DJIA 1920-1940

A lot of people are drawing parallels between 1930-31 and today. I thought let me post a chart of  DJIA over that period to understand what it means for us.

Courtesy: Stockcharts

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

Elinor Ostrom

Elinor Ostrom is no more and economics is poorer today. Her work on management of commons and economics in general was path-breaking. She was the only woman Nobel Laureate in Economics. RIP Ms. Ostrom we will never find someone as capable to carry forward your work.

Rahul

Parallels and differences Germany vs. EU and US vs. China

I would like to draw attention of policy watchers to this interesting parallel - What Germany is to EU, China is to US. I have raised this point earlier as well.

1. Germany is the manufacturing powerhouse primed by debt-accumulation across EU just like China is manufacturing powerhouse primed by US debt. 
2. Both Germany and China hold government bonds in quantities that may break the bond markets and trigger concurrent run on currencies and banks. 
3. Both want others to follow austerity while trying to keep interest rates low and economy primed at low unemployment.
4. In effect, both will have to be architects of bailouts at substantial costs to their respective tax payers. It seems unfair but it is only reasonable way out of the current problem. 

Let us watch what experts recommend to both economies in these scenarios.

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

George Soros - remarks on the Euro

Rocking Jude pointed towards a recent George Soros Speech about EU crisis (among other things) via Business Insider, which I believe is a must read. Here are some diverse but important issues:

1. Soros highlights "you cannot reduce the debt burden by shrinking the economy, only by growing your way out of it." which I agree with. However, those forcing the governments to austerity may do well to remember that in the end, government enjoy a kind of legitimacy that they don't. So if push comes to shove, the politicians will roast them alive and announce a victory parade while they are at it. One of the  solution to a debt crisis is to eliminate the creditor. History bears witness to many such "eliminations" (a few of them quite physical).
2. The objective of the economic studies should not be search for Newtonian-like laws but rather seeking engineering objectives of "fail safe" and "factor of safety" into regulation, policy and economic system as a whole. The current risk management system is falling woefully short.
3. Two-level currency system: An ideal currency system, I think, may be a two level currency system. A currency at the national level should signal the relative prices of goods and services in the economy. An international currency should signal the confidence in the judgement exercised in national currency. The international currency therefore decides the relative prices of currencies and thus of everything.
4. The problem of EU is that at current position it is unsustainable. It has either to go forth (towards complete integration) or go back (break-up). Mustering the political will to forth in such climate is challenging as Soros highlights.

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

Importance of Emerging markets in portfolio

Barry Ritholz has linked to a very important WSJ chart:

Here are my comments:

1. Growth is in EMs: If you use GDP growth in addition to GDP, emerging markets will come out still higher.
2. Currency story: The undervalued currencies of EM economies make it good opportunity from currency gains aspect as well.
3. Known trajectory: EM economies require product and services, regulations, infrastructure along well established and well understood lines. We have done such things in developed markets before and thus it is less risky.
4. Less consumer leverage: One significant difference between other economies and EMs is consumer is not leveraged. In fact there is substantial class of people with good amount of savings and latent demand. Thus, once government policies are on track, you can have growth and not face deleveraging.
5. Political risks: Government or political risks, to my mind are same as developed countries. All politicians are jack-asses and we have seen how politicians from any country, developed or emerging, can turn it into a banana republic. Further, some entrenched vested interest may work against developed economies in this case.

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

Explaining Indian Policy Paralysis

A lot of recent comments, including mine, have pointed out the lack of policy commitment from the government. I believe there is a reason to this policy logjam and it may reverse quite quickly, to surprise of many, making the current time most critical time to invest in the country. To warn this is a conjecture.

1. Indian politics has undergone a change of mechanism in financing. A significant (non-trivial) percentage of money deployed in politics comes from stock markets where it remains invested in distributed accounts. 
2. This implies that the stock markets must have a good peak about a year before the election. Year being the approximate time required to oil the election machinery of the political parties.
3. This also implies that there should be a good opportunity to invest around 2 years before the election without which the peak referred above will have no meaning. 
4. Political money is gained from rent-seeking and corruption and not invested in first three years as it is being collected at that time. It is usually available around 2 years after new government takes office, the bulk being available around 3 years time. (term of government = 5 years in India)
5. Insiders inform me that Late Mr. Pramod Mahajan (parliamentarian of BJP) was amongst the pioneers of such strategy around 2002-03. Subsequently ruling party Congress, inducted relevant talent into this strategy. Some say, former finance minister P. Chidambaram, known for his investment sense, may have used this means earlier. Though I have heard conflicting reports that state branches of parties in South using similar means since 1998-99.
6. While earlier efforts benefitted from a global bull market, current efforts require ingenuity to create returns in an adverse global macro environment. 
7. I hear that ruling party has taken an ingenious approach to current problem. The first phase of the strategy is to create policy misdirection, increase rhetoric and in general cause panic and injure investor sentiment (only enough to create a equity market). The second phase is to establish policy direction and build credible reform base that should lead to uptick in equity markets.
8. The magnitude of money involved is not small. Even small district magistrates have wealth in excess of INR 50 million. Politicians have access to money in excess of INR 200 million each. There are tons of them. However, substantial amount of this money is in black (cash not accounted or declared) and thus cannot be funneled into the equity markets. However, the numbers are mind-boggling.

