Municipal Bonds and Fareed Zakaria

Two things I want to talk about in this blog - about a recent meltdown of municipal bonds prediction by Meredith Whitney (http://seekingalpha.com/article/243169-why-you-should-listen-to-meredith-whitney-s-municipal-bond-default-thesis?source=yahoo) and Fareed's TV interview with a bunch of CEOs on christmas day.

Meredith Whitney predicts a wave of municipal bond defaults that is about to hit the US municipal bonds. She thinks it will probably in the order of $100 to $150 billion. Again she argues based on the sagging revenue base of municipalities and their big pension obligations. But she doesn't take us thru a picture how exactly the municipalities would default. The recent experience of Vallejo,CA and Harrisburg, PA have provided a picture of how difficult, costly and messy it is to default. It is not like a homeowner defaulting on his/her home payments and the creditor can come in to foreclose and auction the property to the higher bidder. and also it is not a like a company that can be either taken over by a new management (after shedding liabilities in a bankruptcy court) or completely folded down in a organized sale of assets. A municipality is a local government entity that is there to provide services to its residents and it can't be liquidated. It is a non-profit entity. The reason they issue bonds is that they have to raise money to undertake big capital projects (like school buildings, sewer, water treatment etc) and they can pay the bondholders over a period of say 10 or 20 years thru assessing property taxes and local sales taxes. The municipalities are in a tough situation right now because their revenues are not enough to pay the annual bond payments plus the other obligations of the municipality (like salaries, pension payments, healthcare premiums, services maintenance etc. ). The economic slow down has affected their revenue base. Defaulting or renegotiating the bond payments is not easy. They have to go thru a court process to do this and it takes money to pay lawyers. The other big issue is that if a municipality does do the default, it will have a hard time raising money next time at good rates. Defaulting doesn't solve any problems for a municipality and it is much better for them to raise taxes or get support from the State govt. Which is why I believe that this wave of municipal defaults will not happen and I am slowly investing in municipal bonds (have a position in AKP that now pays 7.2% tax free yield). The bonds may go down because of default fear and I see it as a good investing opportunity to pick up some yields for the portfolio.

The other issue I want to talk about is the interview of Fareed Zakaria with some CEOs on christmas day on CNN. At the end of the interview, Fareed gave his view on why the US is stuck in this slowdown and high unemployment. His take was that our economy is powered by 70% consumer consumption and we are not investing much in the economy. We need to invest a lot more in R&D and other infrastructure. GDP of an economy powered by 70% consumption is not in and of itself a bad thing. This happens in mature economies where the need to build roads, electric grids is not that great as in developing economies. When consumer consumption is only say 40% of the economic activity, the other 60% is coming from infrastructure investments and net exports. Infrastructure investments like road building is an economic exchange between businesses and the govt and so is not part of end consumer consumption. and yes, the exports driven economy require less internal consumer consumption but as I have said before, all countries in the world cannot run a net export surplus. For long-run growth, we have to improve the skills of our people and that requires a cultural change among the population to see the importance of a high school and graduate education. It is not just building more schools and more universities - the population has to be coaxed to believe that education is a must for living. It is more the soft campaign and marketing stuff. A 70% consumption driven economy is not the problem that is dogging our economy - it is the lack of skills among the population compared to the world that is dogging it. Globalization has allowed Companies to shop around the world for the skills and that has made life a lot more difficult - the competition is not regional but global now.

Should the Fed buy more bonds or not

There were two interesting articles on Barrons this weekend - one arguing for why the Fed should shop till it drops and the other on Lessons of History about hyperinflation due to excessive borrowing. John Hatzius of Goldman Sachs argues that a relatively large percentage gain in the growth of the economy (or GDP) is required to induce a decline in the unemployment rate (Okun's Law). Quantitative easing can release the animal spirits to get the economy going again (even if it is a blunt instrument right now). For him, deflation is a much bigger threat than inflation. On the other side, Victor Sperandeo asks if a nation financing 50% of its budget expenditures in the debt market grow itself out of a collapse? He has some good data. US govt debt is now over $13.7 trillion (not including state's debt of $2.8 trillion and agencies debt of $3.0 trillion). The average rollover period for the debt is 49 months. With recent deficits running over $1 trillion a year, the Treasury issues new debt and refunds old debt at a rate of about $4.3 trillion a year. He thinks investors in US debt will begin something similar to a run on the bank, selling Treasuries, even at severe losses. The break point occurs when a government borrows an amount equal to 40% of its expenditures over an extended period of time. and when this happens, it triggers a hyperinflationary spiral. He uses the example of Zimbabwe currently and France in 1790s as an example. The US still owes most of its debt to its own citizens.

Both these guys just use numbers to justify their stance without looking at the productive capacity of the US economy. Why did Zimbabwe get into hyperinflationary situation - nobody wanted to trade with them anymore and they had killed their agricultural economy due to the land seizure program. The agricultural products and mining products was what Zimbabwe used to trade with the outside world to get other things that they couldn't make internally. Hyperinflation is more a result of losing productivity rather than just printing more money. As I have mentioned in my previous blogs, china is buying US Treasuries not to earn a good return but they have no other avenue to put the dollars to work. Yes, they can buy assets around the world but buying assets in other countries (including the US) is not easy and buying a physical asset requires active management. China could stop trading with us to reduce the flow of dollars to it and it would be more bad to China than the US. Feds buying US Treasuries is not going to trigger inflation unless the banks lend the money and the consumers trigger a demand greater than the installed capacity. The unions at manufacturing companies have a lot less leverage these days to demand big pay raises.

What are the avenues an investor has in putting saved money to work - buy into the stock market or the bond market around the world. If the economy is not growing, then the stock market is not going to give a decent return. Then the main avenue to put the money to work for a greater than zero return is to invest in govt securities and the US Treasuries still offer more protection than other govt securities around the world. If the economy did grow, then the deficit issue of the US govt will get solved and so does the unemployment issue.

Monopoly power on the producer side

I didn't know how to frame this title but still want to capture my thoughts about recent changes we see in monopolistic behaviour. The govt has usually looked at the monopolies in industries serving the consumers and they use a HHI index to assess the competitiveness of an industry and approve/disapprove mergers based on the projected HHI index after the merger. Monopolies are bad because they hold too much market share, have high pricing power and can stifle innovation in their industries because of their power. Compared to a competitive industry, a Monopoly would produce less of a product and charge a higher price for the product. and we break up Monopolies to make the industry more competitive. Basic Microecon classes at universities teaches us all this. This is not the point of my blog.

