Vivek Kaul
Tim Harford writer of such excellent books like The Undercover Economist, The Logic of Life and Adapt, once wrote a blog discussing the perils of a design student trying to make an electric toaster from scratch.
Harford discusses the experience of Thomsan Thwaites, a postgraduate design student, who decided to embark on what he called “The Toaster Project”. “Quite simply, Thwaites wanted to build a toaster from scratch,” writes Harford.
The toaster was first invented in 1893 and is a household good in Great Britain and almost all other parts of the developed world. It costs a few pounds and is very reliable and efficient. But building it from scratch was still not a joke. “To obtain the iron ore, Thwaites had to travel to a former mine in Wales that now serves as a museum. His first attempt to smelt the iron using 15th-century technology failed dismally. His second attempt was something of a cheat, using a recently patented smelting method and a microwave oven – the microwave oven was a casualty of the process – to produce a coin-size lump of iron,” writes Harford.
Next Thwaites needed plastic. Plastic is made from oil. But Thwaites never made it to an oil rig. He finally settled at scavenging plastic from a local dump, which he melted and then moulded into a toaster casing.
More short cuts followed. As Harford writes “Copper he obtained via electrolysis from the polluted water of an old mine… Nickel was even harder; he cheated and bought some commemorative coins, melting them with an oxyacetylene torch. These compromises were inevitable.”
A simple toaster has nearly 400 components and sub components which is made from nearly 100 different materials. So imagine the difficulty if everything had to be procured and made from scratch. As Thwaites told Harford “I realised that if you started absolutely from scratch, you could easily spend your life making a toaster.”
Thwaites finally did manage to make an electric toaster, but it was nowhere as good as the ones easily available in the market. As Harford writes “Thwaites’s home-made toaster is a simpler affair, using just iron, copper, plastic, nickel and mica, a ceramic. It looks more like a toaster-shaped birthday cake than a real toaster, its coating dripping and oozing like icing gone wrong. “It warms bread when I plug it into a battery,” he says, brightly. “But I’m not sure what will happen if I plug it into the mains.””
So dear reader, you might be reading this piece sitting in the air-conditioned comforts of your office on an ergonomically designed chair (hopefully). Or you might be sitting at home reading this on your laptop. Or you must be travelling in a bus/metro/local train hanging onto your life and reading this on your android smartphone. Or you must be waiting for your aircraft to take off and must be quickly glancing through this on your iPad.
The question that crops up here is that how many of the things mentioned in the last paragraph, would you dear reader, be able to make on your own? The answer is none. So then where did all these things that make life so comfortable come from?
Dylan Grice answers this question in the latest issue (dated March 11, 2013) of the Edelweiss Journal. “So where did it all come from? Strangers, basically. You don’t know them and they don’t know you. In fact virtually none of us know each other. Nevertheless, strangers somehow pooled their skills, their experience and their expertise so as to conceive, design, manufacture and distribute whatever you are looking at right now so that it could be right there right now.”
Estimates suggest that cities like London and New York offer ten billion distinct kinds of products. So what makes this possible? “Exchange. To be able to consume the skills of these strangers, you must sell yours,” writes Grice. It is impossible for a single human being to even make something as simple as a toaster from scratch. But when many people specialise in their respective areas and develop certain skills, only then does a product as simple as a toaster become possible.
Let me take my example. I sell my writing skills. With the compensation that I get I buy goods and services that I need for my existence. From something as basic as food, water and electricity, which I need to survive or comforts like buying a washing machine to wash clothes, a refrigerator so that I don’t need to cook on a day to day basis, hiring a taxi to travel in or catching the latest movie at the local multiplex.
At the heart of any exchange is trust. As Grice puts it “we must also understand that exchange is only possible to the extent that people trust each other: when eating in a restaurant we trust the chef not to put things in our food; when hiring a builder we trust him to build a wall which won’t fall down; when we book a flight we entrust our lives and the lives of our families to complete strangers.”
So for any exchange to happen, there needs to be trust. But trust is not the only thing that facilitates exchange. There is another important ingredient. And that is money.
Money has been thoroughly abused all over the world in the aftermath of the financial crisis which broke out officially in September 2008. Central banks egged on by governments all over the world have printed money, in an effort to revive their respective economies. The idea being that with more money in the financial system, banks will lend more which will lead to people spending more and that will help revive the economy.
But all this comes with a cost. “So when central banks play the games with money of which they are so fond, we wonder if they realize that they are also playing games with social bonding. Do they realize that by devaluing money they are devaluing society?” asks Grice.