Thus, I expect:

1. Reform process to gather steam from current levels.
2. Increasingly positive policy news of reform and clarity coming from governments.
3. In general improving investment climate.
4. Proactive and improved response from government to cushion or even counter negative news coming from global economies.
5. Government may talk the market up.

Implication for Equities:

1. I believe this current level is a bottom for next year or more.
2. From this point we will move up is a sustained manner till beyond March of next year (around).
3. At that point we may see a sharp correction as money starts being pulled out of the markets.
4. So, this is time to be long India and get out by March next year.
5. Risk is that if all start working on the same strategy exit needs to be critically examined.

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

Problem of Indian Economy

The problem of Indian Economy needs to be explained better.

Imagine the economy as a car (favourite of economists). The car has an engine of 4 cylinders (say). Then process of policy development adds cylinders to the engine. Thus, with prudent reform and policies the 4-cylinder engine economy can grow to become 6-cylinder engine economy. This is achieved while the 4-cylinder engine is still working and therefore is a complicated process.

First set of problems

Indian Economy is a car with 4 cylinder engine (as against US economy which could be 16 cylinder or China could be 12-cylinder etc). This engine is capable of growing at ~7% steadily. But to grow at 9-10% we need a bigger engine. Sadly, the Indian politician has no inclination to undertake these reforms.

Second set of problems

To add to our woes, the 4-cylinder engine itself is not running to its capacity. Not all cylinders are firing, brakes are engaged slowing the economy and there isn't enough lubrication to transmit all the engine power to the wheels. As a result we are finding it difficult to hold on to 6% GDP growth. Here again the problems are created by political class.

Solutions

In times of global macro-economic distress, one expects politicians to at the very least avoid second set of problems. In corporate lingo, these can be solved by "de-bottlenecking". In other words just simplify the procedure and keep policy clear and simple and you will have solved second set of problems.

Tackling first set of problems is going to be difficult and will need decisive political leadership that sadly is not even available on the far horizon.

 

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

Austerity isn't a choice!

If you are already in debt, then you cannot get out of this mess (or hole) by borrowing more. Or can you?

This is oft repeated argument you will hear in current crisis. Well, here is my clarification.

Who is the "you" in that statement?

If you includes everyone then austerity won't help. If, on the other hand, "you" only refers to government then austerity may help.

What do you do when you find yourself in a deep hole?

Frankly, tell me what would you do? Would you say starve yourself that you may become lighter and thus be easy to pull out by some onlooker or, for that matter, rise to top? Or would you gain strength and carve out steps on the side of the hole and try to climb up? I would definitely do the latter. But it involves digging. But I cannot be expected to dig to make the hole deeper.

In other words, we need to dig, just not deeper. We need stimulus. But one that can create competence and help build a path out of this mess. Thus it becomes very critical for government to choose the projects rightly - something not many governments are good at. 

Big government vs small governments

Just remember, governments must get bigger when everyone else is getting smaller and vice versa.

There! I said it all better than Paul Krugman.

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

Indian Economy: Difference between 2001 and 2012

The difference between Indian Economy of 2001 and 2012 relates to how demand and policy are inter-related.

In 2001, policy certainty (directional certainty) helped drive investments when demand was yet not established. In 2012, demand is well established but it is the lack of policy certainty (again directional) that is preventing investments.

Thus, if India can sort out its politics it can gain quite a bit in a short time. Meaningless ambivalence about policy has condemned India to low growth seen recently. Hopefully the 5.3% quarterly GDP growth may wake the government from its slumber.

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

Rant: Read the Annual Reports for God's sake!

I find it unbelievable to a point of dejection how many people only look at the statements (balance sheet, P&L and cash flow) and discard the rest of Annual Report. I sincerely wish these people read the Annual report in detail (that leaves just a few) with concentration, eyes peeled (Hah! that leaves no one except for John Hempton). I am not demanding a Philip Fisher-type depth, just a bare reading will suffice!

Remember that 

1. The Annual report is a detailed communication that company makes with you. No meeting can cover these many issues in that depth.
2. Most often, there is lot left unsaid in the report. But what is said is no less important. Please read it at least. I can forgive you if you don't understand what is written, but not reading is not an excuse.
3. Many times we don't get picture of how divisions are performing, which products are losing money etc. But use what is given construct a picture of that what you cannot see. Remember Annual report  has legal weight. 
4. Further, quite a few companies are open about information sharing if you just care to read.

