Satyajit Das Tells Us What is Really Happening in China

satyajit das

 

Dear Reader

This is the third and the concluding part of the interview with economic commentator and globally bestselling author Satyajit Das.

Das is an internationally respected commentator on financial markets and economics He is credited with predicting the current financial crisis. He has also featured 2010 Oscar-winning documentary Inside Job.

In this interview I speak to Das around his new book The Age of Stagnation—Why Perpetual Growth is Unattainable and the Global Economy is in Peril. Like his earlier books, Traders, Guns and Money and Extreme Money, this book is also a terrific read and a must for anyone who seriously wants to understand how things haven’t really changed in the aftermath of the financial crisis, and why the future continues to remain bleak.

In the third and the final part of this interview, Das talks about China and tells us what is really happening in there. He also tells us that “No one wants to believe that stagnation or collapse are the only two likely options”.

Happy Reading!
Vivek Kaul

On page 65 of your new book The Age of Stagnation you write: “Half of the investment in China since 2009 has been ineffective”. What makes you say that?

China’s growth especially after 2008/2009 was driven by a massive debt fund investment boom. A good proportion of this investment can be classified as ‘mal investment’; that is, revenues projects where revenues will be insufficient to cover the borrowing or generate adequate financial returns.

The bulk of investment has been by SOEs[state-owned enterprises] in government-backed infrastructure projects – the tiegong­ji (meaning “iron rooster”), a homonym for the Chinese words for rail, roads and airports. The Ministry for railways is planning investments of around $300 billion, adding 20,000 kilometres (“Kms”) of rail track to the existing network of 80,000 Kms. China’s rail network will become the second-longest in the world behind the US, overtaking India.

China is also having a love affair with the superfast train. Undeterred by accidents and the high cost, further expansion of the high speed rail network is under way. A new service between the southern cities of Guangzhou and Shenzhen travels at 380 kilometres per hour (KPH) nearly halving the travel time to 35 minutes. CSR Corp, China’s biggest train maker, has plans for a super train capable of 500 KPH.

What else is it doing?

China is constructing around 12,000 Kms of new expressways at a cost of over $100 billion. China road network of over 60,000 Kms of high-speed roads is only slightly less than the 75,000 Kms in the US. China is planning to expand the high-speed road network to 180,000 Kms even though China has only around 40 million passenger vehicles compared to 230 million in the US.

There is a spate of new airports and expansions of capacity at existing facilities. Jiaxing in eastern Zhejiang province is converting a military landing strip into a commercial airport at a cost of around $50 million. The town is only one hour’s drive on brand new expressways from three of China’s busiest international airports in Shanghai and Hangzhou. There are also plans for a high-speed rail line connecting Shanghai and Hangzhou.

In Hunan, local authorities tore down portions of a modern flyway and used the stimulus funding to rebuild it. Stories of ghost cities, such as the empty newly-built city of Ordos, Zhengzhou New District, Dantu and the orange area to the north-east of the Xinyang, abound. There are ghost shopping malls in many cities.

Could you tell us more?

Based on estimates from electricity meter readings, there are more than 60 million empty apartments and houses in urban areas of China. Many of the properties were purchased by people speculating on rising property prices.

The projects have driven a sharp rise in demand for materials like steel and concrete. China now produces more steel than the next eight largest producers combined. China now produces more cement than the rest of the world. But this over-investment in non-productive, low return projects will ultimately reduce growth.

For the rest of the world, the investment boom fed demand for commodities and machinery in the short run. Ultimately, it will create problems in two ways: firstly, many companies globally have over-invested in capacity based on anticipated Chinese demand that may not eventuate; and second, dumping of Chinese overcapacity on global markets will feed disinflationary pressures.

In your chapter on Brics you write that it would take decades for China to absorb the excess capacity that it has created over the years. Can you elaborate a little on that?

Sino-philes attribute the excess capacity to the collapse of global demand. They assume that global demand will rebound strongly increasing the returns from these investments.

Sino-philes also argue that the investments in infrastructure will produce long term economic benefits and returns from increased productivity. They point to the fact that few investment programs of social infrastructure are profitable. They point to the mid-19th century boom in investment in railways in Western countries, which generated economic benefits, but few made an adequate financial return with many going bankrupt. They also argue that China lacks necessary infrastructure.

 So what is the real issue?

The real issue is whether the specific projects are appropriate. China has six of the world’s ten longest bridges and the world’s fastest train. But 40% of villages lack paved road providing access to the nearest market town. High-speed rail lines in China may increase social return, improving the quality of life for the average Chinese if they are wealthy enough to afford to use them. But the financial return on capital invested in these projects will be low.

While many of these large projects are appealing to politicians and demagogues proclaiming superiority of Chinese technical proficiency, investment in improving ordinary train lines, rural roads, safety and more flexible pricing structures may have yielded higher economic benefits.

There are several concerns now about this economic model.

And which are?

