The question of Cities

Post the Economist debate on Cities, we have a series of fabulous articles on the topic. Let me quickly share a few of them right away. First article, Are mega-cities too big? comes Klaus Desmet and Esteban Rossi-Hansberg. The second article comes from Ryan Avent titled "Why we live in cities?". Other reading includes Richard Florida's book Who is your city? Another includes report from UN Research institute for Social Development titled "Development and Cities". Finally some of my thoughts are captured in the my ebook How Cities Develop.

There is a general agreement on cities being the drivers of economic growth. However, there is much debate about whether cities should be large or small, how they grow, etc. Let me highlight some important issues with respect to cities.

Cities are efficient providers of infrastructure
Investments make sense when they are used by more people. Cities have effective administration because they have piece-meal property - in other words they are dense. These piece-meal property affords economies of scales and better return on infrastructure like drainage, water supply, power etc. It is, therefore, clear why some cities like Detroit are encouraging people to shift out of far-flung suburbs into concentrated city center.

Cities help deploy capital efficiently
Cities allow for specialization and therefore interdependent service opportunities. Away from the city, multi-skilling is essential. City dwellers may get help if their car breaks down, away from the city you may need to know basic break-down procedures yourself. Same goes for food. Cities allow you to buy meals from restaurants etc. so that those expert in cooking and concentrate on cooking food. Thus a city, in effect, comprises core workforce, ancillary workforce and support services. Core workforce related to basic income generating opportunity - in Detroit -it would represent automobile company workers. Ancillary workforce represents those workers that feed into auto firms - like stationary provider, photo-copying machine providers and workers thereof. Further there are workers for support services like restaurants, hair-dressers, etc. This specialization creates far higher productivity and hence better returns on capital.

Cities as hotbed of ideas

On a social level, cities are breeding ground for ideas. The let diverse people mix and therefore create an environment where ideas can breed. The new knowledge economy, therefore, depends on efficient cities and thrives in such environments. Now we can see the conflict between efficient capital deployment and idea generation functions. One needs specialization and homogeneity while other needs generalization and diversity. It is here that cities are likely to break down.

Over past two decades, IT infrastructure has allowed idea-generation function to move online. As the next generation, the digital natives (1), take over, we will see cyber-cities forming for idea generation functions. Further, the capital efficiency too is driven by ideas and hence possibly moving towards cyber-space. 

DESIGN OF CITIES
Design of cities is more landmark-oriented rather than flow oriented. The word "settlement" connects better with access than with landmarks. However, we look at landmarks and try to connect them based on estimates of future population. Don't be fooled by what seems like flow-based design - it isn't the driver of design decisions.

City is a flow of different variables. It is a flow of people to and from workplaces to and from houses. It is a flow of utilities across the sprawl. It is a flow of water, food and essential goods to different areas and evacuation of sewage, drainage and other effluents away from it. However we do not design cities based on efficiency of these parameters, rather we select a location and then try to service it with these amenities.

Rome v/s Las Vegas
The contrast between flow-based design and landmark based design is evident when you contrast Rome and Las Vegas in a simplified way.

Rome had a population of 1million around 10-3BC. At that time it still had a natural gravity driven water system that provided water no only to homes but also to street fountains and the like. There was also a well-designed drainage system. Though, Rome is not a purely flow-based design, it still comes close.

The old Las Vegas on the other hand is landmark based design. There is no business for it to exists in the middle of the desert and away from every amenity possible. Subsequent developments have tried to overcome its shortcomings. Yet, to date, its survival depends on the depleting Lake Mead created by the Hoover dam.

Balancing income and affordability determine the sprawl

Let us assume a person with a specific sum of money. She can, theoretically, buy large tracts of lands away from income generating opportunities. If she has to buy land in the city, in close proximity to income generating opportunities, she can buy very little even after leveraging future incomes. We can imagine a spectrum of affordability, from this maximum land without income opportunities to the minimum space purchasable by leveraging future income. Now the sprawl of the city depends on how geographically spread the affordability spectrum is. It is limited by time and not distance. Thus the geographical sprawl is equal to distance that can be travelled within acceptable commuting time. Hi-speed metros and maglev trains tend to increase the distance within alloted time.

The principles of Acceptable commute distance and acceptable commute time is essential in design of cities and development of sprawl.

Superimposing flow and landmarks measures real estate value
We can draw up monetary value of city's real estate by super-imposing flow and landmark characteristics. Landmarks with high flow are most valuable pieces of real estate in the city. I have distilled some of these thoughts in my "Affinity factor model" for cities.

Some of these ideas have been discussed in my free ebook How cities Develop. You can download it from Scribd by clicking on the link above.

Notes:

(1) Digital Natives refers to children born after 1990s who are far more comfortable with technology than current workers.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle. 

Wage growth and productivity increases

Mark Thoma points to a research paper by Lawrence Mishel and Heidi Shierholz titled "The sad but true story of wages in America". The study points to divergence between increase in productivity and increase in wages. 

First we must be clear with which productivity we are talking about. Increasing labour productivity must be complimented with increasing wages. However, higher productivity without any change in labour productivity need not be. Is this possible? Of course it is. 

