What if I were to say that the home prices in the United States impact the value of your investments in India. You will probably turn around and ask me to go take a walk.
But the fact of the matter is that there is actually a link between the two and we have reached a stage where the link perhaps matters more than it ever did. Nonetheless, before we get into understanding this, it’s important to know how we got here in the first place.
In late 2019 and early 2020, rich world central banks led by the Federal Reserve of the United States, the American central bank, started to print a lot of money, first to take care of the economic slowdown and then the economic contraction because of the spread of the covid pandemic.
The idea was to drive down interest rates. At lower interest rates people were expected to borrow and spend money. Interest rates on thirty year home loans in the United States fell to as low as 2.65% in early January 2021, the lowest they had been since 1971, the year from which this data is available.
Naturally, with interest rates at such low levels, more people started borrowing and buying homes than was the case in the past. While the demand for homes went up quickly, their supply couldn’t go up as quickly to meet this extra demand. Hence, home prices went up, at a very past pace.
In April 2022, home prices in the US, as per the S&P Case-Shiller 20-City Composite Home Price Index, went up by 21.2% in comparison to April 2021. Home prices have been rising at more than 17% year on year from May 2021 onwards. This kind of price rise wasn’t even seen during the real estate bubble of the 2000s.
One straight impact of this has been rising home rents. As per Realtor.com, the median rent in the United States in May 2022 was 23.2% higher than in May 2020 and 15.5% higher than in May 2021. This rise in home rents feeds into retail inflation. As The Economistputs it, in May 2022, the “rising housing costs already accounted for 40% of the monthly increase in the consumer-price index [which measures retail inflation].”
In May 2022, the retail inflation in the United States stood at 8.6%, the highest since December 1981, when it was at 8.9%. People are now building in this high inflation into their monetary calculations; in the home-rents they demand and in the salaries and wages they ask for.
In May 2022, the median one-year ahead expected inflation rate in the United States was 6.6%, the highest that it has been in a while. As any economist would put it, once inflation expectations set in the minds of people it becomes very difficult for central banks to control inflation.
So, in this scenario, it has become very important for the Federal Reserve to control the fast pace at which housing prices have been going up, given that it can’t do much about the high energy prices, due to the war in Ukraine.
The Federal Reserve has decided to gradually withdraw some of the money that it had printed and pumped into the financial system. Between June 2021 and May 2022, it expects to suck out close to a trillion dollars, bringing an era of easy money to an end.
This is already pushing up home loan and other long-term interest rates in the United States. As of June 30, the median interest rate on a 30-year fixed interest rate home loan had risen to 5.7%, from a low of 2.65% in early January 2021.
As the Fed keeps sucking out money, the interest rate on home loans will keep going up and this will hopefully drive down the demand for fresh homes and the rate of price rise of homes. As home price inflation cools down, rental inflation will also cool down and in turn bring down retail inflation. That’s the theory.
Other than taking out the money it had printed, the Federal Reserve also plans to raise its key short interest rate, the federal funds rate. This is expected to drive up short term interest rates in the United States.
The end of the era of easy money and rising interest rates in the United States will have an impact on investments in India. In fact, this is already happening. The foreign institutional investors (FIIs) have already sold Indian stocks worth Rs 2.56 trillion between October 2021 and July 1, 2022. This has led to the value of investments in stocks, equity mutual funds and unit linked insurance plans, falling.
Further, as FIIs sell out of India, they convert their rupees into dollars, leading to a surge in the demand for the dollar and drop in the value of the rupee. One dollar is currently worth around Rs 79. It was worth around Rs 74.5 at the beginning of 2022. This makes life expensive for those looking to study abroad or to go for a foreign holiday.
As the Federal Reserve raises interest rates, the Reserve Bank of India will have to do the same. This will push up interest rates on loans as well as deposits in India. Hence, people with loans are likely to end up paying higher EMIs, whereas people with deposits are likely to earn a higher interest than was the case in the past. Again, this is already happening.
Of course, a big impact of the rise in interest rates in the United States has been on crypto prices, which have crashed by close to 80% from their all-time high-levels, leaving many zoomers poorer.
All in all, as the old cliché goes, when America sneezes, the whole world catches cold.
This piece originally appeared in the Deccan Herald on July 3, 2022, with a different headline.
Bernie Madoff, the man who ran the biggest Ponzi scheme of all time, died in jail on April 14, 2021, fifteen days shy of turning 83.
A Ponzi scheme is a fraudulent investment scheme in which older investors are paid by using money being brought in by newer ones. It keeps running until the money being brought in by the newer investors is greater than the money being paid to the older ones. Once this reverses, the scheme collapses . Or the scamster running the scheme, runs away with the money before the scheme collapses.
The scheme is named after an Italian American, Charles Ponzi, who tried running such an investment scheme in Boston, United States, in 1920. He had promised to double investors’ money in 90 days, which meant an annual return of 1500%. At its peak, 40,000 investors had invested $15 million in Ponzi’s scheme.
