Class warfare is a misguided notion in policy making

President Obama has appointed Vice President Biden to create a task force to help the "middle class." Since the definition of "middle class" has been eluding for most, it is unclear exactly who will be helped by the task force. More importantly, it introduces a notion of class warfare and segmentation in the society. It is equally objectionable to those who may not fit the definition because of wealth and to those because of lack of wealth. We have seen classes in many societies - driven by religion, color and economics. A class based society will be, by definition, sub optimal as it will introduce a wedge into solutions that will help all. The right policies are the ones that will increase societal utility as a whole and not favor one class over another. Optimal policies are the ones that target a solution to the problem - the problem being the existence of classes to start with. The question is both why we have poverty and why not all are able to create wealth. The solution is not reinforcement of existing classes but the complete elimination of them through policies that create an environment that allows everyone to work and compete and thus increase societal utility. Compassion alone is not a sufficient condition for better policy making.

Financial forecasting "hedges"

Most in the print and TV do not say anything without a hedge. This way, nobody is ever wrong. Listening to these expert opinions may help or hurt your portfolio! Here are some examples of statements heard on one of the leading financial and business TV.

(a) Market is in a bottoming process (most used phrase on TV today. This statement is always correct. Nobody, however talks about a "topping" process)

(b) I think it is going to look better but I am not investing yet.

(c) We many not have a V or U shaped recovery. But we are heading in the "right" direction.

(d) Risk appetite will return to market but it will take time.

(e) Investing is a journey. There will be stops and starts.

(f) Market volatility will continue.

(g) It will get better eventually but before that it may get worse.

(h) It may get worse but before that there will be a rally.

(i) It is a great company but there is a chance that the stock price may not do well.

(j) I will buy Oil when it goes up but not before as it may go down.

(k) Oil will go back to $100 eventually but before that it may go down to $20.

(l) We are looking for a turn in the market. We can't say what it is but we will know when it comes.

(m) To win in the market, you have to buy good companies and avoid bad ones.

(n) If you believe market is going up, you should buy. It depends very much on your "outlook".

(o) Apple is an "up" stock but sometimes it goes down big.

(p) Market may go down but I am buying as it can also go up.

(q) I am bullish on the markets but I remain on the sidelines.

(r) Market will meander in a wide trading range.

(s) I am very cautiously optimistic about the market.

(t) Market will test the low again sometime but meanwhile we can expect great rallies.

The incredible story of the Japanese stock market

 

The Japanese stock index (Nikkei) today is 25% less than what it was in January 1984. The GDP tripled in nominal terms during the same time, similar to the US. It is a shocker for any who associate stock prices to GDP in forecasting market trends. Just a few months ago, many emerging market experts were using GDP growth as a proxy for stock market expectations in those countries, with disastrous consequences. Some use the same argument today for the US to prove that the S&P is 50% undervalued.

Stock certificates are claims on the company's ability to generate profits in the future. It is unlikely that one can capture an alpha (risk adjusted excess returns) by just investing in companies that domicile in countries that show fast growth or finding an apparent mismatch between aggregate GDP levels and stock prices. Since current GDP and future expectations of GDP are well known to the markets, such information do not have any premium that can be captured through financial instruments. Also, in an integrated world economy, the domicile of a company is increasingly irrelevant as companies from all around the world constantly shift strategies to adapt to changing growth expectations in different countries. When a shock happens that result in revisions of growth for the country, the financial assets of the companies that are exposed to the country, quickly adjust to it.

The data from Japan may also mean that markets take time to fully adjust to a shock that substantially revises future expectations. Both the 1990 and 2000 bubble bursts took nearly 18 months to fully adjust. This is not a challenge to market efficiency as information during that time provided further clarity as to the full effect of the bubble burst. None of these, however, allow anybody to predict asset prices in the future. On the contrary, it demonstrates that those who are engaged in predicting future prices of commodities (such as stock) using well known macro information may be wasting valuable time and resources.

