Friday, December 27, 2013

NIFTY in 2013 chart


The Nifty over in 2013 did something expected - it did three peak- two troughs ~ 2.5 cycles in one year as shown in the chart below.
NIFTY over 2013 calendar (Bloomberg.com)

Following are the interesting points to note:

Firstly, the amplitude of the first cycle is smaller than second cycle. I see this increasing over the next year. Thus, in 2014, Nifty will have at least 2.5 cycles each with amplitude at least as much as the second cycle of 2013. It means a lot of volatility which is positive or negative depending on how you look at it.

Secondly, the time between the two cycles is quite small and there was a muted volatility (bearish lull between End Jan to Mid April and bullish lull between end oct to Dec). I see this muted periods getting compressed. In effect we may have crudely speaking one more cycle in 2014.

Thirdly, if you see the underlying macro/micro data it has generally worsened over this period though we are near to all time highs. It is quite parallel to US equity markets.

Sunday, December 15, 2013

Irrational Exuberance in Asia - Ghosts of Greenspan in India and China

William Pesek writes an interesting column about easy monetary policies (relatively) in Asia. The central point in the article is that there is a distinct need for reform in Asia; the reform is structural - fiscal and political in nature; the reform is ignored and monetary policy is being used to boost "sentiment"; this cannot last.

I agree with the undertone of the article though there are few distinctions I would draw:

  1. The outline of reform in Asia Ex-Japan is well known. 
    1. It is a well-trodden path by the developed economies. 
    2. What is lacking is either the political will or weaker systems that need reform.
    3. For political will there has to be some margin in growth. This margin was afforded by a developed country demand for developing country goods.
  2. The other reason Central bankers of developing countries are a bit easy with the punch-bowl refills is because the principle strategy for growth is by tagging on to the developed country band-wagon and compete on differentials. 
    1. This strategy requires competitive exchange rate mechanisms while maintaining investment-ability in countries assets.
    2. The so-called monetary tightness / monetary reform have been triggered by either of these two requirements.
    3. Thus, central bankers must keep relative position with developed country monetary policy and amongst each other. Thus if one developing country does QE then it becomes imperative for others to follow in order to maintain export competitiveness.
    4. Changing track from this strategy is difficult during good times and becomes almost impossible when the developed markets are going through a weak economic growth phase.
    5. Even Japan is attached to this strategy.
Thus the irrational exuberance carries forward from US monetary policy. It cannot be attributed to developing countries. What can be blamed on developing countries is their lack of will to develop an alternative model that can sustain the dreams and aspirations of their peoples.

Friday, December 13, 2013

Baltic Dry Index's positive prediction

Have a look at the following chart of the Baltic Dry Index.

I am particularly enthused about BDIY's recent uptick. BDIY was a very strong indicator of Global Trade and economic strength before it lost a bit of credibility in the post-Lehman crisis. The reason I am excited is this:


  1. Shipping industry went through one of the most intensive asset building phase between 2006-2010 with almost double the DWT built as was existing.
  2. This industry-specific weakness was coupled with economic weakness stemming from the global financial crisis.
  3. The Oil-accumulation during post-Lehman phase provided some respite but it tarnished the image of BDIY as predictor of economic performance.
I think the disturbances in BDIY are past us and its present uptick does bore well for us. This means it is time to dip your toes into shipping cos. In India I would go with Shipping Corp [which I have from the previous high :(], Great Eastern Shipping. These companies should benefit from the Iran-Iraq Oil deal.

We need to watch for any global weakness and potential head-and-shoulder formation as happened in 2010.


Thursday, December 12, 2013

2014: Images from the Crystal Ball

It is that time of the year again when I take my crystal ball and peer into the future. So lets get going.

The hand that Yellen plays
I think overall theme of 2014 will be determined by the hand that the US Fed plays over the first two quarters. There are two reasons why I say that. Firstly, Janet Yellen is clearly from the Bernanke School and people expect the QE -based easy monetary policy will continue. Secondly, contra the above Yellen is talking about modifying the nature of QE to be more directed and precise. I think that is full of risks which market has not fully understood as yet.

QE till eternity? Almost!
One thing is clear you cannot have QE taper till you have sustainable employment with a visibility over say a 10-15 year period AND reasonably deleveraged US household. Once that is achieved then you can consider a talk of taper and the resulting volatility will be allayed by stronger household balance sheets and things can progress from thereon. So in effect the following things must happen:
  1. Employment must reach about 95% of the workforce. It should be reasonably certain employment.
  2. Ideally, US need to see emergence of a new industry which has three characteristics - first it fits with the US competitive character; second, it is a mass employer employing relatively lower skilled people and third it has second order, third order effects. Most likely that industry could be in renewable energy or water conservation space.
  3. There must be a reasonable clearing of Household debts and households must be reasonable deleveraged with margin to take on more debt if required.
But it won't happen in 2014
To gather up that kind of employment we need a Fiscal side action. A national overhaul of US infrastructure will raise my hopes though it does not promise the sustainable employment for at least 15 years. But it is a fair shot to say the least. The current Fiscal policy is far too short of any meaningful contribution in this regard.

