Thursday, May 29, 2008

Should Bernanke raise or lower rates?

Who are the biggest losers in the current economic mess in the US? What should people do? What’s the FED to do? Should it raise interest rates? Or should it lower rates?

Much has been said and written about the current housing problem in the US. We now know that this was brought about by mortgage bankers who encouraged borrowers who could not otherwise afford the debt servicing to take out housing loans. These were taken out by enticing so-called sub-prime borrowers with low little to no money upfront, coupled with low introductory rates on the loan that they COULD afford. These special rates normally lapsed after two years.

At the end of two years, regular rates kick in. But this loan structure was pushed to the borrowers on the assumption that when the two year special rate period lapsed, the market value of the house would have increased (These loans were offered during the peak of the housing boom). If and when the house’s value went up, so the belief went, the added market value of the house would amount to additional equity of the borrower on the house. With the added equity on the loan assumed into the loan structure after two years, they all figured that the borrower would qualify to keeping the low rate on the loan.

But the housing boom ended. Interestingly, it ended just when rates first started to go up. And that couldn’t have happened at a more inopportune time. It happened just when investors were starting to get skittish on the loan structures, when a lot of newly-built homes were getting into the market, and many borrowers had already taken up on the “innovative” structure.

When rates went up, it ended the long line of speculators lining up to buy and flip houses. Thus, house prices started to go down. There suddenly was a glut of houses on the market.

When house prices started to go down, this unravelled the very assumptions of the loan structures. When the special rate period started coming due on the first sub-prime loans, the rates of the loans did not go down or even stay put. They went up. At the end of that period, many borrowers simply still did not have enough equity on the house yet. And because houses prices went down, for many of these homeowners, the amount owed to the bank was suddenly much higher than the price of the house itself.

So what is a homeowner/borrower to do? Just imagine yourself with a loan you can’t afford, taken out to finance a house that is now worth even less than the loan itself. You had barely put in equity in the house to begin with because of the loan structure, and all that was to lose was the little money put on the house during the special period. What are you to do? Unless you were back in the street if you defaulted on the loan and let the bank foreclose, you did not have much incentive to continue the loan. In many cases, EVEN IF the borrower would end up on the street upon default, they simply could not afford the loan anymore.

Thus the housing problem started. The more people defaulted, the more houses were put on the market (after foreclosure), the more house values went down, the more people ended up with loans they could no longer afford. This is what we learn in Economics 101 as a vicious cycle.

Now this housing problem is being punctuated by the recent run-up in inflation. Oil prices are going up. Food prices are going up. And just about everything else is getting more expensive as a result.

The Fed’s initial solution to the housing problem was to lower interest rates. This was meant to put a backstop to the vicious cycle of people simply allowing their mortgages to default and further exacerbating the housing crisis. This was meant to make the investors and lenders less skittish and start providing capital to the market again.

But Economics 101 also tells us that when there’s a run-away inflation on hand, the Fed is supposed to increase interest rates. This is meant to put a clamp on capital, and to minimize the velocity of money. With higher interest rates, less companies and individuals take out loans to finance inflationary activities.

But again, there’s still the housing problem to take care of. Higher prices would further exacerbate the vicious cycle of mortgage defaults and house foreclosures.

What’s the Fed to do ? Who suffers if its raises rates? Who suffers if it lowers rates?

For reasons already pointed out, if it lowers rates, inflation is believed to stay, putting a damper on everyone as the price of everything goes higher. If it increases rates, it will make the already long-suffering sub-prime borrowers suffer even more. And it would make the already skittish capital providers withdraw more capital from the market, thereby making the cost of funds more expensive for everyone, including companies and individuals with the best credit scores.

Looks like Bernanke is in a real bind. No matter what he does, he’s bound to make a significant group of people very unhappy and to think this mess was created long before he came to the Fed.

What do you think he should do?

My best guess is that if Bernanke raises rates, the effect of further crimping the capital markets and causing more sub-prime defaults is the much greater evil.

Why? Well, with oil prices going up, everybody’s costs are already going up significantly. A rate increase gives further cost pressure on everyone, particularly those who are of good credit, but cannot otherwise avoid some form of debt in the course of doing regular business.

And with the sub-prime mess already significantly pronounced on the American economy, a low rate will not necessarily cause another run-up in borrowing to finance both speculative and legitimate investing. Banks are still too much in the red to simply lend more. To lend more means that they need to raise more capital to maintain the approved capital adequacy ratios to do more loans.

