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Friday, October 31, 2008

The economics of labour market intermediation | vox - Research-based policy analysis and commentary from leading economists

David Autor has a fantastic post on Vox on economics of labour market intermediation. Labour markets are imperfect and they are kept that way by interest of recruiters and employees. In the end both loose but still there is enough weight in status quo.

Let us consider an employer and a prospective employee. There is no way for the employer to know the employees performance in previous organisation. Therefore the metric is salary drawn currently.  Now if, by any chance, an employee accepts a job with lower salary then his salary growth is lower! This appears unfair - but its actually a manifestation of inefficient market at work. The only way this situation corrects is when imperfection on other side - i.e. you have a desperate employer. 

As per my experience the intermediaries actually twist this situation to the benefit of the employer. Hence most of the time employees distrust HR managers and intermediaries. That is the reason salaries are secret. Often even though companies treat everyone fairly - employees still feel distrust.

In sum, there needs to be two areas of research in this. First - does this behaviour actually benefit the employer at all. Second - does this distort the labour markets to an extent that it impacts the economy. My intuitive guess is no on first count and yes on second. 


Wednesday, October 29, 2008

Banks need to stop hoarding money - or should they?

Mike Shedlock posts an interesting comment to a White house recommendation (directive?) to banks to stop hoarding money. Prof. David Beckworth however explains why banks are hoarding money.

Now we already knew they would happen, didn't we?
The risks arise in the next step. Here the money system goes
into self preservation mode rather than help push the bailout effects down to
individuals and small businesses. Here second bailout will be required. But this
bailout will need concurrent regulatory changes so that the money system does
not simply fatten up – but actually pushes the recovery stimulus down the chain.
The size of this stimulus will be at least twice the first bailout.

I think, these two bailouts will have to clean the system.
Beyond this will be a period of lull. This is the time individuals and small
businesses start reducing their loan outstanding. This is likely to take long
time in case of US.

To my mind this reaction is rational given the accounting requirements and state of real economy.

There is a serious need to assess accounting norms for banks in the light of Fed guarantees. Banks may be holding too much reserves, capitalising a little too much among other things*. So if indeed Fed is going to prevent the systemic collapse then banks may be able to free some money. But of course its not as simple as that - the issue needs more understanding.

Further, with real economy showing signs of slowing, banks are reluctant to lend. (Rather, banks are now being sensitive to slow-down signs that were present even before the financial crisis!) Now is the time for bailout 2 to materialise. Though this one needs to be aimed at the consumer rather than banks. Banks may be used as a transmission mechanism for this bailout.

I dont mean to say that bank's have enough capital - but what I mean is so long as Fed gurantees are in place the banks may be better off (for easing out of this crisis) in lending rather than increasing researves. Banking system may need a lot more capital later once we are out of crisis - but the time to get the capital may not be now!

Development 2.0 is gathering steam

One of the many things Web 2.0 will help streamline is poverty alleviation and development of backward regions of the world. World bank's PSD blog earlier had a post about what this development 2.0 needs. Their recent post hints at a BBC initiative that has potential.

Tuesday, October 28, 2008

USD strength is an opportunity!

Confused Capitalist JW has a post today about how to make money in the moment. I agree with him totally. The current rush to USD assets is actually an opportunity to convert USD liquidity into other currency assets, particularly CNY (Chinese Yuan). If you see the behavior of Chinese markets vis-a-vis global markets you will see some strains of this actually happening. 

Under the hood of these flows, however you will see the reason why the systemic destruction of capital will be cyclical in nature. The cycle is similar to Roger's adoption curve in marketing. Small, smart money managers are "early adopters", big money is fast follower, everyone else follows big money (and that changes the equations - validating the theory - to an extent). The individual investors are typically the laggards - if they follow this they loose money. If they stay put they might make some actually.

The entire cyclical movement of money also lends credit to rising oil and gold price theories. So I will watch these commodities closely. Further the mechanics of this wind-down will be cyclical - with different wave-length. I guess this means its time for traders to earn their money. Welcome to the rough ride roller-coaster!