To me, the analyst who does not have capacity to read is no analyst. The investor who does not want to read is far more dangerous and bunch of investors who don't read are simply today's market participants.

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

Investors are at the gates - When will India open them?

One of the big problems driving Indian inflation is lack of investments. The investors are here; the question is where is the government. 

How to get investments?

First rule of investments is that higher uncertainty should be compensated by higher return potential of investment. If the return available from the Indian market is given then government can increase investment by reducing uncertainty. 

Indian government is doing exactly opposite.

In general government is failing on many levels and the Indian courts are able to stem the erosion in some areas but in critical policy areas the constitutional arm of government, the RBI, is not empowered to do much. And it has done all it can. Sadly RBI cannot undo what 8 years of inaction has borne to bear. 

Policy nuisance 

The current UPA government came after 5 years of NDA rule. The NDA government had good alignment of strategic direction and policy follow-up. In the first term,  the UPA government was befuddled with coalition issues thereby creating policy ambivalence. However the developmental inertia of previous NDA terms proved beneficial in hiding the policy ambivalence. However the second term is characterized by lack of strategic direction in policy. The policy, rather strangely, is moving in the opposite direction in general. The haphazard manner of conducting policy has confused investors, both domestic and foreign. If the government just stops this policy nuisance we can hope to hobble along a reasonably correct path.

Knowing Congress - future is bleak

The most reasonable forecast is bleak. The only possibility is that a looming crisis may kick the government into action. Just like Churchill's America, at the very last, India will do the right thing. So here is waiting for the crisis, hoping for the dark clouds to see some silver lining... 

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

Follow up to S&P rating negative outlook

After the post some people wanted to know if my forecast has changed. Quite the contrary, I think S&P rating outlook downgrade may signal the upcoming improvement in equity performance.

So I think: 

1. A revival of sorts may happen by July this year, peaking around December.
2. Analysts will start upgrading around October by which time I expect the move would be reasonably underway.
3. I think a good strategy should be to invest in any weakness.

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

S&P putting India rating outlook to negative - comments

Everyone knew that India's situation is precarious. Lack of reforms, rising fiscal deficit and lack of focus from a dream-team that brought in first wave of reforms. So it is hardly a surprise that India's rating outlook is changed to negative. It is made big news, was shrugged off by the markets. But it deserves a few comments.

It ratifies that India's policy direction has reversed signifying the third phase of reform process - reversal. Between 2001-2004 the direction of policy reform was positive. Between 2004-08 there was a policy logjam, primarily attributed to stifling policy of the Left parties. However, post-2008 the policy environment has turned adverse despite no participation by Left in present government.

The current policy environment is typically familiar territory of Congress party - it is a poisoned policy environment. There are arbitrary decisions (Spectrum allocation), abnormal legislations (retrospective tax liabilities), populist measures (NREGA, reversal of first fare hike in 8 years in Railways), arbitrary intervention in infrastructure sectors (under the heading of environmental clearances - POSCO deal), gross corruption aimed at filling the party coffers (commonwealth games scandal), disregard for law and order particularly by government, etc.

To top it all, no change of policy-scene is likely in future despite the promises of finance minister and Prime minister. These people were not waiting for S&P to turn negative before bringing in the main reforms. They do not want reform.

For everyone, investors, general public, firms, foreign investors etc, consistent long-term strategic direction about policy is more important that precise current policy regime. It is immaterial if you have high fiscal deficit, but it matters if you have no plan to come out of such deficit. It is immaterial if there are high taxes so long as there is a progressive clarity in tax laws and consistency in application.

In all, the only change possible is that this government is defeated and subsequent government will bring in a clear long-term strategic view to policy making.

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

Deploying Public Assets (spectrum, coal blocks, etc.)

One of the important functions of the government is to deploy public assets for public gain. However, selling these assets or renting them has landed many a government in a soup. Be it the mill-land fiasco in Mumbai, spectrum auctions for 2G or coal block allotment, governments seem to fumble at every step. And this is not the only problem with deployment of public assets. Let us look at problems and solutions to selling or deploying public assets in the interest of public.

The problem with deploying public assets
The process of deploying public assets is difficult. Inappropriate deployment usually turns into allegations of scams and threatens the political order.

