RBI is behaving like a football goalkeeper

Vivek Kaul
A former well respected governor of the Reserve Bank of India (RBI) once told me that in a “moment of crisis the central bank can’t be seen to be doing nothing” even if “do nothing” might be the best strategy to follow.
This might well be the spur behind the RBI’s recent defence of the rupee. It started its defence when the currency first closed in on the 60 per dollar mark, by selling dollars.
But selling dollars couldn’t go on indefinitely. India’s foreign exchange reserves are around $280 billion – equal to around six-and-a-half months’ imports. Such low levels of forex reserves haven’t been seen since the 1990s.
Then the central bank tried to squeeze out rupee liquidity by severely limiting the amount of money that banks could borrow from it at the repo rate, or the rate at which the RBI lends to banks, now at 7.25%.
Banks are now allowed to borrow only up to 0.5% of their deposits at the repo rate. Beyond that, they need to borrow at the marginal standing facility rate, which is at 10.25%. That’s 300 basis points (one basis point equals one hundredth of a percentage) higher than the repo rate.
This has started to push up interest rates in general.
Banks are also supposed to maintain an average cash reserve ratio of 99% with the RBI on a daily basis, against the earlier requirement of 70%.
The RBI had hoped that all these moves would squeeze rupee liquidity out of the market and help it gain value against the dollar.
But nothing of that sort happened. On Tuesday, the rupee lost further value to hit an all-time low of 61.80 to the dollar intraday, before recovering to close at 60.81, again, with RBI intervention.
Several economists have now come around to the view that the rupee will continue to lose value against the dollar. Rajeev Malik of CLSA, for one, sees the rupee hitting 65-70 to the dollar by next year.
Given this, the RBI’s intervention might at best postpone the inevitable.
But the central bank can’t stop trying, can it?
Albert Edwards of Societe Generale has a very interesting analogy explaining this. As he pointed out in a report earlier this year. “When there are problems, our instinct is not just to stand there but to do something… When a goalkeeper tries to save a penalty, he almost invariably dives either to the right or the left. He will stay in the centre only 6.3% of the time. However, the penalty taker is just as likely (28.7% of the time) to blast the ball straight in front of him as to hit it to the right or left. Thus goalkeepers, to play the percentages, should stay where they are about a third of the time. They would make more saves.”
But they rarely do that. “Because it is more embarrassing to stand there and watch the ball hit the back of the net than to do something (such as dive to the right) and watch the ball hit the back of the net,” wrote Edwards.
The RBI is like a football goalkeeper right now. It can’t just stand pat.

The article originally appeared in the Daily News and Analysis dated August 7, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)

Yesterday, once more! Western central banks are fuelling real estate bubbles again


