Global Recession : Is it Keynesian or Hayekian ???

Governments across the globe are using Keynesian stimuli to revive drooping economies. Even George Bush has presided over the greatest stimuli in US history, with a projected fiscal deficit of $1.2 trillion and monetary injection of almost $2 trillion by the Fed.

But is the recession Keynesian? Trillions of dollars of stimuli have failed to end the downswing. Keynesians argue that even trillions are not enough. Really?

The current recession looks more Hayekian than Keynesian. A Keynesian recession represents a sudden fall in demand, and can be remedied within six months by pumping enough purchasing power into the economy. A Hayekian recession, however, is caused by misallocation of resources over a long period, driven by unrealistic interest rates, ending in a bust that requires years of structural adjustment. Such a recession can last a decade (as in Japan in the 1990s).

The many recessions between World War II and the oil shock of 1973 proved amenable to Keynesian remedies. But 1973-80 witnessed a Hayekian recession, caused by excess pumping of money into economies in an attempt to stimulate them. Rising trade union demands meant that the stimuli translated into higher wages and inflation, not higher production. After this era of stagflation, economists could hardly utterly the word ‘Keynesian’ without a snigger — it had become a joke !

However, the recessions of 1991 and 2001 were mild affairs remediable by Keynesian stimuli. Keynes was back in fashion. So, when the subprime mortgage crisis hit the US in 2007, it responded with Keynesian nostrums. But to no avail.

Politicians want to be seen as quick and effective. They love Keynesianism, which puts them in the driver’s seat, allowing them to portray recessions as caused by greedy business villains, and paint themselves as rescuers. But Hayekian recessions occur when politicians themselves distort the economy for years, creating misallocations of resources that ultimately prove unsustainable. The consequent bust cannot be ended by pumping in more money. Rather, the entire economic structure must change to correct the historical misallocations, and make future growth sustainable. This involves wrenching changes in individual, corporate and political behaviour. Neither the public nor politicians are quick to acknowledge a Hayekian recession. They would rather hope it is Keynesian, remediable by pumping in more money. Yet at some point somebody will surely declare that Emperor Keynes has no clothes. The current recession is deeply structural. For a decade, the US has run the biggest trade deficits in history, matched by corresponding trade surpluses of China, Opec, and other Asian countries. After the financial crisis of 1997-99, many Asian countries swore to build large forex reserves to avoid another debacle. So they deliberately undervalued their exchange rates, ran large current account surpluses, and so generated large forex reserves. This had to be mirrored in correspondingly large current account deficits in some other countries. The biggest turned out to be the US itself ! This defied conventional economic logic. Normally, rich countries run trade surpluses, and send their excess savings to poor countries with scarce
capital that are running trade deficits. This normality was turned on its head by Asian countries determined to build large forex reserves after the trauma of 1997-99. These forex reserves went mainly into US gilts.

Suddenly the world was flooded with money. The US trade deficit sent a flood of dollars into Asia and Opec, which then flooded back into US financial markets, mainly through forex reserves. Bernanke called this the Asian savings glut. The flood of dollars drove down long-term interest rates, especially in the US, and drove up asset prices. It became highly profitable for Americans to borrow cheaply to invest in houses, stocks and commodities. Even when the Fed raised short-term interest rates in 2006, long-term rates remained low because of the flood of money from Asia. Innovations in the US financial system, some productive and some mere con-games, encouraged leverage by everybody — individuals, corporations, banks, speculators. This was classical Hayekian misallocation. This misallocation yielded mouth-watering short-term gains. It proved a huge stimulus for the global economy, which grew at its fastest rate in history in 2003-08. Record US trade deficits sucked in record imports of manufactures from Asia and oil from Opec. Asia in turn bought record quantities of commodities from Africa and Latin America to be converted into manufactures for export. Thus the whole world economy boomed as never before, and so did asset prices. Yet the boom was patently unsustainable. American households, who historically saved 6% of disposable income, started saving nothing at all, and dipped into their wealth to spend as never before. Today, this seems terribly irresponsible. Yet the boom had hugely increased the wealth of Americans, and it was logical for them to spend part of this wealth. The spending spree was subsidised by artificially low interest rates, which also generated bubbles in the markets for houses, stocks and commodities.

These bubbles have now burst. A Keynesian stimulus amounts to an attempt to re-inflate those bubbles. That is neither practical nor wise. The US government in 2008 mailed $80 billion to households to stimulate spending, but households spent only $12 billion of that and saved the rest — they knew, even if politicians did not, that the old spending spree had to stop. The world — and India — must accept that the global boom of 2003-08 was based on an unsustainable economic structure. In future, Americans will have to save much more (and export more), and Asians will have to consume much more (and export much less) to end existing global imbalances. This Hayekian adjustment, which started in 2007, may take years to complete. So, the global — and Indian — economy may not revive in mid-2009. Even if it does, the recovery may be so weak as to count for little. Hayekian theory suggests that we may have to wait till 2010 or 2011 for a sustained economic bounce. One ray of hope: the current recession may be partly Keynesian, even if mainly Hayekian. That may diminish its travails.

