Friday, July 31, 2009

Chimerica: Where is China-US relation headed?

Niall Ferguson coined the term Chimerica (China-America), and he analogizes the relationship between China and the US as a marriage on the brink between a frugal husband (China) and a spendthrift wife (US).

In the following stimulating discussion (part of Aspen Ideas Festival Series) on where this Chimerica relationship is headed, Niall Ferguson thinks such relationship is not sustainable and the US and China are on a collision course, just like the rivalry between Britain and Germany in the early 20th century. With China's sheer size and being non-democratic, you would naturally think so.

Jim Fallows disagrees. With many years of on-the-ground experiences in China, he thinks the US and China relation is more like US-Britain, and China's ambition to revive its previous glory as the world power does not necessarily lead to clashes between the two.

I would highly recommend this piece. And I would like to briefly share my thoughts: 1) A rising China is unavoidable and unstoppable; 2) Competition between countries is healthy, and it often spurs innovation and technological break-through; 3) The US needs to be fully prepared for a rising China and strategically position itself in the 21st century. In particular, the US should have a strategy in steering China into a democratic country, remaking a potential adversary into a strong ally.

(click on the graph to play the video;
skip the intro part and go directly to 4:30).

Thursday, July 30, 2009

Bob Shiller comments on recent housing data

Wednesday, July 29, 2009

Roach starting to worry about China

Stephen Roach is chairman of Morgan Stanley Asia.

I've been an optimist on China. But I'm starting to worry

By Stephen Roach

On the surface, China appears to be leading the world from recession to recovery. After coming to a virtual standstill in late 2008, at least as measured quarter-to-quarter, economic growth accelerated sharply in spring 2009.

A back-of-the envelope calculation suggests China may have accounted for as much as 2 percentage points of annualised growth in inflation-adjusted world output in the second quarter of 2009. With contractions moderating elsewhere, China's rebound may have been enough in and of itself to allow global gross domestic product to eke out a small positive gain for the first time since last summer.

That's the good news. The bad news is that China's recent growth spurt comes at a steep price. Fearful that its recent economic short- fall would deepen, Chinese policymakers have opted for quantity over quality in setting macro-strategy, the centrepiece of which is an enormous surge in infrastructure spending funded by a burst of bank lending.

Sure, developing nations always need more infrastructure. But China has taken this to extremes. Infrastructure expenditure (including Sichuan earthquake reconstruction) accounts for fully 72 per cent of China's recently enacted Rmb4,000bn ($585bn) stimulus. The government urged the banks to step up and fund the package. And they did. In the first six months of 2009, bank loans totalled Rmb7,400bn - three times the pace in the first half of 2008 and the strongest six-month lending surge on record.

This outsized bank-directed investment stimulus leaves little doubt as to how bad it was in China in late 2008 and early 2009. An unprecedented external demand shock, stemming from rare synchronous recessions in the developed world, devastated the export-led Chinese growth machine. That triggered sackings of more than 20m migrant workers in export-intensive Guangdong province. Long fixated on social stability, Beijing moved to arrest this deterioration. The government was determined to do whatever it took to restore rapid growth.

Yet there can be no avoiding the destabilizing consequences of these actions. Surging investment accounted for an unprecedented 88 per cent of Chinese GDP growth in the first half of 2009 - double the average contribution of 43 per cent over the past decade. At the same time, the quality of Chinese bank lending most assuredly suffered from the rash of credit disbursements in the first half of this year - a trend that could sow the seeds for a new wave of non-performing bank loans. Just this week, Chinese regulators told banks that new loans must be used to bolster the real economy and not for speculation in equities and real estate.

A little over two years ago, premier Wen Jiabao warned of a Chinese economy that was becoming increasingly "unstable, unbalanced, uncoordinated and ultimately unsustainable". Prescient words. Yet rather than act on those concerns by implementing a pro-consumption rebalancing, growth-hungry China was seduced by the boom in global trade and upped the ante on its most unbalanced sectors. By 2007, investment and exports accounted for about 80 per cent of Chinese GDP. And now, in the face of a severe global recession, China has compounded the very problems the premier warned of: aiming a massive liquidity-driven stimulus at its most unbalanced sector.

This is not a sustainable outcome for any economy - or sustainable support for the world economy. China must redirect economic growth towards internal private consumption. This may require a compromise on the quantity dimension of its growth outcome. But to the extent that leads to improved quality in the Chinese economy, a short-term growth sacrifice is well worth the effort.

Unlike most, I have been a steadfast optimist on China. Yet I am starting to worry. A macro strategy that exacerbates worrying imbalances is ultimately a recipe for failure. In many respects, that's what the global crisis and recession of 2008-09 are all about. China will not get special dispensation from the most critical lesson of this post-crisis era.

Nudge and smart regulation

How to make our regulations smarter and more intelligent by utilizing psychology to shape human behaviors (source: Intelligent Investor of WSJ):

Franklin D. Roosevelt sent Wall Street to the torture rack. Barack Obama is sending Wall Street to the psychology lab.

A key component of President Obama's financial-reform package is its proposed Consumer Financial Protection Agency, which would apply findings from the science of human behavior to ensure "transparency, simplicity, fairness, and access" for borrowers, savers and other financial consumers.

That could make it a lot harder for a part-time worker to end up with an exploding mortgage that eats all her take-home pay. It might even mean that regulators will finally pay attention to the visual presentation of financial data -- color, graphics and other factors that exert powerful sway over your decisions.

regulation based on human nature

The proposal is an outgrowth of "Nudge," the brilliant book published last year by two University of Chicago scholars, economist Richard H. Thaler and law professor Cass R. Sunstein. A longtime friend of President Obama, Prof. Sunstein has been nominated to head the White House's Office of Information and Regulatory Affairs, a job often described as "the regulation czar."

In my view, a behavioral approach is decades overdue. Financial regulations always have been written mainly by lawyers and legislators -- then promptly shot full of holes by promoters who understand how real human beings think and behave.

Lawyers think that the mere disclosure of risks and conflicts of interest provides the information that investors or consumers need. That is a fantasy. Faced with 47 pages' worth of "Risk Factors," investors come away with a warm glow of safety; risks that seem hard to understand appear unlikely to happen, and people who provide you with lots of detail seem likely to be honest.

To inform anyone, information has to be accessible. The central idea in "Nudge" is what Profs. Thaler and Sunstein call "choice architecture" -- the context, format and framing of how decisions are presented to consumers. You will eat more nuts from a big bowl than from a small bowl. You will choose surgery if you are told it offers a 90% chance of survival; you will reject it if you are told there is a 10% chance it will kill you. The same people who would skip investing in a 401(k) if they had to "opt in" to the plan will participate if they have to "opt out" in order to skip it.

Prof. Sunstein, who is awaiting Senate confirmation in his post, declined to be interviewed. Cautioning that he can't speak for the Obama administration or Prof. Sunstein, Prof. Thaler discussed the new regulatory model. "The standard beer can is 12 ounces," he said. "That makes it pretty easy to compare beer prices. So now consider mortgages. It's not that you regulate the interest rates or the fees. But one way to make shopping easier is to make comparing the products simpler."

Thus, suggested Prof. Thaler, every bank or mortgage broker would have to offer two "safe-harbor" products with "standard terms that are easy to understand": a 30-year fixed mortgage with no points or prepayment penalties, and a five-year adjustable-rate mortgage. The market would set the interest rates. "By having these generic, simple mortgages," said Prof. Thaler, "you make everything else comparable."

Banks and mortgage brokers would remain free to offer more complex kinds of loans. However, added Prof. Thaler, "If the broker sells you a teaser-rate mortgage that you can't possibly afford once it resets, then as Ricky Ricardo used to say, he's got some 'splainin' to do" -- including greater potential penalties from regulators. Mutual funds, 401(k)s and brokerage accounts wouldn't be regulated by the new agency but might well be influenced by its rules.

The proposal is about making regulation intelligent, not intrusive, said Eric Johnson, an expert on decision-making who teaches at Columbia Business School. "If you really do want a complicated, high-cost, high-risk mutual fund, you'll still be able to get it. But making sure that at least one option is not a disaster gives people an anchor."

Regulation that recognizes the limits of human rationality is an idea whose time has come. Like any good psychology lab, the proposed new agency will gather reams of data on how real people actually behave and adjust its rules accordingly, in real time. Of course, the financial industry will adjust its own behavior, trying to outsmart the new rules as fast as they are printed. But the war between the regulators and the regulated might finally be based on a realistic view of human nature, not fantasy.

Tuesday, July 28, 2009


Country music got dressed up by economic theories and John Maynard Keynes.

Unemployment and Economic Recovery

Unemployment rate is a lagging economic indicator and it peaks long after recession ends. So how can a lagging indicator affect the burgeoning recovery? You may ask.

