Is Recovery Just Around the Corner? | The Big Picture

Jack McHugh goes on to look for answer to famous question - Is recovery just around the corner?

Sometimes I am ashamed of how pessimistic I have become. But nothing tells me that we are closer to situations when fundamentals are sorted out. I think the bottom here is fixed - its way below from here for US markets. A slower descent implies longer time to see the bottom. Implies more pain - and slower recovery.

With current healthcare situation and age demographics as they are - I see US consumers going towards 15% saving rate as sustainable rate going forward. Under strong dollar regime it means income de-growth and therefore sustainable consumption will be a long long way below current levels. In a weak dollar regime, it would mean, higher inflation sharper fall and concentrated impact of consumption dip - with a possible under-shooting below sustainable consumption level. On a discounted basis these both will be equal impact in all likelyhood.

What this implies is that sustainable world consumption should see a 1.5 the dip seen at US (roughly). So the only way to recovery is when jobs seem safe and incomes stop falling. Note this is just the average - so we will see a dip below this to about 2X US consumption loss. So stock markets should reach corresponding levels.

Newer Orgnisation Structures

One of my pet implication of the global slowdown is changes in organization structures. I think this is one of areas where organization-citizen relationships are going to be redefined. We are going to see restoration of balance in this relationship. Currently, organizations have disproportionate leverage that is being misused. It means new value-chains, new types of organizations based on skills.

No one has noticed but Apple just did that - the application part was moved out of the organization into public domain - modifying the traditional value chain that Friedman mentions.

Further I think organization-employee relationships are going to change fundamentally. We will have new loose forms of organizations that can fail easily and not become tighly controlled - economic behemoths that can hold entire economies to ransom. The new form of organisation will most likely have Schumpeterean creative destrution switch built into their DNA making them more efficient, vibrant through fail-fast, fail-safe means.

Richard Koo on Balance Sheet Recessions

Richard Koo on Balance Sheet Recessions (from Paul Kedrosky) gives an interesting perspective on global crisis and how possibly Japanese way could actually be a best case scenario. At the fag end he goes into really interesting implications for politics, differences between current crisis and Japan that is critical.

Japanese crisis was essentially corporate balance-sheet crisis. Current crisis is US and European household balance sheets and financial institution balance sheet crisis. Japan has strong household and financial balance-sheets. So fiscal stimulus kept Japanese consumption going. In addition, export demand did not actually fall off a cliff. These two issues will make current slowdown actually more horrible.

US households bear weight of global production. US financial bear weight of global capital supply. Both are in a mess. The stimulus required to pull-off a Japan-style escape will be of global proportion - and definitely out of league of Fed. Even by Japanese experience - global deficit would be roughly 8% of GDP. Disproportionate amount of it will come from US which implies ~ 18-20% of current US GDP. This weakens the dollar (that is good) and probably kindle some hope for US economy.

Implications

• Despite everything US and European GDP will have to fall structurally.
• We are looking at structural global GDP contraction - but unevenly spread.
• Solve household balance sheet problem - solve the crisis.
• Global realignment of production and consumption center is evident.
• Unstable political storms are coming - watching Af-Pak closely.
• Increasingly worried about China - hoping sense prevails.
• Increasingly confident of two-engine approach to economy. Wealth creation engine (entrepreneurship) and wealth distribution engine ( domestic consumption & resulting jobs)
• India looks strangely best positioned - thanks to the fact that its government's hands are tied!

Auto Bankruptcy will worsen the slowdown

Obama has been decisive in Auto bankruptcy case. While the intent is commendable, letting Auto companies go bankrupt will damage the US economy more.

Auto Companies represent a really big and powerful wealth distribution engine. At this point, wealth distribution engine health determines how much bailout actually reaches the common person who is at the heart of bailout.

Obama saved banks to ensure credit lifelines to the common person survive. But if auto companies go bankrupt, they take pensions, incomes and multipliers with them. It will be like preventing heart blockage but stabbing the patient! 