Monday, October 27, 2008

Short Selling

There has been a lot of blame allocated to shorts. Ajay Shah put his arguments against banning short-selling in "Why ban short selling?". But there are ways where short-sellers can impact the market mechanism adversely.
Now fundamentally, there is nothing wrong with short-selling. Even shorts with borrowed shares are fine and so are naked shorts. Yet, I haven't read detailed analysis of mechanism of how short-selling is causing the market panic.
Generally markets operate on a play between probabilities. The buyers believes probability of gain in buying the object is high, whereas seller allocates higher probability to making a gain by selling. Short-selling pay-off, in-essence, becomes function of two variables - the probability of the bet and size of the bet. Generally these are independant variables.
However, as we deal with wealth concetration risks, the size of bet starts influencing the probability of the event. When big money moves on a bet - it coordinates the operation across futures and swaps in stocks trading in different geographies leading to coordinated move making the bet a self-fulfilling prophecy. This is precisely the pain area. In order to understand this better we need to know:
  1. How the size of bet influences the probability of event.
  2. Is it possible to increase the size of bet and thereby get a coordinated buy-in in favour of the bet without resorting to illegal, immoral means.
  3. Has it happened in some stocks - and if so how.

In sum, the problem is plausible. But it impacts upside as well. Yet, human nature is not adept at understanding or complaining about this "surprising" good fortune. So how can we deal with it?

Thursday, October 23, 2008

Country defaults lighting the Forex fuse?

There is now talk of run on countries. The countries in question are Iceland, Hungary, Pakistan, Ukraine, Belarus, South Africa, Argentina and South Korea. Have a read here:

Peston's Picks: Now there are runs on countries
Naked Capitalism: Is another Emerging markets Crisis in motion? (Note interesting comments particularly by Richard Kline)

The risk is enhanced by possible political response. The breadth of possible political response of these set of countries is wide as ever. This will no doubt exert pressure on Forex markets. So what will give first.
I have believed in dollar weakness all along. Initially I thought it will be the China RMB USD friction that will trigger it. But increasingly I suspect the wear down will happen from Euro and GBP side. In other words - a European slowdown can visibly translate into Euro weakness more easily than US slowdown reflecting in USD weakness.

Financial Crisis - Goes regional, triggers a real economy shock!

The financial crisis is not becoming real economy crisis in an explosive war-like situation. I wish to highlight the first (noticeable) explosions showing crisis moving regional and hitting the real economy. As always all links refer to (one of my favourite blogs).
This was the result of financial crisis (among others)
Regional Banks post losses
Biggest US Bank Wachovia shows off a BIG loss!

And now here is the quote that ignites the real economy wick!

Ohio’s largest banks all suffered losses. National City said it planned to cut
about 4,000 jobs, or 14 per cent of its workforce, over the next three years
after the bank posted a net loss of $729m, or 85 cents a share. Fifth Third
reported a quarterly loss of $56m, or 61 cents per share, and KeyCorp lost $36m,
or 10 cents per share.

This is phase 2 of the crisis. The repurcussions will move east geographically towards China in coming months. Holt on tight.

Wednesday, October 22, 2008

Depression 2.0 dilemma - Inflation, deflation, capitalise, solvency

If at all you have just one blog to read - please read naked capitalism. Yves Smith is absolute best! Here is another song of praise - naked capitalism: It Isn't Over Until the Fat Lady Sings

The post looks a wide ranging issues including gems people will do well to remember.

oversold does not necessarily mean undervalued

the stock market increasingly seems to serve as a quick proxy for how the economy is doing, when it has a strong propensity to give false positives

Marc Faber comments -

"The governments in this world have no other option but to print money. That will lead down the road to inflation,'' Faber said. "You don't need to be an economist graduated from Harvard to know we're already in a recession. They will just put white paint on a crumbling building...."

"To rebuild economic health in the United States, you need a serious recession that will last several years,'' he said. "The patient that got drunk on credit growth needs to go into rehabilitation. To give him more alcohol, the way the Fed and the Treasury propose to do, is the wrong medicine."

