him the limits of theory, the need to understand what investors are thinking and the value of flexibility in policy making.

“For economists who did not have the opportunity to observe the panic up close as I and most of my colleagues had, the developments in this four-week period must have been bewildering, given how widely events on the ground and theory diverged,” he said.

That perspective may come in handy. The last time the Fed shifted the basic mechanics of monetary policy was in the early 1980s, when Paul Volcker was its chairman. That campaign is remembered as a triumph of central banking. Mr. Volcker succeeded in driving inflation down toward modern levels, ending a long period in which governments had floundered helplessly to prevent rising prices.

But Mr. Faust, the Johns Hopkins economist, says the messiness of Mr. Volcker’s triumph is often overlooked. The Fed’s initial plans did not work and were revised and did not work and were revised again — and still didn’t work.

He said the Volcker episode was a reminder that monetary policy is not figure skating. The Fed is likely to flail, he says, but it will be measured by its success in getting interest rates to rise, not by the grace of its performance.

“If you’re into the internal plumbing, I suspect there will be times when that looks messy because this is new,” Mr. Faust said. “But central banks can raise interest rates, and they will. And as long as that happens, from the standpoint of the broader economy, everything is fine and the rest will be forgotten or become a footnote of history.”

Source: http://www.nytimes.com/2015/09/13/business/economy/the-feds-policy-mechanics-retool-for-a-rise-in-interest-rates.htmlhttp://www.nytimes.com/2015/09/13/business/economy/the-feds-policy-mechanics-retool-for-a-rise-in-interest-rates.html

Fed risks using wrong tool to tighten

The Federal Reserve has been sending strong signals that it is preparing to raise interest rates for the first time since 2006. As the Fed prepares for lift-off, its operational framework and large balance sheet may pose challenges to market functioning.

The Fed’s balance sheet has increased from roughly $1tn at the end of 2007 to well over $4tn at present. This stems from about $3.4tn of purchases of US Treasuries and other bonds under the Fed’s quantitative easing programmes. This took such assets out of market ownership to reside on the Fed’s balance sheet.

This is important because market interest rates are effectively determined in the collateral market, such as the repo, or repurchase market, where banks and other financial institutions exchange collateral (such as US Treasuries, mortgage securities, corporate debt, equities) for money.

Financial agents that settle daily margins may post cash or collateral; this forms the core of the financial plumbing. Such “pledged” collateral is generally received by banks not only via repo markets but also from securities lending, prime brokerage agreements with hedge funds, and derivative positions. The largest suppliers of pledged collateral are hedge funds; other sources include insurers, pension funds, central banks and sovereign wealth funds.

The repo rate is an important market signal and should move in tandem with the fed funds rate; hence the need to have good plumbing.

In 2007, the collateral market was $10tn in size; now it is only $6tn. A further reduction lies ahead, threatening to rust the financial plumbing, as the Fed prepares to raise interest rates.

There are two ways the Fed can tighten monetary policy to control interest rates once it has raised them. The first is to use and expand its so-called reverse repo programme, which soaks up large sums of money from non-banks such as money market funds, but does not release collateral from the Fed’s balance sheet back into the market.

The second is to sell US Treasuries, which similarly mops up cash while also supplying collateral.

The reverse repo programme is currently capped at $300bn per day, but the Fed may raise this cap to ensure reverse repos mop up enough cash to maintain a floor on interest rates. Reverse repos work by persuading non-banks to remove dollars deposited with banks and place them with the Fed, in exchange for collateral such as Treasury bonds. So the Fed becomes the new counterparty to the non-bank, while the bank gets “balance sheet space” as the deposits move to the Fed.

Crucially, this process does not release collateral to the market as the operational structure of the reverse repo facility puts practical restrictions on the reuse of collateral. Thus, none of the collateral within the reverse repo programme can be used to post at central clearing houses, in the bilateral derivatives markets, in the bilateral repo market or delivered against short positions.

The consequence of a sizeable reverse repo programme would be that money becomes scarcer as it is drained from the market, thus raising the repo rate, while collateral becomes proportionately more abundant and therefore cheaper. Thus, by targeting the size of the programme, the repo rate can be made to track the fed funds rate; however, this will result in the repo rate not being a market rate.

A better option would be to keep the reverse repo programme size at its present level and sell US Treasuries . These bonds could be sliced and diced for repos and related collateral usage. While the Fed can control the amount sold, collateral gets reused, which is not under the Fed’s control, so the repo rate may not equate to the fed funds rate. However, selling of US Treasuries can be fine-tuned, to reduce a large wedge between two rates.

It is crucial to ensure that the market plumbing does not get rusty through the use of a large reverse repo programme. A deep and liquid collateral market provides price signals (like the repo rates) that would be weaker under a large programme.

For effective monetary policy transmission, all rates should move in sync with the fed funds rate and this requires good plumbing.

Manmohan Singh is the author of Collateral and Financial Plumbing and a senior economist at the International Monetary Fund; views are his own and not those of the IMF

Source: http://www.ft.com/intl/cms/s/0/0d72eaa8-885f-11e5-9f8c-a8d619fa707c.html

Investing in airports: Flying high

IMAGINE owning a shopping centre that your customers are forced to stay in for several hours. Better yet, everyone who visits is relatively rich, and many are in a giddy holiday mood. Now imagine that the number of these special shopping centres is strictly regulated, giving you a near-monopoly. On top of this you get paid a fee per visitor. No wonder buying airports has become something of an investment fad.

Though potentially lucrative, airports tie up a lot of capital, which is why governments around the world are selling them. Some are being listed on stockmarkets, others sold to private investors. The Japanese government is selling 30-40-year concessions to run some of its airports. France is flogging its regional airports: it sold a 49.9% stake in Toulouse airport to a Chinese-led consortium in December. Investors include pension funds, sovereign-wealth funds, infrastructure specialists and private-equity houses.

What sets airports apart from most investments in infrastructure is their dual income stream: they bring in money both on the aeronautical side (landing fees, contracts with carriers) and from passengers (parking, shopping, hotels). If you own a toll road and traffic dwindles, there’s not much you can do. But with an airport there are lots of levers to pull, such as cutting capital costs, firing staff and upping the price of parking. “We love them because they pay a steady income for our retirees, protect against inflation and are a diversifier,” says Andrew Claerhout of the Ontario Teachers’ Pension Plan (OTPP), which is an investor in four European airports including Birmingham and Copenhagen. Best of all is the bonus that comes from being a monopoly. Returns from well-run airports tend to be in the double digits, markedly higher than more boring assets like bridges.

One way to boost profits is to increase the number of passengers who can be herded through the buildings. Investors including OTPP and Macquarie, a bank, as well as the Belgian government, recently helped to upgrade Brussels airport by linking the European and international terminals, thus centralising security and shopping. Ardian, an investment firm that owns a stake in Luton airport, near London, helped to convince the local train company to increase London-bound services during rush-hour. It also removed a bottleneck at security by opening more lanes and hiring “smiling people” in yellow T-shirts to point passengers to the shortest queue. An upgrade of the terminal, aimed at increasing the number of passengers from 12m to 18m a year, is next.

When an airport has been in public hands, the non-aeronautical parts of the business have often been especially neglected. Buyers often invest in good parking (ie, under a roof and close by), which can become one of the biggest single sources of income. But not all airports are created equal. Those serving capital cities tend to be safer bets, with a steady supply of visitors, come rain or shine (unlike holiday destinations). Ensuring the airport is not dominated by a single carrier is another golden rule, as this makes it vulnerable to strikes or bankruptcy. Buying a stake in an airport of which the government owns a controlling share is risky, as public and private interests are not always aligned.

Europe is currently the hub for airport investing, accounting for more than half of all deals since 2011, according to Preqin, a data firm. That compares to 15% in Asia, 14% in Australasia and 9% in America. But European valuations are reaching dizzying altitudes: Ljubljana airport was sold last year to Fraport, a German airport specialist, reportedly for a lofty 20 times annual earnings. Michael Burns of PwC, a consultancy, points out that the number of passengers is growing twice as fast at many Asian and African airports. By 2020 Indonesian airports will have more traffic than British ones, predicts PwC. More adventurous investors may end up flying long-haul.

Source: http://www.economist.com/news/finance-and-economics/21653675-why-buying-airports-has-taken-flying-high

Financing capital goods: Keeping the grease

THE headlines focused on the fact that GE, a big industrial conglomerate, is beginning to sell off its $500 billion finance arm in small chunks. This week it put a $40 billion portfolio of corporate loans up for sale. But not all of GE Capital will end up on the block: GE is keeping the $90 billion division that finances purchases of medical equipment, power-generation gear and aeroplanes, or leases them to users. In part, that is because those fields are critical to GE: it makes all or part of the products being financed or leased. But it is also because the financing of old-fashioned capital goods is a booming business.

