Saturday, January 24, 2015

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 a 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 an 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 Kejriwal 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, head of the Bank of England and Benjamin Strong, Governor of the Federal Reserve Bank of New York, used all the resources at their 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, whereas 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 the 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 every day 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. The 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 an 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 a 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 to 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.  


9 comments:

  1. Simply simple.
    Let all believe in themselves.
    Every individual is cosmic.
    All knowledge is structured in our consciousness.
    We need to self realize.
    No need to visualize grandeur.
    We are the grandeur.

    This article is amazing flow of nature's intelligence.

    ReplyDelete
  2. This article is one of the great i have seen but are you saying that we should abolish taxes and stop spending on infrastructure? Please answer this

    well i am totally in for gold currenncy by the way. Us federal reserve is the biggest crook.

    ReplyDelete
  3. The best article in last 5 years, in a league with the famous S Gurumirthyji's speeches.

    Thank you Shubhendu for such a lucid writeup on nations' fiat currencies and their interplay. And how interest rates rob people in one nation and help those in other nation. This article cuts right to the nonsense that is the financial system we use today.

    In 1947, Indian Rupee, US $, British pound, Chinese Yuan were are 1:1:1:1.Now Rupee around 68:1, Yuan around 6.3:1 against reserve currency. Granted China is a bigger exporter than Bharat, still iIf Bharat also controlled exchange rates of its currency as Chinese did, Bharat will have roughly same US$ reserves as China. Can you please research and criticise this perspective so it becomes clearer, either way?

    Awesome, just awesome.

    ReplyDelete
  4. Thats great Pathak Ji. Real intelligence at work. How we forgotten very simple things in our day today life and we wanted everything free on the expence of 5 % tax payers .

    ReplyDelete
    Replies
    1. Thank you for your comments. It is not only 5% taxpayers. Remember there are many other forms of taxation, including inflation.

      Delete
  5. hello mr pathak
    you refer this article as simple and easy to understand.. this article has plenty of clear,good understanding of basics in economics, government etc... you are M tech iit person... for you it is easy... but i doubt whether most of the lay men out there will be able to follow you...It took months and years for me to digest the ideas from Milton friedman, jay w richards, walter williams, mike munger, russ roberts, john stossel, peter schiff. gene callahan, paul grignon , richard may bury ,and few from austrian school.... nice to know you were able to get to the nucleus of the issues... however as regards to collecting dollar as reserves, how to pay for imports ?because india requires dollar as that is the reserve currency used... so that area i have to get some clarity...

    ReplyDelete
    Replies
    1. Thank you for your comments. The RBI does not need dollars. The people of the country do, to buy goods and services produced elsewhere. People will import the same way the people of Ghaziabad imported from Atlanta.

      Delete
    2. the idea is since the rbi has the power to print , exclude them. If private people are there, they dont have the power to print and therefore the exchange rate will be different and will reflect the true value of dollars... i think that is the idea you are telling...( i have read a bit of jim rickards currency wars but was not getting a clear picture..) your idea that rbi does NOTneed dollars is totally a different idea that i have never thought of ...

      Delete
  6. Hello,

    I appreciate your efforts to explain the topic of economics in such a simple method without confusing us with jargon words.

    thanks a lot for your work on this blog :)


    ReplyDelete