Reflections

Stimulus: Spending or tax cut?

2009-01-28T19:24:00.000-08:00

While some advocate more spending but others instead favor tax cut as a stimulus to the ailing economy, what is better? What combination is good? I will try to take a qualitative view on the merits of each, leaving to quantitative view to those with established and powerful models.

As written on September 30 and October 12, of the four pillars of the economy, consumption, investment, net exports and government spending, the first 3 are not growing. Let's examine the situation of each sector below:
- In this consumer-led recession, consumption is primarily affected by people losing jobs, the difficulty to borrow, and the fear that things will get worse, so spending is delayed.
(i) For people losing jobs and can't even spend on essentials, tax cuts would not help them directly. Extending unemployment benefits would help them spend on essentials, which helps to keep other people's jobs.
(ii) The difficulty in borrowing stems from (1) financial institutions questioning people's repayment capability and capacity, due to the job cuts or salary cuts as a result of the ailing economy, and (2) the declining asset base on the balance sheet of many financial institutions that make lending less available. (Therefore, capital injection to those institutions on the edge of insolvency, so they could be solvent or buying toxic assets from those healthier so that the market and counterparties have more confidence in investing or deal with them. Otherwise, healthier banks are lumped into the same group as unhealthy banks because outsiders cannot tell which institution is sound. But let's leave that to another discussion.)
(iii) For those with the means to buy, many are holding back because of the fear that things will get worse or that they will lose their jobs (which is a widespread sentiment as reported by recent market surveys). As such, they are either rebuilding their war chest, saving for rainy days down the road, or paying down debt upon realizing the potential dire straits they could be in. A tax cut will not really help, since whatever amount that is retained will likely not be used for purchases. A permanent tax cut will not really help either, since if people lose their jobs, they will not benefit from any permanent tax cuts. Hence, keeping their jobs is key.

On the investment side, housing and business investments are in general not picking up.
(i) On housing, buyers' sentiment is in part similar to consumption in that it is a question of whether they can afford it and whether they should invest now. Of course, the other factor is bank's general reluctance to lend. Of course, if house prices fall enough, more buyers will emerge, but most will still be affected by their outlook on the stability of income going forward.
(ii) On business investment, having a strong current demand and having more certainty about the future (just like consumers) help with the investment appetite. With consumers down the value chain not really spending, investments, in most cases, will unlikely help with spurring demand. Investing in productivity improving equipment and such could help lower cost, which could mean more sales, but it also depends on whether consumers will spend and buy. In addition, in the initial stage of productivity improvement, more workers are not needed unless sales increase to an extent that the current staff cannot effectively handle the increased demand. For taxes, lower interest rates lower the cost of operation in ways similar to a business tax cut, loosely speaking. If long term rates are lowered, as a result of the Federal Reserve buying long-dated treasuries, the longer term cost of capital will be lower as well. Tax cut or not, if the difficulty in borrowing persists or that demand continues to be weak that threaten the survival of companies, a permanent tax cut, will not help company realize this permanent increase of retained earnings.

On the net export side, (i) the stronger dollar, due to weaknesses in other countries and that the USD is considered as a safe haven, (ii) weakness in lending to continue or expand operations, and (iii) the weakness in global demand are all hurting this sector. Factors affecting the business investment side are similarly affecting many businesses in the export sector. In addition, many goods still cost less to produce outside of the U.S., so consumers hoping to save money will more likely opt for cheaper alternatives, produced mostly outside of the U.S. "Buy American" sounds good as a slogan, but how many consumers will pay more in most cases, instead of saving money.

As such, that consumers, investment and net exports are not driving growth, then the government, in this uncertain and down market, is the entity left that could act as one, create jobs (so that people can spend, which in the process helps keep some existing jobs or create new ones.), have a much longer term horizon and have access to a lower cost of capital than other businesses.

Spending helps preserve and/or create jobs. When people, like businesses, have more certainty about their future, they are more willing to buy and invest. Buying helps merchants and their workers. Consumer buying causes businesses to buy from suppliers, all the way down the value-chain and so on.

It is not a surprise that many respected economists on the Republican side, such as Martin Feldstein, are in favor more spending and less tax cuts.

Implications of a greater and faster push of electric cars

2009-01-11T20:08:00.000-08:00

http://online.wsj.com/article/SB123172034731572313.html

This WSJ article is about the new and low cost electric car F3DM by BYD, a Chinese manufacturer. The main hurdle in making electric car practical and cost-effective is the size, weight and capacity of the battery. This new car could enter the market at the end of 2009, earlier than GM's Chevy Volt.

