[email protected],000 – How RBI Played a Part in Creating the Stock Market Bubble

The BSE Sensex, India’s premier stock market index, crossed 50,000 points today in intra day trading. It has risen by more than 80% from around the end of March, when it had fallen to 27,591 points, in the aftermath of the covid pandemic hitting India.

This astonishing rise has now got the Reserve Bank of India (RBI) worried. The RBI Governor Shaktikanta Das, writing in the foreword to the latest Financial Stability Report, pointed out:

“The disconnect between certain segments of financial markets and the real economy has been accentuating in recent times, both globally and in India.”

People who run central banks are not always known to talk in simple English. Das is only following tradition here. The statement basically refers to stock prices. Das feels they have risen too fast in the recent past and have become disconnected from the overall economy.

While the overall Indian economy is expected to contract this year, the stock market has rallied by more than 80%. How is this possible? Or as you often get to hear these days, if the economy is doing badly, why is the stock market doing so well.

Theoretically, a possible explanation is that the stock market discounts the future and the stock market investors think that the future of the Indian economy is bright. Another explanation offered often by the stock market investors is that corporate profits this year have been at never seen before levels.

But even after taking these reasons into account, the current high level is really not justified. As Das put it in his foreword: “Stretched valuations of financial assets pose risks to financial stability.” One way to figure out whether valuations are stretched is to look at the price to earnings ratio of the stocks that constitute the Sensex index.

In January 2021, the price to earnings ratio has been at around 34. This means that investors are ready to pay Rs 34 as price, for every rupee of earning of the companies that make up for the Sensex. Such a high level of the price to earnings ratio has never been seen before. Not even in late 2007 and early 2008, when stock prices rallied big time or the first half of 2000, when the dotcom bubble was on.

Clearly, stock prices are in extremely bubbly territory. The current jump in corporate earnings isn’t sustainable for the simple reason that corporates have pushed up earnings by cutting employee costs as well as raw material costs. This means the incomes of those dealing with corporates from employees to suppliers and contractors, have fallen.

This fall in income has limited the ability of these individuals to spend money. This will lead to lower private consumption in the months to come, which, in turn, will impact corporate revenues and eventually profits. A sustainable increase in profits can only happen when people keep buying things and corporate revenues keep going up.

This brings us back to the question as to why stock prices are going up, when the overall economy is not doing well. A part of the reason is the RBI, though the central bank, rather expectedly, glosses over this totally in the latest edition of the Financial Stability Report.

Since February 2020, the RBI has pumped in a massive amount of money into the financial system through various measures, some of which involve the printing of money. By flooding the financial system with money, or what central banks refer to as liquidity, the RBI has ensured that interest rates in general and bank deposits in particular, have fallen.

The idea here is threefold. A drop in interest rates allows the government to borrow at lower interest rates. This became necessary because thanks to the pandemic, the tax collections of the government have dropped during this financial year. Between April and November 2020, the gross tax revenue stood at Rs 10.26 lakh crore, a drop of 12.6% in comparison to the same period in 2019.

Secondly, lower interest rates ensured that the interest costs of corporates on their outstanding loans, came down. Also, the hope was that at lower interest rates, corporates will borrow and expand.

Thirdly, at lower interest rates, the hope always is that people will borrow and spend more, and all these factors will lead to a faster economic recovery.

But there is a flip side to all this as well. A fall in interest rates has got people looking for a higher return. This has led to many individuals buying stocks, in the hope of a higher return and thus driving up prices to astonishingly high levels.

This can be gauged from the fact that in 2020, the number of demat accounts, which are necessary to buy and sell stocks, went up by nearly a fourth to 4.86 crore accounts. One of the reasons for this is the rise of Robinhood investing in India. This term comes from the American stock brokerage firm Robinhood which offers free online trading in stocks. India has seen the rise of similar stock brokerages offering free trading.

What has added to this is the fact that many unemployed individuals have turned to stock trading to make a quick buck. All it needs is a smartphone, a cheap internet connection and a low-cost brokerage account.

Of course, this search for a higher return isn’t local, it’s global. Hence, foreign institutional investors have invested a whopping $31.6 billion in Indian stocks during this financial year, the highest ever. This stems from the fact that Western central banks, like the RBI, have printed a huge amount of money to drive down interest rates.

This has pushed more and more investors into buying stocks despite the fact that the global economy isn’t doing well either.

