Shaktikanta Das, the governor of the Reserve Bank of India (RBI), projected optimism in the latest monetary policy by reminding us of the great Lata Mangeshkar song “aaj phir jeene ki tamanna hai (Now, again, I desire to live),” from the movie Guide.
The eternal message of optimism needed to be projected in order to defend the monetary policy committee’s decision to not raise the repo rate or the interest rate at which the RBI lends to banks. The repo rate has some impact on the interest rates at which banks carry out their lending. When a central bank raises the repo rate it’s essentially signalling that it is getting worried about inflation or the rate of price rise.
The RBI under Das started cutting the repo rate in February 2019, when it was at 6.5%. By May 2020, it was cut to 4%, which is where it has stayed since. So, the monetary policy has been in what economists like to call accommodative for close to two years. Along with cutting the repo rate, RBI also printed money and flooded it into the financial system by buying bonds.
The idea, in the aftermath of the covid pandemic, understandably, was to drive down interest rates, with the hope that people would borrow and spend more, and industries would borrow and expand, and the government would be able to borrow at low interest rates.
But the times are changing now, with inflation becoming a global phenomenon. As per the February 5th-11th issue of The Economist global inflation now stands at 6%. Retail inflation in the United States in January stood at 7.5%, the highest since February 1982. In December, the retail inflation in the Euro Area was at 5%, the highest it has ever been since data started to be collected in January 1997.
Not surprisingly, central banks all across the world have been raising interest rates. The Bank of England has already raised interest rates twice. The Federal Reserve of the United States will have to soon start raising rates to rein in the four-decade high retail inflation.
Retail inflation in India in December 2021 was at 5.6%, lower than 6% level above which RBI starts to get uncomfortable. Interestingly, the RBI believes that inflation during the next financial year will be at 4.5%. This, given the evidence on offer and the fact that we live in a highly globalized world, seems a tad unlikely.
Oil prices continue to remain high with the price of Brent crude being at $90 per barrel. Also, the supply chain problems, which had cropped all across the world due to the spread of the covid pandemic, haven’t gone away. Then there is the joker in the pack, on which, as always, a lot depends in the Indian case: a normal monsoon. As Dipanwita Mazumdar, an economist at the Bank of Baroda, puts it: “Another upside risk to inflation is the possibility of a below normal monsoon. Statistically, with six successive monsoons, there could be a sub-optimal one this year.”
Further, we have close to 6% retail inflation despite consumer demand at an aggregate level continuing to remain muted. Due to this, companies have been unable to pass on the increase in the cost of their inputs to the end consumers. This can be gauged from the fact that from April to December 2021, the wholesale inflation was at 12.5%, whereas retail inflation was at 5.2%. As Das put it in his statement: “The transmission of input cost pressures to selling prices remains muted in view of the continuing slack in demand”.
The lack of consumer demand has held retail inflation down. Nonetheless, companies have started raising prices as consumer demand has started to pick up. As the RBI’s monetary policy statement put it: “The pick-up in… bank credit, supportive monetary and liquidity conditions, sustained buoyancy in merchandise exports… and stable business outlook augur well for aggregate demand.”
This, in an environment of continued high oil prices, supply chain constraints and more expensive imports, implies higher retail inflation in the months to come, which means the RBI should have started raising the repo rate by now. But it hasn’t.
So, why has the RBI maintained a status quo? It’s the debt manager of the government. The government’s gross borrowing stood at Rs 12.6 lakh crore in 2020-21. It will end up borrowing Rs 10.5 lakh crore in 2021-22, with plans of borrowing Rs 15 lakh crore in 2022-23. Given this, the RBI has to help the government to borrow at low interest rates.
To cut a long story short, the RBI is not bothered about retail inflation, controlling which is its primary mandate. It’s more interested in ensuring that the government is able to borrow at low interest rates.
Finally, Das just quoted one line from the beautiful Lata song written by Shailendra and composed by SD Burman. The next line of the song goes like this: “aaj phir marne ka iraada hai ((Now, again, I desire to die)).” The translation doesn’t do justice to Shailendra’s writing which metaphorically captures the tormented state of mind of a married woman who has suddenly found love in another man, at once feeling both exhilaration and guilt and dejection.
The binaries in economics are never as strong as life and death, nonetheless, they do exist. It’s just that RBI under Das likes to be an optimistic cheerleader rather than an institution which should realistically assess the state of the Indian economy.
Hence, as far as projecting eternal optimism goes, Das should have been quoting the Gabbar Singh dialogue from Sholay written by Salim-Javed: “Jo darr gaya samjho mar gaya (the one who is afraid is dead),” and not Shailendra, SD Burman and Lata’s song.
(A slightly different version of this column appeared in the Deccan Herald on February 13, 2022.)
(If the charts and the images are not loading, click here)
Between 2014-15 and now, taxes imposed by the central government on petrol and diesel have increased by 217% and 607%, respectively. The central government tax on diesel has gone up from Rs 4.50 per litre in 2014-15 to Rs 31.80 per litre currently. This is the real story.
Petrol and diesel prices are at an all-time high across the country. When it comes to petrol, prices have crossed the 100-rupee-per-litre mark, in many states. As expected, the central government is being questioned on this price rise.
On July 2, the finance minister Nirmala Sitharaman said that no discussions were underway to arrest the rising price of petrol and diesel. Her response to a question on rising prices of petrol and diesel was: “When the international price of crude oil is higher, we have to increase the prices and when the international price is lower, we have to decrease the prices here too. This is a market mechanism which is followed by oil marketing companies. We have given them the freedom.”
Citing the financial burden of the central government’s efforts on vaccine procurement, health infrastructure, and free food to the poor, she added that “state governments can give relief by reducing taxes or levies on petrol.”
In fact, a couple of months ago, she had referred to the taxation of fuels as a “dharamsankat”. So, what is this dharamsankat that Sitharaman bemoans?
Also, a lot of WhatsApp forwards have been going around explaining why it is impossible for the Narendra Modi government to cut petrol and diesel prices. One reason being offered is that the government needs to repay oil bonds issued by the previous UPA government. As we had explained on an earlier occasion this isn’t true. It’s just propaganda, albeit excellently run.
In this piece, we take the story forward with the hope that it can tackle some of the WhatsApp propaganda around petrol and diesel prices that is currently on.
In most situations in business, a product is sold at a price which includes the cost of manufacturing the product, the taxes that the company has paid in the process of manufacturing it and the profit margin that the company hopes to earn. Of course, the taxes aren’t a major portion of the overall price.
That’s not true for petrol and diesel in India. Taxes, as we shall see, form a significant part of the overall retail price. The retail price or the price we pay for petrol and diesel at the pump, is made up of four components – a) The price at which the dealer buys petrol and diesel from the oil marketing companies like Indian Oil, Bharat Petroleum or one of the private companies. This price includes the cost of producing petrol and diesel and getting it to the pump where it is sold. It also includes the profit margin of these companies. b) The central government tax. c) The state government tax. d) Dealer commission.
Of the four components, the price at which the dealer buys petrol and diesel from the oil marketing company, is the biggest variable. It is tied to the price of international crude oil. If the price of oil goes up, as it has since April 2020, the price of petrol and diesel also go up. In April 2020, the average price of the Indian basket of crude oil had fallen to $19.9 per barrel.
In June 2021, it averaged at $71.98 per barrel. As of July 13, it had risen to $74.97 per barrel. This, as Sitharaman said, is the main reason for the increase in petrol and diesel prices in the recent past. We would like to say that this is not the reason, but a reason. We will explain the details as we go along.