At the risk of oversimplification, imagine a simple bread bakery. Its output is supported by various types of labour like bakers, sales staff, cleaning crew etc. Now imagine such a bakery buys an automatic bread making machine. All you do is put the dough in from one side and press a button. On the other side you get the most fabulous breads. In the new setup, the output supports sales staff, cleaning crew and a low-cost attendant. Now this machine needs maintenance which is on contract and there has been corresponding employment at the bread-machine manufacturing factory. But you can imagine the number of people supported by volume of bread produced is far lower. These people together take less percentage of sales price of bread but since their number is smaller they earn more. In a way, this is higher order of economies of scale in action. I agree that the knowledge provided by the bread-machine makers is high and deserves the monetary returns it gets. You can imagine this process running over and over again till gains accumulate with those that provide distinct knowledge. For example, the consulting baker at the bread-machine making factory would earn multiple times average baker.

So I would like to see change in capital intensity of production during the same time. An alternate, thus, would be that technology is resulting in polarization of incomes. On one side, it increases the scale that can be achieved by distinctive knowledge provider and hence scales up her returns / income, on the other it reduces the quality of labour required for the process and hence lowering the expected incomes of those still employed.

This change is structural shift from effort-based society to a knowledge-based society. Naturally, those without college degree, in other words ability to do knowledge work, have stagnant pay. In knowledge based society, the quality of effort is reduced and hence pay required to carry out the job reduces. 

To understand real productivity and incomes, we need new concepts such as "wage content of a job" or its reverse "job content of a wage". The former would refer to wage change of specified standard set of jobs, sort of a job basket similar to consumption basket for inflation. The later would refer to the value of work that we can get done at a particular wage. If we measure this over time we will get better understanding of changes taking place in the economy. At the end, the job-profile, income profile and knowledge profile of a country should match and if it does, we can say capitalism is working fine.

I discuss some of these concepts in my book "Subverting Capitalism and Democracy". 

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle. 

Want me to work with you?

I am looking for opportunities on the buy-side. Essentially, doing what I currently do but with added benefit of working with the best minds. If you are looking for someone to work with you please read below.

As an analyst employee, I tend to conform to fund manager's style. I believe a fund manager needs to get all the analysis that makes him or her comfortable about their view. In many cases it means stopping short of my comfort levels. In other cases it means working with specific formats (some fund managers I know respond to font color). 

I may, often, have divergent views than my fund manager. Whether I tell you upfront depends on two things, my relationship with you and how divergent are my views. I will tell you up front without being asked if we have a good equation or if the divergence is too large to be left unflagged. Else, I will wait till you ask for my view. 

I love to meet managements, sell-side analysts, make plant visits etc. If you let me go around a production facility I can tell you how good the management is (are they really doing things they say in MDA). In meetings I want to listen to everything the person has to say (sometimes people ramble on and I don't stop them). I don't check or fidget with my blackberry during meetings. I like to make notes on paper and I discard them later, I file things mentally.

I work with my own projections but I love to unscramble sell-side models. In my assumptions I am more conservative. In a way I deliberate a little more than people like and I doubt every model, every forecast and every assumption. However, I do not change my opinions unless the data changes. 

As an investor, I rely more on management quality than on sell-side projections. I have certain bias against few companies. Some I like to go long whenever opportunity permits (Bharti, L&T etc) and others I love as shorts (ADAG group). In some cases there is logic behind the reasoning (Bharti, L&T etc) while in others (ADAG group) it is more intuitive. 

As an investor, I am terribly risk averse, though the fact that I invest in equities implies some risk-taking. If I smell a rat, I don't want to wait for confirmation about what is wrong with the company. I am happy to close the position. Also, I like positions where there is an easy exit - so I do not invest in small and mid-caps.

I must highlight that I do not understand pharma and insurance. I believe these sectors are more about law-suits and legal skills than about science and finance. But, as I said, I do not understand these sectors.

I love to learn and understand new things. I can listen to new ideas without fatigue for days. These could be in any field from science to religion to cooking - I have varied interests. I follow reasonably advanced mathematics well, so if someone wants to explain calculus, I am game.

I like to go into depth, so I want to know how are oil rigs constructed, how are they anchored, how oil is drilled, why gas is vented off at the rigs, etc in detail. Often I know more about these things than many oil analysts. For metals, the other chemical reactions that can yield the metal and why the current method is preferred over others.

Very many years ago, a fund manager friend highlighted the importance of knowing global history in understanding any industry. What he referred to was the chronology itself. So, oil analyst must know where we struck oil first, how the production centers moved to other countries, how parallel development of technology was critical to such developments. Since then, I read up on general history more than job requires.

People say I am easy to get along with. I don't mind interruptions and am happy to explain things in detail. I am generally patient with people. 

But I know I am quirky person. I like a clean desk. Barring the computer and the phone, there is just a pen and paper on my desk. I hate printouts and like to read on-screen. I prefer iPad. I like to get tea delivered on my desk. I believe admin and HR departments often get tangled up in their own policies. I believe we must fight to retain the best employees.

In sum

I work best with gentle people though I have very high resistance to people who throw tantrums. The best people I know are all very well behaved. I am soft-spoken person. So if you want me to work with you please call me. You can find my CV here. You can reach me at rahuldeodhar [at] gmail [dot] com or call me at +91 -98 20 21 38 13.