This short piece from WSJ takes on this traditional view that unemployment does not matter, and analyzes why in this recession unemployment will become the decisive factor to the path of the US recovery.

Threat of Unemployment

Are markets taking too rosy a view of unemployment? Unemployment is usually seen as a lagging rather than leading economic indicator: In the last two U.S. downturns, firms continued shedding jobs for months after the recession was officially over. Typically, companies only start hiring in earnest once a recovery is clearly under way. But this time, unemployment may play a bigger role in determining the timing and shape of recovery.

True, the markets are currently betting the old orthodoxy still holds sway. Unemployment has climbed quickly. The U.S. rate hit 9.5% in June, higher than any point since 1983, and up from 5.6% a year earlier, one of the steepest annual rises on record. In the euro zone, May's 9.5% unemployment rate was the highest in 10 years. The Organization for Economic Cooperation and Development forecasts rates of 10% in the U.S. and more than 12% in the euro zone in 2010. But that has not stopped equity markets from rallying strongly, amid growing hopes of a recovery this year.

That's partly because job losses and other cost cuts have provided a cushion for corporate profits: 82% of the S&P 500 companies to report so far have beaten second-quarter earnings expectations. The snag is that only 50% have beaten sales targets, as Deutsche Bank points out. For the moment, earnings are only being held up by costs shrinking faster than revenue. For a true recovery, sales need to start growing too. Rising unemployment may make that harder to achieve.

First, the flipside of improved corporate profits is real financial and consumer pain. U.S. credit card bad debt, for example, is rising faster than unemployment. Annualized write-offs of securitized credit card debt hit a record 10.8% in June, according to Moody's. The agency expects that to rise to 12% to 13% in mid-2010. In Europe, Fitch's U.K. credit card charge-off index hit a record high of 9% in April. Historically, investors have assumed that a one percentage point increase in unemployment will lead to a one percentage point increase in bad credit card debt. But the pace of job losses and levels of debt means nobody is confident previous correlations will hold. Similarly, rising unemployment could also hit house prices again, causing further turmoil for mortgage-backed securities.

Meanwhile, high unemployment is also likely to weigh on consumer sentiment. Nearly 60% of U.S. consumers expect high unemployment to persist over the next several years, the University of Michigan reported Friday. That could shape behavior: Federal Reserve Chairman Ben Bernanke warned last week that unemployment could weigh on consumer spending. Continued pressure on sales could be a further impetus for companies to cut costs and jobs, leading to more losses on consumer debt.

Financial Times also has a nice video analysis on that the current earnings growth was driven by aggressive cost cutting, rather than sales. Consumer demand still remains every weak.

(click on the graph to play video; source: FT)

Monday, July 27, 2009

Feldstein warns of 'double-dip' recession

Marty Feldstain says it's likely the economy will be dragged down again in the fourth quarter.  He made a very good point that recovery from inventory buildup does not necessarily mean consumer demand will be bouncing back.  In other words, after a huge debt bubble, there is simply not enough demand out there to sustain the recovery.

Link to video (source: Bloomberg)

Friday, July 24, 2009

Blinder: The economy has hit bottom

There are a few egg-heads Fed commentators worth listening to, Alan Blinder is one of them.  In this piece, Alan Blinder explains how mechanically the economy could see a positive GDP growth in coming quarters, and why hitting the recession bottom can be good news and bad news.

How's the economy, you ask? I have the proverbial good news and bad news, but in this case, they're exactly the same: The U.S. economy appears to be hitting bottom.

First, the good news. Right now, it looks like second-quarter GDP growth will come in only slightly negative, and third-quarter growth will finally turn positive. Compared to the catastrophic decline we recently experienced—with GDP dropping at roughly a 6% annual rate in the fourth quarter of last year and the first quarter of this year—that would be a gigantic improvement.

Furthermore, there is a reasonable chance—not a certainty, mind you, but a reasonable chance—that the second half of 2009 will surprise us on the upside. (Can anyone remember what an upside surprise feels like?) Three-percent growth is eminently doable. Four percent is even possible. Surprised? How, with all our economic travails, could we possibly mount such a boom? The answer is that this seemingly high growth scenario isn't a boom at all. Rather, it follows directly from the arithmetic of hitting bottom.

Bear with me for two paragraphs while I do some numbers. In recent quarters, several critical components of GDP have declined at truly astounding annual rates—like minus 30% and minus 40%. You know the culprits: housing, automobiles and business investment. (Also inventories, about which more later.) Eventually, those huge negative numbers must turn into (at least) zeroes. Notice that the move to zero doesn't constitute a boom, not even a dead cat bounce, but merely the cessation of catastrophic decline. In fact, hitting zero growth and staying there would be a disaster scenario. We'll almost certainly do better.

But watch what happens when—and remember, it's when not if—the arithmetic of bottoming out takes hold. Housing, which is down to 2.6% of GDP, will serve as an example. In the first quarter, spending on new homes declined at a stunning 39% annual rate. If that minus 39% number turned into a zero in a single quarter, that change alone would add a full percentage point to that quarter's GDP growth (because 2.6% of 39% is about 1%). If the move to zero were to happen over two quarters, it would add about a half point to each. Many people think housing may in fact bottom out in the third or fourth quarter. Autos may already have passed their low point. And business investment will follow suit.

Now back to inventories. Recent quarters have seen an almost unprecedented liquidation of inventory stocks, which means that American businesses were producing even less than the paltry amounts they were selling. That, too, must come to an end. As inventory change turns from a large negative number into just zero, GDP will get another a big boost.

Now the key point: None of these events are probabilities; they are all certainties. The only issue is timing, about which we can only guess. But if several of these GDP components happen to bottom out at roughly the same time, we could be in for a big quarter or two.

Feeling a little better? There's more.

Remember the fiscal stimulus that everyone seems to be complaining about? One of the critics' complaints is that little of the stimulus money has been spent to date. OK. But that means that most of the spending is in our future.

And remember all those interest-rate cuts the Federal Reserve engineered in 2008, in a futile effort to stem the slide? The Fed's efforts were futile largely because widening risk and liquidity spreads negated any impacts on the interest rates real people and real businesses pay to borrow. Now those spreads are narrowing, which allows the Fed's rate cuts to start showing through to consumer loan rates, business loan rates, corporate bond rates, and the like. In short, monetary stimulus is in the pipeline—a pipeline that was formerly blocked.

So why, then, is everyone feeling so blue? That brings me to the bad news: The U.S. economy is hitting bottom.

If things feel terrible to you, you're not hallucinating. Economic conditions are dreadful at the bottom of a deep recession. Jobs are scarce. Layoffs abound. Businesses scramble for penurious customers. Companies go bankrupt. Banks suffer loan losses. Tax receipts plunge, ballooning government budget deficits. All this and more is happening right now, in what looks to be this country's worst recession since 1938. At such a deep bottom, few people have reason to smile. (Bankruptcy lawyers maybe?)

What's more, GDP is not terribly meaningful to most people. Jobs are—but they will take longer, maybe much longer, to revive. The last two recessions, while shallow, illustrated painfully that job growth may not resume for months after GDP bottoms out. And the unemployment rate won't fall until job growth rises "above trend" (say, 130,000 net new jobs per month). That's a long way from where we are today. So, even though the economy may be making a GDP bottom about now, the unemployment rate will probably keep rising for months—which is bad news for most Americans.

One last, obvious, but unhappy, point: The bottom of a deep recession leaves the nation in a deep hole. Our economy now has massive unemployment and vast swaths of unused industrial capacity. It will take years of strong growth to return to full employment.

After the last big recession bottomed out at the end of 1982, the U.S. economy rebounded sharply, with a remarkable six-quarter spurt in which annual GDP growth averaged 7.7%. That spurt induced President Ronald Reagan, running for reelection in 1984, to declare "It's morning again in America." Nobody thinks we can repeat that today, hampered as we are by a damaged financial system, decimated household wealth, rising foreclosures, and traumatized consumers who have suddenly learned the virtues of thrift.

So, yes, the good news is also the bad news. The economy is hitting bottom, but it's a long, uphill climb to get out.

Mr. Blinder, a professor of economics and public affairs at Princeton University and vice chairman of the Promontory Interfinancial Network, is a former vice chairman of the Federal Reserve Board.

