Rising commodity prices, excess money and bailouts

World is definitely in perilous situation. Expenses are rising thanks to commodity price increase. Households incomes are falling as businesses fail. Growth is slowing thanks to high cost of debt. Investments are stuck as selling assets at crazy prices is no longer possible. Only thing rising is commodity prices!

Commodity prices - what drives them?

To understand this, we need to go to first principles wherein goods and money are tradable. From here it follows that when the value of money looses its way - goods will be the lodestone, the compass. After all money is used FOR goods! We need to realise that money by itself means nothing. Money is intermediary, a common denominator amongst goods. The best mechanism to protect oneself from arbitrary manifestation of value of money is to have the goods! This has prompted the rush for commodities - the most standardized goods available to international financial community. And naturally, the prices of commodities and goods have lined themselves up in the pecking order of importance to the society. Naturally oil (presumably inelastic demand) pegs itself at the very top.

Cancerous growth of money!

Excess money is one of the root causes of the current situation. The excess money flow was further exaggerated by pegged exchange rates. Initially the increased money supply was cornered effectively by small group, mainly Central banks (reserves) and investors(wealth). The excess liquidity did not reach the masses inflation symptom was masked. The situation seemed like positive spiral. Reserves became trophies and wealth always was one. The ensuing trophy-chase, magnified by leverage, soon trounced one asset class after other. And then we hit the tipping point. Today we are bailing out the first casualties of calamity. The bailout mechanism is infusing more liquidity into the system. Like fighting cancer with cancer or fire with fire. And most likely we will be left with ashes or cancer!

Is capital destruction reasonable solution?

Capital destruction is a painful but sure-fire solution. The least we can do is to stop excess capital creation - that means bailouts will be few and far between. Further on unpegging exchange rates will help destroy some excesses. Write-offs will destroy some more. In worst case only the last person caught holding the bag will be hit. In reasonable circumstances, they will be rehabilitated. In best case - we can rewind and restart where we left off.

Questions from Barry Ritholtz

Barry Ritholtz has posed 12 questions related to current global economic situation to the readers. It has incited lot of interesting responses all must read. Here are my 2 dollars (no cents any more!) on the topic.

US Consumer spending, Housing
From first principles, US consumer spending should reduce until the time incomes become greater than interest cost, food and basic expenses. US housing loans are non-recourse loans (as I understand it) –hence jingle mail is best solution to get rid of the liability. Other loans, particularly credit card loans, might become a threat. To make an impact on the economy, this change requires strong-willed cost cutting across the population. This implies that downturn in US will be both prolonged and deep.

Can US avoid this debt trap?
There is a possibility that through structuring, financial engineering US can get out of this situation. It needs a creative solution involving legal, financial and regulatory skills put together. Following ideas can help define a solution:

• The human life is finite but firms’ life is infinite.
• All dues need not be paid back and all debt cannot be waived off
• The process of repayment of dues may be unfair – some people may choose to pay more than their share. (One example is taxes – taxes are unfair payments between individuals) In addition, some organizations will bear larger losses.

Inflation – how much, how soon, how to avoid
The excess money supply created over the past decade has to manifest itself. For long, this excess money remained contained with few resulting in a crop of billionaires, few sovereign wealth funds and overall salary hikes. After a certain passage of time, this wealth has to trickle down. This is what is happening currently. This will continue until such time the excess wealth exists. Wealth contraction can help correct inflation problem quickly. It implies currency revaluations, deep stock market corrections or pricking of asset bubbles. But this will create a lot of pain for the most important class of people politically – the influencers.

Employment – worse still to come – but totally avoidable
Employment is function of jobs available and skill availability. There is a strong mismatch here. If you don’t have skills jobs will move where skills are available. But will the low-skills jobs come back to you? US, in my humble opinion, needs a stronger manufacturing. That will take-off only if US dollar is correctly priced. We have already seen employment spurts with dollar falls.

Credit Crunch – impact on financial sector
Financial sector has itself to blame with the way it handled the excess money supply. Financial sector will go through salary rationalization, product rationalization, management control rationalization – in simple words it needs to go through Business process re-engineering. All financial companies need to talk to James Champy en masse. There is a lot of cost to be cut in these companies.