Allow me to explain. In the aftermath of the financial crisis, government expenditure all over the world has shot up dramatically. This expenditure could have been met by raising taxes. But when economies are slowing down this isn’t the most prudent thing to do. The next option was to borrow money. But there was only so much money that could be borrowed. So the governments utilised the third possible option. They got their central banks to print money. Central banks used this printed money to buy government bonds. Thus the governments could meet their increased expenditure.
When a government increases tax to meet its expenditure, everyone knows who is paying for it. It’s the taxpayer. But the answer is not so simple when the government meets its expenditure by printing money. As Grice puts it “When the government raises revenue by selling bonds to the central bank, which has financed its purchases with printed money, no one knows who ultimately pays.”
But then that doesn’t mean that nobody pays.
With the central bank printing money, the money supply in the financial system goes up. And this benefits those who are closest to the “new” money. Richard Cantillon, a contemporary of Adam Smith, explained this in the context of gold and silver coming into Spain from what was then called the New World (now South America).
As he wrote: “If the increase of actual money comes from mines of gold or silver… the owner of these mines, the adventurers, the smelters, refiners, and all the other workers will increase their expenditures in proportion to their gains.” These individuals would end up with a greater amount of gold and silver, which was used as money, back then. This money they would spend and thus drive up the prices of meat, wine, wool, wheat etc. This rise in prices would impact even people not associated with the mining industry even though they wouldn’t have seen a rise in their incomes like the people associated with the mining industry had.
So is this applicable in the present day context? The money printing that has happened in recent years has benefited those who are closest to the money creation. This basically means the financial sector and anyone who has access to cheap credit. Institutional investors have been able to raise money at close to zero percent interest rates and invest them in all kinds of assets all over the world. As Ruchir Sharma writes in Breakout Nations – In Pursuit of the Next Economic Miracles:
“What is apparent that central banks can print all the money they want, they can’t dictate where it goes. This time around, much of that money has flown into speculative oil futures, luxury real estate in major financial capitals, and other non productive investments…The hype has created a new industry that turns commodities into financial products that can be traded like stocks. Oil, wheat, and platinum used to be sold primarily as raw materials, and now they are sold largely as speculative investments.”
While financial investors benefit, the common man ends up paying more for the goods and services that he buys, something that is not always captured in the inflation number. As Grice puts it: “So now we know we have a slightly better understanding of who pays: whoever is furthest away from the newly created money. And we have a better understanding of how they pay: through a reduction in their own spending power. The problem is that while they will be acutely aware of the reduction in their own spending power, they will be less aware of why their spending power has declined. So if they find groceries becoming more expensive they blame the retailers for raising prices; if they find petrol unaffordable, they blame the oil companies; if they find rents too expensive they blame landlords, and so on. So now we see the mechanism by which debasing money debases trust. The unaware victims of this accidental redistribution don’t know who the enemy is, so they create an enemy.”
And people all over the world are doing a thoroughly good job of creating “enemies”. “The 99% blame the 1%; the 1% blame the 47%. In the aftermath of the Eurozone’s own credit bubbles, the Germans blame the Greeks. The Greeks round on the foreigners. The Catalans blame the Castilians. And as 25% of the Italian electorate vote for a professional comedian whose party slogan “vaffa” means roughly “f**k off ” (to everything it seems, including the common currency), the Germans are repatriating their gold from New York and Paris. Meanwhile in China, that centrally planned mother of all credit inflations, popular anger is being directed at Japan.”
This is only going to increase in the days and years to come. As Grice writes in a report titled Memo to Central Banks: You’re debasing more than our currency (October 12, 2012) “History is replete with Great Disorders in which social cohesion has been undermined by currency debasements…Yet central banks continue down the same route. The writing is on the wall. Further debasement of money will cause further debasement of society. I fear a Great Disorder.”
The article originally appeared on www.firstpost.com on March 21, 2013
Vivek Kaul is a writer. He tweets @kaul_vivek
central banks
I fear a Great Disorder
Dylan Grice is a strategist with Societe Generale and is based out of London. He is the co-author of the French investment bank’s much-followed Popular Delusions analysis. “History is replete with Great Disorders in which social cohesion has been undermined by currency debasements. The multi-decade credit inflation can now be seen to have had similarly corrosive effects… I fear a Great Disorder,” he says. In this interview he speaks to Vivek Kaul.
What is debasement of currency?
Sometimes the most basic questions are the biggest ones! I’ll try to keep it as simple as possible by defining currency debasement as an increase in the supply of money which increases the purchasing power of whomever issues that money, by reducing purchasing power for everyone else.
