Saturday, November 16, 2013

Inflation numbers

We got the recent inflation numbers this week. The government usually underestimates them. But for the sake of argument lets go with what they say. The CPI (consumer price index) is again in double digits at around 10.09 percentage and the WPI (wholesale price index) hitting the 7 percent mark. Food inflation is as high as 18 percentage. As usual the RBI, the finance minister, the media have their own reasoning for it.

Let us take a step back and understand the terminology here. There is a gross misunderstanding (misleading I should say rather) if you read the message coming out of policy makers and the media.

The basic question : What is inflation?

Before giving out the definition, let me say what is not the definition. Inflation is NOT rise in prices.
Inflation is expanding money supply. Rising prices are a consequence of that.

They often blame the demand-supply for rising prices. The prices do not rise in double digits for multiple years because of demand and supply. Permanent price increases are results of monetary policy only. Demand and supply are one significant factor for inflation but they are mostly short term. India is under significant inflation for the past few years. Demand and supply logics hold true - only if the money supply remains constant. If money supply expands exponentially as in the case of our country, only the RBI and the government are to be blamed for the problem. Blaming the entire problem on supply side bottle necks is just to deflect the problem from its real cause.

The Indian rupee has been expanding for decades now. See below link.

This can be easily reflected in the union budget figures.

The total expenditure amount for the year 2009-2010 was INR10.2 lakh crores.
The total expenditure amount for the year 2012-2013 was INR16.7 lakh crores.

The expanding balance sheets are a positive, for business or industry. It conveys expanding business. More money in the balance sheet reflects more business activity and hence more profits. On the other hand - a expanded or inflated balance sheet of a country with amounts in monetary bills that it can print endlessly - is a sign of serious weakness. If the budget is a surplus budget - meaning the income (tax collection) is more than expenditure - then it is good. But the Indian union budget is always a deficit budget. The expenditure outweighs the income heavily. If the budget is a deficit budget - who pays the difference ? The government borrows the money. Who does it borrow from ? Because of lack of viable creditors, the bulk of the money is borrowed from the RBI in the form of government bonds - who then create money by running the printing press.

Printing new money causes the existing money to lose value.

This excess money supply does not percolate into the society creating productive assets. They are usually squandered. They get misallocated and eventually plundered by few. The real economy would be better off without the excess money. The Non-performing Assets (NPAs) of public sector banks are INR3.25 lakh crores. If you compare it with the above budget figures of the country, they are significant part of it. Unfortunately the NPAs are going to get worse. Because the government owns them - they need to induce cash into it (read bail out) with fresh money., which again expands money supply.

The expanding money supply kills the ordinary saver. Retirement savings of individuals will be blown out causing social problems.  Asset prices become over priced. Recent real estate price escalation is a direct result of the expanding money supply. Misallocation of funds to these sectors have starved other productive sectors of the economy. Hence the growth has stalled.

To rectify the situation - RBI has to suck the liquidity out of the system. There is too much money in the system. Inflation will not come down until the excess cash is sucked out and destroyed. Increasing the interest rate by 25 basis point every other month is not sufficient. The general perception is by decreasing the money supply, it will drag down growth. Unfortunately growth has to be sacrificed in the short term for long term gains. The current rate of inflation is unsustainable. Failure to take hard and unpopular decisions lead to more social problems and more economic disaster in the future. Current trends would lead us to what Argentina went through economically.

Persistent high inflation of course will cause weakness in currency. No wonder the rupee is trading at an all time low against pretty much all the currencies in the world. Indians are earning poor and getting poorer returns for their labor because of its policy makers. Purchasing power of the rupee is going down like a sinking stone in the pond. You can still see news article that says - the weakness in currency would boost exports which is great for the economy. This is an idiotic argument. Exports are results of economic success. If weakness is good for exports - why can't we make it Rs. 200 to a US dollar., why around Rs. 65.

A weak currency reflects a weak country.

Unfortunately all Central banks around the world are increasing the money supply at the same time. Japan being the worst of all. In a world with no gold standard or an equivalent system - these things lead to terminal economic disasters. The pace of money printing has increased post the 2008 financial crisis. The western economies in the US and Europe still recovering from the financial crisis and still not out of the woods with high unemployment and slow growth. In spite of this we see oil above $100 a barrel. Just imagine what would be its price if the economic activity picks up rapidly. The price of oil would at least double from here. Can any economy afford that?

The US Fed is also practicing cheap money policies. It is doing historic blunders. It is pumping in $85 billion dollars every month with the intention of boosting its economy. The result of this is gold being around $1300/ounce and $100/barrel oil. Being the world reserve currency it is exporting inflation to all around the world.

You cannot read a single news paper in India today - without reading the story where the policy makers are trying to impress the foreign investors - FDI  (foreign direct investment) and FIIs (foreign institutional investors). They give the impression that without the foreign money - India cannot survive. Actually the truth is - without the foreign money the current bad policies cannot survive. India does not need foreign investment in any form - it needs only foreign currency. This is to fund the imports. The government would not slash its subsidies, particularly oil and food. To fund these in CAD and fiscal deficit - the easiest way is to get new money from outside. The ultra cheap monetary policy in western nations is currently funding it. But India would soon run out of it. That is why the mere mention of taper in the US is causing the FII to withdraw money from Indian investments sending the rupee to hit new lows.

For years - Indians have moved abroad for work. It is often sighted that they move to seek opportunities, better standard of living, etc. Those reasons mask the original intent. The sad truth is - they go there ONLY to earn in an appreciating currency far higher than the Indian Rupee. Just say - the salary of a Indian software engineer (in purchasing power) is same (or more) in Bangalore than in New York or London? Would any one go for work to the west? This is exactly the same reason we do not go to work in a poor country - say Somalia or Sudan but to rich western nations. Without a high value currency the reason to live abroad makes no sense. The value of the Indian currency is indeed in our policy makers hand and not controlled by foreign nations. Creating a very productive environment would lead to a appreciating currency.

Public awareness is needed about monetary policy. It is a sad truth that subjects like these are not discussed in open forum. This will keep Indian politicians in check. Over years, the political establishment has given undue subsidies and made the poor people more poorer. The fre money helps them to hold on to power. Intentionally people are misled on these subjects. The rich segment of people who understand this - invest in hard assets like gold, silver, rental properties and manage to retain the purchasing power. But the poor and the middle class with relatively less money with salaried income and meager savings get washed away during these times of sudden increase of money supply. This is exactly what is happening in the country now. With no gold standard in place, the governments around the world with huge debts are practicing the easy way out. Appreciating currency promotes hard work and in turn savings. These savings fund investments. Because the savings are hard earned - they get invested only in productive labor and hence productive assets. Expanding money supply causes all the prices to rise. Capital gets misallocation, causing mal investments, low growth rate and resulting low wages. Hope one day we Indians (who already save a lot) live in an environment where our currency appreciates against other nations and we contribute to a flourishing economic activity within the country and not move abroad for earning other currencies.  

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