Why is the current easy-monetary policy ineffective?

Ben Inker, head of GMO's Asset Allocation team had a great article this quarter.

It has been the extended period of time in which extremely low interest rates, quantitative easing, and other expansionary monetary policies have failed to either push real economic activity materially higher or cause in ation to rise. The establishment macroeconomic theory says one or the other or both should have happened by now. It seems to us that there are two basic possibilities for why the theory was wrong. 

The first is a secular stagnation explanation of the type proposed by Larry Summers and others. 

The second possibility for why extraordinarily easy monetary policy has not had the expected effects on the economy and prices is an even simpler one: Monetary policy simply isn’t that powerful. is line of argument (which Jeremy Grantham has written about a fair bit over the years) suggests that the reason why monetary policy hasn’t had the expected impact on the real economy is that monetary policy’s connection to the real economy is fairly tenuous.

In this context, there are some important aspects.

First, monetary policy and economy are connected to each other by feedback loops. By now, every market participant knows that if there is any inflation up-tick the monetary policy will be tightened. This information prods the participants in asset classes where the inflation impact will be low. A look at inflation basket will tell us which are these sectors where price runs will not affect inflation. Exotic assets are in fashion for this reason. Art, diamonds, high-end real estate (trophy), luxury items etc all form part of this group.

Second, why does the low-cost debt not push investment for improving productivity for general items that form part of the inflation basket? The answer is there is no demand. When the market concludes that there is a substantial demand to justify the investment then the investments will come. There is no demand because there is excess capacity, predominantly in China for manufactured goods. This is the reason monetary policy is not effective. 

Monetary policy is effective when there is underlying demand is strong. Without demand monetary policy is just an enabling environment for nothing in particular.  That the monetary policy is not working is itself a data point. It is telling us that the masses do not have the purchasing power to fuel a demand pick-up. There are two reasons.

Most of these masses derive their incomes from the products that make up the inflation basket. If inflation remains subdued, their incomes remain subdued. The low-interest rate has reduced the cost of capital meaning it is cheaper to deploy robots instead of people. So in fact machines are replacing some jobs. These two factors currently suppress the purchasing power. To compensate, people want to build higher threshold of income-level before they start consuming normally. So, the general population is busy buttressing their purchasing power. 

The second reason is that the pre-crisis demand was inflated by debt. The low-cost debt created a hyper-demand which may never return. At the same time, the debts from the past consumption binge have come due. So the indebted families are busy working their debts off. If all the debts of the bottom 50% of the population were simply forgiven, it would have been cheaper than QE. But it would have immediately buttressed the purchasing power of the masses. 

It is a complicated explanation, but it cannot be simplified any more. When feedback systems are interacting, you will get complexity.

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Is assessment of risk a function of interest rate?

The interest rate that can be charged by the bank has  two limits.

The Lower bound equals what the central bank charges the bank. Any lower and the bank will make a loss on its lending portfolio.

The Upper bound is the ability of the risk taker to bear the burden of return. Thus, if a bank lends to a business that makes 10% return on capital employed - it cannot charge more than 10% else it will be unviable for the borrower to seek the debt at all.

The Actual interest rate charged is determined by a combination of the following factors:

1. An assessment of returns of the business based on the economy and her business 
2. Income of the borrower in total 
3. The value of the collateral pledged against the loan as a security should the borrower be unable to bear that return 
4. The demand for loans AND/OR
5. How well the other loans are doing (health of bank's loan portfolio) AND/OR
6. A combination of these along with global factors

Spread

Bankers think of returns as spread they make on top of the lower bound, i.e. rate set by the central bank. 

Risk V/s Spread

Now, in the mind of the banker risk is correlated with the spread. When the banker perceives higher risk she fattens the spread. This "risk" we talk about is risk resulting to the banker. It does not mean risk of the borrower alone. So if the bankers' portfolio is turning bad, the banker will still increase the spread - partly to compensate for the loss she suffers and partly because she assesses the general economic environment to be more risky. Thus, even if the central bank reduces the benchmark interest rate, the banker is reluctant to pass it on if she can avoid it. This creates tighter conditions putting more stress on the borrower. This is why Scot Sumner argues the monetary conditions were actually tight when we were almost at ZIRP.

