Forecasting equity prices in turbulent times

The markets have been very volatile over the past few years. Investing in these times has been fraught with risks. In such a market, it is very difficult to make investment decisions based on valuation models. Almost always these models indicate that stocks are over priced. Equity fund houses are adding to the confusion with their near-random buy-sell ratings. There seems to be little logic behind these recommendations.

However, there is a method wherein we can logically explain the variations in valuations. We can look at equity prices as composed of two components, a value component and an asset inflation component.

Value component can be expressed as a price band based on fundamental assumptions. The output of most models is usually a price band. These assumption are dependent on the company and economic situation. As we tweak these assumptions for a base case, bull case and bear case we end up with a price band. The price or value is based on various valuation models such as sum-of-parts, residual income, etc. Normally, prices should vary within these bands and the inflation component should be bare minimum. However, in recent years the prices have moved out of the valuation range.

The movement is because of asset inflation because of the high liquidity being pumped into the market. Those are not the only reasons and each market has a different variables that influence the asset inflation for that market. The role of equity analyst, therefore, also includes forecasting the expected asset inflation. From a first principles, in a market influenced by foreign capital flows, average daily volume should be a good indicator. For example, in India, the asset inflation component for large cap stocks with high volumes could be to the tune of 35-40%. For mid-caps or firms out of favour the range may be 20-30% while small caps may have inflation factor of 10%. As the global picture changes, the macro analyst can thereafter adjust the asset inflation component at the country level. I believe this is a better way to present equity research prices.

Let us take an example.  Let us say that the value component for stock like Bharti Airtel comes to INR 300 per share. Now telecom as a sector is a little out of favour and the inflation factor for Bharti Airtel would be lower than usual 35-40% for large-cap stocks. Let us say it is 20-25%. Therefore, the expected price range for Bharti Airtel will be INR 360-375.

Disclaimer

Long Bharti

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

The Foreclosure Mess and justice

In the blog "The big picture", David Kotok has a very interesting article on the foreclosure mess. In the context of that article I would like to make a few comments. 

Before the comments, I must state that the issue, like all other in this crisis, straddles the political, legal, social and financial sectors. As a preamble, we must look out for the interest of individual as that is the primary responsibility of the courts and the governance mechanism. We must, like I say in my book, differentiate between real living citizens and firms that have acquired citizenship. It is time for the congress, government and legal apparatus to stand behind the interest of individual. Here are my comments:

First, both the defaulting lender (genuine defaults) and the institutions that misplaced the promisory note are at fault. However, the court has to evaluate the gravity of the situation and that depends on the relative bargaining power of the two parties. The question of relative bargaining power is very important as I discuss in my book Subverting Capitalism and Democracy. The bargaining power equations are clearly favoring the institute. The responsibility of the court is, therefore, to protect the interest of the weak i.e. the individual. Even if it means, in some cases, rewarding the mistakes of individual. Further, the individual will obviously pay for the mistake through higher taxes and loss of jobs. In all fairness, she will pay no matter what the outcome of the foreclosure.

Second, if the chain of title is broken, the person who can defend the title should have the right to initiate foreclosure. However, the person must show unequivocal demonstration of the title. In all probability, an institution within the chain of title cannot establish this without dispute for those downstream will challenge their claim either as fraud or will stake their claim to title. In the light of this claim, it is unreasonable to ask the individual to make a payment.

Third, if it was a matter of making payments, courts could have ordered payments into an escrow account to be allotted to those who can establish rightful ownership. The interest rate or size of payments should be in accordance with the agreement, or if the agreement fails to establish clear rate of interest, it should be at the interest rate set by the Fed. Similarly, courts can initiate a suo-moto foreclosure in cases where it is clear that borrower willfully defaulted and recover the money through auction of the property. The recovered money can then be transferred to escrow account waiting to be claimed by rightful owner.

Fourth, in all fairness, courts must set out limitation date for the title to be clarified. Without a limitation, the process can drag along for years. It is unjust to the individual.

