Tag Archives: Politics

The humble idli, politics and economics

The Indian politician has never been the symbol of economic wisdom. I am truly privileged (/sarcasm) to live in a part of India where politicians never cease to be funny and do hilariously stupid things. The latest in the line of economic foolishness is this

http://articles.economictimes.indiatimes.com/2013-03-02/news/37389936_1_idli-subsidised-canteens-dmk-government

No matter what economic theory says, politicians will play politics and this is just one more example.

First, prices of goods are determined by the forces of demand and supply. Demand and supply, in turn, are determined by the subjective preferences of all the individuals who constitute the market. No one’s whim can supplant the will of the market as a whole.

Second, every unit of every factor employed in the production of a good will be paid its Marginal Value Product. In simple terms, if an additional unit of a factor earns a firm Rs. 5000 per month, Rs. 5000 per month (or a suitably discounted amount to account for the time difference) is what will be paid to the factor. Employers do not whimsically decide what they wish to pay any factor, be it land or labour. In the long run, those who decide on whim will either be put out of business or be taught a lesson by the market.

Third, in the long run, there is no such thing as profit except for the entrepreneur’s act of wisdom in identifying underpricing of factors in the market. Even such profits are short-lived because they attract capital into that line of production leading to falling price spreads and the eventual elimination of profit. All that capitalists earn, in the long run, is the interest income for waiting to consume.

Finally, the real cause of steadily rising prices is government and the politicians themselves. It is government that is responsible for steadily increasing money supply sending prices of all goods and services perpetually upward except for occasional blips. If a politician really wants to address the burning issue of rising prices making essential commodities unaffordable to the poor, he needs to make difficult political decisions and bring government expenditure to the bare minimum, if not to zero. All subsidies and other forms of welfare have to be stopped. Government should, at the worst, limit itself to policing, national defence and judicial services (Frankly, there is no argument for government having a monopoly on these as well, but let me rest that argument for another day).

If idlis currently cost Rs. 3 apiece even at the road-side eateries, that means that no one can afford to sell them at a price below that and hope to stay in business for long. Government may think it is beyond the laws of scarcity, supply and demand but in reality, it is not. Someone will have to bear the cost of these cheap idlis and who better than the tax payer. As the government creates a deep hole in its pockets, what else will it do but dig deep into the pockets of ordinary, hard-working, honestly earning citizens. More taxes are on the way!

And taxes mean that we all pay the price in more ways than one. First, we consume less today than we would if we weren’t taxed. Second, we save and invest less. Therefore, production in the private sector suffers in the long-run. So through a relative shrinking of the production structure resulting in lower supply of goods and services and lowered employment of factors, we all suffer a lower standard of living.

If governments do not explicitly tax citizens to make up the additional deficit, they will have to implicitly tax them by inflating money supply. The consequence of this is the very price rise that politicians seek to contain by subsidising idlis.

The simple lesson that we have to learn and throw at our politicians is this – Prices are a market phenomenon that no politician can hope to control. Rather than engage in futile attempts to control prices, politicians should work towards shrinking government to the point where its existence does not impoverish ordinary people to enrich those in and connected to government.

Union Budget 2013-14 – A repeat of the annual farce

It just happened. Mr. P Chidambaram just laid out the Union Budget for the Fiscal Year 2013-14. As usual, it was accompanied by the usual hoopla including portraying P Chidambaram dancing Gangnam Style and interviewing his granddaughter who has just turned 12 (Bless the child!) and was apparently very excited at being allowed to be in Parliament for the occasion. Newspapers and television channels allotted prime space/time for discussion of budget expectations (pre-Budget) and budget analysis (post-budget).

But how relevant is the Union Budget to our lives really? If at all it is, in what way is it relevant? These are important questions for everyone of us to understand.

What is the Union Budget?

It is basically a declaration of the government’s plans to spend money and its corresponding plans to fund these expenditures. Government incurs a wide variety of expenditures, every one of which needs to be paid for. The Union Budget lays out the sources of funding for government’s expenditures. This is usually in the form of proposals related to taxation of different forms. Announcements are made regarding tax structure and levels of taxation. As part of the Budget, government also makes certain policy announcements. These too, incidentally, take the form of government’s approach to taxing individuals and corporations.

