Tuesday, December 28, 2010

Commodity Prices and Money

We have seen a recent spike in prices of various commodities like Oil, Sugar, Cotton, etc. Paul Krugman in recent blogpost highlights this as indication of finite world. We are scrambling to explain these changes through the lens of demand supply. However, just this time, I think there is another explanation.

Three components of commodity prices
In current scenario we should think of commodity price as comprising three parameters with demand-supply being one of them. The second parameter is inflation adjustment. Third parameter is wealth retention value.

Inflation adjustment refers to change in prices reflecting change to money supply that feeds only few areas within the economic value chain. Usually, the inflation adjustment is negligible as money moves through designated channels. However, in recent times, the excess money has spilled on to commodities and other asset classes creating a price expansion divergent from fundamentals.

Wealth retention value refers to ability of the commodity to retain purchasing power for the future. When money supply is stable and in line with fundamentals, there is not much need for commodity to carry the wealth, money can do it better. However, in cases of rapid monetary expansion rare commodities are required to carry wealth. Higher the monetary expansion, more commodities comes into this fold. In post-war Germany wheat bread too joined this group.

In Sum
So I think we should look at commodity prices through this three-component lens. I believe the fundamental driver, i.e. demand supply, is more or less along the long term trend. However, in recent times we have seen higher inflation component markups for many asset classes. Commodities are simply exhibiting similar behavior. Further, we might see, depending on how much trust our currencies exhibit, some change to the wealth retention component in coming years.

Tuesday, December 21, 2010

Cannot group India with other Emerging market

Over the past years, I spend part of time explaining this fact. India's economic structure is not like other emerging markets and hence we should not club those together. This goes when you are looking at bond yields, currency forecast or simply equity market valuations.

First, India is a consumption economy. Unlike other emerging markets that depend on US consumption, India is driven mostly by domestic consumption. Sectors like IT/ITES do have significant employment here and thus they do contribute indirectly to the consumption. However, the overall impact of IT/ITES is not as substantive as exports are to other emerging markets. Thus we need to look at India through a developed world lens.

Second, India functions despite of its government, again unlike other emerging markets. In other EMs government is a driver or enabler of growth. Not in India. In fact, wherever government interferes you have problems. So in that aspect too India is unlike other EMs.

Third, India has more efficient capital utilization pattern. Overall, the incremental Capital output ratio, ICOR, is higher in India. While a group of economists believe this is reflection of the stage of the economic development rather than character trait of India, I disagree. While the high level of ICOR is misleading, India will have better ICOR than comparable country at similar economic development level. However, this also means India will pay lesser for everything. In other words, if you expect certain demand at a price point in other countries, expect half that demand in India. MNCs found this very challenging at first. But at the right price point, there is ample demand than you can cater to.

Fourth, Indian banks, thanks to RBI's watchfulness, are very conservative. Even in Real estate lending, thanks to the black economy percentage charged by developers, the individual has higher skin in the game than in other markets. 

So during the next year when you look at investing in India, bear in mind that India is a consumption economy like the west. 

But what does this mean?
To me it implies some direct conclusions.

First, India can sustain a higher Debt-GDP ratio than other EMs. Since the payback comes from internal demand generation, the debt is likely to be more robust than other EMs. 

Second, it also means that India's economic model is directionally right, i.e. correct in intent, but low on scale, i.e. India is slow - very slow. This may mean higher stress on currency. Popular opinion on this topic is against me. People expect INR to continue to become cheaper vs. USD because of national debt. However, over time, people will realize the difference and try to flock into the INR. I do not expect it to happen in 2011 or 2012 but I have been wrong before. In any case, if it were to happen expect capital controls and regulation to manage the currency.

Third, infrastructure payback is likely to be longer. With India infrastructure story being marketed to death, I expect lot of infra-investment to come in without acknowledging this fact. Please expect payback to take longer than your models indicate.

Fourth, India may become a consumption driver of the world sooner than other EMs. It might take two decades more, but India may be first to contribute to global consumption rather than other EMs.

In sum
India is unique, it is a culturally in the middle. It is slow, but it is going the right way.





Thursday, December 16, 2010

Difference in wealth and money

Krugman raises an interesting question in his blog titled What is money? I believe this is a very crucial question we need to ask to understand the context of the current financial crisis. I have dealt with this question in detail in my book "Subverting Capitalism and Democracy".

There is a difference between wealth and our bank balance. Wealth is our ability to purchase future convenience (in terms of products and services). But there is no way to understand wealth in isolation, just as there is no way to understand temperature in isolation. To measure wealth we need a metric - money provides us with this metric. 

Metrics, like those for length, time, temperature etc, are very specific and scientifically determined. For example, the length of 1 meter was previously defined as the distance between two marks on the specific rod, placed in International bureau of weights and measures in Paris, made of platinum and iridium alloy measured at 0 degree Celcius. Later, a more specific measure was developed defining 1 meter as distance travelled by light in specified time in vacuum. 

However, metric for wealth, i.e. Money, is not specific and absolute. Money itself changes value all the time. Money itself is a commodity created to measure other commodities against it. But since it is a human creation, there is no supply constraint other than what we have self-imposed. Thus, money obeys all the laws of supply and demand like other commodities. It also means that money appreciates or depreciates depending on demand supply changes in other commodities.

The value of money refers to its ability to purchase goods and services. Therefore, wealth refers to value of money at specific time as the value of money changes with information on demand and supply. Thus if you are on an island where news reaches once a month then most likely the value of money will change monthly. This is one reason why fund managers want to know information earlier than others.

Let us say the monthly information comes through that instead of usual 100 apples (the only item that can be purchased on the island), this time 1000 apples were produced. Now the purchasing power of your money has gone up 10 times simply because there are more goods than money. On the flip side we can argue that prices have fallen because of bumper harvest. In either case the value of money, or your wealth, has changed.

Similarly, if suddenly the supply of money changes drastically we will have to work out the new price levels. Say if money supply increased by factor of 10, but supply of apples was same, then prices should increase by ten-fold and to retain your wealth you must have 10 times as much money as you had before increase in money supply. The same process is immensely complicated in a multi-product complex economy. Thus an individual may have no clue how her wealth may have changed during the process.

Today, economies are creating and pumping money in large quantities. Naturally, currencies are facing uncertain environment. The purchasing power of ALL the currencies is in flux. To protect our wealth, we need to step back a little understand how the currencies stack up then, once the volatility subsides, return into a currency denominated wealth. This is why people prefer to hide or park in a commodity that has very limited supply, like Gold or rare metals.


