Thursday, February 23, 2017

RBI minutes of meeting - Was RBI unanimous in its monetary policy?

The Reserve Bank of India released the minutes of the third meeting of the Monetary Policy Committee (MPC). In that meeting two important decisions were made. Firstly, the rates were left unchanged and second the stance was changed to "neutral" from "accommodative". While the first was in the deliberation set of the market, the second truly spooked the market. Markets were not expecting a change of policy stance. There was speculation about if the decision was, in fact, unanimous or not.

Well, the minutes do not give us that clarity. Indian mentality is to deliberate and discuss the differences and then once consensus is reached, the decision is "unanimous". The deliberations and differences are left out of the public statement. 

The statement includes this explanation as such:

3] According to Section 45ZL of the amended Reserve Bank of India Act, 1934, the Reserve Bank shall publish, on the fourteenth day after every meeting of the Monetary Policy Committee, the minutes of the proceedings of the meeting which shall include the following, namely:–
(a) the resolution adopted at the meeting of the Monetary Policy Committee;
(b) the vote of each member of the Monetary Policy Committee, ascribed to such member, on resolutions adopted in the said meeting; and
(c) the statement of each member of the Monetary Policy Committee under sub-section (11) of section 45ZI on the resolution adopted in the said meeting.
In effect, the minutes of MPC are nothing but public statement or press release for the MPC and is duly sanitised. It does not state of any differences between the MPC members. Nevertheless, the committee seems to have been unanimous on both the aspects of the decision. The committee has made some important statements: [formatting changes for improved readability are mine]

On Inflation 
It is important to note three significant upside risks that impart some uncertainty to the baseline inflation path – 
  • the hardening profile of international crude prices; 
  • volatility in the exchange rate on account of global financial market developments, which could impart upside pressures to domestic inflation; and 
  • the fuller effects of the house rent allowances under the 7th Central Pay Commission (CPC) award which have not been factored in the baseline inflation path.  
The focus of the Union budget on growth revival without compromising on fiscal prudence should bode well for limiting upside risks to inflation. 

On GVA growth 
GVA growth for 2016-17 is projected at 6.9 per cent with risks evenly balanced around it. Growth is expected to recover sharply in 2017-18 on account of several factors. 
First, discretionary consumer demand held back by demonetisation is expected to bounce back beginning in the closing months of 2016-17. 
Second, economic activity in cash-intensive sectors such as retail trade, hotels and restaurants, and transportation, as well as in the unorganised sector, is expected to be rapidly restored. 
Third, demonetisation-induced ease in bank funding conditions has led to a sharp improvement in transmission of past policy rate reductions into marginal cost-based lending rates (MCLRs), and in turn, to lending rates for healthy borrowers, which should spur a pick-up in both consumption and investment demand. 
Fourth, the emphasis in the Union Budget for 2017-18 on stepping up capital expenditure, and boosting the rural economy and affordable housing should contribute to growth. 

The Committee inflation and growth expectations are mapped as follows:

The forecasts do lend legitimacy to the neutral stance. The statement includes emphasis on "caliberated approach" to achieve the 4% target. Urjit Patel clarified that neutral stance implies that rates can move any direction. Thus, in effect turns out to be quite benign policy.

Tuesday, February 21, 2017

Tax as a destabilising force - Border Adjustment Tax

John Mauldin, a prolific commentator, is well connected to the Republican establishment. He has recently concluded a three-part series titled Tax Reform: The Good, the Bad, and the Ugly on the coming tax reform in the US. The parts can be found here - first, second and third. It is a must read. 

The US is trying to simplify tax structures. This, by itself, is nothing new. All the countries have been trying since time immemorial to simplify tax codes. Surprisingly, they keep getting more complicated. I do not think "simplify" means what you think it means. But this time, it does seem simpler. Let us not jump the gun, it is still early days. Let the bureaucrats have a go at it and it will come out as complicated as it has ever been. Nevertheless, the intent seems to be right.

