Some of the earliest banks started operating in Italy somewhere in the twelfth and thirteenth century. These banks were essentially banks of deposits. Merchants deposited their money in the form of gold and silver coins and bars with these banks for safekeeping. The bank in return issued a receipt against this deposit. The receipt could be shown when the coin money was to be withdrawn. Hence, the earliest banks were “banks of deposits” or “store houses of wealth”.
As time went by some banks developed a reputation for probity and honesty. This led to merchants who had accounts with these banks simply transferring receipts of these banks when they had to pay one another instead of going to the bank showing their receipt and withdrawing their gold or silver to pay each other.
Hence, these receipts started functioning as “paper” money. In sometime people running these banks also figured out that their depositors do not all come all on the same day asking for their deposits back. So in the intermittent period they could either lend out the gold/silver to others or simply print fake deposit receipts not backed by any gold or silver bars or coins, but which looked exactly like the original deposit
receipt. Of course they charged a fee for this.
A similar trend seems to have played out in London in the seventeenth century where merchants took to depositing money with the goldsmiths. This happened after King Charles I seized around £130,000 in bullion, deposited by the city merchants at the Tower of London in 1640.
Like the Italian bankers the London goldsmiths also figured out that they could keep lending the gold that was deposited or simply issue fake receipts, and make more money in the process. As Hartley Withers writes in his all time classic The Meaning of Money:
The original goldsmith’s note was a receipt for metal deposited. It took the form of a promise to pay metal, and so passed as currency. Some ingenious goldsmith conceived the epoch-making notion of giving notes, not only to those who had deposited metal, but to those who came to borrow it, and so founded modern banking.
This is how banks evolved from being just banks of deposit to being banks which gave out loans as well. And to this day they work in the same way. This change also gave bank a right to create money out of thin air, something only the governments could do till then.
Let’s try and understand how that happens. Let us say an individual/institution/government deposits $1000 with a bank. Let’s assume that the bank in turn keeps 10% of the deposits (for the ease of calculation) and lends out the remaining 90% or$900 in this case. It thus manages to create an asset from someone else’s money. So we also have a situation here were the money supply has increased by $1900 ($1000 money deposited with the bank + $900 loan given by the bank).
The $900 loan gets deposited with another bank which in turn lends $810 (90% of $900) and keeps $90 with itself. The $810 is deposited in another bank and leads to a loan of $729. So the banks can keep creating money out of thin air and the money supply can keep going up.
This ability of banks to create money out of thin air is believed to be behind the boom and bust cycles (also referred to as business cycle fluctuations) that the world economy has seen over the last three decades. As J write in The Chicago Plan Revisited, a research paper released by the International Monetary Fund (IMF) “sudden increases and contractions of bank credit that are not necessarily driven by the fundamentals of the real economy, but that themselves change those fundamentals.” When banks feel optimistic, they create money out of thin air by lending it and in the process create the boom part of the business cycle. But when the banks feel pessimistic about economies they may call back their loans or not give out loans at all, and in the process create the bust part of the cycle.
The IMF authors feel that this ability of the banks to create money out of thin air needs to be reined in. The ability to create money should rest only with the government. For this to happen they have revisited The Chicago Plan. The plan was first proposed in the aftermath of The Great Depression of the 1930s.
“During this time a large number of leading U.S. macroeconomists supported a fundamental proposal for monetary reform that later became known as the Chicago Plan, after its strongest proponent, professor Henry Simons of the University of Chicago,” write Benes and Kumhof. Over the years Irving Fisher, who was America’s greatest economist of that era, also came to be closely associated with it.
This plan strikes at the heart of how conventional banking works. A bank raises money as deposits and lends it out as loans. The Chicago Plan separates the deposit and lending functions of the bank. So when $1000 is deposited with the bank, the bank will have to hold the entire money with it and act as a “bank of deposit”. It will not be able to lend this money out. So bank deposits cannot fund its loans. This also eliminates the chances of bank run totally. Even if all the customers of the bank come and demand their deposit from the bank at the same time, the bank can easily repay them.
The question that crops up here is that if the bank does not lend out its deposits how does t fund its loans? As per the Chicago Plan the loans will have to be funded separately from sources which are not subject to bank runs. Hence, loans would be funded out of retained earnings of the bank. They could also be funded out of the bank issuing more shares to investors. And a third source of funding, which is at the heart of the Chicago Plan, would come from the government.
