The idea for this piece came after reading the latest edition of Dylan Grice’s fantastic newsletter Popular Delusions. It took my mind back to some stuff I had written about, a while back, in the second volume of the Easy Money trilogy. Now what do they say about the more things change the more they remain the same?
Anyway, Grice’s latest newsletter starts with a comment made by Jerome Powell, the current Chairman of the Federal Reserve of the United States, the American central bank.
As Powell said on CNBC:
“The big picture is still that we’ve seen … three decades, a quarter of a century, of lower and more stable inflation and we’ve seen really the last decade be characterized by global disinflationary forces and large advanced economy nations struggling to reach their 2% inflation goal from below.”
He further said:
“If the economy reopens, there’s quite a lot of savings on peoples’ balance sheets… you could see strong spending growth and there could be some upward pressure on prices. Again though, my expectation would be that that would be neither large nor sustained.”
How do we interpret the above statements in simple English?
1) What Powell is basically saying here is that all the money printing carried out by central banks across the world over the last decade, hasn’t really led to high inflation. In fact, the inflation has constantly been less than the 2% level targeted by the Western central banks (a disinflationary environment as Powell put it).
And he is right. Take a look at following graph which basically plots inflation in the United States, as measured by the core personal expenditures index excluding food and energy. This is the index followed by the Federal Reserve when it comes to inflation.
Since 2008, the year when the financial crisis broke out, the only year in which inflation in the US touched 2%, was 2018. Clearly, the trillions of dollars printed by the Fed since then haven’t led to a high inflation at the consumer level.
I clearly remember that when the Fed started printing money post the breakout of the financial crisis, many writers (including yours truly) said very high inflation was on its way as too much money would end up chasing the same amount of goods and services, and this would drive up prices. But nothing like that happened. (The good bit is that the newspaper I wrote all this in, has since shutdown. So, finding evidence of it won’t be easy :-))
2)Powell also said that while he expects some inflation as people go back to leading normal lives once again post covid, but that’s not something to worry about because it would neither be large nor sustained. Hence, Powell expects the inflation to rise and then settle down.
This leads to the question why inflation has continued to remain less than 2% all these years through much of the Western world, despite the massive amount of money printing that has been carried out.
In an essay written in 1969, the economist Milton Friedman came up with the concept of the helicopter drop of money. As he had written in the essay:
“Let us suppose now that one day a helicopter flies over this community and drops an additional $1,000 in bills from the sky, which is, of course, hastily collected by members of the community.”
The idea here was to distribute money to the public, so that they got out there and spend it, in the process creating inflation and economic growth.
The money printing carried out by the Federal Reserve and other central banks in the recent past and since 2008, was supposed to be a version of this helicopter drop. Of course, there was no helicopter going around dropping money directly to citizens, but central banks printed money and pumped that money into the financial system by buying bonds.
This was supposed to drive down interest rates. At lower interest rates people were supposed to borrow and spend, as they had before the financial crisis, and companies were supposed to borrow and expand.
The hope was that the increased spending would create some inflation and some economic growth along the way, like a helicopter drop is expected to.
The trouble with this argument is that it doesn’t take a basic factor into account, which is, when the money is being dropped from a helicopter, who is standing under it. The point being that people standing under the helicopter are likely to collect the money before others do and this changes the situation.
In fact, this possibility was first observed by Richard Cantillon an Irish-French economist, who lived in the seventeenth and the eighteenth century, before the era of Adam Smith as well as helicopters. Clearly, economists of the modern world, have forgotten him, which is hardly surprising given that economists these days rarely read any history.
When central banks print money, they do so with the belief that money is neutral. So, in that sense, it does not really matter who is standing under the helicopter when the money is printed and dropped into the economy, but Cantillon showed that money wasn’t really neutral and that it mattered where it was injected into the economy.
Cantillon made this observation based on all the gold and silver coming into Spain from what was then called the New World (now South America). When money supply increased in the form of gold and silver, it would first benefit the people associated with the mining industry, that is, the owners of the mines, the adventurers who went looking for gold and silver, the smelters, the refiners, and the workers at the gold and silver mines.
These individuals would end up with a greater amount of gold and silver, that is, money. They would spend this money and thus drive up the prices of meat, wine, wool, wheat, etc. Of course, everyone in the economy had to pay these higher prices. ((I came to know of this effect from Dylan Grice, after having interviewed him many years back and then starting to read his newsletter regularly).
The Cantillon effect has played out since 2008. When central banks printed and pumped money into the financial system, the large institutional investors, were the ones standing under the helicopter.
They borrowed money at cheap rates and invested across large parts across the world, fuelling stock market and bond market rallies primarily, and a few real estate ones as well.
“The Fed creates new money (not more wealth … just new money). This new money goes into the banking system, pretending to have the same value as the money that people worked for. And people with good connections to the banks take advantage of the cheap credit this new money creates to aid financial speculation.”
After the large institutional investors came the corporates, who were expected to borrow money and expand, and create jobs and economic growth in the process. What they did instead was borrow money to buyback their shares.
