Thursday, August 28, 2008

Imagining a GCB and world financial integration


Continued from here. David Smith at EconomicsUK is right. A global central bank would not work, though there is scope for better co-ordination of monetary policy between countries.

Realistically, it would take a really, really major global financial catastrophe before a majority of countries would consent to their CBs being subordinated, and their domestic monetary policy being determined by, such a Global Central Bank. A really major meltdown of global proportions.

Also, for a GCB to work out, it will need to implement differentiated policies across countries, to account for different local growth rates, as opposed to one just one uniform global rate or policy. That means we will need a really smart GCB who can crunch and analyze endless reams of data coming from all corners world-wide, be completely unbiased, and have a better understanding of the global economy than we have now. He will need to quickly determine which region is experiencing real growth vs. having a financial bubble, and which region has the better prospects to attract financial flows, and which will likely suffer an attack in the future.

To be effective, this theoretical GCB should have its own discretion in determining rates, albeit after consultation with the individual country CBs. In most cases, country CBs will have autonomy in setting domestic policy. But since the buck ends with the GSB, it should have an over-ride to the individual decisions of the domestic CBs, if global conditions warrant a policy alignment world-wide. The theory is, having a GCB would be taking the job of global macroeconomic and monetary policy coordination a step further – by putting the final say on these policies to just one governing body with global jurisdiction.

If we were to subject GCB policy-making to an international votation each time, we would likely end up with votes made according to various bloc interests. Therefore, this theoretical GCB should have an international charter, be widely accepted to have a global affiliation and mindset, and should never be construed as acting in the interest of some countries only. Then all countries should willingly comply, and I mean ALL, for its policies to work.

A GCB is unworkable, given our current circumstances. Institutions such as the IMF could only dream of having such power. If multilateral trade talks, such as Doha, have collapsed, how could global financial integration work?

But you never know where globalization could go next. Who knows in 20 years? Perhaps by then, there will be free mobility of anything and everything, including people, such that domestic policies won’t matter as much anymore.

Globalization in the long-term, if continued in its current form, could only lead to either this eventuality, or to another world war. Globalization in its current form will keep on creating intra-country economic dislocations, because while labour and small-scale businesses are stuck in just one country, capital can and will traverse the globe at a blip. A recipe that fosters resentment and protectionism among countries.

As John Lennon used to say, imagine a world without…..

Tuesday, August 26, 2008

10 indications we now need a Global Central Bank

Capital mobility is now global. With more inter-connectedness among nations, it is now increasingly imperative that each individual nation's monetary policies be coordinated to ensure smooth economic results system-wide. We can already see a variety of indications that we now need a Global Central Bank.

1. With global capital mobility, if one country hikes its interest rate to contain domestic inflation, it can attract more capital from overseas, nullifying the hike. Similarly, if the country cuts rates to spur investment, capital might leave the economy for better rates elsewhere.

2. An aggressive money supply policy in one country can spill over excess liquidity into the global system, spreading inflation globally.

3. One country’s active currency management policies artificially inflates/devalues free floating currencies.

4. Because of points 1, 2, and 3, one Central Banker’s monetary policies to cure domestic unemployment might be rendered ineffective.

5. Financial crisis that start in one country can easily spread to other economies.

6. That’s because the same toxic financial security can now have multiple listings in different markets.

7. They can be placed in multiple markets, or owned, by multi-national banks looking for arbitrage opportunities created globally by, among other things, uncoordinated Central Bank policies.

8. Conversely, a domestic bank can itself own multinationally-issued investments.

9. There’s been an explosion in cross-border money laundering.

10. Multinational corporations now also cross-lend funds borrowed elsewhere among subsidiaries located in different jurisdictions.

Now if we only knew how one unified Global Central Bank can be made possible....


Update 1: Here is a link to an on-line discussion on this idea, c/o EconomicsUK. Agree or disagree, identify more issues, or suggest how we operationalize it - add your views to this discussion.

Update 2: This post continued here.

Update 3: Is this the beginning of the end of nation-states

Thursday, August 21, 2008

Globalization: where to from here, part 2

This continues from my previous post on how globalization got us to this point. Now I will go into speculation territory, and try to see where it goes from here. If you haven’t already read them, some of my previous posts here, here, and here indicate my thoughts on where we might go.

In a nutshell, my opinion is that the current inflation is going to be a major equalizer for the global economy.

The inflation we’re experiencing right now is a natural outgrowth of economic development world-wide. Because the benefits of globalization have finally spread to the far quarters of the world, we recently experienced a faster rate of demand creation than existing levels of commodity production can adequately supply.

The inevitable ramification, due to law of supply and demand, is to increase input commodity prices, and consequently, effect a demand destruction in all areas. This destruction will stop when prices across the board decline to levels affordable to a viable number of global consumers and corporations.

A large part of demand destruction will be at the expense of smaller market players who do not currently enjoy economies of scale in their level of business. Inflation will eat into their profits, leaving only companies with larger profit margins who can weather the twin evils of escalating input costs and declining revenues. Large companies are at an advantage. A further qualification though - it is the large, streamlined company that is closest to its market that will be left standing.

Both the developed and developing worlds will probably each have to become more equally divided into being both consumer and producer economies. Developed markets will probably get back some manufacturing advantage, while developing markets will have to find more local businesses that produce local goods for more local consumers, rather than purely for export.

Companies from the developed world will likely focus more on their home markets, or those markets where they have the greatest competitive advantage. They will probably scale back in some foreign markets, leaving wide open opportunities for local companies in those markets to fill.

The question is, however, which of these foreign markets vacated by multinationals will have a big enough local demand to sustain a viable local supplier? On a case to case basis, some locals stepping up will find the chance to gain market traction. Likely, these will be in the consumer staples industries, retail, and banking, precisely those industries where the largest multinaltionals are currently scaling back the most.

