Rise and Fall

Recent trip to the US brought back some great memories. As I flew across the country meeting old friends, it reminded me of America’s massive size and power. Undoubtedly it is the capitalistic centre of the world. It was also equally clear in my two weeks in the country that it is a crossroad. Nothing proves this more than the never-ending discussions of the current political, financial and social problems on streets, bars, airports and these have more than ample coverage on media.

I have always been quite impressed and influenced by the philosophy and vision of America’s founding fathers. The country has prospered on principles of democracy, representation and individual liberty. This has manifested in the form of personal right of ownership of property that eventually led to a personal consumption culture that has made US the powerhouse it is today. But for the first time in centuries its future is uncertain.

Throughout history many strong and massive civilisations and culture have risen and collapsed. If you look back at the Greek, the Roman, Indian, Chinese ancient civilisations or more recently colonial Britain and Russia their downfall has not been brought about but one massive blow but slow accumulation of somewhat anticipated problems. Decline came about gradually due to an inability to adapt to changing environment and conditions in the world.

At first you might think I am alluding to current financial problems but I am not. Of course that is one significant problem but nothing compared to similar challenges faced by Europe. Europe’s own sovereign debt problems are contributing to its demise as a leader in the world. US on this dimension at least is much safer. With Debt/GDP ratio of around 80% it is still lot lesser than troubled European countries with over 100% and Japan with close to 200%. Also, USA has fairly efficient institutions, tax gathering mechanisms and low corruption which are certainly not the case in Greece. While financial position is a risk, I anticipate things will improve as economic cycle reverses.

USA’s long term problem and possible reason for demise is still going to be Oil. Why? Well, like almost all countries in the world, USA is heavily dependent on Oil. But there is one major structural difference. A majority of Americans live in suburbs designed around universal personal automobile use. This culture has had a huge contribution to America’s success as it encourages both home and car ownership. Home ownership in turn facilitates ownership of many other personal consumables. In addition to the suburban lifestyle which is heavily dependent on personal transport, about 90% of overall US transportation is reliant on Oil. As oil prices increase substantially it would become unsustainable for many. Even those who could afford it would be spending a higher portion of their income on ‘gas’ which would mean lesser disposable income to spend on other goods. Personal consumption accounts for 70% of US GDP.

But as Oil price rise wouldn’t that change behaviour and bring down demand? Ideally it should but unlike other countries people don’t have many transport options in US. Europe and Japan has a massive rail and metro system which is connected to the grid and can work of alternative energy sources. China, India and Brazil are making heavy investment in similar mass transit systems. Typically, these mass transit systems take about 20-30 years to fully develop. Even for 1st phase or line of a Metro system you are talking about 5-7 year development period post financial approvals. The rate of growing oil demand is not going to be offset enough by these initiatives but it does provide consumer an alternate mode of transport. However, in most parts of US that alternate does not exist.

This could be very significant and challenging problem if investments are not made now. By every account and given the financial difficulties, US is not planning any major investments in transport infrastructure in the near term. Most economic projection indicate that US would still be the 2nd or 3rd largest economy in the next 50 years but this rests on an assumption of continued 2- 3% growth rate. This could be severely tested if oil price rise predictions come true. There are many ifs and buts in this argument but ‘if’ this was true it’s not something that could be addressed overnight. It requires foresight and planning. Many a country have failed for the similar reasons, is US going to be next?

History of the world economy

Some who are convinced of the infallibility of countries and regions never believe when I mention economic history of the world, its cyclic nature and winners and losers of the past. So when I came across this, I thought I'd post it for anyone who needs convincing. I think the important lesson is "every dog has its day". Important to be humble when you are successful. Someone will beat you, its only a question of time.

More financial troubles ahead?

The news of legislation to increase oversight on Federal reserve got me curious about their current state of affairs.