When companies announce a decision to buyback their shares, it pushes up the possibility of their earning per share going up and this leads to higher stock prices, benefitting the top management of the company who owns company stock. Of course, the company ends up with lesser equity and more debt in the process. But that is a problem for a later date, by which time the top management would have moved on.
So, instead of consumer price inflation, what the world got was asset price inflation, with the values of financial assets, totally out of whack from the underlying fundamentals.
This dynamic has played out again since the beginning of 2020, in the post-covid world. Once the covid pandemic broke out, central banks decided to print and pump money into the financial system, like they had after the financial crisis. The US Federal Reserve has printed more than three trillion dollars and the Bank of Japan has printed more than 100 trillion yen, in the last one year.
And guess who was standing beneath the helicopter this time around? …
But along with this something else happened. The governments of the Western world also decided to send cheques directly to people, so that they could spend money directly and help boost economic activity. .
The trouble was with the pandemic on, people were stuck at homes. Hence, the money got saved and invested. Along with the institutional money, retail money also flowed into financial markets all across the world.
This has sent prices of financial assets soaring. As of March 2, the total market capitalization of the US stock market stood at 191.5% of its gross domestic product. The long term average of this ratio is 85.55%.
As Grice puts it in his latest newsletter:
“As the stock market makes new all-time highs… The IPO market is hot, credit markets are hot, commodity markets are hot, the crypto markets are hot. Everything, it seems is hot.”
Of course, other than the inflation as the Fed likes to measure it, which continues to be under 2%. And given that, all is well.
In every era when the prices of financial assets go up substantially, people forget history. This is not the first time that the Fed and other central banks are ignoring financial inflation and looking only at consumer price inflation.
Something similar happened both before the dotcom and telecom bubble, which burst in 2000 and 2001, and the sub prime and real estate bubble, which burst in 2007 and 2008. The Fed kept ignoring the bubbles while waiting for the inflation to cross 2%. This time is no different. (For details you can refer to the third volume of the Easy Money trilogy).
Inflation targeting as a policy, worked when inflation was high and central banks wanted to bring it down. This happened right through the 1980s and the first half of the 1990s.
Since the mid-1990s, inflation has been low in much of the Western world thanks to Chinese imports and outsourcing. As Niall Ferguson writes in The Ascent of Money – A Financial History of the World: “Chinese imports kept down US inflation. Chinese savings kept down US interest rates. Chinese labour kept down US wage costs.”
This has led to inflation targeting being used in reverse. Instead of trying to control inflation, Western central banks have been trying to create it, using the same set of tools.
As Gary Dugan, who was the CIO, Asia and Middle East, RBS Wealth Division, told me in a 2013 interview:
“We got inflation which was too low. So, we have changed it all around to actually try to create inflation, rather than to dampen it. I don’t think they know what tools they should be using. The central banks are using the same tools they used to dampen inflation, in a reverse way, in order to create it. And that is clearly not working.”
What was true for 2013 is also true for 2021. The playbook of central banks continues to remain the same. As I wrote in a recent piece for the Mint, the whole situation reminds me of the Hotel California song, where The Eagles sang, you can check out any time you want but you can never leave.
The trouble is that along with the money printing there is something else at play this time around. A large part of the global population has been stuck at their homes for more than a year. As they get vaccinated and start living normal lives again, a huge amount of pent-up demand is going to hit the market .
This might lead to inflation as the bond market investors have been fearing for a while, given that supply is not expected to keep up with demand. A higher inflation will mean higher interest rates, something which is not good for the stock market as a whole.
But there is another important factor that needs to be kept in mind. People will be spending their savings . And this means that they will be cashing in on their investments, be it stocks, bitcoin or whatever.
The greater the pent-up demand that hits the market, the higher will be the savings that will be cashed out on and more will be the pressure on the financial markets.
This is an important dynamic that investors need to keep in mind this year.
It wasn’t possible to even speed-read the whole Survey quickly, hence, I missed out on a few points, and am writing about them here. This piece is a follow up and I strongly recommend that you read the first piece before reading this one.
Let’s look at some important points made in the Survey.
1)The spread of corona has led to a massive economic contraction this year. While the growth is expected to bounce back over the next few years, the impact of this year’s contraction isn’t going to go away in a hurry.
As per the Survey, if India grows by 12% in 2021-22 and 6.5% and 7%, in 2022-23 and 2023-24, respectively, the Indian economy will be at around 91.5% of where it would have possibly been if there would have been no covid and no economic contraction, and India would have continued to grow at 6.7% per year on an average, as it has in the five years before 2020-21.
At 10% growth in 2021-22, and 6.5% and 7% growth in 2022-23 and 2023-24, respectively, the Indian economy will be at around 90% of where it could have possibly been, the Survey points out.
This is an important point that we need to understand. While, 2021-22 might see a double digit growth, covid has put us back by more than half a decade, if we look at trend growth.
2) The Economic Survey recommends money printing to finance higher government expenditure. Call me old school, but I always feel uncomfortable when economists recommend outright money printing to fund government expenditure. Of course, there is always a theoretical argument on offer.
