Saturday, May 15, 2004

I'm back... returning to blogging this weekend


My apologies to anyone whose been trying to read this blog regularly. The past two weeks have been exhausting. First there was the end of term madness, then there was a trip, then getting back and getting some work done, a bon voyage party for an academic associate, and finally recuperation.

There are lots of interesting things to talk about, including monetary policy, oil and gold prices, India's political reversal, etc.

It would simply be exhausting in order to jump into it all at once, so I'll be breaking it up into individual topics over the next week or so. Never fear though, things will get back on track and all the important topics covered.

The most stunning news probably however is the reversal of the conservative and pro-free-trade BJP ruling party in Indian parlimentarian politics, see here the report by the Economist.

Congress officials insisted on Friday that India’s economic liberalisation, which began under their last administration and continued under Mr Vajpayee, would remain on track. Nevertheless, the Indian stockmarket slumped amid worries that the inclusion of the Communists in any Congress-led coalition would put the brakes on economic reform and spell the end of India’s privatisation programme. Adding to investors’ worries is the voters’ rejection, in state-assembly elections held simultaneously, of well-known reformist leaders: for instance, Chandrababu Naidu, the chief minister of Andhra Pradesh, helped turn the state capital, Hyderabad, into one of India’s IT hubs, but was swept out of power in a landslide.

After months of self-congratulatory government propaganda about how “India is shining”, the election upset is an embarrassment for almost every pundit and pollster in the country. A BJP victory had supposedly been inevitable, yet the party lost more than 40 of its 182 seats. As Congress struggles to build, and then govern with, a broad coalition, the result may be bad for political stability, as well as for economic reform. But, as Mr Vajpayee graciously conceded in a televised address announcing his resignation on Thursday night, it has been a triumph for democracy. “My party and alliance may have lost but India has won,” he said...

Encouraged by a good showing in state elections last December, BJP strategists had persuaded Mr Vajpayee to call a general election a few months early. They argued that the BJP should capitalise on an economic boom, and on the unrivalled prestige enjoyed by the prime minister himself. A lavish monsoon last year was an important contributor to India’s soaring rate of economic growth, of more than 8% this year, and to what the BJP misdiagnosed as a national “feel-good factor”. But the states of Andhra Pradesh and Karnataka suffered yet another year of drought. There, the shortage of water mattered far more to most voters than the latest call-centre. In fact, the “India shining” campaign had little resonance for the two-thirds of the 670m voters who live in the countryside, and remember the bad years that preceded last year’s monsoon. A quarter of India’s people still live in severe poverty...

An unstable coalition government, relying on the support of the Communists, is unlikely to prove radical, and may be short-lived. But there are some grounds for optimism: Congress’s manifesto commits it to a policy of sustaining and even accelerating current rates of economic growth. With luck, the coalition it is likely to lead will quickly realise that this will be near-impossible without continued reform: cutting the fiscal deficit; continuing to foster competition; and privatising more state-run enterprises. Rural India’s rebuke for the BJP should encourage the new government to spread some of India’s alleged shine to the gloomier parts of the countryside. Properly interpreted, it should not thwart reform, but spur it.

The Christian Science Monitor has a more indepth analysis of the political currents surrounding the popular sentiment on the BJP's modernization and trade programmes.

The surprising result springs from growing discontent among Indian voters about a decade of economic reform and economic growth that left the common man untouched. Yet, while some analysts say a Congress-led government would soften the effects of economic reforms, few expect Congress to halt India's free-market embrace.

"This was a vote against economic disparities" between rich and poor, says Rajeev Bhargava, a political scientist at Jawaharlal Nehru University in New Delhi. "It's not a vote against economic reforms."

The ruling BJP was "overconfident" after winning a series of state elections last fall, Mr. Bhargava says, and quickly called national elections six months earlier than required. But instead of applauding the BJP for economic reform, says Bhargava, the voters - and especially rural and poor voters - sent the BJP a stinging message.

"Ten years of reforms have created two different Indias," says Bhargava. "One looks abroad and links itself to the international world of business and politics. There is another India that was left completely behind. And the second India is the much larger one. This group doesn't express itself on TV or in magazines, and the only way that it can express itself is through the ballot."...