I hope Obama gets his team to explain these things to him before he signs off on anything! Just pray!

Global Slowdown Solutions V: Global Crisis - first principles

Global crisis is a result of three elements freezing together - an overleveraged buyer unable to buy more, a seller without access to credit to create supply and non-existant market where no one trusts anyone.

We cannot fix all three together as all three elements are vastly globalised and hence too big to fix all at once. So it makes sense to get back to basics. The entire economic system was created with demand at the center. When demand existed - supply emerged and market appeared to match producer and consumer. So we need to fix demand first, help supplier get started and things will start taking care of itself. But!

First lets get demand straightened out. Demand in recent past was excessive - it will never be that high any time soon. But however small - we need it. Demand comes from wages and employment certainity. This is the basic of Keynesian stimulus - create jobs system will fix itself. So this would have solved our problem this time as well - had it not been for credit starved supplier.

The supplier, earlier, was driven by equity and debt was but a cash-flow smoothening mechanism. Then we realised the power of leverage to amplify returns, create surplus wealth thereby creating a separate investor class specialising in just providing capital unleashing entrepreneurial energy. This class made the entrepreneurs leverage themselves to the maximum possible limit. This culminates today into credit being necessary mana for the suppliers to produce goods. Without supplier there is no market!

The market essentially is an infrastructure provided to suppliers to help them address demand - through exchange of goods and services. Market works on marginal cost of exchange. Markets usually take care of themselves so long as demand and supply exists. The maximum fixing markets needs is through ensuring rule of law - enforcement of contracts, protection of aggreived, ensuring people don't cheat or muscle out others etc. Markets are even oblivious of fairness of law - so long as law exists and they get implemented markets will get created.

Hence the crisis will be resolved if we solve the demand (consumers') problem first. Then we need to fix suppliers' access to credit. It is ok to have latent unsatisfied demand - that often gets channeled into savings. But excess supply translates into inventories and they have costs and lead to supplier anemia. Ensuring law and order will help markets get back in shape soon enough.

US Solution has been antithetical to first principles

The solution so far has exactly moved in opposite manner. We tried to make market functional by rough-shodding over contracts and ensuring cheater get away with it. We tried to ensure liquidity to help with supplier credit. All this while - the consumer is facing increasing credit card debts, lower job prospects and total loss of confidence in possible return to reality. We haven't really done anything to prevent creditors making predatory moves on consumers.

The solution to the crisis is essentially a modified Keynes' approach. We need to create jobs while fixing the system in coordinated precision. The kind that won Nadia Comaneci her perfect 10. And the stakes are higher there is not saffety net - no silver medal!

Selling Tata Nano to US

Apparantly Tata plans to sell Nano in US by 2011/12.

Fundamentally I think it makes sense in car-oriented US cities now wanting cheaper transport solutions. This is the kind of consumer behaviour shift that we can expect in the coming years. Typically, such changes take decades - but economic hardship can hyper-accelerate them. US consumer will be seen cutting cost and looking for cheaper solutions.

Global Slowdown Solutions IV: Create earnings credit will follow

Current problem won't resolve by just establishing an alternate credit channel. Once the US credit channel is available. Credit flows based on certainity of earnings. Economist's View: Galbraith: No Return to Normal indicates how Galbraith points to this critical point. Let me paraphrase Galbraith:

In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war—from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war.

The New Deal rebuilt America physically, providing a foundation (the TVA’s power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so.

What did not recover, under Roosevelt, was the private banking system. ... If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn’t overcome until the war ended. It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. ... But the relaunching of private finance took twenty years, and the war besides.

A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.

We have to realised that credit and banking feeds off global real economy. It is actually a cost, however small, for the real economy. So once jobs come back and incomes stabilize (at whatever levels), you will see credit coming back. Without certainity of earnings, the credit channel goes in self-preservation mode - waiting for certainity to return. Being global, the channel can absorb far more bailout/stimulus than any single nation can provide.

The problem of global income adjustment and therefore credit offtake ability will hit us next. This is the heart of the problem. Next: we will see how we can fix this!