Will QE lead to a US Inflation?
The whole idea of stimulus is that money will flow through the channel to the places where it can create value- therefore GDP growth- therefore jobs and this cycle will pull the economy out of the doldrums. Today the situation is different. 

First it is difficult to keep injected money within the territorial borders to create the desired effect. This means two things. First the quantum of stimulus required will be far larger considering the wastage. Second, the problems of world have bearing on the quantum. 

Second the mechanism of money flow or money flow channel is not functional so you cannot get the flow to the lower rungs (i.e. from asset investors to asset owners). That implies that the money is sloshing into restricted space. It is spilling into global asset classes searching for a channel to reach the bottom. (EM equities being one of them).

There are two things that must happen before the money starts getting channelized properly. 
  1. You need and investable industry to crop up. And not any industry will do - it must employ relatively lower skilled people in large numbers. When we find such an industry (as a few are being experimented with) we will see money being rapidly absorbed.
  2. The current uncertainty of weak institutions collapsing must go away as in early investment stages any industry is quite vulnerable and ours will be no different. When there is adequate certainty that the weaker or failing institutions may be ring fenced into failing safely then it will start growing.
When growth gains traction it will lead to inflation. The trouble is that US FED does not want inflation but that inflation is decades away. But looking at that possibility it is doing nonsense like QE tapering etc. Naturally, if you want the industry to appear quickly then it is easier done through Fiscal policy than through monetary policy (no doubt monetary policy needs to be accommodative).

Therefore even inflation will not happen in 2014 and it is a good outcome.


The EU curve ball
I think the most weird scenario is that of European Countries. Some are following austerity, others are expanding and the effect is a mixed bag. In fact there is good chance that the next problem will arise in Europe rather than from US tapering.

I think there are more things fundamentally flawed in EU than in US. So I would bet on US in a US v EU debate. Further, I would be wary of developments in EU both political and economic because each has impact on the other.

Further, this problems may come to fruition in 2014. It could be the one almost certain headwind of 2014 unless some dramatic political strategies and monetary policies are put in place. The problematic part is that any meaningful resolution requires massive political coordination spanning different regimes that have different outlook to policies.

I think Martin Wolf has it right in his last video presentation here.

About Indian stock Markets
Indian stock markets are likely to move up till say Jan-Feb and then go through a period of extreme volatility related to elections and possibly few other global factors. The presence of strong and short cycles was critical feature of 2013. I believe this will continue in accordance with slosh-money hypothesis I explained in book and previously on this blog.

The flow and quantum of money means it will keep moving between various asset classes sloshing them with out of the world valuations and ridiculously cheap ticket sizes all in span of 4-5 months. 2013 we had 2 cycles in one year (2 peaks-2 troughs). In 2014 we will have at least 2 (2 peaks-2 troughs) and may be 2.5 (2 or 3 peaks and 3 or 2 troughs).

It means we need to be nimble in investment and must be ready to keep the money off the table. This, as I have experienced in 2013 is more difficult than it sounds. One need not be a daily trader, but the investment strategy must be tested more often than what we previously believed. The days of buy and hold are over and in fact buy and hold has become more destructive option today.

What about Gold and Oil?
To me it seems that Gold and Oil will not be as critical as thought previously. Gold will slowly gain traction and it will go past $3500. The nature and quantum of QE, already delivered and expected to be necessary, will have substantial bearing on the projected price of Gold. The forecast for medium term gold prices varies between $2000 to about $7000 primarily because the fact that the other side of the equation i.e. total amount of money in the system has a wide estimate. Once that clears up the Gold forecast will be much more saner. Having said that, the fact that the total amount of money in the system is unknown/varies drastically itself makes a case for Gold. Thus, I would be buying Gold if I was USD /developed economy buyer. In a different currency, the Gold trade may not be as compelling.

Oil may be more volatile in accordance with the QE news flow. Oil gaining its position as store of value (a story that had abated after Shale and other quasi-oil alternatives). Though Oil as store of value is likely to end disastrously. Oil is no longer the resource crunch story that it was between 2005-2010 period. We have never heard the real oil story. There is no dearth of oil if you set aside the environmental consideration and cost of drilling. So "Peak Oil" really refers to "Peak $50 Oil". The real constraints are in fact the environmental considerations and we may do well to move away from oil sooner than later.

War is coming
So long as US continues on its Japanese strategy, we are going to see possibility of war increasing. It is possible that China will induct 5-6 Aircraft carriers into its navy in 2014 if not more in preparation for war.