 
 

The gear GE sells is expensive; would-be buyers often lack the capital to buy it outright. For GE, therefore, the financial engineering that underpins the use of its wares is as important as the mechanical engineering that created them. Many hospitals, for instance, do not buy expensive scanners from GE, but lease them instead. When it develops improved versions, it helps the hospitals swap the new generation for the old, by passing the outmoded gear to another, thriftier institution, and so on down a long chain. By the same token, the sale of a plane that appears to be from Boeing to an airline may in fact be a sale to GE and a lease to the airline. In 85% of these cases, the plane will have engines made by GE or a joint venture.

Manufacturers have financed purchases of their own products for a long time, with mixed results. General Motors started its own finance operation, General Motors Acceptance Corporation (GMAC), in 1919, which helped it to expand its customer base and thus boosted its profits for decades. Eventually, and disastrously, GMAC expanded into mortgages. Just before the crisis, GM sold half of GMAC to raise money. Its subsequent collapse and nationalisation contributed to GM’s own bankruptcy in 2009.

Yet in 2010, shortly after GM had emerged from bankruptcy and while it was still under government control, it spent $3.5 billion in cash—a vast amount given its straitened circumstances—to purchase AmeriCredit, a Texan subprime auto lender. The company has since been renamed GM Financial. Its assets have grown from $11 billion to $49 billion in five years, an astonishing rate for a financial institution in recent years. China, where car-buyers are beginning to rely more on credit instead of buying with cash, is one area where it is growing fast.

Toyota continues to own a bank in America to help customers finance car purchases. BMW does as well. Car loans, after all, proved much more resilient during the crash than other forms of credit. For companies that do not have such financing arms, often because they use all the capital they can raise cheaply in their core business, a relationship with a finance firm is vital. This is all the more true, says Vincent Caintic of Macquarie, a bank, as ever stricter regulation makes it increasingly expensive for banks to offer car loans and the like.

Element Financial, a Canadian firm, has carved out a lucrative niche financing specific items, such as the railcars produced by Trinity Industries, an American conglomerate, and the small diggers made by Bobcat, part of a South Korean one. It went public in 2011 and its shares are up fourfold since (see chart). Over the same period, the S&P index of North American firms in financial services has not even doubled.

Source: http://www.economist.com/news/finance-and-economics/21653674-why-ge-retaining-one-bit-its-finance-arm-keeping-grease

The economics of bluffing

WILL Greece default on its debts and leave the euro? Will Britain decide to leave the European Union? Politicians in the two countries have threatened, implicitly or explicitly, to take these drastic steps if their European colleagues do not offer them inducements to stay.

Many people regard these threats as a bluff. They think that Greece does not really want to leave the euro, and that David Cameron, Britain’s prime minister, does not want his country to exit the EU. When push comes to shove, Greece will do a deal (see article) and Mr Cameron will persuade British voters to stay in the EU in his planned referendum. But there are risks that neither outcome will turn out as planned. In both cases, political leaders are making a risky bet.

The financial analogy is with writing (selling) an option. In the markets, an option is the right to buy (a call) or sell (a put) an asset at a given price; say shares of Apple at $130. In return for granting the buyer of the option this right, the writer receives a payment called a premium, rather like an insurance company receives a premium for protecting a homeowner against fire or theft. But if Apple shares do rise above $130, the buyer of a call option is likely to exercise it, to the writer’s cost; if they fall below it, the holder of a put option is likely to cash in.

Political leaders in Greece and Britain have in effect written an option on exit. The premium they receive is political popularity—for opposing the demands of international creditors, in the case of Greece, or for asserting Britain’s sovereignty, in Mr Cameron’s.

But in the financial markets, option-writing is a very risky strategy, unless the position is properly hedged. A lot of small profits can be earned from the option premia, only for all the gains to be wiped out when an option is exercised at an unfavourable time. Of course, the buyer of an option is most likely to exercise it when the cost to the writer is greatest.

For the political leaders of Greece and Britain, the difficulty is that they do not get to decide whether the option gets exercised. The other nations within the euro zone and the EU may decide to call Greece or Britain’s bluff. In Britain, the electorate also has the right to exercise the option of exit—which they might use in the referendum to protest against government policies in general rather than voting on the merits of EU membership in particular.

This leads to some complex calculations. Unlike Apple’s shares, the price of Grexit or Brexit at any moment is highly uncertain; political leaders cannot be sure what the costs and benefits will be. So this is rather like an option on one of the complex securities that proliferated before 2007—a collateralised debt obligation based on subprime mortgages, for example. The uncertainty makes it less likely that Europe will exercise the option and risk the departure of Britain or Greece.

If that gives the bluffing states an advantage, they also face a difficult trade-off. The more intransigent their demands, the more they may please their electorates (ie, the greater the “option premium”). However, such intransigence may make it more likely that the option will be exercised. European leaders may feel that making too many concessions to Greece or Britain will simply encourage other countries to make similar demands, and thus destroy the European project. In Britain, there may be a huge gap between the expectations fostered during the negotiating process and the reforms that emerge. This may create the impression that the government has failed, making the public more inclined to vote for exit.

This discrepancy between the high-flying nature of political promises and the mundane reality of policy outcomes lies at the heart of recent voter discontent. Promises may result in short-term electoral success but at the cost of increasing disillusionment in the long term. The most significant short-term influences on growth—the oil price, Federal Reserve policy, China’s success in managing its economic growth—are outside the control of European politicians. National leaders are, in effect, bluffing when they say their own policies can make much difference.

Europe’s failure to generate much in the way of economic or wage growth over the past decade means that voters are not just turning against the parties in power—they have lost faith with the mainstream opposition as well. The effect can be seen everywhere, from the rise of Marine Le Pen in France to the emergence of brand new parties like the Five Star Movement in Italy and Podemos in Spain. Years of short-term gains for the mainstream parties have resulted in a long-term loss.

Source: http://www.economist.com/news/finance-and-economics/21652362-when-political-leaders-turn-option-writers-economics-bluffing

Sewing up lower costs from falling commodity prices

In the past year the prices of many commodities—including cotton and oil—have fallen 30 to 50 percent. That should be good news for most apparel and footwear companies, since these are key raw materials for the production of yarns and the synthetic rubbers used in footwear. Companies are asking themselves how these price falls will translate into cost reductions from their suppliers, and how fast that will happen.

The basic estimates look promising. In a typical, mid-priced knit garment, raw cotton represents around 50 to 60 percent of the total cost of cotton yarns, yarn accounts for about 60 percent of fabric, and fabric for about 50 to 60 percent of the cost of a finished garment. Therefore, given the 30 percent drop in the price of raw cotton in the past year (Exhibit), a buyer might expect a 5 to 7 percent drop in apparel cost, depending on the complexity of the garment. The picture is similar in synthetics, with the price of PET¹ dropping around 25 percent between March 2014 and February 2015.

Few apparel and footwear companies have captured significant commodity-related savings from their suppliers, however. Some companies don’t have a structured process in place to ask for supplier cost reductions when commodity prices fall; others don’t know what cost reduction to ask for when they do. Of those that do ask, many receive small reductions of 1 to 2 percent from some suppliers, while others receive no savings at all.

When pressed to offer commodity-related cost reductions, suppliers may argue that the effects of raw material prices on their own costs have been smaller than estimated, have been diluted by other players in the value chain, or have yet to trickle through to them. (In practice, changes in cotton yarn prices typically lag commodity prices by one to three months.) Without a deep understanding of the whole value chain and such facts at their fingertips, companies find it very hard to counter these points.

To claw back the full savings potential offered by commodity price drops, companies need to develop a detailed picture of the end-to-end value chains of their products, and of the way input cost fluctuations percolate through that chain. That is a complex business, requiring an understanding of the underlying chemistry of key raw materials, the structure of the industries that produce those materials, and the evolution of supply and demand over time. The sidebar below (“From oil to polyester”) describes some of the complexities surrounding the production of PET, one of the most important apparel inputs. A similarly complex value chain exists for many important polymers used in the footwear industry, like EVA (ethylene-vinyl acetate), PU (polyurethane) and SBR (styrene-butadiene rubber).

From oil to polyester

While most apparel companies understand the cotton value chain relatively well, the value chain for polyester is often more of an enigma. Polyester fiber is made from PET (polyethylene terephthalate) that has been melted and spun. PET, in turn is made of two materials: Purified terephthalic acid (PTA) and mono ethylene glycol (MEG). Both these materials are made from oil, and their price tracks the oil price. MEG can also be made from natural gas, but since the marginal producers, especially in East Asia, currently use oil as a feedstock, the MEG price tends to follow the oil price rather than that of gas.