The Survey refers to a speech made by Patrick Bolton, a professor of business at Columbia University in New York, to make the money printing argument and why money printing, where an excess amount of money chases a similar amount of goods and services, doesn’t always lead to inflation.
As the Survey points out:
“Printing more money can result in inflation and loss of purchasing power for domestic residents if the increase in money supply is larger than the increase in output….Printing more money does not necessarily lead to inflation and a debasement of the currency. In fact, if the increased money supply creates a disproportionate increase in output because the money is invested to finance investment projects with positive net present value.”
What does this mean in simple English? The Survey is essentially saying that if the printed money is well utilised and put into projects which are beneficial for the society, it benefits everyone, and doesn’t lead to inflation.
The trouble is a lot of things sound good in theory. One of the major things that the bad loans crisis of Indian banks teaches us is that the Indian system cannot take a sudden increase in investments. There is only so much that it can handle and that’s primarily because there is too much red tapism and bureaucracy involved in getting any investment project going. We are still dealing with the fallout of this a decade later.
Also, how do the government and bureaucrats ensure that the amount of money being printed is just enough and will not lead to inflation. (Central planning keeps coming back in different forms).
The government can print money and spend it. This can ensure one round of spending and the money will land up in the hands of people. Also, as men spend money, this money will land up with shopkeepers and businesses all over the country. The shopkeepers may hold back some of the cash that they earn depending on their needs.
The chances are that most of this money will be deposited back into bank accounts. In the normal scheme of things, the banks would lend this money out. In difficult times, banks are reluctant to lend. Hence, they end up depositing this money with the RBI. The RBI pays interest on this money. As of yesterday, banks had deposited Rs 5.6 lakh crore with the RBI. This is money they have no use for, or to put it in technical terms, this is the excess liquidity in the system.
Money printing will only add to this excess liquidity. Ultimately, for the economy to do well, people and corporates need to be in a state of mind to borrow and banks in the mood to lend. Printing money cannot ensure that.
Over and above this, money printing can and has led to massive financial and real estate bubbles, in the past few decades. This is asset price inflation. While this inflation doesn’t reflect in the normal everyday consumer price inflation, it is a form of inflation at the end of the day. And whenever such bubbles burst, which they eventually do, it creates its own set of problems.
Given these reasons, the chief economic advisor Krishnamurthy Subramanian’s recommendation of money printing by the government is a lazy idea which hasn’t been thought through. (For a detailed argument against money printing, please read this).
3)During the course of this financial year, banks have gone easy on borrowers who haven’t been in a position to repay.
Technically, this is referred to as regulatory forbearance. In this case, the central bank, comes up with rules and regulations which basically allows banks to treat borrowers in trouble with kids gloves. One of the learnings from the bad loans crisis of banks has been that regulatory forbearance of the Reserve Bank of India, India’s central bank, went on for too long.
The banks are yet to face the negative impact of the covid led contraction primarily because of regulatory forbearance. The banking system should be facing the first blows of the economic contraction. But that hasn’t happened, thanks to the Supreme Court and regulatory forbearance. The Supreme Court, in an interim order dated September 3, 2020, had directed the banks that loan accounts which hadn’t been declared as a bad loan as of August 31, shall not be declared as one, until further orders. Hence, the balance sheets of banks as revealed by their latest quarterly results, seem to be too good to be true.
The Survey suggests that an asset quality review of the balance sheets of banks may be in order. As it points out: “A clean-up of bank balance sheets is necessary when the forbearance is discontinued… An asset quality review exercise must be conducted immediately after the forbearance is withdrawn.”
This is one of the few good suggestions in the Survey this year and needs to be acted on quickly, so as to reveal the correct state of balance sheets of banks. The Survey further points out: “The asset quality review must account for all the creative ways in which banks can evergreen their loans.” Evergreening involves giving a new loan to the borrower so that he can pay the interest on the original loan or even repay it. And then everyone can just pretend that all is well.
In fact, even while making a suggestion for an asset quality review, the Survey takes potshots at Raghuram Rajan and the asset quality review he had initiated as the RBI governor in mid 2015.
4) Another point made in the Survey is to ignore the credit ratings agencies and their Indian ratings. As the Survey points out: “The Survey questioned whether India’s sovereign credit ratings reflect its fundamentals, and found evidence of a systemic under-assessment of India’s fundamentals as reflected in its low ratings over a period of at least two decades.”
This leads the Survey to conclude: “India’s fiscal policy must, therefore, not remain beholden to such a noisy/biased measure of India’s fundamentals and should instead reflect Gurudev Rabindranath Thakur’s sentiment of a mind without fear.”
While invoking Tagore, the Survey basically recommends that India’s government borrows more money to spend, taking into account “considerations of growth and development rather than be restrained by biased and subjective sovereign credit ratings”. (On a slightly different note, who would have thought that one day an economist would invoke Rabindranath Thakur’s name to market higher government borrowing).
Whether, the ratings agencies correctly rate India based on its fundamentals is one issue, whereas, whether it makes sense for India to ignore these ratings and borrow more, is another.
As the Survey points out: “While sovereign credit ratings do not reflect the Indian economy’s fundamentals, noisy, opaque and biased credit ratings damage FPI flows.” (FPI = foreign portfolio inflows).
