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

Broke but never bust: The ECB and Swiss National Bank should be much more relaxed about losing money

 

CONTEMPORARY central banking is a strongbox of oddities. Deposits, which normally pay interest, can now incur a charge. Investments in government debt, which normally offer a return, give a negative yield. Faced with this weirdness central banks are trying to respect some cardinal rules of finance, with the Swiss National Bank (SNB) and the European Central Bank (ECB) taking steps to protect themselves from losses and ensure that their balance-sheets add up. The experience of several poorer places suggests they are wrong to do so.

In calm times central banking is simple and profitable. Central banks’ assets—mainly bonds issued by rich countries and blue-chip firms—pay a decent return. Their liabilities—deposits made by high-street banks and banknotes—cost them little or nothing. With this wedge between income and outgoings shareholders receive a dividend. The SNB paid dividends of SFr1 billion ($1.15 billion) to Switzerland’s federal and regional governments in 2012. The ECB’s 2013 payout—divvied up across the euro-area national central banks—was €1.4 billion ($1.9 billion).

The financial crisis changed the business. For one thing central banks are far bigger (see left-hand chart). Between 2006 and 2014 central-bank balance-sheets in the G7 jumped from $3.4 trillion to $10.5 trillion, or from 10% to 25% of GDP. And the assets they hold have changed. The SNB, aiming to protect Swiss exporters from an appreciating currency, has built up a huge stock of euros, bought with newly created francs. The ECB, mindful of tight credit, has lent money to banks and bought corporate bonds. And on January 22nd, as The Economist went to press, it was expected to announce that it would start buying government debt.

The expansion would be greater but for worries about cashflow and capital. Bonds that paid 5% or more ten years ago now yield nothing, and other investments have performed badly (the SNB was stung by a drop in the value of gold in 2013 and cut its dividend to zero). Concerned that its euro holdings might lose value the SNB shocked markets on January 15th by abruptly ending its euro-buying spree. Worries that QE will lead to losses if struggling governments default on their debt have caused weeks of wrangling at the ECB, and may prevent it from buying Greek bonds.

From a narrow accounting perspective this caution seems prudent. With capital of €95 billion supporting a €2.2 trillion balance-sheet, the Eurosystem (the ECB and the national banks that stand behind it) is 23 times levered; a loss of 4% would wipe out its equity. Since two central banks have suffered devastating crunches recently (Tajikistan in 2007, Zimbabwe in 2009) the standard logic seems to apply: capital-eroding losses must be avoided.

But the worries are overdone. For one thing central banks are healthier than they appear. On top of its equity, the Eurosystem holds €330 billion in additional reserves. These funds are designed to absorb losses as assets change in value. Even if the ECB were to buy all available Greek debt—around €50 billion—and Greece were to default, the system would lose just 15% of these reserves; its capital would not be touched.

And even if a central bank’s equity were wiped out it would not go bust in the way high-street lenders do. With liabilities outweighing its assets it might seem unable to pay all its creditors. But even bust central banks retain a priceless asset: the power to print money. Customers’ deposits are a claim on domestic currency, something the bank can create at will. Only central banks that borrow heavily in foreign currencies they cannot mint (as in Tajikistan) or in failing states (Zimbabwe) get into deep trouble.

A helpful bias

The survival of threadbare central banks proves the theory. In the 1980s many emerging-market central banks faced sharply appreciating exchange rates and bought up dollars with newly created cash to cheapen their currencies. Since inflation was a worry they “sterilised” the purchases, mopping up the money by selling bonds to investors. With low-yielding assets (dollars) and high-cost liabilities (domestic-currency bonds) they locked in losses, as a 2008 paper* by Peter Stella and Ake Lonnberg of the IMF shows. By the late 1980s the central banks of Jamaica and Nicaragua were regularly losing 5% of GDP or more per year. After 20 years of losses Chile’s is in negative equity (see right-hand chart).

