Demonetization Has Opened A Window Of Opportunity For Modi

In a televised address to the nation on September 21, 2012, the then Prime Minister Manmohan Singh told the people of India that “Money doesn’t grow on trees”. He was trying to convince the voters that reining in the inordinate government spending and financing some of the trade deficits with Foreign Direct Investment (FDI) is not a bad idea. On November 08, 2016, Prime Minister Modi told the nation in another televised address that the cash portion of the money, that Manmohan Singh claimed didn’t grow on trees, needs to be deposited back into the banks.

There is a core to the economic challenges that led our two Prime Ministers to make these televised announcements and I believe that demonetization has opened a short window of opportunity to solve the underlying problems.

After the 1944 Bretton Woods agreement, and before 1971 when the agreement ceased to exist, money didn’t grow on trees, to the extent that foreign nations, who could redeem their dollar notes with gold, kept tabs on how many notes were being issued by the Federal Reserve. The dollar was backed by gold and so was the rupee pegged to it. The free market didn’t feel the need for an alternative currency as what was available was consistent with, or at least close to, what it would have approved of.

The enormous balance sheet of the Federal Reserve is one evidence of the failure of the post-1971 fiat system and of its inevitable collapse. Free market, having anticipated an impending loss of confidence in fiat currencies, and despite the obsolete pre-1971 regulations, is trying to find solutions. Political capital one needs to muster to end the reign of central banks is formidable; so politicians in developed economies who believe in free market are advocating for the next best, or transitional, alternative – free market competition in currencies.

fredgraph-1

Chapter III, Section 22, Part I of the Reserve Bank of India Act, 1934 gives the central bank the sole right to issue bank notes in India. In 2011, Ron Paul, in an effort to abolish a similar right of the Federal Reserve to issue notes in the U.S. introduced the Free Competition in Currency Act of 2011. He has been warning about the collapse of the fiat system and envisions privately issued sound money based on commodities to save the U.S. from its own government.

Ron Paul could not convince the congressmen and senators in the U.S. to pass the bill. The probability of passing such a bill in India is equally low; even if the Prime Minister gives the bill a consideration, he must face the legacy socialist “economists” in India who might lose their mind over the thought of potential bank runs or over how capitalists will fleece the illiterate with fake currencies the same way they have, over the years, defrauded the poor by selling them mobile phones. They will find it difficult to comprehend why it should be up to the people whether they want to use government’s notes or privately issued notes, the same way they can now decide whether they want to use a government owned MTNL’s service or the one provided by Airtel or Reliance.

The cost of government monopoly over money, reflected in the two televised announcements of our Prime Ministers, far outweighs the cost of bank runs associated with privately issued money. And the forty-five-year-old experiment is yet to unravel to reveal its true cost. After demonetization, the people of India are desperate for cash and a bill that allows private money to compete with government money might be perceived by the voters as a palliative measure rather than an elaborate conspiracy. If the NDA government introduces and passes such a bill, Modi, who is currently being criticized by free market economists across the world for his demonetization step, will be revered by them forever as the 21st century founding father of free India.

To understand in detail and in layman’s terms how fiat currencies, socialist governments and nationalized banks in India has ruined the Indian economy, and how competing currencies can solve our problems, I would encourage you to read the following two articles Republic of Ghaziabad – Part I and Republic of Ghaziabad – Part II. I have written these articles for people who do not understand complex terminologies of economics.

Somebody Else’s Money For Somebody Else

It is intuitive to grasp some of the implications of the recent demonetization of 500 and 1,000 rupee notes by the central government in India. If there is one thing the corrupt government officials are good at, it’s collaboration. Those running a one-man show don’t survive the swamp. When the Indian Revenue Service and the Central Bureau of Investigation are currently not able to effectively prosecute the corrupt government officials they have already identified, owing to an overburdened judiciary, it is unreasonable to expect them to pin down the collaboration that takes place between the good, the bad and the ugly between November 08th and December 30th, the two dates between which one can deposit old notes in a bank. This intuition is likely to kick in when the commotion settles. Right now, it is the thought of a cash hoarder running around and losing sleep over piles of cash under his bed that is keeping people standing in bank queues happy.

Other implications, and the underlying reasons behind demonetization, are not so intuitive to understand. I intentionally did not use the term tax-evaders in the paragraph above when I referred to those with illegitimate hoardings of cash. It would be an egregious error for an economist to conflate businessmen who evade taxes and corrupt government officials who take bribes. What you call tax evasion, a free market economist, in the context of the Indian economy, will, and should, call a tax cut. An effective tax cut that incentivizes businessmen to produce goods and services that people need. A businessman’s wealth is not, unlike the wealth of a corrupt government official, an ill-gotten wealth. He takes risks, employs people, and his wealth is a function of what people were willing to pay for the goods and services he produces.

The idea is not to encourage tax default, but to acknowledge the inefficiency of the tax machinery of the government for a low effective tax rate. Lower taxes, to an extent, imply smaller governments. The period between 1776 and 1913 during which the United States became an industrial superpower, the country had a very small government and income tax was unconstitutional. To understand in layman’s terms how the Indian economy will crumble if all businessmen were to be forced to pay a high tax rate, I would encourage you to read the article Republic of Ghaziabad – Part I. The belief that “taxes are high because businessmen don’t pay them” is a fallacy; many businessmen will simply close their operations if they are forced to pay such high taxes.

But this is not the gravest implication of demonetization; I am confident that businessmen in India are smart enough to find a way around it. The most concerning part is that this is not just demonetization as claimed by the government. I predicted the collapse of the banking system in India in my two articles published in 2015: Will India Be The First Domino To Fall? and You Can’t Just Invest On Hope. The hard-earned money that people deposited in nationalized banks was squandered away during the ten years of the UPA government. These banks financed boondoggles, welfare schemes and luxuries of friends of governments, and have now run out of money. The collapse I predicted is here. I believe that the Finance Ministry is grasping for straws and the demonetization step is a last-ditch effort to postpone the financial crisis. This is not demonetization. This is a bank holiday, and it will backfire.

No set of words capture what happens when money is not in the hands of people but their government better than this quote by Milton Friedman.

 “There are four ways in which you can spend money. You can spend your own money on yourself. When you do that, you really watch out what you’re doing, and you try to get the most for your money. Then you can spend your own money on somebody else. For example, I buy a birthday present for someone. Well, then I am not so careful about the content of the present, but I am very careful about the cost. Then, I can spend somebody else’s money on myself. And if I spend somebody else’s money on myself, then I am sure going to have a good lunch. Finally, I can spend somebody else’s money on somebody else. And if I spend somebody else’s money on somebody else, I am not concerned about how much it is, and I am not concerned about what I get. And that’s government.” 

