2009: Images from the crystal ball!

It is that time of the year - December is here and so are the holidays. Again time to reflect on what is possibly in store for us in the next year. 2008 snapshots from crystal ball panned out pretty well. So here goes!

The monetary system

The monetary system is under terrible duress. With every central bank printing money - there is a great deal of money sloshing around. As of now it is just plugging the holes in the balance-sheets of the big-money operators. Soon this money will spread and it will create problems. However, we still cannot conclusively say if this will lead to inflation. Let me elaborate.

Inflation happens when buyers have too much money and sellers have too few products. It is often referred to as "too much money chasing too few products". 

Lets look at buyers. US, EU and to a certain extent Japan are biggest buyers. All except Japan, are in deep debt hole. Even if money were made available to these buyers, it is unlikely that they will buy. Most likely the excess money will go into debt repayments and savings. Also, I really have my doubts if the buyers will ever get that much money.

Now lets look at the amount of products available. This is a combination of assets and consumables. As a part of the past few years excesses, we have over supply of assets and substantial supply of consumables. In such a situation, it will be difficult to have inflation. 

The only way we can have inflation is if central bankers across the world collaboratively print whole stacks with gay abandon.

Demotion of US Dollar

Currently most of global wealth is held in USD. The de-leveraging has created an artificial strength for the Dollar. This is a concept a lot of analysts cannot cope with. This will cause as much confusion as "change of origin" causes in introductory trigonometry class. Devaluation of US dollar is a concept where the reference point has changed - and the analyst world will take some time to get its bearing on this. So the default argument is to turn a nelson's eye - ignore it. From the world of measuring the absolute (everything in USD terms) - we will move to world of relativity (everything relative to everything else). 

Emergence of "Wealth measurement anchor" is paramount requirement

What we need is to determine and accept a standard metric of value. Gold used to fit this scale earlier. We need to start using PPP determination as a denominator for value. So like in PPP measurement - we take a basket of goods and measure the currency's potency in terms of price of this basket. Just like Noah's ark carried sample species of all kinds, this basket must be representative across the world. On this basis we can measure wealth and arrive at a saner understanding of gain or loss of wealth. 

If all else fails - plain simple gold will do. But this will create a mega-mad rush for gold and create another scare.

Gold and Oil

If monetary environment isn't already complicated - Oil and Gold are adding to the confusion. These two commodities (and precious metal in a secondary sense) make up a set that is in demand globally. One is value retainer and other is a global necessity for economic growth. The prices of these commodities are denominated in USD. We are likely to see massive price correction in these commodities. Rather it is currency devaluation rather than commodity appreciation. So for investors whose wealth is in other currencies - it will be difficult of estimate the prices. Gold however should regain favour as value retainer and see increase in demand. Here are some links about gold price forecasts.

Corner the consumer - up the trade barriers!

There is going to be a great battle for consumers. At the moment, people are too busy looking for money to make the products. Soon people will be looking for consumers to buy these products. So saver countries (where there are lot of savers) will be expected to consume more to benefit producer countries. But this needs exchange rate management e.g.- China is looking to devalue its currency more than US. So we will see a lot of political hardball on exchange rates and tariff and non-tariff barriers. 

Potential for a global war!

While no-one else believes this and to some extent this often gets me ridicule, I believe a global war probabilities have increased significantly. These are not wars triggered by Mumbai attacks or some terrorist strikes. These are old-school wars based on conflict between creditors and debtors. Lord please give us saner politicians for 2009 and beyond.

Pay scales and organisation structures

Pay scales and organisation structures are going to see drastic changes. Firstly the pay-spread (difference in Cost-to-company salaries between CEO and lowest rung employee) will narrow. This is primarily because current financial crisis has put a focus on top management pay scales.

Further, the current recession will increase the need for special talent in corporations. These people will operate outside the organisations as consultants or temporaries. They will work on project basis and move to next companies. Mostly these people will work on organisation structure, costs and other non-intellectual property issues. Core intellectual property work will require in-house employees in classical organisations.

The main area of disruption will be the organisation structure itself. The structure will go through a radical change in the coming years and some sort of prototype should emerge in 2009. The difference between inventors, technicians, implementors and enablers will become more marked. For more details leave a comment for an e-book I co-authored with Anne McCrossan. 

This means that Private equity and consulting industries will go through a tremendous change. There is going to be a new wave of management jargon and it will be much more difficult to separate the wheat from the chaff. I suggest you look at Seth Godin as a new management guru (I know he writes about marketing - but look at Tribes - thats a management book).

In sum

We are looking at an exciting year ahead to say the least. We are looking at a new year where terrorists will have higher leverage (due to financial vulnerabilities), a possible war scenario and new financial and economic system. Lets hope we have the leaders to understand and guide us through this sensibly. So happy new year to all and make sure you savour every second of the celebrations! May peace be with us!

Would asset price fixing have solved the problem?

The response to the crisis has been fast and powerful. The question is - is it the correct response? As Percy Mistry puts it in his Financial Times column, the first montary expansion was directed at averting financial collapse. The second, the one thats currently underway, is about kickstarting the system - getting a consumption driven US economy to consume.

Was there any other way out of this? A possible way could have been US government fixing the price of housing across the country through use of a formula based mechanism. This would have paved a way to price the derivatives and resolve the matter between market participants hopefully without government intervention. Any derivative is first a derivative and gets priced as soon as the asset is priced with fair degree of confidence.

Guaranteeing the home loans at this prices could be a second prop. This would have protected the individual financial system by fixing the floor. 

Beyond this the government should let the financial system resolve itself. First the market participants should start from the floor price set by the government and price discovery will help establish a price level far lower than what we currently see but definitely higher than otherwise. 

This would have created a huge amount of collateral damage. Firms would have been wiped out but the markets would have continued to function because the value of underlying asset was known. But its possible that we would have avoided further cascading effects and impact on individual financials. In the end both will be equally costly - but this one would be much saner.

Now am I missing something here? Probably concurrent devaluation of overseas assets and mark-down of about 600 trillion of derivative positions into something equal to 60 trillion. This looks potential hunting ground for creative accounting standards. But this seems one interesting way. What say?

Links:

Ajay Shah blogs about Percy Mistry column Does anyone have a post recession exit-strategy?

Bailouts and Money flows

Past few months have been riddled with bailouts. And blogosphere was already weighing in on the cost to tax-payer angle. But it is now that the irony of the situation is being exposed. As christmas draws near and bonus figures get announced, we will have Paulson and Co. debate the future of unions and likel pay-cuts they might take.

Its like in the movie "Wall-Street"

The situation is very much like in movie Wall -Street where Gordon Gecko is scheming about unions on airline company while counting on the bonus gain. The movie, Micheal Lewis in Liar's Poker, Raghuram Rajan and others have raised an important issue. That of asymmetry of pay-offs of various stake-holders.

Asymmetry of Payoffs

The pay structure evaluated in cost-to-company terms is disproportionately stacked. The top management gets super high rewards whereas penalties are shared. This is always the case. Across all industries, levels note how proximity to money leads to higher pay-off without any value-addition. There are whole set of arguments if this is fair or not. The least discussed part about this problem is that this asymmetry creates money flow problems.

The GDP growth created by the economy tends to get aggregated at certain pockets thanks to this asymmetry. Further, the consumption basket composition varies significantly as incomes change - therefore it leads to beneficial implication for certain industries.

Problems of the Rich, by the Rich for the Poor!

