Why is there is no lending in crisis?

On LinkedIn, Callum Thomas has shared a post detailing tightness in lending standards and gradual shifting to tight credit conditions.

Lending standards tighten at the exact wrong time in a crisis. Also in a crisis the ratings get downgraded en masse. When we want banks to lend, banks do not want to lend. When we want banks to stop lending, banks get busy making risky loans. This is one problem of banking regulation that has not received enough attention. 

Markets and particularly rating agencies need to appreciate the difference between Macro risk (where all aspects of the economy are impaired) v/s corporate risk (where particular company suffers impairment because of its own actions or inactions).

Credit cannot be pushed - it needs to be pulled. To achieve this, a better mechanism is interest subvention. It seems to be a much better tool when macros risks are prevalent.

An SPV which guarantees interest rate up to X% (ranging from 30-50% of lending rate - so for India it will guarantee 3% interest cost for US it could 0.75%) it should cause firms to pull credit and deploy it for productive uses.

---

Rahul Prakash Deodhar, Advocate, Bombay High Court is also a private investor. He can be reached at rahuldeodhar@gmail.com, on twitter at @rahuldeodhar or at his website www.rahuldeodhar.com.

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms"

Will US Dollar collapse? What will be an alternate currency? What about Gold?

At this point I am not sure Dollar collapse is closer. 

A dollar collapse needs to have three points - 

1. The fundamental weakness in USD (we have this more or less) 
2. a World not reliant on US consumer demand 
3. A strong challenger

Last 2 conditions are not met - at least not yet. Euro has its flaws and needs to iron those out before it can become a challenger. Yuan will not be a challenger. SDR is closest option we have but there are issues there too. I am not confident of the blockchain currencies that exist presently.

IF Dollar is really stressed we may go back to a gold-peg rather than other currencies. In fact, gold peg may be quite a good Fed policy for the short term.

If we correct the SDR structure then eventually even the US would love to have a 2-level currency system. 

Previously I have discussed views on US Dollars here:
Dollar, the International Currency system and the Ghosts of Connally

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

Comments on Ray Dalio's post on Monetary Policy 3 and MMT

Ray Dalio's comments are always well researched and interesting. For starters, I think, Principles for navigating Big Debt Crises is must read. (Its free PDF). His recent post on his LinkedIn blog is about Monetary Policy 3.0 and MMT. 

Some fundamental comments about present crisis:

1. QE only creates a space for fiscal response: Central banks and governments alike misunderstood the role of monetary policy in the 2008 financial crisis. The crisis was different than others we have faced since Great Depression. Per my reading of Keynes (which seems to different than Keynesians and neo-Keynesians both), in such crises, the proper response has to be from fiscal side. The monetary policy merely creates space for the fiscal response or accommodates the fiscal response preventing untoward consequences. The response had to be holistic - a coordinated and sustained monetary and fiscal policy response.
2. Fiscal policy amplification mechanism is broken: Broken may be a harsh word, we may choose "has become messy" in its place. The point is, fiscal policy needs an amplification mechanism. When government starts infrastructure spending, it needs some real value-creating sector to take it from there and start driving the economic engine. At present we do not have such "real value-creating sector" that can boost employments and wages generally. In 1980s we had tech, in 2000s we had internet, now we need something. In absence of a big driver, we need many small ones. If such capability is difficult to create in one sector it is quite difficult to create in more than one sectors too. The solution is to let inherent advantages play out.
3. Inherent advantages are muzzled: Inherent advantages have stopped driving international trade since east asian crisis, and at a larger scale with China's entry to WTO. Instead, we have pegged exchange rates (soft/hard/overt/covert), manipulated tariff and non-tariff barriers, and, in general, non-transparent trade policy. Until that is fixed we cannot have trade based on pure competitive advantage.
4. Small business innovations are indefensible: When people talk of China usurping Intellectual property they usually talk about submarine plans etc. But I am talking of something very basic. Check out new funding projects on kickstarter - innovative shoes, innovative bags, innovative pens, anything that takes your fancy. Just search on alibaba or just wait for few months you will see some products like those (invented by kickstarter entrepreneurs) in the market on mass scale. These products are not sold by those companies who invented them on kickstarter or such platforms. This is IP theft that hurts the most. It removes new business competitiveness right at its infancy.
5. Trickle-up always works; trickle down some times: Monetary policy practitioners and academic economists in general prefer trickle down economics. But empirical evidence says reverse is true. Trickle-up works all the time. Thus, when there is a choice of bail out, we must lean to lower strata. (A) It is more fair and just, (B) better optics and (C) right incentives. But MAIN reason it works because it balances the bargaining power of both sides. Bail out the top and they lean on to regulation to prevent or constrict trickle down stifling the economy. Bail out the bottom and lo and behold all the incentives align beautifully.
6. Certainty of employment and wages is the one super-indicator: The best solution to any crisis is to get certainty of employment and wages going, rest follows from that. Today we have almost full employment but it is uncertain. Wage predictability is also uncertain. That's why the lack of demand is so persistent.
7. Interest Rates are like friction: Too much and too little friction are both bad. Sames goes for interest rates too much is bad, too little is ALSO bad.

