Same Old Hope: This Bubble Is Different

This time is different.

That’s what people argue every time a bubble inflates, and what they think every time they lose money when it pops. But year after year, decade after decade, century after century the process repeats all over again.

Not long ago, the housing bubble burst and brought the global economy to a standstill. Now investors, recognizing that bubbles tend to come in bunches, are on the lookout for the next market to fizzle. Possible candidates are the capital markets in China, commodities like gold and oil, and government bonds in heavily indebted countries like the United States.

Bubbles are episodes of collective human madness — euphoria over investments whose skyrocketing values are unsustainable. They tend to arise from perceptions of pending shortages (as happened last year, with the oil bubble); from glamorized new technologies or investment frontiers (like the dot-com bubble of the 1990s, the multiple railroad bubbles of the 19th century); or from faddish cultural obsessions (like the Dutch tulip bubble of the 17th century).

Often they are based on legitimate expectations of high growth that are “extrapolated into the stratosphere”. Such is the fear over investment in emerging markets like China. “I am a long-term bull on Asia, but right now it’s premature to be celebrating the ‘Asian Century,’ like some investors seem to be doing,” said Stephen Roach, chairman of Morgan Stanley Asia.

But a sovereign debt bubble — which many argue is driving the acceleration in gold prices — could prove far more dangerous. So many countries, like the United States, are running up such large national debts as a percentage of their overall economies that they could risk eventual default. Even without outright default on their obligations, the value of government bonds sold to finance these deficits could plunge, costing investors a lot. Debt crises are usually associated with developing countries, like Brazil, Argentina or Zimbabwe. But they can affect big, rich economies too, where the scale of global damage can be much greater.

The depth and breadth of the pain unleashed by the recent housing bust have led political leaders and central bankers to reconsider their duties to preempt, rather than just respond to, potential bubbles, and the same is true with the potential bubbles that economists foresee today. China has started to tighten monetary policy to rein in the hype surrounding its equities. Politicians in the United States, while torn over the means, are discussing ways to bring the deficit until control. The G20, at its coming meeting in Pittsburgh, is expected to address ways to calm financial frenzies. The solution may involve additional regulation, guidelines for financial compensation and possibly requirements for more market transparency so that, at least in theory, investors can better judge what they are taking on.

But however stringent such new regulations may be, economists say, they cannot completely defeat human nature. Investors will continue to be hypnotized by get-rich-quick deals, seeking investments that magically double, triple even quadruple without toil or trouble.

Ultimately, bubbles are a human phenomenon. Sometimes, people just get a little crazy.

PS: This is a summary of an article from the New York Times. View the original here (Registration required)

Don’t Count Your Recoveries Before They’re Hatched

Ben Bernanke, the Federal Reserve chairman, sees “green shoots.” President Obama sees “glimmers of hope.” And the stock market has been on a tear. Are we out of the woods? Is the recession about to end? The recent news is certainly better but there are many reasons to be cautious about the economic outlook.

The International Monetary Fund (IMF) has just issued its gloomiest forecast ever. It says world GDP, which has never shrunk since the Great Depression, will shrink 1.3% in 2009, and then inch up to 1.9% in 2010. Growth of less than 2% indicates a global recession. So, serious recovery will not come before 2011.

The IMF sees world growth being strangled by what it calls negative feedback loops. The financial crisis first reduces cash flow to producing sectors. This causes a recession, with producing sectors slashing production and employment. But the recession then makes the financial crisis worse — more corporations and individuals default on bank loans. The banks respond by cutting credit further, and this hits production and employment further. This is the negative feedback loop.

The current global recession is likely to be unusually long and severe and the recovery sluggish because it sprang from a financial crisis. New IMF analysis shows recessions tied to a financial crisis, like the current one that has its roots in reckless lending for the U.S. housing market, are more difficult to shake because they are often held back by weak demand. Worse still is that today's recession combines a financial crisis at the heart of the United States, the world's
largest economy, with a broader global downturn making it unique.

The 2001 recession officially lasted only eight months, ending in November of that year. But unemployment kept rising for another year and a half. The same thing happened after the 1990-91 recession. And there’s every reason to believe that it will happen this time too. Don’t be surprised if unemployment keeps rising right through 2010.

Why? “V-shaped” recoveries, in which employment comes roaring back, take place only when there’s a lot of pent-up demand. That’s not what’s going on this time: today, the economy is depressed, loosely speaking, because we ran up too much debt and built too many shopping malls, and nobody is in the mood for a new burst of spending.

Capital Flows And The Financial Crisis

The latest issue of the The Economist has a great article on how America's huge current-account deficit and China's huge Current account surplus together created enormous global imbalances. A growing number of policymakers and academics believe that these lay at the root of the financial crisis.

To read more click here

Something New to Worry About: Deflation

'Inflation' is something that most people understand quite well. Whenever prices rise, the public, the government, the media work themselves into a frenzy. On the other hand, 'Deflation' i.e. a fall in prices is mostly ignored by the public. It might seem hard to understand what the problem is with falling prices. If all they mean is that we can buy stuff for less this month than we could have a month ago, what’s there to worry about?

A lot. If prices persist in their decline, they could be devastating to the economy. To understand the impact of deflation, we have to understand what it really means.

What Is Deflation?
"Deflation" is a contraction in the volume of money and credit relative to available goods.

The most common misunderstanding about inflation and deflation is the idea that inflation is rising prices and deflation is falling prices. General price changes are simply the effects of inflation and deflation.

During a deflationary phase there is a general decline in prices, with emphasis on the word "general". Sector-specific price declines are generally not a problem for the economy as a whole and do not constitute deflation. Deflation occurs only when price declines are so widespread that broad-based indexes of prices, such as the consumer price index, register ongoing declines.