Higher oil prices, inflation and what matters

David Beckworth quotes Caroline Baum and Mark Thoma about oil price increases, its impact on inflation and whether Fed should respond. 

Caroline points out some mistakes when we interpret the metaphors too seriously. Few weeks ago I would have thought that Caroline is unnecessarily critical, that people understand these are metaphors (oil prices are a tax) used for better understanding the impact. However, people are definitely taking these metaphors very seriously. There is a danger of policy response (QE??) being blinded because of such blindness. So in a way we must thank Caroline for the article. 

The fundamental explanation on this topic comes from Mark Thoma. He details a very elaborate explanation. According to him, if central bank is responsible for price rises then it should respond. If the price rise, however, is based on changing fundamentals then central banks have no reason to respond. Such price rise is relative rather than absolute, prices of some goods increase higher than others. 

Hmm!

While I agree with overall analysis, I must put some pointers out. 

Firstly, Oil is different commodity. Oil is embedded within our economic system. This is a result of substantial capital investments over nearly a century. Hence any improvement in alternate technology requires far longer gestation than commonly assumed. Further, the quantum of investments required is also higher. In the intermediate time, oil can fuel general price rise (not just a relative price rise) through cost pressures. If the ability to pass on higher prices is limited, it results in shutting down of unprofitable production facilities leading to job losses. thus, in this sense, oil is inflationary and crimps consumer demand. 

But David is right to mention that such change is a spike and does not indicate a trend change. However, from a layman's perspective, price level is more important in relation to income level than rate of inflation itself. Let us assume prices rise to level of 3X and stay there thereafter. In such case there is immense pain for the lay person in the first year and thereafter as the incomes adjust, things get easier. But what if incomes do not adjust? Then the pain stays on for longer and ruthlessly drags household after household into poverty.

In such a scenario, it is policy response may be warranted. But it is not simply a monetary policy response that will do the trick. Monetary policy action will create a window of opportunity during which investments must be made in alternate technology and improve it. However, after monetary policy action when we see lower oil prices we forget the "improve the alternate technology" part. Meanwhile oil companies continue to invest more into status quo shifting the goal post further.

As an aside, I do believe we are improving technology to reduce oil dependence. However, it is more incidental than deliberate. The development of source independent power grids, energy efficiency norms etc are a step in the right direction.

Principle Reduction in mortgages

Some of the Fed economists have interesting post about principle reduction in the mortgage modification program. The post titled The Seductive But Flawed Logic of Principal Reduction | The Big Picture is available at the big picture blog. I have a few reservations about the logic expressed by the economists.

Some reservations about the article

First and foremost, the article refers to principle reduction as mechanism to create a win-win alternative. I must disagree. Principle reduction is a mechanism for loss sharing and there is no "win" in this.

When a lender and borrower together buy a property (by its economic definition referring to any asset), they are investing in it. This is understood when lender takes to same asset as collateral in lieu of the loan extended to the borrower. The borrower, by paying the interest on the loan, gets the right of ownership of the asset. Thus ideally, the lender will have a capped upside and a capped downside while the borrower will have unlimited upside and limited downside. This is the normal situation. 

However, during the current crisis, the situation took numerous forms all radically different from the normal situation. In most of these cases borrowers or lenders or both are seen to be speculating on house prices. In such cases, the upside and downside of the speculative bet should be equally shared.

Secondly, in specific cases of lender induced speculation, downside should be specifically and singularly borne by the lender. This is particularly true of the sub-prime loan category. Here all the losses should be borne by the lender and not the borrower.

Similarly, if borrowers are alone found to be speculating then they should bear the downside of the deal. Second home purchases are indicative of speculative behavior. Thus second homes should not have principle reduction.

Consequently, a first-home buyer at the mercy of lenders should be allowed principle reduction option.

The big picture story

The main factor in the decision about principle reduction lies away from this discussion. Principle reduction may create a buffer within the household balance sheets. This buffer, it is believed, may be the solution to the current crisis. There are a lot of arguments that agree with this hypothesis.

The resolution of the mortgage side, keeping an eye on the possible macro benefits, may not be fair. But it may work to revive the economy. Keeping this in mind, the financial industry may bite its own tail to save itself and agree with the principle reduction program. In a way, this is a question of bargaining power of government with respect to banks.

Financial Crisis and Democracy

One of the features of the current financial crisis is the way it interacts with democracy. The crisis touches the very core of democracy both in principle and by its sheer size. In this, the current crisis is far different than any we have seen previously.

First, the way in which necessities of few banks have been scaled to compulsory levy on the masses is one example. Within a country, the stress on the lowest income class has increased due to lack of jobs and increased burden of taxes. It will increase further with inflation and cost of basis services rising. All this for no fault of theirs. 

Second, this crisis also spans across democratic divisions of countries. Icelandic population must consider bailing out those of UK and Netherlands who made idiotic investments. In a similar fashion, Germans must consider bailing out Spain, Portugal etc. The US consumer is effectively bailing out the world.

Third, the size of bailout and enormity of impact of actions is such that common people are suffering. Even earlier, there were bailouts and recessions. But never was the scale this large and impact so lasting.

