(HT: NYT)
Monday, December 8, 2008
Paul Krugman on what to do next
Paul Krugman says it is important to immediately get credit flowing again and prop up spending. He feels that the $700 bn recapitalization plan of the US Treasury may be too little too late for three reasons - it is too small (relative to the GDP) compared to the requirements, it's unclear how much of the bailout will reach the components of the shadow banking system (largely unregulated financial organizations including investment banks and hedge funds) that are at the core of the problem, and it is not certain whether banks will be willing to lend out the funds, as opposed to sitting on them.
He predicts that the capital injections will get bigger and more interventionist, something similar to a "full temporary nationalization of a significant part of the financial system". He approves of the Fed's decision to expand its window to accept Commercial Paper (CP) as collateral for its lendings, as being especially important at a time when businesses are getting squeezed off credit. He also feels that given teh globalized and deeply integrated nature of the global financial markets, all such actions should be taken in concert with the major economies of the world. All this should be accompanied with efforts to prevent the contain of the crisis to the emerging economies.
The issue of addressing the global economic slump, is sought to be done through old-fashioned Keynesian fiscal stimulus. Here Krugman argues that the first round of stimulus in US failed because it was too small and ficussed too much on ineffective tax credits. He feels that any new stimulus should focus on sustaining and expanding government spending—sustaining it by providing aid to state and local governments, expanding it with spending on roads, bridges, and other forms of infrastructure.
Paul Krugman's suggestions are mostly informed by the bitter experiences of the Great Depression and the Japanese economic crisis of the nineties. It is alleged that in both cases, the Governments may have done too little too late, and allowed the economic situation to deteriorate into a condition from where retrieval was long drawn out and painstaking.
This line of reasoning appears to be dictated more by a forlorn hope than any objective and rational considerations. Krugman himself makes it clear by writing that we should "approach the current crisis in the spirit that we'll do whatever it takes to turn things around; if what has been done so far isn't enough, do more and do something different, until credit starts to flow and the real economy starts to recover". This is one of the few occasions, I have reservations about what Paul Krugman is advocating, and will elaborate on it in my next post.
He predicts that the capital injections will get bigger and more interventionist, something similar to a "full temporary nationalization of a significant part of the financial system". He approves of the Fed's decision to expand its window to accept Commercial Paper (CP) as collateral for its lendings, as being especially important at a time when businesses are getting squeezed off credit. He also feels that given teh globalized and deeply integrated nature of the global financial markets, all such actions should be taken in concert with the major economies of the world. All this should be accompanied with efforts to prevent the contain of the crisis to the emerging economies.
The issue of addressing the global economic slump, is sought to be done through old-fashioned Keynesian fiscal stimulus. Here Krugman argues that the first round of stimulus in US failed because it was too small and ficussed too much on ineffective tax credits. He feels that any new stimulus should focus on sustaining and expanding government spending—sustaining it by providing aid to state and local governments, expanding it with spending on roads, bridges, and other forms of infrastructure.
Paul Krugman's suggestions are mostly informed by the bitter experiences of the Great Depression and the Japanese economic crisis of the nineties. It is alleged that in both cases, the Governments may have done too little too late, and allowed the economic situation to deteriorate into a condition from where retrieval was long drawn out and painstaking.
This line of reasoning appears to be dictated more by a forlorn hope than any objective and rational considerations. Krugman himself makes it clear by writing that we should "approach the current crisis in the spirit that we'll do whatever it takes to turn things around; if what has been done so far isn't enough, do more and do something different, until credit starts to flow and the real economy starts to recover". This is one of the few occasions, I have reservations about what Paul Krugman is advocating, and will elaborate on it in my next post.
Sunday, December 7, 2008
Nudging homebuyers to buy!!
With the real estate market, across the world, facing a massive slump, both the financial markets (through the mortgages and their securitised versions) and the real economy (through the weakness in the construction sector, with its multiple cross-sectoral linkages) are getting squeezed. Real estate developers and builders, who made windfall profits during the boom, are now crying hoarse and calling for government assistance.
