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Tuesday, June 29, 2010

Counterfactual: US government uses bailout funds to create a bank

Note: This is counterfactual. So US government did not actually do this but I am just guessing what would have happened if they had done it.

During the crisis, US government initiated a bailout of approximately trillion dollars. Out of this about USD 700 billion was under TARP regime. What would have happened if these funds were allotted as equity in starting up a new bank -say US treasury bank or T-bank for short.

T-bank would be mandated to have 50% fresh lending and 50% buying impaired assets through bankruptcy procedures. Every other bank in US and post offices would be required to have a desk for T-bank.

Since the creation of this bank was forced on to the government, government will not pay the other bank branches for use of their office premises. The postal offices should be readily accessible to the government any ways.

T-bank would finance mortgages based on new assumptions about price. The price may be decided as average of past 20-year prices or current prices whichever is lower (or some such super conservative metric). T-bank will only finance 75% of the value of the house so calculated.

Loan against collateral will be instituted in similar to mortgages. An assessment of recoverable value of the collateral will be determined. It will be marked down by certain percentage to ensure full loan recovery in case of default. It will also check for equity contribution from promoters. Promoters will be required to give personal financials for verification. The financials will be checked to verify if promoter equity is indeed equity and not debt masquerading as equity.

T-bank would initiate a simplistic credit card program. Customers will get one-month credit at fixed rate of 10% (or some such number accounting for risks). T-bank credit card will not have fees.

As per the mandate, T-bank will be compulsorily and irrevocably privatized after 20 years at the maximum.

I believe this initiative would have immense advantages.
  1. Since the costs are higher large businesses will not use this service leaving this money free for use by small businesses. T-bank, if so required, can be mandated to lend to SME and individuals only.
  2. It will channel the money flow directly where it might make viable contribution. Creating money in balance sheet of large banks is like pushing on a string. The money simply does not flow to the grass-roots.
  3. The current situation prevents eligible borrowers from borrowing because of the crunch. This is the best time for such borrowers to start enterprises and take risks.
  4. The charges may be higher, but treatment will be fair so competitive forces may start assisting systemic cleanup on credit card and loan frauds.
  5. It neutralizes the possibility that banks may hold the financial system hostage.
  6. It presents no moral hazard since it does not interact with banks' assets at all. 
  7. Further, since treasury or government is backing this bank, it has lower risk. Thus it should be able to access funds at very low rates.
  8. The efficiency of this money, or the impact this money creates, will be far higher thus size of bailout liability will be smaller.

Interesting isn't it?

Friday, June 25, 2010

Impairing household balance sheets

The western household balance sheets are substantially large. But the recent crisis has brought about serious change in asset valuations. As the assets devalue and there is a corresponding impairment in the equity or debt side of the balance sheet.  If asset devaluation reduces your loans then balance sheet quality remains unaffected. For the US housing assets, the debt side was reduced. Hence while winding down of housing reduced the size of balance sheet it could not have impaired its quality. So the problem of US housing may have been lesser than anticipated from household balance sheet point of view.

The bailout, however, shifted this burden from bank balance sheets to government balance sheets. Now, government balance sheets are fed from household and corporate incomes. Thus what was earlier a housing loan problem is now a tax problem. In other words, the problem shifted from household balance sheet to household cash-flow.

On the credit card debt will be more tricky. Credit card debt will not be reduced in usual circumstances. The hit will be on equity side, thus severely impairing the balance sheets.

The cash-inflows are reducing while the outflows remain. The bailout has added a large chunk of committed cash out flow. Households will have to find matching inflows to offset this burden. Thus there is tremendous free cash flow problem.

Increasing government inefficiency, as government gets bigger, will only add to this burden. Unlike housing loan there is no jingle-mail option for taxes. Taxes, like death, are a certainty. So the bailout has shifted what was essentially a quality-neutral adjustment into a large impairment in balance sheet quality. 

So the western households will have to go through a severe pain before consumption returns to the pre-crisis level. This problem is going to haunt us for next half a decade unless we come up with some really radical solution.

Tuesday, June 22, 2010

Two-level currency system

Let me first confess that I was a proponent of single global currency system. The quantum of trades in FX was so huge that I thought it must serve no important purpose as the cost indicate. However, over the past two years my view is now leaning towards a two-level currency system. To understand this let us first understand few short points that I have already made in my book "Subverting Capitalism & Democracy".

Two functions of currency
A currency system needs to have two critical functions. First, it should reliably communicate price information. Second, it should facilitate the transactions in the economy and not hinder it. Given these two functions, a high or loose money supply distorts price information but allows enough money for transactions. A constrained money supply does not allow transactions to happen thus possibly limiting growth. Thus, the increase in money supply should account for the following:

  1. The increase in the economic value being created in the economy. The higher money supply should support the exchange of these new goods, new services etc. (Simplistically let us assume 3 units growth was achieved)
  2. The decrease (or increase) in the need for money because of efficiency in transaction creating additional velocity. This refers to structural increase in velocity rather than cyclical changes (let us assume velocity grew accounting for 2 units increase in money supply)
  3. The increase in money inventory (locked up money) as activity increases (let us say 1 units)

So the net increase in money supply should be +3-2+1 = 2 units. Now each of this is difficult to determine as it is. So I think Milton Friedman implied that the actual increase in money supply should be a little higher than 2 say 2.2 units. This leads to inflation but that is better than deflation (separate debate). 

Further, we need reliable mechanisms to measure each of the three. If there is no confidence on the measurement we do not have a monetary policy. This is the problem with Euro. Fudging of sovereign balance sheets and finances have impaled the confidence in the monetary system.