– Milton Friedman

Let us read the quote above considering the current situation. Under demonetization, a poor woman who has been saving cash to spend on the education of her child will be forced to deposit it in banks operated by the government. The banks (somebody else) will use her money to finance ever-increasing salaries of government officials (somebody else) and to fund “new and innovative” schemes centrally planned for the poor (“somebody else”) by an army of bureaucrats (somebody else). Somebody will use her money to build a toilet for her. Somebody will buy her an LED bulb.

When she asks for her money back, and if the cash withdrawal restriction has been lifted by that time, the RBI will print new notes for her. Direct taxation is not the only way the government takes people’s money. Inflation is a tax, and printing notes out of thin air causes inflation. The woman will not be able to educate her child when she receives the devalued cash as the cost of education would have risen. In effect, she won’t be able to educate her child because somebody else has been granted the power to spend her money on somebody else.

The money she would have spent on the education of her child would have employed a pencil and copy manufacturer, a carpenter and a teacher. Now that money will be spent on salaries of bureaucrats who make decisions for her, on salaries of welfare officials who produce nothing for her, and on LED bulb which she doesn’t think is as important as education for her child. Think about millions of people whose choice to spend their own money in a way they want has been taken away by this step, and you will start getting an idea of the magnitude of the impact of this decision. This, I believe, is more damaging than other consequences associated with demonetization, and will continue to worsen the fundamentals of the economy until the cash withdrawal restriction is lifted.

Lessons On The Economy From Mahabharata

In Mahabharata, Krishna started his campaign against Kansa with a protest against the income tax. He encouraged the dwellers of Gokul not to pay the income tax (Kar) imposed on them by Kansa. Escalation of the conflict between the people of Gokul and the state of Mathura culminated in Kansa’s death at the hands of Krishna. This episode has a striking resemblance to how the United States was founded. In 1765, the American Colonial Society rejected the authority of the British to levy taxes on the people of America. Escalation of this conflict resulted in the defeat of the British and the independence of America in 1776. Between 1776 and 1913, when the United States grew at its fastest pace to become a superpower, the country did not have an income tax (only corporate profits were taxed). The money people earned remained in their hands to be spent on what they deemed fit.

When Krishna tried to convince the people of Gokul not to pay their taxes, he pointed out to them how Kansa, as a king, had abdicated his primary responsibility of protecting the life and property of the people of Gokul. Mahabharata starts with king Bharat defining the role of a government (king). When he announced his decision not to hand over his throne to any of his nine sons, he described the three responsibilities of a king and emphasized that these are his only responsibilities. The first is to protect the life and property of the people from external attacks, the second is to provide justice to the people, and the third is to nominate a worthy successor.

Bharat did not mention redistribution of wealth as a responsibility of a king. It was Duryodhan who later violated this principle and started giving away money (gold) in the treasury (Raj Kosh) to the people of Hastinapur to get public opinion in his favor when he faced a threat from the Pandavas. Charity is embedded in the Hindu culture. A government, by enforcing redistribution, can only demonstrate its distrust of the people.

Since FDR’s new deal in the 1930’s, the U.S. has continued to abandon the principle of minimal taxation and limited government and has started walking on Duryodhan’s path. In 2008, after allowing gambling in the Wall Street casinos, the U.S. government stripped the constitution, laid down by the seven founding fathers, by bailing out the banks, in plain sight, the same way Duhshasana tried to strip Draupadi, wife of the five great warriors, in front of the people who were entrusted with the responsibility of protecting the fundamental principles of governance laid down by king Bharat.

The Indian government needs to learn from Mahabharata, and listen to Dr. Subramanian Swamy when he says that the government should abolish the income tax. The government can perform the three core functions prescribed in Mahabharata without the burden of income tax on the people of India.

I recommend you to read the following two articles to understand how important it is to get rid of the income tax, and to focus on empowering our judiciary. The article Republic of Ghaziabad – Part I explains in layman’s terms how income tax is impeding our economic progress. The article Breaking One Shackle Of The Fatal Conceit explains with the help of an analogy, how the government of India is making the same mistakes that have kept India trapped in poverty for seventy years.

Breaking One Shackle Of The Fatal Conceit

“I am against the system” has been the overarching sentiment and “I will change it” the clarion call of many well-intentioned political leaders that have been voted to form governments at the center and many states in India since her independence. Others have tried to work within the system to serve the population. Regardless of their approach, these leaders have continued to disappoint us in the long run. A prevalent misconception is that these leaders fail us because the system changes them and makes them corrupt. This fallacy has its costs. With no valid rationale to rely upon, the voters in India have turned to faith; it always begins with “I believe that this man is incorruptible. I feel that he is the one who will do it.” And when it ends badly, and it always does, we have someone else raising the hopes of those who were disappointed, and of those who were too young to witness the prior debacle(s).

The repeated failures of our political leaders have nothing to do with their corruptibility, insincerity or their inability to meet the standards of virtue that the voters have come to expect from them. The cause of our failures has a name. It is called the fatal conceit, and we, as a nation, are trapped in it.  This article is not going to discuss the broad, and sometimes well understood, errors of socialism. It will discuss, using an analogy, a specific problem area that is not so well understood, especially in India, but has strengthened our entrapment in the conceit.

If aliens were to land in New Delhi, and see how our political leaders and bureaucrats try to get things done, they might compare them to the passengers of a broken car who, with no knowledge of what makes the vehicle run or why it broke down, roll up their sleeves and start pushing it, pulling it, lifting it and rolling it, just to get it moving. The car does not start, and it never will, with efforts of such kind. But the co-passengers, who themselves don’t realize how the car ought to be run, see, and are appreciative of, the emotions, the honesty, the hard work and the relentlessness with which their leaders try to move the car.

While one doesn’t need an alien brain to deduce that pushing, pulling or rolling a car are not the most efficient ways to move it, and will never appreciate someone trying to run a car without engine oil or gasoline in it, it is not so intuitive to understand what is needed for ‘the system’, which our leaders have been promising to change or which they’ve been trying to serve us with, to function efficiently. The mechanics are subtle and sometimes even counterintuitive.

We will investigate how the mechanics, or lack thereof, have or have not worked on the ground, with the help of experiences of three individuals I recently met – Anil Chowdhary, Lalit Mohan Jindal, and Dr. Subramanian Swamy.

