Felix Salmon links to articles that show real-world examples of why it’s really just better to walk away than it is to try to deal with evil and/or incompetent mortgage servicers.
What we’re seeing here is the mortgage equivalent of credit-card sweatboxes: servicers who make sure to drain homeowners’ savings before they foreclose, since they know that they won’t chase homeowners after foreclosure, even in recourse states. By holding out the promise of a modification tomorrow, they make sure to squeeze every ounce of blood out of the homeowner before finally snatching the home away anyway.
So this is what I’d like to ask Megan McArdle, and others who like to extoll the moral virtues of paying one’s debts: just how much of your life’s savings should you give these snakes before they take your house.
My take on it:
1. Are servicers the real culprits to go after when you’re trying to renegotiate a mortgage? I don’t know how it works in the US, but my gut feel is that these servicers work for the MBS investors. You need to go after the MBS investors if you want a renegotiation. Unfortunately, investment banks have made a real mess, and it now seems impossible to reconstitute who really owns what in MBS.
2. This may devious on the part of the banks who really may still have a way to renegotiate their loans, but extending a loan for as long as they can before they foreclose may be the only way to get back as much of their money as they can. With borrowers having paid no money down on the mortgage, extending and seeing how long borrowers will pay before defaulting is probably a belated way for banks to mitigate their loss. And with many borrowers having no prospects to pay the loan at all going into the future, many banks probably see a renegotiation as the real ‘extend and pretend’ option. The devious part of it though, is that if the banks already see a default down the line, they should just take their losses and foreclose now (and eat their losses) rather than trying to squeeze every last penny from borrowers who have already lost their jobs.
3. In the case of borrowers having no ability to pay the adjusted rates on their ARMM mortgages, but still have paying jobs, banks will need to be coerced to renegotiate. Here, nationalization seems to be the solution. A promising arrangement would probably be to impose a restructuring along the lines of rent-to-own. There have been good discussions on this so far.
4. In the case of borrowers who have the ability to pay their mortgage and only want to walk away, or do a renegotiation, because they are now underwater, the stance should still be ‘a deal is a deal’. Everybody who enters into a contract stares at the prospect of loss. That is why a contract is there, so people adhere to their agreements regardless of what happens after they close the deal. I maintain my position in a previous post.
To prevent this kind of mess of ever happening again, going forward, all mortgage securitizations should have recourse to the originator, and all mortgages should have personal recourse to the borrower. Take away all incentives to game the system.
Wednesday, December 30, 2009
The global economy is the one true macro
Nick Rowe set up an interesting discussion on the pitfalls of using micro concepts to approach macro issues. He rightly argues that macro is different from micro. When you look at the economy as a whole, every micro trade that clears the market involves two parties whose gains or loss from the trade merely offsets each other. Therefore, policymakers cannot generally improve macro conditions, by changing the rules to increase gains for one party, because mostly it will also result in a loss in another part of the economy. Here are Nick’s main points:
If I cut the price of apples, holding money incomes constant, holding all other prices constant, then consumers are better off in real terms. They can afford to buy more goods, and if apples are a normal good, they will spend some of their increased real income on buying more apples...
This "income effect" is total rubbish in macroeconomics. If there are 100 apples sold, and I cut the price of apples by $1, then consumers of apples are $100 richer. But producers of apples are $100 poorer. No effect on aggregate real income. Real income is the quantity of apples. It's GDP! And money income is the price of apples times the quantity of apples....
A fall in the price of apples, relative to the price of other goods, means consumers will substitute away from other goods and into consuming more apples. That makes sense in micro, where we draw the demand curve of apples holding the prices of other goods constant. But in macro, where the price of all goods is on the vertical axis, it doesn't make any sense at all. If the prices of all goods fall, what are they substituting away from? And why?....
If one worker tried to sell his apples for a higher price than the other workers, he might be unemployed. Nobody would want his apples. But then there would be an excess demand for other workers' apples, and an excess demand for their labour. There is no way the labour market/apple market as a whole could be in excess supply, because on average, the price of apples must equal the average price of apples...
And if people want to hang onto their money, rather than buy apples with it, the demand for apples, and the demand for labour, will be deficient. A deficiency of aggregate demand has got nothing whatsoever to do with a deficiency of income. Income is always sufficient. It's always the same as goods sold. A deficiency of aggregate demand is a deficiency of peoples' willingness to get rid of money. The "Paradox of Thrift", and the "Paradox of Toil", are merely corrupt versions of, or way-stations to, the Paradox of Money. Each individual can increase his stock of money by buying less; but in aggregate they fail, but cause unemployment as a side-effect.
I commented that when you have an open economy in a globalized environment, the micro assumptions can hold, and macro assumptions of a closed economy break down.
1. If you make apples $100 cheaper, domestic producers can potentially sell more apples, regardless of the level of demand domestically. It becomes a substitute to apples (or oranges) everywhere else in the world.
2. Hence, even if there is an excess supply of apples in the domestic market, it can still (potentially) sell as much output as it wants.
3. And even if the “paradox of thrift” holds in the domestic economy, the excess supply of apples could clear elsewhere in the global economy. (It also helps if your government controls the value of your currency, which in actuality is an integral part of what you trade in a globalized economy).
Nick replied: If you are talking about a small open economy, (under fixed exchange rates, with a common currency) you are absolutely right. In fact, I would say that SOE macro isn't really macro at all. It's micro. The only true macro is closed economy, and therefore global macro. But if we have national currencies, then I think there are some aspects that can only be handled from a macro perspective.
This reminded me of a post I made in August last year, which argued that national monetary policies (especially of small open economies) were becoming more and more insignificant in a globalized environment. Now that capital mobility is global…
1. If one country hikes its interest rate to contain domestic inflation, it can attract more capital from overseas, nullifying the hike. Similarly, if the country cuts rates to spur investment, capital might leave the economy for better rates elsewhere.
2. An aggressive money supply policy in one country can spill over excess liquidity into the global system, spreading inflation globally.
3. One country’s active currency management policies artificially inflates/devalues free floating currencies.
4. Because of points 1, 2, and 3, one Central Banker’s monetary policies to cure domestic unemployment might be rendered ineffective.
5. Financial crisis that start in one country can easily spread to other economies….
My speculations of a global central bank were rightly trashed in this forum over at EconomicsUK. But nonetheless, there seems to be a disjoint in economics theories as they are applied in a global setting. More importantly, there is a lack of coordinating institutions that would ensure the fair administration of monetary transactions worldwide. We don’t even know how to make them work, if there is a way to make them work.
Globalizing trade and financial flows without the corresponding globalizing of human capital movements has only led to repeated global imbalances. Because governments are still local (or national, for that matter) they still adhere policies that will result in what is good for their local populations. it is they, after all, who are stuck with the net gains and/or losses from globalization. A gain is made for them if a country creates more jobs, decreases its cost of capital, and maintains a stable inflation rate. So a local/national government will do what it can to achieve these aims, no matter if the gains from these aims end up being offset by a loss in another part of the world.
We either need to get rid of nation-states altogether, or we enforce stricter rules on nations participating in global trade.
If I cut the price of apples, holding money incomes constant, holding all other prices constant, then consumers are better off in real terms. They can afford to buy more goods, and if apples are a normal good, they will spend some of their increased real income on buying more apples...
This "income effect" is total rubbish in macroeconomics. If there are 100 apples sold, and I cut the price of apples by $1, then consumers of apples are $100 richer. But producers of apples are $100 poorer. No effect on aggregate real income. Real income is the quantity of apples. It's GDP! And money income is the price of apples times the quantity of apples....
A fall in the price of apples, relative to the price of other goods, means consumers will substitute away from other goods and into consuming more apples. That makes sense in micro, where we draw the demand curve of apples holding the prices of other goods constant. But in macro, where the price of all goods is on the vertical axis, it doesn't make any sense at all. If the prices of all goods fall, what are they substituting away from? And why?....
If one worker tried to sell his apples for a higher price than the other workers, he might be unemployed. Nobody would want his apples. But then there would be an excess demand for other workers' apples, and an excess demand for their labour. There is no way the labour market/apple market as a whole could be in excess supply, because on average, the price of apples must equal the average price of apples...
And if people want to hang onto their money, rather than buy apples with it, the demand for apples, and the demand for labour, will be deficient. A deficiency of aggregate demand has got nothing whatsoever to do with a deficiency of income. Income is always sufficient. It's always the same as goods sold. A deficiency of aggregate demand is a deficiency of peoples' willingness to get rid of money. The "Paradox of Thrift", and the "Paradox of Toil", are merely corrupt versions of, or way-stations to, the Paradox of Money. Each individual can increase his stock of money by buying less; but in aggregate they fail, but cause unemployment as a side-effect.
I commented that when you have an open economy in a globalized environment, the micro assumptions can hold, and macro assumptions of a closed economy break down.
1. If you make apples $100 cheaper, domestic producers can potentially sell more apples, regardless of the level of demand domestically. It becomes a substitute to apples (or oranges) everywhere else in the world.
2. Hence, even if there is an excess supply of apples in the domestic market, it can still (potentially) sell as much output as it wants.
3. And even if the “paradox of thrift” holds in the domestic economy, the excess supply of apples could clear elsewhere in the global economy. (It also helps if your government controls the value of your currency, which in actuality is an integral part of what you trade in a globalized economy).
Nick replied: If you are talking about a small open economy, (under fixed exchange rates, with a common currency) you are absolutely right. In fact, I would say that SOE macro isn't really macro at all. It's micro. The only true macro is closed economy, and therefore global macro. But if we have national currencies, then I think there are some aspects that can only be handled from a macro perspective.
This reminded me of a post I made in August last year, which argued that national monetary policies (especially of small open economies) were becoming more and more insignificant in a globalized environment. Now that capital mobility is global…
1. If one country hikes its interest rate to contain domestic inflation, it can attract more capital from overseas, nullifying the hike. Similarly, if the country cuts rates to spur investment, capital might leave the economy for better rates elsewhere.
2. An aggressive money supply policy in one country can spill over excess liquidity into the global system, spreading inflation globally.
3. One country’s active currency management policies artificially inflates/devalues free floating currencies.
4. Because of points 1, 2, and 3, one Central Banker’s monetary policies to cure domestic unemployment might be rendered ineffective.
5. Financial crisis that start in one country can easily spread to other economies….
My speculations of a global central bank were rightly trashed in this forum over at EconomicsUK. But nonetheless, there seems to be a disjoint in economics theories as they are applied in a global setting. More importantly, there is a lack of coordinating institutions that would ensure the fair administration of monetary transactions worldwide. We don’t even know how to make them work, if there is a way to make them work.
Globalizing trade and financial flows without the corresponding globalizing of human capital movements has only led to repeated global imbalances. Because governments are still local (or national, for that matter) they still adhere policies that will result in what is good for their local populations. it is they, after all, who are stuck with the net gains and/or losses from globalization. A gain is made for them if a country creates more jobs, decreases its cost of capital, and maintains a stable inflation rate. So a local/national government will do what it can to achieve these aims, no matter if the gains from these aims end up being offset by a loss in another part of the world.
We either need to get rid of nation-states altogether, or we enforce stricter rules on nations participating in global trade.
Monday, December 28, 2009
The scalper economy and the fall of small business
In my previous post, commenter Min clarifies why I think an increasing money supply causes a higher rise in prices of scarce resources relative to other goods.
Hedge funds to me are the main reason for the difference. In both equilibria (prior and post monetary loosening), scarce resources remain constant. Expanding fiat currency makes the scarce resource artificially more expensive, relative to other goods. If you take scarce resources that have a stable demand, oil for instance, because it is a necessary component in many activities, many investors could 'rationally expect' that holders of oil will be able to profitably sell it to the market when they take delivery.
Because hedge funds who are merely looking for arbitrage profit enter into the bidding along with bidders who are actually end users, they make pricing for the scarce resource artificially more expensive. This serves to crowd out the smaller businesses who may not have the economies of scale to be able to earn back what it will cost them to buy the scarce input. Think of it like scalpers crowding out potential concert goers with lower income.
