Can't Buy Food... Eat IPADs

Some three centuries ago the French state was in complete disarray, the government ran up huge deficits because of the wars with England and soon this transpired in the form of unabated inflation. It’s people unawares (like most common people are) and reeling under the severe bout of inflation went to their king and complained that they can’t eat bread as it has become too expensive before the king could speak his beautiful wife asked her pupil “To instead Eat Cake”, soon the obliviousness of the French royal family culminated to their demise in the then French Revolution.

History often repeats itself but the irony is that most of us can’t see it as we are it’s participants. It’s like if two trains are running on the same track in the opposite direction they are definitely going to crash into each other however the passengers inside the train would never get to know no matter how many times in the past they have seen it happening from outside. Something interesting happened about 2 weeks back. In one of the seminars the NY Fed President was asked about the Fed’s total obliviousness to inflation when instead the Food and energy inflation was the highest ever recorded since 1974!!!, to this the Great NY Fed President replied that overall inflation was still moderate (their freaking core inflation) and so while the Food inflation maybe high but there are something like “IPAD” that are getting cheaper!!! This statement by the NY Fed President (who is either like most economists completely oblivious to the real world or totally hand in gloves with his crony bankers) is a harbinger of the things to come (just to note that this month his totally manipulated core inflation was also the highest recorded in 2.5 years). While the queen of France could be excused for her comments these are supposedly learned men. If this trend continue the battle lines in Middle East and southern Europe would spread elsewhere, add the last night protests in London to the list. Let me point out that this trend is not just peculiar to Central Bankers in US but everywhere.

The response to the catastrophic disaster in Japan by its Central Bank was to the same predictable action of printing money. The Japanese Central Bank printed some 700 billion dollars!!! In just one week just so that it’s stock market does not crash. The result of this tsunami of money printing was that the Japanese stock market may have fallen overall by just about 6-7% in the last week but the price of rice which last time I checked was what was really needed by those people affected by quake rose by 12% (in a week) and to the best of my knowledge people can’t eat stocks, so great job BOJ.

What many people don’t understand is that the stock market going up is not always a good thing; it is the reason why it goes up and that is more important. During the last 2 years the markets across the world have gone up mainly because of one single reason (Money printing). To explain my point let me pick another lesson from history, that of the famous Weimar Republic. After the end of war in 1918, Germany had a huge task ahead… not only did it need to rebuild but also to pay the obnoxious price of war imposed upon it. Soon it found its hands full and resorted to the old money printing trick. The result on the asset price was as follows:

-          The nominal value of the stock market increased by 89 times in the 8 years following the war (looks good then read further)

-          The value of gold increased by 1600 times!!!

-          It soon took an entire wheelbarrow to buy 2 eggs

-          The people had to be paid their wages twice a day

More importantly with the large population living in tatters and only handful of bankers who were cognizant of this process were able to save their wealth by investing in hard assets thus created a serious communal rift in the society and thus paving the way for Hitler.

I am so glad that the BOJ saved the stock market and saved a few of their friends, while the majority of its people are going to soon feel the impact of higher rice and other commodity price for years. Just wonder why they couldn’t understand that because of the destruction in the quake that since the supply of goods has reduced so should the credit and yes assets have to deflate because of that. The realty is that the governments across the planet are so extended that they have no way but to generate inflation to get out of this mess. Unlike the private sector the government is not a profit generating entity but a welfare entity (supposedly) and so when it runs large deficits the only way it can repay is by increasing taxes… however the reason the taxes are so problematic with the masses is because it leads to transfer of wealth from one person to another and so the government devised another way out of it… debt, by selling its debt the government was able to create the mirage that it was not necessarily a transfer of wealth as my money taken from me would be ultimately returned back to me in the future. However how would the government return this money back, well there could have been just two possible ways either raise the taxes in the future or take more debt and run a ponzi scheme (this is what many developed countries tried for a while) and when this ponzi scheme is about to run its course then what should it do.. well then it came with that brilliant idea of currency. In my last article I explained how currency is nothing but the government liability of the shortest duration. The only difference between currency and other forms of government liability of the shortest duration. The only difference between currency and other forms of government debt is the fact that based upon the currency depends the overall private debt  generated by the fractional reserve system (check the previous article) so contrary to today’s logic in times of slowdown the currency supply should contract because the supply of goods have reduced. The irony is that currency which is essentially government liability and is controlled by just few non-elected representatives across the planet forms one side of almost each transaction and also the modern unit of accounting in economics and this a system that we describe as free markets!!! I wonder how different it is from a politburo of Soviet communists deciding the nations 5 year plan.

