Eurozone crisis and solutions

There was a severe economic and financial crisis between 2007 and 2009, probably the worst since great depression. The crisis was caused by too much easy money, too much leverage by households and financial institutions, excessive risk taking and lax supervision and regulation of the financial system leading to a boom and a bubble followed by a bust and a crash.
One the consequences of the crisis was that when the bust occured, there was a collapse of global economic activity. After the collapse of Lehman, the level of economic activity was falling at the same rate as in the case of the great depression between 1929 and 1931. For 2-3 quarters the fall in output, in employment, in production, in consumption, in investments, in exports and in imports was like the beginning of a new great depression.
What avoided it was the policy response. The policy makers in US, Europe, Japan, China and other advanced and emerging markets, after being behind the curve for a while, starting responding aggresively after the collapse of Lehman. The three main policy actions taken by these economies are

1. Monetary easing - reducing interest rates, printing money to provide liquidity to the economy and to the financial system.


2. Fiscal stimulus - reducing taxes, raising government spending because private demand was collapsing and if there was not public demand and simulus, this could have ended up like the great depression.


3. Rescue (bailout) the financial system - As financial institutions were on the verge of collapse, we decided to backstop and ring fence the financial system. This started to stabilise the financial markets and then the real economy.

So that was the way we achieved the stabilization and then beginning and resumption of economic growth. One of the consequences of the crisis was this crisis was that the crisis which started with too much debt and leverage in the private sector (households, banks and financial institutions , private corporations etc) morphed into one where there is too much public debt, deficits and leverage.
How we ended up in this situation of excess public debt has 3 reasons

1. During the crisis and recession, there were automatic stabilizers. As the incomes were falling, there was less tax revenues and as there was more unemployment, benefits like unemployment benefits were rising thus automatically increasing the defecits.


2. There was an active policy of trying to re-stimulate the economy (Keynesian policies) by trying to raise spending, raise subsidy and reducing taxes as way of boosting public and private sector.


3. The fiscal cost of bailing out banks, financial institutions, corporations and households became very large as the private losses were taken on by the government.
   So we started of with private debt but ended up having too much public debt and fiscal deficits that are difficult, large and unsustainable.

The consequences of the leveraging of the private sector and then the public sector are as follows

1. The recovery in advanced economies from the crisis has been sub-par, anemic and below trend. It has been a U shaped recovery where the growth has been very weak.In a typical recession it is a V shaped recovery with output falling and then recovering very fast.Any time the recession is caused by the financial crisis, the recovery is much slower than otherwise.


2. The question of soverign risks arising from too much public debt and defecit is becoming a widespread problem in all advanced economies and not just in the periphery of the Eurozone. The bond vigilantes have woken up in Greece, Ireland, Portugal, Spain and Italy. They have not yet woken up in countries like the United States, Japan or United Kingdom but even in case of US and Japan we have budget defecits of the order of 10% of GDP. We have public debt in the US that in few years will go up to 100% of GDP and in the Japan; the public debt at a gross level is already at 200% of GDP. In addition to public debt the other important phenomenon is that of an aging population that amount to contingent liabilities or implicit debt of the government deriving from social security systems, pension systems etc that are not fully funded. The other cost of an aging population is the rising healthcare costs. These are unofficial liabilities apart from the public debt. It is clear that unless this public debt problems are not resolved, eventually there is going to be a fiscal crisis even in the US and Japan. When we consider the Eurozone in particular, there are a number of caveats. There is a difference between what is happening in the core of the Eurozone, countries like Germany, France etc that are currently having sustained economic growth from the problems faced by the periphery of the Eurozone like Greece, Portugal, Ireland, Spain and Italy. Even in the case of these periphery countries, all of them cannot be lumped together.

However each of these countries in the periphery of the Eurozone also share a number of factors that are similar even if to a different degree.

1. All of them have a problem of having relatively large budget defecits and large stocks of public debt that are rising as a share of GDP. Of course there differences in the size of debt and defecits as a share of GDP e.g. Greece has a 15% defecit and public debt at 120% of GDP. Each of the countries has gradually cut spending and increase revenues to achieve long term fiscal sustainability.