What this means is that any further cut in credit rating can impact the amount of money being brought in by the foreign investors into India’s stock and bond market. In particular, it can impact the long-term money being brought in by pension funds.
While, the Survey doesn’t say so, it can possibly impact even foreign direct investment.
So, the point is, why take unnecessary panga, for the lack of a better word, with the rating agencies, at a point where the economy is anyway going through a tough time.
In another part, the Survey points out: “Debt levels have reached historic highs, making the global economy particularly vulnerable to financial market stress.”
5) Given that, tax revenues have collapsed, government borrowing money to finance expenditure has gone up dramatically during the course of this year. As the Survey points out:
“As on January 8, 2021, the central government gross market borrowing for FY2020-21 reached Rs 10.72 lakh crore, while State Governments have raised Rs 5.71 lakh crore. While Centre’s borrowings are 65 per cent higher than the amount raised in the corresponding period of the previous year, state governments have seen a step up of 41 per cent. Since the COVID-19 outbreak depressed growth and revenues, a significant scale up of borrowings amply demonstrates the government’s commitment to provide sustained fiscal stimulus [emphasis added] by maintaining high public expenditure levels in the economy.”
Fiscal stimulus is when the government spends more money in order to pump up the economy in a scenario where individuals and corporates are going slow on spending. The total government spending during April to November 2020 stood at Rs 19.1 lakh crore. It has risen by just 4.9% in comparison to April to November 2019. Given that inflation has stood at more than 6% this year, this can hardly be called a fiscal stimulus.
To conclude, economic surveys in the past, other than offering a detailed assessment on the current state of the Indian economy, also used to do some solid thinking about the future or stuff that needs to be done on the economic front.
Over the past few years, a detailed reading of these Surveys suggests that they have become yet another policy document which feeds into government’s massive propaganda machinery, albeit in a slightly sophisticated way.
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.
Mere paas kothi hai na car sajni, Kadka hai tera dildar sajni. — Rajkavi Inderjeet Singh Tulsi, Ravindra Jain, Kishore Kumar, Asha Bhonsle and Ashok Roy, in Chor Machaye Shor.
Okay, I didn’t have to wait for the Reserve Bank of India’s monetary policy declared today, to write this piece. I could have written this piece yesterday or even a month back. But then the news cycle ultimately determines the number of people who end up reading what I write, and one can’t possibly ignore that.
A few hours back, the Monetary Policy Statement was published by the RBI, after the monetary policy committee (MPC) met on 2nd, 3rd and 4th December. The MPC of the Reserve Bank of India (RBI) has the responsibility to set the repo rate, among other things. The repo rate is the interest rate at which the RBI lends to banks, and which to some extent determines the interest rates set by commercial banks for the economy as a whole.
The MPC has been driving down the repo rate since January 2019, when the rate was at 6.5%. The rate had been cut to 5.15% by February 2020, around the time the covid pandemic struck.
By May 2020, the MPC had cut the repo rate further by 115 basis points to an all-time low of 4%. One basis point is one hundredth of a percentage. The idea behind the cut was two-fold.
In the aftermath of the covid pandemic as the economic activity crashed, the tax collections of the government crashed as well, leading to a situation where the government’s borrowing requirement jumped from Rs 7.8 lakh crore to Rs 12 lakh crore.
The massive repo rate cut would help the government to borrow more at lower interest rates. The yield or the return on a ten-year government of India bond in early February was at 6.64%. Since then it has fallen to around 5.89% as of December 4. The government of India borrows by selling bonds. The money that it raises helps finance its fiscal deficit or the difference between what it earns and what it spends.
The second idea was to encourage people to borrow and spend more and businesses to borrow and expand, at lower interest rates. Take a look at the following chart. It plots the average interest at which banks have given out fresh loans over the years.
Source: Reserve Bank of India.
The data on average interest at which banks have given out fresh loans is available for a period of a little over six years, starting from September 2014 and up to October 2020. It can be seen from the above chart that the interest rates in the recent months, have been the lowest in many years. But has that led to an increase in lending by banks, that’s the question that needs to be answered?
As of October 2020, the total outstanding non-food credit of banks by economic activity, had gone up by 5.6% in comparison to October 2019. Banks give loans to the Food Corporation of India and other state procurement agencies to buy rice, wheat and a few other agricultural products directly from farmers. Once we subtract these loans out from the overall loans given by banks that leaves us with non-food credit by economic activity.
Also, it needs to be mentioned here that this is how banking data is conventionally reported, in terms of the total outstanding loans of banks.
When you compare this with how other economic data is reported, it’s different. Let’s take the example of passenger cars.
When passenger car sales are reported, what is reported is the number of cars sold during a particular month and not the total number of cars running in India at that point of time. In case of banks, precisely the opposite thing happens.
What is conventionally reported is the total outstanding loans at any point of time and not the loans given incrementally during a particular period. So, the total outstanding non-food credit of Indian banks by economic activity, as of October end 2020 stood at Rs 92.13 lakh crore. This increased by 5.6% over October 2019.
