Friday, September 24, 2010

Salami tactics

Salami tactics
By Chan Akya

The idea of salami tactics that were first popularized by the communists and Marxists in the run-up to and after the Russian revolution attained a new level of public awareness after the idea was explained in detail during the first episode of the first series of the cult British comedy, Yes, Prime Minister.

Script from the episode details the exchange between the prime minister and his chief scientific advisor (CSA) on whether a nuclear deterrent had any practical or operational credibility (here the prime minister is writing in the first person and the CSA is the second person):

"'Why does the deterrent deter the Russians from attacking us', that's what he was asking. Because, I replied firmly, they know that if they launch an attack I'd press the button."

"You would?" He sounded surprised.

"Well I hesitated, wouldn't I?"

"Well would you?"

"In the last resort, yes. Definitely." I thought again. "At least I think I definitely would."

His questions continued relentlessly. I had to think carefully.

"And what is the last resort?"

"If the Russians invade Western Europe." That at least seemed quite obvious.

[CSA] Professor Rosenblum smiled. "But you would only have 12 hours to decide. So the last resort is also the first response, is that what you're saying?"

Was that what I was saying? It seemed crazy.

The Chief Scientific Adviser stared at me critically. "Well, you don't need to worry. Why should the Russians try to annex the whole of Europe? They can't even control Afghanistan." He shook his head. "No. If they try anything it will be salami tactics."

[Salami tactics was the description customarily given to slice-by-slice maneuvers, ie not a full-scale invasion of the West, but the annexation of one small piece at a time. More often than not, the first steps would not be annexation of land but small treaty infringements, road closures, etc. Ed]

I have thought about salami tactics a lot recently because of the ongoing rally in risky assets across the markets after a summer filled with doubts about the very real possibility of a double dip recession that seemed inevitable for both the US and Europe.

Ups and downs in economic cycles aside - in other words it doesn't really matter if the next US payroll report is a negative 24,000 or negative 125,000; rather what matters is the long-term (secular) direction of the US and European economies. When I wrote The Short List before the summer break (Asia Times Online, July 3, 2010), it made several key points about trends; and even as markets have been range-bound, those issues have come back to the front boiler.

If there is one thing that reading various books written on the events leading up to the 2007 financial crisis has highlighted, it is that very intelligent people failed to see the crisis developing right in front of their eyes simply because they were left to obsess over mundane and ultimately useless details - such as credit ratings, mortgage scores and loans-to-value - rather than the more important holistic questions involving broad strategy and sustainability.

Pensions mess
At the current juncture we appear to be heading for a farcical repeat of history as investors out there are being distracted away from thinking about the following two major (secular even) themes that are likely to dominate the investment landscape for many decades to come. This is the financial and economic equivalent of the old "the Russians are coming" cliche. These are:
  • The burgeoning pensions crisis in Japan, Europe and the United States.
  • Declining profit potential of companies located in Japan, Europe and the US.

    These are significant stories, and they are also inter-linked because the declining consumption of goods and services predicated by an aging population in Europe and the US feeds back into the lower margins for companies based in these countries until eventually the only ones that can afford to operate in these areas are the ones for whom the provision of products and services signifies a marginal cost to the "main" business of making profits in Asia, Latin America and (eventually) Africa.

    Add to this the notion of persistent deflation, which appears inevitable, and it is clear that the credit risks of owning debt in these parts of the world far outstrips the immediate (ie short-term) attractiveness of owning government-issued or highly-rated bonds.
    There is a further linkage here - as markets have panicked themselves into buying government bonds, the resulting decline in bond yields means that the present value of pension obligations has escalated dramatically. Much like in the case of Japan, lower current returns on a rising debt load mean that an eventual increase in debt would prove unsustainable.

    In the first instance, I would like the world to wake up to the dangers of Japan blowing itself up spectacularly over the next decade or so; and in the second, remain cognizant of similar risks bubbling to the surface in Europe and the US. Considered in that light, the "Great Sovereign Debt Crisis" of 2010 would likely seem like a measly appetizer of the sort that supermodels feed on before a fashion shoot; before the main event namely a full blown global sovereign credit crisis emerges by 2020.

