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YE PAISA BOLTA HAI, YE KAISA BOLTA HAI |
Never did I know that a Hindi film song can trigger certain events in your cerebrum which make you want to write a story. Blame it on the vagaries of human mind and sit tight while you read this unusual story. Long time ago, when business was more or less localized, a young, rich and energetic youth departed from his small village to a bigger town in search of merchandise. He had a very novel idea of trading in donkeys. On reaching the town he set shop and put up a large placard mentioning he was willing to buy donkeys for 50 Rs. each. Due to the abnormality of the trade, people gathered around his shop to find out whether he indeed meant business. A person who had brought his donkey with him exchanged it for 50 Rs. The people were stunned on learning that donkeys were worth 50 Rs. A lot of people brought along their donkeys and pocketed 50 Rs. Gradually the donkeys started getting scarce in town and our youth jacked up the price of the donkeys to a 100 Rs. People started flocking nearby villages and towns in search of donkeys which they would exchange for a 100 Rs. Our youth built nice little stables for the donkeys, fed them well and generally took good care of them. He also appointed a watchman for guarding them. As the donkeys got scarce in the town, our friend jacked up the price of the donkeys to 250 Rs. and eventually to 500 Rs. Our friend was a prompt paymaster and the people dealing with him were very happy. Donkeys had become scarce as well as a valuable commodity in the town. Many other people jumped in the donkey business and our friend being the biggest in the business started giving daily rates for each donkey. Eventually the market determined rates for each donkey reached a 1000 Rs. Our friend by this time had a thousand donkeys in stock purchased at an average price of 200 rs. per donkey and thus had become a wealthy person. He became popular among the elite class of people of the town and was now being invited to their meetings and functions. In a particular meeting while he was sitting besides the biggest moneylender of the own he expressed his desire to visit his village for his sister’s wedding. He mentioned that he was willing to sell off his entire stock of donkeys at a lump sum price of rs.800 per donkeys. The money lender sensing the opportunity jumped to the deal and our smart guy pocketed a cool sum in profit never to return to the town again. It was not that the donkeys were not tradable before, they always were. However with a little bit of liquidity and support he helped discover the market for donkeys. The moral of the story is that with liquidity even donkeys can be marketed which again brings me to the song from the Hindi film Kala Bazar directed by Rakesh Roshan released in 1989 in which our very versatile actor Kadar Khan sings (actually sung by Nitin Mukesh in is nasel voice).
Main gangu teli goduraj
Gadhe ke sir pe rakh du taj
Ye paisa bolta hai
Ye kaise bolta hai Let me give you one another example - let us imagine you are deep in debt but every day you write cheques for millions of dollars you don’t have; another luxury car, a holiday home at the beach, the world trip of a life time. Your cheques should be worthless but they keep buying stuff because these cheques you write never reach the bank ! You have an agreement with the owners of the thing that everyone wants call it petrol or gas, that they will accept only your cheques as payment. This means everyone must hoard your cheques so thy can buy petrol/gas. Since they have to keep a stock of your cheques, they use them to buy another stuff too. You write a cheque to buy a TV, the TV Shop owner swaps your cheque for petrol, that seller buys some vegetables of the fruit shop, the fruit vender passes it on to buy bread, the baker buys some flour with it and on it goes round and round but never back to the bank. In effect you received your TV free.
This is what has been done by USA in a much larger scale across the world with the power it has of printing dollars as per its requirements, which I term it as the great American trick. The great American trick reminds me of a dialogue in one of my favourite films ‘The prestige’ which goes like this ‘Every great magic trick consists of three parts. The first part is called `The pledge’. The magician shows you some thing ordinary a deck of Cards or a bird. He asks you to inspect it to see if it is indeed real. But of course……. it isn’t. The second act is called the turn. The magician takes the ordinary some thing and makes it do something extraordinary. Now you are looking for the secret………… but you won’t find it because of course you are not looking. You don’t really want to know. You want to be fooled. But you wouldn’t clap yet. Because making something disappear isn’t enough, you have to bring it back. That’s why every magic trick has a third act, the hardest part the part we call prestige. The American trick as we have discussed in our previous report started way back in the year 1945 when the dollar become the fiat currency post World War II. The great American trick is to finance huge deficits formed due to voracious consumption habits of American society by printing new dollar bills and bringing it back to the American shores as it has the biggest financial and capital market in the world. So every county that runs surplus in the world due to its trade with other countries it has to invest this surplus in the American markets because only American markets are large enough to absorb such liquidity without any asset price run up. This is the position the USA has enjoyed for 70 years…. It has been getting a free world trade ride for all this time. This is the crux of dominance in World trade and is more powerful that the entire Nuclear Weapons held by the USA. USA would use all its might to carry on what it has been carrying on for last 70 years. Any other country in the world which seeks to gain world dominance would have to resort to this great trick which has been practiced by USA for so long.