First, analysts, such as Pivot Capital Management, argue that the efficiency of Chinese investment has fallen. One measure is the incremental capital-output ratio (“ICOR”), calculated as annual investment divided by the annual increase in GDP. China’s ICOR has more than doubled since the 1980s and 1990s, reflecting the marginal nature of new investment. Harvard University’s Dwight Perkins of Harvard argues that China’s ICOR rose from 3.7 in the 1990s to 4.25 in the 2000s. Other researchers suggest that it now takes around $6-8 of debt to create $1 of Chinese GDP, up from around $1-2 around 20 years ago. In the US, it took $4-5 debt to create $1 of GDP just before the GFC. This is consistent with declining investment returns.

Second, increased level of debt and the often uneconomic projects financed has led to increasing concern as to whether the debt can be serviced.

How much is that an issue?

A 2012 Bank of International Settlements (“BIS”) research paper on national debt servicing ratios (“DSR”) found that a measure above 20-25% frequently indicated heightened risk of a financial crisis. Analysts estimate that China’s DSR may be around 30% of GDP (around 11% goes to interest payment and the rest to repaying principal), which is dangerously high.

The debt problems are compounded by other factors. A large portion of the debt is secured over land and property, whose values are dependent on the continued supply of credit and strong economic growth.

A high proportion of debt is short term, with around 50% of loans being for 1 year, requiring refinancing at the start of each year. As few Chinese borrowers have sufficient operating cash flow to repay loans, new borrowings are needed to service old ones.

Around one-third of new debt is used to repay or extend the maturity of existing debt. With a significant proportion of new debt needed to merely repay existing debt the amount of borrowing needs to constantly increase to maintain economic growth.

China observers now worry about whether the high absolute levels of debt, rapid increases in borrowing, increasing credit intensity, servicing problems and the quality or value of underlying collateral are likely to result in a financial and economic crisis – a Minsky Moment.

On slightly different note what do you see the impact of the depreciation of the Chinese yuan on global growth?

Most nations now have adopted a similar set of policies to deal with problems of low economic growth, unemployment and overhangs of high levels of government and consumer debt. In a shift to economic isolationism, all nations want to maximise their share of limited economic growth and shift the burden of financial adjustment onto others. Manipulation of currencies as well as overt and covert trade restrictions, procurement policies favouring national suppliers, preferential financing and industry assistance policies are part of this process.

A weaker currency boosts exports, driven by cheaper prices. Stronger export led growth and lower unemployment assists in reducing trade and budget deficits.

With Europe and Japan still actively trying to weaken their currencies and the US owing its recovery in part to this policy, China will be forced to join the global currency wars.

And what are the Chinese hoping here?

First, they will be hoping that it will provide a needed boost to slowing growth through exports.

Second, it will help with the policy of internal rebalancing away from investment to consumption by offsetting the loss of competitiveness through higher wage costs.

But there are risks. Retaliation in the form of competitive QE programs and intervention is possible. In addition, China risks triggering higher inflation and also uncontrolled capital flight which would expose its financial system vulnerabilities. The country’s foreign currency reserves (already down some US$700 billion to around US$3,300 billion) would fall sharply, reducing its financial flexibility.

You seem to remain unconvinced about the world having come out of the aftermath of the financial crisis and you write that a risk of a sudden collapse is ever-present. Why do you say that?

There are three possible scenarios.

In the first, the strategies in place lead to a strong recovery. The US leads the way. Europe improves as the required internal transfers and rebalancing takes place with Germany accepting debt mutualisation to preserve the Euro. Abe-nomics revives the Japanese economy. China makes a successful transition from debt financed investment to consumption. A financial crisis in China from the real-estate bubble, stock price falls and massive industrial overcapacity is avoided. Other emerging economies stabilise and recover as overdue structural reforms are made. Growth and rising inflation reduce the debt burden. Monetary policy is normalised gradually. Higher tax revenues improve government finances. There is even strong international policy co-ordination, avoiding destructive economic wars between nations.

Oh that is clearly a lot to expect…

Such an outcome is unlikely. The fact that current policies have not led to a recovery after 6 years suggests that they are ineffective.

The second scenario is a managed depression, a Japan like prolonged stagnation.

Economic growth remains weak and volatile. Inflation remains low. Debt levels continue to remain high or rise. The problems become chronic requiring constant intervention in the form of fiscal stimulus and accommodative monetary policy, low rates and periodic QE programs to avoid deterioration.

Financial repression becomes a constant with nations transferring wealth from savers to borrowers to manage the economy. Competition for growth and markets drives beggar-thy-neighbour policies, resulting in slowdowns in trade and capital movements.

Authorities may be able to use policy instruments to maintain an uneasy equilibrium for a period of time. But it will prove unsustainable in the long run. Ultimately, a major correction will become unavoidable, as confidence in policy makers ability to control the situation diminishes.

And what is the final scenario?