US Politics and war
The outcome of US election will have no impact on the crises. The current crises and possible solutions require unreasonably high skills of diplomacy. The potential for wars for forcible resolution of economic litigation will soon increase and pose direct threat to world peace. This will be most inconvenient for US. World economies will not take US opinion courtesy of Iraq and Afghanistan experience. It will take a real leader – a statesman – to sort out this mess without the war pains. I believe Hillary Clinton is lucky to have missed the nomination.

In Sum
We are going through one of the worst phases of economic history. No doubt we will come out of it. The only question is will we come out wiser?

A Threat to Globalisation

Let me first categorically state that I am pro-globalisation. Recently there is a careful weighing of pros and cons of globalisation. You can read Tyler Cowen, Mark Thoma and Brad Delong on this. I have a few points to add to this:
Globalisation as envisaged in theory and the practial globalisation that we are experiencing are two different animals. The first is the goal where the world economic system intends to move to. The second is represents a deviation, an intermediate stage, from the prior status (pre-globalised industrialsation) towards our goal of true globalisation. Let me hypothesize what differences we have.

• We have relatively free capital movement but we have a little restricted labour movement. The difference is in quantum and direction both.
• We have locally-wealthy-but-globally-poor pools able to kick start local economic development - but do not "export" this development through "consumption".
• We have economies that articificially create/sustain some competitive advantages longer than its "best-before-date" either through currency pegs, money market intervention or other things.
• We have created higher income polarity - possibly -keeping certain section of population in the low-income pole through a combination of slower skill-upgradation programmes or by keeping industry profitability low throguh subsidies or under the pretense of inflation targeting. Classic case oil and food - future case WATER!
• On the other pole - i.e. high income pole we have multiplying effects of first - increasing savings for similar incomes and second - increasing incomes through market mechanics. The increased savings are result of either flexi-taxes courtsey capital account convertibility or lower costs courtsey inflation control and subsidy. The increasing incomes is what accelerates the income differential - recently this has happened through asset price bubbles and otherwise through productivity gains as a result of globalisation.
• Further there is huge - amazingly huge - increase in cost of the tools of success in globalised world - parimarily higher (grad and post grad) education, health care (i.e for maintaining employability and lower cost when sick).
• Finally - globalisation, in all probability, seems to be irreversible development and will proceed towards the goal (i.e. real globlisation!).
  

Therefore, the current state has the pros and cons mixed up. The matter needs more debate and in-depth analysis. Today was just a welcome start!

Jeffrey Lacker on - The Fed Risks Moral Hazard

Jeffrey Lacker made a speech in London about Fed's bailout of Bear Sterns. The speech has amazing clarity about financial stability and central banking. It is a must read! Since I read it on the big picture - I am linking to it there.
The Big Picture Lacker: The Fed Risks Moral Hazard

Update:

Now here is the explanation and analysis of the Fed President Jeffrey Lacker's speech by Yves Smith. This is one of the reason why I am a fan of Yves Smith!

Thats why not much to add from my side. Here is the link: naked capitalism: Should the Fed Be Independent?

World without Oil.org

Let me first admit - I have a bias towards simulations and moreso towards game-based simulations.

World without Oil is one example why I have this bias. A few months ago an email exchange with a famous game designer Jane McGonigal introduced me to this game. And how soon have we come to this! The game simulated a world without oil and there is a whole lot of content on what people's responses have been to this crises. I guess that resource is now ripe to be tapped. I believe, the resource needs to be advertised and shared more.

Further I believe, the game now needs to be extended. Here are some ideas:

• First of all make the game global.
• It needs a downloadable mobile scoring app that can keep score for oil savings in 3-4 key areas. It could be - for example - everytime we go for a tank full we enter Odo reading and gas filled and cost/ charges we paid. We score higher if we travel more miles per gallon than average. We score higher for using subway etc.
• Make it include other resources as well - water, food, environment, money(considering US credit crises) etc. If we dont print an email - we get some points for saving a tree - etc.
• Hopefully we can simply enter that into a mobile phone / sms based web server and our points get updated twitter style - then we can blog about it- share it - earn identifiable and referable badges - like belts in karate. Everyone starts with Level 1 and lets say goes to Level 12 - they can display this badge on their website/blog etc.

