Saturday, December 25, 2010

Where All Ends Meet… Time Value of Option on Growth is Current Account and Fiscal Spending...

In the first two articles we discussed how a nation’s currency can cause boom or bust in its economy. In this article we shall go a step further and discuss how in the current world order the currency, fiscal deficits and the current account deficits are playing out on the economic growth and how the only hope for this world to prolong the inevitable is for the US to have a continued fiscal and current account deficit.

I would start with the most basic equation taught to everyone in Eco 101 i.e. Y = C + I + (G-T) + (X-M) i.e. the GDP of any nation is the sum of consumption, investment, net government expenditure i.e. subtract the taxes and current account balance i.e. exports – imports. I would be focusing on the government expenditure and the current account part in this article. Ofcourse the consumption is what drives the current account deficit and investments. So here we go………

Thanks to reduced tariffs and free global trade treaties the investment needed to serve the US consumption is largely happening outside as the factors of production are much cheaper there. It’s important to note that even the trade today is not free or relaxed even though it may seem that way. The exporting nations of Asia hold their currencies pegged against the USD and try to implicitly keep the labour costs and material costs down which means that only US ends up keeping its end of the bargain, in any case the lower interest rate regime of the US since mid 80s has also ensured that the society moves on to become a society of mega spenders as saving at every point of time is reprimanded by Fed by printing more money. So a lower interest rate in US drives the consumer to spend and the investment to support that spending instead of happening in US happens in Asia or Latin America as the factors of production are much cheaper or artificially kept much cheaper there. This in essence means the US ends up having very high current account deficit which implies as the dollars move abroad the Asian producers have the option of

- Either let their exchange rate appreciate and let the automatic mechanism of trade balancing come into play. However this is precisely what these nations are guilty of not doing.

- So this brings us to the second option which is to let this money flow into the domestic economy which can actually be highly inflationary

- Hence the final option is to export these dollars back to US and the world and buy other assets.

This third option is the option that is not only practiced in today’s economic order but has also become so lucrative because now the US need not pay the Chinese for its goods with money but rather with “debt” – vendor finance.

So essentially this means that consumers of the US can buy goods they can’t afford and more importantly the government can maintain a military and fight the wars it can’t really afford!!! So essentially this US runs a CAD (current account deficit) and in return Asia funds the fiscal deficit of US. Now there are four combinations that can happen with these two variables and let’s see how it would impact the world. So the (CAD can go up and down) *(Fiscal Deficit of US can go up and down) = 4 combinations:

Case 1: The Current Account Deficit goes down and the Fiscal Deficit goes up: Well clearly an unsustainable and an instant Armageddon situation for the world as the growth in the developing world slows, the increasing fiscal deficit would be hard to finance by the US and what’s worse is the fact that the slowing of growth would lead to the emerging world selling US assets and the Fed ending up monetizing debt thus driving the whole world into a cataclysmic collapse while the commodity prices shooting the roof. Not an unrealistic scenario though if the consumer in US doesn’t pick up (the CAD goes down as import reduces) and the US government would end up spending more to substitute for the consumer contraction thus increasing the fiscal deficit.

Case 2: The Current Account Deficit goes down and the Fiscal Deficit goes down: Well this can happen in situations; one if the US again enters into recession which as government spending contracts and the Consumer also contracts obviously not a good situation for the world. However the other situation is bloomier which is the US discovers some export industry to bank upon and the investment cycle kicks in because of that followed by the consumer buying US goods and thus the government pulling back. Clearly this is the only situation in which the world would blossom again but as of today looks unlikely. To make it happen in my opinion the US should invest in industries of tomorrow i.e. Clean Energy and high tech (more on this a little later)

Case 3: The Current Account Deficit goes up and the Fiscal Deficit goes down: Well not a scenario that goes hand in hand. This simply implies that American consumer buys more but that clearly shows that the American economy is still structurally weak this would imply that the fiscal deficit can’t really come down. So I would simply strike off this case.