Yet the broader implication of a faster and wider roll out of electric cars is profound, especially in the power market. Aside from the much talked about implications on the environment and oil markets, where there will be less direct pollution from cars, as the combustion of fossil fuel produces various carbon oxides and other particulate matters. Also, the demand growth of petroleum could slow.

In particular, the greater need for offpeak power, where much of that power is produced by nuclear and coal plants, and to some extent in the future by wind, will drive new dynamics in the environmental and fuels markets. But the biggest impact would likely be coming from coal.

[I] Implications on generation fuel mixes:
(The following discussion assumes some technological improvements along the way, but getting a breakthrough sometime somewhere remains an unknown, so let's not rely on it, especially given the efficiency hurdle and physics that governs the conversion of fuel into energy.)

Some power plants run throughout the day, where they are the primary producer of electricity during the so-called offpeak hours. With plug-in vehicles mostly drawing power overnight, there will be a greater need for consistent production of electricity. Most of these plants are hydro, nuclear and coal plants, with wind coming in the future. Let's examine the impact of each of these generation types, as well as natural gas and oil:

- Hydro: Most locations suitable for hydro generation have already been exploited, so it is unlikely to increase generation capacity. The impact will be small.

- Nuclear: Nuclear could form one of the pillars in supporting the increase of offpeak power generation. The nuclear revival could be coming, although the main impediments remain the construction time, cost overruns historically and regulatory approvals. Construction of nuclear plants are plagued by delays throughout its history. A good rule of thumb is that it takes about 10 years to build, at least in the US, with cost overruns. New developments in nuclear reactors where plants will use the same design, unlike the past, could help shave some time off, but it could be hampered by two other factors:
(i) Human capital and regulatory approvals. Nuclear reactors involve highly specialized technologies. Although there are some plants built around the world, none has been built in over 30 years in the US, except some up-rates (ie, increasing generation capacity) of exisiting plant and one unit in the Tennessee Valley Authority. Over these years, there was a significant drop-off in the training of people skilled in nuclear construction and operation. People already working in the industry will approach retirement age by the time many plants are constructed. This talent gap will certainly delay the advent of a large-scale nuclear revival.
(ii) Regulatory approvals could cause substantial delays as well, among them are the siting, where local residents would very likely oppose new constructions, and disposal of spent fuel rods.

- Wind: New installation of wind turbines will help supply part of the power during offpeak hours. But several factors make them less of a contributor than expected.
(i) Places with strong winds are far away from population centers. Even if wind farms were built, transmission lines will have to be erected to transmit power from, say in the U.S., the Plains in the middle of the country to coastal population centers. The permitting and siting of new transmission lines would very likely elicit local oppositions, access right and other legal issues, which are extensive, since these lines will have to transverse a very large distance. Hence, their construction will be delayed.
(ii) Winds are not so consistent, despite improvements in battery technology that can store power. Although wind, whose strength fluctuates a lot within a short time, is typically stronger at night than during the day, if it dies down, their production drops fast. But demand does not respond to this drop in supply. Batteries will remain too expensive to substitute other forms of generation, unless some breakthrough technology comes along. Therefore, some backup generation that can ramp up quickly will be needed. The most likely candidate is natural gas.
(iii) The high frequency of fluctuation in wind generation will cause other backup generation to ramp up much more frequently. The wear-and-tear to these generation facilities and transmission lines, in addition to the reduced stability of the transmission grid, could drive up the hidden cost associated with wind generation.

- Natural gas: Whether it be a backup to the fluctuating wind generation, or simply serving as next fuel of choice after coal, which is cheaper, the greater demand for power will necessitate the new buildout of natural gas plants. As a cleaner burning fuel as well, the global demand for natural gas will increase accordingly. Usual implication to major natural gas countries applies.

- Coal: What I think will be the biggest surprise driver of future energy and environmental policy could be coal.
(i) With the generation cost of natural gas plants in general higher than coal, coal would have to remain a major fuel that supports the growth in power supply.
(ii) Coal plants are faster to construct than nuclear. To meet demand needs, investors might have to return to constructing coal plants and delaying retirement of old ones.
(iii) The freight business that transports coal will flourish, as coal will be transported from major coal producing countries to consuming countries.
(iv) The drive to mine more coal could test safety standards, when producers would seek to produce more at dangerous places and keep cost low. People's lives are at stake.
(iv) *Most important, the delayed retirement of existing coal plants and higher buildout of new ones will drive up future emission prices. While higher emission prices will add to the marginal cost of coal generation, making natural gas generation more competitive, that coal would remain the backbone power generation will increase emissions, which impacts policy.
-- If the objective to reduce emission is to be held fast, then emission prices (be it a tax or permit) will increase substantially and increase the cost of operations across sectors, which could slow growth. If governments succumb to pressure to lower energy prices and, by extension, emission prices, emission will likely be going up. "Dirty" scenarios in climate change predictions could come true. Rest of the "dirty" scenarios will apply.

