Gold

Bitcoin is a bubble, a way to speculate and not the future of money

The actual writing of this piece took around six hours, though I have been thinking on this issue for at least the past nine years since I started writing my Easy Money book. I have been told that the backlash from the bitcoins believers will be huge. All feedback is welcome, as long as you don’t abuse. And if you choose to abuse at least read the piece first. You will be able to abuse better.

 Bulbulon ko abhi intezar karne do. (Let the bubbles wait for now).
— Gulzar, Vishal Bhardwaj, Usha Uthup and Rekha Bhardwaj in 7 Khoon Maaf.

Let’s start this one with a small story.

Salvador Dalí was a famous painter who lived through much of the twentieth century. He was a pioneering figure in what is known as Surrealism.

Other than being a fantastic painter, Dalí was also a sharp businessman. The story goes that once Dalí had treated some friends at an expensive New York restaurant. When the time to pay for the meal came, Dalí instead of paying in dollars, like anyone else would have, decided to carry out a small experiment.

On the back of the cheque Dalí had signed to pay for the expensive meal, he drew a sketch in his inimitable style. He signed it and handed it to the waiter. The waiter passed it on to the manager.

The manager realised the value of what Dalí had given him and decided to frame the cheque and hang it on the wall, making sure that anyone who came to the restaurant saw it.

Of course, this meant that Dalí’s cheque wasn’t encashed and he didn’t really have to pay in dollars for the expensive meal he had taken his friends out for.

This trick worked for Dalí. He was delighted and he used the same trick at different New York restaurants to pay for meals. The managers of all these different restaurants framed the cheque and hung it on one of the walls in their restaurants, so that everybody who came to the restaurant could see and realise that the famous painter Salvador Dalí had dined at the same place as they were.

This interesting story is recounted by Mauro F Guillén in his book 2030—How Today’s Biggest Trends Will Collide and Reshape the Future of Everything: “

Now what was happening here? If I can state this in simple English, Salvador Dalí, had turned his art into money. As Guillén writes:

“The money offered to pay for the meals was never deposited, as the cheques were transformed into artworks and took on a separate life. For Dalí, this maneuver was a stroke of genius. He could print his own money (his drawings had value), and people were willing to accept it as a form of payment.”

The trouble was Dalí went overboard and paid for one too many meals using this trick. In the end, the restaurant managers wised up and Dalí probably had to start paying real dollars for the expensive meals he took his friends out for.

What’s the moral of this story? Anyone can create his or her own money as long as others are willing to accept it, though one thing needs to be kept in mind. As Guillén writes: “As with national currencies, any money can be felled by the laws of supply and demand, as an excessive supply depreciates its worth and reduces people’s willingness to use it.”

What Dalí ended up doing in a very small way, governments have done over and over again, over the centuries. They have gone overboard with printing money and spending it, created high inflation, as too much has chased the same set of goods and services, and in the process destroyed the prevailing form of money. (If you are interested in details, I would suggest that you read my Easy Money trilogy).

Dear Reader, you must be wondering by now why am I recounting this story in a piece which is headlined to be about the bitcoin bubble. Have some patience, everything will become clear very soon. Read on.

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Bitcoin is a digital currency that does not use banks or any third party as a medium or at least that is how it is conventionally defined. It is governed by a string of cryptographical codes, which are believed to be military grade and very tough to break.

The price of a bitcoin has rallied big-time over the last few months. It rose from a little over $10,000 per bitcoin in early September to more than $40,000 per bitcoin in early January. As of January 8, 2021, the price of bitcoin touched an all-time high of $40,599.

One of the core selling points of bitcoins as well as its raison d’être is that unlike paper money they cannot be created out of thin air. The number of bitcoins is finite and the code behind it is so written that they cannot go beyond a limit of 21 million tokens.

Interestingly, mining, or the generation of a bitcoin, happens when a computer solves a complex algorithm. Anyone can try to mine bitcoins, but with a finite number being generated at regular intervals and with an increase in the number of people joining the mining race, it has become increasingly difficult to solve the algorithm and generate bitcoins.

As of January 11, 2021, the number of bitcoins in circulation stood at 18.6 million units. The rate at which bitcoins are being created has slowed down over the years and the last fraction of the 21 millionth bitcoin will be created only in 2140.

The larger point here is that unlike the paper money system (or to put it slightly more technically the fiat money system) which can be manipulated by central banks and the governments, the bitcoin system can’t.

Hence, there is an overall limit to the number of bitcoins that can be created. This is the main logic offered in support of buying and owning bitcoins. Unlike central banks or governments or Salvador Dalí (in case you are still wondering why I started with that story), money in the form of bitcoin cannot be created out of thin air and beyond a certain limit.

In fact, this core idea/message at the heart of the bitcoin was built into the first fifty coins, now known as the genesis block, created by Satoshi Nakamoto, the mysterious inventor behind it. The beauty of bitcoin is that even not knowing who really Nakamoto is, doesn’t impact the way the system he created, works.

The genesis block contained a headline from The Times newspaper published in London dated January 3, 2009. The headline was: “Chancellor on brink of second bail-out for banks”. The headline and the date are permanently embedded into the bitcoin data.

As Nakamoto wrote on a message board in February 2009: “The root problem with conventional currency is all the trust that’s required to make it work… The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.”

Bitcoin was supposed to be this grand idea meant to save the world from the way the central banks and governments manipulate the paper money system. As William Quinn and John D Turner write in Boom and Bust—A Global History of Financial Bubbles: “To its advocates, bitcoin was the money of the future: it could not be devalued through inflation by a central bank, you could spend it on anything without having to worry about government interference or taxes, and it cut out the middleman, namely commercial banks.”

