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Saturday, December 24, 2011

2012: Images from the Crystal ball

At the doorstep of 2012, I am here again looking at the crystal ball. There are signs

Reworking the Macro 
  1. The Eurozone faces tremendous challenges at the moment. 2012 will see the aftermath of the crisis. I imagine the Euro leaders will be able to patch things back, but substantial political sovereignty will have to be ceded. One hopes the sovereignty will be returned post the resolution of the crisis. In any case, Eurozone will spend the next year in hibernation.
  2. As I mentioned in previous post, there are currently two systems - Eurozone system and US-China system. 2012 will see stresses in the US-China system rise dramatically. I think as if rhyming with 2011, we will see stress in US-China system next year same time.
  3. We may see Chinese economy under stress. I am not sure how much will happen next year but China is unusually fast. I think we will see slowing of China - about 5-6% growth level.
  4. The Arab world will experience post-purchase dissonance with respect to new-found political setup. In worst case it means some new dictators will come up and uprising may start all over again or there may be bigger political discussions.
Financial markets
  1. I see increased synchronization - both globally amongst markets and within markets among stocks. Thus, old places to hide may not actually work. 
  2. From the investor standpoint, we will be forced to be more in cash or cash equivalents.  Correspondingly, even when invested, we must look to highly liquid names. I was hoping to see derivative markets in their full splendor at such times, but MF Global and lack of counter-party settlement systems keeps check on the system. 
  3. The other fall-out of this is steeper moves - on upside and downside. It means we can make or lose money super-quick. Markets may rise 20% in a month, fall 20% in the next. We should see more talk about Vix.
  4. Funds with specific low-cash rules should find it difficult. I think in general, the strict rule-based fund management should take a beating. Fund managers with broader mandate are likely to deploy the capital better. 

All in all an interesting year ahead. My best wishes to you all and I will see you next year. Merry Christmas, Happy new Year and happy holidays. Cheers

Thursday, December 22, 2011

Comparing Euro with US-China - MMT

Edward Harrison points to a Randall Wray post about MMT, sovereign debt crisis in Eurozone.

Randall refers to difference in location of monetary policy, within the sovereign in case of UK and outside the sovereign in case of France (with ECB), leading to reduced risk of default. Randall refers to this as one main source of problems of the Eurozone.

However, Euro area is not the only problem. When it comes to difference between where monetary policy is located and where fiscal policy is located, we have two examples of this model operating currently- Euro model and US-China model. Both are at risk, different risk, but definitely at risk.

In principle, US-China model has a similar monetary-fiscal policy situation to Euro area. US sets the monetary policy and that policy trickles down to set of countries that peg their currencies to US Dollar. I have only used China as representative, in reality many more countries peg their currencies to USD and this group is bigger than the Euro-group.[1]

The issues is if you have given up monetary sovereignty, you are eventually forced to give up broad level fiscal sovereignty as well. So a system where monetary policy is regional, you must have a regional fiscal policy at least at a broad level. It all boils down to congruence between fiscal and monetary policy.

The persistence with this monetary-fiscal distortion polarizes the participants creating a production pole and consumption pole. In case of Euro area, we have Germany and Greece as representative poles. In case of US-China model the respective poles are China and US.

Now the difference is Germany, the production pole, has larger influence over monetary policy[2] in Eurozone while its corresponding pole China, has no say in policy of US. 

In the US-China case, US does not seem to have a problem. But actually it does. The model requires the China-group to keep buying US treasuries. This allows US more monetary policy room but forces these countries to absorb, either through government or overseas investment, this impact. It masks the problems of US till one fine day US suffers a heart attack. Further imagine the policy environment if Greece ran the policy in Eurozone. I won't go into more detail here but suffice to say this model is equally broken.

  1. Euro as a group, single entity, also has a similar arrangement. Here Euro-group occupies the position of US and few countries peg their currencies to Euro. In addition, Euro is also influenced by its value with respect to USD. It is sort of a complex fractal. We will leave aside these complications for the moment.
  2. Apologies to those who believe monetary policy is truly independent. And, of course - there is no Santa Claus - it was your parents all along.

Friday, December 16, 2011

Uncomplicate the Taxes

High sovereign debt implies increase in taxes in the near future. However, Barack Obama, who wanted to raise taxes, is facing stiff resistance from the Republicans. So also

There are specific problems with our tax system 
First, it is very difficult to calculate the best tax rate or the lowest tax one can pay through the system. Second, taxes have unintended consequences. They sometimes promote or prevent marriages, home purchases, bigger cars, etc. Government has no business interfering with the lives of taxpayers in such a way. Third, taxes are unfair. The rich often pay lower taxes than the poor. Fourth, there is no way to measure return on taxes just as we measure return on capital. Finally taxes are high because they are paying for over-regulation by government or they are paying for large governments.