Global Meltdown Solution Part III: Alternate credit channel

The global credit channel is a central sysmptoms and collateral damage of current crisis. The core of this is in US and therefore US government agencies are attempting bailout after bailout. The US government is not liable for rescuing an essentially global channel. It's first duty to clean the domestic channel. The two are cross connected to such a degree that they cant tell what they are fixing.

The solution, to my mind, is simple. Create an alternate credit channel - what I call "the modified good bank solution".

• Create a good bank - with regulatory charter that allows lower capital norms, higher government guarantees etc. so that it will have liquidity, capital and ability to acquire assets.
• Let it give credit to worthy borrowers who have the ability to repay.
• Create a mass loan transfer drive - where the borrowers to move their loans to this bank - rather than buying loan books from established banks.
• Accelerate the process by establishing uniform common minimum norms for acquiring loans. Start with lowest risk with highest documentary evidence.
• Augment the document checking using other government agencies workforce.
• Repeat the drives till you have covered big chunk of population. Government can take over some homes and convert them into temporary offices - establish geographically wide network - quickly.
• This bank should be broken up into managable units and privatised at a pre-committed date in 5/7 years time.

The global bailouts are more complex. This should be funded with pooled money. Using the IMF or world bank is a good starting point. More on that later.

Addendum: Why Us needs to fix domestic credit channel first?
US is biggest consumer of the world. The world needs able US consumers to continue to spend albeit to their comfort level (and definitely to lesser degree). The able and wanting consumers are currently being denied a chance to consume. This is dtrimental to everyone.

Global Meltdown solutions Part II: Dispersion of production

Changing producer competitiveness

The question is invariably based on Michael Porter's work on competitive advantage of nation. The only modification is understanding the structural or fundamental advantages. We need to separate out the transient, artificially imposed advantages. A deliberately devalued currency is such a transient man-made advantage. And it will break down. Michael Pettis, makes a fantastic argument how trade policies can influence producer dispersion.

Who will be new producers?

Producers are located due to various competitive advantages of a region. One of the reason is quality and cost of manpower - let us call this man power profile. Similarly we have a job profile of an economy. Job profile, for simplicity sake, is based on technical knowledge prequisites and volume of work. Now ideally in sustainable case the job-profile and man-power profile of an economy should match. Currently there is a mismatch in developed world. US and EU jobs are getting polarised between unmovable low value addition activities on one side and exceptionally high value adding activities on other.

Man-power profile will stablize

The volume of low-value addition jobs will have to rise in US - to fit with lowering relative education standards. Now education system in US is way better than other nations. So we are simply comparing US in the future to US in recent past. The problem is in very short-term jobs movements are a zero-sum game (time till entrepreneurship discovers new jobs). So it means US wanting jobs will mean job losses in other part of the world. That, to my mind, is a seed of discord in near future. Hope is migrant workers might go back to home countries and US might actually have a brain drain to ease the pressure a wee-bit. In medium to long term US entrepreneurs will definitely figure out a way to create value in new and innovative ways -creating jobs for the economy.

Seamless dispersion of production centers
The intersection of man-power and job profiles will mean a more seamless dispersion of production centers across the world. The first demonstration of this will come when some manufacturing jobs moving back to US.

Global Meltdown solution Part I: Consumption centers

Who can be consumers?

Citizens, who have savings and income to replenish the savings post buying goods and services, can be consumers. Rest cannot! That implies the developed world - probably with exception of Germany and Japan, cannot be consumers. China, India, Indonesia and other countries with domestic savings will be our consumers.

Value of consumption

Currently, the exchange rate equations are aligned to repress the consumption behaviour of these populations. In the interest of global recovery these equations will have to be reversed. This will entail a lot of protectionist pressures that are detrimental to consumers. Such measures will wipe out any hint of global recovery.