Analysis of the value chain shows that when oil was at $100 per barrel, it constituted approximately 50 percent of the cost of PET. If oil prices stay around $50 per barrel, PET prices should remain around 25 percent lower than last year. Moreover, overcapacity in the industry means the PET market is highly competitive and prices are set by the marginal producer, resulting in price declines over the past ten years. Thanks largely to overcapacity in China, the PET industry is currently running at only 66 percent of its full utilization. With demand projected to grow at 3 percent a year, overcapacity is likely to continue to keep prices down. Together these factors suggest that polyester prices will stay low at least until the end of 2015.

Companies that have taken such a fact-based and structured approach to supplier negotiations in the response to commodity price changes have been able to capture savings of 4 to 6 percent from their suppliers in a wide range of categories. One large apparel retailer did this by building a “rapid response system” based on detailed analysis of the effect of commodity price changes on the costs of different yarn and fabric types. Significant swings triggered assertive communications with its suppliers, asking for price adjustments within 30 days. The company was able to support subsequent negotiations with the data from its analyses.

The bigger picture

Beyond the specific opportunities related to a better understanding of commodity price effects, a procurement approach built on a deeper understanding of the whole value chain has the potential to offer more than just quick wins. It can also help the industry meet some of its most enduring challenges. For a decade or more, apparel companies have been fighting rising costs, driven by increasing labor, raw material and energy prices, as well as compliance costs in Asia. Their main weapon in this war against inflation has been to move production to lower cost countries and regions. But this strategy has many drawbacks: Supply chains must be reconfigured, and companies need to expend time and effort ensuring new suppliers meet the required standards of quality and environmental and social responsibility. Worse, by focusing so much on where their products are manufactured, these companies may not be paying enough attention to how they are made—and to the opportunities to reduce costs, manage risk and improve efficiency in their existing value chains.
There is also a significant opportunity for the apparel sector to make use of procurement best practices from other sectors. For example, the automotive and electronics industries for years have used advanced sourcing approaches such as Design to Value (DTV) teardowns, cleansheet “should cost” modeling and supplier collaboration. We will show in subsequent articles how these approaches can be adapted for apparel and footwear companies, and how leading players have driven 10 to 20 percent savings through their use.

Source: http://www.mckinsey.com/insights/operations/sewing_up_lower_costs_from_falling_commodity_prices

Money for old folk: The relationship between ageing and inflation is not as simple as economists assume

WHEN it comes to the economic impact of demography, Japan is the wizened canary in the world’s coal mine. It has become older faster than any other big country: its median age went from 34 in 1980 to 46 today, and will continue rising for decades. But it will soon have plenty of greying company, from wealthy countries such as Finland and South Korea to developing giants, including China and Russia. Economists generally agree that the ageing of populations leads to slower growth, because a country’s potential output tends to fall as its labour force shrinks. They also expect heavier fiscal burdens, with governments providing for more pensioners from a smaller tax base.

Until recently, though, there had been little research into how demography affects inflation. The Japanese example of persistent deflation over the past two decades was seen as evidence enough that prices fall when countries age and their growth slows. Shinzo Abe, Japan’s prime minister, has sought to disprove that, espousing massive monetary easing to get prices rising. With inflation slumping far below the Bank of Japan’s 2% target in recent months, it is tempting to conclude that ageing is too powerful a force to overturn. But a new body of research* gives advocates of Abenomics a bit of support, at least on the demographic front. It shows that deflation is not the preordained outcome of ageing.

The problem lies not in identifying the possible links between ageing and prices, but in working out which way they cut. Consider the factors of production. When growth slows businesses rein in investment, so the cost of capital may decline. Yet wages ought to rise when the supply of workers falls. In the realm of fiscal policy, some indebted governments may make painful cuts as pensioners multiply, leading to slow growth and sluggish inflation. But others may opt to monetise their debt, pushing inflation up. (Some suspect this is the ultimate aim of Abenomics.)

How to disentangle these possibilities? In a recent working paper, Mitsuru Katagiri of the Bank of Japan and Hideki Konishi and Kozo Ueda of Waseda University distinguish between the ageing caused by a falling birth rate and that brought on by increased longevity. The main effect of fewer births would be a shrinking tax base; that might prompt the government to embrace inflation to erode its debts and thus stay solvent. But longer lives would cause the ranks of pensioners to swell; their increased political influence, in turn, would augur for tighter monetary policy to prevent inflation eating into savings.

In the case of Japan the authors estimate that the ageing process has led to deflation of about 0.6 percentage points a year over the past 40 years—a huge cumulative impact. That, they believe, is because the big surprise in Japanese demography has been ever-increasing longevity. Fertility rates are close to the levels projected in 2002, but the government has steadily revised up its estimates of lifespans. It is unexpected longevity, not simply ageing, that has been deflationary in Japan.

What about the impact of ageing on financial assets? Economic theory—“the life-cycle hypothesis”—holds that people smooth their consumption over their lifetimes, going into debt when young, buying assets when their earnings peak and selling them to pay for retirement. That, in theory, should lead to lower asset values as countries enter their dotage, but the empirical record is mixed: house prices often fall, but stocks sometimes rise.

An important variable is whether assets sold by pensioners are domestic or foreign. Derek Anderson, Dennis Botman and Ben Hunt of the International Monetary Fund looked at the decrease in Japan’s net savings rate from some 15% of disposable income in the early 1990s to about zero in 2011. What stands out is that many of the liquidated savings had been invested in foreign assets. When Japanese pensioners sold stocks and bonds abroad and repatriated the funds, they fuelled an appreciation in the yen—a consistent problem until 2012. This in turn contributed to deflationary pressure, by lowering the cost of imports. But the researchers also reckon that strong monetary easing combined with a credible commitment to an inflation target would have been sufficient to negate the effect of ageing. In other words, they believe Japan needed Abenomics long before it got it.

Greyflation

A recent paper by Mikael Juselius and Elod Takats for the Bank for International Settlements offers a very different take on how ageing affects inflation, suggesting that Japan may not be typical after all. They look at 22 advanced economies from 1955 to 2010. Japan is, after all, not the only country to have experienced deflation. Sure enough, they find a steady correlation between deflation and demography, but just the opposite of what is commonly assumed. A larger share of dependents—both young and old—is associated with higher inflation, whereas having more people of working age is linked to lower inflation. Their explanation, albeit tentative, is straightforward. Countries with more people consuming goods and services than producing them are liable to have excess demand and thus inflationary tendencies. Those with more producers than consumers will, by contrast, have excess supply and a deflationary bias.

That raises the question of why prices in Japan have fallen for so many years, given its rapidly ageing population. There are several potential culprits: the damaged balance-sheets left by the popping of the asset bubble of the 1980s, say, or the hesitant monetary policy before Mr Abe. But if the paper’s thesis holds true, an ageing population could yet lead to rising prices in the coming years. As the Bank of Japan seeks to vanquish deflation, demography may turn out to be friend, not foe.

Source: http://www.economist.com/ageing15

Economists: Don’t leave home without one

As business leaders seek to stay ahead of the curve, they should ensure that somewhere in their range of view are the ideas of economists. Not forecasts or models or the dry parade of graphs and equations found in the typical introductory textbook, but rather economists’ insights and ideas, which sometimes have an enormous impact on the evolution of industries and also have been put to use in very practical and profitable ways by real companies. I am an economist, so this assertion may seem a bit self-serving. But I wouldn’t make it if there weren’t powerful evidence in its corner.

In this article, I’ll focus on one example: the Internet economy we know today would not have been possible, in scale or in speed of adoption, without an extremely important policy development of the 1970s and 1980s—the deregulation of transportation—in which economists played an important role. Nor would the business model of two of the Internet’s well-known players have been possible without the embrace of an idea—auctions—that has its roots deep in economics. I don’t think the Internet is an isolated case. I’ll close with an example of how a big economic idea could, in the future, have major implications for another major industry: pharmaceuticals.

Transportation deregulation
Had the transportation industry not been deregulated in the 1970s and early 1980s, and had the much more efficient and flexible systems built by companies such as UPS not emerged in response to competition, it is difficult to see how Internet retailers like Amazon, which came along roughly two decades later, would have been able to get started or succeed. Amazon would have had to begin with its own fleet of trucks or even planes to escape the strictures of the pre-1980 regulatory regime, a barrier to entry that almost certainly would have been impossible for new retailers to overcome.

The deregulation of prices and of entry into the transportation industry—especially interstate cargo air traffic and trucking in the mid to late 1970s—is an exciting story in retrospect, but its importance would have been easy to miss at the time. As such, it is a useful reminder for business leaders of the value of keeping their ears to the ground when big economic ideas are playing out in policy arenas. That this particular dismantling of economic regulation happened at all is an amazing fact that contradicts one widely held notion of political economy: a policy benefiting large numbers of people and businesses in a small way is unlikely to be adopted if it imposes large harm on a small, concentrated number of other individuals and businesses.