2. The second similarity is that there are significant troubles with a number of banks and financial institutions. Again this cannot be generalized. The problems are greater in Spain and Ireland that had a real estate bubble that went bust. The problem is less in Portugese, Italian or Greek bank that did not have a housing bubble. In some cases a large portion of the public debt is also held by the banking system and as there is fragility in the government, we have a situation where a soverign risk can become a banking risk and vice versa as the banking losses have been socialized. If the banking system is not recapitalized, there will be a credit crunch as banks will refrain from taking risk and issuing new loans and this will not restore economic growth that will help placate the fiscal problems.


3. The third issue that is common to the periphery of the Eurozone is that in addition to the foreign liabilities of the government, there is also a large amount of foreign debt of the private sector. There were all countries that were running a large trade and current account defecit and when you have these defecits you have to borrow from abroad to finance this excess spending over income and therefore there is an increase not only in the foreign liability of the government but also in the foreign liabilities of the private sector. So these countries have to roll over private debt in addition to public debt and this is another source of vulnerability.


4. The fourth problem is that because of all the above problems, there is lack of economic growth. During the recession there was a severe reduction in output and unfortunately in PIIGS today either output is still falling or in cases where recession has ended , the economic growth is close to zero.


5. The fifth problem is the lack of structural reforms and therefore the potential for actual economic growth remains anemic.


6. The sixth problem that all of these share is the lost of external competitiveness that occured in last decade. This happens due to a number of factors such as

• Most of these economies almost 10 years ago were losing market share in the export markets to countries like China, emerging Asia, central Europe, Turkey that have lower wage and labour cost etc because many of the traditional exports of these countries used to be labour intensive and low value added products like textile, apparel and leather.


• Second factor for the lost of competitiveness was that for a decade the wages in these countries were growing more than productivity and so the unit labour costs are rising this leads to lower competitiveness which is also known as a real appreciation of currency.
  The final reason is the very sharp appreciation of the Euro that occured between 2002 and 2008.
  As a consequence of all of these, there was a growing trade and current account defecit in the periphery countries of the Eurozone.These problems are going to take a number of years to get resolved
  Whenever there is an excessive public and private sector debt, there are only four solutions to it.

1. Economic growth.


2. Save more to reduce debt.


3. Reduce the value of debt through inflation.


4. Orderly restrucuring of unsustainable debt becomes unavoidable and necessary of the 3 options above do not work. This can be painful and something that has to be avoided if possible.

Real estate in Bangalore

This is to make everyone aware of why the prices quoted to buy apartments are still ridiculously high as compared to what it takes to rent it. Look at the below on this page to see the rents that these apartments command

http://bangalore.craigslist.co.in/apa/1044982345.html

Now look at the links that I have provided on this page that takes you to the price quoted on craigslist to buy the same apartment. You will notice that in almost all cases is under 4%. What this means is that if you bought the apartment for cash and rented it out then you would just be making 4% on your investment as against the risk free rate offered by fixed deposit at around 9%. Now consider the case where you are taking a home loan where you are paying upwards of 10% in most cases. With such low rental yields and the housing market in a state of decline for at least the next 5 years, the chances of creating any sort of equity is non existent.

Check the below if you want to do a rent v.s. buy analysis
http://www.nytimes.com/2007/04/10/business/2007_BUYRENT_GRAPHIC.html# -

Tata Sherwood, off HAL Airport rd - flats 2bhk/14 K + M -

Tata Sherwood, off HAL Airport rd - flats 2.5bhk/16 K + M

Tata Sherwood, off HAL Airport rd - flats 3bhk/20 K + M rent 6500000 to buy http://bangalore.craigslist.co.in/reo/1048433744.html

Sobha Iris, Outer Ring Road - 3bhk flat @ 16 K - 18 K rent 6000000 to buy http://bangalore.craigslist.co.in/reb/1036613430.html

Springfields, Sarjapur rd - 3bhk flat @ 25 K 7000000 to buy http://bangalore.craigslist.co.in/reo/1045259004.html

Sobha Jasmine, Outer Ring Road - 3bhk flat @ 25 K and 4 bhk flat @ 40 K to rent 8700000 to buy http://bangalore.craigslist.co.in/reb/1051453522.html

Akme Harmony, Outer Ring Road - 3.5 bhk flat @ 22K - 24 K 7500000 to buy http://bangalore.craigslist.co.in/reb/1004164183.html

Prestige Acropolis, Koramangala - 3bhk flat fully fur @ 65 K 24000000 to buy http://bangalore.craigslist.co.in/reb/1031535677.html

