The collective debt monetization solution?

John Mauldin's latest newsletter draws attention to the common problem of ballooning debt across developed and developing world and has this to say,

If I had come on to this stage four years ago and told you, my friends, that we were going to have 40% of the world’s governmental debt at negative interest rates, $10 trillion on central bank balance sheets, and $10 trillion worth of dollar-denominated emerging-market debt, and that global GDP growth would average only 2%, unemployment would be below 5%, and interest rates would be negative in much of the world and less than 50 basis points in the US, you would have laughed me out of the room. You would have all hit the unsubscribe button. Today’s world was unthinkable a mere four to five years ago.

He describes the Fed's quantitative easing policy as akin to St George fighting to slay the Dragon of Deflation, 

They have manipulated the system and set the wrong price of money. They have created a world where savers are penalized, companies are paid to buy their competition rather than compete, and only the participants on Wall Street are rewarded with appreciation of their assets. My Austrian and monetarist economics school friends, who predicted inflation from all the QE that we saw, have actually seen inflation – it has just been in asset prices that benefited Wall Street and not Main Street.

His denouement, a controlled simultaneous collective monetization and devaluation,

Could we, the major developed countries of the world, all monetize our debts together... We need to do it in a coordinated fashion so that no one major country gets an advantage in terms of currency valuation. It’s a controlled currency war... Central banks and their governments have painted themselves into the mother of all corners, and they are going to paint themselves into more corners because their belief system and their presuppositions are fundamentally wrong. I think they will continue to make the system worse until they have to do something drastic. At that point the only thing they will be able to do collectively is rationalize the debt. One country cannot do that without every country doing it, too. One country doing it alone creates a massive dislocation and a preference for its own currency, which devalues its currency. Without a collective devaluation, we will have currency wars that make the ’30s look like a spring picnic.

It may have sounded unthinkable even a few months back, but central banks now own an increasing share of national debt. This means that a simultaneous collective debt monetization, one which leaves everyone relatively at the same position with respect to the others, is logically possible, notwithstanding the massive moral hazard it would engender. However, the collective action problem is likely to come in the way of its execution, unless the crisis is simultaneously so severe among all major economies that force them into biting the bullet on this course of action. But some of the large economies like Germany do not have a large debt problem and would have no reason to agree to such solutions.

PSU governance reform in China

The FT reports on the latest in China's "crossing the river by feeling the stones" reform strategy. This one involves the appointments to senior leadership positions in State Owned Enterprises (SOEs) and their salaries. 

Top SOE managers are appointed by the Communist party’s personnel department, with input from the State-owned Assets Supervision and Administration Commission, the SOE watchdog. The most important SOE managers have party rank equivalent to cabinet ministers or vice-ministers and often place political or policy considerations over corporate efficiency. A pilot project in 2014 chose five SOEs whose boards of directors would be allowed to choose top managers. Now a cabinet task force has approved an expansion of the pilot to include three to five additional groups, Economic Information Daily, a daily newspaper owned by the official Xinhua news agency, has reported. Once the Communist party’s central committee signs off, Sasac will select the latest crop of SOEs, the paper reported, citing an “authoritative person”.

The plan also calls for a dual-track mechanism for setting SOE executives’ salaries. SOE chiefs endured pay cuts of up to 50 per cent beginning last year as part of an effort to restore discipline and public confidence in SOEs. But the cuts threaten SOEs’ ability to attract top talent. The cabinet’s latest plan allows executives hired through the pilot to earn compensation in line with industry norms, while political appointees will continue to earn government pay.

Admittedly, this would apply only to a small proportion of the 112 Central government owned SOE's which are overseen by Sasac. But the iterative strategy of reform enables the Party to ease in major reforms without aggregating discontent and resistance. Further, it also enables the government to refine the implementation design appropriately based on learnings from the pilots. 

India needs to do the same with PSU governance reforms. Fundamentally, it needs to embrace more open competitive recruitments to top positions within both large PSUs and the federal government bureaucracy. It would do well to experiment with a few medium sized PSUs and a small number of infrastructure Ministries or Mission-mode projects. This should be complemented with far greater operational autonomy for PSUs from their Departments. A few successes with such experimentation can provide the political capital to push forward such reforms on scale. 