Air cargo and trucking fit this description to a T. Economic regulation artificially suppressed competition and kept prices of freight (and passenger) traffic too high. But since freight costs represent only a small fraction of the costs of any retail operation and are not separately broken out, consumers paid only a little bit more than they otherwise might. Moreover, even if consumers knew this, they were too diffuse to oppose the concentrated lobbying efforts of the firms in the transportation industry (and its workforce), which would have been hurt greatly by additional competition. That was true even if the price for keeping it at bay had to be price regulation.

How then did things change in the United States? The starting point was congressional hearings organized by the late Senator Edward Kennedy and his chief staffer on these issues, Stephen Breyer (currently a Supreme Court Justice). The hearings featured economic research that made clear the large price cuts to be expected from dismantling price and entry controls in the airline industry. When Jimmy Carter was elected president, he joined forces with Kennedy (and senators whom Kennedy recruited to the cause) to push deregulation. Carter started with the appointment of two prominent economists, the late Alfred Kahn (as chairman) and Elizabeth Bailey, to the Civil Aeronautics Board, which oversaw the airline industry.

Airline deregulation passed Congress in 1978. Once the deregulation ball was rolling, it next went to the trucking industry, whose prices and routes were just as strictly controlled, even though there were thousands of firms in the industry. Trucking deregulation came in 1980, with the help of some heavy pushing along the way by the Interstate Commerce Commission, headed by another highly regarded economist whom Carter had appointed as chairman (on Kahn’s recommendation): Darius Gaskins. The bottom line is that neither deregulation success would have been possible without many years of prior economic research and, most likely, without articulate economists such as Kahn, Bailey, Gaskins, and the economists they appointed to key regulatory positions. When the stars align in this way, it’s worth paying attention.

Auctions

Economists and their ideas also have had an important impact on the evolution of the Internet directly, not mediated by policy changes, through their championing and theorizing about auctions. In the early 1900s, the whole notion of how prices are set in a market economy was analogized to an auctioneer, since frequently referred to as a “Walrasian auctioneer” in the academic literature. The auctioneer conducts continuous auctions for all kinds of commodities, not just those in scarce supply, to which it was once commonly thought that auctions would be limited.

Auctions played a role in the rise of mobile telephony, which has become deeply intertwined, through smartphones, with the Internet itself. (Economist Ronald Coase proposed auctioning off segments of the electromagnetic spectrum in the late 1950s, an idea that was not adopted until the 1990s.) And auctions also played a direct role in the growth of two well-known Internet companies.

One example is Priceline, launched by Jay Walker, who studied economics at Cornell as an undergraduate and learned his lessons well, especially the lectures and reading materials relating to demand curves, which are constructs in economic textbooks but not directly observable in the real world. Shortly after the Internet’s commercial possibilities became evident, Walker and his colleagues came up with the idea of “name your own price travel”—essentially reversing the typical process, in which firms set prices and then hope that consumers pay them. But Walker’s idea was not just to have consumers offer to pay their own prices: if it had only been that, travelers would have bid a dollar or two, and the airlines and hotels he was seeking to participate (TWA and America West became the first) would have refused. No, Walker’s clever innovation was to require consumers to pay the price they bid if the airlines and hotels on Priceline decided to accept it. That condition made travelers think hard about their bids and induced them to make serious offers.

Priceline is an example of a company founded by an innovator with a background in economics. Another company where economic principles later proved to have importance is Google. The search-engine pioneer generates most of its revenue through an auction-based system of selling ads. The system was developed by two engineers but validated by Google’s chief economist, Hal Varian, who was also the first dean of the School of Information at the University of California at Berkeley.

It’s worth mentioning as a side note that Varian has since overseen the hiring of a large corps of statisticians (mostly) and economists who developed other innovations for the company. Google Trends, for example, tracks search-term volumes, which can be helpful in predicting various real-world events, such as the progress of the flu or forthcoming official unemployment statistics. Indeed, the big data revolution ushered in by the ease of capturing, storing, and analyzing large bodies of data has generated new demand for economists and statisticians. High-tech companies like Amazon, Google, and Yahoo! now employ economists to sift through all kinds of data—retail transactions, browsing patterns, mobile-phone usage—to fine-tune their product offerings, pricing, and other business strategies. While teasing out relationships from masses of data can be helpful, correlations found in them often speak to the past and have limited forward-looking utility. Data mining is likely to be more useful if guided by underlying theories, which is what economists can do.

Looking forward

What do these stories of economic ideas have to do with business leaders today? I’d suggest that, every now and then, economic concepts are likely to make their way forward in surprising places, creating real opportunities for watchful executives and threats for unsuspecting ones. Here’s an idea, developed by economists at MIT, that I believe has promise: the securitization of research and development for pharmaceuticals or medical devices.1

The notion here is to pool the R&D expenses of many different research endeavors, most likely ones that have passed some preliminary vetting (for example, Phase 1 clinical trials mandated by the US Food and Drug Administration). I know that the mere word “securitization” has a bad name in the wake of the financial crisis. But the notion itself is not bad; it’s what’s inside the pools of securities and the completeness of disclosure for investors that matter. Structured the right way, pharma R&D bonds could be not only attractive for investors but also a potentially important way to bring more capital to support research for drug therapies and medical devices that both extend and improve the quality of life for millions of people.

When and how this kind of securitization will happen I don’t know. But I do believe that pharmaceutical researchers and leaders should keep an eye on the potential for it, and I will be surprised if, at some point, economic and financial value don’t shift in surprising ways as a result. Business leaders are unlikely to catch signals like these, though, if they limit their focus on economics to one-off situations—listening periodically to the forecasts of economists, hiring them as experts in lawsuits, or seeking their assistance in very specific projects, such as how best to bid in upcoming federal auctions for the electromagnetic spectrum.

I believe economists have a broader and more ongoing usefulness for business. John Maynard Keynes, one of the most famous economists of them all, surely was right when he observed that “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.” The one qualification I would add is that the originators of the ideas need not be defunct; economics is a living field whose generation of ideas with business relevance bears watching all the time.

Source: http://www.mckinsey.com/insights/economic_studies/economists_dont_leave_home_without_one

Global savings glut suppresses bond yields

Demographics is destiny. This may be a truism for political scientists, but investors ignore the implications at their peril.

At the moment, investors are desperately trying to divine when and how quickly the Federal Reserve will begin to raise interest rates, and the impact on bond markets. The consensus is that any turbulence will be transitory, and bond yields will continue staying “lower for longer”. But don’t bet on them staying low for ever.

 

One of the most notable developments in global markets in recent decades is the inexorable march downwards in bond yields. Since Paul Volcker’s Federal Reserve broke the back of inflation in the 1980s by aggressively hiking interest rates, bond yields have fallen steadily to unforeseen, record-breaking lows — almost irrespective of where the Fed’s main policy rate has been set.

This is partly a result of dissipating inflation, the historical nemesis of fixed income. More recently, extraordinary monetary stimulus has suppressed yields further, driving investors into bonds, with pension plans and insurers major buyers of long-term debt.

But according to many economists, it is also a product of a “global savings glut” from baby boomers stashing away their earnings for their retirement, and developing countries building up their reserves. This has lifted demand for bonds and subduing borrowing costs in the process.

This hypothesis was first articulated by former Federal Reserve chairman Ben Bernanke in 2005. He recently revisited the thesis in a blog post at his new home at the Brookings Centre, arguing once again that the savings glut is a leading cause of low bond yields, not just central bank interest rates or quantitative easing.

According to recent research from Michael Gavin at Barclays, the savings bonanza could account for about 2 percentage points of the decline in the “natural” real interest rates — adjusted for inflation and the economic cycle — over the past three decades, from about 2 per cent in the 1980s to roughly zero today.

But this is unlikely to last. western baby boomers have started retiring and in the coming years will draw down their savings, as the number of working-age people declines.

The developing world is unlikely to be of much help. HSBC’s Karen Ward estimates that emerging economies will add 330m more “peak savers” by 2030, but reckons that this capital is now less likely to flow into western financial markets. “The baby boomers’ twilight years may not be so golden after all,” she warns.

Quantifying the impact is tricky. But Mr Gavin estimates that all things being equal the natural real interest rate will rise by about 1 percentage point over the next five years, 2.25 percentage points over the next decade, and 3.5 percentage points over the next two decades.

Even this may underestimate the coming rise in longer-term bond yields, given that they are currently well below the natural rate thanks to the extraordinary monetary stimulus unleashed by central banks led by the Fed in the wake of the financial crisis. Like a balloon held below water, it may snap higher when finally released.