In such a context, the tax payer, bears unfair burden of this bailouts. Tax-payer has to pay higher for items in consumption basket of the rich - real estate and education. Often they pay more than they can afford - just to break-in into the rich class. However, the unaffordability can catch up based on share of luck and lead to far graver consequences. Therefore Joe the plumber feels like he is on a speeding tread-mill while the energy generated is powering the Rich. So the tax-payer shares the down-side and has no perceptible upside to talk of.

Implications for social peace

Such mechanisms are hotbed for social unrest. It is at this time, government should actively support the cause of the common person. As of date US government is not seen doing anything along this lines. On the contrary, we find the measure undertaken are rubbing salt on deep wounds.

This is also destabilizing force on world peace. I strongly urge the sleepy governments to go into a war ready alert. India wake-up its time to be battle ready. Call me a cynic but its a risk!

Slowdown and credit flow within the manufacturing process

Credit flows within a Customer-shopkeeper-manufacturer-Supplier process. During slowdown the pattern of credit flow changes giving us lead indicators of impending slowdown. The credit flow needs to be analysed and extensively probed for clues for leading indicator for industry cycles and economic cycles. In current cycle the customer went bust hence the inventory destruction will play out longer than earlier when only manufacturer and supplier had inventories.

Usually, the credit within the customer - shopkeeper - manufacturer - supplier process resides across the chain. However, depending on bargaining power and forces best elaborated by Michael Porter, the weightage shifts.

Typically high-demand industries tend to move credit costs to opposite poles. In high-demand scenario, customer end bears a credit costs and so does supplier leaving the manufacturer with close to positive cash-flow business. This could be called the starting point of the end-game. As the inddustry slows, the credit cost moves away from customer-end to the company (in form of inventories) and then to suppliers (delayed payments). The bankrupcies move from suppliers-end towards customer-side. Customer usually does not go bankrupt as banks and FIs refuse to lend to them thereby curtailing demand. Usually, this change of credit cost pattern happens before the industry is about to go bust. Was it the case this time around as well? I hope the research departments have answers.

In current slowdown, banks and FIs didn't follow this responsibility. In fact they inflated the customer giving rise to credit expansion bubble. In our case, customer went bankrupt after buying lot of goods. So now we have inventory pile-up at customer-end, the manufactuers end and we have delayed supplier credit.

Naturally, bankrupcies are looming across the process. Retailers have been the smarter of the lot by not keeping excess inventories. Yet operating on so thin margins, their bankrupcies, when it happens, will be due to all together different cause.

Disclaimer: The post is exteremely generalised and simplified so there will be differences between industries and time-lines. Kindly accomodate.

PS: This marks the 100th post!

I am re-linking to yesterday's Yves Smith post on Stimulus programs. The disucssion in comments is awesome. There one of the questions raised in how dollar depreciation of past few years has not actually mattered for American Jobs. Here is my response -(too late to comment there I guess)

A declining dollar hurts the mfg and export industry in China, India and other countries. There is no doubt. But to move the mfg locations takes time - it takes structural change and confidence (that it wont be a passing competitive advantage). That confidence is coming to companies that US mfg will stay competitive for sometime to come. China's low CNY was more of guarantee that helped manufacturers to shift production. Again, China is also on productivity gain curve - so we still have margin to cut cost. The labour costs were increasing and China also responded by creating labour movement from rural to urban areas. Now you can only shift new labour to cities - till the old displaced labour finds employment. Trust me, you don't want wealthy unemployed labour used to specific lifestyle - bad for social unrest. The other way is to increase capital intensity of mfg. This has happened in tech mfg to a small extent. Here the capital intensity of mfg was increasing. So tech mfg should be closer to moving back into US. (But tech mfg did not fully move out of US did it? we can do with some evidence here). On the flip side this does not create jobs in volumes that US needs. This is the same problem with China - China needs to retain volume jobs. The dollar devaluation of last few years never tipped the scales to realign manufacturing. Theoretically, had it run for some more time, you would have had a tipping point where sustaining low wages would become difficult.

Secondly, either we (US China and world together) engineer a revaluation or turn a Nelson's eye to it - devaluation is going to happen. To control or not to control is the question (a la Shakespeare).

NDK makes a great point about running differential inflation. But I have two worries - first market participants will preempt this by rushing to gold or commodities and the like - creating strong one-time devaluation catastrophe. Second - even if this is managed - it puts US and world through super-slo-mo pain and distress that may be difficult to address in social context.

A note, commentators at the nakedcapitalism.com believe I am suggesting strong dollar - but its other way round. Further, there is a debate about manufacturing - which should be about any "producing" activity rather than manufacturing. In sum, US should produce something that world wants - it may be shoes or it may be website design services - so long as the relation of producer-buyer is unaltered it will work.

Global Rebalancing-wont exchange rate achieve it?

Yves Smith has another excellent post on problems with Keynesian response to the crisis. She quotes Tom Ferguson on how Keynes would have chose global rebalancing as a key solution. There is merit in old Keynesian approach when there is increase debt repayment capability in the future. Currently, US needs jobs and work, but thanks to weird gloabal policies it has neither. So it is dependant on "investor-like" income generation - i.e. through capital appreciation and investment. This, to me, is pushing the ignorant risk-averse citizens along a high-risk cutting edge finance path. This is unfair to US citizens who are not aware how long it will take to repay the stimulus. And dont even think you can print your way out of it! Thus the global rebalancing solution seems only way out. But, as Yves Smith points out, there are hurdles.

I dont see any reason why exchange rate realignment + concerted international financial regulation cannot solve this problem.

Global banking regulation needs reform and Shiller has also highlighted this his new book (I just saw the interview - waiting for the book). There is something fundamentally wrong with accounting policies that let banks lower capital requirements based on "perceived" asset price increases. The same regulation also creates holes in balance sheets as asset prices falls. This regulation needs to be suspended for sometime - (upside suspension), banks be forced to take all the write-downs marking the assets to agreed upon prices (lets call them steady state prices) - and then made to raise capital enough to sustain them.

Secondly exchange rate realignment is absolutely must. I have been harping about this on this blog comments for long now. US must become producer and China and surplus countries must become consumers. Without this there is no resolution of this crisis.

Finally, there is likely to be a diplomatic war to protect and isolate the consumers an keep the consumer to itself. Such a trading barrier game will be detrimental to global prospects and will decrease the total pie. If a big ship(US and EU) is sinking - one way is to protect your resuce boat - or save the ship. Former saves you comfortably but leaves the world with just a boat! and latter is difficult but the Ship stays so we are better off.

What a week! *sigh*

What a week we had.

Mumbai Terror attacks started last Wednesday and it was Friday before it ended with 190+ dead and scores injured. Twitter covered the best news on the Mumbai Terror with real time rumour-destroying coverage from fellow Mumbaikars.

Tanta or Doris Dungey passed away at very young age of 47. James Hamilton has a good post on So long Tanta with a few must-read links.

It is time to sweat the grey -cells to make my country better. The current political system is wreaking havoc with the world's largest democracy. It is time to take action. Welcome to a new revolution!

Great Depression, China, US, War, defaults and other comments

Yves Smith, my favourite financial commentator, has one great post titled China's Smoot Hawley- a reaction to Micheal Pettis (another of my favourites) article. Its an awesome post and worth read - including the comments. I was naturally late to this friday party - so here are my comments on the post!

Hunger of deprived and hunger of developed is different

So pre-Mao chinese hunger and post-Den Chinese hunger are two different animals. If a developed country goes hungry, violence is also a fallout. Sale of guns has risen in US for a good reason. We have to realise that people on ground know best.

China wants to run this game for a wee-bit longer

China has nearly 1.5-2 trillion dollars in USD assets. Now China wants just a little bit of time to save some of it. China believes that this is their sweat money. The way around as they see it is to
let CNY depreciate against the dollar. But this relation is difficult to hold if USD depreciates and commodities rise.

