Economic Crisis – Can perception Beget Recession?

What started as a mere financial crisis in the US has now manifested as a serious economic problem in many countries rendering the Governments and the Central Bankers helpless. The current crisis is comparable to The Great Depression as it impacts people from all walks of life. The road ahead looks gloomy with the writing already on the wall – its recession now in US, UK and Germany with many more countries on the verge of slowdown. It is high time we stopped pointing our fingers at somebody – and did our part in obviating a systemic collapse.

The relationship between ‘financial’ and ‘real’ economies is asymmetrical such that when the financial economy performs well, the benefits accruing to the real economy are lesser than the quantum of negative impact on real economy when the financial economy fumbles. With the financial crisis already hurting the real economy in many ways, two pronged strategy needs to be adopted. Needless to say the first task in hand is to check the financial market crisis (to arrest further problems in real economy) and the second is to restore the real economy.

Financial Markets Problem
The financial markets problem is the direct consequence of the sub-prime crisis. Blame it on falling housing prices, securitization, high leverage, lax in regulation or whatever; the direct loss is restricted to the erosion in the value of investments and job losses in the financial sector. Governments and Central bankers are doing their best to contain the problem from further swelling. The indirect loss is the impact on the real economy and is much severe.

The stakeholders in the financial crisis are few when compared to the numbers in the real economy where the whole system is under consideration. The financial markets sit on top of the real economy and have shaken the whole system.


The Real Economy Problem - Burning the rope at both the ends
As direct fallout of the global financial crisis, the following series of events have lead up to the recessionary fear: (Is US already into recession?)
Upon losing trust on each other, banks are reluctant to lend to other banks for overnight money requirements.
With banks running out of short term liquidity, cost of credit increases. The bailout package and other measures have injected liquidity into the system which has mitigated the problem only to some extent. With the liquidity problem not fully solved, banks are reluctant to lend in anticipation of credit squeeze.
The unavailability of credit and increased cost of credit has reduced consumption.
The quick and steep fall in prices of all asset classes – stocks, bonds, gold, real estate, commodities have eroded the value of assets held by people. The fall in prices has not only resulted in erosion of value of people’s savings but also has increased risk and pessimism in investments. People prefer to stash money neither spending nor investing. Hence the taps of liquidity in the financial markets go dry as the supply subsides.
Unavailability of credit coupled with reduced demand has urged producers to produce less. In order to earn profits, few producers are forced to mark up the prices. This leads to inflation only to introduce more problems.
Firms cut jobs due to declining profits
From a consumers’ perspective, all their savings are losing value against increased prices in consumption. It is like burning the rope at both the ends. Add to that the loss in jobs.
The reduced production has decelerated the GDP growth and has led to unemployment.

Today’s economic status quo is justified by the global financial crisis. Any further slowdown will be largely influenced by sentiments with inadequate backing up of real events.

Role of Sentiment: Is recession a perception game?

Sentiments are common in financial markets but I’m afraid today’s real economy is driven by sentiments. Real events needn’t drive real economy always. At times even perceptions or mere predictions can alter the rules of the game.

The recessionary fear in the minds of economic agents is justified but it should not be allowed to dominate the situation in determining the future state. The very thinking about recession begets recession quickly rather than obviating it. Here’s how stuff works: A consumer with such recessionary thoughts will try to cut down current consumption and save for future. A producer with such a thought will cut down production anticipating reduced demand. At the end of the day, the economic activity reduces and results in a shrinking economy. All stakeholders in the economic system stand to lose – thanks to the deadly perception.

It is at this juncture people have to exercise caution. Rather than falling prey to the perception, fear or just a prediction, let us fight recession. The deadlock has to be resolved:

Events 7-16 explain the deadlock

Don’t stash! Increase Economic Activities
Every stakeholder has to dirty his hand in solving today’s real economic problem. The collective fiscal action coupled with monetary actions will strengthen the defence against slowdown. Consumers should not cut back on their consumption levels but continue to satisfy their needs as they were during normal times. Producers should produce more deploying more capital even if it means considerable reduction in their retained earnings. The solution is similar to priming – you need a cup of water to run the air-locked motor initially and thereby pump more water. This leads to the spiral of growth.

Why wait till the economy recovers itself when someone can initiate it now? One group among consumers or producers has to take the first step in resolving the deadlock. Under the present cold economic condition hope the proposed solution brings in some warmth. This tacit agreement is not completely impossible. Only deliberate cheating can upset the apple cart. But I feel the solution might work well with a considerable number of participation. This might sound like textbook-solution strife with implementation challenges, but it also emerges as the best possible solution among the different alternatives available as of now. In sum let us ignore perceptions; allow our economy to be influenced only by tangible events by acting now. Are you ready to challenge the conventional wisdom?

Do worried people eat more?

We all know the fact that every human being is composed of a meta-physical or psychological ‘soul’ sitting on the top of a biological ‘body’. There is constant interaction between the two systems and its complexity makes it difficult that nobody other than the Creator can decipher the interaction.

