Will indirect tax cut boost consumption?

Govt. reduced Excise duty from--- 10%-8%
Service tax from 12%-10%

So will this reduction in indirect taxes boost consumption? Perhaps partly.

• Textile sector is virtually exempt from excise, expecting the synthetics segment which attracts a low rate of 4% excise.
• Duty reduction on inputs from 10%-8% is immaterial because a ‘passthrough’ in the form of Cenvat credit to the manufacturers.
  But the SSI sector directly benefits, assuming that the duty reduction is passed on by the input manufacturers.

So now what left are the consumer goods and consumers durables. Arguably, in the normal course, the 2% point reduction for them is not likely to result in any appreciable price reduction leading to aggressive consumption.
In the present crisis scenario, 2 factors are significant.

1. The decisions of Dec 7 and Feb 24 mean a cumulative reduction in the duty incidence of the peak rate of Cenvat by a hefty 43%; from 14% to 8%.
2. In the demand recession situation, the industry is likely to pass on the benefit to the consumers.

Talking about services, their cost would come down. But whether it would boost demand is unlikely. Perhaps the govt. perceives the service tax rate reduction.
Based on the response from the first and second stimulus packages, one could be pessimistic about its intended impact. This is despite the sharp fall in the non-food inflation rate, which is right now well below the threshold level. (These measures might lead to near-deflationary situation in the non-food articles).even if it has some positive effect in the short-term, this is expected to have an adverse impact in the long run.

The fiscal deficit now is estimated to be around 7.8% (including off-budget items). In my view, this leaves very limited room for the effectiveness of any monetary policy measures such as rate cuts. This could also disturb the relationship between Public and Private Investments. Fiscal expansion above the threshold might reverse the private investment trajectory. Further, the downgrading of the economic outlook by the rating agencies, if one still takes it serious, might restrict the foreign capital inflow and could mess up the external balances.
· Due to this huge fiscal deficit, investments on infrastructure projects will standstill or get reduced.

The Rocky Road to Recovery

The US Federal Reserve, which helped create the problems through a combination of excessive liquidity and lax regulation, is trying to make amends- by flooding the economy with liquidity, a move that, at best, has merely prevented matters from being worse.

In some ways, the Fed resembles a drunk driver who, suddenly realizing that he is heading off the road starts careening from side to side.

• The response to the lack of liquidity is ever more liquidity. When the economy starts recovering, and banks start lending, will they be able to drain the liquidity smoothly out of the system?
• Will America face a bout of inflation?
• Or, more likely, in another moment of excess, will the Fed over-react, nipping the recovery in the bud? Given the unsteady hand exhibited so far, we cannot have much confidence in what awaits us.

For a long time, the US has played an important role in keeping the global economy going. America’s profligacy- the fact that the world’s richest country could not live within its means—was often criticized. But perhaps the world should be thankful, because without American profligacy, there would have been insufficient global aggregate demand. In the past, developing countries filled this role, running trade and fiscal deficits. But they paid a high price, and fiscal responsibility and conservative monetary policies are now the fashion.

Moreover, growing inequality in most countries of the world has meant that money has gone from those who would spend it to those who are so well off that, try as they might, they can’t spend it all.
The world’s unending appetite for oil, beyond its ability or willingness to produce, has contributed a third factor. Rising oil prices transferred money to oil-rich countries, again contributing to the flood of liquidity. Though oil prices have been dampened for now, a robust recovery could send them soaring again.

For a while, people spoke almost approvingly of the flood of liquidity. But this was just the flip side of what Keynes had worried about—insufficient global aggregate demand. The search for return contributed to the reckless leverage and risk taking that underlay this crisis.

We need not just temporary stimuli, but longer-term solutions. It is not as if there was a shortage of needs; it is only that those who might meet those needs have a shortage of funds.

