Rescuing a Deflationary World

We have had the very unusual spectacle of Asian Central Banks hypnotized by the snarl of the market cobra unleashing its fangs. While it is a natural human reaction to be thus mesmerized into inaction by a Cobra in the wild, there is little room for further inaction by Asian Central Bankers who stand similarly transfixed by an asset market collapse.

We had in a an earlier post (http://ageofdeflation.blogspot.in/2015/08/tantrum-not-us-fed-ahead.html) examined the chances of a USD,CNY and JPY carry trade unwind simultaneously as 1 in 31 and had cautioned that these odds are not so remote- all it needs is some senseless chores by guys with hands on monetary levers. And it has happened too soon for comfort. The US Fed seems hell bent on hiking rates at the same time when CNY and JPY carry trades are bursting. Now that's a sure recipe for disaster.

So what should Asian Central Banks do now that a simultaneous unwind of carry trades is in motion? Simple - ease monetary conditions domestically and let their respective currencies depreciate. Coupled with a possible weighing in of Govts' Fiscal support in the form of either Infrastructure investment or tax breaks for manufacturing and Services, the situation is imminently manageable. 

And what should the US Fed, BoJ and PBoC be doing? Firstly, the US Fed should stop playing the pantomime with the public. Every kid in primary school knows that his/her dad earns a lot less than 8 years ago- a wage deflationary spiral. So notwithstanding the Obama jobs boom, the take-home pay is deflating as efficiency gains outstrip hiring effects. So the lack of inflation is not surprising and the Fed should stop behaving as though if a rate hike does not go through in September it would mean a major loss in credibility. Secondly, the PBoC should finally achieve the lower bound in its targetted monetary policy rates to beat off a very likely deflation over the next 3 - 6 months. Thirdly the BoJ has to stabilize the Yen and ensure that the JPY does not overly strengthen against the US$ in order not to crush off the yen carry trade with precisely the wrong synchronous effect. The watchword here is stability. Reduce volatility. If the market must go down, let it go down 2% in a day for 5 days, rather than 10% in 1 day. 

Bad Bank/Good Bank

Now for some long term fixes- QUARANTINING of banking assets in Asian countries with pent-up credit booms now laid bare by an implosion into Non Performing Assets. The urgent need is for segregating banking assets into Good assets and Banking assets that have turned bad must be quarantined into a Bad Bank . It is important that there is a clear demarcation of bad assets into the single "Bad Bank" which will have separate recovery targets and capitalization. The rest of the "good banks" could only then function better with better credit targeting and allocation without the haunting fear of the ghosts of the past which irrationally constrains credit /raises cost of credit even to deserving borrowers with clean records. 

Government Investment into Non deflationary Infrastructure creation

In an era where every private entity is deleveraging, the State cannot also simultaneously deleverage. To rationalize take a simple case: In a closed economy, where there are only two agents, you and me, my spending is your earning and your spending is my earning. The entire world is a closed economy. If everybody is deleveraging, if unemployment is high, wherefrom economic growth will come? Hence the State has to invest in infrastructure such as Education, transportation, Tourism and the like that are inherently non-deflationary by borrowing at these historically low rates of sovereign bond yields. 

After forceful public investment lifts the economy from the deflation, the private sector develops the 'animal spirits' to restart investment- borrowing and hiring picks up. In this stronger phase of economic growth the private sector is more efficient than the public sector. Now here is where Keynes writings did not resolve issues because he wasn’t around to witness the decadence of public enterprise in the 1970's in the US/UK, and indeed in much of the globe including the USSR. However it was getting very obvious that in the 1970's, the size of the public sector was inefficient, gigantic and it was trying to borrow money from the same public resulting in crowding out of the more efficient private sector. The need of the hour then, was to cut down the size of the government and restrict the role of the state to only those areas where no other actor could qualitatively contribute. That's where Reagan and Thatcher came in, in the 1980's. But this is 2015. The situation is different. We are entering a global deflation. The only way out for a global recovery to gain ground is that Governments globally borrow massively and invest directly in the productive sectors of the economy. Roosevelt's "New Deal" needs to get replicated and for that to happen we need to really ignore traditional thinktanks like the IMF that had messed up in Latin America in the 80's and S.E. Asia in the late 90's and are now looking to repeat the same errors in 2015. Those who hold Reagan and Thatcher in great esteem can come in later, say in 2017, if by that time the global economy has been safely pulled out of the woods, and the private sector is getting back its mojo. By all means then-in 2017, dismantle the government and cut down upon activities that the private sector can do better. There will be lethargy on either ends of the economic cycle. Functioning democracies can tackle this type of lethargy and rent seeking on either ends of the cycle provided institutions are allowed to function the way they ought to.  

