The nature of evil

Why must darkness obscure light? Why must evil triumph over good? Why must our prayers remain unanswered? Why is good mistaken for weakness? Why is friendship taken advantage of?

Why must a 2 year old be an orphan? Why must a family be charred to death? Why must a husband not know where his wife is? Why must he be afraid to face his children?

These are heavy unbearable questions. No matter how steely one's resolve and how unbroken one's spirit is, one must ask: why is life so unfair?

Capitalists of the world unite.. you have nothing (else) to lose

http://pensionpulse.blogspot.com/2008/09/capitalists-of-world-unite.html

ZIRP....

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/09/18/ccambrose118.xml

Read the headline (and tagline) a couple of times. For the US Treasury Bill to go to Zero that basically means that the demand for US Govt Debt is so high that the US does not have to pay any interest to the investor.

Now look at it this way for the investor to refuse interest it basically means he does not care about Return "on" Investment, in fact the only thing he is concerned about now is Return "of" Investment. So if he thinks that the only safe place that guarantees return of principal is US Govt Debt - then this implies that all other categories of debt is unsafe. This includes the debt of other countries and the debt of large corporations. At the extreme even a company like Shell will thus not be able to finance it's debt.

So what happens when Shell can't re-finance its debt? It has a liquidity crisis. OK so it generates liquidity by liquidating its illiquid assets i.e. property, oil rigs, plant and machinery, exploration rights etc. Now think of it on a global scale what if other corporations also face the same crisis - and all of them at the same time must sell their illiquid assets. There will be a buyer's strike. A global asset deflation of the scale that we have never witnessed before.

Corporations that have the most illiquid balance sheets and have the most amount of leverage will be the first to collapse as things turn bad the deflationary fire will reach up to the more stable, better capitalized corporation.

Some questions....

Why is gold "more" protected than other investments, like real estate?

The answer to this is a little complicated and long-winded, you may have to read this a couple of times to "get it". But first we need to go through some basic definitions. Some of these definitions may seem counter-intuitive and contrary to what is generally accepted but as you will see these are the true definitions of these terms.

Inflation: When we think of inflation we think of an increase in the price of good of services. That's not really true, the rise in the general price level of goods and services (most commonly measured through a Consumer Price Index - CPI) is an after-effect of inflation. Inflation is really an increase in the supply of money and credit. Because there is an increase in the supply of money (and credit) there is too much money chasing (relatively) fewer goods, thus the prices of goods as measured by money (the supply of which has increased) rises.

Deflation: The exact inverse of inflation is deflation; when the supply of money and credit contracts then that is called deflation. Because there is a decrease in the supply of money (and credit) there is less money chasing (relatively) more goods, thus the prices of goods as measured by money (the supply of which has decreased) falls.

An important thing to realize is that an increase in the prices of goods and services is the result of past inflations. Consequently when there is deflation it will result in future decreases in the prices of goods and services.

During periods of rising prices and (especially during severe or "hyper"- increases) you do not want to hold cash or cash equivalents. This is because with time can buy less and less of the goods and services you need. Consequently the value of money as measured by the amount of goods and services that can be purchased per unit of said money keeps decreasing. So what do you hold instead? You want to hold assets that can preserve or store value in the face of a general rise in prices. Real Estate, commodities such as Metals, Coal, Crude and Precious Metals i.e. Gold, Silver are such assets - these assets are also called "hard" assets. In fact in extreme increases of prices you want to hold as much debt as possible and use the debt to finance the purchase of these "hard" assets. This is because the rate of interest that you pay on your debt will almost always lag the increase in the value of the asset. Think of it this way: there are two graphs both rising, but the slope of the interest rate is less than the slope of the price increase. As a result Property - which you can easily finance - is a very good asset class to invest during periods of increasing price levels.

So if deflation is the exact inverse of inflation - then during periods of decreases in price levels you want to invest in assets that have the opposite characteristics of "hard" assets and you want to stay away from debt. In fact the only asset class that does well during decreases in price levels is money.

Gold is a very funny asset and has some important characteristics that make it special and different from everything else (including other precious metals such as Ag, Pt etc.)

1. All the Gold ever mined in human history approximately 150,000 - 160,000 tons is still with us.

2. The supply of Gold is very stable and is around 2% of the total Gold supply. It takes around 9-10 years for a new Gold mine to come online and then a further 5-7 years for production to hit the market. Thus from exploration to sale Gold takes about 14-17 years. By which time current Gold mines will be in decline. Thus this supply is not very likely to change over time. In fact in recorded human history there has been only one time in which the supply of Gold has increased dramatically, that's when Spain took the Gold of the Mayas and Aztecs in the 1600s and flooded Europe with it. Thus if Gold were to be used as money it would be relatively free from increases in supply i.e. Inflation.

