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Sunday, March 18, 2012

Why QE or Asset Purchase is bad idea?

In my humble bid to respond to Martin Wolf's post in FT, I must de-clutter the arguments. But first let us look at the questions:
  1. Why suddenly does QE have to be of this large magnitude?
  2. When does QE work? What are different types of liquidity problems that QE can solve?
To answer these questions we must understand how the asset bubble phase worked. Let us take two important policies that aided the previous boom. 

Two policies that aided the boom
First, we were in era of low interest rate and low inflation. Second, inflation, everywhere is measured by estimating changes in the price of basket of goods and services, no matter how exhaustive or qualitatively superior the basket is.

The question really is - what happens to a person who has a lot of money but he cannot put in a basket which is watched closely? Logically, he puts it into another basket. What if there is no other basket? Well, he creates another basket. This is exactly what happened over past three decades. 

People wanted to invest in assets that were included in inflation basket because the goods and services in the basket comprised important daily items. However, they realised that too much investment makes the central bank tighten the money supply by increasing interest rates or calling for higher reserve requirements.

So these people started investing in other baskets - let us call them basket 2. In many countries real estate was in this basket. This created substantial bubble in these asset classes. The level of bubble was so high that these investors baulked at the prices and were reluctant to invest. Some internal value compass was indicating a diversion from reality and presence of unprecedented risks.

So these people had money and no where to invest. So they created a new basket - basket 3. This comprised derivative of assets in basket 2. This reduced the risk associated with assets in basket 2 and calmed the frayed nerves of investors reluctant to invest directly. Now these people can invest, because the risk was, supposedly, reduced. 

The basic rule was to created tradable assets where this excess money can go to without stoking inflationary fires. This is what I call Asset-creator boom.

Two type of Assets
The asset creators initially scouted for most promising of productive assets. However, once all the investable assets were exhausted, they started creating paper assets. These paper assets are not productive and have same utility as coins or chips from a gambling house.

To complicate matters, the developments in this asset class were creating winners everywhere. Traditionally, the gambling house always wins, but here was a gamble where the clients were winning big. Naturally, the paper assets had same problem as that of gambling house chips. They are good enough till the gambling house is good enough to pay money for them. Once the doubts about gambling house start creeping in, there is bound to be trouble.

Since the economic policy remained in this zone for long time,  the quantum of these paper assets grew to large order of magnitude. In comparison, genuine productive assets grew at a modest pace - as they usually do.

The essence of QE
Usually, QE or infusion of liquidity, or asset purchase, is done when there is no buyer for assets and that stalls the economy. When this mechanism was invented or discovered, assets usually referred to productive assets. So even when the central banks buy these assets, the assets do produce something of value. Over time, people tend to appreciate the value of these assets and buy them back from the central bank. Thus QE works when the system has more good productive assets than bad assets.

This time, the central bankers are buying paper assets leading to two major issues. First, the quantum of purchases is going to be substantially large sometimes as much as the real economy itself. Second, no one is going to purchase these assets back from central bank later as they will realise that these are worthless. So, for all practical purposes these assets are destroyed or taken out of the system. Thus, the central bank asset purchase schemes put out a lot of money in the market while reducing the quantum of assets in the system. This is what leads to talk of inflation.

Problem of inflation
Now, we have too much money, pumped in by the central bank, chasing too few productive assets. Note that no one wants to hold the dummy assets any more. 

In our basket-3 type assets, there was a micro-thread connecting these assets to the productive assets. The thread was too weak and too thin that it escaped perception of investors. Hence there was no effect of basket-3 asset bubble on basket-1 goods and services. 

Today, investor want assets strongly linked to productive assets. Naturally, there is a good deal of impact on underlying goods and services. Thus price of these goods and services are becoming increasingly volatile. Inflation is all about changes in prices of these goods and services.

To have sane pricing of goods and services, we will need some equitable relation between total money in the system and total number of productive goods, services and assets. It means this excess money will have to be destroyed. To counter this excess money chasing core, productive assets, central banks have decided to pay interest on money it created, so that this excess money simply sits in a bank account doing nothing. This incentive prevents money from chasing any assets. Further, the central bank knows where the money is sitting so that it can quickly destroy it when it becomes troublesome. Alternatively, the currency will lose its value and adjust to new price equation.

