Monday, May 28, 2012

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............

Tuesday, May 22, 2012

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

Sunday, May 13, 2012

Where is the Money?

So finally writing for this blog after a long time, been busy in non-creative though essential chores. In anycase would try to get frequent again with my blog entries. Even though I didn’t write for the blog, I wrote a few articles that have been published over the past few months and I have posted those below.

Also I am going to post my entire blog to my new site pretty soon. It’s my company site which would have some other content as well apart from the blog articles. There I have added a section “Blog” which would have this blog site and other articles as well as twitter feed updates on some important events across the world.

During this year I have thought of covering extensively on the following three topics:
-        -   Monetary System
-          - Financial Derivatives
-          - Statistics

It will not be as boring as it sounds as I would try to link them to everyone’s daily lives; you would be surprised how especially things like financial derivatives and statistics effect you even though you may not be using them directly. For today let me start with our Monetary System. So here we go….

Sometime back on one my travels, I had a rude awakening, my co-passenger on the flight was a person who has been working in a big private sector (foreign) bank for more than a decade. However I was shocked to see how flimsy was his knowledge of our monetary system and in particular the role of the banks.

So let me ask you a simple question: Let’s say you go to a bank for a loan to start some project, the bank is happy with your project plan and decides to lend you the money. My question is from where does the bank get that money?

If your answer is that it lends the money that depositors give to the bank, I would say join the line of the many that think the same way. This is grossly WRONG!!! This understanding I believe emanates from the period when we used to have commodity based money and like everywhere updating knowledge in Universities is wishful thinking.

The correct answer is that the banks “simply print it out of thin air”. To clarify further, let me ask you this question, let’s assume the start of our paper money system, no one has yet asked for a loan then from where do the depositors get the money to deposit for the banks to then lend?

I hope you get the point, the banks create money out of thin air which it lends out to you, you deposit part of that money to your savings account with that bank (let’s keep it simple for now) and some you give to suppliers, as salaries etc. which are again transferred to the respective saving accounts of those people.

Now if you are thinking what about the governments don’t they create money? Yes they do however there is a difference between money created by government and that created by bank. The government or in today’s chicanery terminology the Central Banks create money what we called as high powered money. This money is transferred to the accounts that the banks maintain with the Central Banks. This high powered money is not what is loaned out, this money moves out of the banking system in only three ways:
  •         Through taxation, as the citizens pay taxes to the government, the banks transfer this high powered money  to the government account again maintained with the Central Bank
  •         The debt the government sells
  •          When you physically withdraw cash from your ATMS, so yes your cash is part of that high powered money.

You may be wondering then what is the use of this high powered money, well even though this component of the money supply is very small, but the government and Central Bank can influence the amount of credit that flows into the system by tweaking around this high powered money.

So remember in this fiat money world:
-          A loan or a credit taken from a bank is printed by the bank out of thin air
-          This credit in turn leads to savings and not the traditional thinking that savings lead to credit
-          This credit plus the high powered money is our total money supply in the system
-          And the most important thing, this system is a giant Ponzi scheme which can only work if we continue to take more and more credit!!!

How is that possible, I know apart from this question there would be many other questions in your minds, would continue with this topic in my next article………….

Pitfalls of Credit Induced Growth - My Article in Hindu Business Line

Date: May 2, 2012


With the operation twist coming to an end in June, the world is all ears to any hints dropped by the Federal Reserve of what may come next. Whether we agree with their existing policy or not it's important that we view the world from their co-ordinates and in particular the role that credit has played in our economy in the past 4 decades; because its only then we would realise that this exercise of bond buying  every year coupled by large government deficits is an exercise that would continue as far as one can see because the moment this stops the natural deleveraging cycle would take over and taking with it years of growth created on the foundations of credit.
 In the era of commodity based money, it was the savings that used to drive credit and thus growth. So people used to save their money in banks and banks used to lend that money to entrepreneurs and corporates. Ever since the dawn of fiat money it is really the credit that drives both savings and growth.
Since 5 centuries it is well known that an increase in credit is accompanied by an increase in growth rate. So post 1970 when the Central Bankers received an almost omnipotent control of the nation’s monetary policy they have used this relationship extensively; hence whenever the economy used to take a breather in order to unwind the malinvestments in the form of lower equity and bond prices particularly of the financial institutions, the Central Bankers always used to come in and artificially reduce the interest rates thus performing two critical actions: 1) Saving the financial institutions equity and bondholders from losses and 2) Reigniting the growth of credit which would then boost the GDP growth
However as a result of these interventions and the supposed transcendence of the period of “The Great Moderation” the malinvestments that would have unwound with some losses to equity and bondholders have become even bigger and now threaten to take down even the savings of the masses if a system wide deleveraging were ever to happen. Post 2008 with the financial and the household sector deleveraging (excluding the massive uptick in student loans) the increase in government debt is avoiding precisely such a scenario.
Now as we understand from preliminary economics an increase in government deficit is equivalent to an increase in private sector savings. So the government deficit is not just providing that marginal growth in credit but also allowing the private sector to de-lever.
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.

