Friday, July 30, 2010

Small and ineffective stimulus in 2007-2009

Paul Krugman has an blog post titled How Did We Know The Stimulus Was Too Small? He discusses three points. First shortfall was about $2 Trillion. Second, the stimulus was designed at $780 billion. Third, the multiplier that was expected to magnify the impact was not properly enabled. 

There are few points and other reasons that I have highlighted over the days:

First part of stimulus went to mending the financial system. This part is basically used in wetting the system rather than actual priming.

Second, the type of activities under stimulus determines the effectiveness of the stimulus. Some activities are better at stimulating than others. Income supporting activities are often better at stimulating than consumption driving activities. Thus the proverbial dig-a-hole-fill-that-hole Keynes stimulus had better bang for the buck than the Obama-Bush please-spend-the-tax-cut stimulus.
Third, individuals save because there is uncertainty about incomes. The only way to counter uncertainty is by creating certainty. It is OK if the level of "certain income" is lower than actual. Once there is certainty that bottom is in place, the direction of wage declines stems and even reverses.
Fourth, the choice of monetary or fiscal stimulus was available in 2007. It is still available provided you write-off the stimuli till date.

Fifth, Scott Sumner proposed that monetary and fiscal policies were acting against each other. There is an element of truth to this argument. However, predominantly the fiscal stimulus failed because it was ill-designed.

Sixth, since banking system was under threat,
    • I would have created a parallel national banking system using post office infrastructure. 
    • This national bank would have bought assets from the consumer (mortgage transfers) at a marked-down prices so that the balance sheet of this bank stayed healthy.
    • Since we did not do this, we have a huge bailout liability and we are still not sure if banks are sound or not.
Seven, if we had designed the stimulus better and gone with a simple job-creating fiscal stimulus, we would have needed far lesser money that we needed to bailout the banks.

In Sum, there were a lot of things wrong with the stimulus. Size was just one of them.


Tuesday, July 27, 2010

Comment on Sumner's article on Reallocation to housing in 2001

  1. I agree with Professor Sumner's general view that during a slump (or reallocation) the right metaphor is like a bicycle going uphill. Fed is the cyclist pedaling vigorously. But if the effort is not about a certain threshold (NGDP) the bicycle will roll backward. You argue that the effort was below the threshold. I agree with this.
  2. While I understand the simplification, I am not convinced with housing vs tech. The reallocation should search for better (more investment worthy) assets. I don't think housing was "better" asset. It was chosen (I think it was deliberately chosen) as it was the only one that could absorb large volume of investments. I believe, had we not interfered, markets would have discovered alternate energy or some other investment-starved sector. 
  3. Housing is wrong choice. It is a dual-good. It sometimes works as consumption good other times it is investment good. Possibly housing as a consumption good may have been a cushion. But as investment good, it was only other bubble. Subprime is not a shock but a logical conclusion of an investment good being pumped with excess investment.
  4. I think there is a threshold level for money ( I use term loosely) in the economy. If total money in the system goes higher than this the system (if we let it be) creates deflation to destroy this excess. This deflation happens at the hands of those who have money invested. It happens in the rich balance sheets. The problem is it often overshoots the ideal level hence we want to control the process. In our zeal to control the process, we shift the deflation hotspot to public balance sheet or citizens balance sheets. This creates a problem of affordability. The few rich balance sheets could have afforded to deflate to a large degree but many poor balance sheets cannot deflate even to hundredth of a degree. Further, the rich balance-sheets willingly took the risk of investment while poor balance sheets were stuffed. This is the socialization of losses we talk about.

I have discussed some of these ideas in my book "Subverting Capitalism & Democracy"

Friday, July 23, 2010

The Problem of Regulation

The regulatory juggernaut has slowly and eventually reached the gates of wall street.

Regulation, it appears, needs to tackle three issues. First, it should clarify the parties involved. In other words, regulation clarifies attribution or ownership. Secondly, it defines the action required. Finally, it defines the timing for the action. The rest of regulation merely defines the referee and the incentive structure to encourage or prevent the actions. Any regulation without these parts is open to be hijacked or misinterpreted. 

Regulation must clearly specify the action that should or should not be taken by the participants. In most cases, regulation must be designed to rebalance the bargaining power equation. The objective is to prevent the stronger player from taking advantage of the weaker player. The consumer financial protection agency is ideally defining such actions. This part often suffers from necessary and sufficient condition dilemma.

