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Snapping at the Heels

The markets seem to be confident of things working out, but the author doesn’t know where this confidence comes from

The Dow Jones is near a historical high, even as the DXY Index is at a mid-term high. For a currency that is almost guaranteed to break up, and/or issue about 3 trillion euro of new currency, the euro is just about 7-8 per cent down from its intermediate highs of 1.35.

The Indian markets, knowing what they know about the country they are in, seem to be trending towards the end of the runway; either they will crash into the ramparts, or they will lumber up towards the sky, at least for a while.

All over the place, the all-knowing markets seem to be very confident that things will work out, and yet…..I don’t know where they get their confidence from!

• If Obama comes back, will we go back into the gridlock that we saw in August 2011? Or will the chastened Republicans just quietly fall in line and wind up their Tea Party? If that happens, will the US continue to run 9 per cent fiscal + current account deficits into 2015, taking them well past the 100 per cent public debt ratio? What will then happen to the $1.6 trillion of balances with the US Fed, which were still lying there at negative real interest rates, when I last checked?

If Obama balances the budget, what will he cut? And if not, what (taxes) will he raise and how does that affect private enterprise? Maybe he will do a little bit of both, cut defence + raise cap gains and dividend taxes, besides rolling back the payroll tax cuts, even remove the mortgage deductions (why not? The last thing you want now is to get any leverage back into housing)

• If Romney comes, that itself scares me to death, but anyway, he will if he must…! The point is, thereafter, will he do what he says, or will he be what he looks…i.e., a politically expedient liar, who speaks with crossed fingers. If he is sensible, he will cut entitlements, maybe a little too deep; it may have humanitarian implications, and history may not remember him well, but the economic damage will be limited. Especially in areas like geriatric care, welfare payments, etc. But a big possibility is that he might cut taxes, which is the easy part, and leave out the rest.

• The Fiscal Multiplier measures the impact of changes in government spending (or taxation) on broader GDP growth. We all know Consumption+ Investment + Govt Spending - Imports + Exports= GDP. What many of us don’t know, is that a change in any one of these ‘components’ will also affect the other components. The net effect of a change in government spending, divided by the change in GDP, is the multiplier

What makes government spending a little unique, especially during a recession, is that it is mostly funded either by debt, or by deficit financing (i.e., printing cash). This produces inflation, which obviously affects consumption. It also affects investment, because that is dependent on savings, which drop in periods of high inflation.

During boom periods, tax revenues are buoyant, so there is no need for the government to pump prime. Theoretically, a utopian government would salt away some of this money, by paying down debt. This rarely happens in practice.

In the middle of a bust, a debt-fuelled spending spree by the government rarely produces the impact that is desired, because the increase in debt is disproportionate and the government misallocates that money to its favourite constituencies, who are either poor or political, i.e., not business. This does not have the knock-on effect on savings and consumption that it is supposed to have, leading to inflationary pressures. Perversely, this inflationary growth in nominal GDP leads to some buoyancy in tax revenues, which can be used to service the debt incurred to fund the government expenditure in the first place.

Rarely, a government has already run up huge debts, which have already been misallocated or frittered away. A large number of developed countries have been running up debts to fund welfare entitlements; among many other things, this is what has created, at least in Europe, a sovereign debt crisis. In many countries in Europe, they have got past the tipping point, i.e. if you cut government spending by 1 per cent, GDP falls by >1 per cent. So if you cut spending by 1 per cent, and GDP falls by (say) 1.7 per cent, then tax revenues fall by 0.5 per cent, leaving you with a marginal impact on the deficit.

This is how it works. Suppose you have expenses of $110, while taxes bring in $100, leaving you with a deficit of -10 per cent. Now, when you cut expenses by $1.1, you are now spending 108.9, while taxes are now down to 99.5 per cent, based on the logic recounted above. This now leaves your deficit at 9.4 per cent, only 0.6 per cent down while GDP is down by 1.7 per cent. This is what we are seeing in Greece and to a lesser extent, in Spain.

Think of government debt as a nicotine addiction. While picking up the chain-smoking habit, you replaced eating with smoking, but at least you were enjoying yourself. Now, as you try to return to eating, the withdrawl symptoms are painful, but the resultant loss of appetite will anyway kill you. So you’re damned if you do and damned if you don’t…

The US is not in such bad shape, but its Fiscal Multiplier has reached 0.5, i.e. a 1 per cent drop in government expenditure will reduce GDP by 0.5 per cent. Given the sclerotic 2 per cent growth rate, a combination of inventory de-stocking and some sustained reduction in government spending will push them close to recession.

A hike in taxes would hurt savings and investments, just what you don’t need. Consumers are anyway too highly leveraged, it is the savers who would have come to your aid, and those, unfortunately, are the rich.

• If you look closer at home, I can’t find anything to celebrate either. Only 215 of the top 1,000 companies in India have free cash flow of any size, and if they don’t borrow any more, they will have to carry the burden of increasing investment rate. The Indian household sector, that great big beacon of hope, has seen a fall in the savings rate. In any case, given the high inflation, savings is a bum’s game in India. We will continue to have red-hot demand from millions of people who shouldn’t have been born in the first place…and their existence will crowd out whatever productive capacity the rest of the country has…

• At the other end, Europe is the big one. If you add the pension obligations of the bankrupt Greek Government, it adds up to $1.2 trillion. That is not the kind of money even the Germans can absorb. Combined Europe has the problem that India has – a bankrupt (Greek) government that keeps increasing its ability to soak up whatever is produced by everyone else

• The only way they will get out of this, will be through a massive inflationary shock. Or an implosion that breaks up the currency union; I believe that the former is more acceptable (provided it is in a controlled fashion) than the latter, which could trigger Armageddon

What I don’t understand is why gold is 30 per cent off its highs, silver 20 per cent, DJIA is right up there, and the euro is back ‘in range’. Our own Nifty is up 26 per cent off its bottom, and about 10 per cent above the levels of August 5, 2011. This, mind you, as we head into another day of Reckoning. Most volatile indices are back at 2007 levels, even as we head into macro headwinds of inflationary shock and bond market revolts. Sounds more like 1973 than 2013; is it because most of the fools in the market right now were born after that year?!!