The way this data is reported does not tell us the gravity of the situation that the banks are in. That comes out when we look at just incremental loans from one year back. The way to calculate this is to take total outstanding loans as of October 2020 and subtract that from outstanding loans of banks as of October 2019. The difference is incremental loans for October 2020. Similarly, the calculation can be done for other months as well.
Let’s take a look incremental loans data over the last three years.
As can be seen the above chart, the incremental loans every month in comparison to the same month last year, have been falling since late 2018, just a little before the RBI started cutting the repo rate. In October 2020, they stood at Rs 4.83 lakh crore, a three-year low.
What does this mean? It means that as the MPC of the RBI has gone about cutting the repo rate, the incremental loans given by banks have gone down as well. This is the exact opposite of what economists and central banks expect, that as interest rates fall, borrowing should go up.
And this has been happening from a time before the covid-pandemic struck. Covid has only accentuated this phenomenon. This also leads to the point I make often that for people to borrow more, just lower interest rates are not enough.
The main point that encourages people and businesses to borrow more is the confidence in their economic future. While the government will try and blame India’s currently economic problems totally on covid, it is worth mentioning here that India’s economic growth has seen a downward trend since March 2018. The economic growth for the period January to March 2018 had stood at 8.2% and has been falling since, leading to a lesser confidence in the economic future, both among individuals and corporates.
In fact, if we compare the situation between March 27, 2020, when covid first started spreading across India, and November 6, 2020, the total outstanding non-food credit of banks has grown by just Rs 2,221 crore (yes, you read that right, and this is not a calculation error).
During the same period, the total deposits of banks have grown by Rs 8.13 lakh crore or 6%. The incremental credit deposit ratio between March 27 and November 6, is just 0.27%. We can actually assume it be zero, given that it is so close to zero. Al these deposits have primarily been invested in government bonds.
Basically, on the whole, the banks have been unable to lend any of the deposits they have got from the beginning of this financial year. Only one part of banking is in operation. Banks are borrowing, they are not lending.
What does this tell us? It tells us that banking activity in the country has collapsed post covid, despite the RBI cutting the repo rate to an all-time low-level of 4%, where it’s 361 basis points lower than the latest rate of retail inflation of 7.61%. Other than cutting the repo rate, the RBI has also printed a lot of money and pumped it into the financial system, to drive down interest rates.
But despite that people and businesses are not borrowing. RBI’s monetary policy has been an even bigger flop than Anurag Kashyap’s Bombay Velvet, Raj Kapoor’s Mera Naam Joker and Satish Kaushik’s Roop ki Rani Choron ka Raja. (I name three different films so that readers of different generations all get the point I am trying to make here).
“In response to the COVID-19 pandemic, the Reserve Bank has focused on resolution of stress among borrowers, and facilitating credit flow to the economy, while ensuring financial stability.”
No explanations have been offered on why the monetary policy has flopped. The current dispensation at India’s central bank is getting used to behaving like the current government.
It is important to understand here why monetary policy has been such a colossal flop this year. The answer lies in what the British economist John Maynard Keynes called the paradox of thrift. When a single individual saves more, it makes sense, as he prepares himself to face an emergency where he might need that money.
But when the society as a whole saves more, as it currently is, that causes a lot of damage because one’s man spending is another man’s income. As we have seen bank deposits during this financial year have gone up Rs 8.13 lakh crore or 6%. On the whole, people are cutting down on their spending and saving more for a rainy day.
The psychology of a recession at play and not just among those people who have been fired from their jobs or seen a fall in their income. It is obvious that such people are cutting down on their spending. But even those who haven’t faced any economic trouble are doing so.
They are doing so in the fear of seeing a fall in their income or losing their job and not being able to find a new one. When the individuals are cutting down on their spending, it doesn’t make much sense for businesses to borrow and expand. In fact, the overall bank lending to the industry sector has contracted by Rs 4,624 crore between October 2019 and October 2020.
Typically, in a situation like this, when the private sector is not in a position to spend, the government of the day steps in. The trouble is that the current government is not in a position to do so as tax revenues have collapsed this year. There other fears at play here as well.
In the midst of all this, Dinesh Khara, the chairman of the State Bank of India told the Business Standard, that bank lending rates “have actually bottomed”. Given that banks have barely lent anything this year, it makes me sincerely wonder what Mr Khara has been smoking. Clearly, it makes sense to avoid that.
To conclude, monetary policy should not get the kind of attention it gets in the business media, simply because, it is dead, and it has been dying for a while. The trouble is, there are one too many banking correspondents and even more central bank watchers, including me, who need to make a living.
And very few among us, are likely to ask the most basic question—why monetary policy is not working.
Le jayenge le jayenge dilwale dulhaniya le jayenge — Rajkavi Inderjeet Singh Tulsi, Ravindra Jain, Kishore Kumar, Asha Bhonsle and Ashok Roy, in Chor Machaye Shor.
It’s 2019, and you are out watching an international cricket match.
You didn’t book tickets quickly enough and are sitting in one of the upper stands, pretty far away from where the action is.
Instead of sitting and watching the match, you stand up to get a better view. Of course, by doing this, you end up blocking the person behind you. He also has to get up to get a better view of the cricket.
