Future doctoral theses about the Great Tremor of 2008 will ask how it was that the Fed chief, who was an academic economist, came to back so wholeheartedly the proposals of the investment banker heading the US Treasury. If Herbert Hoover and FDR in the 1930s started something called fiscal policy for the first time, George W Bush’s lameduck year has marked the total subjugation of monetary policy.
In his 1945 classic, History of Banking Theory, the University of Chicago’s Lloyd Mints said: “No reorganisation of the Federal Reserve System, while preserving its independence from the Treasury, can offer a satisfactory agency for the implementation of monetary policy. The Reserve banks and their branches should be made agencies of the Treasury and all monetary powers delegated by Congress should be given to the Secretary of the Treasury…. It is not at all certain that Treasury control of the stock of money would always be reasonable… but Treasury influence cannot be excluded by the creation of a speciously independent monetary agency that cannot have adequate powers for the performance of its task…” Years later, Milton Friedman himself took a similar position suggesting legislation “to end the independence of the Fed by converting it into a bureau of the Treasury Department…”(see, for example, Essence of Friedman, p 416).
Ben Bernanke’s Fed has now ended any pretence of monetary policy’s independence from the whims and exigencies of executive power. Yet Dr Bernanke’s fellow academic economists have been unanimous in advising caution, patience and more information and reflection upon the facts. The famous letter of 122 economists to the US Congress was a rare statement of sense and practical wisdom. It agreed the situation was difficult and needed bold action. But it said the Paulson-Bernanke plan was an unfair “subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.”
Besides, the plan was unclear and too far-reaching. “Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards…. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, America’s dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.”
The House’s initial bipartisan “backbench revolt” against “The Emergency Economic Stabilisation Act of 2008” (ESSA) followed this academic argument and rejected the Bernanke Fed’s advice. Is there an “emergency”, and if so what is its precise nature? Is this “economic stabilisation”, and if so, how is it going to work? The onus has been on Dr Bernanke and his staff to argue both, not merely to assert them. Even if the House “held its nose” and passed the measure for now, the American electorate is angry and it is anybody’s guess how a new President and Congress will alter all this in a few months.
Several academic economists have argued for specific price-stabilisation of the housing market being the keystone of any large, expensive and risky government intervention. (John McCain has also placed this in the political discussion now.) Roughly speaking, the housing supply-curve has shifted so far to the right that collapsed housing prices need to be dragged back upward by force. Columbia Business School economists Glenn Hubbard and Chris Mayer, both former Bush Administration officials, have proposed allowing “all residential mortgages on primary residences to be refinanced into 30-year fixed-rate mortgages at 5.25 per cent…. close to where mortgage rates would be today with normally functioning mortgage markets….Lower interest rates will mean higher overall house prices…” Yale’s Jonathan Koppell and William Goetzmann have argued very similarly the Treasury “could offer to refinance all mortgages issued in the past five years with a fixed-rate, 30-year mortgage at 6 per cent. No credit scores, no questions asked; just pay off the principal of the existing mortgage with a government check. If monthly payments are still too high, homeowners could reduce their indebtedness in exchange for a share of the future price appreciation of the house. That is, the government would take an ownership interest in the house just as it would take an ownership interest in the financial institutions that would be bailed out under the Treasury’s plan.”
Beyond the short run, the US may play the demographic card by inviting in a few million new immigrants (if nativist feelings hostile to the outsider or newcomer can be controlled, especially in employment). Bad mortgages and foreclosures would vanish as people from around the world who long to live in America buy up all those empty houses and apartments, even in the most desolate or dismal locations. If the US’s housing supply curve has moved so far to the right that the equilibrium price has gone to near zero, the surest way to raise the equilibrium price would be by causing a new wave of immigration leading to a new demand curve arising at a higher level.
Such proposals seek to address the problem at its source. They might have been expected from the Fed’s economists. Instead, ESSA speaks of massive government purchase and control of bad assets “downriver”, without any attempt to face the problem at its source. This makes it merely wishful to think such assets can be sold for a profit at a later date so taxpayers will eventually gain. It is as likely as not the bad assets remain bad assets.
