Author Archives: Bala

The Coal Pricing Dispute between NTPC and Coal India – The real issue

This video sheds some light on an interesting issue that is playing out in the real world. The simple question at the heart of this complex discussion is

“How should the correct price of coal be determined?”

Another issue underlying the ongoing search (as illustrated in the video discussion linked above) for an answer to this important question is that the correct price depends on the quality of the coal being supplied. As seen in the linked video, the dispute between Coal India Limited (CIL) and NTPC fundamentally focuses on the correct way to determine the quality of the coal being supplied as a means to determining the correct price of the coal being supplied by CIL to NTPC.

What I am not going to do in this article

I am not going to analyse the arguments given by NTPC, CIL and the different experts weighing in on the matter and come up with my own wise formula for the pricing of coal.

Why I am not going to do that

Simply put, attempting to come up with my own wise formula for the price of coal would be rather presumptuous on my part. I would actually have to pretend that such a formula makes sense. The truth is that any such attempt is fundamentally unwise and is therefore bound to be incorrect.

What I am going to do

I am going to use the very existence of this dispute to highlight a fundamental and very important economic point – that the market process is the only correct way of discovering the correct price of any good and that any attempt at coming up with a number that is supposed to denote the correct price is necessarily going to be arbitrary and that there is no way of knowing whether the number so identified is the correct one. I am also going to use this understanding to identify what would be a sensible solution to situations of the kind that NTPC and CIL find themselves in.

What is price?

Price is the ratio of the quantities in which the two goods that constitute an exchange are exchanged. If 3 horses are exchanged for 267 barrels of fish, the price of a horse is

Phorse    =    Number of barrels of fish/Number of horses
             =    267/3 barrels of fish per horse
             =    89 barrels of fish per horse

If 3 horses are exchanged for Rs. 6 lakh, then the price of a horse is

Phorse    =    Number of units of money/Number of horses
             =    Rs. 6 lakh/3 horses
             =    Rs. 2 lakh per horse

What determines the price of a good?

The price of any good is determined by the subjective valuations of all the individuals who participate voluntarily in the market process. Every individual enters the market with a value scale on which different goods and multiple units of the same good are ranked. The immediate outcome of this is that for every unit of a good, every buyer has a certain maximum buying price above which he does not have a demand for that unit of the good while every seller has a minimum selling price below which he is not ready to supply that unit of the good. This combined with the Law of One Price translates into saying that at every hypothetical price that one may take up, every buyer demands a certain quantity of the good in question while every seller is ready to supply a certain quantity of the good.

This array of quantity demanded or supplied by an individual at every hypothetical price is what we understand as the individual demand or supply schedule. Since the individual demand and supply schedules only specify the quantity of a good that that individual demands or is ready to supply at every hypothetical price, it is both possible and meaningful to add the individual quantities demanded and supplied by every individual at every hypothetical price into what we may call a market demand and supply schedule for the good. The market demand and supply schedules tell us the total quantity that all the individuals who participate in the voluntary market process put together demand or are ready to supply at every hypothetical price.

Economic reasoning helps us identify two very fundamental laws that help us understand a basic feature of these market demand and supply schedules – The Law of Demand and The Law of Supply. These may be stated and understood as below.

  • The Law of Demand – At a higher hypothetical price, the total quantity demanded will be the same or lower. Conversely, at a lower hypothetical price, the total quantity demanded will be the same or higher.
  • The Law of Supply – At a higher hypothetical price, the total quantity supplied will be the same or higher. Conversely, at a lower hypothetical price, the total quantity supplied will be the same or lower.
  • From these laws, we see that at sufficiently low hypothetical prices, total quantity demanded would be more than total quantity supplied while at sufficiently high hypothetical prices, total quantity demanded would be less than total quantity supplied. At some price in between, demand will be equal to supply and the market is said to be cleared. This hypothetical price which emerges through a market process is called the market clearing price. At any price other than the market clearing price, mismatch between quantity demanded and supplied would drive the price back towards the market clearing price, which is therefore also understood as an equilibrium price.

    Thus we see that individual valuations work through a complex market process to ensure that a particular price emerges or is discovered for each good. These individual valuations cannot be known to any individual or data collection mechanism. They are known only through the preferences demonstrated by individuals in actual voluntary exchange. Therefore, the correct price of a good cannot be known to any individual. No amount of experience, expertise or computational capability can replace the market process and come up with a correct price.

    The additional complexity in the discovery of prices of producers’ goods

    The process described above explains the discovery of the prices of consumers’ goods, i.e., goods that immediately and directly satisfy human ends. Producers’ goods, however, are a more complex affair as they are valued not for their own immediate usefulness in satisfying human ends but for their usefulness in eventually churning out consumers’ goods. For instance, coal is valued not for its immediate usefulness but for its usefulness in operating thermal power plants which produce electricity which is in turn valued because it may be further transmitted and distributed for consumption either in further production or in running appliances like bulbs, fans, air-conditioners, televisions, microwave ovens, mixers, grinders and a whole host of home appliances that immediately and directly satisfy human ends.

    Producers’ goods are valued by producers. A producer produces to further exchange his output for monetary revenue, which in turn would help him obtain consumers’ goods to satisfy his own ends. Economic theory explains that the valuation of producers’ goods in done by every producer based on his estimate of the contribution of the marginal unit of a given supply of a producers’ good to his revenue. This concept, called the Marginal Value Product or MVP is imputed backwards by the producer based on his subjective assessment of the quantitative relationship between the marginal unit of the supply of the producers’ good and the revenue obtainable from the sale of the final consumers’ good (called the production function).

    Economic theory demonstrates that every producer whose subjective imputed assessment or MVP of a given supply of a producers’ good is greater than a hypothetical price would have a demand for the producers’ good at that hypothetical price. A fundamental economic law known as The Law of Returns demonstrates that the relationship between the MVP and the quantity of any producers’ good would take the form of a downward sloping curve. In other words, it establishes that the Law of Demand as defined for consumers’ goods works just as well for producers’ goods, i.e., at higher hypothetical MVP, quantity demanded of any producers’ good would be lower while at lower hypothetical MVP, quantity demanded of any producers’ good would be higher. The downward sloping MVP curve thus becomes the downward sloping demand curve for the producers’ good.

    Economic reasoning further establishes that the opportunity cost of supplying a produced producers’ good is zero, which would result in a vertical supply curve for the producers’ good. The interaction of the downward sloping demand curve and the vertical supply curve establishes the market price of the producers’ good.

    Summarising the complexity in discovering the prices of producers’ goods

    Prices of producers’ goods are also eventually determined by the subjective valuations of all the individuals who constitute the market. Their valuations as consumers determine the market prices of consumers’ goods. Their valuations as producers based on their subjective assessment of the demand schedules of consumers’ goods further determine the prices of producers’ goods. So we see that a complex but strong and robust market process based on valuations that cannot all be known to any individual drives the determination of the market price of any producers’ good.

    Why is this process failing to work in the coal market and why are NTPC and CIL engaged in a tussle?

    The reason is very simple. The market process has been disrupted by the establishment of two massive monopolies on the two sides of the coal exchange market. CIL and NTPC are both government entities with a monopoly on the supply of coal and the production of coal-based thermal power respectively. There is therefore no real free market in coal. In the absence of a free market for coal, there cannot be a market process for the discovery of the price of coal. The act of creating these two monopolies is a direct subversion of the market process. Problems related to the pricing of coal are an inevitable outcome of such subversion.

    Citing, as the Chairman of NTPC does in the video, that NTPC is working as per the regulations of the CERC (Central Electricity Regulatory Commission) does not constitute an answer. It is only an example of bureaucratic washing-my-hands-off-the-matter. The claim that pricing should be according to calorific value is also a very poor answer because it is a technocratic solution, not a market solution. A bunch of technical experts sitting together and systematically analysing reams of data does not constitute a market process of price discovery. It still remains a technocratic solution that will necessarily end up as arbitrary number fixing with no connection to the complex market processes that would otherwise determine the price. Government getting in and mediating the discussion will only transform the price that emerges thus from a technocratic solution to a political solution, not an improvement in any sense.

    What would constitute a real solution?

    The real solution would require breaking the monopoly of NTPC and CIL over their respective product markets. It will, in all probability, involve breaking the huge monoliths into multiple smaller pieces and completely privatising their ownership and operations. It would involve government completely renouncing its claims over the underlying resources by transferring them in their entirety to private hands and letting the new owners decide how to operate their individual facilities. It would involve further privatising the entire mechanism of transmission and distribution of power, thus letting the market decide what is the proper price of every factor of production including coal. Clearly, this solution is very challenging and there is bound to be a lot of political opposition to its implementation. That, however, does not take away from the fact that absent a free market in power, pricing of goods like coal will continue to attract controversy and remain a festering problem periodically inviting technocratic and political intervention to throw up inappropriate solutions.

    Related articles:
    Key Concepts in Economics – 3 – Subjective Value to Exchange and Price discovery

    Follow-up on the CAD question – Value of a currency, gold reserves and FRB

    In response to my previous article, Aditya Sood had asked the following question.

    Sir, I have a question. From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past. The fractional reserve is a new thing. So who decided that value of a currency should be de-linked from an underlying commodity? Was it that all countries saw some flaws in that system and decided to shift to a new one ? Or is it that one particular country/group of people enforced it upon the rest ? If yes, how did they manage to convince all the countries about shifting to a new system?

    Also, when this delinking took place, did anyone (economists etc.) see any alarm bells ringing?

    Aditya’s question contains so many clues to the kind of misunderstanding that exists among ordinary people and the extent to which education is required to enable ordinary people to understand the varying grotesqueries of the prevailing system of money and banking.

    Misunderstanding No. 1

    Aditya asks

    From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past.

    The important point to understand is that in the not too distant past, commodities like gold and silver were money. There was no such thing as a currency independent of coins of these precious metals and there was therefore no question of the value of a currency being linked to its gold (or silver) reserves.

    The clue to understanding these lies in understanding how some of the important modern currencies got their name. Take the British Pound, for instance. Ever wondered why it is called the Pound, or more specifically the Pound Sterling? Simply because the unit of money in England in the 1600’s was 1 lb (by weight) of Sterling Silver. 1 lb being a large weight (453.592 gms to be precise), there were other smaller units such as the shilling and the pence that served as the unit of money in smaller value exchanges. Each of these units stood for a definite weight of the same money commodity – Sterling Silver.

    The concept of monetary unit is important to understand while we understand money. The monetary unit is a conveniently chosen quantity of the underlying money commodity. Money is a good like any other good and is one of the commodities exchanged in any trade transaction, it being the generally accepted medium of exchange. Every good in every exchange is exchanged in a certain quantity and so is money. The concept of the monetary unit is a method to specify and identify the quantity of the money commodity involved in an exchange. When the price of a good is quoted as 10 shillings, it means the quantity of sterling silver contained in, say, 10 coins marked 1 shilling each. In this sense, the monetary unit is similar to the unit of measurements like the metre, the kilogram and the litre.