With 2 trillion at stake - War is not yet a possibility

The cost of Iraq war was about a trillion (vague recollection). And it was a trillion dollar
"stimulus". As one part of the world's "skin in the US game" increases the probability of war will
increase. War has many benefits for regimes. It aggregates the population, it creates employment, creates a stimulus, creates an enemy outside of the regime. In this matter India is lethargic and will never have enough "mind in this game". But war is on the horizon - and I am scared.

China and India must become consumers - US must become producer

I have been making this point for like ages now (even in comments to your posts). A recovery without demand from China and India will not happen. US is not going to be a consumer - it has to be a producer. The best way to get these 3 billion people into consumption fold is by letting exchange rates correct. SE Asia and other surplus countries will need to do the same.

Import restriction response is a threat

I hope there is enough sense to not impose import restrictions. Yet, I fear India and China will impose them eventually. There will be a race to corner the "able" consumers for domestic industries. China has a difficult decision to make then. The domestic consumer will be a loser and their money will be looted by domestic corporation. Though it will be done sophisticatedly as a economic process.The best way to get domestic consumption going is to first get the latent demand for best brands going. For that you need to keep imports open.

USD and Gold - Printing currency does not matter

There is a lot of talk that Us can print its way out of the crisis. It is surely doing that. However,
real value is able to discount this printing phenomenon. The only way this might work is - if US has some means where it can aggregate this printed money and destroy it as write-down or something. Printing will set the new money in motion and it has to be collected and destroyed else there will be devaluation.
Currently"US denominate" (in terms of thoughts) people are asking this question hence possibility of US dollar depreciating does not seem feasible - it never does to local as it does not matter so long as other things remain equal. But "other things" like commodities do not remain equal - hence the effect is actually measured as rise in commodity prices. (Or conversely - commodity tries to retain value - whereas USD depreciates).
Further one must understand that equity is open to risks whereas debt has the habit of correcting / adjusting for currency changes. (Particularly cross currency debt).

In sum

Welcome to eye of the storm!!

Links:

Yves Smith, Naked Capitalism, China's Smoot Hawleys

Micheal Pettis, China Financial Markets, Rising unemploymentt and trade policies

Soverign Wealth accumulation and wealth dispersion process efficiency

The last decade was characterised by excessive accumulation of wealth by soverign entities. Central Banks accumulated large surplus - that was parked in US treasuries and later in riskier asset classes (through SWFs). This is one of the primary drivers of the current crisis. VoxEu examines the reason for soverign wealth accumulation and suggests that this was primarily done to avoid exchange rate appreciation.

Economy as a Wealth managing engine
Any domestic economy serves as wealth creating and wealth distributing engine. We can imagine an economy as equivalent to two different motors linked in tandem (feeding into each other). Entreprenuership is common name given to the wealth creation motor. Governments add inefficieny into this motor by interfearing with it. What governments are really concerned about is the woking of the other motor - the wealth distribution motor.

In case of economies creating wealth using labour arbitrage, it is the wealth distribution motor that matters more. If this motor is working perfectly then the national income is able to percolate to the lowest rungs of the society. Unfortunately this is not so in developing Asia. The local governments role is of creating, improving and efficiently running this engine. But the measures taken by developing Asian governments had, intentionally or otherwise, no such effect. Indian government is talking of inclusive development - but its only lip-service. Only China built infrastructure but followed policy of enforced migration (to and from) and managed this to certain extent. These indicate a weakness of this critical motor in developing Asia.

The policy of accumulating further wealth while leaving the wealth distribution mechanism broken has lead to rise of very-high income population in developing Asia while low end remains poor. It is interesting that this is a good policy so long as reserve build-up is within a certain limit. Beyond this limit, a policy of allowing exchange rate appreciation may have achieved better wealth dispersion (at least globally) - than what we have achieved. This policy would have raised inflation, and consequently incomes across the income pyramid.

In Sum
There is a need to put this VoxEu research under further scrutiny. There is definitely a lot of merit in the argument. We need to understand the wealth distribution/dispersion process in more detail. Obviously the theory I suggested above has holes and needs thorough examination.

Links:
Asian Exchange Rate asymmetry - Voxeu.org

Financial Crisis - Moving Towards a solution

Finally the quest for solution, both long term and short term, has began. It was going on in hapazard manner across blogs and opinions in newspapers but the most intelligent response comes from Voxeu.org.

They have published and edited version of essays suggesting action plan for G20 leaders to stabilise the economy and fix the financial system. Its 76 pages all worth reading!! Enjoy!

The Core of the organisation - the Honda story

I have read a lot of talk about Core-competency in the past decade. I have seen companies make a mockery of the core-competency issue. I often look at the top management and check how many of the top management team came from "core-competency team". In most - hardly any. Many in fact absued it so much that management gurus like Tom Peters were left screming on their blogs!

Organisations have to evolve an ethic of honouring its core-competency. Forbes highlights how Honda promotes in engineers to top ranks - and not marketers or accountants - engineers! This is the truest way to honour your commitment to "core competency".

Hat tip - Paul Buchheit

Are the store-shelves empty?

We are precariously placed in the recession। Sadly my reading of political and economic news tells me that the top honchos have just messed up pretty big. I am looking for validation.

Just want to know if the store shelves in major super markets are full or empty। At this time, they should start stacking up for Christmas sale - so it should be full।

Can you help me with feedback over next few days? If possible can you post pictures? or email them to rahuldeodhar (-a-t-) yahoo (d-o-t) com! Do include brief store details - name, area, city etc.

The Chinese Dilemma!

There is an interesting post at Marginal Revolution on Chinese model. Tyler Cowen smartly collects lot of pros and cons on the matter. Yet, this is very critical at this stage.

World economy had predominantly two engines of growth - the US consumer and Chinese producer. Both had second and third order effects that accelerated the economy. Now US consumer is dysfunctional - at least for some time to come. So the world looks at China!

China is also aware of the issue. It wants the huge savings rate to translate into consumption and therefore demand. The only way to get the saving population to start spending and kick-start consumption is to let them buy brands that have build up aspirations in their minds. This will be possible with letting CNY appreciate and letting the products be available freely.

The trouble is this will make non-china manufacturing cheaper - leading to job loss from manufacturing sector. However if China really wants to move to a consumption driven economy then there will be job shift to services and out of manufacturing.

This is more critical now। If China misses a step then we are all goner! The question is will china bite the bullet!

Links:

Marginal Revolution - Tyler cowen - This is another premium blog on finance and economics.

We were warned!!

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.

"How to avoid the credit crunch?"

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

By now you must have recognised this is Shakespeare's Hamlet! Edited snippets from Lord Polonius' advice to son Lartes.

-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)

Hat tip - to Free exchange blog from The Economist (for inspiration!)

Interesting reading about China

All roads lead to China -by Richard Burbaker has a post with interesting link to China Dilemma - a collection of 18 chapters though he mentions 19.


Link:
The Big Picture | All Roads Lead To China

"Commodities as Anti-Dollar"?

Yves Smith has a recent post on whether commodities, particularly oil is finding favour as anti-dollar. In the comments, you will find some arguments about oil demand and fundamentals.

I think Oil price movement were retro-fitted to fundamentals. In other words, the movement in oil was primarily as a value retainer against dollar. But two things happened that twisted the outcomes. First, dollar strengthened (for whatever reasons) and second more money rushed into oil taking it too far away from retro-fitted fundamentals.