Adarsh Palm Meadows - 3bhk villa @ 1.9 L 32000000 to buy http://bangalore.craigslist.co.in/reo/1002674845.html

Sriram Spandana, off Inner ring rd, Koramangala - 3bhk flat/22 K + M with soft furnishings 7000000 to buy http://bangalore.craigslist.co.in/reb/1012462541.html

MIMS Ardendale, Whitefield - 3/4bhk villa @ 35 - 45 K No buy info

Akme Ballet, off Marathalli - 4bhk pent hz - 40 K 6700000 to buy http://bangalore.craigslist.co.in/reb/1023008068.html

Prestige St.Johns Wood, Koramangala - 2bhk flat fully fur - 45 K + M No buy info - Zen Gardens, Artillery rd - 3bhk fully fur - 95 K No buy info

The purpose of this illustration is to make buyers aware of what to look for when you are considering to buy a property v.s. the decision you make to rent one.

The coming economic downturn and how it can be shortened

The current economic crisis is comparable to that during the period before the great depression. It is interesting to see what got us to this state; the outlook for the world economy and what the appropriate measures are that can be taken to avoid a big L shaped multi year recession as was the case in Japan.

What are causes of financial crisis? What has been the impact?

It is clear that the cause of the current financial crisis has been the massive leverage that has been building up in the financial and the household sector for the past many years.
For a good number of years now the cycles of boom and bust have been around with each of these cycles creating and bursting bubbles bigger than the one before. Preceding the starting phase of each of these bubbles has been the drastic reduction of interest rates which created sufficient liquidity to channel money into creation of bubbles. In the late 90’s this resulted in the tech bubble that burst in 2001. In order to prevent a recession at that time, the policy response of the US Federal Reserve was to reduce interest rates and thus leading to the housing bubble. The household sector kept borrowing money to finance the purchase of houses and this led to massive run up of home prices. The US financial sector on the other hand packaged these mortgages into mortgage backed securities (MBS) and that into collaterized debt obligations (CDO). These are essentially complex financial instruments with illiquid markets currently that were wrongly rated AAA by the rating agencies and then were sold to markets around the world thus destroying transparency with all of them making a lot of money during the securitization. The world of finance is built on trust and once there is a lot of junk held by counter parties then no one knows as to the solvency of the party they are dealing with and thus creating a tremendous amount of counter party risk. When the best of the financial institutions like AIG, Merrill Lynch, Washington Mutual, Wachovia, Lehman brothers etc go belly up, there is a generalized loss of confidence.

The current crisis has also led to the demise of the shadow banking system, the ones that are not subject to regulation and was responsible for most of the financial intermediation in the last 20 years that could benefit from regulatory arbitrage. These include non-bank mortgage lenders, SIVs and conduits, broker dealers, hedge funds, private equity funds and money market funds. Most of these institutions have the features of regulated banks where they borrow short in liquid ways, most of them being heavily leveraged and then lending in ways that are illiquid or on a longer term.

In case of regulated banks, this maturity mismatch leads to the banks being considered fragile and the illiquid ones being subject to a run on the bank. To prevent this, the deposit insurance and the central banks were created many years ago which in addition to controlling inflation and growth in the economy, would also act as the lender of the last resort. In the case of the shadow banking system however, both the deposit and central bank’s lender of last resort role was missing thus making it a fundamentally fragile system as it was essentially a non-regulated system on steroids. The current financial crisis in short has been the unraveling of this mistake.

• The first step of this was the collapse of the non-bank mortgage lenders, like Fannie and Freddie, that engaged in sub-prime kind of lending and these went belly up when the toxic nature of those securities was understood.
• The next to go were the SIVs, like Cheyne, and conduits that were funding themselves with short term commercial paper and investing them into MBS and CDOs. The run then extended to the broker dealers with ones like Lehman brothers and Bear Stearns going belly up, other like Merrill Lynch having to get merged into a traditional bank like BOA and others like Goldman Sachs and Morgan Stanley having to be converted into bank holding companies being subject to regulation thus leaving no independent broker dealer left standing. This again was due maturity mismatch and their fundamental business model being flawed and during the crisis had to resort to the PDCF lending by the Fed thus needing regulation in terms of more liquidity, more capital, less leverage and more long term funding. The traditional broker dealer model no longer exists.
• The next to be affected were the money market funds as they had invested in toxic paper and the Fed had to intervene again to guarantee them with deposit insurance and thus get back into traditional ways of operation.
• The next to be impacted in terms of redemptions were hedge funds that had again borrowed short and lend long like the broker dealers.
• The private equity operators were the ones to be affected next due to the activities like leveraged buyout kind of activities when credit spreads were much lower and leverage ratios were very high.
  

