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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.

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 Feds rethink policies that encourage home ownership - 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.

Pensions are complicated

The Economist has a nice blogpost about Jobs, pensions and markets: Required reading | The Economist. Here is one important quotation:
Public sector pension funds have just followed the pattern of private sector schemes. Step one, promise employees better pension benefits in lieu of higher pay. Step two, allow older employees to retire early as a "cost-saving" measure. Both employ the economics of the never-never.
And this,
Pension funds are classic Ponzi schemes in which the benefits of retirees depend on the income generated by new employees. (This is true even of funded schemes, since they invest either in equities, a claim on the profits generated by future workers, or government bonds, a claim on their taxes.) They were thus bound to be in trouble once the demographic pattern shifted, and the next generation was no bigger than the last.
This is already a hot political issue as my US colleague notes in this post; as in Britain, attacks on public sector pensions are generally launched by the taxpayers' party (Republicans. Conservatives) and resisted by the public sector workers' party (Democrats, Labour). It will also be a legal issue. In Colorado, retirees are suing over plans to reduce the scope of their inflation protection.

The pension problem is not that straight forward. Paul Krugman posted an interesting study about public-sector and private sector wages. He points to a study by John Schmitt which concludes that after adjusting for education and age, public sector workers are not overpaid as compared to private sector employees. Wages ultimately impact pensions, so ideally pension liabilities should not be unjustly high. 

However, as the article points out, the pension scheme by design is flawed. We need other means to protect the lifestyle of the retired worker. By protect we do not absolve the worker of economic prudence, but ensure that some fixed income can be earned without having to continue rigorous work. So in the post-retirement phase the work is different. Such work opportunities must be available in the first place. Singapore uses such a concept creatively.

While, pensions scheme design may be flawed, it does not allow government to renege on its promises to older workers. I discussed earlier that changing terms of pension being equivalent to breaking contract or promises to the employees. I believe the modification of terms by government for common people is not a prudent move, particularly considering the enthusiasm with which AIG was paid.

In Sum
We do need pension reforms, but it has to be humane. Governments cannot simply cut pensions just because they cannot pay. After all didn't monarchy do it in similar way - spend and if you cannot pay kill your creditor.

Wednesday, August 11, 2010

Who is Rich?

The philosophical answer to the question "those who have more than they need" was always disconcerting. I never related with it. But looking at the situation of developed markets today, I have rediscovered the wisdom in the words. 

An indebted rich nation is not rich
By all counts, average American household is indebted. Those with high income but still indebted to the hilt cannot be considered rich. These households need to scale down their spending. To add to their woes, these households are facing an increasing tax burden.

Tax burden on households is based on incomes not profits
And this is a critical difference between corporates and individuals. When corporates face higher taxes, they increase their costs by investing in assets, paying higher salaries, etc. Thus, in my view taxing corporates is a better alternative than taxing individuals.

Taxing rich is better than taxing poor
Though this is obvious, rich often use corporations to park their earnings and thus get taxed lower. There should be differential rates for different income slabs - particularly at high income levels. Here the size of population is small but the value of tax collect is large.

Tuesday, August 10, 2010

Friday, August 06, 2010

Will Japanese Investment Overseas decline?

A consistent overseas investment by Japan was a critical phenomenon since the early 90s. Thanks to low interest rates at home and relatively benign economic growth outlook, Japanese were (to an extent) forced to invest overseas. 

Over the 90s Annaul Japanese overseas investment averaged $20 billion. In the first half of this decade, it inched up to about $ 30 billion. However, over the past five years it has accelerated from $50 billion to $ 100 billion in 2008. The net overseas investment reached a peak in 2008 and came off in 2009 according to recent report titled Japanese FDI: Recent Trends and Outlook Investment overseas by Japan institute of Overseas Investment.  It begets one question.