3. Gold has very little industrial usage - its major use is as jewelery. As you are probably aware in India people often buy and gift jewelry not just for consumption but also as security and to use as money when in need. In fact this is true the world over.

4. Gold is almost indestructible (If I remember right you need Aqua Regia to dissolve Gold), relatively portable.

Because of these reasons Gold has and will continue to be regarded as money. In fact in the Foreign Exchange markets Gold trades like any other currency.

So in a deflationary scenario Gold should do well. I expect the world's industrial economies to fall into a deflationary depression thus the only asset class that will do well is money and it's equivalent - Gold falls in that category.

Why do you say that this worldwide depression is impossible to reverse? Haven't we faced crises of more severe magnitude before, and, come out of it before? Why is this depression more severe than (say) the Great Depression of 1929, starting with the crash of US stock market on the infamous "Black Tuesday"?

I'm not saying this is the end of mankind as we know it. We will get through this, it just so happens that we will fall into a deflationary depression and then with time (5 years, 10 years who knows how long...) we will come out of it. It will be more severe than 1929 (which by the way was exactly the same thing) simply because the magnitude of the deflation is much larger. If you think of it as a wave, the amplitude of the wave is greater by several degrees of magnitude consequently the effects of the wave will be that much more severe.

You say that "cash and cash equivalents" are the best bets to invest in - in that case, why is US dollar is better mode of saving than, say, Euro or Yen? Isn't this meltdown expected to affect all industrial markets?

The Dollar is the best of a worse lot. The Euro has political issues. No currency without the backing of a stable nation state survives for very long. The European Monetary Union is a grand experiment that will unfortunately fail if it is not accompanied by a political union. Japan's economy is in terminal decline because of demographic issues unless they start allowing massive immigration their economy will slowly reduce to insignificance.

AIG bailout doesn't change a thing

I think they should just merge with LIC.. :-)

Seriously its a $85B loan at 850 bps over Libor - which is around 2.9%? - so that's 11.4%. The Interest expense alone is $2.4B per quarter. The last 3 quarters their loss was $14B the only quarter they made money - they made about $3B. But lets say by some miracle they manage to make the interest payment.

Their B/S equity is 78B - so not only are they wiping that out they are effectively making the firm insolvent. I just don't see how this preserves the firm's credit rating, which was the original intent no? Admittedly the equity is book value but in this situation I don't expect a buyer to pay a whole lot more than book.

Which brings me back to my original point.. This doesn't change anything but it does give AIG's counterparties time to unwind their position, and maybe that's all that the Fed wants at this point. But you have to wonder that if it takes $85B (there's no way in hell that the loan is going to be repaid fully) to buy time, what sort of dis-orderly liquidation were we looking at?

Mutually Assured Destruction

We are faced with the total and complete annihilation of modern capitalism as we know it. With Lehman bankrupt and hence it's debt gone to junk status, AIG facing ratings downgrades and WaMu down to junk, here's whats going to happen as the dominoes fall one by one:

1. Lets say that I am financial institution. My balance sheet is probably a couple of hundred billion dollars, but the equity position (i.e. assets less liabilities) is quite possibly in the tens of billions of dollars i.e. at the minimum a 10 to 1 leverage. Lets assume that I have been conservative with my investments and most of my Assets are AAA (the highest investment grade) rated. So I don't have to carry that much Cash because the value of these investments should cover my liabilities.

2. Therefore as and when these investments receive a ratings downgrade I must increase the level of cash that I carry, so that I can cover the loss in value of the erstwhile AAA investments. If I can't raise cash then my own ratings get downgraded.

3. That in itself is not so bad except....everything and everyone else (i.e. other financial institutions) is leveraged and at equilibrium. So if I can't raise cash not only do I get downgraded but anyone else holding investments issued by me is affected and they have to raise capital to cover the loss in values of paper that I have issued or contend with having their rating lowered.

4. Well that's still not fatal in itself .... except much of the investments that I have made and others have made based on paper I have issued are made up of derivatives which are not regulated and are of indeterminate value. Or to be precise whose value can be determined only by a bunch of PhD(s) and a gaggle of lawyers.

5. Now all these investments are interconnected and held by State funds, mutual funds, world funds , sovereign funds and god knows what else then the entire world's markets melt down together because no one knows what the true values of any investment are and therefore no one can be trusted to make good on any liability.

Default thus turns to liquidation... KABOOM!

For the record I am short the US Financial Sector, Short Crude and Natgas, Short Small Cap and Short Basic Materials.

Senators Ask Fannie, Freddie to Freeze Foreclosures

Bloomberg says:

U.S. Senate Banking Committee members urged Fannie Mae and Freddie Mac, the mortgage companies placed under federal control this week, to freeze foreclosures on loans in their portfolios for at least 90 days.