Anil Chowdhary

Anil Chowdhary is a BJP Parshad in the Govindpuram locality of Ghaziabad. He is an ambitious politician; I first got a glimpse of the municipal work he has been able to facilitate in the public park of Govindpuram (pictures below). It has two gazebos, swing sets, and paved path around the park for walking and running. Anil has certainly got the car moving, but not with engine oil and fuel. He has tied ropes to the axle of the car and is pulling it relentlessly. The car is still broken. Let’s get on the ground to better understand the analogy.

During the mid-19th century, Ellis Sylvester Chesbrough was assigned the task to build the sewer system of Chicago. The city of Chicago sits on a flat plain, and engineers of the time didn’t think it was possible to design an underground sewer system in the city. So Mr. Chesbrough did something nobody had imagined. He lifted the entire city of Chicago using jackscrews; an unbelievable engineering feat. 150 years later, the engineers of Ghaziabad did something even more unbelievable; they tried to reverse the laws of physics. They built a sewer system in Govindpuram against the natural incline of northern plains. A kindergarten kid in India would tell you that the rivers in the subcontinent flow from north to south. The engineers built the sewer lines to flow from south to north. It has been a nightmare for the people of Govindpuram, especially when it rains and the rain water flows in the opposite direction.

On top of this engineering marvel, a man, in the process of constructing the basement of his house, poured cement into one of the primary sewer lines and blocked it.

I asked Anil “Why don’t you penalize this person and repair the sewer line? I am sure there must be a provision in the contract signed between the state and the plot owner when the land was sold. Or there must be a law under which Parshads can impose penalties to punish damages caused to public property. Is it not possible for you, as the representative of the people of Govindpuram, to file a lawsuit against the state government for using public money for building a dysfunctional, and a potentially life-threatening sewer system?” Anil was quick to reply to the first part of my question “There is a provision in law to levy fines or to get the sewer line repaired, but if I impose a penalty, or try to get my laborers inside his basement to unclog the line, I will probably need to take the offender to court only to get stuck in a long trial. He is not going to comply otherwise.”

There are two reasons why the car does not start for Anil. Firstly, the engine oil is in short supply; the courts, that resolve friction between moving parts of the system, are overburdened and therefore slow to respond. The second reason is a result of the first. Having lived with this state of the judiciary, people’s understanding of its role, and their expectations from it, especially in the matters of disputes that do not involve private property, have waned over the years. The passengers don’t know that the car needs engine oil. The people of Govindpuram, who could have themselves taken the “sewer-clogger” and the authorities that approved the sewer design to court under several sections of the current law, don’t do it because a legal resolution is, or rather has become, as counterintuitive to them, as it is to our political leaders.

So Anil does what he can do in his capacity as a Parshad. He has been trying to reason with the offender to get the sewer line working again. He is trying to move the car by tying it to a horse. A lawsuit against the municipal corporation, I guessed, was out of the question for him. To be fair to Anil, producing engine oil is not his job.

Note here, that we are not talking about the fatal conceit, the inevitable failure of central planning, or about how keeping the involvement of the government, in making the choice of engineers and contractors in building the sewer system of Govindpuram, at a minimal level, would have prevented the waste in the first place. That discussion, as mentioned above, is not in the scope of this article. Neither are we talking about how the engine oil ought to be produced. Judicial and police reforms are also out of the scope of this article. The goal of this article is to illustrate how important good quality engine oil is to get the car started.

Our conversation drifted to the central government’s Clean India campaign. Garbage disposal, as opposed to sewerage, is strictly a municipal subject, so it comes directly under Anil. There is garbage on the roads and around local markets. Stray dogs fight over the jurisdiction of the areas with maximum garbage and sometimes forget that humans are not their competitors. It’s quite a spectacle. Anil has got dumpsters installed on the side of the roads as a temporary solution, but there is litter around them too.

My questions to Anil were becoming repetitive. “Can’t you impose penalties on people who litter garbage around the dumpsters, on the road, or near the market? Have you examined the private garbage collectors who might be violating their contract with the municipal corporation” My questions might have been repetitive, but they are valid; there is no need for an earth-shattering revolutionary solution to make India clean. The problem is simple and so is the solution.

Anil’s answer should not surprise you if you’ve lived in Ghaziabad (the city’s crime rate rivals that of Chicago). “Forget about taking the contract between private garbage collectors and the municipal corporation to court, there are a few people in this area that take pride in littering garbage. They feel that doing something that the law does not permit demonstrates their power. They have connections with the ruling party in the state. If I knock on their door with a summon in my hand, I will probably need bodyguards. Then there are others who will simply take the summon courteously only to later throw it in a dustbin.” Anil, in his answer, indicated that the small amount of engine oil he has access to has become useless, as the mechanism to deliver the oil to the engine is not working. He does not have access to a functional police.

I’m glad that he didn’t say “Where will I get the evidence to furnish in court?” A summon by a police officer who has witnessed littering is a sufficient enough deterrent (I will explain in a bit). I was also relieved that he did not suggest the hundreds of expensive bureaucratic “intuitive-fixes” on the lines of “installing CCTV cameras to collect evidence”, for if he did, he would have shown, that like the passengers of the broken car, he too missed an aspect that is crucial to understand how the car runs. Dr. Subramanian Swamy often explains it with the help of an equation. If α is the probability of being caught in the act, B is the benefit one gets out the act, and P is the penalty of getting caught, then your expected return R is equal to α X P + (1- α) X B. For the expected return of the act to be negative, we need that P > B [(1/ α) -1]. You don’t necessarily need a high α, all you need is that the penalty P is high enough to make the return negative. Besides, the benefit B one gets in littering garbage is not monetary; it only takes a little bit of effort not to litter. So even if α is low, a summon from an officer who can testify, under penalty of perjury, should be a sufficient deterrent.

[Side Note: I don’t want to digress into the topic of how the engine oil ought to be produced or how we can enhance its quality, and I am not sure whether a video recorded on a mobile phone is an admissible evidence in a court for misdemeanors, but it seems to me that it might be difficult for someone to deny when he/she is confronted with a video of him/her littering garbage.]

And don’t worry, there won’t be havoc with police officers accusing their enemies, or enemies of their relatives, of littering garbage. Conflicts will still be settled in courts. Most people won’t litter only because they don’t want to go through the trouble of appearing in a court.

