Vivek Kaul
How the mighty fall.
Montek Singh Ahluwalia, the deputy chairman of the Planning Commission, is now talking about the Indian economy growing at anywhere between 5-5.5% during this financial year (i.e. the period between April 1, 2012 and March 31, 2013).
What is interesting that during the first few months of the financial year he was talking about an economic growth of at least 7%. In fact on a television show in April 2012, which was discussing Ruchir Sharma’s book Breakout Nations, Ahluwalia kept insisting that a 7% economic growth rate was a given.
Turns out it was not. And Ahluwalia is now talking about an economic growth of 5-5.5%, telling us that he has been way off the mark. When someone predicts an economic growth of 7% and the growth turns out to be 6.5% or 7.5%, one really can’t hold the prediction against him. But predicting a 7% growth rate at the beginning of the year, and then later revising it to 5% as the evidence of a slowdown comes through, is being way off the mark.
And when its the deputy chairman of the Planning Commission who has been way off the mark with regard to predicting economic growth, then that leaves one wondering, if he has no idea of which way the economy is headed, how can the other lesser mortals?
Forecasting is difficult business. The typical assumption is that those who are closest to the activity are the best placed to forecast it. So stock analysts are best placed to forecast which way stock markets are headed. The existing IT/telecom companies are best placed to talk about cutting edge technologies of the future. Political pundits are best placed to predict which way the elections will go and so on.
But as we have seen time and again that is not the case. Surprises are always around the corner.
One of the biggest exercises on testing predictions was carried out by Philip Tetlock, a psychologist at the University of California, Berkeley. He asked various experts to predict the implications of the Cold War that was flaring up between the United States and the erstwhile Union of Soviet Socialist Republic at the time.
In the experiment, Tetlock chose 284 people, who made a living by predicting political and economic trends. Over the next 20 years, he asked them to make nearly 100 predictions each, on a variety of likely future events. Would apartheid end in South Africa? Would Michael Gorbachev, the leader of USSR, be ousted in a coup? Would the US go to war in the Persian Gulf? Would the dotcom bubble burst?
By the end of the study in 2003, Tetlock had 82,361 forecasts. What he found was that there was very little agreement among these experts. It didn’t matter which field they were in or what their academic discipline was; they were all bad at forecasting. Interestingly, these experts did slightly better at predicting the future when they were operating outside the area of their so-called expertise.
People get forecasts wrong all the time because they are typically victims of what Nassim Nicholas Taleb in his latest book Anti Fragile calls the Great Turkey Problem. As he writes “A turkey is fed for a thousand days by a butcher; every day confirms to its staff of analysts that butchers love turkeys “with increased statistical confidence.” The butcher will keep feeding the turkey until a few days before Thanksgiving. Then comes that day when it is really not a very good idea to be a turkey. So with the butcher surprising it, the turkey will have a revision of belief – right when its confidence in the statement that the butcher loves turkeys is maximal and “it is very quiet” and soothingly predictable in the life of the turkey.”
When Ahluwalia insisted in late April 2012 that the economy will at least grow at 7% he was being a turkey. He was confident that the good days will continue, and was not taking into account the fact that things could go really bad. As Ruchir Sharma writes in Breakout Nations a book which was released at the beginning of this financial year “India is already showing some of the warning signs of failed growth stories, including early-onset of confidence.”
In fact, expecting a trend to continue, is a typical tendency seen among people who work within the domain of finance and economics. As a risk manager confessed to the Economist in August 2008, “In January 2007 the world looked almost riskless. At the beginning of that year I gathered my team for an off-site meeting to identify our top five risks for the coming 12 months. We were paid to think about the downsides but it was hard to see where the problems would come from. Four years of falling credit spreads, low interest rates, virtually no defaults in our loan portfolio and historically low volatility levels: it was the most benign risk environment we had seen in 20 years.”
Given this, it is no surprise that people who were working in the financial sector on Wall Street and other parts of the world, did not see the financial crisis coming. This happened because they worked with the assumption that the good times that prevailed will continue to go on.
Taleb calls the turkey problem “the mother of all problems” in life. Getting comfortable with the status quo and then assuming that it will continue typically leads to problems in the days to come. That brings me to Ahluwalia’s new prediction. “I would not rule out 7% next year”. He continues to be believe in the number ‘seven’. How seriously should one take that? As hedge fund manager George Soros writes in The New Paradigm for Financial Markets — The Credit Crisis of 2008 and What It Means “People’s understanding is inherently imperfect because they are a part of reality and a part cannot fully comprehend the whole.”