In an economy that is weak, it acts as a stronger head wind for borrowers. It reduces their ability to borrow and to service their current borrowing. They want to pay down their debt and reduce their loans. Therefore, the economy contracts further. The banks seem happy at first, but soon realise that other borrowers who are not prudent are pushed to default. The implication of this on the bank depends on the mechanics of the process - the proportion of those who default v/s those who pay back, the chronology in which it happens etc.

In the next phase, the economy recovers, predominantly with equity capital. Equity can absorb the losses since it is built for higher risk. The surviving firms and individuals are left with core strength to  thrive in intense competition and are more prudent with capital allocation. The banks thereafter can lend to these survivors to help them scale up.

What does this mean?

This means, 

1. There is inherent value to competitiveness that signifies its ability to survive and repay the debt and repay the equity at decent returns. This ability reduces with increasing leverage by the borrowers. Thus when Anat Admati suggests investment banks have capped leverage ratios to 20 or 10 it makes sense.
2. Banks' business model seems to encourage the use of debt only to amplify equity returns. It is fine in a way but if that is the objective then banks should reduce/cut lending at lot earlier than they do. Naturally, in times of distress when the return ON capital matters lesser than the return OF capital, banks get into big trouble. It seems they get confused about what is their business model. 
3. Maybe, better than ZIRP, unleashing a new Government-backed Good Bank to pick up assets at distressed prices at lending rates with narrow and fixed spreads can work better. If the size of this bank is large enough in relation to the banking system, it may result in a lesser shock to the economy.

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Yeah! On Brexit!

Yeah Brexit is a reality! Signifies a few things:

1. Politicians have misused / abused the Brexit debate
1. The political and ruling classes are disconnected from the realities faced by the worker class. A sort of marxist dream has come true. Not only can't the politicians talk reasonably with the masses but they also don't seem to care. John Mauldin highlighted Peggy Noonan's protected v/s unprotected rationale - it is playing out now. Necessary corollary - we might be looking at a Trump victory.
2. A sub-set of the worker class problem is the migrant issue. The migrants coming into do have a group of anti-community / anti-EU society that has entered EU creating social tension. While, most of the migrants are male - a statistic that is queer for war-related migration. I would have thought it should be more women and children (as per UN 62% of all migrants out of 800,000 that have traveled to Europe in 2015 are men). 
3. Sadly, this has confused the domestic worker class about rational economic threat to their incomes and political threat to safety and well being. The first is short term set-back but results in long term prosperity. The second is a bit scary. The pro-Brexit vote is more because of second than first.
2. Media hasn't done its bit to inform the average person.
1. Media's lack of responsibility since the crisis has been alarming. But the polarised opinion on Brexit put up by media are disappointing. 
2. The irrational rabble rousing has overwhelmed the thoughtful assessments and complexity of the issues has been trivialised. 
3. Common people in developed countries are going to loose
1. The discrepancy between easy capital mobility and difficult labour mobility affects the working class. If left unresolved, we will end up with capital controls. (Yeah it is a long way away but we are on that road). Alternatively, we can hope that labour mobility will ease up and people will realise their folly. 
4. Our lack of understanding of economics has come to haunt us.
1. Currently, only low income-low skilled people from under-developed countries want to migrate to developed countries because these people are squeezed to be producers in their own country. Similarly, the developed country people are tickled into consuming more than they can afford so that the status quo continues. The developed world citizens do not want to impair their life-style by migrating to developing countries. (That is because developing countries make it difficult to get the same life-style as developed countries - I mean in terms of law and order and quality of education etc.). This one-way traffic had to stop some time.
2. With cheap capital, replacing a low-skill worker by expensive robots is feasible. This pains the working class no end. These people are caught between rock and hard place. They are being forced to go down to low-skill but on-site jobs. (the famous McJobs!)
3. It is this anxiety that has been exploited for Brexit. So part of the blame goes to the economist and finance experts too. These are the very people who look shocked at Brexit vote.

