Sunday, October 26, 2008

Shiva's Dance and the Stock Market: Creative Destruction

This article is being written in the evening of Friday 24 October when the Stock market – already at nearly 45% of what it as at its peak value 10 months ago shrank another 12% today to take the market back three years.

This wild fluctuation in productivity is the kind of fluctuations seen in some physical property at a phase transition.

I have written the blog just to acquaint myself with the phenomenon and ask some questions. As such the blog may be long even for my close and dear ones. I have therefore divided it into three parts so that one may pause in between. I think the subject is serious enough and I have not taken it frivolously.

Creative Destruction

So, is this the beginning of a change towards another model for economic growth? Is this a New Wave of economic thinking that engulfs and destroys the old. Is this the dance of Shiva symbolizing the dance of the force of creative destruction. Enshrouded in the flames of the Universe, Shiva dances the tandava creating the new destruction which resolves and maintains the new order. Shiva triumphantly raises his feet when stamping out the demon or dwarf symbolizing ignorance of the new construction. Shivas face shows no remorse or triumph. One can perhaps see in the face a firm sense of accomplishment showing that the deed that had to be done has been done.

There is a well discussed Schumpeterian model of Creative Destruction for economic growth in which an entrepreneur enters the market through a new innovation that is so radical that it destroys other entrepreneurs who, till that time, controlled and enjoyed an area of the market. There is a new spirit of creative activity to establish the new order that accompanies this transition to a new order after the Creative Destruction has taken place. This creative destruction generates the next sustained phase of economic growth measured, say, by the productivity or GDP.

The Shivas of the economic world being merely mortals now may not be able to dance the tandava with such finesse. The present destruction of the Stock markets may nevertheless have a purpose of destroying the old and creating the new. It implies that the Stock market, as we know it, may not be the same again; just as the memory cards of digital cameras may not be the same as the film rolls of the mechanical camera, or as e-mails are different from written letters, and green fields are different from genetically modified farms.

Now, as we ought to know, productivity has been a classical economic term to justify economic prosperity. Productivity or GDP is measured in terms of economic output per employed person. Among methods that increase GDP are to have capital accumulation through investments, increasing efficiency by removing obstacles to work, and wasting less materials and energy.

The Creative Destruction introduced by economically rich countries now is to outsource their work to China and India, thereby destroying jobs and skill at home. China excelled in organized and flawless mechanical production, while India contributed to the clerical work using the tradition that had sustained the British Empire. It increased the GDP of the outsourcing nation because of the reduced number of employed people and increased profits because of the reduction in Labour costs. It also divorced the requirements of the people with the centers of production. Thus In India, instead of indigenous traditional and tested foods, we have pesticide-laden broccoli, strawberries, pepperoni, and tomatoes that wont decay and wont taste. We now use western perfumes instead of fresh garden flowers. Our IT people work their best hours of their best years being instructed by external sources.

Growth based on Creative Destruction rejects most time the theory of equilibrium. Under equilibrium conditions growth could be continuous without any catastrophic changes accompanying the transitions. However, if the interval is short, there are some very heavy downsides also, as so vividly popularized in Tofler’s book “Future Shock” albeit in a different language and context. There is a shift in values of the whole society and the prevailing social order. There is no philosophy in democratic reasoning (tyranny of the masses) on why a social order should not shift or why there should not be a change in public social behaviour as long as there are justifiable pluralities including mass hysteria.
When there is Creative Destruction, it becomes increasingly difficult, both for the entrepreneur as well as the consumer, to adjust to the many new products that appear every year and keep track of the services required to maintain it. The very fact that we accept a new technological product so frequently (example, the various types of mobiles, with SMS, camera, email, Bluetooth, blackberry, GSP, that appears with increasing price and newer features regularly) means that we are showing a consumer boredom to be alerted only by the forceful jingle of the advertiser’s intrusions. The advance of modern technology has taken place without preparing our modern man for it.

Crash of Oct 08

The present position of the Stock Market (I am not an investor) may not have been designed or aimed at Creative Destruction. I get the suspicion that once we recover from the heap and dust of broken markets we may as well bring about a new order without the Stock market.

In this catastrophic and discontinuous scenario of change one requires only a consideration of basics or first-order parameters. This should be easy to obtain. What follows is what I have garnered from a brief perusal of the web. It should serve to understand the likely important points that led to the crisis. At worst it should serve to make the layman reader familiar with the jargon for future reference/study.

The main culprit in this crisis is the lowering of interest rates on well-recognized investments such as fixed deposits in Indian banks, or treasury bonds of America. The idea was that there is no point in keeping huge amounts of money as deadwood. They had to be lured out of the static mode and made more dynamic and peripatetic, garnering more profit for the banks though more attractive investments. This was achieved simply by reducing the interest rates on fixed deposits or static money (some attribute the move to Alan Greenspan).