I am inclined to believe that instead of waiting for outside help, they ought to be looking towards the market for the way out. Fortunately, the markets appear to be more resilient. For example, some real estate developers in the US have come up with the Rent Now, Buy Later plan, under which prospective owners can lease property now with the option to buy it later, using part of the rent (a major portion) toward the purchase cost.
Rent-to-own options, which come in many variations, have become increasingly common in the US, especially for developers in areas where home foreclosures are high. Real estate brokers have been revamping their approaches to marketing hard-to-move property with offers similar to people to "test drive" homes and neighborhoods, and by offering renting with an option to buy.
Renting to own can be attractive for both sides of a real estate transaction. It brings cash flow to properties that otherwise might be stagnant. And buyers lacking adequate down payments (perhaps because of stock losses), struggling with poor credit, or even recovering from a recent foreclosure, can build up savings and rebuild creditworthiness in order to get a mortgage.
In many ways, rent-to-own model of marketing homes is a pro-active nudge aimed at helping buyers make choices, especially at such difficult times. Time for the DLFs and Unitechs of India to collaborate with financiers and offer similar innovative products?
I am inclined to believe that instead of waiting for outside help, they ought to be looking towards the market for the way out. Fortunately, the markets appear to be more resilient. For example, some real estate developers in the US have come up with the Rent Now, Buy Later plan, under which prospective owners can lease property now with the option to buy it later, using part of the rent (a major portion) toward the purchase cost.
Rent-to-own options, which come in many variations, have become increasingly common in the US, especially for developers in areas where home foreclosures are high. Real estate brokers have been revamping their approaches to marketing hard-to-move property with offers similar to people to "test drive" homes and neighborhoods, and by offering renting with an option to buy.
Renting to own can be attractive for both sides of a real estate transaction. It brings cash flow to properties that otherwise might be stagnant. And buyers lacking adequate down payments (perhaps because of stock losses), struggling with poor credit, or even recovering from a recent foreclosure, can build up savings and rebuild creditworthiness in order to get a mortgage.
In many ways, rent-to-own model of marketing homes is a pro-active nudge aimed at helping buyers make choices, especially at such difficult times. Time for the DLFs and Unitechs of India to collaborate with financiers and offer similar innovative products?
Credit crunch and Indian banks
Following on the heels of the ECB, Bank of England, and other Central Banks, the RBI has finally cut (full text of press release here) the benchmark repo rate by 100 basis points to 6.5% and reverse repo rate by the same margin to 5%. Now that the proverbial horse has been taken to water, the eagerly awaited answer is whether the banks will pass on the benefits to borrowers by way of lower lending rates?
The fundamental problem with the financial markets in India today is the apparent reluctance of banks to lend to businesses. Though the dramatic cuts in reserve ratios and repo rates, LAF auctions, and repurchase of MSS bonds in past few weeks have relased an additional Rs 3,00,000 Cr into to the banking system, not much of this has found its way into financing investments in the economy. Instead, the banks have preferred to invest in the safety of low yielding Treasury securities and the RBI.
There have been many reasons attributed to this reluctance. The uncertainty surrounding the financial markets and the effects of the sub-prime mortgage crisis have become so deep that counter party risks are very high. Safety and not returns have become the first priority for banks.
Another area of concern for the banks is the high cost of their present liabilities, especially with the strong possibility that rates will fall steeply in the coming months. The average cost of working funds for banks is well over 7%, with at least 30-35% of the deposits priced upwards of 9%. The expectations of rate cuts and plummeting equity markets has also led to the shift of assets and cash surpluses by many coporates and Public Sector Units to the safety of bank deposits. The banks too, faced with capital scarcity, have been competing with each other in attracting these deposits, often offering very high rates. The result of this is that many banks may not be in a position to pass on the full beneifts of rate cuts to its borrowers without seriously undermining their balance sheets.
The banks in turn argue that they have not been reluctant, but have been weighed down by the sharply increased demand for funds from the corporate sector which has been squeezed off its other regular sources of funds. Businesses have four major sources of investment funding - equity markets, external commercial borrowings, profits and bank loans. The first two, which formed 40% of the funds for Indian industry in 2007-08, has dried up, while the third is declining with the economy. This has left banks as the primary source of funds, thereby sharply increasing the demand for bank loans (credit growth has been at a scorching annualized rate of 28%). The banks have been clearly unable or unwilling to meet this increased demand, despite the dramatic increase in liquidity.
