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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
  • Republic Of Ghaziabad – Part II

    "The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."

    - Friedrich A. Hayek

    The plight of a weaver in Uttar Pradesh who toils day in and day out and yet sees her real earnings dwindle year after year to a point where she is not able to afford milk for her newborn child, can be attributed directly to a few policies and Acts that are not even questioned, if not brandished, by the very politicians and bureaucrats who are, or at least say they are, sincere in their hearts and care about the interests of the poor.

    When terrorists kill women and children using arms and ammunition, everybody can see the crime and the criminals and almost everyone who comes to know of the act condemns it. There are two major differences between terrorism and economic ignorance perpetrated by politicians and bureaucrats; the culprit is not conspicuous and the casualties are much higher in the latter.

    This article throws light on how brutal it can get when a bunch of bureaucrats and politicians, despite having the best of intentions, end up hurting the very sections of the society they start out to help.

    Let us expose the most unusual suspect first. Economists in the U.S. won't speak of it as they want to be in good terms with Uncle Sam. Economists in India don't speak of it for they fear becoming a laughing stock if they stand behind something that mainstream economists do not endorse. So nobody speaks of the machinations embedded in our foreign exchange reserve policy that drain the wealth of the poorest in our nation. A sound economist can see it with absolute clarity that the huge pile of reserves of fiat foreign currencies, that the RBI is holding, is directly responsible for the impoverishment of millions of poor Indians.

    As in my previous article 'Republic of Ghaziabad', we will stay away from any technical terms that might give "economists" an opportunity to blabber about something they don't understand. For those who have not read the article, I would encourage you to read it here: Republic of Ghaziabad (reading it is not necessary to understand the contents of this article).

    Ghaziabad was an island in the Indian Ocean. To put things in perspective, let us revisit, in flashback, one development that had taken place in Ghaziabad during its golden period. Shyam, an owner of a private bank in Ghaziabad, had started issuing notes against the goods people deposited in his bank; when someone deposited four kilograms of wheat in his bank, he would issue four notes, each saying "I, Shyam, promise the bearer of this note one kilogram of wheat". The notes could be traded in the market by the depositor. Instead of directly trading in goods, the people of Ghaziabad started trading with notes issued by Shyam. The bearers of the notes held the title to the goods promised on the notes and could go to the bank and claim the goods.

    Note that any island dweller with a note could go to the bank and claim the goods promised on it, so Shyam could not print notes (money) out of thin air.

    The invention of currency notes improved the efficiency of trade in Ghaziabad. It also enhanced the trade between Ghaziabad and a neighboring island called Atlanta. Wheat produced in Ghaziabad was popular in Atlanta. Boats manufactured in Atlanta were of much better quality and were cheaper than the boats made in Ghaziabad. Prior to the invention of notes, people of Ghaziabad and Atlanta traded in goods. One boat was typically exchanged with 80 - 120 kilograms of wheat. As notes became a prevalent means of trade in Ghaziabad, the people of Atlanta started demanding the notes issued by Shyam to purchase wheat from farmers. Businessmen in Atlanta knew that Shyam was a reputed banker and that they could rely on the notes issued by him, i.e. they could go to his bank and claim the goods promised on the notes. They also knew that the government of Ghaziabad had an efficient judicial system that could be relied upon if someone breached a contract or committed fraud within Ghaziabad.

    A private bank in Atlanta also issued similar notes. Businessmen of Atlanta offered to exchange notes issued by the bank in Atlanta with notes used in Ghaziabad. The first reaction of the people of Ghaziabad was - "What will we do with your notes? Eat them?" The businessmen replied "Like each of your note is good for one kilogram of wheat, each of our note is good for one boat manufactured in Atlanta. You can go to the bank in Atlanta, produce a note on the counter and claim a boat."

    After thoroughly investigating the operations of the bank in Atlanta, the people of Ghaziabad agreed to trade in currencies. Reflective of the prior exchange rate of the underlying goods, i.e. wheat and boats, one note of Atlanta could be exchanged with 80 - 100 notes of Ghaziabad. Notes of Atlanta became expensive when the fishermen of Ghaziabad demanded more boats. One Atlanta note could be exchanged with 120 notes of Ghaziabad during such times. When the people of Ghaziabad did not need as many boats, one Atlanta note could be exchanged with as low as 80 Ghaziabad notes. The exchange rate was determined by how the people of Ghaziabad valued the goods produced in their land versus the goods produced in Atlanta.

