Paper Money

Of Government Taxes, Bitcoin and the Fiction of Money

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?

As L Randall Wray writes in Modern Money Theory:

“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?

As Jacob Goldstein writes in Money – The True Story of a Made-Up Thing:

“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.

A Humble Request to the Modi Govt: Paper Money Works on Trust, Don’t Destroy It

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Money. Money. Money. It’s so funny. It’s a rich man’s world.

Or so sang the Swedish band Abba, many many years back. Rich man or poor man, money essentially functions on trust.

And the trust in Indian money has been destroyed repeatedly since November 2016, when demonetisation was unleashed on the hapless people of this country.

As we explained last week, demonetisation, the need of the Modi government to portray it as a success, and the lack of currency replacement at the pace it should have been replaced, has been responsible for the current currency shortage in large parts of the country.

Let’s look at Table 1, which basically lists the cash withdrawals made at ATMs using debit cards.

Table 1:Source: State Bank of India 

What does Table 1 tell us? It tells us that more cash is withdrawn from ATMs in the second half of the financial year (i.e. the period between October to March) than in the first half.

There are several reasons for it. The big festivals (Dusshera, Diwali, Christmas, Holi etc.) all fall in the second half of the year. So, does the procurement season for agriculture. This automatically means that the country on the whole withdraws more cash from ATMs in the second half of the year than it does in the first.

Now look at Table 1 carefully. The rate of increase in cash withdrawals has slowed down post 2012-2013. One possible reason for this has been the increase in digital transactions, which have gone up, but are still not big enough.

In 2016-2017, cash withdrawals in the second half of the year fell by 22.1%. This happened because in the aftermath of demonetisation there simply wasn’t enough cash going around in the system.

In 2017-2018, cash withdrawals in the second half of the year, are likely to be 12.2% more than the first half. (We use the term likely because the figure for cash withdrawals for March 2018, is an estimate).

This 12.2% growth is on a much larger base, than 2012-13. The cash withdrawals in the first half of 2012-2013 were around half of the cash withdrawals in 2017-2018.

Why have the cash withdrawals in 2017-2018 been much more? A major reason for this lies around the proposed Financial Resolution and Deposit Insurance Bill. At the core of this Bill, lies the suggestion that the deposits can be used to a rescue a bank or financial firm in trouble. But the truth is a little more complicated than that, as I had explained in a December 2017 piece.

The timing of this Bill coming after demonetisation was all wrong and created suspicions in the minds of people. And after that the university of WhatsApp struck, and many forwards started going around. These forwards wrongly suggested that the government had plans of seizing the money in banks.

But as is wont these days, people tend to believe what they read on their phones than logical and nuanced arguments offered elsewhere.

This fear of the government seizing deposits has to some extent led to people withdrawing more cash from ATMs than they otherwise would. In the four talks that we have given since November 2017 (in Greater Noida, Chennai, Mumbai and Hyderabad), the number one question that we got asked was, will the government seize our money?

This column originally appeared on Equitymaster on April 23, 2018.

This fear has been quite palpable, and the Modi government needs to address it.

 

The paper money that we use these days has no value of its own. It’s not like the money of yore, like gold or silver or tobacco or many other commodities, which had an inherent value of their own.

 

When it comes to paper money, it has value because the government of the day says so and people believe in it. It works purely on trust between the government and the citizens.

As Yuval Noah Harari writes in Sapiens—A Brief History of Humankind: “Money isn’t a material reality—it’s a psychological construct… Money is accordingly a system of mutual trust, and not just any system of mutual trust: money is the most universal and most efficient system of mutual trust ever devised.”

 

And it is this trust that makes money go around. As Harari writes: “Because my neighbours believe in them. And my neighbours believe in them because I believe in them. And we all believe in them because our king believes in them and demands them in taxes, and because our priest believes in them and demands them in tithes.”

 

This trust in money was first destroyed during demonetisation, when the government set a last date (December 30, 2016) beyond which it wouldn’t accept Rs 500 and Rs 1,000 notes (For the record, the Bundesbank, the German central bank, still converts deutschemark, the German currency before euro became the currency of the Eurozone, into euros).
This trust continues to be destroyed with all the rumours around the FRDI Bill continuing to go around. These rumours need to be addressed, which they haven’t been.