Here is a brief on the major credit market indicators.
Treasury Securities
Investors have taken money out of stocks, corporate bonds and money market funds to buy safe assets, thereby forcing down the yields on Treasuries. A declining yield is an indicator of greater concern with the financial markets. The most appropriate measure of the flight to safety is the Statutory Liquidity Ratio (SLR), which is presently in the range of 26%, against the mandatory requirement of only 24% (and effective requirement of only 21.5%).
The reverse repo window of the RBI has been witnessing heightened activity in since the middle of November, with banks queing upto deposit their surpluses for the relatively meagre 6% returns offered. Despite the declining SLR, the investments to deposit ratio for banks has climbed from 28.27% to 30.48% over the past month. In October, banks lent just Rs 27,000 Cr, whereas they invested Rs 90,000 Cr in G-Secs.
Expectations of rate cuts and the hope of making significant risk-free profits (especially at such bleak times) from the greater chances of capital gains from rising bond prices (as rates fall, yields decline, thereby pushing up bond prices) has been another incentive for banks to invest in long dated government securities.
Contrary to conventional bond market wisdom which says that yields rise as maturity lengthens, yield curve had become inverted - long-term yields lower than short-term yields. Inverted yield curves indicate tight immediate credit conditions besides uncertainty about the future. Though it has flattened out in the past few days, the 91-days Treasury Bill and the benchmark Government Security of 10-year residual maturity are both being quoted at the same, around 7% yield, underscoring the deep concerns about declining economic activity.
Commercial Paper
CP or short term debt issued by the larger private businesses, often for a few days, and purchased mainly by banks and financial institutions, has dried up. This is indicated by the widening spreads between rates on Government securities and CPs of the same maturities. Higher spreads have made it difficult for both businesses and banks to run their daily operations. The CP market has virtually ground to a halt, as the spreads with T-Bills for even AAA rated companies have ballooned to more than 600 basis points.
Call money rates
Overnight rates at which banks borrow capital to meet their daily working capital requirements had reached very high levels of over 24%, indicating the magnitude of the credit crunch. Typically, overnight call money rates move in the band between the repo and reverse repo rates. However, these rates have fallen to around 6% in recent days and the repo auctions under the Liquidity Adjustment Facility (LAF) has stopped attracting bids, an indication of the easing of the liquidity conditions.
The fundamental problem with the financial markets in India today is the apparent reluctance of banks to lend to businesses. Though the dramatic cuts in reserve ratios and repo rates, LAF auctions, and repurchase of MSS bonds in past few weeks have relased an additional Rs 3,00,000 Cr into to the banking system, not much of this has found its way into financing investments in the economy. Instead, the banks have preferred to invest in the safety of low yielding Treasury securities and the RBI.
There have been many reasons attributed to this reluctance. The uncertainty surrounding the financial markets and the effects of the sub-prime mortgage crisis have become so deep that counter party risks are very high. Safety and not returns have become the first priority for banks.
Another area of concern for the banks is the high cost of their present liabilities, especially with the strong possibility that rates will fall steeply in the coming months. The average cost of working funds for banks is well over 7%, with at least 30-35% of the deposits priced upwards of 9%. The expectations of rate cuts and plummeting equity markets has also led to the shift of assets and cash surpluses by many coporates and Public Sector Units to the safety of bank deposits. The banks too, faced with capital scarcity, have been competing with each other in attracting these deposits, often offering very high rates. The result of this is that many banks may not be in a position to pass on the full beneifts of rate cuts to its borrowers without seriously undermining their balance sheets.
The banks in turn argue that they have not been reluctant, but have been weighed down by the sharply increased demand for funds from the corporate sector which has been squeezed off its other regular sources of funds. Businesses have four major sources of investment funding - equity markets, external commercial borrowings, profits and bank loans. The first two, which formed 40% of the funds for Indian industry in 2007-08, has dried up, while the third is declining with the economy. This has left banks as the primary source of funds, thereby sharply increasing the demand for bank loans (credit growth has been at a scorching annualized rate of 28%). The banks have been clearly unable or unwilling to meet this increased demand, despite the dramatic increase in liquidity.