While none of these banks toppled, hawks have other fears. Like any firm, central banks face running costs. The urge to pay the bills could tempt them to print money rather than focus on inflation. Another worry, set out in a 2005 paper by John Dalton and Claudia Dziobek of the IMF, is that low capital could lead to a loss of independence. While negative capital doesn’t matter much it doesn’t look great; a central bank embarrassed by its capital deficiency might seek a capital injection from its finance ministry and be captured by boom-hungry politicians. In either case, capital erosion might mean a bias towards higher inflation.

There is some evidence for this. In a 2012 paper Gustavo Adler and Camilo Tovar of the IMF and Pedro Castro of the University of California, Berkeley, test the relationship between bank capital and interest-rate policy. Collecting data for 41 advanced and emerging economies between 2002 and 2011, they work out what a hypothetical central bank, behaving optimally, would do. They contrast this with the central bank’s choices and seek to explain why the two might diverge. They find that large deviations can be explained by a weak capital position. Flaky-looking central banks might lower interest rates by up to 72 basis points.

Doves should cheer this. Falling returns on government bonds mean central banks’ income will dwindle. Given their pumped-up balance-sheets, some losses are likely. None will fail, but a few might chase their losses by printing money and pushing rates down. In a world on the brink of deflation, bias towards a little more inflation would be no bad thing.

Source: http://www.economist.com/news/finance-and-economics/21640363-ecb-and-swiss-national-bank-should-be-much-more-relaxed-about-losing

Switzerland's monetary policy: The three big misconceptions about the Swiss franc

ON THURSDAY January 15th Switzerland’s central bank, the Swiss National Bank (SNB), removed the cap on its currency, which it had imposed over three years ago and reaffirmed only three days before its repeal. The doffing of the cap surprised and upset the foreign-exchange markets, hobbling several currency brokers, including Alpari (which happens to sponsor the London football team I support). Many commentators nonetheless welcomed the cap’s removal, arguing that the policy was either unsustainable, protectionist or risky, exposing the SNB to grievous losses. I find these criticisms of the cap unconvincing—and not just because I am a West Ham United fan. Let me address each of them in turn.

Misconception 1: The cap on the Swiss franc was unsustainable

Exchange-rate pegs often fail. To prop up its currency, a central bank might have to buy large amounts of its own money in exchange for dollars or euros. Eventually, it will exhaust its hard-currency reserves forcing it to abandon its peg.

The first thing to understand about the Swiss drama is that it is the exact opposite of this more familiar case. The Swiss central bank was trying to keep its currency down not prop it up. To achieve this goal, the SNB had promised to sell as many Swiss francs as necessary (in exchange for “unlimited quantities” of foreign currency). The promise was credible, because a central bank can print its own currency without limit. It cannot run out of its own money to sell. The cap was, therefore, sustainable if the SNB had wished to sustain it.

If a central bank overworks the printing press, its money will eventually lose value, of course. Inflation and depreciation set a limit on the power of central banks. But the Swiss had imposed the cap precisely because they wanted to raise domestic inflation from dangerously low levels (consumer prices fell by 0.3% in the year to December 2014, according to the Federal Statistics Office). Persisting with the currency cap might have pushed up prices. But that is no objection to the policy; on the contrary, it was the objective of it.

Misconception 2: The Swiss central bank needed to worry about big losses on its euro holdings

The second misconception is less basic. Every economist knows that a central bank cannot run out of its own currency. But many believe the Swiss cap was unsustainable for a different reason.

If the SNB had stuck with its cap, buying as many euros as people were willing to sell at its set price of 1.20 Swiss francs, its holdings of the single currency would have swollen in size. By the end of September 2014, it already held over €174 billion, according to its balance sheet. With the single currency weakening in anticipation of further monetary easing by the European Central Bank, this hoard was likely to grow to epic proportions.