However, these local companies will have a natural limit to their growth, and that limit is what local demand can sustain. Companies located in countries with smaller populations or poorer citizens will therefore will likely remain smaller than those in countries with larger and more prosperous countries. Most likely, just as the market suspects, after this crisis, the biggest competitors of US and European countries will be those from the BRIC countries.

Some manufacturing workers in the developed world will probably get back their jobs, once growth comes back, because this time around, cost differentials between the First and Third World will have narrowed. Moreover, companies will be more streamlined than they were before globalization, to make up for the fact that more of them now flourish worldwide.

Some back office process outsourcing will also likely be scaled back , as inflation in developing markets makes the cost of locating labor there comparable to just locating them in the home markets of the outrsourcers. Some companies will still accelerate outsourcing though, specifically in those areas where developing countries have already developed a local infrastructure that can sustain a competitive advantage to developed markets. Processes that would otherwise be done by highly paid staffers in the developed world will continue to be outsourced, i.e., tax and legal back office support, and maybe finance and accounting support, too.

Developing countries that peg their currencies to the US dollar will have to decouple, or the slowdown in the US will spread more deeply into their economies. The falling value of the dollar will make inflation more unbearable to their local consumers, many of whom already earn less than their US counterparts, and hence, are likely to sustain greater demand destruction if their dollar-pegged currencies fall further in value. This is certainly not a good way to create a viable local economy that can take the place of falling US consumer demand.

The developed world will remain the font of innovation, and this will be the basis for any resurgence in their part of the world. Developing markets still cannot innovate as fast or as dramatically as the West. Perhaps it has something to do with having a smaller home consumer market with which to experiment new products on.

So while much of the developing markets will probably specialize in the lower-cost standardized products, companies from the industrialized world will continue to make profitable niches in more customized, high-end products. Developing markets seem to excel at doing standardized processes more cheaply and more consistently in greater amounts, while developed countries seem to excel at tinkering with existing products. That's a big reason why companies from the developing world counter-intuitively establish subsidiaries in more expensive locations such as the US, to be in the thick of innovation.

This also indicates that once growth comes back in the world, and consumers in the developing world reverse the demand destruction happening right now, many of them will again want to buy goods manufactured in the developed countries. Whether because of better research, design, or innovation, products from the US for example, remain coveted status symbols in much of Asia.

Once the financial markets get through with their current panic, product innovation rather than financial innovation will be the focus of investments in the developed world. The growth in the financial markets will likely swing back to venture capitalists and private equity, while hedge funds will probably scale back.

Economists have always argued that markets eventually find an equilibrium. I think this is going to be the case. But since countries and companies have for long erected many barriers and constraints toward reaching this sooner, the pain we are now experiencing in reaching equilibrium is going to be more painful and more lingering than otherwise it would have been.

In the end, my feeling is that globalization will find its equilibrium. There might eventually be some minor variations to what I envisioned, as individual market participants try to outwit the market, but the world will eventually settle to a new equilibrium.

Looking at it from an even longer –term view, though, changing global demographics will also make a difference in the kind of new world order we achieve. That is an even bigger challenge to project, and I will leave that for someone else to tackle.

Wednesday, August 20, 2008

Globalization: Where to from here?

Where is globalization headed, and are we on the right track with it? Many people are likely asking these questions right now, as they have always asked at its every stage.

Firstly, let’s try to see if we can re-trace how we got here, and precisely what aspects of globalization got us to this. Let me tell you though, this analysis will entail some subjective judgments on my part. I don’t have all the necessary data to make a fully informed description, and in any case, I’m pretty sure that even the bright boys of the Fed and the major think tanks will find it a strain to do a fairly accurate forensic analysis of globalization, since there simply is too much diverse data to crunch. In the end, you have to make your own conclusions on how to connect all the dots, based on what has been observed thus far.

Globalization as we experienced it in the last three decades has departed from the kind we have seen in previous periods in history. Prior to the last thirty years, we really had nothing more than global trade among nations. Nations with a comparative advantage in producing one good exported a surplus to other countries, in exchange for goods where these other countries had a comparative advantage. This increased the diversity of products available in all countries that participated, not to mention enriched many parties who facilitated such trades.

The globalization that we saw in the past three decades was more the distribution and outsourcing of business processes of large corporations into different countries. In other words, it is not the physical trading of end products, but the parceling of different corporate activities of single corporations into different locations, mainly to arbitrage differences in cost, expertise, and logistical practicality. More likely than not, it was to arbitrage cost.

It was the next logical step in the globalizing of business. Companies that traded in different localities would, in the process of conducting their businesses, discover different ways to enhance profitability, productivity, and to differentiate themselves from the competition. In the process of doing so, major activities were uprooted from their home countries and transferred to other countries that could offer lower input labor costs.

The first to be outsourced were basic manufacturing processes. Then it led to the outsourcing of more complicated production processes, eventually to the outsourcing of the back office work that facilitated the corporate administration of the business itself. The latest to be outsourced has included even the more expensive research, analysis, and design of the products of these companies.

Outsourcing has had a lot of enemies from countries from both sides of the deal – the ones that lost the jobs, and the ones that got them. We know what happened to the countries that lost jobs to outsourcing. Significant portions of their population lost jobs, and continue to be displaced by this phenomenon.

But the sourcing of corporate activities to countries where they could be done more cheaply has led to huge increases in the productivity of the outsourcing companies. These companies were able to lower the selling price of their products, thereby making them affordable to a larger number of consumers in their home countries. The lower cost likely also led to significant increases in profitability of these same companies, which translated into newly-created wealth for their shareholders.

In many cases, the displaced workers likely found new jobs in other companies. Since the increased productivity and lower prices led to new wealth in the developed countries, these became funds that could be released for new ventures and businesses. And because the prices of goods were going down in these developed countries, excess discretionary income was created for the consumer, which led to opportunities for newer businesses.

This influx of new businesses likely created new jobs for many of the displaced. These new businesses likely were not as labor-intensive as before, but rather smaller, and tended to focus on the small niches created by rising discretionary income.

