Eugene Fama still swears by efficent markets

 FT carries a terrific interview with Eugene Fama, Nobel Laureate and author of the concept of "efficent markets". that idea that market prices capture all the information that is available, so they are right. Meaning, it's hard for investors to beat the market. The best thing to do for investors, therefore, is to simply invest in passive funds, that is, funds that mimic the broad market.

The fundamental inference has proved right over the past several decades:

The latest data from S&P Global, a company that produces financial benchmarks, indicates that less than 10 per cent of American stockpickers and under 20 per cent of British ones have beaten the market during the past decade. The numbers are similar elsewhere in the world, and get worse the longer the timeframe. This is a major reason why trillions of dollars keep gushing out of traditional, actively managed funds and into cheap, passively managed ones.

Why do people keep investing in mutual funds that manage funds actively? Well, every investor hopes he has found the 10 per cent of fund managers who outperform the market.

Fama concedes that sometimes market prices may not be right but that doesn't disprove the basic hypothesis. For the most part, it's hard to beat the market. Stock pickers who claim otherwise are plain wrong. Fama has a great quote for them:

I’d compare stock pickers to astrologers, but I don’t want to bad-mouth the astrologers.

Ukraine's push into Kursk: what exactly does it mean?

Ukraine stunned Russia- and the world- with its surprise thrust into Kursk close to the Northern part of Ukraine. The people of Ukraine exult in the fact that Ukraine has captured over 1000 sq kms of Russian territory in a matter of few days when it took more than a year for Russia to capture similar ground in Ukraine and at a much bigger cost in human lives.

Several interpretations of the move have been made. One, President Zelensky wants to use captured Russian territory as a bargaining chip in any future peace negotiations. Two, Ukraine wanted to assure the West that it retains its fighting capability and can put Russia on the back foot after more than a year of being on the defensive. Three, Ukraine hopes that its push into Kursk will force Russia to divert troops from the Donbas region and slow down Russia's year-long offensive in that region.

The Institute for the Study of War, based in Washington, offers a cautious view:

The Ukrainian incursion into Kursk Oblast and Russian offensive operations in eastern Ukraine are not in themselves decisive military operations that will win the war. Both Russian and Ukrainian forces lack the capability to conduct individual decisive war-winning operations and must instead conduct multiple successive operations with limited operational objectives that are far short of victory, but that in aggregate can achieve strategic objectives. It is too early to assess the outcomes and operational significance of the Ukrainian incursion into Russia and the ongoing Russian offensive effort in eastern Ukraine. The significance of these operations will not emerge in isolation, moreover, but they will matter in so far as they relate to a series of subsequent Russian and Ukrainian campaigns over time.

FT worries about whether the transfer of large number of troops from the East to the Kursk front will make it easier for Russia to make gains in the Donetsk region that is the focus of its efforts. Crucially, Ukraine has not yet succeeded in getting Russia to divert forces away from the Donetsk region and to Kursk:

Russian soldiers are still grinding their way through Ukrainian defences, capturing villages and towns and bringing Moscow closer to its stated goal of complete control of the Donetsk region in eastern Ukraine. On Monday, Russian troops appeared to have captured nearly all of the town of Niu-York, entered nearby Toretsk and were encroaching on the logistical hub of Pokrovsk. One Ukrainian artillery brigade commander in eastern Ukraine told the Financial Times that part of the reason for the Russian advance was Kyiv moving its scarce resources north.....

....Ukrainian soldiers and military analysts tracking the war said there had been no clear indication that Russia was moving a consequential amount of forces from the hottest area on the frontline in its east. “Despite the successes of the defenders in the Kursk region, the Russians have not yet transferred their troops en masse from here,” said Ukraine’s 47th Mechanised Brigade. “Its main strike force remains.”

The Economist, which has been for long hawkish on Russia's operations in Ukraine and a cheer-leader, for Ukraine offers a surprisingly downbeat assessment. It sees Ukraine's drive into Kursk as a desperate move to save the career of Ukraine's army chief, General Oleksandr Syrsky. It also sees worrying signs of Russia getting its response to the Kursk threat right:

The plan to invade part of Russia did not come from a happy place. In early July, General Syrsky, Ukraine’s newly appointed top commander, was under pressure. For months he had been grappling with a less-than-ideal inheritance from his predecessor, Valery Zaluzhny, and the army’s leadership was at odds with the president over mobilisation policies, leading to significant manpower shortages. In America Congress had delayed support. Avdiivka, a stronghold north of Donetsk, had consequently fallen. Front lines in the Donetsk region were crumbling, most especially around the logistical hub of Pokrovsk. Rumours circulated that General Syrsky was on the verge of being dismissed....