But while Jha says the Congress will shift the government's policies to focus on the problems of poorer Indians, Congress is unlikely to abandon reform altogether. Instead it is likely to pump government money into needed infrastructure projects like electrical power plants and highways, all in an effort to create hundreds of thousands of new jobs. It will also slow down the pace of reform, delaying efforts to take away subsidies that benefit middle and lower income households, on items like cooking gas, electricity, or education.

Bhargava says the results took people by surprise mostly because the urban Indian chattering class - including politicians, academics, and news reporters - are themselves cut off from rural India.

"It's very typical of people who rely on urban media for their information," he says. "They get taken in by their own hype, and start believing that it's true. The BJP completely lost touch with the people."

Daniel Drezner recently had an article about the "turning of the tide" regarding the rhetoric about trade- in the favor of trade. To be fair he also has a new article up exploring the political dimensions of the Indian episode.

However Dan's analysis leaves out an important point. The elites and intellectuals who had dominated the political discourse of trade in India had completely mistaken public sentiment on the topic. This cost them a political majority for the BJP party despite impressive official growth statistics, numerous "star" or hiprofile projects to accentuate the public relations of the prosperity the trade programmes were bringing, and an impressive level of support for the BJP's handling of foreign policy. There are certain parallels to the 1992 election loss of GHB in the United States. [Full Disclosure: I voted for George Herbert Bush in the 1992 Presidental election - and would again in a heartbeat.]

With the full power of industry funded groups, (jury-rigged) government statistics, and academics (defending idealistic models that have little resemblence to actual practices), and the political lobby of elites it's little wonder that the formal rhetorical battle has been pretty much won by the powers that be. What is less certain though is whether or not the average person has been truly convinced that the evidence of their eyes and pocketbooks can be rationalized by numbers and arguments by talking heads and wonk-style books.

The right-wing has been infamous for bashing the opinion generated "inside the Belt-way" (the ring of highways surrounding the DC metro area) and academic intellectuals disconnected from the real world, and instead appealing to the "silent majority" whose opinions vastly differ from the sophicasted and erudite beliefs of the social elites.

I see no reason to break with tradition. I would as a conservative point out that the opinion of the average person in this country on trade is still up for grabs even if the dominating meme on the airwaves happens to be the pro-"free trade".

It is without question that we are experiencing now a (long overdue) economic recovery and that this has mostly been due to the cheap money afforded by the Federal Reserve.

Yet the recovery is sickly. Job creation has been suspiciously long delayed, and the fact that it is picking up now in official statistics is no refutation that trade-related job transfers overseas along with capital flight may not have played a role in delaying that job-growth. There is the vastly over-inflated real estate market which is still scorching hot, and either it is a bubble or it is definitive proof that the CPI really is fixed. When housing prices which form such a large portion of the American lifestyle's long term costs are rising so precipitiously, and the CPI is showing tiny increases in inflation then there is something seriously wrong.

Buttonwood in The Economist explores some of the dynamic issues associated with market risk in the incipient interest rate environment.

THIS year’s dramatic rally [in bonds] has assumed that inflation is conquered, at least for the foreseeable future. Rising yields would indicate a change in that sentiment. As for Wall Street, its giddy share prices are partly explained by low bond yields, so it would presumably suffer a sharp correction if those yields rose…at current levels the bond market deeply trusts the Federal Reserve’s ability to deliver low inflation.” Plus ça change. Buttonwood wrote the above sentences in October 1993, a month after joining The Economist, and ended his piece by quoting an analyst who expected a rise in rates by the Fed “to cause anything from panic to riot”. And a riot of sorts there was. As the Fed doubled rates in 1994, to 6%, bond yields shot up, the mortgage-backed securities market fell apart and stockmarkets had a horrid time. So did emerging markets: spreads over Treasuries on emerging-market debt soared and the year ended with Mexico’s tequila crisis. [emphasis added]

The oldman has long insisted that the official statistics regarding inflation have contained biases that understated price increases and consequently overstated actual economic growth and productivity. However as The Economist explores, the current monetary policies of the world central banks are skewed toward an explosive situation where even official government metrics of inflation may be set for a disasterous rise. You can also view the brief Brad Delong entry, where he hilights the contrasting US and China central bank policy. Remember the oldman has stated that one of the requirements for managing this tricky situation is international coordination between the central banks.