Credit Defaults : worst is yet to come !!!

On January 9, Standard & Poor’s announced that Greece, Spain and Ireland were on review for a possible downgrade, indicating that a Eurozone country could default. If financial crises have taught us one thing, it is to take such “black swan possibilities” (as Nicholas Nassim Taleb would describe it) seriously. A sovereign default by a small country could wreak havoc on the markets for credit default swaps (CDS) and might even destroy financial institutions in other Eurozone countries. It could trigger panic rise in bond yields and the threat of contagion could turn into a self-fulfilling prophecy. A far more serious threat would be a cascading series of defaults that would eventually include one or more of the Eurozone’s large countries. The 10th birthday of Eurozone seems to be holding out ominous portents.

Of late, sovereign CDS prices of the world’s rich nations have increased dramatically. In the past three months, the US Federal Reserve has created more credit than it has ever done before. The sum of its earning assets, known in trade parlance as reserve bank credit, has grown at the outstanding rate of 2,922 per cent. The CDS price of the US has risen to a record 57 basis points in the face of deteriorating credit conditions of banks and non-finance companies and concerns over the $1,000 billion it needs to raise in bonds to tide over the crisis. On similar grounds, the CDS on Spain, which like the UK and the US has seen its property bubble burst, rose to 106 basis points, while that of France has risen to 56 basis points and Germany to 43 basis points.


It now costs £110,000 to insure £10 million of UK debt against default over five years, or £50,000 more than it did in the middle of November 2008. The same cost £8,000 in February 2008. The rise is due to concerns of the amount of bonds the government will have to issue to bail out the banks and stimulate the economy. The UK is forecast to raise £135 billion annually — three times more than in past years, until 2013. To add to the woes, the collapsing UK housing market will add to the strain. Ironically, it costs more to insure the UK against default than some of its major banks such as HSBC and Lloyds.

Italy’s CDS price is the highest amount the G-7 nations at 161 basis points or ¤161,000 to insure ¤10 million of debt over five years. The reasons being that Italy’s debt/GDP ratio has escalated to 103 per cent or the highest in the Eurozone. Among the highest sovereign CDS prices are for Argentina (trading at 4,050 basis points) and Ukraine (trading at 2,400 basis points). The economies of Latvia, Bulgaria, Ukraine, Pakistan and Iceland are being singled out as the most vulnerable and Moody’s has placed them on negative watch.


Greek bonds are trading at a significantly higher yield than Germany, showing a perceived default risk. The spread of Greek bonds over German bonds is 2.32 percentage points, almost 10 times its level two years ago. Spanish spreads have risen above 90 for the first time as well. An Intrade prediction puts the odds on a current Eurozone member leaving the euro by the end of 2010 at about 30 per cent. The market is nervous about other nations on the Eurozone’s periphery, notably Ireland and Spain, which got over-extended during the credit bubble. Argentina, Venezuela and Iceland have the highest default risk, with Russia not far behind. Germany, Japan and France all have lower defaults risk than the US at the moment.

In 2006, Pakistan issued a 30-year bond at a spread of just 300 basis points over Treasuries. That is a very low level for a country with such poor economic fundamentals and a history of political instability. Although Pakistan has not yet defaulted, their bonds trade at about 40 cents on the dollar, suggesting that the likelihood of Pakistan defaulting is now imminent.


Other sovereign entities have already defaulted. The Seychelles defaulted in August 2008. On December 13, 2008; Rafael Correa, Ecuador’s president, said his nation intended to default on its foreign debt.
Fears have also mounted recently that Argentina will struggle to meet its 2009 debt servicing payments of $21 billion, but economists believe it will avoid defaulting, in view of the fact that the state went so far as to nationalise private pension funds just to meet its obligations.

As massive de-leveraging takes place, it leads to increased market volatility and absence of players from the credit markets. This is turn leads to various bond market dislocations.

For instance, over the past few years Russia (rated BBB) has been running large deficits and has substantially more government debt as a percentage of Gross Domestic Product. On the other hand, Turkey has been running large fiscal deficits and has relatively more government debt as a percentage of Gross Domestic Product. Yet, on account of the anomalies mentioned above, Turkish dollar bonds yield a little over 8 per cent, whereas Russian sovereign debt yields more than 11 per cent.
Emerging market debt spreads have yet to adjust fully to the realities of weaker global growth, falling commodity prices and higher defaults. Historically, emerging market debt has traded on similar spreads to high yield as both have similar underlying credit quality. Yet, currently spreads on high yield are about 1,400 basis points wider than emerging market spreads.


Many emerging market countries have weak fundamentals with several countries like Hungary, Ukraine and Pakistan are at the beck and call of the IMF. At current spreads, investors are not being fully compensated for the risks in many of these countries.

High-yield spreads are above 2,000 basis points and still widening. This provides a premonition of how much emerging market spreads might widen, particularly the sub-investment-grade issuers !

A letter that shook investor trust !!! Satyam Chairman's confessional letter

Following is the original letter Satyam Computer Services Chairman, Mr B. Ramalinga Raju, wrote to the company’s board.