    Honest price discovery, a pillar of free market, relayed information about what goods were valued by the people of Ghaziabad, and helped the people who produced those goods climb up the socioeconomic ladder.

    With increase in trade, the pattern of employment changed. Boat makers in Ghaziabad who could not make good quality and cheaper boats became unemployed temporarily before switching to producing goods and services that people of Ghaziabad and Atlanta valued more. Some of them were employed by wheat farmers whose wheat was in demand in Atlanta. Some were employed by fishermen who had purchased boats manufactured in Atlanta. As a result of this free trade between Ghaziabad and Atlanta, the people of Ghaziabad enjoyed better quality and cheaper fish.

    Note that the people of Ghaziabad did not export for the sake of exporting or to create jobs; they exported only to be able to import the goods they could consume.

    Now we come out of the flash back and enter the period when the economy of Ghaziabad had picked up the road to serfdom.

    Arvind Modi, Narendra Swamy and Subramanian Kejriwal were three elected government officials of Ghaziabad. The government under their leadership had completely strayed away from its core responsibility of protecting life and property and of resolving conflicts. They had nationalized Shyam's bank and had assumed, by force, the authority to issue notes in Ghaziabad. The island was in a state of chaos and the government was grasping for straws to put the economy back on track. Modi, Swamy and Kejrial knew that investments create wealth. However, nobody in Ghaziabad wanted to invest, so they reached out to a businessman in Atlanta and requested him to invest in Ghaziabad.

    The entrepreneur expressed his concerns "The risk of investing in Ghaziabad is very high. You don't have an efficient legal mechanism for resolving business conflicts. The law and order situation is not the best either. I appreciate your love for the poor but what if in the future you promise something to the voters to get elected and print notes to fulfill those promises. I will be left holding the proverbial bag filled with devalued notes. I have invested in Ghaziabad before but at that time, your judicial system was the best in the world. Shyam owned the bank and maintained a credible supply of notes. I could go to his bank and exchange one note with one kilogram of wheat. With the government in charge of printing notes, I don't know if I will get one kilogram or half a kilogram or anything at all for the notes I earn in the future. That is too much risk for me."

    Faced with this conundrum, Modi, Swamy and Kejriwal turned to their wild card - Rahul Chidambaram.

    The trio called Rahul and asked him for a recommendation. Rahul had forgotten to wear his underwear that day and was struggling to hold his pants up. But that did not stop him from giving a genius of an idea. "Why don't you print some notes and buy the notes printed in Atlanta from wheat farmers? If the bank has a lot of Atlanta notes on its balance sheet, the businessmen of Atlanta will feel confident about investing in Ghaziabad. It will also help us look good when we borrow from Atlanta. Moreover, it will make our notes cheaper to the people of Atlanta and we will be able to export more goods and services to them. Exports create jobs. And jobs create wealth. It is a cycle you know. Those rascals must have stolen the drawstring from my pants" Rahul said angrily. He then squatted to prevent slippage wondering if he himself took the drawstring out of his pants to spin a top when he was playing with village kids near a well last week.

    Modi, Swamy and Kejriwal looked at each other. There was a familiar spark in their eyes; they thought "Forget about fiscal discipline, monetary rectitude and a sound system of justice to attract investors. We will just print notes and buy the notes printed in Atlanta. Who does it hurt anyway?"

    The bank started printing notes at an unprecedented scale to purchase Atlanta notes from wheat farmers. The artificial demand of Atlanta notes by the government made them very expensive; it de-linked the exchange rate from a genuine valuation by the people of Ghaziabad. One could get 400 - 500 notes of Ghaziabad with just one Atlanta note. As a result, the labor in Ghaziabad became cheaper for the people of Atlanta. Businessmen in Ghaziabad opened huge massage parlors (service sector) and employed cheap labor to provide massage services to the people of Atlanta. The people of Atlanta preferred Eucalyptus oil for their massages. Farmers in Ghaziabad who grew fodder for cattle in their fields started growing Eucalyptus trees.

