Wednesday, May 30, 2012

Wide Angle 50 - How an Economy grows and why it crashes - Part 2

  Continuing the story of Usonia. Before that, the minor matter of having completed 50 wide angles – self pat on back. Last time, we saw how Usonia was all out of fish in their reserves and it was becoming impossible to match the value of the Fish Reserve notes (FRN) to actual fish since there were none left.

Sinopia to the rescue:
                The Fed was out of fish and the senators and current chief Lindy B met to discuss the way forward, some senators suggested they tell the truth to the islanders which was obviously not accepted. Lindy asked the brilliant economist Ben Barnacle to take over at the bank. Ben suggested inspiring confidence among the citizens by spending more FRNs so that they could start spending again – if needed, they could drop FRNs from palm trees. No one could figure out how to spend more when the problem rose from spending too much but they all kept quiet since they didn’t have Ben’s economic training. Fate intervened though, one of the island’s ambassadors from a far flung island called Sinopia brought some strange looking people with him.
                In Sinopia, the citizens still fished entirely by hand and they were ruled by an all-powerful king. In Sinopia, all citizens were required to fish but their catch did not belong to them. Instead, the fish were turned over to the king who then decided which subjects deserved how much. In this system, the king and his court dined on ocean delicacies while the average Sinopian got by on half fish per day. Much like Usonia before the first development of capital, Sinopia had no savings, no credit and no business. From the Usonian perspective, the Sinopian economy was stuck in the dark ages.
                What the Sinopian king had decided was that since the Usonian economy was prosperous he wanted the same level for his island. He also concluded that since the FRNs were used as money across the ocean by all so possessing them was a good thing. The Sinopian ambassador offered fresh fish in return for FRNs to the Usonians. The senators were overjoyed and the deal was struck. On asked by the ambassador whether the FRNs would always have real fish to back them, Lindy assured him, “Just look around, do you think we are short of fish?”
                The deal went ahead, each day, fresh fish filled canoes came from Sinopia which were exchanged for canoes filled with FRNs. The technicians of Usonia used these fish to replenish the Fish reserves at the bank and use them to prop up the currency. The Sinopian king did not know what to do with the FRNs so he decided to order the nets that Usonian manufacturers made so well to improve the efficiency of the Sinopian fishing. The rest of FRNs which was essentially trade surplus he left in the Fish Reserve Bank since Sinopia did not have a banking system.
                The transactions brought a boom to Usonia because of the foreign demand as well as deposits of Sinopian fish swelled the availability of credit. Even though the Usonians were spending more than they saved, there was still plenty of fish available to lend at low rates of interest. With plenty of real fish to add meat to bones of official fish, Usonia’s problem of fish-flation disappeared. With plumper fish, prices stopped rising and living standards rose again.
                The Sinopian king also added some incentive to his people so that they would keep fishing – those who purchased nets from the king could keep all the extra fish they caught. This resulted in an increase in the Sinopians’ daily fishing activities. They accumulated savings and expanded production. As a result, Sinopian entrepreneurs were now able to build factories to make other goods like spoons and bowls. Even though most Sinopians still lacked these things, they sold these goods back to Usoina for more Fish Reserve notes.

Service Sector steps up:
                The influx of Sinopian savings pushed down interest rates and the Usonian entrepreneurs came for loans for companies that required local workers to deliver a service since these jobs could not be outsourced and were less capital intensive. Celebrating this, Ben Barnacle explained that the Usonian economy had developed to the point where the lowly process of fishing and production could be relegated to poorer economies leaving Usonians free to pursue more sophisticated service sector jobs like chefs, storytellers, tattoo artists and the like. Evidence of this was the descendants of Charile who opened Surfing universities across the island striking a deal with Sinopian producers to manufacture the boards there. The activities like surfboard design and surfing instruction remained at home.
                The Usonians were now specializing in consumption while Sinopians were striving hard to work and save for a better future where they could stop fishing and live off the FRNs. Ben Barnacle theorized this by saying that Usonia had a comparative advantage at consuming and this was a great benefit to the entire ocean. The optimistic, can-do spirit of Usonia meant that their citizens never feared to spend as a result other islands could outsource consumption to Usonia. On the flip side, he explained that the Sinopians were considered best at generating savings and manufacturing products. Therefore it was more efficient to outsource production to Sinopia.

