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Wednesday, December 17, 2008

2009: Images from the crystal ball!

It is that time of the year - December is here and so are the holidays. Again time to reflect on what is possibly in store for us in the next year. 2008 snapshots from crystal ball panned out pretty well. So here goes!

The monetary system
The monetary system is under terrible duress. With every central bank printing money - there is a great deal of money sloshing around. As of now it is just plugging the holes in the balance-sheets of the big-money operators. Soon this money will spread and it will create problems. However, we still cannot conclusively say if this will lead to inflation. Let me elaborate.
Inflation happens when buyers have too much money and sellers have too few products. It is often referred to as "too much money chasing too few products". 

Lets look at buyers. US, EU and to a certain extent Japan are biggest buyers. All except Japan, are in deep debt hole. Even if money were made available to these buyers, it is unlikely that they will buy. Most likely the excess money will go into debt repayments and savings. Also, I really have my doubts if the buyers will ever get that much money.

Now lets look at the amount of products available. This is a combination of assets and consumables. As a part of the past few years excesses, we have over supply of assets and substantial supply of consumables. In such a situation, it will be difficult to have inflation. 
The only way we can have inflation is if central bankers across the world collaboratively print whole stacks with gay abandon.

Demotion of US Dollar
Currently most of global wealth is held in USD. The de-leveraging has created an artificial strength for the Dollar. This is a concept a lot of analysts cannot cope with. This will cause as much confusion as "change of origin" causes in introductory trigonometry class. Devaluation of US dollar is a concept where the reference point has changed - and the analyst world will take some time to get its bearing on this. So the default argument is to turn a nelson's eye - ignore it. From the world of measuring the absolute (everything in USD terms) - we will move to world of relativity (everything relative to everything else). 

Emergence of "Wealth measurement anchor" is paramount requirement
What we need is to determine and accept a standard metric of value. Gold used to fit this scale earlier. We need to start using PPP determination as a denominator for value. So like in PPP measurement - we take a basket of goods and measure the currency's potency in terms of price of this basket. Just like Noah's ark carried sample species of all kinds, this basket must be representative across the world. On this basis we can measure wealth and arrive at a saner understanding of gain or loss of wealth. 

If all else fails - plain simple gold will do. But this will create a mega-mad rush for gold and create another scare.

Gold and Oil
If monetary environment isn't already complicated - Oil and Gold are adding to the confusion. These two commodities (and precious metal in a secondary sense) make up a set that is in demand globally. One is value retainer and other is a global necessity for economic growth. The prices of these commodities are denominated in USD. We are likely to see massive price correction in these commodities. Rather it is currency devaluation rather than commodity appreciation. So for investors whose wealth is in other currencies - it will be difficult of estimate the prices. Gold however should regain favour as value retainer and see increase in demand. Here are some links about gold price forecasts.

Corner the consumer - up the trade barriers!
There is going to be a great battle for consumers. At the moment, people are too busy looking for money to make the products. Soon people will be looking for consumers to buy these products. So saver countries (where there are lot of savers) will be expected to consume more to benefit producer countries. But this needs exchange rate management e.g.- China is looking to devalue its currency more than US. So we will see a lot of political hardball on exchange rates and tariff and non-tariff barriers. 
Potential for a global war!
While no-one else believes this and to some extent this often gets me ridicule, I believe a global war probabilities have increased significantly. These are not wars triggered by Mumbai attacks or some terrorist strikes. These are old-school wars based on conflict between creditors and debtors. Lord please give us saner politicians for 2009 and beyond.

Pay scales and organisation structures
Pay scales and organisation structures are going to see drastic changes. Firstly the pay-spread (difference in Cost-to-company salaries between CEO and lowest rung employee) will narrow. This is primarily because current financial crisis has put a focus on top management pay scales.

Further, the current recession will increase the need for special talent in corporations. These people will operate outside the organisations as consultants or temporaries. They will work on project basis and move to next companies. Mostly these people will work on organisation structure, costs and other non-intellectual property issues. Core intellectual property work will require in-house employees in classical organisations.

The main area of disruption will be the organisation structure itself. The structure will go through a radical change in the coming years and some sort of prototype should emerge in 2009. The difference between inventors, technicians, implementors and enablers will become more marked. For more details leave a comment for an e-book I co-authored with Anne McCrossan. 

This means that Private equity and consulting industries will go through a tremendous change. There is going to be a new wave of management jargon and it will be much more difficult to separate the wheat from the chaff. I suggest you look at Seth Godin as a new management guru (I know he writes about marketing - but look at Tribes - thats a management book).

In sum
We are looking at an exciting year ahead to say the least. We are looking at a new year where terrorists will have higher leverage (due to financial vulnerabilities), a possible war scenario and new financial and economic system. Lets hope we have the leaders to understand and guide us through this sensibly. So happy new year to all and make sure you savour every second of the celebrations! May peace be with us!

