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Shubhendu Pathak Education B.Tech - Indian Institute of Technology, Delhi M.Tech - Indian Institute of Technology, Delhi MBA Finance - Goizueta Business School, Emory University CFA Level I
  • Don't Bailout The Banks - An Email To The Finance Minister Of India

    Honorable Finance Minister of India,

    On Tuesday, June 10, 2014 prominent bankers in India met you to lobby for a National Asset Management Company (NAMC). If this proposal, or anything even closely resembling it, goes through, it will break the backbone of the Indian economy.

    Three years ago, when I wrote an email to the then Finance Minister of India, I anticipated this moment. At that time, almost all the economists and bureaucrats, oblivious to the fundamentals at play, were hailing the ~9% rate of "growth". Below is an excerpt from one of my emails I wrote on August 3, 2011 to Pranab Mukherjee warning him about an impending slow down in the economy and a subsequent banking crisis:

    "Up until this point, everything will go as it should but then our government will feel the pressure to intervene and, might deviate the economy from the path to correction. This is where India would need a strong political will and a strong Finance Minister to take the right steps and steer us through the crisis, not out of political expedience but for the nation's interest.

    The pressure will come from a choice between the interest of the party, which is re-election, and that of our nation, which is a sound economy. India is financing its current account deficit with its capital account surplus. Revenue from 3G license auction enabled the government to finance the spending for one year and kept the fiscal deficit close to 5%. Amount of short term debt and debt to foreign countries are at unprecedented levels. The collapse will result in a reduced tax base and the government will not be able to meet its fiscal commitments. Going bank on these commitments will jeopardize its re-election. On the other hand, there will be banks crying SOS. In these banks the government might find an accomplice. Instead of cutting spending, allowing the banks to fail and seizing the opportunity to disinvest, the government might relent to the pressure and take steps that will increase its chances of re-election. It might be tempted to reduce the interest rates, bail out the banks and borrow more, from people and from the banks. In the worst case scenario, the government will pursue quantitative easing and increase spending to spur growth. This might keep a temporary lid on interest rates and allow the government to borrow more. However, this will result in more inflation, and eventually inflationary expectations and a downgrade will increase the interest rates triggering the ultimate inflationary collapse leaving the Indian economy paralyzed.

    Paying taxpayers' money to the banks for the risks they have taken is the worst mistake the government can make. It is like giving a gambler money to play in a casino with a condition that profits will belong to the gambler, and losses to the tax payers. The government should not follow this path under any circumstances."

    [The full email is pasted post script.]

    As expected, NPAs of the 40 listed banks have swelled to more than $40 billion with more than 40% increase in 2013 alone. These banks are now lobbying with the Finance Ministry to set up a NAMC, a government sponsored enterprise, to use public money to pay for their private mistakes. If the government surrenders to these lobbying efforts, it will not only create a moral hazard but will also worsen inflation in India.

    The government, already more than a trillion dollar in debt, is running a massive fiscal deficit, so in effect, what the banks are proposing is an Indian version of Quantitative Easing (QE) i.e. printing money to buy bad assets from the banks. Emulating the QE program of the U.S. is not pragmatic; the QEs that the Fed has been pursuing since November of 2008 have already started backfiring. I have discussed the dynamics prevailing in the U.S. economy in my article "The Changing Game of Ben Bernanke". When you read this article, please keep in mind that, unlike the U.S. dollar, the Rupee does not enjoy a reserve currency status. So any QE by the RBI is going to have very quick repercussions.

    Governments all over the world want to be seen as trying to do something. However, any form of government intervention to come out of this situation will only worsen it. Why? Because what is happening is not a problem; it is a solution, and the most efficient one. Market forces are working to liquidate the malinvestments of the past several years and put the freed resources to more efficient uses. An intervention by the government will only prolong the painful period of recovery our economy must go through.

    Let us take an example to understand the implications of a government bailout of banks. A samosa maker applies for a $10,000 loan from a bank to invest in a state of the art machine that makes spherical samosas. The bank makes an assessment of his ability to pay back the loan using the revenue from his business and extends him a line of credit against the machine as collateral. Unfortunately, customers did not appreciate spherical samosas any more than they did the regular ones, and the smell of the oil the machine used for lubrication became a cause of concern for some of the customers. As a result, the samosa maker incurs losses and is not able to pay back the loan. The loan becomes a non performing asset for the bank. The bank confiscates the machine but is unable to sell it in the market even at a high discount. Free market is working to liquidate the malinvestment, i.e. investment that people do not value.

    The bank now goes to the Finance Minister and asks for money to cover its losses. The banker knows that the government has a lot of money it collects from hard working individuals, many of whom are very poor. It is a myth that the poor in India don't pay taxes. The price poor people pay for goods would have been much lower if the government did not collect taxes on just crude oil for example. In fact, the poor might be paying a higher percentage of their income in taxes, as a greater portion of their income goes into consuming artificially high priced goods. "Subsidies" in India are not subsidies, they only reduce a fraction of the tax burden imposed by the government. So the banker in effect asks the Finance Ministry to give him poor people's money to cover for his mistake.

    The government is running a fiscal deficit, so to pay the bank, it "borrows" from the RBI. The RBI prints money out of thin air and gives it to the bank. More money pours into the market. More money chasing the same amount of goods (remember there are no additional goods in the form of spherical samosas in the market) causes more inflation, which hits the poor the hardest as they are the last recipients of the new money supply. In short, the bank and the borrower benefit at the expense of the poorest in India. The bailout also creates a moral hazard; with the government's put option, the bank is now encouraged to make even riskier loans to more samosa makers. Similarly, when the government goes into debt to pay the salaries of an ever increasing army of government officials who don't produce anything, it creates inflation as there are no goods to back up the additional money supply. Even if a state government is not able to pay its debt, it should be allowed to default, so that it is not able to raise money for unnecessary projects in the future.