- Oil: Oil-fired plants are usually too expensive. With their combustion technology, they are polluting as well, so they are unlikely to help.

- Other renewables: Solar will likely remain expensive; biomass could run into multitude of problems. First generation biofuels, such as those that use corn, will compete with food supply. Another consideration is possibly the rate of regeneration of biofuel sources - ie, how much can be burned and how fast can they be regenerated? Can they meet demand like other fossil generation such as coal and natural gas?

[II] Implication on prices
The load factor, which compares the offpeak load with peak load, will also flatten. It is because the peak load, say at mid-day on a hot summer day, will continue to be driven by factors such as cooling demand (or heating demand in cold winter days), but offpeak power prices will be higher as well, since the demand for electricity due to charges will be higher. Having wind as a major component of power generation will cause spikes in power prices, as a dying down of wind will require higher cost generation to quickly substitute. Net-net, the average power price will increase.

Essentially the above is a brief description of the energy supply picture.

Solution? With these supply-side dynamics, maybe the only good way out of the run-away growth would have to be conservation...

Are we close to another beginning of a commodity spike down the road?

2008-12-05T18:29:00.000-08:00

The negative U.S. and global economic outlook is putting substantial pressure on commodities. Economic data continued to confirm the deterioration. The nonfarm payrolls number of 533K released by the Labor Department on Friday was substantially above market estimates in the 300K's. In addition, crude on Friday held up by closing at $41.74/bbl, above the $40/bbl level but off from the $54.4 mark last week. Natural gas had broken the $6/mmBtu level and ended the week at $5.735/mmBtu. However, trading volume has been light across the board, impeding a proper functioning of the price discovery process. In particular, crude and most other commodities are generally exhibiting super-contangos (ie, future prices way higher than near-term prices).

While one should not catch a falling knife, what about a contrarian take? These super-contangos could be caused by two major factors, among others: the lack of liquidity or appetite for trading that put near-term storable commodities below the cost of carry, and the notion that a downturn will substantially curb demand and, therefore, supply-side investment. This increases the probability of supply tightness further out the curve. This decline in investment could affect reservoir management especially in ways that reduce future output. Chesapeake Energy cut its capital budget and planed to build cash over the next two years. The Saudis also suggested that $75/bbl oil is the price for marginal producers. Regardless of whether this could be a signal for price targeting, the current price level disincentivizes producers with higher variable costs.

While it is possible that available storage has been taken, so the cost of carry cannot be arbitraged away, but there have not been reports on this. One contrary indicator is the large build in Crude stocks in Cushing, OK, (a location designated by NYMEX, the commodities exchange, for oil delivery, when futures (or one of many kinds of financial) contracts expire and the holder of a contract has to take delivery of the commodity) which is most probably deliveries against the November contract and perhaps some level of speculative filling ahead of the December contract or further out the curve.

Further, fiscal stimulus in the form of large scale infrastructure investments, which aim to create jobs, are typically energy-intensive, in contrast with modern growth engines in the service sector. As such, the demand erosion in one segment will likely be partially offset by growth in fiscally-stimulated sectors, along with a slowing of projected efficiency gains.

But then again, don't stand in front of a moving freight train. The contrarian play may not work at all in the near-term!

This downturn may be taking place in a different environment, but China still acted. Will other governments?

2008-11-09T22:25:00.000-08:00

Now that China has put out a large domestic spending plan that amounts to USD586 billion, other governments world-wide strongly affected by the crisis might have to take similar steps, especially given faltering consumer spending and investments. But since the world is different from the past, such as improved technology, greater interconnectivity and higher mobility of workforce, would the downturn play out differently? What’s the resulting impact on developing countries?

With consumers being engines of the economy, their general lack of access to credit, fear of job losses and the resulting belt-tightening are causing a sharp downturn in spending. As such, on the investment component of the GDP, there is a lack of will for businesses to invest; home values, still at elevated levels, have to come down, causing investments to continue to suffer. In the US, the rising dollar does not help with the trade balance, also hurting the export industry, aside from the credit issues. We might be entering a deflationary environment, with input (eg, fuel, commodities) prices falling and firms cutting prices to clear inventory. A deflationary spiral would be a bad outcome.

But this downturn takes place under a different environment, with improved technology and greater mobility of workforce, than previous ones, so could the situation be different?

