Buy USA policy is bad

Two main articles that i have read over the last week, set the tone for this blog. One is on whether we are staring at a Hayekian recession(by Swaminathan in ET) and secondly the "Buy USA" policy attached to the fiscal stimulus package of US. 

The Hayekian recession broadly states that misallocation of resources in a system over a period of time leads to a situation of boom and bust which can only be corrected by removing the imbalances. Keynesian policy is different in this regard, as it formulated pumping of money into the system to recover the economy. I am of the view that Keynesian policies might not work this time round. The current situation has been brought about by a spending by US (and few other countries) and saving by exporting countries. This imbalance in the global economy led to booming asset prices and the aftermath. To recover form this situation, the solution as per Hayekian , is to make the exporters start spending ( ignite the domestic demand) and the US export. 

The next issue of "Buy USA" is linked to this as it is contradictory to the Hayekian solution. "Buy USA" would lead to a wave protectionism something which the world economy and US in particular cannot afford. Domestic demand in US is at its weakest and 'buy USA' policy  would not be able to stimulate the domestic demand sufficiently.  

The world not requires concentrated action by all the countries to get out of the mess in which the US has to lead, but the recent postures of US (smack with China on currency, protectionism measures) do not give a healthy sign in this regard.

View on US interest rates and Dollar

The main issue being faced by US currently is how to increase government expenditure without hampering the fiscal deficit to a great extent. As per the current statistics from Economist, the budget deficit is expected to rise to $1.2 trillion in the current fiscal, nearly 8% of the US GDP. This would be the highest post 1940’s and worse than the era of high inflation seen in the early 1980’s. Let us take a step backward to the post war era in US. This was a period of gold standards and Keynesian economics. Increased government expenditure finally made it difficult for US to hold onto the gold standard. The money supply expanded less than two fold during 34 years prior to Nixon action and after that action, money supply expanded 13 fold. The revocation of gold standard played an important part in the high inflation experienced in late 1970’s.

The current high fiscal deficit coupled with the increase in money supply being made by the Fed by taking in collaterals (Fed takes in collateral from banks and increases their deposits being held with the Fed. No actual money transfer takes place, but the banks have that amount of capital free to be deployed) has the ability to increase the inflation and interest rates in US going forward.

This is a phenomenon that has been seen across economies which have faced economic crisis. US has been immune to the problem of being able to find investors who would readily buy the bonds it issued. The current interest in US treasuries has been primarily due to the decreased preference for risk. My view is that the risk aversion would decrease and in case other economies start recovering earlier than US, then it will be tough for US to find investors at low yields. The era of strong dollar has come to an end. The performance of dollar going forward would mimic the economy’s performance vis- a-vis other economies coupled with inflation rates. The strong performance of the dollar over the last 3 months should not be viewed as a long term shift but rather a short term unstable shift.

Fiscal Stimulus : Part II

With respect to the last post, Sanjay has raised an interesting point on whether consumer confidence can be raised in any other way without infrastructure spending. This post is an attempt to answer that question. Let's step back and go back to the post "Delevering part I". In that post i had given an illustration on the how the liquidity cycle operates. In the current scenario in US we are facing a deadly combination of fall in consumer demand, fall in private investment and liquidity issues. All of this is exacerbated by the fact that the jobs fall is preceeding output fall currently. In the sense companies are quick to cut jobs. All of this is just to get an idea about the current scenario in US.

Coming back to the question of Sanjay, lets us just think what is the primary reason that will make the consumer start spending again. Stable Income and a sense that the prices are not going to keep falling. Please keep in mind that i am stressing on Stable and not on the quantum of income, to indicate that the consumer should be confident of getting a pay cheque at the end of the month. The three important elements i stated in the first paragraph (liquidity, private investment and consumer spending) are interlinked. The cycle is a self feeding mechanism which moves in both directions swiftly. 

The following steps could be a way of reducing the reverse flow of the cycle (other than the "normal" way).

1.  Government makes firing illegal (other than for illegal and harmful activites by employee)for a short duration of time and gives the companies the flexibility to cut salaries (even of unionised employees).

2.  Floor prices to all assets linked to the prices before the bubble period taking into account the due increases due to inflation.

