Posted by: Ravi Saraogi | August 11, 2012

Change of blog address…

I have changed the blog address to www.economese.wordpress.com

Please click on the above link.

Thank you

 

 

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Posted by: Ravi Saraogi | July 7, 2012

A Guide to the Gold Standard

April 1933, the US goes off the gold standard

The April 20, 1933 edition of the The New York Times read, “GOLD STANDARD DROPPED TEMPORARILY TO AID PRICES AND OUR WORLD POSITION; BILL READY FOR CONTROLLED INFLATION.”

The temporary suspension of the gold standard turned out to be anything but temporary, which reminds me of a Milton Friedman quote, “Nothing is so permanent as a temporary government program.”

The purpose of this post is to show that it is technically possible to implement a gold standard today. Many criticisms against the gold standard claim that it is not possible to shift to a gold standard. These criticisms range from – the money supply will fall, there will be chaos if many agencies control money supply, there is not enough gold in the world to shift to a gold standard. These criticisms are baseless and betray an understanding of what money really is.

Once we have clarified  (hopefully) that it is technically possible to implement a gold standard, whether we should shift to a gold standard is an altogether different question. So, the way to argue against the gold standard is to debate along ideological lines. If someone argues that we should not implement the gold standard because the government should control the money supply, that’s fine. The nature of the debate then  boils down to whether the government should control the money supply or not. However, if one argues against the gold standard saying that it is not possible to implement the same, the debate does not stand any merit.

I myself am guilty of the same misunderstandings that I attempt to clarify through this post. On 4 December , 2010, I had put a post in this blog with the title In defense of fiat moneyMuch of what you will read in this post will directly contradict what was argued earlier.

What is so special about gold?

First and foremost, the Austrian economists do not support the gold standard because it has some mystical properties. As our economy moved from barter to exchange based on money, gold came to be widely accepted as the best medium of exchange. This was because gold satisfied the many qualities of a good medium of exchange, like acceptability, durability, portability, homogeneity, scarcity.

Murray Rothbard in his book, What has the government done to our money, says

Historically, many different goods have been used as media (medium of exchange): tobacco in colonial Virginia, sugar in the West Indies, salt in Abyssinia, cattle in ancient Greece, nails in Scotland, copper in ancient Egypt, and grain, beads, tea, cowrie shells, and fishhooks. Through the centuries, two commodities, gold and silver, have emerged as money in the free competition of the market, and have displaced the other commodities.

Thus, the Austrians support the gold standard as gold is what the market accepted as money before the government monopolized the money supply. It is not for any economist to decide what commodity should be used as money. Our monetary history suggests that gold was established by the market as the best form of money. In case some other commodity had been established as money, we would have been arguing for a monetary system based on a different commodity.

What is the Gold Standard?

Simply put, a gold standard means a monetary system based on the commodity gold. Does this mean you will have to carry gold bars in trucks to make payment for buying real estate? No. You can make payments in paper receipts which will be redeemable in gold. Who has the obligation to redeem the paper receipts for gold? Obviously, the entity who has issued the receipts; which brings us to a very contentious question – who has the right to issue such redeemable paper receipts?

In a gold standard, anybody who has gold can issue such receipts. Suppose the government has gold reserves of 1 tonne. It can issue its own paper receipts, say the ‘dollar’ and define it as equal to 1 gram of gold. This will allow the government to issue 1 million dollars. Similarly, anyone can take out their own paper receipts. If you have 1 tonne of gold, you can take out your own receipts, and label it ‘rupiya’ and define it as 1 kg of gold. This will allow you to print 1000 rupiya. You can take this rupiya to the market and buy goods and services.

Will the market accept your rupiyas as payment? That will depend on your credibility in the market. Say you went to purchase a car and it costs 1 kg gold. You can use your one rupiya to buy the car. The car dealer can later knock at your door and ask you to redeem your one rupiya for 1 kg gold. If you do not redeem your rupiya, your credibility declines, and in the future, market participants may refuse to accept rupiyas.