As fiat currency becomes more and more a policy tool, it becomes more and more perilous to conduct regular commercial business activities. But it provides more opportunities for arbitrage, as an expanding currency lifts other investments, such as equities and properties. Funds pile on these risky investments, as they rush out of traditional bonds and savings accounts, whose nominal yields are at zero but whose expected real yields are negative due to the policy’s induced inflation expectations.
It now becomes more profitable and more logical to engage in speculative financial activities as opposed to real economy industrial activities. Now are you still wondering why we are getting more of these rather than more small businesses starting up? Bernanke, be careful what you wish for. You just might get it.
Hedge funds to me are the main reason for the difference. In both equilibria (prior and post monetary loosening), scarce resources remain constant. Expanding fiat currency makes the scarce resource artificially more expensive, relative to other goods. If you take scarce resources that have a stable demand, oil for instance, because it is a necessary component in many activities, many investors could 'rationally expect' that holders of oil will be able to profitably sell it to the market when they take delivery.
Because hedge funds who are merely looking for arbitrage profit enter into the bidding along with bidders who are actually end users, they make pricing for the scarce resource artificially more expensive. This serves to crowd out the smaller businesses who may not have the economies of scale to be able to earn back what it will cost them to buy the scarce input. Think of it like scalpers crowding out potential concert goers with lower income.
As fiat currency becomes more and more a policy tool, it becomes more and more perilous to conduct regular commercial business activities. But it provides more opportunities for arbitrage, as an expanding currency lifts other investments, such as equities and properties. Funds pile on these risky investments, as they rush out of traditional bonds and savings accounts, whose nominal yields are at zero but whose expected real yields are negative due to the policy’s induced inflation expectations.
It now becomes more profitable and more logical to engage in speculative financial activities as opposed to real economy industrial activities. Now are you still wondering why we are getting more of these rather than more small businesses starting up? Bernanke, be careful what you wish for. You just might get it.
Friday, December 25, 2009
An open letter from a drug dealer
This is an open letter to the general public, on behalf of people like me involved in the human well-being enhancement industry. You generally know more us more for the disparaging term “drug dealers”. I am writing this letter to you to air our side of the equation, and to remind everybody that we too act within market constraints.
You see, most of us in the well-being enhancement profession generally deal with sophisticated consenting adults who know exactly what it is they are doing. They come to us, transact profitable economic trades, because they have specific rational and logical objectives. They may come to us to help them deal with an emotional loss, they may have to deal with recurrent depressions, a sense of unbelonging, or simply they want to improve their current state of mood. We have perhaps been involved in a lot of improved marriages, much-quickened health recoveries, improved character of public events and gatherings, and in the general perceived intelligence and talent of people who make use of our products. Society needs what we provide.
Indeed, we would not exist if it were not for the continuing patronage of our willing clients. We are simply providing a service that our drug users demand. And don’t forget too that consumption of our products consists a tiny percentage of the total transactions that people engage with us. That is, the people we transact with may not always be the end-users of our service. They may in turn around and supply this useful commodity to others also in need of our value-enhancing contributions. This then leads to a much wider net of general well-being enhancement, not to mention opportunities for our own clients to also make boatloads of money. Remember, too, that we are not paid to look after the general health of our clients.
Now don’t judge us if we, due to our dealer job, will have the ability to know which users would be willing to pay more just to get a sufficient supply of our products. Our decision to then price our products accordingly is nothing more than just a reaction to the market forces that everybody else adheres to. Remember, we could be wrong and we end up losing a much-needed user. But this comes with the risks of doing business.
After all, we’re just ordinary businessmen also doing God’s work. Our thanks go to Goldman Sachs, as well as to Henry Blodget, for helping us get our thoughts in order, to make our case much clearer to you, the general public. Goldman Sachs remains our most admired company, and we continue to mine its employee rolls in search for potential new lucrative transaction opportunities.
You see, most of us in the well-being enhancement profession generally deal with sophisticated consenting adults who know exactly what it is they are doing. They come to us, transact profitable economic trades, because they have specific rational and logical objectives. They may come to us to help them deal with an emotional loss, they may have to deal with recurrent depressions, a sense of unbelonging, or simply they want to improve their current state of mood. We have perhaps been involved in a lot of improved marriages, much-quickened health recoveries, improved character of public events and gatherings, and in the general perceived intelligence and talent of people who make use of our products. Society needs what we provide.
Indeed, we would not exist if it were not for the continuing patronage of our willing clients. We are simply providing a service that our drug users demand. And don’t forget too that consumption of our products consists a tiny percentage of the total transactions that people engage with us. That is, the people we transact with may not always be the end-users of our service. They may in turn around and supply this useful commodity to others also in need of our value-enhancing contributions. This then leads to a much wider net of general well-being enhancement, not to mention opportunities for our own clients to also make boatloads of money. Remember, too, that we are not paid to look after the general health of our clients.
Now don’t judge us if we, due to our dealer job, will have the ability to know which users would be willing to pay more just to get a sufficient supply of our products. Our decision to then price our products accordingly is nothing more than just a reaction to the market forces that everybody else adheres to. Remember, we could be wrong and we end up losing a much-needed user. But this comes with the risks of doing business.
After all, we’re just ordinary businessmen also doing God’s work. Our thanks go to Goldman Sachs, as well as to Henry Blodget, for helping us get our thoughts in order, to make our case much clearer to you, the general public. Goldman Sachs remains our most admired company, and we continue to mine its employee rolls in search for potential new lucrative transaction opportunities.
Thursday, December 24, 2009
Can there be financial black holes/debt deflationary spirals?
There is an interesting discussion sparked by Nick Rowe over at Worthwhile Canadian Initiative about financial black holes. Here and here.
FINANCIAL BLACK HOLES
Nick Rowe asks: Like physics, modern macroeconomic theory predicts the possibility of "black holes"…. If the economy gets too close to a black hole, it can't escape, and is sucked into a deflationary death-spiral. If nominal interest rates are at or near zero, and so at their lower bound, any deficiency of aggregate demand causes increased deflation, which in turn causes increased expected deflation, which in turn causes higher real interest rates, which in turn reduce aggregate demand, which in turn causes increased deflation...and so on. The price level and real output should both fall to vanishing point. Money in a black hole should have infinite value, yet nobody will buy anything with it….
So where are they? Why can't we see them? We sure have sailed our macroeconomic spaceships close enough to the boundaries of predicted black holes plenty of times. Why didn't any economy ever get sucked into one, and collapse into an infinitely valuable pinpoint?
A reader, Doc Merlin, comments :There is no such thing as a deflationary spiral. I have never ever seen it happen, never watched it, never seen it talked about in history. However, we have seen multiple times, INFLATIONARY death spirals…..Deflation is its own cure, because as prices drop, people will naturally want to consume more.
My own take, I can think of 4 variables which can help prevent the prevalence of black holes
1. growing population
2. growing productivity
3. growing trade
4. constant influx of new technology or products
An economy with high indebtedness, that cannot be paid for due to a lack of all 4, can probably experience a so-called financial black hole. In other words, my take on it is that we have so far avoided any instances of deflationary spirals because the world has always been growing somehow somewhere. And now, due to the gains from globalization, countries that may have otherwise experienced a slowing down of points 1 or 2, may compensate for it by an increase of point 3. Also, because globalization has increased the economies of scale for a lot of market innovations, it has enabled point 4 to remain constant.
However, there can be no escaping a market saturation, once a hitherto unmarketed-to geoeconomic area has been fully integrated to the global economy, and eventually trade growth will slow. So too, as a country’s population attains some affluence and occupational specialization, family rearing takes a back seat and even population growth slows down. Hence, the constant source of economic growth that we can expect going into the future, both at the business and at the macro level, will be to increase productivity or to introduce new technology or new products. These do not always come cheap. Debt, therefore, becomes more common among firms, and tolerance for larger portions of it become the norm.
DEBT
As debt becomes accepted as a necessary growth booster in the commercial arena, so too its prevalence become natural in the consumer arena. If businesses can borrow in anticipation of earning the cash to pay for it, why can’t an individual too borrow, if he believes the investment outlets available to him will enable to him to earn the necessary cash to pay it off.
So what we have is an economy, one that might be experiencing a stagnant population growth, a slowing productivity growth (due to constant misallocation of resources to endeavours that turn out to be counter-productive) but experiencing an increasing indebtedness among its population. I need not recount here how the increasing tolerance for debt plus "irrational exuberance" became strong factors in causing the credit crisis.
Now how can an economy pay for its collective debt obligations when the time comes, when there is a lack of growth in any of the 4 areas? This is where modern monetary policy theory comes in, to induce firms to invest (or induce households to purchase housing and durables)
Nick Rowe (talking about Keynes): Keynes is not sure whether an economy can escape the black hole of a deflationary spiral. If it does escape, it can only escape via the effects of an increase in M/P. And it will be more likely to escape if M/P increases due to a rising numerator M than a falling denominator P. Because falling P may create expectations of further deflation, which would further reduce aggregate demand.
COSTS OF DOING BUSINESS
Well and good if the increase in money supply does the job and avoids the debt deflationary spiral. However, this purely monetary theory does not consider a relatively more modern occurrence – the existence of hedge funds and other investment pools. These funds exist solely to arbitrage away any inefficiencies that are introduced to the market, both by the market itself, and by the government. So if money supply is increasing, it is actually creating an imbalance in the economy. It makes whatever scarce resources there are to become even more expensive. And hedge fund managers, being the arbitrage machines they are, try to profit by buying whatever resources they can identify that would have stable anticipated demand. These are therefore bid up more than they should.
So what happens to the business, the households, the economic actors who are meant to revive the economy via the increase of productivity or the introduction of new technology or new products? Their costs of production rise. As if it were not already risky to embark on costly new business endeavours, via a rising debt, in an economy with stagnating populations and saturated markets, you now have to do it in an environment where your cost of inputs may have been bid up beyond what it is could be profitable to turn up a finished product.
Thus, a focus on reviving the economy, and on preventing a deflationary spiral, via a monetary easing, has ended up introducing a new complication for the players necessary to turn the economy around. It has ended up spoiling the conditions necessary to spur more active market activities.
What happens then if no one is left to try to increase productivity or introduce new products and technologies? You go back to the possibility of a financial black hole.
That’s why I’m with Mark Thoma on this. Fiscal policy is a better policy alternative than monetary policy. Nick Rowe himself doesn't seem to side for more use of monetary policy (though he argues, correctly in my opinion, that it is not useless). But support should be going more towards helping build the market by focusing investment on industry-specific concerns, not on quantitative easing that goes nowhere and just increases business complexity or everyone. help industry rebuild itself. That’s what China is doing more of, and Western economies are well-advised to do the same.
FINANCIAL BLACK HOLES
Nick Rowe asks: Like physics, modern macroeconomic theory predicts the possibility of "black holes"…. If the economy gets too close to a black hole, it can't escape, and is sucked into a deflationary death-spiral. If nominal interest rates are at or near zero, and so at their lower bound, any deficiency of aggregate demand causes increased deflation, which in turn causes increased expected deflation, which in turn causes higher real interest rates, which in turn reduce aggregate demand, which in turn causes increased deflation...and so on. The price level and real output should both fall to vanishing point. Money in a black hole should have infinite value, yet nobody will buy anything with it….
So where are they? Why can't we see them? We sure have sailed our macroeconomic spaceships close enough to the boundaries of predicted black holes plenty of times. Why didn't any economy ever get sucked into one, and collapse into an infinitely valuable pinpoint?
A reader, Doc Merlin, comments :There is no such thing as a deflationary spiral. I have never ever seen it happen, never watched it, never seen it talked about in history. However, we have seen multiple times, INFLATIONARY death spirals…..Deflation is its own cure, because as prices drop, people will naturally want to consume more.