(1) Would improved technology help? It will, but more in the long run as technology looks to be correlated with increasing productivity. (Hence, economies still have to recover first. However, ways that increases aggregate demand in the short that also helps increase productivity in the long run would be most appropriate. Infrastructure projects are therefore usually taken.) What about the web or the higher interconnectivity around the world? It is hard to say outright. Nonetheless, fundamentally, the web is a platform that consumers and producers transact, rather than doing it on the street, so the basic economic interaction between consumers and producers remain the same. Thus, if demand falters, so does production. Moreover, if the wealth generated by the web is not “tangible,” but people treat it as if it were tangible, then the bursting of the asset bubble could be worse then, as the true value is realized. This happened after the bursting of the technology bubble earlier.

(2) The mobility of the global workforce has also improved significantly in recent years, but it is the very mobility of workforce that will make the situation in many OECD countries worse. As wages in those countries are still high, then moving operations to low wage countries will continue. In the last couple of years when the economy was booming, some companies have slowed or reversed the pace or direction of outsourcing, due partly to customer-service issues and time-zone differences. This reversal to some extent cuts into corporate profit but was more than offset by gains during the boom. But with profits shrinking during the recession, firms would likely to take greater advantage of this labor arbitrage and began another wave of outsourcing/offshoring, now perhaps on more core operations that do not have to be in high-wage countries.

At first glance, developing economies might appear to benefit from it. Nevertheless, I’d think that the benefits are likely to be offset by losses in other areas. As exports still account for a large portion of their economies, internal demand looks unlikely to bridge the gap left by falling exports. In fact, many who work in the exports industries will or are afraid that they would lose their jobs, which dampens the propensity to spend. In fact, this is happening in China as well, as domestic consumption falls measurably in Q3. China is also working off its own real estates bubble.

The role of government could be key. Since self-interests prompt people to hoard cash and not spend, then the hope for a recovery from either consumers or businesses could prove elusive. Given the severity of the downturn, then a coordinated effort is needed to boost the economy, so the government, which is the single biggest entity in the economy, would need to take the lead.
China has taken that step, with the massive government spending program. Will others do the same? Or will they have the means to do the same?

Carbon-absorbing rocks and the implementation?

2008-11-04T17:31:00.000-08:00

Essentially the researchers discovered that certain rock formation off the coast of Oman has substantial carbon absorbing capability, upto billions of tons a year, if the rock-cracking process can be self-sustaining. For comparison, coal plants in the U.S. emit between 1-2 billion tons per year. Since carbon dioxide travels long distance and stays in the air, then carbons can be stored with little leakage - a major problem that confronts typical carbon capture and sequestration (CCS) techniques.

CCS works by transporting emitted carbon dioxide and pumping it into some underground storage locations, such a porous aquifiers. But the high cost of transport and building pipelines makes it uneconomical. Carbon dioxide leaking from those locations is also a major problem.

Instead, this new proposed method uses the carbon-dioxide-absorbing ability of sea water and a convection system that pumps sea water deep into the rock formation in one hole and releases the "decarbonized" water in another hole. The rock formation peridotite has a large amount of olivine, which contains magnesium and oxygen, among others. The olivine reacts with water and leaves behind large amounts of dissolved magnesium and bicarbonate. With bicarbonate, the carbon concentration in the water can be increased by 10 times as well. As the water gets deeper into the ground and temperatures get higher, magnesium, carbon and oxygen are released to form magnesium carbonate and dolomite (with calcium). They expand the rock in size, creating more pores and fractures. The chemical reaction also generates heat, making the process self-sustaining. Then the water exits, rises to the sea surface and absorbs more carbon dioxide, completing the convection cycle.

If the science works and it works on a large scale, then it'd be an economical partial solution to carbon emissions, but what about the money needed to pay governments to allow this kind of operation off their coast? Would it involve a global payment system or be incorporated into some permit trading system in some form similar to the CDM? Perhaps it could work like the reforestation mechanism in CDM (Clean Development Mechanism). The CDM was established by the UN following the Kyoto Protocol, which allows for the creation and trading of emission credits through the capture of greenhouse gas and reforestation, among others.

==
Kelemen and Matter (2008) "In situ carbonation of peridotite for CO2 storage," Proceedings of the Nationa Academy of Sciences, 105(44)

PNAS abstract: http://www.pnas.org/content/early/2008/10/31/0805794105.abstract

Also at Technology Review: http://www.technologyreview.com/energy/21629/?a=f

Impact of the global recession on future energy prices

2008-11-02T21:40:00.000-08:00

The current global slowdown in energy demand growth, and lower oil and energy prices could pave the way for sharply higher prices when economies begin to recover.

(1) While we will very likely see a global recession, which decreases demand of oil and eases prices, the relative reduction in the size of oil exploration and production now will mean much higher oil prices in the future, I believe.