In short the shadow banking system has essentially collapsed and the traditional banks have been severely weakened. Due to this seizure of banking there has been a lack of credit availability to the corporate sector with even the AAA rated ones being impacted. The Fed had to thus intervene in the commercial paper market as corporate sector could not raise the funds. The central banks thus instead of being the lender of the last resort has been converted to being lender of the only resort in this situation to the traditional banks, shadow banks and corporate sector and that is close to a systemic failure of the entire financial system.This has led to the stock markets crashing; inter bank spreads rising, money markets being shut down and the widening of credit spreads.

The policy response to be crisis has been coming on thick and fast but there is a growing disconnect between the actions taken and the market response. The 29 billion bailout Bear Stearns creditors and the creation of the PDCF in March 2008 resulted in a rally in the stock markets, money market and credit markets that lasted for 8 weeks into April and May. When Fannie and Freddie was deemed to fail and threaten the system in early and the treasury secretary Henry Paulson got the approval of congress to rescue them if needed, the markets rallied for 4 weeks. When the actual 300 billion dollar bailout had to happen in early September, the markets rallied for just 1 day with the US government taking on 6 trillion dollar worth on its balance sheet. The very next day there was a risk of Lehman collapsing and the following week was the 85 billion dollar bailout of AIG but the stock markets fell 5% that day. The following policy responses like the 700 billion dollar rescue package, the Fed paying interest rates on reserves thus massively being able to increase the support for financial system, the extend of credit by the Fed to the corporate sector for the first time since great depression, the coordinated interest rate cut by the Fed, ECB and other central banks has done nothing but a massive collapse of the stock market as the trust in the policy makers.

What is outlook for US economy (V shaped, U shaped or L shaped recession) and what are the possible fixes?

The scenario of a short 6-8 month recession is clearly out of the window. There is going to be a prolonged recession to go along with the financial and banking crisis in the US and the advanced economies. The emerging markets are going to also face recessionary pressures making this a global crisis.
What needs to be seen if the appropriate policy measures can be taken to avoid a severe multi year L shaped recession as was the case in Japan.
Several policy responses are in order according to leading economists. These include

• Additional policy rate cuts on top of the 50 basis point rate cut announced last week especially in Europe where at least a 150 basis point cut is needed. In the US the rates are already pretty low and a liquidity trap is to be avoided but a further 50 basis point cut is still in order to bring rates to 1%.
• Monetary easing alone will not be sufficient as the counter party risk still remains very high and so the interbank and credit spreads remain considerably higher than policy rates. There is a significant risk of run on the uninsured deposits in the banking system even after the limit in the US was raised from 100k to 250k as 2 trillion out the 7 trillion bank deposits in the US still remain un-insured and there are similar risks in other developed countries. At this point a blanket guarantee of all deposits is in order and even though this creates a moral hazard as in the S&L crisis where some took advantage of the situation to attract more deposits only on the basis of the guarantee provided.
• To prevent a moral hazard of blanket guarantee, the period should be limited to 6 months during which a triage of good banks needs to be done. Currently there are good and bad banks within the system that adds to counter party risk. The solution is to identify and injecting capital i.e. recapitalize the good banks and letting the bad ones fail. Creating more liquidity alone, as per the current TARP (troubled asset repurchase plan) will not be sufficient. Public capital should be used to buy preferred shares which would mean quasi nationalization of a good chunk of banks in the US and Europe. At this point there is no other alternative other than government ownership in the banks to continue providing credit. Matching contributions are required from existing share holders in terms on tier 1 capital and suspension of dividend.
• The ongoing liquidity measures such as the Fed stepping into the commercial paper market have to be continued.
• The bad debt of the banks also related to the debt in the household sector in terms of mortgage, credit card debt, auto loans etc and the consumer recession in the US would mean finding ways to reduce this debt burden and restore ability to spend like the HOLC plan during great depression.
• A massive fiscal stimulus is also needed to counter the falling aggregate demand, falling consumer consumption, fall in residential investment and fall in capital spending by corporate. Because of the recent events, corporate spending is likely to be subdued as the future is unclear and the cost of credit remains high. The involves massive public spending in terms of infrastructure, public works, grants to state governments etc to prevent a fall in aggregate demand.
• International coordination and is needed with support from international financial institutions like IMF, IDB etc to provide liquidity support to countries like Iceland that have been impacted by the crisis to act as international lender of last resort.
• The international imbalances will still need to be financed with the US going to run trillion dollar plus deficits in the coming 2-3 years. If the financing from the gulf, China and emerging markets do not come through then that would be a major source of economic re-balancing in the coming years. This will be unlike in the previous years where China used to vendor finance the US with the surpluses because the imports by the US is likely to come down substantially. International bargaining is still required to help US get over the purchase of the bad assets as per TARP.