3.  Make it mandatory for banks to lend/keep the liquidity flow.

These are extreme steps and is a gross manipulation of the market. But we need to consider the fact that in the current scenario market is in a distress and needs to be fixed.

Fiscal Stimulus : Does "productive spending" have any role in revival

Most of the fiscal stimulus plans being announced always have a stress on productive spending. Take for example the view of Mr. Obama, on his big infrastructure push to kick start the US economy. Most of the push of the fiscal plan is on building infrastructure in terms of roads, flyovers etc. The role of such infrastructure spending in restarting the economy has still not be confirmed. Many people relate back to the New Deal era which also was a infrastructure development oriented fiscal plan. 

Whether the New Deal revived the US economy is still an unanswered question. The economy recovered during the 1933-1936 period and then again fell during the recession of 1937. The failure of the New Deal to revive the economy is due to the certain policies that worked at cross purposes. The government was increasing its spending and at the same time cutting the incomes in the hands of the employees, and tried to increase food prices with supply curtailment. All of this restricted the consumption and employment of the people. 

Coming back to the point, fiscal stimulus would be useful only if it is able to stimulate public consumption. Increased consumption by the people is the only way to get out of a deflation. Increasing public spending without increasing the confidence of the people to spend would not be of much use. It would only increase the deficits and make it even more difficult to revive the economy. Japan is a case point in this regard.Care always has to be taken in this regard. Demand revival is important than investments. It is important to know that Keynes never stated that the government spending should be productive only that pay people to dig and fill.

Deflationary Scare

It was not long ago when i was a proponent of the "stagflation" theory. The period was Jan 2008, when i was of the strong view that the world was moving towards a high inflation period on the back of high commodity prices. I had even bought Gold ETF's after selling all my stock holdings (currently equity exposure is ZERO ;-)). Things have changed a lot after that, the scenario of high inflation no longer exists, we are seriously looking at a scenario of deflation. Deflation is as bad as high inflation, but driven by expectations. One caused by bubbles and another caused in the aftermath of one. Deflation is certainly a rare event, the last the world had seen a strong bout of it was during the Great Depression on 1929. Japan's lost decade is another fitting example of what happens in a deflationary economy. Expectations of lower prices or price falls can feed themselves in the current environment. 

Cut backs by banks in giving credit and falling incomes --> cutbacks in spending --> cutbacks in private investment -->cutbacks in employment  and falling incomes.

The cycle can be broken by fiscal and monetary measures.But monetary measures need a strong financial and banking system working, which is in a mess currently and credit markets clearly non functional. The case for a strong fiscal measure is quite strong. Some countries have already started moving towards increased government spending in creating infrastructure and employment. China has launched a program to increase spending to improve infrastructure in the country. But one has to wait and see what would be the effect of it. US is following a piecemeal approach with adhoc measures to save industries. Not sure how useful these measures. A better means would be to directly put in measures to increase consumer spending. The US government seems to be acting after the event/industry falls rather than before it falls. 

But again just spending by government might not aid in getting out of the rut, Japan has spent a lot during its lost decade (fiscal deficit stands at 150% of GDP) but it still could not get out of the rut. The G20 meeting is currently being held, lets see what they do about it.

FED Actions

The main actions of the FED yesterday were, lowering interest rates and providing swap lines to emerging economies. The second action would play an important role rather the first one. As i said in the previous post, cutting interest rates would not restart the cycle, the swap lines would aid in restarting more than interest rate cuts. Swap lines would allow countries which have been hit by the liquidity crunch do to higher external liabilities, to access dollars directly from the US government. It is step in the right direction and would allow for orderly unwinding of the leverage. The main issue that US would face going forward is similar to the one it faced domestically,"which countries are too big to fail?". My view is that a better way to go about this problem would be to segregate countries in the three baskets i had given in the "delevering part ii" post. Countries which fall under category 3 would be the ones fit for swap lines. Countries under 2 would be better suited to go to IMF. IMF is well placed to handle it rather than the US government.

Are we looking at the foundations for another bubble..may be or maybe not. We got to see whether delevering is going to happen or not. Else we are in for a rough ride. Delevering is important as another important responsibility of many central banks is to have price stability. Going from one bubble to another would only make mockery of price stability mechanisms.