The disturbing part is the way BAT or Border Adjustment Tax is supposed to work. John paints a pretty grim picture and rightly so of the adverse consequences of ill-thought out Border adjustment tax. Mauldin and his friend Charles Gave, both seem to suggest that this move will disturb the present equilibrium. Other republicans do not think so. But there is merit in Mauldin-Gave arguments.

And then I read the US intelligence’s ‘Global Trends, Paradox of Progress’ report. That is another bleak report. What is disturbing is that the world seems to be in a precarious balance at present and 5 years out. Some situations in next 5 years as highlighted by the report:

Now the timing of BAT by Trump has become exceptionally crucial. At times in history you get amplified impact because historically small acts happened at unstable times. Here we are faced with a big act at unstable point. In effect, we are beholden to Trump's good sense, pragmatism and sense of leadership.

Interesting times these.

Monday, February 20, 2017

Why is the current easy-monetary policy ineffective?

Ben Inker, head of GMO's Asset Allocation team had a great article this quarter.

It has been the extended period of time in which extremely low interest rates, quantitative easing, and other expansionary monetary policies have failed to either push real economic activity materially higher or cause in ation to rise. The establishment macroeconomic theory says one or the other or both should have happened by now. It seems to us that there are two basic possibilities for why the theory was wrong. 
The first is a secular stagnation explanation of the type proposed by Larry Summers and others. 
The second possibility for why extraordinarily easy monetary policy has not had the expected effects on the economy and prices is an even simpler one: Monetary policy simply isn’t that powerful. is line of argument (which Jeremy Grantham has written about a fair bit over the years) suggests that the reason why monetary policy hasn’t had the expected impact on the real economy is that monetary policy’s connection to the real economy is fairly tenuous.

In this context, there are some important aspects.

First, monetary policy and economy are connected to each other by feedback loops. By now, every market participant knows that if there is any inflation up-tick the monetary policy will be tightened. This information prods the participants in asset classes where the inflation impact will be low. A look at inflation basket will tell us which are these sectors where price runs will not affect inflation. Exotic assets are in fashion for this reason. Art, diamonds, high-end real estate (trophy), luxury items etc all form part of this group.

Second, why does the low-cost debt not push investment for improving productivity for general items that form part of the inflation basket? The answer is there is no demand. When the market concludes that there is a substantial demand to justify the investment then the investments will come. There is no demand because there is excess capacity, predominantly in China for manufactured goods. This is the reason monetary policy is not effective. 

Monetary policy is effective when there is underlying demand is strong. Without demand monetary policy is just an enabling environment for nothing in particular.  That the monetary policy is not working is itself a data point. It is telling us that the masses do not have the purchasing power to fuel a demand pick-up. There are two reasons.

Most of these masses derive their incomes from the products that make up the inflation basket. If inflation remains subdued, their incomes remain subdued. The low-interest rate has reduced the cost of capital meaning it is cheaper to deploy robots instead of people. So in fact machines are replacing some jobs. These two factors currently suppress the purchasing power. To compensate, people want to build higher threshold of income-level before they start consuming normally. So, the general population is busy buttressing their purchasing power. 

The second reason is that the pre-crisis demand was inflated by debt. The low-cost debt created a hyper-demand which may never return. At the same time, the debts from the past consumption binge have come due. So the indebted families are busy working their debts off. If all the debts of the bottom 50% of the population were simply forgiven, it would have been cheaper than QE. But it would have immediately buttressed the purchasing power of the masses. 

It is a complicated explanation, but it cannot be simplified any more. When feedback systems are interacting, you will get complexity.

Tuesday, February 14, 2017

Should democracies reclaim power over production of money?

Ann Pettifor writes a blog post drawing on her new book "The Production of Money: How to Break the Power of Bankers" saying as much. At the outset I must say that I love to read her articles and posts and I have tremendous respect for her.