And since when is it happening?
In the story of our civilisation, coins of a defined weight first appear at around at around 700BC. Around 400BC Aristophanes references inflation in his comedyThe Frogs, probably a reference to the currency debasement caused by the Peloponnesian war. So money debasement is as old as money itself. Traditionally, money debasement would involve issuers or traders ‘clipping’ tiny amounts of gold or silver from the coin, but still passing that coin on as though it was of a given weight. After a few rounds of clipping, your ounce of silver might only be worth nine tenths of an ounce of silver. Or maybe treasuries would mint gold or silver coins alloyed with base metals, again hoping that no one would notice. The intention was again to pass a coin containing less than an ounce of silver off as an ounce of silver and the effect would be an increase in the price level. Since more gold coins were needed to obtain a given amount of gold, more coins were also needed to buy given goods.
And why would people do this?
It’s important to understand that currency debasement is a mechanism for redistributing wealth. Anyone clipping coins kept the clippings for themselves and therefore secured an increase in their purchasing power. Any treasurer minting coins alloying gold or silver with copper or tin similarly benefitted because they now had more coins. Since the twentieth century the dominant circulating currency has been paper money and more recently, electronic money. Currency debasements have taken different shapes and forms this century – from the hyperinflations of central Europe following WW1 to the credit inflations of the 1920s or 2000s – but the fundamental principle has remained the same: the supply of money was increased in a way which redistributed societies’ wealth towards the issuer of the new money and away from everyone else.
What is the Cantillon effect?
Cantillon observed that when precious metals were imported into Spain and Europe from the New World in the sixteenth century causing a general price increase, the gold miners – the money creators, in other words – and those associated with them benefitted. When they spent their new found wealth on goods like meat, wine, or wool the prices of meat, wine and wool would rise as would the incomes of anyone involved in the production of those goods. For this group, money creation was highly beneficial. The problems arise for other groups. Anyone not involved in the production of money or of the goods the newly produced money purchased, but who nevertheless consumed them – a journalist or a nurse, for example – would find that the prices of those goods had risen while their incomes hadn’t. In other words, their real incomes had declined. Cantillon, writing before the days of Adam Smith, was the first to articulate it. I find it very puzzling that this insight has been ignored by the economics profession. Economists generally assume that money is neutral. And Milton Friedman’s allegory about the helicopter drop of money raising the general price level completely ignores the question of who is standing under the helicopter.
Why do governments debase money?
Governments usually raise revenue through taxation which has the benefit of being transparent and open. Everyone knows why they are poorer and by how much. They know who the perpetrator is, if you like. But raising money by simply creating it, debasing the existing currency stock is very different. For the government, the effect is the same. Whether printing money today, or clipping coin in the past, the debasement represents a real increase in government revenues and therefore purchasing power. But it’s better increasing in tax revenues because you can pretend you’re not actually raising taxes. You can hide what you’re doing. By printing one billion dollars, it now has one billion dollars more to spend without having to be open about what you’ve done. But we know that revenue cannotbe raised without someone somewhere paying. And here is the problem such an action creates: who pays?
Who pays?
The answer is that no one knows who or by how much. Most people are completely unaware that they are even being taxed. Keynes said that inflation redistributed wealth arbitrarily and in a way in which “not one man in a million is able to diagnose.” All people see is that they are suffering a decline in their own purchasing power. They can’t afford to buy the things they used to buy. They know something is wrong but they don’t know why. And they don’t who to blame. They don’t know who the perpetrator of this wrong they’re suffering is, so the group dynamic unleashes suspicion and speculation just like it does in Agatha Christies novels.
Could you explain that in detail?
Unfortunately, things being more complex in the real world than in whodunit novels, the group finds someone to blame. But there does seem to be a coincidence of past currency debasements with past social debasements in which society looks for an enemy to blame for its problems. History is replete with Great Disorders in which social cohesion has been undermined by currency debasements. The multi-decade credit inflation can now be seen to have had similarly corrosive effects. Yet central banks continue down the same route. The writing is on the wall. Further debasement of money will cause further debasement of society. I fear a Great Disorder.
Can you give us an example?
In medieval Europe, for example, the seventeenth century currency debasements coincided with the peak in witch trials. During the French (and Russian revolutions), rapidly debased currency coincided with the revolution’s transition from a representative movement to one which becomes bloody and self-consuming. The hyperinflations in Central Europe after WW1, most infamously in Weimar Germany but also in Austria and Hungary saw societies turning viciously on their Jewish communities. In Zimbabwe more recently, the white farmers were made scapegoats for the country’s ills and in Venezueala today, Chavez blames “profiteers” variously defined.