    Even if investors were to not pay attention to these facts, they should at least remain cognizant of recent historical returns. Bloomberg shows the following chart for the Dow Jones Industrial Average for the period from September 1999 to September 2010, ie a range of 11 years. Over the period, precious nothing has happened despite the gut-wrenching volatility of these years. The world's most-watched stock market has (basically) produced no real returns at all, even before one considers the vagaries of inflation:

    Over a similar period, namely from 2001 to the present, Bloomberg shows the following chart for current yields on the US 10-year government bond yield, highlighting the amazing bull market in bonds, which is unlikely to be repeated for the next few years if for no other reasons than purely mathematical ones.

    But we have seen this movie before, even if our brains refuse to acknowledge this reality. This was called Japan, and it has played in front of our eyes for the past 20 years (note here that the graph is slightly misleading in the sense that the purported "negative" return for the bonds, ie Japanese government bonds (JGBs) is actually a positive figure that signifies deflation, in turn feeding into the compound negative return for equities over the period):

    Rising government debt
    All of this is relevant precisely because of the vast increases in the present value of pension obligations once we start playing around with expected returns. For these purposes, the present value is the amount you would set aside today, with certain assumptions on returns. A sample calculation is shown below, which compares the immediate (present) value (PV) of a constant stream of pension payments of say 25,000 per year with the usual simplifying assumptions on timing. With that in mind, a typical long stream of income requirements (over 15 years, which is consistent with the increased life expectancy in the US, Japan and Europe) shows an exponential increase in the PV - a simple change from 5% to 1% takes the PV up five times, to 2.5 million, from 0.5 million.

    Annual income
    Discount rate


    Present value

    Put another way, the gap in pension income would become a significant drag on US and European economies over the next few years, with governments having to dig ever deeper into their pockets for welfare funding. Calculating the gap is easy, by fixing an amount that is available today and then assessing annual income relative to the expected income of 25,000 in the above example.

    Pension pot
    Annual income


    Expected income

    In this case, our standard pensioner has set aside 500,000 to fund his lifestyle; if one uses the discount rates as the actual
    income rates every year, we get the symmetric results that show a rapid decrease in disposable income for declines in annual returns. Thus, the pension who created a conservative pension pot with an assumption of 5% annual returns would have significant surpluses if returns went to, say 10%. This would equate to greater capital formation, that is, money available for conspicuous consumption such as an expensive car or a younger wife, or even new business investments and the like. On the other hand, a decline in the annual returns (which is now more likely) would create a significant gap; the declines in disposable income having to be met with the social funding obligations of the government and the like.

    The pensions gap is thus the core weakness of governments across Europe and the US; and it is the main reason why a spiral of rising debt loads with all its attendant problems appears inevitable. Rising tax rates and demands for higher wages (to compensate for reduced investment income) coupled with the needs of an aging population on social aspects such as job security imply that the competitiveness of European and US businesses is set to decline precipitously over the coming years. The resulting decline in profits would pummel stock valuations.

    Financial salami
    It stands to reason that anyone looking at this would have an aneurism and sell everything in the markets to stock up on guns and gold; and yet, on balance, more people recently are buying risk than selling it. That brings us to the question at the top of this article, namely how are the salami tactics being implemented this time around?

    From what I can see, slice by slice the following is happening across the markets:

    First, distraction - namely the creation of a host of sensational and speculative stories in the media that receive saturated coverage, in effect creating significant noise that blocks out all rational and well-poised analysis of longer-term issues.

    In this matter, any number of issues can be used - ranging from the fracas around the American Tea Party movement (yes, I believe that even those opposed to US government have a starring role to play, albeit unintentionally), the French ban on burqas (see Burqas over the Bastille, Asia Times Online, July 24, 2010), the controversy about rights for homosexuals in the US and so on. With enough distraction, even people who are mighty concerned about the longer-term state of affairs would give up thinking and join the festival of self-pity.

    Second, confusion - namely to create the notion of "emergency" short-term measures that are designed to correct a specific situation that had gotten out of hand, all the while reassuring a gullible public that the measures would be reversed once the situation becomes normal. In the world of economics and finance, I add to this category all the central bank liquidity (quantitative easing, or QE), bank bailouts, fake stress tests and whatever else (see Unholy trinity sets up bank failures, Asia Times Online, July 31, 2010).