The transition wasn't equally easy for everyone. Moreover, because of the downward effects of the globalization of processes, many of the displaced and existing workers in the developed countries could no longer demand increasing wages from their employers. Because much of the work they did could now be standardized, codified, and therefore, be done in any other place in the world, this constrained their ability to negotiate increasing amounts of compensation. For a while, the decreasing cost of goods mitigated this stagnation in wages.

In the meantime, corporate shareholders continued to enjoy increasing profits, whether they invested in developing countries directly, or indirectly, through their companies that outsourced to those countries. Much of this new-found wealth needed to be re-invested. Not everything was re-invested in the same business or to the developing countries. They needed to diversify, so they invested some in their own countries.

There were fewer investing opportunities available to them domestically because much of the capital-intensive production facilities were already being set up in developing countries. Yet new wealth continued to flow back to the developed countries in the form of profits. Because there were fewer business opportunities than available funds, money began to flow to speculative assets – stocks, property, financial instruments, etc. For as long as new money poured into these assets, they increased in value, and seemed to be sensible thing to do. Bubble after bubble therefore arose in many of these assets.

Surely, once a significant froth develops in an asset, there has to be a correction. These investible funds have grown exponentially, both because of continuing profitability of the globalized businesses, and because the continuing profits in assets that appreciated in value created more funds. Because of the current size of the outstanding investment, the froth has lately become very big, and very speculative. The sub-prime capital market that recently burst in the US, a market for an asset class invested in by funds in other developed markets looking for yield, is one such example.

Because of the size of the losses, and the growing inter-connectedness of the financial markets in the developed economies, this latest contagion has the potential to undermine the rest of the other-wise still humming economies of these developed countries.

So how about on the other side of the fence - the developing world?

Well, as new investment continued to flow into their countries from the developed world, this created new jobs and new opportunities for the locals. Many who would otherwise have wallowed in poverty working in the farm now found work in the new industrial sites being set up.

Globalization has been a boon for countries with rapidly growing populations. These population increases would have been catastrophic had it not been for globalization. There is only so much work to be done in the farm, and hence, many of these people would be unemployed if not for the new factories.

Low-cost labor was therefore in plentiful supply for the outsourcers. For as long as new people arrived to staff new capacity, these outsourcers could secure a continuous outflow of cheap goods.

Now, because this labor was plentiful, they were never paid the same as they would have been had they been in the companies’ home country. That was the point of locating the factory there in the first place, so they could secure cheap labor.

So no significant market arose in the developed markets for the very products these factories and companies were creaking out. For many of those toiling in the factories, the goods they made were a luxury they can only dream of.

That began to change when relatively more middle class range of services began to be outsourced – the back office work. This paid more than the traditional factory work. And this was a boon for the next generation of Third World workers – the ones who had gone on to higher education, thanks to the money earned by their parents or older brothers and sisters employed in the industrial factories.

When these higher-paying jobs began to arrive in the developing world, demand was created for more of the middle class luxuries previously unaffordable there. This increased demand led to inflationary prices for these goods. Because these goods were marketed globally, this led to global inflationary prices.

Then, because of years of trade surpluses enjoyed by their governments, much needed infrastructure developments projects finally got under way. If you were a nation whose manufactured goods were affordable in many developed nations, but had a citizenry who could not afford much of what was being produced elsewhere, you’re going to ring year after year of trade surpluses. For as long as this led to currency coming in to bolster economic development, everything went according to plan.

Now what happens when there are simply too many countries investing in infrastructure projects, all at the same time? Right. This leads to inflationary prices for all input costs.
This is where we are in the world right now.

Developed countries that have enjoyed years of increasing productivity gains due to outsourcing have morphed into consumerist economies. Outsourcing may have led to stagnant wages for many, but the declining price of goods immediately resulting from it has pretty much mitigated its effect.

They have an investor class increasingly bowed by an increasing pile of liquidity and cash, but not enough useful investments to put them into. In all likelihood, much of this wealth will be invested in low-yielding placements, or worse, in investments that will lose significant value.
Then you have the developing nations, whose people are only now beginning to afford First World luxuries, but not in significant enough numbers as to replace the loss of business with a major trading partner.

And then you have a newly increasing global inflation, due to the slowly increasing number of people demanding the same products, driving up the scarcity of certain commodities.
What might happen next? Not necessarily bad things, I think. I’ll try to offer up some speculations in my next post.

Monday, August 18, 2008

10 overlooked reasons to love inflation


Inflation gets its share of flak, and for good reason. It is a wealth destroyer, and it lessens people’s purchasing power. But there can also be a good side to inflation. Following are my 10 overlooked reasons why inflation can be good. I will be brief on each point to let the reader add his own thoughts.

1. It is a good indicator that many people in the world are coming out of poverty, which is always good.
2. It encourages conservation, as people try to get more use out of existing items.
3. It promotes demand destruction in relatively more frivolous items.
4. It evens out the playing field for companies around the world – countries in developing countries will now have similar cost structures as those in developed countries, giving developed country businesses a respite from attacks by lower-cost competitors.
5. Businesses in developing countries are also given a respite as companies from developed countries are sometimes forced to retreat back to their home markets in efforts to cut costs.
6. It lessens global carbon footprint and encourages investment in alternative sources of energy.
7. It forces more innovative thinking as the primary source of new wealth creation, in place of simply relying on asset appreciation, whose value is usually destroyed by inflation.
8. It is now less likely for financial bubbles to crop up.
9. It might eventually be a war-deterrent because inflation makes waging wars costlier.
10. It might eventually solve the developed world’s growing obesity problem.

Ok, ok. The bad effects of inflation still outweigh the points above, and all except point one can happen in a low inflation environment. But since this could be the only positive reading on the economy you’re going to get all day, try to be more appreciative.