Not consuming is always an option

Typically protectionist measures reduce the quality of local goods, increase prices and thereby cheat consumers out of their hard earned money. Today, the globalised consumer, is aware of product benchmarks and price parity across geographies. In current situation, consumers may simply "not consume" inferior products. They will choose to increase their savings.

How protectionism is detrimental to the world?

This means the advantages of protectionism will accrue only if it continues for prolonged period of time in near future. Till it continues - global depression will continue. It means you will see more enforcement at customs counters in airports, ports and national borders. It means increased smugling of attractive goods establishing a supply chain for drugs, weapons and other illegal trade. All detrimental in socio-economic terms.

Global Meltdown solution - Introduction

I have been amongst the most pessimistic about the prospects of global economy. There has been a lot of harping about what got us into the current mess. Together the blogosphere has painted a picture of gloom. And now that we have painted this dark tunnel it is time to paint the light and the end of it! It is time to decipher the solution to the crisis.

One of the reason great depression lasted as long as it did was because of delay in acknowledging the solution. The solution was always there - no doubt - but it took time for the solution to win over the decision-makers into coordinated action.

Thanks to globalisation and internet based coordination, we should be able to do it faster this time. If only we had the solution - or may be we do!

I present my side of solution in next few posts. Let us march towards a light - any light to begin with!

Defer the US debt!

What if China and Japan the major creditors of US reach an agreement to defer the US debt repayment. China and Japan own the largest set of US treasuries with certain interest rate. US needs cash to service the debt - in current situation this cash will be better spent on re-creating jobs. This is one type of response to a debt-default situation. Convert the debt into equity or preferred equity with payments deferred over time with a slight moratorium included.

I think this should be a good aim for US political establishment to start off the recovery process. It will be even better if China and other US creditors unilaterally take this stand.

Or possibly I am going nuts.

Which country comes out of slowdown earlier?

To understand this, I believe we can look at two metrics.

Capital waiting to be deployed could be a metric to understand how effectively can the wealth creation engine be primed. The current US consumption based wealth-creation will have to be rewired to domestic demand driven wealth creation. This is one reason why investors look for telecom and FMCG companies. They are better wired for such situations. But the real boost comes from entreprenerial activity that feeds into such sectors or creates new markets around such concepts. These entrepreneurs drive value creation and GDP growth. The question really is how much capital is available to be deployed into the economy. This consitutes available bank credit,

The second metric is effectiveness of the wealth distribution engine. We can call it multiplier effect. If an economy has enough structures to distribute the wealth creation across the population then better are its chances in current situation. Here, a consumption based economy like India would feature higher than manufacturing-export let China. But evaluating this factor is a little soft-factor based analysis.

Investors have figured out the first one and therefore rushing into China. Yet, most have very limited understanding on how the second factor works. I think both factors are necessary to create a push out of the slowdown. But given how connected capital is globally, I think the weight of second factor might be higher. What say ye?

Worst Recession ever!

The current recession is now definitely going to be worse than the Great Depression. The excesses that created the mess are being stretched beyond sustainability. Now even Niall Ferguson and Nouriel Roubini agree on this.

The main reason is US government, taking heart from USD's global reserve currency status, is priming the economy at an unimaginable scale. Taking the US example lot of countries are attempting a similar strategy. It would be important to note that this is not simply printing money but creating debt.

The current strength of USD is due to global slowdown. The world will soon realise that depending on US consumption is not going to happen anytime in near to medium term. As the relative strength of domestic markets start, we can forsee a battle for share of pockets of savers. This, to my mind, will be the begining of the end of US dollar.

Personal and Government indebtedness

The contextual relationship between balance sheet of citizens and their government, to my mind, holds the key to evaluating responses to current crisis. We see three main segregations:

• China and some developing countries – where both government and personal savings are high
• US and developed world – where both government and personal debts are high
• Countries like India – where personal savings are high but government is seriously indebted.
  

Keynes solution is meant for the Chinese situation. So Chinese are spot on with their solution. But it is still not clear if this will work in China. Keynes’ solution needs a robust wealth-distribution mechanism that China lacks. Therefore, we need to watch Chinese government actions keenly. Other countries with surplus will be better off if they have access to markets for their produce and Keynes-style stimulus will be the way to go.