Now we are about to witness a second flight into "value". Are we foreseeing another commodity upswing? I think we need to watch Oil, Gold and other key commodities. But one thing is sure - perishable agri-commodities will not be able to retain value for the length of time that we are looking at.

Time to watch out and hold tight!

Links

naked capitalism: Is the "Commodities as Anti-Dollar" Trade Back?

The economics of labour market intermediation | vox - Research-based policy analysis and commentary from leading economists

David Autor has a fantastic post on Vox on economics of labour market intermediation. Labour markets are imperfect and they are kept that way by interest of recruiters and employees. In the end both loose but still there is enough weight in status quo.

Let us consider an employer and a prospective employee. There is no way for the employer to know the employees performance in previous organisation. Therefore the metric is salary drawn currently.  Now if, by any chance, an employee accepts a job with lower salary then his salary growth is lower! This appears unfair - but its actually a manifestation of inefficient market at work. The only way this situation corrects is when imperfection on other side - i.e. you have a desperate employer. 

As per my experience the intermediaries actually twist this situation to the benefit of the employer. Hence most of the time employees distrust HR managers and intermediaries. That is the reason salaries are secret. Often even though companies treat everyone fairly - employees still feel distrust.

In sum, there needs to be two areas of research in this. First - does this behaviour actually benefit the employer at all. Second - does this distort the labour markets to an extent that it impacts the economy. My intuitive guess is no on first count and yes on second. 

Links:

The economics of labour market intermediation | vox - Research-based policy analysis and commentary from leading economists.

Banks need to stop hoarding money - or should they?

Mike Shedlock posts an interesting comment to a White house recommendation (directive?) to banks to stop hoarding money. Prof. David Beckworth however explains why banks are hoarding money.

Now we already knew they would happen, didn't we?

The risks arise in the next step. Here the money system goes
into self preservation mode rather than help push the bailout effects down to
individuals and small businesses. Here second bailout will be required. But this
bailout will need concurrent regulatory changes so that the money system does
not simply fatten up – but actually pushes the recovery stimulus down the chain.
The size of this stimulus will be at least twice the first bailout.

I think, these two bailouts will have to clean the system.
Beyond this will be a period of lull. This is the time individuals and small
businesses start reducing their loan outstanding. This is likely to take long
time in case of US.

To my mind this reaction is rational given the accounting requirements and state of real economy.

There is a serious need to assess accounting norms for banks in the light of Fed guarantees. Banks may be holding too much reserves, capitalising a little too much among other things*. So if indeed Fed is going to prevent the systemic collapse then banks may be able to free some money. But of course its not as simple as that - the issue needs more understanding.

Further, with real economy showing signs of slowing, banks are reluctant to lend. (Rather, banks are now being sensitive to slow-down signs that were present even before the financial crisis!) Now is the time for bailout 2 to materialise. Though this one needs to be aimed at the consumer rather than banks. Banks may be used as a transmission mechanism for this bailout.

Note:

I dont mean to say that bank's have enough capital - but what I mean is so long as Fed gurantees are in place the banks may be better off (for easing out of this crisis) in lending rather than increasing researves. Banking system may need a lot more capital later once we are out of crisis - but the time to get the capital may not be now!

Links:
Mish's Global Economic Trend Analysis: White House: "Banks Need To Stop Hoarding Money"
Second bailout - FIs into self-preservation mode

Macro and other Musings - Is there are credit crunch?

Development 2.0 is gathering steam

One of the many things Web 2.0 will help streamline is poverty alleviation and development of backward regions of the world. World bank's PSD blog earlier had a post about what this development 2.0 needs. Their recent post hints at a BBC initiative that has potential.

Links:
Development 2.0
A lesson in openness - PSD Blog - World Bank Group

USD strength is an opportunity!

Confused Capitalist JW has a post today about how to make money in the moment. I agree with him totally. The current rush to USD assets is actually an opportunity to convert USD liquidity into other currency assets, particularly CNY (Chinese Yuan). If you see the behavior of Chinese markets vis-a-vis global markets you will see some strains of this actually happening. 

Under the hood of these flows, however you will see the reason why the systemic destruction of capital will be cyclical in nature. The cycle is similar to Roger's adoption curve in marketing. Small, smart money managers are "early adopters", big money is fast follower, everyone else follows big money (and that changes the equations - validating the theory - to an extent). The individual investors are typically the laggards - if they follow this they loose money. If they stay put they might make some actually.

The entire cyclical movement of money also lends credit to rising oil and gold price theories. So I will watch these commodities closely. Further the mechanics of this wind-down will be cyclical - with different wave-length. I guess this means its time for traders to earn their money. Welcome to the rough ride roller-coaster!

Short Selling

There has been a lot of blame allocated to shorts. Ajay Shah put his arguments against banning short-selling in "Why ban short selling?". But there are ways where short-sellers can impact the market mechanism adversely.

Now fundamentally, there is nothing wrong with short-selling. Even shorts with borrowed shares are fine and so are naked shorts. Yet, I haven't read detailed analysis of mechanism of how short-selling is causing the market panic.

Generally markets operate on a play between probabilities. The buyers believes probability of gain in buying the object is high, whereas seller allocates higher probability to making a gain by selling. Short-selling pay-off, in-essence, becomes function of two variables - the probability of the bet and size of the bet. Generally these are independant variables.

However, as we deal with wealth concetration risks, the size of bet starts influencing the probability of the event. When big money moves on a bet - it coordinates the operation across futures and swaps in stocks trading in different geographies leading to coordinated move making the bet a self-fulfilling prophecy. This is precisely the pain area. In order to understand this better we need to know:

1. How the size of bet influences the probability of event.
2. Is it possible to increase the size of bet and thereby get a coordinated buy-in in favour of the bet without resorting to illegal, immoral means.
3. Has it happened in some stocks - and if so how.

In sum, the problem is plausible. But it impacts upside as well. Yet, human nature is not adept at understanding or complaining about this "surprising" good fortune. So how can we deal with it?

Country defaults lighting the Forex fuse?

There is now talk of run on countries. The countries in question are Iceland, Hungary, Pakistan, Ukraine, Belarus, South Africa, Argentina and South Korea. Have a read here:

Peston's Picks: Now there are runs on countries
Naked Capitalism: Is another Emerging markets Crisis in motion? (Note interesting comments particularly by Richard Kline)

The risk is enhanced by possible political response. The breadth of possible political response of these set of countries is wide as ever. This will no doubt exert pressure on Forex markets. So what will give first.

I have believed in dollar weakness all along. Initially I thought it will be the China RMB USD friction that will trigger it. But increasingly I suspect the wear down will happen from Euro and GBP side. In other words - a European slowdown can visibly translate into Euro weakness more easily than US slowdown reflecting in USD weakness.

Financial Crisis - Goes regional, triggers a real economy shock!

The financial crisis is not becoming real economy crisis in an explosive war-like situation. I wish to highlight the first (noticeable) explosions showing crisis moving regional and hitting the real economy. As always all links refer to Nakedcapitalism.com (one of my favourite blogs).

This was the result of financial crisis (among others)
Regional Banks post losses
Biggest US Bank Wachovia shows off a BIG loss!

And now here is the quote that ignites the real economy wick!

Ohio’s largest banks all suffered losses. National City said it planned to cut
about 4,000 jobs, or 14 per cent of its workforce, over the next three years
after the bank posted a net loss of $729m, or 85 cents a share. Fifth Third
reported a quarterly loss of $56m, or 61 cents per share, and KeyCorp lost $36m,
or 10 cents per share.

This is phase 2 of the crisis. The repurcussions will move east geographically towards China in coming months. Holt on tight.