Why China and India should float their currencies to be long term competitive

China and India still manage their currency pegs in an apparent attempt to make the countries more competitive. This assumes two things: (a) A few people in each country know what the optimal exchange rates are and (b) by keeping such an exchange rate, they can strategically engineer the country to be more competitive. Both of these ideas are false.

First, by maintaining an artificial exchange rate,  both countries are propping up industries such as commodity manufacturing (in China) and commodity services (in India) behind an unsustainable labor cost advantage. These artificial currency regimes create inefficient allocation of capital (by the private sector and the government) as well as human resources (by individuals electing to follow certain education and career paths). If the explosion in employment in these industries was largely driven by labor arbitrage, masses of population will be unemployed and unable to transition to other industries in the future when such an arbitrage ceases to exist. This is a catch 22 for policy makers as by holding the tiger by its tail (by keeping artificially low exchange rates), they have gotten into a situation that they cannot let the tail go (as it will create significant immediate unemployment and social unrest). This is a good lesson for future policy makers.

It is probably better for both China and India to take the short term pain (rise in unemployment and slower growth) for long term gain. A floating currency will force companies to compete directly based on skills and innovation (rather than artificial low cost). This will result in a more optimal allocation of capital and human resources into different segments. If China and India really want to be long term competitive economies, there is no other way than having free floating currencies and joining the international economic society, unhindered.

Finally, the idea that few government bureaucrats can strategically engineer optimum long term growth by managing currency rates is preposterous.

Back to work

The (inauguration) party is over and now it is back to realty. The new administration has number of challenges. Fiscal policy has limitations and assuming that the government can solve the structural problems in the economy may lead us to the wrong path. What makes the economy work is the private sector, risk taking and creativity. Aiding any of these will help us recover but not age old prescriptions of heavy and mindless spending - sort of fiscal shock to stir the economy into action. Such fiscal shocks do not work and will drive us toward  a regime of higher inflation and lower productivity in the future.

What we need is a complete restructuring - that includes the failure of unprofitable business models ran by incompetent people, incentives for innovation and higher flexibility. The aspect of flexibility gets little attention in policy prescriptions. US has a higher level of labor flexibility compared to other countries - aided by location flexibility and diversity. But that is not to say that the flexibility can be further increased by good policies. Any move toward protectionism in trade and immigration will reduce flexibility and the ability of the economy to recover. Similarly, any reduction in incentives for business investment (either through higher marginal income taxes or government mandated costs) will reduce flexibility in the entire economy and dampen innovation. Increasing innovation is the ultimate flexibility enhancer. This can only be done by allowing free flow of ideas and trade and an economy driven by creation of new businesses allowed by lower income taxes and no mandated costs.

It is time to get to work.

Are manned space missions worthwhile?

Ever since the ambition of landing a human on the Moon was stated and achieved, manned space flights have been integral to the strategy pursued by many space administrations around the world. Manned space missions are more costly than non-manned ones. Unless the incremental benefits from manned missions is positive, they will destroy economic value of the portfolio of missions pursued by NASA and other space agencies. The first mission to the Moon, the one proposed by the current administration to Mars as well as the variety of manned programs under development in many countries currently - all appear to be designed with the goal of "increasing national pride" rather than improving information and knowledge. Many science programs in schools and other organizations also seem to assume without question that manned space missions are "a good" to society.

The fundamental question is what the benefits are from manned space missions. One argument is that such missions collect information that cannot be gathered from the Earth. Advancing technology may make this less likely. If technology does not advance fast enough, sending probes can be an alternative. But this is a chicken and egg problem. If we assume that manned space missions are the way to collect information, resources will flow into technologies that assist manned missions, slowing down innovation in technologies that may have brought us the same information by other ways (observation, probes). Another argument is that we have to be "prepared" to leave the earth and these manned space missions allow us to understand the challenges of long space flights when we leave. This argument also suffers from the same issue as before. If we assume that humans, as they exist today, need to be transported to hitherto unknown space location in the future, much resources will be spent in designing the transportation mechanism and less on changing what is transported.