For US and other developed countries, the same Keynesian solution will put their future in jeopardy. Beyond a certain tipping point, there will be a bigger crisis looming. It will start with Chinese stopping the US bail out. China is bailing out the US who is in turn bailing out most of the world. Surprising that Chinese want so less say in who gets their money. Possibly, they got a raw deal. Anyways, if China continues stimulating both US and domestic Chinese economy, it will end up like India! As the scale of stimulus or bailout increases, I get ever so more worried.

India is in further mess. It has the consumers who can spend but its government cannot do anything to stimulate the economy. So India will have to sit tight till domestic economy revives on its own. It won’t grow at a pace similar to past 2-3 years but it will still grow robustly. Indian slowdown is likely to be deep and short. After the initial bubble bursting, you will see Indian consumer wring his/her hand in despair and get about their normal trend-line consumption.

So in all, everyone has large problems.

Surviving the current crisis

Current crisis is going to test the best. It is going to strain finances to the brink of banckrupcy. So how can small businesses survive in this challanging environment? Simply put, using two rules. Cash is king. Stay humble - stay together. Let me elaborate.

Cash is King!

In any crunch / slowdown what matters is staying power. Cash gives you a fantastic buffer to outlast the crisis. Here are a few steps that can help conserve cash but remember each case is different - so careful with these.

Income Side

1. Diversify income streams: Now is the time to cross-sell ancillary stuff around your key products. Generally - lower cost items that enhance longevity of the product get better business in these times.
2. New Products? Remember the customer focus has changed from "saving time" to "saving cost"! In tough times objects not central to functionality are difficult to sell. So T-shirts about your brand are less likely to sell at premium. But smaller price point items that reduce cost for customers are desired.
3. Merchendise ads: It might make sense to sell merchendise at cost as a substitute for local advertising. (Caution alert)
4. Mittens with ovens: Give add-ons and make selling price reasonable. Be fair to all - be fair to youself in setting the price. Sometimes add-ons help - again things ancillary to the product use will get better sales. Give away mittens with ovens!

Cost side:

1. Know your costs: 10% discount if you by bigger lot - may not always be a good idea.
2. Cut costs like crazy: Reduce inventory, negotiate with suppliers for discounts.
3. Throwing away money? Reduce wastage, a lot of things can be reused - if not by you - by others who will pay for the stuff.

Employees or your team?

Big corporations are quite fast at reducing employee head-counts. In my view, this is a really wrong move - more so if you touted "employees are my assets" mantra. I believe employees are like players on your team. In such times rather than cutting employees - you can change payment terms. An employee taking home $1000 can now take home $500 as fixed cost + $500 as variable. For next 5 years base the variable on cash contribution to the business. And remember - pay-cuts go from top to bottom and hikes go from bottom to top.

Henry Ford v/s Greg Mankiw and real arguments for free trade!

Greg Mankiw, whose work and insight I really admire, argues against protectionism of Obama government. However, he does make the popular point - that lower Chinese Yuan helps keep cost of US consumption basket lower. Henry Ford turned this argument on its head and increased wages of his labourers so that they can afford to buy the cars Ford made. In the same vein, I think Americans would be happy to afford higher cost products and buy them rather than have low cost products that they cannot afford. To make it clear, I am not denying the beneficial effects of lower cost products. Just that the real argument for free trade is different.

US needs to keep the roads to China well-paved. Sooner or later the Chinese Yuan will appreciate against the US dollar. Then US will need China to keep trade barriers lowers to allow US access to Chinese markets. But that means keeping US trade barriers down in current scenario. Obama talk on protectionism might only serve to precipitate the currency regime change. But even just talk will be harmful for US interest in the longer term. Obama will do well to take up Wen Jaibao's free trade argument.