Vivek Kaul

A major reason behind the financial crisis that started in late 2008 was the fact that the Western countries had built many more homes than were required to house their populations. Once the home prices started crashing what followed was an economic catastrophe from which the world is still trying to come out.
Ironically the solution that central banks came up with for mitigating the negative effects of the financial crisis was to get home prices up and running again. This was done by printing money and pumping it into the financial system and ensure that the interest rates remain at very low levels. The hope was that at low interest rates people will borrow money and buy homes. 
Initially people stayed away but gradually they seem to be getting back to borrowing and home prices in Western countries are up and running again. 
As Albert Edwards of Societe Generale writes in a report titled 
If UK Chancellor George Osborne is a moron, Fitch’s Charlene Chu is a heroine “Young people today haven’t got a chance of buying a house at a reasonable price, even with rock bottom interest rates. The Nationwide Building Society data shows that the average first time buyer in London is paying over 50% of their take home pay in mortgage payments – and that is when interest rates are close to zero!…The OECD has recently identified UK house prices as between 20-30% too high (depending on whether you compare prices with rents or incomes – link). To be sure the UK is nowhere near the most expensive, with some of the usual suspects such as Canada, Australia and New Zealand even worse.”
Home prices in the United States have also been rising steadily since the beginning of 2012. The S&P Case-Shiller 20-City Home Price Index has risen by 13.4% since the beginning of 2012. Even with this price rise, home prices in the United States are still 25% lower than the peak they achieved in April 2006. 
Real estate prices in Western countries should not be rising at such high rates. They have huge amounts of land to build all the homes that they need. Hence, real estate prices in a country like America, which is not really short of land have rarely risen at a very fast pace. Housing prices in America had remained flat for a large part of the 20th century. Prices rose on an average at the rate of 0.4% per year (adjusted for inflation) for the period between 1890 and 2004. In fact in many parts of the country the pries had actually gone down.
For smaller countries like the United Kingdom land may be an issue, but the population density is not very high. The United Kingdom has around 255 people living per square kilometre. In comparison, Japan has 337 people living per square kilometre and India has 367. So there is enough land going around given the population. 
But more than these reasons the biggest reason why home prices should not be rising at the rates that they are is simply because the home ownership rates in these countries are very high. In June 2004, at the peak of the real estate boom, 69.2% of US households owned their own homes, up from 64% in 1995. Home ownership in the United Kingdom peaked in 2001 at 69%. Since then home ownership rates have fallen. In the United States, it has fallen to around 65%. In the United Kingdom it is at 64%. 
Even with the falling home ownership rates a major part of the population in these countries owns the homes that they stay in. The falling home ownership rate in the aftermath of the financial crisis only means one thing and that is that there were many more homes built than required. And a lot of homes were bought not to live in, but for speculation. 
The governments and central banks are now trying to get the speculation going again. In the United States this is important because home equity loans were responsible for a lot of consumption. Home equity is the difference between the market price of a house and the home loan outstanding on it. Banks give a loan on this home equity. 
Charles R Morris writing in 
The Trillion Dollar Meltdown: Easy Money, High Rollers, And the Great Credit Crash explains this phenomenon: “Consumer spending jumped from a 1990s average of about 67% of GDP to 72% of GDP in early 2007. As Martin Feldstein, a former chairman of the Council of Economic Advisers, has pointed out, that increase was financed primarily by the withdrawal of $9 trillion in home equity.”
Feldstein’s study was carried out for the period between 1997 and 2006. A study carried out by Alan Greenspan estimated that in the 2000s, home equity withdrawals financed 3% of all personal consumption. But this was a low estimate. Home equity supplied more than 6% of the disposable personal income of Americans between 2000-2007, another study pointed out. In fact, by the first quarter of 2006, home equity extraction made up for nearly 10% of disposable personal income of Americans. 
And all this consumption in turn created economic growth. If home prices keep going up, more home equity will be created and people can borrow against that. Also as home prices go up, people feel wealthier and tend to spend more, which helps economic growth. 
Governments are trying to encourage banks to give out loans so that people can buy homes. George Osborne, the British chancellor of the exchequer (the Indian equivalent of the finance minister) has come up with a “help to buy” scheme. In this the government will guarantee up to 20% of the home loan to encourage lending to borrowers with small savings. As Edwards writes “This means that if a borrower defaults on a loan, the taxpayer will be liable for a proportion of the losses.”
Criticism for this scheme has come in from various fronts. Andrew Bridgen, senior economist for Fathom Consulting, a forecasting firm run by former Bank of England economists, said: “Help to Buy is a reckless scheme that uses public money to incentivise the banks to lend precisely to those individuals who should not be offered credit. Had we been asked to design a policy that would guarantee maximum damage to the UK’s long-term growth prospects and its fragile credit rating, this would be it.” (As Edwards quotes in his report)
This is precisely what happened in the United States as well in the run up to the financial crisis, wher
e the government nudged banks and other financial institutions to lend to people who were in no position to repay the loan.
Central banks can afford to keep interest rates low primarily because of the policy of inflation targeting that they follow. There mandate is to maintain the rate of inflation at a certain rate and do everything required for that. Increasing real estate prices do not get captured in the rate of consumer price inflation, which central banks tend to use for inflation targeting. 
In fact inflation targeting was one of the reasons behind the global real estate bubble of the 2000s. As Stephen D King writes in 
When Money Runs Out – The End of Western Affluence “Take, for example, inflation targeting in the UK. In the early years of the new millennium, inflation had a tendency to drop too low, thanks to the deflationary effects on manufactured goods prices of low-cost producers in China and elsewhere in the emerging world. To keep inflation close to target, the Bank of England loosened monetary policy with the intention of delivering higher ‘domestically generated’ inflation…The inflation target was hit only by allowing domestic imbalances to arise: too much consumption, too much consumer indebtedness, too much leverage within the financial system and too little policy-making wisdom.” 
The same thing seems to be happening right now. With inflation rates too low the central banks have been maintaining low interest rates, so that people consume more and that in turn hopefully creates some inflation. But that in turn means doing the same things that led to the financial crisis. 
Governments and central banks pushing up real estate prices does help in the short term and translates into some sort of economic growth. But it does have serious long term repercussions as we have seen over the last few years. As Edwards writes “What makes me genuinely 
really angry is that burdening our children with more debt (on top of their student loans) to buy ridiculously expensive houses is seen as a solution to the problem of excessively expensive housing…First time buyers need cheaper homes not greater availably of debt to inflate house prices even further. This is madness.”
To conclude, let me quote economist Robert J Shiller from 
The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It “The idea that public policy should be aimed at…preventing a collapse in home prices from ever happening, is an error of the first magnitude. In the short run a sudden drop in home prices may indeed disrupt the economy, producing undesirable systemic effects. But, in the long run, the home-price drops are clearly a good thing.” 