    So, in response to Aditya’s question, it is not that the value of the Pound Sterling was fixed as 1 pound of sterling silver. It was simply that the Pound Sterling was defined as 1 pound (by weight) of sterling silver.

    Misunderstanding No. 2

    Taking the same part of Aditya’s question

    From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past.

    the second important misunderstanding that is visible is that there was no such thing as the currency of a country. There was money, which was largely coins of specific weight and purity of metals like gold and silver, and there were different such units, each of a specific weight and purity and minted at a particular mint. In any economy, multiple forms of money were simultaneously in circulation and there even existed exchange rates among the different currencies depending on their defined weight and purity, the age of the coins and their wear and tear, and, last but not the least, the reputation of the mint itself.

    In America in the 1700’s, for instance, Spanish silver coins were the most popular form of money. The most popular coins of all were the thalers. The name thaler is a shortened form of the longer Joachimsthaler which in turn stood for coins minted at the mint of a Count Schlick from the Joachimsthal or Joachim’s Valley region of Bohemia (modern day Czechoslovakia). These coins flowed into America thanks to the robust trade with Spain, what with large tracts of America then being Spanish colonies (Does The Mask of Zorro remind you of something related?). The reliability of these coins soon made them the most popular coins in trade. Even the Joachimsthaler was later to be upstaged by the even more reliable Maria Teresa Thaler. At the time of American Independence, a choice had to be made as to the unit of money of the newly independent States of America. The unanimous choice was the already prevailing thaler renamed as the Dollar.

    The thaler stood for 371 ¾ grains of pure silver and the dollar too was chosen to stand for the same quantity of the same metal. In effect, it was just a formal acknowledgement of what was already the market’s choice of the money commodity and the monetary unit.

    In addressing Aditya’s question, what we therefore see is that different regions ended up using different monetary units of one or the other of precious metals like silver and gold and that in each region one of these monetary units ended up being predominant due to various market factors.

    Misunderstanding No. 3

    I apologise for quoting the same bit from Aditya again, but it is interesting to note how many misunderstandings are revealed by just 1 sentence. He asked

    From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past.

    The notion of gold reserves being linked to the amount of money in circulation is an outcome of certain banking practices that started becoming prevalent in the late 17th and early 18th centuries. I am referring primarily to the emergence of paper money and demand deposits a money substitutes. The point is simple – paper money as we know it is a relatively recent phenomenon. For a large part of history, gold and silver coins served as the money.

    Paper money emerged in the form of receipts issued by warehouses that stored money proper (gold and silver coins). Over time, these receipts started circulating in lieu of the money proper, the coins in storage. This evolved further into the concept of savings banks which accepted deposits of coins against which they issued bank notes. Savings banks, like their predecessors, the warehouses, charged their clients for the storage of the coins.

    By the 16th and 17th centuries, these bank notes had become widely accepted as money substitutes that could, on demand, be redeemed in the money proper. However, savings banks observed that only a small fraction of their bank notes actually returned for redemption at any point in time. This served as a great temptation for the savings banks to in a practice that is today known as Fractional Reserve Banking.

    Banks started issuing bank notes of cumulative face value far greater than the actual number of units of money proper in storage. The actual reserves of money proper they held was a fraction of the total face value of their own bank notes that they had put into circulation. This is the concept of the fractional reserve underlying the concept of Fractional Reserve Banking.

    Operationally, every Fractional Reserve Bank is fundamentally insolvent. It has made promises that it just does not have the ability to keep. If a bank has a reserve ratio of 10%, any number more than 10% of the total notes emitted coming in for redemption at a time means that the bank has to make public its insolvency and shut down.

    But why did banks risk such insolvency? The reason was that the money could be loaned out at interest and the bank could earn an actual profit in money proper. Basically, banks were getting to earn easy money by lending out other people’s property that had been given to them for safekeeping.

    This system of Fractional Reserve Banking, while temporarily profitable, is not without its consequences. Bank notes emitted thus were offered as loans to producers. Thus, they were injected into the production system as credit expanded beyond the actual pool of available real savings. This was, as is to be expected, accompanied by interest rate depression below the free-market level. In simple terms, as explained out here, this is precisely how the inflationary boom is created. However, as explained by ABCT, the seeds of the inevitable economic depression are sown during the inflationary boom. The economic depression would start with a spate of bank runs, leading to widespread closure pressures on highly inflationary fractional reserve banks.

    Unfortunately, the Fractional Reserve Banking system was also a convenient way for governments to raise resources for their ever-burgeoning spending plans. Fractional reserve banks were therefore able to lobby governments to protect them from the effects of their own irresponsibility. This close, symbiotic relationship between governments and the banking system grew ever stronger through a series of boom-bust cycles throughout the 18th and 19th centuries eventually leading to a system of governments taking control of the system of money by instituting Central Banks and conferring on them a monopoly over the issue of the fiat money and control over the banking system.

    The biggest step in this process was the setting up of the Federal Reserve Bank of the US in 1913 with a monopoly over the issue of US Dollars. The inflationary practices of the banking system under the Federal Reserve’s watch led to the Crash of 1929 and the Great Depression of 1929-1945. Under the pretext of the Great Depression, the US government moved the monetary system further from a linkage to real money such as gold through policies such as outright gold confiscation and devaluing the dollar from 1/20.6 oz of gold to 1/35 oz of gold. The argument cited was that the demand to hold gold was responsible for the Depression. The reality was that the government wanted to put an end to the commodity-based monetary system and free itself from the strict limits imposed on government spending by the laws of economics.

    The US thus moved from a gold standard to a notional gold exchange standard where US citizens could not redeem dollars in gold but foreigners and their governments could. By 1971, however, the situation worsened on account of further inflationary fractional reserve banking and the US was about default on its obligation to redeem dollars in gold to foreigners. That was when the then President Nixon repudiated all obligations of the US government to redeem dollars in gold, thus putting the entire world on a pure fiat standard. The UK had already done so in 1931 leaving the Dollar as the sole global currency.

    This, in short, is how the monetary system of the world transformed from a pure commodity-based monetary system to a pure fiat monetary system controlled by governments through Central Banks and the rest of the banking system. Basically, the banking system followed practices that landed them in trouble and created economic depressions. The blame was steadily and repeatedly placed on precious metals, especially their scarcity, eventually leading to a government takeover of the system of money and the banishment of silver and gold from their market anointed role as money proper.

    What do we learn from this deviation into history?

    It is incorrect to make statements like value of a currency being linked to the reserves held by the government or a monetary authority like a Central Bank. The monetary system of today is essentially the outcome of a systematic though protracted government takeover of a market determined system of money.

    Addressing the rest of Aditya’s questions

    Aditya then asks

    The fractional reserve is a new thing.

    It evolved basically as a way to earn money from nothing and grew by lobbying support from governments that benefited from FRB.

    So who decided that value of a currency should be de-linked from an underlying commodity?

    If one person or entity should be blamed, it is the US government. At a more general level, it is the banking system, Central Banks and governments that, through their machinations, moved the monetary system off a commodity base into a pure fiat system.

    Was it that all countries saw some flaws in that system and decided to shift to a new one?

    No. The commodity-based system of money had no major flaws. In fact, it is precisely the scarcity of precious metals that makes them good monetary materials. Rather, it was that governments and the banking system the world over saw a commodity-backed monetary system as a serious limitation on their inflationary and extravagant ways and foisted an FRB system on the markets. When their system failed (as it is expected to), they blamed the failure on the commodity and used it as an excuse to take control of the monetary system and change it to something that was more beneficial to them.

    Or is it that one particular country/group of people enforced it upon the rest ?

    Not exactly, various governments, in their own ways, encouraged, fostered and finally acted to enforce a pure fiat monetary system.

    If yes, how did they manage to convince all the countries about shifting to a new system ?

    No one had to convince any one. Every government and every fractional reserve bank wanted this system. Since governments were ready to use the power in their hands to make this happen, they did.

    Also, when this delinking took place, did anyone (economists etc.) see any alarm bells ringing?

    There were economists of the Austrian School like Ludwig von Mises who cautioned against these moves but they were largely ignored.

    What we can learn from this

    Most of us carry a number of misconceptions that distort our view of the working of the world. A lot of what we hear from most common sources needs to be questioned if we are to make sense of what is happening in the world around us. History shows us that those who are in charge of the system of money and banking are themselves responsible for the key monetary and economic problems of the day. Unless we grasp this fundamental issue, we will find it very difficult to comprehend true and lasting solutions to serious economic challenges.

    What sense do we make of bad news?

    It seems to be the season of bad news. Here, here, here, here and here with some honourable exceptions here and here, various sectors of industry led by the automobile sector seem to be facing slow or negative growth in the last financial year. What sense do we make of these disparate bits of data coming from different corners of the market?

    Why are auto sales falling?

    Before answering this question, it is important to understand that what we are witnessing is a broadbased fall in sales across the automobile industry, not just in one or two firms. This means that people have, in general, chosen not to buy new automobiles, which in turn means that they have chosen to retain their existing mode of transportation, which could be private or public transportation.

    Second, a significant proportion of automobile purchases (2 and 4 wheelers) in India happens with a bank financing the purchase, usually paying a large chunk (70-80%) of the price. The buyer of the automobile pays for it on a 3-5 year EMI schedule. That people are not ready to borrow in order to finance automobile purchases indicates that either funding is not available as easily as before or has become too costly, or the borrowers perceive greater uncertainty regarding their future income and are therefore reluctant to take up the responsibility of paying for a new vehicle under a scheme of EMIs.

    So, if automobile sales are indeed falling, it must be a combination of these factors
    1. People choosing to retain existing modes of transportation
    2. Funding not as easily available as before
    3. People not ready to borrow now and pay EMI later due to fundamental uncertainty over their own income
    that underlies the problem. But then that raises the further question of why such an outcome should occur, that too across the entire automobile industry after so many years of spectacular, non-stop growth? The answer lies not in an analysis of the automobile industry and its markets but in understanding the broader economic climate in which the auto industry currently operates.

    The economic climate

    Since 2007, the global economy and the Indian economy along with it have been muddling through what is today called The Great Recession and is being recognised as one of the longest periods of economic growth challenges since the Great Depression. On paper, the recession started in December of 2007 and while there are debates about the official end date, the problems that started in 2007 are far from over. Every now and then, a new crisis pops up and there is a mad scramble to contain it. It was Greece a few months ago and it is Cyprus now. Heaven knows what it will be in the near and distant future.