However since there are no free lunches liquidity can be created but not controlled. Marc Faber in his wonderful book ‘ Tomorrow’s gold’ has mentioned about a gigantic bowl with continuous flow of water that is perched on a very large bamboo tower on top of the earth. The flow of water is controlled by the world’s central bankers. However the bowl being so large and perched on such flexible tower is unstable and will lean according to the pressure exerted on the tower by the people below. In an equilibrium the cash would overflow from the bowl into the earth economics evenly and thus all assets classes would appreciate at the same rate. However such equilibrium conditions seldom exists and the tilt of the bowl is controlled by the bias of the interiors which in turn can be manipulated by opinion leaders, the media analysts strategists politicians and economist. Hence the flow of liquidity moves across separate regions of world creating boom and eventually busts in them which is important for our report as it helps us understand opportunities and threats that are omnipresent around the world. All studies of contemporary economics are studies of liquidity and thus this preface was important to our report.
It is pertinent to note that having covered the two important periods we have reached our final chapter which depicts important events post attack on World Trade Centre which are as follows.
a) The destruction of companies due to unfolding of global crisis.
b) The destruction of countries post crisis.
c) The way forward.
a) The destruction of Companies
We had discussed in our previous report the reasons for the rise and fall of the Nasdaq. We also discussed that around 3 trillion dollars were absorbed by the governments sponsored enterprises Fannie Mae and Freddie Mac which added fire to the real estate prices at the start of the new millennium. Rising property prices sustained the American Consumer during the post Nasdaq collapse recession till the time the unthinkable happened. The attack on the World Centre tantamounted to pushing the already weak economy into an outright recession. Though very few people agree with me the American economy slipped into a coma, on the day of the attack thus marking an end of an era. In the USA it wiped out the lingering euphoria from the roaring nineties with its dot com bubble, surging stock market and unbridled optimism and replaced it with a cloud of uncertainty , a heightened sense of fragility and lowered expectations of growth. This was followed in 2002 by major accounting scandals to push several high flying American companies into recession.
A wrong idea is the most resilient parasite and once it takes hold of the brain, it is impossible to eradicate. After raging 2 Wars in Iran and Afganistan at a cost of approximately 6 trillion dollars the weak American economy never recovered from its obsession with Al qaida and Osama Bin Laden. According to me of the two i.e. Bin Laden and George W Bush, Bush was the greater villain. Would you believe that Bush ramped up deficit of approx. 6.5 trillion dollars during this time which is approximately half the deficit of USA of 14 trillion dollars and this led to a permanent damage to the economy leading to a point of no return. The Federal reserve had began tightening credit since 1999 and till mid 2004 had reduced the fed rate from 6.5% to 3.5% due to the recession. Post attack the fed immediately injected 100 billion dollars per day in three days and reduced the interest rate to 1.75% in another 3 months. Hence the fed rate which was 6.5.% in January,2001 was reduced to 1.75% in December,2001. All the central bankers around the world with the exception of ECB simultaneously lowered the interest rates. Holding the federal funds rate below 2% for 3 years was sufficient to rekindle asset prices. By the time the fed pushed rates up to 2.25% at the end of 2004, the U.S property market was on fire. As a creator of wealth, a font of financing and driver of global economic growth American’s property bubble was to put the Nasdaq bubble to shame. The 3 trillion dollar increase in the balance sheets of Fannie Mae and Freddie Mac had an extraordinary impact on the US as well as global economy by driving up property prices in America. Americans had come to view their homes as ATM’s from which they could extract equity at will. Consumption fuelled the economy and pulled imports into the USA in extraordinary amounts creating a world wide economic boom. In 2004, the U.S current account deficit broke through 5% of GDP and increased to 6% in 2006. During those years powered by debt financed consumption in the USA the economy grew at its fastest pace in 30 years. Huge sums were being accumulated around the would as the American consumers voracious appetite refused to die down. Nearly all the dollars accumulated by the Central Bank of the USA’s trading partners were reinvested in dollar denominated assets in order to generate a return leading to overhearing of the American economy. To put things in place the fed increased its funds rate from 1% in 2004 to 4.75% over the next two years. However the yield on the treasury remained at around 5% due to unanticipated inflow of funds driving up us bond prices and reducing bond yields which led to a very dangerous state of affairs. As the bond yields were at an extremely low level Central Banks outside the World inundated with dollars needed dollar denominated AAA bonds to invest. Since the US govt. was not issuing more debt and Fannie and Freddie were reined in , the private sector stepped in with Asset backed securities (ABS) issuance of trillions of dollars . As the private sector grew their liabilities they had to grow their assets to generate profits. To do so, they hired tens of thousands of mortgage brokers to call up people with poor credit records and encourage them to borrow money. Subprime mortgages were handed out by the loan originators with little concern about the borrowers ability to repay. The originators had no intention of holding the loans to maturity as they securitized them, brided the rating agencies for AAA ratings and sold them off to gullible investors around the world. We have discussed in previous reports about liquidity being a good servant but a very bad master . The flow of funds in the USA was a lethal Cocktail. But as against the Asian Crisis of 90’s or the Mexican and latin American crisis of 80’s America was no developing country, it still controlled a quarter of the World’s GDP and it had been the main driver of growth for the other quarters of the world as well.
