Wednesday, August 18, 2010

More links for August 18, 2010


Ben Bernanke: Wall Street's Servant – Dean Baker, Huffington Post

A ‘Fat Cat’ Strikes Back – Newsweek: For someone who benefitted from a lower-than-lax regulatory environment under Republican rule, its not surprising that Steve Schwarzman has declared war on Obama.

Mel Brooks and the bankers – VoxEU: Its not funny.

Central Bank Autonomy: the real reasons – Mark Thoma, Fiscal Times

Capitalist Myopia – Maxine Udall: Is there any way of avoiding it?

US National Universities Rankings – US News: For those of you who like to know.

A history of how we have fallen

Barry Ritholtz attributes the above to the industrial revolution. I attribute it to our inborn resistance to change. Coupled with high tolerance, its a killer…

Is the RBI just another regulator?

Following Dr. Subbarao’s speech which strove to position the RBI as the only choice for a coordinating regulator, comes this speech from Rakesh Mohan, a former Deputy Governor. Another memorial lecture was hijacked by a blatantly political agenda, and yet the case for RBI’s primacy amongst financial regulators was strengthened only marginally.

Most central bankers, past & present, would agree with the two speeches, not only because they believe it in the underlying cause, but because their approach has been blinkered by their past. They believe that banks are special but the financial crisis of 2008 proved them wrong. Shadow banks emerged as the lead protagonists in the financial crisis of 2008 and central banks couldn’t do anything about it till it was too late. Whether central banks chose to look the other way or were completely ignorant of emerging risks is irrelevant. All that matters is that non-banks could contribute to financial instability in equal measure as banks.

Lest you get me wrong, I agree that the monetary authority should be the coordinating regulator. But that the monetary authority should also be responsible for regulating a segment of the market is another matter altogether. In doing so, the monetary-regulatory body that emerges is powerful but with little responsibility and ownership of other market segments, prone to respond to demands of the segment they regulate even at the expense of other segments. Also, since this entity has very little control over other market segments, its prone to ignore developments that threaten market stability in these segments. Our current system looks more like the US system, with a central bank responsible for monetary policy and bank regulation and an independent regulator (in our case, multiple independent regulators) for the securities market. And this is the very system that failed. But is giving the RBI an exalted position a solution? Not if we are serious about reform.

Rakesh Mohan uses the UK as an example, saying that their move to fold the FSA back into the Bank of England argues for RBI supremacy. Well, it doesn’t. What it does argue for is unification of all agencies under the monetary authority where a homogeneous regulatory framework treats all market segments with equal respect and seriousness. It makes the case for treating banks as just another market segment, and not a market segment deserving special treatment. On the other hand, if the RBI becomes the coordinating regulator, as these gentlemen desire, it grants the bank regulator an exalted status when compared to other regulators. This will only result in more mayhem rather than less.

For a unified regulatory environment to work, it is essential that all regulations be accorded equal importance. Only then will it be possible for the regulator(s) to be in a position to recognize risks, no matter which segment of the financial sector they arise. And for that the RBI, in its current form, cannot survive. For the RBI Governor to be accepted as the head of a unified regulatory framework, this position needs to transform into one which carries direct responsibility only for the conduct of monetary policy. With bank regulation delegated to a Dy. Governor, it will be possible to merge other financial regulators with the RBI with the Chairperson/Head of these regulators as Dy. Governors. But this is just one way and experience indicates that it may not be the right one.

The RBI has always been an excellent regulator. But as I have mentioned earlier, its conduct of monetary policy has been disastrous. It has worked hard to hide its monetary policy failures behind its regulatory successes. And its done so very well. But if one were to look at normal parameters for measuring the efficacy of monetary policy, like inflation, growth & domestic stability, the RBI has failed at every step. This experience suggests that the RBI would be better positioned as a bank regulator, surrendering its monetary policy and financial stability roles to an organization formed expressly for this purpose. This entity will also oversee the functioning of all financial regulators, including RBI.

However, the Committee proposed by the The Securities and Insurance Laws (Amendment and Validation) Bill, 2010 [PDF] is not a complete solution. Its brief is to settle inter-regulatory disputes, some of which have held back critical developments in the Indian financial markets and that can only be good. But it cannot ensure financial stability. For that, more meaningful reform is needed.

Reform which does not insist on maintaining status quo at the RBI.

Tuesday, August 17, 2010

Links for August 18, 2010


Ireland: A recession of the banks, by the banks, and for the banks – P O Neill

Can the Nation Stimulate Its Way to Prosperity? – Boston Fed: The other side of yesterday’s argument.

Monetary policy for the 21st century – interfluidity: Completely out of the box. In fact, there is no box…

The Global Cities Index 2010 – Foreign Policy: How does your city fare?

Safe drinking water for all? Now that’s real innovation!

World Population Graph

Have interest rates peaked?

So inflation is down to a single digit (barely) after a period of 6 months. Through this time, there has been a lot of discussion about monetary policy response to this phenomenon – one that seems to beset India every few years. And there will still be some hawks saying the RBI hasn’t done enough, but the fact remains, there wasn’t much the RBI could do in the situation. Inflation was, and still is, largely a supply side issue. And its retreat is a statistical event foretold by many, including me.