Wednesday, December 15, 2010

Jobs, Skills and development

Noni Mausa, in her blog Tunnel Under Snow: The trace elements of a nation, highlighted a comment she made on a spectacular discussion at Angry Bear about Sir James Goldsmith's views about jobs, skills and development. The original post makes a great reading and the comments, more so by Noni, simply elevate it to a must read discussion.

The arguments are often made against trade related job realignment. Make no mistake, trade does lead to realignment of jobs. Low value add jobs move from higher income countries to lower income countries. Except, of course, those jobs that cannot be moved like Janitors, hair dressers, restaurant operations etc. However, the idea of development means that the rest of the economy must be able to pay higher for these services even though the skills may not be dramatically high value adding. To pay higher and higher for same services we have two options.

First, we can improve productivity of jobs that cannot be moved. That is why floor cleaners at airport use a electric cart with mops rather than do it the old fashioned way like the floor cleaners in poor countries do. Essentially, as income increases, economies tend to throw capital at essential-labour problems to make them cheaper. Capital, naturally, is cheaper in high income countries. This worked fine in times when capital mobility was a constraint. However, the advent of GATT, WTO and later developments have made capital mobility almost frictionless. Thus this difference has been effectively negated and the only differentiation is now in wages.

Second, we can add more value that high-income people will appreciate and hence pay for. Thus, fashion consciousness in high income hair salons is higher than that in low income ones. Low income countries have tailors, while high income ones have clothes designers who have a reputed brand to talk about. The communication revolution has effectively negated this trend as well again reducing the differentiation to wages.

What this means is countries will have the jobs profile similar to the skill profile of the population. In other words, we are looking at a wage-skill rebalancing across the world. Thus we need to look at the skill profile of the economy and match the job profile with it. The skill profile can be managed through immigration i.e. by allowing those with relevant skills to come into the country. So US will do well to export financiers and import engineers. In that sense, the direction of the discussion is correct.

In other words, for arguments sake, a country of doctors will need to import engineers or entice customers to come over for treatment. Enticing customers seems ridiculous but hospitals in India are already offering low cost health care services to wealthy foreigners who fly in get their dental, cardiac treatments done and fly back after recovery. It is called medical tourism.

I have discussed the importance of matching job profile and skill profile within economies in my book "Subverting Capitalism and Democracy".



Friday, December 10, 2010

Identifying Asset bubbles

Recently, Scott Sumner and Arnold Kling blogged about asset bubbles. Scott Sumner post is about bubble deniers and how cognitive bias affects our assessment of about predicting bubbles. Arnold Kling takes one central point out of the Sumner argument - how to define a bubble. I think he views Prof. Sumner's post narrowly but his own definition is fabulous. That got me thinking about predicting asset bubbles. Let me explain it. The underlying principle Mr. Kling uses is this:

Asset profitability = rental rate + appreciation - interest cost
The logic is, so long as the asset profitability is positive at given price, the price is justified and hence not in a bubble territory. Let me distill the equation a bit more. I am simplifying here but, rental rate represents income from asset, appreciation represents rate of price appreciation and interest cost represents cost of capital. We also need to remember that that the equation deal in expectations. So asset profitability is expected asset profitability, rental rate is expected rental rate and so on. Further, to be consistent with units, we have to use rates (first derivatives) everywhere. Thus we have,
Asset Profitability = rental rate + Rate of appreciation - weighted average cost of capital (or WACC)
Hence, the limiting condition for asset profitability is,
Rental rate + Rate of Appreciation > WACC
Mr. Kling suggests that prices are in bubble territory when
Rate of Appreciation > WACC (given Rental rate > = 0)


Interpreting the asset bubble condition
Please examine the equation for bubble condition. There is no variable called price. Is it a surprise that the equation, as distilled does not involve absolute prices  or price income ratio or other related variable at all? Well the equation leads us to very important conclusions.

First, we understand the influence of interest rate on asset bubbles. We understand why raising interest rate pricks bubbles. It increases the RHS of the bubble condition. Now raising interest rate or cost of debt by 1% will increase cost of equity by more than 1%. Thus WACC will increase in relative proportion. We must note that WACC is very difficult to determine at a macro level - for the entire market. WACC also increases when risk perception of the environment increases thus popping bubbles. That may be the reason why extraneous events that affect the risk perception for capital pops bubbles and cools asset prices.

Second, asset prices move within a spectrum. Do note the way equation is derived. It shows us how asset price rise, initiated by fundamentals, moves into bubble territory. At one end of the spectrum are assets that depreciate - like machinery. The decision to buy them depends on how much rental rate (or income from that assets) exceeds the WACC. If the rental rate covers the depreciation(1) then assets become profitable. At the other end of the spectrum are assets where Rate of Appreciation is greater than WACC. I expect price of every asset moves within such a spectrum, from the rental rate covering for WACC and depreciation on lower side to the bubble zone where rate of appreciation exceeds WACC.

Third, asset bubbles can be identified by relative prices. The equation helps us understand if the prices we pay are bubble prices or genuine prices for our point of view. We cannot determine if the market as a whole is in a bubble territory or not. To know if markets as whole are in bubble we again go back to two principles. First is the notion that it is difficult for a market participant to estimate market WACC. Second represents the ability to stack assets in order of hierarchy based on rental rate. For any given WACC we can determine relative price hierarchy and thus estimate if rate of appreciation is higher than WACC.


Note:
(1) Here we must understand the difference between financial definition of depreciation and effective depreciation that includes maintenance and upkeep costs. Firms use factory maintenance programs to reduce the effective rate of depreciation.

Wednesday, December 08, 2010

How lower Interest Rate create Malinvestments?

Hayek argues about lose monetary policy resulting in malinvestments. But it is important to know how.In essence, there are three components to the argument.

First, interest rate represent the hurdle or minimum threshold return a business must produce. The return on capital is measure of the strength of business model and execution skill of the firm. The higher the return more capable the firm, stronger its business model, better its execution. (Note: does not indicate causality but simply co-existence).