Not surprisingly, the scheme collapsed in less than a year’s time, under its own weight. All Ponzi was doing was taking money from newer investors and paying off the older ones.
Once Boston Post ran a story exposing his scheme in July 1920, many investors demanded their money back and Ponzi’s Ponzi scheme simply collapsed, as money being brought in by newer investors dried up, while older investors had to be paid.
Madoff was smarter that way. His scheme gave consistent returns of around 10% per year, year on year. The fact that Madoff promised reasonable returns, helped him keep running his Ponzi scheme for decades. But when the financial crisis of 2008 struck, it became difficult for him to carry on with the pretence and the scheme collapsed.
As I wrote in a piece for the Mint newspaper yesterday, Madoff was Ponzi’s most successful disciple ever. While Ponzi’s investment scheme started in December 1919, it collapsed in less than a year’s time in August 1920. On the other hand, documents suggest that Madoff’s scheme started sometime in the 1960s and ran for close to five decades.
Nevertheless, both Madoff and Ponzi, would have been proud of the Ponzi schemes of 2021. The only difference being that the current day Ponzi schemes are what economist Nobel Prize winning Robert Shiller calls naturally occurring Ponzi schemes and not fraudulent ones like the kind Ponzi and Madoff ran.
A conventional Ponzi scheme has a fraudulent manager at the centre of it all and the intention is to defraud investors and take the money and run before the scheme collapses. A naturally occurring Ponzi scheme is slightly different to that extent.
Shiller defines naturally occurring Ponzi schemes in his book Irrational Exuberance:
“Ponzi schemes do arise from time to time without the contrivance of a fraudulent manager. Even if there is no manipulator fabricating false stories and deliberately deceiving investors in the aggregate stock market, tales about the market are everywhere. When prices go up a number of times, investors are rewarded sequentially by price movements in these markets just as they are in Ponzi schemes. There are still many people (indeed, the stock brokerage and mutual fund industries as a whole) who benefit from telling stories that suggest that the markets will go up further. There is no reason for these stories to be fraudulent; they need to only emphasize the positive news and give less emphasis to the negative.”
Basically, what Shiller is saying here is that the stock markets enter a phase at various points of time, where stock prices go up simply because new money keeps coming in and not because of the expectations of earnings of companies going up in the days to come.
Ultimately, stock prices should reflect a discounted value of future company earnings. But quite often that is not the case and the price goes totally out of whack, for considerably long periods of time.
A lot of money comes in simply because the smarter investors know that newer money will keep coming in and stock prices will keep going up, and thus, stocks can be unloaded on to the newer investors. Hence, like in a Ponzi scheme, the money being brought in by the newer investors pays off the older ones. In simpler terms, this can be referred to as the greater fool theory.
The investors buying stocks at a certain point of time, when stock prices do not justify the expected future earnings, know that greater fools can be expected to invest in stocks in the time to come and to whom they can sell their stocks.
Of course, this is not the story that is sold. If you want money to keep coming into stocks, you can’t call a prospective fool a fool. There is a whole setup, from stock brokerages to mutual funds to portfolio management services to insurance companies selling investment plans, which benefit from the status quo. Their incomes depend on how well the stock market continues to do.
They are the deep state of investment and need to keep selling stories that all is well, that stocks are not expensive, that this time is different, that a new era is here or is on its way, that stock prices will keep going up and that if you want to get rich you should invest in the stock market, to keep luring fools in and keep the legal Ponzi scheme, for the lack of a better term, going.
— Bernie Madoff
This is precisely what has been happening all across the world since the covid pandemic broke out. With central banks printing a humongous amount of money, interest rates are at very low levels, forcing investors to look for higher returns. A lot of this money has found its way into stock markets. The newer investors have bid stock prices up, thus benefitting the older investors. The deep state of investment has played its role.
Of course, the counterpoint to whatever I have said up until now is that unless new money comes in, how will stock prices ever go up. This is a fair point. But what needs to be understood here is that in the last one year, the total amount of money invested in stocks has turned into a flood. Take the case of foreign institutional investors investing in Indian stocks.
They net invested a total of $37.03 billion in Indian stocks in 2020-21. This was almost 23% more than what they invested in Indian stocks in the previous six years, from April 2014 to March 2020. This flood of money can be seen in stock markets all across the world.
Clearly, there is a difference, and the stock market has worked like a naturally occurring Ponzi scheme, at least over the last one year.
This Ponziness is not just limited to stocks. Take a look at what is happening to Indian startups…oh pardon me…we don’t call them startups anymore, we call them unicorns, these days. A unicorn is a startup which has a valuation of greater than billion dollars.
How can a startup have a valuation of more than a billion dollars, is a question well worth asking. I try and answer this question in a piece I have written in today’s edition of the Mint newspaper.
As mentioned earlier, there is too much money floating all around the world, particularly in the rich world, looking for higher returns. Venture capitalists (VCs) have access to this money and thus are picking up stakes in Indian startups at extremely high prices.
