“Everyman takes the limits of his own field of vision for the limits of the world.”  - Schopenhauer 

The 19^th century philosopher’s quote reflects a symmetric nature. The limits of the world should feedback to limit the possibilities of our actions. Monetary policy is perceived as a panacea for the western world. The recent data and history refutes this predilection. 

Burgeoning public deficits has forced austerity measures across the world. Resultant increase in public discontent precipitates via elections. The displacement of the incumbent party and uprising of the extreme ideologies vindicates the truculence of public. Circumscribed policy makers have turned towards central bankers for solutions. Rising unemployment, declining aggregate demand and languid growth rates are issues in need of critical attention. 

Since the tumultuous days of late 1970s, central bankers have enjoyed two decades of global growth and low unemployment; albeit driven by credit growth. The halcyon days are over post the 2008 meltdown. Interest rates have been cut to the bone balance sheets have been expanded; resulting in negative real long term interest rates.  Yet, the outlook remains parlous for the global economy and financial stability.  

The rise of true multinational corporation has been a key economic development since 1990. These institutions can channelize capital and labor across different economies; at times orthogonal to the monetary policies pursued by local central banks. Cheap credit provided by the Federal Reserve, may precipitate at manufacturing facility in a more competitive labor market economy, such as Latin America or Asia. This serves to explain the sustained growth in top line of certain multinationals while their counterparts catering to local economy have seen precipitous decline in earnings. Hence the private market channel of engendering growth through money supply has been transposed. 

The employment situation appears anemic with unemployment rates still at elevated rates. Empirical evidence suggests that labor and capital shall be deployed only when there is a positive risk adjusted return on investment. The job creation over the last 20 years was primarily fueled by perception of return fueled by leverage. This is transmitted in hiring across the supply chain; from property developers and construction companies to build properties to in leverage finance industry to fuel credit. In a deleveraging world and contracting aggregate demand, the reverse process functions. Without Schumpentarian creative destruction forces and increased leverage; monetary policy will be unable to foster job creation. 

In essence, the “anomalous” decade of sustained global economic growth was not a direct consequence of monetary policy. Light regulation, lower capital requirements, higher leverage, correlated mal-investments all served as necessary ingredients. Central bankers cannot now be called upon to rescue the Titanic; especially when one is not controlling the ship. Policies implemented with misunderstood economic framework could have pernicious effects on the global financial system. If status quo is maintained, future students of history and economics are likely to befit today’s central bankers with Einstein’s definition of insanity.

“No man is an island entire of itself….And therefore never send to know for whom the bell tolls, It tolls for thee.” – John Donne

The seventeenth century poem that inspired Ernest Hemingway towards his seminal piece, stresses the inter-connectivity of human beings. Societies, political states do not thrive when isolated from one another. International cooperation is critical if we were to emerge unscathed from the crisis. 

The global imbalances are apparent, the prodigal west and the parsimonious east. The west needs to increase competitiveness of domestic labor. This is achieved either through currency devaluation or through wage cuts and austerity or a combination of both. Quantitative easing strives to achieve the first. But in a world where every central bank resorts to this measure or peg their currency to US Dollars, this measure fails. A reduction in real wages is well under a state’s control, albeit very unpopular and leads to national resentment. Despite measures for reduction in spending are being contrived, none of them are in practice. The deficits number in Spain came in 2% lower than the target that was revised down by 3%. The persistent increase in debt ceiling and the subsequent failure of the super-committee is an instance in point. 

The creditor countries should seek to modify the investment driven, currency-pegged export driven model to a consumption based society. The structural change is hard to inculcate post the austerity measures put in place by the IMF, post the currency crisis in late 1990s. 

On the topic of IMF, the recent $400 billion in IMF resources is misleading. 82.5% of this is contributed by the European block. The rest of the world is unwilling to bail out Europe, including US and Canada. Pictures of European officials with Champagne and caviar discussing austerity portray the disillusionment prevalent in Europe. The credibility and impartiality of the IMF, with a heavy European influence, are also under scrutiny. Social change in the west is also an integral part of the re-balancing that the world needs. International cooperation and understanding of the situation at hand is critical to address the problem. Process of addressing structural can do without obdurate public, venal bankers and depraved politicians. 

Research carried internally suggests that all of the global growth in the last decade was driven by credit growth. In a world faced with deleveraging and austerity, true technological advancements can alone fuel growth. The alternative case of competitive currency devaluations to increase nominal growth and inflate away debt can have dire consequences. Hopefully scientists, engineers and fundamental value generators will step up to the humanity’s call.