When he does this, he ends up blocking the view of the person behind him. And so, it goes. Pretty soon, everyone in the rows behind you has also stood up to get a better view.
Economists have a term for a situation like this. They call it the fallacy of composition or the assumption that what’s good for a part (that’s you in this case) is good for the whole (the people sitting behind you) as well.
So, why are we talking about cricket and sports here? What’s true about watching sports in a stadium is also true for the economy as a whole.
John Maynard Keynes, the most famous and influential economist of the twentieth century (and perhaps even the twenty first), came up with a concept called the paradox of thrift, where thrift refers to the entire idea of using money carefully.
Keynes studied the Great Depression of 1929. He concluded that during tough economic times, when the going is difficult, people become careful with spending money and try and save more of it. While this makes perfect sense at the individual level, it doesn’t make much sense at the societal level because ultimately one man’s spending is another man’s income.
If a substantial portion of the society starts saving, the paradox of thrift strikes, incomes fall, jobs are lost, businesses shutdown and the governments face a pressure on the tax front. The government also faces the pressure to do something about the prevailing economic situation.
This is precisely the situation playing out in India currently. The paradox of thrift is at work. Bank deposits between March 27 and September 25, the latest data that is available, have gone up by 5.1% or Rs 6.9 lakh crore to Rs 142.6 lakh crore. This is twice more than the increase that happened during the same period last year.
As far as loans are concerned, outstanding loans of banks have shrunk during this financial year. On the whole they haven’t given a single rupee of a new loan (loans are again meant to be spent).
Keynes had suggested that during tough economic times, when the private sector, both individuals and corporations are not spending much money, the government needs to step in and act as the spender of the last resort. In fact, Keynes rhetorically even suggested that if nothing, the government should get workers to dig holes and fill them up, and pay them for it.
When the workers spend this money, it would start reviving the economy. Economists refer to the situation of the government spending money in order to get economic growth going again as a fiscal expansion or a fiscal stimulus.
Since the start of this financial year, everyone who is remotely connected to economics in India in anyway, be it journalists, economists, analysts, corporates, fund managers and even politicians, have been demanding a bigger fiscal stimulus from the government to get economic growth going again.
The government has responded in fits and starts. Last week the central government came up with a few more steps including the LTC cash voucher scheme, special festival advance scheme, loans to states for capital expenditure and an additional capital expenditure of Rs 25,000 crore.
The fact that one week later one’s not hearing much about these moves, tells us they have already fizzled out. They didn’t have much legs to stand on in the first place. Let’s look at these moves pointwise before we get into greater fiscal stimulus as a strategy, in detail.
1) The government announced last week that in lieu of leave travel concession (LTC) and leave encashment, the central government employees can opt for a cash payment. This money has to be used to take make purchases.
LTC is a part of the salaries of central government employees. Instead of traveling in these difficult times in order to avail the LTC, the employees can opt for a cash payment. But this cash payment comes with certain terms and conditions.
Employees who opt for an encashment need to buy goods/services which are worth thrice the fare and one time the leave encashment. Only the actual fare of travelling can be claimed as a tax exemption. Tax has to be paid on the money spent on other expenses during travelling, like hotel and restaurant bills.
This money will have to be spent on buying stuff which attract a minimum 12% goods and services tax (GST), by paying through the digital route to a GST-registered vendor. It is expected that the scheme will cost the government Rs 5,675 crore. Over and above this, it will cost the public sector banks and public sector units another Rs 1,900 crore. This works out to a total of Rs 7,575 crore.
The question is will people opt for this scheme or not, given that they need to spend money out of their own pocket (i.e. their savings) in order to get a tax deduction. It needs to be mentioned here that the increase in dearness allowance of central government employees has been postponed until July 1, 2021. This will act against the idea of spending. Also, there is paperwork involved here (always a bad idea if you want people to spend money).
2) Over and above this, all central government employees can get an interest-free advance of Rs 10,000, in the form of a prepaid RuPay Card, to be spent by March 31, 2021. This is expected to cost the central government Rs 4,000 crore. It’s not clear from the reading of the press release accompanying this announcement, whether it’s compulsory for central government employees to take this card, given that this money will have to ultimately be repaid.
Also, this is not fiscal expansion in the strictest sense of the term given that LTC is already a part of the employee pay and has been budgeted for. As far as the Rs 10,000 being given as an advance is concerned, it is an interest free advance. The government will bear the interest cost on this, which will be an extremely small amount. The employees will have to repay the advance.
3)The central government is also ready to give state governments Rs 12,000 crore for capital expenditure. These loans will be interest free and need to be repaid over a period of 50 years. This money needs to be spent by March 31, 2021. A state government will be given an amount of 50% of what it is eligible for first. The second half will be given after the first half has been spent.
One can’t really question the logic behind this move. But the question that arises here is, are state governments in a position to spend this money in the next five and a half months?
4)Finally, the government has decided to spend an additional Rs 25,000 crore (over and above Rs 4.12 lakh crore allocated in the budget) on roads, defence, water supply, urban development and domestically produced capital equipment. Again, one can’t question the basic idea but one does need to ask here whether this is yet another attempt to manage the narrative.