Many of these startups have revenues of a few lakhs and losses running into hundreds or thousands of crore. The losses are funded out of money invested by VCs into these unicorns.
The losses are primarily on account of selling, the service or the good that the startup is offering, at a discounted price. The idea is to show that a monopoly (or a duopoly, if there is more than one player in the same line of business) is being built in that line of business and then cash in on that through a very expensive initial public offering (IPO).
As and when, the IPO happens, a newer set of investors, including retail investors, buy into the business, at a very high price, in the hope that the company will make lots of money in the days to come. Interestingly, IPOs which used to help entrepreneurs raise capital to expand businesses, now have become exit options for VCs.
If an IPO is not possible, then the VC hopes to unload the stake on to another VC or a company and get out of the business.
In that sense, the hope is that a newer set of investors will pay off an older set, like is the case in any Ponzi scheme. Of course, this newer set then needs another newer set to keep the Ponzi going.
The good thing is that when investors buy a stock of an existing company or in a new company’s IPO, they are at least buying a part of an underlying business. In case of existing companies, chances are that the business is profitable. In case of an IPO, the business may already be profitable or is expected to be profitable.
But the same cannot be said about many digital assets that are being frantically bought and sold these days. There is no underlying business or asset, for which money is being paid. Take the case of Dogecoin which was created as a satire on cryptocurrencies.
As I write this, it has given a return of 24% in the last 24 hours. An Indian fixed deposit investor will take more than four years to earn that kind of return and that too if he doesn’t pay any tax on the interest earned.
Why is Dogecoin delivering such fantastic returns? As James Surowiecki writes in a column: “There is no good answer to that question, other than to say Dogecoins have gotten dramatically more valuable because people have decided to act as if they’re more valuable.”
As John Maynard Keynes puts it, investors are currently anticipating “what average opinion expects the average opinion to be.” Carried away by the high returns on Dogecoin, the expectation is that newer investors will keep investing in it and hence, prices will keep going up. The newer investors will keep paying the older ones. That is the hope, like is the case with any Ponzi scheme, except for the fact that in this case, there is no fraudulent manager at the centre of it all.
Of course, the only way the value of Dogecoin and many other cryptocurrencies can be sustained, is if newer investors keep coming in and at the same time, people who already own these cryptocurrencies don’t rush out all at once to cash in on their gains.
If this does not happen, as is the case with any Ponzi scheme, when existing investors demand their money back and not enough newer investors are coming in, this Ponzi scheme will also collapse.
–– Charles Ponzi
Given this, like is the case with people who are heavily invested in stocks, it is important for people who are heavily invested in cryptos to keep defending them. Of course, a lot of times this is technical mumbo jumbo, which basically amounts to that old phrase, this time is different.
But this time is different is probably the oldest lie in finance. It rarely is.
And if dogecoin was not enough, we now have investors going crazy about non-fungible tokens (NFTs), which in simple terms is basically certified digital art. As Jazmin Goodwin points out: “For example, Jack Dorsey’s first tweet is now bidding for $2.5 million, a video clip of a LeBron James slam dunk sold for over $200,000 and a decade-old “Nyan Cat” GIF went for $600,000.” The auction house Christie sold its first ever NFT artwork for $69 million, in March.
In a world of extremely low interest rates and massive amount of printing carried out by central banks, there is too much money going around chasing returns.
There aren’t enough avenues and which is why we have financial and digital assets now turning into naturally occurring Ponzi schemes, giving the kind of returns that the original Ponzi scamsters, like Ponzi himself and his disciple Madoff, would be proud off.
Madoff’s scheme delivered returns of 10% returns per year. Ponzi promised to double investors’ money in three months or a return of 100% over three months. As I write this, Dogecoin has given a return of more than 600% over the last one month.
Here’s is how the price chart of Dogecoin looks like over the last one month.
In 1968, sociologists Robert K Merton and Harriet Zuckerman, came up with the concept of the Matthew Effect of accumulated advantage. The term takes its name from the Gospel of Matthew, which points out: “For to everyone who has will more be given, and he will have abundance; but from him who has not, even what he has will be taken away.”
In simpler terms, the Matthew Effect of accumulated advantage is stated as the rich become richer and the poor get poorer. This is precisely how things have played out over the last one year, as the covid pandemic has spread through India and large parts of the world.
Let’s take a look at the different ways in which this has happened.
1)Central banks in the rich world have printed a massive amount of money post covid. Just the Federal Reserve of the United States has printed more than $3.5 trillion between end February 2020 and now. Other big central banks like the Bank of England, the Bank of Japan and European Central Bank have also done the same.
This has been done in order to drive down interest rates. The hope is that at lower interest rates people will borrow and spend money, and businesses will borrow and expand. This will help the economy revive. Many rich countries have put money directly in the bank accounts of people, encouraging them to spend.
Some of this money has found its way into stock markets all around the world, including India, driving stock prices way beyond what the earnings of companies justify. The foreign institutional investors invested a whopping $37.03 billion in Indian stocks in 2020-21, the highest they have ever invested. The next best being $25.83 billion in 2012-13.