Goldman Sachs and bubbles

Listen to this heated debate on whether Goldman Sachs manipulated the market and engineered every bubble since the Great Depression.  I reckon it's hard to justify such claim but without correcting the perverse incentives on Wall Street, traders of Goldman Sachs and alike will soon again risk the whole financial system in order to earn their big fat bonuses. I don't blame Goldman Sachs; I blame the misaligned incentive system.  (source: On Point)

Thursday, July 23, 2009

Bernanke: The Fed's exit strategy

Ben Bernanke again (see his previous speech) outlines how the Fed will drain the liquidity out of the system in order to avoid the danger of inflation. The Fed got plenty of tools; but these are not what matter.  What matters is whether the Fed can keep its independence in conducting monetary policy, and whether the Fed can find the right timing to tighten.  I put 80% chance on that the Fed can keep its independence; but 20% chance on the Fed can find the right timing, given their failure to spot the housing bubble and the previous bubble.  (Warning: this piece requires readers to have some basic understanding of Fed's balance sheet and common monetary policy tools)

The depth and breadth of the global recession has required a highly accommodative monetary policy. Since the onset of the financial crisis nearly two years ago, the Federal Reserve has reduced the interest-rate target for overnight lending between banks (the federal-funds rate) nearly to zero. We have also greatly expanded the size of the Fed's balance sheet through purchases of longer-term securities and through targeted lending programs aimed at restarting the flow of credit.

These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credit markets, including the markets for interbank lending, commercial paper, consumer and small-business credit, and residential mortgages.

My colleagues and I believe that accommodative policies will likely be warranted for an extended period. At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. The Federal Open Market Committee, which is responsible for setting U.S. monetary policy, has devoted considerable time to issues relating to an exit strategy. We are confident we have the necessary tools to withdraw policy accommodation, when that becomes appropriate, in a smooth and timely manner.

The exit strategy is closely tied to the management of the Federal Reserve balance sheet. When the Fed makes loans or acquires securities, the funds enter the banking system and ultimately appear in the reserve accounts held at the Fed by banks and other depository institutions. These reserve balances now total about $800 billion, much more than normal. And given the current economic conditions, banks have generally held their reserves as balances at the Fed.

But as the economy recovers, banks should find more opportunities to lend out their reserves. That would produce faster growth in broad money (for example, M1 or M2) and easier credit conditions, which could ultimately result in inflationary pressures—unless we adopt countervailing policy measures. When the time comes to tighten monetary policy, we must either eliminate these large reserve balances or, if they remain, neutralize any potential undesired effects on the economy.

To some extent, reserves held by banks at the Fed will contract automatically, as improving financial conditions lead to reduced use of our short-term lending facilities, and ultimately to their wind down. Indeed, short-term credit extended by the Fed to financial institutions and other market participants has already fallen to less than $600 billion as of mid-July from about $1.5 trillion at the end of 2008. In addition, reserves could be reduced by about $100 billion to $200 billion each year over the next few years as securities held by the Fed mature or are prepaid. However, reserves likely would remain quite high for several years unless additional policies are undertaken.

Even if our balance sheet stays large for a while, we have two broad means of tightening monetary policy at the appropriate time: paying interest on reserve balances and taking various actions that reduce the stock of reserves. We could use either of these approaches alone; however, to ensure effectiveness, we likely would use both in combination.

Congress granted us authority last fall to pay interest on balances held by banks at the Fed. Currently, we pay banks an interest rate of 0.25%. When the time comes to tighten policy, we can raise the rate paid on reserve balances as we increase our target for the federal funds rate.

Banks generally will not lend funds in the money market at an interest rate lower than the rate they can earn risk-free at the Federal Reserve. Moreover, they should compete to borrow any funds that are offered in private markets at rates below the interest rate on reserve balances because, by so doing, they can earn a spread without risk.

Thus the interest rate that the Fed pays should tend to put a floor under short-term market rates, including our policy target, the federal-funds rate. Raising the rate paid on reserve balances also discourages excessive growth in money or credit, because banks will not want to lend out their reserves at rates below what they can earn at the Fed.

Considerable international experience suggests that paying interest on reserves effectively manages short-term market rates. For example, the European Central Bank allows banks to place excess reserves in an interest-paying deposit facility. Even as that central bank's liquidity-operations substantially increased its balance sheet, the overnight interbank rate remained at or above its deposit rate. In addition, the Bank of Japan and the Bank of Canada have also used their ability to pay interest on reserves to maintain a floor under short-term market rates.

Despite this logic and experience, the federal-funds rate has dipped somewhat below the rate paid by the Fed, especially in October and November 2008, when the Fed first began to pay interest on reserves. This pattern partly reflected temporary factors, such as banks' inexperience with the new system.

However, this pattern appears also to have resulted from the fact that some large lenders in the federal-funds market, notably government-sponsored enterprises such as Fannie Mae and Freddie Mac, are ineligible to receive interest on balances held at the Fed, and thus they have an incentive to lend in that market at rates below what the Fed pays banks.

Under more normal financial conditions, the willingness of banks to engage in the simple arbitrage noted above will tend to limit the gap between the federal-funds rate and the rate the Fed pays on reserves. If that gap persists, the problem can be addressed by supplementing payment of interest on reserves with steps to reduce reserves and drain excess liquidity from markets—the second means of tightening monetary policy. Here are four options for doing this.

First, the Federal Reserve could drain bank reserves and reduce the excess liquidity at other institutions by arranging large-scale reverse repurchase agreements with financial market participants, including banks, government-sponsored enterprises and other institutions. Reverse repurchase agreements involve the sale by the Fed of securities from its portfolio with an agreement to buy the securities back at a slightly higher price at a later date.

Second, the Treasury could sell bills and deposit the proceeds with the Federal Reserve. When purchasers pay for the securities, the Treasury's account at the Federal Reserve rises and reserve balances decline.

The Treasury has been conducting such operations since last fall under its Supplementary Financing Program. Although the Treasury's operations are helpful, to protect the independence of monetary policy, we must take care to ensure that we can achieve our policy objectives without reliance on the Treasury.

Third, using the authority Congress gave us to pay interest on banks' balances at the Fed, we can offer term deposits to banks—analogous to the certificates of deposit that banks offer their customers. Bank funds held in term deposits at the Fed would not be available for the federal funds market.

Fourth, if necessary, the Fed could reduce reserves by selling a portion of its holdings of long-term securities into the open market.

Each of these policies would help to raise short-term interest rates and limit the growth of broad measures of money and credit, thereby tightening monetary policy.

Overall, the Federal Reserve has many effective tools to tighten monetary policy when the economic outlook requires us to do so. As my colleagues and I have stated, however, economic conditions are not likely to warrant tighter monetary policy for an extended period. We will calibrate the timing and pace of any future tightening, together with the mix of tools to best foster our dual objectives of maximum employment and price stability.

—Mr. Bernanke is chairman of the Federal Reserve.

Wednesday, July 22, 2009

What India must do to become an affluent country

Martin Wolf writes on FT on what India must do to catch up with China and become an affluent country in a generation. Compared to China, in my mind, India enjoys the advantage of being a democratic country (Indians may not feel the same way), but its caste system, poor infrastructure, and bureaucracy are really dragging its feet.

I am a true believer of competitions, including competitions between countries. Without China's fast growth since 1978, India may not have had the urge to initiate its own reform in mid 90s; and without India rising in IT and innovation, China may still have specialized in manufacturing only. Competition can produce win-win situation. Most politicians focus on how to grabbing a bigger share of the same pie; economists, fundamentally optimists, focus on how to create a much bigger pie, even sharing a smaller part of it.

What India must do if it is to be an affluent country

What will the world economy – indeed, the world – look like after the financial crisis is over? Will this prove to be a mere blip or something more fundamental? Much of the answer will be provided by the performance of the two Asian giants, China and India. Rightly or wrongly, it is widely accepted that China will continue to grow very rapidly. But what is the likely future for India?

I attended debates on this question in Mumbai and Delhi two weeks ago. The occasion was the launch of a report prepared by the Centennial Group for this year's Emerging Markets Forum.* It addresses a provocative question: what would need to change if India were to become an affluent country in one generation? The answer is: a great deal. But one thing is clear: after the performance of the past three decades, the goal is not laughable.

Since 1980 the average living standards of Chinese and Indians have, for the first time in the histories of these two ancient civilisations, experienced a sustained and rapid rise. In one generation, India's gross domestic product per head rose by 230 per cent – a trend rate of 4 per cent a year. This would seem a fine accomplishment if China's had not increased by 1,090 per cent – a trend rate of 8.7 per cent. Yet even if India has lagged behind, the change has been large enough for aspiration to replace resignation as the ethos of a large and rising proportion of Indians.

The recent past offers at least four further reasons for optimism. First, the rate of growth has been accelerating: over the five years up to and including 2008, the average annual rate of economic growth was 8.7 per cent, up from 6.5 per cent at the previous peak in 1999. Second, vastly higher savings and investment underpin this acceleration, with gross domestic savings up to 38 per cent of GDP in the financial year 2007-08. Third, India's economy has globalised, with the ratio of trade in goods and services up to 51 per cent of GDP in the last quarter of 2008, up from 24 per cent a decade before. This was not far behind China's 59 per cent of GDP (see chart below).