In order to lure the investor into making risky investments they were fed with images of huge profits. One of these is the idea of subprime mortgages first introduced it seems by Gordon Brown as finance secretary in the Tony Blair government of UK. Subprime just means interest rates which are lower than the prime lending rates of banks. The prime lending rates are based on a serious assessment of the investment and the assets available to the borrower.

The “creative” part of the modern banking system was that subprime lending was given to those who could not have obtained loans otherwise. Incredible as it may seem now, there were “balloon mortgages” (pay only interest for the first years and then pay a huge sum), “liar loan” (you simply lie about your annual income), “adjustable rate mortgage loan” (where the amount lost due to a reduced initial interest is added to the principal and interest increased later), “ninja loan” (acronym from No Income No Job and no Asset). Once these safety barriers were broken there was immense competition between banks to lower standards and give loans decreasing at the same time the requirements for financial security.

Lewis Ranieri at Salomon Brothers now thought up the idea of buying the mortgages from banks and turning them into securities, and adding to it other securities backed by “assets” such as credit cards, and auto loans to make a bundle of securities which are then sold to investment banks. Bundles of such bundles are then sold to Wall Street Firms to create mortgage-backed securities. The mortgages of these securities from pooled mortgages and packaging them into securities which are then recombined to form a collateralized debt obligation may be considered to be an Innovation. It was not yet an act of Creative Destruction.

Such camouflaging under the name of securities led to investments of the order of more than ten trillion dollars. Appadiya!!! Added to this was the new source of money from the Indian and Chinese economies as well as other economies. There was unending money in the global pool which had to be soaked up. This was the effect of globalization of economies. Chickens were counted before they were hatched. The boom in the stock market was a direct consequence.

Because the ignorant borrowers didn’t read the hidden impact of interest rate of clauses in their agreements the mortgage soon became unaffordable to the borrower. There came foreclosure. Banks were aware of this possibility. The strategy was that they would buy up the house from the defaulter at a rate lower than the prevailing market rate and this would lead to more profit.

Wall Street firms noticed they did not get enough profits, retail and investment banks suffered. When banks restructure loans without going to the original bond holder, then it is assumed that the bank owns the control of the loans along with the built-in liabilities. Because of the huge scale of the loans and the liabilities the banks had no idea about how to restructure the loans. Computer models from prime lending days (pre 2003 some say) were not prepared to address the complex financial landscape because of the fast supply of money. There were a whole range of ill-defined issues (1099, FAS 140) that prevented prompt pre-emptive action rapidly.

The crisis in the business financing or credit industry emerged. Trickle of expected modeled-in foreclosures soon developed into an avalanche. The effect was global.

Credit was stopped. Deleveraging was initiated to reduce companies’ debts by selling investments to pay back loans or to get liquidity in cash flow. Usually high-yielding assets are sold; prices of these assets then lowered forcing other investors in these assets to sell at still lower prices.

Japanese Yen and American dollars are perfect currencies to fund leveraged carry trades because of the very large banks in Japan and US and their very low interest rates, which, strangely, started the whole crisis. There was a huge global requirement for dollar and yen. American dollars can be printed without any guarantee of payment of the printed value. Federal Reserve Chairman Bernanke and Treasury Secretary Paulson print money and supply them at an incredible pace. The dollar and yen became strengthened because of this demand.

The fundamentals do not support a strong dollar. The printing of money should cause inflation since money supply is increasing.

Then came the seven hundred billion dollar (~3500 dollar per individual over-18 American) “bailout” program about which there are very sketchy details. It was supposed to prevent banks from collapsing because of lack of cash infusion by buying up bad debts, extending bank deposit insurance and expired tax breaks mainly to get Republican (some of whom had withheld support earlier) support . The amount was based on the finances require to shore up the lower value of a security because of the sub-prime mess to its intrinsic value. The Treasury buys up a certain amount of quality (with adequate credit ratings of borrowers, delinquency status) from institutions offering lowest prices nin a “reverse auction” procedure in exchange for treasury bonds.

The politicians talked about the American taxpayer. Taxpayers would face deeper economic troubles if financial markets remain clogged. This bailout was supposed to protect lost jobs, higher unemployment, more foreclosures and a contraction of the overall economy. The bailout was also intended to protect against the loss of taxes should the financial institute collapse and drive the country faster into recession. Naturally, the bailout was to be such that the executives of banks were given adequate compensation. After five years if the institutions do not pay back, the profits would remain privatized, and the losses, as usual, would be communitized among the tax payers How comfortable!