    If there is something the Finance Ministry can do, i.e. if it prioritizes strengthening of the fundamentals of the Indian economy over short term alleviation of banks and malinvested borrowers, it is using this opportunity to sell off government's stake in banks and completely deregulate the banking industry. I have made the case for privatizing the banks in layman's language in my article "Republic of Ghaziabad".

    I hope you don't fall for fear mongering, which might ensue if you don't bail out the banks, and take the right steps.


    Shubhendu Pathak


    Email 2/5

    Sub: Indian Economy and Our Last Hope

    Date: August 03, 2011

    Honourable Finance Minister,

    It is with sincere regard for your service to the nation and trust in your will to solve the problems in India that I am sharing this concern and analysis with you. This email is in continuation of my previous email titled 'Economy of India and Our Fight Against Corruption' dated June 16, 2011 in which I described the odds stacked against the Indian economy. I have attached that email post script. As you might have noticed, many events I had described in the email have started playing out.

    In this email I discuss the recent steps taken by the government and the pitfalls that the government should avoid when our economy starts shrinking in the coming months.

    The RBI recently took the right step of increasing the interest rates to slow down inflation in India. The ensuing effects of this step i.e. a slowdown in the economy will put tremendous pressure on the government to steer away from the current stance. The following analysis suggests that the government and the RBI should not move away from the current stance of increasing interest rates under any circumstances, and should take additional steps to move away from the dollar to solve the inflation problem in India.

    The government's current step of increasing the interest rates to control inflation, although correct, is only a part of the solution of the inflation problem in India. The argument that inflation in India is due to global increase in commodity prices and supply side pressures is a complete nonsense. The inflation is occurring in India primarily due to two reasons. Cheap dollars available to investors abroad are being used to pump up a speculative bubble in India. The government is buying these dollars and expanding its dollar reserves, and printing rupees out of thin air, by encouraging new loans, to maintain the currency peg. The U.S. is printing the dollars into oblivion and we are bearing the brunt. This same mistake, called sterilization in China, is driving inflation in their country. There are many lessons to learn from China; this is definitely not one of them. In addition to the government reserves, there are illegitimate dollars, either bought in exchange for rupees or deposited directly, which many allege are more than the reserves, that are being stacked in Swiss banks. The other reason of inflation is the indiscriminate spending by the government. The government has raised the salaries of government officials and waived off loans of farmers, with a complete disregard of their productivity.

    All the recipients of this newly issued money, i.e. people employed by the service sector and the government now have more money to bid for the goods available in the market. This is driving the prices higher in India.

    On top of this problem, the goods available in the market are reducing because the economy is shifting away from manufacturing. The industrial sector growth is waning at an alarming rate; it slowed to 5.6% in May compared to 8.5% a year ago. Trade deficit is about 7% of GDP. Majority of our imports are consumed and do not contribute to capital formation. We are now importing more than we are exporting, consuming more than we are producing. The question is 'Where are the dollars to finance the trade deficit coming from?' They are coming from investors who are selling dollars to buy rupees to speculate in the Indian market. Why are they selling their dollars? They are selling their dollars because they are available to them at a very low, and manipulated, interest rate.

    The inflation is wiping out the savings of hard working Indians, and transferring the wealth to recipients of the new credit supply. These recipients are people working in the Finance, Insurance and the Real Estate sector (also known as the FIRE sector for understandable reasons), and other service sectors that are essentially exchanging debts, speculating and not adding much value to the economy.

    Although increasing interest rates will restrict the money supply and strengthen the rupee, speculation encouraged by the rupee purchased by dollars will be hard to curb. The cheaply available dollars will keep on pouring. In addition to increasing the interest rates, the government will have to stop purchasing more dollars or dollar denominated assets, and move away from the policy of pegging the rupee to the dollar. Unless, the government does so, inflation will continue to rise. An interest increase without stemming the root cause will not curtail inflation.

    The rupees purchased with the dollars are primarily being invested in the FIRE sector. The U.S. has become a net consumer of the world, and by buying these dollars, we are not only feeding it, but are allowing growth of a little parasite, the speculative service sector, within our economy. It is like the big parasite has infected our economy with a baby parasite which is growing every day. High interest rates and a diversification away from the dollar will kill this parasite and we should allow that to occur.

    Confused economists will cry that we need dollars to buy oil, so we should devalue the currency so that we can export enough to get the required dollars. The fact is that market forces are much more efficient in deciding how much oil our economy actually needs, and will drive the valuation of the rupee in accordance. Any manipulation leads to misallocation of resources; a pertinent example of this misallocation is that of the employees in the FIRE sector buying bigger and bigger cars and using them to commute to and fro office every day. These people add little value to the economy by exchanging debts, but are able to buy big cars that consume oil and jam the roads of Indian cities. When this phony service sector collapses, we would not need the oil that is currently being wasted by these commuters, and the resources that are currently being used to manufacture big cars will be available for use in areas that make meaningful contributions to the economy. People will start buying efficient cars like Alto and Maruti 800 instead of gas guzzlers, and the Indians driving the cars would be the ones who are earning money via addition of value.

    Economic virtues suggest that the correct way to encourage exports is to become efficient in production so that prices decrease and our products become competitive even with a strong currency. This will take time but it is exactly what we need. Expanding credit supply to devalue a currency only transfers wealth from hard working individuals to speculators.

