Crisis Basics: Solvency Crisis Vs. Liquidity Crisis

Let us understand what a solvency crisis and liquidity crisis are.

A Liquidity Crisis

Here is a popular example that was given in past few years. “A tourist stops at a motel and gives the manager a $100 cash deposit while he looks at the rooms. The manger runs and pays off his $100 debt to the butcher. The butcher runs and pays off his $100 debt to the farmer. The farmer pays off his debt to the feed store, and then the feed store owner pays off his debt to the motel owner. The motel owner then gives the $100 deposit back to the tourist.” This is a liquidity crisis.

Point to note:

1. All people were in debt. The size of debt is immaterial. The hotel manager could have had debt of $1million to various vendors.
2. The debt was used to create value. That, is the most important aspect of this debt.
3. The value dominoes were stalled because of lack of liquidity which the tourist provided.

A solvency crisis

Here let me use the example from Bob Steinke. 

Imagine instead that a restaurant owner takes out a small business loan to stock his wine cellar. The next day Bernie Madoff comes in and drinks $1000 of wine, paying with cash. The restaurant owner turns around and invests that cash in Madoff’s hedge fund. The next day Madoff comes back and drinks another $1000 of wine, paying with cash (the same $1000 bill he used yesterday), and the restaurant owner turns around and invests that money with Madoff too. This continues ten times. Madoff has drunk $10,000 of wine, and has a $10,000 debt (the investment he is supposed to eventually return to the restaurant owner), but he only has $1000 of cash to repay that debt. Madoff has a solvency problem. His net worth is less than zero. Temporary use of some cash, to be paid back later, would not solve this problem. This situation is different because value was actually destroyed. The $1000 of cash still exists, but $10,000 of wine disappeared into Madoff’s stomach, and Madoff didn’t produce anything of equal value he could use to pay for the wine.

Points to note:

1. Debt was created just as in previous case.
2. Debt was deployed to non-productive ventures. In this example Madoff drank-off all the wine. It means value was destroyed.
3. The debt domino does not stall easily in this case unless doubt creeps into the mind of the restauranteur.

Therefore

1. Now clearly solvency crisis seems bad one. If only we had someone who could tell the restauranteur that Madoff was a crook. That someone, in many cases, should have been the ratings agency.
2. Whenever there are debts, there are also bad debts. Good debts are deployed towards creating value higher than the value of the debt. 
3. This begs further explanation. Let us assume an entrepreneur takes $100 of debt @ interest rate of 10% per annum. This debt is employed to do work that ideally produces output greater than $110 in one year. Thus, debt of $100 creates, let us say, $130 of value. Then we say that debt of $100 create $10 of value for the creditor and $20 value for the entrepreneur. 
4. From the creditor's perspective, let us say the creditor makes 100 such loans. So the total debt is $10,000. Potential value it should create for the creditor = $1000. 
5. Now imagine one entrepreneur fails and loses everything. 
6. From the creditor's point of view there is not yet a problem as other 99 loans are good. The creditor will lose $100 of capital and $10 of interest. Thus, the creditor will earn $890 in that year. In technical parlance we would say, the creditor had write-off of $110.
7. Solvency crisis happens with size of bad debts is higher than the value created by good debt.

The problem of misdiagnosing a solvency crisis as a liquidity crisis

The authorities tend to pump in more money to solve what they term, rightly or wrongly, as a liquidity crisis. The money often goes to Madoffs of the world who disappear with the money. The problem gets compounded when a solvency problem is thought to be a liquidity problem.  This actually increases the level of bad-debts in the system.

The way out of the solvency crisis 

There are various ways out of solvency crisis, each dependent on the size and structure of the problem. 

1. One way out is to write off the debt and start afresh. Everyone takes a hit and blames their naivety and goes back to work. 
• This is relatively easy when the size of the problem is relatively small, as in our example above. 
• There is a problem with relative size of bad debt is colossal. In such cases, creditors need to be wound down in a systematic manner. At the same time, the resulting recession has to be managed by promoting employment and counter-recession measures.
2. Textbook way is a little different. Technically, it is possible to increase the level of the good debt to such an extent that the bad debt can be written off without any problem. There are two ways to create good debt. 
• First, by reducing interest rate marginally bad debt can become good debt. It is interesting to note that the first approach works only if the amount of bad loans is uncomfortable but not catastrophic like we had in 2007. In other words, the difference between good and bad debt has a bearing on effectiveness of this approach. Monetarist do not agree with this pre-condition. They believe this approach can work for any difference between good and bad debt.
• Second, by pumping in additional money into the system. The additional money, ideally, will create value that will dwarf the losses from bad debts. This is like making a line smaller by drawing a longer line beside it. The second approach only works when you have body of projects that can absorb the new capital and still be classified as good debt. The gains from these projects must be quick and substantial. For example, if by some stroke of policy we can quadruple the exports then debt required to fund that policy can become this text-book solution.
3. The third way of escaping a solvency crisis is what I call the Chinese-bank way. In this mechanism, you combine all bad debts, distressed assets into a special purpose vehicle. This cleans up the balance-sheet of corporates holding those assets in first place giving them room to borrow and invest in their businesses. The special purpose vehicle is then backed by government whose solvency, ideally, is not a problem. Over a period of time as industry grows back into a healthy state, government offloads its stake in SPV to the markets which digest these debts. 
1. Naturally, these bad debts are a little different from other bad debts. These bad debts must be productive under some conditions, which are denied because of the impending crisis and may return when the crises abates.
2. If government is holding really bad bad-debts then it can write-off the SPV investment and claim the debts as taxes either from public or corporates at later date.