I would love to brainstorm on this. If anyone is interested let me know!

Excess Money and its flow pattern

I am sure you people have already heard this podcast from Russ Roberts' interview of Gene Epstein on Gold Fed and money. There is something really interesting in the points he makes. Epstein talks about 2 ways US fed govt can monetize its deficit.

• First is the monetising of future revenues - pushing incomes up so that taxes go up and therefore government revenues.
• The second is creation of future debt Fed buying government notes and bonds and supplying money.
  

The interesting part is - the first goes through the economy across income classes (leading to distribution of the excess money) and therefore creates expected outcomes (inflation). The second, however, is cornered by "big money" (SWF and likes) and never goes into the system. Or actually it takes longer and and more complicated feedback loop to distribute the effects of the excess money. This leads (or led) everyone to believe - falsely - that system is still stable. The reality remains that system has just postponed its instability. Possibly, what we are seeing is the "mean reversion" after some of the effects became evident.

It would be wonderful to know what Yves Smith and others think on this one. Let me know what you think about this one.

Negative equity on cars - is it damaging?

Felix Salmon in his excellent blog at portfolio.com discusses Why negative equity in car loans is not a problem? To me the post looks at the perspective of financial institution rather than a household that is in debt.

Ideally, asset backed debt is safer for the debtors as they can sell the asset and square-off the debt at any point. In case of negative equity the debtor is in lose-lose situation. If they sell off the asset they loose a tool for income generation, while simultaneously retaining a part of the liability. This puts the household further into the debt trap. I guess Prof. Elizabeth Warren will have to downgrade her forecasts even further. This implies that consumption will suffer for longer than anticipated period.


Such situations elaborate the difference between debt and equity. When the worst strikes - equity vanishes but debt sticks on! And it creates problems. Hence I believe, the appropriate title should be Why negative equity on car loans is not a problem for banks? What say ye?

Financial crises and Recession risks

The current financial crises problem is a problem of capital destruction leading to recessionary risks.

The destruction of capital is happening at financial institution level and individual level. At the financial institutional (FI) level - where brokers who have guranteed capital (i.e. deals etc) are finding it diffficult to fund these commitments. At the individual level wherein individuals are finding it difficult to repay their debt.

The government and quasi- government institutions are targeting relief efforts at the first level. This is primarily to avoid a systemic default and thereby keep a channel open for aid to reach the second level. It is also logistically difficult to address the individuals directly. The recessionary risk, consequently, also attacks two levels - firms (broader than FIs) and individuals. The capital destruction puts a lot of strain on spending plans of firms making them costly. This also puts strain on individuals' spending plans. A slowdown in the consumer spending is catastrophic for an economy like US.

Now given the eminent slowdown in consumer spending, the FIs go into a mode of self preservation. They push the risks down the chain - through higher interest rates, higher equity contribution for same level of spending. This prevents the government aid from reaching to the individual (where it should actually flow). In fact even if now government were to push aid to individuals - institutions will nullify the effect by cornering higher share of the pocket from individuals for repayment.

This is primarily (and simplistically) why no recession-avoiding efffort will be of any use. The only beneficiaries will be share holders of financial institutions. Even those can realise the value in the longer term. In fact this aggravates the probability of recession by pressurising the marginal borrowers (who were good but just so) because of higher interest cost. The situation parallels that shown in movie Titanic where the people on rescue boats refused lower class passengers letting them drown to protect themselves. Fed has given the boat to the FIs and most likely FIs wont allow anyone (individuals) to get on board. The individuals will either drown sooner or later in the sea of debt! Here comes the iceberg - all hands to the bridge!

The best the regulator can do is to efficiently catalyze the process - i.e. lessen the pain on the down swing and push the economy back on to growth track.

Dollar headed for a decline?

Late last year I made some observations about the economic future and some of them are panning out as expected. As mentioned pressure on US dollar is considerable. Mark Thoma in Economists' view linked to Martin Feldstein's falling dollar article.