For the current financial year Ahluwalia as someone who closely observes the economic system could not comprehend the ‘whole’. Whether he is able to do that for the next financial year remains to be seen.
The article originally appeared on www.firstpost.com on February 18, 2013
(Vivek Kaul is a writer. He can be reached at [email protected])
Month: February 2013
Arindam Chaudhuri is the Subrata Roy of the MBA business
Vivek Kaul
One of my bigger regrets in life is that I spent two years doing a post graduate diploma in management (or what is better known as an MBA). Around 16-17 months into the course came the realisation that I was wasting my time. Since I had already wasted a lot of time, I thought wasting a few months more and completing the course would do me no harm. And which is precisely what I did.
The course barely helped me improve intellectually (though I have to concede that I ended up learning some versions of compound interest, which I still use to make a living) but it did help me improve my job prospects.
The institute I did my MBA from was neither recognised by the All India Council for Technical Education(AICTE) nor was it affiliated to any university. Despite that students did not shy away from applying and the application to acceptance ratio was around 200:1 (which meant for every 200 people who applied only one was finally selected).
To give the institute due credit at no point did they try to mislead. Time and again they repeated the fact that their course was not recognised. But that did not make any difference to those applying. They came by the droves. What also helped was a lot of positive coverage in the media.
This was primarily because the institute figured in the top 20 in most business school rankings at that point of time. What it told the potential applicants was that despite not being recognised the institute was reasonably good and one would have decent job prospects after completing the course.
While I did not gain much from the course (having chosen the wrong specialisation and then losing interest totally), most of my batchmates thought the education offered was good (if not excellent) for the kind of money that was charged. In MBA lingo, there was great bang for the buck. And more than 10 years later, most of my batchmates have high paying high flying jobs .
The point I am trying to make here is that being affiliated to a university or being recognised by the AICTE has nothing to do with offering quality education which can make one employable. If that was the case our universities wouldn’t be churning out so many unemployable graduates and engineers. So in that sense I really do not have a problem with the existence of an MBA chain like Indian Institute of Planning and Management (IIPM).
There is a clear cut reason behind the mushrooming of MBA institutes(like IIPM) across the country. As the Indian economy expanded over the last two decades there has been a greater need for people who have some understanding of management and business.
The seats in government run MBA institutes (the IIMs, and business schools run by universities) have remained stagnant over the years. Only in recent years has the government started expanding, by setting up more IIMs.
Hence there has been a great demand for an MBA degree, given the perception that it improves job prospects significantly. And since everybody couldn’t get into an IIM, entrepreneurs all over the country sniffing an opportunity jumped in setting up MBA institutes. The AICTE was more than helpful when it came to approvals and that explains how all kinds of institutes got approved.
In states like Maharashtra where politicians run most education institutes, these MBA institutes immediately got a university affiliation.
Setting up an education institute with approvals is one thing but providing quality education is totally another thing. So even though all these institutes with approvals were set up, the quality of their education and infrastructure was suspect and continues to remain suspect.
The point here is that since the government couldn’t cater to the demand given that it had more pressing needs, the private sector came in. Hence, all kinds of institutes were set up, the good, the bad and the ugly. In fact one education entrepreneur regularly set up MBA institutes when the economy was on its way up, and shut them down when the economy flagged.
A fair comparison for the MBA education system in our country is the banking system. A November 2011 presentation made by the India Brand Equity Foundation ( a trust established by the Ministry of Commerce and the Confederation of Indian Industries (CII)) makes some very interesting points:
– Of the 600,000 village habitations in India only 5 per cent have a commercial bank branch
– Only 40 per cent of the adult population has bank accounts.
Given this it is no surprise that a lot of Indians don’t deposit their savings with banks because around where they live there are no banks. Or the amount of money they want to save is so small that it is not profitable for banks to entertain them.
Hence, they end up saving money with firms like Sahara and other non banking firms. The lack of banking facilities has allowed firms like Sahara to thrive and become very big. And one of the things about becoming big is that you want to continue to remain big, doing whatever it takes. As Raghuram Rajan and Luigi Zingales write in the Saving Capitalism from the Capitalists “Those in power – the incumbents – prefer to stay in power.”
