Comment on Sumner's article on Reallocation to housing in 2001

Scott Sumner has an interesting article today about reallocation into housing in 2001.

1. I agree with Professor Sumner's general view that during a slump (or reallocation) the right metaphor is like a bicycle going uphill. Fed is the cyclist pedaling vigorously. But if the effort is not about a certain threshold (NGDP) the bicycle will roll backward. You argue that the effort was below the threshold. I agree with this.
2. While I understand the simplification, I am not convinced with housing vs tech. The reallocation should search for better (more investment worthy) assets. I don't think housing was "better" asset. It was chosen (I think it was deliberately chosen) as it was the only one that could absorb large volume of investments. I believe, had we not interfered, markets would have discovered alternate energy or some other investment-starved sector. 
3. Housing is wrong choice. It is a dual-good. It sometimes works as consumption good other times it is investment good. Possibly housing as a consumption good may have been a cushion. But as investment good, it was only other bubble. Subprime is not a shock but a logical conclusion of an investment good being pumped with excess investment.
4. I think there is a threshold level for money ( I use term loosely) in the economy. If total money in the system goes higher than this the system (if we let it be) creates deflation to destroy this excess. This deflation happens at the hands of those who have money invested. It happens in the rich balance sheets. The problem is it often overshoots the ideal level hence we want to control the process. In our zeal to control the process, we shift the deflation hotspot to public balance sheet or citizens balance sheets. This creates a problem of affordability. The few rich balance sheets could have afforded to deflate to a large degree but many poor balance sheets cannot deflate even to hundredth of a degree. Further, the rich balance-sheets willingly took the risk of investment while poor balance sheets were stuffed. This is the socialization of losses we talk about.

I have discussed some of these ideas in my book "Subverting Capitalism & Democracy". 

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Buy my book "Subverting Capitalism & Democracy" is available on Amazon.

The Problem of Regulation

The regulatory juggernaut has slowly and eventually reached the gates of wall street.

Regulation, it appears, needs to tackle three issues. First, it should clarify the parties involved. In other words, regulation clarifies attribution or ownership. Secondly, it defines the action required. Finally, it defines the timing for the action. The rest of regulation merely defines the referee and the incentive structure to encourage or prevent the actions. Any regulation without these parts is open to be hijacked or misinterpreted. 

Regulation must clearly specify the action that should or should not be taken by the participants. In most cases, regulation must be designed to rebalance the bargaining power equation. The objective is to prevent the stronger player from taking advantage of the weaker player. The consumer financial protection agency is ideally defining such actions. This part often suffers from necessary and sufficient condition dilemma.

Necessary condition and sufficient conditions are best understood through the example of fire. The existence of fuel, air (or oxygen to be specific) and a spark are necessary conditions for a fire. However existence of a fire is sufficient to prove existence of fuel, air and the spark. Regulators often go to depths defining necessary conditions but often do not define the sufficient condition. Over time, the necessary conditions increase as new special cases are discovered. It makes the regulation unwieldy and creates loopholes in the regulatory paradigm. 

However, just defining the sufficient condition leaves the law ambiguous. This is the type of ambiguity that Paul Volcker likes. However, in the wrong hands such an ambiguity corrupts the system.

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Excerpt from my book "Subverting Capitalism & Democracy" is available on Amazon.

Real Estate Mortgage problem and deflation

Barry Ritholtz links to a post by Dhaval Joshi, chief strategist at RAB Capital about size of the housing mortgage debt problem. Dhaval Joshi quantifies the size of the problem. He believes the value has to drop by about $4 Trillion to revert to mean values. This is approximately 27% of annual US GDP. This size of deflation has repercussions.

In whose hands assets deflate matters

Typically, asset price increases happens at the hands of the rich. (The causality is inverse - asset price increases result in wealth.) However, where does the asset price decrease happen? The answer to this question determines the power of the corresponding economic slowdown. 