It’s very important the people understand that what they are earning every month by putting in their time and hardwork is essentially government debt that the Central Banks can print as much as they wish with the flick of a finger and distribute it to their crony bankers. Think about it this way that you have spend hours of your personal time and studied hard and passed the exam, at the time of the convocation the Director of the college announces that passing the exam was not necessary and everyone would get the degrees simply because his son failed in that exam.  So it’s important do away with the “cash” as soon as you have it and invest it in hard assets and especially not to deposit much of it in banks and thus not allowing them to play with under the fractional reserve system .

Often there is this propaganda that commodities don’t yield any cash flow and so are not good investments, while I agree to this hypothesis in normal times but these times are hardly normal… please not the key word in their argument “cash flow”…. While fixed income and equities would yield some cashflow 1 year down the road, however what good would be that cash if it’s value has significantly eroded because of the inflation generated by money printing. Don’t fall for these arguments, in an environment like this hard assets are the ones that would outperform because when the money is provided to a corporate he buys those hard assets first operates upon it in the second stage and sells it in the third stage so by the time he gets the “cash flow” to the shareholders in the third stage that money has significantly lost its purchasing power.

There are only 2 ways to deal with this situation, either do what people in Middle East and parts of Europe are doing or play the cards smartly that are dealt to you by the Central Banks and it’s pretty simple buy commodities (mainly bullion and agri) and hedge it by shorting equity (let me be clear even though equities would go up because of the money printing the pace at which the commodities would appreciate would far outweigh that of the equities. The hedge is important because we would have intermittent collapse of liquidity like the one we had in 2008 and this hedge would keep you in the game………

PS: With China increasing the prices of its rare earth metals soon Mr. Dudley (President of NY Fed) would find his IPADs also getting expensive not sure what would he eat for some food for thought.

Incas Curse and the Deal with the Devil

US GDP no. came in a couple of weeks back, apparently the reported nominal GDP growth rate was 3.5% and the real GDP growth rate was 3.2% so in essence according to this data the inflation figure was just 0.3%!!! and I always thought that statistical chicanery is the monopoly of communist and dictatorial regimes. Infact sovereign slanders and lies are becoming fashionable these days, a clear trend in how big a soup these governments are, what’s more it is applicable to all categories of governments be it the oldest or biggest democracy in US and India or communism in China and as we are seeing it now under the dictatorial regimes of Middle East. Anyways probably this is not the right forum for sovereign government bashing so I will limit myself to the economic thought. In one of my last articles I alluded to the fact that a nations currency is linked to its productivity and with the certainty of the demise of the fiat currencies investing in Gold and Silver might be prudent but one should keep in mind that if the value of Gold and Silver goes up one is not creating wealth but rather preserving wealth (no doubt it is also important) but this point should always be kept in mind. To explain it further let me take you some 500 years back to the Incas civilization, back then the Inca society was based on toil and innovation. Their legends of gold and silver deposits attracted the Spanish invaders, the Incas were swiftly defeated and what we saw was one of the biggest plunders of history. The Incas used to consider gold and silver extracted from their mountains as metal of God and instead of circulating it in their economy, they used to store it in their temples dedicated to God. They found little use for them in their society beyond a point infact on the contrary excess of this metal was considered as a bad omen for their society. So to their astonishment they found it quite curious as to why the Spaniards were after this metal. In any case after the plunder, the Spanish sailors sailed back from their golden voyage with the hope that with this loot the Spanish Splendor would reign supreme for generations to come. Well that was the hope.. Instead the Spanish empire and economy saw a decline that pushed the once great power in Europe to the second rung.