In sum

We can notice that quite a few ways for countering this crisis have been tried. We haven't had much success. As stated, half-hearted attempts to solve the problem compound this problem, thus, we are in a bigger soup. Let us hope, further solutions are better managed.

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

Jeremy Grantham knows we were warned!

Years back in 2008, I wrote a post about how Shakespeare's Polonius (from Hamlet) had good advice for us investors. Today, Jeremy Grantham, in his quarterly newsletter, discovers that very advice.

Here is my post from 2008: "How to avoid the credit crunch?"

I was really surprised when I realised that entire credit crunch and related problems were highlighted and we were warned back in 16th century itself.

For Rating Agencies
See thou character. Give thy thoughts no tongue,
Nor any unproportioned thought his act.

For investors - particularly those who misguide people on CNBC
Give every man thy ear, but few thy voice;
Take each man's censure, but reserve thy judgment.

For US / UK and European Consumers
Costly thy habit as thy purse can buy,

For Mortgage dealers (they heeded but CDS borrowers didnt)
Neither a borrower nor a lender be;
For loan oft loses both itself and friend,

For all market operators
This above all: to thine ownself be true,
And it must follow, as the night the day,
Thou canst not then be false to any man

Here is the full advice:
Yet here, Laertes! aboard, aboard, for shame!
The wind sits in the shoulder of your sail,
And you are stay'd for. There; my blessing with thee!
And these few precepts in thy memory

See thou character. Give thy thoughts no tongue,
Nor any unproportioned thought his act.

Be thou familiar, but by no means vulgar.
Those friends thou hast, and their adoption tried,
Grapple them to thy soul with hoops of steel;
But do not dull thy palm with entertainment
Of each new-hatch'd, unfledged comrade. Beware
Of entrance to a quarrel, but being in,
Bear't that the opposed may beware of thee.

Give every man thy ear, but few thy voice;
Take each man's censure, but reserve thy judgment.

Costly thy habit as thy purse can buy,
But not express'd in fancy; rich, not gaudy;
For the apparel oft proclaims the man,
And they in France of the best rank and station
Are of a most select and generous chief in that.

Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.

This above all: to thine ownself be true,
And it must follow, as the night the day,
Thou canst not then be false to any man.
Farewell: my blessing season this in thee!

- Shakespeare in Hamlet (Lord Polonius advice to son Lartes)

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

Commodity valuation

A lot of people believe in strength of commodity prices but the boom is fragile for the following reasons.

Substantial part of valuation depends on strong and sustained commodity consumption driving growth in India and China. The growth is unlikely to be either strong or sustained (in near term). This may take the wind out of the boom.

But I believe we have underestimated two other reasons.

Commodities as store of value
A part of boom in commodities can actually be explained as a result of money trying to protect value of developed countries investors. To protect value, you translate your money into equivalent basket of benefits (goods and services) that can be bought with your money. So we can imagine the equation as (money I have in year "t") = (sum of products and services that can be bought in year "t").

Every year this equation must be evaluated from the RHS not LHS. Thus, the true comparison can be achieved when we compare (sum of products and services that can be bought in year "t") vs. (sum of products and services that can be bought in year "t+1"). Ideally, we must be able to buy more products and services in "t+1".

However, in common parlance we do compare LHS. The question we ask ourselves is "do I have more money than last year?" It is a misleading question. People get fooled when the answer is yes. In fact, American middle class thought they had more money in every subsequent year. But in real terms the wages are stagnant for more than 2 decades.

To protect the RHS value, investors try to hoard certain commodities that are irreplaceable. The degree of irreplaceability, knowledge of alternatives, certainty of whether commodities will indeed be part of value-store equation are all unknowns.

The Real Chinese demand
The resource intensity of growth of China will reducing drastically. This is simply because of three main reasons.

Firstly, China has built out infrastructure for next N years, advancing their consumption of commodities. This will revert to mean in the next N-4 years. (The value of N is matter of debate).

Secondly, China has already bought or locked in its commodity requirement for next few years and this has no price implication for commodities hereafter.

Lastly, it has to reduce drastically just to make scientific sense. This will have new winners and losers within different commodities. 