In such a scenario, one can understand why there are political issues. The developments in Middle East and North Africa (MENA) are, in all likelihood, the first steps. The citizens there were confident that their governance structure was not the best and felt compelled to deploy better mechanisms like democracy. In developed and democratic world, we are not sure what is a better alternative. But in any case this situation will not resolve in a year. We will have to live with this for the better part of this decade.

Retrofitting explanations - Don't listen to Finance news channels!

Why are food prices soaring? Why did the markets rise? Why did they tank? We get decisive answers to these question on news channels on daily basis. But almost everyone of them uses explanation retrofitting.

For example, take rising food prices. In such a context, discussing prices only in relation to demand supply seems inadequate. It may still be dominant variable influencing prices but the recent changes to prices cannot be explained by demand supply alone. For one, the change in consumption of emerging economies and change in prices over 5 year period does not tally the thesis. To infer demand supply realities from prices, i.e. doing reverse, is like retrofitting explanation to fit the thesis. Investors and talking heads are guilty of this en masse. The problem with retrofitting explanation is that it checks all the boxes, every cause-effect link seems strong. Except, there is often no link in reality.

Imagine what would happen if we started a school science experiment to produce oxygen only there won't be a test tube to collect the oxygen we have isolated. That would be released into the air. Thereafter, the teacher will ignite a match near the place where oxygen should have been collected and it will burn - a test that confirms oxygen. Now did the match burn from the oxygen we isolated from the experiment or did it burn using oxygen from the ambient air itself? In science this is a flawed experiment. But if a finance channel would definitely report it as success and, in all probability, markets will rise 1-2% because of such discovery!

To be fair to economics scientists, social systems are difficult to model because of this problem. The economists and social scientists know this and thus are always tentative in their evaluations. Famously, they are two-handed, they always propose an alternative explanation starting with "on the other hand...". Market analysts, on the other hand, are forceful in their views and exude confidence where there is none to be found in the foundations itself.

Investors, thus, must be vary of making mental models based on the forceful arguments of the market analysts. Such mental models are often just assumptions because of the flawed fundamentals. And these are the most difficult assumptions to challenge.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle. 

Missing the technical bounce-back on Nifty

Indian markets had a technical bounce back and I missed it! At first I was expecting some kind of a pause at 5400 on Nifty. However the type of fall in the markets over the past few days coupled with the volumes had me in a fix. It looked like markets would simply drive through 5400 and land somewhere closer to 5300 or lower. So I had invested not more than 10% of the cash. Nevertheless I exited out of my positions and will patiently for levels of around 5200 for another mini-bottom.

Meanwhile, as we discussed earlier, the market is on track to form first of its two corrections. To quote my earlier post:

We will have two bottoms and three tops during 2011. Depending on how you look at the cycles, we had 2 or 3 of them last year. Consequent to the cyclicality, portfolios will have to churn thus leading to healthy performance of the brokerages and investment banks. I would expect asset managers to have a decent year again.

I believe we will be set for the peak around May-June or thereabouts and a correction around September. It is possible that the September correction will be shallower than the one we are experiencing right now. Naturally, I expect alert fund managers to have a decent year in calendar 2011. In these views I am contradicting most experts and talking heads.

Note & disclaimer:
This is not advice to buy or sell or trade in any security. Please invest post careful research and analysis. I will not bear responsibility for your actions.

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My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Defining Real Productivity

I read that again! Someone just said "The productivity of developed market work-force is higher than developing market work-force." And it irritated me again. It is time to refine the concept of productivity. 

Why is it irritating?

Let us imagine two fellows, one out of shape banker who rides a car, while other, a physically fit cyclist Lance Armstrong-like fellow. Now the banker can definitely ride longer, faster than our Lance Armstrong. 

But that does not say anything about physical potential of the two competitors. If we want to choose one of them as a contender for survival course, it would be impossible to choose based on this view. Rather, the only thing it shows us is the difference between availability of productivity enhancing capital investments.

In terms of economies, what such a difference in labour productivity implies is the need for investment. In other words, it shows us that the developing economy in question needs capital infusion for being competitive.

We need to measure Real Productivity

I think we need another variable. Let us call it "real productivity". This variable will be designed to be used while comparing two economies at different points in the development scale. This should help us understand various things including ability of the workforce to adapt to change, ability to deliver variety of work, etc.

Real Productivity will, possibly, refer to volume of various types of work achieved in one day adjusted for capital assistance. It will be profile (distribution) of workforce against predefined job categories. The job categories on one side will be highly knowledge intensive and on the other end will be highly physical oriented. The profile of developing country workforce will be bottom-loaded while that of developed country will be top-loaded. Somewhere between the two extremes of the distribution lies an important threshold. Below this threshold the factor limiting the workforce is external or opportunity related like financial capital in the form of equipment and machinery. In other words by bringing the capital it is possible to improve productivity. Above the threshold, the factors limiting productivity are structural in nature - like education or skills. These factors take long time to change and cannot be resolved easily. At the threshold is a chasm that can be bridged only through proper policy direction and grass-root efforts. Whether a country (i.e. economy) crosses this chasm depends on quality of their government. The differences across the chasm are not easily bridged and hence the competitive advantage is not under threat. However, if an economy has already crossed the chasm it can pose a significant threat as the factors differentiating it with other economies are easily corrected.

