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

Corruption - Inflation & The Great Economic Malaise

This article of mine is published in Hindu Business Line on Oct 1, 2012. Link: http://www.thehindubusinessline.com/opinion/article3951736.ece

“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.

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.

QE - Unbounded

This article of mine was published in Hindu Business Line on September 16, 2012. Link: http://www.thehindubusinessline.com/todays-paper/tp-opinion/article3898284.ece

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.

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......

The Rupee Debauchery

This article of mine is published in The Economic Times on June 23, 2012 (Link)

Way back in 1957 Ayn Rand in her magnum opus showed the world as to what happens when the looting runs dry. When the government starts to trample over the productive society and re-distribute wealth it can certainly make some quick electoral gains but soon the nation is driven out of its vitality and resources; very soon there is nothing left for the government to re-distribute.

The sharp depreciation in the currency, a falling growth and rising inflation are just some signal towards such a scenario and to blame it like every other piece of internal economic travesty on some distant western country is an attempt to run away from reality.

The Indian rupee has been among the three worst performing currencies vis a vis the dollar in the past one year.  That is indeed quite an achievement considering that all our South Asian neighbours have done better than us.

The recent moves by the RBI including asking exporters to convert 50% of their dollar holdings into the rupee would do little in arresting this slide till the fundamental reason behind this fall is not addressed. Infact this move by the RBI reminds us of an old adage “Desperate Times Call for Desperate Measures” and the fear is that more such capital intrusions can come into play in the future should this slide in the rupee continue. While there can be several factors that can influence the short to medium term movement of a currency, on a secular basis the price of a currency is pretty much dependent on the forces of supply and demand. So in essence the increase in the amount of credit net of the actual growth (of real goods & services) is what determines the relative value of the currencies in the end.

A brief glance at net credit growth (credit growth net off GDP growth) of India and US shows that the net credit growth in India has been almost consistently higher (by a wide margin) than that of US except for a five year interlude between 2003-07. This fact as one can see clearly superimposes itself on the direction of the Indian rupee that depreciates remarkably over this period except for that five year hiatus.

It is indeed conspicuous to see the consistent low GDP/Credit ratio of India vis a vis the US. While the lower productivity of Indian labour can be cited as one of the reasons for this phenomenon, however this argument can be easily put into question by the outperformance shown by the Indian economy during its 2003-07 heydays. So clearly if the lower labour productivity argument does not hold much water then what could be the reason for this abysmally low GDP/Credit ratio for Indian economy and consequently the state of our currency.

The answer can be seen in the next graph. As one can see the prime reason for this state of the Indian economy has been the extreme government activism and control. This is reflected in the ratio of the annual government credit to the private sector credit offtake. It was only when the government reigned in its penchant of spending the taxpayer’s money that the Indian economy saw its most meteoric rise. Certainly the easy global credit conditions did help but this was the case even in the 90s when the Indian economy lagged compared to its other Asian and South American peers.

Since the beginning of 2008 the government’s plunder of the taxpayer’s money is back with a vengeance, with the government credit offtake over the private sector credit offtake rising rapidly. This has ensured again that the country’s productivity goes lower thus lowering the supply of real goods and causing the inflation to shoot up. Infact these re-distributionist policies of the government is the single biggest factor for the debauchery of our currency.

The currency of a country is like a stock that people own but unlike stocks that is owned by a few, the currency is the asset held by every citizen. Infact the poorer a citizen chances are the more of is his wealth stored in the form of currency. A depreciating rupee robs him of his hard earned wealth and transfers it to people holding other assets or foreign currencies. This would counteract any of the government intentions to help him out of his pecuniary.

While we all want poverty in this country to reduce substantially, however as the past 40 years since independence have shown this cannot be achieved by government playing Robin Hood but by ensuring rule of law, reduced corruption, legal and financial reforms. All of these are certainly difficult to achieve and may not yield quick electoral dividend and so are unlikely to materialise in the near future. While these policies of re-distribution may have helped the incumbent in the past election, but if the current fall in the rupee is any indication, the government may soon run out of resources to repeat the redistributionist bonanza spree unlike the last time and then may end up facing the wrath of the electorate.

Currency Architecture: Gold Standard vs Monopolised Fiat Standard

In my previous post I had mentioned how every 40-50 years we have a change in our currency architecture. This period is quite chaotic not just economically but also politically and has coincided with wars or geopolitical disturbances.