I was amused by the article and commented on one particular statement. Here it is:

"Despite the recent dollar decline, America’s trading partners still have large trade surpluses. ... So the more competitive dollar is not causing fundamental trade problems for America’s trading partners."

Whoa! While I agree that US dollar needs to correct itself to more competitive levels, the above statement is discomforting. As Alex mentioned if dollar decline was for real US trade deficit should have increased. Thats not happened because "almost" all trading partners have currencies pegged (overtly or covertly) to the dollar. Hence dollar decline takes all this basket of currencies lower.

The "almost" in above statement refers to oil! Oil is delinking from USD denomination. Other commodities are catching onto this idea. And all US trade partners need oil and commodities. As oil and key commodities move relative to dollar you will see more pain for US and trading partners, creating an incentive to stem the currency depreciation.

Now comes the main dilemma - as these countries move away from dollar peg - their reserve start losing value. At the least $ 1.5 trillion is held in reserves by major trading partners - even a percentage point here makes quite a big contribution to their GDP - so its like rock and hard place situation.

This, to my mind, will put a hell lot more downward pressure on the dollar than has ever seen before!

Though this raises US mfg competitiveness but hits Europe hard in their face. The trading partners' might face crises - and lets hope its just monetary and not a social unrest. (thats why you have something called country risk)

To my mind a stronger USD easing out is much better way out of current mess. Funnily US has an incentive/self interest to devalue the dollar - but doing so will mean push everyone into a deep downward spiral.

RD

This summarises my logic neatly. And I even got a comment reply from Organic George. Here it is:

Organic George says...
Rahul is spot on with his "delinking" comment.My company trades commodities from all over the world. We understand that the Euro is the new dollar when it comes to pricing.

I guess most of the Irory tower crowd is waiting for one of their own to write a paper to prove it.

It feels good to get a positive response. And its also in the news as Yves Smith points out! I am definitely elated!

Asset prices rising - Is trouble brewing?

There are reasons to believe that "investor demand" is driving asset prices through the roof. The "investor" crowd dynamics and the wealth they bring to this party may be acting as a self-reinforcing mechanisms at the core of this increase. If this party has gone on too far then we are in for trouble. A really big trouble.

Invested - appreciated - invested more!
This cycle has continued in almost every globalized economy. The increasing returns from the initial run of this cycle did bring in lot of new investors. The cycle, luckily, kept going enriching investor class substantially. This brought into "investment focus" various "asset classes" - like commodities, real estate, currencies etc. The cycle kept turning till about June 2007.

The last buyer - Where art thou?
Typically all investments terminate with end-user or what we can call the last buyer. Road investment look for the car /truck driver - mall investments look for the shopper - and houses look for the person wanting to stay.
The real estate sector, typically, is the first to look for last buyer. But there we had some interesting toxic concoction brewing - with easy credit flowing into the sector. As the sub-prime crises unfolded last year - the real estate sector finally started looking for the last buyer. It didn't find any.
The reality dawned upon the masses that "real estate" was priced too high for the real buyer. Based on current prices the real buyers will have to slog for many years before they can make any significant impact as "last buyers".
This is probably true for all "asset classes". Real estate (residential and commercial), stocks, bonds, non-agri commodities, derivatives across the globe are at the vortex of this hurricane. These asset classes have experienced tremendous upward force. The asset classes at the periphery - agri-commodities, are beginning to feel the force putting upward pressure on inflation - particularly food prices.

A Quick conclusion
If the hypotheses is true we are in for a particularly long painful period.
Even most powerful hurricane drops the things it throws in the air. So will prices drop - in real terms - either through inflation shooting up making this new wealth worthless or prices will deflate to a pain-point.
The most dramatic inflection point will come, if at all, within two quarters where large money will take sides on either possibilities - anticipating a killing. Let us brace for impact.
Meanwhile - we will look at what may have caused this in a little more details - and like always only hypotheses.

 

Technorati Tags: asset prices,recession,US slowdown

US indebtedness - The scope of the debt trap

Technorati Tags: US Slowdown

The long-term implications of high US personal (or family) debt may be worse than we anticipate. Various forecasts, discounting economic outputs from "back-to-normal" scenario 2-4 years in the future, may not have accounted for the problem correctly.