New exploration and production, along with necessary infrastructure investments, could take 10 years or so before oil could start flowing. (Similar outcome, but in shorter time frames, will probably play out in other energy commodities.) Even though many large oil majors have not announced any significant cutbacks in oil investments, the national oil companies (NOCs), controlled by various governments and all in the top 10 in terms of production, may think differently. Higher oil prices to a certain level benefit them more (such as Venezuela). Hence, as the pressure to produce more is off with the sharp drop in oil prices, they could reduce their investment both to conserve cash and, consequently, raise longer term prices. NOCs also tend not to have good reservoir management, where, loosely speaking, the full production of the field may not be reached. Mismanagement could in fact reduce the amount of oil recoverable as well. Hence, on this thesis, a slower growth in supply over the medium and long term is likely.

(2) Alternative energy development is hampered by both the lack of fund due to the recessions and lower energy prices. Without a certain amount of promising alternatives in the pipeline, there would be few substitutes if the supply and demand of traditional energy sources become tight again.

The weak credit environment is already impacting start-ups on solar, bio-fuels or other alternative energy sources, with stories from the venture capital industries about cutbacks. Large scale investments such as nuclear, where a plant costs billions to construct, are likely to be substantially slowed. Wind farms could still be built given government tax breaks, but the bottle necks come from transmission lines. Again, billions of investments are needed for the build-out, assuming all else being equal, including legal issues about access rights, compared with several months ago. Of course there could be "disruptive technologies" that come about and could change the world in short order, but should we count on that? If Paul Romer's Endogenous Growth Theory is any guide, the amount of resources put in would, broadly speaking, affect the R&D outcome.

As such, as the world economy recovers down the road, sharply rising energy prices could very well slow the rate of growth.

A moving goal post

2008-10-27T20:23:00.000-07:00

I wonder when this gyration in the market will subside. When will deleveraging, or the unloading of debt to boost return, be done?

(1) For investment firms, if I understand the process correctly, the deleveraging goal post might be moving, prolonging a rather painful process. (Leverages are essentially debt that firms borrow to boost return. Say if I have $1's worth of asset, borrow $4 and invest $5, then a 10% increase in return, ie $0.5, is almost equivalent to a 50% increase in return, since the original amount of asset was $1.) The problem is that the $1's worth of asset might be devaluing, which lengthens the deleveraging process. Say a firm wants to reduce its leverage from 20:1 to 10:1, it will have to sell assets. If the market is under massive deleveraging pressure, prices of assets are also driven down. Even if a firm has reduced its position from 20 to 10, if the value of assets are similarly driven down from $1 to, for argument sake, $0.5, then a 10:0.5 ratio is effectively a 20:1 ratio.

Given how long it took to build up this leverage and the size of it, the unwinding process will take time or that quick action will surely cause turmoil. Quick action is what is being observed now, driven in part by margin calls, redemption requests (or anticipation of such), or flight to safety from volatile assets to something safe.

(2) The next to deleverage are those consumers who loaded up with debt for purchases. I wonder how much banks and other financial institutions have marked down or set aside sufficient amount of reserves for the anticipated defaults on credit card, auto and loans on other purchases. (I still see ads where you can buy furnitures and don't pay until 2010 or 2012...)

One bright spot is the falling fuel prices that helps keep money in people's pockets, but it may not last long, given that some refined products' prices, such as a barrel of reformulated gasoline (RBOB), are less than a barrel of benchmark crude oil. This assumes, of course, that crude oil prices stay in the same range.... more later...

Implications on the new land reform in China

2008-10-22T23:20:00.001-07:00

A colleague and I were chatting about what Gartman wrote in his letter. With individuals in China being able to own land, Gartman asserted that farmers will become more productive. What are the other implications?

(1) Will farmers, in an effort to boost yield, "overwork" their land? With heavy use of fertilizers and little crop rotation, they can raise their standard of living quickly, but sacrifice the longer term productivity of the land.

(2) How much effort will there be to educate people with their newfound right to own land? Are there enough legal safeguards against exploitation? When people's standard of living is rather low, some may be persuaded to sell their land or effectively give up their claim on the cheap. Besides more education, perhaps individual owners can form some kind of cooperatives and bargain collectively to gain leverage, just like labor negotiations.

(3) Aside from the land-related issues, how will this reform impact the demographics in those places, now that people may have more incentives as agri-entrepreneurs, instead of being de facto peasants? There had been a talent drain as many able adults left the countryside to work in cities. Although they did earn more, families were also separated and children grew up not seeing their parents, ripping apart the delicate family fabric. Children were also not receiving the complementary education from being with their parents.