Depression 2.0 dilemma - Inflation, deflation, capitalise, solvency

If at all you have just one blog to read - please read naked capitalism. Yves Smith is absolute best! Here is another song of praise - naked capitalism: It Isn't Over Until the Fat Lady Sings

The post looks a wide ranging issues including gems people will do well to remember.

oversold does not necessarily mean undervalued

the stock market increasingly seems to serve as a quick proxy for how the economy is doing, when it has a strong propensity to give false positives

Marc Faber comments -

"The governments in this world have no other option but to print money. That will lead down the road to inflation,'' Faber said. "You don't need to be an economist graduated from Harvard to know we're already in a recession. They will just put white paint on a crumbling building...."

"To rebuild economic health in the United States, you need a serious recession that will last several years,'' he said. "The patient that got drunk on credit growth needs to go into rehabilitation. To give him more alcohol, the way the Fed and the Treasury propose to do, is the wrong medicine."

Chirstopher Whalen comment - In anticipation of such heavy losses, banks are now diverting capital into loan loss reserves rather than seeking to make new loans.

And a fantastic snippet from Andrew Ross Sorkin at the New York Times:
“Our purpose is to increase confidence in our banks and increase the confidence of our banks, so that they will deploy, not hoard, their capital,” Mr. Paulson said in a statement Monday. “And we expect them to do so, as increased confidence will lead to increased lending. This increased lending will benefit the U.S. economy and the American people.”...But Mr. Paulson is making a big assumption about confidence, because until the real economy recovers — which could take more than a year — lending to Main Street is unlikely to return rapidly to normal levels.“It doesn’t matter how much Hank Paulson gives us,” said an influential senior official at a big bank that received money from the government, “no one is going to lend a nickel until the economy turns.” The official added: “Who are we going to lend money to?” before repeating an old saw about banking: “Only people who don’t need it.”

Housing has another 10-15% to fall (see here for a reminder), and that assumes no overshoot or second leg down due to a sharp increase in unemployment. And this won't happen quickly, either. Alt-A and option ARM resets continue at high levels through 2011 (in fact, 2009 is a bit of a lull, so we might have a false sense that the crisis here has passed midway through the year).

Here we need to pause and remember two main things. First is unless we know what is everyone hiding and what is it exactly worth we wont get anywhere. Second is markets have failed till now so there has to be someone willing to roll up his/her sleeves and get his/her hands dirty and really look at every single mortgage / asset. Asset backed instruments will work better if we have better information on underlying assets.

So now will someone please stand-up and help me look at this crumbling house in US that sits in balance sheet of bank in timbucktoo!

LEssons for Poverty alleviation - The economics of civil strife

Dr. Dani Rodrick points to an article by Oeindrila Dube and Juan Vargas. (Dani Rodrik's weblog: The economics of civil strife). The paper concludes that when prices of labour intensive commodity rise - strife reduces a benefits are wide spread. Whereas when prices of capital intensive commodity rises - strife increases if benefits are concentrated. This has some lessons for poverty alleviation programs.

I am tempted to go to my example of snakes-and ladder model for poverty. Here snakes are poverty creators and ladders are poverty alleviaters. Ladders are typically income related and snakes are expense related.

In the context of ladders, poverty alleviation has two-fold objectives. First is to have ladder-accessibility to all (income growth / economic growth of labour intensive activities). Second is to have more ladders (income generating activities supporting /surrounding the capital intensive sectors)

A quick view on the strife part of paper

In my view, strife actually happens when both the above conditions are negated. Or if income generating opportunities are not available to large scale population while being selectively available to few. AND whatever other income generating opportunities are available are not growing. When oil prices increase in Columbia did not translate into ancillary economic activity then strife is definite.

Getting over Lehman

To many this post may sound a little late, but for the past few weeks there have been a spate of shows in the media on current financial crisis. Mostly the shows interview/seek opinions from morons but occassionally an expert pops in with same I-blame-Lehman punditry that I am sick of by now. These experts are misguiding the people.

So I want to rant on one of their two main arguments. First is Lehman is dead because of excessive leverge and financial stupidity and thank god for it. Then these people go on to rant upon how the business model is flawed.

Lehman problem is a little different - the business model is built on high leverage and Lehman's ability to manage it. The leverage was 32 times its equity at the time of default. Lehman underestimated the size of bets - money betting for a fall in its share price. If they would have correctly anticipated this then they would be out of trouble.

Before the recession, it was John Peirrepont Morgan who (with similar model) helped US wrest the development initiative from Britain and France. This business model in general and particularly Lehman gave the US - silicon valley, factory based manufacturing, organised retail industry after 1930 recession. These are the very institutions that have helped the US keep up, nay lead the economic development of the world. Without Lehman, and its ability to manage this leverage US would have fallen before the rise of Japan in 1980. US also owes the latest "best decade" (time around Clinton era) to capital sourced from this very model. The excesses during that era - spawned biggest bubble ever - its still inflating in other parts of the world. This bubble pushed the innovation envelope beyond the regulatory scope and therein lies the problem. US has lot that it owes to this model.

There is a lot of blame-game and political gibberish that surrounds demise of Lehman and current financial crisis. Ordinary citizens will do well to not heed any media and rather read up on opinions of unbiased professors from top educational institutes. My reading leads me to believe that both Obama and McCain have misunderstood the problem. Obama has good economic research support - but his speeches do not communicate the understanding of his team. But I would bet on Obama (just purely based on his team).

Fundamentally, average US Joe and Jane are equally to blame for the current crisis. The average Joe and Jane spent more than they earn or could earn in the near future. The number of clothes, toys, electronics, etc that people have bought are actually lower. The most people spent was on housing. At a very fundamental level, its not their fault as well -as human emotions are wired differntly and if there is nothing perceptible (like own money) to loose people tend to take risk - thats what people did with housing. But people should have known better - afterall even though it wasnt perceptible it was still their money. People dont realise what costly mistake they have done. It will impact their economic well-being for next decade. Unfortunately ignorance is not an excuse - so the blame and misery is compounded. So everyone has skeletons in their cupboards.

For average US citizen to survive the crisis, it will take boot strapping. But bootstrapping will happen when the current debt is paid off. And its going to take a really long time to work through it. Prof. Elizabeth Warren has amazing work in this field. She is also trying to protect average Joe /Jane from transactions where housing companies duped the citizens. Further she is trying to protect them from credit card bills as well. It would be great if people support her.

Lastly, the ability to ride out of this current crisis rises out of capability and opportunity to innovate and create new sources of value addition. This happens through new businesses, SME and related job creation. With Lehman's and demise of high risk capital - US has lost its main recovery financier. It is thus that US will cede its economic supremacy to others unless US fixes the system. Does it have the political comprehension and will to do so? Its for US citizens to decide.

Solving the Poverty problem

The global elites are debating about eradication of poverty. Let me quickly summarize my view on poverty.

What is poverty problem?
Poverty is not going to go away. At any point in time there will be poor people. The real problem of poverty is that poor people do not have the means to move out of poverty. In other words, this is structural poverty. I have looked at this in my earlier post - “Why certain people stay poor?"

Poverty that will not go away should be transient poverty. Where people fall into poverty because of illness or bad luck etc but have access to resources to help them get back into income generating households.

The solution
The poverty solution will have two main elements. First is identification of threshold for the economy. Second is enabling this segment with tools and resources to move out of poverty cycle.

Poverty and its relation to population under certain threshold income
I have a problem with calculation of this threshold income. Generally, poverty is defined as people earning under a certain threshold income. The threshold income, therefore, is calculated using consumer price indices of various items required for minimum subsistence.
Rather threshold income should be X-sigma deviation from median population. This approach is far more likely to identify target population.