A slightly different version of this column appeared in the Deccan Herald on January 17, 2021. It was updated after the Sensex first crossed 50,000 points during intra day trading on January 21, 2021.

An Open Letter to Bitcoin Bhakts

Vo intizār thā jis kā ye vo sahar to nahīñ
— Faiz Ahmed Faiz.

A couple of days back I wrote a long piece on bitcoin. As expected the backlash was huge, though a couple of people did engage very nicely and in a fact-driven way (You know who you are, so, thanks a tonne for that).

But a bulk of the response from the bitcoin believers was like we know everything about bitcoin and this guy doesn’t know what he is talking about. Of course, they didn’t say this in as polite a way as I am putting it here (or as one believer put it, it was 5,100 words of potty).

In this piece I wanted to list out a random list of points which I have been thinking about over the last couple of days since I published the bitcoin piece. Some of these points have got to do with investing in general and some with bitcoin in particular. Of course, there are points about the bhakts, the bitcoin bhakts, as well.

The conclusion at the end of this piece is the same as the last bitcoin piece, which is that, the life of bitcoin started with an ambition to become a cryptocurrency which wanted to replace the global paper money system. But it has ended up becoming an object of pure speculation and nothing else. (I can already see the bitcoin bhakts going: good you have mentioned this upfront, we don’t need to read beyond this. Our beliefs are safe).

So, here we go.

1) I had been postponing writing the bitcoin piece for a while now. This was probably my way of coping with the backlash I was expecting once the piece was published. But I am glad that I wrote it. What it told me was that bitcoin bhakts like bhakts in general and investing bhakts in particular, are a petulant lot. You don’t agree with them and they are ready to get you.

In a way it’s like god, religion and parents. My god is the best. My religion is the best. My daddy is the strongest. My mother is the sweetest. And my bitcoin is the best. And if you don’t agree with me then you don’t know anything and you are going to get it from me.

2) A very strong unwavering belief hurts when it comes to investing. I have now spent nearly two decades, starting in 2002, writing about business, economics, finance and investing. And I have seen this sort of behaviour before. When I first started writing about a bubble in real estate, sometime in 2013, I got a similar response from real estate investors all over India, like I have from the bitcoin believers, over the past two days.

Real estate prices in 2013 had been rallying for more than a decade and almost no one was ready to believe at that point of time that they could fall or stagnate for a long period of time. Many didn’t even believe there was a bubble.

In fact, many people still don’t, holding on to their investment in the belief that the happy days of pre 2013 will be back. (Now only if these people knew how to calculate the internal rate of return on any investment, which they clearly don’t). Of course, the reason for holding on to real estate can always be an emotional one as well.

So, yes, the bitcoin bhakts aren’t the first believers. There have been believers before them and there will be believers after them. This time is no different.

3) One response that came over and over again was that this guy (that is me) has no idea what central banks have been up to over the years. They have printed so much money, you know. What is he even talking about. 

Well, to set the record straight, anyone who has followed my writing over the years would know the number of times I have written about money printing and central banks and how it is a bad idea. I have also written three books on this issue. I mean I have almost made a career out of it.

But the more important point here is that just because central banks have been printing money doesn’t mean that the paper money system is going to come to an end  quickly and bitcoin will takeover. This is a great example of lazy thinking, and the fact that the human mind is not built to think through complex multi-dimensional issues. This is bounded rationality at work and the bitcoin bhakts have also become a victim to that.

We all need reasons for doing something and more often than not the reasons are very simplistic. Like the case here. Bitcoin will take over the world because central banks have been printing money and now that I have bought bitcoin I need to firmly believe in this. Really

As I explained in my previous bitcoin piece there is a huge status quo which is a powerful force and which benefits from the paper money system in its present form and they aren’t just waiting there to rollover, once the bitcoin bhakts come attacking.

The paper money system that bitcoin bhakts keep talking about has the American dollar at the heart of it. The world trade happens largely in dollars, giving the United States an enormous exorbitant privilege. While every other country in the world needs to earn dollars, the US can simply print it.

And given this, this is a privilege the United States isn’t really going to let go in a hurry. Why do you think US consumption is around a fourth of the global economy, while the country has only 5% of the world’s population? Which US politician in his or her right mind, is not going to worry about this dynamic?

Yesterday, someone on Twitter, shared a news-item which said that an American Senator was in favour of bitcoin as money. I am sure random American Congressmen support random things. Take the case of former Congressman Ron Paul, who supported gold as money for years on end. That does not mean that the American financial system will move to gold as money. So, we are talking change at a systemic level here, not some random guy supporting some random thing, please understand that.