Better simplify the tax system
It might be better if tax was simplified into just one tax, either on income or consumption. Incomes should not be classified according to their sources. All incoming cash flow should be treated as income. There should be no part exemption what so ever. Government can define a level of income below which tax rate is nil. Above that income, taxes should be at one single rate. The only flexibility in policy will be to determine what rate should be.

The common argument is about the beneficial taxes on cigarettes. Those are not taxes. Those are penalties imposed on cigarette manufacturers for damaging lives of people. Those should be recovered as penalties and directed towards treatment of heart and lung diseases.

Tax filing has been made easy. What is difficult is to figure how much tax
 we have to pay. That has to be easier. We need to protect individuals from complexity in taxes. Just like the Consumer Financial Protection Agency (CFPA) is trying to simplify credit card agreements, it should also simplify tax calculations.

Thursday, December 15, 2011

The Rakoff manifesto

Judge Rakoff's principle based on Contract rights and duties vs. legal rights and duties

Two types of rights (and/or duties)

First are rights created out of mutual agreement, called contractual rights. These exists separately outside the law. Only when there is dispute, the law intervenes. Even then, law only intervenes to clarify what is the real agreement between the parties and has it been honored. Contractual rights exist within the boundaries of law - sort of like a playground where you are free to do what you want so long as you don't hurt anyone. Second are rights created by law. These are typically like the classrooms of strict schools - ordered and disciplined, everything is straitjacketed here. Punishment is imposed by the law to those who transgress the rights of others or duties imposed on them. 

Important consideration is that contractual rights cannot infringe legal rights. Thus contracts to commit illegal acts are void.

Settlement agreement with SEC
Settlement agreements, though contractual in nature, affect rights created by law when settlement is about illegal activity. Hence I agree with Judge Rakoff, one cannot have a settlement and also be considered not guilty. 

I think Judge Rakoff is on the right track. 
  1. You cannot settle away an illegal act. And more so when the parties to settlement are not the only ones who are affected. The problem occurs when the other parties are kept in the dark and have no clue they have suffered from illegal acts. The SEC is duty-bound to expose such acts not merely settle them out. Hence the para "But the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances."
  2. Courts are not house of power that can be called at the whim of parties. In the particular case, SEC wanted the courts to apply injunctive relief to which the counter-party, Citi Group had agreed. The role of the Court was that of an umpire. 

Wednesday, December 14, 2011

Basics: General Investment strategy

A very basic view of investment strategy is given below. I will need to explain a few terms below, but do spend time with this chart. In a nut-shell, that is all there is to investment.

Here are some basics you need to keep in mind before using that chart:

  1. We first need to do research to understand what is a good company and a bad company. I prefer to meet the management before conclusively tipping myself into either category. Companies with hints of fraud (refer to John Hempton's treatise on Chinese companies and some other fraudsters).
  2. Unclear company refers to company which cannot be classified as either. 
    • It does mean that you have conclusively eliminated the possibility of apparent fraud. Yet, something about such companies do not feel right. (yes, feel!). 
    • Alternatively, you are not convinced about the business models of such companies, though the companies may be upright and well governed.
  3. I presume we will know about bear and bull markets. Unclear markets are typically directionless markets or range bound markets.
  4. Uncertain investment strategy means, you cannot invest without substantial research. I must repeat SUBSTANTIAL research. It means unless you have a full scale financial model with sensitivities to various scenarios, macro and industry forecasts, appreciation of changing minor trends, met customers, suppliers, industry experts etc, you cannot take a call. It is like a minefield, you are taking a risk and analytical advantage can alleviate some of the risk.
  5. Going Long for uncertain companies in bull market has one disclaimer that such companies must not have fraud-flags, even feeling types. Ideal strategy for that box is "uncertain".
  6. Companies move in an out of categories. But if a company goes bad, it rarely turns good. I know people will dispute this, but that is my experience. Better stay away or go short.
  7. Ideal chart is 3-D where another axis, industry, needs to be included. This parameters takes into account business cycles. One can logically interpolate my strategy from this chart and apply it to business cycle. If someone can make me a 3D chart please email me or leave a comment.

Saturday, December 10, 2011

Fraud and illegality in the Crisis

Till recently, that is about a year ago, I believed that substantial part of causes of the crisis were a result of mistakes, incompetence and lack of understanding. However, stark evidence is emerging as to substantial fraud and illegal dealings.  

