domingo, 8 de noviembre de 2009

Lessons learned from the visit of Krugman to Buenos Aires

Lessons learned from the visit of Krugman to Buenos Aires

Introduction

Paul Krugman, in the speech delivered to thousands of persons in awe, which was only interrupted by a ring tone, analyzed during an hour his views on the economy of the world. Both in the speech and in the press conference, I felt that I was listening to a wise and tactful ambassador, different from that controversial and ironic Paul Krugman that I enjoy very much when reading his papers and journalistic articles.
Certainly, the content of his message was as rich as usual and those who could read between the lines got some very interesting ideas.
Today in this document, I will make a summary of the topics delivered by the Nobel Prize winner and afterwards I will submit some brief conclusions.

Not just a real estate bubble

Krugman pointed out that the disproportionate increase in real estate prices was the consequence and not the cause of the global financial outburst after Lehman Brothers. In other words, the causes of the crisis could be the excessive flow of funds derived to the financial system , not only to the US ; the high volume of liquidity helped the banks to build up the huge portfolio of derivatives that spread throughout the world and that increased exponentially due to the multiplying effect of the financial products. Krugman also mentioned that the bubble occurred in other countries such as Spain and England, which joined the speculative trend straightforward.
Those huge flows of money were also transferred to Eastern Europe, thus generating currency crisis and hyperinflation. The economist mentioned Latvia, a country that suffered a similar process as Argentina.

Similarly, the Nobel Prize winner highlighted that, apart from the “bubbles”, there was another reason originating the crisis: only official banks were under the umbrella of the regulators, however, other structures were left out of the regulations which, in spite of the fact that they were not banks, operated by taking and lending money. Those so called banks are “REPOs” and other “financial derivatives”.

What is the meaning of a REPO?

REPO is an operation under a repurchase agreement by which one entity sells an asset, usually a debt bond to an investor, at the same time he agrees its future purchase at a specified price.

What is the meaning of a financial derivative?

“A financial derivative” (derivative instrument) is a financial product with a value based on the price of another asset, thus its name. The related asset is called the underlying asset, for instance gold. The underlying assets can be varied: equity, stock indexes, fixed income, rate of exchange or raw material”.(Barron´s-Dictionary of Finance and Investment Terms).
As can be observed, the multiplying effect of these instruments is endless, everything based on the guarantee of just one good (for instance, real estate) generating the financial instrument.


Considering the aforementioned, the question would be: how such extreme situation of deregulation was reached enabling the implementation of sectors parallel to official banks.
And the answer would be that many global political and financial sectors considered that the market would be self governed without the governmental official participation.
The results are evident.

Which factor contributed to US’s overcoming of the crisis?

It was not an extraordinary aid but:

In the first place, the central banks did not make the same mistakes as those made in the crisis of 1930: in that moment interest rates were hiked while in the 2007 crisis, interests rates dropped, with a high volume of liquidity injected to the market.
In addition, nowadays Governments have a greater power of action as compared to the beginnings of the XX century; therefore they can maintain and even increase public expenditure while fiscal income decreases. Thus, they foster consumption and investment in times of crisis.
Similarly, the political power could assist banks by purchasing illiquid assets and so help entities with cash to meet their obligations, and avoid massive bank runs.
Finally, incentive plans help overcoming difficulties, but in a smaller scale as the aforementioned actions. In this sense, plans could “only” avoid 1.5 million of new dismissals in a labor market of 154,577,000 employees.

The “end of the world” is over, but we stand far from getting back to the good old times.

In the next 6 to 8 months a new contraction of the global economy is expected since companies are approaching the process of building new stocks; and if the demand does not quickly reactivate –unlikely to happen-, dismissals will return and industrial production will drop down.

In the coming years, it is likely to expect a growth of the economy, while the unemployment issue in the US will extend until 2012. These will be the “normality” features in the future economy.

Several questions answered by Krugman:

Why the economy recovery will be slow?
Because, at the moment, no dynamic circumstances which trigger an economic growth of big proportions is visualized (for example, Internet arrival that created the "dot com" boom)

How countries recovered in previous crises?
For example, after the 1930’s crisis, and also in the Second World War, during which countries lined up within a productive project, leaving aside the problem of inflation and fiscal deficit increase

Or also, devaluing the exchange rate and markedly increasing their exports to generate favorable cash flow balances. The problem is that this crisis is global and not all the countries could export their production; because there is obviously the need of other countries to buy the goods.

How it is perceived the recovery of the current crisis?
It will not come from the US, a country that will have to resolve its problems derived from the sub-prime mortgages. Neither, it will be guided by Europe, absorbed in settling fiscal and currency difficulties of several of the 19 members of the EU. Least by Japan, that must revitalize its depressed internal demand. Then, only remains the expectation that China shall be the “pusher” for the global economy.