4) I was also told repeatedly that bitcoin is an anonymised peer to peer network and I was making the mistake of looking at it as a centralised system. Well, that is really rich coming from guys who are buying bitcoin from brokers and giving away all their identity details. The moment you are doing that you are buying a speculative asset and not a future form of anonymised money.

5) When I said that barely anyone accepts bitcoin as a payment, two people wrote to me to say that they did. This is precisely the point I was trying to make. They were the exception that proves the rule.

In fact, as the American journalist James Surowiecki wrote in a recent post on bitcoin: “The blockchain analysis company Chainalysis, for instance, found that in the first four months of 2019, just 1.3% of total transactions involved merchants.”  A bulk of bitcoin payments were used to pay for illicit goods and services like drugs and online gambling. (This is not to say that paper money isn’t used for these things. It is. But then the bulk of payments are for regular everyday transactions).

Also, even with these payments, bitcoin payments form an insignificant part of the overall whole. As Surowiecki writes: “On average, there are now around 325,000 Bitcoin transactions — including trades — per day. There are roughly a billion credit card transactions per day.” Over and above this, there are debit card transactions, cash transactions and digital money transactions, to consider. Bitcoin is nowhere in all this.

This is primarily because the bitcoin system is very slow to process transactions. It can process seven transactions a second. Visa, on the other hand, processes 6,000 transactions a second.

I can go on and on why bitcoin is not a medium of exchange, like a good form of money should be, but I will leave it at this.

6) The main reason why very few businesses accept bitcoin as payment is the volatility of its price, Surowiecki points out. Let’s say a business takes payment in bitcoin. Chances are that the next morning the price falls majorly, then the business can end up with a loss on the transactions it made a day before. (Of course, the price can go up as well… but then this is business not gambling).

The volatility of price comes from the fact that most people buying bitcoin are in it, in order to make a quick buck. They see an asset whose price is going up, they buy it. When they see an asset whose price is going down, they sell out. Of course, there are believers as well.

7) This is an interesting one. I learnt yesterday that you identify a bitcoin bhakt, the moment he says HFSP to you. For all the Boomers out there, HFSP stands for Have Fun Stay Poor. Apparently, this is something that bitcoin bhakts say often when people question their core beliefs. It’s an easy, slightly humorous way to get back without necessarily having to think through what the person questioning their core beliefs is basically trying to say. (It’s all potty you know).

Also, it is important to understand, different people are mentally built differently, when it comes to how they look at money. In my scheme of things return of capital is more important than return on capital when it comes to money and investing. Money has never come easily to me and whatever I have I would rather protect it than take a punt with it. If that means staying poor in the eyes of bitcoin bhakts, then so be it.

But then that shouldn’t stop you from buying bitcoin. If you feel it needs to be a part of your investment portfolio and if you feel that you are okay taking the risk, then please go ahead. It is your hard earned money at the end of the day.

8)  The recent interest shown by hedge fund managers basically should tell everyone very clearly that bitcoin as an object of speculation is now entering the mainstream. Of course, this means that the price of the thinly traded bitcoin can go up even further. So, there might be more money to be made. But then do remember that hedge funds are a mercurial lot. They can go out of a trade much faster than they get into it.

Hence, the oldest cliché in investing, don’t put all your eggs in one basket, applies to bitcoin as well. If you want to speculate, please go ahead and do it. But don’t bet your life on it.

9) Many bitcoin bhakts believe in anarchy when it comes to the money system. They seem to be okay with different forms of cryptocurrencies competing with each other, a few dying in the process and the best ones continuing to exist.

It is important to understand here, that there is a difference between money and mobile phones. While mobile phone brands can keep changing, depending on customer preferences and specifications on offer, the same argument applied to money doesn’t really work.

A major reason for the evolution of standardised fiat paper money lies in the fact that there were too many forms of money going around and this caused needless confusion and built huge costs of doing business into the system. A lot of this standardisation happened through the centuries and made lives easy for business and normal mortals. Of course, there are problems with this system.

10) I also understood something all over again. As the American novelist Upton Sinclair once remarked: “It is difficult to get a man to understand something, when his salary depends on his not understanding it.” When the price of an investment asset is going up at an extremely fast pace, all people can see is that it’s going up, without realising that it’s going up because it’s going up.