As the expenditures of the government typically exceed its tax revenues, the government usually also indicates its borrowing plan. This is usually indicated by the Fiscal Deficit. The larger the fiscal deficit, the more the government will need to create new money or borrow from the markets.

An important supporting document usually released just before the Budget is the annual Economic Survey. This document is put together by the Ministry of Statistics and Programme Implementation through the different statistical bodies working under it. The Economic Survey presents the state of the economy in terms of the total output of goods and services in the just-concluding fiscal year. The MSPI also comes up with projections on various macroeconomic indicators, the one most watched out for is the GDP growth estimate for the coming fiscal year, i.e., the year for which the Union Budget is being presented.

The perceived relevance of the Union Budget

Ordinary people look to the budget to know how much tax they are going to bear in the year ahead. Business houses look out for policies that would particularly impact the businesses they are into or plan to enter, specifically through proposals related to taxation. Economists study the Budget in terms of the macroeconomic consequences of its implementation. That means looking out for the impact of policy initiatives on key economic indicators such as growth, inflation, unemployment, etc.

Is the budget relevant to the common man?

Of course it is. It tells people how much of their income they get to keep and how much will be taken away by government. The common assessment of the budget is largely in terms of who will be benefited by it and who harmed, and by how much. A broader assessment of the Budget is in terms of the macroeconomic effects of Budget proposals. Typical analysis looks at which sectors and industries would be benefited by the budget proposals and which ones adversely affected, in what way and to what extent. Even broader analysis looks at GDP growth estimates, the impact on the economic climate and key economic variables like money supply.

How to judge a Budget?

Every affected party typically evaluates the budget in terms of the impact on him. Those who carry a relatively larger burden typically deride the budget while those who are relatively less burdened or benefited praise it. Economists judge it is terms of the extent to which it addresses what they see as the key macroeconomic issues of the day. An economist who sees slow growth as the problem would judge it according to the extent to which it will accelerate growth.

How do we judge Budget 2013-14?

In simple terms, it is a bad budget. Frankly, any budget that does not show zero expenditures and hence zero revenues is a bad budget. The best that one can say about this and any budget is if it indicates an intention to slowly roll back government expenditure to the point where it eventually just does not exist and therefore government has no need to identify sources of revenue.

Why do I say this?

Government spending money is nothing more than a form of intervention in the otherwise free market. Any government intervention in the economy is economically detrimental. Since the Budget is essentially a statement on government’s plans to spend money, and tax and borrow to fund it, thus intervening in the economy at many levels, it is fundamentally bad.

Is this an extreme view?

Of course it is. But then one needs to decide whether an extreme view is necessarily an unsound view. For instance, none of you would argue that I am presenting an unjustifiably extreme view point if I say that a person who wants to stay alive and maintain good health should consistently eat healthy foods and not regularly consume a mixture of healthy foods, unhealthy foods and poison. So, do not be in a hurry to judge what I say as unsound just because it is extreme.

What is the justification for this extreme view?

The free market is the complex of voluntary exchanges engaged in by all individuals. The very fact that every exchange is voluntary means that every individual is ex-ante subjectively better off as a result of every exchange he decides to enter into. Since every exchange leaves every person better off, the sum total of all exchanges leaves every individual at the point of greatest possible well being given his circumstances.

Government intervention in the form of taxation followed by spending, on the other hand, is a form of violent exchange. One individual is coerced into parting with his resources so that government may pass it on to other individuals. While the recipients benefit, the individual who is coerced to part with his resources is clearly worse off. The very fact that the individual is coerced tells us that whatever he may get in exchange for the resources he is forced to give up is valued less by him than what he gives up. Therefore, he is clearly worse off. It is impossible for the economist to square this off with the benefits accruing to the beneficiaries because (the economic concept of) value is a subjective quantity that is not amenable to interpersonal comparison of any kind. So any attempts at cost-benefit analysis of tax and spend policies are essentially economically unsound. The only thing that is certain is that some people are worse off as a result of the intervention. This is in keeping with the fundamental nature of violent exchange as can be seen in the simple case of robbery.

Government intervention through tax and spend policies also diverts resources from private preferences for consumption and investment into consumption according to the political preferences of those in government. It draws society’s scarce resources away from the market where they are applied to the satisfaction of the ends most valued by all individuals. These resources are no more available for consumption and investment by individuals and the economy is consequently adversely affected.