  • First was the Robo-signing scandal (which still thrives) where banks first signed thousands of mortgage applications without any background checks. When a lender behaves in such a manner, he has clearly acquiesced to default.
  • Then there was a random credit card fees scandal that Elizabeth Warren talked about. To be sure this was known before but the scale, I realised later, was huge!
  • There were some hints, particularly how Eliot Spitzer was sidelined when pursing the money trail. Eliot Spitzer was also to blame, in my opinion, he should have kept his pants zipped.
  • Next came Madoff which was more accounting scandal in the family of Enron. One might have thought we had learnt our lessons but that was clearly naive thinking.
  • Then came Bloomberg expose about secret Fed facilities to big banks. The problem here is the way Fed is structured as against normal central banks. In many ways Fed looks like a club of bankers rather than a government sponsored, independent controller of monetary policy. Fed reform is critical and I find both Senate and the House, i.e. the Congress lacking in will and expertise. 
  • Further, we get the news that Treasury secretary Hank Paulson had a closed door meeting about possible liquidation of Freddie and Fannie while claiming they were healthy to the public.
  • The ultimate was expose about Congress being allowed to trade on inside information. This is becoming tragic. This is US we are talking about not some banana republic. 
  • Then, the way MF Global was handled, the way client money was dealt with.

One important common ingredient has been how effectively democracy has been subverted by these forces. MF Global showcases how financial institutions are able to subvert the right to property, a fundamental right at the core of democracy, by allowing financial institution to use personal money to further their cause. Janet Tavakoli's recent article is right - this is class 1 fraud

Finally, I am surprised at my naivete. I also wonder why no one has yet gone to jail.

Thursday, December 08, 2011

Elite Bonds are equivalent to sub-prime SIVs

Germany and France are mulling elite bonds - essentially government bonds issued by AAA rated countries of EU to finance sub-prime countries of EU.

I read this as equivalent to sub-prime SIVs at the height of Sub-Prime Crisis. At that time, sub-prime loans were bundled with prime loans to create a fiction of higher ratings. The assumption was that these individual component loans are not correlated.

I see the same problem with elite bonds though mechanism is a little different. A curtain is drawn over the component EU states to give illusion of AAA ratings to the Greek Debt. If we have learnt something from the sub-prime crisis this bond issue should fail. 

However, I don't think we have learnt any thing from it. So prepare for a Christmas surge in global equity markets.

Monday, December 05, 2011

Walkout - Rethinking Economics

A Harvard class of Introductory Economics recently walked out of Prof. Mankiw's lecture on introductory economics. Prof. Mankiw posted a response yesterday stating that it is a simple introductory course and not a doctrine and should be approached as method or a tool. Peter Dorman countered that there are essential gaps in introductory economics and the course needs to change, a small protest does push things in right direction.

I think the protest was wrong but I disagree with Mankiw.

I think the first main malady economics suffers is listening. A lot of economists talk about Keynes - Hayek debate as though it is equivalent to the intellectual volleying we are having today. Let us remember Keynes and Hayek actually listened to each other. Most economists I read are almost blind to other side. It is like left-inclined and right-inclined economists are playing rock-paper-scissors. 

Economists fraternity must realise lack of listening skill is what is wrong with economists. The Harvard students, in their first class itself, showed exactly this tendency. That is what saddens me.

Here are some of my thoughts about economics.
  1. Teachers must present to the students the entire spectrum left to right, and let them choose. In Chicago, Milton Friedman and fellow Professor used to do exactly that. Friedman is known rightist while his colleague taught the leftist view.
  2. While I like professors taking side they believe in, I think a reverse role-play would do world of good. It would have been good to have Milton Friedman teaching leftist view, in true spirit. It would have done him a world of good.
  3. Keynesian economics, as I understand it, was forming on base of data, information, ideas, theories and other socio-cultural inputs. I think that is what economics must try to be. If he had lived longer, I believe, you may have seen Keynes disagree with current bailouts.
  4. Economics and economists are too literal. They just focus on the written word and many times leave out the context thus missing the meaning. They are worse than law students. Scientists, on the other hand, can focus on written word because they have a language of mathematics that allows them to do so. If economics needs a language the current variety of mathematics is definitely inadequate.

Wednesday, November 30, 2011

Solving Euro Crisis

Martin Wolf has a column about what IMF must tell the EU leaders. It is a rather generic diagnosis but it got me thinking. Here are my steps to solving a Euro Crisis.

Step 1: Put out the fire 

I borrow from Martin Wolf here. We need the EU leadership to come up with a "credible commitment to halt the contagion". Without this there is no tomorrow. You may read the entire suggestion by Martin Wolf.
There needs to be a credible commitment to halt the contagion, for sovereigns, banks and markets. One possibility would be to guarantee financing of rollover of public debts and fiscal deficits for Italy, Spain and Belgium for 2012 and 2013. That would cost up to €1,000bn ($1,300bn), though even this might be insufficient to arrest the contagion, given its current extent (see chart). The resources needed could come from leveraging the European Financial Stability Facility or from the European Central Bank or both, with the former taking on the risk of loss and the ECB offering liquidity. In the longer term, a conditional eurobond may provide a workable answer, as John Muellbauer of Nuffield College, Oxford, has argued.
Step 2: Create certainty to induce demand
I take it further than Martin Wolf here. He simply states that households must spend. I would go further, and correct the job-side first. The reason households are not spending lie in two categories, first is ability and second is intention. Both are missing. We can transfer a million Euros in each persons bank account and give them the ability but we cannot give them intention.  