When housing asset prices declines, the asset is usually at the hands of common person and the downside impact of price decline hits the common person's financials. In that context, the current crisis was safer (we may say most crises are). In this crisis, we can argue, a dotted line ownership of the assets, through MBS and related derivatives, was in the hands of the financial institution. The devaluation of assets, thus, was happening at the hands of the rich. (It was also happening at the hands of the poor is incidental for what I am saying).

I contend that bailouts are causing a change of hands. Through bailouts, the burden was passed from financial institutions to the tax payer who is the common person. I think the bailout may have doubled the burden on the US tax payer. Can we say, US tax payer will effectively bear a burden of nearly $6 trillion?

In this context my public bank proposal seems more effective
If the government had set up a public bank to buy back mortgages from current banks, we may have avoided twin problem. I had proposed that the bailout money be used to create a public bank that will buy existing mortgages from the home-owners allowing them to reduce their debt while pushing money in proportion to asset quality. This solution appears more favorable to me now. First, the large burden of bailout would not rest on tax payers. It would have gone to other investors when the bank is finally privatized. Second, it would put a bottom on the home prices and thus not allow household financial to deteriorate drastically.

Given the options on the table, even now this looks better.

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

Healthcare and Pension - Unkept Promises?

The US deficit situation is dire. The option proposed is a drastic cut in healthcare and pension. Aside from the economic imperative, we need to ask if it is fair.

It was an unfair promise

One can say that American workers (including knowledge workers) overestimate their contribution, at least compared to the workers (note-1) globally. On the flip side, we can say that the wages the world over are depressed.  In whatever terms, option of cheaper workforce existed. Prior to the tech boom, such a workforce was not accessible (note -2). Thus the dependance on American workforce was higher which reflected in the wages and benefits. We may conclude that on the whole, American workers were promised higher benefits in terms of healthcare and pensions.

But it was a promise nevertheless

But whatever the promise was, the benefits were promised to the workforce. It gave the population a feeling of comfort about their future. It is possible that this comfort allowed them to spend more than otherwise acceptable. To renege on this commitment can be viewed, to a large extent, as a betrayal of the population.

On the other side, I cannot see why the ratings agencies cannot consider this as a default? At the very least it is restructuring and definitely not a behaviour fitting a AAA institution. The problem, I think, is how a government and its people are perceived. The sovereign ratings refer the ratings of the government. Can we think of government as different from its people? In spirit of the political set up, no. But reality suggests differently. 

Political setup is far removed from the general population

The political establishment is no longer a true representative of the general population. There has been a systematic undermining of legitimate political rights of the general population as I argue in my book. That we are discussing openly laws or portions of laws being thwarted by big institution is a disgusting reality. Just today, Barry Ritholtz highlights on the Times covers about lobbying efforts.

In such a scenario, is it fair that government should be seen as acting in connivance with the general population? I don't think so. This does turn many assumptions about "investment grade" upside down. Even then, I do not see investors discussing these issues.

Worse, the population is too naive to understand

The final straw is the reluctance of the population to understand. As if it is in a deep slumber, the general population does nothing! To a certain extent, they deserve it. 

Notes

1. For the purpose of the discussion we adjust for productivity - implying we are comparing workers with similar productivity level.
2. The tech boom combined with globalisation enabled better access to such cheaper workforce option. It is one possible causes that may have resulted in wage stagnation in US.

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

Measuring real value

What is a measure of real value?

Now we cannot measure value but in terms of money. It means all our measurement of value is relative. It is like measuring time in terms of heart beats - 1 minute is 60 beats. Now if you start running (say printing more money) then will you have more minutes? Of course not! We will have to adjust the equation of how many beats make up a minute.

Modified Gold standard or constant money
Let us look at the modified gold standard - modified for simplicity. The total amount of gold in the world would remain constant. We would keep creating more value. So there will be natural deflation. The amount of deflation will tell us how much value we created. This is fine overall but total amount of gold is not fixed. It grows arbitrarily. So when Spanish empire discovered huge silver mine (also used like gold) they had a problem. So will we if some buried gold is suddenly discovered. Further, as I argued in my book, gold promotes hoarding while slight inflation promotes transactions (or velocity hence GDP). So gold may not be appropriate.