The question is, in these times of easy money, has bitcoin reached anywhere near its original goal or is it just another way of pure speculation.

Let’s look at this pointwise.

1) Here is a chart of the price of bitcoin in dollars since July 18, 2010 (I couldn’t find the price of bitcoin before this in the public domain, hence, the random date).


Source: https://in.investing.com/crypto/bitcoin/historical-data

It doesn’t take rocket science to understand that if you have been a long-term investor in bitcoin, you would have made shitloads of money by now. But the fundamental question is, is bitcoin money or even the future of money, as it is made out to be, by those who are in love with it, or is it simply another form of speculation.

One of the key characteristics of money is that it is a store of value. The recent rally in bitcoin has led to many bitcoin believers telling us that bitcoin is a store of value. This comes from a very shaky understanding of what the term store of value actually means.

A store of value basically means that something has a stable value over time. As Jacob Goldstein writes in Money: The True Story of a Made-Up Thing: “If $100 buys your family a week’s worth of groceries today, there is a very good chance it will buy approximately a week’s worth of groceries a year from now. The dollar is a good store of value (it tends to lose about 2 percent of its value every year).”

Let’s look at what has happened to bitcoin over the last few months. It rose from a little over $10,000 per bitcoin in early September 2020 to more than $40,000 per bitcoin in early January 2021.

As of January 8, 2021, the price of bitcoin touched an all-time high of $40,599. As I write this early in the morning on January 14, 2021, the price of a bitcoin is around $37,329. The price has fallen by 8% in a little over five days’ time. So, where is the stability of value? And this isn’t a one-off event. Bitcoin has moved rapidly up and down on many occasions.

But this is a very simple point. Here’s the more complicated point . The price of a bitcoin as of September 5, 2020, was $ 10,092. On January 8, 2021, it reached $40,599, a rise of 302% in a matter of a little over four months.

If bitcoin really was money, using which we could make and receive payments and borrow and lend, the recent rally would have created a havoc in the economy.

What does the rise in the value of any form of money really mean? It means that the price of everything that money can buy is falling. And in this case prices would have fallen big-time. As Goldstein puts it: “This rise in the value of bitcoin would have caused a deflation far worse than the one in the Great Depression.” Deflation is the scenario of falling prices and is deemed to be dangerous because people keep postponing their consumption in the hope of getting a lower price. This hurts businesses and the overall economy.

Now take a look at the following chart which plots the price of a bitcoin in dollars between December 2017 and December 2018.

Source: https://in.investing.com/crypto/bitcoin/historical-data

The price of a bitcoin as on December 16, 2017, was $19,345. A year later on December 15, 2018, it had fallen by 83% to around $3,229. What would this have meant if bitcoin really was money? It would mean that the price of money has fallen and hence, the price of other things has gone up. In this case, it would mean very high inflation, even hyperinflation.

In its current form, bitcoin is no store of value. If it was to be used as money, the world would hyperventilate between deflation and inflation.

2) Another key characteristic of money is that it is a medium of exchange or to put it in simple English, it can be used to buy things (like Dalí bought meals at expensive restaurants).

According to financial services company Fundera 2,352 American businesses, accept bitcoins as a payment. The United States is the mecca of bitcoin believers. As per the US Census Bureau there were around 7.7 million companies in the US with at least one paid employee. This statistic doesn’t inspire much confidence. Barely anyone takes payments in bitcoins even in the United States.

Of course, it takes time for any new form of money to be adopted, but for something that has been around for 12 years, the rate of adoption seems quite poor.

Personally, I don’t know of any business that accepts bitcoin as a payment in India. Maybe, there is some coffee shop in Bengaluru that does. Dear reader, if you know of it, do let me know.

3) The bitcoin believers like to compare it with gold. The reason gold has acted as a hedge against the proclivity of the governments and central banks to create paper money out of thin air, is that it cannot be created out of thin air. While alchemists, which included Isaac Newton as well, have tried this over the centuries, no one has been successful in developing a chemical formula that converts other metals into gold. Bitcoin works because of a similar dynamic, the believers tell us. There is a limit to the number of bitcoins that can be created and as time passes by it becomes more and more difficult to mine bitcoins. That’s how the code behind bitcoin is written.

But the thing is that the code behind bitcoin is freely available. Anyone can take it and tweak it and come up with a new kind of money. Over the years this has happened and many of these new forms of money have ended up as shitcoins.

As Quinn and Turner write:

“In August 2016, one bitcoin was trading at $555; in the next 16 months its price rose by almost 3,400 per cent to a peak of $19,783.3 This was accompanied by a promotion boom, as a mix of cryptocurrency enthusiasts and opportunistic charlatans issued their own virtual currencies in the form of initial coin offerings, or ICOs. These coins had, on the face of it, no intrinsic value – to entitle their holders to future cash flows would have violated laws against issuing unregistered securities – but they nevertheless attracted $6.2 billion of money from investors in 2017 and a further $7.9 billion in 2018.”

A lot of this money never came back to the investors. There is no way to make sure that this won’t happen in the future.

Also, at a broader level, a free market in money is a bad idea. The United States went through this situation sometime in the nineteenth century (Something I discuss in detail in the first volume of Easy Money). It was very easy to get a banking license and banks could print their own money.

As Goldstein writes: “Not all banks were shady. Not even most banks were shady. But the notes printed by the shady banks looked as legit as the notes printed by the honest banks. And there were a lot of notes—at one point, the Chicago Tribune reported that the country had 8,370 different kinds of paper money in circulation.” Imagine the confusion this would have created.

