Answers to Barry Ritholtz's 10 questions about S&P downgrade

Barry Ritholtz asks 10 questions about S&P downgrade and I answer most of them below:

Here it goes:

1. The change in trajectory of US debt was in service of Banks: It began with TARP, and continued with every other bailout/stimulus/economic plan. What was S&P’s role in creating that crisis?

 S&P is centrally responsible. So are US regulators, banks and those crying hoarse. Let us remember there is plenty of blame to go around for GFC. 

2. How will non-US investors (Private and Central Banks) view the downgrade?

Most non-US investors already discount the news. However, investment strategies will compel some to act if another agency downgrades.  

4. What does the downgrade do to US currency — is that the true impact of the credit downgrade?

Over 5 year horizon I think USD will begin to decline. A declining dollar is in the interest of US. It will reinforce US manufacturing. Immediately, though, flight to cash and commodities seem to be possible options.  

5. Will borrowing costs likely increase for the US? What about consumers?

Borrowing costs for US entities will increase. I suspect the ability to pass on these cost to consumers will remain under pressure. Consumer rates, after accounting for all adjustments, a quite high. It will impact borrowing cost of investors, leverage will be difficult to come by.   

8. Why did the rating agency not wait until the special committee / debt ceiling deal was completed later this year?

I think the rating rationale was more political than financial – more related to “willingness to pay” rather than “ability to pay”. The debt committee would have done more related to “ability to pay”. The statements by politicians about “debt ceiling debates hereafter should be conducted this way”, “maybe default is a good option” etc. makes one really skeptical of US governance. You see such things in banana republics not US – definitely not a behaviour of AAA rated sovereign. 

9. The Rating Agencies were downgraded by Dodd-Frank, with all regulatory and legal references to be removed. Was S&P’s move retaliatory?

I don’t think so.  

10. How will US markets open on Monday in response to the downgrade?

Move to cash and commodities could be a good idea to bet on. Though one can never be adequately sure. 

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

Impact of the US Rating downgrade

The rumours of a downgrade had started during US trading hours, but the actual S&P announcement came post market hours, so Friday's market closing does not reflect the ratings impact.

Immediate impact - is it the last straw?

With concerns on US growth slowdown and EU debt crisis already troubling markets, this is another nail in the coffin. The immediate reaction should be negative: equities sell off, commodities fall, bond yields rally, dollar weakens, safe haven assets (gold, CHF, JPY) appreciate. However, it is not clear if this impact will persist beyond the near term.

On bond yields 

Some are arguing that since it was well known that the US would get downgraded, this is priced in and that there may not be much lasting impact. Moreover, Moody's and Fitch still have the US at AAA for now. Analysis of the impact of past rating downgrade of other countries on their long-term yields has shown that yields rose in the days before the downgrade and then either fell or were unchanged after the actual downgrade.

Over a few years, one can expect yields to trend upwards, till the US regains its AAA ratings. If the situation deteriorates further, there is likely to be sustained uptrend in the bond yields.

Money moving out of US treasuries
The US downgrade raises two medium-term issues with respect to money movement.

First, the downgrade will accelerate the already ongoing trend of reserve diversification away from the US dollar. Confidence in dollar's reserve status will be tested by the markets. This may be a slow moving process or in the worst case scenario, this can trigger panic reaction.

Second, some funds may start taking money out of US as they are mandated to invest in AAA only. However, a lot of funds rely on ratings of two agencies and not just one, so this effect may be more prominent if one other ratings agency follows S&P.

Further, the question remains, where will they invest? None of the other AAA rated countries have the size and liquidity that the US markets offer. Norway, Singapore, Australia, Sweden are some of the AAA rated countries where investors could flock and put pressure on their currencies to appreciate. 

In such a scenario, people expect this money to move in emerging markets through a diversified investment approach. Thus, post the initial risk aversion shock, they expect EM markets to show positive reaction over the medium term. I do not agree with this. There is no reason to trust Indian or other treasuries over US treasuries.

I think people may shift into commodities. Commodities will start acting like stores of value. Thus, we will see an increase in commodity prices. This will adversely impact EM inflation leading to weakness in EM. EM central banks will be forced to revalue their currencies with respect to USD, triggering the realignment process.

In sum
A lot depends on whether beyond the near-term negative reaction, there is further panic or sanity prevails at some point.

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

Who is rich?

How do we determine which nation is richer? Normally, we use metrics like GDP, GDP per capita etc. By many metrics the west and developed countries are rich. But are they really rich? I am not sure.

We evaluate wealth or richness at a point in time. As a concept, we have create this utopian set of goods and services that the richest nation must ideally consume. This rich consumption basket includes high quality healthcare, regular electricity supply, cars and automobiles etc. In other words, this basket comprises necessities and comforts. We measure how much a nation needs to spend to achieve this utopian consumption basket, how much it earns and that difference gives us how rich it is.

I disagree.

Let us imagine a nation of chronically ill people. The median income in this nation is 100 units. However, their illness implies that they require 110 units for consumption - 10 units for their needs and 100 units for medications. Now since all the other nations earn a maximum of 20 units, we can say this nation is rich. But other nations are healthy and they only need 10 units - they save 10 units of their earnings. In this case, the other nations are actually richer. Very simply, a nation of savers should be richer than nation of borrowers.

I think at all times, we should be net savers, in high investment phase, the level may be low or nearly zero with positive bias. I think a nation of savers has the option to stop consuming comfort goods while those who borrow set in motion a negative spiral that reduces jobs, hence consumption potential of both comforts and necessities. Importantly, it impairs repayment potential. It is difficult to initiate a turn around.