I believe real analysis will only come if we use absolute metric for value. Why can't there be a debate about possible metrics? It is remarkable that for all the human progress we are not able to create an absolute metric for value. 

How much is real estate as a percentage of total assets?

I often wonder what the does the fixed asset block at a country level looks like. 

Companies report their asset base in terms of land and property, plant and machinery, investments, cash and deposits, even goodwill (brands or excess payments for acquisitions) etc. In a company the investments we are told what is approximate value of this investment. (In some cases you have to work around but you can tell). 

If we have the total asset and those invested in real estate, then we know how much percentage change in real estate prices will impact the economy. True, it won't tell us GDP impact, but it will tell us the scale.  The impact will manifest in variety of direction but the quantum of impact is a critical variable. 

Let me give an example. A small meteor can strike anywhere on the planet and we really don't care. For a medium meteor, the point of impact matters. It creates a tsunami or a crater etc. But if a truly large meteor strikes then it does not matter where it strikes. The result is the same - total wipeout.

To parallel with financial crisis, I think we still do not know what is the size of real estate problem. The real estate problem encompasses the following:

1. Housing i.e. houses and residential buildings in possession of consumers.
2. Rental housing - those residential buildings owned by businesses but meant for renting.
3. Real Estate owned by companies. Like land for factories etc.
4. Commercial Real Estate like malls, theaters, office complexes.
5. Agricultural land owned by people and companies
6. It does not include lands that we cannot sell or lease like forest lands for example or gardens.

Then we need to find out  what is the amount of loan for which this stands as collateral. We can then estimate the impact of 1% change of valuations. My guess is the total size of real estate assets will be like 2/3rd of total global assets. The total loans outstanding against these assets is an unknown. We can agree that the problem is not small. The question is how big is it.

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

Retaining US jobs

Yves Smith commented on Andy Grove's post about retaining US jobs. I am worried about the very idea of job exports.

Job profile of the economy

In an ideal state, every economy should have a job profile of its citizens. Job profile will be based on skills available in the workforce. For example, (pardon all the cliches across the post) France and Italy will have higher clothes designers than manufacturers while China will have more clothes manufacturers than designers. This is result of natural specialization and, as such, ties in with two great works by Michael Porter and Adam Smith. So there is nothing fundamentally wrong with exporting jobs. the problem is what jobs do you export.

America is exporting the keep-jobs

Based on the education, skills and experience of workers, we may possibly conclude that America needs these jobs. It needs the car-manufacturing jobs and IT hardware jobs. But these jobs are going overseas. Why? The only reason why jobs are being exported is because it is cheaper to get the job done elsewhere. The labour in developing countries is cheaper in US dollar terms. This could be true because of two reasons:

First is the well understood relative currency valuation reason. If in relative terms Chinese auto worker is paid the same as US auto worker, then the only reason will be currency disadvantage. But is Chinese auto worker paid the same as US auto worker in relative terms? I don't think so. The relative wages are similar in high-tech industry like Pharma, IT services industry, computer chip design, architectural firms etc. But not in auto basic skill industries like auto, garmenting etc.

Second, if there is relative difference in wages, it could be because Chinese labour is poor and hence ready to work at cheaper prices. This is a fundamentally sound case and more applicable to auto, garmenting and other basic skill jobs. These jobs will eventually move.

Implication of job migration

There are some critical points we can decipher from this reality.

First, every job profile seems to have an average purchasing power parity wage. So for each combination of skill, output, education, experience and productivity there is a world parity wage. I call this wage content of a job (in my book) where job refers to one requiring standard profile. If your wage is higher than the wage content of that job you are doing, then you are at high risk of being laid-off.

Second, if Americans are desperate for these jobs, it implies that skill levels in America are more aligned with these jobs. In other words, the American skills difference and wage difference does not reconcile. It means US wages are out of line and need to come down to international wage content levels. We can achieve it by deflation or by resetting the currency. Either ways, it is not pleasant.

