Efficiency of governance

Edward Harrison at nakedcapitalism points to Slovenia going the Greek route. Slovenia, it seems, needs to cut budgetary spending and undertake pension reforms. At the slightest of such references, the right-wingers jump into the fray stating "we need a smaller government". Now you know how I hate when government modifies its promises on healthcare and pension for the old. In this case, smaller government refers to government expenditure in line with the government revenues.

Often that is reduced to lesser people employed by the government. It means less police, less hospital staff, less departments to control something-that-should-not-be-controlled, etc. In other words, smaller government often boils down to lesser governance. But it need not be if we have higher productivity of government staff.

We need to improve the efficiency of governance. A lot of duties of government have been clarified in the constitution. One, I believe, is left behind. In the constitution, it must be made clear that government must strive to lower the cost of governance. It must increase the the deliverables (governance) and reduce the burden on the tax payer (cost of governance). We have seen companies reduce cost, why can't the government? There is a distinct lack of focus on government productivity. It is time to introduce such metrics and track them over time.

I think before we talk of smaller government, let us talk of efficient government. Let us talk of increasing governance and increasing efficiency of government.

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

The end of middle income trap

There is a lot of research about the middle income trap where the GDP of countries grows but stalls once it reaches the Middle Income group.

How the US kept its lead?

The US kept its lead by being at the frontiers of development. First it was the manufacturing productivity boom of the 1900s where Henry Ford found ways to deploy labour in a new way multiplying the productivity. The next few decades was more of no-competition-post-WW1-WW2 phase that created man-power shortage. The US kept its lead by bringing the women into workforce imitating the western Europeans. Over the next few decades, US deployed economies of scale to keep productivity high. This was the dawn of the technical age with new machines aiming for quality and speed. The next phase was information age. Again US companies leading the information era created unparalleled advantage using technology. 

What comes next, is the crucial question. It is not yet clear. However, what is clear is that it will definitely require more knowledge and technological input than previously. Can the silicon valley, which has delivered quite a few technological winners, give US the next advantage? The chances are getting smaller every day. But that is nothing to do with Silicon Valley itself, but the political climate in which it must operate. Stifling immigration laws that prevent talent from coming through, unfriendly tax regime that will definitely be a burden on small businesses, lack of science and math educated population and global reach of the VCs may thwart the leadership position of Silicon Valley. Further, technology now allows interactions across the globe allowing crucial connections between VCs and founders possible. There are two areas where size of investment could make a difference. These two areas would be renewal energy and water treatment.

The connection with Middle Income Trap
With the US and developed world acting as a source of demand, and simultaneously as a frontier of development, implied that middle income countries were reliant on currency valuations to ensure competitiveness. The currency strategy, it implies, were creating a ceiling for these countries in terms of incomes. Quite a few countries, like Malaysia, have little difference with US or other developed countries when it comes to actual productivity (as defined in engineering not economics). The lower economic productivity is a function on artificial factors.

I believe we are at a stage when technological edge of the developed countries is not substantial. It is possible that new developments will come from across the world and some other country, possibly China, will take a leadership role in the coming decades. As a corollary, it will escape the middle income trap. With this as an example, it will be possible for others to use similar strategy.

Developed world median-incomes may decline  
Concurrently, the median incomes in the developed world, may decline upsetting the conventional benchmarks for what is classified as a middle-income-group. The current crisis, is creating ample structural shifts to hasten this process. Soon, we will see a realignment of real wealth.

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

Does the US have enough manufacturing?

There is an interesting article on Huffington Post wherein David Henderson counters a series of posts from Ian Fletcher who argues US has less manufacturing that it needs. Overall, I am in Ian's camp but with differences. I wish to make some different argument about why US needs more manufacturing.

Manufacturing jobs vs. manufacturing output alone

Firstly, it is important to concern ourselves with manufacturing jobs rather than manufacturing output alone because jobs and employment determine the consumption level. 