After Brexit what next?

1. In an age of increasing inter-connectedness a Brexit vote is first step trying to reverse the globalisation. There are reasons why anti-globalisation forces have followers - I wrote about this messy intermediate globalised system that is straining the worker class. But advantage really lies in globalisation and not protectionism.
2. Unfortunately, the competitive raising of protectionist barriers will only increase. Marine Le Pen is demanding referendum for France. The northern EU members and Germany will soon be left looking stupid. So instead of PIGS defaulting and exiting - non-PIGS will drop off the union.
3. The war on globalisation had to fought on "sovereignty" issue. It is a political war connected with Swiss bank hidden wealth, Tax havens and other "loop holes". 
4. Once successful politically, these initiatives will turn on economic policy. The good work of integrating the world will be undone by economic and fiscal policies. 

Brexit will be a slow poison

The consequences of Brexit are far more dangerous but they will take time to play out. That means markets and asset prices will remain volatile. Consequently, long term investment in future shall remain the exclusive domain of governments. Add to this the renewed focus on austerity - 1937 looms all over again.

So it is said - may you live in interesting times.

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

Money Supply and GDP growth

Here is a chart I made showing money supply v/s GDP growth of top 4 developed economies. Tell me what do you think about this.

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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!

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

DJIA 1920-1940

A lot of people are drawing parallels between 1930-31 and today. I thought let me post a chart of  DJIA over that period to understand what it means for us.

Courtesy: Stockcharts

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

War between Democracy and Capitalism

A few days ago Greek PM decided to take a referendum about EU bailout package. It represented an opportunity for democracy to validate capitalism. Alas pseudo-capitalists arm-twisted Greece into backing out of a momentous occasion. Today, markets are cheering, if you believe the talking heads on TV, resignation of Italian PM. I find that alarming. 

Frankly, today's EU is the theater of war between capitalism and democracy. Well, the capitalism here is pseudo-capitalism. I cannot believe why capitalism should be at logger heads with democracy. In any case, I must warn that this is all taking turn for the worse.

Any significant victory of capitalism against democracy should be, will be short-lived. The rights that create and nurture capitalism sprout from fertile bed of democracy. The problem is once capitalism tries to thwart democracy, it may have to deal with a horrible backlash - a move towards socialism. It is a situation I hate.

The world needs someone with the vision of John Pierpont Morgan who can confine some of the big-wigs in a room and talk some sense into them. Sadly, none comes to mind - the whole pack is short of ideas and, more importantly, morals.

 Apologetic plug - I discuss a possible win-win outcome in my book link below.

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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.

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

Can China become a Consumer-economy quickly?

In its latest issue The Economist says

It would hasten the reorientation of China’s economy from exports to consumer spending, give its central bank more freedom to fight inflation, and divert demand to depressed Europe and America, catalysing an essential rebalancing of the global economy.

I contend that it is not easy to create a domestic-demand focussed economy or consumer economy as we call it. In my June 2009 post titled "China domestic demand and other notes", I explained:

Creating domestic markets is not easy and does not simply happen by throwing capital. Domestic tastes and preferences, as we see in India, are lot different than we anticipated. Same logic should hold for China. It is easier to customize goods (and services like restaurant services) are easy to manage – but inflexible goods (capital goods e.g.) take long time. The changes cascade from consumer side till they reach the top end. Examples:

1. A large part of textile industry may be geared to service cotton clothes – whereas Chinese might prefer silk. (OK I simplified it a bit too much)  
2. You take milk, some producers added some hormones to aid milk production. Resulting milk was not safe for children. Now we need institutions, legal, regulatory etc that create a feedback system to discover and curb such practices. These complex frameworks anchors in democratic setup – leading us to political minefield.

If someone clarified the entrepreneurial scene – we may actually get better clues about domestic demand. Large entrepreneurial pool backed by venture funds experimenting with products and distribution is the best way to create (and an indicator for thriving or potentially thriving) domestic market.