The article originally appeared on www.firstpost.com on July 10, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 


As yen hits 100 to US$, get ready for more currency wars

Vivek Kaul 
Ushinawareta Nijūnen or the period of two lost decades for Japan(from 1990 to 2010) might finally be coming to an end. Or so it seems.
And Japan has to thank Abenomics unleashed by its current Prime Minister Shinzo Abe for it. Abe has more or less bullied the Bank of Japan, the Japanese central bank, to go on an unlimited money printing spree, until it manages to create an inflation of 2%.
The Japanese money supply is set to double over a two year period. And all this ‘new’ money that is being pumped into the financial system, will chase an almost similar number of goods and services, and thus drive up their prices. Or so the hope is.
The target is to create an inflation of 2% and get people spending money again. When prices are rising or are expected to rise, people tend to buy stuff, because they don’t want to pay a higher price later (This of course is true to a certain level of inflation and doesn’t hold in the Indian case where retail inflation is greater than 10%). As people go out and shop, it helps businesses and in turn the overall economy.
In an environment where prices are stagnant or falling, as has been the case with Japan for a while now, people tend to postpone purchases in the hope of getting a better deal. The situation where prices are falling is referred to as deflation.
In 2012, the average inflation in Japan was 0%, which meant that prices neither rose nor they fell. In fact, in each of the three years for the period between 2009 and 2011, prices fell on the whole. This has led people to postpone their consumption and hence had a severe impact on Japanese economics growth. To break this “deflationary trap”, Shinzo Abe and the Bank of Japan have decided to go on an almost unlimited money printing spree.
A major impact of this policy has been on the Japanese currency ‘yen’. As more yen are created out of thin air, the currency has weakened considerably against other major currencies. One dollar was worth around 78 yen, on October 1, 2012. Yesterday, yen weakened beyond 100 to a dollar for the first time in four years. As I write this one dollar is worth around 101.1 yen.
This weakening of the yen has helped Japanese businesses which have a major international presence spruce up their profits. As the news agency Bloomberg reports “The weaker yen helped Mazda, Japan’s fifth-largest car company, post a profit of 34 billion yen for the fiscal year that ended March 31, compared with a loss of 107.7 billion yen the previous year. A one-yen change against the dollar, euro, Canadian dollar and Australian dollar has a 9.1 percent impact on Mazda’s operating profit…That compares with 4.7 percent at Fuji Heavy Industries Ltd, which makes Subaru cars, and 3.1 percent at Toyota.”
When yen was at 78 to a dollar, a Japanese company making a profit of $1 million internationally would have made a profit of 78 million yen. Now with the yen at 101 to a dollar, the same company will make a profit of 101 million yen, which is almost 29.5% more.
This increase in profit it is hoped will also encourage Japanese companies to pay their employees more. Albert Edwards of Societe Generale writing in a report titled Thoughts on Asia – will a yen slide trigger an EM currency crisis? 1997 redux dated April 17, 2013, cites a survey which suggests that Japanese companies may be short on labour. “This suggests that Prime Minister Abe will indeed get his way on a rapid return of wage inflation to boost consumption,” writes Edwards.
And this boost in consumption will get the Japanese economy going again. So does that mean Japan will live happily ever after? Not quite.
As the Japanese central bank prints more and more yen, the returns from Japanese government bonds are expected to go up. As Edwards writes “if the market really believes that it is committed to the 2% inflation target (and I certainly do), then Japanese bond yields(returns) will quickly attempt a move above 2%.” In early April the return on a ten year Japanese government bond was at 0.45% per year. Since then it has risen to around 0.69% per year.
And this can lead to a major crisis in Japan. If returns on existing bonds go up, the government will have to offer a higher rate of interest on the new bonds that it issues to make them interesting enough for investors.
As Satyajit Das writes in a research paper titled The Setting Sun – Japan’s Financial Miasma “Higher interest rates will increase the stress on government finances. Even at current low interest rates, Japan spends around 25-30% of its tax revenues on interest payments. At borrowing costs of 2.50% to 3.50% per annum, two to three times current rates, Japan’s interest payments will be an unsustainable proportion of tax receipts.”
Now that’s just one part of it. If the government has to spend more of the money than it earns towards interest payments that means there will be less left for meeting other expenditure. So it will either have to borrow more or ask the Bank of Japan to print more money to finance its expenditure, given that there is a limit to the amount of money that can be borrowed. Either option doesn’t sound good. Das estimates that Japan’s gross government debt will reach around 250-300% of its gross domestic product by 2015, a very high level indeed.