Equity markets are also likely to be rattled. Niels Jensen of Absolute Return Partners pointed out in a recent letter to clients that middle-aged workers tended to favour stocks, but shifted sharply into bonds when retirement loomed. “What has been a tailwind for many years is likely to turn into a sizeable headwind in the foreseeable future,” he warned.

Still, nothing is set in stone. The financial crisis and the uncertain future facing many pension plans could lead to a long-lasting shift in attitudes towards thrift. How savers respond to shifts in interest rates remains unclear. Countries could also respond to the demographic challenges by lifting retirement ages or becoming more receptive to immigration.

Japan is the canary in the coal mine. Its household savings rate has declined in tandem with the average age, which is now the highest in the world. But so far there is no discernible impact on the Japanese bond market. Corporate savings have climbed as investments have dipped, and the Bank of Japan’s QE programme has pinned down yields.

But the forces of demographics move slowly, and it will take years — possibly decades — before any impact becomes apparent.

Source: http://www.ft.com/intl/cms/s/0/fda6e646-e4d1-11e4-8b61-00144feab7de.html#axzz3XmTZNo6e

The back office start-ups that serve the sharing economy

Ever wanted to rent out your spare room or holiday home on Airbnb or HomeAway, but had neither the time nor a fondness for dealing with guests? Now you could call on start-ups such as Guesty, Urban Bellhop or Huitly, who will handle the messy business of welcoming visitors and cleaning up after them on behalf of busy hosts.

Or maybe Uber drivers are not sure how to track expenses or get a nicer car to improve their ratings. Those services can now be outsourced to companies such as Zen99, Breeze or Intuit.

The idea of the so-called sharing economy is only a few years old, but a host of even newer start-ups and consultants are popping up in Silicon Valley that aim to make it just that much easier for people to make spare cash by sharing their apartments, cars and odd-job skills. Call them the sharing economy’s back office.

Part of the allure of these start-ups is that the companies they support are so new that they themselves are still working out the kinks in their models, whether it is how to track expenses or how to co-ordinate with guests in another timezone.

Derek Davis, a Los Angeles-based accountant, was in a ride-sharing car when he got the idea for his new start-up, Tabby. His driver did not realise that the company he worked for was not handling his taxes for him as a traditional US employer would. Because Uber, Lyft and other sharing-economy companies such as handyman platform TaskRabbit or courier service Postmates treat workers as contractors not employees, those workers need to track their business expenses themselves and file quarterly taxes.

So he launched Tabby to help with the ad­ministrative burdens. It links with work­ers’ credit and debit cards to pull in automatically a list of their purchases, and allow them to categorise expenses as work or personal by swiping left or right, much like the dating app Tinder. “This is insane. It’s 2015, and we’re still keeping paper receipts,” says Mr Davis.

Likewise, Zen99 helps workers to estimate taxes and find insurance plans. It recently graduated from Y Combinator, the prestigious Silicon Valley accelerator that launched Airbnb, among others.

Then, for when Uber and Lyft drivers are involved in an accident, there is Breeze. The start-up has partnered with Peers, an advocacy group for the sharing economy, to offer a $19.99 a month programme called Keep Driving. It will lend a new car to drivers who are involved in an accident but want to keep working. Breeze also lends out cars to would-be drivers without wheels. For $195 a week and a $250 upfront fee, drivers in San Francisco, Los Angeles or Seattle can use a 2015 Toyota Prius.

Other companies help sharing-­economy workers focus more on the niceties of customer service. Most not­able are those that work on short-term rentals and holiday listings, such as Airbnb or the publicly listed vacation home rental service HomeAway.

“To be a good owner you need to be a good hotelier, and some are good at that and some aren’t,” says Brian Sharples, HomeAway’s chief executive.

Guesty charges Airbnb hosts a fee of 3 per cent on each reservation to screen potential guests, schedule cleaning, co-ordinate key exchanges and manage the apartment’s profile on the site. One option it does not offer is an in-person concierge service. For that, there are companies such as Airenvy or Urban Bellhop.

“It is a funny thing,” says Alex Chriss, a vice-president at Intuit, who worked on the development of its software for the self-employed.

“This on-demand idea has made it so easy for the consumer to push a button and get a ride or delivery — and on the other side it’s so messy.”

Source: www.ft.com/intl/cms/s/0/2a6735cc-b044-11e4-92b6-00144feab7de.html

Why S&P 500 can reach the 3,000 level by 2020

We are working through a curious period in financial history during which neither capital nor labour has pricing power. Neither can generate much income. Average earnings in nominal and real terms have barely grown, while capital sits idly in cash deposits or in government bonds yielding next to nothing. Whether you are working or investing, income is hard to come by.

We know the reasons why. The power of labour to command a greater share of the economic pie has been undone around the world by policy initiatives focused on labour mobility. In most developed countries, labour’s share of GDP has been falling. Even in the US economy, which added a record 3m jobs last year, labour’s share sits at 50-year lows. Employment growth has been offset by weak wage growth. Productivity gains have passed to the owners of capital, allowing operating margins to rise.

Concurrently, the propensity of developed nations to accumulate savings faster than income growth compresses yields everywhere. Wealthy nations with excess savings and little growth, such as Japan, Germany and Italy, can only export capital, lowering yields. Central banks’ quantitative easing programmes exaggerate the yield compression. Their bond-buying further crowds these countries out of their own domestic sovereign and credit markets compounding the effects abroad.

If we are to believe economist Thomas Piketty, income will become even more prized. He argues the capital/income ratio is set to rise for the rest of this century. Private capital stands at 450 per cent of income today and is set to approach 700 per cent by 2100. Net savings (after capital appreciation) are currently rising approximately twice as fast as income. An ageing population will constrain income growth, and further exaggerate the problem, even as rates of return decline. Mr Piketty describes a world in which too much capital chases too little income.

So in this financial climate how would we value an asset class that offered a current real yield and that had consistently increased its income in double digits each year? Highly, one might think.

And yet this is precisely what the S&P 500 has offered. At the close of the third quarter of 2014, the S&P 500 notched up its 15th consecutive quarter of double-digit dividend growth. Dividend per share growth over 12 months to the third quarter of 2014 was 11.3 per cent. Over the 15-quarter period, dividends per share have averaged 14.2 per cent growth. It is little wonder the US equity market has been one of the most rewarding asset classes in recent years.

"We can find no other asset class that offers this level of income growth in dollar terms. Emerging markets offer little dividend growth in US dollar terms. Currency headwinds and falling returns on equity are the obstacles"

Is this set to continue? We think so. We can find no other asset class that offers this level of income growth in dollar terms. Emerging markets offer little dividend growth in US dollar terms. Currency headwinds and falling returns on equity are the obstacles.

In Europe we may hopefully see single-digits, but a lot will depend on the euro/dollar level. Japan, as always, is a wild card and depends largely on corporate governance reform, and the capacity of investors to convince companies to distribute excess cash.

In contrast, dividend per share growth for the S&P 500 is likely to stay at double-digit levels. This is above earnings growth but the payout ratio is 32 per cent. We need to anticipate a fall in dividends from energy companies, but this will be more than offset by dividend growth from the financial sector, which is still low.

S&P 500 dividends benefit from a high level of diversification, unlike other benchmarks where dividends are concentrated in one or two sectors, or even a handful of stocks. More than 400 stocks in the S&P 500 pay a dividend. Nine out of 10 sectors increased dividends in the past 12 months. Six of these increased dividends by 10 per cent or more. Consumer discretionary, IT and industrials were among these, emphasising that the regulatory risk to dividends is lower than elsewhere.

In the age of income investing, the income growth properties of the S&P 500 will continue to be highly valued. According to our estimates, S&P 500 dividends could exceed $48 by 2016 and $60 is not beyond reach by the end of the decade. If we assume a 2 per cent dividend yield, its 10-year median, the S&P 500 could exceed 2,400 before the next president is inaugurated. A level of 3,000 is within reach before the decade is out.

Source: http://www.ft.com/intl/cms/s/0/ff1c88f6-a588-11e4-8636-00144feab7de.html#axzz3RSBoBmRj

China finds opportunities in oil price drop

This week, Cnooc announced plans to reduce capital spending as the government and large state-owned enterprises respond to the collapse in oil prices. China’s third-largest oil producer said it would cut development spending by 67 per cent and, albeit less dramatically, reduce exploration and production capital expenditure.

At the same time, the Beijing government and refiners such as Zhuhai Zhenrong have increased their purchases of crude oil to record levels. Sinopec, another big state-owned energy enterprise, opened up a tank farm for crude oil on the resort island of Hainan in November.

These apparently contradictory signals reflect changes in the sources of growth in a slowing Chinese economy and show how the government and corporate China are exploiting the collapse to reduce their longer-term vulnerability to price swings in the volatile energy market.