But its not as if lower inflation means lower prices. For the month of July 2010, prices have increased by 1.04% in absolute terms, an annualized increase of 12.41%. Inflation has decreased because prices had increased by 1.57% (annualized 18.89%) in July 2009. When Inflation for June 2010 was calculated it analyzed price changes in the period July 2009 – June 2010. This indicated an increase of 10.55%. When inflation for July 2010 is calculated, the relevant period is August 2009 – July 2010. Price changes in July 2009 were excluded from the period and those in July 2010 included. As mentioned earlier, since the rate of price increases was higher in July 2009 than experienced last month, the inflation rate reduced to 9.97%. This is normally termed the “base effect”.

But prices increasing at an annualized rate of 12.41% means that the possibility of inflation rearing up again is still high. Which brings us to the components of current inflation. Looking at last month, prices in the Primary Articles sub-group have increased by 1.85% (annualized 22.24%) and prices in the Fuel, Power, Light & Lubricant sub-group have increased by 3.21% (annualized 38.46%). For the last 12 months these increases are 14.94% and 14.29% respectively. Inflation in the Manufactured Products sub-group over the last one year is 6.15% and for last month, its negative 0.09%. And this would, beyond doubt, present the RBI with its latest challenge.

Falling prices are never good for economic growth. Monetary policy tries to control the rate of increase only and is seldom designed to achieve a decrease. When prices fall, consumption gets delayed, especially in durables, as consumers wait for prices to fall further. Coupled with high interest rates, deflation can stall an economy as consumers save to earn interest and benefit from price decreases. And while there are still some prices in this subgroup which have risen, this hasn’t been enough to stop the index from falling.

The possibility of inflation rising again always exists. But, the base effect in coming months is extremely sharp which reduces the probability significantly. If the index remains constant, meaning prices remain where they were at the end of July, inflation will drop sharply as seen in the table below.

Commodity Name July September November
ALL COMMODITIES 9.97% 8.20% 6.19%
I PRIMARY ARTICLE 14.94% 12.55% 7.63%
II FUEL POWER LIGHT & LUBRICANTS 14.29% 12.13% 11.87%

With Manufactured Products inflation at 6.15% and prices reducing, the situation has reversed. There is no justification for any more rate hikes. And if these prices continue falling, it would be time to cut rates before we know it.

Links for August 17, 2010


Robert Sloss predicted the iPhone in 1910 - Tyler Cowen

Want to bust the jargon? You need to Unsuck it.

The Fed uses research to justify stimulus. The Central-Bank Balance Sheet as an Instrument of Monetary Policy – New York Fed.

Price Discrimination Explains...Macro? Arnold Kling

There’s a real shortage of good stuff out there today. Happy reading!

Sunday, August 15, 2010

Ground Zero & the Mosque

I don’t know if you’ve been following the debate summed up by this excellent piece in The Hindu.

I’ve thought really hard whether to comment on it. Most economists have, taking positions either in favor or against the construction of the mosque. And the debate has slowly degenerated into one that forces people to take sides for and against the rights of a religious community. Bog posts talk about “good” and “bad” followers of Islam, about the rights of a community which many believe, erroneously, to be characterized by its association with the perpetrators of the 9/11 attack and whether public sentiment will be hurt if the mosque is permitted. And the basic question is lost and remains unanswered.

The basic question is whether any religious monument should be permitted at a site where many people from many religions lost their lives. Should their falling be represented and remembered by religious monuments, when they fell in a war fought in the name of religion?

To my mind, the answer has little to do with which religious group wants to construct the monument and more to do with whether religious monuments are the right way to honor their passing. And the answer remains the same whether its a mosque, church, synagogue or temple.

To a certain extent, debates like these, are windows into the thought process of a people. And all that is visible here is confusion and misdirection.

My column on

I recently wrote a column for It can be found here.

Honestly, the editing made it far better than it was originally, and for that I thank Dr. Richard Baldwin, Founder & Editor-in-Chief of Vox.

In its own words, is “a policy portal set up by the Centre for Economic Policy Research ( in conjunction with a consortium of national sites. Vox aims to promote research-based policy analysis and commentary by leading scholars. The intended audience is economists in governments, international organisations, academia and the private sector as well as journalists specializing in economics, finance and business. Assistance for the Centre's work on Vox has been provided by the European Union, through its programme of support for bodies active at the European level in the field of active European citizenship.”

Friday, August 13, 2010

Links for August 13, 2010


Challenging Keynesianism: Greg Mankiw

Economy Lost Momentum While I Was Pulling Weeds: Caroline Baum – A must read, if only for sheer writing brilliance. Especially the second paragraph under “Speed & Steroids”

Animated map of nuclear explosions, 1945-1998: And they dare to tell us!!

The great false choice, stimulus or austerity: Food for thought

Cockroach Theory and Levy Flight: Sheer indulgence after food above…

Is the CD Deshmukh Memorial Lecture a political event?

Going by Dr. Subbarao’s contribution this year, it certainly seems to be. This speech, if one were to take it at face value, exhibited a complete lack of awareness regarding monetary matters which drew a sharp & detailed rebuttal from Ila Patnaik.

However, I believe that the speech was made with a very specific intention. While a large chunk of the speech was dedicated to it directly, with the RBI Governor detailing the reasons why he believes that the RBI should be the coordinating regulator, the rest of the speech dealt with the proposed environment in which this should happen, albeit indirectly.

