Fenil's Library

Vivek Kaul. Mumbai

Late evening. A little drizzle. Me and her sitting on a bench overlooking the sea, under a single umbrella.

“So?” she asked.

“This is nice,” I replied.
“Nice? That’s all? You use the word nice whenever you don’t know what you want to say!”

“Kind off.”

“I am bored,” she said coyly. “Since you claim you can link anything to anything. Let’s play a game. I will come up with three words and you link them.”

“Suits me.”

“So my three words are dollar, oil and gold.”

“You can’t think of anything but economics these days?”

“Chickened out already?”

“Not at all. But you should get ready to get back into history if you want to understand the link.”

“Yeah I am ready.”

“In the 1930s, Texas, the second largest American state, was producing so much oil that the price at times fell to as low as ten US cents a barrel (a barrel of oil is equal to around 159 litres). Now this was something that oil companies did not like. The Texas state government gave Texas Railroad Commission the power to regulate drilling of oil and thus set production levels. Once the commission could regulate the production level, it could regulate supply of oil and hence indirectly regulate the price of oil, as well. This price became to be known as the Texas price and over a period, the Texas price became the US price and the US price became the world price. This arrangement worked very well for the US companies, which till the 1950s produced nearly half of the world oil. Hope this part is clear?” I asked.

“Yeah. Till now I have understood everything.”

“In 1928, Saudi Arabia gave an exploration license to Standard Oil Company of California for around 35,000 gold sovereigns. The company stuck oil in 1937. After this, more and more companies stuck oil in the Middle East. In 1960, the Organisation of Petroleum Exporting Countries (Opec) was formed. Opec comprised largely of oil producing countries from the Middle East. It was formed so that the countries could take on the big international oil companies, who till then had been dictating terms. Juan Palo Perez Alfonso, the Venezuelan oil minister, was the brain behind Opec. And the irony was that he had studied the way the Texas Railroad commission works when he had been exiled to the US. He used the Texas model to establish Opec.”

“You really seem to have history and economics all figured out,” she said.

“Well with your increasing interest in economics, I need to be ready all the time,” I said. “Now let me explain a few things about the dollar. Between the end of World War II and August 15, 1971, the US dollar was pegged to gold, with one troy ounce of gold (around 31.1 grams) being worth $35. Meaning, the US was ready to convert dollars to gold at any point of time. This ensured the dollar became the international reserve currency with other countries carrying out trade with each other in dollars because it was convertible into gold. All this led to a lot of dollar pile-ups across the world. Also, the US itself printed a lot of dollars to bankroll the Cold War and the Vietnam War. This led to a situation where more and more countries started to exchange their dollars for gold. The amount of gold that the US government had was not infinite. So, on August 15, 1971 then-President Richard Nixon decided the US would no longer convert dollars into gold.”

“Aren’t you deviating from the point? Where is the link?” she interrupted.

“Have some patience my dear. Till August 15, 1971, the US dollar was essentially gold. After that, it became a concept, an idea or just a piece of plain paper which had the backing of the world’s biggest superpower nation. Also, during the first decade, Opec was not successful at doing what it was established to do. Between June 5 and 10, 1967, the Six-Day War broke out between Israel on one side and Egypt, Jordan and Syria on the other side. At that point, Opec had cut production by 1.5 million barrels, primarily to punish the US which was an ally of Israel. The production cut hardly mattered, because the US started to pump oil from its spare production capacity. Oil production in the US peaked in 1970, and has been going downhill since then. At the same time, the American addiction to oil has been on its way up. In October 1973, Egypt and Syria went to war with Israel. This war came to be known as the Yom Kippur War. Opec, knowing well that America’s oil production had peaked, imposed an oil embargo. From October to December the Opec price of oil increased from $2.20 per barrel to $11.65 per barrel. Why do you think Opec had the audacity to do that?”

“Because, as far as I can see from what you said, oil production in the US had peaked in 1970. So the US did not have any spare capacity to pump up production and meet the shortfall from Opec’s cut in production. And given America’s addiction to oil, they had to pay the price Opec demanded.”

