Saturday, December 31, 2011

Let’s Take It Backwards – Ruminations for a Foresight

Sometimes one has to take a step back to move forward.

As we end this year today and enter into a New Year one could be excused of being curious how this New Year would shape. I am certainly of the opinion that the world is witnessing some serious structural changes that would hopefully make it a better place in a decade or so but in between that period we would witness unforeseen chaos. Ofcourse no one has an authority over predicting the future however I guess most of believe one simple law that the “nature ultimately corrects the anomalies and take us to the point of sustainability”, to see where this point might lie “let’s take it backwards”.

The main anomaly/fragility I find in the world today is:
-         -  The unnatural government monopolized fiat currency system

From this very anomaly flow two other anomalies/fragilities:
-          - Universities across the world conditioning young minds with wrong economic concepts
-         -  Reward of labour taken away from the productive sector of economy and given to the unproductive sector

The Unnatural government monopolized fiat currency system:

Back in 1776 when Adam Smith wrote “The Wealth of Nations” he talked about the selfish motive of individuals that ironically leads to a functioning of a well functioning economy. This thought in my opinion is absolutely correct and also formed the bedrock of the modern economic machine. However in this context where do the governments fit in?

Surely they are also a part of the society and thus following the analysis of Adam Smith the people in government are also driven by their self interest. So what really is the self interest of people in government?

Well in my opinion again it is “power”; the power to control the destiny of others and the sovereign currencies is one of the most important tools by which they exercise this power. To give an instance, under the presidency of Abraham Lincoln a civil war broke out between the North and Southern states of America, to fund the war Lincoln needed money; ofcourse taxation would have been a way but it would have been grossly unpopular so his advisor asked him to fund the war by simply printing fiat dollar (which has become a norm across the world now). However Lincoln had his doubts, he asked his advisor how do I make people accept this fiat money, the solution was very simple… ask the people to pay their taxes in this fiat currency.

This fiat currency is the instrument by which the government controls not just the economic activity but also as we are seeing now our social lives. Unfortunately we have been brought up to think this cocktail socialism that has carried on since the abolition of gold standard in 1971 and went berserk ever since Alan Greenspan became the Central Banker as free markets. The only way to bring an end to this is by denationalising currency, i.e. bringing it out from the control of government and the few big banks.

Because of this power to siphon off your hard earn wealth without most people even noticing we find the governments becoming too powerful and entering other aspects of our lives and this where the other two points of fragilities come into play.

Universities across the world conditioning young minds with wrong economic concepts:

Teaching a wrong idea is more dangerous than teaching how to pull a trigger, as a misfired can affect lives of a few people but a wrong idea can stray an entire generation onto the wrong path.

A few days back Larry Summers , who happens to be the dean of Harvard, an ex-treasury secretary and was until very recently was heading Obama’s economic team said that “It’s ironic that the solution to the problem of too much debt and consumption is again too much debt and consumption”, listening to this I should have probably thanked my stars that I didn’t go to Harvard but that doesn’t matter as even in Indian colleges the course content is simply copied from such universities which happens to contain lot of macroeconomic gibberish of Keynesian and Monetarist variety (and ofcourse not to mention the financial statistics and option pricing). Ever since leaving college I have found these tools specially Keynesian, as a total waste in understanding the economic machine. I can go on to say that the two years spent in the study of these concepts was a waste of time and I had to spend extra effort unlearning them than I would have spent otherwise. The only purpose that these tools serve is to construct an analytical relationship between a set of variable at a “given point of time” (notice the quotes). However this is of no significant value in a dynamic world.

So the question is why these thought processes become so widespread, simple because under the garb of these economic views the government can have the authority with fiscal and monetary interventions. So the government essentially employs economists with these thought process and since the primary objective of the universities is to provide employment, a person equipped with these ideas find greater chances of employability.

Reward of labour taken away from the productive sector of economy and given to the unproductive sector:

Perhaps the biggest problem the world is facing today is misdirection of resources. The true reason why free markets flourished while socialism collapsed was one “incentives”; free markets gave rewards in lieu of your contribution to society. Aren’t our scientists, engineers, doctors the real people who improve the productive capacity of this world and make it a better place and then shouldn’t they receive the greatest rewards for their labour. However again because of this monopolized fiat monetary system we see that a few banks are hoarding on the wealth and adding very little value to the society and this is giving rise to serious imbalance in this world. Because of this a lot of talented people are going into this sector, the work where demands people of far less talent instead. To give a simple example:

If I want to buy a house and no one in the economy has more than 1 million dollars, the price of the house can never exceed that number. However now come our great banks that are actually nothing but agents spreading the government control of money; through the magic of fractional reserve banking they simply print 9 million dollars out of thin air and give it to an individual at 10% interest. This causes the value of the house to jack up to 9 million dollars and for this useless activity of printing money the banks garb a cool million dollars.

So in short without adding any productive value in this society the banks have accumulate a million dollars; what a waste of resources!!! And they can do it because they have the access to the government money first over any other individual and then on the top of that they have the license to exercise fractional reserve lending; which is nothing but a complete fraud and if done by any common individual can land him into jail.

The first Great War was fought when almost the entire world was captured by few powers and the conflict was the only option to gather more resources. Today as the world population has grown and evolved the need for resources has never been greater; however with the government interventions through monetary and fiscal stimulus, the brazen monopoly of credit by banks and the policy of too big to fail has led to stark misallocation of resources. These are the changes that would be brought about ultimately and probably in this very decade, however if history is any guide then no one likes to relinquish authority by will. While I would resist making any predictions and leave it at the judgment of the readers, all I would like to say is that as we enter into this New Year we are really entering interesting times and if during the course of the year any one wants to understand where the world is headed my suggestion would be to “Take It Backwards”…….

Thursday, December 15, 2011

When All Roads Lead To Rome

This article of mine was published in Hindu Business Line print edition on December 8 (link). Has been some time wherein I wrote an article just for this blog so planning to write an article next for this blog in which I would continue my option pricing series.
Here is the article...........

Italy is among the richest countries in the world, a member of G7; among the top 10 largest economies; the population in northern parts of Italy is among the wealthiest by per capita; home to some of the top manufacturing brands and a gold reserve which is second only to Germany in the Euro region (valued at around 400 billion dollars). However now with each passing day the Italian economy is pushed deeper into to the abyss, a nation stripped off its democratic virtues; people burdened with taxes; a government saddled with debt and a nation with uncertain fate.

It’s indeed a real travesty that a nation with so many resources at its disposal is looking at a bleak future with no daylight in sight and one wonders why it is so?

Well a look at this chart can answer a lot of these questions. This graph maps the industrial production of Germany and Italy since 1993. Notice how much abreast the industrial production of these two countries used to move before the introduction of Euro in 1999. However since that time this gap has been widening and today with industrial production of Italy sagging while that of Germany rising, this gap has widened to historical levels!!!
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The ills of this Italian economic catastrophe lie in none other than this common currency “The Euro” which is destined to create disparity instead of parity among nations

A currency may be a store of value for an individual but for a society at large it is nothing but a way to transfer wealth and so an increase or decrease in the currency supply doesn't actually change the overall wealth of the society; it simply moves it from one person to the other. Remember a currency is nothing but a short term government liability and so a currency note printed by the Central Bank and given to banks increases the assets of the banks but at the same time increases the liabilities of the government by an equal amount, so net impact on global wealth is “zero”. However this increase in government liability now has to be serviced by ordinary citizens; they end up doing this by either putting in more hours than usual at work for the same pay or giving away more from their existing share of their income to the government in form of taxes.

Central banks already have monopoly over money creation and thus can easily transfer wealth these days by creating more money (to the benefit of capital owners and debtors over labours and savers) or by reducing its supply (to the benefit of labours and savers)

By giving away the power to print money this transfer of wealth is now happening not just between individuals but also between countries in Europe. Euro on a consolidated basis is a weaker currency for Germany and a much stronger currency for Italy in other words there are too few euros for Italy and too many for Germany.

So with such a strong currency there is little incentive for the capitalists in Italy to setup industries thus reducing the country’s productivity and industrial growth (as seen in the graph). Consequently the government ends up picking up the slack (over 50% is government contribution to Italian GDP) by running exorbitant debt that now it cannot repay. Such a condition is advantageous for a country like Germany; this is not to say that Germany and German workers are not good at their work but this provides an even extra edge as with reduced competition from Italian industries it ends up selling lots of its products. A look at the graph below would tell you the story.