Inflation v/s Deflation

Cassandra has a post on Inflation v/s Deflation that highlights and links to some interesting points-of-views on the debate. The most interesting bit she quotes from Dr. Perrry Mehrling is:

Everything in the post is correct, and very much on the minds of every Fed watcher. The question is, what does it mean? I have what may be a contrarian view.

It seems to me that what we are seeing is simply the balance sheet consequences of the Fed's decision to take the wholesale money market onto its own balance sheet. Banks (and other entities) that used to lend to one another, are now lending and borrowing through the intermediation of the Fed. This is so not just domestically but also internationally (the huge swap line), since foreign banks used to fund dollar asset holdings in the dollar money market.

In this view, inflation seems much less likely. Why not? If the original wholesale money market borrowing and lending was not inflationary, then why should its substitute be inflationary? Indeed, the real question is whether the expansion of the Fed's balance sheet is keeping pace with the contraction of money market credit more generally. If not, then the consequence may be deflationary.

David Pearson argues in comments that inflation and deflation are also impacted by velocity. The arguments by Cassandra and David Pearson are interesting to say the least.

My thoughts are more aligned with fluid dynamics when thinking of money flow. This is not a laminar flow or a standard textbook turbulent flow. This is, to my mind, a special case of turbulent flow. I think big money will swamp certain markets testing the regulatory strengths of gate-keepers - while we have dry patches of liquidity crunch at some other places. The "tipping point" (as David puts it) is going to be realisation of true value of US treasuries. That will start a true "dance of the headless chickens" in the big-money space.

Capitalism Fundamentalist

I have often mentioned that the balance of power between corporates and citizens is misaligned. Naomi Klien in her book The shock Doctrine Rise of Disaster Capitalism tries to examine that same issue. Here is Naomi in interview with Charlie Rose. There are three different issues involved. First, corporations do get favoured status v/s the citizens and that hurts vast majority citizens to favour a few. Second, this is usually forced at the time of crisis. Third, usually government is the one that enables the favouring of status.

Naomi, further, gets into a debate with Milton Friedman's ideas. However, in certain areas, she does mention that she is simply against this collusion between governments and MNCs. Ithink this is playing wrongly on the word "shock" and mis-construing Milton Friedman. Kindly note that I do not fully endorse Friedman's policies but I agree about his views on difference between "intent" and "experience" of soft-hearted well-meaning policies. Austrian Economists has post on Milton Friedman's arguments against Naomi Klein in the video editing (there are 6 other videos if you like this one).

Charlie Rose asked her about India and China - she does mention about China but ignores India. India is real example as it followed the traditional middle-ground between socialism and capitalism. Indian constitution states the country as "socialist". And Indian experience shows correct example of her first quote "Only a crisis actual of perceived produces real change - when the crisis hits the change depends upon ideas that are lying around." India is a classic case of this being done in right fashion. Indian 1991 balance of payment crisis led us on reform path that has put more people out of poverty than 40 years of semi-socialist administration.

I believe she is correct in her observation of collusion between corporates and governments. I believe that this is being "streamlined" and this threatens the very roots of capitalism - as even Milton Friedman would argue. I am hoping that experts like Prof. Elizabeth Warren will restore this balance. I am hoping this "credit shock" will be a good time to "push this reforms"! :)

Monetary policy of China - is it a fault line?

Prof. Micheal Pettis is one of best commentators on China. His latest post on monetary conditions in China is a little scary. I have few points:

1. I don't think China will be able to undertake fiscal expansion to the scale required.
2. A monetary contraction is higly likely to impair Chinese financial system.

Essentially China is exactly where US was in Great Depression. The scale is different and scale can be China's enemy no.1! Further China agreeing to fund further US treasury expansion looks unreasonable. It will possibly compound the problems - as China cannot accept the entire lot US dishes out and retain enough capacity to wait it out. It is at this point fair income-distribution structure prevents social unrest. China will have to fix this urgently.

In sum, thats a whole lot of trouble heading China's way. Thankfully, Chinese government acts fast - let us hope it does so now as well. Else all the world is going to be in trouble!