I can relate to this equation with one of my personal experiences. I used to speed on the highways of Georgia like there was no tomorrow. I never got caught. In the summer of 2012, when I was driving from Atlanta to Washington D.C., I was chased by a police officer and served a summon to appear in court. The police officer was supremely disgusted having chased my car in the middle of the night at more than 90 miles per hour. (Speeding 20 miles per hour above the 70 miles per hour speed limit is a Class-I misdemeanor in the state of Virginia.) I had to hire a lawyer and pay a huge penalty. I stopped speeding even before the court penalized me, and haven’t exceeded the speed limit since. The people in the U.S. who want to start the car have access to high-quality engine oil; the rule of law.

Anil is also trying to enforce a regulation to limit the number of floors that can be built on a plot of land. What intrigued me was that he is doing so to solve a relatively simple problem. “Parking space in the area is limited and when people rent out their multi-storied houses, there might be chaos.” he says. Unlike in the U.S., where neighborhoods decide on such subjects with a majority vote, Anil needs a court order, and he has been able to secure one. When I asked, “Don’t you think that giving parking permits to each homeowner, with temporary permits for guests, is a better solution?” Anil said that he fears for his life “If I try to tow a car that does not have a parking permit, they will come after me with a bamboo stick.” I thought in my mind “Won’t the same people come after you when you try to limit the number of floors?” but I guessed that there are a few regulations that even the most reprobate won’t dare to break. Just because he does not have access to engine oil, Anil is trying to roll the entire car to move it.

“You don’t understand the situation in India.” he continued.  “Just to get an injunction on a few illegal shops, that clearly violated the town planning rules, I have been running up and down the Allahabad High Court. A housing unit was recently rented by three rowdy brothers who eve teased women in the area. An old man in the neighborhood confronted them, and after a few days when he went to the police station to lodge a complaint, he found that the goons had already filed a complaint against him accusing him of stalking their mother. Now tell me what should one do?”. Anil held a meeting in the neighborhood and was successful in encouraging the home owners to take a stand against the goons. The issue got resolved without, repeat: without, a court intervention. Without the engine oil.

Our current government at the center is devising new ways to move the car with the Clean India campaign and Smart Cities with state-of-the-art sewer systems. These are same-old ways of pushing, pulling and rolling the car. There is no doubt that our leaders have been emotional, honest, hardworking and relentless. And it is hard to criticize their sincere efforts. But as Milton Friedman often said, “Sincerity is an overrated virtue.” These leaders with their sincere initiatives might move the car, but what they certainly will not be able to do is to start it. All they need to do to start the car is to empower Anil and the people of Govindpuram with an effective judiciary and police.

Lalit Mohan Jindal

Lalit Mohan Jindal is my batch mate from IIT Delhi. He passed the civil service exam after his graduation and is now an IRS officer in Delhi. In the room of Aravali hostel, we frequently discussed national and local political issues. “I want to bring about a change” was a common theme of his answers when he was asked about his motivation to prepare for the civil service exam. In our last two meetings, I have seen his frustration growing. In our latest meeting, we had a chance to discuss his work in the IRS in detail. Lalit is working on an online system that will enable tracking of pending cases of Income Tax violations easier. “Officers keep rotating, and the new officer who takes charge loses track of the cases, pending in courts, that were filed by the preceding officer(s). Courts are overburdened and there is a lot of backlog”, he says. “This gives tax defaulters an upper hand when a case goes to court. Besides, there are certain loopholes in the current law that benefit the defaulters who show income as interest-free loans; tax officers like me keep looking for those generous creditors, who the defaulters sometime claim they met at a local tea-shop.”

The first limitation faced by Lalit is almost identical to the one faced by Anil. Both have an insufficient supply of engine oil. The second limitation is a bit different. While Anil needed a functional police, Lalit needs laws with fewer loopholes. The engine oil that Lalit has access to is of low quality and does not have the required additives.

We cannot hold Lalit responsible for the same reasons we could not hold Anil responsible. Lalit cannot produce engine oil. So he does what he can do in his capacity as an IRS officer. Lalit is pursuing a bachelor degree in law (LLB) from Delhi University to be able to file cases that make it easier for the courts to adjudicate; so as to make the best use of the limited supply of low-quality engine oil he has. But is that an efficient solution? That seems to go against the premise of a modern economy, i.e. specialization of labor. Wouldn’t it be more effective, if both Lalit had Anil had access to a resourceful judiciary that resolves conflicts efficiently?

Our political leaders and bureaucrats have, over the years, come up with different ways to push, pull and roll the car Lalit is struggling with. The voluntary disclosure schemes launched by several governments have created a moral hazard and made Lalit’s job even more difficult. In trying to roll the car, they have scratched it all over. Some governments have even come on television to verbally threaten to punish the tax violators. All these are anything but ways to start the car.

[Side Note: I should point out, that this article is not in support of income tax. Income tax is a menace and should be abolished. I am only using Lalit’s experience as an example to show the vital role of engine oil.]

Dr. Subramanian Swamy

Dr. Swamy needs no introduction. He has been appreciative of my articles on economics, and that inspired me to meet him in person. In the meeting, Dr. Swamy talked about his current struggle to bring economic reforms in India. We also discussed his paper Political Structure and Economic Reforms, a comparative appraisal of India and China. A section of the paper discusses an issue that is relevant to this article. It talks about two fundamental premises of causation that can potentially keep the leaders, who do understand how the car runs, from starting it.

It essentially says that a politician who is trying to push, pull or roll the car is perceived by the passengers as a sincere leader. The passengers, in the course of time, have come to expect that a leader ought to push the car with his muscular strength. This is because the passengers have never witnessed a car start before. On the other hand, a politician trying to add engine oil and fuel in the car, or trying to repair the gear box, might be perceived as a conspirator trying to blow it up. Moreover, there is a wealthy restaurant owner, near the place where the car has broken down, who benefits from the slow-moving car; the passengers have no other choice but to eat at his place. And this restaurant owner, unlike the passengers, can anticipate the losses he will have to bear if the car starts running; so he tries to make sure that the mechanic never reaches the car. In such circumstances, it is difficult for any politician to try to start the car and infuriate both the passengers and the influential restaurant owner.

Dr. Swamy’s paper does not talk about engine oil. It talks about the broken gear box. The passengers are you and I who will oppose if any politician talks about privatization of banks, the restaurant owners are the wealthy businessmen who fraudulently default on multi-billion dollar loans from these banks, and Subramanian Swamy is the mechanic that the restaurant owners are trying to stop from reaching the car.

Coming back to the specific problem area of engine oil, Dr. Swamy has been successful in getting results out of several courts in India. He is not an exception by chance or due to any favors granted to him by the judiciary. He is an exception because he is brilliant, relentless, well connected, knows the law, knows economics and knows politics. Even a drop of engine oil is sufficient for this mechanic. Besides, many of his cases are high profile and followed by the media, bringing attention and pressure from the voters.

