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An Insightful article on the Greek Sovereign Default Crisis.
Greece will default on its national debt. That default will be due, in large part, to its membership of the European Monetary Union. If it were not part of the euro system, Greece might not have gotten into its current predicament and, even if it had gotten into its current predicament, it could have avoided the need to default.
Greece’s default on its national debt need not mean an explicit refusal to make principal and interest payments when they come due. More likely would be an IMF-organised restructuring of the existing debt, swapping new bonds with lower principal and interest for existing bonds. Or, it could be a “soft default” in which Greece unilaterally services its existing debt with new debt rather than paying in cash. But, whatever form the default takes, the current owners of Greek debt will get less than the full amount that they are now owed.
The only way that Greece could avoid a default would be by cutting its future annual budget deficits to a level that foreign and domestic investors would be willing to finance on a voluntary basis. At a minimum, that would mean reducing the deficit to a level that stops the rise in the debt-to-GDP ratio.
To achieve that, the current deficit of 14 per cent of GDP would have to fall to 5 per cent of GDP or less. But to bring the debt-to-GDP ratio to the 60 per cent level prescribed by the Maastricht Treaty would require reducing the annual budget deficit to just 3 per cent of GDP — the goal that the eurozone’s finance ministers have said Greece must achieve by 2012.
Reducing the budget deficit by 10 per cent of GDP would mean an enormous cut in government spending, or a dramatic rise in tax revenue — or, more likely, both. Quite apart from the political difficulty of achieving this would be the very serious adverse effect on aggregate domestic demand and, therefore, on production and employment. Greece’s unemployment rate is already 10 per cent, and its GDP is already expected to fall at an annual rate of more than 4 per cent, pushing joblessness even higher.
Depressing economic activity further through higher taxes and reduced government spending would cause offsetting reductions in tax revenue and offsetting increases in transfer payments to the unemployed. So, every planned euro of deficit reduction delivers less than a euro of actual deficit reduction. That means that planned tax increases and cuts in basic government spending would have to be even larger than 10 per cent of GDP in order to achieve a 3 per cent-of-GDP budget deficit.
There simply is no way around the arithmetic implied by the scale of deficit reduction and the accompanying economic decline: Greece’s default on its debt is inevitable.
Greece might have been able to avoid that outcome if it were not in the eurozone. If Greece still had its own currency, the authorities could devalue it while tightening fiscal policy. A devalued currency would increase exports and cause Greek households and firms to substitute domestic products for imported goods. The increased demand for Greek goods and services would raise Greece’s GDP, increasing tax revenue and reducing transfer payments. In short, fiscal consolidation would be both easier and less painful if Greece had its own monetary policy.
Greece’s membership in the eurozone was also a principal cause of its current large budget deficit. Because Greece has not had its own currency for more than a decade now, there has been no market signal to warn Greece that its debt was growing unacceptably large.
If Greece had remained outside the eurozone and retained the drachma, the large increased supply of Greek bonds would cause the drachma to decline and the interest rate on the bonds to rise. But, because Greek euro bonds were regarded as a close substitute for other countries’ euro bonds, the interest rate on Greek bonds did not rise as Greece increased its borrowing — until the market began to fear a possible default.
The substantial surge in the interest rate on Greek bonds relative to German bonds in the past few weeks shows that the market now regards such a default as increasingly likely. The combination of credits from the other eurozone countries and lending by the IMF may provide enough liquidity to stave off default for a while. In exchange for this liquidity support, Greece will be forced to accept painful fiscal tightening and falling GDP.
In the end, Greece, the eurozone’s other members, and Greece’s creditors will have to accept that the country is insolvent and cannot service its existing debt. At that point, Greece will default.
Thursday, April 29, 2010
Thursday, April 15, 2010
The Pendulum is swinging !!!
A special report on innovation in emerging markets
IN 1980 American car executives were so shaken to find that Japan had replaced the United States as the world’s leading carmaker that they began to visit Japan to find out what was going on. How could the Japanese beat the Americans on both price and reliability? And how did they manage to produce new models so quickly? The visitors discovered that the answer was not industrial policy or state subsidies, as they had expected, but business innovation. The Japanese had invented a new system of making things that was quickly dubbed “lean manufacturing”.
This special report will argue that something comparable is now happening in the emerging world. Developing countries are becoming hotbeds of business innovation in much the same way as Japan did from the 1950s onwards. They are coming up with new products and services that are dramatically cheaper than their Western equivalents: $3,000 cars, $300 computers and $30 mobile phones that provide nationwide service for just 2 cents a minute. They are reinventing systems of production and distribution, and they are experimenting with entirely new business models. All the elements of modern business, from supply-chain management to recruitment and retention, are being rejigged or reinvented in one emerging market or another.
Why are countries that were until recently associated with cheap hands now becoming leaders in innovation? The most obvious reason is that the local companies are dreaming bigger dreams. Driven by a mixture of ambition and fear—ambition to bestride the world stage and fear of even cheaper competitors in, say, Vietnam or Cambodia—they are relentlessly climbing up the value chain. Emerging-market champions have not only proved highly competitive in their own backyards, they are also going global themselves.
The United Nations World Investment Report calculates that there are now around 21,500 multinationals based in the emerging world. The best of these, such as India’s Bharat Forge in forging, China’s BYD in batteries and Brazil’s Embraer in jet aircraft, are as good as anybody in the world. The number of companies from Brazil, India, China or Russia on the Financial Times 500 list more than quadrupled in 2006-08, from 15 to 62. Brazilian top 20 multinationals more than doubled their foreign assets in a single year, 2006.
At the same time Western multinationals are investing ever bigger hopes in emerging markets. They regard them as sources of economic growth and high-quality brainpower, both of which they desperately need. Multinationals expect about 70% of the world’s growth over the next few years to come from emerging markets, with 40% coming from just two countries, China and India. They have also noted that China and to a lesser extent India have been pouring resources into education over the past couple of decades. China produces 75,000 people with higher degrees in engineering or computer science and India 60,000 every year.
The world’s biggest multinationals are becoming increasingly happy to do their research and development in emerging markets. Companies in the Fortune 500 list have 98 R&D facilities in China and 63 in India. Some have more than one. General Electric’s health-care arm has spent more than $50m in the past few years to build a vast R&D centre in India’s Bangalore, its biggest anywhere in the world. Cisco is splashing out more than $1 billion on a second global headquarters—Cisco East—in Bangalore, now nearing completion. Microsoft’s R&D centre in Beijing is its largest outside its American headquarters in Redmond. Knowledge-intensive companies such as IT specialists and consultancies have hugely stepped up the number of people they employ in developing countries. For example, a quarter of Accenture’s workforce is in India.
Both Western and emerging-country companies have also realised that they need to try harder if they are to prosper in these booming markets. It is not enough to concentrate on the Gucci and Mercedes crowd; they have to learn how to appeal to the billions of people who live outside Shanghai and Bangalore, from the rising middle classes in second-tier cities to the farmers in isolated villages. That means rethinking everything from products to distribution systems.
Anil Gupta, of the University of Maryland at College Park, points out that these markets are among the toughest in the world. Distribution systems can be hopeless. Income streams can be unpredictable. Pollution can be lung-searing. Governments can be infuriating, sometimes meddling and sometimes failing to provide basic services. Pirating can squeeze profit margins. And poverty is ubiquitous. The islands of success are surrounded by a sea of problems, which have defeated some doughty companies. Yahoo! and eBay retreated from China, and Google too has recently backed out from there and moved to Hong Kong. Black & Decker, America’s biggest toolmaker, is almost invisible in India and China, the world’s two biggest construction sites.
But the opportunities are equally extraordinary. The potential market is huge: populations are already much bigger than in the developed world and growing much faster (see chart 1), and in both China and India hundreds of millions of people will enter the middle class in the coming decades. The economies are set to grow faster too (see chart 2). Few companies suffer from the costly “legacy systems” that are common in the West. Brainpower is relatively cheap and abundant: in China over 5m people graduate every year and in India about 3m, respectively four times and three times the numbers a decade ago.
This combination of challenges and opportunities is producing a fizzing cocktail of creativity. Because so many consumers are poor, companies have to go for volume. But because piracy is so commonplace, they also have to keep upgrading their products. Again the similarities with Japan in the 1980s are striking. Toyota and Honda took to “just-in-time” inventories and quality management because land and raw materials were expensive. In the same way emerging-market companies are turning problems into advantages.
Until now it had been widely assumed that globalisation was driven by the West and imposed on the rest. Bosses in New York, London and Paris would control the process from their glass towers, and Western consumers would reap most of the benefits. This is changing fast. Muscular emerging-market champions such as India’s ArcelorMittal in steel and Mexico’s Cemex in cement are gobbling up Western companies. Brainy ones such as Infosys and Wipro are taking over office work. And consumers in developing countries are getting richer faster than their equivalents in the West. In some cases the traditional global supply chain is even being reversed: Embraer buys many of its component parts from the West and does the assembly work in Brazil.
Old assumptions about innovation are also being challenged. People in the West like to believe that their companies cook up new ideas in their laboratories at home and then export them to the developing world, which makes it easier to accept job losses in manufacturing. But this is proving less true by the day. Western companies are embracing “polycentric innovation” as they spread their R&D centres around the world. And non-Western companies are becoming powerhouses of innovation in everything from telecoms to computers.
Rethinking innovation
The very nature of innovation is having to be rethought. Most people in the West equate it with technological breakthroughs, embodied in revolutionary new products that are taken up by the elites and eventually trickle down to the masses. But many of the most important innovations consist of incremental improvements to products and processes aimed at the middle or the bottom of the income pyramid: look at Wal-Mart’s exemplary supply system or Dell’s application of just-in-time production to personal computers.
The emerging world will undoubtedly make a growing contribution to breakthrough innovations. It has already leapfrogged ahead of the West in areas such as mobile money (using mobile phones to make payments) and online games. Microsoft’s research laboratory in Beijing has produced clever programs that allow computers to recognise handwriting or turn photographs into cartoons. Huawei, a Chinese telecoms giant, has become the world’s fourth-largest patent applicant. But the most exciting innovations—and the ones this report will concentrate on—are of the Wal-Mart and Dell variety: smarter ways of designing products and organising processes to reach the billions of consumers who are just entering the global market.