The final scenario is the mother of all crashes. Financial system failures occur as a significant number of sovereigns, corporate and households are unable to service their debt. Defaults trigger problems in the banking system which leads to a major liquidity contraction, which in turn feeds back into real economic activity. Falls in employment, consumption and investment drive a severe contraction. The problems are global with developed and emerging markets affected.

The downturn is exacerbated by the limited capacity of policy makers to respond. Weakened public finances and policy options (QE and low rates) exhausted in fighting the last crisis limit the ability of governments to respond to a new crisis. Emerging markets are now unlikely to be a source of demand due to their problems. Geo-political stresses are higher than in 2007/ 2008.

Unsurprisingly, no one wants to believe that the stagnation or collapse are the only two likely options. Hubris, as humorist PJ O’Rourke noted is one of the great renewable resources.

Concluded…

The column originally appeared on the Vivek Kaul Diary on January 29, 2016

“The toxic effects of policies have now created conditions for a new financial crisis”

satyajit dasDear Reader

This is the second part of the interview with economic commentator and globally best-selling author Satyajit Das.

Das is an internationally respected commentator on financial markets and economics He is credited with predicting the current financial crisis. He has also featured 2010 Oscar-winning documentary Inside Job.

I would like to state here that I actually understood how financial derivatives caused a major part of the current financial crisis only after reading Extreme Money authored by Das. Until then my understand was shaky.

His first general book Traders, Guns and Money is a master class on derivatives, given that Das’s technical tomes on financial derivatives running into thousands of pages, remain a standard reference on Wall Street.

In this interview I speak to Das around his new book The Age of Stagnation—Why Perpetual Growth is Unattainable and the Global Economy is in Peril. Like his earlier books this book is also a terrific read and a must for anyone who seriously wants to understand how things haven’t really changed in the aftermath of the financial crisis, and why the future continues to remain bleak.

This is the second part of a three-part interview. The concluding part will appear tomorrow.

Happy Reading!
Vivek Kaul

 

Do you see all the debt that has been accumulated by governments over the years, ever being repaid? How do you see this playing out?

Interestingly, total public and private debt in major economies increased not decreased since 2008. The Table below sets out the changes in debt levels in the global economy:

Global Stock of Debt Outstanding

(US$ Trillion, Constant 2013 Exchange Rates)

 200020072014Compound Annual

Growth Rate (%)

Type of Debt   2000–20072007-2014
Household1933408.5%2.8%
Corporate2638565.7%5.9%
Government2233585.8%9.3%
Financial2037459.4%2.9%
Total Debt871421997.3%5.3%
Total Debt (as % of GDP)246%269%286%  

Source: Richard Dobbs, Susan Lund, Jonathan Woetzel and Mina Mutafchieva (2015) Debt and (not much) deleveraging, McKinsey Global Institute: 2

Total debt has continued to grow at a slower rate than before the GFC but remains well above the corresponding rate of economic growth. Higher public borrowing has largely offset debt reductions by businesses and households.

Could you tell us a little more about that?

Between 2007 and 2014, the ratio of public sector debt to GDP in advanced economies increased by 35 percent of GDP, compared to an increase of 3 percent between 2000 and 2007. The increase in government debt reflected the effects of the GFC. It was designed to support the financial system. Government spending sought to boost demand and growth. The increase in debt predictably was highest in the worst affected countries, such as the UK, Greece, Spain, Portugal and Ireland.

Given slow growth, low inflation rates and the balance between tax revenues and expenditure and inflation rates, government debt to GDP ratios are forecast to rise for the foreseeable future in the US, Japan and many European countries. In many countries, government debt has reached levels which are unsustainable. It is unclear how these highly indebted economies will reduce the level of government debt.

Why do you say that?

Debt can only be reduced through strong economic growth. Many economies in the world today have debt-to-GDP ratios of 300 percent. If the average interest rate is 3 percent, then to meet interest payments the economy would need to grow at 9 percent (300 percent [debt] times 3 percent [interest rate]), an unlikely nominal rate of expansion.

The alternative is debt forgiveness, defaults or inflation. But all these steps, other than growth are not without consequences. Savings designed to finance future needs, such as retirement, are lost. This in turn results in additional claims on the state to cover the shortfall or reduce future expenditure which crimps economic activity. Significant write-downs on sovereign debt would trigger major crises for banks and pension funds. The resulting losses to savers would trigger a sharp contraction of economic activity. National governments would need to step in to inject capital into banks to maintain the payment and financial system’s integrity.

In One Lesson: The Shortest & Surest Way to Understand Basic Economics, Henry Hazlitt summarised the problem: “Everything we get, outside of the free gifts of nature, must in some way be paid for. The world is full of so-called economists who in turn are full of schemes for getting something for nothing. They tell us that the government can spend and spend without taxing at all; that it can continue to pile up debt without ever paying it off, because ‘we owe it to ourselves’.” It is useful to remember that.

One of the things you write is that the stock markets have decoupled from the real economy. Why do you say that?

Equity prices now do not correlate to fundamental economic factors, such as nominal gross domestic product or economic growth, or, sometimes, earnings.