His well-publicized cases have a crucial implication. Remember the second reason why the people of Govindpuram avoid going to courts to resolve their conflicts? Dr. Swamy’s cases have the potential to restore that lost confidence in the judiciary. Moreover, if the penalty P awarded in any of his cases is high enough, and even if the courts send just one, who is proven guilty, for a life in prison, the publicized negative return R can create a deterrence significant for a billion.

Why is it not obvious to economists in India?

Just imagine what Anil, Lalit, Dr. Swamy and millions of others can achieve if they are empowered with a judiciary and police that resolves conflicts quickly and reasonably. Yet, we don’t see our economic advisors talking about it. It seems to me that the role judiciary plays in a free market is not obvious to them. The prime minister, the chief ministers, and their ministers have an incentive to be “the one” to do it all, and all they end up doing is pushing, pulling or rolling the car. Instead of pointing out how the car needs to be started, our “economists” have simply continued to endorse new and innovative boondoggles. In 2016, we saw billions of dollars being allocated for schemes that can only come from a government trapped in the fatal conceit. The amount of funds earmarked for the development of judicial infrastructure in states, on the other hand, was a mere $135 million.

There is a reason for this ignorance among economists in India. All the developed countries in the world today were built on the rule of law and limited government. The former is taken so much for granted by prominent economists of these countries that they don’t even mention it in their discourse; the same way prominent physicists don’t talk about the transitive axiom of mathematics when they discuss complex formulae. It is human nature to take something that has existed for long for granted, and the rule of law has existed in some of these countries for more than 200 years. What you do hear from them are their views on fiscal and monetary policies, i.e. limiting the role of the government in commerce. The U.S. is the hub of thought leaders in economics who shape the intellectual environment of the world. Since FDR’s new deal in the 1930s, the U.S. has continued to abandon the principle of limited government that made it a superpower, and many free-market economists in the country are not happy with the current state of the union.

Economists in India seem to be influenced by this intellectual environment, as all the noise you see them make is around fiscal and monetary policies. Whether they even comprehend the two correctly is a different subject. There is a clear neglect of the axiom, the indispensable role that the government ought to play, in delivering an effective mechanism to resolve conflicts. This is similar to what happened in 1947, when the Indian leaders, trained in Great Britain under the influence of Harold Laski of the London School of Economics and his associates, were swayed by the intellectual environment of the time, and failed to apply their mind to abandon central planning and government control. We should be careful not to repeat that mistake again and disregard an axiom that free-markets cannot live without. Otherwise we will find ourselves pushing, pulling and rolling the car after seventy more years in 2086. I have discussed other repairs that our car needs in a few of my other articles: Republic of Ghaziabad – Part IRepublic of Ghaziabad – Part II, and Republic of Ghaziabad – Part III.

Republic of Ghaziabad – Part III

Once upon a time, there was a village in an island called Ghaziabad. It was located in the Indian Ocean. Fishing and farming were the two major sources of income in the village. There was a very wise fisherman in the village. His name was Ram Kumar. He had been fishing in the ocean for more than 25 years and knew everything there was to know about fishing: how to knit fishing nets, when and where in the ocean to catch what kind of fish, how to preserve his catch, how to avoid poisonous stingrays while fishing, methods to use the direction of the Westerlies to his advantage etc.  Ram Kumar was well respected in the fishing community. Other villagers, who produced fruits, vegetables and wheat, happily exchanged their produce for the fish brought to the local market by Ram Kumar. Certain varieties of fish, that only he knew how to catch, were in high demand in the village.

One day, Ram Kumar was lying on a cot in his garden sipping his evening tea when an idea came to his mind “I have knowledge and skills that everybody in Ghaziabad reveres. If people value my knowledge more than the fish I catch for them, they should be willing to pay more for it.”

He decided to open a fishing school. Ram Kumar was an astute businessman. He first set the price for a one year course on fishing at 24,000 kg of wheat and spread the word around to test the waters.  A wheat producer in Ghaziabad, who had an unemployed son, heard about the offer and thought “It is true that Ram Kumar’s skills are valuable, but I don’t think my son will gain so much knowledge and skills that he will be able to pay back 24,000 kg of wheat after graduating from his school.”

One month passed by and nobody showed interest in his school. This made Ram Kumar to reconsider his ask price. He reduced his price to 5,000 kg of wheat, and shortened the length of the course to eight months. Twenty students showed interest in his revised offer. If Ram Kumar went forward with the price, he would have earned 100,000 kg of wheat (20 X 5,000 kg) from his venture. In other words, this particular transaction would have generated, for the village, an economic value worth, at least, 100,000 kg of wheat, as determined by the participants of the transaction i.e. Ram Kumar, the twenty parents and their children.

Ram Kumar further contemplated reducing his offer price to 2,000 kg of wheat. He conducted a survey that showed that forty students would have joined his school at the price, but his revenue would have declined to 80,000 kg (40 X 2,000 kg) of wheat and his costs would have risen. So Ram Kumar decided to stick with his earlier offer.

Note that by maximizing his profits, Ram Kumar ensured a more efficient allocation of resources available to the people of Ghaziabad. Had Ram Kumar opted for a lower price, he would have used more resources – more chalks, more chairs, more boats, more fishing nets, and above all more man hours.

Ram Kumar decided to bid for a nearby plot of land to open the school. He easily outbid the other bidder, a man who wanted to grow walnuts on the land. Ram could outbid him because he knew he could earn more from the land than the walnut grower. He could earn more from the land because the people of Ghaziabad were willing to pay more for his education. They were willing to pay more because they saw more value in the education Ram Kumar was going to provide than the value they saw in the walnuts the walnut grower was going to produce.

Note that a free market auction of the land (a natural resource) ensured that the will of the people of Ghaziabad played a key role in deciding what the resource would be used for. The land was not given for free for education because some experts in the government thought that education was better for the society than walnuts. It was decided by the people of Ghaziabad, as measured by their willingness to pay.  Don’t yet jump on the bandwagon screaming “The poor cannot pay” We will get to that in a bit.