There's another quote:

"This action would provide immediate relief to many homeowners'' and let the companies "turn these non-performing loans into performing assets to minimize losses,'' Senators Charles Schumer, Robert Menendez and other panel Democrats said today in a letter to the companies and the Federal Housing Finance Agency, which is overseeing them under the government conservatorship.

Umm.. No. If not collecting the EMI on a loan makes the loan into a "performing asset and minimizes losses" we would have to rewrite the history of banking, in fact while we're at it why don't you change the definition of all loans and just start calling it gifts - because thats what these supreme intellects propose.

I guess politicians all over the world are the same, and here was I thinking that only our Desi politicians had a monopoly on economic illiteracy.

Never Forget...

Here's to you Jeremy, this last pepperoni slice is for you.

So much for Gustav

Well so much for Gustav - turned out to be quite literally a tempest in a teacup. Looks like my bet on NATGAS turned out wrong and NATGAS, Crude and Gold all collapsed through early trading on Tuesday AM. Crude is at $110, NATGAS at $7.50 and Gold at $819.
I am currently down about 7% from my position and am seriously considering throwing in the towel. It looks demand destruction is going to trump all other themes. I full expect Crude to go down to $75.

Gustav takes aim at N'awlins, oil prices

I think the story is in NATGAS rather than crude. If Gustav is anywhere near what Katrina was, the effect should be more pronounced in Natgas.

What with the Russian imbroglio and Natgas already heavily oversold, I expect gas to go upto 10.5. For the record I am long UNG at 38.5.

Chindia

An interesting paper by W. Michael Cox and Richard Alm of the Dallas Fed (link above) posits India is poised to benefit more in the long run from its services driven approach towards development over China - which has taken a more conventional manufacturing/export driven route towards development.

A couple of things stood out: In 1980 China's per capita income was $556 in 2007 it was $4766, India's on the other hand was $917 and $2534. Compounded annually China's per-capita income growth rate in the last 27 years has been about 8%. India's on the other hand was 4%. Note these are NOMINAL figures in US $. Given that the CPI denominated in US $ has probably been around 6% in this period (http://www.economagic.com/em-cgi/data.exe/feddal/cpimsa). India's REAL per-capita growth in 27 years has been -2% and China's +2%.

The paper says that the typical Indian services worker generates about $25000 per year in productivity. Based on personal experience I think that's too high. It should be in the $15000 (About 6,00,000 INR) per year region: We have 35 employees our revenue is about 200,00,000 INR - which makes the per employee revenue to be about 5,70,000 INR. Admittedly my sample is very skewed and I am only considering one imperfect firm. But I believe my company is the typical small-sized services firm that will make up the bulk of future growth in services exports. That would put the services worker's productivity squarely in the same range as China.

For all practical purposes China is a middle-income country (or will be shortly), India on the other hand has languished in the emerging column for the last 3 decades and looks to continue doing so for my lifetime. I think India's time as a counter-weight (economically and geo-politically) to China is past.

Pakistan Outlaws Falling Prices

Securities can trade within their daily limit of 5 percent "but not below the
floor-price level'' of yesterday's close.

I had to re-read this a couple of times. So they are outlawing the fall of stocks prices below the last closing price. While they're at it why don't they outlaw gravity, or perhaps one can't fall below however much one has risen.....

This is the original post on the Karachi Stock Exchange: http://www.kse.com.pk/kse4/notices2/shownotice.php?id=004177

A Savings glut

There's a theory out there (can't remember who came up with it) - the problem with the world is not too much debt but rather too much savings. Because of the Chinese one-child policy, China's Seniors have saved like crazy. (The thinking goes since you won't have enough children to take care of you - you need to save). All these savings need to find a home, hence the financial engineering to create new products to capture these savings.

Which of course means that with ample supply of debt - consumers, corporations and investors go on a buying binge. Guess what happens when the binge ends? I doubt the saver is going to be immune from the after-effects.

Happy 4th

I was driving to work and this was playing on 107.1 FM Rainbow

Sammy Kershaw's - Honky Tonk America

Reserves and Deficits

The RBI released a report on Balance of Payments over Q4 2007-2008. I stumbled upon this on my weekly browse to the RBI site (yeah I know.. I have no life) - link on the title of the post.

It's a very entertaining and revealing document, a couple of things caught my eye.

• Import payments increased by 37.2 % - reflecting an increase in the basket of international crude that we buy from $56.4 to $93.9.
• Oil Imports increased by 88.9%
• Given that the price rise was 66% - it basically means we are consuming more even at increased prices.
• The trade deficit was 23.8 Billion US$ - a YoY increase of 85%, again reflecting the increase in oil imports.
• Invisible receipts grew by 26.2% and the invisible surplus was 22.8 Billion US$ - a YoY increase of 33%. Invisibles of course means software, ITeS, travel and remittances from the diaspora.
• Which meant that the net deficit was 1 Billion US$.