Thursday, December 11, 2008

Would asset price fixing have solved the problem?

The response to the crisis has been fast and powerful. The question is - is it the correct response? As Percy Mistry puts it in his Financial Times column, the first montary expansion was directed at averting financial collapse. The second, the one thats currently underway, is about kickstarting the system - getting a consumption driven US economy to consume.

Was there any other way out of this? A possible way could have been US government fixing the price of housing across the country through use of a formula based mechanism. This would have paved a way to price the derivatives and resolve the matter between market participants hopefully without government intervention. Any derivative is first a derivative and gets priced as soon as the asset is priced with fair degree of confidence.

Guaranteeing the home loans at this prices could be a second prop. This would have protected the individual financial system by fixing the floor. 

Beyond this the government should let the financial system resolve itself. First the market participants should start from the floor price set by the government and price discovery will help establish a price level far lower than what we currently see but definitely higher than otherwise. 

This would have created a huge amount of collateral damage. Firms would have been wiped out but the markets would have continued to function because the value of underlying asset was known. But its possible that we would have avoided further cascading effects and impact on individual financials. In the end both will be equally costly - but this one would be much saner.

Now am I missing something here? Probably concurrent devaluation of overseas assets and mark-down of about 600 trillion of derivative positions into something equal to 60 trillion. This looks potential hunting ground for creative accounting standards. But this seems one interesting way. What say?


Monday, December 08, 2008

Bailouts and Money flows

Past few months have been riddled with bailouts. And blogosphere was already weighing in on the cost to tax-payer angle. But it is now that the irony of the situation is being exposed. As christmas draws near and bonus figures get announced, we will have Paulson and Co. debate the future of unions and likel pay-cuts they might take.
Its like in the movie "Wall-Street"
The situation is very much like in movie Wall -Street where Gordon Gecko is scheming about unions on airline company while counting on the bonus gain. The movie, Micheal Lewis in Liar's Poker, Raghuram Rajan and others have raised an important issue. That of asymmetry of pay-offs of various stake-holders.
Asymmetry of Payoffs
The pay structure evaluated in cost-to-company terms is disproportionately stacked. The top management gets super high rewards whereas penalties are shared. This is always the case. Across all industries, levels note how proximity to money leads to higher pay-off without any value-addition. There are whole set of arguments if this is fair or not. The least discussed part about this problem is that this asymmetry creates money flow problems.
The GDP growth created by the economy tends to get aggregated at certain pockets thanks to this asymmetry. Further, the consumption basket composition varies significantly as incomes change - therefore it leads to beneficial implication for certain industries.
Problems of the Rich, by the Rich for the Poor!
In such a context, the tax payer, bears unfair burden of this bailouts. Tax-payer has to pay higher for items in consumption basket of the rich - real estate and education. Often they pay more than they can afford - just to break-in into the rich class. However, the unaffordability can catch up based on share of luck and lead to far graver consequences. Therefore Joe the plumber feels like he is on a speeding tread-mill while the energy generated is powering the Rich. So the tax-payer shares the down-side and has no perceptible upside to talk of.
Implications for social peace
Such mechanisms are hotbed for social unrest. It is at this time, government should actively support the cause of the common person. As of date US government is not seen doing anything along this lines. On the contrary, we find the measure undertaken are rubbing salt on deep wounds.
This is also destabilizing force on world peace. I strongly urge the sleepy governments to go into a war ready alert. India wake-up its time to be battle ready. Call me a cynic but its a risk!

Friday, December 05, 2008

Slowdown and credit flow within the manufacturing process

Credit flows within a Customer-shopkeeper-manufacturer-Supplier process. During slowdown the pattern of credit flow changes giving us lead indicators of impending slowdown. The credit flow needs to be analysed and extensively probed for clues for leading indicator for industry cycles and economic cycles. In current cycle the customer went bust hence the inventory destruction will play out longer than earlier when only manufacturer and supplier had inventories.

Usually, the credit within the customer - shopkeeper - manufacturer - supplier process resides across the chain. However, depending on bargaining power and forces best elaborated by Michael Porter, the weightage shifts.

Typically high-demand industries tend to move credit costs to opposite poles. In high-demand scenario, customer end bears a credit costs and so does supplier leaving the manufacturer with close to positive cash-flow business. This could be called the starting point of the end-game. As the inddustry slows, the credit cost moves away from customer-end to the company (in form of inventories) and then to suppliers (delayed payments). The bankrupcies move from suppliers-end towards customer-side. Customer usually does not go bankrupt as banks and FIs refuse to lend to them thereby curtailing demand. Usually, this change of credit cost pattern happens before the industry is about to go bust. Was it the case this time around as well? I hope the research departments have answers.

In current slowdown, banks and FIs didn't follow this responsibility. In fact they inflated the customer giving rise to credit expansion bubble. In our case, customer went bankrupt after buying lot of goods. So now we have inventory pile-up at customer-end, the manufactuers end and we have delayed supplier credit.