Finally, the democratic political system, for all its frailties, works. Indian democracy is a wonder of the political world. What happened in the past election seems a big development – the re-election of a Congress-led government, with a big increase in the party's seats. It is widely believed that this reflects a choice of competence over caste and secularism over sect. Not least, the electorate registered approval of the competence and integrity of Manmohan Singh, the prime minister. I have been lucky to have known Dr Singh for three and a half decades. I admire nobody more. I only hope he is prepared to use his possibly final period in office boldly.

So what needs to happen if Indians are to enjoy an affluent lifestyle? The answer, suggests the report, is that India must sustain growth at close to 10 per cent a year over a generation. This is not inconceivable: China has managed that, from a lower base, over three decades. But it is a massive task, particularly for so huge, diverse and complex a country. Extraordinary change would have to occur, inside India and in India's relationships with the world.

For this to be conceivable, at least four things would have to happen: the world must remain peaceful; the world economy must remain open; India must avoid the stagnation into which many middle-income countries have fallen; and, finally, the resource and environmental implications of its rise to affluence must be managed.

Moreover, India itself must overcome three big challenges: maintaining, indeed strengthening, social cohesion at a time of economic and social upheaval; creating a competitive and innovative economy; and playing a role in its region and the world commensurate with the country's size and rising importance. In fundamental respects, India must turn itself into a different country.

Not least, as the report makes clear, India would have to be governed quite differently. In India a vigorous, albeit too often corrupt, democratic process has been superimposed on the "mindsets, institutional structures and practices inherited from the British Raj". India has prospered despite government, not because of it. It is a miracle that the giant has fared as well as it has. But if this country is to prosper it must create infrastructure, provide services, promote competition, protect property and offer justice. The country must move from what the report calls "crony capitalism and petty corruption" to something different. The quality of government, widely believed to be deteriorating, must, instead, radically improve.

Just how far the transformation would have to go is shown by the "seven inter-generational issues" on which this report focuses: first, tackling disparities, not least among social groupings, but without further entrenching group-based entitlements and group-based politics; second, improving the environment, including the global environment; third, eliminating India's pervasive infrastructure bottlenecks; fourth, transforming the delivery of public services, particularly in India's ill-served cities; fifth, renewing education, technological development and innovation; sixth, revolutionising energy production and consumption; and, finally, fostering a prosperous south Asia and becoming a responsible global power.

I take two big things from the analysis in this report, one for India and another for the world.

For India, I conclude that even sustaining recent performance is going to be very hard. The era when the country could prosper just by stopping government from getting in the way is ending. India now requires efficient, service-providing government by competent technocrats and honest politicians. Of course, many foolish interventions still need to be removed. The government also needs to refocus its limited energy and resources on its essential tasks. But it must be able to perform these tasks far more effectively than it can today.

What I take for the world is that India, for all the huge challenges it confronts, is likely to continue its rise, if more slowly than the report assumes. The job of adjusting the familiar western ways of thinking about the world to the new realities has hardly begun. Within a decade a world in which the UK is on the United Nations Security Council and India is not will seem beyond laughable. The old order passes. The sooner the world adjusts, the better.

Remembering Peter Bernstein

I have planned to send out this earlier, but somehow I forgot. Peter Bernstein, one of the few shining stars in investing, co-founder of Journal of Portfolio Management, and author of nearly a dozen popular investment books, including Against the Odds, passed away in June. Here is a piece remembering him from WSJ (the highlights are mine). I truly enjoyed this piece, and his wisdom.

Investing has yielded a few stars so famous they are known by first name. Warren Buffett is one. Peter L. Bernstein -- the economist, investment consultant and prolific author who died on June 5 at 90 -- was another.

Mr. Bernstein saw the boom and bust of the 1920s first-hand in New York. In 1929, Mr. Bernstein's father, Allen, sold the family leather factory "for a price he never dreamed he would get" and put all the proceeds into the stock market, buying "other people's companies at prices they never dreamed they would see, either," Mr. Bernstein recalled, paraphrasing his father.

Peter L. Bernstein

Then the stock market crashed, nearly wiping out the family.

Mr. Bernstein never forgot the lesson. Seven decades later, he wrote: "What we like to consider as our wealth has a far more evanescent and transitory character than most of us are ready to admit." He urged investors to regard their gains as a kind of loan that the lender -- the financial market -- could yank back at any time without any notice.

A classmate of John F. Kennedy in Harvard College's class of 1940, Mr. Bernstein entered finance in 1941, joining the research department of the Federal Reserve Bank of New York.

After the U.S. was attacked by Japan, Mr. Bernstein tried to enlist as a pilot in the Air Force, but his poor eyesight made him ineligible. Instead, he served as an intelligence officer for the Office of Strategic Services in London during the Blitz, where he said he learned mental resilience.

In his almost 70-year career, he taught economics at Williams College, worked as a portfolio manager at Amalgamated Bank and ran the investment-counseling firm of Bernstein-Macaulay, co-founded by his father and Frederick Macaulay, who invented the modern discipline of bond investing.

In 1974, as Wall Street was suffering its worst market decline since 1929, Mr. Bernstein co-founded the Journal of Portfolio Management to improve risk management with insights from academic research.

His introduction to the maiden issue reads as if it were written yesterday: "How could so many have failed to see that all the known parameters were bursting apart?...It was precisely our massive inputs and intimate intercommunication that made it impossible for most of us to get to the exits before it was too late."

He was the author of 10 books, five of which he published after the age of 75. Two of them, "Capital Ideas," a history of modern finance, and "Against the Gods," a dazzling survey of probability and risk, were international best sellers. With his wife and business partner, Barbara Soskin Bernstein, Mr. Bernstein also published "Economics & Portfolio Strategy," a biweekly newsletter.

Mr. Bernstein generally shunned making black-and-white predictions, but in an interview with The Wall Street Journal in early 2008, he warned that "we are going to have an extremely risk-averse economy for a long time....The people who think we will have turned [the corner economically] in 2009 are wrong."

Late in his life, Mr. Bernstein often joked that he had made his living for decades by repeatedly "telling people what they know only too well already."

In 1970, he asked rhetorically, "What are the consequences if I am wrong?" and said "no investment decisions can be rationally arrived at unless they are [based upon] the answer to this question." He counseled investors to take big risks with small amounts of money rather than small risks with big amounts of money.

The same focus on the consequences of error was one of the main themes of "Against the Gods," which he published more than a quarter-century later.

Also in 1970, Mr. Bernstein wrote: "We simply do not know what the future holds." Over the ensuing decades, he returned again and again to that phrase in his speeches, articles and books, because he felt it captured the central truth about investing.

Asked in 2004 to name the most important lesson he had to unlearn, he said: "That I knew what the future held, that you can figure this thing out. I've become increasingly humble about it over time and comfortable with that. You have to understand that being wrong is part of the [investing] process."

Tuesday, July 21, 2009

Greenspan on the threat of inflation

In this FT piece, Maestro Greenspan identifies another channel that inflation may be the real threat down the road.  He hypothesizes that equity market does not purely reflect or predict what is going on in the real economy; but it causes the real economy to swing both ways, and it operates through company's balance sheet.   "I recognize that I accord a much larger economic role to equity prices than is the conventional wisdom. From my perspective, they are not merely an important leading indicator of global business activity, but a major contributor to that activity, operating primarily through balance sheets."

Having dealt with the Congress for many years, Greenspan is really worried about politicians messing up with the Fed. "But I see inflation as the greater future challenge. If political pressures prevent central banks from reining in their inflated balance sheets in a timely manner, statistical analysis suggests the emergence of inflation by 2012." 

Adding to the problem is the bleak fiscal health in the country and the huge budget deficits will induce politicians to print more money to finance the debt.

With Greenspan on board, now in the inflation camp, we have John Taylor (the author of Taylor Rule), Fred Mishkin (former Fed governor), Jim Grant, Marc Farber and Jim Rogers (all legendary investors); in the deflation camp, we have Paul Krugman (2008 Nobel prize winner in economics), Robert Shiller (owner of Case-Shiller index), David Rosenberg (former ML chief economist), Ben Bernanke (Fed chairman) and Janet Yellen (SF Fed president).  With so much divide in both academics and the profession, and so much uncertainties ahead of us, prudent investors should always hedge the inflation risk in their portfolio.  Both TIPs and gold serve the purchase.  If the Fed manages to rein the liquidity in a timely manner and inflation is under control, you are unlikely to lose your investment value on both; if inflation runs rampant, you are a sure winner.