Fish Window closed:
                The other islands began to get wary of the acceptance of FRNs which was enhancing Usonia’s economic powers especially Bongobia. Chuck DeBongo, the charismatic leader of Bongobia started to send more and more of his financial agents to the bank’s fish window to exchange his notes for real fish. When those withdrawals started to make a real impact on the fish reserves, official fish started to become smaller again and fishflation came back. To prevent this, close the bank’s fish window to foreign depositors. From now on, the value of FRNS on the international market would be determined by what someone was prepared to trade for them, not because they could be redeemed for fish. In truth, the notes’ value would hang on Usonia’s status as a great economic and military power.
                This caused some flutter among islands who started to sell of FRNs but since the FRNs were a favoured mode of transactions across the ocean, the fall stabilized. The currency crisis was over, fishflation was under wraps and FRNs maintaining their status despite closing of the fish window, the Usonian economy settled down. A few years later, a boost to prosperity was provided by election of Roughy Redfish to senator-in-chief. He lowered taxes, rolled back burdensome regulations on business and reduced trade barriers. However, he failed to reduce government spending – the gap between what Senate spent and what it raised in taxes continued to grow.

Hut glut:
                We now enter familiar and recent territory. For generations, owning a hut was considered a dream on the island and people bought huts after saving for a lifetime paying cold, hard fish. Over time, banks started making hut loans to the island’s more secure borrowers. These loans had an underlying security which was the hut itself, if the buyer could not pay back, the hut could be sold. Some islanders resented the fact that access to hut loans was so unequal. The wealthy usually got loans easily while those who had no savings or poor credit were being denied. Sensing a potent campaign issue, the Senate got into action.
                Senator Cliff Codd argued that hut ownership was at the core of the Usonian dream and he mandated creation of two agencies – Finnie Mae and Fishy Mac to buy hut loans from the bank. These loans would be ultra low interest and with little down payments. The hut buyer would then pay back the agencies directly. The bank would immediately get back its money which it would use to make new loans and be rewarded a generous fee. With the Senate guarantees in place, the bank dropped interest rates as it no longer needed extra revenue to protect from default.
                Another agency, Sushi Mae was devised to underwrite loans for youngsters wishing to enrol in surfing school. With easy access to Sushi Mae loans, tuition fees were increased aggressively without worrying about pricing its customer off the market. Soon, tuitions began rising much faster than the overall rate of fishflation. Most economists assumed that the higher prices were reflective of the increased social value of a surfing degree. In a few years, surfing school tuition became one of life’s most daunting costs.
                Due to low interest rates, demand for huts rose astronomically and the peripheral industries like hut decoration etc. grew too. So did prices of huts and this resulted in a hut glut. Everyone hailed this as a revolution and a period of tremendous economic boom  followed with the huts at the core of the whole mania.

Hut rut:
                Even more familiar and more recent territory. One particular luxurious hut complex called Crater View condos went unsold because of high prices. Suddenly, everyone began to sell which resulted in an over supply of huts in the market and prices plummeted. Finnie and Fishy crashed leaving a pile of useless loans. The senators and chief George Bass and then Barry Ocuda tried to raise customer confidence by providing stimulus packages – they wanted to get customers spending again buying houses in fear that falling prices would mean a deteriorating economy. This of course did not work because the prices were beyond anyone’s reach and hence no one was buying, however more incentives were given to buy. In addition, Ocuda decided to transform the economy by adopting Llama based carts (which were thought to be less polluting) and re-laying the paths across the islands for Llamas to boost the economy. Nothing worked and the economy remained in a rut.

Sinopia wises up:
                Sinopians were still working very hard and producing things and savings but they barely had a life. The Sinopian king was made to realize this by a simple farmer – why not use the goods we make and fish we create and trade them inside the island thus satisfying our own needs instead of going after worthless FRNs. The value of FRNs was only because of Sinopian fish and they had made the products too so all they had to do was trade their goods for real fish.  The king agreed and decided to stop trading fish with FRNs.

