Real Estate forecast - I told you so edition

Back in the middle of 2007 it was clear that property markets across the world are overheating. However, ground realities, in terms of property off-take were yet to show visible signs of a slowdown. During a presentation to top management of an Indian public-sector bank, I advocated enhancing the credit standards for lending to real estate developers. I had mentioned that a slowdown in Indian real estate markets is imminent and while timing cannot be correctly ascertained, we (me and my employer) believed that it could be sooner rather than later. My presentation was met with intense skepticism and hostility. The real estate loan portfolio, the bank recently declared, has lost all its capital and not much hope exists of any recovery. In the details I find that almost all the loans since 2007 have gone bad.

Now, apart from a little trumpeting "I told you so", there are important lessons. First, from a credit side, an early warning is a boon. It presents an opportunity for actionable strategy. The bank in question could have easily adjusted its loan portfolio by tightening the credit norms and intensively screening the borrowers. For short term equity investments, the early warning is nearly meaningless.

In the later part of the 2007, I made another forecast about Chinese real estate developers, this time for equity investment. The firms, some mentioned in the Bloomberg report above, were showing robust growth and off-take. Yet, by all measures, a slowdown in Chinese residential market was imminent. The question was of timing. The early warning is difficult to interpret in case of equities. It was generally agreed to reduce exposure to these companies. Yet, the timing of it all remained an issue.

The idea in ST equities is to forecast the trigger. Clearly, for property developers, the trigger is capital availability. For real estate developers, the first step of a slowdown shows constraints in long term capital availability. In the later stages, short term funding becomes difficult to tie-up. Leading to panic selling of sale-able units leading to softening of prices.

The 2007-call turned out ok because of global slowdown of 2008 pulling out capital thus leading to correction in real estate developer stocks. However, recently, S&P Cut China Property Developers to ‘Negative’ - Bloomberg. It means developers may suffer even more in coming months.

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

Investments in India - building long term advantage

India has always admired the high Chinese domestic investment. Policy makers have also talked of striving for higher investment-led GDP growth in India. Contrast that with a fall in investment numbers and we seem to have a problem. 

In light of huge global over-capacities, particularly in metals etc., is it right for India to invest in similar capacities? I believe this is not a right way of deploying resources at the moment. For a start, it is advisable to invest in things that the world cannot provide, either because it is too local or because the global investment climate does not allow it. In both these cases there is a huge opportunity.

In terms of local investments, infrastructure is paramount. In fact investment can be directed at easily accessing the idle global capacity. Thus transportation infrastructure, namely ports, highways, ware-houses and terminals, railways etc., makes a good case for itself. Such infrastructure will also unleash local supply-chain efficiency reducing cost of goods while maintaining better quality. Agricultural produce, on which 55% of Indian population still depends, will be main beneficiary. Long ago, my colleagues at CRISIL did a study that indicated it was possible to double farm incomes by improving supply chain. I believe we underestimated the impact on incomes and possibly the doubling can be achieved with today's income.

Second dimension that needs impetus is information. For a country that is a leader in IT, we have poor information infrastructure. We can plan for unique products effectively. Small cars, unique food items (like spices, fruits and flowers unique to our climate etc.), IT services etc. can be strengthened. Rather than recreate redundant infrastructure, we must deploy investments to strengthen our advantages.

The impetus, at the moment, must come from the government. Almost all areas where India has advantage, save for IT, we have no policy backing. Organized industry hardly has any presence in such areas. Primarily, that is due to lack of clarity from government and proper strategic direction among private players. Let us hope things change and we make right investment and create sustainable value than create redundant supply that will wither the value away.

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

How Low interest rates create mal-investment?

Interest rate identifies the minimum return that the business must generate. In a way, it is a fitness test for the business. It signals to the entrepreneur if he/she is truly adding value to the economy or if they are better off doing something else. Thus in a way, interest rate represents a threshold above which businesses should operate. This is Hayekian view of interest rates. 

Low interest rates and value addition 

When interest rates are too low, they are encouraging entrepreneurs to take risk. This impacts the business models differently. 

At one end are business models, like infrastructure projects, that cannot add threshold value in the initial years of the venture. The low interest rate regime, allows a valuable gestation period for such business models. Often, government artificially lowers interest rates for such projects. 

At the other extreme, there are weak business models, those that are viable only in low return scenario. In a low-interest rate regime, even such business models get funded. These business models, however, die out once the interest rates start rising. In between, there are experimental and innovative business models. Some of these use the low interest rate period to forge better, more robust models. Such businesses thrive later. Others, however, end up going bust. 