    Although increasing the interest rates is the right step, it is what will follow that will determine whether we emerge out of this 'manthan' with a weak or a strong economy. The inflation, lagged by an increase in credit supply which has taken place over several years, will continue to rise, and the RBI should continue to increase the interest rates, not slowly but at a very rapid rate regardless of the slowdown in the economy. This will trigger a deflationary collapse of the phony service sector economy we have built over the past few years. This is good as it is the service sector that is responsible for inflation, both because it is the channel via which new money is being sprinkled on the economy, and because the sector is not producing any goods people can buy. No matter how bad the collapse may look, this would be the healthy approach and will allow our economy to recover after a couple of years.

    However, governments all over the world are known for taking the wrong decisions, and I hope that you do not relent to the pressure of following the confused herd when our economy slows down. With rising interest rates, many businesses will fail and the speculative bubble will burst. The double whammy for the Indian economy will come from the collapse of the U.S. economy. This is tied to the propped up demand in the U.S., some of which has found its way to the Indian economy in the form of service sector jobs. When the interest rates rise and/or U.S. economy collapses the resulting urban army of unemployed people will default on their home and car loans adding to the bank losses. Indians who were feeling wealthy due to their high home prices and spending a little more than they otherwise would have spent will reduce their discretionary spending. Manufacturing sectors will not be spared as the phony demand evaporates leading to more layoffs. Reduced demand for homes due to high interest rates, and a high inventory in the market will drive the house prices further down leading to more defaults.The banks will have to book massive write downs.

    Up until this point, everything will go as it should but then our government will feel the pressure to intervene and, might deviate the economy from the path to correction. This is where India would need a strong political will and a strong finance minister to take the right steps and steer us through the crisis, not out of political expedience but for the nation's interest.

    The pressure will come from a choice between the interest of the party, which is re-election, and that of our nation, which is a sound economy. India is financing its current account deficit with its capital account surplus. Revenue from 3G license auction enabled the government to finance the spending for one year and kept the fiscal deficit close to 5%. Amount of short term debt and debt to foreign countries are at unprecedented levels. The collapse will result in a reduced tax base and the government will not be able to meet its fiscal commitments. Going bank on these commitments will jeopardize its re-election. On the other hand, there will be banks crying SOS. In these banks the government might find an accomplice. Instead of cutting spending, allowing the banks to fail and seizing the opportunity to disinvest, the government might relent to the pressure and take steps that will increase its chances of re-election. It might be tempted to reduce the interest rates, bail out the banks and borrow more, from people and from the banks. In the worst case scenario, the government will pursue quantitative easing and increase spending to spur growth. This might keep a temporary lid on interest rates and allow the government to borrow more. However, this will result in more inflation, and eventually inflationary expectations and a downgrade will increase the interest rates triggering the ultimate inflationary collapse leaving the Indian economy paralyzed.

    Paying taxpayers' money to the banks for the risks they have taken is the worst mistake the government can make. It is like giving a gambler money to play in a casino with a condition that profits will belong to the gambler, and losses to the tax payers. The government should not follow this path under any circumstances.

    The scenario described above has already started playing out. The banks have purchased about $ 39 billion worth of SLR securities since April, double the amount of loans issued during the period. Another gimmick that banks might try when the interest rates rise further is that of holding securities under the HTM category so that they don't have to mark them to market. Efforts like these are like manipulating a thermometer when it reads a higher temperature. Please kick them out of your office when they give you this argument.

    One advantage that India has over other economies is the massive holdings of gold with the families. Some people might make the mistake of not defaulting due to social taboos and pay for their loans from their family savings or holdings of gold. Although, the likeliness of this happening is less, the government should discourage this as it is tantamount to stealing hard earned money from people and giving it away to speculators. This gold will help India recover in later years.

    In the Ponzi scheme of the U.S. dollars, as with all the Ponzi schemes, the last ones out will suffer the most. China has already started making its moves. Let us not be the last ones to move away from the dollar. We can use the reserves to buy gold and future contracts of oil. We can also make efforts to trade with the OPEC in their own currencies or a basket of currencies and export agricultural commodities to these countries. This will need a lot of guts and efforts from our politicians, but it will be worth the effort.

    I sincerely hope that you take the right steps in the coming months, and that history looks back at you as the captain who steered India through the crisis.

    I would greatly appreciate a reply/acknowledgement from you.


    Shubhendu Pathak

    CC: Dr. D. Subbarao, Honourable Governor, RBI

    BCC: Dr. Manmohan Singh, Honourable Prime Minister

    Jun 14 6:45 PM | Link | Comment!
  • Republic Of Ghaziabad

    "The nine most terrifying words in the English language are: I'm from the government and I'm here to help."

    - Ronald Reagan

    'Help the poor'. Wherever on the planet, whenever in history these words have come from a government, a social and economic disaster has followed. If we focus on history lessons from East Germany - West Germany, South Korea - North Korea or even the current state of the U.S. to illustrate the point, the economically literate will get a chance to confuse us with terminologies they themselves don't understand. Economy is not a controlled experiment where data can be used to validate a theory. Validity of a theory in economics is better established by how well it explains the relationship between cause and effect. It is not a rocket science. So let us build up from the axioms and corollaries of economics to understand how a help promised by the government not only makes no economic and social sense but is also morally corrupt.

    Axioms are simple. Parallel lines do not intersect. At least one human has to work to produce a good or service that can be consumed by someone. In mathematics, complex theorems are built on axioms. Governments, banks, insurance companies, concept of a contract etc. are built on axioms in economics.

    This story is of a small island called Ghaziabad. It was located in the Indian ocean and had a population of 50, 25 males and 25 females. There were five tasks each individual on the island performed to survive 1. caught fish 2. cultivated land 3. cut wood for fuel 4. made clothes 5. brought water from a waterfall 5 km from the dwelling place. Each island dweller carried out these five tasks during the day to survive, went to sleep at night to recover from fatigue and woke up in the morning to carry out the same five tasks the next day. There was no holiday in Ghaziabad. Everybody worked every day just to survive. Nobody had time to enjoy luxuries of life or even to take care of someone who fell ill.

