Category Archives: Everyday Finance

So, what should we do?

Much water under the bridge, many tons of newsprint in the recyling bin and many million bytes through the gates later, where do we find ourselves?

Bang in middle of the cesspool, I’m afraid. Its a quagmire! you say. Its quicksand, say the traders. Whatever you do, you cannot extricate yourself from this mess that free markets have landed us in.

Free – bosh, free with MY money, they were. That was the banks. And now, what are the governments doing? Spending my tax money from the future! Money I havent even earned to be taxed on yet! And given the redundancies, do we know if I will have tax to pay?

So,what should we do?

First, educate ourselves and face up to the truth. One, all spending is not evil. What is spending for one, is income to another.  Two: capitalism is not evil, just went down the path of greed and forgot to balance that with fear. Three: We are stuck in a vicious downward spiral, with overspend as our only paddle. Four: We have to think and make our way out of this mess, governments alone cannot do it.

Governments have started flooding the markets with money. Quantitative easing they call it. So, instead of us overspending on our credit cards and flooding the market with money, the government does it. How does this help? One perspective says that all that is happening is that consumer choice is being replaced by government control. Conventional wisdom says that the market is always right and the consumer is king.The consumer will always reward true value with custom and this will determine the survivors. Darwinian, in the sense of survival of the fittest. Replacing this with government control only centralises the decision making, making it so that bigger chunks can be dished out. So, big boss decides who gives value and who gives not.

The freedom tribe may have problems with this (and I count myself amongst them), but this is not the time to voice that (I hope others do). For I see the logic here. You cannot save them all, and small drips of funds may not be enough. It is better to consolidate and save the more worthy ones. So squeeze individual credit and splurge as a nation.

There are problems with this approach too, some very serious. First, who decides which company or area is a deserving recipient of our collective funds? Who can decide which ones are fit enough to survive and will deliver value on our investment? Both the jury and the candidates are under my doubting microscope here.

Then, there is the more serious issue of where the money goes. Deflation (especially in a recession) plus new money supply does imply inflation, but not in a good way. Economists fear stagflation,for the way out of it is steep, long and painful. The big fear here is that prices will rise faster and before jobs and paypackets revive. Which will leave many racing between the dole queue and the vegetable patch. This is a very serious concern and should be keeping policy makers awake nights.

Is there a way around this? Maybe.

It is going to be a tightrope walk, but the guys in charge have to balance credit with inflation, which is what they are supposed to do anyway – but this time they have to actively manipulate and manage it. Easier credit will help businesses survive, but ease it too much, and prices will start to rise. The mantra for this, handed down from the gods of economics, is – inflation is more money chasing fewer goods.

The first part of that has been implemented. More money is being pumped in. Now – to make sure that it does not chase a stagnant level of goods and services. Revival depends not upon the amount of money sloshing around. It depends upon what we do with it.

And what we do with this money depends upon how it is doled out. The governments are calling the shots, so it is now up to them to ensure that it is put to productive use.

 

 

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Irrational Exuberance

The title of this post is from a famous speech made by Alan Greenspan in 1996, which was followed by a crash of the stock markets etc. In that speech, he said that he pointed out that ‘irrational exuberance could lead to unduly escalated asset values’.

This, in a normal market would mean that a correction would be due. When prices (such as stock prices) rose too high, they would not reflect the true underlying value of the businesses they represent. Market makers should be able to spot this and start selling over priced assets, thus correcting the valuations to the right level. If the asset values had risen too high, then of course the fall would be harder – also known as a crash.

This (as he pointed out) is not worrisome if it does not affect the real economy – ‘production, jobs and price stability’. And warned of the complexity of the interactions of the asset markets and the (real) economy.

That mini-bust came and went. And then it was exuberant again.

After a while, irrationally so. We gave up on pure rationality, gave in to our fear and greed and went along for the ride.

We bought and bought and bought. We bought houses we did not need. We bought goods we could not pay for. We bought stocks just because some-one gave us a tip. We bought credit. We bought the hope of an unbounded future. We bought recklessness and untempered faith.

And some of us, funds, bought stuff that had been sold on before, just in new packaging. Bank A has a package of mortgages – solid as houses – lets buy that! Look here, Bank B has a package of credit card debt that they don’t know what to do with – we’ll take two! Cheap, recycled (must be good for earth (huh?)!) bundles of unreasonable borrowing – shall we have that too, dear?

