Western central banks maybe holding less gold than they claim


The price of gold as on January 1, 1979 was $226 per ounce (one troy ounce equals 31.1 grams).
On August 6,1979, Paul Volcker took over as the Chairman of the Federal Reserve of United States. The price of gold on that day was at $282.7 per ounce having risen by 25% since the beginning of the year.
When Volcker took office things were looking bad for the United States on the inflation front. The rate of inflation was at 12%. The price of gold against the dollar had also been rising at a very past pace. The price of gold on August 31, 1979, at the end of the month in which Volcker had taken charge was at $315.1 per ounce, up by 11.5% from the day he took charge.
The world had clearly lost its faith in the dollar. By the end of September 1979, gold was quoting at $397.25 per ounce having gone up by 26% in almost one month. And so the dollar would continue losing value against gold. On January 21, 1980, five and a half months after Volcker had taken over as the Chairman of the Federal Reserve of United States, the price of gold touched an all time high of $850 per ounce. In a period of five and a half months the price of gold had risen by an astonishing 200%. What was looked at as a mania for buying gold was essentially a mass decision to get out of the dollar and buy gold.
The mania ended quickly and the very next day(i.e. on Jan 22, 1980) the price of gold was down by around 13.2% to $737.5 per ounce. The price of gold kept falling over the next two decades and reached a low of $252.8 on July 20, 1999.
The central banks of Western Countries (i.e. United States, Canada, Japan and Europe) were the largest hoarders of gold. With gold prices having fallen to levels of $250 per ounce, the value of their gold holdings had taken a tremendous beating over the years. Also sitting in their vaults gold wasn’t earning any interest either. Hence they started lending out this gold to banks known as bullion banks.
As Eric Sprott & David Baker write in a recent report titled Do Western Central Banks Have Any Gold Left? “It made perfect sense for Western governments to lend out (or in the case of Canada – outright sell) their gold reserves in order to generate some interest income from their holdings. And that’s exactly what many central banks did from the late 1980’s through to the late 2000’s.”
This allowed the Western central banks to put gold which is essentially a useless asset to some use. As James Turk and John Rubino write in The Collapse of the Dollar and How to Profit from It – Make a Fortune By Investing in Gold and Other Hard Assets “Lending, for instance, involves, the central bank transferring gold to a major private bank, known as bullion bank, which pays the central bank a small-but-positive interest rate, then sells the gold on the open market,” write the authors. This allowed central banks to convert their gold into cash and also earn some interest on it.
Sprott and Baker suggest that “Collectively, the governments/central banks of the United States, United Kingdom, Japan, Switzerland, Eurozone and the International Monetary Fund (IMF) are believed to hold an impressive 23,349 tonnes of gold in their respective reserves, representing more than $1.3 trillion at today’s gold price.”
While it did not matter what central banks did with their gold in the eighties, nineties and even in the 2000s, things have changed now. These countries now are highly indebted and are printing money left, right and centre to repay their accumulated debt as well as get their economies up and running again.
Given all the money printing that is happening it would be good for them if they do have some gold left in their vaults and haven’t lent out all of it. “The times have changed however, and today it absolutely does matter what they’re doing with their reserves, and where the reserves are actually held. Why? Because the countries in question are now all grossly over-indebted and printing their respective currencies with reckless abandon. It would be reassuring to know that they still have some of the ‘barbarous relic’(as John Maynard Keynes referred to gold) kicking around, collecting dust, just in case their experiment with collusive monetary accommodation doesn’t work out as planned,” write Sprott and Baker.
The central banks do not have to declare about the gold that they are lending out. So it continues to show as a part of their book even though they have lent it to bullion banks, which in turn have gone ahead and sold that gold. As the authors point out “Under current reporting guidelines, therefore, central banks are permitted to continue carrying the entry of physical gold on their balance sheet even if they’ve swapped it or lent it out entirely. You can see this in the way Western central banks refer to their gold reserves. The UK Government, for example, refers to its gold allocation as, “Gold (incl. gold swapped or on loan)”. That’s the verbatim phrase they use in their official statement. Same goes for the US Treasury and the European Central Bank.”
So the actual physical gold with the central banks might be much lesser than they claim. Also, Sprott and David feel that central banks are continuing to “lend” out their remaining gold reserves. This they conclude through a mismatch in the supply and demand for gold. The demand from the five main sources i.e. gold being bought by central banks all over the world, US and Canadian mint sales of gold coins, gold bought by exchange traded funds, Chinese consumption of gold and the Indian consumption of gold has increased by 2,268 tonnes over the last 12 years. Over and above this there is demand from private buyers of gold which go unreported.
“Then there are all the private buyers whose purchases go unreported and unacknowledged, like that of Greenlight Capital, the hedge fund managed by David Einhorn, that is reported to have purchased $500 million worth of physical gold starting in 2009. Or the $1 billion of physical gold purchased by the University of Texas Investment Management Co. in April 2011… or the myriad of other private investors (like Saudi Sheiks, Russian billionaires, this writer, probably many of our readers, etc.) who have purchased physical gold for their accounts over the past decade. None of these private purchases are ever considered in the research agencies’ summaries for investment demand, and yet these are real purchases of physical gold,” write Sprott and David.
Hence, the gold demand figures that are actually reported are actually underreported as many of the investments in gold aren’t taken into account. And thus demand is made to match supply of gold which is believed to be at 3700 tonnes. If more accurate demand numbers were to be used a huge discrepancy between demand for gold and the supply of gold, would be revealed. And the demand side would exceed the annual supply of gold. “In fact, we know it would exceed it based purely on China’s Hong Kong gold imports, which are now up to 458 tonnes year-to-date as of July, representing a 367% increase over its purchases during the same period last year. If the imports continue at their current rate, China will reach 785 tonnes of gold imports by year-end. That’s 785 tonnes in a market that’s only expected to produce roughly 2,700 tonnes of mine supply, and that’s just one buyer,” write the authors.
So the question is where is all this gold coming from? It might very well be that Western Central Banks are continuing to lend gold to bullion banks which in turn are continuing to sell this gold. As Sprott and David point out “They (i.e. Western Central Banks) are the only holders of physical gold who are capable of supplying gold in a quantity and manner that cannot be readily tracked… it can only lead to the conclusion that a large portion of the Western central banks’ stated 23,000 tonnes of gold reserves are merely a paper entry on their balance sheets_– completely un-backed by anything tangible other than an IOU from whatever counterparty leased it from them in years past.”
What are the implications of this on the price of gold? As the Turk and Rubino write “Because the bullion banks have promised to eventually return the borrowed gold to the central banks, they are, in effect, “short” gold. That is, at some point in the future they are obligated to buy gold in order to repay the central banks.” And when this happens “the result will be a classic “short squeeze,” in which everyone tries to buy at once, sending gold’s exchange rate through the roof.”
Of course, the assumption here is that central banks demand their gold back. Whether that happens, remains to be seen. As Sprott and David conclude “At this stage of the game, we don’t believe these central banks will be able to get their gold back without extreme difficulty, especially if it turns out the gold has left their countries entirely.We might also suggest that if a proper audit of Western central bank gold reserves was ever launched…the proverbial cat would be let out of the bag – with explosive implications for the gold price.”
The article originally appeared on www.firstpost.com on October 26, 2012. http://www.firstpost.com/economy/western-central-banks-may-hold-less-gold-than-they-claim-503343.html
 
