Yves and Megan - A class act!

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

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

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

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

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

Of course this is way to simplified.

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

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

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

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

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

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

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

Finally -Yves Smith the dictator – Manhattan Project

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

Another Bailout is needed!

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

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

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

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

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

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

US Taxpayer generously bails out the world(?)

Brad Setser -Sharing upside and downside risk

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

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

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

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

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

Lehman, AIG and missing solution to global crisis

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

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

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

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

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

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

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

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

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


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

Tim Duy explains current situation

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

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

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

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

Welcome to the down-cycles.

Update:

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

Cyclicality of global slowdown projection

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

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

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

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


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

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


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

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

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

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

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

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

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

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

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

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

China, US Dollar and making money in this situation!

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

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

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

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

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

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

A battle of minds for America's creditors

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

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

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

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

Chinese Currency problem!

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

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

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

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

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

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

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

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

Bailout, and government response - other view

There is an interesting post today at naked capitalism: Stiglitz; "Fannie’s and Freddie’s free lunch about justification of bailouts. US government is busy bailing out over-aggressive risk taking institutions with risk-averse sweat-and-blood money of the taxpayer who is more concerned about ways of paying his dues in a gloomy job market. This is wrong. But situation has grey areas when viewed from government side.

The institutions blame their woes on a US slowdown unashamedly pointing finger at the maxed out US consumer who has loan is past, present and future earnings to the devil himself. Let me remind you that these were the very devils who cheered on the US consumer down the valley of distress as they minted money at his/her expense. They sacrificed the consumer for the shareholder. As a reward, their shareholders lavished the boards and executives with benefits and bonuses. Today the US government is doing the exact reverse thing. It is bailing out the carefree risk-lords with shareholders’ money. At both side it is the layman at the receiving end. Yet it is not so simple.

From a government’s perch, the reality is confusing. Institutions are taxpayers themselves and hence stakeholders. They are also income sources and service providers for citizens. A large number of institutions are foreign exchange earners for their country. Governments view certain sectors as drivers of competitive advantage. US views finance and money management as its competitive advantage. A government might opine that a running system is easier to coax into order than let the system falter. Yet whatever the reason, they must be elaborated and opened to public scrutiny.

There are of course many lessons from the current crisis. Arnold Kling has thrown in his perspective here. However, that is when the sun breaks out. Right now, from within the eye of the storm, things are more difficult and often survival or preservation always gains top priority. We tend to salvage whatever we can even disregarding our lives. The roar of the catastrophy drowns the calls of prudence. I believe something similar is happening with governments globally. In their rush to do something – they may not necessarily do the right thing.

A comprehensive regulatory overhaul is definitely a take-away from this crisis. I believe, it is also important to take this regulation global. Further, taxation and social security needs to be overhauled. At the farthest “public goods” need to be defined and reworked. The most essential takeaway will be a disaster control program that tests scenarios and develops action plans to emergency alleviation. The system of academics, consultants and media (what we have currently) does not create enough accountability to identify scenarios and develop action plan. No doubt the system currently does that. But it is not treated seriously enough to become a disaster management system. Else the forecasts of lot of bloggers (including high profile ones like Dr. Roubini) would have triggered an enquiry.

Dollar and Yuan

We have two dramatic posts one detailing dethroning of the dollar at Vox and Yves Smith points to possible slow appreciation of Yuan here naked capitalism: China to Slow Yuan Appreciation? This is the essential dilemma that global central banks face today. The artificial currency pegs that Dr. Roubini calls Bretton Woods 2.

The first part dollar dethroning indicates that in the long term countries should not keep pegged to the dollar. The second argues that in the near term, China would refrain from un-pegging from the dollar. Now this is classic! If China sticks on to dollar too long, it will have to contend with inflation and systemic issues including devaluing reserves. On the other hand if goes for one-off devaluation it will expose its exports sector to global competition abruptly. But it will bring 300 million Chinese (the affluent ones) into the global consumer community. At the moment, that will be a big blessing.

Current exchange rate system is creating / forcing people to be global workers and local consumers. This benefits the local economy at the expense of global systemic balance. To ensure counter balancing we need global consumers and global workers supported by global capital and global regulation. By embracing the globalized system, all nations have committed to this balanced cooperative world vision. And I hope nothing we do can upset this eutopian step.

How did Germany avoid great inflation in 1979? � Mostly Economics

How did Germany avoid great inflation in 1979? Mostly Economics
Amol Agarwal points to interesting paper relating to German experience with inflation during the 1979 slowdown. Broadly the learning implies controlling the money supply using predictable medium term targets.

I do not believe at this stage simple controlling will help. This might result in excess money, accumulated in one part of the system (or big money), broadcasting it into the broader system. This permeation will absolutely guarantee high inflation. Conversely, less painful (for the masses) solution may be to keep excess money localized and slowly suck it out of the system.