.....Evidence of an intensifying response inside Kursk is now clear. Ukrainian soldiers on the ground inside Russia say they are already beginning to see a different level of resistance. Losses are increasing. The Russians have reinforced with better trained units, including marines and special forces. They had studied the area.

Finally, Moon of Alabama, a military blog, offers the startling view that it was Britain, not the US, which knew about Ukraine's plans for Kursk and provided the necessary backing:

Britain, in a bipartisan move, wants to prolong the war in Ukraine. It suggested to and helped Ukraine to invade Russia even as it knew that this would interrupt peace talks in Qatar. It also promised to press its allies  for long range attack permission against Russia. But the U.S. and Germany are still blocking such attacks. Zelensky now complains that Britain failed to deliver on its promise.

The U.S., miffed about the British involvement in a likely useless Ukrainian attack on Russia, is leaking about the Ukrainian/Russian negotiations in Qatar. 

The above is largely based on the U.S. claims that it was not really involved in the planing of the Kursk incursion.

Whatever the long-term significance of the Ukrainian move, there is little doubt that is at the moment a PR coup for Ukraine and a massive blow to President Putin. Ukraine crows that Putin's red lines for the West are just bluff;  Russia does not have the capacity to retaliate massively and Ukraine has in itself to hand Russia a military defeat.

Whether Putin can prove this narrative wrong or not may well determine not just the outcome of this conflict but Putin's own future. 

Remembering Harry Dexter White

The IMF's magazine, Finance & Development, carried this article and this one on one of the two men responsible for the creation of the IMF and the World Bank, known as the Bretton Woods twins after the conference at the site that led to their founding. The two articles are both authored by James Boughton, historian of the IMF. The man we are talking about is Harry Dexter White, then Chief Economist at the US Treasury. The other man was none other than John Maynard Keynes.

Keynes came to his meetings with White with idealistic fervour. He wanted a global central bank that would create an international currency as part of the post- War order. White would have none of it. Since the US was the primary global power and would be  mostly underwriting the expenses of the IMF/World Bank, he was clear that the US would call the shots. The IMF would be, not a central bank, but an entity that would promote global economic stability. And it was the US dollar that would serve as the reserve currency.

There were other differences between the two men. Keynes wanted Britain and the US to write up the charter for the IMF/World Bank. White wanted a large number of countries to be involved. Controversially, he wanted to involve the Soviet Union too in the effort. That hope was dashed by the Cold War. It was not until the dissolution of the Soviet Union in 1991 that White's vision was realised. White wanted to give all countries some say in the governance of the IMF through voting rights. Keynes had wanted the debtor countries, including the UK, to call the shots.  

The world economy, Boughton notes, evolved in ways that neither White nor Keynes could have imagined. The world economy grew much faster than they had expected after WW2. The IMF lacked the resources to cope with the demands made on it. White mooted the idea of a new asset for the purpose. This fructified much later as Special Drawing Rights (SDRs).

White and Keynes, however, agreed on the role of capital flows:

White and Keynes agreed that the IMF should discourage countries from being open to capital flows. The Fund’s charter specified that countries could borrow from the IMF only to finance trade deficits, not to counteract large capital outflows. It also authorized the IMF to require countries to impose capital controls when necessary. But the global economy changed as it grew. Because bank loans and international bonds became more widely used to finance trade between countries, the IMF eventually reversed course and began urging most countries to open their financial markets to foreign competition. Today, the IMF takes a more cautious approach, recognizing both the benefits of openness and the risks of volatility and loss of control.

White's career had an unfortunate end. During the Red Scare of the 1940s, White came under scrutiny for his meetings with Soviet officials during the creation of the Bretton Woods institutions. He was suspected of passing on documents to the Soviet Union.  

During the investigations of the McCarthy era, attacks on his motives ranged from the questionable to the bizarre. His meetings with Soviet officials around the time of Bretton Woods were interpreted as espionage. His efforts during the war to hold the Nationalist government in China accountable for hundreds of millions of dollars in U.S. financial aid were interpreted as an effort to undermine Chiang Kai-shek in favor of Mao Tse-tung

Three days after the hearings, in which White defended himself vigorously, White died of a heart attack. He was again vilified years later during the McCarthy hearings. He was now accused of being a Soviet spy. His reputation was tarnished. Mercifully, he was not around to witness his fall. 

Is Elon Musk making a big mistake?