To conclude, the life of bitcoin started with an ambition to become a cryptocurrency which wanted to replace the global paper money system. It has now become a speculative asset at best and nothing more.

As The Economist recently put it, rising prices of bitcoin “may be good news for those holding bitcoin that others are piling in, but speculators’ enthusiasm suggests that cryptocurrencies will fall far short of their founders’ lofty aspirations”.

Satoshi Nakamoto, the mysterious inventor of bitcoin, whoever he is, wherever he is, must be a rich man today. Nevertheless, he must be a terribly disappointed man as well.  This wasn’t what he was trying to engineer.

The sad thing as always is, in life, things rarely go as planned.

Kyon Dare Zindagi Mein Kya Hoga
Kuch Na Hoga To Tajruba Hoga.
— Javed Akhtar.

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.

*****

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.

2021 – The Chinese Problem in Your Personal Finance

Dear Reader, before you start thinking that I have click-baited you one more time, let me assure you that’s not true. Your personal finances in 2021 will actually face a Chinese problem.

But before we go into this, let’s first understand a few aspects about the Chinese saving habit over the years. Let’s look at this pointwise.

1) As is well known, the Chinese physical infrastructure over the years was funded through massive domestic savings being invested in bank deposits. As Charles Goodhart and Manoj Pradhan write in The Great Demographic Reversal: “Interest rates were set well below the rate of growth and the rate of inflation. While the economy grew on average by around 10% over 1990–2010, the inflation-adjusted deposit rate over the same period averaged −3.3% (for a 1.4% average for the nominal deposit rate versus an average annual inflation rate of 4.75%).”

Hence, the rate of interest rate was lower than the prevailing rate of inflation, for a period of two decades. If one were to state this in a simple way, the low interest rates acted effectively as a tax on Chinese households.

2) This tax did not matter much because the savings were channelised into investments. This created economic growth and the average income of a Chinese kept going up, year on year. Hence, while the interest being earned on the accumulated wealth was low, the regular yearly income kept going up.

3) Low interest rates led to an interesting behaviour at the household level. As Goodhart and Pradhan point out, there was “a negative correlation between urban savings and the decline in real deposit rates.” “When banks fail to protect household savings, households tend to save more, not less, in order to achieve a ‘target’, whether that is for education or the purchase of a home.”
Basically, given the negative real rate of interest on bank deposits, where inflation was higher than the interest rate, Chinese households saved more money in bank deposits in order to achieve their targeted savings. Options of investing in other avenues were extremely limited.

Now the question is how does all this apply to your personal finance in India in 2021. Allow me to explain pointwise.

1) Interest rates on bank fixed deposits have collapsed. The interest offered on fixed deposits of more than one year, currently stands at around 5.5% on an average. This when the rate of inflation as measured by the consumer price index in November 2020 stood at 6.93%. Hence, the real rate of interest is in negative territory. If after tax the rate of return on fixed deposits is taken into account, the gap gets even bigger.

2) The major reason for this collapse in interest rates has been a collapse in bank lending. Given that banks, on the whole, have barely given out fresh loans since March, they possibly couldn’t keep paying a high rate of interest on deposits. Hence, the crash in interest rates. But what has added to this is the Reserve Bank of India (RBI) policy of flooding the financial system with money, in order to drive down interest rates further. The excess money in the financial system, which the banks deposit with the RBI, stood at Rs 6.25 lakh crore as of December 31, 2020.

3) From the indications that the RBI has given, this excess liquidity in the financial system is likely to continue. The idea is to help ease the burden on current loans of corporates. In a year the tax collections have collapsed this also helps the government to borrow at extremely low interest rates. At the same time, the hope is at lower interest rates corporates will borrow and expand. But that is not happening. Data from the Centre for Monitoring Indian Economy shows that announcements of new investment projects in terms of value fell by 88.3% during the period October to December 2020. Investment projects completed were down by 74%. So, the corporates aren’t in the mood to borrow and expand.

There are a couple of reasons for this. Many corporates continue to remain over-leveraged. Still others don’t have enough confidence in India’s economic future, irrespective of what they say in the public domain. As they say, the proof of the pudding is in the eating.

4) What does all this have to do with personal finance? What happened in China is happening in India as well. The bank savings have gone up dramatically during 2020. Between March 27 and December 18, they were up by Rs 9.15 lakh crore. In comparison, the increase during similar periods in 2019 and 2018, had stood at Rs 4.35 lakh crore and Rs 3.90 lakh crore, respectively. Of course, all this increase in saving is not just because of low interest rates. Some of it is because of fewer opportunities to spend money in 2020. Some of it is because of the general uncertainty that prevails. Some of it is because of jobs losses and the fear of job losses. And some of it is because Indians, like the Chinese, are saving more, in order to achieve the savings target for the education of their children or their weddings, or for the purchase of a home.