The problem of sovereign debt
The ideal solution to our crisis was thus. The central bank creates excess money and gives it to investors. These investors, worried of the risk in the system, invest in government securities. This gives government enough money to deploy in programs that can promote real, productive growth of the economy. Meanwhile, as the growth returns, investors are more confident of what are good assets. They buy these assets from central bank thus returning the excess money.

This time, the excess money available with investors was truly large. The government could not come up with a credible list of projects that will build long term advantage of the country. Hence, investors have started demanding that the government either tighten their belts to meet their obligations or show how their spending will create future returns. Government has been able to do neither. Therefore, we see substantial demand that government undertake austerity measures. Government, on the other hand, believes that since the central bank purchased assets no questions asked, the investors should also purchase government bonds no questions asked. A sort of quid-pro-quo. But investors have not kept their end of the bargain.

One wonders, if this conditionality should have been embedded at the time of central bank asset purchase and if it was wise to believe that investors will uphold their end of the bargain. The question therefore remain, why did the central bank have to purchase bad assets at all? Why QE?

In sum
Nevertheless, that is the story of QE. Those are the reasons QE will not work. It is said that false money created from casinos should have been destroyed at the hands of the gamblers. By purchasing these gambling chips for real money, the central bankers have, in effect, sold the tax-payers and citizens short. Hence, QE is, for all practical purposes a bad idea.

Tuesday, March 13, 2012

Taleb on Antifragility | EconTalk | Library of Economics and Liberty

I like what Nassim Taleb usually writes. Here he is talking on Anti Fragility talking with Russ Roberts who produces an incredible podcast at EconTalk. I am a regular listener. Taleb on Antifragility | EconTalk | Library of Economics and Liberty.

The critical question he thinks about is how to design antifragile systems. Particularly relevant is the discussion on definition of Antifragility: (worth reproducing)

What is the opposite of fragile? And of course we think we know what that is. The opposite of fragile is robust, you say; it may be unbreakable. But you argue that's not right way to think about it. It doesn't capture the essence of fragility. So, why do we need another term? Because if you send a package by mail to your cousin in Australia and it has champagne glasses, you write "Fragile" on it. If it is something that is robust, you don't write something on the package. You don't say you don't care, you can do whatever you want. So the fragile, the upper bound comes back unharmed or [?] and of course the worst is completely destroyed. So, that's the fragile. The robust has an upper bound of unharmed and a lower bound of unharmed. The empty fragile would be a package on which you'd write: Please mishandle. Because a lower bound would be unharmed. And the upper bound would be improved--you'd get, instead of sending 6 champagne glasses, 8 would arrive. Exactly. Like in mythology. Or they'd be better glasses, stronger somehow. Like the Hydra--you cut one head, two heads grow back.
Must listen.

Sunday, March 11, 2012

Crisis Basics: Solvency Crisis Vs. Liquidity Crisis

Let us understand what a solvency crisis and liquidity crisis are.

A Liquidity Crisis
Here is a popular example that was given in past few years. “A tourist stops at a motel and gives the manager a $100 cash deposit while he looks at the rooms. The manger runs and pays off his $100 debt to the butcher. The butcher runs and pays off his $100 debt to the farmer. The farmer pays off his debt to the feed store, and then the feed store owner pays off his debt to the motel owner. The motel owner then gives the $100 deposit back to the tourist.” This is a liquidity crisis.

Point to note:
  1. All people were in debt. The size of debt is immaterial. The hotel manager could have had debt of $1million to various vendors.
  2. The debt was used to create value. That, is the most important aspect of this debt.
  3. The value dominoes were stalled because of lack of liquidity which the tourist provided.
A solvency crisis
Imagine instead that a restaurant owner takes out a small business loan to stock his wine cellar. The next day Bernie Madoff comes in and drinks $1000 of wine, paying with cash. The restaurant owner turns around and invests that cash in Madoff’s hedge fund. The next day Madoff comes back and drinks another $1000 of wine, paying with cash (the same $1000 bill he used yesterday), and the restaurant owner turns around and invests that money with Madoff too. This continues ten times. Madoff has drunk $10,000 of wine, and has a $10,000 debt (the investment he is supposed to eventually return to the restaurant owner), but he only has $1000 of cash to repay that debt. Madoff has a solvency problem. His net worth is less than zero. Temporary use of some cash, to be paid back later, would not solve this problem. This situation is different because value was actually destroyed. The $1000 of cash still exists, but $10,000 of wine disappeared into Madoff’s stomach, and Madoff didn’t produce anything of equal value he could use to pay for the wine.

