The Rotten Heart of Europe

Posts have been light lately because, in addition to a flurry of school-related activity, I was working my way through Bernard Connolly's excellent "The Rotten Heart of Europe". I'm fairly certain I first heard of this book through Lars Christensen over a year ago (sometimes I forget the source of reading recommendations, but thanks, Lars!). I had read certain parts of the book before this but never really found myself with the time to plow through the entire thing. I'm glad I finally got round to doing it. It's not the easiest read in some ways because it deals in great detail with the political decisions driving the bizarre economics of the Exchange Rate Mechanism, and it can sometimes be challenging for an outsider to try and understand the perverse choices politicians make. But despite - or maybe because of - the challenging nature of the material, it deserves to be read, and re-read. At many points, I marvelled at Connolly's erudition and prescience, and his ability to write with such insight about both politics and economics. Over and over, I thought to myself "well, that assertion is a little overblown" - and then realized that many things that would've been considered unlikely at the time have already come to pass. I highly recommend it, and rather than trying to summarize it, I just wanted to make a few points that the book revealed to me.

1) The Eurozone is a political construction. That seems obvious, but comes across over and over through this book. Understanding the politics of the Eurozone is absolutely critical to understanding its economics. Lars and I have often lamented that it seems like the political and legal news keeps slipping into the financial section. After reading this book, I realize there simply cannot be any other way. As Connolly notes, "the emergence of 'central bank watchers' implies that markets do not know what decision rules are being used by the central banks and have to try to deduce these uncertain rules from their actions and, perhaps even more important, their pronouncements." Unfortunately, this also means that investors have to make bets on political outcomes that aren't always clear. 

2) We don't sufficiently understand the politics of the Eurozone. Following on from (1), the task of investors and economic actors is significantly complicated by trying to understand political mechanisms that aren't necessarily clear. Despite the surfeit of digital and literal newsprint devoted to the area's politics, I'm still left with the uneasy feeling that there's much of importance bubbling beneath the surface that I and other outsiders will simply never be privy to. Specifically:

- It's clear that there is a tremendous amount of political will from elites to keep the Eurozone together. I didn't understand this point well enough two years ago when I thought the Euro could well break up, and having read this book, I understand its origins better. At times, this political will is all the more baffling when you read just how painful the ERM experience was - and yet politicians decided to take it a step further. Of course, the Russian threat is making clear why some smaller nations desire broader integration with Europe (not to mention what Connolly calls "the Golden Calf of Structural Funds"). But now that everyone understands the political will to keep the Eurozone together, there are two new threats: (a) complacency from top-level officials to (b) the possibility of backsliding from structural reform. Of course, some of this backsliding is a response to the Euro's shortcomings. Connolly notes numerous instances of governments offsetting tight monetary policy with fiscal profligacy and harmful supply-side policies.

- Central bank politics. Connolly quotes an unnamed Bundesbank staffer who quips that "in every central bank, politics is king." Rotten Heart lays bare the unusual political role of the Bundesbank, and the internal struggles between Schlesinger and Tietmeyer. I'm as guilty as anyone of referring to "the ECB", but of course, this supposedly monolithic beast is made up of lots of individuals representing the (often divergent) interests of their own nations and institutions. I was reminded of a quote from James March: "We know more about abstract agents dealing with abstract principals than we do about real bureaucrats dealing with real politicians." Furthermore, Connolly notes that "the biggest problem for the Bundesbank in explicit inflation-targeting was precisely its explicitness...'Price stability' could mean anything it suited the Bundesbank to have it mean." While many commentators have raged at the ECB for failing its mandate, that mandate is actually unacceptably vague, as Jurgen Stark recently reminded us.

3) Never underestimate the importance of luck. Or to be more precise in this instance, the importance of geopolitics (i.e. the interaction of geography and politics). The terrible insecurity France and Belgium seem to feel is in some ways an artifact of history and geography. Similarly, Ireland's willingness to submit itself to boom-bust cycles is driven by its desire to be out of the UK's political sphere of influence. UK citizens can thank their lucky stars (from an economic perspective) that their physical separation from continental Europe has contributed to their avoiding the pull of the Euro.