It is easy to understand why Cnooc is cutting back spending. The economy is growing slightly below the level the cadres have commanded and slowed to 7.1 per cent in the final quarter of 2014. Reinforcing that trend is the fact that the energy intensity of Chinese production has gone down. Chinese crude oil demand per unit of gross domestic product has been dropping by 4.3 per cent a year since 2005, according to data from JPMorgan Private Bank.

Moreover, as the sources of growth shift slowly from manufacturing to services and from exports to domestic demand, that drop will probably accelerate, making further oil capex cuts likely — and shareholders happier.

But China is also looking ahead and taking advantage of the speedy and unexpected reversal in the oil price.

The increase in demand for crude on the mainland comes because China is exploiting lower oil prices to dramatically boost its storage capacity for both commercial and strategic reasons. By doing so, it will address one of its perennial weaknesses, its reliance on imported energy, and make itself more competitive.

The move comes at a moment when pessimism about Chinese prospects generally is on the rise. That downbeat attitude reflects chronic excess capacity, an overbuilt property market and concerns about a corporate sector that has borrowed too much, whether in renminbi or appreciating US dollars.

The way China is taking advantage of the declining oil price also suggests that some of the pessimism is unwarranted. The dramatic expansion in commercial and strategic holdings of crude while the price is half of what it was just months ago is only part of the story. The government is also increasing taxes rather than pass on the full benefit of bargain fuel prices to consumers.

Those taxes will go partly to dealing with China’s monumental environmental issues, according to Miswin Mahesh, Barclays’ commodities analyst in London. That spending should be good for China and its neighbours, if the past is any guide.

Up to now, Chinese growth has been good news for the rest of the world. In 1990, China’s contribution to global GDP growth was 5 per cent. Since 2010, the figure has swelled to more than 40 per cent. Its role as a crutch for world growth has become especially important as the growth rate of other emerging markets has fallen. (Last year emerging markets as a whole grew only 4 per cent — the worst figure since 2009 — and this year may even drop slightly below that.)

China’s demand for crude is already lifting the fortunes of shippers and others. Among the biggest beneficiaries of the increase in Chinese appetite for crude is Iran, says Amrita Sen, chief oil analyst with Energy Aspects in Houston and London. Indeed, Chinese demand for oil from Iran accounts for more than India, Japan, and South Korea combined. (All these countries have received specific exemptions from US-imposed sanctions on Iran, and they may also import more than the level the waivers allow.)

Earlier on, before China received permission from the US to procure Iranian oil, the country paid for its Iranian imports in renminbi. But today, Ms Sen says, the Chinese are using dollars. That benefits both sides. Tehran finds dollars more useful than renminbi as there are still controls on what Iran can do with its Chinese currency.

At the same time, China has clearly decided it is better to obtain real assets such as oil with its dollars than to purchase paper securities. Right now, both US Treasuries and the US dollar look attractive, while oil does not. But China always takes the long view — and in the long term neither Treasury securities nor the greenback seem as attractive as they do today — at least as seen from Beijing.

Source: http://www.ft.com/intl/cms/s/0/b083f7b4-ab8d-11e4-b05a-00144feab7de.html#axzz3Qnw9Fh8K

The on-demand economy

Workers on tap

IN THE early 20th century Henry Ford combined moving assembly lines with mass labour to make building cars much cheaper and quicker—thus turning the automobile from a rich man’s toy into transport for the masses. Today a growing group of entrepreneurs is striving to do the same to services, bringing together computer power with freelance workers to supply luxuries that were once reserved for the wealthy. Uber provides chauffeurs. Handy supplies cleaners. SpoonRocket delivers restaurant meals to your door. Instacart keeps your fridge stocked. In San Francisco a young computer programmer can already live like a princess.

Yet this on-demand economy goes much wider than the occasional luxury. Click on Medicast’s app, and a doctor will be knocking on your door within two hours. Want a lawyer or a consultant? Axiom will supply the former, Eden McCallum the latter. Other companies offer prizes to freelances to solve R&D problems or to come up with advertising ideas. And a growing number of agencies are delivering freelances of all sorts, such as Freelancer.com and Elance-oDesk, which links up 9.3m workers for hire with 3.7m companies.

The on-demand economy is small, but it is growing quickly (see article). Uber, founded in San Francisco in 2009, now operates in 53 countries, had sales exceeding $1 billion in 2014 and a valuation of $40 billion. Like the moving assembly line, the idea of connecting people with freelances to solve their problems sounds simple. But, like mass production, it has profound implications for everything from the organisation of work to the nature of the social contract in a capitalist society.

Baby, you can drive my car—and stock my fridge

Some of the forces behind the on-demand economy have been around for decades. Ever since the 1970s the economy that Henry Ford helped create, with big firms and big trade unions, has withered. Manufacturing jobs have been automated out of existence or outsourced abroad, while big companies have abandoned lifetime employment. Some 53m American workers already work as freelances.

But two powerful forces are speeding this up and pushing it into ever more parts of the economy. The first is technology. Cheap computing power means a lone thespian with an Apple Mac can create videos that rival those of Hollywood studios. Complex tasks, such as programming a computer or writing a legal brief, can now be divided into their component parts—and subcontracted to specialists around the world. The on-demand economy allows society to tap into its under-used resources: thus Uber gets people to rent their own cars, and InnoCentive lets them rent their spare brain capacity.

The other great force is changing social habits. Karl Marx said that the world would be divided into people who owned the means of production—the idle rich—and people who worked for them. In fact it is increasingly being divided between people who have money but no time and people who have time but no money. The on-demand economy provides a way for these two groups to trade with each other.

This will push service companies to follow manufacturers and focus on their core competencies. The “transaction cost” of using an outsider to fix something (as opposed to keeping that function within your company) is falling. Rather than controlling fixed resources, on-demand companies are middle-men, arranging connections and overseeing quality. They don’t employ full-time lawyers and accountants with guaranteed pay and benefits. Uber drivers get paid only when they work and are responsible for their own pensions and health care. Risks borne by companies are being pushed back on to individuals—and that has consequences for everybody.

Obamacare and Brand You

The on-demand economy is already provoking political debate, with Uber at the centre of much of it. Many cities, states and countries have banned the ride-sharing company on safety or regulatory grounds. Taxi drivers have staged protests against it. Uber drivers have gone on strike, demanding better benefits. Techno-optimists dismiss all this as teething trouble: the on-demand economy gives consumers greater choice, they argue, while letting people work whenever they want. Society gains because idle resources are put to use. Most of Uber’s cars would otherwise be parked in the garage.

The truth is more nuanced. Consumers are clear winners; so are Western workers who value flexibility over security, such as women who want to combine work with child-rearing. Taxpayers stand to gain if on-demand labour is used to improve efficiency in the provision of public services. But workers who value security over flexibility, including a lot of middle-aged lawyers, doctors and taxi drivers, feel justifiably threatened. And the on-demand economy certainly produces unfairnesses: taxpayers will also end up supporting many contract workers who have never built up pensions.

This sense of nuance should inform policymaking. Governments that outlaw on-demand firms are simply handicapping the rest of their economies. But that does not mean they should sit on their hands. The ways governments measure employment and wages will have to change. Many European tax systems treat freelances as second-class citizens, while American states have different rules for “contract workers” that could be tidied up. Too much of the welfare state is delivered through employers, especially pensions and health care: both should be tied to the individual and made portable, one area where Obamacare was a big step forward.

But even if governments adjust their policies to a more individualistic age, the on-demand economy clearly imposes more risk on individuals. People will have to master multiple skills if they are to survive in such a world—and keep those skills up to date. Professional sorts in big service firms will have to take more responsibility for educating themselves. People will also have to learn how to sell themselves, through personal networking and social media or, if they are really ambitious, turning themselves into brands. In a more fluid world, everybody will need to learn how to manage You Inc.

 Source: http://www.economist.com/news/leaders/21637393-rise-demand-economy-poses-difficult-questions-workers-companies-and

 

The future of work: There’s an app for that  

HANDY is creating a big business out of small jobs. The company finds its customers self-employed home-helps available in the right place and at the right time. All the householder needs is a credit card and a phone equipped with Handy’s app, and everything from spring cleaning to flat-pack-furniture assembly gets taken care of by “service pros” who earn an average of $18 an hour. The company, which provides its service in 29 of the biggest cities in the United States, as well as Toronto, Vancouver and six British cities, now has 5,000 workers on its books; it says most choose to work between five hours and 35 hours a week, and that the 20% doing most earn $2,500 a month. The company has 200 full-time employees. Founded in 2011, it has raised $40m in venture capital.

