Gates Foundation - Initiatives for the Future

A few last comments (for now) on the future.

The Gates Foundation annual letter is out and focuses on four developments that they both foresee and are pushing in the developing world.
1) Infant Mortality - Five simple steps to drastically improve infant mortality.
2) Africa Agricultural Productivity - Agricultural productivity by region of the world over the last 100 years is fascinating. Africa has lagged far far behind in these agricultural developments. This problem is more complex than infant mortality because best practices change according to both climate and infrastructure.
3) Mobile Banking - Discussed here previously.
4) Electronic Learning - Discussed here previously. The potential impact combined with mobile developments is interesting to note.

Antibiotics and Desalinization

In a previous series I pointed out two potential critical turning points in our potential future. The first was antibiotics (downside risk), and the second was low-cost desalinization (upside potential). In the past few months there have been breakthroughs in each of these areas. Although the breakthroughs could be considered "small," these smaller breakthroughs are necessary steps to reach the eureka breakthrough moment.

Antibiotic breakthrough: Multiple target binding bacteria as well as a novel method to efficiently test many many more antibiotics. My long run bet on humanity just might be shorter than I anticipated.

Desalinization continues to push forward. Graphene had already been established in prior studies and experiments, primarily from Lockheed. However, one primary challenge has been to develop a method to efficiently clean the filters. This appears to be a change in concepts for filter cleaning which can be further improved upon.

I want to reiterate the importance of desalinization in a slightly different way. There are a lot of young marginally employed males living in areas facing water scarcity because these regions are arid and have poor water management. As water shortage becomes an ever more serious issue to those living in these areas, these young men could become a local destabilizing force, and consequently become these regions can export this instability throughout the world.

Imagine an environment with a severe water shortage and no job prospects. Your short-sighted government and their cronies wasted it all and, for some reason you don't understand, the government is not able to get more of it. The gut reaction for many (most?) is to throw these pernicious and evil officials out by any means possible, especially once the photos leak of lavish parties and swimming pools behind those 50 foot walls of theirs.

Hubris and Statistics

I recently finished a fascinating Econtalk podcast with Joshua Angrist dealing with different methods in Econometrics and how slowly we have gained knowledge in the field over time. The podcast had me reflecting on four of my statistics-related experiences. All are examples of hubris or folly (primarily mine) in the use of statistics.
Disclaimer: My work is not this disgraceful all the time. I label these "learning experiences" for a reason.

1) Econometrics Competition - This might surprise most of the people who know me, but I once won an econometrics competition. Each candidate needed to submit a model together with the theoretical reasoning to justify along with their data. The product we were dealing with was somewhat of a signalling/luxury good, so my model included an exponential component as well as an attempt at instrumental variables. I somehow won. However, when actually applying the model later in the real world, it was simply mediocre and no better than many of the other submissions. Getting the good job sticker sadly did not enhance my ability to predict the future.

2) Predicting tax revenue - In college I worked on a predictive tax revenue model for a nearby municipality. The municipality needed to decide a budget in August of the preceding year, but it was still unaware of what tax revenue, primarily sales revenue, would be for the next year. My team and I were able to create a very strong predictive model. There was just one problem. Our largest errors from prediction were quarters in the two final years, 2001 and 2002. There was this invention called the internet, and online sales started to heavily impact municipal sales tax revenue. The model still performed decently, but the world is not a statistical distribution with 11 fixed primary variables that were true for the last 15 years and will be true for the next 15 years. The world is a complex place, and what makes it complex is not just the randomness and noise, but also the unprecedented. This same lesson applied to the airball in AAA rated mortgage-backed securities five years later.

3) Inverted demand curves - Another project I once worked on dealt with perishable goods that actively changed prices. I was assigned to come up with a type of elasticity and competitive response framework, but I was only provided the company's pricing data. After about 20 hours of fiddling, I discovered that the demand curve was inverted. The more the price was raised, the more quantity sold increased. I discovered the ever elusive Giffen good! I wasn't quite that naïve, but I didn't take the time to structure my thoughts and the request before diving in. Then the realization came, "Of course. We raise prices in anticipation of higher volume." This isn't randomized data that they created for this test. They just want after-the-fact justifications. Also, without competitive data and other critical pieces of information that drive sales, even a randomized experiment would likely lead to incorrect results, as the pricing effects would likely be overwhelmed by the noise of holidays, competitive price changes, weather, advertising, etc. I wasted time with a comically obvious error because I was "thinking fast" before I was "thinking slow." Just because one's task is thinking doesn't mean one is being thoughtful.