Also as things stand as of now it looks like the Bank of Japan will have to finance a major part of Japanese government expenditure in the years to come by printing money. As Dylan Grice wrote in an October 2010, Societe Generale report titled Nikkei 63,000,000? A cheap way to buy Japanese inflation risk “Japan’s tax revenues currently don’t even cover debt service and social security, persistent and growing fiscal burdens. Therefore, once the Bank of Japan is forced into monetisation of government deficits, even if only with the initial intention of stabilising government finances in the short term, it will prove difficult to stop. When it becomes the largest holder and most regular buyer of Japanese government bonds, Japan will be on its inflationary trajectory.” And this is not an inflation of 2% that we are talking about.
The yen weakening against other international currencies is making Japanese exports more competitive. A Japanese exporter with sales of a million dollars in early October, would have made 78 million yen (when one dollar was worth 78 yen). Now the same exporter would make 101 million yen.
The weakening yen allows Japanese exporters to cut their prices in dollar terms and become more price competitive. If a price cut of 20% is made, then sales will come down to $800,000 but in yen terms the sales will be at 80.8 million yen ($800,000 x 101). This will be higher than before. Also a cut in price might help Japanese exporters to increase total volumes of sales.
The trouble of course is that this will hit other major exporters like South Korea, Taiwan and Germany. As Michael J Casey
points out in a column on Wall Street Journal website Japan might be a hobbled economy but it is still the third largest in the world, accounting for almost one-tenth of world gross domestic product. So when the Bank of Japan prints as much yen as this, it provokes a worldwide adjustment in relative prices. Electronics producers in South Korea, Taiwan and, to an increasing degree, China, automatically face a price disadvantage versus their Japanese competitors, for example.”
Also interest rates on American and Japanese bonds are currently at very low levels. And this has sent investors looking for return to other parts of the world. Take the case of New Zealand. Foreign money has been flooding into the country. When foreign money comes into a country it needs to be exchanged for the local currency (the New Zealand dollar in case of New Zealand). This leads to a situation where the demand for the local currency increases, leading to its appreciation.
One New Zealand dollar was worth around 64.6 yen on October 1, 2012. It is currently worth around 84.4 yen. An appreciation in the value of a country’s currency hurts its exports. On Wednesday (May 8, 2013), the Reserve Bank of New Zealand, decided that it will intervene in the foreign exchange market to weaken the New Zealand dollar.
How does any central bank weaken its currency? When a huge amount of foreign money comes in, it increases the demand for local currency. The central bank at that point floods the foreign exchange market with its own currency, to ensure that there is enough of it going around. This ensures that the local currency does not appreciate. If the central bank floods the market with more local currency than the demand is, it ensures that the local currency loses value against the foreign money that is coming in.
The question is where does the central bank get this money from? It simply prints it.
The thing to remember is that if Japan can print money to cheapen its currency so can other countries like New Zealand. It is not rocket science. Its what Americans call a no brainer. In fact, yen started appreciating against the dollar once the Federal Reserve of United States, the American central bank, started printing money to revive economic growth. And this has also been responsible for Japan starting to print money. As Casey points out “Together, the U.S. Federal Reserve and the Bank of Japan will print the equivalent of $155 billion every month for an indefinite period.” This will spill over to more countries printing money to hold the value of their currency or even cheapen it.
The currency war which is currently on between countries as they print money to cheapen their currencies will only get worse in the days and months and years to come.
Australia is expected to join this war very soon. Countries are also trying to control the flood of foreign money by cutting interest rates. The Australian central bank cut interest rates on Tuesday (i.e. May 7, 2013). The Bank of Korea, the South Korean central bank also cut interest rates on Thursday (i.e. May 9,2013). China has put measures in place to curb foreign inflows.
As Greg Canvan
writes in The Daily Reckoning Australia “So as the US dollar moves above 100 yen for the first time in four years…Get ready for an escalation in the currency wars.”
To conclude, it is important to remember what H L Mencken, an American writer, once said “
For every complex problem there is an answer that is clear, simple, and wrong.” If only creating economic growth was just about printing more money…
The article originally appeared on www.firstpost.com on May 11, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)