The bank will have to borrow money from the government to fund its loans. The government can ‘print’ this money that it will lend to banks. Hence, this is the way the government can control money in the economy. When it wants to expand money supply it can lend more and vice versa. Banks cannot create money out of thin air because they are not allowed to lend their deposits.
“The control of credit growth would become much more straightforward because banks would no longer be able, as they are today, to generate their own funding, deposits, in the act of lending,” write the IMF authors.
Also, the government will lend against certain assets of banks. These assets can be included while calculating the net debt of the government and deducted from its total debt. The government can also buy back government bonds held by banks against the loans it will give to banks to fund their loans. Either ways the net debt of the government could come down dramatically.
The government could also use the same method to buy out private debt from these banks. It could buy back private bonds against cancellation of government loans to these banks. And why would the government do that? “Because this would have the advantage of establishing low-debt sustainable balance sheets in both the private sector and the government, it is plausible to assume that a real-world implementation of the Chicago Plan would involve at least some, and potentially a very large, buy-back of private debt,” write the IMF authors.
That’s the plan. But the bigger question that the plan does not answer is how much can governments be trusted when it comes to printing money?
A slightly shorter version of this article appeared in Daily News and Analysis on October 24, 2012.
(Vivek Kaul is a writer. He can be reached at [email protected])
Adi Godrej’s Marie Antoinette moment: Indian farmer should invest in stocks
“Qu’ils mangent de la brioche” is a French phrase which means “let them eat cake” in English. It is often attributed to the French Queen Marie Antoinette. She had apparently said this to peasants when she came to know that they had no bread to eat.
There is no record that the Marie Antoinette, wife of Louis XVI ever uttered these words. But the myth has held even after all these years. And the story does make a broader point about the rich often having no idea about the state of the poor in their country.
A good example of this is Adi Godrej, the current president of the Confederation of Indian Industry (CII), who recently had his Marie Antoinette moment. In a recent interview to the Tehelka magazine Godrej suggested that the Indian farmers should sell their land and invest the money they get in stocks and mutual funds.
“If India has to become a developed country, you cannot have the livelihood of hundreds of millions of people depending on agriculture. They have to move on. They have to move into industry, into services. That’s how you develop a country. That has happened in every country,” Godrej said.
He further went onto add that the money that the farmers get by selling their land should be invested in stocks, so that it does not run out soon. “Why should it run out soon? It can be invested. It can be made into a much bigger value than land. Land has the lowest appreciation of all assets. The best investments are in stocks. Somebody should advise them to invest it in mutual funds so their wealth will rise faster,” Godrej said.
Let’s try and examine these statements in a little more detail. Agriculture contributes around 14% of India’s gross domestic product (GDP). This has fallen dramatically since 2004-2005, when it used to contribute around 19% of India’s GDP. At the same time it employs around 58.4% of India’s population. (Source: http://www.india.gov.in/sectors/agriculture/index.php).
So 58.4% of India’s population contributes around 14% of India’s GDP. It need not be said that this is a terribly inefficient way of working. Ruchir Sharma of Morgan Stanley calls this “a disturbing tendency of the farmer to stay on the farm” in his book Breakout Nations.
The contribution of agriculture to the overall GDP is expected to continue falling in the years to come. A calculation carried out by the Planning Commission shows that the contribution of agriculture to the total GDP would fall to as low as 7% by 2025-2026. This calculation assumes a fairly optimistic growth of 4% per year in agriculture GDP. At a growth rate of 2%, agriculture’s contribution to overall GDP by 2025-2026 is expected to be at 5.2%.
In making these calculations the Planning Commission assumes that the overall GDP will keep increasing by 8% every year, which is a very optimistic assumption to make given the current state of affairs. (You can see the calculations here).
But even assuming a 4% growth rate for agriculture and just 6% for overall GDP, the contribution of agriculture to the overall GDP can be expected to fall to around 9.8% (This is my calculation and not of the Planning Commission),from the current 14%.
So theoretically the contribution of agriculture to GDP will fall in the coming years. This can be said with utmost certainty. This means that other sectors of the economy like services and industry will grow at a much faster rate. Hence, it makes sense for farmers to sell their land, move on from farming and move onto other sectors of the economy.