The role of banks is to identify each of these business models and fund them while appropriately mitigating the risks.

 

How low interest rate leads to mal-investment 

A bank takes risk by investing in a venture. Interest rate is also a reward bankers get, for taking the risk. This is another way of framing the value addition threshold principle. Yet, the difference in the two has implications for the economy. 

Banks are conditioned to finance lowest risk assets that are available to them. Debt simply happens to be a low risk asset. So if banks have the opportunity to invest in assets more liquid and less risky, banks will move away from debt. Even in lower interest rate scenario, those projects with best risk-return trade-off should get financed. However, anecdotally, lower interests rates actually lead to mal-investment, to borrow Hayek’s term. This is other aspect of the reputation problem we discussed earlier. 

Lower yielding large borrowings backed by reputed corporates get access to financing more easily than new ventures. This means, irrational mega-projects or mal-investments of large corporates get financed at the cost of genuine investments of new ventures. Typically, irrational mega-projects consume a lot of credit requiring load syndication. This has twin benefits for bankers. First, there is a higher degree of comfort in being with the herd. Secondly, bankers do not have to go through credit appraisal of many small entities of questionable risk profile. This makes them assign a lower risk to these projects than appropriate. Despite the low interest rates, the risk with new ventures is always higher. Further, debt is not a very liquid asset at the lender-borrower level. 

The second blow to new ventures comes from crowding out. It implies that even in a low interest rate environment, small businesses and entrepreneurs may not have access to lower cost capital. Therefore this impacts the long-term strength of the economy. In high interest rate scenario, the irrational mega-projects seem less promising. Hence, contrary to popular belief, it may be easier for smaller businesses to compete in high interest rate scenarios.

This post is excerpted from my book "subverting Capitalism & Democracy.

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

Greece and the labors of Hercules

Greek government is considered to be down and out. But may not be though a rescue is certainly a herculean task. The difficulty of Greek situation is not the economics, but the intersection of problems of different dimensions, primarily political and economic.

Problems with economics

Political parties need to understand that the first task is to get the greek economy moving. It means unemployment must reduce, demand, preferably localized demand and supply needs to get moving. Usually, housing and construction are good bets to create localized demand-supply dynamics going. However, in the recent crisis, this very sector was at the center of the recession. Hence the onus of recovery should lie with some other sector. Probable alternatives could be tourism (outside demand, localized supply), infrastructure (hopefully localized) etc.

However, even with full employment and reasonably stable demand Greek government may not be able to pay back the debt. That means some hair-cuts are required. This is also aligned correctly with incentives. Lack of due-diligence from borrowers is no excuse and they must take a hair-cut.

Problem with politics

The problem of politics is vastly bigger than the economic problem. The greeks do not trust their government. This fact is manifested in their tax-evasive behavior. A population that does not trust a body they themselves elected, implies that something is broken in the greek political system. That needs to be fixed.

Once the political system starts fixing itself, tax reforms need to be undertaken. It is my guess that most of tax evasion stems from tax confusion and subsequent concessions (wrongfully targeted). A simplification of taxes will improve the collection.

The problems with political system may also indicate problems with legal system (including law and order). Usually that translates as "corrupt people are set free in the courts". This needs to change. The people who have defrauded the nation should be brought to justice. As we start seeing these changes, the political climate will improve and system may begin to correct itself.

In sum

The political problem is worse of the lot. Fixing it may be more complicated - indeed a Herculean task. The whole, financing elections and bargaining power of those financiers may be threatened. Such problems are present in almost all democracies of the world. If a greek revolution takes place it will change the political future of the world. Greece, that once gave us democracy, may give us the next solution.

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

Mechanics of Asset Bubbles

This is my 250th post on this blog. Thank you for being kind and patient readers.

Barry Ritholtz has a post titled Checklist: How to Spot a Bubble in Real Time | The Big Picture. He puts across a list of conditions that we can watch to spot bubbles. While I agree with the post as a whole I would like to make some modifications to it from investor's thinking point of view. Barry himself is an investor so the end objective of the post is same as mine, to find opportunity to make money.

Let us delve into the mechanics of asset bubbles. All bubbles eventually burst. To understand nature of bubble burst however we must understand bubbles. The nomenclature "bubbles" is misleading when compared to their bursting behavior. Asset bubbles are more like balloons rather than bubbles. Some deflate gradually, some burst open when pricked by risks, others inflate to the point of no return. It is important for investors to identify the bubble and understand when it may burst.