    One day a dweller who was better than others at catching fish suggested to his friend - "It takes me a lot of time to cut wood. I have a good spear I made and my aim is pretty accurate but I don't have arms as strong as yours. I will catch some fish for you tomorrow. Can you get me some wood". His friend agreed - they entered into a contract. The next day, the fisherman saved the energy he used to waste cutting wood and the lumberjack was glad not chasing fish with his broken spear. Happy with the outcome of this arrangement, the two men started doing it every day. They spent their saved time and energy in luxury activities, climbing trees, swimming in the ocean, looking for lice in each other's hair and what not. When other people saw them spend quality time, they got motivated and followed suit. Specialization of labor, the premise of modern economy, was born.

    The benefits of specialization of labor were so intuitive that after about a year the village had each individual performing just one task the individual was good at. 10 people caught fish, 10 cultivated land, 10 cut wood for fuel, 10 made clothes, and 10 brought water from the waterfall. As a result, production in the island increased significantly and the fruits of labor were enjoyed by all.

    However, there were a few growing concerns in Ghaziabad. The word about the prosperity of the island had spread and there were rumors that people from a neighboring island were planning to plunder some of the houses. The dwellers also suspected that one of the lumberjacks had turned into a thief and was stealing goods from their houses. When the dwellers went out to work, they were worried about the safety of their assets back at home. In addition to this problem, one contract between a lumberjack and a fisherman was violated. The fisherman refused to give the lumberjack the fish due for the day claiming that he did not receive any wood; the lumberjack insisted that he had left the wood in front of the fisherman's house. This had led to tension between the two families. Afraid that their contracts might be violated, some of the lumberjacks started fishing again.

    The productivity of the island started falling. The seniors in the island became concerned about the future of Ghaziabad and held a meeting. It was decided that three people will be appointed to protect the life and personal property of people and to ensure completion of contracts between individuals on the island. One person would guard the beach from potential external attacks, one would guard houses during the day, and one would resolve conflicts whenever a contract was violated.

    To ensure that the appointed individuals can focus on their jobs, they were not required to produce anything for themselves. It was decided that fishermen will give them two fish every day, cloth makers will give them one pair of clothes every two months, farmers will give them adequate quantity of grains and someone will bring them drinking water. Consensus on who to appoint for the job could not be reached so it was decided that people who had the maximum number of island dwellers supporting them will hold the position. Elections were held and a team of three credible individuals was appointed. In the island of Ghaziabad, government was born.

    The role of this government, which people felt was necessary, was to create an environment conducive for efficient production and trade. It was not formed to help the poor, it was not formed to provide education, it was not formed to provide water, it was not formed to control the prices of essential goods. It was formed so that people could do what they did more efficiently.

    With an assurance that their assets were in safe hands, people started going to work. Fishermen and lumberjacks started exchanging goods again as there was someone reliable to resolve conflicts. The economy of Ghaziabad was back on track.

    One more prosperous year passed by. Some interesting developments took place on the island. Four cloth makers thought - "People spend so much time in the evening to start a fire, why not make something that will make it a little easier to create fire." They saved some extra clothes during the year and started working on a process to manufacture matchsticks from locally found chemicals. They exchanged the clothes they had saved during the year for fish and grains to survive while they worked on this new venture. After a few months of hard work the team found success. The product became popular overnight. Matchsticks saved everybody so much time that lumberjacks were willing to give ten days of wood supply and fishermen were willing to give ten kg of fish in exchange for just one pack of matchsticks.

    Note that the fishermen and lumberjacks were willing to pay so much not because they were forced to do so but because they felt that one pack of matches was worth that value. The fishermen could catch more fish and the lumberjacks could cut more wood in the time they saved every day by using the matchsticks they purchased. The value of matchsticks was measured by the amount of goods (money) people were willing to pay for them. The engineers had anticipated the needs of the people of Ghaziabad and had assumed certain amount of risk; they could have lost all their savings had their venture been unsuccessful. Looking at how the risk was rewarded, other people were motivated to take similar risks to build new things and to produce existing goods more efficiently.

    One of the lumberjacks called Shyam had a ground breaking idea. He had a credible image in Ghaziabad and his ability to evaluate the risk of new ventures was well known. He asked his friends to save their extra clothes, wood, fish and matchsticks with him for a year. He promised to give back the savers more than they saved with him after a year. He then identified islanders trying to create new things or working on producing existing things more efficiently and gave them clothes to wear and fish to eat till the time they were working on their initiatives. If the initiative was successful, Shyam was paid back more than what he invested. Some of the dwellers were not successful and were not able to pay back but Shyam got enough from the successful ones and became wealthy. Before people of Ghaziabad gave Shyam their savings, they did a lot of research to make sure that he was trustworthy and competent, and that he was investing their savings responsibly. After making this assessment about him, they made the decision to invest their own hard earned goods. The savers were rewarded for the risk they took when Shyam paid them back more than they saved with him. Bank was born.

    Let us not go into fiat money, central banking, or the fractional reserve banking system. In fact, let us not even go into money, as that will again give the economically literate a chance to confuse us. Money was invented only to reduce the complexities of the barter system. Let us keep our resolve to stick to the basics.

    The island economy started growing at a very rapid pace as people working on ideas had easy access to savings. A farmer borrowed savings from Shyam and worked for four months to develop a process to produce fertilizers from bat droppings he collected from the floor of a nearby cave. Yield of his farmland increased so much that he was able to sell his grains for much less; he could exchange four month's supply of wheat for just a couple of clothes. Cloth makers now had more grains they could save with Shyam. A sixteen year old child prodigy invented a barrel with wheels using which he was able to bring water from the waterfall for ten people at once. Women who earlier spent most of their time bringing water from the waterfall started weaving clothes and exchanged them for water. The women became so efficient at making clothes that they not only made a lot of extra clothes but the clothes they made were of a much higher quality. They used extra clothes to buy matchsticks and saved even more time.