Sunday, August 17, 2008

Cities, corporations, and tax benefits


Businesses are earning less, and paying less taxes as a result. Some are going bust, ceasing payments altogether. Financial firms are taking huge losses, and declaring tax credits going forward many, many years.

City governments losing tax revenue are the latest to ask, “Where’s the beef?”

Friday, August 15, 2008

Today belongs to the "local" big boys


By now, it’s more or less official. The entire global economy is in a slowdown. From the US and Canada, to Europe, Australia, and the emerging markets of Asia – every single economy is now scaling back.

For the US, the reasons are a credit crunch and property bubble deflation. For Europe and the other developed economies, the slowdown is due to the immediate effects of the US deflation. For much of the emerging markets, it’s either scale back or suffer hyperinflation.

So what does this global slowdown mean for that much-vaunted of all globalization’s creatures – the multinational corporation?

Well, as I mentioned in a previous post, today belongs to the big boys. But as mentioned in another post, the strong influence of these multinationals is likely to be kept within the developed markets. In much of the emerging markets, the results for these multinational giants will be sketchy. In the end, it will boil down to whether the multinational has lower-cost competitors in a particular market.

Being a multinational entails a lot of costs. Being a multinational entails having a large bureaucracy to handle all the complexities and needs of far-flung outposts. Larger human resource support and accounting staffs, larger logistics and infrastructure support costs. (Wasn’t it the cost of maintaining far-flung outposts that brought down the Roman Empire? Just checking)

The small locally-based competitor neither has the luxury nor the need for such bureaucracy. The company president likely knows the office janitor in these firms. Hence, in terms of pricing its end product, an essentially efficient competitor’s product will likely be more affordable than a multinational’s.

In a world besieged by the twin spectres of inflation and job instability, what do you think a hapless consumer is likely going to do? That’s right. He will choose the lower-priced alternative, whenever it is sensible, and all chances he can.

The stagflation environment has had a good effect on the profitability of McDonalds and Walmart in the United States. As more and more consumers trade down to the cheaper alternatives, more expensive competitors lose out and these companies gain.

But are McDonalds and Walmart cheapest in all markets they compete in? Not by a long shot.

In many emerging markets, local food chains exist that trounce Mcdonalds in terms of cost. Ditto for other “high priced” US exports such as KFC, Pizza Hut and Wendy’s. These food chains will lose out to smaller, cheaper alternatives in many countries. Usually, it is in the poorer economies where cheaper alternatives exist. So in a nutshell, what I’m saying is that McDonalds, KFC, and Wendy’s are likely losing business in the emerging markets – right now.

And Walmart? Walmart couldn’t even enter some markets because they have already been outflanked by nimble local competitors who know better where to cut costs, and how to cater to the local clientele. It’s probably now losing the little market share that it already has in those markets that it managed to penetrate. Better for it to just focus its efforts now on the market where it is king, the US.

Dell, Hewlett Packard, Toshiba, Samsung. Great big giant multinationals all. Great big lumbering giants all, as far as some emerging markets are concerned. They simply cannot compete with locally assembled products made by enterprising local producers who essentially use the same components, but only have a tenth of the overhead cost these guys have.

And Procter and Gamble? Unilever? J&J? They’re doing great guns in the developed markets right now. Having greater reach than their smaller competitors, they are able to out-compete everybody else in their category. In the developed markets that is.

In the emerging markets? Sorry to spoil the party for these guys, but cheaper alternatives do exist. At this time and age, there is no such thing as a secret formula that makes their products superior to products made by competitors in emerging markets. Many competitors do produce cheaper products with similar quality.

Now, what these local guys will never have is the reach of P&G, J&J, and Uni-L. That necessarily means that they can never compete head to head with these giants in all the other markets that these multinationals are in. But in the small local country niche that these locals do sell in, these emerging markets competitors are probably now raking it in, as cash-strapped consumers in these economies realize that they don’t need to be as glamorous as the folks shown on the ubiquitous ads produced by these multinationals seem to be. These days, it pays more to be practical.

So what does this over-all trend mean for these multinationals? Not much negative probably in terms of bottom line. What they do lose out in the emerging markets, they gain over competitors without reach in the developed markets. But many of them are probably losing their emerging markets beachhead slowly but surely.

With the financial mess currently holding down the world’s giant financial supermarkets, i.e., UBS, Merrill Lynch, Citigroup, have been scaling back big-time. This is good news for local competitors of these financial firms.

With no giant global bank breathing down their necks and throwing excess global liquidity at all the available deals in their small markets, the financial players in these emerging markets are probably taking advantage of this lull by going out and getting some reach of their own right now. The better to hold out against the CitiGIANTS once they are once again ready to pounce around the world.

How about multinational service providers?

It will probably be a better fate for multinational giants that have decided to partner with a local firm in these markets. The Big 4 accounting firms, for instance. Since their services are provided by local partner firms in the developed world, their pricing tends to be more attuned to local affordability.

But it will be scale back time for service providers that employ US standards in pricing their services. That includes you, McKinsey, Mercer, and IBM. Also you, UBS, Goldman Sachs, and ING.

So do these market changes point to long-term ramifications? Who knows?

If history is any indication, once emerging markets consumers are once again prosperous enough to buy a Levi's Jeans, a Big Mac, and a Pizza Hut Supreme Pizza, they will do so, and these multinationals will be back in the emerging markets with a vengeance.

But for now, these markets will be owned by the local “big boys” in these niche economies.

Tuesday, August 12, 2008

US and Japan: Similar economic problems?

So which way is the current US economic slump going, and what is needed to fix it? To get clues toward answers, ask the Japanese. This slump is in many ways similar to what happened in Japan 1992, a stagnation that continues to this day.