My own take, I can think of 4 variables which can help prevent the prevalence of black holes
1. growing population
2. growing productivity
3. growing trade
4. constant influx of new technology or products
An economy with high indebtedness, that cannot be paid for due to a lack of all 4, can probably experience a so-called financial black hole. In other words, my take on it is that we have so far avoided any instances of deflationary spirals because the world has always been growing somehow somewhere. And now, due to the gains from globalization, countries that may have otherwise experienced a slowing down of points 1 or 2, may compensate for it by an increase of point 3. Also, because globalization has increased the economies of scale for a lot of market innovations, it has enabled point 4 to remain constant.
However, there can be no escaping a market saturation, once a hitherto unmarketed-to geoeconomic area has been fully integrated to the global economy, and eventually trade growth will slow. So too, as a country’s population attains some affluence and occupational specialization, family rearing takes a back seat and even population growth slows down. Hence, the constant source of economic growth that we can expect going into the future, both at the business and at the macro level, will be to increase productivity or to introduce new technology or new products. These do not always come cheap. Debt, therefore, becomes more common among firms, and tolerance for larger portions of it become the norm.
DEBT
As debt becomes accepted as a necessary growth booster in the commercial arena, so too its prevalence become natural in the consumer arena. If businesses can borrow in anticipation of earning the cash to pay for it, why can’t an individual too borrow, if he believes the investment outlets available to him will enable to him to earn the necessary cash to pay it off.
So what we have is an economy, one that might be experiencing a stagnant population growth, a slowing productivity growth (due to constant misallocation of resources to endeavours that turn out to be counter-productive) but experiencing an increasing indebtedness among its population. I need not recount here how the increasing tolerance for debt plus "irrational exuberance" became strong factors in causing the credit crisis.
Now how can an economy pay for its collective debt obligations when the time comes, when there is a lack of growth in any of the 4 areas? This is where modern monetary policy theory comes in, to induce firms to invest (or induce households to purchase housing and durables)
Nick Rowe (talking about Keynes): Keynes is not sure whether an economy can escape the black hole of a deflationary spiral. If it does escape, it can only escape via the effects of an increase in M/P. And it will be more likely to escape if M/P increases due to a rising numerator M than a falling denominator P. Because falling P may create expectations of further deflation, which would further reduce aggregate demand.
COSTS OF DOING BUSINESS
Well and good if the increase in money supply does the job and avoids the debt deflationary spiral. However, this purely monetary theory does not consider a relatively more modern occurrence – the existence of hedge funds and other investment pools. These funds exist solely to arbitrage away any inefficiencies that are introduced to the market, both by the market itself, and by the government. So if money supply is increasing, it is actually creating an imbalance in the economy. It makes whatever scarce resources there are to become even more expensive. And hedge fund managers, being the arbitrage machines they are, try to profit by buying whatever resources they can identify that would have stable anticipated demand. These are therefore bid up more than they should.
So what happens to the business, the households, the economic actors who are meant to revive the economy via the increase of productivity or the introduction of new technology or new products? Their costs of production rise. As if it were not already risky to embark on costly new business endeavours, via a rising debt, in an economy with stagnating populations and saturated markets, you now have to do it in an environment where your cost of inputs may have been bid up beyond what it is could be profitable to turn up a finished product.
Thus, a focus on reviving the economy, and on preventing a deflationary spiral, via a monetary easing, has ended up introducing a new complication for the players necessary to turn the economy around. It has ended up spoiling the conditions necessary to spur more active market activities.
What happens then if no one is left to try to increase productivity or introduce new products and technologies? You go back to the possibility of a financial black hole.
That’s why I’m with Mark Thoma on this. Fiscal policy is a better policy alternative than monetary policy. Nick Rowe himself doesn't seem to side for more use of monetary policy (though he argues, correctly in my opinion, that it is not useless). But support should be going more towards helping build the market by focusing investment on industry-specific concerns, not on quantitative easing that goes nowhere and just increases business complexity or everyone. help industry rebuild itself. That’s what China is doing more of, and Western economies are well-advised to do the same.
Tuesday, December 22, 2009
Why are we even encouraging strategic defaults?
Felix Salmon has a post up, arguing about reducing the shame of default. He seems to be advocating that more people with underwater mortgages default on the mortgage, both as favour to themselves and to teach errant bankers a lesson. He says “If there’s less shame attached to default, we will end up with exactly what we want — less badly-underwritten credit, a more solvent society, and much less tail risk. We went far too many years believing without really analyzing the proposition that credit is nearly always a Good Thing.”
Well, that not only seems unhelpful but can only make things worse. What we need to be doing is shaming bankers, the ones who misled the people who shouldn’t be borrowing into taking out loans they have no hope of paying, so the bankers find a way of renegotiating these mortgages. We shouldn’t be reducing shame of default of the borrowers.
What would happen to the financial system once everyone no longer has shame of default? More defaults leading to more underwater mortgages leading to more defaults, all the way down to financial armageddon. Why stop at mortgages? What about all other indebtedness backed by any sort of asset that may have gone down in value? Stock loans? Equipment loans? People have also been known to borrow against these. And not paying debts because banks didn’t do their jobs properly could be just one step away from not paying taxes because the government isn’t spending your tax money correctly. Is that next?
Pls. let’s bring the talk back on how the mortgages can be realistically and orderly fixed. Nationalize the guilty banks, fire the errant bankers, institute the needed financial reforms. Threats like making personal defaults more common seem attractive at first, but they will only lead to more pain down the road. If defaults become at all common, it won’t be long before we forever say good-bye to any notion of providing credit to anyone.
Well, that not only seems unhelpful but can only make things worse. What we need to be doing is shaming bankers, the ones who misled the people who shouldn’t be borrowing into taking out loans they have no hope of paying, so the bankers find a way of renegotiating these mortgages. We shouldn’t be reducing shame of default of the borrowers.
What would happen to the financial system once everyone no longer has shame of default? More defaults leading to more underwater mortgages leading to more defaults, all the way down to financial armageddon. Why stop at mortgages? What about all other indebtedness backed by any sort of asset that may have gone down in value? Stock loans? Equipment loans? People have also been known to borrow against these. And not paying debts because banks didn’t do their jobs properly could be just one step away from not paying taxes because the government isn’t spending your tax money correctly. Is that next?
Pls. let’s bring the talk back on how the mortgages can be realistically and orderly fixed. Nationalize the guilty banks, fire the errant bankers, institute the needed financial reforms. Threats like making personal defaults more common seem attractive at first, but they will only lead to more pain down the road. If defaults become at all common, it won’t be long before we forever say good-bye to any notion of providing credit to anyone.
Monday, December 7, 2009
To save globalization, we need to first rein in globalization
Back in August of last year, before the Lehman bankruptcy, and before the beginning of the financial meltdown , I tried to summarize how I saw, from my perch in the world, the world had fared in terms of globalization, and what specific long-term trends had gotten us to where we were. This was close enough to what became more or less a common consensus.
I then speculated as to what was to come next. With the exception of further financial meltdown due to the fall of Lehman, I could say that we are more or less on this path I foresaw.
My speculation was an optimistic one, optimistic in the face of the growing uncertainty of the third quarter of 2008. I remain convinced that the stage we are in is part of a longer-term secular global rebalancing, and we will eventually stabilize at a new more balanced equilibrium.
I just want to reiterate that this global rebalancing will be the greatest source of growth, as well as the greatest challenge, for capitalism in the coming decade. The developed world needs to rebuild its manufacturing base, while the developing nations need to develop a thriving consumer economy. Much capital investment for production needs to be rebuilt in the developed countries, while much more advanced distribution chains and financial networks need to be established in the developing nations.
Developed countries need to rediscover the original source of their development – a strong and vibrant producer economy that provides ample employment for their domestic consumers. Developing nations need to do the mirror image – to develop a domestic consumer base that will enable their local manufacturers to thrive even in the face of a slowdown in the rest of the world.
For these rebalancing efforts to continue advancing towards their objectives, two requirements need to be addressed. First, the capitalist investors and business men in the developed countries need to be assured that their investments will not be endangered by undercutting from foreign competitors organized only for maximum producer efficiency. Second, the capitalist investors and businessmen in the developing countries need to be assured that the government will provide enough safety nets for their local populace, such that a more consumerist mentality will take root, and that the government will be there to help them in the crucial but likely costly project of enriching the locals, to enable them to become more active buyers of their end products.
The success of this global rebalancing will probably lead to this much longer-term result. But to achieve this result, which I consider the final end and epitome of globalization, we need to do the ironic thing first. We need to rein in globalization at this time.
I then speculated as to what was to come next. With the exception of further financial meltdown due to the fall of Lehman, I could say that we are more or less on this path I foresaw.
My speculation was an optimistic one, optimistic in the face of the growing uncertainty of the third quarter of 2008. I remain convinced that the stage we are in is part of a longer-term secular global rebalancing, and we will eventually stabilize at a new more balanced equilibrium.
I just want to reiterate that this global rebalancing will be the greatest source of growth, as well as the greatest challenge, for capitalism in the coming decade. The developed world needs to rebuild its manufacturing base, while the developing nations need to develop a thriving consumer economy. Much capital investment for production needs to be rebuilt in the developed countries, while much more advanced distribution chains and financial networks need to be established in the developing nations.
Developed countries need to rediscover the original source of their development – a strong and vibrant producer economy that provides ample employment for their domestic consumers. Developing nations need to do the mirror image – to develop a domestic consumer base that will enable their local manufacturers to thrive even in the face of a slowdown in the rest of the world.
For these rebalancing efforts to continue advancing towards their objectives, two requirements need to be addressed. First, the capitalist investors and business men in the developed countries need to be assured that their investments will not be endangered by undercutting from foreign competitors organized only for maximum producer efficiency. Second, the capitalist investors and businessmen in the developing countries need to be assured that the government will provide enough safety nets for their local populace, such that a more consumerist mentality will take root, and that the government will be there to help them in the crucial but likely costly project of enriching the locals, to enable them to become more active buyers of their end products.
The success of this global rebalancing will probably lead to this much longer-term result. But to achieve this result, which I consider the final end and epitome of globalization, we need to do the ironic thing first. We need to rein in globalization at this time.
Wednesday, November 18, 2009
Prospects for 2010 world economy
As we near the end of the year, I'd like to make an overview of my current views of where we might find ourselves next year. This is an aggregation of much of recurring themes in this blog plus some additional points made by similarly-oriented blogs in recent weeks. First the set-up:
The US is a consumption and finance and investment-oriented economy. The US has already ceded most of its production and manufacturing industries abroad, and has recently been outsourcing most of its service industries. The economy has hollowed out and the only way the economy managed to hum along in the last few years is by people continuing to consume and to make financial investments. Because people were losing income due to outsourcing activities of companies, they managed to continue their consumption activities by getting into more debt. They were able to secure debt because they were able to borrow against the increasing values of heir homes and investments. This increasing value was only possible for as long as more people were chasing into houses as an appreciating asset, but had to stop when many people can no longer realistically afford the increasing prices. This was an unsustainable source of growth for the economy and unsustainable source of consumption funds for the people. Everything started to unravel last year.
But since the US remains a hollowed out economy, the only way for the government and the Fed to keep the economy afloat was to support the continuing of investment activities. Financial institutions that stand to lose a lot due to loan delinquencies are being kept afloat because the fed is buying all their assets and providing them with liquidity. This is resulting in an increase in money supply, and has been supporting the rally in equities in the US. It is also supporting a massive dollar carry trade that has resulted in rallies in emerging economies, commodities, and emerging economy currencies.
This is again unsustainable. The only reason that the US economy has not imploded is because it has managed to export its loose monetary policies abroad.