    Did the sixteen year old prodigy's tanker make the women unemployed? (Will FDI in retail increase unemployment of shopkeepers? Did metro, cars, buses and auto-rickshaw drivers make men running horse-carts unemployed?)

    A fisherman had spent sleepless nights making a bigger and stronger fishing net. He caught so much fish every day that it became difficult for him even to unload and pack them. He offered one fish to any dweller willing to help him for an hour to unload and pack the fish in banana leaves. Employment was born.

    Note that the fisherman did not force employment upon the employee. He offered him an opportunity to exchange his labor for fish. The employee accepted the employment because he thought that he would not be able to catch or earn one fish in an hour anywhere else using his current level of skills. It was a win-win for both of them.

    On the other side of the island, lumberjacks were facing a problem. The name of the problem was Black Recluse, a spider common in the woods of Ghaziabad. The spider bite was so poisonous that any lumberjack bitten by it had to take bed rest for at least a month. This had put some of the lumberjacks in a very difficult situation as they could not support their families during the recovery period. To solve this problem, lumberjacks of Ghaziabad formed an association and built a huge storage facility. Every lumberjack who stored one log of wood in this facility every month could use the wood in the facility in case he was bitten by a spider. Insurance was born.

    Government, banks and finally insurance. These institutions provided so much stability to Ghaziabad that it became an ideal economy for neighboring islands. There was so much production in the island that charity was common. Women gave extra fish to people who could not afford them. Cloth makers gave clothes to people who could not temporarily work due to bad health. The system nurtured the inherent human nature to indulge in charity and to treat fellow islanders as brothers. Civilization was at its peak.

    One more year passed by and the next election was upon Ghaziabad. The incumbent government decided to fight the election. Their campaign pitch was - "We carried our responsibilities diligently. We protected life, prevented theft and made sure that transactions were carried out properly. Vote for us and we will continue our sincere service to the people of Ghaziabad" Another team of three individuals Arvind Modi, Narendra Swamy and Subramanian Kejriwal was planning to fight the election and was rapidly gaining popularity in Ghaziabad. (The names are purely coincidental.) They were proposing a plan where every unemployed dweller on the island will get free fish and clothes. "We should at least provide basic livelihood to everybody on the island. It is their right" they said. People were initially confused. They asked - "We have not seen you guys produce a thing in your life. How are you going to give clothes and fish to these dwellers?" To this they answered - "We will collect it from cloth makers and fishermen. We will make this collection mandatory." Cloth makers and fishermen were furious at this idea and started a campaign against the team.

    Legend has it that it was all Rahul's idea. There was a village fool in Ghaziabad, his name was Rahul Chidambaram. He lived in a world of his own - talking to himself, running after kids who teased him and making various types of sounds from his armpits. He used to intentionally burp very loudly whenever anyone asked him his name. One day Modi, Swamy and Kejriwal were walking on the beach when they saw Rahul at a distance playing a game of 'who can pee the farthest' with kids. Kejriwal said to him jokingly - Will you vote for three for us if we fight the election. Rahul thought for a few minutes then said - "only if you give me some clothes and fish". Kejriwal, Modi and Swamy looked at each other and thought - "What a great idea? Forget about all the responsibilities, protecting property and life and yada yada. We will just promise fish and clothes to people. We will make the rules of the game. We will rule." And they decided to fight the elections.

    The team won with an overwhelming majority. Even some of the fishermen and cloth makers who did not feel like working anymore voted for them. Under the new government, hard working cloth makers and fishermen saw their produce being taken away against their will. Many fishermen closed their operations. People of Ghaziabad now had an incentive not to work and live off of production of others. Youngsters were not motivated to gain fishing and cloth making skills; they thought it was government's responsibility to feed them.

    The team announced new job vacancies in the government. They needed someone to collect fish and cloth from fishermen and cloth makers. When people asked how they will pay the employees, they said - "We will collect more fish and clothes from the fishermen and the cloth makers". Even more fishermen closed their operations after this announcement. As a result, fish became so scarce that lumberjacks had to cut wood for an entire day just to pay for one fish.

    Next election came and Swamy, Kejriwal and Modi with the best of their intentions announced "Fish are scarce. We don't want anybody to die of hunger. How can you ask a hungry man to work? We need to put price cap on fish. We need to collect more fish from these fishermen." The team further deviated from their initial responsibility to protect the life and personal property of people and to ensure completion of contracts between individuals on the island.

    Running out of fish and clothes to fulfill their promises, the team overtook Shyam's bank (nationalized it) and started giving saved clothes and fish to people. When the savers asked "Shyam paid us back if the investments were successful. We don't trust your investment skills. What if our savings are invested in ventures that are not successful". The team said "Don't worry about it. We will collect more from people and give it to you. We will sell the resources on the island and cover the losses." They "guaranteed" their savings.

    The guarantee purportedly devised to prevent run on the banks, that are essentially nationalized, is a part of an insidious arrangement. The RBI printing money out of thin air to "lend" to the government or to pay the savers is even more insidious. It devalues the savings. The power given to the RBI to lend to the government and to carry out open market operations is one of the root causes of the evil. Governments and friends of governments can destroy an economy via inflation with this unnecessary power.