Some comments about Monetary Policy 3:

1. Debt financed Fiscal spending financed by QE: I don't agree with Ray Dalio that this was pursued after 2008 financial crisis. The fiscal spending was essentially going to the same group who could access the QE funds. Yes, there was fiscal deficit and increased fiscal spending and yes there was QE to finance it. But this is exactly the wrong kind of stimulus as I have written since 2009 itself.
2. Giving $10,000 to one person Vs $100 to 100 persons Vs $1 to 10,000 people: Helicopter money is not easy to design. The behavioral response in each of three cases varies drastically.The range of outcomes possible is mind boggling.
3. Spending conditions interfere political rights: If I am tasked to spend $10,000 can I give it to someone from my family to pay down her loan? Does that amount to spending? Should I buy something? What thing? These questions are difficult to answer, monitor and control. 
4. A little inflation is necessary: People will spend when they can surely afford it (condition above - certainty of employment and wages) and it will get costlier tomorrow. Inflation is important, zero inflation may not be that great.

The examples of Monetary policy 3.0: 

The best part of the analysis is the historical perspective Ray Dalio gives. Sharp readers of this blog will immediately note that there are fundamental differences between the conditions in various situations described and those existing now. That is acceptable difference.

Particularly interesting is the Roosevelt response in 1930s. It still forms the basic template for solution today. However, we are at a slightly different position today than in 1930s. So we have to make more adjustments than Dalio may seem to suggest. [Dalio is NOT suggesting it - it appears simple but it is incredibly complex - politically, fiscally and economically]

In Sum

Do not understand these comments as put down of Ray Dalio (as if he cares what I think!). I admire the man because he is being honest and creating a framework to solve the crisis. Good intentions and honest efforts deserve praise - even if the guy making those efforts is one of the richest.

From my side, I solved this crisis puzzle back in 2009 itself.

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms"

Can only US markets go higher in the face of tariffs and other trade headwinds?

In one word - NO!

One the trade front, the US needs other countries (suppliers) as much  as other countries need US as a consumer No. 1. Yet, the consumption burden falls excessively on the US. That too is not sustainable. In the natural course of things this burden should gradually pare down. This natural process was impeded by interventions in currency and trade policy by (a) East Asian economies following 1997 crises and (b) Japan first then China. 

In the first case, the impact is benign as the comparative sizes of the economies in South East Asia and US/UK etc is too big. 

The second case turned out to be problematic, though bit less, in case of Japan. Absent the computer and technology revolution, US would be in same position as today as in post-Japanese growth phase. At the time when the US jobs were diminishing in the face of Japanese competition and trade, Tech was already cooking in the oven. The massive productivity boom unleashed by tech was supported by job growth in new sectors. These sectors pulled decent quantum of current workforce and modified the training profile of upcoming workforce.

Today, there seems to be no new sector that is vigorously attracting the current workforce into itself. There are two reasons for this. First, the speed of Chinese growth is dramatically higher than Japanese growth. What Japan achieved between 1945-1980, China achieved between 1980-2000. Second, Japan started at the time of man-power constraint. China started gaining traction when manpower was becoming surplus. Therefore, job "protection" in developed world has become important.

The trade fears can be allayed / calmed if there is another sector that can create as many jobs for the profile of workforce that exists today and about 20 years from now. Absent that, growth will require  fighting for a larger share in a diminishing pie - a potent trigger for conflict.  The war can be won by biggest bully if he is alone. But when there are a few contenders it takes time to settle the pecking order. Many skirmishes (I mean trade & currency conflicts) need to happen to settle that order. For strategy suggestions we can look at how pecking order is established in prisons. The strategies will be same the tools will be sophisticated. 

Thus, US cannot do trade wars alone. US needs its own "gang". That gang was NATO, NAFTA and these days the "Quad".  The Stock markets of one gang may rise if the gangs are tighter) and they may decouple from other gang. But only US markets rallying is not possible.

---

 Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

Tax as a destabilising force - Border Adjustment Tax

John Mauldin, a prolific commentator, is well connected to the Republican establishment. He has recently concluded a three-part series titled Tax Reform: The Good, the Bad, and the Ugly on the coming tax reform in the US. The parts can be found here - first, second and third. It is a must read. 

The US is trying to simplify tax structures. This, by itself, is nothing new. All the countries have been trying since time immemorial to simplify tax codes. Surprisingly, they keep getting more complicated. I do not think "simplify" means what you think it means. But this time, it does seem simpler. Let us not jump the gun, it is still early days. Let the bureaucrats have a go at it and it will come out as complicated as it has ever been. Nevertheless, the intent seems to be right.

The disturbing part is the way BAT or Border Adjustment Tax is supposed to work. John paints a pretty grim picture and rightly so of the adverse consequences of ill-thought out Border adjustment tax. Mauldin and his friend Charles Gave, both seem to suggest that this move will disturb the present equilibrium. Other republicans do not think so. But there is merit in Mauldin-Gave arguments.

And then I read the US intelligence’s ‘Global Trends, Paradox of Progress’ report. That is another bleak report. What is disturbing is that the world seems to be in a precarious balance at present and 5 years out. Some situations in next 5 years as highlighted by the report:

Now the timing of BAT by Trump has become exceptionally crucial. At times in history you get amplified impact because historically small acts happened at unstable times. Here we are faced with a big act at unstable point. In effect, we are beholden to Trump's good sense, pragmatism and sense of leadership.