But Microeconomic theories (atleast the ones I know) have always looked at Monopolies serving the end consumer - like AT&T, Standard Oil, Microsoft etc. but what about those companies that act as monopolies to manufacturing companies - like a Walmart. Walmart almost dictates pricing terms to its suppliers and the suppliers don't have much of a say or choice to go somewhere else to sell their wares. If they don't sell to Walmart, they pretty have to shut down a large portion of their production capacity. This pressure from Walmart then pushes these companies at first to seek efficiencies in production in the US and after that they can only get those costs down by moving to a lower-cost overseas operation. But this causes these companies to lay off employees in the US. So are we increasing unemployment in the country by having these kind of Monopolies like Walmart - they may not be charging a high price to a consumer but extract low prices from their suppliers. Google is another example. They hardly charge anything from a user for e-mail or its search function from a consumer but it has almost 65% of the market share in the search space. They can dictate terms to the companies seeking to advertise on its search pages. I am just raising a question whether Monopolies should strictly be looked at from the point of view of how they behave with a consumer. Is there a potential fallout for an economy by having companies with monopolistic power with their suppliers? What we pay for something is earnings for another. Porters five forces does look at all the sources of power for an industry - should the govt only look improving the bargaining powers of a consumer in a Monopolistic industry - should they also not look at improving the bargaining power of suppliers?

exchange rate wars - continued part 2

Let me get more of my thoughts on this before I get overly influenced by the rightists or leftists views on the QE2. There was an interesting article in Barrons a few weeks back with the title 'Monetary Steroids' by Randall Forsyth. I quote a few sentences from the article. "The trade deficit is a symptom, not the cause of a complex of economic problems. To target a trade deficit is lunatic", Goldman writes on his Inner workings blog at www.atimes.com. "Roberty Mundell shoed in his Nobel Prize-winning work that trade deficits arise from an excess or deficiency of savings in a national economy; if the chinese want to save 50% of GDP, they can only do so by exporting goods, because there aren't sufficient outlets for savings inside China". For the US to increase its savings rate and stop importing goods from Japan and China would mean the US economy would have collapsed, adds Goldman.

I have made this point before in my other blogs - every country in the world can't be net exporters unless we start trading with some outer space aliens. and add to that a corollary, every country can't have a positive savings rate. The desirable equilibrium is to have minor trade deficits/surpluses and average savings rate close to zero. If the chinese or indians have a 40 ro 50% savings rate, it is unsustainable. They can only sustain it by being big net exporters, causing trade frictions and currency exchange rate wars. The govts of the big savings countries need to get their citizens to spend money internally on goods and services. That can be done by providing safety nets like social security, unemployment benefits, universal health care coverage, disability protection etc so that every citizen doesn't see the need to save a big cushion of cash for some unforseen calamity in their life. By saving a big percentage of their income, they are not driving demand for internally produced products and services and so those products & services have to be exported to keep people employed. and these countries initially have a cost advantage to export these goods but then try to sustain the same export advantage using currency manipulation. The country that is losing jobs because of this will retaliate - one tool of easy retaliation is to try to devalue their own currency, which is what the US is trying right now. This is not a solution to the problem but just a response to what the other party is doing. will talk about some solutions in my next blog.

Exchange rate wars

Interesting to see a lot of news article in the last few days about exchange rate wars and our Treasury Secretary asking China (without mentioning it by name but alluding to it by referring to big economies) to allow its currency to appreciate against the US dollar. http://http//news.yahoo.com/s/nm/20101006/ts_nm/us_currencies. The House has passed a bill allowing companies to seek compensation for imports from countries with misaligned exchange rates though Senate is yet to vote on it. You just can't write a letter to china asking for a compensation. So it has to be through WTO and I am not sure if WTO has made any past trade judgements based on fairness of exchange rates. This is all posturing by the Congress to show they are doing something. I am not that interested in discussing the politics of the exchange rate war but will try to talk about the fundamentals behind exchange rates. That way, we can have some sane discussion of what these exchange rate policies by different govts all over the world have on our future economic growth.

I have talked in general about exchange rates in some of my posts earlier. A monetary instrument like the dollar, remnimbi, rupee, pound etc itself is our creation. We don't have a universal world currency for trade (even though the US would like to call its dollar as a world currency) within and outside a country's border. Since we are still stuck in the notion of geographical boundaries for an entity called a country, we have different monetary instruments in the different countries. But countries have to trade with the other countries in the world in this global economy and so we get into exchange rates to figure out how much one country's monetary instrument is worth against another country's monetary instrument in the global trade. A balanced trade would have every country importing as much as it exports - they would import and export different things based on their competitive advantage in the global world. The exchange rates, if freely floated, would move up or down to get this balanced trade happen in every country. But this doesn't happen in reality due to a lot of reasons - one primary reason being that every country wants to export more than it imports. It is based on an archaic value system where individual country economies believe in saving money, even though money is just a paper we created to represent a goods or services.

Why do countries want to export more than it imports -it is a much easier economy to manage. When the exports exceed imports, everybody in the economy can save. You are not relying on just internal demand for your goods and services. If you are say an internal economy with no trade with the outside world, there needs to be borrowers and savers to keep the economy running. If some people save and if it is not borrowed, then the economic activity will weaken. Everybody can not save in an internal economy as the economic activity depends on a circle of production and consumption.

Coming back to exchange rate fundamentals, let's discuss it thru an example. Say the only countries in the world are the US and China. The currency in the US is a dollar and the currency in china is a yuan. Assume at the start the exchange rate is 1 US dollar = 7 Yuan. The US buys $1 billion worth of goods from China and China buys Y3.5 billion worth of goods from the US. At the end of the year, US has Y3.5 billion and China has $1 billion. US can not use Yuan internally and China cannot use US$ internally. If they were to swap their currency holds, then the exchange rate would come out to be 1 US dollar = 3.5 Yuan. This would be an outcome of a free floating market for both the currencies., which is very different from the initial exchange rate of 1 US$ = 7 Yuan we started off with. If the purchases of goods and services by china had been higher than the US, we could have had a devaluation of the Yuan too. A country that doesn't produce much but imports a lot of stuff from other countries will suffer exchange rate devaluations as they have very little to offer to the outside world (Zimbabwe is a prime example). But we know the currencies are not freely floated in many of the countries in the world and the central banks control the exchange rates. How does this happen?

If Chinese businesses had $1 billion in currency at the end of the year, the central bank of china will guarantee to convert this $1 billion into Y7 billion. These businesses don't have to go to an exchange market to get their currency converted. They can convert it thru their banks. What about the Y3.5 billion that chinese had bought from the US - they actually didn't buy it using their Yuan but used a portion of the $1 billion to pay the US businesses. So at the end of the year, they will be left with $500 million after paying $s for the goods they bought from the US. This $500 million can be converted at the central bank into Y3.5 billion. Due to this conversion, the chinese economy has the goods it bought from the US as well as an extra Y3.5 billion in the economy. By fixing the exchange rate, the central bank is pushing more local currency in their country and could lead to inflation but not necessarily in the CPI index. Usually leads to increase in property prices but again not a certainty either. The central bank of China then takes this $500 million and lends it to the US govt. by investing in US Treasuries. This way the money that left the US comes back as a loan - this is not a good thing for the US in the long term.

I will explore more of the effects of the exchange rate fix by countries in my next blog.

socialism vs capitalism

The book review section in Barrons last weekend was interesting - one book talked about the failure of market efficiency and why a lot of govt regulation is needed for a capitalistic society. It derided the economists who rely on the market forces to set asset prices. also berated about how trickle down economics doesn't work. The other book, written in the 1890s, talked about the evils of socialism. The evils of socialism was brought forth thru a story of a family and how they experience the force of socialism. The protaganist believes fully in a socialist society. The daughter saves money to buy a home and becomes devastated when the state takes control of all private assets. This book was published much before the soviet or the chinese communist revolutions.