In that sense Sahara led by Subrata Roy and IIPM led by Arindam Chaudhuri are very similar. Both thrived primarily because the system that was in place was not big enough to meet the demand of the citizens of this country. They created their own system to exploit this demand and became very big in that process. And now that they are big, they want to remain big. It is a natural progression of things.
This has led to Sahara trying almost every possible way to stay in business and not hand over the Rs 24,000 crore that the Supreme Court has directed it to pay the Securities and Exchange Board of India. In IIPM’s case it has meant an all out effort to remove almost every negative thing that gets said against it and Arindam Chaudhuri. Also being a big advertiser in newspapers has meant that no newspaper of standing writes anything against it.
To conclude, getting a government approval to set up an MBA institute is no guarantee for quality education. Hence, I really have no problem in non AICTE affiliated/non university recognised business schools operating because those with approvals aren’t any great shakes either.
But at the same time, it is important that prospective candidates who want to do an MBA make informed judgements. And to do that they need access to all kinds of information and not only the brochure of the institute they want to apply to.
Hence, it is preposterous that any negative information on IIPM gets contested in lower courts around the country and is ultimately removed from the internet. If after going through this information students still want to apply and join IIPM, then it is really their choice and that should be respected.
The point is that if prospective MBA candidates would have to make their decisions to figure out which institutes to apply for only on the basis of information provided by those institutes and their brochures, then they would end up counting chickens before they are hatched.
The article originally appeared on www.firstpost.com on February 16, 2013
(Vivek Kaul is a writer. He can be reached at [email protected]. He did his post graduate diploma in management (PGDM) from the Symbiosis Centre for Management and HRD. The institute is now a part of the Symbiosis International University, a deemed university)
KFA and Sahara: How they have damaged capitalism
Vivek Kaul
Capitalism is a bad word these days.
And who made it a bad word? The communists? The trade unionists? Those fired from their jobs? Those who fear they might be fired from their jobs? The politicians? Or simply put you and I?
Well, actually none of the above.
Capitalism has been given a bad name by those who practise it i.e. the capitalists. And the capitalists in this have been helped by the politicians and the other insiders.
In India this role has been played to the hilt by Vijay Mallya of Kingfisher and Subrata Roy of Sahara.
As Raghuram Rajan and Luigi Zingales write in Saving Capitalism from the Capitalists “Throughout its history, the free market system has been held back, not so much by its own economic deficiencies as Marxists would have it, but because of its reliance on political goodwill for its infrastructure. The threat primarily comes from…incumbents, those who already have an established position in the marketplace…The identity of the most dangerous incumbents depends on the country and the time period, but the part has been played at various times by the landed aristocracy, the owners and managers of large corporations, their financiers, and organised labour.”
Lets look at this statement first in the context of Kingfisher and then Sahara. The Kingfisher crisis has been on for sometime now and the firm has not been allowed to fail. In fact last year there was a lot of talk of even the government of India stepping in to rescue the airline. But thankfully, the government which continues to blow up the taxpayer’s hard earned money on Air India, chose not to do so with Kingfisher.
Before that as per an announcement made in April 2011, the banks which had loaned a lot of money to Kingfisher agreed to convert Rs 1400 crore of it into equity at a premium of more than 60%.
Of course with the benefit of hindsight one can clearly say that what were they thinking? At the time of conversion of debt into equity Kingfisher shares were priced at Rs 39.9 and the debt was converted into equity at a price of Rs 64.48. As I write this the share price of the former airline is at Rs 9.56 on the Bombay Stock Exchange (BSE). Interestingly, there are sellers willing to sell the share at this price but there are no buyers in the market. So this price doesn’t really have any meaning. A stock market like any other market needs sellers and buyers to function.
If there are no buyers there is no market. As of December 31, 2012, the State Bank of India, IDBI Bank, ICICI Bank and Bank of India owned 8.78% of the shares of the company. This was down from the 18.78% that these banks along with Punjab National Bank and UCO Bank held as on March 31, 2011, after the banks had converted their debt into equity. So these banks have managed to whittle down their holding in the airline but even with that they may have been left holding onto a stake which is worth next to nothing now. Since the latest numbers as on March 31, 2013 are not available it can’t be said with clarity what stake banks have still left in the airline.
Also, this is only the part that was converted into equity. Over and above this there is Rs 7,723 crore of debt that Kingfisher Airlines still owes the banks. The banks have a collateral worth Rs 5,237 core against the outstanding loans of Kingfisher. Experts remain sceptical on how much collateral, which includes Mallya’s bungalow at Candolim in Goa among other things, the banks will be able to sell to recover their loans.