However the combination of low interest rates and the large quantity of cheap mortgages being thrust on low income earners drove the US property prices to dizzying heights in 2006. As a direct result, the global economy was on fire with commodity prices soaring and oil reaching $ 150 a barrel. The boom wrapped around the World, from primary commodity producers in Latin America and even Africa to the property market in Mumbai, China and London. As discussed in our previous report, moderation collectively is an impossible task and thus it all started getting bad from the end of 2007. Various big companies and bank with 100 years track records were on the edge of bankruptcy or were on life support in the form of government aid. Bear Sterns, HBOS, BNP Paribas, Citigroup, WAMU, Wacho via , AIG, Merryill lynch and ultimately Leahman whose was the biggest bankruptcy ever filed. On September 15th 2008 Lehman Brothers which was founded in the year 1850 filed for chapter 11 bankruptcy protection citing bank debt of $613 billion , $155 billion in Bond debt and assets worth $ 639 billion. The global derivatives i.e. Asset backed Securities markets had grown to 760 trillion dollars at the end of 2007 which is unimaginable.
Every credit bubble eventually implodes as the asset prices become so inflated that society cannot earn enough money to service the interest on its debt- the same debt which drove up the asset prices in the first place. The financial sector makes every effort to roll over the debt so borrowers can avoid default and sooner or later the panic steps in and then the game is up. It becomes clear that the economic fundamentals are so poor that the credit can’t be repaid. Then no more credit can be extended and the economic structure built on seemingly unlimited supply of credit collapses. Debtors default and creditors fail. Hence,liquidity is the mother of everything in financial markets and we should always respect it.
b) The destruction of Countries
The financial crisis that broke out in the USA in 2008 destroyed 35 trillion of wealth globally by 2009 reducing the total market cap of publicly traded companies around the world from around 65 trillion dollars to approx 30 trillion dollars in 2009. It took more than 23 trillion dollars of pubic funds to stabilize world markets and still only 3/4th of the peak market capitalization in 2007 has been recouped. The crisis has left the credit markets around the world dangerously anemic and the real economy operating on intensive care and life support measures from government. This is because the bailout and stimulus money has failed to work on the demand side of the economy which has already been plagued by over capacity fueled by inadequate workers income marked by excessive debt and by a drastic reversal of the wealth effect on consumer demand from the bursting of the debt bubble. The bursting of the debt bubble destroyed the wealth it buoyed but it left the debt that fuelled the bubble standing as liability in the economy. The new government money came from adding to the national debt which the tax payers will have to pay back in future. This money went to bail out distressed banks and financial institutions which used it to profit from global carry trade speculation, as hot money that exploited interest rate arbitrage trades between economics. This toxic debts have remained in the global economy at face value having only been transformed from private debts to public debts to prevent total collapse of the private sector. Such massive public spending has left many countries around the world with looming sovereign debt crisis.