Inspite of this deficit the Reserves grew by about 25 Billion US$

There seems to be two main contributors: Short-Term Trade Credits and FDI, that allowed the reserves to grow. If you look back at the data for 2006 and 2007, in each of these years the Current account surpluses of 4.49 Billion and 4.25 Billion don't justify the reserve increases of 13 Billion and 20 Billion respectively.

Kind of obvious when you think about it. If we're not earning enough money (through trade) then the only way our bank balance (as represented by our Reserve) can increase is if we borrow the money.

In a declining Dollar - appreciating rupee regime this seems to make all the sense borrow in Dollar invest in Rupees, earn profits and then repay with less rupees than you started out with. But what happens when this reverses - the Bernanke Fed has the cojones to hike rates (in fact they maybe compelled to sooner rather than later) and the Dollar finally catches a bid.

I'm pretty sure that all these increases in the Capital Account (FDI, FII Portfolio flows, ECB, Short Term Credits) will start going the other way. All these folks buying into the India story will start selling their rupees. In this scenario any decrease in Crude prices is likely to be nullified by a Rupee depreciation. Furthermore if the RBI suddenly decides to try to buy Rupees in an attempt to stabilize the currency this could mean a curency attack.

Add political uncertainity to the mix and things don't look so good now. Perhaps that's whats got the SENSEX spooked.

The return of the Bond Vigilante?

Hmmm... Interesting that the yield on the 10 year has bottomed and moved steadily up since the middle of march.

Here's what I posit - this is the dreaded inflation expectation. The Bond Market believes that rates are headed higher in the medium term, because the Fed (and other Central Banks) must start to pay heed to inflation.

Here's the 1 Month



Notice how this has started moving up at about the same time. If the Bernanke Fed were to raise rates at this juncture it would mean a total implosion of the US (and quite possibly global) Banking System. But if they don't ... the Bond Market is going to force their hand.

In the 1980s and early 1990s the fixed income investor was notorious for selling (and driving up yields) at the slightest whiff of inflation - these so-called bond vigilantes had promised never-again to believe the Central Banks. Since then they've gone the way of Chandler, Ross, Monica, Joey, Phoebe and the blonde chick who married Brad Pitt - yes to retirement....

But like the Ronin in Yojimbo is the bond vigilante back?

The 4 phases of inflation

The RBI raised the Repo (to 8.5%) and CRR (to 8.75%) rates by 50 bps. Hopefully it's not too little too late - given that actual CPI is probably going to come in higher than 12%. Bank Deposit rates should crest 10% easily in the next couple of weeks.

In light of this I read an interesting interview on Financial Sense (linked to the title of this post). But one excerpt caught my eye:

So we've gone from phase one where money supply is growing but the currency is not losing value because people trust it. We are now in phase two where the currency is in trouble, it is falling, money velocity is increasing and expectations for inflation are going up, and we are heading into phase three where velocity really starts to ramp up, prices are rising much faster than the supply, the currency is being ditched, which is what is occurring right now overseas by those that are accumulating dollars. And eventually you get to phase four where the currency collapsed and that's the final phase, which is the hyperinflationary phase.

Ominous stuff...

11% and counting

The headline inflation number came in at 11%. This is just the projected number when the actual numbers come in - I full expect it to be above 12%.

Taylor rule says that for every 1% increase in the inflation rate the nominal interest rate should go up by more than 1%. Which means that the RBI is going crank up the rates like no tomorrow. I fully expect the rates to go up to 13-14%. Which would mean that the Rupee should rise relative to the US$.

Now is the time to go into Cash. Take $ debts and wipe out all Rupee debts.

Between a Rock and a Hard Place

Don't look now but the yields on the short-end (2 and 5 year) US $ Treasury Bills have been ratcheting upwards. Take a look at :



Note the upward shift at the short-end of the curve.

Treasuries are pricing in an increase in the Fed Funds Rate (FFR). I don't buy the Recovery in 2008 argument so what that means is that the Fed needs to raise rates to fight inflation (or more correctly inflation expectations). Most likely the ECB and the Japs let Bernanke have it - "listen you old so and so... if you don't raise rates now the dollar is f*&^%$#"

This Car does 120 miles on one Charge

Very Cool:

http://www.aptera.com/about.php

Central Bankers hostage to the Past

Over the past week Bernanke (and Paulson) have been jawboning the Dollar higher. It struck me that these guys seem to be hostage to their past.

All Central Banks profess to have a twin mandate: 1) Price Stability and 2) Economic Growth. But when the cycle turns (the current situation would qualify) price stability and economic growth are bipolar requirements. In these situations Central Banks must choose one of the following:

1) Raise interest rates and thus control inflation, which would dampen Growth.

