Counter intuitive = Low rates / ZIRP/NIRP policies are actually bad for economy

We are told that when interest rates are too low, they are encouraging entrepreneurs to take risk. So we have low interest rate policy LIRP, Zero interest rate policy, ZIRP and negative interest rate policy NIRP.

However, these policies impacts the business models differently. At one end are business models, like infrastructure projects, that cannot add threshold value in the initial years of the venture. The low interest rate regime, allows a valuable gestation period for such business models. Often, government artificially lowers interest rates for such projects. At the other extreme, there are weak business models, those that are viable only in low return scenario. These business models, however, die out once the interest rates start rising. In between, there are experimental and innovative business models. Some of these use the low interest rate period to forge better, more robust models. Such businesses thrive later. Others, however, end up going bust. The role of banks is to identify each of these business models and fund them while appropriately mitigating the risks. 

How low interest rate leads to mal-investment 

A bank takes risk by investing in a venture. Interest rate is also a reward bankers get, for taking the risk. Ideally, even in lower interest rate scenario, those projects with best risk-return trade-off should get financed. 

However, in reality, lower yielding large borrowings backed by reputed corporates get access to financing more easily than new ventures. This means, irrational mega-projects or mal-investments of large corporates get financed at the cost of genuine investments of new ventures. Typically, such irrational mega-projects consume a lot of credit requiring load syndication. This has twin benefits for bankers. 

First, there is a higher degree of comfort in being with the herd. Secondly, bankers do not have to go through credit appraisal of many small entities of questionable risk profile. This makes them assign a lower risk to these projects than appropriate. Intelligent investors will find that this contradicts with the "diversification as risk management" strategy. But being with herd has a stronger lure and is treated as risk mitigation (though wrongly).

Further, at lower interest rates, debt starts being used as an instrument to amplify equity returns. With unchanged return on capital employed, you can have higher return on equity when return on debt reduces. Return on debt is function of interest rates and lower share it claims from the total returns made by the firms. 

Thus the second blow to new ventures comes from crowding out. It implies that even in a low interest rate environment, small businesses and entrepreneurs may not have access to lower cost capital. Therefore this impacts the long-term strength of the economy. 

In high interest rate scenario, the irrational mega-projects seem less promising. Hence, contrary to popular belief, it may be easier for smaller businesses to compete in high interest rate scenarios.

This is particularly true when there is some demand in the system.

What happens when there is no demand?

When there is no demand in the economy, low interest rates / ZIRP / NIRP etc are said to stimulate this demand. This, to my simplistic mind, sounds like offering desserts to the already overfed diner  (AOD) with the hope to eliminate world hunger. Let me explain.

We hope this AOD, when offered with a free desserts will take them and pass them along to the hungry. In this method we depend on the magnanimity of intentions of our already overfed diner. Then we presume he shall act on his instincts and find worthy hungry who can transmit the benefits to others. It is quite possible our Glutton may pass the desserts to his friends or family and each can be a little more fatter. Are we, then to wait for all the gluttons to be severly beefed up or porked up before the trickle down starts to the hungry?

It sound like bull-shit method to me. Particularly I cannot understand why you are preventing the hungry from feeding themselves - either by employing them or letting entrepreneurs do it by financing them with reasonably priced debt/credit. These entrepreneurs are left to finance their ventures with credit cards, overdrafts and other very high cost financings at considerable peril. Now since these financing schemes are not on the business side, they are paid out of the post-tax income generated by the firm (but they should have been tax deductable at firm stage itself). This is doubly onerous for the entrepreneurs. 

Treat Interest rate like friction

A better model is to think of interest rate like engineers think of friction. Some is good, too much is bad, too little is bad too. In fact friction analogy should be best suited for determining neutral rate of interest. 

Economist too think of interest rate as friction. To the economist - road mileage of the car represents growth, fuel represents capital availability or liquidity. The economists' metaphor of friction is flawed. They need to get their metaphor right.

Engineers will tell you - you need to maximize friction at the tyres and eliminate it from the engines. At the clutch and brakes too you need friction. So you need interest rates high at some places and low at some others. So Economists better figure out where you want low interest rates and where you want high interest rates. Note the question is where not when. 