A case for gold at $10,000 per ounce

goldVivek Kaul 
The funny thing is that the more I think I will not write on gold, the more I end up writing on it. So here we go with one more piece analysing the prospects of the yellow metal.
The recent past has seen a host of analysts and economists turn negative on gold. One of the reasons for this has been the feeling that the developed world (US, Europe and Japan i.e.) which had been reeling under the aftermath of the financial crisis since 2008 is now on a roadmap to sustainable recovery.
The irony is that analysts and economists jump at any opportunity to predict a recovery but are nowhere to be seen when a recession is looming. As Albert Edwards of Societe Generale writes in a report titled We still forecast 450 S&P, sub-1% US 10year yields, and gold above $10,000 released yesterday “There are some ever-present truths in this business. Economists usually forecast a return to trend growth and will never forecast a recession. Equity strategists tend to forecast the market will rise 10% each year and will never forecast bear markets.”
So dear readers this is an important fact to be kept in mind when reading any dire forecast on gold. As Edwards puts it “The late Margaret Thatcher had a strong view about consensus. She called it: “The process of abandoning all beliefs, principles, values, and policies in search of something in which no one believes, but to which no one objects.” The same applies to most market forecasts. With some rare exceptions…analysts don’t like to stand out from the crowd.”
And the consensus right now seems to be that gold is done with its upward journey. The logic being offered is that all the money printing that central banks around the world have indulged in since the end of 2008, has helped them repair their respective financial systems and economies. (To know why I don’t believe that is the case click here).
To achieve this economic stability a huge amount of money has been printed. As Gary Dorsch, an investment newsletter writer wrote in a recent column “So far, five central banks, – the Federal Reserve, the European Central Bank, Bank of England, the Bank of Japan and the Swiss National Bank have effectively created more than $6-trillion of new currency over the past four years, and have flooded the world money markets with excess liquidity. The size of their balance sheets has now reached a combined $9.5-trillion, compared with $3.5-trillion six years ago.”
While this money printing has ‘supposedly’ helped the countries in the developed world move towards economic stability, at the same time it has not led to any inflation, as it was expected to. And this is the main reason being cited by those who have turned bearish on gold.
Gold has always been bought as a hedge against the threat of high inflation. And if there is no inflation why buy gold is the argument being offered.
On the face of it this seems like a fair point to make. But lets try and understand why it doesn’t work. It is important to understand that free money does not and cannot exist. As Dylan Grice of Societe Generale wrote in a report titled The Market for honesty: is $10,000 gold fair value? released in September, 2011 “Since there can be no such thing as a government, or anyone else for that matter, raising revenue ‚at no cost‛ simple logic tells us that someone, somewhere has to pay.”
The point being that when the government finances itself by getting the central bank to print money, someone has to bear the cost.
The question is who is that someone. As Grice wrote “This is where the subtle dishonesty resides, because the answer is that no-one knows. If the money printing creates inflation in the product market, the consumers in that product market will pay. If the money printing creates inflation in asset markets, the purchaser of the more elevated asset price pays. Of course, if the printed money ends up in asset markets even less is known about who ultimately pays for the government’s ‘free lunch’…The ‘free lunch’ providers will be the late entrants into whatever asset-bubble or investment fad the money printing inflates.”
So how does this work in the current context? While the money printing hasn’t led to product inflation in the developed world, the stock markets in the developed world, particularly in the United States and Japan, have been rallying big time. Despite the fact that the respective economies are not in the best of shape. Hence, the money printing even though it hasn’t led to consumer price inflation, it has led to inflation in the stock market. And those investors who will enter these stock markets late, will ultimately bear the cost of all the money printing.
Money that leaves the printing presses of the government need not always end up with people, who use it to buy consumer products and thus push up their price. As Grice puts it “By now, some of you might feel this all to be irrelevant. Surely, you might be thinking, the plain fact is that there is no inflation. I disagree. To see why, think about what inflation is in the light of the above thinking. I know economists define it as changes in the price of a basket of consumer goods, the CPI(consumer price index). But why should that be the definitive measure, given that it’s only one of the many possible destinations in money’s Brownian journey from the printing presses? Why ignore other destinations, such as asset markets? Isn’t asset price inflation (or bubbles as they are more commonly known) more distortionary and economically inefficient than product price inflation?”
The consumer price index which measures inflation is looked at as a definitive measure by economists. But there are problems with the way it is constructed. As a recent report titled Gold Investor: Risk Management and Capital Preservation released by the World Gold Council points out “The weights that different goods and services have in the aforementioned indices do not always correspond to what a household may experience. For example, tuition has been one of the fastest growing expenses for US households but represents only 3% of CPI (consumer price index). In practice, tuition costs correspond to more than 10% of the annual income even for upper-middle American households – and a higher percentage of their consumption.”
This helps in understating the actual inflation number. There are other factors at play as well which work towards understating the actual inflation number. As the World Gold Council report points out “Consumer price baskets are frequently adjusted to incorporate the effect that advancement in technology (e.g. in computer hardware) have on prices paid. These so called hedonic adjustments can overstate reductions in price compared to what consumers pay in practice. For example, a new computer can have the same nominal price as it did five years ago, but adjusting for the processing speed and storage capacity it appears cheaper.”
Then there are also methodological changes that have been made to the consumer price index and the way it measures inflation over the years, which in practice do not always reflect the full erosion of the purchasing power of money.
The following chart shows that if inflation in the United States was still measured as it was in the 1980s would be now close to 10% instead of the official 2%.