Yes! Government does build roads and bridges and other things that we call infrastructure. It does run schools and hospitals. It does engage in a wide range of welfare activities. But the important point to note is that none of these was voluntarily preferred by the people who constitute the market. If they had, there would have been no need for government to fund them by coercively taking away private resources. Anyone who wants to argue based on the positive effects of government spending would be well reminded of Frederic Bastiat’s point about the seen vs the unseen.

While it is tempting to look at the roads and bridges built, the schools and hospitals run and the poor fed and clothed by government’s spending, it is also important to look at what the individuals whose resources were coercively taken away would have done with these resources had they not been taken away. All the spending and the consequent production in those lines, the spending and production that never happened but would have happened, is the unseen that we should take note of.

As Bastiat notes in the example of the baker whose shop window is broken by a stone throwing vandal, society is a net loser in such cases because while the breaking of the window results in income and employment in the glass making and allied industries, some other industry where the baker would have spent the money he spends to mend the window loses income and employment. The baker now has only a shop window. Had the window not been broken, he would have had the window AND whatever else he would have spent on, say a suit. From an economic perspective, we can clearly see that society is a suit less as a result of the broken window.

Anyone claiming that the government’s spending and the subsequent spending of the income by the recipients of the government’s largesse has beneficial effects would essentially be engaging in a modern instance of the Broken Window Fallacy.

Further, it is important to note that all government expenditure is fundamentally consumption. The mere building of structures and implements does not constitute investment from an economic perspective. If I build a pathway to beautify my garden, it would constitute consumption and not investment, unless of course I plan to capitalise it when I sell the house subsequently. Similarly, for the government functionary, the dam or the road is an end in itself and not a means to another economic end (though it is indeed a means to a political end – more public support and a longer stint in power).

Conclusion

Like every government budget presented thus far, Budget 2013-14 too is an exercise in interventionism. The Budget is fundamentally a political and not an economic document. It is just a refined way of adding gloss to the Broken Window Fallacy and justifying unsound economic policies. It only lays out whom the government plans to enrich at someone else’s expense. It is a sophisticated cover for the government’s essentially violent actions aimed at redistributing wealth according to the preferences of those in power. The sooner finance ministers get down to the job of reducing government expenditures systematically, preferably with the aim of bringing them down to zero, the sooner we will be on the path of greater well-being for all.

GDP – A poor and misleading economic indicator

GDP or Gross Domestic Product is the most popular concept used to quantify the total output of goods and services in an economy. It is the sum total of the value of

  1. Private spending on consumers’ goods
  2. Private spending on durable capital goods (like plant & machinery)
  3. Government spending
  4. Net exports (Exports (X) – Imports (M))

The figure thus obtained would be called Nominal GDP or GDP at current prices. However, one of the primary uses of GDP is to compare economic output across different time periods. In such a comparison, we need to bear in mind that

Value of spending = Volume x Price

So, Nominal GDP can go up from one year to the next due to 2 reasons

  1. Increase in the volume of goods and services produced
  2. Increase in the prices of goods and services produced

Spending more for the same volume of goods and services does not indicate greater well-being. Therefore, to make GDP a measure of well-being, it is considered essential to adjust the Nominal GDP figure for the increase in prices that occurred from one period to the next.

This is called the inflation adjustment of GDP and the resulting figure is called Real GDP or GDP at constant prices. With this, economists feel that they have a good measure to track improvement in human well-being through the greater production and consumption of goods and services. The GDP growth rate figures we read about in newspapers and magazines are nothing but percentage changes in this Real GDP figure from one year to the next.

Why GDP is considered important

GDP is supposed to measure the total output of goods and services in a certain geographical region. The logic is that the more we are able to consume, the more ends we are satisfying as human beings and therefore the better off we are. Rich people (and rich nations) consume more while poor people (and poor nations) consume less. In fact, this is the reasoning behind using Per Capita Income (PCI) calculated as

PCI = Real GDP/Population

as a measure of the income of individuals in a geographical region. Typically, rich countries have high PCI and poor countries have low PCI.

Is GDP a good economic indicator?

GDP is definitely a popular and the most commonly used measure of economic output. Governments across the world, their economists and statisticians and even those in academia use it extensively a measure of economic output and prosperity. Despite all its popularity, however, the concept GDP is a deeply flawed measure of economic output.