1. We need to reverse the worrying trends of growing inequality. More progressive income taxation will also help stabilize the economy, through what economists call ‘automatic stabilizers’. It would also help if the advanced developed countries fulfilled their commitments to helping the world’s poorest by increasing their foreign-aid budgets to 0.7% of GDP.
2. The world needs enormous investments if it is to respond to the challenges of global warming. Transportation systems and living patterns must be changed dramatically.
3. A global reserve system is needed. It makes little sense for the world’s poorest countries to lend money to the richest at low interest rates. The system is unstable. The dollar reserve system is fraying, but is likely to be replaced with a dollar/euro or dollar/euro/yen system that is even more unstable. Annual emissions of a global reserve currency could help fuel global aggregate demand, and be used to promote development and address the problems of global warming.
   This year will be bleak. The question we need to be asking now is, how can we enhance the likelihood that we will eventually emerge into a robust recovery?

How to Fail to Recover

The stimulus will strengthen America’s economy, but it is probably not enough to restore robust growth. This is bad news for the rest of the world, too, for a strong global recovery requires a strong American economy.

America’s recovery program, lie not in the stimulus package but in its efforts to revive financial markets. Its failures provide important lessons to countries around the world, which are or will be facing increasing problems with their banks.

• Delaying bank restructuring is costly, in terms of both the bailout costs and the damage to the overall economy in the interim.
• Governments do not like to admit the full costs of the problem, so they give the banking system just enough to survive, but not enough to return it to health.
• Confidence is important, but it must rest on sound fundamentals. Policies must not be based on the fiction that good loans were made, and that the business acumen of financial-market leaders and regulators will be validated/return back, once confidence is restored.
• Bankers can be expected to act in their self-interest on the basis of incentives. Perverse (bad) incentives fueled excessive risk-taking, and banks that are near collapse but are too big to fail will engage in even more of it. Knowing that the government will pick up the pieces if necessary, they will postpone resolving mortgages and pay out billions in bonuses and dividends.
• Socializing losses while privatizing gains is more worrisome than the consequences of nationalizing banks. American taxpayers are getting an increasingly bad deal. In the first round of cash infusions, they got about $0.67 in assets for every dollar they gave (though the assets were almost surely overvalued, and quickly fell in value). But in the recent cash infusions, it is estimated that Americans are getting $0.25, or less, for every dollar. Bad terms mean a large national debt in the future. One reason we may be getting bad terms is that if we got fair value for our money, we would now be the dominant shareholder in at least one of the major banks.
• Don’t confuse saving bankers and shareholders with saving banks. America could have saved its banks, but let the shareholders go, for far less than it has spent.
• Trickle-down economics almost never works. Throwing money at banks hasn’t helped homeowners: foreclosures continue to increase. Letting AIG fail might have some systemically important institutions, but dealing with that would have been better than to gamble upwards of $150 billion and hope that some of it might stick where it is important.
• Lack of transparency got the US financial system into this trouble. Lack of transparency will not get it out. The Obama administration is promising to pick up losses to persuade hedge funds and other private investors to buy out banks’ bad assets. But this will not establish ‘market prices’, as the administration claims. With the government bearing losses, these are distorted prices. Bank losses have already occurred, and their gains must now come at taxpayers’ expense. Bringing in hedge funds as third parties will simply increase the cost.
• Better to be forward looking than backward looking, focusing on reducing the risk of new loans and ensuring that funds create new lending capacity. Bygone are bygones. As a point of reference, $700 billion provided to a new bank, leveraged 10 to 1, could have financed $7 trillion of new loans.
• The era of believing that something can be created out of nothing should be over. Short-sighted responses by politicians- who hope to get by with a deal that are small enough to please taxpayers and large enough to please the banks- will only prolong the problem. An impasse is looming. More money will be needed, but Americans are in no mood to provide it- certainly not on the terms that have been seen so far. The well of money may be running dry, and so, too, may be legendry optimism and hope.

What is the Deficit Endgame?

No one yet has any idea about when the global financial crisis will end, but one thing is certain:
Government budgets deficits are headed into the stratosphere.

What may happen?

• Although governments may try to cram public debt down the throats of local savers (by using, for example, their rising influence over banks to force them to hold a disproportionate quantity of government paper), they will eventually find themselves having to pay much higher interest rates as well. Within a couple years, interest rates on long-term US Treasury notes could easily rise 3-4%, with interest rates on other governments’ paper rising as much, or more.
• Interest rates will rise to compensate investors both for having to accept a larger share of government bonds in their portfolio and for an increasing risk that governments will be tempted to inflate away the value of their debts, or even default.
  