Asset ownership and dispersion - median asset ownership

Another aspect of debate is asset ownership dispersion as against asset ownership alone. This works just like employment intensity. The more dispersed the asset ownership within the country richer the country. Ideally, median household asset ownership makes more sense. If we look at asset ownership of household and find income generating assets then the country is definitely richer. These could be, saving deposits, equity shares (positive on MTM or yielding reasonable dividends), house that can be rented (fully paid up or rent greater than mortgage payment), vehicles for hire, etc. The consumption goods are TV, computer (used as consumption good rather than income generating asset), vehicle (personal use - not for hire), etc. These consumption goods should be expensed rather than be treated as assets.

Thus, a nation that has higher net assets (total assets less debt) at a median level should be richer.

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

Challenges of Journalism (chapter from my book)

The recent News of the World scandal left me dejected. The rot in media has reached epidemic proportions. 

Amongst all the institutions in a democracy, media has the most powerful role. It is not a pillar of democracy without reason. It is an active observer of the world. It is, to a degree, omnipresent. Therefore, it often acts as eyes and ears of the law enforcement setup. Media is not impartial. It is partial to the public interest and public interest alone. But the foremost role of media is in its ability to view the world through the changing social lens. It has the power and knowledge to debate the changing values and, to a certain degree, influence the course of the society. It is unfortunate that media has failed us.

The revival of journalism must start with examination of its shortcomings. The very definition of journalist is no longer clear.

Who is a journalist?

Journalist clearly does not refer to employees of media institutions. It would be unfortunate to call celebrity experts as journalists. (The term celebrity expert refers to those people who specialise in affairs and the private life of celebrities. It does not refer to experts who are celebrities.) Neither should sports reporters be called journalists. In today’s context, some of the real journalists are simply bloggers. It was never more important to define journalists than today. Journalist should be defined as agent who furthers the principles of the democratic system we discussed earlier. Only journalists should be allowed the privileges embedded in the democratic setup. Thus, in my view, News of the World should not get journalistic priviledges. It should be treated differently. 

Social connectedness of journalists

The degree of separation between journalists and any individual should be as low as possible. It should be closer to one. Unfortunately, the journalists of today are no longer connected to individuals and their issues. That is why we need celebrities to further genuine causes like planting trees etc. It is imperative that journalists go closer to the individuals and communities.

Focus on speed

The other factor ailing journalism is the focus on speed. That takes away any opportunity for in-depth analysis. Top newspapers are shifting to a two-step approach, journalists usually report the facts on the ground and the section editor thereafter goes through with in-depth analysis.

This model is well developed in financial media. There, providers like Bloomberg, Reuters provide data at varying frequency while the teams of analysts from various brokerages analyze the data and provide the expert perspective.

While I understand the motivation behind this setup, I think it is inadequate. Journalists, in certain cases, operate more like detectives and there is nothing to replace real evidence. Even financial analysts regularly meet with companies and validate the information they receive from data sources.

Further, journalists are more than detectives. They have to sniff out stories where there is no report of a crime. This requires, what experts call, “nose for the job”. The depth of journalism, at least in such analytical stories, suffers to a great extent.

Journalists need an aggregator of facts

In the context of current problems, media should at least function as an aggregator of facts and data. Here we refer to media as separate from journalism. The journalists, even if external to such organisations, may be able to mine the data and evolve their analysis. These facts, once established, should be available in public domain. It should be possible to augment and improve them through subsequent fact-finding missions by other media employees.

Journalists, in such a scenario, are moving away from traditional media hierarchy. We need to create recognition for this new breed of journalists.

Problem of continuity

Journalism requires longer follow-ups, particularly for important issues like WTO negotiations, carbon emissions, financial crisis etc. As the events continue to unfold the scope, severity and depth of investigation and understanding changes. Journalists today, are not able to follow through with their stories. In a way, it is easy to follow the scandals of top sportsman or politicians. However, the important debates, related to US healthcare, foreign policies etc, are very difficult to follow.

Popular bloggers, with their subject focus, are able to do a better job at following stories with arguments as commentary. The quality of discussion is enriched. It is probably the reason why top journalists now have their own blogs.

Imperatives

It is critical to design a system where journalists are able to work for the democratic system and further its goal. The system should start by redefining what journalism is supposed to be at its core. Such a system may be actually evolving as a network of bloggers, but it needs to be nurtured and expanded. Further, the current model of subsidising journalists with revenues from corporates or entertainment will not be enough to sustain this key pillar of democracy.

From my book Subverting Capitalism and Democracy - chapter titled Challenges of Journalism

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

Global Realignment of Economic Power

Just days before I was thinking how this feels like pre-Bear Sterns days and today Yves Smith has a post titled Shades of 2007. It indeed does feel like it. In a way, there is nothing new. We know how it will end.

However, I fear there is more coming. Something more interesting that we haven't really thought about.

I believe, soon we should enter an era of realignment of economic power. We tend to believe the west is generally rich. But it may soon change. As the screws of austerity will tighten across EU and even the US, the developed world may realize that they are not so rich after all.

To say that such a realignment will be challenging will be an understatement. We will have to evaluate the correct value of each currency, rework the location of manufacturing capacities and realize that the savers of the world will be real demand drivers of global consumption. The process is likely to take 2-3 decades or more.

The question that consumes me, how should we preserve and increase our wealth?

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

Cartoon - Barack Obama secret thoughts

Obama - Secret Thoughts by Rahul Deodhar

Note: I promise to improve my sketching.

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

Cartoon - PIIGS

All Rights Reserved - Rahul Deodhar

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

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.