(Vivek Kaul is a writer. He can be reached at [email protected])
 

Gadkari cannot say “mere paas saasu ma hai”


Vivek Kaul
So the tables seem to have turned. The story has moved on from Robert Vadra to Nitin Gadkari. Veerapa Moily, the Union Corporate Affairs Minister, had been quick to jump to Vadra’s defence and had said “I have already verified these allegations and no wrongdoings have been found in any of the six Robert Vadra-owned companies.”
Now with allegations against Gadkari coming out thick and fast, Moily has jumped in at the same quick speed and ordered an inquiry against Gadkari. “I have told our ministry to make some discreet inquiry to find out what exactly is the matter… are there any violations of the Companies Act?” said Moily. He also added the ministry would probe it as the matter was in the public domain. “It is all coming in the newspapers,” he said.
What is interesting here is that Vadra’s dealings with DLF are also in the public domain and the news was all coming in the newspapers, as Moily put it in Gadkari’s context. That being the case shouldn’t Moily have ordered a “discreet inquiry” against Vadra as well?
Digivijay Singh, the chief muck raiser and one of the General Secretaries of the Congress party, has written a letter to the Prime Minister Manmohan Singh. “Gadkari has also said he is open to a free and fair investigation. [He] being the national president of the BJP, it is in the fitness of things that his case is properly investigated and he gets a fair opportunity to prove his innocence and clear his name,” wrote Digvijay Singh in his letter to the Prime Minister. “A prime facie case does exist,” added Singh, and requested the Prime Minister to ask the Corporate Affairs Ministry to initiate an inquiry by the Serious Fraud Investigation Office.
There are two things that come out of this statement. In the Congress’ world view of things Robert Vadra remains a private individual. Though he must be the only private individual in the country who is being defended by some of the top Congress leaders (you can read a more detailed argument on this here). But Gadkari is not a private individual and hence he needs to be investigated. The second point is that Digvijay Singh sees a prima facie case existing for an investigation in case of Gadkari. I agree. But it also exists in the case of the Vadra-DLF dealings. I am sure Diggi Raja would have a different view on that.