The below presented thought struck my mind few days back…I don’t know whether it is true always but the below lines argue that people tend to eat more when they are depressed.

Feeling happy or worried becomes a mere psychological feeling if it is short-lived. On the other hand, if the intensity of the feeling is medium, the effects spill over into the body as well. A happy person feels energy in his body parts while a sad person experiences frustrated muscles. The person eats less when feeling dejected for some time.

When the intensity of the feeling increases considerably, the effects are more pronounced in the ‘body’. People who are feeling worried for more weeks feel depressed and tend to eat lot more than regular quantity. Their frustrated muscles simply absorb/burn energy by consuming food.

People who eat a lot more can be tested for depression. Though it is not the only condition to test for depression, this along with already established other tests can substantiate the findings.

There is a common notion that people who are happy eat more but my argument is that people are depressed eat even more!

Innovation and Risk

In today’s dog eat dog competitive environment, businesses are flooding the market with new products and services in an attempt to create and capture customer value. Businesses rely on technology and innovation to gain competitive advantage, without which they will miss the bus. Be it external transactions like electronic fund transfer, placing e-orders to suppliers, enhancing customer relationship or internal process improvements, resource planning, cost cutting and knowledge management and a host of other business processes, technology has altered the rules of the game. Growth in top-line is effected by both product and process innovation whereas bottom-line is increased by process innovation. And this works the same way for firms in all industries.

Needless to say, risk is inherent in any activity. Technology in many ways is helping firms to reduce risk in otherwise more risky business activities. For e.g. Robots are employed to execute activities that humans cannot perform safely. Though the risk of failure of a robot cannot be ruled out, proper design could ensure absolute safety. Overall, technology helps the firms to carry out their whole range of activities effectively.

Innovation risk: Interestingly, the level of uncertainty is uncertain in the case of innovation! According to Niall Fitzgerald, Ex-chairman, Unilever, “Zero Risk = Zero Innovation”. All innovations smack of ‘innovation risk’. An example of potential innovation risk in today’s business context is space tourism which would have remained an untapped business opportunity if not for technology, innovation and little risk taking. "We need an environment that allows and rewards risk in innovation. The X PRIZE is about allowing people to think out of the box, pursue crazy ideas and have a little bit of risk taking," says Peter Diamandis, chairman, president and founder of the X PRIZE, a $10 million purse to jump-start the space tourism industry through competition between teams of entrepreneurs and rocket experts around the world.

Innovation is inevitable. Risk is manageable. In most case, risk stems from inappropriate usage! Let us understand the importance of innovation and the risk involved, with few examples:

Medicine: Innovation in the field of medicine has gone a long way in offering superior health solutions. Many life saving drugs and better diagnostic systems have saved millions thus far. Cloning is deemed to be the next big thing in the business of medicine. Partial understanding about the innovation forces people to arrive at biased, quick conclusions. This scientific advancement could have enormous benefits for humans by enabling organ replacement which could save many valuable lives. Being overly sceptical and hyping the potential medical risk simply discourages further innovation.

Finance: Microfinance is a form of financial innovation that has illuminated the lives of millions of rural population. In the words of Jonathan Morduch, "Microfinance stands as one of the most promising and cost-effective tools in the fight against global poverty." The system is designed such that the credit risk of small loans repayment is nothing but zero. This illustrates risk free innovation is possible.

The field of finance has witnessed many other innovations over the past few decades. Products like mutual funds are for common men who have limited understanding of the financial markets. Complex products like derivatives, exchange traded funds and risk transfer instruments are no child’s play. These instruments were designed for knowledgeable players in the market. Against this background, the case of sub-prime crisis is often misunderstood. Financial innovation in the form of CDO and CDS instruments is beneficial for banks as they securitize risky loans and sell them to investors who are willing to stomach such risks. Now whom shall we blame for the global financial crisis? Definitely not the financial innovation per se, but the misuse of the instruments! Despite being aware of the inherent risks, investors willingly hold such risky portfolios for want of higher returns. Once the borrowers defaulted and housing prices declined, the financial institutions had to collapse.

As life gets complex everyday, technology helps to simplify things for us. Agriculture and allied businesses are greatly benefited by computers that solve sophisticated mathematical models to predict monsoon quantity and timing. Clean energy from nuclear sources and other non-conventional sources is not possible without innovation. The list of innovation in business is endless and it touches all aspects of our lives.

In sum, innovation and technology have transformed the way businesses operate and what they offer to consumers. Many of the innovations are considered risky only in hindsight after somebody has already misused. Some other innovations are deemed risky purely because of the fear of misuse in future. Thorough understanding of innovation by all stakeholders and sensible usage can obviate risk and do full justice to the purpose of the innovation. Let us not over emphasise risk and thereby stifle innovation and technological advancements that are in many ways helping the businesses to improve our standard of living! After all, “Just as energy is the basis of life itself, and ideas the source of innovation, so is innovation the vital spark of all human change, improvement and progress” – Ted Levitt.