Writing in the Financial Times, James W. Paulsen, chief investment strategist at Wells Capital Management, advised Investors not to be too concerned about slower earnings growth. Mr. Paulsen forecast a 2,600 target for the S&P 500, or an annualised five-year return in excess of 10 per cent, including dividends. He warned investors about “becoming too myopically focused on these mainstream issues lest [they] miss what could be the second confidence-driven bull market of the post-war era”. Given that shares represent claims on the earnings derived from the real economy, this is puzzling.

It indeed is…

Veteran Legg Mason fund manager Bill Miller once observed that: “The common view [is] that the weak stock market reflects a weakening economy. But we think the converse is more likely: the weak stock market is causing the economy to weaken”.  Equity analyst Laszlo Birinyi supported this view of causality: “The relationship between the stock market and the economy is tangential, not causal”. It is not clear why the equity market should drive the real economy, rather than the other way around.

There may be some possible explanations for the divergence between the real economy and equity prices. First, share values are increasingly affected by opaque accounting and what one observer termed the ‘expectations machine’; that is, manipulating and beating expectations rather than absolute performance criteria. Then there are higher levels of corporate activity such as share repurchases and mergers and acquisitions which affect values.

Second, equity markets have become instruments of economic policy, as policy makers try to increase asset values to generate higher consumption driven by the ‘wealth effect’. Monetary measures, such as zero interest rate policy and quantitative easing, distort equity prices. Dividend yields that are higher than bond interest rates now drive valuations. Future corporate earnings are discounted at artificially low rates.

Any other reasons?

Third, the increased role of high frequency trading (“HFT”) has changed equity markets. HFT constitutes up to 70% of trading volume in some markets. The average holding period of HFT trading is around 10 seconds. The investment horizon of portfolio investors has also shortened. In 1940, the average investment period was 7 years. In the 1960s, it was 5 years. In the 1980s, it fell to 2 years. Today, it is around 7 months. The shift from investing for the long run has fundamentally changed the nature of equities, with momentum trading a larger factor.

Fourth, the increasing effect of HFT has increased volatility and the risk of large short term price changes, such as that caused by the ‘flash crash’, discouraging some investors.

Fifth, alternative sources of risk capital, the high cost of a stock market listing, particularly increasing compliance costs, increased public disclosure and scrutiny of activities including management remuneration as well as a shift to different forms of business ownership, such as private equity, have changed the nature of equity market. New capital raisings are increasingly viewed with scepticism as private investors or insiders seek to realise accreted gains, subtly changing the function of the market.

Sixth, financialisation may facilitate market manipulation, whereby the corrosive impact of insider trading and market abuse erodes investor confidence.

Financial instruments, such as shares and their derivatives, are intended as claims on real businesses. Over time, trading in the claims themselves have become more rewarding, leading to a disproportionate increase in the level of financial rather than business activity.

You write: “politicians and central bankers gambled that growth and increased inflation would over time correct the problems”. But things did not turn out as they expected. What went wrong there?

Policy makers assumed that the Great Recession of 2007/8 was a cyclical downturn not a structural change. George Soros got it absolutely right: “[It] resembles other crises that have occurred since the end of the Second World War at intervals ranging from four to 10 years…there is a profound difference: the current crisis marks the end of an era of credit expansion based on the dollar as the international reserve currency. The periodic crises were part of a larger boom-bust process. The current crisis is the culmination of a super-boom that has lasted for more than 60 years.”

And what happened because of the mis-diagnosis?

Given the mis-diagnosis, policy maker reacted with their usual responses: fiscal stimulus and looser monetary policy (low rate and then QE). This was never going to work as the debt overhang meant private economic activity did not recover to pre-crisis levels. Low rates did not actually encourage borrowing and spending.

The GFC left a legacy of large debts, forcing households to reduce spending so as to repay borrowings, with low-income households reducing spending by twice as much as richer households. The debt overhang and caution about borrowing has reduced the impact of low interest rates. Households are unwilling or unable to increase debt. The fall in house prices in some countries, and the resulting decline in household wealth, has made borrowing difficult; lending against home equity has decreased. Banks have also tightened lending standards, in response to loan losses. These factors mean that a consumption-based economic recovery is unlikely without income redistribution to households with a higher propensity to spend, or finding a new source of demand. The lack of demand has resulted in weak investment, also slowing growth.

As result, the global economy is locked into a path of low growth and low inflation tending to disinflation or deflation. That would be fine if it were not for the high levels of debt which will spiral out of control in such conditions.

So what was really needed?

What was needed were major structural changes: dealing with the excessive debt, dealing with global imbalances, addressing the unfunded entitlements which affect public finances and rebalancing between the real and financial economy. Then, there were other issues like demographics, slowing productivity and innovation as well as the problems of inequality, environment and scarce resources. But no government has had the political courage to tackle these issues to the degree necessary.

So what they did was make a bad situation worse by increasing debt. The toxic effects of the policies have now created the conditions for a new financial crisis.