In the US/UK today, the excess money has already permeated through the system. Increased debt burden and consumption triggered by rising house prices have already spread the excess money deep and wide. Hence a monetary tightening at this stage will have high adverse impact on US/UK population. More money in the system and alive and kicking employment alone could have been a solution if it weren't for the high household debt. Household debt burden simply inflates if value of money goes down. Hence bankruptcy laws and loop-holes therein are most critical. Prof. Elizabeth Warren realizes this and hence her strong emphasis on modification to bankruptcy laws. I understand South Korea, Australia and EU are in same situation as US/UK.

In the rest of the world, the money has not permeated as well. Sovereign funds, reserves and to some extent big money have limited the spread. In any case situation is better than US/UK. Here monetary tightening might be a useful tool. Emerging markets and other countries could do better than emulate the west in this regard.

The future is tough! Let us just hope we don't forget the lesson this time!

Rising commodity prices, excess money and bailouts

World is definitely in perilous situation. Expenses are rising thanks to commodity price increase. Households incomes are falling as businesses fail. Growth is slowing thanks to high cost of debt. Investments are stuck as selling assets at crazy prices is no longer possible. Only thing rising is commodity prices!

Commodity prices - what drives them?

To understand this, we need to go to first principles wherein goods and money are tradable. From here it follows that when the value of money looses its way - goods will be the lodestone, the compass. After all money is used FOR goods! We need to realise that money by itself means nothing. Money is intermediary, a common denominator amongst goods. The best mechanism to protect oneself from arbitrary manifestation of value of money is to have the goods! This has prompted the rush for commodities - the most standardized goods available to international financial community. And naturally, the prices of commodities and goods have lined themselves up in the pecking order of importance to the society. Naturally oil (presumably inelastic demand) pegs itself at the very top.

Cancerous growth of money!

Excess money is one of the root causes of the current situation. The excess money flow was further exaggerated by pegged exchange rates. Initially the increased money supply was cornered effectively by small group, mainly Central banks (reserves) and investors(wealth). The excess liquidity did not reach the masses inflation symptom was masked. The situation seemed like positive spiral. Reserves became trophies and wealth always was one. The ensuing trophy-chase, magnified by leverage, soon trounced one asset class after other. And then we hit the tipping point. Today we are bailing out the first casualties of calamity. The bailout mechanism is infusing more liquidity into the system. Like fighting cancer with cancer or fire with fire. And most likely we will be left with ashes or cancer!

Is capital destruction reasonable solution?

Capital destruction is a painful but sure-fire solution. The least we can do is to stop excess capital creation - that means bailouts will be few and far between. Further on unpegging exchange rates will help destroy some excesses. Write-offs will destroy some more. In worst case only the last person caught holding the bag will be hit. In reasonable circumstances, they will be rehabilitated. In best case - we can rewind and restart where we left off.

Questions from Barry Ritholtz

Barry Ritholtz has posed 12 questions related to current global economic situation to the readers. It has incited lot of interesting responses all must read. Here are my 2 dollars (no cents any more!) on the topic.

US Consumer spending, Housing
From first principles, US consumer spending should reduce until the time incomes become greater than interest cost, food and basic expenses. US housing loans are non-recourse loans (as I understand it) –hence jingle mail is best solution to get rid of the liability. Other loans, particularly credit card loans, might become a threat. To make an impact on the economy, this change requires strong-willed cost cutting across the population. This implies that downturn in US will be both prolonged and deep.

Can US avoid this debt trap?
There is a possibility that through structuring, financial engineering US can get out of this situation. It needs a creative solution involving legal, financial and regulatory skills put together. Following ideas can help define a solution:

• The human life is finite but firms’ life is infinite.
• All dues need not be paid back and all debt cannot be waived off
• The process of repayment of dues may be unfair – some people may choose to pay more than their share. (One example is taxes – taxes are unfair payments between individuals) In addition, some organizations will bear larger losses.

Inflation – how much, how soon, how to avoid
The excess money supply created over the past decade has to manifest itself. For long, this excess money remained contained with few resulting in a crop of billionaires, few sovereign wealth funds and overall salary hikes. After a certain passage of time, this wealth has to trickle down. This is what is happening currently. This will continue until such time the excess wealth exists. Wealth contraction can help correct inflation problem quickly. It implies currency revaluations, deep stock market corrections or pricking of asset bubbles. But this will create a lot of pain for the most important class of people politically – the influencers.

Employment – worse still to come – but totally avoidable
Employment is function of jobs available and skill availability. There is a strong mismatch here. If you don’t have skills jobs will move where skills are available. But will the low-skills jobs come back to you? US, in my humble opinion, needs a stronger manufacturing. That will take-off only if US dollar is correctly priced. We have already seen employment spurts with dollar falls.

Credit Crunch – impact on financial sector
Financial sector has itself to blame with the way it handled the excess money supply. Financial sector will go through salary rationalization, product rationalization, management control rationalization – in simple words it needs to go through Business process re-engineering. All financial companies need to talk to James Champy en masse. There is a lot of cost to be cut in these companies.