“That’s right to an extent. The global demand for oil had gone up from 3.7 million barrels per day (mbpd) in 1950, to 25.6 mbpd in 1970. So, an increase in demand was a definite reason for demanding a higher price. But what one must remember is that by taking dollar off from the gold standard, the US had the ability to print as many dollars as they wanted to, as they did not have to bother about having to face the risk of converting those dollars into gold. And given their addiction to the so-called American way of life, they would print as many dollars as required to pay Opec’s price. Opec of course, understood this. If what you are earning is paper, then you’d rather have more of it than less of it. Once the US was ready to pay, the rest of the world followed.”

“Interesting. What happened after that?”

“Mohammad Reza Shah Pahlavi, the Shah of Iran, was overthrown by Ayatollah Khomeni on February 11, 1979. By May 14, 1979, the Opec price was at $13.34 per barrel. Oil till then was sold under long-term contracts. There was turmoil in Iran, causing its oil production to fall dramatically. This sent the spot price of oil through the roof, as Iran is the second-largest producer of oil within Opec after Saudi Arabia.”

“Spot price?”

“The day-to-day purchase market for oil was at Rotterdam in The Netherlands. Here, the price of oil shot up from $13.34 per barrel on May 15 to $34 per barrel on May 17. Iran cashed in on this and sold off their oil at the spot market. Soon, other Opec members followed. The spot price reached $40 per barrel and Opec raised its price to the same level. Opec again cashed in on the America’s addiction to oil and the fact that it could print as many dollars as it wanted to buy oil. With an increase in price, the inflow of dollars for the Opec nations shot up. Saudi Arabia and some other Opec countries started to use these dollars to buy gold and the price of gold also shot up through the roof, going from $258 per ounce in May 1979 to $678 per ounce in 1980.”

“But all that is history. What is the learning in the present day and context?”

“Well. I thought you would have got the point already. The price of oil fell to a low of around $30 a barrel, as economies all over the world crashed, reducing prospective demand for oil. But since then, the price of oil has been rising again and has risen to $60 a barrel. Opec of course understands that America can just print dollars to buy oil, as long as the international market for oil continues to be priced in dollars. Given that, why not have more dollars than less? So, production of oil by Opec members has been adjusted accordingly to ensure a good price. Other than this, if Opec countries start buying gold with the dollars that they are earning — as they have in the past — imagine what would happen to the price of gold.”

“But how can you be so sure?” she asked.

“Sure? In life, decisions are based on two kinds of guesses we make: wild guesses and educated guesses. I’d like to believe I’m making an educated guess!”




k_vivek@dnaindia.net

This article borrows heavily from ideas expressed originally in Gold, Oil and Money in the Free Market, http://www.usagold.com/halloffame.html #anchor318280 and The Last Oil Shock - A Survival Guide to the Imminent Extinction of Petroleum Man, David Strahan, John Murray Publishers, 2008.

People aren’t willing to spend money — neither their own, nor borrowed

Vivek Kaul. Mumbai

“So where do we go from here?” she asked early one morning as I sat watching the rain falling outside, sipping my cup of coffee.

“Why do we need to go anywhere from here? You know, I remember reading somewhere, we are where we are because that’s where we are meant to be,” I replied with a grin.

“Smart reply. I will let you be for the time being. But tell me something, I read this small snippet in the newspaper today that the consumer price inflation in the United States for the month of June 2009 was only 0.7%.”

“So?” I asked.

“Well, the US has been printing dollars big time and hoping to spend it in order to revive the economy. The money supply in the US has increased by more than 100% in the recent past (See graph). History tells us increased money supply leads to a situation wherein a lot of money chases fewer goods, leading to increased prices or inflation. But that doesn’t seem to be happening. Why is that?”