Explaining why GDP is a very poor economic indicator

{This is going to be a fairly long explanation. So do bear with me and stay on and read it all (if you have come this far). I am taking as much effort as possible to keep it simple.}

Understanding the organisation of production

Consider an economy that uses silver as the money, where the unit of the money is 1 ounce of silver (1 oz = 31.1034 gms). Let us say that in this economy, the total output of consumers’ is goods is 100 oz. Clearly, these consumers’ goods have to be produced for people to consume them. Let us further say that these consumers’ goods were produced through a production process involving 6-stages of transformation. Of these 6 stages, only one stage, which we label Stage 1, churns out consumers’ goods while the others produce producers’ goods that are further transformed in subsequent stages to eventually get transformed into consumers’ goods in Stage 1.

Any production process uses 3 types of producers’ goods (also known as factors of production) – Land, Labour and Capital Goods. Of these, Land and Labour are considered the Original Means of Production while Capital Goods are understood as Produced Factors of Production. In our stylised view of the economy, Stage 6 (the stage farthest from the stage of consumption) applies only Land (L6) and Labour (l6) to produce a Capital Good. Let us label this CG5. In Stage 5, CG5 is applied along with more Land (L5) and Labour (l5) to produce a further Capital Good, CG4. Generalising this, in Stage i (i >1), CGi, Li and li are applied to produce CGi-1 till eventually, in Stage 1, CG1, L1 and l1 are applied to produce Consumers’ Goods worth 100 oz.

This may be summarised in an even more stylised form as shown below

Stylised representation of a 6-Stage Production System

Please note that in this construct, each capitalist is buying the services of the capital good and not the whole good itself. A simple instance of this is that land used in production is rented and not bought. This, however, does not present a challenge to economic theory, as the price of the whole capital good is just the net present value of its future rentals. Let us now assume the following table of prices of factors of production (their services).

Table 1 - Prices of Factors of Production

So, we see that the capitalist in Stage 1 gets 100 oz upon sale of his consumers’ goods but he immediately turns around and spends 95 oz on buying factors of production so that he may produce the next period’s consumers’ goods. This 95 oz is the saving made by the Stage 1 capitalist period after period. The same is true of capitalists in all stages. The table below illustrates the income and saving by capitalists in every stage of our 6-stage production system.

Table 2 - Prices of Factors of Production

The time element in production

One important aspect of production that is mostly ignored is the time taken to produce. All production takes time. We should not get misled by the fact that at the time consumers’ goods are being produced in Stage 1, producers’ goods are being produced in every other stage. These producers’ goods are intended to and will eventually be transformed into consumers’ goods in subsequent periods. If we take the time taken in each stage to be 1 year, the table below illustrates the important time element of production.

Table 3 - The Time Element of Production

We see that in order for 100 oz worth of consumers’ goods to be available now (Year 0), it is necessary that the Stage 6 capitalist should have initiated a round of production of CG5 6 years ago. Similarly Capitalists in stages 2 to 5 should have initiated a round of production of their capital goods 1 to 5 years ago respectively. In other words, the production process for the consumers’ goods that we buy today started 6 years ago. If those capitalists had not started the production process 6 years ago, we would have no consumers’ goods to consume today.

Similarly, the capital good of which the capitalist in Stage 6 starts production now becomes a consumers’ good only 6 years from now, i.e., at the end of year 6. At the end of each year, the capital good produced moves to the next stage of production till it comes out as a consumers’ good 6 years later.

Alternatives in organising production and the role of the capitalist

There are 2 ways in which this production can be organised.

  1. Joint ownership of the factors of production – In this case, the Land and Labour factor owners jointly own the capital goods till the last stage where they become the owners of the final consumers’ good at the time of sale. In this case, they will have to wait until the final sale to earn an income and be able to consume.
  2. Capitalist ownership of the factors of production – In this case, capitalists at every stage advance money (from their saved capital), and get to own the factors of production (their services in our construct) and hence the output of their stage. Further, the owners of Land and Labour factors get to consume right at the beginning of the process while the Capitalists do the waiting till the end of their stage.