I have an issue when people claim trickle down economics doesn't work. Trickle down economics isn't supposed to work irregardless of what skills the masses have. One has to have the skills that is demanded in the society to benefit from trickle down economics. If rich people want to buy private jet planes, then the company making the jet planes must be able to find the skills in the marketplace associated with the jet plane manufacturing. The people employed in this manufacturing plant will demand some other consumer goods and the firm providing these goods must be able to find people with skills to make that product. and so on it goes. But if I have a skill that is not demanded by the market or have no skills at all, trickle down economics will not work for me. This does not mean that the concept of trickle down economics doesn't work. If all I know is to raise horses and horses are not in demand in the economy or if there are too many people with the same skills compared to the market demand, I will not get gainful employment and will not benefit from the growth of the larger economy.

Can market forces get asset prices right and if they do or don't, what is the consequence of that? I will have to explore this in my later blogs.

Interest rates – raise or lower, do they matter

I saw an article this morning about a few people calling on the Fed to raise interest rates by 2 percentage point. Here is a link to the article.
http://www.bloomberg.com/news/2010-08-22/bernanke-must-raise-benchmark-2-points-in-prescient-rajan-s-latest-warning.html

If you read the article, you will see my yawn on it. You can keep arguing this way or the other and still make sense. This is because these guys talk purely from a monetary point of view and don’t talk about the fundamental hinge of an economy, which is the exchange of goods and services. If all you talk is dollars, interest rates, Fed’s balance sheet etc, you can argue for any monetary policy. Greenspan can argue that the Feds can’t do anything about asset prices but they certainly can do something about the underwriting standards of loans – it is not the low interest rates that fuelled the asset bubble in the US (it may have abetted it) but the asset bubble was created thru NiNa loans and really poor underwriting standards. You can have an asset bubble even in a high interest rate environment if the banks were willing to lend without any proof of income generating capacity.

It is worth asking why even have an interest rate in an economy. Interest rate is needed because the person who has saved money (or who has underconsumed) will not lend the money without seeing value for it – an interest on the loan provides the value. In a large economy, to have an efficient way to lend money, we have institutions called banks to collect deposits and lend money. The bank is the intermediary for us to lend to people who need the money. Why does somebody need to borrow money – because they have to pay for resources now before they can generate a profit. A company can borrow money thru different ways and a bank loan is just one mechanism – equity capital is another.

High interest rates are associated with high inflation. People are willing to borrow at high interest rates because they know they can pay it back with rising prices of their products. If their profit margin is 10% on a sale of $100, it would be $10 of profit. If the profit margin remained the same and the sale price inflated by 10% to $110, the profit will now be $11. So the company has the extra $1to pay a fixed rate loan from last year.

Low interest rates are associated with low inflation. But the interest rates are just responses to an inflationary or deflationary environment. Why does inflation happen – because the people demand more of the products than what can be supplied by the economy. If there is a supply glut, very hard to create inflation.

If you do a zero interest rate, you can theoretically kill the morale of an economy and create zombie banks. In a zero interest rate, nobody wants to lend and so borrowing can't happen (unless the Fed funds the borrowing) but if the borrowing doesn't happen, you could choke new supply coming on line and hopefully that will create an excess demand over supply eventually. But the process to get thru the excess supply will be so excruciating that the govt won't allow it to happen.

Let me talk more on this subject in my next blog.

Supply Destruction

This is the other way to combat deflation I talked about in last blog. If there is an excess capacity in the economy for producing a certain good or services, it will drive down the price being charged for that good or services. Basic microeconomics of supply greater than demand leading to lower prices. and lower average prices of all goods and services in an economy is deflation. In a normal economy, as competitors get more efficient, prices go down, businesses in the lower quartile of operating costs in the industry will shut down when the prices go down below their operating costs. This is a normal economic fundamental and weeds out the inefficient businesses and allocates the resources to more efficient activity. This happens all the time in a competitive economy and is very good for economic growth. The demand for the products is there and the more cost efficient competitor is able to capture a bigger share of the demand by being able to drive down costs and in effect charge lower prices than other competitors.

If the demand for a certain product and services in the economy goes down, that is ok as the human and capital resources could be shifted to other products and services that are high on demand. But what if the demand for all products and services in the economy go down, that creates deflation. Suddenly there is excess capacity in the economy compared to the demand. Companies are cutting jobs just to survive but due to high fixed costs, are willing to cut prices to move products. There are only a few big survivors in any given segment of an industry and they are not willing to shut down to reduce capacity - the govt doesn't want to shut them down and are more prone to bailing them out. This creates deflationary conditions. One prime example is housing industry - there are more homes now than what people need right now. So the supply is greater than demand and the sellers are willing to cut prices just to make a sale. This price cut then affects the value of all the other neighbouring homes.

One way out of this to cause supply destruction. Instead of selling homes at a lower price, the govt or some other body could buy them off and destroy those homes. They may be spending money on buying those homes but they are also taking away future supply from the market, thereby reducing the price fall. akin to a stimulus spending. The problem with this approach is how to implement it. Any way of implementation will be highly unfair to a number of segment of people and that's where it will be conterversial. What price should the govt buy the house at, which houses should the govt buy - it won't be easy. Supply destruction other than thru market forces is very difficult to implement unless nature somehow works to create hurricanes, tornadoes etc nationwide to take supply out of the market but again nature may be taking the wrong supply out of the market, exacerbating the situation.

Negative Interest rates

I had mentioned about some ideas I had to combat deflation and one of the ideas is negative interest rates. The zero interest rate seems to be the floor in interest rates in everybody's mind. Why can't we go lower than that? If we think people aren't spending on goods & services now because they believe that the prices of those goods & services will go down in the future, then a negative interest rate may spur spending now. If the reduction in exchange of goods & services is not due to people's expectation of lower price tomorrow but in general a lower appetite to exchange, then negative interest rates won't help and neither an increased money infusion by the Fed would help. In that case, you need to be thinking of supply destruction to stave off deflation - I will discuss this idea in my later blogs. Negative interest rates may be thrown aside as an impractical one but would the declaration of negative interest rates at the banks spur spending now?

If a consumer is faced with a choice of negative interest rate on his deposits in a bank, he could withdraw all the cash and keep it in a safe besides his bed, he could spend it on goods & services with the thinking it is better to spend than lose value of his savings, he could invest the money in the stock or bond market. Thru this, we may create a business around Cash Safes around the country - where businesses would keep your cash in a safe for a nominal fee/year - this nominal fee/year will be akin to a negative interest rate though but maybe smaller than what the banks would charge. would there be a bank run across the nation because of this? Instead of the retail banks charging negative interest rates, the Feds could charge negative interest rates on excess reserves kept by the banks at the Fed. This is more of a signal by the Fed that it could go negative on interest rates and would the signal itself fuel spending by consumers. kind of opposite to Inflation - in inflation, people buy things now as they expect prices to rise tomorrow and this expectation feeds more inflation. would the expectation of negative interest rates create some psychological behaviour from consumers to buy things now. With negative interest rates at the Fed, the banks then won't keep those excess reserves at the Fed and may feel pressure to lend them out. The mortgage rates may drop further and create some additional refinancing, home buying.

This negative interest rate is just an idea I am throwing out there and I will try to explore it further in my future blogs when I get a chance. I haven't seen this idea being talked about or discussed about in the financial media as one tool to fight deflation. Everybody says that Feds can't go lower than zero on interest rates - is that really true. We may never have had to experiment with going negative on interest rates before but now it is worth talking about and seeing what behaviour it will create in the economy and if it can be another tool for the Fed?