Interesting times these.

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

Idiotic debate on Demonetization

Since the announcement of demonetization we have quite a lot of noise but no analysis. I am on the look out for genuine criticism of the policy.

Semantics of false criticism

There is a lot of criticism of the government's policy. The international criticism is uninformed and disconnected from Indian ground realities. Quite a bit is a shallow analysis of Nigeria, USSR and some other countries which had demonetized previously. Generally, the criticism falls into the following buckets:

1. Demonetization alone will not stop black money: That is not proper criticism. 
1. The government never maintained that it will. 
2. In fact, Finance ministry circular highlights various measures undertaken by the government till date. 
3. Further, the prime minister indicated that this was just the beginning and more announcement will come.
2. Removing 85% of the currency will cause a lot of pain to the people: 
1. Well when you ask the people, most are happy with it. Some are very angry. In a country of 1.2 billion you will have voices. 
2. The prime minister took a smart-phone based app poll which revealed 90% approve of the move. Media quickly jumped up stating the questions are biased. I myself took the poll. The questions were not as biased as media made them out to be. It is a fair poll - you CAN express dissent if you don't like the move.
3. But the fact remains none of the media channels or anyone tried to do a sms-based poll. We can have a poll for Indian Idol or some crazy show, can media people not fashion a proper poll and report if people are indeed pro- or against.
4. I tried to go through You-Tube videos about demonetisation uploaded after November 28. I suspected people will give proper reaction once they have been in ATM lines for a few days. I left out videos uploaded by news channels and focussed on videos uploaded by general people. Not many have uploaded but I found one by Roshini Ali & her friend exploring the poor of Kolkata informative. One other fellow explored Mumbai and Aurangabad but he wasn't as comprehensive as Roshini Ali.
3. Economy will be hurt as currency is withdrawn from circulation
1. This is the closest people have come to making rational arguments. I don't mind general public making this argument. But from experts, I expect more.
2. Many experts confuse the measured part of the economy (GDP etc) with unmeasured part (black economy). In an extreme view, since the black economy is not measured its destruction won't affect measured economy. That is flawed as black and white economies intermingle often. Yet they are not quite as intermingled as people make it out to be.
3. A substantial part of the black economy comes from tax evasion. For example, sales without bill are quite rampant in India. Over billing (for cold drinks) is also rampant. These are black transactions. With proper triggers, these transactions will come to the white economy. (Though demonetization is not that trigger).
4. Only time will tell if it works:
1. I understand general public expressing this sentiment. It is a healthy attitude to take.
2. But when experts take this position, I don't like this. I expect the experts to define their goals for the policy - when will they say it worked. 
3. And I want them to state it now not once results are out. Because once data is available the narrative will be tailored to the outcome.
4. Further, be realistic as to what can be achieved by demonetization. I don't want people setting targets "I want black money to become zero".
5. I want to see the goal post that is set out by all these experts.
5. Bull-shit interviews/feedback:
1. Many interviews of government officials and supporters of policy are quite brash. The interviewer does not want to know the policy but instead he wants to hammer the expert. Karan Thaper did that to Bibek Debroy (who I don't really admire - but he is most lucid in the lengthy Ashok Malik interview).
2. Most media reporting is negative and most general people reporting is positive. One TV channel interviewed a Hindi Speaking shopkeeper in Chennai.
3. If I watch TV channels interviews then I get different pictures. Pro-government channels say good things and anti-government channels always highlight bad things.
4. Some channels have shown non-working ATMs quite a few times. And others have shown longer queues giving impression that the queues are that long all the time. People who are on the ground dont find that many long queues all the time.
5. I have concluded that most of the people do not yet understand what exactly the possible strategy is. None have read the Arthakranti proposal even those who have interviewed the founder Anil Bokil.

Basic framework

Just wanted to clarify one thing here.

Tackling Black money requires a repository of measures. Yes many measures together will help reduce black money. Black money cannot be eliminated completely, it can be reduced drastically.

Demonetisation results in many things out of which one is hurting black money transactions. It freezes the black money transactions and not the assets created out of black money. It also results in other effects - anti-counterfeiting, promoting cash-less transactions etc.

The two are only slightly overlapping. Government hasn't claimed that demonetisation is only aimed at black money. It has correctly stated the what demonetisation can achieve. To confuse the two only shows your ignorance.

Policy Details - possible and others

For interested readers who want to know what is the possible logic behind Government's measures, you can parse some of the links here:

1. Amithabh Kant on CNN (focusses on going cash-less)
2. Anil Bokil on ABPMaza (in Marathi) in Anil Bokil in Hindi
3. Arthakranti Proposal (click here for benefits, benefits to individuals, objections)
4. Bibek Debroy on Demonetisation and other issues
5. Ken Rogoff author of The curse of Cash advises gradual demonetisation of high-value notes.
6. James Henry's article calling for surprise currency recall (from Ken Rogoff)

Setting Goalposts

It is important to set out clear goals when we announce the success of a measure. My goalpost is thus:

1. I want to evaluate current demonetisation on following parameters:
1. Total amount deposited with banks / total currency in circulation: I suspect we will get close to entire currency in circulation back into the bank accounts/exchanged. This is because I suspect counterfeit currency in the system is to the tune of 40% i.e. ~ Rs. 6 Trillion making total currency in circulation at ~Rs. 20Trillion.
2. GDP in Q3 and Q4 of FY 2017 should not reduce more than 1.5%. Thus I expect Q3 and Q4 to be at least 5.8%
3. Net bank deposits gain: After stabilization, i.e. say by Sep 2017, bank deposits should appreciate by at least 40% of currency in circulation i.e. Rs. 6 Trillion. This is figure after deposits and withdrawals have stabilized.
4. Share of E-transactions: As per Mastercard data 2% of transactions (number) are cash-less. I would like this number to be around 33% ~ 1 of every 3 transactions should be cashless. 
2. With respect to Black Money targeting, there should be a continuous targeting of black money holders and black economy.
3. Tax simplification and rationalization proposal in Union Budget 2017 (which will be in January). I think we should try Banking Transaction Tax once 2 out of 3 transactions are cashless.

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

Destabilised Eurasia and possibility of War - The SE Asia - East Asia equation

The events of the past few weeks and years have had a decisive geo-political point to them particularly concerning South-East and East Asia. Let me enumerate a few here. 

1. In 2015 Japanese parliament permitted their army to go aggressive( with US blessings). They have been making ships and aircraft carriers since few years ago  displayed in Aussie, Singapore, Japan and US joint exercise - small allegedly helicopter carrier or something.  
2. Last week I was seeing Singapore Air Force Fighter planes on evening patrols. Also every day they have the another surveillance plane - it is not the boeing posiedon in the air. 
3. On friday, India announced surgical strikes on terror bases in Pakistan Occupied Kashmir. 
4. Last week, Singapore PM met Japanese PM Abe. Last month he met Obama. Chinese news paper is accused Singapore of siding with US. This week Singapore PM is meeting Narendra Modi.
5. Last week Japanese PM Abe met Narendra Modi and promised him some military tech and other assistance including manufacturing assistance.
6. Phillipines has abandoned US and is courting China. Durtete made a statement that he received encouragement from China and Russia on his anti-US remarks.
7. Last month the International Arbitration Tribunal restrained China from claiming rights on South China Sea.
8. Last month Austrailia published a white paper on maritime defence highlighting the need to protect the interest in the northern coasts and in the Pacific. Australia does not have any threat from any country in the Pacific save China. It is way far out and super friendly with most of the major powers. It has a love-hate relations with some island countries where China has become active.
9. US is offering F-16 (yeah the old ones) to India for make-in-India option. (The tech is old but the offer is quite lucrative)

So what is happeneing?

China is being encircled. Japan south Korea Taiwan Singapore, Australia and India are coming together step by step. South Africa is in the mix too. Philippines has chosen to side with China - or so it seems. Vietnam is on the fence blowing hot and cold. Laos is stuck between Vietnam and China but I sense it is more pro-china. Thailand is becoming more democratic but depends on their king who is about to die or may have died. 

Since China is being encircled, it thinks it can break the mix by encircling India. China thinks it can corner India because of its alliance with Pakistan. So Pak will keep India engaged on west and china will keep it busy on the east taking India out of the equation. So a day after announcement of surgical strikes we had reports of China reducing Bramhaputra waters for dam construction.

But, on day of surgical strike Iran attacked pakistan (which is weird). Afghanistan is already sick of  Pakistan. Now Pakistan thinks it too is being encircled by adversaries. Tajikistan is not really happy with Pakistan either. But it is more worried about China. So goes for Kyrgyzstan and we come to Mongolia and Russia which surround China. 

Within China too,  in Hong Kong separatist sentiment is acting up, mostly without encouragement of the west. Then there are other prennial problems in China - including Tibet, Uyghurs and others.

So we have China trying "string of pearls" strategy around India. World trying "string of pearls" around China. 

Why India is crucial element in the mix?

India is important because it is a navy that controls the major trade routes to Europe and East america. It saves a trip across Africa. So China wants to circle indian ocean by involving Africans - twin benefits resources and strategic support. So this is a move-counter move strategy. India is but small player if you ask me. I think US is the big bro here. We are seeing Obama's east pivot in action. 

Why is China all riled up?

China is being choked economically by all - sort of as a payback for its merchentilist begger thy neighbour policy. Actually when Milton Friedman was asked about dumping of low cost products, his argument was simply it benefits the importer. It means (to me, Milton did not say it so) that after the value is over you can reverse the equations by ring-fencing the excess capacity from creating problems for you.

The second narrative Chinese use is that its almost $4Trillion US Dollar reserves may lose value and thus cause wealth loss. This narrative is easy to sell to general pulic and it will make for a good anti-US story.

This has a lot of implications for China. It may wreck it from within. An empowered peasantry   / rural-folk may bring down the corporates to its knees using exactly the same arguments that Mao used. The citizenry may become subversive when faced with no jobs, or rapid decline in wealth as a result of capacity destruction. These will be difficult to control in a country of 1.6 billion. The cost of political unrest for Chinese Communist Party is too high. That could be one reason for Chinese aggression.