    Third, obfuscation - namely to hide relevant information from the investing public with a view to keeping the game going for just a little while longer. This is the primary reason why senior "risk" managers in the developed world - that is, the heads of government, finance ministers and so on - are actually spending a lot of time explaining how things aren't as bad as they appear. They may or may not be, but the role of a risk manager is to prepare for an eventuality rather than go through the motions of his job by assuming the status quo persists indefinitely. With the general public possessing the attention span of a garden mouse and the investing public not boasting a significant improvement over that figure, it becomes a plausible strategy over the long term.

    Last, seizure - namely to wait until the very last moment and then take aggressive action; such as forced seizures of pension funds, nationalization of investment pools, mandating government-owned entities or departments to perform asset strips and so on. In various countries the process would be timed and executed differently depending on how wide the population is distributed and the prevalence of income inequality as a guiding force to populist seizures. Economist and New York Times columnist Paul Krugman talks about a 60% tax in the US, while the government of Japan talks about seizing unclaimed bank balances; soon the talk will turn to reality.

    Greek example
    Let us look at a concrete example of how salami tactics allow a particularly bad financial crisis to linger on for months at hand without any resolution, and yet with no end-game in sight either. Enter, stage left, Greece. Look at the graph of five-year credit default swaps (CDS) provided by Bloomberg on Greece, and one can see that anyone who did NOT panic to cover in February and March was basically destroyed by the volatility that came through thereafter. The much-vaunted improvements have done nothing for the country, as insurance premiums (ie CDS levels) are still massively elevated relative to a year ago.

    Consider then the "salami" tactics that allowed most holders of Greek sovereign debt at the start of this year to remain holders to this day:
    1. Distraction - when the Greek financial crisis became the main talking point earlier in the year, the first act was to focus on distraction. This was achieved by talking about the assistance given by Goldman Sachs to the previous Greek government in hiding their gross debt figures. News reports of the strikes across the country with images of people hurling objects and setting fire to buildings soon followed; and the end result is that the financial aspects of the Greek crisis took a back seat to the "people angle", ie socio-political, rather than purely economic, commentary that is so favored by news networks.

    2. Confusion - the notions of whether Greece would default or not became a matter of much conjecture, with the Germans saying one thing and the French quite another. Then the British, Spanish and Dutch all weighed in with their own views of the situation and of course, rolled in the International Monetary Fund (IMF). This confusion was designed to keep people invested in the country's debt, because of course no one would offer a price to buy something like that when all this confusion raged. Thus, a whole coterie of reluctant investors stood around, waiting for a bailout.

    3. Obfuscation - this was achieved on multiple fronts, by the simple expedient of designing the bailout package to meet all near-term obligations but leave the sustainability of the debt load itself unaddressed. Banks that owned exposure to Greek sovereign debt in Europe were reassured by another act of obfuscation, namely the entirely silly "stress tests" that were designed exclusively for them to pass. There was talk of assistance from the IMF et al, and yet no material improvements in the actual revenue situation in Greece.

    4. Seizure - eventually Greece will default, and in doing so it would seize the savings of various European nations that have bandied together to provide aid required to the country. This is the end-game, and everyone knows it. Yet, the general trend in the market is to not think too much about that and instead focus on the small (and immaterial) positive bits of news along the way. You know, the ones on the lines of "they don"t cheat on taxes as much as previously". Gee, what a relief that is.

    In the Yes, Prime Minister episode with which I started this article, the CSA outlines his version of how the Russians could take Europe without the UK ever firing a shot.

    CSA: "Scenario one - Riots in West Berlin, buildings in flames. East German fire brigade crosses the border to help. Would you press the button ... ? The East German police come with them. The button ...?

    "Then some troops, more troops just for riot control, they say. And then the East German troops are replaced by Russian troops. Button ...?

    "Then the Russian troops don't go. They are invited to stay to support the civilian administration. The civilian administration closes roads and Tempelhof Airport - now you press the button?"

    Prime minister: "I need time to think about it."

    CSA: "You have 12 hours."

    PM: "Have I?"

    With a wry smile, one has to acknowledge that this is precisely what is happening in (and going forward, to) the world of finance. Me, I am still following the advice outlined a few years ago in my article In gold we trust (see Asia Times Online, September 8, 2007).

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