The total capital expenditure that the government has budgeted for this financial year is Rs 4,12,009 crore. In the first five months of the financial year (April to August 2020), the government has managed to spend Rs 1,34,447 crore or around a third of what it has budgeted for. Last year, in the first five months, the government had spent around 40.6% of what it had budgeted for.
In this scenario, it is more than likely that the government will not get around to spending the extra Rs 25,000 crore. The government systems can only do a certain amount of work in a given period of time, their scale cannot be suddenly increased.
If one doesn’t nit-pick with the four above points, it needs to be said that the amounts involved are too small to even make a dent into the economic contraction expected this year. The economy is expected to contract by 10% this financial year. This means destruction of Rs 20 lakh crore of economic value, given that the nominal GDP in 2019-20, not adjusted for inflation, was Rs 203.4 lakh crore.
The government expects the moves announced last week to boost the expenditure in the economy by Rs 1 lakh crore. The mathematics of this Rs 1 lakh crore is similar to the mathematics of the Rs 20 lakh crore stimulus package (which actually added up to Rs 20.97 lakh crore) earlier in the year. As we saw earlier, the chances that the government ending up spending the Rs 4.12 lakh crore originally allocated for capital expenditure is difficult. Hence, how will it end up spending the newly allocated Rs 25,000 crore?
The government also expects the private sector spending to avail of the LTC tax benefit to be at least Rs 28,000 crore. What no one has talked about here is the fact that while there is an income tax benefit available, one also needs to pay a GST. Net net, there isn’t much benefit left after this. For someone in the marginal bracket of 20% income tax, after paying a GST of 18% to make these purchases, there isn’t much of a saving. Also, to spend three times the amount to avail of tax benefits, isn’t the smartest personal finance idea going around.
******** In the recently released OTT series Scam 1992 – The Harshad Mehta Story, there is a scene in the second episode, in which a newsreader is seen saying that this year’s budget has a deficit of Rs 3,650 crore for which no arrangements have been made (or as the newsreader in the series said, jiske liye koi vyawastha nahi ki gayi hai).
Given that the makers of the series have stuck to details of that era as closely as possible, I was left wondering if the Rs 3,650 crore number was correct or made up. I went looking for the budget speech of 1986-87 made by the then finance minister Vishwanath Pratap Singh, and found it.
This is what Singh said on page 32 (and point 168) of the speech: “The proposed tax measures, taken together with reliefs, are estimated to yield net additional revenue of Rs 445 crores to the Centre. This will leave an uncovered deficit of Rs 3650 crores. In relation to the size of our economy and the stock of money, the deficit is reasonable and non-inflationary [emphasis added].”
The number used in the series is absolutely correct. Hence, the makers of the Scam 1992, have gone into this level of detailing.
Dear Reader, you must be wondering by now, why have I suddenly started talking about the budget speech of 1986-87. This random point in the OTT series made me realise something. At that point of time, the government could get the Reserve Bank of India to monetise away the fiscal deficit or the difference between what it earned and what it spent.
This meant that the RBI could simply print money and hand it over to the government to spend it. Of course, money printing could lead to a higher amount of money chasing a similar number of goods and services, and hence, higher inflation. This explains why Singh in his budget speech emphasises that the uncovered deficit of Rs 3,650 crore will be non-inflationary. Not that he knew this with any certainty, but there are somethings that need to be said as a politician and this was one of those things.
As a result of two agreements signed between the RBI and the government (in 1994 and 1997) and the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, the automatic monetisation of government deficit was stopped.
The government funds its deficit by selling bonds to raise debt. The FRBM Act prevented the RBI from subscribing to primary issuances of government bonds from April 1, 2006. In simple terms, this meant that it couldn’t print money and hand it over directly to the government by buying government bonds.
Now why I have gone into great detail in explaining this will soon become clear.
As I wrote at the beginning of this piece, many journalists, economists, analysts, corporates, fund managers and even politicians, have been demanding a greater fiscal stimulus from the government. In short, they have been wanting the government to spend more money than it currently does.
The question is why is the government not going in for a bigger stimulus? The answer lies in the fact it simply doesn’t have the money to do so. The gross tax revenue of the government has fallen by 23.9% this year. Hence, it doesn’t even have enough money to finance the expenditure it has budgeted for. So, where is the question of spending more?
Of course, people who have been recommending a larger fiscal stimulus understand this. They simply want the RBI to print money and finance the government expenditure. Well, the RBI has been indirectly doing so. Take a look at the following table.
RBI –The Rupee Machine.
Source: Monetary Policy Report, October 2020.
What does the table tell us? It tells us that between early February and end September, the RBI has pumped in Rs 11.1 lakh crore into the financial system. How has it done so? Simply, by printing money in most cases. This does not apply to the cash reserve ratio cut, which meant banks having to maintain a lower amount of money with the RBI and hence, leading to an increase in the money available in the financial system to be lent out.
Here is the thing. The RBI prints money and buys bonds to introduce money into the financial system. Of course, it does not buy these bonds directly from the government. Nevertheless, even this indirect buying ends up financing the government fiscal deficit.
