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Currency of ChangeBy: Procyon Mukherjee
The World’s Balance Sheet, Household balance sheet et alOn 30
th
March Alan Greenspan delved into a particularly interesting topic in theFinancial Times. He explained that the world’s economic balance sheet hadassets at fair value on one side and the equity (wealth) on the other, the debt andderivatives simply cancelled out. He talks about a decrement of a staggering $40Trillion in the combined equity that is roughly 60% of the world’s GDP; thisproliferates as a decrease of an equivalent amount from the assets as well. Theimplication of this statement is many fold. The change in world’s finances andfortunes in the last one year had taken the wind out of its sails, by a stratosphericamount, the stock markets saw a more than 50% contraction, the real estatefollowed suit or preceded it with a shrinkage; the commodity linked assets had asimilar fate. When the balance sheet size contracts, the power to leverage assetsshrinks, the power to grow dwarfs as well. What is left is the continual urge tocreate conditions where fresh infusion of capital could be made as productive aspossible.For all this to return in a rally within a few quarters is a pipe dream, which manybelieve or are made to believe; reality is distant from it. Aspirations can rallyaround a dream for the future, with job losses multiplying every month, thisdream is not in the right direction for change to happen soon.Small lessons from the last bubbleThe article by Steven Gjerstad and Vernon L Smith in the Wall Street Journal on6
th
April brings out a very relevant point in relation to the last bubble that theworld has seen. While it was no different than the dot com boom and burst it wasdifferent in one aspect that the loss got transmitted through the maze of fictitioushedges that the financial system created to ward off the credit risks. This losstransmission ability of a bursting bubble never got seen in such rapaciousproportion than this time. The other point that this article points at is that thehousehold income in U.S. hardly changed whereas the housing prices drove thewealth effect out of proportion, so when the prices have gone back, this wouldcause widespread misery to people entrapped in debt.The article by Roger Altman in FT on 6
th
April, takes us a step further by pointingat the peaking of the net worth of the households at $64 Trillion in 2007 to$51500 at the end of 2008 and this when the household debt is at 130% ofincome, it shows the shrinkage in assets would tend to make spending more
 
difficult as the illusive wealth effect seems to be fading fast and sharp. The jury isstill out about the enduring effects of the wealth factor as this act on bothdirections; the rise of the halo effect of wealth created in an upturn of the assetprices work in the other direction, when the sudden drop takes place in the samevery assets and the consumers move to savings instead of spending. In the laststock market boom and bust at the beginning of this century, this phenomenonwas not seen in so much in evidence as is evident in the current crisis, perhapsexacerbated by the financial crisis of the banks and due to the effect oftransmission.The household balance sheet to be brought back to better shape would needdebt to be driven down, but that to happen when the equity has shrunk by a largeamount, would mean that discretionary spending to be curtailed. The need forcapital therefore would be coming down.The corporate balance sheet has a far deeper problem to be sorted out. Thosethat had leveraged their assets for a buy out have the maximum shrinkage intheir net worth, those that have not have still the problem of sales receding fasterand investments not paying off as growth drivers have changed.The bank balance sheet have toxic assets that even if removed from the balancesheet would not be able to erase the liabilities unless they can be packaged andsold at a price that would leave some gains at the end. But this to happen wouldmean governments to take the brunt of these losses with tax payer money. Thebigger problem is that banks have losses that take a substantial portion of theirequity or capital away from being lent to lenders. The amount of lending neededto make the markets claw back to normal levels would mean large capitalinfusion into the banking system and there is not much that can be expected fromthe households and the reliance on the central banks and government would beattracting a lot of other issues; the federal reserve balance sheet although notbad for the time being could turn for the worse when in some time the inflationarypressures mount or the budget deficits create additional problems in the future.The great economists of the world have interpreted the challenges in manydifferent ways and there seems to be convergence in some of the points, butdivergence still exists. The monetarist stance would be towards looking at taxcuts and making money available to the people for more spending instead ofgoing through the circuitous route of making it available through public spendingby the government. The excess money supply through lower CLR did notinfluence much though and with interest rates now at historical lows, themonetarist philosophy seems to be drawing less attention. The Keynesians areback it appears and in more ways than one it appears that we move towards amore government ‘intervened’ market system, at least for the near term. But firstlet us look at what some of the great economists of our time seem to be saying.
 
J Bradford Delong of Berkeley, in his essay on 30
th
April, Kick-startingEmployment, had pointed to the popular view of government being the spenderof last resort and thus both in the act of buying up bonds and raising their pricesin the process it will thus shift the focus on corporate bonds and mortgages thushelping to kick-start employment. His views on the need to run extra-large deficitspending by the government however needs to taken with a pinch of salt.Mr. Greenspan’s prescription seems to be pointing towards a revival of the stockmarkets or at least a part of it, but it is not clear how it would happen. Surely itcould not happen from the bailing out of banks, which is just a process ofrecapitalizing them or helping to deleverage them. Even that act runs into someproblems due to adverse selection sighted by Stiglitz (1
st
April ’09 in New YorkTimes) as the process led by Treasury is marred by an asymmetry that the bulkof the risks are taken by the tax payers while the gains are better distributedtowards the entrants who put the new equity for the assets gone bad. Theprocess as per Stiglitz resembles the market for lemon problem, as banks onlyknow far better than anyone else which lemon is worse than the other. Howeverthis could be improved with more information availability and thus people whenthey would find these assets less risky it would aid their prices to go up as perDeLong.Tainted balance sheets of companies have two possible problems, one is theproblem of liquidity, the other is the problem of a continuing squeeze on the networth as the difference of assets and liabilities keep falling short of the need. Tothe first problem there has to be focus on shifting to making the assets moreefficient in terms of turns so that speed of money collection over spends could beincreased, no small problem though to achieve this. The solution to the secondproblem is essentially the non-banking example of re-capitalization.How did currency influence some of the severe shock events?Steve Johnson on March 22 FT writes in his article ‘Currency volatility promptsradical rethink’ that currency assets in the downturn actually moderatelyoutperformed any other asset class. Defying conventional logic, which says that itis a zero sum game as with zero beta one class of investors can make moneyonly at the expense of others, but in carry trade ‘the practice of borrowing in low-yielding currencies and buying higher-yielding ones – benefits from a riskpremium akin to that of equity markets, and therefore can deliver long-termpositive returns’, is what he proves with examples. He goes on to prove thatwhile a very large number of players including government and the corporate tryto hedge their losses without a profit motive, the other class of currency traderswho were profit seekers were uniquely positioned to make gains on volatility. Till
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