No visitor to the emerging world can fail to be struck by its prevailing optimism, particularly if his starting point is the recession-racked West. The 2009 Pew Global Attitudes Project confirms this impression. Some 94% of Indians, 87% of Brazilians and 85% of Chinese say that they are satisfied with their lives. Large majorities of people in China and India say their country’s current economic situation is good (see chart 3), expect conditions to improve further and think their children will be better off than they are. This is a region that, to echo Churchill’s phrase, sees opportunities in every difficulty rather than difficulties in every opportunity.
This special report will conclude by asking what all this means for the rich world and for the balance of economic power. In the past, emerging economic leviathans have tended to embrace new management systems as they tried to consolidate their progress. America adopted Henry Ford’s production line and Alfred Sloan’s multidivisional firm and swept all before it until the 1960s. Japan invented lean production and almost destroyed the American car and electronics industries. Now the emerging markets are developing their own distinctive management ideas, and Western companies will increasingly find themselves learning from their rivals. People who used to think of the emerging world as a source of cheap labour must now recognise that it can be a source of disruptive innovation as well
IN 1980 American car executives were so shaken to find that Japan had replaced the United States as the world’s leading carmaker that they began to visit Japan to find out what was going on. How could the Japanese beat the Americans on both price and reliability? And how did they manage to produce new models so quickly? The visitors discovered that the answer was not industrial policy or state subsidies, as they had expected, but business innovation. The Japanese had invented a new system of making things that was quickly dubbed “lean manufacturing”.
This special report will argue that something comparable is now happening in the emerging world. Developing countries are becoming hotbeds of business innovation in much the same way as Japan did from the 1950s onwards. They are coming up with new products and services that are dramatically cheaper than their Western equivalents: $3,000 cars, $300 computers and $30 mobile phones that provide nationwide service for just 2 cents a minute. They are reinventing systems of production and distribution, and they are experimenting with entirely new business models. All the elements of modern business, from supply-chain management to recruitment and retention, are being rejigged or reinvented in one emerging market or another.
Why are countries that were until recently associated with cheap hands now becoming leaders in innovation? The most obvious reason is that the local companies are dreaming bigger dreams. Driven by a mixture of ambition and fear—ambition to bestride the world stage and fear of even cheaper competitors in, say, Vietnam or Cambodia—they are relentlessly climbing up the value chain. Emerging-market champions have not only proved highly competitive in their own backyards, they are also going global themselves.
The United Nations World Investment Report calculates that there are now around 21,500 multinationals based in the emerging world. The best of these, such as India’s Bharat Forge in forging, China’s BYD in batteries and Brazil’s Embraer in jet aircraft, are as good as anybody in the world. The number of companies from Brazil, India, China or Russia on the Financial Times 500 list more than quadrupled in 2006-08, from 15 to 62. Brazilian top 20 multinationals more than doubled their foreign assets in a single year, 2006.
At the same time Western multinationals are investing ever bigger hopes in emerging markets. They regard them as sources of economic growth and high-quality brainpower, both of which they desperately need. Multinationals expect about 70% of the world’s growth over the next few years to come from emerging markets, with 40% coming from just two countries, China and India. They have also noted that China and to a lesser extent India have been pouring resources into education over the past couple of decades. China produces 75,000 people with higher degrees in engineering or computer science and India 60,000 every year.
The world’s biggest multinationals are becoming increasingly happy to do their research and development in emerging markets. Companies in the Fortune 500 list have 98 R&D facilities in China and 63 in India. Some have more than one. General Electric’s health-care arm has spent more than $50m in the past few years to build a vast R&D centre in India’s Bangalore, its biggest anywhere in the world. Cisco is splashing out more than $1 billion on a second global headquarters—Cisco East—in Bangalore, now nearing completion. Microsoft’s R&D centre in Beijing is its largest outside its American headquarters in Redmond. Knowledge-intensive companies such as IT specialists and consultancies have hugely stepped up the number of people they employ in developing countries. For example, a quarter of Accenture’s workforce is in India.
Both Western and emerging-country companies have also realised that they need to try harder if they are to prosper in these booming markets. It is not enough to concentrate on the Gucci and Mercedes crowd; they have to learn how to appeal to the billions of people who live outside Shanghai and Bangalore, from the rising middle classes in second-tier cities to the farmers in isolated villages. That means rethinking everything from products to distribution systems.
Anil Gupta, of the University of Maryland at College Park, points out that these markets are among the toughest in the world. Distribution systems can be hopeless. Income streams can be unpredictable. Pollution can be lung-searing. Governments can be infuriating, sometimes meddling and sometimes failing to provide basic services. Pirating can squeeze profit margins. And poverty is ubiquitous. The islands of success are surrounded by a sea of problems, which have defeated some doughty companies. Yahoo! and eBay retreated from China, and Google too has recently backed out from there and moved to Hong Kong. Black & Decker, America’s biggest toolmaker, is almost invisible in India and China, the world’s two biggest construction sites.
But the opportunities are equally extraordinary. The potential market is huge: populations are already much bigger than in the developed world and growing much faster (see chart 1), and in both China and India hundreds of millions of people will enter the middle class in the coming decades. The economies are set to grow faster too (see chart 2). Few companies suffer from the costly “legacy systems” that are common in the West. Brainpower is relatively cheap and abundant: in China over 5m people graduate every year and in India about 3m, respectively four times and three times the numbers a decade ago.
This combination of challenges and opportunities is producing a fizzing cocktail of creativity. Because so many consumers are poor, companies have to go for volume. But because piracy is so commonplace, they also have to keep upgrading their products. Again the similarities with Japan in the 1980s are striking. Toyota and Honda took to “just-in-time” inventories and quality management because land and raw materials were expensive. In the same way emerging-market companies are turning problems into advantages.
Until now it had been widely assumed that globalisation was driven by the West and imposed on the rest. Bosses in New York, London and Paris would control the process from their glass towers, and Western consumers would reap most of the benefits. This is changing fast. Muscular emerging-market champions such as India’s ArcelorMittal in steel and Mexico’s Cemex in cement are gobbling up Western companies. Brainy ones such as Infosys and Wipro are taking over office work. And consumers in developing countries are getting richer faster than their equivalents in the West. In some cases the traditional global supply chain is even being reversed: Embraer buys many of its component parts from the West and does the assembly work in Brazil.
Old assumptions about innovation are also being challenged. People in the West like to believe that their companies cook up new ideas in their laboratories at home and then export them to the developing world, which makes it easier to accept job losses in manufacturing. But this is proving less true by the day. Western companies are embracing “polycentric innovation” as they spread their R&D centres around the world. And non-Western companies are becoming powerhouses of innovation in everything from telecoms to computers.
Rethinking innovation
The very nature of innovation is having to be rethought. Most people in the West equate it with technological breakthroughs, embodied in revolutionary new products that are taken up by the elites and eventually trickle down to the masses. But many of the most important innovations consist of incremental improvements to products and processes aimed at the middle or the bottom of the income pyramid: look at Wal-Mart’s exemplary supply system or Dell’s application of just-in-time production to personal computers.
The emerging world will undoubtedly make a growing contribution to breakthrough innovations. It has already leapfrogged ahead of the West in areas such as mobile money (using mobile phones to make payments) and online games. Microsoft’s research laboratory in Beijing has produced clever programs that allow computers to recognise handwriting or turn photographs into cartoons. Huawei, a Chinese telecoms giant, has become the world’s fourth-largest patent applicant. But the most exciting innovations—and the ones this report will concentrate on—are of the Wal-Mart and Dell variety: smarter ways of designing products and organising processes to reach the billions of consumers who are just entering the global market.
No visitor to the emerging world can fail to be struck by its prevailing optimism, particularly if his starting point is the recession-racked West. The 2009 Pew Global Attitudes Project confirms this impression. Some 94% of Indians, 87% of Brazilians and 85% of Chinese say that they are satisfied with their lives. Large majorities of people in China and India say their country’s current economic situation is good (see chart 3), expect conditions to improve further and think their children will be better off than they are. This is a region that, to echo Churchill’s phrase, sees opportunities in every difficulty rather than difficulties in every opportunity.
This special report will conclude by asking what all this means for the rich world and for the balance of economic power. In the past, emerging economic leviathans have tended to embrace new management systems as they tried to consolidate their progress. America adopted Henry Ford’s production line and Alfred Sloan’s multidivisional firm and swept all before it until the 1960s. Japan invented lean production and almost destroyed the American car and electronics industries. Now the emerging markets are developing their own distinctive management ideas, and Western companies will increasingly find themselves learning from their rivals. People who used to think of the emerging world as a source of cheap labour must now recognise that it can be a source of disruptive innovation as well
Wednesday, April 7, 2010
THE GREAT FINANCIAL CRISIS OF 2008-09 / WHAT WENT WRONG ?
A special report on financial risk in context of the financial crisis.
Source : The Economist.
THE revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature.” So wrote Peter Bernstein in his seminal history of risk, “Against the Gods”, published in 1996. And so it seemed, to all but a few Cassandras, for much of the decade that followed. Finance enjoyed a golden period, with low interest rates, low volatility and high returns. Risk seemed to have been reduced to a permanently lower level.
This purported new paradigm hinged, in large part, on three closely linked developments: the huge growth of derivatives; the decomposition and distribution of credit risk through securitisation; and the formidable combination of mathematics and computing power in risk management that had its roots in academic work of the mid-20th century. It blossomed in the 1990s at firms such as Bankers Trust and JPMorgan, which developed “value-at-risk” (VAR), a way for banks to calculate how much they could expect to lose when things got really rough.
Suddenly it seemed possible for any financial risk to be measured to five decimal places, and for expected returns to be adjusted accordingly. Banks hired hordes of PhD-wielding “quants” to fine-tune ever more complex risk models. The belief took hold that, even as profits were being boosted by larger balance sheets and greater leverage (borrowing), risk was being capped by a technological shift.