The less than benign effects of PE investments

Fascinating investigative report in the Times on the increasing role of private equity firms in the delivery of essential public services, especially emergency services, in the US since 2008. It documents the problems faced by ambulance service providers TransCare and Metro/Rural whose promoters aggressive cost cutting, revenues increasing, and financial efficiency driven strategies  not only led to their bankruptcies but also seriously compromised emergency services. It writes,

Unlike other for-profit companies, which often have years of experience making a product or offering a service, private equity’s primary expertise is in making money. And in many of these businesses, The Times found, private equity firms applied a sophisticated moneymaking playbook: a mix of cost cuts, price increases, lobbying and litigation. In emergency care and firefighting, this approach creates a fundamental tension: the push to turn a profit while caring for people in their most vulnerable moments. For governments and their citizens, the effects have often been dire. Under private equity ownership, some ambulance response times worsened, heart monitors failed and companies slid into bankruptcy... Private equity gained new power and responsibility as a direct result of the 2008 crisis. As cities and towns nationwide struggled to pay for basics like public infrastructure and ambulance services, private equity stepped in... Since the 2008 financial crisis, private equity firms have gone from managing $1 trillion to managing $4.3 trillion — more than the value of Germany’s gross domestic product — according to the advisory firm Triago. Retirement nest eggs are fueling the growth and sharing in private equity’s risks and returns: Nearly half of private equity’s invested assets come from pensions...

Warburg Pincus, Kohlberg Kravis Roberts & Company, and other major private equity firms have invested in emergency services, a business that routinely holds the lives of customers in its hands. While this represents one small corner of private equity, which traditionally used debt to seize underperforming companies, it captures the industry’s newfound pervasiveness. K.K.R. — a firm memorialized in “Barbarians at the Gate,” a book that chronicled a defining 1980s Wall Street deal — also invested in public water services. Blackstone is now America’s largest landlord of rental houses. And in the mortgage industry, until recently the province of banks, the Fortress Investment Group controls a huge bill collector.

Another article documents similar problems in the housing market by tracking the activities of three of the dozen or so largest PE firms. Their entry was facilitated in the aftermath of the sub-prime crisis when the Federal government agencies sold tens of thousands of discounted mortgages to PE investors, with limited safeguards and protections for homeowners. Further, big banks and regional lenders too pulled back after regulatory backlash for aggressive foreclosures. The PE firms that swept into that space, mopping these houses up as another one of their distressed assets, applied their standard industry practices on individual homeowners, with less than benign consequences. The Times writes,

The rising importance of private equity in the housing market is one of the most consequential transformations of the post-crisis American financial landscape. A home, after all, is the single largest investment most families will ever make. Private equity firms, and the mortgage companies they own, face less oversight than the banks. And yet they are the cleanup crew for the worst housing crisis since the Great Depression...

Lone Star Funds’ mortgage operation has aggressively pushed thousands of homeowners toward foreclosure, according to housing data, interviews with borrowers and records obtained through a Freedom of Information request. Lone Star ranks among the country’s biggest buyers of delinquent mortgages from the government and banks. Nationstar Mortgage, which leaped over big banks to become the fourth-largest collector of mortgage bills, repeatedly lost loan files and failed to detect errors in other documents. These mistakes, according to confidential regulatory records from a 2014 examination, put “borrowers at significant risk of servicing and foreclosure abuses.” Unlike the banks, Nationstar wears many hats at once: mortgage bill collector, auction house for foreclosed homes and lender to new borrowers. By working every angle, and collecting fees at each step, the company faces potential conflicts of interest that enable it to make money on what is otherwise a costly foreclosure process.

In the rental market, The Times found, other big private equity firms largely bypassed the nation’s poorest neighborhoods as they scooped up and renovated foreclosed homes across the country. Those firms include Blackstone, a huge private equity firm and the nation’s largest private landlord of rental houses. These decisions point to shortcomings of the government’s response to the housing crisis. Rather than enact sweeping changes to housing policy, the government largely handed the problems to a new set of companies.

The script that invited PE firms into the housing market has not played out as expected,

In 2012, America was still in the grips of the worst housing crisis in decades. Foreclosure signs lined the American landscape, casting a shadow on more than 3.5 million homes... And soured mortgages made by banks were weighing on the government because it had insured them against default. The government, eager to stem its own losses, decided to ramp up the sale of distressed mortgages to investors. In all, it has sold more than 100,000 soured mortgages to investors — one of the largest such series of sales. The mortgage sales enticed private equity firms like Lone Star into the mortgage market, where they saw bargains.