So what really happened, why didn’t all this gold took the Spanish nation far ahead of everyone or were the Incas really right in their thinking that excess of this metal could lead a society to ruination. Well believe it or not they were!!! The Spaniards were indeed stuck by the “Incas Curse”. Hey but hold on wasn’t this article about economics and currency and certainly not about ghost stories. Indeed it is about economics because the “Incas curse” was nothing but “Inflation!!!”.  It doesn’t matter on what the currency of a nation is issued… Paper or Gold if we increase its supply and the quantity of goods produced remain the same it would lead to inflation. So since gold had practically very little in producing anything tangible, it merely acted as an increase in currency supply.

With this context in my mind let me move the topic of QE 2 and some of the misconceptions that I hear around me.

Well not just general public but even many of the fund managers have this misconception that QE 2 is fresh money printing. Well in layman terms maybe yes but the answer is not really!!! As I explained in my earlier articles money is nothing more than the liability of the government with the shortest duration (let’s for simplicity assume one day although it is a variable and can go to as low as 0)

So Money like government debt is a liability and since it is not backed by anything both are the same. So let me define money again: Money is a government debt of shortest Duration and hence the most liquid. Currently with 2 trillion dollars of base money and about 13 trillion dollar of conventional US Federal Debt the net Federal liability is about 15 trillion dollars. What the Federal Reserve is doing is tweaking this distribution or what I would say is performing a maturity swap wherein it replaces the relatively longer term liability (5-10 year debt) with shorter term liability (US dollars). My point is that unlike what most people including some seasoned fund managers feel QE 2 unless made permanent is not leading to the creation of new money and in a fiat monetary system that the world is in cash and government debt are replaceable. Infact this last point is very critical to keep in mind.

So that brings me to the next question, if QE 2 is not really leading to the creation of new money then is it really inflationary. Well in the short term it is definitely inflationary however in the long run all bets are off. Let me explain, since the duration of cash is low (assume it to be 1 day) it makes sense to put that money into an asset where its value is preserved and so the existing treasuries, stocks, commodities and other debt instruments are ideal for this purpose. So as the long dated liabilities are replaced with cash, some other asset classes definitely get a kick owing to the shorter duration of cash if it is perceived that the cash would loose its value in the future. So the next point is where would this cash go. Well it should into 2 avenues 1) A place where its purchasing value is preserved 2) Where there is value, growth but more importantly momentum. Hence longer dated treasuries may loose value and commodities would gain value along with some equities. So yes temporarily this is inflationary but lets look at it a little longer.

Lets say that the Fed buys bonds of 100 billion worth of face value at 5% coupon payments 1 year down. So at the end of 1 year the buyer of that bond (assuming he bought at par) would receive 105 billion dollars.  However if the inflation expectations become high then the value of the bond falls far below the face value (let’s say 95) so in essence by buying it today the Fed is pumping in 95 billion dollars today whereas it could have pumped 105 billion dollars had it done it 1 year into the future. So the world is essentially short of 10 billion dollars one year into the future.

This is a dangerous game to play as its tantamount to saying that since God can’t help me let me have a Deal with the Devil. It can work only in two situations:

1)    If there is an existing demand for short term liquidity for productive spending which is clearly not the case

2)    It has been evaluated that if the equity market goes up by x percent then the consumer spending increases by 3.5 of x percent. So let’s say that if the equity markets go up by 60 percent then the consumer spending due to the wealth effect would increase by 2.1 percent and since consumer is 70% of US GDP it increases by about 1.5% and this increase in consumer spending could then kick start the investment cycle in the country. 

Well all I would say is that the price of failure could be very high for getting such a small kick from the economy. Because if it doesn’t work out then as I pointed above that the world could actually get into a deflationary tailspin where asset prices across the board start to collapse.

However going by the actions of the Central Bankers wherein they are ready to put a floor every time S&P falls by 10% it may so happen that they might start buying assets themselves!!! thus bringing another twist to the tale and finally bringing the reality of inflation. The reason I call it a deal with the Devil is because if it doesn’t work out (and the chances are that it would not) then we could see a collapse in asset prices across the board as the future liquidity dries up and if to stop this collapse from happening the Central Bankers make the effects of QE2 permanent by putting back the proceeds of federal debt into the market and buying other assets then this “Deal with the Devil” could end up invoking the “Incas curse” and that could unleash the same deadly magic on this world as it did some 500 years back on the Spanish Empire……..

