‘What a way to run a country’

Clive Crook wrote an interesting piece in FT recently on how the States are facing real challenges in meeting fiscal constraints while Washington – both the Congress and the Executive – ‘fiddles’. He wondered, in conclusion, if it was the right way to run a country. The article is worth a read. Close on the heels of that piece comes this one at Free Exchange. The blogger observes that this was no way to run a country. That makes it two of them.

Then, as part of his daily Breakfast serving, David Rosenberg of Gluskin Sheff notes that 

The United States is a 236-year old country, and almost 40% of the entire public sector debt has been built up by the current Administration in barely more than two years. The United States has a monetary base of $2.06 trillion, and nearly 60% of that has been created since Helicopter Ben took over the cockpit in early 2006. A 236 year-old country, and well over half of the stock of money has been created in just the past half-decade. Remarkable. [The full stuff is here. But, it might need you to subscribe. For now, it is free]

In recent testimonies and public statements, Mr. Bernanke has refused to take any responsibility for the spike in global commodities prices. I was pleasantly surprised to note that the Wall Street Journal is not impressed with that abdication of responsibility:

Asked about all this at a recent House hearing, Fed Chairman Ben Bernanke said QE2 is a success because stock prices are rising. He blamed the increase in commodity prices on other things, such as growing world demand and the weather. Mr. Bernanke holds himself accountable only for the asset price increases that are popular.

If that answer sounds familiar, it is because Mr. Bernanke said the same thing in 2003 and 2004 when the Fed last fretted about deflation. Then the Fed also maintained a policy of negative real interest rates for years and blamed asset price spikes on everyone else. Once again the Fed seems to have worried about deflation long after the threat had passed and even as price pressures from its easier policy were preparing to build. Let’s hope it turns out better than it did the last time. [Full edit here]

Thanks to good friend Srinivas Thiruvadanthai at Levy Forecasting, I was alerted to this useful speech by the President of the Federal Reserve Bank of Kansas City. It is good to know that it is not just outsiders/arm-chair critics who are displeased with the progress (or, the lack of it) on financial sector reform in the US. The speech is short and worth reading.

We have a government and the Congress that are cooking up irresponsible and short-term focused fiscal policy that does nothing to address fundamental issues, a Central Bank governor who thinks that successful monetary policy is all about creating and fostering asset bubbles and all three of them that combine to do nothing on an all-powerful financial sector. Indeed, this country deserves a AAA credit rating and a stock market that trades at 24 times cyclically adjusted earnings.

[p.s: Talking of the power of the financial sector, the pressure being brought to bear on Philipp Hildebrand of the Swiss National Bank to resign made for sad reading]

Two important reading links

Arvind Subramanian has a perceptive piece on why the fledgling outbreak of democratic instincts on Arab Streets (if it could be called that) would not lead to any economic boom. Besides the point he is rising – that rent-based societies do not allow for development of economic institutions – Arab societies are much more insular than they should be, if they are to build viable, prosperous liberal/democratic societies. The piece is worth a read.

Those of you who know how the National Association of Realtors (NAR) was a cheerleader for the housing boom even all the way into 2008 would know how to cut through the polite noise in this article and reach the appropriate conclusion on the issue of the exaggerated reporting of US home sales by NAR.

Is this the dark matter…?

… that Ricardo Hausmann referred to, as not being reflected in the US current account balance? This is what the Federal Reserve Chairman and his c0-authors conceded in their working paper on how the preferences of international investors also played a role in enhancing the supply of artificially created high-quality paper based on sub-prime mortgages!

Looking back on the crisis, the United States, like some emerging-market nations during the 1990s, has learned that the interaction of strong capital inflows and weaknesses in the domestic financial system (emphasis mine) can produce unintended and devastating results. [Full paper here]

To refresh memories, this is what Ricardo Hausmann and his co-author wrote in November 2005:

The bulk of the difference with the official story comes from the unaccounted export of knowhow carried out by US corporations through their investments abroad, explaining why the US appears to be a consistently smarter investor, making more money on its assets than it pays on its liabilities and why the rest of the world cannot wise up. In addition, the value of this dark matter seems to be rather stable, indicating that they are likely to continue to compensate for the measured trade deficit.

Globalization has made the flows of dark matter a very significant part of the story and the traditional measures of current account balances paint a very distorted picture of reality. In particular, it points towards imbalances that are not really there, making analysts predict crises that, for good reason, remain elusive. [Full paper here]

Readers are invited to draw their own conclusions.