The new Chinese leadership will face tougher challenges converting its economy from a producer-driven economy to a consumer-driven economy. Further, the lack of sustainable global demand will not ease the pressure on Chinese government. When the problems of worker migration will ease the problems of worker wages will begin. It will take a great deal of proactivity on part of the new Chinese Leadership to manage these. Further, this is the first truly non-revolution leadership so we are yet to see their mindset.

All said, I see some notoriety involving Chinese sooner or later.

Finally,
As I head to the beach, let me say this, we seem to be in much saner times than we actually are. Insanity is quite a short jump from us at any time. So in such times let sanity prevail, let talents rise and pseudo-leaders fall and let peace be upon us.

Tuesday, October 15, 2013

Happy Dassera - Why we Indians buy Gold during Dassera / Diwali period?

Indian fetish for gold is well known. The whole of the country goes to the goldsmith and buys their gold during Dassera/Diwali period leading to a huge buying spree. A lot of people ask me how the custom of buying gold during the Dassera (leaves of specific tree that are deemed to be gold) / Diwali period (actual buying of gold) came into being. Then they read wikipedia and various stories about Kuber (the God's treasurer) and other related stories. Here is the real(!) explanation.

Actually the story starts with Ramayana. Ravana, the demon king, had accumulated huge pile of gold and it was kept in Sri Lanka. Ravana being conqueror of three worlds had quite a stock pile at this place. The Ramayana has vivid description of gold-palaces and gold plated public places in Lanka. Nonetheless, he was all powerful so the stock pile was out of bounds for accumulation for the rest of the world.

The sequence of events unfolded such that Rama ended up defeating Ravana killing him on the day of Dassera. Naturally the assets of Ravana were accessible to the investors after that point. Therefore, the price of gold dropped drastically leading to a buying frenzy fuelled by suppressed demand.

The South which got wind of the end of Ravana started trading in gold contracts using tree leaves. The North got the information about demise of Ravana when Rama arrived in his plane (with of course quite a bit of gold) by Diwali. (No bloomberg in those times!)

Today, the situation is quite the reverse, gold prices actually go up during the festive times and therefore it makes no sense to buy gold on Dassera / Diwali period. Rather buy it a month or two before.


To me this story seems more plausible than all the mythical stories we have been fed. But then I am a rationalist.


Money Supply - when and how QE becomes dangerous

To understand how money supply becomes dangerous, let us begin with our equation which is now modified as follows:

Just to reiterate, here:
M = Money supply
V = Velocity of Money
MA = Original money supply
VA = Velocity of the money supply
MB = Money supply added during QE
VB = Velocity of this expanded money supply
P = Price of good (product or service) "i"
Qi = Quantity of good (product or service) "i" sold
n = Total number of goods
M*V = Money Momentum
PI = Purchase Intensity

Makings of a recession or slowdowns
Before a slowdown we have MB equal to zero as there is no QE. When a slowdown strikes Qi reduces drastically. To compensate the reduction of Qi, central bank injects MB. In the ideal case the velocity VB should be positive and commensurate with MB (the quantum of additional money supply). Now as we discussed the exact mechanics of QE were designed to keep VB low so that injection of money does not cause runaway inflation.

To adjust to excess money supply, the purchase of some items increases. If such items are assets, then we have the hoarding vs. building problem we spoke about. The exact response of the economy depends on the mechanics of QE. However, either ways it plants the seeds for future problems.

When does QE turn bad
When the economy does finally recover, the right side of the equation starts gaining traction. To compensate, the two components on the left, VA and VB have to adjust (assuming no further QE is added). Now the nature of velocity is such that increments in micro-V (velocity at individual level) are more step-changes rather than smooth analogue. Therefore even when the Velocity in the equation is smoother than the micro-V, it increases quite drastically. The pace of increase of the velocity is remarkably higher than pace at which fundamental growth can take place - i.e. growth in "n"or "Q". The excess therefore spills over to "P" or the price leading to inflation. At such moment, there is required to be a mechanism to absorb excess liquidity. But then a precise mop does not exist that can mop at the right places. The result is that there is inflation in certain goods while others are relatively stable.

The argument the inflationists are making is two-fold - first that the increase in V post revival will be far too drastic to allow for commensurate growth in "n" or "Q" to temper the price rise and secondly the central banks will not be able to mop up the rest. In fact, Bernanke's QE strategy created the VA-VB split to allow for quick withdrawal i.e. the second kind of problem. However, this design kept VB low increasing the quantum stimulus required. In other words, Bernanke's design increases the first type of problem.

Lastly, higher the quantum of QE the more difficult it is to mop it up. Which means the economy will absorb it relatively quickly and this absorption will result into a high-inflation scenario.

The correlated bad effects
The US economy being the global leader and dollar being global reserve currency, there are correlated bad effects to deal with. When inflation gains traction, there is change in the value of holdings of other countries in US (dollar reserves which were necessary for currency management). If the change in value is substantial then there will be a possibility of renewed currency wars.

If the inflation increases beyond control then there is a risk of currency losing its function as carrier of information (of value). This triggers a wider crisis globally.