“In research we have done on the history of financial crisis, we find that public debt typically doubles, even adjusting for inflation, in the three years following a crisis. Many nations, large and small, are now well on the way to meeting this projection.”

Scenario: China
China’s government has clearly indicated that it will use any means necessary to backstop growth In the face of a free fall in exports. How? It has $2 trillion in hard currency reserves to back up their promise.
China’s claim that its GDP grew at a 6% rate, during the end of last year, is suspect. Exports have collapsed throughout Asia, including Korea, Japan, and Singapore. Arguably India, and to a lesser extent Brazil, have been holding out a bit better. But few emerging markets have reached a stage at which they can withstand a sustained collapse in the developed economies, much less serve as substitute engines of global growth.

Scenario: United States of America
US long-term growth could be particularly dismal, as the Obama administration steers the country toward more European levels of welfare assistance and income redistribution.
President Barack Obama’s new budget calls for a stunning $1.75 trillion deficit in the United States, a multiple of the previous record. Even those countries that are not actively engaged in a fiscal orgy are seeing their surplus collapse and their deficits soar, mainly in the face of falling tax revenues. Income in the US and euro- area both appear to have declined at an annualized rate of roughly 6% in the fourth quarter of 2008; Japan’s GDP fell at perhaps twice that rate.

Scenario: Europe
Countries with European-style growth rates could handle debt obligations of 60% of GDP when interest rates were low. But, with debts in many countries raising to 80% or 90% of GDP, and with today’s low interest rates clearly a temporary phenomenon, trouble is brewing. Many of the countries that are piling on massive quantities of debt to bail out their banks have only tepid medium term growth prospects, raising real questions of solvency and sustainability.
Italy, for example with a debt-to-income ratio already exceeding 100% has been able to manage so far thanks to falling global rates. But as debts mount, and global interest rates rise, investors will become rightly nervous about the risk of debt restructuring. Other countries, such as Ireland, UK, and the US, started with a much stronger fiscal position, but may not be much better off when the smoke clears.

Scenario: India
Prime Minister Manmohan Singh’s tax cuts and extra spending plans will widen the budget deficit to 6 percent of gross domestic product in the year ending March 31 from a target of 2.5 percent. That will force the government to borrow a record 3.62 trillion rupees ($71 billion) next year. Indian government debt is the equivalent of 80 percent of the nation’s GDP.

Exchange rates: A wild card
Exchange rates are another wild card. Asian central banks are still nervously clinging to the dollar. But with the US printing debt and money like it is going out of style, it would appear the euro is set to appreciate against the dollar two or three years down the road.

Outlook

• With the credit crisis still making it difficult for many small and medium-size businesses to obtain even the minimal level of financing necessary to maintain inventories and conduct trade, global GDP is on a precipice in 2009. There is a real possibility that global growth will register its first contraction since World War 2.
• As debt mounts and the recession lingers, we are surely going to see a number of governments trying to lighten their load through financial repression, higher inflation, partial default, or a combinations of all three. Unfortunately, the endgame to the great recession of the 2000’s will not be a pretty picture.
• In all likelihood, as slew of countries will see output declines of 4-5% in 2009, with some having true depression level drops, of 10% or more. Worse yet, unless financial systems spring back, growth could disappoint for years to come, especially in ‘ground zero’ countries such as the US,UK, Ireland and Spain.

Banks' failure

The aftermath of the banking crisis requires Nations think about not only the most appropriate form of banking legislation, but also the appropriate size of the state.

There has always been competition between different sorts of banking regulation. On the one hand, there is the idea- which defined banking for much of:

• In the American history- that banks should be close to the risks that they must judge. Here they were confined to one state. Most of nineteenth-century US banks did not have branches. They cannot distribute the risk. They had large intervention of political centralization.
• The alternate approach was that of Canada, which, because of its roots in secure British rule, had much less fear of political centralization, and was prepared to tolerate a nation-wide banking system. Canada’s large banking system distributed risk more widely, and also fared better in episodes of financial panic, whether in 1907 or in 1929-1933.
  

The larger bank principle has two chief attractions.

1. It promises more effective risk management, because large banks are less exposed to a single sort of customer (in contrast to rural American banks, which suffered when American farmers suffered).
2. It lends itself much more effectively to long-term strategic thinking about the overall direction of the national, or even the international, economy.