This sent stock prices soaring with the Sensex, India’s most famous stock market index, gaining 68% in 2020-21. In fact, the market capitalisation of all BSE listed stocks (not just the 30 Sensex stocks) went up by Rs 90.82 lakh crore in 2020-21.
The poor don’t buy stocks, the rich do. The rally in the stock market has benefitted them tremendously, making them richer. In 2019-20, investment in shares and debentures (which includes mutual funds), despite all the hype, formed a minuscule 3.39% of the overall Indian household financial savings. In 2020-21, this would have definitely gone up, but given its low base it would have still formed a very small part of the overall financial savings of Indian households.
As per the 10th Edition of Hurun Global Rich List 2021, India added 55 new dollar billionaires in 2020, with the total number of billionaires in the country going up to 177, a 45% jump in the number of billionaires in comparison to 2019. If one looks at the list of the richest Indian billionaires, most of their wealth is in the stock market. And with stock markets rallying big time in 2020-21, their wealth has gone up.
2)Like the central banks of the rich world, the Reserve Bank of India (RBI) also joined the money printing party and printed Rs 3.6 lakh crore between the beginning of March 2020 and the end of March 2021. This has primarily been done in order to drive down interest rates and help the government borrow at lower interest rates. The central government borrowed Rs 12.8 lakh crore last year and is expected to borrow Rs 12.06 lakh crore in 2021-22.
While money printing helps the central government borrow at lower rates, it hurts the middle class and the poor, who invest in fixed deposits and other forms of fixed income investments to save money. It needs to be remembered that most Indians save by investing in fixed deposits, small savings schemes, provident and pension funds and life insurance. In 2019-20, 84.24% of the household financial savings were made in these financial instruments. Low interest rates largely mean lower returns from these investments.
In the last two years, the average interest rate on bank term deposits (fixed deposits, recurring deposits, etc.) of more than one year has come down dramatically. It was at 7.5% in March-April 2019. In March 2021, it stands at 5.5%. A bulk of this fall has happened from the beginning of 2020. Recently, the government had majorly cut the interest rates on small savings schemes for the period April to June. Nevertheless, it reversed the decision overnight, probably because of the assembly elections that were still on. It is now expected that the government will cut the interest rate on small savings schemes for the period July to September.
Lower interest rates, hurt the middle class and the poor especially when the rate of inflation is as high as the interest rates on offer.
The money printing by the RBI to drive down interest rates is likely to continue in the months to come. The Indian central bank is expected to print Rs 1 lakh crore during April to June . This means that bank interest rates will continue to remain low, continuing to hurt the poor and the middle class.
3)While the Indian economy is expected to contract during 2020-21, data from Centre for Monitoring Indian Economy (CMIE) shows that the listed corporates (both financial and non-financial) have made their highest profits ever during the period July to September 2020 and October to December 2020.
As Mahesh Vyas of the Centre for Monitoring of Indian Economy pointed out in a recent piece: “In the December 2020 quarter, the net profit of listed companies exceeded…the record profits of September 2020.” The net profit during the quarters stood at Rs 1.51 lakh crore and Rs 1.53 lakh crore, respectively. These were the highest quarterly profits ever made by listed Indian corporates.
This means that owners of these businesses have grown richer and so has the top management of these companies given that they own employee stock option plans and benefit from the dividends paid by the companies every year.
But how did listed Indian corporates make their highest profits ever, while the economy was contracting? The net sales of the non-financial companies, which are a bulk of the listed corporates, fell by 10.4% in the quarter ending September and by 0.9% in the quarter ending December, in comparison to a year earlier, but the companies still made record profits. This happened primarily because the companies were able to drive down their operating expenses.
In the quarter ending March 2020, the operating expenses or the cost of running a business, made up 91.1% of their sales. In the quarters ending September 2020 and December 2020, the operating expenses amounted to 81.4% and 82.8% of the sales, respectively.
In simple English, the companies slashed employee expenses and they renegotiated their contracts with their suppliers and contractors, to drive down their costs. The larger businesses benefitted in the process at the cost of the smaller ones.
Of course, if a small company gets paid a lower amount of money from a large company, it also has to renegotiate the money it is paying to its employees and suppliers. This also leads to job losses as smaller companies then need to fire employees in order to cut costs and continue to stay viable.
This has played out for the last one year and continues to play out now as well, with the second wave of covid spreading. It is not easy to put a number to this phenomenon, but that does not mean that this is not happening or is not important.
4)Data from the Centre of Monitoring Indian Economy shows that the size of the labour force between January 2020 and March 2021, has shrunk by 1.66 crore. This when the size of the working age population or the population greater than 15 years of age has increased by 2.88 crore during the same period.
What this means is that many individuals who can’t find jobs, have stopped looking and simply dropped out of the workforce. To be counted as a part of a labour force, an individual needs to be either employed or unemployed and be looking for a job.