It was also easy for counterfeiters to manufacture their own paper money. In this scenario, a guide called Leonori’s New York Bank Note List, Counterfeit Detector, and Wholesale Prices Current was published once a month. An issue of this guide, dated 18 November 1854, shows that 1,276 such banks were in operation in various states and 825 different kinds of forged notes were in circulation. The financial system was in a total anarchy.

While it is easy to make a case for a non-government decentralised money system, what may lie in store isn’t something we may want in the first place. The sad part is very little thinking has happened on this front. Saying, let the best money win is a very insensitive way to go about it.

4) The bitcoin code which limits their number to 21 million units is written in C++. As Sean Williams writes on Fool.com: “Last I checked, code can always be erased and rewritten. While it’s unlikely that a community consensus would be reached to increase the circulating supply of bitcoin, the possibility of this happening isn’t zero.” Anyway this possibility isn’t going to arise until 2140, when the last fraction of the bitcoin will be mined, and by then you and I, won’t be around. So, it doesn’t really matter.


5) Let’s talk a little more about paper money. Why do others accept it as money? Because they know that the government bank/central bank deems it to be money and hence, still others will accept it as money as well.

As L Randall Wray writes in Modern Money Theory – A Primer on Macroeconomics for Sovereign Monetary Systems:
“The typical answer provided in textbooks is that you will accept your national currency because you know that others will accept it. In other words, it is accepted because it is accepted. The typical explanation thus relies on an ‘infinite regress’: John accepts it because he thinks Mary will accept it, and she accepts it because she thinks Walmart will take it.”

While this sounds correct there is a slightly more nuanced answer to the question.

There are three main powers that any government has: 1) The right to “legal” violence. 2) The right to tax. 3) The right to create money out of thin air by printing it.

As Wray writes:

“One of the most important powers claimed by sovereign government is the authority to levy and collect taxes (and other payments made to government, including fees and fines). Tax obligations are levied in the national money of account: Dollars in the United States, Canada, and Australia; Yen in Japan; Yuan in China; and Pesos in Mexico. Further, the sovereign government also determines what can be delivered to satisfy the tax obligation. In most developed nations, it is the government’s own currency that is accepted in payment of taxes.”

What does this mean?

As Wray puts it:

“Ultimately, it is because anyone with tax obligations can use currency to eliminate these liabilities that government currency is in demand, and thus can be used in purchases or in payment of private obligations. The government cannot easily force others to use its currency in private payments, or to hoard it in piggybanks, but government can force use of currency to meet the tax obligations that it imposes… It is the tax liability (or other obligatory payments) that stands behind the curtain.”

Hence, the government creates demand for paper/fiat money by accepting taxes in it. This has ensured that the paper money system has kept going despite its weaknesses.

What this also means is that for bitcoin to become popular and move beyond the nerds, it needs a use case as solid as paying taxes in what government deems to be money, is.

It is worth remembering here what Wray writes: “For the past 4,000 years (“at least”, as Keynes put it), our monetary system has been a “state money system”. To simplify, that is one in which the state chooses the money of account, imposes obligations (taxes, tribute, tithes, fines, and fees), denominated in that money unit, and issues a currency accepted in payment of those obligations.”

This is not to say that governments haven’t destroyed money systems in the past. The history of money is littered with examples of kings, queens, rulers, dictators, general secretaries and politicians, representing governments in different eras, having destroyed different money systems at different points of time. But the government has always comeback and controlled the money system the way it has wanted to.

And unless governments and central banks start taking a liking to bitcoin, there is no way its usage is going to spread to a level where it can hope to challenge the prevailing paper money system. It is worth remembering that if governments start taking interest in bitcoin, it in a way beats the entire purpose behind its creation.

Also, every government will want to protect its right to create money out of thin air. Right now bitcoin is too small in the overall scheme of things for governments to be bothered about it and hence, they have largely humoured it (not in India though).

The market capitalisation of bitcoins (number of coins multiplied by the dollar price) as of January 8, peaked at around $759 billion. The global GDP in 2019 was around $88 trillion. So the price of bitcoin even at its peak was lower than 1% of the global GDP.

Hence, the bitcoin story is like that of a rich Indian father basically allowing his son to play around, until he thinks that the son now needs to grow up.

6) There is another point that needs to be made here regarding the paper money system. This is something I realised while writing the third volume of Easy Money  and it makes me sceptical of anyone who wants to write off the paper money system in a hurry. (Before you jump on me for being a blanket supporter of the paper money system, I am not, but then that doesn’t mean I don’t see logical arguments when they are offered).

Many years back, in one of my first freelancing assignments, I happened to interview the financial historian Russel Napier. He explained to me the link between paper money and democracy. As he told me on that occasion:

“The history of the paper currency system, or the fiat currency system is really the history of democracy … Within the metal currency, there was very limited ability for elected governments to manipulate that currency. And I know this is why people with savings and people with money like the gold standard. They like it because it reduces the ability of politicians to play around with the quantity of money. But we have to remember that most people don’t have savings. They don’t have capital. And that’s why we got the paper currency in the first place. It was to allow the democracies. Democracy will always turn towards paper currency and unless you see the destruction of democracy in the developed world, and I do not see that, we will stay with paper currencies and not return to metallic currencies or metallic-based currencies.”

Back then bitcoin wasn’t really on the radar. The reason people with savings liked gold back then, is why many of them like bitcoins now.

The twentieth century saw the rise of both paper money and democracy. Pure paper money started coming into being after the First World War. The reason for this is very straightforward. In a democracy whenever there is a crisis, the politicians and the technocrats advising them need to be seen to be doing something.

As an ex-RBI Governor once told me, do nothing cannot be a strategy. And this need to be seen to be doing something, can most easily be fulfilled by manipulating the paper money system that prevails in a democracy. It gives central bankers the option of printing money and driving down interest rates in the hope that people will borrow and spend more and businesses will borrow and expand.

