The "long" fiscal stimulus - a belated recognition of infrastructure spending?

Prof Tyler Cowen has a strange post. He points to the inadequacy of short-term stimulus spending, however large, to tide over deleveraging balance sheet recessions. He is therefore surprised that

"For all the talk of a 'large stimulus', you don’t hear much about a 'longer stimulus'."

He has this concern about short-term pump priming, whatever its size,

"The problem with a 'too small' stimulus is that you get an initial economic boost, but when the stimulus expires the economy slumps back down, as indeed happened in mid 2011. Ideally a stimulus employs some idle labor, stops it from depreciating, and tides those workers over until they can look for other jobs in fundamentally better economic conditions... If conditions are not improving soon, the ability of the stimulus to 'buy time' for those workers isn’t worth much... We end up having spent a lot of money to postpone our adjustment problems, rather than achieving takeoff. Deleveraging recessions last a long time, as shown by Rogoff and Reinhart. The need for continuing deleveraging implies that even a stimulus twice the size of ARRA won’t turn the tide."

In the circumstances, his suggestion,

"In those cases a well-designed stimulus program should not be so 'timely'. For a given presented expected value sum spent on stimulus, it is better to spread it out across the years. It is better to help a smaller set of workers for five years (or however many years it takes for most of the deleveraging to end), after which they are reemployable, than to temporarily boost a larger number of workers for two years, and then leave them back in the dust because deleveraging is still going on."

Here we go! There appears to be, to put it very charitably, an element of selective amnesia in Tyler's post here. This is effectively an admission of ideological failure (or, is it an error of judgement?) and an advocacy for focusing stimulus spending on creating durable public infrastructure assets atleast now.

In some sense, it is a classic case of the two-handed economist at work, albeit with a time lag in the action of the two hands. The one hand which had considered, debated and opposed the same when the ARRA was being formulated now appears to have changed track and embraced infrastructure spending when the earlier assumptions were proved wrong.

As early as late 2008, when the ARRA was being conceptualized, there was an intense and often acrimonious debate about the nature of the stimulus. Conservatives, who even then opposed any fiscal action, were willing to go only as far as tax cuts. They had opposed it on the grounds that there was no shelf of "shovel ready" infrastructure projects and that such spending takes time before its shows any stimulus effect on the economy. Marginal Revolution itself had directly posted and linked to several such views. In contrast, liberal economists like Paul Krugman, Mark Thoma and Brad DeLong felt that the recession was likely to persist for long and therefore preferred direct spending in infrastructure assets.

From hindsight, even the most conservative of economists would admit that the best course of fiscal policy action in late 2008 would have been to spend money on public infrastructure creation. The ultra-low interest rates, now certain to persist well into 2013 and atleast for a couple of years beyond that, would have provided unbelievably cheap financing for atleast 7-8 years. If in 2006, Congressmen and academics had been offered the prospect of accessing interest free loan for 8-10 years to repair America's battered infrastructure, many of them would have readily grabbed that opportunity. In fact, even the China-bashing Americans would have derived some vicarious pleasure from the realization that China was subsidizing America's infrastructure creation by offering virtually interest free loans!

In fact, Tyler's invocation of Reinhart-Rogoff now to fortify his argument about the pernicious nature of deleveraging recessions, appears to be a case of "what is sauce for the goose (is not) sauce for the gander"! Interestingly, Messers Krugman and Co had then invoked precisely the same duo to base their claim for infrastructure spending based stimulus. They had argued, based on the substantial body of empirical evidence presented by Reinhart-Rogoff about the average lengths of banking crisis induced recessions, that the Great Recession was likely to be a long drawn out one and therefore there was enough time for infrastructure spending to be effective.

The ideal course of action in late 2008 would have been to adopt a two-pronged approach, one which many of the aforementioned liberal/Keynesian economists did advocate, involving long-term stimulus on infrastructure creation and automatic stabilizers like unemployment insurance and food stamps to cushion the worst hit by the recession. Any tax cuts and other stimulus spending would have been an additional bonus.

I am inclined to believe that the impact of such spending on the economy as a whole would have been positive in many dimensions. Apart from the fact that it would have repaired or replaced the country's battered infrastructure, it would also have generated a significant multiplier on the economy on many fronts. It would have brought to work idle resources, encouraged businesses to not postpone investments, spurred market confidence (yes, the "confidence fairy"!) in the long-term health of the country, and so on. Given the fact that these investments were in any case necessary, one would also have to add the opportunity cost benefits of the ultra-low interest rates to calculate the multiplier.

In view of all the aforementioned, the final paragraph to Tyler's post is a sad commentary of the dark age of macroeconomics,

"Oddly, there is not much discussion about the length of fiscal stimulus. But there should be."

PS: I just did not have to energy to mine the numerous links in MR, and Krugman, Thoma and DeLong's blogs that contain the specific material from 2008-09 that I have alluded to in the post. I guess I am lazy! Anyways, interested readers could do so from here and here.

Is the German resilience fading?

Amidst all the gloom and pessimism that has enveloped Europe, the one silver lining has been the surprising resilience of the German economy. Its exports have increased, unemployment rate has fallen to pre-recession lows, and the economy has been fairly robust.

However, given the depth of the problems facing other Eurozone economies, especially the PIIGS, it was to be expected that they started sapping the strength of the German economy. In many respects, Germany, by the mere fact of being the largest economy in the region, is inherently vulnerable to any long-term crisis in its neighbourhood. Its economy is closely integrateed with other Eurozone economies. More importantly, and this is the immediate concern, its banks are heavily exposed to the sovereign debts of the PIIGS economies.

In cliched terms, Germany today is the victim of the adage that "if a bank lends $100 to a person, then its repayment is his problem; whereas if it lends $100 million, then its repayment is the bank's problem!" A periodic survey conducted by the Center for European Economic Research (ZEW) reported that in August its index of current economic conditions in Germany suffered its largest one-month decline since it began to be calculated in 1991.



Though very few analysts see inherent problems with the German economy, more than half of them think the economy will get worse over the next six months, while less than one-tenth of them think the situation will improve over that time. As the crisis has prolonged, the inevitability of Germany being affected increased and the pessimism grew in proportion. The immediate trigger may have been the signals given last month while approving the Eurozone bailout plans that creditors may have to take haircuts. The German banks would be the biggest losers if this were to happen.