With ownership of their own land, would they decide to stay? If that is partly the objective of the new legislation, what are other support functions available to keep people there? I do not know how popular micro-lending is, but it may be helpful to expand that to help develop both the core agri-businesses and other supporting activities. Maybe financial institutions like the Agricultural Bank of China can continue to play a major role in that regard.

Weekend thoughts

2008-10-19T20:50:00.001-07:00

This is one of the quieter weekends over the past few weeks. Has the eye of the storm passed? I sure hope so. Did we see the capitulation in the stock market that signifies the end of a rout?

The credit market did thaw to a certain extent, but the effect seems to be very limited. News reports are saying that banks have begun lending to banks now, although such lending, much of it I think, is guaranteed by the government, so banks are making guaranteed money over the risk-free interest rate. Although many other interest rates, such as mortgages, are tied to some interbank lending rates such as LIBOR, will financial institutions actually start lending to borrowers without the guarantees? The slowdown in the economy will certainly bring more defaults. With the broader market being very unpredictable in a very short period of time, the risk rises substantially for lending past even a few days. For example, the overnight LIBOR dropped quite a bit, but not so much for anything longer term. In fact, longer term rates have increased, since the government will have to borrow more, depressing bond prices and increasing the yield.

I was in Georgetown this weekend, where the mood on campus was pretty positive and M Street remained crowded. Although shops on M Street do cater to people other than students, from this albeit very ancedotal evidence, perhaps students may be the segment of the population that is relatively shielded from this economic downturn, unless they have serious trouble getting student loans and/or parents start cutting off credit cards. Some are worried about their job prospects, but how much of the budget can a student cut? Fewer nights out may mean more gatherings/parties inside, with more consumption of pizza. In contrast, with polls out saying that over 60% of the population are worried about their jobs, spending cutbacks will definitely come from the adults.

2008-10-13T19:44:00.000-07:00

Something new just happens everyday these days. And these days, they are dominated by economic and financial news. Not that I wanted to focus on them solely, but both my occupation and the economist in me really got me thinking...

The current massive government intervention puts a floor on the stock market and rebuilds the confidence for lending. The Dow went up by 900+ points, the most in 75 years! By the time the next one comes around, say 75 years from now, I will be over 100. That might not be the best time for me (or anyone) to be invested in the market, as getting a heart attack then is the surest way for anyone to go to heaven (or hell... it depends...)

What the British and Europeans have put out for the rescue plans, with the US poised to follow, contain some key elements proposed by economists:

(1) Guarantee some form of bank lending. This is akin to guaranteeing bank deposits, which helps to prevent bank-runs. Similarly, banks are in the business of lending. If banks have the ability to lend but not lending because of a mistrust of counterparties (e.g. other banks), then liquidity (e.g. cash) is trapped inside banks. Guaranteeing bank lending would give lenders the confidence to lend to others protected by the guarantee. Banks are mistrustful of each other because many of them know the tricks of the trade, how CDOs and other assets are put together and sold to others.

Perhaps the guarantees should involve some sort of capital requirement, so that bad banks would not make the risky lending that, if those bets go right, they get a higher return, if not, those banks would fail anyway. The capital requirement is like the margin requirement in trading. In case a trading partner defaults, the margin could still cover the losses, if not partially. In any case, governments carry a big risk with this kind of guarantee, particularly when a bad bank in the program fails.

(2) Recapitalize banks: As values of assets are marked down substantially, depleting banks' capital base, banks need to be recapitalized. Governments would inject capital, perhaps through the issuance of preferred shares with a relatively low interest rate so that it won't become too much of a burden on banks. But it'd be hard (esp. politically) for governments to choose which ones to support and which to fail.

(3) Form asset management companies to buy assets from banks: This is essentially the original intent of first rescue package in the US. By having these banks selling those bad assets to the management company, the balance sheets would hopefully look clearer and better. The process would take longer.

But what is interesting is the latest article on the WSJ on how some of the biggest hedge fund managers have decided to exit the markets and stay on the sideline. Of course, information could be deceptive and decisions made yesterday could be reversed today, given new and important events and information. As such, they might be in the market again.

Yet, how long will this bounce last, especially with the following?
Short term
- the liquidity that helped drove the asset inflation in the past few years has been and is contracting as the shadow banking system shuts down
- the continued deleveraging taking place in the market is probably not complete, especially when some firms that were leveraged up to 20:1 have to get down to 10:1 or so, and when the "1" keeps getting smaller with asset marketdowns, threatening the capital base
- margin calls induced selling
Longer term
- the recession is driven primarily by consumers. Prior recessions in recent years were business-led and consumer spending was able to reenergize the economy to some degree.
- the debt burden of governments will likely give upward pressure on interest rates and crowd out private debt. The US government might be an exception, with the flight of safety to the Dollar perhaps keeping rates low.