Case 4: The Current Account Deficit goes up and the Fiscal Deficit goes up: Well this is one scenario which can either prolong this problem and can indeed make it even graver or if played out well can even solve this crisis!!! This combination would continue what is happening in the world that is the emerging markets growing, US getting into more debt which would be bought by Fed and by Asia but here is what this strategy can buy “Time” this strategy buy us time and like any option this also has it’s time value. If US does invest during this time in technologies of the next generation that can really shoot up the productivity i.e. green energy, high tech like maybe high tech agriculture, nanotechnology, nuclear technology etc. then it would get rid of it’s structural deficiencies and can move gradually from a case of high CAD and Fiscal deficit to a low CAD and Fiscal Deficit and thus sustained growth, however if nothing changes it would mean that US ends up into a bigger debt spiral and this would mean that someday someone would realize that would they are holding is a complete junk that they would end up selling and thus inducing even more selling bringing this world to a complete financial breakdown.

So to conclude I would say that Ironically US running Current Account and Fiscal Deficits is the only hope for this world. Spending on Current Account and Fiscal Deficit is what I call the "Time Value" of the option on "Growth",.

I believe we are just a few year away from witnessing which turn this world takes, will this debt spiral and money printing lead us to a financial collapse and a new world order emerging out of it or will the US invest in these new technologies and seal another US decade or perhaps even a century for itself. Till that happens as I say that there be chaos before the pattern emerges……………..

Thursday, December 23, 2010

Where All Ends Meet… Why a continued US Fiscal & Current Account Deficit are essential

This article is a continuation of my previous thoughts; probably this title suited it more. In the first article I tried to argue how the value of the currency is linked to the nation’s productivity. In this article we would explore the currency issue further and link it with the basic economic framework of today.

Let’s first explore as to how the credit is created and how money supply can lead to growth or bust and finally how we are sitting on a pile of trash. A borrower deposits 100 rupees with a bank, the bank is expected to maintain a cash reserve ratio of 10% which essentially means that he can keep 10 rupees and lend out the 90. This 90 again finds its way into the banking system and again 9 rupees is held back and 81 rupees are lent out (ofcourse assuming there is sufficient demand for that liquidity) and as this process goes on the 100 rupees of deposit becomes 1000 rupees in credit. This is called magic in common banter and money multiplier in economic talk. Now if the demand for credit is greater than this credit of 1000 rupees the Central Bank follows an accommodative monetary policy and supplies some more cash into the banking system. Had the country been following a gold standard the Central Bank would have been restricted in the amount of cash it could infuse thus restricting this growth. However since the human demand is infinitum, the key to success of this “Non Collateralized Monetary Policy” and I will come back on this term is for the Central Bank to pull out the liquidity if the demands are unjustified, which brings me to the second point… What does one means by unjustified demand….

The term unjustified demand in my opinion is any demand which would lead to investments that end up generating insufficient cash flows. Ofcourse in a capitalistic economy where risk taking is at the core and failures are part of life there are bound to be unprofitable investments and so that is why the “interest rates should be what they should be”, the cost of money should correspond to the risk in the investment but in any case if the overall risk of non-profitable investments increase in a certain sector the Central Bank has the tools i.e. adjusted risk weightages of loans given in that sector to deal with it and if this risk increases on an overall macro level the Central Bank should stop providing that extra liquidity or should even pull it out by adjusting the interest rates or changing SLR or CRR ratios. High interest rates act as a deterrent for risky investments as the cost of failure is higher and so my first issue with the current setup is that the interest rates have been so low for so long that it has inevitably turned the whole world into a casino.

Before I link this with the fiscal and Current account aspects let me quickly explain what I meant by “Non Collateralized Monetary Policy”…. Now when the bank issues loans against the deposits it basically issues cheques. So let’s say it has 100 rupees in it’s vaults, the bank can issue a cheque worth 90 rupees and give it to someone in form of loan. The collateral for that 90 rupees is the 100 rupees kept in the bank vaults. In a similar way the currency note or the cash number in your bank account that you are holding is a cheque that the “Great Central Bank” is issued you, but considering the amount of money supply in the economy what is the collateral held by these Central Banks…. Well China holds over 1 trillion dollar resevers in form of dollars so let’s see what reserves the US central bank holds whose dollars China is holding as collateral….

Ready……….. Nothing!!! The world is holding cheques issued by a bank that has no collateral to back it…… Blind following the Blind, well maybe not in every case and this we would explore a little later but anyways as the countries start realizing this more they would move towards hard assets from paper assets and so the commodity bull market of last 10 years has still some distance to go.