Fish hit the fan:
                As the fish supply dried up, fishflation came back and when the fish disappeared from vaults, the island returned from where it had started  -  no savings, no credit, no investment. The senators were arguing on how to stimulate the economy but no one had an answer what they could stimulate it with. Suddenly, they saw Sinopian ships coming towards the island. Everyone was overjoyed that the Sinopian fish were now available but what the Sinopians simply did was bought everything on the island with their FRNS and real fish. Since no one on Usonia had any real fish, the Sinopians could outbid everyone, while leaving they left behind the worthless FRNs.
                The senators surveyed the devastation and wondered where it had gone wrong. They had spent so why did the economy not grow. Finally, it dawned on them, it was simpler than they thought. Addressing the population still looking for answers, Senator Ocuda uttered the most honest words any politician could say ,”Does anybody here remember how to make a net? I think it is time we all went fishing.”

                This Wide Angle was not meant for my own thoughts since the story itself says so much. However a few parting thoughts – an economy is quite similar to a home. You cannot spend more than you make. You can only spend inside what you earn. You save and then invest thus improving what you do and also to earn more and pave for a better future. That is the same for a country. Governments often get into trouble by spending more than they have. When the gaps get too big, difficult choices arise.
                One is to increase revenue by raising taxes, which is quite unpopular. Another option is to cut government spending like subsidies, bad loans, expenditure on salaries etc. Politically, this is more difficult than raising taxes since no government wants to give things up and the affected parties vote. To avoid these unpopular options, governments choose to default i.e. tells its creditors that it cannot pay the full debt. The fourth and often favoured option is to inflate money i.e. simply printing more notes that pays the creditors but what they get is not worth much. Inflation is simply a means to transfer wealth from anyone who has savings in a particular currency to anyone who has debt in the same currency.
                Another peculiar problem for the US is that its citizens are not saving but taking loans – the savings are being done in developing countries like China and India. The reserve status of the dollar is basically helping keep this imbalance of trade afloat. Like it happened in Usonia, this arrangement is going to break some day and the resulting crash will be devastating – it started in 2008 but the stimulus provided by the administrations has delayed the pain.
                Closer home, we never had  good policies to begin with because of the whole emotional, socialist, left ward political management of the economy. There was brief hope from 1992 to 2004 when successive governments committed themselves to fiscal discipline, disinvestment and reducing subsidies. However with the “aam aadmi” government back, we have seen the worst of economic decisions like NREGA, loan waivers to farmers and almost no reform. What we are seeing is results of that mismanagement, inflation rate nearing two digit (remember inflation was at 3% around 2003-2004) and economic problems for everyone. The sad fact of India is that these things are not even remotely close to discussion in anyone’s minds, they should be because it is your taxes and economic potential that is being mismanaged and it will bite you in one way or other in the future – in the past, one had Western countries to escape to, that may not be such a great option anymore since they are in a Usonia like situation themselves.
                Finally, the voice of the free market advocate is generally a lone cry in the dark since despite being simple, these concepts are technical and more difficult to grasp than emotional statements like “there should be no poverty, garibi hatao” or “aam aadmi ko kya mila”. This book and this column are representations of that lone cry, hope someone hears it.

Wide Angle 49 - How an Economy grows and why it crashes - Part 1

                It’s been a long time but the radio silence was deliberate, both you and me have more interesting things to look at what with the fun things happening in the country and world. Have been watching lot of diverse movies (developed a taste for European movies) and reading books on different topics but there was not much new or interesting to comment on or propagate. However, the latest book I read is so incredibly simple and conceptually clarifying that it warranted a write up. You HAVE to read this book but if you don’t, I am going to write down most of what is in it because it is so worth knowing. The name of the book is “How an Economy grows and why it crashes” by Peter Schiff and Andrew Schiff.
                Peter Schiff is the son of a renowned American economist Irwin Schiff who belongs to the true free market school of thought (also called Austrian school of economists as against the Keynesian school). Irwin Schiff consistently fought against the growing government influence on American economy (and its mismanagement) and in his later years got jailed for 15 years because he did not pay taxes deliberately. The Schiffs believe firmly in free market economics as professed when America was founded and this book outlines that thought in a very simple fable like story. It resonates with what I grew up believing (thanks dad) and which is such an anathema in India. However, the story that has been told is so simple and clear that even a non-believer (or a firm leftist) may pause for a minute and say “maybe this makes sense”. I will not preach after narrating this story, will only leave you to draw your own conclusions especially on the economy of India. I will also break this into two parts for reading convenience though sending them together.