Perhaps because I live in Hong Kong, where the monetary authority’s foreign assets amount to over 120% of the economy’s annual output, big central-bank balance sheets don’t scare me. But others worry. They point out that if the franc were ever permitted to rise against the single currency, the Swiss central bank would suffer an enormous loss on its euro assets. Euro holdings worth, say, 240 billion francs at the capped exchange rate would be worth 40 billion less in the Swiss currency if it rose by 20%.

If the loss were big enough, the central bank’s assets (which include its euro holdings) might end up being worth less than its liabilities (which are overwhelmingly in its home currency). The central bank, known until last week for its quiet conservatism, would be technically insolvent.

That would be a little awkward. It would not be easy to explain the central bank’s predicament to its shareholders, who include the Swiss cantons, or to unsympathetic political parties, such as the Swiss People’s Party—which has already sponsored an unsuccessful referendum to force the SNB to hold at least a fifth of its assets in gold.

But although insolvency is humbling for a central bank, it is far from crippling. “Central banks may operate perfectly well without capital as conventionally defined,” pointed out Peter Stella in a working paper published by the International Monetary Fund back in 1997. Central banks cannot go bust in the way that a commercial bank can. They can always pay their bills, because they print the money they owe.

Their debts are also peculiar. The SNB’s liabilities are chiefly Swiss francs. For the most part, as its balance sheet shows, they take the form of simple banknotes or the deposits that commercial banks hold at the central bank.

The franc, like all fiat money, is not backed by anything tangible. People accept it as payment because they are confident other people (including the tax authorities) will accept it. Try to redeem a banknote at the central bank and all you will get is a newer banknote. That is all that a central bank’s liabilities promise: I owe you an IOU.

These debts are also uniquely easy to service. Banknotes pay zero interest. Deposits at the SNB now yield even less than that: depositors pay the central bank, not the other way around.

Central banks do not, then, have to worry much about satisfying their creditors. Nor are they judged by the returns they earn for shareholders. They are judged by their ability to keep inflation in check and the financial system stable. Their balance sheet—the size and mix of their assets and liabilities—is important insofar as it serves that mission. It is a macroeconomic tool, not a statement of financial success or failure.

The SNB itself understands this. After it reported big losses on its foreign-exchange holdings in 2010 and early 2011, it faced doubts about its financial strength. Some people speculated that it might eventually suffer from negative net worth (also known as “negative equity”). In a 2011 speech, Thomas Jordan, who now heads the institution, answered these concerns directly.

“Might the SNB lose its capacity to act as a result of a negative equity level? And, if its equity were negative, would the SNB have to be recapitalised, or might it even have to go into administration?...[T]he short answer to all these questions is ‘No’.”

If the SNB ever became insolvent, it would not be the first central bank to suffer such an indignity. The Czech central bank and the Bank of Chile, among others, functioned perfectly well for years with liabilities that exceeded their assets.

Some economists argue that negative net worth is damaging for other reasons. It undermines a central bank’s “institutional credibility”, even if it doesn’t impair its day-to-day viability. These economists worry that a broke central bank might compromise its independence by going cap in hand to the government, asking to be recapitalised. Or it might print currency willy nilly to cover its losses and earn its way out of its financial hole. Either response would damage its standing as the guardian of the nation’s money.

But these worries hardly apply to the SNB. It has suffered losses (now and in the past) because its currency has strengthened, a reflection of the confidence foreigners place in it. If anything, “institutional credibility” is a cause of its balance-sheet problem not a potential casualty of it. Right now, the Swiss National Bank’s ability to prevent inflation is not in doubt. What is in doubt is its ability to create it.

Besides, a central bank’s financial strength is not ultimately the source of its operational independence. If a society is not, on balance, committed to price stability, the central bank will struggle to achieve it, no matter how strong its balance sheet. By the same token, if inflation is sufficiently unpopular, the state will give its central bank the leeway it needs to prevent it. That remains the case even if the central bank needs recapitalising once in a while.