Not Just a Greek Tragedy

“Timeo danaos et dona ferentes” – Virgil in Aeneid (II, 49)

If in the ancient world, one was to beware of the Greeks bearing gifts, the modern day analogy would be the bankers. The ongoing saga of the European debt issue underlines two issues. First, the lack of understanding of the problem at hand and second, the attempted solutions that benefits the banks at the expense of the taxpayers.

The problem at hand is rather a complex one. Greece is at debt-to-GDP ratio of 160% coupled with unemployment rate of 16% and a GDP that’s been contracting since 2009 at an annual rate of 5.5%. The solvency of Greece is in question. The EU/IMF through the ESM framework is addressing this fiscal issue. However Greece also runs persistent current account deficits to the tune of 10% p.a. The interbank market within the EU broke in mid-2007. The PIGS were able to source funding through ECB’s replacement lending which has now ballooned to $500 billion. This problem is well elaborated by Hans-Werner Sinn, the president of the IFO institute. Hence no amount of adjustments to fiscal balance sheet will account for the ballooning external funding and create massive imbalances in Target2 Accounts for ECB. The Euro framework has to be radically restructured and restructured pretty soon. Privatization of assets is also being pursued as a solution. If a corporate were to reduce its total debt-to-total working capital, it doesn’t proceed by liquidating all the assets. Not only does this reduce its revenue but also hurts the viability and the going concern of the company. The idea is beyond preposterous!

The EU/IMF is willing to extend more debt for Greece in exchange at senior grade for full repayment of the existing debt. The size of the current loan is roughly $150 billion for 10 million Greeks, that’s about $15,000 per Greek at sub below market rate of 5%. This is at the expense of 50% haircut to the pension fund, further budget cuts and layoffs. Pain is good for the average Greek. During the Asian currency crisis, IMF enforced high-interest rates, tightened money supply, bankrupting most banks and corporations. Millions fell below the poverty line especially in Thailand, South Korea and Indonesia. Pain was good for Asians and Asian corporations. The banks made additional 3% by lending to Greece than to Germany. The additional return reflected the increased risk, which has to be borne by the lender. Surely an unpleasant consequence, but pain isn’t good for the European bankers.

To put in perspective, Goldman Sachs helped Greece and other countries to mask their debt and deficits to join the Euro. Why are they not being prosecuted for aiding a country to falsifying documents and “massaging the numbers”? This adds to mortgage securities scandal, foreclosure fiasco, insider trading, aiding Libyan governments and wealth funds in embezzlement. The list is endless.

Financial corporation’s sole purpose is to allocate capital efficiently. Instead they are replete with criminal activities that endanger the political and societal structure in the world. Wonder when the citizens of the world will wake up to the simple truth.

A Question of Trust

"I'm not upset that you lied to me, I'm upset that from now on I can't believe you." - Friedrich Nietzsche

The Goldman Sachs scandal brings to light the functioning of modern day financial system. Evident from the recent senate hearing concepts of ethics, morality and humility are often lost on Wall street. Origin of finance lies in origin of trust, a fundamental foundation of any societal state. The essence of trust is evident even in the basic human actions. A shake hand for instance expresses an idea that I trust the other person with one hand that he/she would not strike me a blow, but will retain the other as a protection. Every society operates in the assumption that the framework and implementation of law that would protect the rights and liberties of each of its citizen. By participating in any society, each citizen lay their "trust" these laws will be followed and enforced.

When a key member of the society engages in an act of commerce by concealing the true value of good its transacting in, it destroys the essence of this trust. All citizens of the global society should question the current framework of finance. Do you trust your banker to protect and act in your interest? Do you trust the bank's business model that would install confidence in their solvency through tough times? Above all do you trust the central bank/government to preserve the value of your underlying currency (unit of account)? If the recent scandals at Goldman Sachs or the obfuscation of public finances by European governments, are anything to go by the society needs to restructure the global financial system.

The first step in this process is to realize that finance is a service industry. It does not produce anything substantial neither does it propel humanity forward. A service or knowledge industry cannot form a stable base of any society. If everyone is servicing one another, who is actually involved in production? The core of the society should focus on addressing the impending needs such as clean water harvesting, climate change, renewable energy, food shortages etc. The above needs are easy to identify and many companies are working towards a solution. The need for restructuring of the financial system isn't quite obvious yet, but in due course it will be. When the system is restructured, it must be built from foundations of trust.

