The Big Balance Sheet Economy

Decoupling is Bunk, But is there a way to make money of the idea

2009-06-05T13:03:00.000-07:00

The thoroughly discredited decoupling meme is back. Felix Salmon does a good job of fisking it.

Emerging-market stocks are high-beta assets, and in times of general volatility, as we’ve seen over the past couple of years, they exhibit really high volatility. You need a strong stomach to invest in them, and you’re likely to get whipsawed quite a lot. But as a result, trying to extrapolate a big-picture global macroeconomic forecast from a relatively short-term movement in emerging-market stock indices is a fool’s game. I don’t think that EM stocks have ever been good forecasters of anything; there’s certainly no reason to believe they’re demonstrating something in particular right now.

Decoupling is what happened in the 1990s, when US equities soared as the emerging markets (and Japan) tanked. Between January 1994 and December 2000, MSCI Emerging markets index (ETF: EEM) returned -6.6%, annualized. During the same period, the S&P returned 18.25%, average annualized! That is decoupling! Needless to say, the US is a large economy with a large domestic economic and financial base. It can withstand, even thrive, amid collapsing Asian economies. That is not the case with emerging markets today. The US is still large in relation to the world economy and the EMs are not big enough yet.

However, from Jan. 2001, emerging markets have returned 10.5%, annualized, whereas the S&P 500 has posted a -3.1% loss, annualized. That is a huge outperformance. This despite, the horrendous 54% collapse in the EM index last year. Yet one could quibble that by picking 2001, we are comparing S&P at its worst overvaluation to EMs at their relative low valuation point. There is probably some truth to that. If however, we want to shorten the time frame, then we also need to adjust the portfolio size for relative volatilities. EM volatility (historical) is about 1.5 to 2 times (depending on the time frame and time period of analysis) that of S&P. So, let us see how EEM compared with SSO (double long S&P).

Essentially, if you had gone long EEM and short SSO, you would have cleaned up! Especially in 2008! This after the emerging markets had a blow off top in 2007. Amazingly, during the S&P's latest bull phase, the trade would have underperformed, although not something that a normal investor cannot bear. Another point to note: emerging markets bottomed in November and never went below that (although individual EMs, such as Russia did). whereas the S&P broke decisively below its November low in March 2009. So, decoupling is bunk, but there might be some germ of an idea there that needs development. In any case, you can make money off it. I think that S&P has a tremendous down leg from here. If you don't have the stomach to play it straight. You could hedge it with EM longs. Who knows, it might turn out to be a Texas hedge--make money on both sides of the trade!

Inflation, Schminflation; the 10-year is a steal; Fed on hold till 2011

2009-05-30T15:10:00.000-07:00

Warning--long post. Bottomline: inflation is headed down for the next 12-18 months at least. The Fed won't raise until 2011, possibly 2012, and that too only if the sanguine economic outcome obtains. The 10-year US treasury is a screaming buy. You can play it through IEF, TLT, options on them.

No sooner have the stock markets rallied, inflation-hawks, hyperinflationistas, so-called bond vigilantes have come out of their foxholes in full force. The long end of the yield curve has sold sharply, the 10-year yield up from its low of 2.07% earlier this year to a high of 3.7% a few days back. The usual arguments-- "we are printing money up the wazoo," "US federal debt burden is unsustainable," Chinese don't want to hold Treasuries,"--are back in full force. Of course, no one really bothers to explain how we are actually going to get to high inflation from the current deflationary environment. Printing money, running deficits are axiomatically supposed to create inflation, if not today, definitely someday in the indefinite future. Never mind that printing money and running deficits for a long, a very long time, has not exactly been very successful in creating inflation in Japan, let alone hyperinflation.

Anyway, since we are interested in the mechanisms of inflation and not content with axiomatic assertions, I will explain why a rising inflation trend is far away. First, there cannot be any sustained rise in inflation without a sustained increase in inflation in nominal wages. Unit labor costs are the dominant influence on inflation in the long run (see chart below).

Low labor cost inflation is the main reason why headline inflation has been relatively low even when commodity prices were zooming in 2007-2008, unlike what happened in the 1970s and early 1980s. Take a look the following chart of PPI (producer price index) broken up by stage of processing. Crude goods inflation has been almost as high as in the mid 1970s reflecting commodity price rises, whereas in finished goods, where the labor input is predominant, inflation did not rise as much as back then.