OR

2) Keep the Monetary Spigot flowing thus supporting growth but fueling the inflationary pyre.

Depending on the Central Bank's read of their economic history they seem to chose one or the other. Witness Trichet and the ECB being much more hawkish on inflation. I daresay their worldview is colored by the Austrian and Weimar hyper-inflationary episodes.

On the other hand Greenspan and Bernanke seem to me more concerned about potential deflationary episodes - a'la the Great Depression. Thus their policy reaction is always to ratchet down monetary rates. (Volcker though would seem to defy this explanation.)

In India we have been lucky never to have seen hyper-inflationary episodes. In fact when inflation hits double digits governments usually fall. The RBI seems to have had a pro-active stance on inflation and keeping monetary policy generally tight. Economists here seem to have based their world-view on the Austrian model.

Cost of Delivery

We just had a baby - a baby girl (Yayyy!!!). This is our second, the elder sibling is a boy about 4.5 years old. We're all stoked with this new addition to the family.

The delivery was normal, she was born 3.44 kgs and after about a week both Mum and daughter are doing great. What surprised me was the cost. Mum got admitted one day prior (she was induced), and stayed for 4 nights post delivery. She had a single Air-Conditioned room to herself with an attached loo, and a TV too. In all the room was as good as a 3-star hotel room.

The cost for the mother Rs. 30,093 and for the baby Rs. 8,296. This is all inclusive Room + Medicine + Doctor + Nursing + Taxes. In all the cost of the baby being delivered was less than a $1,000.

The end of fiat - part 1

May you live in interesting times.
This ancient Chinese Curse certainly holds true for us. We are living at a time that our children will look back and consider to be an important inflexion point in mankind's economic and financial history.

The symbol of America's might (no - not the 11 carrier battle groups, but...) the almighty US $ is on its deathbed. After almost two decades of too loose monetary policy the sins of Greenspan have finally caught up with us all.

I fully expect that within the next decade the US $ will no longer be the world's reserve currency. International Financial flows will now be denominated in some other currency. This new currency may be an existing one, but in all likelihood the signs point to a new monetary system - perhaps backed by precious metal and commodities.

This seismic shift will change the world as we know it and will create opportunities for the prepared and trap those still looking towards the old system to regenerate itself.

To anticipate the future one must be aware of the process of going from past to present. In this series I will attempt to trace the evolution of the current monetary system, and look back at the various mis-steps that signal its ultimate demise. To conclude thise series I will anticipate different scenarios that may crop up - and how best to be prepared for them.

Money
To the man on the street money is the coins and bills that he has in his wallet and the balance in his bank account. In general we don't spend much time worrying about what money is. Its more important to us that we get more. People worry about what money IS only when money ceases to function properly.

Wikipedia defines money as a good that acts as a:
Unit of Account, Store of Value, Medium of Exchange

But in my view Money is first and foremost a "Medium of Exchange" - all other definitions follow as corrolaries of that. In this function money makes possible the exchange of goods and services, without it nothing but the most basic form of goods and services (a hunter-gatherer economy) is possible.

Throughout history man has used various goods as money - sea-shells, animal skin/fur, livestock and precious metal. All these goods were portable, imperishable, retain (or increase in) value and had the same percieved value in the mind of the buyer and the seller. It is critical that these characteristics be applicable to all goods that are used as money because it is only these contribute to money's intrinsic value.

Think about it this way, if I were to sell you a product and you would give me money in return. But if that money were to vanish (i.e. rot away or dissolve in rain...) or lose its value before I can engage in another transaction the money itself would not be of much use and I would not use it as my medium.

It turns out that the easiest way to ensure that is to use different commodities as money. After all a barrel of oil is a barrel oil to both the buyer and a seller. This so-called "commodity money" - especially precious metals was widely used in most major economies up until the Industrial Revolution.

Since then various governments have issued currency that have been backed by Gold. In which case the government issues what is essentially a bearer cheque - that is backed by the balance that the government treasury has in terms of gold.

This is the "Gold Standard" - this basically means that a government issues currency equal to only what it has in Gold in its vaults. In which case one unit of the currency gives the bearer claim to a certain amount of gold that is secured in the government's vault. The amount of gold that the currency unit is redeemable for is the "currency-peg" and ensures that the currency does not lose its value.

The US $ was on the Gold Standard from 1880-1914. WWI forced all the major economies to print more currency than could be supported by the Gold in their vaults. In the aftermath of the Second World War - the western economies established the Bretton Woods Framework this essentially meant that all currencies of the world would be pegged to the US Dollar and the US Dollar would be pegged to the value of Gold. To be precise 1 US $ = 888.671 milligrams of Gold. The US Treasury also promised to redeem dollars for Gold should anyone (any Central Bank to be precise) ask for it.