There was something self-serving about this. The more that risk could be calibrated, the greater the opportunity to turn debt into securities that could be sold or held in trading books, with lower capital charges than regular loans. Regulators accepted this, arguing that the “great moderation” had subdued macroeconomic dangers and that securitisation had chopped up individual firms’ risks into manageable lumps. This faith in the new, technology-driven order was reflected in the Basel 2 bank-capital rules, which relied heavily on the banks’ internal models.
There were bumps along the way, such as the near-collapse of Long-Term Capital Management (LTCM), a hedge fund, and the dotcom bust, but each time markets recovered relatively quickly. Banks grew cocky. But that sense of security was destroyed by the meltdown of 2007-09, which as much as anything was a crisis of modern metrics-based risk management. The idea that markets can be left to police themselves turned out to be the world’s most expensive mistake, requiring $15 trillion in capital injections and other forms of support. “It has cost a lot to learn how little we really knew,” says a senior central banker. Another lesson was that managing risk is as much about judgment as about numbers. Trying ever harder to capture risk in mathematical formulae can be counterproductive if such a degree of accuracy is intrinsically unattainable.
For now, the hubris of spurious precision has given way to humility. It turns out that in financial markets “black swans”, or extreme events, occur much more often than the usual probability models suggest. Worse, finance is becoming more fragile: these days blow-ups are twice as frequent as they were before the first world war, according to Barry Eichengreen of the University of California at Berkeley and Michael Bordo of Rutgers University. Benoit Mandelbrot, the father of fractal theory and a pioneer in the study of market swings, argues that finance is prone to a “wild” randomness not usually seen in nature. In markets, “rare big changes can be more significant than the sum of many small changes,” he says. If financial markets followed the normal bell-shaped distribution curve, in which meltdowns are very rare, the stockmarket crash of 1987, the interest-rate turmoil of 1992 and the 2008 crash would each be expected only once in the lifetime of the universe.
This is changing the way many financial firms think about risk, says Greg Case, chief executive of Aon, an insurance broker. Before the crisis they were looking at things like pandemics, cyber-security and terrorism as possible causes of black swans. Now they are turning to risks from within the system, and how they can become amplified in combination.
It would, though, be simplistic to blame the crisis solely, or even mainly, on sloppy risk managers or wild-eyed quants. Cheap money led to the wholesale underpricing of risk; America ran negative real interest rates in 2002-05, even though consumer-price inflation was quiescent. Plenty of economists disagree with the recent assertion by Ben Bernanke, chairman of the Federal Reserve, that the crisis had more to do with lax regulation of mortgage products than loose monetary policy.
Equally damaging were policies to promote home ownership in America using Fannie Mae and Freddie Mac, the country’s two mortgage giants. They led the duo to binge on securities backed by shoddily underwritten loans.
In the absence of strict limits, higher leverage followed naturally from low interest rates. The debt of America’s financial firms ballooned relative to the overall economy (see chart 1). At the peak of the madness, the median large bank had borrowings of 37 times its equity, meaning it could be wiped out by a loss of just 2-3% of its assets. Borrowed money allowed investors to fake “alpha”, or above-market returns, says Benn Steil of the Council on Foreign Relations.
The agony was compounded by the proliferation of short-term debt to support illiquid long-term assets, much of it issued beneath the regulatory radar in highly leveraged “shadow” banks, such as structured investment vehicles. When markets froze, sponsoring entities, usually banks, felt morally obliged to absorb their losses. “Reputation risk was shown to have a very real financial price,” says Doug Roeder of the Office of the Comptroller of the Currency, an American regulator.
Everywhere you looked, moreover, incentives were misaligned. Firms deemed “too big to fail” nestled under implicit guarantees. Sensitivity to risk was dulled by the “Greenspan put”, a belief that America’s Federal Reserve would ride to the rescue with lower rates and liquidity support if needed. Scrutiny of borrowers was delegated to rating agencies, who were paid by the debt-issuers. Some products were so complex, and the chains from borrower to end-investor so long, that thorough due diligence was impossible. A proper understanding of a typical collateralised debt obligation (CDO), a structured bundle of debt securities, would have required reading 30,000 pages of documentation.
Fees for securitisers were paid largely upfront, increasing the temptation to originate, flog and forget. The problems with bankers’ pay went much wider, meaning that it was much better to be an employee than a shareholder (or, eventually, a taxpayer picking up the bail-out tab). The role of top executives’ pay has been overblown. Top brass at Lehman Brothers and American International Group (AIG) suffered massive losses when share prices tumbled. A recent study found that banks where chief executives had more of their wealth tied up in the firm performed worse, not better, than those with apparently less strong incentives. One explanation is that they took risks they thought were in shareholders’ best interests, but were proved wrong. Motives lower down the chain were more suspect. It was too easy for traders to cash in on short-term gains and skirt responsibility for any time-bombs they had set ticking.
Asymmetries wreaked havoc in the vast over-the-counter derivatives market, too, where even large dealing firms lacked the information to determine the consequences of others failing. Losses on contracts linked to Lehman turned out to be modest, but nobody knew that when it collapsed in September 2008, causing panic. Likewise, it was hard to gauge the exposures to “tail” risks built up by sellers of swaps on CDOs such as AIG and bond insurers. These were essentially put options, with limited upside and a low but real probability of catastrophic losses.
Another factor in the build-up of excessive risk was what Andy Haldane, head of financial stability at the Bank of England, has described as “disaster myopia”. Like drivers who slow down after seeing a crash but soon speed up again, investors exercise greater caution after a disaster, but these days it takes less than a decade to make them reckless again. Not having seen a debt-market crash since 1998, investors piled into ever riskier securities in 2003-07 to maintain yield at a time of low interest rates. Risk-management models reinforced this myopia by relying too heavily on recent data samples with a narrow distribution of outcomes, especially in subprime mortgages.
A further hazard was summed up by the assertion in 2007 by Chuck Prince, then Citigroup’s boss, that “as long as the music is playing, you’ve got to get up and dance.” Performance is usually judged relative to rivals or to an industry benchmark, encouraging banks to mimic each other’s risk-taking, even if in the long run it benefits no one. In mortgages, bad lenders drove out good ones, keeping up with aggressive competitors for fear of losing market share. A few held back, but it was not easy: when JPMorgan sacrificed five percentage points of return on equity in the short run, it was lambasted by shareholders who wanted it to “catch up” with zippier-looking rivals.
An overarching worry is that the complexity of today’s global financial network makes occasional catastrophic failure inevitable. For example, the market for credit derivatives galloped far ahead of its supporting infrastructure. Only now are serious moves being made to push these contracts through central clearing-houses which ensure that trades are properly collateralised and guarantee their completion if one party defaults.
The push to allocate capital ever more efficiently over the past 20 years created what Till Guldimann, the father of VAR and vice-chairman of SunGard, a technology firm, calls “capitalism on steroids”. Banks got to depend on the modelling of prices in esoteric markets to gauge risks and became adept at gaming the rules. As a result, capital was not being spread around as efficiently as everyone believed.
Big banks had also grown increasingly interdependent through the boom in derivatives, computer-driven equities trading and so on. Another bond was cross-ownership: at the start of the crisis, financial firms held big dollops of each other’s common and hybrid equity. Such tight coupling of components increases the danger of “non-linear” outcomes, where a small change has a big impact. “Financial markets are not only vulnerable to black swans but have become the perfect breeding ground for them,” says Mr Guldimann. In such a network a firm’s troubles can have an exaggerated effect on the perceived riskiness of its trading partners. When Lehman’s credit-default spreads rose to distressed levels, AIG’s jumped by twice what would have been expected on its own, according to the International Monetary Fund.
Mr Haldane has suggested that these knife-edge dynamics were caused not only by complexity but also—paradoxically—by homogeneity. Banks, insurers, hedge funds and others bought smorgasbords of debt securities to try to reduce risk through diversification, but the ingredients were similar: leveraged loans, American mortgages and the like. From the individual firm’s perspective this looked sensible. But for the system as a whole it put everyone’s eggs in the same few baskets, as reflected in their returns (see chart 2).
Efforts are now under way to deal with these risks. The Financial Stability Board, an international group of regulators, is trying to co-ordinate global reforms in areas such as capital, liquidity and mechanisms for rescuing or dismantling troubled banks. Its biggest challenge will be to make the system more resilient to the failure of giants. There are deep divisions over how to set about this, with some favouring tougher capital requirements, others break-ups, still others—including America—a combination of remedies.
In January President Barack Obama shocked big banks by proposing a tax on their liabilities and a plan to cap their size, ban “proprietary” trading and limit their involvement in hedge funds and private equity. The proposals still need congressional approval. They were seen as energising the debate about how to tackle dangerously large firms, though the reaction in Europe was mixed.
Regulators are also inching towards a more “systemic” approach to risk. The old supervisory framework assumed that if the 100 largest banks were individually safe, then the system was too. But the crisis showed that even well-managed firms, acting prudently in a downturn, can undermine the strength of all.
The banks themselves will have to find a middle ground in risk management, somewhere between gut feeling and number fetishism. Much of the progress made in quantitative finance was real enough, but a firm that does not understand the flaws in its models is destined for trouble. This special report will argue that rules will have to be both tightened and better enforced to avoid future crises—but that all the reforms in the world will never guarantee total safety.
Source : The Economist.
THE revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature.” So wrote Peter Bernstein in his seminal history of risk, “Against the Gods”, published in 1996. And so it seemed, to all but a few Cassandras, for much of the decade that followed. Finance enjoyed a golden period, with low interest rates, low volatility and high returns. Risk seemed to have been reduced to a permanently lower level.
This purported new paradigm hinged, in large part, on three closely linked developments: the huge growth of derivatives; the decomposition and distribution of credit risk through securitisation; and the formidable combination of mathematics and computing power in risk management that had its roots in academic work of the mid-20th century. It blossomed in the 1990s at firms such as Bankers Trust and JPMorgan, which developed “value-at-risk” (VAR), a way for banks to calculate how much they could expect to lose when things got really rough.
