brain drain in 2012

what it is

“Brain drain” is a term coined in the UK after WWII to describe the outflow of human intellectual/scientific/economic talent from a country.  Motivation for the outflow can sometimes be religious or ethnic persecution in the home country.  More benignly, brain drain is more likely motivated by economic prospects that are perceived to be significantly better away from the home country.  According to Wikipedia, the term may have been initially used to describe the movement of British citizens to the US, or to the inflow into the UK of citizens of India.

where is it happening today?

What forms of brain drain can be seen in today’s world?

the Eurozone

–I think we should watch the EU carefully, especially southern Europe.  On the one hand, government finances in Italy, Greece… can’t be fixed by raising taxes.  People will move into other parts of the Eurozone, for one thing,  History also shows that higher tax rates invariably trigger increased tax evasion.  So higher rates can end up generating lower revenue.  (This isn’t just a European phenomenon:  New Jersey has just released an economic study showing the state is suffering a net loss of $150 million in annual tax revenues as a consequence of two income tax rate hikes early in the last decade).

Even though cost-cutting will be the main tool European governments will use to balance heir budgets, the economic stagnation that austerity measures will produce may cause an outflow of intellectual talent from southern Europe to France or Germany, or outside the Eurozone to the UK.

the US

–Anecdotal evidence suggests there’s a budding trend toward emigration from the US to China, because of the latter’s superior economic prospects.  There’s also a movement on the Northeast to create publicly funded schools that emphasize Asian culture and history–and where instruction might be in Mandarin.

–a combination of high taxes, lack of home-grown engineering graduates and immigration restrictions that severely limit the number of Indian and Chinese engineers able to work in the US has meant a continual outflow of technology manufacturing away from the US.


–To my mind, the most curious case of potential brain drain is that recently reported by the Wall Street Journal It’s the potential outflow of wealthy Chinese from the mainland.  They’re not seeking political or economic freedom, or at least not simply that.  What’s prompting them to consider emigration–overwhelmingly to either the US or Canada–are social concerns, including:

–poor schools

–bad medical treatment


in that order.  Also:

–unsafe food (local municipal authorities sometimes offer industrial waste disposal sites for lease as agricultural land), and

–the one-child policy.

investment implications

At this point, these developments are more curiosities than anything else.  But events in southern Europe bear close watching.  That’s the place where emigration has the most potential for economic disruption, in my opinion.

the EU financial crisis won’t be over any time soon

how the EU got into this fix

1.  For many years the EU ran a money policy that was just right for a Germany struggling with the integration of the former East Germany, which had been run into the ground economically during Soviet rule.  But that stance was much too stimulative for peripheral countries like Ireland and Spain.  The extra money sloshing around there found its way into highly speculative real estate.  This ultimately resulted in lots of bad bank loans.

2.  The big commercial banks in the EU served as a dumping ground for large amounts of toxic sub-prime securities from the US.

3.  Rather than recapitalizing its banks in 2009, as the US did, the EU decided to paper over their losses and hope that economic growth would eventually restore the capital the banks had lost.  That has proved to be a big mistake.

These factors have been well-known for years, however.

What’s relatively new is concern about the EU’s “bad boys,”  Greece and Italy.

4.  It took several years of truly heroic economic reform for Italy to meet the minimum standards for approval to enter into the Eurozone.  The other members might have hoped Italy would continue to strengthen itself once it was in.  But instead, Italy used the borrowing power of the euro to avoid any further adjustment to a fast-changing world, preserving an increasingly non-competitive status quo by running up excessive government debt.

In hindsight, Greece seems to have gotten into the euro only because all parties decided to pretend it met the minimum criteria.  Once in, Greece borrowed up a storm and lied about it for close to a decade–both understating the amount of debt it was running up and overstating its economic growth.  That deceit ended only when a new party took power in Athens last year.  If that weren’t bad enough, the big EU commercial banks appear to be on the losing side of billions of euros of Greek credit default swaps.

where we are now


The EU and the IMF are trying to arrange a partial bailout of Greece.  They’re doing so in a way they think will avoid triggering the CDS payout provisions, even though Greece will only have to pay back half of the face value of the bonds it has issued.  This is not a move calculated to win friends (or trust) among those who have been betting on Greek default, implying that the amounts are large enough that the banks can’t afford to pay.

The big question is whether Greece will go along with the austerity measures the IMF is proposing in exchange for debt forgiveness.  Another new government is in place.  It’s made up of “technocrats,” which means roughly that they’re supposed to wield a cost-cutting axe and then withdraw from public life.  But will Athens actually do any of the things it has promised?  No one knows.

