There’s a Basic Disconnect in Trump’s Plan to Make America Great Again

donald trumpThis is the third and the final column in the series, where I explain that Donald Trump’s idea of making America great again, by imposing tariffs, is not going to work.

Dear Reader, before you start reading this column, it perhaps makes sense to read the two columns published before this, in order to get a complete perspective on the topic. (You can read the columns here and here).

In today’s column we will take a look at how Trump’s entire idea of driving up exports while driving down imports, is contradictory to say the least. Let’s start by looking at Figure 1, which basically plots the trade deficit of the United States over the years.

Figure 1: US trade deficit (in $ million) 

Trade deficit is a situation where the imports of a country are more than its exports. We can see that the United States has run a trade deficit with the rest of the world over the last four decades. The trade deficit peaked between 2004 and 2008, fell for a few years after that, and started going up again.

The American trade deficit came down in the years 2009 and 2010, and these were years when the American economy and the global economy, were both not doing well. Now let’s take a look at Figure 2, which basically plots the exports and imports of the United States over the last four decades.

Figure 2: 

Figure 2 makes for a very interesting reading. The exports and the imports curves of the United States, move more or less in the same way. This basically means that when imports go up, exports also go up and vice versa. Why is that the case? The reason for this is very straightforward. The United States is the largest market in the world. When it imports stuff, it pays dollars to other countries, which are exporting stuff to the United States. These countries can then use these dollars to pay for American exports.

Hence, if Trump keeps going ahead with imposing more tariffs on imports into the US, as he has suggested for a while, he will deny other countries an opportunity to earn “enough” dollars through which they can pay for their imports from the US, which are basically the exports for the US. The larger point being that it is not possible to increase American exports and decrease American imports at the same time. This is the simplistic plan that Trump has to make America great again and there is a basic disconnect at the heart of it. Also, any such plan will have a negative international impact.

Now let’s take a look at Figure 3, which basically plots the American trade deficit with one country, and that is China.

Figure 3: 

Figure 3 clearly shows that the American trade deficit with China has gone up dramatically over the years. The Chinese imports help keep inflation low in the United States. They also help keep interest rates low, as the dollars earned by the Chinese, have over the years found their way back into the United States and are invested in American treasury securities and other debt securities. This foreign demand for American financial securities has helped keep interest rates low in the US. Over and above this, there is another major point that arises here. Take a look Figure 4. It plots the overall trade deficit of the United States, along with the trade deficit that the country runs with China.

Figure 4: 

Figure 4 tells us very clearly that over the years, the trade deficit with China has formed a greater proportion of the overall trade deficit run by the United States. In 2017, the trade deficit with China formed nearly 66% of the overall trade deficit.

Much has been said about the fact that Trump is basically not thinking about the long-term, but is trying to beat down American trading partners into giving American companies better terms. The trouble is that the bulk of the American trade deficit is with China and unless Trump takes on China, the gains of his so called policy are going to be very low.

Of course, it is not easy to bully China, given that other than helping maintain a low inflation and low interest rates in the US, the Chinese also own more than a trillion dollars of American government treasury securities and if push comes to the shove, it can use these treasury securities, as a bargaining tool.

Also, the current Chinese regime is turning more and more authoritarian and is unlikely to take to any bullying by the US, lightly. The only way America can become great again on the industrial front is, if it is able to compete with the products being produced internationally, both on the price as well as the quality front.

The column originally appeared on Equitymaster on March 16, 2018.


Trump’s Trade Wars Will Hurt Dollar’s Exorbitant Privilege

Dear Reader, we would suggest that before you start reading this column, you read the column published yesterday. In yesterday’s column we saw how the tariffs unleashed by the US President Donald Trump will hurt America, instead of making it great again. Reading this column, before you read today’s column, will give you a complete perspective on the issue. This is the second in a series of three columns on the issue. The third column will appear on Thursday.

The American dollar is at the heart of the global financial system as it has evolved. The reasons for this are historical.

