Vivek Kaul
The Dow Jones Industrial Average (DJIA), America’s premier stock market index, has been quoting at all-time-high levels. On 7 March 2013, it closed at 14,329.49 points. This has happened in an environment where the American economy and corporate profitability has been down in the dumps.
The Indian stock markets too are less than 10 percent away from their all-time peaks even though the economy will barely grow at 5 percent this year.
All the easy money created by the Federal Reserve is landing up in the stock market. So the stock market is going up because there is too much money chasing stocks. ReutersIn this scenario, should one dump stocks or buy them?
The short answer is simple: as long as the other markets are doing fine, we will do fine too. The Indian market’s performance is more closely linked to the fortunes of other stock markets than to Indian economic performance.
So watch the world and then invest in the Sensex or Nifty. You can’t normally go wrong on this.
Let’s see how the connection between the real economy and the stock market has broken down after the Lehman crisis.
The accompanying chart below proves a part of the point I am trying to make. It tells us that the total liabilities of the American government are huge and currently stand at 541 percent of GDP. The American GDP is around $15 trillion. Hence the total liability of the American government comes to around $81 trillion (541 percent of $15 trillion).
Source: Global Strategy Weekly, Cross Asset Research, Societe Generate, March 7, 2013
The total liability of any government includes not only the debt that it currently owes to others but also amounts that it will have to pay out in the days to come and is currently not budgeting for.
Allow me to explain. As economist Laurence Kotlikoff wrote in a column in July last year, “The 78 million-strong baby boom generation is starting to retire in droves. On average, each retiring boomer can expect to receive roughly $35,000, adjusted for inflation, in Social Security, Medicare, and Medicaid benefits. Multiply $35,000 by 78 million pairs of outstretched hands and you get close to $3 trillion per year in costs.”
The $3trillion per year that the American government needs to pay its citizens in the years to come will not come out of thin air. In order to pay out that money, the government needs to start investing that money now. And that is not happening. Hence, this potential liability in the years to come is said to be unfunded. But it’s a liability nonetheless. It is an amount that the American government will owe to its citizens. Hence, it needs to be included while calculating the overall liability of the American government.
So the total liabilities of the American government come to around $81 trillion. The annual world GDP is around $60 trillion. This should give you, dear reader, some sense of the enormity of the number that we are talking about.
And that’s just one part of the American economic story. In the three months ending December 2012, the American GDP shrank by 0.1 percent. The “U3” measure of unemployment in January 2013 stood at 7.9 percent of the labour force. There are various ways in which the Bureau of Labour Standards in the United States measures unemployment. This ranges from U1 to U6. The official rate of unemployment is the U3, which is the proportion of the civilian labour force that is unemployed but actively seeking employment.
U6 is the broadest definition of unemployment and includes workers who want to work full-time but are working part-time because there are no full-time jobs available. It also includes “discouraged workers”, or people who have stopped looking for work because economic conditions make them believe that no work is available for them. This number for January, 2013, stood at 14.4 percent.
The business conditions are also deteriorating. As Michael Lombardi of Profit Confidential recently wrote, “As for business conditions, they appear bright only if you look at the stock market. In reality, they are deteriorating in the US economy. For the first quarter of 2013, the expectations of corporate earnings of companies in the S&P 500 have turned negative. Corporate earnings were negative in the third quarter of 2012, too.”
The average American consumer is not doing well either. “Consumer spending, hands down the biggest contributor of economic growth in the US economy, looks to be tumbling. In January, the disposable income of households in the US economy, after taking into consideration inflation and taxes, dropped four percent—the biggest single-month drop in 20 years!,” writes Lombardi.
Consumption makes up for nearly 70 percent of the American GDP. And when the American consumer is in the mess that he is where is the question of economic growth returning?
So why is the stock market rallying then? A stock market ultimately needs to reflect the prevailing business and economic conditions, which is clearly not the case currently.