 

Ultimately, any form of paper money works on trust. And if this trust is destroyed, nothing really is left because ultimately the only difference between a Rs 10 note and a Rs 2,000 note, is the quantity of paper and the ink, used in making these two notes, look different.

 

 

 

 

 

Regular Demonetisation of Paper Money is a Stupid Idea

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On November 8, 2016, Modi announced the decision of the government to demonetise notes of Rs 500 an Rs 1,000. Several economists have made suggestions since then on what the prime minister Narendra Modi, should be doing next to tackle the huge amount of black money in the country.

One suggestion has been made by Soumya Kanti Ghosh, the group chief economic adviser of the State Bank of India (SBI), the largest bank in the country. In a column in the Business Standard titled Demonetisation and Note Burning and dated November 15, 2016, Ghosh wrote: “We suggest that this demonetisation may be carried out over periodic intervals with the surprise element and the government makes its intention clear on that. In such an eventuality, people will be discouraged to hold cash.”

What Ghosh is essentially saying here is that the government should carry out regular demonetisation of currency in the years to come. This basically means that the government should regularly make old currency useless and introduce new currency. He also suggests that the government retain the surprise element of the move like it did this time around.

This means that one fine evening (or morning or afternoon for that matter), the prime minister should suddenly announce to the nation, like he did this time around, that the high-denomination notes are basically useless now and new ones will be introduced. Ghosh hopes that by doing this people will be discouraged from holding on to cash. In the process the economy will move from being an “informal economy to a more formal economy”. In simpler terms, it means that the black portion of the economy will come down.

This I think is a stupid suggestion. Allow me to explain.

Paper money doesn’t have any value on its own, like various other forms of money like gold or silver, have had over the years. The Rs 10 note is not very different from the demonetised Rs 500 note except for the colour of the ink and the amount of paper used, to make it. The difference in the value of the notes is clearly not Rs 490. A Rs 10 note has a purchasing power of Rs 10 because the government deems it so. And so was true for the Rs 500 note, before it was demonetised.

So what is paper money? It is primarily a token deemed to have a certain value by the government and which everyone accepts and is used to carry out transactions in the everyday economy.

Without enough paper money in the economy, people can’t carry out transactions and the economy comes to a standstill. This is what is happening right now all-across the country. Mobile phone sales have collapsed. People aren’t buying two-wheelers. Restaurants are deserted. And normal taxis are not getting enough business. The farming economy has slowed down tremendously. Daily wage workers like plumbers and electricians are not getting enough work. For more examples, you can open any newspaper and there will be enough stories there. Generally, business is slow.

This isn’t surprising given that close to 86 per cent of the currency by value has been rendered useless by the demonetisation move. Of course, this wouldn’t have mattered if Indians were used to transacting through debit cards, credit cards, net banking, wallets and so on. The show would have gone on.

But that has not happened.  India is a country where a bulk of transactions are still carried out in cash.  An estimate made by  the Fletcher School at the Tufts University in the United States, said that in 2012, in India, 86.6 per cent of the transactions by value were carried out in cash. While this figure would have come down since then, it would still be at a very high level.  In comparison, card transactions stood at 4.1 per cent of the total transactions. The electronic transactions stood at 6.8 per cent.

Another research paper titled The Cost of Cash in India points out that “the ratio of currency to GDP in India (12.2%) is higher than countries such as Russia (11.9%), Brazil (4.1%), and Mexico (5.7%)”.

We can be prude about the matter and say that people should move away from cash, but societal habits are not easy to change. Given this, high importance of cash in our lives, it isn’t surprising that business in all kinds of markets has come down substantially. There isn’t enough token or paper money going around for people to carry out these transactions.

The only way to tackle this is to put out enough new money into the financial system in order to replace the old money. This will ensure that people will go back to carrying out transactions and businesses will go back to being normal again. But this is easier said than done.

Economist Saumitra Chaudhuri writing in The Economic Times said that “the timeline to replace the existing stock of 1,658 crore pieces of Rs 500 notes will run into May 2017.” He arrives at this number taking into account the printing capacity of the existing mints. This basically tells us that the implementation of the demonetisation move wasn’t really thought through. As usual we have managed to screw up on the implementation bit. And this has created problems in the everyday economy.