The assumptions that most people make is that developing country workforce is still across this chasm. That is where I do not agree with them. If not India, China and Brazil have already crossed the chasm. It is only a matter time before they catch up with other developed economies. Having said that, it is possible to back-track across the chasm as well. A political unrest and upheaval tends to set the nation back.  

In sum
We need a new metric to understand the changing economic landscape of nations. A "real productivity" variable as we discussed should improve our understanding of this economic landscape.

Inflation in terms of income and prices

Inflation has emerged as one of the key challenges of the world at this time. However we tend to reflect on inflation in terms of prices of basket of products and services. I think such a metric serves us to understand only a part of the problem.

Inflation, as we measure it today, does not measure social benefits when job scenario is difficult. The theory behind inflation posits that when the inflation becomes known wages should adjust to reflect the same. If wages are stable and prices start rising, inflation rightly triggers alarm bells. However, if prices are stable and incomes are falling then inflation data tends to mask the underlying decline in living standards.

Generally, policy makers use two variables, inflation and real average income growth, together. However, rarely do we see both variables in same discussion. The problem arises because of difference in measurement techniques of prices and wages. However, limitations of measurement should not be a cause for erroneous policy.

I think we need to define inflation as difference between wage rise and price rise. Or we may use another metric that measures this difference. I believe it should give a proper indication of the on-the-ground situation of the economy. 

Thus, in the developed world, with economies losing jobs, we expect this metric to expand conveying the increasing difficulty in sustaining a lifestyle. This comes over a decade of falling prices with stable incomes which we may parallel with deflation. 

How such a variable will influence policy response is a difficult question. However, it should definitely improve our understanding of the realities.

Market Timing Anxiety

During the start of the year I had written about wanting to move to cash. Indian equity markets subsequently crashed and are staring down a possible decline to 5400 levels on the Nifty. I did move into cash but just in nick of time. The result is that my gains are lower than what could have been had I exited without hesitating like I did.

Now I am faced with exactly opposite conundrum. A lot of stocks have started hovering around the "buy" level. But the Nifty is still at 5600 level with still about 200+ point decline a distinct possibility. I am waiting with baited breath. But waiting has it anxious moments. The high volatility implies that market moves in dramatic fashion making it difficult to watch. There is no apparent reason (one that has materialized since beginning of 2011). 

At such moments the noise on TV and within research reports is further unnerving. Goldman Sachs recently revised the target price of few stocks down by 20-35% and still rates the stock buy. Some stocks are already above their revised target price. I don't know if research quality has declined to this extent or is it my nerves. 

The TV anchors are busy retrofitting explanations to the market movements. I read three on tueday. Half an hour after the RBI policy markets gave it a thumbs up, an hour later markets behaved as if they had already priced-in the rate hike and by end of day RBI rate hikes had caused catastrophic slide in Indian equity markets. I think reporting levels have dropped beyond redemption. It may make sense to free up the bandwidth these channels occupy.

Anyways, are you waiting too? And do you feel as anxious?

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My book "Subverting Capitalism & Democracy" is available on Amazon

Why RBI could not raise interest rate more than 25bps?

Yesterday the Reserve Bank of India (RBI) announced hike in Repo and reverse repo rates by 25bps each. Some commentators argued that RBI is behind the curve and should be aggressive in rate hikes. I disagree.

India is not entering the Volcker age

The question of aggressive RBI puts the Indian economy in some ways (not in magnitude) similar to US when Paul Volcker became the Fed chairman. There is high demand side pull and supply side needs catch up. But there is a key difference in India's position.

India needs investments in supply infrastructure

India needs more than INR 2 Trillion worth of investments to de-bottleneck the supply side. I am not talking about creating supply but simply reducing wastage and time lags to ensure supply gets to consumer. This investment is required in roads, cold-chains, food processing, storage and markets etc. This infrastructure is government responsibility. Either government create this infrastructure or create conditions in which private player can create it. Without this not much can be achieved on supply side.

Interest rate puts pressure on this investment

By increasing interest rates in arbitrary manner RBI will create uncertainty that will impact these investments in two ways. First, it will postpone the investments because of uncertain business environment. Secondly, it will increase the cost of capital and thus reduce profitability of these investments.

Hence, I believe, the RBI acted prudently to signal inflation concerns but allow markets to steadily adjust to higher interest environment. 

Why did the US leverage itself so much?

There has been some discussion in the blogosphere about Peter Thiel's interview Back to the Future with Peter Thiel - Interview - National Review Online. One of the central question in the discussion is Why US leveraged itself to this extent - referring to the excess debt carried by US households. 

The question reminds me of an Aesop's fable about donkey and goat. A man is leading a donkey on a leash when a few people decide to play a prank on him. In turns one of them would appear to pass down the road and ask him why he is walking his goat instead of carrying it on his shoulders. After a few passes the person is convinced that his donkey is actually a goat and tries to carry it over his shoulders.

The same is situation with US consumers. Over time people have been telling the US consumer that loans to them are most safe. Over time US consumers were convinced that they can safely borrow more as future growth will take care of the repayment. The situation worked well for a generation and there was no reason to assume it was broken. So they never stopped even when the future growth was no longer certain. In fact US consumer continued borrowing despite evidence that with current policy (marked down exchange rates and export-oriented growth models) US is nearly certain to have de-growth.