I wonder what will happen tomorrow!

How will the stabilization plan take shape?

2008-10-12T01:15:00.000-07:00

I wrote the following in response to a friend's email:

How will the stabilization plan take shape?

In the US, following the mode of the RFC (Reconstruction Finance Corporation) would put the government in a tough spot in choosing which banks to keep and which to fail. I believe that was one of the sticking points as the rescue bill was negotiated, where congressmen were pressed hard by community banks for some protection, which aren’t too big to fail. (I think that the raising of FDIC insurance limit, which really wasn’t the real problem, was one of the things they fought for.) But clearly, with what happened on Friday to the Big 3 commercial banks (didn’t see Wells Fargo’s stock), perhaps there is already a preference for which ones to prop up. Nevertheless, the nationalization of banks would dilute current outstanding shares and drive down the stock price. Perhaps the first to be injected with government capital, or even nationalized, could be Morgan Stanley, especially if the Mitsubishi UFJ bid fails or is deemed inadequate.

More crucial is that some quick and credible actions must be taken shortly globally. The capitulation was delayed, which might have taken place on Friday, had that unknown intervention did not happen after the quick 600 point drop in the Dow just after the open. What little confidence left in the market could be gone if market players believe that even the G7 cannot come up with something to right the market and system. If that happens, the consequence could be ugly. The government could keep propping up the market, just like Taiwan did for the past few years, to buy some more time. One success story was Hong Kong during the Asian Financial (Currency) Crisis, where it stepped in to buy stocks. But then HK’s reserve was very large and that speculators were massively shorting stocks, not being forced to sell like what we have now.

Perhaps the US, G7 and such have to ask the Middle East, China, Japan and others with large reserves to join in to help invest or nationalize banks and corporations. Those countries would probably agree, as none of them want to see recessions in the US and Europe to be deep and long. Foreign ownership restrictions would have to be waived. While the US could ask them to buy more treasuries instead, those countries would likely want to ask for more say in return, where a simple ownership of treasuries would not achieve.

Challenging times indeed.

Reflection on the initial rejection of the rescue package

2008-10-12T01:14:00.000-07:00

Originally written on Sept 30, 2008

I watched with disbelief that the majority of people in the country did not like this rescue plan. What are the implications in the political arena and in our communities?

- Political Arena:
The stock market (the Dow) was only down 777 points because investors and traders believe that either those members of Congress who are posturing will come around and support the bill, or that some members of Congress were scared to see what happened in the market and will end up voting for the bill. But its passage is not a certainty: on a micro level, if a member of Congress were given two choices: a high probability of keeping his seat and let the economy tank by voting no, or a high probability of losing his seat but save the economy, what would he choose? His job or the bigger economy? Losing the power and prestige of being a member of Congress, or not get elected and need to find a job? The choice is clear. If the stalemate continues, the stock market is poise to go down further.

- Communities:
What people can't see is the credit market behind the scenes, which is not really functioning now.

The reasons why this bill is extremely important are that:
(1) wage payments are at risk: businesses, big and small, use short term lending to obtain the short term cash needed to pay workers. Now that banks are very unwilling to lend to each other and investors unwilling to buy short term debts so companies can borrow, businesses would face a cash-crunch and possibly unable to pay their workers and bills due to a lack of short term liquidity.

(2) jobs are at risk: when businesses cannot pay each other and their workers, what is the reason for holding on workers? Labor hoarding takes place when businesses think that they would weather the storm, and that it is cheaper to hold workers than to let them go and need to find new ones when the economy picks up. But it appears that both for the short and medium term, the economy will not recover, so letting workers go seem to make business sense, when the survival of the business itself is in question.

(3) purchases are at risk: when lending to businesses is not taking place, then lending to consumers is not likely to take place either. Borrowings have been the engine for the consumer-led growth in this country, both in terms of getting cash by tapping the equity of one's home, or borrowing to buy things, such as car loans, credit card loan, lines of credit or personal loans. With little to no lending, there will little transactions. Hence, those who need the money by selling things could not sell them, further eroding the financial situation of households.

(4) on the consumer side, capital preservation prevails and substantially slows the economy: banks are unwilling to lend to each other because they do not trust lending money to others and they also want to preserve what they have. Likewise, people would want to preserve their cash and assets, so they spend less and hoard more. Given the economic situation, enough people will be doing that that consumer-led economy will experience a substantial slowdown.

(5) on the investment side, business will not invest and housing will not pick up: internally, businesses have substantial problems borrowing, which put a constraint on what they can do. Externally, the pull-back in consumer spending will limit the appetite for businesses to expand or maintain the current operation. A contraction could happen as a result. On the housing side, borrowing difficulties simply crimp demand, as everyone knows.