Second, credit flows to those with history. Bankers or creditors in general, prefer to lend to large firms because of reputation, size and volume of credit that can quickly be deployed. In a low interest rate environment, bankers will prefer to loan a project of a large firm with ROCE of 5% rather than lend to 30 small firms with ROCE of 15%. This behaviour stifles the flow of credit to vibrant smaller enterprises, thus restricting new innovations. Because of this low-cost finance availability, it is possible that large corporates create unjustified barriers to entry (for example, dealer credit) to prevent new entrants. Further, it also creates anemic large projects that not only falter at the first sign of trouble, but also impose amplified collateral damage to the banking and credit system as a whole.

Based on my experience, the investment relevance - interest rate curve is a bell-shaped curve. If interest rates are too low then they result in malinvestments. If they are too high they strangle the economy. In between is a sweet spot policy makers should aim for.

Third, interest rate regime sets the benchmark for risk. Every investor, particularly those like mutual funds or pension funds, has a minimum expected return. This return is adjusted in keeping with planned expenses, payout of costs already incurred, adjustment for inflation etc. This minimum expected return is not a fancy number we expect to see, but rather a minimum threshold to ensure you cover your costs.

To hit this minimum return, investors now need to take more risks. In other words, we have modified the risk calibration. Each modification creates a portfolio churn, sometimes increasing the risk within the portfolio, sometimes reducing the risks as signaled by the interest rate regime changes. This is a form of mal-investment.

However, lower interest rates do help longer gestation vibrant projects. Infrastructure (or rather appropriate infrastructure) comes under this classification. Thus, a low interest rate environment can be used to create a longer term strategic advantage. Clearly, such process must involve stricter policy oversight and control.




Tuesday, December 07, 2010

When to support Asset Prices and at what level?

Back in 2007-09, during the peak of the crisis, world central bankers and regulators initiated strong actions to support asset prices. Some of the ideas continue to seep into the current bailout and stimulus strategy. However, to my mind, supporting asset prices is not a right strategy as it depends on the level at which supports are extended. Let us look at dynamics of asset prices to understand if their actions were warranted or not.

The asset price support strategy is in effect a response to bursting of asset bubble. There are two central considerations about supporting asset prices. First, should we support asset prices at all. Second, if we had to support, at what prices level should we support?

Why support asset prices at all?
The logic for sustaining asset price level rests on the fact that negative asset prices hurt a lot more than declining incomes. This is particularly true if the assets have claims on income (because of debt funding of assets). The collapse in claims result in cascading effects on the economy resulting in asset price deflation spiral.

For example, if a person or household earning $1000 per month with a conservative mortgage payment of $500 loses employment, then it immediately goes under prompting a loss to the bank. As the bank tries to recover its money by asset sales, the value of asset declines if many people lose their jobs and houses simultaneously. The situation is converse of a bank run. In a bank run, the liabilities of the bank get called in while assets are locked up. In this case, assets start getting marked down thus increasing the risk of liabilities being called in. Hence it renders banks undercapitalized. An undercapitalized bank freezes the entire money flow channels as it desperately tries to hold on to all the money it can.

At what prices should we support asset prices?
Given that there are situations wherein asset prices may need support, the question comes at what price can support be justified? To answer this question we must understand asset prices in more detail.

Asset prices have an income equivalence. In other words, every price point of an asset corresponds to an income level of the population. For example, if a person can spend only $100 on a car, then that will form the ultimate ceiling on the cost of making a car. Similarly, if an income producing asset can produce $100 worth of income (present value discounted appropriately), then that forms the ceiling of the asset price. For houses the income of future buyer will form the ceiling price of the house. This principle is captured as affordability ratio. About 100 years of data indicate that typically the house price is 5-7 times the current annual household income of the buyer. Conversely, when we support asset prices at a certain level, we should be sure of incomes rising to near affordable limits in short span of time (no longer than 6 months). This makes sure that prices can be sustained by the buyers through their own work and contribution.

Support for asset prices, particularly housing, should come at affordable prices and not at artificially high prices created during bubble times. I would also venture that the support for asset prices should be established at a point just below the affordable price so that tax payers' (those bailing out or helping support the prices) interests are protected.




Thursday, December 02, 2010

Income bubble or asset bubble?

What is the objective of QE2? Is it holding asset prices higher or is it pulling incomes higher? In other words, is the purpose of QE2 to create asset bubble or income bubble? In any situation, I prefer income bubble to asset bubble. I always thought it was ridiculously straight-forward. But may be the US FED and authorities do not understand it. Or may be I don't get it. So let me put the arguments out.

Rising asset prices do not give as much benefit as rising income. 
To gain advantage out of rising asset prices you need to monetize the assets. The monetization is advantageous if you replace the higher value asset with other asset. Replacing asset value with consumption is wrong. Any financial analyst worth his salt will explain that it impairs the balance sheet. Further, using asset values to create more debt is absolutely mindless. 

If asset prices have to be artificially inflated, it means there was mal-investment in the first place. If asset prices are held up, it gives the signal to the market to create more assets. This is exactly opposite of the signal we intend to give to markets.

When policy makers want to support asset prices they create a price floor. This only allows the prices to increase. They expect higher asset prices to translate into higher consumption expenditure (through wealth effects) and thereafter into higher incomes (through consumption led growth). It seems to be a round-about way of achieving growth. 

Contrast to that, working with incomes is better. 
Rising incomes create surplus disposable cash. Thus,  income creates direct support for asset prices. Let me highlight the support is direct. Now, working with income relates more to working on unemployment (or ensuring full employment) than issuing income diktats. Keynes understood this mechanism and hence advocated full employment. Full employment is able to efficiently translate income growth towards best skills. 

Thus, the objective of bailout or economic revival policy should be full employment and not a certain level of asset prices.

Tuesday, November 30, 2010

Behaviour of Indian Equity Markets

In the recent time Indian equity market are showing four distinct behaviour clusters. These zones are independent in the sense that their behavior does not seem to correlate with news or other stimuli. If that were the case, it would not be worth commenting on. However, this behaviour  is important to note this as it affects the trading strategy.

The trading happens in four peculiar disjoint zones. 

First zone represents the newly started pre-market operations. The price movements in this segment are very difficult to predict and the pre-market prices do not reflect in any way the likely direction markets may take post open. I avoid using the prices set in this phase totally.

The second zone represents the market open to about mid-day wherein European markets open. However, the timing match with European markets is not exact. The second zone lasts till about 1.30 -2 pm India time. 

Post this till close at 2.30 -3 pm represents the third zone. The performance in this zone is drastically different from performance in the second zone. Note, it is not necessarily opposite, just different. The markets may expand on second zone performance or simply reverse it.