Of course, this has its own problems (as I keep highlighting in my pieces over and over again). But then, the prevailing system does really allow politicians to show that they are trying. Any other system would take this option away from politicians. Hence, the paper money system is not going to be replaced in a hurry. No government is going to let go of this privilege.

7) This is a slightly technical point, but I think it needs to be made. As I have mentioned through this piece, over the years it has become more and more difficult to mine bitcoins. Now bitcoin farms with giant racks of mining computers, are needed to mine bitcoins. The days when bitcoins could be mined using the processing power of a PC are long gone.

The bitcoin farms, as they are known as, need a lot of electricity. Hence, mining operations have moved to countries where electricity is cheap. They have moved to countries like Iceland, Mongolia and primarily, China.

This has created another problem. As Goldstein writes: “By the beginning of 2020, Chinese miners had grown so large that they controlled most of the processing power on the bitcoin network. And the way the code for bitcoin was written gave them control over the system.”

While, bitcoin might be a decentralised democratic system running on code, but it’s people who ultimately control the mining of bitcoins and hence, can direct its future.

So, will the future of bitcoin be driven by China? And if that turns out to be the case, what does this do to its chances of spreading as actual money, used in the selling and buying of things? There are no easy answers to these questions.

8) One of the key points of bitcoins was that it was a non-government decentralised money system which promised freedom from the middlemen. But that hasn’t really happened. As Quinn and Turner write: “[Bitcoin] had promised freedom from middlemen, but trading it without a third party was cumbersome unless the user was expert in cybersecurity.”

If you are using a broker to trade bitcoin it beats the entire idea of freedom from middlemen. Also, the moment you convert your money into fiat money and the money comes into your bank account, the entire idea of remaining unknown and the government not knowing what you are doing goes for a toss. Hence, you may have your reasons to buy bitcoins, but basically you are speculating.

9) You might want to ask why you haven’t heard all this in the mainstream media. The reason for that lies in the fact that the incentives of the media are misaligned these days. Most investment related news is presented as a money-making opportunity. Hence, in this case the bitcoin believers have gotten more space and screen time in the media.

Many of the bitcoin believers are like the original investors in a Ponzi scheme. They have an incentive to talk up bitcoin, get more investors into it, drive up its price and make more money in the process. (In fact, these are precisely the kind of stock market investors that you get to see on TV and read in the media most of the time, but that is another topic for another day).

Also, given the extremely short attention spans that people have these days, the written word doesn’t find much of an audience. As Quinn and Turner put it: “More fundamentally, the move away from the written word to television financial news, docusoaps and social media may corrode the ability of investors to think clearly and understand the complexities of the financial system.”

You cannot understand economic history and the complexities of the financial system by watching TV or watching stuff over the internet or even listening to extremely detailed podcasts (podcasts can just give you a flavour of things and a feeling that you are actually learning a lot). The only way to understand complex issues is to read, read and read more.

In an era of short attention spans, bitcoins are just the right asset to speculate on. Their price goes up or falls even before you can say Virat Kohli. (This is another reason to support my writing).

10) We live in an era of easy money. Central banks have printed trillions of dollars during the course of 2020 to drive down interest rates in the hope of encouraging people to borrow and spend and businesses to borrow and expand. Interest rates are in negative territory in some of the European nations.

In this scenario of very low interest rates, investors are desperate to earn returns. Hence, a lot of money has been invested into stock markets all over the world, driving them to levels not justified by earnings that companies are expected to earn in the years to come.

Some money has also found its way into bitcoins. As The Economist puts it: “The current surge seems to have been spurred by interest from the financial establishment, most of which had long scorned it.” In simple English, hedge funds are buying bitcoins. Given that bitcoins are thinly traded, this has driven up prices by astonishing levels. Hence, like stock markets, bitcoin is also in bubble territory.

And as we have seen over the past few decades, hedge fund money can be quite mercurial. They can drive down prices faster than they drove them up.

To conclude, the fact that the price of bitcoin is so volatile tells us that most people investing in it aren’t really bothered about the long-term story of bitcoin as money, the bitcoin believers try selling all the time. If they did believe in this story they would have bought bitcoin and held on to it. But as the crash of 2018 showed that is clearly not the case.

As Saifedean Ammous writes in The Bitcoin Standard, the bible of the bitcoin believers:

“Buying a Bitcoin token today can be considered an investment in the fast growth of the network and currency as a store of value, because it is still very small and able to grow many multiples of its size and value very quickly. Should Bitcoin’s share of the global money supply and international settlement transactions become a majority share of the global market, the level of demand for it will become far more predictable and stable, leading to a stabilization in the value of the currency.”

(Ha ha, this is to show that I also read stuff I don’t really agree with).

I am not clairvoyant. This may happen. This may not happen. My reading of economic history tells me it won’t. But then I might turn out to be wrong. What do they say about history not repeating itself but rhyming? But what if it doesn’t rhyme as well?

There are no guarantees when it comes to economics. The trouble is that while you are waiting for all this to happen, the price of a bitcoin is at the level of a very very very very expensive large cap stock and its volatility is that of a small cap penny stock.

So, if you do invest in bitcoin, do understand that you are taking a punt, you are speculating, you are hoping that the price goes up and does not fall. Also, don’t go looking for fundamental reasons for investing in it.

Given that investing in bitcoin is equal to taking a punt, please don’t bet your life on it. As the old cliché goes, don’t put all your eggs in one basket.

PS: This doesn’t mean I don’t believe in digital money. I do. But I also believe that it will be controlled by large corporations and the governments.