The sheer size of numbers here tells us that it is the poor who are dropping out of the workforce, giving up on job search. Also as I have discussed in the past, women have faced the brunt of India’s unemployment problem.
5) The rise of the internet and the availability of cheap broadband has ensured that the need to have all hands on the deck is no longer there.
Of course, this does not mean that everyone can work from home. The working class has faced the brunt of the crisis. As Scott Galloway writes in Post Corona – From Crisis to Opportunity: “Most working-class people… can’t do their jobs at home, since they are tied to the store, warehouse, factory, or other place of work.”
People working in factories, hotels, bank branches, hospitals, real estate projects, mom and pop shops, emergency services, delivery services, etc., or driving cabs for that matter, need to turn up at their places of work and job sites every day.
Also, extended working from home, will end up having other major economic consequences. Other than permanent employees, every office has office maintenance jobs which are not on the rolls of the company. Most large offices have canteens run by a contractor. Some companies offer pick up and drop facilities to their employees.
This is how services companies create low-skilled and semi-skilled jobs. Around many large office complexes there are tapris (very small shops) selling tea, coffee and food. Further, the app cab drivers and normal taxi drivers, have already seen their business go down.
Working from home has already hit people in these professions hard. Again, while it is not easy to put a number to this phenomenon, that does not mean that this is not happening or is not important.
6)Given these factors, it is hardly surprising that many people have dropped out of the middle class. A Pew Research centre analysis found that “the middle class in India is estimated to have shrunk by 32 million in 2020 as a consequence of the downturn, compared with the number it may have reached absent the pandemic.”
This accounted for three-fifths of the global retreat in the number of people in the global middle class (defined as people with incomes of $10.01-$20 a day).
While the number of people dropping out of the middle class is high, the increase in the number of poor is shocking beyond belief. Their number is “estimated to have increased by 75 million because of the COVID-19 recession.” This also accounts for around three-fifths of the global increase in poverty.
In fact, this is something that Nobel Prize winning economist Angus Deaton confirms in a recent research paper, where he points out:
“China did better than almost all other countries, while India did worse. China’s 1.4 billion people experienced few deaths and growth in per capita income, which took them closer to the richer countries of the world and decreased (weighted) global inequality. India’s 1.4 billion people experienced many more deaths, as well as a large drop in income, which increased (weighted) global inequality.”
Of course, with the second wave of covid starting, all this is likely to continue. One point that we need to consider here is the ability of individuals to make a living in the years to come. School and college students are being taught digitally since the last one year. It needs to be considered here that not every student has access to a computer. Further, even if there is access to a computer, it might have to be shared among multiple siblings. Then there is the question of internet speed, electricity and so on.
The quality of education being delivered digitally will impact the earning capacity of many middle class and poor students, in the years to come.
In short, like the disease itself, the negative economic effects of covid, especially among the poor and the middle class, will continue to be felt in the years to come.
The idea for this piece came after reading the latest edition of Dylan Grice’s fantastic newsletter Popular Delusions. It took my mind back to some stuff I had written about, a while back, in the second volume of the Easy Money trilogy. Now what do they say about the more things change the more they remain the same?
Anyway, Grice’s latest newsletter starts with a comment made by Jerome Powell, the current Chairman of the Federal Reserve of the United States, the American central bank.
As Powell said on CNBC:
“The big picture is still that we’ve seen … three decades, a quarter of a century, of lower and more stable inflation and we’ve seen really the last decade be characterized by global disinflationary forces and large advanced economy nations struggling to reach their 2% inflation goal from below.”
He further said:
“If the economy reopens, there’s quite a lot of savings on peoples’ balance sheets… you could see strong spending growth and there could be some upward pressure on prices. Again though, my expectation would be that that would be neither large nor sustained.”
How do we interpret the above statements in simple English?
1) What Powell is basically saying here is that all the money printing carried out by central banks across the world over the last decade, hasn’t really led to high inflation. In fact, the inflation has constantly been less than the 2% level targeted by the Western central banks (a disinflationary environment as Powell put it).
And he is right. Take a look at following graph which basically plots inflation in the United States, as measured by the core personal expenditures index excluding food and energy. This is the index followed by the Federal Reserve when it comes to inflation.
Since 2008, the year when the financial crisis broke out, the only year in which inflation in the US touched 2%, was 2018. Clearly, the trillions of dollars printed by the Fed since then haven’t led to a high inflation at the consumer level.
I clearly remember that when the Fed started printing money post the breakout of the financial crisis, many writers (including yours truly) said very high inflation was on its way as too much money would end up chasing the same amount of goods and services, and this would drive up prices. But nothing like that happened. (The good bit is that the newspaper I wrote all this in, has since shutdown. So, finding evidence of it won’t be easy :-))
2)Powell also said that while he expects some inflation as people go back to leading normal lives once again post covid, but that’s not something to worry about because it would neither be large nor sustained. Hence, Powell expects the inflation to rise and then settle down.