The final zone is the last 30mins to 1 hour of trade. This zone appears occasionally. But can make or break your day trades.



Monday, November 22, 2010

QE2 polarizing Haves and Have-nots

The policy of supporting asset prices at artificially high levels through easy money policy is popularly referred to as QE2. This policy is widening the difference between Haves and Have-nots. 

Preventing new net Asset ownership
Asset Price support helps those who owns assets, while denying those who do not own assets an opportunity to ever own any asset. If you own some asset, you can convert it into others. If you do it skillfully by selling your asset at its peak price and buying other assets at their lowest prices, then you get richer. In other words, we are all asset managers.

What happens if we do not own any asset to start with? Well, earlier, your hard work, your labour value was an asset. But today that won't get you far. You need to start with an asset if you want to get close to median income. And that is where credits or loans come in. At a very basic level, you can get a students loan and improve your labour value and convert it into a labour category that markets value. This is the central utility of credit to our economy.

The Income-asset price connection
Usually asset price - income cycle works other way around. Higher median incomes drive asset prices up. The converse is not always true. In other words, higher asset prices need not drive median incomes. Note the use of word "median"income.

Here it is important to explain that at a gross level the asset price-income cycle is reversible. It means if we use total national income and asset prices across all assets in our cycle then we get a reversible cycle.

However, the moment we consider median incomes the reversibility breaks down. With each iteration, the income of the rich increases while those of the poor reduces. The median income reduces as we push through with these cycle.

Ben Bernanke is operating at a gross level but real economy will recover only when median incomes start stabilizing. Thus the Fed's policies of QE-X won't achieve anything unless Fed starts looking at median income levels. I hope they get it sooner than later.




Friday, November 19, 2010

Higher Food Prices and Poverty


Dani Rodrik asks if higher food prices mean higher poverty or does it mean higher income for the poor. He points to several articles and essays on this topic (refer notes below).


The issue is complicated. Just as we have expense basket we also have income basket. Agriculture appears in income basket of low-income HH. An increase in food prices, at least those forming part of income basket, should ideally help these low-income HH. However, the reality is different for most countries.

Often, most of price rise is effected at middleman levels (know for sure about India). The reason is typically inadequate market infrastructure for farm goods. Thus in countries where agri-product markets are well evolved, higher food prices tend to seep to the low income HH whereas in other areas they don't. (Some logical assumptions included).

Further, if a certain section of the low-income population is suffering drastically because of food price increases then it is difficult to justify the increase. Urban poor almost always suffer because of any food price increase. However, if urban poor can return to rural areas then it is possible to tweak their income basket to their advantage. This obviously depends on how volatile the price rise is.

The point is, whether the net impact of increasing food prices is beneficial depends on various factors. First, it depends on the profile of income basket and how much of income basket is increasing. Second, it also depends on how effective are agri product markets. Thirdly, it also depends on polarization of income baskets within lower income class.

Notes:

Dani Rodrick 2007 post - Food prices and poverty
Dani Rodrick 2008 post - Food prices and poverty confusion or obfuscation
Johan F.M. Swinnen - The right price of food
Maggie McMillan - Does OECD support for agriculture increase poverty in developing countries?
World Bank Implications of higher global food prices for poverty in low-income countries
World Bank Distributional effects of WTO agricultural reforms in rich and poor countries


Monday, November 15, 2010

The idea of taxes

Scott Sumer discusses taxes TheMoneyIllusion » Income: A meaningless, misleading, and pernicious concept. There have been responses by Bob Murphy, Richard Thaler and others all linked in his recent post titled Comment on Murphy and Thaler. I wish to draw attention to a more fundamental issues.

Firstly, we set the tax rates and plan expenditures accordingly. Why can't we do the reverse? I know the wording may not be clear so let me explain to the best of my abilities. Government sets tax rates, looks at collections, plans expenditure that (hopefully) results in more income and hence more taxes. This is a loop of sorts. However, I think we should go the reverse way, every year we should look at important, unavoidable, expenses and then deduce the tax rates from those. In the first case we tend to expand or contract government consumption (for the lack of better word - expenditure may not be appropriate) to fit the tax collections. In the second case we adjust the tax rates to fit with expenditure. It may lead to other issues related with fiscal deficits, productivity and development focus, and others. We will deal with them in a later post.

Second, taxes are less about being complicated right and more about being fair and easy. We have yet to discover a best first principles solution to tax calculation. Any mechanism we use ends up with unfair outcomes for certain portion of population. But if we stick to being fair, people should not have reason to complain. So I agree with you when you say that consumption is a better alternative.

Finally, taxes should not create distortions. Taxes are not means to guide the population and this, as such, should be considered as encroachment on civil liberties. Government has not business nudging people to have more babies, get more insurance, consume more, or invest in tax-havens etc. Alas, I am in a minority on this issue.



Friday, November 05, 2010

A logic against QE

Now that extra $600 billion is available to play, world markets are enjoying the party. However, there is a strong logic that suggests QE won't work without other changes. Here is my attempt to explain it:

Let us take a simplistic equation [1],
Personal Income = Expenditure = Price * Volume

In this equation, Volume represents volume of various goods we buy. Volume of goods consumed represents our quality of life. Simply put, if we are able to buy 2 computers every year, then our quality of life is better than if we can afford just one. So volume going up is a good thing in general. 

Price represents price of each of those goods. If price goes up and volume remains same or increases, then the price increase is acceptable. However, if price goes up and volume goes down, we have a problem. In economic theory, both phenomenon are defined as inflation. But effect of one is acceptable while other reduces the quality of our lives. We end up with inflation when there is too much money in the system and too few goods.

Now let us come to income. Income for the next year feeds on changes in price and volume in previous year. This is called feedback loop. So in general, if prices or volumes or both rise then incomes will follow.

However, within this generalization we have some specific differences. If volumes rise the chances that employment will increase is higher. If only prices rise and volumes don't (i.e. there is still extra inventory or idle capacity at current employment level) then employment does not rise. To take it a step further, if prices rise (because costs are higher) and volumes fall (as in bad kind of inflation) then employment may actually reduce. 

In current scenario, the income feedback loop is broken and we are pumping money by trillions. Unless we fix the income feedback loop, we are going to have inflation of bad kind. There is a tremendous risk to standard of living. It is surprising that politicians of the world do not understand this simple logic. I am beginning to smell malicious intent here. The only other alternative is incredulous stupidity.