Broadly there are 2 currency systems that we have followed over the last century. 1) Commodity Based and 2) Debt Based. I am of the view that it is impossible to run a communist monetary system that we have today and then poses as if there is any semblance of free markets. Why I call the current monetary setup as such is because the price is set by the government and distribution is controlled through few private institutions "Banks".

In this post I would broadly point out the advantages and disadvantages of the two systems and a possible way forward. Although this topic needs detail explanation but the idea in this blog is to give a glance of things.

Gold Standard: The biggest disadvantage of this system is that the credit supply here is restricted to the amount of gold in the system. It is tantamount to restricting opportunities for young bright kids.

There are two advantages of this system:

- Even though the credit becomes restricted but the system is still somewhat (atleast partially) free market as a government is bound by this system cannot interfere during downturns.

In this system it is the savings that drive credit so the risk reward distribution is more just/correct.

Fiat Monetary System: The biggest advantage of this system is that the supply of credit is pretty much unrestricted and infact the demand for credit drives the supply. It is no question that it is a powerful system that can drive remarkable growth as we have seen since 1960s in many countries (Bretton Woods agreement was not completely fiat based as dollar was still linked to gold but was still more flexible).

During this period many regions of the world saw growth rates at levels never seen in human history. However there are two big problems with this system:

- It is at the end a government monopolised system so the government/Central Banks intervene during every small downturn thus preventing the unwinding of credit due to the misallocation of capital which has led us to the point where now the demand for credit has dried up and any small unwinding/deflation of credit would cause a catastrophe

- The risk rewards are skewed away from labour to equity holders and banks causing the income disparity to grow remarkably (Refer: (Link))

So obviously the current setup is not sustainable and neither is the solution to go back to the gold standard. The system that would work is which takes good features from both these systems i.e. a free market based monetary system.

In this system, money like any other commodity could be produced/printed by anyone, well maybe subject to some basic norms/conditions like we have in many industries. The free market would then decide whose money is worth its salt i.e. people would hold the money that would have stable purchasing power over time or slightly increasing purchasing power.

However more importantly such a type of architecture would not only take into cognizance the good features of both of the standards but also eliminate their negatives. Before I point them out let me clarify one thing: There would always be a phenomena of wealth transfer via one asset class to another. This is the nature of capitalism and its beauty defined mathematically as “stochasticity or randomness”. This very feature enables man to grow and achieve things from nowhere and hence this phenomenon is not what we want to control but instead give people a choice. Please note that the key here is randomness i.e. not because of planned intervention of the government.

So a market based monetary system wherein different currencies are allowed can be accomplished by:

-       Removing the bondage that tax has to be paid in the government printed notes

-       Eliminating any capital gains on various assets (I don’t include real estate in this though which in my opinion should be taxed)

-       Removing a government monopoly on the tax currency would also force the government to reduce its size

This system would combine all the advantages of other two systems:

-       This system would not be a government monopoly so:

o   as mentioned before thus the price of the money would be determined by the market

o   The government would not be able to avoid the downturn caused by the unwinding of the malinvestments

-       The competition would ensure credit supply would not be a constrained (just like in any other product) so it is going to be a demand based credit system

-       The risk/reward would be justifiably distributed as unlike previously now the labour could choose to be paid in a currency where if for some reason the business doesn’t do well the loss would be shared between the creditor and the entrepreneur. This was not possible earlier because there was a government/bank monopoly on the currency and any such setup in this new system would be rejected by the labour. This is because as explained in my post before (Link) the reason why labour settles for less compared to the entrepreneur is because he/she doesn’t take risk of the success of the business.

Next post on this topic would be about the currency myths.

Adios – Acropolis, Countdown to June 17

This article of mine is published in Hindu Business Line on June 16 (Link)

The people of Greece have set themselves for a historic re-election on June 17; the results of which may reshape not just the European but the global political and the economic landscape. If the elections concluded about a month ago are any indications then this one could be a harbinger of the rocky times ahead. Such had been the impact of the elections in May that the financial markets are still rolling over across the Atlantic and the Pacific.