Conclusion
The current economic crisis has shown that instead of de-coupling between the US and emerging markets, the real outcome has been a re-coupling. The initial effects of this were inflationary with higher commodity prices but the risk going forward is that of deflation. If appropriate policy responses are not taken then this could well turn out to be a long and deep depression.

References

http://www.rgemonitor.com/

Nouriel Roubini, Chairman, RGE Monitor and Professor of Economics, Stern School of Business, New York University

The big bailout and its implications

The biggest bailout of the financial markets in the US is in progress and it is important to know the reasons for why this has become necessary and the implications of this on the US dollar.

Outcome of a successful bailout

The world economy in the past few years has been characterized by huge financial imbalances that have been complementary. Over the last 4 yrs the developing countries in the world have run a current account surplus of 2.5 trillion dollars. In the year of 2008 alone this figure has been over 800 billion dollars. These surpluses have helped finance the US current account deficit over the last few years. This has helped maintain a low interest rate regime and create the housing bubble which set the stage for the recent financial crisis. Over the last few months the dollar has been weak (10% fall against Euro, 15% fall against the Australian dollar etc)because the stability of the financial markets (in terms of conservatorship of Fannie Mae, Freddie Mac and AIG, collapse of Bear Stearns and Lehman brothers, sale of Merrill Lynch), cut the interest rates from 5.5% to 2% (during the great depression, raising the interest rates from 1.5 to 3.5% to maintain a strong dollar has been attributed to making things worse), injection of 400 billion dollars in liquidity and the prevention of total collapse of the housing market have been taken on by the Federal reserve and policy initiatives not seen in the US since the 1930’s. The possibility of a total collapse of the American financial system looked possible around 9 months ago and could lead to the new great depression. The banking losses could have been so large as to overwhelm the financial system. There has been a write off of 520 billion of bad loans during this period, half in the US and the other half in Europe. Total equity of the banking system in the US is 1.3 trillion dollars. The IMF estimates that there will be a further 500 billion of losses in the next 6-9 months.

Now the focus shifts from monetary policy by Federal Reserve to the intervention by treasury with the 700 billion dollar rescue package (unlike the RTC measure during the S&L crisis where over a 1000 thrift institutions went bust and was bought by the government for nearly 400 billion paying lowest price for assets to be later sold for 200 billion causing the tax payer to bear the rest). This will be used to buy the assets (estimated at 500-600 billion by the IMF) from the banks at a value between marked-to-market rates (rates that the banks value assets as per accounting rules) and hold-to-maturity rates in a way that isn’t too negative for the banks (by keeping purchase rates low) in terms of having to raise more capital and also not putting the tax payers at risk (by keeping purchase rates high). This could stabilize the US economy by middle of next year and prompt a rally in financial stocks and reduce risk of bankruptcies. If the rescue package does not come through then it could result in 300-400 bank failures, further fall of bank stocks and prolong the credit crunch by reducing the ability to make loans. In case the price offered for the assets are close to the marked-to-market rates, there is the possibility of banks not wanting to sell them at low valuations and this causing more failures and needing further capital infusion in time (as was the case in Japan in the 90’s). So 700 billion dollars may not be big enough to buy all the illiquid assets (1.5 trillion dollars worth at hold-to-maturity value) at a rate that will satisfy the institutions holding them unless there is a move from transparency to prudence i.e. by changing accounting rules.