Does this mean you will starve to death with nobody willing to sell you food? Of course not. Even if the credibility of your rupiya has gone for a toss, you can always turn in your gold to the government and receive dollar in exchange. Or you could turn over your gold to a bank whose currency is widely accepted by the public. Or, you could simply melt your gold into smaller units and use it directly for exchange.

The point I am trying to make here is that in a free market gold standard, the market will decide the paper receipts or currency that will be used. Will there be multitude currencies and chaos? No. History suggests that the market will eventually settle to a few different types of paper receipts. Maybe, only dollars will be used or maybe, currencies issued by certain trust worthy banks will be used. (It may be mentioned here that currency issued by different banks will not be a problem, just as having savings account at different banks is not a problem. Inter bank transactions can take place through a clearing house, as is presently done.)

Paper currency issued by different participants in the gold standard are simply receipts for a claim towards gold. As gold is the real money in a gold standard, we stumble on an important question. Who has the right to mine gold? Well, no points for guessing, but obviously the Austrian reply to this question will be – its a free market, everybody has the right to mine gold.

Suppose you want to buy a car, which costs 1 kg gold. You have two choices – either you can mine 1 kg gold and pay for your car, or you can choose to work somewhere and get 1 kg of gold as wages. Which option you choose depends on which activity will demand the least effort from your side – this is similar to saying which activity is profitable to you. Similary, a mining company will mine gold till the time it is profitable for it to do so. It may seem that in a gold standard, private  mining companies will earn super normal profits and will become masters of the universe. This is not true.

An example will clarify.

Assume a mining company can hire laborers for 1 kg gold per day to work on its gold mines, and each laborers can mine 5 kg of gold per day. Can such a situation arise in a free market? Of course not. Why would anyone accept 1 kg gold in payment for extracting 5 kg of gold? One can argue here that independently (without machinery of the mining company), the laborer will be unable to mine gold, and hence he may accept a lower payment that the value of gold he produces. Even then, what prohibits another company which can buy machinery and hire laborers to start mining operations? Eventually, as long as mining gold remains a profitable activity, the supply of gold will keep on increasing, adding to the existing supply of gold stock in the economy. Eventually, the “price” of gold (in terms of its purchasing power in buying goods and services) will fall to match the cost of extracting gold and we reach a sort of “steady state” supply of gold.

As we can see above, the supply of gold, which is to say the supply of money in a gold standard, is determined by the market. It is important to mention here that the initial stock of gold, as well as the addition to gold stock through mining, are irrelevant from the point of view of operation of the gold standard.

We can take a stylized example of an economy to understand the above point.

Assume an economy which produces only one good – say 1000 units of X. Assume the initial stock of gold in this economy is 1000 kgs and gold is the accepted medium of exchange. This 1000 kgs of gold is split between two market participants, say A and B, equally – 500 kgs each. What will be the price of one unit of X in this economy? X will cost 1 kg gold, and both A and B can buy 500 units each of X. Now, in the same example, assume that the initial stock of gold, which is split evenly between X and Y, is 1 kg. The price of one unit of X will be 1 gm and A and B can both still buy 500 units each of X. Now assume that because of a certain technological innovation, it has become easier to mine gold and the stock of gold in the economy increases to 2000 kgs. Ceteris paribus, the price of one unit of X increases to 2 kgs of gold and A and B can both still buy 500 units of each.

In a fiat money economy, the way to think about this is to imagine that one morning when you wake up, you are told that an extra “zero” has been added to all monetary denominations. So Rs 10 is now Rs 100. What used to cost Rs 10 before will now cost Rs 100. Similarly, if you were earning Rs 10 before, you will now earn Rs 100. In real terms, nothing changes. By adding an extra zero, we have increased the monetary base in an economy ten times. If the initial stock of money in an economy was Rs 10 lakh, it is now Rs 100 lakh. In real terms, nothing changes. In nominal terms, the purchasing power of rupee has fallen – what you could previously buy with Rs 10 will now cost Rs 100.