4) Never underestimate the importance of insecurity. Similar to the above, and understanding "real bureaucrats dealing with real politicians", one must be sensitive to the blinding insecurity that drives so many important decisions. Insecurity towards Germany, the US and the "Anglo-Saxon" model of capitalism seem to have driven France into this unhappy marriage. Connolly is particularly (and rightfully) harsh towards British politicians who fear that Britain will be "left out". Nick Clegg is peddling that line today. In hilarious fashion, Connolly refers to these people as "behaving like the 'Fat Boy' in Pickwick by telling tales to make the flesh creep." Perhaps unkindly, I cannot get away from the image of two drunks clinging to each other feebly for security. The solution is probably to stop drinking, rather than clinging ever more desperately. Equally, the concept of a "Latin Monetary Union" was raised in the past (as it is today), and nothing is more insulting to the insecure as being seen as part of an unwanted club.

5) The Eurozone crisis remains unresolved. Earlier this week, I listened to a nuanced debate on the crisis. That debate and reading Rotten Heart have strengthened my belief that there are, sadly, many ways this could go wrong. I tend to think of myself as an optimistic person, and I don't want to be a perma-bear on Europe (see my earlier post on the conundrum of investing in the Eurozone). It seems, however, that we are in one of those momentary periods of calm that should not be underestimated (or should at least built into one's financial models). Rightfully, there has been much talk about the effects of deflation and low NGDP on prolonging the crisis. However, at least the ECB's task is made easier by generalized low inflation throughout the Eurozone. As I mentioned earlier, it is far from a monolithic creature, and there may actually be greater danger in recovery. Many of the periods of ERM crisis that Connolly outlines are sparked by divergence between the German economy and other ERM members. Trichet's attempt to raise rates in this iteration of the crisis shows the recurrence of this issue. Proponents of the Euro must hope that all its constituent economies recover in tandem. Unlike in Rotten Heart, politicians and central bankers seem to have done a better job of coordinating their rhetoric this time round. Fewer people seem to playing the role of Schlesinger, if you will. But it's a step too far to hope that economic recovery will be synchronous, despite the efforts towards banking union and structural reform. The remaining disparities between Eastern and Western Germany are a warning as to the pace at which convergence can occur (compare the GDP per capita of Hamburg or Bremen to Brandenburg or Berlin). Continued divergence between France and Germany will be particularly dangerous. While sympathetic to the economic views of many Euroskeptic parties, I cannot abide the unabashed racism and xenophobia. There are, however, many who have no such compunction, and their numbers are growing, even in traditionally Europhile France. With remarkable foresight, Connolly warns, "Either [a future ECB] will act in French interests or it will not. If it does, then Germany will destroy it, putting an end to fifty years of a 'European Germany'. If it does not, then it might well destroy France." One cannot help but worry that we'll reach a turning point in this incessant crisis, and sigh, as Connolly's unnamed French official, "Alors, c'est bien foutu, le systeme."

You Can Profit From Other People's Bias!

In the past week, I've observed several oddities that could be described as market failures, or at the very least as market "bifurcation", where demand appears to have gaps:

1) Long-term unemployed vs. short-term unemployed. This piece from Tim Harford argues that workers who have been out of work for more than 6 months are likely to be marginalized by potential employers for no reason other than the duration of their unemployment. If you want your heartstrings tugged a bit, try this article from the New York Times.

2) Graduates vs. non-graduates. Bryan Caplan, featured on this EconTalk episode, goes through some of the evidence for the signalling model of education. As he notes, it's odd that academics resist a model that is so clearly borne out by personal experience. This holds true even for jobs where university education is completely unnecessary. Just today, I heard a female senior banker tell graduate students that an important element of her career success was always having full-time nannies, but she noted, "I only hire graduates." The point of that, she said, was so that the nanny would be intelligent and proactive enough to deal with mini-crises at home on his/her own without troubling her at work - a perfectly reasonable viewpoint, except that there are lots of intelligent, resourceful people who don't have university degrees, and could probably fill that role quite adequately.