The answer lies in all the money that is being printed by the Federal Reserve of the United States, the American central bank. Currently, the Federal Reserve prints $85 billion every month, in a bid to keep long-term interest rates on hold and get the American consumer to borrow again. The size of its balance-sheet has touched nearly $3 trillion. It was at around $800 billion at the start of the financial crisis in September 2008.
As Lombardi puts it, “When trillions of dollars in paper money are created out of thin air and interest rates are simultaneously reduced to zero, where else would investors put their money?”
All the easy money created by the Federal Reserve is landing up in the stock market.
So the stock market is going up because there is too much money chasing stocks. The broader point is that the stock markets have little to do with the overall state of economy and business.
This is something that Aswath Damodaran, valuation guru, and professor at the Columbia University in New York, seemed to agree with, when I asked him in a recent interview about how strong is the link between economic growth and stock markets? “It is getting weaker and weaker every year,” he had replied.
This holds even in the context of the stock market in India. The economy which was growing at more than 8 percent per year is now barely growing at 5 percent per year. Inflation is high at 10 percent. Borrowing rates are higher than that. When it comes to fiscal deficit we are placed 148 out of the 150 emerging markets in the world. This means only two countries have a higher fiscal deficit as a percentage of their GDP, in comparison to India. Our inflation rank is around 118-119 out of the 150 emerging markets.
More and more Indian corporates are investing abroad rather than in India (Source: This discussion featuring Morgan Stanley’s Ruchir Sharma and the Chief Economic Advisor to the government Raghuram Rajan on NDTV). But despite all these negatives, the BSE Sensex, India’s premier stock market index, is only a few percentage points away from its all-time high level.
Sharma, Managing Director and head of the Emerging Markets Equity team at Morgan Stanley Investment Management, had a very interesting point to make. He used thefollowing slide to show how closely the Indian stock market was related to the other emerging markets of the world.
India’s premier stock market index, is only a few percentage points away from its all-time high level.
As he put it, “It has a correlation of more than 0.9. It is the most highly correlated stock market in the entire world with the emerging market averages.”
So we might like to think that we are different but we are not. “We love to make local noises about how will the market react pre-budget/post-budget and so on, but the big picture is this. What drives a stock market in the short term, medium term and long term is how the other stock markets are doing,” said Sharma. So if the other stock markets are going up, so does the stock market in India and vice versa.
In fact, one can even broaden the argument here. The state of the American stock market also has a huge impact on how the other stock markets around the world perform. So as long as the Federal Reserve keeps printing money, the Dow will keep doing well. And this in turn will have a positive impact on other markets around the world.
To conclude let me quote Lombardi of Profit Confidential again “I believe the longer the Federal Reserve continues with its quantitative easing and easy monetary policy, the bigger the eventual problem is going to be. Consider this: what happens to the Dow Jones Industrial Average when the Fed stops printing paper money, stops purchasing US bonds, and starts to raise interest rates? The opposite of a rising stock market is what happens.”
But the moral is this: when the world booms, India too booms. Keep your fingers crossed if the boom is lowered some time in the future.
The article originally appeared on www.firstpost.com on March 8, 2013.
Vivek Kaul is a writer. He tweets @kaul_vivek
Financial Crisis
Why the dollar continues to look as good as gold
Vivek Kaul
Over the last few years a mini industry predicting the demise of the dollar has evolved. This writer has often been a part of it. But nothing of that sort has happened.
There are fundamental reasons that have led this writer and other writers to believe that dollar is likely to get into trouble sooner rather than later. The main reason is the rapid rate at which the Federal Reserve of United States has printed dollars over the last few years. This rapid money printing is expected to create high inflation sometime in the future.
But whenever markets have sensed any kind of trouble in the last few years money has rapidly moved into the dollar. In fact, even when the rating agency Standard & Poor’s downgraded America’s AAA status, money moved into the dollar. It couldn’t have been more ironical.
What is interesting nonetheless that the doubts on the continued existence of the dollar are getting graver by the day. Gillian Tett, the markets and finance commentator of The Financial Times has a very interesting example on this in her latest column Is Dollar As Good as Gold published on March 1, 2013.