In Sum

The hazards of the LIRP, ZIRP and NIRP far outweigh the benefits. These policies do not pass the smell test. We need a better understanding of interest rate as a tool for improving economic growth.

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Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms". A version of this argument was made in Subverting Capitalism back in 2010 and also posted on this blog in 2012. Nothing, it appears, has changed.

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)

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

Capitalism V Democracy - Yanis Varoufakis

Yesterday, I saw the TED talk by Yanis Varoufakis (linked below) titled Capitalism will eat democracy: unless we speak up. It is quite a watch so I embed it here.

His suggestion is that we have to choose between a Matrix like dystopia v/s a Star Trek like utopia. The primary observation is that unbridled capitalism will ensure that the democracy works for the super rich but not for the poor. I agree with him as an assessment of the present state of affairs. But that does not cover the issue fully.

Capitalism can eat democracy but what about the reverse?
While it is true that democracy cannot eat up capitalism, politicians can. We have it happening right now - in India, China, Russia etc. These politicians become businessmen and plunder the country. This is no true politics but predatory politics can impair the la and order machinery to quickly discend into anarchy.

Crony capitalism v servile democracy v servile capitalism
Crony capitalism is a misnomer. A crony means friend - sort of an equal. But this is not a relationship between equals.

The government officers and politicians are eager to serve the capitalist. When chairman or office bearers of NRA speak they listen - not both sides listen but enough people on both sides listen. If Zuckerberg or Paige or Dimon or Buffet were to say something both parties will listen. I read somewhere that 80% of 2013 US presidential election funding was made by 150 odd individuals. Please tell me their views carry the same weight as mine. This is servile democracy. Yanis Varoufakis talked about Larry Summers (in other talk in Austin) telling him that if he becomes an insider then he will be given magical things. That is servile democracy not crony capitalism. This is a rich man trying to train a dog with dog biscuits.

There is other side to this too. In India businessmen are servile and politicians are the lord-masters. Things have changed - but not too much. It is easy to scuttle a truly new challenger to established business houses. If you take the paper spending on infrastruture - India can have better infrastructure than the very best countries in Europe - may be twice over. This is servile capitalism. There are whole networks that have come up around these politicians to create extortionist "business models".

Where will the fight between capitalism and democracy lead us is anybody's guess! But one thing is clear.

Capitalism and Democracy as competing systems

Capitalism and democracy are said to be collaborating or complementing systems. But we should start thinking of capitalism (more specifically markets) and democracy (specifically government) as both competing and complementing systems together. They both allow the masses to exercise their opinions. Marktes allows the individual to exercise it through buying i.e. through markets, democracy allows him to exercise it by voting in a government.

Now buying is something we do almost every day. Thus, we this part of the system is more evolved, sensitive. This system is also keenly improving itself to make sure the customer preferences are communicated to the top - it is thus more efficient than the political system. But let us remember they can be inefficient too.

The political system works like a broken market system. Here the opinion or choice of majority is forced on everyone. Imagine if markets worked like democracy - everyone may be forced to wear XXL size blue man shirt (coz majority favours it). 

By now you must think that they operate in different spheres and so it is not a problem. But it is! Notice that the burden on government to make itself more palatable to all of its citizens not just the majority is quite high. It is higher than the burden on market to service all types of demand. That is because there is an alternative when market fails to understand the opinion of minority - some niche player can fill it. In case of government - there is no niche player alternative. Therefore, Government must be held accountable more than the capitalist. And it must uphold the rule of lawso as to ensure capitalism is working smoothly.

Just think - marxism is actually a response to servile politics impairing the demands of working class (the proletarait) by the capitalist (bourgeoisie) who were friends of politicians/rulers. Then the Soveit collapse was actually a response to the politicians exploiting the political system to their economic advantage. In some way reverse of the first wave.

So the point is...

We need a mechanism to ensure the bargaining power between capitalism and democracy is maintained. Without such a mechanism we may end up in some trap or the other.

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The ideas expressed in this post first appeared in my book  Subverting Capitalism and Democracy. Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms". 

Why is resolving Non-Performing Loans (NPL) is so difficult?