Chirstopher Whalen comment - In anticipation of such heavy losses, banks are now diverting capital into loan loss reserves rather than seeking to make new loans.

And a fantastic snippet from Andrew Ross Sorkin at the New York Times:
“Our purpose is to increase confidence in our banks and increase the confidence of our banks, so that they will deploy, not hoard, their capital,” Mr. Paulson said in a statement Monday. “And we expect them to do so, as increased confidence will lead to increased lending. This increased lending will benefit the U.S. economy and the American people.”...But Mr. Paulson is making a big assumption about confidence, because until the real economy recovers — which could take more than a year — lending to Main Street is unlikely to return rapidly to normal levels.“It doesn’t matter how much Hank Paulson gives us,” said an influential senior official at a big bank that received money from the government, “no one is going to lend a nickel until the economy turns.” The official added: “Who are we going to lend money to?” before repeating an old saw about banking: “Only people who don’t need it.”

Housing has another 10-15% to fall (see here for a reminder), and that assumes no overshoot or second leg down due to a sharp increase in unemployment. And this won't happen quickly, either. Alt-A and option ARM resets continue at high levels through 2011 (in fact, 2009 is a bit of a lull, so we might have a false sense that the crisis here has passed midway through the year).

Here we need to pause and remember two main things. First is unless we know what is everyone hiding and what is it exactly worth we wont get anywhere. Second is markets have failed till now so there has to be someone willing to roll up his/her sleeves and get his/her hands dirty and really look at every single mortgage / asset. Asset backed instruments will work better if we have better information on underlying assets.

So now will someone please stand-up and help me look at this crumbling house in US that sits in balance sheet of bank in timbucktoo!

LEssons for Poverty alleviation - The economics of civil strife

Dr. Dani Rodrick points to an article by Oeindrila Dube and Juan Vargas. (Dani Rodrik's weblog: The economics of civil strife). The paper concludes that when prices of labour intensive commodity rise - strife reduces a benefits are wide spread. Whereas when prices of capital intensive commodity rises - strife increases if benefits are concentrated. This has some lessons for poverty alleviation programs.

I am tempted to go to my example of snakes-and ladder model for poverty. Here snakes are poverty creators and ladders are poverty alleviaters. Ladders are typically income related and snakes are expense related.
In the context of ladders, poverty alleviation has two-fold objectives. First is to have ladder-accessibility to all (income growth / economic growth of labour intensive activities). Second is to have more ladders (income generating activities supporting /surrounding the capital intensive sectors)
A quick view on the strife part of paper
In my view, strife actually happens when both the above conditions are negated. Or if income generating opportunities are not available to large scale population while being selectively available to few. AND whatever other income generating opportunities are available are not growing. When oil prices increase in Columbia did not translate into ancillary economic activity then strife is definite.

Monday, October 20, 2008

Getting over Lehman

To many this post may sound a little late, but for the past few weeks there have been a spate of shows in the media on current financial crisis. Mostly the shows interview/seek opinions from morons but occassionally an expert pops in with same I-blame-Lehman punditry that I am sick of by now. These experts are misguiding the people.
So I want to rant on one of their two main arguments. First is Lehman is dead because of excessive leverge and financial stupidity and thank god for it. Then these people go on to rant upon how the business model is flawed.
Lehman problem is a little different - the business model is built on high leverage and Lehman's ability to manage it. The leverage was 32 times its equity at the time of default. Lehman underestimated the size of bets - money betting for a fall in its share price. If they would have correctly anticipated this then they would be out of trouble.

Before the recession, it was John Peirrepont Morgan who (with similar model) helped US wrest the development initiative from Britain and France. This business model in general and particularly Lehman gave the US - silicon valley, factory based manufacturing, organised retail industry after 1930 recession. These are the very institutions that have helped the US keep up, nay lead the economic development of the world. Without Lehman, and its ability to manage this leverage US would have fallen before the rise of Japan in 1980. US also owes the latest "best decade" (time around Clinton era) to capital sourced from this very model. The excesses during that era - spawned biggest bubble ever - its still inflating in other parts of the world. This bubble pushed the innovation envelope beyond the regulatory scope and therein lies the problem. US has lot that it owes to this model.