Asset bubbles have three central elements. First being spotting inflating asset prices. The second refers to spotting risks that may cause bubble to burst. The third refers to spotting the timing of bubble bursts. Barry's post deals with all three however, I believe, they are mixed up in his list. 

Spotting possibilities of bubbles

To know if there is a possibility of a bubble we need to consider a few indicators:

1. Standard deviation of valuations: As standard deviations increase beyond 2, we should start considering a possibility of bubbles.
2. Elevated returns: The returns in the markets are high and, more importantly, consistently high. The consistency bit is a flag.
3. Unusually low volatility: The low volatility is another, albeit important, side of consistency in high returns. Volatility is an indicator of doubt. It indicates how much the market believes in higher asset prices. Higher volatility indicates that markets are testing the reasonableness of prices. It may be possible to have reasonably consistent annual returns but  still have high volatility throughout the year. 
4. Robust trading volume: It is difficult to imagine a healthy increasing volumes accompanied by low volatility but such conditions do exists during bubble period. The number of houses bought, number of people who trade in equity markets, etc.
5. Increase in employment: Driven by the bullish forecasts the bubble-prone sector goes into a hiring overdrive.
6. Increase in credit growth: Credit is a measure of low-risk-seeking capital. When all investors think the sector is low-risk quantum of credit flows to the sector increases seeds future bubbles.

Risks to bubbles

While above indicators reveal the possibility of a bubble, they do not specifically indicate the risks that may cause the bubble to burst. The risks emerge from causes of bubbles to their effects.

1. Perverse Incentives: These are difficult to track down before the burst but is eventually obvious. A diligent investor needs to understand the "why" behind the behavior of participants in that sector.
2. Unintended consequences: The frontiers of regulations (or de-regulations) often harbor seeds of bubbles. The problem with regulations in particular is that it can be reversed in a spur-of-the-moment decision by relevant authorities leaving investors in the lurch.
3. Excess Leverage: As the popular opinion of low-risk permeates through the financial world, firms are encouraged to take on more debt increasing their leverage. Increasing equity prices also puts pressure on management to deliver high returns. Managers rejig the capital structure to increase return on equity for the same return on capital. The easiest way to achieve this is by increasing leverage.
4. New products: Barry refers to only financial products however any product that teases regulatory acceptability can create risks. Financial products are more potent because they tend to affect multiple sectors and economy as a whole. Naturally, financial products have been at the forefront of biggest bubbles in history.

Understanding timing of bubble bursts

A few behaviors are prominently visible during the late stage of bubble formations. Typically,

1. Declining credit spreads: While I am using Barry's headings, the central idea he points to is bigger than credit spreads. During late-bubble phase, the price or yield or return distribution and risk distribution do not match. In normal times, higher risk implies lower prices and higher-but-volatile returns expectations while lower risks implies higher prices and lower but more stable return expectations. In other words risk-return equations become asymmetrical.
2. Declining credit standards: This is another face of risk-return asymmetry we discussed above. Firms with strained balance sheets get easy access to credit. It also indicates lower default rates on credit side and further acceleration in credit growth in the sector. The latest credit investments may be difficult to recover and hence are as good as write-offs.
3. Tortured Rationalizations: Almost all bubbles have advocates who have strong beliefs that they validate using unverifiable, anecdotal but mismatched data or new metrics that have no history. Be it eye-balls, estimating number of millionaires as proxy for premium housing demand, etc.
4. Trading volume spike: We note that high and steadily increasing volumes are marks of bubbles but accelerating volumes - spikes - indicate that end is near.
5. Interest rate changes: A credit-driven bubble is sensitive to interest rate changes. However, the sector may not react at the turn of interest rate policy. So when the central bank raises rates after a long cycle of declining rates, there seems to be no effect on the bubble sector. It is after two or three rate hikes that suddenly things start to fall apart.

While spotting bubbles is difficult, the difficulty can be reduced. Bubble-spotting is iterative process and takes a while to establish the conditions for bursting of bubble.

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

Austerity not a medicine for all occasions

One of the key lessons of the great depression is that austerity is not a medicine for all occasions. However, over the subsequent excesses we seem to have lost out on this learning.