The basic hope of Ghosh of SBI is that with frequent demonetisation people will get on to other more formal mechanisms of paying than cash. That is likely to take place. But what will also happen is that more amount of black money will now quickly move into gold. There is nothing stopping that from happening.

And the thing is that India produces almost next to no gold. We import almost all of the gold that we consume. This has its share of repercussions on the balance of payments and the rupee dollar exchange rate.

But there is a bigger worry. All paper money essentially works on faith. This faith leads people to believe, that a piece of paper with some ink, digits and promises on it, is basically money. It is this faith which leads people to believe that a Rs 10 note has a purchasing power of Rs 10 and a Rs 100 note has a purchasing power of Rs 100, though essentially there isn’t much difference between the notes.

This faith is what basically keeps paper money going as money. I know for sure that when I use rupees to pay for goods or services, they will be accepted by others. And this is what keeps the economy going. If this faith breaks down, paper money breaks down. People move on to other forms of paper money or simply gold.

Let’s look at some evidence of what regular demonetisation does to an economy. One country which has gone through regular demonetisation of a large scale is Myanmar (or Burma as it is more commonly known as in India).

As the Federal Reserve Bank of San Francisco points out in a document titled Burma—Paving the Road to a Modern Banking System: “After the 1962 coup, the government installed a socialist economic system and nationalized all banks, including foreign banks. Subsequently, three major demonetizations occurred in 1964, 1985, and 1987. In the latest 1987 demonetization, the Ne Win military regime effectively declared about 75 percent of the cash in circulation illegal and eliminated three banknote denominations without exchange or compensation. The demonetization eroded most of the populace’s savings and resulted in widespread protests and the 1988 coup. Demonetization coupled with rampant inflation in the 1990s has led to the retainment of little faith in the storage value of the kyat. As a result, the economy is partly dollarized.”

While, the Indian demonetisation is nowhere as extreme as the ones in Burma, but the part in italics in the above paragraph is what is important. Regular demonetisation has led to people having little faith in the Burmese currency kyat. Hence, people prefer to deal in dollars rather than the local currency.

This is something recounted by a writer on the National Public Radio website: “[In 1987]… the country’s leader created new bills overnight in denominations that were multiples of nine — his lucky number… So people started to sock away their extra money in U.S. currency. And when your life savings is a few U.S. $100 bills, you want to keep them pristine.”

Regular demonetisation can lead to people losing faith in the country’s currency and moving on to dollars. And that is something no Indian government would want. Other than losing control on the monetary policy, it is going to have other repercussions as well. In the Indian case, more and more people will simply move to gold, given our love for the yellow metal.

Once this is considered, the suggestion from the chief economic adviser of the country’s largest bank, seems rather silly. The only possible explanation for it lies in the fact that he was perhaps trying to please his political bosses.

The column originally appeared in Vivek Kaul’s Diary on November 17, 2016

MONEY LESSONS FROM A TORN NOTE

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Over the last two months I have been carrying a slightly torn one hundred rupee note in my pocket. Nobody wants to accept it.

The note is slightly torn on the upper left hand side but the serial number is still visible. This essentially means that there is nothing wrong with the note and it continues to be a legal tender.

As Charles Wheelan writes in Naked Economics—Undressing the Dismal Science: “Consider a bizarre phenomenon in India. Most Indians involved in commerce—shopkeepers, taxi drivers, etc.—will not accept a torn, crumpled, or overly soiled rupee note.”

This entire act of not accepting torn notes doesn’t make any sense. As Wheelan writes: “The whole process is utterly irrational, since the Indian Central Bank [the Reserve Bank of India] considers any note with serial number—torn, dirty, crumbled, or otherwise to be legal tender. Any bank will exchange torn notes for crisp new ones.”

As the Reserve Bank of India points out: “Soiled notes are those which have become dirty and slightly cut…The cut in such notes, should, however, not have passed through the number panels. All these notes can be exchanged at the counters of any public sector bank branch, any currency chest branch of a private sector bank.”

The exchange facility is also available for mutilated notes or notes “which are in pieces and/or of which the essential portions are missing can also be exchanged.”

Given this, why do people still not accept soiled as well as mutilated notes? As Wheelan writes: “Rational people refuse legal tender because they believe that it might not be accepted by someone else…The whole bizarre phenomenon underscores the fact that our faith in paper currency is predicated on the faith that others place in the same paper.”