And companies simply are already saddled with too much costs now, with the price of oil eating into their margins. To add more cost by borrowing at this point in time is tantamount to a reckless bet on both the company’s and the economy’s future. Both finance officers and bankers should be conscious of the increased dangers of providing more capital to a company that has decreasing profit margins, and in a lot of cases, losing sales due to decreased consumer spending.

So with this assumption (I admit this is another assumption, much like what the mortgage lenders assumed into their loan structures), a decrease in rates will not cause as much damage as feared.

An increase in rates however – well, you can just imagine the further damage that might come from our vicious cycle going into hyper-drive. A rate increase will also likely result in more companies closing shop, putting more people on the street, and maybe putting the vicious cycle into ultra-drive.

Which is not to say that I favour a lowering of interest rates. After all, the further the Fed lowers rates, the further depreciation there will be on the US dollar, the further will US inflation be exacerbated. (How many times have I used this word today?)

Maybe the best is for Bernanke to just stay put. To just – how did they say it last year – hover like a helicopter.

But then again, I am not Bernanke. I do not see what he sees now. Who knows? We might just see another drastic volatility coming up sometime soon.

Is China the reason for the steep rise in inflation?

A lot of economists right now are saying the increase in oil and food prices are due to the depreciation of the US. Dollar. This depreciation has been attributed as well to the rise of price of gold and many other commodities.

It is true that, since the US dollar is the de facto currency of value of just about everything, its depreciation means that everything is now more expensive when looked at using the USD. Therefore, the lower the USD goes, the higher the dollar price of everything becomes. And the lower the USD goes, investors who used to hold USD-denominated instruments look for alternatuves, such as commodities.

But there had to be a more fundamental cause to all this commodity inflation that we are all finding ourselves in. after all, not everyone lives in the USA, and not every country buys for these commodities using USD.

Many have to buy these commodities by exchanging their local currencies with the USD. And as far as I read about, everybody in the world is finding the price of commodities now very expensive. Everybody! Including those who come from countries with appreciating currencies.

The fundamental reason for the increase in commodities prices is that there’s just more demand for them, and supply is not keeping up.

But I would like to attribute another, and may I add, also fundamental reason for the increase in price of commodities for everyone. I haven’t seen or heard this talked about by any of the economists on TV or print, but I daresay this might be too crucial to overlook.

I think global commodities are very expensive now because China has been keeping its currency too low. Meaning, it has been controlling its currency such that it is now priced below its intrinsic value.

Everybody knows this. It’s been going for some time. But just how has this been contributing to this hyper-inflation we’ve been seeing lately?

Well, China keeps its currency low for one important goal – so that the price of its manufactured goods will remain low when computed by its global customers, and compared to its global competitors. A lower Chinese currency translates to lower price of goods when an American or German buys it. It is cheaper when compared with the Mexican product that can be the next alternative.

So what? Everybody benefits because everybody else gets to buy cheaper goods, right? That can’t be a contributing reason to global inflation, can it?

Well, let’s put this analysis one step further. If the US keeps buying these artificially-low-priced Chinese goods (Artificially-low, again, because of the government-controlled currency), what happens to the US currency?

Well, if Americans keep buying more goods than they are able to sell (because their products are more expensive by comparison), then the US keeps incurring trade deficits. We’ve been seeing this US deficit with vis-a-vis China ever since the turn of this century. So, more money has been going out of their economy than has been coming in. therefore, their currency depreciates.

Conversely, what should now happen to the counterparty to their deficit – China? Well, China has been incurring the mirror-image trade surplus to the US trade deficit. More money has been coming into China than has been going out. And this doesn’t even include the massive capital account surplus that China has been incurring, as investors keep trickling in trying to fund the great China dream of selling their wares to its billion plus population. So China’s currency should have been rising, right?

In fact, it should have risen already to the point that parity should have been reached a long time ago. By parity, the value of their currency should have risen to the point where the equivalent value of a cost of good in China should be the same when compared to an American good made in the USA, where the relatively more expensive cost of production should have been offset by the relatively lower-valued currency.

Has this happened? Not from what any of us has seen. And that’s because the Chinese government intervenes to keep the value of its currency low. The longer they can keep the value of their currency low, the longer their products will seem cheaper when compared to US and other countries’ products the longer they can keep incurring trade surpluses with everybody else.