The basic question that remains is that why would banks convert debt into equity at a premium of more than 60%, for an airline that even then had never made money? The answer probably lies in the fact that most of the banks that had given loans to Kingfisher, with the possible exception of ICICI Bank, were public sector banks. It can be safely said that political pressure was at play. The fact that Mallya is a member of the Rajya Sabha must have helped.
Hence those who Rajan and Zingales call the incumbents i.e. the promoter, his financiers and the politicians kept Kingfisher going, when it clearly was in no position to continue. And we have now ended up with a situation which is clearly messier.
No one in their right mind will now buy the airline given that it would be cheaper and easier to start a fresh airline than clear up the mess inside Kingfisher and re-launch it.
The moral of the story is that while capitalism creates, it is very important to let it destroy as well, otherwise there are costs for the society to bear.
In the aftermath of Kingfisher going bust the Ministry of Civil Aviation does not seem to be in the mood to issue fresh licenses, such is the fear of another airline going bust. Also, when Spice Jet recently cut ticket prices, the Ministry went out of its way to ensure that other players did not match that price. The logic being that if tickets are sold at a lower price there would be more losses, more airlines getting in trouble (read Air India) and so on.
In the process the prospective consumer i.e. you and me, lose out on cheaper tickets and perhaps better service, which would be the case with more airlines in the fray.
And more than anything the employees of the airline who had gone back to work on the assurances of the top management, continue to remain largely unpaid.
If the process of trying to rescue the airline had not been prolonged for so long, things would have been better for everyone concerned, except perhaps the promoter.
Now lets come to Sahara. Sahara is an even more blatant example of why you need to save capitalism from the capitalists. Here is a firm, which has been directed by no less than the Supreme Court of India to hand over more than Rs 24,000 crore to the Securities Exchange Board of India (SEBI) to repay its investors and is not doing so. In fact as an earlier column pointed out Sahara is probably even going against the decision of the Supreme Court. This cannot happen without political support.
In fact till date, politicians who jump at every opportunity to be seen as messiahs of the masses, haven’t spoken a word against Sahara. This is probably also linked to the fact that most politicians run cricket in India by controlling the state boards and the district cricket associations and Sahara remains the biggest sponsor of what was once called the gentleman’s game. As the old saying goes, you don’t bite the hand that feeds you.
Meanwhile the unsuspecting poor of the country continue to handover their hard earned money to Sahara. It is safe to say that Sahara has inspired a whole host of other firms to raise money from the unsuspecting public in India, knowing fully well that even if they do not follow the law of the land, things would just be fine. It also explains to a large extent why pyramid and Ponzi schemes continue to flourish in India. Nobody ever gets punished.
Rajan and Zingales point out that “Those in power – the incumbents – prefer to stay in power.” And in order to do that they tend to go any extent possible. In the process things get messier.
Hence, it is important for firms which are no longer viable to be allowed to fail, and if they are not in the mood to do it themselves, then they the law of the land should ensure that they do fail. As a certain Frank Borman once said “I’ve long said that capitalism without bankruptcy is like Christianity without hell.”
The article originally appeared on www.firstpost.com on February 16, 2013
(Vivek Kaul is a writer. He can be reached at [email protected])
Why are journos so bad with numbers?
Vivek Kaul
“Numbers don’t lie,” goes the old adage. I don’t think that is true.
Numbers do lie. Or more specifically, numbers can be made to lie.
Allow me to elaborate. Today’s edition of The Economic Times, India’s largest business daily and the second largest business daily in the world, has this headline “Exports enter positive zone after eight months.”
Prima facie there is nothing wrong with the statement. Exports grew by 0.82% in January 2013 to $25.5 billion. But then exports can never be looked at in isolation.
How much did imports grow by? Imports rose 6.1% to $45.6 billion. This means that India had a trade deficit (the difference between imports and exports) of more than $20 billion ($45.6 billion – $25.5 billion). This is the second highest trade deficit the country has ever seen and you don’t need to be an economist to understand that can’t be good.
While the The Economic Times story does go onto elaborate about the imports and the trade deficit without sounding negative, the headline is totally misleading.
Lets try and convert percentages to absolutes and see what we can come up with. Exports grew by around $207.4 million in January 2013 in comparison to exports during the same period last year. What about imports? Imports grew by nearly $2.62 billion in January 2013 in comparison to the imports during the same period last year.
This means that the growth of imports was 12.6 times the growth of exports in January 2013. That is the real number. It doesn’t lie. And it is worrying.
The question now is why did The Economic Times choose to highlight a minuscule (and probably even statistically insignificant) 0.82% rise in exports, than a rise in imports which was many times more, and clearly a sign of worry?
The first reason could be that the newspaper has a policy of highlighting positive news when there is a choice between positive and negative news. Now that I am in no position to comment on.
But the second reason, which I have clearly more proof for across newspapers, is that a lot of journalists do not understand basic fifth standard mathematics and end up committing mistakes like the one above.
I have seen stock market reporters get excited on the Sensex (India’s premier stock market index) registering the highest gains during the course of a particular trading day. When you quiz them about are they talking percentages or absolutes, they sheepishly answer absolutes.
And how does that matter? When the Sensex is at 20,000 points, a rally of 500 points means a gain of 2.5%. When Sensex is at 10,000 points a rally of 250 points can mean a gain of 2.5%. So while reporting losses or gains it is very important to talk in percentages and not absolutes. Obviously saying that the Sensex has risen by 500 points makes a much better headline than saying that the Sensex rose by 2.5%.
Talking about headlines, a prospect of a great headline can even turn non stories into stories in a newspaper. A story that was widely reported across the Indian media in late March 2006 was when the Sensex crossed the Dow Jones Industrial Average (the premier index of American stocks) for the first time. The Sensex was then at 11183.48 points and the Dow was at 11,154.54 points. And so the Sensex was at a higher level than the Dow.
Nobody really asked what the two numbers actually meant? Both the Sensex and the Dow were constructed very differently and given that there was no way they could be compared. (You can read why here). But “have numbers-will compare” is a syndrome that is visible across newspapers.
Another common mistake which I have talked about earlier as well is that people tend to add or subtract percentages. My favourite example on this is that of Jerry Rao’s column which appeared in The Indian Express on October 6, 2008.
“If stock market wealth drops by 50 per cent in six months, we get concerned. We conveniently forget that it went up by 200 per cent over the previous two years. At the end of 30 months we are still 150 per cent ahead,” wrote Rao. (Read the full article here)
This is absolutely wrong. Let me explain. Let us say a particular stock is selling at Rs 100. It goes up by 200% to Rs 300 ( Rs 100 + 200% of Rs 100). After that it falls by 50%. The new price of the stock is Rs 150 ( Rs 300 – 50% of Rs 300).
This means a stock which was at Rs 100 is now quoting at Rs 150. Hence, the gain on the stock is 50% and not 150% as Rao pointed out in that column.
Another favourite example of mine is on inflation. I don’t remember how many times I have been asked “how can you say inflation is falling when prices are going up?” In fact during the writing of this article a few years back, it took me some time to explain the concept to the individual editing the story.
What is inflation? It is rate at which prices rise. So let us say you bought a kg of rice in 2011 at Rs 20 per kg. In 2012, the same rice is selling at Rs 30. Hence the inflation in the price of rise has been 50% (Rs 10 expressed as a percentage of Rs 20). In 2013, the same rice is selling at Rs 40, which means the inflation in the price of rice has been 33% (Rs 10 expressed as a percentage of Rs 30). What do we have here? The price of rice has gone up by Rs 10, year on year, in both the cases. But the inflation during the first year was 50%. And the inflation during the second year was 33%.
The point here being that the rate at which prices are rising has fallen. If inflation had been 50% even during the second year then the price of one kilogram of rice would have been Rs 45 and not Rs 40. This is a basic point which a lot of people do not understand.
So yes, prices go up, even when inflation goes down!
Lest I be accused of only highlighting problems with Indian newspapers here is a gem I came across in The New York Times recently. I am reproducing three paragraphs from the story below.
Kristina Collins, a chiropractor in McLean, Va., said she and her husband planned to closely monitor the business income from their joint practice to avoid crossing the income threshold for higher taxes outlined by President Obama on earnings above $200,000 for individuals and $250,000 for couples.
Ms. Collins said she felt torn by being near the cutoff line and disappointed that federal tax policy was providing a disincentive to keep expanding a business she founded in 1998.
“If we’re really close and it’s near the end-year, maybe we’ll just close down for a while and go on vacation,” she said.
What these paragraphs tell us is that Kristina Collins, the person quoted in the story, does not understand how marginal tax rates work. And neither do The New York Times journalists who wrote the story, otherwise they wouldn’t have used the example in the first place.