3) Creditworthy vs. non-creditworthy. Some private equity guys I wrote about last week told a conference they were concerned because "banks are only too willing to lend right now." I was too polite to point out in the Q&A session that this kimono-opening was only for those deemed creditworthy by the market. Perhaps Greece's return shows that the bifurcation is being eroded. As most of you know, Greece has returned to international capital markets with a 5-year bond yielding just 4.95%. Consider me skeptical about Greece's prospects, but what's more interesting is that this triumphant return at a (relatively) low yield is occurring in the midst of poor SME lending trends in peripheral Europe. Is the love beginning to be spread across Europe slowly, or have peripheral sovereigns simply been admitted to the cool kids' club?

I understand that there are informational asymmetries in some of these markets that perhaps result in these phenomena (I'm somewhat familiar with the literature on creditworthiness and information asymmetry, but much less so on long-term unemployment/education, and welcome suggestions, if anyone's got them). But of course it's pretty arbitrary as to where those kinks occur. The graduate/non-graduate divide is clear but I wonder about the long-term unemployed. Do we see the same differences at 3, 4 or 5 months? What miraculously happens at 6 months to convince employers that the workers are damaged goods? Furthermore, I sometimes think we can take the information asymmetry argument too far. For example, you often hear undergraduates being taught that job applicants know their qualities as an employee, but employers don't. That's pretty crazy. Unless you're being hired to do the exact same job you've done before, or are being hired for a job that is clearly within your capabilities, you probably have almost as much doubt as your potential employer as to whether you'll succeed. Equally, you can hire someone with a stellar resume, who impressed you in face-to-face interviews, and then find out... nope... it's not working. So "information asymmetry" should not be confused with "uncertainty".

For some, these "gaps" are particularly interesting because there are quasi-arbitrage opportunities. Obviously, if as in case (3), there are two credit instruments with similar creditworthiness and tenor, but different yields, there is a trading opportunity. And of course investors make this sort of judgment every day, particularly with "bruised fruit", where markets over-react to poor, temporary factors and bid securities down below their fundamental values. It would be even more important on a personal level to try and arbitrage numbers (1) and (2). Sometimes this sort of talk makes people uncomfortable. I told a white, liberal, free-market-skeptical friend that there was a terrific opportunity in hiring qualified minority workers who other employers were stupidly ignoring because of prejudice. Of course, the minority workers might not get paid the same amount (by me) as a white worker would in the marketplace, but it seemed to me that we would both be better off - I, for hiring a productive worker at below market rates (meaning I could earn higher margins than competitors), and the worker for having work, wages and experience that he could parlay into another job if he so desired. My friend told me I was being an "exploitative capitalist" (thankfully I'm Indian, or he would've thrown "white" in for good measure). I'm confident, though, that my friend would have far less compunction about paying a higher wage to a college graduate than to a non-graduate, or paying a higher wage to someone who'd been poached from another job rather than "saved" from long-term unemployment. 

I'm always interested to hear about people successfully taking advantage of these market gaps, so I was pleased to see that the NYT covered Robert F. Smith of Vista Partners, whose firm uses a personality test to identify workers with leadership potential and innate analytical abilities. "Not only are many of these workers less expensive than their better-credentialed peers, but to Mr. Smith, they are often more driven to succeed. And employing them, he believes, provides a social good." My friend would call him an exploitative capitalist, I'm sure, but we need more ideas like that to help non-graduates and the long-term unemployed even the playing field. Oh, and what the hell, maybe even peripheral European corporates while we're at it.

"Long-Term Investing", Eurozone Bank Recapitalization, and Investors' Tangibility Bias

This is a grab-bag of thoughts that struck me today while I was at an asset management conference.