China is the largest holder of US debt. Since it has been the largest surplus nation that benefited from US trade deficits, it ended up with the most US denominated IOUs. China is a production oriented economy. It is managing its currency by pegging it to the US dollar. This has kept its exports to the US competitively priced. Now that the dollar has been depreciating, both because of the US recession, and more so because of the loose US monetary policy, the yuan has followed it in debasement. China keeps the currency peg so that its can continue its exporting activities. It needs to do so because it needs to provide employment for millions of rural Chinese people migrating to the urban areas looking for work. If they do not find work, the government is concerned they will rebel against the Communist government. So as an integral part of its stimulus during the current global economic downturn, much stimulus money has gone into investing for more factory production capacity. This is in the hope that a recovery will result in exports rising again, leading to more employment for rural migrants.
But because the US recovery policy has only benefited capitalistic investors and financial institutions, many Americans still do not have the stable income to buy goods from China. For this reason, economists are worried that China will export its excess capacity. In other words, it will flood the world with its goods which it will likely sell below cost.
This will be the final nail in the coffin for many manufacturing industries world wide and will result in more job losses. This means less people able to buy goods, further feeding the bad feedback loop.
So we see the deflation coming very soon in manufactured goods that will lead to many losses to companies involved in the production economy. But we also see inflation coming in investment assets due to the US exporting its loose policy.
Some economists are worried that China will stop buying US Treasuries because the US is debasing its currency. A debased currency helps a debtor because the value of the debt goes down. If the US cannot earn enough to pay for its debt it simply prints more money. If China stops buying US Treasuries as a result, the dollar will go down in value steeply.
But there is now a growing sentiment that China cannot do it without hurting itself more. This is like the saying “Owe the bank $100 and the banks owns you. Owe the bank $100 Million and you own the bank”. There is also the belief that if China will suddenly sell its dollar holdings in the market, the US will simply resort to capital controls. That means the US will stop buying its own currency, and hence no nation will want to buy China’s dollar holdings.
But China has slowly been getting rid of its US dollars, by using it to buy into global commodities, global companies, and even global companies producing commodities. This is further leading to the global inflation in commodities .
This will increase the cost of the most basic inputs of production, so that even more businesses will suffer and probably close. The poorest economies of the world will bear the strongest brunt of this commodity inflation. Food will become too expensive for the poorest people.
This is going to be most problematic for countries that have been mirroring the US’ loose monetary policy. Canada has been mirroring the loose policy because it needs to have a competitive currency because the US is its biggest trade partner. But the medium-term effect of this currency debasement is to make the local currencies lose value vs the global prices of these rising commodities.
Since many people are losing income, the government is losing tax revenue. And more people are turning to government safety nets (if there are any) to support themselves. Thus, government finances are deteriorating. Many countries that have to borrow in US dollars are going to have problems down the road, and the only way the government will manage to stay afloat is to raise taxes.
The US government is lucky in that it is able to borrow in its own currency. Also, because it is a global standard currency, it can just print more money to finance its deficits. A problem with that is the debasement of its currency, and the fact that it exports its debasement to countries that mirror the US moves.
Local governments in the US, which cannot print money but can only tax its constituents, are now feeling the pain. Many are already going bankrupt, and California is the leading state going down this road. To raise money, it will need to raise taxes. But if it raises taxes, people will just move out of California, confounding the tax revenue losses.
3 things seem likely to happen next year:
1. Deflation in manufactured goods
2. Inflation in investment assets, most especially commodities
3. Increase in government taxes
The only way to halt this imbalance getting worse is to halt globalization, halt international money flows, halt international trade, and halt the international movement of people.
Nobody knows if the US dollar will be winner in the long-term or a loser, and people are hedging with gold. But gold is already too high. If inflation becomes too high, people will still likely not be paying purchases with gold anyway. Bartering may come into vogue.
If populist sentiment in the US increases, it will probably nationalize the too big to fail banks because they already have national guarantees anyway, and their market making activities are deemed too important (sounding more and more like a social utility rather than a for-profit function). It will therefore likely be safe to put your money as deposits in them but unsafe to invest in their stocks or bonds.
I think countries will retreat into national groupings at the most. So businesses in Asia will focus on regional blocs like the ASEAN, while companies here will have NAFTA all to themselves.
The US is a consumption and finance and investment-oriented economy. The US has already ceded most of its production and manufacturing industries abroad, and has recently been outsourcing most of its service industries. The economy has hollowed out and the only way the economy managed to hum along in the last few years is by people continuing to consume and to make financial investments. Because people were losing income due to outsourcing activities of companies, they managed to continue their consumption activities by getting into more debt. They were able to secure debt because they were able to borrow against the increasing values of heir homes and investments. This increasing value was only possible for as long as more people were chasing into houses as an appreciating asset, but had to stop when many people can no longer realistically afford the increasing prices. This was an unsustainable source of growth for the economy and unsustainable source of consumption funds for the people. Everything started to unravel last year.
But since the US remains a hollowed out economy, the only way for the government and the Fed to keep the economy afloat was to support the continuing of investment activities. Financial institutions that stand to lose a lot due to loan delinquencies are being kept afloat because the fed is buying all their assets and providing them with liquidity. This is resulting in an increase in money supply, and has been supporting the rally in equities in the US. It is also supporting a massive dollar carry trade that has resulted in rallies in emerging economies, commodities, and emerging economy currencies.
This is again unsustainable. The only reason that the US economy has not imploded is because it has managed to export its loose monetary policies abroad.
China is the largest holder of US debt. Since it has been the largest surplus nation that benefited from US trade deficits, it ended up with the most US denominated IOUs. China is a production oriented economy. It is managing its currency by pegging it to the US dollar. This has kept its exports to the US competitively priced. Now that the dollar has been depreciating, both because of the US recession, and more so because of the loose US monetary policy, the yuan has followed it in debasement. China keeps the currency peg so that its can continue its exporting activities. It needs to do so because it needs to provide employment for millions of rural Chinese people migrating to the urban areas looking for work. If they do not find work, the government is concerned they will rebel against the Communist government. So as an integral part of its stimulus during the current global economic downturn, much stimulus money has gone into investing for more factory production capacity. This is in the hope that a recovery will result in exports rising again, leading to more employment for rural migrants.
But because the US recovery policy has only benefited capitalistic investors and financial institutions, many Americans still do not have the stable income to buy goods from China. For this reason, economists are worried that China will export its excess capacity. In other words, it will flood the world with its goods which it will likely sell below cost.
This will be the final nail in the coffin for many manufacturing industries world wide and will result in more job losses. This means less people able to buy goods, further feeding the bad feedback loop.
So we see the deflation coming very soon in manufactured goods that will lead to many losses to companies involved in the production economy. But we also see inflation coming in investment assets due to the US exporting its loose policy.
Some economists are worried that China will stop buying US Treasuries because the US is debasing its currency. A debased currency helps a debtor because the value of the debt goes down. If the US cannot earn enough to pay for its debt it simply prints more money. If China stops buying US Treasuries as a result, the dollar will go down in value steeply.
But there is now a growing sentiment that China cannot do it without hurting itself more. This is like the saying “Owe the bank $100 and the banks owns you. Owe the bank $100 Million and you own the bank”. There is also the belief that if China will suddenly sell its dollar holdings in the market, the US will simply resort to capital controls. That means the US will stop buying its own currency, and hence no nation will want to buy China’s dollar holdings.
But China has slowly been getting rid of its US dollars, by using it to buy into global commodities, global companies, and even global companies producing commodities. This is further leading to the global inflation in commodities .
This will increase the cost of the most basic inputs of production, so that even more businesses will suffer and probably close. The poorest economies of the world will bear the strongest brunt of this commodity inflation. Food will become too expensive for the poorest people.
This is going to be most problematic for countries that have been mirroring the US’ loose monetary policy. Canada has been mirroring the loose policy because it needs to have a competitive currency because the US is its biggest trade partner. But the medium-term effect of this currency debasement is to make the local currencies lose value vs the global prices of these rising commodities.
Since many people are losing income, the government is losing tax revenue. And more people are turning to government safety nets (if there are any) to support themselves. Thus, government finances are deteriorating. Many countries that have to borrow in US dollars are going to have problems down the road, and the only way the government will manage to stay afloat is to raise taxes.
The US government is lucky in that it is able to borrow in its own currency. Also, because it is a global standard currency, it can just print more money to finance its deficits. A problem with that is the debasement of its currency, and the fact that it exports its debasement to countries that mirror the US moves.
Local governments in the US, which cannot print money but can only tax its constituents, are now feeling the pain. Many are already going bankrupt, and California is the leading state going down this road. To raise money, it will need to raise taxes. But if it raises taxes, people will just move out of California, confounding the tax revenue losses.
3 things seem likely to happen next year:
1. Deflation in manufactured goods
2. Inflation in investment assets, most especially commodities
3. Increase in government taxes
The only way to halt this imbalance getting worse is to halt globalization, halt international money flows, halt international trade, and halt the international movement of people.
Nobody knows if the US dollar will be winner in the long-term or a loser, and people are hedging with gold. But gold is already too high. If inflation becomes too high, people will still likely not be paying purchases with gold anyway. Bartering may come into vogue.
If populist sentiment in the US increases, it will probably nationalize the too big to fail banks because they already have national guarantees anyway, and their market making activities are deemed too important (sounding more and more like a social utility rather than a for-profit function). It will therefore likely be safe to put your money as deposits in them but unsafe to invest in their stocks or bonds.
I think countries will retreat into national groupings at the most. So businesses in Asia will focus on regional blocs like the ASEAN, while companies here will have NAFTA all to themselves.
Thursday, October 1, 2009
Global Rebalancing and sustainable recovery
Let me just momentarily dip back into the blogosphere with this link to Edward Hugh’s post…… The G20 and Why Export Dependency And Global Imbalances Matter
Edward touches up on several recurring themes here in my blog, many of which I touched as I tried to figure out what was going on with the global economy. Edward links them all up – changing demographics, global financial and investment flows, developed country investment managers’ quest for yield that took them to the most speculative areas of the world. His main point – many of what we see are symptoms of major demographic change. He comes to the same conclusions –the need for a rebalancing of the global economy, and the taking up of the consumption slack by the developing world.
This is what we need to see for green shoots to truly sprout. Otherwise, we will only keep coming back to the same old issues over and over.
But in order to have permanently sustainable development, emerging countries need to learn to get their acts together. Getting them to do so successfully would be the next worthwhile arena of discussion.
Edward touches up on several recurring themes here in my blog, many of which I touched as I tried to figure out what was going on with the global economy. Edward links them all up – changing demographics, global financial and investment flows, developed country investment managers’ quest for yield that took them to the most speculative areas of the world. His main point – many of what we see are symptoms of major demographic change. He comes to the same conclusions –the need for a rebalancing of the global economy, and the taking up of the consumption slack by the developing world.
This is what we need to see for green shoots to truly sprout. Otherwise, we will only keep coming back to the same old issues over and over.
But in order to have permanently sustainable development, emerging countries need to learn to get their acts together. Getting them to do so successfully would be the next worthwhile arena of discussion.
Friday, May 29, 2009
Auf weider sehen
A year into my blog, I find a need to break. What a year it has been covering world economics. From the threat of inflation to its wild swing into deflation, events have led to a point where no economic doctrine was safe from intense scrutiny and questioning. It was a year to think unconventionally, yet it was also a year to remember what may have been conventional but recently forgotten.
How will I look back to these writings a year or two from today? Who knows? I haven't been shy with the projections and semi-predictions. Some have come to pass, many may yet prove erroneous, some I believe will yet come about as I expect.
Perhaps I will get back after a year's absence. But for now, I wish you all well in your endeavors.
How will I look back to these writings a year or two from today? Who knows? I haven't been shy with the projections and semi-predictions. Some have come to pass, many may yet prove erroneous, some I believe will yet come about as I expect.
Perhaps I will get back after a year's absence. But for now, I wish you all well in your endeavors.
Friday, May 22, 2009
Ironies in economic behaviour
I listed the following economic truisms last year. I repost them here, as a reminder to both individuals in regulating their future behaviour, and to policymakers designing tweaks in the economic system.
1. Quest for everything at the cheapest cost. Not only has this led to the occasional substandard or dangerous product, this has also led to global wages standardizing down instead of up. Do the math.
