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Wednesday, August 31, 2016

Why are taxes so complicated?

Apple’s skirmishes with the taxman have brought the issue of taxes to the fore again. It all started with Warren Buffet’s assertion that he paid less tax than his secretary. We wondered what magic formula achieved that!

What is wrong with taxes? Why don’t we understand what is going on? Many reasons but mainly because tax is complicated — too damn complicated. I haven’t met a person who can mentally calculate his or her taxes even when they know their income precisely — not even with a calculator. These calculations aren’t even in the ballpark. So why is tax so complicated? Politicians and taxmen alike tend to confuse the debate with many terms and jargon.

What is a Tax?
Tax is actually a charge paid to the government for the services it renders — i.e. maintaining law and order, national security and general governance to cover the costs for that (such as salaries of army, police, judiciary, bureaucracy etc). It is also a source of finance for government investments say in infrastructure (think highways, dams, railways, space program etc). Taxes also pay for government expenditure on other things such as bailouts, promotion of job-creating industries, pensions, healthcare etc.

To pay for all these activities, government formulates a “tax strategy”. Tax strategy is combination of various taxes imposed on the public (citizens and non-citizen residents) to make up its income. It generally combines Direct and Indirect taxes, income and expenditure taxes etc. It may also include tariffs, duties, cess and fees under many different names.

Direct versus Indirect Taxes
Now government can take the taxes in two ways. Direct taxes are taxes those directly collected by the Government like, say, income tax etc. Indirect taxes are levied on the manufacturers or employers and these are then passed on to the citizens.

The direct and indirect taxes are important because of ease of collection. Indirect taxes are easier to collect but increase the transaction costs in the economy. Thus, if there are excise duties across the value chain, then such products have to be that much more competitive with respect to other global products just because of tax accounting.

Income Tax and Expenditure Tax
Government has at its hand two types of taxes. It can tax income at the hands of the earner. It can tax the consumer at the time of consumption. Notice that the timing the taxes are collected is different. That has an important bearing on this discussion. Between receipt of income and actual consumption is a quantum of time that can be controlled by the citizen. This has important bearing on the nature of tax government wants to impose.

When recessions strike the government is required to give a fiscal stimulus. When the tax backing such investment can be collected is now left to the consumer. After recessions typically, the consumers are reluctant to spend thus delaying the tax collection and putting government commitments to lenders at risk. An income tax, however, comes in as soon as income recovers. That used to create a big problem for the governments. However, with present technology and statistical analysis, governments need not have these

Expenditure tax has its advantages. It penalises those who consume more as against those who consume less. The argument against expenditure taxes is that incomes are higher than expenditures and thus tax collection is more. The counter argument is that expenditure tax leads people to invest rather than consume.

Tariffs, duties, cess and other fees
All these items are basically a charge on specified group of persons (natural persons i.e. people or legal persons i.e. corporations). These charges are meant to nullify some anomalies arising out of policies. Thus, if tax on cars is 30% on price of car, then if you import the car then you will also have to pay 30% “import duty” to bring you inline with those buying locally.

Why are taxes so complicated?
There are three sources of complexities in taxes. First is that tax law itself is complicated. Secondly, the constitution of the country creates complications that show up as complexity in taxes. Third type of complexity is result of Governments using tax laws and bending constitutional mandates to further their public policy.

Complications of Tax law
When you read the tax law, it is usually in two parts — tax rates and “interventions”. Interventions generally take the form of exemptions,deductions and tax breaks.

First part deals with tax rates. Tax rates by themselves may be different. Income tax rates are decided on slabs. For example, income below $20,000 may not be taxable, between 20,001 to 50,000 be taxed at 10%, between 50,001 to 100,000 be taxed at 15% and so on. It is easy to understand that the higher the tax exempt income, higher the tax rate others have to bear.

Exemptions are incomes or expenditures by law exempted from tax. Thus, income from renting a housing may be exempt. So when computing your taxable income, you don’t include the rent in it.

Deductions are amounts you invest in certain schemes that you can deduct from your taxable income. Thus, amount invested in pension plans may be deducted from your taxable income before tax is computed.

Then there is something called Tax-break. These are most notorious of all interventions. By this mechanism certain persons (natural or legal) can be made exempt from paying taxes if they satisfy certain conditions.

If taxes seem complex by now wait till you hear of this new type of complexity.

Constitutional complexity
The constitution in most countries grants the right to the government to levy tax. Now no country has one government, there are at least three sets of government in any country — city level, state level and national government. Constitution has granted each of them some tax they can levy. It is different for different countries but the principle is the same. These taxes taken together result in massive compliance exercise that is both time consuming and complex.

Governments overreach when they want to increase tax collection. So they invent some other thing to add to the tax burden adding to complexity. For example, if state or city government can tax land, national government may impose environmental cess on those lands which are not tree covered. It may be so that environmental policy is with national government, and land taxes with city government but now national government has got its pound of flesh out of land taxes.

Tax as an instrument of public policy
Governments, with all nice intentions, tend use taxes to further their public policy aims. For example, to promote job growth, they may want to give tax exemptions to various industries, tax breaks, they decide what the level of exemptions — what incomes are exempt from taxes. Or, say when they want to support home buying, then the government may give you deductions if you buy a house and lighten your tax burden. All these things combined make the tax calculations too complicated. These interventions are nothing but Government trying to influence society — they are using tax as instrument of public policy. It is wrong for many reasons.

The concessions given to further public policy have two ill effects. Firstly, they do not convey transparently what benefits were given to whom and thus it is underhanded. Secondly, they are wasteful as they cannot be pin-pointed to deserving persons. There remain, deliberately or not, various loopholes that creep into the legal draft of the law when it does come out. US tax code is rife with instances where industries on one side of the road has received tax-break while that on other side hasn’t.