Points to note:
  1. Debt was created just as in previous case.
  2. Debt was deployed to non-productive ventures. In this example Madoff drank-off all the wine. It means value was destroyed.
  3. The debt domino does not stall easily in this case unless doubt creeps into the mind of the restauranteur.
  1. Now clearly solvency crisis seems bad one. If only we had someone who could tell the restauranteur that Madoff was a crook. That someone, in many cases, should have been the ratings agency.
  2. Whenever there are debts, there are also bad debts. Good debts are deployed towards creating value higher than the value of the debt. 
  3. This begs further explanation. Let us assume an entrepreneur takes $100 of debt @ interest rate of 10% per annum. This debt is employed to do work that ideally produces output greater than $110 in one year. Thus, debt of $100 creates, let us say, $130 of value. Then we say that debt of $100 create $10 of value for the creditor and $20 value for the entrepreneur. 
  4. From the creditor's perspective, let us say the creditor makes 100 such loans. So the total debt is $10,000. Potential value it should create for the creditor = $1000. 
  5. Now imagine one entrepreneur fails and loses everything. 
  6. From the creditor's point of view there is not yet a problem as other 99 loans are good. The creditor will lose $100 of capital and $10 of interest. Thus, the creditor will earn $890 in that year. In technical parlance we would say, the creditor had write-off of $110.
  7. Solvency crisis happens with size of bad debts is higher than the value created by good debt.
The problem of misdiagnosing a solvency crisis as a liquidity crisis
The authorities tend to pump in more money to solve what they term, rightly or wrongly, as a liquidity crisis. The money often goes to Madoffs of the world who disappear with the money. The problem gets compounded when a solvency problem is thought to be a liquidity problem.  This actually increases the level of bad-debts in the system.

The way out of the solvency crisis 
There are various ways out of solvency crisis, each dependent on the size and structure of the problem. 
  1. One way out is to write off the debt and start afresh. Everyone takes a hit and blames their naivety and goes back to work. 
    • This is relatively easy when the size of the problem is relatively small, as in our example above. 
    • There is a problem with relative size of bad debt is colossal. In such cases, creditors need to be wound down in a systematic manner. At the same time, the resulting recession has to be managed by promoting employment and counter-recession measures.
  2. Textbook way is a little different. Technically, it is possible to increase the level of the good debt to such an extent that the bad debt can be written off without any problem. There are two ways to create good debt. 
    • First, by reducing interest rate marginally bad debt can become good debt. It is interesting to note that the first approach works only if the amount of bad loans is uncomfortable but not catastrophic like we had in 2007. In other words, the difference between good and bad debt has a bearing on effectiveness of this approach. Monetarist do not agree with this pre-condition. They believe this approach can work for any difference between good and bad debt.
    • Second, by pumping in additional money into the system. The additional money, ideally, will create value that will dwarf the losses from bad debts. This is like making a line smaller by drawing a longer line beside it. The second approach only works when you have body of projects that can absorb the new capital and still be classified as good debt. The gains from these projects must be quick and substantial. For example, if by some stroke of policy we can quadruple the exports then debt required to fund that policy can become this text-book solution.
  3. The third way of escaping a solvency crisis is what I call the Chinese-bank way. In this mechanism, you combine all bad debts, distressed assets into a special purpose vehicle. This cleans up the balance-sheet of corporates holding those assets in first place giving them room to borrow and invest in their businesses. The special purpose vehicle is then backed by government whose solvency, ideally, is not a problem. Over a period of time as industry grows back into a healthy state, government offloads its stake in SPV to the markets which digest these debts. 
    1. Naturally, these bad debts are a little different from other bad debts. These bad debts must be productive under some conditions, which are denied because of the impending crisis and may return when the crises abates.
    2. If government is holding really bad bad-debts then it can write-off the SPV investment and claim the debts as taxes either from public or corporates at later date.

In sum
We can notice that quite a few ways for countering this crisis have been tried. We haven't had much success. As stated, half-hearted attempts to solve the problem compound this problem, thus, we are in a bigger soup. Let us hope, further solutions are better managed.