The first narrative fits the bill better because of the related developments. There was no reason for announcing a "make in India" policy when there is excess global supply. Not unless the Chinese capacity was suddenly going to be unavailable. And someone could pick up the slack. Indian PM Modi saw an opportunity in this and embarked on the picking up pieces. FYI none of the Chinese investments into Make-in-India have materialized. Foxconn which promised to set up an iPhone factory has backed out. Others are mostly European and american cos who continue on.

Is China a potent threat to US?

At present China is not a threat to the US. 

It does not have a wherewithal to pick up a fight with US. At least that is the public view. China needs at least 5 aircraft carrier units to be as aggressive as they are trying to be. It has none at the moment. Big daddy US has five major assets in Pacific including Okinawa. US also has two Aircraft carrier groups in Mediterranean Sea and Indian Ocean. India has two in the Indian ocean. 

China is a threat to India. It is an ally of Pakistan and has a long border-dispute with India. India needs to be wary and after fall of Soviet Union there is no regional counter-balance. India must ally with US. There is no other way. US knows this and promoting technology transfer to Indian defence. 

China is also a threat in South China sea. It is here that US is more worried. It is claiming more land and nautical area and becoming more assertive.

The least-expected strategy for China will be to challenge US. That will be a surprise and alter the military-power equations. For this it needs some greographical spread. By itself, China has tough geography which makes it difficult for it to create big trouble that could alter global balance of power equations.

The solution - A China circle

The Chinese circle comprises China, Pakistan, North Korea, some countries in Africa, some in Pacific Oceans including Laos. These countries have received heavy Chinese aid and China supports some questionable regimes in certain regions. Phillipines is becoming a China ally. The Burmese junta enjoys some support from the Chinese.

Clearly with this motley crew China cannot take on US or other major country. But what it can do is create strategic assets in these countries from where it can create trouble. The dirty work still comes to China's share. 

The tools

If China wanted to be a credible threat it should be building at least 10 Aircraft carrier units (including cruisers, frigates, destroyers, submarines, logistics ships). A better strategy would be to build them inland somewhere in Hainan (lake) or more likely in Sichuan (totally on dry land). Then one fine day plonk these in the sea. An event like that could alter the geo-political equations quite rapidly.

Yet such kind of shifting of balance of power is not possible easily. There are pretty unpredictable players in the mix.

The no-nonsense player -Russia

Russia is sitting on the fence. The Russian approach is just like in world war 2 - corrupt but away from the mess. It will take sides when it is forced to take sides. It has hinted that it may start supplying aircrafts to Pakistan and may have helped china build their J20 fighter which is copy of the F22 raptor. Russians are playing both sides as of now. They are cooperating with the West in Arabian geographies and counter-balancing them in Asian geographies.

Their problem is that they are too close to conflicts but not too powerful to force a resolution anywhere. Even Soviet Russia would have found difficult to contain China in its present state.

Pakistan the unpredictably-unpredictable player

The issue was easy to solve if Pakistan was not a long-term US ally. Because Nehru sided with Russians, Pak went to the US and US is feeling guilty of abandoning pak even when it housed Osama. If Pakistan was just another country in the equation, the US policy would have tilted pro-India by now and we would have been in a new stable-stalemate situation. The world would be chugging along by now.

The problem is that US would always help build Pakistani capability to counter-balance India. To the US, pakistan-India parity was the policy objective. US realised it late that Pakistan was playing double game. With US technology seeping into China and the inventory falling into the terrorist hands, US realised Pakistan is not a strategic asset but a mere pawn. It is China that was the new threat.

My guess

It is possible that the China is using the uncertainity related to US presidential election to test some destabilisation strategies. They see a window of opportunity and it expires on November with elections in US as the new president (even if Trump wins) will be briefed about all important issues and most likely toe the usual line. The uncertainty will reign till November as Obama may not be able make longer term commitments right now. So we have to sit tight for 1or 2 months. This is peak of crisis as we get to see. Then big daddy will be back in the saddle and world will be back to its normal stalemate situation. If this is indeed correct, then we should see a major policy decision by the new US President immediately upon taking office. It could be a pro-India change or opening of a full-functional base in South East Asia augmenting the one in Singapore and Okinawa.

In Sum

Something is definitely going on in the SE Asia / East Asian region. 

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

Why is QE — ZIRP/NIRP not working?

Most people wonder as to why Quantitative Easing (QE) along with low interest rate policy is not making their life easier. John Mauldin and Neil Jensen in their letters are wondering where the road to recovery is? Where is the inflation? Where are the corporate profits? Where is the growth? QE and low interest rate policy were the response of FED to the crisis of 2008. Some central banks have already gone Negative interest rate policy. But as yet, they are not working. Why? Because they are not supposed to work.

The crisis of 2008 was the result of few forces striking together — an over leveraged borrower, inflated prices of collateral and banking system with management’s hand in the cookie jar (lower provisioning and accounting gimmicks to announce record profits), resultant working capital -denied supplier and a proprietary money-desk betting on failure of the main street engineered by bank runs. When the crisis unfolded the prop-bets made a X amount of money, main-streets bets lost a 10X amount of money and banks ended up in trouble. FED’s response — lowering interest rates and priming the pump through QE was designed to recapitalize the banks and not rebalance the economy. When viewed through this lens the action of the FED makes more sense.