So if things go well, the package could be positive for the economy and positive for the dollar. The deficit would however go to over a trillion dollars next year but the hope is that the imbalances would fund this as China would possibly intervene to keep their currency low by purchasing more of US treasury bills (200-300 billion). Saudi Arabia needs US military support and this would help fund the deficit as well. So this will keep the dollar in a trading range and help in a recovery by end of 2009.

Other considerations

The bailout has already deteriorated the US government’s balance sheet. This however does not signal an imminent weak dollar as with the experience shown in Japan where a similar episode in 91-92 still resulted in a stronger yen in 93. The purchase of dollar denominated assets has been slowing down from the beginning of the credit crisis in Aug 2007 but this is likely to pick up after the bailout.

There are 2 forces at play here. One is the inflationary pressures that would arise if the US government was to monetize the losses and as a result print more money and the other is the deflationary pressures (probability higher than the inflationary scenario) due to the non-existence of the investment banks and thus bringing down of leverage in the system (conversion of trillion dollar investment banks like Morgan Stanley and Goldman Sachs to bring down leverage from 40 times to around 12 times) which would somewhat prevent the move from US dollar to real assets in some cases (especially in cases where there is a peg against the dollar as in the case of Hong Kong and the middle east where there is limited scope for monetary policy) thereby adding to strength in the dollar but would also tend to be dollar negative in case inflationary pressures tends to rear its head first before deflationary pressures set it.
The dollar however has fallen from being 70% of the world’s reserve currency to 63% and this is likely to trend downwards. There is also a case for movement from fixed currency regime (USD) to bi-polar reserves (USD and Euro) or even multi-polar reserves (Asian currencies in addition to USD and Euro). This is because the US currently has a low interest rate regime and the countries pegged to the USD have high inflation. By moving to a bi-polar currency regime, there can a mix of Euro (which is more inflation control driven) and the USD (which is market driven) this giving a good balance when looking at pegged currency.

The dollar will remain volatile in the short run regardless of whether the bailout passes. The key drawbacks in the bailout could be the inability in clearly defining the class of the assets (high grade debt sliced and packaged with debt of poor quality) and in determining which institutions should be getting funds from the bailout (risk for smaller institutions being ignored for helping bigger ones and the complex interlinking between the institutions). By the time the bailout is implemented there is bound to be many failures albeit of smaller banks and thus tending to reduce the demand for US assets.

There are 2 primary reasons for countries holding US based assets. One for purposes of liquidity and the other for purposes of investment. The liquidity factor still is dollar positive as there is flight from risk (as indicated by the increase in custody under the New York Fed) but the investment factor is dollar negative due to the ongoing credit crisis and causing the dollar to be volatile. The bailout package would serve to allay fears of a meltdown but not yet build confidence. There is interplay of confidence crisis, liquidity crisis and solvency crisis. There is some way to go before all the three are under control.

The other point to consider is the cost of the bailout. Today the US government intervention will save Wall Street. But what happens when Uncle Sam needs help. The current cost includes 700 billion dollars in the bailout, 200 billion in liquidity already provided for Freddie and Fannie bailout, 85 billion for AIG rescue. This amounts to over a trillion dollars added to the deficit (8% of GDP needing 4.5 to 5 billion each day to fund itself) and the question arises as to whether the Chinese and the Saudis will want to continue to fund. This is because today foreign countries hold about 1.5 trillion in US treasury and about a trillion in US agency paper (which is mostly gone now after the bank failures). Would the foreign countries be able to soak up the additional 1.8 trillion deficits in addition to the 2.5 trillion currently held in treasury bills and agency paper? The answer is most likely a “no”. The alternative would then be for the US government to print money and monetize the losses. This would be inflationary for the entire world. So with the issuance of bond or with the printing of new money it looks like a down trend for the dollar in the next 18-24 months.

In the near future the tendency would be move money to relatively risk free assets and there is no easy replacement for US treasuries. Gold is generally considered a good hedge against inflation but not at times of massive de-leveraging as is the case now. In case of a dollar weakens in the coming months, it would cause the commodity prices to rise again after factoring in reduced demand from a slowing world economy and thus causing imported inflation.
Another consequence of the bailout could be higher government bond yields (over 5% for 3.8% currently) to keep the 4.5 to 5 billion USD inflows needed everyday in the assumption that the assets bought with the bailout can be sold for a profit in the coming years to be able to return to a current account surplus. The consumer spending decline the coming quarters would add to the higher household savings rate from 0 to about 2% thus shoring up the current account. The non-oil current account deficit has shrunk by 1% of GDP and what has kept it high has been the oil price increases.