4) Willful Ignorance - I was performing a project for a company that was to be acquired. During this work I discovered that the revenue from the existing customer base was on a downward trajectory and the rate of new customer acquisition was obviously slowing (very negative second derivative) in every existing market in which the company participated. The company was making up for this revenue by incrementally adding a few medium-sized markets periodically to the mix, but with every round these new markets were less and less favorable for the company. I took this analysis with some statistical tools and presented it to some senior management members. I was immediately shut down with explanations like, "well, there's no seasonality control here" and other explanations that did not hold any water whatsoever. Shortly thereafter I was reassigned and then pushed out. It wasn't until after that I had realized the obvious, "They were selling the company, you nincompoop. Of course they don't want to provide ammunition to their buyers."

Statistics is a tool. Outside of a laboratory, and even sometimes within a laboratory, it's a very imperfect tool, and sometimes an irrelevant tool. The future is complex and filled with new challenges and people with their own agendas. If you don't stop and look around once in a while, you could miss it.

Government Defaults - Why is Japan Not Bankrupt?

In the previous post the fundamentals of government defaults were examined. Given the fundamentals, how is Japan not bankrupt? The debt level is over 2x GDP and there is no end of deficits in sight. Why isn't there a run on the Yen today?* One approach is look at the Japanese situation under the national accounting formula (see twin deficit theory), propensity to pay, and ability to monetize.
1) According to the national accounting formula, Budget deficit = Savings + Trade Deficit - Investment. Japanese savings rates are high, have not shown to decrease significantly despite an aging demographic, and the residents tend to keep their cash within the country. Japanese households not only save, but they save in Yen. There have been signs that high savings have recently begun to slacken.
2) Because of deflationary trends over the last twenty years, the Japanese government has been able to monetize its current debt through the central bank. The central bank has expanded its balance sheet significantly.
3) The Japanese government has been able to monetize its current debt from investors through negative real rates. Simply put, over the last eighteen months Japanese bonds have paid less than the inflation rate. This is similar to having someone pay you for the opportunity to lend you money.
4) The Japanese governments have shown political will to pay. There aren't rumors flying about minority parties saying that they will simply default.

That keeps things limping along. However, according to the fundamentals, Japan has no good options left. Escaping the present problem is not because of a fault of courage or competence, and it is not driven by government corruption. It is not like the movie "Dave," where if those in charge can just put their heads together and put special interests aside they can find the solution and come up with the money. Defining "survival" as "not defaulting, technically or otherwise," the historical survival rate for countries in similar situations is zero. The Japanese miracle would be navigating the next ten years without default. What are some potential options?
- Productivity improvements, which necessitates upending many aspects of the social and labor structure. This was supposed to be the "third arrow" of Abenomics (reforms named after the Prime Minister) but it is politically difficult and has yet to make its appearance. Mark as doubtful.
- Population growth, which necessitates either having more children or importing immigrants preferably at least a medium skilled or high potential. Incentivizing people to have more children is very difficult, and concerning immigration, those that are more familiar with the political conditions in Japan tell me this is a complete non-starter. Mark as doubtful.
- Narrow or zero out the current deficits, then thread the needle between nominal interest rates, inflation, and GDP growth. This is theoretically possible, especially because of the prefecture system. It is similar to the United States in that the federal government runs deficits and transfers money to smaller government sub-entities. The Japanese national government can dramatically lower the transfers to prefectures and run at least primary surpluses (revenue minus spending excluding interesting payments). Mark as possible.
- Monetize - Central bank threads the needle between hyperinflation and hitting the print key and gobbling up the debt. This is already occurring, as the central bank's balance sheet has nearly doubled over the last two years, but it will prove ever more difficult to implement.
- Asset/liability balancing - The Japanese government has a huge relative amount of assets on its balance sheet compared to other countries. If these assets are only tapped at critical junctures to navigate this process, it might be just enough lifeline to pull through.