Indeed the University of Chicago’s Casey Mulligan has argued there is a financial crisis involving the banking sector but not an economic one: “We’re not entering a second Great Depression.” The marginal product of capital remains high and increasing “far above the historical average. The third-quarter earnings reports from some companies already suggest that America’s non-financial companies are still making plenty of money…. So, if you are not employed by the financial industry (94 per cent of you are not), don’t worry. The current unemployment rate of 6.1 per cent is not alarming, and we should reconsider whether it is worth it to spend $700 billion to bring it down to 5.9 per cent.”
Dr Bernanke has been a close student of A Monetary History of the United States in which Milton Friedman and Anna J Schwartz argued that the Fed inadvertently worsened the Great Contraction of 1929-1933 by not responding to Congress. Let not future historians find that the Fed, at the behest of the Treasury Secretary, worsened the Great Tremor of 2008 by bamboozling Congress into hasty action.
Progress Comes From Learning, Enterprise, Exchange, Not The Parasitic State
By Subroto Roy
First published in The Statesman, Editorial Page Special Article,
February 22 2008
P Chidambaram, Montek Ahluwalia and Manmohan Singh, like their BJP predecessors, delude themselves and the country as a whole when they claim responsibility for phenomenal economic growth taking place. “My goal is to continue to maintain growth but at the same time the government reserves the right to make rapid adjustments depending upon the evolving international situation” is a typical piece of nonsensical waffle.
Honest Finance Ministers in any country cannot take personal responsibility for rates of economic growth nor is any government in the world nimble, well-informed and intelligent enough to respond to exogenous shocks in a timely manner. The UPA and NDA blaming one another for low growth or taking credit for high growth merely reveal the crude mis-education of their pretentious TV economists. There are far too many measurement and data problems as well as lead-and-lag problems for any credibility to attach to what is said.
Per capita real GDP
Indian businessmen and their politician/ bureaucratic friends seem to think “growth” refers to nominal earnings before tax for the corporate sector, or some such number that can be sold to visiting foreigners to induce them to park their money in India: “You will get a 10 per cent return if you invest in India” to which the visitor says “Oh that must mean India has 10 per cent growth going on”. Of such nonsense are expensive Davos and Delhi conferences made.
What is supposed to be measured when we speak of economic growth? It is annual growth of per capita inflation-adjusted Gross Domestic Product (National Income or Net National Product would be better if available). West Germany and Japan had the highest annual per capita real GDP growth-rates in the world starting from devastated post-War initial conditions. What were their rates? West Germany: 6.6 per cent in 1950-1960, falling to 3.5 per cent by 1960-1970, and 2.4 per cent by 1970-1978. Japan: 6.8 per cent in 1952-1960; 9.4 per cent in 1960-1970, 3.8 per cent in 1970-1978. Thus, only Japan in the 1960s measured more than 9 per cent annual growth of real per capita GDP.
Now India and China are said to be achieving 9 per cent plus routinely. Perhaps we are observing an incredible phenomenon of world economic history. Or perhaps we are just being fed something incredible, some humbug. India’s population is growing at 2 per cent so even if the Government’s number of 9 per cent is taken at face-value, we have to subtract 2 per cent population growth to get per capita figures. Typical official fallacies include thinking clever bureaucratic use of astronomically high savings rates causes growth. For example, Meghnad Desai of Britain’s Labour Party says: “China now has 10.4 per cent growth on a 44 per cent savings rate… ” Indian savings have been alleged near 32 per cent. What has been mismeasured as high savings is actually paper expansion of bank-deposits in a fractional reserve banking system induced by runaway government deficit-spending in both countries.
Real economic growth arises from spontaneous technological progress, improved productivity and learning-by-doing of the general population. World economic history suggests growth occurs in spite of, rather than due to, behaviour of an often parasitic State. Technological progress in a myriad of ways and discovery of new resources are important factors contributing to India’s growth today. But while the “real” economy does well, the “nominal” paper-money economy controlled by Government does not.