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My book "Subverting Capitalism & Democracy" is available on Amazon

Krugman, Ferguson and/on Zakaria

Fareed Zakaria is one of the most insightful host and journalist. In this episode, the presents the two sides of Austerity vs. Stimulus debate. I have already presented my thoughts about Austerity vs. Stimulus.

I want to make a few comments.

First, only certainty can fight uncertainty. In times of uncertainty, like today, the objective of policy is to increase certainty. So a roadmap for reform and policy changes for 10 years and a political consensus (bipartisan or multi-party political consensus as applicable in each nation) and commitment is essential. So Niall Ferguson is spot on with this point. I believe any reasonable certainty will work rather than a specific austerity oriented certainty.

Second, we can kill certainty by acting without a plan - or let me rephrase - by appearing to act without a plan. Conversely, just by acting decisively you can create certainty. I believe the US president should split his speech into two parts - the unchanging goals and course correcting strategies. In both aspects he should communicate decisive action communicating certainty. A plan will definitely help.

Third, Krugman is correctly pointing out that stimulus has not reached the masses. The objective of stimulus, to my mind, was to create income certainty. Whatever the reason, the stimulus has failed to achieve this objective. In this aspect, I think Keynes is being misunderstood and then derided for what may be out-of-context interpretation of his ideas.

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My book "Subverting Capitalism & Democracy" is available on Amazon

Austerity vs. Stimulus

Paul Krugman has reignited the debate about proposed austerity and continuing stimulus. I think we need to understand one more side to the argument. 

The problem 

The economic problem relates to creating jobs and businesses. Basically, we need avenues for people to start earning. Once people earn, they will pay taxes and spend a little from the surplus. This will make the economy self-sustaining. This has two steps. First, we cannot increase the burden of the people further. Second, what we spend should be big enough to generate incomes large enough to pay for it. This is essentially the dilemma. This is the reason why we need stimulus.

But the stimulus is not yet efficient

Though we have been living off stimuli for past two years, the mechanics of stimulus is not fully developed.

To reiterate my earlier position, this crisis has its roots in the certainty of income. A stimulus is efficient if it improves the certainty of income. The certainty is more important than the amount of income. The certainty of income will come from jobs (created by businesses large and small) and small businesses. It is clear that small businesses are critical link as they reduce the owners and few other people from list of those who want jobs. This is where stimulus should reach. But the stimulus is not reaching the intended location - able and potent small businesses and individuals.

The flow of money is such that the beneficiaries of the stimuli are not actually the ones who need it. Sadly, the reverse is also true. Those who are supposed to pay for the stimulus are not actually the ones who can. This is a double blow to the effectiveness of stimulus. But the fact that stimulus is misdirected does not mean that it is not needed.

Austerity won't help either

Austerity will severely constrain the opportunities of the masses. It will definitely aggravate the problems. Worse, at this point, austerity will wipe out any gains from earlier stimuli and render them useless. The prior stimuli will now appear as a burden without any gain or impact. When we have a fire we need water. The fact that some people wasted water should not stop us from bringing more.

What it means

At the start of the crisis, I had mentioned that either approaches may work if we fully commit ourselves right at the beginning. At the beginning we started with stimulus approach. Now we should fully commit to it. Our commitment issues may make the situation even worse. We will end up with larger liabilities and no jobs to pay them. It will push the world over the edge. 

So

We need to get two things done:

1. Examine what is preventing the earlier stimulus from working. Get the efficiency of stimulus going IMMEDIATELY.
2. Get more stimulus to where it is needed, FAST.

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My book "Subverting Capitalism & Democracy" is available on Amazon

Value of Gold relative to financial assets

Paul Kedrosky is a very insightful commentator and today he shared a linked from JP Morgan research titled Gold is Way Under-owned Compared to Other Times When the World Sucked. The post comprises mainly a chart shown below:

Now, shouldn't the real value created between 1982 and 2009 account for the difference?