Discussions concerning the RBI’s role in the economy came to a head recently with the government replacing the ULIP Ordinance with The Securities and Insurance Laws (Amendment and Validation) Bill, 2010 [PDF]. This Act provides for the establishment of a joint body to reconcile and rationalize jurisdiction disputes between the 4 regulators (RBI, SEBI, IRDA &  PFRDA) by a joint committee which apart from representation from these regulators, will have the Union Finance Minister, The Finance Secretary & The Secretary (Financial Services) in the Ministry of Finance as members with the Union Finance Minister chairing it. In a concession to the RBI, The RBI Governor will not just be an “ex-officio member”, as stated in the ordinance, but the “ex-officio Vice-Chairperson” of the Joint Committee. The Committee will then follow any procedure it considers suitable and inform the Central Government of its decision within three months. The decision will be binding on all regulators.

The RBI has always believed that it is far more important than any of the other financial regulators, and with good reason. After all, RBI decisions touch far more lives, and exert greater influence over the economy, than those of other regulators. However, in expressing the underlying reason for this “seniority” the RBI often, intentionally, mixes its up. This was evident in Dr. Subbarao’s speech as well.

He takes the RBI’s current responsibilities and builds a case for such seniority being formalized by law at a time when the scope of the RBI’s responsibilities is being intensely contested. To say that the monetary authority should also be the prudential regulator for banks as they are the primary channel for transmission of monetary policy is denying current reality. Financial system risk is no longer restricted to banks and non-banks, including Mutual Funds, play an important role as well. The monetary authority, therefore, needs to have authority over all forms of financial risk in the system. The RBI tries to achieve this by making a case for increased power. I think it is better achieved by reducing it. Let me explain.

RBI’s role as a monetary authority would be enhanced if it were to delegate all prudential regulation, including that of banks, to other regulators, specializing in various types of financial risk. As a monetary authority, its role can then be strengthened by giving it the power to supervise the functioning of all regulators without undue favoritism. Currently, with bank & NBFC prudential regulation entrusted to the RBI, it has a tendency to favor these over other financial intermediaries, which in reality, works against efficient transmission of monetary policy as was evident in the events of late 2008. In this case, the RBI was very willing to look at the problems faced by banks, but agreed to assist the mutual fund industry only after intense discussion and convincing. The result was financial mayhem. The suspicion RBI harbors about the intentions & regulatory framework surrounding other financial intermediaries is an outcome of its regulatory ownership of banks & NBFCs. It believes other regulators to be deficient not because it knows them to be so, but because it believes that it does a far better job than them. If we take this competitive ego out of the picture, the monetary authority will be far better placed to manage systemic financial risk.

But for such a monetary authority to be empowered to this extent would need it to be accountable for its actions. After all, we cannot have an unaccountable body overseeing all prudential financial regulations and this is where the rest of the speech fits in. Dr. Subbarao, using archaic arguments, goes to great lengths to avoid any form of accountability for the RBI. He maligns the concept of inflation targeting as detrimental to the RBI’s other aims, namely development and financial stability, without defining a target for either. If the RBI wishes to support growth and control inflation in a financially stable environment, it can specify the target and relative priority for each and justify every action on this basis. If it believes that inflation in India comprises mostly of factors exogenous to monetary policy, as Dr. Subbarao states in the speech, let it define the inflation it is willing to target. Many central banks do the same by ignoring food & energy prices (both exogenous factors) and focusing on managing core inflation But it needs to come forth and say what it wants to manage, define a target and justify all actions on that basis. This would also lend greater discipline to RBI’s decision making and reduce the scope of personality driven monetary policy which is common under the present system.

By avoiding any form of quantification, the RBI wants to gain control over all financial regulations without any form of accountability. Without the increased power it strives for as well, it is evident that the RBI needs to be more accountable in its role of monetary authority. With increased power, it would be critical. As mentioned earlier, its a two step process. We need to create a Monetary Policy & Financial Stability Board in which the current RBI Governor and two relevant Deputy Governors assume the role of Chairperson and Members of the Board respectively. Chairpersons of other regulatory bodies like SEBI, IRDA & PFRDA should also be inducted on this board. The RBI, or what is left of it, should be headed by the senior-most remaining Dy. Governor. Similarly, other regulators can be led by the senior-most of their second line. However, this arrangement is only to ease transition, after which all members and the Chairperson of this board will be appointed by the Central Government. All regulatory bodies should then function under the supervision of the Board which takes ownership for monetary policy and financial stability with measurable targets and complete accountability.

The RBI’s current stance is working against the emergence of a cohesive regulatory framework for the financial market as a whole. To designate a particular regulator as senior increases the risk of financial market development being skewed towards the industry it regulates. It’s not a risk India can afford to take.

But the speech was disappointing at another level as well. The CD Deshmukh Memorial Lecture is an event many look forward to, anticipating words of genuine wisdom. Well, this year, we got a political statement guised as wisdom. Extremely convenient wisdom.

A version of this post appeared on my Business Standard Blog on August 13, 2010

Links for August 12, 2010


Tell me once again, why are humans the superior species? Rational decision making, of course!

Renminbi-Yen-Dollar Collision Course – Tim Duy making a hell of a lot of sense

The Proud, The Rich, The Reserves: Worth watching…

Pushing on a string: The Fed’s new attempt at “stimulus”

US trade gap swells to 21-month high – & China trade surplus soars as domestic demand flags – Financial Post: What, me worried?