Finally, in all the situations the outcome for banks, mortgage brokers and investors in mortgages are grim. Either way, we have a problem on our hand. It clearly means that banks and other intermediaries will need a bigger capital buffer than what they are currently carrying. Further, approximate estimates peg the capital requirement to be much higher than during 2008 Lehman episode.

It appears that the financial institutions may have realized this and initiated a global pull-back of capital. It is possible the recent correction in global equity markets are a result of this problem.

Notes

The Foreclosure Mess | The Big Picture

Subverting Capitalism and Democracy

Why foreign funds are preferring EM banks?

I was wondering why banks are the first object of desire for foreign funds in the emerging markets. Given the view on the currencies, I expected foreign funds to go after relatively(in currency adjusted terms) cheap EM- hard assets. I did not think banks would be such overwhelming favorites. However, the preference for banks seems to have some logic.

Banks in emerging markets have lower cost of funds as EMs have higher savings. The stress on bank incomes is lower as economy is growing and banks have first claim on the corporate income. Third, despite inflation pressures, FII flows and US FED's near zero interest rates are keeping the interest cost low. This has reduced the probability of defaults for large borrowers. No wonder this is most viable entry point for foreign funds.

Disclaimer

Long SBI

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

Fighting the Currency War

There is a lot of debate about how to fight the impending currency war. The problems are more from the US point of view rather than elsewhere. Let me explain.

US cannot unilaterally set its exchange rate. 
There are two ways of modifying exchange rate.  One ways is to clearly set the exchange rate and defend it using central bank intervention. This tool is available to smaller economies who peg their exchange rates to the dollar. But it is not available to the US as the economies of other countries depend on the US consumer. Its only way out is to convince other countries, those whose domestic jobs and economies depend on US consumer, to ease the exchange rate. US tried to convince China with the same intent. However, it is not China alone that poses a problem. The entire set of countries that use this export-dependent strategy should revalue their currencies simultaneously. Since these countries are adamantly defending the relative exchange rates, US seems to be in a state of crisis.

The other more fundamental way is to indicate to the world that the stock of money has gone up disproportionately as compared to GDP.  US has tried to print money. But it has not caused any effect. The printed money simply flows out of US into global equities, commodities and other asset classes. Further, if I get more US Dollars I can park them with other economies and wait for exchange rate reset to give me substantial gains. The more exchange rates are suppressed, the more I have to gain.

This conundrum, obscene as it is, is due to the fact that USD is also an international currency. To have a credible effect, the volume of printing must be in relation to global GDP and not simply US GDP. At USD 15 trillion, US GDP is about a third of global GDP. So you need three times more printing. Further, if US currency devalues erratically then the entire burden of currency will fall on US domestic economy. Herein lies the dilemma. It is a lose-lose proposition.

But there may be another way 
I think US may be better served by front-ending its borrowing program. The US can initiate a borrowing program equivalent of 10 years of borrowing. This program should be completed within a year. Only a part of this program will be successful. However, it will pull the global liquidity towards US while money printing is pushing liquidity out of US. It will force other banks to print and buy US bonds or let their exchange rates appreciate. Usually, governments are wary of failed bond auctions. In the case of US, this is not an option for the other countries. They need the US consumer more than US needs them. US can also set trade limits based on amount of USD reserves held. In other words, let other countries put a price on each job they are defending.

However, US needs to have a credible plan to invest this high liquidity that will flow into the country. Using this liquidity, US should get out of the recession.

Then, we must consider unintended consequences. A front-ending of borrowing may upset lenders like China. How China will react to such a policy is unclear. But it is reasonable to assume it won't be pleasant. In effect we will face a lot of unpleasantness. But then it is a war, isn't it?

Notes

Marting Wolf makes a similar argument

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

Tax reforms - Ezra Klein makes a valid suggestion

Ezra Klein comes around to the idea that I have been talking about for years. He argues that we should get a receipt for our taxes.