Elon Musk, as is well known, has thrown his not inconsiderable weight behind Donald Trump. His recent interview with Trump was meant to boost the latter through access to a platform with a huge audience.

Musk's support is partly a matter of conviction: he genuinely believes that Trump is the best bet for the US. He backs Trumps' economic policies, as do many other business leaders in the US.

But if Musk thinks that he can benefit from a Trump presidency or if he believes that Trump will dance to his tune, he may well be mistaken, says this article in the Economist. 

The article makes the point that in the interview, it was clearly Trump who was calling the shots. It goes on to cite a recent book that shows how many business leaders' attempts at gaining from backing particular presidents did not work out:

John D. Rockefeller ignored Washington as he built Standard Oil into a vast monopoly in the late 1800s. But when antitrust fervour rose in the 1890s he sought to squash it by backing William McKinley, a president he thought he had in his pocket. McKinley was assassinated in 1901. His replacement was Theodore Roosevelt, a man Standard Oil had unwisely recommended as McKinley’s vice-president because he was too much trouble as governor of New York. Thus began the Progressive Era, and the eventual dismantling of Rockefeller’s monopoly

......Lee Iacocca, who ran Ford and then Chrysler, was a master White House manoeuvrer. He helped persuade Richard Nixon to protect the car industry from Ralph Nader’s safety onslaught. He won loan guarantees for Chrysler from Jimmy Carter in the 1970s. But though he liked Ronald Reagan personally, he rejected the then-president’s free-market tilt and tried (unsuccessfully) to get more government support for his business.

The regulatory state is much bigger than it was earlier. No business leader can afford to seriously antagonise the state, however big he may be. If Musk's bet does not work out, he can pay heavily for it. But even if it does, Musk may not have it his own way- as the history of businessmen's relationship with presidents clearly indicates.

Starbucks CEO ouster: board too deserves scrutiny

The board of directors has ousted its CEO, Laxman Narasimhan, and installed a replacement. I read this detailed story about what brought about the CEO's fall- and, more interestingly- about how the board of Starbucks engineered his ouster.

Narasimhan was removed in less than two years at the helm. The story dwells at great length- and with evident relish- on the behind-the-scenes action that followed his April announcement of poor sales performance at Starbucks and the 16 per cent drop in the stock price that followed the next day. The Chairman of the board held meetings with  a leading investor and set up a meeting with Brian Niccol, Narasimhan's successor. 

A month after the April results, Satya Nadella,  Microsoft CEO, had left the board saying he was doing so with a heavy heart but while affirming full confidence in Narasimhan. The CEO had little inkling of his impending removal. Then, after everything was sewed up, came the "brutal" call from the Chairman to Narasimhan: he was out.

I must confess I read the story in some amazement. The way it is presented, we are supposed to applaud the cloak-and-dagger methods of the board in getting rid of a non-performing CEO. After going through the story carefully, however, I have a few questions:

• Where was the need for such secrecy? What if the board had conveyed to Narasimhan its discomfort with his performance and indicated to him that they might have to consider replacing him? Would the heavens have fallen? What is great about a board ambushing its CEO?
• The story says this is the third CEO change in three years. The same board had hailed Narasimhan as the "inspiring leader" Starbucks needed when it appointed him. What does this say about the board's judgement in selecting the CEO?
• The new CEO comes in with a package of $100 million, a huge increase over the package of $28 million offered to Narasimhan. What if the change does not work? Who would be accountable for the staggering package ? 
• The Chairman will cede her chair to Niccol, the new CEO, so that he is chair-cum-CEO. In governance terms, this is regressive. Separation of the two roles is considered the better option.

It may well be that Narasimhan had to go. But the board's own functioning needs to be put under the lens.That it's a star-studded board is all the more the reason to wonder about its functioning. 

Indian economy's hidden strengths

 An article in FT lists some not-so-obvious strengths of the Indian economy:

i. A leader in services, which positions it well to take advantage of the growing role of services in the global economy. In other words, missing the manufacturing bus may not be such a big loss.

ii.  A talented workforce: A large workforce in which one third of students choose a STEM degree. One might add: having such a large talent pool makes for intense competition for jobs. Whoever gets in would a high degree of competence.

iii. Entrepeneurial spirit: which makes possible Jugaad or innovation in various fields. India landed a spacecraft on the moon at a fraction of what it cost others.

iv. A large and vibrant capital market, which is crucial to raising capital and imposing market discipline on firms.

v. Resilience of the economy: being services driven makes for resilience as does a democratic system. Growth may be slower in other places but it is also steady.