Before I get into some other points let us try and understand what the Gadkari case is all about. Gadkari calls himself a social entrepreneur. He was the Chairman of Purti Sugar Ltd till about fourteen months ago. “Purti Sugar Ltd. is a sort of cooperative that is owned by the farmers it was meant to benefit. It’s true that the list of shareholders is long, about 10,000 names, that carry the flavour of rural Maharashtra. But farmers (if they are, indeed, farmers) own only 10% of Purti. Mr Gadkari himself owns only 200 shares. The bulk of Purti is owned by just 18 companies. These companies invested about Rs 2-4 crore each, to form the bulk of Purti’s paid up capital of Rs 68 crore. This, essentially, was Purti’s start up money,” Sreenivasan Jain recently wrote in DNA. Purti Sugar is located at Khursapar (Bela) village near about 60 KM from Nagpur.
So far so good. What makes things interesting is the fact that some of the companies that invested in Purti Sugar were not found to be operating at their registered addresses. “When our reporters paid them a visit at their registered addresses, they (surprise, surprise) hit a dead end.Two of the firms — Swiftsol India and Earnwell Traders — are registered at a chawl in the Mumbai suburb of Malad, surprising for companies which have invested about Rs 4 crore in Purti. None of the residents at the given addresses had heard of Swiftsol or Earnwell. The same dead end at the addresses of Chariot Investrade, Regency Equifin, Leverage Fintrade, etc scattered across suburban Mumbai and Kolkata,” wrote Jain.
This is something that a report in The Times of India said as well. “According to records with the Registrar of Companies, five private limited companies with shareholdings in Purti Group—Nivita Trades, Swiftsol (India), Rigma Fintrade, Ashwami Sales and Marketing and Earnwell Trades—are registered in and supposedly operating from a room in Dube Chawl on Andheri-Kurla Road (seen at left). Four other shareholders—Jasika Mercantile, Leverage Fintrade, Regency Equifin and Chariot Investrade—are registered in an under-construction building meant to house slum-dwellers under the SRA scheme.”
What complicates matters further is the fact that Manohar Panse, who used to be Gadkari’s driver, was also a director in many of these companies. A couple of employees of Purti and even Gadkari’s accountant were directors in these firms.
It is well known that businesses tend to operate through a web of companies when they want to hide the real owner’s identity. Also it is easier to channelise ill gotten wealth through a maze of companies. Prima facie that is what seems to be happening in the case of Purti Sugar as well. So the accusation against Nitin Gadkari is pretty strong and hence an investigation is called for.
Robert Vadra was smart on this account. He also operates through several companies (Sky Light Hospitality, Sky Light Reality, Real Earth Estates, North India IT Parks, Blue Breeze Trading etc). But the ownership in each and every case can be easily traced back to him and his mother Maureen.
Getting back to Gadkari, one of the invetors in Purti was Ideal Road Builders(IRB). As Jain writes “Ideal Road Builders purchased shares worth Rs 1.85 crore in Purti in 2001, just over a year after Mr Gadkari demitted office as Maharashtra’s public works department minister. During his tenure, Ideal was awarded a number of contracts by the PWD department, which eventually led to it becoming one of Maharashtra’s leading toll road companies. DP Mhaiskar, founder of Ideal Road Builders, also bought shares worth about Rs 2 crore in Purti. Together, IRB and Mr Mhaiskar control about 8% of Purti Group… In 2010, Purti Group received a secure loan of Rs 165 crore from a company called Global Safety Vision, which has DP Mhaiskar as its director. With this one loan, Purti was able to repay all its outstanding debt.”
So the question being asked here is did Mhaiskar and IRB invest in Purti because Gadkari as the PWD minister awarded contracts to IRB? Gadkari was the PWD minister in the Shiv Sena-BJP government that ruled Maharashtra in the mid and late nineties. Hence, a case for a quid pro quo seems to exist and can be established if a proper investigation is carried out.
In case of Robert Vadra and DLF, things were a little different. DLF gave Vadra an advance of Rs 50 crore against a piece of land of 3.5 acres that Vadra sold to DLF. This advance was paid in installments starting in the year 2008—2009(the period between April 1, 2008 and March 31, 2009). The advance stayed on the books of Vadra for a period of between three to four years. An advance is typically given short term. DLF explained this to be a normal commercial transaction but has been unable to tell us about other cases in which it carried out a similar transaction. The advance was essentially an interest free loan to Vadra. Other than this DLF gave Vadra’s companies other advances as well. It also gave an unsecured loan of Rs 5 crore to Real Earth Estates Private Ltd, a Vadra company.
Vadra used this money to go on a property and flat buying spree in Rajasthan and Haryana. (You can read about it here and here). But what is difficult to establish is how did DLF benefit from all this? Allegations are being made that the Congress government in Haryana went out of its way to favour DLF. Was this because DLF was being nice to Vadra? This business-politics nexus is not easy to establish as it is in the case of Gadkari and IRB.
Other than the government breathing down Gadkari’s neck, the Rashtriya Swayamsevak Sangh (RSS) which installed him as the president of the Bhartiya Janata Party seems to have asked him to come clean on all the allegations by the end of this month. Vadra on the other hand has the full support of his mother-in-law’s party.
At the heart of both the Vadra and Gadkari issues is the nexus between businessmen and politicians. The basic difference is that Vadra is Sonia Gandhi’s son in law and Gadkari is not. To conclude, the smartest thing that Vadra ever did was to marry Priyanka Gandhi. “Mere paas Saasu Ma Hai,” Vadra can say proudly. Gadkari meanwhile needs to consult a good astrologer and figure out when his stars will turn around.
The article originally appeared with a different headline on www.firstpost.com on October 24, 2012. http://www.firstpost.com/politics/why-sonias-son-in-law-is-better-off-than-rsss-favourite-son-501065.html
(Vivek Kaul is a writer. He can be reached at [email protected])
 