This leads to the question why inflation has continued to remain less than 2% all these years through much of the Western world, despite the massive amount of money printing that has been carried out.
In an essay written in 1969, the economist Milton Friedman came up with the concept of the helicopter drop of money. As he had written in the essay:
“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community.”
The idea here was to distribute money to the public, so that they got out there and spend it, in the process creating inflation and economic growth.
The money printing carried out by the Federal Reserve and other central banks in the recent past and since 2008, was supposed to be a version of this helicopter drop. Of course, there was no helicopter going around dropping money directly to citizens, but central banks printed money and pumped that money into the financial system by buying bonds.
This was supposed to drive down interest rates. At lower interest rates people were supposed to borrow and spend, as they had before the financial crisis, and companies were supposed to borrow and expand.
The hope was that the increased spending would create some inflation and some economic growth along the way, like a helicopter drop is expected to.
The trouble with this argument is that it doesn’t take a basic factor into account, which is, when the money is being dropped from a helicopter, who is standing under it. The point being that people standing under the helicopter are likely to collect the money before others do and this changes the situation.
In fact, this possibility was first observed by Richard Cantillon an Irish-French economist, who lived in the seventeenth and the eighteenth century, before the era of Adam Smith as well as helicopters. Clearly, economists of the modern world, have forgotten him, which is hardly surprising given that economists these days rarely read any history.
When central banks print money, they do so with the belief that money is neutral. So, in that sense, it does not really matter who is standing under the helicopter when the money is printed and dropped into the economy, but Cantillon showed that money wasn’t really neutral and that it mattered where it was injected into the economy.
Cantillon made this observation based on all the gold and silver coming into Spain from what was then called the New World (now South America). When money supply increased in the form of gold and silver, it would first benefit the people associated with the mining industry, that is, 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.
These individuals would end up with a greater amount of gold and silver, that is, money. They would spend this money and thus drive up the prices of meat, wine, wool, wheat, etc. Of course, everyone in the economy had to pay these higher prices. ((I came to know of this effect from Dylan Grice, after having interviewed him many years back and then starting to read his newsletter regularly).
The Cantillon effect has played out since 2008. When central banks printed and pumped money into the financial system, the large institutional investors, were the ones standing under the helicopter.
They borrowed money at cheap rates and invested across large parts across the world, fuelling stock market and bond market rallies primarily, and a few real estate ones as well.
“The Fed creates new money (not more wealth … just new money). This new money goes into the banking system, pretending to have the same value as the money that people worked for. And people with good connections to the banks take advantage of the cheap credit this new money creates to aid financial speculation.”
After the large institutional investors came the corporates, who were expected to borrow money and expand, and create jobs and economic growth in the process. What they did instead was borrow money to buyback their shares.
When companies announce a decision to buyback their shares, it pushes up the possibility of their earning per share going up and this leads to higher stock prices, benefitting the top management of the company who owns company stock. Of course, the company ends up with lesser equity and more debt in the process. But that is a problem for a later date, by which time the top management would have moved on.
So, instead of consumer price inflation, what the world got was asset price inflation, with the values of financial assets, totally out of whack from the underlying fundamentals.
This dynamic has played out again since the beginning of 2020, in the post-covid world. Once the covid pandemic broke out, central banks decided to print and pump money into the financial system, like they had after the financial crisis. The US Federal Reserve has printed more than three trillion dollars and the Bank of Japan has printed more than 100 trillion yen, in the last one year.
And guess who was standing beneath the helicopter this time around? …
But along with this something else happened. The governments of the Western world also decided to send cheques directly to people, so that they could spend money directly and help boost economic activity. .
The trouble was with the pandemic on, people were stuck at homes. Hence, the money got saved and invested. Along with the institutional money, retail money also flowed into financial markets all across the world.
This has sent prices of financial assets soaring. As of March 2, the total market capitalization of the US stock market stood at 191.5% of its gross domestic product. The long term average of this ratio is 85.55%.
As Grice puts it in his latest newsletter:
“As the stock market makes new all-time highs… The IPO market is hot, credit markets are hot, commodity markets are hot, the crypto markets are hot. Everything, it seems is hot.”
Of course, other than the inflation as the Fed likes to measure it, which continues to be under 2%. And given that, all is well.
In every era when the prices of financial assets go up substantially, people forget history. This is not the first time that the Fed and other central banks are ignoring financial inflation and looking only at consumer price inflation.
Something similar happened both before the dotcom and telecom bubble, which burst in 2000 and 2001, and the sub prime and real estate bubble, which burst in 2007 and 2008. The Fed kept ignoring the bubbles while waiting for the inflation to cross 2%. This time is no different. (For details you can refer to the third volume of the Easy Money trilogy).
Inflation targeting as a policy, worked when inflation was high and central banks wanted to bring it down. This happened right through the 1980s and the first half of the 1990s.