The Art of Asymmetric Arbitrage

I am engaged in this constant game of probabilities, evaluating asymmetry between the price of a given asset or its derivative and its risk. Money is made in the capital markets by first correctly identifying such an asset (believe me, no mean task) but even tougher is executing your strategy. Ofcourse I am not alone in this, knowingly or unknowingly the whole world is engaged in this activity, in case of equity markets the "fundamental analyst" who finds value in every other stock is a typical example, although he/she may not be aware of this. When that analyst says that the price of a stock is 20% cheaper than its fundamental value (never understood what this means in a world of unknowns.. anyways) he is pricing that asset with the underlying risk of earnings, interest rates and time so basically three unknowns.. meaning he is claiming to be a visionary who can see the future values of these 3 components and I always wonder why we call Heisenberg a genius when he was not able to see even one. Saying that a stock has 20% upside potential in the next one year, simply means he/she is mispricing risk..... why well because first in normal circumstances the whole world is looking at that stock and chances are that it is being fairly priced and for a 20% upside potential (again questionable) there is no reason to bet a 100% downside!!! The most sure way of making money in capital markets is arbitrage. Ofcourse you don't get too many arbitrage opportunities though. The reason is that in normal arbitrages like Put Call Parity, Cash Future arbitrage etc. both the price and the risks are known accurately. What I am going to discuss is called asymmetric arbitrage. Since early 1900 when Bachelier wrote his paper it is an established fact that markets are not normal, infact in this world full of traders the asset prices have the tendency of becoming absolutely depressed to be maniacally priced...... The reason, well the conditioning of human mind is such that it thinks linearly and not just in markets but in leading the lifestyle as well. 

Let me pick a simple example... let us say there are two rooms one of which has the probability of gold deposits. In Room A the probability is 90% and in Room B the probability is 1% and 9% chance that someone made a fool of you. To search for gold in Room B you have to pay an X amount and to search in Room A you have to pay a 70X amount. Which one would you choose? Well I think the answer to this are just 2 either I choose Room B or I choose nothing. The reason is simple since the probability of finding gold in Room A is so skewed towards it will attract too many people and so in essence my probability of finding gold in that room is actually not 90% but more closer to 0%!!! because I am not just playing against the static game but also the against the probability of one of those millions finding the gold. This is exactly where the market presents an arbitrage opportunity because the the real risk is hidden beneath the headline. When it becomes so obvious that a stock is going to go much much higher or lower the returns on the side of the crowd become highly negatively skewed. Again let me explain by taking an example... Let's say that I go to see a show in which the anchor throws gold coins at random intervals, the show has a ticket price X; now this news spreads and lots of people want to see this show, two things would happen either I share my seat with someone and thus reducing the chance of catching that golden coin by k times or pay a much higher price for the ticket and in turn for sure reducing my potential benefit, because no-one can evaluate the crowd it is impossible to fathom the potential reduction in rewards and so we observe maniac prices somewhere and depressed prices elsewhere. Evaluating such situations in markets and taking the opposite side of the trade is what I call "The Asymmetric Arbitrage". So let me reiterate the point of this arbitrage... Since the payoff of a specific trade is so skewed on one side that it ends up attracting so many market participants who thereby by their sheer force of numbers reduce the payoff to such an extent that the opposite end of the trade becomes more attractive.