1) "Long-term investing" means different things to different people. It's fairly common to hear investors claim that they're long-term investors (particularly those with a value bias). But I see at least two possible definitions of long-term investing when it comes to specific securities:

a) Being patient for a cycle to turn and for the market to recognize the value of a security. It's uncontroversial that patience is often required for successful investing. However, implicit in this is that the annualized return on the security may not be as high as expected (not to mention that capital is tied up in the process). There's also the danger that stubbornness can be mistaken for patience. It's no wonder there's a dark joke that "an investment is a trade that hasn't worked out yet."

b) Deliberately being invested in a security for a long period of time. I can't think of anything inherently good or bad about this from the standpoint of investment results (though I'd argue that it's better for capitalism when long-term shareholders can engage with, and discipline, management), but many value investors are not long-term investors by this second criterion. They do not necessarily plan to be long-term shareholders (see joke above). Buffett described himself as a "cigar butt" investor, but changed his viewpoint influenced by his interactions with Charlie Munger, as well as his poor investment in Berkshire Hathaway (I initially typed Berkshite Hathaway, and even Buffett may agree that was an accurate, if unintended description of the investment!). Many special situations/deep value investors are proud cigar butt investors. Surprisingly, I think some growth-oriented investors fulfill this criterion much better. Phil Fisher, generally considered a "growth investor", wanted to own companies for a long time and profit from their long-term earnings accretion, rather than profit from a one-time reassessment of a company's fundamentals. (His book, Common Stocks and Uncommon Profits, was something I wrestled with for awhile in my more strictly value-oriented days.) But these days, most people think of growth investors as trading in high-flying, momentum stocks. Are growth investors getting a raw deal in public perception?

2) Who is financing the great Eurozone bank recapitalization? We keep hearing that the Asset Quality Review will allow banks to deleverage, thereby reviving bank lending and the credit transmission mechanism for monetary policy. But I heard today from some very smart distressed debt investors from big name funds (Baupost, Oaktree, Apollo, Strategic Value and CarVal) who said how uncomfortable they were with distressed debt valuations in general, including for financials. (On a day when the Spanish government 5-year yield traded below the comparable US security, I have to think they've got a point. Anyone making the argument that Spanish deflation makes that a natural state of affairs is crazy, since unlike Japan, the Euro periphery may eventually decide enough is enough.) The CIO of a very large hedge fund also told me that they were interested in European bank investments (through various parts of the capital structure) but that "others are interested at much higher prices than we are." So who is providing the capital to Eurozone banks? Whoever they are, they must be either more risk-tolerant or less return-sensitive than the distressed guys I heard from today.

3) Do investors suffer from tangibility bias? I've always assumed that investors prefer returns from tangible assets to intangible ones, which might explain why people often overpay for property. Institutional investors often talk about investing in "real assets" like real estate, shipping and aircraft. But take shipping for example - surely one of the most volatile industries to invest in, and a veritable minefield for the uneducated investor. It's precisely the "real" nature of the asset that leads to volatility since a low elasticity of supply means you end up with a large fleet for ages. I know there's stuff out there on tangible versus abstract risks, but I haven't seen any mention of such a bias in behavioural economics. Does anyone know if there's research on this relating to investments? 

A More Perfect Ownership

I wrote a post several weeks ago questioning the narrative that the Glazers had been bad for Manchester United. The inevitable backlash raised some worthwhile questions, and I explored the MUST website to see what alternatives were being proposed by other fans. MUST suggest some form of fan/community ownership. Andy Green, who has written widely on the financial situation at MUFC, similarly views the club as a "community asset". I'm not an expert on different forms of sports ownership, so these seem like valid options, but I thought I'd start with a more basic question: what would be the characteristics of the ideal ownership structure of Manchester United, and what form should that ownership then take? Then, does the current ownership structure meet those criteria? Finally, what, if anything, can we do to improve the structure? For those not intimately interested in Manchester United, consider this an analysis of the company's strategy and corporate governance.