    When Modi, Swamy and Kejriwal saw palatial massage parlors in Ghaziabad, they thought "That son of a gun was right. What great free market economists could not conceive of in two hundred years and efficient republics could not achieve in decades, this genius has accomplished with a single stroke. Print notes, exchange them with Atlanta notes, sit on the stack and do nothing. Yes that is right - Just sit on the stack of Atlanta notes. Why did we not think of this elixir before?"

    The massage parlor owners were gung ho about the newly discovered miracle cure. They exclaimed "The bank does not have enough Atlanta notes. The notes that the bank has collected so far are not even sufficient to cover our external debt. The government should collect more notes from Atlanta. We need to devalue our notes even more to be able to export more."

    When the people of Atlanta saw that the bank of Ghaziabad was collecting their notes, they thought - "People of Ghaziabad will never get their hands on the notes that the government of Ghaziabad is collecting and we will never have to deliver the boats promised on the notes. On the other hand, we are getting wheat and cheap massages by simply giving them our notes. We should print more notes." So they printed more and more and more. The government of Atlanta publicly lauded the government of Ghaziabad "The economy of Ghaziabad is very robust. They have so many of our notes. They are even lending the notes back to us and earning even more notes.". The economists of Atlanta decorated Rahul Chidambaram with numerous awards and called him 'the best free market economist on the planet'.

    When fish became difficult to catch in the Indian Ocean due to seasonal effects, the fishermen of Ghaziabad desperately needed Atlanta notes to buy efficient boats, but the notes had become very expensive. They had to compete with the government of Ghaziabad to buy Atlanta notes. While the fishermen could have used the notes to purchase productive boats from Atlanta, the bank just sat on the notes it had collected. Not only did the fishermen remain poor, the people of Ghaziabad were deprived of cheaper fish. Many island dwellers who could not afford expensive fish had to sleep hungry.

    One day, a weaver in a village in Ghaziabad went to a milk shop and offered to exchange one note with a liter of milk. The milk-man said "I am sorry sister. The bank, now owned by the government, has printed so many of these notes to purchase the notes of Atlanta that when I went to the bank to claim the wheat promised on the notes, the teller told me that each note is now only worth half a kilogram of wheat. The bank does not have enough savings (goods) to back up the notes they have printed. So now I charge two notes for one liter of milk." The weaver could not understand. She asked "How is this possible? The note says that it is worth one kilogram of wheat. I earned this note with honesty and hard work and now it is not even worth what it says on the note." The poor woman held back her tears. She was forced to use some of the notes she had saved for an emergency to buy milk for her child.

    After a few weeks, the weaver came back to purchase milk and offered two notes to the milk-man. The milk-man said "Sister. Now I need three notes for a liter of milk. When the bank printed new notes, the first recipients of the notes were the masseurs of Ghaziabad. The masseurs exchanged their Atlanta notes, that they earned by massaging the people of Atlanta, for new notes printed by the bank. The masseurs also got new notes, created by the bank out of thin air, loaned out to the owners of the massage parlors. For some time, these masseurs enjoyed lower prices of goods like the clothes you produce and the milk I offer. Now they are using their notes to bid up the exchange rate of everything. I too have to feed my kids you see. So I have increased the price of milk." The milk-man continued. "I know you live from hand to mouth so saving money in the bank for a considerable duration, to increase your notes at the rate of price rise, is not an option for you. But there is one thing you can do to keep up. You can start charging more notes for the clothes you make. Then you will be able to afford milk for your child". The weaver said "But what about the hard work I did last month to earn the notes I already have." The milk-man replied "I am sorry sister, a portion of that labor has been stolen by Modi, Swamy and Kejriwal".

    Her throat choked as she asked - "What if I come back and you raise the price again? My child is malnourished and might not survive another winter. I don't have much savings left." The milk-man said "Your concern is not unwarranted. In fact it is more likely to happen as the government continues to print more notes. Unfortunately, that is the uncertainty we have to learn to live with. You may try reaching out to Modi, Swamy and Kejriwal. They are building toilets using the tax money they collect from the masseurs. Their economists have calculated that a toilet would be valuable for you. You can ask them to give some of that money directly to you. They might return to you what they have stolen from you so that you can decide what to do with your money. You can also request them to sell the notes of Atlanta that they have been collecting so that this insidious transfer of wealth, from you and the fishermen in Ghaziabad to the consumers of wheat in Atlanta and the masseurs in Ghaziabad, is stopped once and for all. But I would not count on it because of two reasons. One, the fishermen, like you, don't know how their wealth is being stolen and who is stealing it. And two, the masseurs who are the beneficiaries of this note-collection policy of the government now have tremendous political clout and will do everything in their power to prevent Modi, Swamy and Kejriwal from selling the Atlanta notes with the bank."