Now another way  to look at a stock price from the prism of asymmetry is that the stock price is a sum of buying a call option on the Earnings of a company and selling a call option on the interest rate. The multiple you pay over earnings is proportional to the time for which you have bought and sold the options. Now since generally in a low interest rate environment the volatility in interest rates is less than earnings (except probably in hyper inflationary period) and the returns from business more than the interest rate the price of the call is more than the price of sold call option. If I give you an option of taking 100000 dollars now or toss a coin and if it comes heads take 200000 dollars else nothing, which option would you choose. Similarly if a risk free rate on some deposits is 10% and a PE on some stock in excess 20 which means that even for an ROE of 30% my next year return on paid equity is 5%, followed by 6.5%, 8.75%, 11.35%. My point is that would you take the 1 lakh dollars now or wait for the toss in this case approx. 10 years of unexpectedness (ofcourse there could always be positive surprises in stocks.. what I call the randomchalice price). The point that I am trying to drive is that in an easy liquidity environment when interest rates are artificially too low the sold leg of your stock (i.e. call option on interest rate) becomes too cheap and the call option on earnings of your stock becomes too expensive (as earnings are high) which essentially means you are sitting exactly on the other end of the asymmetric arbitrage by selling the bargain call and buying the maniacally overpriced put and since arbitrage is a sure way to make money.. If I extend this argument further in this case of de-arbitrage it is a sure way to loose money as just explained above.

Where All Ends Meet… Time Value of Option on Growth is Current Account and Fiscal Spending...

In the first two articles we discussed how a nation’s currency can cause boom or bust in its economy. In this article we shall go a step further and discuss how in the current world order the currency, fiscal deficits and the current account deficits are playing out on the economic growth and how the only hope for this world to prolong the inevitable is for the US to have a continued fiscal and current account deficit.

I would start with the most basic equation taught to everyone in Eco 101 i.e. Y = C + I + (G-T) + (X-M) i.e. the GDP of any nation is the sum of consumption, investment, net government expenditure i.e. subtract the taxes and current account balance i.e. exports – imports. I would be focusing on the government expenditure and the current account part in this article. Ofcourse the consumption is what drives the current account deficit and investments. So here we go………

Thanks to reduced tariffs and free global trade treaties the investment needed to serve the US consumption is largely happening outside as the factors of production are much cheaper there. It’s important to note that even the trade today is not free or relaxed even though it may seem that way. The exporting nations of Asia hold their currencies pegged against the USD and try to implicitly keep the labour costs and material costs down which means that only US ends up keeping its end of the bargain, in any case the lower interest rate regime of the US since mid 80s has also ensured that the society moves on to become a society of mega spenders as saving at every point of time is reprimanded by Fed by printing more money. So a lower interest rate in US drives the consumer to spend and the investment to support that spending instead of happening in US happens in Asia or Latin America as the factors of production are much cheaper or artificially kept much cheaper there. This in essence means the US ends up having very high current account deficit which implies as the dollars move abroad the Asian producers have the option of

- Either let their exchange rate appreciate and let the automatic mechanism of trade balancing come into play. However this is precisely what these nations are guilty of not doing.

- So this brings us to the second option which is to let this money flow into the domestic economy which can actually be highly inflationary

- Hence the final option is to export these dollars back to US and the world and buy other assets.

This third option is the option that is not only practiced in today’s economic order but has also become so lucrative because now the US need not pay the Chinese for its goods with money but rather with “debt” – vendor finance.

So essentially this means that consumers of the US can buy goods they can’t afford and more importantly the government can maintain a military and fight the wars it can’t really afford!!! So essentially this US runs a CAD (current account deficit) and in return Asia funds the fiscal deficit of US. Now there are four combinations that can happen with these two variables and let’s see how it would impact the world. So the (CAD can go up and down) *(Fiscal Deficit of US can go up and down) = 4 combinations:

Case 1: The Current Account Deficit goes down and the Fiscal Deficit goes up: Well clearly an unsustainable and an instant Armageddon situation for the world as the growth in the developing world slows, the increasing fiscal deficit would be hard to finance by the US and what’s worse is the fact that the slowing of growth would lead to the emerging world selling US assets and the Fed ending up monetizing debt thus driving the whole world into a cataclysmic collapse while the commodity prices shooting the roof. Not an unrealistic scenario though if the consumer in US doesn’t pick up (the CAD goes down as import reduces) and the US government would end up spending more to substitute for the consumer contraction thus increasing the fiscal deficit.