Thursday, August 12, 2010

Links for August 11, 2010

I must admit this one shocked me. Dr. D. Subbarao, whose actions held promise spoke in Hyderabad recently and said all the wrong things. The speech is here. Ajay Shah’s brief reaction is here and Ila Patnaik’s critique, here. Will post a note on it soon, focusing on RBI’s ambition of becoming the co-ordinating regulator. The other points have been more than amply rebutted by Shah & Patnaik.

Get Rid of Them! Bill Black’s “alternative to the Rating Agencies: I cannot help but agree. Credit ratings give a false sense of security to lenders and discourage independent assessment. Regulatory support to this practice needs to be discontinued. And if it was the independence of the lender (from borrower influence) that concerns regulators, how can they believe that an agent of the borrower will represent associated risks better? Its a question all regulators, including SEBI, need to mull.

The next big thing – Structured Notes: What? you haven’t bought one yet!!

You just have to click this graphic… one of the coolest I’ve seen in days.


And for the finale, something I never thought I would hear from a “developed” market maven

Time to regulate volatile food markets - Joachim von Braun

Wednesday, August 11, 2010

Links for August 10, 2010

Found a way to post links from my phone. It's slightly messy, but it works. So here goes...

Proved! Rubik Cube can be solved in a maximum of 20 moves. Imagine that...

A long, long paper on what caused the crisis by Kevin Villani

Full paper [PDF, 1mb]:

A clue to the Jobless Recovery? Maybe...

Micro houses in Japan; Should other cities learn?

40 economists agree on a subject! This has got to be a first... Reboot America; A manifesto arguing for more fiscal stimulus.

Small mercies...

So the Fed, moving into the second phase of Quantitative Easing or QE II, has finally succumbed to the pressure piling on it. But in the bad news, there's good. Though, it'll use maturity proceeds from Agency debt and MBSs to buy more assets from the market, it will "restrict" itself to buying long-term treasury debt.

While I have very little faith in the efficacy of this quasi-Keynesian intervention, it will at least result in a better balance sheet for the Fed. That is, if one considers US treasury debt to be better than the maturing MBSs.

But this, only time will tell...

Tuesday, August 10, 2010

A word on links

Another day without internet connectivity means another day without me posting links. I can post text from my phone but I can't post links. And just when I had promised myself that I would post them everyday... It figures.

A word on the links I post. I don't always post links that I agree with, or those that agree with me. I have, and will, post links which take an opposing stand on issues. Most often, I will not qualify these links with my own comments; I believe it will cause prejudice in readers' minds. If I want to react to them, and some of them are worth the effort, I will do it in a separate post. Hence, a link posted here does not mean I agree with it. Just that it's worth reading. That's what I'd like to ensure.

Am I a socialist?

A reader, frustrated by my apparent duplicity, asked me how I can possibly say that RTE & Right to Food are worthwhile programs when my writings are predominantly libertarian in nature. I can only thank my reader, who goes by the name Dyslexic, for questioning the consistency of my beliefs. Without it, I would probably never have the opportunity of clarifying why I believe in what I do. I do now, and this is it.

Human beings are capital. A government’s basic duty is to maximize productivity of this capital, even at the cost of all other forms of capital like land and money. All schools of economic thought agree on this basic principle, but each goes about it in a different way. Libertarians believe in liberty and freedom of choice to be the foundation of human welfare. Keynesians believe in value maximization through government intervention where required, and Communists believe that human choice has no role to play at all. Here’s what I believe in,

1) The government should not limit industry and enterprise.
2) It should not own or manipulate the currency.
3) It should stay out of business.
4) It should do everything required to protect property and life from domestic and foreign aggression and finance it from tax receipts.
5) It should develop infrastructure, both physical & social, and finance it from tax receipts.

I know the social infrastructure part of 5 seems at odds with the first 4, but is it really? Physical infrastructure cannot be more important than social infrastructure like education and healthcare. Especially when inequality has reached frightening proportions and very little of it can be blamed on lack of initiative from the poor. In parts of the country which have been ignored, access to physical and social infrastructure is non-existent. The only thing one can find in abundance here is poverty. In these places, as in some developed parts of the nation as well, parents don’t send their children to school because 1) there are no schools and 2) even if there are, they need another earning member in the house. In this environment, making education a right is probably the only way to encourage parents to do the “right” thing. With poverty as widespread as in our nation, parents need all the encouragement they can get to send children to school. Rather than look at Right to Education as only a child’s right to be educated, I look at it as also the government’s right to demand that every child be educated.

The Right to Food has other roots. Have we ever wondered how we can have deaths due to, and suicides because of the fear of, starvation when every needy person has access to heavily subsidized food through the Public Distribution System(PDS)? Well, the answer lies in the unique way loans are structured in rural areas. When marginal farmers, farm workers or migrant workers take a loan from moneylenders, they are required to deposit their Ration Card & entitlement booklet with the lender. The money lender then draws food from the PDS using these cards and sells them in the open market, with the difference being treated as interest payment. When the loan is repaid, the Ration Card & booklet is returned. If the borrower cannot repay the loan, he/she literally starves to death or commits suicide to hasten the process. Right to Food proposes to tackle this menace by terming demand for such collateral as depriving the borrower of his/her Right to Food, making it a criminal offense. At the moment, its a civil matter.