Now here I give you Alan Greenspan:

Inflation - the real threat to sustained recovery

The rise in global stock prices from early March to mid-June is arguably the primary cause of the surprising positive turn in the economic environment. The $12,000bn of newly created corporate equity value has added significantly to the capital buffer that supports the debt issued by financial and non-financial companies. Corporate debt, as a consequence, has been upgraded and yields have fallen. Previously capital-strapped companies have been able to raise considerable debt and equity in recent months. Market fears of bank insolvency, particularly, have been assuaged.

Is this the beginning of a prolonged economic recovery or a false dawn? There are credible arguments on both sides of the issue. I conjectured over a year ago on these pages that the crisis will end when home prices in the US stabilise. That still appears right. Such prices largely determine the amount of equity in homes – the ultimate collateral for the $11,000bn of US home mortgage debt, a significant share of which is held in the form of asset-backed securities outside the US. Prices are currently being suppressed by a large overhang of vacant houses for sale. Owing to the recent sharp drop in house completions, this overhang is being liquidated in earnest, suggesting prices could start to stabilise in the next several months – although they could drift lower into 2010.

In addition, huge unrecognised losses of US banks still need to be funded. Either a stabilisation of home prices or a further rise in newly created equity value available to US financial intermediaries would address this impediment to recovery.

Global stock markets have rallied so far and so fast this year that it is difficult to imagine they can proceed further at anywhere near their recent pace. But what if, after a correction, they proceeded inexorably higher? That would bolster global balance sheets with large amounts of new equity value and supply banks with the new capital that would allow them to step up lending. Higher share prices would also lead to increased household wealth and spending, and the rising market value of existing corporate assets (proxied by stock prices) relative to their replacement cost would spur new capital investment. Leverage would be materially reduced. A prolonged recovery in global equity prices would thus assist in the lifting of the deflationary forces that still hover over the global economy.

I recognise that I accord a much larger economic role to equity prices than is the conventional wisdom. From my perspective, they are not merely an important leading indicator of global business activity, but a major contributor to that activity, operating primarily through balance sheets. My hypothesis will be tested in the year ahead. If shares fall back to their early spring lows or worse, I would expect the "green shoots" spotted in recent weeks to wither.

Stock prices, to be sure, are affected by the usual economic gyrations. But, as I noted in March, a significant driver of stock prices is the innate human propensity to swing between euphoria and fear, which, while heavily influenced by economic events, has a life of its own. In my experience, such episodes are often not mere forecasts of future business activity, but major causes of it.

For the benevolent scenario above to play out, the short-term dangers of deflation and longer-term dangers of inflation have to be confronted and removed. Excess capacity is temporarily suppressing global prices. But I see inflation as the greater future challenge. If political pressures prevent central banks from reining in their inflated balance sheets in a timely manner, statistical analysis suggests the emergence of inflation by 2012; earlier if markets anticipate a prolonged period of elevated money supply. Annual price inflation in the US is significantly correlated (with a 3½-year lag) with annual changes in money supply per unit of capacity.

Inflation is a special concern over the next decade given the pending avalanche of government debt about to be unloaded on world financial markets. The need to finance very large fiscal deficits during the coming years could lead to political pressure on central banks to print money to buy much of the newly issued debt.

The Federal Reserve, when it perceives that the unemployment rate is poised to decline, will presumably start to allow its short-term assets to run off, and either sell its newly acquired bonds, notes and asset-backed securities or, if that proves too disruptive to markets, issue (with congressional approval) Fed debt to sterilise, or counter, what is left of its huge expansion of the monetary base. Thus, interest rates would rise well before the restoration of full employment, a policy that, in the past, has not been viewed favourably by Congress. Moreover, unless US government spending commitments are stretched out or cut back, real interest rates will be likely to rise even more, owing to the need to finance the widening deficit.

Government spending commitments over the next decade are staggering. On top of that, the range of error is particularly large owing to the uncertainties in forecasting Medicare costs. Historically, the US, to limit the likelihood of destructive inflation, relied on a large buffer between the level of federal debt and rough measures of total borrowing capacity. Current debt issuance projections, if realised, will surely place America precariously close to that notional borrowing ceiling. Fears of an eventual significant pick-up in inflation may soon begin to be factored into longer-term US government bond yields, or interest rates. Should real long-term interest rates become chronically elevated, share prices, if history is any guide, will remain suppressed.

The US is faced with the choice of either paring back its budget deficits and monetary base as soon as the current risks of deflation dissipate, or setting the stage for a potential upsurge in inflation. Even absent the inflation threat, there is another potential danger inherent in current US fiscal policy: a major increase in the funding of the US economy through public sector debt. Such a course for fiscal policy is a recipe for the political allocation of capital and an undermining of the process of "creative destruction" – the private sector market competition that is essential to rising standards of living. This paradigm's reputation has been badly tarnished by recent events. Improvements in financial regulation and supervision, especially in areas of capital adequacy, are necessary. However, for the best chance for worldwide economic growth we must continue to rely on private market forces to allocate capital and other resources. The alternative of political allocation of resources has been tried; and it failed.

The writer is former chairman of the US Federal Reserve

Monday, July 20, 2009

Two American Models: California vs. Texas

California is broke; Texas performs the best during this recession.

A debate on two different American models and who may have America's future. From my favorite On Point with Tom Ashbrook at local Boston station.

Forever, it seemed, California was the bright horizon of the American dream. The Golden State, with surf and mountains, high tech and endless bounty.

Now, California is broke. Worse than broke. And if you look at the economic numbers, the new American champ among the fifty states is… Texas. The Lone Star State. Immigrants, ranchers, oil men, builders. The fastest-growing population in the country.

So, is this the very different new horizon of the American dream? Texas?

This Hour, On Point: California, Texas, and the debate over who may have the model for the American future.

China is building strategic reserve in commodities

The earlier evidence was further confirmed by more data recently that China has been stockpiling copper and other commodities strategically. This is a smart move on Chinese side, but it shows the recovery in China was not strong as the commodity price would have indicated. Read this analytical piece from WSJ.

What is China going to do with all that copper? Move the futures markets, for one thing.

Bolstered by stockpiling, the country's imports of the red metal in the first half jumped 69% from year-earlier levels. Seizing upon last year's drop in prices, China's State Reserve Bureau now holds at least 235,000 metric tons of copper, nearly as much as the London Metal Exchange warehouses hold to back futures trading.

Arbitragers followed suit, after the SRB's buying helped push copper prices inside China well above those abroad. Deutsche Bank estimates factories and warehouses in the country hold as much as one million metric tons of copper in total -- equivalent to nearly a month's global consumption.


Meanwhile, LME copper futures are up 63% since February. What next? The market's already proved its susceptibility to speculation about the SRB's next move. In June, reports the government had turned seller fueled a sharp price retreat.

A paucity of information doesn't help. An official from China's National Development and Reform Commission last month said stockpiling had ceased. But not everyone's convinced. After all, with copper still well below last year's peak of nearly $9,000 a metric ton, China might want to keep building its position.

Bulls also say investment in power-generation capacity, a recovering construction industry, and buoyant car sales may see China gobbling up its copper reserves. This is all causing a wide divergence in views for the second half of the year. Price targets range from $3,500 a metric ton, a 31% drop from current levels, to $7,000 a metric ton, a 37% rise. Even more than usual, the outcome will be in Beijing's hands.

The Economy Is Even Worse Than You Think

Opinion piece from WSJ: Unemployment is worse than you think. This does not bode well for consumptions, which accounts for 70% of American economy, and may dash any hope of a quick turnaround.

The recent unemployment numbers have undermined confidence that we might be nearing the bottom of the recession. What we can see on the surface is disconcerting enough, but the inside numbers are just as bad.

The Bureau of Labor Statistics preliminary estimate for job losses for June is 467,000, which means 7.2 million people have lost their jobs since the start of the recession. The cumulative job losses over the last six months have been greater than for any other half year period since World War II, including the military demobilization after the war. The job losses are also now equal to the net job gains over the previous nine years, making this the only recession since the Great Depression to wipe out all job growth from the previous expansion.

Here are 10 reasons we are in even more trouble than the 9.5% unemployment rate indicates:


- June's total assumed 185,000 people at work who probably were not. The government could not identify them; it made an assumption about trends. But many of the mythical jobs are in industries that have absolutely no job creation, e.g., finance. When the official numbers are adjusted over the next several months, June will look worse.

- More companies are asking employees to take unpaid leave. These people don't count on the unemployment roll.

- No fewer than 1.4 million people wanted or were available for work in the last 12 months but were not counted. Why? Because they hadn't searched for work in the four weeks preceding the survey.

- The number of workers taking part-time jobs due to the slack economy, a kind of stealth underemployment, has doubled in this recession to about nine million, or 5.8% of the work force. Add those whose hours have been cut to those who cannot find a full-time job and the total unemployed rises to 16.5%, putting the number of involuntarily idle in the range of 25 million.