Since the mid-1990s, inflation has been low in much of the Western world thanks to Chinese imports and outsourcing. As Niall Ferguson writes in The Ascent of Money – A Financial History of the World: “Chinese imports kept down US inflation. Chinese savings kept down US interest rates. Chinese labour kept down US wage costs.”
This has led to inflation targeting being used in reverse. Instead of trying to control inflation, Western central banks have been trying to create it, using the same set of tools.
As Gary Dugan, who was the CIO, Asia and Middle East, RBS Wealth Division, told me in a 2013 interview:
“We got inflation which was too low. So, we have changed it all around to actually try to create inflation, rather than to dampen it. I don’t think they know what tools they should be using. The central banks are using the same tools they used to dampen inflation, in a reverse way, in order to create it. And that is clearly not working.”
What was true for 2013 is also true for 2021. The playbook of central banks continues to remain the same. As I wrote in a recent piece for the Mint, the whole situation reminds me of the Hotel California song, where The Eagles sang, you can check out any time you want but you can never leave.
The trouble is that along with the money printing there is something else at play this time around. A large part of the global population has been stuck at their homes for more than a year. As they get vaccinated and start living normal lives again, a huge amount of pent-up demand is going to hit the market .
This might lead to inflation as the bond market investors have been fearing for a while, given that supply is not expected to keep up with demand. A higher inflation will mean higher interest rates, something which is not good for the stock market as a whole.
But there is another important factor that needs to be kept in mind. People will be spending their savings . And this means that they will be cashing in on their investments, be it stocks, bitcoin or whatever.
The greater the pent-up demand that hits the market, the higher will be the savings that will be cashed out on and more will be the pressure on the financial markets.
This is an important dynamic that investors need to keep in mind this year.
It wasn’t possible to even speed-read the whole Survey quickly, hence, I missed out on a few points, and am writing about them here. This piece is a follow up and I strongly recommend that you read the first piece before reading this one.
Let’s look at some important points made in the Survey.
1)The spread of corona has led to a massive economic contraction this year. While the growth is expected to bounce back over the next few years, the impact of this year’s contraction isn’t going to go away in a hurry.
As per the Survey, if India grows by 12% in 2021-22 and 6.5% and 7%, in 2022-23 and 2023-24, respectively, the Indian economy will be at around 91.5% of where it would have possibly been if there would have been no covid and no economic contraction, and India would have continued to grow at 6.7% per year on an average, as it has in the five years before 2020-21.
At 10% growth in 2021-22, and 6.5% and 7% growth in 2022-23 and 2023-24, respectively, the Indian economy will be at around 90% of where it could have possibly been, the Survey points out.
This is an important point that we need to understand. While, 2021-22 might see a double digit growth, covid has put us back by more than half a decade, if we look at trend growth.
2) The Economic Survey recommends money printing to finance higher government expenditure. Call me old school, but I always feel uncomfortable when economists recommend outright money printing to fund government expenditure. Of course, there is always a theoretical argument on offer.
The Survey refers to a speech made by Patrick Bolton, a professor of business at Columbia University in New York, to make the money printing argument and why money printing, where an excess amount of money chases a similar amount of goods and services, doesn’t always lead to inflation.
As the Survey points out:
“Printing more money can result in inflation and loss of purchasing power for domestic residents if the increase in money supply is larger than the increase in output….Printing more money does not necessarily lead to inflation and a debasement of the currency. In fact, if the increased money supply creates a disproportionate increase in output because the money is invested to finance investment projects with positive net present value.”
What does this mean in simple English? The Survey is essentially saying that if the printed money is well utilised and put into projects which are beneficial for the society, it benefits everyone, and doesn’t lead to inflation.
The trouble is a lot of things sound good in theory. One of the major things that the bad loans crisis of Indian banks teaches us is that the Indian system cannot take a sudden increase in investments. There is only so much that it can handle and that’s primarily because there is too much red tapism and bureaucracy involved in getting any investment project going. We are still dealing with the fallout of this a decade later.
Also, how do the government and bureaucrats ensure that the amount of money being printed is just enough and will not lead to inflation. (Central planning keeps coming back in different forms).
The government can print money and spend it. This can ensure one round of spending and the money will land up in the hands of people. Also, as men spend money, this money will land up with shopkeepers and businesses all over the country. The shopkeepers may hold back some of the cash that they earn depending on their needs.
The chances are that most of this money will be deposited back into bank accounts. In the normal scheme of things, the banks would lend this money out. In difficult times, banks are reluctant to lend. Hence, they end up depositing this money with the RBI. The RBI pays interest on this money. As of yesterday, banks had deposited Rs 5.6 lakh crore with the RBI. This is money they have no use for, or to put it in technical terms, this is the excess liquidity in the system.
Money printing will only add to this excess liquidity. Ultimately, for the economy to do well, people and corporates need to be in a state of mind to borrow and banks in the mood to lend. Printing money cannot ensure that.
Over and above this, money printing can and has led to massive financial and real estate bubbles, in the past few decades. This is asset price inflation. While this inflation doesn’t reflect in the normal everyday consumer price inflation, it is a form of inflation at the end of the day. And whenever such bubbles burst, which they eventually do, it creates its own set of problems.