In Sum - Can we prevent bad after-effects of QE
We can but in all probability we won't looking at current politics. Avoiding the bad side-effects requires integrated monetary-fiscal approach. There is not much room for political compromise as most of the activities are almost imperative. We need the US politicians to be lot more saner than they actually are. But is it expecting too much? I don't know.

Note: This post is derived from my book Subverting Capitalism and Democracy. You can read the book at the link below.

Sunday, June 16, 2013

What is worse? Comments on John Mauldin's Economists are still clueless

John Mauldin's weekly newsletter is a must read as always. This time he titles it Economists are still clueless. He rants about how economists failed to predict the crisis totally.

However, my problem is not that the economists failed to predict the crisis, nor it is that they have been repeatedly failing at it. My problem is that economists still do not understand how economic systems work. The present economic model has serious gaps that fail to even indicate a remote possibility of an interlinked financial system, etc.

There is serious difference of opinion among economists about how economics actually works. And this makes it less of a science than an art. No doubt there are large number of variables involved in the process, the problem is that these variables have inter-dependencies that economists themselves are not aware of.

I believe the basic model I have proposed in Subverting Capitalism - that of bargaining power within a transaction based economy is better alternative to map economics as a whole. Secondly, I believe my model will take us towards a coherent view of micro and macro economic study rather than the difference we see today.



Bank Deposits, Savings and function of Money

We will divert from our series a bit and get to an important aspect of Money which is its function.  However, Money performs two functions.

Raison d'etre of money
Money came into being to facilitate exchange of goods. Money split the old time barter (which was one transaction) into two transactions (goods-I-have for money and money for goods-I-want). This allowed for both transactions to achieve market efficiencies. Enabling transaction is the first function of Money. So money is medium of exchange. In this process Money conveys information about prices of goods. When the prices change, it conveys information about changes to the product or the environment or some other thing. This information function of money is as important as the second.

Second function of money is that of a store of value. Value of money means its purchasing power. Bank deposits are storing value. Technically, money should not be performing this function. But this function is inadvertently taken up by money when the information about the product or money itself changes the price levels and hence the purchasing power. Thus, for example, after exchanging goods-I-have for money, when I was having money with me, the price of goods-I-want halved. That means the purchasing power of money increased and thus money became more valuable.

Thus when we hold money and there is change in the information available leading to change in prices, the function of money is that of store of value.

What should money do?
  1. Money should enable transactions - so it must not hinder your transactions (by credit card not being available). Or by becoming so valuable itself that people want to post-pone their transaction to get a better deal.
  2. It should convey information about prices so that you can compare and match your funds, needs and compare alternative purchases (apples vs apples vs oranges etc). This information must be reasonably stable. So if I understand that price of a shirt is about $25 then tomorrow it cannot be $150 or $5 because that will create confusion. But it can be say $23 or $27 and it would not be much of problem.
  3. Money has no business being store of value by itself. However, the fact remains that money remains the only way to measure value. We do not have other unit to measure it.
Douglas Rushkoff (starting about 23 min) on money should push transactions.



Use of money and current and deposit accounts
So actually, money in our current account is actually money to be used for transaction as a medium of exchange while the money we have in time-deposits or other deposit accounts is actually money as a store of value. Now if you ask any lay person, if the amount of money in both the accounts reflects this functional segregation and you will find it does not. The way we use money mixes up the two functions of money.


One way to clarify the usage is to make it clear that current account is your money awaiting transaction while deposit account is your investment into the bank. This segregation will make it clear to users what exactly they are using money as. Thus, banks should provide the analysis of expenses from the account and that should indicate a certain current account balance. The rest should be into deposit accounts.

Now, from the level of deposit insurance available to the bank, there should be disclosure about the amount of your money protected by deposit insurance. When deposit insurance is applied it must be applied to current account first and then to deposit account.

Purchasing power of the money
In an ideal case the purchasing power of the money should remain perfectly the same. If the purchasing power remains exactly the same the productivity gains will result in lowering of prices which is also termed as deflation. Now we also do not want that because in a deflationary scenario, holding money becomes lucrative as its value only increases and this affinity for money creates a hindrance in transactions. As we discussed, ideally money should not hinder transactions in any way.

To overcome this, we settle for a slight inflation. If we do it right, then the inflationary force exactly balances out the productivity gains and therefore results in no change in the prices. But such ideal outcome is not possible. So the policy maker must err in his judgement. A better side to err (it is debatable) is on the side on inflation but only ever so slight inflation.

George Selgin on Good Deflation and Bad Deflation


In Sum
The function of money and our appreciation of the function itself has policy implication. We must understand the function of money before we understand monetary policy itself.


Note: This post is derived from my book Subverting Capitalism and Democracy. You can read the book at the link below.

