Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Sunday, 30 June 2013

The Grim Central Banking Fairytale

Once upon a time there was a bright young boy called Eco who was the sole breadwinner for his family. He was diligent and innovative, usually managing to grow his income steadily every year. His only flaw was a tendency to binge ever so often. This usually happened after a string of successes at work led him to believe that his future income would continue to grow at a fast clip. It made him borrow heavily from moneylenders and go on a partying spree. Although his family loved his binges since they shared in the borrowed bounty, they detested the inevitable hangovers which followed and the consequent loss of income as Eco’s work suffered. They tried several ways and consulted many wise men to temper his binges and cure his hangovers but it was of no avail.

Then one day, a doctor of little renown called Greenspan visited their village and convinced Eco’s family that he could cure the boy’s flaw. He was a believer in the Rand(om) school of sophistry whose core thesis was that sickness was entirely the patient’s fault and no medicine was the best medicine. Dr. Greenspan stuck to his strong beliefs as long as his patients displayed outward signs of health.

Over the years Dr. Greenspan cemented his reputation and his popularity with Eco’s family by never interfering to temper Eco’s binges. Sometimes he admonished Eco’s intemperate lifestyle but he never failed to quickly administer a large dose of alcohol whenever a hangover seemed imminent.

Eco’s family were delighted with the good doctor’s ministrations. They were even more ecstatic about the money Eco was bringing home. In their haste to spend on baubles, they never realised that Eco has borrowed a large part of the money from moneylenders. Under the influence of Dr. Greenspan, Eco’s occasional overconfidence about his future income now turned into a firm belief.

However every party must end and after two decades of partying with wild abandon, the strain began to tell on Eco. His youth was long gone and his internal organs were failing. But Dr. Greenspan made sure that Eco looked his usual boyish self and an epitome of health. At this point Dr. Greenspan, now an old man, expressed a desire to retire. Eco’s family were sorry to let him go and they appointed another highly regarded doctor, Dr. Ben and hoped that he would live up to Dr. Greenspan’s high standards.

No sooner had Dr. Ben taken over that Eco suffered a complete breakdown. Initially Dr. Ben brushed it off as a mild case of work-stress which would soon pass. But he was quickly forced to put Eco on life support when his condition worsened markedly. Now Dr. Ben fervently believed that most patients in Eco’s situation died because their doctors were too parsimonious in doling out alcohol. He was certainly not going to be one of those doctors. He explained to Eco’s panicked family that since the breakdown was the result of excessive drinking, the recovery required administering even greater doses of alcohol.

Most unquestioningly acquiesced in his prescription since doctors commanded great respect in the village. The few who did question the sagacity of the learned doctor and his team were dismissed as cranks and troublemakers. The large doses of alcohol soon revived Eco and his pain subsided somewhat. He was still too weak to get out of hospital and more worryingly his recovery soon stalled. The pain returned and he was in danger of relapsing. Eco’s continual partying had not only destroyed his system but also, like any addict, made him increasingly immune to the abused drug. His family were not only horrified by his condition but alarmed by the sudden influx of bills which they were unable to pay without Eco's money. So they decided to lend a hand in ensuring Eco’s recovery. They reasoned that eating rich food and living the good life had led to his breakdown and thus a little starvation and austere living might do him good.

Eco’s deteriorating condition drove Dr. Ben and his team to desperation and they decided to administer opium alongwith his daily alcohol. The effect, at least on surface, was magical. The blood came back to his sallow cheeks and he sat up and started walking about. Although he went back to work, he was not his old self and couldn’t work as hard as before. The truth was that even though he tried very hard he had little strength to carry on as before. Moreover, now he was also addicted to opium. Every time the learned doctor even mentioned a reduction in the opium dosage, Eco suffered a fainting fit.

Dr. Ben and his team were now trapped. Reduce the dosage and Eco’s fits might get worse but continuing with the dosage would permanently destroy what remained of his internal organs. Meanwhile Eco’s family continued in their attempt to starve him to make him stronger. His opium-addled smile made most of them believe that he was on the road to recovery. The moneylenders were also happy since they believed that the learned doctor and his team would be able to keep Eco working to pay off his loans.

And as this is a fairytale, they all lived happily ever after.

Sunday, 23 June 2013

Fortuitous circumstance and the appearance of skill

The current travails of gold and silver obliquely remind me of experiences I had in my previous life as a sell-side trader. This is because of the incredibly fortuitous timing of my January article in LiveMint. Back then, I'd written a piece advising dumping gold and silver (Gold and Silver: A Wealth Hazard). It was published on 25th January when Gold was at $1660 and silver was at $31.56. Since then both have continued to sell-off. By 1st March gold had declined to $1582 and silver to $28.01. Then came the famous crash in mid-April when gold closed at $1380 and silver at $23.47. The subsequent dead-cat-bounce unwound in May as both continued their downward journey to end up currently at $1295 and $19.87(1).

This is a "guru-dom" establishing result because in markets nothing succeeds like a successful prediction. On the rare occasions when a forecast is proved right almost immediately, it gives the appearance of extreme perspicacity on part of the forecaster. As a result, pure luck is mistaken for skill. There were plenty of traders blindly swinging the bat and connecting to reach superstardom and a series of guaranteed bonuses until the inevitable miss.