Her diagnosis is that our present predicament is the following: (emphasis mine)
It is my view that current economic disorder is largely caused by the invisibility, the lack of transparency, and the intangibility of the international financial system – the cause of recurring global economic failure. The fact that the system cannot be seen or understood, that it is opaque to society, means that it cannot be changed or transformed by society. Widespread ignorance of the workings of the great public good that is our monetary system has made society vulnerable. Ignorance enables those financial interests that have wrested control of the system away from democracies, to continue to undermine the security of society. 
If democracies are to once again subordinate the finance sector to the role of servant to the real economy, it is vital that the public gains greater understanding of the monetary system – which I believe to be a great public good. That is the ambition of my modest book, The Production of Money.
This book indeed will be interesting. At present, I am only commenting about this post. I am with her up to this point.  Understanding the monetary and banking system is indeed important. But then she cites an example of the system:
The reality of life under a model that elevates the global over the domestic economy was starkly exposed recently by the fate of a small tea room based in Highcliffe Castle, Dorset. The tea-room had been owned and run by a local, Sean Kearney, for 17 years. It was put out to tender by the council. The company that won the tender was a global behemoth – the $14bn Aramark corporation, that owns prisons and canteens worldwide and is headquartered in Philadelphia. 
This ‘storm in a tearoom’ as The Times dubbed it, was a classic example of how today’s economic model fails the people of Britain. It pits the minnow of a locally-owned tea room against a globally powerful and financially mobile shark. This is not free market competition. This is grossly unfair, economic slaughter of a viable business. As a result Sean Kearney may well now become one of those ‘left behind’ by British government policies.
I am not sure I understand this. There are too many confusing ideas at play. Are we against a buyout of small companies by big ones? Are we against a buyout of local companies by foreign companies? Are councils beholden to grant tenders to local individuals? 

Then she says:
Depressingly, our politicians – on both sides of the House – learn nothing from this. Despite all the nationalist rhetoric, we know that the dominant economic model that led to the populist uprising for Brexit has not been seriously challenged by the Conservative party, or any of our politicians. The government will continue to stand aside as footloose, mobile capital uses its absolute advantage to swallow up the enterprising minnows of the economy, and to wreak havoc on society’s social, economic, and political goals.
This example is very casually stated - it does not buttress the case of the book. In fact, governments that intervene in such deals are frowned upon by commentators like Ann Pettifor. Such protectionist interventions are limited to companies where strategic interests are involved. (Ports, dams, critical road or intellectual property etc.) What is surprising are the steps suggested to control the capital are even more onerous.
Capital control over both inflows and outflows, is, and will always be a vital tool for doing so. In other words, if we really want to ‘take back control’ we will have to bring offshore capital back onshore. That is the only way to restore order to the domestic economy, but also to the global economy. 
Second, monetary relationships must be carefully managed – by public, not private authority. Loans must primarily be deployed for productive employment and income-generating activity. Speculation leads to capital gains that can rise exponentially. But speculation can also lead to catastrophic losses. Loans for rent-seeking and speculation, gambling or betting, must be made inadmissible. 
Third, money lent must not be burdened by high, unpayable real rates of interest. Rates of interest for loans across the spectrum of lending – short- and long-term, in real terms, safe and risky – must, again, be managed by public, not private authority if they are to be sustainable and repayable, and if debt is not going to lead to systemic failure. Keynes explained how that could be done with his Liquidity Preference Theory, still profoundly relevant for policy-makers, & largely ignored by the economics profession.
This takes the pendulum in the other direction. I have a problem with this approach.

Removing the power of creating money from Banks 
It is a bad idea. The function of banks in a properly governed system is to create money where there is a potential for creating value. This distributed money creation helps create money at the point where it is most useful. And the same time if it is not useful a money incurs a cost that is interesting and expense on the bank's balance sheet. The core principles of this process have been undermined in the recent years. But that does not mean the principle is bad. 