Thursday, June 06, 2013

Money Supply Inflation and Economic Growth

After having discussed the basics of Money supply and Inflation, it is essential to discuss growth based on our model of money supply. At the moment, we are assuming there are no imports/exports. Let us refer to our equation:

Now using this equation it is clear that there are only three ways of creating growth in the economy. First two are obvious. First, increase "n" or number of products available in the economy. Thus, when new products and services are discovered we have growth. Secondly, by increase "Q" by increase of  population since when number of people increase, the total product consumed also increases thereby leading to growth. These are obvious and let us call them basic growth. It is the third that is interesting.

Increase in Q or Quantity by increasing Purchase intensity
Purchase intensity means the amount of product "i" one person buys. When the purchase intensity increases the demand goes up and leads to growth. But the beauty is it is "purchase" and not "consumption". Thus, even hoarding will also create growth. Now this seems silly when you relate it to goods but relate it to assets and things start looking quite different. We will term them differently, one we will call Asset building and other we will call asset hoarding.

Asset building is excess creation of assets than required or justified by future demand of such assets. Such asset building also creates demand if asset creation involves economic activity i.e. leads to increase in "n" or modifies the "PI" of existing goods as a consequence. Thus, if some one buys homes and blocks them, you have demand since other products related see increased consumption (steel, cement, wood, etc.) *(Refer Note)

Asset hoarding is of different type, say buying mines and mineral deposits, hoarding leads to inflation and not to real growth. This type of asset hoarding works on Pi and thus does not contribute to real growth. Concurrently, asset hoarding of this nature, ties up money supply reducing its velocity.

QE and growth
It is clear that QE is effective when it triggers basic growth or asset building even though such asset building may be excess. (Refer Note 2). If QE leads to asset hoarding then it does not lead to growth but leads to inflation. 


Notes:
  1. There is slight technicality here, homes though termed as assets can also be termed as consumption goods. But the principle is applicable for all assets that influence n or PI.
  2. Technically, the difference is "how much excess". Some excess is allowed but major excesses leads to depressing of long term demand and as such creates a drag. Essentially, asset building prepones the future demand.



Tuesday, June 04, 2013

About Money Supply and Inflation

A lot of times we discuss money supply and possible inflation it can cause and wonder why it doesn't cause that inflation. So here I attempt to explain what happens with money supply and when inflation happens and when it doesn't.

Here is the modified Money supply equation.

Here:

M = Money supply
V = Velocity of Money
P = Price of good (product or service) "i"
Q = Quantity of good (product or service) "i" sold
n = Total number of goods
M*V = Money Momentum

Explanation of the equation - ideal money supply
The Money Momentum must be equal to economic activity in the country. In any given period, there is a change in the total number of goods available (i.e. "n") in the economy, there is change in quantity of available goods sold (i.e. Q) in the economy and there is change in the velocity of money (i.e. "V") in the economy). Central banks must consider all these variables to tweak Money supply (i.e. "M") and if done successfully there will be no change in the price of the goods (i.e. "P").

Real Economic growth
Real economic growth, from layman perspective, refers to growth in the products and services produced by the economy. When the price of the goods increases but the quantity produced does not it does not imply real economic growth but refers to inflation. In our equation, real economic growth comes only from the following two ways:
  1. Increase in Q for various goods: Thus, if suddenly more people start going to their hair-dressers to get their hair done up then you will have economic growth.
  2. Increase in number of goods available in the economy: If total number of products in the economy increases then there is economic growth. For example, when telephone was invented, it lead to new products and services being made available to the consumers which would be economic growth.

What is inflation and deflation
When there is no increase in the price of goods then we have no inflation. Conversely, when the price of goods drops then we have deflation. Thus so long as the variable P in above equation remains the same we have neither inflation nor deflation.

What is velocity of money?
In layperson language, Velocity of money is number of times money changes hands. Thus, if $100 was paid by one person to A, then A to B who paid to C and who, lastly, paid to D, then velocity will be 4 within that period. 

Because of velocity, in any given period many more people feel they have money than actual money in the system. In above example, 4 people were able to conduct their transactions each worth $100 while in reality there was only one $100 bill floating in that economy.

So why do economist want to increase money supply?
Generally, during crisis, the velocity of money decelerates abruptly as people want to hold on to the money they have. This reduces the Money Momentum drastically leading to collapse of demand and therefore slowdown. 

To prevent this, central bankers pump in money to compensate the loss in velocity thereby holding the prices level in the economy up. This stabilizes the economy and pacifies the participants. In the current crisis too, US Fed has increased Money supply exponentially as seen in alongside figure (from St. Louis Fed from business insider).

The question really is whether the increase has compensated the change in velocity or not. The answer is slightly more complicated.

What Fed did
Let me interpret the Fed actions using our Money supply equation. Let the Money supply M has been split into two components and let us assume MA is usual money supply while MB is what Fed added post crisis. 