Suddenly it seemed possible for any financial risk to be measured to five decimal places, and for expected returns to be adjusted accordingly. Banks hired hordes of PhD-wielding “quants” to fine-tune ever more complex risk models. The belief took hold that, even as profits were being boosted by larger balance sheets and greater leverage (borrowing), risk was being capped by a technological shift.
There was something self-serving about this. The more that risk could be calibrated, the greater the opportunity to turn debt into securities that could be sold or held in trading books, with lower capital charges than regular loans. Regulators accepted this, arguing that the “great moderation” had subdued macroeconomic dangers and that securitisation had chopped up individual firms’ risks into manageable lumps. This faith in the new, technology-driven order was reflected in the Basel 2 bank-capital rules, which relied heavily on the banks’ internal models.
There were bumps along the way, such as the near-collapse of Long-Term Capital Management (LTCM), a hedge fund, and the dotcom bust, but each time markets recovered relatively quickly. Banks grew cocky. But that sense of security was destroyed by the meltdown of 2007-09, which as much as anything was a crisis of modern metrics-based risk management. The idea that markets can be left to police themselves turned out to be the world’s most expensive mistake, requiring $15 trillion in capital injections and other forms of support. “It has cost a lot to learn how little we really knew,” says a senior central banker. Another lesson was that managing risk is as much about judgment as about numbers. Trying ever harder to capture risk in mathematical formulae can be counterproductive if such a degree of accuracy is intrinsically unattainable.
For now, the hubris of spurious precision has given way to humility. It turns out that in financial markets “black swans”, or extreme events, occur much more often than the usual probability models suggest. Worse, finance is becoming more fragile: these days blow-ups are twice as frequent as they were before the first world war, according to Barry Eichengreen of the University of California at Berkeley and Michael Bordo of Rutgers University. Benoit Mandelbrot, the father of fractal theory and a pioneer in the study of market swings, argues that finance is prone to a “wild” randomness not usually seen in nature. In markets, “rare big changes can be more significant than the sum of many small changes,” he says. If financial markets followed the normal bell-shaped distribution curve, in which meltdowns are very rare, the stockmarket crash of 1987, the interest-rate turmoil of 1992 and the 2008 crash would each be expected only once in the lifetime of the universe.
This is changing the way many financial firms think about risk, says Greg Case, chief executive of Aon, an insurance broker. Before the crisis they were looking at things like pandemics, cyber-security and terrorism as possible causes of black swans. Now they are turning to risks from within the system, and how they can become amplified in combination.
It would, though, be simplistic to blame the crisis solely, or even mainly, on sloppy risk managers or wild-eyed quants. Cheap money led to the wholesale underpricing of risk; America ran negative real interest rates in 2002-05, even though consumer-price inflation was quiescent. Plenty of economists disagree with the recent assertion by Ben Bernanke, chairman of the Federal Reserve, that the crisis had more to do with lax regulation of mortgage products than loose monetary policy.
Equally damaging were policies to promote home ownership in America using Fannie Mae and Freddie Mac, the country’s two mortgage giants. They led the duo to binge on securities backed by shoddily underwritten loans.
In the absence of strict limits, higher leverage followed naturally from low interest rates. The debt of America’s financial firms ballooned relative to the overall economy (see chart 1). At the peak of the madness, the median large bank had borrowings of 37 times its equity, meaning it could be wiped out by a loss of just 2-3% of its assets. Borrowed money allowed investors to fake “alpha”, or above-market returns, says Benn Steil of the Council on Foreign Relations.
The agony was compounded by the proliferation of short-term debt to support illiquid long-term assets, much of it issued beneath the regulatory radar in highly leveraged “shadow” banks, such as structured investment vehicles. When markets froze, sponsoring entities, usually banks, felt morally obliged to absorb their losses. “Reputation risk was shown to have a very real financial price,” says Doug Roeder of the Office of the Comptroller of the Currency, an American regulator.
Everywhere you looked, moreover, incentives were misaligned. Firms deemed “too big to fail” nestled under implicit guarantees. Sensitivity to risk was dulled by the “Greenspan put”, a belief that America’s Federal Reserve would ride to the rescue with lower rates and liquidity support if needed. Scrutiny of borrowers was delegated to rating agencies, who were paid by the debt-issuers. Some products were so complex, and the chains from borrower to end-investor so long, that thorough due diligence was impossible. A proper understanding of a typical collateralised debt obligation (CDO), a structured bundle of debt securities, would have required reading 30,000 pages of documentation.
Fees for securitisers were paid largely upfront, increasing the temptation to originate, flog and forget. The problems with bankers’ pay went much wider, meaning that it was much better to be an employee than a shareholder (or, eventually, a taxpayer picking up the bail-out tab). The role of top executives’ pay has been overblown. Top brass at Lehman Brothers and American International Group (AIG) suffered massive losses when share prices tumbled. A recent study found that banks where chief executives had more of their wealth tied up in the firm performed worse, not better, than those with apparently less strong incentives. One explanation is that they took risks they thought were in shareholders’ best interests, but were proved wrong. Motives lower down the chain were more suspect. It was too easy for traders to cash in on short-term gains and skirt responsibility for any time-bombs they had set ticking.
Asymmetries wreaked havoc in the vast over-the-counter derivatives market, too, where even large dealing firms lacked the information to determine the consequences of others failing. Losses on contracts linked to Lehman turned out to be modest, but nobody knew that when it collapsed in September 2008, causing panic. Likewise, it was hard to gauge the exposures to “tail” risks built up by sellers of swaps on CDOs such as AIG and bond insurers. These were essentially put options, with limited upside and a low but real probability of catastrophic losses.
Another factor in the build-up of excessive risk was what Andy Haldane, head of financial stability at the Bank of England, has described as “disaster myopia”. Like drivers who slow down after seeing a crash but soon speed up again, investors exercise greater caution after a disaster, but these days it takes less than a decade to make them reckless again. Not having seen a debt-market crash since 1998, investors piled into ever riskier securities in 2003-07 to maintain yield at a time of low interest rates. Risk-management models reinforced this myopia by relying too heavily on recent data samples with a narrow distribution of outcomes, especially in subprime mortgages.
A further hazard was summed up by the assertion in 2007 by Chuck Prince, then Citigroup’s boss, that “as long as the music is playing, you’ve got to get up and dance.” Performance is usually judged relative to rivals or to an industry benchmark, encouraging banks to mimic each other’s risk-taking, even if in the long run it benefits no one. In mortgages, bad lenders drove out good ones, keeping up with aggressive competitors for fear of losing market share. A few held back, but it was not easy: when JPMorgan sacrificed five percentage points of return on equity in the short run, it was lambasted by shareholders who wanted it to “catch up” with zippier-looking rivals.
An overarching worry is that the complexity of today’s global financial network makes occasional catastrophic failure inevitable. For example, the market for credit derivatives galloped far ahead of its supporting infrastructure. Only now are serious moves being made to push these contracts through central clearing-houses which ensure that trades are properly collateralised and guarantee their completion if one party defaults.
The push to allocate capital ever more efficiently over the past 20 years created what Till Guldimann, the father of VAR and vice-chairman of SunGard, a technology firm, calls “capitalism on steroids”. Banks got to depend on the modelling of prices in esoteric markets to gauge risks and became adept at gaming the rules. As a result, capital was not being spread around as efficiently as everyone believed.
Big banks had also grown increasingly interdependent through the boom in derivatives, computer-driven equities trading and so on. Another bond was cross-ownership: at the start of the crisis, financial firms held big dollops of each other’s common and hybrid equity. Such tight coupling of components increases the danger of “non-linear” outcomes, where a small change has a big impact. “Financial markets are not only vulnerable to black swans but have become the perfect breeding ground for them,” says Mr Guldimann. In such a network a firm’s troubles can have an exaggerated effect on the perceived riskiness of its trading partners. When Lehman’s credit-default spreads rose to distressed levels, AIG’s jumped by twice what would have been expected on its own, according to the International Monetary Fund.
Mr Haldane has suggested that these knife-edge dynamics were caused not only by complexity but also—paradoxically—by homogeneity. Banks, insurers, hedge funds and others bought smorgasbords of debt securities to try to reduce risk through diversification, but the ingredients were similar: leveraged loans, American mortgages and the like. From the individual firm’s perspective this looked sensible. But for the system as a whole it put everyone’s eggs in the same few baskets, as reflected in their returns (see chart 2).
Efforts are now under way to deal with these risks. The Financial Stability Board, an international group of regulators, is trying to co-ordinate global reforms in areas such as capital, liquidity and mechanisms for rescuing or dismantling troubled banks. Its biggest challenge will be to make the system more resilient to the failure of giants. There are deep divisions over how to set about this, with some favouring tougher capital requirements, others break-ups, still others—including America—a combination of remedies.
In January President Barack Obama shocked big banks by proposing a tax on their liabilities and a plan to cap their size, ban “proprietary” trading and limit their involvement in hedge funds and private equity. The proposals still need congressional approval. They were seen as energising the debate about how to tackle dangerously large firms, though the reaction in Europe was mixed.
Regulators are also inching towards a more “systemic” approach to risk. The old supervisory framework assumed that if the 100 largest banks were individually safe, then the system was too. But the crisis showed that even well-managed firms, acting prudently in a downturn, can undermine the strength of all.
The banks themselves will have to find a middle ground in risk management, somewhere between gut feeling and number fetishism. Much of the progress made in quantitative finance was real enough, but a firm that does not understand the flaws in its models is destined for trouble. This special report will argue that rules will have to be both tightened and better enforced to avoid future crises—but that all the reforms in the world will never guarantee total safety.
The need to re-write Economics text-books.
The crisis is changing how macroeconomics is taught....
An insightful article from THE ECONOMIST.
Mar 31st 2010
From The Economist print edition
IN MORE than 30 years of teaching introductory macroeconomics, says Alan Blinder of Princeton University, he has never seen interest as high as it was last year. At Harvard, says David Laibson, students in his undergraduate macroeconomics course are “chomping at the bit”. At elite American universities, where endowments have shrivelled and hiring is down, increased interest in economics is among the most benign of the recession’s effects.