Characteristics of the ideal ownership structure

It goes without saying that all fans want to see United compete for and win trophies, but also to play entertaining, stylish football. The off-pitch set-up of the organization allowing for such on-pitch success is therefore paramount. I was greatly influenced by this article on Steve Jobs, as well as John Kay's book "Obliquity", in thinking about the type of organization that could provide a foundation for United's sporting success. This list is obviously not exhaustive but here are some qualities we'd all like to see:

A) Put football before profits, to paraphrase Jobs ("put products before profits"). In sporting terms, this means investing appropriately in staff, players and infrastructure. The "appropriate level of spending" does not necessarily mean more spending; it means being competitive in the market while using funds wisely and negotiating player deals effectively. To this end, it would be great to see Financial Fair Play being aggressively monitored by the authorities so that clubs aren't in a spending arms race.

Glazer verdict: This will be the biggest source of controversy, so let me just say "mixed". Many would like to see them re-invest more of the club's profit into players. I'm willing to believe that, when pushed, they'll be ready to spend. This summer should prove a litmus test of the Glazer ownership, but regardless of whether they step up or not, I firmly believe that the profit motive can be aligned with long-term interests, and in many ways, can spur value creation for fans and owners alike. Gus Levy, of Goldman Sachs, used to say that the firm was "long-term greedy", eschewing short-term profit in favour of long-lasting relationships with clients. (Goldman's ability to tread that line is doubtful, but I still enjoy the quote.) I wonder if Manchester's political leanings make United fans particularly averse to the idea of for-profit ownership being aligned with fans' interests, and if so, this bias needs to be corrected.

B) Able to raise capital at the lowest cost. This is tied to (A). Many fans were up in arms over the club's debt load, and cynical about the IPO. Assuming we are not backed by the largesse of a rich owner unmotivated by financial concerns, it is important for the club to have various sources of funding for investment in staff, players and infrastructure. Profits are one source, but the capital markets are another source. I have no issues with using physical assets like Old Trafford, Carrington, Littleton Road and The Cliff as collateral if this provides a lower cost of capital, although I'm opposed to selling Old Trafford's naming rights.

Glazer verdict: Poor in the early days, considerably better since. The financial future of the club appears to be secure, even though I've written about why I think it's a relatively poor business from a purely financial standpoint. 

C) Appreciate the importance of the club's Manchester heart while continuing to build the club's global reach. As a fan from outside Manchester, I think of local fans as primus inter pares - first among equals. The club's soul is rightly and obviously in Manchester. Implicit in this is ensuring that ticket prices are affordable for local fans, especially youth. Yet at the same time, in order to expand (and as a price of success), the fan base will get ever more global. (Consider the fact that the population of Greater Manchester is just 2.7m, compared to 7.7m in Greater London. But of course Barcelona has a population of 1.6m and Madrid 3.2m, so local population isn't everything. The history of colonialism is still a big factor in the attraction of English and Spanish clubs abroad). There is a risk in this endeavour of course, as the passion of the fan base may get diluted. I'm reminded of this Little Richard song: "He got what he wanted but lost what he had." But I know some very, very passionate United fans from outside Manchester - I'm one of them.

Glazer verdict: I'm not from Manchester so it's hard for me to weigh in on this one. My impression is that they did a very poor job in the early days with ticket price hikes etc. These days, football tickets are expensive everywhere, and I don't think United prices are out of line with the rest of the country. That said, there's more to engaging the community than just ticket prices, and I think there's always room for improvement on this measure. I think they're doing a great job of expanding the global fan base with tours and the like, although these obviously have to be weighed against pre-season preparation.

D) Creatively increase the stream of revenues. It's easy to poke fun at the club's ever expanding list of commercial partnerships, but of course these offer a very important source of funds for the players we covet, while keeping ticket costs down.

Glazer verdict: Well done, but the club's position as commercial juggernaut should not detract from the footballing performance. The profit motive is a wonderful incentive to continue improving this side of the business.