This is a very interesting point. At the end of the day, paper is money is just paper with some ink on it. A 100-rupee note is ten times as valuable as a ten rupee note simply because the Reserve Bank of India (or the government) says so. The ink and the paper used in a 100-rupee note is not ten times as valuable as the ink and the paper used in a ten-rupee note.

Paper money essentially works on confidence, which the government by recognising it as official money, helps build.  Further, it continues to have value, typically as long as people using it, continue to accept it. I will accept a payment in paper money only when I am sure that I can use that paper money to make my payments in the future.

As Mervyn King, former governor of Bank of England, writes in his new book The End of Alchemy: “Whatever form money takes, it must satisfy two criteria. The first is that money must be accepted by anyone from whom one might wish to buy ‘stuff’ (the criterion of acceptability). The second is that there is a reasonable degree of predictability as to its value in a future transaction (the criterion of stability).””

As per King’s second point, the confidence in paper money breaks down if it starts lose value at a very rapid rate i.e. when the prevailing inflation touches high levels. People then don’t like the idea of being paid in paper money because it is rapidly losing its purchasing power. In such scenarios people like being paid in the form of gold or silver or some other commodity.

In India, the first condition that King lays out, the criterion of acceptability, breaks down in case of a torn note. The moment a note is torn, it is not accepted as a payment even though it continues to be a legal tender. And it is not accepted as a payment by one person because he knows others won’t accept it.

What seems to be rational at an individual level becomes irrational at the systemic level. Meanwhile, I think I will have to finally make that trip to the bank.

(Vivek Kaul is the author of the Easy Money trilogy. He can be reached at [email protected])

The column originally appeared in the Bangalore Mirror on March 30, 2016

“We are in for another deflation shock…So actually it’s time to own cash”