Let us compare two polar opposites, an economy with 100 people employed in producing 100 units of GDP output vs. an economy where 100 units of GDP output is created by 1 person with 99 unemployed. We can imagine the difference in consumption patterns of the economies. 

That is why I believe, if consumption has to increase (reflecting on economy getting richer), not only does output have to increase but employment has to be high. 

Low cost capital reducing employment intensity of production

The reason why employment intensity of US manufacturing is reducing can be attributed to cheap capital. In most manufacturing activities, capital and labour are competitors. A higher capital intensity reduces labour intensity. 

The relative cheap capital flood of past two decades has come to haunt the US. The easy capital has reduced the employment intensity of its manufacturing and rendered thousands unemployed. Economists will argue that these unemployed are free to engage in other value-adding activity. But that is not easy.

Job and skill match

I have always believed that the job profile of the economy should match its skill profile. A nation of plumbers will need plumbing jobs, a nation of software programmers will need IT jobs. Each nations needs jobs that match its skill profile. I think US has lower manufacturing jobs than its skill profile requires.

Skill profile can be changed, but that takes time. Adaptability to different jobs itself is a skill, a very valued one at that. How adaptable is US workforce? This question must be answered relatively. Is US workforce easier to adapt than Chinese workforce? I have my doubts.

Hence, I believe, US needs more manufacturing jobs rather than simply manufacturing.

Selling rights as opposed to assets - FDI conundrum

The other argument often looks at the capital account surplus as a counterweight to current account deficit. I would not club all the in-bound investments into one. It matters what the US is selling. Is it selling rights as against assets? I refer to rights as rival assets (parallel to rival goods) while simple assets are those with non-rival quality.

[Note: Rival assets are those assets that can be duplicated. A building can be duplicated but not a port or a road. Technically assets are always rival but we need to make distinction to understand the quality of what is being sold. We can sell factories and recreate everything. But we cannot sell ports, roads, beaches, monuments etc. and expect to recreate it. Thus what is asked of Greece is selling rights not assets.]  

Thus, when we look at in-bound investments (FDI) we must look at what is being sold before we can comment if it is a fair deal.

In sum

I believe Us skill profile needs more manufacturing jobs rather than simply manufacturing output. So long as jobs are taken care of, it does not matter if US has enough manufacturing or not.

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

My cartoon about Greek situation

All work copyright Rahul Deodhar

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

Curbing the exuberance in oil (& commodity) prices

The fluctuations in oil prices and commodities are creating a problem for global regulators. There is a way to make the volatility go away while allowing for liquidity. Oil prices dropped $6 as the reserves were released. If not speculation, what is this?

Reign of speculators

Physical delivery accounts for only ~3% of the trading that takes place. The rest of the trade is mere speculation or hedging. A lot of arguments are made about the 97% providing liquidity for the 3%. To me, that is too much liquidity. Its corollary, high liquidity means inflation, implies that prices are too high. My gut feel (no research backing) is that this figure should be ~20-30% if not more.

Compulsory delivery

Now if delivery is compulsory for these traders it will make it difficult for random speculators. But it is very difficult to create and enforce compulsory delivery mechanism. In some cases there is legitimate re-sale to other parties (high-seas sale). However, the principle can be deployed with adjustments. Let me explain this mechanism.

Hurdle costs

What we need is to get the investor to block a percentage of capital required for storage and an annual fee for maintenance and upkeep. This will create a hurdle costs for investors. If they are legitimate investors or genuine traders then there is no extra cost as they already have infrastructure for storage and delivery.

The capital requirement will have to be deployed for each commodity or at least specific types of commodities. e.g. grains may have a single warehouse but oil and grain will have separate investments and upkeep costs. 

Trading Caps within hurdle costs

Once the investor pays the capital for storage and maintenance, he creates a maximum allowed position that commodity or commodity group. Hedging may be allowed for 100% of the volume occupied. 