It is a very difficult situation, and I would put even odds on a technical default in some form in the next ten years.

*For the sake of both simplicity and the fact that there are others leagues more knowledgeable than I, I won't delve into the complex banking/government financing structure and its corresponding risks

Government Defaults - Why is Venezuela Bankrupt?

Japan's debt to GDP is over 200%, while Venezuela's is around 50%. Why is it that Venezuela is in the middle of a cash crisis but Japan is not yet? A few facts on the Venezuelan economy:

- Accuracy: Exact numbers on debt, GDP, and inflation do not have high confidence. Negative impact.

- Debt to GDP: Estimates of debt to GDP put it around 50%-65%. This can be positive (low) or negative (high) depending on the other factors.

- Propensity: The government has defaulted five times in the last twenty-five years. Negative impact.

- Collateral: Overseas seizable assets. Positive impact.

- Budget deficit: Venezuela's budget deficit zeroes out only when oil is above $117.

- National Account Theory: Budget Deficit = Savings + Trade Deficit - Investment. Savings are low in a high inflation environment. Investments have been historically low as well. In order to run a trade deficit, a capital inflow is needed.

- Oil: Oil has accounted for 96% of its export revenue, and the price of oil has dropped by nearly half over the last year. Negative impact.

- Cutting spending: There are a few options, many of which have historically led to coups and unrest. Negative impact.

On net, this is why Venezuela's government is in dire straits. There are some holding out, believing that the upside is there, but the consensus is heavily in the default camp barring a dramatic increase in oil prices in the near-term.

Understanding Government Defaults

With the recent fall in oil prices, the analysis and rumors have been flying about the government default by oil revenue-dependent nations. Also, there has been a resurgence of prediction of the imminent demise of the Japanese government's finances by its mind-boggling debt ball. Now is an opportune time to review the fundamentals of government defaults, and why they are not nearly as simple as many believe.

Assuming that a nation's government will continue to exist and will attempt to make interest payments on debt in good faith, there are fundamental economic and demographic variables to predicting a government default. Below are six of the primary fundamentals that analysts utilize to evaluate the near to medium-term viability of government debt. While others exist, the below six hit the primary categories.

Current load - The ratio of the government's debt to GDP. This is similar to the proxy for the gross debt to revenue used to analyze the default risk of companies. At a certain point, it does not matter how good the product or service is, there is simply too much debt to service and stay solvent.

Current trajectory - The current and near-term forecast of deficit spending.

Cut/Tax your way out I: Ratio of government spending to GDP. In theory, the higher the level of government spending, the easier it would be to find non-critical services to cut. In reality, many countries with high level of spending would have civil unrest even with minor cuts. However, the theoretical basis remains, and to a certain degree it is practical. Conversely, if spending to GDP is low, there should be ways to close some of the gap with types of taxation that do not result in massive deadweight social losses that strangle the private sector (e.g., Laffer curve).

Cut/Tax your way out II: Deficit / Spending. If a government is relatively close on a percentage basis to its total spend, it is more likely that a mixture of tax and spend policies can close the gap. Closing the gap on a 40% spend with a 25% tax base is going to prove politically difficult to impossible. However, closing 60% spend with a 45% tax base is extremely difficult, yet plausible.

Populate your way out - At a basic level, it is more credible for 100 people to pay off a given debt than 50. Debt risk is evaluated on streams of future payments. If there are few people to produce those future payments, the risk rises. Also, even if per capita GDP is constant, it is politically easier to freeze government spending and grow population than to cut spending on a falling population.

Market confidence - 10 Year Bond Yields. This is a bit of circular reasoning, but if others believe that the bonds are sound, then the bonds are sound and the debt will roll over. If others do not believe that the bonds are sound, then it will be difficult to roll the debts over. If it's difficult to roll the debts over, interest rates will go up. If interest rates go up, more debt will need to be borrowed.