Russell Napier a consultant with CLSA and one of the finest financial minds in the world, sees another deflationary shock coming. “Yes I am looking at a global deflation shock. So I see all the markets global equity markets coming down,” he says. When asked to predict a level he adds “I will just go back to my book the Anatomy of the Bear which was published in 2005 and in the book I forecast that the equity market, the S&P 500(an American stock market index constructed from the stock prices of the top 500 publicly traded companies) will fall to 400 points (On Friday the S&P 500 closed at 1,428.5 points)….So I am happy to stick with the number of 400 and then just tell everybody else who sort of reads this interview to work out what that means for the rest of the world,” he told Vivek Kaul in an exhaustive free wheeling interview.
How do you see thing in Europe right now?
My focus of the way I try to look at these economies is really to look at the financial conditions, the banking systems, credit availability etc. Those numbers are about bad for Europe. If you look at bank lending in Europe it is contracting to the private sector. The money they are lending is going to the governments. The key issue really is that is lack of credit going to the European private sector due to lack of supply or demand? There is more and more evidence that it is actually demand, and that just makes it just a more difficult problem to solve.
Why is that?
When your banking system is incapable of providing credit there are lots of things you can do to help it. But when people fundamentally don’t want to borrow and corporates don’t want to borrow then it’s a different situation. What would normally happen is quantitative easing and trying to keep money growing at a time when bank credit is contracting. But for political reasons that is difficult in Europe. So  Europe is facing a very difficult and nasty economic downturn, and things are going to get significantly worse. It’s worth adding on Europe as well that there is a chance that somebody is going to have to leave the Euro as early as next year. All seventeen members have to ratify the fiscal compact which is a major constitutional change. Still quite a few of them haven’t ratified it and maybe that  early as first quarter next year some country may be unable to ratify that fiscal compact. And at that stage we would have a crisis for the euro because the country that fails to ratify wouldn’t be able to stay in the euro. So we are all rolling into a European crisis next year.
So what can keep the euro going?
Ultimately the only thing that can keep Europe going is can they become a Federal States of Europe?
Can they?
No.  that is highly unlikely. There are seventeen members of the euro zone and all of them have to make the same constitutional changes and the same surrenders of sovereignty.  And this is not an economic call. This is a political and social call. And it is highly unlikely that all sovereign states will end up surrendering their sovereignty to a Federal government of Europe.
How do you see the things in the United States?
There is a much more mixed picture coming out of the United States of America. Bank credit is expanding and the private sector is borrowing. What is interesting is that small and medium enterprises have been borrowing and we have been seeing a growth there for over a year now.  That is normally a very good sign of thing because those are normally the people who create jobs.
What about other borrowing?
Banks balance sheets have premium components to them in terms of credit. And one is credit to small and medium enterprises. The other is mortgage credit. There is no sign of growth of mortgage credit. The other is consumer credit.  There is no sign of growth in consumer credit either. At this stage one can be more optimistic about the United States simply because small and medium enterprises are borrowing.
But what about the long term view?
I have a longer term problem with the United States which isn’t going to show up quarter to quarter in the growth numbers but it is structurally the most important thing that is going on there. The rate at which foreign central bankers particularly the Chinese are accumulating treasuries has dropped very dramatically. The Chinese are not buying and actually seem to be selling United States treasuries. Along with the Federal Reserve of United States they are the biggest owners of treasuries. They are neck and neck. When the biggest owner of treasuries is effectively a forced seller, it has to make you cautious on America despite the shorter term positive data coming out.
What will be the impact of this?
If the Chinese are not going to be funding the American government it’s more of an onus on the American savers to fund the American government. With savings being a reasonably finite number then there is less to lend to the private sector. I see us already in a larger picture trend of America where the savings of America will be increasingly be funding the American government and not the private sector. At the minute that is not having any negative impact or particularly negative impact on private sector credit availability. But ultimately it will.
That being the case are Americans saving enough to bankroll the American treasury?
The answer to that is no. They are not saving enough to bankroll the American treasury and the private sector. You have to put them both together. If you look at a country like Italy in Europe the government always gets funded. The governments always get funded someway. Likewise, the American government will always be funded. And if has to force the American people to buy treasuries it will force the American people to buy the treasuries. The question is are they saving enough to fund the government and also fund the demand of the private sector for capital as well. My answer to that is definitely no. But if it comes to push whether the government is funded or the private is sector funded, even in America which is ideologically more to the right, more free market than elsewhere, even there you will find the savings are forced towards the government and away from the private sector.
That being the case how do you expect the US government to finance its unfunded liabilities over like social security, mediclaim etc, over the years? One estimate even puts the unfunded liabilities at $222trillion.
In the short term as long as they can keep borrowing at this level they will probably keep borrowing at this level.  There is a basic rule.  A government that can borrow at 2% will borrow at 2%. That’s an entirely and completely unsustainable path for the American government. But it is just so easy to borrow at 2% that they will continue to do that. So that reality for America will not dawn for unfunded liabilities until it has to borrow at a more realistic interest rate, which is inevitable. The numbers you point out are absolutely huge but it’s becoming incredibly difficult to say when that will happen, when they will have to live with proper real interest rates. It could be several years. It could be several days. But eventually of course they will have to do that. And there is a whole host of solutions for the United States government.