A tax utilization break-up

While the general budget does give a broad outline, person specific contributions should be a right of the citizenry. Ezra draws similarity with food ingredients and calorie break up. To take the analogy further, government budget is equivalent of stating national food ingredient and calorie consumption. It makes little sense to the individual. We should get a break up for how our taxes are allocated.

Individual tax allocation choice

I often think about giving the choice of allocating tax dollars to the individual. I believe, in a sense, it will be a pragmatic manifestation of democracy. Embedded within this idea are two critical ideas.

First relates to relation between democracy and empowerment. A first principles analysis suggests that democracy is about empowerment of the masses. Our recent iteration of democracy is masses empowering the government. There is a substantial difference in these two points of view. 

The idea refers to the differences between masses and government. Our iteration of democracy views masses (or citizenry) and government as two separate agents. The result of this differences is evident in intellectual differences in opinion of masses and those of government.

Further more, government is now a seat of power and thus no different from the monarchs and nobles of yore. The first principles seat the power at the hands of the people. It creates government as an agent to exercise this power. Government does not acquire but borrows the power from the people to enable people to exercise their mind and opinion.

The second idea relates to the (wrongful) importance of keeping tax policies away from citizens. Governments, like monarchs and nobles before, believe people do not want to pay taxes. They have no qualms in believing that these same people will understand credit card statements easily. I do not agree with this point of view. I believe, if we trust the citizens to allocate taxes we may get a fairer spending that may actually benefit the citizens.

I believe, by taking away the ability to direct taxes from the citizens, government is limiting democratic rights. Years ago, before the advent of computers, it was not possible to allow citizens to take this responsibility. However, current technology that allows these same citizens to vote in American idol based on performance, can be used to allow citizens to make these important choices.

In sum

Sometimes, by giving responsibility to citizens, we may make them responsible. We can also foresee a possible disaggregation of governments into policy designers and bureaucracy. We do not need to career politician as a policy designer.

Links:

Ezra Klein - Shouldn't taxpayers get a receipt?

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I discuss governments and taxes in my book "Subverting Capitalism & Democracy" is available on Amazon

Roller coaster - Welcome to the first loop

The equity markets are rising the world over. The rise, I believe, is our first loop in the roller coaster out of crisis of 2008. This cyclicality was to be expected. We are, now, close to the pre-Lehman levels for key global markets. Yet, I believe we are still part of the overall down-cycle.

Cyclicality is result of slosh money 

As I mentioned in my book, the cyclicality is the result of slosh money. As I define it, slosh money refers to large pools of capital that can move through the global economic system stressing the archaic regulatory framework. 

Slosh money is herded thanks to lack of divergence of opinions. The lack of diversity of opinions is truly surprising. In times of crisis, the diversity of fund allocation increases, may not be within a fund, but overall between various funds. I do not see this diversity developing.

The down-cycle continues

The down-cycle will continue post these current peaks. I still stand by my 2008 post about cyclicality. The frequency of the down-cycle has come out to be 8 GDP reporting periods rather than 4 as I predicted. The bottom of the next cycle will be deeper and sharper than the first cycle. The next cycle may be, in good probability, the last leg of down-cycle. 

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

Trade Wars & Currencies

Michael Pettis worries about a trade war between surplus countries and deficit countries. The basis of the war is two fold.

First, the US Dollar is the unofficial world currency. In that role, it has to function as a store of value and a facilitator of international economic growth. As such the US has to bear the responsibilities. This constrains the US Government. 

Second, we can alter or manage other global currencies and its value in US Dollar terms. This comes at a significant costs but it is doable. The most popular method is through intervention by central banks. Central banks buy or sell their US Dollar holding to keep the exchange rates in check.