Of Global FX Devaluation Wars and Zero Sum Games

This is not a blame-fire write-up on China or any specific Country's FX devaluation policy because every country has done this at one point or the other in its history. Why blame China for a 3.5% CNY depreciation , for example, if Japan and the EU have both devalued their currencies by a flat 30-40% in the past couple of years. 

So this is not about naming and shaming FX de-valuers. This is about the nature of these beggar thy neighbour policies which are essentially Zero sum games. Over the last 5 years which country has truly benefited by playing the devaluation game? Name one country. I can't think of a single one. Because when the US is done in weakening the US$, the EU starts devaluing the EUR, and when both these guys are done, Japan says 'me too' and starts the same game- only to be followed famously by China now. So there's no great shakes in getting to devalue that filthy lucre that you print Mr. Central Banker so-and-so. What you can do, the next guy can overdo it, and destroy whatever little temporary benefit on the current account that you had derived previously. 

So we come to the central theme of this Global Devaluation Game- There's Nash equilibria out there- One of which is quite a no brainer - it happened way back in the 1930s and then exploded in 1939 in the form of a World War. Its all in the history books- well, Wiki is actually more accessible than those old books anyway!!

So why is everyone playing this game? Do they not know what is going on? Off course these guys are pretty smart. & Who told you that the great depression and the World War II was a very horrible time? Did you ask all those pumped up Bankers and Armament /Weapon producers who never sent their sons to fight in the War and die in those stupid bombings? The idea is to have a deflationary world- have unemployment - lots of it-so that young people are frustrated enough to believe and do anything preposterous - like frenziedly participating and dieing in another World War. That's the idea- Only a War, in this perverted scheme, can be suitably ignited to maximise the Keynesian pump priming that induces Sovereigns borrowing obscene sums of money to finance Wars run by Armaments /Weaponry Industry producing costly and immediately saleable weapons to kill those very young agitating to do something, anything. Problem solved. Big profits for the big guys and coffin caskets for everyone else. What a great time for these brainy chaps, no? Yes they are indeed very clever. Ask them why they have not used the record low sovereign bond yields in the G7 to borrow and invest in Infrastructure? They will speak some Hayekian non-sense like "Public borrowing crowds out private sector borrowing". Ask them where is the private sector borrowing now that Governments has actually desisted from investment? There's only share buybacks and cash surpluses maintained by private sector? Then they say, "Where is the climate for Investment? Governments need to create that climate first...", when it was these Hayekians who themselves stopped the Governments from actually doing so. You can easily understand why they say such dumb things. They are playing according to a script. They have the media, the smooth talking economists, everyone on their rolls. They are gunning for something big. Your money, your job, your son- & they will send across his body/news about his liquidation- one fine day, when they are done. Ask them why they will not allow Governments to borrow at close to zero costs and invest in supporting the economy through Infrastructure investments while they are ready to bankroll States/Nations in costly and meaningless Wars? Answer is profit margin. The margins are very poor when you do things the right way. But if you do it in the name of Lucifer, Well !! Well !! Stupendous margins in lending money at highest rates to war torn nations , not to mention the easy money that arms suppliers make on the rebound. Just add those coffins to the cost that simple folks will suffer BUT these smart guys will NOT INCUR.

This Nash equilibrium is being forced upon the world to benefit a very small circle of guys who will happily enjoy as millions and billions perish in another World War. 

So you get the drift- Ukraine, Afghanistan, Iran, Middle East, Africa- ISIS, Boko Haram etc. etc.

There's one Nash equilibrium which can be a regulated equilibrium where an optimal or a sub-optimal Nash equilibrium can be enforced if the G20 were to come together on issues like FX devaluation and trade. Since it is very clear that the Nash equilibrium discussed earlier is not in the interest of either Global peace or the World community, classical Game theory says that regulated behaviour amongst participants of the game can avoid a bad Nash equilibrium and move to another Nash equilibrium which is either optimal or close to optimal- but definitely atleast better than that bad Nash equilibrium. 

There has to be a global leadership away from the present one which takes on the onerous task of regulating the G20 away from the bad Nash Eq. This leadership is non-existent at present but the need is to get together and take the teetering world away from this bad Nash eq. Any effort is better than no effort- anything. 