2. Quest for maximum utility. When it comes to scarce resources, every additional utility we squeeze for the present, we are taking away an equal utility from the future. Do the math.
3. Quest for the riskless reward. The recent derivative innovations has only led people take even bigger risks, while at the same time diversifying the risk onto everybody else.
4. Quest for overspecialization/division of labor. This has led to people putting ever greater focus on ever more specific tasks and objectives, each time leading to greater over-all loss of sight of how real value is created.
5. Quest for the person who will take the first step during uncertain situations. This has led to longer and deeper recessions than necessary, and also to lack of innovation during times when it is needed the most.
6. Quest for someone else to pay your liabilities. This has led to the proliferation of all sorts of insurance and health management firms that either end up in bankruptcy, or taking money from people while avoiding paying claims at all costs.
7. Quest for the greater fool. This has led to momentum investing in the stock market and in all other financial markets. Everybody hopes that there will always be that someone else who will bail him out after he makes that one last bold move at the “peak” of the market.
1. Quest for everything at the cheapest cost. Not only has this led to the occasional substandard or dangerous product, this has also led to global wages standardizing down instead of up. Do the math.
2. Quest for maximum utility. When it comes to scarce resources, every additional utility we squeeze for the present, we are taking away an equal utility from the future. Do the math.
3. Quest for the riskless reward. The recent derivative innovations has only led people take even bigger risks, while at the same time diversifying the risk onto everybody else.
4. Quest for overspecialization/division of labor. This has led to people putting ever greater focus on ever more specific tasks and objectives, each time leading to greater over-all loss of sight of how real value is created.
5. Quest for the person who will take the first step during uncertain situations. This has led to longer and deeper recessions than necessary, and also to lack of innovation during times when it is needed the most.
6. Quest for someone else to pay your liabilities. This has led to the proliferation of all sorts of insurance and health management firms that either end up in bankruptcy, or taking money from people while avoiding paying claims at all costs.
7. Quest for the greater fool. This has led to momentum investing in the stock market and in all other financial markets. Everybody hopes that there will always be that someone else who will bail him out after he makes that one last bold move at the “peak” of the market.
Friday, May 15, 2009
Rise of the dragon currency
Nouriel Roibini is warning how financial power is currently transferring at a rapid pace towards China, as a result of US need to fund its deficit.
China is a creditor country with large current account surpluses, a small budget deficit, much lower public debt as a share of G.D.P. than the United States, and solid growth. And it is already taking steps toward challenging the supremacy of the dollar. Beijing has called for a new international reserve currency in the form of the International Monetary Fund’s special drawing rights (a basket of dollars, euros, pounds and yen). China will soon want to see its own currency included in the basket, as well as the renminbi used as a means of payment in bilateral trade.
Brad Setser explains why China will want to do so.
China’s basic problem is not that it is running a large current account surplus and accumulating financial claims on the world. Rather, its problem is that those financial claims are denominated in dollars and euros rather than in China’s own currency. If China was lending to the US – and Europe – in renminbi, China could continue to run large current account surpluses without taking on as much financial risk as it is now. If the US was required to pay China RMB, not dollars, China wouldn’t need to worry about about of inflation in the US that led the dollar to depreciate – or for that matter a dollar depreciation that wasn’t the product of a rise in US inflation.
Roubini further warns.. Now, imagine a world in which China could borrow and lend internationally in its own currency. The renminbi, rather than the dollar, could eventually become a means of payment in trade and a unit of account in pricing imports and exports, as well as a store of value for wealth by international investors. Americans would pay the price. We would have to shell out more for imported goods, and interest rates on both private and public debt would rise. The higher private cost of borrowing could lead to weaker consumption and investment, and slower growth.
We have reaped significant financial benefits from having the dollar as the reserve currency. In particular, the strong market for the dollar allows Americans to borrow at better rates. We have thus been able to finance larger deficits for longer and at lower interest rates, as foreign demand has kept Treasury yields low. We have been able to issue debt in our own currency rather than a foreign one, thus shifting the losses of a fall in the value of the dollar to our creditors. Having commodities priced in dollars has also meant that a fall in the dollar’s value doesn’t lead to a rise in the price of imports.
Brad again: The problem of course is that is that China’s own choices more than anything else constrain the renminbi’s ability to serve as a global reserve currency. China’s currency isn’t freely convertible and its capital account is heavily managed. And China’s government doesn’t exactly welcome foreign inflows of any sort — and it certainly doesn’t want to increase its dollar holdings to allow other countries to increase their stock of renminbi denominated reserves. Letting other central banks hold RMB means letting other central banks speculate on RMB appreciation …
The US shouldn’t welcome a world where Asian countries try to maintain undervalued currencies – and thus run large, sustained external surpluses – while minimizing their risk by running up renminbi and yen denominated claims on the US, Europe and potentially a host of emerging economies.
China should allow its currency to appreciate, offset the drag from slower growth of exports with aggressive policies to stimulate domestic demand (including the rapid implementation of a broad social safety net, even if this produces sustained budget deficits) and bring its current account surplus down. China’s government would no longer steadily accumulate large quantities of dollar reserves. More balanced trade flows would allow the RMB to eventually float – allowing China to direct domestic monetary policy toward stabilizing China’s own economy rather than stabilizing its exchange rate.
But for as long as the US will remains a debtor without choice, and China its primary creditor, how could this alternative be possible?
* Both articles are must-reads to understand the dynamics of the possible China-US currency standoff.
China is a creditor country with large current account surpluses, a small budget deficit, much lower public debt as a share of G.D.P. than the United States, and solid growth. And it is already taking steps toward challenging the supremacy of the dollar. Beijing has called for a new international reserve currency in the form of the International Monetary Fund’s special drawing rights (a basket of dollars, euros, pounds and yen). China will soon want to see its own currency included in the basket, as well as the renminbi used as a means of payment in bilateral trade.
Brad Setser explains why China will want to do so.
China’s basic problem is not that it is running a large current account surplus and accumulating financial claims on the world. Rather, its problem is that those financial claims are denominated in dollars and euros rather than in China’s own currency. If China was lending to the US – and Europe – in renminbi, China could continue to run large current account surpluses without taking on as much financial risk as it is now. If the US was required to pay China RMB, not dollars, China wouldn’t need to worry about about of inflation in the US that led the dollar to depreciate – or for that matter a dollar depreciation that wasn’t the product of a rise in US inflation.
Roubini further warns.. Now, imagine a world in which China could borrow and lend internationally in its own currency. The renminbi, rather than the dollar, could eventually become a means of payment in trade and a unit of account in pricing imports and exports, as well as a store of value for wealth by international investors. Americans would pay the price. We would have to shell out more for imported goods, and interest rates on both private and public debt would rise. The higher private cost of borrowing could lead to weaker consumption and investment, and slower growth.
We have reaped significant financial benefits from having the dollar as the reserve currency. In particular, the strong market for the dollar allows Americans to borrow at better rates. We have thus been able to finance larger deficits for longer and at lower interest rates, as foreign demand has kept Treasury yields low. We have been able to issue debt in our own currency rather than a foreign one, thus shifting the losses of a fall in the value of the dollar to our creditors. Having commodities priced in dollars has also meant that a fall in the dollar’s value doesn’t lead to a rise in the price of imports.
Brad again: The problem of course is that is that China’s own choices more than anything else constrain the renminbi’s ability to serve as a global reserve currency. China’s currency isn’t freely convertible and its capital account is heavily managed. And China’s government doesn’t exactly welcome foreign inflows of any sort — and it certainly doesn’t want to increase its dollar holdings to allow other countries to increase their stock of renminbi denominated reserves. Letting other central banks hold RMB means letting other central banks speculate on RMB appreciation …
The US shouldn’t welcome a world where Asian countries try to maintain undervalued currencies – and thus run large, sustained external surpluses – while minimizing their risk by running up renminbi and yen denominated claims on the US, Europe and potentially a host of emerging economies.
China should allow its currency to appreciate, offset the drag from slower growth of exports with aggressive policies to stimulate domestic demand (including the rapid implementation of a broad social safety net, even if this produces sustained budget deficits) and bring its current account surplus down. China’s government would no longer steadily accumulate large quantities of dollar reserves. More balanced trade flows would allow the RMB to eventually float – allowing China to direct domestic monetary policy toward stabilizing China’s own economy rather than stabilizing its exchange rate.
But for as long as the US will remains a debtor without choice, and China its primary creditor, how could this alternative be possible?
* Both articles are must-reads to understand the dynamics of the possible China-US currency standoff.
Friday, May 8, 2009
Where to look for green shoots of recovery
In a regular business recession, businesses that over-expanded whittle down their excess inventory, and reinvest capital in more profitable lines. Once inventories are at a more sustainable level and capital redeployed to more appropriate endeavors, growth should come back.
What the US has now is a capitalist recession. In this particular recession, investor/capitalists over-invested in speculative assets and mostly funded these purchases with massive debt. Before growth will come back, debt levels will have to be paid down. But how can debt be paid down if the investment was in non-income generating assets that have, at best, now come down in value, or at worst, unsellable?
To recover from debt, capitalists have had to hoard capital and cut down private consumption. Ditto their lenders, who also have had to swallow massive writedowns, now also hoarding capital and cutting private consumption.
So viable businesses, if there are any left, starve from a lack of capital, while most barely survive from the loss of consumers. This leads to more hoarding and clampdown on consumption. So where can “green shoots” of recovery come from?
Certainly not from the economy in capitalist recession. As we’ve mentioned many times before, you will have to look to those economies that have not been profligate with spending and borrowing - economies who have merely had a business recession.
Once inventories in these economies have come down to more sustainable levels (given the lowered demand) and capital redeployed to more appropriate endeavors (businesses that stimulate domestic consumption), growth should come back. Not just to these economies, but eventually, to economies in capitalist recession.
Look for these green shoots in the emerging markets. But be patient. It will take years for these shoots to become noticeable.
Now, it is possible for the US, being a hothouse for technology, to sprout green shoots by solving current problems in health care, alternative energy, and environmental care. But given the capital hoarding going on there, the capital will have to come from Asia.
What the US has now is a capitalist recession. In this particular recession, investor/capitalists over-invested in speculative assets and mostly funded these purchases with massive debt. Before growth will come back, debt levels will have to be paid down. But how can debt be paid down if the investment was in non-income generating assets that have, at best, now come down in value, or at worst, unsellable?
To recover from debt, capitalists have had to hoard capital and cut down private consumption. Ditto their lenders, who also have had to swallow massive writedowns, now also hoarding capital and cutting private consumption.
So viable businesses, if there are any left, starve from a lack of capital, while most barely survive from the loss of consumers. This leads to more hoarding and clampdown on consumption. So where can “green shoots” of recovery come from?
Certainly not from the economy in capitalist recession. As we’ve mentioned many times before, you will have to look to those economies that have not been profligate with spending and borrowing - economies who have merely had a business recession.
Once inventories in these economies have come down to more sustainable levels (given the lowered demand) and capital redeployed to more appropriate endeavors (businesses that stimulate domestic consumption), growth should come back. Not just to these economies, but eventually, to economies in capitalist recession.
Look for these green shoots in the emerging markets. But be patient. It will take years for these shoots to become noticeable.
Now, it is possible for the US, being a hothouse for technology, to sprout green shoots by solving current problems in health care, alternative energy, and environmental care. But given the capital hoarding going on there, the capital will have to come from Asia.
Friday, May 1, 2009
The curse of the big, publicly-held company
The bigger the company, the more lavish its executive perks. And the bigger the company, the more likely it will be a publicly-held company.
Just about every corporate malfeasance seems to have been committed by those at the top of the publicly-held toy company, Mattel over the years – accounting fraud, lavish entitlements, golden parachutes given despite disastrous management reigns, corporate property theft, and endless litigations. These and other ‘dirty laundry’ are aired in the book, “Toy Monster, the big, bad world of Mattel” by Jerry Oppenheimer.