With low-yield funds from the FED, banks bet in the markets and earn capital gains to buffer their balance-sheets. With the balance-sheets bolstered with excess capital, the banks may, if they take fancy to it, then start lending to the main street thereby kickstarting the main-street which will hire more, jobs will come back, incomes will rise and debt will be repaid and world will be glorious once again.

This lens also tells us that FED is not going to raise interest rates any time soon. Not yet. The reason is that banking system is ever more skewed. The banks figured out way to make money for the management and shareholders without going through all that trouble. Just bet on the markets — inflate the asset prices (we are at upper end of the PE multiple band for stocks, Housing prices are recovering when quality of jobs is declining) make the bets, earn the money, keep provisioning low but DON’T announce record result as some costs have gone up. If you are wondering which costs are going up when inflation seems to have losts its mojo — don’t ask me. “The math dont add up mate!” Since provisioning is not adequate, if asset prices were to correct, banks will be in ever more trouble. The “Too big to fail” have become “If I fail you really get fucked” big. They need high asset prices and INCREASING asset prices to justify and unwind this shit.

Oh and if you want a way to fix the banking for real — fix the main street and banks will fix themselves.

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

Dollar, the International Currency system and the Ghosts of Connally

US Dollar took over as the world currency thanks to Bretton Woods 1944 at the end of the World War II. With the world facing tremendous calamity, a sensible system was put in place, incorporating the learnings from the failures of Treaty of Versailies.

Begining its inception, the European states set out on a development spree that has since remained unmatched. Even the rise of China in peacetime does not match the speed and quality of development. But with development, there appeared cracks in the Bretton Woods system. Well, not exactly the Bretton Woods system - but the currency system. There appeared an fundamental incompatibility between the unique construction of US Dollar and the structure of Bretton Woods.

The Construct of US Dollar

US Dollar created in the aftermath of American struggle for independance was gold backed as was required to be able to trade in the global system. At the early stage, US Dollar was indeed made out of gold-silver mix (1:15) and each dollar was backed by 1.60gm of gold. The gold-silver ratio was reduced to 1:16 thereby devaluing the gold equivalence which now came to 1.5gm gold for each dollar. The new coins were made by gold-silver mix so exact devaluation can be debated. However, the weights of the coins continued to be reduced over the 19th century.

This bimetallism had to be gradually dropped since the silver coin weights were reduced and later substantial silver deposits were discovered leading to wild price fluctuations. Thus US Dollar came to exclusive gold standard. The formal gold standard act backed the Dollar with 1.67gms of Gold - a smaller devaluation by itself.

Note that at the time, Pound Sterling was the dominant currency and it was exclusively backed by gold. The Pound also fluctuated in its gold peg till early 19th century where the British put in place the gold standard. Their wide-spread empire and british respect for the value of the pound contract meant it quickly became global currency. US Dollar was emulating this precedent. 

In this process the pegs to the gold were altered by World War I and subsequently in 1931 Britain gave up the Gold Standard, leaving American Dollar as strong contender for world currency. All this was formalized in 1944 at Bretton Woods.

The Second part of Bretton Woods Agreement

At Bretton Woods it was also agreed that exchange rates between some dominant currencies would be pegged to the US Dollar and they were backed by Gold. With such a policy in place, European countries started on most ambitious reconstruction plan. This was supposed to be an opportunity for the American companies and it was. But it also created many European companies who became competitive vis-a-vis their american counterparts and started a cross-flow of trade and commerce. In the process, more US Dollars were created and soon there were too many and not enough gold to back it. 

This fact was noticed by the trading community who started bidding up the Gold prices prompting John Connally to push for abandoning the gold standard. He said later "My philosophy is that all foreigners are out to screw us and it’s our job to screw them first."

The Fiat-Dollar era  

The Fiat Dollar continued its run as the global currency thanks to burgeoning US population, US growth and demand from US markets. International trade soon became thoroughly Dollarized. The dollar-peg concept went from Europe to Japan. The latest in that phase came the dollar-peg by East Asian Tigers and mainly China. These countries vountarily gave up their freedom to conduct their monetary policy - depending on prudence of the US FED. This system then created today's unique problems.

Now with US being the defacto currency in the world, US lost its ability to devalue. Faced with this situation, US followed what John Connally famously said "The dollar is our currency and it is your problem". It printed and printed and printed. And so did everyone else - by default. In effect we do not see US Dollar being devalued - the point gold bugs keep making. Without the devaluation US is not getting the turbo-boost to kick start the growth leading many to call the other countries' monetary policy as "predatory". This problem is a corollary of the famous "Impossible Trinity" or "Mundell-Fleming Trilemma".

What should be the decent international currency system?

It is now clear that monetary policy independance can be given up volantrily and also taken away by coordinated action. The solution many propose is to go back to Gold standard - which may be a good intermediate arrangement - but not a good long term arrangement. A better idea is to go for a two-level currency system. SDR may be a good starting point - but SDR's may not give us the true global currency we need.

The global currency and relatively-fixed (stable) peg to global currency could be a good system. It will leave the monetary policy freedom with national central banks and yet keep the system stable most of the time.