In terms of world GDP, the US has a fourth, European Union almost another fourth and the rest of it is mostly with Asia and Japan. However it is only the US fixed income markets that allow almost half of the investable surpluses to be put into. Even if people wanted to move into yen or Euro denominated assets, the choices are thus limited and this making dollar a currency of choice in the near term. A weak dollar is not in any countries favor as it would hamper growth.

Conclusion

In spite of the bailout being dollar negative, there isn’t clear alternative to the dollar in the short run and long term viability of dollar denominated assets as a legal tender would be determined by how soon the alternatives emerge. The Renminbi could serve as the reserve currency of choice taking into the consideration the vast size of Chinese economy in future but that would need measures like convertibility and a developed fixed income market.

The bailout itself only address the aspect of taking bad debt off the bank's balance sheet but as to whether it will help re-capitalize the banks is yet to be seen. Moreover it does nothing to address the problem of reducing household debt and thus can leading to much more foreclosures in the coming months. In short the bailout may prevent an immediate meltdown but does not solve the problem wholistically.

Note : This blog is based on discussions from the world economic forum.

Reasons for rising prices and possible solutions

Rising prices is caused by an increase in the supply of money caused by the government at a rate more rapid than the supply of gold and silver. Defining inflation in terms of one of it's major symptoms, rising prices, says nothing about the cause. On the basis of the definition of inflation as rising prices, people wrongly attribute every possible cause of increasing prices e.g. bad weather causing poor crop thus raising prices. Thus they believe that inflation can be caused either by "demand pull", that is, by spending outstripping the growth in the supply of goods and thus "pulling up the prices" or by "cost push", that is, by rising costs forcing up prices.
The current rise in inflation around the world can be attributed to the enormous credit expansion that was done by the U.S. federal reserve during the 2001-2005 periodin an attempt to stay clear of recession following the tech-bubble burst and 9/11. This cheap money led to widespread speculation in housing that inflated housing prices in the U.S. The securitised paper based on these mortgages created a flood of liquidity all around the world. India and China benefitted during this time from export of good and services respectively. During the same time the U.S. was fighting a costly war in Iraq and the government was financing this war at a global cost by willingness of central banks around the world, including India, to accumulate this vast amount of dollars. In order to maintain export competitiveness, India like most other countries adopted a strategy to buy dollars and release a lot of local currency into the system. This explains the cheap loans in housing and auto sector that was available in India during the 2004-2006 period.The cheap credit made the performance of all industries in India as well as assets classes like real estate and stock markets to grow at a tremendous pace. Commodity prices were largely subdued as in generally the case in periods of rapid credit expansion.
The over-inflated housing prices by mid 2005 caused the fed to start raising interest rates to cool off the housing market. This caused the monthly payments of mortgageholders to go up that speculation in the housing market to cease abruptly. Lax lending practices by banks to supply cheap credit to people who could not afford to them, sub-primemortages, led to the rise in payment defaults and thus a drastic reduction on the perceived value of mortagage backed securities. This led to a steep fall in the assets held by major banks which in turn meant a reduction in overall money supply in compliance with the reserve requirements for banks. To prevent a large scale deflation, which would cause the prices of goods and wages to fall in line with the available money supply, the federal reserve is in the process of pumping even more dollars. This in turn expands credit (by wanting to preserve a weak currency) in countries dependent on export earnings from the US and stoking inflation up. As the value of the dollar is diminished, the prices of commodities in general and oil in particular rose in an attempt to preserve the value of their dollar based value.
The consequence of the lost value in the mortgage securties has been a large scale sell off in most asset classes worldwide. In India too the stock market fell by over30% from its peak in January 2008 as investment banks had to sell securities to meet the margin requirements. The appreciation of major currencies like the Euro and the Yen against the U.S. dollar made carry-trade positions (borrowing in cheap currency to make a bigger investment gain) to unwind causing further fall in the value of securities. The period of cheap money is coming to a close and what follows is a major correction is prices of across all asset classes.
The rise in inflation in India currently can be attributed to the "wage-push inflation" (rising wages increasing costs of production and prices), "profit-push inflation"(rising prices due to businesses such as cement and steel wanting to maximize profits) and a rising price of commodities such as oil that is a major factor of production. .The natural way for gain control over this would be to reduce the money in the economy by either increasing interest rates or increasing the reserve requirements of banks. The government also needs to adopt a policy of not supporting the U.S. dollar and instead require the exporters to increase value of exports by supplying goods of better value to the importing nation.
It is only by controlling the causes of inflation can the symptom of rising prices be managed effectively and till then growth needs to be sacrificed because inflation impacts far more people and creates bigger economic inequality within society.