Will Japanese FDI reduces substantially or even reverses?
A lot of factors that contributed to Japanese investments have changed.
  • Japanese domestic economic climate may be about to change. We are not sure whether it will recover or fall into a depression, but it is unlikely that the economy will amble along directionless in the next decade.
  • The age profile and dependancy ratio has weakened over the years. At some point it will change from creating a pension and savings pool to using it. Thereafter we may see a draw on pensions and savings funds.
  • There is also a higher global uncertainty to deal with. 
So what?
With about $100 billion at stake, I was about to dismiss Japanese investments as marginal. These days scams and Ponzi schemes run into trillions. But that is not true. 
  • $ 100 billion is a substantially large FDI investment, it is almost size of a small country. 
  • There are bound to repercussions for a capital-starved world economy. World economy is capital starved with large-scale frauds and write-offs and thus a bit more vulnerable than otherwise. The sovereign balance sheets are stretched to the breaking point.  In many countries bond vigilantes are doing their proverbial dance of death. 
  • China may take up the slack with its large surplus. However, people are wary of Chinese influence.
In Sum
While it may not be earth-shattering, but changing preferences in Japanese investments is bound to have some impact on global economy. We need to understand it better.

Wednesday, August 04, 2010

Elizabeth Warren - Election vs. Selection

There is a huge debate about what prevents US president Obama from nominating Dr. Elizabeth Warren, the Harvard Law professor to head the Bureau of Consumer Financial Protection Agency. Recently Fortune asks the question in an article titled Why not Elizabeth Warren for BCFP? The Warren episode exposes a fundamental political problem of election vs. selection. Political parties prefer voters and population in general to "select" one candidate.

Difference between Selection and Election
Selection refers to making a choice between available alternatives. While, procedurally similar, election refers to choosing amongst ourselves. By crowding out real representatives, career politicians leave the voters with non-options. What remains can hardly be called "election". There is hardly any difference in actions, thought processes or ideas amongst competing candidates. No matter who we select, the outcome is always detrimental to the population. Since conventional mechanism is not available, we should use opportunity to put real people's representatives in a position where they can make a difference. Such opportunity came up twice in recent past. 

The emergence of Paul Volcker as a champion of prudent finance promised to be the first moment. It passed away quietly partly, I presume, because of Volcker's age and responsibility he already shouldered. He was relegated to the role of an advisor who probably no one heeds.

The impending nomination of Elizabeth Warren promises to be the second case. I must confess that I am fan of Prof. Warren and I believe she is a true champion of middle class America. In fact, I believe, her expertise should be used diversely to advantage of common people.

Politicians be warned!
During my school years I often wondered how could Marie Antoinette could be so far removed from reality to ask the people of have cake instead of bread. I am no longer surprised. I think today's politicians are further away from reality than Marie Antoinette ever was. The appointment of Dr. Warren presents the first opportunity to redeem the political apparatus. Remember the fate of Marie Antoinette at the end of the French Revolution. 

Monday, August 02, 2010

The crisis of middle-class America

FT, more often than not, does a better job of reporting than many other newspapers. Here is FT talking about middle class America - / Reportage - The crisis of middle-class America. The examples are well chosen. People with income twice the national median, working four jobs (between two adults) are not able to reliably meet their obligations. Some are stretched by healthcare expenses others while others are fighting through job losses. One can only imagine what happens at lower-than-median incomes.

Welcome to the new normal
One of the harsh realities economists talk about is the "new normal". It includes a lifestyle with smaller cost footprint. It means scaling back on purchases. It means no new clothes, no new cars, no computers and cameras. The middle class is not saving, it is simply adjusting to new levels and risks associated with their income. At least a third of American households are in this situation. So we can only imagine what it will do for a consumption-led GDP. The future does not look bright. 

The question of jobs
The government needs to look at the profile of population and profile of jobs available for the population. I mentioned in an earlier post that every economy has an ideal job profile based on education and skill levels of the population. America is losing those jobs that its people are qualified to do. They are losing these jobs thanks to uncompetitive currency, higher wages and benefits and possibly inflexible workforce (in education). This will cause further pain in the coming years.

Declining Wage profile
Just as economy has a job profile, similarly every job profile has an associated income profile based on global wages adjusting for productivity. The wages in US are higher, I believe, than global wages AFTER adjusting for productivity.  So the incomes for those jobs that americans have will not rise much or may even fall. It will stretch middle class households beyond redemption.

Volcker-Warren conundrum
At such times, America should call Volcker-Warren combine to lead the entire financial reform process.   The Warren appointment is being fought at the CFPA level itself so that it is easier to control the Warren-influence over the general Financial reforms process. I hope, rather pray, that Warren ultimately triumphs. She is the only hope in otherwise hopeless economic and political landscape. Same goes for Volcker, the ultimate Volcker rule is so watered down, I doubt Paul Volcker is really satisfied with it. It is time for leaders of America to stand up and be counted. Alas, there aren't any.