Do we really believe we are creating real value? We believe stock markets are ways to invest into things that create value. Now what happens to the value we have created between 1982 and 2009. Gold is growing very slowly while we have (assuming) created a lot of real value. This real value will sit in as financial assets thereby reducing share of gold. Right?

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

Counterfactual: US government uses bailout funds to create a bank

Note: This is counterfactual. So US government did not actually do this but I am just guessing what would have happened if they had done it.

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During the crisis, US government initiated a bailout of approximately trillion dollars. Out of this about USD 700 billion was under TARP regime. What would have happened if these funds were allotted as equity in starting up a new bank -say US treasury bank or T-bank for short.

T-bank would be mandated to have 50% fresh lending and 50% buying impaired assets through bankruptcy procedures. Every other bank in US and post offices would be required to have a desk for T-bank.

Since the creation of this bank was forced on to the government, government will not pay the other bank branches for use of their office premises. The postal offices should be readily accessible to the government any ways.

T-bank would finance mortgages based on new assumptions about price. The price may be decided as average of past 20-year prices or current prices whichever is lower (or some such super conservative metric). T-bank will only finance 75% of the value of the house so calculated.

Loan against collateral will be instituted in similar to mortgages. An assessment of recoverable value of the collateral will be determined. It will be marked down by certain percentage to ensure full loan recovery in case of default. It will also check for equity contribution from promoters. Promoters will be required to give personal financials for verification. The financials will be checked to verify if promoter equity is indeed equity and not debt masquerading as equity.

T-bank would initiate a simplistic credit card program. Customers will get one-month credit at fixed rate of 10% (or some such number accounting for risks). T-bank credit card will not have fees.

As per the mandate, T-bank will be compulsorily and irrevocably privatized after 20 years at the maximum.

I believe this initiative would have immense advantages.

1. Since the costs are higher large businesses will not use this service leaving this money free for use by small businesses. T-bank, if so required, can be mandated to lend to SME and individuals only.
2. It will channel the money flow directly where it might make viable contribution. Creating money in balance sheet of large banks is like pushing on a string. The money simply does not flow to the grass-roots.
3. The current situation prevents eligible borrowers from borrowing because of the crunch. This is the best time for such borrowers to start enterprises and take risks.
4. The charges may be higher, but treatment will be fair so competitive forces may start assisting systemic cleanup on credit card and loan frauds.
5. It neutralizes the possibility that banks may hold the financial system hostage.
6. It presents no moral hazard since it does not interact with banks' assets at all. 
7. Further, since treasury or government is backing this bank, it has lower risk. Thus it should be able to access funds at very low rates.
8. The efficiency of this money, or the impact this money creates, will be far higher thus size of bailout liability will be smaller.

Interesting isn't it?

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

Impairing household balance sheets

The western household balance sheets are substantially large. But the recent crisis has brought about serious change in asset valuations. As the assets devalue and there is a corresponding impairment in the equity or debt side of the balance sheet.  If asset devaluation reduces your loans then balance sheet quality remains unaffected. For the US housing assets, the debt side was reduced. Hence while winding down of housing reduced the size of balance sheet it could not have impaired its quality. So the problem of US housing may have been lesser than anticipated from household balance sheet point of view.

The bailout, however, shifted this burden from bank balance sheets to government balance sheets. Now, government balance sheets are fed from household and corporate incomes. Thus what was earlier a housing loan problem is now a tax problem. In other words, the problem shifted from household balance sheet to household cash-flow.

On the credit card debt will be more tricky. Credit card debt will not be reduced in usual circumstances. The hit will be on equity side, thus severely impairing the balance sheets.

The cash-inflows are reducing while the outflows remain. The bailout has added a large chunk of committed cash out flow. Households will have to find matching inflows to offset this burden. Thus there is tremendous free cash flow problem.

Increasing government inefficiency, as government gets bigger, will only add to this burden. Unlike housing loan there is no jingle-mail option for taxes. Taxes, like death, are a certainty. So the bailout has shifted what was essentially a quality-neutral adjustment into a large impairment in balance sheet quality. 