How did the Japanese mess start? A summary by Satya Gabriel: Investors in Japanese assets began to project what would prove to be unsustainable growth rates in exports and domestic demand into the foreseeable future, bidding up asset values to unrealistic levels…. Japanese banks joined in the speculative bubble by not only financing the overinvestment boom of manufacturers but also financing real estate projects that depended on the aforementioned rapid rates of output and market share growth to generate the incomes that would make these real estate ventures profitable. Bankers expected that economic growth would generate more demand for office space, keeping occupancy rates high and generating growing rental incomes. Everybody seemed to be expecting the same thing --- that somehow Japan would keep growing both domestic demand and exports until the world was awash in Japanese goods and there would be little room left for American or European or any other manufacturers but the Japanese. The domestic side of this calculus did not seem to take into account the rapid aging of the Japanese population and the impact such aging would have on domestic demand curves. As for export expectations, in order to satisfy the earnings growth that seemed built into market valuations of exporters would have required the complete capitulation of American and European (and, perhaps, other Asian) firms to the Japanese corporate behemoth.

The bursting of the speculative bubble had serious repercussions in the Japanese banking system. Banks in Japan used their holdings of stock and real estate as part of their overall capital base upon which they determined the size of their loan portfolio. As equity prices and real estate market values collapsed, so did the capital base of the banking system. The banks were forced to severely contract their lending. Hardest hit by this credit crunch were smaller, more aggressive firms that are often the catalyst for major technological and marketing innovations in an economy.

If supply exceeds demand and there is no reasonable expectation that demand will pick up then the boards of directors of firms will not approve productive investment. Lower interests rates won't solve this problem. After all, who would borrow at any positive real rate of interest in order to build new plant and buy new equipment to produce output that goes unsold? Negative expectations can become reinforcing.

Reductions in productive investment can drive aggregate demand lower and make a whole panoply of other economic agents feel more pessimistic. As wage laborers (who are also the vast majority of consumers) become more concerned about their future then they become less likely to spend and aggregate demand falls further. Cuts in interest rates may even have the perverse effect of convincing economic agents that the economy is worse than they thought and reinforce the negative behavior that drives the economy lower (thus proving their assessment was correct). The Bank of Japan did not seem to get the basic point that expectations about future prospects for the economy can override interest rate cuts in determining the impact of monetary policy --- this was a point that John Maynard Keynes had made abundantly clear in his General Theory of Employment, Interest, and Money. Keynes called this problem a "liquidity trap."


Another site adds: From 1997 to 1998, banks and consumers preferred holding cash to investments because banks tightened the monitoring of performance. Short of credit, many companies went bankrupt. The reduction of government spending and banking reforms led to deflation.

The Japanese government has hesitated to resort to market measures in this economic recession (e.g., letting ailing banks and ailing big companies “die” through bankruptcies, because this would create great social instability, which traditionally has been avoided through a total employment policy). Unemployment has reached a historic high, for sure, but letting more companies go bankrupt would lead to an even higher rate of unemployment. So the government has allowed some companies to go bankrupt while bailing out some others.


Didn't they already try fiscal stimulus? Why didn't it work? Adam Posen, in his US Congressional testimony on the mater: Fiscal policy works when it is tried. The problem is that the Japanese government and the Ministry of Finance have way overstated the amount of fiscal stimulus in which they actually engaged. In total, around 23 trillion yen (4.5% of a year's GDP) was injected into the economy from 1992-97, in contrast to claims of 65-75 trillion yen. The government actually took a total 2.0% out of the economy in tax rises and spending cuts over the same years, which meant that the total stimulus was really small compared to the growth shortfall. In September 1995, they did pass a package that was large (1.5% of GDP) and 60% of the size they claimed, and they did get strong growth in 1996.

A better way out of the problem seems to be the following proposals. From Satya Gabriel: The Japanese government needed to stimulate those areas of the Japanese economy that have the highest "value added" or the greatest percentage of relatively advanced technology as inputs and outputs. Rather than construction spending, the Japanese government might have gotten more "bang for their buck" by spending on improvements in the high technology infrastructure of schools, colleges, universities, and the governmental bureaucracy; spurring increased research and development spending within Japanese firms (and not just the keiretsu industrial firms); and, on significantly reducing the environmental problems in the country (which could have spill-over effects in technological development and a positive effect on the "psychological mood" of Japanese citizens, at the same time). But no less important than doing a better job of targeting fiscal stimulus, the Japanese government needs to improve the lives of the Japanese citizens, to restore their confidence in the future, and by this approach to encourage more consumer spending and portfolio investments in Japanese equities.

A very vocal and prolific critic of the Japan mess has been Japanese economist Kaneko Masaru. Kaneko wants to bolster the financing and functions of the large-scale systems within which actors confront and cope with risks of the marketplace and life in general (e.g. sickness and ageing). These reforms include the funding and administration of pensions, inter-governmental relations and other public-sector systems. Kaneko argues that enhancing equity and socializing many of these risks more broadly will facilitate the country's industrial transformation. This is because, he insists, the holes in the current safety net impede labour mobility, restrict consumers' willingness to spend, and hinder the overall political economy's capacity to adjust to changing needs and opportunities.

The gargantuan public debt built up under the current political order has not brought the high interest rates that would have resulted if domestic savings were as scarce as in, say, the United States. But as Kaneko and a host of other public finance specialists have warned, the risk of Japan's falling into a 'debt trap' increases with each weighty dollop of deficit spending. A debt trap refers to the grave situation that occurs when a country is forced to issue new bonds in order to finance interest payments on past debt. Borrowing money to pay for past borrowing, especially when much of it was spent on unproductive assets, means deep trouble. As the state prints more and more of its increasingly dubious currency, the result is often hyperinflation and the politically destabilizing impoverishment of the middle classes.

Disposition of Japan's bad loan problem requires the use of public funds (to rebuild the banks' reserves) and the rescheduling of debt for firms in the grey zone. But in tandem, there must be strict inspection standards as well as a thorough investigation of bankers' responsibility for the financial debacles of the 1990s. Kaneko warns that fixing the bad loan problem will only serve to prevent a collapse of the financial system: it will not restart Japan's economy and could lead to a serious crisis of its own making if not coupled with stimulative measures.