Continuous deficit financing for half a century has led to exponential growth of public debt and broad money. The vast growth of bank-deposits has been misinterpreted as indicating unusual savings behaviour when it in fact signals vast government debt being held by nationalised banks. What Messrs Chidambaram, Ahluwalia,Manmohan Singh, the BJP et al have been presiding over is annual paper-money supply growth of 22 per cent! That is what they should be taking honest responsibility for because it certainly implies double-digit inflation (i.e. decline in the value of paper-money) perhaps as high as 14 or 15 per cent. If you believe Government numbers that inflationis near 5 per cent you may believe anything.
The mainsprings of real growth in the wealth of the individual, and so of the nation, are greater practical learning, increases in capital resources and improvements in technology. Deeper skills and improved dexterity cause output produced with fewer inputs than before, i.e. greater productivity. Adam Smith said there is “invention of a great number of machines which facilitate and abridge labour, and enable one man to do the work of many”.
Consider a real life example. A fresh engineering graduate knows dynamometers are needed in testing and performance-certification of diesel engines. He strips open a meter, finds out how it works, asks engine manufacturers what design improvements they want to see, whether they will buy from him if he can make the improvement. He finds out prices and properties of machine tools needed and wages paid currently to skilled labour, calculates expected revenues and costs, and finally tries to persuade a bank of his production plans, promising to repay loans from his returns.
Overcoming restrictions of religion or caste, the secular agent is spurred by expectation of future gains to approach various others with offers of contract, and so organize their efforts into one. If all his offers ~ to creditors, labour, suppliers ~ are accepted he is, for the moment, in business. He may not be for long ~ but if he succeeds his actions will have caused an improvement in design of dynamometers and a reduction in the cost of diesel engines, as well as an increase in the economy’s produced means of production (its capital stock) and in the value of contracts made. His creditors are more confident of his ability to repay, his buyers of his product quality, he himself knows more of his workers’ skills, etc. If these people enter a second and then a third and fourth set of contracts, the increase in mutual trust in coming to agreement will quickly decline in relation to the increased output of capital goods. The first source of increasing returns to scale in production, and hence the mainspring of real economic growth, arises from the successful completion of exchange.
Risk and enterprise
Transforming inputs into outputs necessarily takes time, and it is for that time the innovator or entrepreneur or “capitalist” or “adventurer” must persuade his creditors to trust him, whether bankers who have lent him capital or workers who have lent him labour. The essence of the enterprise (or “firm”) he tries to get underway consists of no more than the set of contracts he has entered into with the various others, his position being unique because he is the only one to know who all the others happen to be at the same time. In terms introduced by Professor Frank Hahn, the entrepreneur transforms himself from being “anonymous” to being “named” in the eyes of others, while also finding out qualities attaching to the names of those encountered in commerce.
Profits earned are partly a measure of the entrepreneur’s success in this simultaneous process of discovery and advertisement. Another potential entrepreneur, fresh from engineering college, may soon pursue the pioneer’s success and start displacing his product in the market ~ eventually chasers become pioneers and then get chased themselves, and a process of dynamic competition would be underway. As it unfolds, anonymous and obscure graduates from engineering colleges become by dint of their efforts and a little luck, named and reputable firms and perhaps founders of industrial families. Multiply this simple story many times, with a few million different entrepreneurs and hundreds of thousands of different goods and services, and we shall be witnessing India’s actual Industrial Revolution, not the fake promise of it from self-seeking politicians and bureaucrats.
First published in The Sunday Statesman, Feb 11 2007, The Statesman, Feb 12 2007
Editorial Page Special Article
TWO and a half millennia ago, the Greeks described how brightly coloured textiles imported from India were popular among the Persians. Five centuries later, the Roman historian Pliny complained that India every year “took from Italy a hundred million sesterces in return for spices, perfumes and ornaments”. Montesquieu observed in 1748: “All peoples who have traded with India have always taken metals there and brought back commodities. Indians need only our metals, which are the signs of value. In all times those who deal with India will take silver there and bring back none”.
