Posted by: Ravi Saraogi | December 4, 2010

In defense of fiat money…

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,


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.

Posted by: Ravi Saraogi | December 2, 2010

Driver for EM Equities?

I read an article on Business Standard (click here) a few weeks back that offers a very nice perspective about the direction Emerging Market (EM) equities will take next year. It tries to analyze the question by looking at the relationship between US monetary policy and EM equities. It goes like this,

1990-1995 : Inverse relationship between US interest rates and EM equities

Low US interest rates drove capital  into EM economies. This was also a period when most Asian economies had current account deficit (CAD) and a leveraged private sector. They benefitted from low US interest rates.

1995 onwards: Relationship breaks down. Direct relationship between US interest rates and EM equities

Asian equities became a function of global growth expectations. Rising interest rates in the US signalled good health of it’s economy, which bode well for global growth and export demand.

So to answer the question what will drive EM equities next year, we need to access whether global economic recovery or loose monetary policy will impact EM more.

If we believe loose monetary policy will be the driving force, its bulls all the way with QE2 nicely lined up. (Capital controls and assets bubbles may be spoilers though)

If we belive do not believe in decoupling, then EM equities are a function of global growth expectations.

And obviously, if we believe, EM economies will successfully align themselves to be driven by domestic consumption, none of the above really matters.

Lets wait and watch.

Posted by: Ravi Saraogi | September 13, 2010


US Government Deficit - Historical

President Barack Obama released a budget plan that expects the federal deficit for 2010 to be a record $1.56tn, surpassing last year’s record of $1.4tn. That translates to a fiscal deficit of 10 per cent to the GDP. The US debt-to-GDP ratio already stands at 93 per cent.

How will this debt be financed? Lets delve deeper into this.

First the basics. Suppose the US government budgets for an expenditure of USD 100, but its revenues (through taxation and other sundry revenue sources) are only USD 90. This entails a budget deficit of USD 10, which is financed through borrowings. The Treasury issues bonds of face value USD 10, and makes good the deficit.

The buyers of the US government bonds can be classified under three heads- private investors, foreign central banks and the Federal Reserve. Private investors include private retail investors (this forms a very small proportion) and private institutional buyers (like banks, insurance companies and trusts). Foreign central banks are also important buyers of US government bonds. Countries like China and India run a huge trade surplus with the US, and the dollars they have accumulated through such trade are invested back in US securities (see previous post). Then there is the Federal Reserve. And this is where things get a little murky.

Federal Reserve, for all practical purposes, is simply an extension of the US Government. So, the Fed buying US government bonds is simply a transfer of debt from one part of the government to another. As for where does the Fed get the dollars to buy the bonds? It prints them. The Federal Reserve does not have the power of taxation to raise money, so it simply prints money to finance government debt.  This is referred to as monetization of debt or deficit financing.

The way this works is as follows. Suppose the US Treasury wants to spend USD 10 bn, but it only has USD 9 bn as tax revenues. It issues bonds for USD 1 bn in the market. The Fed comes in now to conduct its open market operations. It prints USD 1 bn and buys the bonds. Assume the interest payment on the bonds amounts to USD 10 mn. The Treasury pays this interest to the holder of the bonds, which is now the Federal Reserve. The Fed uses part of this money, say USD 1 mn, to pay for its day to day running expenses (like staff salary, premises, printing cost, etc) and holds USD 9 mn as surplus, which is returned back to the Treasury. And this completes the cycle.

So, when debt monetization takes places, what is the cost to the Treasury of financing the USD 1 bn deficit? It is simply the cost of printing that amount of money, i.e., USD 1 mn, which is 0.1 per cent of the deficit. This power to print money, and finance any deficit simply out of thin air, is referred to as ‘Seigniorage’ and is a sovereign prerogative of the government.

This is how Wiki defines the term ‘Seigniorage’,

“Seigniorage can be seen as a form of tax levied on the holders of a currency…. The expansion of the money supply causes inflation in the long run. This means that the real wealth of people who hold cash or deposits decreases and the wealth of the issuer of the money increases. This is a redistribution of wealth from the people to the issuers of newly-created money (the central bank) very similar to a tax.”

The above definition does a wonderful job of explaining the economic impact of seigniorage.  And the term assumes special significance in today’s economic scenario as going forward, the US governments is slyly going to rely on this form of taxation to get their fiscal house in order. In fact, given the scale of fiscal stimulus undertaken, it is in fact impossible to cover up for all that spending without significantly relying on seigniorage at some point of time.

The brunt of this will be borne by the people who hold dollars – the US citizen and foreign central banks who have dollar holdings. How all this will unwind in the future, will be very interesting to see. More on this in a subsequent post.

Posted by: Ravi Saraogi | May 28, 2010

How the Global Economy functions…

A simple and lucid framework to help you understand the present functioning of the global economy-

Balance of payments of a country can be broken down into two parts- trade balance and capital account balance. Summing up the two parts should give us zero as they are an accounting identity. So,

Trade balance (surplus/deficit) = Exports – Imports

Capital account balance (surplus/deficit) = Capital inflows – Capital outflows

Balance of payments = trade balance + capital account balance

If trade balance is in surplus, the capital account balance will be in deficit of an equal magnitude and if trade balance is in deficit, capital account balance will be in surplus of an equal magnitude (to finance the deficit).