Note:
[1]: I have made many assumption, including no savings or debt. This is to simplify the logic.
Paul Krugman's latest post on Why Inflation targets need to be high wonkish works on similar logic but assumes sufficiently high inflation will fix income loop.

Tuesday, November 02, 2010

Why Koreans still work at 75?

Tyler cowen links to an interesting post about age and employment across countries. The article suggests we rethink the early retirement norm. Here are my comments:

First, retirement should be a personal choice depending on factors such as health, financial comfort etc. It was nudged into a norm through the use of social security. Instead of the lump sum social security, we must rethink the size, frequency and conditionality of social security payouts. We may, for example, decide on step -wise increasing payouts starting at age 55. We may, as another idea, keep the size of payout restricted for those in employment, within the principles of fairness and social justice.

Second, even if we accept the principle behind retirement, the exact age itself must change. The retirement age is a leftover from a effort dominated era. In those times, productivity waned with strength and thus older you got less productive you were. But no longer. We are now a predominantly knowledge economy. And knowledge productivity increases with age. (It also vanishes with new knowledge.)

Third, in the short term, whether adding the retirees to working population helps or not depends on skill profiles. If skill profiles of older workers is different from younger workers then entrepreneurs may devise methods to deploy these skills to economic gain. However, if these skills are similar to those of younger population then demand supply equations will come into play and overall effect will either be lower wages or unemployment. 

Fourth, in the long term, younger workers will get re-skilled (hopefully fairly quickly) and create a skill difference that will help the economy.

Fifth, whatever new form social security takes, it cannot undermine the promises made earlier. Government or any party must be held accountable to the promises they make. The lives of individuals are based on these promises. Had the government not promised social security, people may have saved for themselves instead of spending everything.

In sum, the idea behind social security is laudable. The implementation leaves a lot of scope for improvement. 

Friday, October 29, 2010

Are Trade and currency openness complementary?

The recurring discussion about US-China trade deficit and the resultant "currency war" left me wondering about a different solution. Can we link trade and currency openness?

The principle is simple, a country should be allowed as much freedom in trade as it allows freedom in pricing exchange rates. If a country has restrictive exchange rates, it should have trade restrictions as well. In a sense, this should prevent countries creating too-big-to-fail currency problems like China has.

With its asset boom, ghost cities, empty offices, China should have eased up a lot earlier. Given the artificial controls on its currency, the markets could not (or did not) adjust the balance accordingly. The question I pose, essentially a hypothesis, is, doesn't this indicate that the two freedoms, that of currency and trade, be complementary?




My book "Subverting Capitalism & Democracy" is available on Amazon

Thursday, October 28, 2010

Why some imbalances are more important than others?

I am linking to Scott Sumner again. He has a post that identifies the current account imbalances between countries. And he is right, in terms of imbalances, nordic countries have highest per capita surplus than others. However, surplus of some countries hurts us more than others. 

As I mention in my book, the net impact of surplus or deficit depends on the skill profile of the nation as a whole. If the skill profile of two nation matches then the current account surpluses have detrimental impact on the one with deficits. The problem with large nations is that even if the profile of nation as whole is not alike the amount of overlap is significant.

It is because of this mismatch that US is losing jobs. Further, US has not invested in the "next big thing" whatever that is, to create alternative employment for those who lose jobs. 


Links

Monday, October 25, 2010

Comeptitive devaluations - Krugman, Sumner and Yglesias

Scott Sumner remarks on Paul Krugman's post "Worst economist in the world". Krugman is not impressed with the logic, neither is Sumner. Sumner also points to Matt Yglesias who dissects the argument. But the journalist's argument has merit. It is slightly different but I would give it a benefit of doubt. Let me explain:

In normal circumstances, "competitive devaluation"results in inflation. Inflation is OK if income distribution mechanisms are working. So if employment is robust, economic engines are operating, then the transmission of higher oil prices into higher incomes creates a balancing effect by creating higher ability to spend. 

Currently, those mechanisms are not working. So "other things being equal" does not apply today. Thus, higher oil prices will impair the household balance sheets further. At the same time, the increase in input costs will either weigh in on corporate performance or get transmitted to households again. Thus, the rise in oil prices is ominous for households.

However, they have no bearing on international trade. It cancels out.

Meanwhile, there is an argument about commodities being store of value. We need to understand the argument carefully. Store of value has to be independent. Commodities are co-dependent on the economy. Commodities carry value because of the demand. At higher prices, elasticities tend to affect demand and hence the value. The commodity prices may reach higher but will have to come back to demand-supply equilibrium. 

Thus, commodity prices contain two intersecting variables. A measure of value and price as indicated by demand supply balance. Since these two variables are finely mixed up we cannot separate one from other. Thus it is inappropriate to draw conclusions from the prices of commodities.





Links

Wednesday, October 20, 2010

Forecasting equity prices in turbulent times

The markets have been very volatile over the past few years. Investing in these times has been fraught with risks. In such a market, it is very difficult to make investment decisions based on valuation models. Almost always these models indicate that stocks are over priced. Equity fund houses are adding to the confusion with their near-random buy-sell ratings. There seems to be little logic behind these recommendations.

However, there is a method wherein we can logically explain the variations in valuations. We can look at equity prices as composed of two components, a value component and an asset inflation component.

Value component can be expressed as a price band based on fundamental assumptions. The output of most models is usually a price band. These assumption are dependent on the company and economic situation. As we tweak these assumptions for a base case, bull case and bear case we end up with a price band. The price or value is based on various valuation models such as sum-of-parts, residual income, etc. Normally, prices should vary within these bands and the inflation component should be bare minimum. However, in recent years the prices have moved out of the valuation range.

The movement is because of asset inflation because of the high liquidity being pumped into the market. Those are not the only reasons and each market has a different variables that influence the asset inflation for that market. The role of equity analyst, therefore, also includes forecasting the expected asset inflation. From a first principles, in a market influenced by foreign capital flows, average daily volume should be a good indicator. For example, in India, the asset inflation component for large cap stocks with high volumes could be to the tune of 35-40%. For mid-caps or firms out of favour the range may be 20-30% while small caps may have inflation factor of 10%. As the global picture changes, the macro analyst can thereafter adjust the asset inflation component at the country level. I believe this is a better way to present equity research prices.