Misconception 3: The cap was protectionist

When the SNB imposed the cap back in September 2011, the Swiss franc was strengthening fast, bid up by “refugee-capital” seeking a safe haven from the eurozone’s troubles. The strong franc made Switzerland’s upscale goods even pricier abroad, damaging its exporters’ competitiveness.

The cap put a stop to that. It thus drew criticism from economists worried about the impact on Switzerland’s trading partners. Ted Truman of the Peterson Institute for International Economics has described the cap as “openly protectionist”. According to other commentators, the cap contributed to the “currency wars”, in which countries try to seize market share from each other by weakening their exchange rates. By removing the cap, Switzerland was acting like a “good world citizen”, according to Dean Baker of the Center for Economic Policy Research, giving an “economic boost” to other countries that will enjoy healthier trade balances as a result.

When the SNB introduced the cap, it was indeed concerned about the “massive overvaluation” of the Swiss franc. Safe-haven flows were driving up the currency, displacing its manufacturers, just as oil or gas earnings can hollow out a country’s industrial base. The Swiss cap was helpful in preventing Dutch disease.

But the central bank’s main motivation for imposing the cap was not protectionism. It was trying instead to avert the risk of deflation. In keeping the currency down, it was trying to drive prices up. This ambition to raise prices is at odds with the notion that it was seeking to protect Swiss exporters. Because in raising inflation, the SNB would have reduced Switzerland’s competitiveness (all else equal) not sharpened it. If an exporter’s local prices and wages go up, it becomes less competitive abroad, even if the exchange rate remains the same.

Currencies, it is fair to point out, move much faster than goods prices or wages. So although inflation would have eroded the competitiveness of Swiss exporters eventually, it would have taken time. Currency appreciation, on the other hand, worked with brutal speed.

In seeking gradual inflation rather than abrupt currency appreciation, the SNB was therefore helping the country’s exporters. But in doing so, it was not defying fundamental market forces. It was instead choosing to expose exporters to one set of market forces rather than another: the sluggish forces of the goods market, rather than the bone-shaking forces of the foreign-exchange market. Neither market is perfect. The goods market is bogged down by inertia, transaction costs and long-term contracts that inhibit price flexibility. The currency markets, on the other hand, are swayed by bouts of speculation and skittishness. Neither does an unimpeachable job of setting an economy’s terms of exchange with the rest of the world.

In practice, there is an easy way to tell the difference between the SNB’s policy and that of the “currency warriors”, mercantilist central banks that suppress their exchange rates for competitive gain. Like the SNB, the currency warriors buy dollars or euros to keep their currencies cheap. In so doing, they create additional local money, just as the SNB did. But unlike the SNB, they “sterilise” their interventions, withdrawing this extra money from circulation (either by selling other assets or raising reserve requirements on banks). This prevents prices from rising, thus preserving the competitive advantage their cheap currency provides.

The SNB was not waging this kind of warfare. In printing francs it was keeping its currency down but not its prices. If its policy had hurt its trading partners, they were free to retaliate by printing more money themselves. This tit-for-tat monetary easing would not have resulted in a zero-sum scramble for a fixed amount of global demand. It would instead have helped to increase world demand, in a process of mutually-assured reflation.

The Swiss policy was not, then, protectionist in intent, nor was it unsustainble. It exposed the Swiss National Bank to a loss of face, but not to a financial loss of any great economic consequence. I believe currency pegs remain a legitimate monetary choice—as long as central banks allow prices to adjust accordingly—if not always a wise one. I also think the removal of the Swiss cap was unnecessarily disruptive. The SNB must now find a new way to fend off deflation. And West Ham must find a new sponsor for its kit.

Disclaimer: This article does not represent investment advice or any kind of professional counsel, nor does it represent an offer to buy or sell securities or investment services. The opinions, which are subject to change, are those of the author not BNY Mellon Investment Management.

