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.

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.

Friday, March 13, 2009

Investor unconventionality -a behavioral way to fix capitalism

Are we doomed to experience historically wider fluctuations in all financial markets going forward?

We know that there are more and more finance practitioners out there whose sole purpose and economic livelihood is to shuffle assets around, i.e. trade. We also know that, increasingly, more specialized information previously unavailable to a multitude are becoming more ubiquitous, allowing more analytical symmetry among investors, if not exactly 100% information symmetry.

So……as more and more investors are aware of the same new information, and making investment decisions based on the same homogenous analytical framework, we find more and more of them chasing the same high yield investments as each other. Their investment choice correlation becomes 1.

This herd behaviour reinforces everybody’s strongest convictions, and makes both their biggest hopes and fears come true. As events converge, and investment outcomes for a broader array of investors become they same, investor behaviour becomes the same. For example, widespread expectation of inflation makes everybody bullish on commodities, deflation expectations make everybody bullish on cash, depression concerns make everybody run for the exits, and so on and so forth.

As investors begin to make the same reactions and counter-reactions, strategic moves become crowded, with investors piling up after one another trying to beat each other to the bell – in every financial market, in every investment asset, in every investment locale.

Conditions previously-considered black swan events therefore become more common. A black swan event in an extreme end of the spectrum can then lead on to the black swan event in the other extreme event of the spectrum, and then on and on. Could we consider the widespread acceptance of toxic CDOs, the massive leveraging, and the massive use of complex derivatives black swan events in themselves, as much as the financial implosion that followed?

Could collective mass hysteria on a global scale be as much a black swan event as the probability that the world can experience collective bullishness, and that hey could adopt a collective belief that the world is getting better just because they are reinforcing each other’s collective bullishness?

Perhaps we should start celebrating individual, institutional, and national differences, rather than encouraging more than global homogeneity. We should encourage more people imbibed with unconventional thoughts than those who merely make the same conclusions as everybody else.

Perhaps then, capitalism becomes powered once again by the invisible hand of the market (which is supposed to achieve more stable equilibriums over a longer period of time), rather than the strong arm of manias (which leads to constant waves of reflexive outcomes and disruptions).

Thursday, March 5, 2009

A cure for declining productivity: Promote small-scale enterprise

John Quiggin writes on a theme that he has been going on about for ages, the declining growth rate of productivity and/or innovation. He starts off by pointing: to work by Michael Mandel suggesting that much of the measured productivity growth in the US has been bogus (see also Matt Yglesias on this). I agree, particularly as regards the financial sector.

I agree and I think the implications are profound, if still hard to predict with any accuracy. There has been a huge shift in the location of innovation, with much of it either deriving from, or dependent on, public goods produced outside the market and government sectors, which may be referred to as social production.

My take on this is that we have simply allowed some business firms to grow too large. It is saying something when the bankruptcy or illiquidity of one or two companies can wreak havoc on an entire economy, albeit large ones like that of the US.

The growth of many firms has caused the decline of the small firm, which had been the source, more so than large firms, of
• More mass-based employment
• Most spurts of genuine innovation, and
• Truly market-based competition.

Large firms, particularly those that have an entrenched monopoly, tend to spend a great deal of attention towards:
• Quashing new competition, particularly up and comers who may have genuine ground-breaking innovation that could dislodge their own companies
• Buying off small companies, not for the sake of propping them up, but so that their new innovations never bear fruit and dislodge their own entrenched technologies
• Hamper innovation by making the barriers to entry in the market too high for people who may otherwise have truly remarkable innovation.

It is true that having large firms in themselves caused much productivity improvement in recent years, primarily that which comes from having large economies of scale. But economies of scale is hardly a sustainable source of productivity improvement, let alone ground-breaking new innovation.

It’s time for the pendulum to swing the other way. Greater regulation is needed. Not the kind that will impede innovation. But the kind that takes away barriers to innovation imposed on the market by entrenched private interests.

Wednesday, March 4, 2009

When Giants Fall

Like the other great spasms in our history, the one that now seems to be unfolding is unlikely to be narrow in scope, shallow in depth or short-lived in duration. In fact, the myriad strains that have built up over the course of the past several decades will continue to break loose in a seemingly endless sequence, careening into one another like a long line of cascading dominoes……

......people will have to evaluate circumstances as realistically as possible and figure out for themselves what their options are – as individuals, owners, managers, and investors
. So goes a crucial excerpt from the new book by author and co-blogger, Michael Panzner, titled “When Giants Fall”.

This book will likely elicit strong reactions from people, both good or bad. It’s going to either make people more afraid, or more vigilant…. more pessimistic, or more aware,…….more distrustful of institutions, or more trusting of those that they do choose to rely on. One thing is for sure, this book is going make you sit up and think.

Throughout the book, Panzner goes on about the ramifications of a world struggling with the large void that will be left when the US falls from its vantage as the sole economic, military, and political superpower. He takes note of the political tensions being created by a more confident China, the new political realignments that link Russia with China, China with Latin America, Russia and Saudi Arabia - alignments that bypass the US and will likely diminish its influence in years to come. He takes note of changing demographics, peak oil, increase in carbon emissions, and the possible negative effects of a return to nuclear power.

He then talks about the growing social and civil unrest in various parts of the world, the loss of status of the US dollar as a safe haven, the growth of sovereign wealth funds, and their potentially increasing influence in how the US conducts its economic and industrial policy. He mentions about the rising tide of isolationism and protectionism throughout the world.

Many of the points Panzner makes are clear, and closely parallel what other observers such as myself have already been noticing in bits and pieces over these last few years. But he takes it up another notch, and projects a future where violence will further increase, economic uncertainty prevails, and power failures, rising crime, and infrastructure failure could become common.

This scenario, which became common in places such as Kosovo, Bosnia, and Somalia in the last decade, are unheard of, and unimaginable, in the developed world. Yet, Panzner imagines how these could stem from the current mess being experienced by the US and other rich nations. While it is true that some scenarios he envisions seem too far-off from the current status, we should keep in mind that before social and economic hardship swept over the above-mentioned places, they were generally peaceful, and the descent they went down to were probably furthest from everybody’s mind at the time.

My main take away from reading this book is that these are all dire predictions, which we may or may not find the world getting into in the next few years. But it pays to be aware. And, being aware, we may perhaps try harder to change our current lack of resolve and cooperation. After all, to know the future is to know how to alter it.

When Giants Fall seeks to provide a roadmap for businesses, managers, and the people in general, for how the world will likely evolve, and how people will likely adapt to the changes. Readers of economic blogs will likely see common threads in the topics covered by the book, but I’m sure they will find interesting the new synthesis that Panzner comes up with, as he tries to take things to the next step.

I’m reminded of the scene in a movie I saw once, where the playground bully decides to become nice and refrain from his bullying ways. So soon after the other children cheered for their newly-found freedom from this bully, they find themselves confronting new and possibly worse situations. New little bullies suddenly rise among them, little kids form into little gangs for common protection, or to gain prominence when each one acting along couldn’t, and suddenly there is more violence and mayhem in the playground. If this is the scene we are going to find ourselves in, we will need all the guides we can get.