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

Where do we go, nobody knows

Most medium-long term investors are facing a tough question. Where do I invest, apart from Gold and soft commodities? The fundamentals of US doesn't look attractive as I have pointed out in my earlier posts. Lets travel east across the Atlantic.

Couple of centuries ago, the sun never set in the British empire; and now the light seems to be fading quickly.  England became the world's first industrialised nation in late 18th century. It relied upon its colonies to bring in resources. English factories processed the goods and sold them all over the world. Cities grew and large industrial centres were established as a result the island was prosperous. Currently North sea oil and London's financial services account for 95% of UK's GDP. Depleting oil reserves, low oil prices, financial turmoil and reduced tax collection worries me. Coupled with QE and high deficit as a %GDP makes me not to invest in UK for years to come. 

Eastern Europe is on the verge of bankruptcy. They have $500 bln  (50% GDP) to pay out on maturing debt this year. The stakeholder of the debt is western europe banks and sovereign states; who themselves are crippled by slump in manufacturing, increased national debt and a real estate bubble. Driven by their own exposure to the rest of the region, Germany and France are willing to help the "union". Im deeply skeptical on the effectiveness of the plans put forward. 

Moving further east, I will not put a nickel into India. India is a land of hundreds of languages, cultures and traditions mixed together that its never meant to be a country. It is defined by a silly line draw on the map by the clumsy English. The Indian government has the spell of satan, anything it touches turns rotten. The IT sector is an instance in point. The government regulated the hardware industry imposing taxes and involving with the private sector. It neglected the software industry as it saw no value in services business. And two decades later the results are too obvious. The IITs were the best education system in the world as it was run purely in a meritocratic manner. It brought together brilliant young minds in a competitive environment without any intervention from the government. My concern is with the onset of economic downturn, the government is getting involved with every parts of the economy including education. Im skeptical about India's growth, peace in the region and am increasingly skeptical of the quality of future graduates from IITs. 

The only bright spot seems to be China. China is a capitalistic economy. In fact they have understood that for capitalism to work efficiently, it needs government intervention; which I shall cover in my next post.  

"Where do we go nobody knows

Don't ever say you're on your way down, when..

God gave you style and gave you grace"         

- Coldplay

 

Deja Vu

"Mankind never learns from its mistakes hence history repeats itself" – Bible

The rise and fall of most great empires have striking similarities, and I would like to highlight one such example. The growth of Rome was fueled by increased agricultural productivity, transparent governance on a diligent citizens and strong army. Education system was great, dining and art were at their peak. They accepted other cults and religions; personal and social ethics was at its peak. The empire flourished for two centuries right from Julius to Alexander Severus.

The decline in Roman empire was the systemic economic weakness that crept during the pan romana period (3rd century). First the empire was built upon the labour of the exploited aka slaves. Second, the maintenance costs of the empire were huge and continued to expand all the time. The upholding of the Roman standard of culture meant huge amounts had to be spent to provide an adequate supply of the amenities that were considered essential to the full life or a Roman citizen. The empire had to be policed and the imperial post and the ever expanding army had to maintained.

The empire found itself in a catch-22 situation in which there no solution to the problem. On the one hand there was the ever growing need to maintain the affluent lifestyle and on the other the ever diminishing capacity to carry it through. Taxes were increased and Hardin, then ruler of the empire, started borrowing money through issuance of notes. Historians argue that the enormous borrowing coupled with lack of investments continued for five decades. The eventual explosion of the empire was caused by the lack of circulating currency in the western empire. Two reasons for the lack of funds were the hoarding of bullion by Roman citizens, and the widespread looting of the Roman treasury by the 'barbarians'. These two factors, coupled with the massive trade deficit brought down the once great empire.

At the root of every great empire lies an idea. Patliputhra was an idea, Rome was an idea and America was also an idea. The spirit that fuels an idea and creates an empire typically runs out of steam over time. The society increasingly become lethargic, inefficient and complecent laying seeds for its own demise. As bitter as this sounds, we are witnessing an empire falling from a cliff. But a different kind of new world order will emerge. The engine that drives the global economy will be where people are. It will be a bumpy and ugly journey to the new destination. I do hope an eventual destination would be one world with one dream. Empires, countries and states are just imaginary lines drawn on the globe by men hungry for power. The challenges facing humanity today are universal and we need an united world to fulfill those dreams. Unfortunately I do not have a time machine to fast forward. Until then I shall stock up in gold bars, cans of beans and sacks of rice !!

Lack of Trust

The fabric of any society lies in trust. In our personal lives, we trust our family our close friends and our life partner. Society and civilization grew as an extension of this trust. In modern day, we trust our government, our firms and institutions to uphold their responsibilities and trust. The origin of finance lies in trust too and credit is a measure of this trust. 

Financial transactions are a set of promises. Money is an agreement that a piece of paper can be exchanged for goods or services. Financial framework began with small loans within families and trusted friends. As the circle of borrowers and lenders grew, the complexity of financial transactions increased; promises became harder to enforce. The modern financial structure became so complex and interconnected that businesses had to trust each other for the engine to run smoothly. Men and society in general, driven by greed, lost corporate and personal ethics. Trust was lost, credit bubble burst and the engine has stopped running. The fed can try to expand balance sheet, buy agency or corporate debt might even buy long dated treasury; but none of these will promote easing of credit. 

I would like highlight few instances of lack of trust that reinstates my point. First in my article written in November '08, I had indicated that the first bailout package would neither be enough nor be properly used. Out of the first $350 bln, $18.5 bln was used to pay wall street bonuses. So the poor taxpayer who has seen his net wealth reduce by 50% has paid out even more money to the greedy, corrupt and rouge bankers and traders. Second, can I trust the rating agencies, research analysts and regulators? When State Street posted unanticipated record losses last weeek, 9 analysts had a buy and 8 were on hold. Kudos to your hard work and million dollar pay. Regulators were on top of their game that we have witnessed countless of ponzi schemes and fraud accounting. Rating agencies downgrade Greece and South Korea who are in downturn, but hey we in the US are still AAA despite nightmarish CA deficits and total external debt. 

In terms of market, I ask the same questions. Can I trust the profitability, capital structure and the sustainability of corporations in US? Can I trust that the policy-makers understand the complexity and depth of the problem that their bailout packages can revive the system with no medium/ long term fiscal problems? If you have the answers for these you know the state of S&P, dollar and interest rates. 

Trust is an acceptance of other's value and ethics. In the modern world , man and hence society has lost corporate and personal morality. Most people ask me what will turn this crisis around and I wonder maybe when society adheres to Goethe's words

"As soon as you learn to trust yourself, you will know how to live."