Evaluating commodity boom is difficult
Thus, the factors affecting commodity prices and demand are different than normally discussed. I am yet to see a reasonable assessment of the two main changes above. Hence, I advise to be really, really careful with commodities. At least do not build any position you cannot liquidate quickly. 

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

The Value of Indian Rupee

The Economist recently published the Big Mac Index that shows Indian Rupee as most undervalued currency contrary to the popular perception of its value. The Big Mac is priced at $1.62 in India vs. $4.2 in the US thereby giving undervaluation of 2.6x.

It raises some hard questions:

1. Has Indian Government absorbed substantial part of costs? Indian government subsidizes diesel and that could show up as mark down. This bloats the government balance sheet but keeps inflation from showing up in consumer goods prices. This has double effects, when high oil prices are absorbed by the government, Indian prices languish. Further, when the global prices start correcting, Indian prices tend to remain firm.
2. INR is undervalued because Indian government finances are not in good shape. India's government finances look more like developed countries than developing countries. To compound the problems, Indian export basket is quite price sensitive while import basket is not. So then does it mean Indian inflation has substantial way to go? 
3. Does it mean that Big Mac Index works better when government budget is nearly balanced?
4. Another important thing is that the price of entry-level burger at McDonalds has been coming down since McDonalds came to India. Part of the reason is product development, but significant part is because of raw material efficiency. This latent competitiveness has not yet been harnessed, but if done so, will make India more resilient to global factors. It may even make Indian exports more competitive.

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

Sticky Wages, Prices and effects of pouring money

Scott Sumner has a post about pouring of money - i.e. effects of expanding money supply. He disagrees with the metaphor that money pours into certain asset classes. While I agree with the principles behind Scott Sumner's post, I find most of times the metaphors send better signals for interpretation. But my main point is about prices and wages.

Prices and wages are embodiment of information - historical, present and future. If they change too quickly then the historical aspect is lost. For better or worse, our scale of value are anchored to the past. It does get influenced by present and to a less degree by expectations of future. But if we lose our anchor point or the reference scale then our mental models collapse and we lose our sense of reality. Thus, if we get paid $30,000 in year 1, $3,000 in year 2 and $3million in the next year, we will develop a sense of confusion.

Then comes the question of pouring. What pouring refers to is change in the relative value of asset classes. Imagine a spread of assets along a value spectrum, sort of a hierarchy (with sometimes assets jointly occupying a hierarchal position). 

If money increase does not modify the hierarchy then it does not impact much. If it does then it creates gainers and losers just because money is created. For example, if a really thirsty person would rather be just under the tap than away where water will eventually get to him. 

The argument therefore is whether the government or central bankers be allowed to create such distortion that has no grounding of productivity or real value creation.

One can argue that over long term the asset hierarchy goes back to a certain mean. But during the time a distortion is set in motion and the time we get back to time-tested mean we can extract advantage. Finance is prepping to do just that.

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

United States of Europe

In principle, there is not much difference between United States of America (as it was intended) and United States of Europe (as it is perceived as of date). 

1. USA was a federal structure in a true sense. Barring money, national security and foreign policy, not much role was envisaged for the central government. However, just like in the case of USA, USE must be wary of tendency of the central government to start hijacking things to itself. Sometimes there are legitimate reasons for doing so, for example:
1. Inter-state issues of national security and policy. For example, establishing of FBI, DEA etc.
2. Creating economic efficiency. For example, inconsistent laws between states creates problems and there is good argument for center to create a unifying law.
2. Other times, central agency takes up power at times of crisis when collaborated and concurrent action is required by all the states together. Naomi Klein in Shock Doctrine, highlights some of the instances where disaster was used to by-pass checks and balances of the system.

Implication

So I don't see any problem when there exists a possibility of politically uniting Europe. If handled properly, it could be successful. However, odds are always stacked against it. Pursuing it at this moment will be a mistake. I am reminded of the quote, friendship always exists among equals. In today's Europe, there is no equality and hence no friendship.

Aside

If you have enough decentralization, then any aggregation at the top level has little or no effect. It is the centralization that starts creating the problem. It belittles the citizen and magnifies the government. 

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

Types of Investment and India's low-hanging fruit

I think India is much better placed at the moment primarily because there is lot of low hanging fruit. I attempt to list a few. When it comes to investment we have two kinds of investment. 

1. The first represents fairly well understood investments where there is ample evidence of cost and benefit and technology is available from the experience of the first world countries. The road-map for development of such infrastructure, its costs, pay-off timelines etc. is well known.
• Agricultural productivity
• Basic Infrastructure - roads, power
• Second-level infrastructure like cold chains, transportation hubs etc.
2. The second is complicated and more like venture capital where risks are higher. Here the objective is to invest in areas that will value-drivers of the future. Here we are breaking new ground and the pay-offs are not clear. US and first world countries are required to invest in such type of infrastructure.
• Alternate energy
• New types of infrastructure including 4G telecom and other related such as NFC payments
• High-end infrastructure e.g. intelligent Highways etc.