By 1944, it was clear that the Allied forces are going to win the Second World War. In July 1944, they gathered at the Mount Washington Hotel, Bretton Woods, New Hampshire in the US, to design a new financial system for the world. Europe had been totally destroyed during the course of the war and even countries like Britain and France were in a bad shape despite being on the winning side. European countries were in no position to negotiate. And so, the American dollar was placed at the heart of the financial system that evolved at Bretton Woods.

The US was ready to convert dollars into gold at the rate of $35 for one ounce (31.1 grams) of gold. This came to be known as the Bretton Woods Agreement. It made the
American dollar the premier international currency of choice, as it was the only currency that could be converted into gold.

This ensured that over a period of time countries moved to carrying out their international trade primarily in American dollars. It also ensured that countries held their foreign exchange reserves in dollars because dollar was the only currency which could be converted into gold.

This structure that emerged gave the American dollar an exorbitant privilege. While the rest of the world had to earn these dollars by exporting stuff, the United States could simply print them and buy all the stuff that it needed. This has been one of the primary reasons why United States, over the decades, has turned into a big buyer of things. All the American buying drives global demand.

Given that the dollar became the international trading and reserve currency, the oil cartel OPEC (Organization of the Petroleum Exporting Countries), also sold the oil that it produced, in dollars. This was one more reason for the world to buy and sell stuff in dollars. Every country did not produce the total oil it consumed, and in order to import enough oil to fulfil its consumption needs, it needed dollars. The only way to earn these dollars was to price its exports in dollars.

In fact, the Saudi Arabia led OPEC continuing to price oil in dollars, is one of the major reasons why dollar continues to be the major reserve as well as trading currency of the world. Even the Americans recognise this fact.

As Nassim Nicholas Taleb writes in his new book Skin in the Game—Hidden Asymmetries in Daily Life: “It is clear since the attack on the World Trade Center (in which most of the attackers were Saudi citizens) that someone in that nonpartying kingdom had a hand—somehow—in the matter. But no bureaucrat, fearful of oil disruptions, made the right decision—instead, the absurd invasion of Iraq was endorsed because it appeared to be simpler.”

So, dollar due to various reasons is the international currency in which people and countries want to deal with. As George Gilder writes in The Scandal of Money—Why Wall Street Recovers But the Economy Never Does: Today it [i.e. the dollar] handles more than 60 percent of world trade, denominates more than half the market capitalization of world stocks, and partakes in 87 percent of global currency trades.”

Given this, over the years, countries have accumulated huge dollar reserves. A significant chunk of these reserves have been earned by exporting stuff to the United States.  The United States is the biggest economy in the world. It accounts for nearly one-fourth of the world’s GDP. By virtue of this, it is also the world’s biggest market, where China, Japan and countries from South- East Asia sell their goods and earn dollars in the process.

It is also the world’s biggest consumer of oil and consumes nearly a fourth of the global oil production. This meant that oil-rich states such as Saudi Arabia could sell oil to it and thus earn dollars in the process.

The dollars earned by other countries haven’t stayed in the vaults of their central banks. They have been invested in American treasury securities and other debt securities. Treasury securities are basically financial securities issued by the American government to finance its fiscal deficit, which is the difference between what a government earns and what it spends. Take a look at Figure 1. It basically plots the foreign investment in American treasuries over the last 40 years.

Figure 1:

Source: Board of Governors of the Federal Reserve System (US)


The foreigners currently own more than $6 trillion of American government treasury securities. This along with the easy money policy initiated by the Federal Reserve of the United States, in the aftermath of the financial crisis that broke out in September 2008, has ensured that the interest that the US government pays on these securities has been around 2% per year, over the last five years.

The interest paid on the US treasury securities sets the benchmark for other loans in the American financial system (or for that matter any other financial system) because lending to the government is deemed to be the safest form of lending. Over and above this, the foreigners have invested close to $3.3 trillion in other American debt securities.

This inflow of dollars into the United States has kept interest rates low. These low interest rates have kept the American consumption story going to some extent. As the American stand-up comedian George Calrin once said: “Consumption is the new national pastime. People spending money they don’t have on things they don’t need, money they don’t have so they can max out their credit cards… And they didn’t like it when they got it home anyway.”

Donald Trump’s tariff policy will attack at the heart of this model. Countries earn dollars by exporting stuff to the United States and other parts of the world. These dollars then find their way back to the United States where they are invested in treasury and other debt securities, and help maintain low interest rates.