There is a lot of blame-game and political gibberish that surrounds demise of Lehman and current financial crisis. Ordinary citizens will do well to not heed any media and rather read up on opinions of unbiased professors from top educational institutes. My reading leads me to believe that both Obama and McCain have misunderstood the problem. Obama has good economic research support - but his speeches do not communicate the understanding of his team. But I would bet on Obama (just purely based on his team).

Fundamentally, average US Joe and Jane are equally to blame for the current crisis. The average Joe and Jane spent more than they earn or could earn in the near future. The number of clothes, toys, electronics, etc that people have bought are actually lower. The most people spent was on housing. At a very fundamental level, its not their fault as well -as human emotions are wired differntly and if there is nothing perceptible (like own money) to loose people tend to take risk - thats what people did with housing. But people should have known better - afterall even though it wasnt perceptible it was still their money. People dont realise what costly mistake they have done. It will impact their economic well-being for next decade. Unfortunately ignorance is not an excuse - so the blame and misery is compounded. So everyone has skeletons in their cupboards.

For average US citizen to survive the crisis, it will take boot strapping. But bootstrapping will happen when the current debt is paid off. And its going to take a really long time to work through it. Prof. Elizabeth Warren has amazing work in this field. She is also trying to protect average Joe /Jane from transactions where housing companies duped the citizens. Further she is trying to protect them from credit card bills as well. It would be great if people support her.

Lastly, the ability to ride out of this current crisis rises out of capability and opportunity to innovate and create new sources of value addition. This happens through new businesses, SME and related job creation. With Lehman's and demise of high risk capital - US has lost its main recovery financier. It is thus that US will cede its economic supremacy to others unless US fixes the system. Does it have the political comprehension and will to do so? Its for US citizens to decide.

Wednesday, October 15, 2008

Solving the Poverty problem

The global elites are debating about eradication of poverty. Let me quickly summarize my view on poverty.

What is poverty problem?
Poverty is not going to go away. At any point in time there will be poor people. The real problem of poverty is that poor people do not have the means to move out of poverty. In other words, this is structural poverty. I have looked at this in my earlier post - “Why certain people stay poor?"

Poverty that will not go away should be transient poverty. Where people fall into poverty because of illness or bad luck etc but have access to resources to help them get back into income generating households.

The solution
The poverty solution will have two main elements. First is identification of threshold for the economy. Second is enabling this segment with tools and resources to move out of poverty cycle.

Poverty and its relation to population under certain threshold income
I have a problem with calculation of this threshold income. Generally, poverty is defined as people earning under a certain threshold income. The threshold income, therefore, is calculated using consumer price indices of various items required for minimum subsistence.
Rather threshold income should be X-sigma deviation from median population. This approach is far more likely to identify target population.

Poverty and relation to people at bottom of income pyramid.
Poverty is not about people being at the bottom of income pyramid. There will always be people at the bottom of the pyramid. The argument is what if the bottom is higher now. I have a problem with this approach as well. If everyone is higher then we have inflation. It means poor people though not poor by definition, continue to get low quality goods. To add to this they are not even defined poor so no reform reaches them.

Why this solution does not work?
Readers will recognize that the solution I have proposed is not new. And experience suggests it does not work. The main reason is lack of other infrastructure.

  1. Poverty reduces access to legal protection. Poor people do not have resources (mainly time – as it directly impacts income) to strive for justice. Hence they can be taken for a ride.
  2. Poverty increases current or future health-care expenses. As I highlighted earlier, healthcare represents a snake in this snake-and-ladder game of climbing the income pyramid. Rising healthcare cost are sure to keep poor families continuously poor.
  3. Poverty reduces probability for higher education thereby creating ceiling for income growth of the household. Thus occasional poverty (in a lifecycle of a family) become sustained or structural poverty.
  4. Poor people do not have time to identify best employment opportunities for themselves. They have to go by word of mouth or past skills.