  

For India, substantial opportunities exists in the first part. This is what makes India an attractive destination. Starting around 1995, a lot of attempts have been made in estimating this demand. Most have been unsuccessful, but a substantial body of knowledge has emerged in this process. Today is the best time of all for companies to undertake massive infrastructure building projects. The question really is, will government facilitate the process balancing protection of citizen's rights and goals of developments.

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

2012: Images from the Crystal ball

At the doorstep of 2012, I am here again looking at the crystal ball. There are signs

Reworking the Macro 

1. The Eurozone faces tremendous challenges at the moment. 2012 will see the aftermath of the crisis. I imagine the Euro leaders will be able to patch things back, but substantial political sovereignty will have to be ceded. One hopes the sovereignty will be returned post the resolution of the crisis. In any case, Eurozone will spend the next year in hibernation.
2. As I mentioned in previous post, there are currently two systems - Eurozone system and US-China system. 2012 will see stresses in the US-China system rise dramatically. I think as if rhyming with 2011, we will see stress in US-China system next year same time.
3. We may see Chinese economy under stress. I am not sure how much will happen next year but China is unusually fast. I think we will see slowing of China - about 5-6% growth level.
4. The Arab world will experience post-purchase dissonance with respect to new-found political setup. In worst case it means some new dictators will come up and uprising may start all over again or there may be bigger political discussions.

Financial markets

1. I see increased synchronization - both globally amongst markets and within markets among stocks. Thus, old places to hide may not actually work. 
2. From the investor standpoint, we will be forced to be more in cash or cash equivalents.  Correspondingly, even when invested, we must look to highly liquid names. I was hoping to see derivative markets in their full splendor at such times, but MF Global and lack of counter-party settlement systems keeps check on the system. 
3. The other fall-out of this is steeper moves - on upside and downside. It means we can make or lose money super-quick. Markets may rise 20% in a month, fall 20% in the next. We should see more talk about Vix.
4. Funds with specific low-cash rules should find it difficult. I think in general, the strict rule-based fund management should take a beating. Fund managers with broader mandate are likely to deploy the capital better. 

All in all an interesting year ahead. My best wishes to you all and I will see you next year. Merry Christmas, Happy new Year and happy holidays. Cheers

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

Comparing Euro with US-China - MMT

Edward Harrison points to a Randall Wray post about MMT, sovereign debt crisis in Eurozone.

Randall refers to difference in location of monetary policy, within the sovereign in case of UK and outside the sovereign in case of France (with ECB), leading to reduced risk of default. Randall refers to this as one main source of problems of the Eurozone.

However, Euro area is not the only problem. When it comes to difference between where monetary policy is located and where fiscal policy is located, we have two examples of this model operating currently- Euro model and US-China model. Both are at risk, different risk, but definitely at risk.

In principle, US-China model has a similar monetary-fiscal policy situation to Euro area. US sets the monetary policy and that policy trickles down to set of countries that peg their currencies to US Dollar. I have only used China as representative, in reality many more countries peg their currencies to USD and this group is bigger than the Euro-group.[1]

The issues is if you have given up monetary sovereignty, you are eventually forced to give up broad level fiscal sovereignty as well. So a system where monetary policy is regional, you must have a regional fiscal policy at least at a broad level. It all boils down to congruence between fiscal and monetary policy.

The persistence with this monetary-fiscal distortion polarizes the participants creating a production pole and consumption pole. In case of Euro area, we have Germany and Greece as representative poles. In case of US-China model the respective poles are China and US.

Now the difference is Germany, the production pole, has larger influence over monetary policy[2] in Eurozone while its corresponding pole China, has no say in policy of US. 

In the US-China case, US does not seem to have a problem. But actually it does. The model requires the China-group to keep buying US treasuries. This allows US more monetary policy room but forces these countries to absorb, either through government or overseas investment, this impact. It masks the problems of US till one fine day US suffers a heart attack. Further imagine the policy environment if Greece ran the policy in Eurozone. I won't go into more detail here but suffice to say this model is equally broken.

Notes:

1. Euro as a group, single entity, also has a similar arrangement. Here Euro-group occupies the position of US and few countries peg their currencies to Euro. In addition, Euro is also influenced by its value with respect to USD. It is sort of a complex fractal. We will leave aside these complications for the moment.
2. Apologies to those who believe monetary policy is truly independent. And, of course - there is no Santa Claus - it was your parents all along.