Intention needs to be induced and can be induced by bringing certainty on the income side. Once people are confident that they will have income they will start spending. Alas, the political policies do not inspire much confidence.

Here income means income less bare essentials. Bare essentials should include food, basic healthcare and basic transportation. Both healthcare and transportation need to be credible. 

Thus, income can be created by creating, for the short term, jobs that tie-in with the competencies of the population. It means if Greeks are good at mining then create more mines, if they are good at electronics build more electronic factories.

Secondly, we need cost ceilings on food, healthcare and transportation. This will help limit the expense side. 

Long term solutions
For the longer term, multi-pronged approach is required. 
  1. We need to improve employability for new-age jobs through training. This goes concurrently with old-world jobs we force them to have. 
  2. We need comprehensive reform of entire social system, starting from economy, judiciary, taxation, media and politics.
  3. We must take the learning from EU crisis and go for a two-tiered world currency system. This will allow monetary policy and fiscal policy to have equivalence. EU can take two routes, member countries can cede fiscal freedom to EU governments or we can dissolve the EU as a monetary union. Dissolution must be structured and old loans must be marked to new loans in fair manner.

Tuesday, November 29, 2011

Occupy Economics- Alternative to Capitalism

Nancy Folbre has a post on NY Times blog asking what is alternative to capitalism. My immediate thoughts went to "nothing is wrong with capitalism per se, it is simply today's capitalism that is the problem". However, I thought let me expand on that idea a bit and explain it in detail. So here goes.

We must look at economic systems in broader range. At one end we have law-of-jungle style systems with basic legal structure and not much else - lets call it North side*. (I don't want to use left and right as it may cause confusion). On the other we have an equitable society with perfect equality - this becomes the south side. Within such a spectrum, let us imagine a center. Usual capitalistic systems (the most perfect we had), I venture, lie to the north of such center but never to the extreme. Socialist systems lie to the south of this center and still never to the extreme.

One can debate how far North the capitalist systems are currently, or how far south are the proposed socialistic alternatives are. But best option, I believe, is to create a balance that is possible at the center. It means we need a capitalistic society that is more south than what we like or we need a socialistic society that is more north than we assume.

The point is further complicated because capitalist systems tend to move Northwards easily. Conversely, Socialistic systems tend to move southwards easily. "More of what works" seems to be driving force. It means when we adopt a capitalistic system, we must focus on adding clear, precise, boundary regulations to let markets function effectively. Conversely, if we adopt socialistic system, we must focus on deregulating regulation in spheres that can stand on its own. As a metaphor, capitalism is like an open field game (soccer) and referee must move along with the ball. Socialism is like lawn tennis, you play where referees sit. Thus, moderation is best solution.

Systemic faults in Capitalism & Democracy

Brief synopsis of my book "Subverting Capitalism & Democracy"

A consensus is emerging that the crisis of 2007-09 was primarily caused by following seven factors: the property bubble; explosion in debt; fragility and dominance of financial sector; weak risk assessment; monetary policy errors; saving glut in developing countries like China; and complacency and incompetence of regulators including rating agencies. The scale of the damage has been attributed to a perfect storm – a concurrent failure of all the above factors. However, we should ask why these factors emerged in the first place and why did all of them fail simultaneously. These are symptoms of a structural decay of the democracy-capitalism system. 

Finance sits at the top of the bargaining power hierarchy. Through a multi-tiered incentive structure, financiers influence virtually every aspect of corporate decision-making. The financial innovations, riding atop asset bubbles, pushed expected returns higher. It pushed the corporates to take even more risks on their balance sheets as Wall Street cheered on. High leverage, currency exposure, cross-country acquisitions, unrelated diversifications, exposure to exotic products, reduced R&D spending, experimenting with buyouts and share buybacks, etc left corporate balance sheets vulnerable. These dynamics fanned the property bubble and led to an explosion of debt. 

The concentration of power is not a design feature of the capitalist system. Our transaction-based economic system is fractal in nature and the concentration of power was simply an emergent property, an unintended result, of this fractal system. Over time, as countless transactions aggregated, the bargaining power concentrated with the financiers. Occasionally when bargaining power does aggregate with certain economic agents, the democratic set-up is supposed to provide the counter-balancing force. Governments or regulators step in to level the playing field. 

But, government waited for markets to self-regulate. To understand government behaviour, we have to view government and markets as competing systems addressing citizens’ needs. Governments create services for few and charge everyone through taxes. Markets are efficient, they charge as per usage. Hence, in good times, there is pressure on government to step back. At times, governments even abandon areas where markets are ill developed. Only in a crisis do we realise the distinction between the two. Markets are exclusive, accessible to only those who have measurable value to offer. Conversely, governments, by definition, are inclusive. Government is the right of the citizen while market is just a privilege. Naturally powers of the government supersede those gained by markets. The question therefore arises, why didn’t government use its powers? 

