On Schumpeter

In the last issue of The Economist, a new column was created in the Business section and the editors named it Schumpeter. After months of exhorting on Keynes and the fiscal pump-priming that would be necessary to put the World economy back on path of recovery, it is past overdue that Schumpeter, a compatriot and no-less great economist to Keynes, and his ideas be explored and talked about in main-stream media.

As summarized by The Economist, the central themes behind Schumpeter's theories are Innovation, Entrepreneurship and the process of Creative Destruction. The weekly journal is drawing parallels between these motifs and the business enterprises that it find it apt to name the business column after the Austrian Economist.

In my opinion, Schumpeter's theses are even more relevant to the macro-economic environment than Keyne's.

In the just-ended G20 Summit in Pittsburg, world leaders were congratulating themselves and putting out a message that because of collective actions of governments in the major economies in undertaking unprecedented monetary expansions and massive Keynesian-prescribed fiscal spendings, the world economy has regained stability and is poised to grow again. Although the official statement acknowledges much are to be done in reforming and restructuring, suspicion that the proclamation is nothing more than lip-service runs high. This is especially so when one reviews some of the actions promised subsequent to the collapse of Lehman Brothers a your earlier vis-a-vis the progress status in the past 12 months:

1. To reform too-back-to-fail financial institutions; All major Western banks that required massive governments' aids (and most of their CEOs) remain intact. In fact, in some cases, they are even bigger because of mergers and acquisitions.

2. To ensure banks unload toxic assets from their balance sheet; The U.S. Treasury-sponsored plan never took off.

3. To regulate bank executives' compensations; Executives continue to take home fat pay-cheques.

4. To address unregulated financial derivative markets; To begin with, lawmakers are divided as to which government body or bodies should be tasked with the mandate. Amidst the confusion, of course, the markets remain unregulated.

Indeed, it can be argued that the 'stabilised' world economy resulted from government interventions such as bailouts, easy and cheap credits and fiscal stimulus, belies the imbalances in the system: Fiscal deficits in U.S. and U.K. at unprecedented post-war high; housing bubbles are forming in Asian countries; Dollar value continues to fall while commodity prices remain stubbornly high; inflation is raring to go.

In short, the Keynesian-inspired dosages of novocaine is effective in alleviating the economic pains but the roots to the problem remain unresolved. The numbing effect gives us the false impression that the crisis is over and the good-old days have returned. Yet, the decaying tooth is just one gulp of cold water away from unleashing a new wave of pain.

Indeed the U.S. economy has undergone the Keynesian-induced expansion almost 40 years ago when President Nixon declared: "I am now a Keynesian in economics" as he swiftly unpegged U.S. Dollar from the restrictive Gold Standard and continued with his wildly popular deficit-spending. While the economy received an immediate boost in which conveniently afforded Nixon a landslide victory in the 1972 re-election, it did not take long for unemployment to begin climbing while inflation remain stubbornly high and rose through the roof aided by the two oil shocks. The term "stagflation" was later coined to described the Keynesian conundrum of rising unemployment AND inflation.

That is not to entirely discredit Keynesian initiatives in buffering the economies from hard-landing. In my opinion, fiscal stimulus is justified provided that it is, as described by Lawrence Summers, "targeted, timely and temporary". By administering adequate amount fiscal expenditure and interest rate easing, the economies are provided with cushion to ease the pain brought about by necessary adjustments, as prescribed by Schumpeter's creative destruction.

In the analogy of decaying tooth, by applying the anesthetic, it lessen the pain of extracting the decayed tooth. But extracted, it must be.

In the process of creative destruction, old business models that are no longer efficient and relevant should be allowed to fail. Entrepreneurs will then step in and innovate in providing goods and services that meet the market demands with the free-up resources. At the same time, entrepreneurs should be made aware that any potential returns are coupled with market risks. Should their venture fail, the entities should be dismantled and economic resources should again be channelled by market forces into other economic activities.

In order for the Invisible Hands to work best in a capitalistic system, adequate returns should be appropriately accorded to successful innovations and risk-taking entrepreneurs. Yet at the same time, should any business venture fail, the process of creative destruction, as dictated by market forces, should be allowed to run its course. Any efforts in propping up inefficient markets (such as the housing markets) and ineffective institution (such as the car industries), such as those we are witnessing in the Western countries, will merely delay the clearing of market and prolong the beginning of sustainable recovery.