The moral of the story is that the situation is not as simple as those who have turned bearish on gold are making it out to be


The moral of the story is that the situation is not as simple as those who have turned bearish on gold are making it out to be. Given that, how does one view the recent fall in prices of gold on the back of this evidence? As Edwards puts it “Gold corrected 47% from 1974-1976 before rising more than 8x to US$887/oz in 1980. A steep correction is normal before the parabolic move.”
Both Edwards and Grice expect gold to touch $10,000 per ounce (one troy ounce equals 31.1 grams). As I write this gold is currently quoting at $1460 per ounce, having risen from the low of $1350 per ounce that it touched sometime back.
Central banks around the world have tried to create economic growth by printing money. But their efforts to do so are likely to backfire. As Edwards writes “My working experience of the last 30 years has convinced me that policymakers’ efforts to manage the economic cycle have actually made things far more volatile. Their repeated interventions have, much to their surprise, blown up in their faces a few years later. The current round of QE will be no different. We have written previously, quoting Marc Faber, that “The Fed Will Destroy the World” through their money printing. Rapid inflation surely beckons.”
And that’s the point to remember: rapid inflation surely beckons. And to be prepared for that it is important to have investments in gold, the recent negativity around it notwithstanding.
To conclude let me again emphasise that this is how I feel about gold. I may be right. I may be wrong. That only time will tell. So please don’t bet your life on it and limit your exposure to gold to around 10% of your overall investment.
It is important to remember the first few lines of Ruchir Sharma’s Breakout Nations: “The old rule of forecasting was to make as many forecasts as possible and publicise the ones you got right. The new rule is to forecast so far into the future that no one will know you got it wrong.”