    The milk-man's face contorted. One could see pain in his eyes, but he did not stop "Sister, you are lucky in some regard. Rice and cotton farmers cannot even raise the price of their produce. The government has outlawed free market in those farming segments (APMC Act). I have heard that Rahul gave the government this idea to secure food for the poor. Now, only people with government licenses (Aartis) can make wholesale purchases. Without even breaking a sweat in the field, these license holders are making all the profits by selling the produce at a high price to the people of Ghaziabad. One of my friends is a rice farmer. He wanted to treat his ill mother but could not afford it with his existing level of earnings. As you know the cost of healthcare has also risen. When he tried to sell his produce in the market at a higher price, the government license holders threatened to boycott him, and when he did not listen, they sent goons who beat him to death. The police and the judicial system no longer protects property rights. Cartels which were impossible to form earlier are now rampant. When you meet Modi, Swamy and Kejriwal, please ask them to abolish this law as well. I doubt they will listen to you because the license holders have become very wealthy and have close friends in the government. But since you are going to meet them, there is no harm in trying"

    Before 1971, and more so before 1934, one could go to a bank in the U.S., produce a dollar bill on the counter, and demand the amount of gold promised on the note. With the Gold Reserve Act of 1934, the U.S. changed the nominal value of the U.S. dollar from 1.505 grams of gold to 0.888 grams of gold. With a single stroke, the U.S. government slashed in half the amount of gold the Federal Reserve owed to the world. Finally in 1971, after printing an enormous amount of dollars without any backing of gold, the U.S. completely de-pegged the dollar from gold and defaulted on its obligations. Since 1971, the Federal Reserve has had the liberty to print as many dollars as it wants. The Federal Reserve is printing more and more and more.

    In 1926, Montagu Norman, Governor of the Federal Reserve Bank of New York, used all the resources at his disposal to defeat Basil Blakett's plan to establish a full gold standard in India. After the push from the U.S. for central banking in India, the RBI was established on April 01, 1935; perhaps the biggest April Fool of the Indian population. Later in 1944 at the Bretton Woods agreement, the U.S. dollar was accepted as the reserve currency. However, in 1947, the British, lacking resources after they were brutally hammered by the Axis powers all over the globe, relinquished their influence over the subcontinent to their war ally, the Soviet Union. Under the Soviet influence, the RBI did not collect the notes printed in the U.S. After the collapse of the Soviet Union in 1991, the RBI started collecting dollars as reserves. The U.S. printed the dollars, and the RBI collected them from exporters, transferring the wealth of savers and producers (weavers and fishermen) in India to consumers in the U.S. (people of Atlanta) and a few exporters (masseurs) in India. Strange as it may sound but it is true: The foreign exchange reserve policy of India subsidizes consumption in the U.S.

    The foreign fiat reserves with the RBI is the cumulative purchasing power stolen from the poorest in India to benefit essentially two set of people, exporters in India and consumers outside India; both enjoy at the expense of the poorest in India. Total foreign reserves stand at more than $300 billion. That is about Rs. 15,000 for every man woman and child in India. That is somebody's education you stole. That is somebody's healthcare you stole. That is someone's new born child's milk you stole. Can there by anything more insidious than that? Can there be anything more foolish than collecting fiat notes of a foreign country? The saddest part is that politicians come on national television and brag about how sound our foreign reserves are.

    When you see a Rs.120 crore fancy BPO or IT building in a city in India, don't delude yourself by calling it development. It is just that the building is visible and the mechanism with which Rs. 1 was stolen from each of the 120 crore poor Indians is not.