Some observers, wanting the state to back off as much as possible, appear confident that tax cuts would provide sufficient stimulus. But Kaneko argues that the emphasis should be on spending. Yet rather than expand the deficit and pump more large-scale public works into the economy, what is required is a full-scale reconstruction of the flow of public finances and a concomitant shift to small-scale projects and welfare-related services (especially directed towards the needs of the environment, the aged and the handicapped). In particular, because over two-thirds of Japanese public spending is done at the local level, fiscal decentralization features prominently in Kaneko's reform model.


Distinctively Japanese measures for a distinctively Japanese mess? Perhaps. But given the similarities in causes, perhaps the solutions will have to be similar in many ways. Japan had yet to implement a successful solution when this current mess that started in the US hit them.

Just when Japan finally seemed able to export its way out of its mess, world economic activity began slowing down. Now that everyone the world over has the same problem, no country can expect another to solve its own mess. Everyone will have to start with their own domestic market.

Saturday, August 9, 2008

Demographics and Financial Markets: Existing Studies

Yes, there have been studies on what could happen to financial markets in developed countries when the baby boomers retire. These are some materials from a conference, as linked by Global Economy Matters.

The studies take off from public knowledge that demographically large numbers of people will retire from active working life more or less at the same time, and tries to project the implications to saving and investing. Philip Davis in his study posits the following hypothesis:

The permanent income hypothesis, while not explicitly basing saving on age, has the insight that the individual’s consumption is likely to depend on permanent rather than current disposable income. People will only consume if they believe it will be sustained. Consequently, if increases in their income are expected to be temporary, they will save rather than increase their consumption. The underlying assumption is that people seek to avoid fluctuations in their consumption when income fluctuates. Furthermore, when actual income is below permanent income, that is, in retirement, they may decumulate wealth.

Following this insight, the life-cycle hypothesis of consumption suggests that in one’s life, consumption may well exceed income as individuals may be taking major purchases related to buying a new home, starting a family, and beginning a career. At this stage in life, individuals may borrow based on their expected labour income in the future (human wealth), if financial markets are sufficiently developed and liberalised. In mid-life, these expenditures begin to level off while labour income increases. Individuals at this point will repay debts and start to save for retirement in equities, bonds, pension schemes, etc. At retirement, income normally decreases, and individuals may start to dissave. This involves selling off some of their assets, including pension fund decumulation.

A study by Robin Brooks, however, yielded empirical results that run counter to the hypothesis:

Empirical evidence does not point to a strong historical link between demographics and financial markets. While the existing literature has found that the relative importance of middle aged cohorts tends to be associated with relatively high real stock and bond prices, this paper holds that this relationship does not hold for countries with strong equity market participation among households, such as Australia, Canada, New Zealand, the UK and the US. In these countries, higher real financial asset prices tend to be associated with a large share of the population in the old tail of the age distribution, consistent with survey evidence from the US that shows that households build up financial wealth well into old age and then do little to run it down in retirement. Taken at face value, this suggests that real financial asset prices in these countries will actually rise as the population continues to age, though a number of considerations – including the changing nature of markets over time and general equilibrium considerations – caution against drawing this conclusion. Nonetheless, this finding underscores that historical evidence provides little support for the hypothesis that asset prices and returns will fall abruptly when the baby boomers retire.

By my own best guess, I don’t think anybody would be able to know for certain where financial markets are headed. It takes more than just national demographic data nowadays to know for sure. With global capital mobility, who knows where money could be going next. Perhaps long before the big retirement bulge comes, a significant amount of First World money may have moved somewhere lese. Then perhaps by the time that mass retirement happens, all the money in the world are already in the developed countries.

The sea change in economic events are now global, and any study done to determine financial flows should now study the whole world’s demographic data. And even then, an ever-changing changing macroeconomic mix everywhere constantly rebalances the playing field elsewehere.

In any case, perhaps when the developed countries’ boomers retire, they will likely be replaced by the much younger, but equally numerous Gen Y of the same countries as the bulk of the new generation of savers and investors. Since they are less likely to look forward to sufficient Social Security pension, they will probably be much more aggressive investors. Once retirees shift from equities to fixed income securities, these Gen Y could probably become the big equity players of the day. Insurance and pension firms who find themselves paying out on policies to boomer clients would do well to recruit more of these Gen Y investors as new sources of placements. (See graph of US birth trend, closely approximated by that of developing countries)
The case might be different for sovereign bonds of the ageing countries. More retirees means less income taxes and more benefit payouts. So more bonds may be forthcoming from sovereigns in the future.

But then, who has a crystal ball that sees this long into the future? Did anybody guess five years ago where we would be this year? I wonder how we’re doing if I check back on this post in five years’ time.

Friday, August 8, 2008

Declining Social Security benefits and retiree migration

Continuing from my last post on healthcare, I will briefly give my two cents worth on the problem of Social Security.

The debate on whether Social Security in the developed world is going to be insolvent has been going on since the 1970s. Primary reason again is the anticipation of massive numbers of boomers retiring en masse. Add to this the fact that people are living longer.

When you add the numbers of boomers who will start taking benefits to the numbers of existing elderly who will still likely continue taking benefits, you have a potential recipe for fiscal disaster. The average life expectancy has been increasing every year, as great numbers of the existing elderly continue to outlive even their own previous expectancies.

Some estimates put the ratio of retiree to worker in the developed world will eventually reach as high as two to five by 2020. (More resources compiled here)

To alleviate this, and to lengthen the solvency of Social Security, several reform proposals have been proposed, and some have been enacted. The proposals revolve primarily around three legs:
- Decreasing retirement benefits
- Increasing contribution of those still working
- Increasing the retirement age, and hence, the age when people start taking benefits

Decreasing benefits can only go so far before Social Security benefits become entirely meaningless. Ditto increasing contribution from workers. After all, those still working have their own personal expenses, still have growing families and mortgages and, most now have to save up more personally for their own retirements, in anticipation of declining Social Security benefits.