I just realized the article would probably become huge if I bring in the next point which is linking today’s monetary policy with the 2 critical components in economics Fiscal spending and Current Account. So with this thought till next time……………. Maybe in this case I should have changed the title :)

Monday, December 6, 2010

The Currency Conundrum…What’s the real worth -1

“He who tampers with the currency robs labor of its bread.” ~ Daniel Webster

The brashness with which the Central Banks across the globe, well really in the States (openly) and in Japan and the Euro area (covertly) are printing money raises the questions as to the real worth of the currency or rather more fundamentally from where does the currency attains its value. I would be less opinioned in this part of the article and would just talk about one most the most fundamental tenet of economy “The Currency”.

I would like to divide this topic into two parts, in this part I would talk about the fundamentals and basics of currency and as I said by being less opinionated (although would be hard….) and in the second my opinion on the endgame of the current situation. Nevertheless it is critical that the readers must understand that there is difference between working for money (that’s what most people end up doing) and working for wealth. Working for money is a complete fallacy as money can be printed in as much quantity by the Central Banks and thus keeping money in cash is the biggest mistake that working class people fall for. Ok more on it in the next article let’s discuss about currency now……..

Some four decades back Milton Friedman came up with a simple but an epic equation PQ=MV, not only it produced déjà vu with another great work of E=mc2 but following the monetarist approach of Friedman the world came out of the stagflation era by early 1980s. However please remember that like any economic variable growth (represented by Q in the equation) also responds to the relationship of marginal utility of money i.e. growth may increase as an increasing function of money growth followed by relationship of equality and finally as a decreasing function of monetary growth i.e. the relationship is linear only for certain period.

So after a sufficient history lesson let’s check the variables… (P – Price, Q-Growth, M-Money Supply and V-Velocity of money) the velocity of the money is generally a constant over the short and medium term except in cases of hyperinflation or severe deflation when it spikes and infact is the most important determinant of these two situations. Now the first question to answer is if returning to something like a gold standard would work. Well the answer to that is an affirmative ‘No’ because it is simply too restrictive. Let’s see how does the monetary policy accommodates for growth. Assume an economy X produces 100 units of goods/unit of asset, each costing 1 $ and let there be 100 $ in circulation (assume velocity of money to be 1) owing to some discovery or investment (IT, better production knowledge, education, roads etc.) to an increased productivity and this causes the economy to produce 150 units of goods/unit of asset. To support this if the currency under circulation is not increased then this could have a serious deflationary impact (since velocity of money remains constant over short and medium term period) and this could hamper growth. So the Central bank should increase money supply. Having a gold standard can cramp up this growth as that would mean that the currency supply can increase only marginally.

What this means is that the value of the currency actually maps the productivity. Let’s take a hypothetical example of two countries X and Y a labour in country X produces 2 units while in country Y produces 1 unit and let’s assume there is just one unit of labour available. Now if the value of currency is same in both the countries then it would imply that a citizen of country Y can buy 2 units while the citizen of country X can buy just 1 unit. Well not really all this would do is that the citizens of country X would not be ready to sell anything to country Y at that price and this would lead to a devaluation of the currency of country Y.

Now there are certain ways of bringing about this devaluation and this is what I am going to discuss next

- Market demand and supply: In a floating rate regime the currency would automatically adjust under market forces
- A Sovereign Decree: In a fixed rate regime a decree can be issued changing the rate of the peg.
- Printing more money: A weakened currency can have several consequences:
- It will no doubt make your goods attractive by bringing a nations currency more inline with its productivity
- It can reduce the value of the internal liabilities
- It may increase the value of external liabilities
- It may increase notional value of assets (not real value) atleast temporarily and may lead to internal inflation and in some cases global inflation
- More importantly it can have severe effects on the critical component called ‘Velocity of Money’ and if that happens it simply means that the Central Bank basically has lost control over its monetary policy.

Let me emphasize that ultimately the foreign currency must find its way to the issuer in exchange for some goods or services. If the productivity is of that country is less, then its currency has to depreciate to make it a fair exchange and infact market forces generally ensure this to be the case at most times in a floating rate regime.

I have tried to set the context in this article about currency and monetary policy, in the next part I would explore the critical relationship between Money Supply and Velocity of Money and comment upon the current monetary policies.