IMF, debt and the death of traditional banking


Vivek Kaul
Some of the earliest banks started operating in Italy somewhere in the twelfth and thirteenth century. These banks were essentially banks of deposits. Merchants deposited their money in the form of gold and silver coins and bars with these banks for safekeeping. The bank in return issued a receipt against this deposit. The receipt could be shown when the coin money was to be withdrawn. Hence, the earliest banks were “banks of deposits” or “store houses of wealth”.
As time went by some banks developed a reputation for probity and honesty. This led to merchants who had accounts with these banks simply transferring receipts of these banks when they had to pay one another instead of going to the bank showing their receipt and withdrawing their gold or silver to pay each other.
Hence, these receipts started functioning as “paper” money. In sometime people running these banks also figured out that their depositors do not all come all on the same day asking for their deposits back. So in the intermittent period they could either lend out the gold/silver to others or simply print fake deposit receipts not backed by any gold or silver bars or coins, but which looked exactly like the original deposit
receipt. Of course they charged a fee for this.
A similar trend seems to have played out in London in the seventeenth century where merchants took to depositing money with the goldsmiths. This happened after King Charles I seized around £130,000 in bullion, deposited by the city merchants at the Tower of London in 1640.
Like the Italian bankers the London goldsmiths also figured out that they could keep lending the gold that was deposited or simply issue fake receipts, and make more money in the process. As Hartley Withers writes in his all time classic The Meaning of Money:
The original goldsmith’s note was a receipt for metal deposited. It took the form of a promise to pay metal, and so passed as currency. Some ingenious goldsmith conceived the epoch-making notion of giving notes, not only to those who had deposited metal, but to those who came to borrow it, and so founded modern banking.
This is how banks evolved from being just banks of deposit to being banks which gave out loans as well. And to this day they work in the same way. This change also gave bank a right to create money out of thin air, something only the governments could do till then.
Let’s try and understand how that happens. Let us say an individual/institution/government deposits $1000 with a bank. Let’s assume that the bank in turn keeps 10% of the deposits (for the ease of calculation) and lends out the remaining 90% or$900 in this case. It thus manages to create an asset from someone else’s money. So we also have a situation here were the money supply has increased by $1900 ($1000 money deposited with the bank + $900 loan given by the bank).
The $900 loan gets deposited with another bank which in turn lends $810 (90% of $900) and keeps $90 with itself. The $810 is deposited in another bank and leads to a loan of $729. So the banks can keep creating money out of thin air and the money supply can keep going up.
This ability of banks to create money out of thin air is believed to be behind the boom and bust cycles (also referred to as business cycle fluctuations) that the world economy has seen over the last three decades. As J write in The Chicago Plan Revisited, a research paper released by the International Monetary Fund (IMF) “sudden increases and contractions of bank credit that are not necessarily driven by the fundamentals of the real economy, but that themselves change those fundamentals.” When banks feel optimistic, they create money out of thin air by lending it and in the process create the boom part of the business cycle. But when the banks feel pessimistic about economies they may call back their loans or not give out loans at all, and in the process create the bust part of the cycle.
The IMF authors feel that this ability of the banks to create money out of thin air needs to be reined in. The ability to create money should rest only with the government. For this to happen they have revisited The Chicago Plan. The plan was first proposed in the aftermath of The Great Depression of the 1930s.
“During this time a large number of leading U.S. macroeconomists supported a fundamental proposal for monetary reform that later became known as the Chicago Plan, after its strongest proponent, professor Henry Simons of the University of Chicago,” write Benes and Kumhof. Over the years Irving Fisher, who was America’s greatest economist of that era, also came to be closely associated with it.
This plan strikes at the heart of how conventional banking works. A bank raises money as deposits and lends it out as loans. The Chicago Plan separates the deposit and lending functions of the bank. So when $1000 is deposited with the bank, the bank will have to hold the entire money with it and act as a “bank of deposit”. It will not be able to lend this money out. So bank deposits cannot fund its loans.  This also eliminates the chances of bank run totally. Even if all the customers of the bank come and demand their deposit from the bank at the same time, the bank can easily repay them.
The question that crops up here is that if the bank does not lend out its deposits how does t fund its loans? As per the Chicago Plan the loans will have to be funded separately from sources which are not subject to bank runs. Hence, loans would be funded out of retained earnings of the bank. They could also be funded out of the bank issuing more shares to investors. And a third source of funding, which is at the heart of the Chicago Plan, would come from the government.
The bank will have to borrow money from the government to fund its loans. The government can ‘print’ this money that it will lend to banks. Hence, this is the way the government can control money in the economy. When it wants to expand money supply it can lend more and vice versa. Banks cannot create money out of thin air because they are not allowed to lend their deposits.
“The control of credit growth would become much more straightforward because banks would no longer be able, as they are today, to generate their own funding, deposits, in the act of lending,” write the IMF authors.
Also, the government will lend against certain assets of banks. These assets can be included while calculating the net debt of the government and deducted from its total debt. The government can also buy back government bonds held by banks against the loans it will give to banks to fund their loans. Either ways the net debt of the government could come down dramatically.
The government could also use the same method to buy out private debt from these banks. It could buy back private bonds against cancellation of government loans to these banks. And why would the government do that? “Because this would have the advantage of establishing low-debt sustainable balance sheets in both the private sector and the government, it is plausible to assume that a real-world implementation of the Chicago Plan would involve at least some, and potentially a very large, buy-back of private debt,” write the IMF authors.
That’s the plan. But the bigger question that the plan does not answer is how much can governments be trusted when it comes to printing money?
A slightly shorter version of this article appeared in Daily News and Analysis on October 24, 2012.
(Vivek Kaul is a writer. He can be reached at [email protected])
 