Will leave you with three centrepiece blog extracts over the past 5 months- its worth a read to understand and read between the lines and join the obvious dots.

I. 20th May 2015

http://ageofdeflation.blogspot.in/2015/05/infrastructure-creation-fiscal-deficit.html

"...There is an urgent need to re- engineer strategy now that advanced economies have simultaneously launched an FX war on developing countries using zero lower bound interest rates and unconventional monetary policy. Developing economies cannot afford to join this zero sum game because their per capita incomes are very low compared to the developed economies. Ideally , all Governments in developed economies should use their prevalent low interest rates to borrow and supplement collapse in private demand by spending on infrastructure-both greenfield and maintenance of depreciating works. But these geniuses refuse to even consider such a policy relook and instead continue to debase their currencies in the hope of exporting their way out of deflation. The Nash equilibrium is very simple-Developing economies ape the same strategem and world spirals down a never ending FX war.

But there's a way out -There's another solution with superior payoffs as compared to the suboptimal Nash equilibrium above. Suppose developing countries that have the fiscal and inflationary room to increase government involvement in infrastructure spending, do so, then the resultant demand generation there can reinvigorate demand slowly elsewhere(especially in the developed world). This can serve a very useful purpose-Developed nations trying to export there way out of deflation will eventually export the deflation to developing countries if the latter fall into the Nash trap. Hence it is now in the interest of developing countries to search for demand generation internally. China best fits the bill with very healthy government finances and an Imminent deflation it wants to desperately avoid."

II. 10th June 15
http://ageofdeflation.blogspot.in/2015/06/the-real-malinvestment.html

"I can hear you say - But there's deflation already on in major economies, and higher investments at this stage will create more of the excess capacity and recreate stronger deflationary headwinds. Not if real unemployment is already in double digits and if the investment is likely to draw the pool of the unemployed or underemployed folks back to a decent job- which it will. These extra jobs/work that the investment creates will fuel demand immediately while the capacity creation comes only with a time lag - think 'Golden Gate bridge'. Since capacity creation comes only with a time lag post demand creation , as described above- the two are mutually reinforcing and there is no deflationary impact as is being feared by the Austrian school. ....

....but the underinvestment in most of the Western world is even worse and Chinese over-investment is a kid in size relative to the chimpanzee of the underinvestment pogrom that the 'Austrian' guys are doing to the great detriment of their respective economies. "

III. 18th March 2015
http://ageofdeflation.blogspot.in/2015/03/what-negative-sovereign-yields-signal.html

"...it is vey clear that in a deflationary environment private sector spending collapses and with negative yields supporting sovereign borrowing with beneficial fiscal spinoffs , the need of the hour is to sharply expand public investment in infrastructure,research and education. The answer is obvious-in the face of collapsing private sector demand only public sector demand can galvanize a deflating economy back to a modicum of health."

Tantrum Not ! US Fed Ahead !

Review time folks!!!- 17th March 2015 carried the following blogpost:

http://ageofdeflation.blogspot.in/2015/03/fighting-deflation-in-india-amidst.html

entitled “Fighting Deflation in India Amidst Capital flow Vulnerabilities and Imminent US Fed Rate  Hike“

So hows it been over the last 5 months or so? Lets review it now -

RBI cut repo rate once in June ‘15 by 25 bps. Indian 10 yr sovereign is almost unchanged at 7.8%. The US Fed has not moved and we think it will move in September or December for the first token increase in almost three quarter of a decade. US 10 year yields have moved up by about 20 bps to 2.25%. India’s FX reserves has increased by USD 20 Billion thanks to RBI’s strenuous efforts in this direction, even though Gold prices and bond holding MTMs have fallen- which goes to say that had these asset prices remained same over the 5 month period, the increase in reserves would have been optically higher. Our original model says under such conditions the currency should move almost as per the forward rate curve, and it has. There has not been much volatility in the currency pair since March, again in agreement with the model.

So what is next? The question uppermost on the minds of everyone is whether a US Fed Monetary Policy tightening will induce the same kind of volatility that we witnessed in July 2013? The US Fed is now getting very certain that their target Federal Funds rate should be at least 125-150 bps higher until December 2016 next year given the strength of the US economy, if not more. The issue at hand is critical- what if US$ carry trade unwind and JPY carry trade unwind were to coincide with a Chinese stock market crash(See https://ageofdeflation.wordpress.com/2015/07/10/avoiding-chinese-collapse-and-a-simultaneous-jpy-carry-trade-unwind/) when the US Fed has hiked rates by 125-150 bps by 2016 end? Then it will be a global market crash- India included- and Indian asset markets will take a drubbing in such a worst case scenario(this scenario has a 3% probability).  