Austerity is not a solution for US

There is hardly any doubt about ability of US to compete. In fact, if the fat corporate balance sheets are to go by, US companies are in their best shape among past 5 years. Yet, the unemployment numbers are languishing which makes US a pump needing priming. Such priming will be achieved through a jobs program to create next-gen infrastructure that will allow US manpower to compete in knowledge era. Austerity, in this case, will impair future competitiveness. However, the kind of priming as envisioned in the Fed's quantitative easing program is nothing but wasteful. These programs do not have well established working channels to reach fruition. 

Greece and wasting water priming the pump

We don't waste water priming the pump so long as the pump works and there is water at the end of the well. In case of Greece, both parts seem to be a problem. In such case, austerity is a better alternative till the economic engine is repaired. Further, Greek government must set in place tax reforms allowing fair and easy collection of taxes. Once such necessary conditions are in place, then Greece will need a spending program to kick start growth in a sustainable manner.

Implications for markets and democracy

The problem with misunderstanding related to austerity is two-fold. The problem with austerity is that it will wreck havoc with asset prices in general impairing genuine investment leading to future problems. The second problem is the people's confidence in the system is shaken leading to anarchy and threat to general system of law and order. In short, the cost of misunderstanding austerity will be massive.

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

Geoffrey West on corporation and cities onEdge.org

My day was made when I read the edge piece today. Geoffrey West, professor, talks about interesting aspects of Why Cities Keep Growing, Corporations And People Always Die, And Life Gets Faster.

As an investor, company life-cycle represents a lesser-debated frontier. Analysts tend to rely on the accounting view of going-concern. Yet, the permanence we take for granted is a mirage. However, understanding when the decline of the firm comes about is easier said than done. 

Dr. Geoffrey West points to yet unpublished (and still being verified) work that says firms scale sub-linearly. In other words as firms get bigger, they become less profitable and they eventually perish. Compare this with cities (which he discusses before firms) that grow super-linearly. In other words as cities get bigger, they become more beneficial for its inhabitants. So then, should investors stop companies from growing? And how should one view the increase in scale. 

I think as investors it highlights a very important and much neglected area.

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

Wary of QE2 withdrawal effects!

At a time when Indian markets were nearing valuation comfort, they surged again. Usually, it would be a positive reinforcement and time to get in. However, I am not sure today. The risks arising out of end of QE2 pose significant threat to markets.

On its own, the end of QE2 alone would be a perceptible trigger. But more important is the situation of world economies at this point. With EU on the brink of another crisis, waning strength of US recovery and still-to-gain-traction Japan, we are at the most unstable point in recent years. At such a time a withdrawal of QE from US may not auger well for the markets. 

I guess we must hold on tight and keep powder dry for there may be interesting times to invest in very near future. 

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

Krugman & Delong and Weak Dollar

Brad Delong links to the Krugman post titled A Weaker Dollar Is in America's Interest. I have always maintained that weaker dollar is essential for US economy to recover. Weaker dollar has come about using a different mechanism that investors anticipated.

The value of any currency refers to or is derived in relation to a basket of goods. The basket has significant number of commodities. So as investors moved the commodity prices up, the value of the US dollar automatically depreciated. In other words, investors created this devaluation and not the central bank.

The process, however, is fraught with risks. In a world of pegged currencies, we now have devalued the entire currency universe. This, to my mind, is not correct. The purchasing power of other currencies, particularly the Yuan, should be higher. The discrepancy has crept in because of central bank action. Developing countries are worried about export competitiveness declining with even small appreciation in currency. As a result they have to tolerate higher inflation and no amount of domestic slowdown may correct it. Only those countries that have strong economic transmission mechanisms can tolerate inflation. However, this is only short term relief. As transmission mechanism takes effect, it translates into higher wages and thus lower competitiveness.

With the Chinese reserves topping USD3 trillion, I guess we have some more time. I had mentioned in an earlier posts that it will take doubling of Chinese reserves till we have decisive action. At the time Chinese reserves were close to USD 2 trillion. So I am expecting this process to continue for some more time in accordance with the phases I mentioned back in video (relinked below) in 2009.

USD Dollar Views from 2009(links to old post)

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

Commodity markets and synchronized investment

John Kemp has a piece on the financial post titled Analysis: Commodity markets wobble | Investing | Financial Post. He argues that prices have diverged from fundamentals and talking heads are merely retrofitting explanation to reality.

Broadly, I want to add that such trend build-up is seen in many asset classes. The bubble-like behavior needs a sustained up move and as the move loses momentum, downward forces take effect. The downward action, in most cases, is swift leaving many (occasionally including yours truly) in the lurch.