Handy is one of a large number of startups built around systems which match jobs with independent contractors on the fly, and thus supply labour and services on demand. In San Francisco—which is, with New York, Handy’s hometown, ground zero for this on-demand economy—young professionals who work for Google and Facebook can use the apps on their phones to get their apartments cleaned by Handy or Homejoy; their groceries bought and delivered by Instacart; their clothes washed by Washio and their flowers delivered by BloomThat. Fancy Hands will provide them with personal assistants who can book trips or negotiate with the cable company. TaskRabbit will send somebody out to pick up a last-minute gift and Shyp will gift-wrap and deliver it. SpoonRocket will deliver a restaurant-quality meal to the door within ten minutes.

The obvious inspiration for all this is Uber, a car service which was founded in San Francisco in 2009 and which already operates in 53 countries; insiders say it will have sales of more than $1 billion in 2014. SherpaVentures, a venture-capital company, calculates that Uber and two other car services, Lyft and Sidecar, made $140m in revenues in San Francisco in 2013, half what the established taxi companies took (see chart 1), and the company shows every sign of doing the same wherever local regulators give it room. Its latest funding round valued it at $40 billion. Even in a frothy market, that is a remarkable figure.

Bashing Uber has become an industry in its own right; in some circles, though, applying its business model to any other service imaginable is even more popular. There seems to be a near-endless succession of bright young people promising venture capitalists that they can be “the Uber of X”, where X is anything one of those bright young people can imagine wanting done for them (see chart 2). They have created a plethora of on-demand companies that put time-starved urban professionals in timely contact with job-starved workers, creating a sometimes distasteful caricature of technology-driven social disparity in the process; an article about the on-demand economy by Kevin Roose in New York magazine began with the revelation that the housecleaner he hired through Homejoy lived in a homeless shelter.

This boom marks a striking new stage in a deeper transformation. Using the now ubiquitous platform of the smartphone to deliver labour and services in a variety of new ways will challenge many of the fundamental assumptions of 20th-century capitalism, from the nature of the firm to the structure of careers.

The young Turks

The new opportunities that technology offers for matching jobs to workers were being exploited well before Uber. Topcoder was founded in 2001 to give programmers a venue to show off. In 2013, it was bought by Appirio, a cloud-services company, and now specialises in providing the services of freelance coders. Elance-oDesk offers 4m companies the services of 10m freelances. The model is also gaining ground in the professions. Eden McCallum, which was founded in London in 2000, can tap into a network of 500 freelance consultants in order to offer consulting services at a fraction of the cost of big consultancies like McKinsey. This allows it to provide consulting to small companies as well as to concerns like GSK, a pharma giant. Axiom employs 650 lawyers, services half the Fortune 100 companies, and enjoyed revenues of more than $100m in 2012. Medicast is applying a similar model to doctors in Miami, Los Angeles and San Diego. Patients order a doctor by touching an app (which also registers where they are). A doctor briefed on the symptoms is guaranteed to arrive within two hours; the basic cost is $200 a visit. Not least because it provides malpractice insurance, the company is particularly attractive to moonlighters who want to top up their income, younger doctors without the capital to start their own practices and older doctors who want to set their own timetables.

The Los Angeles-based Business Talent Group provides bosses on tap for companies that want to tackle a specific problem without adding another senior executive to the payroll: Fox Mobile Entertainment, an online-content provider, turned to it for a temporary creative director to produce a new line of products. Creative companies add a twist to the model: they demand ideas, rather than labour and services, and give a prize or prizes only to the ones they find interesting. Innocentive has applied the prize idea to corporate R&D; it turns companies’ research needs into specific problems and pays for satisfactory solutions to them.

A job for the afternoon

Tongal does the same thing with its network of 40,000 video-makers. In 2012 Colgate-Palmolive, a consumer-goods company, offered $17,000 to anyone who could make a 30-second advertisement for the internet. The ad was so good that the company showed it at the Super Bowl alongside blockbuster ads that cost hundreds of times more. Members of the Quirky network post their product ideas on the company’s website. Other members vote on the attractiveness of each idea and come up with ways of turning it into reality. Since its birth in 2009 the company has acquired over a million members and brought 400 products to the shops.

Perhaps the most striking of all the on-demand services is Amazon’s Mechanical Turk, which allows customers to post any “human intelligence task”, from flagging objectionable content on websites to composing text messages; workers on the site choose what to do according to task and price. The set-up uses to the full most of the capabilities and advantages that make on-demand business models attractive: no need for offices; no full-time contract employees; the clever use of computers to repackage one set of people’s needs into another set of people’s tasks; and an ability to access spare time and spare cognitive capacity all across the world.

The idea that having a good job means being an employee of a particular company is a legacy of a period that stretched from about 1880 to 1980. The huge companies created by the Industrial Revolution brought armies of workers together, often under a single roof. In its early stages this was a step down for many independent artisans who could no longer compete with machine-made goods; it was a step up for day-labourers who had survived by selling their labour to gang masters.

These companies introduced a new stability into work, a structure which differentiated jobs from one another more clearly than before, thus providing defined roles and new paths of career progress. Many of the jobs were unionised, and the unions fought to improve their members’ benefits. Governments eventually built stable employment along these lines into the heart of welfare legislation. A huge class of white-collar workers enjoyed secure jobs administering the new economy.

For a while after the second world war everybody seemed to benefit from this model: workers got security, benefits and steady wage rises; companies got a stable workforce in which they could invest with a fair expectation of returns. But the model started to get into trouble in the 1970s, thanks first to deteriorating industrial relations and then to globalisation and computerisation. Trade unions have lost power in the private sector, particularly in America and Britain, where legislation has reduced their ability to take action (see chart 3). Companies kept stricter control of their labour costs, increasingly contracting out production in industrial businesses and re-engineering middle-management. Computerisation and improved communications then sped the process up, making it easier for companies to export jobs abroad, to reshape them so that they could be done by less skilled contract workers, or to eliminate them entirely.

This has all resulted in a more rootless and flexible labour force. Pensioners and parents wanting or needing to spend more time on child care swell the ranks of students and the straightforwardly unemployed. A recent study by the Freelancers Union, a pressure group for freelance workers, suggests that one in three members of the American workforce (and a higher proportion of younger people) do some freelance work.

The on-demand economy is the result of pairing that workforce with the smartphone, which now provides far more computing power than the desktop computers which reshaped companies in the 1990s, and to far more people (see chart 4 on next page). According to Benedict Evans of Andreessen Horowitz, the new iPhones sold over the weekend of their release in September 2014 contained 25 times more computing power than the whole world had at its disposal in 1995. Connected to each other and to yet more data and processing power in the cloud, these devices are letting people design or find ad hoc answers to all sorts of business problems previously solved by the structure of the firm.

Coase and effect

The way economists understand firms is largely based on an insight of the late Ronald Coase. Firms make sense when the cost of organising things internally through hierarchies is less than the cost of buying things from the market; they are a way of dealing with the high transaction costs faced when you need to do something moderately complicated. Now that most people carry computers in their pockets which can keep them connected with each other, know where they are, understand their social network and so on, the transaction costs involved in finding people to do things can be pushed a long way down.

This has a range of knock-on consequences, all of which are becoming key features of the on-demand economy. One is further division of labour. Thomas Malone, of the MIT Sloan School of Management, argues that computer technology is producing an age of hyper-specialisation, as the process that Adam Smith observed in a pin factory in the 1760s is applied to more sophisticated jobs.

Another is the ability to tap underused capacity. This applies not just to people’s time, but also to their assets: to drive for Lyft or Uber, you do need a car. The on-demand economy is in many ways a continuation of what has been called the “sharing economy” exemplified by Airbnb, a company which turns apartments into guesthouses and their owners into hoteliers. For people with few assets, though, on-demand labour markets matter more.

And new areas are being opened to economies of scale. SpoonRocket prepares its food in two central kitchens in San Francisco and Berkeley. It delivers food quickly because it keeps a fleet of cars, equipped with thermal bags to keep the food warm, roaming the streets of San Francisco. “We’re like a gigantic cafeteria serving all of San Francisco,” says Anson Tsui, one of the company’s founders.

Scheduling success

The aim of the on-demand companies is to exploit low transaction costs in a number of ways. One key is providing the sort of trust that encourages people to take a punt on the unfamiliar. Customers worry about the quality of their temporary employees: nobody wants to give the key to their apartment to a potential burglar, or their health details to a dud doctor. Potential freelances, for their part, do not want to have to deal with deadbeats: about 40% of freelances are currently paid late.

On-demand companies like Handy provide customers with a guarantee that workers are competent and honest; Oisin Hanrahan, the company’s founder, says that more than 400,000 people have applied to join the platform, but only 3% of applicants get through its selection and vetting process. The workers, for their part, can hope for a steady flow of jobs and prompt payment with minimal fuss. Handy’s computer system also tries to schedule each worker’s jobs in such a way as to minimise travel time.