As I mention in the book, the blame for the last leg of overextending consumer was the result of big-money. Big money required paper to play with and creating the paper implied creating real assets even when there was no demand. I think that makes Gary Shilling's ideas, particularly the one of selling consumer financiers, make lot of sense.

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My book "Subverting Capitalism & Democracy" is available on Amazon 

Adjusting money supply in aftermath of a crisis

The rapid expansion in monetary policy in the aftermath of current crisis was criticized by many. However, I believe it was necessary (combined with other things).

In my book I explained that inflation is a tax against status quo. It is designed to make it costly to simply hoard money. A crisis, often, results in inappropriate(1) accumulation of money. The accumulation often uses mechanism that do not create value. Inflation, in aftermath of such a crisis, may all those with genuine value creation mechanisms to rise above the scamsters.

Thus, increase in money supply seems desirable as it will nudge inflation while allowing money to move to value creators. However, this is contingent on a premise that new mechanisms are genuine and not simply new scams. The US has failed in ensuring this. That is why unemployment is high and rising while money sloshes around without effect.

Note:

(1) How we define inappropriate is another question for other time.

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My book "Subverting Capitalism & Democracy" is available on Amazon 

2011 - Images from Crystal ball!

Welcome to the new year! I wish the new year comes with merry news and prosperity more than your expectations. Let us look at what we should expect in 2011. I will not bore you with ideas like fall of Europe, growth in US etc. Commentators and analysts have already tackled those. I would like to leave you with some other ideas related to the markets.

First, the very short term - we are likely to have at least 2 mini cycles in 2011. By that I mean that, most likely, we will have two bottoms and three tops during 2011. Depending on how you look at the cycles, we had 2 or 3 of them last year. Consequent to the cyclicality, portfolios will have to churn thus leading to healthy performance of the brokerages and investment banks. I would expect asset managers to have a decent year again.

Second, we will see return of genuine Keynesians. By genuine Keynesians I mean focus on jobs rather than income, focus on employment certainty rather than uncertain stimuli, focus on sustainability rather than pump-priming. Like churchill said, we will eventually do the right thing after we exhausted all other options. It means a further crisis in housing markets may be addressed differently than previous ones.

Third, we will start discussing infrastructure in developed world. In India, 2011 promises to be year of infrastructure. After lackluster performance in 2010 and surge in demand, I expect Indian infrastructure  companies to be back with a bang. But more important is discussion about infrastructure will happen in the west. In these discussions we will find the seeds of future infrastructure companies and ideas. New cities in context of internet and social connectivity, infrastructure of future in terms of public transportation, lower energy consumption and good old core infrastructure like power, water etc should emerge by end of 2011.

Finally, this year may, in all probability, mark the beginning of the age of the Miser. Depending on how you look at it, we are close to the end or already past the age of consumption. The age of saving and hoarding money is upon us. The age of consumption lasted more than 30 years. So like many investment managers, I have not seen the era where people were scrambling to hoard money. This period is likely to throw up many different surprises for us.

1. Return of the garage: Over the 60s to 80s People spent innumerable man-hours in their garage fixing things extending the usable life of the product. The 80s and 90s changed the products in the garage but the spirit remained. If 60s was about cars, farm and household machines, office appliances then 80s was about computers and cell phones and microprocessors. The importance of the garage has gradually diminished from 60s to 00s. This may change over the next 20 years. I expect the usable life of products will be enhanced.
2. The return of services: The revenue models of many firms depends on the use-and-throw model. The service aspect of the product is reduced to minimum. If we see a return of the service model, we may see rework of business models. It means more consulting and organizational restructuring.

Commodity Prices and Money

We have seen a recent spike in prices of various commodities like Oil, Sugar, Cotton, etc. Paul Krugman in recent blogpost highlights this as indication of finite world. We are scrambling to explain these changes through the lens of demand supply. However, just this time, I think there is another explanation.

Three components of commodity prices

In current scenario we should think of commodity price as comprising three parameters with demand-supply being one of them. The second parameter is inflation adjustment. Third parameter is wealth retention value.

Inflation adjustment refers to change in prices reflecting change to money supply that feeds only few areas within the economic value chain. Usually, the inflation adjustment is negligible as money moves through designated channels. However, in recent times, the excess money has spilled on to commodities and other asset classes creating a price expansion divergent from fundamentals.

Wealth retention value refers to ability of the commodity to retain purchasing power for the future. When money supply is stable and in line with fundamentals, there is not much need for commodity to carry the wealth, money can do it better. However, in cases of rapid monetary expansion rare commodities are required to carry wealth. Higher the monetary expansion, more commodities comes into this fold. In post-war Germany wheat bread too joined this group.

In Sum
So I think we should look at commodity prices through this three-component lens. I believe the fundamental driver, i.e. demand supply, is more or less along the long term trend. However, in recent times we have seen higher inflation component markups for many asset classes. Commodities are simply exhibiting similar behavior. Further, we might see, depending on how much trust our currencies exhibit, some change to the wealth retention component in coming years.

Cannot group India with other Emerging market

Over the past years, I spend part of time explaining this fact. India's economic structure is not like other emerging markets and hence we should not club those together. This goes when you are looking at bond yields, currency forecast or simply equity market valuations.