Laws in India are seldom what they seem to be. To judge their suitability based on narrow interpretations of their motives is probably the biggest mistake one can make. An unrelated case that comes to mind is our DTAA with Mauritius. A recent article in the Business Standard had a finance ministry official lamenting the cost of the DTAA, pegging it at Rs. 2,000 crs. p.a. Such statements are common, and we wonder why the government puts up with the loss. Well, how about because the DTAA was not signed in isolation. It was signed along-with another treaty, one which gave the Indian Navy right to be positioned in Mauritius alongside French & British, both of which are former colonial rulers of Mauritius. This gives the Indian Navy unparalleled presence in the Indian Ocean. Now look at the Rs. 2,000 cr. cost of the DTAA. Doesn’t seem like much, does it? Then why are these statements made at all? Its about government allocations. The Ministry of Finance’s loss is the Ministry of Defense’s gain, but one it has never acknowledged officially. The day the MoD admits that it gains from this treaty, the MoF will be in a position to demand compensation to the extent of, well, Rs. 2,000 crs. p.a. So there.

No links for August 9, 2010

Can’t post any links for today. My internet connection has slowed to a crawl (I’m getting 20th century (dial-up) download speeds measured in bytes/sec) and have had a hell of a time trying to read even my basic fare. My apologies.

Sunday, August 8, 2010

Links for August 7-8, 2010

Picture 2

The world’s smallest monkey, the Pygmy Marmoset – New Scientist

Economics Is A "Science" Part One & Two– Sauvik Chakraverti

BlackBerry irritates spy masters –

What collapsing empire looks like – Glenn Grenwald

Penis can only take so much electricity, surgeons warn – Looks like Ranchhoddas Chanchad could have been guilty of forcible birth control.

Just what kind of money is this?

Is this a strange question? Think about it…

Just what kind of money is this, when the only way to preserve its value is to lend it? If you hold it idle, it loses value. If you invest it in anything other than debt you may beat inflation, but then again, you may not. So the only way to preserve its purchasing power with any certainty is to lend it, and lend it to someone who is sure to pay you back. Which in most cases is the government, because regardless of how badly they mess up, they can always create more money to pay you back. But this means modern currency serves only as a “medium of exchange” outsourcing the “store of value” function to debt. And if one of money’s primary functions is assigned to debt, is it any surprise that debt has become the foundation for our economies?

But is that all our money is meant to be? Something that has “value in exchange” but no “value in use”? And if it doesn’t have value in use, how can it have value in exchange and/or be an effective store of value? On the hope that this mysterious “value in exchange” would persist tomorrow, next month and next year?

From the time Richard Nixon decided to default on the US Dollar's obligatory link to gold, mankind has wondered what money had become. But Milton Freidman, with glib tongue and circular reasoning, convinced all who needed to be convinced that this was everything money was ever meant to be. I believe he exhausted people into accepting his theories, though the only proof I can offer for this belief is experiential. Argue with a modern monetary theorist, and I can guarantee you a headache, even if you are Arnold Kling. Politicians in the 1970s didn’t stand a chance. It was either accept or suffer. They, being politicians, chose to accept.

Circularity characterizes every chartalist currency argument, not just those connected with the importance of central banks, as Arnold mentions in his post. Imagine this conversation,

Me: Modern money has no value in use, so how can it have value in exchange?

Demented Chartalist (DC): As long as it can be exchanged for something valuable, it has value.

Me: But how can something without value be exchanged for something valuable?

DC: I never said it didn’t have value. In fact, I remember telling you that it did.

Me: So tell me once again, why does it have value?

DC(rolling his eyes): Because it can be exchanged for valuable things!

Me: But how can it be exchanged for valuable things when it doesn’t have value?

DC(smiling benignly): But it can be, so it does.

Me: So if it can’t be, then it won’t?

DC: Precisely! But that’s not going to happen. The government won’t allow it.

Me: Aah! So it has value because the government says so?

DC: Don’t be obtuse. It has value because it does, and the government likes it that way.

Me: But why does the government like it?

DC: Well, because the government can make all it needs without spending any of it to do so. And even if it did have to spend some of it, it could always make more.

Me(kneading my temples): But if the government can make all it wants without spending any of it, then how does it have value?

DC(smiling tolerantly): Didn’t we get past that?

Me(in pain): No, we did not! If the government can get it without exchanging anything valuable for it, then how can it have value?

DC(slowly): Because the government can exchange it for valuable things.

Me(with quivering lower lip): But how can the government not exchange anything valuable for money and then exchange money for something valuable? How?

DC(pityingly): You still don’t get it, do you? Because it can… That’s the beauty of the system. It can.

Me(weeping): No, I don’t get it… How can they.. Why can they… but…

DC(gently): I think you’re too overwrought to have understood. Do you want me to start over, a bit slower this time?

At which point I run out wailing like a little girl, damaged for life…

Living in a world with modern currency is like being imprisoned in a Joseph Heller book.

And I am Yossarian.

A version of this post appeared on my Business Standard Blog on August 6, 2010

Friday, August 6, 2010

Links for August 6, 2010


New post on my Business Standard Blog – Just what kind of money is this?