http://money.msn.com/investing/no-debt-no-cuts-no-new-taxes
 

‘World is trapped in low growth; there is no magic cure’

Satyajit Das is an internationally renowned derivatives expert. His works include Swaps/Financial Derivatives Library, a four-volume, 4,200-page reference work for practitioners on derivatives, and the best-selling Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives. His latest book Extreme Money – Masters of the Universe and the Cult of Risk deals with the messy details of the 2008 financial crisis, the lessons from which have still not been learnt.
In this freewheeling interview with Vivek Kaul, he talks about how the world is trapped in a slow growth cycle and how cheap money is more likely to set off asset price bubbles than stimulate growth when people are trying to cut debt levels. This in the second and concluding part of the interview, the first part being published on Saturday (read here).
In a recent column you wrote “Mr Economy has…not made the recommended changes necessary for a return to full health”. Could you elaborate on that?

The economic and financial problems of the global economy have a number of inter-related causes and these have barely begun to be addressed. Excessive debt was one of the problems. But five years on, borrowing levels remain unsustainable. Debt levels for 11 major nations have increased from 381 percent of GDP in 2007 to 417 percent of GDP in 2012. Debt has increased in Canada, Germany, Greece, France, Ireland, Italy, Japan, Spain, Portugal, the UK and the US. There has been a shift of debt from private lenders to governments.  But that just shifts the problem and has triggered the sovereign debt crisis.

Satyajit Das in this file photo.
Have other causes been addressed?