India produces very little oil of its own. In fact, the overall import dependency in April and May this year was at 85.4%. We are heavily dependent on oil imports. Hence, if price of oil goes up internationally, the price of petrol and diesel also go up within the country.
Now getting back to the components of the retail price of petrol and diesel. The second component is the central government tax, which is the central excise duty. This is fixed and only changes when the government decides so. (The central excise duty has further components, but we won’t get into that in this piece).
Then comes the state government tax on petrol and diesel. Some states refer to it as sales tax and in some other states it is called the value added tax. This tax is over and above the central excise duty and varies from state to state.
The pumps through which petrol and diesel are retailed also need to make some money. They earn a dealer commission, which is also a part of the per litre retail price . Having said that, the dealer commission is a small fraction of the total price, and mostly inconsequential in affecting the final retail prices of petrol and diesel.
Let’s look at the retail price breakdown of petrol and diesel in Delhi as of July 1, 2021. The following table shows us that.
Table 1. Price breakdown of petrol and diesel (in Rs per litre): July 1, 2021 (Delhi)
Let’s consider the price of petrol and try and understand this structure in detail. The price charged to the dealer is Rs 39.33 per litre. On this the central government charges an excise duty of Rs 32.90 per litre. Then there is a dealer commission of Rs 3.82 per litre.
These three entries add up to Rs 76.05 per litre. On this price, the Delhi government charges a value added tax of 30%, which works out to Rs 22.82 per litre. This is added to Rs 76.05 per litre and it adds up to a retail selling price of Rs 98.87 per litre of petrol.
It is interesting to note, the value added tax of the state government is charged on Rs 76.05 per litre, which also includes a central excise duty of Rs 32.90 per litre. This means that when you and I buy petrol we are paying a tax on a tax. This is true across the length and breadth of India and not just in Delhi.
Also, it is worth mentioning that the value added tax or the sales tax of the state governments is ad valorem, which means it is a certain proportion of the sum of the dealer price, central excise duty and dealer commission.
So, if the dealer price goes up or the central government decides to increase the excise duty, the state governments earn a higher tax per litre of petrol sold. What is true for petrol is also true for diesel, though the numbers change and so does the calculation accordingly.
Now let’s look at what proportion of the retail sales price do each of the four components form. Figure 1 and Figure 2 show that for petrol and diesel, respectively. The data is as of July 1.
Figure 1 and Figure 2 make for a very interesting reading. In case of petrol, the dealer price forms 39.8% of the retail price of petrol. The rest are largely taxes, imposed both by the central government and the state government. The taxes added up to 56.4% of the retail selling price of per litre of petrol in Delhi as of July 1.
Along similar lines, the dealer price makes for 46.8% of the retail price of diesel. The rest are largely taxes. Taxes amount to 141.7% of the dealer price for petrol and 107.3% of the dealer price for diesel. So, taxes form a significant portion of the price of petrol and diesel.
The interesting thing is that the central excise duty on petrol and diesel has been raised over the years. Up until early May 2020, the excise duty on petrol was Rs 22.98 per litre. It was raised to Rs 32.98 per litre. When it comes to diesel, the excise duty was raised by Rs 13 per litre, from Rs 18.83 per litre to Rs 31.83 per litre.
From February 2, 2021, the total excise duty on petrol and diesel has stood at Rs 32.90 per litre and Rs 31.80 per litre, respectively. Clearly, a significant proportion the increase in price of petrol and diesel over the last one year has been due to an increase in the excise duty charged by the central government. Hence, it’s not just about global oil prices going up, as Sitharaman would like us to believe.
In fact, in May last year, India had the distinction of being the highest taxer of auto fuels in the world, a whopping 69%. Since then, the portion of petrol and diesel prices that goes towards taxes, to both the central government and the state governments, has come closer to 50%, although the retail price at the pump has increased. Irrespective of whether it is 69% or 50%, taxes on petrol and diesel in India are high. Has it always been like that, or is it a recent development?
Let’s examine. Figure 3 plots the breakdown of the retail price of petrol over the years in Delhi (We are not obsessed with Delhi. But regular data in the public domain is only available for Delhi, hence, limiting our choice). For the sake of avoiding visual clutter, we have considered only the price in the month of May every year. In fact, petrol prices change frequently, sometimes several times a month due to fluctuations in crude oil prices.
Also, the central excise duty has been hiked more than once during some years. Thus, the chart below does not capture every price point over the last eight years but is still a good representative of the overall trend.
Source: Petroleum Planning and Analysis Cell
Now let’s try and understand this in detail. A look at the above chart tells us very clearly, the central government taxes on petrol have gone up over the years, from Rs 10.39 per litre in May 2014 to Rs 32.90 per litre in May 2021. This is a jump of around 217%. The state government value added tax in Delhi has also gone up from Rs 11.90 per litre to Rs 21.81 per litre, a jump of around 83%.
Clearly, taxes on petrol, more at the central government level than the level of state governments, have gone up over the years, and this has pushed up the retail selling price. Take a look at Figure 4 and Figure 5. They plot the proportion of each component in the retail selling price of petrol and diesel in May 2014 and May 2021, respectively.
Source: Petroleum Planning and Analysis Cell
Source: Petroleum Planning and Analysis Cell
As can be seen from Figure 4 and Figure 5, the price charged to the dealer, which was 66% of the retail selling price of Rs 71.41 per litre in May 2014, has since fallen to around 38% of the retail selling price of Rs 94.49 per litre in May 2021.
The central excise duty as a part of the retail selling price of petrol has jumped from 14.5% to 34.8%. This shows again that the increase in central excise duty has been a major reason for the increase in the price of petrol over the years. The increase in state government taxes have also played their role.
In fact, the dealer price of petrol in May 2014 was Rs 47.12 per litre in comparison to Rs 35.99 per litre in May 2021. Despite this, the retail selling price of petrol in May 2014 was at Rs 71.41 per litre, which was significantly lower than Rs 94.49 per litre in May 2021.
All that is true for petrol is also true for diesel. Figure 6 plots the price breakdown for diesel over the years. As can be clearly seen, the central government tax has gone up from Rs 4.50 per litre in May 2014 to Rs 31.80 per litre in May 2021, a jump of around 607%.
Meanwhile, the state government tax has almost doubled from Rs 6.61 per litre to Rs 12.50 per litre. When it comes to the dealer price for diesel, it was at Rs 44.98 per litre in May 2014 and at Rs 38.49 per litre in May 2021. Despite this, the retail selling price of diesel in May 2014 was at Rs 57.28 per litre, which was significantly lower than Rs 85.38 per litre in May 2021.
Source: Petroleum Planning and Analysis Cell
Let’s take a look at some interesting insights that emerge from the data above:
1) The price paid to the dealer was the highest in 2014. Since then, the dealer prices have come down, although not in a linear fashion. This is primarily because the average price of the Indian basket of crude oil in May 2014 stood at $106.85 per barrel. The oil price has seen a largely downward trend since then.
2) There have been some ups and downs when it comes to the dealer price, with the lowest prices for both petrol and diesel recorded in 2020, when they were around half of the price in 2014. This was on account of the price of the Indian basket for crude falling to $30.61 per barrel during May 2020, the lowest in any May since May 2014. Compared to the lows of 2020, dealer prices have risen by over 60% which explains the recent price surge at the pump. As explained earlier, retail prices have also gone up due to a massive increase in the central excise duty on petrol and diesel by Rs 10 per litre and Rs 13 per litre, respectively, in early May 2020.
3) From 2014 to 2021, taxes imposed by the central government have increased by around 217% on petrol and around 607% on diesel. The bulk of these increases were over two periods – from 2014 to 2015, and from 2019 to 2020, either by co-incidence or by design, both these periods were immediately following Narendra Modi’s election victories.