Here is a brief on the major credit market indicators.
Treasury Securities
Investors have taken money out of stocks, corporate bonds and money market funds to buy safe assets, thereby forcing down the yields on Treasuries. A declining yield is an indicator of greater concern with the financial markets. The most appropriate measure of the flight to safety is the Statutory Liquidity Ratio (SLR), which is presently in the range of 26%, against the mandatory requirement of only 24% (and effective requirement of only 21.5%).
The reverse repo window of the RBI has been witnessing heightened activity in since the middle of November, with banks queing upto deposit their surpluses for the relatively meagre 6% returns offered. Despite the declining SLR, the investments to deposit ratio for banks has climbed from 28.27% to 30.48% over the past month. In October, banks lent just Rs 27,000 Cr, whereas they invested Rs 90,000 Cr in G-Secs.
Expectations of rate cuts and the hope of making significant risk-free profits (especially at such bleak times) from the greater chances of capital gains from rising bond prices (as rates fall, yields decline, thereby pushing up bond prices) has been another incentive for banks to invest in long dated government securities.
Contrary to conventional bond market wisdom which says that yields rise as maturity lengthens, yield curve had become inverted - long-term yields lower than short-term yields. Inverted yield curves indicate tight immediate credit conditions besides uncertainty about the future. Though it has flattened out in the past few days, the 91-days Treasury Bill and the benchmark Government Security of 10-year residual maturity are both being quoted at the same, around 7% yield, underscoring the deep concerns about declining economic activity.
Commercial Paper
CP or short term debt issued by the larger private businesses, often for a few days, and purchased mainly by banks and financial institutions, has dried up. This is indicated by the widening spreads between rates on Government securities and CPs of the same maturities. Higher spreads have made it difficult for both businesses and banks to run their daily operations. The CP market has virtually ground to a halt, as the spreads with T-Bills for even AAA rated companies have ballooned to more than 600 basis points.
Call money rates
Overnight rates at which banks borrow capital to meet their daily working capital requirements had reached very high levels of over 24%, indicating the magnitude of the credit crunch. Typically, overnight call money rates move in the band between the repo and reverse repo rates. However, these rates have fallen to around 6% in recent days and the repo auctions under the Liquidity Adjustment Facility (LAF) has stopped attracting bids, an indication of the easing of the liquidity conditions.
What is Depression Economics?
Brad DeLong reviewing the revised version of Paul Krugman's book, The Return of Depression Economics and the crisis of 2008, defines "depression" thus
Cast yourself back 500 years ago to the docks where Antonio, the merchant of Venice, is loading the goods for a venture onto one of his ships: the spices of the Indies, the silks of Cathay and the intoxicants of Araby. But in order to carry out his venture, he needs investors: Shylock, say. Suppose that the morning comes to set sail and Shylock balks -- says that he needs his money now to pay for the wedding of his daughter or that the venture is too risky and he wants to keep his wealth close at hand.
Suppose also that Shylock's change of mind is a general change of mind -- that no replacement financier can be found. What happens? With a sigh, Antonio unloads his ship and carries his spices, silks and intoxicants off to the local market, sells them and then returns his money to Shylock. No big problem.
Now flash-forward to today. The capital stock of our economy no longer consists of valued consumption goods -- spices, silks, intoxicants -- for which there is a ready consumer market. The capital stock of our economy instead consists of the semiconductor fabrication facilities of Applied Materials, the patents of Merck, the roadbed of CSX -- not at all the kind of things that command money on short notice in the consumer marketplace.
Now what happens when everybody -- or a small but coordinated subset of everybodies -- decides that they want liquidity (their money now rather than in the five to 10 years it will take enterprises to pay dividends) or safety (the world is risky enough, thank you, and they don't care about the upside as long as they are protected on the downside)?
In normal times, when one investor wants more liquidity or safety, another will be willing to take on duration and risk, and they will simply swap portfolios at current market prices. But in abnormal times, they cannot: The semiconductor fabs are long-run, durable, risky assets that cannot practically be liquidated. And so when the everybodies all decide that they want liquidity and safety -- well, the economy cannot magically liquidate the fixed capital stock at a reasonable price. And to liquidate at falling prices creates mass unemployment. This is the key to "depression economics." And this is why the industrial business cycle emerged as a disease of the Industrial Revolution.