And that’s what Godrej suggested in his interview to Tehelka. But even after that if the Indian farmer is unwilling to sell his land there must be some reason to it.
Akhilesh Tilotia of Kotak Institutional Equities has done some interesting analysis on this. As he points out in a recent report “a farmer makes about Rs30,000 per acre a year (assuming two crops a year) if he grows staples like wheat or paddy. One can argue that the price at which a farmer should be happy to sell the land would be at Rs 2-3 lakh an acre (or seven to ten times his annual income from the land).”
But then money is not the only issue at hand. As Tilotia writes “However, there is an element of sustainability and certainty for the farmer from agriculture and he suffers from a lack of skill to get him or his family employed elsewhere (either in the plant coming up or in the urban services industry): All this means the farmer is looking at farming as a means of livelihood and not from a pure ‘return on capital’ perspective.”
The average farmer does not want to sell out because he is not skilled enough to do anything else. A lot of them are still uneducated given that the effective literacy rate in India is around 74%.
Also the average land holding of an Indian farmer is around 1.4 hectares (one hectare equals around 2.5acres).This is very small and even if he sells, he is unlikely to make much money from it. The right to property is not a fundamental right in India. And over the years the government of India has acquired land forcibly from the citizens of this country at rock bottom prices. This is an impression that cannot be gotten rid off overnight. And hence the Indian farmer is unwilling to sell his land.
But things have gradually started to change as the government has started to offer reasonable prices for acquiring land. “National Highway Authority of India’s cost of acquisition of land was Rs 25lakh per acre in Financial year (FY) 2011…It acquired 8,533 hectares in FY2011, up from 3,120 hectares in FY2009. In FY2012, NHAI expects to acquire 12,000 hectares. The size of land acquisition is up 4 times over the past four years when the going narrative has been that land acquisition has been made impossible in India,” writes Tilotia.
So just saying that the Indian farmer needs to move is not enough. The conditions have to be right for him. He needs to have the skill-set to move on, which he currently doesn’t. Very little attempts are made by the government to rehabilitate those whose land is acquired. And more than that, the farmer needs to be offered the right price, which he wasn’t being offered till very recently.
The other suggestion that came from Godrej was that farmers should invest in stocks and mutual funds. It would be nice if he goes through a November 2011 presentation made by the
by the India Brand Equity Foundation (IBEF). This shouldn’t be difficult given that IBEF is a trust established by the Ministry of Commerce with the CII. As pointed out earlier Godrej is the President of the CII.
The presentation throws up some interesting facts: A few of them are listed below:
– Despite healthy growth over the past few years, the Indian banking sector is relatively underpenetrated.
– Limited banking penetration in India is also evident from low branch per 100,000 adults ratio – – Branch per 100,000 adults ratio in India stands at 747 compared to 1,065 for Brazil and 2,063 for Malaysia
– Of the 600,000 village habitations in India only 5 per cent have a commercial bank branch
– Only 40 per cent of the adult population has bank accounts.
Given this it is unlikely that many Indian farmers have banks accounts. How can those who don’t even have bank accounts be expected to invest in the stock market? Also the stock returns in India even over the long term haven’t been great. The BSE Sensex over a period of 20 years has given a return of 8.9% per year. And even these returns haven’t been guaranteed.
So the first thing that Indian farmers should be doing is opening bank accounts.
Also, how can farmers be expected buy stocks when even the Indian middle class, which makes much more money than the Indian farmer has stayed away from investing in stocks. And there are genuine reasons for it.
As Shankar Sharma of First Global told me in a recent interview I did for the Daily News and Analysis(DNA): “We see too much of risk in our day to day lives and so we want security when it comes to our financial investing. Investing in equity is a mindset. That when I am secure, I have got good visibility of my future, be it employment or business or taxes, when all those things are set, then I say okay, now I can take some risk in life. But look across emerging markets, look at Brazil’s history, look at Russia’s history, look at India’s history, look at China’s history, do you think citizens of any of these countries can say I have had a great time for years now? That life has been nice and peaceful? I have a good house with a good job with two kids playing in the lawn with a picket fence? Sorry boss, this has never happened.”
This statement is as valid for the Indian farmer as it is for the Indian middle class. And so it’s time Adi Godrej realised that things in the real India are a little different. Marie Antoinette
may not have said “let them eat cakes” but Adi Godrej surely did.