Two-level currency system
An ideal system, I think, may be a two level currency system. A currency at the national level should signal the relative prices of goods and services in the economy. An international currency should signal the confidence in the judgement exercised in national currency. The international currency therefore decides the relative prices of currencies and thus of everything.

In pre-Bretton-Woods  era we had gold as an international currency while Bretton-Woods established US Dollar in that role. The system, however, leaves the world vulnerable to US monetary policy misgivings. The world does not have a mechanism to communicate the confidence in US monetary policy.

In sum
When we evaluate US monetary policy, I believe, we should do it in relation to world GDP growth, interest rates rather than simply to US growth and interest rates.

A currency without the legal charter to measure other economic variable does not make sense. Thus, community-level currencies (some experiments are being conducted in the UK) do not make sense unless they are deflationary by design.

We need a extra-national currency to signal confidence in national monetary policies. The money supply, in this case, should grow at the pace of world growth.

Over time as confidence in global measurements of economic activity grows, we can move to a single currency albeit accompanied by a single global monetary policy. Till such time a two-level system may be better.

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

Sunday, June 13, 2010

Income and intensity of unrest

History is littered with examples of the ruling class trying to keep the masses impoverished. I always wondered why it was necessary to keep people impoverished. Why can't people be rich and still suppressed? It seems to me that the problems of poor and nearly poor have different impact on social unrest. First, money gives a means to the poor to battle for their rights. Second, if people with means see someone they can identify with being oppressed then they are more likely to do something about it.

What this means is that income distribution in the form of a pyramid, lowest income has highest population, is better suited for oppressive regimes. And as income distribution turns into a diamond shape (middle class has most population) things start turning around. For a while middle class builds safety nets to prevent falling back. But once such a safety net is in place, it seems, this mass of population gets politically active.

The unrest so caused, is more potent and revolutionary than unrest of poor masses. I believe China is at such a point. The flexibility of Chinese political system will be tested very soon (may be 3-5 years). The political system in China is more rigid than a democratic system. If its leaders are able to understand and respond to these changes (they have shown more promise than politicians of other nations), then China will be the superpower. Otherwise we will see flimsy wars and deliberate crisis creation to take focus away from internal situation.

India is also likely to see this change in similar time frame, but the democratic setup is super-flexible and thus unlikely to impact much in India. The changes too are much more evenly spread. A lower-income-class bias in policy has started gaining traction since 2005.

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

Friday, June 11, 2010

Co-locating Risk and Rewards

If risks and rewards are not located at the same place it indicates that the system is broken. In a fundamentally sound system, higher risks yield higher rewards while lower risks yield lower returns. Stability and resilience of earnings or profits is characteristic of lower risks. High risk earnings tend to be volatile. However, when a sector gets stable high earnings without as much volatility we must conclude that system is broken. This is typical of financial system. 

The risks are being accumulated at government agencies while rewards will be released privately. It is one of the reason why Too-big-to-fail was a hazard. In simple words, TBTF held governments hostage forcing a transfer of risks and penalties to the public system. 

Firms routinely exercise strategies and tactics to shift risk out of the firms domain while retaining the rewards within the firms' domain. This, to my mind, is the goal of the bargaining power struggle well characterized by Michael Porter. Porter also suggested, as I interpret, that the system will stabilize at the point of fairness.

A fair firm is one that has returns in line with the risk it takes. It is able to take such risks because of knowledge and understanding of the process. However, through regulation and other intervention, it is possible to tip the bargaining power dynamics one way or other. I believe that is exactly what led to current crisis.

A crisis-detection system should use this property to flag potential crisis.

Thursday, June 10, 2010

Emerging Markets are too small!

There has been some talk lately about Emerging Markets, mainly China, saving the world through growth. I do not think that is possible. The size of developed markets is simply too large for emerging market growth to register any meaningful impact.

US, Western Europe and Japan together account for almost $40 trillion of world GDP of ~$55 trillion. US is about ~$14 trillion, Europe is ~ $17 trillion, Japan is ~ 5 trillion. BRIC countries account for $8 trillion. A meaningful part of BRIC's domestic GDP is dependent on growth in developed world. A slowdown in these countries will impact this part of GDP. BRIC countries may be able to cannibalize domestic GDP from developed world but overall we will be net losers.
An analogy I like is that of Titanic. The developed world economies are like titanic while emerging markets are like small yachts.Yachts cannot save all the passengers from the Titanic. So we should work to keep titanic afloat.
Co-dependent growth is the best way out. But such growth is not possible unless we put our houses in order.

Tuesday, June 08, 2010

Government and Markets are competing systems

After I shared the list of ideas (download from Scribd) I discussed in my book "Subverting Capitalism & Democracy" (buy on amazon) I have received my first feedback. Ellen Di Resta, an innovation consultant and a dear friend, liked my proposition that Government and Markets are competing systems. Understanding the implied competition is critical to understanding role of governments and markets.

I believe that both government and markets are will of the people. People express their opinion through votes and through prices. Today, voting is limited - at the most about 50% people vote. while  almost everyone, including the poor, are connected to the markets. It appears that markets are better equipped to solve or do as people want. However, there are differences. 

Firstly in the way we pay for services of governments and markets. Markets use efficient mechanisms (pay-per-use) while government uses unfair mechanisms (everyone pays - as taxes).

Secondly, markets are exclusive. They are open to those who bring value to exchange. The influence on market is proportional to the value you bring to the market. Government, on the other hand, is inclusive, more just. Everyone has the "right" to participate. Everyone participates equally.

I argue that since people participate in both, they often confuse their roles. This allows, I believe, expanding governments, weaker regulations and general dissatisfaction with the government about taxes. I believe we need to fix this to get to a better system. 

We should interpret the responsibility of government in this context.