Making sense of sub-prime

The sub-prime issue is one that has been in the forefront for anything that has to do with allocation of capital in the past few months. So what is sub-prime and why is it causing so much pain for people all round the world.? To understand more on this join me to for a trip to Blunderland. People of this country have been work hard for a living and are the envy of the rest of the world. Everyone wants to go there as life seems good there.
One summer the banks in Blunderville start to give out money to people in Blunderville to buy lemons with the condition that they need to pay it back over 30 yrs at a very low cost ( read rate of interest). The cost being low, many people start buying lemons. Seeing the sudden increase in the demand for lemons, the farmers start cultivating more and more but they are not able to keep up with the overwhelming demand for lemons. People holding lemons then decide that they are willing to let go of a few but of course at a much higher price than they bought it for. All the second hand buyers are happy to pay the price because they too can get the banks to pay the increased price. The prices of lemons in Blunderville keep increasing but it makes everyone richer and so everyone is happy. The bigger the lemon, the higher the price. Some people even pack the lemons in good looking wrappings and that increased the value of the lemon to much more than what it takes to wrap it. The people who do not have money to make the payments (read sub prime borrowers) are offered loans but are told that they would be able to make the payments because the value of lemons never go down.
After a while the banks decide that they could make the people even happier. Since the value of the lemons they hold have all gone up, why not let them borrow even more money. So for the increased value of lemons from the time when people bought them, banks give them more money. People at Blunderville are all extremely happy and then start buying things from the rest of the world.
The banks meanwhile decide that for them to let this happy situation to continue they need to sell the loans to others who may be interested in sharing the increased value in lemons. They issue a lemon certificate, the holder of which is entitled to get a share of the payment made by lemon holders for well into the future. These lemon certificates are bought by banks all around the world and they too decide that lemons indeed have tremendous value and so they do the same. The new lemon economy causes the prices of other assets such as shares and land to go up in value around the world but everyone is happy because everyone feels richer. Everyone puts money back into Blunderville to be a part of the rise of the lemons.
After a while the wealth generated by lemon holders are so large that the prices of everything in Blunderville go up and so the banks decide to increase the cost of money. The people holding very high value lemons and people who were making a small monthly payment everyday suddenly find that they are unable to find new buyers or unable to make payments. All the people are bewildered as to why the mere raising of cost of borrowing makes their lemons less valuable. With lesser number of buyers for lemons, some people start to reduce prices. The people with lemons now face the situation of having to repay the original amount taken to buy lemons, the extra money borrowed to match the perceived increase in value of lemons and not being able to find new buyers at a higher price. The price of lemons start falling continously and so some people decide it is not worth repaying the money to the banks, afterall they have very little of their own money in lemons. With no new buyers the lemons start to pile up and the prices keep coming down. People who had no money to pay for lemons initially find that the money they need to pay every month to the bank has gone up but they are not as inclined to pay now as they see lesser value in lemons. In the meanwhile, the holders of the lemon certificates start to get worried as they could not see the price of lemons falling or in some cases they did not even know that they were holding lemon certificates.
After a while everyone begin to realise that lemons arent that valuable after all. They blame each other for not realising this earlier. Banks and other lemon holders start selling other assets like shares to meet their obligations and thus causing the prices of other assets to come down too. Blunderville wants to keep the prices of lemons at their past highs by providing cheap money but then the rest of the world decides that they do not want to keep supporting the lemon economy.
In essence sub-prime is about thinking that by merely supplying people with cheap money to buy lemons (read houses) and then riding reckelessly on the false notion till the prices of the lemons bought with borrowed money went so high that no one wanted them. Sadly enough people are always in search on new lemons in Blunderville. As to whether the rest of the world will do their part to support Blunderville is yet to be seen.