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.

Goldman Sachs is a great vampire squid? No, more like......

Published in a recent issue of Rolling Stone is an article titled "Inside the Great American Bubble Machine" which examined how Goldman Sachs has purportedly "engineered every major market manipulation since the great depression."

In its opening lines, Matt Taibbi, the author, described Goldman Sachs as "The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money."

The description reminded me of the Alien creature in the film "Alien". In the 1979 sci-fi classic, an extra-terrestrial creature attaches itself onto the face of one crew member of the space craft. The parasitic "facehugger" is keeping its host alive by supplying him with oxygen while attempting to reproduce. Its spider-like legs grip firmly onto the host head and its long tail is wrapped tightly around his neck.


Upon further reflection, however, I think a even better analogy for GS and other industrial players from the film is "The Company" rather than the facehugger. Here is why: As the story develops, it is reveal that the commercial space craft chartered for space mining by The Company (the name of the Company was not reveal until later installment of the Alien series) has a hidden mission unknown to the crew- to return the Alien to Earth for further commercial (read profitable) development at all costs (read crews' lives are expendable).

Though the mission is not successful at the end of the film, the first in a series of four (not counting the unrelated spin-off such as Alien vs. Predator), the Aliens become a greater threat to humanity.

If financial institutions are The Company, then naturally CDOs, MBSs, CDSs etc must be the Aliens that they were breeding for achieving greater profitability. In their eyes, these creatures were perfect organisms that can be used to hedge away risks while delivering better returns and at the same time cut away excess costs. Eventually, not unfamiliar to audience who has seen it in many films from Frankenstein to Alien to Spiderman, tragedies follow as human-beings get carried away and consumed by our greed and own creations.

I believe the story of the 2008 financial tsunami has by no mean ended but merely turning over a chapter. Why so much conviction?

A few days ago, it was reported that Ridley Scott, the director of Alien, is in talk to direct alien 5, 30 years after he made the original.

Profit Flaunting no More?

Three months ago, I logged a post titled "Profit Flaunting" in which I observed the Western banks peculiar behaviour of flaunting their profit for first quarter than had not yet ended. Perculiar because such disclosures were not required by securities guidelines and regulations. Nevertheless, the market reacted positively and their share prices promptly jumped. Indeed the momentum generated followed through and led the equity markets worldwide into successive months of upward movement.

We are now near the end of the second quarter but we have yet to hear any preliminary announcement from any major banks- flaunting type or otherwise. Are we to infer from the non-announcement or should we just sit tight and await the normal flow of announcement?

090626 Update: Standard Chartered PLC has announced that it has made good profit for the first five months of the year.

The Conundum of High Treasury Yields Amidst a Strong Equity Market

10-year treasury yield has reach multi-month high in recent weeks while equity markets too were reaching year's highest levels. This seem to go against the conventional thinking that interest rates and share prices are inversely related.

I think this is not the normal business cycle that retain normal correlation. The 'Black Swan' we are witnessing is caused by the actions of the Fed. Specifically, the act of printing money, or 'quantitative easy' as a better name, has upset the system.

In a normal cycle, as economy overheats, monetary policy is expected to be tighten and treasury yields go up due to slowing money supply. Equity prices hence go down due to higher cost of funds. As economy slows, perhaps even becomes recessionary, the Fed engages in a expansionary monetary policy and money supply is growing again. All the while, the Fed is only setting a benchmark rate and letting the market decides the actual interest rates.

Presently, with the Fed directly purchasing treasury bonds, the money supply is immediately increased due to expanding monetary base. Hot money created is chasing stocks higher while bond traders are factoring in the possibility of climbing inflation by bidding for treasuries at higher yields.

Meanwhile, aggregate demand and economy's production capacity remain relatively unchanged.

Therefore, I think the debate over whether we are in an inflationary or a deflationary cycle is irrelevant- we are in both. i.e. asset prices are going up (note the price movement of crude oil) while wages and other production costs are stagnant (due to overcapacity).

It seems the Fed has not learned any lesson from the era of stagflation in the 1970s, which is to control the money supply and putting price stability at the highest priority. By control I don't mean keeping it fixed but any easing of monetary policy should be done in moderation and all the while letting the market know that price stability is top priority. Quantitative easing runs in contrary to objective of maintaining long term stability of both price level and economic activities. In addition, the direct purchase of treasury bonds and other commercial papers set a precedent and may impair the Fed's Independence. In future, Fed may be pressured politically into taking such inflationary action.

To prove my point, last week's 10-year treasury yield reached a 2009 high of 4% but subsequently retreated due to intervention from the Fed. It has purchased in total close to US$150 billion of the US$300 billion target, barely two and a half months since the start of the programme. There are already opinion by economic columnist hinting that it should raise the US$300 billion cap.

Once the expectation of inflation is out of the bottle, it is very difficult to contain.

Would the over-extended treasury market collapse and bring about a plunging US Dollar?

That would be a disaster that US government will do its best to avoid. I think that scenario will not happen as USD is still the reserve currency and all the major holders of treasury bonds, namely the central banks around the world, will be serving their own vested interest in supporting the US treasury bond market.

However, with ever-increasing supply, treasuries prices will continue on its downward trend. As yields move in opposite direction as bond prices, long term interest rate will stay high and move higher. Along the way, USD will be under pressure as US budget deficit continue to grow due to higher refinancing costs.

US equity market will be stagnant- on one hand negatively affected by high interest rate while on the other positively impacted by 1. the government spending; 2. hot money arising from expanded money supply; and 3. assured profit due to government guarantees (from TARF to bank deposits to motor vehicle warranties to commercial papers purchased by the Fed, you name it).

Not much restructuring will occurs as companies are largely above water, albeit barely, so there is no incentive to rock the boat.

I am afraid my prognosis shall be that US will be entering its own lost decade a la that of Japan.

It will take another Paul Volcker to bring major changes that will involve some level of pain to shake the economy out of the malaise.

To quote Nassim Taleb: "The Obama administration's attempts to fight the financial crisis with more cash is like treating a bad tooth with Novocain instead of a root canal."