Another cause was global imbalances – major current account surpluses and deficits with China, Japan and Germany exporting more than they import. There has been some improvement because of the slowdown in economic activity and the reduction in the availability of financing. But the large exporting countries remain resistant to abandoning their export-based economic model. Excessive financialisation (debt, complex products, etc) was another factor.
Little progress has been made in bringing the banking system under control.  In fact, low interest rates and poor returns in many asset classes has set off a new boom in financial products – even things like CDOs (collateralised debt obligations) are now coming back into fashion. Most importantly, the world hasn’t learnt that perpetual growth and improvements in living standards driven by financialisation is not sustainable. But just because you ignore the facts doesn’t mean that they go away.
You recently wrote “physical examination revealed that the US is in marginally better condition than other organs – the “cleanest dirty shirt” is the expression.” What do you mean by that?
People have been quick to proclaim the Chinese or BRIC century. I would be cautious about that. I think the US will do better than most people think, although they will not be immune to some of the broader issues. The US remains the world’s largest economy, around 25 percent of global GDP, almost twice the size of China, the second largest economy. America remains relatively wealthy, with per capita GDP of around US$50,000, five or six times China’s per capita income. The US has significant financial assets despite losses caused by the financial crisis. Structurally, the US can function better because it can operate successfully as a closed economy.
What do you mean by that?
America’s economy is focused on its large domestic market. It is less exposed to trade (around 15 percent of GDP) than other large economies. American dominates key 21st century industries, such as technology and software, pharmaceuticals, complex manufactured products (aerospace, defence hardware, heavy machinery), entertainment and services. The US remains a major food producer. It is a net exporter of food, controlling almost half of world grain exports. It is also rich in mineral resources. Historically dependent on oil imports which make a substantial part of its $600 billion trade deficit, the US is cutting imports and increasing its energy independence through increased production of shale gas and oil.
The US also has greater policy flexibility. The US dollar remains the world’s reserve currency. The US borrows in its own currency. There is a ready market for its securities, both domestically and internationally. The US also has favourable demographics. It has high population growth relative to other industrialized countries, which have below-replacement fertility rates. Also, it is worth remembering that the US is, by a considerable margin, the pre-eminent global military power.
How do you view things in Europe? Do you see the euro surviving?

The survival of the euro is an unproductive tangent, beloved of commentators. Whether or not it survives is largely irrelevant. Most European countries have high debt levels, budget and trade deficits, social spending inconsistent with tax revenues and poor industrial competitiveness (with some exceptions). They are tied together by a rigid monetary system and inflexible currency arrangements. The European banking system has large exposure to sovereign bonds issued by peripheral nations. Intellectually and institutionally, Europe is unable to deal with its debt crisis.
Europeans believe stabilisation and recovery can be achieved through greater integration. Even if issues of national sovereignty can be overcome, integration will not work. Unsustainable levels of debt do not magically become sustainable by changing the lender or guarantor. The monetary arithmetic of European debt problems is that the EU and Germany, its main banker, do not have enough funds to rescue the beleaguered eurozone members. Austerity would doom Europe to a prolonged and severe recession as the debt burden is worked off. The alternative, a debt write-off, would result in a significant loss of wealth for the mainly Northern European lenders, triggering an economic contraction and prolonged period of economic stagnation. It’s Catch-22.
You recently wrote ” Mr Economy is delusional, believing complete recovery is imminent. Presented with contrary evidence, you quoted philosopher Friedrich Nietzsche: “There are no facts only interpretations”. Could you elaborate on that?

Everyone now sees what they want to see in the news flow and policy announcements. Financial markets have largely decoupled from the real economy. Investors have this Pavlovian reaction to interest rate cuts and further quantitative easing. Firstly, other than lowering the cost of carry, these cuts are meaningless outside the specific assets that the central banks are buying. Secondly, the policy actions are a response to low growth, poor investment, unemployment, etc, all of which are negative for risky assets. Thirdly, there is minimal evidence that the low rates, etc, are actually having much effect. Yet, everybody believes that they are the right remedy. Strange!
You quote economist Wynn Godley: “Governments can no more control stocks of either bank money or cash than a gardener can control the direction of a hosepipe by grabbing at the water jet”. Why do you say that?


Financial markets have largely decoupled from the real economy.
To cure a disease you need to be able to diagnose it. Then, the treatment has to be reliably effective. Economics and economic policy lack these critical criteria. We know very little about how economies work. Our models are inexact – a former Goldman Sachs quant and a trained physicist Emmanuel Derman once pointed out that no one in finance and economics actually knew what a good model (in the sense that it applies in science) looks like. For example, we are still arguing about what caused the Great Depression and whether the policy measures – Keynesian spending, etc – actually worked. Our tools – fiscal and monetary policy – are also limited, especially currently. Keynesians want government spending financed by taxation or borrowing to restore Mr Economy’s health. But there is no evidence that it can arrest long-term declines in growth.
Could you elaborate on that?