I once heard a (fictional I think) story about Britain. In the 90s it was noticed that more Brits preferred to stay single than to marry. Naturally, the cable channels were quick to host debate shows on declining moralities of the Brits. It was then discovered that despite not marrying, Brits tend to stay with same partners. Quickly the hollow debates went after religion values of marriage etc. Ultimately it was discovered that this so-called moral decline was because of an innocuous clause in the tax code which imposed additional tax on married couples than two single adults. Talk of unintended consequences!

If government wants to subsidise certain industry let it do it by direct transfers or refunds. The problem with this argument is that citizens themselves do not accept it because government is quick to accept money but very lethargic when it comes to a refund. In corrupt countries there are palms to grease — if you are in India you have to grease the entire bureaucratic system and bureaucrat themselves.

The resulting of Complexities
The complexities in Tax system are not the only problem. They are genesis of the worse problems.
Individuals v/s corporates

There is a fundamental flaw in the tax system that treats income tax of individuals and corporates differently. The tax system believes that income of the corporation is its profits which is revenue less costs (crudely). In case of individual no consideration is given to expenses. Thus individual is taxed on revenues while corporates are taxed on profits. This difference has to go away. Now to be fair, individual tax rate is lower than corporate tax rate for precisely this reason. Yet, this difference coupled with tax avoidance mechanisms and other invented devices contribute heavily to discrepancy between the individual who cannot game the tax system and the corporate which can.

Tax avoidance
When the underlying system is complex, private parties more than government agencies are able to take advantage of the system. In the 2008 financial crisis, the average paying rating agencies were not competent enough to see through the complexities created by highly-paid bankers. Same logic holds for tax too.

With loopholes this wide, rich people with boundless ingenuity come up with schemes that help them avoid taxes. So people invest more in housing if rents are tax free. Such tax avoidance has created an industry of accountants whose only job is to avoid taxes. It is also in the interest of these accountants to keep tax codes unnecessarily complex.

When tax avoidance increases the burden falls on the poor who are ill-equipped to handle the complexities of taxes.

Transfer pricing — The bigger problem Tax evasion
One of the worst ways of evading taxes is by using transfer pricing technique. Let us imagine I make shirts under my company X Inc. and it costs be $50 to make the shirt which retails for $100. But I am based in a country where tax rate is 20%. So I make incorporate a different company X Ireland Inc. where tax rate is 1%. So X Inc. sells all the shirts to X Ireland Inc. at $51. And I pay tax on $1 at 20% i.e. 20 cents. Then X Ireland Inc. sells the shirts at $100 world wide. I pay 1% on $49 profit i.e. 49 cents. So my total liability is 49+20 = 69 cents. If I was doing business completely from my home country I would have to pay 20% of $50 i.e. $10 in taxes. This $9.31 is deemed to be legitimately avoided. I think not! This is tax evasion not tax avoidance. A small business cannot compete with this company.

This transfer pricing game is played at various levels. Corporates play countries v/s countries, pit state v/s state and city v/s city to extract maximum benefit. This benefits are solicited through industry bodies, professional institutes and other mechanisms of lobbying. Eventually tax payers are paying for this too.

Money laundering
The Global cooperation in taxes was brought about because of money laundering. All money laundering channels were discovered and they remain operational because of their use in tax avoidance / tax evasion. These networks have now been used to finance terror network which brought them into focus.

Taxes need urgent global reform
We need a simpler tax system that is easy to understand and easier to comply with. The complexities need to be resolved. Most of the countries in the world have a unified expenditure tax system (GST it is usually called). Such a system should be created for all taxes. We need to do away with exemptions, deductions and tax-breaks. The government aid, if necessary, should be given directly by cash transfer.

Second, we need international cooperation with respect to tax regimes. It is in the interest of all the countries of the world that tax is paid to the government to which it is due. There are efforts being put together to track and prosecute tax evasion through Global Forum on Transparency and Exchange of Information for Tax Purposes. This is a welcome initiative, though too many bureaucrats are discomforting. I hope it does not end up complicating the Taxes rather than simplifying and checking evasion.

If tax is a necessary evil, it is unnecessarily complex convoluted evil. May the Founding fathers should have put in a fundamental right that taxes shall be simple to understand and easy to compute and pay. Taxes should be simple and straight-forward. A healthy global tax system will empower our governments.

Monday, August 29, 2016

Dollar, the International Currency system and the Ghosts of Connally

US Dollar took over as the world currency thanks to Bretton Woods 1944 at the end of the World War II. With the world facing tremendous calamity, a sensible system was put in place, incorporating the learnings from the failures of Treaty of Versailies.

Begining its inception, the European states set out on a development spree that has since remained unmatched. Even the rise of China in peacetime does not match the speed and quality of development. But with development, there appeared cracks in the Bretton Woods system. Well, not exactly the Bretton Woods system - but the currency system. There appeared an fundamental incompatibility between the unique construction of US Dollar and the structure of Bretton Woods.

The Construct of US Dollar
US Dollar created in the aftermath of American struggle for independance was gold backed as was required to be able to trade in the global system. At the early stage, US Dollar was indeed made out of gold-silver mix (1:15) and each dollar was backed by 1.60gm of gold. The gold-silver ratio was reduced to 1:16 thereby devaluing the gold equivalence which now came to 1.5gm gold for each dollar. The new coins were made by gold-silver mix so exact devaluation can be debated. However, the weights of the coins continued to be reduced over the 19th century.

This bimetallism had to be gradually dropped since the silver coin weights were reduced and later substantial silver deposits were discovered leading to wild price fluctuations. Thus US Dollar came to exclusive gold standard. The formal gold standard act backed the Dollar with 1.67gms of Gold - a smaller devaluation by itself.

Note that at the time, Pound Sterling was the dominant currency and it was exclusively backed by gold. The Pound also fluctuated in its gold peg till early 19th century where the British put in place the gold standard. Their wide-spread empire and british respect for the value of the pound contract meant it quickly became global currency. US Dollar was emulating this precedent. 

In this process the pegs to the gold were altered by World War I and subsequently in 1931 Britain gave up the Gold Standard, leaving American Dollar as strong contender for world currency. All this was formalized in 1944 at Bretton Woods.