In essence, they tried to do the wrong things better rather than do the right things badly.

To be continued…

Disclosure: Satyajit Das wrote the foreword to my book Easy Money: Evolution of Money from Robinson Crusoe to the First World War

The interview originally appeared in the Vivek Kaul Diary on January 28, 2016

“The build-up of debt over last 25 years has been excessive, beyond repayment capacity.”

satyajit das
Dear Reader,

This is a special edition of the Vivek Kaul Diary. This is the first time I am interviewing someone for the Diary. In this interview I speak to Satyajit Das, an internationally respected commentator on financial markets, credited with predicting the current financial crisis. He has also featured 2010 Oscar-winning documentary Inside Job.

I would like to say here that personally I have learnt a lot from reading what Das has written over the years. His two books Traders, Guns and Money and Extreme Money have been a master class on derivatives as well as how they caused the financial crisis.

Honestly, if you were to read only one book on the financial crisis, it has to be Extreme Money.

In this interview I speak to Das around his new book The Age of Stagnation—Why Perpetual Growth is Unattainable and the Global Economy is in Peril. Like his earlier books this book is also a terrific read and a must for anyone who seriously wants to understand how things haven’t really changed in the aftermath of the financial crisis, and why the future continues to remain bleak.

This is the first part of a three-part interview. The other two parts will appear over the next two days.

Happy Reading!
Vivek Kaul

I would like to start with a clichéd question. Why did very few economists and experts see the economic crisis coming?

I think Richard Breeden, a former chairman of the SEC, probably identified the reason best: “It’s probably a better question for a psychologist. There’s a group dynamic…nobody likes to be the person who sends everybody home from the party when they’re having a good time.”

People rarely see what is front of them because of a mixture of ideology, biases and incentive structures. Proponents of markets are never going to concede that the mechanisms had failed or were even capable of failure.

Most economists and experts are guilty of ‘groupthink’. People with similar backgrounds and largely insulated from outside opinions tend to make decisions without critically testing, analysing and evaluating ideas or evidence. They collective rationalise, convinced about the inherent morality of their views, their unanimity and invulnerability. They also hold stereotyped views of outsiders and do not tolerate dissent. People work in neat silos and don’t look outside their narrow specialisation.

People employed by financial organisations are deeply compromised, forced to propagate the party line. Upton Sinclair was correct in noting that “it is difficult to get a man to understand something when his salary depends on his not understanding it”.

What made you feel that a crisis was on the way?

My only advantage is that I am not beholden to anybody or any organisation. I don’t have strong ideologies. My interest is in facts and trying to understand them. I am extremely pragmatic, adhering to what works or doesn’t. It is a luxury.

But you also need to be lucky, especially on timing of events.

One of the first things you write in your book is “future generations may have lower living standards than their parents”. This I would guess is one of the key points of the book as well. Why do you say this?

Future economic historians may come to regard the last two centuries and especially the post WW2 period, as an exception in terms of large improvements in livings standards.

Ultimately, prosperity depends on economic growth. If growth is slower and more volatile in the future then future generations will have lower living standards. The reasons are fairly simple.

First, much of the recent prosperity was built on debt funded growth which is not repeatable. An unknown portion of this debt will have to written off either explicitly (default/ restructuring) or implicitly (through reduction in purchasing power through inflation or financial repression). A large amount of wealth will be wiped out.

Second, environmental damage will restrict future growth. This will be through acceptance of lower levels of economic activity as the world restricts the use of fossil fuels which is unlikely. The alternative will be lower growth as a result of the catastrophic costs of climate change, in terms of damage, dislocation or shortages of essential goods and services.

Can you give us an example?

For example, India will have to accept the problems of water shortages and lower food production as well as having to deal with the forced displacement of a large part of the population of Bangladesh. There are also ancillary costs like health costs from air, water and soil pollution.

Third, resources like water, food and energy will get scarcer and therefore more expensive.

Fourth, our model for dealing with these issues is simply to extend and pretend and kick the problem further down the road. In effect, past and present generations will have enjoyed the benefit but the costs will be borne by future generation, reducing their living standards.

The problem will manifest itself at an individual level in three ways. A large part of future generations will find employment, particularly secure and well-paid jobs, more difficult to obtain. A commentator in Greece argued, with black humour, that the government could save money on education because it was unnecessary to prepare people for jobs that did not exist.

Purchasing houses and large capital goods may become harder. Also, the idea of a finite working life followed by retirement will become a luxury for most. People will have to work till they die or are unable to work.

We see all these trends already in many societies.

Much of the world’s population (probably 5-6 billion of the 7 billion on earth) are already in the position that I have described. It is the other 1-2 billion who aspired to a better life for themselves and their children who will have to adjust their expectations, which have been set too high.

You write that “we may never know the real cost of the financial crisis”. Why do you say that?