The easiest part of domestic demand stimulus is to allow top brands to enter the domestic market and give them some price leeway through currency appreciation. Louis Vitton bags, Chanel perfumes etc will kick start domestic consumption faster.

What is a consumer economy?
I must reiterate that consumer-economy is not a simple concept. It represents a system with various parts    many contradicting the political climate in China.

Principle of Choice: Consumer economy is under-pinned by a principle of choice. The consumers get choice and their choosing creates a feedback loop that allows such preferences to be incorporated into national manufacturing and service capacities. Let me give and example.

Imagine a population that fancies, say, sour cream flavoured potato chips, but without any chips manufacturing capacity it does not yet know of it. Manufacturers must experiment with various flavours and then, by trial and error, or through research, arrive at this conclusion. This implies a cycle of investment in various flavours which gets wasted, stock outs of preferred flavours and large inventories of less preferred ones etc.

Principle of Consumer orientation: A consumer economy must necessarily be consumer oriented. I am sure you have noted the pun but people often forget this. Existence of choice necessitates competition and, hopefully, benefit of the consumer rises to the top of priority list. This seemingly simple mechanism is very difficult to implement. Milk producers can collude in using hormones or additives that may be detrimental to consumers and rival producers should feel free to expose such practices rather than cower and join forces with them.

Institutions of dispute resolution: A mechanism of choice and consumer orientation, as discussed above, leads to disputes and conflicts. A system of institution is required for resolution. Independent courts and free press are part of such institutions.

Political implications

Thus we observe the congruence between democratic principles in political systems and consumer orientation in economic systems. Both these systems feed off each other and reinforce each other. In the democratic world, we almost take this congruence for granted. It is this congruence that is critical problem for Chinese authorities. Therefore I don't believe the process of reorienting China into a consumer economy is going to be easy without corresponding political reform. But we can always wait and watch, I will be happy to be proven wrong.

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

  

Understanding the behaviour of the US Dollar

I have often written about mainstream media missing the bigger picture about the US Dollar. I always wondered how some of the astute commentators, some I respect highly, would miss the bigger picture. I have been asked why, despite my talk about US macro weakness, does the USD appreciate in times of risk aversion. I think I should take one more shot at explaining one aspect of the US Dollar issue.

Dollar behavior is aggregate of multiple forces

The US dollar is influenced by following forces:

1. Adjustment of US economic activity in terms of skill, ability and productivity of the population. 
• With rising capital intensity the minimum qualification requirements are changing. This change is not in sync with the US population in terms of availability of skill, ability and productivity. 
• I know some people will react to inclusion of productivity in the list, but careful assessment will indicate its aptness. 
• This adjustment is rather complex and will take years to play out. Thus the effect of this force, my guess is, will be rather small at the moment. However, once the realization is complete, there may be a drastic impact on the US Dollar.
• This force will augment a devaluation of US dollar.
• In geek-speak, since force is a vector, both the magnitude and direction of this force are not  manifesting itself effectively as yet. The magnitude is small and direction may be opposite to what can be expected.
2. Forces creating adjustment of prices. 
• The term price has two elements to it. First one represents the information about how relative value of goods and services stack up against each other, or simply inter-goods comparison. The Second and more relevant for us is the information about how the value of goods stack up in relation to those in other countries, or simply, price comparison between countries for similar goods. 
• My sense is that relative prices of non-food goods and services are far cheaper in developed economies than in emerging market economies (though not for all products and services). 
• As we establish clarity in this, we will see inflation in USD terms while deflation in other currencies if they let their currencies float to their natural level. However many countries have pegged currencies, particularly those with large dollar reserves. The pegging process will create inflationary forces in these countries as well. Their central banks thereafter will be forced to choose between inflation and losses on external account. It appears they will prefer losses than inflation. 
• This will be devaluing force for the US dollar.
3. Risk Aversion forcing the US Dollar denominated money to return home. 
• One of the tenets of risk aversion is that during such times investor feels safer at home, keeping money in her own currency. It is a fact that US has been biggest investor for some time now and hence risk aversion creates a demand for dollars. 
• The fact to be noted is that this is mostly private investment and hence more fickle.
• This force is supporting the US dollar.
• At the moment, this force has the right magnitude and direction to support US Dollar appreciation.
4. Subdued Capital withdrawal by those with US Dollar reserves - particularly China and Japan. 
• For reasons best known to them China and Japan have continued to pledge their support to the USD. China with nearly 3.2 trillion USD and Japan with 1.1 trillion hold considerable sway in the market. 
• Here the investments are initiated by the respective governments and thus more stable but changes can be abrupt. It is sort of a dormant volcano, if it erupts, there will be tremendous loss. Similarly, if, for any reason, any tiny bit of doubt crops up in these governments, we will see tremendous meltdown.