4)The first round of hikes in central excise duty in 2014 was effectively done to capture the gains from the drop in crude oil prices. The average price of the Indian basket of crude oil in May 2014, the month in which Modi was elected the prime minister, had stood at $106.85 per barrel. By January 2016, it was down to $28.08 per barrel. Instead of passing on lower prices to the consumer, the government decided to bolster tax revenues when global oil prices fell. Thus, the end consumer did not see a price decrease from the fall in crude oil prices.
5)After that, from 2015 to 2019, the central government tinkered with the central excise duty with marginal increases or decreases to keep the retail price somewhat bounded. In fact, in October 2017 and October 2018, the excise rate on both petrol and diesel was cut by Rs 2/litre and Rs 1.50/litre, respectively, to counter the increasing oil prices. The 2019 general elections also likely influenced these cuts.
6)The next big hike in central excise was in early May 2020, again around the same time when global oil prices plummeted in the aftermath of the covid pandemic, when the duty on petrol was increased by Rs 10/litre and that on diesel by Rs 13/litre. The price of the Indian basket of crude averaged at $19.9 per barrel in April 2020. It has since risen to more than $70 per barrel. But with a rise in oil prices in 2021, the excise tax has not been reduced. Hence, a higher oil price and a higher excise duty have both contributed to the rise in pump prices of petrol and diesel.
7) The charts above are for Delhi. As explained earlier, each state has a different value added tax or sales tax when it comes to petrol and diesel and a slightly different trend over the last eight years. A detailed analysis of every state is outside the scope of this piece. Nevertheless, the broader point stays the same. A major reason for the increase in the retail selling price of petrol and diesel, and the fact that petrol is selling at more than Rs 100 per litre in many states, is because the central excise duty on petrol and diesel, has been increased majorly over the years. The increase in state government taxes have also had a small role to play.
Officials in both the central government and state governments know that the current petrol and diesel prices are placing a high burden on the end consumer. Both sense discontent brewing on this issue, which can ultimately cost at the ballots. So, both stand to gain, if taxes are cut and prices fall.
Crucially, both have the ability to reduce the retail price, by lowering their portion of the tax. But the way things are currently it seems that the state governments would prefer the central government reducing excise duty, and the central government would prefer the state governments reducing the sales tax or the value added tax.
Given that both sides are standing firm, the consumer has ended up teary-eyed. Also, as we have seen, the central government taxes on petrol and diesel have gone up significantly more than the state taxes. Clearly, the ball is in the central government’s court.
To add more intrigue to the petrol and diesel tax saga, there is one other thing to consider. A part of the central excise duty is shared with the states. This part is referred to as the divisible pool. Much of the increase in central excise since May 2014 has been in the form of surcharge and cess, which are not shared with the states. We have discussed this in detail in an earlier piece.
As of 2021, only Rs 1.40 of Rs 32.90 collected through the central excise duty on per litre of petrol, and only Rs 1.80 of the Rs 31.80 collected through the central excise on per litre of diesel, goes to the divisible pool.
Since the states get 42% of the revenue from the divisible pool, they end up getting 59 paisa per litre which is a mere 1.8% of excise duty collected by the central government on per litre of petrol. For diesel, the states’ share comes to 76 paisa per litre amounting to 2.4% of the central excise duty per litre of diesel.
Given that the central government has employed such a strategy of actively undercutting states’ revenue from the central excise duty collections on petrol and diesel, it is a tad optimistic to expect the state governments to be enthusiastic about a coordinated approach, where both the central government and the state governments reduce the taxes they collect on sale of petrol and diesel at the same time.
Central government dependence
In the last couple of years, the central government has become overly dependent on the central excise duty that it earns on the sale of petroleum products (primarily petrol and diesel). In 2014-15, the central government had earned Rs 99,068 crore from this. This jumped to Rs 2.23 lakh crore in 2019-20. It jumped to an all-time high of Rs 3.72 lakh crore in 2020-21.
This compensates for the massive fall in corporate tax or the income tax paid on corporate profit. This had stood at Rs 6.64 lakh crore in 2018-19. In 2020-21, it fell to Rs 4.57 lakh crore, a drop of about a third. This happened because in September 2019, the government reduced the base rate of corporate tax to 22%, from the earlier 30%. Hence, the collections of corporate taxes fell in 2020-21, despite the massive increase in profits of listed corporates during the year.
Over and above this, a badly designed and run Goods and Services Tax has not brought in the amount of taxes it was expected to. As the Fifteenth Finance Commission Report put it: “In terms of government finances, [GST] was expected to improve the overall tax-GDP ratio in the medium term and lead to higher Union [central government] transfers to States.” But that hasn’t happened. This can clearly be seen in Figure 7.
Source: Centre for Monitoring Indian Economy.
There is no free lunch in economics. The costs of a fall in corporate tax collections and weaker than expected GST collections, are being borne by everyone who buys petrol and diesel in a direct way. In an indirect way, we are paying for it in the form of higher inflation.
This is why the central government cannot reduce excise duty on petrol and diesel. Their finances have become too reliant on the revenue generated by the excise duty on petrol and diesel.
The economy was already on weak footing when Covid hit. The pandemic triggered a massive reduction of economic activity – one that is still on going, which has reduced tax inflow from other sources. The fact that corporate income tax was cut hasn’t helped either.
Additionally, there are more financial demands on the government than the past. The government needs money to finance pandemic-induced expenses like vaccine procurement and improving healthcare delivery. All this could have been easily done if corporate income tax rates hadn’t been cut or GST had been launched and run properly.
In such an environment of decreased income, the government is unable to wean itself off taxes it earns from the sale of petrol and diesel. In many ways this dilemma is self-imposed since this government’s original sin was its economic mismanagement before the pandemic hit. You construct a house poorly and a storm hits. Now you are drenched due to a leaking roof. Is the storm the only one to blame?
Good policy, bad policy
As a thought experiment, say the central government reduces the central excise duty on petrol and diesel by Rs 10/litre. The immediate knock-on effect will be one of the following three scenarios. One, the government will have to scale back spending to make up for the loss in revenue. Two, the government will increase a different tax (as we said earlier there is no free lunch). Three, the government takes on a higher fiscal deficit (the difference between its annual expenditure and revenue).
Given this, the government has decided to continue with the high central excise duty on petrol and diesel. But is that the best option available?
High prices of petrol and diesel cause misgivings in a large section of the electorate, especially the middle class and the poor. That the Modi government is willing to risk this public sentiment speaks to their confidence in assuaging voters through other avenues. While it’s for the government to figure out its politics on this issue, the economics of the decision though, can be debated.
As always, the economic argument on general topic of taxation of petrol and diesel is nuanced. An increase in taxes on petrol and diesel (such as the central excise) has two negative economic impacts.
One, this leads to a higher inflation. Most goods need to be transported from where they are produced to where they are consumed, and the primary mode of transport of goods in India are trucks that run on diesel. So, when diesel prices go up, due to higher taxes or otherwise, price of most goods also increase. Inflation has its impact on consumption and that in turn slows down economic growth.
Two, a higher tax on petrol and diesel, is the opposite of a consumer stimulus i.e., it takes money out of people’s pockets. Higher fuel costs mean lesser disposable funds for other purchases, which then depresses demand for goods and services.
One criticism of India’s economic response to the covid pandemic has been that most of the government actions have been directed towards suppliers and firms, instead of the consumers. Most developed nations have put money directly in the hands of citizens to revive consumer demand.
Whether India’s fiscal situation allows for a meaningful stimulus is debatable, but surely a negative stimulus (which is what the higher central excise duty on petrol and diesel works out to), cannot help with the economic revival.