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

Uncomplicate the Taxes

High sovereign debt implies increase in taxes in the near future. However, Barack Obama, who wanted to raise taxes, is facing stiff resistance from the Republicans. So also

There are specific problems with our tax system 

First, it is very difficult to calculate the best tax rate or the lowest tax one can pay through the system. Second, taxes have unintended consequences. They sometimes promote or prevent marriages, home purchases, bigger cars, etc. Government has no business interfering with the lives of taxpayers in such a way. Third, taxes are unfair. The rich often pay lower taxes than the poor. Fourth, there is no way to measure return on taxes just as we measure return on capital. Finally taxes are high because they are paying for over-regulation by government or they are paying for large governments.

Better simplify the tax system

It might be better if tax was simplified into just one tax, either on income or consumption. Incomes should not be classified according to their sources. All incoming cash flow should be treated as income. There should be no part exemption what so ever. Government can define a level of income below which tax rate is nil. Above that income, taxes should be at one single rate. The only flexibility in policy will be to determine what rate should be.

The common argument is about the beneficial taxes on cigarettes. Those are not taxes. Those are penalties imposed on cigarette manufacturers for damaging lives of people. Those should be recovered as penalties and directed towards treatment of heart and lung diseases.

Tax filing has been made easy. What is difficult is to figure how much tax we have to pay. That has to be easier. We need to protect individuals from complexity in taxes. Just like the Consumer Financial Protection Agency (CFPA) is trying to simplify credit card agreements, it should also simplify tax calculations.

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

The Rakoff manifesto

Judge Rakoff's principle based on Contract rights and duties vs. legal rights and duties

Two types of rights (and/or duties)

First are rights created out of mutual agreement, called contractual rights. These exists separately outside the law. Only when there is dispute, the law intervenes. Even then, law only intervenes to clarify what is the real agreement between the parties and has it been honored. Contractual rights exist within the boundaries of law - sort of like a playground where you are free to do what you want so long as you don't hurt anyone. Second are rights created by law. These are typically like the classrooms of strict schools - ordered and disciplined, everything is straitjacketed here. Punishment is imposed by the law to those who transgress the rights of others or duties imposed on them. 

Important consideration is that contractual rights cannot infringe legal rights. Thus contracts to commit illegal acts are void.

Settlement agreement with SEC

Settlement agreements, though contractual in nature, affect rights created by law when settlement is about illegal activity. Hence I agree with Judge Rakoff, one cannot have a settlement and also be considered not guilty. 

Yves Smith has a post on JP Morgan being impacted by Rakoff decisions (read down to comments too) speaks of this debate. (The post itself speaks about not allowing insurance for fraud etc).

I think Judge Rakoff is on the right track. 

1. You cannot settle away an illegal act. And more so when the parties to settlement are not the only ones who are affected. The problem occurs when the other parties are kept in the dark and have no clue they have suffered from illegal acts. The SEC is duty-bound to expose such acts not merely settle them out. Hence the para "But the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances."
2. Courts are not house of power that can be called at the whim of parties. In the particular case, SEC wanted the courts to apply injunctive relief to which the counter-party, Citi Group had agreed. The role of the Court was that of an umpire. 

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

Basics: General Investment strategy

A very basic view of investment strategy is given below. I will need to explain a few terms below, but do spend time with this chart. In a nut-shell, that is all there is to investment.

Here are some basics you need to keep in mind before using that chart:

1. We first need to do research to understand what is a good company and a bad company. I prefer to meet the management before conclusively tipping myself into either category. Companies with hints of fraud (refer to John Hempton's treatise on Chinese companies and some other fraudsters).
2. Unclear company refers to company which cannot be classified as either. 
• It does mean that you have conclusively eliminated the possibility of apparent fraud. Yet, something about such companies do not feel right. (yes, feel!). 
• Alternatively, you are not convinced about the business models of such companies, though the companies may be upright and well governed.
3. I presume we will know about bear and bull markets. Unclear markets are typically directionless markets or range bound markets.
4. Uncertain investment strategy means, you cannot invest without substantial research. I must repeat SUBSTANTIAL research. It means unless you have a full scale financial model with sensitivities to various scenarios, macro and industry forecasts, appreciation of changing minor trends, met customers, suppliers, industry experts etc, you cannot take a call. It is like a minefield, you are taking a risk and analytical advantage can alleviate some of the risk.
5. Going Long for uncertain companies in bull market has one disclaimer that such companies must not have fraud-flags, even feeling types. Ideal strategy for that box is "uncertain".
6. Companies move in an out of categories. But if a company goes bad, it rarely turns good. I know people will dispute this, but that is my experience. Better stay away or go short.
7. Ideal chart is 3-D where another axis, industry, needs to be included. This parameters takes into account business cycles. One can logically interpolate my strategy from this chart and apply it to business cycle. If someone can make me a 3D chart please email me or leave a comment.

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

Fraud and illegality in the Crisis

Till recently, that is about a year ago, I believed that substantial part of causes of the crisis were a result of mistakes, incompetence and lack of understanding. However, stark evidence is emerging as to substantial fraud and illegal dealings.  