The Second part of Bretton Woods Agreement
At Bretton Woods it was also agreed that exchange rates between some dominant currencies would be pegged to the US Dollar and they were backed by Gold. With such a policy in place, European countries started on most ambitious reconstruction plan. This was supposed to be an opportunity for the American companies and it was. But it also created many European companies who became competitive vis-a-vis their american counterparts and started a cross-flow of trade and commerce. In the process, more US Dollars were created and soon there were too many and not enough gold to back it. 

This fact was noticed by the trading community who started bidding up the Gold prices prompting John Connally to push for abandoning the gold standard. He said later "My philosophy is that all foreigners are out to screw us and it’s our job to screw them first."

The Fiat-Dollar era  
The Fiat Dollar continued its run as the global currency thanks to burgeoning US population, US growth and demand from US markets. International trade soon became thoroughly Dollarized. The dollar-peg concept went from Europe to Japan. The latest in that phase came the dollar-peg by East Asian Tigers and mainly China. These countries vountarily gave up their freedom to conduct their monetary policy - depending on prudence of the US FED. This system then created today's unique problems.

Now with US being the defacto currency in the world, US lost its ability to devalue. Faced with this situation, US followed what John Connally famously said "The dollar is our currency and it is your problem". It printed and printed and printed. And so did everyone else - by default. In effect we do not see US Dollar being devalued - the point gold bugs keep making. Without the devaluation US is not getting the turbo-boost to kick start the growth leading many to call the other countries' monetary policy as "predatory". This problem is a corollary of the famous "Impossible Trinity" or "Mundell-Fleming Trilemma".

What should be the decent international currency system?
It is now clear that monetary policy independance can be given up volantrily and also taken away by coordinated action. The solution many propose is to go back to Gold standard - which may be a good intermediate arrangement - but not a good long term arrangement. A better idea is to go for a two-level currency system. SDR may be a good starting point - but SDR's may not give us the true global currency we need.

The global currency and relatively-fixed (stable) peg to global currency could be a good system. It will leave the monetary policy freedom with national central banks and yet keep the system stable most of the time.


  1. Volcker's FT Alphaville interview
  2. Economist on Mundell-Fleming Trilemma
  3. Yanis Varoufakis - And the weak shall suffer what they must. (book)

Friday, August 26, 2016

Capitalism V Democracy - Yanis Varoufakis

Yesterday, I saw the TED talk by Yanis Varoufakis (linked below) titled Capitalism will eat democracy: unless we speak up. It is quite a watch so I embed it here.

His suggestion is that we have to choose between a Matrix like dystopia v/s a Star Trek like utopia. The primary observation is that unbridled capitalism will ensure that the democracy works for the super rich but not for the poor. I agree with him as an assessment of the present state of affairs. But that does not cover the issue fully.

Capitalism can eat democracy but what about the reverse?
While it is true that democracy cannot eat up capitalism, politicians can. We have it happening right now - in India, China, Russia etc. These politicians become businessmen and plunder the country. This is no true politics but predatory politics can impair the la and order machinery to quickly discend into anarchy.

Crony capitalism v servile democracy v servile capitalism
Crony capitalism is a misnomer. A crony means friend - sort of an equal. But this is not a relationship between equals.

The government officers and politicians are eager to serve the capitalist. When chairman or office bearers of NRA speak they listen - not both sides listen but enough people on both sides listen. If Zuckerberg or Paige or Dimon or Buffet were to say something both parties will listen. I read somewhere that 80% of 2013 US presidential election funding was made by 150 odd individuals. Please tell me their views carry the same weight as mine. This is servile democracy. Yanis Varoufakis talked about Larry Summers (in other talk in Austin) telling him that if he becomes an insider then he will be given magical things. That is servile democracy not crony capitalism. This is a rich man trying to train a dog with dog biscuits.

There is other side to this too. In India businessmen are servile and politicians are the lord-masters. Things have changed - but not too much. It is easy to scuttle a truly new challenger to established business houses. If you take the paper spending on infrastruture - India can have better infrastructure than the very best countries in Europe - may be twice over. This is servile capitalism. There are whole networks that have come up around these politicians to create extortionist "business models".

Where will the fight between capitalism and democracy lead us is anybody's guess! But one thing is clear.

Capitalism and Democracy as competing systems
Capitalism and democracy are said to be collaborating or complementing systems. But we should start thinking of capitalism (more specifically markets) and democracy (specifically government) as both competing and complementing systems together. They both allow the masses to exercise their opinions. Marktes allows the individual to exercise it through buying i.e. through markets, democracy allows him to exercise it by voting in a government.

Now buying is something we do almost every day. Thus, we this part of the system is more evolved, sensitive. This system is also keenly improving itself to make sure the customer preferences are communicated to the top - it is thus more efficient than the political system. But let us remember they can be inefficient too.

The political system works like a broken market system. Here the opinion or choice of majority is forced on everyone. Imagine if markets worked like democracy - everyone may be forced to wear XXL size blue man shirt (coz majority favours it). 

By now you must think that they operate in different spheres and so it is not a problem. But it is! Notice that the burden on government to make itself more palatable to all of its citizens not just the majority is quite high. It is higher than the burden on market to service all types of demand. That is because there is an alternative when market fails to understand the opinion of minority - some niche player can fill it. In case of government - there is no niche player alternative. Therefore, Government must be held accountable more than the capitalist. And it must uphold the rule of lawso as to ensure capitalism is working smoothly.

Just think - marxism is actually a response to servile politics impairing the demands of working class (the proletarait) by the capitalist (bourgeoisie) who were friends of politicians/rulers. Then the Soveit collapse was actually a response to the politicians exploiting the political system to their economic advantage. In some way reverse of the first wave.

So the point is...
We need a mechanism to ensure the bargaining power between capitalism and democracy is maintained. Without such a mechanism we may end up in some trap or the other.

The ideas expressed in this post first appeared in my book  Subverting Capitalism and Democracy. Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms". 