The Govt Should Ignore Jewellers’ Strike

gold

The jewellers went on a strike on March 2, 2016. On March 20, it was reported that they had called off their strike after suffering losses of Rs 18,,000 crore. But that did not turn out to be the case. Media reports suggest that on March 21, a section of the jewellers continued to strike.

A PTI reports suggests that: “Most jewellery shops and establishments in the national capital remained shut on Monday despite government’s assurance that there will be no harassment by excise officials. Some jewellers kept their shops shut in Mumbai as well.”

Meanwhile the strike has caused a lot of trouble and heartburn for brides to be. A recent report in The Hindustan Times discusses the plight of women who are about to get married and do not have their gold jewellery in place. The report quotes one such bride to be as saying: “I’m hoping this strike will come to an end soon otherwise I have to go for imitation jewellery on my D-day.”

The brides to be have been left in limbo because the gold jewellers have been on a strike for close to three weeks. The jewellers are striking against an excise duty of 1% on “articles of jewellery [excluding silver jewellery, other than studded with diamonds and some other precious stones]” that the finance minister Arun Jaitley proposed in the budget of the government, for 2016-2017, that he presented last month.

The jewellers are also protesting against the mandatory quoting of the Permanent Account Number(PAN) for cash transactions of Rs 2 lakh or more. This change came into effect from January 1, 2016, and hence, has been place for well over two months. Before this, quoting the PAN was necessary for cash transactions of Rs 5 lakh or more.

Media reports now suggest that the jewellers are claiming that this change has had a huge impact on their sales. Given this, they want the Rs 5 lakh limit to be reinstated.

So what is it that the jewellers fear? They want the government to withdraw the 1% excise duty because they fear harassment by excise inspectors. While this is a legitimate concern, the government has asked excise officials not to make factory visits. A section of the jewellers called off the strike on this assurance from the government. Also, it is important to understand that the 1% duty will generate an extra audit trail.

Further, it is important to understand that gold in its various forms remains an important conduit for black money. Black money is essentially income which has been earned but on which taxes have not been paid.

As the White Paper on Black Money released by the ministry of finance in 2012 points out: “Cash sales in the gold and jewellery trade are quite common and serve two purposes. The purchase allows the buyer the option of converting black money into gold and bullion, while it gives the trader the option of keeping his unaccounted wealth in the form of stock, not disclosed in the books or valued at less than market price.”

The beauty of gold is that a lot of wealth can be stored in a very small space. A lot of black money in the form of gold can be stored in a single locker. Hence, instead of holding on to paper money the holders of black money prefer converting it into gold. Also, with gold there is no fear of wear and tear as is with paper money.

A study on black money carried out by business lobby Federation of Indian Chambers of Commerce and Industry(FICCI) points out that: “Nearly 70-80 % of the transactions involving Jewellery are made using cash (black money).” This clearly explains how those with black money like to hold their wealth in the form of gold.

As the FICCI study points out: “Undisclosed sale of gold, silver etc. results in escapement of applicable tax liabilities Tax authorities have estimated purchases of gold bullion and Jewellery as the second-largest parking space for black money, next to Real Estate.”

Given this, the move to make PAN card mandatory for cash transactions of Rs 2 lakh or more when it comes to making jewellery purchases, is an important move. If it leads to the sales of jewellers falling, then so be it. The black money wallahs might figure out alternative parking spaces for their money, but then why should the government make it easy for them? I mean you should not be able to get out of your house, walk down your street and convert your black money into gold. It has to be a little more difficult than that.

The FICCI study further points out that: “Apart from unreported cash transactions that lead to black money, jewellers (specifically small jewellers) often sell ornaments that are made using adulterated gold. This practice also contributes to black money, as the jeweller typically does not report the full profit made by selling ornaments at premium rates (when they were made using adulterated gold, which is cheaper).”

Hence, while gold jewellery is a conduit for black money, it also helps generate black money. Further, many jewellers discourage the use of plastic money and customers who want to use their credit card or debit card to make the payment, are typically asked to pay 2% extra.

One excuse offered by jewellers is that many buyers do not have a PAN card. Well, if someone is in a position to pay Rs 2 lakh or more for jewellery, I am sure he can get a PAN card made as well. It shouldn’t be that difficult.

Once these factors are taken into account, it is in the best interest of the country that more jewellers are brought under the tax ambit. And that being the case, the government should not back down on its recent moves and let the jewellers’ strike continue.

The column originally appeared in the Vivek Kaul Diary on Equitymaster on March 23, 2016

It doesn’t make any sense to hand over your gold to the govt

gold

The Prime Minister Narendra Modi launched the gold monetisation scheme as well as sovereign gold bonds, yesterday. The scheme and the bonds try to address India’s obsession with gold and the macroeconomic fall out of that obsession.

While nobody really knows how much gold is owned by Indian households, various estimates keep popping up. The estimates that I have seen in the recent past put India’s household gold hoard at 20,000-22,000 tonnes (Don’t ask me how these estimates are arrived at. I have no idea).

In this column I will just concentrate on the gold monetisation scheme and leave the analysis of the sovereign gold bonds for Monday’s column (November 9, 2015). I will also discuss the macroeconmic fall out of India’s obsession with gold on Monday.

The idea behind the gold monetisation scheme is to put India’s idle gold hoard to some use. Under this scheme, you can deposit gold with the bank and earn an interest on it. The Reserve Bank of India (RBI) issued a notification on November 3, 2015, which said that the banks would pay an interest of 2.25% if the gold is deposited for the medium term and 2.5%, if the gold is deposited for the long term. The medium term is a period of five to seven years whereas the long term is a period of 12 to 15 years. (For those interested in knowing the entire process of how to go about it, can click here).