More than two millennia ago it was Greece that gave a voice to it citizens by the power of ballot, that template the world has been following since then. Following these elections the Greek electorate may not just free themselves from the shackles of a disastrous currency union but in the process may also make the citizenry of the world reject any future bailout of the financial institutions with taxpayers money. With all this talk of over 300 billion dollars provided to Greece in form of the bailout money, the fact of the matter is that over the last 2 years Greece has just served as a conduit for bailing out the insolvent European financial institutions (see graph) with just 20% of the bailout money reaching to the Greek masses and the rest being divided amongst the various financial institutions.

With the so called “radical left” Syrzia party of Greece not ready to join any pro-bailout coalition; the party has seen its popularity soar after the first round of polling in May and if it ends up forming the next government after June 17 then all bets are off. Although their leader Alexis Tsipras has rejected the bailout terms as null and void but has publicly stated his intention to keep Greece in the Euro, however anyone with some IQ would know that this position is untenable as a rejection of the bailout agreement would mean a Greek Euro exit. To be clear, leaving the Euro would surely put Greece under the weather for a couple of years with the country facing the prospects of bank runs, capital controls which can be followed by a bout of high inflation possibly even hyperinflation (when drachma is reintroduced) but if it is done in a planned way the damage could be contained somewhat, like pegging the drachma with Euro to start with and then making it to float as time passes. This can be accomplished with assistance from ECB and IMF as remember ECB still holds a substantial amount of Greek debt and so is on the hook. More importantly Greece would have something to look forward to in the future after this brief quagmire. This prospect is certainly far better than a never ending depression that has already carried for 5 years now!!!

The reason why no currency union without a fiscal union has ever worked in the history is because it is economically untenable and only leads to a transfer of wealth. The Euro is the modern day paradigm of the biggest currency union experiment that fell apart in 1930s “the gold standard”. Euro on a consolidated basis is a weaker currency for Germany and a much stronger currency for countries like Greece, Italy and Spain. Over the years this fact has manifested itself in the increasing Current Account Deficit in Greece and others while at the same time an increasing Current Account Surplus for Germany (see graph).

This should have led to a decline in money supply within the domestic economies of these countries leading them into a deflationary spiral. However being part of the Euro Zone there was little restriction on the capital flows and the ECB accepted all the government bonds on equal terms at its discount window. So to avoid the deflationary scenario either the government of these countries stepped in by increasing their spending or the capital flows came in the housing/real estate sector attracted by the panoramic views and the blue hue of the Mediterranean Sea. In either case this led to an investment or consumption linked boom in the Mediterranean countries and a manufacturing linked growth in Germany.

So even as a transfer of wealth was taking place as many industries started to shift their bases out of the Mediterranean countries and malinvestments kept on growing an artificial façade of boom was maintained for some years delaying the natural adjustment process which has now become apparent when the credit/capital flows have slowed down much like the bust of 1930s that followed the decade termed as the “Roaring Twenties” and like then when the world was on a “gold standard”, this time it’s the euro that is causing a deflationary depression in these countries.

As many European Nations are now realising that by surrendering their rights to the printing presses in the hands of some foreign bureaucrats/technocrats they have given up not only given up their economic but also their political freedom. Although things might become worse for Greece in the coming days but hopefully after these elections this country would see light at the end of the dark tunnel that this nation has been traversing through in these last 5 years and in this process pave the way for the economic liberation of the other citizens of Europe who are forced to live under this flawed economic structure called the Euro which is serving nothing but fuelling the hubris of the political and economic elites.

Inflation or Deflation - Between the devil and the deep blue sea - Part 2

So let's continue with Part 2 of my post on the two ends the world is staring at "Deflation and Inflation".  to Part 1 can be read here (Link).

To summarise in Part 1 I had discussed that:

- I defined inflation  as an increase in credit supply and base money and deflation as vice versa (not just increase or decrease in WPI/CPI index which is nothing but one of the symptoms where inflation might show up)

- Inspite of the loose monetary policies from various Central Banks around the world it's deflation that we should be more worried about for the time being and not very inflation or hyperinflation.

- This is because most of the countries are reaching the end point of credit demand either because of demographics or because of high existing indebtedness

Now for Part 2:

The currency debauchery story that is floating around has been partly due to the arrogance shown by Bernanke in one of his now famous helicopter drop speech (Link) where he mentions how Central Banks can counter deflation by simply dropping dollar bills from the helicopter. Well to be fair the wordings are not his own but I have also read the same lines in one of the articles written by Milton Friedman. in any case as I indicated before that this story is on the same lines the new paradigm before the 2000 bust or the globalization gain story pre 2008.

