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.
Wednesday, September 8, 2010
Tuesday, August 24, 2010
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.
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.
Monday, August 23, 2010
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.
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.
Monday, August 9, 2010
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?
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?
Monday, August 2, 2010
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.
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