Budget advice

Chetan Ahya contends that India’s fiscal policy is behind India’s inflation problem. He thinks that government stimulus measures boosted consumption expenditure by way of transfers to households. It is hard to argue with that.

Bibek Debroy thinks that the Central Government budget should be about rationalisation of expenditure and not about inclusion. If it is inclusion, then the attention ought to be on the budgets of State governments, he argues. He is disappointed that both the GST and the Direct Taxes code have watered down the exemptions-rationalisation part. So are we.

Talking of exemptions, Mani Shankar Aiyar writes a rhetorically strong piece for ‘Inclusion’. See here for the full piece. He is right to question the exemptions. But, he is wrong to argue that, because there are exemptions, farm loan waivers are right! Two wrongs do not make a right. It would have been at least defensible to argue that as long as there are exemptions for the rich, for IT companies, etc., there should be direct cash transfers to farmers.

In this regard, it is encouraging – no matter how far it is still from becoming a nation-wide reality – to note that the government has set up a taskforce under Mr. Nandan Nileikani on direct cash transfers, notwithstanding the mendacious comments from Mr. Harsh Mander. I did not know that he was a member of the National Advisory Council. Unfortunate.

Why did economists miss the crisis?

Raghuram Rajan at the Chicago University Booth School of Business. He is not in their Economics Department. He was chosen by fellow economists as the economist with the most important ideas in a post-crisis world. See here (ht: Ram Narayan).  Hence, his comments carry significance. His latest blog post is on the question of why economists failed to see the crisis of 2008. [It is a different story as to whether the y would see the crisis of 2012 coming]

I do not know if the view that is gaining ground is that the system bribed economists to stay silent. I am not going to contest Raghu on that one.

He dismisses ideology since both believers in market efficiency and non-believers missed predicting the crisis. He dismisses corruption though he acknowledges enough instances of bias to welcome disclosure of conflicts of interest. I hope that disclosure happens more often. Economists call for transparency and disclosure of information from governments. It is about time that they turned the spotlight on themselves on that issue.

He zeroes in (if I understand him correctly) on compartmentalisation and specialisation as potential causes. Economists are too narrowly focused on selected areas within the broad discipline and that there is no reward for generalists within the academic community. Again, he may well have a point there. He should know better.

I would supplement his analysis with the following observations:

(1) He dismisses the role of ideology too quickly. Some one who wrote the brilliant book, ‘How to save capitalism from capitalists’ should not be too dismissive of the role of ideology in precipitating the crisis and hence those ideologically inclined would not have seen it as an issue and a risk. Market efficiency might be technically defined as a statement that securities prices reflect all available public information and hence return on securities is essentially unforecastable based on known public information.

But, that narrow definition has not prevented Wall Street for appropriating for itself the advantages of the theory:  since they are participants in a market that is deemed efficient and hence, their decisions and actions must be efficient! Otherwise, the market would not be efficient. Therefore, the government should lay its hands off Wall Street.

Those who believed in financial market efficiency did not ask hard questions enough on how financial market efficiency came to stand for ‘hands off’ policy towards the financial sector.

Hence, ideology played a role in precipitating the crisis and in making many economists blind to its role in the crisis.

(2) I suspect that Raghu is again focusing on the US centric crisis when he refers to ‘US politicians pushing the private sector into financing affordable housing’. This crisis was global. There were housing bubbles in many countries.  The reason why not many economists raised a flag is due to their belief in ‘Great Moderation’. The fact that many picked Ben Bernanke as the most currently influential economist is proof of that. See here. The Federal Reserve Chairman believed in the role of policymakers in bringing about great moderation.

Most of them believed that, due to the crafty steering of monetary policy in the 1980s and 1990s, Western policymakers had conquered business cycles and hence risks have been largely eliminated or diversified away.

They did not believe that the great moderation of the 1980s, 1990s and partially up to 2007 was due to special factors: Commodities were declining in prices up to the end of the millennium (excess supply, slow growth in world demand, accent on conservation, climate change had not begun, etc.), labour power had been tamed by Mrs. Thatcher and Reagan, the European Union was focused on creating monetary union with low inflation, demographics were in a sweet spot in the developed world and ensured moderate to strong growth, internet and TMT boom boosted productivity, consumer choices and lowered prices.