Readings

1. Volcker's FT Alphaville interview
2. Economist on Mundell-Fleming Trilemma
3. Yanis Varoufakis - And the weak shall suffer what they must. (book)

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

Hussman's timing may be wrong again!

John Hussman predicts epic stock crash in his recent newsletter. He says:

The financial markets are establishing an extreme that we expect investors will remember for the remainder of history, joining other memorable peers that include 1906, 1929, 1937, 1966, 1972, 2000 and 2007.

He follows up with another gem:

Enlightened members of the FOMC should even question the theoretical basis for their actions. The Phillips Curve is actually a scarcity relationship between unemployment and real wage inflation – basically, labor scarcity raises wages relative to the price of other goods (see Will The Real Phillips Curve Please Stand Up and the instructive chart from former Fed governor Richard Fisher in Eating our Seed Corn). That’s the only variant of the Phillips Curve that actually holds up in the data, and there is no evidence that this or other variants can be reliably manipulated through monetary changes.

Only long-term sustainable, predictable employment creates a turnaround. Till this I agree with him. Now comes the crucial issue of timing. Here he says:

They want to believe that the Federal Reserve has their backs; that as long as the Fed doesn’t explicitly hike interest rates, the market will move higher indefinitely. We saw one question last week that asked “What if the Fed doesn’t raise rates for another 20 years?” Let’s start with an aggressive, optimistic estimate. If we assume that despite conditions warranting two decades of zero interest rates, nominal GDP and corporate revenues will grow at their long-term historical norm of 6% annually over the coming 20 years, we would expect the total return of the S&P 500 to average about 5.5% annually over the next two decades (see Ockham’s Razor and the Market Cycle for the arithmetic behind these estimates). Even in this optimistic scenario, to imagine that this path would be smooth would have no basis in history, requiring the absence of any external shock for the entire period (and I’ve already demonstrated, I hope, that many of the worst market declines in history have been accompanied by Federal Reserve easing).

If Fed hikes, it will interfere with the risk equation causing "a breakdown in market internals" as Hussman calls it causing precipitation. But it is unlikely that Fed will hike. Fed may experiment with a token hike but may quickly reverse. Or, more likely, Fed will signal a prolonged pause (lasting more than a year or two). 

If Fed does not hike, things won't be as simple as 5.5% annual growth. It will be more. The past data behind this calculations comes from low monetary expansion era. When there is a flood of money, prices should inflate commensurately. Thus, if Fed does not hike,  S&P may average annual growth of ~10% or more for few years. 

Hence, S&P may double from here before Hussman's prediction comes true. We, no doubt, are establishing an extreme. We are confounded by its extremity.

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms". 

What we need to estimate effects of multi-country QE?

I was thinking about ways to estimate impact of QE on potential offered by different equity markets in general or asset markets in general.

Currently we do not have money inflow metrics (i.e. indexed price and volume data) for all asset classes. Nor do we have an exhaustive asset class database (types of asset classes e.g. art). Without these metrics it is difficult to construct a true impact of QE on global markets in general and specific markets in particular. Maybe someone can construct some sort of blended index.

I suspect when we do construct some quasi-indicators we will find that M3 has grown disproportionately with GDP and the difference can be explained by blended asset class inflation.

Once the global effect is understood, the specific country level effect can be understood using a parametrized gravity model. Such model will tell us how the excess liquidity will move. 

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

Yen Vs. RMB - China crippling Japanese companies?

Yves Smith asked "Has Chinese Currency Manipulation Succeeded in Breaking Japanese Manufacturers?" bringing out the effects of currency management. You can read the sorry strategic choices facing the Japanese regulators.

China is buying yen forcing appreciation that renders Japanese companies less competitive. China is also buying Japanese bonds. Now Japan must buy US Dollar to keep their exports competitive. Now, both countries are dependent on US/EU/developed world demand and hence they are fighting amongst themselves to capture the reducing developed world consumption share.

This is a problem you face when the market country undertakes QE. The supplier country has no choice but to undertake its own QE without which it suffers loss in competitiveness. The quantum of QE the supplier country must undertake is not merely equivalent to QE undertaken by market country but must also adjust for QE by other supplier countries and relative competitiveness between suppliers inter se. Thus, the supplier countries must do a lot more and therefore must face correspondingly lot more risks.

Thus, my advice to Japan would be to print till balance is restored. (This is not my optimal recommendation but I believe this will be best way to achieve their intent.

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

Non-choice in next US presidential elections

First Matt Stoller has an amazing piece up at nakedcapitalism. He is highlighting how there is no debate on essentials in this election. His quote "the two candidates are speaking not to the voters, but to the big money". This is exactly what I wrote about in my book Subverting Capitalism and Democracy.  

Big money in politics

If you want to know how much big money is influencing the process, here is another discussion about money in politics by Hacking Society where the numbers given are as below (about 1.50minutes to 3 minutes):

1. 0.26% of Americans give more than $200 in election finance for congressional election.
2. 0.05% give maximum amount to any congressional candidate.
3. 0.01% give more than $10,000
4. 0.000063% or 196 people finance 80% of the superpack money in Presidential election.

These figures are astounding! Just imagine what are these 196 people getting for all this money. In their normal day job they examine microscopically ever dollar they spend and yet they are spending all this money for superpacks? 

What will be the policies of new President?