The EU is simultaneously preparing Plan B, which would be to expel Greece from the euro.


Greece is poor and too small to matter.  Italy, on the other hand, is wealthy and too big to fail.  Italy, too, has just installed a new government of “technocrats.”  It has also successfully gone through a severe restructuring in the past, just to get into the euro in the first place.  So history says Italy can (and will) do so again.

my thoughts

Good news on restructuring in Greece or Italy will be slow in coming, because political processes take time to work out.  Bad news, on the other hand, like that Athens refuses to do anything, tends to surface right away.  Because of this, I think the news flow from the EU for the next few months will be generally neutral to negative and will be a net drag on world stock markets.

My guess is that markets are now almost fully discounting the possibility that Greece will leave the euro and that Italian economic reform will be slow but ultimately successful.  For what it’s worth, that’s also my base case.

I’ve argued in previous posts that the EU as a whole is already small enough in world terms that its likely economic performance isn’t enough to move the global needle one way or the other.

The real worry for non-EU investors is that failure of a large EU financial institution as a result of the EU’s cumulative problems will happen–and that this will have a Lehman-like negative effect on world trade.  I think this outcome is highly unlikely.

If that’s correct, we have two potentially negative influences from the EU to deal with in the coming months:

–uncertainty about Italy, and

–bouts of panicky selling by Europeans, for whom the crisis is far more important than it is for the rest of the world.

On the other hand, I agree with Goldman that a self-sustaining economic recovery in the US  is already underway.

My conclusion?  …avoid the EU for now and watch for potential weakness elsewhere to upgrade your portfolio holdings.

Europe’s deal on Greek debt

the Greek sovereign debt deal

Europe appears to have reached another milestone in its circuitous journey toward resolution of its twin debt crises–Greece and its banks’ unknown, but presumably very large, exposure to sub-prime mortgage debt.

Yesterday’s development is that commercial banks in the EU have agreed to “voluntarily” agree to forgive half the amount the Greek government owes them and write down the value of their Greek sovereign debt by 50%.

Although sharply higher stock prices in Asia, Europe and in pre-market trading in the US signal investor relief, I don’t think it’s particularly surprising that the banks would accede to the wishes of their governments to do so.  For one thing, defying your central bankers is never a good idea.  But in this case agreement brings tangible advantages to the banks as well.

Press reports have made it clear that, earning once again their reputation as the world’s ultimate “dumb money,” the big EU commercial banks had enabled hedge funds to bet heavily on a Greek default by taking the other side of hundreds of billions of euros of credit default swaps.  So the banks would be facing mammoth losses if Greece defaulted and they had to pay off.

But the EU has found what it considers a loophole in the language of the CDS contracts. Technically speaking, it argues, if creditors “voluntarily” forgive a portion of Greece’s debt–which they have just agreed to do–that action doesn’t count as a default; the CDS payoffs aren’t triggered.

Maybe this interpretation is sound, maybe not.  But it’s what the EU is going to do.  National regulators will certainly order their banks not to pay any CDS claims.  Hedge funds can sue.  Litigation would doubtless be long and expensive, however.  And it would provoke the ire of EU politicians, who might find ways to make litigants’ lives more difficult in other areas.

So the bank agreement appears to make the threat to bank solvency of their CDS exposure go away.

what I make of the EU situation

To my mind, resolution to the EU financial crisis has three possible outcomes:

1.  The Greece et al sovereign debt crisis spins out of control–causing the failure of one or more major banks, a run on the euro and a collapse of the EU political structure.  While this is going on, we discover that one of the now-defunct institutions has a crucial, but hitherto unappreciated, role in world commerce.  So the global economy comes to a screeching halt, just like it did after the Lehman bankruptcy.

There’s no evidence there’s an EU Lehman and it’s hard to believe the world would shoot itself in the foot a second time.  On the other hand, the EU has shown itself particularly ill-suited to deal with a financial crisis.  recent trading show clearly that global equity investors have been worried about this possibility, but I regard Lehman II as about as unlikely as you can get.  It’s even less likely today.

2.  Same as #1, except no Lehman.  That is to say, a big banking failure paralyzes the EU.  Most of the economic damage is domestic.  There are ripple effects elsewhere, but they’re not gigantic.

It seems to me that today’s news is also the start of taking this worry off the table.

how important is the EU?

Sizing the problem in the most simple-minded way (all I’m capable of), the world economy is divided about 50-50 into emerging and developed markets.  Half the developed part is the US and another 5% is the UK.  That leaves 20% for Euroland.