Beware the Ides of March

The soothsayers warning to Julius Caesar is well applicable to today's global economy. Wall street and main street have cheer-leaded the global economy to a "V shaped recovery". At prima facie, the global fiscal and monetary stimulus seems to have worked. GDP is non-negative, unemployment isn't collapsing and retail sales numbers are positive and the party with big bonuses is back on wall street...

However soothsayers are worried about the following issues. The contraction of credit in China, parliamentary election in Australia, Aussie housing bubble, Japan in a political and economic mess, PIIGS, the problem at the Euro, chances of hung parliament in UK, Bank of England facing the stagflationary checkmate, the state and local problems in US (California, Illinois, Arizona, Florida, New Jersey to name a few), the Commercial real-estate time bomb, Volcker Rule, the oncoming maturities of optionARMs and Prime loans etc. These are impending problems in 2010 that needs to be addressed. Its time to face the music, extend and pretend will no longer work. But the policymakers have exhausted their ammunition last year and it is very interesting how they try to combat the oncoming problems.

Im compelled to dwell little in to an economic thought that should have been discussed in schools, instead of teaching myths and forcing down garbage through students minds. A balance sheet recession emerges after the bursting of an asset price bubble. This leaves the private sector with more liabilities than assets on balance sheet thus debt minimization becomes the goal of the private and household sector. This happens despite zero interest rates, money pumped in to the financial sector. The newly generated debt repayments that enter the banking system does not leave the system due to lack of borrowers. This deflationary gap continues to push the economy towards a contractionary equilibrium aka depression. Thus the government and central banks can keep extending their balance sheet, but private sector will keep deleveraging. Hence no amount of stimulus or money printing will solve the problem which is endemic at the micro economy. But the former actions will bring to light the inflated government debt and question the credibility of the curre
ncy system involved. Hence as misunderstood by wall street titans and economic professors, an inflationary and deflationary outcome is simultaneously possible.

The elitists at main street and wall street have engaged in solutions without even inquiring in to the problem at hand. Little thought would lead to the realization that the western world has morphed in to a FIREconomy. As the name implies it is an economy driven by Finance, Insurance and Real estate. These sectors employ the majority of people. who have no skills what so ever (including myself); who do nothing but pass around pieces of paper and have a self-proclaimed notion of creating wealth. And to top it all the society is guided by "enlightened men" aka economists. The problem with economics is two fold. Firstly it is a social science, which is not a science as it does not have any laws. General theory of relativity is a law, Philips curve is not a law. Economic principles are not bounded by principles of rationality. Secondly, economics is an observation of trade and commerce. We don't need thousands of meteorologists to study the weather pattern, society will continue to exist with or without them. Real growth always comes from technological innovation that improves the quality of human life. The sole objective of finance, aside from handling the settlement system for trade and commerce, is to provide working capital to lenders who might create these paths of innovation. However, borrowing to speculate on asset prices is a ponzi behavior, that produces nothing of tangible value to society. Hence I do beg to differ with Goldman Sachs CEO who believes they are doing "God's Work".

The crux of the problem facing humanity is a broken political and financial system. The democratically elected political system is incentivized to engage in policies that might bode well in short term with no concerns for medium to long term consequences. Added to this a financial system that works not only through an ever expansionary credit but also by striving to maintain the credibility of the underlying central bank. Both of these systems are doomed to fail by structure.

Profound changes are impending on humanity over the next 25 years. The systemic economic crashes are symptoms of the structural breakdown. We are in the process of a turning around an inflexion point. So strap your belts on, as its going to a fun ride !!

Origin of Money

Origin of money parallels with origin of society. In primitive society say person A produced butter and person B produced eggs. Person A might enter in to an agreement with person B to exchange a pound of butter for dozen eggs. Thus the concept of "price" of a good was created determined by individual's propensity to consume different goods. As society grew and more players entered the market, bartering became increasingly complex as each individual's utility function varied with commodity and time.

Hence a commodity that was easily marketable to be used as a medium of exchange was created. The commodity, to be chosen, must have two requirements: low cost of production and divisible into smaller units without loss in value. Historically different commodities have served this purpose sugar, tea, nails (yes in Scotland), copper. But over time two commodities emerged in the free competition of the market: Gold and Silver. Coins of gold and silver were used as a medium of exchange all around the world and soon became "units" of money. The unit of money was simply the unit weight of gold or silver and the modern day "fiat currencies" refer to these units. The British currency "pound sterling" referred to value of a pound of silver. The count of Joachim's coins became popular as was referred to as "Joachim's Thalers" or "Thalers" and eventually into what we know today as "Dollars".