Source: http://www.economist.com/blogs/freeexchange/2015/01/switzerlands-monetary-policy

Out of favour Reits offer contrarian rate bet

This is a tough time for contrarians looking for bargains in the US equity market. Everyone is still enjoying the dance. Bad news does little or nothing to dent enthusiasm.

There is, however, at least one sector that has conspicuously failed to join in the party. Real estate investment trusts started to drop sharply back in May, and have not recovered. Virtually the entire sector suddenly went out of favour.

Using the FTSE-Nareit indices, US Reits are down 10.1 per cent since the beginning of May, even when yield is included, while the iShares Mortgage Real Estate exchange-traded fund, which tracks the Nareit index of mortgage Reits, has fallen 19.8 per cent. Meanwhile, the S&P 500 has gained 15.4 per cent.

There is an obvious reason for this. Reits are an interest rate play. Reits rely on debt markets to finance their attempts at growth, making them rate-sensitive.

They are required to pay out at least 90 per cent of their taxable income in dividends each year to maintain their status. With short-term interest rates held close to zero by the Federal Reserve, this made Reits very attractive – especially as they can now easily be bought through exchange traded funds.

Once the Fed started talking about “tapering” its monthly bond purchases, it was no surprise that bond yields rose and Reit shares fell.

The response to the Fed’s decision not to taper in September, however, has been surprising. Stocks have set new highs, but 10-year bond yields are still a full percentage point above where they were when taper talk started in May. Other instruments popular for their high income, such as utility stocks, high-yield bonds and master limited partnerships holding oil pipelines, have recovered significantly. Yet Reits are bumping along, barely above their lows for the year.

Reit opportunity?

Could this have created a Reit buying opportunity? There are two ways this might happen. First, the market may be wrong about interest rates. The consensus expectation is that tapering will happen fairly early next year, probably in March. While not great for Reits, the sell-off so far should have taken much of this risk into account.

If this does not happen, or if incoming Fed chair Janet Yellen succeeds in jawboning bond yields downward with strong forward guidance, then securities that offer an income will be popular again. That points particularly to Reits which hold mortgage-backed bonds – which have recently fallen far out of favour. A recent brutal sell-off hit Reits such as Annaly (now at its lowest level in more than a decade) and American Capital (at a four-year low), which hold bonds issued by the federal mortgage agencies and fund themselves largely through the repo market. When rates are rising, leveraged plays on mortgage-backed bonds are naturally unpopular, so these could be value traps.

What are the chances the market is wrong about rates? Under Mr Bernanke, the Fed tried to persuade traders that tapering was not the same as tightening monetary policy, and failed. Ms Yellen is geared to make another attempt; staff at the central bank have had an extra year to make their case, and this time they may succeed.

Also, the US economy might fail to continue its recovery, causing rates to fall.

Look for value

A second way for Reits to offer value lies in the way investors bought them during the upturn. The average Reit buyer would have been unlikely to have taken notice of any statistic other than yield, and buying through ETFs – almost by definition indiscriminate – has dominated the sector.

So, anyone with a grasp of how to value a Reit should be able to find bargains. Look for value, and for Reits whose line of business gives them a chance of strengthening in line with the market – even if rates rise and the economy recovers.

As a whole, US equity Reits trade at a discount of 6.8 per cent to net asset value, according to SNL Financial. But some are at a far deeper discount, with multifamily rental Reits selling for 18 per cent less than their net asset value.

Is this as tasty as it looks? Jason Lail, manager of property research for SNL Financial, suggests this sector could offer protection if rates rise as expected. Demand to rent apartments might rise if mortgage rates rise, putting ownership out of reach for many. And if the economy is strengthening, the army of twentysomethings now living with their parents might have enough money to rent.

Another sector that should benefit from an economic rebound is hotels (whose “leases” are renewed every night, and which trade at slightly below their net asset value).