Poverty and relation to people at bottom of income pyramid.
Poverty is not about people being at the bottom of income pyramid. There will always be people at the bottom of the pyramid. The argument is what if the bottom is higher now. I have a problem with this approach as well. If everyone is higher then we have inflation. It means poor people though not poor by definition, continue to get low quality goods. To add to this they are not even defined poor so no reform reaches them.

Why this solution does not work?
Readers will recognize that the solution I have proposed is not new. And experience suggests it does not work. The main reason is lack of other infrastructure.

1. Poverty reduces access to legal protection. Poor people do not have resources (mainly time – as it directly impacts income) to strive for justice. Hence they can be taken for a ride.
2. Poverty increases current or future health-care expenses. As I highlighted earlier, healthcare represents a snake in this snake-and-ladder game of climbing the income pyramid. Rising healthcare cost are sure to keep poor families continuously poor.
3. Poverty reduces probability for higher education thereby creating ceiling for income growth of the household. Thus occasional poverty (in a lifecycle of a family) become sustained or structural poverty.
4. Poor people do not have time to identify best employment opportunities for themselves. They have to go by word of mouth or past skills.

The legal and healthcare related infrastructure can prevent poor household from sinking further. It is a down-side protection. Then you need up-side push. This requires infrastructure like free education, employment exchanges, access to finance for entrepreneurship, technical support for diversification of household income etc.

In sum…
Poverty is recognized to be the bane of the modern economic landscape. But escaping structural poverty is possible.

Legal and healthcare infrastructure is systemic necessity. A lot of work has been done on education for the poor as well. Mobile phone based employment exchange for the poor is technically feasible. Access to capital through micro-finance is well researched. All the pieces of the puzzle are in place. It is just a matter of connecting the dots.

This post is dedicated to Blog Action Day 2008 on Poverty.

Previous posts on poverty:
1) Layout of poverty (Jan 10, 2008)
2) Why certain people stay poor? (Dec 03, 2007)
3) Selling costly products to bottom of pyramid (Nov 08, 2007)
4) How city development impacts poverty - Why Bihar should ensure there are no slums in Mumbai? (Dec 03, 2005)

Yves and Megan - A class act!

Yves Smith and Megan McArdle - two of the most important voices in the current day finance and economics come together over a wide-ranging chat. Yves talks about wide array of things I like including Mandelbrot and Peter Lynch. Fantastic interview – must watch all 67 minutes of it!

Here are a few comments I have based on the interview.

Size of the financial system is huge and you have to shrink to manageable size before you can rescue it.
Yves and Megan mention that the government would have to buy an asset valued on the books at 70cents at 75 cents to capitalise the system. Now we have a system where company accountants set the floor and government tries to fund accordingly. 

I think it would be better if instead of capitalising the system, government set itself up as buyer of last resort. Lets say if government sets a price at which it will buy those assets at 30cents. Thus government would set the floor and then investors can compete for price discovery.

The central point here is what is the amount government should value it at. In the case of housing at least it might be a little easier. Average (median) house prices should be around 20-30% lower than average (median) incomes. That can be set as the bottom in case of housing.

Of course this is way to simplified.

Embedded leverage – defaults increase from 3% to 6% impacts capital adequacy disproportionately.
What happens if this happens to higher rated tranch – i.e. AAAs? In such a scenario, the entire basket (all tranches AA, BBB etc) get impacted. Going forward this is what is likely to happen. I think this is much more likely and dangerous!

Falling dominoes – system that’s far more interlinked for its own good
There are few metaphors on stopping the falling dominos. The first is what is called the scorched earth policy. Here you create controlled destruction to offset the oncoming destruction. So to stop forest fires controlled fires are used. Second is containing the damage. This is how they stop flooding of submarines in case of water breach.

Yves invokes references from Mandelbrot - that was fabulous I thought. It leads us to solutions for self propagating replicating and cascading systems. These systems must have identified points for intervention. Yves refers to these points and need to create such points. 

The dominoes set-up for world records usually use such points. In case the dominoes accidently fall. Using these points you can isolate the rest of the system by decoupling at those points.

Yves recommends regulatory constraints on who can trade what with whom. That is one way. Other way is to continuously test the system - like hackers test the IT system security of enterprises. Thats because no matter what regulations you can set - there will be ways to break it.

10-year reduction in mortgage defaults – why you cannot trust it?
This is one exceptional point raised in the question. If 10 years data tells you that mortgage defaults are reducing will you believe it? It depends! In fact Taleb actually warns of exactly this. 

Aesop has a fable wherein the Ogre keeps its life in a little bird and thus becomes powerful. The hero has to attack the bird or in this case the underlying asset. If house prices exceed the median incomes and stray way out of line then you know that the last 10 year data is misleading you.

Finally -Yves Smith the dictator – Manhattan Project

Now this is one part that I would really love to hear more of. that section was too brief. I think we need to prod Yves into a plan for the Manhattan project. Very amazing Yves and Megan.

Another Bailout is needed!

I have been harping on the fact that the impending recession is result of excess money. Therefore unless money supply contracts and goes below a certain threshold, we are unlikely to see any recovery. We are now in the first step of capital destruction.

Like I mentioned earlier, in the first step, it is the money system that bears the risk. The regulator has no alternative but to ensure that the system survives. This is where the current bailout package (lets call it bailout 1) is aimed at.

The risks arise in the next step. Here the money system goes into self preservation mode rather than help push the bailout effects down to individuals and small businesses. Here second bailout will be required. But this bailout will need concurrent regulatory changes so that the money system does not simply fatten up – but actually pushes the recovery stimulus down the chain. The size of this stimulus will be at least twice the first bailout.

I think, these two bailouts will have to clean the system. Beyond this will be a period of lull. This is the time individuals and small businesses start reducing their loan outstanding. This is likely to take long time in case of US.

Further to this is the rosy skies and sweet smell of growth and increasing wealth.

Notes:
What is currently called bailout is actually second bailout – the first was tax rebate stimulus of USD 150billion in around Feb- March 2008

US Taxpayer generously bails out the world(?)

Brad Setser -Sharing upside and downside risk

Prof. Brad Setser has a wonderful post on the US taxpayer bailing out “global” financial system. He examines the various ways in which the US could have bailed out the system while ensuring it gets something in return. The current bailout terms actually make the US taxpayer party to downside risks without any means to access the upside gains.

This touched a niggling thought in my mind. Is the US taxpayer carrying the burden of global financial system bailout?

US taxpayer is financing the “global” liquidity crises. Is it not similar to central bank intervening in domestic markets to provide liquidity? So in effect, the US is acting like central bank of the world. Then does the US have the clout/muscle to regulate globally?

If US attempts so - is a political transgression. Naturally, this will lead to diplomatic games that often result in lot of dinner and drink expenses and little else.

If not, US taxpayer is getting a raw deal. In effect, the already stretched taxpayer is bearing the global financial rescue burden. At this point, it is overwhelming. Add to it consumption responsibility that developing countries expect US to carry out. I think the system is near break. It is MUST that global leaders / central banks sit and hammer out the solution at a global level. Else, we will be perilous close to political turmoil.

Lehman, AIG and missing solution to global crisis

Goodbye Lehman
Lehman Brothers’ is no more. But, instead of cheering the Fed for not using tax-payers money, I think Fed has not fully nullified the threat. Moreover, I am siding with Lehman.