(The article originally appeared on www.firstpost.com on September 12,2012. http://www.firstpost.com/business/adi-godrejs-marie-antoinette-moment-indian-farmer-should-invest-in-stocks-452776.html)
(Vivek Kaul is a writer and can be reached at [email protected])
Post-WPI, Subbarao’s music may be more Baba Sehgal than Ilaiyaraaja
As I sit down to write this it is a rather cloudy, dull and insipid morning in Mumbai. An old Tamil number Vaa Vennila composed by the music maestro Ilaiyaraaja and sung by S P Balasubrahmanyam and S Janaki, is playing in the background. I happened to discover this song a few days back, quite by chance, and it has been playing nonstop on my laptop since then. It’s the most melodious composition that I have heard in a long-long time.
Dear Reader, before you start breaking your head over why am I talking about an old Ilaiyaraaja number, when the headline clearly tells you that I should be talking about other things, allow me to explain.
For a music director to be able to create melody a lot of things need to come together. First and foremost the tune has to be good. On top of that the musicians have to be able to flesh out the tune in a way that the music director had originally envisaged it. The lyrics need to make sense. The singers need to get the right emotion into the song and of course not be out of tune. The director of the movie needs to have the ability to recognize a good song when he hears one and not fiddle around with it. And so on.
The point I am trying to make is that “melody” cannot be created in isolation. A lot of things need to come together to create a melodious song and to have an individual born and brought in erstwhile Bihar of Kashmiri Pandit parents, who does not speak a word of Tamil (and not much Kashmiri either), humming it nearly 26 years after it was first released.
What is true about Ilaiyaraaja’s ability to create melody is also true about the ability of Duvvuri Subbarao, the governor of the Reserve Bank of India(RBI), to influence the Indian economy and take it in the direction where everyone wants him to.
The inflation number
The wholesale price index (WPI) inflation number for the month of June 2012 was released sometime back. The inflation has fallen to 7.25% against 7.55% in the month of May. The number has come in much lower than what the analysts and the economists were expecting it to be.
This is likely to lead to calls for the Reserve Bank of India (RBI) RBI to cut the repo rate.
The first quarter review of the monetary policy of the RBI is scheduled on July 31,2012. Industrialists, economists and analysts would want the RBI to cut the repo rate on this day. The repo rate is the interest rate at which RBI lends to the banks.
The first quarter review of the monetary policy is scheduled on July 31,2012. Industrialists, economists and analysts want the RBI to cut the repo rate on this day. The repo rate is the interest rate at which RBI lends to the banks.
So what is the idea behind this? When the RBI cuts the repo rate it is trying to send out a signal to that it expects the interest rates to come down in the months to come. If the banks think that the signal by the RBI is credible enough then they lower the interest rate they pay on their deposits. They also lower the interest rates they charge on their long term loans like home loans, car loans and loans to businesses. With people as well as businesses borrowing and spending more it is expected that the slowing economic growth will be revived.
That’s how things are expected to work in theory. But economic theory and practice do not always go together. The trouble is that even if the RBI cut the repo rate right now, the credibility of the signal would be under doubt, and banks wouldn’t cut interest rates. This is primarily because like Ilaiyaaraja, Subbarao and the RBI also do not work in isolation.
More loans than deposits
The incremental credit deposit ratio of the banks in the six month period between December 30,2011 and June 29,2012, has been 108%. What this means that during this period for every Rs 100 that banks have borrowed by raising deposits, they have loaned out Rs 108. Hence, banks have not been able to match their deposits to loans. They have been funding their loans out of deposits they had raised in periods previous to the six month period considered here. Given the shortage of deposits that banks are facing it doesn’t make sense for them to cut the interest rates on their deposits, even if the RBI were to go ahead and cut the repo rate. And if they can’t cut interest rates on their deposits there is no way the banks are going to cut interest rates on their loans. But why are banks facing a shortage of deposits?