If Trump and America shut out the American market to other countries, the countries exporting stuff to the US (Japan, China, South Korea, Taiwan, and a whole host of other countries), will not earn as many dollars as they currently are. And if they don’t earn enough dollars, the likelihood of them continuing to invest in American debt securities, is very low. This will mean that the interest rates in the United States will start to rise. This is something that the country which is currently going through an early stage of economic recovery, cannot really afford.

Further, the other countries might also start to try and price their exports in currencies other than the dollar, as well. China has been working towards this for quite a while. Trump’s decision to introduce tariffs might just be the final push that the country needs.
If countries start pricing their exports in non-dollar currencies, Trump’s plan to impose tariff will hurt the exorbitant privilege that the dollar has enjoyed over the years.

In fact, in the third and final column in this series, which will appear on Thursday, we will see why Trump’s plan of trying to increase American exports while shrinking its imports, is essentially contradictory in nature.

The column originally appeared on Equitymaster on March 13, 2018.

Trump’s Trade Wars Aren’t Going to Make America Great Again

donald trump
Donald Trump’s campaign slogan while fighting the American presidential elections, was to ‘Make America Great Again’. On March 1, 2018, a little over a year after taking over as the 45th president of the United States, Trump announced a 25% tariff on steel and a 10% tariff on aluminium.

The question is, how does this fit into Trump’s plan to make America great again? Trump plans to drive up exports and drive down imports. By driving down imports through tariffs, the American consumer will be forced to buy stuff produced within the country. This will encourage domestic industry and in turn create jobs. By driving up exports, again domestic industry will be encouraged and this will create jobs. QED.

Now only if it was as simple as that. The trouble is that most politicians while making economic decisions look at only the first order effects of their decisions. In the current case this basically means that the steel tariff of 25%, will also allow the American domestic steel industry to compete.

As of now the American steel industry cannot compete simply because it cannot produce steel at a price at which steel can be imported into the United States. The tariff of 25% will make imported steel costlier and in the process allow American steel companies to compete. And this will create jobs. At least that is what Trump and his advisers who have helped him to arrive at this decision, hope for.

This is the first order effect of Trump’s decision which looks just at the impact of the tariff  on the American steel producers. As Henry Hazlitt writes in Economics in One Lesson: “Those who favour it [i.e. tariffs] think only of the interests of the producers immediately benefitted by the particular duties involved. They forget the interests of the consumers who are immediately injured by being forced to pay these duties.”

Hazlitt is talking about the first order effect of Trump’s decision which benefits American steel companies and the second order effect of Trump’s decision which hurts American companies consuming steel.

Steel (either imported or produced in America) is bought by other American companies. It is used as a major component while making buildings, tools, ships, automobiles, machines, appliances, and weapons. Other than weapons, the United States cannot do without the other things listed in the last sentence.

On second thought, given the American obsession with guns, neither can the country do without weapons.

Steel is also used as a major input into building physical infrastructure.

While the tariff on steel will make American steel producers viable, it will make steel more expensive for American steel consumers, as they will have to pay more for steel. This increase in cost will be passed on to the end consumers. So, everything from cars to appliances to homes will cost more. The end consumer only has so much money going around. Hence, he or she may not buy the stuff he has been planning to, due to higher prices. If he does so, his expenses will have to increase or he will have to balance his overall expenses, by cutting down on his other expenditure.

As Hazlitt writes: “The added amount which consumers pay for a tariff protected article leaves them just that much less with which to buy all other articles. There is no net gain to industry as a whole.” This is a very basic point which politicians encouraging any sort of protectionism don’t seem to get.

The tariffs will impact the overall sales of other American businesses, which might in turn fire people to maintain their profitability. It’s just that it is not possible to exactly quantify these job losses and loss of business.

As Hazlitt writes: “It would be impossible for even the cleverest statistician to know precisely what the incidence of the loss of other jobs had been—precisely how many men and women had been laid off from each particular industry, precisely how much business each particular industry had lost—because consumer had to pay more [for steel in this case].”