Problems for US

The impossible trinity applies to the dollar's case in a different manner. US government has open capital system and flexible exchange rate so technically this should be a non-issue. But there is a problem for US. The objective for managing the trinity is to manage the economy and the trinity represents tools to that effect. In the case of the current trade war with US and surplus countries, these tools contradict each other and render US policies useless. The constraints will either cause US to bailout the world or there has to be a restructuring of the global currency system.

A two-level currency system

It is clear that US dollar cannot and should not serve as a global and national currency. A rational solution that maintains the sovereign independence while serving global trade and growth needs comes from a two-level currency system I proposed earlier.

Links:

Micheal Pettis in FT

Yves Smith on Micheal Pettis

Two-level currency system - Rahul Deodhar

PS: This is the 200th post on this blog. I started the blog in 2004 with focus on companies, innovation, investments and ideas about future. Over past few years the focus has been exclusively on the crisis and its solutions. It is read by 20 people every day. Thank you for being by co-travelers.

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

Pseudo Keynesianism

As a solution to the crisis, I am more inclined with Hayek approach of taking the pain quickly and all up front rather than prolonging it as Keynes recommends. However, I dispute the interpretation of Keynes by modern media and experts.

Michael Pento has an interesting article about Keynesian approach. He uses the metaphor of an obese man getting opinion from Hayek and Keynes. While Hayek advises cutting down on food, Keynes advises opposite. And there in lies my problem with interpreting Keynes in modern context. 

At a very simplified level, Keynes suggested that keeping the aggregate demand stable should be the focus of government. While this is true, I believe given the context of the situation Keynes lived in, it is not the interpretation we must derive for our times.

My interpretation of Keynes

Keynesian solution, to my mind, is about bringing certainty on the job side. At what level of income this certainty comes is, just my argument not Keynes, immaterial. So the objective of Keynesian stimulus is to create stable employment. The aim of stimulus is not to push the money through the banking system to achieve this effect, but to use a robust, loss-less mechanism to achieve this end. If the banking system is impaired, it cannot be loss-less mechanism of choice. In such cases direct government employment is better alternative.

Keynes famously argued that how you deploy this manpower is irrelevant. For all practical purposes, he argued, you may simply dig a ditch and fill it up. The real deployment of Keynesian stimulus was targeted towards infrastructure construction. The highway program is a prime example. 

In my view, Keynes would have agreed with Hayek's solution. His endeavor may have been to achieve the change without the pain involved in Hayek's solution. Whether it is possible to change without the pain is a different question.

Keynes and Hayek as alternative approach to same solution

I believe, there are two ways to solve the crisis. 

First is by using the Keynesian solution in the right context. So focus on employment rather than bailouts. Focus on flexible employment rather than entrenching unions. A misdirected Keynesian approach is very costly.

Second approach is by using Hayek's solution. Take the pain, and thereafter let the economy revive. This approach does cost less and has no future tax repercussions.

The dangerous combination
Often what results as policy makers with little grasp of Keynesian option abandon it earlier and switch to Hayek eliminating all the future tax benefits built into Hayek's solution while causing as much pain before the recovery. The Hayekian recovery also takes longer as the first round of Keynesian stimulus, in all probability, has added to mal-investments. We are exactly at this point. The first few rounds of stimuli have been hardly successful. They have or will soon result in mal investment. Where will go next?

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

The truth behind Encouraging home ownership

Here is a link I got today through Yves Smith at nakedcapitalism.com. Feds rethink policies that encourage home ownership - USATODAY.com. With the amount hubris exposed in recent months I doubt if home ownership was promoted for the sake of citizens.

Asset backed paper vs. Casino's deck of cards

A casino has as many decks of cards as it needs. The real world casino "the financial markets" do not have such access. They need each card to be backed by an "asset". Asset could be wide variety of things. It could securities or bonds which are ownership title of businesses. Assets could be the resources in stock piles or a right to use (mining) those resource like oil, coal etc. Now what if there is too much money at the hands of the too few people (mostly what I call big money - funds). These people can gamble a bit but soon the price behind one deck of cards goes through the roof. That is the time to bring in additional deck. So how can we create such real world card decks easily? Home mortgages!