    Like any depression, The Great Recession is just a period of correction that consists of identification of a cluster of entrepreneurial error. In simple terms, a large number of businesses suddenly and surprisingly find that they are and have been producing things that people do not need and are therefore staring at deep losses and capital erosion. As Austrian Business Cycle Theory explains, this cluster of errors is created during the preceding inflationary boom (in this case by the boom of 2001-2007) and is caused by a combination of misleading interest rate signals given to producers, credit injection into the production system and monetary inflation, causing intertemporal discoordination, i.e., a mismatch between consumers’ consumption decisions and producers’ corresponding production decisions.

    That producers en masse suddenly find far fewer takers for their goods, as automobile manufacturers currently do, is a result of this intertemporal discoordination. When this happens, what a sensible producer should do is to understand the economic climate, try to develop a better forecast of what the future, medium and long-term, is likely to look like and adjust production decisions accordingly. This could mean, in some cases, producing less of the good. It could even mean completely ending certain lines of production, i.e., shutting down certain businesses.

    Such decisions are usually accompanied by a lot of pain as many people are put out of employment and, in many cases, will need to reskill themselves to the requirements of the new production structure. This puts further strain on many already struggling businesses leading to more business failures and more people being out of unemployment. While this sounds painful, it is just the market’s way of clearing past production decisions that are not in line with consumer preferences.

    This process goes on till the market clears out all such poor decisions and leaves the production system in sync with consumer preferences. Capital is taken out of the hands of those who made poor forecasts of the future into the hands of better forecasters, i.e., from failed entrepreneurs to successful entrepreneurs. This is the proper point of economic recovery. Further economic expansion would, under a free market, be triggered by fresh decisions to save and add to the capital available to be advanced for production for a more distant future.

    An alternative, equally or more likely in today’s FRB system, is that the banking system interrupts the market’s cleaning up process and initiates a fresh round of interest rate depression through credit expansion and monetary inflation, thus flooding the market with cheap money and cheap loans. This time, however, one would also have to contend with the possibility that such measures are not guaranteed to work like they have in the past. Experiments in the Western world indicate that such attempts have not really led to an economic recovery this time round.


    What the auto industry is going through today could very well be one of the manifestations of the bursting of the bubble created from 2001 to 2007. If people are not buying as many cars as they are producing, it is probably because they do not wish to see producers produce as many cars as they are producing. It is possible that the market is crying for a correction and that producers need to cut-back production to the level customers are ready to support. This is clearly one of the possibilities for any producer. Alternately, producers could place their bets on the RBI, through the banking system, inflating a new bubble through a fresh round of credit expansion and monetary inflation. In this case, they need to hold their horses for the recovery to happen while being prepared to profit the most by being at the vanguard of the recovery.

    Clearly, therefore, each entrepreneur will have to decide which scenario is likely to play out and what is the most appropriate course of action for him. It’s not easy, but no one ever said that operating a business in an environment of uncertainty created by endless meddling in the market would be easy. The times sure are challenging and let’s hope many entrepreneurs do make their way heroically through this economic fog to do what they do best – meet customer needs in the best possible way.

    What we need to take home, and what this article seeks to emphasise, is the point that in many circumstances, having sound economic understanding can help us understand business situations far better than those economically uninformed or ill-informed can. We can also see that cutting through the fog and making sense of complex situations is made possible by a good grasp of sound economic principles. The situation created by falling sales of the automobile industry in India only highlights the point that learning sound economics is a critical prerequisite for any aspiring business manager seeking to create a career out of making effective business decisions in a complex economic environment.

    Understanding the impact of RBI’s Repo and Reverse Repo Rate Cut

    It has happened as expected. RBI has announced a 25 basis point cut in the Repo and Reverse Repo rates. For the less exposed, this means that the Repo Rate has fallen from 7.75% to 7.5% while Reverse Repo Rate has fallen from 6.75% to 6.5%. What does this mean to different people? The segments we cover in this article are Banks, Industry, ordinary people and the broader economy.

    Impact on Banks

    To understand the impact of a cut in Repo and Reverse Repo Rates on banks, it is important to understand the role they play in banking. Repo and Reverse Repo are basically instruments used by the RBI to influence the total monetary base of banks.

    To get a grip on this, it is important to understand how banks work and what the term monetary base means. Banks engage in a practice called Fractional Reserve Banking (FRB). As explained in the linked article, under FRB, a bank lends many multiples of the actual cash in hand. This cash they have is what I mean by monetary base. Clearly, any addition to the monetary base adds to the bank’s ability to make loans by creating money from nothing (as explained in the linked article).

    In India, banks’ monetary base takes 2 forms – CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio). CRR is the amount of actual cash that banks need to hold with the RBI. SLR refers to the amount (by value) of approved securities (government bonds, gold and approved, privately issued financial instruments) that banks are mandated to hold. Currently, CRR is 4% and SLR is 23%. Together, they constitute the monetary base of the Indian banking system.

    However, what CRR and SLR do not cover is the extent to which the RBI can lend to banks. That is covered under the Repo and Reverse Repo. In a Repo or a repurchase agreement, the Repo seller (the bank) sells an approved security to the RBI with the understanding that at a certain date in the future, the bank will buy the security back from the RBI. The bank gets cash and the RBI the security.

    One would expect that this would not influence the monetary base because while the bank gets cash and adds to its CRR base, it loses possession of the security and falls behind on its SLR base and can therefore not lend more. The interesting part is that this problem in the way of expanding bank lending is eliminated by the way the Repo system works.

    Very interestingly, during the term of the Repo, the bank is allowed to count the security thus sold to the RBI as part of its investments to fulfil the SLR requirement. So, the net effect of a Repo transaction is an addition to the bank’s cash reserves without falling behind on SLR requirements. With this, the bank can now engage in much more lending.

    At the end of the term of a Repo, the bank buys the security back from the RBI at a price higher than the original sale price. The difference expressed as a percentage of the original sale price is the Repo Rate. Thus, Repo Rate is used to calculate the price at which the security is bought back by the bank. It is the equivalent of an interest paid by the bank to RBI.

    It might seem that at the time the bank buys the security back, its cash reserve falls. However, the bank can then enter into a fresh Repo transaction and sell the security back to the RBI, bringing the cash reserve back to the higher level. In this manner, Repo becomes a means for the RBI to maintain a steady level of lending to banks.

    But all this additional lending would mean more purchases of securities to meet SLR requirements. This would mean the need to deploy cash for the same. That cash would go outside the system of lending and reduce the system’s lending potential. This problem is solved by what is called the Reverse Repo.

    In a Reverse Repo, the RBI sells an approved security to the bank with the understanding that it will buy it back at a future date at a higher price. The difference between the 2 prices expressed as a percentage of the original selling price (per annum) is called the Reverse Repo Rate. The Reverse Repo Rate thus becomes the interest rate received by the bank for lending cash to the RBI.

    The important point for us to note is that a bank may show securities bought from the RBI through the Reverse Repo window as part of its SLR commitments. Further, as in the case of the Repo, at the end of the term of the Reverse Repo, the bank can enter into a fresh Reverse Repo with the RBI.

    Summarising the understanding

    Bank XYZ hits its lending limit based on its CRR and SLR. It sees potential for more lending. It offers RBI a portion of the securities it holds as part of a Repo transaction and gets cash. It deploys 23% of this new cash to obtain securities under the Reverse Repo window from the RBI, thus keeping the cash within the system. The bank now gets to create new money amounting to 1/(CRR+SLR) times the money borrowed under the Repo window and lend it out at interest. The Repo window thus becomes a cheap source of borrowing for banks.

    The impact of a cut in Repo and Reverse Repo Rates

    A cut in Repo and Reverse Repo rates basically reduces the bank’s cost of borrowing from the RBI to add to its reserves. It enables banks to either increase the interest rate spread on loans made by the bank or offer borrowers lower rates of interest without eating into its own interest rate spread. Thus, a cut in Repo and Reverse Repo Rates increases the banking system’s potential by expanding more loans in a profitable manner.

    Impact on Industry

    With lower repo and reverse repo rates, industry gets to borrow more and even gets to pay lower interest rates on its borrowing. Therefore, those businesses that are in a position to secure additional lending from the banking system will benefit from lower repo and reverse repo rates.

    Impact on ordinary people

    The impact on ordinary people can be felt in 2 ways. In the nearer term, greater lending to businesses will lead to more business investment and employment opportunities. In the medium and longer term, however, the dominant factor influencing ordinary people will be the increased money supply (inflation), which will send prices of consumers’ goods soaring, resulting in future pressure to raise interest rates thus forcing the pricking of the inflationary bubble and the onset of the depression.

    Impact on the broader economy

    In the long-run, reducing Repo and Reverse Repo rates is harmful for the economy as it is just a means to lend reserves to banks, enabling them to engage in far bigger inflation to undertake much more credit expansion through FRB. While this lending will have some short-term positive effects, in the long-run, it creates and worsens the inflationary boom of the familiar boom-bust cycle. It also sets the conditions for the inevitable raising of interest rates thus pricking the inflationary bubble and triggering the depression.


    Thus we see that the policy of reducing Repo and Reverse Repo rates is essentially bad for the economy in the long-run because it greatly aids the creation of the business cycle. It also hurts ordinary people by sending prices soaring. Industry and the banking system, however, benefit in the short run. This explains why a policy of lowering repo and reverse repo rates finds fairly broad-based support from the banking industry and general industry as well.

    The hidden side of RBI’s push for more electronic payments

    In this article, the RBI is cited to be pushing for electronic payments as a replacement for cheques for loan repayments. The obvious explanation is that ECS will eliminate all the time and effort involved in collecting, depositing cheques and then getting them cleared. This is supposed to leave the banking system more efficient.

    What is not stated is the deeper reason for the move – to make people more accustomed to making electronic payments for everything to eventually make the move to eliminating cash.

    Now, cash is a bothersome thing. As long as people have a concept of cash and want it for various purposes, the banking system has to keep some cash. This is the reasoning behind having reserve ratios like CRR and SLR. With these, the bank is supposedly in a position to comfortably meet demand for cash.

    Why does people having a demand for cash make it bothersome?

    If people did not have a demand for cash, there is no operational limit to how much money the central bank and the entire banking system can create. We will then land in Inflationist Utopia where money creation and credit expansion can go on unbridled. That also means that all limits on government spending are eliminated.

    Is it possible that this Inflationist Utopia is RBI’s goal?

    Is MNREGS a significant cause of rapidly rising prices?

    The Financial Express reports thus – ‘Rural wage hike pushing inflation, posing challenge for RBI’. It goes on to quote an Assocham spokesperson thus.

    “Near 20 per cent annual increase in the wage inflation in rural areas is building up price pressures on food articles like cereals, rice and wheat, and is posing a big challenge for the Reserve Bank which is being called upon to cut the policy interest rates on Tuesday,” industry body Assocham said.

    So what sense are we to make of this? Why would rural wages shoot through the roof in this manner? As far as I understand, there are two possible reasons. The first is that agriculture has seen such a tremendous productivity increase that marginal value product of a unit of labour has really gone up 20%. Alternately, as I explained out here, a steady rise in prices is possible only if inflationary policies greatly and steadily increase money supply.