Given that the government has been addicted to taxes it earns from petrol and diesel, for more than a few years now, it has gone slow on disinvestment of its stakes in public sector companies as well as the land owned by them. The revenue that could potentially come in from here, could reduce the dependence on taxes coming in from the retail sale of petrol and diesel. But that hasn’t happened.
On the flip side, there is an argument in favour of higher taxes on petrol and diesel, related to environmental impact. Given the negative impact of fossil fuels on carbon emissions and global warming, higher taxes on petrol and diesel could/should in theory dampen their demand. However, in India, this line of reasoning is not very convincing.
Figure 8 shows the annual consumption of demand of petrol and diesel.
Source: Petroleum Planning and Analysis Cell
Other than 2020-21 which was affected by lockdowns and curfews, the demand for petrol and diesel has increased each year, despite changing prices. Moreover, diesel makes up for most of the fuel consumption, and it is particularly insensitive to price fluctuations since it is used for commercial transport and so the cost is passed on to the end consumer.
As RS Sharma, former chairman of ONGC said in 2018: “Demand for diesel is typically inelastic as most of the rise in price is borne by the end consumer and can be seen to directly impact inflation.”
Of course, one can’t rule out the possibility that if petrol and diesel prices had not increased due to a higher central excise duty, the demand would have grown even more. One cannot even quantify how the increased prices may incentivise adoption of alternative sources of energy, electric vehicles and such.
The trade-off between economic development and environmental stewardship is the ultimate dharamsankat of our times and taxes on petrol and diesel do lie in that realm. But we doubt that is on Sitharaman’s mind.
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Anything can be money if individuals on both sides of the economic transaction are ready to accept it as money. As Yuval Noah Harari writes in Sapiens – A Brief History of Humankind: “Money is anything that people are willing to use in order to represent systematically the value of other things for the purpose of exchanging goods and services.” Of course, for something to emerge as a form of money at a societal level, it needs to be widely accepted.
This is the hope that the believers in bitcoin and other cryptocurrencies have been peddling for a while to make them look like attractive investments. That one day when enough number of people across the world are tired with the government backed fiat money or paper money as it more popularly known, cryptos will take over.
Of course, you can’t wait for that to happen, and you need to buy bitcoin now. This is one of the ways in which the fear of missing out or FOMO, is created.
So how logical is this argument? How much should we trust it? These are questions well worth asking.
If you look at the history of money, different things have been money at different points of time. In the prisoner-of-war camps of the Second World War, cigarettes emerged as a form of money. They are a great example of the fact that anything can be money if both the sides of the economic transaction are willing to accept so. Also, any system where conventional money is not around, like in a prison, does not continue to stay in a vacuum, and newer forms of money emerge.
Different agriculture commodities including tobacco have been money at different points of time. So have been different metals, everything from iron and bronze to silver and gold.
Hence, different things have been money at different points of time, during the course of human history. What this tells us is that as long as enough people accept something as a form of money, it can continue functioning as money, until it doesn’t.
This means that bitcoin and cryptocurrencies can also become a form of money, over a period of time. Nevertheless, if we leave it at just this, it will be lazy reasoning at best. Also, this is where things get a tad complicated.
Allow me to explain.
Pure paper money or fiat money or money not backed by any commodity (gold, silver, tobacco, iron, copper etc.) has been around for many centuries, nevertheless, it has flourished and been widely accepted only in the last hundred years.
Why is that the case? Why do people happily and readily accept money not backed by any commodity as a form of payment, on most days?
“The typical answer provided in textbooks is that you will accept your national currency because you know others will accept it. In other words, it is accepted because it is accepted. The typical explanation thus relies on an “infinite regress”: John accepts it because he thinks Mary will accept it, and she accepts it because she thinks Walmart will probably take it.”
To put it a tad simplistically, paper money is accepted because paper money is accepted. Are we saying there is a mass delusion at work? Is fiat money fiction?
“Money is a made-up thing, a shared fiction. Money is fundamentally, unalterably unalterably social. The social part of money—the “shared” in “shared fiction”—is exactly what makes it money. Otherwise, it’s just a chunk of metal, or a piece of paper, or, in the case of most money today, just a number stored on a bank’s computers.”
Now that maybe true, but that’s not important. What is important is to understand what keeps this shared fiction, this mass delusion, this myth, or whatever else you might want to call it, going. And this is where the government, which issues fiat money and controls the fiat money system, comes in.
For the government, it is important that its citizens continue to believe in the shared fiction of fiat money and continue accepting it as a form of payment. What keeps it going? Before answering this question, it is important to understand that there are three things that make a government a government: a) The right to tax. b) The right to legal violence. c) The right to create money out of thin air.
Two out of three rights are important to the context of bitcoin and cryptocurrencies. The right to tax and the right to create money out of thin air. In the past, I have talked extensively about the fact that any government letting bitcoin and cryptocurrencies operate smoothly is essentially giving away its right to create money out of thin air. And they aren’t exactly waiting to do it. (You can read about this here, here and here).
So, what about the right to tax that any government has?
As Wray writes:
“One of the most important powers claimed by sovereign government is the authority to levy and collect taxes (and other payments made to government, including fees and fines). Tax obligations are levied in the national money of account: Dollars in the United States, Canada, and Australia; Yen in Japan; Yuan in China; and Pesos in Mexico. Further, the sovereign government also determines what can be delivered to satisfy the tax obligation. In most developed nations, it is the government’s own currency that is accepted in payment of taxes.”
And not just in developed nations, even in lesser developed ones, the governments accept tax payments in the fiat money of the country. This is what keeps the fiat money system going. As Wray writes: “It is because anyone with tax obligations can use currency to eliminate these liabilities that government currency is in demand, and thus can be used in purchases or in payment of private obligations. The government cannot easily force others to use its currency in private payments, or to hoard it in piggybanks, but government can force use of currency to meet the tax obligations that it imposes.”
In simple terms, government taxes can only be paid in fiat money and that creates demand for fiat money or paper money not backed by anything, and keeps the system going.
A counter argument to this might be that while this might be true in countries where taxes form a significant part of the economy, but how does it work in countries where taxes are not a significant part of the economy. Why does the paper money system still hold?
The answer lies in the overall structure. Companies which operate in a country need to pay taxes to the government in fiat money. So, they carry out their business in fiat money; accept and make payments in it. This means their employees, suppliers (their employees), contractors (their employees), distributors (their employees) and so on, everyone gets paid in or must pay in paper money as well.
When people who are a part of the overall business system, which needs to pay different kinds of taxes, get paid in paper money, they go out and spend that paper money. Hence, individuals and institutions who sell to these people, must then accept paper money. So, the cycle keeps going. And there is demand for paper money or fiat money.
Also, it is worth mentioning here that taxes form a significant part of the economy in any developed country in the world. For any monetary revolution to happen, the governments in these countries need to buy the idea of bitcoin and other cryptos, and also actively promote them. El Salvador classifying bitcoin in a legal tender isn’t going to help that cause. Or the fact that Nigerians have taken on to bitcoin like no one else. These are exceptions to the rule.
The larger point here is that the structure of fiat money being needed to pay government taxes, keeps the paper money system going and will continue to keep it going in the time to come. The demand for fiat money will remain. As long as that is the case, bitcoin and other cryptos will be a sideshow at best, keeping the believers interested, at least for a while.
Also, governments are not going to give up on their right to create money out of thin air. This explains why money central banks are now in the process of planning and/or launching their respective central bank digital currencies.
