Following is a commentary on the future directions of the market (the Nifty index) from a leading business paper,

“The current up move may halt around the 5500-level. After that, we could either enter a phase of prolonged consolidation in the range of 5000-5500 or the index could once again drift lower to retest the 4700 odd levels.” (emphasis mine)

Translated into plain English, the above means,

“The markets may stop going up. It could remain where it is. Or it could go down.”

Poor Economics, by Abhijit Banerjee and Esther Duflo, has won the Financial Times and Goldman Sachs’ Business Book of the Year award. The book deals with “radical new ways of tackling global poverty.”

This reminded me of a paper my friend George and I had written some years back. An excerpt from the paper (you can download the entire paper here),

We believe that poverty, hunger and malnutrition in the global economy can be eliminated without any aid. The commodification of development, through the creation of an incentive structure, which results in a self regulating market where every market participant gains, is the essence of our idea. There is no philanthropy involved.

There are several multilateral, bilateral and unilateral organizations working towards eradicating poverty. Billions of aid money has been disbursed for this purpose. Yet, the problem of poverty remains huge.

Maybe its time to do things differently.

When I was at school, my English language examinations had an essay writing section with 20% weight in the overall score. The topics generally required the student to come up with a creative fictional prose. I was terrible at writing fiction. To make up for this, I made a genuine effort to brush up my vocabulary to make my writing fetch more marks. I used to write down words in a notebook and rote them with a religious fervor. By the end of school, I was writing essays with such complex words that I would have difficulty in understanding them if I were to read them today.

During the next three years of my graduation, I was of the opinion that good writing should involve maximum use of jargon, difficult words and complex sentences. After all, what better way to convince a reader that you are an ‘expert’ than to communicate in such difficult terms that the reader is left feeling uneducated?

How wrong I was.

My professional life turned this opinion upside down. My work demanded strict adherence to the The Economist Style Guide. Language I was told should be crisp and to the point. Jargon and difficult words should be avoided. Sentences should be short and should not involve even one extra word than what is required. A part of the style guide was accessible online but it has now temporarily been removed. You can purchase a hard copy of the style guide here.

The more complex the language, the less the writer himself understands what he is writing. There are obviously numerous exceptions. The one that immediately comes to my mind is F.A. Hayek. I have personally found his way of writing a little difficult to follow, but it cannot certainly be said that he did not understand what he was writing. Another exception is that language is a function of time. So if you pick up one of Keynes’ essays, you would find the style of language quite different, but that again does not mean Keynes did not know what he was writing.

Krugman provides a link to an excellent article by George Orwell on English language. It is a must read. Orwell gives examples of poor style of writing that has gained popularity by appearing ‘scientific.’

Here is an example,

On the one side we have the free personality: by definition it is not neurotic, for it has neither conflict nor dream. Its desires, such as they are, are transparent, for they are just what institutional approval keeps in the forefront of consciousness; another institutional pattern would alter their number and intensity; there is little in them that is natural, irreducible, or culturally dangerous. But on the other side, the social bond itself is nothing but the mutual reflection of these self-secure integrities. Recall the definition of love. Is not this the very picture of a small academic? Where is there a place in this hall of mirrors for either personality or fraternity?

- from Essay on psychology in Politics (New York)

With regard to sentences like the above, Orwell says,

“….quite apart from avoidable ugliness, two qualities are common to all of them. The first is staleness of imagery; the other is lack of precision. The writer either has a meaning and cannot express it, or he inadvertently says something else, or he is almost indifferent as to whether his words mean anything or not. This mixture of vagueness and sheer incompetence is the most marked characteristic of modern English prose…“

Another excerpt from Orwell’s article,

I am going to translate a passage of good English into modern English of the worst sort. Here is a well-known verse from Ecclesiastes:

[Sentence 1] I returned and saw under the sun, that the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favour to men of skill; but time and chance happeneth to them all.