Monday, August 22, 2016

Reorienting Singapore - Ideas for a Future Economy

Singapore is unique country. The Singapore government works better and more efficiently than its corporates. So naturally, it wasn't surprising to find the Government of Singapore exploring new policy options to ensure Singapore continues its development. The urgency with which Singapore Government is looking for these new themes is indeed creditable.

There is a Committee on Future Economy. This committee comprises many thinkers and business leaders. The committees presented some ideas at the IPS CFE conference. I am parsing through the ideas in the sessions - all make interesting food for thought but not out of the ordinary. Be ready to sift through jargon and buzzwords while picking the best ideas.

Here are some of my thoughts on these things:

Keeping aging population employed, relevant and highly paid
First we need to abandon the concept of "job" or employment using same skills over entire lifetime. Some skills stay relevant and even appreciate with practise. Surgery, tailoring, etc come to mind. There not much is required to be done so long as the skills remain relevant. But even master tailors and surgeons will also need to be aware of the advancing robotics wave. Thus, we definitely need to reskill the greying workers. The question really is how to reskill in a way that augments the skills they have acquired and makes these workers into super-constributors. One way is to take the skills they have acquired over lifetime and let them impart these skills to new workers. In areas where robots are taking over, these workers can evaluate the robots or augment the research in robotics.

Opportunities for section of population with varying skills
How to ensure employability of part of population of varying skills? 
  1. Take the art route. And we need not ignore the digital art - Singapore can become a hub of say world class web-designers, interface designers etc. The key question is what domestic set of skills can be made available to the world that will have sustainable advantage? 
  2. Dragon purse effect: Allow citizens to create something artistic and using SMEs explore if it finds relevant demand in the world. If yes, then it can be expanded into a proper global scale product. This is like next step of kickstarter - a place where entrepreneurs can innovate new products and try it on smaller scale. A dragon purse was a hit world-wide. So what can be the next dragon purse.
  3. The key question will be how to ensure that the core of what is found in Singapore can be deployed globally in such a manner that benefits will flow to Singapore? 

Reinventing Construction
Singapore is as unique as Netherlands in the fact that it has natural constraints to deal with and has the technology and capital to solve the problem. Netherlands also has innovative ideas. Does Singapore? I think so. Just that we need to look widely.
  1. With an eye to global warming, Singapore needs to raise its height by about 5 meters above mean seal level. It means gradual planned buffer creation across most of the city. This area needs to be explored.
  2. Singapore can invest in breathable green materials construction techniques for office and residential buildings. The idea is to use architecture, materials and structural engineering to reduce (and if possible eliminate) requirement of air conditioning.
  3. Urban agriculture idea is not new. But creating enabling buildings is not given as much a priority. By the looks of it, the future buildings will have to work with plants, crops, animals and poultry. Again needs investigation and trials. A country like Singapore can effectively be leader of such technology.

Hi-tech Industries such as medtech, Predictive Tech etc.
There are a few hi-tech industries that can play to Singapore's advantage - high-tech manufacturing and pure high-tech industries.
  1. Medtech is high-tech manufacturing type industry. What is unique about medtech type industries is that they are highly technology dependant and thereafter entire global demand can be serviced through small worker-less fully robotized factories.  Chip-design industry has similar characteristics. While, the intellectual property is difficult to replicate, the production is easily replicable with cheaper capital and easily available robotics. When medtech wants to retain its Singapore advantage then it must create a network of med-tech testing environment (can test in China and India - will be lower cost). Thus, you leverage proximity and access (to ASEAN, India, China, Indonesia - populus markets) for testing and deployment.
  2. Similarly, a pure high-technology industry includes Predictive Technologies is rightly highlighted as relevant industry for Singapore. These are pure high-tech industries. Another like Algorithm designdata analytics, etc. will make high return, small team tech companies possible. 
  3. For both types of industries, the research in engineering sciences and applied mathematics is essential. Universities can highlight potential candidates and these bright candidates may then be financed to create startups locally.
  4. These companise individually may be small teams but collectively will be large employers and require plethora of suppert services that will be employment generating. 

Innovation - always by the SME   
SMEs are preferred entities to undertake innovation. Allow SMEs to fail fast, fail often and fail safe - and then wait that is all it takes for innovation to flourish. Celebrating failure is as important as celebrating success. Yet these three things - fails fast, fail often and fail safe require enormous infrastructure and social development. 
  1. Principle-based regulation: The search for light-touch regulation is not easy. Light touch regulation implies a quicker resolution of liabilities and protection of genuine risk-takers from being unnecessarily hounded. That should suffice. Other aspect of light touch regulation are actually ease of doing business which are fairly well developed in Singapore. It is also better to guard against misuse of personal health and financial data than regret the "light touch" later. So right-touch is better than light touch. These aspects are easy to deal with using "principle based regulation" letting the courts follow the spirit of the law rather than rigid enforcement of letter of law. That is advantage of the common-law system as practised by Britain and US.
  2. An evolved Intellectual property law framework: Hi-tech industries along with innovation as a focus implies creation of intellectual property. Intellectual property can quickly devlove into what is referred to as "problem of commons" or "gridlock economy". In either case the innovation suffers and the innovator lands in trouble. To counter this, a quick-resolution mechanism for intellectual property is required - starting from registering unique IP, resolving disputes and trading IP. 
  3. Government contribution: Government can give access to the international patents database so as to prevent duplicate research and ensure that when IP is granted in Singapore (certain class of IP) then it is really at the cutting edge of the stream and thereafter can be traded across the world.