There are four causes of Deflation are:

1. Decreasing Money Supply
2. Increasing Supply of Goods
3. Decreasing Demand for Goods
4. Increasing Demand for Money

Danger Of Deflation

A sustained drop in prices hurts in two ways.

Impact On Consumer Spending
Because consumers and businesses expect that prices will continue to fall, they would be likely to cut back further on spending and investment. As spending dries up, the economy starts to shrink. As GDP shrinks, so do the companies providing those goods and services for consumers. As companies shrink or go out of business, unemployment rises. Out-of-work consumers have less money to spend, which cuts deeper into the economy. Once the cycle takes hold, it's very difficult to stop. A downward "spiral" begins, feeding on pessimism.

Impact On Debt Servicing
Even more debilitating is the impact on on consumers’ ability to service their debts.
Suppose you have a loan of Rs 10000 and you earn Rs 1000/year. There is heavy deflation, prices and salaries fall. Your salary might go down to Rs 900/year, but your loan would remain the same. Suddenly repaying the loan has gotten a lot tougher.

A deadly mix of falling prices and high leverage could foment a “debt-deflation” of the type first described by Irving Fisher, an American economist, in 1933. In this worst-case scenario, banks concerned about their corporate customers’ indebtedness demand debt liquidation, which forces firms to sell off assets at fire-sale prices to pay them back. Money in circulation declines as banks hoard the dollars, which causes spending to drop and prices to fall, depressing businesses’ net worth and profits and throwing many into bankruptcy. Companies cut production; workers are laid off. This deepens pessimism and leads to more hoarding of money.

The current American Federal Reserve chairman, Ben Bernanke made a presentation before The National Economists Club, Washington, D.C.on November 21, 2002. It is a really good document considering that it was written way back in 2002
(You can read the 2002 speech here)

US T-Bills Giving Zero Return

On 9^th December 2008 the US Government sold $30 billion in four-week Treasury bills at zero percent. In the market equivalent of shoveling cash under the mattress, hordes of buyers were so eager to park money in the world’s safest investment, United States Government debt, that they agreed to accept a zero percent rate of return. Investors shaken by the losses in the markets are pouring cash into government bonds from every corner of the globe.

Why is this significant? I will get to that but first some key facts:

• A T-Bill or a Treasury Bill is a short-term debt obligation backed by the U.S. government with a maturity of less than one year.

• T-bills are commonly issued with maturity dates of 28 days (or 4 weeks, about a month), 91 days (or 13 weeks, about 3 months), 182 days (or 26 weeks, about 6 months), and 364 days (or 52 weeks, about 1 year)

• Like zero-coupon bonds, they do not pay interest prior to maturity; instead they are sold at a discount of the par value to create a positive yield to maturity. US Government Treasury bills are regarded as the least risky investment in the world.

The formula for the calculation of the yield on T-Bills is:

Significance Of T-Bill Yields

In itself the zero percent interest rate is no reason to panic. This is good news for American taxpayers in general. Low interest rates on government debt allows the United States to finance its $700 billion bailout of the financial system very cheaply. But it also underlines stubborn anxiety in the financial markets that could keep world economies sluggish for years to come. This extremely cautious approach reflects concerns that a global recession could deepen next year, and continue to jeopardize all types of investments.

High demand for government debt rather than corporate debt could stifle economic growth. Even though Central Banks all over the world have reduced interest rates, borrowing costs for companies remain stubbornly high. Corporate bond rates have been surging to record levels which makes it more expensive for companies to raise money. And when companies can't raise money, they often have to cut costs, sometimes through layoffs.

The worry is that the government will become the most attractive lender and borrower in the market — crowding out others in the private sector.

PS: Daily Treasury Yield Rates are available at the following website:

http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

Worry About The Credit Crisis

What is the most important part of a house? Is it the garden, the living room? Maybe it's the kitchen. Actually, it is the electrical wiring and the plumbing - the bits you cannot see. So it is with financial markets. The stockmarkets are the most visible part of the system. The money markets, however, are the plumbing of the system. Normally, they function efficiently, allowing investment institutions, companies and banks to lend and borrow trillions of dollars. They are only noticed when they go wrong. And, like plumbing, when they do get blocked, they make an almighty mess.

First, the problem. It is widely assumed that central banks (The Reserve Bank of India, for example) set the level of interest rates in their domestic markets. But the rate they announce is the one at which they will lend to the banking system. When banks borrow from anyone else (including other banks), they pay more. Every day, this rate is calculated through a poll of participating banks and published as Libor (London Interbank Offered Rate) or Euribor (Euro Interbank Offered Rate). Normally, these are only a fraction of a percentage point above the official interest rates.

In the last few months the spread between the Libor and the Fed Funds Rate has widened to almost 200 bps(basis points). The width of the margin reflects investors’ worries about the strength of the banks. Three months is now a long time to trust in the health of a bank. In addition, banks are anxious to conserve their own cash, in case depositors make large withdrawals or their money gets tied up in the collapse of another bank, as with Lehman.

Why do these markets matter? First, the rates on loans paid by many consumers (floating rate home-loans, for example) and companies are set with reference to the money markets. Higher rates for banks mean higher rates for everyone. Second, if the markets are blocked for more than a week some companies may find it hard to get any finance at any price. That could mean more bankruptcies and job losses. Third, more banks could go bust if the blockage continues, making investors even more risk-averse. The downward spiral would worsen.

Deprive a person of oxygen and he will turn blue, collapse and eventually die. Deprive economies of credit and a similar process kicks in. So it is safe to say that, until the money markets behave more normally, the financial crisis will not be over. And until the financial crisis is over, the global economy may not recover.