So the western households will have to go through a severe pain before consumption returns to the pre-crisis level. This problem is going to haunt us for next half a decade unless we come up with some really radical solution.

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

Two-level currency system

Let me first confess that I was a proponent of single global currency system. The quantum of trades in FX was so huge that I thought it must serve no important purpose as the cost indicate. However, over the past two years my view is now leaning towards a two-level currency system. To understand this let us first understand few short points that I have already made in my book "Subverting Capitalism & Democracy".

Two functions of currency

A currency system needs to have two critical functions. First, it should reliably communicate price information. Second, it should facilitate the transactions in the economy and not hinder it. Given these two functions, a high or loose money supply distorts price information but allows enough money for transactions. A constrained money supply does not allow transactions to happen thus possibly limiting growth. Thus, the increase in money supply should account for the following:

1. The increase in the economic value being created in the economy. The higher money supply should support the exchange of these new goods, new services etc. (Simplistically let us assume 3 units growth was achieved)
2. The decrease (or increase) in the need for money because of efficiency in transaction creating additional velocity. This refers to structural increase in velocity rather than cyclical changes (let us assume velocity grew accounting for 2 units increase in money supply)
3. The increase in money inventory (locked up money) as activity increases (let us say 1 units)

So the net increase in money supply should be +3-2+1 = 2 units. Now each of this is difficult to determine as it is. So I think Milton Friedman implied that the actual increase in money supply should be a little higher than 2 say 2.2 units. This leads to inflation but that is better than deflation (separate debate). 

Further, we need reliable mechanisms to measure each of the three. If there is no confidence on the measurement we do not have a monetary policy. This is the problem with Euro. Fudging of sovereign balance sheets and finances have impaled the confidence in the monetary system.

Two-level currency system

An ideal system, I think, may be a two level currency system. A currency at the national level should signal the relative prices of goods and services in the economy. An international currency should signal the confidence in the judgement exercised in national currency. The international currency therefore decides the relative prices of currencies and thus of everything.

In pre-Bretton-Woods  era we had gold as an international currency while Bretton-Woods established US Dollar in that role. The system, however, leaves the world vulnerable to US monetary policy misgivings. The world does not have a mechanism to communicate the confidence in US monetary policy.

In sum

When we evaluate US monetary policy, I believe, we should do it in relation to world GDP growth, interest rates rather than simply to US growth and interest rates.

A currency without the legal charter to measure other economic variable does not make sense. Thus, community-level currencies (some experiments are being conducted in the UK) do not make sense unless they are deflationary by design.

We need a extra-national currency to signal confidence in national monetary policies. The money supply, in this case, should grow at the pace of world growth.

Over time as confidence in global measurements of economic activity grows, we can move to a single currency albeit accompanied by a single global monetary policy. Till such time a two-level system may be better.

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

Income and intensity of unrest

History is littered with examples of the ruling class trying to keep the masses impoverished. I always wondered why it was necessary to keep people impoverished. Why can't people be rich and still suppressed? It seems to me that the problems of poor and nearly poor have different impact on social unrest. First, money gives a means to the poor to battle for their rights. Second, if people with means see someone they can identify with being oppressed then they are more likely to do something about it.

What this means is that income distribution in the form of a pyramid, lowest income has highest population, is better suited for oppressive regimes. And as income distribution turns into a diamond shape (middle class has most population) things start turning around. For a while middle class builds safety nets to prevent falling back. But once such a safety net is in place, it seems, this mass of population gets politically active.

The unrest so caused, is more potent and revolutionary than unrest of poor masses. I believe China is at such a point. The flexibility of Chinese political system will be tested very soon (may be 3-5 years). The political system in China is more rigid than a democratic system. If its leaders are able to understand and respond to these changes (they have shown more promise than politicians of other nations), then China will be the superpower. Otherwise we will see flimsy wars and deliberate crisis creation to take focus away from internal situation.