The management/resolution of NPLs has acquired renewed focus with banking sector under stress for many years. The Economist comments on it this time about Italy's NPL problem. More significant is the commentary on various approaches, IMF recommendations, KKR's Pillarstone initiative etc. making it a must read. But it misses some quite important issues with respect to NPLs in general.

Failure of NPL liquidation - some blame lies with Accountants

The PwCs, EYs, Deloittes and their ilk must take some blame. Many of the bad loans have accounting folly at its heart - some deliberate and some not, some before loans are made and some after. Time and again, accounting firms have washed their hands off their audit responsibility and liabilities arising therefrom. Recently some firm has sued PwC for their failure to report material issues. If auditors completely trust the company managements they are auditing, then the purpose of the audit is not satisfied. 

The shady entrepreneurs

The proportion of shady, shifty characters in this distressed assets pool is quite high. Some distressed loan assets are deliberately impaired on the books for tax fraud or money laundering. Data mining algorithms cannot detect this - even analyst cannot easily detect this. Such frauds have to be sniffed out - at least till Artifical intelligence becomes more robust.

Slow courts and costly Alternate Dispute resolution (Arbitration, mediation etc.) mechanisms

Invariably, a fair proportion of the distressed asset pool goes for legal resolution. NPL problems are higher in countries with weaker judicial controls, higher cost dispute resolution. The process of dispute resolution quickly unravels both the ability to pay and gives a remarkbly clear insight as to the intention to repay. However if the process is too slow and too costly, it defeats the purpose. This is a problem in Italy and also in India.

Much blame lies on Incompetent Banks

The substantial blame though must lie with the bankers:

1. Lack of accounting analysis skills: Many banks which make loans cannot make proper assessment of accounting statements. Data mining algorithms are good at assessing the "ability to pay". They cannot assess the "intention to pay". Lack of Intention to Pay has created many NPLs.
2. Illogical the use of collaterals: Banks are notorious in having collateral that is highly correlated with loan asset itself, over-valued or pledged in part to many. This is a childish mistake to make for a professional setup. At times, an intellectually superior form of syndicated lending (the whole syndicate holds one collateral) is used. When trouble strikes the legal disputes arise within the syndicate itself. 
3. Poorly-constructed contracts with borrowers: Such contracts make the payments unpredictable in quantum and timing thus surprising the borrower. It quickly cascades into penalties and surcharges and it goes downhill from there.
4. Too Centralized decision making as to loan eligibility: Most borrower eligibility tests are done centrally these days. Thus it leaves no incentive for the bank manager / officer to dig deeper into the borrower's records. It makes the incentives wrongly aligned.
5. Flawed loan portfolio construction: Loan portfolios are too correlated This is a result of too much market focus. Banks push certain products that they find easy to sell - consumer loans, credit cards, personal loans etc. When the lending starts concentrating they do not quickly take corrective actions to balance the portfolio. If the banks' entire portfolio comes under stress at the same time, it cascades into more distress.

Basics of borrower assessment

Any borrower assessment has two component - ability to pay AND the commitment or the intention to pay. Sometimes the last two differentiated. The ability to pay is well understood which refers to  the capacity to bear the repayment of the loans. The intention to pay tries to determine if the borrower intends to cheat or not. The commitment to pay points to whether the borrower intends to pay  but disputes the computation of the payment and hence may have withheld the payments - committed but not paying, or the borrower does not intend to pay at all and is finding loopholes to delay the foreclosure process.

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

Free Trade - or no free Trade - either ways it ain't free!

Econgirl commented about the latest free-trade issue.  It is a must read - continue down to the comments too! Then David Henderson commented about it on his blog and the comments where @econgirl responded to his question. All must read in the overall dialogue about free trade.