Also, as the RBI notification issued on October 22, 2015, points out: “The designated banks will accept gold deposits under the Short Term (1-3 years) Bank Deposit (STBD) as well as Medium (5-7 years) and Long (12-15 years) Term Government Deposit Schemes. While the former will be accepted by banks on their own account, the latter will be on behalf of Government of India.”

What this means is that individual banks are free to decide on the interest that they will offer on the gold they collect in the short-term for a period of one to three years.

So, the question is will this scheme succeed in getting India’s hoard of gold out from homes and into the banks? The first thing we need to look at is the existing gold deposit scheme which was launched in 1999. The RBI notification issued in October 1999 states that “individual banks will be free to fix the interest rates in tune with their costing considerations. Interest will be payable in cash at fixed intervals or at maturity as decided by the bank.”

Under this scheme the State Bank of India allowed people to deposit gold for three, four or five years. The interest paid on gold was 0.75% for three years and 1% for four and five years, respectively. The minimum deposit had to be 500 hundred grams of gold.

The scheme did not manage to collect much gold. An article in The Financial Express points out: “The existing scheme, introduced 16 years ago, mobilised only 15 tonnes of gold—as the minimum deposit was 500 grams and the interest rate was a mere 0.75% for a three-year deposit.” There was no upper limit to the amount of gold that could be deposited.

As I pointed out earlier in this column, estimates suggest that India has around 20,000 tonnes of gold. When compared to that fifteen tonnes is not even a drop in the ocean.

Further, October 22, 2015 RBI notification on the new gold monetisation scheme clearly states that: “The minimum deposit at any one time shall be raw gold (bars, coins, jewellery excluding stones and other metals) equivalent to 30 grams of gold of 995 fineness. There is no maximum limit for deposit under the scheme.”

So the minimum amount of gold that can be deposited under the new scheme is just 30 grams in comparison to the earlier 500 grams. Over and above this, the gold can be deposited up to a period of 15 years in comparison to the earlier five. Further, the rate of interest on offer is either 2.25% or 2.5%, which is higher than the earlier 0.75-1%.

On all these counts the new gold monetisation scheme is a significant improvement on the gold deposit scheme. Given this, will gold move from Indian homes to banks (and indirectly to the government, given that banks are running a major part of the scheme on behalf of the government)?

Before answering this, it is worth asking here, why do Indians buy gold? It is a part of our tradition and culture is the simple answer. What does that basically mean? It means we buy gold because our ancestors used to buy gold as well. We also buy gold because it is easy to sell during times of emergency. We are emotionally attached to the gold we buy and like seeing it in the physical form. This makes it highly unlikely that the gold monetisation scheme will be a smashing success.

Any more reasons? Gold is a very easy way to hide black money (essentially money which has been earned and on which tax has not been paid). A lot of black money can be stored by buying just a few bars of gold. People who have invested their black money in gold are not going to come forward with it and deposit it in banks. That is really a no-brainer.

Further, the customer agreeing to deposit the gold the bank will “have to fill-up a Bank/KYC form and give his consent for melting the gold.” The gold will be melted in order to test its purity. Also, the “the gold ornament will then be cleaned of its dirt, studs, meena etc.”

The question is how many women would like to see their gold jewellery melted so that they can earn a return of a little more than 2% per year on it? I don’t think I need to answer that question.

These reasons best explain why the gold deposit scheme launched in 1999 has been a huge failure. And they also explain why the current gold monetisation scheme is unlikely to lead to any major shift of gold from homes to the government.

This brings me to the question whether you should be depositing your gold with the banks (and essentially the government)? One reason why people buy gold is because they believe that it acts as a hedge against inflation. The evidence on whether gold acts as a hedge against inflation is not so straightforward.

As John Plender writes in Capitalism—Money, Morals and Markets: “In real terms, the price of gold in 2012 was similar to the prevailing price in 1265.” So doesn’t that mean that gold has acted as a store of value over the last 1000 years? Not really. As Plender writes: “Over much of that time, though, the yellow metal failed to live up to its reputation as a solid store of value.”

Why does Plender say that? Dylan Grice, who used to work for Societe Generale explains this. As Grice writes: “A fifteenth-century gold bug who’d stored all his wealth in bullion, bequeathed it to his children and required them to do the same would be more than a little miffed when gazing down from his celestial place of rest to see the real wealth of his lineage decline by nearly 90 per cent over the next 500 years.”

In fact, even those who had bought gold at the peak of the 1971-1981 bull market in gold would have lost around 80% of their investment in real terms, over the next two decades.

Nevertheless, if you believe that gold acts as a hedge against inflation, should you hand over your gold to the government? Inflation more often than not is due to the “easy money” policies run by the government. This could mean inflation created through money printing or keeping interest rates too low for too long.

When gold and silver were money, the governments destroyed money by debasing it, i.e., lowering the content of precious met­als in the coins they issued.

When paper money replaced precious metals as money, the governments destroyed it by simply printing more and more of it. Now they create money digitally.

So the last thing you should do is hand over gold to the government. The reason you are holding gold is because you don’t trust the government to do a good job of managing the value of money. And given that, it’s best that the hedge (i.e. gold) be with you. If that means losing out on interest of 2.25-2.5% per year, then so be it.

Postscript: On Monday (Nov 9, 2015) I will be analysing the sovereign gold bonds which have been launched as well. Look out for that.