Costs of crisis are always complex. There are measureable losses in the value of financial assets like equities, property and loan write-offs. There are structural effects which economist refers to as hysteresis; that is a single disturbance which affects the course of the economy. An example is the delayed effects of unemployment. As unemployment increases, more people adjust to a lower standard of living. There is reduction of potential output. There are complex questions about what period we measure losses over.

The 2007/2008 financial crisis illustrates this point. Large financial institutions throughout the world collapsed or suffered near fatal losses. Values of houses and financial assets, like shares, fell sharply. In the real economy, there was a sharp downturn in economic activity, unemployment often for prolonged periods, housing foreclosures and evictions and failures of businesses.

What is the biggest number you have come across with regard to the cost of the financial crisis?

In 2009, the IMF estimated the cost to that stage at around US$12 trillion, equivalent to around 20 percent of the entire globe’s annual economic output. In 2013, Tyler Atkinson, David Luttrell and Harvey Rosenblum, three economists at the Federal Reserve Bank of Dallas, tentatively quantified the loss to the US economy as between US$6 and US$14 trillion, around US$19,000 to US$45,000 per person. Under certain assumptions, they found that the loss could be higher – US$25 trillion or over 150% of GDP, almost US$80,000 per American. No one may ever know the full cost.

There are huge indirect costs like lost human potential and suffering, which we do not measure. A diary entry at the time of the Great Depression in Siri Hustvedt novel Sorrows of An American reads: “A depression entails more than economic hardship, more than making do with less. That may be the least of it. People with pride find themselves beset by misfortunes they did not create; yet because of this pride, they still feel a pervasive sense of failure… People become powerless.” We don’t measure that.

On page 34 you write: “everybody, it seemed, agreed with Oscar Wilde that living within one’s income merely showed a lack of imagination”. Why do you say that? Isn’t it a very fierce indictment of the Western World?

Developed economies are now 60-70% consumption.

If we look at the post war period then you see a persistent pattern of promoting consumption. Initially, it was about meeting unsatisfied needs. Over time, it shifted to manufacturing demand though a variety of strategies ranging from advertising to planned obsolescence.

Consumption driven economies require you to keep consuming to drive economic activity to provide employment to give you income to buy more things you don’t really need. There is a piece of graffiti art by Bansky which I have always liked. It reads: “join a hilarious adventure of a lifestyle – work, buy, consume, die”.

In Das Kapital, Karl Marx identified this inherent tendency of capitalism towards overproduction. Theologian Reinhold Niebuhr saw society as enslaved to its productive process, reversing the normal process of producing to satisfy consumption needs. Economists dismiss overproduction, arguing that supply creates its own demand (known as Say’s Law). They view consumer needs as essentially unlimited, with people wanting more and better goods.

It may be an indictment of Western economic system.  My objective was not judgemental. It was to describe what was happening. In essence, economic growth and prosperity were by-products of consumption, unsustainable resource exploitation and serious environmental damage. It would be fair to say in recent decades nobody was took the advice of 19th century philosopher John Stuart Mill “[seeking] happiness by limiting … desires, rather than in attempting to satisfy them”.

There is a great belief among economists that borrowing leads to economic growth. How true is that? Has the impact of debt on growth come down over the years?

There is nothing inherently good or bad about debt. It can be used to drive economic growth, allowing immediate consumption or investment against the promise of paying back the borrowing in the future. Spending that would have taken place normally over a period of years is accelerated because of the availability of debt.

The use of debt can be beneficial, where the economic activity generated is sufficient to repay the borrowing with interest. This requires borrowing to finance assets or investments which generate income or value to repay principal and interest. A significant proportion of current debt does not meet this test.

Only (around) 15-20% of total financial flows went into investment projects with the remaining 80-85% being used to finance existing corporate assets, real estate or unsecured personal finance to facilitate consumption. Borrowings were frequently used to finance pre-existing assets where anticipated price rises were to be the source of repayment.

Under these conditions, a slowdown in the ability to borrow ever increasing amounts can lead to a sharp fall in asset prices to levels below the outstanding debt creating repayment difficulties. This is precisely what happened in 2007/2008 and is likely to happen again, sooner than people think.

The build-up of debt over the last quarter of a century has been excessive, beyond repayment capacity.

Could you elaborate on that?

In the lead up to 2007/2008, there was a rapid build-up in debt in developed economies. Between 2000 and 2009 total global credit grew from US$57 trillion to US$109 trillion, equating to a growth of 7.5% per annum, around double the growth in economic activity. In many countries, debt reached three to four times Gross Domestic Product (“GDP”), levels not normally reached other than in wartime (i.e. 1914-1918 and 1939-1945) when the result was losses for creditors of the losing states.

The other problem is that you need to borrow ever increasing amounts to both repay existing borrowing but also to maintain economic growth. By 2007/2008, the US needed $4-$5 of debt to create $1 of economic growth, compared to an additional $1-$2 of debt per additional $1 of GDP in the 1950s.