That leaves increasing retirement age as the only reform that can potentially go on indefinitely.

An alternative proposal under discussion is to turn Social security into a defined contribution fund. Currently, it is akin to a defined benefit fund, where the recipients are guaranteed a certain pension income, no matter how long in retirement they live. In a defined contribution program, while the pension income will still be guaranteed for the life of the recipient, the amount of benefit received will fluctuate, depending on the current financial market returns of the amount that they have contributed to the program.

This is interesting, given that it is patterned after the existing structure of private insurance and pension programs. But this still leaves retirees with the risk of receiving in some years, perhaps for many years, benefits that are in no way sufficient to support their needs. Remember, in times of high inflation, just when the cost of living is increasing, that’s also the time when financial returns of investments go down, and hence will lead to lower benefits under this proposal.

Let me add another option for retirees. It has nothing to do with Social Security reform. After all, I am on the camp that believes it can only be reformed so much, before it eventually becomes insolvent due to increasing numbers of elderly taking benefits. My proposed option is retiree migration.

If a retiree can expect a diminishing pension income in retirement, it starts making sense to live where costs of living are significantly lower. Previously, American retirees made Florida into a retirement haven. But cities in the same economy will still have proximate costs of living.

That then leads to retiring in cheaper economies. The developing world, specifically countries that do not have a history of bubble economic growth. The influx of currency from retirees from the developed world coming to spend their retirement days there will likely be beneficial to these economies, so many countries will probably be open to this.

The influx of money from retirees, if in large enough amounts, could potentially increase the cost of living in these developing countries, thereby making the initial benefit of moving to that country disappear. That is why a solution such as this needs to be two-pronged, and reciprocal.

Essentially, the biggest consumers in any economy are those still working, since most of them still likely have growing families, are yet into their wealth accumulating years, and buying their homes for the first time. If you have large amounts of these working age people living alongside people living on retiree income, the retirees will always lose out.

So, a countervailing strategy is to allow migration of many of the productive working age population of these developing countries to the developed world. This is assuming that the developed world continues to achieve the highest productivity gains in the world. If the developed countries slow down their productivity gains, that takes away the incentive of the working age population of developing countries to move, since added migration to a developed country whose economy doesn’t grow sufficiently enough will only decrease the over-all standard of living there.

But then, any economy that attracts more of the productive working age people is likely to increase its productivity over that of another country that doesn’t, and certainly over that of one that loses them.

Hence, the increased growth in economic development of a country that gets more working age people will likely attract more of them, leading to a virtuous cycle of continuing the productivity gain. The country that loses these workers will essentially experience a fall in its standard of living, making it more affordable for people living on retirement income from the developed world. And for as long as money trickles into these countries to support the retirees who have decided to move there, an equilibrium could be achieved where the country losing productive people will cease declining its standard of living at a certain point.

This scenario is similar to what has been experienced by cities within the same economy. Productive people move to where their efforts can enable them to build more wealth, while retired people move to where the cost and pace of life is more conducive to their state in life.

The difference this time, the migration will be global. But hey, goods and capital already have free mobility in our globalized world. The only major ingredient that needs to freely move around are the people. In a world where everything else is mobile, it doesn’t make sense to put a constraint on one factor of the economy. That will only create bottlenecks to growth, and economic hardship across the world.

The next stage of globalization, if we are to derive the full benefits of globalization, will involved moving people to where they will best achieve a quality of life. This experiment could start with the retirees.

update: social security won't ever bankrupt

Tuesday, August 5, 2008

Privatize or Socialize: Solutions to the Healthcare ticking bomb

By this point, it is no secret that healthcare will grow to become one of the largest, if not the largest, global industry in the coming decades. Healthcare is no longer just a concern of the developed countries, as even the developing countries are finding themselves becoming what we have come to refer to as “greying countries”.

With the continuing increase in life expectancy, more and more people are rushing into the senior demographic. Many of today’s seniors are likely going to be still around in ten years, but more are going to be joining them in the coming years. And with the baby boomers of the developed countries joining this demographic en masse in this coming decade, we are bound to see a boom in the following:
- Significant increase in number of retirees
- Significant growth in healthcare expenses

From a practical standpoint, one’s retirement years are the worst possible years in which to increase healthcare expenses. No other expense can be as great as healthcare, one cannot really avoid it if he wants to, and one’s need for it only increases as one grows older and less able to earn a livelihood by which to pay for the care.

Therefore, much discussion has been made regarding this long-anticipated demographic transition. Much has been proposed. Much debated and argued about. (This is a good link of resources)

One of the most significant debates has been in how best to provide healthcare for the greatest majority, as more members of society become dependent on it. Should it be provided by private companies, or should it be a socialised expense? Is it better done through the private sector, or by the government?

The US is a prime example of a country that has organized its healthcare sector on the former, while Canada, France, and Norway, are prime examples of those who organized healthcare provision around the government.

Private sector proponents expound the benefits of market competition, private enterprise, and the invisible hand in providing the best possible care to those in need.

Social democrats lean more on the conviction that government best provides healthcare, since private enterprises will always do everything for profit. Healthcare is a right common to all, these social democrats say, and no one should be denied it because of the inability to pay. More importantly, since healthcare is a significant expense, and one that concerns large populations at any given time, they believe that only the government has the scale and scope large enough to achieve the efficiencies and reach necessary.

Lately, with the increase in the number of uninsured Americans needing more and more healthcare, even the US is now debating the merits and costs of a privatized healthcare system. Stories abound of needy patients being thrown out into the street by hospitals because they can no longer pay their bills. Stories abound of people who go without medicine, and die because of it. Go watch Michael Moore’s “Sicko” documentary, if you would like a comprehensive array of arguments against the privatized healthcare system.