What is important is real consumption of goods and services. Money is simply used to exchange goods and services. If there is a huge initial pile of gold, prices will be quoted in tonnes or million tonnes. If we have very limited supply of gold, prices will be quoted in grams or milligrams. We can use any unit we want, it couldn’t matter less.

Can we shift to a Gold standard today?

Yes we can. Most of the criticisms against the gold standard have already been addressed above. We saw how in a free market gold standard, even though everybody has the right to issue currency, there is no chaos or dooms day. The market will choose as currency the paper receipts which have the highest credibility for redemption in gold. In fact, the term ‘dollar’ originated from minting of coins by The Count of Schlick, whose coins earned a reputation for their quality. Even though anybody could mint coins, the ‘dollar’ minted by The Count emerged as universal acceptance.

Murray Rothbard in his book, What has the government done to our money, says

The dollar began as the generally applied name of an ounce weight of silver coined by a Bohemian Count named Schlick, in the sixteenth century. The Count of Schlick lived in Joachim’s Valley or Jaochimsthal. The Count’s coins earned a great reputation for their uniformity and fineness, and they were widely called “Joachim’s thalers,” or, finally, “thaler.” The name “dollar” eventually emerged from “thaler.”

We also saw how the initial stock of gold or increase/decrease in supply of gold pose no difficulties in the technical operation of the gold standard. These are not merely assertions but facts that can be verified by studying monetary history.

Though we have implicitly addressed the criticism that there is not enough gold to shift to a gold standard, lets discuss this again through an example.

Assume an economy is running on gold standard. The gold reserves in this economy is 1000 kg and a dollar is defined as 10 kg of gold. Thus, there are 100 dollars in this economy. Now, the government abolishes the gold standard and monopolizes the function of issuing currency in the economy. With the link between the dollar and gold reserves broken, the government is now free to print dollars without any corresponding increase in gold reserves. Ten years later, the supply of dollars in the economy has increased to 1000 dollars.

If the government wants to re-introduce the gold standard, with the initial stock of gold reserves (1000 kg ) and the inflated supply of  1000 dollars, the dollar will have to redefined from being equal to 10 kg of gold to 1 kg of gold. We can shift back to the gold standard with the same initial gold reserves but an inflated paper money supply. The question of insufficient gold reserves does not arise. Ludwig Von Mises had remarked that an ounce of gold is sufficient to run a gold standard. I think we can appreciate the significance of this quote in the context of the above example.

We now need to address a final point before closing this post. Lets continue with the above example.

Before the government redefines the dollar as being equal to 1 kg of gold, the “price” of gold observed in the fiat economy will be lower than this rate, i.e., the dollar will be overvalued and gold undervalued. This is to be expected as under a fiat money system, the supply of dollars increase as a much faster rate than the supply of gold reserves. Gold has to be mined from the depths of the earth while money can be printed in bulk effortlessly. In our example, assume the price of gold in the fiat economy is half a dollar for 1 kg of gold. This creates a confusion that we need  2000 kgs of gold to convert the 1000 dollars into gold and shift to a gold standard. Since the gold reserves are only 1000 kgs, there must be “insufficient gold.” As we have seen, this betrays an understanding that money is not an independent entity, but a unit of account. The dollar simply has to be redefined to “equate” the available gold reserves with the existing supply of paper money.

When the government redefines the dollar as 1 kg of gold, immediately we see that gold has “appreciated” and the dollar has “depreciated.” 1 kg of gold previously used to fetch you half a dollar. After the introduction of the gold standard and the redefined dollar, 1 kg of gold will fetch you 1 dollar.