Here it is in modern English:

[Sentence 2] Objective considerations of contemporary phenomena compel the conclusion that success or failure in competitive activities exhibits no tendency to be commensurate with innate capacity, but that a considerable element of the unpredictable must invariably be taken into account. 

Now analyze these two sentences a little more closely. The first contains forty-nine words but only sixty syllables, and all its words are those of everyday life. The second contains thirty-eight words of ninety syllables: eighteen of those words are from Latin roots, and one from Greek. The first sentence contains six vivid images, and only one phrase (“time and chance”) that could be called vague. The second contains not a single fresh, arresting phrase, and in spite of its ninety syllables it gives only a shortened version of the meaning contained in the first. Yet without a doubt it is the second kind of sentence that is gaining ground in modern English. I do not want to exaggerate. This kind of writing is not yet universal, and outcrops of simplicity will occur here and there in the worst-written page. Still, if you or I were told to write a few lines on the uncertainty of human fortunes, we should probably come much nearer to my imaginary sentence than to the one from Ecclesiastes.

As things stand, if a person were to express his views using Sentence 2 instead of Sentence 1, he would easily pass as an ‘expert.’ Sentence 1 is ordinary and fails to generate awe and mysticism – two attributes the ‘expert’ needs to rise above the commoners.

There are numerous ‘experts’ who hide behind the cloak of poor writing. The shaky foundations of their knowledge will stand exposed if their writing is stripped of jargon and convoluted sentences. A true expert on the other hand communicates with clarity and precision, demonstrating his subject matter expertise. If you watch Milton Friedman’s documentary series “Free to Choose,” you will know what I am talking about.

The bottom line – clarity in language demonstrates clarity in thoughts.

Friday (5 August) was an eventful day. One that has provoked me enough to write. So here goes….

First and foremost, a quick update on the horror unfolding before us.

Lets look at the US 10 year government bond yields and the S&P500 index,

US 10 year bond yield (Blue) vs S&P 500 Index (Red)

Quickly recall (refer previous post) the story behind the curves. Fear of a double dip in the US pushed the bond yields down in Q32010. Faced with a slowing economy, investors switched money from risky assets (like equities) to bonds, driving up bond prices and lowering yields (price and yield is inversely related). In a desperate attempt to shore up the markets, Ben Bernanke announced the second round of quantitative easing (QE2) in November 2010. Bond yields hardened on the prospects of the monetary stimulus giving a boost to the US economy. Investors were shifting from bonds to risky assets to ride the wave of economic optimism. Bond prices fell (driving yields higher) and the S&P500 equity index soared.

Now, everything seems to be falling apart. Look at the S&P500 index over the past 10 days,

S&P 500 Index

After a 2.56 per cent fall on 2 August, it crashed by 4.78 per cent on 4 August. To put it in perspective, this was the worst day on Wall Street since December 2008 (the peak of the sub prime crisis). The US 10 year yields had a similar story to tell,

US 10 year Government bond yield

The mad rush into bonds has pushed down the yields by over 50bps in the past one month. Such is the frenzy to exit risky assets and park money in bonds and bank deposits, that Bank of New York Mellon is now going to charge large clients for keeping their deposits. Put another way, the bank is offering a negative interest rate. Really absurd? I thought so too. But it makes perfectly good sense. The bank has been receiving huge cash piles from its institutional clients afraid to deploy their holding given the rise in uncertainty. The bank cannot deploy these deposits for giving loans as they can be withdrawn anytime. For the same reason, it cannot invest them in long term bonds which offer a positive rate of interest. The only option is to churn these deposits in very short term debt instruments, which offer (no prizes for guessing) zero yield. (The intraday yield on 1 month US government bond turned negative on 4 August. Read here)

Near zero yield on 1 month US government bond

So, why the sudden panic? This can be the subject of a new blog post all together. But lets try and summarize the glut of problems.