Case 2: The Current Account Deficit goes down and the Fiscal Deficit goes down: Well this can happen in situations; one if the US again enters into recession which as government spending contracts and the Consumer also contracts obviously not a good situation for the world. However the other situation is bloomier which is the US discovers some export industry to bank upon and the investment cycle kicks in because of that followed by the consumer buying US goods and thus the government pulling back. Clearly this is the only situation in which the world would blossom again but as of today looks unlikely. To make it happen in my opinion the US should invest in industries of tomorrow i.e. Clean Energy and high tech (more on this a little later)

Case 3: The Current Account Deficit goes up and the Fiscal Deficit goes down: Well not a scenario that goes hand in hand. This simply implies that American consumer buys more but that clearly shows that the American economy is still structurally weak this would imply that the fiscal deficit can’t really come down. So I would simply strike off this case.

Case 4: The Current Account Deficit goes up and the Fiscal Deficit goes up: Well this is one scenario which can either prolong this problem and can indeed make it even graver or if played out well can even solve this crisis!!! This combination would continue what is happening in the world that is the emerging markets growing, US getting into more debt which would be bought by Fed and by Asia but here is what this strategy can buy “Time” this strategy buy us time and like any option this also has it’s time value. If US does invest during this time in technologies of the next generation that can really shoot up the productivity i.e. green energy, high tech like maybe high tech agriculture, nanotechnology, nuclear technology etc. then it would get rid of it’s structural deficiencies and can move gradually from a case of high CAD and Fiscal deficit to a low CAD and Fiscal Deficit and thus sustained growth, however if nothing changes it would mean that US ends up into a bigger debt spiral and this would mean that someday someone would realize that would they are holding is a complete junk that they would end up selling and thus inducing even more selling bringing this world to a complete financial breakdown.

So to conclude I would say that Ironically US running Current Account and Fiscal Deficits is the only hope for this world. Spending on Current Account and Fiscal Deficit is what I call the "Time Value" of the option on "Growth",.

I believe we are just a few year away from witnessing which turn this world takes, will this debt spiral and money printing lead us to a financial collapse and a new world order emerging out of it or will the US invest in these new technologies and seal another US decade or perhaps even a century for itself. Till that happens as I say that there be chaos before the pattern emerges……………..

Where All Ends Meet… Why a continued US Fiscal & Current Account Deficit are essential

This article is a continuation of my previous thoughts; probably this title suited it more. In the first article I tried to argue how the value of the currency is linked to the nation’s productivity. In this article we would explore the currency issue further and link it with the basic economic framework of today.

Let’s first explore as to how the credit is created and how money supply can lead to growth or bust and finally how we are sitting on a pile of trash. A borrower deposits 100 rupees with a bank, the bank is expected to maintain a cash reserve ratio of 10% which essentially means that he can keep 10 rupees and lend out the 90. This 90 again finds its way into the banking system and again 9 rupees is held back and 81 rupees are lent out (ofcourse assuming there is sufficient demand for that liquidity) and as this process goes on the 100 rupees of deposit becomes 1000 rupees in credit. This is called magic in common banter and money multiplier in economic talk. Now if the demand for credit is greater than this credit of 1000 rupees the Central Bank follows an accommodative monetary policy and supplies some more cash into the banking system. Had the country been following a gold standard the Central Bank would have been restricted in the amount of cash it could infuse thus restricting this growth. However since the human demand is infinitum, the key to success of this “Non Collateralized Monetary Policy” and I will come back on this term is for the Central Bank to pull out the liquidity if the demands are unjustified, which brings me to the second point… What does one means by unjustified demand….

The term unjustified demand in my opinion is any demand which would lead to investments that end up generating insufficient cash flows. Ofcourse in a capitalistic economy where risk taking is at the core and failures are part of life there are bound to be unprofitable investments and so that is why the “interest rates should be what they should be”, the cost of money should correspond to the risk in the investment but in any case if the overall risk of non-profitable investments increase in a certain sector the Central Bank has the tools i.e. adjusted risk weightages of loans given in that sector to deal with it and if this risk increases on an overall macro level the Central Bank should stop providing that extra liquidity or should even pull it out by adjusting the interest rates or changing SLR or CRR ratios. High interest rates act as a deterrent for risky investments as the cost of failure is higher and so my first issue with the current setup is that the interest rates have been so low for so long that it has inevitably turned the whole world into a casino.