How it begins:
                The story is about an island where three people live – Able, Baker and Charlie. There is no food grown on the island, the only source of food is fish which are homogeneous around the island and in large quantity. The men can only fish with bare hands and this enables them to catch one fish a day which also is their diet for the day. If one of them doesn’t fish that day, he cannot eat. They don’t have time to do anything else but fish and they cannot save anything. In essence, the island has no savings, no credit and no investment and life is hard. Before we discuss further, in this story, a fish cannot be destroyed or doesn’t despoil so can be stored forever.
                Able decides one day that he has had enough and thinks up of a device that may help him catch more than one fish – a net. He foregoes eating for two days while building the net. His friends pity him and warn him that he is doing something foolish and risky – if the net doesn’t work, he will go hungry. Able succeeds and builds his net, then shows that he can catch two fishes instead of one in a day. What he has done is under-consumed, taken a risk and created capital. Essentially – capital (which means only money these days) is a piece of equipment (in a broad sense) that is built and used not for its own sake but for building or making something else that is wanted. Able doesn’t want the net, he wants fish, the net helps him get more fish. The net is therefore a piece of capital and hence is valuable.
                From this simple act, the island’s economy was about to change in a very big way. Able has just increased his productivity and that is a good thing for everybody. By increasing productivity, Able is now able to produce more than he can consume, from gains in productivity all other economic benefits flow. Essentially, this has created savings which is also spare production which is the lifeblood of a healthy economy.

Sharing of Wealth:
                Able started fishing with his net and started stocking on two fish a day. He could now afford to fish for a day and then relax the other day eating his spare fish. He kept working every day thus increasing his stock. Charlie and Baker started getting restive and asked him to lend them his spare fish so they could spend couple of days building their own nets without worrying about eating. Able dithered till they sweetened the pot saying they would give him two fish back for every one he lent them. He exercised this option, Charlie and Baker got their fishes, made their nets, earned more, paid Able back and everyone benefited.
                How did this work – Able under-consumed, took a risk and created capital. He wanted more profit from his savings so he took a risk and lent to the other two. They used this capital to improve their productivity thus paying back the loan and in turn getting prosperous without having to under-consume. This could have gone other ways – on watching Able get rich, the other two could have bullied him into sharing wealth dubbing him elitist, or Able would have felt guilty and given away his fish asking for nothing in return. Charlie and Baker would have had no incentive because of lack of burden of repayment and they would probably have whiled away their time eating extra fish and playing basketball. The charity option sounds magnanimous but it doesn’t improve the island’s productivity the way a business loan would. This is the idea of credit.

Economic Expansion:
                A few weeks had gone and all the three started bringing in two fish a day. Wise that they were, they only ate one fish a day thus saving on fishes. Baker thought, “If we have expanded production with hand nets, why not kick it up a notch and go industrial?” He sketched out plans for an elaborate fish catching device that would revolutionize the island’s economy – a huge underwater trap with one way doors that could catch fish continually day or night. If it worked, they would never have to fish again. However, he realized he couldn’t do this by himself – his savings, strength and ideas were inadequate – he asked the other two and a joint venture was  born. The three pooled their savings, invested, took a risk and built the contraption. Result was them catching 20 fishes a week. Their savings started piling up which enabled them to create a new fish catcher and more.
                The three now devoted their time to other things – Charlie built surfboards resulting in a new ultracool leisure activity. Able used his savings to establish a clothing company while Baker used his time to focus on fixing the island’s transportation problems and designed the island’s first canoe and cart.

                Tales of this unprecedented luxury spread to other islands where fishing was still done by hand and no one had time to surf. In search of a better life, immigrants arrived. The greater productivity of the island meant that it could support a greater population which led to greater economic diversity. Some new immigrants went into servicing the mega fish catchers, others borrowed extra fish to clear ;and for farming, the diversified economy soon gave rise to hut builders, canoe builders, wagon builders and so on. People started working for others using their skills appropriately and the extra income gave rise to spending. Key point is they saved first and then consumed.