Dr Pettifor suggests that a public body needs to take charge of this function. In fact, governments or public agencies are absolutely the worst agency to create money. If you imagine a bureaucratic agency like central bank to take it over then you will end up with delays. Further such bureaucratic institutions are open to regulatory capture by the same banks.

The alternative is the political system. Political systems are best geared to determine "policy direction" and not operations. Thus, without expertise, if you let politicians determine the money creations you will have a worse system than what you have.

The problem with the present system is not that it has failed. But it is that it does not fail enough. The regulatory mechanisms are mollycoddling the banking industry. Because of regulatory interventions, banks do not fear the losses from risk-taking. In my book, Subverting Capitalism & Democracy I call this failure of attribution. Regulation should make these losses more directly attributable to the banks. So no bailouts. Increase capital buffers - Anat Admati recommends 30%. There should also be an unlimited liability to shareholders to the extent of losses caused by their firm. 

The "bad" debt and capital issue
Dr Pettifor is right when she says that interest rates cannot be ridiculously high. Credit-card industry is a prime example. It is in a dire need for regulatory oversight. The Elizabeth Warren's initiative to reduce the credit-card agreement to readable short form is commendable.

She is also right to the extent that loans should not be made for non-productive uses. In effect, she implies we need to differentiate good debt from bad debt. This is absolutely critical and I have said so before. Productive debt creates an asset of higher value than the debt itself.

The question we need to ask is why banks were ready to lend for non-productive activities. The answer lies in the export-led growth model pursued by developing countries - first Japan, then South East Asia and then finally China. To hold their exchange rates low they created dollar reserves sending large amounts of capital into the US. The US has benefitted enormously from this available capital. It pushed the risk curve lower thereby sending funds (venture capital) into high-risk ventures. Without the return-lowering effect of this capital Google, Yahoo, Facebook none of this would be possible.

Another side of the problem, the expert central banks have kept interest rates too low for too long. This low-interest rate regime has caused some damage resulting in mal-investment. It has also pushed capital as an alternative to labour leading to lower quality employment.

In recent years the tide has turned. The new capital was generated by consumption overseas. This capital does not want to return to the US - because of taxes and other reasons. But more importantly, this capital does not want to finance bad investment (debt or equity). If you really think it through most of the low-hanging "productive" opportunities are in developing countries. In effect, what the capital is saying is that - on a post-tax level the capital cannot create a positive, real return in the US. If such returns were possible this capital would have flown back to the US.

The real problem
Dr Pettifor's line that "you need to cut out the bankers from the production of money" may be paraphrased for marketing reasons but it is not a solution. However simple we want life to be, the reality is it is quite complex. The solution to the 2008 financial crisis is fixing the various failed incentives structures created by public systems. The solution is not the let public systems go berserk in other areas. The solution is to reorient the incentives - one by one. It is not a glamorous solution but it is the only thing that will work.

Wednesday, February 08, 2017

Unmanufacturing Revolution - Is it the future?

Today I came across an article about Apple wanting to sell refurbished iPhones in India. The author, Tim Culpan, goes on to state that India could disassemble the iPhone for Apple. In this, there could be much more value. I agree.

Unmanufacturing is organised processing of manufactured products to their basic salvageable state. It is not new. India is a leader in Ship-breaking. There is no reason to believe we can do far better in unmanufacturing for electronic goods too. For quite some time we have focussed on manufacturing jobs and manufacturing contributing to the GDP. There could be substantial value in this activity too. 

Electronic waste processing is just one aspect of the work. As companies focus more on sustainability and recycling, we should be able to process all products - automobiles (cars, ships, aeroplanes), electronic goods (computers, phones etc.) durables (washing machines and etc.) to demolition (processing of buildings etc.).

This is not waste processing - which is a different and also lucrative business. This is about high-value items being disassembled to recycle the critical parts such as precious metals etc.

Done at a large enough scale, in a proper systematic manner, it can open up huge opportunities for employment.