If homes were exhausted, we can create MBS, CDO - more decks! Once that is done we can create default swaps on them. If those were exhausted we can create CDS on insurers of CDOs. Jolly God! here is the eternal fountain of asset paper - inexhaustible source of deck of cards!

Morality for you - profits for me!

I am surprised how economist expect the homo economicus can be expected to behave rationally for everything else except for mortgages defaults. I would rather encourage people who cannot pay to default. After all companies do it all the time and their credit rating does not get impacted.

Comments on Microsoft

John Hempton, who fabulously broke the banking solvency talked about Microsoft recently. In the third post in the series titled Microsoft – an accounting geek’s summarizes his purpose and lessons. I wanted to add some comments to this since the first post. So here it is:

1. Bundled software in India:
• India still sells laptops without the operating system. The proportion has gone down but it still exists where dominant volumes are.
• Ubuntu and Linux overall has not caught on because it is not user friendly. As it gets friendlier, expect Indians to move to Linux versions faster than Microsoft can cope with. All Microsoft needs to do is support XP. A lot of pirated Windows XP is still being used.
• Such a response is currently underway in mobile phones. I believe it makes sense it happens in mobiles first because, device capability is limited, hardware is cheap (from china) and Indians have unique needs (apparently more Indians need dual SIMs than elsewhere - in pagers we preferred the alpha-numeric ones etc.) I can't see why it cannot happen in laptops. (More about it below)
2. India Volume play suits Apple more: If you think about volumes as a driver, Apple makes much better sense. 
• We are paying $1000 for iPhones and if you see the penetration you will be amazed. If iPhone were to be available at $500 equivalent Apple would not be able to handle the sales volume. The user interface is mind-blowingly simple even my mom and dad got it right away. (They don't speak computer English). It is very intuitive. Through iPhones and iPads Apple can make a huge in-road into Indian market. They have to price it right though.
• Why I discussed about iPads is that most users do not need a laptop or a computer. They simply need a device that can connect them to the net. A phone is a little small for the purpose but a tablet is ideal. Indian government announced a tablet PC for $35 and it is pretty ok with camera and it works on Android. (It is for education institutes)
3. User friendliness is still paramount: While I worked on and loved Unix (was a programmer) but I think for regular computer usage, MacOS, Windows make lot more sense. Android is emerging as a significant alternative in tablets but it is nearly as good as windows CE. 
4. Distributed legal liabilities: Unix and its versions are popular for server side because of customizability. There is other side to the equation. Security is costly and Microsoft cannot release a lower end product without risking security issues. It is an easy legal target if it fails. So it has to put in lot of effort just to ensure base level security. Linux falls through the legal cracks as the legal liabilities are diffused. Just as small revenues amplify so do small legal claims.
5. About security: Security issues are dominant concern for Microsoft. It does not have control over where its operating system is being deployed. It does not know if clients are updating the OS or not. With emergence of Software as a service model (SAAS), Microsoft will breathe easy. I expect as SAAS starts getting prominence, MS will start unleashing its programming prowess to more beneficial use.
6. Still top institutional service provider: Microsoft juggernaut is large and has tremendous inertia backing it. The IT departments of top Microsoft clients are testing versions to be released in 2011 and 2012. Frankly, even Apple does not have that kind of sales and testing infrastructure on institution side.
7. MS as fast follower: For the consumer side, Microsoft is better characterized as a fast follower than a tech leader. It has always copied Apple and will continue to do so. (Panasonic to a Sony). There are two scenarios from here:
• Currently the environment is in flux so we cannot see Microsoft response but response will come and it will eat away a substantial share.
• The model has changed to a long-tail model. Microsoft noticed this with Zune. It came in very late once the product stabilized but that was too late for the market. So it is match step-by-step in phones. Here too it is a bit late but faster than with Zune. Eventually it will figure out.
8. It is the Microsoft game: The game Apple is playing was invented by Microsoft: 
• Microsoft dis-assembled the IT hardware and software value chain. It broke the integrated approach of IBM. Apple followed IBM model in hardware and OS and used Microsoft approach with additional software. But overall Apple is still more in IBM mode.
• Apple is breaking the mobile phone software value chain but it retain the hardware approach of IBM in phone space. In phone space it HAS to break the software value-chain. It is doing this through App architecture. That is straight into MS territory. Apple will face same issues as MS if it were as important to business community as MS. Thankfully Apple is sticking to consumer electronics side.
• Blackberry is more like thin-client server model we know. A Google-wave like protocol will break this model. My guess is Microsoft will break blackberry.
• The reason MS cannot fight easily because of legacy codes. Phones need light codes but MS codes is HUGE. But in phones and in computers MS has changed its stance to scrapping old format all together. MS will gain from it because there is so much knowledge that it has but cannot use - now all that will be possible.