This is not to say that this world would not be hit by the hyperinflationary monopolised fiat currency collapse but for that to happen we have to first hit the deflationary milestone. Let me explain:

Even if Bernanke & Milton Friedman have expressed their desire to drop dollar bills from the helicopter, under the current existing accounting and legal framework within which the Fed is working they cannot do that. As of now the interest rates are already 0 or close in all developed world so every year because people are already saturated with debt, the natural tendency of the credit market is to unwind the excesses thus taking this world towards deflation. To avoid such a scenario most of these Central Banks intervene and buy Government debt, agency paper, some Central Banks like Japanese and Swiss also buy some Stock index ETF's. However for now let me consider the case of Fed, as per the legal sanction currently it can buy Government debt and Agency paper. By doing this they do two things:

- The savings go in various instruments including debt, commodities, stocks etc. so the Fed is removing some quantity of these instruments from the market and thus lifting the price of stocks, commodities etc.

- As some debt is removed the yields across all asset classes go down thus making it to appear that the cost of capital has come down (atleast on the surface) leading to some credit growth.

This phenomena can continue with the moderate rate of success till the world doesn't go into another downturn as part of the natural business cycle leading to a slowdown or decline in the credit growth and when that happens under the Fed is going to come short as there may not be enough of these instruments that the Fed would be able to buy soon enough to stop the credit unwind leading to a deflationary spiral.

However then would the time in my opinion that these legal and accounting sanctions of the Fed would be modified leading the Fed to realise it's long time dream "Dropping the Dollar Bills from the Helicopter" and here is how it may happen:

During 2008 when the world saw for the first time ever a decline in net credit under the special bill passed by US Senate the Fed bought not just government debt and agency paper but also lot of other garbage on banks balance sheets, while this helped the banks to stabalise but the US public was still indebted.

So maybe next time when such a cycle hits with an even bigger force the Fed may be authorised to buy the mortgage debt and credit card debt directly of the US public directly from US  banks. Now this debt  could be recast partially by extending maturity decreasing interest rates and part of it could be forgiven, ofcourse that would mean that the Fed liabilities i.e. the US dollar bills would be against technically an NPA. However please remember that Fed can't really go broke as it has the access to in Bernanke's words "the printing press". So yes to avoid the ignominy of classifying these assets as NPA's the US government may come in and issue very long term 0 coupon bonds. 

What would this whole thing accomplish, well this is a practical way that tantamounts to the "Bill Dropping" thing that the Fed wants to do. Once this exercise is complete the US citizens would not just be free of the debt load but the deflation would have stopped and most of the media would have proclaimed the people at the Fed to be geniuses once again. So with the US citizens free of debt load and their expectations set at the fact that the Fed and government is there to bail them out would begin another credit cycle and that in my opinion is what would start the world into the hyperinflationary currency debauchery endgame.

Let me add that the changes in world monetary system is nothing new and it happens every 40-50 years. The world got off the gold standard in 1930s (during the great depression), then it was the end of Bretton Woods system in 1971. In my next article I would discuss some common myths in the currency markets.......

Countering Anti Gold Tirade

Would continue with the Part 2 of the Deflation vs Inflation debate, for now posting my recent publication in Hindu Business Line Link

Even though the gold contract has broken through the 30,000 rupees barrier, we still hear of statements coming out from some of the country’s bankers and government officials aimed at discouraging people to invest in Gold, terming such a saving as wastage of “National Wealth” and impacting growth. Gold is blamed for two primary reasons. The investment is non-productive as gold is hardly used in industrial production and it has contributed to the high current account deficit of the country.

Assuming these comments are well intentioned they only demonstrate a colossal misunderstanding of the very concept of “Savings”. What’s worse is that such comments implicitly demeans the smart Indian masses who know it better than most, how to preserve whatever little wealth they have than most of their western counterparts.

Savings is a process by which you don’t immediately consume the fruits of your labour so that you are able to consume a little more at a later stage in life or during some emergency. So when you save, you give up consumption of real resources like oil, labour, food etc. and these resource are thus freed to be then taken up by the entrepreneurs and put into productive use by the process of investment, thus increasing the productivity of the nation and its people and in the process generating what we call future wealth and economic growth.

With this understanding one should realise that you can save by buying into bonds, equities, bullion, cash or even for that matter a “pebble on the roadside!!!”; it is certainly not a “wastage of national wealth” as such a saving  would mean that real resources are freed for the entrepreneur to invest and create new products. So by calling gold investment a wastage is simply erroneous and misleading, on the contrary as indicated above the savings should happen in assets which actually have no real use, apart from this two other features that determines the popularity of the saving asset is that it should neither be abundant nor too scarce and whose quantity can’t be increase at free will; gold pretty much fits that bill.

The asset in which you save the fruits of your labour acts as a wealth transfer medium and so even if your saving decision is not a wastage of the wealth of the society as a whole, it would certainly determine how better off would you be some years down the road when you chose to consume those savings; at the expense/benefit of others.

Certainly saving in the roadside pebble would turn out to be worthless for you and as we would see by investing in gold, Indian’s have been able to preserve their wealth from the government’s constant financial repression.

Coming onto the second point for gold bashing; gold leads to a loss of precious forex reserves. Well granted that since India imports its entire gold needs there is an argument atleast on the surface against loss of foreign reserves due to gold. However it is a very superficial way of looking at things, loss of forex reserves is a natural market phenomenon under the current economic context and gold just acts as a medium for that. Let me explain briefly

There is only one way for the runaway inflation to come down, by reducing the credit growth in the economy. This can be easily achieved without compromising growth if the government is able to reduce its penchant to spend the taxpayers money however without any move on the fiscal side; on the monetary front this can be achieved by the Central bank pushing the interest rates even higher; there is a third way by which the credit in the system can be reduced, as the forex reserves move out of the country the corresponding liabilities against them i.e. the rupee liquidity has to reduce sans of any RBI intervention through OMO’s or CRR cuts and this  is exactly what is happening through the gold imports. In any case the forex inflows can be replenished by issuing Gold Bonds, however this would be a wrong step as it would mean increasing the money supply/credit in the domestic economy and thus stoking further inflation, pretty much counteracting the impact of gold imports.

So investing in gold is not a waste of national wealth but a preservation of individual wealth as the real resources within the country are not affected, the pillage of the real resources is happening because of the government’s obstinacy to continue spending which is reflected by the free markets in the form of higher interest rates and forex outflows.

Lastly an argument can be made that instead of gold if money can be put in stocks; while stocks are surely a good medium to save one’s wealth; however unlike gold the supply of stocks can be changed by keystrokes, but more importantly a look at the graph would show that compared to gold timing is extremely important while putting your savings in stocks as they would not prove to be an ideal hedge against inflation because unlike gold by investing in stocks the total credit/money supply in the economy doesn’t come down.

As one can see, gold has been a more stable investment vehicle over stocks, rising gradually over the years. Stocks are far more volatile and although they have certainly outperformed over gold intermittently (during periods of increased private sector credit growth and low inflation) but ultimately they mean revert to the trendline set by gold (happens during periods of credit slowdown or high inflation).

 

So investing in Gold is by no means a national waste of resources but instead it’s a medium by which the economic follies of the government are corrected. Sure the reduction in credit growth does hurt the profitability of the banks and that’s why they have every right to be against investing in this metal but as explained before their profitability does not vanish in thin air but transferred to the bullion investors.

Inflation or Deflation - Between the devil and the deep blue sea - Part 1

So let's continue with our analysis of the current monetary system. In the last 2 articles we discussed the following:

- In a fiat monetary system it's the credit that leads to savings and not vice versa
- This system is one big Ponzi scheme as it can only continue if people take in more debt or new people come in debt
- The system by its very design (not intentionally ofcourse) leads to a transfer of wealth in the following order:

• People working on fixed wages are the biggest losers as they have all downside risk & no upside reward
• The entrepreneurs have both downside risk  and upside reward though their upside reward is a little skewed
• The biggest beneficiaries are the banks as they have no downside risk (as they print money out of thin air; not a laborious task i guess :) ) and all upside

Please note again, the intention is not to blame any specific group or industry, just stating as things are under the current system.

In this article we are going to discuss a very important debate that has engulfed the investment community of what end the world would see "Inflation" or "Deflation". I would discuss this topic in two parts.

First let me put forth the correct definition of inflation/deflation, it's not the increase in CPI, that is only one of the symptoms of inflation. Inflation is increase in money supply (base money + credit) and deflation is decrease in this money supply. This money supply can go into wages, commodities, stocks so CPI is just one of the symptoms of inflation. With a quantitative easing/LTRO episode happening once every 6 months it is now almost a common understanding that with such a massive money printing effort going on the world would up in some hyperinflation debacle and buying into stocks or commodities are the way to go.