Future of Work - Implications
It is well accepted that future work will be more like a free-agent rather than life-time employment at specific skill. It will be multi-skilled (may types of work at once), simultaneously (many jobs at once) and within multiple teams that come-together and get disbanded at hyperspeed. All this requires development of infrastructure. 
  1. A skill repository is essential: The construction value chain is an example - the developer knows who is best architect for the job, who is a good contractor, electrician, plumbing contractor etc. and they all come together for a project (while some may be working on more than one project) to deliver a unique product. The question is why cannot other businesses do it. It is because transaction costs are too high. If there were a skill repository (indicating who has the best skills for a particular job) and it was easily accessible, then you could hire these experts easily (band and disband easily). 
  2. Legal innovation required for future work: Future work also requires development of standardized contracts so that both parties are protected in such transaction. It also requires grievance redressal and dispute resolution mechanisms. It also creates a new set of jobs that addresses background checking, feedback taking, maintaining work histories and customer reviews. Lets say Singapore were to partner with Linkedin and augment the database Linkedin has with fact-checked database. Wont it be easy for prospective employers and service seekers to hire those people? Data on new skills sought by the employers can be mined, appreciated for long-term skill development and it can become input into human resource policy.
  3. Safety net: With firms not able to help create employee safety nets, it may be required of the government to create a mechanism for these free-agent workers to bolster their safety nets. Some hand-holding and some compulsion may be necessary so as to ensure that longer lifespans are happier lifespans.
Second mover/ Fast Follower strategy for innovation
Seond mover or fast follower strategy made famous by Panasonic case in business schools has some merit for flexible economies. But sadly the fast follower days are over. These days winner takes all approach is dominant. A more relevant model for this era is the "long-tail" model. There is only one facebook. Singapore may heed the story of mySpace which was the first mover, but lagged in innovation and quickly faded into obscurity. For most of the industries Singapore intends to rely on, this is the reality. In such a case, a fast-follower or second mover strategy cannot help Singapore. In fact Singapore needs to be a leader and additionally be flexible to keep its advantage.

Globalisation and Regionalisation
Singapore is welcome in China as well as India. Singapore should use this advantage to develop supply chains which are regional and supply global products with these supply chains. Just like the Apple HQ is at Cupertino but production is in China, we can have highly value-adding HQs in Singapore and production in China, Vietnam Indonesia, India tc. Engineering excellence is not geography centric. The passionate drive to make your product superior can be recreated anywhere. What you need is an environment where entrepreneurs can fail safely without being judged harshly (socially more than financially).

I think the Future Economy deliberation has just started. Maybe if they could ask me for what I think! ;)

Friday, August 19, 2016

Why is resolving Non-Performing Loans (NPL) is so difficult?

The management/resolution of NPLs has acquired renewed focus with banking sector under stress for many years. The Economist comments on it this time about Italy's NPL problem. More significant is the commentary on various approaches, IMF recommendations, KKR's Pillarstone initiative etc. making it a must read. But it misses some quite important issues with respect to NPLs in general.

Failure of NPL liquidation - some blame lies with Accountants
The PwCs, EYs, Deloittes and their ilk must take some blame. Many of the bad loans have accounting folly at its heart - some deliberate and some not, some before loans are made and some after. Time and again, accounting firms have washed their hands off their audit responsibility and liabilities arising therefrom. Recently some firm has sued PwC for their failure to report material issues. If auditors completely trust the company managements they are auditing, then the purpose of the audit is not satisfied. 

The shady entrepreneurs
The proportion of shady, shifty characters in this distressed assets pool is quite high. Some distressed loan assets are deliberately impaired on the books for tax fraud or money laundering. Data mining algorithms cannot detect this - even analyst cannot easily detect this. Such frauds have to be sniffed out - at least till Artifical intelligence becomes more robust.

Slow courts and costly Alternate Dispute resolution (Arbitration, mediation etc.) mechanisms
Invariably, a fair proportion of the distressed asset pool goes for legal resolution. NPL problems are higher in countries with weaker judicial controls, higher cost dispute resolution. The process of dispute resolution quickly unravels both the ability to pay and gives a remarkbly clear insight as to the intention to repay. However if the process is too slow and too costly, it defeats the purpose. This is a problem in Italy and also in India.

Much blame lies on Incompetent Banks
The substantial blame though must lie with the bankers:

  1. Lack of accounting analysis skills: Many banks which make loans cannot make proper assessment of accounting statements. Data mining algorithms are good at assessing the "ability to pay". They cannot assess the "intention to pay". Lack of Intention to Pay has created many NPLs.
  2. Illogical the use of collaterals: Banks are notorious in having collateral that is highly correlated with loan asset itself, over-valued or pledged in part to many. This is a childish mistake to make for a professional setup. At times, an intellectually superior form of syndicated lending (the whole syndicate holds one collateral) is used. When trouble strikes the legal disputes arise within the syndicate itself. 
  3. Poorly-constructed contracts with borrowers: Such contracts make the payments unpredictable in quantum and timing thus surprising the borrower. It quickly cascades into penalties and surcharges and it goes downhill from there.
  4. Too Centralized decision making as to loan eligibility: Most borrower eligibility tests are done centrally these days. Thus it leaves no incentive for the bank manager / officer to dig deeper into the borrower's records. It makes the incentives wrongly aligned.
  5. Flawed loan portfolio construction: Loan portfolios are too correlated This is a result of too much market focus. Banks push certain products that they find easy to sell - consumer loans, credit cards, personal loans etc. When the lending starts concentrating they do not quickly take corrective actions to balance the portfolio. If the banks' entire portfolio comes under stress at the same time, it cascades into more distress.

Basics of borrower assessment
Any borrower assessment has two component - ability to pay AND the commitment or the intention to pay. Sometimes the last two differentiated. The ability to pay is well understood which refers to  the capacity to bear the repayment of the loans. The intention to pay tries to determine if the borrower intends to cheat or not. The commitment to pay points to whether the borrower intends to pay  but disputes the computation of the payment and hence may have withheld the payments - committed but not paying, or the borrower does not intend to pay at all and is finding loopholes to delay the foreclosure process.

Thursday, August 18, 2016

Should banks create money?

Bloomberg has a post about centralizing money supply - whole money, as they call it. It is not a very good idea. This is not the first time such suggestions have come up. As mentioned in the article, Irving Fisher first proposed a similar plan in the wake of the great depression. Since then many have proposed this idea but not many understand money creation.