US Politics and war
The outcome of US election will have no impact on the crises. The current crises and possible solutions require unreasonably high skills of diplomacy. The potential for wars for forcible resolution of economic litigation will soon increase and pose direct threat to world peace. This will be most inconvenient for US. World economies will not take US opinion courtesy of Iraq and Afghanistan experience. It will take a real leader – a statesman – to sort out this mess without the war pains. I believe Hillary Clinton is lucky to have missed the nomination.

In Sum
We are going through one of the worst phases of economic history. No doubt we will come out of it. The only question is will we come out wiser?

A Threat to Globalisation

Let me first categorically state that I am pro-globalisation. Recently there is a careful weighing of pros and cons of globalisation. You can read Tyler Cowen, Mark Thoma and Brad Delong on this. I have a few points to add to this:
Globalisation as envisaged in theory and the practial globalisation that we are experiencing are two different animals. The first is the goal where the world economic system intends to move to. The second is represents a deviation, an intermediate stage, from the prior status (pre-globalised industrialsation) towards our goal of true globalisation. Let me hypothesize what differences we have.

• We have relatively free capital movement but we have a little restricted labour movement. The difference is in quantum and direction both.
• We have locally-wealthy-but-globally-poor pools able to kick start local economic development - but do not "export" this development through "consumption".
• We have economies that articificially create/sustain some competitive advantages longer than its "best-before-date" either through currency pegs, money market intervention or other things.
• We have created higher income polarity - possibly -keeping certain section of population in the low-income pole through a combination of slower skill-upgradation programmes or by keeping industry profitability low throguh subsidies or under the pretense of inflation targeting. Classic case oil and food - future case WATER!
• On the other pole - i.e. high income pole we have multiplying effects of first - increasing savings for similar incomes and second - increasing incomes through market mechanics. The increased savings are result of either flexi-taxes courtsey capital account convertibility or lower costs courtsey inflation control and subsidy. The increasing incomes is what accelerates the income differential - recently this has happened through asset price bubbles and otherwise through productivity gains as a result of globalisation.
• Further there is huge - amazingly huge - increase in cost of the tools of success in globalised world - parimarily higher (grad and post grad) education, health care (i.e for maintaining employability and lower cost when sick).
• Finally - globalisation, in all probability, seems to be irreversible development and will proceed towards the goal (i.e. real globlisation!).
  

Therefore, the current state has the pros and cons mixed up. The matter needs more debate and in-depth analysis. Today was just a welcome start!

Jeffrey Lacker on - The Fed Risks Moral Hazard

Jeffrey Lacker made a speech in London about Fed's bailout of Bear Sterns. The speech has amazing clarity about financial stability and central banking. It is a must read! Since I read it on the big picture - I am linking to it there.
The Big Picture Lacker: The Fed Risks Moral Hazard

Update:

Now here is the explanation and analysis of the Fed President Jeffrey Lacker's speech by Yves Smith. This is one of the reason why I am a fan of Yves Smith!

Thats why not much to add from my side. Here is the link: naked capitalism: Should the Fed Be Independent?

World without Oil.org

Let me first admit - I have a bias towards simulations and moreso towards game-based simulations.

World without Oil is one example why I have this bias. A few months ago an email exchange with a famous game designer Jane McGonigal introduced me to this game. And how soon have we come to this! The game simulated a world without oil and there is a whole lot of content on what people's responses have been to this crises. I guess that resource is now ripe to be tapped. I believe, the resource needs to be advertised and shared more.

Further I believe, the game now needs to be extended. Here are some ideas:

• First of all make the game global.
• It needs a downloadable mobile scoring app that can keep score for oil savings in 3-4 key areas. It could be - for example - everytime we go for a tank full we enter Odo reading and gas filled and cost/ charges we paid. We score higher if we travel more miles per gallon than average. We score higher for using subway etc.
• Make it include other resources as well - water, food, environment, money(considering US credit crises) etc. If we dont print an email - we get some points for saving a tree - etc.
• Hopefully we can simply enter that into a mobile phone / sms based web server and our points get updated twitter style - then we can blog about it- share it - earn identifiable and referable badges - like belts in karate. Everyone starts with Level 1 and lets say goes to Level 12 - they can display this badge on their website/blog etc.

I would love to brainstorm on this. If anyone is interested let me know!

Excess Money and its flow pattern

I am sure you people have already heard this podcast from Russ Roberts' interview of Gene Epstein on Gold Fed and money. There is something really interesting in the points he makes. Epstein talks about 2 ways US fed govt can monetize its deficit.

• First is the monetising of future revenues - pushing incomes up so that taxes go up and therefore government revenues.
• The second is creation of future debt Fed buying government notes and bonds and supplying money.
  

The interesting part is - the first goes through the economy across income classes (leading to distribution of the excess money) and therefore creates expected outcomes (inflation). The second, however, is cornered by "big money" (SWF and likes) and never goes into the system. Or actually it takes longer and and more complicated feedback loop to distribute the effects of the excess money. This leads (or led) everyone to believe - falsely - that system is still stable. The reality remains that system has just postponed its instability. Possibly, what we are seeing is the "mean reversion" after some of the effects became evident.

It would be wonderful to know what Yves Smith and others think on this one. Let me know what you think about this one.