The root of government problems lies in the broken political system. The political system had the incentive to be silent. The cost of politics has increased. It is kept high artificially to restrict the access to political office. Naturally, the politician is now very attentive to her campaign financers. In the process voters are being denied their right. Voters choose their candidate from amongst those pre-selected by influential contributors. The voters don’t have a real choice. 

Governments, globally, have a strong election focus. The lack of genuine upper house in parliaments may have caused this short-termism. In a bicameral legislature, the role of upper house was to bring strategic focus and act as a check on the lower-house populism. Sadly, many nations have actually abolished the upper house. Where it exists, the upper house has become an instrument to repay political debts. 

The surrender of politics compromised the government and the regulatory machinery. The laws have become vague allowing room for interpretation and, consequently, rent-seeking. Laws can be compromised using, what is called, the necessary and sufficient condition problem. No matter how elaborately necessary conditions are written, there will always be a loophole. For example, imagine a case where mugging is defined as stealing at gunpoint. Gun is the necessary condition for mugging. Now if a victim is mugged at knifepoint, can the thief get away just because he used a knife instead of a gun? This is exactly what is happening in financial crimes. That mugging happened is sufficient condition. Laws must be based on sufficient conditions. We are about to make similar mistakes when developing a regulatory framework for too-big-to-fail institutions. 

The intent of the law can also be compromised within the details of the wording. No matter how finely you read the law, if the intent is compromised, the wording is meaningless. During the crisis, many financial firms have abided the law in letter and violated it in spirit. Some have even blatantly violated the law by paying an insignificant share of profits as fines. The legal system has not shown true appreciation for the intent of the laws. Hence the weakened legal system must also bear part of the blame for the crisis. 

Finally, blame for the crisis must also be allocated to the observer i.e. the media. It was the responsibility of media to explore and expose the possibility of this crisis. It is clear that media needs to be cleaned up. We must separate journalism from what is essential gossip reporting. The power of media, the access, the privileges, should be limited to journalists. We also need new business models to fund journalists. The current business models create harbour conflicts of interests similar to rating agencies. The democracy-capitalism system was envisaged as a self-preserving, counter-balancing structure protecting the interests of citizens or commoners. The factors we discussed above structurally weakened the system. This system is definitely not going last this decade. Now is the time to set it right.

Sunday, November 20, 2011

Pricing EU break up using the Soviet breakup

Gillian Tett, my favourite columnist, recently drew parallels between Russian break-up in late 80s and a possible breakup of EU. The general lessons are critical when politicians consider the future of EU. But what I want to point out is a little different.

Today a lot of analysts talk about default of Greece being priced in. Some also say market understands the price of breakup of EU. I would like to see a paper that uses Soviet breakup of mid-80s and then draws up a scenario for EU breakup, in terms of costs, markets and general investment trends. That analysis will be more meaningful. One may deduce a milder process of EU breakup learning from the Russians.

Gillian Tett talks about some differences in institutional infrastructure. She believes presence of central banking, expertise on monetary policy etc. will stand EU in good stead. However, she points out, todays economies are far more integrated than the isolationist (my insertion) Soviets. It is possible we may be effectively pulling the rug from under our feet.

Friday, November 18, 2011

Euro Crisis - A of tragedy of Commons

European Union was evolved to create an unified market. It implied giving away some monetary policy control to reduce the transaction costs (or friction) in trade between Euro countries. It was understood that each country will maintain fiscal health. There were no rules of resolution in case someone didn't. All this reads like problems we encounter as tragedy of commons.

Elinor Ostrom has suggested a few issues with tragedy of commons that are directly applicable to Euro Crisis. There are a number of factors conducive to successful resource management but absent in current Euro-land.

  1. One factor is the resource itself; resources with definable boundaries (e.g., land) can be preserved much more easily. Does it mean that the fiscal health should have had boundaries?
  2. A second factor is resource dependence; there must be a perceptible threat of resource depletion, and it must be difficult to find substitutes. This was clearly missing - the peoples of Greece, Italy etc, I am assuming, did not believe things will come to this.
  3. The third is the presence of a community; small and stable populations with a thick social network and social norms promoting conservation do better - trust. Trust is something that is missing.
  4. A final condition is that there be appropriate community-based rules and procedures in place with built-in incentives for responsible use and punishments for overuse. None prescribed as yet.
Here is Elinor Ostrom explaining the tragedy of commons.

Wednesday, November 16, 2011

Future of Economics

Imagineering is still a long way away. Fundamental impediments to imagineering skill exists. For example, many have a narrow focus and abstract the system to solve their problem.