Now, the book is mostly about the personal backbiting and internal politicking that went on at Mattel, and as such, are not the main concerns of this site. But since I have read it (and it’s an interesting read for those of you who like reading about insider dramas at big corporations), I want to raise the human interest themes of the book to a more macro-level question: Just how much better governed are public companies than privately owned ones?
We know that going public tends to bring in more professional management, who should be bringing in best practices, to a company. But once you have management who are company insiders but are divorced from the fiduciary duties coming from true personal ownership of the firm, and who are in a position to negotiate for themselves better returns (whether in the form of salaries, wages, or stock options) than its small, passive shareowners, are we at all surprised that these things constantly happen at the large public companies?
Stock options were supposed to have better aligned company management interest with the interest of the small shareowner. But still, this didn’t prevent unscrupulous executives from writing for themselves backdated options, options with low exercise prices, or instituted other methods that ensured their options were never ‘out of the money’, regardless of what happened to the stock in the long-run (meaning in the years after they have left the company).
Now, just because a company is public doesn’t mean it automatically gets the best executives who can bring in the best practices. In reality, being a public company actually meant the company can now afford to participate in bidding wars to lure ‘rock star’ CEOs, those who are best at promoting their agenda and in keeping themselves in the limelight.
Are we then surprised that as companies got bigger, more politicking and backbiting went on, and those who managed to get to the top often are those who really are the most narcissistic, opportunistic go-getters? It’s the shareholders who end up paying more, to get these people - who end up driving the company to the ground.
And who is to keep the CEO from looting the company, usually by negotiating lavish perks and a golden parachute for himself? Is it the Board of Directors? Not if they are cronies who also profit from giving these concessions to the CEO. We see a bit of that also in the Mattel story.
So you ask me, where do I think the real wealth creation will come from in the years to come? As far as 'public wealth creation' is concerned, without a doubt, my answer is, from the smaller companies, as they always have been ever since companies started becoming public. Who should we be looking out for in terms of providing better economic incentives? I don’t have to repeat myself on that.
Just about every corporate malfeasance seems to have been committed by those at the top of the publicly-held toy company, Mattel over the years – accounting fraud, lavish entitlements, golden parachutes given despite disastrous management reigns, corporate property theft, and endless litigations. These and other ‘dirty laundry’ are aired in the book, “Toy Monster, the big, bad world of Mattel” by Jerry Oppenheimer.
Now, the book is mostly about the personal backbiting and internal politicking that went on at Mattel, and as such, are not the main concerns of this site. But since I have read it (and it’s an interesting read for those of you who like reading about insider dramas at big corporations), I want to raise the human interest themes of the book to a more macro-level question: Just how much better governed are public companies than privately owned ones?
We know that going public tends to bring in more professional management, who should be bringing in best practices, to a company. But once you have management who are company insiders but are divorced from the fiduciary duties coming from true personal ownership of the firm, and who are in a position to negotiate for themselves better returns (whether in the form of salaries, wages, or stock options) than its small, passive shareowners, are we at all surprised that these things constantly happen at the large public companies?
Stock options were supposed to have better aligned company management interest with the interest of the small shareowner. But still, this didn’t prevent unscrupulous executives from writing for themselves backdated options, options with low exercise prices, or instituted other methods that ensured their options were never ‘out of the money’, regardless of what happened to the stock in the long-run (meaning in the years after they have left the company).
Now, just because a company is public doesn’t mean it automatically gets the best executives who can bring in the best practices. In reality, being a public company actually meant the company can now afford to participate in bidding wars to lure ‘rock star’ CEOs, those who are best at promoting their agenda and in keeping themselves in the limelight.
Are we then surprised that as companies got bigger, more politicking and backbiting went on, and those who managed to get to the top often are those who really are the most narcissistic, opportunistic go-getters? It’s the shareholders who end up paying more, to get these people - who end up driving the company to the ground.
And who is to keep the CEO from looting the company, usually by negotiating lavish perks and a golden parachute for himself? Is it the Board of Directors? Not if they are cronies who also profit from giving these concessions to the CEO. We see a bit of that also in the Mattel story.
So you ask me, where do I think the real wealth creation will come from in the years to come? As far as 'public wealth creation' is concerned, without a doubt, my answer is, from the smaller companies, as they always have been ever since companies started becoming public. Who should we be looking out for in terms of providing better economic incentives? I don’t have to repeat myself on that.
Friday, April 24, 2009
Are most pension funds ponzi schemes?
Hedge funds, mutual funds, pension funds, pre-need funds…you name it, they’ve all taken a beating these past couple of years. Many are likely one step away from possible liquidation, as security assets across all classes, across all sectors, and across all types have all fallen from their all-time highs. And as fund assets fall, many open ended funds have experienced massive withdrawals, which have resulted in further writedowns, further losses, and further fund deterioration.
We are a long way off from the time when investing in funds were thought of as sensible savings. Now, many types of funds are proving to be major wealth destructors. Could this have been foreseen by more people beforehand?
It seems , for now at least, that the biggest source of growth for many of these funds was not their managers’ asset selecting prowess, but their ability to continually attract more capital into their portfolios. As more money came in, fund values increased, and as more funds resulted in more purchases of security products, it all resulted in the virtuous cycle of investor confidence leading to better results. Now, it’s the other way around. Now, it’s panic leading to the vicious cycle of even worse results.
So just how much of these funds’ previous success was really due to asset selection vis-à-vis funds attraction? Getting at an answer should be crucial in determining whether continuing to have a multitude of funds, all independently striving to attract capital to redeploy towards various assets, really results in increased wealth creation over-all. After all, if it turns out that many of these arrived at their previous stellar returns merely because they were successful in growing their assets under management, then it can lead us to believe that many funds are really giant ponzi schemes – with stellar results only possible for as long as more investors are being attracted into the game.
Another question I keep asking is, just how much higher can we expect the return on investing in funds, on average, supposed to be than over-all growth in the economy? After all, if the general performance of securities assets depend on the fundamental performance of the companies who issued them, and the fundamental performance of companies, on average, depends on over-all economic growth, well….you get the message.
Is it then more sensible to just have one giant fund, one whose performance will correspond to that of the economy, and be divorced from success in attracting capital? To do this, it would be important to make it the only game in town. In other words, anybody wishing to invest in a pension fund will have no other choice but this fund. This fund will grow as the population of premium payors grows, not because a multitude of funds constantly involve themselves in a pyramiding scheme of selling assets at constantly higher rates to one other. Just make sure that those receiving pension payouts are always outnumbered by those making premium payments.
I admit I’m no actuarian, and I haven’t run any numbers. But at a conceptual level, it seems having one giant fund can make sense, more than having a multitude of small funds, many too small to weather major economic storms, to be the arbiter of people’s savings.
For more detailed ruminations on this particular subject, Leo Kolivakis over at Pension Pulse would probably be your best source.
We are a long way off from the time when investing in funds were thought of as sensible savings. Now, many types of funds are proving to be major wealth destructors. Could this have been foreseen by more people beforehand?
It seems , for now at least, that the biggest source of growth for many of these funds was not their managers’ asset selecting prowess, but their ability to continually attract more capital into their portfolios. As more money came in, fund values increased, and as more funds resulted in more purchases of security products, it all resulted in the virtuous cycle of investor confidence leading to better results. Now, it’s the other way around. Now, it’s panic leading to the vicious cycle of even worse results.
So just how much of these funds’ previous success was really due to asset selection vis-à-vis funds attraction? Getting at an answer should be crucial in determining whether continuing to have a multitude of funds, all independently striving to attract capital to redeploy towards various assets, really results in increased wealth creation over-all. After all, if it turns out that many of these arrived at their previous stellar returns merely because they were successful in growing their assets under management, then it can lead us to believe that many funds are really giant ponzi schemes – with stellar results only possible for as long as more investors are being attracted into the game.
Another question I keep asking is, just how much higher can we expect the return on investing in funds, on average, supposed to be than over-all growth in the economy? After all, if the general performance of securities assets depend on the fundamental performance of the companies who issued them, and the fundamental performance of companies, on average, depends on over-all economic growth, well….you get the message.
Is it then more sensible to just have one giant fund, one whose performance will correspond to that of the economy, and be divorced from success in attracting capital? To do this, it would be important to make it the only game in town. In other words, anybody wishing to invest in a pension fund will have no other choice but this fund. This fund will grow as the population of premium payors grows, not because a multitude of funds constantly involve themselves in a pyramiding scheme of selling assets at constantly higher rates to one other. Just make sure that those receiving pension payouts are always outnumbered by those making premium payments.
I admit I’m no actuarian, and I haven’t run any numbers. But at a conceptual level, it seems having one giant fund can make sense, more than having a multitude of small funds, many too small to weather major economic storms, to be the arbiter of people’s savings.
For more detailed ruminations on this particular subject, Leo Kolivakis over at Pension Pulse would probably be your best source.
Friday, April 17, 2009
A time for regulation
The free market has been responsible for a lot of technological progress. It is also responsible for the improvement of life standards and the continued increase of productivity in the economy. It has also been known to bring prices down through price competition.
But a free market has also been responsible for a lot of the problems and inefficiencies in the economy today. This comes largely from the selfish pursuit of individuals to maximize their gains, or their utility, even if it comes at the expense of the whole.
A doctor wishing to guard against malpractice liabilities may prescribe more tests than is necessary, thus increasing healthcare costs for everyone. Meanwhile, patients seeking to recover more than is justified may also be contributing to the doctors’ fears of malpractice liabilities. Meanwhile, overall costs go up, not just for those whose healthcare really warrants it, but also for those who may otherwise have gotten treatment for much less.
A bank trying to earn more fees will underwrite more loans than is prudent, but unload the risky assets to investors seeking more yield. To fool themselves of their prudence, they will seek the input of ratings agencies, themselves seeking to earn more fees, to provide AAA ratings to these assets. As more transactions make underlying asset prices go higher, the greater momentum there is for everyone to earn more by doing more of the same.
Individual agents doing what is best for them in a free market society. Actions that lead to worse consequences for society as a whole. So, do we dismantle the free market?
Unfortunately, there is no better alternative for now. The free market works best because of two things: As an organism, it has 1) no ideology ,and 2) no conscience. Hence, we could say that there is no one vested interest in a market that is truly free. What happens is the consequence of actions made by consenting parties to achieve their individual goals. What clears a free market is generally the greatest good for the greatest number.
Nonetheless, not everyone in the market is equally bright, equally informed, or equally just. Very often, the best outcomes in a market go to those who can game the system – those who are more bright, more informed, and less attuned to justice and fairness.
Sometimes, market outcomes come about from unintended consequences of actions made by individual agents not trying to gain more, but just seeking to protect themselves. Consider the doctor in the example above.
We might say that these outcomes happen precisely because the market has no conscience. We might also say that the market is myopic, only seeking what is best among participants at that point in time. Who’s to say that the best outcome is being attained when companies mine all the world’s oil, and pollute the environment, in order to meet the never-ending demand for goods of a growing population, at the most affordable price for the greatest number? What happens tomorrow, when all the resources are mined out, and the environment is unalterably changed? Who’s to pay for that?
Other people might say this is where government comes in, to provide the macro insight, the long-term planning, and….to wit, the necessary conscience to society. But is the government really the best entity to provide these? And what if its efforts to undertake these functions undermines the original advantages of having a free market?
There is no permanent right answer. We should just do our best to see what is most optimal given current circumstances, and know that since society is made up of individuals and group making actions that affect the whole, there will come a time when the pendulum will lead us back to where we were before.
Today is the day for more regulation. Tomorrow, we can dismantle those that just get in the way.
But a free market has also been responsible for a lot of the problems and inefficiencies in the economy today. This comes largely from the selfish pursuit of individuals to maximize their gains, or their utility, even if it comes at the expense of the whole.