However, there are two issues that make China a long term prospect more than a current reality:
On the one hand, its economy is growing but it still represents half of the American or the European economy.
On the other, the Yuan value is set by the political power and lacks free convertibility. For the rest of the world, there is no flexible and accessible market for that currency. Thus, when the US Dollar slumps against the Euro, it does not slump against the Yuan, originating a model which distorts reality.

In what way the US can achieve a faster recovery (since it is still the largest market in the world)?

Through a greater expansion of public expenditure and this can be done since the US still finds investors who are willing to fund the deficit at low rates, at least in the short term. But this policy does not seem to be carried out, due to the opposition of a significant portion of the political sector and the press. The most favorable thing to do would be to increase private investments. But it is unlikely that this will happen within a context of high industrial idle capacity and a consumer low demand.

Krugman expects and wishes that investments in the sectors linked to ecology-green industry encourage the return of the private investors to the investment market.
What’s been said aims, in short, to a long period of weakness for the US.

US indebtedness

Paul Krugman considers that increasing the indebtedness of his country will not worsen the current situation. Before the crisis, the American debt represented 40% of its GDP, and it could climb to 90% in the coming years. However, countries like Belgium or Italy evidence a higher indebtedness than 100% of their GDP, without generating a financial crisis.

In the US process, it is essential that people keep on trusting the US Dollar and lending money to the Treasury, at rates closed to 4% annual.


Currency

Given the central role of the US dollar in the international commercial and financial transactions and even in daily activities, it is not expected that the North American currency will lose in the near future its leadership. There is no other currency nowadays that can fill the same functions as the “greenback”. For the North American currency the only problem would be the loss of people’s credibility. This did not seem to happen during the crisis.
On the other hand, the Yuan is not ready to contend with the US dollar, since the Chinese currency is “non- convertible” and therefore not internationally tradeoff.
The Euro seems to be the strongest competitor for the US dollar; however it is completely far from the North American currency’s strength and global coverage. This is so because the European currency evidences the unequal reality of 19 countries with different fiscal and solvency risks. Certainly reliability differs at the moment of investing in Euros in Germany, Spain or Italy. This characteristic leads to the fact that the EU currency lacks an integrated financial market to compete with the US dollar.
Asian currency is completely disregarded as an economic competitor with the North American currency due to the significant economic and social discrepancies existing in Asian countries.

Brazil, Russia and “ICHS”

We have heard a careful consideration in the sense that it is not always true that good performance during a crisis implies success during good times.
It seems that for the Nobel Prize winner, our neighbor represents a promising future.. and will continue to be so until it is proved that its economic model can be implemented not merely during a moment of crisis.
He was also uncertain as regards Russia’s evolution and finished his comment by saying that successful countries in the future would not be “BRICS”, but “ICH” (China and India).


Argentina

Krugman revealed that our country does not fill much space in his agenda neither in President Obama's , which can be positive. He believes that the relative position of our country faced with the crisis was “positive, as opposed to 2002.
The economist that supported the country's exit from convertibility and subsequent renegotiation of the sovereign debt, considers that our country needs to build a (reputation” (international credibility and reliability). This could be achieved by maintaining the direction of the regulations and policies implemented during reasonable periods of time.
Finally, he insisted on the benefits for our country derived from the commodities’ boom in the world, and at the same time he explained that agricultural taxes are not successful worldwide.

The future debate

Future strategic commodities will be related to environment: air, fresh water, climate, general environment.
It is expected that companies will make considerable investments in environmental sanitation and in the reduction of contaminating gases emissions. This will decrease their profitability in the short term.
It is estimated that the global GDP could decrease from 2 to 3% due to the necessary steps to reduce contaminating gases by 20%.
Additionally it is believed that there will be changes in the economies due to the climate change, which could lead to new investments in “green” projects.


Conclusions

If I would make a summary of the North American economist's comments and my own reflections from what has been mentioned I would highlight 5 topics:

1. The US economy is weakened and it will take years to gain strength again, but the general opinion is that it will be accomplished. Besides, the US is still the leading power in the world.
2. So far the US dollar is the undisputable leader. Even facing severe problems and surrounded by competitors, there is no competitor able to replace it as the prime currency in the financial and commercial world.
3. China is the fastest growing nation and where the future lies. But nowadays, this nation needs strong political, economic and social achievements to be considered a leading power. India would go hand in hand with this giant in the development process.
4. The commodities demand will continue to grow. However in the next few years, fresh water and non polluted air will be the core elements, the demand of which will grow exponentially due to the shortage of such resources.
5. Our country has the potential for growth but it is not under the strategic range of the “leading “countries. Gaining credibility is basic for our economic and social development.

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