CHEAP money and expensive oil sounds to many like a dangerous, inflationary combination. Nominal interest rates remain at historic lows in the United States, Japan and the euro area, while oil prices (unadjusted for inflation) are hovering around 13-year highs. China in particular is both awash with liquidity and thirsty for petroleum. Inflation there is at a seven-year high, with consumer prices rising by 3.8% in April compared with the year before, according to figures released on Friday May 14th. Meanwhile, sales of petroleum and related products grew by more than half over the same period. According to the International Energy Agency, China now consumes 6m barrels of oil per day, 1m more than a year ago.

Saudi Arabia, with its large reserves and spare capacity, remains the “swing producer” of the oil world. Its energy minister, Ali al-Naimi, has already urged petroleum exporters to raise the supply of oil in order to bring prices down. Many now fear that Alan Greenspan—who, as chairman of the Federal Reserve, acts as the swing producer of the financial world—will rush to tighten the supply of money. The futures market suggests that American interest rates, still at 1%, will double before the end of the year, and reach 3.5% by the end of 2005. Mr Greenspan himself, however, shows no signs of being rushed into anything. Oil prices may be surging and China may be overheating, but inflation in America remains manageable. According to figures released on Friday, consumer prices rose by 0.2% in April, month-on-month (the figure for the year to April was 2.3%). Mr Greenspan’s pace, then, as he promised at the Fed’s last meeting, is “likely to be measured”.

This situation is likely to be resolved in either one of two ways. Either the American dollar will experience a 30% devaluation and oil and gold prices will rise roughly 25% with a potential US debt and bond market crisis, or there will be an increase in real inflation world wide of perhaps 10%. Why 10%? Well to put it crudely, the US GDP share of the world GDP is about 30%. If the US manages to spread the damage around with the cooperation of central banks, that would mean roughly dividing by a bit more than three (3). The world wide rise in price metrics would be in actuality about 8-9% inflation increase across the board.

There are intermediate or mixed strategy scenarios, the two options above only present the extremes. Why a 30% devaluation? According to Brad Delong, his excellent summary in the form of a modernized Platonic discourse summarizes what would be a complete unwinding of the divergences in the markets if market efficiency were to be allowed by government policy to "correct the market".

Studentios: So what should U.S. long-term interest rates be?

Aristodemos: On the international side, to reduce an unsustainable 5% of GDP trade deficit down to a sustainable 2% of GDP trade deficit requires--according to standard rules of thumb--a 30% decline in the trade-weighted value of the dollar. That should take place in the medium to long run of less than a decade. That implies that the yield on U.S. 10-year Treasuries should be 3 percentage points above the yield on Europeans...

Xenophilos: On the domestic side, we expect investment as a share of GDP to rise by 2 further percentage points in the medium run as the recovery takes hold. We don't expect the private savings rate to recover. We don't expect the government budget deficit to fall. We do expect the net capital inflow to decline from 5% of GDP to 2% of GDP. That's a 5% of GDP investment financing gap to close, which would normally requires a 2.5-5 percentage point increase in interest rates.

Sophia: The market doesn't see it. [emphasis added]

There are three things that are clear
1. There will be a market correction of one sort or another, it is merely a choice of poisons of preference at this point.
2. No one can tell you exactly when that market correction will take place. Keynes can be quoted here to profit: "The market can stay irrational longer than you can stay solvent."
3. The really interesting details from the view points of mere mortals are the where the money is to be made.


As my friend Larry once noted, no one can reliably predict exact market turning points in either individual equities or market movements. The best anyone can do is capture the "fat" of the shift - you'll miss the first 10% of any move and you'll miss (on average) the last 10% of any move but it is possible to capture the middle 80% of any given move. It's also never possible to always see the winners, but it is possible to avoid the stinkers - even if in the process you once in a while mistake a winner for a stinker. Remember the primary principle of financial investing is to protect the principal. This has been a principle egregiously violated by the banking, financial advising, financial management, and regulatory organizations in this country. You want to protect what you have while adding to what you have at a reasonable return to risk ratio whenever possible. This fundamentally conservative ethic of investing is different from financial trading based upon speculation, which seeks to make big bucks by making big bets, but accepts unreasonable risks in return.

The series of articles that I am going to proceed to write, on the gold market, on the oil market, on the Chinese currency (the renmimbi) will explore the details of such a general shift in the markets and the local and regional impacts on various economies throughout the world.

However in this article I've laid out the main rationale for why there should be a shift and roughly how big that shift will be. Everything else is just details, but as they say the devil is in the details, and since Mammon is the devil of money that's where we need to dig in order to find just exactly what is going on with the money.

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