• First was the Robo-signing scandal (which still thrives) where banks first signed thousands of mortgage applications without any background checks. When a lender behaves in such a manner, he has clearly acquiesced to default.
• Then there was a random credit card fees scandal that Elizabeth Warren talked about. To be sure this was known before but the scale, I realised later, was huge!
• There were some hints, particularly how Eliot Spitzer was sidelined when pursing the money trail. Eliot Spitzer was also to blame, in my opinion, he should have kept his pants zipped.
• Next came Madoff which was more accounting scandal in the family of Enron. One might have thought we had learnt our lessons but that was clearly naive thinking.
• Then came Bloomberg expose about secret Fed facilities to big banks. The problem here is the way Fed is structured as against normal central banks. In many ways Fed looks like a club of bankers rather than a government sponsored, independent controller of monetary policy. Fed reform is critical and I find both Senate and the House, i.e. the Congress lacking in will and expertise. 
• Further, we get the news that Treasury secretary Hank Paulson had a closed door meeting about possible liquidation of Freddie and Fannie while claiming they were healthy to the public.
• The ultimate was expose about Congress being allowed to trade on inside information. This is becoming tragic. This is US we are talking about not some banana republic. 
• Then, the way MF Global was handled, the way client money was dealt with.

One important common ingredient has been how effectively democracy has been subverted by these forces. MF Global showcases how financial institutions are able to subvert the right to property, a fundamental right at the core of democracy, by allowing financial institution to use personal money to further their cause. Janet Tavakoli's recent article is right - this is class 1 fraud. 

Finally, I am surprised at my naivete. I also wonder why no one has yet gone to jail.

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

Elite Bonds are equivalent to sub-prime SIVs

Germany and France are mulling elite bonds - essentially government bonds issued by AAA rated countries of EU to finance sub-prime countries of EU.

I read this as equivalent to sub-prime SIVs at the height of Sub-Prime Crisis. At that time, sub-prime loans were bundled with prime loans to create a fiction of higher ratings. The assumption was that these individual component loans are not correlated.

I see the same problem with elite bonds though mechanism is a little different. A curtain is drawn over the component EU states to give illusion of AAA ratings to the Greek Debt. If we have learnt something from the sub-prime crisis this bond issue should fail. 

However, I don't think we have learnt any thing from it. So prepare for a Christmas surge in global equity markets.

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

Walkout - Rethinking Economics

A Harvard class of Introductory Economics recently walked out of Prof. Mankiw's lecture on introductory economics. Prof. Mankiw posted a response yesterday stating that it is a simple introductory course and not a doctrine and should be approached as method or a tool. Peter Dorman countered that there are essential gaps in introductory economics and the course needs to change, a small protest does push things in right direction.

I think the protest was wrong but I disagree with Mankiw.

I think the first main malady economics suffers is listening. A lot of economists talk about Keynes - Hayek debate as though it is equivalent to the intellectual volleying we are having today. Let us remember Keynes and Hayek actually listened to each other. Most economists I read are almost blind to other side. It is like left-inclined and right-inclined economists are playing rock-paper-scissors. 

Economists fraternity must realise lack of listening skill is what is wrong with economists. The Harvard students, in their first class itself, showed exactly this tendency. That is what saddens me.

Here are some of my thoughts about economics.

1. Teachers must present to the students the entire spectrum left to right, and let them choose. In Chicago, Milton Friedman and fellow Professor used to do exactly that. Friedman is known rightist while his colleague taught the leftist view.
2. While I like professors taking side they believe in, I think a reverse role-play would do world of good. It would have been good to have Milton Friedman teaching leftist view, in true spirit. It would have done him a world of good.
3. Keynesian economics, as I understand it, was forming on base of data, information, ideas, theories and other socio-cultural inputs. I think that is what economics must try to be. If he had lived longer, I believe, you may have seen Keynes disagree with current bailouts.
4. Economics and economists are too literal. They just focus on the written word and many times leave out the context thus missing the meaning. They are worse than law students. Scientists, on the other hand, can focus on written word because they have a language of mathematics that allows them to do so. If economics needs a language the current variety of mathematics is definitely inadequate.

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

Solving Euro Crisis

Martin Wolf has a column about what IMF must tell the EU leaders. It is a rather generic diagnosis but it got me thinking. Here are my steps to solving a Euro Crisis.

Step 1: Put out the fire 

I borrow from Martin Wolf here. We need the EU leadership to come up with a "credible commitment to halt the contagion". Without this there is no tomorrow. You may read the entire suggestion by Martin Wolf.

There needs to be a credible commitment to halt the contagion, for sovereigns, banks and markets. One possibility would be to guarantee financing of rollover of public debts and fiscal deficits for Italy, Spain and Belgium for 2012 and 2013. That would cost up to €1,000bn ($1,300bn), though even this might be insufficient to arrest the contagion, given its current extent (see chart). The resources needed could come from leveraging the European Financial Stability Facility or from the European Central Bank or both, with the former taking on the risk of loss and the ECB offering liquidity. In the longer term, a conditional eurobond may provide a workable answer, as John Muellbauer of Nuffield College, Oxford, has argued.