Delevering Part II

Carrying forward form the last post, so where does the government get the money to do the infusion. The government may also look at cutting interest rates to make it more attractive to spend and borrow. But in these times where no one is lending due to counter party distrust, lower interest rates may not do the trick. Going to low on them might leave your monetary policy with no room for further measures. Coming back to our discussion, the following might be the possible ways 

1. Own funds : Countries which are flush with money accrued during the last few years of boom, have the fire power to infuse the their economies with cash and make it easier to restart the cycle. They may even undertake fiscal measures not worrying much about fiscal deficits. China is one prime example to an ideal member to this group.These countries may even play an important role in changin the world order in terms of financial strenght. There is a lot of talk of new "Bretton Wood " system to be created, these countries may try to play an important role if at all such a system is created. Do not think US will be sole financial super power which can do anything. After this fiasco we can expect other countires to force US to follow the disciple it preaches others to follow. These countries are the one'w which are most favourably placed, on an overall level they can make the delevering process quite smooth if they want it. Else if they are interested in keeping the bubble going they can also do so through domestic consumption.

2. Go IMF/other countries: Few countries may find that the cost of restarting the system is too big for them to fund. They are either near bankruptcy or either very close to it. Iceland, Hungary are few examples. I have not mentioned Pakistan here as i believe that the issue with Pakistan is more to do with lack of governance and terrorism. It would have faced the current situation even during the best of times. These countries are in for a tough time. They would have to follow strict policies and endure pain in the short term. Citizens of these countries would face harsh realities atleast for some time to come.

3.Sell Bonds/ Curtail expenses: Some of the countries like India and US, have the firepower to infuse thier economies with cash. But their are limts to which they can do the infusion. India and US have fiscal deficits. Their current account deficits till now have been funded by foreign investors of varying kinds. The twin deficts of fiscal and current always have created issues, as flight of money out is always accompanied by a weakening economy. This further restricts the government from going on a spending exercise to jump start the economy. India is already looking at breaching its fiscal targets for the current year. The money used in restarting the economy would come either by raising money through bonds at high interest rates or via curtailment of expenses in some sectors. Retracting expenses also is counter productive as government spending in absence of domestic consumption would be necessary. If the bonds do not get sold, the they are in for a rough ride. Can't say much about this group, the actions they take would determine to a great extent. Some of them my create another bubble to restart and then cut back on leverage. Some may follow the same path of the last few years after restarting.The former might go throught a tough period in the short term but the latter is in for a greater blowup.

If you think there are other possible ways please do get back.

Delevering Part I

Delevering is a term which we are hearing a lot these days. Liquidity crunch, an offshoot of the delivering process, is another most often heard term.  I have tried to explain the process of delivering can be explained in the following example,

Assume a simple economy which contains the following key players, B, C and I.B is a bank, C is a common man and I is an industry.  All the three players are interlinked, C lends to banks in form of deposits, B lends to I in form of loans and I lends to C and gets services of C in return. In the actual world the arrows are bi-directional, but let us assume that in this case the arrows are uni directional. This is simplistic view of the economy but the basic idea that everything is interlinked in a circular manner is captured by this m

odel. As long as the money keeps moving from one arm to another, this model works fine. Increasing speed of movement gives a feeling of increasing wealth. The model has an in build feedback mechanism, which if not checked (regulator’s role, who failed miserably in the current world ) can lead to high levels of leverage. Ultimately one of the parties might get suspicious about the ability of the entity to which it has lent to pay back. If B stops lending to I or if C thinks that B may not be able to repay him back, then the entire model comes to a sudden halt. B does not lend to I and wants I to return the money he lent so far, I will not take any services from C (As he wants to pay back B) and C stops lending to B as he is not sure of his services to I getting him money. Thus everything is in a gridlock.Thus, everyone wants their money back, thus leading to a liquidity crunch. This is the current scenario being 

faced by most of the economies worldwide.  

The only way to break this gridlock is to bring back the confidence that each of the players would pay back its lenders. The outsider to this system is the Government (G), which is trying to pump in money into the banks and try to restart the system and slowly bring down the leverage levels in the system.

The next topic of my blog would be how the government gets the money to fund this process and the consequences of such infusion.

