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.