Of course, people who do not like to pay their fair share of taxes also do not like the idea of being a part of the formal financial system (which is what fiat money system on its whole is at the end of the day). Therefore, people who are a part of the black economy like to convert their profits on which they haven’t paid cash, into other assets like real estate (held benami), gold (easy to store), precious stones (easy to move around) etc. It also explains why people operating in the black illegal economy love bitcoin and other new forms of crypto.
On the flip side, those who run the fiat money system have been abusing it post 2008, when the financial crisis broke out, and post late 2019, when the world was hit by the Covid pandemic.
A lot of fiat money has been created out of thin air, to get economic activity and economic growth going again. This is offered as a major reason by crypto believers, as to why the world should be shunning paper money and buying bitcoin and other cryptos. There is a lot of paper money being created out of thin air, but only 21 million bitcoin are only ever going to be mined.
Hence, the cryptosystem is built around the concept of scarcity whereas with more and more paper money being created, high inflation can become the order of the day and wealth stored in fiat money can lose value at a very fast pace.
The trouble with this argument is that while more bitcoin cannot be created, anyone and everyone, who understands these things, can create a new cryptocurrency. Which is why there are thousands of cryptos going around. As renowned investor Ray Dalio put it in a note on bitcoin: “Competition will, play a role in determining bitcoin and other cryptocurrency prices. In fact, I assume that better ones will come along and displace this one because that is the way the evolution of everything works.” Given this, in the years to come, gold will still be around, about bitcoin, we really don’t know.
So, the point is you don’t know which crypto is going to be around in the days to come. And given that, how do can you ensure that the value of your wealth remains the same, by investing in crypto. Plus, at the risk of sounding cliched, the price volatility of cryptos continues to remain a huge risk.
Something which falls by 50% in a matter of months, cannot even aim to be an asset class, forget being a form of money. The crypto believers now offer the example of stablecoins, which are basically cryptos pegged to paper or fiat money. They have price stability. But their stability comes from being linked to fiat money in the first place.
As Mark Carney writes in Value(s) — Building a Better World For All: “The highest-profile examples of stablecoins… are best thought of as payments systems rather than money per se since they derive their moneyness from the underlying sovereign currencies.”
To conclude, a small story. Before the crypto crash happened, a gentleman on Twitter very confidently told me that he would rather buy dogecoin, which was launched as a joke on bitcoin, than the US dollar. This is because the dogecoin wasn’t being created out of thin air (which is not true, given that the amount of dogecoin goes up every year, but we will ignore that here) and the dollar was.
His point was that the US dollar was not backed by anything. The US dollar is not backed by anything in the physical sense of the term, but it is backed by the US sovereign, the biggest economy in the world, perhaps the most innovative economy in the world and the biggest empire the world has ever seen. Also, the dollar has an exorbitant privilege. While other countries need to earn it, the US can simply print it. Which explains why the demand of for the dollar continues to remain solid, despite its abuse.
Yes, to that extent, it is not backed by anything and bitcoin and other cryptos are backed by everything.
What I can’t get my head around is that if you can’t trust the government (and there are reasons not to), how can you trust a few random guys launching their own crypto in their own backyard. Something which can be moved up and down by a few tweets. How is this fiction better than the government’s fiction? I really don’t have an answer for that.
For May 2021, inflation as measured by the consumer price index (CPI) stood at 6.3%. It was the highest since November 2020, when it had stood at 6.93%.
Of course, this has been splashed all over the media since yesterday evening when the figures were published. But do you ever sit back and think about what does inflation really mean for you? (I mean why would anyone sit back and think about inflation, but nonetheless please humour me for a bit). If you haven’t, let me set the cat among the pigeons.
1) The government publishes inflation as measured by the CPI every month. So, when it says inflation in May 2021 stood at 6.3%, does it mean that inflation for you, dear reader, also stood at 6.3%? Or that you paid 6.3% more for things on an average in May 2021 than you did in May 2020? Have you ever thought about this? The CPI consists of many items whose prices are regularly tracked by the government (specifically, by the ministry of statistics and programme implementation). All these items have a certain weight in the index.
So, food items overall have a weight of 39.06% of the index. The assumption here is that the average Indian makes nearly two-fifths of his expenditure every month on food.
If you are reading this, chances are your expenditure on food every month as a proportion of your total expenditure, is lower than 39.06%. I say this simply because you are reading this in English, and anyone who can read English in India, is likely to be better off than an average Indian.
Hence, inflation of 6.3%, isn’t your rate of inflation. It can be higher or lower than this, depending on stuff you regularly consume.
Take the case of petrol prices. They have risen by 62.28% in the last one year, if we look at the inflation as measured by the wholesale price index (this data as per inflation as measured by CPI, hasn’t been published in the recent months).
In inflation as measured by the wholesale price index, petrol prices have a weight of 1.6%. In inflation as measured by CPI, they have a weight of 2.19%. Your expenditure on petrol as a part of your overall expenditure, is likely to be more than this.
Also, on a slightly different note, rising petrol, diesel and gas prices, feed into food prices, because food needs to be moved from where it is produced to where it is consumed.
2)As people earn more, their spending on food as a proportion of their overall spending comes down. Also, within the food basket, spending on cereals comes down and spending on foods which have protein (eggs, pulses, meat, etc.), goes up. The spending on milk also goes up.
When it comes to the CPI, this can simply be gauged from the fact that the weightage that food has in the urban part of the CPI is much lower than the rural one. When it comes to urban India, the weightage of food items in the CPI stands at 29.62%. In case of rural India, the weightage is much higher at 47.25%.
This is primarily because the average urban Indian earns more than an average rural Indian and hence, incurs a lower proportion of the overall expenditure on food.
Of course, as people earn more, their spending on items other than food increases and that starts to matter more. Even here the stuff that CPI measures and your regular consumption basket may not intersect. Let’s take the case of household goods and services, a heading under CPI.
This heading keeps track of inflation of bedsteads, almirahs, dressing tables, chairs, furniture, bathroom and sanitary equipment, bedsheets, mosquito nets, air conditioners, sewing machines (yes, still!), washing machines, invertors, refrigerators, etc. In May 2021, the inflation for all these items overall stood at 3.89%.
Here is the thing. While these items are important in the overall scheme of comfortable middle class living, they do not have any impact on regular expenditure, given that they are one-off purchases. Hence, they don’t impact your regular consumption and, in the process, your regular inflation.
But this is a point that is not important for the government. The government is trying to figure out the rate of inflation for the society at large, so that this can help in other ways, like figuring out the adequate level of interest rates for one.
3)But there is a flip side to the above point as well. The health inflation in the last one year has been 8.44%. Now anyone who has had to deal with India’s urban private health system in the last one year, will tell you that is a load of bunkum. Prices have gone through the roof and the rate of inflation doesn’t really capture it.
Of course, going to the hospital is also not something that most people do regularly (I am not talking about basic visits to a personal physician here). Hence, anyone who has had to spend some time in a hospital this year, or has had to finance a close one’s stay, would have ended up spending a lot of money and paid significantly higher prices than last year.
So, one-off expenditures during a particular year can really make a mess of your finances, and that is something the inflation as measured by CPI doesn’t really capture.
Also, on a slightly different note, as Madan Sabnavis, the Chief Economist of CARE Ratings puts it: “Problem with most of the inflation numbers relating to personal care, health, recreation, transport is that once prices are increased they would not come down and hence becomes a new base.”
The point being that inflation measures the rate of increase in price over a period of one year. Hence, the annual inflation itself may not be high, but that doesn’t necessarily mean that things are not expensive.
4)Different states have different rates of inflation in different years. In 2019-20, among large states, Kerala had the highest rate of inflation at 6.1%. Bihar had the lowest at 2.2%.
Source: Reserve Bank of India.