If you are a gold mining company (or individual) and were previously selling a kg of gold for half a dollar, you can now exchange the same for one dollar. If it was profitable to sell a kg of gold at half a dollar, its two times more profitable to sell a kg of gold for a dollar. This will lead to more companies (or individuals) engaging in gold mining. This process will continue until rampant mining bids up the cost of gold mining to such an extent that the profit return on gold mining falls to the return observed in other industries. The laws of normal profit which apply to any other industry in a free market economy will apply in the mining industry too.

Why did the Gold standard collapse?

If indeed the gold standard is a workable solution, why did it collapse? To answer this question, we will have to take a voyage through the monetary history of the world. We can keep this topic for a future blog post. Suffice it is to say here that the gold standard did not meet its demise because of any inherent flaws.

Indeed, the gold standard did not collapse – it was abandoned by the government.

 

——–

A single blog post cannot do justice to a topic as wide as monetary systems. I intend to write more on this in the future. In case you are not convinced regarding some points or feel that more clarity is required, please feel free to drop a comment and I will try to elaborate further.

Posted by: Ravi Saraogi | June 27, 2012

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

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.

Posted by: Ravi Saraogi | June 26, 2012

The Libertarian Reading List – The 30 day challenge

Image

F.A. Hayek

I recently came across a collection of 30 articles, meant to be read over 30 days, to understand the Austrian school of economics. Why I think this is important –

1) With the global economy in turmoil, we keep hearing about different policy prescriptions to deal with the crisis. It is a good time now to get acquainted with the different school of economic thoughts. This will help in making sense of the wonderful debate that brews everyday in the blogosphere.

2) I feel the Austrian perspective on Economics is ignored in educational institutes. The set of 30 articles may be a good starting point to coherently understand the Austrian school. So while we know quite a bit on Keynesian economics, the above looks like a good place to read about a starkly different point of view.

Disclaimer – I have not yet read any of the articles. 30 articles in 30 days seems difficult for me. So I have customized the challenge as the 120 day challenge. Will try to cover one article in 4 days. In case I stick to this and have something interesting to share, will update on a follow up blog post.

Posted by: Ravi Saraogi | November 6, 2011

How to cut gibberish

Following is a commentary on the future directions of the market (the Nifty index) from a leading business paper,

“The current up move may halt around the 5500-level. After that, we could either enter a phase of prolonged consolidation in the range of 5000-5500 or the index could once again drift lower to retest the 4700 odd levels.” (emphasis mine)

Translated into plain English, the above means,

“The markets may stop going up. It could remain where it is. Or it could go down.”

Posted by: Ravi Saraogi | November 5, 2011

Eradicating poverty without aid

Poor Economics, by Abhijit Banerjee and Esther Duflo, has won the Financial Times and Goldman Sachs’ Business Book of the Year award. The book deals with “radical new ways of tackling global poverty.”

This reminded me of a paper my friend George and I had written some years back. An excerpt from the paper (you can download the entire paper here),

We believe that poverty, hunger and malnutrition in the global economy can be eliminated without any aid. The commodification of development, through the creation of an incentive structure, which results in a self regulating market where every market participant gains, is the essence of our idea. There is no philanthropy involved.

There are several multilateral, bilateral and unilateral organizations working towards eradicating poverty. Billions of aid money has been disbursed for this purpose. Yet, the problem of poverty remains huge.

Maybe its time to do things differently.

Posted by: Ravi Saraogi | October 23, 2011

Language

When I was at school, my English language examinations had an essay writing section with 20% weight in the overall score. The topics generally required the student to come up with a creative fictional prose. I was terrible at writing fiction. To make up for this, I made a genuine effort to brush up my vocabulary to make my writing fetch more marks. I used to write down words in a notebook and rote them with a religious fervor. By the end of school, I was writing essays with such complex words that I would have difficulty in understanding them if I were to read them today.

During the next three years of my graduation, I was of the opinion that good writing should involve maximum use of jargon, difficult words and complex sentences. After all, what better way to convince a reader that you are an ‘expert’ than to communicate in such difficult terms that the reader is left feeling uneducated?

How wrong I was.