The Bank:
                At about this time, the incidents of fish pilferage, looting started increasing. An islander named Max Goodbank decided to launch a revolutionary service. He built a large, climate controlled facility staffed by tough goons. The new “bank” would safely store the island’s collective fish savings and consequently solve the theft problem. However, if he only charged a storage fee, his profit potential was limited. He understood the value of savings and he knew he could do a better job at lending than a typical islander. He was also particularly good at evaluating business plans and structuring equitable loans. With fish earned from loans of neighbour’s fish, he would pay interest to depositors and wages to his goons. He would keep the leftover profit to himself.
                The Goodbank Savings and Loan was thus born – the Ables of the bank could store their savings to Goodbank when they underconsumed, those requiring loans in order to finance capital projects could see Mr. Goodbank. To keep this running, Max had to keep his loan business profitable which meant he had to carefully screen borrowers, collect interest and foreclose on collateral when loans failed. Second, he had to keep his depositors happy through regular interest payments. Last, he had to attract more borrowers to keep the cycle running. Failure to do so would mean loss of his deposits and loss of job.
                Max handled this all through something called interest rates since he was in the best position to determine the best interest rates to pay depositors and charge borrowers. Despite his administering the rates, the entire interest rate system fluctuated according to market conditions beyond Max’s control. Sometimes, big gains in productivity swelled the island’s savings. When the vault was filled, the bank would drop rates charged on loans because the losses were easier to bear in relative terms and the healthy economy that produced the savings would provide a fertile ground for new businesses. With little need to attract new savings, and lower rates charged to borrowers, such an environment led to lower payments to depositors, which would discourage savings.
                When savings dipped, opposite forces would come into play that would tend to encourage savings thereby replenishing bank coffers. This is the interest rate cycle followed in a normal economy which is almost always disrupted by government intervention – making banks invest in unviable populist projects, loan waivers and what not.

Infrastructure and Trade:
                The need to improve infrastructure on the island was getting dire with the increasing population especially water. This impacted the productivity of the island, Able Fisher V (Able’s great-great-great grandson) thought up of a water works system for which he needed a loan of 182, 500 fish which deterred him. Luckily, Maxine Goodbank (another descendant) weighed in the risks and gave him the loan which resulted in the Able Waterworks and solved the water problem of the island.
                The second bit was inter-island trade which caught on with islands trading what they had in abundance with other islands which had something else in abundance.

                The island had grown into a major economy and there were constant  frictions, crimes and attacks by other islanders especially the fearsome Bongobians. After experimenting with different chieftains, the islanders decided to put together a government that would be accountable to the people and would be limited in its ability to take away the freedoms that had brought the island its prosperity in the first place. It was decided that the islanders would elect 12 senators, including a senator-in-chief. To protect the island from invasions, the senate would create and oversee a navy of spear-packing war canoes. To promote social stability, the senate would establish a system of courts to settle disputes and a police squad to enforce the decrees of the judges.
                In order to finance this modest apparatus, the islanders agreed to pay a yearly fish tax. All fish sent in to the government would go into a special government account at the bank from which the senators would draw funds to meet expenditures. In order to ensure that the senators did not overreach, a constitution was drafted and a supreme judge was put in place to enforce the constitution and maintain a check on the political ambition of senators. When the constitution was voted on and passed, the island nation was called the Republic of Usonia.