Suppose banking failure(s) caused a severe recession in the euro area.  Real output drops by 5%.  That would reduce total world output by 1% (5% x .2), and developed world output by 2%, in the year following the blowup.  factoring in ripple effects, the developed world would stagnate; the developing world would power along, but a bit more slowly.  The whole world would grow at, say, 2.5% next year instead of 3.5%-4.0%, if the blowup happened now.

…something you’d like to avoid, but not such a big deal.

As surprising as this thought may be to Americans with cultural roots in Europe, Euroland is no longer big enough to matter that much to overall world growth, except in extreme circumstances.

True, Europe has a lot of accumulated wealth–which we’ve seen on display, I think, in the periodic panic selling that has marked the past few months.  But it’s too wrapped up in what looks to an outsider like petty regional politics to focus on getting GDP to expand.  And much of the rest of the world is passing it by.

3.  The financial crisis is addressed, the banks recapitalize and the EU begins to heal its wounds, following the general trajectory of the US economy with a three-year lag.  Dreary as it sounds, I think this is both the most favorable and most likely case.

equity implications

Not much different from what I’ve been writing for a long time.  In cases #1 and #2, equity investors would be better off not holding EU-listed securities and should shade their other holdings away from companies with a large percentage of their business in the EU.

In case 3, it’s safe to dip a toe in the water.  But growth outside the EU will likely be much better than growth inside.  So the relative winners will be EU-listed firms with large exposure to foreign markets.  In a non-recessionary EU, these stocks stand to be winners on the world equity stage as well, since EU investors will likely concentrate heavily on them.

more on “discounting”


“Discounting” is the jargon that Wall Street uses to describe the process of factoring changes in consensus beliefs about future happenings into today’s stock prices.  I’ve outlined the basics of discounting in an earlier post.

fundamental vs. technical analysis

Fundamental analysis, the study of company-specific and economy-wide economic and financial information, and technical analysis, the study of charts, can be seen as two approaches to discounting.  In the first case, researchers try to figure out what information is most important for making a security’s price go up or down, and then actively search for relevant data.  In the second, investors study chart patterns as a way of figuring out what fundamental analysts are doing and then riding on their coattails.

the internet

The internet has changed the amount, quality and cost of information in dramatic fashion. For example:

–When I was building an international equity investing organization for a major financial institution in the early 1990s, it cost about $300,000 a year in today’s dollars to get access to all corporate SEC filings.  The data came on microfiche and was available about six weeks after the documents were filed.  Today, the information is free on the SEC’s Edgar website; documents are available the instant they’re filed (companies do this electronically).

–Thanks to regulation FD (Fair Disclosure), company presentations are routinely webcast and are available through the company website.  Typically, they’re archived for at least a year.  True, breakout sessions at conferences, small group meetings or one-on-ones aren’t, but these mostly serve to fill in the blanks for analysts not familiar with a firm.  Companies may sound like they’re revealing new information, but they’re not.

–A Bloomberg terminal still costs $30,000-$50,000 a year, depending on its capabilities.  But discount brokers offer most of what an individual investor needs to their customers on their websites for free.

discounting and Greece

Discounting isn’t a one-time event.  It’s a process.

1.  For one thing, what’s painfully obvious to a seasoned observer or an industry specialist may only dawn on the average investor a considerable time later.

2.  Also, bad news that relates to a specific event is typically not fully discounted until the event occurs–no matter how far in the future that may be.  The financial crisis in Greece is a good example.

A year ago, a new administration in Athens revealed that the country had been falsifying its national accounts for many years.  Greece had taken in less in taxes and also spent a lot more than it had ever revealed.  How so?  Its membership in the EU had allowed it to borrow much more than it could ever repay.

For at least six months, it has been clear that either the rest of the EU will be forced to pick up the tab and let Greece remain in the EU, or that Greece will default and lose its EU membership.  In default, holders of Greek sovereign debt would lose most of their money.  But, since that’s mostly big EU banks which might need government bailouts as a result, the effect is basically the same.  EU taxpayers ultimately foot the bill.

Over recent months, however, EU stock markets–and the financials, in particular–have been subject to periodic waves of selling, driving prices ever lower, as investors express their fears about Greece.  …despite the fact that in general terms everyone has already read the closing chapter of the story.

This pattern of discounting the same news over and over again is typical.  It begins in denial (inadequate discounting) and may end in despair (overdiscounting), the same emotional pattern that shapes a bear market.  While bear markets end in a whimper sometimes, however, discounting that anticipates a discrete event usually involves a final selling bout as the event actually occurs.