Well all I would say is that this is another one of those theories that has sprang along like the investment theme that fueled the Nasdaq rally (remember: increase in productivity) or the 2003-07 rally (this time it's different theme as real business are showing growth). While I believe hyperinflation is a possibility but in my opinion the way to hyperinflation is laden through a hyper-deflation as a lot of things would have to happen should the world monetary system witness a hyperinflation collapse.

So let's discuss first why I believe the threat of deflation is more pronounced. During the peak of the credit cycle in 2007, US saw a 4.5 trillion dollar credit creation now as we have discussed in the modern monetary system the savings = credit + government deficit so this net amount of savings is what goes into stocks/ commodity investment, real estate, bonds and finally saving accounts.

What has happened post the end of this credit cycle is that US and most of the western world has reached the saturation point of credit creation simply because of demographics and their people are already under huge debt.So as you can guess that with a lesser credit growth the savings would come down which would lead to a collapse of stock prices etc. Earlier whenever credit growth used to slow down the Central Banks used to cut the interest rates and thus boosting the credit growth, however now with the interest rates near the zero threshold this is no longer an option. Now to avoid such a scenario two things are happening, the US government is running more than  a trillion dollar deficit (this adds to the savings) and the Federal reserve and now the ECB is buying this debt thus making the extra savings created because of government deficit to go into stocks, commodities, real estate, corporate bonds etc. However in spite of all these efforts the global credit growth is far below the average credit growth seen during 2003-07 and we are almost 4 year into the recovery, the very nature of monetary system ensures that we enter into a recession every 6-7 years. Why?

Let me explain: Let us say a company takes a 5 year loan and starts producing things, looking at the business potential more companies take such a loan and enter into the business, because of this other business also start to grow. However the profile of the loans taken by the company is for a 5 year term and after 5-6 years  when the companies start to repay the loan there is suddenly a deflationary environment created leading to a recession. This is what we call a business cycle from the monetary perspective or in other words a credit cycle.

So inspite of such a loose monetary policy the world is unable to generate sufficient credit growth, what would happen when we hit the peak of one of these business cycle which is no doubt coming, the credit growth can again slip down and chances are that it can go into the negative. Global credit growth has gone into the negative only once (in a year) in the past 40 years and that was in 2008 and we know what happened then... So I would submit again that irrespective of what we hear in the financial media which is again one of those old stories recycled to sell the gullible investors with crap stocks; the threat of deflation is more pronounced. Ofcourse since I believe this monetary system is unsustainable this is not an unexpected or undesired outcome but simply an inevitable outcome.

We would continue with this discussion in our next article wherein we would also see what changes would have to happen for the world to finally see a hyperinflationary outcome, till next time............

Addendum from previous article:

This is from the previous article wherein I would explain how things behave differently when we have savings driving credit growth and not vice versa.

For this let me clarify that any depositor depositing his money in the bank is lending to the bank and like any business of lending there are risks involved contrary to the perception of risk free lending that has been created, thanks to the modern monetary system.

So let's say a farmer produces 100 kgs of copper and intends to consume 80 kgs and save 20 kgs of wheat in a bank. The bank issues that 20 kg of wheat to the entrepreneur with which he pays off the salaries of his two employees which they again deposit in the bank. Again for some reason the project doesn't materialises. However unlike last time in this case the two employees would get their payment irrespective and the loss would be borne by the depositor which is fair as he was involved in the business of lending and should take the hit if the project doesn't go well.The fundamental reason why this happens when savings lead to credit is because here the risk is rightly transferred to a third depositor whose deposits made the project possible unlike in the previous scenario where the employees of the company were themselves the only depositors as credit lead to creation of savings............

Monopolised Fiat Monetary System - Treadmill to Hell

Please take a note of the word "Monopolised" in the title as I am not against a competitive fiat monetary system (more on it in later articles).

Imagine a condition wherein someone is robbing you everyday and instead of shouting for help, hitting that person or complaining to the police you are actually "Thanking Him" for his great service and showing your utmost gratitude. You must be thinking that it' crazy to even imagine such a situation, well sadly modern day banking does exactly that. 