During the British period, India remained a great trading nation. JM Keynes found Britain, the world’s largest exporter in 1913, exporting more to India than anywhere else, and Germany, the world’s fastest growing economy in 1913, receiving 5 percent of its imports from India and sending it 1.5 percent of exports, making India the sixth largest exporter to Germany (after the USA, Russia, Britain, Austria-Hungary, France) and eighth largest importer from it (after Britain, Austria-Hungary, Russia, France, the USA, Belgium, Italy). India’s share of world exports during 1870-1914 may have been about 3-4 per cent. As of 1917-1918, India’s balance of payments and fiscal budget appear idyllic: an export surplus of £61.42 million, official reserves of £66.53 million, total claims on the rest of the world of £127.5 million (or 32.85 million troy ozs of gold), and a 1916-1917 budget surplus of £6,594,885.
Even at mid-20th Century, India was still a trading power with 2 percent of world exports and a rank of 16 in the world economy after the USA, Britain, West Germany, France, Canada, Belgium, Holland, Japan, Italy, Australia, Sweden, Venezuela, Brazil, Malaya and Switzerland.
Yet during the second half of the 20th Century, the Indian subcontinent collapsed to near insignificance in world trade and payments. The traditional export surplus implied a high “treasure” demand for precious metals on capital account; this was reversed and the new India became a chronic trade-deficit country dependant on foreign borrowings and grants. Of world merchandise exports, the subcontinent’s share today is 0.8 of 1 per cent, and of Asia’s 6 percent (India accounting for two thirds); by contrast, Malaysia alone accounts for 0.9 of 1 percent of world exports and 6.5 percent of Asia’s. Most poignantly, among 11 major developing countries (Korea, Taiwan, Singapore, Hong Kong, Argentina, Brazil, Chile, Mexico, Israel, Yugoslavia), India’s share of manufactured exports to the world fell from 65 per cent in 1953 to 51 percent in 1960 to 31 per cent in 1966 to 10 per cent by 1973. Our legendary textiles lost ground steadily. As of 1962-1971, India held an average annual market-share of almost 20 percent of manufactured textile imports into the USA; this fell to 10 percent by 1972-1981 and less than 5 percent by 1982-1991. India’s share of Britain’s imports of textile manufactures fell from 16 per cent in the early 1960s to less than 4 per cent in the 1990s. India and Sri Lanka once dominated world tea exports but lost rapidly to Kenya, Indonesia and Malawi. Of total British tea imports, Sri Lanka’s market-share fell from 11 percent in 1980 to 7 per cent by 1991 while India’s fell from 33 percent in 1980 to 17 per cent by 1991. Today India may not be in the top thirty largest merchandise exporting countries of the world.
Several causes may be identified for our historical collapse in world trade and payments. These include Western protectionism e.g. of domestic textiles between 1965-2005, and emergence of new technologies like synthetic fibres, plastics, tea-bags etc as well as new competitors in the world marketplace willing to use these. Successful commerce depends on intangible quantities like trust, reliable information and contacts between individual contracting parties. Decline in our shares of world exports led to wastage of such informational capital and commercial trust. Foreign importers established new relations with India’s competitors, and for Indian entrepreneurs (now facing lessened foreign protectionism or newly liberalized domestic policies) to win new customers or win back old ones becomes doubly difficult.
But the most important cause of the decline was undoubtedly the political discord and trauma leading to economic disintegration of Old India into modern India, Pakistan, Sri Lanka and Bangladesh. Partly as a result of their conflict, independent India and Pakistan deepened government requisitioning and rationing of foreign exchange purportedly as part of pseudo-socialist “planning”.
Trade policy followed the British pattern of import quotas imposed to conserve hard currency and save shipping space during war. Discretionary controls were in place by 1942 on grounds of “essentiality” and non-availability from indigenous sources. War needs over-rode others, and consumer goods banned ~ favouring their production by domestic business houses. In 1945 consumer goods were placed on open general license, as “the pattern of post-war trade should not be dictated by perpetuation of controls set up for purely war-time purposes”, and in 1946 there was further liberalization in view of India’s enormous sterling balances. But by March 1947 this ended, and import of gold and 200 “luxury” goods were banned. Only a few “essential” goods remained on the open list.