Probabilities scientifically to all the possible 8 scenarios:

State of Macroeconomy	Probability of Macro economy to exist at the given state; incorporating all publicly known information	Expected Policy Response from Aug '15 until Dec'16
eco doing gr8; inflation at 5%	20.00%	25 bps rate cut
eco doing gr8; inflation at 6%	37.50%	no rate cut
eco doing gr8 inflation at 5.5%	10.00%	no rate cut
eco not doing well but inflation at 6%	10.00%	no rate cut
eco doing badly, inflation at 4%	7.50%	50 bps rate cut
eco doing great ; inflation at 7%	7.00%	25 bps rate hike
eco doing great inflation hitting 7.5%	5.00%	50bps rate hike
eco doing very badly inflation at 3%	3.00%	75bps rate cut

The Average expected Policy response is -6 bps, with Standard deviation  of 24.5 bps. So (Mean - Sigma is -30.5 bps) and (Mean + Sigma is +18.5 bps).  

So what about the Indian 10 year yield and the USD/INR? Based on the probability distribution of various scenarios as above, and based on the likeliest concurrent US Fed /US Economic scenarios as detailed below, the currency and the 10 yr yield in India would stand at three different combinations (a),(b),(c) as detailed in the last column below:

State of Macroeconomy	Probability of State 0f Macro economy to exist	Expected Policy Response from Aug '15 untill Dec'16	State of Macroeconomy	us fED fUND RATE	US 10 Yr	India FX Reserves	INR	India 10 YR
eco doing gr8; inflation at 5%	20.00%	25 bps rt cut	eco doing gr8; inflation at 5%	1.5	4.25	Unchanged	(a) 68.8 (b) 69.1 (c) 69.45	(a) 8.15% (b) 7.8% (c) 7.4%
eco doing gr8; inflation at 6%	37.50%	no rate cut	eco doing gr8; inflation at 6%	1.5	3.75	Unchanged	(a) 68.8 (b)69.15  (c) 69.35	(a) 7.9% (b) 7.5% (c) 7.25%
eco doing gr8 inflation at 5.5%	10.00%	no rate cut	eco doing gr8 inflation at 5.5%	1.5	4	Unchanged	(a) 68.8 (b) 69.1 (c) 69.45	(a) 8.15% (b) 7.8% (c) 7.4%
eco not doing well but inflation at 6%	10.00%	no rate cut	eco not doing well but inflation at 6%	1.5	3.25	Unchanged	(a) 68.8 (b) 69.15 (c) 69.25	(a) 7.4% (b) 7.1% (c) 6.9%
eco doing badly, inflation at 4%	7.50%	50 bps rate cut	eco doing badly, inflation at 4%	0.75	2.5	320 Billion US$	(a) 68.8 (b) 69.15 (c) 69.35	(a) 7.5% (b) 7.1% (c) 6.9%
eco doing great ; inflation at 7%	7.00%	25 bps rate hike	eco doing great ; inflation at 7%	1.5	3.25	Unchanged	(a) 68.8 (b) 69.15 (c) 69.35	(a) 7.65% (b)7.25% (c) 7%
eco doing great inflation hitting 7.5%	5.00%	50bps rate hike	eco doing great inflation hitting 7.5%	1.5	3	Unchanged	(a) 68.8 (b) 69.15 (c) 69.35	(a) 7.65% (b) 7.25% (c) 7%
eco doing very badly inflation at 3%	3.00%	75bps rate cut	eco doing very badly inflation at 3%	1.5	3.75	300 billion US$	(a) 68.8 (b) 69.1 (c) 69.3	(a) 8.35% (b) 8.0% (c) 7.8%

Having run the numbers, the takeaway is mainly that there is very less chance(3%) of markets getting spooked in India against a general reversal of carry trade in the US and in Japan. So less reason to worry overall. Indian sovereign yield hunters need to sharply look out for signals from the FX markets including USD/INR and India’s FX reserves and not to forget the steepness of the US Yield curve. Having said that, 3% probability is 1 in 33 and not so uncommon after all. Some concerted tomfoolery is all that is required to hit that!! Hope folks across vales and ponds are a bit mindful of that when they go about their daily chores.

Charts for reference - US 10 yr; USD/INR FX; Indian FX reserves