Disclaimer: I am an Apple fan but I love Microsoft as well. MS Excel is probably the best product every produced. It also makes awesome mice. This is discussion about future of tech and not stock analysis of Microsoft.

Pensions are complicated

The Economist has a nice blogpost about Jobs, pensions and markets: Required reading | The Economist. Here is one important quotation:

Public sector pension funds have just followed the pattern of private sector schemes. Step one, promise employees better pension benefits in lieu of higher pay. Step two, allow older employees to retire early as a "cost-saving" measure. Both employ the economics of the never-never.

And this,

Pension funds are classic Ponzi schemes in which the benefits of retirees depend on the income generated by new employees. (This is true even of funded schemes, since they invest either in equities, a claim on the profits generated by future workers, or government bonds, a claim on their taxes.) They were thus bound to be in trouble once the demographic pattern shifted, and the next generation was no bigger than the last.

This is already a hot political issue as my US colleague notes in this post; as in Britain, attacks on public sector pensions are generally launched by the taxpayers' party (Republicans. Conservatives) and resisted by the public sector workers' party (Democrats, Labour). It will also be a legal issue. In Colorado, retirees are suing over plans to reduce the scope of their inflation protection.

The pension problem is not that straight forward. Paul Krugman posted an interesting study about public-sector and private sector wages. He points to a study by John Schmitt which concludes that after adjusting for education and age, public sector workers are not overpaid as compared to private sector employees. Wages ultimately impact pensions, so ideally pension liabilities should not be unjustly high. 

However, as the article points out, the pension scheme by design is flawed. We need other means to protect the lifestyle of the retired worker. By protect we do not absolve the worker of economic prudence, but ensure that some fixed income can be earned without having to continue rigorous work. So in the post-retirement phase the work is different. Such work opportunities must be available in the first place. Singapore uses such a concept creatively.

While, pensions scheme design may be flawed, it does not allow government to renege on its promises to older workers. I discussed earlier that changing terms of pension being equivalent to breaking contract or promises to the employees. I believe the modification of terms by government for common people is not a prudent move, particularly considering the enthusiasm with which AIG was paid.

In Sum
We do need pension reforms, but it has to be humane. Governments cannot simply cut pensions just because they cannot pay. After all didn't monarchy do it in similar way - spend and if you cannot pay kill your creditor.

Who is Rich?

The philosophical answer to the question "those who have more than they need" was always disconcerting. I never related with it. But looking at the situation of developed markets today, I have rediscovered the wisdom in the words. 

An indebted rich nation is not rich

By all counts, average American household is indebted. Those with high income but still indebted to the hilt cannot be considered rich. These households need to scale down their spending. To add to their woes, these households are facing an increasing tax burden.

Tax burden on households is based on incomes not profits
And this is a critical difference between corporates and individuals. When corporates face higher taxes, they increase their costs by investing in assets, paying higher salaries, etc. Thus, in my view taxing corporates is a better alternative than taxing individuals.