First part of Imagineering is Engineering, an ethic that transforms theoretical science into applied science. In engineering, the stability of system is more important and thereon you make micro changes and measure the systemic stability. Economics takes a reverse approach, you estimate micro changes based on some logic and then try and build a system that is hopefully stable.

Economics is, till now, emerging as a theoretical science. No doubt economic systems are complex, but so were all other systems till we understood them. The deterministic nature of other system is function of our understanding. Even economics is macro-deterministic but micro-indeterminate.

In the end, Mark Thoma is right to say that we are moving in the right direction.

Tuesday, November 15, 2011

Die Creditor Die!

Felix Salmon links upon Krugman V/s Summers debate. One of the central point about the current crisis is that how can we solve the problem of excess debt by taking on even more debt? I propose to answer this question. We can't!

To put it simply, what the Keynesian remedy is to offset short term debt with a far longer term debt -  reducing the annual payout while retaining the liability for substantially long period. The process works when you can replace the current creditor (one who is rather short-term focused) with a visionary long term creditor (or someone whose liabilities tend to stretch out for equally longer term). The new creditor bails out the previous one backstopping the losses. The new creditor needs a pretty strong liability that they propose to take to match this super-long term assets.

But we realize the folly in this option immediately. The new type of creditor is absent. The conditions are not exactly conducive for emergence of this very long term liability holder. A typical condition could be found at the beginning of the baby-boomer generation.

In reality the visionary long term creditor is same as one has super-long term liabilities. Invisible hand forces them into heroism we attribute to altruist nature. Americans (and recently Europeans) love to imagine China in all its altruist glory donning this role. Folly again my friends. 

But there is another way to reduce this debt. Let the creditor die. It sounds horrible but it is one way that is still available. When the creditor dies so do the obligations and then we have a clean slate.

That is precisely why banks or creditors should not become too concentrated. History is rife with example of creditors impaled by the mob or forced to surrender their rights. It is in the interest of creditors that there are many of them, at least more than 1%. Alas, we have not heeded history. Creditors beware!

Monday, November 07, 2011

War between Democracy and Capitalism

A few days ago Greek PM decided to take a referendum about EU bailout package. It represented an opportunity for democracy to validate capitalism. Alas pseudo-capitalists arm-twisted Greece into backing out of a momentous occasion. Today, markets are cheering, if you believe the talking heads on TV, resignation of Italian PM. I find that alarming. 

Frankly, today's EU is the theater of war between capitalism and democracy. Well, the capitalism here is pseudo-capitalism. I cannot believe why capitalism should be at logger heads with democracy. In any case, I must warn that this is all taking turn for the worse.

Any significant victory of capitalism against democracy should be, will be short-lived. The rights that create and nurture capitalism sprout from fertile bed of democracy. The problem is once capitalism tries to thwart democracy, it may have to deal with a horrible backlash - a move towards socialism. It is a situation I hate.

The world needs someone with the vision of John Pierpont Morgan who can confine some of the big-wigs in a room and talk some sense into them. Sadly, none comes to mind - the whole pack is short of ideas and, more importantly, morals.

 Apologetic plug - I discuss a possible win-win outcome in my book link below.

Tuesday, November 01, 2011

Explaining Currency Valuation

My attempts to explain currency value continue. I was thinking how we tend get caught up with mechanical determinants of currency value. One way of thinking about currency is to think about two different things. First being capability of the nation and second being a mechanism to measure it.

Capability refers to ability of the country to produce surplus benefit. I am deliberately using vague terms because what one nation construes as benefit may not be the same for others. But key term is surplus. Surplus implies the nation must produce more than it needs for subsistence. So benefit must be discretionary.

The Mechanism
The mechanism to measure it is simply numerical denominator of that value into discrete quanta. If the denominator is high, we can split the value into smaller parts - more numerous shares within the pie but size of the total pie remains the same.

Understanding the complexity of currency valuation
Imagine there are 100 units of currency and 100 widgets (all exactly the same). The equivalence is 1unit of currency for 1 widget. This is a stable version of ideal.

Let us introduce a slight complexity. Imagine, suddenly we have 200 units of currency instead of 100, the equivalence will be 2 units of currency for 1 widget. This is called inflation.

Let us bring add a little more complexity. In this, the number of widgets also keeps growing as does the currency. Now there are three scenarios. 
  1. Widgets grow to 200 and currency also grows to 200. Here we have continuity in ideal situation.
  2. Widgets grow to 200 currency grows only to 150. Here we have deflation.
  3. Widgets only grow to 200 but currency grows to 400. This amounts to inflation.
Now imagine instead of just one type of widget we have two types of widgets. First one is food widget which is highly in demand and other is fun widget which comes after food. Now imagine if an economy produces only fun widgets and there are not enough food widgets for the population. In such case, food inflation will spike up - i.e. currency value of food widgets will grow higher and that of fun widget, naturally, will grow lower.