“The conventional answer is that due to a recessionary situation, the increased money supply is not leaving the banks. That is, banks are not willing to lend, which means people cannot borrow to buy goods, as they had been doing in the past. Take the case of automobiles. The average price of cars being sold in the US before the recession set in was $30,000. The only reason most people could buy such cars is because they had easy access to debt. Now they don’t, so car sales have collapsed. And when cars aren’t selling, car manufacturers obviously cannot raise prices. Other than this, people have also realised the merits of saving money. Savings in the US are now at around 5% of the gross domestic product (GDP), in comparison to a negative savings rate till sometime back.”

“But why this sudden spurt in savings?” she interrupted.

“Well you need to realise that since the beginning of the recession in December 2007, around $13.87 trillion of wealth has been destroyed. Most of it, of course, has been due to a crash in housing prices. A fall in stock market levels has also added to this wealth destruction. What this means is that people are feeling poorer. And when people feel poor, they do not go out and spend. The tendency is to save and hold on to what you have. Other than this, a lot of people have been fired from their jobs. Official figures suggest that nearly 9.5% of the US population is unemployed, and around 6.5 million people have lost their jobs. These numbers do not include people who are working part-time, but want to work full-time, and cannot do that because there are not enough jobs going around. Now, I need not tell you that the last thing on anyone who has lost his job is spending money. And of course, even those who haven’t lost their job will be doubly careful about spending money when they see people around them being fired,” I explained.

“But isn’t the US government spending money to revive the economy? A stimulus package worth $787 billion is being executed to revive the economy.”

“Yeah, it is. But remember the wealth destroyed stands at $13.87 trillion and the money being spent is $787 billion. It is like you losing a hundred rupees and I giving you six rupees to compensate for it. Obviously, that is not enough. When wealth destruction has happened on such a massive scale, any stimulus can only have a limited impact. Of the total plan of $787 billion, $287 billion was in the form of temporary tax breaks. This has been partly negated as many American states on the brink of bankruptcy have started to increase taxes. Increased taxes mean lesser money in the hands of consumers to spend. As I have told you before, nearly 70% of the US GDP comes from consumption. If consumption doesn’t pick up, GDP growth doesn’t pick up. And for consumption to pick up, people have to borrow and spend money as they did in the past. This is rather ironical given that it was excess borrowing that caused all these problems in the first place. The solution is what caused the problem.”

“There you go getting all philosophical again!”

“What all this means is that people are not willing to spend their own money, nor spend borrowed money. Which means you can’t have a situation wherein more money is chasing few goods. Hence, there is no increase in prices, and a low inflation of 0.7%. But that, as I said, is the conventional argument that everybody seems to be making.”

“Oh. Kahani main twist!”

“Yeah. What everyone seems to be talking about is that an increase in money supply hasn’t led to an increase in prices. But what nobody seems to be talking about, is how an increase in money supply has ensured that the purchasing power of money hasn’t gone up.”

“Purchasing power of money hasn’t gone up? What do you mean by that?” she asked.

“Let me explain. Money has a certain purchasing power. Let’s say you can buy 2 kg of a fruit for Rs 100 on a certain day. Sometime later, you may be able to buy the same 2 kg of fruit for Rs 75. What does that mean? It means the purchasing power of money has gone up. Why? It has gone up because the price of what you are buying has fallen and hence you can buy more goods with the same amount of money or the same amount of goods with a lower amount of money.”

“Okay. So I understand what purchasing power means. But what is its link with what
you have been trying to say?”

“If the money printing wouldn’t have happened, money supply wouldn’t have gone up. If money supply wouldn’t have gone up, the prices of goods and services — which have held up more or less constant — would have fallen. So, an increased money supply has ensured that some amount of money has chased goods and services. This has enabled companies to either hold on to their prices, or to not cut prices as much as they would have had to, in case there was no money printing.”

“Hmmm. I guess I understand now. But what is the trouble with prices not falling?”

“It leads to a situation where the mechanism of price is not allowed to work and prices of goods and services don’t reach their correct level. They are propped up by the increased money supply. Now money printing cannot keep continuing for eternity. Thus, there is always a danger of the prices falling more in the future, whenever the currency printing stops. And that my dear is a scary thought.”

“Well like you keep postponing the answer to my questions, I guess economies work the same way,” she said, having the last laugh.




References:
Inflation: What You See and What You Don’t See, Thorstein Polliet, June 30, 2009
The Financial and Economic Argument for No Green Shoots: No Deus Ex Machina for the Economy. 10 Charts Showing why There will be no Second Half Recovery in 2009, www.usagold.com, July 8, 2009

Ignore naysayers and stay invested in Indian stocks; the magic will work in the long run

Devendra Nevgi

The first Budget of the new UPA government was presented on July 6.
The buildup to the Budget included a sharp move in stock markets after the alliance’s strong majority in the general elections. The move was fuelled by expectations from the UPA of sweeping reforms and deregulation. The Economic Survey released earlier added fuel to this fire of irrational expectations.

Closer to Budget Day, the expectations marginally toned down. Nevertheless, on B-Day, the markets tanked by 870 points, around 6%, the largest fall in the history of Indian stock markets on Budget Day. Here, the first lesson is that Budget expectations could have been managed through the use of a more efficient communication policy.

Without going in the intricacies of the Budget, I would like to highlight the finance minister’s first few statements, on the fact that the Budget is not the only event where policies can be framed, nor is it a magic wand to trigger off instant results. Reforms are a long-term process.

Maybe investors in India have gotten used to a 20/20 cricket match when they should be looking to win the Test match series, and hence the knee-jerk reaction on July 6.
This brings up another issue — should the Budget be presented at 5 pm like in the earlier days, with no special Budget session, so that investors get a chance to react to it after due analysis?

Though the so-called “road map of deregulation, fiscal consolidation, and reforms” was missing in the Budget document — which was the major source of disappointment for the markets — there were many aspects which could benefit the country in the long run. Also, there was nothing in the Budget to lower the earnings expectations of corporates, except for companies which pay MAT, which was raised by 5%.

The focus of the Budget remained on bringing economic growth (9%) back on track by stimulating rural demand, creating jobs and boosting consumption by lowering direct taxes, which would leave more money in the hands of consumers.

Social and infrastructure sectors remained the focal points of the Budget. And note that excise benefits given earlier in the year as a part of the stimulus were not rolled back.

Another much-debated aspect of this Budget and the reason for the steep fall in markets was the ballooning central fiscal deficit which, now estimated at 6.8% of GDP, may be much higher if we add the state deficits and the off-balance sheet liabilities and be in the range of 11-12% of GDP.

I differ on this debate over the fiscal deficit. Let us understand that in the last 18 months, the world has gone through the worst financial crisis since the Great Depression, and that India is not insulated from its effects.

Globally, governments and central banks are working overtime to enact stimulus and policies to bring growth on track. Fiscal stimuli and lowering of policy interest rates has been an integral part of their moves.

What the FM is doing, is adopting an “anti-cyclical fiscal policy” (raising public spending in economic downturns and vice versa), which every authority in the world is doing now, and rightly so.

Many of the countries have increased their deficits closer to double digits in their bid to stimulate demand by increasing spending. In fact, India should also move to a cyclically-adjusted fiscal deficit target, where the deficit targets move according to the prevailing economic cycle.

If growth has to be a priority, the temporary higher deficit is bearable and the ensuing growth will help the government to scale back expenditure and the deficits in coming years. But yes, sustained higher deficits — if there is no revenue growth — do create problems such as choking up growth, crowding out private investments and taking interest rates higher, which governments have to be wary of.

But an astute monetary policy and RBI’s support to the government borrowing programme can counterbalance some of these ill-effects.

What is more important and relevant is that the deficits should not rise due to non-productive expenditure, viz, expenditure which cannot buoy growth in future. In the Budget, the significant rise in the allocations to infrastructure (up to 9% of GDP) and to the rural sector is an example of productive expenditure. And fiscal stimulus works through the real economy much faster than other policy tools like interest rate cuts.

Here, I wish to bring forward the economic theory of “Ricardian Neutrality”, which goes: During periods of higher fiscal deficits, private economic agents (individuals, households, firms, etc) expect that there will be a rise in the future tax burden (to reduce deficits). They accordingly save more of their current income to later offset the fall in the future income, which cancels out the negative effects of fiscal deficits on demand. For instance, the savings ratio in the US is at a 15-year-high now, when its deficit is rising.

If the global rating agencies move to downgrade India’s rating based on a standalone factor of higher fiscal deficits, the rating of many other countries would have to follow suit.

The current situation does demand priority to growth over the risk of a downgrade. Among the factors taken into account by rating agencies are:

The country’s openness to trade and capital flows and experience in adapting to associated fluctuations

The country’s stable political system with strong, long-established institutions, its ability to respond to changing economic and financial circumstances, and its transparency in policymaking

India has achieved some of these, such as a stable political system with strong, long-established institutions and its ability to respond to changing economic and financial circumstances.

Conclusion
The Budget is not the end of the world, since it’s only a projected statement of accounts of the government. It need not always be a long-term policy statement. Temporary higher fiscal deficits are not always bad in the short run, though if sustained, they can prove disastrous.

Reforms, divestments, fiscal consolidation and deregulation can follow and need not wait for Budget Day. India will continue to grow at 6-7% for the next few decades and hopefully, the FMs gamble of growth will work over the next few years.

There is nothing in this Budget to revise the corporate earnings growth lower. So why then did the stock market fall by 6%? Ask the short-term leveraged FIIs. Stay invested in Indian stocks and the magic will work in the long run.

The author is a qualified chartered accountant and an independentfinancial expert. He can be contacted at deven.nevgi@gmail.com

With the money-printing press on its side, the government can keep borrowing money to spend more than it earns

Vivek Kaul. Mumbai

“With the monsoons arriving, the wet look among women is back, I guess,” I said.

“Don’t know about the wet look, but I had to wade through knee-deep water to get back home today. And Pranabda’s Budget was an exceptionally dry Budget. ‘Monsoon main sukha Budget,’ went the headline in a Hindi newspaper,” she replied.

“Yeah and more than that, the fiscal deficit numbers are getting scarier,” I elucidated.

“There you go again, trying to show off that you understand economics.”

“Why not? As the film heroines say “flaunt it, if you have it.””

“But why is the scenario scary?” she asked.

“Fiscal deficit, as you’d know, is the difference between what the government earns and what it spends. Typically, most governments spend more than what they earn, and hence the deficit. Now let us take a look at the Indian deficit numbers. In the financial year 2007-08 (i.e. between April 1, 2007 and March 31, 2008) the government spent Rs 1,26,912 crore more than what it earned. For the financial year 2009-10 (i.e. between April 1, 2009 and March 31, 2010), the government plans to spend a whopping Rs 4,00,996 crore more than what it earns.”

“Or 6.8% of the gross domestic product (GDP)?” she interrupted.

“Yeah. The GDP of India is assumed to be at Rs 58,56,569 crore for 2009-10. The projected fiscal deficit expressed as a percentage of this stands at 6.85% to be very precise. But this does not give the correct picture.”

“Then what gives the correct picture?”

“The fiscal deficit of India in 2007-08 stood at Rs 1,26,912 crore. In comparison to that, the projected fiscal deficit of Rs 4,00,996 crore for the financial year 2009-10 is 216% more. What that means in simple English is that the income of the government of India has been more or less constant over the last few years, though its expenditure has been going up. In 2007-08 the income of the government of India stood at Rs 5,85,759 crore. For the year 2009-10 the income has been projected to be Rs 6,19,842 crore. This means that the income has gone up by 5.8%. The expenditure for 2007-08 stood at Rs 7,12,671 crore whereas the projected expenditure for 2009-10 stands at Rs 10,20,838 crore or a whopping 43.2% more. The trouble with expressing fiscal deficit as a percentage of GDP is that we never really understand the enormity of a situation. In 2007-08, the government earned Rs 5,85,759 crore and it spent Rs 7,12,671 crore, which means it spent Rs 1,26,912 crore or 21.7% more than what it earned. In 2009-10, it is projected to earn Rs 6,19,842 crore and spend Rs 10,20,838 crore, which means that it plans to spend 64.7% more than what it earns. Now that better expresses the enormity of the situation,” I explained.

“But where will the difference come from?”

“Let me ask you a question. When in a given month your expenditure is more than your income, what do you do?”

“I dip into my savings,” she replied.

“What if you do not have any savings?” I questioned again.

“Oh then I use my credit card. I have one too many of them anyway.”

“Yeah you use your credit card, which means you borrow. Similarly when the government spends more than what it earns, it borrows by issuing financial securities known as treasury bills and bonds or government securities. So in the year 2007-08 the government borrowed Rs 1,26,912 crore to service its deficit. And in the year 2009-10, it will have to borrow Rs 4,00,996 crore to fund its deficit.”

“Hmmm. So what is the problem with that?”

“Hold on, babes. Let me complete. When you have to repay the debt you have taken on your credit card, what do you do? You either spend less in the months to come or increase your income.”

“Yeah, any logical individual would do that.”

“But you must remember that the government cannot suddenly increase its income to pay off its debt, neither can it cut down on its expenditure. So what does it do to pay off its debt or even servicing the interest on that debt? It takes the third way out.”

“The third way?”

“Yeah. Let us take your case. What if you did not have enough money to repay your credit card bill? What would you do? You would try and use your second credit card to pay off the amount due on your first credit card. And when things get difficult on your second credit card, you would use your third credit card to pay off the dues on the second card. And so the story would go on, till you run out of cards.”

“Yeah. Of course. But what has my ability to repay my credit card bills got to do with the government of India?” she asked.

“Like you, the government takes on more debt to repay its earlier debt as well as to repay existing loans. Let me explain. In the year 2007-2008, the interest payment of the existing debt of government of India stood at Rs 1,71,030 crore whereas it borrowed Rs 1,26,912 crore to fund its deficit. What this means in simple English is that some portion of the interest to be repaid (Rs 1,71,030 crore - Rs 126,912 crore = Rs 44,118 crore) was being paid out of actual earnings and not just by borrowing more. Now for 2009-2010, the interest payments of the government stand at Rs 2,25,511 crore whereas the projected fiscal deficit stands at Rs 4,00,996 crore. What this means is that nearly 56.2% of borrowed money is just being used to service past debt. The government does not earn enough money to pay back the interest on its debt. So what does it do? It takes on more debt to pay interest on its existing loans. A perfect Ponzi scheme! The word Ponzi comes from Charles Ponzi, an American-Italian, who in the year 1919, promised to double investors money in 45 days. What he essentially did was to create an illusion of a successful business by using the money brought in by new investors to pay off the old investors. Essentially, the capital of the scheme was used to pay interest as well as repay the money invested. This is what most governments which spend more than what they earn have been doing over the years, including the government of India.”

“So what you are effectively saying is that the government never runs out of credit cards?”

“Exactly.”

“But tell me something, don’t investors who buy bonds issued by the government to funds its fiscal deficit know this?”

“Of course they do. But governments have the right to print money which you and I don’t. So worst comes to worst, they can always print money to repay interest as well as principal. As the fiscal deficit increases the temptation for the government to print money and repay debt as well as interest on that debt, increases. In fact of the fiscal deficit of Rs 4,00,996 crore projected for 2009-10, the Reserve Bank of India will pick up half of the bonds being issued to fund the deficit. What this means in simple English is that big time money printing to fund the deficit has already started. Financial history tells us very clearly that high fiscal deficits have never been such a great idea. It ultimately leads to governments printing money big time, increased inflation and in some cases even the collapse of a currency. Pranabda should keep that in mind.”