Necessary condition and sufficient conditions are best understood through the example of fire. The existence of fuel, air (or oxygen to be specific) and a spark are necessary conditions for a fire. However existence of a fire is sufficient to prove existence of fuel, air and the spark. Regulators often go to depths defining necessary conditions but often do not define the sufficient condition. Over time, the necessary conditions increase as new special cases are discovered. It makes the regulation unwieldy and creates loopholes in the regulatory paradigm. 

However, just defining the sufficient condition leaves the law ambiguous. This is the type of ambiguity that Paul Volcker likes. However, in the wrong hands such an ambiguity corrupts the system.

Friday, July 16, 2010

Real Estate Mortgage problem and deflation

Barry Ritholtz links to a post by Dhaval Joshi, chief strategist at RAB Capital about size of the housing mortgage debt problem. Dhaval Joshi quantifies the size of the problem. He believes the value has to drop by about $4 Trillion to revert to mean values. This is approximately 27% of annual US GDP. This size of deflation has repercussions.

In whose hands assets deflate matters
Typically, asset price increases happens at the hands of the rich. (The causality is inverse - asset price increases result in wealth.) However, where does the asset price decrease happen? The answer to this question determines the power of the corresponding economic slowdown. 

When housing asset prices declines, the asset is usually at the hands of common person and the downside impact of price decline hits the common person's financials. In that context, the current crisis was safer (we may say most crises are). In this crisis, we can argue, a dotted line ownership of the assets, through MBS and related derivatives, was in the hands of the financial institution. The devaluation of assets, thus, was happening at the hands of the rich. (It was also happening at the hands of the poor is incidental for what I am saying).

I contend that bailouts are causing a change of hands. Through bailouts, the burden was passed from financial institutions to the tax payer who is the common person. I think the bailout may have doubled the burden on the US tax payer. Can we say, US tax payer will effectively bear a burden of nearly $6 trillion?

In this context my public bank proposal seems more effective
If the government had set up a public bank to buy back mortgages from current banks, we may have avoided twin problem. I had proposed that the bailout money be used to create a public bank that will buy existing mortgages from the home-owners allowing them to reduce their debt while pushing money in proportion to asset quality. This solution appears more favorable to me now. First, the large burden of bailout would not rest on tax payers. It would have gone to other investors when the bank is finally privatized. Second, it would put a bottom on the home prices and thus not allow household financial to deteriorate drastically.

Given the options on the table, even now this looks better.

Healthcare and Pension - Unkept Promises?

The US deficit situation is dire. The option proposed is a drastic cut in healthcare and pension. Aside from the economic imperative, we need to ask if it is fair.

It was an unfair promise
One can say that American workers (including knowledge workers) overestimate their contribution, at least compared to the workers (note-1) globally. On the flip side, we can say that the wages the world over are depressed.  In whatever terms, option of cheaper workforce existed. Prior to the tech boom, such a workforce was not accessible (note -2). Thus the dependance on American workforce was higher which reflected in the wages and benefits. We may conclude that on the whole, American workers were promised higher benefits in terms of healthcare and pensions.

But it was a promise nevertheless
But whatever the promise was, the benefits were promised to the workforce. It gave the population a feeling of comfort about their future. It is possible that this comfort allowed them to spend more than otherwise acceptable. To renege on this commitment can be viewed, to a large extent, as a betrayal of the population.

On the other side, I cannot see why the ratings agencies cannot consider this as a default? At the very least it is restructuring and definitely not a behaviour fitting a AAA institution. The problem, I think, is how a government and its people are perceived. The sovereign ratings refer the ratings of the government. Can we think of government as different from its people? In spirit of the political set up, no. But reality suggests differently. 

Political setup is far removed from the general population
The political establishment is no longer a true representative of the general population. There has been a systematic undermining of legitimate political rights of the general population as I argue in my book. That we are discussing openly laws or portions of laws being thwarted by big institution is a disgusting reality. Just today, Barry Ritholtz highlights on the Times covers about lobbying efforts.

In such a scenario, is it fair that government should be seen as acting in connivance with the general population? I don't think so. This does turn many assumptions about "investment grade" upside down. Even then, I do not see investors discussing these issues.

Worse, the population is too naive to understand
The final straw is the reluctance of the population to understand. As if it is in a deep slumber, the general population does nothing! To a certain extent, they deserve it. 

  1. For the purpose of the discussion we adjust for productivity - implying we are comparing workers with similar productivity level.
  2. The tech boom combined with globalisation enabled better access to such cheaper workforce option. It is one possible causes that may have resulted in wage stagnation in US.