This is beneficial for producers too

Today, producers make investment looking at commodity prices and later the prices fall, it will create huge losses. Therefore, producers are reluctant to deploy capital till they are sure the high prices are result of fundamental factors rather than speculation. Hence, oil exploration that could be viable when crude is at $80 is not undertaken till crude goes above $100 and stays there for some time. In short, producers cannot trust the prices communicated by the markets. This leads to a build up of supply side pressures creating an inflationary spiral that abruptly breaks down.

In sum

Such limits should reduce the rampant speculation. This, I believe, will allow for real markets to clear at correct prices. It will ease the burden on consumers and will correctly determine the return on investment by producers.

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

The June uptick in Indian markets

BSE Sensex June 21-28, 2011, Google Finance

We have clocked 3 days of super-normal uptick in Indian stock markets. Just as I was not clear about what spooked the Indian markets a few days before on June 20th, I am not sure what has gone right since that time. 

I think, with respect to Indian markets, we are entering a period of volatility in the Indian markets. The reasons are plenty.

First, it is now a consensus view that inflation will move to double digits soon. What is not understood is real life meaning of this stubbornly high inflation extending beyond two years now. The price acceleration that is implied by continued higher inflation will either impact corporate margins, or impact demand i.e. revenues, or both. To complicate matters further, the investment required for supply-side easing are not coming through. Corporate India is reluctant to work on their long term capacity addition plans. This is clearly not a situation where markets should be heading higher.

Second, there is impending specter of Euro-crisis going out of control. Europe is a huge market for Indian exporters. A slowdown in this area will have a shake out. Even excluding Europe, global demand picture looks soft.

Third, the recent fuel price hikes have complicated the fiscal situation. Indian fuel pricing and tax structure is needlessly complicated. The crude imports are taxed, processing is taxed, there is a sales tax and service charges. Ultimately, the whole oil business contributes substantially to the governments kitty.  Any altering of the tax structure is negative for fiscal deficit which is already under stress.

All in all, there is no reason for the markets to behave as they are behaving. While I dipped a week ago at the lower points, I believe there is still down-side risks. We haven't yet completed the correction we were in.

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

Of nations and states - can we impose president's rule on Greece?

First, let me clarify what I mean by that. In India, rogue states, where the democratic processes fail because of whatever reason, are subject to the President's rule. The Indian system is a parliamentary democracy with the Prime Minister as the head of central government while states are headed by Chief Minister. The President is the head of the country overall heading its army, judiciary, education etc. The President also appoints governor and through them acts as a counter-balance to ensure constitution is upheld. In case democracy cannot function properly, because of natural calamity or because of law and order issues, President's rule is imposed.

Greece needs such a rule from EU as its political processes are broken. Those need to be set in order. Till such a time, there is no use giving any bailout money to the Greeks. All that money will go down the drain. But this is not possible in the EU mechanism as it will undermine the Greek sovereignty as a country. Hence EU, through IMF, is trying to achieve the same effect.

The problem, however, is that within the EU recommendations are issues that are essentially pro-creditor sanctions, Shylock's pound of flesh if you will allow it. Eliminate those conditions and we may reach a tactical solution. Any other way Greece won't accept.

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

What spooked the Indian markets yesterday?

NSE Nifty-50 India June 20, 2011

Yesterday, Indian markets tanked in the first session. Look at the adjoining chart of Nifty, which is broader 50 stock index and more liquid. Popular media identified the reason as renegotiation of a tax treaty between India and Mauritius. I don't believe it. I think this is an example of retrofitting explanations. 

First, look at the reason. Tax treaty being negotiated has been under negotiation since 2006. The negotiations broke down in 2008 and resumed earlier this year. There has been no meeting, no discussion and no rumor that the treaty was signed. I don't think investors are as idiotic to sell-off on this kind of event. Can we assign it to irrational behavior? I don't think so. If it was a precipitation of Greek crisis I could assign it to irrational behavior but not this. This is pure idiotic if traders have behaved the way did. I simply cannot believe people who pulled the trigger were looking at the treaty. The treaty negotiation news conveniently broke at the wrong time.