More on proposed legislation >

http://www.marketwatch.com/story/fed-audit-bill-gets-backing-from-key-lawmaker-2009-09-25

I wanted to investigate how much Fed's credit has expanded in the past year see if there are signs on trouble as we emerge from the recession. Its the first time I'm looking at Fed's balance sheet and am not even sure I can understand it. However, whatever little I did understand makes me very nervous.

http://www.federalreserve.gov/releases/h41/Current/

Reserve bank credit has almost double the past year from $1.1 trillion to $2.1 Trillion. About $900 Billion of it coming in increased Treasury Securities. But I also noticed that fed has about $690 Billion in Mortgage backed securities. I wondered if this was marked to market which I doubted and the footnote provided more details.

"Guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. Current face value of the securities, which is the remaining principal balance of the underlying mortgages"

It appears that they are not marked to market but at face value of remaining principal balance which is cause for concern as these were trading at 10 cents to the dollar when they were bought. Most market participants thought that they would collect the fraction of the face value due to defaults. Fed is holding off selling these MBS for now but when the eventually do sell them they might incur a huge loss. I wonder what it means for a central bank but a $300 - $400 B loss on $2.1 T balance sheet can't be good.

Coming bank to increased credit and corresponding increase in treasury securities, it has to be inflationary. When the economy shows any sign of recovery inflation might be a big problem leading to a weak dollar. Further, holders might look to offload their US treasuries leading to Dollar plummeting. We might be in for serious currency crisis with lot of volatility world over.

Again, I am not a economist and most of what I have said is speculative. However, whatever I do understand is concerning. I did search for other who might be looking at fed's growing balance sheet. While most did say inflation is on cards I found this one particularly interesting saying that its not necessary and not inevitable. This one's explains it via basic marco-economic principles.

http://taxesandbudget-blog.ncpa.org/the-feds-balance-sheet-and-inflation/

All said and done I am still wary of another impending shock and I think its best to be prepared.

Rampant consumerism needs a cutback

Couple of posts earlier I wrote about how increasing leverage and spending was risky. 

http://anandologue.blogspot.com/2009/01/no-lesson-learnt.html

At least someone agrees with me. The savings rate in the US is on the increase from -6% to 3.4%. 

Its interesting to note that most economists and government still think that increasing spending is the answer. What matters is how the increase spending is used. As an individual if you are under financial stress you curtail your expenditure and save a little to get out of strife. So why is it so different for the country as a whole. Well if you can borrow some money and invest in improvement in productivity etc that gives you a higher return than what you borrowed at, well then you are creating value. However, if you  borrow to spend, that's digging a deeper hole. I guess what matters more is not whether you have big bailouts but how you use the money to get higher returns than what you borrowed it for.

No Lesson learnt

As I see it, the current US&World financial crisis was a result of greed. If we dig deeper we can also say that it was due to improper valuation of risk. Now that US economy is in a big hole what's the solution - borrow some more? I am not sure if anyone else sees the problem as one of living beyond the means requiring to curtail expenditure and increase savings rather than borrowing some more.

The current US federal debt is around $10.6 trillion-1. With the proposed second bailout this might well inflate to $12 trillion by the end of year. Every penny US borrows it has to pay interest on. As of now US and Federal reserve has the luxury of keeping interest rates low while still having people interested in funding US debt. This keep the interest payments down to very low. Since the world considers US dollar as a reserve currency, in the time of crisis such as this, they are happy to transfer their assets to US dollar. Hence US dollar is also very strong at the moment. However, things are bound to change sooner or later.

Emerging economies are posting relatively strong growth and sooner or later people will start to look for alternative investments that they do not consider to be much riskier. It would then be harder for US to raise money at very low interest rates, they might have to raise them a notch. The interest payments will at the same time start to balloon. Of course US has nothing to worry about as it can print more money as and when it wishes. However, the inflationary effect of such an action might result in US dollar falling sharply. This in turn would require Fed to raise interest rates to prop up US dollar. 

In past several countries have faced these economic and financial crises and as far as I can tell IMF always advocates tightening on spending. I understand why spending is required to stimulate the economy but feel that we must consider the additional risk that comes along with it. So the question is whether government should in turn be advising citizens to save, live within the means and forgo certain pleasures at present to ensure a safe and secure future. Or is the American lifestyle uncompromisable at all cost. Is US willing to take a risk of deeper collapse to ensure a quicker recover? Appears we have not learnt anything from the current debacle.

-1 http://en.wikipedia.org/wiki/United_States_public_debt