Indians fret about having fallen behind in living standards. If one looks at a 75 year time frame, then the task in the initial decades for India was simply holding together as a nation: not many gave it a high chance of doing so. 

India has proved them wrong. That task accomplished, India turned its energies towards raising standards of living. We should be getting there by 2047. You have to ask yourself: how many large economies have done as well while preserving democracy? 

India must set realistic growth aspirations

The Indian economy has grown at 7 per cent p;us for three years since the pandemic and is poised for a fourth year of growth of around 7 per cent. There are many who think that if growth of 7 per cent is possible on the present basis, why not aim for even higher growth on the strength of "big bang" reforms? Why not aim at a growth rate of 8 or 9 per cent? 

India has grown at 8 per cent or 9 per cent in short spurts in the past. What we are looking at is a sustainable growth rate over the next 20 years or so until 1947 by when we hope to become a developed country, which means reaching a per capita income of $14,000 at today's prices (which is the lower end threshold of developed country status).

Leave us aside the political feasibility of the "big bang" reforms. What is the track record of growth across economies? Very few economies have grown at 7 per cent plus over 20 years. Fewer still have grown at 7 per cent after reaching Middle Income Country (MIC) status. Now, factor in the reality that the world economy is becoming less open than it was in the decades following WW2. If you take all this into account, it seems that a growth rate of 6.5 per cent (that is, a compounded annual growth rate) of 6.5 per cent over the next 20 years would be a considerable achievement. 

More on this in my last BS column, Don't count on a growth miracle.

Don’t count on a growth miracle 

In a volatile global landscape, sustained growth rate of more than 7 per cent is quite a challenge   

T T Ram Mohan

The recent Budget has assumed real gross domestic product (GDP) growth of 6.5 per cent for FY24-25. The latest Economic Survey forecasts growth of 6.5-7 per cent.  Would-be reformers in India are asking for more. They urge the government to do whatever it takes to boost GDP growth to 8, 9 or even 10 per cent. Aiming for a higher growth rate has become a sort of test of the government’s machismo.

The gratifying part of current growth aspirations is that there is a sense all around that a long-term growth rate of 6.5 per cent for India is achievable. Yet, few had forecast such an outcome, least of all after the Covid pandemic struck India in March 2020.

For years, commentators warned us  that a growth rate higher than 5-6 per cent would not be possible unless the government summoned the will to push through “second-generation” reforms. The slowdown in growth during the three years preceding the pandemic seemed to confirm these apprehensions. 

None of those reforms have happened. Yet, the economy grew at over 7 per cent for three years after the pandemic and is now poised for a fourth year of growth close to 7 per cent. 

In FY 2024, as the Economic Survey points out, the Indian economy returned to the pre-pandemic growth trajectory. This is an impressive feat. The US returned to the trajectory even earlier, then veered off and returned to the trajectory a second time. Europe is yet to get back to the pre-pandemic growth trajectory. China got back very quickly to the pre-pandemic trajectory but has since departed from it. India’s recovery appears more sure-footed. That is something to celebrate. 

High growth rates after the pandemic have been driven by rising capital expenditure at the Centre. Critics said such increases were unsustainable. They said such increases would happen at the expense of fiscal consolidation and would cause the public debt-to-gdp ratio to rise. Unless private investment picked up, growth would sputter. 

They have been proved wrong on these counts as well. The central government’s capital expenditure as a proportion of gdp has doubled from 1.7 per cent in FY20 to 3.4 per cent in FY25. Yet, the gross fiscal deficit is projected to rise from 4.6 per cent to merely 4.9 per cent of GDP.   The total public debt –to-gdp ratio fell from FY21 to FY23 and rose marginally in FY24. Growth remains robust without the desired rise in private investment. Public investment-led growth has turned out to be more sustainable than analysts had thought. 

The reforms brigade now clamours for even higher gdp growth driven by further reforms- more fiscal consolidation, more privatisation, more labour reforms, more free trade. The clamour appears disconnected from reality. It is not just that the “second-generation” reforms have proved to be politically infeasible for nearly two decades and look even more remote in today’s setting. It is that growth miracles – growth of over 7 per cent for long periods- are rare for a Middle Income Country (MIC) and will become rarer still in the emerging global economic environment. 

That is the stark message from the World Bank’s World Development Report (WDR), 2024. The report focuses on the difficulties nations face in breaking out of the “Middle Income Trap”, that is, those with annual income per capita ranging from $1,136 to $13,845. India is now a lower MIC. It seeks to join the ranks of higher income countries by 2047 by growing at least 7 per cent for the next two decades. That would mean replicating the record of South Korea, which has the finest record of breaking out of the “Middle Income Trap”. 