What does this mean? It means that the inflation you experience also depends on which part of the country you are in and the inflationary pressures it is experiencing during a particular year. Of course, within a state, whether you are in an urban area, or a rural one, also makes a difference. 5)Clearly, the official rate of inflation doesn’t tell you much about anything. Hence, what can you do about it? First and foremost, you need to do an expenditure audit and figure out the things you spend your money on regularly (you will be surprised). This shouldn’t be so difficult if you make purchases online or make payments digitally or use plastic money.
The important point here is to identify the most important items and not every possible one, and keep track of expenditure on the important items, over a period. A simpler method is to just keep track of regular monthly expenditure and that too can give you some inkling which way your finances are headed, and whether you are spending more or less than you were doing in the past.
This is not a totally foolproof and methodical system but more of a crude method to get around the uselessness of the official rate of inflation at an individual level, when it comes to consumption. Of course, there are other implications which I do keep talking about.
The actual writing of this piece took around six hours, though I have been thinking on this issue for at least the past nine years since I started writing my Easy Money book. I have been told that the backlash from the bitcoins believers will be huge. All feedback is welcome, as long as you don’t abuse. And if you choose to abuse at least read the piece first. You will be able to abuse better.
Bulbulon ko abhi intezar karne do. (Let the bubbles wait for now). — Gulzar, Vishal Bhardwaj, Usha Uthup and Rekha Bhardwaj in 7 Khoon Maaf.
Let’s start this one with a small story.
Salvador Dalí was a famous painter who lived through much of the twentieth century. He was a pioneering figure in what is known as Surrealism.
Other than being a fantastic painter, Dalí was also a sharp businessman. The story goes that once Dalí had treated some friends at an expensive New York restaurant. When the time to pay for the meal came, Dalí instead of paying in dollars, like anyone else would have, decided to carry out a small experiment.
On the back of the cheque Dalí had signed to pay for the expensive meal, he drew a sketch in his inimitable style. He signed it and handed it to the waiter. The waiter passed it on to the manager.
The manager realised the value of what Dalí had given him and decided to frame the cheque and hang it on the wall, making sure that anyone who came to the restaurant saw it.
Of course, this meant that Dalí’s cheque wasn’t encashed and he didn’t really have to pay in dollars for the expensive meal he had taken his friends out for.
This trick worked for Dalí. He was delighted and he used the same trick at different New York restaurants to pay for meals. The managers of all these different restaurants framed the cheque and hung it on one of the walls in their restaurants, so that everybody who came to the restaurant could see and realise that the famous painter Salvador Dalí had dined at the same place as they were.
Now what was happening here? If I can state this in simple English, Salvador Dalí, had turned his art into money. As Guillén writes:
“The money offered to pay for the meals was never deposited, as the cheques were transformed into artworks and took on a separate life. For Dalí, this maneuver was a stroke of genius. He could print his own money (his drawings had value), and people were willing to accept it as a form of payment.”
The trouble was Dalí went overboard and paid for one too many meals using this trick. In the end, the restaurant managers wised up and Dalí probably had to start paying real dollars for the expensive meals he took his friends out for.
What’s the moral of this story? Anyone can create his or her own money as long as others are willing to accept it, though one thing needs to be kept in mind. As Guillén writes: “As with national currencies, any money can be felled by the laws of supply and demand, as an excessive supply depreciates its worth and reduces people’s willingness to use it.”
What Dalí ended up doing in a very small way, governments have done over and over again, over the centuries. They have gone overboard with printing money and spending it, created high inflation, as too much has chased the same set of goods and services, and in the process destroyed the prevailing form of money. (If you are interested in details, I would suggest that you read my Easy Money trilogy).
Dear Reader, you must be wondering by now why am I recounting this story in a piece which is headlined to be about the bitcoin bubble. Have some patience, everything will become clear very soon. Read on.
Bitcoin is a digital currency that does not use banks or any third party as a medium or at least that is how it is conventionally defined. It is governed by a string of cryptographical codes, which are believed to be military grade and very tough to break.
The price of a bitcoin has rallied big-time over the last few months. It rose from a little over $10,000 per bitcoin in early September to more than $40,000 per bitcoin in early January. As of January 8, 2021, the price of bitcoin touched an all-time high of $40,599.
One of the core selling points of bitcoins as well as its raison d’être is that unlike paper money they cannot be created out of thin air. The number of bitcoins is finite and the code behind it is so written that they cannot go beyond a limit of 21 million tokens.
Interestingly, mining, or the generation of a bitcoin, happens when a computer solves a complex algorithm. Anyone can try to mine bitcoins, but with a finite number being generated at regular intervals and with an increase in the number of people joining the mining race, it has become increasingly difficult to solve the algorithm and generate bitcoins.
As of January 11, 2021, the number of bitcoins in circulation stood at 18.6 million units. The rate at which bitcoins are being created has slowed down over the years and the last fraction of the 21 millionth bitcoin will be created only in 2140.
The larger point here is that unlike the paper money system (or to put it slightly more technically the fiat money system) which can be manipulated by central banks and the governments, the bitcoin system can’t.
Hence, there is an overall limit to the number of bitcoins that can be created. This is the main logic offered in support of buying and owning bitcoins. Unlike central banks or governments or Salvador Dalí (in case you are still wondering why I started with that story), money in the form of bitcoin cannot be created out of thin air and beyond a certain limit.
In fact, this core idea/message at the heart of the bitcoin was built into the first fifty coins, now known as the genesis block, created by Satoshi Nakamoto, the mysterious inventor behind it. The beauty of bitcoin is that even not knowing who really Nakamoto is, doesn’t impact the way the system he created, works.
The genesis block contained a headline from The Times newspaper published in London dated January 3, 2009. The headline was: “Chancellor on brink of second bail-out for banks”. The headline and the date are permanently embedded into the bitcoin data.
As Nakamoto wrote on a message board in February 2009: “The root problem with conventional currency is all the trust that’s required to make it work… The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.”
Bitcoin was supposed to be this grand idea meant to save the world from the way the central banks and governments manipulate the paper money system. As William Quinn and John D Turner write in Boom and Bust—A Global History of Financial Bubbles: “To its advocates, bitcoin was the money of the future: it could not be devalued through inflation by a central bank, you could spend it on anything without having to worry about government interference or taxes, and it cut out the middleman, namely commercial banks.”
The question is, in these times of easy money, has bitcoin reached anywhere near its original goal or is it just another way of pure speculation.
Let’s look at this pointwise.
1)Here is a chart of the price of bitcoin in dollars since July 18, 2010 (I couldn’t find the price of bitcoin before this in the public domain, hence, the random date).
It doesn’t take rocket science to understand that if you have been a long-term investor in bitcoin, you would have made shitloads of money by now. But the fundamental question is, is bitcoin money or even the future of money, as it is made out to be, by those who are in love with it, or is it simply another form of speculation.
One of the key characteristics of money is that it is a store of value. The recent rally in bitcoin has led to many bitcoin believers telling us that bitcoin is a store of value. This comes from a very shaky understanding of what the term store of value actually means.
A store of value basically means that something has a stable value over time. As Jacob Goldstein writes in Money: The True Story of a Made-Up Thing: “If $100 buys your family a week’s worth of groceries today, there is a very good chance it will buy approximately a week’s worth of groceries a year from now. The dollar is a good store of value (it tends to lose about 2 percent of its value every year).”
Let’s look at what has happened to bitcoin over the last few months. It rose from a little over $10,000 per bitcoin in early September 2020 to more than $40,000 per bitcoin in early January 2021.