Look around you. What do you see? Start with the land of the rising sun – Japan. The problem with this economy is that everything apart from the Sun seems to be falling or has been in a state of falling. A stagnating economy for the past 20 years has put the phrase ‘the lost decade’ to shame. Debt to GDP ratio in excess of 200%. Double whammy of an ageing and shrinking population. The glimmer of hope in Japan is its export industry. But with the Yen strengthening like it has, even the export industry is feeling the squeeze. The previous week, when the Yen was threatening to breach its all time against the dollar, the Bank of Japan was left with no option but to intervene in the forex markets to pull the currency down. If the all this wasn’t bad enough, the Tsunami in February caused severe supply side disruptions in the economy. And kindly add the bill of reconstruction to the already inflated government debt. All in all, here is an economy with such deep structural problems that you just tend to wonder – how in earth did the patriotic and hard working Japanese land in this situation?

Japan GDP growth rate

Move over to the sick man of the world – Europe. Well, there is just one word to describe the problem here – PIIGS. Portugal, Ireland, Italy, Greece and Spain. Debt problems in Portugal, Ireland and Greece has already caused quite a furore. Yet, these economies summed up are a minuscule part of the European Union. Spain and Italy, unfortunately, are not a small part of the European Union, and definitely not when summed up.

Greece 10 year bond yields

The Greece 10 year bond yields are at 15%. How will a debt laden economy refinance its debt at those levels? It will send its already strained finances into a complete tailspin. So expect Greece to be perpetually dependent on aid and bail outs. Similar is the story for Portugal and Ireland.

Greece, Portugal and Ireland are oldies in the bail out club. The newest kids on their way to join them are Spain and Italy. Look at the bond yields below and you will see that the debt market is already beginning to frown at Spanish and Italian debt.

Italy 10 year government bond yields - past 3 months

Spain 10 year government bond yield - Last 3 month

Germany and France are the only saving grace in European Union. And hence, the tax payers in these countries will bear the brunt of the bail outs being given to the countries in the periphery. All in all, Europe continues to be ‘the sick man of the world’.

Coming to the US of A, well what can we say. Standard and Poor’s has cut the sacrosanct AAA rating on US government bonds to AA+. The ISM survey for manufacturing is falling. GDP growth is falling below 1 per cent. The S&P 500 is correcting. Bond yields falling. Consumer spending shrunk for the first time in June since the last two years. Household budget is still very leveraged. Housing prices are showing tepid rise if not falling. The political gridlock over the raising of the US debt ceiling ended in a debt deal that speaks volume about the willingness (or unwillingness rather) of US policy makers to address the debt issue. Unemployment refuses to budge below 9 per cent.

The Fed Chief, the hirsute Bernanke, does not believe an economy which runs on paper money can ever deflate. Because as he very succinctly put in 2002, in a system of paper money, it is easy to generate inflation by simply printing money. Any surprise then that we had a QE1 and then a QE2. Yes they help in lifting sentiments, but without any corresponding changes in policy to address structural issues, such monetary stimulus only adds to the glut of dollar sloshing around the global economy.

Below I am quoting Bernanke in his famous 2002 “printing press” speech,

“ Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation”.

After reading the above lines, one would not have any difficulty in visualizing Bernanke as below,

Bernanke and his printing press

What Bernanke is basically saying is that the US can never have deflation. Because the moment the economy shows sign of going into a deflationary spiral, the Fed will open the flood gates of its printing press. Imagine what the Chinese must be feeling. They are the single largest foreign holder of US bonds. Rampantly printing dollars will eventually lead to a severe debasement of the US dollar and force the Chinese to book  forex losses on its holding of US treasuries. Not a thing to look forward to when your forex reserves total 1.8 trillion dollars.

If problems in the developed world is not enough, what the emerging markets are going through is equally frightening. But I am so tired that lets just stop here with the solace that the problems in the emerging markets are cyclical and not structural. And in that limited sense, the global economy will start to rely increasingly on emerging markets to deliver growth.