Yet the crisis has also highlighted flaws in the existing macroeconomics curriculum. Greg Mankiw, a Harvard economist and the author of a bestselling textbook, points out that students can hardly be expected to make sense of the crisis if they know virtually nothing about things like the role of financial institutions. Yet if there is a “financial system” in most introductory texts, Mr Blinder observes, it usually focuses on the demand and supply functions for money. “The current curriculum fails to give students even imperfect answers” to their legitimate questions about recent economic events, he says.
Changes are coming. Mr Blinder is one of the authors of another popular undergraduate textbook, which he is now revising. In the process, he is having to think long and hard about how to balance the need for more detail about things like finance with the constraints under which introductory macroeconomic courses are taught. The new edition is likely to have a prominent place for the idea of leverage and how it contributed to the crisis. That is fairly simply explained. But some additional complexity will be unavoidable.
For instance, the convenient fiction of a model of the economy with a single interest rate was defensible as long as different rates moved in concert. This, Mr Blinder says, is no longer something that students can be told “with a straight face”. Some discussion of the role of securitisation and systemic risk is essential, even if it feels like a lot of detail for beginners to grasp. Mr Blinder, with a nod to Albert Einstein, says that economists need to remember that things should be made as simple as possible, but no simpler.
Revised textbooks will soon find their way into bookshops. Charles Jones of Stanford University has put out an update of his textbook with two new chapters designed to help students think through the crisis, and is now working on incorporating these ideas into the body of the book. A new edition of Mr Mankiw’s book should be out in about a year. And Mr Blinder’s publishers aim to have his revised text on sale by June.
Courses in many leading universities are already being amended. Mr Laibson says he has chosen to teach his course without leaning on any standard texts. Francesco Giavazzi of the Massachusetts Institute of Technology is now devoting about two-fifths of the semester’s classes to talking about how things are different during a crisis, and how the effects of policy differ when the economy hits boundaries like zero interest rates. Discussion of the “liquidity trap”, in which standard easing of monetary policy may cease to have any effect, had fallen out of vogue in undergraduate courses but seems to be back with a vengeance. Asset-price bubbles are also gaining more prominence.
An insightful article from THE ECONOMIST.
Mar 31st 2010
From The Economist print edition
IN MORE than 30 years of teaching introductory macroeconomics, says Alan Blinder of Princeton University, he has never seen interest as high as it was last year. At Harvard, says David Laibson, students in his undergraduate macroeconomics course are “chomping at the bit”. At elite American universities, where endowments have shrivelled and hiring is down, increased interest in economics is among the most benign of the recession’s effects.
Yet the crisis has also highlighted flaws in the existing macroeconomics curriculum. Greg Mankiw, a Harvard economist and the author of a bestselling textbook, points out that students can hardly be expected to make sense of the crisis if they know virtually nothing about things like the role of financial institutions. Yet if there is a “financial system” in most introductory texts, Mr Blinder observes, it usually focuses on the demand and supply functions for money. “The current curriculum fails to give students even imperfect answers” to their legitimate questions about recent economic events, he says.
Changes are coming. Mr Blinder is one of the authors of another popular undergraduate textbook, which he is now revising. In the process, he is having to think long and hard about how to balance the need for more detail about things like finance with the constraints under which introductory macroeconomic courses are taught. The new edition is likely to have a prominent place for the idea of leverage and how it contributed to the crisis. That is fairly simply explained. But some additional complexity will be unavoidable.
For instance, the convenient fiction of a model of the economy with a single interest rate was defensible as long as different rates moved in concert. This, Mr Blinder says, is no longer something that students can be told “with a straight face”. Some discussion of the role of securitisation and systemic risk is essential, even if it feels like a lot of detail for beginners to grasp. Mr Blinder, with a nod to Albert Einstein, says that economists need to remember that things should be made as simple as possible, but no simpler.
Revised textbooks will soon find their way into bookshops. Charles Jones of Stanford University has put out an update of his textbook with two new chapters designed to help students think through the crisis, and is now working on incorporating these ideas into the body of the book. A new edition of Mr Mankiw’s book should be out in about a year. And Mr Blinder’s publishers aim to have his revised text on sale by June.
Courses in many leading universities are already being amended. Mr Laibson says he has chosen to teach his course without leaning on any standard texts. Francesco Giavazzi of the Massachusetts Institute of Technology is now devoting about two-fifths of the semester’s classes to talking about how things are different during a crisis, and how the effects of policy differ when the economy hits boundaries like zero interest rates. Discussion of the “liquidity trap”, in which standard easing of monetary policy may cease to have any effect, had fallen out of vogue in undergraduate courses but seems to be back with a vengeance. Asset-price bubbles are also gaining more prominence.
Wednesday, March 31, 2010
Inflation Kills !!!
An excellent article on Inflation. It relates inflation to investments and personal finances.
Which decade witnessed the largest stock market decline in U.S. history? The
decade starting with the Great Depression? The Panic of 1987? The most recent
decade with its two crashes? After adjusting for inflation, it turns out that the
1970s was the worst. While the Great Depression produced the largest nominal
percent point drop, it also generated a period of deflation. So there were fewer
dollars to spend, but each dollar retained bought you more bananas. Total real
purchasing power was "only" reduced by about 45%. In contrast, the OPEC
crisis during the 1970s, along with its double-digit inflation, reduced purchasing
power by almost 50%.
Indeed, one of the biggest threats to your portfolio's performance over time is
inflation. For every additional point of inflation, your portfolio will lose about 20% of its purchasing
power over the next 25 years. In addition, taxes are levied on your portfolio's nominal return, even if it
does not experience a real increase in purchasing power. All combined, you can easily lose a third or more
of the value of your portfolio over time with just a tiny bit of extra inflation.
Moreover, unlike jarring market crashes -- such as the Great Depression or the recent crisis -- inflation
lurks in the shadows. It destroys value by gradually eroding real returns over time. It is financial death by
a thousand cuts. Investors too often look at "the numbers" in their portfolio without asking what those
numbers can actually buy over time. It's a classic mistake that John Maynard Keynes termed "money
illusion."
But there are two good reasons to now start paying close attention to inflation again. First, the expansion
of the Federal Reserve's money supply during the past 18 months has been enormous and unprecedented.
As Milton Friedman most clearly articulated decades ago, more money chasing the same number of
goods usually generates higher prices. In fact, had the recent monetary explosion happened during
"normal" times, prices would have likely doubled. Second, projected federal deficits are ballooning out of
control. According to the Congressional Budget Office, the new Obama Budget will add almost $9.8
trillion to the national debt over the next decade. Astonishingly, the market has even recently priced some corporate bonds corporate bonds as safer than government securities. Eventually, it will be too tempting to reduce the
value of this snowballing debt simply by printing more money.
Inflation hawks have now begun circling. Some investment advisors are urging their clients to buy gold
and other commodities in order to maintain purchasing power as the value of the dollar shrinks. But these
hawks are no longer just located in the outer circles. At a recent FOMC meeting, the Kansas City Federal
Reserve's president broke ranks with the rest of the members by voting against the continued era of cheap
money. Even the Chinese government, who now holds almost 10% of U.S. debt, has expressed a desire
for a new currency to replace the U.S. dollar as the world's benchmark, although concerns about a massive
Chinese selloff of dollars are likely overblown.
To be sure, recent core inflation numbers (that exclude volatile food and energy) have been well below
expectations. Given the severity of the economic slump, many experts believe that low inflation will
continue for a while. In March, the presidents of the regional Federal Reserve banks in Chicago and St.
Louis called for continued "accommodative" monetary policy, which is just code language for more of the
same loose controls on the money supply. Opinion pieces in the Wall Street Journal and New York Times
have even argued that the deficit hawks should simply go away.
For investors, however, the current debate over the inflation outlook is incomplete and misleading.
Diversified investors hold many types of assets. Some of these investments are more sensitive to inflation
over the short run while some are more sensitive over the long run. Both time horizons should matter to
investors.
In the short run -- say over the next three years -- inflation is likely to continue to be quite low. One
reason is that explosive growth in the Federal Reserve's balance sheet has been mostly matched by
enormous increases in excess reserves held by commercial banks despite a very steep yield curve. In
other words, the banks are "hoarding the cash," preventing it from becoming part of everyday
transactions. Why? One reason that is the Federal Reserve now pays banks interest to encourage them to
hold additional reserves. Some banks also fear that rising short-term interest rates will increase their costs
over the life of the loan. (Their fears are indeed reflected in prices of one-year futures contracts for Fed
Funds.) More importantly, the banking sector is just in "Phase One" of the residential real estate mortgage
crisis, the so-called "subprime" mess. Phase Two -- defaults of "Alt A" types of residential loans that were
often issued to sole proprietors with less formal income documentation -- will begin later this year. Phase
Three -- defaults of "Option ARM" loans in which interest rates sharply increase a few years after the
loans start -- will begin to increase next year. Banks need to reserve against all of these potential losses.
Of course, if banks happen to be over-reserving for these losses, then inflation might come sooner if the
Fed can't quickly yank money out of the banking system. But that scenario is unlikely. Indeed, "Phase
Four" of the mortgage crisis -- this one stemming from the commercial lending side -- has received very
little attention this far. If anything, banks are probably still not reserving enough for these defaults.
Combined with the recent economic slowdown in Europe, it is likely that inflation will be held in check
for a while.
But longer-run inflation (beyond five years) should be on everyone's radar screen. In fact, it is unlikely
that the current yields on 30-year Treasury securities will be enough to cover inflation over time, much
less provide a real return. Present value shortfalls in Social Security and Medicare are in excess of $70
trillion and will likely lead to an "inflation tax." Yields on 10-year Treasury securities -- which
policymakers try to keep low because of their indirect relationship to mortgages -- may not be high
enough to cover inflation.