There are a few things that need consideration:

1. The losers of free-trade - how adaptable they remain after they lose: In many cases, these people are lost - this is a political price we are paying. Thus, a $10 gain per-consumer v/s say a total job loss of 10,000 people (hypothetical primary loss) usually it remains concentrated (think Detroit) and second and third order economic losses. Now in monetary terms, the gain-loss may be whatever, but when a group of people loses their livelihood without any margin or buffer to create new opportunities for themselves, then it makes for a difficult choice.
2. The initial condition is responsible for the losers being as many as they currently are: If the trade was always free, the adjustment would have taken place a long time ago, giving the population enough margin to adjust. However, the governments by their initial protectionist intervention create a bigger adjustment problem in the future. When a competency develops in a country, the government rallies behind the firms with the very policies which later accumulate into a bigger problem. The adjustment to new potential trade-based threat can be innovation or it can be defeat. The auto-industry failed to innovate - something Tesla did, Ford and GM should have done years ago. But those are victims of their own success. At present, China is funding auto-tech companies to bring out a competitor to Tesla. 
3. Free trade - v/s Fair trade: Indeed some countries do "dump" products on to other markets. At the same time, some countries do use "non-tariff barriers" for the protection of domestic industry. When is the "fire-sale" not dumping and when "non-tariff barriers" are not protectionist can only be answered on a case-by-case basis. This ambiguity is used to target Free-trade unfairly. 
4. Economic V/s moral - politics enters through morality: Can we allow some trade partner using slave labour to create losses in our country? Economics says why not, morality says no. Blood diamonds are an example. That is where politics comes in. So while overall benefits of free trade may be high - the morality over why the government should not choose one set over other is a strong political motive against change of status quo. Of course people selectively forget that it was government intervention that helped the problem to get bigger.

So in an ideal case:

• Free Trade is the default. Government has no business interfering in that unless some moral issue arises. The scope of these issues are pretty narrow - slavery etc.
• Countries should progressively move all policy towards sector neutrality - including trade policy. Thus, a government would be right to have 50% markup over all goods/services entering the country/sold in the country without discrimination.
• Then let this state continue and let governments step away from the issue altogether. (more on this in another post).

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

Irrational Exuberance in Asia - Ghosts of Greenspan in India and China

William Pesek writes an interesting column about easy monetary policies (relatively) in Asia. The central point in the article is that there is a distinct need for reform in Asia; the reform is structural - fiscal and political in nature; the reform is ignored and monetary policy is being used to boost "sentiment"; this cannot last.

I agree with the undertone of the article though there are few distinctions I would draw:

1. The outline of reform in Asia Ex-Japan is well known. 
1. It is a well-trodden path by the developed economies. 
2. What is lacking is either the political will or weaker systems that need reform.
3. For political will there has to be some margin in growth. This margin was afforded by a developed country demand for developing country goods.
2. The other reason Central bankers of developing countries are a bit easy with the punch-bowl refills is because the principle strategy for growth is by tagging on to the developed country band-wagon and compete on differentials. 
1. This strategy requires competitive exchange rate mechanisms while maintaining investment-ability in countries assets.
2. The so-called monetary tightness / monetary reform have been triggered by either of these two requirements.
3. Thus, central bankers must keep relative position with developed country monetary policy and amongst each other. Thus if one developing country does QE then it becomes imperative for others to follow in order to maintain export competitiveness.
4. Changing track from this strategy is difficult during good times and becomes almost impossible when the developed markets are going through a weak economic growth phase.
5. Even Japan is attached to this strategy.

Thus the irrational exuberance carries forward from US monetary policy. It cannot be attributed to developing countries. What can be blamed on developing countries is their lack of will to develop an alternative model that can sustain the dreams and aspirations of their peoples.

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Comparing Euro with US-China - MMT

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

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

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

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

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

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

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

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

Notes:

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

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

Global Realignment of Economic Power

Just days before I was thinking how this feels like pre-Bear Sterns days and today Yves Smith has a post titled Shades of 2007. It indeed does feel like it. In a way, there is nothing new. We know how it will end.

However, I fear there is more coming. Something more interesting that we haven't really thought about.

I believe, soon we should enter an era of realignment of economic power. We tend to believe the west is generally rich. But it may soon change. As the screws of austerity will tighten across EU and even the US, the developed world may realize that they are not so rich after all.

To say that such a realignment will be challenging will be an understatement. We will have to evaluate the correct value of each currency, rework the location of manufacturing capacities and realize that the savers of the world will be real demand drivers of global consumption. The process is likely to take 2-3 decades or more.

The question that consumes me, how should we preserve and increase our wealth?

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