Ideally, the left hand side should have looked like (MA+MB)*V to have the maximum effect. However, Feds action created amounts to splitting the above equation to something like this:

Note that each type of money supply has its own velocity component to it. The Fed policy and the mechanism they used kept the VB very close to zero but not exactly equal to zero. Naturally, it has miniscule impact on the whole economy. Therefore there is no inflation.

Notes:
  1. In reality, economists cannot measure Velocity and it is the variable that is calculated. In principle, that is wrong. Velocity does not adjust itself and is independent variable depending on psychology, mood, history etc. What really happens is economists tend to guess the change in velocity. Their guesses tend to be wrong and we end up with changes in prices. Milton Friedman believed that we should err on the side of inflation (slight) rather than deflation.
  2. It is also incredibly difficult to estimate the right hand side of the equation. If one really does go through the fine-print we realize that it is all guesswork on RHS too. The key as an expert once told me is to have consistent guesswork so that changes are almost correctly perceived. Now whether the guesswork is consistent or it has been tweaked a bit here and there has tremendous implication about what the central bankers should do.
  3. This post has been adapted from my book "Subverting Capitalism and Democracy".


Monday, June 03, 2013

Revisiting my assessment of Financial Crisis

Back in 2009, I made an assessment about the financial crisis. In 2013, I agree with most of my assessment. Some of the parts of the situation have changed a bit but the overall picture has not been modified as you can make out.
I have been amongst the most pessimistic about the prospects of global economy. There has been a lot of harping about what got us into the current mess. Together the blogosphere has painted a picture of gloom. And now that we have painted this dark tunnel it is time to paint the light and the end of it! It is time to decipher the solution to the crisis.
One of the reason great depression lasted as long as it did was because of delay in acknowledging the solution. The solution was always there - no doubt - but it took time for the solution to win over the decision-makers into coordinated action. Thanks to globalisation and internet based coordination, we should be able to do it faster this time. If only we had the solution - or may be we do!
I present my side of solution in next few posts. Let us march towards a light - any light to begin with!

Who can be consumers?
Citizens, who have savings and income to replenish the savings post buying goods and services, can be consumers. Rest cannot! That implies the developed world - probably with exception of Germany and Japan, cannot be consumers. China, India, Indonesia and other countries with domestic savings will be our consumers. 

Value of consumption

Currently, the exchange rate equations are aligned to repress the consumption behaviour of these populations. In the interest of global recovery these equations will have to be reversed. This will entail a lot of protectionist pressures that are detrimental to consumers. Such measures will wipe out any hint of global recovery. 

Not consuming is always an option

Typically protectionist measures reduce the quality of local goods, increase prices and thereby cheat consumers out of their hard earned money. Today, the globalised consumer, is aware of product benchmarks and price parity across geographies. In current situation, consumers may simply "not consume" inferior products. They will choose to increase their savings. 

How protectionism is detrimental to the world?

This means the advantages of protectionism will accrue only if it continues for prolonged period of time in near future. Till it continues - global depression will continue. It means you will see more enforcement at customs counters in airports, ports and national borders. It means increased smugling of attractive goods establishing a supply chain for drugs, weapons and other illegal trade. All detrimental in socio-economic terms.

Changing producer competitiveness
The question is invariably based on Michael Porter's work on competitive advantage of nation. The only modification is understanding the structural or fundamental advantages. We need to separate out the transient, artificially imposed advantages. A deliberately devalued currency is such a transient man-made advantage. And it will break down. Michael Pettis, makes a fantastic argument how trade policies can influence producer dispersion. 
Who will be new producers?
Producers are located due to various competitive advantages of a region. One of the reason is quality and cost of manpower - let us call this man power profile. Similarly we have a job profile of an economy. Job profile, for simplicity sake, is based on technical knowledge pre-requisites and volume of work. Now ideally in sustainable case the job-profile and man-power profile of an economy should match. Currently there is a mismatch in developed world. US and EU jobs are getting polarized between unmovable low value addition activities on one side and exceptionally high value adding activities on other. 
Man-power profile will stabilize
The volume of low-value addition jobs will have to rise in US - to fit with lowering relative education standards. Now education system in US is way better than other nations. So we are simply comparing US in the future to US in recent past. The problem is in very short-term jobs movements are a zero-sum game (time till entrepreneurship discovers new jobs). So it means US wanting jobs will mean job losses in other part of the world. That, to my mind, is a seed of discord in near future. Hope is migrant workers might go back to home countries and US might actually have a brain drain to ease the pressure a wee-bit. In medium to long term US entrepreneurs will definitely figure out a way to create value in new and innovative ways -creating jobs for the economy. 

Seamless dispersion of production centers
The intersection of man-power and job profiles will mean a more seamless dispersion of production centers across the world. The first demonstration of this will come when some manufacturing jobs moving back to US.