Like what?
There is a thing called financial repression which is effectively forcing people to lend money to the US government or forcing financial institutions to lend money to the US government. That  is the path to travel for all the developed world countries. But there will have to be a renegotiation of benefits to the baby boom generation. Every society has to choose where the burden has to fall. Does it fall on tax payers? Does it fall on savers? Or does it fall on people who are recipients of this dole of money from the government. It will be a mix of all of these. So at some stage we will have to see a major renegotiation of the obligations that were signed for the baby boom generation in the 1960s. But it could be many years away.  I have to stress that this will be political dynamite. No society wants to withdraw benefits from its retired or elderly population. But the entire western world faces the reality that is exactly what it will have to do.
Do you see what they call the American dream changing?
It has massively changed over the last two decades already. American people sustained by going from one person working to two persons working and then adding significant leverage to it.  So the dream has been extended through those two mechanisms and clearly it is not going to go much further from here. It’s a much harder slog from here given excessive levels of debt on the starting position. It’s not only an American phenomenon but it’s a developed world phenomenon. It’s easy to be negative but the only possible positive way out of this is some technological innovation which gives us some very high levels of no inflationary growth and very high levels of productivity.
Could you elaborate on that?
If you read financial history sometimes these things just come along. They surprise everybody.  One thing that is that could do it is cheap energy.  Shale oil and shale gas are the main places we would be looking at for cheap energy. But it is worth stressing that we are going to need a very high level of real economic growth. So in America it will have to be in excess of 4% or maybe as high a 4.5%.  That’s the sort of real economic growth that would help countries grow their way out of the debt problem and meet most of the potential liabilities going forward. One shouldn’t rule out that we have that wonderful outcome but it still does seem like very unlikely.
Talking about technological innovation can you give me some examples from the past?
Yeah absolutely. They have really been energy related. In United Kingdom the canals were such a revolution that the transportation cost collapsed. The price of coal in some major cities came down by 60-70% due to the introduction of canals.  Obviously when energy prices fall by that much you get a productivity revolution. The railways had several impacts. Electricity which we didn’t really get going into the industrial process until the start of the last century, had a major impact. The automobile had a major impact. These are the types of major technological innovations which can change the world. When you can give the world cheap energy then that’s when you can begin to talk about much higher levels of growth.  It is almost impossible to tell where these things come from but one that is sort on the horizon is shale oil and shale gas and potentially what that can do. But I want to stress it is going to have to produce levels of real economic activity in America, which haven’t seen for a very very long period of time, perhaps ever.
Do you the American government defaulting on all the debt it has accumulated?
They will not default in the technical term of the word default which obviously means refusing to pay back in dollars the debt in principle. That would be definition of default. That seems unlikely.  But we are already in a situation where the Federal Reserve of the United States has intervened in the treasury market to hold the treasury yield below the level of inflation. Now that is not a default. But if you own treasuries and the yield is below the rate of inflation then the real value of your investment is declining in dollar terms. In terms of you and I investing in that treasury market it means that we are losing capital and therefore I would call this a democratic default. The second democratic default which I will come to America and the whole developed world will eventually be restrictions of free movement of capital. We are heading towards a world of controls and capital restrictions, which was a norm from 1945 to 1980-81.
Do you see them printing money to repay all the accumulated debt?
The answer is that partially they are already doing it. Quantitative easing is a form of printing money. Therefore you can say that is a process that is underway. So I have no doubts whatsoever that the Americans will be printing money to satisfy their foreign creditors.
Do you see that leading to a hyperinflation kind of scenario?
No. It is always assumed that if there is a dramatic sale of the treasuries by the Chinese, the Federal Reserve will simply buy all those treasuries and simply create lots of money in the process. If that mechanism happened you would end up with hyperinflation. But it’s worth remembering that there is a technical definition of hyperinflation and that is a rate of inflation of 50% per month or more. So it’s a very high number. Sometime people think that 20% per annum is hyperinflation but its 50% per month technically. The Federal Reserve is not stupid enough to do that. It would not simply print all the money it could to do to repay its creditors.
So what will happen?
What will happen is that there will be some money printing and as I stressed inflation will be higher than yield of treasuries. But Plan B is financial repression which is to effectively force the financial institutions and the people of America to buy the treasuries. Now this does not involve printing of money. I am sure that if the Federal Reserve sees inflation climbing to anywhere near 10% it would go to the government and say that we cannot continue to print money to buy these treasuries and we need to force financial institutions and people to buy these treasuries. In India you must be aware that banks have to compulsorily buy government debt. We can force banks and government companies to have a minimum amount of their assets in government debt. The road to hyperinflation is well known by central bankers. It has never ended well even though it can wipe out your debt very very rapidly indeed. Nevertheless, the political and social implications of that are truly dire. It tends to throw up despots and destroy democracies.  Financial repression if you are a saver is a terrible but is much less painful than hyperinflation.
