Uncomfortable Answers to Questions on the Economy

We have heard that Fannie and Freddie, may cripple the US financial system. We have heard about the increasing job losses and plummeting home prices in USA. Economists keep debating whether it is recession already in the world's largest economy. Something has clearly gone wrong with the economy. But how bad are things, really? And how bad might they get before better days return? Are you are interested in knowing the answers to the following questions:

• Is this a recession?
• How bad is housing?
• When will banks revive?
• Is my job safe?
• Are consumers done?
• Who’s to blame?

If yes, please read this informative article in NY Times.

Time to Let Fannie and Freddie Wither?

In good times, they were superfluous. Now they're only as good as their U.S. guarantee .

Are Fannie Mae (FNM) and Freddie Mac (FRE) really too big to fail? That's certainly a widely held assumption across much of the political spectrum. But while it's clear that Fannie and Freddie can't be allowed to go under abruptly, a good case could be made that the two mortgage financing giants headquartered in Washington's Beltway are part of the problem in housing (BusinessWeek, 6/26/08) rather than part of the solution. If that's so, then this might be an opportune moment to let them begin slowly to wither away, argues Peter Coy in this interesting article in BusinessWeek.

The trouble with the guarantees that Fannie and Freddie make on mortgages is that in good times, they're superfluous—it's easy to get a mortgage even without that guarantee—while in the bad times, such as now, it becomes clear that the guarantees are only as good as the U.S. government's credit. Now that money is tight, Administration officials are quietly discussing how to stage a possible bailout if matters get worse. It's a classic example of privatized gains and socialized losses. That's why this might be the right time to let the two wither away.

The Indian context
The recent mortgage crisis in USA have also lead to difficulties abroad. The travails of Northern Rock and its bailout had lessons for Indian banks as also regulator. Takeover of small banks which have successfully ruined themselves by bigger banking entities, mainly on the dictats of RBI, is nothing new in India. The periodical criss that afflicts the Indian banking system (especially small banks / co-operative banks) can be mainly attributed to mis-management/dubious deals, poor appraisal skills, lax regulatory environment, as also shoddy work done by auditors who are supposed to be the watchdogs and who have generally failed to blow the whistle. The rise and fall of Global Trust Bank, the Nedungadi saga etc are examples from the recent past. While RBI has been generally quick in ordering compulsory merger with bigger entities (mainly to protect depositors), it has still not yet been tested on a bigger scale with failure of bigger bank(s). May be, bigger entities don't fail, because of the oft repeated argument that they are too big to fail! That's why banks like Indian Bank (and many other similar banks) were repeatedly capitalised by the Government. Somehow there is this feeling that RBI (or Government) would come to their rescue and hence no bank in India will fail. The power of Employee Union (controlled by communists) and their voting power (during elections) gives a false sense of security to the irresponsible management(s) to continue to mis-manage. I keep wondering whether would it be a good idea to allow a few institutions to sink. That would encourage a more responsible approach to lending by other surviving institutions. But, can that happen in a democracy like India?

That leads us back to the BusinessWeek's article mentioned above wherein it quotes Presidential candidate John McCain as voicing the conventional wisdom that Fannie Mae and Freddie Mac are really too big to fail by saying "They must not fail." Democrat Charles Schumer, the New York senator, also agreed, saying: "Markets should be assured that the federal government will stand by Fannie Mae and Freddie Mac." If this happens in the USA, what do we say about forced mergers that happen in India due to RBI's dictat?

The Fed bailout of Bear Stearns, forced NYTimes to ask - "WHAT are the consequences of a world in which regulators rescue even the financial institutions whose recklessness and greed helped create the titanic credit mess we are in? Will the consequences be an even weaker currency, rampant inflation, a continuation of the slow bleed that we have witnessed at banks and brokerage firms for the past year? Or all of the above? Stick around, because we’ll soon find out. And it’s not going to be pretty."

Stick around, says NYTimes. Let's wait and watch. Who knows, we may soon find out the consequences.

Whip Inflation Now

Highlights from John Mauldin's "Thoughts from the Frontline".

President Nixon instated price controls on the 15th of August, 1971. Inflation was a little over 4% at the time. Price controls manifestly did not work (resulting in shortages of all sorts and a deep recession) and were rescinded a few years later. President Ford went to Congress with programs to fight inflation that was running closer to 10% in October of 1974, with a speech entitled "Whip Inflation Now" (WIN). He famously urged Americans to wear "WIN" buttons. That policy too was less than effective, and the buttons, in a history replete with silly gestures by governments, should stand on anyone's top ten list of such silly gestures. Cynics more thoughtfully wore the buttons upside down and said the inverted letters (which looked like NIM) stood for "No Immediate Miracles." They were right. There was no miracle, just eventual pain and lots of it. Ultimately, Paul Volker defeated inflation, but at the cost of two serious recessions and a lot of economic misery, with unemployment levels over 10% for nine months in 1983.

Some call for the Fed to raise rates so that we do not have to experience another lost decade like the '70s and then ultimately see some future Volker forced to raise rates and drive unemployment back to 10%. Others suggest that "core" inflation is what should be paid heed to, and urge caution. "What will Ben do?" As Donald Coxe has noted, North America has had an 18-year run of remarkably good weather in our growing season. You have to go back 800 years to get a string of years that were that good. Yet today food reserves of all types are at decades-long lows. There is very little room for any type of problem.