    Export is not an end in itself. It is a means to import goods and services that are produced more efficiently elsewhere. Printing notes to collect foreign fiat currencies does not create employment. It only changes the pattern of employment. It might look like a virtuous cycle of investment, employment and demand creating prosperity for all, but that is far from true. Visible is the employment in sectors that benefit (masseurs and eucalyptus farmers). What is not easily visible is the misery brought by the devaluation.

    Also killed in the process is a genuine price discovery, the soul of free market, that enables people who provide value ride up the ladder. A masseur suddenly becomes valuable for the society and a farmer toiling in heat and dust is forced to commit suicide.

    Confront an exporter and he will start squawking like a parrot "If we don't export, the foreign businessmen will import/invest and take all our money. China also collects reserves. How will we buy oil? The interest rates in the U.S. are so low; it is an unfair competition for our businessmen who don't have access to cheap capital, so we should at least give them this cushion. The income of the poor has risen because of the note collection policy."

    What will the foreigners do with our currency notes? Eat them? No, they won't eat our money. They will use it to buy something of value that we create for them. And when they spend the money they earn, productive and valuable jobs will be created in sectors that are truly valuable. Collecting reserves is one wrong thing that the Chinese have done; they have started realizing their mistake and are moving away from their peg. A country does not buy oil, the people of the country do. Except for strategic defense purposes, it makes no sense for the government to collect fiat reserves to secure future purchases of oil. If the Federal Reserve is printing notes and keeping their interest rates low, an inflow of dollars will make the rupee rise against the dollar (demand and supply). Foreigners will find it difficult to purchase the rupee. In other words, the amount of FDI will be driven by what is valued by the 1.2 billion people of India and not a few bureaucrats in the government. "The income of the poor has risen because of the note collection policy." Really? Tell that to the weaver who is not able to afford milk for her new born child. Tell that to the rice farmer who is not able to afford medical care for his mother.

    The fear of the foreign investor, the government is trying to lure, is not unfounded. The state of our judicial system is not the best. The government is more than $1 trillion in debt and there is nothing stopping the government from simply taking on more debt and monetizing it (printing notes). It is natural for the investor to expect some form of solace from the government. It is natural for a foreign investor to expect it, but is criminal for the government to grant it by collecting reserves.

    Investors are better attracted by rule of law and a reliable judicial system that resolves conflicts efficiently. Majority of the resources available to the government should be dedicated to that cause. Confidence in the rupee ought to be restored by a prudent fiscal policy (possibly a constitutional amendment that does not allow the total government debt to exceed 10% of the GDP in the future i.e. post a default which is likely imminent if the government does not pick the road to hyperinflation, killing the economy once and for all) and a reliable monetary policy (limiting the ends towards which the RBI can carry out open market operations, preferably limiting its mission to being a lender of last resort). And finally, the RBI should return the purchasing power stolen from the poorest in India by selling its fiat reserves in a time bound fashion.

    Yes, fiscally responsible road is not an easy one to tread on. Yes, a reliable monetary policy calls for restraint and patience. Yes, it is a mammoth task to achieve rule of law and establish an efficient judicial system. But an "easy way out", which is not even a way out is simply criminal.

    Akin Culprits

    It is time for another flashback. During the free market regime in Ghaziabad, Shyam lent out money at an interest rate that was determined by the level of savings and the demand for credit in Ghaziabad. When people saved more and the demand for credit was low, Shyam loaned out notes at lower interest rates. When people saved less and the demand for loans was high, he increased the interest rates. Shyam evaluated all the loan applications thoroughly and charged a premium for projects with high risk. He did not "decide" the interest rate. It was determined by the demand and supply of notes and credit risk of projects. When interest rates were high, it meant that there was less to be loaned out for investment. "That makes sense." Shyam explained "Only something that is saved can be invested. When savings are low, only businesses that are the healthiest, i.e. businesses that people value the most, are able to pay back a high rate of interest. Other businesses, that don't provide as much value, are automatically culled out. There are no experts who determine lending targets or impose priority sectors upon us. Every transaction that occurs on this island is reflective of the will of the people of Ghaziabad."

    Not all people came to the bank at once to get their saved goods. So Shyam could loan out more notes than what he could issue directly against the goods people saved with him. But he could issue new notes only to the extent that the people of Ghaziabad didn't lose confidence in his bank. He could not print notes out of thin air; depositors kept a check on where and how much Shyam was investing. A sound fractional reserve banking system was born.