To conclude, I am spooked. And it seems the markets are too. What if all this is just the tip of the iceberg? When all the band aids and short term bailouts and printing money and accumulating more debt is over, and they fail to get markets out of their miseries, where does that leave us? Was the sub prime mess just prelude to a mega crisis in coming? A crisis where the PIIGS default on their debt bringing a sever contraction in Europe. Where the deflationary fears in the US leads the Fed to print so much dollars that they devalue by 50%. Where such a devaluation in the dollar devastates the export industry in China and other emerging markets. Think about what will happen to commodity prices and oil when turmoil in the global economy causes the Chinese economy to slow down. And what those low commodity and oil prices will do to countries like Brazil, Russia, Australia and the middle east.

Spooky times indeed.

Bond yields always tell a nice story. Have a look at the graph below,

In 1Q2010, the 10 year US government bond yield was in excess of 3.5%. A higher long term bond yield can indicate optimism about the heath of an economy. There are several hypothesis for the same, one of them being that interest rate on long term bonds contains information about future short term rates. A low long term interest rate is an indication of lower short term rates. Short term interest rates are low in a recessionary economy, as an economy in downturn is characterized by low inflation. Also the monetary authority of a recessionary economy will hold down the interest rates as part of a counter cyclical monetary policy. Going by this logic, in 1Q2010 , investors were generally sanguine about the growth prospects of the US economy. This is also confirmed by the rally in S&P  500 between February and May 2010.

The rally in developed markets (DM) helped lift sentiment in emerging markets (EM) with the iShare MSCI EM exchange traded fund gaining in the same period. MSCI EM is a benchmark used to monitor equity performance in emerging markets. Since histroical price data for this proprietory index is not publicly available, I have used the performance of iShare MSCI EM exchange traded fund which tracks the MSCI EM index.

In 2Q2010, structural issues in developed economies came to the front. The burgeoning US government debt and sticky unemployment figures spooked markets. Combined with the sovereign debt crisis in the Euro region, a bear market set in. The 10 year yield fell from a high of 4% to 2.4% in October 2010 and the S&p 500 also corrected during the period. Out of investor fear in developed economies, a rotation trade started with investors pushing up EM equity at the expense of DM equity. The iShare MSCI EM ETF gained around 25% in 2Q2010.

Then came October 2010 and everything changed. Just when investors had written off DM equity as an asset class, the mood suddenly turned bullish. There was widespread expectations of a second round of quantitative easing by the Fed and the investors started pricing that towards the close of 2Q2010. As expected, the Fed announced an asset purchase policy of US$600 bn on November 5th. The 10 year yield rallied close to a high of 3.8% by February 2010 and the S&P500 returned 15% in the the 5 months since October 2010. And yes, the rotation trade reversed with EM equity under performing DM equity. Investors were beginning to get concerned with rising inflation in emerging markets in 3Q2010. This coupled with the better outlook of the US economy took the sheen off equity markets in EM.

If you read my previous post ‘The real motive behind QE2‘, I had mentioned  that an asset purchase policy should lead to a fall in yields as the government buys back bonds, pushing up their prices and lowering yields. This was also the official reason given by the Fed for the asset purchase programme – to lower long term borrowing costs. The exact opposite happened. Bond yields soared. However, nobody was complaining as the higher bond yields were interpreted as improving outlook for the US economy.

Now, where are we in March 2011. If you look at the graphs, you will see that the bond yield is now falling and the S&P500 is correcting. Does this herald an end of the QE2 backed short term optimism? If the mood turns bearish, will there be another QE3? Will the weakness in DM equity bring down EM equity with it? Or will a rotation trade emerge with investors moving money from developed markets to emerging markets?

All questions worth pondering on…

On 3rd November, the US announced Quantitative Easing Part 2. This entailed an asset purchase program of USD 600 bn. The official rational – to lower the cost of long term borrowing. The rational according to me – to pursue a covert policy of dollar devaluation.

The rabbit is out of the hat now. The past few days has seen a rapid increase in the US 10 year bond yields. From 2.9 per cent on 6 Dec, the yields have hardened to 3.22 per cent today. A jump of close to 10 per cent. If anybody had any misgivings about long term interest rates falling post QE2, I hope they are laid to rest.