After the British left, political/bureaucratic control of imports and foreign exchange were extended, not removed. Intricate restrictions, subsidies, barriers and import-licensing (based on obsolete war-time “essentiality” and “actual user” criteria) continued, now in name of “import-substitution” and “planning”. Major industries were nationalized, and these became leading consumers of imports obtained by administrative rationing of the foreign exchange earned by export sectors. As consumer goods’ imports were most restricted, Indian businesses predictably diverted to produce these in the large highly protected domestic markets that resulted, causing monopolistic profits and financing of a vast parallel or “black” economy with its thriving hawala sector. Restriction of consumer goods’ and gold imports also caused smuggling and open corruption in Customs. The international price of the rupee was viewed not as reflecting demand for foreign relative to domestic moneys but as just another administered price to be used by politicians and bureaucrats. Foreign exchange earnings of exporters were confiscated in exchange for rupees at the administered rate. Foreign currency thus requisitioned was (and still mostly is) disbursed by rationing in the following order of precedence: first to meet Government debt repayments to international organizations, and Government expenditures abroad like maintenance of embassies and purchase of military imports, plus politicians’ and bureaucrats’ foreign travel etc; secondly, for import of food, fertilizers, petroleum; thirdly, for imported inputs required by Government firms; fourthly, for import demands of those private firms successful in obtaining import licenses; lastly, to satisfy demands of the public at large for purposes like travel or study abroad.
After devaluing with sterling in 1949, the rupee was maintained at the same value for 17 years despite weakening reserve positions and numerous shocks to the economy like the 1962 war with China, 1965 war with Pakistan, and droughts and food crises. Devaluation on June 6 1966 to Rs. 7.50 per US dollar met political opposition and contributed to Congress Party losses in the 1967 elections. The rupee did not respond to sterling’s devaluation in November 1967 and was not adjusted downwards though the economy continued to suffer shocks like the rise in petroleum prices, refugees from the Pakistan civil war, and domestic strikes and political instability. In August 1971, India pegged to the dollar and devalued with the dollar’s depreciation but in December again linked to sterling at Rs 18.97. When sterling depreciated after floating in June 1972, the rupee effectively devalued with it, and until July 1975 there were three small devaluations against sterling. In September 1975, India pegged (within margins) to an undisclosed basket of hard currencies including the dollar, yen and deutschmark, and between 1981-1985, the rupee was slowly managed downwards, without political resistance. From September 1985-July 1991, it followed a more rapid downward course depreciating 40 per cent, while the dollar depreciated as well against major currencies, suggesting the dollar weighed heavily in the basket to which the rupee was pegged.
Narasimha Rao, P Chidambaram and others received from Rajiv Gandhi in his last months the results of a “perestroika-for-India” project, and started a process of economic liberalisation. Chidambaram said at the time the reforms “were not miraculous” but based on rewriting the Congress manifesto: “We were ready when we came back to power in 1991”.
On July 1 1991, the rupee devalued 9 percent and on July 3 a further 11 percent. The new Government’s March 1 1992 Budget placed the rupee experimentally on a dual rate, implicitly taxing exporters who had to surrender 40 percent of their forex at an officially determined rate and could sell 60 percent in an open market. On March 1 1993, the rupee began to be made convertible for current account transactions, i.e. for import and export of goods and services. Trade reforms included removing many import quotas and some export subsidies. But grave fiscal and monetary problems were not (and have never been) addressed with any seriousness.
Balance of payments
The “balance of payments” sums a country’s current and capital accounts. In Western countries, the capital account consists of net trading in long and short-term securities like private stock and government debt ~ domestic securities being bought and sold freely by foreign residents and foreign securities by domestic residents. Prices determined by competitive trading are very sensitive to interest-rate differences. In India (and Pakistan etc) genuine capital account transactions have not existed since the 1930s, and do so only in highly distorted form even today. The traditional export surplus and positive current account, balanced by net inflow of precious metals, had been wiped out and current account deficits were coupled with overvalued currencies and closed capital markets – along with repressive financial policies causing capital flight of an elite nomenklatura. The inherent risk of unproductive use of funds by borrowers and consumers of forex (mostly Government) were shifted to export and other hard-currency earning sectors.