The article originally appeared on www.firstpost.com on April 26, 2013 

(Vivek Kaul is a writer. He tweets @kaul_vivek. He has investments in gold through the mutual fund route) 


High inflation is inevitable, we just don’t know when

InflationVivek Kaul 
There are good times. There are bad times. And there are bad times which don’t seem like bad times, at least to some people. Central bank governors all over the world live in bad times which don’t seem like bad times to them.
In the last few years, central banks of United States, Great Britain, Euro Zone, China, Switzerland and now Japan, have printed tremendous amount of money. “So far, five central banks, – the Federal Reserve, the European Central Bank, Bank of England, the Bank of Japan and the Swiss National Bank have effectively created more than $6-trillion of new currency over the past four years, and have flooded the world money markets with excess liquidity. The size of their balance sheets has now reached a combined $9.5-trillion, compared with $3.5-trillion six years ago,” writes investment newsletter writer Gary Dorsch.
This has been done with the hope that pushing all this new money into the financial system will ensure that interest rates continue to remain low. Low interest rates would make the citizens of their respective countries borrow and spend more more. And at the same time banks and financial institutions would also be happy to lend more, given that there is so much more money going around. This will help businesses and the overall economy.
There was also the hope that all this new money would create some inflation as it chases the same amount of goods and services, leading to a rise in prices. When people see prices rising, or expect prices to rise, they are more likely to buy goods and services, than keep their money in the bank. That was the logic. And when that happened businesses would do well and so would the overall economy. But that hasn’t happened.
So central banks have gone ahead and printed even more in the ‘hope’ that people borrow and spend and some inflation is created. The fact that all this new money floating around hasn’t led to a high inflation has been used as a justification for printing even more money in the hope of creating some inflation. That’s the most harebrained logic that one can ever come across.
The fact that doing something (i.e. money printing) that should have resulted in something else (i.e. some inflation), but is not resulting in that something else (i.e. inflation), is being used to justify doing more of that something (i.e. money printing).
Also central banks, their governors and their respective governments have suggested time and again that all the money printing will lead to only some inflation, which they will be able to manage and not very high inflation that will go beyond their control.
It has also been suggested in recent times that very high inflation scenarios don’t just occur because of excessive money printing but there are other reasons to it as well. One theory which has gained popularity in recent times is that high inflation happens when there are supply shocks.
Lets take the case of German hyperinflation of 1923 where inflation reached a peak of 1000 million % a year and which remains the most discussed case of the twentieth century.
James Montier writing in a research paper titled 
Hyperinflations, Hysteria, and False Memories points out “Germany’s productive capacity had been significantly damaged by World War I, both in terms of the losses inflicted and the resources redirected to military use. Allied troops occupied the Ruhr Valley – the seat of much of Germany’s manufacturing base. These events clearly constituted a large supply shock.”
So basically what Montier suggests is that Germany was not producing enough goods to meet the needs of its citizens. It was also not in a position to import given that it did not have the money (or gold as it was in those days) to pay for the imports. And as there were not enough goods going around that led to high inflation.
Fair point. But this doesn’t necessarily mean that the excessive money printing wasn’t responsible for high prices that prevailed. The price of basic necessities went through the roof. A kilo of butter cost 250 billion marks and a kilo of bacon 180 billion marks.
The German government had been printing an excessive amount of money to finance its expenditure. It did not earn enough revenue to meet its expenditure. In 1922 a trillion marks were printed as the deficit shot through the roof. In the first six months of 1923, nearly 17 trillion marks were printed. With such an astonishing amount of money being printed, money started to lose its value dramatically. By August 1923, one dollar was worth 620,000 marks(the German currency) and by early November was worth 620 billion marks.
As the currency lost value, the government had to keep printing more of it, to meet its expenditure. So the more money the government printed, the more it lost value, and in turn, the government had to print even more money.
The industry which thrived during this period was the money printing industry. Thirty paper mills and 133 printing plants were working, but still could not turn out enough money required to keep up given the huge denominations they had reached.
So yes, a supply shock was responsible for an increase in prices, but so was money printing. And Germany was not the only country that went through this. There were other countries that went through a similar scenario which had supply shocks and printed an excessive amount of money also.
As Forrest Capie writes in a research paper titled 