Taxonomy of centralized money creation idea
The money creation ideas are varied:
  1. Gold money: This is natural money creation. No one has any control over the money creation. Previously, gold, silver, diamonds, precious stones and other valuables (and sometimes sea shells too) were used. Many serendipitous discoveries of valuables created havoc with the money supply. Discovery of Potosi in South America and thereafter further discoveries of gold and silver had the effect of expanding Spanish money supply. 
      1. Not under any control: Neither governments nor banks, no one has any control over the money creation process.
      2. But Non-Arbitrary: It depends on the amount of gold you have. If you want more gold, you better import more gold by giving some valuable service to the other countries  who have gold. Over time as the total amount of gold available starts reducing you need to offer more and more to the countries that have gold.
      3. Though subject to Nature: If by chance you discover a gold mine, you will be filthy rich, though if you discover too much then it may unleash inflation. Spain is believed to have faced such inflation on the discovery of silver mines in the South American colonies.
      4. Deflationary and restrictive: As economic activity grows it becomes too high compared to the total amount of gold available to back it. Thus it tends to slow the economic growth pace. (Don't know if that is good or bad).
      5. Favours status quo, old money and advantageous to miserly: Since total value of gold you have increases with time, people tend to postpone purchases and hold on to gold. Spending happens when absolutely necessary.
      6. Exploitation and Theft prone: A doctor can charge atrocious fees from a rich person because of bargaining power equations. Gold can also be stolen. Stealing credit cards is less useful.
  2. Gold-backed money: Introduced to circumvent the deflationary gold currency, countries peg the value of their currency to the gold they can back it with. When people talk of gold standard they are referring to this type of money creation. 
    1. Partly Government controlled: Government issues currency and states the total amount of gold they back it with. So a gold-to-dollar exchange rate is established. The government can improve its reserves and thus improve money creation. 
    2. Non-arbitrary: In its pure form it is non-arbitrary and similar to gold-money.
    3. Not purely nature driven but subject to shocks: Since the government has control over the amount of money and amount of gold, the money creation is not as whimsical as simply discovering a gold mountain. Governments can reset the exchange rate to compensate for some changes. But arbitrary government intervention results in shocks and disruptions.
    4. Mostly deflationary: Governments cannot measure economic activity easily (yes GDP calculations are guess-work and there is no Santa Claus just in case you were wondering). That leaves money creation open to political whims and fancies and invites tampering of measurement of the economic health. Mostly governments are slow to acknowledge the real growth in economy since it is always backward looking. It realises the growth till the growth results in deflationary pressures then increases money supply and causes a spike.
    5. Perception of money losing value as government reset gold rate: As total amount of product and services of value in the economy rise more than amount of gold to back it up, the government is forced to alter the gold-dollar exchange rate downward leading to people feeling that each dollar is worth lesser in terms of gold though purchasing power may be higher.
  3. Government-created money: This is non-gold standard money. Simply speaking the government issues money and backs it with a promise. This is what people wrongly believe is the current regime. 
    1. Full government control: The government has effective control over the process. This is a mixed bag. It depends on the government. 
    2. Some central bank control: The exact control depends on how money is created, is it by using government bonds then bought to a certain extent by central banks or some other way (simply printing).
    3. Depends on confidence in Government: Prudent governments enjoy advantages but if you are Zimbabwe then you will end up in trouble.
    4. Inflation/deflation depends on policy: If a government print too much then it stokes inflation and too little results in deflation. Prudently executed (Milton Friedman's about 3% money supply growth) works fine.
    5. Value of money depends on inflation: If the government is able to deal with money creation effectively then a mild inflation - say 2% may result. There is not too much loss in value and it can be notices only over long time frames when quality of life changes are also noticeable.
  4. Money created by banks: Mostly commercial banks create money by giving loans. These loans do not exist as money. This is the most misunderstood money creation mechanism. It is distributed money creation, without extreme control. Bankers and regulators forget that its success depends on devising proper incentives. 
    1. Less government control:No country uses this method exclusively. Both Government-created and bank-created money is deployed. Thus there is always government control of some sort. Also since government is also a borrower (a big one at that), it has control.
    2. Part central bank control: Central bank exercises additional kind of controls in this mechanism. First, it can partner with government in its money creation process by buying government bonds etc. Second, it controls the lending to the banks and thus influences at what levels of risk do banks create money. The key word is influences and not dictates. Thus this process is often likened to "pushing at a string" (which is difficult, you can pull at a string pushing does nothing unless there is pulling at other end by the banks).
    3. Control to banks: In this scenario, Banks can ALSO determine whether to create money or not. That decision is based on whether the person demanding the money will be able to repay it or not. If he can, it means he is creating value with this money and thus able to repay it. 
    4. Decision at the point of demand of debt: The decision to create money is forward looking. It is made at the point the person makes a demand for the debt. That borrower is expecting to create future value. If by banks assessment that value can be generated ONLY then money is created.
    5. Depends on incentives: After reading this if you wonder why banks lend for consumption goods or lend to uncreditworthy borrowers - it is because of incentives. The power to create money is substantial power and with bad incentives, it can cause systemic harm as seen in 2008 crisis.
    6. Central bank oversight: Central banks have oversight duty to watch what kind of money is created by the banks. The nature of lending is supposed to be value-focussed. Some consumer lending at the time economy is entering a pro-longed boom phase can be advantageous. But in an economy which cannot sustain a prolonged growth phase, these are risky loans and their proportion needs to be limited.

My suggestion
Out of the options, I prefer the last one - a combination of bank created and government created money. It is quite forward looking and takes place at the point of demand. It needs a lot of oversight and decentralisation. I have argued that IT systems have in fact centralized the loan decision making than allow the front-line managers to make them. This has resulted in an inaccurate assessment of borrowers and partly responsible for the 2008 crises. Amar Bhide also makes a case for intelligent decision making in his book "A call for judgement".

What should governments spend on when faced with fiscal stimulus?