To an extent, these criticisms of privatized healthcare are true. No one can expect a business organized for profit to go out and conduct a profitable business in a largely altruistic activity such as providing care. Doctors cost money to educate and employ. Medicines cost money to develop, produce, and distribute. Hospitals cost money to build, staff, and to stock with the necessary equipment and supplies. Medical procedures cost money to organize and operate, and the more complicated the procedure, the more money it will take. For these activities to be done by a company organized to maximize investment return to its shareholders only increases healthcare’s cost to society. If healthcare were to continue to be provided by private sector initiatives and entities, we invite the inevitability of providers colluding to increase costs, and thereby profits, for themselves.

On the other hand, socialized healthcare is no solution either. In a socialized setting, there are no incentives, only directives. And in a socialized setting, all directives come from the government. With its scale and scope of reach also comes scale and scope of problems. Many problems, when attacked at the governmental level, become a matter of which majority is more preferred, more vocal, or more political. At the governmental level, many decisions are made by compromises, rather than by market discipline, or market intuition.

In a socialized healthcare setting, the government has the incentive to control expenses by minimizing the construction of more hospitals, the education of more doctors and healthcare professionals, or the development of cures for a variety of diseases. To a government bureaucrat, all these personal stories of tragedy and charity are reduced, if not to the level of dollars and cents as it would be by a private health provider, to the level of statistics, politics, and agenda.

What government, already fazed by the difficulties of balancing its budget, fighting crime, building roads and bridges, maintaining an army and keeping a full economy, is going to set aside a significant chunk of scarce government funding to build perhaps, two hospitals a year, or set aside a billion dollars to fund research on cancer, or to train the next generation of doctors and nurses? Government can definitely help, but it would by no means ensure that everybody is happy, and gets the healthcare they need.

In a socialized setting, doctors do not have the incentives to get more new patients once they have reached a certain level or quota. They certainly will not have the incentive to get the patients that will require more intensive care and monitoring, since these will only increase their working hours, or greatly increase their malpractice risk, without correspondingly increasing their level of professional income. In a socialized setting, therefore, you will likely find doctors turning away patients, and more of those turned away will likely be those in greatest need of healthcare.

In a socialised setting, therefore, one’s existing relationship with a family doctor can become a very precious, and very scarce, asset. One will likely avoid making big decisions, such as moving to another area to work, if it would mean giving up his existing relationship with his doctor, and risk going to an area where his chances of securing a similar relationship is significantly smaller. In Canada, for instance, there are instances of patients who endure long waiting periods just to secure the services of a family doctor. Away from the metropolitan cities, a pregnant woman can already be due before she finds a qualified obstetrician to look after her pregnancy.

This presents big social costs. Who will move to a province that is generally known to have a low ratio of healthcare providers to the general population? How can businesses attract talent there then? Taking this argument further, how can more students be enticed to become doctors if the government will have a say in where they practice, how much patients they take in, or whom and how much they charge?

In a nutshell, what I am saying is that basing the healthcare argument just on whether it should be socialized or privatized is not addressing the roots of the problem at all. Both systems have their advantages and costs. Both have their limitations, and both have their attractions.

What is necessary to go in the right direction of solving the problem, I think, is in increasing society’s ability to pay for healthcare.

Healthcare is scheduled to become the largest expense, and most possibly, the largest sector in the global economy in the coming decades. Unfortunately, unlike manufacturing, trading, or many service industries, healthcare is not value-creating. It is, by its essence, value-consuming.

What do I mean? Well, the business, or for that matter the country, that sells a tangible product - creates livelihood for its employees, promotes trade among the economy, and creates profit for the business, or surplus for the economy - profit or surplus which can then be used to fund more activities. Healthcare, meanwhile, while providing livelihood for its practitioners, eats away from its patients’ incomes, and the more healthcare needed, the more income eaten away.

And even if the care is paid for by a private insurance, or by a socialized government-funded program, it takes away resources that might have been used to grow the economy. The more sick people a country has does not bode well for the country, no matter how much income that could mean for its domestic healthcare economy. Sickness is always value-consuming, and the more that it spent on it, the less is spent elsewhere on value-creating activities.

An ageing country, with more of its people entering the time in their lives where they are able to work less, but require more in terms of care, is a country that will experience a significant decline in over-all standard of living, no matter if its healthcare is funded for by private sector programs, or by the government.

This is a phenomenon never before experienced in history. Historically, people have been involved in livelihoods where they worked until they could no longer stand up, in which case, they will soon die. There has never been an instance before when a significant portion of the population is retired, living longer, and requiring medicines and cures for illnesses never before available, but incurring expenses never before seen by people who have essentially stopped working.

The only way that society can escape this unprecedented ticking bomb is to ensure that healthcare does not , in fact, grow to become the biggest sector in the economy.

More activity has to be in value-creating activities. What does this entail? I can only think of two basic but broad implications.

Firstly, people will need to continue working, to pay for their healthcare, for as long as they need it. That could mean working until they are ready to kick the bucket. Secondly, and I think this was the assumption in the minds of the original architects of Social Security and Socialized Healthcare – the number of people in working age should perhaps at least be ten times as much as the number of people taking healthcare benefits. That means that the larger the number of people expected to enter their senior phases in coming years, the greater the proportion of people need to be born to take their place in the productive economy, when that time comes.

This means that, ever-growing life expectancy, plus ever-growing healthcare expenses, can only be sustained in the long-term - if coupled with an ever growing young population. No greying countries allowed.

update: social security won't ever bankrupt

Sunday, August 3, 2008

Secret Washington thoughts....


To cut or not to cut...OMG, this is giving me a big headache....



Do I see a massive recession ahead?








Shit! it's here. It's here!






Sir, our solution will call for a massive budget deficit and will bring down the dollar......

Dontcha worry, Hank. That's paht of mah grand plan tuh defeat China in trade. Now they don't have a reason tuh incuhr any muh suhpluses with us. Their doller holdings are renduhred wuhthless. Last laugh's ours, yihaaa!