Dear Board members,



It is with deep regret and tremendous burden that I am carrying on my conscience, that I would like to bring the following facts to your notice:



1. The balance sheet carries as of September 30, 2008:



a) Inflated (non-existent) cash and bank balances of Rs 5,040 crore (as against Rs 5,361 crore reflected in the books);



b) An accrued interest of Rs 376 crore, which is non-existent;



c) An understated liability of Rs 1,230 crore on account of funds arranged by me;



d) An overstated debtors’ position of Rs 490 crore (as against Rs 2,651 reflected in the books)



2. For the September quarter (Q2) we reported a revenue of Rs 2,700 crore and an operating margin of Rs 649 crore (24 per cent of revenue) as against the actual revenues of Rs 2,112 crore and an actual operating margin of Rs 61 crore (3 per cent of revenues). This has resulted in artificial cash and bank balances going up by Rs 588 crore in Q2 alone.



The gap in the balance sheet has arisen purely on account of inflated profits over several years (limited only to Satyam standalone, books of subsidiaries reflecting true performance). What started as a marginal gap between actual operating profit and the one reflected in the books of accounts continued to grow over the years. It has attained unmanageable proportions as the size of the company operations grew significantly (annualised revenue run rate of Rs 11,276 crore in the September quarter of 2008, and official reserves of Rs 8,392 crore). The differential in the real profits and the one reflected in the books was further accentuated by the fact that the company had to carry additional resources and assets to justify a higher level of operations thereby significantly increasing the costs.



Every attempt made to eliminate the gap failed. As the promoters held a small percentage of equity, the concern was that poor performance would result in the takeover, thereby exposing the gap. It was like riding a tiger, not knowing how to get off without being eaten.
The aborted Maytas acquisition deal was the last attempt to fill the fictitious assets with real ones. Maytas’ investors were convinced that this is a good divestment opportunity and a strategic fit. Once Satyam’s problem was solved, it was hoped that Maytas’ payments can be delayed. But that was not to be. What followed in the last several days is common knowledge.





I would like the board to know:



1. That neither myself, nor the Managing Director (including our spouses) sold any shares in the last eight years - excepting for a small proportion declared and sold for philanthropic purposes.



2. That in the last two years a net amount of Rs 1,230 crore was arranged to Satyam (not reflected in the books of Satyam) to keep the operations going by resorting to pledging all the promoter shares and raising funds from known sources by giving all kinds of assurances (statement enclosed only to the members of the board).
Significant dividend payments, acquisitions, capital expenditure to provide for growth did not help matters. Every attempt was made to keep the wheel moving and to ensure prompt payment of salaries to the associates. The last straw was the selling of most of the pledged shares by the lenders on account of margin triggers.



3. That neither me nor the managing director took even one rupee/dollar from the company and have not benefited in financial terms on account of the inflated results.



4. None of the board members, past or present, had any knowledge of the situation in which the company is placed. Even business leaders and senior executives in the company, such as, Ram Mynampati, Subu D., T.R. Anand, Keshab Panda, Virender Agarwal, A.S. Murthy, Hari T., S.V. Krishnan, Vijay Prasad, Manish Mehta, Murli V., Shriram Papani, Kiran Kavale, Joe Lagioia, Ravindra Penumetsa, Jayaraman and Prabhakar Gupta are unaware of the real situation as against the books of accounts. None of my or managing directors’ immediate or extended family members has any idea about these issues.

Having put these facts before you, I leave it to the wisdom of the board to take the matters forward. However, I am also taking the liberty to recommend the following steps:



1. A task force has been formed in the last few days to address the situation arising out of the failed Maytas acquisition attempt.
This consists of some of the most accomplished leaders of Satyam: Subu D, T.R. Anand, Keshab Panda and Virendra Agarwal, representing business functions, and A.S. Murthy, Hari T. and Murali V. representing support functions.
I suggest that Ram Mynampati be made the chairman of this task force to immediately address some of the operational matters on hand. Ram can also act as an interim CEO reporting to the board.



2. Merrill Lynch can be entrusted with the task of quickly exploring some merger opportunities.



3. You may have a ‘restatement of accounts’ prepared by the auditors in light of the facts that I have placed before you.

I have promoted and have been associated with Satyam for well over 20 years now. I have seen it grow from few people to 53,000 people, with 185 Fortune 500 companies as customers and operations in 66 countries. Satyam has established an excellent leadership and competency base at all levels. I sincerely apologise to all Satyamites and stakeholders, who have made Satyam a special organisation, for the current situation. I am confident they will stand by the company in this hour of crisis.

In light of the above, I fervently appeal to the board to hold together to take some important steps. Mr T.R. Prasad is well placed to mobilise support from the Government at this crucial time. With the hope that members of the task force and the financial advisor, Merrill Lynch (now Bank of America), will stand by the company at this crucial hour, I am marking copies of the statement to them as well.

Under the circumstances, I am tendering the resignation as the chairman of Satyam and shall continue in this position only till such time the current board is expanded. My continuance is just to ensure enhancement of the board over the next several days or as early as possible.

I am now prepared to subject myself to the laws of the land and face the consequences thereof.



(B. Ramalinga Raju)