Australia's "Dutch Disease"?

The outback economy of the world, Australia, has been one of the strongest performing economies in the developed world for nearly three decades now, even managing the buck the Great Recession. But the strength conceals some areas of concern, which have been amplified by economic trends of the past decade. The biggest concern, as a recent FT op-ed suggested, may be the possibility of an affliction of the Dutch disease, driven by its recent commodities export boom.

The Dutch disease refers to the phenomenon, which has origins in Holland following the discovery of natural gas in the North Sea in the 1960s, wherein the domestic currency appreciated dramatically in response to a surge in exports of gas, thereby making the other exports extremely uncompetitive and adversely affecting the long-term health of the country's economy.

The FT has an excellent analysis which writes that Australia may be facing much the same situation, on the back of a commodities export boom driven by China's insatiable appetite. The share of commodities in merchandise exports have ballooned since the middle of the last decade, with the source of this demand being East Asia, mainly China (it takes up 26% of Australian exports).





It does not require much analysis to detect signs of concern from this trend, especially for a less diverse economy like Australia. There are several signatures of imbalances creeping in. It is estimated that though the natural resources sector only represents 10% of the economy, it sucks up 70% of capital expenditure. Mining projects worth A$ 832bn, or 60% of GDP are currently under execution or consideration. The structural impact of these investments could be staggering. And finally, there is the big external risk that such dependence, especially to one country, poses to the Australian economy. The FT writes,

"Booming sales of iron ore and coal have meant the country has hitched its fortunes to China like no other developed nation. That intimacy exposes it to the whims of a communist Asian power that could readily dump Australia if cheaper commodities were to be sourced elsewhere.

In the immediate future, the China-fuelled boom and the growing might of the mining industry are destabilising Australia’s economy by propelling the currency upward, squeezing trade-exposed industries ranging from manufacturing to tourism and boosting inflation. A shortage of workers for big resources projects has led to wage spikes that threaten to spill over into less buoyant industries.

Just ask manufacturers trying to export and those industries trying to compete with imports made cheap by the local dollar, which – long weaker than the greenback but this year bouncing either side of parity – reached a nearly three-decade high last month of US $1.10."

The graphic below shows that Australian dollar has been appreciating steadily against the US dollar since the turn of the millennium, coinciding with the spectacular growth of demand for commodities from China. After the recession indiced blip in 2007-08, it has been rising again since January 2009.



The rising Australian dollar is starting to impact manufacturing and agriculture, apart from the country's other major source of revenues, tourism. Recently, BluScope Steel, the nation's largest steel manufacturer, closed down "one of only three of the nation’s blast furnaces as part of an overhaul to cope with a surging local currency". Interestingly, for a country which is among the largest iron ore exporters, Australia does not have a strong steel industry.

Another area of concern is the apparent lack of plan to take a share in the windfall profits that are coming out of this boom and filling the coffers of mining giants like BHP and Rio TInto. Unlike the example of Norway and many Middle Eastern economies which have established rainy day funds or sovereign Wealth Funds financed out of resource booms, Australia does not have any and proposals to impose some windfall taxes on the minerals extracted have fallen by the wayside. In fact, and in a testament to the power wielded by the increasingly dominant mining lobby, a proposal to introduce a mining super tax was among one of the reasons for the exit of the previous government of Kevin Rudd. The watered down version proposed by the Gillard government is still awaiting Parliamentary nod.

Update 1 (18/6/2012)

FT reports of the possible emergence of a two-speed Australia revolving around commodities,

The Treasury estimates the resource-related sectors of the economy will grow by an average of 9 per cent a year over the next two years. In contrast, the non-resources part of the economy will grow at an annual average rate of 2 per cent over the same period. The two-speed economy is reflected in recent data, which show demand in resource-rich Western Australia rose 14.5 per cent in the year to March 2012 – almost three times the national average – but just 1.9 per cent in New South Wales.

The spectacular growth of commodity resource extraction has had the predictable effect of crowding out resources from all other sectors and eroding their relative competitiveness. 

The PIIGS story in graphics

More from the Der Spiegel graphics. The scale of the economic recovery challenge facing the PIIGS economies is truly staggering on all macroeconomic fronts - high debt-to-GDP ratios, unsustainable fiscal deficits, and high unemployment rates.



However, given the magnitude of the sovereign debt crisis in these economies, with the truly extraordinary liquidity crunch faced by these economies, the EU response has been limited. The graphics here show the amounts of bonds getting due for repayment in each of the PIIGS economies.

Except, for Ireland and Portugal, the amounts are huge for the others, especially the two big economies of Italy and Spain. And the European Financial Stability Fund (EFSF) clearly does not have the buffer to meet this kind of liquidity demand if the need arises. In fact, in all the PIIGS economies, government bonds worth 795 bn Euros come for repayment by end-2013, whereas, the EFSF will be able to cover just 440 bn Euros.



As the graphic nicely illustrates, the real challenge for Europe will be if and when Italy gets priced out of the markets. If that happens, that will be the ultimate test of Europe's (and German's) commitment to a single currency. Given the massive capital infusions that would then be required, Eurozone will fall apart without the liquidity support.

More on the Dark Age - overcoming the obsession with mathematical models?

John Kay argues that the fundamental challenge for economics profession today is to abandon its exclusive focus on deductive model-based approach with its focus on rigour and consistency (and expressed exclusively with the tools of mathematics) and embrace elements of real-world observations based inductivism which also draws heavily from cross-disciplinary research (which are not exactly amenable to being reduced to mathematical models). He writes,

"Consistency and rigour are features of a deductive approach, which draws conclusions from a group of axioms – and whose empirical relevance depends entirely on the universal validity of the axioms. The only descriptions that fully meet the requirements of consistency and rigour are completely artificial worlds... deductive reasoning is the mark of science: induction – in which the argument is derived from the subject matter – is the characteristic method of history or literary criticism.

But this is an artificial, exaggerated distinction. Scientific progress – not just in applied subjects such as engineering and medicine but also in more theoretical subjects including physics – is frequently the result of observation that something does work, which runs far ahead of any understanding of why it works. Not within the economics profession.

There, deductive reasoning based on logical inference from a specific set of a priori deductions is 'exactly the right way to do things'. What is absurd is not the use of the deductive method but the claim to exclusivity made for it. This debate is not simply about mathematics versus poetry. Deductive reasoning necessarily draws on mathematics and formal logic: inductive reasoning, based on experience and above all careful observation, will often make use of statistics and mathematics.

Economics is not a technique in search of problems but a set of problems in need of solution. Such problems are varied and the solutions will inevitably be eclectic. Such pragmatic thinking requires not just deductive logic but an understanding of the processes of belief formation, of anthropology, psychology and organisational behaviour, and meticulous observation of what people, businesses and governments do.

The belief that models are not just useful tools but are capable of yielding comprehensive and universal descriptions of the world blinded proponents to realities that had been staring them in the face. That blindness made a big contribution to our present crisis, and conditions our confused responses to it."

The central challenge as the mainstream in the profession see it is to develop a model (preferably one that can be simulated on a computer) of the economy which is not only able to explain why events happen as they do but also make reasonably accurate predictions of them. Kay explores the various possible interpretations that have sought to correct the obvious flaws in the standard DSGE models, consequent to the soul-searching that followed the sub-prime crisis and its aftermath.

In response to the crititicism of the Lucasian DSGE model, its Chicago supporters have sought to make it even more complex in order for it to be more realistic! They have introduced more parameters to represent the complex problems that abound in the real world, which takes into account market frictions and transaction costs. Another response has come from those like Joe Stiglitz who while retaining many of Lucas assumptions have introduced greater importance to information imperfections (for example, Ricardian equivalence's assumptions of households having information about future budgetary problems is now questioned).

Some others, from the complexity economics school, have put forward agent-based modelling solutions, based on specific behavioural and other heuristics generally observed in the real-world. All these solutions satisfy the "requirement" of being mathematical and computer simulatable. However, questions about their real-world effectiveness remain.

Without offering any specific model, John Kay argues in favor of a less mathematics based approach. He writes,

"Another line of attack would discard altogether the idea that the economic world can be described by any universal model in which all key relationships are predetermined. Economic behaviour is influenced by technologies and cultures, which evolve in ways that are certainly not random but that cannot be fully, or perhaps at all, described by the kinds of variables and equations with which economists are familiar. The future is radically uncertain and models, when employed, must be context specific."

The crux of the debate is that all conventional approaches to explaining and forecasting macroeconomic phenomena assume that it has to be contained in a logically consistent and theoretically sound model. It assumes that it is possible to collapse all the different (and there are a maddening array of them) scenarios into this one comprehensive model.

Therefore, the supporters of the Lucasian school try to formulate a single model that can satisfactorily explain all the different types of economic recessions. Accordingly, it seeks to use the same model, with its standard set of assumptions, to explain aggregate demand slumps caused by as widely varying factors as the routine ones (say, monetary policy induced) to those spawned by banking crisis and resultant balance sheet damages.

The result is a failure to satisfactorily explain the present balance sheet recession, especially in conditions of persistent high unemployment rates and zero nominal interest rates. In response, the freshwater economists have either adopted a postion of ostrich like denial or have tried to tinker with the existing models, introducing newer parameters and assumptions to explain market frictions, and in the process drawing them further away from reality.

What if there is no such magic model that can be formulated? Is it possible to forecast macroeconomic outcomes with any great degree of accuracy, beyond estimating the broad trends? What if the degree of relevance of each assumption varies widely across different contexts, to be so irrelevant at certain times as they are relevant at other times, and in which case the model itself should assume a completely different character? More importantly, is there really a need to have a universal, one-size-fits-all model?

The Age of Debt in graphics

Der Spiegel has an excellent graphics feature on the global debt crisis. The sovereign debt situation among the developed economies is truly staggering. It is now clear that the past two decades of the Great Moderation, was atleast partially, driven by a spectacular build up of debt.



One of the macroeconomic policy contributors was the deliberate policy of keeping interest rates at ultra-low levels for an extended period of time.



The crisis-ridden Eurozone economies have debt-to-GDP ratios that are way above the danger mark. Except for four smaller economies, the ratio is above the Maastricht Stability Pact limt of 60% of the GDP.



The US public debt has exploded since the turn of the century, driven by the Bush-era tax cuts and structural problems related to health care costs for an aging population, and continues to grow with the fall in revenues due to the Great Recession.





The revenues and expenditures of the US government is heavily unbalanced...



The ultra-low interest rates, its "exorbitant privilege" (the fact that the US borrows in its own currency), and the unmatched safety and liquidity offered by US Treasuries mean that the debt concerns were manageable. However, now with the debts burgeoning, economic weakness and high unemployment persisting, and the government's commitment to repay debts questioned with a sovereign debt ratings downgrade, the debt situation raises serious concerns.



Among the foreign creditors, the Chinese Central Bank stands out. Though there is little serious concern about them pulling out, the long-term implications of recalibrating sovereign debt portfolios is not in the interest of the US economy.



If there has to be one villain of the piece in the great American debt story, it has to be George W Bush!



James McDonald has this essay in FP magazine which chronicles the rise of the debt overhang among Western economies, though he appears to confuse the policies that led to this state with Keynesianism. His arguement that more borrowing may not be part of the solution is debatable. Since he himself admits that the private sector is in no position to handhold the recovery, is there any alternative source of growth other than the government? See also this and this.

Changing Inflation dynamics in India

An excellent recent speech (via Mostly Economics) by the Executive Director of RBI, Deepak Mohanty, reveals certain interesting trends in India's inflation dynamics. A few points from the speech

1. The role of food inflation

He finds a structural break in the mid-2000s in India's WPI-based inflation, which is the measure of the policy headline inflation. The historical average long-term inflation rate of around 7.5%, which moderated in the first half of 2000s to about 5.2%, started rising in the second half to touch an average of 5.5%. More worryingly, the volatility in WPI inflation increased sharply.



The driving force behind this rise was primary food inflation, in particular protein items. He says,

"Protein inflation has assumed a structural character and is partly driven by demand factors. Within the protein group, persistence was lower for pulses as well as 'egg, meat and fish', but it was markedly higher for milk... Increase in demand for protein appears to be an inevitable consequence of rising affluence. This process was further accentuated by renewed global food price shock during 2010-11. Among the processed food items, the persistence of inflation for edible oils was high."

2. Core inflation

The inflation in non-food manufactured products, which represents the core-inflation, and which has a weight of 55% in the WPI, too has inched upwards since 2009-10. It averaged 4% in the 2000s, and even moderated in the second half of the decade, only to start rising from 2009-10. Deepak Mohanty claims that "the non-food manufactured products inflation shows a major structural break towards the middle of 2009-10 around the time the global commodity prices rebounded".



In fact, he even finds that industrial raw material prices also showed a structural break in early 2009 and the average price increase has been high and volatile.



The coincidence of the recent rise in core-inflation and the similar rise in industrial raw material costs, with the global commodities price increases, lends credence to the view that both are interconnected. He writes that the "pass-through from non-food international commodity prices to domestic raw material prices has increased particularly in the recent years reflecting growing interconnectedness of domestic and global commodity markets".

3. Demand side factors

The less discussed side of our inflation story is the rise in the purchasing power and resultant demand-side pressures, an inevitable consequence of the last decade of high growth. In fact, the the NSSO surveys (61st round and 66th round) shows that the nominal wage rates of skilled workers in both rural and urban areas increased much faster in the second half of the 2000s than in the first half. While the real wage rates declined in the first half, it increased significantly in the second half of 2000s. The wages of the rural unskilled labour has increased sharply, both in nominal and real terms, since the beginning of 2010.



As indicated earlier, a clear manifestation of this trend is the sharp spike in the consumption share of protein items in the rural and urban consumption baskets. The increase in wage rates of the unskilled rural labourers has certainly played a role in contributing to this spike in protein consumption.



In the formal sector, company finance data suggest that the wage bill has risen at a faster rate since the middle of 2009-10.

The construction risk transfer through takeout financing

I had blogged earlier about how infrastructure financing can be made more attractive for investors by a two-step financing pattern. This would involve separating the construction activity and its attendant risks from the project life-cycle costs and financing the two separately.

This approach assumes importance in view of the considerable construction risks associated with many infrastructure projects in India, which in turn increases the financing cost and therefore raises doubts about its financial viability. The broad strategy would therefore be to finance the construction with short-term loans, preferably raised by the government (since government is best able to bear the common site-clearance related construction risks) and then swap the loan with long-term bonds once the construction is completed and construction risk has been off-loaded.

In this context, the recent announcement on liberalised takeout financing conditions by the state-owned India Infrastructure Finance Company Ltd (IIFCL) assumes significance. The IIFCL plans to take over projects immediately after their commercial operation date (COD) from the original financiers (mainly banks) and pass on interest rate concessions to project developers. As part of this, a lender financing the infrastructure project can enter into an arrangement with IIFCL for transferring to the latter the outstanding in respect of such financing in its books on a pre-determined basis.

Takeout financing is attractive to banks as it addresses sectoral/group exposure issues and asset-liability mismatch concerns (banks give most of their loans as short-term ones, 3-5 years). Interest rates on the loan taken out by IIFCL is likely to be an estimated 75-200 basis points lower than the original project loan. The project developer would benefit from this reduction in cost of capital. The IIFCL has so far inked takeout financing agreements aggregating about Rs 3,100 crore with a host of banks, including Union Bank of India (Rs 1,020 crore), Central Bank of India (Rs 1,000 crore); Punjab National Bank (Rs 180 crore), and Punjab National Bank (Rs 600 crore).

This intermediation role by the IIFCL will align the incentives of all project parties to commission the project within time and access the take-out loan swap at the much lower cost of capital.

Incentivizing efficient road usage - per kilometer driving tax?

Arguably the biggest challenge with traffic management in coming years would be the issue of managing demand response among private vehicle users. Congestion tax, road toll, vehicle miles travelled tax, and so on are being experimented in different cities across the world.

In this context, Times points to an experimental six-month road pricing trial conducted in Eindhoven, where a few cars were outfitted with a meter, hooked to wireless internet and a GPS, that would inform drivers in real-time of a road fee which is calculated based on the vehicles fuel efficiency, miles driven, time of road use, and the route being used. The fee is a measure of the cost to the society in the form of pollution, traffic congestion, greenhouse gas emissions and wear and tear on roads. At the end of each month, the vehicle’s owner would receive a bill detailing times and costs of usage, not unlike a cellphone bill.

The trial, which logged more than 200,000 test kilometers, showed that with the help of technology, drivers can be motivated to change their driving behavior, reducing traffic congestion and contributing to a greener environment. Its findings include,

"70% of drivers improved their driving behavior by avoiding rush-hour traffic and using highways instead of local roads. On average, these drivers in the trial saw an improvement of more than 16% in average cost per kilometer... Instant feedback provided via an On-Board Unit display on the price of the road chosen and total charges for the trip is essential to maximizing the change in behavior."

The Netherlands is debating the introduction of a new road-use charge, per-kilometer driving tax, starting in 2012 for trucks and lorries, and 2013 for passenger cars, and become nation-wide by 2016. Its objective is to reduce traffic delays and CO2 emissions and lower private vehicles road use and increase public transit use. The government was to reduce or even eliminate conventional taxes on vehicle purchases and registration and replace them with a single per-kilometer driving tax. However, political considerations have forced these plans to be atleast delayed.

Update 1 (31/8/2014)

On July 1, 2013, Oregon initiated a two-year pilot project, covering 5000 cars and light commercial vehicles voluntarily enrolled, to collect a Vehicle Miles Traveled (VMT) tax. The legislation replaced the state's gas tax with a "pay-per-mile road usage charge", whereby drivers who agree will pay 1.5 cents per mile driven instead of the 30 cents per gallon they currently pay.

As Atlantic put it, the VMT tax is radical because,

But the greatest potential of Oregon's program is its ability to change the way Americans think about the cost of driving. Right now the cost of road maintenance is hidden in the price of fuel. In a mileage-based funding system, such as Oregon's, drivers would receive monthly statements showing their driving activity and road expenses. The entire funding system becomes more like a utility—like an electricity or cable bill—enabling people to adjust their behavior in response to their expenses.

Such road pricing schemes have great flexibility in incentivizing driving behaviours. It can be used to charge congestion pricing, varying charges based on vehicle type, and so on. 

The institutional cash pools and the demand for safe assets

Gillian Tett points to a possible explanation for the massive investor flight to US Treasuries despite its ratings downgrade by S&P last week. She has an interesting interpretation of an excellent working paper by an IMF economist Zoltan Pozsar that traces the rise of the shadow banking sector over the past two decades to an explosive growth in institutional cash pools during the same time and their preference for safety and counter-party risk diversification.

The paper highlights the spectacular growth in volumes of institutional cash pools in recent years, on the back of the rise of the asset management sector and centralized treasury operations by companies. From just $100 bn two decades back, institutional cash managers now control between $2,000bn and $4,000bn globally. The share of cash held by individual companies has exploded from just over $100 mn across the world to an estimated $75bn with individual securities lenders, $20bn with asset managers, and $15bn with large US companies.





The practice was to invest this liquid cash pool in bank accounts. However, once the US FDIC limited deposit insurance to only upto the first $100,000 of any account from 1990, investors started searching for alternative short-term, liquid, and risk-free investment opportunities. Repurchase deals (backed by collateral), money market funds (often implicitly backed by banks), and highly rated short term securities (such as triple A rated asset backed commercial paper or mortgage bonds) were natural options.

Zoltan Pozsar also finds that institutional cash pools prefer not being intermediated through the traditional banking system, as they prioritize principal safety and portfolio diversification over yield and are hesitant (in many cases due to fiduciary reasons) to take on too much direct, unsecured exposures to banks through even insured deposits. The author writes,

"Between 2003 and 2008, institutional cash pools’ cumulative demand for short-term government guaranteed instruments (as alternatives to insured deposits) exceeded the supply of such instruments by at least $1.5 trillion. The “shadow” banking system rose to fill this vacuum, through the creation of safe, short-term and liquid instruments. Thus, from this perspective the "shadow" banking system was just as much about networks of banks, investment banks and asset managers working together to respond to institutional cash pools’s preference to invest cash at a distance from banks as it was about banks’ funding preferences and off-balance sheet banking. From this perspective, the rise of "shadow" banking has an under-appreciated demand-side dimension to it...

In other words, what looks like undesirable regulatory arbitrage from the perspective of regulated institutions, was desired portfolio diversification from the perspective of institutional cash pools. This is to say that if regulatory arbitrage inspired the pejoratively-sounding term shadow banking, cash portfolio diversification could imply renaming it to market-based banking."

Consequently, it should come as no surprise that in 2007, just 16-20% of these funds were invested in bank deposits, while the rest went into Treasuries, commercial papers, and securities traded in the shadow banking sector, whose emergence coincided with and was maybe even caused by the rapid growth in the institutional cash pools. Once the shadow banking system froze in the aftermath of the sub-prime meltdown, these cash pools have been left with Treasuries as the only remaining investment avenue with the required depth.

The US-EU debt crisis has exacerbated the market uncertainty and accelerated the flight to the safety of US Treasuries. In simple terms, even with all the downside risks associated with the US economy, its government securities appear the least risky among all available alternatives required to accommodate this huge cash pool.

Austerity before recovery in G-7 economies

All talk of austerity and fiscal consolidation masks the alarming fact that three-and-half years since the recession struck, the economic output of all G-7 economies, except Canada, remains below the pre-recession peak. In other words, but for Canada, none of the others, including Germany, have regained their GDP lost during the recession.

The graphic below captures the quarterly real GDP trajectories, including the latest of Q2 2011, of all the seven economies since the pre-recession peak.

The global economic power shift

The spectacular growth of emerging economies led by China in the past decade or so has dramatically altered the global economic power equations. The sub-prime meltdown and the resultant Great Recession have only accelerated this trend. The Economist has two graphics that captures the essence of this shift.

Whereas the real GDP in most developed economies is still below its end-2007 level, the same has risen more than 20% for emerging economies. This has hastened the process of convergence between the shares of the two parts of the world economy.



The rapid rise of emerging economies since 1990 has seen them close in on the developed economies in their respective global shares across a range of parameters.



If GDP is measured at purchasing-power parity, emerging economies overtook the developed world in 2008 and are likely to reach 54% of world GDP this year. Further, they accounted for three-quarters of global real GDP growth over the past decade. Though they consume 60% of the world’s energy, 65% of all copper and 75% of all steel, given the low per capital consumption, there is plenty of room for even more growth.

At a time when public debt is the biggest macroeconomic concern, emerging economies are responsible for only 17% of all outstanding government debt. The long-term outlook for these economies over the coming years appears bright, with less debt, more favourable demography and huge potential to lift productivity, besides considerable room for further growth.

Efficiency trends in power trading market

I have blogged earlier about the anachronism in continuing the non-transparent OTC trade-based sytem of power sales when there were two functional power exchanges in the country.

The OTC trader-based system does not facilitate efficient price discovery, despite regulatory provisions on the profits that can be made, since the transactions takes place in private with little public disclosure of details. It is all the more unexceptionable given the with limited depth and breadth in the exchanges. Banning all OTC trades and bringing them into the fold of the exchanges would multiply its liquidity and optimize price discovery efficiency of the exchanges.

Currently, the two operational power exchanges in India, IEX and PXI, offer day-ahead and week-ahead contracts. The bilateral OTC trading term ahead contracts vary from hours to many years. Such traded power (less than an year contracts), including the unscheduled interchanges (UI), form about 10% of the power generated in the country.

A test of the logic behind this assumption is the trends in market share distribution between the OTC and exchange markets. If the exchanges were more transparent and efficient, it was natural to expect them to increase their market share at the expense of the traders. And, recent trends point to exactly this happening. The Businessline reports that cheap prices in the exchanges are driving consumers - industrial and distribution utilities - away from traders. It writes,

"In 2010-11, the value of deals on the PXs surged to Rs 5,389 crore, a 51 per cent growth (or Rs 1,826 crore in absolute terms) over the deal values clocked the previous fiscal. Volumes more than doubled on the bourses. Correspondingly, the bilateral trader market, or short-term deals executed through a power trader, was down by almost Rs 800 crore during the year even as volumes remained flat. One of the key reasons for the PXs gaining favour over the traders is the lower electricity prices discovered on the two operational bourses — IEX and PXIL.

At Rs 3.47/unit, the average price on the PXs was a good Rs 1.30 lower than the corresponding price of Rs 4.79/unit for deals involving traders in 2010-11. As a result, the gap between the volumes for deals involving traders and those transacted on the PXs has narrowed sharply last fiscal... Thanks to the surge in business on the bourses, cumulative deal value surged to Rs 18,657 crore in 2010-11."

One way to compare the relative efficiencies of the two markets is to compare their prices. The graphic below of prices in June 2011 reveals that even in case of contracts with duration less than a week, which are also offered in the exchanges, the prices were lower in the exchanges (even with the daily average) than with traders.



The differential in prices (between the exchanges and OTC traders) with contracts that are greater than a week too are disproportionately higher. The case for banning OTC trades could not have been more convincing.

Update 1 (11/9/2011)

In the corruption filled environment, it was only natural before skeletons came out from the cupboard of OTC trades executed by state utilities. Businessline reports that the Uttar Pradesh Power Corporation (UPPCL) signed a one-year deal with a private power generator in Gujarat, routed through a private power trader in the western State, to buy some 600 MW at around Rs 4.70 a unit. The price is well above the average of less than Rs 3 a unit on the power exchanges over the last two months.

In fact, the average electricity price discovered on the two operational bourses — IEX and PXIL – was Rs 3.47 a unit, well below the corresponding price of Rs 4.79 a unit for deals involving traders in 2010-11.

Negative interest rates in Switzerland

Amidst all the turmoil in Europe and the global financial markets, a less reported but remarkable event happened when the Swiss interest rates, including medium-term rates, in the LIBOR market plunged into negative territory. In other words, instead of being paid by their borrowers, lenders would now have to pay for the privilege of getting borrowers to accept their money!

As the Eurozone economies plunged into crisis, Swiss Franc emerged as a possible safe haven. The resultant capital inflows boosted the Franc by over 20% against the Euro, hurting Swiss exports and economic growth. In fact, as Gillian Tett writes, the Goldman Sachs has described it as "the most overvalued currency" in recent history, 71% stronger than fundamentals justified.

In response, early this month, the Swiss National Bank (SNB) acted aggressively to lower interest rates to virtually zero (from 0.25%), inject unsterilized cash, build up sight deposits (cash withdrawable on demand from the central bank) with the SNB, and repurchase outstanding SNB bills and use the proceeds to buy Euros in the forex market. The SNB press release said,

"Effective immediately, the SNB is aiming for a three-month Libor as close to zero as possible, narrowing the target range for the three-month Libor from 0.00-0.75% to 0.00- 0.25%. At the same time, it will very significantly increase the supply of liquidity to the Swiss franc money market over the next few days. It intends to expand banks' sight deposits at the SNB from currently around CHF 30 billion to CHF 80 billion. Consequently, with immediate effect, the SNB will no longer renew repos and SNB Bills that fall due and will repurchase outstanding SNB Bills, until the desired level of sight deposits has been reached."

The results of this aggressive response has been spectacularly successful, with interest rates on Swiss two and three-year government bonds falling into negative territory and spreads with German bund widening on the negative side. The Swiss ten year bonds have fallen off precipitiously in the last two months. The futures markets are currently predicting negative rates until 2013 and minus 8 basis points next summer.





This effectively means that "if you want to lend Swiss francs or make a deposit in the next year, you must pay for that privilege", an anomaly that has led to Gillian Tett of FT to describe it as "Alice in Wonderland" economics! Alternatively, anyone holding two-year or three-year Swiss bonds is now demanding that the price exceeds the coupon-included return in order to be tempted to sell.

Apparently, this is not the first instance of negative interest rates. In the 1970s the SNB imposed negative interest rates on foreign accounts to deter inflows; and in 2008 some short-term Swiss market rates briefly turned negative. That also happened in Japan in the late 1990s and recently some dollar short-term rates have touched negative territory. However, in all these cases, the negative rates covered only ultra-short rates, whereas the present Swiss situation is for medium-term rates covering the next two years. In simple terms, borrowers could take out a two-year loan with the assurance that they would need to be paid by the lenders for the next two years.

However, given the depth of the financial crisis, as FT Aplphaville says, even this situation is fraught with dangers. Technically, the build up of sight deposits (which would be used as reserves by banks) should "cause Swiss rates to fall sharply since the more reserves banks hold, the less they require to borrow from each other and the lower the rate falls". FT Alphaville writes about the distortionary possibilities,

"Since the SNB pays zero on its sight deposits, there is a very real risk banks might be encouraged to hoard cash on deposit rather than to lend it out for a negative rate. This would be the exact opposite of expanding the money supply. It might even be contractionary.

Now, the SNB is probably hoping that the extreme unattractiveness of having to pay an additional rate to hold Swiss francs will be enough to encourage holders of the currency (especially those abroad) to sell the franc and move elsewhere. This, theoretically, should flood the market with Swiss francs, lowering exchange rates and easing liquidity. But there is still the danger that the move could drive Swiss francs straight into the coffers of Swiss-based banks, who would then be unwilling to lend them out at a negative rate.

In that circumstance, a deflationary spiral motivated by 'capital preservation' could begin. Once that starts, no matter how much 'QE' money is printed, it becomes completely ineffective at boosting the money supply. In fact, if anything, it arguably becomes a deflationary force because the money is being pumped directly into a liquidity trap, in which capital preservation (rather than yield) is the chief priority of banks and depositors. Which, by the way, happens to be exactly what happened during the Great Depression."

This has echoes of the Great Depression (see this Ben Bernanke paper), when "the market for unsecured lending died a death because counterparties no longer trusted each other",

"Everyone turned towards a collaterised lending regime, one in which only the very best collateral (Treasuries and gold) would do. This had the effect of causing a run towards Treasury securities. No matter how much money was printed by the Fed to ease liquidity concerns it only intensified the obsession with capital preservation. Largely by eliminating the number of Treasury securities in the market. Since, there was no one the banks could lend money to in the wider market due to credit concerns, Treasuries became a bit of a Giffen good. The money had to be parked somewhere... With capital preservation becoming the top priority for banks, institutions were willing to pay more than the face value of Treasury securities, because investing elsewhere would come with too great a risk of default."

