Perils of discretionary stimulus spending

This NY Times article talks about the difficult decision that the Obama administration faces on deciding on the right stimulus to aid the ailing economy:

The unexpectedly deep plunge in home sales this summer is likely to force the Obama administration to choose between future homeowners and current ones, a predicament officials had been eager to avoid.

This is the kind of dilemma that one is bound to face on a discretionary stimulus spending. We know that Keynesian economics dictates increased spending when the economy is depressed but it does not say which is the right stimulus and which is not, especially when such a stimulus while helping one section of the population, hurts the other. At some point, such as now when the elections are closeby, this is likely to become less of a economic decision but more of a political decision.

Low interest rate regime

Five year US Treasury yield curve reached it's lowest since the beginning of the year:This is good news from different counts:

• The borrowing costs are lower and hence the US govt can push for more stimulus much needed for the current economy
• The possibility of future hyperinflation seems low, at least that gathered from the view of bondholders
• There isn't any deteriorating confidence on US' capability to repay its debt. There aren't bond vigilantes as people fear, but there are rather bond market deficit cheerleaders!

Household finances yet to recover

The financial obligation ratio published by US fed shows that the homeowners are still paying a higher than normal fraction of their income on mortgage obligations.

After reaching its peaking in Q1 2008 at 11.35% this number is slowly dropping, but it hasn't yet reached the comfortable 9-10% range. This number does not totally capture the extend of indebtedness of homeowner during the housing bubble, as most of the loans had teaser rates for the first few years and ample provisions for refinancing. But still this is a good enough indication that it will take a few more years before the household finances reach their stable state.

Parallel world

It is interesting to see how the macroeconomic conditions of EMEs have evolved at a stark contrast to that of the developed nations post financial crisis. EME countries such as India and China have already emerged strong from the crisis. Reserve Bank of India estimated a growth rate of 8.4% in its last estimate for 2010-2011, revised from previous 8.2%. China is expected to grow at 10.5%. While the western countries are worrying about a double dip recession, deflationary condition or a permanent shift to the natural rate of unemployment, the EMEs are concerned about their rising inflation resulting from rising demands.

There are many reasons for the better fortune of these emerging markets. Important of them all, the role of developing countries has taken a complete U-turn in the last decade or so. Previously these were the recipient of capital while now they are the donors of capital. Learning from the East Asian crisis of late 1990s, these countries have moved towards a sustainable current account model. Like the story of the grasshopper and the ant, during the good times western countries, predominantly the US had increased its domestic spending without saving for the future. This was incentivized by lax monetary policy, tax cuts and easy liquidity which eventually lead to the asset bubble. In the same time, developing countries were building on their reserves keeping the exchange rate low. When the conditions went bad, these countries were in a much better position to fight global economic crisis and could quickly recover.

The unprecedented boom and burst of property market in US and Europe was largely absent in developing countries. In countries like India and China, the buyer always has to put a substantial portion of capital upfront (as much as 40%), hence there is a large cushion before the loan goes bad. The lending system is still old-school, with banks lending money against its deposits. Hence these banks have every incentive to make sure that the loan doesn’t go bad. Also defaulting on their loan is not a socially accepted norm unlike in US where things like strategic defaults are common (even those who can very well afford to pay their mortgages, ask Chamillionaire). Hence even though the property prices went down, it did not see the kind of fall that the western countries experienced.

The financial markets in emerging markets are still nascent and these were relatively untouched by the financial innovation such as CDO-squared, synthetic-CDOs, CDS etc. Even the penetration of basic financial instruments such as mutual funds are quite low in these markets.

Hence even though emerging economies are not completely decoupled from the rest of the world, we can see a separate trend developing across these two parts of our world.

No stimulus debate for India

Now that the US economic recovery seems much slower that originally predicted, there has been a lot of debate in the US on whether to increase economic stimulus or to opt for economic austerity. The democrats (and the fed) favoring the former while the republicans favoring the latter. Keynes Vs Hayek debate still rages on. (And we even have a rap anthem for this debate: "Fear the Boom and Burst" , a youtube hit). All this raging debate is likely going to stop fed or the government on taking drastic action to revive the economy.

While back in India, there is no question but to gradually cut back the stimulus. Growth is strong, inflation is worryingly high. There are good signs that RBI will continue withdrawing its monetary stimulus. The interest rates will likely be further raised to combat the inflation problem. On the fiscal front, our stimulus is much lesser (.6% of GDP in 2009) than other bigger economies like US (2.0%) or China (3.1%). Hence there is nothing much to cut back here.

In contrast to US, here in India we leave the policy matter to the experts and there is little debate on whether Keynes is right or it is Hayek. All we need is affordable food prices. Thankfully so!

European stress test

Much awaited stress test results of European banks arrived on Friday and as expected the test did fail some of the banks. For the test to be credible, it was expected that some banks had to fail, but the question was which ones? Greek banks were of obvious concern but it turned out that apart from one bank all others did pass the stress test. Spain banks had mammoth share of failed banks with 5 cajas failing. Germany's Hypo Real Estate was the 7th unfortunate one to fail.

It is natural to ask if these stress tests were credible enough to pull up investor confidence on the passed banks? The whole point of stress test was to separate out Akerlof's lemons from the market. The tests practically could not have failed the bigger banks as it would have worsened the European economy already in a dire state, and the whole point of this test was to help revive the economy. In the other end the test could not have passed all the banks, which would definitely question the rigorousness of the tests. Hence the results of the test are pretty much as expected. A small number of banks failed. We can only wait and see if this will have a strong positive impact. But there are already questions on the credibility of these tests.