    And over the last couple of years, the Government of India, through various State governments, has really been flooding the rural markets with money through the MNREGS. So should we be surprised that rural wages have increased as much and as rapidly as they have? If we are, then it is time to revise our economics fundamentals. That such an outcome is inevitable could have been known right at the time of conceiving of a scheme like MNREGS. Why then are such policies being pushed? These and many other such tough questions are what we should be asking policy makers, but only an economically literate population can do so.

    Cantillon Effects and the “strange” divergence between CPI and WPI

    This article focuses on a certain divergence between two popularly used measures of price inflation – WPI and CPI – to explain the limited room available to the RBI in cutting interest rates as demanded by many sections of industry. My article seeks to explain that such a divergence is not unusual and in fact normal in an economy driven as much by credit injection through monetary inflation as the economy of today is.

    In economic theory, the term Cantillon Effects refers to the asymmetric distortionary effect of inflation (defined in the Classical tradition as an increase in the money supply) on the prices of goods. In simple terms, an increase in money supply does not lead to a uniform rise in the prices of all goods and services. Some prices rise more while some others may rise less, stay stable or even fall in the face of inflation.

    Why would there be Cantillon Effects of inflation?

    The important point is that money always and everywhere exchanges for particular goods and not for all goods, definitely not for a basket of goods like the ones for WPI and CPI calculations. A good way to understand this is to imagine for a moment that the good Angel Gabriel decides to double the money stock of some good people (while they are asleep) in a certain society. The next morning, this economy sure has greater money supply but the additional money supply is in the hands of particular individuals only.

    The additional stock of money immediately influences the value scales of the particular individuals alone to begin with. The marginal unit of money becomes less valued to these people and therefore a certain number of units of particular goods that were earlier considered less valuable than the marginal unit of money may suddenly appear more valuable than the marginal unit of money. So, these people step out and buy these goods. In economic terms, the demand schedules of these buyers have been influenced and their demand curves have been shifted rightward. The demand curves for the particular goods see a rightward shift as well.

    However, the value scales of suppliers of these goods do not see any change as nothing has changed for the suppliers. This results in an unchanged supply curve, which, in conjunction with a rightward shifted demand curve, will lead to a higher equilibrium price for the particular goods that these people buy.

    In the meantime, demand and supply schedules of other goods remain unaffected and their prices remain unaffected as well. Thus, we see that injecting money into the hands of particular people can raise the prices of some goods while having no influence whatsoever on the prices of other goods. This phenomenon is what we understand in Economics as Cantillon Effects.

    The “strange” divergence between WPI and CPI

    Let us first remind ourselves that we are right now at the end-stage of a previous round of inflation created by an out-of-control fractional reserve banking system. During any such inflationary period, there will be Cantillon Effects of the inflation. In the early stages of such an inflation, the money injected by the banking system into the production structure will necessarily be spent first on buying factors of production including capital goods, land and labour. This spending works its way through the system of production till it lands in the hands of the owners of land, labour and capital as rent, wages and interest respectively.

    Therefore, the immediate effect of the initial inflation is necessarily to raise the prices of producers’ goods, which in turn will cause an index like the WPI to rise while leaving the prices of consumers’ goods relatively unchanged, thus leaving an index like CPI relatively unchanged as well. It is only in the late stages of the inflationary process when the land and labour factor owners and capitalists spend their income on consumers’ goods that their prices and hence CPI go up. At that stage, we may very well witness a rise in CPI being accompanied by a much smaller rise in WPI.

    The kind of move that the article cited above speaks of is therefore nothing unusual and is in fact to be expected in an economy driven by inflationary credit expansion by a fractional reserve banking system.

    Policy implications

    Actually, there are few or no policy implications. Any attempt by the RBI to push money supply up by dropping rates is likely to lead to greater credit expansion through inflationary banking or money injection into the system of production. Therefore, the first effects are once again likely to be on the prices of producers’ goods, i.e., on the WPI. It is only in the future that the effect on consumers’ goods prices will become visible and the CPI goes up again.

    Unless the banking system is completely broken and has no avenues into which credit can be injected, it is certainly possible for the banking system to inject newly created money into the production system. There is therefore little to fear and no reason to argue that the RBI has little headroom in tinkering with interest rates, especially once it has, as has every central bank, chosen the path of inflationary banking.

    How many regulations is too many?

    This article quoting the economist Raghuram Rajan (now tipped by some to be the next RBI Governor) brings up an important issue – that of regulation. Unlike Mr. Raghuram Rajan, I would argue in much simpler terms. The number of regulations is too many if their number exceeds zero. In simpler terms, every regulation is one too many.

    What is regulation

    The word regulation is one of these new-age words that had crept into our vocabulary in a rather insidious fashion. Today, most people look upon regulation as something necessary without which unbridled greed will result in undesirable outcomes. “Some regulation is necessary”, argue most people.

    But what IS regulation? Very simply, it is a set of mandates or restrictions imposed by government on particular sets of citizens. Depending on the particular regulation, the set could become large enough to encompass all citizens. However, the important point to note that every regulation is an act of coercing one or more citizens with the aim of making them follow particular courses of action or preventing them from following particular courses of action.

    So, regulation is coercion. Economically speaking, it is a form of violent exchange. From the perspective of economics, violent exchange lowers overall well-being. The victim of the violent exchange is forced to give up a more valued good for a less valued good or nothing at all. The recipient of the violent exchange clearly benefits, but the impossibility of comparing value across people leaves us with only one certainty. There is loss of utility and well-being to the person being coerced. The rest of it is plain wishful thinking.

    Regulation and the labour market

    This is especially true in the labour market where capitalists can only offer any factor of production its discounted marginal value product, i.e., the present value of its future marginal contribution to revenue. If capitalists are forced to pay more, they will employ less of the factor until the factor price equals its DMVP once again. The result of regulations in the labour market is, therefore, chronic unemployment.

    All forms of labour regulation – minimum wages, mandatory contributions, gratuity, firing restrictions, child labour laws, etc. – raise the costs of employment. Therefore, they are all retrogressive. So, the only real solution is to repeal ALL these retrogressive regulations in the labour market. The only hurdle is the political one. The rest is just playing with words.

    Why are cereal prices high?

    This is priceless. ROFL stuff. Article 1 says that the Central Government is not allowing export prices of wheat to fall below a certain level. That level, incidentally, would make their minimum support price look ridiculous by placing a huge subsidy (that only means much bigger than the current one) burden on government, but that’s my observation, not the article’s. As per the article, it is ministers of the Central Government who are refusing to allow wheat export prices to fall below the prices at which the Central Government sells wheat to biscuit manufacturers.

    And then there is Article 2 that blames State governments for prices not falling and for stocks piling up and rotting in godowns. It even cites economic theory by mentioning that record stocks should send prices crashing down and ends by saying that the fact that they are not must be because of hoarding.

    Ah! There it comes!!! The evil hoarder is responsible for all the miseries of the common man and government is the saviour. Let the crackdown start and let’s have punitive punishment meted out to the greedy people who are ready to watch millions starve.

    Yes! Repeat after me until you really believe it!! Government manipulation of the money supply and its tampering with the price mechanism have nothing to do with high and ever rising prices. If you repeat it enough times, it will become the truth. So repeat it blindly without thinking.

    Economic science is in dire straits

    This article brings out quite well and rather unintentionally a lot of what’s wrong with Economic science in India (and frankly, the entire world) today. Particular points in the article are especially revealing. Take this segment, for instance, where the author gives you a mental image of the typical macroeconomist.

    …. he’ll tell you that he actually studies the impact of soft coal prices in the Ruhr on the velocity of the money supply in West Germany in the 1970s and something else you will never learn because you suddenly hear your phone ring.

    So what IS the macroeconomist doing? He is building a model. A model is a mathematical framework that gives us the values of certain output variables for different combinations of input variables. The model does this by assuming certain mathematical relationships between the input and output quantities.

    Why is the macroeconomist trying to build a model? The primary purpose of modelling is to be able to predict outcomes of actions and choices. To do this, a model first tries to explain observed correlations between the same input and output variables in one or more historical circumstances. The more the number of such instances in which the model makes accurate predictions and the lower the error, the more robust the model is said to be.

    Where would such models be used? One key use of such models is in policy formulation and evaluation. The term policy in particular refers to the particular approach that government would take to the broader economy or a specific segment thereof, which in turn translates to the manner in which government chooses to intervene in the economy or a particular segment of it. Thus, we see that models are primarily used in shaping and evaluating government interventions in the economy.

    Another key use is to help businesses in making better economic forecasts and therefore in making better business decisions.

    What is the problem with this approach?

    The problem is very fundamental. Model building is based on assumptions that are absolutely unsuited to the study of Economics. Every model assumes certain constant quantitative causal relationships between the input and output variables. As a social science that may be defined as the study of exchange, sound economic theory cannot assume any such constant quantitative causal relationships between variables.

    Unlike in the natural sciences where twice the volume of water flowing into a leak-free pipe will mean twice the water flowing out as well, in Economics, the subject of the study is man. The singular trait of man is his unpredictability. No two human beings may be assumed to behave the same way in the same circumstances. The same human being may not behave the same way in the same circumstances at different points in time.

    What this translates to is this – In the natural sciences, if a stone thrown up today falls back to the ground, a stone thrown up in identical fashion tomorrow will fall back to the ground as well. In economics, however, such automatic repetitive and repeatable behaviour cannot be expected because we are talking of people, not stones.

    What models end up doing, therefore, is that they make unreal assumptions about human behaviour in order to make their predictions fit observations at some point in time. The problem in doing so is that past robustness of a model in explaining is no indication of its correctness or its future accuracy. People change, and with that change economic outcomes. Models cannot predict the manner in which people can change.

    Modelling in economics is little different from voodoo. Personally, I like to call it the virgins in the volcano method of economics. In simple terms,

    The model says that there is a strong correlation between the number of virgins that fell down the volcano and the amount of rain that fell every year. So in order to improve rainfall this year, let’s throw a couple more virgins down that volcano right away.

    What we learn is that the very attempt at creating economic models is fundamentally and deeply flawed. What do we say about economics education when modelling is the core of the development of economic science? May I say “Heaven help us”?

    The sad state of the policy on FDI in retail

    [Update: An alternate interpretation of the real estate issue has been added]

    This was a good wake up call back to reality after all the dreaming about the possibility of 100% FDI going all the way to convertibility on the capital account. No! The Indian government is not going to do the economically sensible thing. It will insist on putting spokes in the wheel and hurdles in the path of the eager investor.

    It will burden the capitalist with burdens so big that he will begin to wonder if all the hoopla about the humongous Indian market is worth it at all. It will get down to telling the capitalist how to run his business and where to put his money. It will dictate what goods he may sell, where he may source his goods from and therefore at what cost, thus throwing all business strategies of the capitalist out of the window.