Any move into Reits is a bet that the market is wrong about rates. But for anyone who thinks US rates will fall or stagnate next year, Reits repay close study. After an almost uniform rise in the US market, they appear to be the most attractively priced way to make that bet.

Source: http://www.ft.com/intl/cms/s/0/9520ba6a-56b7-11e3-8cca-00144feabdc0.html#axzz3PTZUNDox

China’s Stimulus Quagmire

Even with Monday’s 7.6% decline, China’s stock market is on a historic tear, having risen more than 50% over the past year. Yet much of this investor frenzy is based on three flawed premises: that China’s decelerating growth necessitates stimulus, that such stimulus will reduce borrowing costs for firms, and that lower borrowing costs will incentivize spending and ultimately jumpstart growth.

New data from my firm’s China Beige Book—the largest private study of China’s economy—belie each of those assumptions. Our data make it clear that China doesn’t desperately need to stimulate its economy, that its recent attempts to lower interest rates via stimulus have done the opposite, and that if Beijing opts for large-scale stimulus anyway, it won’t work as intended.

Market participants often seem to misunderstand what China’s slowdown means. While the economy has continued to decelerate broadly, important components—including profit performance and the labor market—have shown overall improvement since 2014’s second-quarter nadir. In the just-completed fourth quarter, China Beige Book data on sales, profits and job growth all looked a bit better, as they had in the third quarter. This is a tentative rebound, to be sure, but it is hardly the gloom and doom narrative that most commentators (glued to older data) have now accepted as gospel.

Recent “stimulus” measures, including November’s cut to the benchmark lending rate, haven’t reduced borrowing costs for firms. The opposite has happened. Since last year’s second quarter, according to our data, the cost of capital has risen across the board—for bank loans, shadow-bank loans and especially bonds.

Perhaps most frequently overlooked: Firms still don’t want to borrow. The share of firms applying for and receiving loans dropped again in the fourth quarter, to the lowest levels we have recorded since beginning to survey in the first quarter of 2012. Since then, the share of firms borrowing has now dropped by more than half.

Crucially, firms don’t want to spend either. In the fourth quarter, growth in capital expenditure ticked down for the fourth straight quarter, also notching our survey’s all-time low.

Even the fourth quarter’s best performers—services firms—are caught in the wave: In multiple regions this quarter, including those that house the critical cities of Shanghai, Guangdong and Chongqing, services firms saw improved revenue growth, yet the proportion that hiked capital expenditures dropped anyway, in some cases dramatically. If firms don’t want to spend, monetary stimulus is a lost cause.

Plummeting crude-oil prices are a reason for optimism, given that China is a huge net consumer of energy. Our data track a steady pattern of disinflation in the Chinese economy since the first quarter of 2013, with sales prices, wages and material-input costs all continuing to rise, but ever more slowly. With the impact of cheap oil yet to be felt, 2014’s disinflation could become outright deflation in 2015.

Producer deflation is much better for an economy than consumer deflation. But with the economy slowing, Japan undertaking record quantitative easing and the eurozone headed in that direction, any sort of deflationary headwind may make it awfully hard for Beijing to resist another large stimulus of its own.

Here we get to the critical takeaways for investors: China’s slowdown may create the illusion that China has little choice but to stimulate, but our data show otherwise. Yet even if such stimulus is ultimately enacted, it simply will not work as intended.

Firms haven’t been interested in borrowing or spending on new projects for a year now. It is possible that low enough interest rates could change their behavior but to date rates haven’t been pushed downward by easing measures.

Instead, what companies are most likely to do if more liquidity is injected into the system is jump deeper into the roaring stock market. Already some of the inflows into stocks have come from the floundering property sector that Beijing has tried to stabilize.

If more firms move capital into stocks, the result won’t be more growth but rather more out-of-control prices for equities. And the structural impediments that are slowing China down will remain untouched.

Source: http://www.wsj.com/articles/leland-r-miller-chinas-stimulus-quagmire-1421688876