To Invest or Not to Invest

During the recent crashes in the stock market, many people have been discussing whether it is a good time to start investing in the market. I have second thoughts on getting back into the “gambling den”.  The main concerns I have

1.       Service sector slowdown: The growth of any economy is driven by one of the four main drivers, Consumption, Investment, Exports and Government expenditure. Indian Economy has been driven by software exports (rather export of services) during the initial years. Software exports have laid the path to a consumption and investment driven economy. Increasing spending by IT professionals led to growth in many sectors like Retail, Travel, BFSI and other related sectors. Spending by the people employed in these sectors has led to a growth in economy. Easy of access to money aided in the explosive growth. The growth has attracted increasing investments by foreign investors, which have aided in funding the increasing infrastructure being built by private and public entities.

In the current scenario, each of the services which were the main growth engines are slowing down. IT sector is facing slowdown due to lack of economic growth in their main markets, increasing aversion to spend due to uncertainty with regard to job is also causing a slowdown in other sectors. The lack of confidence of the industry is apparent in the slowdown of uptake in commercial space.

2.       India’s “subprime”: The last few years have seen an explosive growth in credit in the Indian economy. The fact that credit has played an important role is evident from the release of a new movie “EMI”.  Low interest rates in the earlier part of the decade has led to increase in car loans, housing loans, credit card spending etc., but the increase in interest rates over the last few years has led to shrinking disposable incomes. With the slowdown in service sector space, defaults are expected to increase going forward. The recent RBI report has given a hint in this direction. Credit card receivables have risen by huge margin as compared to last year.  Even if the defaults do not increase, low disposable incomes might reduce discretionary spending.

3.       Lack of acceptance of problem:  If you see the views of the people on TV, you may hear many terms like bear cartel, FII sell off, conspiracy theories. Most of the people who are airing these views were the ones who were hankering about the all the defunct theories to justify the sky high valuations seen in the markets. Everyone is happy when the markets go sky high, but the moment they start going in the other direction everyone tries to stop it. The earlier they realize that the world is going through a phase of deleveraging which is leading to this sell off, the better to them. We need to be discussing the impact of this and the ways to reenergize the economy rather than wasting time trying to find conspiracy theories.

4.       Lack of bandwidth with the Government: One standard way of getting out the mess generally has been to increase spending by the government. With the government facing both a current account deficit and fiscal deficit, it has to been seen how far the government will go with increasing fiscal deficits.

5.       Increasing protectionism: Slowdown among all the world economies and increasing unemployment in these countries might lead to a strong wave of protectionism. Offshoring might be hit due to these measures, further reducing our service sector growth. The shot of this happening is long shot but still such a concern exists. 

Paths of Recovery

Now that we are in an economic crisis is official,let us have a look at the probable paths of recovery the economy might take,I am able to think of two possible paths that the economy might take,

1. De- Leveraging: Out of the two, this would be the most painful and the one that would delay the recovery.  One prime difference between 2001 and the current crisis in India would primarily in the amount of leverage in  the economy during these periods.  Leverage as a concept has grown quite strongly in India over the last 3- 4 years. Most of the households in India have used leverage in building up assets(like houses) and buying goods (like cars). Going forward, most employees in the service sector primarily would see either a fall in their incomes or jobs. For this set ,which has been the major beneficiary of the boom of 2003-07 ,current crisis would be the first major crisis which threatens their livelihood. Any de-leveraging being done by this set in terms of curtailed credit spending would mean a delayed recovery for the economy till everyone builds up a sufficient equity base to fund their purchases. For the economy to take this path, the scars left by the crisis should be strong enough on the people. Or the government/ society makes saving a virtue once again.

But are there any economies which have not seen build up of leverage in the last few years. The winners,  if the economy takes this path, would be the countries which have high savings and limited debt. They would be able to reverse the process quickly and at minimal pain.

2.       Another bubble: If the government wants to increase the growth at any cost, then it may lay the foundations for another bubble. Most of the governments and articles always treat recession as something that has to be avoided at all costs. This might lead to discouragement of the De- leveraging process. In the short term it might be beneficial but it would make it even more difficult to get out of the addiction to leverage, similar to a drug addiction.

Practically the end result should be a mix of these, but do you think is there a third path that I have overlooked?