    The simple case of mandatory investment in real estate

    This is from the newspaper article cited today.

    Senior executives and representatives of these companies met government officials in New Delhi this week to lobby for concessions. These included relaxing the local sourcing conditions, making investment in real estate part of the mandatory $50-million investment that foreign retail companies have to make in back-end infrastructure, as well as lowering the minimum investment figure itself.

    The hallmark of a real estate bubble is that property prices go completely out of sync with rental prices of the same property. For instance, when a plot of vacant land that would get a bare rental price of Rs. 3 lakh p.a. has a market price of Rs. 1 crore or more, the market is betting that the prevailing expectation on interest rates is around 3%. This is simply because the market price of the land is nothing more than the discounted present value of all future rental income flows against that property. Given that land rentals are best seen as rentals in perpetuity, the discounted present value of all future rental income flows is nothing but the sum to infinity of a Geometric Progression with
    • initial term (a) = Rental Price of land/(1+i/100) (Year 1 rental comes at the end of the year in the basic model)
    • common factor (r) = 1/(1+i/100)

    Market price of land = {Rental Price/(1+i/100)}/{1–(1/1+i/100) or

    Market price of land = Rental Price/(i/100)

    So a market price of Rs. 1 crore given a rental price of Rs. 3 lakh implies an expectation that

    i = (3 lakh/1 crore)*100 or 3%

    A 3% nominal rate of interest when price inflation is estimated anywhere from 6% (based on WPI) to 11% (based on CPI) means negative expectation on real interest rate. If ever you could say B-U-B-B-L-E, it is under such circumstances.

    So, given that there is indeed a bubble in real estate, it is eminently possible that a multinational that specialises in the business of retail and is focused on keeping costs as low as possible as part of its business strategy would clearly have reasons to prefer leasing to buying, especially if it can get the requisite security of tenure. If, on the other hand, it is forced to invest in Real Estate, there is clearly less capital left to invest in other aspects of the business. In this manner, government actually gets to tell the retail chain where to put their capital.

    A company whose core competence is running a chain of retail supermarkets through leased real estate would hardly consider it its core competence to make profits through real estate plays. By forcing the retail chain to play the real estate game, government is actually dictating their business strategy. Someone tell me what sense this makes!

    [Update] – It may also be interpreted that these retail chains are asking to be allowed to include their real estate investments as part of the mandatory $50 million that they have to invest in back end infrastructure. If this interpretation were correct, then all they are trying to do is to free themselves from other mandatory investments and leave themselves free to make the rest of the investments most in keeping with their business plans. Not allowing them to do so, however, will still remain another way of dictating investment terms to the investing capitalist. I fail to see how this makes sense at all.[Update ends]

    30% mandatory local sourcing hurts the Indian consumer

    The policy on FDI in retail includes a mandatory requirement of 30% local sourcing. If the retailer prefers to source from suppliers in other countries, it implies that suppliers in this country are overall less efficient and involve greater cost for the retailer. Protecting local industry in this manner automatically implies hurting the local consumer burdening him with higher costs. In the name of protecting the Indian manufacturer, this policy hurts the Indian consumer.

    To make matters worse, it is a classic case of Bastiat’s dictum of the seen vs the unseen. The employment that is created in the lines of production favoured by the policy is very visible and is seen. The employment destroyed in the industries that are disfavoured because the consumer now has less disposable income and is therefore unable to spend on those is unseen and can never be known or estimated, though it is very real.

    The most one can say is that the spending caused by the policy is forced upon the consumer while the unseen spending that the customer would have engaged in would have been volitional and would hence have left him better off. That he would be better off is a logical necessity as the very use of force indicates that the option being forced is valued less by the consumer for if it weren’t, the force wouldn’t be needed in the first place. Thus, in economic terms, the policy of forced local sourcing leaves the Indian consumer worse off.

    Time to review the policy

    If the government wants to do something good for Indians in general, it needs to reconsider its policy on FDI in retail and allow foreign capitalists to invest as they wish to and stop dictating terms to them.

    An economic depression is not a bad thing

    Most people I speak to think that an economic depression is a problem that needs to be solved. Take a look at this article, for instance. This notion is far from correct. An economic depression is a period of necessary correction. An economic depression is necessarily and always preceded by an inflationary boom.

    The real problem is the inflationary boom for which the bust is the cure

    During the boom, policies targeted at interest rate depression allow the banking system to expand credit way beyond the available pool of real savings. This results in massive investments into projects that never would have been invested in on the free market. At the very least, new investments would need to be accompanied by
    1. additional net saving by consumers
    2. movement of capital from lines of production of other less preferred goods
    These prevent the possibility of an inflationary boom. These conditions are a logical necessity for the new investment to happen.

    However, an inflationary boom creates malinvestments. The process of creating the inflationary boom necessarily also includes the pins required to prick the bubble at some unexpected point in time. When this happens, the market reassesses all the investments made and sorts them into good and bad investments. This is done through the profit/loss mechanism and made explicit through the phenomenon of business bankruptcy. While this process involves pain, without it, the market cannot realign investments to be in line with consumer preferences, especially across time periods.

    Economists would say that the boom causes intertemporal discoordination while the bust corrects those errors and brings about the highly necessary intertemporal coordination once again.

    The free market is capable of keeping the inflationary boom in check

    Even if the banking industry or a segment of it were to engage in fractional reserve banking by emitting far more paper, plastic and electronic forms of money than the real money commodity that they have on hand, the free market has a built-in mechanism to keep this under check. This is called bank failures.

    Let us take, for instance, a region that uses dollars defined as a 1 ounce coin made of sterling silver as the unit of money. If a bank with $1 million in real dollars issues $10 million in paper dollars, the over-supply of paper dollars can easily be identified by the market. Further, the fact that on this market, every bank’s notes would be clearly identified with the bank (they would be printed as XYZ bank notes) and the market would easily be able to establish different rates of discounts for notes issued by different banks.

    A more inflationary bank’s notes would be more deeply discounted than the notes of a less inflationary bank. Prices of goods might be quoted in dollars but one would have to fork out more $1 notes of an inflationary bank than the quoted dollar price. For instance, if an inflationary bank’s notes faced a discount of 50% on the market, a customer wishing to buy a good priced at $50 by paying in notes of the inflationary bank will need to fork out notes of $100 face value. If the discount were 75% because the bank is perceived as highly inflationary, he will need to fork out notes of $200 face value. Thus, the greater the inflationary condition that the market sees in a bank, the less valuable would be the money substitutes emitted by the bank.

    Further, the more inflationary a bank is assessed to be, the more likely it is to be brought down by note and deposit holders walking into the bank’s branches and asking for real money in exchange. While this could be due to a loss of trust in the bank, it could also be because a trusting customer has issued a cheque to the customer of another bank that is asking the inflationary bank to pay in real dollars (which it does not have).

    Such failures of fractional reserve banks would lead to a more cautious public wary of inflationary fractional reserve banks. Fractional reserve banks would then have to incentivise people to place money in their accounts, which in turn would raise the cost of their funds available for loans. In addition, being rated as a non-inflationary bank would make a bank more attractive to a public seeking greater safety of their money. In this process, the very service of getting rated on inflationary practices would become a valuable service that could be offered by rating agencies. Thus, we see that on the free-market, there exist many possibilities of mechanisms to keep fractional reserve banking in check.

    If fractional reserve banking is in check, so is the inflationary boom. Thus, we see that an inflationary boom of the kind that we see today is impossible on the free market and that it is only fractional reserve banking with no market controls that causes the inflationary boom.

    When we will encounter massive inflationary booms

    Massive inflationary booms necessarily require massive interventions that prevent the functioning of market mechanisms. These typically take the form of government action aimed at protecting the inflationary segments of the banking industry. Today, these take the following forms
    1. Central Banking with a monopoly on money issue and bank licensing
    2. Central Banking as a source of lending of last resort to failing banks
    3. Deposit insurance that is politically motivated and priced
    4. Legal tender laws that force acceptance of inflated money substitutes at par
    5. Capital gains taxes on alternate forms of money
    In the absence of these forms of protection, it is impossible for a fractional reserve banking system to become as prevalent as it has become today.

    The conclusion

    We need to stop fearing or hating the economic depression. What we really need to be wary of is the inflationary boom that forces the pain of the bust on people at large. We also need to fear all the interventions that make the inflationary boom possible and the periodic pain of the depression a “necessary” feature of our lives.

    How inflationary banking creates economic depressions and recessions

    In response to my post of yesterday , a student of mine, Sankalp, had asked this question to which I responded thus. Sankalp raised an important point that I am sure a lot of people believe. With a little elaboration from my side, his question becomes this

    What is the problem in banks being inflationary by nature if by engaging in such inflation, they will be able to lend much more and a lot more investment can happen? Would not an economy where lending is constrained by the actual amount of cash experience highly hampered growth in comparison?

    Ordinary people see no problem in this state of affairs. Those with an exposure to mainstream economics would in fact jump to a fierce defence of this system and argue that growth would become highly constrained if the banking system were to allow cash to sit idle in the bank’s vaults while thousands of investment-worthy projects gather dust and go to rust.

    The Austrian School of Economics in the tradition of Carl Menger, Böhm Bawerk, Ludwig von Mises, Friedrich Hayek and Murray Rothbard takes a radically different view of this situation. Austrian School economists explain that the much dreaded economic depression (including its modern semantic avatars, the economic recession, slowdown, downturn or whatever you wish to call it) is caused by the inflationary banking system.

    The explanation, known by the name Austrian Business Cycle Theory, originated in the work of Ludwig von Mises in his book, The Theory of Money and Credit (1912) and was further developed by his student, Friedrich Hayek, in his books Monetary Theory and the Trade Cycle and Prices and Production. In fact, Friedrich Hayek went on to win the Nobel Prize in Economics in 1974 for his Business Cycle Theory, the only Austrian School economist to do so till date.

    The brief version of Austrian Business Cycle Theory

    In an earlier post, I had presented a stylised representation of a production system in which the original means of production, labour and land, are applied across various stages of production and eventually transformed into consumers’ goods. We saw in that case that the consumers’ goods output worth 100 oz was made possible and supported by a total capitalist saving of 318 oz.

    What would happen if consumers were to decide to save 20 oz? Two things happen.
    1. Consumption now falls to 80 oz
    2. Capitalist savings go up to 338 oz
    But what is the use of greater saving being available from capitalists when people have decided to consume less? The trick is to recognise that saving is a deferral of consumption, not permanent abstinence from consumption. In simpler terms, the saving is intended as future consumption. Saving is a decision to change the time of consumption.

    This decision by consumers gets communicated to producers through a fall in the rate of interest. Producers take a cue and decide to rejig their production for a more distant future. In doing so, the production system becomes longer, with more stages of production. Hayek presented this in a highly stylised form using what are today known as Hayekian triangles as shown below.