Second, some rudimentary analysis of treaty will tell you that Mauritius government is against taxation or sharing crucial information (though they have agreed to collaborate with Indian agencies on investigations). Further, most of Indian bureaucrats and politicians have routed money back through Mauritius. In effect, both sides of the negotiating table do not want capital gains tax or information sharing. So not much is going to be achieved on the treaty front. A rudimentary analysis will tell you this.

Third, look at the sharp fall with volumes. I guess a first trigger is through some algorithm at play rather than a thinking trader. The later drop down is more from margin calls being triggered than any fundamental issue. It is possible the algorithm may have estimated a fall to 5275 levels and adjusted to this very quickly triggering a panic in the process. It looks more like a work of computer than a human being.

In sum, I do not think a flesh and blood trader could have dumped that much volume in that short a time on that news. Alas, in the din of media drums the real explanations may be lost for ever. 

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

Of nations and states - issues of democracy and economics

One of the central themes of Greek crisis is the distinction between Greek government's duty as a national government and its duty as a member of a currency club. The difference is important and we must focus on it a little more than traditional media does.

Let us look at a mechanism for national and state governments, say in US. The US follows a federal system which means the states are as good as independent nation except for some national issues for which these states have agreed to collaborate. The collaboration, in principle, is rather limited. The role of the central government is to create a basic infrastructure that will reduce the cost of interactions (of which doing business is but a part) among states. Therefore, the central government creates a currency system, maintains an army for protection of national borders, sets up court system to resolve inter-state or supra-state (pollution, foreign policy, FTAs etc) issues etc. The central government also ensures all states maintain cordial relations and there is no free-riding etc.

Because of the activities of the central government and its role as defined by federal structure, it is incumbent on the central government to undertake some policies. Monetary policy, by virtue of being issuer of currency, defense, by virtue of maintaining the armed forces and fiscal policy for creating inter-state infrastructure and assets. In return for these services the state give the center a part of their tax collections (I refer to the ideal - normally, central government is given the right to tax a few things). 

Let us look at Greece and EU. The union is in a formative stage because the differential responsibilities are not spelled out clearly. Greece has ceded its monetary policy by virtue of being in the currency union but the union has not bothered to enforce compliance of basic principles of natural justice. Concurrently, EU has not truly unionized the regional banks (by which I mean, made the banks truly European). Thus banks continue their country-focus leading to asymmetric losses to one country (government and citizens) if they were to fail. All this puts pressure on the country-level fiscal policy (i.e. taxes, government jobs and spending) which is independent.

Here we must spell out the disconnect clearly. The aim of the government is the welfare of its people. The aim of policy is to be fair resolution mechanism for both parties. If we go for fair resolution we will hurt the greeks more than what should be fair. If we given in to greek population, we will be unfair to the savers of Germany and elsewhere. The solution is to use bit of both. However, in the overall scheme, we must side with welfare of population. Democracy has to supercede economics.

Unless this political-economic mess is sorted through law (treaty or agreement), there is unlikely to be a systematic solution to the PIIGS crisis. Every time a country faces a problem we will have a big discussion, rhetoric and grand standing and negotiations that lead to nowhere. Solve this and you will bring certainty to the markets and economies.

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

Is QE-5 a possibility? (huh?)

I know we are still debating if QE3 is a possibility or not. However, there is not much to debate. Let me state a few points.

First, we need stimulus from the government. We need that stimulus to start putting people to work. Ideally, the people should create infrastructure that will be needed in the coming century rather than re-work the old one. I believe there are two such opportunities - one is green and other blue. I refer to the green energy and potable water management issues. However, if we are not sure that these are issues worth pursuing, we can re-work the old infrastructure. Mend the highways, fix the sidewalks, mend the piping etc. The key is to get employment up.

Second, any stimulus that creates monetary easing without an impact on employment will go waste. Well, it won't go waste exactly. It will eventually inflate bubbles in commodities or some other asset classes accessible to the rich. However, it will not start the engines of the economy in any sustainable way. Popular opinion rightly calls it kicking the can down the road.