But what about the Western world practicing austerity to repay its debt?
True austerity is when you if you simply closed down on the government spending and accepted the economic consequences of that and still kept taking in the tax revenues. But that’s apolitically painful way of doing it. True austerity is highly unlikely. What Europe has nothing like sufficient austerity to take them to a situation where they can repay the government debt. So the only way out is repression, which is simply funding the government by forcing the people and financial institutions to buy government securities. That’s a very painful thing if you are a saver, but so much better than austerity, default and hyperinflation. It is ultimately the most acceptable form of getting out of this problem. Even with repression we are talking about a couple of decades before we could gain levels of gearing in the developed world drawn towards normal levels.
Do you see the paper money system surviving?
Yes I do see the paper money system surviving. To say that it doesn’t survive means we replace it with something that is based or anchored on metal. But 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 the 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.
What about gold?
Gold is never easy to predict and it is particularly difficult at the moment. In the long run view which I have just run through that repression is ultimately the best choice for democracies, gold is the best asset class. It is the standout asset class. In a world of negative real interest rates prolonged for some decades gold does really well. And secondly in a world where tax rates are going up where the government needs to get more private wealth under its own control then gold is small, portable and hidable and therefore becomes an asset of choice. So my long term prognosis for gold remains very good. In the short run I am concerned that if we get another economic setback from here and we see growth coming down from here, the price of gold may come down. But I would say any declines in the price of gold are wonderful opportunities to buy some more and for the long term holder gold remains essential.
What are the other asset classes you would bullish is on?
I tend to believe that we are in for another deflation shock. The Asian crisis of 1998 was a deflation shock and we had one in 2002 when the American economy slowed and Mr Bernanke had to make his helicopter speech. We had another one post Lehman Brothers. So what you would want to look at is what asset classes did well during those periods? And really very little does well when we have deflation shocks. Whether deflation turns up or not the shock is very bad for pro-growth assets. So actually it’s time to own cash.  Cash has historically been a good preserver of health during periods of deflation. It is worth buying debt of some of the governments that don’t have very much debt. There are some countries out there with small amount of government debts and they are small such as Singapore and Norway. So I would recommend cash and very small holding in government debt in markets where the governments don’t have very much debt. Also when markets have come down a bit we are looking to buy equities and we are looking to buy gold.
By when do you see this deflationary shock coming?
Well its coming. It is very rare for these things to erupt in the morning. Lehman Brothers was the exception a bank with $600billion of liabilities going bust suddenly threatens the stability of the entire financial system. Sometimes it happens like that but rarely. It happened like that in the 1930s with the bankruptcy of Creditanstalt (An Austrian bank which went bankrupt in 1931 and started a chain of bankruptcies). Occasionally it can be a major event. But it can be just like it was in 2003 just slower and slower growth.  The only sort of one red flag which could suddenly jump and signal deflation is if someone leaves the euro because clearly if it’s a major currency leaving the euro they will be re-denominating their debts in their domestic currency which is tantamount to a large default on the global banking system. That is a small chance of that early next year.
What if the country is Greece?
Frankly Greece defaulting on its debts isn’t going to make much difference to a banking system but makes a big difference to the IMF and the government. But more likely it’s just going to be slower and slower growth coming forward particularly in China.  The world has bet a lot on Chinese growth. The more the growth slows in China and capital flows out of China, the more the world begins to realise that its China which has been the source of global growth and global inflation, and if that’s not there we are more likely to get deflation. So that’s the more likely scenario rather than a Lehman Brothers style event.
So you are basically saying that the high Chinese growth rates will now be a thing of the past?
Yes unless they do some major reforms. And in my opinion that they need to do is reforms which will encourage private Chinese capital to remain in China and invest in China. And at the minute where is very limited reason for the Chinese private capital to remain in China because the returns are so poor. So anything they could do to open up the financial system for private sector investment and private sector competition would be good. And more importantly allow the private sector to take over some state owned enterprises and restructure them. If they are prepared to make that giant leap in terms of reforms then there is every prospect that keep they will keep capital in China. The good thing is we are getting a new administration. The bad thing is it is very difficult to predict what a new Chinese administration stands for. But soon enough we will know and if they come up with some policies like this, then there are many reasons to be more optimistic about the outlook for global growth.
By what levels do you see the stock markets falling in the coming deflationary shock?
I will just go back to my book the Anatomy of the Bear which was published in 2005 and in the book I forecasted that the equity market, the S&P 500(an American stock market index constructed from the stock prices of the top 500 publicly traded companies) will fall to 400 points (On Friday the S&P 500 closed at 1,428.5 points). As you know in March 2009 it got to 666points. It got somewhere there but it did not get to 400. So I am happy to stick with the number of 400 and then just tell everybody else who sort of reads this interview to work out what that means for the rest of the world.
The interview originally appeared in the Daily News and Analysis on October 15, 2012. http://www.dnaindia.com/money/interview_we-are-in-for-another-deflation-shock-so-actually-its-time-to-own-cash_1752471
(Interviewer Kaul is a writer. He can be reached at [email protected])