In 1971 (again forced by War - Vietnam in this case) Nixon removed the US Dollar from the Gold Standard. Since then no currency in the world has been backed by Gold.

Instead the current monetary system in its place is a fiat money system. Fiat money is backed by faith in the government that it will make good its promise to repay its obligation. In a fiat money system, money is not backed by any physical commodity but rather the only thing that gives it value is its relative scarcity.

Consider this: When you exchange a good or service for currency. You are recieiving a promissory note from the government's Treasury. If the currency is backed by gold (or silver or some precious metal) - then you have received a promissory note that is backed by an asset. The Treasury is obligated to return to you an equivalent amount of the asset in lieu of the currency should you wish to redeem it. On the other hand in a fiat currency all you receive is a promissory note that is backed the credit of the issuer i.e. the Treasury. The Treasury is not obligated to return anything, the currency's holder simply believes in the Treasury to make good it's debt. A currency backed by credit is thus as good as the intent of the issuer to repay its obligations. Unfortunately History has numerous examples where the issuer's intent has not been so honorable.

Fiat Money - A brief history of financial armageddon.

Fiat money systems have been around for a long - long time. The first recorded instance of fiat money, is the Roman Emperor Nero (yes the one who played his fiddle while Rome burned) who in 64 AD got the idea of putting less silver in his coinage and decreed that the value of the coinage would be worth the same in silver - inspite of there being less of it. This allowed the emperor to continue his lavish spending and caused the wealthy to either hide their wealth or flee from the confiscating government. This did not have a happy ending as we know.

In the 9th century the Chinese started experimenting with paper money. In 1023 the S'ung issued the first real paper notes - these notes would be valid for 3 years and then redeemed at a 3% charge to face value after that period. Unfortunately the abuses started immediately, though the notes were valued at a certain exchange rate for gold, silver, or silk, in practice convertibility was never allowed. Then, the notes were not retired as they printed many more of them. The government made several attempts to support the paper by demanding taxes partly in currency and making other laws, but the damage had been done, and the notes fell out of favour.

In 1790 - revolutionary French Government confiscated land from aristocrats and issued "assignats" which paid interest against the properties. Land was auctioned off in exchange for these notes, inflation rose to 13,000% by 1795.

In 1862 Abraham "Honest" Lincoln passed the Legal Tender Act allowing the Government to issue paper money, backed by nothing but government promises. A huge inflation transpired that caused the practice to fall out of favor until the Federal Reserve System was put in place in 1913.

In the aftermath of WWI - the Weimar Republic (Germany after the Kaiser had abdicated) found itself destitute and unable to pay reparations to the Victorious Allies. So they printed money in huge quantities to pay reparations.

The inevitable consequence was inflation the likes of which history had never seen before.
In Weimar people had to bring a Wheelbarrow of currency to buy groceries, householders heated their homes by buring Marks instead of firewood (because it was cheaper to burn it with currency). I had an economics professor who had lived through the holocaust and he told us a story of his father in Weimar Germany. His father had bought an insurance policy in about 1905 and paid the premiums for about 25 years, then around 1930 he cashed the policy and with the proceeds he bought a loaf of bread.

But the collapse of fiat money is not limited to history. In this present day and age Zimbabwe is perhaps the posterchild of the excesses of fiat money. In Zimbabwe this is what the bill for a Dinner for one looks like:

This is a 250,000,000 Zimbabwe Dollar Bill - about 10 cents as of 8th June 2008:

A Zimbabwe Currency has an expiration date and is technically worthless after it expires.

Fiat and Fraud
Fiat money is always issued by the monetary authority. The way this works is that the Government (i.e. the legislative branch) requires money to fund its expenses and its current income (through taxes) doesn't cover its total expenses. This so-called fiscal deficit needs to be made up through debt. So the government asks the monetary authority - the Central Bank, to issue it currency to make up the fiscal deficit. The government issues an IOU (also known as a Treasury Note or Treasury Bill) and the Central Bank simply prints the cash in exchange for this IOU. The Bank of course charges an interest rate from the government and the government makes this interest payment to the holder of the IOU. The government then merrily proceeds to exchange this cash for goods and services that it needs. Voila! we have now created money out of thin air.

OK so now that we have created money and the Government has exchanged it with other producers and citizens for real goods and services. Why does the citizenry continue accepting this currency when they know fully well that this is simply paper backed only by their belief in the Government's intentions. The answer is twofold.

The Government has mandated that this currencyis the ONLY legal "medium of exchange" for transactions and no other currency or commodity can be used in its place. Secondly the government accepts this fiat currency for payment of taxes - this in turn creates demand for the fiat currency.

These are the two pillars that make a fiat currency possible, by forcing people to use the fiat money and by creating demand we forget that the intrinsic value of the currency is the belief that the Government will make its debt to the Central Bank.