Before I link this with the fiscal and Current account aspects let me quickly explain what I meant by “Non Collateralized Monetary Policy”…. Now when the bank issues loans against the deposits it basically issues cheques. So let’s say it has 100 rupees in it’s vaults, the bank can issue a cheque worth 90 rupees and give it to someone in form of loan. The collateral for that 90 rupees is the 100 rupees kept in the bank vaults. In a similar way the currency note or the cash number in your bank account that you are holding is a cheque that the “Great Central Bank” is issued you, but considering the amount of money supply in the economy what is the collateral held by these Central Banks…. Well China holds over 1 trillion dollar resevers in form of dollars so let’s see what reserves the US central bank holds whose dollars China is holding as collateral….

Ready……….. Nothing!!! The world is holding cheques issued by a bank that has no collateral to back it…… Blind following the Blind, well maybe not in every case and this we would explore a little later but anyways as the countries start realizing this more they would move towards hard assets from paper assets and so the commodity bull market of last 10 years has still some distance to go.

I just realized the article would probably become huge if I bring in the next point which is linking today’s monetary policy with the 2 critical components in economics Fiscal spending and Current Account. So with this thought till next time……………. Maybe in this case I should have changed the title :)

The Currency Conundrum…What’s the real worth -1

“He who tampers with the currency robs labor of its bread.” ~ Daniel Webster

The brashness with which the Central Banks across the globe, well really in the States (openly) and in Japan and the Euro area (covertly) are printing money raises the questions as to the real worth of the currency or rather more fundamentally from where does the currency attains its value. I would be less opinioned in this part of the article and would just talk about one most the most fundamental tenet of economy “The Currency”.

I would like to divide this topic into two parts, in this part I would talk about the fundamentals and basics of currency and as I said by being less opinionated (although would be hard….) and in the second my opinion on the endgame of the current situation. Nevertheless it is critical that the readers must understand that there is difference between working for money (that’s what most people end up doing) and working for wealth. Working for money is a complete fallacy as money can be printed in as much quantity by the Central Banks and thus keeping money in cash is the biggest mistake that working class people fall for. Ok more on it in the next article let’s discuss about currency now……..

Some four decades back Milton Friedman came up with a simple but an epic equation PQ=MV, not only it produced déjà vu with another great work of E=mc² but following the monetarist approach of Friedman the world came out of the stagflation era by early 1980s. However please remember that like any economic variable growth (represented by Q in the equation) also responds to the relationship of marginal utility of money i.e. growth may increase as an increasing function of money growth followed by relationship of equality and finally as a decreasing function of monetary growth i.e. the relationship is linear only for certain period.

So after a sufficient history lesson let’s check the variables… (P – Price, Q-Growth, M-Money Supply and V-Velocity of money) the velocity of the money is generally a constant over the short and medium term except in cases of hyperinflation or severe deflation when it spikes and infact is the most important determinant of these two situations. Now the first question to answer is if returning to something like a gold standard would work. Well the answer to that is an affirmative ‘No’ because it is simply too restrictive. Let’s see how does the monetary policy accommodates for growth. Assume an economy X produces 100 units of goods/unit of asset, each costing 1 $ and let there be 100 $ in circulation (assume velocity of money to be 1) owing to some discovery or investment (IT, better production knowledge, education, roads etc.) to an increased productivity and this causes the economy to produce 150 units of goods/unit of asset. To support this if the currency under circulation is not increased then this could have a serious deflationary impact (since velocity of money remains constant over short and medium term period) and this could hamper growth. So the Central bank should increase money supply. Having a gold standard can cramp up this growth as that would mean that the currency supply can increase only marginally.

What this means is that the value of the currency actually maps the productivity. Let’s take a hypothetical example of two countries X and Y a labour in country X produces 2 units while in country Y produces 1 unit and let’s assume there is just one unit of labour available. Now if the value of currency is same in both the countries then it would imply that a citizen of country Y can buy 2 units while the citizen of country X can buy just 1 unit. Well not really all this would do is that the citizens of country X would not be ready to sell anything to country Y at that price and this would lead to a devaluation of the currency of country Y.