To understanding politicians and their actions, it is important to know who they put to work for them. If you have read or seen Harry Potter, you must have learnt how important house-elves are (Dobby and Kreacher). Many commentators cribbed how there was no change between the economic and financial advisors in Bush era and Obama era. Matt Stollers points out that "Obama appointed Erskine Bowles. - Clinton put Erskine Bowles, a conservative Democrat, in charge of the effort o work with Newt Gingrich to cut Social Security for recipients and pour some of the Social Security trust fund into the booming stock market".

So essentially, Americans are faced with nothing new in policy initiatives and at worst drastic cutbacks in social security and other benefits.

---

Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".

LIBOR and US Dollar

The ongoing Libor scandal is interesting to watch for other reasons as well.

First, Libor is benchmark against all the debt-risk is priced. Ok, Us treasury yields are the main benchmark, but Libor performs quite similar function. What the scandal tells us is than since last so many years this benchmark was flawed. Therefore, real Libor must be something different and hence the risk linked to it must be adequately readjusted.

Second, how will you readjust the risk without knowing what the benchmark should be. In geometry a similar problem occurs when there is a change of origin. When axes or origin are/is changed the coordinates make no sense unless you know the coordinates of new origin as per the old axis. It creates a hell lot of confusion in the geometry class when this concept is taught. Same confusion can be caused in debt markets as well. Bankers will need to reprice the debt.

Same is true with US Dollar

We really don't know what is the real value of dollar but we know value of all other currencies relative to the dollar. So watch the Libor scandal unravel will point us to important lessons for dollar. So watch carefully!

---

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.

---

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.

---

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

Explaining Currency Valuation

My attempts to explain currency value continue. I was thinking how we tend get caught up with mechanical determinants of currency value. One way of thinking about currency is to think about two different things. First being capability of the nation and second being a mechanism to measure it.

Capability

Capability refers to ability of the country to produce surplus benefit. I am deliberately using vague terms because what one nation construes as benefit may not be the same for others. But key term is surplus. Surplus implies the nation must produce more than it needs for subsistence. So benefit must be discretionary.

The Mechanism

The mechanism to measure it is simply numerical denominator of that value into discrete quanta. If the denominator is high, we can split the value into smaller parts - more numerous shares within the pie but size of the total pie remains the same.

Understanding the complexity of currency valuation

Imagine there are 100 units of currency and 100 widgets (all exactly the same). The equivalence is 1unit of currency for 1 widget. This is a stable version of ideal.

Let us introduce a slight complexity. Imagine, suddenly we have 200 units of currency instead of 100, the equivalence will be 2 units of currency for 1 widget. This is called inflation.

Let us bring add a little more complexity. In this, the number of widgets also keeps growing as does the currency. Now there are three scenarios. 

1. Widgets grow to 200 and currency also grows to 200. Here we have continuity in ideal situation.
2. Widgets grow to 200 currency grows only to 150. Here we have deflation.
3. Widgets only grow to 200 but currency grows to 400. This amounts to inflation.

Now imagine instead of just one type of widget we have two types of widgets. First one is food widget which is highly in demand and other is fun widget which comes after food. Now imagine if an economy produces only fun widgets and there are not enough food widgets for the population. In such case, food inflation will spike up - i.e. currency value of food widgets will grow higher and that of fun widget, naturally, will grow lower.

Now reality is far more complex. Instead of few types of widgets, we have vastly innumerable and ever expanding universe of products and services. Further, each product does not have same relative position to the universe, they keep changing. In other words its chaotic.

The question, therefore, is how to ascertain how much increase in currency is ideal. Clearly, there is no easy answer.

Cannot decipher if currency is correctly valued 

Never, and I am going out on a limb here, is a currency correctly valued as per its fundamentals. Rather, the value of currency is the opinion of select few stating that value is within ball-park. It is relatively easier to know when a currency is not in ballpark of its fundamental value.  In other words, while we cannot determine what the value of currency should be, we can be reasonably certain what it should NOT be. Any analysis beyond this is self-justification or retrofitting explanation to suit analysis.

Borrowing from Physics, currency values seem to obey something similar to the Heisenberg's Uncertainty principle. We can predict the value of any currency generally, but never exactly. And just like the Heisenberg's principle, the very act of determining the value upsets the value.

What should NOT be the value of the currency?

The key lies in looking at the "benefit" we stated earlier. "Benefit" is net of two things. On one hand, lets call it the income side, it includes the ability to produce larger number of widgets (productivity), the ability to produce wider variety of widget (innovation) and the ability to produce unique widgets (strategic advantage). On the expense side, we have committed expenditure including non-discretionary spending and part of income committed to taxes and debt repayment. Benefit, to reiterate, is net of these two things.

When we compare currencies of two nations, if the difference in benefit is largely or appreciably in favour of one, then the currency of that nation should be strong and other should be weak. Again, we cannot exactly determine the difference as discussed earlier but only generally.

About US dollar
My contention is that US Dollar is artificially high considering US economy offers no particularly differentiated benefit as compared to other economies. This is also generally true of all developed nations. That is why I am skeptical of developed economy currencies.

---

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

US Dollar views

I am starting a new initiative. I will hereafter add videos rather than posts. Here is the first one on US dollar.