The column originally appeared on The Daily Reckoning on Nov 6, 2015

Why governments, politicians and businessmen hate gold

gold
Yesterday Switzerland voted on whether its central bank should be holding more gold as a proportion of its total assets. Gold currently makes up for around 7% of the total assets of Swiss National Bank, the country’s central bank.
The proposal dubbed as “Save Our Swiss Gold” had called for increasing the central bank’s holding of gold to 20% of its total assets. It was more or less rejected unanimously with nearly 78% of the voters having voted against it.
This proposal was backed by the right-wing Swiss People’s Party and came out of the concern that the Swiss National Bank had sold too much of its gold in the years gone by.
Interestingly, Switzerland was on a gold standard till 1999 and was the last country to leave it. In a gold standard the paper money issued by the central bank is backed by a certain amount of gold held in the vaults of the central bank.
What this means is that the central bank and the government cannot issue an unlimited amount of paper money. The total amount of paper money that can be issued is a function of the total amount of gold that the central bank holds in its vaults.
In April 1933, when the Great Depression was on in the United States, the Federal Reserve of the United States had around $2.7 billion in gold reserves, which formed around 25 percent of the monetary gold reserves of the world. At the same time, the ratio of paper money to gold was at a healthy 45 percent, more than the decreed 35–40 percent. (Source: J.W. Angell, “Gold, Banks and the New Deal,” Political Science Quarterly 49, 4(1934): pp 481–505)
That’s how the gold standard worked.
Getting back to the Swiss vote on gold, other than the Swiss People’s Party, the other parties as well as businessmen were opposed to it. As the Wall Street Journal reports “The initiative was widely criticized by Switzerland’s political and business communities.”
This isn’t anything new. The politicians over the last 100 years have not liked the gold standard because it limits their ability to create money out of thin air. And as far as businessmen are concerned they usually tend to go with what the politicians are saying.
As Raghuram Rajan and Luigi Zingales write in Saving Capitalism from the Capitalists: “The First World War and the Great Depression created great dislocation and unemployment… Workers, many of whom had become politically aware in the trenches of World War I, organized to demand for some form of protection against economic adversity. But the reaction really set in during the Great Depression, when they were joined in country after country by others who had lost out—farmers, investors, war veterans, the elderly.”
The politicians could not do much about it given that most of the world was on the gold standard. And given this, they could not print money and flood the financial system with it. “The gold standard … imposed tight budgetary discipline on governments, which made it difficult for them to intervene much in economic affairs… Politicians had to respond, but such a large demand for protection could not be satisfied within the tight constraints imposed by the gold standard. Hence, the world abandoned the straitjacket of the gold standard… With their ability to turn on or turn off finance, governments obtained extraordinary power,” write Rajan and Zingales.
This explains why governments hate gold.
In 2012, I had the pleasure of speaking to the financial historian Russell Napier. And he made a very interesting point about the rise of democracy and paper money having gone hand in hand. As he put it: “The history of the paper currency system, or the fiat currency system is really the history of democracy… Within the metal currency, there was very limited ability for elected governments to manipulate that currency.”
Napier further pointed out that most people don’t have savings. As he explained: “And I know this is why people with savings and people with money like the gold standard. They like it because it reduces the ability of politicians to play around with the quantity of money. But we have to remember that most people don’t have savings. They don’t have capital. And that’s why we got the paper currency in the first place. It was to allow the democracies. Democracy will always turn toward paper currency and unless you see the destruction of democracy in the developed world, and I do not see that, we will stay with paper currencies and not return to metallic currencies or metallic based currencies.”
With paper currencies around, politicians (even honest ones) feel that they have the ability to bring an economy out of a recession, by getting their central banks to print money and flood the financial system with it, so as to maintain low interest rates.
At low interest rates the hope is that people will borrow and spend more. In a gold standard all this wouldn’t have been possible. But that as we have seen over the last few years has led to other problems.
Having said that, the fundamental problem with paper money, that it can be created out of thin air, remains. Or as Ben Bernanke, the former Chairman of the Federal Reserve of United States, put it in 2002: “The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.”
This is what the US government has done with the help of its central bank, the Federal Reserve, over the last few years, largely during the years in which Bernanke was the Chairman.
As on September 17, 2008, two days after the investment bank Lehman Brothers went bust, and the financial crisis well and truly started, the Federal Reserve held US government treasury bonds worth $479.8 billion. Since then, the number has jumped up to $2.46 trillion. Where did the Fed get the money to buy these bonds? It simply printed it. And then it bought bonds to pump that money into the financial system.
In fact, it also printed money to buy bonds other than treasury bonds as well. This was done so as to flood the financial system with money, in the hope of keeping interest rates low, in order to get people to borrow and spend again, and hopefully create economic growth.
While that has happened to a limited extent, financial institutions have borrowed this money at low interest rates and invested this money in large parts of the world chasing returns.
The Fed decided to stop printing money towards the end of October 2014. But now it needs to keep telling the financial markets that it won’t go about withdrawing the trillions of dollars that it has printed and pumped into the financial system, any time soon. We need to see what happens when it decides to start withdrawing all the money it has printed and pumped into the financial system.
To conclude, it is worth remembering what economist Stephen D. King writes in When the Money Runs Out “A central banker who jumps into bed with a finance minister too often ends up with a nasty dose of hyperinflation.”

