Friday, June 22, 2012

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.

Monday, June 18, 2012

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.

Friday, June 15, 2012

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 fa├žade 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.

Thursday, June 14, 2012

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.......

Tuesday, June 5, 2012

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.