Given these reasons, the chief economic advisor Krishnamurthy Subramanian’s recommendation of money printing by the government is a lazy idea which hasn’t been thought through. (For a detailed argument against money printing, please read this).
3)During the course of this financial year, banks have gone easy on borrowers who haven’t been in a position to repay.
Technically, this is referred to as regulatory forbearance. In this case, the central bank, comes up with rules and regulations which basically allows banks to treat borrowers in trouble with kids gloves. One of the learnings from the bad loans crisis of banks has been that regulatory forbearance of the Reserve Bank of India, India’s central bank, went on for too long.
The banks are yet to face the negative impact of the covid led contraction primarily because of regulatory forbearance. The banking system should be facing the first blows of the economic contraction. But that hasn’t happened, thanks to the Supreme Court and regulatory forbearance. The Supreme Court, in an interim order dated September 3, 2020, had directed the banks that loan accounts which hadn’t been declared as a bad loan as of August 31, shall not be declared as one, until further orders. Hence, the balance sheets of banks as revealed by their latest quarterly results, seem to be too good to be true.
The Survey suggests that an asset quality review of the balance sheets of banks may be in order. As it points out: “A clean-up of bank balance sheets is necessary when the forbearance is discontinued… An asset quality review exercise must be conducted immediately after the forbearance is withdrawn.”
This is one of the few good suggestions in the Survey this year and needs to be acted on quickly, so as to reveal the correct state of balance sheets of banks. The Survey further points out: “The asset quality review must account for all the creative ways in which banks can evergreen their loans.” Evergreening involves giving a new loan to the borrower so that he can pay the interest on the original loan or even repay it. And then everyone can just pretend that all is well.
In fact, even while making a suggestion for an asset quality review, the Survey takes potshots at Raghuram Rajan and the asset quality review he had initiated as the RBI governor in mid 2015.
4) Another point made in the Survey is to ignore the credit ratings agencies and their Indian ratings. As the Survey points out: “The Survey questioned whether India’s sovereign credit ratings reflect its fundamentals, and found evidence of a systemic under-assessment of India’s fundamentals as reflected in its low ratings over a period of at least two decades.”
This leads the Survey to conclude: “India’s fiscal policy must, therefore, not remain beholden to such a noisy/biased measure of India’s fundamentals and should instead reflect Gurudev Rabindranath Thakur’s sentiment of a mind without fear.”
While invoking Tagore, the Survey basically recommends that India’s government borrows more money to spend, taking into account “considerations of growth and development rather than be restrained by biased and subjective sovereign credit ratings”. (On a slightly different note, who would have thought that one day an economist would invoke Rabindranath Thakur’s name to market higher government borrowing).
Whether, the ratings agencies correctly rate India based on its fundamentals is one issue, whereas, whether it makes sense for India to ignore these ratings and borrow more, is another.
As the Survey points out: “While sovereign credit ratings do not reflect the Indian economy’s fundamentals, noisy, opaque and biased credit ratings damage FPI flows.” (FPI = foreign portfolio inflows).
What this means is that any further cut in credit rating can impact the amount of money being brought in by the foreign investors into India’s stock and bond market. In particular, it can impact the long-term money being brought in by pension funds.
While, the Survey doesn’t say so, it can possibly impact even foreign direct investment.
So, the point is, why take unnecessary panga, for the lack of a better word, with the rating agencies, at a point where the economy is anyway going through a tough time.
In another part, the Survey points out: “Debt levels have reached historic highs, making the global economy particularly vulnerable to financial market stress.”
5) Given that, tax revenues have collapsed, government borrowing money to finance expenditure has gone up dramatically during the course of this year. As the Survey points out:
“As on January 8, 2021, the central government gross market borrowing for FY2020-21 reached Rs 10.72 lakh crore, while State Governments have raised Rs 5.71 lakh crore. While Centre’s borrowings are 65 per cent higher than the amount raised in the corresponding period of the previous year, state governments have seen a step up of 41 per cent. Since the COVID-19 outbreak depressed growth and revenues, a significant scale up of borrowings amply demonstrates the government’s commitment to provide sustained fiscal stimulus [emphasis added] by maintaining high public expenditure levels in the economy.”
Fiscal stimulus is when the government spends more money in order to pump up the economy in a scenario where individuals and corporates are going slow on spending. The total government spending during April to November 2020 stood at Rs 19.1 lakh crore. It has risen by just 4.9% in comparison to April to November 2019. Given that inflation has stood at more than 6% this year, this can hardly be called a fiscal stimulus.
To conclude, economic surveys in the past, other than offering a detailed assessment on the current state of the Indian economy, also used to do some solid thinking about the future or stuff that needs to be done on the economic front.
Over the past few years, a detailed reading of these Surveys suggests that they have become yet another policy document which feeds into government’s massive propaganda machinery, albeit in a slightly sophisticated way.