Interpreting US Dollar movement

It is important to know the forces above and what impact they have on the US Dollar movements. We realize that most of the devaluation forces are diffused and their magnitude is small. However, a keen investor will realize that the alignment between these forces is increasing and we may soon reach a tipping point in favor of devaluation. Further, the forces supporting the US Dollar are fickle and may reverse quite quickly.

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

Limits to total capital in the system

One of the implication of the crisis is that there is a limit to total capital in the system. While the statement is simplistic, it has more sophisticated underpinnings. In a sense, we collectively found that there is too much capital in the system and too little stock of assets, goods, services etc (hereafter simply referred as assets and goods) to show for it.

Clearly at some point we realized that our stock of assets and goods contains too many derivatives  and too few real assets and goods. At such point the capital locked in or residing in some of these derivatives (the bad ones specifically) was under risk. Economists would call this misallocated capital. This capital should have evaporated in a true capitalist system so as to keep the Darwinian selection mechanism healthy.

Yet, what happened was transfer of this mal-investment to government and hence to public shoulders. By virtue of the fact that governments cannot be obliterated, the capital must also continue to burden us till the government sees light of the day.

Whatever the reality, the crisis does indicate a threshold for level of capital in the global economy where things are at equilibrium. The questions are many. 

How can decipher the exact amount of capital stock existing in some secular value terms? How can the world estimate the collective stock of assets and goods to correspond to this stock of capital?

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

Realignment: Ratings and relative risk stack

Investors think of risk associated various assets (across classes) in relative terms. We have a notional relative assessment - A is riskier than B but C is more risky than A etc. This applies to asset classes and specific assets within them. So Manhattan land parcel may be riskier than NY state debt etc.

Thus, we have a stack of assets. We can imagine this as a deck of cards that the investor carefully aligns according to their risk profiles. On one side, lets say the bottom of the deck of cards, we have less risky and they get progressively more risky as we reach the other end, i.e. the top.

The S&P ratings change signals a change in the order of this stack - sort of shuffling of the cards. Some investors believe that shuffling happened a long time ago and S&P is just highlighting it. Others believe there has been no shuffling of the deck and previous order remains valid.

In essence, each investor is making his or her own assessment. We are all on our own.

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

Answers to Barry Ritholtz's 10 questions about S&P downgrade

Barry Ritholtz asks 10 questions about S&P downgrade and I answer most of them below:

Here it goes:

1. The change in trajectory of US debt was in service of Banks: It began with TARP, and continued with every other bailout/stimulus/economic plan. What was S&P’s role in creating that crisis?

 S&P is centrally responsible. So are US regulators, banks and those crying hoarse. Let us remember there is plenty of blame to go around for GFC. 

2. How will non-US investors (Private and Central Banks) view the downgrade?

Most non-US investors already discount the news. However, investment strategies will compel some to act if another agency downgrades.  

4. What does the downgrade do to US currency — is that the true impact of the credit downgrade?

Over 5 year horizon I think USD will begin to decline. A declining dollar is in the interest of US. It will reinforce US manufacturing. Immediately, though, flight to cash and commodities seem to be possible options.  

5. Will borrowing costs likely increase for the US? What about consumers?

Borrowing costs for US entities will increase. I suspect the ability to pass on these cost to consumers will remain under pressure. Consumer rates, after accounting for all adjustments, a quite high. It will impact borrowing cost of investors, leverage will be difficult to come by.   