At the time of financial crisis of 2008-09, we were lucky to have the best monetary policy experts around. They seemingly used their various tools - some conventional and other unconventional. Yet about 8 years after we find we need fiscal stimulus as Mario Draghi put in an ECB statement in early summer. Luckily the US presidential candidates agree with this view. So in all likelihood, we should see some fiscal stimulus coming in.

Yet, the understanding on the fiscal side does not seem to be as well developed as the monetary sides. For one, exactly what Keynes prescribed is still much debated. Second governments don't know what to spend on. Obama famously called for "shovel-ready" projects. Milton Friedman (who died in 2006) would cringe in his grave. There is nothing more dangerous than a government committed to a fiscal stimulus that does not know what to do with it.

Looking at Roosevelt
It is, however, well-accepted that after the World War II, the Roosevelt initiative of building inter-state highway was one of the biggest fiscal stimuli to the US economy. The genesis of this project was the cross-country trip Roosevelt took in mid-1920s which may have given him a hint of its potential. Once it was implemented, its fruits accrued at least till late 1990s. Even in the era when the internet made distance irrelevant, these highways continued to contribute by way of lower transportation cost thereby giving firms advantage in making supply available at lower costs than otherwise. 

If fiscal policy is to be deployed today where can we deploy it? What areas would have as much purchase as did the highway program of 1930-40?

To answer this we need to imagine the economy as a network of value chains. Such a network has some common elements which need government support. These are the areas where fiscal policy needs to be directed. This is the efficiency angle. If any government wants to orient its economy in a certain direction then this would be the time to make investments in the missing parts of the value-chain that can be shared in the new era. 

A few I can think of:
  1. Going green: Reducing Oil-dependance is an option : The very basic pieces of all value chains do contain energy. So an advantage in green energy may be quite advantageous in the long term. Green energy needs a lot of work but could be a potential candidate. It could do with some sort of Manhattan Project 2.0 (the first was for nukes) for making green energy possible. They could standardize the electrical charging stations for hybrids, developing standards and technology to allow smaller wind mill operators to supply into the grid at a time of their convenience. Tesla is looking at this vision through private means.
  2. Going blue: Usable water: Food and water will continue to form part of value chains at a very basic level. While global food production is quite high (we destroy a lot of excess food), same cannot be said of global nourishment.  It is undeniable that whatever food we grow we will need potable water. Many say if we find green energy then we can desalinate the water. But low fresh water has an ecological impact on bio-diversity, food-chain dynamics etc. that cannot be dismissed. In that sense, the bio-diversity advantage may trickle into better nourishment and healthier foods - who knows. So I would focus on water management.
  3. Carbon catchment could be more urgent: In his TED talk Bill Gates made a very poignant statement - we need ZERO emissions, not lower emissions. It is clear that we cannot cut emissions fast enough. But can we trap emissions before they cause global warming? Maybe we should! This is more engineering problem rather than technology problem and may be more beneficial. Alas, its effects are very difficult to quantify.

The nature of fiscal stimulus
The exact quantum of fiscal stimulus is immaterial, though it has to substantial. What matters more is how long is that quantum spread and the conviction behind it. That will decide its efficacy. The fiscal needs to be prolonged, substantial and certain. An uncertain prolonged stimulus or variable stimulus without visibility will have no appreciable impact. 

Ideally, it should also be employment intensive. Higher employment intensity will allow the benefits to spread faster through the economy.

The goal of the stimulus is to increase the certainty of jobs and employment while laying down a basic infrastructure for the future. If it achieves this then such a stimulus will work. With a certainty of income will come spending and further downstream positive economic effects.

Note: the suggestions made are simply most promising areas at the moment as per my reading. 

Wednesday, August 17, 2016

Is assessment of risk a function of interest rate?

The interest rate that can be charged by the bank has  two limits.

The Lower bound equals what the central bank charges the bank. Any lower and the bank will make a loss on its lending portfolio.

The Upper bound is the ability of the risk taker to bear the burden of return. Thus, if a bank lends to a business that makes 10% return on capital employed - it cannot charge more than 10% else it will be unviable for the borrower to seek the debt at all.

The Actual interest rate charged is determined by a combination of the following factors:

  1. An assessment of returns of the business based on the economy and her business 
  2. Income of the borrower in total 
  3. The value of the collateral pledged against the loan as a security should the borrower be unable to bear that return 
  4. The demand for loans AND/OR
  5. How well the other loans are doing (health of bank's loan portfolio) AND/OR
  6. A combination of these along with global factors
Bankers think of returns as spread they make on top of the lower bound, i.e. rate set by the central bank. 

Risk V/s Spread
Now, in the mind of the banker risk is correlated with the spread. When the banker perceives higher risk she fattens the spread. This "risk" we talk about is risk resulting to the banker. It does not mean risk of the borrower alone. So if the bankers' portfolio is turning bad, the banker will still increase the spread - partly to compensate for the loss she suffers and partly because she assesses the general economic environment to be more risky. Thus, even if the central bank reduces the benchmark interest rate, the banker is reluctant to pass it on if she can avoid it. This creates tighter conditions putting more stress on the borrower. This is why Scot Sumner argues the monetary conditions were actually tight when we were almost at ZIRP.

In an economy that is weak, it acts as a stronger head wind for borrowers. It reduces their ability to borrow and to service their current borrowing. They want to pay down their debt and reduce their loans. Therefore, the economy contracts further. The banks seem happy at first, but soon realise that other borrowers who are not prudent are pushed to default. The implication of this on the bank depends on the mechanics of the process - the proportion of those who default v/s those who pay back, the chronology in which it happens etc.

In the next phase, the economy recovers, predominantly with equity capital. Equity can absorb the losses since it is built for higher risk. The surviving firms and individuals are left with core strength to  thrive in intense competition and are more prudent with capital allocation. The banks thereafter can lend to these survivors to help them scale up.