AMF Paper on Reserve Accumulation and International Monetary Stability (PDF): Suggesting a new global currency and a path to its birth.

How Much Debt Should Households Have? – Economix Blog, NYTimes

Some inflation is good – AV Rajwade, Business Standard

The Road to Serfdom Is Lawlessness: Inside Goldman Sachs – Jesse’s Cafe Americain

Yen has edge over gold in battle for supremacy – Peter Tasker, Financial Times

The money-inflation connection: It's baaaack! – FRB Atlanta

From sense to nonsense in just a few words…

Steven Kopits of Douglas-Westwood has taken it upon himself to list Do’s & Don’ts emerging from an analysis of the Gulf of Mexico oil leak and its aftermath. And what starts off as perfectly reasonable, well thought out advice ends with a ridiculous assertion worthy only of an oil industry insider desperate to protect his company’s interests.

The last in the list of do’s and don’ts in this post (via Econbrowser’s James Hamilton) is “Don’t permit unlimited liability”. And apart from the usual threat of how this would spell disaster for the US economy as offshore oil companies will just up and leave for friendlier jurisdictions, is this gem

“Liability needs to consider not only the damage inflicted, but also the ability of a given company to pay”

There is nothing more to say.

Links for August 5-6, 2010


Still Jackasses – Arnold Kling Slightly old, but one of the best posts I have read.

Why the Fed is irrelevant – Hussman Funds Even older, but definitely worth reading

Environmental Concern and the Business Cycle: The Chilling Effect of Recession Finally, proof that people only worry about the environment when doing well…

Do capital markets create their own fuel?

Learning about inflation from a box of eggs – Ajay Shah

Logomotive versus locomotive – Bibek Debroy on the the new Rupee Symbol

Prepare for more inflation…

Sharad Pawar is at it again. Despite lower output and holding 3 times the normal buffer stock, the government plans to acquire a record 35% of total rice output.

I guess they’d rather let it rot in FCI storage than let us eat it.

Thursday, August 5, 2010


Its official. The first phase of Quantitative Easing did not really work out all that well. And its almost certain that on August 10, the Federal Reserve will decide to take another shot at it.

But apart from inscrutable nomenclature, which essentially means monetization or the creation of money by a monetary authority to acquire assets from either the banking system or the government, there is a lot else that is wrong with it. Traditionally, monetization has almost always been undertaken to allow a government to spend more than it earns and it usually takes the form of the monetary authority paying the government for debt instruments issued by it. This debt can take many forms, from low coupon instruments without any defined repayment which the government issues only to the monetary authority (who else would buy them?) to regular government bonds which the monetary authority could actually sell to market participants if times turned. In all these cases, the monetary authority has an asset it can value at par, which allowed it to match its assets and liabilities without booking a revenue charge. But that makes monetization just another form of government borrowing, right? Well no, it doesn’t.

If one looks beyond the veil and consolidates the account of the monetary authority with the government, then debt owed by the government to the monetary authority would disappear from the books leaving only the money issued as a liability on the consolidated account. This would effectively mean that all money backed by domestic government debt, is in essence, created without any incremental assets to back it. So why the elaborate farce? Well, it sounds so much better when you hear that the currency you hold is a liability of the monetary authority fully backed by assets, doesn’t it?

But the Fed has taken this travesty to a completely different level. It has bought, and wants to buy mortgage backed securities (MBS) from the banking system hoping that this will encourage banks to start lending again. There is also the highly desired possibility that it will result in US Dollar weakness and higher inflationary expectations. The Fed hopes that low interest rates and elevated inflationary expectations would boost aggregate demand and allow business to recover. Lets count the ways that this can go wrong.

1) These securities are liquidity impaired for a reason. They are failed contracts which would trade at a steep discount to par value if they could be traded at all. The reasons why they aren’t traded include the lack of confidence buyers have in paying anything for them and the fact that if they were sold at market clearing rates, most banks in the US would be bankrupt. In buying these, the Fed is committing to hold them to maturity or default, whichever happens earlier as no bank will ever buy them from the Fed. At the moment, banks are valuing these securities at close to their par value and the only way they will not go bankrupt will be for the Fed to buy them at this value. This means the Fed would be left holding securities worth less than what they paid. Its the same as issuing currency notes at a discount.

2) Moreover, since these aren’t traded and there is no market valuation available, the Fed will also value them at cost, effectively delaying loss recognition to when defaults occur. Its criminal when a commercial enterprise cooks its books in this manner, but for the monetary authority of the world’s largest economy, its despicable. I am assuming defaults will occur because the manner in which these securities were structured and issued ensured that many are reasonably suspect and it would be naive to believe that banks would sell only the one’s that aren’t.

3) The US Government has been extremely critical of China’s monetary policy which allows the Chinese monetary authority to create money by buying foreign currencies. They believe that it distorts the currency market and allows China to weaken its currency below levels justified by its fundamentals. But by issuing currency in exchange for impaired domestic assets, the US wants to achieve the same outcome. Initial indications of currency weakness already exist with the US Dollar hitting a 15-year low against the Yen on mere expectation. Why doesn’t the Fed just jump on the bandwagon and buy Euros and Yen instead. Then if the US Dollar depreciates, the Fed will actually be in the money. The only catch in doing so, apart from the loss of face internationally, would be that banks would continue to hold these impaired securities along with the potential loss. Which makes me wonder, does the Fed really want to undertake quantitative easing to improve the economy or just nationalize bank losses in the guise of QE?