Now reality is far more complex. Instead of few types of widgets, we have vastly innumerable and ever expanding universe of products and services. Further, each product does not have same relative position to the universe, they keep changing. In other words its chaotic.

The question, therefore, is how to ascertain how much increase in currency is ideal. Clearly, there is no easy answer.

Cannot decipher if currency is correctly valued 
Never, and I am going out on a limb here, is a currency correctly valued as per its fundamentals. Rather, the value of currency is the opinion of select few stating that value is within ball-park. It is relatively easier to know when a currency is not in ballpark of its fundamental value.  In other words, while we cannot determine what the value of currency should be, we can be reasonably certain what it should NOT be. Any analysis beyond this is self-justification or retrofitting explanation to suit analysis.

Borrowing from Physics, currency values seem to obey something similar to the Heisenberg's Uncertainty principle. We can predict the value of any currency generally, but never exactly. And just like the Heisenberg's principle, the very act of determining the value upsets the value.

What should NOT be the value of the currency?
The key lies in looking at the "benefit" we stated earlier. "Benefit" is net of two things. On one hand, lets call it the income side, it includes the ability to produce larger number of widgets (productivity), the ability to produce wider variety of widget (innovation) and the ability to produce unique widgets (strategic advantage). On the expense side, we have committed expenditure including non-discretionary spending and part of income committed to taxes and debt repayment. Benefit, to reiterate, is net of these two things.

When we compare currencies of two nations, if the difference in benefit is largely or appreciably in favour of one, then the currency of that nation should be strong and other should be weak. Again, we cannot exactly determine the difference as discussed earlier but only generally.

About US dollar
My contention is that US Dollar is artificially high considering US economy offers no particularly differentiated benefit as compared to other economies. This is also generally true of all developed nations. That is why I am skeptical of developed economy currencies.

Saturday, October 15, 2011

Can China become a Consumer-economy quickly?

It would hasten the reorientation of China’s economy from exports to consumer spending, give its central bank more freedom to fight inflation, and divert demand to depressed Europe and America, catalysing an essential rebalancing of the global economy.
I contend that it is not easy to create a domestic-demand focussed economy or consumer economy as we call it. In my June 2009 post titled "China domestic demand and other notes", I explained:
Creating domestic markets is not easy and does not simply happen by throwing capital. Domestic tastes and preferences, as we see in India, are lot different than we anticipated. Same logic should hold for China. It is easier to customize goods (and services like restaurant services) are easy to manage – but inflexible goods (capital goods e.g.) take long time. The changes cascade from consumer side till they reach the top end. Examples:
  1. A large part of textile industry may be geared to service cotton clothes – whereas Chinese might prefer silk. (OK I simplified it a bit too much)  
  2. You take milk, some producers added some hormones to aid milk production. Resulting milk was not safe for children. Now we need institutions, legal, regulatory etc that create a feedback system to discover and curb such practices. These complex frameworks anchors in democratic setup – leading us to political minefield.
If someone clarified the entrepreneurial scene – we may actually get better clues about domestic demand. Large entrepreneurial pool backed by venture funds experimenting with products and distribution is the best way to create (and an indicator for thriving or potentially thriving) domestic market.
The easiest part of domestic demand stimulus is to allow top brands to enter the domestic market and give them some price leeway through currency appreciation. Louis Vitton bags, Chanel perfumes etc will kick start domestic consumption faster.
What is a consumer economy?
I must reiterate that consumer-economy is not a simple concept. It represents a system with various parts    many contradicting the political climate in China.

Principle of Choice: Consumer economy is under-pinned by a principle of choice. The consumers get choice and their choosing creates a feedback loop that allows such preferences to be incorporated into national manufacturing and service capacities. Let me give and example.
Imagine a population that fancies, say, sour cream flavoured potato chips, but without any chips manufacturing capacity it does not yet know of it. Manufacturers must experiment with various flavours and then, by trial and error, or through research, arrive at this conclusion. This implies a cycle of investment in various flavours which gets wasted, stock outs of preferred flavours and large inventories of less preferred ones etc.

Principle of Consumer orientation: A consumer economy must necessarily be consumer oriented. I am sure you have noted the pun but people often forget this. Existence of choice necessitates competition and, hopefully, benefit of the consumer rises to the top of priority list. This seemingly simple mechanism is very difficult to implement. Milk producers can collude in using hormones or additives that may be detrimental to consumers and rival producers should feel free to expose such practices rather than cower and join forces with them.

Institutions of dispute resolution: A mechanism of choice and consumer orientation, as discussed above, leads to disputes and conflicts. A system of institution is required for resolution. Independent courts and free press are part of such institutions.

