Wednesday, January 1, 2014

Two of My Posts from last year not updated on the blog

Charlatan Caesar & Voodoo Economics

First Eco Post for this year, I am afraid to say that this year has not started on a very bright note. The capital of India is ruled by a Marxist party and like all Communist parties initially do, they also are wolves that have come in sheep's clothing. To be fair our country's economic agenda was being directed by NAC through proxy for almost last 10 years it's just that these characters are now coming in the foreground. Infact two of their main members wanted to be part of NAC sometime back but were denied entry, so now they plan to have one of their own in the national capital!!! Readers following me on FB & twitter are already aware of my despise for them & that is because of good reason. These kind of policies & groups take our nation down the drain, look what has happened in the last few days; with the announcement of a slew of subsidies a race to bottom has begun with demands for cutting electricity & water tariffs coming from many parts of the country. That is the reason I call these parties as dangerous & should be finished off at their infancy. Unfortunately they have generated a kind of romantic juvenile fantasy and many people are just following it like those small creatures followed the Pied Piper; I am sure you know where. All I remember right now is a quote by Mark Twain that says ~ "It's easier to fool people than to convince them that they have been fooled". Alright so after a long prologue coming to their recent economic actions........

So like any socialist party as soon as it got to power it has announced a slew of subsidies or in other words indirectly funding its election campaign using other people's money. Some of my friends are trying to justify these subsidies by giving them funky names and how subsidy provided in particular for water supply is path-breaking and can really lead to water conservation. Really!!! I would address each of these points specifically but "Governance" is not doing sham of symbolism everyday by the roadside & transferring benefits from one pocket to other or from the future to the present (subsidies) but efficient delivery. Had the revenue received from water been put into improving supply that would have been delivery & corruption free government but this kind of governance requires time, experience & creativity and doesn't deliver "quick votes" which they are really after!!!

First let’s discuss about subsidies in general. Well directed subsidies sometimes are needed but essentially any subsidy can be funded by 3 ways:                                                                                                   

1)    Cross Subsidy: Increasing price of some other service or the increasing the skew of the same service provided by the government to fund the subsidy, well it does have some merit and so we already have progressive pricing slabs in almost all services & IT taxes, however increasing skew big time gives rise to market anamolies & malpractices, we already observe this in the oil sector where there is a huge price differential between kerosene and petrol & the sale of diesel SUVs

2)    Increasing taxes: Since I am talking of state finances here let me restrict to that, a State in India can raise resources mainly through indirect taxes which is not progressive, so a poor pays the same as rich and hence revenue raised by increase in subsidy would come back to hit the poor the most and also leads to mispricing of 2 or more resources, the subsidised product & the ones that are taxed thus leading to unwanted alterations in the economy. So for e.g. increase taxes on a product would lead to reduction in demand -> thus reduced production & supply -> less employment -> less demand for other products thus a vicious cycle of lower growth & with less production & taxes of higher inflation.

3)    Taking on debt: The worst of all measures to raise revenue by government, increase in unproductive credit (till recently by this UPA government as well) which in other words means increase in money supply without concurrent increase in actual supply of goods & services is inflationary. Always remember inflation hits the poorest the hardest because it essentially means a transfer of wealth from people holding fiat (government money) to the ones holding real & financial assets (rich people).

So with this background let’s pick on the water subsidy sham. First let me talk about how grossly misdirected this subsidy really is. Delhi is the second most prosperous city in the country after Mumbai and second most prosperous state in this country after Goa. DJB has about 1.5 million connections that would cover around 8-9 million people. However more importantly this leaves out people living in jhuggis, slums & many unauthorised colonies. So essentially the poorest section who would still spend about 120-150 rupees for 30 min of tanker water & thus only caters to the middle and upper middle class section of one of the wealthiest city in the country & to what extent well about 150-200 rupees per month!!! Shouldn’t the same money be better used to increase and improve the water infrastructure & wouldn’t that be called an effective & corruption free government? 

Another argument laid out is some fantasy of water conservation, Really!!! Well one of the problem with Socialism is that it assumes people to borgs or automatons who make decisions on some obvious looking mathematical equations & that’s one of the reasons it has been a gross failure. Yes, penalties on externalities impact behaviour but if the penalties are low then to the contrary thinking they fuel the unwanted behaviour & if they are very high then they lead to malpractices. So if someone thinks that a water bill of a couple of hundred rupees extra per month of a middle class family in a well off city like Delhi would persuade him/her of conserving water then he is living in a fantasy land on the contrary for someone using less water may start using more of it to fill up the limit. Behavioural economics work in strange ways when the utility of a commodity is higher than what they are charged for. 

As an interesting example of behavioural economics to show as to what happens when utility of something is mispriced: In a city of Israel, day care centers almost uniformly closed at 4pm, parents would then pick up their kids & rarely did they came after 4:30 pm. & Why was it that they were rarely very late? Simply because one teacher used to stay back till all kids were handed to their parents & so the economic cost of being late was taking advantage of the generosity of that teacher, face him/her in the eye & apologize for the inconvenience. Then as part of an economic experiment in some of the centers a small financial penalty was introduced on parents showing up late & surprise, surprise!!! In the centers where this penalty was introduced the frequency of parents coming late shot dramatically with their tardiness level going up by twice than the pre-fine level. That is, introducing a fine caused twice as many parents to show up late. Why because the economic charge shifted now to a small fine & thus mispricing the penalty.

So enough discussed, as for electricity subsidy; see a comparison chart of Delhi vis-à-vis other cities before subsidy announcement.

So in other words the poor would ultimately end up paying for the government largesse on water & electricity by still waiting for tankers to supply them water & increased indirect taxes later on.

Delhi is a cosmopolitan city, people come here from all parts of India not because of any love for the city but based on cold calculations of how much they are going to earn, save and spend. By mispricing pubic goods & services all one is doing is inviting chaos, congestion and social tensions but probably that’s what someone wants to thrive upon.

Friday, November 9, 2012

FDI - If you have a hammer not everything is a nail

Today I would like to touch upon the raging issue of "FDI". Being a "centreright" myself I am an ardent supporter of free market but that also means that one should keep a sense of reason and rational alive. I am afraid to say so but the fact is that the reason why majority (certainly not all) of our top journalists are psuedo liberals is because the only way you could have climbed the upper echelons in the previous decades was by being a sycophant and not applying your brain, so before 1990s anything foreign was bad and now anything foreign is not just good but is characterised as "Reforms" and anyone who opposes it is termed as a backward moron.

Well let me start my argument by saying that when you have a hammer in your hand not everything you see is a nail. Let me first point out quickly and we have discussed this many times before as to what makes an economy grow: Increase in goods and services ->To achieve this objective we need to increase productivity -> One way is to start from scratch and create new machines etc. (a slow process), other way is to import them from abroad -> Requires FX reserves.

So FDI in turn solves this conundrum and also directly brings in the technology as well thus giving a further  boost to productivity and hence growth, so then where is the problem FDI must be good isn't it. Well not everytime specially in sectors of Retail, Real Estate (excluding construction of projects etc.) and Finance.

First in these sectors there is nothing really technological that FDI develops that can boost productivity and hence supply of goods, In India unlike the West we have a perennial supply problem and not really a demand problem.

Ok so even if you agree with the notion that investment in these sectors,retail to be specific for today's discussion may not increase too much productivity but then atleast we are getting foreign inflows, surely this is what we need in the sequence of events that I discussed before then what's the harm. Well this is where a little bit of thinking comes into picture.

First of all there are lot of sectors in manufacturing, mining,refining, exploration,research and infrastructure that is opened to FDI, why can't India attract much dollars in those is a pertinent question (we can discuss this some other day), second certain point is that with only 30 percent of sourcing to be done internally and that too monitored by the corrupt system it would not be long before one can see Chinese goods flooding domestic markets thus threatening the domestic manufacturing setup. But I guess these two points even though critical you must have heard at various places. There is a third critical point to fill in the puzzle and it relates to the monetary impact.

Credit growth without a corresponding growth on the output and productivity leads to inflation and consequently deflation. These are not just monetary phenomenons as I have been discussing in my previous articles but inflation is essentially misallocation of capital accompanied by re-distribution of wealth  specially widening the income gap which is eventually followed by a deflationary spiral. When foreign capital comes in a corresponding amount of rupee liquidity gets created, further if these forex inflows are absorbed by RBI then they act as leverage to the rupee liquidity just like taking a position in futures market you deposit some margin. Now as discussed in previous many articles i.e. under the modern monetary mechanics the increase in credit is equivalent to the increase in money supply and since the credit has to be repaid back, the money supply would shrink unless replaced at a faster rate by infusion of more credit.

This my dear readers is a problem in the West and Japan since 2008 with people already under debt thus making it harder for the dollar credit/money supply to increase. With the opening up of sectors like retail and finance in emerging markets it provides an easy avenue for this to happen; without setting up much of fixed/physical infrastructure.and expending any serious technical know-how to foreign lands.

From our perspective, since interest rate abroad is far lower the new infusion of credit has to be replaced at even faster rate than the domestic factors could supply e.g. if the foreign inflows lead to creation of metro then even though the credit/money supply has increased but because of the forex we were able to buy goods that helped in building that metro and because of that it takes less time to travel thus increasing the overall output which may  increase the demand for productive credit and thus even when the foreign credit is paid back, the domestic credit backed by increased output can replace it without causing much of a flutter in the exchange rate and the output (Link).

However if the same capital goes into unproductive use then there is no increase in productive demand for credit thus when the foreign credit retreats then either we set ourselves to witness a deflationary spiral as the equivalent rupee liquidity also ceases to exist or with the intervention of government unproductive credit is increased causing a waterfall decline in exchange rate. In either case real output is severely impacted, the credit goes into unproductive use and in wrong hands (increased graft), widening the income gap and ensuring that poverty remains in this land and ofcourse doling out some pieces of bread from the amassed wealth to the many fools on the eve of elections to get votes and celebrating a triumph of democracy in front of the cameras and fluttering lights.

In an ideal world there should be a free flow of capital, goods and labour. But we are not living in such a world; when the inflow of labour and goods are heavily regulated it's stupid to allow inflow of capital in such sectors that serve no role in increasing the productive assets of the country and only serve as a conduit to redistribute wealth and thus eventually reduce actually output.

So why would someone persist with such a flawed policy, well I can think of four reasons as of now:

- Flawed Thinking
- External pressure/charm (refurbishing one's image) remember the dollar liquidity has to increase to avoid the Western world to get out of the credit mess
- Need more conduits to transfer money to and fro (India and abroad)
- Giving permission for new business opportunity would mean more power which is nothing but a proxy for more graft rewarded in the form of sizeable equity in the new businesses

Sunday, September 30, 2012

Corruption - Inflation & The Great Economic Malaise

This article of mine is published in Hindu Business Line on Oct 1, 2012. Link:

“When you see that in order to produce, you need to obtain permission from men who produce nothing -- when you see money flowing to those who deal, not in goods, but in favours -- when you see that men get richer by graft and pull than by work, and your laws don’t protect you against them, but protect them against you, then you may know that your society is doomed.” ~ Ayn Rand
These words foresight-fully surmise the root cause for most of the ills that have plagued our nation for the last 65 years. Notwithstanding the breath of fresh air brought about by the loosening of bureaucratic shackles as a result of the economic liberalisation, India finds itself at the bottom of the pile on various socio-economic indicators.  What’s worse is that not just have we been unable to catch up with the western nations but have fallen behind even when compared to many of our Asian & South American peers.

The only way for the living standard of millions in this country to improve is by increasing the availability of various goods and services in the economy (defined by GDP growth) and ensuring that these increased resources are not held by just a few people. Often inflation is defined as money losing its purchasing power, the fact is that this is the most innocuous form of inflation for e.g. 10% inflation in this case would mean a 10% increase in money supply distributed equally within the population while at the same time the supply of goods & services remain the same. The most damning from of inflation is when the same 10% increase in money supply goes to a handful of people and thus the living standard of almost the entire population shrinks by 10%; unfettered graft in the society is the main reason behind any prolonged inflation of this kind which leads to a large number of people in abject pecuniary even as the economy might clock a decent GDP growth for a few years.

It is important to understand how as a result of the unfettered graft this phenomenon of wealth transfer has been playing out in this country.
To start, a sectoral breakup of our economy reveals its fault lines. The output/per capita of agriculture (which sustains majority of our workforce) as a percentage of overall GDP has been declining over the years or in other words people working in this sector are increasingly finding it difficult to access resources produced in other sectors of the economy.
Considering that in a normal course it’s difficult for this sector to show high growth, the prognosis for the Indian economy looks simple; move the excess workforce into manufacturing and allied industries. With so much people employed, the supply of goods would increase and with it the living standards of a large population. The reason why this beautiful sculpture has never taken any shape is because the key to increase production dramatically is by improving the productivity of labour which happens only by using technology and capital goods/machinery. A developing nation like India can either hope to create them indigenously but that would mean slow growth rates or import these from abroad.
However corruption leads to a gross misallocation of capital which in turn implies that a lot of capital held by a few, goes into consumption especially of luxury goods, real estate, stocks etc. So while there is an actual need to import machinery and capital goods to boost supply instead funds are squandered on consumption related and other imports. As can be seen from the graph, India’s import of capital goods and other manufactures products as a percentage of total merchandise goods has been consistently lowest when compared to other developing peers.

Hence due to a lack of infusion of manufacture goods there is a natural dearth of supply of essential goods and services thus leading to an increase in their prices and hence depriving a large part of the population from access to these goods and thus lowering their living standards.
A decreasing supply (growth) in the face of a given credit growth leads to a consistent depreciation of the exchange rate thus making the import of capital goods further difficult and contributing to further increase in prices. Perhaps an apt example for this is the recent increase in the prices of diesel and LPG cylinders soon after "Coalgate" came into light. But for a depreciating rupee, the cost of petroleum products was much lower from their all time high (in USD). Had the mines been auctioned, the revenue from these auctions could have been used to reduce the outstanding debt of the GOI, a reduced non-productive government credit and thus money supply would have led to some appreciation in exchange rate and thus reducing the subsidies on petroleum products automatically negating the need for the price rise. People who would have bought the coal mines would have been largely for genuine business and would have started the production rather than holding onto them for trading profits and the country at large would have received increased supply of goods and lower levels of inflation, of course the mine owners and some investors would have seen lesser equity appreciation i.e. a transfer of wealth would have happened from a few to the masses.
Instead today as this episode has shown that because of graft the income is being transferred to a handful of individuals from the masses, partly reflected in the higher equity prices (see graph).

The good thing about this country is that people have the right to choose their own destiny. So as this nation fast approaches another election; if the Indian masses and it's diaspora want to see a better future for their children and not the ignominy that this nation has faced for more than half a century, they must keep in mind that this unfettered graft is not just a social evil but the root cause of the economic malaise prevalent in this country and the response that is needed is something similar to what happened when elections were held after emergency which instilled the fear of God among the political classes so as to not fiddle in that area again.

Thursday, September 27, 2012

Why Wage earners would always lag behind under the current monetary setup - Story of Wages, Capital & Middlemen (Banks)

The growing wealth disparity has become a raging issue in the upcoming Presidential elections. Both sides are promising to tackle this issue from their own idiosyncratic viewpoints. While the democrats want to tax the rich in order to reduce this income gap; the republicans think that a slowing economy due to excessive regulations is a result of this widening disparity. The Federal Reserve has also time and again expressed its empathy and concern over this phenomenon. What is however unmistakably clear is the fact that this process that started to gain traction since 1970 i.e. since the onset of the monopolised fiat monetary system has been responsible for stealing the vitality from the millions of American households.
While it’s true that our current monetary setup has broken the shackles of the past wherein the supply of credit was restricted by the amount of gold and thus enabling various parts of the world including US to witness unforeseen growth and so it would be naïve to return back to the previous system, however a fatal flaw of this setup has meant that steadily fewer people would end up controlling large chunk of the economic resources and thus not just widening the income gap but also paving the way for a plunge in future growth rates.
Under the previous commodity based monetary system, the depositors used to deposit their savings in form of gold or gold backed dollar bills in their banks and this used to form the basis of the credit that the bank used to lend forward so in other words the savings would lead to credit. In the prevailing system the banks create credit out of thin air and lend it to the borrower which is simultaneously deposited in the bank account. Thus under the current monetary setup it is the credit that leads to savings and deposits.
The problem with the current setup is that unlike previously wherein the price for the malinvestments was paid by savers, today the bill for the malinvestments fall on the doorsteps of the workers themselves. Infact any loss from the malinvestments in a sector would impact that particular sector first followed by the banks which would then transmit the losses to various other sectors of the economy like a nerve centre of the brain. So the current fiat monopolised monetary setup converts the unwinding of malinvestments in a particular sector into a full blown downturn for the entire economy.
This phenomenon of wealth transfer taking place today can be explained more clearly by the following scenario.
An entrepreneur planning to setup a business hires some workers. These workers can be compensated in two ways; a share of the profits (equity) or a fixed compensation.
The entrepreneur would now approach the bank to get a loan which he would use to pay off his workers atleast till his business start to generate cashflows.  The workers would in turn deposit these wages into their bank accounts which would now constitute the liabilities of the bank.
In the first scenario the risk for the success of the project is shared between the entrepreneur and the workers and so the compensation of the workers is higher. In the second scenario the risk is shared between the entrepreneur and "the bank" and "not the Workers" and so they are given lesser compensation. However as we are going to see the workers still share the risk and are not even compensated for it anymore, all because of the monetary system.
Now let's say that the project has failed and hence has not generated any cashflows, the bank would have to right-off that loan (an asset on the books of the bank), following the rules of accounting it has to wipe-off an equal amount in liabilities which would mean that the salaries of the workers would now be obliterated. So as in scenario one because the project has failed the entrepreneur and the bank gets nothing but more importantly even the workers would have nothing; which is unfair as they took to the option of lesser compensation because they wanted to have their pay irrespective of the state of the project.
However if the project succeeds the entrepreneur makes millions, bank is going to have an interest income but the workers would have no upside but only the pay which was unfairly computed as it was assumed that the workers are taking no risk.

So the irony of the current monetary system is that the people working at fixed pay have no upside to the success of any business but downside to its failure, banks have no downside but upside (interest income if project succeeds & no real losses as they anyways printed money to lend which would be written off) and people working for equity have both upside and downside.  Under the earlier setup the risk of the failure of the project was passed on to the savers and not the workers.
Ofcourse in practical parlance to avoid such a possibility in which the banks would have to right-off the savings of the workers, the Central Banks constantly aim at boosting the credit growth in the economy and inflating the money supply which only creates an illusion wherein the people working on fixed pay appear not to lose money but this scenario changes nothing as they are still losing out in the same "real terms" to the banks and people working for equity.
As a result of these actions not just the wealth disparity in US and across the world has exploded but the malinvestments have been prevented from getting unwound. As a result the financial sector which is supposed to play a tertiary role has grabbed the bulk of economy (see graph) and the wealth is moving in the hands of a few people at an increasing rate.

Even though US has registered decent GDP growth over the last 3-4 decades but thanks to the grotesque monetary tools the living standards of a majority of the population has not changed by much and now with even the growth slowing down, the monetary authorities have to choose between the devil and the deep blue sea because pursuing the old policies would mean a slow bleed in the living standards of the people while  failing to do anything would end up with a catastrophic unwinding of the massive malinvestments which threatens to take down the savings of the masses. The only way out of this mess is to move away from the monetary setup that is akin to “cocktail socialism” and give way to a system wherein the quantity of credit and its price (interest rate) is determined by the forces of free market rather than a politburo of the Central Bankers.

Sunday, September 16, 2012

QE - Unbounded

This article of mine was published in Hindu Business Line on September 16, 2012. Link:

The Federal Reserve with its latest policy announcement of buying 40 billion USD worth of MBS securities without specifying any time frame has provided a shot of morphine to the wandering markets. The price reaction on the long dated MBS bonds, stocks and commodities has been nothing short of stupendous but certainly not unprecedented.
However before getting sucked into the bullish bandwagon it’s important to understand the dynamics involved in the QE operations and to be clear of what the Fed objectives really are and how successful can it be in achieving them.
First there is a misconception or rather a folklore among large number of people and even many in the financial industry that a QE tantamounts to printing of money and hence can lead the world into some kind of hyperinflationary tailspin something like we saw in Weimar Germany or a modern day Zimbabwe, the reality is far from it. What America is witnessing today is something that Japan has been undergoing for the past 2 decades. It has seen zero interest rates, QE programs that involved not only buying JGB’s (Japanese government debt) and other mortgage and corporate debt but also Index futures. However inspite of all this the Japanese stock market is almost a fifth of its peak and the economy chugs along in and out of the negative growth territory.
The reason for this is that under the current fiat monetary setup, it is the loan operation conducted by the banks i.e. banks giving loans to people, corporates and governments is what creates the money supply. In essence when someone approaches the bank for getting a loan then under the prevailing system the banks create credit out of thin air and lend it to the borrower which is simultaneously deposited in the bank account. The loans constitute an asset on the banks’ balance sheet and the deposits an equivalent liability. So please note that worthy borrowers and investment opportunities are critical in boosting the credit and thus money supply in the economy.
Talking from the perspective of “commercial banks” what the Fed QE2 earlier and now QE3 operation would do is to remove some of these assets which were treasuries in case of QE2 and Mortgage backed securities in case of QE3 with another asset which is of the shortest duration i.e. US dollar. This in no way would increase the banks’ ability to lend as that is not a problem to start with today atleast in US or in other words the banks today are not reserve constrained. The only reason why QE1 was so phenomenally successful was because at that time during the peak of the financial crisis, the banks were reserve constrained and the QE operation at that time provided the banks with the much needed reserves. Infact from the perspective of banks the QE is pretty similar to the Open Market Operations that Central Banks across the world constantly engage in with some subtle differences:
-          To start with the investment banks and funds are generally kept out of Open Market Operations
-          While the securities are temporarily removed from the bank’s balance sheet in Open Market Operations, they are permanently removed incase of QE
-          More importantly the open market operation is done to remove liquidity pressure i.e. provide the banks with adequate reserves but the QE is being done even when banks don’t have a problem of reserves
Having said that the Fed really aims to achieve two objectives with these policies namely reducing the interest rates and boosting consumption as it believes that higher asset prices would make the consumer feel richer and thus he would be more prone to increase his consumption.
Today not just banks but also several large and small investment funds also hold a lot a of MBS and treasury paper, this Fed operation would remove these assets from their books as well which would then enable them to either buy more of these assets or invest in other corporate bonds, stocks etc. thus boosting the asset prices atleast in the short term or in other words reducing the interest rates on bonds and other securities. Interest rates are definitely one of the key components that determine the demand for credit and thus influence the money supply in the economy. However apart from interest rates there are other factors as well that determine the credit demand which include demographics, investment avenues and opportunities as well as existing level of debt in the economy. So with interest rates already at record low any further reduction in the rates is not going to boost the credit demand until the existing levels of debt which is the single biggest problem in the US economy is allowed to liquidate. The deleveraging of the US consumers and various sectors of the economy especially the financial sector is critical for any market rally or US recovery to be sustainable in the future.
This is because while the consumer and various sectors of the US economy de-lever i.e. the credit growth slows down or even goes in negative, the money supply growth would not be sufficient to keep asset prices elevated and thus any short-lived asset market rally would take the wind out of the Fed’s objective to boost consumption.

So to counter any decline or slowdown in credit growth and thus the money supply, the US government is constantly running annual deficits in excess of trillion dollars. Just so that the annual trillion dollar additional government debt doesn’t overwhelm the system, the Federal Reserve will constantly engage in its bond buying exercise and thus try to keep the bond and stock markets afloat. This has although not been sufficient to take the economic growth to new highs but , the misallocation and thus destruction of the resources in the real economy as result of this wasteful and distributional nature of government spending continue thus ensuring that the next fall would be even bigger.