A doctor wishing to guard against malpractice liabilities may prescribe more tests than is necessary, thus increasing healthcare costs for everyone. Meanwhile, patients seeking to recover more than is justified may also be contributing to the doctors’ fears of malpractice liabilities. Meanwhile, overall costs go up, not just for those whose healthcare really warrants it, but also for those who may otherwise have gotten treatment for much less.
A bank trying to earn more fees will underwrite more loans than is prudent, but unload the risky assets to investors seeking more yield. To fool themselves of their prudence, they will seek the input of ratings agencies, themselves seeking to earn more fees, to provide AAA ratings to these assets. As more transactions make underlying asset prices go higher, the greater momentum there is for everyone to earn more by doing more of the same.
Individual agents doing what is best for them in a free market society. Actions that lead to worse consequences for society as a whole. So, do we dismantle the free market?
Unfortunately, there is no better alternative for now. The free market works best because of two things: As an organism, it has 1) no ideology ,and 2) no conscience. Hence, we could say that there is no one vested interest in a market that is truly free. What happens is the consequence of actions made by consenting parties to achieve their individual goals. What clears a free market is generally the greatest good for the greatest number.
Nonetheless, not everyone in the market is equally bright, equally informed, or equally just. Very often, the best outcomes in a market go to those who can game the system – those who are more bright, more informed, and less attuned to justice and fairness.
Sometimes, market outcomes come about from unintended consequences of actions made by individual agents not trying to gain more, but just seeking to protect themselves. Consider the doctor in the example above.
We might say that these outcomes happen precisely because the market has no conscience. We might also say that the market is myopic, only seeking what is best among participants at that point in time. Who’s to say that the best outcome is being attained when companies mine all the world’s oil, and pollute the environment, in order to meet the never-ending demand for goods of a growing population, at the most affordable price for the greatest number? What happens tomorrow, when all the resources are mined out, and the environment is unalterably changed? Who’s to pay for that?
Other people might say this is where government comes in, to provide the macro insight, the long-term planning, and….to wit, the necessary conscience to society. But is the government really the best entity to provide these? And what if its efforts to undertake these functions undermines the original advantages of having a free market?
There is no permanent right answer. We should just do our best to see what is most optimal given current circumstances, and know that since society is made up of individuals and group making actions that affect the whole, there will come a time when the pendulum will lead us back to where we were before.
Today is the day for more regulation. Tomorrow, we can dismantle those that just get in the way.
Friday, April 10, 2009
Is The Geithner Plan necessary? Rationale of the Public Private Investment Program
There have been many articles out that criticized the Geithner Plan, mainly because it it’s a mechanism that further privatizes the gains and socializes the loss from the toxic assets held by US banks. With a mechanism where the government leverages the private sector bidder for the assets 7 times, and has a proportional share of the loss but a 50% sharing in the gains, this is indeed a private sector subsidy of a massive scale.
But we have to ask ourselves the question – why did the government decide to make this kind of lopsided proposal? To get the toxic assets out of the bank’s books. Keeping the toxic assets, which have continually slid in value as more home defaults arise, has continually eaten away at the banks’ equity capital. If more defaults are to happen, more writedowns will have to occur, and more banks will end up insolvent.
The Geithner Plan provides a nice way to entice private sector investors - the hedge funds and investment banks – to buy the assets and take them out of the commercial banks’ books. Because the leverage provided by government increases their potential returns on the investment, it incentivises them to bid higher for the assets, thereby restoring capital to the commercial banks.
But we have to ask ourselves a question again – Does anyone really believe that these toxic assets may be worth more than how much they are currently valued? Because if current market value is correct, any rational investor shouldn’t bid more than that, and perhaps should bid less to account for further possible writedowns. The only way anybody can earn a positive return is if these toxic assets end up more valuable than they are currently worth. And many investors seems to think that way, given the various ways they are now trying to game the public private investment program, the “Geithner Plan”. Even the commercial banks, the entities supposed to be helped by the plan by being rid of the assets, seem to be coming up with ways to still end up with the assets.
So what gives? Perhaps insiders know these assets are worth more than the market is currently pricing them. After all, if the banks have thought all along that the toxic assets were to end up continually writing down their equity capital, they would have rid of them a long time ago. Yet they continue holding on to them. Perhaps some people really believe that home defaults will end up a small minority in the toxic asset pool, and more borrowers will end up paying out to maturity.
If that’s the case, the Geithner Plan is a mechanism that will transfer wealth not just from the taxpayer to the hedge funds, but from the commercial banks to the hedge funds. If you were a commercial bank, you’d find ways to end up with the assets back in your hands. Otherwise, hedge funds will end up with the largest gains, at taxpayer’s cost, while taking the gains away from commercial banks.
So is the Geithner Plan the best way to help the banks? If everybody – the government, the commercial banks, the hedge fund investors – believe that toxic assets will end up worth more than they currently do, then maybe we should just suspend marking-to-market for toxic assets, until we do see if they're right. They may end up right, and the taxpayer and the commercial banks need not lose out on anything. I don’t need to repeat what my stand is on mark-to-market acounting (See previous posts here, here, and here). That, or just nationalize the banks where government will buy the assets, so taxpayers get both possible gains and losses.
But we have to ask ourselves the question – why did the government decide to make this kind of lopsided proposal? To get the toxic assets out of the bank’s books. Keeping the toxic assets, which have continually slid in value as more home defaults arise, has continually eaten away at the banks’ equity capital. If more defaults are to happen, more writedowns will have to occur, and more banks will end up insolvent.
The Geithner Plan provides a nice way to entice private sector investors - the hedge funds and investment banks – to buy the assets and take them out of the commercial banks’ books. Because the leverage provided by government increases their potential returns on the investment, it incentivises them to bid higher for the assets, thereby restoring capital to the commercial banks.
But we have to ask ourselves a question again – Does anyone really believe that these toxic assets may be worth more than how much they are currently valued? Because if current market value is correct, any rational investor shouldn’t bid more than that, and perhaps should bid less to account for further possible writedowns. The only way anybody can earn a positive return is if these toxic assets end up more valuable than they are currently worth. And many investors seems to think that way, given the various ways they are now trying to game the public private investment program, the “Geithner Plan”. Even the commercial banks, the entities supposed to be helped by the plan by being rid of the assets, seem to be coming up with ways to still end up with the assets.
So what gives? Perhaps insiders know these assets are worth more than the market is currently pricing them. After all, if the banks have thought all along that the toxic assets were to end up continually writing down their equity capital, they would have rid of them a long time ago. Yet they continue holding on to them. Perhaps some people really believe that home defaults will end up a small minority in the toxic asset pool, and more borrowers will end up paying out to maturity.
If that’s the case, the Geithner Plan is a mechanism that will transfer wealth not just from the taxpayer to the hedge funds, but from the commercial banks to the hedge funds. If you were a commercial bank, you’d find ways to end up with the assets back in your hands. Otherwise, hedge funds will end up with the largest gains, at taxpayer’s cost, while taking the gains away from commercial banks.
So is the Geithner Plan the best way to help the banks? If everybody – the government, the commercial banks, the hedge fund investors – believe that toxic assets will end up worth more than they currently do, then maybe we should just suspend marking-to-market for toxic assets, until we do see if they're right. They may end up right, and the taxpayer and the commercial banks need not lose out on anything. I don’t need to repeat what my stand is on mark-to-market acounting (See previous posts here, here, and here). That, or just nationalize the banks where government will buy the assets, so taxpayers get both possible gains and losses.
Friday, April 3, 2009
MENA and ASEAN, new regional trading centres on the rise
We could be seeing a pick up in mergers and acquisitions activity some time soon. Perhaps not in the developed markets, but in the emerging markets. I have been anticipating something like this to happen for some time, and the recent confluence of events could naturally lead to this.
OPPORTUNITIES FOR THE BIGGER BUT LOCAL COMPANY
As I have previously noted, the companies and businesses that will best weather these uncertain times, and get out of it alive, will be those that are the biggest in their industries. Smaller companies, even those that occupy specific niches, are in for wild times ahead.
To recover and regroup in this turbulent time, multinational companies from the developed world will likely focus more on their home markets, or those markets where they have the greatest competitive advantage. They will probably scale back in emerging markets, leaving wide open opportunities for local companies based in those markets to fill.
Going forward, both developed and developing economies will each become more equally focused on being both consumer and producer economies. However, developing economy companies will have a natural limit to their growth, and again, that limit is what local demand can sustain.
CREATING A BIGGER MARKET
The question therefore is, which of these emerging economy markets vacated by multinationals will have a big enough local demand to sustain a viable local supplier? On a case to case basis, with multinational companies leaving their markets, some local companies bold enough to step up to the plate will finally find the chance to gain market traction without severe competitive pressures from Western firms. And yet, companies located in countries with smaller populations and poorer citizens will still likely remain smaller than those in countries with larger and more prosperous countries. This limitation is also a crucial constraint to how much higher local levels of local wages can increase, which, again, is a crucial function of the rise of a viable local consumer market.
In this new economic reality, the biggest advantages, will go to companies fortunate enough to be located in countries with large domestic populations. Larger economies provide much larger opportunity base for local companies to grow. That’s why we always hear Brazil, Russia, China, and India, large countries with large populations and large markets.
Much smaller countries, therefore, are better off forming into regional trading blocs with their closest neighbours. The European Union is the best model for this. The much bigger common market in which to create demand for their products significantly offsets any reverse growth from a much smaller home market. In the tradition of the EU, I suspect the rise of the regional blocs MENA and ASEAN.
MENA, the acronym for Middle East and North Africa, is the regional commodity and financial powerhouse bloc, now reeling from the drop in oil prices. ASEAN, the association of Southeast Asian nations, is the group of manufacturing and off-shoring centres previously responsible for bringing world consumer goods prices down, until China entered the picture.
In response to the rise of these blocs, previously nationally-based firms and conglomerates in these areas will have to start looking beyond their borders, and MERGE with like companies – to create the scale, the scope, and the size they need to profitably and effectively create a sustainable local market.
Likely, these mergers will be in the consumer staples industries, retail, and in banking, precisely those industries where the largest multinaltionals are currently scaling back the most.
ADJUSTING TO A BIGGER THE MINDSET
The goal of becoming the back-end supplier of finished goods for some other global company is now insufficient to guarantee continued economic prosperity. To maintain economic prosperity for all, countries need to diversify away from focusing on exporting specialized goods to global but narrowly specific sectors into selling a greater array of products and services FOR DOMESTIC CONSUMERS.
The rising pan-Middle Eastern and Pan-Asian emerging economy companies therefore need to be willing to pay better than lowest wage, and focus their business-building efforts on developing niche markets in their new regional economies, rather than simply trying to be the lowest cost global producer for a commoditized and undifferentiated product.
For this mental reorientation to work, change efforts need to be macro in scale. Only in an environment where all businesses are focused on creating greater value for the local consumer, while at the same time creating a local consumer able and willing to buy their goods, will this change work. Macro-scale efforts can only start making sense when small countries stop thinking in terms of just their local economies, and start thinking in terms of creating regional markets.
With regional markets, companies can finally have the scale, the scope, and the size they need to successfully spruce up a big and affluent customer base. After all, Henry Ford could not have done what he did had he been limited in growth opportunity to just Michigan. For him to grow and successfully profit from his innovations, he benefited significantly from having the entire US economy as a platform to roll out his business. Equally, since his competitors, suppliers, and partners also had the entire US economy as their oyster, they too could plan and organize and cost their businesses with that scale in mind.
When the developing world has finally succeeded in getting much of its local wages and standards of living to developing world parity, then maybe globalization can start to work, and we can once again strive to bring down international barriers everywhere else.
OPPORTUNITIES FOR THE BIGGER BUT LOCAL COMPANY
As I have previously noted, the companies and businesses that will best weather these uncertain times, and get out of it alive, will be those that are the biggest in their industries. Smaller companies, even those that occupy specific niches, are in for wild times ahead.
To recover and regroup in this turbulent time, multinational companies from the developed world will likely focus more on their home markets, or those markets where they have the greatest competitive advantage. They will probably scale back in emerging markets, leaving wide open opportunities for local companies based in those markets to fill.