    It can get a bit confusing when money is involved in transactions - "The government pays the farmer with money, the government pays the doctor for his services with money, the government pays teachers for education with money." The government does not produce anything. Money is title to goods or services; it does not come out of thin air. Neither do savings. Someone has to work hard to create savings. The one who saves has the right to invest her/his savings where he/she feels the reward is worth the risk. In a true republic the saver has this basic right. When people gave their savings to Shyam, they did their research on his credentials and kept a check on where their savings were being invested. People now with "guaranteed" savings stopped researching before they gave their savings to the team. Kejriwal, Modi and Swamy neither had the competence nor was there any pressure from the savers to invest in the right areas. The trio started giving money to their friends who could convince them easily. When they lost money, they just increased the tax.

    They also started making new rules - who can sell fish, what price can one charge etc. They appointed a planning commission to suggested areas where people should invest. The experts in the commision said - "Fishermen have become very wealthy. Only fishermen who will manufacture salt will be allowed to fish. The people of island need salt. There is a very high demand for it."

    If people need something, they pay for it, be it water, electricity, education or salt. Profit is a measure of value addition. If a business is not making profit producing a good or service, it means that people do not appreciate the value addition the business is offering. When a third party applies its mind and forces a business to invest somewhere, it essentially overrules the will of the people. Without exception, such an application of mind leads to misallocation of resources.

    What about national highways? What about water? Let us take national highways as an example as it seems most intuitive that they are a government responsibility. If people of Delhi say that red light should mean stop and people of Haryana say that red light should mean go, there is going to be a lot of confusion, so rules that fall under this category can be made by the government such as town planning (so that someone does not open a loud factory in the middle of a residential area), road maps (so that people don't build roads every which way) etc. But whether to build a national highway should be a decision made by the people. How? Build-Own-Transfer model has the answer. Highways' value should, like any other good or service, be measured by users' willingness to pay for it. Entrepreneurial individuals will assess this value and decide whether to build the road. An entrepreneur will build a road if he/she feels that its value will be appreciated by people i.e. people will pay for it. The resources the entrepreneur will use will be commensurate to the value of the road as measured by people's willingness to pay for it. If the entrepreneur builds a bad road, people won't pay to use it. The highway will be transferred as a national asset after a certain period of time.

    Governments are known to build roads to nowhere i.e. roads that provide no value. Government's sole responsibility in commerce is to provide an environment conducive for trade, not to apply its mind to interfere in it. No matter how intuitive it may sound, it should never be decided by a third party what goods or services people want to consume or what might benefit them. It takes a strong resolve and character to leave this power with the people. We will discuss one such resolve displayed by one of the 19th century presidents of the U.S. For now, let us return to the island of Ghaziabad.

    To cover for bank losses and to fulfill the promises given to the people of Ghaziabad, the government started collecting even more tax. With 40% of their catch being taken away by the government, even more fishermen stopped fishing. The sixteen year old prodigy who could earlier eat healthily by working for a few hours could only get one fish in exchange of a tank of water and was forced to stop his operation. By the time he came home after pulling the tanker all day, he was so hungry that one fish was not sufficient for him. Women started going to fetch water from the waterfall. As a result, clothes they made became scarce. Rape and theft were common as the team lost focus on its primary responsibility of ensuring safety of life and property. Very few people entered contracts as the authority to enforce them had weakened. Nobody wanted to produce so the team started giving perks to individuals to set up big production facilities. As a result, wealth disparity started increasing.

    The fabric of human nature that inspires every human to take care of others started deteriorating. People stopped charity as they thought it was government's responsibility to take care of "them". "Them" vs. "Us" was born. The "We" started deteriorating. Attitude of people changed to align with the existing set of incentives. Earlier hard work and risk was rewarded and 'Power' was defined as "The ability to help others by producing things that they needed". The new system rewarded connections with the government. The definition of 'Power' changed to "The ability to create problems for others". National character started shaping up in accordance. Everybody thought that everybody else is corrupt by nature. The death spiral had begun. In a few years the economy of Ghaziabad resembled that of India.

    This question from the bleeding hearts always seem to touch a nerve - "But then what will happen to the people dying on streets? Who will take care of them? Only a person who has not seen hunger can ignore their plight."

    When the government decides to help the poor with someone else's money, is essentially weakens the fabric of human nature; it doubts the inherent nature that inspires every human to indulge in charity, to treat a fellow national as his own brother and to take individual responsibility. It does not only make no economic sense but is also morally corrupt to the core. It takes a strong resolve and character to resist the temptation to help the dying with somebody else's money.

    Economists continue to site what the U.S. government is doing today to defend welfare policies. What made the U.S. a wealthy nation is not what it is doing today. Today, it has picked up a road to collapse. The U.S did not have income tax prior to 1913 (only profits were taxed). Income tax was unconstitutional before the 16th amendment. Similarly, the Fed was not allowed to buy the U.S. treasuries. It was only during the crisis of World War I that an exception was made to finance the war. Unfortunately this power given to the Fed was never reverted.

    The nation was built on sound principles. There is a very famous example from the glorious days of the U.S., the days that made the country a superpower. Members of the congress wanted to pass the Texas Seed bill in 1887 to help the farmers suffering from drought in the state of Texas. President Grover Cleveland vetoed the bill. The excerpt below from his reply to the congress summarizes his thinking.

    "I can find no warrant for such an appropriation in the Constitution, and I do not believe that the power and duty of the general government ought to be extended to the relief of individual suffering which is in no manner properly related to the public service or benefit. A prevalent tendency to disregard the limited mission of this power and duty should, I think, be steadfastly resisted, to the end that the lesson should be constantly enforced that, though the people support the government, the government should not support the people.

    The friendliness and charity of our countrymen can always be relied upon to relieve their fellow citizens in misfortune. This has been repeatedly and quite lately demonstrated. Federal aid in such cases encourages the expectation of paternal care on the part of the government and weakens the sturdiness of our national character, while it prevents the indulgence among our people of that kindly sentiment and conduct which strengthens the bonds of a common brotherhood."