1. An infant nation is compelled to deploy the assets it owns in a legal environment that is not yet sophisticated and evolved. Thus, such a nation is faced with immediate prospects of inappropriate deployment and therefore political disorder.
2. Asset deployment theories themselves are still evolving. Thus, the jury is still out on whether renting is better than sale of assets in conditions of uncertainty, how long should lease durations be,etc.
3. The asset pricing mechanism is ill-developed for untested or new technology. Here, it is difficult to estimate the present value of the asset. These new technologies are sensitive to choices and, in scientific parlance, to initial conditions. thus, what may be a good technology elsewhere,and therefore priced at premium, may become a failed idea at high costs. In such cases it is nearly impossible to estimate in advance and accordingly price such assets.
4. The question of opportunity cost is of prime importance. If I sell an asset to a firm and the firm does not develop it but simply sits on it. That may be advantageous for that firm but it defeats the purpose of sale of assets by the state.
5. The risk being taken in new development must be paid for. In other words, when the entrepreneurs bid for a technology that has not established itself, they are taking risk. If the government starts demanding higher initial payments, the entrepreneurs' risk is amplified resulting in under-developed sector. A better way is to let the initial payment be lower while gain from profit sharing or revenue sharing mechanism.

Two types of asset sale problems or mistakes
Even when there is no corruption, there are two types of problems or mistakes government can face or make with asset deployment. 

1. The government sells the asset at lower than market value thus resulting in loss for the exchequer. This is usually because the government cannot value the asset correctly. Alternatively, government is advised to "leave some value on the table". In all these circumstances, the exchequer is the loser. 
2. The second type involves selling the asset at market price but to someone less qualified or simply, preferring one buyer over the other. Here the problem is not for exchequer directly. Here the shareholders of the company denied the asset end up losers while those of winning company gain windfall profits. It is possible that the preferred buyer may not have technical capabilities to effectively deploy the investment thus resulting in second order loss for exchequer. 

Out of the two types of problems with asset deployment, first is detrimental to the exchequer but the second is indifferent (at least directly). It follows that the level of tolerance for first type of mistake should be lower than the second one.

Types of Asset pricing
Asset pricing depends on various mechanism for cash flows and availability of asset itself. 

1. One-time sale - this transfers public asset to private ownership: This involves higher risk to government as the real value of the asset may not be correctly assessed at the time of sale. However, once sale has concluded there is not much that can be legally claimed from this type of transaction. 
2. One-time payment for right of usage for few years and renegotiated every few years: This is capitalized rent and the value of this changes as perception of risk changes. The risk involves depends on what the asset is and how long is the first lease period. E.g. Mumbai Mill lands have been leased to companies on 99 year leases. Recently 99 year period has expired but the ownership of those lands has not reverted back to government.
3. One-time license-fee payment followed by share of revenues/profits: Here the one-time component is lesser to account for untested risk that entrepreneur must take. Thus, this option is less risky for entrepreneur as well as government. There are sub-categories within this option depending on where the government takes its cut - at revenue stage or at operating profit stage or net profit stage.
4. Only share of revenues or profits: Technically Taxation achieves this effect either through general tax or specific industry based levy, either in the form of excise, cess etc.

The first three methods are used where the asset is scarce (usually resources like spectrum, mines, land etc.). The fourth method is used for everything else.


Structure of Corruption around these problems
Corruption is structured around these potential problems to aggravate the loss to exchequer. Following problems occur generally:

1. Asset is impaired and sold thereafter: Impairment can be positive act or negative acts. Positive act means the asset is deliberately impaired wherein losses increase and asset appears hopeless. A negative act means allowing the asset to degenerate without actively doing so.
2. Mechanism of Asset pricing is changed midway: Here the original intention of pricing the asset is ignored. First, the asset is priced lower to encourage investment by lowering the risk in the asset deployment. Thereafter, an argument is evoked at the deployment is only profitable at such low prices and hence the asset value is actually low. Thus, Mill lands went from following method 2 above to method 1 without commensurate payment.
3. Concessional rate for PSU buyers: In this form the government allots a public asset to a public sector undertaking (PSU) company. This seemingly benevolent act can be hideously corrupt. Unless the PSU is 100% owned by the government, it is reducing public gain and has same effect as selling the asset at throw-away prices. A PSU in receipt of such asset must not complain if the government caps the prices of the end-products it produces.
4. Concessional allocation to PSU and subsequent divestment: This is modified part of third problem in which asset is alloted to a 100% government owned PSU and thereafter the ownership is divested. This buries the asset under the PSU performance and makes it less valuable to lay-person. 
5. Asset Valuation is not proper: In this case, the sum-of-parts value of the asset is higher than the asset itself. Thus the parts must be valued appropriately. Thus the land owned by a specific PSU that is divested may be of more value for other use than for use of PSU itself.
6. Profitability Estimation is impaired: This form works with assets like airports and roads where the right to collect toll or charge for services is leased to private entities. Recent experience suggests the estimation can go wrong in both ways as has happened in toll-roads and airports privatized recently.
7. Arbitrarily choosing pricing mechanism for two similar assets (Inconsistency): For reasons unknown, without effecting a policy change, government allots one asset in one manner and other using different pricing mechanism.
8. Granting asset to unqualified buyer: When asset is granted to an unqualified buyer who sells the license to other party at substantial profit, there is ground for doubt to believe that asset is underpriced and opportunity exists for arbitrage trade.