India is also likely to see this change in similar time frame, but the democratic setup is super-flexible and thus unlikely to impact much in India. The changes too are much more evenly spread. A lower-income-class bias in policy has started gaining traction since 2005.

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My book "Subverting Capitalism & Democracy" is available on Amazon

Co-locating Risk and Rewards

If risks and rewards are not located at the same place it indicates that the system is broken. In a fundamentally sound system, higher risks yield higher rewards while lower risks yield lower returns. Stability and resilience of earnings or profits is characteristic of lower risks. High risk earnings tend to be volatile. However, when a sector gets stable high earnings without as much volatility we must conclude that system is broken. This is typical of financial system. 

The risks are being accumulated at government agencies while rewards will be released privately. It is one of the reason why Too-big-to-fail was a hazard. In simple words, TBTF held governments hostage forcing a transfer of risks and penalties to the public system. 

Firms routinely exercise strategies and tactics to shift risk out of the firms domain while retaining the rewards within the firms' domain. This, to my mind, is the goal of the bargaining power struggle well characterized by Michael Porter. Porter also suggested, as I interpret, that the system will stabilize at the point of fairness.

A fair firm is one that has returns in line with the risk it takes. It is able to take such risks because of knowledge and understanding of the process. However, through regulation and other intervention, it is possible to tip the bargaining power dynamics one way or other. I believe that is exactly what led to current crisis.

A crisis-detection system should use this property to flag potential crisis.

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My book "Subverting Capitalism & Democracy - Systemic Faults that caused the crisis" is available on Amazon

Emerging Markets are too small!

There has been some talk lately about Emerging Markets, mainly China, saving the world through growth. I do not think that is possible. The size of developed markets is simply too large for emerging market growth to register any meaningful impact.

US, Western Europe and Japan together account for almost $40 trillion of world GDP of ~$55 trillion. US is about ~$14 trillion, Europe is ~ $17 trillion, Japan is ~ 5 trillion. BRIC countries account for $8 trillion. A meaningful part of BRIC's domestic GDP is dependent on growth in developed world. A slowdown in these countries will impact this part of GDP. BRIC countries may be able to cannibalize domestic GDP from developed world but overall we will be net losers.

 

An analogy I like is that of Titanic. The developed world economies are like titanic while emerging markets are like small yachts.Yachts cannot save all the passengers from the Titanic. So we should work to keep titanic afloat.

 

Co-dependent growth is the best way out. But such growth is not possible unless we put our houses in order.

Government and Markets are competing systems

After I shared the list of ideas (download from Scribd) I discussed in my book "Subverting Capitalism & Democracy" (buy on amazon) I have received my first feedback. Ellen Di Resta, an innovation consultant and a dear friend, liked my proposition that Government and Markets are competing systems. Understanding the implied competition is critical to understanding role of governments and markets.

I believe that both government and markets are will of the people. People express their opinion through votes and through prices. Today, voting is limited - at the most about 50% people vote. while  almost everyone, including the poor, are connected to the markets. It appears that markets are better equipped to solve or do as people want. However, there are differences. 

Firstly in the way we pay for services of governments and markets. Markets use efficient mechanisms (pay-per-use) while government uses unfair mechanisms (everyone pays - as taxes).

Secondly, markets are exclusive. They are open to those who bring value to exchange. The influence on market is proportional to the value you bring to the market. Government, on the other hand, is inclusive, more just. Everyone has the "right" to participate. Everyone participates equally.

I argue that since people participate in both, they often confuse their roles. This allows, I believe, expanding governments, weaker regulations and general dissatisfaction with the government about taxes. I believe we need to fix this to get to a better system. 

We should interpret the responsibility of government in this context.

Links

My book - Subverting Capitalism & Democracy on Amazon

List of ideas discussed in the book - on scribd (free download)

Ellen Di Resta

The Search for Growth

Sovereign balance sheets are under intense media scrutiny. Sadly, the scrutiny lacks actual analysis. What makes a debt-to-GDP of 120% for a country more palatable than debt-to-GDP of 80% for the other? The answer is growth. So where is growth going to come from?