The emphasis on one-off results is a little strange not least because it suffers from a small sample size. There is always a guaranteed winner in a coin-toss (which is a fair approximation of zero-sum financial bets since the P&L evaluation period is short - an year maximum even for instruments which mature 30 or more years later). Correctly predicting one or even a few such tosses does not imply skill. Instead true skill is determined by the analysis behind the prediction rather than the immediate success/failure of the prediction itself. Even astute traders/investors get it wrong fairly often but over time sound analysis is going to produce more successful forecasts than pure chance. Moreover, successful traders/investors overlay it with the ability to determine and limit the downside in case the prediction takes time to come good or fails completely.

But I'm quite pleased with this fluke and if such a run of luck continues I might end up as a celebrated market pundit opining on TV and make a fortune selling books and periodicals.  

(1) All prices from FT data archive

Tuesday, 18 June 2013

Is Euro the next Yen?

A corollary of Eurozone’s economic woes being compared to Japan is the idea that Euro is the new Yen. Indeed the Euro’s resilience and recent rally seem to indicate that the currency will continue to strengthen despite macroeconomic weakness. Widening Eurozone current account surpluses support this argument.  Just as the Japanese export machine continued to run current account surpluses and contributed to the Yen’s spectacular rise after the bust in 1990, Eurozone’s widening current account surplus supports the argument for Euro’s rise.
However just as Portugal is not Greece; Ireland is not Portugal; Spain is not Portugal, Ireland or Greece; Italy is not part of P,I,G,S and Cyprus is not a template; Eurozone is not Japan. For starters one is a country and the other a voluntary association which assumes that the recent 60 years are historically more representative than the centuries of fratricidal conflict following (and preceding) the collapse of Pax Romana. The social tensions which ensue from an economic crash and prolonged recession are better handled by a cohesive nation than by an amalgamation of nation states. The elite’s political will notwithstanding, the people have the final say (does the name ‘USSR’ ring a bell?).

Even ignoring the inherent political weakness at the heart of the European project, data does not support Euro being the next Yen. First, even though Eurozone’s current account surplus has increased it is nowhere near the level Japan was consistently running post-crash (Graph 1) and which contributed to Yen strengthening. Moreover, there is a limit to which the Eurozone’s current account surplus can increase since it is caused by demand destruction (as I showed earlier) rather than all nations successfully matching German export prowess.

Graph-1: Current Account Surplus
Source: IMF

Second, Japan’s debt dynamics were also benign as it started with a gross debt-GDP ratio of 66% in 1991 and a net debt-GDP ratio of 12%. Eurozone’s welfare state has a gross debt-GDP ratio of 95% and net debt-GDP ratio of 74%. Unless growth ignites, servicing the debt is going to be punishing especially since there is little appetite for fiscal transfers (unless they are surreptitiously effected through the monetary backdoor). Moreover with compartmentalised government bond markets which depend on foreign buying, the Eurozone cannot achieve the incredible debt-GDP levels of Japan.

Third, growth is unlikely to ignite given the global economic malaise. At least post-crisis Japan faced a more favourable global growth backdrop allowing it to export and grow. Japanese real GDP growth post-crisis (1991) was better than what the Eurozone is currently experiencing (Graph 2). The latter has to struggle against a slow US recovery and Chinese slowdown.

Graph-2: GDP growth
Source: IMF

Finally, Eurozone policies are making the situation worse. Japan exploited a favourable growth climate by combining a successful (albeit costly in the long-run) ‘extend and pretend’ financial sector response with fiscal pump priming rather than austerity. This allowed unemployment to stay low (Graph-3). Eurozone on the other hand is forcing internal devaluation on its members. Exploding unemployment is the natural consequence. Instead of the barbarous relic of the gold standard in the 30s, southern Europeans are being ground by the Euro-standard.

Graph-3: Unemployment
Source: IMF 

In the final analysis, the Euro is likely to stay supported as long as the current account surplus is meaningful and internal tensions remain contained. But this is an unstable equilibrium unlike the Japanese case. Moreover, the stronger the Euro, the greater the internal devaluation required and stronger the internal stresses. In light of this, belief that the Euro is the next Yen looks misplaced.

Sunday, 2 June 2013

India vs China - The last graph in the debate

The Economist's article on global poverty has a graph which effectively settles the India vs. China comparison (A version of the original reproduced below). 

Poverty Distribution

Source: Chandy L., Ledlie N., Penciakova V., The Final Countdown: Prospects for Ending Extreme Poverty by 2030, The Brookings Institution, April 2013

Chest thumping about democracy, free press and other standard arguments cannot excuse India's abysmal record in reducing poverty. Over the last 20-odd years while China has pulled a huge majority of its citizens out of poverty, India seems to have twiddled its thumbs. The marginal change in the peak to the left of $1.25 and the fattening of the tail on the right tells India's story quite succinctly. The relatively better off and better connected made hay while India shone while the great majority continued to live in darkness (often literally given the abysmal state of electricity generation and provision). No amount of moralistic posturing can condone such a monumental failure of government.

P.S. While I believe that Chinese growth has been lopsided and the day of denouement is near but even if China experiences a mammoth crash it is unlikely to massively reverse progress on poverty elimination. And ultimately that is the material point.