    Following this veto, President Cleveland donated his personal money to the farmers of Texas.

    There is a radical difference between a Democracy and a Republic. In a Democracy a government does what the majority wants. In a Republic the power of the government is limited and cannot be increased even if majority wants it. India calls itself a Republic but operates like a Democracy. We adopted this form of government in 1947 and picked up the road to collapse. We will become a true Republic when 1.2 billion people are free to choose how they want to serve each other.

    "I will give you a talisman. Whenever you are in doubt, or when the self becomes too much with you, apply the following test. Recall the face of the poorest and the weakest man whom you may have seen, and ask yourself, if the step you contemplate is going to be of any use to him. Will he gain anything by it? Will it restore him to a control over his own life and destiny? In other words, will it lead to Swaraj (rule of the self) for the hungry and spiritually starving millions? Then you will find your doubts and your self melt away."

    - Mohandas Karamchand Gandhi

    The poor woman who walks for miles every day to get water does not need help from the government; she needs Swaraj.

    Jan 26 1:39 PM | Link | 1 Comment
  • Their Grievances Justified – A Case In Defense Of Capitalism And Paul Krugman

    The dynamics of greed, or a milder version of it called 'pursuit of wealth', has favored the rich over the poor in the past few decades. The norm of greed, nevertheless, was and has been equally endorsed by both the classes. Greed is not only supposed to make you wealthy. It can also make you poor, not because of the underlying risks, but due in part to the dynamics of the new economic model. Failure to comprehend this model can grossly misdirect grievances of both the 99% and the 1%.

    During the last few decades, and more so in the last fifteen years, the rich became rich by earning what was spent by the poor. What the 99% spent by selling the claims on their future earnings, the 1% earned by selling them goods and services. When it became clear that there were no future earnings to claim, the stakeholders should have taken the losses. At least that is what the virtue of capitalism suggests: risk controls greed.

    Missing or obscured in the equation, however, was the risk. An examination of how and where the risk was placed and how the steps taken to "solve" the situation guided the distribution of claims can help us better judge whether the responsibility lies in mere deviation from rectitude of the 100%, or a criminal offence on the part of the 1%, or a little less than 1% to be precise.

    Pure and simple trade is - I provide you with goods and services and hold claims on what you produce in the future. I take the risk and it is my loss if you don't produce anything in the future. In the new economic model the claims on future earnings of the spender, the 99%, are not held by the producer, the 1%. The risk is held by "someone else". The 1% keeps what it earns. This is why the 1% was happy when the welfare program was in effect replaced by a program meant to pander to the greed of the 99%. NINJA loans, LIAR loans and credit card loans financed all the spending and the 1% earned all that was spent with little or no risk.

    Do the 99% deserve sympathy? Certainly not for the reasons they sight. The 99% were let off the hook for the risks tied to claims on their future earnings were grossly underestimated, thanks to both the government support for many of these debts and the alleged fraud perpetrated via the collusion of banks and rating agencies. Yes, the banks too helped the 99% spend at their will for it was the demand for MBSs and CDOs that was in effect encouraging the inordinate lending. A portion of the extra dollars that went abroad due to the continuing trade deficit were circulated back into these claims perpetuating a vicious cycle, amplified by various feedback loops, of borrowing and spending; the mighty ability of the United States to earn and pay back was undermined by this modern Opium. When the market forces started functioning and it became clear that the spender is never going to be able to pay back, the holders of the hyper-valued claims started to fail.

    The 99% could just move away as they had no risks tied to the collateral, and that is exactly what they did. They walked away from the obligation and started saving, and the businesses that thrived on this spending started to fail. Government shifted a portion of the debt on its balance sheet. The poor became less poor now that the debt was purchased by the government. The rich did not become less rich. People who became rich in the process of this debt financed spending remained rich, thanks to the anthropomorphic nature of corporations. Insider trading further stacked the odds against the 99% invested in stocks.

    The banks were not allowed to fail. The government incurred debt to pick up the slack in spending, purchased much of the toxic assets and lowered interest rates to prop up the remaining collateral. So instead of the 99%, now the government will have to pay for the claims. The government will pay back this debt from tax revenues of future earnings. So in effect, the money that the 1% have is actually (a function of) the future earnings of tax payers. How did the 1% earn this money? It depends on who are we talking about. Many corporations (employees and shareholders) provided goods and services to earn this money; that seems legitimate, for it might not be justified to expect them to evaluate the supposed risk the spenders, the 99%, were offering. That risk was not written on the dollar bills they were spending; the risk had been taken by the mythical "someone else". Bank employees allegedly colluded with rating agencies, sold the claims on earnings, and took the cut; prima facie this is tantamount to criminal conspiracy and fraud.

    Of course, we cannot ignore China, the elephant in the room, before discussing the fairness of the next steps. The Chinese situation is plain and simple trade - The producer (China) sells goods, and bears the risk that the buyer (the United States) might not pay it back. So Chinese seem worse off than the rich in the U.S. who bore no such risk. On the brighter side, however, the Chinese gained enormously via access to capital goods that the Unites States, Germany and Japan took decades to develop. Chinese now have all these capital goods and more than $ 3 trillion to spare. The moment the Chinese de-peg the Yuan, and start consuming the products they produce, the inflation that the U.S. has been exporting to China will start showing inside the U.S. The resulting spike in interest rates will both reduce the tax base and increase the costs to service the debt and will force either default or hyperinflation upon the U.S. So in effect, the steps Chinese, the primary financier, take in the near future will determine the fate of the 99% and the 1% in the U.S.