Dismal to worse!
Here comes figures indicating that 533,000 jobs were lost in November, the biggest single month of losses since 1974, taking unemployment to 6.7%, the highest since 1993.
This unemployment rate does not include those too discouraged to look for work any longer or those working fewer hours than they would like. Add those people to the roster of the unemployed, and the rate hit a record 12.5% in November, up 1.5 percentage points since September. The share of all men aged 16 and above who are working is now at its lowest level since the government began keeping statistics in the 1940s. The number of people working a part-time job, counted as employed, because they couldn’t find a full-time job rose by 621,000 last month. 1.2 milion jobs have been lost in the three months of September-November.
The rising job losses will increase the pressure to mount a large enough fiscal stimulus. Jan Hatzius of Goldman Sachs estimates the need for a $1.2 trillion stimulus for the next two years, in order to offset private sector retrenchment. Meanwhile the growth forecast is that the US economy will continue to decline throughout 2009, at about 2%.
Paul Krugman says that the employment-population ratio, the ratio of employed Americans to the adult population, had been declining since beginning of 2007, is now falling off the cliff! More on the dismal unemployment figures here.
This unemployment rate does not include those too discouraged to look for work any longer or those working fewer hours than they would like. Add those people to the roster of the unemployed, and the rate hit a record 12.5% in November, up 1.5 percentage points since September. The share of all men aged 16 and above who are working is now at its lowest level since the government began keeping statistics in the 1940s. The number of people working a part-time job, counted as employed, because they couldn’t find a full-time job rose by 621,000 last month. 1.2 milion jobs have been lost in the three months of September-November.
The rising job losses will increase the pressure to mount a large enough fiscal stimulus. Jan Hatzius of Goldman Sachs estimates the need for a $1.2 trillion stimulus for the next two years, in order to offset private sector retrenchment. Meanwhile the growth forecast is that the US economy will continue to decline throughout 2009, at about 2%.
Paul Krugman says that the employment-population ratio, the ratio of employed Americans to the adult population, had been declining since beginning of 2007, is now falling off the cliff! More on the dismal unemployment figures here.
Explaining entrepreneurship and development
I had posted esarlier here and here about the debate surrounding the utility of growth clusters and mega-regions.
Alfred Marshall had emphasised three different types of transport costs – the costs of moving goods, people, and ideas – that could be reduced by industrial agglomeration. First, he argued that firms would locate near suppliers or customers to save shipping costs. Second, he developed a theory of labour market pooling to explain clustering that takes advantage of scale economies associated with a larger pool of workers and firms. Finally, he began the theory of intellectual spillovers, which has been re-christened as "network effects" in recent times.
Edward Glaeser and William Kerr find support for all the three Marshallian theories in their new research and claim that market effects, such as proximity to input suppliers and labour market pooling, play a big role in explaining spatial differences in entrepreneurship and economic development, while there is less support for factors like entrepreneurial culture and industrial diversity. They find that co-agglomeration arising through shared natural advantages is more important than any single Marshallian factor, but not as important as the cumulative effect of the three Marshallian factors.
Alfred Marshall had emphasised three different types of transport costs – the costs of moving goods, people, and ideas – that could be reduced by industrial agglomeration. First, he argued that firms would locate near suppliers or customers to save shipping costs. Second, he developed a theory of labour market pooling to explain clustering that takes advantage of scale economies associated with a larger pool of workers and firms. Finally, he began the theory of intellectual spillovers, which has been re-christened as "network effects" in recent times.
Edward Glaeser and William Kerr find support for all the three Marshallian theories in their new research and claim that market effects, such as proximity to input suppliers and labour market pooling, play a big role in explaining spatial differences in entrepreneurship and economic development, while there is less support for factors like entrepreneurial culture and industrial diversity. They find that co-agglomeration arising through shared natural advantages is more important than any single Marshallian factor, but not as important as the cumulative effect of the three Marshallian factors.
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