Despite these capabilities, Handy is not necessarily looking at huge success, any more than the other Ubers-of-X are. There are three reasons for scepticism about their chances.

The first is that on-demand companies trying to keep the costs to their clients as low as possible have difficulties training, managing and motivating workers. MyClean, a cleaning service based in New York City, tried using purely contract workers, but discovered that it got better customer ratings if it used permanent staff. The company thinks that better services justify higher labour costs. Uber drivers complain that the company pays them like contract workers while seeking to manage them like regular employees: they are told to take regular rather than premium fares, but are not reimbursed for their fuel. America’s gathering economic recovery may make it harder for companies to attract casual labour as easily as they have done in the past few years.

The second problem is that on-demand companies seem likely to be plagued by regulatory and political problems if they get large enough for people to notice them. American on-demand companies are terrified that they will be stuck with retrospective labour bills if the courts force them to reclassify their workers as regular employees rather than contract workers (a classification which is not always consistent from jurisdiction to jurisdiction, raising the level of anxiety). Handy at one point included a clause in its contracts imposing any such retrospective costs on its clients, though it has now withdrawn it.

Faced by the threat of Uber, established taxi companies around the world have organised strikes, filed lawsuits and leant on regulators. In the Netherlands Uber has been banned; South Korea is treating it as an illegal taxi service. In Germany anti-Uber feeling has nurtured a broader criticism of “Plattform-Kapitalismus”; its perceived readiness to reduce all aspects of people’s lives, from spare rooms to spare time, to assets to be auctioned off is seen as deeply dehumanising. But such protests often act as advertising for the services they are aimed against. And a recent study revealed that American politicos spend more on Uber than on regular taxis when campaigning, a strong indication that the road ahead is likely to remain clear.

The third issue is size. The on-demand model obviously has network effects: the home-help company with the most help on the books has the best chance of providing a handyman at 10:30 sharp. Yet scaling up may be difficult when barriers to entry are low and bonds of loyalty are non-existent. It will be hard to get workers to be loyal to just one middleman. A number of Uber drivers also work for Lyft.

In many service industries it is hard to see obvious economies of scale on a national or global level. Being the best dry-cleaning service in Cleveland does not necessarily offer a killer edge in Cologne. And taste can be fickle, especially with companies that often look like positional goods that trade, at least in part, on the cachet that they confer to their consumers. Many of the people who currently regard SpoonRocket as cool may drop it if it becomes a national brand. On-demand companies may find themselves stuck in a world of low margins, high promotional costs and labour churn as they struggle to attain the sort of market dominance that locks in their network advantages. Alfred, a subscription service, is already aggregating the work of specific on-demand companies such as Instacart and Handy to offer its Boston members a one-stop shop; such aggregation could drive down prices for the basic on-demand providers yet further.

Everyone a corporation

Even if the eventual on-demand victors do carve out profitable domestic-service businesses, many observers doubt that their model is more broadly applicable. Some critics argue that on-demand companies like BloomThat and Handy may be capable of delivering flowers or cleaning houses, but when it comes to companies in the main flow of the knowledge economy they are destined to remain marginal. This objection, though, is not very convincing. The sort of people currently using Uber are subject to the same forces as the people who drive them from place to place.

The knowledge economy is subject to the same forces as the industrial and service economies: routinisation, division of labour and contracting out. A striking proportion of professional knowledge can be turned into routine action, and the division of labour can bring big efficiencies to the knowledge economy. Topcoder can undercut its rivals by 75% by chopping projects into bite-sized chunks and offering them to its 300,000 freelance developers in 200 countries as a series of competitive challenges. Knowledge-intensive companies are already contracting out more work to the market, partly to save costs and partly to free up their cleverest workers to focus on the things that add the most value. In 2008 Pfizer, a pharma company, undertook a huge self-examination under the heading PfizerWorks. It realised that its most highly skilled workers were spending 20% to 40% of their time on routine work—entering data, producing PowerPoint slides, doing research on the web. The company now contracts out much of this work.

Thus more and more of the routine parts of knowledge work can be parcelled out to individuals, just as they were previously parcelled out to companies. This could be bad news for the business models of professional-service companies which use juniors to do fairly routine work—thus providing the firm with income and the juniors with training—while the partners do the more sophisticated stuff. As on-demand solutions and automation prove applicable to more and more routine work, that model becomes hard to sustain. InCloudCounsel undercuts big law firms by as much as 80% thanks to an army of freelances that processes legal documents (such as licences, accreditation and non-disclosure agreements) for a flat fee.

The key role that cutting things up into routines plays in both spheres suggests that the interaction between the on-demand economy and automation will be a complex one. Gobbetising jobs with the aim of parcelling them out to people who don’t see or need to see the big picture is not that different from gobbetising them in a way that allows automation. Often the first activity may prove a prelude to the second; it is easy to see Uber as a forerunner to an eventual system that has no drivers at all. In other cases, though, the cost-efficiency of contracting out may reduce the incentives to automate.

What sort of world will this on-demand model create? Pessimists worry that everyone will be reduced to the status of 19th-century dockers crowded on the quayside at dawn waiting to be hired by a contractor. Boosters maintain that it will usher in a world where everybody can control their own lives, doing the work they want when they want it. Both camps need to remember that the on-demand economy is not introducing the serpent of casual labour into the garden of full employment: it is exploiting an already casualised workforce in ways that will ameliorate some problems even as they aggravate others.

The on-demand economy is unlikely to be a happy experience for people who value stability more than flexibility: middle-aged professionals with children to educate and mortgages to pay. On the other hand it is likely to benefit people who value flexibility more than security: students who want to supplement their incomes; bohemians who can afford to dip in and out of the labour market; young mothers who want to combine bringing up children with part-time jobs; the semi-retired, whether voluntarily so or not.

Megan Guse, a law graduate, says that the on-demand model allows her to combine a career as a lawyer with her taste for travel. “A lot of my friends that have gone the Big Law route have these stories about having to cancel weddings, vacations and miss family events. I can continue working while being in exotic places.” Flexibility is also valuable for elite workers who want to wind down after decades of selling their soul to their companies. Jody Greenstone Miller, the founder of Business Talent Group, says that her company’s comparative advantage lies in rethinking corporate time: by breaking up work into projects, she can allow people to work for as long as they want.

A limited Utopia

The on-demand economy is good for outsiders and insurgents—and for entrepreneurs trying to create new businesses using such people. Matt Barrie, the founder of Freelancer.com, links the fate of two groups of potential winners: entrepreneurs in the rich world who have few resources will be able to link up with workers in the poor world who have little money. In Europe the labour market drives a wedge between insiders who have lots of protections and outsiders who don’t; on-demand arrangements may give outsiders a chance of breaking in. Thus in countries such as France, Italy and Spain, on-demand companies may improve the job chances of the young unemployed.

If this seems attractive, it is also a measure of the way that the on-demand economy will contribute to pressure to reduce labour rights in all sorts of situations; a growing abundance of on-demand employees with no normally accepted rights such as sick-pay and overtime will give employers at firms with more standard structures an incentive to cut back. The more such pressures spread, the more protests against “Plattform-Kapitalismus” the world is likely to see.

The on-demand economy will inevitably exacerbate the trend towards enforced self-reliance that has been gathering pace since the 1970s. Workers who want to progress will have to keep their formal skills up to date, rather than relying on the firm to train them (or to push them up the ladder regardless). This means accepting challenging assignments or, if they are locked in a more routine job, taking responsibility for educating themselves. They will also have to learn how to drum up new business and make decisions between spending and investment.

At the same time, governments will have to rethink institutions that were designed in an era when contract employers were a rarity. They will have to clean up complicated regulatory systems. They will have to make it easier for individuals to take charge of their pensions and health care, a change which will be more of a problem for America, which ties many benefits to jobs, than Europe, which has a more universal approach. They will also have to encourage schools to produce self-reliant citizens rather than loyal employees.

One of Gilbert and Sullivan’s oddest operettas, “Utopia Limited—or the Flowers of Progress”, focuses on an exotic South Sea island which, under the influence of Victorian industrialism, sets about turning all the inhabitants into limited companies. It is rarely performed today, in part because the targets of its on-the-nose-in-1893 satire seem remote. But perhaps, after a century in which companies were vast things, such a satire of corporate individualism is due for a revival or two. If so, the piece will be easier than ever to stage: if there are not already on-demand services that can provide Polynesian props, semi-retired set designers and down-on-their-luck tenors at the swipe of a screen, there soon will be.

Source: http://www.economist.com/news/briefing/21637355-freelance-workers-available-moments-notice-will-reshape-nature-companies-and