With Obama agreeing to the extension of tax cuts, markets have factored in a higher federal deficit next year, leading to a sharp rise in yields. Whatever impact QE2 might have had on the long term yields, this one single move has turned the table upside down.

What to watch out for going forward? The value of the dollar. If I was to hazard a guess, the dollar should weaken going forward – fits neatly with Obama’s plan to try and double US exports in the next five years.

Post QE2, there has been a sharp proliferation in opinion that gold standard is the way to go. The paper money, it is alleged, has brought the world nothing but inflation and debt. Several virtues of gold standard are then highlighted.

I find the scathing criticism of paper money unjustified.

A simple look at the quantity theory of money tells us the following,

MV = PT

where, M= total amount of money in circulation

V = velocity of circulation of money

P = price level

T = amount of transactions in an economy

V is a behavioral constant.

In gold standard, M is inelastic, and given the behavioral constant V, leads to an inelastic P x T. So you don’t get inflation, but you also don’t get rapid growth in an economy as the monetary base M grounds T. T cannot increase rapidly if M remains inelastic as there is a limit to the amount of transactions a given M can support.

In the system of fiat money (paper money), M is elastic and controlled by the central bank. The increase in M (with the V constant at some level), brings a corresponding increase in P x T. Now, how much of this growth is contributed by P and how much by T is very debatable and hence an outright criticism of the paper money system is unjustified.

By making the money supply elastic, we have added to our repository a tool with which to experiment on economic growth. Sometimes, this experiment malfunctions, but suggesting a return to gold standard is like throwing the baby out with the bath water.

I read an article on Business Standard (click here) a few weeks back that offers a very nice perspective about the direction Emerging Market (EM) equities will take next year. It tries to analyze the question by looking at the relationship between US monetary policy and EM equities. It goes like this,

1990-1995 : Inverse relationship between US interest rates and EM equities

Low US interest rates drove capital  into EM economies. This was also a period when most Asian economies had current account deficit (CAD) and a leveraged private sector. They benefitted from low US interest rates.

1995 onwards: Relationship breaks down. Direct relationship between US interest rates and EM equities

Asian equities became a function of global growth expectations. Rising interest rates in the US signalled good health of it’s economy, which bode well for global growth and export demand.

So to answer the question what will drive EM equities next year, we need to access whether global economic recovery or loose monetary policy will impact EM more.

If we believe loose monetary policy will be the driving force, its bulls all the way with QE2 nicely lined up. (Capital controls and assets bubbles may be spoilers though)

If we belive do not believe in decoupling, then EM equities are a function of global growth expectations.

And obviously, if we believe, EM economies will successfully align themselves to be driven by domestic consumption, none of the above really matters.

Lets wait and watch.

US Government Deficit - Historical

President Barack Obama released a budget plan that expects the federal deficit for 2010 to be a record $1.56tn, surpassing last year’s record of $1.4tn. That translates to a fiscal deficit of 10 per cent to the GDP. The US debt-to-GDP ratio already stands at 93 per cent.

How will this debt be financed? Lets delve deeper into this.

First the basics. Suppose the US government budgets for an expenditure of USD 100, but its revenues (through taxation and other sundry revenue sources) are only USD 90. This entails a budget deficit of USD 10, which is financed through borrowings. The Treasury issues bonds of face value USD 10, and makes good the deficit.

The buyers of the US government bonds can be classified under three heads- private investors, foreign central banks and the Federal Reserve. Private investors include private retail investors (this forms a very small proportion) and private institutional buyers (like banks, insurance companies and trusts). Foreign central banks are also important buyers of US government bonds. Countries like China and India run a huge trade surplus with the US, and the dollars they have accumulated through such trade are invested back in US securities (see previous post). Then there is the Federal Reserve. And this is where things get a little murky.