Government spending boosts activity temporarily, but may create excess capacity in the absence of underlying demand. Nostalgia about President Roosevelt’s infrastructure projects during the Great Depression is misplaced. Excess electricity generation capacity from dam projects was only absorbed by wartime demand for defence equipment. In any case, as tax revenues have fallen due to slower economic activity, governments have already borrowed to finance large budget deficits. Governments’ ability to borrow to finance further spending is increasingly limited, without resort to innovative monetary techniques. The limits of government’s ability to borrow and spend are highlighted by the European debt crisis. Investors are increasingly concerned about public finances, becoming reluctant to finance nations with high levels of debt or demanding high interest rates.
That’s a very different point of view…

Having reduced interest rates to zero, central banks are changing the quantity of money. Central banks believe that they can keep rates low and print money to finance government debt purchases indefinitely. But greater government spending, lower rates and increased supply of money may not boost economic activity. Crippled by existing high levels of debt, low house prices, uncertain employment prospects and stagnant income, households are reducing, not increasing, borrowing. For companies, the absence of demand and, in some cases, excess capacity, means that low interest rates are unlikely to encourage borrowing and investment. The policies also have serious and destabilising side effects – new asset bubbles are being set off.
Could you explain this in detail: “Mr. Economy now has a serious chronic condition with limited prospects of a full cure? He might continue to live but in an impaired state of no or low growth for a prolonged period. The threat of a sudden life threatening seizure cannot be discounted. Constant management will be needed.”
Despite all the policy debate, I think there is no way out of this. We are now trapped in a period of low growth as we try to work off the excessive debt. There is no magic cure. The analogy is that you have a chronic but incurable condition and you need to manage it, but there is always the risk of a life threatening episode. You just are hoping you have enough drugs – printing presses to create money – to manage the slide. That’s it. Whether this is doable or not, I have no idea. It has never been done on this scale. Japan is the closest analogy. Also what this means in terms of social cohesion and the ability to maintain democracies are unknown. How can countries live with 25 percent unemployment (50 percent plus for under 25s) and for how long? We are not talking about an economic problem any more – you are talking about a profound test of society and the political system. That is what has to be managed. I hope our masters know how to do this!
One of the first things you say in Extreme Money is that “modern economies have ceased to make anything”. Why do you say that?
There was a shift from real engineering to financial engineering. It has several different elements. The UK was once the centre of manufacturing in the world. What does it make today? It is an economy built mainly on the financial services sector, property and services. The US makes more but has moved the bulk of their manufacturing offshore, to places like China and India, where it is cheaper. Individual businesses also have become financialised. At one level, firms used financial engineering – mergers and acquisitions, rejigging capital structures with more debt, share buybacks – to boost stock prices. It was also about financial services becoming integral to businesses – vendor financing of sales of cars, trucks or industrial equipment, trading assets to make money, etc. The reinvention of GE under Jack Welch, whereby GE Capital (which is like a financial institution) came to dominate the business, is a good example of this.
You write “business improvements are risky and very slow, akin to watching grass grow. *Financial changes are easier, more predictable and, most important quicker.” Can you elaborate on that?
Making money from real businesses – new products, investing, managing, operational improvements – takes time. Financial engineering is easier and a lot quicker.  For example, in the 1980s the yen appreciated, creating havoc amongst Japanese exporters, who were reliant on the cheap yen for competitiveness. Exporters changed strategy, moving production facilities offshore. Unfortunately, you cannot move a car plant to Mobile, Alabama, overnight. Japanese companies used financial speculation to cover up the weak profitability of their businesses. More recently, in January 2011, the Japanese carmaker Honda announced losses of  ¥15 billion ($180 million) from trading in shrimp and shellfish. There is a well-worn joke: “’How many workers does it take for Toyota to make a motor car?’ Answer: ‘Four. One to design it, one to build it and two to trade the long bond.’”
You write, “In their song Once in a Lifetime... David Byrne and The Talking Heads asked the question of the times: ‘How did you get that large automobile, the beautiful house, and the gorgeous wife?’” What’s this got to do with the financial crisis?
Underpinning the crisis is the fact that people wanted to get better living standards. Economic growth driven by financialisation was a means to that end. So the question that Byrne asked was the question everyone should have asked – how could we have got these things without the money and without seemingly have had to work for it. The fact is that much of the world didn’t pay its way. They borrowed from thrifty Asians and Germans to fulfil their needs for instant gratification. Unfortunately, it means that the borrowers are in trouble but ultimately the savers will have to pay for it all as governments wipe out their savings – either through financial repression, such as a low interest rates or high inflation.
Has the world learnt from the mistakes it made leading to the financial crisis?

No, not really. We keep repeating the same mistakes over and over. Hegel was correct when he observed that the only lesson of history is that no one heeds the lesson of history.
The interview originally appeared on www.firstpost.com on October 22, 2012.  http://www.firstpost.com/world/world-is-trapped-in-low-growth-there-is-no-magic-cure-498385.html
Vivek Kaul is a writer. He can be reached at [email protected]

Why’s the world going gaga over Gangnam Style?