Free Refinancing

There was another news I heard on NPR recently about a proposal by Fannie Mae and Freddie Mac to do a blanket refinancing of all the mortgages they hold in order to reduce the monthly payments of those homeowners. The adminstration is wanting the banks to reduce loan payments to a lot of distressed homeowners and this hasn't happened in practice as refinancing requires paperwork and adhering to the new credit standards set up by the banks (like need to have a certain equity in the home to qualify for the lowest mortgage rates!) and the distressed homeowners won't be able to make it thru the process. So this new idea of blanket refinancing - the homeowners would get a sheet of paper saying that their loans will be modified to the new rates and all they have to do is to sign the paper. This is like giving free money to a certain section of the population and is highly unfair to non-homeowners. This is a selective cash distribution to a group favoured by the adminstration and fails the fairness test of policies in a big way. and I don't know the number of homeowners that would benefit from this. Any MBS security held outside Fannie and Freddie wouldn't be able to go thru this process -that's what I think.

QE2 and Stimulus round 2

Last week, we heard a number of reports on either quantitative easing 2 by the Fed or a call for a new stimulus program by the govt. - one a monetary and the other a fiscal tool to get the economy out of deflationary tendencies. all these people talk about such tools without considering the fundamentals behind the economy's current turmoil. QE2 would mean that the Treasury would buy more Treasury securities to add to it already bloating balance sheet and convert it into monetary units at bank deposits. The idea is that the banks would lend this money into the economy and fuel growth - but the banks already have a trillion dollars that they have kept in fed custody and are not lending out. Why would the banks lend out a new increase in deposits.

The QE2 is a way of printing money to finance the govt deficit - the govt borrows money from the market and issues Treasury securities. The Feds then buy those T securities and give money back in a sense to the initial lenders. Before the Feds bought the Treasury securities, the money was borrowed from one and spent by the other. With the Fed buyout, the govt has essentially gotten free money from the printing press of the Feds. A continual QE2 with deficit spending would steadily increase money supply and so should fuel inflation. But inflation also requires consumers to spend on things that is in short supply and must be able to borrow to spend the money. In an economy with bank lending controlled by the govt., this can be done by doling out free money to the consumers or a select section of the population and this happens in a lot of countries. The free money is then used to demand a lot of products and services, creates a supply shortage and shoots up inflation. But in the US, the banks are not going to lend free money after the mortgage crisis they have gone thru recently. Even with record low interest rates, a lot of people can't qualify for a mortgage loan because it has to be backed by a decent income and down payment - which doesn't exist for a lot of people. All the policy makers should think about the fundamentals of the economy and not just look at the next fiscal or monetary tool. The last monetary tool created the mortgage mess, shot up prices way beyond people's income generating capacity and we are trying all we can to keep it at that high level.

Private Cos profiting from stimulus

I am sort of wandering into another thought in this blog about stimulus rather than discussing the middle ground that I was going to talk about. The govt has extended unemployment benefits now for 99 weeks. The private companies are benefiting heavily from this govt spending on deficit. The private cos are able to layoff the workers but the workers are getting money from the govt to spend on consumer products that these cos are selling. The private cos revenues are being sustained by the govt while they are able to shift the employee cost to the govt, giving them greater margins. The govt is taking on the debts thru deficit spending and those debts are shifting to the private cos balance sheet as cash. The govt's debts are ultimately the citizen's responsibility - it will have to get paid thru higher taxes or higher inflation. The deficit spending may be a stealth way of moving wealth to the coffers of the private cos - controlled by a small group of shareholders. Which is why the govt should increase taxes to spend on unemployment benefits rather than use deficit spending. Why shouldn't private cos and employed citizens not pay for the unemployment benefits. A society needs to create jobs for everybody and if it can't, then it must support the unemployed to become employed. I suspect the deficit spending is unfairly shifting wealth to the rich and may not be right just because of that.

More stimulus or not?

There are two camps out there in the economic world on ideas of how to get out of this recession. Krugman says that we have to keep spending more stimulus, throw the kitchen at it until the economy rebounds. The other camp talks about allowing deflation to occur, get all the excesses out of it, let it bleed until it reaches its new equilibrium and then the economy can have a fresh start to growing again. Both the camps focus on the fiscal and monetary policies of the economy without actually talking aboout the fundamentals of economic activity. As I have said before, money is just a proxy for economic activity and it can't be used to explain or correct everything about the economy. The economy is hinged on exchange of goods and services and an economy grows if this is exchange happens at a faster pace due to productivity increases.

By providing more stimulus, you could temporarily goose up the economy. Govt spending is never targeted at value-adding work but rather based on politically motivated allocations. no NPV valuation is done on govt spending and so it is unlikely that govt spending will give a sustainable boost to the economy - mostly it will be short-term boost. The other argument about letting the economy fall is not a good option either. Modern economy runs on optimism and entrepreneurship and you don't want to kill that spirit by going into serious deflation. The good option is somewhere in the middle of both Krugman and the deflationists. I will discuss the options out there more in my next blog.

Interest rate in Credit

A drop in an interest rate is like giving free money to a person who has borrowed in the past. It is somewhat of taking excess resource from the savers and giving it to the spenders. The savers and spenders must be in balance to utilize all the resource in an economy efficiently. but I can only charge interest if there is competition to get at my excess resource.

Going back to the farmer - machine model, I am going to borrow 5 bushels of wheat/year for 2 years if only I can sell the machine to the farmers for atleast 10 bushels - the machine takes 2 years to build and costs 10 bushels to build. If I need to pay interest on the borrowing, I need to sell it higher than 10 bushels. The 10 farmers are going to pay 10 bushels or higher only if the machine can increase their production by 5 bushels/year or more, assuming a 2-year machine life. This circle will keep going at higher interest rate as long as the machines are being improved to increase productivity. Once the productivity stops, the interest rate would go down to zero. At zero interest rates, things could break down as there would become a deadlock between farmers and machinists, leading to a downward trend in productivity.

How does population increase feature in this - say economy adds 1 extra worker per year. There is need to feed the extra worker but the extra worker can also work. GDP will be measured by how many bushels are being exchanged every year. Does the extra worker's increase in goods exchange translate to better living conditions than in the past - could lead to downward standard of living or upward depending on the skill base the person brings. the economy will benefit if the extra person is helpful in increasing the productivity.

What is Credit?

What is credit in the fundamental sense? I want to build a house and to do that, I have to pay now for the resources used to build the house but I will earn enough only in say 20 or 30 years. There is a farmer with excess wheat production. He could lend it to you now for paying later in instalments. You borrow the wheat and give it to the people who will build your house. Everybody benefits in this game as the farmer would have thrown away his excess wheat without somebody borrowing it and giving it to the people needing the wheat. Instead of one farmer, this could be a bunch of farmers pooling their excess production to lend it. They would rather lend it than just give it away for free to some needy poor people. By my borrowing, I employ the needy poor people to build a house for me and earn the wheat that way. This borrowing has now created new assets in the economy compared to the option of just giving away the wheat for free to the poor. This borrowing doesn't create inflation in the economy as there is enough supply to satisfy the demand. and good assets are being built with excess savings.