Recently, there was a bill introduced in the Congress to cancel the $2 Mil spent on scanning the universe in search of extra terrestrial intelligence. The organization that was doing it actually uses idle time on personal computers to analyze the data and seek information from such data. The $2 Mil was too high for some but not the Billions currently spent on manned space missions. This is the same level of ignorance that led us to cancel the superconducting supercollider project in Texas, setting us back many decades in the advancement of fundamental knowledge

The best way to understand this is to imagine that humans are a colony of ants. By observing the environment around us, we have figured out that the world is really really big (much bigger than our immediate neighborhood). To understand the world better, should the ants spend a large percentage of their resources in creating a tin can that will take one ant 1 mile away or attempt to invent something that may give them a better feel for the world (by observing).? I believe the answer is clear. Fundamental understanding is much more valuable than any piece of information gathered from next door. This is especially true if such data collection is as expensive as manned space missions.

Why bartering may be better when intermediaries are inefficient

Today most transactions do not include the bartering of real assets. One of the reasons is that the needs of a buyer and a seller cannot be matched perfectly in most cases. Thus cash is used as a mechanism to transport value of a real asset from one to the other, typically through intermediaries. For example, an entrepreneur who may want to sell part of her company for services such as those provided by employees and suppliers can do direct bartering. She can sell pieces of the company directly to the employees (this is done sometimes) and suppliers. Alternately, she can find an intermediary (say, an investment bank) who will help her sell pieces of the company to investors for cash which she can then use to pay for services. If such an intermediary is inefficient, the transaction destroys the value of the real asset (in this case the company) compared to plain vanilla bartering directly with employees and suppliers. Similarly, if one wants to sell his house in the city and move to the country he could look for somebody who needs a house in the city and has a farm house to sell. Real estate transactions through intermediaries could destroy significant value in this case. Bartering, in most cases may be a more efficient transaction and may not include any cash.

Cash, because of its convenience, thus has ushered in a system of highly inefficient intermediaries who help destroy the value of real assets. Most buyers and sellers do not consider bartering an option as the instinctual reaction is to seek an intermediary. Since intermediaries have staked out monopolistic positions in many areas, any transactions through them will be highly inefficient for the owners of real assets. Internet, has the potential for removing most of these intermediaries and return the society to more efficient transactions between buyers and sellers. If bureaucrats can look outside their small boxes, this can then be extended across country boarders without taxes and regulations. At that scale, aided by a robust technology, bartering can render high efficiency to people across the world. Just the removal of inefficient and incompetent intermediaries can enhance world GDP significantly.

Auto manufacturers compete to save the world through electric cars

Suddenly, every auto manufacturer is racing to bring electric cars to consumers in a concerted effort to save the world (and in some cases attempting to profit from it). Lately many politicians and policy makers have challenged the automakers to do exactly that - clean the world of pollution through "plug in electric cars." As one of them remarked, "plug in cars solve many of the problems we currently face. If we had them, you just plug them in at night and we do not need to worry about crude oil any more. We also do not have any pollution." Such world transforming insights happen rarely. Unfortunately, there is a minor detail that was left out. Unlike Internet - that was shown to be a series of pipes delivering information costlessly, those electric outlets are not generally connected to "free flowing electricity machines." Electricity has to be generated (typically by fossil fuel or nuclear fuel), transported to the point of consumption (40% is lost in this process) before it can magically jump into the battery in the car, apparently saving the "pollution problem.". The batteries are heavy and costly to build as well (using current technology) and so the efficiency of the delivered unit of output (in this case a mile of transportation in the car) per unit of energy consumed can be quite low after taking into account total cost of production. Electric cars are neither pollution reducers nor crude oil stoppers. Electric cars made using conventional technology shift pollution not reduce it. This is another case of policy making and decision making based on misinformation. It looks like financial aid will flow from Washington to everywhere electric cars are made using traditional battery technologies and not to where new technologies are invented in power generation, transmission, storage and consumption. Let's hope that automakers who made such brilliant investment decisions will not be back seeking a bailout of electric car plants in two years.