[Side Note: A free market solution to spend on primary and secondary education would be to auction the land to the highest bidder and distribute the receipts as vouchers, which can be spent on education, to all the parents in Ghaziabd]

Ram inaugurated his school with the final price of 5,000 kg of wheat for eight months of training. A private banker called Shyam reached Ram Kumar “I am sure there are many talented students who don’t have 5,000 kg of wheat to pay you. My detailed analysis of demand and supply in Ghaziabad shows that your students are going to earn well, and should be able to earn back the fee you are charging within three years of graduation. I will offer loans to all the students who get admission in your school. You prefer bright students, don’t you? Otherwise, someone else will open a school, admit all these bright students, and outcompete you.” Ram agreed to the proposition.

As expected, after eight months, fishermen trained in the school started catching and selling fish in Ghaziabad. Ram was happy with his earnings of 100,000 kg of wheat. The students were happy earning more than they would have earned without the training. The private bank was happy with the students paying back their loans. The villagers were happy with cheaper and high-quality fish made available by the skilled youth. There was a very poor man in the village called Nirdhan Thakur. His son could not get into Ram’s school, but he too was happy. His son got employed by one of the fishermen who graduated from Ram’s school. The twenty fishermen saved their earnings in Shyam’s bank. With more savings in his bank, Shyam was able to give out more loans to businesses in Ghaziabad. Businessmen who could secure these loans were happy. Villagers employed by the businessmen were happy.

There was one man who was not happy. His name was Gyan Bahadur.  He was an aspiring politician in Ghaziabad. One day he gathered a bunch of people near a local courtyard and started shouting at the top of his lungs “Ram Kumar has made a business out of education. Education is a birth-right. Education builds nations. It should not be used for making profits. We should force Ram Kumar to charge a lower fee so that the poor can study. We need to give free land to open schools, and provide loans to anyone who can secure an admission. It should be mandatory for the banks to provide education loans. If you elect me, I will collect wheat and fish from the people of Ghaziabad and open free schools. We will educate one generation and all our problems will go away.”

He struck a chord with a lot of villagers and won the next election. Gyan Bahadur did everything he said he would do. Ram Kumar was forced to lower his fee. He lost his motivation and closed down his school. Many other fishermen, who were not as competent as Ram Kumar, thought “We should open a school. The people of the village are going to pay for the land. The banks are going to pay the fee. What do we have to lose?” Five such fishermen opened new schools and priced their courses at 200 kg of wheat. Gyan Bahadur collected wheat and fish (tax) from the people of Ghaziabad and opened five more schools. Two of the schools he opened did not teach fishing at all. They taught subjects that a group of “experts” in education thought were necessary for the society. One of the schools taught how to interact with aliens from another planet. The will of the people of Ghaziabad was taken out from the equation, and replaced by the knowledge of the all wise Gyan Bahadur and his group of experts.

One thousand villagers signed up for the schools. Banks gave loans to anybody who could secure an admission. The banks did not care who got the loans because Gyan Bahadur had promised that if the students did not pay back the loans, he would collect wheat and fish from the people of Ghaziabad and pay the banks. The students did not care whether they will be able to pay back the fee after graduating, because there was no pressure from the banks to pay back the loans. The school owners did not care what was taught in their classes as the students did not care. Gyan Bahadur did not care as he had won the election and that is what it seemed to him was the right thing to do. “I am doing it for the poor” he thought.

Nirdhan Thakur, who had another son, was very happy with the scheme. He thought “The fee is low. The bank is giving us the loan. Even if my son is not able to pay back the loan, Gyan Bahadur will pay. We have nothing to lose.”  There were tears of joy and praises for the messiah Gyan Bahadur in Ghaziabad. “The man on the white horse has arrived” declared a clairvoyant in the village.

After about one year, the reality started setting in. All the one thousand students who graduated started looking for fishing jobs. Nobody in Ghaziabad wanted that much fish. Unemployed, under debt, and having wasted one full year, the students were worse off after their graduation. Gyan Bahadur had taken wheat and fish from the people of Ghaziabad to build schools, leaving the people with less to save in the banks. Moreover, a good chunk of the savings left with the banks was used to give out student loans. This double whammy left the banks with less to lend to other businesses. As a result, several businesses closed down creating even more unemployment in Ghaziabad. The vicious downward spiral had begun.

When Gyan Bahadur realized his mistake after six years and tried to establish free market in Ghaziabad,  another politician gathered a crowd in the local courtyard shouting slogans and offering free education and free other stuff to the people of Ghaziabad. He defeated Gyan Bahadur in the next election.

After a decade, both the sons of Nirdhan Thakur lost their jobs. One of his two sons committed suicide. Nobody was there to shout slogans for him in the courtyard. Nobody was there to wipe his tears.

What we discussed above is an over-simplified demand-supply dynamic of a single tradable good (fish). There are hundreds of thousands of goods and services and producing each one of them requires different knowledge and a large number of different skill sets. And there are a billion of us; each one, every minute, with his individual demand and supply, carving out, for the society, a sustainable path that generates value for all. No single human, or a group of experts, can determine better than a billion individuals, what they demand, what needs to be supplied, and how much of what resources ought to be allocated to meet the demands. Commercial interference (price controls, subsidies, guaranteed loans, free land, government administered schools etc.) in higher education will only destroy the marvelous workings of the invisible hand.

“Education spending will be most effective if it relies on parental choice and private initiative – the building blocks of success throughout our society.” – Milton Friedman

There is a ground for government financing, repeat: financing (not administration), of primary and secondary education; voucher system promoted by Milton Friedman best preserves the operations of the invisible hand. There is a marginal case for the government to administer, repeat: administer (not finance), a self-financing program (fund) for higher education but that would require a level of sophistication that is lacking in our current administration. Besides, education would be far more effective if the government first achieved the object in judiciary, police and defense, its three primary responsibilities. My other two articles Republic of Ghaziabad and Republic of Ghaziabad – Part II explain in the form of a story, similar to the one above, why and how our government strayed away from the three primary responsibilities and what needs to be done to bring true Swaraj (rule of the self) in India.

Republic of Ghaziabad – Part II

“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” – Friedrich A. Hayek

The plight of a weaver in Uttar Pradesh who toils day in and day out and yet sees her real earnings dwindle year after year to a point where she is not able to afford milk for her newborn child, can be attributed directly to a few policies and Acts that are not even questioned, if not brandished, by the very politicians and bureaucrats who are, or at least say they are, sincere in their hearts and care about the interests of the poor.

When terrorists kill women and children using arms and ammunition, everybody can see the crime and the criminals and almost everyone who comes to know of the act condemns it. There are two major differences between terrorism and economic ignorance perpetrated by politicians and bureaucrats; the culprit is not conspicuous and the casualties are much higher in the latter.

This article throws light on how brutal it can get when a bunch of bureaucrats and politicians, despite having the best of intentions, end up hurting the very sections of the society they start out to help.