I believe this is as much a result of group think as speculation. Algorithm-based trading, herding aided by technology (mass-emails) and lack of diversity of ideas probably causes synchronized money flows resulting in self-reinforcing behavior. Some fund managers interested in exploiting this behavior often talk about leading such trends or buying stocks not companies.

A typical trend comprises of four phases accumulation, discovery, bull-run and realization. Accumulation happens when prices are low for sustained period of time. At such times a section of population accumulates the assets leading to firming of its price. The group is led by fundamental investors and many others follow suit. Discovery happens as more and more people realize the downside resilience of the prices of that asset. Technical charts start suggesting potential for up-moves. Early speculators jump on the bandwagon and soon this phase moves into a bull-run. In bull-run the prices start accelerating, crossing the targets investors have in mind, but the move shows no signs of abating. The prices soon reach the bubble territory and often confidently march on prompting investors to re-look at fundamentals to see if they are missing something. As prices cross the bounds of incredulity, realization dawns about weak fundamentals and all the hell breaks loose. The synchronized move out of the asset creates more distress to prices that warranted by fundamentals.

While I am critical of this issue, the issue itself is not new. Such behavior is a reality of the market. It is merely exposed more during volatile times. In periods of stability the trends hide this behavior from public scrutiny.

Volatility and investments

As the markets are getting more volatile by the day, we turn our focus to impact of this volatility. In general, volatility is enemy of long term investment. It is a friend of aggressive trader when luck is favourable. It promotes, a sort of, alignment towards short term.

Current macro climate in India is sensitive to such short-term focus. India needs long term investments that should boost supply to accommodate the growing demand. Such investments are are difficult to conceive during times of high volatility. The attempt of policy-makers should be to create pockets of certainty in areas that can be controlled. Particularly, monetary policy, fiscal policy and government regulation need to demonstrate continuity and stability thus not contribute to the already existing volatility.

China has successfully shown policy continuity and stability that promotes such investment. India needs to learn from China in this regard.

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

Super Boom - 500% increase in stock prices

Barry Ritholtz comments on plausibility of Jeff Hirsch's Super Boom: Why the Dow Jones Will Hit 38,820 and How You Can Profit From It | The Big Picture. As Barry mentions, it is plausible. However, timing the bottom still remains a challenge.

I believe there were trends ready to take over during episodes Jeff points to. There was the automobile boom, suburban boom and consumer products boom, the internet and computing boom etc. The problem is, as of now, I do not see any sector ready to create the growth momentum required for 500% increase in stock prices. I was looking at alternative energy among other things, but it doesn't seem to be a big contender as yet.

For a sector to be an able contender to create (not simply augment or drive) growth momentum it needs a few qualities. It needs to be a mass employer at a value-chain level. It needs to create productivity gains in existing economic engine while creating ancillary products and services that are growth engines in their own right. The first past will help finance investments in the technology while the second will create exponential gains in the sector both in terms of adoption and profitability.

Alternative energy cannot, as yet, be a mass employer. Though it can create energy independence and help the economic engine. To be specific, I think the sector has the potential to become a top trend creator in 10 years time. Another sector in its infancy could be water management and treatment. In my view, healthcare services or healthcare delivery services as industry fellows call it, may be a reasonable bet. I do not have much conviction in the idea as yet, but it ticks off some important boxes. It can be a mass employer, it will help improve productivity of economic engine (by keeping labour employable), it is a critical need so funding should not be an issue. The missing link is the exponential take-off. Unless people come up with innovation, I do not see exponential take-off materializing easily.

In all probability, the identification of trend should take at least couple of years. Till such time I do not see the beginning of the 500% trend. However, I am convinced that once such a trend is in place, we will see a period of sustained growth as the trend propagates through the global economy and benefits begin to stabilize. I am not sure if the percentage 500% is relevant but a sustained growth is always welcome. So let us hope for a quick revival!

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

Good debt and bad debt

Michael Pettis clarifies the difference in his post Reforming the banks.

The relevant paragraph reads:

The reason debt levels always seem to grow unsustainably, I suspect, is that in the initial stages of the growth model much if not all of the investment is economically viable as it pours into building necessary infrastructure whose profits and externalities exceed the cost of the investment. The result is real growth. At some point, however, the combination of subsidies, distorted incentives (in which investment benefits accrue to those making the investment while costs are shared broadly through the banking system), and very cheap financing costs leads inexorably to wasted investment and debt rising faster than asset values. This is when the debt burden begins to rise in an unsustainable way.