But what if it never does, what if the "fiscal deficit" is never reduced but keeps on increasing and increasing.... what if the government simply keeps rolling over the debt? In which case the Government's intent is to defraud the holder of the IOU.

Unfortunately we have historical evidence that fiat currencies ALWAYS suffer from the dishonorable intention of the issuer. In other words FIAT = FRAUD

To Reva or Not to Reva

I've been thinking of getting rid of a Hyundai Santro that we own. I use the car exclusively for driving to and from Work. That's a 14 km. drive each way, about 30 kms. daily for 300 days a year. The car has about 50,000 kms on it and is 4 years old. It runs about 12-13 kms, per litre of petrol so my daily commute costs (approx.) Rs. 120.

If I do sell the Santro - I'm seriously considering going in for a Reva. It's a fully Electric Car and is designed solely for In-City driving - my commute would be ideal for the car. The Reva costs about Rs. 4L ,I should get at least Rs. 2L for my car so I'll have to pony up another 2L. The Reva's operating cost is about Rs. 1 per km (as opposed to Rs. 4 per km with the Santro). So my daily savings is about Rs. 90 and on a yearly basis this would be Rs. 27,000.

That's not enough for me to get rid of the Santro just for the savings (it would take me 22.5 years to recover the additional cost at a 12.5% discount rate), but if I were to ditch the Santro anyway, buying a Reva might be worthwhile.

So what's stopping me well I can think of two reasons why Not to Reva:

1. Charging the car. I live in an apartment complex, and I don't have a designated parking spot, which means I can't charge at home. I do have a reserved parking space at work and I have enough pull (being the owner of the company) to swing a 15Amp. socket next to my parking spot. So I can charge it at work. The car needs 8 hours for a full charge, which basically means it has to be charged the whole time I'm at work. I won't be able to charge the car when I don't go to work - so what happens when I'm on vacation or its a long weekend or I'm sick etc. etc..... I need to find out if the car's battery runs down if its just sitting there. I suspect it does - in which case what is the time frame? How long can I keep the car idle before I MUST charge it again.
2. There's no dealership in Mumbai - which means I need to order the car sight unseeen... ummmm... I don't think so.

So for now I'm not going to buy a Reva. But I'm also not going to ditch my Santro just yet. I'll be keeping tabs on when/if Reva opens a dealership here, then I might just go all green.

In-Flay-Shun

The government finally bit the bullet. Petrol prices increased by 5 bucks and Diesel by 3. I drive a Skoda Octavia which has a 55 litre tank. So a fill-up now costs Rs. 165 more. I generally fill'er up once a month and at most twice. So a monthly fill-up is now Rs. 330 more at most. In the grand scheme of things not a big deal. But.....

I think this is too little too late. Crude prices have gone up by over 30% since the last time prices were increased, a 10% or so increase in pump-prices is hardly going to make the Oil Marketing Companies whole. Unfortunately the UPA is between a rock and a hard place. On oneside there's the oil companies that need to be given cash to survive and on the other there's Sonia and the Reds.

The Reds say that any increase in fuel prices means an increase in overall consumer prices which they call "inflation". Lets leave that argument aside for a minute. What do the Reds propose? Continue giving subsidies and increase them as world crude prices increase. How would the government fund these increasing subsidies simple: 1) Taxes OR 2) Debt.

An increase in taxes means that private consumption and investment/savings are crowded in favour of increase in government revenue which doesn't bode so well for domestic growth. It's also somewhat inequitable given that those that consume oil products don't necessarily pay taxes. In which case those that do pay taxes will have to share in a disproportionately higher burden of the increase on fuel prices. Given that India's governments are not usually known to do the "right" thing - I fully expect the government to levy some sort of cess to fund the increased subsidy.

They can take on additional debt (which is what the Oil Bond is) - which of course means increased government debt. The Reds don't care in fact I don't think they understand what an increase in public debt means. Our public debt is about 55% of our GDP (about 0.5 Trillion US$) - someone, someday will have to payup and when that time comes god save us all. Government postpone that day of judgement by making "minimum payments" in the hope that inflation will eat away the principle and repaying the debt won't be so much of a burden.

In fact in this age of fiat currencies it is the government which controls the value of the currency - consequently it is in the interest of a heavily indebted government to "print" (or create by other means) currency - and use these newly printed currency to repay past debts. I daresay this is what the US is doing... but that is another story for another day.

Let's go back to the Reds' (and Sonia's) basic premise:
Increasing fuel prices will increase the general price of all goods and thus cause inflation.

Increase in prices is a symptom of too much money chasing too few goods. Prices increase when money supply has increased too much (i.e the increased money supply is not supported by higher economic growth) in the past. Changing the price of one input is not going to change inflation one iota.