Let us expose the most unusual suspect first. Economists in the U.S. won’t speak of it as they want to be in good terms with Uncle Sam. Economists in India don’t speak of it for they fear becoming a laughing stock if they stand behind something that mainstream economists do not endorse. So nobody speaks of the machinations embedded in our foreign exchange reserve policy that drain the wealth of the poorest in our nation. A sound economist can see it with absolute clarity that the huge pile of reserves of fiat foreign currencies, that the RBI is holding, is directly responsible for the impoverishment of millions of poor Indians.

As in my previous article ‘Republic of Ghaziabad’, we will stay away from any technical terms that might give “economists” an opportunity to blabber about something they don’t understand. For those who have not read the article, I would encourage you to read it here: Republic of Ghaziabad (reading it is not necessary to understand the contents of this article).

Ghaziabad was an island in the Indian Ocean. To put things in perspective, let us revisit, in flashback, one development that had taken place in Ghaziabad during its golden period. Shyam, an owner of a private bank in Ghaziabad, had started issuing notes against the goods people deposited in his bank; when someone deposited four kilograms of wheat in his bank, he would issue four notes, each saying “I, Shyam, promise the bearer of this note one kilogram of wheat”. The notes could be traded in the market by the depositor. Instead of directly trading in goods, the people of Ghaziabad started trading with notes issued by Shyam. The bearers of the notes held the title to the goods promised on the notes and could go to the bank and claim the goods.

Note that any island dweller with a note could go to the bank and claim the goods promised on it, so Shyam could not print notes (money) out of thin air.

The invention of currency notes improved the efficiency of trade in Ghaziabad. It also enhanced the trade between Ghaziabad and a neighboring island called Atlanta. Wheat produced in Ghaziabad was popular in Atlanta. Boats manufactured in Atlanta were of much better quality and were cheaper than the boats made in Ghaziabad. Prior to the invention of notes, people of Ghaziabad and Atlanta traded in goods. One boat was typically exchanged with 80 – 120 kilograms of wheat. As notes became a prevalent means of trade in Ghaziabad, the people of Atlanta started demanding the notes issued by Shyam to purchase wheat from farmers. Businessmen in Atlanta knew that Shyam was a reputed banker and that they could rely on the notes issued by him, i.e. they could go to his bank and claim the goods promised on the notes. They also knew that the government of Ghaziabad had an efficient judicial system that could be relied upon if someone breached a contract or committed fraud within Ghaziabad.

A private bank in Atlanta also issued similar notes. Businessmen of Atlanta offered to exchange notes issued by the bank in Atlanta with notes used in Ghaziabad. The first reaction of the people of Ghaziabad was – “What will we do with your notes? Eat them?” The businessmen replied “Like each of your note is good for one kilogram of wheat, each of our note is good for one boat manufactured in Atlanta. You can go to the bank in Atlanta, produce a note on the counter and claim a boat.”

After thoroughly investigating the operations of the bank in Atlanta, the people of Ghaziabad agreed to trade in currencies. Reflective of the prior exchange rate of the underlying goods, i.e. wheat and boats, one note of Atlanta could be exchanged with 80 – 100 notes of Ghaziabad. Notes of Atlanta became expensive when the fishermen of Ghaziabad demanded more boats. One Atlanta note could be exchanged with 120 notes of Ghaziabad during such times. When the people of Ghaziabad did not need as many boats, one Atlanta note could be exchanged with as low as 80 Ghaziabad notes. The exchange rate was determined by how the people of Ghaziabad valued the goods produced in their land versus the goods produced in Atlanta.

Honest price discovery, a pillar of a free market, relayed information about what goods were valued by the people of Ghaziabad, and helped the people who produced those goods climb up the socioeconomic ladder.

With an increase in trade, the pattern of employment changed. Boat makers in Ghaziabad who could not make good quality and cheaper boats became unemployed temporarily before switching to producing goods and services that people of Ghaziabad and Atlanta valued more. Some of them were employed by wheat farmers whose wheat was in demand in Atlanta. Some were employed by fishermen who had purchased boats manufactured in Atlanta. As a result of this free trade between Ghaziabad and Atlanta, the people of Ghaziabad enjoyed better quality and cheaper fish.

Note that the people of Ghaziabad did not export for the sake of exporting or to create jobs; they exported only to be able to import the goods they could consume.

Now we come out of the flash back and enter the period when the economy of Ghaziabad had picked up the road to serfdom.

Arvind Modi, Narendra Swamy and Subramanian Kejriwal were three elected government officials of Ghaziabad. The government under their leadership had completely strayed away from its core responsibility of protecting life and property and of resolving conflicts. They had nationalized Shyam’s bank and had assumed, by force, the authority to issue notes in Ghaziabad. The island was in a state of chaos and the government was grasping for straws to put the economy back on track. Modi, Swamy and Kejriwal knew that investments create wealth. However, nobody in Ghaziabad wanted to invest, so they reached out to a businessman in Atlanta and requested him to invest in Ghaziabad.

The entrepreneur expressed his concerns “The risk of investing in Ghaziabad is very high. You don’t have an efficient legal mechanism for resolving business conflicts. The law and order situation is not the best either. I appreciate your love for the poor but what if in the future you promise something to the voters to get elected and print notes to fulfill those promises. I will be left holding the proverbial bag filled with devalued notes. I have invested in Ghaziabad before but at that time, your judicial system was the best in the world. Shyam owned the bank and maintained a credible supply of notes. I could go to his bank and exchange one note with one kilogram of wheat. With the government in charge of printing notes, I don’t know if I will get one kilogram or half a kilogram or anything at all for the notes I earn in the future. That is too much risk for me.”

Faced with this conundrum, Modi, Swamy and Kejriwal turned to their wild card – Rahul Chidambaram.

The trio called Rahul and asked him for a recommendation. Rahul had forgotten to wear his underwear that day and was struggling to hold his pants up. But that did not stop him from giving a genius of an idea. “Why don’t you print some notes and buy the notes printed in Atlanta from wheat farmers? If the bank has a lot of Atlanta notes on its balance sheet, the businessmen of Atlanta will feel confident about investing in Ghaziabad. It will also help us look good when we borrow from Atlanta. Moreover, it will make our notes cheaper to the people of Atlanta and we will be able to export more goods and services to them. Exports create jobs. And jobs create wealth. It is a cycle you know. Those rascals must have stolen the drawstring from my pants” Rahul said angrily. He then squatted to prevent slippage wondering if he himself took the drawstring out of his pants to spin a top when he was playing with village kids near a well last week.