My professional life turned this opinion upside down. My work demanded strict adherence to the The Economist Style Guide. Language I was told should be crisp and to the point. Jargon and difficult words should be avoided. Sentences should be short and should not involve even one extra word than what is required. A part of the style guide was accessible online but it has now temporarily been removed. You can purchase a hard copy of the style guide here.

The more complex the language, the less the writer himself understands what he is writing. There are obviously numerous exceptions. The one that immediately comes to my mind is F.A. Hayek. I have personally found his way of writing a little difficult to follow, but it cannot certainly be said that he did not understand what he was writing. Another exception is that language is a function of time. So if you pick up one of Keynes’ essays, you would find the style of language quite different, but that again does not mean Keynes did not know what he was writing.

Krugman provides a link to an excellent article by George Orwell on English language. It is a must read. Orwell gives examples of poor style of writing that has gained popularity by appearing ‘scientific.’

Here is an example,

On the one side we have the free personality: by definition it is not neurotic, for it has neither conflict nor dream. Its desires, such as they are, are transparent, for they are just what institutional approval keeps in the forefront of consciousness; another institutional pattern would alter their number and intensity; there is little in them that is natural, irreducible, or culturally dangerous. But on the other side, the social bond itself is nothing but the mutual reflection of these self-secure integrities. Recall the definition of love. Is not this the very picture of a small academic? Where is there a place in this hall of mirrors for either personality or fraternity?

– from Essay on psychology in Politics (New York)

With regard to sentences like the above, Orwell says,

….quite apart from avoidable ugliness, two qualities are common to all of them. The first is staleness of imagery; the other is lack of precision. The writer either has a meaning and cannot express it, or he inadvertently says something else, or he is almost indifferent as to whether his words mean anything or not. This mixture of vagueness and sheer incompetence is the most marked characteristic of modern English prose…

Another excerpt from Orwell’s article,

I am going to translate a passage of good English into modern English of the worst sort. Here is a well-known verse from Ecclesiastes:

[Sentence 1] I returned and saw under the sun, that the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favour to men of skill; but time and chance happeneth to them all.

Here it is in modern English:

[Sentence 2] Objective considerations of contemporary phenomena compel the conclusion that success or failure in competitive activities exhibits no tendency to be commensurate with innate capacity, but that a considerable element of the unpredictable must invariably be taken into account. 

Now analyze these two sentences a little more closely. The first contains forty-nine words but only sixty syllables, and all its words are those of everyday life. The second contains thirty-eight words of ninety syllables: eighteen of those words are from Latin roots, and one from Greek. The first sentence contains six vivid images, and only one phrase (“time and chance”) that could be called vague. The second contains not a single fresh, arresting phrase, and in spite of its ninety syllables it gives only a shortened version of the meaning contained in the first. Yet without a doubt it is the second kind of sentence that is gaining ground in modern English. I do not want to exaggerate. This kind of writing is not yet universal, and outcrops of simplicity will occur here and there in the worst-written page. Still, if you or I were told to write a few lines on the uncertainty of human fortunes, we should probably come much nearer to my imaginary sentence than to the one from Ecclesiastes.

As things stand, if a person were to express his views using Sentence 2 instead of Sentence 1, he would easily pass as an ‘expert.’ Sentence 1 is ordinary and fails to generate awe and mysticism – two attributes the ‘expert’ needs to rise above the commoners.

There are numerous ‘experts’ who hide behind the cloak of poor writing. The shaky foundations of their knowledge will stand exposed if their writing is stripped of jargon and convoluted sentences. A true expert on the other hand communicates with clarity and precision, demonstrating his subject matter expertise. If you watch Milton Friedman’s documentary series “Free to Choose,” you will know what I am talking about.

The bottom line – clarity in language demonstrates clarity in thoughts.

Posted by: Ravi Saraogi | August 7, 2011

The Spooky Times

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.