How does China manage this? Well, you know all that extra boatloads of money that’s been coming into China vis-a-vis what’s been getting out. China has been putting it to goo use (for them, that is investing this money in US Treasuries. In short, they themselves are funding the US trade deficit, by being America’s de facto creditor of the same deficits. Hence, USD has historically maintained its upward value, because China keeps demanding more of it.

Lately, because the American government has been incurring budget deficit in relation with the war in Iraq, and because of the ever-present trade deficits cannot, in reality, be incurred into eternity, the USD has finally been experiencing a downturn.

So we find a world where the USD is going down, but the currency of its mirror-image trading partner, which is still pegged to the USD, remains low.

What’s the implication of this? Well, we see a world where the irrepressible American propensity to consume continues to go unabated, but now it has a new major competitor in the wings – competing for the same scarce world resources – a potentially as-irrepressible Chinese consumer that is only now beginning to afford the same luxuries.

This newly-heightened competition for the essentially same supply of commodities is increasing global prices.

You would think, and I wouldn’t blame you if you did, that because the Chinese government is artificially keeping the value of their currency low, that the Chinese consumer is at a disadvantage – that the value of these commodities, when translated into the low Chinese currency, will be so out of reach for the typical Chinese consumer.

To a large extent, that’s true. There’s a lot of gnashing going on right now in China, perhaps much more than the gnashing going on right now in the US. Only we don’t get to hear them because the Chinese government may be muffling all of it. Or maybe the Chinese are just so used to hardship that they just don’t complain as much.

But to a large extent also, the Chinese government is allowing the Chinese people some leeway by subsidizing the cost of these commodities. After all, if the reason the cost of these goods is so high locally is because of government intervention, it’s only fair that government intervention find a way to alleviate to effects, right?

So again, to a large extent, this contributes to the still-growing demand of the Chinese for commodities. Because they can still afford it - because their government, flush with trade surplus cash – is subsidizing them, the Chinese continue to buy.

The real losers here are those nations whose people enjoy neither the direct subsidy of the Chinese government, nor the indirect subsidy of the same Chinese government, through the purchase of that nation’s Government Treasuries.

That could be you. Now isn’t that a bummer? Down to Chinese currency control!!!

the uneven effects of globalization

We are recently seeing a more refined effect of globalization, particularly in the larger economies. You know, this includes countries large enough to happen to have significant industries in several economic sectors – manufacturing, commodities, energy, services, consumer, industrial, IT….

This refined effect is - that in any one single country, a significant downturn in one of the major sectors of the economy need not mean a down-turn in the overall economy.

Let’s take the case of Canada. Canada is a large country. It has major industry clusters in all the economic sectors mentioned above. These clusters tend to be largely based in specific provinces. That’s why they are called clusters.

Manufacturing and industrial firms have mostly clustered around Ontario. Most likely, this is because they are a capital-intensive sector, and the financial sector has largely clustered itself in Ontario as well.

Oil and energy has largely clustered in Alberta– largely because there are significant chunks of oil-rich soil in Alberta. Materials mining has been more democratic. There are mines everywhere - from British Columbia, Yukon, Alberta, Saskatchewan, to Manitoba, Ontario, Quebec, all the way to the Atlantic provinces.

Now how are all these related to point above?

If you’ve been reading the newspapers lately, you know that we are currently experiencing a global rise in demand for oil and energy, for commodities, and for food. You know that prices for these have significantly shot up in the last few years. The steepest price climb has been in the last year alone.

This has significantly benefited all economies that happen to enjoy resource-rich lands, the likes of Alberta, and to a lesser extent, Saskatechewan. All over these provinces, per capita income has been going up, and with it consumption per capita has been going up, and as a significant after-effect, real estate in the provinces have been going up, as more people move into these booming economies, and speculators join the fray, by bidding up real estate prices, in anticipation of more people coming into these areas. Good for them.

Now you know also that there has been a significant down-turn in the manufacturing sectors of developed countries as a result of jobs going to lower-cost countries. In Canada’s case, this has largely been avoided previously by going into specific market niches where Canada enjoys significant technological advantage, and which requires jobs that deploy the local population’s superior skill sets.

Lately, manufacturing provinces such as Ontario and Quebec have been finding it harder to keep ahead. And this is now partly because of the successes of the resource provinces, such as Alberta and Saskatchewan.


Because though they all have their own distinct provincial characteristics and separate economic focus, they are still part of the same one country. And they all use the same currency. That means, a significant increase in the fortunes of one province will have a profound effect on the fortunes of the other provinces. Not necessarily for the better as well.

Because of the increased global demand fro the commodity products of Alberta and Saskatechan – oil, energy, materials, fertilizer for food production- Canada enjoys significant trade surplus coming from these provinces. Because of the trade surplus, Canada’s currency continues to ratchet up, as more money comes into the economy than out.

Because the currency is appreciating, over-all cost of Canadian goods in terms of other currencies is also going up. If your product happens to be an essential that is currently much in demand, such as those priduced by Alberta and Saskatchewan, all is still well and good. You will continue to move product. But if your product is the high-end manufactured good, such as those of Ontario and Quebec, you’re in trouble.

Because of the constantly increasing cost of basic commodities, countries around the word are now increasingly having to make an important allocation decision – whether to use the decreasing buying power of their local currency for the more essential goods, such as food, energy, and materials, or the relatively more luxury-oriented or discretionary items, such as cars, car parts, planes, etc .

Basics wins out every time. At least during times of scarcity.

Because Alberta and Saskatchewan continue incurring trade surpluses, the Canadian currency continues its rise, or at the least, doesn’t depreciate compared with the currencies of those countries that are net buyers of Alberta’s goods.

Because Canadian currency becomes more expensive as a result, Ontario’s and Quebec’s products look even more expensive. And this presents and even bugger hurdle for the sales arms of their manufacturing companies. It gets harder to move their manufacturing products. Manufactured products of countries with depreciating currencies become cheaper by comparison. Even Canadians on strict budgets (who wouldn’t be, in times high inflations such as this?) would rather buy the cheaper alternatives.

So, we see a situation where, the more successful provinces such as Alberta becomes, the drearier the future looks like for provinces like Ontario. Canada is like the ship that suddenly gets swept up in a rising tide. It could either completely topple over, or it can avoid completely toppling and sinking, if it finds a new equilibrium where one side is deeper under water, while the other side ends up reaching up much higher out of the tide’s way. Right now, at least, Alberta is that side higher out of harm’s way, Ontario is the one deeper in the water.

Many Ontarians could very well avoid an unemployed fate by moving out west to Alberta. Unfortunately, this is not for everybody. In a sinking ship, you don’t want everybody rushing and packing into one side, lest the ship topple over into that side and sink everyone. If everybody goes over to Alberta, the economy might just overheat, and this will result in too high unemployment, and greater inflation in that area. Everybody will just be more miserable vis-à-vis only the manufacturing people over in Ontario bearing all the misfortune.

What are Ontario and Quebec to do then? What are ways for them to cope without necessarily encouraging a mass exodus of people over to Alberta?

Well, if you cant move all the people, why not move some of the money?

Capital is generally known to move from a place of lower return to a place of higher return. So what Ontario and Quebec need to do is promise a greater return on people’s money than Alberta does. With that, investment should come to these provinces to fund future growth.

Easier said than done. Figuring out ways to grow is always hardest at just the time when you are experiencing a severe contraction. But thinking minds better set down to doing just that. The longer the contraction is allowed to go unabated, the harder it will be for these provinces to get back on even keel.

the unintended effects of globalization

Global food and energy prices are going up. Oil prices are going up. Materials and commodities prices are going up. Steel, iron, gold, wheat, rice, sugar, corn, meat, etc…..

We are told this is because of increasing global demand for these goods. So this is another effect of globalization that, it seems, wasn’t though through clearly when “globalization” was first propounded as the next great “Holy Grail” of capitalism. Globalization was supposed to lead to improved global conditions and standards of living. Globalization was supposed to lead to more and better trade among nations. It was supposed to lead to greater prosperity for all.

Everybody rose and applauded when China , the last big bastion of socialism, joined the WTO.

Then all of a sudden, this led to what some labelled the big “sucking sound”. The sound of jobs (from more developed countries) moving out of their home countries and into China. Not just China, actually, but to much of the developing world.

China became known as the factory of the world. India, the back office of the world. Singapore, long the export processing center of the East, is trying to be the IT center of the world. And so on and on…

There was much gnashing of teeth among those who lost jobs, only to see these jobs shipped off to foreign lands. Not much chance for these people to chase after those jobs anymore. They were told to “re-tool”, “re-position” themselves, “re-engineer” their career.

All was well because, as all experts kept telling them, only the lowest value-added positions were being shipped overseas. That freed the people of the developed countries to focus on higher value-added services, or jobs that provided better growth – monetarily, intellectually - and promised better job security and satisfaction.

Okay. People who’ve been out of school several years are now being told to accept the reality of having to up-grade themselves. This involved anywhere from attending a few days’ worth of seminars, to an apprenticeship, or going back to school altogether.

Most times, this entailed new costs. Education doesn’t come cheap. And it came a time when many have already lost their principal source of income.

Now that’s proving to be just the beginning of a long-drawn-out period of adjustment.

With global growth comes increased demand for the world’s scarce resources. That includes all of the commodities, materials, energy , etc. I specified above. After all, economic development doesn’t come out of thin air.

Countries that are experiencing jobs growth because of globalization need to build new infrastructure. They need to build new schools, to teach their people how to do the jobs that are falling on their laps. They need to build more factories, roads, bridges, buildings. They need to buy more computers, telephones, pencils, paper, what have you.

Not to mention, these people who now have new jobs, who used to get by on smaller portions of food during their meals- whose food essentially used to come from what could be picked off from the tree in the backyard, or the fish that they caught themselves from the river- they now have more money to buy a decent meal from the new supermarkets and hypermarkets now mushrooming all over their homeland. It’s their just reward, of course. They have been working so hard. Worked longer hours than some guys in the developed countries who used to do these, and to keep costss low, received lower pay for the same amount of work.

Now who wouldn’t want to reward themselves a bit for their efforts? They would probably want to give their families, who never used to see beef on the table, the joyous experience of tasting a succulent morsel.

And if they liked the experience, they would probably buy beef again. For as long as they afforded it.

Now that capitalism has caused the worldwide miracle of globalizing modern-day conveniences – even putting the previously-unheard of luxury of eating beef, on what used to be the most down-trodden of the world’s peasantry, we are seeing the adverse effects on that most elementary of economics principles – the law of supply and demand.

Capitalism, with its ever short-term view (I will only do what is best for my neighbour for as long as its serves my self-interest, and in the long run we are all dead) has successfully increased global demand for goods and services. But in its focus on short-term profits, neglected the long-term goal of sustainability.

SUSTAINABILITY! How can these capitalist moguls have forgotten that if everybody in the world will suddenly be a customer for cars, air travel, and next-day parcel delivery, there will suddenly be a spike in demand for oil, for steel (to makes more planes and cars), for ALL materials necessary to manufacture them, to make them run, for them to run on.

How can they have forgotten that if more people are now part of the global grid of trade, more people will now be clamouring for more upscale things in life, such as meat, that can only be adequately supplied if you have enough grains and feedstuff for an ever-increasing cattle of cows.

There was no coherent plan to raise the long-term productivity of producers of these most basic of goods. Why? Because in the last twenty to thirty years, there had been a glut of these same products. Therefore, nobody bothered to look for better ways to increase productivity in producing them.

Nobody was going to look for a new oil well, if that would mean a further dive in an already low price of oil. Nobody was going to figure out how to increase corn yield, if there already were bumper crops every year, and it pays more not to plant than to plant.

So now we find ourselves in a wonderful confluence of events – a perfect storm. All thanks to globalization, and the attendant short-term thinking with which it was executed.

People in developed countries are losing jobs, thanks to jobs moving to lower-cost countries. People all over the world are experiencing double digit inflation, thanks to increased global demand that has been coupled with long-term planning that reached only to the level of finished goods (not commodity inputs).

Everybody is now feeling the pain. Even the ex-peasants who only recently began to enjoy some of the convenience of the modern world. Now even they cannot sustain their newly-found small luxuries.

And what about the new gleaming factories in the developing world? What happens to these when their target markets – The developed countries of the world – cannot anymore afford, or even want to – continue patronizing their business?

What will happen to global trade then? And the long-held promise of globalization, what then?

hark, the rogue economist!

This is my first blog as the rogue economist.

Why rogue economist? Most times, most people look at everyday events through common perceptions, using long-held beliefs, thereby arriving at the same tried and tested formulas and solutions. JK Galbraith called this constant re-use of old frameworks for new situations as adhering to "conventional wisom".

In these trying economic times, it pays to be a little rogue, don't you think?