In the uncertain environment, as the prices of Treasuries went up (and the yields fell down), banks purchased more of the same. The same story is being repeated today with Swiss Government Bonds, pushing yields into negative territory.

As an update, it does now appear that the SNB's aggressive actions have not been as successful as initially thought in curbing the Franc's rise.

Update 1 (19/12/2014)
Switzerland announced that from January 22, 2015, it intends to charge negative interest rate of 0.25% on bank deposits held with the central bank which are beyond 10 million francs. However, this will be applicable only on financial institutions. Its objective is to make short-term Swiss assets like franc-dominated money market funds and debt securities unattractive to foreign investors, thereby stemming capital inflows (as capital flees in search of safe Swiss assets) and limiting the appreciation of the franc.

This follows the ECB's decision in June to impose a negative 0.1% rate on excess reserves of banks with it, which was raised to minus 0.2% in September. The ECB's decision though was taken to encourage banks to lend. 

Warren Buffet advocates higher taxes

In a forthright NYT op-ed, displaying leadership that have been missing in action elsewhere, Warren Buffet takes the issue head on and advocates higher taxes on the well-off.

Lamenting that while most Americans struggle to make ends meet, the mega-rich continue to get their extraordinary tax breaks (more specifically the 15% capital gains tax on carried interest earned by investors), he questions the oft-repeated claim that higher taxes disincentivizes effort,

"I have worked with investors for 60 years and I have yet to see anyone — not even when capital gains rates were 39.9 percent in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off. And to those who argue that higher rates hurt job creation, I would note that a net of nearly 40 million jobs were added between 1980 and 2000. You know what’s happened since then: lower tax rates and far lower job creation."

For the record, he himself was taxed at only 17.4% of taxable income, a lower percentage than was paid by any of the other 20 people in his office, whose tax burdens ranged from 33-41% and averaged 36%. And his advice for the 12 member Congressional Committee entrusted with the responsibility of reducing 10 year US budget deficit by atleast $1.5 trillion, is emphatically unambiguous,

"I would leave rates for 99.7 percent of taxpayers unchanged and continue the current 2-percentage-point reduction in the employee contribution to the payroll tax. This cut helps the poor and the middle class, who need every break they can get. But for those making more than $1 million — there were 236,883 such households in 2009 — I would raise rates immediately on taxable income in excess of $1 million, including, of course, dividends and capital gains. And for those who make $10 million or more — there were 8,274 in 2009 — I would suggest an additional increase in rate. My friends and I have been coddled long enough by a billionaire-friendly Congress. It’s time for our government to get serious about shared sacrifice."

It will not be a surprise if the Tea Party conservatism in the US is outflanked by the alleged "victims" themselves of higher taxation. If this gathers momentum and others join in support of higher taxes on themselves, then we could have the extraordinary event of tax payers mobilizing and demanding higher taxes on themselves, thereby forcing a "reluctant/hesitant" government to actually raise taxes on the super-rich. Is it a sign of the bankruptcy and partisanship of the current political leadership and the statesmanship of a handful of America's super-rich?

Update 1 (23/8/2011)

Warren Buffet's proposals to increase the current 35% top rate for those making morethan $1 million, a further increase for those more than $10 m, and taxing dividends and capital gains (currently, they are taxed at a maximum rate of 15 percent) as ordinary income, elicits a strong approval from Bruce Bartlett.

Austerity and the debt spiral

Italy becomes the latest economy to join the austerity bandwagon. Faced with a public debt burden amounting to 120% of GDP and the domino effect of sovereign default threat from the other PIIGS, the Italian government has agreed to a $65 bn austerity program in return for ECB buying Italian bonds to prevent its borrowing costs from rising any further. As part of this, the government would increase taxes and cut local government transfers in an effort to balance the budget by 2013.

I have blogged earlier about the fundamental problem with contractionary austerity policies when the economy is in a deep recession. Far from bringing in the "confidence fairies" and putting the economy back on the recovery path, such policies exacerbate the recession and pushes the economy further down.

In simple terms, during recessions, resources - labour, capital, factories etc - are forced to remain idle and consumers cut down on purchases and businesses on investments. This gets amplified when household balance sheets are bruised, the unemployment rate is very high, and external markets too are in similarly bad shape. Governments typically step in to retrieve such situations with demand management policies. But when interest rates are touching zero-bound and the public debt is raising alarms, conventional monetary policy becomes less effective and there is strong ideological and political push-back on further fiscal stimulus spending.

Into this environment, if austerity programs are introduced, more resources become idle and aggregate demand slumps further. As the economy tanks, tax revenues decline and debt-to-GDP ratios increase and the relative value of the public debt increases. The economy shrinks further and slips down the slippery slope. As the country slips further deep into debt, bond investors start to worry they won’t get their money back. A debt spiral, a vicious circle of sinking confidence, rising borrowing costs and, ultimately, rising debt burdens is the inevitable result.

The Times has an excellent graphic that captures this downward spiral.

The real meaning of US ratings downgrade

Since the dust has settled down on the decision by the Standard & Poor's to downgrade the rating on long-term US debt, it may be appropriate to dwell into its real meaning. Far from the dreaded scare scenarios, the impact appears to have been more benign.

If the bond markets are any indication, and they are arguably the best barometer of market perceptions, then the US ratings downgrade appears to either have had no impact or, perversely enough, made the US debt more attractive. Subsequent to the announcement, investors have been piling into US debt, not out of it, driving down yields on 10 year Tresuries to its lowest in two years.



This flight to US Treasuries in the aftermath of the market uncertainty created by ratings downgrade and the Eurozone debt-crisis, is to be expected given the natural investor reaction of fleeing to "safe havens". For all talk of Euro-assets and gold, US Treasuries and other highly rated American corporate securities remain the assets of choice for global investors seeking a "safe haven", and will continue to remain so for the foreseeable future. No other asset categories posses the level of "institutional strength, depth and liquidity of the market", besides lower risk.

This market response is also an accurate reflection of the reality underlying America's current debt "crisis". A simple arithmetic calculation of the US debt situation reveals that the relative magnitude of the short and medium-term US debt servicing burden is more easily manageable than imagined, especially at the prevailing interest rates. Paul Krugman calculates that an additional trillion dollars in debt with 30 year bonds (at a real interest rate of 1.25%) translates to $12.5 bn in additional real interest payments or 0.07% of GDP in future debt-service costs. In any case, in this time of deep debt over-hang, there are several countries with much higher debt-to-GDP ratios who continue to enjoy the triple-AAA rating.