Both these operations are justified under the garb of the fact that there still is a lot of slack in the economy which brings me to an important point associated with the credit growth of the past four decades. As can be observed from the graph, the impact of a dollar increase in credit on GDP has reduced significantly every decade. So much so that now the real GDP increases by just 8 cents for every dollar increase in credit.

The secret of the reducing efficacy of credit on GDP can be observed in the next graph. As one can see that even though the credit has been increasing over this time the financial sector of the economy has seen a massive growth while the credit growth in corporate sector has lagged behind, so much so that now the total credit in the financial sector overwhelms that of the productive corporate sector. Isn’t it ironic that a sector like financial which is supposed to be a facilitator or tertiary to the main economy is now infact the leader as far as its contribution to total credit is concerned. This is precisely due to the irresponsible policies of the Central Bankers that didn’t allow the unwinding of the bad debts of this sector and letting the bondholders and equity holders be wiped out. So with every single intervention these debts instead of getting unwound have only ballooned. As a result of this each of the recoveries since 2001 has produced fewer jobs.
Post 2008 with the overall credit in the financial sector reaching its zenith, what the policy makers are now hoping is that the corporate sector slowly picks up this debt that the financial sector unwinds and during this transitory phase the government carries the baton helped ofcourse by the Federal Reserve. However this is the same misguided hope that has led the world into the current mess. The government expenditure accompanied by the Federal Reserve’s bond buying programs is nothing more than a transfer of wealth, the same phenomena that has been happening for the last 40 years in the fiat money regime i.e. from people who earn their money from labour to holders of assets thus widening the income gap.
So meanwhile our policy makers wait for the corporate sector to takeover the credit creation baton, the misallocation and thus destruction of the resources in the real economy continue thus ensuring that the next fall would be even bigger.

Budget Points to Lack of Fiscal Discipline - My article in Hindu Business Line

Date March 20, 2012 

With the budget and the RBI economic policy out of the way, the critical policy week for the Indian economy has proved to be a damp squib as the neither any credible action on tightening of the fiscal policy came through in the budget nor did the RBI relented on reducing the interest rates.
To be fair unlike the last year this time around the projected numbers on the revenue side are more realistic and the budget does attempt to talk about controlling the expenditure. The revenues estimates through direct tax collection assume a private sector credit growth of around 21% (the average of last 8 years) from the existing 16% which is certainly achievable if the government keeps its expenditure under control and consequently the RBI cuts the interest rates.
As a matter of fact the government has projected its credit requirements to increase by just about 13% (the lowest in the last 5 years) which if proven correct would make all the pieces of the budget fall into the right places perfectly. However the expenditure that it has projected to put across this number is a bit baffling.
The bloated government expenditure is primarily on account of two factors: The ever bulging food, fuel and fertiliser subsidy bill and it’s excessive re-distributionist policies that are squandering away precious economic resources and causing serious misallocations of capital without having much of an effect in increasing the real supply and economic productivity. It was critical for this budget to address the government expenditure issue as this has resulted into the country falling into an inflation and slowdown quagmire.
The budget does propose to cap the subsidies to 2% of GDP but the implementation is left in the hands of the executive. The fiscal deficit has been proposed to be brought down to 5.1% but the money reserved for subsidies provide some food for thought over the credibility of the forecast. While the fertilizer subsidy is proposed to be brought down by 6000 crores, the oil subsidy is planned to be cut by 25000 crores over the previous year i.e. a cut of about 36%! This can only happen if the oil prices collapse (unlikely unless we have a global recession) or the government actually raises the prices especially of diesel, kerosene and other petroleum products. If the previous year is any indication where the government missed its fiscal deficit target by 130 basis points, this price rise is unlikely to fall through.
The Brent crude prices are already averaging over 120 dollars/barrel which is about 7% more than last year’s average. Even assuming these prices hold through the year and the growth in crude oil demand stays at around 3 percent, the oil subsidy bill could actually grow to 75000 crores.
Inability to the pass the increased subsidy bill would add around 40000 crores to the government borrowing. This increase would negatively impact the private sector credit growth and in turn the government revenue estimates and may add in excess of 50000 crores to the government borrowing program. Suffice it to say that if the government is unable to pass part of this bill onto the consumers as indicated in the budget, it would end up increasing the government’s fiscal deficit to 5.5% and its expected credit growth by over 20% from last year. This may again restrict the hands of RBI in slashing the interest rates aggressively thus hampering the private sector credit creation and as a result the country may see a prolonged period of high inflation and lower growth.

This year has been a difficult one for the Indian economy. As more and more economic resources were being driven into stimulating the already high consumption levels, capital investment took a backseat. As a matter of fact the gross capital formation is actually estimated to be negative for this year. This has happened only 2 times in the last 2 decades (1996-97 and 2000-01). This is a serious problem for a fast growing economy like India as this would mean severe supply constraints going forward.

If the government is able to come out good on its promises in this budget things would look better the next year, otherwise the only hope would be that global liquidity conditions remain benign abroad thus enabling the private sector to cater to its capital requirements and avoiding the country’s growth rate from slipping down further.