What does this mean?
This means, 
  1. There is inherent value to competitiveness that signifies its ability to survive and repay the debt and repay the equity at decent returns. This ability reduces with increasing leverage by the borrowers. Thus when Anat Admati suggests investment banks have capped leverage ratios to 20 or 10 it makes sense.
  2. Banks' business model seems to encourage the use of debt only to amplify equity returns. It is fine in a way but if that is the objective then banks should reduce/cut lending at lot earlier than they do. Naturally, in times of distress when the return ON capital matters lesser than the return OF capital, banks get into big trouble. It seems they get confused about what is their business model. 
  3. Maybe, better than ZIRP, unleashing a new Government-backed Good Bank to pick up assets at distressed prices at lending rates with narrow and fixed spreads can work better. If the size of this bank is large enough in relation to the banking system, it may result in a lesser shock to the economy.

Tuesday, August 16, 2016

Of Free drinks and negative interest rate policy...

If soft drinks (Coke/Pepsi/tea/coffee etc.) were freely available would you tend to have more of it? Often I end up having one extra coke. If its tea/coffee I end up having even more. I will have to work it off that day through exercise or it will cause some harm in the long term. 

Zero interest rate policy (ZIRP) is like that - if you already wanted Coke and it was easily available you end up having a little more Coke. Likewise, if you already wanted debt, and it was easily available at almost zero cost, then you will have a little more. But not a lot more - coz you have to work it off.

But what if you don't want them?
Say your doctor told you to not have soft drinks at all - no tea/coffee too. Now will you have that? NO? Even if I give you some money - say 2 cents - to have these soft drinks? Still NO? 

Well, me giving you some money is similar to Negative interest rate policy (NIRP). Or similar to one aspect of NIRP. You get a tiny advantage if you take on debt. Is it that difficult to understand why it doesn't work as central bankers hope?

But may be NIRP could work...
Now some will agree that ZIRP may not work, but, they say, NIRP could work. They point to the second aspect of NIRP which is that if you save you get taxed extra. Now if I have $100 in cash in a bank, next year I will have only $98 so next year I will be able to spend less than I can do today. Isn't that an incentive for spending now rather than next year? I say not always!

There are a few reasons:

  1. If the trends are deflationary your $98 next year may be able to buy as much as $100 today - sometimes even more. If the efficient market hypothesis* were working prices would adjust to reflect the new purchasing power. NIRP would create some deflationary force as well. Yes, it is small but it is deflationary never the less. So unless the NIRP was creating an overwhelming inflationary force, it may push a precariously balanced economy into deflation. 
  2. The NIRP tax does not affect those paying down an earlier debt. In fact, it encourages people to swap new debt for old debt. Debt repayment helps you avoid the tax. This is even more deflationary.
  3. NIRP does not work if I anticipate unpredictable cash requirements - say because I want to keep some money to invest when prices correct, or I think my business loan may need to be repaid if my business does not do well in next quarter, or I expect health care costs etc. In fact, it works reverse - in such cases, I would be encouraged to save $102 or $104 just to keep a buffer.
  4. NIRP may push those with huge cash balances to move cash abroad. Do you think Apple and Google will bring that extra cash into a country with NIRP? No way! They might move it to a destination where it will be easier to hold cash. So is this what you want to happen? NO! Who gets affected is the individual who keeps getting taxed extra.
  5. I may not want debt or I may not want to spend at all. I have the clothes, I have the phones, computers, TV, house, car, swimming pool etc - all the goodies I can spend on when you nudged me to spend the last time. Now I have mostly everything I need. So why should I spend on something I am not excited about? Beats me!

* I don't think Efficient market hypothesis works on a "point-in-time" basis - though it works on an average basis.

Tuesday, August 02, 2016

Free Trade - or no free Trade - either ways it ain't free!

Econgirl commented about the latest free-trade issue.  It is a must read - continue down to the comments too! Then David Henderson commented about it on his blog and the comments where @econgirl responded to his question. All must read in the overall dialogue about free trade.

There are a few things that need consideration:

  1. The losers of free-trade - how adaptable they remain after they lose: In many cases, these people are lost - this is a political price we are paying. Thus, a $10 gain per-consumer v/s say a total job loss of 10,000 people (hypothetical primary loss) usually it remains concentrated (think Detroit) and second and third order economic losses. Now in monetary terms, the gain-loss may be whatever, but when a group of people loses their livelihood without any margin or buffer to create new opportunities for themselves, then it makes for a difficult choice.
  2. The initial condition is responsible for the losers being as many as they currently are: If the trade was always free, the adjustment would have taken place a long time ago, giving the population enough margin to adjust. However, the governments by their initial protectionist intervention create a bigger adjustment problem in the future. When a competency develops in a country, the government rallies behind the firms with the very policies which later accumulate into a bigger problem. The adjustment to new potential trade-based threat can be innovation or it can be defeat. The auto-industry failed to innovate - something Tesla did, Ford and GM should have done years ago. But those are victims of their own success. At present, China is funding auto-tech companies to bring out a competitor to Tesla. 
  3. Free trade - v/s Fair trade: Indeed some countries do "dump" products on to other markets. At the same time, some countries do use "non-tariff barriers" for the protection of domestic industry. When is the "fire-sale" not dumping and when "non-tariff barriers" are not protectionist can only be answered on a case-by-case basis. This ambiguity is used to target Free-trade unfairly. 
  4. Economic V/s moral - politics enters through morality: Can we allow some trade partner using slave labour to create losses in our country? Economics says why not, morality says no. Blood diamonds are an example. That is where politics comes in. So while overall benefits of free trade may be high - the morality over why the government should not choose one set over other is a strong political motive against change of status quo. Of course people selectively forget that it was government intervention that helped the problem to get bigger.

So in an ideal case:
  • Free Trade is the default. Government has no business interfering in that unless some moral issue arises. The scope of these issues are pretty narrow - slavery etc.
  • Countries should progressively move all policy towards sector neutrality - including trade policy. Thus, a government would be right to have 50% markup over all goods/services entering the country/sold in the country without discrimination.
  • Then let this state continue and let governments step away from the issue altogether. (more on this in another post).