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Had Italy been able to use its Lira it would certainly have devalued its currency by printing more money and thereby transferring some of the wealth from its labour to its capital holders, thus unleashing the country’s entrepreneurial spirit and giving an incentive for more people to start industries.

The fiat monopolised currency system existing today in any case is flawed and on the top of that a common currency area is structurally and economically wrong and as we are seeing today has disastrous consequences. By giving away the right to the printing presses not only have the Italians and other European countries given away their economic fates to foreign masters but have also as we are seeing today, possibly given away their democratic ethos. Not only is it unfair for the common Italian citizens to pay for the folly of the bankers but living under this flawed economic structure, they are also paying for the misjudgments and hubris of their politicians and economic elites. It’s time for Italy to exit this common currency experiment and in the process pave the path for others to follow.

Sunday, December 4, 2011

Time for Redemption: Don't Blame The Oriental Land

This article of mine was published in Hindu Business Line on November 19 ( link ) , posting it here on the blog with some additions.

The world is steadily but surely moving towards an era of trade wars and protectionism. With the controversial bill to punish China over its currency having been approved by the Senate, the Sino-US tensions have moved up by a few notches.

When there is dis-illusionment among the masses and the protestors are on the streets it’s rather easy to put the blame for one’s precarious state of affairs on a distant foregin land and it’s government.

The reality is that it’s not the Chinese policies but the policies of the US itself that has been responsible the nations huge indebtedness, joblessness and high Current Account Deficits.

Ever since 1980s the US financial sector has been in trouble for some reason or the other, be it the tequilla crisis, LTCM, Asian crisis, the subprime crisis and now ofcourse the sovereign debt crisis and everytime the response of the US government (infact most Western governments for that matter) has been pretty predictable; transferring of the bank’s bad debts onto its own balance sheet thereby increasing the soveregin debt load and the Central Bank happily monetizing a part of it.

The problem with money printing and issuing sovereign guarantees is that it never increases the wealth of the society; money is a store of value for an individual but for the society as a whole it is just a medium to transfer wealth from one person to the other or more broadly from one sector of the economy to another. As a result of the government’s and Central Bank’s fire fighting exercises over the  last three decades, everytime the financial sector was saved capital was transferred from the manufacturing and other prodcutive sectors of the US economy and given to the financial sector.

Chart a

Chart b

 As one can see from the graphs above; that thanks to the government bailouts and Fed money printing the bloated financial sector sucked resources from every other sector of the economy specially the manufacturing sector. Even here a large part of what is actually accounted for as the contribution of financial sector to the US GDP is the non productive activity of flipping around assets and derivatives and generating a fee income. One can only fathom of the numbers considering the 700 trillion dollars market with a daily turnover of as much as 40 trillion (globally). As also seen from the graph, for all the GDP contribution that the financial sector makes to the US economy its contribution to job creation has been paltry to say the least.

Had all these dollars that were generated to save the defunct financial sector botteled up inside the US, the CPI levels would have exploded; instead it was because the Oriental land came to its rescue by happily servicing the US citizens with cheaper goods due to its lower labour cost and cheaper currency that the US was able to maintain its mojo.

The symbiotic relationship wherein the Chinese sold their goods and services for US dollar and then recycycled them back to US by buying up the treasury bonds is what gave the US government the ability to run its various social welfare programs and ofcourse save the banks every now and then.

Chart c
As can be seen from the graph, post 2007 with the bailouts having become bigger, the fiscal deficits have outgrown the Current Account Deficits forcing the Fed to intervene with it’s massive QE programs.

It’s not the weaker Chinese yuan that is the reason for US woes, the trouble lies with the government and the Fed “Put” on the US financial sector that has led to serious mis-allocation of capital. Infact the only reason why the bloated financial sector which has taken away the productive jobs but has still not managed to completely take away the purchasing power from the US citizens thereby draining the vitality of the average US household is because of the cheaper Chinese goods for which the cheaper yuan has a big role to play.

A bill in the US senate is required to be passed, but not against the Chinese currency manipulation rather against the Fed and government’s policy towards what they term as “Too Big To Fail”.