Money is itself a commodity and like all commodities its value is set up total stock and demand from society to hold it. Once there is enough supply of money, no increase in supply will improve the functioning of the market. An increase in money supply, like with any commodity, will merely dilute the effect of each unit of money. With majority of countries off the gold standard and the central bankers who have let the printing machines run at full speed are efficiently devaluing the unit of money. The scale of credit creation is so large that a currency crisis is inevitable. So it doesnt matter if your fiat money is in dollars in FDIC "insured" bank or in other currency in a safe foreign bank or under your mattress, its value is going to depreciate.

Thanks to all our fed chairmen and treasury secretaries, the society has come to this mess due to their profound grasp of the basic understanding of how society works. Obama, although a great statesmen at heart, has given power to people who neither saw this problem coming nor do they understand how to fix it. The policymakers are bestowed with immense power as their policies based on feeble assumptions ruin the lives of billions of people. The current economic meltdown in an instance in point. In fact, some of the policies that they are enacting are even unconstitutional. American principles of freedom and liberty are not at threat from fundamentalists in middle east but from corrupt and incompetent policymakers in Main Street.

"Never spend your money before you have it." - Thomas Jefferson

To be or not to be...

"Man by nature is a political animal" - Aristotle

The second century B.C Greek philosopher, believed that a concept of city/ state is organic with each individual at the top and the collective entity at the bottom. Freedom is achieved when each individual is allowed to pursue his/ her self interest as long as it doesn't interfere with some one else pursuing the same goal. I look to understand if these principles might hold in the US going forward. I begin with analyzing the state of the economy.

The total national debt in US (excluding future social security and medicare obligations and those of Freddie and Fannie) stands at $11 trillion or 80% of GDP. The outstanding MBS and the public mortgage backed securities guaranteed by Freddie and Fannie amounts to $8 trillion. The private sector debt has ballooned to nightmarish levels. The ratio of total credit to GDP in US exceeds $50 trillion or 350% of GDP. This is the largest ratio for any society in the history of mankind. By guaranteeing the majority of debt, the US society (government + citizens + corporations) is bankrupt.

Inflation, a noun form of the verb to inflate, which derives from the Latin word inflatus, i.e to swell or to blow up. In modern day, courtesy Arthur Burns's tweaks in 1972, inflation is measured as rise in prices of goods and services excluding food and energy. Since the prices have been steadily decreasing, most economists and policymakers are worried about deflation. But with the FED increasing (via printing) money supply something has to be inflated as money always chases goods. Hence the inevitable question is what is inflated? The answer is US treasuries, US dollar and stock markets. The world has finally learnt not to lend anymore to US (buy their debt). With the treasury issuing $100 bln of debt every alternate week its inevitable that treasury and the dollar collapses.

When the bubble blows the dollar could depreciate by at least 20 times. This is an automatic "transfer of wealth" to other economies that are fiscally sound, like China. It will not only address the size of outstanding debt in the US but also adjust the large global fiscal imbalances. Such substantial shifts causes hyperinflation and social unrests and ill-will as witnessed by banana republics in the past.

Socialism seems to be more welcomed in US and its understandable. Majority of the population is in grim situation; loosing jobs, mounting debt payments; threat foreclosing their house with little or no savings! They are looking for the government to "bail" them out; increase jobless benefits and back their debts. And the government, in its extreme sense of wisdom, chooses to tax the remaining yet the productive part of the economy.

Great inventions and discoveries have never come through orders from government. Thomas Edison or Albert Einstein came up with inventions and ideas driven by a self-motivated passion. Silicon valley came was developed as result of actions by a collection of bright individuals than from creation of state or federal government. The current administration is sowing the seeds of socialism with increased regulation, higher taxes and greater barriers to entry of new businesses.

In sum, I question the rational to be in America or have assets in US dollars. The principles that built this country have been torn apart the last few decades; with ever deteriorating fiscal condition, potential currency crisis, increased socialist principles I reflect if the concepts of freedom and state hold good in future. The early fathers and more recently the "brain drain" from Asia came to America in search of these ideals. Perhaps its time for every American who values freedom and liberty or everyone who is in America to look for outside pastures.

"May you live in interesting times." - An old Chinese curse