From the first principles approach, we know growth is derived from two sides. First, an increase in the penetration of current activity to cover more population leads to growth. Second, inventing new activities leads to growth.

Developing countries are growing using the first method. They have population where goods and services are yet to reach and mature. The risks involved in such growth are well understood.

Developed countries essentially rely on second approach to growth. The technology boom created one innovation driven growth wave in late 80’s and early 90’s. Internet created next one in late 90’s and early 2000. So where will the developed countries get the next source of growth? The answer is still not clear.

First, the tech-led triggered after more than 3 decades of scientific research. Modern computers and the Internet were inventions of 60’s and 70’s before they became a true mass-invention capable of driving GDP growth. At the moment only alternative energy seems to be on such a take-off point. In my limited understanding both nanotech and biotech will take more time and won’t be mass-inventions for another few decades.

Finally, it means that investors should be better off targeting “penetration-led” growth in the interim.

West - decline or browning

Stephen King of HSBC has come out with a new book. According to the reviews, it forecasts the decline of the west in the context of the current crisis. I was of a similar opinion. 

The decline of west is not specifically a decline but more like mean reversion. Asia was a significant player in the global context for mos of the past 2000 years. The recent 500 years have pushed the west ahead. With this background, coupled with the current weakness in the households and governments, there is a compelling case for a relative decline or more correctly a stagnation of the west.

Yet the infrastructure in west is fundamentally very sound and hence it is hard to make a definitive conclusion. A more reasonable approach seems to be one suggested by John Hempton. He refers to what I call a "browning" of the west. It implies a population growth through migration, predominantly from Asian region.

If and how will the western world react to this new trend remains to be seen. One predictable response should be a wave of protectionism against people movement. Possible job protection and corresponding labour harsher labour laws is likely. Yet even this is not certain. Europe has shown surprising resilience in protecting and upholding democracy and capitalism. It is possible they might stand up to negative developments again. 

Exchange Rate Conundrum

There is a great deal of talk about pressurizing China to appreciate its currency. The talk is bunk. The idea behind Chinese currency appreciation is not simply about China but it is about an exchange rate regime change. Asking China to let its currency appreciate in isolation will achieve nothing.

The old regime, dominated by US Dollar and other western currencies, was installed through higher savings and purchasing power (ability and intent). The intent to consume remains strong in the western economies. But the ability is seriously impaired due to lack of savings. So the old regime is falling unless we do something about it.

On the other side, a new regime is yet to emerge. China and eastern countries have higher savings rate (ability to spend), but seem to be lacking the intent. It is believed that the savings rate is excessive and may translate into consumption. Michael Pettis, professor from Peking University, believes this savings rate cannot rapidly translate into consumption. The savings are earmarked for social security, pension and education. Thus the demand that we expect from China or other eastern countries will not be that high. In other words, to be a strong consumer for the world, China will need much higher savings and purchasing power.

A rising currency can reinforce purchasing power for any economy. Importing capital goods becomes cheaper. Importing key raw materials becomes easier. There are lot of cost efficiencies that are generated. However, it exposes the economy to competition from overseas. It means employment is threatened. If economy has large population at lower incomes then it reduces consumption at national level. This is a good move for an economy where income pyramid is fatter in middle. It is natural that China would feel threatened by such a move.

There is other way to sustain the economy in appreciating currency environment. This stems from Porter’s competitive advantage of nations. Economies should start building sustaining competitive advantages. Low labour cost is not a sustainable advantage; rather it is a self-cancelling strategy over long term. The answers lie in Germany, in all likelihood.

In sum, it is time to establish a new regime based on fundamentals rather than managed currencies.  In such a regime, those with purchasing power will have stronger currencies than those without. There has to be global agreement on this regime to make it effective. Without it, we are going to wander aimlessly as far as exchange rate scenario is concerned.

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My book "Subverting Capitalism & Democracy - Systemic faults that caused the financial crisis" is available on Amazon.