First, India is a consumption economy. Unlike other emerging markets that depend on US consumption, India is driven mostly by domestic consumption. Sectors like IT/ITES do have significant employment here and thus they do contribute indirectly to the consumption. However, the overall impact of IT/ITES is not as substantive as exports are to other emerging markets. Thus we need to look at India through a developed world lens.

Second, India functions despite of its government, again unlike other emerging markets. In other EMs government is a driver or enabler of growth. Not in India. In fact, wherever government interferes you have problems. So in that aspect too India is unlike other EMs.

Third, India has more efficient capital utilization pattern. Overall, the incremental Capital output ratio, ICOR, is higher in India. While a group of economists believe this is reflection of the stage of the economic development rather than character trait of India, I disagree. While the high level of ICOR is misleading, India will have better ICOR than comparable country at similar economic development level. However, this also means India will pay lesser for everything. In other words, if you expect certain demand at a price point in other countries, expect half that demand in India. MNCs found this very challenging at first. But at the right price point, there is ample demand than you can cater to.

Fourth, Indian banks, thanks to RBI's watchfulness, are very conservative. Even in Real estate lending, thanks to the black economy percentage charged by developers, the individual has higher skin in the game than in other markets. 

So during the next year when you look at investing in India, bear in mind that India is a consumption economy like the west. 

But what does this mean?

To me it implies some direct conclusions.

First, India can sustain a higher Debt-GDP ratio than other EMs. Since the payback comes from internal demand generation, the debt is likely to be more robust than other EMs. 

Second, it also means that India's economic model is directionally right, i.e. correct in intent, but low on scale, i.e. India is slow - very slow. This may mean higher stress on currency. Popular opinion on this topic is against me. People expect INR to continue to become cheaper vs. USD because of national debt. However, over time, people will realize the difference and try to flock into the INR. I do not expect it to happen in 2011 or 2012 but I have been wrong before. In any case, if it were to happen expect capital controls and regulation to manage the currency.

Third, infrastructure payback is likely to be longer. With India infrastructure story being marketed to death, I expect lot of infra-investment to come in without acknowledging this fact. Please expect payback to take longer than your models indicate.

Fourth, India may become a consumption driver of the world sooner than other EMs. It might take two decades more, but India may be first to contribute to global consumption rather than other EMs.

In sum

India is unique, it is a culturally in the middle. It is slow, but it is going the right way.

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My book "Subverting Capitalism & Democracy" is available on Amazon 

Difference in wealth and money

Krugman raises an interesting question in his blog titled What is money? I believe this is a very crucial question we need to ask to understand the context of the current financial crisis. I have dealt with this question in detail in my book "Subverting Capitalism and Democracy".

There is a difference between wealth and our bank balance. Wealth is our ability to purchase future convenience (in terms of products and services). But there is no way to understand wealth in isolation, just as there is no way to understand temperature in isolation. To measure wealth we need a metric - money provides us with this metric. 

Metrics, like those for length, time, temperature etc, are very specific and scientifically determined. For example, the length of 1 meter was previously defined as the distance between two marks on the specific rod, placed in International bureau of weights and measures in Paris, made of platinum and iridium alloy measured at 0 degree Celcius. Later, a more specific measure was developed defining 1 meter as distance travelled by light in specified time in vacuum. 

However, metric for wealth, i.e. Money, is not specific and absolute. Money itself changes value all the time. Money itself is a commodity created to measure other commodities against it. But since it is a human creation, there is no supply constraint other than what we have self-imposed. Thus, money obeys all the laws of supply and demand like other commodities. It also means that money appreciates or depreciates depending on demand supply changes in other commodities.

The value of money refers to its ability to purchase goods and services. Therefore, wealth refers to value of money at specific time as the value of money changes with information on demand and supply. Thus if you are on an island where news reaches once a month then most likely the value of money will change monthly. This is one reason why fund managers want to know information earlier than others.

Let us say the monthly information comes through that instead of usual 100 apples (the only item that can be purchased on the island), this time 1000 apples were produced. Now the purchasing power of your money has gone up 10 times simply because there are more goods than money. On the flip side we can argue that prices have fallen because of bumper harvest. In either case the value of money, or your wealth, has changed.

Similarly, if suddenly the supply of money changes drastically we will have to work out the new price levels. Say if money supply increased by factor of 10, but supply of apples was same, then prices should increase by ten-fold and to retain your wealth you must have 10 times as much money as you had before increase in money supply. The same process is immensely complicated in a multi-product complex economy. Thus an individual may have no clue how her wealth may have changed during the process.

Today, economies are creating and pumping money in large quantities. Naturally, currencies are facing uncertain environment. The purchasing power of ALL the currencies is in flux. To protect our wealth, we need to step back a little understand how the currencies stack up then, once the volatility subsides, return into a currency denominated wealth. This is why people prefer to hide or park in a commodity that has very limited supply, like Gold or rare metals.

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My book "Subverting Capitalism & Democracy" is available on Amazon 

Jobs, Skills and development

Noni Mausa, in her blog Tunnel Under Snow: The trace elements of a nation, highlighted a comment she made on a spectacular discussion at Angry Bear about Sir James Goldsmith's views about jobs, skills and development. The original post makes a great reading and the comments, more so by Noni, simply elevate it to a must read discussion.