The news agency Reuters has a story on how 780 workers of the Novolipetsk Steel will lose their jobs. The company imports two million tonnes of steel slabs per year from its Russian parent company. It then rolls these slabs into sheets for various American companies, ranging from Home Depot to Harley Davidson to Caterpillar.

The customers of this steel company now need to be ready to accept a 25% increase in the price of steel. If they do, the company survives. If they don’t, then the company will have to start firing workers. This is the second order effect of a tariff, which is not very clear up front.

If these companies accept a 25% increase it will only be in a situation where they can’t source the steel they need from a cheaper source. Further, it will lead to a rise in the price of their end product, depending on what proportion steel forms of their total inputs.

Also, it is worth remembering here, that if America can impose tariffs on its imports, other countries can do the same on their imports, hurting American exports. In fact, this is precisely how things played out in the aftermath of the First World War, when America tried to protect its domestic industry through tariffs. In return, other countries imposed tariffs on their imports and this led to the start of the global trade war, hurting American exports.

Hence, driving down imports, while trying to drive up exports, is sort of contradictory. There are many other aspects to this, which we shall see in tomorrow’s column.

The Economist estimates that steel and aluminium accounted for around 2% of the total American imports of $2.4 trillion, last year. This formed around 0.2% of the American GDP. Given this, currently the level of protectionism unleashed by the American president is very small. But the level of rhetoric that Donald Trump has unleashed around the issue, it doesn’t seem that he is going to stop just at this. This also becomes clear from the fact that on March 6, 2018, Gary Cohn, the chief economic adviser of Trump, quit.

We will return to this discussion in tomorrow’s column.

The column originally appeared on Equitymaster on March 12, 2018.

Is Federal Reserve Getting Ready for an ‘Easy Money’ Confrontation with Donald Trump?

3D chrome Dollar symbol

We were at the Taj Mahal Hotel in Mumbai, attending the Equitymaster conference over the last two days. Overlooking the dark waters of the Arabian Sea and the Gateway of India, as we ate, talked and heard, we also sat back and thought about how the end of the easy money era would play out.

As we heard Marc Faber and Ajit Dayal lay out their ideas, we got more ideas. And we came to an old conclusion, all over again: forecasting, especially about the future, is a difficult business. But then someone’s got to take a shot at it. Everyone in the investing world cannot be cautiously optimistic. We have clearly have had enough of that term.

So how is this end of the era of easy money, likely to play out? The Federal Reserve of the United States, the American central bank, has started shrinking its massive balance sheet from October 2017 onwards. Between October 3, 2017 and January 29, 2018, the Federal Reserve has shrunk its balance sheet by around $40 billion, we can see that from the Fed documents. But there is still a long way to go, given that the size of the Federal Reserve’s balance sheet is still more than $4.4 trillion.

In the aftermath of the financial crisis that started in September 2008, once the Lehman Brothers, the fourth largest investment bank on Wall Street went bust, and many other financial institutions in the Western world almost went down with it, the Federal Reserve decided to print a lot of money. But just printing money wasn’t enough, this money, had to be pumped into the financial system as well.

This printed money (or rather created digitally) was pumped into the financial system by buying American treasury bonds and mortgage backed securities. American treasury bonds are bonds issued by the American government in order to finance its fiscal deficit, or the difference between what it earns and what it spends.

Mortgage backed securities are essentially securitised financial securities which are derived from mortgages (i.e. home loans). As of September 1, 2008, the Federal Reserve had assets worth $905 billion. As it got around to buying treasury bonds and mortgaged backed securities, it expanded its balance sheet very quickly. The size of Federal Reserve’s balance sheet peaked at $4.51 trillion, towards the end of December 2016.

The idea was that all this money floating around in the financial system would drive interest rates low and keep them there. This happened. Over and above this, the hope was that the companies would use low interest rates as an opportunity to borrow, invest and expand. This would create jobs and employment, would lead to spending and create faster economic growth.

The companies didn’t quite behave the way they were expected to. Yes, they did borrow. But they borrowed to buyback their shares and reduce the number of outstanding shares, and hence, pushed up their earnings per share.