Over the weekend, the G-20 seems to have given the EU an ultimatum to resolve the Greek crisis quickly.  We’ll see tomorrow how the markets react.

more problems from Greece

Last week, the new Greek finance minister tried to renegotiate the bailout plan the country had agreed to with the rest of the EU, by suggesting weaker austerity.  After that overture was rebuffed, the Greek government–the one that revealed the prior administration had been falsifying the national accounts for years, triggering the current crisis–was found to be preparing legislation for a necessary parliamentary vote that incorporated the weaker austerity measures the EU had rejected.  Apparently, Greece was planning to ratify the weaker terms and then present the rest of the Eu with a fait accompli.

Now it appears the Greek government may not have the votes to pass any austerity plan.

It’s hard to know which side to have sympathy for–Greece, which merrily used its EU membership to run up bills it knew it never could pay, or the rest of the EU, which fudged its membership criteria to get  Greece in and which seems to have known what Greece was up to, but just underestimated the extent of the fraud.

I think the EU has two objectives:

–it wants to avoid having its banks forced to write down the Greek government bonds they’re stuffed to the gills with; and

–it wants to avoid setting a precedent that Ireland and Portugal, if not Italy and Spain, could reasonably expect to follow.

Greece, on the other hand, seems to fully appreciate the maxim that if you owe $20,000 to the bank you’re in trouble; if you owe $200 million, the bank is in trouble.

Today’s development is that large French banks have “voluntarily” proposed to roll over much of their Greek debt for thirty years, while reducing interest and reinvesting a large part of the coupon payments into new Greek sovereign debt.

A wildcard in these proceedings is credit default swaps–how large, who owns them and what are the precise terms.  History tells us that Continental European banks tend to be the ultimate “dumb money,”  which would lead to the surmise that there are a lot of CDSs and European banks are on the losing side in case of default.

The burning question, then, would be about the terms.  Let’s say the EU as a whole reaches an internal agreement about Greek debt that it believes solves the problem without requiring the banks to write down any of their Greek bondholdings.  What happens if the rating agencies declare that despite this legal paper shuffling, the solution is in fact a default.  Does this trigger the credit default swaps?  My experience says “Yes” is probably the correct answer, but I don’t know.

It seems to me we’re entering the final innings of the game.  The outcome is still in doubt, and no one is leaving the ballpark.

From an equity investing point of view, I think the negative effects of an ugly outcome to the Greek situation will be felt mainly in European financial companies and in firms doing most of their business in Europe.  A good portion of the ugliness has to already be discounted in global stock prices.  Still, this is an issue to watch carefully to make sure the ripples don’t spread far wider than one might expect.

The mess in Greece–any silver linings?

the mess

When Greece was admitted into the EU about a decade ago, there were suspicions that the country had fudged its economic numbers a bit to meet the minimum criteria for entry. But the EU chose to look the other way.  In the middle of the decade, more evidence of cheating was uncovered, but again the EU chose to look the other way.

the discovery

Last year, after a change of government, the new administration confirmed that Greece had indeed been cooking the books in its reports to the EU , to its citizens and to the outside world, in a major way for years.

With a lag of some months, these revelations have sparked the currency and bond crisis, akin to the Asian developing market worries of 1997, that we are in now.


We all know the negatives.  Are there any positives to be taken from the situation?  I think so.  Specifically,

1.  Better now than a year ago, when the whole world was falling apart.

2.  It appears that the EU is finally going to address the Greece issue instead of papering it over.  Germany, ever the economic policeman of Europe, seems unwilling to move down a slippery slope of denial and compromise. And even if it were, world government bond markets will no longer allow that to happen.  It’s unclear what the ultimate outcome for Greece will be—the two polar cases are its leaving the EU and and an IMF-led policy overhaul—but some thing definitive will happen.

3.  The Greece situation probably puts an end for a long while to the idea that the euro can replace the dollar as the world’s reserve currency, or even serve as a viable second team substitute.  This probably buys some time for the US to get its own fiscal house in order, but I think that’s a mixed blessing.

The implication for China, which is already offloading dollars through acquisitions and foreign aid as fast as it can, of the unsuitability of the euro as a home for its foreign currency reserves is to push harder to advance the renminbi as a medium for inernational trade.

3.  Germany vs. Greece can easily be seen as the pattern for the way a possible confrontation years down the road between China and the US might develop.   As such, it may serve as a salutary warning to the US.  I would particularly note that the Greek crisis came out of nowhere but quickly developed a savage intensity.  Scary.  And hopefully motivation to avoid the Greek outcome through sensible economic policy at any cost.

(On the other hand, given the strange (to me) way Washington operates, politicians could easily regard the real failing of Greece to be ruling out devaluation as an option by entering the EU.  This would imply that Congress and the sitting administration should set the inflationary ball rolling sooner rather than later.  Not good.  Also not a silver lining, and therefore a topic for another day.