The legal and healthcare related infrastructure can prevent poor household from sinking further. It is a down-side protection. Then you need up-side push. This requires infrastructure like free education, employment exchanges, access to finance for entrepreneurship, technical support for diversification of household income etc.

In sum…
Poverty is recognized to be the bane of the modern economic landscape. But escaping structural poverty is possible.

Legal and healthcare infrastructure is systemic necessity. A lot of work has been done on education for the poor as well. Mobile phone based employment exchange for the poor is technically feasible. Access to capital through micro-finance is well researched. All the pieces of the puzzle are in place. It is just a matter of connecting the dots.

This post is dedicated to Blog Action Day 2008 on Poverty.

Previous posts on poverty:
1) Layout of poverty (Jan 10, 2008)
2) Why certain people stay poor? (Dec 03, 2007)
3) Selling costly products to bottom of pyramid (Nov 08, 2007)
4) How city development impacts poverty - Why Bihar should ensure there are no slums in Mumbai? (Dec 03, 2005)

Friday, October 03, 2008

Yves and Megan - A class act!

Yves Smith and Megan McArdle - two of the most important voices in the current day finance and economics come together over a wide-ranging chat. Yves talks about wide array of things I like including Mandelbrot and Peter Lynch. Fantastic interview – must watch all 67 minutes of it!

Here are a few comments I have based on the interview.

Size of the financial system is huge and you have to shrink to manageable size before you can rescue it.
Yves and Megan mention that the government would have to buy an asset valued on the books at 70cents at 75 cents to capitalise the system. Now we have a system where company accountants set the floor and government tries to fund accordingly. 

I think it would be better if instead of capitalising the system, government set itself up as buyer of last resort. Lets say if government sets a price at which it will buy those assets at 30cents. Thus government would set the floor and then investors can compete for price discovery.

The central point here is what is the amount government should value it at. In the case of housing at least it might be a little easier. Average (median) house prices should be around 20-30% lower than average (median) incomes. That can be set as the bottom in case of housing.

Of course this is way to simplified.

Embedded leverage – defaults increase from 3% to 6% impacts capital adequacy disproportionately.
What happens if this happens to higher rated tranch – i.e. AAAs? In such a scenario, the entire basket (all tranches AA, BBB etc) get impacted. Going forward this is what is likely to happen. I think this is much more likely and dangerous!

Falling dominoes – system that’s far more interlinked for its own good
There are few metaphors on stopping the falling dominos. The first is what is called the scorched earth policy. Here you create controlled destruction to offset the oncoming destruction. So to stop forest fires controlled fires are used. Second is containing the damage. This is how they stop flooding of submarines in case of water breach.

Yves invokes references from Mandelbrot - that was fabulous I thought. It leads us to solutions for self propagating replicating and cascading systems. These systems must have identified points for intervention. Yves refers to these points and need to create such points. 

The dominoes set-up for world records usually use such points. In case the dominoes accidently fall. Using these points you can isolate the rest of the system by decoupling at those points.

Yves recommends regulatory constraints on who can trade what with whom. That is one way. Other way is to continuously test the system - like hackers test the IT system security of enterprises. Thats because no matter what regulations you can set - there will be ways to break it.

10-year reduction in mortgage defaults – why you cannot trust it?
This is one exceptional point raised in the question. If 10 years data tells you that mortgage defaults are reducing will you believe it? It depends! In fact Taleb actually warns of exactly this. 

Aesop has a fable wherein the Ogre keeps its life in a little bird and thus becomes powerful. The hero has to attack the bird or in this case the underlying asset. If house prices exceed the median incomes and stray way out of line then you know that the last 10 year data is misleading you.

Finally -Yves Smith the dictator – Manhattan Project

Now this is one part that I would really love to hear more of. that section was too brief. I think we need to prod Yves into a plan for the Manhattan project. Very amazing Yves and Megan.