Housing officials reckoned that private equity firms would bring about change. For one thing, these firms were among the only investors with pockets deep enough to take on billions of dollars worth of ailing mortgages. And they could be more flexible than the banks in keeping Americans in their homes because they had bought the mortgages at steep discounts. But instead of showing greater flexibility, Lone Star — much like the banks before it — has often remained rigid about modifying mortgages. And in some cases it has moved quickly to foreclose, taking possession of homes to sell them, according to dozens of court proceedings, as well as interviews with borrowers and housing advocates.

Further, as Rana Faroohar has written in her recent book, the concentrated entry (into a few markets) of PE firms may have forced up property prices in those areas, a fact reflected in the continuing decline in share of Americans who call themselves homeowners, and spawning a widening inequality in the market,

PE investors have become the single largest group of buyers in the residential housing market, purchasing $20 bn worth of steeply discounted properties between 2012 and 2014 alone and reaping huge rewards as housing prices have slowly risen from their troughs. Blackstone, the biggest PE firm, with more than $330 bn in assets under management, has become the richest investor landlord in the country, with a portfolio of 46,000 homes and other properties that generated $1.9 bn worth of income in 2014, making real estate the largest profit center for the firm... One study of the housing market in cities and towns across America found that the top 10% richest markets, ranked by the aggregate value of owner-occupied homes, held 52% of total housing wealth, equivalent to nearly $4.4 trillion. The bottom 40%, by contrast, held only 8%. It's a stark statement about who has profited, and who hasn't, from the housing recovery. 

The causal chain has played perfectly to script. As the flush of institutional money has raised property prices, housing has become unaffordable for an increasing number, who have sought to rent than own, thereby forcing up rents, and increasing the profitability of PE investments,

Not since 1986 have fewer rental properties been empty in the US, and rents are rising sharply in many cities as a result. According to Harvard's Joint Center for Housing Studies, the share of moderately to severely cost-burdened renters (meaning those who pay at least 30% of their income in rent) grew to represent half of all American renters in 2013, up from 38% in 2000. "We get losts of people coming to us saying, we wanted to own, but all the affordable properties have been bought up, so now, we're renting from Blackstone for more than the price of a mortgage," says Atlanta-based Tony Romano, the organizing director for the nonprofit Right to the City alliance , which has produced a number of studies on the consequences of PE moving into the housing market. 

Update 1 (02.08.2016)
Times has this excellent interactive graphic on the increasing role of PE firm's in American lives.

So much credit for so little output?

A feature of China's recent economic growth has been the central role of debt. Real estate and now stock markets are sustained by ever increasing volumes of debt.

The graphic below captures the scale of capital misallocation without proportionate increase in output.

Total social financing, a broad measure of funds secured by households and non-financial companies, topped $22 trillion in March, more than twice China’s $10.4 trillion GDP, according to official data. There’s no equivalent metric in the U.S., but household debt stood at $14.3 trillion while non-financial debt totaled $13 trillion at the end of the first quarter, according to the Federal Reserve. The combined tally of $27.3 trillion is roughly 1.5 times the U.S. GDP.

The scale and speed of credit expansion has been staggering!

Update 1 (05.07.2016)
Bloomberg captures the scale of credit growth in China in terms of the difference between its present rate and trend rate. It is atleast a quarter more than the trend rate.

China analyst Charlene Chu estimates that as much as 22% of all China's outstanding credit may be non-performing by the end of 2016, compared with the official bad-loan number for banks in March of 1.75%. Recognition of bad loans is clearly an area where India trumps China!

Australia fact of the day

From the FT,

With the exception of China itself, there’s no country on earth which has derived more benefits from the rapid growth and industrialisation of China.

And the country is all set to break Netherland's modern era record of the longest recession-free streak of 26 years between 1982 and 2008, on the back of the discovery of North Sea oil.  

The four macros and the way forward

Noah Smith identifies four different versions of macroeconomics and feels that the formal academic macroeconomics has failed everyone,

The first is what I call “coffee-house macro,” and it’s what you hear in a lot of casual discussions. It often revolves around the ideas of dead sages - Friedrich Hayek, Hyman Minsky and John Maynard Keynes. It doesn’t involve formal models, but it does usually contain a hefty dose of political ideology. The second is finance macro. This consists of private-sector economists and consultants who try to read the tea leaves on interest rates, unemployment, inflation and other indicators in order to predict the future of asset prices (usually bond prices). It mostly uses simple math, though advanced forecasting models are sometimes employed. It always includes a hefty dose of personal guesswork.