Federal Reserve, for all practical purposes, is simply an extension of the US Government. So, the Fed buying US government bonds is simply a transfer of debt from one part of the government to another. As for where does the Fed get the dollars to buy the bonds? It prints them. The Federal Reserve does not have the power of taxation to raise money, so it simply prints money to finance government debt.  This is referred to as monetization of debt or deficit financing.

The way this works is as follows. Suppose the US Treasury wants to spend USD 10 bn, but it only has USD 9 bn as tax revenues. It issues bonds for USD 1 bn in the market. The Fed comes in now to conduct its open market operations. It prints USD 1 bn and buys the bonds. Assume the interest payment on the bonds amounts to USD 10 mn. The Treasury pays this interest to the holder of the bonds, which is now the Federal Reserve. The Fed uses part of this money, say USD 1 mn, to pay for its day to day running expenses (like staff salary, premises, printing cost, etc) and holds USD 9 mn as surplus, which is returned back to the Treasury. And this completes the cycle.

So, when debt monetization takes places, what is the cost to the Treasury of financing the USD 1 bn deficit? It is simply the cost of printing that amount of money, i.e., USD 1 mn, which is 0.1 per cent of the deficit. This power to print money, and finance any deficit simply out of thin air, is referred to as ‘Seigniorage’ and is a sovereign prerogative of the government.

This is how Wiki defines the term ‘Seigniorage’,

“Seigniorage can be seen as a form of tax levied on the holders of a currency…. The expansion of the money supply causes inflation in the long run. This means that the real wealth of people who hold cash or deposits decreases and the wealth of the issuer of the money increases. This is a redistribution of wealth from the people to the issuers of newly-created money (the central bank) very similar to a tax.”

The above definition does a wonderful job of explaining the economic impact of seigniorage.  And the term assumes special significance in today’s economic scenario as going forward, the US governments is slyly going to rely on this form of taxation to get their fiscal house in order. In fact, given the scale of fiscal stimulus undertaken, it is in fact impossible to cover up for all that spending without significantly relying on seigniorage at some point of time.

The brunt of this will be borne by the people who hold dollars – the US citizen and foreign central banks who have dollar holdings. How all this will unwind in the future, will be very interesting to see. More on this in a subsequent post.

A simple and lucid framework to help you understand the present functioning of the global economy-

Balance of payments of a country can be broken down into two parts- trade balance and capital account balance. Summing up the two parts should give us zero as they are an accounting identity. So,

Trade balance (surplus/deficit) = Exports – Imports

Capital account balance (surplus/deficit) = Capital inflows – Capital outflows

Balance of payments = trade balance + capital account balance

If trade balance is in surplus, the capital account balance will be in deficit of an equal magnitude and if trade balance is in deficit, capital account balance will be in surplus of an equal magnitude (to finance the deficit).

The developed nations (read US, EU) import like crazy from developing nations (read China, India). Thus,

Trade balance (developed nations) = deficit (imports > exports)

Trade balance (developing nations) = surplus (exports>imports)

As we know, the US$ is the world currency. So, if Chindia (China + India) exports, it receives US$. And if it imports, it pays in US$. Since exports > imports for Chindia, these guys are getting more dollars than using them. So, they are accumulating dollars.

What does Chindia do with these dollars? They need a safe avenue to invest them, and what can be more safe than the US govt bonds. So Chindia buys US govt bonds (which the US govt issues to finance its deficit).

So,

Capital account balance (developed nations) = surplus (inflow of dollars from Chindia that buy US govt bonds)

Capital account balance (developing nations) = deficit (outflow of dollars for buying dollar denominated US govt bonds)

These capital account surplus/deficit offset the surplus/deficit trade balance.

In summary,

Chindia produces,  sends the good for US consumption and accumulates dollar. The US consumes. And in huge quantities. It starts running a deficit and has to print bonds to finance the deficit. These same bonds are then bought by Chindia, so the dollars come back to the US. The US can now again buy from Chindia and Chindia can now again start exporting to the US.

And the cycle continues…..