    Fig 1 - Hayekian Triangles representing the effect of new capitalist saving on the structure of production

    Originally, a total saving of 160 oz churned out an output of 80 oz worth consumers’ goods. Now, a total saving of 180 oz churns out an output of 60 oz worth consumers’ goods. In our 6-stage production structure, a similar outcome would occur with a corresponding increase in the number of stages of production.

    Many outcomes result. The immediate fall in demand for consumers’ goods leads to a fall in their prices. This is transmitted up the production structure, but the lower consumption does not put factors out of employment. The lower interest rate causes remoter stage capital goods prices to rise on account of much lower discounting (lower interest rates) of their imputed future contribution to revenue (called their discounted marginal value product). In the long run, greater availability of savings results in increased demand for factors in remoter stages of production.

    The addition of stages implies greater specialisation and division of labour implying more efficient production thus leading to greater volume of consumers’ goods output in the future. This leads to a further fall in consumers’ goods prices in the future. However, when the greater output of consumers’ goods hit the market, the saved funds are now available to support their consumption. For the same 60 oz of spending, consumers get to consume the greater output of the longer and hence more efficient production system. This is the normal process by which an economy advances and standard of living improves.

    Inflationary credit expansion and the production structure

    When the banking system inflates money supply, it does so by injecting credit into the production system in the form of loans made to producers. This injection, however, takes place without saving by consumers. An injection of 80 oz of credit makes the production structure as long as in the earlier case with the 80 oz of consumers’ goods output being supported by a total apparent capitalist saving of 240 oz.

    Fig 2 - Hayekian Triangles representing the effect of credit injection through monetary inflation on the structure of production

    To achieve this credit expansion, the banking system will need to depress the interest rate. This lowered interest rate raises the prices of remoter stage capital goods as in the case of real savings, shifting factors of production there. However, the greater availability of capital without a fall in the demand for consumers’ goods results in a rise in the prices of factors of production. When the greater income is spent on consumers’ goods, their prices start going up as well, though after the prices of capital goods and their factors of production go up.

    A general feeling of prosperity is created all around as capital goods prices, consumers’ goods prices, wages and rents go up and profits emerge in the economy. This is the inflationary boom like the one we experienced from 2001 to 2007.

    However, inflationary pressures soon catch up and the system is forced to raise interest rates. Production processes that started in the reduced interest rate regime suddenly become impossible to continue further. To make matters worse, when the greater output of the more efficient, longer production structure hits the market, savings are not available to be spent on them. Unsold inventory piles up and businesses rack up huge losses.

    The result is widespread business failure including failure of financial institutions that made loans to borrowers who end up defaulting. This is what we understand as the bust, commonly known as an economic depression or recession.

    What we see

    The lengthening of the production structure caused by genuine saving was stable and sustainable in the long run. Lengthening fuelled by credit expansion, however, is unstable as the manner in which it is done creates pressures that force an untimely increase in interest rates resulting in the depression stage of the business cycle. We see that once the inflationary boom is triggered by credit expansion through monetary inflation by the banking system, the bust is inevitable.

    Thus, Austrian Business Cycle Theory helps us understand that it is the inflationary banking system that is the primary cause of all the misery created by the phenomenon of economic depressions. The key question now is

    Are these boom-bust cycles inherent to the capitalist system of production or are they a result of intervention in the economy? Is it at all possible to eliminate the business cycle?

    These important questions shall be the subject of another post on another day.

    Fixing Inflation

    This article raises an issue very relevant to the times we live in – fixing inflation. Summarising what Mr. Subbarao says, inflation is a supply side problem. That means that according to him, inability of the system of production to keep up with the ever-rising demand for goods and services is responsible for steadily rising prices. This inability, he implies, is due to fiscal policy failures and a slow pace of reform dragging economic growth down. The responsibility for fixing the problem, as per Mr. Subbarao, lies with the government. In his opinion, there is precious little that the RBI can do to stimulate growth without stoking the fires of inflation.

    Mr. Chidambaram, on the other hand, believes that he has done what he could and was expected to do, i.e., keep fiscal deficit under control, to keep inflation under control, and that the ball is now in the RBI’s court. He believes it is time for the RBI to cut interest rates and tinker with other parameters in its control (like CRR and SLR) to boost growth.

    What do we, as ordinary people, make of this debate happening in rarefied environs? Let me make a beginning by focusing, in this article, on inflation.

    What is inflation?

    The commonly accepted definition of inflation is the steady rise in prices, which is measured through price indices like WPI and CPI. The Classical (Original) definition of inflation, however, is the increase in money supply. This might come as a surprise to many of you because all you may have heard is the commonly accepted definition given above. So here, here, here and here are some links that confirm what I am saying.

    Which of these is meaningful and useful?

    Only the Classical definition of inflation is meaningful and helps us understand real world phenomena like ever-rising prices while the commonly accepted definition is utterly useless.

    Why is the Classical definition meaningful and useful?

    Money is a commodity like any other. It has a price too. That price is determined, like it is for all other commodities, by the forces of supply and demand. When money supply increases, the price of money falls. When the price of money falls, the prices of goods and services denominated in that money rise. A steady rise in the supply of money causes a steady rise in prices. Thus, the Classical definition of inflation helps us understand the real world phenomenon of rising prices from fundamentals and is therefore meaningful.

    Why is the commonly accepted definition of inflation useless?

    Defining inflation as the steady rise in prices tells us nothing about what caused prices to rise in the first place. Explanations like the demand-pull and cost-push theories, and structural/built-in inflation are based on elementary economic fallacies and errors. For instance, if we say that prices are rising because demand is rising, what caused the demand to rise in the first place? If we say prices rise because costs rise, aren’t costs prices themselves? Are we then not bound to explain what caused THOSE prices to rise first? If we do not, would we not be guilty of engaging in circular reasoning by saying that rising prices cause prices to rise? And is saying that some price rise is “built-in” not a negation of economic theory itself, especially price theory, which seeks to explain prices from fundamentals?

    A small point of caution while using the Classical definition of Inflation

    It often happens that productivity improvements send supply of goods and services up so rapidly that we do not see rising prices but stable or even mildly falling prices. In such cases, it is important to bear in mind that in the absence of inflation, prices of these goods and services would have been much lower than they currently are. So, merely observing stable, slowly rising or mildly falling prices in the face of increase in money supply does not negate the Classical definition of inflation.

    What causes money supply to increase steadily?

    As explained in my previous post, the banking system that we live with is the fundamental and most proximate cause of inflation. Fractional Reserve Banking is based on creating money many multiples of the monetary base we start with. A banking system with a 10% reserve ratio can multiply every Re. 1 into Rs. 10. The Rs. 9 is addition of money supply by the banking system.

    Central Banks (like RBI) make matters worse. They have reserve ratios of their own based on which they lend reserves to banks. The US Fed, for instance, has a reserve ratio of 35%. This means that the Fed multiplies the banking system’s monetary base by 1/0.35 or 2.9 times. Combined with the banking system’s reserve ratio, every $1 can be multiplied into $29. The inflationary potential of the banking system is thus magnified by Central Banks.

    Government spending draws resources from the private sector through taxation and borrowing. All this leads to a pressure to keep increasing money supply.

    It is these 3 factors – the Banking System, Central Banks and Government – that are responsible for causing inflation (as per the Classical definition).

    What does this help us do?

    At the very least, it helps us pin the blame for the phenomenon of ever-rising prices. At a deeper level, it gives a solution to the problem. All it takes to solve the problem of inflation is for the triumvirate identified above to stop engaging in inflation (as per the Classical definition).

    The question is, would they? And if they would not, why is it so? These are important questions that we will find answers to in subsequent posts.

    Why the SBI Chairman is calling for rate cuts

    I just chanced upon this article and thought it would be helpful to explain why representatives of the banking industry frequently make such demands. This is meant as a primer for those with little introduction to banking and finance.

    Here’s how the banking system works. It is called a system of Fractional Reserve Banking. Unlike ordinary people, banks can lend many times the amount of money that they actually have on hand. If you have Rs. 1000 on hand, the maximum amount you can lend to someone is Rs. 1000. A bank, however, gets to lend many multiples of Rs.1000 depending on the regulatory regime, i.e., the reserve requirements imposed by the central bank (the RBI in India).

    This is made possible by a simple accounting trick. Imagine a bank with the following balance sheet

    Table 1 - Balance Sheet of a Hypothetical Bank upon launch

    One would expect that the bank will be able to lend a maximum of 1,000,000 and end up with a balance sheet that looks like this.

    Table 2 - Expected Balance Sheet of a fully loaned up bank

    We think that the bank has 1,000,000 in cash to pay all deposit holders if need be. However, under fractional reserve banking, a bank needs to keep only a fraction of the total deposits as cash in reserve. This fraction is called the reserve ratio. These days, it is usually set by the central bank of each country though prior to central banking, banks used to set their own reserve ratios.

    A bank with a 10% reserve ratio needs to keep only 100,000 as reserve against deposits of 1,000,000. Conversely, a cash base of 1,000,000 can support a deposit base of 10,000,000. This means that the bank’s balance sheet can look like this.

    Table 3 - Balance Sheet of a fully loaned up Fractional Reserve Bank with a 10% Reserve Ratio

    Thus, we see that fractional reserve banking enables banks to lend far in excess of their actual cash holdings. They do this by adding units of money to the total money supply by adding it into new or existing deposit accounts. This is reflected in the jump in deposits held in bank from 1,000,000 to 10,000,000.

    Basic arithmetic tells us that if a bank gets to borrow 1,000,000 at 8% and lend 10,000,000 at 12%, it must be enormously profitable. So, there is phenomenal incentive for banks to borrow to add to their cash base and grow by increasing the total amount they have loaned out. In order to do this, banks need a source of near unlimited lending. That source is the central bank (the RBI in India).

    The Repo window of the RBI is basically a means for banks to augment their cash reserves through sale of bonds to the RBI (repo) or borrowing reserves from the RBI (reverse repo). Interest rates (Update: Please note that interest rate here stands for repo/reverse repo rates) determine how much a bank can add to its cash base through this window. Higher interest (Update: repo/reverse) rates mean lower addition to the cash base while lower interest (Update: repo/reverse repo) rates mean higher addition to the cash base. Therefore, it must be obvious that banks would prefer lower interest (Update: repo/reverse repo) rates all the time.

    Lowering the reserve ratio has a dramatic effect on how much the banking system can lend out on the same cash base. A drop in the reserve ratio from 10% to 9% will leave our hypothetical bank’s balance sheet looking like this.

    Table 4 - Balance Sheet of fully loaned up Fractional Reserve Bank after cut in Reserve ratio to 9%

    The banking system thus gets to lend out an additional amount greater than its actual cash base. While the actual additional amount of lending possible depends on the original reserve ratio and the extent of the cut, the simple arithmetical point is that it a cut in the reserve ratio necessarily means additional lending possibilities for banks. Combined with a cut in repo and reverse repo rates, it can indeed add significantly to the banking system’s ability to create new loans.