Conditions in which very rapid inflation has appeared “Austria, Germany, Hungary, and Poland all had substantial and growing deficits built up prior to or coincidental with the inflation.” Austria, Hungary and Poland had peak inflation rates of 4 million %, 14,000% and 23,000%. So a supply shock would have definitely added to inflation but that does not mean that all the new money being printed and put into the financial system had no role in creating inflation.
Lets take the case of China in the late 1930s and 1940s. Japan invaded China in 1937 and occupied around one third of the country which included much of its eastern part. This meant that China no longer had access to taxes from the part under occupation of Japan. Also once this conflict ended, a civil war started in China. Hence, there was a prolonged supply shock. And this Montier argues led to very high inflation. Again this argument just covers one side of the picture.
Inflation in China at its peak crossed 50% per month. As Capie writes “There were clearly a long and accelerating inflation through these years with prices rising first by 27 per cent then 68 per cent, then more than doubling and so on until in 1947 monthly rates in excess of 50 per cent were reached.”
But was it only because of a supply shock? In 1936-37, the Chinese government revenue was equal to its expenditure. The situation changed in the years to come as war expenditure went through the roof. “When the Japanese attacked, the leader of the Nationalist Government pledged total war without regard to cost, and in the next few years no attempt was made to match increased expenditure with increased revenues,” writes Capie. By 1948, the government was spending more than twice of what it was earning. The difference being made up through printing money.
As soon as the war with Japan ended, a civil war broke out in China. And each of the factions engaged in civil war produced its own money. “Between 1937 and 1949, three governments – the Nationalists, the Japanese, and the Communists – occupied China. Each one issued its own currency (indeed, multiple currencies were issued by each authority). These bodies effectively engaged in monetary warfare, with each producing “propaganda stating that the currency of their enemies was falling rapidly in value,” writes Moniter.
In fact, money supply expanded by 700% between 1946 and 1947. And this also added to an increase in prices other than the supply shock. As Capie writes “Over the whole period of war, the money supply grew by 15,000 per cent, wholesale prices rose by over 100,000 per cent…The vastly increased note issue of the Central Bank of China lay behind the huge expansion in the money supply.”
So an increase in money supply remains an important reason behind high inflationary scenarios, there is no denying that.
Another reason often offered to argue that there will be no high inflation in countries that are currently printing money is that high inflation is an economic curse that only developing countries face. The example that is often given is that of Zimbabwe.
Between August 2007 and June 2008, the money supply in Zimbabwe went up 20 million times. With the money supply increasing by such a huge amount, inflation went through the roof. In early 2008, consumer price inflation was said to be at 2 million percent. By the end of the year it had sped to around 230 million percent.
It is argued that United States, United Kingdom, the Euzo Zone and Japan are no Zimbabwe. Of course that is true. But people who argue along these lines are victims of what we can call the black swan syndrome. Till the first Europeans landed in Australia it was thought that all swans are white. Only when they landed in Australia did they realise that swans could be black too.
Just because high inflation has happened in Zimbabwe, a developing country, in the recent past, it cannot be argued that high inflation cannot plague developed countries as well. In fact, the high inflation that prevailed in Israel in the 1970s and the 1980s is an excellent example of how high inflation can occur even in a reasonably developed country.
As Albert Edwards of Societe Generale writes in a research report titled 
Nikkei 63,000,000? A cheap way to buy Japanese inflation risk “Think about that for a moment. Japan is an advanced economy, a developed democracy and certainly no Zimbabwe. But Israel was all of those things too. It simply found itself politically committed to a level of expenditure – military and social – which it couldn’t fund. Instead of taking the politically unpalatable course of cutting that expenditure, it resorted to the tried and-tested tactic of buying time with printed money. Between 1972 and 1987 Israel’s CPI rose by a factor of nearly 10,000. Inflation averaged around 84% and peaked at an annualised 500% in early 1985.”
Like Israel, countries in the developed world where countries have found themselves politically committed to a level of expenditure that they cannot meet through their earnings and have been printing money in order to meet it. Just because this hasn’t led to high inflation till now is no basis for arguing that it won’t lead to inflation in the future as well.
Given the inevitability of high inflation, gold as a form of investment still remains very relevant despite the recent fall in prices. Having said that one shouldn’t be betting one’s life on it, given that it is difficult to predict when this will happen. As James Rickards the author of 
Currency Wars and a Partner in Tangent Capital Partners, a merchant bank based in New York, recently told The Real Asset Report “I recommend an allocation to gold from investable assets of 10% for the conservative investor and 20% for the more aggressive investor.”

 The article originally appeared on www.firstpost.com on April12, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek)