Saturday, February 19, 2011

Incas Curse and the Deal with the Devil

US GDP no. came in a couple of weeks back, apparently the reported nominal GDP growth rate was 3.5% and the real GDP growth rate was 3.2% so in essence according to this data the inflation figure was just 0.3%!!! and I always thought that statistical chicanery is the monopoly of communist and dictatorial regimes. Infact sovereign slanders and lies are becoming fashionable these days, a clear trend in how big a soup these governments are, what’s more it is applicable to all categories of governments be it the oldest or biggest democracy in US and India or communism in China and as we are seeing it now under the dictatorial regimes of Middle East. Anyways probably this is not the right forum for sovereign government bashing so I will limit myself to the economic thought. In one of my last articles I alluded to the fact that a nations currency is linked to its productivity and with the certainty of the demise of the fiat currencies investing in Gold and Silver might be prudent but one should keep in mind that if the value of Gold and Silver goes up one is not creating wealth but rather preserving wealth (no doubt it is also important) but this point should always be kept in mind. To explain it further let me take you some 500 years back to the Incas civilization, back then the Inca society was based on toil and innovation. Their legends of gold and silver deposits attracted the Spanish invaders, the Incas were swiftly defeated and what we saw was one of the biggest plunders of history. The Incas used to consider gold and silver extracted from their mountains as metal of God and instead of circulating it in their economy, they used to store it in their temples dedicated to God. They found little use for them in their society beyond a point infact on the contrary excess of this metal was considered as a bad omen for their society. So to their astonishment they found it quite curious as to why the Spaniards were after this metal. In any case after the plunder, the Spanish sailors sailed back from their golden voyage with the hope that with this loot the Spanish Splendor would reign supreme for generations to come. Well that was the hope.. Instead the Spanish empire and economy saw a decline that pushed the once great power in Europe to the second rung.

So what really happened, why didn’t all this gold took the Spanish nation far ahead of everyone or were the Incas really right in their thinking that excess of this metal could lead a society to ruination. Well believe it or not they were!!! The Spaniards were indeed stuck by the “Incas Curse”. Hey but hold on wasn’t this article about economics and currency and certainly not about ghost stories. Indeed it is about economics because the “Incas curse” was nothing but “Inflation!!!”.  It doesn’t matter on what the currency of a nation is issued… Paper or Gold if we increase its supply and the quantity of goods produced remain the same it would lead to inflation. So since gold had practically very little in producing anything tangible, it merely acted as an increase in currency supply.
With this context in my mind let me move the topic of QE 2 and some of the misconceptions that I hear around me.
Well not just general public but even many of the fund managers have this misconception that QE 2 is fresh money printing. Well in layman terms maybe yes but the answer is not really!!! As I explained in my earlier articles money is nothing more than the liability of the government with the shortest duration (let’s for simplicity assume one day although it is a variable and can go to as low as 0)
So Money like government debt is a liability and since it is not backed by anything both are the same. So let me define money again: Money is a government debt of shortest Duration and hence the most liquid. Currently with 2 trillion dollars of base money and about 13 trillion dollar of conventional US Federal Debt the net Federal liability is about 15 trillion dollars. What the Federal Reserve is doing is tweaking this distribution or what I would say is performing a maturity swap wherein it replaces the relatively longer term liability (5-10 year debt) with shorter term liability (US dollars). My point is that unlike what most people including some seasoned fund managers feel QE 2 unless made permanent is not leading to the creation of new money and in a fiat monetary system that the world is in cash and government debt are replaceable. Infact this last point is very critical to keep in mind.
So that brings me to the next question, if QE 2 is not really leading to the creation of new money then is it really inflationary. Well in the short term it is definitely inflationary however in the long run all bets are off. Let me explain, since the duration of cash is low (assume it to be 1 day) it makes sense to put that money into an asset where its value is preserved and so the existing treasuries, stocks, commodities and other debt instruments are ideal for this purpose. So as the long dated liabilities are replaced with cash, some other asset classes definitely get a kick owing to the shorter duration of cash if it is perceived that the cash would loose its value in the future. So the next point is where would this cash go. Well it should into 2 avenues 1) A place where its purchasing value is preserved 2) Where there is value, growth but more importantly momentum. Hence longer dated treasuries may loose value and commodities would gain value along with some equities. So yes temporarily this is inflationary but lets look at it a little longer.

Lets say that the Fed buys bonds of 100 billion worth of face value at 5% coupon payments 1 year down. So at the end of 1 year the buyer of that bond (assuming he bought at par) would receive 105 billion dollars.  However if the inflation expectations become high then the value of the bond falls far below the face value (let’s say 95) so in essence by buying it today the Fed is pumping in 95 billion dollars today whereas it could have pumped 105 billion dollars had it done it 1 year into the future. So the world is essentially short of 10 billion dollars one year into the future.
This is a dangerous game to play as its tantamount to saying that since God can’t help me let me have a Deal with the Devil. It can work only in two situations:
1)    If there is an existing demand for short term liquidity for productive spending which is clearly not the case
2)    It has been evaluated that if the equity market goes up by x percent then the consumer spending increases by 3.5 of x percent. So let’s say that if the equity markets go up by 60 percent then the consumer spending due to the wealth effect would increase by 2.1 percent and since consumer is 70% of US GDP it increases by about 1.5% and this increase in consumer spending could then kick start the investment cycle in the country. 
Well all I would say is that the price of failure could be very high for getting such a small kick from the economy. Because if it doesn’t work out then as I pointed above that the world could actually get into a deflationary tailspin where asset prices across the board start to collapse.

However going by the actions of the Central Bankers wherein they are ready to put a floor every time S&P falls by 10% it may so happen that they might start buying assets themselves!!! thus bringing another twist to the tale and finally bringing the reality of inflation. The reason I call it a deal with the Devil is because if it doesn’t work out (and the chances are that it would not) then we could see a collapse in asset prices across the board as the future liquidity dries up and if to stop this collapse from happening the Central Bankers make the effects of QE2 permanent by putting back the proceeds of federal debt into the market and buying other assets then this “Deal with the Devil” could end up invoking the “Incas curse” and that could unleash the same deadly magic on this world as it did some 500 years back on the Spanish Empire……..