When something as old as Lehman fails, it must be one hell of a crisis. Actually, it is, and I have been harping on it. Yet the fact remains that something that survived the great depression will be no more. Many people have said that Dick Fuld was wrong in not selling to KDB. Yet surprisingly employees of Lehman I know – believe there must be a reason. Some say if you prick Dick Fuld, he bleeds green! They still believe in their top boss –even after the bankruptcy.

I do not believe that incredibly talented people at Lehman did something way different than what GS, MS and ML have done. There is something fundamentally wrong when you see Lehman and ML scurrying for capital – like there is no tomorrow.

Fed solution not complete
The Fed’s reaction to Lehman’s troubles was erratic. On one hand, it did not bail our Lehman but bailed out AIG. So they bust their argument about tax-payers money. I think Fed, with all the experience at the table, has failed to deliver creative solution to the crisis.

So where is the solution?
A single regulator, even as big as the Fed, cannot deliver a solution to current crisis. I think a global consensus needs to evolve. Global central bankers acting in sync can possibly solve this crisis sooner. It is time to take the John Pierpont Morgan solution. Get all central bankers into one room and lock the room until they get to the solution.

The current crisis begs for a need for new globally relevant regulatory framework. This framework needs to buy time for companies under attack – while not using any taxpayer’s money. However, looking at WTO, I think we are long way away from such a situation.

One other important learning from the crisis is that global accounting practices are not as robust as they seem. The root cause of this crisis rest in the accounting principles that allow asset values to move away from ground realities. Asset values moved along with fabricated-market realities leading to self-propagating bubbles.

Another accounting goof-up has been notional value changes creating real cash-flow profits. There is evidence of similar occurrence in a lot of trusts and funds. It seems irrational to me.

Aligned incentives are critical for firm survival. In this matter, I think Lehman was much better off. The employee benefit program tied long-term employees’ fate into the fate of the firm. I believe you cannot get better than this. A real hard look at compensation is definitely warranted.


Lastly
I end with a hope.
I hope in 2 years time, Dick Fuld and his team miraculously claws back with the Lehman Brothers’ name. I hope to see those golden letters on greenback on that building in Wall Street – just where they were for more than a century. I hope Dick Fuld has something up his sleeve. I really hope. And, I hope they do it soon.

Tim Duy explains current situation

Mark Thoma links to Tim Duys article on US and Japan equivalence here.

• The loss of US policy independence in accordance with the impossible trinity
• This poses threats to globalization in the context of US losing independence.
• US (excess consumption no saving) is polar opposite of Japan (lower consumption high savings).

This implies that for any real progress US demand contraction must happen. In this context, Larry Summer’s call for second stimulus may look ridiculous – but so long as global central banks are playing the game it doesn’t matter. To be fair, there is not much option left with Fed. Further, this is supposed to buy time – US may not be able to play this hand later in the game. I think this only postpones the inevitable fall of dollar.

The current new-found affinity for US dollar is actually repulsion to EM markets rather than affinity to US dollar. This money will go to newly spiced up US exporters. Exporters loose their competitiveness as it is derived from US dollar weakness. People loose money. It doesn’t matter in which currency you loose it – its lost. Loosing it in dollars makes it little better for the rest of us because there are just too many dollars sitting in vaults these days.

Welcome to the down-cycles.

Update:

Wall Street Journal concurs here. Link through The Big Picture - Barry Ritholtz

Cyclicality of global slowdown projection

In brief…
Current market slowdown will express itself in a cyclical matter with cycles accelerated or compressed within a short span of time. It is better not start pre-mature celebrations. It makes more sense to track the frontier of this storm wave. However, 5 years down from today we will marvel at the low-high-low-high forecast cycles wondering what were analysts thinking!

Into the cycle…
On the first anniversary of the slowdown, the US GDP was revised upwards much to the cheer of the markets. Experts like Tyler Cowen, Brad DeLong and others have already looked under the hood and have not found anything remarkable. US GDP seemingly grew on the back of strong manufacturing performance. The news coincided with a slowdown in Europe. This gave a chilling clue that possibly US growth came at the expense of a European growth. This newfound US competitiveness against the EU is primarily due to exchange rate weakness of the dollar. The dollar regained strength on the news of GDP uptick undoing the competitive forces. Thus, the situation is now ripe for US consumer uptick expectation and further realignment when it does not happen.

The down cycle oscillations…
The situation is likely to oscillate for at least another cycle. All the gains in competitiveness are still addressing American and European consumers. This, to my mind, is critical weakness of the currency system. I expect this cycle to oscillate until European consumers stop consuming at the next uptick, waiting for growth that is more fundamental and hence robust. Therefore, the last cycle will not produce a GDP increment as this time. The sooner this stabilizes the better. The more these cycles run on, the more loss of confidence will create panic. How long will this run and how spectacularly will it end is difficult to predict.

The consolidating cycles – more oscillations…
The next wave of cyclicality will hit when actually Chinese and Indian consumers hit the global markets. As global manufacturers rush to address this demand, they will unleash a new wave of competition. The resultant action will create a cyclical rebalancing in currency markets. Even this cyclicality will create an oscillation difficult to fathom/ predict.


The wavelength of the cycle…
Making money given the cyclicality of the world economy in the near-term, implies understanding the wavelengths of the cycles. As of now I believe we can only expect to understand down-cycle waveleangth. The consolidating-cycles will be far more complex and knowing their wavelength will be more difficult.

The down-cycles, as mentioned above, we can argue will have peak-to-trough time of at least 2 GDP reporting periods. Implying these will play out over little less than a year. Lead indicators of GDP like retail sales, car sales, energy consumption, inventories etc. also tend to influence markets during down-cycles. However, I think these indicators distort the way GDP growth diffuses through the economy and hence may mislead the markets. Actual GDP measurements may turn out to be more robust on upside and downside than predicted using lead indicators. Thus what was a single cycle may actually be aggregation of auxiliary-cycles. The main cycle though can be expected to follow GDP readings. The imposing auxiliary -cycles, if large enough in magnitude, can distort the wavelength.


In sum…
The near-future is going to be cyclical, with accelerated/compressed cycles. Most likely cycles will have wavelength (twice of peak-to-trough) of 4 GDP reporting periods. Auxiliary-cycles may play spoil-sport within the cycle. Making money in such an environment is equivalent to wave-surfing. At each peak you have to make enough to take you till the next peak! Thus making money is quite tough and entails highest risks. Welcome to the beach!

Central Bank problems - US investments, growth v/s inflation, Exchange rate hurdle

I am hearing repeated instances of global central banks now focussing on growth. Earlier, amdist the whirlwind shock wave of global economic downturn and rising oil prices, central bankers chose to slow the economy with a use of lagged monetary policy instruments. Now as oil and commodity prices subside, central banks look to fan the growth fires again. I believe most of it is a farce. Particularly so in case of China. Brad DeLong links to James Fallow's take on China in two parts first part and second part here. I think James Fallow has mis-interpreted the situation.

Formula economics
Emerging economies learnt the formula for growth in the past decade. It involved promoting investment and job creation, encouraging spending thereby triggering a virtuous cycle of development. This formula is great to initiate or prime the economy - but it is poor mechanism for transmission of wealth across income classes. Savings and host of economic factors ensure that the distribution of wealth so generated is lop-sided favouring the higher-income class.

The mistake
Most of the economies seems to have decided that answer to rising in-equality is in faster-higher-better priming. Partly, they cast their economies in the mould of market-share winning corporates. And like corporates these economies are intent on keeping "costs" down. The resultant "profits" were enormous and increasing. But there was a little difference with normal corporates. The employees of normal corporates interact back with the market. But employees of this nation-corporate only interact with themselves. (Either because of direct or indirect trade barrier like managed exchange rates) Therefore the higher profits could not be channeled into stake-holders - due to fear of inflation. So these had to be invested somewhere. So it is that this enormous forever-swelling pool of money found its way into US assets. Pushing the US consumer to carry this "little" extra burden. Then the unthinkable happened - US broke down - it was the last (Yuan) straw that broke the US back.