The global credit channel is a central sysmptoms and collateral damage of current crisis. The core of this is in US and therefore US government agencies are attempting bailout after bailout. The US government is not liable for rescuing an essentially global channel. It's first duty to clean the domestic channel. The two are cross connected to such a degree that they cant tell what they are fixing. 
The solution, to my mind, is simple. Create an alternate credit channel - what I call "the modified good bank solution".  
  • Create a good bank - with regulatory charter that allows lower capital norms, higher government guarantees etc. so that it will have liquidity, capital and ability to acquire assets.
  • Let it give credit to worthy borrowers who have the ability to repay.
  • Create a mass loan transfer drive - where the borrowers to move their loans to this bank - rather than buying loan books from established banks.
  • Accelerate the process by establishing uniform common minimum norms for acquiring loans. Start with lowest risk with highest documentary evidence.
  • Augment the document checking using other government agencies workforce.
  • Repeat the drives till you have covered big chunk of population. Government can take over some homes and convert them into temporary offices - establish geographically wide network - quickly.
  • This bank should be broken up into managable units and privatised at a pre-committed date in 5/7 years time.
The global bailouts are more complex. This should be funded with pooled money. Using the IMF or world bank is a good starting point. More on that later.
Addendum: Why Us needs to fix domestic credit channel first?
US is biggest consumer of the world. The world needs able US consumers to continue to spend albeit to their comfort level (and definitely to lesser degree). The able and wanting consumers are currently being denied a chance to consume. This is dtrimental to everyone.

Current problem won't resolve by just establishing an alternate credit channel. Once the US credit channel is available. Credit flows based on certainity of earnings. Economist's View: Galbraith: No Return to Normal indicates how Galbraith points to this critical point. Let me paraphrase Galbraith:
In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war—from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war. 
The New Deal rebuilt America physically, providing a foundation (the TVA’s power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so. 
What did not recover, under Roosevelt, was the private banking system. ... If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn’t overcome until the war ended. It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. ... But the relaunching of private finance took twenty years, and the war besides. 
A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.
We have to realised that credit and banking feeds off global real economy. It is actually a cost, however small, for the real economy. So once jobs come back and incomes stabilize (at whatever levels), you will see credit coming back. Without certainity of earnings, the credit channel goes in self-preservation mode - waiting for certainity to return. Being global, the channel can absorb far more bailout/stimulus than any single nation can provide. 
The problem of global income adjustment and therefore credit offtake ability will hit us next. This is the heart of the problem. Next: we will see how we can fix this!
Global crisis is a result of three elements freezing together - an overleveraged buyer unable to buy more, a seller without access to credit to create supply and non-existant market where no one trusts anyone. 
We cannot fix all three together as all three elements are vastly globalised and hence too big to fix all at once. So it makes sense to get back to basics. The entire economic system was created with demand at the center. When demand existed - supply emerged and market appeared to match producer and consumer. So we need to fix demand first, help supplier get started and things will start taking care of itself. But! 
First lets get demand straightened out. Demand in recent past was excessive - it will never be that high any time soon. But however small - we need it. Demand comes from wages and employment certainity. This is the basic of Keynesian stimulus - create jobs system will fix itself. So this would have solved our problem this time as well - had it not been for credit starved supplier. 
The supplier, earlier, was driven by equity and debt was but a cash-flow smoothening mechanism. Then we realised the power of leverage to amplify returns, create surplus wealth thereby creating a separate investor class specialising in just providing capital unleashing entrepreneurial energy. This class made the entrepreneurs leverage themselves to the maximum possible limit. This culminates today into credit being necessary mana for the suppliers to produce goods. Without supplier there is no market! 
The market essentially is an infrastructure provided to suppliers to help them address demand - through exchange of goods and services. Market works on marginal cost of exchange. Markets usually take care of themselves so long as demand and supply exists. The maximum fixing markets needs is through ensuring rule of law - enforcement of contracts, protection of aggreived, ensuring people don't cheat or muscle out others etc. Markets are even oblivious of fairness of law - so long as law exists and they get implemented markets will get created. 
Hence the crisis will be resolved if we solve the demand (consumers') problem first. Then we need to fix suppliers' access to credit. It is ok to have latent unsatisfied demand - that often gets channeled into savings. But excess supply translates into inventories and they have costs and lead to supplier anemia. Ensuring law and order will help markets get back in shape soon enough. 
US Solution has been antithetical to first principles
The solution so far has exactly moved in opposite manner. We tried to make market functional by rough-shodding over contracts and ensuring cheater get away with it. We tried to ensure liquidity to help with supplier credit. All this while - the consumer is facing increasing credit card debts, lower job prospects and total loss of confidence in possible return to reality. We haven't really done anything to prevent creditors making predatory moves on consumers. 
The solution to the crisis is essentially a modified Keynes' approach. We need to create jobs while fixing the system in coordinated precision. The kind that won Nadia Comaneci her perfect 10. And the stakes are higher there is not saffety net - no silver medal!