Now, let us look at compensation inflation, which is the main driver of unit labor costs (productivity is important at low levels of inflation, but if we are talking about raging inflation, changes in productivity are insignificant). The ECI, published by the Bureau of Labor Statistics (BLS) is the most comprehensive measure of compensation costs. It is broken into wages and benefits. I show below wages and total compensation.

Unfortunately, the series gos back only to 1976. Nonetheless, the basic point is clear. Compensation inflation is low and declining. Of course, rising unemployment rate is putting immense downward pressure on wages. Back in the 1970s, even with high unemployment, was inflation remained at high levels and did not start coming down until Volcker jacked up interest rates to 20%, creating what was then the worst recession in the postwar era. Higher levels of unionization, oligopolistic industries, and limited global competition meant that workers could ask for and get pay raises to compensate for inflation, thus sustaining the wage-price spiral. Fat chance of that happening today. Also, the overall unemployment rate covers up a major distinction between the 1970s--a distinction that goes to the heart of why workers had more bargaining power back then. Take a look at the unemployment rate of men over 25.

Compared with the 1970s, the unemployment rate of men over the age of 25 is much worse today. The overall, unemployment rate in the 1970s was driven by a huge increase in the labor force--thanks to baby boomers and an increase in the participation rate of women. The economy actually created a huge number of jobs but was overwhelmed by the increase in supply. Unemployment was disproportionately concentrated in the recent entrants. Older, experienced workers had more stability and thus greater bargaining power. That is certainly not the case today. Today's situation, like the early 1980s, suggests a steep decline in wage inflation (see the ECI chart). Given where it is starting from, outright deflation wages is very likely.

Lastly, if you look at the chart of ECI, which plotted along with the unemployment rate, you can see that to get wage inflation trending up again, the unemployment rate probably needs to come down to 5 percent or lower range. The unemployment rate today is at 8.9% and rising sharply. After the last recession, it took about 2 and a half years after the official business cycle trough (November 2001) for the economy to start adding jobs. The Fed started to hike rates only after that. And this was in the midst of a housing bubble. We may well not see job growth before 2011. Even if we do, it will take much longer to get the unemployment rate down a number that is see as politically acceptable and potentially inflationary down the line. Yet, the market has convinced itself that inflation is just around the corner.

Notes on India's Elections

2009-05-17T06:00:00.000-07:00

I am an economist and usually don't comment on politics. However, remember that economics started as political economy.

The results of the recently concluded elections have shocked some and thrown the supporters of BJP into despondency. In despair, the wrong lessons are being learned and (foisted upon by those who would like the BJP disappear). Here are my quick thoughts:

Let me start with the positives first (positive reinforcement and all that!). The Left has been decimated. As that astute sage Rajaji said long back, the communists are the number 1 enemy. Growing up in Calcutta in the 1970s and 1980s, I remember how the left used to rail against dynastic politics. Back then the Congress was the enemy number 1 for the left. It is amazing how the Left was willing to support the same dynastic Congress to tackle the current perceived enemy number 1--the BJP. The frog made a deal with the snake. Well now, the snake is reaching out to your own family member. The Left got a shellacking in its impregnable Bengal bastion. Actually the Bengal results point to a broader pattern (more on that later). The left lost all the border states except Cooch Behar. Now, those are incidentally the states that have the highest Muslim presence. Essentially, the Left has been left holding the Bengali Hindu votes. Nandigram was ostensibly the trigger behind the Muslim desertion of the Left. But somehow I doubt that. Those votes are not coming back. There is a lesson in this for the Bengali Hindu bhadralok as well.
The BJP did NOT lose because of Varun or Modi. On Modi, the last time I checked , the BJP won 15 seats out of 26, more than it did in 2004. BTW, Gujarat has been heavily hit by the global recession--diamond cutting in Surat, textile exports. So, some loss was expected. But Modi held ground. In fact, the BJP did well in all its bastions where there was no infighting. If people are put off by polarization, then BJP should have lost in Karnataka. BJP's loss in Rajasthan reflects infighting as well its Achilles heel--the problem of caste. The Gujjar reservation fiasco is still fresh. In UP, the BJP has no leader worth his salt. MM Joshi, Rajnath Singh are all washed up old geezers. Actually Varun's success amid this ruin, points to the potential for Hindu consolidation.
Mayawati and Mulayam did not exactly get wiped out. But like the Left in Bengal they lost the Muslim vote. Muslims recognize that Congress is now their best bulwark. From mayawati's statement it appears that she is still trying woo Muslims back. it may work at the state level. However, it will not work at the national level. The OBC-muslim alliance is not workable going forward. OBCs have been the rising force. They are an upwardly mobile group, seeking to assert their place in the sun. Muslims essentially act out of a defensive mindset (in some ways like the Left). With the Brahmin-Bania no longer in power, the OBCs in the North have nothing against Hindutva per se. In fact, most of the ascendant BJP leaders in the North are from OBC background (Swapan Dasgupta has made the point that BJP is now an OBC party). In that sense, the recent elections were a setback to the rising OBC aspirations. Narendra Modi is an OBC. Kalyan Singh is an OBC. BJPs future lies with the OBC.
BJP should quit trying to woo the mythical urban middle class that somehow can't stand Varun's polarizing remarks. The urban middle class did not come out to vote. The turnout in Bombay was shameful. if after 26/11, BJP can't win in Bombay, it will NEVER win in Bombay.
Just as with the Republicans in the US, the minorities will NEVER vote for BJP. In fact, they actively set aside their difference to vote against the BJP--Exhibit Kanyakumari. I have always suspected that there are many more Christians (especially in TN) than the official 2% figures. I distinctly remember having classmates in IITM who were christians but availed of the SC quota (which legally is not available to Dalit Christians). I think the entire 22;5% SC+ST will eventually become Christians --too much global and domestic money working toward that goal. This has clearly had some effect in Tamil Nadu, Andhra and Orissa. Like the Left in Bengal, Laloo in Bihar, Mulayam and Behenji in UP, the Dravidianist Tamils (non-Christian ones) are eventually going to get their comeuppance. Their brethren in Sri Lanka were left to hang dry by a DMK that did nothing and yet was never punished. The wily coot Karunanidhi played this game well tactically but this may turn out to be the beginning of the end of the middle caste hegemony in Tamil Nadu.
The industry seems to be relieved that the Congress will now not have the Left holding back on reforms. This is poppycock. The Congress under the Gandhis has never been for reforms. For the record Manmohan Singh is a puppet and was always a puppet. Manmohan Singh the reformer title was gained under Rao, who was the reformer behind the facade. Manmohan Singh was the apolitical face put on reforms. The Congress inherited a sound economic foundation in 2004 and the global economy was soaring for the next four years. That papered over atrocious economic policy (save the exemplary job done by the RBI under sagacious YV Reddy). The fiscal deficit is now soaring and for a developing country, India has one of the highest debt-to GDP ratios. India is turning Latin America when Brazil and Mexico are decidedly turning their back to the failed policies of the past. Nonetheless, the immediate future is not bleak. The fall in oil and other commodity prices is a boon for India, which is a net commodity importer. Besides, India, unlike China is driven by domestic demand. The long-term future is however bleak. Argentina's experience is instructive. Argentina was the 6th richest country in the world in 1900. Then it started voting in the Perons (equivalent to the Gandhi family in India). Decades later, it is a middle income country and a pariah in the international financial markets.

Balance Sheet Dynamics

2009-04-07T18:47:00.000-07:00

Paul Krugman recently posted his preliminary thoughts on the 'Balance Sheet Recession,' a meme started by Richard Koo, who wrote a book by the same name about Japan's bust. Krugman writes:

"As I see it, the balance sheet recession approach to the business cycle is a close cousin to a once-influential but largely forgotten literature: the “non-linear” theory of the business cycle. The original version, by John Hicks (”A contribution to the theory of the trade cycle”), set up the basics. The idea was that in the short run the economy is unstable: an economic boom causes rising investment spending, which further feeds the boom, and so on, while a slump depresses investment spending, deepening the slump, etc.. Hicks’s big contribution was to add limits to the boom and slump: a “ceiling” set by the economy’s capacity, a “floor” set by the fact that investment can’t go negative.

....What Koo is arguing for is something similar, but with debt playing the role played by capacity in the old trade cycle. When the economy is growing, taking on more debt seems OK, and rising debt feeds rising spending, which feeds the boom. Eventually growth has to slow, however, and the debt starts to drag down spending, which reduces income, forcing more deleveraging, and so on to the floor. Then debt slowly gets paid down, until the cycle is ready to start again."