4) Another assumption the Fed is making is that consumers and businesses would want to borrow. But businesses are hoarding over $1.24 tln in cash and any expenditure would come from this first. US Household Debt still totals $2.5 tln with the average household spending over 17.5% of disposable income on financial obligations. There is a significant possibility that US businesses may not want to invest, and US households may not want to borrow more despite low rates and easy availability. Think about it, residential mortgage rates are at an all time low. Does this sound like borrowers want to borrow, but lenders don’t have the cash? I would bet, like the previous round of quantitative easing, banks will park this new money in reserves with the Fed, and the Fed will push the string harder with another round of monetization.

QE III, anyone?

Of Governors and “Senior Officials”…

Over the last few days, apart from the regular newspaper columns and opinions, many readers have emailed saying the RBI is either confused about what its doing, or is acting under political influence. This feeling was compounded when an unnamed “senior official” , in comments soon after the recent policy announcement said that the current inflationary environment needed “aggressive policy action” and current policy wouldn’t tame inflation.

I agree with the official partly. Current monetary policy will not tame inflation, but that’s where my agreement with the unnamed official ends. It won’t do so, not because more needs to be done, but because current inflation has less to do with monetary policy and more with supply side shocks and international market movements. Inflation will reduce, but purely due to statistical reasons I have outlined earlier. Also, if any form of monetary policy can have a meaningful impact on current inflation, it will have to be the exchange rate policy and not the interest rate policy. Granted that there are signs of inflation getting broad-based, but isn’t that expected after a sharp increase in fuel costs. After all, transportation is an significant part of final cost in virtually every product today.

Though comments of this nature confuse the market and observers about RBI’s real thoughts, this isn’t a new phenomenon. Dr. Y.V. Reddy, when he was Dy. Governor, frequently & publicly disagreed with his Governor, Dr. Bimal Jalan. And it was always caused by his angst of Dr. Jalan’s refusal to combat everything through interest rate hikes.

In reality, the formative years for most of the RBI’s middle & top brass were simpler times. Times when the exchange rate was decided by the RBI and obeyed by the market. Times when the possibility of attracting capital flows in excess of our requirements was unimaginable. Times when inflation was largely a domestic phenomenon (remember oil prices remained stable for a long long time before going through the roof only in the 21st century, and when they did spike we had ourselves a crisis) and India was still a nation where individuals could only save, and not borrow. Times when the government did not have to borrow from the market to fund it’s deficit and wasn’t affected by interest rate changes significantly.

In these times when inflation rose, interest rates were hiked regardless of what constituted inflation. And it wasn’t because  that was the right thing to do. It was the only thing they could do. As an added benefit, the purchasing power of savings was protected, at least partly, due to such higher rates which imparted moral underpinning to actions devoid of any other kind. To a large section of these people, every step of the liberalization process has been accompanied by a growing feeling of inadequacy, driven by their inability to deal with the consequences. Consequences like excessive capital flows and their impact on the exchange rate, like domestic prices which are increasingly connected to global prices and the fact that inflation can now exist without any domestic reason whatsoever.

Faced by their own inadequacy, and the lack of an incentive to change with the times, their thoughts turned into dogmatic beliefs that need to be defended with quasi-religious zeal. They oppose and object to anything that reduces the power they had over markets, like capital flows and flexible exchange rates. But more than anything else, they object when the only policy instrument they are familiar with is not used to impose sacrifice and austerity on an increasingly indulgent population.

A minority, however, chose to adapt. Excited by liberalization and the opportunities it offered, they updated their knowledge and enhanced their skills. It is this minority that stood by Dr. Jalan in his efforts to forge a new path for Indian monetary policy. One that was characterized by transparency and an open minded analysis of the suitability of traditional policies, parameters and goal posts. It was at this time when the foundation for India’s best economic years was cast. Monetary policy then was an eclectic mix of the traditional and the unconventional. But it wasn’t always so. In his initial years as governor, Dr. Jalan was fairly tentative in his attempts to break the mold. He spent the first couple of years identifying and manning  key positions with the right people. It was in his third year as governor, in 2000 when he eventually succeeded, aided by the team he had painstakingly built.

But this divide doesn’t exist just within the RBI. Outside as well, we see a clear divide between those who look at headline inflation and demand hikes and those who analyze the components and request patience, realizing that there is nothing, absolutely nothing to be gained by hiking rates in the current environment. This divide existed during Dr. Jalan’s time and exists now.