Given that real stimulus will take a form of modified Keynesian approach- we need to know what are the "highways" of today. During the last depression, the building of highway and rail infrastructure got the US out of trouble. This time, to my mind, it has to be Green and Blue infrastructure. 
Going Green
US has been victim of development invention. Most of the infrastructure / engineering of the country is based on older technology thats not green. Few years ago when the green revolution was knocking at the doorstep, it was difficult to see how US and developed world can re-engineer the entire setup to go green in a meaningful way. Luckily the current situation presents us with an opportunity to do just that. In doing so, US will lay the foundation for competitiveness for the coming decade or more while adding to comfort on global warming. 
Going Blue
While green is important, blue is even more so. By blue I mean developing potable water resources. Greening, apart from using lower emission fuels, also means creating tree cover and rebuilding green-ecosystems. Initiating this will require potable water sources. Further water is the most essential commodity for sustaining life. Investing in rain water collection ponds and lakes, water seepage assistance to rebuild ground water resources etc will have to take precedence. India has got an initiative off-ground through India water portal
Implications for cities and homesteads
If at homestead level we can create sustainable water and green infrastructure, we will have a much better self-sustaining planet. That imlies our city-oriented development models will have to be modified to make it more sustainable. 
Implications for current economic slowdown
The ability of these initiatives to create jobs is under-rated. If properly deployed these initiatives may create more jobs and more self-satisfaction than most optimistic forecast. These initiatives have unique character. They need huge manpower up front and then possibly the overall manpower requirement for sustaining this effort will be about 3% of original. This means they can create enough jobs to reduce unemployment rates by some percentage points in initial years. And the man-power can be freed in few years as economic activity resumes full steam. 
In Sum
Green and Blue are compulsions. We either take up our share of responsibility or implications are large and life-threatening. As they say, "nature does not do bailouts". The opportunity has presented itself - lets grab it!

 Next I will look at what has changed and what can be our road ahead from this point on.

Friday, May 31, 2013

QE and the priming of the World Economy

Steve Keen has a super post explaining why QE does not work or explaining how in fact it is supposed to work. At the same time, world worries about the effect of impending withdrawal of QE. But my focus is somewhat different.

Can the QE be expected to create a global turnaround?
I would say no. The reason I am keep a small probability open is because theoretically it is possible but quite a long shot. If you look at Prof. Keen's first cut model, the Banks need to buy assets (he calls it stocks but assets is better term) from the economy. This creates money supply which allows producers access to capital, employ people and therefore give consumer access to income and therefore spending power leading to pick up. As you will note, this is not quite that simple.

In principle, I would say the current model of QE will work if banks make tremendous profits and spend it priming the spending cycle to create employment and resulting spending. Now you realize that to effect that kind of priming, bank profits will have to soar and corresponding banker salaries have to push far northward. All in all, not happening.

The purchase we get from this type of QE per dollar of traction gained by the economy is fairly low.

What kind of QE WILL work?
Any QE which will create jobs with certainty of income over reasonable period of time, say 15 years, will be adequate. The exact amount of income does not matter so long as it is above a bare threshold and so long as it is decently correlated with nature of job. Even when so provided, the purchase from such QE will come over 3 year period provided there are correlated reforms in market place to protect the income from malicious extortion using penal mortgage rates or credit card frauds etc.

For the record, any kind of job will do but jobs which build future capability will be more valuable than crude "dig-a-hole-fill-that-hole" jobs. The benefit from these jobs will be a bonus. Ideally, you want the population to work on the next big thing. At the moment it is not clear what that thing is - it is most likely green and blue.

What has the current QE achieved?
One may ask if the current QE is totally useless. It is not. The crisis of 2008-2009 was result of three things freezing together - an over-leveraged consumer, a credit-starved producer, non-functioning market. The present QE worked on easing the producer, though at a great cost. Sadly, it has not quite helped with over-leveraged buyer or not much has been done to fix the market. Further the over-leveraged consumer is going to bear the burden of easing of producer through higher taxes limiting his ability to spend for quite some time. In effect, the current QE has eased the producer at some cost to the consumer.

My approach would have been different. I would have focussed on the jobs and when income stabilizes the credit would have automatically flowed to productive quarters. The benefit of this approach was its moral compass was pointing correctly. Government was taking care of people rather than focussing on the corporates, returns on credit would have been available where it was productive. Where credit was lent inappropriately it would have been marked down by players themselves because of inter-firm rivalry. And in the process, the overall expenditure would have been lower.

What kind of recession are we in?
The worst kind! No, it is not smaller than the Great Depression rather it is quite larger than that. We are at the threshold of global realignment of geographical dispersion of production and consumption. The ideal world we imagined when we studied "competitive advantage of nations" will come to bear if each of the nation acts prudently. This cannot happen in the current environment of mistrust and currency wars. We need sanity to prevail - and usually, it doesn't and usually this kind of thing results in a real war. On that somber note I leave you, let us pray sanity prevails and politicians do the right thing.