Note: The list is not exhaustive as people are infinitely more creative than anyone can anticipate.

The solution
The real solution is not a model for asset pricing but one of transparency. 

1. Conservative approach: I believe, from the exchequer's point of view the risks associated one-time outright sale are quite high. Instead, a non-trivial license fee in addition to share of revenues forms a better alternative. It allows for future adjustments of asset value and exchequers share in the same.
2. Transparency: If the process is transparent and mechanisms are fair, there is not much corruption that can happen. 
3. Changes to reflect true assessment of changing value of asset: If it so appears that initial payments were underpriced, then subsequent revenue sharing could be raised and net effect can still be adjusted.
4. Consistent changes: Any policy driven choice must be applied consistently. Thus if government chooses auction method then auction should be followed everywhere. If First-come-first approach is used it should be used consistently and fairly.
5. Principles of natural justice and equity: Any solution accepted by government must abide with principles of justice and equity enshrined in the constitution. Thus, if all qualified parties are given equal opportunity to bid for asset, there is not much scope of corruption.

In Sum

The focus of asset deployment is to get best value for the asset being deployed for public interest. The duty of the government is to deploy public assets for public gain. So long as basic principles are adhered we can have a flexible system that can account for past mistakes in an on-going manner.

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

Why QE or Asset Purchase is bad idea?

In my humble bid to respond to Martin Wolf's post in FT, I must de-clutter the arguments. But first let us look at the questions:

1. Why suddenly does QE have to be of this large magnitude?
2. When does QE work? What are different types of liquidity problems that QE can solve?

To answer these questions we must understand how the asset bubble phase worked. Let us take two important policies that aided the previous boom. 

Two policies that aided the boom

First, we were in era of low interest rate and low inflation. Second, inflation, everywhere is measured by estimating changes in the price of basket of goods and services, no matter how exhaustive or qualitatively superior the basket is.

The question really is - what happens to a person who has a lot of money but he cannot put in a basket which is watched closely? Logically, he puts it into another basket. What if there is no other basket? Well, he creates another basket. This is exactly what happened over past three decades. 

People wanted to invest in assets that were included in inflation basket because the goods and services in the basket comprised important daily items. However, they realised that too much investment makes the central bank tighten the money supply by increasing interest rates or calling for higher reserve requirements.

So these people started investing in other baskets - let us call them basket 2. In many countries real estate was in this basket. This created substantial bubble in these asset classes. The level of bubble was so high that these investors baulked at the prices and were reluctant to invest. Some internal value compass was indicating a diversion from reality and presence of unprecedented risks.

So these people had money and no where to invest. So they created a new basket - basket 3. This comprised derivative of assets in basket 2. This reduced the risk associated with assets in basket 2 and calmed the frayed nerves of investors reluctant to invest directly. Now these people can invest, because the risk was, supposedly, reduced. 

The basic rule was to created tradable assets where this excess money can go to without stoking inflationary fires. This is what I call Asset-creator boom.

Two type of Assets

The asset creators initially scouted for most promising of productive assets. However, once all the investable assets were exhausted, they started creating paper assets. These paper assets are not productive and have same utility as coins or chips from a gambling house.

To complicate matters, the developments in this asset class were creating winners everywhere. Traditionally, the gambling house always wins, but here was a gamble where the clients were winning big. Naturally, the paper assets had same problem as that of gambling house chips. They are good enough till the gambling house is good enough to pay money for them. Once the doubts about gambling house start creeping in, there is bound to be trouble.

Since the economic policy remained in this zone for long time,  the quantum of these paper assets grew to large order of magnitude. In comparison, genuine productive assets grew at a modest pace - as they usually do.

The essence of QE

Usually, QE or infusion of liquidity, or asset purchase, is done when there is no buyer for assets and that stalls the economy. When this mechanism was invented or discovered, assets usually referred to productive assets. So even when the central banks buy these assets, the assets do produce something of value. Over time, people tend to appreciate the value of these assets and buy them back from the central bank. Thus QE works when the system has more good productive assets than bad assets.

This time, the central bankers are buying paper assets leading to two major issues. First, the quantum of purchases is going to be substantially large sometimes as much as the real economy itself. Second, no one is going to purchase these assets back from central bank later as they will realise that these are worthless. So, for all practical purposes these assets are destroyed or taken out of the system. Thus, the central bank asset purchase schemes put out a lot of money in the market while reducing the quantum of assets in the system. This is what leads to talk of inflation.

Problem of inflation

Now, we have too much money, pumped in by the central bank, chasing too few productive assets. Note that no one wants to hold the dummy assets any more. 

In our basket-3 type assets, there was a micro-thread connecting these assets to the productive assets. The thread was too weak and too thin that it escaped perception of investors. Hence there was no effect of basket-3 asset bubble on basket-1 goods and services. 