The article appeared originally on www.equitymaster.com on Dec 1, 2014

With Kisan Vikas Patra 2.0 now invest your black money with the government

indian rupees“If you can’t beat them, join them,” goes the old adage.
The government of India has done just that by relaunching the Kisan Vikas Patra (KVP). An investment in the newly launched KVP will double in 100 months. This means a return of 8.7% per year. It also comes with a lock-in of two and a half years.
There are no tax benefits, neither at the time of investment nor when the investment matures. Initially, the KVPs will be sold through post offices. But over a period of time the government plans to sell KVPs through some designated branches of public sector banks as well.
“The basic aim is to provide an investment opportunity to people who do not know where to invest and put their money into options like Ponzi schemes,” the finance minister Arun Jaitley said at the relaunch of the scheme.
A ponzi scheme is a fraudulent investment scheme in which money is repaid to old investors by using money being brought in by new investors. The scheme runs as long as the money being redeemed by the old investors is lower than the money being brought in by the new investors. The moment this reverses, the scheme collapses.
In the recent past, the country has seen a whole host of Ponzi schemes like Sahara, Saradha, Rose Valley etc. But how will the KVP stop people from investing in Ponzi schemes?
A major reason why people invested in Ponzi schemes over the last few years lies in the fact that real returns (i.e. nominal return minus the rate of inflation) on fixed income investments (like fixed deposits, post office savings schemes etc.) was negative over the last few years.
Between 2008 and 2013, both consumer price inflation and food inflation were greater than 10%, for large periods of time. In this scenario, the returns on offer on fixed income investments were lower than the rate of inflation.
Given this, individuals had to look at other modes of investment, in order to protect the purchasing power of their accumulated wealth. A lot of this money found its way into real estate and gold, which delivered good returns for most of that period. And some of it also found its way into Ponzi schemes, which promised a slightly higher rate of return than fixed deposits and other fixed income investments.
Inflation has fallen over the last few months, and after many years, the real return on fixed income investments is in the positive territory. This is, as true for KVPs, as it is for fixed deposits offered by public sector banks.
Take the case of a fixed deposit of less than Rs 1 crore with a tenure of one year to less than five years, offered by the State Bank of India. Such a deposit pays an interest of 8.75% per year, which is as good as the return of 8.7% per year offered by KVPs.
Further, the fixed deposit doesn’t come with a lock-in, unlike KVPs which have a lock-in of two and a half years. Also, those who have dealt with post offices on a regular basis will know that dealing with (even) public sector banks is relatively easier than dealing with a post office.
So, there is no basic case for investing in a KVP. Also, for those investing for the long term, instruments like PPF which are not taxed on maturity, remain a considerably better bet. Those comfortable with investing in debt mutual funds are also likely to get higher after tax returns in the long term, once indexation(or inflation in simple terms) is taken into account while calculating capital gains.
And as far as not investing in Ponzi schemes is concerned, the returns offered on KVP are not high enough to stop people from investing in Ponzi schemes.
The government also wants to increase savings by getting people to invest in this scheme. As Jaitley said at the launch “Over the last two three years, when economic growth slowed, our savings rate declined…So it is very necessary to encourage people to increase domestic savings.”
The latest RBI annual report points out that “the household financial saving rate remained low during 2013-14, increasing only marginally to 7.2 per cent of GDP in 2013-14 from 7.1 per cent of GDP in 2012-13 and 7.0 per cent of GDP in 2011-12…the household financial saving rate [has] dipped sharply from 12 per cent in 2009-10.”
Household financial savings is essentially the money invested by individuals in fixed deposits, small savings scheme, mutual funds, shares, insurance etc. It has come down from 12% of the GDP in 2009-10 to 7.2% in 2013-14. A major reason for the fall has been the high inflation that has prevailed since 2008. The return on offer on KVPs is similar to other forms of fixed-income investments available in the market and there is no reason that it should lead to higher financial savings.
So that brings us to the question, why did the government launch KVPs then? Before we understand that, here are a few more features of the scheme. The KVPs as mentioned earlier come with a lock-in of two and a half years. They come in denominations of Rs 1000,Rs 5,000, Rs 10,000 and Rs 50,000 and there is no upper limit to the number of KVP certificates that can be bought. Hence, there is no limit to the amount of money that can be invested in the scheme.
As far as fulfilling know your customer requirements are concerned, the gazette notifications states that the individual buying the KYC will have to provide proof of name and residence. No PAN card details will have to be provided.
And here comes the clincher—the KVP will be a bearer instrument, which will not carry the name of the investor. Jaitley stated this at the event to relaunch the KVP. “So people with currency can invest in this,” Jaitley said. “This will be a bearer instrument just like currency and easy to encash,” he added.
So what does this really mean? There are some basic know your customer norms that need to be followed. But the KVP certificate will not carry any name on it, and that essentially makes it an anonymous instrument, once it has been issued.
With this move, the government is hoping that the KVPs will be used to launder black money. In fact, this was precisely the reason the scheme was discontinued in November 2011, a recent report in the Business Standard points out.
Black money over the years has gone into gold and real estate, where it isn’t productive enough. If it finds its way into the coffers of the government, it can be used more productively, or so the government would like to believe.
It would also lead to higher financial savings and in the process lower interest rates. The government will benefit because it will be able to finance the fiscal deficit at lower interest rates. Fiscal deficit is the difference between what a government earns and what it spends and is financed through borrowing.
The fact that the relaunched KVP is a bearer instrument, without the name of the investor and without any need to provide an identity proof, makes it ideal to invest black money in.
As R Jagannathan writes on Firstpost.com “Since it is a bearer certificate without limit, KVPs are likely to be more popular with the better off than just the poor…Rs 1 crore invested in KVPs of the face value of Rs 50,000 each will involve the creation of only 200 certificates. Not a very big pile and very portable for black money holders.” In fact, given the fact that it is a bearer instrument, KVPs can almost be used as a currency as well.
In the old days when the government wanted to access the black money in the country, it used to launch income tax amnesty schemes, where individuals could pay a one time tax on their accumulated black money and escape punishment. In its current form, the KVP looks more like a quasi-amnesty scheme. In fact, it is even better given that no tax needs to be paid on it.
It would have been a good idea to demand the PAN number from those investors who buy KVPs of Rs 1 lakh or more. Nevertheless, the question is, should a government which has strong views on “black money” actually be launching a scheme, which makes it convenient for people to invest black money and that too with the government?

The article originally appeared on www.equitymaster.com on Nov 20, 2014