Answers: Business Quiz #1

1. Who composed the sound logo of Intel?
   Walter Werzowa
2. Where is the museum ‘Tons of Memories’ located?
   It is located in the Bat and Ball Inn - a joint venture between Robin Uthappa, S Sree Santh and J.K.Mahendra (former Kerala Ranji cricketer and National junior selector).
3. What do you mean by ‘Golden Handcuff’ in HR parlance?
   Golden handcuffs are a system of financial incentives designed to keep an employee from leaving the company.
4. What is project ‘De Bello’?
   BHP Billiton's codename for its planned merger with Rio Tinto - project DeBello
5. What is the fund co-founded by Rajat Gupta, Ex-McKinsey chairman?
   New Silk Route
6. What is the common thread in the names of the companies – Goldman Sachs, Barclays?
   The names in bold are the derived from the names of the Sons-in-law of the founders.
7. Who extended the marketing mix from 4Ps to 7Ps?
   Booms and Bitner
8. What is common to Robert Rubin, Hank Paulson and John Thain?
   All are alumni of Goldman Sachs
9. How is Enron known today?
   Enron Creditors Recovery Corporation.
10. What is common between Berkshire Hathaway and Suzlon?
    History – both companies were into textiles before.
11. Who are the architects who designed the ‘Bird’s Nest’ the venue of Olympics 2008?
    Herzog and de Meuron
12. How is ‘The 5% Club’ which was formed in 1976, known today?
    Minnesota Keystone Program.

Business Quiz #1

Hi Folks,

This is my first set of questions...

Send the answers along with feedback to debalaji@gmail.com

Questions:

1. Who composed the sound logo of Intel?
2. Where is the museum ‘Tons of Memories’ located?
3. What do you mean by ‘Golden Handcuff’ in HR parlance?
4. What is project ‘De Bello’?
5. What is the fund co-founded by Rajat Gupta, Ex-McKinsey chairman?
6. What is the common thread in the names of the companies – Goldman Sachs, Barclays?
7. Who extended the marketing mix from 4Ps to 7Ps?
8. What is common to Robert Rubin, Hank Paulson and John Thain?
9. How is Enron known today?
10. What is common between Berkshire Hathaway and Suzlon?
11. Who are the architects who designed the ‘Bird’s Nest’ the venue of Olympics 2008?
12. How is ‘The 5% Club’ which was formed in 1976, known today?

Inflation Management: Divide Interest Rate and Rule Inflation

Inflation Management: Divide Interest Rate and Rule Inflation

Olympics 2008 was the headline grabber for nearly a month. But a recurring weekly headline these days is the soaring inflation levels in many economies. And it seems like ‘north’ is the only direction that inflation would like to walk around in the near future.

Central Bank and the Government take monetary and fiscal measures respectively, in an attempt to maintain a comfortable inflation level. When the present economies are struggling to contain inflation, the idea proposed in this blog might bring down inflation to a certain level; after which the normal routine of control measures can be continued.

The fact that inflation hardens interest rates is well known. But can an economy tame inflation by having disparate interest rate policies for corporate and retail borrowers? This blog describes the merits, demerits and feasibility of this idea at a very high level without delving into numbers.

Let us assume an interest rate regime, where the central bank can tweak the lending rates for corporate and retail borrowers separately. This helps in the current context, where the focus is on reducing consumption levels to fight inflation.
1. By the law of inverse variation, consumption levels can be decreased by increasing the interest rates to borrowers. The increase in the cost of borrowing reduces the aggregate demand in the economy, forcing the suppliers to reduce prices.
2. By the law of direct variation, a softer interest rate to the supplier will encourage investments in production. The increased volume of output will drive the prices further down.

How to use this tool? Fiddling with the interest rate should be done only to bring the economic situation under control. This should be a short term approach after which the central bank should revert to its own earlier practices of inflation management.
When to use? This works only in situations where price levels can be reduced by reducing the consumption quantity.

Merits
A quick and short term solution can be arrived at.

Demerits
1. Consumers fail to understand the long term benefits as there are more bad news in the short run. The poor who need more money during high inflation will be more worried with increase in borrowing rates.
2. The Government might be misconstrued as adopting Capitalist ideals by favouring companies over consumers.
3. The banks prefer lending to retail borrowers as against companies as the returns are higher.
4. How much of consumption will be reduced because of increase in interest rate is vague.

5. The problem of Moral Hazard will become unavoidable. People needing money for personal reasons might convince the bank to lend for their fictitious businesses. This level of micro-management for banks is a headache.

Feasibility
This idea will help only when the merits outweigh the demerits and all stakeholders arrive at a consensus. The economic system should be compatible as the risks involved are more.

However, on the face of it, the sounds like "plugging one hole is opening up many bigger holes at the wrong places"

Thanks for reading till the end.

If you think this article is weird, how can a B-school student write any better? We are a different tribe!
For proof: http://in.youtube.com/watch?v=8Vx1BTBhg4c

For management quizzers, there’s more from this blog. Check the quiz section for interesting questions.
Please mail your feedback to debalaji@gmail.com
Thanks.

Bye. Catch you in the next post.