5) This has repercussions. With people saving more and with banks being unable to lend that money, interest rates have come down. And people saving more in response to the lower interest rates, means extended lower interest rates. This is not good news for savers. It is also not good news for consumption. If people are saving more, they are clearly spending lesser. This is the paradox of thrift or saving. When an individual saves more, it makes sense for him or her at an individual level. When the society as a whole saves much more than it was, it hurts the economy simply because one man’s spending is another man’s income. Over a period of time, this leads to job losses, more paradox of thrift and further job losses.

At the risk of sounding very cliched, there is no free lunch in economics. The RBI’s policy of flooding the financial system with money in order to help the corporates and the government, is basically hurting individual savers, consumption and the overall economy. The savers are paying for this lunch. And unlike the corporates, the savers have no unified voice. The government, obviously, is the government.

While, there is no denying that with lending not happening bank deposit rates had to fall, but the RBI policy of driving them down further, is something that is hurting the economy.

6) So, where does that leave the Indian saver? Some individual savers are betting on the stock market. But the price to earnings ratio of the Nifty 50 index as of January 1, stood at 38.55, an all-time high level. If you have the heart to invest in stocks at such a level, best of luck to you. Some others are betting on bitcoin, which has given a return of more than 75% in dollar terms, in the last one month.

Also, unlike the Chinese, the prospects of an increase in the yearly income of an average Indian, over the next years, at best remain subdued. Hence, the humble Indian fixed depositor, who liked to fill it, shut it and forget about it, so that he could concentrate on many other issues that his or her life keeps throwing up, clearly has a problem in 2021.

To conclude, all of you who write to me asking for a safe way of investing so that you can earn a 10% yearly return, well, sorry to disappoint you, no such way exists. At least not in 2021. Of course, there are always Ponzi schemes to invest in, some fraudulent, and some not so fraudulent.

The choice is yours to make.

PS: Wishing all my readers a very Happy New Year. Hope 2021 is much better than 2020 was for each one of you.

10 Things Women Can Do to Manage Personal Finances Better in 2021

Aage aage wo chale peeche saari duniya
din na dekhe raat na dekhe peeche padi hai duniya
aur nahi koi aur nahi wo to hai rupaiya
gol gol chaand sa rupaiya
kaisa hai ye khwab sa rupaiya

— Visheshwar Sharma, Kalyanji Anandji, Kishore Kumar and Surendra Mohan, in Hiraasat.

Okay, the headline was clickbait.

But now that I have your attention I have a few important things to share. I make a living by writing regularly on economics and finance. But this isn’t how it always was.

For my first couple of years in journalism, I largely wrote on personal finance topics. It took me a couple of years to figure out that between the product sellers and the personal finance writers, the subject was made needlessly complicated.

The trick wasn’t to try and understand every new product/idea that hit the market, which is what personal finance pages in newspapers and personal finance websites and magazines cater to, because they need to fill up space, so that they can gather advertisements against that space. Of course, personal finance writers need to keep writing about newer things and same things in newer ways, to keep their jobs.

When it comes to companies selling personal finance products, they are largely in the business of raising money and not necessarily managing it well

Hence, what is more important is to understand the broader principles of the subject and then stick to them over a period of time.

In the last fifteen years I have ended up advising more women on personal finance issues than men. In my limited experience, women seem to be more interested in understanding the nuances, the men typically play know it all when it comes to personal finance.

In this piece, I will elaborate on principles I think every woman should follow when it comes to managing her money and personal finances. (In fact, most of these principles can be followed by men as well, but then they know it already).

If you aren’t following these principles, 2021 is just about here and now is as good a time to start as any.

Here we go:

1) Save for the sake of saving. This is a very simple principle but many women I have come across, just don’t get it. They want to save for their next holiday, the next diamond ring, the next home, the next car, the children who aren’t there yet, the next whatever

In fact, Morgan Housel makes this point beautifully in his recent book The Psychology of Money: “Only saving for a specific goal makes sense in a predictable world. But ours isn’t. Saving is a hedge against life’s inevitable ability to surprise the hell out of you at the worst possible moment.”