So what is an investor to do about inflation? The traditional choice is to invest in commodities, metals, oil
and the like. The broadest investible measure of commodities is almost 85% correlated with the
Consumer Price Index (CPI) on an annual basis, meaning that the value of commodities tends to move in
the same direction as inflation. Gold is almost 60% correlated, oil stands at 21%, and real estate and
natural gas are both at 5%.
But, contrary to conventional wisdom, none of these asset classes are actually good inflation hedges
anymore. They are already too popular.
Indeed, don't be fooled by correlation. Two data series can appear to be highly correlated even though one
of them consistently underperforms the other. In fact, commodities are about the only major asset class
that actually underperforms the CPI over time. More targeted sector plays -- such as gold, oil and natural
gas -- tend to beat the CPI, but not by nearly enough to compensate for their enormous risks (they are
about twice as risky as the S&P 500). In fact, corporate bonds and equities actually appear to do a better
job of "keeping up" with the CPI over time on a risk-adjusted basis, despite their low mathematical
correlation.
A few specific investment recommendations, starting with the lowest hanging fruit:
Increase your exposure to Treasury Inflation Protected Securities (TIPS) inside of your tax
advantaged retirement accounts. Put a quarter or more of your retirement stash into TIPS.
While TIPS are not tax efficient enough for taxable accounts, they provide a good inflation
hedge for retirement accounts where taxes are either deferred or already paid.
1.
For your taxable accounts, buy $10,000 per year in Treasury I Bonds. Like TIPS, I Bonds
provide solid protection against inflation. Unlike TIPS, you are not taxed on "phantom
income" along the way. Because I Bonds are such a "win-win", the government caps the
amount that you can purchase each year to $5,000 in paper form and $5,000 in electronic
form. So do both.
2.
Invest up to 15% of your portfolio in emerging market equities. To be sure, many of these
markets have already experienced large gains recently. But they still offer a "twofer" of
sorts: a hedge against U.S. currency depreciation as well as diversification into countries
that still have strong growth prospects.
3.
Move some of your lower yield government bond portfolio toward Ginnie Mae centric
mutual funds. Ginnie Mae's are the only mortgage-backed securities carrying the full faith
and credit of the federal government. They usually provide a yield between one half a
percent and one percent greater than comparable maturities.
Which decade witnessed the largest stock market decline in U.S. history? The
decade starting with the Great Depression? The Panic of 1987? The most recent
decade with its two crashes? After adjusting for inflation, it turns out that the
1970s was the worst. While the Great Depression produced the largest nominal
percent point drop, it also generated a period of deflation. So there were fewer
dollars to spend, but each dollar retained bought you more bananas. Total real
purchasing power was "only" reduced by about 45%. In contrast, the OPEC
crisis during the 1970s, along with its double-digit inflation, reduced purchasing
power by almost 50%.
Indeed, one of the biggest threats to your portfolio's performance over time is
inflation. For every additional point of inflation, your portfolio will lose about 20% of its purchasing
power over the next 25 years. In addition, taxes are levied on your portfolio's nominal return, even if it
does not experience a real increase in purchasing power. All combined, you can easily lose a third or more
of the value of your portfolio over time with just a tiny bit of extra inflation.
Moreover, unlike jarring market crashes -- such as the Great Depression or the recent crisis -- inflation
lurks in the shadows. It destroys value by gradually eroding real returns over time. It is financial death by
a thousand cuts. Investors too often look at "the numbers" in their portfolio without asking what those
numbers can actually buy over time. It's a classic mistake that John Maynard Keynes termed "money
illusion."
But there are two good reasons to now start paying close attention to inflation again. First, the expansion
of the Federal Reserve's money supply during the past 18 months has been enormous and unprecedented.
As Milton Friedman most clearly articulated decades ago, more money chasing the same number of
goods usually generates higher prices. In fact, had the recent monetary explosion happened during
"normal" times, prices would have likely doubled. Second, projected federal deficits are ballooning out of
control. According to the Congressional Budget Office, the new Obama Budget will add almost $9.8
trillion to the national debt over the next decade. Astonishingly, the market has even recently priced some corporate bonds corporate bonds as safer than government securities. Eventually, it will be too tempting to reduce the
value of this snowballing debt simply by printing more money.
Inflation hawks have now begun circling. Some investment advisors are urging their clients to buy gold
and other commodities in order to maintain purchasing power as the value of the dollar shrinks. But these
hawks are no longer just located in the outer circles. At a recent FOMC meeting, the Kansas City Federal
Reserve's president broke ranks with the rest of the members by voting against the continued era of cheap
money. Even the Chinese government, who now holds almost 10% of U.S. debt, has expressed a desire
for a new currency to replace the U.S. dollar as the world's benchmark, although concerns about a massive
Chinese selloff of dollars are likely overblown.
To be sure, recent core inflation numbers (that exclude volatile food and energy) have been well below
expectations. Given the severity of the economic slump, many experts believe that low inflation will
continue for a while. In March, the presidents of the regional Federal Reserve banks in Chicago and St.
Louis called for continued "accommodative" monetary policy, which is just code language for more of the
same loose controls on the money supply. Opinion pieces in the Wall Street Journal and New York Times
have even argued that the deficit hawks should simply go away.
For investors, however, the current debate over the inflation outlook is incomplete and misleading.
Diversified investors hold many types of assets. Some of these investments are more sensitive to inflation
over the short run while some are more sensitive over the long run. Both time horizons should matter to
investors.
In the short run -- say over the next three years -- inflation is likely to continue to be quite low. One
reason is that explosive growth in the Federal Reserve's balance sheet has been mostly matched by
enormous increases in excess reserves held by commercial banks despite a very steep yield curve. In
other words, the banks are "hoarding the cash," preventing it from becoming part of everyday
transactions. Why? One reason that is the Federal Reserve now pays banks interest to encourage them to
hold additional reserves. Some banks also fear that rising short-term interest rates will increase their costs
over the life of the loan. (Their fears are indeed reflected in prices of one-year futures contracts for Fed
Funds.) More importantly, the banking sector is just in "Phase One" of the residential real estate mortgage
crisis, the so-called "subprime" mess. Phase Two -- defaults of "Alt A" types of residential loans that were
often issued to sole proprietors with less formal income documentation -- will begin later this year. Phase
Three -- defaults of "Option ARM" loans in which interest rates sharply increase a few years after the
loans start -- will begin to increase next year. Banks need to reserve against all of these potential losses.
Of course, if banks happen to be over-reserving for these losses, then inflation might come sooner if the
Fed can't quickly yank money out of the banking system. But that scenario is unlikely. Indeed, "Phase
Four" of the mortgage crisis -- this one stemming from the commercial lending side -- has received very
little attention this far. If anything, banks are probably still not reserving enough for these defaults.
Combined with the recent economic slowdown in Europe, it is likely that inflation will be held in check
for a while.
But longer-run inflation (beyond five years) should be on everyone's radar screen. In fact, it is unlikely
that the current yields on 30-year Treasury securities will be enough to cover inflation over time, much
less provide a real return. Present value shortfalls in Social Security and Medicare are in excess of $70
trillion and will likely lead to an "inflation tax." Yields on 10-year Treasury securities -- which
policymakers try to keep low because of their indirect relationship to mortgages -- may not be high
enough to cover inflation.
So what is an investor to do about inflation? The traditional choice is to invest in commodities, metals, oil
and the like. The broadest investible measure of commodities is almost 85% correlated with the
Consumer Price Index (CPI) on an annual basis, meaning that the value of commodities tends to move in
the same direction as inflation. Gold is almost 60% correlated, oil stands at 21%, and real estate and
natural gas are both at 5%.
But, contrary to conventional wisdom, none of these asset classes are actually good inflation hedges
anymore. They are already too popular.
Indeed, don't be fooled by correlation. Two data series can appear to be highly correlated even though one
of them consistently underperforms the other. In fact, commodities are about the only major asset class
that actually underperforms the CPI over time. More targeted sector plays -- such as gold, oil and natural
gas -- tend to beat the CPI, but not by nearly enough to compensate for their enormous risks (they are
about twice as risky as the S&P 500). In fact, corporate bonds and equities actually appear to do a better
job of "keeping up" with the CPI over time on a risk-adjusted basis, despite their low mathematical
correlation.
A few specific investment recommendations, starting with the lowest hanging fruit:
Increase your exposure to Treasury Inflation Protected Securities (TIPS) inside of your tax
advantaged retirement accounts. Put a quarter or more of your retirement stash into TIPS.
While TIPS are not tax efficient enough for taxable accounts, they provide a good inflation
hedge for retirement accounts where taxes are either deferred or already paid.
1.
For your taxable accounts, buy $10,000 per year in Treasury I Bonds. Like TIPS, I Bonds
provide solid protection against inflation. Unlike TIPS, you are not taxed on "phantom
income" along the way. Because I Bonds are such a "win-win", the government caps the
amount that you can purchase each year to $5,000 in paper form and $5,000 in electronic
form. So do both.
2.
Invest up to 15% of your portfolio in emerging market equities. To be sure, many of these
markets have already experienced large gains recently. But they still offer a "twofer" of
sorts: a hedge against U.S. currency depreciation as well as diversification into countries
that still have strong growth prospects.
3.
Move some of your lower yield government bond portfolio toward Ginnie Mae centric
mutual funds. Ginnie Mae's are the only mortgage-backed securities carrying the full faith
and credit of the federal government. They usually provide a yield between one half a
percent and one percent greater than comparable maturities.
Sunday, March 28, 2010
Fasten Your Seat Belts - India Poised for 10% Growth !!!
Watch out for India during the next 5 years... Says Managing Director of the Boston Consulting Group, India. Read on to know the reasons.....
Many Indians firmly believe that their future is decided by the constellation of stars at the time of their birth. The moment a child is born, parents and grandparents rush to an astrologer to get the newborn baby’s horoscope made, and then spend their lives to fit into the foretold pattern. So what is the future foretold for India, which is no longer a newborn country but could be termed a youth in the recent history of nation states?