Where will Central banks find growth?
Now central banks are looking for growth. Now the same old principles wont apply. US consumer is not going to take any more burden. New consumers will have to be introduced into the system. China and India - these two countries who can inject tremendous amount of vitality into the system because of sheer numbers. But at current exchange rates both China and India are too small to carry the burden of US consumer.

Exchange rate correction will wipe out USD investment
As mentioned in yesterday's post, exchange rate revaluation will impact at least 2 trillion of China holdings. Opening the domestic market to world will further deplete this reserve. China will find itself in apparantly bad situation (first-order effect is pain). Fundamentally however this situation will better address the income discrepancy than its current policy - through third and fourth order effects. Yet can any country set aside the pain. I doubt - rather this will trigger a battle for consumer.

A confusing implication
Now there is a reverse implication of this. The "real" savings estimated in terms of purchaing power of future goods - will decline so long as exchange rate barriers dont break. This while savings are actually rising and inflation is low - and exchange rates are pegged. Anecdotally we can see amount of money required to maintain lifestyle is increasing faster than what inflation and wealth increase are telling us.

Key take-away
Exchange rate is key hurdle - from multiple sides - in addition to conventional fundamental reasons. There is going to be lot of pressure on Yuan at-least. Thats why my higher conviction on Yuan appreciation.

-------------
Notes:
#) Some ideas half -developed - but important to highlight so posted half-baked.
#) James Fallow asked straight questions - I call them level 1 questions - we need to ask level 2 questions. E.g. relative pay-of to Chinese worker should be made in PPP terms or relative to China income distribution.
#) Just as I finished this I get this amazing article at Vox by Robert Dekle, Jonathan Eaton and Samuel Kortum. Will comment on it later.

China, US Dollar and making money in this situation!

Yves Smith is back to her best. She weaves together of thoughts on US situation, Chinese options and possible solutions at naked capitalism: Summers: "The global consensus on trade is unravelling". It raises many questions like Why is China buying US debt? And more generally Can you even think of making money in this situation? Here are my thoughts on the same.

China has limited options. A large part of its wealth is loaned to the US. Now the only volatile variable in this is exchange rate. If you have 2 trillion dollars sitting out there when exchange rate varies by 10% - I am sure you heart is in your mouth. If that much money has to retain value then it has to sit on something more robust than US debt!
For China, the only other way to retain value is to keep the relationship intact (because China CAN control one side of the peg!). But by committing to manage exchange rate - China now has no option but to be the large buyer of additional US debt. This is fine if China believes it can shore-up all the "remaining" US debt.
Now this situation is ripe for other nations, funds, entities to gradually off-load their USD holdings and retire to the peace of Euro, gold or some other value retainer. They are attracted by buying options for raw-materials i.e. food and energy. That makes the case for rising energy and food prices. This is same old logic behind this new-found attraction - hedging. Countries would ideally like to lock their costs in current prices to protect against future rise. So US debt problem now extends to US assets.

Where will China get the money to buy US assets?
While large part of the money comes from running trade surplus (for a little while), some part also comes through Chinese savings and investments. Chinese FDI is in a position to buy lot of US assets and given the situation - it will do so. Implication is if you have to shore up the Yuan for sometime and release it later - you will make a tidy dollar profit - if it is of any value.

So how do we retain - rather add value - sit on cash?
Sitting with cash (in local currency) is great stratgy for retaining value in local context. US domestic investors are ok with dollar profit - if they are going to spend it domestically. But most investors look to increase or at least preserve value. This was ok when dollar was default currency. It helped measure value - hence retain and enhance value. That was why nations bought US assets not because they were unusally attractive.
The other metric of value is the purchasing power. Lets say 10 dollars fetched one meal in 2008. Then all the current holdings should be measured in no. of meal terms. Then its easier to measure and enhance value again. So the best value retainers will be derieved from future consumption basket. So in-effect real hard-core hedging should help retain value. If smartly done - you may end up top of the heap.

Surely there is some hidden risk there too...
The situation becomes more critical if we realise that "contract enforcability" underlying the hedges can be threatened. This risk is sure to increase as money involved increases - i.e. when China realises it holds larger and larger share of US debt outstanding - and by that time China's stake would be probably greater than 4 trillion. Once China does realise - we are going to be in really, really tough times. In old times - this situation would be enough to cause a war. In today's times I hope not.

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Note: - The nakedcapitalism post is must read. It connects, complements and analyses this theme from Larry Summers FT article, Brad Setser (article I linked yesterday), William Greider, Dani Rodrik, Thomas Palley and El-Erian. I am fan of Yves Smith!
Also Steven Kamin has interesting findings at Vox.

A battle of minds for America's creditors

There is a great new post from Brad Setser at CPR. He highlights a quote from Dr. Yu Yongding that highlights the dilemma facing China as an investor in US debt.

“If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic … If it is not the end of the world, it is the end of the current international financial system.” "-Dr. Yu Yongding @ Brad Setser: Follow the Money

US creditors are in a waiting game. It is also a losing game. So long as they pick-up the US debt instruments, and supply more credit to US - things are fine. This is aggravating the US deficit problem. If US policymakers start rectifying the problem - they will do things that will upset this fine balance. It takes me back to my december 2007 post.

This waiting game has big money at stake. The pay-offs are larger and margin of error is small. This looks like a lose-lose game to me. What say ye?

Chinese Currency problem!

Real Time Economics : Economists React: 'Fundamental Alleviation Unlikely' for China

Its time to put higher conviction on my view that Chinese currency must appreciate. There is too much weighing in on the this side of the bargain that it will happen. Foreign currency inflows. to my mind, are anticipating a gain from one-time appreciation of the Chinese currency. Further let me speculate that with a one-off appreciation China will see a run on the currency. Foreign capital is likely to pull out possibly netting up to 15% return for the expedition.

This is running very similar to GBP devaluation. I would really love to know which side is Soros playing this time. After all its a known game for him.

The American Scholar - The Disadvantages of an Elite Education - By William Deresiewicz

The American Scholar - The Disadvantages of an Elite Education - By William Deresiewicz
(Jane McGonigal from Avant Game twittered about this link. ) talks about short-comings of US education. The most fantastic part for me was the following quote

Being an intellectual begins with thinking your way outside of your assumptions and the system that enforces them. But students who get into elite schools are precisely the ones who have best learned to work within the system, so it’s almost impossible for them to see outside it, to see that it’s even there. Long before they got to college, they turned themselves into world-class hoop-jumpers and teacher-pleasers, getting A’s in every class no matter how boring they found the teacher or how pointless the subject, racking up eight or 10 extracurricular activities no matter what else they wanted to do with their time.

During the earlier years innovation and challenging the boundaries by simple interaction of different cultures. There were barriers to cultures interacting. Thus top schools, by getting a diverse group together, facilitated the best learning environments. The system was right for the time.
Today technology has broken those barriers. Today learning must come from independent thought. And this is very difficult to induce independant thought. Schools are now trying to build on the diversity base, that they are familiar with, and add newer cross-discipline projects.

Cross-disciplining is expected to be next level of idea generation. Economics interacting with Physics, Medicine with mathematics, economics and thermodynamics - a lot of these fields are cropping up. I believe, education is in good hands. The most we can accuse it is for being slow with change.