    No signals from the government suggest that it wants to avoid the inflationary path. Spare a thought here for the Good Samaritan, who worked hard, spent responsibly, and saved for future consumption. Although a very rare species, he does deserve sympathy, as he now stands as the ultimate loser for he did not enjoy the "risk free" exuberance back then and will now look at his savings wiped out as the government tries to inflate its way out of the mess.

    Having said that, let us examine the other end of the spectrum advocated most fiercely by Peter Schiff. Taking a situation to an impractical level sometimes helps form rational perspectives, so let us do that here. What will happen if we bring capitalism back to the United States - say, as close as we can get to laissez faire? - Stop all monetary and fiscal stimuli, allow the interest rates to rise, demolish the regulatory burden, reduce government spending and stop all forms of wealth redistribution. Not new to the Americans, this is the old American - Grover Cleveland style, a path strictly guided by the constitution. Of course, under such a scenario, the Chinese can just forget about all their claims on future earnings of Americans. Many businesses will close down as the spenders lose access to debt they cannot pay back and the spending patterns readjust. Banks will fail, and will be allowed to fail. New healthy businesses and financial institutions will come up, and the entrepreneurial spirit of the mighty United States will spring back before anyone in the world can realize. However, the foundation of this resurgence would not be as sound as it seems. Under this reversion to capitalism, a portion of the wealth that the 1% own will effectively be what the debt holders around the world earned and will never be paid back. The 99% can live with that. However, not all the government debt is external. Internal debt represents money that future tax payers will earn. The existing 1% possess some of this wealth as well. The 99% can object to that as they never voted for the government to take on the debt. It should have been the banks and holders of the debt that should have taken the losses. Even if we ignore the origin of wealth of the 1%, wealth disparity under this transfer to capitalism will be enormous. While the wealthy will have the luxury of choosing between starting a business and enjoying their wealth, it will be a matter of survival for the 99%. A reasonable assumption that legitimizes sympathy for the 99% is that they could not have been expected to behave in any other way. Is a citizen of the United States expected to deny if he/she is offered a free lunch? How could he/she be expected to pay the price of the steps taken by the government and the banks? Disparity between competent and incompetent makes sense in capitalism where risk ensures fitness. It does not make any sense if some reckless intervention of the government leaves all the capital that engineers and scientists have developed over decades of hard work into the hands of a certain few. Who will answer the indebted generation some of who have not yet taken birth and whose wealth is already in the hands of the existing 1%?

    Before discussing the merit of Paul Krugman's argument, let us try to identify the root causes that led us into this mess. Intellectual tycoon, politician and economist Subramanian Swamy often discusses in his speeches the structure of society in ancient India as described in the scriptures. The model has an element of relevance here. The Varna Vyavastha (presently known as the caste system) was never meant to be hereditary as it exists in India today. Two great sages Maharshi Bhrigu and Maharshi Bharadwaja led a debate to decide the structure of the Hindu society. (You can imagine it as the greatest philosophers, psychiatrists, mathematicians, economists etc. of the time coming on a platform to discuss the structure of the society.) The outcome of the debate was that there should be four sections of society in alignment with inherent human nature.

    Elements of power were recognized as knowledge, weapons, wealth and land. To avoid centralization of power, any single person could hold only one of these elements. The highest and the most revered class was that of intellectuals. However they were not allowed to hold wealth, weapons or land. Second in line were kings who had access to weapons. However, they were not allowed to take decisions without the approval of intellectuals. The third caste was that of businessmen, who did not have the intellectual ability to create, neither had the heart to defend their wife and children, but had the risk appetite (financial) and ability to execute businesses within the framework created by intellectuals. They possessed wealth but did not enjoy any social status. Their social status was determined by how much charitable they were. The last caste was that of labor. Transfer from lower to higher caste was a norm; in fact some of the greatest intellectuals in India were born in low caste families.

    There are many parallels that can be drawn from this model but let us focus on human motivations. Let us start with two basic primitive motivations: animals want to secure food to survive and want to pass their genes to the next generation. Recognition from other animals, power to control, and access to territory all help achieve these two objectives. Humans desire these same elements - social recognition, power, and access to wealth driven by these primitive instincts. These elements are not absolute, they are relative. So, a human driven by these elements cannot be satisfied with a finite amount of these elements. (I am not touching the spiritual realm which deals with the absolute and might not be applicable to the current scenario. Pursuit of knowledge is considered closest to the spiritual realm.)

    If you create an environment where wealthy are revered and where they can influence decisions to control, you effectively give all the three elements of power to a few. This is the present situation in the United States. Access to capital (that was developed by scientists and engineers and proliferated by industrialists with decades of collaboration), social recognition (driven recently primarily by the media), and control of power via government (lobbying for unconstitutional favors) all belong to a few. This has enormous economic and biological ramifications for mankind. Distributing this power fairly will be impossible unless something unprecedented happens as it is human nature not to let go of what he/she has without resistance.

    This brings me to the argument raised by Paul Krugman where he argues that a fake alien invasion can bring the economy out of the current slump in eighteen months. The idea of alien invasion may seem dissociated from reality, but this argument is strongly rooted in the relationship between human motivations and economy. Under war-like situations, human motivations make a radical shift. During wars, a lower standard of living does not invoke frustration, it becomes sacrifice. Massive build-up of capital takes place driven by sacrifice of the poor and the rich alike. Wealthy become less wealthy as capital gets devalued. When the war is over, capital goods can be re-tooled for production. The fit regain control of this capital. Aligned human motivations and hard work can indeed bring back the economy on the right track very quickly. The merit of this argument cannot be discounted on the basis of its "impracticality". If there is any argument that directs us to the virtues that can reinstate the health of the economy, its merit, at least in theory, should not go unappreciated.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Feb 20 10:53 AM | Link | Comment!
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