To be continued…

Disclosure: Satyajit Das wrote the foreword to my book Easy Money: Evolution of Money from Robinson Crusoe to the First World War

 

How Low Interest Rates Have Hurt Economic Recovery

satyajit das
In the aftermath of the financial crisis that broke out in September 2008, after the investment bank Lehman Brothers went bust, central banks all across the Western world drove interest rates close to 0%.

This was referred to as the zero interest rate policy or ZIRP. The hope was that with ZIRP the interest rates on loans offered by banks would remain very low and in that environment people would borrow and spend more.

They would buy more cars…More homes…More TVs..

And this would ensure an economic recovery. QED.

But things did not turn out to be as simple as that. As Satyajit Das writes in his new book The Age of Stagnation—Why Perpetual Growth is Unattainable and the Global Economy is in Peril: “Low rates also discourage savings. But sometimes, in a complex cycle of cause and effect, they may perversely reduce consumption as lower returns force people to save more for future needs.”

And in fact low interest rates may also lead to lower consumption. How is that possible? As Das writes: “Citigroup equity strategist Robert Buckland has argued that low rates and QE reduce employment and economic activity, rather than increasing them. These policies encourage a shift from bonds into equities.”

Interestingly, those who have retired from work have had to shift their money into stocks because of low interest rates. As Das writes: “In October 2014 an American retiree with US$1 million invested in secure, two-year US government bonds would have earned US$3900 in annual interest, 92 percent less than the US$48,000 they would have received in 2007. The retired and savers in advanced economies were forced to purchase riskier securities or invest in dividend-paying stocks to earn a return.”

And these investors were looking for income from the investments they had made in stocks. As Das writes: “As investors are looking for income rather than capital growth, they force companies to increase dividends and undertake share buybacks. To meet these pressures, companies must boost cash flow and earnings, by shedding workers and reducing investments to cut costs. The process increases share prices and returns for shareholders of the company, but is bad for the overall economy.”

What does this mean? With interest rates on bank deposits and other fixed income investments at very low levels, people have moved their money to equity. These investors force companies to increase dividends and at the same time buyback its own shares. When a company buys back its own shares a lesser number of shares remain in the open market, pushing up the earnings per share. With fewer shares going around, it also increases the chances of a higher dividend per share.

Interestingly, with interest rates at such low levels, companies have been borrowing money to buy back their own shares. As Albert Edwards of Societe Generale wrote in a research note in November: “The primary driver for the rapid rise in bank lending…has been borrowing by US corporates and we all know they have been using the Fed’s free money not to invest in capacity expanding expenditures, but rather to buy back mountains of their own shares…Corporate debt borrowing at an $674bn annual rate [is] closing in rapidly on the all-time borrowing splurge of 2007!

Also, in the pressure to boost earnings companies have had to fire people and at the same time reduce investments to cut costs. This has led to hire share prices but it has also led to a situation where employees have been fired from their existing jobs and new jobs haven’t been created. Any person who has been fired or is likely to be fired is unlikely to go out shopping, as the basic idea behind lower interest rates is.

This has an impact on consumption and economic growth. Hence, in a very perverse sort of way, low interest rates may have had a negative impact on consumption. And this has meant economic growth has not recovered as fast as it was expected to.

Also, the ZIRP has pushed up stock markets all over the developed world and in the process helped the rich become richer. As L Randall Wray writes in Why Minsky Matters—An introduction to the Work of a Maverick Economist: “According to a study by Pavlina Tcherneva, 95 percent of the benefits of the recovery from the global financial crisis have gone to the top 1 percent of the income distribution. Another study finds that the top one-thousandth (top 0.1 percent) of the U.S. population now owns fifth of all the wealth.”

The trouble is that the rich do not increase their consumption if they get richer. As Das writes: “Higher income households have a lower marginal propensity to consume, spending a lower portion of each incremental dollar of income than those with lower incomes. US households earning US $35,000 consume an amount from each additional dollar of income that is around three times that of a household with an income of US$200,000. Given that consumption constitutes around 60-70 percent of economic activity, concentration of income at the higher end limits growth in demand.”

And this explains why low interest rates through large parts of the Western world haven’t had the kind of impact that they were expected to. What this tells us is that there are no universal solutions to problems even though economists and politicians often sound very confident while offering them.

And this is something dear readers that you need to keep in mind the next time you hear a politician or an economist, talk about the economy, with great confidence. Economics is not an exact science.

Disclosure: Satyajit Das wrote the foreword to my book Easy Money: Evolution of Money from Robinson Crusoe to the First World War

The column appeared on the Vivek Kaul Diary on January 18, 2016

Dear Mr Modi who will sort out the mess at Food Corporation of India?

narendra_modi
Data released by the Petroleum Planning and Analysis Cell(PPAC) suggests that on January 13, 2016, the price of Indian basket of crude oil touched $27.32 per barrel. I expect the government to increase the excise duty on petrol and diesel soon, to capture the benefit of this ‘further’ fall in the price of oil.

If and when this happens this will be the eight such rise since November 2014. While the government has been quick to increase excise duty on petrol and diesel in order to shore up its finances, the same enthusiasm has been missing when it comes to controlling wasteful expenditure.