It was all working so well. Everybody was doing something, rushing around looking busy. The cake would surely rise, and keep rising and then we’d have a party.

There were a few people, I’m sure who looked around themselves and said,”this is madness, it can’t last”. Some remebered their thrifty grandparents but their lessons seemed so irrelevant to the times. There were those who looked at the buy-to-let market in the UK and realised that the boom was over, but then there were many more new naive entrants to this market who did not have a clue, who carried on buying. Others looked at the stock markets, and then at the fundamental values of the companies and said to themselves, “This is like the dot-com bubble, it cannot last”. And watched the prices rise again, regretted the missed opportunity for profit and joined in again. And so we rose and floated away into the sunset.

Till night fell. And we were too far out to turn back safely.

Some of us will sink, will not survive. Others will find islands and turn into Robinson Crusoe. Others will build new boats and paddle slowly back. Some will find a ride on other people’s boats. And then, some will create opportunities along the way.

We need to decide which of these we want to be.

 

(c) meetasengupta

Of Rationality

Assumption number one of all socio economic sciences is rationality. All economic theories depend on this assumption, all models of financial behaviour are built to the expectation that the participants in the money game will behave rationally. If rational behaviour does not occur, the theories and models are rubbish – of less value and must be looked at again (rubbish).

So what is this rationality? It means that given a set of choices, people will always choose the option that gives them maximum value. So, if you have a choice between two banks to save your money in, one offering 3% and the other offering 4% returns, you will choose the one that gives you higher returns. Another example: if you have a sum of money to invest, you will invest it in a project that promises you the best returns (adjusted for risk).

Sometimes this does not work, of course. We are human beings and do not always operate in our best interests. (My coaching business is built on this assumption!) Going back to the example of the investor in a project: suppose he has two choices. One with a cousin whose family have been very kind to him and put him through school where the investment will yield 10% return. The other option is to invest in the bank at 10.5%. Both investments are for the same time period. The cousin’s business is of course more risky than the bank, but not really very much more. It is an established business and he just needs the money to refresh his machinery. The business has been giving higher profits than the 10% promised for this deal, so we are quite sure we will get the money back. What should our investor do?

Rationality demands that he maximises his returns and invest in the bank. But when unquantifiable emotions of loyalty, friendship or even fear come into the picture, economic decision making will not necessarily be rational. How will the computers and the financial models deal with this issue?

This is not the only time when rationality is abandoned. How many of us have said, “I must have a salad for lunch” and ended up eating something much more calorific? The rational decision making process was abandoned for something that gave a different kind of value. Or invested our purchasing dollars in the chocolate market when other markets made stronger calls on our wallet.

Why bother with rationality at all? Why does it matter? Because all of our markets are built and sustained on their ability to predict. The salad bar stocks as much salad as they predict rational customers will buy. If impulse takes over from rationality, then the shopkeeper must hold wasted stock, which, since it is perishable is a clear loss. 

Banks too have the same principle. They hold only as much loose cash as they predict will be required by their customers on a daily basis. The rest of the money that we put with them is invested in other people’s projects – locked away for a few years – you many say. If rationality gives way to fear, there will be a run on the bank. They will need to pay out more than they predicted, which of course isn’t there, at least for now.

What does that mean for us, the ordinary joe-on-the-street? Do we hold on to rationality just to keep their precious models and big banks going? Because, I’m going to do what’s right for me.

 

Yup, agreed.

And that’s the difference between micro and macro economics. Ditch the jargon, stay with the story. If I, blogjoe, feel insecure about my income and savings, I will start hoarding my money. Hell, I’ll even buy 50 cans of baked beans every few months and save them up. And so will a lot of people, because they are doing what’s right for them. If I could, I’d even stock up electricity payments and such like. And, I’m going to stop buying shoes, bags, chocolate, newspapers, cut back on cigarettes and alcohol.

What does that do to the economy if all of us do this? It kills the shoe industry, bag industry, chocolate industry etc. And they are employers too….but not for long. No income for them means no pay for their employees. Redundancies loom. Less money to spend means more companies in trouble, means more redundancies.

Does everybody suffer? And what does this have to do with rationality?

No, everybody does not suffer: The baked bean companies should do very well if all of us keep buying (till we get sick of them and the economy picks up!) Utilites are essentials, they should do well, as should discount retailers.  Our economic behaviour is perfectly rational, from our point of view. But my rationality is not our rationality. Once we understand that, we begin to understand why we are in a recession.

 

(c) meetasengupta