Tuesday, July 13, 2010

Measuring real value

What is a measure of real value?
Now we cannot measure value but in terms of money. It means all our measurement of value is relative. It is like measuring time in terms of heart beats - 1 minute is 60 beats. Now if you start running (say printing more money) then will you have more minutes? Of course not! We will have to adjust the equation of how many beats make up a minute.

Modified Gold standard or constant money
Let us look at the modified gold standard - modified for simplicity. The total amount of gold in the world would remain constant. We would keep creating more value. So there will be natural deflation. The amount of deflation will tell us how much value we created. This is fine overall but total amount of gold is not fixed. It grows arbitrarily. So when Spanish empire discovered huge silver mine (also used like gold) they had a problem. So will we if some buried gold is suddenly discovered. Further, as I argued in my book, gold promotes hoarding while slight inflation promotes transactions (or velocity hence GDP). So gold may not be appropriate.

I believe real analysis will only come if we use absolute metric for value. Why can't there be a debate about possible metrics? It is remarkable that for all the human progress we are not able to create an absolute metric for value. 

Friday, July 09, 2010

How much is real estate as a percentage of total assets?

I often wonder what the does the fixed asset block at a country level looks like. 

Companies report their asset base in terms of land and property, plant and machinery, investments, cash and deposits, even goodwill (brands or excess payments for acquisitions) etc. In a company the investments we are told what is approximate value of this investment. (In some cases you have to work around but you can tell). 

If we have the total asset and those invested in real estate, then we know how much percentage change in real estate prices will impact the economy. True, it won't tell us GDP impact, but it will tell us the scale.  The impact will manifest in variety of direction but the quantum of impact is a critical variable. 

Let me give an example. A small meteor can strike anywhere on the planet and we really don't care. For a medium meteor, the point of impact matters. It creates a tsunami or a crater etc. But if a truly large meteor strikes then it does not matter where it strikes. The result is the same - total wipeout.

To parallel with financial crisis, I think we still do not know what is the size of real estate problem. The real estate problem encompasses the following:
  1. Housing i.e. houses and residential buildings in possession of consumers.
  2. Rental housing - those residential buildings owned by businesses but meant for renting.
  3. Real Estate owned by companies. Like land for factories etc.
  4. Commercial Real Estate like malls, theaters, office complexes.
  5. Agricultural land owned by people and companies
  6. It does not include lands that we cannot sell or lease like forest lands for example or gardens.

Then we need to find out  what is the amount of loan for which this stands as collateral. We can then estimate the impact of 1% change of valuations. My guess is the total size of real estate assets will be like 2/3rd of total global assets. The total loans outstanding against these assets is an unknown. We can agree that the problem is not small. The question is how big is it.

Wednesday, July 07, 2010

Retaining US jobs

Yves Smith commented on Andy Grove's post about retaining US jobs. I am worried about the very idea of job exports.

Job profile of the economy
In an ideal state, every economy should have a job profile of its citizens. Job profile will be based on skills available in the workforce. For example, (pardon all the cliches across the post) France and Italy will have higher clothes designers than manufacturers while China will have more clothes manufacturers than designers. This is result of natural specialization and, as such, ties in with two great works by Michael Porter and Adam Smith. So there is nothing fundamentally wrong with exporting jobs. the problem is what jobs do you export.

America is exporting the keep-jobs
Based on the education, skills and experience of workers, we may possibly conclude that America needs these jobs. It needs the car-manufacturing jobs and IT hardware jobs. But these jobs are going overseas. Why? The only reason why jobs are being exported is because it is cheaper to get the job done elsewhere. The labour in developing countries is cheaper in US dollar terms. This could be true because of two reasons:

First is the well understood relative currency valuation reason. If in relative terms Chinese auto worker is paid the same as US auto worker, then the only reason will be currency disadvantage. But is Chinese auto worker paid the same as US auto worker in relative terms? I don't think so. The relative wages are similar in high-tech industry like Pharma, IT services industry, computer chip design, architectural firms etc. But not in auto basic skill industries like auto, garmenting etc.

Second, if there is relative difference in wages, it could be because Chinese labour is poor and hence ready to work at cheaper prices. This is a fundamentally sound case and more applicable to auto, garmenting and other basic skill jobs. These jobs will eventually move.

Implication of job migration
There are some critical points we can decipher from this reality.

First, every job profile seems to have an average purchasing power parity wage. So for each combination of skill, output, education, experience and productivity there is a world parity wage. I call this wage content of a job (in my book) where job refers to one requiring standard profile. If your wage is higher than the wage content of that job you are doing, then you are at high risk of being laid-off.