- The average work week for rank-and-file employees in the private sector, roughly 80% of the work force, slipped to 33 hours. That's 48 minutes a week less than before the recession began, the lowest level since the government began tracking such data 45 years ago. Full-time workers are being downgraded to part time as businesses slash labor costs to remain above water, and factories are operating at only 65% of capacity. If Americans were still clocking those extra 48 minutes a week now, the same aggregate amount of work would get done with 3.3 million fewer employees, which means that if it were not for the shorter work week the jobless rate would be 11.7%, not 9.5% (which far exceeds the 8% rate projected by the Obama administration).

- The average length of official unemployment increased to 24.5 weeks, the longest since government began tracking this data in 1948. The number of long-term unemployed (i.e., for 27 weeks or more) has now jumped to 4.4 million, an all-time high.

- The average worker saw no wage gains in June, with average compensation running flat at $18.53 an hour.

- The goods producing sector is losing the most jobs -- 223,000 in the last report alone.

- The prospects for job creation are equally distressing. The likelihood is that when economic activity picks up, employers will first choose to increase hours for existing workers and bring part-time workers back to full time. Many unemployed workers looking for jobs once the recovery begins will discover that jobs as good as the ones they lost are almost impossible to find because many layoffs have been permanent. Instead of shrinking operations, companies have shut down whole business units or made sweeping structural changes in the way they conduct business. General Motors and Chrysler, closed hundreds of dealerships and reduced brands. Citigroup and Bank of America cut tens of thousands of positions and exited many parts of the world of finance.

Job losses may last well into 2010 to hit an unemployment peak close to 11%. That unemployment rate may be sustained for an extended period.

Can we find comfort in the fact that employment has long been considered a lagging indicator? It is conventionally seen as having limited predictive power since employment reflects decisions taken earlier in the business cycle. But today is different. Unemployment has doubled to 9.5% from 4.8% in only 16 months, a rate so fast it may influence future economic behavior and outlook.

How could this happen when Washington has thrown trillions of dollars into the pot, including the famous $787 billion in stimulus spending that was supposed to yield $1.50 in growth for every dollar spent? For a start, too much of the money went to transfer payments such as Medicaid, jobless benefits and the like that do nothing for jobs and growth. The spending that creates new jobs is new spending, particularly on infrastructure. It amounts to less than 10% of the stimulus package today.

About 40% of U.S. workers believe the recession will continue for another full year, and their pessimism is justified. As paychecks shrink and disappear, consumers are more hesitant to spend and won't lead the economy out of the doldrums quickly enough.

It may have made him unpopular in parts of the Obama administration, but Vice President Joe Biden was right when he said a week ago that the administration misread how bad the economy was and how effective the stimulus would be. It was supposed to be about jobs but it wasn't. The Recovery Act was a single piece of legislation but it included thousands of funding schemes for tens of thousands of projects, and those programs are stuck in the bureaucracy as the government releases the funds with typical inefficiency.

Another $150 billion, which was allocated to state coffers to continue programs like Medicaid, did not add new jobs; hundreds of billions were set aside for tax cuts and for new benefits for the poor and the unemployed, and they did not add new jobs. Now state budgets are drowning in red ink as jobless claims and Medicaid bills climb.

Next year state budgets will have depleted their initial rescue dollars. Absent another rescue plan, they will have no choice but to slash spending, raise taxes, or both. State and local governments, representing about 15% of the economy, are beginning the worst contraction in postwar history amid a deficit of $166 billion for fiscal 2010, according to the Center on Budget and Policy Priorities, and a gap of $350 billion in fiscal 2011.

Households overburdened with historic levels of debt will also be saving more. The savings rate has already jumped to almost 7% of after-tax income from 0% in 2007, and it is still going up. Every dollar of saving comes out of consumption. Since consumer spending is the economy's main driver, we are going to have a weak consumer sector and many businesses simply won't have the means or the need to hire employees. After the 1990-91 recessions, consumers went out and bought houses, cars and other expensive goods. This time, the combination of a weak job picture and a severe credit crunch means that people won't be able to get the financing for big expenditures, and those who can borrow will be reluctant to do so. The paycheck has returned as the primary source of spending.

This process is nowhere near complete and, until it is, the economy will barely grow if it does at all, and it may well oscillate between sluggish growth and modest decline for the next several years until the rebalancing of excessive debt has been completed. Until then, the economy will be deprived of adequate profits and cash flow, and businesses will not start to hire nor race to make capital expenditures when they have vast idle capacity.

No wonder poll after poll shows a steady erosion of confidence in the stimulus. So what kind of second-act stimulus should we look for? Something that might have a real multiplier effect, not a congressional wish list of pet programs. It is critical that the Obama administration not play politics with the issue. The time to get ready for a serious infrastructure program is now. It's a shame Washington didn't get it right the first time.

Make saving more exciting

In 2007, Americans spent $92.3 billion on legalized gambling; but saved only $57.4 billion. This Intelligent Investor piece by Jason Zweig offers some interesting perspective on how to offer "exciting" incentives for Americans to save.

Based on recent headlines, you might think that Americans are finally saving again. Want to bet?

In 2007, the latest year for which final numbers are available, Americans spent $92.3 billion on legalized gambling, according to Christiansen Capital Advisors; that same year, says the U.S. Bureau of Economic Analysis, Americans saved only $57.4 billion.

So, if Americans are to save more, maybe we should make saving feel more exciting than just a dull deposit into a bank account.

The BEA recently estimated that personal saving -- what is left of Americans' disposable income after all our spending -- has risen to a 6.9% annual rate. Starting in the late 1980s, the personal-saving rate began to fall from the 8%-to-10% range. By 2005, households were spending 99.6 cents of every dollar they earned. Now, however, frightened by foreclosures and menaced by rising unemployment, Americans are saving almost as much as they used to.

Intelligent Investor

Or are they?

Charles Biderman of TrimTabs Investment Research, an economic-analysis firm in Sausalito, Calif., has studied the saving rate for years. He adjusted for one-time boosts from the stimulus package and used daily income-tax reports from the U.S. Treasury to take the latest job losses into account. By this revised estimate, the saving rate may actually be running as low as 0.9%. (People who have been thrown out of work often can't save.) A BEA spokesman declined to dispute Mr. Biderman's adjustments, saying only "TrimTabs has a different method of calculating."

It makes sense that the saving rate might be lower than it looks; spendthrifts don't turn into misers overnight. But we would be better off as an economy and as a society if Americans spent less and saved more.

The late, great investment manager Sir John Templeton warned me 20 years ago: "Those who spend too much will eventually be owned by those who are thrifty." If you wonder how China, Japan, Hong Kong and Taiwan ended up amassing $1.65 trillion in U.S. Treasury bonds, the answer lies largely in our own credit-card bills.

Today, credit cards and online shopping make deferring gratification harder than Ben Franklin ever could have imagined. And Americans are in hock up to their ears, with $10.5 trillion in mortgages and another $2.6 trillion in consumer credit. It isn't any wonder that saving feels impossible to many people.

But psychologists have long known that people tend to overestimate the odds of rare events. Applying that behavioral insight, finance professor Peter Tufano of Harvard Business School has devised a clever program called "Save to Win." Launched earlier this year for members of eight credit unions in Michigan, it is a cross between a certificate of deposit and a raffle ticket. Members who put $25 or more into a Save to Win one-year CD are entered into a monthly "savings raffle" for prizes up to $400, plus one annual drawing for a $100,000 jackpot. Only Michigan residents are eligible to participate.

This unusual CD is federally guaranteed by the National Credit Union Administration and pays between 1% and 1.5% annual interest, a bit lower than conventional rates. In 25 weeks, the program has attracted about $3.1 million in new deposits, often from people who have never been able to set money aside.

Takisha Turner, 33 years old, is a dispatcher for the valet-parking department at Greektown Casino in Detroit. Ms. Turner doesn't gamble, but she has always struggled to save. She had only about $10 in her savings account at Communicating Arts Credit Union when she walked in a few weeks ago and heard about Save to Win.

"The teller said somebody else she told about it won," says Ms. Turner, "so I said, 'Well, you must be good luck then.' I thought it was a good idea, because earning interest means you win anyway. So I put down the minimum, $25." This past week, Ms. Turner won $400. She plowed the $400 back into her Save to Win account, getting a second shot at winning the $100,000 grand prize.

People love to gamble and hate to save. With Save to Win, says Communicating Arts Credit Union President Hank Hubbard, "You are sort of betting, but there's no losing." If we are to become a nation of savers again, we will need more innovations like this -- and the regulatory flexibility to allow them.

Sunday, July 19, 2009

Stock market cycles

If you believe stock market, like the economy, has its own cycles, then we've got a trouble.

