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Tuesday, April 08, 2008

Financial crises and Recession risks

The current financial crises problem is a problem of capital destruction leading to recessionary risks.

The destruction of capital is happening at financial institution level and individual level. At the financial institutional (FI) level - where brokers who have guranteed capital (i.e. deals etc) are finding it diffficult to fund these commitments. At the individual level wherein individuals are finding it difficult to repay their debt.

The government and quasi- government institutions are targeting relief efforts at the first level. This is primarily to avoid a systemic default and thereby keep a channel open for aid to reach the second level. It is also logistically difficult to address the individuals directly. The recessionary risk, consequently, also attacks two levels - firms (broader than FIs) and individuals. The capital destruction puts a lot of strain on spending plans of firms making them costly. This also puts strain on individuals' spending plans. A slowdown in the consumer spending is catastrophic for an economy like US.

Now given the eminent slowdown in consumer spending, the FIs go into a mode of self preservation. They push the risks down the chain - through higher interest rates, higher equity contribution for same level of spending. This prevents the government aid from reaching to the individual (where it should actually flow). In fact even if now government were to push aid to individuals - institutions will nullify the effect by cornering higher share of the pocket from individuals for repayment.

This is primarily (and simplistically) why no recession-avoiding efffort will be of any use. The only beneficiaries will be share holders of financial institutions. Even those can realise the value in the longer term. In fact this aggravates the probability of recession by pressurising the marginal borrowers (who were good but just so) because of higher interest cost. The situation parallels that shown in movie Titanic where the people on rescue boats refused lower class passengers letting them drown to protect themselves. Fed has given the boat to the FIs and most likely FIs wont allow anyone (individuals) to get on board. The individuals will either drown sooner or later in the sea of debt! Here comes the iceberg - all hands to the bridge!

The best the regulator can do is to efficiently catalyze the process - i.e. lessen the pain on the down swing and push the economy back on to growth track.

Tuesday, April 01, 2008

Dollar headed for a decline?

Late last year I made some observations about the economic future and some of them are panning out as expected. As mentioned pressure on US dollar is considerable. Mark Thoma in Economists' view linked to Martin Feldstein's falling dollar article.

I was amused by the article and commented on one particular statement. Here it is:
"Despite the recent dollar decline, America’s trading partners still have large trade surpluses. ... So the more competitive dollar is not causing fundamental trade problems for America’s trading partners."
Whoa! While I agree that US dollar needs to correct itself to more competitive levels, the above statement is discomforting. As Alex mentioned if dollar decline was for real US trade deficit should have increased. Thats not happened because "almost" all trading partners have currencies pegged (overtly or covertly) to the dollar. Hence dollar decline takes all this basket of currencies lower.
The "almost" in above statement refers to oil! Oil is delinking from USD denomination. Other commodities are catching onto this idea. And all US trade partners need oil and commodities. As oil and key commodities move relative to dollar you will see more pain for US and trading partners, creating an incentive to stem the currency depreciation.
Now comes the main dilemma - as these countries move away from dollar peg - their reserve start losing value. At the least $ 1.5 trillion is held in reserves by major trading partners - even a percentage point here makes quite a big contribution to their GDP - so its like rock and hard place situation.
This, to my mind, will put a hell lot more downward pressure on the dollar than has ever seen before!
Though this raises US mfg competitiveness but hits Europe hard in their face. The trading partners' might face crises - and lets hope its just monetary and not a social unrest. (thats why you have something called country risk)
To my mind a stronger USD easing out is much better way out of current mess. Funnily US has an incentive/self interest to devalue the dollar - but doing so will mean push everyone into a deep downward spiral.

This summarises my logic neatly. And I even got a comment reply from Organic George. Here it is:

Organic George says...
Rahul is spot on with his "delinking" comment.My company trades commodities from all over the world. We understand that the Euro is the new dollar when it comes to pricing.

I guess most of the Irory tower crowd is waiting for one of their own to write a paper to prove it.

It feels good to get a positive response. And its also in the news as Yves Smith points out! I am definitely elated!