Third, the burden of any stimulus, right or wrong, however, remains on tax payer. Hence, we do not have a lot of room on this matter. The tax payers ability to pay remains the upper limit for such luxuries. With the number of tax-payers on the decline, because of age and unemployment both, this is a shrinking pool. The governments could, in theory, allow immigration and thus increase the number of tax payers but I doubt they would come if job situation is weak. The most potent immigration idea was recently highlighted by mayor Bloomberg - entrepreneurship or start-up visa and visas with higher education degrees.

In sum, so long as these wasteful QE continues, we will need more. QE3 is a given. The question is whether we will be asking for QE4, QE5 etc. I guess we will be; till such time as employment is the focus of the QE. Thereafter, we won't need any. Let us hope QE3 is the right kind of QE.

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

Smphony Orchestras and consumption baskets

Tyler Cowen points to the financial distress in upper echelons of music industry in his post Symphony orchestras and sectoral shifts — Marginal Revolution. I brings an important point to fore. We need to have a different consumption basket for different income class.

While the financial crisis unfolded, and as it continues, we see marked difference in the consumption behavior across income class. Alas we do not have data to support this. I venture the consumption basket of lower income class has seen inflation (relatively speaking with constant or slightly increasing prices and declining wages). 

Similarly, the consumption basket of the rich has undergone changes too. The discretionary consumption expenses should have reduced. Discretion, however, means different things to different income classes. For the rich, it may mean no symphonies and operas. However, consumption may not include cars or other items.

At the least, we should construct consumption basket across income classes through credit card data. It will give important insights for policy makers.

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

Real Estate forecast - I told you so edition

Back in the middle of 2007 it was clear that property markets across the world are overheating. However, ground realities, in terms of property off-take were yet to show visible signs of a slowdown. During a presentation to top management of an Indian public-sector bank, I advocated enhancing the credit standards for lending to real estate developers. I had mentioned that a slowdown in Indian real estate markets is imminent and while timing cannot be correctly ascertained, we (me and my employer) believed that it could be sooner rather than later. My presentation was met with intense skepticism and hostility. The real estate loan portfolio, the bank recently declared, has lost all its capital and not much hope exists of any recovery. In the details I find that almost all the loans since 2007 have gone bad.

Now, apart from a little trumpeting "I told you so", there are important lessons. First, from a credit side, an early warning is a boon. It presents an opportunity for actionable strategy. The bank in question could have easily adjusted its loan portfolio by tightening the credit norms and intensively screening the borrowers. For short term equity investments, the early warning is nearly meaningless.

In the later part of the 2007, I made another forecast about Chinese real estate developers, this time for equity investment. The firms, some mentioned in the Bloomberg report above, were showing robust growth and off-take. Yet, by all measures, a slowdown in Chinese residential market was imminent. The question was of timing. The early warning is difficult to interpret in case of equities. It was generally agreed to reduce exposure to these companies. Yet, the timing of it all remained an issue.

The idea in ST equities is to forecast the trigger. Clearly, for property developers, the trigger is capital availability. For real estate developers, the first step of a slowdown shows constraints in long term capital availability. In the later stages, short term funding becomes difficult to tie-up. Leading to panic selling of sale-able units leading to softening of prices.

The 2007-call turned out ok because of global slowdown of 2008 pulling out capital thus leading to correction in real estate developer stocks. However, recently, S&P Cut China Property Developers to ‘Negative’ - Bloomberg. It means developers may suffer even more in coming months.

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

Investments in India - building long term advantage

India has always admired the high Chinese domestic investment. Policy makers have also talked of striving for higher investment-led GDP growth in India. Contrast that with a fall in investment numbers and we seem to have a problem. 

In light of huge global over-capacities, particularly in metals etc., is it right for India to invest in similar capacities? I believe this is not a right way of deploying resources at the moment. For a start, it is advisable to invest in things that the world cannot provide, either because it is too local or because the global investment climate does not allow it. In both these cases there is a huge opportunity.