But the larger banks can get into trouble when these two principles get mixed up. The idea of the larger bank reached its high point in continental Europe, and especially in Germany, whose big banking system developed out of trade finance and into industrial finance in the late nineteenth century.

By that time, countries were looking with eager interest at financial models developed elsewhere. The most interesting and attractive potential model for the US was German-style universal banks, which were imitated in Russia, Japan, Italy, and Egypt.

By 1931, even Britain found it hard to resist the German model. By the 1990’s, however, emulation of other banking models was back in fashion. Financial empire building drove late twentieth-century globalization. There was a competitive race across the Atlantic and – to a lesser extent- the pacific.

Gradual integration of the potentially vast European capital market and the creation of cross-border European banks as a result of mergers, made it look as if a new European breed of super-banks was emerging. Likewise, Japan responded to its banking crisis by creating very large merged institutions, while the US repealed much of the depression-era legislation that restricted banking.

US exported its new banking model to the emerging- market economies. Spanish and U S banks moved heavily into Latin America.

But the new super-banks were inherently vulnerable because of the vast diversity and complexity of their transactions. Long before the emergence of the sub-prime mortgage problem, Citigroup was damaged by the behavior of its London traders, who tried to manipulate the European government bond market, and by its Tokyo traders.

It is much simpler for a transnational manufacturing corporation to implement controls to ensure product quality. By contrast, in a company whose business is financial intermediation, millions of judgments are made independently, and their implications may be serious enough to threaten the entire firm.

There is a danger that in the push to nationalize banks as a consequence of the financial crisis, governments will see it as their duty to implement strategies.

Time to Nationalize Insolvent Banks

Time to Nationalize Insolvent Banks

· With the United States and global economy sliding into a severe recession, bank losses would extend well beyond sub-prime mortgages to include:
ð sub-prime, near prime, and prime mortgages;
ð commercial real estate;
ð credit cards, auto loans, and student loans;
ð industrial and commercial loans;
ð corporate bonds;
ð sovereign bonds and state and local government bonds;
ð And losses on all of the assets that securitized such loans.
· The latest estimates by a research report suggest that total losses on loans made by US financial firms and the fall in the market value of the assets they hold (things like mortgage-backed securities) will peak at about $3.6 trillion.
- US banks and broker dealers ----$1.8 trillion;
- other financial institutions in the US and abroad-----$1.8 trillion
The capital backing the banks’ assets was only $1.4 trillion last fall, leaving the US banking system some $400 billion in the hole, or close to zero even after the government and private-sector recapitalization of such banks.
· Another $1.5 trillion is needed to bring banks’ capital back to pre-crisis level, which is needed to resolve the credit crunch and restore lending to the private sector.
So, the US banking system is effectively insolvent in the aggregate; most of the British banking system looks insolvent, too, as do many continental European banks.
There are 4 basic approaches to cleaning up a banking system that is facing a systemic crisis:
1. Recapitalization of the banks, together with a purchase of their toxic assets by a government “bad bank”,
2. Recapitalization, together with government guarantees- after a first loss by the banks- of the toxic assets;
3. Private purchase of toxic assets with a government guarantee (the current US government plan);
4. Outright nationalization (or call it “government receivership” if you don’t like the dirty N-word) of insolvent banks and their resale to the private sector after being cleaned.
Of the 4 options, the first 3 have serious flaws.
· In the “bad bank” model, the government may overpay for the bad assets, whose true value is uncertain. Even in the guarantee model there can be such implicit government overpayment (or an over-guarantee that is not properly priced by the fees that the government receives).
In the “bad bank” model, the government has the additional problem of managing all the bad assets that it purchased- a task for which it lacks expertise. And the very cumbersome US Treasury proposal- which combines removing toxic assets from banks’ balance sheets while providing government guarantees- was so non-transparent and complicated that the markets drove as soon as it was announced.
Thus, paradoxically Nationalization,
· Will be a more market-friendly solution: it wipes out common and preferred shareholders of clearly insolvent institutions, and possibly unsecured creditors if the insolvency is too large, while providing a fair upside to the tax-payer. It can also resolve the problem of managing banks’ bad assets by reselling most of assets and deposits- with a government guarantee- to new private shareholders after a clean-up of the bad assets (as in the resolution of the Indy Mac bank failure).
· It also resolves the too-big-too-fail problem of banks that are systematically important, and that thus need to be rescued by the government at a high cost to taxpayers.
Indeed, the problem has now grown larger, because the current approach has led weak banks to take over even weaker banks. Merging zombie banks is like drunks trying to help each other stand up. JPMorgan’s takeover of Bear Stearns and WaMu; Bank of America’s takeover of Countrywide and Merrill Lynch; and Wells Fargo’s takeover of Wachovia underscore the problem. With nationalization, the government can break up these financial monstrosities and sell them to private investors as smaller good banks.
Whereas Sweden adopted this approach successfully during its banking crisis in the early 1990’s, the current US and British approach may end up producing Japanese-style zombie banks- never properly restructured and perpetuating a credit freeze. Japan suffered a decade-long near-depression because of its failure to clean up the banks. The US, the United Kingdom, and other economies risk a similar outcome- multi-year recession and price deflation- if they fail to act appropriately.