(click to enlarge; source: David Rosenberg)

China in brighter green; too early for bubble talk

China's recent Q2 GDP grew by 7.9%, showing the economy is in strong recovery, also confirming my early observation that despite its high openness to international trade, China's growth is largely independent from the US. With China's green shoots greener, investors worldwide poured in huge amount money into the region. Since Chinese stock market is still largely closed for the foreign investors, Hong Kong has had a big surge. Are we witnessing another great stock bubble forming in China? This piece from Economist says it's still too early for the bubble talk.

CHINESE growth was already the envy of the world. Now recession-stricken countries will be turning an even brighter green. On July 16th new figures showed China's GDP growth quickened to 7.9% in the year to the second quarter. That is healthy enough by anyone's standards but the headline number conceals a more astonishing rebound. Goldman Sachs estimates that GDP grew at an annualised rate of 16.5% in the second quarter compared with the previous three months (see chart 1). Over the same period, America's economy probably contracted again. China's economic stimulus has clearly been hugely effective. So effective, indeed, that some economists are now worrying it may be working rather too well.

In the year to June fixed investment surged by 35%, car sales rose by 48%, and purchases of homes by more than 80%. After falling last year, home prices are now rising briskly in some big cities, and share prices have soared by 80% from their November low. Domestic spending has been spurred partly by the government's stimulus package, but probably even more important was the scrapping of restrictions on bank lending late last year. In June new lending was more than four times larger than a year earlier (chart 2).

One reason why the economy has rebounded so quickly is that much of the slowdown was self-inflicted, rather than the result of America's economic collapse. In 2007 concerns about overheating prompted the government to curb the flow of credit for construction and home buying. This caused China's economy to slow sharply even before the global financial crisis. Then, last November, the government turned the credit tap back on full.

That has given a big boost to domestic spending but raised concerns that the flood of liquidity will push up inflation, fuel bubbles in shares and housing, and store up bad loans. The M2 measure of money surged by 29% in the year to June. In fact the risk of high inflation in the near future appears low: Chinese consumer prices fell by 1.7% in the year to June, and spare capacity at home and abroad is holding down prices. But asset prices could be a bigger danger. According to one estimate, 20% of new lending went into the stockmarket in the first five months of this year.

It is probably too soon to use the word "bubble". The stockmarket is still at only half its 2007 peak and, although house prices have risen sharply this year in Shanghai and Shenzhen, the nationwide average is barely higher than it was a year ago. But the pace of bank lending is unsustainable, and America's recent experience suggests that it is better to prevent bubbles forming than to mop up the mess afterwards. Several officials at the central bank have said lending should be curbed.

At the moment, the prime minister, Wen Jiabao, is signalling that he wants monetary policy kept fairly loose. Exports remain weak and the government fears premature tightening could derail the recovery. It is also keen to create jobs and maintain social stability in the months before the 60th anniversary of Communist Party rule in October.

Still, the central bank has begun to tug gently at the reins. It has nudged up money-market interest rates and warned banks that it intends to increase its scrutiny of new bank loans. The China Banking Regulatory Commission has warned banks to stick to rules on mortgages for second homes, which require a down-payment of at least 40% of a property's value.

The recent rebound in house sales is, in fact, exactly what the government is aiming for, since it is using property as a way to spur private consumption. Higher house sales encourage more spending on furniture and consumer appliances. Construction also creates lots of jobs; indeed, it employs almost as many workers as the export sector. Since October the government has encouraged people to buy houses by cutting the minimum mortgage down-payment on their main home from 30% to 20% and by reducing stamp duty and other taxes on property transactions. Stronger sales are now feeding through into new house building: housing starts rose by 12% in the year to June, the first growth in 12 months.

Given the importance of property to domestic demand, the government is highly unlikely to want to clamp down hard on the housing market. Despite the recent lending boom, Chinese banks' mortgage lending is still very conservative compared with that in America—at the peak of America's housing bubble it was easy to get a mortgage for 100% or more of the value of a home. Nevertheless, the lesson of America's financial crisis for China's government is plain: overly loose lending should never be ignored.

Saturday, July 18, 2009

Racial divide in unemployment

Everybody knows:

A Widening Gap

Friday, July 17, 2009

Is Fed's independence at risk?

Certainly a lot of people are worried.

This is the much circulated petition for keeping the Fed independent against the backlash from the Congress (the highlights are mine).

Open Letter to Congress and the Executive Branch

Amidst the debate over systemic regulation, the independence of U.S. monetary policy is at risk. We urge Congress and the Executive Branch to reaffirm their support for and defend the independence of the Federal Reserve System as a foundation of U.S. economic stability. There are three specific risks that must be contained.

First, central bank independence has been shown to be essential for controlling inflation. Sooner or later, the Fed will have to scale back its current unprecedented monetary accommodation. When the Federal Reserve judges it time to begin tightening monetary conditions, it must be allowed to do so without interference.

Second, lender of last resort decisions should not be politicized.

Finally, calls to alter the structure or personnel selection of the Federal Reserve System easily could backfire by raising inflation expectations and borrowing costs and dimming prospects for recovery. The democratic legitimacy of the Federal Reserve System is well established by its legal mandate and by the existing appointments process. Frequent communication with the public and testimony before Congress ensure Fed accountability.

If the Federal Reserve is given new responsibilities every effort must be made to avoid compromising its ability to manage monetary policy as it sees fit.

More details here at WSJ.

What I've been doing

You may have noticed that I blogged a lot less lately...No, I was not on vacation or lying on the beach. Instead, I was finishing a paper on China's research center and its impact on Chinese firms' productivity growth. It's a very interesting topic and I believe this is the first paper that systematically pins down and analyzes where China's R&D capability lies at the micro-level. It will be included as one of the three chapters in my PhD dissertation.

Here is the link to the paper. Hope you enjoy it. (*for non-technical readers: just browse thru the introduction and conclusion section, plus the nice graphs at the end).

Sunday, July 12, 2009

Perverse incentives remain intact on Wall Street

Designing the right incentive system without jeopardizing the whole financial system and losing the talent at the same time remains to be a difficult task. The current revision in comp scheme that pays more in base salary and most in cash seems to have done nothing to change that. The perverse incentives structure is largely intact. Reports WSJ:

Congress wants to lower Wall Street bonuses, blaming them for encouraging the excessive risk-taking that helped cause the financial crisis. But the haphazard way that pay practices are being altered may yet yield the worst of all worlds, higher fixed costs and less accountability, without removing the threat of talent walking out the door.

Banks like Citigroup and Bank of America that still have funding from the Troubled Asset Relief Program are dealing with restrictions on the bonuses they can pay top employees. To keep the rank and file happy, Citigroup is raising base salaries for many of its 300,000 employees who are eligible for a bonus. Morgan Stanley also has increased base pay, from about $300,000 to $400,000 for managing directors. Even stronger performers, such as J.P. Morgan Chase, are considering raising base pay. Credit Suisse is considering all options.

The result: higher fixed costs, even as many banks continue to struggle. When guaranteed salaries rise, so do a range of juicy benefits, as well as severance packages, which are based on salaries. With banks facing increased regulation and higher capital requirements, reducing flexibility on pay could be another blow to investors.

There also is a question of whether higher cash salaries really will mean lower bonuses. The danger is that, even if the likes of Goldman Sachs Group pay out less than half of net revenue in compensation, less-profitable firms might feel forced to pay out a higher portion to keep up. Goldman said it has no plans to adjust the way it pays employees; stars will continue to receive the bulk of pay in bonuses tied to performance.

A perverse outcome of the Wall Street crisis is that compensation as a proportion of revenue could actually rise. Pearl Meyer, of Steven Hall & Partners, estimates that Wall Street pay will end up topping 60% of revenue for the foreseeable future, up from about 50% in past years. It could hit 70% at some smaller financial firms, she said.

To be sure, the "comp ratio" mightn't stay at elevated levels as revenue improves. Morgan Stanley said its payouts looked high in the first quarter because movements in the price of its debt reduced net revenue. Banks said bonuses will be trimmed to keep overall compensation about the same.

Citigroup said its changes were aimed at reducing the focus of employees on short-term results and keeping more of them at the bank for the long haul.

But salaries are paid in cash, while bonuses are usually in cash and shares that vest over time. More cash upfront arguably gives them fewer reasons to stick around or worry about the long-term performance of their firms. At the same time, bonuses aren't going away, so some traders and bankers will continue to embrace risk to try to score the highest payouts. A rise in base pay might help retain middle-performing staff, but it is unlikely to attract or retain the best traders and bankers.

The crisis should lead to a more rational pay structure on Wall Street, with pay remaining flexible and bonuses paid largely in stock that can be clawed back if necessary. Instead, as salaries rise and guaranteed bonuses start to make a comeback, Wall Street firms risk adopting a new set of bad habits.


Is China overinvesting?