The problem has more been pronounced in Europe. Mahatma Gandhi once said ‘ All compromise is based on give and take but there can be no give and take on fundamentals. Any compromise on mere fundamentals is a surrender. For it is all give and no take’. Europeans have been easy on fundamentals from the day they formed the EMU (European monetary Union) as against the political union. The best way to understand the problem is to think of the Euro as monetary thermostat with Euro members as occupants of the monetary skyscraper with only one thermostat. For the resident on the shady side, such as Germany the temperature makes them very comfortable by facilitating exports. But for the PIGS i.e. Portugal, Italy, Ireland, Iceland, Greece and Spain on the sunny side the temperature is wrong. It makes their exports too expensive and encourages a lack of discipline. Worst of all the Single currency has made it all too easy to borrow money and run up debt. To be sure, the economics of Southern Europe would have struggled even without being yoked to the Euro. But I think its reasonable to blame the Euro for turning those problems into a catastrophe. In the first place the Euro made the debts those nations carried look safer than it actually was and this made it possible for them to borrow money at implausible low interest rates. If the European banks that are large holders of Portuguese Greek, Italian and Spanish debt had been forced to lend to those countries in Escudos , Drachma, Lira and Pestas, they would have charged higher interest rates because of currency risks associated with those loans- much as they did when they lent to Iceland in Kronur. Real estate bubbles were just one of the consequences.Cheap money enabled countries to run up big debts, pay high wages to government employees and create false prosperity that encouraged customers to spend and borrow. The strong Euro created another problem i.e. it raise the cost of exports for the sunny side nations making them less competitive in world markets while making imports less expensive increasing trade deficits and unemployment. The third major flaw of the currency is that each nation in the Euro Zone does not enjoy the flexibility of devaluation of currency. History has taught us, Countries in crisis always come out of them by devaluing the currency thereby increasing export competitiveness and making import dearer. This option however is not available to the Euro Zone countries.
How each country in the Euro zone got involved in the crisis varies. For example,Ireland bank lent the money to property developers generating a massive property bubble. When the bubble burst, Ireland’s government and tax payers assumed private debts. In Greece, the government increased it commitments to public workers in the form of extremely generous pay and pension benefits. Iceland’s banking system grew enormously creating debts to global investors several times GDP. Spain and Italy are more exposed to public debts internally and hence are less exposed to risks unless something serious crops up. Portugal on the other hand has been plagued with problems since the Carnation revolution as every democratic government has encouraged over expenditure and investment bubbles through unclear public private partnership and funding of numerous effective and unnecessary external consultancy and advisory of committees and firms. This allowed considerable slippage of state funds leading it to the verge of bankruptcy by 2011. Complete lack of trust among banks and freeze in the transactions amongst financial institutions post the collapse of lehman brothers proved the extent of inter connectedness among financial institutions in the world. When strong interconnections are created in complex economic systems they create large no of feed back process leading to extremes.
Feedback processes in an economy can create market bubbles, encouraging consumers and countries to take on extreme levels of debt, as the weak euro zone countries have done. At other times they create economic death spirals, such as when banks refuse to lend to homeowners because they fear the price of homes will drop. When qualified buyers can’t get mortgages to buy homes, home prices decline even further. A number of solutions have been proposed to deal with the crisis. Some economists have suggested expanding the European Central Bank’s charter so it can become a lender of last resort. Others have suggested issuing eurobonds. In return for taking on the risks associated with eurobonds, the stronger euro zone members are demanding ironclad commitments to budgetary discipline from the troubled members. There is a fundamental problem with these proposals. They all increase the number of strong interconnections, which means they will increase the amount of positive feedback in the systems. One consequence might be to kick off economic tailspins – feedback processes – in the Portuguese, Italian, Greece, and Spanish economies. Strict budgetary discipline would cause these countries to raise taxes, which would slow economic activity and cause earnings and profits to shrink. This would reduce the tax base and require further increase in taxes to generate the same income for the state, causing the economy to slow down even more – a death spiral. My guess is that the positive feedback loops created by attempts to preserve the current structure will lead to yet bigger economic problem in the future. Even Germany isn’t immune. Just the talk of Eurobonds is creating feedback loops that makes it more difficult to auction off German debt to banks and investors, worried that Germany would have to take on obligations that would harm its economy, ended up buying just 3.6 billion of 6 billion-euro offering in Germany’s recent bond auction. A long-term solution to the euro problem would require more homogenous economies. The would take years and would require the creation of a central authority, as well as the surrender of a significant amount of sovereignty. Unless this can be accomplished, the current solutions will be at best short term. Another approach would be to use short-term fixes to ameliorate the current situation while unwinding the euro. Countries with major problems could return to their old currencies and support could be given to troubled banks to help them deal with solvency issues. One thing is certain : no matter which direction the Europeans take, there will be enough problems to keep the current crop of financial ministers employed for years to come. But if I were in charge, I would get my resume in order, take the heat, and unwind the euro.