Recession Insurance

Recession Insurance
The current global economic crisis is an opportunity for some new experimentation that might not lead to its resolution, but might also set in place institutions that help to prevent future crisis. Recession insurance is one such idea.
About:
Governments may offer ‘recession insurance’. Companies and/or individuals would buy insurance policies, pay a regular premium for them, and receive a benefit if, some measure of the economy, such as GDP growth, dropped below a specified level. Such insurance would help firms and people deal with the ‘extreme uncertainty’ of the current economic environment.
Benefits:
v In contrast to fiscal policy, recession insurance imposes no costs on the government, for if it stimulates confidence, then the risk being insured against is prevented. The government’s ability to offer such insurance on a large scale is sufficient to make it costless, so can favor a public scheme over private insurers initially will work.
v The real problem that we are currently facing is one of paralysis: uncertainty has placed many spending decisions—by business (on higher output) and by consumers (on the items that businesses produce) --- on hold. Reducing uncertainty might augment, or even be superior to, fiscal stimulus programs, for it would address the root cause of the unwillingness to spend.
v Banks might condition loans to their purchase of recession insurance, which might help credit markets function better, addressing a serious problem underlying the current crisis.
Tantalizingly, this would create ‘a market-based view of future output and the likelihood of severe shocks’, although yet to be explained how this market would be structured.
The IMF authors are not saying that governments should do this with recession insurance, so perhaps they mean that governments would auction off the policies, which would create a market price. But the market price would depend especially on how much insurance a government decided to auction off, because the supply would influence the price both directly and through the insurance’s effect on the underlying recession risks.
Governments are in a good position to create new risk-management policies, and they can then set an example for private insurers to follow. But, as an alternative to the IMF proposal, there could be purely private recession insurers.
Any instances?
v Such insurance already exists on a small scale in the form of credit insurance against unemployment in America. A New York- based firm, the Assura Group, has been working for four years on a plan to launch privately issued supplement unemployment insurance to anyone.
v In a recent paper, an economist proposed that governments issue shares in their GDP, with each share amounting to a trillionth of GDP. These ‘trills’ would help individual countries manage their GDP risks. We thought that the issuers of such securities would have, in effect, a form of recession insurance.
Get started
1. First one needs to find the market-price of these recession insurance policies.
To create a market price for recession risk is to offer the commodity company’s shares, like for oil price risk, but plans for GDP risk are on the drawing board. These securities can be offered in pairs- one long and one short- and, unlike in a government- run scheme, in whatever quantity the market demands.
One problem with market-based policies is strategic adoption and cancellation. GDP risk is a long-term risk. The price of the insurance would have to be adjusted regularly to adjust for varying public knowledge of the likelihood of a recession, and people could not be allowed to cancel their policies, and stop making payments, whenever the economic outlook became rosier.
2. Once we have a market price for recession insurance or similar products, the question then arises: will it be so high that few people want to buy? (Will there be any buyers?). We know that we are probably in a recession right now, and may be for some time. So the expected losses currently are enormous. As a result, people may balk at the price and not want to buy the insurance. The only insurance that people might think they can afford could carry a large deductible, and if the deductible is very large, people might not feel so reassured by this insurance.