Political implications
Thus we observe the congruence between democratic principles in political systems and consumer orientation in economic systems. Both these systems feed off each other and reinforce each other. In the democratic world, we almost take this congruence for granted. It is this congruence that is critical problem for Chinese authorities. Therefore I don't believe the process of reorienting China into a consumer economy is going to be easy without corresponding political reform. But we can always wait and watch, I will be happy to be proven wrong.


Sunday, October 09, 2011

Understanding the behaviour of the US Dollar

I have often written about mainstream media missing the bigger picture about the US Dollar. I always wondered how some of the astute commentators, some I respect highly, would miss the bigger picture. I have been asked why, despite my talk about US macro weakness, does the USD appreciate in times of risk aversion. I think I should take one more shot at explaining one aspect of the US Dollar issue.

Dollar behavior is aggregate of multiple forces
The US dollar is influenced by following forces:
  1. Adjustment of US economic activity in terms of skill, ability and productivity of the population. 
    • With rising capital intensity the minimum qualification requirements are changing. This change is not in sync with the US population in terms of availability of skill, ability and productivity. 
    • I know some people will react to inclusion of productivity in the list, but careful assessment will indicate its aptness. 
    • This adjustment is rather complex and will take years to play out. Thus the effect of this force, my guess is, will be rather small at the moment. However, once the realization is complete, there may be a drastic impact on the US Dollar.
    • This force will augment a devaluation of US dollar.
    • In geek-speak, since force is a vector, both the magnitude and direction of this force are not  manifesting itself effectively as yet. The magnitude is small and direction may be opposite to what can be expected.
  2. Forces creating adjustment of prices. 
    • The term price has two elements to it. First one represents the information about how relative value of goods and services stack up against each other, or simply inter-goods comparison. The Second and more relevant for us is the information about how the value of goods stack up in relation to those in other countries, or simply, price comparison between countries for similar goods. 
    • My sense is that relative prices of non-food goods and services are far cheaper in developed economies than in emerging market economies (though not for all products and services). 
    • As we establish clarity in this, we will see inflation in USD terms while deflation in other currencies if they let their currencies float to their natural level. However many countries have pegged currencies, particularly those with large dollar reserves. The pegging process will create inflationary forces in these countries as well. Their central banks thereafter will be forced to choose between inflation and losses on external account. It appears they will prefer losses than inflation. 
    • This will be devaluing force for the US dollar.
  3. Risk Aversion forcing the US Dollar denominated money to return home. 
    • One of the tenets of risk aversion is that during such times investor feels safer at home, keeping money in her own currency. It is a fact that US has been biggest investor for some time now and hence risk aversion creates a demand for dollars. 
    • The fact to be noted is that this is mostly private investment and hence more fickle.
    • This force is supporting the US dollar.
    • At the moment, this force has the right magnitude and direction to support US Dollar appreciation.
  4. Subdued Capital withdrawal by those with US Dollar reserves - particularly China and Japan. 
    • For reasons best known to them China and Japan have continued to pledge their support to the USD. China with nearly 3.2 trillion USD and Japan with 1.1 trillion hold considerable sway in the market. 
    • Here the investments are initiated by the respective governments and thus more stable but changes can be abrupt. It is sort of a dormant volcano, if it erupts, there will be tremendous loss. Similarly, if, for any reason, any tiny bit of doubt crops up in these governments, we will see tremendous meltdown.
Interpreting US Dollar movement
It is important to know the forces above and what impact they have on the US Dollar movements. We realize that most of the devaluation forces are diffused and their magnitude is small. However, a keen investor will realize that the alignment between these forces is increasing and we may soon reach a tipping point in favor of devaluation. Further, the forces supporting the US Dollar are fickle and may reverse quite quickly.

Sunday, September 18, 2011

A World Central Bank

the creation of an International Monetary Policy Committee composed of representatives of major central banks that will report regularly to world leaders on the aggregate consequences of individual central bank policies.
While this is still recommendatory in nature, it has pricked a few ears already. The implied loss of sovereignty is the usual contentious issue. However there are a few issues.

The global nature of banking and finance implies that regulatory and policy mechanisms be equally global. Such realities compel a kind of global cooperation that may not work without appropriate legal support. The financial system, in this regard, has become similar to international navigation, global climate or such other global systems.

The legal support, possibly in the form of treaties accepting the global policy direction, may indeed reduce the sovereign freedom a nation enjoys.

A solution, I believe, will be to create a global monetary policy with a new two-level global currency system. This system should allow the national central bankers to create a monetary policy based on  specific national requirements.

The global currency to signal confidence in national monetary policies. Each national currencies will be valued in terms of a global currency based on various factors. One of the factors will be their alignment with global monetary policy. Thus a country that has a relatively expansionary policy will see a currency devaluation. 

Such system incorporates, to my mind, the benefits of a gold based currency system while limiting (or possibly eliminating) its deflationary effects.