The third is academic macro. This traditionally involves professors making toy models of the economy -- since the early ’80s, these have almost exclusively been DSGE models. Though academics soberly insist that the models describe the deep structure of the economy, based on the behavior of individual consumers and businesses... they contain so many unrealistic assumptions that they probably have little chance of capturing reality. Their forecasting performance is abysmal. Some of their core elements are clearly broken. Any rigorous statistical tests tend to reject these models instantly, because they always include a hefty dose of fantasy. The fourth type I call Fed macro. The Federal Reserve uses an eclectic approach, involving both data and models. Sometimes the models are of the DSGE type, sometimes not. Fed macro involves taking data from many different sources, instead of the few familiar numbers like unemployment and inflation, and analyzing the information in a bunch of different ways. And it inevitably contains a hefty dose of judgment, because the Fed is responsible for making policy.

And on the way forward,

the new macroeconomics will focus on empirics and falsification -- in other words, looking at reality instead of making highly imaginative assumptions about it... macro will be fertilized by other disciplines, such as psychology and sociology, and will incorporate elements of behavioral economics... I think the new macroeconomics won’t just be new kinds of models and a more empirical focus; it will redefine what “macroeconomics” even means. As originally conceived, macro is about explaining national-level data series like employment, output and prices. Eventually, economists realized that to explain those things, they would need to understand the smaller pieces of the economy, such as consumer behavior or competition between companies. At first, they just imagined or postulated how these elements worked -- that’s the core of DSGE. Economists now realize that consumers and businesses behave in ways that are much more complicated and difficult to understand. So there has been increased interest in what’s called “macro-focused micro” -- studies of businesses, competition, markets and individual behavior that have relevance for macro even though they weren’t traditionally included in the field. Examples of this would include studies of business dynamism, price adjustment, financial bubbles and differences between workers.

This presentation by Justin Wolfers captures the problems with academic macro. But I am not sure that academic macro-economists are likely to discard their models in a hurry. For a start, it is difficult to shed layers on layers of orthodoxy accumulated over a long career so easily. More importantly, macro-focused-micro, involving disciplines like agent-based modelling, and rigorous empiricism and cross-disciplinary approaches do not lend itself to being neatly and consistently researched, comprehended and disseminated as a unified narrative. 

In this context, I am reminded of a course taught by Dani Rodrik a few years back. After each class, I would hear disappointed course mates complain that there were no clear and actionable takeaways. That's precisely the point.

I feel a clearer way to look at modern macro would be to use these newer lenses to acknowledge the complex nature of the underlying problem, become aware of all the instruments and tool-kits for its examination, select the most appropriate model(s) as the specific situation demands, and finally apply your informed judgement to choose the right course of action. This is very different from algorithmic application of a model to determine policies.

Markets in education - Growing too large and too fast is hard

The publicly financed but independently run Charter Schools are often thought as the solution to addressing quality in school education in the US. It was, therefore, with great expectations that Michigan embraced Charter Schools a few years back in an effort to improve its schools. As a Times investigation indicates, the results have been less than benign, with less than 10% of high school seniors being "college ready" on reading tests,

Detroit schools have long been in decline academically and financially. But over the past five years, divisive politics and educational ideology and a scramble for money have combined to produced a public education fiasco that is perhaps unparalleled in the United States. While the idea was to foster academic competition, the unchecked growth of charters has created a glut of schools competing for some of the nation’s poorest students, enticing them to enroll with cash bonuses, laptops, raffle tickets for iPads and bicycles. Leaders of charter and traditional schools alike say they are being cannibalized, fighting so hard over students and the limited public dollars that follow them that no one thrives. Detroit now has a bigger share of students in charters than any American city except New Orleans, which turned almost all its schools into charters after Hurricane Katrina. But half the charters perform only as well, or worse, than Detroit’s traditional public schools...