Now there are certain ways of bringing about this devaluation and this is what I am going to discuss next

- Market demand and supply: In a floating rate regime the currency would automatically adjust under market forces
- A Sovereign Decree: In a fixed rate regime a decree can be issued changing the rate of the peg.
- Printing more money: A weakened currency can have several consequences:
- It will no doubt make your goods attractive by bringing a nations currency more inline with its productivity
- It can reduce the value of the internal liabilities
- It may increase the value of external liabilities
- It may increase notional value of assets (not real value) atleast temporarily and may lead to internal inflation and in some cases global inflation
- More importantly it can have severe effects on the critical component called ‘Velocity of Money’ and if that happens it simply means that the Central Bank basically has lost control over its monetary policy.

Let me emphasize that ultimately the foreign currency must find its way to the issuer in exchange for some goods or services. If the productivity is of that country is less, then its currency has to depreciate to make it a fair exchange and infact market forces generally ensure this to be the case at most times in a floating rate regime.

I have tried to set the context in this article about currency and monetary policy, in the next part I would explore the critical relationship between Money Supply and Velocity of Money and comment upon the current monetary policies.

The final bubble....... And the empire falls

Man has come a long way since the epoch of modern day history but even today if one views the world from the heights of the Acropolis or from the shallows, it becomes amply clear that not much has changed, humanity is still slave to the natural laws of cyclicality and creative destruction, which means that no strong how strong the global power is it paves way for another global player to rise to supremacy. If anything that has changed is that the time at ascendancy has become smaller. What's more the reasons of fall are similar and the fluttering attempts to maintain supremacy exactly the same.

Let me emphasize that the rise of any empire is governed by economics of wealth and albeit that also becomes the reason of it's fall. As by now you must have gauzed about which nation I am going to talk about in this article so let me take you back in time to relive some other great powers in medieval-modern human history. It should be interesting to note that the fall from divinity is swift contrary to the popular perception of a gradual decline. Let's start with the mighty Great Britain, not so long ago it controlled an Empire that was greater than the dream of the great Macedonian Emperor and the scourge of that Fascist Dictator and it all fell apart in the blink of an eye. After the end of the WW II Britain was burdened under that same four letter word that broke the back of every empire "Debt"; wonder why are they all four lettered. The cost of managing it's empire became unbearable and it all began to fell apart starting with India. More interesting is the fact that the harbingers of this was omnipresent as they are today, as the debt burden of Britain started increasing in the midst of 1930s due to the Great Depression, it's military expenditure started declining and then there came a tipping point when the cost of servicing it's debt exceeded it's military expenditure and I think that was the end game for Britain although the chapter was filmed at a later date. This relationship is not a freaky statistic correlation but a part of a well thought out analysis. What this indicated is that the empire has overstretched the limits of expansion and the Marginal gains from any further expansion is negative and hence it can only go down from here.

It's similar to any war wherein when the marginal cost of servicing an overstretched army becomes negative, the army can go no further and the whole thing trips over. In the real world everything acts at the margin, for a period of time nothing seems to happen and then suddenly something shakes the world. The realty is that the world is a mixture of Newtonian and Quantum laws, just as an electron is excited to the next higher level only when a certain amount of energy is given to it in a similar way actions of market participants keep on fueling an event till that slight marginal input makes it to explodes.

Today the current power is moving on a path that has been traversed by every known superpower in the history ever since Nero. Some two centuries back Rome faced a similar dilemma wherein it had stretched it's forces beyond their marginal peripheries and soon suffered with ever increasing Trade and Fiscal deficit; sounds familiar!! read more......

Ofcourse to fund this twin deficit the empire was soon engulfed under a quantum of debt, coupled with deflation due to the bullion hoarding..... and then came the final blow; to get out of this debt and deflation trap the currency was debased and so was the empire...... Today the characters remain the same, what has changed is only the face and the writing is on the wall, all it requires is a stamp of time.