Bridging the Output Gap

8/14/2019 Bridging the Output Gap

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the same, there is a looming problem in the economy as the reduced output clearly affects income of people who get eventually displaced.

Okuns Law very simply brings this connection between unemployment and output through his famous

equation: Output Gap is equal to beta times cyclical unemployment percentage, where beta is derived

from the regression between natural output and natural unemployment.

Firms also face the same brunt of output gap as an economy does, but some who are free riders, who

wait for the demand to return, could be less lucky in the interim period. The more bold ones who take

out existing assets and restructure to place these assets in better orientation to the demand for the future, get the double benefit when the demand returns, as they have better cost advantages and productivity as well, to back them.

Let us see whether an economy could do this. It would mean that a large pool of people engaged in

production of certain outputs are cut back and are re employed in a more productive orientation, where demand could be spurred through certain starting incentives. I think some European economies have

done it and succeeded to stymie the slide of output. The bulk of the American economy however did not, thus the banks flushed with funds at very low lending rates did not have options to invest in output enhancing assets in the same economy. They did some quick re jigging of their portfolio, moved to

economies that had higher chances of output gaps being reduced, but there was already quite a crowd out there. With current output growth projected at very low levels and unemployment rate at high

levels, this created a certain uneasiness which lasted for a couple of quarters. The solution to this conundrum was provided by commodities, which was again an example of changing risk portfolio of the banks.

It started with oil, then it moved to Aluminum and Gold remained the altogether safest haven, ever.

The crowding of the oil tankers around Singapore did catch attention of people, large tankers being

berthed for good for long. The hardening of the tanker rates followed; as a follow through one also noticed the hardening of the general freight rates in non oil sector as well. The very fact that in a severe

downturn the shipping industry did not go through a complete collapse this time was a surprise.

The Oil contango clearly showed the opportunity, at $5 per barrel on a $50 per barrel, it was a high

potential for selling forward in cash and carry trades. The suffering shipping industry from production cuts saw some glimmer of hope and offered to support this through lucrative offers for these trades in

terms of oil carrying costs, as large warehousing in oil as an alternate solution did not exist. The

economics was simple, if there was a contango that was large enough to support the gap of carrying costs in a relatively low interest rate regime, there was a way to reduce the output gap of oil.

The Aluminum industry saw the opportunity early enough, which was a mix of factors related with the

most commoditized player in the industry, United Rusal. The consortium of banks lending to Rusal were also steeped in this puzzle of getting Rusal out of the muddle as their fortunes were linked. So when LME of Alumium touched $1500/T $1600/T, and virtually it meant taking out capacities and idling them,

the banks stepped in to fill up the output gap puzzle with the following solution.


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If the contango in Aluminum was above $35 per ton cash to three months, there was sense in locking metal in financing deals as the cost of warehousing also crashed and there were more people available

to offer warehouses in a dropping market, and when the rates touched $1/ton/month in the private warehouses, it made perfect sense to make money in these deals. The banks used Aluminum as

collateral and Rusal sold forward almost their entire production and got cash in return as Glencore the

buyer was also an investor in Rusal. When the quantities touched almost a million tones, the contango still remained and the act lasted more than originally thought it would.

When one looks at the implication of this on a grand scale in the market of Aluminum it means that

currently there is 7.5 Million tonnes of Aluminum locked in various warehouses in these kinds of

financing deals. It is relatively risk free as long as the contango lasts as the banks have the stocks as collateral. It is like saying that financing is a consumer of last resort holding 20% of the pie of the

worlds aluminum production.

But like all paradoxes, there is an underlying paradox that one cannot lose sight of. If this form of output gap solution was possible, in a number of commodities that have matured trading markets, then one could have avoided all recessions and this would have provided perfect opportunity for more stability in

prices, which then would bring the contango down, thus endangering the very basis on which the whole

premise of doing business lie.

There is a premium component that we cannot lose sight of. The premium is a reflection of the physical

side of the transactions in the market. If the premium of Aluminum rises there could be many traders who would be interested to do physical trades and get the short term benefit of making money from the higher premium, which he would lose if he did not take the opportunity. In fact as the premium rises, it

rises because the physical demand needs to be balanced by the availability of supply at a price that makes economic sense. In sum, premium rise would make more metal available for sale for the traders,

thus taking metal off the warehousing deals and the contango loses the shine as more supply is made available. If the underlying demand becomes stronger the tension between these alternate proposals of business becomes even tenser.

Very low interest rates, actually is another part of the puzzle. Had the interest rates been higher the

whole economics would have shifted. The real reason why this game is still lasting is because at such low

interest rates the banks seeking investment avenues have a much larger pool of money and a much lower pool of safe havens. The commodities market like oil, Aluminum and gold provide them just the perfect haven where inventories could be collaterized and money could be made from the contango.

The depreciation

of

the

dollar

provides

the

perfect

icing

on

the

cake.

There

is

additional

money

to

be

made if carry trades could be done with the dollar, as instead of zero interest rates, the interest rates would be actually negative if money was borrowed in dollars.

The dollar therefore completes the tango for the sequence to last longer than we thought.

When the end consumer sees this tango, he cannot help gasping for breath to have better credit

conditions sorted out for himself or his related business. But he has a collateral problem to deal with,


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which makes his case weak. Had he been part of this tango, it truly would have meant spreading the risk in a just way. In the current dispensation, it is actually he who would eventually pay the price of a

hardened interest rate, because at the moment he is not even in the reckoning for getting part of the pie at low rates. This asymmetry unless sorted out, the real bridging of the output gap would never be

possible at a speed that would benefit large number of people in the economy. The sharing of the risks

has always been the most puzzling phenomenon, and banks again have picked up their best options amongst many.

Taking Amartya Sens view from his book, the Idea of Justice, there is always one option amongst many

that we choose from. It may not be the best seen from different angles, as absolute justice is an illusion.

Germany for example chooses short time work and protects jobs, U.S. on the other hand does not. Surely Germany has much less unemployment rate that spills over to its GDP as we see in their recovery.

U.S. recovers in GDP, with a higher unemployment rate. The question is whether the two results are similar and are good for the economy in the long run.

Zurich,

13 th November09

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Bridging the Output Gap