Or the high growth demands a higher investment to GDP ratio?  The analysis from Economist.

China's capital spending could soon be bigger than America's

DESPITE falling exports, China's economic growth has remained relatively strong this year thanks to a surge in investment sparked by the government's stimulus measures. Official data show that fixed-asset investment leapt by an astonishing 39% in the year to May, or by a record 49% in real terms. Sowing more today should yield a bigger harvest tomorrow, but how wisely is this capital being used?

Official figures almost certainly overstate the size of the spending boom: local bureaucrats may well be exaggerating investment in order to impress their masters in Beijing. More important, the government's figures misleadingly include land purchases and mergers and acquisitions. But even if measured on a national-accounts basis, like GDP, investment is probably growing at a still-impressive real annual rate of around 20%. This year China's domestic investment in dollar terms is likely to exceed that in America (see chart).

There is widespread concern that this investment boom is adding to China's excess capacity. Investment amounted to 44% of GDP last year (compared with 18% in America), which many economists reckon was already too much. Worse still, as well as forcing state firms to invest, the government is directing state-owned banks to lend more, despite falling corporate profits. Many of those loans could turn sour. Like Japan in the 1980s, it is argued, an artificially low cost of capital causes chronic overinvestment and falling returns. If so, it will end in tears. To assess that risk you need to ask two questions. How much excess capacity was there already? And where is the new investment going?

There is certainly excess capacity in a few sectors (steel and some export industries, such as textiles). But the best measure of spare capacity for the economy as a whole—the difference between actual and potential GDP, or "output gap"—is probably only about 2% of GDP, compared with an average of almost 7% in the rich world.

The large role played by state-owned banks is bound to have resulted in some misallocation of capital, but a recent study by Helen Qiao and Yu Song at Goldman Sachs argues that concerns about overinvestment are exaggerated. A successful developing economy should have a high ratio of investment to GDP. And a rising rate does not mean that the efficiency of capital is falling; capital-output ratios are supposed to increase as economies develop. America's capital stock is much larger relative to its GDP than China's, with 20 times more capital per person than in China.

A better measure of capital efficiency is profitability. Profits have indeed slumped over the past year, but taking the past decade to adjust for the impact of the economic cycle, profit margins have not narrowed as one might expect if there were massive spare capacity. The argument that the average cost of capital is ludicrously low is also no longer true. China's real interest rate is now 7%, which is among the highest in the world.

Where is the new investment going? There has been little new spending in industries with overcapacity, such as steel and computers. But the surge in state-directed investment has fuelled fears about its quality. In its latest China Quarterly Update, the World Bank calculates that government-influenced investment so far this year was 39% higher (on a national-accounts basis) than a year earlier, while "market-based" investment rose by a more modest 13%. This implies that government-influenced investment accounts for about three-fifths of the growth in investment this year, up from one-fifth last year.

The usual assumption is that government investment is less efficient and will therefore harm long-term growth. But the fastest expansion in spending has been in railways (up by 111% this year). As a developing country, China still lacks decent infrastructure; railways, in particular, have long been an economic bottleneck. Investment in roads, the power grid and water should also yield high long-term returns by allowing China to sustain rapid growth.

And the government is focusing its infrastructure stimulus on less developed parts of the country where the benefits promise to be greatest. According to Paul Cavey at Macquarie Securities, fixed-asset investment in western provinces was 46% higher in the first four months of this year than in the same period of 2008, almost double the rise in richer eastern provinces.

Some of the money being spent in China will inevitably be wasted, but it is wrong to denounce all government-directed investment as inefficient. In the short term it creates jobs, and better infrastructure will support future growth. It is certainly not a substitute for the structural reforms needed to lift consumer demand in the longer term, but it could help. After all, without running water and electricity, people will not buy a washing machine.

Talking about Asia's consumption

Economist has a good analysis of consumption in Asia during the current crisis and how its quickly rebound means to the rest of the world. One note is that albeit the savings rate is high in Asia, the consumption is not as low as widely reported.

Can Asians replace Americans as a driver of global growth?

ASIA'S emerging economies are bouncing back much more strongly than any others. While America's industrial production continued to slide in May, output in emerging Asia has regained its pre-crisis level (see chart 1). This is largely due to China; but although production in the region's smaller economies is still well down on a year ago, it is rebounding in those countries too. Taiwan's industrial output rose by an annualised 80% in the three months to May compared with the previous three months. JPMorgan estimates that emerging Asia's GDP has grown by an annualised 7% in the second quarter.

Asia's ability to decouple from America reflects the fact that the region's downturn was caused only partly by the slump in American activity. In most Asian economies falling domestic demand was more important than the drop in net exports in explaining the collapse in GDP growth. The surge in food and energy prices in the first half of 2008 squeezed profits and spending power. Tighter monetary policy aimed at curbing inflation then further choked domestic demand.

The recent recovery in industrial production reflects the end of destocking by manufacturers as well as the large fiscal stimulus by most governments. But the boost from both of these factors will fade. Meanwhile, export markets in developed economies are likely to remain weak. So the recovery in Asian economies will stumble unless domestic spending, notably consumption, perks up.

Consumers' appetite to spend varies hugely across the region. In China, India and Indonesia spending has increased by annual rates of more than 5% during the global downturn. China's retail sales have soared by 15% over the past year. This overstates the true growth rate because it includes government purchases, but official household surveys suggest that real spending is growing at a still-impressive rate of 9%. In the year to May, sales of household electronics were up by 12%, clothing by 22% and cars by a stunning 47%.

Elsewhere in the region, spending has stumbled, squeezed by higher unemployment and lower wages. In Hong Kong, Singapore and South Korea real consumer spending was 4-5% lower in the first quarter than a year earlier, a much bigger drop than in America. But Frederic Neumann, an economist at HSBC, sees tentative signs that spending is picking up. Taiwan's retail sales rose in May for the third consecutive month. Department-store sales in South Korea rose by 5% in the year to May.

It is often argued that emerging Asian economies have large current-account surpluses—and are thus not pulling their fair weight in the world—because consumers like to save rather than spend. Yet this does not really fit the facts. During the past five years consumer spending in emerging Asia has grown by an annual average of 6.5%, much faster than in any other part of the world. It is true that consumption has fallen as a share of GDP, but that is because investment and exports have grown even faster, not because spending has been weak. Relative to American consumer spending, Asian consumption has soared (see chart 2).

In most Asian economies, private consumption is 50-60% of GDP, which is not out of line with rates in countries at similar levels of income elsewhere. China, however, is an exception. Private consumption there fell from 46% of GDP in 2000 to only 35% last year—half that in America. In dollar terms, spending is only one-sixth of that in America. (Singapore's consumption is also low, at just under 40% of GDP.)

This explains why China's government has recently taken bolder action than others to boost consumption. Over the past six months the government in Beijing has introduced a host of incentives to encourage households to open their wallets. Rural residents get subsidies for buying vehicles and other goods such as televisions, refrigerators, computers and mobile phones; urban residents get a subsidy if they trade in cars and home appliances for new goods; tax rates on low-emission cars have also been cut. There is huge potential for higher consumption in the countryside as incomes rise: only 30% of rural households have a refrigerator, for example, compared with virtually all urban households.

The government has also introduced several measures this year to improve the social safety net, such as spending more on health care, pensions and payments to low-income households. On June 19th it ordered all state-owned firms that had listed on the stockmarket since 2005 to transfer 10% of their shares to the National Social Security Fund to shore up its assets. The short-term impact is likely to be modest but if such measures ease households' worries about future pensions and health care, it could in the long term encourage them to save less and spend more.

Another way to boost consumption is to make it easier to borrow. In most Asian economies household debt is less than 50% of GDP, compared with around 100% in many developed economies; in China and India it is less than 15%. South Korea is the big exception: households have as much debt relative to their income as Americans and their saving rate has fallen over the past decade from 18% of disposable income to only 4%. In many other Asian economies financing for consumer durables is virtually nonexistent. Promisingly, the Chinese bank regulator announced draft rules in May to allow domestic and foreign institutions to set up consumer-finance firms to offer personal loans for consumer-goods purchases.

These measures are a modest step in the right direction. But a bigger test of Asian governments' resolve to shift the balance of growth from exports towards domestic spending is whether they will allow their exchange rates to rise. A revaluation would lift consumers' real purchasing power and give firms reason to shift resources towards producing for the domestic market. But so far, policymakers have been reluctant to let currencies rise too fast.

Asian spending is already an important engine of global growth. Even before the crisis, emerging Asia's consumer spending contributed slightly more (in absolute dollar terms) to the growth in global demand than did America's. But it could be even bigger if Asians enjoyed the full fruits of their hard labour, rather than subsidising Western consumers through undervalued currencies. It is time for an even greater shift in spending power from the West to the East.