Posted by: Ravi Saraogi | March 13, 2011

What the bond yield tells us…

Bond yields always tell a nice story. Have a look at the graph below,

In 1Q2010, the 10 year US government bond yield was in excess of 3.5%. A higher long term bond yield can indicate optimism about the heath of an economy. There are several hypothesis for the same, one of them being that interest rate on long term bonds contains information about future short term rates. A low long term interest rate is an indication of lower short term rates. Short term interest rates are low in a recessionary economy, as an economy in downturn is characterized by low inflation. Also the monetary authority of a recessionary economy will hold down the interest rates as part of a counter cyclical monetary policy. Going by this logic, in 1Q2010 , investors were generally sanguine about the growth prospects of the US economy. This is also confirmed by the rally in S&P  500 between February and May 2010.

The rally in developed markets (DM) helped lift sentiment in emerging markets (EM) with the iShare MSCI EM exchange traded fund gaining in the same period. MSCI EM is a benchmark used to monitor equity performance in emerging markets. Since histroical price data for this proprietory index is not publicly available, I have used the performance of iShare MSCI EM exchange traded fund which tracks the MSCI EM index.

In 2Q2010, structural issues in developed economies came to the front. The burgeoning US government debt and sticky unemployment figures spooked markets. Combined with the sovereign debt crisis in the Euro region, a bear market set in. The 10 year yield fell from a high of 4% to 2.4% in October 2010 and the S&p 500 also corrected during the period. Out of investor fear in developed economies, a rotation trade started with investors pushing up EM equity at the expense of DM equity. The iShare MSCI EM ETF gained around 25% in 2Q2010.

Then came October 2010 and everything changed. Just when investors had written off DM equity as an asset class, the mood suddenly turned bullish. There was widespread expectations of a second round of quantitative easing by the Fed and the investors started pricing that towards the close of 2Q2010. As expected, the Fed announced an asset purchase policy of US$600 bn on November 5th. The 10 year yield rallied close to a high of 3.8% by February 2010 and the S&P500 returned 15% in the the 5 months since October 2010. And yes, the rotation trade reversed with EM equity under performing DM equity. Investors were beginning to get concerned with rising inflation in emerging markets in 3Q2010. This coupled with the better outlook of the US economy took the sheen off equity markets in EM.

If you read my previous post ‘The real motive behind QE2‘, I had mentioned  that an asset purchase policy should lead to a fall in yields as the government buys back bonds, pushing up their prices and lowering yields. This was also the official reason given by the Fed for the asset purchase programme – to lower long term borrowing costs. The exact opposite happened. Bond yields soared. However, nobody was complaining as the higher bond yields were interpreted as improving outlook for the US economy.

Now, where are we in March 2011. If you look at the graphs, you will see that the bond yield is now falling and the S&P500 is correcting. Does this herald an end of the QE2 backed short term optimism? If the mood turns bearish, will there be another QE3? Will the weakness in DM equity bring down EM equity with it? Or will a rotation trade emerge with investors moving money from developed markets to emerging markets?

All questions worth pondering on…

Posted by: Ravi Saraogi | December 8, 2010

The real motive behind QE2

On 3rd November, the US announced Quantitative Easing Part 2. This entailed an asset purchase program of USD 600 bn. The official rational – to lower the cost of long term borrowing. The rational according to me – to pursue a covert policy of dollar devaluation.

The rabbit is out of the hat now. The past few days has seen a rapid increase in the US 10 year bond yields. From 2.9 per cent on 6 Dec, the yields have hardened to 3.22 per cent today. A jump of close to 10 per cent. If anybody had any misgivings about long term interest rates falling post QE2, I hope they are laid to rest.

With Obama agreeing to the extension of tax cuts, markets have factored in a higher federal deficit next year, leading to a sharp rise in yields. Whatever impact QE2 might have had on the long term yields, this one single move has turned the table upside down.

What to watch out for going forward? The value of the dollar. If I was to hazard a guess, the dollar should weaken going forward – fits neatly with Obama’s plan to try and double US exports in the next five years.

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