With this framework in mind, examine the table below, which includes a few countries that have a high level of "chatter" on their debt levels.

Type	Variable	Japan	Greece	Italy	Spain	US
Load	Gov Debt to GDP, 2013	227%	175%	133%	92.1%	102%
Trajectory	Federal Deficit, % GDP, 2013	-7.6%	-12%	-3%	-6.8%	-2.8%
Cut/Tax I	Total Gov Spend / GDP, 2013	42%	52%	50%	45%	42%
Cut/Tax II	Fed Deficit / Spend	-53%	-26%	-6%	-18%	-19%
Grow	GDP Annual Growth, 2014	-1.9%	1.9%	-0.5%	1.6%	2.4%
Populate	Population 5 year CAGR	-0.1%	-0.2%	0.4%	0.2%	0.7%
Market	Bond 10Y, Dec 2014	0.4%	7.3%	2.0%	1.8%	2.3%

(Source: tradingeconomics.com)

While the framework does give an idea of the medium-term fiscal health of the entity, its primary use is to act as a launching board to ask additional questions. How is Japan not in default with a debt to GDP of 230%? Why does Italy pay a lower yield than the US? This second level of analysis then takes us into the near-term variables with more qualitative aspects, namely, current access to capital, currency effects, and perception of the propensity to pay. The next two posts will examine the narrative around two extreme cases that seem to defy the fundamentals, but for much different reasons -- Japan and Venezuela.

Body Snatchers

Continuing on the Management Frameworks post, I'd like to think that I have a good eye for evaluating employee potential. Of course, in interview situations I side with Google in that I, like most managers, haven't much of a clue how the employee could turn out. However, in the day-to-day grind in a collaborative work environment, I am pretty good at looking past what most consider glaring flaws and evaluating characteristics that drive value. A principal reason for this is that I've been considered at various points in my careers as someone with glaring flaws. For example, two complaints I have received in the past are that I talk too fast and do not possess enough gravitas, Nevertheless, I was able to demonstrate this to others as a strength as I deconstructed a potential decision into the assumptions underpinning the framework. I could then not only make recommendations based on data and assumptions, but also point out critical weaknesses where the decision could come crashing down if certain events did not go as planned. The management decision could be made (make vs. buy, acquire vs. divest, expand vs. contract) together with parallel decisions to contain the risks of taking that action. I am now better at talking slower, assuming the listener is less familiar with the issue than I am, and even, perhaps, letting my dulcet baritone voice lend to my gravitas. Over time I gained a reputation for structured decision making and providing a clear framework for my direct reports. Perhaps because I have gone through an experience like this, I've learned to ignore a little better my natural biases (e.g., He's tall, dark, and handsome; he must be leader!) and look for underlying traits that drive value creation. I have my mental checklist to check off as I'm working with colleagues: understands quickly and asks questions when they do not understand, takes a holistic approach on the impact to the company, does not "write off" colleagues and does not take criticisms as a personal affront, etc.

About two years ago I stole a "low value" employee from another team with little protest. He was performing glorified data entry/adjustments for account reconciliations. He was very young (23) and a bit rough around the edges in some areas, but he definitely possessed nearly all of the primary characteristics of a dream candidate. I would certainly score him as higher potential in the critical attributes than I was at his age. A year later he was considered one of the highest potential employees. Two years later he was rotating through teams, mostly independently of my work, and doing the same restructuring and optimization that I had done for the last two years. He was slated to move into a mid-management position in 2015, with a target of senior management within four years. Then the other shoe drops. A competitor swoops in, based on the recommendation of a former employee who was let go and jumped to the competitor, and makes an offer for a very solid mid-management position at a great salary. He isn't quite ready for the position, but I know that after some missteps and learning, six months from now he will be doing fine. The position accelerates his career and will probably be more entertaining than his current path. All I could say to him was good luck. This was the first time that one of the high value employees that I have grabbed and groomed has jumped ship.

Some would make the argument, "what's the point of developing them if they are only going to head to another company?" I would answer that I had 15 months of stellar performance from an employee, and if I can't develop other employees to perform similarly I am not much of a manager or leader.