E) Footballing knowledge/vision. This is a tricky one. I've heard many fans say "Well, we ended up with David Moyes because the Glazers don't know anything about football." Yet at the same time, I'm wary of owners who are overly involved in footballing decisions. Arguably, Abramovich's heavy hand has offset some of the good that his ill-gotten millions offer Chelsea. Perhaps a middle ground is to say that it's important that the club's owners, as well as its executive and footballing leadership have a vision for the club. While I'm completely in favour of fan involvement (see the last section), it is interesting that Jobs warns about being a slave to focus groups. I'm happy to admit that we fans are the most fickle of focus groups, so there are times when our voice should be overruled. 

Glazer verdict: Poor. See the next section on the club's corporate governance structure for my assessment of the situation.

Overall verdict: I maintain my view that the Glazer ownership has improved United in some ways, and made the club ever more accessible to global fans. On the very controversial issue of whether they are investing appropriately for the future, we'll have an excellent opportunity in the summer to see their response to the squad's clear shortcomings. There is, however, room for improvement.

How can the ownership structure be improved under the current circumstances?

Firstly, there is some ambiguity as to the club/company's corporate governance structure. In the annual report filed by the club on 24 Oct 2013, there are two different lists of club directors. On page 86 of the PDF (not the number at the bottom of the page), they list the following directors: Avram Glazer, Joel Glazer, Ed Woodward, Richard Arnold, Michael Bolingbroke, Kevin Glazer, Bryan Glazer, Darcie Glazer Kassewitz, Edward Glazer, Robert Leitao, Manu Sawhney and John Hooks. On page 416 of the PDF, there is a similar list but EXCLUDING Robert Leitao, Manu Sawhney, and John Hooks, and INCLUDING Sir Bobby Charlton, Sir Alex Ferguson, David Gill and Michael Edelson.

On the club website, there is a similar list to PDF page 86. I was unable to find any SEC filings explaining the difference.

Let me make a few points on this matter:

a) The company/club should clarify this discrepancy. Obviously there is a difference between being a director of the football club and being a director of the listed entity, but this is not entirely clear in the filings, and it should be. The responsibilities of these individuals should be laid out explicitly.

b) Following on from (a) what exactly is the role of Sir Alex Ferguson? Who on the board is in charge of decisions, such as the hiring and firing of the football manager? This should be clarified, and improved so that the Board is receiving a diverse set of sophisticated and knowledgeable opinions. Fergie is unquestionably a managerial genius but his input needs to be supplemented with other views.

c) Following on from (b), there are far too many people from the Glazer family on the board of this company or club. Assuming that the list from the website is the most updated one, 6 out of the 12 directors are from the Glazer family. This is particularly silly since there seems to be a lot of overlap in what they bring to the board (which frankly does not appear to be very much). The board seems to contain solid experience in sports business management (through the Glazers' ownership of Tampa Bay), finance and luxury retail. But the board should consider replacing some of the Glazers with sophisticated footballing people. Frankly, I'd like to see Gary Neville on the board, although that could be awkward since he'd be overseeing his brother (probably not for the first time, eh, Gaz?) and his brother's boss. 

One method of actively changing the club discourse could be to raise a crowd-sourced fund to purchase a small stake in the company, and push for a seat on the board as a "community representative director". I haven't valued the stock recently so I have no opinion currently whether the purchase would make sense from a financial perspective (I'm doubtful), but it could be a way to engage with the club constructively. (I bet a fund could raise £10m easily - might even be too big for crowd-funding! That's a drop in the ocean in terms of the club's market cap, but possible enough to agitate for change.) The representative should be well-versed in finance and sport business as well as football. He/she should also be keenly interested in Manchester while representing the club's global fan base. I believe someone like Gerald Shamash could serve in this role, or make some suggestions on the matter. 

Whether or not this activism comes to pass, the current leadership should implement changes to improve the club's corporate governance. The suggestions are in the interests of fans and shareholders alike (and I mean ALL shareholders, not just the Glazers or passive minority shareholders). A stronger organizational set-up will lead to a stronger United, and hopefully 20 more titles.