Today, investor want assets strongly linked to productive assets. Naturally, there is a good deal of impact on underlying goods and services. Thus price of these goods and services are becoming increasingly volatile. Inflation is all about changes in prices of these goods and services.

To have sane pricing of goods and services, we will need some equitable relation between total money in the system and total number of productive goods, services and assets. It means this excess money will have to be destroyed. To counter this excess money chasing core, productive assets, central banks have decided to pay interest on money it created, so that this excess money simply sits in a bank account doing nothing. This incentive prevents money from chasing any assets. Further, the central bank knows where the money is sitting so that it can quickly destroy it when it becomes troublesome. Alternatively, the currency will lose its value and adjust to new price equation.

The problem of sovereign debt

The ideal solution to our crisis was thus. The central bank creates excess money and gives it to investors. These investors, worried of the risk in the system, invest in government securities. This gives government enough money to deploy in programs that can promote real, productive growth of the economy. Meanwhile, as the growth returns, investors are more confident of what are good assets. They buy these assets from central bank thus returning the excess money.

This time, the excess money available with investors was truly large. The government could not come up with a credible list of projects that will build long term advantage of the country. Hence, investors have started demanding that the government either tighten their belts to meet their obligations or show how their spending will create future returns. Government has been able to do neither. Therefore, we see substantial demand that government undertake austerity measures. Government, on the other hand, believes that since the central bank purchased assets no questions asked, the investors should also purchase government bonds no questions asked. A sort of quid-pro-quo. But investors have not kept their end of the bargain.

One wonders, if this conditionality should have been embedded at the time of central bank asset purchase and if it was wise to believe that investors will uphold their end of the bargain. The question therefore remain, why did the central bank have to purchase bad assets at all? Why QE?

In sum

Nevertheless, that is the story of QE. Those are the reasons QE will not work. It is said that false money created from casinos should have been destroyed at the hands of the gamblers. By purchasing these gambling chips for real money, the central bankers have, in effect, sold the tax-payers and citizens short. Hence, QE is, for all practical purposes a bad idea.

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

Taleb on Antifragility | EconTalk | Library of Economics and Liberty

I like what Nassim Taleb usually writes. Here he is talking on Anti Fragility talking with Russ Roberts who produces an incredible podcast at EconTalk. I am a regular listener. Taleb on Antifragility | EconTalk | Library of Economics and Liberty.

The critical question he thinks about is how to design antifragile systems. Particularly relevant is the discussion on definition of Antifragility: (worth reproducing)

What is the opposite of fragile? And of course we think we know what that is. The opposite of fragile is robust, you say; it may be unbreakable. But you argue that's not right way to think about it. It doesn't capture the essence of fragility. So, why do we need another term? Because if you send a package by mail to your cousin in Australia and it has champagne glasses, you write "Fragile" on it. If it is something that is robust, you don't write something on the package. You don't say you don't care, you can do whatever you want. So the fragile, the upper bound comes back unharmed or [?] and of course the worst is completely destroyed. So, that's the fragile. The robust has an upper bound of unharmed and a lower bound of unharmed. The empty fragile would be a package on which you'd write: Please mishandle. Because a lower bound would be unharmed. And the upper bound would be improved--you'd get, instead of sending 6 champagne glasses, 8 would arrive. Exactly. Like in mythology. Or they'd be better glasses, stronger somehow. Like the Hydra--you cut one head, two heads grow back.

Must listen.

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

Crisis Basics: Solvency Crisis Vs. Liquidity Crisis

Let us understand what a solvency crisis and liquidity crisis are.

A Liquidity Crisis

Here is a popular example that was given in past few years. “A tourist stops at a motel and gives the manager a $100 cash deposit while he looks at the rooms. The manger runs and pays off his $100 debt to the butcher. The butcher runs and pays off his $100 debt to the farmer. The farmer pays off his debt to the feed store, and then the feed store owner pays off his debt to the motel owner. The motel owner then gives the $100 deposit back to the tourist.” This is a liquidity crisis.

Point to note:

1. All people were in debt. The size of debt is immaterial. The hotel manager could have had debt of $1million to various vendors.
2. The debt was used to create value. That, is the most important aspect of this debt.
3. The value dominoes were stalled because of lack of liquidity which the tourist provided.

A solvency crisis

Here let me use the example from Bob Steinke. 

Imagine instead that a restaurant owner takes out a small business loan to stock his wine cellar. The next day Bernie Madoff comes in and drinks $1000 of wine, paying with cash. The restaurant owner turns around and invests that cash in Madoff’s hedge fund. The next day Madoff comes back and drinks another $1000 of wine, paying with cash (the same $1000 bill he used yesterday), and the restaurant owner turns around and invests that money with Madoff too. This continues ten times. Madoff has drunk $10,000 of wine, and has a $10,000 debt (the investment he is supposed to eventually return to the restaurant owner), but he only has $1000 of cash to repay that debt. Madoff has a solvency problem. His net worth is less than zero. Temporary use of some cash, to be paid back later, would not solve this problem. This situation is different because value was actually destroyed. The $1000 of cash still exists, but $10,000 of wine disappeared into Madoff’s stomach, and Madoff didn’t produce anything of equal value he could use to pay for the wine.