Let us take an example.  Let us say that the value component for stock like Bharti Airtel comes to INR 300 per share. Now telecom as a sector is a little out of favour and the inflation factor for Bharti Airtel would be lower than usual 35-40% for large-cap stocks. Let us say it is 20-25%. Therefore, the expected price range for Bharti Airtel will be INR 360-375.


Disclaimer
Long Bharti








Tuesday, October 19, 2010

The Foreclosure Mess and justice

In the blog "The big picture", David Kotok has a very interesting article on the foreclosure mess. In the context of that article I would like to make a few comments. 

Before the comments, I must state that the issue, like all other in this crisis, straddles the political, legal, social and financial sectors. As a preamble, we must look out for the interest of individual as that is the primary responsibility of the courts and the governance mechanism. We must, like I say in my book, differentiate between real living citizens and firms that have acquired citizenship. It is time for the congress, government and legal apparatus to stand behind the interest of individual. Here are my comments:

First, both the defaulting lender (genuine defaults) and the institutions that misplaced the promisory note are at fault. However, the court has to evaluate the gravity of the situation and that depends on the relative bargaining power of the two parties. The question of relative bargaining power is very important as I discuss in my book Subverting Capitalism and Democracy. The bargaining power equations are clearly favoring the institute. The responsibility of the court is, therefore, to protect the interest of the weak i.e. the individual. Even if it means, in some cases, rewarding the mistakes of individual. Further, the individual will obviously pay for the mistake through higher taxes and loss of jobs. In all fairness, she will pay no matter what the outcome of the foreclosure.

Second, if the chain of title is broken, the person who can defend the title should have the right to initiate foreclosure. However, the person must show unequivocal demonstration of the title. In all probability, an institution within the chain of title cannot establish this without dispute for those downstream will challenge their claim either as fraud or will stake their claim to title. In the light of this claim, it is unreasonable to ask the individual to make a payment.

Third, if it was a matter of making payments, courts could have ordered payments into an escrow account to be allotted to those who can establish rightful ownership. The interest rate or size of payments should be in accordance with the agreement, or if the agreement fails to establish clear rate of interest, it should be at the interest rate set by the Fed. Similarly, courts can initiate a suo-moto foreclosure in cases where it is clear that borrower willfully defaulted and recover the money through auction of the property. The recovered money can then be transferred to escrow account waiting to be claimed by rightful owner.

Fourth, in all fairness, courts must set out limitation date for the title to be clarified. Without a limitation, the process can drag along for years. It is unjust to the individual.

Finally, in all the situations the outcome for banks, mortgage brokers and investors in mortgages are grim. Either way, we have a problem on our hand. It clearly means that banks and other intermediaries will need a bigger capital buffer than what they are currently carrying. Further, approximate estimates peg the capital requirement to be much higher than during 2008 Lehman episode.

It appears that the financial institutions may have realized this and initiated a global pull-back of capital. It is possible the recent correction in global equity markets are a result of this problem.

Notes

Thursday, October 14, 2010

Why foreign funds are preferring EM banks?

I was wondering why banks are the first object of desire for foreign funds in the emerging markets. Given the view on the currencies, I expected foreign funds to go after relatively(in currency adjusted terms) cheap EM- hard assets. I did not think banks would be such overwhelming favorites. However, the preference for banks seems to have some logic.

Banks in emerging markets have lower cost of funds as EMs have higher savings. The stress on bank incomes is lower as economy is growing and banks have first claim on the corporate income. Third, despite inflation pressures, FII flows and US FED's near zero interest rates are keeping the interest cost low. This has reduced the probability of defaults for large borrowers. No wonder this is most viable entry point for foreign funds.

Disclaimer
Long SBI





Wednesday, October 13, 2010

Fighting the Currency War

There is a lot of debate about how to fight the impending currency war. The problems are more from the US point of view rather than elsewhere. Let me explain.

US cannot unilaterally set its exchange rate. 
There are two ways of modifying exchange rate.  One ways is to clearly set the exchange rate and defend it using central bank intervention. This tool is available to smaller economies who peg their exchange rates to the dollar. But it is not available to the US as the economies of other countries depend on the US consumer. Its only way out is to convince other countries, those whose domestic jobs and economies depend on US consumer, to ease the exchange rate. US tried to convince China with the same intent. However, it is not China alone that poses a problem. The entire set of countries that use this export-dependent strategy should revalue their currencies simultaneously. Since these countries are adamantly defending the relative exchange rates, US seems to be in a state of crisis.

The other more fundamental way is to indicate to the world that the stock of money has gone up disproportionately as compared to GDP.  US has tried to print money. But it has not caused any effect. The printed money simply flows out of US into global equities, commodities and other asset classes. Further, if I get more US Dollars I can park them with other economies and wait for exchange rate reset to give me substantial gains. The more exchange rates are suppressed, the more I have to gain.

This conundrum, obscene as it is, is due to the fact that USD is also an international currency. To have a credible effect, the volume of printing must be in relation to global GDP and not simply US GDP. At USD 15 trillion, US GDP is about a third of global GDP. So you need three times more printing. Further, if US currency devalues erratically then the entire burden of currency will fall on US domestic economy. Herein lies the dilemma. It is a lose-lose proposition.

But there may be another way 
I think US may be better served by front-ending its borrowing program. The US can initiate a borrowing program equivalent of 10 years of borrowing. This program should be completed within a year. Only a part of this program will be successful. However, it will pull the global liquidity towards US while money printing is pushing liquidity out of US. It will force other banks to print and buy US bonds or let their exchange rates appreciate. Usually, governments are wary of failed bond auctions. In the case of US, this is not an option for the other countries. They need the US consumer more than US needs them. US can also set trade limits based on amount of USD reserves held. In other words, let other countries put a price on each job they are defending.

However, US needs to have a credible plan to invest this high liquidity that will flow into the country. Using this liquidity, US should get out of the recession.

Then, we must consider unintended consequences. A front-ending of borrowing may upset lenders like China. How China will react to such a policy is unclear. But it is reasonable to assume it won't be pleasant. In effect we will face a lot of unpleasantness. But then it is a war, isn't it?


Notes

Friday, October 01, 2010

Tax reforms - Ezra Klein makes a valid suggestion

Ezra Klein comes around to the idea that I have been talking about for years. He argues that we should get a receipt for our taxes.