In terms of local investments, infrastructure is paramount. In fact investment can be directed at easily accessing the idle global capacity. Thus transportation infrastructure, namely ports, highways, ware-houses and terminals, railways etc., makes a good case for itself. Such infrastructure will also unleash local supply-chain efficiency reducing cost of goods while maintaining better quality. Agricultural produce, on which 55% of Indian population still depends, will be main beneficiary. Long ago, my colleagues at CRISIL did a study that indicated it was possible to double farm incomes by improving supply chain. I believe we underestimated the impact on incomes and possibly the doubling can be achieved with today's income.

Second dimension that needs impetus is information. For a country that is a leader in IT, we have poor information infrastructure. We can plan for unique products effectively. Small cars, unique food items (like spices, fruits and flowers unique to our climate etc.), IT services etc. can be strengthened. Rather than recreate redundant infrastructure, we must deploy investments to strengthen our advantages.

The impetus, at the moment, must come from the government. Almost all areas where India has advantage, save for IT, we have no policy backing. Organized industry hardly has any presence in such areas. Primarily, that is due to lack of clarity from government and proper strategic direction among private players. Let us hope things change and we make right investment and create sustainable value than create redundant supply that will wither the value away.

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

How Low interest rates create mal-investment?

Interest rate identifies the minimum return that the business must generate. In a way, it is a fitness test for the business. It signals to the entrepreneur if he/she is truly adding value to the economy or if they are better off doing something else. Thus in a way, interest rate represents a threshold above which businesses should operate. This is Hayekian view of interest rates. 

Low interest rates and value addition 

When interest rates are too low, they are encouraging entrepreneurs to take risk. This impacts the business models differently. 

At one end are business models, like infrastructure projects, that cannot add threshold value in the initial years of the venture. The low interest rate regime, allows a valuable gestation period for such business models. Often, government artificially lowers interest rates for such projects. 

At the other extreme, there are weak business models, those that are viable only in low return scenario. In a low-interest rate regime, even such business models get funded. These business models, however, die out once the interest rates start rising. In between, there are experimental and innovative business models. Some of these use the low interest rate period to forge better, more robust models. Such businesses thrive later. Others, however, end up going bust. 

The role of banks is to identify each of these business models and fund them while appropriately mitigating the risks.

 

How low interest rate leads to mal-investment 

A bank takes risk by investing in a venture. Interest rate is also a reward bankers get, for taking the risk. This is another way of framing the value addition threshold principle. Yet, the difference in the two has implications for the economy. 

Banks are conditioned to finance lowest risk assets that are available to them. Debt simply happens to be a low risk asset. So if banks have the opportunity to invest in assets more liquid and less risky, banks will move away from debt. Even in lower interest rate scenario, those projects with best risk-return trade-off should get financed. However, anecdotally, lower interests rates actually lead to mal-investment, to borrow Hayek’s term. This is other aspect of the reputation problem we discussed earlier. 

Lower yielding large borrowings backed by reputed corporates get access to financing more easily than new ventures. This means, irrational mega-projects or mal-investments of large corporates get financed at the cost of genuine investments of new ventures. Typically, irrational mega-projects consume a lot of credit requiring load syndication. This has twin benefits for bankers. First, there is a higher degree of comfort in being with the herd. Secondly, bankers do not have to go through credit appraisal of many small entities of questionable risk profile. This makes them assign a lower risk to these projects than appropriate. Despite the low interest rates, the risk with new ventures is always higher. Further, debt is not a very liquid asset at the lender-borrower level. 

The second blow to new ventures comes from crowding out. It implies that even in a low interest rate environment, small businesses and entrepreneurs may not have access to lower cost capital. Therefore this impacts the long-term strength of the economy. In high interest rate scenario, the irrational mega-projects seem less promising. Hence, contrary to popular belief, it may be easier for smaller businesses to compete in high interest rate scenarios.

This post is excerpted from my book "subverting Capitalism & Democracy.