These buybacks essentially benefitted the rich Americans who owned shares. The benefits were two-fold. First, they had an opportunity to sell their shares back to the companies buying them. And second, as the stock market rallied because of improved earnings and all the money floating around, those who owned shares benefitted.
But this wasn’t really what the Federal Reserve had hoped. The consumers were also supposed to borrow and spend at low interest rates. But that didn’t quite play out the way the Federal Reserve had hoped.

What happened instead was that large financial institutions borrowed money at very low interest rates and invested them in stock and bond markets all over the world, including India. These trades are referred to as the dollar carry trade. This led to stock markets rallying all over the world, irrespective of the fact whether the earnings of the companies were improving or not.

The Federal Reserve has decided to gradually start withdrawing all the money that it has put into the global financial system. Between October and December 2017, it planned to sell treasury bonds and mortgage backed securities worth $10 billion. Between January and March 2018, this will go up to $20 billion a month. Between April and June 2018, this will go up to $30 billion a month. Between July and September 2018, the Federal Reserve plans to sell bonds worth $40 billion a month. After that the amount will rise to $50 billion a month.[i]

How does the actual evidence look like? As mentioned earlier in the piece, the Federal Reserve had managed to shrink its balance sheet by $40 billion between October 3, 2017 and January 29, 2018. From the looks of it, the Federal Reserve seems to be doing what it said it would do. Nevertheless, these are early days.

In 2018, the Federal Reserve is expected to shrink its balance sheet by $420 billion and 2019 onwards, the balance sheet is expected to shrink by $600 billion a year. With the Federal Reserve taking money out of the financial system, there will be lesser money going around, this is likely to push up interest rates. In fact, the yield (i.e. return) on the 10-year treasury bond has crossed 2.85%. This yield acts as a benchmark for other kinds of lending, simply because lending to the American government is deemed to be the safest form of lending. With interest rates expected to go up, the carry trades are expected to become unviable. This will lead money being withdrawn from stock and bond markets all over the world.

In fact, regular readers would know that we have already discussed a large part of what has been written up until now. But now comes the completely crazy part. The United States government is expected to borrow $955 billion, during the course of this year, to meet its expenses. It is further expected to borrow a trillion dollars, in each of the next two years. Basically, the American government needs to borrow close to $3 trillion between 2018 and 2020.

During the same period, the Federal Reserve is working towards withdrawing more than $1.6 trillion ($420 billion in 2018 + $600 billion in 2019 + $600 billion in 2020) from the financial system. In this scenario, when the Federal Reserve is withdrawing money from the financial system and the government needs to borrow a huge amount of money, it is but logical that the interest rates in the United States are going to go up.

This will impact the carry trades. Hence, stock markets and bond markets will have a tough time all over the world. Of course, all this comes with the assumption that the Federal Reserve will continue doing what it is. The question is will it continue to withdraw the printed money it has pumped into the financial system?

Now this is where things get really interesting. The American society as a large is a highly indebted one. The total household debt of the Americans as of September 30, 2017, stood at $12.96 trillion. The debt has been going up for 13 consecutive quarters now. This debt includes, home loans, auto loans, student loans, credit cards outstanding, etc.
Hence, rising interest rates will hurt the average American as the EMIs will go up. It will also hurt the American government which is in the process of borrowing more, in the years to come. Governments, because they borrow as much as they do, as a thumb rule, like low interest rates.

In this scenario, if the Federal Reserve continues withdrawing the printed money, it is more than likely to run into a confrontation with the American president Donald Trump. Trump has only recently chosen Jerome Powell as the Chairman of the Federal Reserve, after Janet Yellen. One school of thought seems to suggest that Powell, given that he has been appointed by Trump, is likely to bat for Trump and go easy on withdrawing money from the financial system, and allowing interest rates to go up. But it is not just up to him. The American monetary policy is decided by the Federal Monetary Policy Committee (FOMC), which has Powell and 12 other members.

In fact, even if that Powell does not bat for Trump, the FOMC might still vote to go slow on allowing interest rates to rise. Ultimately, the Federal Reserve has to ensure that the American economy continues to remain on a stable footing. If rising interest rates end up hurting the American economy, the FOMC will have to react accordingly. No Federal Reserve decisions are written in stone and can always be changed.