Naturally, bankrupcies are looming across the process. Retailers have been the smarter of the lot by not keeping excess inventories. Yet operating on so thin margins, their bankrupcies, when it happens, will be due to all together different cause.

Disclaimer: The post is exteremely generalised and simplified so there will be differences between industries and time-lines. Kindly accomodate.
PS: This marks the 100th post!

Wednesday, December 03, 2008

I am re-linking to yesterday's Yves Smith post on Stimulus programs. The disucssion in comments is awesome. There one of the questions raised in how dollar depreciation of past few years has not actually mattered for American Jobs. Here is my response -(too late to comment there I guess)
A declining dollar hurts the mfg and export industry in China, India and other countries. There is no doubt. But to move the mfg locations takes time - it takes structural change and confidence (that it wont be a passing competitive advantage). That confidence is coming to companies that US mfg will stay competitive for sometime to come. China's low CNY was more of guarantee that helped manufacturers to shift production. Again, China is also on productivity gain curve - so we still have margin to cut cost. The labour costs were increasing and China also responded by creating labour movement from rural to urban areas. Now you can only shift new labour to cities - till the old displaced labour finds employment. Trust me, you don't want wealthy unemployed labour used to specific lifestyle - bad for social unrest. The other way is to increase capital intensity of mfg. This has happened in tech mfg to a small extent. Here the capital intensity of mfg was increasing. So tech mfg should be closer to moving back into US. (But tech mfg did not fully move out of US did it? we can do with some evidence here). On the flip side this does not create jobs in volumes that US needs. This is the same problem with China - China needs to retain volume jobs. The dollar devaluation of last few years never tipped the scales to realign manufacturing. Theoretically, had it run for some more time, you would have had a tipping point where sustaining low wages would become difficult.
Secondly, either we (US China and world together) engineer a revaluation or turn a Nelson's eye to it - devaluation is going to happen. To control or not to control is the question (a la Shakespeare).
NDK makes a great point about running differential inflation. But I have two worries - first market participants will preempt this by rushing to gold or commodities and the like - creating strong one-time devaluation catastrophe. Second - even if this is managed - it puts US and world through super-slo-mo pain and distress that may be difficult to address in social context.
A note, commentators at the believe I am suggesting strong dollar - but its other way round. Further, there is a debate about manufacturing - which should be about any "producing" activity rather than manufacturing. In sum, US should produce something that world wants - it may be shoes or it may be website design services - so long as the relation of producer-buyer is unaltered it will work.

Global Rebalancing-wont exchange rate achieve it?

Yves Smith has another excellent post on problems with Keynesian response to the crisis. She quotes Tom Ferguson on how Keynes would have chose global rebalancing as a key solution. There is merit in old Keynesian approach when there is increase debt repayment capability in the future. Currently, US needs jobs and work, but thanks to weird gloabal policies it has neither. So it is dependant on "investor-like" income generation - i.e. through capital appreciation and investment. This, to me, is pushing the ignorant risk-averse citizens along a high-risk cutting edge finance path. This is unfair to US citizens who are not aware how long it will take to repay the stimulus. And dont even think you can print your way out of it! Thus the global rebalancing solution seems only way out. But, as Yves Smith points out, there are hurdles.

I dont see any reason why exchange rate realignment + concerted international financial regulation cannot solve this problem.

Global banking regulation needs reform and Shiller has also highlighted this his new book (I just saw the interview - waiting for the book). There is something fundamentally wrong with accounting policies that let banks lower capital requirements based on "perceived" asset price increases. The same regulation also creates holes in balance sheets as asset prices falls. This regulation needs to be suspended for sometime - (upside suspension), banks be forced to take all the write-downs marking the assets to agreed upon prices (lets call them steady state prices) - and then made to raise capital enough to sustain them.

Secondly exchange rate realignment is absolutely must. I have been harping about this on this blog comments for long now. US must become producer and China and surplus countries must become consumers. Without this there is no resolution of this crisis.

Finally, there is likely to be a diplomatic war to protect and isolate the consumers an keep the consumer to itself. Such a trading barrier game will be detrimental to global prospects and will decrease the total pie. If a big ship(US and EU) is sinking - one way is to protect your resuce boat - or save the ship. Former saves you comfortably but leaves the world with just a boat! and latter is difficult but the Ship stays so we are better off.

Tuesday, December 02, 2008

What a week! *sigh*

What a week we had.

Mumbai Terror attacks started last Wednesday and it was Friday before it ended with 190+ dead and scores injured. Twitter covered the best news on the Mumbai Terror with real time rumour-destroying coverage from fellow Mumbaikars.

Tanta or Doris Dungey passed away at very young age of 47. James Hamilton has a good post on So long Tanta with a few must-read links.

It is time to sweat the grey -cells to make my country better. The current political system is wreaking havoc with the world's largest democracy. It is time to take action. Welcome to a new revolution!