What sort of great disorder do you expect to play out in the days and years to come?
Although what we’ve seen in the last few decades has been an unprecedented credit inflation, which is a different type of currency debasement to the monetisations of the past or quantitative easing of today, today’s problems have the hallmarks of past inflations. So we see Cantillon redistributions in the very sudden increase in wealth inequality which has favoured those closest to the money creation (the financial sector and anyone with access to cheap credit). Everyone else has suffered. Median US household incomes have stagnated during the past twenty years while there is a record number of US households on foodstamps.
That’s a fair point…
We also see the in-group trust turn to suspicion as societies look for someone to blame. The 99% blame the 1%, the 1% blame the 47%, the public sector blame the private sector, and private sector blames the public sector. In the Eurozone the Northern Europeans blame the Southern Europeans, Germans blame Greeks, Greeks blame bankers. In Spain, the Catalans blame the Castillians and want independence. Meanwhile in China, popular anger seems to be deliberately directed by the Party towards the Japanese. So everywhere you look, everyone is blaming everyone else for the overall malaise. But that malaise is really just a consequence of the various credit inflations each of those societies experienced. The US, China, Spain, Greece etc all experienced one way or another, quite extreme credit inflations. In all of this I just think we’re seeing the usual debasement of society we might expect following a currency debasement.
But the money printing isn’t stopping…
The central banks’ solution to these problems is to print more money. But I think this solution is actually the problem. I understand why they’re doing it, and I appreciate what a difficult situation they find themselves in. But since these problems have been cause by their past currency debasement – asset price inflation engineered by credit inflation – I don’t see why another round of more traditional currency debasement is going to heal anything. I hope I’m wrong by the way, but I’m worried that this is the beginning of a Great Disorder in which social frictions increase. I’m concerned that distrust deepens both within societies and between them and inflation ultimately becomes uncontrollable. Obviously, financial markets reflect an environment like this, the financial analogue to less trust being higher yield. So I think the historically low yields we see today in bond, equity and real estate markets will go much higher. Of course, that implies their prices go much lower.
A shorter version of the interview appeared in the Daily News and Analysis on November 12, 2012.
(Vivek Kaul is a writer. He can be reached at [email protected])
Gold is about to touch Rs 30,000. What to do now?
The price of gold has been rising and might touch Rs 30,000 per ten grams very soon(it is currently around Rs 29,300 per 10 grams). If you had invested Rs 1 lakh in gold five years back, it would currently be worth around Rs 3.1lakh. In comparison Rs 1 lakh invested in the stocks that constitute the BSE Sensex would now be worth Rs 1.22 lakh.
So clearly gold has done much better than Indian stocks have. But will it continue to give the kind of returns that it has in the past? Before I try and answer that question, let’s get into a little bit of history and try and understand why people buy gold.
Queen Elizabeth I who ruled England in the sixteenth century used to have a financial advisor by the name of Sir Thomas Gresham. Gresham had been appointed to clear up the financial mess created by the Queen’s father Henry VIII and her brother Edward VI, who had ruled before her.
Between them they had completely destroyed the pound by debasing it and ensuring that there was very little silver left in it. Kings and governments throughout history have had a habit of debasing coins and other forms of money. Nero, King of Rome, and who watched it burning, was one of the first Kings to debase coin.
Debasement was a practice where the ruler or the government of the day decided to lower the metal content of the coin while keeping its value unchanged. Let us try and understand this through the example of a coin which has a face value of 100 cents (or any other unit for that matter). The face value of a coin is referred to as its tale. This coin is made up of a metal (gold or silver) and the metal content of the coin is worth 100 cents as well. The metal content in a coin is referred to as specie.
So in this example the tale of the coin is equal to its specie, which is the ideal situation. Now the ruler decides to debase the coin by 20%. So he reduces the metal content or the specie value of the coin by 20% to 80 cents. But at the same time he maintains the face value of the coin at 100 cents. And thus debases the coin.
In most situations the rulers used to pocket the metal (gold or silver) they had saved by debasing the coin. The situation in Britain at the start of Elizabeth’s rule was similar and the market that was full of debased coins.
She wanted to correct the situation and decided to launch new silver coins where the tale of the coin was equal to its specie i.e. the face value of the coin was equal to the amount of metal in it.
But her financial advisor Gresham thought that there would be a major problem in doing that. He felt that the bad money would drive out the good. This essentially meant that the citizens of the country would hold onto the full metal new coins and try and carry out their transactions through the existing debased coins.