A tax utilization break-up
While the general budget does give a broad outline, person specific contributions should be a right of the citizenry. Ezra draws similarity with food ingredients and calorie break up. To take the analogy further, government budget is equivalent of stating national food ingredient and calorie consumption. It makes little sense to the individual. We should get a break up for how our taxes are allocated.

Individual tax allocation choice
I often think about giving the choice of allocating tax dollars to the individual. I believe, in a sense, it will be a pragmatic manifestation of democracy. Embedded within this idea are two critical ideas.

First relates to relation between democracy and empowerment. A first principles analysis suggests that democracy is about empowerment of the masses. Our recent iteration of democracy is masses empowering the government. There is a substantial difference in these two points of view. 

The idea refers to the differences between masses and government. Our iteration of democracy views masses (or citizenry) and government as two separate agents. The result of this differences is evident in intellectual differences in opinion of masses and those of government.

Further more, government is now a seat of power and thus no different from the monarchs and nobles of yore. The first principles seat the power at the hands of the people. It creates government as an agent to exercise this power. Government does not acquire but borrows the power from the people to enable people to exercise their mind and opinion.

The second idea relates to the (wrongful) importance of keeping tax policies away from citizens. Governments, like monarchs and nobles before, believe people do not want to pay taxes. They have no qualms in believing that these same people will understand credit card statements easily. I do not agree with this point of view. I believe, if we trust the citizens to allocate taxes we may get a fairer spending that may actually benefit the citizens.

I believe, by taking away the ability to direct taxes from the citizens, government is limiting democratic rights. Years ago, before the advent of computers, it was not possible to allow citizens to take this responsibility. However, current technology that allows these same citizens to vote in American idol based on performance, can be used to allow citizens to make these important choices.

In sum
Sometimes, by giving responsibility to citizens, we may make them responsible. We can also foresee a possible disaggregation of governments into policy designers and bureaucracy. We do not need to career politician as a policy designer.

Links:


I discuss governments and taxes in my book "Subverting Capitalism & Democracy" is available on Amazon

Tuesday, September 28, 2010

Roller coaster - Welcome to the first loop

The equity markets are rising the world over. The rise, I believe, is our first loop in the roller coaster out of crisis of 2008. This cyclicality was to be expected. We are, now, close to the pre-Lehman levels for key global markets. Yet, I believe we are still part of the overall down-cycle.

Cyclicality is result of slosh money 
As I mentioned in my book, the cyclicality is the result of slosh money. As I define it, slosh money refers to large pools of capital that can move through the global economic system stressing the archaic regulatory framework. 

Slosh money is herded thanks to lack of divergence of opinions. The lack of diversity of opinions is truly surprising. In times of crisis, the diversity of fund allocation increases, may not be within a fund, but overall between various funds. I do not see this diversity developing.

The down-cycle continues
The down-cycle will continue post these current peaks. I still stand by my 2008 post about cyclicality. The frequency of the down-cycle has come out to be 8 GDP reporting periods rather than 4 as I predicted. The bottom of the next cycle will be deeper and sharper than the first cycle. The next cycle may be, in good probability, the last leg of down-cycle. 


Tuesday, August 24, 2010

Trade Wars & Currencies

Michael Pettis worries about a trade war between surplus countries and deficit countries. The basis of the war is two fold.

First, the US Dollar is the unofficial world currency. In that role, it has to function as a store of value and a facilitator of international economic growth. As such the US has to bear the responsibilities. This constrains the US Government. 

Second, we can alter or manage other global currencies and its value in US Dollar terms. This comes at a significant costs but it is doable. The most popular method is through intervention by central banks. Central banks buy or sell their US Dollar holding to keep the exchange rates in check.

Problems for US
The impossible trinity applies to the dollar's case in a different manner. US government has open capital system and flexible exchange rate so technically this should be a non-issue. But there is a problem for US. The objective for managing the trinity is to manage the economy and the trinity represents tools to that effect. In the case of the current trade war with US and surplus countries, these tools contradict each other and render US policies useless. The constraints will either cause US to bailout the world or there has to be a restructuring of the global currency system.

A two-level currency system
It is clear that US dollar cannot and should not serve as a global and national currency. A rational solution that maintains the sovereign independence while serving global trade and growth needs comes from a two-level currency system I proposed earlier.





Links:
Two-level currency system - Rahul Deodhar

PS: This is the 200th post on this blog. I started the blog in 2004 with focus on companies, innovation, investments and ideas about future. Over past few years the focus has been exclusively on the crisis and its solutions. It is read by 20 people every day. Thank you for being by co-travelers.


Saturday, August 21, 2010

Pseudo Keynesianism

As a solution to the crisis, I am more inclined with Hayek approach of taking the pain quickly and all up front rather than prolonging it as Keynes recommends. However, I dispute the interpretation of Keynes by modern media and experts.
Michael Pento has an interesting article about Keynesian approach. He uses the metaphor of an obese man getting opinion from Hayek and Keynes. While Hayek advises cutting down on food, Keynes advises opposite. And there in lies my problem with interpreting Keynes in modern context. 

At a very simplified level, Keynes suggested that keeping the aggregate demand stable should be the focus of government. While this is true, I believe given the context of the situation Keynes lived in, it is not the interpretation we must derive for our times.
My interpretation of Keynes
Keynesian solution, to my mind, is about bringing certainty on the job side. At what level of income this certainty comes is, just my argument not Keynes, immaterial. So the objective of Keynesian stimulus is to create stable employment. The aim of stimulus is not to push the money through the banking system to achieve this effect, but to use a robust, loss-less mechanism to achieve this end. If the banking system is impaired, it cannot be loss-less mechanism of choice. In such cases direct government employment is better alternative.

Keynes famously argued that how you deploy this manpower is irrelevant. For all practical purposes, he argued, you may simply dig a ditch and fill it up. The real deployment of Keynesian stimulus was targeted towards infrastructure construction. The highway program is a prime example. 

In my view, Keynes would have agreed with Hayek's solution. His endeavor may have been to achieve the change without the pain involved in Hayek's solution. Whether it is possible to change without the pain is a different question.

Keynes and Hayek as alternative approach to same solution
I believe, there are two ways to solve the crisis. 

First is by using the Keynesian solution in the right context. So focus on employment rather than bailouts. Focus on flexible employment rather than entrenching unions. A misdirected Keynesian approach is very costly.