If there are excess resources in the economy, you want to grand credit to people to use those resources. credit tries to soak up the excess resources to build new assets for the economy. granting credit is not easy - have to avoid the moral hazard. If credit is not given with strings attached, it won't be used to build assets. asset building is very essential to an economy to raise the standard of living. If I get a $ for free,, I could just use it to pay somebody to massage my body. I don't have the pressure to use the $ to build something that will increase my earnings power. This is where collateral comes to play in credit granting.

What are assets doing to us - making life easier for us. With an asset called a house, we don't have to keep looking for a cave every night to sleep in or be afraid to sleep the night in fear of dangerous animals hurting us. Same thing goes for roads - helps us get from X to Y faster and comfortably.

Asset price increase?

How does an asset increase in price? If the needed resources will cost more to build the asset, its price will increase. Consider a 10-year life asset. In one year, only 10% of the existing assets will be built but all of the 100% assets will increase in price in anticipation of the future cost of replacing the assets. This is fine except that an asset could be sold today to raise cash from the increasing asset value. In cases of immovable assets like land, its price will increase if the economic activity supported by the land increases in value. If I can sell 10 times more items from a specific location than I did 10 years back, the value of the land will also increase to reflect the increased economic activity. In my next blog post, I will try to analyse credit from a fundamental point of view - let's see how much traction I will get on it. Asset price increase is closely related to credit availaibility as well and is worth analysing it.

Assets in an economy

It has been more than a month since I posted anything on my blog. have to try to keep up the momentum in July. want to discuss assets in general as asset prices get talked a lot in economic viewpoints. Assets support an economic activity, have a longer life, gets consumed over a period of years. machine, building etc - maintenance cost, depreciation a meassure of its annual consumption. Land doesn't get consumed in the same way. improvements to land do have similar characteristics as a machine consumption. Land is limited, land supports other economic activities on it and so value of land is connected to the economic activity supported on it.

What's an asset worth? There are 15 people in the economy - all are currently farmers but we can shift some farmers to become workers to build a machine. Say it takes 2 years to build a new machine using 5 workers and the machine will last for 2 years. say every person normally consumes 1 bushel of wheat/year, and without the machine, they can produce 1 bushel/year. with machine, they can produce 2 bushel/year. They can either use bumper crops or underconsume for 2 years to support the 5 workers for two years to build the machine. Once machine is built, production of wheat doubles, back to normal consumption. What is the value of the machine - 10 bushels as they have to provide 10 bushels in 2 years to get a new machine. Clearly the asset price represents the resources it takes to build the asset currently. The machine build is a win for the economy. Previously with 15 people working the farms, they produced 15 bushels of wheat/year but now with 10 people working the farms with the machine, they can produce 20 bushels of wheat/year.

Savings - part 4

I talked about the savings part going towards value-adding investment projects in my last blog. When we are funding our savings towards investment projects, we are under-consuming in the present to be able to consume better stuff in the future. Take for example road building. It may be a road to connect two villages - tarred roads help us travel the distance between two points faster as it enables automobiles to ply on it in a fast and smooth fashion. We may fund our savings to build roads - the building of a road requires human resources to engineer the road, to build the road-laying machines,dig out the dirt and actually lay the road. The savings used to fund the roads are used to channel the human resources available in the economy towards this effort. Once the road is built, it will lead to more opportunities between the two villages to exchange goods and services and so the savings would earn a return from that road building investment. If the road was a road to nowhere, it wouldn't have much impact to future economic activity and so will not be a good use to savings except for keep some human resources busy during the present to build the road to nowhere.

Coming back to the second use of savings to fund retirement - when we retire, we want to consume without the ability to actually work in the economy. simple enough. How do you fund the retirement years. There are a number of ways. In the olden days, the societal value called for the kids to take care of their old parents. So the parents had to just support themselves, their kids and their old parents during their work life and then depend on the kids to support them when they were old. This is like giving fish to your old parents when you were able to catch it and then expect your kids to give you fish for survival when you are old and no longer able to catch it. works well if the local societal value binds everybody in the society to do this. This is still voluntary but societal pressures will exist to support your old parents. Once people became more mobile and the neighbours didn't know each other much, this system broke down. Then the govt. came to support the cause of the older people. The govt took away a portion of every working person's salary and used it to give a pension (or social security) payment to the older people. This is very similar to the original approach of kids supporting their parents except now the govt had to come in between the kids and the old parents to enforce this support through the use of a tax (though it is not called a tax but a social security funding). The third approach is to start saving on your own every month towards retirement and hope to cash those in the retirement years. It is like putting an extra fish a day in a deep freezer. There is cost to maintain the deep freezer and the deep freezer may fail at some point and all your saved fish could turn rotten. It is much better to loan out the extra fish to somebody out there who can use it to invest in a value producing project. There is risk on this too as the loan may turn sour. Loaning out your saved fish is similar to putting money away in a 401k account that is invested in different companies around the world. These different companies are able to tap into the money to use in value adding project. We now again come back to the concept of using savings to fund value adding projects in the economy. In this scenario, we are under-consuming to consume at a much later point in life. In effect, sometimes we under-consume to consume in a shorter future period or a longer future period, depending on the reason behind our under consumption. But the under-consumption and the resulting savings must be used to fund value adding projects in the economy for us to be able to tap into it for future consumption.

Savings - part 3

On the savings front, I think there are two fundamental types of savings. One type of savings is to use savings to fund new projects that could provide better value to society. The other type of savings is related to saving for retirement - underconsume now to be able to consume in old age when we won't have the ability to work. Let's take Peter Schiff's fish example to develop this thought further. Say there are 10 working people catching fish and another 10 working people making clothes. Everybody needs one fish to survive daily. The fish catchers can catch two fish daily and so they eat one fish and trade the other fish to buy clothes. Everybody would like to put on a new cloth everyday and the clothes making people can make 2 clothes each day and so they use one cloth and trade the other cloth to buy fish. In this simple economy, all the 20 working people eat one fish and put on a new cloth every day. All the people have to walk now to get to the next village and it would be nice if they had a faster mode of transportation. All the 20 people are working now and so don't have any time to devote to other stuff. The fish catchers could decide to underconsume on the cloth and decide to wear them for two days instead of one. Two things happen by this decision - the fish catchers will have an extra 5 fish per day in total due to reduction in trade. This underconsumption will also drop the trade demand for the cloth to 5 per day from 10 per day initially. Five clothes makers can satisfy this demand by working full time - 1 cloth for them and 1 cloth for fishmakers. The other five cloth makers only need to work half-time - just 1 cloth for them. They have the other half a day free and they need to do something to feed themselves. Here is where the fish makers use their fish savings - they would provide 1 fish to each of the 5 half-time clothes makers to work on producing a bicycle. It is a risky project - it could fail without producing a bicycle but if it did succeed, it would free a lot of time for everybody to shuttle between the neighbouring villages and they could trade more with those neighbours who would become more accessible. But the fish makers are using their savings to try to build something better for the society and add value to the societal standard of living. By under-consuming on an existing item, they are able to use their savings to channel resources (the five clothes makers) to work on a new value adding project. This is one of the fundamental use of Savings to drive value. If the 5 clothes makers didn't do much for the loaned fish, the Savings would have gone waste. I will talk about the retirement aspect of savings in my next part of the blog.