As of January 8, 2021, the price of bitcoin touched an all-time high of $40,599. As I write this early in the morning on January 14, 2021, the price of a bitcoin is around $37,329. The price has fallen by 8% in a little over five days’ time. So, where is the stability of value? And this isn’t a one-off event. Bitcoin has moved rapidly up and down on many occasions.
But this is a very simple point. Here’s the more complicated point . The price of a bitcoin as of September 5, 2020, was $ 10,092. On January 8, 2021, it reached $40,599, a rise of 302% in a matter of a little over four months.
If bitcoin really was money, using which we could make and receive payments and borrow and lend, the recent rally would have created a havoc in the economy.
What does the rise in the value of any form of money really mean? It means that the price of everything that money can buy is falling. And in this case prices would have fallen big-time. As Goldstein puts it: “This rise in the value of bitcoin would have caused a deflation far worse than the one in the Great Depression.” Deflation is the scenario of falling prices and is deemed to be dangerous because people keep postponing their consumption in the hope of getting a lower price. This hurts businesses and the overall economy.
Now take a look at the following chart which plots the price of a bitcoin in dollars between December 2017 and December 2018.
The price of a bitcoin as on December 16, 2017, was $19,345. A year later on December 15, 2018, it had fallen by 83% to around $3,229. What would this have meant if bitcoin really was money? It would mean that the price of money has fallen and hence, the price of other things has gone up. In this case, it would mean very high inflation, even hyperinflation.
In its current form, bitcoin is no store of value. If it was to be used as money, the world would hyperventilate between deflation and inflation.
2)Another key characteristic of money is that it is a medium of exchange or to put it in simple English, it can be used to buy things (like Dalí bought meals at expensive restaurants).
According to financial services company Fundera 2,352 American businesses, accept bitcoins as a payment. The United States is the mecca of bitcoin believers. As per the US Census Bureau there were around 7.7 million companies in the US with at least one paid employee. This statistic doesn’t inspire much confidence. Barely anyone takes payments in bitcoins even in the United States.
Of course, it takes time for any new form of money to be adopted, but for something that has been around for 12 years, the rate of adoption seems quite poor.
Personally, I don’t know of any business that accepts bitcoin as a payment in India. Maybe, there is some coffee shop in Bengaluru that does. Dear reader, if you know of it, do let me know.
3)The bitcoin believers like to compare it with gold. The reason gold has acted as a hedge against the proclivity of the governments and central banks to create paper money out of thin air, is that it cannot be created out of thin air. While alchemists, which included Isaac Newton as well, have tried this over the centuries, no one has been successful in developing a chemical formula that converts other metals into gold. Bitcoin works because of a similar dynamic, the believers tell us. There is a limit to the number of bitcoins that can be created and as time passes by it becomes more and more difficult to mine bitcoins. That’s how the code behind bitcoin is written.
But the thing is that the code behind bitcoin is freely available. Anyone can take it and tweak it and come up with a new kind of money. Over the years this has happened and many of these new forms of money have ended up as shitcoins.
As Quinn and Turner write:
“In August 2016, one bitcoin was trading at $555; in the next 16 months its price rose by almost 3,400 per cent to a peak of $19,783.3 This was accompanied by a promotion boom, as a mix of cryptocurrency enthusiasts and opportunistic charlatans issued their own virtual currencies in the form of initial coin offerings, or ICOs. These coins had, on the face of it, no intrinsic value – to entitle their holders to future cash flows would have violated laws against issuing unregistered securities – but they nevertheless attracted $6.2 billion of money from investors in 2017 and a further $7.9 billion in 2018.”
A lot of this money never came back to the investors. There is no way to make sure that this won’t happen in the future.
Also, at a broader level, a free market in money is a bad idea. The United States went through this situation sometime in the nineteenth century (Something I discuss in detail in the first volume of Easy Money). It was very easy to get a banking license and banks could print their own money.
As Goldstein writes: “Not all banks were shady. Not even most banks were shady. But the notes printed by the shady banks looked as legit as the notes printed by the honest banks. And there were a lot of notes—at one point, the Chicago Tribune reported that the country had 8,370 different kinds of paper money in circulation.” Imagine the confusion this would have created.
It was also easy for counterfeiters to manufacture their own paper money. In this scenario, a guide called Leonori’s New York Bank Note List, Counterfeit Detector, and Wholesale Prices Current was published once a month. An issue of this guide, dated 18 November 1854, shows that 1,276 such banks were in operation in various states and 825 different kinds of forged notes were in circulation. The financial system was in a total anarchy.
While it is easy to make a case for a non-government decentralised money system, what may lie in store isn’t something we may want in the first place. The sad part is very little thinking has happened on this front. Saying, let the best money win is a very insensitive way to go about it.
4)The bitcoin code which limits their number to 21 million units is written in C++. As Sean Williams writes on Fool.com: “Last I checked, code can always be erased and rewritten. While it’s unlikely that a community consensus would be reached to increase the circulating supply of bitcoin, the possibility of this happening isn’t zero.” Anyway this possibility isn’t going to arise until 2140, when the last fraction of the bitcoin will be mined, and by then you and I, won’t be around. So, it doesn’t really matter.
5)Let’s talk a little more about paper money. Why do others accept it as money? Because they know that the government bank/central bank deems it to be money and hence, still others will accept it as money as well.
As L Randall Wray writes in Modern Money Theory – A Primer on Macroeconomics for Sovereign Monetary Systems: “The typical answer provided in textbooks is that you will accept your national currency because you know that others will accept it. In other words, it is accepted because it is accepted. The typical explanation thus relies on an ‘infinite regress’: John accepts it because he thinks Mary will accept it, and she accepts it because she thinks Walmart will take it.”
While this sounds correct there is a slightly more nuanced answer to the question.
There are three main powers that any government has: 1) The right to “legal” violence. 2) The right to tax. 3) The right to create money out of thin air by printing it.
As Wray writes:
“One of the most important powers claimed by sovereign government is the authority to levy and collect taxes (and other payments made to government, including fees and fines). Tax obligations are levied in the national money of account: Dollars in the United States, Canada, and Australia; Yen in Japan; Yuan in China; and Pesos in Mexico. Further, the sovereign government also determines what can be delivered to satisfy the tax obligation. In most developed nations, it is the government’s own currency that is accepted in payment of taxes.”
What does this mean?
As Wray puts it:
“Ultimately, it is because anyone with tax obligations can use currency to eliminate these liabilities that government currency is in demand, and thus can be used in purchases or in payment of private obligations. The government cannot easily force others to use its currency in private payments, or to hoard it in piggybanks, but government can force use of currency to meet the tax obligations that it imposes… It is the tax liability (or other obligatory payments) that stands behind the curtain.”
Hence, the government creates demand for paper/fiat money by accepting taxes in it. This has ensured that the paper money system has kept going despite its weaknesses.
What this also means is that for bitcoin to become popular and move beyond the nerds, it needs a use case as solid as paying taxes in what government deems to be money, is.
It is worth remembering here what Wray writes: “For the past 4,000 years (“at least”, as Keynes put it), our monetary system has been a “state money system”. To simplify, that is one in which the state chooses the money of account, imposes obligations (taxes, tribute, tithes, fines, and fees), denominated in that money unit, and issues a currency accepted in payment of those obligations.”
This is not to say that governments haven’t destroyed money systems in the past. The history of money is littered with examples of kings, queens, rulers, dictators, general secretaries and politicians, representing governments in different eras, having destroyed different money systems at different points of time. But the government has always comeback and controlled the money system the way it has wanted to.
And unless governments and central banks start taking a liking to bitcoin, there is no way its usage is going to spread to a level where it can hope to challenge the prevailing paper money system. It is worth remembering that if governments start taking interest in bitcoin, it in a way beats the entire purpose behind its creation.