The WDR pours cold water on such ambitions not only for India but for other aspirants as well. It states bluntly, “Given the changes in the global economy since the time that Korea was a middle-income economy, it would be fair to conclude that it would be a miracle if today’s middle-income economies manage to do in 50 years what Korea did in just 25”. 

 

The WDR report makes a point well known to students of economics from the Solow growth model:  Increases in investment can drive growth only up to a point. Thereafter, growth happens through increases in productivity. For productivity to grow, nations can induct technologies from elsewhere or they can innovate themselves. These steps are far more difficult than the initial one of simply raising the level of investment in the economy. That’s why becoming a MIC is easier than growing from that point into a high-income country. 

 

Growth in the MICs has already shown signs of slowing. Average annual income growth in these countries slipped by nearly one-third in the first two decades of this century—from 5 per cent in the 2000s to 3.5 per cent in the 2010s. Today, MICs face a whole set of adverse conditions: geopolitical tensions and fragmentation in the world economy, higher debt servicing obligations, and the costs of climate change.

The WDR 2024 report complements the findings of a study carried out by   the World Bank in 2008 under the leadership of Nobel Laureate Michael Spence.  That study that showed that growth of over 7 per cent for over 25 years from any starting point, not just from a MIC starting point, is a tall order- only 13 economies had been able to do so. Of these, nearly half were small economies. 

The economies that had grown rapidly had had the benefit of a post- WW2 world environment that was substantially open to free trade. 

If India can manage to sustain growth of 6.5 per cent over two decades starting from a MIC status in the bleakest international environment in two decades, it would be quite a feat. Those who would aim higher think that fixing several things in the Indian economy will automatically translate into a higher growth rate. 

They are mistaken. We have to reckon with serious constraints to growth and stability that emanate from outside. The sharp rise in geopolitical tensions in recent weeks and the sell-offs in financial markets in the past week only serve to reinforce this point. The Economic Survey’s conservatism about the growth rate for FY 24-25 may turn out to have been well-founded.  

Monetary policy: Is the status quo justified?

The RBI decided to maintain the policy rate at 6.5 per cent in its Monetary Policy Statement of August 2024.

The growth forecast for FY 24-25 remains 7.2 per cent. The inflation forecast remains 4.5 per cent. What is the case for cutting the policy rate and for not cutting the rate?

i. The case for cutting the policy rate

• With inflation projected at 4.5 per cent, the real rate is 2 per cent. This is too high. A real rate of 1.0 per cent is the "neutral rate", that is, where inflation is stable and growth is maximised. So, there is adequate scope for cutting the policy rate. The problem is that the RBI's estimate of the neutral rate has changed. In FY 22, the neutral rate was estimated at 08-1 per cent. More recently, it estimates the neutral rate at 1.4-1.9 per cent. If you accept the upper end as the estimate, the present neutral rate of 2 per cent seems okay

ii. The case against cutting the policy rate:

• The neutral rate argument apart, the RBI governor has said repeatedly that the RBI wishes to move the inflation rate down to 4 per cent. Food inflation remains elevated. Cutting the policy rate at this point would thus not serve the objective of meeting the inflation target of 4 per cent.
• India's growth rate of 7.2 per cent is pretty impressive in what is the bleakest world economic environment in the past two decades. Even if growth falls to 7 per cent, that would be good enough. It is incorrect to suppose that cutting the policy rate can enhance the growth rate. Why risk higher inflation when the growth rate does not have much chance of accelerating?
• The rupee is pushing close to Rs 84 to the dollar. A cut in the rate would make it difficult for the RBI to contain the rupee below Rs 84, beyond which it does not wish to see the rupee depreciate. The stance could change if the Fed and European banks cut their rates down the road. But a rate cut at this point would be imprudent in relation to maintain stability in the rupee exchange rate.

I would add one more point to the case against cutting the policy rate: geopolitical tensions. There has been an escalation in the situation in both Ukraine and Gaza. Neither conflict has thus far affected the global economy significantly. But we don't quite know when "managed escalation"- the game that NATO and Russia and Israel and Iran and its proxies have been playing- will get out of hand. 

As I write, Israel is bracing for a massive retalisation from Iran and its Lebanese ally, Hezbollah. If a regional war breaks out, oil prices could shoot up and render all macroeconomic estimates meaningless. Better to err on the side of caution in these troubled times- especially when gdp growth is over 7 per cent.