Points to note:

1. Debt was created just as in previous case.
2. Debt was deployed to non-productive ventures. In this example Madoff drank-off all the wine. It means value was destroyed.
3. The debt domino does not stall easily in this case unless doubt creeps into the mind of the restauranteur.

Therefore

1. Now clearly solvency crisis seems bad one. If only we had someone who could tell the restauranteur that Madoff was a crook. That someone, in many cases, should have been the ratings agency.
2. Whenever there are debts, there are also bad debts. Good debts are deployed towards creating value higher than the value of the debt. 
3. This begs further explanation. Let us assume an entrepreneur takes $100 of debt @ interest rate of 10% per annum. This debt is employed to do work that ideally produces output greater than $110 in one year. Thus, debt of $100 creates, let us say, $130 of value. Then we say that debt of $100 create $10 of value for the creditor and $20 value for the entrepreneur. 
4. From the creditor's perspective, let us say the creditor makes 100 such loans. So the total debt is $10,000. Potential value it should create for the creditor = $1000. 
5. Now imagine one entrepreneur fails and loses everything. 
6. From the creditor's point of view there is not yet a problem as other 99 loans are good. The creditor will lose $100 of capital and $10 of interest. Thus, the creditor will earn $890 in that year. In technical parlance we would say, the creditor had write-off of $110.
7. Solvency crisis happens with size of bad debts is higher than the value created by good debt.

The problem of misdiagnosing a solvency crisis as a liquidity crisis

The authorities tend to pump in more money to solve what they term, rightly or wrongly, as a liquidity crisis. The money often goes to Madoffs of the world who disappear with the money. The problem gets compounded when a solvency problem is thought to be a liquidity problem.  This actually increases the level of bad-debts in the system.

The way out of the solvency crisis 

There are various ways out of solvency crisis, each dependent on the size and structure of the problem. 

1. One way out is to write off the debt and start afresh. Everyone takes a hit and blames their naivety and goes back to work. 
• This is relatively easy when the size of the problem is relatively small, as in our example above. 
• There is a problem with relative size of bad debt is colossal. In such cases, creditors need to be wound down in a systematic manner. At the same time, the resulting recession has to be managed by promoting employment and counter-recession measures.
2. Textbook way is a little different. Technically, it is possible to increase the level of the good debt to such an extent that the bad debt can be written off without any problem. There are two ways to create good debt. 
• First, by reducing interest rate marginally bad debt can become good debt. It is interesting to note that the first approach works only if the amount of bad loans is uncomfortable but not catastrophic like we had in 2007. In other words, the difference between good and bad debt has a bearing on effectiveness of this approach. Monetarist do not agree with this pre-condition. They believe this approach can work for any difference between good and bad debt.
• Second, by pumping in additional money into the system. The additional money, ideally, will create value that will dwarf the losses from bad debts. This is like making a line smaller by drawing a longer line beside it. The second approach only works when you have body of projects that can absorb the new capital and still be classified as good debt. The gains from these projects must be quick and substantial. For example, if by some stroke of policy we can quadruple the exports then debt required to fund that policy can become this text-book solution.
3. The third way of escaping a solvency crisis is what I call the Chinese-bank way. In this mechanism, you combine all bad debts, distressed assets into a special purpose vehicle. This cleans up the balance-sheet of corporates holding those assets in first place giving them room to borrow and invest in their businesses. The special purpose vehicle is then backed by government whose solvency, ideally, is not a problem. Over a period of time as industry grows back into a healthy state, government offloads its stake in SPV to the markets which digest these debts. 
1. Naturally, these bad debts are a little different from other bad debts. These bad debts must be productive under some conditions, which are denied because of the impending crisis and may return when the crises abates.
2. If government is holding really bad bad-debts then it can write-off the SPV investment and claim the debts as taxes either from public or corporates at later date.

In sum

We can notice that quite a few ways for countering this crisis have been tried. We haven't had much success. As stated, half-hearted attempts to solve the problem compound this problem, thus, we are in a bigger soup. Let us hope, further solutions are better managed.

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

Jeremy Grantham knows we were warned!

Years back in 2008, I wrote a post about how Shakespeare's Polonius (from Hamlet) had good advice for us investors. Today, Jeremy Grantham, in his quarterly newsletter, discovers that very advice.

Here is my post from 2008: "How to avoid the credit crunch?"

I was really surprised when I realised that entire credit crunch and related problems were highlighted and we were warned back in 16th century itself.

For Rating Agencies
See thou character. Give thy thoughts no tongue,
Nor any unproportioned thought his act.