Like when the covid pandemic hit India in late March, people who had saved money for the sake of saving and had money in the bank account, were able to handle the situation in a much better way. If you lost your job and had money in the bank account you didn’t have to take on the first new job that came along. You could wait for something better.

As Housel puts it: “Savings without a spending goal gives you options and flexibility, the ability to wait and the opportunity to pounce. It gives you time to think. It lets you change course on your own terms.”

Further, if you save for the sake of saving and have money in the bank, you will be able to make the decisions, right or wrong, you want to make in life, and which might even mean not being pressurised by your family to get married to the next guy they discover on Shaadi.com.

If this isn’t important I don’t know what is. Hence, being financially independent is very very important and that can only happen if you save for the sake of saving.

In fact, as Housel puts it:

“We can leave aside rich, but independence has always been my personal financial goal. Chasing the highest returns or leveraging my assets to live the most luxurious life has little interest to me. Both look like games people do to impress their friends, and both have hidden risks. I mostly just want to wake up every day knowing my family and I can do whatever we want to do on our own terms. Every financial decision we make revolves around that goal.”

 

This should be the ultimate goal of saving and money in the bank account should not be a signalling effect for the society at large.

2) If you work for a company, be aware of how your salary is structured. Too many companies use the cost to company (CTC) approach to take their employees for a ride. If you don’t understand the items that make up your salary, ask around, Google, do whatever is needed to understand them. I come across way too many women who work very hard on their job, but have no idea of their salary structure (This is not to even remotely suggest that men have it all figured out). If you have ESOPs as a part of your CTC, know when they will vest and when you can sell them. The same when it comes to the soft loans that you can take from the company. It’s slightly difficult to understand this, but it’s not rocket science.

3)  I think this is the most important point that I will make in this piece. Way too many women I know, leave the managing of their finances to their fathers (a horrible horrible idea because they will make you buy LIC policies), spouses (might end up taking too much risk than you prefer) or boyfriends (you might just breakup, who knows).

I mean if you work so hard to earn the money that you do, why not spend some time to figure out how to manage it well. As I said earlier, money in the bank, helps us make the decisions that we want to. If you can spend a week planning a ten-day holiday that you take during the course of a year, I am sure you can spend a few days understanding how to manage the money you work so hard to earn through the year.

4) This is a tricky point and hasn’t gone down too well with most women I have shared it with. Don’t have all your money in joint bank accounts with your spouse (works for the husbands as well). I am not remotely trying to suggest that if things don’t work out between you guys, he will cheat you on the money front (he may, but then who am I to suggest that). But untangling these things can be quite a pain.

So, it makes sense to have one joint account for the shared expenses, but beyond that have your money in your bank account. (Believe me, if things don’t work out, you are going to thank me forever for this).

5) This is another tricky point. If your father/husband/boyfriend/brother manages your money, be aware of where that money is parked. Be aware of the loans your husband has taken on. Again, I am saying this from experience. Many women just tend to be totally unaware on this front and then one day when the father dies, the husband leaves or the boyfriend breaks up, the reality of the situation suddenly hits them. Just getting a bank account shut after someone’s death can be a huge pain, if you are unaware of the details.

6) Many women don’t like the idea of managing their money because they think there is a lot of maths involved in it (Again, this is not to suggest that men understand the maths). It’s just basic fifth standard maths, which is not difficult to understand at all.

7) Make sure that you are making full use of the tax deductions available to you as a married couple. (Again, the husband may have no idea, doesn’t mean you also don’t).

8) Diamond jewellery looks great on you and please wear it by all means but don’t go about buying diamonds all the time. It’s a bad idea. Selling diamonds can be a difficult business in case of an emergency. (Don’t believe me, just Google).

9) If you are starting out and don’t know how to go about managing your money, just do a recurring deposit with a bank to start with. It won’t give you a great return but some money will start accumulating and some money is better than no money. Also, don’t buy an insurance policy unless your family is dependent on you or you have outstanding liabilities.

10) And finally, since we are about 2021, do remember that sometimes return of capital is more important than return on capital. 2021 will be that kind of year. Manage your money accordingly.

To conclude, these points go beyond doing the basic things, like investing regularly over a long period of time to ensure that you end up making decent returns and not necessarily the highest returns, not having all your investments in one asset class (diversification), buying a house to live in and thinking very carefully about buying another house, not over-leveraging yourself and not making any investment decisions which will keep you awake at night. Nothing is worth ruining a good night’s sleep.