(6) on the export side, the relatively strong dollar and tight credit will hamper the export sector: the US economy is weak, but others are weaker. Of the 5 largest economic entities, US, EU, Japan, UK and China, the first 4 may be on the verge of or are already in recession and China is slowing down. The relative weakness of most other economies makes the USD stronger, which hurts exports by raising export prices. This weakens the demand for exports. Even if the effect is not that large, the difficulty in obtaining credit to finance operations and expansions will hamper the production side for export

(7) the government is hardly an economic engine: the money that the government has spent is not enough to lift the GDP. A lot of that money actually went to buy up financial assets, which are not "productive" in the economic sense.

(8) the credit situation may further discourage foreign investors to lend to the U.S. The weak economy is not attractive to foreign investors. Foreign investors, which in large part have been financing the boom in the credit-driven US economy, would not be as willing to buy US debt (ie, Treasury). The smaller demand drives interest rate up, making the debt financing and repayment more difficult. This filters down to the broader economy, where the credit market is already under tremendous stress. In addition, a bad economy reduces tax revenues and weakens the government's position to pay off the national debt.

Finally, some say that it is wrong to bailout these financial services firm because of the high pay and severance packages these heads of corporations receive. But given the gravity of the situation, comparing the benefits that a $700 billion would bring, vs the, say, $700 million or $7 billion, of cost that could go to these people, quickly tells a story that the 1% of cost is minimal. One doesn't have to deal with those people now.

Deal with what's urgent and important now. Wake up and stop the bickering.

The place we live and climate change

2008-10-12T01:12:00.000-07:00

Originally written on Feb 3, 2007

Debates abound about what should be done, who should do what and when should one start. Be it demand-side conservation, or supply-side emission abatement, everyone can help slow and stablize the warming process and we should start now. But some may ask why: why should we do this, why don't China and India cut emissions and we have to do it, and why start now?

Fictional scenario:
- Imagine the following: everyone lives around a pond. The pond is where everyone gets water from and dumps waste. On one side of the pond, some live a good life at the expense of creating both organic and inorganic waste, all dumped into the pond. Those who are poor are trying to catch up, also dumping into the pond. The pond used to be full of life, with clear water. Fish used to be able to digest some of the waste, but the waste is just too much. The water turns yellow. People on both sides of the pond blame the other side. People keep blaming, little to nothing is done and the water turned brown. Arguments turn into fights, especially for the section of the pond with cleaner water. Those who have no access to clean water got sick and died. Irrigation no longer works...

Other potential scenarios:
- imagine living under 100F+ heat, say, for an extended time in the summer (picture India)
- imagine living in hunger, as crop yield drops, due to extreme weather, drought or heat (many are not as fortunate as us; picture Sub-Saharan Africa)
- imagine living in strife - the last generation fought for freedom; this generation fights for oil; the next generation could be fighting for water and other basic resources

What should be done:
- Demand-side conservation can start with something as little as turning off unused lights, electronics and appliances. Fuel efficiency and insulation are actually good, not only do they help the environment, but they also increase competition by introducing substitutes and entrants, spurring innovations and lower prices as demand for fuel decreases.
- Supply-side emission abatement can start with putting a price on pollution, so that emitters are more responsible with what they do and not transfer their unwanted stuff to others. (Just like with free food, people take more, but with a price, people usually get what they need.) Cap-and-trade with proper market design so far works.

Who should do what:
- Everyone can do something. Why wait for your neighbors to start when you can start now? Your energy bill would most probably go down!
- As for the India-China-not-in-complia

nce argument, it is only a bargaining strategy. China and India would actually suffer more if they don't curb emissions and they know it. Whenever I visit China now, I rarely see blue sky. Water from the tap is yellow. In India, sudden monsoon destroys crop and kills more people than in the past. Temperature in the summer is higher and sustains longer than before.
- So, show leadership, spur innovation and get the edge!

When should one start:
- Why not sooner the better? Lower energy bills translate into real savings; getting into the habit can help one weather surges in energy prices much better; getting a jump on innovations entails possible first-mover advantages, opening up new markets (or what some people called blue ocean strategy), encouraging "Creative Destruction;" starting sooner may yield benefits: the greening of Seoul in South Korea markedly lowers the city's temperature (the reduced use of air-conditioners as a result also helps curb the increase in temperature); the existing emission abatement programs of acid rain and smog in the U.S. help bring much more health, environmental and economic benefits than costs.

All in all, there is a lot that one can do, everyone can do something, mostly for limited cost, and the starting point is not too far. Now is the time.