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

Greece and the labors of Hercules

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

Problems with economics

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

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

Problem with politics

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

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

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

In sum

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

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

Mechanics of Asset Bubbles

This is my 250th post on this blog. Thank you for being kind and patient readers.

Barry Ritholtz has a post titled Checklist: How to Spot a Bubble in Real Time | The Big Picture. He puts across a list of conditions that we can watch to spot bubbles. While I agree with the post as a whole I would like to make some modifications to it from investor's thinking point of view. Barry himself is an investor so the end objective of the post is same as mine, to find opportunity to make money.

Let us delve into the mechanics of asset bubbles. All bubbles eventually burst. To understand nature of bubble burst however we must understand bubbles. The nomenclature "bubbles" is misleading when compared to their bursting behavior. Asset bubbles are more like balloons rather than bubbles. Some deflate gradually, some burst open when pricked by risks, others inflate to the point of no return. It is important for investors to identify the bubble and understand when it may burst.

Asset bubbles have three central elements. First being spotting inflating asset prices. The second refers to spotting risks that may cause bubble to burst. The third refers to spotting the timing of bubble bursts. Barry's post deals with all three however, I believe, they are mixed up in his list. 

Spotting possibilities of bubbles

To know if there is a possibility of a bubble we need to consider a few indicators:

1. Standard deviation of valuations: As standard deviations increase beyond 2, we should start considering a possibility of bubbles.
2. Elevated returns: The returns in the markets are high and, more importantly, consistently high. The consistency bit is a flag.
3. Unusually low volatility: The low volatility is another, albeit important, side of consistency in high returns. Volatility is an indicator of doubt. It indicates how much the market believes in higher asset prices. Higher volatility indicates that markets are testing the reasonableness of prices. It may be possible to have reasonably consistent annual returns but  still have high volatility throughout the year. 
4. Robust trading volume: It is difficult to imagine a healthy increasing volumes accompanied by low volatility but such conditions do exists during bubble period. The number of houses bought, number of people who trade in equity markets, etc.
5. Increase in employment: Driven by the bullish forecasts the bubble-prone sector goes into a hiring overdrive.
6. Increase in credit growth: Credit is a measure of low-risk-seeking capital. When all investors think the sector is low-risk quantum of credit flows to the sector increases seeds future bubbles.

Risks to bubbles

While above indicators reveal the possibility of a bubble, they do not specifically indicate the risks that may cause the bubble to burst. The risks emerge from causes of bubbles to their effects.

1. Perverse Incentives: These are difficult to track down before the burst but is eventually obvious. A diligent investor needs to understand the "why" behind the behavior of participants in that sector.
2. Unintended consequences: The frontiers of regulations (or de-regulations) often harbor seeds of bubbles. The problem with regulations in particular is that it can be reversed in a spur-of-the-moment decision by relevant authorities leaving investors in the lurch.
3. Excess Leverage: As the popular opinion of low-risk permeates through the financial world, firms are encouraged to take on more debt increasing their leverage. Increasing equity prices also puts pressure on management to deliver high returns. Managers rejig the capital structure to increase return on equity for the same return on capital. The easiest way to achieve this is by increasing leverage.
4. New products: Barry refers to only financial products however any product that teases regulatory acceptability can create risks. Financial products are more potent because they tend to affect multiple sectors and economy as a whole. Naturally, financial products have been at the forefront of biggest bubbles in history.

Understanding timing of bubble bursts

A few behaviors are prominently visible during the late stage of bubble formations. Typically,