Savings - part deux

I was talking to a friend of mine over the weekend after writing the first part on the Savings topic. He was suggesting that we as consumers need to make some sacrifices - meaning consume a little less and save more. I can understand cutting down office drive time, live more closer to the office - by doing that, we are cutting down on oil consumption and doing something good for the environment. Most oil is imported and so would not have a big direct impact on US jobs. maybe live in smaller sq ft homes - again benefits the environment by cutting down usage of natural gas, electricity etc. but how far do you go down this sacrifice path - do you cut down all non-essential consumer things. If so, that will have a direct impact on jobs. If we save more, there should be some capitalist who will be able to borrow that money and produce something that is valuable to society. If all the savings is just going into financing wasteful govt spending, those savings won't have much value to the society as a whole. We have to be careful on the reasons behind asking everybody to save more and under consume. If those savings can't be put to greater use within the society, there won't be any value to those savings. yes, there is a need for people to save some amount of money for an emergency so that they have some time to reach in logical way to some sudden changes in life like job loss, additions to family, sickness, accident etc. But beyond that, there needs to be a real reason for savings. If everybody has to save because they won't get another job for the next 10 years if they lose their current job, then the economy as a whole has failed and no amount of savings is good enough for such scenarios.

There is this argument that people in the US are not saving enough for retirement and so they should start saving more for retirement. but all those savings could be lost in the stock market if the fundamental economy is not strong enough. If it can be shown that some parts of the economy is getting starved of capital because of the current over-consumption trends in a certain other part of the economy (that over-consumption is driving more money and human resources into a wasteful activity), then it is needful to ask people to underconsume in those sectors to allow some more value-adding sector to get more capital allocation and grow.

Savings - to be or not to be

Peter Schiff keeps talking about the importance of savings in an economy. I wiil go thru a few sentences from his book - 'the lender can benefit only if the borrower benefits' - I agree with this concept. 'but like any other resource, savings must be accumulated before it can be lent out', 'it is essential that Able, Baker, and Charlie continue to underconsume and save for a rainy day'. He goes on to say 'It's production that adds the value','Savings creates the capital that allows for the expansion of production. As a result, a dollar saved makes more of a positive economic impact than a dollar spent'. I have a hard time appreciating this view. How can everybody in an economy save? He has already said that there are borrowers and savers in the economy and that the lender (or saver) benefits only if the borrower benefits. There are only certain things we can save for a rainy day - like some stockpile of essential food items to temporarily respond to a natural calamity or a stockpile of oil to have some time to respond to an Arab oil embargo. These are one time stock building for an emergency. Most of economic activity is around exchange of goods and services between human beings. You are not going to underconsume a haircut to save for a rainy day. The savings is not a well understood concept - everybody keeps harping about savings without understanding it clearly.

Robert Reich's NPR commentary 051910

Today Mr. Reich commented about how the hedge fund mgrs make out-sized earnings and somehow that is supposed to be bad. Top hedge fund mgrs probably made $1 billion last year but they took some risky market positions to earn that. and the US govt is not out to bail them if their risky bets turn out sore. The point was about closing a loophole to tax these earnings as ordinary income rather than get the 15% capitals gain treatment - I agree with that point. but then he went to say how that $1 bil could have been used to pay the salary of 25,000 teachers in the US instead of one hedge fund mgr. This $1 bil wouldn't be there unless the hedge fund mgr took the positions he took in the mkt. It is not like the hedge fund mgr hoodwinked school districts or the state govt or the federal govt and made this money by taking it away from them. The hedge fund mgr saw some arbritrage opportunities in the mkt and took positions to profit from it and by doing that made the market more efficient. and the hedge fund mgr will probably either invest the earnings in the market or spend the money buying goods and services in the economy. and the money gets back into the economic cycle again.

Peter Schiff's new book 'how an economy grows and why it crashes'

I just finished reading Peter Schiff's book. Not a lot of economic insights to be gained from that book. gives a very simplfied picture of an economy using fishes and then gripes about the lack of savings in the US. This is a common gripe from many mainstream economists. but they fail to appreciate that there is a glut of savings in the world that we are able to borrow upon. Savings don't have much value if there are no borrowers to borrow it to make some productive economic exchange of goods and services. If Able had a glut of fish to sustain him for say 10 years, he could retire from fishing for 10 years but he won't have any other luxury provided other than his meal of fish food. If he wants to get some service provided by others in the island, he has to lend his extra savings to other borrowers so that they can create other services in the island. There needs to be borrowers for Able to benefit from his fish savings - without that, he will be just a bum on the beach able to survive eating his fish.

In my next blogs, I will try to go thru chapter by chapter of his book and try to construct an alternate economic model using his same fish example. I agree with Peter Schiff on some of his scorn for the Keynesian economists. Keynesian govt spending is necessary when the overall economic market goes thru a crisis and liquidity dries up due to build up high distrust in the market. The govt can try to cushion those crisis by deficit spending but they can only do so a for a limited time. If the economy itself has fundamental problems, govt over-spending can't sustain economic activity beyond a short period of time. A limited time could mean about one to two years.

Fiscal Stimulus Leakage

We have had huge fiscal stimulus by the US govt and the US govt has also bailed out many of the big banks. We should have seen huge increase in economic activity given the size of the stimulus but the unemployment is still high. I was discussing this with a friend a week back. One of the thing that came up was the high leakage of the fiscal stimulus overseas due to the heavy automation of the infrastructure work in the US - the stimulus was supposed to be aimed at shovel ready infrastructure projects. One thing is that there were not many shovel ready projects to immediately fund and so the fiscal stimulus is only slowly seeping into the economy. The other interesting thing relates to the heavy automation of infrastructure work. Say 20 years back, they needed 10 people for a road laying job. Now that same job may require only 3 people with machines being able to replace the other 7 people. If $100 was spent earlier on 10 people, now $30 may be spent on 3 people and $70 to buy the machines. So a big chunk of the money is being spent to buy the machinery. If the machinery was made in the US, then that money would eventually end up as wages to the US workers. But that machinery is made in China, Japan or Korea and end up supporting employment overseas. The govts of these foreign countries end up getting the $70 and then they lend it to the US govt by buying US Treasuries. In effect, the US govt tried to spend $100 in the US economy but only $30 got into the US economy and the other $70 came back to fund the US deficit. So the the US govt spending is currently not as effective as it would have been previously when many of the manufacturing jobs were in this country. The US govt now has to do repeated stimulus to get the same effect of a past stimulus. and the US stimulus ends up stimulating the rest of the world (supplying the manufactured products to the US economy) more than the US for every $1 spent by the US govt.

Buffett and Squanderville

I had a discussion with a friend of mine on the US trade deficit and on an article published by Buffett in 2004 on Thriftville vs Squanderville. I am posting this on my blog to keep track of these kind of discussions.

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Meanwhile, the citizens of Thriftville begin to get nervous. Just how good, they ask, are the IOUs of a shiftless island? So the Thrifts change strategy: Though they continue to hold some bonds, they sell most of them to Squanderville residents for Squanderbucks and use the proceeds to buy Squanderville land. And eventually the Thrifts own all of Squanderville.
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If thriftville citizens don't believe in the squanderbonds, the squanderville residents know more about their bonds and so will not give squanderbucks for the squanderbonds. They already know those squanderbonds are not worth much. ok, you may say that the squanderville govt will give thriftville squanderbucks in redemption of the squanderbonds. Those squanderbucks won't buy much property of squanderville either - as they try to buy property, thriftville citizens will find that the property costs in thriftville shoots sky high.