3. The way forward
We resorted to super bubble hypothesis selecting certain events with merit to arrive at conclusion as to why did we reach at a point of financial catastrophe which tantamounted to falling of a cliff for the world economy. Had huge amount of money not been printed by the central bankers around the world we would be in dire straits. This automatically leads to a pertinent question of the future of world economy. As we discussed in our reports, we found that only a few countries really exert influence on the remaining countries. Hence the report boiled down to a study of very few countries with economic muscle and more so that of the U.S.A.
As all people aspire to progress in all spheres of life more so monetarily, collectively nations aspire to progress in all spheres more so financially. However nations do not think tactically they think strategically.They plan for the longer term as politics too is ultimately a subset of economics. Each nation is always in a rate race and there is a jungle law out there where might is right. Each stronger nation tries to exert its might over smaller nations and influence its policy. The strength of a nation,basically depends on 3 factors :-
a) The ability to sustain growth on a long term basis.
b) The defence capabilities (which is basically a subset of a))
c) The demographics of the population.
The demographics of a nation is basically an uncontrollable factor which is nowadays inversely proportionate to the wealth of the nations. The defence capabilities are naturally depended on the amount of money a nation spends on defence and research related to defence. The crucial question now boils down to how a nation sustains its growth over the long term. Any nation with good and business friendly government, hardworking and entrepreneurial people can grow and do wonders. However, the sustainability of the growth depends on various factors. A sustained growth without proper investment in infrastructure leads to over heating of the economy and stokes inflation. A export centric model followed by a country for growth leads to huge accumulation of forex reserves which too leads to high inflation. Huge forex reserves appreciates the local currency which then slows down exports and thereafter the economy. Slowing exports leads a country to further devalue its currency which again tantamounts to stroking inflation. Huge inflation and current account deficits all lead to a run on the local currency and then all such countries are back to where they started from or even worse. Mexico, Argentina, Russia, Japan etc are all examples of this. A very pertinent fact which I wish to make is growth sooner or later stops in such countries for variety of reasons and then the music starts in which the local currency is attacked by speculators around the world. This has been happening since the collapse of the Bretton Woods system has collapsed and will keep on happening till a new system other than the current dollar denominated system is replaced. There has been a talk by leading columnist Martin Wolf of financial Times for a new financial architecture calling for a Bretton Woods II summit wherein the dollar should be super seeded as the base currency. Zhou Xiaochuan , the governor of the People’s bank of china came out in favour of keynes idea of centrally managed global reserve currency on the lines of Bancor due to the national currencies being unsuitable for use because of Triffin dillemma. Bancor was conceptualized by Keynes as a supernational currency to be introduced after World War 2 that would be used in international trade as unit of account within a multilateral barter Clearing System or the international clearing union.However we should not forget that 62% of international trade currently is done in dollars and for U.S.A to give up its biggest weapon in its armoury, a catastrophe not less than World War II will have to befall on U.S.A.
Don Corleone said to Michael in God father ‘so Barzini will move against you first. He will set up a meeting with someone that you absolutely trust, guaranteeing your safety. And at that meeting you will be assassinated. Listen, whoever comes to you with this Barzini meeting he’s the traitor. Don’t forget that.’ Any body can recollect this dialogue from God father which has particular relevance in World economic stage today wherein China would come with an offer,the USA cannot refuse due to its dire financial condition. America sooner or later would face catastrophic problems due to its huge accumulation of debt,lack of employment and voracious consumption habits on borrowed credit in its people. It has an inherent problems of meddling in another country’s affairs and hence would need finance from other countries which will be refused by other countries due to lack of trust in dollars.Let us not forget China has 1 trillion dollars invested in American G-secs presently. A time would come when some catastrophe would make the USA very vunerable and at that point China and its allies would step in with additional support in exchange of USA agreeing to change to the proposal of SDR’s i.e. Special drawing rights as the centrally managed global reserve currency. This was exactly what was done by USA to bail out debt ridden UK for 1 billion dollars in the year 1945 post World War II in exchange for accepting dollar as the fiat currency of the World.
U.S.A and Germany post formation of Euro has escaped overheating of economy as they own the fiat currencies of the world. The federal reserve can print any no: of currency notes without importing inflation because all the notes that it prints comes back to its shores. We have discussed this as the Great American trick and as long as this continues history will keep on repeating itself .Till that time ‘picture abhi baki hai mere dost………………………………………’.
Warm Regards
CA Parikshit Pradip Joshi
Pradip J Joshi & Co
Chartered Accountants.
402 Chartered House
Dr C H Street,Marine Lines
Mumbai 400 002.
Maharashtra,India.
O:22081541,22005241
D:22091929
M:09819632325
E:parikshit@capradipjoshi.com
W:www.capradipjoshi.com |
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