How? Let’s say the government sells bonds to finance its fiscal deficit. The financial institutions (banks, insurance companies, provident funds, mutual funds etc.) buy these bonds directly from the government (actually through primary dealers, but let’s keep this simple because the concept is more important here).
When they do this, they have handed over money to the government and have that much lesser money to lend. By printing money and pumping it into the financial system, the RBI ensures that the money that banks have available for lending doesn’t really go down or doesn’t go down as much, because of lending to the government.
Hence, in that sense, the RBI is actually indirectly financing the government. (It’s just buying older bonds and not newer ones).
The point being that despite the 1994 and 1997 agreements and the FRBM Act of 2003, the RBI is already financing the government fiscal deficit, albeit in an indirect way.
Of course, this financing is only enough to meet the current budgeted expenditure of the government. The thing is that the journalists, economists, analysts, corporates, fund managers and even politicians, want the government to spend more.
In fact, people in favour of a larger fiscal stimulus are okay with the RBI financing the government directly instead of this roundabout way. It seems that might be possible as well. As Viral Acharya, a former deputy governor of the RBI, writes in Quest for Restoring Financial Stability in India, published in July earlier this year:
“A recent amendment of the RBI Act allows the central bank to re-enter the primary market for government debt under certain conditions, annulling the reform of 2003 and recreating investor expectations of deficit monetization.”
Hence, the RBI can directly finance the government fiscal stimulus by printing money, buying government bonds and giving the government the money required to spend.
The question is why has the government not gone down this route? The fear of an even higher inflation seems to be the answer. If there is one thing in economics that the current government is bothered about, it is inflation, in particular food inflation. The food inflation in September 2020 stood at 10.7%. During this financial year, it has been at a very high level of 9.8%.
The money supply in the economy (as measured by M3) has gone up at a pace greater than 12% since June, thanks to the RBI printing and pumping money into the financial system. For fiscal expansion more money will have to be printed and pumped into the financial system, hence, there is the risk of inflation rising even further.
A few experts have said that in a situation like this growth is more important than inflation. Some others have said that inflation is not a real danger currently.
A government focussed on narrative and perception 24 x 7 would not want to take the risk of inflation at any point of time, especially when food inflation is already close to 11% and there is grave danger of it seeping into overall retail inflation (as measured by the consumer price index).
There are other risks to printing money directly and the country’s public debt going up. Foreign investors can leave India. The rating agencies can cut the ratings. (You can read about it here). This stems from the fact that investors are not as comfortable holding investment assets in a currency like the Indian rupee vis a vis a currency like the American dollar or the British pound or the currency of any other developed country.
As L Randall Wray writes in Modern Monetary Theory: “There is little doubt that US dollar-denominated assets are highly desirable around the globe… To a lesser degree, the financial assets denominated in UK pounds, Japanese yen, European euros, and Canadian and Australian dollars are also highly desired.” This allows these countries to print money in a way that India cannot even dream of.
Also, if the government wanted to go the fiscal stimulus route, it should have done so at the very beginning. But instead it chose monetary expansion, with the RBI printing money and pumping it into the financial system, cutting the repo rate or the interest rate at which it lends to banks and getting banks to lend to certain sectors.
All this, in particular money printing by the RBI to drive down interest rates, has already led to the money supply going up. A larger fiscal stimulus will lead to the money supply going up even further increasing the possibility of a higher inflation.
****** There is a new theory going around especially among the stock market wallahs who think they understand economics.
The foreign currency reserves with the RBI have gone up from $440 billion towards the end of March to around $509 billion as of October 9. What if a part of this can be converted into rupees and the money can be handed over to the government to spend, is the crux of the new theory going around.
Only someone who does not understand how these foreign currency reserves ended up with the RBI in the first place, would suggest something like this. The RBI buys foreign currency (particularly the American dollar) in order to intervene in the foreign exchange market.
Let’s say a lot of foreign money is coming into India. This increases the demand for the rupee and it leads to the appreciation of the rupee. The appreciation of the rupee makes imports more competitive, hurting domestic producers (not good for atmanirbharta). It also makes exports uncompetitive. In this scenario, the RBI intervenes. It sells rupees and buys dollars (Of course, these rupees have to be printed or rather created digitally these days).
The point being that the dollars end up on the balance sheet of the RBI, only after it has introduced rupees against them into the financial system. So, where is the question of printing and introducing more rupees against the same set of dollars? (Which is why I keep saying that stock market wallahs should stick to earnings growth and not make a fool of themselves by coming up with such silly theories).
One way of raising money against these foreign exchange reserves is to borrow against them. But that would make India look very desperate and weak on the international as well as the domestic front. Do we really want to do that?
One thing that the government needs to pursue seriously is an asset monetisation programme. This involves selling its stake in public sector units which are in a position to be sold. Even public sector units that cannot be sold have a lot of land lying idle.
This land needs to be monetised. This will take time. Nevertheless, the thing is that the Indian economy will need massive government support even in 2022-23. And if the government starts the monetising process now, it will be prepared in 2022-23 to help the economy.