Going forward, both developed and developing economies will each become more equally focused on being both consumer and producer economies. However, developing economy companies will have a natural limit to their growth, and again, that limit is what local demand can sustain.
CREATING A BIGGER MARKET
The question therefore is, which of these emerging economy markets vacated by multinationals will have a big enough local demand to sustain a viable local supplier? On a case to case basis, with multinational companies leaving their markets, some local companies bold enough to step up to the plate will finally find the chance to gain market traction without severe competitive pressures from Western firms. And yet, companies located in countries with smaller populations and poorer citizens will still likely remain smaller than those in countries with larger and more prosperous countries. This limitation is also a crucial constraint to how much higher local levels of local wages can increase, which, again, is a crucial function of the rise of a viable local consumer market.
In this new economic reality, the biggest advantages, will go to companies fortunate enough to be located in countries with large domestic populations. Larger economies provide much larger opportunity base for local companies to grow. That’s why we always hear Brazil, Russia, China, and India, large countries with large populations and large markets.
Much smaller countries, therefore, are better off forming into regional trading blocs with their closest neighbours. The European Union is the best model for this. The much bigger common market in which to create demand for their products significantly offsets any reverse growth from a much smaller home market. In the tradition of the EU, I suspect the rise of the regional blocs MENA and ASEAN.
MENA, the acronym for Middle East and North Africa, is the regional commodity and financial powerhouse bloc, now reeling from the drop in oil prices. ASEAN, the association of Southeast Asian nations, is the group of manufacturing and off-shoring centres previously responsible for bringing world consumer goods prices down, until China entered the picture.
In response to the rise of these blocs, previously nationally-based firms and conglomerates in these areas will have to start looking beyond their borders, and MERGE with like companies – to create the scale, the scope, and the size they need to profitably and effectively create a sustainable local market.
Likely, these mergers will be in the consumer staples industries, retail, and in banking, precisely those industries where the largest multinaltionals are currently scaling back the most.
ADJUSTING TO A BIGGER THE MINDSET
The goal of becoming the back-end supplier of finished goods for some other global company is now insufficient to guarantee continued economic prosperity. To maintain economic prosperity for all, countries need to diversify away from focusing on exporting specialized goods to global but narrowly specific sectors into selling a greater array of products and services FOR DOMESTIC CONSUMERS.
The rising pan-Middle Eastern and Pan-Asian emerging economy companies therefore need to be willing to pay better than lowest wage, and focus their business-building efforts on developing niche markets in their new regional economies, rather than simply trying to be the lowest cost global producer for a commoditized and undifferentiated product.
For this mental reorientation to work, change efforts need to be macro in scale. Only in an environment where all businesses are focused on creating greater value for the local consumer, while at the same time creating a local consumer able and willing to buy their goods, will this change work. Macro-scale efforts can only start making sense when small countries stop thinking in terms of just their local economies, and start thinking in terms of creating regional markets.
With regional markets, companies can finally have the scale, the scope, and the size they need to successfully spruce up a big and affluent customer base. After all, Henry Ford could not have done what he did had he been limited in growth opportunity to just Michigan. For him to grow and successfully profit from his innovations, he benefited significantly from having the entire US economy as a platform to roll out his business. Equally, since his competitors, suppliers, and partners also had the entire US economy as their oyster, they too could plan and organize and cost their businesses with that scale in mind.
When the developing world has finally succeeded in getting much of its local wages and standards of living to developing world parity, then maybe globalization can start to work, and we can once again strive to bring down international barriers everywhere else.
Friday, March 27, 2009
Simon Johnson: The financial community's quiet coup
Simon Johnson today writes in the Atlantic an interesting article (HT Felix Salmon). It starts off with a description of the typical country that looks to the IMF for assistance. Being a former chief economist for the IMF, he should know: Typically, these countries are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks. Emerging-market governments and their private-sector allies commonly form a tight-knit—and, most of the time, genteel—oligarchy, running the country rather like a profit-seeking company in which they are the controlling shareholders. When a country like Indonesia or South Korea or Russia grows, so do the ambitions of its captains of industry. As masters of their mini-universe, these people make some investments that clearly benefit the broader economy, but they also start making bigger and riskier bets. They reckon—correctly, in most cases—that their political connections will allow them to push onto the government any substantial problems that arise.
But inevitably, emerging-market oligarchs get carried away; they waste money and build massive business empires on a mountain of debt. Local banks, sometimes pressured by the government, become too willing to extend credit to the elite and to those who depend on them. Overborrowing always ends badly, whether for an individual, a company, or a country. Sooner or later, credit conditions become tighter and no one will lend you money on anything close to affordable terms.
The downward spiral that follows is remarkably steep. Enormous companies teeter on the brink of default, and the local banks that have lent to them collapse. Yesterday’s “public-private partnerships” are relabeled “crony capitalism.” With credit unavailable, economic paralysis ensues, and conditions just get worse and worse. The government is forced to draw down its foreign-currency reserves to pay for imports, service debt, and cover private losses. But these reserves will eventually run out. If the country cannot right itself before that happens, it will default on its sovereign debt and become an economic pariah. The government, in its race to stop the bleeding, will typically need to wipe out some of the national champions—now hemorrhaging cash—and usually restructure a banking system that’s gone badly out of balance. It will, in other words, need to squeeze at least some of its oligarchs.
Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or—here’s a classic Kremlin bailout technique—the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk—at least until the riots grow too large.
Johnson’s main point in the article is that the US response to its current crisis situation is indistinguishable from the typical emerging economy country that has sought IMF assistance. In place of the traditional crony oligarchs of the emerging economy, just insert “the financial community”. In the last three decades, the US financial community has grown tremendously in power, and has been perceived to be successful in lobbying the government for bailouts and massive subsidies, just as the problems they are now in are due to their own over-reaching. In the end, it is the taxpayers who pay, the very people who never participated in the gains. So what is Simon Johnson’s prescription?
The challenges the United States faces are familiar territory to the people at the IMF. If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say: nationalize troubled banks and break them up as necessary.
Of course, for this prescription to be followed, you would have to assume that the US is not yet a fully-evolved banana republic, and that its oligarchs – the financial community - are not yet so fully entrenched. If they already are, to the extent oligarchs are in emerging economies, then the propagation of their power is paramount to the continuity of incumbent political power.
In emerging economies, it is common to find oligarchs fully entrenched in the capitalization of the country’s most key natural resources, or they have cornered a monopoly on a staple franchise in the economy, that shrinking the oligarch’s influence is tantamount to shrinking economic activity. And since they tend to be key political kingpins, sitting politicians typically owe their positions to their alliances with the oligarchs.
So ask yourself this: Is this now the case with the financial community in the US? If it is, then the nationalization prescription won’t be followed, in Johnson’s words “at least until the riots grow too large”.
Update: Dani Rodrik responds to Simon Johnson.
But inevitably, emerging-market oligarchs get carried away; they waste money and build massive business empires on a mountain of debt. Local banks, sometimes pressured by the government, become too willing to extend credit to the elite and to those who depend on them. Overborrowing always ends badly, whether for an individual, a company, or a country. Sooner or later, credit conditions become tighter and no one will lend you money on anything close to affordable terms.
The downward spiral that follows is remarkably steep. Enormous companies teeter on the brink of default, and the local banks that have lent to them collapse. Yesterday’s “public-private partnerships” are relabeled “crony capitalism.” With credit unavailable, economic paralysis ensues, and conditions just get worse and worse. The government is forced to draw down its foreign-currency reserves to pay for imports, service debt, and cover private losses. But these reserves will eventually run out. If the country cannot right itself before that happens, it will default on its sovereign debt and become an economic pariah. The government, in its race to stop the bleeding, will typically need to wipe out some of the national champions—now hemorrhaging cash—and usually restructure a banking system that’s gone badly out of balance. It will, in other words, need to squeeze at least some of its oligarchs.
Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or—here’s a classic Kremlin bailout technique—the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk—at least until the riots grow too large.
Johnson’s main point in the article is that the US response to its current crisis situation is indistinguishable from the typical emerging economy country that has sought IMF assistance. In place of the traditional crony oligarchs of the emerging economy, just insert “the financial community”. In the last three decades, the US financial community has grown tremendously in power, and has been perceived to be successful in lobbying the government for bailouts and massive subsidies, just as the problems they are now in are due to their own over-reaching. In the end, it is the taxpayers who pay, the very people who never participated in the gains. So what is Simon Johnson’s prescription?
The challenges the United States faces are familiar territory to the people at the IMF. If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say: nationalize troubled banks and break them up as necessary.
Of course, for this prescription to be followed, you would have to assume that the US is not yet a fully-evolved banana republic, and that its oligarchs – the financial community - are not yet so fully entrenched. If they already are, to the extent oligarchs are in emerging economies, then the propagation of their power is paramount to the continuity of incumbent political power.
In emerging economies, it is common to find oligarchs fully entrenched in the capitalization of the country’s most key natural resources, or they have cornered a monopoly on a staple franchise in the economy, that shrinking the oligarch’s influence is tantamount to shrinking economic activity. And since they tend to be key political kingpins, sitting politicians typically owe their positions to their alliances with the oligarchs.
So ask yourself this: Is this now the case with the financial community in the US? If it is, then the nationalization prescription won’t be followed, in Johnson’s words “at least until the riots grow too large”.
Update: Dani Rodrik responds to Simon Johnson.
Friday, March 20, 2009
Mapping uncharted economic territory
Americans shouldn’t really be blaming the Fed for what it has been doing lately. After all, it’s been doing what it’s mandated to do, which is to prevent further economic collapse, given the tools available to it, which is monetary policy.
If the Fed does nothing now, the collapse might be even worse. However , we do know that its actions are likely setting the stage for high inflation, or currency depreciation, down the road. This does not bode well for US economic power going forward.
But if the US declines as an economic power, who will take its place as numero uno? China? China has its own problems now. The key engine for its spectacular growth – exports, is now in steep decline. And it’s likely to get worse, as the economy of its chief export country, the US, gets worse.
At this time, no other country seems likely to step forward as the next clear economic power. There will definitely be no growth happening in a stagnant economy, so China will weaken if it doesn’t manage to stimulate its own economy.
It’s a toss up with the country where monetary policy is inducing inflation. On one hand, people will be forced to stop deferring purchases once they know money is about to lose value. But then again, local businesses will find it tough to survive in this kind of environment. It could end up a case of survival of the biggest.
But a country with high inflation does experience currency devaluation. That means its exports are getting cheaper. But in a world comprised of stagnant countries with weak domestic demand, and countries experiencing similar hyperinflation, it’s unclear who could end up being the economic savior (buyer). And with a weak currency, a high inflationary country doesn’t have the purchasing power to buy imports to stimulate stagnant economies.
This is uncharted territory.
If the Fed does nothing now, the collapse might be even worse. However , we do know that its actions are likely setting the stage for high inflation, or currency depreciation, down the road. This does not bode well for US economic power going forward.
But if the US declines as an economic power, who will take its place as numero uno? China? China has its own problems now. The key engine for its spectacular growth – exports, is now in steep decline. And it’s likely to get worse, as the economy of its chief export country, the US, gets worse.
At this time, no other country seems likely to step forward as the next clear economic power. There will definitely be no growth happening in a stagnant economy, so China will weaken if it doesn’t manage to stimulate its own economy.
It’s a toss up with the country where monetary policy is inducing inflation. On one hand, people will be forced to stop deferring purchases once they know money is about to lose value. But then again, local businesses will find it tough to survive in this kind of environment. It could end up a case of survival of the biggest.
But a country with high inflation does experience currency devaluation. That means its exports are getting cheaper. But in a world comprised of stagnant countries with weak domestic demand, and countries experiencing similar hyperinflation, it’s unclear who could end up being the economic savior (buyer). And with a weak currency, a high inflationary country doesn’t have the purchasing power to buy imports to stimulate stagnant economies.
This is uncharted territory.
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