Second, if Americans are desperate for these jobs, it implies that skill levels in America are more aligned with these jobs. In other words, the American skills difference and wage difference does not reconcile. It means US wages are out of line and need to come down to international wage content levels. We can achieve it by deflation or by resetting the currency. Either ways, it is not pleasant.

Monday, July 05, 2010

Krugman, Ferguson and/on Zakaria

Fareed Zakaria is one of the most insightful host and journalist. In this episode, the presents the two sides of Austerity vs. Stimulus debate. I have already presented my thoughts about Austerity vs. Stimulus.

I want to make a few comments.

First, only certainty can fight uncertainty. In times of uncertainty, like today, the objective of policy is to increase certainty. So a roadmap for reform and policy changes for 10 years and a political consensus (bipartisan or multi-party political consensus as applicable in each nation) and commitment is essential. So Niall Ferguson is spot on with this point. I believe any reasonable certainty will work rather than a specific austerity oriented certainty.

Second, we can kill certainty by acting without a plan - or let me rephrase - by appearing to act without a plan. Conversely, just by acting decisively you can create certainty. I believe the US president should split his speech into two parts - the unchanging goals and course correcting strategies. In both aspects he should communicate decisive action communicating certainty. A plan will definitely help.

Third, Krugman is correctly pointing out that stimulus has not reached the masses. The objective of stimulus, to my mind, was to create income certainty. Whatever the reason, the stimulus has failed to achieve this objective. In this aspect, I think Keynes is being misunderstood and then derided for what may be out-of-context interpretation of his ideas.

Friday, July 02, 2010

Austerity vs. Stimulus

Paul Krugman has reignited the debate about proposed austerity and continuing stimulus. I think we need to understand one more side to the argument. 

The problem 
The economic problem relates to creating jobs and businesses. Basically, we need avenues for people to start earning. Once people earn, they will pay taxes and spend a little from the surplus. This will make the economy self-sustaining. This has two steps. First, we cannot increase the burden of the people further. Second, what we spend should be big enough to generate incomes large enough to pay for it. This is essentially the dilemma. This is the reason why we need stimulus.

But the stimulus is not yet efficient
Though we have been living off stimuli for past two years, the mechanics of stimulus is not fully developed.

To reiterate my earlier position, this crisis has its roots in the certainty of income. A stimulus is efficient if it improves the certainty of income. The certainty is more important than the amount of income. The certainty of income will come from jobs (created by businesses large and small) and small businesses. It is clear that small businesses are critical link as they reduce the owners and few other people from list of those who want jobs. This is where stimulus should reach. But the stimulus is not reaching the intended location - able and potent small businesses and individuals.

The flow of money is such that the beneficiaries of the stimuli are not actually the ones who need it. Sadly, the reverse is also true. Those who are supposed to pay for the stimulus are not actually the ones who can. This is a double blow to the effectiveness of stimulus. But the fact that stimulus is misdirected does not mean that it is not needed.

Austerity won't help either
Austerity will severely constrain the opportunities of the masses. It will definitely aggravate the problems. Worse, at this point, austerity will wipe out any gains from earlier stimuli and render them useless. The prior stimuli will now appear as a burden without any gain or impact. When we have a fire we need water. The fact that some people wasted water should not stop us from bringing more.

What it means
At the start of the crisis, I had mentioned that either approaches may work if we fully commit ourselves right at the beginning. At the beginning we started with stimulus approach. Now we should fully commit to it. Our commitment issues may make the situation even worse. We will end up with larger liabilities and no jobs to pay them. It will push the world over the edge. 

We need to get two things done:
  1. Examine what is preventing the earlier stimulus from working. Get the efficiency of stimulus going IMMEDIATELY.
  2. Get more stimulus to where it is needed, FAST.

Thursday, July 01, 2010

Value of Gold relative to financial assets

Paul Kedrosky is a very insightful commentator and today he shared a linked from JP Morgan research titled Gold is Way Under-owned Compared to Other Times When the World Sucked. The post comprises mainly a chart shown below:

Now, shouldn't the real value created between 1982 and 2009 account for the difference?
Do we really believe we are creating real value? We believe stock markets are ways to invest into things that create value. Now what happens to the value we have created between 1982 and 2009. Gold is growing very slowly while we have (assuming) created a lot of real value. This real value will sit in as financial assets thereby reducing share of gold. Right?