    Thus, it becomes clear why the banking industry is perpetually calling for lower interest rates and lower reserve ratios. The economic consequences of these are, of course, an entirely different matter and I shall tackle them some other time.

    Excise evasion charges and Cadbury India Limited – Part 2 – The gloves come off

    This is perfect follow-up to yesterday’s post where I had spoken of a certain perspective on right and wrong with specific application to The Excise Act. Note this point I made in yesterday’s post.

    The income of the producer is his rightful property.

    And in the article I have linked today, note the quote in para 3 which is attributed to the official who did not wish to be named. He says (and I quote)

    “Let them criticize. How can you collect money from people and not deposit it with the government? It is the government’s money,”

    There he goes begging the very question that I asked in the previous post. The simple question is, how does a portion of the property of the producer become the property of government (for how else could he call it the government’s money)?

    This is precisely the point. Is he saying that passing The Excise Act into law magically transforms the producer’s property into government’s property? So government can pass titles to ownership to itself by just passing an act into law, can it? What is the source of this magical power? What is the limit of this magical power? What is it that government cannot transfer title to itself to by passing more suitable acts into law or by amending existing law? I am scared. I would be surprised if you aren’t.

    Excise evasion charges and Cadbury India Limited

    This is an interesting bit of news. The reason I find it interesting is that it raises fundamental and searching questions about our sense of right and wrong and our attempts as a society to transform these into a code of law.

    Let us assume for a moment that Cadbury India did indeed evade excise duty. What is the underlying premise in this incident? It is that as per The Law (Please note that I am NOT saying as per law. There is a difference between law and The Law. I am leaving that for another day.), it is a criminal offence to use any technique to avoid paying what the makers of The Law decide is due to government (which is nothing but the makers of The Law themselves). If Cadbury India has done this, it should be deemed to have committed a criminal act and criminal proceedings should be initiated against it and those in Cadbury India who are responsible for this act.

    Before we jump in judgement at Cadbury India, let us pause for a moment to think of a fundamental question – Did they do anything wrong? I know that a majority out there would say “Of course, YES! Why do you even have a doubt?” So let me ask another question – Why is what they did wrong? The answer I am most likely to get is “They broke The Law, didn’t they? That’s why they are wrong.”

    But then I have another question – Why is breaking The Law wrong? Is it possible that The Law is wrong? In that case, a person could be doing the right thing but faces the strong arm of The Law because he fell on the wrong side of it? What should we do when a provision in Law is clearly wrong? Should we just shrug our shoulders and tell the victim “Tough luck, mate”?

    I have a serious problem when The Law departs from basic notions of right and wrong. I do understand that quite a few people think that right and wrong are matters of individual opinion but I beg to differ. I think right and wrong are objectively definable, especially in the interpersonal space. For instance, none of us would say that whether murder and robbery are right or wrong is a matter of individual opinion. Killing another person may not be wrong if it is in self-defence, but that is not a matter of opinion but of the facts of the case.

    As I understand right and wrong, a simple theoretical and conceptual yardstick can be used to determine whether an action is right. See if the action involved
    1. the initiation of force (aggression) against person or property
    2. the commission of fraud
    Any one of these two qualifies an action as wrong. This is why murder and robbery are so obviously wrong.

    When I apply this yardstick to the Central Excise Act under which Cadbury India is accused of the crime of evasion, I am unable to escape the conclusion that the Law is wrong. The Law basically empowers government to compel producers to part with a portion of the income they receive from sale of their manufactured goods in favour of government. The income of the producer is his rightful property. Compelling a person to part with his property involves aggression or the threat thereof. Imagine a local Mafioso threatening producers in his zone of influence to part with a certain percentage of the income they receive from production to obtain his protection. Clearly, we would call it extortion and understand it as wrongful.

    What I fail to understand is how the Central Excise Act is any different from the Mafioso’s threat of “pay or else”. Excise duty collection, like every other form of taxation, is an act of coercive expropriation, i.e., forcible taking away of the property of another individual. By the simple yardsticks I have given above, coercive expropriation is wrong because it involves aggression against property, which if successfully resisted invites aggression against person. So why do we accept it as right when government puts it in the statute book? Does the statute book have the magical power to turn wrong into right and vice versa?

    This is a deep and important question for all of us to answer. The answers that we give will determine the shape of the society we create for ourselves. If we accept the legitimisation of aggression through statute, we will eventually end up in a society where aggression is a way of life, i.e., the society of the warrior. If, on the other hand, we reject the legitimisation of aggression, we can pave the way to a society based on peaceful coexistence, cooperation, specialisation, division of labour, and voluntary exchange, i.e., the society of the trader. Which one we choose is up to us.

    One thing is certain. The society of the trader will be more prosperous and happy. How do I know that? That’s what economic theory is all about.

    When KFC goes veg, the market wins

    We live in an age of metaphors. We use all kinds of violent terminology to denote the most peaceful of all human relationships – business. Terms like price-war, hostile takeover, predatory pricing, price gouging, etc., are common place. None of these terms has any place in discussions of business and the economy, but in the age of metaphors, anything goes.

    In these times, here’s an example to demonstrate a simple point that economic theory makes – No business, however big, can defy consumer preferences for long if it wants to stay in business.

    Having stayed in Ahmedabad for 3 years, I have been amazed by the preponderance of vegetarian restaurants there and by how rare are restaurants that serve non-vegetarian fare out there. That was when I understood that Gujaratis, be it Hindu or Jain, are predominantly vegetarian.

    Take it from me – Gujaratis are NOT the symbol of asceticism. They love their food. They love their fun. They show their love for life on their shirt sleeves. They love eating out more than you can imagine (if you haven’t been to any part of Gujarat, you can’t know this really well). During my 3-year stay there, festival holidays were the worst days to go out to dine at a restaurant. The queue everywhere, especially at the good and sought after restaurants, would take 40-45 minutes to clear. And let’s not discuss Sundays.

    With all this culture of eating out, Gujarat must be the dream of any restaurant chain, right? Wrong! Especially if your brand is Whatever Fried Chicken and your menu largely revolves around the different ways in which you could cook and serve the meat of that bird. For how many years can franchisees of the biggest international chain wait till the magic of the brand will cause the preferences of the Gujarati to change enough to draw them in droves to chomp on the chicken nuggets? The interest costs sure must have been piling up.

    It comes as no surprise that KFC decided to go veg. Personally, I knew it was only a matter of time before it happened. As I understand economics and marketing, the way a business makes money is by offering goods and services that people value, i.e., express a preference for over the money they have in hand (or in fact the other goods they could buy with that money). Those that fail to do so will not get the business. There are only 2 ways to address this
    1. Go out of business
    2. Change your products to meet customer preferences

    What has happened is to be celebrated, for the free market has won and once again demonstrated that no business entity, however large, can act against consumer preferences for long. It has demonstrated that no business entity is immune to the forces of supply and demand, and the law of scarcity.

    The best part of this is that no one has lost. If KFC does perform well going forward, it would have won customers over. If customers do find KFC’s veg menu good, they would have won the challenge of communicating their preferences to the producers. Above all, it is a victory for the free-market (as I’ve already said) and, it goes without saying, for those (like me) who proclaim its virtues from the rooftops.

    p.s: As a vegetarian, I am yet to step into an outlet of KFC till-date, not even for their low-price ice-creams.

    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

    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).


    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.

    Orwellian Nightmares

    In his epic book, 1984, George Orwell lays out in all its gory detail, the entire philosophy behind the Statist machinery that has taken control of our lives and uses us (all people) as pawns in the games Big Brother plays. The most striking (to me) aspect of the book is the concept of “NEWSPEAK” that he introduces. What makes this striking concept scary is that we are living through this process of concept destruction through language destruction, albeit in a slow and gradual process of the same, but are completely oblivious to it. All around us, concepts are being mutilated and destroyed and we, the people who are affected by it, remain mute spectators because we do not understand either what’s happening or its implications for us.

    To understand what I mean, let me delve a little into 1984 and NEWSPEAK. What is NEWSPEAK? It is a language developed by the State machinery to regulate the thoughts that people can have. But how can control on language control the thoughts people can have? Here is how.

    Language is the most fundamental tool of concept formation. As human beings, we are able to hold an extraordinary volume of concepts interlinked in extremely complex ways. The tool that makes this feat possible is language.

    The fundamental building blocks of language are words. Words are labels for concepts that we hold in our mind. Concepts themselves are of different types. The most fundamental concepts of all are concepts of “existents” or distinct things that exist. When we talk of the “table”, “car” or “tree”, we  are referring to things that exist. We come to be aware of their existence through our sensory apparatus. This awareness is processed by our cognitive apparatus and converted into concepts stored in our mind.

    The second level of concepts is abstractions. Abstractions are not things that “exist” but are identified by us as attributes of existents. For instance, “length”, “weight”, “volume”, “area”, “colour”, “texture” and various other attributes of things do not exist. It is we who, in our effort to form concepts of existents, identify these attributes, associate them with existents and thus form concepts of these attributes. “Length” does not “exist”. An existent possesses a certain length, i.e., the existent exists in a region defined by the end-points A and B where the “distance” between A and B is the length of the “existent”.

    The third level of concepts is abstractions from abstractions. For instance, when you say “The rope has a length of 10 m”, the “10 m” or the measurement of the “length” is an attribute of the attribute “length” of the “existent”, the rope.

    An important point to note is that abstraction can proceed in two broad directions.

    1. Differentiating existents and previous level abstractions from each other to form narrower concepts
    2. Integrating existents and previous level abstractions into broader, encompassing concepts

    An even more important point is that higher level abstractions are formed from concepts of existents or lower level abstractions. The first level abstractions are themselves formed by abstracting from concepts of existents. This means that for any abstraction, there exists a train of abstractions that one can work through backwards till we eventually reach the concept of an existent which we may call the “referent” of the abstraction. All abstractions have meaning only in relation to this existent. They have no independent existence beyond the existents themselves.

    This multilayered, interlinked complex of concepts is what we call our “knowledge”. We hold all our knowledge in the form of words, each of which refers to a concept and the concept in turn automatically denotes all the attributes we have associated with that concept in the process of forming it or later.

    Any set of concepts will be united in some respect. For instance, the concepts “table”, “cars” and “telephone”, while fundamentally standing for existents that are clearly distinguished from each other, are all “existents”. They are all particular units of the broader category “existence” or all that exists. At the same time, every concept is distinct from every other concept in at least 1 respect for otherwise it would be superfluous to even hold a distinct concept in our mind and give it a name. For instance, different shades of a colour, say red, are different from each other. There exist many names such as magenta, red, pink, crimson, etc., all of which refer to different shades of red. Feelings and emotions, for instance, may exist in different degrees. “Anger” and “Rage” are different degrees of a particular emotion.