8. Why did the rating agency not wait until the special committee / debt ceiling deal was completed later this year?

I think the rating rationale was more political than financial – more related to “willingness to pay” rather than “ability to pay”. The debt committee would have done more related to “ability to pay”. The statements by politicians about “debt ceiling debates hereafter should be conducted this way”, “maybe default is a good option” etc. makes one really skeptical of US governance. You see such things in banana republics not US – definitely not a behaviour of AAA rated sovereign. 

9. The Rating Agencies were downgraded by Dodd-Frank, with all regulatory and legal references to be removed. Was S&P’s move retaliatory?

I don’t think so.  

10. How will US markets open on Monday in response to the downgrade?

Move to cash and commodities could be a good idea to bet on. Though one can never be adequately sure. 

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

Impact of the US Rating downgrade

The rumours of a downgrade had started during US trading hours, but the actual S&P announcement came post market hours, so Friday's market closing does not reflect the ratings impact.

Immediate impact - is it the last straw?

With concerns on US growth slowdown and EU debt crisis already troubling markets, this is another nail in the coffin. The immediate reaction should be negative: equities sell off, commodities fall, bond yields rally, dollar weakens, safe haven assets (gold, CHF, JPY) appreciate. However, it is not clear if this impact will persist beyond the near term.

On bond yields 

Some are arguing that since it was well known that the US would get downgraded, this is priced in and that there may not be much lasting impact. Moreover, Moody's and Fitch still have the US at AAA for now. Analysis of the impact of past rating downgrade of other countries on their long-term yields has shown that yields rose in the days before the downgrade and then either fell or were unchanged after the actual downgrade.

Over a few years, one can expect yields to trend upwards, till the US regains its AAA ratings. If the situation deteriorates further, there is likely to be sustained uptrend in the bond yields.

Money moving out of US treasuries
The US downgrade raises two medium-term issues with respect to money movement.

First, the downgrade will accelerate the already ongoing trend of reserve diversification away from the US dollar. Confidence in dollar's reserve status will be tested by the markets. This may be a slow moving process or in the worst case scenario, this can trigger panic reaction.

Second, some funds may start taking money out of US as they are mandated to invest in AAA only. However, a lot of funds rely on ratings of two agencies and not just one, so this effect may be more prominent if one other ratings agency follows S&P.

Further, the question remains, where will they invest? None of the other AAA rated countries have the size and liquidity that the US markets offer. Norway, Singapore, Australia, Sweden are some of the AAA rated countries where investors could flock and put pressure on their currencies to appreciate. 

In such a scenario, people expect this money to move in emerging markets through a diversified investment approach. Thus, post the initial risk aversion shock, they expect EM markets to show positive reaction over the medium term. I do not agree with this. There is no reason to trust Indian or other treasuries over US treasuries.

I think people may shift into commodities. Commodities will start acting like stores of value. Thus, we will see an increase in commodity prices. This will adversely impact EM inflation leading to weakness in EM. EM central banks will be forced to revalue their currencies with respect to USD, triggering the realignment process.

In sum
A lot depends on whether beyond the near-term negative reaction, there is further panic or sanity prevails at some point.

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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.

Greece and the labors of Hercules

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

Problems with economics

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

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

Problem with politics

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

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

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

In sum

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

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

Krugman & Delong and Weak Dollar

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

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

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

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

USD Dollar Views from 2009(links to old post)

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

Higher oil prices, inflation and what matters

David Beckworth quotes Caroline Baum and Mark Thoma about oil price increases, its impact on inflation and whether Fed should respond. 

Caroline points out some mistakes when we interpret the metaphors too seriously. Few weeks ago I would have thought that Caroline is unnecessarily critical, that people understand these are metaphors (oil prices are a tax) used for better understanding the impact. However, people are definitely taking these metaphors very seriously. There is a danger of policy response (QE??) being blinded because of such blindness. So in a way we must thank Caroline for the article. 

The fundamental explanation on this topic comes from Mark Thoma. He details a very elaborate explanation. According to him, if central bank is responsible for price rises then it should respond. If the price rise, however, is based on changing fundamentals then central banks have no reason to respond. Such price rise is relative rather than absolute, prices of some goods increase higher than others. 