In particular, a severe trade-deficit had followed petroleum-price rises in the late 1970s, which continues today. There has been some exploration, discovery and extraction of domestic supplies of oil and gas, but no significant move to conserve or find economical alternatives to use of imported energy. (Indeed a coal-exporting petroleum-importing nation with the most heavily used railways in the world made an unprovoked decision to abolish steam-locomotives in favour of diesel and electric. And now, very expensive foreign nuclear plants are planned to be imported on a turnkey basis under a false assumption these will help India’s energy sector.)
India gained from exporting temporary workers to the Gulf since the 1970s but that could hardly finance the increased oil bill. Instead there has been large growth of foreign debt since the 1970s, mostly owed by the Government (and recently by large private businesses) to Western financial markets via brokerage of Western governments and organizations they control. India’s foreign debt amounts to more than $100 being owed by each of our one billion citizens, each of us having to earn five or six dollars every year on average just to meet interest payments due to foreign creditors.
This has been accompanied in the last few years by foreign exchange reserves (the residual in the balance of payments) seeming to grow rapidly, and rising reserves have been perceived as a sign of optimism. Just as bad luck came by way of large oil-price increases, we have seen windfall gains from spread of American “information technology” ~ causing an even larger surplus on services as Indian computer-workers are exported, or new foreign investment is lured by low costs of “business process outsourcing” using our “reserve army” of labour and seemingly cheap real estate.
Rising forex reserves may or may not indicate a better financial position just as rising debt may or may not indicate a weaker financial position. A cash-rich person or company or country may have enough liquid resources to meet an immediate payments’ crisis ~ but may have become cash-rich merely by having borrowed more. A country’s forex reserves may be rising because foreigners have lent it more or have been exploiting arbitrage opportunities presented by multiple exchange-rates or interest-rates or other capital market inefficiencies, or even because reserve-assets have appreciated in world markets due to currency movements.
Similarly, it is not the absolute size of a debt that matters but productivity of the use to which it has been put. At a conference on a “perestroika-for-India” in May 1989 at the University of Hawaii, the late Milton Friedman remarked that one man can be heavily indebted yet have used his debt for investment in capital and hence real growth, while another man can be less heavily indebted but have used borrowed money for debauchery or other wasteful consumption.
For countries too, it is the use to which debt has been put ~ the nature of assets that have been created with the debt ~ that is fundamental. If our foreign debt has been used by Government to create roads and bridges or improve agricultural productivity, fertile capital assets have been invested in, which lead to economic growth and well-being.
If borrowed foreign money has been mostly spent on fancy tanks and bombers (or even passenger aircraft, which mostly earn domestic and not foreign currency) or on foreign trips for politicians and bureaucrats, it has likely gone on sterile consumption goods for the elite. Since Pakistan and India are armed with foreign weapons intended to be used mainly against one another, the arms’ merchants on both sides have been laughing all the way to their Swiss banks for decades. Pakistan and India’s weapons’ imports have been effectively paid by their Governments having borrowed what now constitutes the bulk of their enormous sovereign debts. Requisitioning forex has permitted military generals, politicians, bureaucrats and other lobbies to spend as they wish foreign monies earned by relatively meagre export sectors under conditions of severe international competition.
The RBI is presently engaged in a false convertibility whereby the organised private sector can purchase foreign assets, and the elite can transfer $50,000 annually to their adult children already exported abroad. Truly freeing the rupee today would involve allowing, overnight, any Indian to hold gold, foreign currency and foreign exchange bank accounts freely at his/her local bank (just like those glamorous NRIs). But some 50% or more of public expenditure is being financed by debt compulsorily held by nationalized banks, and this would leave Government with the problem of finding real resources to pay interest and amortisation on the sovereign debt. Moving towards convertibility may induce severe inflation and instability caused by exposure of the weakness of the banks, as their assets (especially Government debt) come to be valued at international prices. Yet without a convertible rupee, proper valuation at world prices is not possible of any paper assets in India (including shares), nor is there any incentive for a responsible fiscal and monetary policy to emerge, even while the nomenklatura continue in capital flight, and India’s masses unknowingly inherit large accumulating rupee and dollar-denominated public debts.
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