Felix Salmon has an excellent post which adds a much needed sense of perspective to the S&P decision. The S&P, he writes, measures only the "probability of default", not the details of the default - the recovery value for investors (amount that will be left after default), time the issuer will remain in default, or the expected way in which the default will be resolved. In other words, the S&P rating decision does not convey any signal about what happens after the decision to default, on the ultimate losses that investors are likely to suffer.

This also brings us to the distinction between the S&P and other rating agencies. In keeping with the information failure that abounds in financial markets, the important fact that different rating agencies actually rate different things is not as widely known. The ratings of different agencies are most often used interchangably, atleast certainly in policy making circles. Unlike S&P's focus on default probability, Moody's is interested in expected losses.

A sovereign credit rating of the kind signalled by S&P's "is therefore primarily a function of a country’s willingness to pay, rather than its ability to pay". S&P's ratings are not investment-advice, but a rating of how likely a creditor will default. In contrast, Moody's rates specific instruments and the expected value of their losses if the issuers default. It assumes that people will use its ratings in the context of deciding which bonds to buy and which bonds to sell. In investment speak, a S&P downgrade is not a "sell" rating as is the case with a Moody's downgrade!

In the context of the US, this difference means a lot. It is politically possible that the US Government, driven by the Conservative push, could formally default. But nobody doubts that any such "legal default" will be only temporary, before sense kicks-in and bond holders are paid out in full. The expected losses being virtually nothing (except for the market determined losses), it is no surprise that Moody's retained its triple-A rating for the US debt. In other words, the S&P downgrade means that the political possibility of a US sovereign default has increased, though it tells little about whether investors should exit US Treasuries.

In simple terms, the S&P ratings downgrade is more a reflection of the market's perceptions of the crisis in American polity than problems with its short to medium-term fiscal balance. And academics and commentators would do well to confine themselves to this interpretation, as investors already appear to be following.

And for all those still sceptical, there is the example of Japan.



Japan lost its triple-A rating in 2002, and early this year S&P took a second shot, with another downgrade to double A minus. Japanese bond yields have continued to fall, with yields on 10 year bonds dipping below 1% briefly last week. The FT describes this as "the lowest level of interest rates anywhere since Babylonian times"!

Manias and Panics!

Charles Kindleberger in a picture!



(HT: Kaltoons via Paul Krugman)

More lessons from the iPhone story

Apple has undoubtedly been the most enigmatic company of its times, a touchstone for technical excellence and commercial nous. The Economist has an excellent graphic on the iPhone 4, which shows who makes what inside the iPhone, and how much the various bits cost.



There are three observations from the graphic. One, Apple has ceased to be a manufacturer. It does not make iPhone itself - it neither manufactures the components nor assembles them into a finished product. The components come from a variety of suppliers and the assembly is done by Foxconn, a Taiwanese firm, at its plant in Shenzhen, China. This leaves Apple free to concentrate on "designing elegant, easy-to-use combinations of hardware, software and services".

Second, Samsung, which is Apple's closest competitor in the smartphones market, is also its largest supplier, accounting for 26% of the component cost of an iPhone. As The Economist writes, Samsung provides some of iPhone's most important components - the flash memory that holds the phone's apps, music and operating software; the working memory, or DRAM; and the applications processor that makes the whole thing work. This gives an insight into Samsung's own business model - "acting as a supplier of components for others gives it the scale to produce its own products more cheaply".

Third, the last two years have seen a dramatic shake-up in the global smartphones market, comparable to anything elsewhere in history. Apple's increase in market share from 13% to 19.1% pales in comparison to Samsung's spectacular rise from just 5.6% to 16.2% and Nokia's precipituous decline from 37.3% to 15.7%.

Update 1 (23/1/2012)

Even though Chinese workers contribute only about 1 percent of the value of the iPod, the export of a finished iPod to the United States directly contributes about $150 to our bilateral trade deficit with the Chinese.

Hal Varian

The 20 MW wind turbine?

It is a sign of the amazing advances in technology, driven by commercial considerations, that Don Quixote's "giants" keep getting ever more humongous by the day.

One of the biggest constraining factors with wind power was the need for massive tracts of land to develop reasonably large windfarms. However, in recent years, as windpower emerged as a favored source of renewable energy, manufacturers have been working to make wind mills bigger, so that they can reach faster and steadier winds and the blades can cover larger areas. Wind farm developers too have been trying to get lesser numbers of larger turbines to generate the same power. The current leader in this race is the German wind turbine manufacturer Enercon GmbH.

The Enercon E-126 turbine - with a hub height of 135 m (443 ft), rotor diameter of 126 m (413 ft), total height of 198 m, total weight of 6000 mt - can generate 7.5 MW power per turbine today. Its first turbine was installed at Emden in Germany 2007, and a total of 24 are operational today, with the biggest farm using the turbine being at Estinnes, Belgium. The world's largest wind farm, the Markbygden Wind Farm, with 1,101 turbines covering just 500 sqkm to generate 4000 MW is under construction in northern Sweden and will contain approximately 150 Enercon E-126 7.5 MW wind turbines.

A Times report points to a study commissioned by the European Commission, 'Upwind: Design Limits and Solutions for Very Large Wind Turbines', which has found that a 20 MW turbine — with each blade probably more than 120 meters long — was "feasible".



Research and development work on wind turbines has proliferated around matters like how to pitch, or angle, the blades and how to monitor wind speed and direction at a turbine more accurately, using lasers. Further, since many of the best wind sites have already been claimed, developers are forced to build in place not so windy, which in turn makes innovation all the more crucial for cost-effectiveness.

The most active area of innovation has been in the design of gearbox, which speeds up the wind-powered rotations of the blades. A big breakthrough in recent years has been the use of a technology called direct drive that replaces the less reliable and high maintenance gearbox with a lower-speed generator. One of the key differentiators of the Enercon-126 is the use of a gearless, direct drive mechanism.

See also this graphic of global wind power capacity in 2010.