Once these special/one-off factors began to fade, the moderation disappeared and cycles re-appeared. Economists turned policymakers, basking in their own glory, failed to see that coming nor did other economists who were cheerleading them. There were several honourable exceptions.

So, what is my submission?

Raghuram Rajan is right about academics’ specialisations and narrow focus, lack of incentive for generalisation, being responsible for academic economists missing the crisis.

Just yesterday, I was discussing with a distinguished economist who refused to accept that easy money policy of the Federal Reserve was responsible for the rise in the prices of commodities or for speculation in commodities. He argued that correlation was not the same as causation. This argument vindicates lack of experience in the real world of financial markets.

Nonetheless, specialisation and compartmentalisation are only partial answers.

Ideological belief in market efficiency (broadened to include acceptance of the efficiency of financial market participants!) and hubris were other contributory factors.

Postscript: Generalists-economists exist outside academics. Economists and strategists working for investment banks see financial market action. They could observe mispricing of risk: abundant faith in carry-trade, currencies out of alignment with fundamentals, massive compression of spreads on high-yield and emerging market bonds, etc.. All of them were evident leading up to 2007-08. But, for the most part, their incentives are aligned with generating revenues for their firms and not with warning about risks in the financial markets.

Update: Gavyn Davies has this sober and interesting angle on the issue of why economists missed the crisis. Career risk management means that economists are not capable of predicting disruptive events. It does not make sense to do so. But, this is a good defence for professional economists. But, academic economists should be exempt from this fear, by and large.


Standard Chartered’ Gerard Lyons’ has put out his Global Economic and Financial Outlook (10th Feb. 2011 – available to clients only). Some key sentences and the final disconnect between the sentences and his conclusion. They mirror the title of his piece  – ‘Diverging and disconnected world’.

At Davos, I felt there were some ‘elephants in the room’ – big issues that need to be recognised but which people pretend are not there: the shadow banking industry, global imbalances and the US budget deficit.

While the German pursuit of a hard-line may make sense from a domestic perspective, there is no easy way out of the euro area’s problems. Policy statements cannot replace economic reality. The periphery faces deep recession. Debt rescheduling is inevitable.

It is vital for the world, for Asia, as well as for China that it addresses its inflation challenges now. This is no time to wait.

In our view, the world economy is in a super-cycle: a sustained period of high economic growth, lasting a generation or more.

John Mauldin had written an interesting post on 29th January 2011, the day after the US Government released its fourth quarter GDP numbers.  The US reported 3.2% annualised GDP growth in Q4. This was despite a 3.7% contraction from inventory investment. So, every one thinks that it stores up an upside rebound in the next quarter. But, here is the rub (paraphrased from his post):

It is important to note why inventories subtracted 3.7% from growth. It is because the deflator for imported goods went up. Why? The price of crude oil shot up 10% in Q4 alone and that is 40% annualized. Remember that the USA reports GDP growth on a QoQ annualized basis.

As the price of crude oil rises 40% annualized in Q4, the import price deflator jumps, real imports get marked down and, importantly, the existing inventory of crude oil gets marked down in price too. Therefore, inventory is valued less and it reduces growth!

But, note here that this is offset by a 3.4% positive contribution from net exports because real imports get marked down due to the jump in the Deflator for imports!

There is no conspiracy therory here but just a statistical explanation.

Needless to add, I warmed up to this observation of his:

I just see a bubble in complacency. The market is going up, so all must be right with the world.

‘Truth and Beauty’ (Eric Kraus) has posted another of his racy and well-written investment letters. The introductory text whets one’s appetite, as usual:

The degree of complacency among investors is truly impressive, as the Middle East – a region which has long produced far more history than could be consumed locally – threatens to become suddenly interesting again. The effects of expansionary monetary policy, and commodity price inflation, can show up in the most unexpected places… Beware those emerging economies sitting on socio-political fault lines. 

Meanwhile, with the US desperately trying to keep the bubble inflated, an increasing number of countries are biting the bullet and withdrawing stimulus – with China hiking for the third time in five months, some of our strategist peers are scurrying to get out of the way, reallocating from the EM to the DM just as fast as their little legs will carry them. [Full letter here]

Now that I could put in one blog post observations on complacency by three financial market participants, not including TGS, it is not possible to say that not many saw the (next) crisis coming. TGS will have more to say on Raghuram Rajan’s post on the matter of economists missing the last crisis totally.