Dr. Subbarao is charting a course similar to Dr. Jalan’s. In his latest monetary policy statement are signs of a new found independence in thought and a self assurance which was missing in earlier policy statements. And while current inflation still doesn’t demand the sharp interest rate increases he has imposed, neither rates nor liquidity are, at the moment, serious threats to growth. The 10 year GOI benchmark yield has remained stable moving from 7.89% on March 19, 2010 just before the rate hikes began to, well, 7.89% on August 3, 2010. Hardly a sign of bond market distress. While there are those who will see this as a worrying sign of inefficient monetary policy transmission and still others who would claim this to be a sure sign that RBI is behind-the-curve, I would contend that it reflects an increased certainty regarding the conduct of monetary policy which has compensated, at least in part, for higher overnight rates. The hands off approach to exchange rate volatility is another example of change. In refusing to control the exchange rate market on a day to day basis and increasing the range of tolerable movement, both positive & negative, Dr. Subbarao has relieved the RBI and the Indian debt market of a great burden. This preference towards domestic stability at the cost of exchange rate volatility is welcome, more so when compared to Dr. Reddy’s time when fixation with exchange rate stability caused unprecedented volatility in domestic overnight rates. The worst episode, in March 2007 saw interbank call rates move between 2.50% and 75% within the month (Source: RBI)

While I have, and continue to, oppose rate hikes, I sense light at the end of the tunnel. This isn’t a governor who is confused or tentative. This is a governor finding his feet and preparing to make a difference, allowing his detractors small victories that don’t cause much harm; gaining strength with each passing month.

I take the comments of the anonymous senior official as a sign that interest rate hawks are playing a smaller role in policy making. So now, all they can do is speak.

A version of this post appeared on my Business Standard Blog on August 4, 2010

Have money, will spend…

The only comfort one can draw is that most of the expenditure is for worthy initiatives.

In the meantime, the debt market will probably have to shed its expectations of a reduced government borrowing programme. The 10 year GoI yield didn’t react badly though, because at least some of the proposed expenditure would result in an immediate increase in market liquidity. So aal isz well…

The US Government is accepting donations…

And no, its not for Haiti.

Tuesday, August 3, 2010

A headline foretold…

In The Economic times today: Inflation is on downward slide on RBI, Govt action: Meena

‎I really, really don’t like doing this but statements like these just leave me fuming. Back in March when inflation was high(er), I wrote that it would reduce, but purely due to statistical reasons. I also mentioned that it would be accompanied with almost everyone who can, falling over themselves to claim credit for this statistical happening. What amazes me about the statement above is not that it was made, but made when inflation hasn’t even reduced by all that much.

The least our politicians and bureaucrats can do is wait till what they are claiming credit for actually occurs, especially when they have nothing to do with it.

Monday, August 2, 2010

I don’t understand you, so YOU must be confused.

Mythili Bhusnurmath thinks the RBI is confused. I think she is.

Let me elaborate.

Ms. Bhusnurmath believes the unequal change in the Reverse Repo and Repo Rates is a sign of RBI’s diffidence since it doesn’t give an unambiguous signal of the RBI’s intent to hike rates in the war against inflation. As I have mentioned in an earlier post (many posts, actually), the difference between the Reverse Repo and the Repo rate is potential volatility in overnight rates which, for the efficient transmission of monetary policy actions, needs to be kept at a minimum. A narrowing of the corridor was, and is, needed to impart a modicum of stability to overnight rates and taking it as a sign of anything else is a mistake.

The we have the statement that given the inflation environment, the RBI should be in liquidity absorption mode rather than liquidity injection mode. This implies utter confusion in Bhusnurmath’s mind on how the overnight markets actually function. The market’s need for liquidity is something the RBI does not control. At any given time, it exists regardless of RBI policy stance. What the RBI does control is the manner in which the liquidity is made available with the intention of influencing future need.

It can either maintain liquidity in excess of such requirements and absorb the excess every day by borrowing at the Reverse Repo rate. If the RBI wouldn’t borrow at this rate, there would be no takers for the excess, which would result in the overnight rate falling below the Reverse Repo rate. This is the liquidity absorption mode and the operative rate here is the rate at which the RBI borrows, the Reverse Repo Rate, which provides a floor to overnight rates.

The other way to provide the banking system with the required liquidity is called the liquidity injection mode. In this mode, market liquidity is maintained at a level short of system requirements and the RBI injects liquidity everyday by lending to banks at the Repo rate. If the RBI did not lend at this rate or if system liquidity requirements are greater than its capacity to borrow, the shortage of liquidity would drive rates up to levels beyond the Repo rate which is the operative rate in this mode and provides a ceiling to overnight rates.

The liquidity absorption mode is characterized by excess system liquidity which needs to be absorbed by the RBI at the lower of the two policy rates resulting in lower overnight rates. The liquidity injection mode is characterized by deficient system liquidity which needs to be injected by the RBI at the higher of the two policy rates resulting in, well, higher overnight rates. Bhusnurmath’s contention that the RBI should be in liquidity absorption mode to combat inflation more effectively, therefore, defies logic.

There is also the contention that the RBI should have hike rates more sharply but let’s look at reality. Ever since the RBI started hiking rates this year, the Reverse Repo rate has been increased by 1.25% and the Repo Rate by 1.00%. The RBI has also moved from liquidity absorption to liquidity injection. The combined impact has resulted in overnight rates rising from the Reverse Repo floor of 3.25% earlier to the Repo ceiling of 5.75% now, an increase of 2.50% in just 4 1/2 months. How much sharper do rate hikes get?

This is precisely the reason why the LAF corridor needs to be narrowed further. Despite the fact that the RBI has used the width of the corridor to its advantage and achieved an effective increase of 2.50% in overnight rates, for an observer, it has hiked rates its policy rates by merely 1.25%. This results in accusations that the RBI isn’t doing enough, when in reality, it has done a whole lot more. If the corridor had been narrower, the RBI would have had to actually hike rates by 2.50% to achieve a similar result, but since these hikes would have been explicit, unfounded accusations such as these would have been avoided.