Lessons we may learn.

Is the collapse of the stock market due to a collapse of the modern way of thinking? Is it an example of Creative Self-Destruction? Or is just a just outcome of excessive greed?

In the left of figure at the top of this page, I have shown the changes in the Dow Jones index over the last twenty years or so. Between 1988 and ~1994 there were no discontinuities in the prices and shows linear increase in the index. After 1994 the Dow Jones prices increase at a faster rate to fall again around 2002-3 and 2008 as shown by the dips in the stock prices at those years. The lowest point in these dips fall on the dotted line extended from the prices between 1988 and 1994. If these dips are taken as corrections, the crash of Oct 2008 would only be that required of a correction which was long overdue. The Down Jones prices have increased nearly four times this last twenty years or so implying a compound interest rate of 8%. This is the normal rate for a fixed deposit in a standard bank such as the Reserve Bank of India. There has been no loss. Only some excess greed of some investors has been exploited and used to mop up some ill-protected funds.

If this is the case it would only show that the money has been all along in safe hands. It reminds me of an incident from my school days. I once borrowed the equivalent of three quarters of a rupee from my classmate in school who shared my bench. It was a princely sum at that time. I could not pay it back in the time I said I would. I would try to make it up by sharing some of my lunch box with him several times. He happily did it and I thought it was sufficient recompense. The boy did not ask for the money. Two years later when we were to leave school, and we were taking leave from each other on the last-but- one day in school, this boy, Vishnu, asked me for his money back (twelve annas of those days). “I come from a Marwaadi family” he said. “We worship money and it is our duty to protect it. I have to protect my god. Please return the money tomorrow. I am not asking you for any interest.” I did that. I learnt that the Marwaadi money lender is as important to the environment as any other since they don’t encourage frivolous use of money unless they get to eventually own it and protect it.

So where did all that money above the dotted line in the figure on the left go? Will it go to those institutions which gave it more protection? Will it be through the bail-out plan, for example? Probably.

Maybe the Stocks and Share Markets just mopped up the unprotected and fundamentally weak (mainly paper money, in any case) and protected it.

Will it recur in the future? Will the mopping-up game start again? Or will a new game start. Will it be a new dance of Shiva? Will there be a new wave of Creative Destruction? Will the Stock markets never recover again and be driven to obsolescence? Will there be a new division of citizenship with a class of affluent people benefiting from centralized services according to the dictates of a centralized Entertainment and Beauty industry and another class of people who provide these services? Will we finally become like the Eloi and the Morlocks of H. G. Wells’ “Time Machine?”

Will I pass away before that happens?

A second more intriguing thought is the possibility that the stock-market crash is simply a new form of Destruction. Is it similar in some way to that of the 9/11 destruction of the Twin Towers of New York? What are the similarities>
· The securities required in the subprime market were unusually lax just as the securities were at the airports at the time of the 9/11 disaster.
· It took the market regulators by surprise just as 9/11 took the air control operators by surprise. It seems that it took an unusually short time of four or five quarters between 2005 and 2006 for the mortgage crisis to actually blow up and be detected. After this, the markets were left standing helplessly waiting to fall just as the twin towers stood after the impact.
· There is an eerie similarity to the rush to war in Iraq in seven days and the passing of the 700 billion bailout bill by American law makers in seven days. “Just because God made the world in seven days does not mean we have to pass this bill in seven days (Rep. Joe Barton). Is it because they wanted to hush-hush other insights into the crash? Is it reflected in sustained increase in stock prices in Arab world despite severe decrease in Oil prices?
· The figure on the right at the top of this page shows the way the stock prices (S&P 500) changed en route to Oct 24. The take-off point was around the middle of September. Another 9/11?

If this is the case we can be sure that the crash of Oct 08 will mark a defining moment of change for the stock market as we know it. Will it for the good or the bad?

Shiva only knows!


Surabhi said...

read it!!!! need to read it again to understand it!!! looks like a lot of research

drivenwide said...

One economist who works for a big investment company mentioned on a business report that ‘if’ a recession takes place, it will be a consumer based one not ‘corporate’, as he then went on to reminded us of what occurred in the 90’s (corporate defaults which lead to a recession). Of course this is incorrect and he works for a corporate entity that does not want to admit weakness (profit losses). The truth is a global recession will be from both sides, both consumer and corporate.

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Anirban said...

Loved the conept of creative destruction. Like Freddy Mercury said, Video killed the Radio star. One thing makes way for another. The little Shiva dances, and having danced, moves on....

Anirban said...

...Or was it Buggles who said that...