The question is how quickly is this likely to happen? Now that is a very difficult question to answer. But my best guess (and I use the word very very carefully here) is that during the second half of the year, the Federal Reserve might have to reverse its policy of taking out all the money that it has put into the global financial institution.

Up until then, a lot of damage will be done to the stock and bond markets around the world. The funny thing is that though the Federal Reserve is now pulling out money to let interest rates rise, the European Central Bank continues to buy bonds issued by its member governments and the 10-year government bond yields of European countries, is significantly lower than that of United States.

What does this mean in an Indian context? Unless, the American Federal Reserve reverses its current policy, the Indian stocks are going to have a tough time. That is a given. What happens next, if and when Federal Reserve changes track? Will another easy money start? On that your guess is as good as ours.
Let’s watch and wait!

The column originally appeared on Equitymaster on February 12, 2018.

The Old-New Investment Lessons from the Recent Stock Market Crash

It took the BSE Sensex, India’s premier stock market index, a period of nine months (from late April 2017 to late January 2018), to go from 30,000 points to higher than 36,000 points. This meant a return of more than 20% in a period of just nine months.

In an era when fixed deposits give a post-tax return of 5% per year, a return of 20% in less than a year, has to be fantastic. Of course, there are many listed stocks which have given more than 20 % returns, during the same period.

Between January 29 and February 6, 2018, the BSE Sensex has fallen by around 5.8% and wiped out one-third of the gain between April 2017 and January 2018. A week’s fall has wiped off one-third of the gain over a period of nine months.

When the stock market falls, a new set of investors learn, the same set of lessons all over again. What does this mean?

The price to earnings ratio of the BSE Sensex crossed 26 in late January 2018. This basically means that an investor was willing to pay Rs 26 for every one rupee of earning for the stocks that make up the Sensex.

Between April 2017 and January 2018, the price to earnings ratio of the Sensex had moved from 22.6 to 26.4. This meant that while the price of the stocks kept going up, the profit of the companies they represent, did not move at the same speed. Ultimately, the price of a stock is a reflection of the profit that a company is expected to make.

The price to earnings ratio of NSE Nifty touched 27 in late January 2018. The midcap stocks were going at a price to earnings ratio of 50. And the small caps had touched a price to earnings ratio of 120.

Such price to earnings ratios, or what the stock market likes to call valuation, were last seen in 2000 and 2008. With the benefit of hindsight, we now know that at both these points of time, the stock market was in a bubbly territory.

In fact, all the occasions when the price to earnings ratio of the stock market was greater than in the recent past, were either between January and March 2000, when the dotcom bubble and the Ketan Parekh stock market scam were at their peak, or between December 2007 and January 2008, when the stock market peaked, before the financial crisis which finally led to many Wall Street financial institutions going more or less bust, broke out.

Nevertheless, the stock market experts told us that this time is different because there was no bubble in the United States of the kind we saw in 2000 or that the financial crisis that broke out in 2008, was a thing of the past. Hence, there was no real reason for the stock market to fall. (Of course, to these experts, the lack of earnings growth did not matter).

The trouble is that when the markets are in bubbly territory, there typically is no reason for them to fall, until some reason comes along. The first reason came in the form of the finance minister Arun Jaitley, introducing a long-term capital gains tax of 10% on stocks and equity mutual funds. This tax will have to be paid on capital gains of more than Rs 1 lakh, starting from April 1, 2018.

Investors took some time to digest this, and the stock market fell by 2.3%, a day after the budget. If this wasn’t enough, the yield on the 10-year treasury bond of the American government came back into the focus.

This yield jumped by around 40 basis points to 2.85%, in a month’s time. This yield sets the benchmark interest rates for a lot of other borrowing that takes place. In the aftermath of the financial crisis that broke out in September 2008, the central banks of the Western world, led by the Federal Reserve of the United States, printed a lot of money to drive down interest rates.

This was done in the hope of people borrowing and spending money and the economies recovering. That did not happen to the extent it was expected. What happened instead was that large financial institutions borrowed money at low rates and invested them in stock markets all across the world. This phenomenon came to be known as the dollar carry trade.