Before going ahead let my also clarify that that banks are just taking advantage of this monetary system as most given an opportunity would do, infact most people working in these institutions   are not even aware of this phenomena.

Also please don't begin to step up the defense for the banks along the lines of how important a service they perform for this society by channeling the savings to entrepreneurs, I would first refer you to my previous post "Where is the Money?" (link) to drive the point how in a fiat monetary system the savings don't lead to credit creation but on the contrary it's the credit that leads to savings. With this concept in mind, in this article I would drive home the point left open in my previous post and add a new one:

- Why this system is a one giant Ponzi scheme (continuation from the last article) or in other words a treadmill to hell (as in real hell, not the abbreviated form my B-School)

- How this wealth transfer or robbery taking place because of modern day banking

So let me elucidate on the point  "Why this system is one giant Ponzi Scheme" by giving a simple examples:

Now suppose you want to buy a car but don't have the money to do so, you would go to the bank to take a loan, as stated earlier even the bank does not have a money to make that loan but thanks to the government issued diktat it can print money out of think air (bank credit) and charge you an interest on it against a collateral (car) which is owned by someone else for now . First of all such a contract in any other field of business (to the best of my knowledge) would be considered null and void except banking. How can you take a loan against a collateral that you don't even own?? 

Anyways coming back to our original point, now let's say you have bought the car thanks because of a loan of ten thousand dollars from the bank, now the bank charges a 10% interest on that loan and so let's say you would have to pay back 11 thousand dollars after one year. However in our economy there are only ten thousand dollars (remember in a fiat monetary world credit drives money supply and consequently savings) and so in this type of system unless you or someone else comes in and take more debt you would end up defaulting on your car loan, not matter how hard you work!!!

So you can see that this system can only survive we people get deeper into debt!!! and that is why I call this a "Ponzi Scheme".

So to keep this system going more and more people go deeper into debt or new people enter into debt and with every debt that we take and then try to service it with our toil the bank gets a piece in the form of interest payments and this payment it gets for doing what???

Nothing but printing the money out of thin air (remember: "not channeling the savings to productive economy") or in other words all that bank is doing is inflating the money supply and slowly sucking real resources from the economy in the form of interest payments or more directly (as it can keep your house if you default on your debt).

Let me introduce another example for this "transfer of wealth phenomenon". Let us say that you plan to setup a business that would need 2 workers. Now this how things can work:

- The workers that you hire are equally risk taking and decide that they would not take any salary but would instead take a share of the profit. This means that the workers are almost taking an identical risk like you and should be compensated accordingly (in this case a share of the profits).

- A second scenario can happen in which the workers want to play it safe and hence want a fixed compensation, in this case they would get a lesser compensation as they are not bearing any risk for the success of your business.

Now for this second scenario, you don't have any money to pay the workers but surely a great idea and operational competence. You approach the bank and get a loan of 50k to pay the workers, the workers deposit this money in their bank accounts.

So in the first scenario the risk for the success of the project is shared between yourself and the workers and so your workers are compensated highly. In the second scenario the risk is shared between you and "the bank" and "Not the Workers" and so they are given lesser compensation. However as you are going to see now that it's really the poor workers that still share the risk and are not even compensated for it anymore, all because of the monetary system.

Now let's say that your project has failed and has not generated any cashflow, the bank would have right-off that loan (an asset on the bank books), following the rules of accounting it has to wipe-off an equal amount in liabilities and as we just saw the poor workers had deposited that salary in the bank account which would now be obliterated. So as in scenario one because the project has failed you don't get anything, the bank would have nothing but more importantly even the workers would have nothing; which is unfair as they took this option of lesser compensation because they wanted to have their pay irrespective of the state of the project.

However if the project succeeds you are going to make millions, bank is going to have an interest income but the workers would have no upside and only the pay that they were promised which was wrongly computed as it was assumed that the workers are taking no risk.

So I hope you have got the irony of the system, i.e. under the current monetary system 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. 

Ofcourse in practical parlance to avoid 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 loose money but this scenario changes nothing as they are still loosing out in the same "real terms" to the banks and people working for equity.

So in other words if most of you have noticed or heard of the increase in the wealth disparity in the last 30-40 years it's because in 1970 we went on a monopolised fiat monetary system.....

In the next article I will show how the system would work in a different monetary system wherein it is the savings that drive the credit growth and not vice versa