    Thus, we see that our ability to form a wide variety of concepts and hold an extensive body of knowledge in our mind is critically dependent on suitable words to use to identify and refer to these concepts.

    How is all this that I have said about language and words relevant to Orwell’s 1984? Very simply, the book is set in a (fictional) period where totalitarian dictatorships have taken over the entire world. Now, these totalitarian regimes are, as per the story, extremely sophisticated tyrannies. They are tyrannies unleashed not by individuals but by a “Party” which subscribes to a certain ideology.

    The goal of the Party is to stratify society permanently into 3 classes – the rulers or the Inner Party (themselves, ~5% of the population), the machinery or the Outer Party (~15% of the population) and the mass of people who don’t matter who are called the Proles.

    One of the most important goals of the Party is to reduce the population to a state where no individual is capable of even thinking negatively about the Party or Big Brother (the personification of the Party). This goal is sought to be achieved by the Party through the destruction of language. This is the role of Newspeak in 1984.

    In NEWSPEAK, the only words allowed are words denoting concepts of existents and those concepts of abstractions that are either neutral or can be used only in praise of the Party. If entire generations grow up learning NEWSPEAK, it is possible to have the entire population incapable of being hostile to the State and in fact loving it wholeheartedly.

    How is all this relevant to us today? Simply put, we are slowly but steadily lurching towards the Orwellian nightmare through systematic destruction of concepts. To give you a feel for it, let me take a simple example from my favourite field of study, Economics.

    All of us are familiar with the economic concept inflation. Ask any moderately educated person “What is inflation?” and the answer would be “The steady rise in prices”. But how many of us know that the concept “inflation” once stood for something very different?

    As recently as the early 1900’s, the term inflation stood for an increase in the money supply or the quantity of money in circulation. Starting with this definition, economic theory then goes on to explain the effect of inflation on prices of economic goods. The effect can be summarized as below.

    1. If the supply and demand of a good were changing such that the price of the good has a tendency to remain stable, inflation would cause its price to rise
    2. If the supply and demand of a good were changing such that the price of the good has a tendency to rise, inflation would cause its price to rise even faster
    3. If the supply and demand of a good were changing such that the price of the good has a tendency to fall, inflation would cause its price to fall less, remain stable or even rise

    Summarising the above even more succinctly, one can say that the effect of inflation is to keep prices higher than they would have been in the absence of inflation.

    Economic theory also explains that inflation, when carried out through the banking system and its machinery of credit expansion, has far more deleterious effects on the economy as a whole and on the well-being of every citizen. At a basic level, it creates a situation where those closer to the source of the inflation are benefited by impoverishing those further away from the source of inflation.

    At a deeper level, however, this inflation, working in conjunction with its equally dangerous twin, credit expansion beyond the available pool of real savings, causes the dreaded economic phenomenon called the Economic Depression. All of us understand that economic depressions cause untold human misery. What many of us fail to realize is that inflation by the banking system is at the heart of the creation of the boom-bust cycle of which the Depression is only the bust phase.

    Armed with this understanding, it becomes very easy for anyone at all to answer the question “Who is responsible for the misery caused by rising prices and, more importantly, for all the suffering wrought by the boom-bust cycle?”

    The answer is, very simply, “Whoever is responsible for the inflation is responsible for all this human misery”. But then, who IS responsible for inflation? Who or what causes inflation? This answer too, in today’s world, is very simple. There are 3 entities.

    1. Government
    2. Central Banks
    3. The entire banking system

    Thus, the original definition of inflation combined with economic reasoning permits ordinary people to identify those responsible for their suffering and to direct their anger at them. Interestingly, the list includes the very entities that are today masquerading as the saviours of the people.

    On the other hand, if we start with the definition of inflation as “the steady rise in prices”, economic reasoning is utterly incapable of explaining what causes this inflation. The only explanations we get are

    1. Demand-Pull – A perfect example of question-begging
    2. Cost-Push – A perfect example of circular reasoning given that the “input costs that are supposed to be responsible for the “inflation” are themselves prices and their rising price is itself part of that very “inflation”
    3. Structural inflation – A perfect example of abdication of academic responsibility

    Incidentally, this nonsense is what is taught at most B-Schools (including the top ones) and prestigious university economics courses.

    The important point to note is that with the revised (I should say mutilated) definition of inflation, it becomes impossible for people to point their finger at the real culprits and bay for their blood. In fact, it becomes possible for the culprits themselves to, like the thief in the parable, point fingers at someone else and shout “Thief! Thief!” to avoid getting caught. The best example of this is the standard finger-pointing at “greedy speculators” and “evil hoarders” every time uncontrollable and rapid price rise becomes a serious political issue threatening the survival of the then government.

    Who is responsible for this switch in definitions? Could I say “The Inner Party”? All I wish to say to the reader is “Wake up and smell the coffee”.

    Free Market in Credibility

    I have always wondered about a question.. How do we verify credibility data in a free market?? I mean in case of investor trusts to invest in some bonds..

    A former student of mine posed this question to me because (I guess) I keep saying “free market good – government bad”. I also guess that he is a person seriously intrigued by my insistence on this point and who is bothered by this question. I further guess that the reason he asked this question is that he is not convinced that something like a reasonable guarantee of a person’s or an agency’s credibility is possible in a free market or at least not more certain than under a system where government enforces certain norms.

    Understanding credibility

    What is credibility? It is simply the answer to the question “How certain can I be that this person I am dealing with will deliver as he is promising to?” In simple terms, a man’s credibility is a measure of the trust that others are willing to place on him. When an individual is highly trusted, he is said to have a high credibility and when he is not, he is said to have a low credibility.

    Second, what is the realm of credibility? It is the set of all situations where an individual promises to behave in a particular manner or deliver a particular outcome. Based on the promise, the recipient of the promise agrees to behave in a certain corresponding manner or deliver a certain outcome. For instance, an employer promises an employee a certain wage to be paid on a certain date of the month. In exchange for this promise, the employee agrees to apply his labour (mental and physical) on tasks as designated by the employer (directly or through his representatives).  In this circumstance, each party, i.e., the employer as well as the employee, trusts the other to act as promised.

    If one of them (say A) fails to act as promised, the trust of the other party (say B) gets dented. B is now less willing to trust A.  The more frequently A reneges or even fails to deliver (even though the intent may be to deliver), the less willing B would be to trust him. A is then said to have lost credibility (in the eyes of B). If A engages in such behaviour with many individuals (C, D, E, etc.), then his credibility would become low with C, D, E, etc. If other individuals (P, Q, R, etc.) come to know of A’s behaviour pattern through B, C, D, E, etc., they would tend to have a lower level of trust in A’s promises and A may be said to have low credibility with P, Q, R, etc., as well.

    On the other hand, if A were to keep his promises, B, C, D, E, etc., would have a greater level of trust in A and A may be said to have a high credibility. Other individuals P, Q, R, etc., who learn about A’s behaviour pattern from B, C, D, E, etc., would now also repose a higher level of trust in A and A may be said to have a higher level of credibility.

    What happens when an individual changes his behaviour pattern? Over a period of time, his credibility changes. If a hitherto credible individual starts reneging on his promises, his credibility falls depending on how quickly the information spreads to other individuals. The faster information spreads, the faster his credibility falls. Rebuilding credibility after it falls very low is, however, likely to be a much slower process because people would in general be once bitten twice shy. However, it is indeed possible for a person to rebuild his lost credibility by working hard at keeping up his promises.

    We thus learn something very important about the concept “credibility”. The extent of credibility an individual possesses depends on his behaviour pattern and in particular on his attitude to the promises he makes to other individuals.

    Why is credibility an important issue?

    Credibility is important because in many of our interactions and exchanges with people, we are placed in a position where we need to trust them. When we visit a doctor, we trust that the doctor knows what he is doing and that following his advice is likely to heal us. When we lend money to someone against a promise to repay the loan as per agreed upon terms, we trust the other person to repay as agreed. Even personal relationships rest on trust. The wife trusts her husband’s fidelity and the parent trusts that his child does indeed behave well when he is not watching her. Entire civilized societies exist because people trust others to behave in a particular manner.

    In fact, with the exception of cash-and-carry and barter transactions, all exchanges that people have with each other rest on a foundation of trust. One can even say that without trust, the entire fabric of civilization would come crashing down.

    At an individual level, a person’s credibility is a reflection of the trust that he is able to inspire in others. If A has a low credibility with B, C, D, etc., then the latter are very unlikely to have exchanges with him, at least in the areas of low credibility.

    Credibility takes even more importance when we are dealing with people we do not know too well.  Before we place our trust in an individual, we would like to verify that the individual is indeed worthy of our trust, i.e., if he has a high level of credibility. Before entrusting our health to a particular doctor or our money to a particular investment firm we would like to check their credibility with others who have had an opportunity to experience that doctor’s or investment firm’s past behaviour, especially with regard to keeping up his/its promises.

    How the free market would deal with credibility

    If the explanation of credibility given above is reasonably valid, then we see that credibility is a “good” of value to a whole host of people. In fact, one can even say that credibility is a good of value to everyone though the only issue might be whose credibility and in what areas. A doctor’s credibility in the area of repaying loans he has taken is of no consequence to patients who seek his treatment.

    If credibility is a good of value, it is clearly possible to have a “market in credibility”. What this means is that it then becomes economically worthwhile for some people (A, B, C, etc.) to specialize in the area of gathering information about the behaviour and performance of other people (P, Q, R, etc.) working in various areas of activity. The information thus gathered may be analysed to identify behaviour patterns that will help yet other individuals (X, Y, Z, etc.) understand the credibility of P, Q, R, etc.

    X, Y, Z, etc., thus become potential customers of A, B, C, etc., who provide the former an insight into the credibility of individuals P, Q, R, etc., with whom X, Y, Z, etc., plan to have transactions, be they of a personal or commercial nature. Conversely, P, Q, R, etc., may also thus become potential customers of A, B, C, etc., if it is in their interest that potential customers X, Y, Z, etc., get reliable information about their past behaviour and thus get a good assessment of their credibility.

    Like for every other good, price of information related to credibility would be arrived through the operation of the forces of supply and demand. Which areas of information the market would cater to would in turn depend on the customers’ valuation of the information. If people in general regard certain types of information as more valuable, they would be willing to offer more for it. Conversely, people would be willing to offer less for information that they consider less valuable.

    Summarising the explanation

    Credibility is a good of value to all individuals, to each in areas relevant to him/her. As a good of value, it can be produced and exchanged in the free market of voluntary exchange. The free market, where anyone is free to produce and exchange any good, would therefore witness the provision of “credibility verification/validation services” just as it would witness the provision of cars, toothpastes, televisions, healthcare services, education and a whole host of other products that we are used to seeing produced and exchanged. There is therefore no need for anyone to worry about how a free market would be able to deal with issues of credibility.