They would melt the newer coins for the greater amount of silver in them and sell them for their precious metal content. Hence bad money would drive out the good. This phenomenon came to be known as the Gresham’s law. Gresham decided to solve problem by exchanging all the old coins for new coins. This would ensure that there would be no old coins in the market and people would move onto using the new coins as money.
Even though Gresham’s name came to be attached to this phenomenon, this had been happening for thousands of years. “,“Under the Greeks and Romans, when gold coins were debased, few people were dumb enough to want to exchange their old coins that had high gold content for newer ones that had low gold content, so older good coins disappeared as people hid them,” writes hedge fund manager John Mauldin.
In fact it is even being observed today, though in a different form. Central banks and governments around the world have been printing money in the hope of tiding over the financial crisis and reviving economic growth in their respective countries.
When the governments print money there is much more money in the financial system than before, and hence the money gets debased. To protect themselves against this debasement people buy gold, something that cannot be created out of thin air and thus is expected to hold value.
So as governments have been printing money, people have been buying gold and the price of gold has been going up. Till early 1930s, paper money around the world used to be backed by gold or silver. This meant that citizens at any point of time could go to the central bank of the governments and its various mints and exchange their paper money for gold or silver.
Hence whenever people saw that the government was resorting to money printing, they could get their money converted into gold or silver, and thus ensure it did not lose its value. Now the paper money is not backed by anything except a fiat from the government which deems it to be money.
Given this, now whenever people see more and more of paper money, the smarter ones simply go out there and buy that gold. Hence, as was the case earlier, bad money (that is, paper money), drives out good money (that is, gold) away from the market.
But that’s just one part of the story. The governments around the world are likely to continue printing more money, in the hope that people spend this money and this revives economic growth. This in turn would mean that the price of gold is likely to go up in dollar terms. It is important to remember that gold is bought and sold worldwide in dollar terms and not in terms of Indian rupees. Hence whether Indians will continue to benefit from the price of gold continuing to go up will depend on a few other factors.
Let us examine four possible scenarios:
1) The price of gold goes up in dollar terms and the rupee continues to depreciate against the dollar: This is what has happened over the last one year. In dollar terms gold has given a return of 6.1% over the last one year. But in rupee terms the return is almost four and a half times more at 27.3%. Why is this the case? A year back one dollar was worth Rs 44. Now it’s worth almost Rs 54. So the gold price has increased in dollar terms but because of the depreciation of the rupee, the returns of gold in rupee terms are a lot higher. If gold quotes at $1600 per ounce (around 31.1grams), and one dollar is worth Rs 44, then the price of gold in rupee terms is Rs 70,400(1600 x 44) per ounce. If one dollar is worth Rs 54, the price of gold increases to Rs 86,400 per ounce. So the depreciation of the rupee against the dollar can spruce up returns for the Indian gold investor. Even if gold prices remain flat, and the Indian rupee keeps depreciating against the dollar, there is money to be made in gold. But the ideal situation for an Indian gold investor is that the price of gold goes up in dollars and at the same time the rupee depreciates against the dollar.
2) The price of gold in dollar terms falls and the rupee depreciates against the dollar, so as to knock off the fall in price in dollar terms: This is a phenomenon that has been observed over the last six months. The price of gold in dollar terms had gone down by around 7.4%, whereas in rupee terms the return on gold has been around 1%. This is because six months back one dollar was worth around Rs 51, now it’s worth Rs 54. So even though the price of gold has fallen in dollar terms, a depreciating rupee has more than made up for it.
3) The price of gold in dollar terms falls and the rupee appreciates against the dollar: This is a scenario that the Indian gold investor does not want. An appreciating rupee will further accentuate the negative returns of gold. This is a scenario that is highly unlikely. The chances of gold price falling majorly remain low as there is no end in sight to the financial crisis. Also with the government of India being in the mess it is, the chances of rupee appreciating also remain very low.
So the moral of the story is that even if the price of gold goes up in dollar terms, for Indian gold investors to continue to make money, the rupee has to either depreciate against the dollar or to at least remain flat. The rupee is likely to continue to lose value against the dollar and thus there are still more gains to be made on gold. But these gains will be rather limited till gold does not rally majorly against the dollar, which it hasn’t for the last one year.
The moral of the story is that stay invested in gold. But don’t bet your life on it.
(The article originally appeared on http://www.firstpost.com/investing/gold-is-about-to-touch-rs-30000-what-to-do-now-299622.html on May 7,2012. Vivek Kaul is a writer. He can be reached at [email protected])