A sign of conflicts to come?

Remember last spring? It seems an age ago now. The fear then was of resource scarcity: of rising oil prices, and of rising food prices, as biofuels crowded out food production and population continued to grow. Environmental worries also reflect resource scarcity, albeit of another type. Once this crisis is over, whenever that is, all these concerns will inevitably come back on the agenda, and could easily dominate it for the rest of the century.

In that context, one of the most alarming news stories, to me, of last year, was that involving Korea’s Daewoo Logistics leasing almost half of Madagascar’s arable land on a 99 year basis. Here is a pretty positive account of the deal in Time magazine. Why my alarm? Because the deal reflected the fact that

“[Food-importing countries] have lost trust in trade because of the price crisis this year,” says Joachim von Braun, director of the International Policy Food Research Institute in Washington.

Thus, from a Korean point of view,

“We want to plant corn there to ensure our food security. Food can be a weapon in this world,” said Hong Jong-wan, a manager at Daewoo. “We can either export the harvests to other countries or ship them back to Korea in case of a food crisis.”

The latter quote, taken from this FT piece, should send shivers down the spine of anyone with a sense of history. (The article also makes it clear that the agreement was far less positive for Madagascar than had at first been reported.) Markets are a political institution. The deal they represent is straightforward: if you are willing to pay the going price, then you can buy what you need. When countries start to doubt whether that deal will remain valid going forward, and in consequence act to carve out sources of supply for their own exclusive use, the geopolitical consequences can be catastrophic.

As I contemplated this story, I idly wondered what would happen if, in a decade or two, some African or Latin American country decided that it wanted to renege on such a deal which had been struck by a previous government with, say, China or India. And so it was with considerable interest that I read this from the BBC. I don’t suppose the Koreans will invade Madagascar! But one can predict that this will not be the only occasion on which such a domestic backlash occurs. Why on earth would anyone assume otherwise?

The moral is straightforward. In addition to tackling the underlying problems of resource scarcity, we need to credibly commit to keeping international markets open over the decades to come. And in order to be able to do that, governments need to get the macroeconomics right, now. Otherwise, as the example of the Great Depression shows, this will just be a taste of things to come. And that won’t just be bad news for the economy.

Geithner Plan Published

Official details here and here. It’s pretty much as I described yesterday and I’m no more impressed than before.  In particular, it hardly takes a corporate finance expert to figure out that “The equity co-investment component of these programs has been designed to well align public and private investor interests in order to maximize the long-run value for U.S. taxpayers” is a bit of a fib.   Funnily, toxic (or troubled) assets have now been renamed “legacy assets”!  This terminology might be appropriate if we were dealing with newly-cleansed banks with new ownership and management.  However, as I’m reminded every time I see this man’s happy smiling face, that just ain’t the case.

On the 9.5% Budget Deficit Target

In my comments on John McHale’s recent post and also on the radio at the weekend, I suggested that the government should probably stick to the 9.5% target set out in January’s Addendum document.  While the document did not contain details about how the government was going to make these adjustments, it was still a clear commitment to stick to a particular path to get back towards a 3% deficit by 2013.  If three months later, we were seen to already be well off these targets, the concern would have to be that the international bond market would judge us as being incapable of sticking to a plan.

However, having thought about this a bit, I’d be inclined now to argue that there probably has been so much slippage already this year that sticking to a 9.5% target for the calendar year 2009 may not be a good idea. My impression now is that the implementation gaps in getting the changes in the April 7 budget made effective will mean that we will only see about half of the budgetary improvement that these measures would bring in a full calendar year.  So, for instance, suppose that without adjustments the deficit is likely to be 13.5% for 2009. In that case, getting to 9.5% for the year would require 8 full percentage points of full-year-equivalent adjustments.

A better strategy would be to make adjustments that leave the government running an effective deficit in the second half of the year of 9.5%, and so facing into the 2010 budget in exactly the position that they had promised to be in.  In the example of a no-adjustments deficit of 13.5%, this would amount to running a deficit for 2009 of 11.5%, which could be interpreted as 13.5% for the first half of the year and 9.5% for the second half.

In a sense, this is a recommendation to government as to how to “spin” an outcome which looks like slippage from the January plan as still being, in a sense, consistent with it.  Beyond that, those economic commentators that will want to criticise the government for failing to meet its own plan, if indeed it announces a target higher than 9.5%, should keep in mind that meeting this target would require starting 2010 with a budget deficit well below what was envisaged in that plan.

Why Should Geithner’s Auctions Work?

According to the New York Times, pools of distressed mortgage-related assets of US banks have been 30 cents bid, 60 cents offered, in recent weeks. The bidders are hedge funds, the potential sellers under-capitalised, but State-guaranteed, US banks.

The Geithner plan appears to include a new type of investment vehicle with capital structure 3% private equity, 12% taxpayer equity, and 85% debt, also provided by the taxpayers. The holders of the 3% private equity would provide management and would bid for the distressed assets at auction. The expectation is that they would bid more than 30 cents on the dollar, thus improving banks’ balance sheets.

If the State equity is fully participating, it changes nothing from the standpoint of the fund manager. Only if the 85% debt is available at terms better than debt currently available to the hedgies (who will bid no more than 30 cents) can the plan work. The NY Times says that the 85% debt will be non-recourse, which certainly helps, and that it will be ‘cheap’, details to follow!. If it is provided at anything close to T-bill rates or short Treasury note rates, it’s a steal, and the Geithner hedge funds will of course bid more than 30 cents. I suspect that 85% non-recourse lending to distressed-asset hedge funds is not available at non-stratospheric prices right now. This is not a certainty-equivalent game since nobody knows the true value of the distressed assets, but cheap, non-recourse leverage will improve the bid price for any plausible distribution of returns.

The government could achieve the same objective by lending cheap non-recourse money to existing hedgies, unless I am missing something. But this would lack opacity. The critical economic component in all of these plans (including bad banks and insurance schemes) is the distribution of gains and losses. The critical political components appear to be fig-leaf involvement of private equity, the avoidance of overt nationalisation, and non-transparency.

More on Cyclical versus Structural Components of the Fiscal Deficit

My previous post highlighted that the structural component of the budget deficit is relatively high. Right now, a return to economic growth will not deliver big revenue gains,  in view of the reduction of cyclically-sensitive income taxes over the last decade, such that the cyclical element in the budget is measured as low.

One feature of the upcoming fiscal adjustment could be to shift the attribution of the overall deficit between structural and cyclical components.  In particular, if cyclically-sensitive taxes are increased, then the cyclical component of a given deficit will increase and the structural component will decrease, since economy recovery will then ‘do more of the work’ in returning the overall fiscal balance to good health.

That is, a X percent deficit reduction package could translate into an X+Z improvement in the structural deficit and an X-Z improvement in the cyclical deficit.   This is relevant, since the key target should be to reduce the structural deficit.