The developed nations (read US, EU) import like crazy from developing nations (read China, India). Thus,

Trade balance (developed nations) = deficit (imports > exports)

Trade balance (developing nations) = surplus (exports>imports)

As we know, the US$ is the world currency. So, if Chindia (China + India) exports, it receives US$. And if it imports, it pays in US$. Since exports > imports for Chindia, these guys are getting more dollars than using them. So, they are accumulating dollars.

What does Chindia do with these dollars? They need a safe avenue to invest them, and what can be more safe than the US govt bonds. So Chindia buys US govt bonds (which the US govt issues to finance its deficit).


Capital account balance (developed nations) = surplus (inflow of dollars from Chindia that buy US govt bonds)

Capital account balance (developing nations) = deficit (outflow of dollars for buying dollar denominated US govt bonds)

These capital account surplus/deficit offset the surplus/deficit trade balance.

In summary,

Chindia produces,  sends the good for US consumption and accumulates dollar. The US consumes. And in huge quantities. It starts running a deficit and has to print bonds to finance the deficit. These same bonds are then bought by Chindia, so the dollars come back to the US. The US can now again buy from Chindia and Chindia can now again start exporting to the US.

And the cycle continues…..

Posted by: Ravi Saraogi | May 18, 2010

Institute for New Economic Thinking

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 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.

Posted by: Ravi Saraogi | May 16, 2010

The world of finance…

I believe the world of finance is unnecessarily made out to be too complex. The greatest hurdle in promoting the finance literacy and increasing financial inclusion is the image of finance as an arcane world that is comprehended only by ‘experts’. And matters become worse when these ‘experts’ let you down, as was the case during the sub prime crisis. There is obviously a vested interest in keeping things the way they are. I really sometimes wonder that the art of investing if broken down to the bare basics, isn’t all that complex at all. The habit of saving and evaluating financial instruments like bonds, equities, commodities, etc for making an investment decision can be achieved without complete reliance on the people of finance.

The case which I find most disturbing is the way ULIPs are sold in India. Every instance that I have come across of ULIPs being peddled is fraught with so much of misinformation that it seems downright illegal. Having talked to numerous people who have bought this instrument for tax savings purposes, not even one has come out as having properly understood the pros and cons of buying a ULIP. Let me clarify one thing at the outset, ULIPs are not an inferior investment product. However, without understanding the basic structure of a ULIP and without comparing it with an ELSS scheme, an investor will not be in a position to understand that an ELSS may actually make more sense for him than a ULIP.

More on this later.

Posted by: Ravi Saraogi | January 23, 2010

Aadiyatna Fund Launched…

In my previous post, I had talked about the launch of a fund that will invest in different asset classes, with the dual objective of giving superior returns as compared to the benchmark Sensex and to expose the readers of this blog to the world of trading. It is with great pleasure that I announce the launch of Aadiyatna, our very own proprietary investment fund. Aadiyatna is a partnership between George, Prajjwal and me, with a pooled in capital. For the purpose of discussions on the activities of the fund, we have launched a blog dedicated to this fund

I will also occasionally update the activities of the fund on this blog. But I would suggest you visit the aadiyatna blog for frequent and more detailed updates on the fund.

Posted by: Ravi Saraogi | September 9, 2009

Things to come….

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 🙂




Original comment by Somya

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


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

Posted by: Ravi Saraogi | August 14, 2009

Celebrating Freedom

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.


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.


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.

Posted by: Ravi Saraogi | April 28, 2009

Liquidity Trap: Revisited

I had touched on the concept of liquidity trap in my previous few posts. I am revisiting the concept here in this small post for the benefit of those who might not still be clear about it. Look at the graph below.


It basically plots the benchmark interest rate set by the major cental bankers against time. What do you see? The benchmark interest rates for US has hit the zero lower bound while for UK and EU, they are very close to zero. Obviously, interest rates cannot turn negative. Now look at the graph below-


The inflation rate in the US has turned negative at -0.38 per cent for the month of March 2009 after a continued and sharp fall since July 2008. Let us compute the real interest rate in March 2009 for the US, which is defined as nominal interest rate minus inflation-

Real Interest Rate = 0.00 – (-0.38) = 0.38 per cent

Definitely low by any standards. However, consider what the real interest rate would have been if the inflation was something like 3.85 per cent (the average inflation rate in the US for the year 2008),

Real Interest Rate = o.oo – 3.85 = -3.85 per cent

Yes, a negative real rate of interest, which would have offered a much larger boost to the economy and given greater traction to the monetray policy operations of the Federal Reserve. As the economy heads deeper into deflation, even with the benchmark interest rates kept at zero, the real rate of interest, reflecting the acutal cost of borrowing, will keep on rising. The above situation is referred to as a liquidity trap and it is easy to see that the monetray policy becomes completely ineffective in influencing the economy, with fiscal policy being the only tool in the hand of the government to bring the economy out of a recession.

Published by: Ravi Saraogi

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