Taxing rich is better than taxing poor
Though this is obvious, rich often use corporations to park their earnings and thus get taxed lower. There should be differential rates for different income slabs - particularly at high income levels. Here the size of population is small but the value of tax collect is large.

Reference
New Yorker on Tax reform

QE-2?

Here is an awesome cartoon. Concept by yours truely and illustrated by Martin Whitmore.

Will Japanese Investment Overseas decline?

A consistent overseas investment by Japan was a critical phenomenon since the early 90s. Thanks to low interest rates at home and relatively benign economic growth outlook, Japanese were (to an extent) forced to invest overseas. 

Over the 90s Annaul Japanese overseas investment averaged $20 billion. In the first half of this decade, it inched up to about $ 30 billion. However, over the past five years it has accelerated from $50 billion to $ 100 billion in 2008. The net overseas investment reached a peak in 2008 and came off in 2009 according to recent report titled Japanese FDI: Recent Trends and Outlook Investment overseas by Japan institute of Overseas Investment.  It begets one question.

Will Japanese FDI reduces substantially or even reverses?

A lot of factors that contributed to Japanese investments have changed.

• Japanese domestic economic climate may be about to change. We are not sure whether it will recover or fall into a depression, but it is unlikely that the economy will amble along directionless in the next decade.
• The age profile and dependancy ratio has weakened over the years. At some point it will change from creating a pension and savings pool to using it. Thereafter we may see a draw on pensions and savings funds.
• There is also a higher global uncertainty to deal with. 

So what?

With about $100 billion at stake, I was about to dismiss Japanese investments as marginal. These days scams and Ponzi schemes run into trillions. But that is not true. 

• $ 100 billion is a substantially large FDI investment, it is almost size of a small country. 
• There are bound to repercussions for a capital-starved world economy. World economy is capital starved with large-scale frauds and write-offs and thus a bit more vulnerable than otherwise. The sovereign balance sheets are stretched to the breaking point.  In many countries bond vigilantes are doing their proverbial dance of death. 
• China may take up the slack with its large surplus. However, people are wary of Chinese influence.

In Sum

While it may not be earth-shattering, but changing preferences in Japanese investments is bound to have some impact on global economy. We need to understand it better.

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

Elizabeth Warren - Election vs. Selection

There is a huge debate about what prevents US president Obama from nominating Dr. Elizabeth Warren, the Harvard Law professor to head the Bureau of Consumer Financial Protection Agency. Recently Fortune asks the question in an article titled Why not Elizabeth Warren for BCFP? The Warren episode exposes a fundamental political problem of election vs. selection. Political parties prefer voters and population in general to "select" one candidate.

Difference between Selection and Election

Selection refers to making a choice between available alternatives. While, procedurally similar, election refers to choosing amongst ourselves. By crowding out real representatives, career politicians leave the voters with non-options. What remains can hardly be called "election". There is hardly any difference in actions, thought processes or ideas amongst competing candidates. No matter who we select, the outcome is always detrimental to the population. Since conventional mechanism is not available, we should use opportunity to put real people's representatives in a position where they can make a difference. Such opportunity came up twice in recent past. 

The emergence of Paul Volcker as a champion of prudent finance promised to be the first moment. It passed away quietly partly, I presume, because of Volcker's age and responsibility he already shouldered. He was relegated to the role of an advisor who probably no one heeds.

The impending nomination of Elizabeth Warren promises to be the second case. I must confess that I am fan of Prof. Warren and I believe she is a true champion of middle class America. In fact, I believe, her expertise should be used diversely to advantage of common people.

Politicians be warned!

During my school years I often wondered how could Marie Antoinette could be so far removed from reality to ask the people of have cake instead of bread. I am no longer surprised. I think today's politicians are further away from reality than Marie Antoinette ever was. The appointment of Dr. Warren presents the first opportunity to redeem the political apparatus. Remember the fate of Marie Antoinette at the end of the French Revolution. 