As Tett writes “Should we all worry about the outlook for the mighty American dollar? That is a question that many economists and market traders have pondered as economic pressures have grown. But in recent weeks Virginia’s politicians have been discussing it with renewed zeal. Last month Bob Marshall, a local Republican, submitted a bill to the local assembly calling on the state to study whether it should create its own “metallic-based” currency.”
The reason for this as the bill pointed out was that “Unprecedented monetary policy actions taken by the Federal Reserve … have raised concern over the risk of dollar debasement.”
In fact Virginia is not the only state in the United States that has been talking about a currency backed by a precious metal(read gold). As Tett puts it “So guffaw at the Virginia bill if you like. And if you want an additional chuckle, you might also note that a dozen other state assemblies, in places such as North and South Carolina, have discussed similar ideas; indeed, Utah has a gold and silver depository which is trying to back debit cards with gold.”
The point is that the debate on the demise of the dollar if it continues to be printed at such a rapid rate, is now moving into the mainstream.
So what will be the fate of the US dollar? Will it continue to be at the heart of the global financial system? These are questions which are not easy to answer at all. There are too many interplaying factors involved.
While there are fundamental reasons behind the doubts people have over the future of the dollar. There are equally fundamental reasons behind why the dollar is likely to continue to survive. But one good place to start looking for a change is the composition of the total foreign exchange reserves held by countries all over the world. The International Monetary Fund puts out this data. The problem here is that a lot of countries declare only their total foreign exchange reserves without going into the composition of those reserves. Hence the fund divides the foreign exchange data into allocated reserves and total reserves. Allocated reserves are reserves for countries which give the composition of their foreign exchange reserves and tell us exactly the various currencies they hold as a part of their foreign exchange reserves.
Dollars formed 71% of the total allocable foreign exchange reserves in 1999, when the euro had just started functioning as a currency. Since then the proportion of foreign exchange reserves that countries hold in dollars has continued to fall. In fact in the third quarter of 2008 (around the time Lehman Brothers went bust) dollars formed around 64.5% of total allocable foreign exchange reserves. This kept falling and by the first quarter of 2010 it was at 61.8%. It has started rising since then and as per the last available data as of the third quarter of 2012, dollars as a proportion of total allocable foreign exchange reserves are at 62.1%. The fall of the dollar has all along been matched by the rise of the euro. But with Europe being in the doldrums lately it is unlikely that countries will increase their allocation to the euro in the days to come. Between first quarter of 2010 and the third quarter of 2012, the holdings of euro have fallen from 27.3% to 24.14%.
So the proportion of dollar in the total allocable foreign exchange reserves has fallen from 71% to 62.1% between 1999 and 2012. But then dollar as a percentage of total allocable foreign exchange reserves in 2012 was higher than it was in 1995, when the proportion was 59%.
So when it comes to international reserves, the American dollar still remains the currency of choice, despite the continued doubts raised about it. One reason for it is the fact that there has been no real alternative for the dollar. Euro was seen as an alternative but with large parts of Europe being in bigger trouble than America, that is no longer the case. Japan has been in a recession for more than two decades not making exactly yen the best currency to hold reserves in.
The British Pound has been in doldrums since the end of the Second World War. And the Chinese renminbi still remains a closed currency given that its value is not allowed to freely fluctuate against the dollar.
So that leaves really no alternative for countries to hold their reserves in other than the American dollar. But that is not just the only reason for countries to hold onto their reserves in dollars. The other major reason why countries cannot do away with the dollar given that a large proportion of international transactions still happen in dollar terms. And this includes oil.
The fact that oil is still bought and sold in American dollars is a major reason why American dollar remains where it is, despite all attempts being made by the American government and the Federal Reserve of United States, the American central bank, to destroy it. And for this the United States of America needs to be thankful to Franklin D Roosevelt, who was the President from 1933 till his death in 1945 (in those days an individual could be the President of United States for more than two terms).
