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Day 1 of Robert Wenzel’s 30-day reading list

27 Jun

Henry Stuart Hazlitt (November 28, 1894 – July 9, 1993) was an American economist, philosopher, literary critic and journalist for such publications as The Wall Street Journal, The Nation, The American Mercury, Newsweek, and The New York Times, and he has been recognized as a leading interpreter of economic issues from the perspective of American conservatism and libertarianism – Wikipedia

As per my previous post, I have set out on a task to go through Robert Wenzel’s 30 readings prescribed for an introduction to the Austrian school. The below are my thoughts on the first reading, ‘The Task Confronting Libertarians’ by Henry Hazlitt.

Hazlitt mentions early in the article that libertarians are a minority, and the task laid before them of defending free markets and civil rights is tremendous. It is important to think over this again. We do not realize how pervasive government intervention has become. We regard many activities as unquestionable prerogative of the government- like issuing currency. A lot of conventional brain washing has to be reversed before it may strike someone – why should the government really control the money supply? It is in this sense that libertarians are a minority- what they question has already been settled by the society in favour of the government.

Hazlitt outlines some basic principles which a libertarian can use to defend the free market ideology. They are a nice summary of some standard criticisms against government intervention.

One simple truth that could be endlessly reiterated, and effectively applied to nine-tenths of the statist proposals now being put forward or enacted in such profusion, is that the government has nothing to give to anybody that it doesn’t first take from somebody else.

Any government expenditure has to be met by taxes. A government may borrow, but borrowings too have to be eventually redeemed by the tax payers. In a paper currency system, the government may print money, but printing money is also financed by a covert ‘inflation tax.’ The bottom line- there is no free lunch. We may clamour for government subsidy on petrol, but its our own money that will be used to finance such a subsidy program.

Hazlitt writes,

Thus, it can be pointed out that the modern welfare state is merely a complicated arrangement by which nobody pays for the education of his own children, but everybody pays for the education of everybody else’s children; by which nobody pays his own medical bills, but everybody pays everybody else’s medical bills; by which nobody provides for his own old-age security, but everybody pays for everybody else’s old-age security; and so on.

As noted before, Bastiat exposed the illusive character of all these welfare schemes more than a century ago in his aphorism: “The State is the great fiction by which everybody tries to live at the expense of everybody else.”

Another line of argument against government intervention would be to question “Instead of what?” This would be the opportunity cost argument against government expenditure. For e.g., a tax financed aid program launched by the government would preempt resources from some other use.

The third basic principle of ‘knowing the consequences’ is what I find the most appealing.

Another very important principle to which the libertarian can constantly appeal is to ask the statists to consider the secondary and long-run consequences of their proposals as well as merely their intended direct and immediate consequences.

Lets take an example. The Indian government recently introduced legislation to reserve 25% seats in private schools for students from disadvantaged sections of the society. The ‘direct and immediate’ consequences of this are so attractive that it looks like a great piece of legislation. After all, what could be wrong in giving disadvantaged students access to top class education facilities? Its only when the ‘secondary and long-run consequences’ of this policy are considered that a different picture emerges. What impact will this move have on the supply of quality schooling in India? Does this legislation redeem the government of improving the state of public schools in villages? How will the quality of education be impacted? What does the historical precedent of reservations suggest – like reservations in India’s higher educational institutes? Has the policy worked there against the stated objectives? One also needs to consider the negative effects of the increase in government confidence to introduce such legislation elsewhere. Tomorrow, will the government legislate that out of 4 seats in a car, one seat has to be reserved for a disadvantaged pedestrian?

There are many such questions. One could go on and on. The bottom line being that government intervention, albeit for a noble cause, can bring the baggage of unintended consequences with it. And whats worse is that such unintended consequences only becomes obvious after close examination.

One could mention here an oft repeated point by Milton Friedman – government policy should be evaluated based on its actual impact, not on the basis of its stated objectives.

My own addition to the Hazlitt’s basic principles on how to defend libertarian views-

Its very simple. Replace the word ‘government’ in an argument with the name of a politician – for starters, you can use Lalu Prasad Yadav.

The poor in a society will be looked after by the government.

The poor in a society will be looked after by Lalu Prasad Yadav.

You will immediately see the difference. The first sentence sounds very credible because it evokes images of a paternal body called ‘government’ which looks after its citizens, much like a shepherd looks after his sheep. However, the government is nothing more than the politicians who constitute the government. In this sense, the word ‘government’ is actually an euphemism – an euphemism for corrupt politicians. A point made evident by the second sentence.

The Spooky Times

7 Aug

Friday (5 August) was an eventful day. One that has provoked me enough to write. So here goes….

First and foremost, a quick update on the horror unfolding before us.

Lets look at the US 10 year government bond yields and the S&P500 index,

US 10 year bond yield (Blue) vs S&P 500 Index (Red)

Quickly recall (refer previous post) the story behind the curves. Fear of a double dip in the US pushed the bond yields down in Q32010. Faced with a slowing economy, investors switched money from risky assets (like equities) to bonds, driving up bond prices and lowering yields (price and yield is inversely related). In a desperate attempt to shore up the markets, Ben Bernanke announced the second round of quantitative easing (QE2) in November 2010. Bond yields hardened on the prospects of the monetary stimulus giving a boost to the US economy. Investors were shifting from bonds to risky assets to ride the wave of economic optimism. Bond prices fell (driving yields higher) and the S&P500 equity index soared.

Now, everything seems to be falling apart. Look at the S&P500 index over the past 10 days,

S&P 500 Index

After a 2.56 per cent fall on 2 August, it crashed by 4.78 per cent on 4 August. To put it in perspective, this was the worst day on Wall Street since December 2008 (the peak of the sub prime crisis). The US 10 year yields had a similar story to tell,

US 10 year Government bond yield

The mad rush into bonds has pushed down the yields by over 50bps in the past one month. Such is the frenzy to exit risky assets and park money in bonds and bank deposits, that Bank of New York Mellon is now going to charge large clients for keeping their deposits. Put another way, the bank is offering a negative interest rate. Really absurd? I thought so too. But it makes perfectly good sense. The bank has been receiving huge cash piles from its institutional clients afraid to deploy their holding given the rise in uncertainty. The bank cannot deploy these deposits for giving loans as they can be withdrawn anytime. For the same reason, it cannot invest them in long term bonds which offer a positive rate of interest. The only option is to churn these deposits in very short term debt instruments, which offer (no prizes for guessing) zero yield. (The intraday yield on 1 month US government bond turned negative on 4 August. Read here)

Near zero yield on 1 month US government bond

So, why the sudden panic? This can be the subject of a new blog post all together. But lets try and summarize the glut of problems.

Look around you. What do you see? Start with the land of the rising sun – Japan. The problem with this economy is that everything apart from the Sun seems to be falling or has been in a state of falling. A stagnating economy for the past 20 years has put the phrase ‘the lost decade’ to shame. Debt to GDP ratio in excess of 200%. Double whammy of an ageing and shrinking population. The glimmer of hope in Japan is its export industry. But with the Yen strengthening like it has, even the export industry is feeling the squeeze. The previous week, when the Yen was threatening to breach its all time against the dollar, the Bank of Japan was left with no option but to intervene in the forex markets to pull the currency down. If the all this wasn’t bad enough, the Tsunami in February caused severe supply side disruptions in the economy. And kindly add the bill of reconstruction to the already inflated government debt. All in all, here is an economy with such deep structural problems that you just tend to wonder – how in earth did the patriotic and hard working Japanese land in this situation?

Japan GDP growth rate

Move over to the sick man of the world – Europe. Well, there is just one word to describe the problem here – PIIGS. Portugal, Ireland, Italy, Greece and Spain. Debt problems in Portugal, Ireland and Greece has already caused quite a furore. Yet, these economies summed up are a minuscule part of the European Union. Spain and Italy, unfortunately, are not a small part of the European Union, and definitely not when summed up.

Greece 10 year bond yields

The Greece 10 year bond yields are at 15%. How will a debt laden economy refinance its debt at those levels? It will send its already strained finances into a complete tailspin. So expect Greece to be perpetually dependent on aid and bail outs. Similar is the story for Portugal and Ireland.

Greece, Portugal and Ireland are oldies in the bail out club. The newest kids on their way to join them are Spain and Italy. Look at the bond yields below and you will see that the debt market is already beginning to frown at Spanish and Italian debt.

Italy 10 year government bond yields - past 3 months

Spain 10 year government bond yield - Last 3 month

Germany and France are the only saving grace in European Union. And hence, the tax payers in these countries will bear the brunt of the bail outs being given to the countries in the periphery. All in all, Europe continues to be ‘the sick man of the world’.

Coming to the US of A, well what can we say. Standard and Poor’s has cut the sacrosanct AAA rating on US government bonds to AA+. The ISM survey for manufacturing is falling. GDP growth is falling below 1 per cent. The S&P 500 is correcting. Bond yields falling. Consumer spending shrunk for the first time in June since the last two years. Household budget is still very leveraged. Housing prices are showing tepid rise if not falling. The political gridlock over the raising of the US debt ceiling ended in a debt deal that speaks volume about the willingness (or unwillingness rather) of US policy makers to address the debt issue. Unemployment refuses to budge below 9 per cent.

The Fed Chief, the hirsute Bernanke, does not believe an economy which runs on paper money can ever deflate. Because as he very succinctly put in 2002, in a system of paper money, it is easy to generate inflation by simply printing money. Any surprise then that we had a QE1 and then a QE2. Yes they help in lifting sentiments, but without any corresponding changes in policy to address structural issues, such monetary stimulus only adds to the glut of dollar sloshing around the global economy.

Below I am quoting Bernanke in his famous 2002 “printing press” speech,

” Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation”.

After reading the above lines, one would not have any difficulty in visualizing Bernanke as below,

Bernanke and his printing press

What Bernanke is basically saying is that the US can never have deflation. Because the moment the economy shows sign of going into a deflationary spiral, the Fed will open the flood gates of its printing press. Imagine what the Chinese must be feeling. They are the single largest foreign holder of US bonds. Rampantly printing dollars will eventually lead to a severe debasement of the US dollar and force the Chinese to book  forex losses on its holding of US treasuries. Not a thing to look forward to when your forex reserves total 1.8 trillion dollars.

If problems in the developed world is not enough, what the emerging markets are going through is equally frightening. But I am so tired that lets just stop here with the solace that the problems in the emerging markets are cyclical and not structural. And in that limited sense, the global economy will start to rely increasingly on emerging markets to deliver growth.

To conclude, I am spooked. And it seems the markets are too. What if all this is just the tip of the iceberg? When all the band aids and short term bailouts and printing money and accumulating more debt is over, and they fail to get markets out of their miseries, where does that leave us? Was the sub prime mess just prelude to a mega crisis in coming? A crisis where the PIIGS default on their debt bringing a sever contraction in Europe. Where the deflationary fears in the US leads the Fed to print so much dollars that they devalue by 50%. Where such a devaluation in the dollar devastates the export industry in China and other emerging markets. Think about what will happen to commodity prices and oil when turmoil in the global economy causes the Chinese economy to slow down. And what those low commodity and oil prices will do to countries like Brazil, Russia, Australia and the middle east.

Spooky times indeed.

In defense of fiat money…

4 Dec

Post QE2, there has been a sharp proliferation in opinion that gold standard is the way to go. The paper money, it is alleged, has brought the world nothing but inflation and debt. Several virtues of gold standard are then highlighted.

I find the scathing criticism of paper money unjustified.

A simple look at the quantity theory of money tells us the following,

MV = PT

where, M= total amount of money in circulation

V = velocity of circulation of money

P = price level

T = amount of transactions in an economy

V is a behavioral constant.

In gold standard, M is inelastic, and given the behavioral constant V, leads to an inelastic P x T. So you don’t get inflation, but you also don’t get rapid growth in an economy as the monetary base M grounds T. T cannot increase rapidly if M remains inelastic as there is a limit to the amount of transactions a given M can support.

In the system of fiat money (paper money), M is elastic and controlled by the central bank. The increase in M (with the V constant at some level), brings a corresponding increase in P x T. Now, how much of this growth is contributed by P and how much by T is very debatable and hence an outright criticism of the paper money system is unjustified.

By making the money supply elastic, we have added to our repository a tool with which to experiment on economic growth. Sometimes, this experiment malfunctions, but suggesting a return to gold standard is like throwing the baby out with the bath water.

Institute for New Economic Thinking

18 May

I came across an excellent article by Sanjaya Baru in the 17th May 2010 edition of Business Standard, titled ‘Renewing Economics’, in which he talks about the Institute for New Economic Thinking, established by the legendary investor George Soros to rethink economics. You can visit the homepage of the institute at http://www.ineteconomics.org for more details on this. Going forward, it would be really interesting to see what perspectives the institute comes up with. I was very happy to know that YV Reddy, the previous Governor to the Reserve Bank of India, is part of the institute’s advisory board.

There was an excellent quote by Soros in the same article, which I would like to reproduce here…

“Economic theory has modelled itself on theoretical physics…… It has sought to establish timelessly valid laws that govern economic behaviour and can be used reversibly both to explain and predict events. But instead of seeking laws capable of being falsified through testing, economics has increasingly turned itself into an axiomatic discipline consisting of assumptions and mathematical deductions – similar to Euclidean geometry.” (emphasis mine)

Couldn’t agree more I think.

Things to come….

9 Sep

This post is a reply to a comment by Somya.

Dear Somya

You have touched on a very crucial point. For creating a class of informed investors, which this blog aims to do, we will now launch a dedicated investing section to help our readers make more informed investment decisions. For starters, we will be starting a fund which will invest in equities, so that readers of this blog can follow the trading history and see for themselves how different investment strategies play out in the real stock market. As responsible advisors, we obviously do not guarantee that the replication of our trading strategies will yield profits. However, the aim is more to educate readers about different investment options, strategies and asset classes. Through this experiment, our readers can get a feel of how it is to invest in the stock market, and for those who already invest, we can share our thoughts on the trading strategies.

The above is in the planning process and I will keep you informed about the same. Thank you for the invaluable feedback. And keep visiting informedinvestors 🙂

Regards

Ravi

——-

Original comment by Somya

Time: Monday September 7, 2009 at 8:25 pm
IP Address: 122.164.185.165

Hi,

I am not an investor and know nothing about the stock market. Hence, I am not an informed investor at all. But of late I have realized the importance of having at least some amount of knowledge about the financial markets (I have started earning you see!). Hence, I have a sincere request to make.

I was watching BBC news today and they happened to present a report on the financial markets. After almost one year since the financial turmoil struck the U.S. having a ripple effect on the rest of the world, BBC report tried to analyze the situation in India. This got me very interested.

The benchmark index in India last year had fallen by almost 50% leading to investors loosing incomes in as much as seven figures. Industries which relied heavily on exports suffered immensely with demand falling drastically from the Europe and the U.S. FIIs pulled out all their money from our country leading to a bottleneck situation. Growth rates fell, inflation levels rose, rupee depreciated further due to FII pull outs, people lost jobs, stock market became all of a sudden a nightmarish dream for even the unaffected.

After a year has passed by, India seems to have recovered much faster that expected. Benchmark index has improved by almost 66% (not sure whether I have this correct) since then and a certain head of a magazine named Mint said that India was in many ways isolated from the crisis. After a year, inventories in the Europe and the U.S. have dried up because of which import demand is slowly picking up now, the obvious benefits reaped by industries like textiles in India. People seem to be investing again, though with a more cautious attitude now.

I sincerely request you to make your blog more lively and informative and talk about the current scenario. Now that considerable time has passed since the crisis, much can be concluded upon. You blog should be doing that. Also, BBC in this entire month will be talking about the fin crisis and I am sure will come up with very interesting observations and hypothesis to work upon. Please update your blog frequently so that uninformed investors like me could be more informed.

Thanks. Regards, Somya Sethuraman

Celebrating Freedom

14 Aug

Jawaharlal Nehru

Jawaharlal Nehru

Long years ago we made a tryst with destiny,

and now the time comes when we shall redeem our pledge,

not wholly or in full measure, but very substantially.

At the stroke of the midnight hour, when the world sleeps,

India will awake to life and freedom…….

After a hiatus of three months, I am updating my blog on the auspicious day of our independence. Vande Mataram.

The Wholesale Price Index (WPI) never fails to surprise. While my flatmate, Supari Gupta, cribs about increasing dal, moong and other prices (sugar prices are on such steroids that the fund managers of Smart Portfolio have lined up a battery of sugar stocks to invest in, from Andhra Sugar to Sakhti Sugar and god knows what not sugar), the WPI inflation continues to plunge deeper and deeper into negative territory. So much so, that commentators have now started criticizing the index as far fetched from ground realities and faulty. There is also a clamor to shift focus to Consumer Price Index (CPI) inflation.

WPI inflation for the week ended 2nd Aug 2009 stood at -1.74 per cent, down from -1.58 per cent in the preceding week. This was surprising as we are witnessing rising food prices on the fear of a drought. However, a closer analysis would tell us that the above figures can be explained and  the wholesale price index is not so misleading as it is made out to be.

graph

As the graph above suggests, the WPI inflation for food articles does capture the surge in food prices neatly. The WPI inflation for all commodities shows a fall because of two reasons- the weighting scheme and the high base effect. Primary articles gets a weight of 22.02 per cent, fuel, power, lights and lubricants 14.23 per cent and manufactured products 63.75 per cent. Thus, even with increasing food prices, a generally cooling manufacturing prices makes the overall inflation benign.

Another reason for the apparent contradiction of falling WPI numbers in the face of increasing prices is the high base effect. WPI inflation is constructed on a year on year basis. If a basket of goods costs Rs. 100 on 1st Aug 2008, and the same basket of goods costs Rs. 102  on 1st Aug 2009,  then inflation on 1st Aug 2009 would be computed as 2 per cent, i.e., inflation is measured relative to prices existing in the preceding year.  Thus, if prices was unusually higher for some weeks in the previous year, the inflation figures for the  same weeks this year would be lower. This is exactly what has happened to the WPI inflation figures for the the week ended 2nd Aug 2009, as the graph below would testify. The wholesale price index showed a huge uptrend in August the previous year, contributing to the high base effect.

graph2

Because of the above factors, the latest WPI inflation figures may seem surprising, but they are certainly not reasons to doubt the ability of the index to capture price changes in the Indian economy.

India far from a Deflationary Spiral

23 Apr

deflation

From an inflation scare to a deflation scare, the wheel has come full circle. While the first half of 2008 was spent speculating how high inflation would go, the second half was spent wondering how low inflation would reach, and now, we are all spooked about the possibility of a deflationary spiral. The inflation, which peaked at 12.91 per cent in the second week of August 2008, has been declining since then at a rather alarming pace, plunging to 0.26 per cent in the second week of March 2009, before recovering a little to 0.30 percent in the third week of March 2009.wpi1

Source: Office of the Economic Adviser, Ministry of Commerce and Industry 

Deflation is much feared in the developed world, as falling prices can quickly grow into a deflationary spiral. A deflationary spiral refers to a condition in which prices fall on account of low aggregate demand, and consumers, anticipating a further fall in prices, delay their consumption, leading to an additional fall in aggregate demand and another level of price reductions. A deflationary spiral also leads to excess capacity and a fall in investments. As was seen during the Great Depression of the 1930s, the problem of falling prices, if not checked, can cause an economy to slide into an extended phase of widespread recession.

 A deflationary spiral is also feared because it can cause an economy to fall in a ‘liquidity trap’, in which, aggregate demand and investment remain low even though the nominal interest rate is near zero. This is because in a ‘liquidity trap’, though the nominal rates of interest are lowered by the central bank, the real interest rates remain high on account of falling prices. Real interest rate is obtained by subtracting from the nominal interest rate, the ongoing rate of inflation. For e.g, let the nominal interest rate in the economy be 2 per cent p.a. Now, if the rate of inflation in the economy is 1 per cent, the real interest rate works out to be a paltry 1 per cent p.a. If however, the economy is going through a deflation of 1 per cent (i.e., an inflation rate of negative 1 per cent), the real interest rate works out to be 3 per cent p.a., which is a lot higher than that for the inflationary economy.

 An economy caught in the vortex of a liquidity trap will find itself incapable of conducting monetary policy operations as further lowering of nominal interest rates when they are already near the zero-lower bound is not possible. Getting out of a liquidity trap involves managing inflationary expectations in an economy, which can be difficult as the Japanese case would suggest, which kept its policy rates close to zero for most of 1990s, trying to break from a liquidity trap like condition.

Should India be worried? Several factors suggest that the Indian economy is in no immediate danger of a deflationary spiral and its negative effects. What India is going through at the present is more of disinflation rather than deflation. While deflation is defined as negative growth in prices (inflation based on WPI, though near zero, has not turned negative yet), disinflation refers to a continued fall in the rate of inflation.

Moreover, even if WPI inflation is expected to turn negative in months ahead, inflation based on Consumer Price Index (CPI) for industrial workers, the most widely tracked CPI index, was still at double digit level for the month of Jan 2009 (CPI is computed every month, as opposed to WPI, which is a weekly series) at 10.44 per cent, showing a little dip to 9.6 per cent only in February 2009. The CPI data for the month of March 2009 will be released on 30th April and before that, it is too early to say whether the dip in February 2009 will be continued. cpi1

 Source: Labour Bureau, Government of India 

India is also far from the scare of a liquidity trap as the RBI has enough room to cut policy rates in order to lower borrowing cost in the economy. The repo rate (the rate at which the central bank lends) presently stands at 5 per cent and the reverse repo (the rate at which funds can be parked with the RBI) at 3.5 per cent. The cash reserve ratio stands at 5 per cent. Thus the key policy rates have still a long way to go before they hit the zero lower bound constraint where the monetary policy becomes ineffective. 

Thus, the Indian economy, which is expected to grow at over 5 per cent this fiscal, is far from a deflationary spiral. What the current fall in inflation does is offer room to the RBI to further decrease key policy rates in order to lower lending rates in the economy. Such a move would not only give a monetary push to the economy but will also lay to rest any danger of a deflationary spiral in the future.

Published by: Ravi Saraogi