Let’s take the case of the Food Corporation of India(FCI). Last week the Supreme Court was hearing a case concerning the loaders at FCI and the exorbitant salaries they draw. As the judges reacted: “The report shows that in August 2014, 370 labourers received more than Rs 4 lakh in salary. Around 400 others got between Rs 2 lakh and 2.5 lakh in the same month…How is that possible?

The judges were essentially referring to the Report of the High Level Committee on Reinventing the Role and Restructuring of Food Corporation of India (better known as the Shanta Kumar committee report). This report was released in January 2015.

In fact, as the Shanta Kumar committee report points out: “Some of the departmental labours (more than 300) have received wages (including arrears) even more than Rs 4 lakhs/per month in August 2014. This happens because of the incentive system in notified depots.

Interestingly, even those who did not get paid Rs 4 lakh in August 2014, get paid quite a lot. The average salary of an FCI worker was Rs 79,588 per month between April and November 2014, which is seven to eight times higher than what a contract labourer gets paid. As can be seen from the following table the average salary of a worker has more than doubled between 2009 and 2014.

Financial yearAverage Salary
2009-1038459
2010-1153389
2011-1263763
2012-1371358
2013-1478549
April to Nov 201479588
Source: Shanta Kumar Committee Report

As the Shanta Kumar committee report points out: “FCI engages large number of workers (loaders) to get the job of loading/unloading done smoothly and in time. Currently there are roughly 16,000 departmental workers, about 26,000 workers that operate under Direct Payment System (DPS), some under no work no pay, and about one lakh contract workers. A departmental worker (loader) costs FCI about Rs 79,500/per month (Apri-Nov 2014 data) vis-a-vis DPS worker at Rs 26,000/permonth and contract labour costs about Rs 10,000/per month.”

There are a few points that need to be made here. First, is the fact that workers are paid different wages depending on how they are categorised, even though the do the same work. Hence, an FCI worker gets paid eight times that a contract worker gets paid. This is not fair.

The second point is why pay workers close to Rs 80,000 per month for loading and unloading stuff, when the same job can be carried out at the cost of Rs 10,000 or Rs 26,000 per month? This is a clear waste of money. The Supreme Court judges put the loss at Rs 1800 crore. This doesn’t sound much on its own, given the big numbers we are used to when we talk about the government.

But compare this with the plan outlay of the ministry of environment for 2015-2016, which is at Rs 1,446.60 crore. As the budget document points out: “The Plan outlay of Ministry of Environment, Forests & Climate Change is Rs 1,446.60 crore. An Amount of Rs 758.16 crore is allocated for Ecology and Environment which, inter alia, includes Rs 63.14 crore Conservation of Natural Resources and Ecosystems, and Rs 213.05 crore for Research and Development, Rs 100 crore for National Coastal Management Programme and Rs 76.10 crore for Environmental Monitoring and Governance.  Rs 150 crore has been provisioned for National Adaptation Fund for Climate Change.”
The point being there are better ways of spending money than paying an FCI worker Rs 79,500 per month.

Also, it is not surprising that those making Rs79,500 per month or more, get cheaper contract labour to do their work. If I was earning Rs 4 lakh per month and was in a position to outsource my work to someone at the cost of Rs 10,000 per month, I would do the same thing.

As the Shanta Kumar committee report points out: “Some of the departmental labours (more than 300) have received wages (including arrears) even more than Rs 4 lakhs/per month in August 2014. This happens because of the incentive system in notified depots, and widely used proxy labour. This is a major aberration and must be fixed, either by de-notifying these depots, or handing them over to states or private sector on service contracts, and by fixing a maximum limit on the incentives per person that will not allow him to work for more than say 1.25 times the work agreed with him. These depots should be put on priority for mechanization so that reliance on departmental labour reduces.”

The Supreme Court judges have given the government a time of 10 days to respond on how this daylight robbery of the country can stop. “Labourers in FCI have an aggressive past. Officers have been murdered. There is a clique that is operating there and FCI has become a hen that lays golden eggs for them. The FCI is literally held to ransom by the labourers and their unions and there is something seriously wrong with it,” the Supreme Court judges said.

The prime minister Narendra Modi before he became the prime minister talked a lot about “minimum government maximum governance”. This is one area where the slogan can be put into practice. The loot of the nation by a few thousand workers of the FCI needs to stop. The money thus saved needs to be put to better use.

The question is will this stop? The trouble is that after being elected Modi has continued with the maximum government handed down to him. Any elected official (or for that matter even any individual) has limited time and mind-space to tackle things. This is even more true for this government, where the lack of ministerial talent is glaringly obvious and the government is run more and more by the prime minister’s office.

The prime minister’s office is busy with many things, propping up loss making units like Air India and MTNL, being among them. In this environment does it have the time and the mind-space to tackle the mess that FCI is in?

The column originally appeared in the Vivek Kaul’s Diary on Equitymaster