Government gets creative:
                The economy grew and only a few people were now needed to bring in fish. Tertiary sectors like hut furnishings, drum making and even theatre troupes flourished. In between, some senators made an emotional appeal that voting eligibility should be extended to non-tax payers as well, this brought to the polls a great many voters who were far less interested in government budgetary prudence. As the government payroll grew along with the economy, the job of senator gained in status and appeal and it started attracting ambitious go-getters. It also incentivized the hopefuls to draft policies that got them votes rather than enact correct policies.
                One particular senator, Franky Deep, wanted to give islanders freebies to get elected forever but couldn’t since all the government had was what they raised in taxes. The senate didn’t catch any fish, they could only take to give. After a very bad monsoon, Franky got elected on the plank of instituting a government reconstruction program for the neediest citizens – he got elected. His victory started the spending for which there were not enough fish reserves. To cover the gap, Franky came up with an idea – they government issued paper money called Fish Reserve Notes which would be redeemable for actual government fish stored at the GoodBank. Citizens could get their fish immediately or use the notes to trade for other goods and services just as they would with real fish.
                Franky got his friend nominated as a judge to pass this change to the constitution and he was off. The Fish Reserve Notes (FRN) were also a hit amongst citizens since they were easy to carry and smelt better as well. Meanwhile, Franky’s advisors scoured the island looking for worthy projects to fund. When they found a project that would guarantee enough support from potential voters, they would hand out the new notes to make It happen.
                Soon, the actual fish available in Goodbank vaults began to run out due to Fish Reserve Notes being handed over indiscriminately. Max rushed to Franky and his advisors asking him to stop issuing Fish Reserve Notes and raise taxes so that the reserves could be replaced. The politicians laughed at the idea – a recipe for political disaster. They told him their new scheme, a team of technicians would use body parts of dead fish and construct a completely artificial fish out of a real fish that would look like a real fish. This could be used to replenish the fish reserve. Max resisted saying the “official” fish was skimpier than a genuine fish and that people would know. Franky replied that the official fish would be only 10% smaller than real fish (10 official fish to every 9 real) and they would also pass a law preventing the islanders from comparing them to real fish. They would tell everyone that their scientists had discovered a new disease among unprocessed fish and they would require everyone to turn in their genuine fish for officially decontaminated fish as soon as they are caught.
                To keep the people from fishing themselves so they could not see real fish, they decided to establish a Fishing Department which would have the sole responsibility for catching fish. To keep people from discovering that the value of their fish holding was down, the government would have a new agency called Fish Deposit Insurance Corporation which would insure the fish. Once the people knew that the Senate was behind their deposits, no one would withdraw their fish. Max tried to fight this but was conveniently bumped off and the transition from real to “official” fish took place. The GoodBank Savings and Loans was now called Fish Reserve Bank and its new chairman was Alan Greenfin.

Shrinking Fish:
                The Senate had a free hand on spending now. They announced grandiose projects, plans and paid for them using Fish Reserve Notes. Some projects benefited the islanders example bigger canoes for the navy, new system of cart paths for transportation. There were others like the controversial Clean Rocks Jobs Program which were harder to quantify. The new Fishing Department was now up and running and most of the employees in these new found government departments were happy because of the pay and security. The actual fish catching however started lagging because Fishing Department had no incentive to take risks and make profits hence it failed to become a model of efficiency.
                Soon so many FRN had been issued that the technicians had to increase the conversion rate, the ten to nine ratio of official fish to real fish now became five to four. As official fish became smaller, it soon became apparent to the islanders that they could no longer survive on one fish per day, they had to eat two at a minimum to survive. Since fish were used as money on the island, the prices for everything went up and the problem of “fishflation” was born. No one understood what caused the prices to rise but Alan Greenfin stood up and explained it with a theory called “cost-price-fish-push”. He argued that high employment (thanks in part to government jobs) combined with a strong economy creates greater demand for fish and forces up prices. As proof of their prosperity, he pointed out that most islanders were now eating twice as many fish as their parents.
                The spending by government kept increasing and fish kept getting smaller causing fish-flation. When fish-flation became rapid, islanders finally noticed that the fish they withdrew from the bank were smaller than the fish they deposited. So, despite the enticement of interest paid on their savings, they began to save less while many discontinued saving completely. Instead fish had to be spent quickly to avoid losses due to rapidly increasing prices. Since fish-flation discouraged savings, bank deposits dwindled. As a result, there were less fish available for funding projects and businesses. In response, business cut back and workers were laid off. When unemployment reached crisis level, people demanded that government do something.
                In response, Senate set strict limits on how much companies could pay workers, under what circumstances they could be hired and fired and how much the businesses could charge for their products. With these constraints, it became more difficult to do business and to grow them. The process continued, FRNs were produced in ever greater numbers while the fishing fleet returned with fewer and fewer actual fish. As official fish shrunk to just one-tenth of their former size, even Greenfin knew that he could not stretch the fish skin any further. When there were only bones left in the vault, he ran over to the senate and called an emergency meeting.

                Usonia was in trouble…enter Sinopia. Rest of the story in part 2.