Case 2 is the almost universal one, especially in more advanced economies. The important point to note is that the Capitalist in the production process plays a very important role. He offers his capital (created by prior savings or deferral of consumption) to factor owners and thus makes production without waiting (to consume) possible for others. For instance, the capitalist in Stage 1 offers savings of 95 oz (80 for CG1 and 15 for L1 and l1) and applies them to produce consumers’ goods worth 100 oz. This division of roles makes organised production more possible. The capitalist’s offer of his capital is made at the beginning of each stage while he gets income from sale of the output of his stage at the end of his stage.

The source of factor incomes and the importance of Capitalist Saving

A common misconception in economic theorising is to treat the economy as some kind of circular flow. This error is especially committed by proponents of the Keynesian School of Economics. This erroneous view leads most people to imagine incomes to factors of production as originating from consumers’ spending. The image many carry in their mind is of the capitalist getting income from the consumer and passing it on to factor owners while doing little himself and pocketing a portion of the income (some like the Marxists claim unfairly).

What really happens, as we have seen in our example, is that incomes to all factor owners come, not from consumer spending but from capitalist saving. This is true of every stage of production where the capitalist of that stage offers his savings to factor owners to make that stage of production possible without further waiting by the factor owners. Each capitalist at every stage makes a saving at the start of each round of production to buy the services of the factors of production, including those of capital goods produced in the previous stage. The table below illustrates this. Row 3 represents the Year with 0 standing for “now” and –i standing for i years ago.

Table 4 - Timing of Income and Saving of Capitalists at all stages

In the real-world case of a production system that produces 100 oz worth consumers’ goods every period, we see that such a production system is possible on a sustained basis only if the capitalists of all 6 stages keep engaging in the same saving period after period. In this specific example, the total saving required is (95+76+57+43+28+19) = 318 oz.

Without this saving, the production process will soon come to a standstill and there would be no consumers’ goods output to buy and consume. This total savings by all capitalists, also called Gross Savings, is the true measure of the magnitude of economic activity. While it appears as though adding together the savings of different stage capitalists involves some double counting (the payments made for CG2 are already included in the price of CG1 and hence of the consumers’ good), the error in this notion is that it fails to account for the fact that at any point in time, the payments made in different stages become part of the value of consumers’ goods output of different periods. For instance, while the Stage 1 capitalist gets 100 oz for the consumers’ goods offered now, the 95 oz that factor owners get now is for the 100 oz worth consumers’ goods output of Year 1. Further, it completely glosses over the fact that it is the cumulative saving by ALL capitalists that makes sustained production possible. The charge of double counting is therefore completely unjustified.

Under this system of thought, the total output of the production system is the total payments made at all stages of the production system, i.e., consumers’ goods payments of 100 oz + gross savings of capitalists, i.e., 418 oz. We may call this figure Gross Domestic Expenditure (GDE).

What is really wrong with GDP

Given this complexity of a capitalist system of production, the concept of GDP takes into account only the payments made by consumers and those payments by capitalists that are for durable capital goods. In our construct, since every capitalist buys only the services of capital goods and not whole capital goods, GDP in this system would be just 100 oz (the amount spent on consumers’ goods).  This view completely misses out the total advances made by capitalists towards the purchase of the services of capital goods, land and labour. By doing so, it misses out the heart of a capitalist economy and hence tells us very little about the real magnitude of economic activity.

Thus, we see that GDP is a highly deficient measure of economic output.

Things get worse for GDP

The onset of a recession is always marked by a spike in interest rates and a consequent sharp drop in spending in remoter stages of production. This results in a fall in spending on consumers’ goods, which manifests itself as a drop in GDP. Many modern governments looking at this and guided by Keynesian macroeconomic theory say “Hey! GDP is falling. So let the government spend more and boost GDP and thus income. After all, Y = C + I + G + X – M. If I has fallen inexplicably and C too as a result, then higher G will make up for these.” So governments spend more and boost GDP. A general feeling of economic recovery spreads. The truth, however, is that while GDP might go up, GDE still remains low because boosting GDP does not influence the underlying factors that caused capitalist spending on production in remoter stages to drop. The economy remains moribund or, worse, the recession deepens.

The conclusion

GDP is a poor measure of economic well-being. It does not even measure economic output well. To make matters worse, it is even misleading and guides policy makers towards wrong-headed policies. The sooner we get over this misplaced faith in GDP as an indication of economic well-being, the better off we will all be.