Lets take this hypothetical scenario. In order to win next year's general elections the UPA declares that it will give free Petrol, free Diesel, free LPG and free Kerosene to all and sundry and it will fund the 100% subsidy by issuing more Oil Bonds. These Oil Bonds will be denominated in Rupee. As they continue to issue Oil Bonds Rupee Interest Rates are going to keep rising and rising and rising ..... eventually no-one is going to want to hold a Rupee for love or for god. That is what is happening in Zimbabwe right now. A Dinner for One in Zimbabwe costs Z$ 1,243,255,000.00.

Unfortunately the sad reality is that the above scenario might in fact happen one day....
Anyway so what can be done to control inflation. Unfortunately there is only one medicine - and that is to engineer a deflation through a decrease in money supply.

Tighten Mr. Reddy Tighten Now, Tighten Before its too late..........

I-Pee-El

I was up until 1:00 AM watching Rajasthan take on Chennai in the IPL final. It was a good game - worthy of a final. The papers say it was a "heart-stopper", but the match wasn't really ever in the balance after Rajasthan had batted through their 10 overs with Watson and Pathan still at the crease. I realize the winning runs were scored of the last ball but consider this:

1. Chennai scored 163 - I would say about 20 less than par. At about the mid-point of the Chennai innings they were 80 - odd with Dhoni and Raina batting. I would have bet on a score of 180-185. That they didn't get there is a credit to Tanveer, Watson and Pathan who really applied the brakes in the second-half of the Chennai Innings. That meant Chennai were always going to have to fight to make a match of it.
2. In the 7th over of the Rajasthan innings - Asnodkar and Akmal managed to get out, that was about the only time Chennai had a realistic chance of winning, sure Watson, Pathan and Jadeja being bowled, run out and needlessly caught added to the drama. But that's just 'B-K-T' : bekaar ka tension.
3. I thought Rajasthan paced their innings beautifully, there was always one batsman who knocked the ball around and scampered through for ones and twos, and another who slogged. When Yusuf Pathan and Shane Watson were batting, Watson would just casually flick the ball on the onside and turn over the strike to Pathan who would then tee off.
4. 8 runs in the last over, 3 wickets in hand, Balaji - the worst of the Chennai bowlers - bowling and two internationals (Warne and Tanveer) at the crease the result was never in doubt.

The match was in a stadium a couple of klicks from where I live - I could see the lighted towers on my way back and forth from the grocery store. Its a good looking stadium and the grass looks really green. But the "Pee" facilities are pretty bad.

I'd been to the first match at the stadium between Mumbai and Hyderabad - Gilchrist gave everyone a master class in one-day batting, and another between Mumbai and Rajasthan. There are no seat numbers so once you get in its pretty much a free for all. The crowd is reasonably well behaved (for India that is) - and you have a very good view of the action, I had a Rs. 1,000 ticket in the first match and Rs. 600 ticket in the second.

But I had to use the facilities in the break between the innings and there was a queue literally a mile long, when I did get to the bathroom, it was wet - with water (or so I hoped) on the floor - and the stench of thousands of people having "I-Pee-Eled" before me.

I had thought about buying a Season Ticket for the next round of IPL, especially of they hold the Mumbai home matches in Navi Mumbai - but until they do something about the bathrooms, I think I'll pass.

Money, Money, Money....

Been reading up on some great posts on the blogosphere about the death of the fiat currency.

Take a look at:
Ty Andros at
http://www.financialsense.com/fsu/editorials/andros/2008/0118.html
and
Economicrot at
http://www.slideshare.net/contrarian2day/us-economic-outlook-200811-updated/

Ty Andros is a little bit of a gold-nut so I take his posts with more than just a grain of salt, but he had an interesting chart on Money and Credit creation:

As of October 2007 India's M3 registered a 20%+ YoY growth . For the macro-nically challenged M3 is a broad measure of money supply that is the sum of all currency in circulation, all checking account balances, all deposits - generally all currency, instruments that are considered to be "money".


That piqued my curiosity sufficiently that I had to go and search for trends in money supply. So I sauntered over to http://rbi.org.in/ and looked over their publications to try and get a measure of M3 (a.k.a Broad Money) and try and lay it over the reported CPI (Consumer Price Index) change.


Of course the babus over at the RBI refuse to make things easy for the rest of us, they keep changing the base year for the index every 20 years or so, I had to go back and do all sorts of re-indexing (thank god for excel!) to get a sensible number.

Anywhooo - here's what it looks like:

So while in 2006 M3 grew over 20% (which is what he is showing) in 2007 and 2008 the growth in M3 is 21%+.
Unsurprisingly CPI has started moving up (8.7% as of 30.5.2008). Interestingly M3 grew annually at a rate between 15-20% from 1970 onwards. And 1980 to 1989 was a period of dis-inflation (Increase in CPI at a reducing rate), with one year where the CPI actually deflated.