Changing Fortunes of China

Before 1970's, only Socialism can save China;

In the 70's and 80's, only China can save Socialism;

In the 90's and 2000's, only Capitalism can save China;

After 2008, only China can save Capitalism?!

Moore Securatisations?

Michael Moore premiered his latest film, "Capitalism: A Love Story" at the Venice Film Festival over the last weekend. True to his provocative style of "documentary" making, Moore concluded at the end of the film, according to this Reuters article, "Capitalism is an evil, and you cannot regulate evil."

The article also quoted him saying to the audience in venice: "Essentially we have a law which says gambling is illegal but we've allowed Wall Street to do this and they've played with people's money and taken it into these crazy areas of derivatives,"

While I cannot say I agree with Moore's conclusion (though I have not seen the film), I do see some merit in his argument on the differential treatments on gambling and Wall Street's behavior. Consider this other article on NYTimes.

To summarise, after messing with the housing markets by packaging and selling housing loans as securities which culminated into the Financial Tsunami and billions of dollars are pumped as bailouts, the Wall Street is slowly recovering and contemplating a new purpose: Bundling of life insurance policies.

It works this way: investment banks will purchase life policies from insurance companies, bundle and package them as securitised bonds and sell them to investors. This way, while they, the investment banks, earn a fee, the insurance companies monetise their insurance policies on hand in one lump-sum, the bond holders receive the regular yields as the policy holders continue to pay their premiums in installments.

For the policy holders, nothing changes or so it seems. They will continue to service their premiums and the payouts (if they are alive after years or decades) will, instead of coming from the insurance companies that sold them the policies, come from the capital of the bond funds which are to be subject to a minimum rating from a reputable rating agency.

One can almost read the caveat emptor clause on such bonds: "The instrument contains risk in that of the aging process of the collective policy holders, i.e. the longer they live, the less the realisable eventual returns to the bondholders."

Talk about re-regulating Wall Street. Don't bet on it.

Federal Reserve's Timing

More than once has the U.S. Federal Reserve assured the world that it is able to keep inflation at bay. That despite its massive quantitative easing effort, it has the capability to drain the excess liquidity from the money supply once recovery is fully entrenched, thereby averting any inflationary risk.

As Bernanke said: ""We are confident that we have the necessary tools to implement that strategy when appropriate."

I think there are two key phrases in his statement: "necessary tools" and "when appropriate".

As demonstrated by Paul Volcker, the Fed's Chairman between 1979 and 1987, to slay the inflation dragon, you just have to strangle it hard and long enough while enduring any pains that it might inflict upon you in its last-breath struggle. At the time of his first appointment, the inflation rate was hovering at 13%. Volcker pushed the benchmark federal funds rate from 11% to as high as 20% - 7% above the inflation rate, and as a result inflation rate was lowered to around 3%. The casualty: the recession of the early 1980's.

So I do not doubt that Feds has the necessary tools to extinguish any inflationary flare-up. After all, as demonstrated by Volcker, the Fed can go few notches higher even if draining the liquidity it pumped in over the past 12 months proved not enough to contain the inflation genie. But I am rather skeptical on whether they will be applied "when appropriate". I am doubtful because:

1. It is much harder to discern the threat of inflationary onslaught. Because of cacophony of noises from employment data to assets (mainly housing and equity) prices to core and general inflation rates are pointing at different directions, the Fed will have a hard time picking up the right signal and act accordingly.

One of the reasons for the noises is because the Fed has become a quasi-political organization. Unlike ECB where price stability is its ultimate measurement of success, the Fed is charged with ensuring sustainable economic growth. And over the years, it can be observed that the Fed, with pressures exerted upon it by the politicians, are willing to amplify the decibel level of economic indicators such as unemployment rates, default rates for housing loans etc. Which leads me to the second and more important point;

2. Even if a clear sign of rapidly building inflationary pressures can be detected accurately, will the Fed, being also concerned about the overall immediate state of economy and watched over by the politicians, act decisively or will it stall in implementing the necessary tightenings?

Given the track records of the Fed over the past years, in particular its reaction to the past economic slowdowns in this decade, my prognosis remain unchanged; i.e. inflation will return while world economy continues to limp along. In other words, stagflation will rear its head after an absence of 3 decades.