The oil subsidy for this year is already over
The budget for the year 2012-2013 had made a provision of Rs 43,580 crore for oil subsidies. This provision is made to compensate the oil marketing companies (OMCs) Indian Oil Corporation, Bharat Petroleum and Hindustan Petroleum, for selling diesel, kerosene and LPG at a loss. Four months into the financial year the government has already run out of this money. The government has compensated the OMCs to the extent of Rs 38,500 crore for products at a loss in the last financial year (i.e. the period between April 1, 2011 and March 31,2012). This payment was made in this financial year and hence has been adjusted against the Rs 43,580 crore provisioned against oil subsidies in the budget for the current financial year.
The OMCs continue to sell these products at a loss. In the month of April 2012 they lost around Rs 17,000 crore by selling diesel, kerosene and LPG at a loss. In the last financial year the government compensated 60% of this loss. The remaining loss the government forced the oil producing companies like ONGC and Oil India Ltd, to compensate. So using the rate of 60%, the government would have to compensate around Rs 10,200 crore for the losses faced by the OMCs in the month of April. Add this to the Rs 38,500 crore of payment that has already been made, we end up with Rs 48,700crore. This is more than the Rs 43,580 crore that had been budgeted for.
The OMCs continue to lose money
The losses made by OMCs have come down since the beginning of the year. In April, the OMCs were losing Rs 563crore per day. A recent estimate made by ICICI Securities puts the number at Rs 355crore per day. At this rate the companies will lose around Rs 130,000 crore by the end of the year. Even if oil prices were to continue to fall the companies will continue losing substantial amount of money.
All this will mean an increase in expenditure for the government as it would have to compensate these companies to help them continue their operations and prevent them from going bust. An increase in expenditure would mean an increase in the fiscal deficit. Fiscal deficit is the difference between what the government spends and what it earns. The fiscal deficit for the current year has been budgeted to be at Rs 5,13,590 crore. It is highly unlikely that the government will be able to meet this target, given the continued losses faced by the OMCs.
Further borrowing from the government would mean that the pool of savings from which banks and other financial institutions can borrow will come down. This means that to banks will have to continue offering higher interest rates on their fixed deposits and hence keep charging higher interest rates on their loans.
The consumer price index (CPI) inflation for the month of May stood at 10.36%, higher than the 10.26% in April. This is likely to go up even further in the days to come. The WPI inflation coming for the month of June has come in at xx%. And this is likely to push the CPI also in the days to come. CPI inflation will be pushed further given that the government increased the minimum support price on khareef crops from anywhere between 15-53% sometime back. These are crops which are typically sown around this time of the year for harvesting after the rains (i.e. September-October). The MSP for paddy (rice) has been increased from Rs 1,080 per quintal to Rs 1,250 per quintal. Other major products like bajra, ragi, jowar, soybean, urad, cotton etc, have seen similar increases. Also, after dramatically increasing prices for khareef crops, the government will have to follow up the same for rabi crops like wheat. Rabi crops are planted in the autumn season and harvested in winter. This will further fuel food inflation. Food constitutes around 50% of the consumer price index in India. In this scenario of higher inflation it will be very difficult for the RBI to cut the repo rate. And even if it does cut interest rates it is not going to be of any help as has been explained above.
The way out of this mess is rather simple. Oil subsidies need to be cut down. That is the only way the government can hope to control its fiscal deficit. If things keep going the way they are I wouldn’t be surprised if the fiscal deficit of the government even touches the vicinity of Rs 6,00,000 crore against the budgeted Rs 5,13,590 crore.
Only once the government gives enough indications that it is serious about controlling the fiscal deficit, will the market start taking the interest rate policy of the RBI seriously. Before that even if the RBI were to cut interest rates it wouldn’t have an impact.
For Duvvuri Subbarao to make melody like Ilaiyaraaja does a lot of things which are not under his control need to come together. Ilaiyaraaja has control over the people he works with. He can tell his musicians what to play. He can ask his singers to sing in a certain way. He can ask his lyric writer to write a certain kind of song. And so on. Subbarao does not have the same control over the other players in the economy.
So in the meanwhile it is safe to say that try he might as much to make melody like Ilaiyaraaja, chances are he is likely to come up a song Baba Sehgal once made. It was called “Main Bhi Maddona”. For those who have heard the song will know that melody has never been “murdered” more.
(The article originally appeared on www.firstpost.com on July 16,2012. http://www.firstpost.com/economy/post-wpi-subbaraos-music-may-be-more-baba-sehgal-than-ilaiyaraaja-378448.html)
Vivek Kaul is a writer and can be reached at [email protected]