Also, every government will want to protect its right to create money out of thin air. Right now bitcoin is too small in the overall scheme of things for governments to be bothered about it and hence, they have largely humoured it (not in India though).
The market capitalisation of bitcoins (number of coins multiplied by the dollar price) as of January 8, peaked at around $759 billion. The global GDP in 2019 was around $88 trillion. So the price of bitcoin even at its peak was lower than 1% of the global GDP.
Hence, the bitcoin story is like that of a rich Indian father basically allowing his son to play around, until he thinks that the son now needs to grow up.
6)There is another point that needs to be made here regarding the paper money system. This is something I realised while writing the third volume of Easy Money and it makes me sceptical of anyone who wants to write off the paper money system in a hurry. (Before you jump on me for being a blanket supporter of the paper money system, I am not, but then that doesn’t mean I don’t see logical arguments when they are offered).
Many years back, in one of my first freelancing assignments, I happened to interview the financial historian Russel Napier. He explained to me the link between paper money and democracy. As he told me on that occasion:
“The history of the paper currency system, or the fiat currency system is really the history of democracy … Within the metal currency, there was very limited ability for elected governments to manipulate that currency. And I know this is why people with savings and people with money like the gold standard. They like it because it reduces the ability of politicians to play around with the quantity of money. But we have to remember that most people don’t have savings. They don’t have capital. And that’s why we got the paper currency in the first place. It was to allow the democracies. Democracy will always turn towards paper currency and unless you see the destruction of democracy in the developed world, and I do not see that, we will stay with paper currencies and not return to metallic currencies or metallic-based currencies.”
Back then bitcoin wasn’t really on the radar. The reason people with savings liked gold back then, is why many of them like bitcoins now.
The twentieth century saw the rise of both paper money and democracy. Pure paper money started coming into being after the First World War. The reason for this is very straightforward. In a democracy whenever there is a crisis, the politicians and the technocrats advising them need to be seen to be doing something.
As an ex-RBI Governor once told me, do nothing cannot be a strategy. And this need to be seen to be doing something, can most easily be fulfilled by manipulating the paper money system that prevails in a democracy. It gives central bankers the option of printing money and driving down interest rates in the hope that people will borrow and spend more and businesses will borrow and expand.
Of course, this has its own problems (as I keep highlighting in my pieces over and over again). But then, the prevailing system does really allow politicians to show that they are trying. Any other system would take this option away from politicians. Hence, the paper money system is not going to be replaced in a hurry. No government is going to let go of this privilege.
7)This is a slightly technical point, but I think it needs to be made. As I have mentioned through this piece, over the years it has become more and more difficult to mine bitcoins. Now bitcoin farms with giant racks of mining computers, are needed to mine bitcoins. The days when bitcoins could be mined using the processing power of a PC are long gone.
The bitcoin farms, as they are known as, need a lot of electricity. Hence, mining operations have moved to countries where electricity is cheap. They have moved to countries like Iceland, Mongolia and primarily, China.
This has created another problem. As Goldstein writes: “By the beginning of 2020, Chinese miners had grown so large that they controlled most of the processing power on the bitcoin network. And the way the code for bitcoin was written gave them control over the system.”
While, bitcoin might be a decentralised democratic system running on code, but it’s people who ultimately control the mining of bitcoins and hence, can direct its future.
So, will the future of bitcoin be driven by China? And if that turns out to be the case, what does this do to its chances of spreading as actual money, used in the selling and buying of things? There are no easy answers to these questions.
8)One of the key points of bitcoins was that it was a non-government decentralised money system which promised freedom from the middlemen. But that hasn’t really happened. As Quinn and Turner write: “[Bitcoin] had promised freedom from middlemen, but trading it without a third party was cumbersome unless the user was expert in cybersecurity.”
If you are using a broker to trade bitcoin it beats the entire idea of freedom from middlemen. Also, the moment you convert your money into fiat money and the money comes into your bank account, the entire idea of remaining unknown and the government not knowing what you are doing goes for a toss. Hence, you may have your reasons to buy bitcoins, but basically you are speculating.
9)You might want to ask why you haven’t heard all this in the mainstream media. The reason for that lies in the fact that the incentives of the media are misaligned these days. Most investment related news is presented as a money-making opportunity. Hence, in this case the bitcoin believers have gotten more space and screen time in the media.
Many of the bitcoin believers are like the original investors in a Ponzi scheme. They have an incentive to talk up bitcoin, get more investors into it, drive up its price and make more money in the process. (In fact, these are precisely the kind of stock market investors that you get to see on TV and read in the media most of the time, but that is another topic for another day).
Also, given the extremely short attention spans that people have these days, the written word doesn’t find much of an audience. As Quinn and Turner put it: “More fundamentally, the move away from the written word to television financial news, docusoaps and social media may corrode the ability of investors to think clearly and understand the complexities of the financial system.”
You cannot understand economic history and the complexities of the financial system by watching TV or watching stuff over the internet or even listening to extremely detailed podcasts (podcasts can just give you a flavour of things and a feeling that you are actually learning a lot). The only way to understand complex issues is to read, read and read more.
In an era of short attention spans, bitcoins are just the right asset to speculate on. Their price goes up or falls even before you can say Virat Kohli. (This is another reason to support my writing).
10)We live in an era of easy money. Central banks have printed trillions of dollars during the course of 2020 to drive down interest rates in the hope of encouraging people to borrow and spend and businesses to borrow and expand. Interest rates are in negative territory in some of the European nations.
In this scenario of very low interest rates, investors are desperate to earn returns. Hence, a lot of money has been invested into stock markets all over the world, driving them to levels not justified by earnings that companies are expected to earn in the years to come.
Some money has also found its way into bitcoins. As The Economist puts it: “The current surge seems to have been spurred by interest from the financial establishment, most of which had long scorned it.” In simple English, hedge funds are buying bitcoins. Given that bitcoins are thinly traded, this has driven up prices by astonishing levels. Hence, like stock markets, bitcoin is also in bubble territory.
And as we have seen over the past few decades, hedge fund money can be quite mercurial. They can drive down prices faster than they drove them up.
To conclude, the fact that the price of bitcoin is so volatile tells us that most people investing in it aren’t really bothered about the long-term story of bitcoin as money, the bitcoin believers try selling all the time. If they did believe in this story they would have bought bitcoin and held on to it. But as the crash of 2018 showed that is clearly not the case.
“Buying a Bitcoin token today can be considered an investment in the fast growth of the network and currency as a store of value, because it is still very small and able to grow many multiples of its size and value very quickly. Should Bitcoin’s share of the global money supply and international settlement transactions become a majority share of the global market, the level of demand for it will become far more predictable and stable, leading to a stabilization in the value of the currency.”
(Ha ha, this is to show that I also read stuff I don’t really agree with).
I am not clairvoyant. This may happen. This may not happen. My reading of economic history tells me it won’t. But then I might turn out to be wrong. What do they say about history not repeating itself but rhyming? But what if it doesn’t rhyme as well?
There are no guarantees when it comes to economics. The trouble is that while you are waiting for all this to happen, the price of a bitcoin is at the level of a very very very very expensive large cap stock and its volatility is that of a small cap penny stock.
So, if you do invest in bitcoin, do understand that you are taking a punt, you are speculating, you are hoping that the price goes up and does not fall. Also, don’t go looking for fundamental reasons for investing in it.
Given that investing in bitcoin is equal to taking a punt, please don’t bet your life on it. As the old cliché goes, don’t put all your eggs in one basket.
PS: This doesn’t mean I don’t believe in digital money. I do. But I also believe that it will be controlled by large corporations and the governments.