Coming back to reality, china can't do much with the $2 trillion of US bonds - if they try to buy land assets in the US, the huge liquidity will shoot up property prices here that they would only be able to buy say 10% of what they thought they could buy. A foreign country never gets to own another country by stealth - they own it by attacking it militarily (or meddling around using military powers). If china doesn't believe in the US bonds, nobody is preventing them from buying up private businesses here (if they can get thru all the regulatory loopholes). It will be actually good that they did that instead of buying the US bonds. but buying private businesses also carries with the responsibility of managing it - it won't be a passive investment any more. are they up for it? and the chinese assets could be seized by a class action lawsuit by chinese US citizens who have suffered human rights abuse back home.

and you have a hangup with default. defaults and bankruptcies happen all the time in the US - that is a good way of eliminating the weaklings and having more efficient firms survive. Whenever a bank gives a loan to you, your credit score is used to set the interest rate. The higher interest rates for higher risk customers is done on the assumption that a certain percentage of customers are going to default. It is accepted part of the system. Venture capitalists do fund people who have failed more than a few times starting businesses. You give credit to entities after looking at their business case and if the entity fails, it doesn't mean all the employees of the firm will become slaves to the creditor. The creditor is looking for yield and there is always risk in losing it all. The different creditors have different priorities in collecting the liquidated assets, based on how the debt was secured.

Trade deficits are created not by the action of just one trading party but by both. If china had allowed free floating of its currency, its currency would have kept rising to eliminate the trade deficit. They created their dollar reserve by deciding to keep the yuan pegged to the dollar at a low level. They released more yuans into their economy thru that process and high inflation is an effect of that. The chinese govt. is seeing the high inflation and not able to decide what to do. Without foreign exchange manipulation, you don't get huge trade deficits. There is no trade deficit between Massachussets and Missouri - Mass residents won't sell to Missouri residents without getting properly compensated for it.

Every country in this world wants to be a net exporter and that is a mathematical impossibility. All the asian economies want to save 30% of their salaries and that is not sustainable - you can only do that if you remain a perpetual exporter. Their savings will get spent by the consuming nations like the US. and there is no point in saving money beyond a certain emergency need. At an individual level, you are exposed to job losses but at the system level, the job losses won't be more than say 20% (which was at the height of the depression in the 30s). That is why countries create safety nets which are like insurance systems to increase economic acitivity. If you are a self-contained nation (net zero export-import), any savings will get wiped by slowing down of the economy to a level where the average savings comes down to zero. Money is just a medium to trade and it has no value by itself other than what is set in the market in terms of its tradability.

I do consider the govt deficit to be a serious problem compared to the trade deficit. China is abetting the US govt to run these deficits by buying the govt. bonds. The govt deficit can not run at this current pace for long. increase in taxes, decrease in govt spending - something has to happen and usually this country does take some steps or the market forces it to. I am quoting Buffet again below:
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I will close by reminding you again that I cried wolf once before. In general, the batting average of doomsayers in the U.S. is terrible. Our country has consistently made fools of those who were skeptical about either our economic potential or our resiliency. Many pessimistic seers simply underestimated the dynamism that has allowed us to overcome problems that once seemed ominous. We still have a truly remarkable country and economy.
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The US is still an amazing country compared to the rest of the world. In fact, Buffet lost money on his currency bets as the US currency actually appreciated after Jan 2004. During last year's crisis, the whole world flocked to the US dollar. and Buffet said that he is making a bet on the US economy when he bought CSX a few months back.

Economic Model - 4

In the simple model I described earlier, the economic model is limited by the fact that once a farmer gets a massage, the farmer has to wait for the masseuse to buy a bushel of wheat before he can pay for another massage. I also arbitrarily said that one massage is equivalent to 1 bushel of wheat = 10 cents. The market may set different rates. How does a market set different rates? based on supply and demand. In this model, say a farmer decides that one massage for 1 bushel is too little and so demands more massages. The farmer may demand 2 massages for 1 bushel - the masseuse has to eat food to survive but the farmer could survive without a massage though he would like to have a massage. So the farmer only pays 5 cents for a massage now and the masseuse has to give 2 massages before he can get his bushel of wheat. What if the farmer demands 5 massages for 1 bushel of wheat - the masseuse may have to overwork so much that he would decide to leave this line of work and become a farmer himself. Either that or he must keep improving the massage experience every year to keep the farmers craving for the massages. This always happens in the service industry - people want some better experience to keep buying next year. Today's ipod becomes boring next year and apple has to keep offering some other addition to the ipod to keep luring the existing customers (and also lure new customers who weren't impressed with last year's ipod). In this example, the price of wheat or massage would be set up based on supply/demand. To keep his well being, the farmers may need to get some minimum massages every year and so there will be some masseuses around after some of them get out of the business. The minimum massage could be 5 massages per year. So there must be enough masseuses to provide 10*5 massages every year to the farmers. I will explore next a 3 entity model - that gets more interesting than the two entity model and will bring about a lot of revelations about the workings of our modern economy. I would also need to introduce some credit infusion function into the economy by the banks.

Economic Model - 3

Back to my example of 10 farmers and 10 masseurs, each farmer produces 20 bushels of wheat. Normal consumption of food for each person is 10 bushel of wheat per year. Each person gets 10 massages during a year normally. I am going to seed this system with $0.1 of money for each person - total of $2 in the system. At the beginning of the year, each person has $0.1. The current rate is $0.1 per massage and $0.1 per bushel of wheat. The farmer will spend his $0.1 to get a massage and then the masseuse will buy 1 bushel of wheat for $0.1 from the farmer. There is no savings in this system. Everybody spends their entire money. In reality there is savings and I will expand the model later for it. Over the course of a year, each farmer would have spent $1 on 10 massages and earned $1 selling 1o bushels of wheat. At the end of the year, each farmer and masseuse will be left with $0.1 to start spending next year. The GDP would be $20 as $20 of economic transactions took place in this economy. We had $2 in the system and produced $20 worth of economic transactions - this is the money multiplier effect. The multiplier effect will be more evident when we have three entities rather than two and how an increase in savings will reduce this money multiplier effect. Now what if the farmer finds a way to produce more 30 bushels of wheat. The farmer could decide to eat 5 more bushels and doesn't have a need for another 5 bushels. He can sell it to the masseuse but the masseuse would have to give more massages for it. With the increased production of wheat, the economic transaction between a farmer and a masseuse could be 15 bushels of wheat and 15 massages. The farmer and masseuse could still trade at $0.1 for both the massage and bushels but there will be 15 transactions now instead of 10. The GDP would now become $30. Without any increase in the amount of money in the economy, we were able to increase the total economic value of transactions as we had more transactions in this case.