    With genuine healthy credit backed by sound savings, the economy of Ghaziabad started growing at a rapid pace. Two wheat farmers in Ghaziabad, Ashok and Kamal, applied for credit in Shyam's bank; both wanted to buy an ox. Shyam investigated the creditworthiness of Ashok and Kamal and found that Ashok was more productive than average farmers in Ghaziabad, wherewas Kamal was not creditworthy and might have run away with the money. Shyam decided to give a loan to Ashok and turned down Kamal's application. Ashok used the notes to buy an ox. He also offered to purchase Kamal's land. Kamal found the price offered by Ashok to be very attractive, as he could not even dream of making that much amount of money farming on the land his entire life. Ashok could offer such an attractive price for the land as he was more productive than Kamal, and therefore could get more out of the land. Ashok bought Kamal's land and started cultivating it. As a result of these two transactions, more land came under productive cultivation.

    Note that no land acquisition act was required to bring the land under more productive private uses. Repeat: private uses.

    Kamal used the money he got from Ashok to open a samosa shop. On her death bed, Kamal's mother had whispered a secret samosa recipe into his ears. He bought potatoes grown in one of Ashok's farms, added value to them using the secret recipe and sold the samosas to the people of Ghaziabad. One of Kamal's sons started tilling land for Ashok and learned valuable farming skills in the process. Ashok's nephew, who was unemployed before, started frying samosas at Kamal's shop. Even Rahul got a job; he became a sign spinner for the samosa shop; Kamal gave him a samosa everyday for spinning a sign for an hour. All of them, Ashok, Kamal and Shyam and their families were better off. The people of Ghaziabad got cheaper food grains and an option to purchase delicious samosas. Numerous such transactions took place in Ghaziabad opening new opportunities for the people of Ghaziabad to add value to the economy.

    Now we come back out of the flashback to the period when the economy of Ghaziabad had started tottering under the new government. Modi, Swamy and Kejriwal were initially blinded by the prosperity of masseurs and eucalyptus farmers. They were busy celebrating the success of Rahul's genius idea of collecting Atlanta notes. "Look at the wealth around you. Look at the growth rate. Look at the reserves. Look at the massaging skill sets our masseurs have developed" they boasted. However, after about a year, the reality started setting in. They could not understand why there was so much price rise and why so many farmers and weavers were protesting.

    Modi, Swamy and Kejriwal went running to Rahul's house and prostrated before him. Rahul nodded his head with reproach as he spoke "You guys just don't get it. It is simple. The banks are not giving credit to the poor. Besides that, you are charging a very high rate of interest on loans. It is impeding investments. I am going to give you two solutions. Lower the interest rates by issuing more notes and give credit to the poor. Problem solved. And for the last time, just don't barge into my house when I am reading." Rahul then got back to reading his favorite book 'Chacha Chaudhary aur Raka ka Intakaam'.

    Modi, Swamy and Kejriwal started giving loans to farmers. Unlike Shyam who had an incentive to investigate the creditworthiness of the farmers who applied for loans in his bank, the government gave credit to just about anybody who cared to apply for a loan. The bank gave credit to both Ashok and Kamal. Even Rahul applied for a loan to buy an ox. "I want to milk it every day for breakfast." he wrote in his loan application. His loan was approved.

    When Ashok went to purchase an ox, he could not find one. Kamal and Rahul had bought the ox Ashok had planned to purchase. Ashok had to spend more money to buy an ox from a nearby village. Kamal and Rahul stopped paying back their loans after about six months. The bank raised the interest rates to make up for the bad loans, making credit expensive even for productive farmers like Ashok. Productivity of the labor in Ghaziabad started stagnating. When people started worrying about whether they will get their deposits back, the government guaranteed their deposits (DICGC). The guarantee was essentially meaningless as the government could simply print notes and devalue the savings to pay back the depositors. As a result, the depositors stopped caring where their money was being invested.

    Despite an increase in the number of bad loans, the bank employees demanded an increment in their wages. The wage hike was approved by the government. "It is somebody else's money" Modi, Sawmy and Kejriwal thought. So they stole more wealth from the poor (printed more notes) and gave it to the bank officials. A note in retrospect - When Shyam owned and operated the bank and his customers stopped paying back their loans, his bottom line took the hit.