Step 2: Create certainty to induce demand

I take it further than Martin Wolf here. He simply states that households must spend. I would go further, and correct the job-side first. The reason households are not spending lie in two categories, first is ability and second is intention. Both are missing. We can transfer a million Euros in each persons bank account and give them the ability but we cannot give them intention.  

Intention needs to be induced and can be induced by bringing certainty on the income side. Once people are confident that they will have income they will start spending. Alas, the political policies do not inspire much confidence.

Here income means income less bare essentials. Bare essentials should include food, basic healthcare and basic transportation. Both healthcare and transportation need to be credible. 

Thus, income can be created by creating, for the short term, jobs that tie-in with the competencies of the population. It means if Greeks are good at mining then create more mines, if they are good at electronics build more electronic factories.

Secondly, we need cost ceilings on food, healthcare and transportation. This will help limit the expense side. 

Long term solutions

For the longer term, multi-pronged approach is required. 

1. We need to improve employability for new-age jobs through training. This goes concurrently with old-world jobs we force them to have. 
2. We need comprehensive reform of entire social system, starting from economy, judiciary, taxation, media and politics.
3. We must take the learning from EU crisis and go for a two-tiered world currency system. This will allow monetary policy and fiscal policy to have equivalence. EU can take two routes, member countries can cede fiscal freedom to EU governments or we can dissolve the EU as a monetary union. Dissolution must be structured and old loans must be marked to new loans in fair manner.

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

Occupy Economics- Alternative to Capitalism

Nancy Folbre has a post on NY Times blog asking what is alternative to capitalism. My immediate thoughts went to "nothing is wrong with capitalism per se, it is simply today's capitalism that is the problem". However, I thought let me expand on that idea a bit and explain it in detail. So here goes.

We must look at economic systems in broader range. At one end we have law-of-jungle style systems with basic legal structure and not much else - lets call it North side*. (I don't want to use left and right as it may cause confusion). On the other we have an equitable society with perfect equality - this becomes the south side. Within such a spectrum, let us imagine a center. Usual capitalistic systems (the most perfect we had), I venture, lie to the north of such center but never to the extreme. Socialist systems lie to the south of this center and still never to the extreme.

One can debate how far North the capitalist systems are currently, or how far south are the proposed socialistic alternatives are. But best option, I believe, is to create a balance that is possible at the center. It means we need a capitalistic society that is more south than what we like or we need a socialistic society that is more north than we assume.

The point is further complicated because capitalist systems tend to move Northwards easily. Conversely, Socialistic systems tend to move southwards easily. "More of what works" seems to be driving force. It means when we adopt a capitalistic system, we must focus on adding clear, precise, boundary regulations to let markets function effectively. Conversely, if we adopt socialistic system, we must focus on deregulating regulation in spheres that can stand on its own. As a metaphor, capitalism is like an open field game (soccer) and referee must move along with the ball. Socialism is like lawn tennis, you play where referees sit. Thus, moderation is best solution.

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

Systemic faults in Capitalism & Democracy

Brief synopsis of my book "Subverting Capitalism & Democracy"

A consensus is emerging that the crisis of 2007-09 was primarily caused by following seven factors: the property bubble; explosion in debt; fragility and dominance of financial sector; weak risk assessment; monetary policy errors; saving glut in developing countries like China; and complacency and incompetence of regulators including rating agencies. The scale of the damage has been attributed to a perfect storm – a concurrent failure of all the above factors. However, we should ask why these factors emerged in the first place and why did all of them fail simultaneously. These are symptoms of a structural decay of the democracy-capitalism system. 

Finance sits at the top of the bargaining power hierarchy. Through a multi-tiered incentive structure, financiers influence virtually every aspect of corporate decision-making. The financial innovations, riding atop asset bubbles, pushed expected returns higher. It pushed the corporates to take even more risks on their balance sheets as Wall Street cheered on. High leverage, currency exposure, cross-country acquisitions, unrelated diversifications, exposure to exotic products, reduced R&D spending, experimenting with buyouts and share buybacks, etc left corporate balance sheets vulnerable. These dynamics fanned the property bubble and led to an explosion of debt. 

The concentration of power is not a design feature of the capitalist system. Our transaction-based economic system is fractal in nature and the concentration of power was simply an emergent property, an unintended result, of this fractal system. Over time, as countless transactions aggregated, the bargaining power concentrated with the financiers. Occasionally when bargaining power does aggregate with certain economic agents, the democratic set-up is supposed to provide the counter-balancing force. Governments or regulators step in to level the playing field. 