The arguments are often made against trade related job realignment. Make no mistake, trade does lead to realignment of jobs. Low value add jobs move from higher income countries to lower income countries. Except, of course, those jobs that cannot be moved like Janitors, hair dressers, restaurant operations etc. However, the idea of development means that the rest of the economy must be able to pay higher for these services even though the skills may not be dramatically high value adding. To pay higher and higher for same services we have two options.

First, we can improve productivity of jobs that cannot be moved. That is why floor cleaners at airport use a electric cart with mops rather than do it the old fashioned way like the floor cleaners in poor countries do. Essentially, as income increases, economies tend to throw capital at essential-labour problems to make them cheaper. Capital, naturally, is cheaper in high income countries. This worked fine in times when capital mobility was a constraint. However, the advent of GATT, WTO and later developments have made capital mobility almost frictionless. Thus this difference has been effectively negated and the only differentiation is now in wages.

Second, we can add more value that high-income people will appreciate and hence pay for. Thus, fashion consciousness in high income hair salons is higher than that in low income ones. Low income countries have tailors, while high income ones have clothes designers who have a reputed brand to talk about. The communication revolution has effectively negated this trend as well again reducing the differentiation to wages.

What this means is countries will have the jobs profile similar to the skill profile of the population. In other words, we are looking at a wage-skill rebalancing across the world. Thus we need to look at the skill profile of the economy and match the job profile with it. The skill profile can be managed through immigration i.e. by allowing those with relevant skills to come into the country. So US will do well to export financiers and import engineers. In that sense, the direction of the discussion is correct.

In other words, for arguments sake, a country of doctors will need to import engineers or entice customers to come over for treatment. Enticing customers seems ridiculous but hospitals in India are already offering low cost health care services to wealthy foreigners who fly in get their dental, cardiac treatments done and fly back after recovery. It is called medical tourism.

I have discussed the importance of matching job profile and skill profile within economies in my book "Subverting Capitalism and Democracy".

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My book "Subverting Capitalism & Democracy" is available on Amazon 

Identifying Asset bubbles

Recently, Scott Sumner and Arnold Kling blogged about asset bubbles. Scott Sumner post is about bubble deniers and how cognitive bias affects our assessment of about predicting bubbles. Arnold Kling takes one central point out of the Sumner argument - how to define a bubble. I think he views Prof. Sumner's post narrowly but his own definition is fabulous. That got me thinking about predicting asset bubbles. Let me explain it. The underlying principle Mr. Kling uses is this:

Asset profitability = rental rate + appreciation - interest cost

The logic is, so long as the asset profitability is positive at given price, the price is justified and hence not in a bubble territory. Let me distill the equation a bit more. I am simplifying here but, rental rate represents income from asset, appreciation represents rate of price appreciation and interest cost represents cost of capital. We also need to remember that that the equation deal in expectations. So asset profitability is expected asset profitability, rental rate is expected rental rate and so on. Further, to be consistent with units, we have to use rates (first derivatives) everywhere. Thus we have,

Asset Profitability = rental rate + Rate of appreciation - weighted average cost of capital (or WACC)

Hence, the limiting condition for asset profitability is,

Rental rate + Rate of Appreciation > WACC

Mr. Kling suggests that prices are in bubble territory when

Rate of Appreciation > WACC (given Rental rate > = 0)

Interpreting the asset bubble condition
Please examine the equation for bubble condition. There is no variable called price. Is it a surprise that the equation, as distilled does not involve absolute prices  or price income ratio or other related variable at all? Well the equation leads us to very important conclusions.

First, we understand the influence of interest rate on asset bubbles. We understand why raising interest rate pricks bubbles. It increases the RHS of the bubble condition. Now raising interest rate or cost of debt by 1% will increase cost of equity by more than 1%. Thus WACC will increase in relative proportion. We must note that WACC is very difficult to determine at a macro level - for the entire market. WACC also increases when risk perception of the environment increases thus popping bubbles. That may be the reason why extraneous events that affect the risk perception for capital pops bubbles and cools asset prices.

Second, asset prices move within a spectrum. Do note the way equation is derived. It shows us how asset price rise, initiated by fundamentals, moves into bubble territory. At one end of the spectrum are assets that depreciate - like machinery. The decision to buy them depends on how much rental rate (or income from that assets) exceeds the WACC. If the rental rate covers the depreciation(1) then assets become profitable. At the other end of the spectrum are assets where Rate of Appreciation is greater than WACC. I expect price of every asset moves within such a spectrum, from the rental rate covering for WACC and depreciation on lower side to the bubble zone where rate of appreciation exceeds WACC.

Third, asset bubbles can be identified by relative prices. The equation helps us understand if the prices we pay are bubble prices or genuine prices for our point of view. We cannot determine if the market as a whole is in a bubble territory or not. To know if markets as whole are in bubble we again go back to two principles. First is the notion that it is difficult for a market participant to estimate market WACC. Second represents the ability to stack assets in order of hierarchy based on rental rate. For any given WACC we can determine relative price hierarchy and thus estimate if rate of appreciation is higher than WACC.


Note:
(1) Here we must understand the difference between financial definition of depreciation and effective depreciation that includes maintenance and upkeep costs. Firms use factory maintenance programs to reduce the effective rate of depreciation.

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My book "Subverting Capitalism & Democracy" is available on Amazon