All this money flowing in drove up stock prices. The problem is that as the 10-year treasury bond yield approaches 3 %, dollar carry trade will become unviable in many cases. Given this, many carry trade investors are now selling out of stock markets, including that of India.

The larger point here is that nobody exactly knows when the stock market will reverse. The way the market has behaved over the last few days, has proved that all over again.

The sellers are not selling out because the valuations are too high (they were too high even a month or two back). They are selling out because of an entirely different reason all together; investors are selling out because they are seeing other investors selling out. The herd mentality that guides investors to buy stocks when everyone else is, also forces them to sell when everyone else is.

Also, the stock market, when it falls can fall very quickly. The last generation of stock market investors learnt this when the BSE Sensex fell by close to 60 % between January 9, 2008 and October 27, 2008.

Is it time for this generation of stock market investors to learn the same lesson all over again? On that your guess is as good as mine.

Stay tuned!

The column originally appeared on Firstpost on Feb 6, 2018.

The Javed Akhtar Syndrome in Real Estate


Poets usually write poems on love, breakups, betrayal, friendships, alcohol, the women serving alcohol, the world at large, politics and so on. But very rarely does a poet write a poem or a couplet on the unaffordability of real estate in India. But Javed Akhtar has done that:

sab kā ḳhushī se fāsla ek qadam hai.
har ghar meñ bas 
ek hī kamra kam hai

A loose translation of this in English would be as follows: “Everyone is just one step away from happiness; Every house has just one room less”.

Given the fact that Akhtar has spent a large part of his adult life in Mumbai, the above couplet reflects or rather captures the sensibilities of the city that never sleeps, very beautifully.

Dear Reader, you must be wondering, why am I talking about a couplet written by Javed Akhtar on a rather muggy Tuesday in Mumbai. Allow me to explain.

Over the weekend, I met a friend who wants to sell his one-room-kitchen (a very Mumbai thing) apartment and buy a one-bedroom-hall-kitchen (one BHK) apartment. Basically, he feels his current apartment has one room less and he wants an apartment which has one room more than his current one.

Of course, the transaction cannot be carried out, unless he is able to sell his current apartment. The money generated from that will partly be used to pay off the current home loan. The new apartment will be bought with whatever remains after selling off the current apartment and repaying the home loan; along with this a fresh larger home loan will have to be taken. Over and above this, some financial savings accumulated through investing in mutual funds through the SIP route, will also have to be used.

My friend had bought the apartment for Rs 50 lakh, nearly three years back. He is looking at a price of at least Rs 60 lakh. In fact, more than looking, he is specifically anchored on to that price and won’t sell for anything less than that price.

As Garly Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes and How to Correct Them: “Anchoring is really just a metaphoric term to explain the tendency we all have of latching on to an idea or fact and using it as a reference point for future decisions. Anchoring can be particularly powerful because you often have no idea that such a phenomenon is affecting you.”

This is not the first time I am discussing the phenomena of anchoring in real estate, nevertheless, this example is interesting and different, because anchoring, as we shall see, is happening at multiple levels.

My friend is anchored on to a price of Rs 60 lakh because he feels that at that price he will be in a situation of no-profit no-loss, while selling his current apartment. The extra Rs 10 lakh, over and above the price he bought the apartment for, should take care of the home loan EMIs and the maintenance charges paid, over the last three years. This is his logic for being anchored on to a price of Rs 60 lakh.

The trouble is that at that the few buyers who have approached him do not want to pay more than Rs 55 lakh, while my friend remains stuck on the Rs 60 lakh figure.

In this case, the transaction is what we can call a relative transaction. The money that my friend gets for selling the current apartment will be used to buy a bigger apartment in the same locality that he lives in.

If he waits too long to get a price of Rs 60 lakh, chances are that the price of the bigger apartment that he wants to buy will also go up. Currently, the bigger apartment is available for a price of around Rs 80 lakh.

I tried explaining this point to him without much success. In fact, after I explained this point to him, my friend told me that he had a buyer who was willing to pay Rs 60 lakh. The trouble was that this prospective buyer needed to sell an apartment in another city to be able to raise the amount.