But, government waited for markets to self-regulate. To understand government behaviour, we have to view government and markets as competing systems addressing citizens’ needs. Governments create services for few and charge everyone through taxes. Markets are efficient, they charge as per usage. Hence, in good times, there is pressure on government to step back. At times, governments even abandon areas where markets are ill developed. Only in a crisis do we realise the distinction between the two. Markets are exclusive, accessible to only those who have measurable value to offer. Conversely, governments, by definition, are inclusive. Government is the right of the citizen while market is just a privilege. Naturally powers of the government supersede those gained by markets. The question therefore arises, why didn’t government use its powers? 

The root of government problems lies in the broken political system. The political system had the incentive to be silent. The cost of politics has increased. It is kept high artificially to restrict the access to political office. Naturally, the politician is now very attentive to her campaign financers. In the process voters are being denied their right. Voters choose their candidate from amongst those pre-selected by influential contributors. The voters don’t have a real choice. 

Governments, globally, have a strong election focus. The lack of genuine upper house in parliaments may have caused this short-termism. In a bicameral legislature, the role of upper house was to bring strategic focus and act as a check on the lower-house populism. Sadly, many nations have actually abolished the upper house. Where it exists, the upper house has become an instrument to repay political debts. 

The surrender of politics compromised the government and the regulatory machinery. The laws have become vague allowing room for interpretation and, consequently, rent-seeking. Laws can be compromised using, what is called, the necessary and sufficient condition problem. No matter how elaborately necessary conditions are written, there will always be a loophole. For example, imagine a case where mugging is defined as stealing at gunpoint. Gun is the necessary condition for mugging. Now if a victim is mugged at knifepoint, can the thief get away just because he used a knife instead of a gun? This is exactly what is happening in financial crimes. That mugging happened is sufficient condition. Laws must be based on sufficient conditions. We are about to make similar mistakes when developing a regulatory framework for too-big-to-fail institutions. 

The intent of the law can also be compromised within the details of the wording. No matter how finely you read the law, if the intent is compromised, the wording is meaningless. During the crisis, many financial firms have abided the law in letter and violated it in spirit. Some have even blatantly violated the law by paying an insignificant share of profits as fines. The legal system has not shown true appreciation for the intent of the laws. Hence the weakened legal system must also bear part of the blame for the crisis. 

Finally, blame for the crisis must also be allocated to the observer i.e. the media. It was the responsibility of media to explore and expose the possibility of this crisis. It is clear that media needs to be cleaned up. We must separate journalism from what is essential gossip reporting. The power of media, the access, the privileges, should be limited to journalists. We also need new business models to fund journalists. The current business models create harbour conflicts of interests similar to rating agencies. The democracy-capitalism system was envisaged as a self-preserving, counter-balancing structure protecting the interests of citizens or commoners. The factors we discussed above structurally weakened the system. This system is definitely not going last this decade. Now is the time to set it right.

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

Pricing EU break up using the Soviet breakup

Gillian Tett, my favourite columnist, recently drew parallels between Russian break-up in late 80s and a possible breakup of EU. The general lessons are critical when politicians consider the future of EU. But what I want to point out is a little different.

Today a lot of analysts talk about default of Greece being priced in. Some also say market understands the price of breakup of EU. I would like to see a paper that uses Soviet breakup of mid-80s and then draws up a scenario for EU breakup, in terms of costs, markets and general investment trends. That analysis will be more meaningful. One may deduce a milder process of EU breakup learning from the Russians.

Gillian Tett talks about some differences in institutional infrastructure. She believes presence of central banking, expertise on monetary policy etc. will stand EU in good stead. However, she points out, todays economies are far more integrated than the isolationist (my insertion) Soviets. It is possible we may be effectively pulling the rug from under our feet.

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

Euro Crisis - A of tragedy of Commons

European Union was evolved to create an unified market. It implied giving away some monetary policy control to reduce the transaction costs (or friction) in trade between Euro countries. It was understood that each country will maintain fiscal health. There were no rules of resolution in case someone didn't. All this reads like problems we encounter as tragedy of commons.

Elinor Ostrom has suggested a few issues with tragedy of commons that are directly applicable to Euro Crisis. There are a number of factors conducive to successful resource management but absent in current Euro-land.

1. One factor is the resource itself; resources with definable boundaries (e.g., land) can be preserved much more easily. Does it mean that the fiscal health should have had boundaries?
2. A second factor is resource dependence; there must be a perceptible threat of resource depletion, and it must be difficult to find substitutes. This was clearly missing - the peoples of Greece, Italy etc, I am assuming, did not believe things will come to this.
3. The third is the presence of a community; small and stable populations with a thick social network and social norms promoting conservation do better - trust. Trust is something that is missing.
4. A final condition is that there be appropriate community-based rules and procedures in place with built-in incentives for responsible use and punishments for overuse. None prescribed as yet.

Here is Elinor Ostrom explaining the tragedy of commons.

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