I was reminded of this in a recent discussion on the Indian economy with the chairman of a large US-based MNC who was visiting India. We discussed how India seemed to have come out of the economic crisis stronger than most nations, perhaps by a combination of luck (we had the right stars in our corner!) and design. But, more important was the simple question he posed to me: Was India’s remarkable growth story of this decade “capped out” or was it the beginning of the next wave of growth, a destiny perhaps foretold by the stars?
To set the context for this interesting question, let us first take a short historical tour of India’s GDP growth in the last 45 years. In the first decade of this period (1965-74), the average GDP growth was 3.1 per cent. The next 30 years saw the average GDP growth increase in each decade (1975-84, 1985-94, 1995-04) to 4.9 per cent, 5.5 per cent and 6.1 per cent, respectively. The first five years of the current decade (2005-14) saw the GDP growth increase further to 7.9 per cent despite one of the worst economic crises of our lifetime. India has emerged from the crisis remarkably unscathed and much stronger than many other countries, and this was reflected in the optimism of our finance minister’s recent Budget speech where he did mention the magic figure of 10 per cent-plus GDP growth. Of course, he did leave the timeline somewhat undefined as “within the next few years”.
We all know that many of the drivers of our economic growth are in place. The 11th Five Year Plan calls for more than doubling investments in infrastructure to over Rs 20,00, 000 crore as compared to the 10th Five Year Plan. The government proactively talks about the need to reduce transaction costs through policies like goods and services tax (GST), and achieve financial consolidation through implementation of the Finance Commission recommendations. Equally well-known is the fact that foreign direct investment (FDI) into India has been growing rapidly and we have seen the second wave of big overseas investments in the last three years. On this score, it is interesting to note that for the first time in 2008, FDI from Japan into India exceeded that into China.
Let me point out two interesting elements of our economy’s journey in next five years. We know that among many differences between Indian and China’s economy, a key difference is the fact that the Indian economy is much more consumption-driven while China’s is an investment-led economy. This difference will play a big role as we should see a big impact on the Indian economy because of dramatic growth in consumption in many products — this is called “hockey stick” growth — due to a historic combination of changing dependency ratio and growth in middle class. Dependency ratio, which gives the ratio of typical dependents in a society (age below 19 years and over 60 years) to working-age population (20 to 59 years), will see a historic shift in India from 1.04 to 0.76 in the next five years, with the largest part of our population entering the working age of 20 years. Combine this with growth of 15 per cent in the number of middle-class households in India in the same five-year period and a “consumption hot-spot” is created.
The other interesting element is the role of the manufacturing sector. Few years ago, I remember pointing out proudly to overseas visitors the fact that over 50 per cent of India’s GDP was contributed by the services sector, an economic structure similar to that of more developed economies. The unspoken implication was that India had perhaps jumped the traditional stage of economic development and was well on its way to a more mature economic structure. We now realise that view was erroneous. I was pleasantly surprised by the statement made by the finance minister in his Budget speech this year that manufacturing sector is the growth driver for the Indian economy. Clearly, there seems to be a significant change in the thinking of the government on the role of the manufacturing sector and its contribution to our economic development. This sector has to play the critical role in creating significant share of the 220 million new jobs that India needs in the next 15 years, which will be crucial to our economic growth.
So, what has this economic discourse got to do with astrology and stars, and with the question posed by the MNC CEO on the GDP growth? I am not an astrologer, though at the prodding of my wife I must admit I have been to see some of them and, to just please my wife, tend to agree with her when she says confidently that some event in our lives was predestined. Despite the natural instinct of a rationalist, let me don the hat of an “economic astrologer” and say that whatever we do (or don’t do), India’s stars are so arranged in their constellation that we are destined to achieve an average GDP growth rate of over 10 per cent in the next five years!
Let me explain why. In recent years, the only country that has delivered a consistent 10 per cent-plus GDP growth rate is China. So, to answer the question about what will take India to 10-per cent GDP growth, I looked at China for some pointers. If you look at its performance in the last 10 years, it had been growing at about 7-8 per cent till about 2002 when it switched gears to a growth trajectory of 10 per cent-plus GDP (the highest was 13 per cent in 2007). I looked at its economic characteristics in 2002-03 when this change happened and compared these with India in 2010 to draw any parallels. I was quite astonished to see the parallels — India today is exactly where China was six-seven years ago when it moved to the 10 per cent growth trajectory. Let me share four key data points to illustrate this.
China’s average income level in public purchasing power parity (PPP) terms in 2002 was close to $3,000 — this is same as India’s per capita income in PPP terms today.
China’s FDI in 2002 of around $39 billion is very close to India’s FDI levels today. India’s investment as a percentage of GDP, which used to be around 23-24 per cent for many years, has grown to about 38-39 per cent in 2009. Guess what China’s investment was as a percentage of GDP in 2002? It was 38 per cent!
The final parallel is on exports. China’s exports, which have been one of the key drivers of its GDP growth, are around 36 per cent of its GDP today. When it took off in 2001, it was just 23 per cent. Guess what India’s exports were in 2009? They were 23 per cent of its GDP!
Sceptics will claim that these are just numbers, and coincidences occur in only reel life, not in real life. The believers will see this as signs from heaven that India’s future destiny is written in the stars, and despite all the challenges we face (and I am sure China faced its own set of challenges in 2002), we are on our way to the 10 per cent growth trajectory. So, are we going to fulfil our destiny or let the challenges steal our future away?
You decide.
Many Indians firmly believe that their future is decided by the constellation of stars at the time of their birth. The moment a child is born, parents and grandparents rush to an astrologer to get the newborn baby’s horoscope made, and then spend their lives to fit into the foretold pattern. So what is the future foretold for India, which is no longer a newborn country but could be termed a youth in the recent history of nation states?
I was reminded of this in a recent discussion on the Indian economy with the chairman of a large US-based MNC who was visiting India. We discussed how India seemed to have come out of the economic crisis stronger than most nations, perhaps by a combination of luck (we had the right stars in our corner!) and design. But, more important was the simple question he posed to me: Was India’s remarkable growth story of this decade “capped out” or was it the beginning of the next wave of growth, a destiny perhaps foretold by the stars?
To set the context for this interesting question, let us first take a short historical tour of India’s GDP growth in the last 45 years. In the first decade of this period (1965-74), the average GDP growth was 3.1 per cent. The next 30 years saw the average GDP growth increase in each decade (1975-84, 1985-94, 1995-04) to 4.9 per cent, 5.5 per cent and 6.1 per cent, respectively. The first five years of the current decade (2005-14) saw the GDP growth increase further to 7.9 per cent despite one of the worst economic crises of our lifetime. India has emerged from the crisis remarkably unscathed and much stronger than many other countries, and this was reflected in the optimism of our finance minister’s recent Budget speech where he did mention the magic figure of 10 per cent-plus GDP growth. Of course, he did leave the timeline somewhat undefined as “within the next few years”.
We all know that many of the drivers of our economic growth are in place. The 11th Five Year Plan calls for more than doubling investments in infrastructure to over Rs 20,00, 000 crore as compared to the 10th Five Year Plan. The government proactively talks about the need to reduce transaction costs through policies like goods and services tax (GST), and achieve financial consolidation through implementation of the Finance Commission recommendations. Equally well-known is the fact that foreign direct investment (FDI) into India has been growing rapidly and we have seen the second wave of big overseas investments in the last three years. On this score, it is interesting to note that for the first time in 2008, FDI from Japan into India exceeded that into China.
Let me point out two interesting elements of our economy’s journey in next five years. We know that among many differences between Indian and China’s economy, a key difference is the fact that the Indian economy is much more consumption-driven while China’s is an investment-led economy. This difference will play a big role as we should see a big impact on the Indian economy because of dramatic growth in consumption in many products — this is called “hockey stick” growth — due to a historic combination of changing dependency ratio and growth in middle class. Dependency ratio, which gives the ratio of typical dependents in a society (age below 19 years and over 60 years) to working-age population (20 to 59 years), will see a historic shift in India from 1.04 to 0.76 in the next five years, with the largest part of our population entering the working age of 20 years. Combine this with growth of 15 per cent in the number of middle-class households in India in the same five-year period and a “consumption hot-spot” is created.
The other interesting element is the role of the manufacturing sector. Few years ago, I remember pointing out proudly to overseas visitors the fact that over 50 per cent of India’s GDP was contributed by the services sector, an economic structure similar to that of more developed economies. The unspoken implication was that India had perhaps jumped the traditional stage of economic development and was well on its way to a more mature economic structure. We now realise that view was erroneous. I was pleasantly surprised by the statement made by the finance minister in his Budget speech this year that manufacturing sector is the growth driver for the Indian economy. Clearly, there seems to be a significant change in the thinking of the government on the role of the manufacturing sector and its contribution to our economic development. This sector has to play the critical role in creating significant share of the 220 million new jobs that India needs in the next 15 years, which will be crucial to our economic growth.
So, what has this economic discourse got to do with astrology and stars, and with the question posed by the MNC CEO on the GDP growth? I am not an astrologer, though at the prodding of my wife I must admit I have been to see some of them and, to just please my wife, tend to agree with her when she says confidently that some event in our lives was predestined. Despite the natural instinct of a rationalist, let me don the hat of an “economic astrologer” and say that whatever we do (or don’t do), India’s stars are so arranged in their constellation that we are destined to achieve an average GDP growth rate of over 10 per cent in the next five years!
Let me explain why. In recent years, the only country that has delivered a consistent 10 per cent-plus GDP growth rate is China. So, to answer the question about what will take India to 10-per cent GDP growth, I looked at China for some pointers. If you look at its performance in the last 10 years, it had been growing at about 7-8 per cent till about 2002 when it switched gears to a growth trajectory of 10 per cent-plus GDP (the highest was 13 per cent in 2007). I looked at its economic characteristics in 2002-03 when this change happened and compared these with India in 2010 to draw any parallels. I was quite astonished to see the parallels — India today is exactly where China was six-seven years ago when it moved to the 10 per cent growth trajectory. Let me share four key data points to illustrate this.
China’s average income level in public purchasing power parity (PPP) terms in 2002 was close to $3,000 — this is same as India’s per capita income in PPP terms today.