Economic Model - 2

I need to start with something more simple than the model I proposed in my last blog. I will add more entities later. To start off, I am going to say there are only farmers and masseurs. The farmers produce wheat to eat and the masseurs give massages to ease the body as a service. Let me say there are 10 farmers and 10 masseurs in the economic exchange. The farmers normally produce 20 bushels of wheat. Normal consumption per person is 1 bushel of wheat. Normally the farmers would consume 10 bushels and trade 10 bushels to get massages. The masseurs get 10 bushels to consume by giving massage service to the farmers. This barter exchange is only between two entities and so don't need a monetary instrument but I am going to introduce one to describe this transaction using money. We have to seed this system with money intially so that people will have money to use for transactions. We have to establish a time period to track the transactions and it will be assumed to be a normal year. I am going to give each farmer one US$ and give masseurs nothing intially. The masseurs have to earn money from the farmers by giving service to them and then use that money to buy wheat from the farmers. We need one more entity called the Bank - this bank is both a normal bank and a Federal reserve. In the course of a year, if the farmers spend all their money on masseurs, they would give masseurs $10. The masseurs would also buy 10 bushels of wheat by paying the farmers $10 for a bushel unit price of $1/bushel. In a GDP sense, we have had $20 worth of GDP in this economy. The farmers can make more bushels than 10 by working a bit harder. If the masseurs provide the same kind of massages every year, farmers may reduce their massages as it becomes more mundane. The masseurs try to improve their massaging service every year to keep the farmers coming to their shops.

Economic Model - 1

As I said in my earlier blog, I am going to try to develop a simple money flow model and use that to explain a lot of economic phenomena. I will refine the model as I develop it to correct errors that may prop up. My first take on the model would be to have an economy around satisfying basic needs of humans - food, shelter and clothing plus I will add entertainment to represent some generic services. Say I have got 20 farmers, 10 artisans, 10 manufacturing people, 10 entertainers and 50 other people who tend households. The 50 people who tend households are not directly involved in an economic exchange but manage a number of things and could represent wifes, children. There is a total of 100 people in this economy. There will also be a bank and a govt but they will just be entities making some decisions rather than have human resources working for them. Let's say the farmers grow wheat and cotton - one for food and the other for clothing. The manufacturers may manufacture both machines and cloth. The artisans could build a number of things like house, barns etc. Say the 20 farmers can currently grow 100 bushels of wheat per year and each person consumes 1 bushel of wheat per year for minimal survival. Every household has a shelter but would like to expand on it using the artisans. The manufacturers currently make 100 cloth per year and everybody's cloth only last one year. The manufacturers have capacity to make more cloth and some machinery for farming. In a bartering system, the 20 farmers would give 20 bushels of wheat to artisans in exchange for making upgrade to their 20 houses. The 20 farmers would give 20 bushels of wheat to manufacturing people to get 20 cloth from them. They would also give 20 bushels of wheat to entertainers to get entertained. The farmers themselves need 40 bushels of wheat tof feed themselves and their dependents. Same thing goes for the artisans who will upgrade or maintain houses for manufacturers in return for cloth. This is kind of perfect bartering system where everybody makes enough for everybody else. The real world doesn't happen like this. I am going to start using the concept of money to depict these exchanges. It becomes easier to track things but the money should always be linked to the exchanges happening to understand economic phenomena.

Economic Model build

I have built a complex money-flow model using a process simulation software to understand macro economic phenomena but want to start out with a simpler model to explain some of the effects of macro economic decisions. This simpler model will help me frame a number of economic questions and the results we would expect from economic changes. One of the things I am trying to establish with these models is that we need to think economy in terms of exchange of goods and services and not entirely on just monetary value. Money is our creation to help with the economic exchanges but we get stuck on the money itself rather than think of the fundamental exchanges that money represents. Money is like blood, it helps with the transfer of oxygen, nutrients etc to various parts of our body but the body is more about actions, thoughts, reproduction.

Health care overhaul cost

There is a lot of talk about the healthcare overhaul and how expensive it will be for the tax payers to fund this overhaul. Yes, there is a cost to the government to fund this overhaul and ultimately all government costs will be borne by the taxpayers. But tracking the cost is more of an accounting exercise and masks the real issues with it. We are spending more on healthcare as a percentage of our income but that is not a bad thing. 100 years back, people spent a high percentage of their income on food. There were a lot of people working in the agriculture sector. We automated a lot of things in farming and so didn't need that many human resources to make the same or more quantity of food today. That meant the human resources could be used in some other actitivity of the economy and it did happen with more people working in the manufacturing sector. Now we are able to get our manufactured goods made from human resources outside the country and so the human resources inside the country can provide other services to the economy. We all want to keep our health in a good shape, live longer and demand health services towards achieving those goals. There is a large number of people in the economy who are providing those health services. Economy is ultimately about exchange of services and goods among the human population. and we as a population will spend a higher percentage of our income on things that we value more. The economy grows as the velocity of exchange of goods and services increases. The money we pay the health care system is in turn spent on providing salaries to the doctors, nurses, equipment manufacturers who in turn spend that money getting other goods and services from the rest of the population.

The question on providing health care services to everybody in the population is more about fairness. If I can shine a shoe twice as fast as another person, I expect to receive more goods or services in return compaed to the slower shiner. Should I subsidize the goods and services for the slow shiner? The amount of money a person has in a society in a way measures the value of goods or services the person has provided to the society. Should a person who has less money be able to get a similar health care services as a person with more money? In owning automobiles, a person with less money can buy a cheaper car and a person with more money can buy an expensive car. But there doesn't seem to be a cheaper or expensive version of healthcare services - can a person get a lower quality heart-bypass?

Credit creation

Senator Jim Bunning's action is interesting. His motives for the bill blockage may be many but his blocking of the bill is trying to withhold unemployment payments to the unemployed plus a few other payments like to transportation workers. We are trying to create more credit in the economy and should we then block these govt payments? These govt payments may not be paid for but that is just accounting. Modern economy thrives on credit creation - it can't deal with deflation. A hundred years back,, a person has to save the full amount to say buy a house. With modern economics, we don't want the person to save for a lifetime to buy a house. That person will be able to provide services to the economy over time and the person should be given a credit to borrow on the future value of his services. This increases the level of transactions between people in an economy. We may measure GDP of an economy in terms of monetary value but that monetary value is a measurement of the exchange of goods and services happening in an economy. As we increase the speed of this exchange, the economy will thrive. But people won't exchange unless they feel they are getting value in this exchange. A fruit grower is not going to exchange more fruits for another ipod if he already owns a number of ipod. He will be willing to exchange it for an iphone as it provides more value to him compared to the ipod. Coming back, credit creation is geared towards increasing the exchange of goods and services within an economy. If credit creation is done at a rate that is excessive, it will lead to inflation - basically increases the nominal amount of an exchange without leading to higher exchange activity. Credit creation will be excessive if credit is given to people in excess of the future value of their services rendered to the economy. With new businesses, one doesn't know the value of the service that will be created and so it is difficult to judge if the given credit is excessive or not. but with mortgage lending, if it is given to people without any verification of salary (which could be used to measure the long-term value of the person's services), you could easily get into an excessive credit situation.

I want to start blogging about my thoughts on the economic issues at hand using the goods and services approach rather than the monetary approach that is being done in the media. The monetary approach almost assumes a US$ or say a Japanese yen as something of an independent object itself and economic discussions are argued just based on the changes in this monetary object. The monetary object is man's creation to enable easier commerce and it does make it easier to analyse economic decisions but would lead to wrong conclusions if it is used as the sole parameter to compare various economic policies. I may not be making a lot of sense in the above sentence but my point of view should become more clear when I start discussing the monetary approach vs the goods & services approach in my blogs.