1. Declining credit spreads: While I am using Barry's headings, the central idea he points to is bigger than credit spreads. During late-bubble phase, the price or yield or return distribution and risk distribution do not match. In normal times, higher risk implies lower prices and higher-but-volatile returns expectations while lower risks implies higher prices and lower but more stable return expectations. In other words risk-return equations become asymmetrical.
2. Declining credit standards: This is another face of risk-return asymmetry we discussed above. Firms with strained balance sheets get easy access to credit. It also indicates lower default rates on credit side and further acceleration in credit growth in the sector. The latest credit investments may be difficult to recover and hence are as good as write-offs.
3. Tortured Rationalizations: Almost all bubbles have advocates who have strong beliefs that they validate using unverifiable, anecdotal but mismatched data or new metrics that have no history. Be it eye-balls, estimating number of millionaires as proxy for premium housing demand, etc.
4. Trading volume spike: We note that high and steadily increasing volumes are marks of bubbles but accelerating volumes - spikes - indicate that end is near.
5. Interest rate changes: A credit-driven bubble is sensitive to interest rate changes. However, the sector may not react at the turn of interest rate policy. So when the central bank raises rates after a long cycle of declining rates, there seems to be no effect on the bubble sector. It is after two or three rate hikes that suddenly things start to fall apart.

While spotting bubbles is difficult, the difficulty can be reduced. Bubble-spotting is iterative process and takes a while to establish the conditions for bursting of bubble.

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

Austerity not a medicine for all occasions

One of the key lessons of the great depression is that austerity is not a medicine for all occasions. However, over the subsequent excesses we seem to have lost out on this learning.

Austerity is not a solution for US

There is hardly any doubt about ability of US to compete. In fact, if the fat corporate balance sheets are to go by, US companies are in their best shape among past 5 years. Yet, the unemployment numbers are languishing which makes US a pump needing priming. Such priming will be achieved through a jobs program to create next-gen infrastructure that will allow US manpower to compete in knowledge era. Austerity, in this case, will impair future competitiveness. However, the kind of priming as envisioned in the Fed's quantitative easing program is nothing but wasteful. These programs do not have well established working channels to reach fruition. 

Greece and wasting water priming the pump

We don't waste water priming the pump so long as the pump works and there is water at the end of the well. In case of Greece, both parts seem to be a problem. In such case, austerity is a better alternative till the economic engine is repaired. Further, Greek government must set in place tax reforms allowing fair and easy collection of taxes. Once such necessary conditions are in place, then Greece will need a spending program to kick start growth in a sustainable manner.

Implications for markets and democracy

The problem with misunderstanding related to austerity is two-fold. The problem with austerity is that it will wreck havoc with asset prices in general impairing genuine investment leading to future problems. The second problem is the people's confidence in the system is shaken leading to anarchy and threat to general system of law and order. In short, the cost of misunderstanding austerity will be massive.

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

Geoffrey West on corporation and cities onEdge.org

My day was made when I read the edge piece today. Geoffrey West, professor, talks about interesting aspects of Why Cities Keep Growing, Corporations And People Always Die, And Life Gets Faster.

As an investor, company life-cycle represents a lesser-debated frontier. Analysts tend to rely on the accounting view of going-concern. Yet, the permanence we take for granted is a mirage. However, understanding when the decline of the firm comes about is easier said than done. 

Dr. Geoffrey West points to yet unpublished (and still being verified) work that says firms scale sub-linearly. In other words as firms get bigger, they become less profitable and they eventually perish. Compare this with cities (which he discusses before firms) that grow super-linearly. In other words as cities get bigger, they become more beneficial for its inhabitants. So then, should investors stop companies from growing? And how should one view the increase in scale. 

I think as investors it highlights a very important and much neglected area.

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

Wary of QE2 withdrawal effects!

At a time when Indian markets were nearing valuation comfort, they surged again. Usually, it would be a positive reinforcement and time to get in. However, I am not sure today. The risks arising out of end of QE2 pose significant threat to markets.

On its own, the end of QE2 alone would be a perceptible trigger. But more important is the situation of world economies at this point. With EU on the brink of another crisis, waning strength of US recovery and still-to-gain-traction Japan, we are at the most unstable point in recent years. At such a time a withdrawal of QE from US may not auger well for the markets. 

I guess we must hold on tight and keep powder dry for there may be interesting times to invest in very near future. 

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

Krugman & Delong and Weak Dollar

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

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

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

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

USD Dollar Views from 2009(links to old post)

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