At the end of the Second World War Roosevelt realised that a regular supply of oil was very important for the well being of America and the evolving American way of life. He travelled quietly to USS Quincy, a ship anchored in the Red Sea. Here he was met by King Ibn Sa’ud of Saudi Arabia, a country, which was by then home to the biggest oil reserves in the world.
The United States’ obsession with the automobile had led to a swift decline in domestic reserves, even though America was the biggest producer of oil in the world at that point of time. The country needed to secure another source of assured supply of oil. So in return for access to oil reserves of Saudi Arabia, King Ibn Sa’ud was promised full American military support to the ruling clan of Sa’ud..
Saudi Arabia over the years has emerged as the biggest producer of oil in the world. It also supposedly has the biggest oil reserves. It is also the biggest producer of oil within the Organisation of Petroleum Exporting Countries (OPEC), the oil cartel. Hence this has ensured that OPEC typically does what Saudi Arabia wants it to do. Within OPEC, Saudi Arabia has had the almost unquestioned support of what are known as the sheikhdom states of Bahrain, Kuwait, United Arab Emirates and Qatar.
In fact, in the late 1970s efforts were made by other OPEC countries, primarily Iran, to get OPEC to start pricing oil in a basket of currencies (which included the dollar) but that never happened as Saudi Arabia put its foot down on any such move. This led to oil being continued to be priced in dollars and was a major reason for the dollar continuing to be the major international reserve currency.
It is important to remember that the American security guarantee made by President Roosevelt after the Second World War was extended not to the people of Saudia Arabia nor to the government of Saudi Arabia but to the ruling clan of Al Sa’uds. Hence, it is in the interest of the Al Sa’ uds to ensure that oil is continued to be priced in American dollars.
And until oil is priced in dollars, any theory on the dollar being under threat will have to be taken with a pinch of salt because the world will need American dollars to buy oil. Also it is important to remember that financially America might be in a mess, but by and large it still remains the only superpower in the world. In 2010, the United States spent $698billion on defence. This was 43% of the global total.
So dollar in a way will continue to be as good as gold. Until it snaps.
The piece originally appeared on www.firstpost.com on March 5, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek and continues to actively bet against the dollar by buying gold through the mutual fund route)
Gold price falling? Why it’s still okay to buy the metal
Vivek Kaul
Gold prices fell below Rs 30,000 per ten grams for the first time in seven months on February 21, 2013. Data from www.goldprice.org shows that the yellow metal has fallen by around 6.5% in dollar terms over the last 30 days. In rupee terms the fall has been a little lower at 5.7%.
This fall has meant that everyone who has been recommending gold (including this writer) have ended up with eggs on their face. But every forecast cannot be right all the time. There are situations when a forecast is wrong till it is proved right.
Allow me to explain. Every bull market has a theory. So why has the price of gold gone up over the last few years? The answer is very simple. Central banks around the world have printed a lot of money. This money has been pumped into the financial system with the hope that banks will lend it to people and businesses, who will then spend this money and thus help in reviving the economy.
The fear was that with all this extra money chasing the same number of goods and services, there would be a great rise in prices. To protect themselves from this rise in price and loss of purchasing power, investors around the world had been buying gold. This pushed up its price. Unlike paper money gold cannot be created out of thin air by the government and thus is looked upon as a hedge against inflation.
But the inflation is still to come. And so this theory which drove up the price of gold doesn’t seem to be working. As a result the price of gold has taken a beating. With no inflation there is really no reason for people to buy the yellow metal and protect themselves against loss of purchasing power.
As Gary Dorsch, Editor, Global Money Trends points out in a recent column “So far, five central banks, – the Federal Reserve, the European Central Bank, Bank of England, the Bank of Japan and the Swiss National Bank have effectively created more than $6-trillion of new currency over the past four years, and have flooded the world money markets with excess liquidity. The size of their balance sheets has now reached a combined $9.5-trillion, compared with $3.5-trillion six years ago.”
But even with so much money being printed there has been very little inflation. So money is being diverted to other asset classes rather than buying up what John Maynard Keynes referred to as the barbarous relic.
