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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.