What Collins is effectively saying in the story is that she and her husband shut shop the moment their income starts to approach $250,000. Why? The moment the income crosses $250,000 a higher rate of tax kicks in. What Collins and the journalists have assumed that the higher rate of tax is applicable on the total income. And that is clearly wrong. It is only applicable on the amount of income greater than $250,000. So if for the sake of argument the couple makes $260,000 during the course of the year, then the higher rate of tax is not applicable on the entire $260,000 but on $10,000 ($260,000 – $250,000).
And here is my all time favourite mathematical blooper in a newspaper, having have saved the best for the last. In a story published in The Economic Times on January 3, 2012, it was reported that “The markets have punished the two companies. Network18′ s market cap is down 171.57% since January 5, 2009 while TV18’s has fallen 560.23% in the same period.”
How can the market capitalisation of any company fall by more than 100%? Market capitalisation of a company is the number of shares the company has multiplied by its stock price. So let us say a stock is quoting at Rs 1000. The price falls to zero (for the sake of argument) and so does the market capitalisation. In that case the price has fallen by 100% (Rs 1000 expressed as a percentage of Rs 1000) and so has the market capitalisation.
The price of any stock cannot go below zero. So the question is how can the market capitalisation fall by 171.57% or 560.23%? I have no clue. If you do, please let me know.
The article originally appeared on www.firstpost.com on February 14, 2013
(Vivek Kaul is a writer. He can be reached at [email protected]. His last full time job was with The Economic Times)
Why Chidu and Subbu do not have much control over the fiscal deficit
Vivek Kaul
In the past few pieces I have written about the huge amount of money being printed by central banks and governments all across the developed world.
The Federal Reserve of United States, the American central bank, has expanded its balance sheet by 220% since early 2008. The Bank of England has done even better at 350%. The European Central Bank came to the party a little late and has expanded its balance sheet by around 98%. The Bank of Japan has been rather subdued in its money printing efforts and has expanded its balance sheet only by 30% over the last four years. But is now joining the money printing party and is looking to print as many yen as required to get an inflation of 2% going.
The idea as I have mentioned in a couple of earlier pieces is to create some consumer price inflation to get consumption going again. As a greater amount of money chases the same amount of goods and services, the hope is to create some inflation. When people see prices going up or expect prices to go up, they generally tend to start purchasing things. This helps businesses as well as the overall economy. So by trying to create some inflation or at least create some inflationary expectations, the idea is to get consumption going again.
But this trick practiced by central banks hasn’t worked. Inflation has continued to elude the developed world.
Central bank governors and governments when they decide to print money are essentially following the Chicago university economist Milton Friedman. Friedman had even jocularly suggested that a recessionary situation could be fought by printing and dropping money out of a helicopter, if the need be, to create inflation.
The idea behind this assumption is that just by dropping money out of a helicopter there will be in an increase in money supply and the inflation will be created. So in that sense it did not really matter who is standing under the helicopter when the money is dropped. But French economist Richard Cantillon who lived during the early eighteenth century showed that money wasn’t really neutral and it mattered where it was injected into the economy. In the modern sense of the term, it matters who is standing under the helicopter when printed money is dropped from it.
Before we get back to Cantillon, let me deviate a little.
Christopher Columbus wanted to discover the sea route to India. He went on his first journey to find India on the evening of August 3, 1492. Before that he had managed to negotiate a contract with King Ferdinand and Queen Isabella of Spain, which entitled him to 10% of all the profit
But he ended up somewhere else instead of India. An island he named San Salvador, which the locals called Guanahani. The question though is why did he want to go to India? It seems he had read the published accounts of Marco Polo and was very impressed by the wealth that lay in store in India.
Columbus made three more journeys in search of a sea route to India, but never found it. In the end, it didn’t really matter, because the Spaniards found what they were looking for: gold and silver, in ample amounts. Though not in India, as was the original plan, but in what came to be known as the “New World” immediately and South America a little later. Within half a century of Columbus’ first expedition, the Spaniards had found most of the treasure that was to be found in the New World.
With all this silver/gold coming into Spain from the New World there was a sudden increase in money supply and that led to inflation in Spain. Richard Cantillon studied this phenomenon and made some interesting observations.