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

The crisis of middle-class America

FT, more often than not, does a better job of reporting than many other newspapers. Here is FT talking about middle class America - FT.com / Reportage - The crisis of middle-class America. The examples are well chosen. People with income twice the national median, working four jobs (between two adults) are not able to reliably meet their obligations. Some are stretched by healthcare expenses others while others are fighting through job losses. One can only imagine what happens at lower-than-median incomes.

Welcome to the new normal

One of the harsh realities economists talk about is the "new normal". It includes a lifestyle with smaller cost footprint. It means scaling back on purchases. It means no new clothes, no new cars, no computers and cameras. The middle class is not saving, it is simply adjusting to new levels and risks associated with their income. At least a third of American households are in this situation. So we can only imagine what it will do for a consumption-led GDP. The future does not look bright. 

The question of jobs

The government needs to look at the profile of population and profile of jobs available for the population. I mentioned in an earlier post that every economy has an ideal job profile based on education and skill levels of the population. America is losing those jobs that its people are qualified to do. They are losing these jobs thanks to uncompetitive currency, higher wages and benefits and possibly inflexible workforce (in education). This will cause further pain in the coming years.

Declining Wage profile

Just as economy has a job profile, similarly every job profile has an associated income profile based on global wages adjusting for productivity. The wages in US are higher, I believe, than global wages AFTER adjusting for productivity.  So the incomes for those jobs that americans have will not rise much or may even fall. It will stretch middle class households beyond redemption.

Volcker-Warren conundrum

At such times, America should call Volcker-Warren combine to lead the entire financial reform process.   The Warren appointment is being fought at the CFPA level itself so that it is easier to control the Warren-influence over the general Financial reforms process. I hope, rather pray, that Warren ultimately triumphs. She is the only hope in otherwise hopeless economic and political landscape. Same goes for Volcker, the ultimate Volcker rule is so watered down, I doubt Paul Volcker is really satisfied with it. It is time for leaders of America to stand up and be counted. Alas, there aren't any.

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

Small and ineffective stimulus in 2007-2009

Paul Krugman has an blog post titled How Did We Know The Stimulus Was Too Small? He discusses three points. First shortfall was about $2 Trillion. Second, the stimulus was designed at $780 billion. Third, the multiplier that was expected to magnify the impact was not properly enabled. 

There are few points and other reasons that I have highlighted over the days:

First part of stimulus went to mending the financial system. This part is basically used in wetting the system rather than actual priming.

Second, the type of activities under stimulus determines the effectiveness of the stimulus. Some activities are better at stimulating than others. Income supporting activities are often better at stimulating than consumption driving activities. Thus the proverbial dig-a-hole-fill-that-hole Keynes stimulus had better bang for the buck than the Obama-Bush please-spend-the-tax-cut stimulus.

Third, individuals save because there is uncertainty about incomes. The only way to counter uncertainty is by creating certainty. It is OK if the level of "certain income" is lower than actual. Once there is certainty that bottom is in place, the direction of wage declines stems and even reverses.

Fourth, the choice of monetary or fiscal stimulus was available in 2007. It is still available provided you write-off the stimuli till date.

Fifth, Scott Sumner proposed that monetary and fiscal policies were acting against each other. There is an element of truth to this argument. However, predominantly the fiscal stimulus failed because it was ill-designed.

Sixth, since banking system was under threat,

• I would have created a parallel national banking system using post office infrastructure. 
• This national bank would have bought assets from the consumer (mortgage transfers) at a marked-down prices so that the balance sheet of this bank stayed healthy.
• Since we did not do this, we have a huge bailout liability and we are still not sure if banks are sound or not.

Seven, if we had designed the stimulus better and gone with a simple job-creating fiscal stimulus, we would have needed far lesser money that we needed to bailout the banks.

In Sum, there were a lot of things wrong with the stimulus. Size was just one of them.

Links

Krugman's Post "How did we know the stimulus was too small?"

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

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.