Why non voters have to have a say in economic policy

Most solutions considered to mend the financial system, the economy and ailing companies require a massive transfer of money from the next generation to the current. Since policy makers are elected (or appointed by the elected) only by those who are old enough to do so, this process is likely inefficient, if not unfair. Decisions made by those who are the beneficiaries of the policy against a cohort, who do not have a voice (under the age of 18) in the policy appears unfair. A new system is needed where transfer of wealth policies need to be ratified by those who are paying for it and not just made by those who benefit by it.  Given the asymmetric effects of the policy changes made by the "grown ups," it is conceivable that the "non grown-ups" can challenge the current system.

Lowering the age limit for participation in the electoral process is the easiest fix. It is unclear why 18 magically makes somebody eligible to participate in the process. Since age has never proven to be correlated with good decisions in the electoral process, such an arbitrary cut off seems misplaced. Another possibility is to provide electronic means of participation (such as the Internet) for everybody who wants to voice an opinion on a suggested policy. For reasons unknown, most countries continue to use antiquated processes and technology for the voting process. Since changing the "established voting process" may drive some "grown-ups" crazy, we can at least experiment with it in providing specific feedbacks to policy changes. It is possible that if such an electronic voting mechanism is established for up/down votes on suggested policies, better long term policies will be made as everybody who is affected by it can now participate. A third alternative is to set maximum age limits for policy makers. Since we have already established minimum age for both the agent (policy maker) and the principal (voters), this should not be too shocking to most.

Economic value justification is needed for policy changes

Over the last several months, it has almost become fashionable to react to problems without a plan. Both fiscal and monetary response to the financial troubles have been completely reactive and tactical. Most ask if such policies are efficacious but a more relevant question is what the cost and benefit of such policies are. For example, if one pumps large amount of money (printed or otherwise), it is possible to reduce deflationary pressures in the short run. However, the cost of doing so can be enormous both in terms of forced wealth transfer from one generation to another as well as hyperinflation down the road. Policies need to be evaluated and assigned an economic value just like any project in the private sector. When a company undertakes a project, decision makers evaluate returns (considering costs and benefits) and in better companies, managers are held accountable for such returns. Both the evaluation (i.e the value of the policy) as well as accountability (to the results of the policy change) appear to be missing in contemporary policy making. This is not a sustainable situation. Just like companies who take up negative value projects go bankrupt (unless of course they are bailed out), policy makers who constantly conduct negative value policies will drive us toward worse situation. It is important that an economic value justification is provided each and every time a policy change is announced. Such a justification has to consider both the short and long term effects (just like any private company will do). In effect, every policy change has to produce a plan and a Net Present Value (NPV) of the suggested change considering all associated uncertainty and flexibility. Those who do not understand this should not be in policy making positions at all.

Why Green Cards should have an expiry date

Green Cards in the US are issued to foreign nationals who contribute to the country in special ways or to those whose family ties require them to be in the US. Currently, Green Card holders can continue to be in the country without ever bothering to apply for a citizenship in the US. As a former Green Card holder this does not make sense to me. It is understandable for somebody to go to another country looking for jobs, education, partners, family and knowledge. But to remain in the country without applying for a citizenship of the country implies that the person does not subscribe to the culture and philosophy of the country. If this is the case, it is not fair to the citizens of the country. I can fully understand the tactical needs to move from one country to another (harsh regimes in own country, famine, education, jobs) but to remain there (say for more than a decade) without ever applying for citizenship is not fair to those who are already there and who define the country.

This is not just true about the US but every country in the world. Each country has its own culture, ideals and customs and it is important for anybody who seeks citizenship to one (different from the one he or she was born without choice) to fully accept the consequences. In other words moving from one country to another can be a tactical hedge but it should have a time limit (as most hedges do). If one moved to another country purely for the love for the culture, customs and people of that country, applying for the citizenship of that country should be automatic. Thus, Green Cards in the US should be issued with a time limit forcing those to convert to citizenship within the time limit. This will allow those who subscribe to the country's ideals to remain there and those who do not, to return to where they came from.