IS THE DEFLATIONARY TRAIN UNSTOPPABLE? NOT REALLY

LITTLE HOPE FROM MONETARY POLICY

Monetary policy operates through the financial system and banks are capital constrained. Even if intermediaries could lend, consumer balance sheets are not looking great with significant decline in asset values and the resulting increase in leverage. Credit off-take for capex will be cautious given that consumer demand is imploding. Conventional monetary policy is not working and will not work.

DIRECT GOVERNMENT SPENDING IN ISOLATION WILL LEAD TO A FEEBLE RECOVERY WHICH IN ALL LIKLIHOOD WON’T BE SELF SUSTAINING

There will certainly be a first round effect of direct government spending. But in the current environment, I remain doubtful about the efficacy of the multiplier effect. Heightened uncertainty will mute the second round effect due to a rising propensity to save. In fact, I think tax cuts will likely fail completely.

BEST USE OF GOVERNMENT MONEY IS A CLEANUP OF FINANCIAL INTERMEDIARIES

I do not think that bad loans need to be restructured or forgiven outright. Debt relief might create a perverse effect as it will encourage people who are current on their payments to default (worsening the problem). And I can’t think of a way to negate this incentive problem.

The value of doubtful loans or securitized assets needs to be written down fully. Private sector needs to step in with valuation expertise to lend credibility to the exercise. Once the quantum of capital shortage is known, the government needs to inject equity directly. I do not see any problem with public sector ownership of financial institutions as long as there is explicit commitment to privatize at some future date. The authorities need to step in when market failure is apparent. Right now is not the time to ensure allocative efficiency. The first priority is to allocate, then ensure that it is done the right way.

Once trust returns in the financial system, banks need to focus on the developing world to fund projects. The world needs to return to normal. The wealthy save and lend, the poor borrow and invest to create factories, roads and bridges.

MEANWHILE MONETIZED DEFICITS ARE REQUIRED TO SIDESTEP THE DYSFUNCTIONAL POLICY TRANSMISSION AND PREVENT DEFLATIONARY EXPECTATIONS FROM GETTING ENTRENCHED

Given the complexity of the politico-economic process, this clean up will take time and the government needs to sidestep the normal economic process and spend by borrowing directly from the central bank. This will provide a floor to the economy and prevent deflationary expectations from gaining traction.

EVEN WHEN DONE RIGHT; THIS PROCESS WILL TAKE A LONG TIME AND THE DEVELOPING WORLD WILL TAKE THE LEAD IN GROWTH

The factories in Asia that catered to U.S. consumers will no longer be viable. Consumer preferences differ in the less developed economies due to cultural dissimilarity and income levels. No amount of monetary easing can create huge demand for certain luxury goods in countries such as India and China. Production structures in export oriented economies will need to undergo painful restructuring to cater to domestic demand.

IF MY IDEAL POLICY WORLD MATERIALIZES, DEVELOPING COUNTRY EQUITIES WILL OUTPERFORM OVER THE NEXT COMPLETE CYCLE

The world worked in the following way over the last 5-years: home prices climbed leading to a positive wealth effect on U.S. consumption. This demand spilt into the external sector resulting in a higher current account deficit. Similar housing booms in Spain, Ireland and U.K. also reflected in expanding trade deficits. Export oriented economies such as Japan, China, Rest of Asia, and Germany expanded rapidly. This synchronous global upturn led to spiraling commodity prices, transmitting the up-cycle to countries such as Russia, Chile, and Australia. International investors financed the burgeoning U.S. external gap by driving the dollar lower. Global central banks bought U.S. assets (treasuries and agencies) to prevent their currencies from appreciating to benefit from U.S. demand. This chain is broken. Implications are obvious.