This buyer, because my friend had become anchored to a price of Rs 60 lakh, was also anchored to that price. Given that he was a senior citizen, he was not in a position to raise a home loan. Hence, he needed someone to pay Rs 60 lakh for his flat to be able to purchase my friend’s flat.

No one was willing to pay Rs 60 lakh for the flat. In this case, the prospective buyers were willing to pay anything in the range of Rs 55-60 lakh. But that was clearly not enough. And given this, the sale of both the flats remained stuck.

This example clearly shows as to how anchoring works at multiple level and not just at one level, as is often believed. This anchoring essentially stops the market from working. The more general conclusion from this example would be that anchoring working at multiple levels, is one of the reasons why the buying and selling of real estate has slowed down majorly.

The sellers (not necessarily the builders) are still expecting prices that their homes were worth until a few years back. But the buyers, who have paid more than their fair share over the years, are currently not willing to pay the price that the sellers want.

Ultimately, this anchoring on to a specific price will break down. It’s just that it won’t happen overnight and will take some time.

Until then writers like me will have enough masala to keep writing on real estate.

Keep watching this space!

The column originally appeared on Equitymaster on November 14, 2017.

Economic Lessons from a Computer Printer


A few years back when I quit business journalism to write fulltime, one of the first things I did was to buy a computer printer. This was primarily to help my reading habit, given that I can’t read long documents on a computer. Also, it helped me to print and send out invoices conveniently, instead of having to visit a shop every time I needed to send out an invoice.

Like any good Indian, I bought the cheapest branded printer that was available. It cost just Rs 3,000. It was only when I started printing stuff did I realise how expensive the printer really was. While, the printer cost just Rs 3,000, every time I bought a cartridge, it cost Rs 800-900. And cartridges kept running out at a very fast pace. At best, I could print around 130-150 pages with a single cartridge. It was only then I realised that the printer was just something the company sold, so that they could get the consumers to buy cartridges, which is where the actual money was made.

As Even Davis writes in Post Truth—Why We Have Reached Peak Bullshit and What We Can Do About it: “By keeping a headline price low, the hope is that we assume that the overall price is low… We judge the cost of a product on the headline price, so the headline price will be kept low… There are the up-front prices versus the ongoing charges. Teaser mortgage rates that become expensive later, cheap printers with expensive cartridges and cheap razors with expensive blades are all examples of the same thing.”

In fact, in some cases the consequences can be dire. One of the reasons behind the current financial crisis was the bursting of the home price bubble in the United States and other parts of the Western world. A major reason behind the bubble was the fact that the EMIs that needed to be paid on home loans had crashed dramatically because of teaser rate mortgages (or home loans as we call them in India). In a teaser rate home loan, the interest rate is much lower in the initial years, after which it goes up dramatically.

This led to a lot of people who shouldn’t have gotten a home loan in the first place getting one. The trouble was that once the high EMIs kicked in (remember it was a teaser loan with low EMIs initially) the borrowers simply did not have the money to keep repaying the loan. So, first the teaser loans led to the home prices going up. Once the EMI defaults started, it led to a price crash, which was one of the reasons which fuelled the financial crisis.

What is the bigger lesson here? As Davis writes: “We tend to make important judgements on the basis of a few key indicators, and so by manoeuvring those indicators our perception can be controlled.” Like anyone buying a printer for the first time looks just at the price (and possibly the brand). He or she doesn’t bother about the cost of running the printer over the longer term. Companies manufacturing the printer manipulate the situation by selling printers for low prices. This basically leads to people buying the printer.

Such manoeuvring also happens in other areas. As Davis writes: “We think that good magazines have good covers, so when we observe a good cover we infer that the magazine underneath will be worth buying. As long as editors understand this rule of thumb, then you can expect inordinate effort to go into the design of the cover, even to the possible detriment of the rest of the magazine.”

Anyone who has read Indian magazines over the last two decades would know that while magazine covers have improved dramatically, the same cannot be said about the articles being published.

The moral of the story is “that as long as we come to a judgement based on only a selection of the available evidence, canny communicators will have a disproportionate impact on our thinking by being selective in the evidence they put forward.”
As the old adage goes, what you see is what you get.

(The column was originally published in the Bangalore Mirror on July 26, 2017).