Vivek Kaul
This year’s top video on YouTube has been Gangnam Style, a South Korean song which has taken the world by storm. And as happens with anything that becomes successful people have started to look for reasons behind its success. The song has been labeled the crossover from the East to the West something that took actor Jackie Chan three decades to achieve.
One article looking into the success of the song pointed out “Yet, its rise to universality is no fluke. Its success occurs when the world is shifting in radical ways, at a time when individuals, empowered by the information technology, can change world history”.
The problem with this argument is that the same information technology was available to other songs and artists. Take the case of the home grown Kolaveri Di which took India by storm early this year. Like Gangnam Style the song had been put up on YouTube and it was trending within days of its upload.  But its popularity never spread beyond India and Indians. How do you explain that? If information technology was the only criteria then Kolaveri Di should have been as big a hit as Gangnam Style, perhaps even bigger given that a sufficient number of Indians live in all corners of the globe.
So what is happening here? As Paul Ormerod explains in his new book Positive Linking – How Networks Can Revolutionise the World “As usual, we could in principle always tell a story after the event which purports to the account for the much further greater popularity of one video compared to another.” What this basically means is that it is easy to rationalise success by spinning a story around it once it has happened. But that doesn’t mean that those were the reasons for the success. Like the success of Kolaveri Di was attributed to its KISS (keep it simple stupid) strategy.
But the point is if identifying success was so easy we would all be doing it. Michael Mauboussin has a very interesting example in his soon to be released book The Success Equation – Untangling Skill and Luck in Business, Sports and Investing. Llyod Braun, Chairman of ABC Entertainment Group had proposed a show called Lost. It was a cross between Cast Away, a movie that featured Tom Hanks stranded on a desert island, and Survivor, a reality TV show about contestants who compete with one another in the wilderness and then vote to remove members  until only one person is left. “Michael Eisner, the CEO of Disney…heard the pitch and rated Loss a 2 on a scale of 1 to 10, 1 being the worst…Eisner later called the show “terrible”…Despite Eisner’s dim view of the show Lost was a smash success…Lost ran for six reasons and improved ABC’s slumping ratings and profits,” writes Mauboussin. The irony was that Braun who had proposed the show had already been fired by then.
So the history of cultural markets is full of such examples which were written off. As  Duncan J Watts writes in Everything is Obvious – Once You Know the Answer “The history of cultural markets is crowded with examples of future blockbusters – Elvis, Star Wars, Seinfeld . Harry Potter, American Idol – that publishers and movie studios left for read while simultaneously betting big on total failures.”
Another great example is Slumdog Millionaire which almost did not release and went to DVD straight away. The film went onto to win eight Oscar awards. The Hangover was another such hit. Made at a low budget of $35million, the movie went onto earn close to $468million.  Closer to home critics wrote of Sholay as dead ember and Hum Aapke Hain Koun as an extended wedding video. We all know what happened there. And since then scores of Hindi movies which are versions of these two movies have been made.
JK Rowling’s Harry Potter and the Philosopher’s Stone was rejected by 12 publishers till Bloomsbury agreed to publish it.  The first print run of the book was 1000 copies. Once the book was a super-hit it was deemed as a phenomenon waiting to happen.   Michael Maouboussin explains this tendency in a research paper titled Was Harry Potter Inevitable? “Our society often associates success with quality. In a fiercely competitive market, the thinking goes, only the best products rise to the surface. Once a product is a hit, whether a blockbuster movie or a bestselling book, we readily point to the attributes that make it so appealing,” he writes.
Maouboussin gives a more detailed explanation for the phenomenon in his new book. “If you are like me, you have a hard time accepting that there isn’t just a little special about The Da Vinci Code, Titanic, or the Mona Lisa. The very fact that they are so wildly popular seems to be all the evidence you need to conclude that they have some special qualities that makes them stand above all the rest. But all three were surprises. Our minds are expert at wiping out surprises and creating order, and order dictates that these products are special.”
Hence, the reasons highlighted have nothing to do with the success, typically. People like the product (be it a book, a song or a movie) initially and once the product becomes slightly popular they tend to become more popular because they are popular. This is referred to as the Matthew Effect after a verse in the Gospel of Matthew “For whosever hath, to him shall be given, and he shall have more abundance.”
But that clearly doesn’t stop people from coming up with more and more explanations for success. As Watt puts it “In the end, the only honest explanation may be the one given by the publisher of Lynne Truss’s surprise bestseller, Eats, Shoots and Leaves, who, when asked to explain its success, replied that “it sold because lots of people bought it.” Similarly Gangnam Style worked because a lot of people heard it. Its success was a total ‘fluke’.
The article originally appeared in the Daily News and Analysis dated October 22, 2012. http://www.dnaindia.com/money/report_whys-the-world-going-gaga-over-gangnam-style_1754813
(Vivek Kaul is a writer and he can be reached at [email protected])