Hmm!

While I agree with overall analysis, I must put some pointers out. 

Firstly, Oil is different commodity. Oil is embedded within our economic system. This is a result of substantial capital investments over nearly a century. Hence any improvement in alternate technology requires far longer gestation than commonly assumed. Further, the quantum of investments required is also higher. In the intermediate time, oil can fuel general price rise (not just a relative price rise) through cost pressures. If the ability to pass on higher prices is limited, it results in shutting down of unprofitable production facilities leading to job losses. thus, in this sense, oil is inflationary and crimps consumer demand. 

But David is right to mention that such change is a spike and does not indicate a trend change. However, from a layman's perspective, price level is more important in relation to income level than rate of inflation itself. Let us assume prices rise to level of 3X and stay there thereafter. In such case there is immense pain for the lay person in the first year and thereafter as the incomes adjust, things get easier. But what if incomes do not adjust? Then the pain stays on for longer and ruthlessly drags household after household into poverty.

In such a scenario, it is policy response may be warranted. But it is not simply a monetary policy response that will do the trick. Monetary policy action will create a window of opportunity during which investments must be made in alternate technology and improve it. However, after monetary policy action when we see lower oil prices we forget the "improve the alternate technology" part. Meanwhile oil companies continue to invest more into status quo shifting the goal post further.

As an aside, I do believe we are improving technology to reduce oil dependence. However, it is more incidental than deliberate. The development of source independent power grids, energy efficiency norms etc are a step in the right direction.

Financial Crisis and Democracy

One of the features of the current financial crisis is the way it interacts with democracy. The crisis touches the very core of democracy both in principle and by its sheer size. In this, the current crisis is far different than any we have seen previously.

First, the way in which necessities of few banks have been scaled to compulsory levy on the masses is one example. Within a country, the stress on the lowest income class has increased due to lack of jobs and increased burden of taxes. It will increase further with inflation and cost of basis services rising. All this for no fault of theirs. 

Second, this crisis also spans across democratic divisions of countries. Icelandic population must consider bailing out those of UK and Netherlands who made idiotic investments. In a similar fashion, Germans must consider bailing out Spain, Portugal etc. The US consumer is effectively bailing out the world.

Third, the size of bailout and enormity of impact of actions is such that common people are suffering. Even earlier, there were bailouts and recessions. But never was the scale this large and impact so lasting.

In such a scenario, one can understand why there are political issues. The developments in Middle East and North Africa (MENA) are, in all likelihood, the first steps. The citizens there were confident that their governance structure was not the best and felt compelled to deploy better mechanisms like democracy. In developed and democratic world, we are not sure what is a better alternative. But in any case this situation will not resolve in a year. We will have to live with this for the better part of this decade.

Inflation in terms of income and prices

Inflation has emerged as one of the key challenges of the world at this time. However we tend to reflect on inflation in terms of prices of basket of products and services. I think such a metric serves us to understand only a part of the problem.

Inflation, as we measure it today, does not measure social benefits when job scenario is difficult. The theory behind inflation posits that when the inflation becomes known wages should adjust to reflect the same. If wages are stable and prices start rising, inflation rightly triggers alarm bells. However, if prices are stable and incomes are falling then inflation data tends to mask the underlying decline in living standards.

Generally, policy makers use two variables, inflation and real average income growth, together. However, rarely do we see both variables in same discussion. The problem arises because of difference in measurement techniques of prices and wages. However, limitations of measurement should not be a cause for erroneous policy.

I think we need to define inflation as difference between wage rise and price rise. Or we may use another metric that measures this difference. I believe it should give a proper indication of the on-the-ground situation of the economy. 

Thus, in the developed world, with economies losing jobs, we expect this metric to expand conveying the increasing difficulty in sustaining a lifestyle. This comes over a decade of falling prices with stable incomes which we may parallel with deflation. 

How such a variable will influence policy response is a difficult question. However, it should definitely improve our understanding of the realities.