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.