Tuesday, July 10, 2012

Currency & Decoupling Myths - Part 1

Two themes are fairly popular in the financial/investment community over the past few years. 1) A waterfall decline in the value of the dollar and 2) The decoupling of emerging markets specially a country like India. Both these statements are based on a very shallow analysis and understanding of the economic dynamics at play. While I don't argue with the fact that all government monopolised paper currencies are undesirable and would ultimately loose their value (including the dollar) and there might be some emerging market that may stand on its own feet in the wake of the global economic tremors which I hope would be India but the reality is that these cases are not that straightforward and a lot of things have to turn before they actually happen. What I mean is that under the current dispensation the dollar might actually strengthen a lot atleast against emerging market currencies and the India might end up submerging under the wave of economic upheaval.

It is critical to understand the key difference that distinguishes a developing/emerging economy from a developed economy and it is certainly not the GDP or per capita. It is technology, capital stock and labour productivity. For US there is an extra dimension of defense & military prowess. I would like to add that though a higher living standard in form of per capita is certainly one of the main aims of economic growth, it is important as to how you achieve it as here means are equally important than the ends. So many middle east nations inspite of having a high per capita incomes don't qualify as developed nations.

The amazing growth and the inflation of the asset prices that we saw in the last decade was certainly jaw dropping but in no way unprecedented. The only difference being that unlikely previously this time the many parts of the world are on fiat standard or should I say more appropriately a proxy dollar fiat standard. The reason for this remarkable period of prosperity on such a global scale was the global liquidity from the developed world. You must have heard this argument many times before but let me explain in a little detail how this thing works by taking a very simple example.

Let us a say that a factory in India produces "hand-made" textiles. It employs 1 labour and so can produce 10 dresses a day. There is a machinery in US which if used can increase the factory output by 100% i.e. 20 textiles a day. That machine costs 1000 dollars and a textile can sell for 10 dollars abroad.

A more traditional way to growth was to develop expertise back home and build that machine using which the production of textile would increase and in the mean time train and recruit more labour if required. This would certainly increase the growth rates albeit quite slowly and pretty much what happened in large parts for the world in 17th and 18th century. However a faster way to grow and  in my opinion the smarter way to grow is to why re-invent the wheel, acquire the technology already created and grow rapidly, pretty much what has been happening in the emerging markets.

Now the machine can be acquired in two ways both happen due to a monetary phenomena and influence both demand and supply.

1) Since one has to pay for the machine in dollars it is but natural India can try to acquire dollars by selling its textile to US. However there has to be a demand in US for these dresses, well the credit binge of the last decade assured that and so many countries ran huge current account surpluses with US and other developed markets to acquire their currencies using which they could then acquire these capital goods and increase their production dramatically.

2) There is another way in which the dollars are acquired and this is again due to the credit binge of the last decade. As I explained in one of my blog posts before (Link) that the savings ultimately is equal to the credit created net off government deficit/surplus. So because of this massive credit expansion the dollars first looked for yields within US and then these savings went abroad. So to return to our example, let us say some one from US would want to invest in the textile mill 1000 dollars, the mill owner would then quickly acquire that machine thus increasing his production thus creating self fulfilling prophecy and justifying that investment.

Since the reported GDP is a spending metrics/measure so as a result there is a consumption led growth in US and an export/investment and consumption led growth in emerging markets. Capital good companies of the US would certainly do well.

So to summarise be it the export led growth of many emerging and commodity based economies or the so called internal consumption and investment growth stories like India, both need the constant supply of dollars and other developed market currencies to keep their growth engine going and to say that because Indian economy is not export dependent and so can decouple is the a shallow understanding or a misrepresentation of the monetary dynamics.

Sure there are also some countries that can decouple and India has a couple of features namely 1) a vibrant entrepreneur class and a 2) a large educated workforce however on the flip-side it also a very large pool of population that in malnourished and underdeveloped and under the current dispensation at the Centre a government that believes in nothing but looting of productive resources and re-directing them in order to fund it's electoral chances as it did the last time.

In any case for India or for that matter any emerging market to decouple it is important that it develops a strong technical and capital foundation or attract highly productive labour to it's shores which only one or two out of a hundred would manage to do. So be careful against this decoupling mis-propaganda.

Let me extend the above argument further to throw some light on the currency myth and almost a consensus in the financial industry of an impending precipitous dollar decline in my Part 2 of this article later......