China’s FDI in 2002 of around $39 billion is very close to India’s FDI levels today. India’s investment as a percentage of GDP, which used to be around 23-24 per cent for many years, has grown to about 38-39 per cent in 2009. Guess what China’s investment was as a percentage of GDP in 2002? It was 38 per cent!
The final parallel is on exports. China’s exports, which have been one of the key drivers of its GDP growth, are around 36 per cent of its GDP today. When it took off in 2001, it was just 23 per cent. Guess what India’s exports were in 2009? They were 23 per cent of its GDP!
Sceptics will claim that these are just numbers, and coincidences occur in only reel life, not in real life. The believers will see this as signs from heaven that India’s future destiny is written in the stars, and despite all the challenges we face (and I am sure China faced its own set of challenges in 2002), we are on our way to the 10 per cent growth trajectory. So, are we going to fulfil our destiny or let the challenges steal our future away?
You decide.
Friday, March 26, 2010
Today's Article - 27th March 2010
Bimal Jalan: The working of India's democracy
An excellent article on challenges faced by Indian Political system by Dr. Bimal Jalan. The author was formerly the Governor of the Reserve Bank of India.
Not so long ago, in 2008, when Barack Obama was elected president of the US, all of us — in India and the rest of the world — hailed it as the triumph of American democracy. For the first time, after the adoption of the US Constitution in 1787, a person of African origin was elected to the highest office of the state with a sizeable majority.
However, the universal feeling of triumph about the working of American democracy soon yielded place to a sense of despondency. The fate of a popular health Bill proposed by President Obama for approval by the US Congress in 2009 became highly uncertain in view of the power of business lobbies and the ideologies of a few legislators. Fortunately, a few days ago, the Bill was approved by a very narrow margin.
This is not all. In the context of a deep financial crisis and bailout of banks by the government, the US Congress has been considering some legislative proposals to put in place a more efficient regulatory system. The legislative process to introduce such a system has not yet been completed because of a handful of Senators.
In the words of Nobel laureate Paul Krugman, in a recent article, “The US is paralysed in the face of mass unemployment and out-of-control health-care costs. Don’t blame Obama. There’s only so much one man can do, even if he sits in the White House. Blame our political culture instead, a culture that rewards hypocrisy and irresponsibility rather than serious efforts to solve America’s problems.” (“March of the Peacocks”, Business Standard, January 30).
Among large democracies, the US is not alone in facing a crisis in delivering what people want. The UK is another example, where the government is getting bigger, with the state’s share of GDP rising from 37 per cent in 2000 to 52 per cent in 2009. The average citizen, on the other hand, has become poorer with a higher level of unemployment. The same is the case with Japan, and countries in the European Union (Portugal, Ireland, Greece and Spain, the so-called PIGS !).
In the midst of all this “darkness”, as it were, where does India stand? The short answer is that our position is not any better. In addition to “systemic” problems, like erosion of collective responsibility, excessive centralisation and widespread political corruption, the faith of the ordinary citizen in the working of their elected government has been further shaken by two landmark events in the last three months.
In December 2009, there was a sudden announcement in favour of a separate state of Telangana, followed by an equally abrupt decision to postpone it. And now, a few days ago, we had the spectacle of some MPs being forcibly carried out of the Rajya Sabha so that the landmark legislation on women’s reservation could be approved the same day. And then, the pause — and announcement that this Bill will be introduced in the Lok Sabha later after consultations with all parties !
What are we to make of all this? There is no straight or unequivocal answer. I, however, believe that in the light of recent events, it is even more urgent now to take some relatively simple measures to strengthen the working of India’s politics. In view of constraints of space, let me just mention a few such measures that can be introduced if there is a consensus among three leading party formations in Parliament (the Congress party, the NDA and the Left). The emergence of such a consensus was the most gratifying development in respect of the Women’s Reservation Bill.
An unintended consequence of some recent amendments to the Constitution (i.e. the 52nd Amendment of 1985 and the 91st Amendment of 2003), combined with the power of parties to issue whips, has been to make individual members of Parliament fully subordinate to their leaders. The power of party leaders vis-a-vis elected members has been further compounded by an amendment in 2003 in the Representation of the People’s Act which removed the domicile requirement for election to the so-called Council of States (Rajya Sabha). An immediate priority is to revoke all amendments, which are designed to “dis-empower” elected members.
Cutting across political parties — in power and in Opposition — nearly 25 per cent of elected members in the Lok Sabha have criminal antecedents. An important reason for the attractiveness of politics as a career of choice by persons with criminal records is the enormous judicial delay in deciding such cases, and the power of political leaders to further delay the investigation and prosecution.
This incentive may be completely reversed by a relatively simple measure — by providing that elected candidates with pending criminal cases cannot take the “oath of office” until their cases have been heard by courts, and that such cases would have priority over other pending cases. Just consider the impact of this “reverse incentive” — in order to avoid immediate hearing of cases, the incentive would be to avoid getting elected to Parliament or state legislatures!
A related measure to make politics less remunerative is to reduce the power of ministries to “allocate” public resources, such as mineral rights, spectrum, gas etc. If an autonomous Election Commission, appointed by the government, can organise free and fair elections in the largest democracy in the world, similar agencies can be established to allocate public resources as per policies approved by the Cabinet.
Finally, the prevailing practice of passing several Bills at the end of the day at the discretion of the executive branch, without discussion or actual voting, has to be simply abolished — except in an emergency — to enable Parliament to perform its assigned role under the Constitution.
I believe that if the above measures are taken, or at least considered by Parliament, the working of Indian democracy by the people would become less oligarchic and more accountable
An excellent article on challenges faced by Indian Political system by Dr. Bimal Jalan. The author was formerly the Governor of the Reserve Bank of India.
Not so long ago, in 2008, when Barack Obama was elected president of the US, all of us — in India and the rest of the world — hailed it as the triumph of American democracy. For the first time, after the adoption of the US Constitution in 1787, a person of African origin was elected to the highest office of the state with a sizeable majority.
However, the universal feeling of triumph about the working of American democracy soon yielded place to a sense of despondency. The fate of a popular health Bill proposed by President Obama for approval by the US Congress in 2009 became highly uncertain in view of the power of business lobbies and the ideologies of a few legislators. Fortunately, a few days ago, the Bill was approved by a very narrow margin.
This is not all. In the context of a deep financial crisis and bailout of banks by the government, the US Congress has been considering some legislative proposals to put in place a more efficient regulatory system. The legislative process to introduce such a system has not yet been completed because of a handful of Senators.
In the words of Nobel laureate Paul Krugman, in a recent article, “The US is paralysed in the face of mass unemployment and out-of-control health-care costs. Don’t blame Obama. There’s only so much one man can do, even if he sits in the White House. Blame our political culture instead, a culture that rewards hypocrisy and irresponsibility rather than serious efforts to solve America’s problems.” (“March of the Peacocks”, Business Standard, January 30).
Among large democracies, the US is not alone in facing a crisis in delivering what people want. The UK is another example, where the government is getting bigger, with the state’s share of GDP rising from 37 per cent in 2000 to 52 per cent in 2009. The average citizen, on the other hand, has become poorer with a higher level of unemployment. The same is the case with Japan, and countries in the European Union (Portugal, Ireland, Greece and Spain, the so-called PIGS !).
In the midst of all this “darkness”, as it were, where does India stand? The short answer is that our position is not any better. In addition to “systemic” problems, like erosion of collective responsibility, excessive centralisation and widespread political corruption, the faith of the ordinary citizen in the working of their elected government has been further shaken by two landmark events in the last three months.
In December 2009, there was a sudden announcement in favour of a separate state of Telangana, followed by an equally abrupt decision to postpone it. And now, a few days ago, we had the spectacle of some MPs being forcibly carried out of the Rajya Sabha so that the landmark legislation on women’s reservation could be approved the same day. And then, the pause — and announcement that this Bill will be introduced in the Lok Sabha later after consultations with all parties !
What are we to make of all this? There is no straight or unequivocal answer. I, however, believe that in the light of recent events, it is even more urgent now to take some relatively simple measures to strengthen the working of India’s politics. In view of constraints of space, let me just mention a few such measures that can be introduced if there is a consensus among three leading party formations in Parliament (the Congress party, the NDA and the Left). The emergence of such a consensus was the most gratifying development in respect of the Women’s Reservation Bill.
An unintended consequence of some recent amendments to the Constitution (i.e. the 52nd Amendment of 1985 and the 91st Amendment of 2003), combined with the power of parties to issue whips, has been to make individual members of Parliament fully subordinate to their leaders. The power of party leaders vis-a-vis elected members has been further compounded by an amendment in 2003 in the Representation of the People’s Act which removed the domicile requirement for election to the so-called Council of States (Rajya Sabha). An immediate priority is to revoke all amendments, which are designed to “dis-empower” elected members.
Cutting across political parties — in power and in Opposition — nearly 25 per cent of elected members in the Lok Sabha have criminal antecedents. An important reason for the attractiveness of politics as a career of choice by persons with criminal records is the enormous judicial delay in deciding such cases, and the power of political leaders to further delay the investigation and prosecution.
This incentive may be completely reversed by a relatively simple measure — by providing that elected candidates with pending criminal cases cannot take the “oath of office” until their cases have been heard by courts, and that such cases would have priority over other pending cases. Just consider the impact of this “reverse incentive” — in order to avoid immediate hearing of cases, the incentive would be to avoid getting elected to Parliament or state legislatures!
A related measure to make politics less remunerative is to reduce the power of ministries to “allocate” public resources, such as mineral rights, spectrum, gas etc. If an autonomous Election Commission, appointed by the government, can organise free and fair elections in the largest democracy in the world, similar agencies can be established to allocate public resources as per policies approved by the Cabinet.
Finally, the prevailing practice of passing several Bills at the end of the day at the discretion of the executive branch, without discussion or actual voting, has to be simply abolished — except in an emergency — to enable Parliament to perform its assigned role under the Constitution.
I believe that if the above measures are taken, or at least considered by Parliament, the working of Indian democracy by the people would become less oligarchic and more accountable
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