Second approach is by using Hayek's solution. Take the pain, and thereafter let the economy revive. This approach does cost less and has no future tax repercussions.

The dangerous combination
Often what results as policy makers with little grasp of Keynesian option abandon it earlier and switch to Hayek eliminating all the future tax benefits built into Hayek's solution while causing as much pain before the recovery. The Hayekian recovery also takes longer as the first round of Keynesian stimulus, in all probability, has added to mal-investments. We are exactly at this point. The first few rounds of stimuli have been hardly successful. They have or will soon result in mal investment. Where will go next?

Saturday, August 14, 2010

The truth behind Encouraging home ownership

Here is a link I got today through Yves Smith at nakedcapitalism.com. Feds rethink policies that encourage home ownership - USATODAY.com. With the amount hubris exposed in recent months I doubt if home ownership was promoted for the sake of citizens.

Asset backed paper vs. Casino's deck of cards
A casino has as many decks of cards as it needs. The real world casino "the financial markets" do not have such access. They need each card to be backed by an "asset". Asset could be wide variety of things. It could securities or bonds which are ownership title of businesses. Assets could be the resources in stock piles or a right to use (mining) those resource like oil, coal etc. Now what if there is too much money at the hands of the too few people (mostly what I call big money - funds). These people can gamble a bit but soon the price behind one deck of cards goes through the roof. That is the time to bring in additional deck. So how can we create such real world card decks easily? Home mortgages!

If homes were exhausted, we can create MBS, CDO - more decks! Once that is done we can create default swaps on them. If those were exhausted we can create CDS on insurers of CDOs. Jolly God! here is the eternal fountain of asset paper - inexhaustible source of deck of cards!

Morality for you - profits for me!
I am surprised how economist expect the homo economicus can be expected to behave rationally for everything else except for mortgages defaults. I would rather encourage people who cannot pay to default. After all companies do it all the time and their credit rating does not get impacted.

Friday, August 13, 2010

Comments on Microsoft

John Hempton, who fabulously broke the banking solvency talked about Microsoft recently. In the third post in the series titled Microsoft – an accounting geek’s summarizes his purpose and lessons. I wanted to add some comments to this since the first post. So here it is:
  1. Bundled software in India:
    • India still sells laptops without the operating system. The proportion has gone down but it still exists where dominant volumes are.
    • Ubuntu and Linux overall has not caught on because it is not user friendly. As it gets friendlier, expect Indians to move to Linux versions faster than Microsoft can cope with. All Microsoft needs to do is support XP. A lot of pirated Windows XP is still being used.
    • Such a response is currently underway in mobile phones. I believe it makes sense it happens in mobiles first because, device capability is limited, hardware is cheap (from china) and Indians have unique needs (apparently more Indians need dual SIMs than elsewhere - in pagers we preferred the alpha-numeric ones etc.) I can't see why it cannot happen in laptops. (More about it below)
  2. India Volume play suits Apple more: If you think about volumes as a driver, Apple makes much better sense. 
    • We are paying $1000 for iPhones and if you see the penetration you will be amazed. If iPhone were to be available at $500 equivalent Apple would not be able to handle the sales volume. The user interface is mind-blowingly simple even my mom and dad got it right away. (They don't speak computer English). It is very intuitive. Through iPhones and iPads Apple can make a huge in-road into Indian market. They have to price it right though.
    • Why I discussed about iPads is that most users do not need a laptop or a computer. They simply need a device that can connect them to the net. A phone is a little small for the purpose but a tablet is ideal. Indian government announced a tablet PC for $35 and it is pretty ok with camera and it works on Android. (It is for education institutes)
  3. User friendliness is still paramount: While I worked on and loved Unix (was a programmer) but I think for regular computer usage, MacOS, Windows make lot more sense. Android is emerging as a significant alternative in tablets but it is nearly as good as windows CE. 
  4. Distributed legal liabilities: Unix and its versions are popular for server side because of customizability. There is other side to the equation. Security is costly and Microsoft cannot release a lower end product without risking security issues. It is an easy legal target if it fails. So it has to put in lot of effort just to ensure base level security. Linux falls through the legal cracks as the legal liabilities are diffused. Just as small revenues amplify so do small legal claims.
  5. About security: Security issues are dominant concern for Microsoft. It does not have control over where its operating system is being deployed. It does not know if clients are updating the OS or not. With emergence of Software as a service model (SAAS), Microsoft will breathe easy. I expect as SAAS starts getting prominence, MS will start unleashing its programming prowess to more beneficial use.
  6. Still top institutional service provider: Microsoft juggernaut is large and has tremendous inertia backing it. The IT departments of top Microsoft clients are testing versions to be released in 2011 and 2012. Frankly, even Apple does not have that kind of sales and testing infrastructure on institution side.
  7. MS as fast follower: For the consumer side, Microsoft is better characterized as a fast follower than a tech leader. It has always copied Apple and will continue to do so. (Panasonic to a Sony). There are two scenarios from here:
    • Currently the environment is in flux so we cannot see Microsoft response but response will come and it will eat away a substantial share.
    • The model has changed to a long-tail model. Microsoft noticed this with Zune. It came in very late once the product stabilized but that was too late for the market. So it is match step-by-step in phones. Here too it is a bit late but faster than with Zune. Eventually it will figure out.
  8. It is the Microsoft game: The game Apple is playing was invented by Microsoft: 
    • Microsoft dis-assembled the IT hardware and software value chain. It broke the integrated approach of IBM. Apple followed IBM model in hardware and OS and used Microsoft approach with additional software. But overall Apple is still more in IBM mode.
    • Apple is breaking the mobile phone software value chain but it retain the hardware approach of IBM in phone space. In phone space it HAS to break the software value-chain. It is doing this through App architecture. That is straight into MS territory. Apple will face same issues as MS if it were as important to business community as MS. Thankfully Apple is sticking to consumer electronics side.
    • Blackberry is more like thin-client server model we know. A Google-wave like protocol will break this model. My guess is Microsoft will break blackberry.
    • The reason MS cannot fight easily because of legacy codes. Phones need light codes but MS codes is HUGE. But in phones and in computers MS has changed its stance to scrapping old format all together. MS will gain from it because there is so much knowledge that it has but cannot use - now all that will be possible.

Disclaimer: I am an Apple fan but I love Microsoft as well. MS Excel is probably the best product every produced. It also makes awesome mice. This is discussion about future of tech and not stock analysis of Microsoft.