Bottom line, Bernanke is in a very difficult position. Inflation by any standards is too high. But the cause of the inflation is not something in the Fed's control. To bring inflation back to 2%, he would have to savage the economy, perhaps at least as much as Volker did. Do you want to see unemployment go to 8-10%? Volker was dealing with wage inflation. Everything had cost of living adjustments (COLAs) back in the late '70s and early '80s. Spiraling wages were one of the primary causes of inflation, if not the most important. A higher Fed funds rate could do something about rising wages by increasing the unemployment rate. Tough love, but effective. Volker had to kill inflation expectations. Today, that is not (so far) Bernanke's problem.

Raising rates in any serious manner would whip inflation but would kill the economy at this point. Rates will need to go back up at some point, but not until the economy shows signs of a rebound. Countries throughout Asia would love to have a 4.2% inflation rate. Indonesia is at 10.4%, almost twice what they were a year ago. Vietnam would love to have such mild inflation, as its own level is up over 25%. Inflation in China is 8%. Inflation is up throughout the continent. And oil and food are the culprits. Korea is particularly strained. Korea has seen its import prices rise by almost 45% in the last 12 months.

What good would a rate hike do? How much more oil or corn would be produced? Why increase our pain when there could be no positive result? The central banks of the world got by for years with easy monetary policies (think Greenspan) because of rising productivity, cheap energy, increased international trade, a disinflationary environment because of cheap Asian labor and imports, etc. Now that economic regime has come to an end. Stability had bred instability in a very uncomfortable Minsky Moment. There are no good solutions. There will only be a choice of how much and what type of pain. The US, Europe, and Japan are entering Muddle Through World. The rest of the world is faced with increased volatility. This is a tough environment in which to be a central banker.

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The Indian context
"Inaction may be India's solution" - Financial Times. Though humorous it speaks volumes about the difficulties in fighting price rise in a country which is very sensitive to price rise and which is going for an election next year. The ADB cautions that rising inflation could also hit investment and corporate earnings, and destabilise governments in Asia.

Annual inflation in India rose to 8.75% for the week ended May 31, 2008 which is a 7-year high. There is a consensus view that the near-term battle against inflation in India has been lost and inflation is likely to settle down around 9-10% in the near-term. So, the struggle has now shifted to how to bring it under control in the medium-term. And this is after taking up short-term administrative measures to try to stop price rises, including cutting import duties on edible oils, fuels and other food items, introducing export curbs on essential items and suspending futures trading in staple foods such as rice and wheat.

Interestingly, inspite of these measures, there is a view that the Government will not be able to stop it from accelerating beyond 10%. The only consolation (if at all we can call it that way) is that price gains in neighboring Pakistan accelerated to 19.3% in May, the highest in 30 years. Inflation in Vietnam was 25.2% in the same month, the fastest since 1992, and in Indonesia consumer prices jumped 10.4% from a year ago. But this is no consolation. In a democratic country, where elections are due next year, the poor are more likely to vote, with anger, at the extra-ordinary increase in prices of essential day-to-day consumption items.

Major steel producers decided to reduce prices by Rs 4,000 a tonne after meeting the Prime Minister Manmohan Singh on May 7, 2008. Some cement companies have also announced Rs 3 to Rs 7.5 reduction on a bag of 50 kg. However, it is believed that the government persuasion which lead the commodity manufacturers to reduce prices may not have long lasting effect, as their input costs also are increasing.

While inflation rate at 8.75% has brought out headlines in newspapers crying for immediate action, some economists assert that India's method of calculating inflation is wrong as there are serious flaws in the methodologies used by the government. How does India calculate inflation? And how is it calculated in developed countries? India uses the Wholesale Price Index (WPI) to calculate and then decide the inflation rate in the economy. Most developed countries use the Consumer Price Index (CPI) to calculate inflation. As a common man, I am a witness to the phenomenal increase in all items of daily use, which unfortunately doesn't reflect in the 8.75% inflation rate. To me, the inflation rate clearly appears to be understated. Thus, the actual inflation rate is expected to be much higher than what the official figures indicate.

As an outside observer, I believe that the Reserve Bank of India (RBI), is currently caught between two divergent objectives viz., currency rate management and inflation targeting. The appreciation in the Indian rupee which was happening, suddenly reversed trend and the rupee has gone back from around Rs.39 (for 1 USD) to around Rs.43 (for 1 USD) in a relatively short span of time. May be the outcry from export sensitive sectors employing large number of labour in concentrated locations / industry segments forced the Government to nudge RBI to allow the Indian rupee to depreciate vis-a-vis the USD. But it has also bloated the petroleum bill.

Today, we are at a situation where a very large segment of the population is suffering from the impact of inflation (which is the cruelest form of tax on the poor). May be allowing the currency to increase could be one of tools to use against inflation. How does it matter to the Aam aadmi that sensex is rising or falling? As of now, the situation is clearly unsatisfactory. Whip Inflation Now, is the message for politicians.