Also this lack of inflation has made central bank governors and politicians around the world victims of what Nassim Nicholas Taleb calls the great turkey problem. As he writes in his latest book Anti Fragile “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.””
With the butcher feeding it on a regular basis, the turkey starts to expect that the good times will continue forever and the butcher will continue feeding it. That is what seems to be happening with central bank governors and politicians around the world. The fact that all the money printing has not produced rapid inflation till now has led to the assumption that it will never produce any inflation. Ben Bernanke, the Chairman of the Federal Reserve of United States, the American central bank, has even gone to the extent of saying that he was 100% sure he could control inflation.
And using this conclusion central banks are printing even more money. This is like the lines from La Haine, a French film released in 1995 “Heard about the guy who fell off a skyscraper? On his way down past each floor, he kept saying to reassure himself: So far so good… so far so good… so far so good.”
But the person falling from a skyscraper has to hit the ground at some point of time. The good days of every turkey being reared by a butcher also comes to an end. As Taleb writes “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.”
Or as the line from La Haine goes “How you fall doesn’t matter. It’s how you land!”
Similarly all the money printing has to end up somewhere. As Taleb puts it “central banks can print money; they print print and print with no effect (and claim the “safety” of such a measure), then, “unexpectedly,” the printing causes a jump in inflation.”
Or as James Rickards author Currency Wars: The Making of the Next Global Crises puts it “They can’t just keep printing…All major central banks are easing…Eventually so much money will be printed that this will lead to inflation.”
There is a reason to why the inflation is taking time even with governments around the world printing money rapidly. Henry Hazlitt has an explanation for it in his brilliant book, The Inflation Crisis and How to Resolve it.
In the initial stages of inflation, the man on the street does not know that the government is printing money and hence he has confidence in the paper money he is using. He does not think that the paper money is going to lose value anytime soon, and does not rush out to spend it. Gradually news starts to get around the government is printing money and this is when there is some rush to spend money before it loses its value. This is when prices start to go up at the rate at which money is being printed. In the final stage, as the central bank backed by the government of the day, continues to print money, people start to feel that this will continue indefinitely. And hence they try to get rid of paper money, as soon as they get it. This in turn leads to prices rising at a rate even faster than the rate at which money is being printed.
This is how most inflations evolve whenever governments print money at a very rapid rate.
Once the market starts discounting the idea of inflation, the price of gold will rise at a very rapid rate. But till that happens, people like me, who have and continue to recommend investing in gold, will look stupid. Also it is important to remember that every bull market has its bear runs. In the middle of the bull run in gold prices in the seventies gold prices fell by nearly 44%. The price of gold as of end of December 1974 was at $186.5 per ounce (one ounce equals 31.1 grams). By end of August 1976, it had fallen to $104 per ounce, or nearly 44.2% lower. But prices rallied again from there and peaked very briefly at $850 per ounce on January 21, 1980.
So as I said at the beginning forecasts can be wrong for a long time, till they are proven right. And when they are proved right, even for a brief period, its then when the ‘real money’ gets made.
Taleb talks about people who had been predicting a financial crisis in the developed world. There predictions were wrong for a very long till they were proven right. As he writes “You were wrong for years, right for a moment, losing small, winning big, so vastly more successful than the other way.”
Hence, I would still recommend buying gold, limiting it to around 10% of the overall portfolio or even lower, depending on how much money you are willing to back what is a particularly risky trade. Investment in gold has to be looked upon as a speculation on the continued printing of money and the eventual arrival of rapid inflation. This strategy can prove to be tremendously beneficial. As Taleb writes “If you put 90 percent of your funds in boring cash…and 10 percent in very risky, maximally risky, securities, you cannot possibly lose more than 10 percent, while you are exposed to massive upside.” Gold has to be played like that.
The article originally appeared on www.firstpost.com on February 22, 2013
(Vivek Kaul is a writer. He can be reached at [email protected]. Nearly 14% of his investment portfolio is in gold through the mutual fund route. He continues to buy gold through the SIP route)
Why Montek has a turkey problem while forecasting
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])
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])