I think this is an incomplete picture of balance sheet dynamics. It ignores the asset side altogether and the positive feedback loops between assets, debt, and demand. Here is my simple schematic representation (I have a more complex representation that takes into account physical capacity and investment, but I leave it for later):
I have represented here the cycle when it is virtuous--asset prices, debt, and demand are all rising and reinforcing each other. Rising leverage allows asset prices to be bid up and fuels demand as well. Rising asset prices in turn fuel demand through wealth effects and also by facilitating borrowing against collateral (think of mortgage refinancing). Rising demand rationalizes rising asset valuations and generates the cash flow needed to justify rising leverage. However, well before the last stages of the virtuous cycle (bubble mania), demand, income, and cash flows have started to fall behind asset prices and debt. In other words, balance sheets have started to outpace the real side of the economy. In the last stage, that is the bubble stage, debt is increasingly fueled toward asset speculation, incomes have started to stagnate and demand is propped up by leverage. When this increasingly unstable arrangement starts to unravel, the big balance sheet dynamics start to go into reverse. What was a virtuous cycle now becomes a vicious downward spiral--falling demand and incomes causing debt service problems, which in turn leads to falling credit, leading to falling asset prices and so on. We are in the vicious cycle right now. Balance sheets are still too big in relation to the real economy.

I have developed my framework and ideas by building on Minsky's financial Keynesianism (more on that later) and marrying it with John Sterman's systems dynamics models. I will explain my framework in more detail in future posts.

The Myth About Foreigners Financing America

2009-04-03T13:07:00.000-07:00

Like the proverbial sky falling on the head fear, the financial community is perennially worried that foreigners will stop financing America's current account deficit--specifically, that they will stop buying Treasury debt and start selling it. The events of the past ten months should have put such thoughts to rest, but alas. Amid America's gravest financial crisis since the Depression, investors globally have actually flocked to the dollar and Treasuries with great gusto.

People think of 'our dependence on foreigner investors' as if America were perched on a high tree trunk and foreign investors were armed with saws, ready to cutoff the limb. The analogy is not bad, except that it has the actors switched. The question is not, "What will happen to us if foreigners stop buying our debt?" but, "What will happen to other countries if they can no longer sell us their goods?"

Two fallacies underlie the worry that we will be abandoned by foreign investors. The first is that foreigners somehow bring money to our markets that otherwise would not be there, and the second is that they can make money disappear from our economy. Last time I checked, Treasury debt was denominated in dollars, and the United States was obligated to make interest and principal payments in dollars. I also note that the Federal Reserve, not international investors, determines the US money supply. Only if foreigners actions made the Fed compelled to support the dollar through higher interest rates would domestic credit conditions tighten.

Foreign investors can affect currency markets, but they can only frighten or briefly disrupt the Treasury market. Suppose a foreign investor becomes fed up with financing America's debts, so he sells all his US government bonds and converts the proceeds to euro, yen, or gold. Unless he does business with Houdini, the dollars do not disappear or magically turn into gold, yen , or euro. Now someone else owns the dollars and what will they do with them? Dollars pulled out of the US asset markets by foreigners wishing to repatriate do no vanish but instead keep flowing back to the same markets.

Widespread selling of dollar denominated assets could put great pressure on the dollar's exchange rate. Although the supply of dollars is not changed, the bond market could sell off because it believes that the weak dollar will cause inflation, forcing the Fed to tighten. But these are effects on perception. To be sure, such misplaced perceptions could cause momentary turmoil in the bond market, but economic reality would soon bring it back to balance.

A drop in the US dollar would have little effect on US inflation (certainly not in the current environment of massive slack in global capacity). The influence of exchange rates on import prices has waned in recent times. US consumers pricing power has become increasingly dominant and overcapacity has created chronic buyers' markets, which was not the case in the 1970s.

Which brings us to the bigger question. Who is dependent on whom? The precipitous decline in global economic activity in the past six months, especially in China, and the rally in Treasury bonds reveal how much the global economy is dependent on US demand rather than how much US is dependent on foreigners for financing. China (or for that matter anyone else) is not buying Treasury securities out of munificence. Nor is their buying of Treasury securities 'financing' anything. Rather China acquires dollars when it agrees to accept dollars are payment for goods it sells in the US. How it allocated the thus acquired dollars to various dollar-denominated assets is a portfolio choice not a financing decision. Of course, China could decide not to accept dollars as payment for goods. But then where are they going to sell their goods to keep their factories running and, more importantly, keep their vast population gainfully employed? As long as the rest of the world has not figured out a way to generate domestic demand sufficient to keep its domestic supply gainfully employed, the world will remain dependent on the US consumer as the buyer of last resort.