This explanation points to a difference between productive and unproductive debt that we discussed in earlier post. Productive debt creates an asset of higher value than itself. Let us highlight this sentence:

Productive debt creates an asset of higher value than the debt itself.

Please refer to the causality, critical to the equation. With housing, the sentence was correct except for the causality. The causality in housing was reverse - it was higher housing prices that were creating debt not other way round.

Snippet: What is a risk-free return?

In this snippet I restrict the question to investment firms and investors. These firms and investors get capital at some expected rate of return. Thereafter, the firms use their knowledge and management skills to generate returns  on this capital. Ideally, the returns they generate are higher than those expected by providers of capital. Further, and let us read this carefully, the returns these firms generate are higher than returns they could generate through any other activity.

In such cases, Risk-free return is rate of return slightly higher than cost of capital for these firms.

Your comments?

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

Crisis and plight of common man?

John Mauldin describes a letter sent by one of his readers. The reader, Bill, asks why is it that economists and analysts are promoting austerity implying pain for the common man. He particularly points to capitalism working for "have-gots" rather than the common man. John Mauldin answers well but I would like to add a few points.

The crisis is a problem for "have-gots" but the correct have-gots are ones who have got the debt. It is debt that is the problem for common person, not job or income. Somehow, we must realize that the mechanics of debt is not properly explained to the lay-person. Debt is good if it creates something that can repay the debt - a production asset. The collateral is just to allay the fears of the lender. Some how we created debt for assets that did not generate returns to repay the debt - like housing. These are, in my book, consumption assets and not production assets. 

The future for those with unpaid debt is bleak. Further, those who do not have enough savings, are likely to suffer next. To get through this phase of economic consolidation we need people to have strong backing of savings. These are usually the rich people, but this also includes those who were prudent with their money.

The question of austerity and jobs, to my mind, are mixed up. We need austerity in programs that are wasteful. However, constraining job-creating projects under the name of austerity is not a right remedy. Jobs are what will get the economy out of the woods.

The question, therefore, is why is there no job recovery. My sense is that we are undergoing a phase transformation in terms of employment profile of the economy. This is, in many ways, what Alwin Toffler calls "waves". The first wave created an agrarian-dominated employment profile. The second wave created a factory work-dominated profile. The third moved the profile to services and within services to technology driven services. We are awaiting the fourth transformation.

The problem with phase transformation is that individuals are often well-versed in older wave skills rather than new wave skills. To change this, we require extensive training and education. However, before we begin training, we need to know what the wave is. To survive this period of uncertainty we need savings and monetary solidity. The common person, almost always, does not have this. The dilemma, therefore, is how to assist the population while we determine what the next wave will be.

As a solution for this problem, Keynes suggested creating any job, even digging and filling ditches will do. Such a program goes against the principle of austerity. However, to my mind, Keynes' solution about  job creation represents way out.

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

Reallocating labour - A Thought experiment in economists

Imagine one day economics dies off. We would naturally retrench all the professors of economics. According to their theories, their resources should be better utilized in some other work. The question is what work and how long will it take before they take up other jobs.

The point I am making is that reallocation of labour to other industries and other tasks is not easy. It is a painful process with a lot of stress and agony for the household involved. Economics professors, I am sorry to say, do not understand the problems involved. In a specialized work force these problems compound as set back to income and dignity is enormous. For example, if only jobs available were those of plumbers, and a less qualified economist is a better plumber, it will difficult for the better qualified economist to swallow the reality.

Keynesian approach makes jobs paramount because Keynes understood these problems. While I am not a Keynesian, as goes their definition, I do agree with focus on jobs during times of crisis.

Keynes, some say, likes to maintain status quo while Adam Smith actually hails the reallocation of resources. I believe Keynes and Adam Smith are at different end of the spectrum. If Adam Smith is looking at a car at rest, Keynes is looking at situation where car is speeding out of hand. Keynes' solution on maintaining jobs is akin to ABS braking in cars. In cars, as we know, it is better to have traction and hence brakes are applied and released repeatedly to achieve better braking. If we were to stomp on the brakes we will skid out of control. Similarly, maintain jobs in the times of crisis gives the economy traction to change course and ease into a new reality.

As far as I understand Keynes is a solution for crisis. The mistake Keynesians make is to apply Keynes' theories out of context.

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

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.