To throw the competition wide open, Michigan allowed an unusually large number of institutions, more than any other state, to create charters: public school districts, community colleges and universities. It gave those institutions a financial incentive: a 3 percent share of the dollars that go to the charter schools. And only they — not the governor, not the state commissioner or board of education — could shut down failing schools. For-profit companies seized on the opportunity; they now operate about 80 percent of charters in Michigan, far more than in any other state. The companies and those who grant the charters became major lobbying forces for unfettered growth of the schools, as did some of the state’s biggest Republican donors... Even as Michigan and Detroit continued to hemorrhage residents, the number of schools grew. The state has nearly 220,000 fewer students than it did in 2003, but more than 100 new charter schools. As elsewhere across the country, charters concentrated in urban areas, particularly Detroit, where the public schools had been put under state control in 1999. In 2009, it was found to be the lowest-performing urban school district on national tests... Detroit was soon awash in choice, but not quality.

It has this on the dynamics of choice, 

Nationally, some charter school groups praise Michigan for allowing so many institutions to grant charters. But the practice has also allowed bad schools to languish: When universities have threatened to close them, other universities have granted another charter. By 2015, a federal review of a grant application for Michigan charter schools found an “unreasonably high” number of charters among the worst-performing 5 percent of public schools statewide. The number of charters on the list had doubled from 2010 to 2014. “People here had so much confidence in choice and choice alone to close the achievement gap,” said Amber Arellano, the executive director of the Education Trust Midwest, which advocates higher academic standards. “Instead, we’re replicating failure.”

The campaign to attract students would not be out of place even in Kota in Rajasthan,

With all the new schools, Detroit has roughly 30,000 more seats, charter and traditional public, than it needs. The competition to get students to school on count day — the days in October and February when the head count determines how much money the state sends each school — can resemble a political campaign. Schools buy radio ads and billboards, sponsor count day pizza parties and carnivals. They plant rows of lawn signs along city streets to recruit students, only to have other schools pull those up and stake their own.

And about the inequitable effects of such unfettered markets and choice in Detroit,

Charter schools are concentrated downtown, with its boom in renovation and wealthier residents. With only 1,894 high school age students, there are 11 high schools. Meanwhile, northwest Detroit — where it seems every other house is boarded up, burned, or abandoned — has nearly twice the number of high school age students, 3,742, and just three high schools. The northeastern part of the city is even more of an education desert: 6,018 high school age students and two high schools to serve them. In a city of 140 square miles, transportation adds another layer to school selection. Few schools offer busing. And Detroit, long defined by the auto industry, never invested much in public transportation. A mile and a half to school can become an hour-and-a-half journey. 

 The verdict after nearly two decades of markets and competition,

For parents, the search remains for good schools — charter or public.

Several lessons from this excellent long form. The point that unfettered markets, or even any unregulated market, can help achieve learning outcomes is pure logical fantasy and does not need any reiteration. I have also blogged several times that over a long enough period, greater choice is more likely to generate sub-optimal outcomes. 

The more important point here is that Michigan tried to expand Charters across the State is quick time and it failed. Doubtless Michigan's already weak education system had made the original challenge even more daunting. But even good school systems will struggle to cope up with the scope of what Michigan did. 

This has great relevance to public policy at large. The challenge is not so much as to produce islands of excellence as to use public policy to improve the general standards across entire systems. And, as the example of choice and vouchers has shown, the two are not exactly similar, maybe even contradictory, set of challenges. Governments in many parts of the world, especially in developing countries, face the challenge of turning around poor performing education and healthcare systems. They are attracted by innovations like Charter schools, vouchers, capitation payment model, health insurance, PPPs and so on in the belief that such initiatives can quickly help improve general standards. But as the example of Michigan and several others from across the world and over time show, the desired transformations rarely ever happen. 

Thailand did not develop its capitation model of healthcare in a few years. It carefully built up its primary care and other public facilities over decades so that when it embraced the capitation model at the turn of the millennium, it had in place the foundations to support the model. Similarly, Finland developed its impressive school system over decades of effort. It struggled over generations to create the present eco-system which values education and teaching.

Transforming poor quality education and health systems take time and are generational projects. It requires careful design, persistent and laborious efforts, close engagement among stakeholders, flexibility in implementation that allows local initiative, enormous patience, and deep tolerance for failures. Unfortunately, the political and administrative dynamics of change are not readily amenable to such long drawn approaches. 

In the circumstances, the best that can be done is to understand the challenge in its true perspective. Then a two-track approach would have to be followed. At one level, the long-term enablers have to be gradually eased in to achieve the transformation. At the more immediate level, there has to be a steady stream of initiatives that respond to political and administrative exigencies and imperatives. I'll try to outline the specifics of such a strategy in coming posts.