For investors - particularly those who misguide people on CNBC
Give every man thy ear, but few thy voice;
Take each man's censure, but reserve thy judgment.

For US / UK and European Consumers
Costly thy habit as thy purse can buy,

For Mortgage dealers (they heeded but CDS borrowers didnt)
Neither a borrower nor a lender be;
For loan oft loses both itself and friend,

For all market operators
This above all: to thine ownself be true,
And it must follow, as the night the day,
Thou canst not then be false to any man

Here is the full advice:
Yet here, Laertes! aboard, aboard, for shame!
The wind sits in the shoulder of your sail,
And you are stay'd for. There; my blessing with thee!
And these few precepts in thy memory

See thou character. Give thy thoughts no tongue,
Nor any unproportioned thought his act.

Be thou familiar, but by no means vulgar.
Those friends thou hast, and their adoption tried,
Grapple them to thy soul with hoops of steel;
But do not dull thy palm with entertainment
Of each new-hatch'd, unfledged comrade. Beware
Of entrance to a quarrel, but being in,
Bear't that the opposed may beware of thee.

Give every man thy ear, but few thy voice;
Take each man's censure, but reserve thy judgment.

Costly thy habit as thy purse can buy,
But not express'd in fancy; rich, not gaudy;
For the apparel oft proclaims the man,
And they in France of the best rank and station
Are of a most select and generous chief in that.

Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.

This above all: to thine ownself be true,
And it must follow, as the night the day,
Thou canst not then be false to any man.
Farewell: my blessing season this in thee!

- Shakespeare in Hamlet (Lord Polonius advice to son Lartes)

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

Commodity valuation

A lot of people believe in strength of commodity prices but the boom is fragile for the following reasons.

Substantial part of valuation depends on strong and sustained commodity consumption driving growth in India and China. The growth is unlikely to be either strong or sustained (in near term). This may take the wind out of the boom.

But I believe we have underestimated two other reasons.

Commodities as store of value
A part of boom in commodities can actually be explained as a result of money trying to protect value of developed countries investors. To protect value, you translate your money into equivalent basket of benefits (goods and services) that can be bought with your money. So we can imagine the equation as (money I have in year "t") = (sum of products and services that can be bought in year "t").

Every year this equation must be evaluated from the RHS not LHS. Thus, the true comparison can be achieved when we compare (sum of products and services that can be bought in year "t") vs. (sum of products and services that can be bought in year "t+1"). Ideally, we must be able to buy more products and services in "t+1".

However, in common parlance we do compare LHS. The question we ask ourselves is "do I have more money than last year?" It is a misleading question. People get fooled when the answer is yes. In fact, American middle class thought they had more money in every subsequent year. But in real terms the wages are stagnant for more than 2 decades.

To protect the RHS value, investors try to hoard certain commodities that are irreplaceable. The degree of irreplaceability, knowledge of alternatives, certainty of whether commodities will indeed be part of value-store equation are all unknowns.

The Real Chinese demand
The resource intensity of growth of China will reducing drastically. This is simply because of three main reasons.

Firstly, China has built out infrastructure for next N years, advancing their consumption of commodities. This will revert to mean in the next N-4 years. (The value of N is matter of debate).

Secondly, China has already bought or locked in its commodity requirement for next few years and this has no price implication for commodities hereafter.

Lastly, it has to reduce drastically just to make scientific sense. This will have new winners and losers within different commodities. 

Evaluating commodity boom is difficult
Thus, the factors affecting commodity prices and demand are different than normally discussed. I am yet to see a reasonable assessment of the two main changes above. Hence, I advise to be really, really careful with commodities. At least do not build any position you cannot liquidate quickly. 

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

The Value of Indian Rupee

The Economist recently published the Big Mac Index that shows Indian Rupee as most undervalued currency contrary to the popular perception of its value. The Big Mac is priced at $1.62 in India vs. $4.2 in the US thereby giving undervaluation of 2.6x.

It raises some hard questions:

1. Has Indian Government absorbed substantial part of costs? Indian government subsidizes diesel and that could show up as mark down. This bloats the government balance sheet but keeps inflation from showing up in consumer goods prices. This has double effects, when high oil prices are absorbed by the government, Indian prices languish. Further, when the global prices start correcting, Indian prices tend to remain firm.
2. INR is undervalued because Indian government finances are not in good shape. India's government finances look more like developed countries than developing countries. To compound the problems, Indian export basket is quite price sensitive while import basket is not. So then does it mean Indian inflation has substantial way to go? 
3. Does it mean that Big Mac Index works better when government budget is nearly balanced?
4. Another important thing is that the price of entry-level burger at McDonalds has been coming down since McDonalds came to India. Part of the reason is product development, but significant part is because of raw material efficiency. This latent competitiveness has not yet been harnessed, but if done so, will make India more resilient to global factors. It may even make Indian exports more competitive.

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