What he said was that when money supply increased in the form of gold and silver it would first benefit the people associated with the process of money creation, the mining industry in general and the owners of the mines, the adventurers who went looking for gold and silver, the smelters, the refiners and the workers at the gold and silver mines, in particular.
These individuals would end up with a greater amount of gold and silver i.e. money, before anyone else. This money they would spent and thus drive up the prices of meat, wine, wool, wheat etc. This new money would be chasing the same amount of goods and thus drive up prices.
This rise in prices would impact people not associated with the mining industry as well, even though there incomes hadn’t risen like the incomes of people associated with the mining industry had. As Dylan Grice an analyst formerly with Societe Generale told me a few months back “The problems arise for other groups. Anyone not involved in the production of money or of the goods the newly produced money purchased, but who nevertheless consumed them – a journalist or a nurse, for example – would find that the prices of those goods had risen while their incomes hadn’t.”
This is referred to as the Cantillon effect. “Cantillon, writing before the days of Adam Smith, was the first to articulate it. I find it very puzzling that this insight has been ignored by the economics profession. Economists generally assume that money is neutral. And Milton Friedman’s allegory about the helicopter drop of money raising the general price level completely ignores the question of who is standing under the helicopter,” said Grice.
The money printing that has happened in recent years has unable to meet its goal of trying to create consumer price inflation. But it has benefited those who are closest to the money creation like it had in Spain. In the present context, this basically means the financial sector and anyone who has access to cheap credit (i.e. loans).
Institutional investors in the developed world have been able to raise money at close to zero percent interest rates and invest that money in financial assets all over the world, and thus driven up their prices. As Ruchir Sharma writes in Breakout Nations – In Pursuit of the Next Economic Miracles:
What is apparent that central banks can print all the money they want, they can’t dictate where it goes. This time around, much of that money has flown into speculative oil futures, luxury real estate in major financial capitals, and other non productive investments…The hype has created a new industry that turns commodities into financial products that can be traded like stocks. Oil, wheat, and platinum used to be sold primarily as raw materials, and now they are sold largely as speculative investments. Copper is piling up in bonded warehouses not because the owners plan to use it to make wire, but because speculators are sitting on it…figuring that they can sell it one day for a huge profit.
Other than this all the money printing has also led to stock markets across the world reaching levels they were at before the financial crisis started. Investment banks and hedge funds have borrowed money at very low interest rates and invested it all over the world.
This has led to an increase in price of oil as well, something that impacts India majorly. Currently one basket of Indian crude costs around $108 per barrel. The Indian government hasn’t passed on this increase in oil prices to the Indian consumer and sells products like diesel, petrol, kerosene as well cooking gas at a loss.
The losses thus faced by the oil marketing companies on selling diesel, kerosene and cooking gas are compensated for by the government.
This means increased expenditure for the Indian government and thus a higher fiscal deficit. Fiscal deficit is the difference between what the government earns and what the government spends.The other impact because all this money printing has been an increase in price of gold. Investors all over the world have been buying gold as more and more money is being printed. The Indian investors are no exception to this rule. India produces very little gold of its own. Hence, most of the gold being bought in India needs to be imported. When these imports are made India needs to pay in dollars, because gold is bought and sold in dollars internationally.
In order to pay in dollars, India needs to sell rupees and buy dollars. This means that there is an increase in the supply of rupees in the market, and the rupee loses value against the American dollar.
A little over a year back one American dollar was worth Rs 49. It touched around Rs 57 by the middle of 2012. Currently one dollar is worth around Rs 53.5.
When the rupee loses value against the dollar it means that India has to pay more in rupees for the imports it makes. India’s number one import is oil. Hence, with the rupee losing value against the dollar over the course of the last one year, India has been paying more for the oil being imported in rupee terms.
This has in turn has led to increasing government expenditure and therefore a higher fiscal deficit. A higher fiscal deficit means that the government has had to borrow more and that in turn has meant higher interest rates as well. This explains to a large extent why the government has in recent times tried to control the import of gold by increasing the duty on it and thus control the value of the rupee against the dollar.
What this entire story tells us is that the likes of P Chidambaram and D Subbarao have far lesser control over the Indian economy and the fiscal deficit of the government, there attempts to prove otherwise notwithstanding. So as long as the Western world continues to print money prices of oil and gold will continue to remain high. Hence, that Indians will continue to buy gold and the oil bill will continue to remain high.
The article originally appeared on www.firstpost.com on February 12, 2013
(Vivek Kaul is a writer and he can be reached at [email protected])