    When the interest rates started rising, the bank printed more notes to create an artificial supply of savings and lowered the interest rates for priority segments determined by a committee of experts in the bank. The recipients of the new notes (created out of thin air) started bidding up the price of goods in Ghaziabad. The weaver was doomed twice, once by the note-collection policy and then by a suppressed interest rate.

    The government was one of the biggest beneficiaries of low interest rates; it could borrow and spend unlimited amount of money on salaries of government officials. Everybody started desiring government jobs where one could get notes printed by the government and enjoy a secure life at the expense of the producers and savers in Ghaziabad.

    The downward spiral did not stop. In one of the local elections, Rahul suggested to the government "If you waive off my friend Kamal's loan, he and his family will give you their vote." The government, unlike Shyam, did not care if the notes lost their value. So they printed more notes and waived off many such loans. Ashok who was sincerely paying back his loan felt cheated and stopped making the payments; many hard working farmers followed suit. Due to a significant rise in the number bad loans, the bank stopped lending to farmers altogether. The farmers in Ghaziabad started borrowing from ruthless local lenders (Sahukars). With the government spending only a fraction of its budget on maintaining law and order and judiciary, the local lenders felt confident threatening the farmers and harassing them for money. Many farmers decided to commit suicide instead of facing the ordeal. In the past, when the government spent almost all its resources on maintaining a rule of law, local lenders had access only to the collateral posted by the farmers, and not their life or liberty.

    Financial inclusion is a symptom of wealth that comes with free market. You cannot force financial inclusion and expect wealth creation for the poor.

    Businesses that people value will thrive when the banks are not owned and operated by the government and when the RBI is not allowed to interfere with the interest rates. Stealing the savings of the hard working poor in India by artificially decreasing the interest rates (printing notes) to achieve what might look like development in the short run is as heinous a crime as a terrorist attack.

    And lastly, except for an emergency of war, the RBI and nationalized banks should not be allowed to purchase government bonds enabling the government to spend poor people's money on salaries of government officials and wasteful schemes. That is one change in the policy of the RBI that can constrain the governments guided by Rahul Chidambaram from becoming a burden on the society.

    If you are deluded into thinking that there is an arcane science behind monetary policy, or if you are befuddled by some "economist" regurgitating terminologies, I would encourage you to read the most definitive paper on monetary policy by Milton Friedman published in 1968: The Role of Monetary Policy. Monetary policy cannot be used to stimulate growth. Milton Friedman's last recommendation, after he saw what happened in the three decades post 1971, was a return to gold standard. As regards to fiscal policy, Dr. Friedman believed that J.M.Keynes, before his demise in 1946, was about to come out in public with a paper criticizing the ridiculous extent to which his disciples had applied his theories, that were more relevant during the preceding wartime, to please government officials who were desperate to be seen in public as trying to do something to solve the "problem". Unfortunately, he passed away before he could do so. Today, all you need to be recognized as an economist is a PhD degree and an ability to squawk "Lower the interest rates", "Spend more on infrastructure."

    Yes, establishing a healthy system of private credit is an enormous task that cannot be completed overnight. Yes, prohibiting the central bank from interfering with the interest rates can cause some pain in the short term. Yes, maintaining law and order and establishing a sound judicial system, to deter local lenders from harassing poor farmers, is difficult to achieve. But an "easy way out" which is far from a way out is simply criminal.

    Side note: No land acquisition was required to facilitate the transaction that took place in Ghaziabad between Ashok and Kamal, to bring the land under a more productive private use. If the government acquires land for projects (freeways, new cities etc.), it should be auctioned, so that entrepreneurs can compete with each other to purchase the land and use it for most productive businesses/infrastructure. Complex 'public private partnerships' that force the taxpayers to bear the risk of such projects do not make any economic sense.

    The government "help"

    Government is good at one thing: It knows how to break your legs, hand you a crutch, and say, "See, if it weren't for the government, you wouldn't be able to walk."