Quick Recovery? No; Great Depression Act II? Nyet

2009-03-26T10:31:00.000-07:00

Those who cannot remember the past are condemned to repeat it.--George Santayana

History does not repeat, but it rhymes.--Mark Twain

After ignoring history for far too long, it seems that financial market participants are learning the wrong lessons from it. Great Depression Act II, Japan lost decade (or two decades) are the templates currently in vogue. While there is no sugarcoating the economic outlook over the next year, the bright side is that the US and the world economies are NOT likely to experience a repeat of the Depression nor of Japan. Policymakers have learned their lessons from the 1930s and the Japan in 1990s. Policymakers around the world, in particular the Fed and the Treasury, recognizing the gravity of the situation have already displayed a willingness to massively and creatively use government balance sheets to cushion the transition. Fed and Treasury actions (and actions by the respetive authorities in the case of UK as well) have been far, far more aggresive and quick than Japan in 1990s, let alone the US in the 1930s. Consider some of the differences with Japan:

Japan's bubble burst in 1990 and the Bank of Japan did not lower overnight borrowing rates to below 3% until 1993. Rates were lowered to zero only in 1999! The Fed got to practically zero in less than a year in contrast!
Japan's government was running a surplus until 1992 and the deficit was 2% of GDP in 1993, a swing of 3 percentage points from 1992 and 4 percentage points from 1990. In contrast, the US federal government deficit is projected to be a whopping 12.1% of GDP in 2009 (CBO estimate) , a massive swing of nearly 9 percentage points from 2008!

Now, one can argue about the long run consequences of these measures (and I will go into that in posts), there is little doubt that that kind of stimulus is bound to have positive short-run effects. The stimulus naysayers will point to the still weak economy and stock markets and argue that the measures are ineffective. But that argument assumes that things would be no worse without the stimulus. The real benchmark for assessing the efficacy of the stimulus is unfortunately a counterfactual--how would things be if we did nothing. We simply do not know for sure. Economics is not a pure science like physics or chemistry--we cannot run controlled experiments to generate counterfactual scenarios. We have to live with uncertainty in estimates. The reality is that we did nothing during the 1930s (actually, that is not literally true, but by today's standard, nothing is close enough) and Japan did a lot but not enough and not quickly enough (recall that homily about a stitch in time). Using those as rough (very rough) guides, it is fair to say that US will experience a crisis that is less severe than the Depression and less prolonged than Japan's stagnation. Unfortunately, that may not be good enough for those expecting a return to the boom times.

The World is Free Riding on the Back of the American Taxpayer

2009-03-23T18:46:00.000-07:00

Forty years ago Charles De Gaulle railed against the unfair gains that accrued to the US from dollar's hegemony and today an UN panel egged by Russians and Chinese is egging the world to move away from dollar as the reserve currency. It is ironic that this development is happening even as European banks have received billions from the Fed via AIG. That is the Fed has been subsidizing European governments effectively. It is not clear at all that the ordinary US taxpayer benefits much from the dollar's reserve status. If anything, the dollar's reserve status most likely visits some version of the Dutch disease on the average American worker, who has seen tardy improvement in living standards and considerably more career and income insecurity over the past two decades. I won't digress into that topic now. I want to focus on the free riding the rest of the world does.

The ECB and the Eurozone gets kudos from perennial hyperinflationistas and the usual American baiters who would like to see the US fall hard. But if the Fed took a leaf out of the ECB's book and the Federal government followed the European governments, then the world economy would be in a deepening crisis (not that it is out of the woods now by any stretch of imagination). And judging by the developments of the last two quarters, the rest of the world would have been considerably worse than the US. After all Japan, Korea, Germany among others have seen their activity fall off a cliff and at a much faster pace than the US. However, the moment the US succeeds in injecting a sense of stability, the dollar tanks, world equities outpace US stocks, and everybody gets to lecture the US on the crappy outlook for the dollar. While the US taxpayer is carrying the full burden of the stabilizing, they will capture only a small fraction of the upside (I know, I know, the US holds risky foreign assets, which will appreciate more in a stable world than safe dollar assets held by foreigners). Seems like a bad trade to me.