Debt stick on - even increases in bad times
Debt, much unlike losses, has an uncanny ability to stick - tying up future cash-flows for years, thereby constraining future consumption. Debt sticks on through job-losses, bankruptcies. In fact it increases - either in form of accumulated interest or future interest rates or loan availability. At least in India, where we do not have personal bankruptcies, this created systemic household poverty for generations. Drawing parallels from that, I believe, the time it will take to get the balance-sheets of US families to saner level of gearing might be much longer. Further more, for US, this exercise needs to be undertaken in/around recession years. Though it may not be generations, like in developing India, but it cannot be simply 2-4 years we anticipate.

Debt cause social pain
Corporate turnaround experts understand the kind of discipline and dispassionate execution it requires just to make small improvements. And it is still easier with a "company" than with household expenditures. Household cannot cut jobs and costs the way corporates can. Governments in progressive countries, like in US, tend to intervene with additional spending on social support - particularly education and healthcare. That spells problem for US.

In sum
We need to understand for median household debt what would be a good time frame get back in shape. We also need to understand the costs required to get them back in shape. The real future outcomes will lie hidden in these details.
As soon as we correctly value and discount these costs, the bearish-ness will vanish. Bulls don't like bullshit about recovery. Show us a real recovery and it's cost and we will "bear" it all the way into a bull run!

 

International Finance - A systemic weakness?

In my last post, I mentioned that wealth concentration exposed the financial systems to risks. The risk is compounded by inherent weakness of the financial system that  were not designed to accommodate. These systems are weak and plagued by complicated issues.

• Firstly, these were created as a subset of national governance systems. Consequently the flexibility of these systems are limited by the overall governance infrastructure in each nation.
• Also, unlike the capital movements, these standalone national regulatory systems are not inter-connected in any meaningful manner. Meaning any response to international financial crises will be subject to foreign-policy-like ambiguities and negotiations and, therefore, delays.
• The regulations are patchy - unable to control global momentum.

Popular, informed expert opinion is also weighing in on this shortcoming.
You can read Michael J. Panzner

in the modern global financial system, where many participants are either unregulated or are monitored by a patchwork of country or sector-specific regulatory overseers, chances are that a derivatives-related catastrophe will see a similar lack of coordination that will produce a far more devastating outcome than if it was a purely domestic affair.

It is one thing for a central banker to summon the heads of various financial firms into a room to sort out the mess at hedge fund LTCM, as the New York Federal Reserve chief reportedly did in 1998. Despite the fact that the Fed had limited statutory authority in the matter, it is not hard to see why none of those who were asked to attend turned down the "invitation."

However, if a derivatives time-bomb is set off by the failure of a large London-based hedge fund, will a banker in the Cayman Islands, an investor in Japan, an insurer in Germany, and a regulator in France feel similarly inclined to respond, or even to take the lead? That is assuming, of course, that those affected even understand what is going on or why it may be relevant to their own interests. Overall, there appears to be little, if any strategy in place for dealing with cross-border financial upheaval.

And Marshall Jevons linking to Davos

At the World Economic Forum in Davos, Mr Knight said the “major challenge” for regulators was the “the Balkanisation of regulation – fragmented across market segments, across national jurisdictions and yet we want to have a global financial system”.

And Dani Rodrick

How do you deal with capital flows when they are so prone to boom-and-bust cycles and generate (roughly once a decade) financial crashes with painful economic consequences?  The mainstream answer is that you do not regulate capital flows directly--through capital controls such as financial transactions taxes or deposit requirements--but you rely instead on prudential regulation of financial intermediaries. The best way to avoid crashes, this argument goes, is not to "throw sand in the wheels of international finance" (as Tobin famously put it), but to make sure that intermediaries do not take excessive risks.

In Sum...
A system so designed will be prone to momentum effects. The momentum is aggravated by wealth concentration. International finance needs to evolve beyond the free capital movement to counter this risk. A system of seamless regulatory response needs to be developed. Hopefully the thinkers at Davos will lay the first stone of a potent globalized interlinked system.