    - Harry Browne

    When elected men with immaculate virtue use eminent domain to determine the greater good, you can be assured of one thing - The end result will not be good, let alone greater. Banks nationalized for the greater good? Collecting fiat foreign currency reserves for the greater good? Regulations on businesses for the greater good? APMC Act for the greater good? Sale of acquired land at throw away prices for the greater good? Interfering with interest rates for the greater good? Oh no, your greater good is bad. My greater good is actually good. Isn't it? Do you think the banks were nationalized for the greater bad? Do you think the enormous regulations on businesses were put in place for the greater bad? It is always something that is done for the greater good that further traps our nation into poverty because strangled in the process is the spirit of free market. Good institutions are the ones that don't rely on virtuous men running them. Governments are not an exception.

    Unfortunately, there is always someone in the government yearning to pull a Rahul Chidambaram. More often than not these ideas are endorsed by our "economists". The irony is exacerbated by a scarcity of recognized genuine free market economists in economies that were once the bastions of free market. In the United States, where free market was embraced more than two hundred years ago, the current state of affairs is such that economists are acclaimed only if they don't know, or pretend not to know, anything about economics; mindless cheerleaders of regulation and big governments are decorated for their brilliance in economic thinking. Again, no one other than Milton Friedman, who won the Nobel prize in economics in 1976, admitted that he could come out openly against big governments only at the end of his career when he had very little to lose. The U.S. government did not listen to him at the time and now, three decades later, the country is on the brink of an economic collapse that many free market economists believe will dwarf the 2008 meltdown. (You can read about the dynamics of the imminent economic crisis in the U.S. in my article 'The Changing Game of Ben Bernanke' published in 2013)

    Our nation needs genuine free market economists to put down ideas proposed by Rahul Chidambaram before they do any damage, and to redirect all the resources at the disposal of the government towards its three responsibilities: External security (defense), internal security of life and property (police), and an efficient judicial system to resolve conflicts. Our nation cannot afford to invest in anything but these three tried and tested foundation stones of a Republic that have produced the nations that we call superpowers.

    "There are four ways in which you can spend money. You can spend your own money on yourself. When you do that, you really watch out what you're doing, and you try to get the most for your money. Then you can spend your own money on somebody else. For example, I buy a birthday present for someone. Well, then I am not so careful about the content of the present, but I am very careful about the cost. Then, I can spend somebody else's money on myself. And if I spend somebody else's money on myself, then I am sure going to have a good lunch. Finally, I can spend somebody else's money on somebody else. And if I spend somebody else's money on somebody else, I am not concerned about how much it is, and I am not concerned about what I get. And that's government."

    - Milton Friedman

    The government has racked up Rs. 50,000 of debt for every man, woman and child in India. Yes, you read it right, the total government debt is $1 trillion. The government has spent all this money on us for our greater good. Can you even begin to imagine how much we would have gotten for ourselves if each one of us was given Rs. 50,000 in cash? And this is just the portion of the government spending that was financed by debt. The total money the government has spent on us is several folds higher.

    If the government has surplus money it gets from the sale of natural resources, it should be given to her in cash so that she can get the most out of it. Don't take away from her the power to decide how she wants to spend her own money. Don't take the liberty to overpower her will. Don't spend her money on building toilets for her. Don't spend her money by buying LED bulbs for her. Don't spend her money by purchasing electricity for her. Don't spend her money by securing insurance for her. Don't spend her money by building schools for her child. Don't spend her money by selling a natural resource at a low price (on an assumption by some expert in the government that she needs to buy the cheaper goods produced using the natural resource). Don't waste her money on welfare bureaucracy. Let her decide if she wants to build a toilet, buy LED bulbs, purchase milk for her newborn child or do anything else with her money. She will definitely get the most out of her money, and when she spends it, free market, if not stifled by the government, will work to produce what she demands much more efficiently. When she and many other women like her demand toilets, entrepreneurs, without any government support, will compete with each other to build cheaper and better toilets. If she decides to spend her money on healthcare, somebody will decide pursue a career in healthcare and become a doctor and someone will open a health insurance company. When she demands skill development for her child, somebody will open a school to provide exactly the skills that she demands for her child (and not some worthless skills determined by bureaucrats sitting in Delhi). That is power to the people. Stealing her money and then giving it back to her in terms of what a bunch of experts in the government deem fit is no less cruel than a terrorist attack.

    Jan 25 2:56 AM | Link | Comment!
  • 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
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