Modi, Swamy and Kejriwal looked at each other. There was a familiar spark in their eyes; they thought “Forget about fiscal discipline, monetary rectitude and a sound system of justice to attract investors. We will just print notes and buy the notes printed in Atlanta. Who does it hurt anyway?”

The bank started printing notes at an unprecedented scale to purchase Atlanta notes from wheat farmers. The artificial demand of Atlanta notes by the government made them very expensive; it de-linked the exchange rate from a genuine valuation by the people of Ghaziabad. One could get 400 – 500 notes of Ghaziabad with just one Atlanta note. As a result, the labor in Ghaziabad became cheaper for the people of Atlanta. Businessmen in Ghaziabad opened huge massage parlors (service sector) and employed cheap labor to provide massage services to the people of Atlanta. The people of Atlanta preferred Eucalyptus oil for their massages. Farmers in Ghaziabad who grew fodder for cattle in their fields started growing Eucalyptus trees.

When Modi, Swamy and Kejriwal saw palatial massage parlors in Ghaziabad, they thought “That son of a gun was right. What great free market economists could not conceive of in two hundred years and efficient republics could not achieve in decades, this genius has accomplished with a single stroke. Print notes, exchange them with Atlanta notes, sit on the stack and do nothing. Yes, that is right – Just sit on the stack of Atlanta notes. Why did we not think of this elixir before?”

The massage parlor owners were gung ho about the newly discovered miracle cure. They exclaimed “The bank does not have enough Atlanta notes. The notes that the bank has collected so far are not even sufficient to cover our external debt. The government should collect more notes from Atlanta. We need to devalue our notes even more to be able to export more.”

When the people of Atlanta saw that the bank of Ghaziabad was collecting their notes, they thought – “People of Ghaziabad will never get their hands on the notes that the government of Ghaziabad is collecting and we will never have to deliver the boats promised on the notes. On the other hand, we are getting wheat and cheap massages by simply giving them our notes. We should print more notes.” So they printed more and more and more. The government of Atlanta publicly lauded the government of Ghaziabad “The economy of Ghaziabad is very robust. They have so many of our notes. They are even lending the notes back to us and earning even more notes.”. The economists of Atlanta decorated Rahul Chidambaram with numerous awards and called him ‘the best free market economist on the planet’.

When fish became difficult to catch in the Indian Ocean due to seasonal effects, the fishermen of Ghaziabad desperately needed Atlanta notes to buy efficient boats, but the notes had become very expensive. They had to compete with the government of Ghaziabad to buy Atlanta notes. While the fishermen could have used the notes to purchase productive boats from Atlanta, the bank just sat on the notes it had collected. Not only did the fishermen remain poor, the people of Ghaziabad were deprived of cheaper fish. Many island dwellers who could not afford expensive fish had to sleep hungry.

One day, a weaver in a village in Ghaziabad went to a milk shop and offered to exchange one note with a liter of milk. The milk-man said “I am sorry sister. The bank, now owned by the government, has printed so many of these notes to purchase the notes of Atlanta that when I went to the bank to claim the wheat promised on the notes, the teller told me that each note is now only worth half a kilogram of wheat. The bank does not have enough savings (goods) to back up the notes they have printed. So now I charge two notes for one liter of milk.” The weaver could not understand. She asked “How is this possible? The note says that it is worth one kilogram of wheat. I earned this note with honesty and hard work and now it is not even worth what it says on the note.” The poor woman held back her tears. She was forced to use some of the notes she had saved for an emergency to buy milk for her child.

After a few weeks, the weaver came back to purchase milk and offered two notes to the milk-man. The milk-man said “Sister. Now I need three notes for a liter of milk. When the bank printed new notes, the first recipients of the notes were the masseurs of Ghaziabad. The masseurs exchanged their Atlanta notes, that they earned by massaging the people of Atlanta, for new notes printed by the bank. The masseurs also got new notes, created by the bank out of thin air, loaned out to the owners of the massage parlors. For some time, these masseurs enjoyed lower prices of goods like the clothes you produce and the milk I offer. Now they are using their notes to bid up the exchange rate of everything. I too have to feed my kids you see. So I have increased the price of milk.” The milk-man continued. “I know you live from hand to mouth so saving money in the bank for a considerable duration, to increase your notes at the rate of price rise, is not an option for you. But there is one thing you can do to keep up. You can start charging more notes for the clothes you make. Then you will be able to afford milk for your child”. The weaver said, “But what about the hard work I did last month to earn the notes I already have.” The milk-man replied, “I am sorry sister, a portion of that labor has been stolen by Modi, Swamy and Kejriwal”.

Her throat choked as she asked – “What if I come back and you raise the price again? My child is malnourished and might not survive another winter. I don’t have much savings left.” The milk-man said “Your concern is not unwarranted. In fact, it is more likely to happen as the government continues to print more notes. Unfortunately, that is the uncertainty we have to learn to live with. You may try reaching out to Modi, Swamy and Kejriwal. They are building toilets using the tax money they collect from the masseurs. Their economists have calculated that a toilet would be valuable for you. You can ask them to give some of that money directly to you. They might return to you what they have stolen from you so that you can decide what to do with your money. You can also request them to sell the notes of Atlanta that they have been collecting so that this insidious transfer of wealth, from you and the fishermen in Ghaziabad to the consumers of wheat in Atlanta and the masseurs in Ghaziabad, is stopped once and for all. But I would not count on it because of two reasons. One, the fishermen, like you, don’t know how their wealth is being stolen and who is stealing it. And two, the masseurs who are the beneficiaries of this note-collection policy of the government now have tremendous political clout and will do everything in their power to prevent Modi, Swamy and Kejriwal from selling the Atlanta notes with the bank.”

The milk-man’s face contorted. One could see pain in his eyes, but he did not stop “Sister, you are lucky in some regard. Rice and cotton farmers cannot even raise the price of their produce. The government has outlawed free market in those farming segments (APMC Act). I have heard that Rahul gave the government this idea to secure food for the poor. Now, only people with government licenses (Aartis) can make wholesale purchases. Without even breaking a sweat in the field, these license holders are making all the profits by selling the produce at a high price to the people of Ghaziabad. One of my friends is a rice farmer. He wanted to treat his ill mother but could not afford it with his existing level of earnings. As you know the cost of healthcare has also risen. When he tried to sell his produce in the market at a higher price, the government license holders threatened to boycott him, and when he did not listen, they sent goons who beat him to death. The police and the judicial system no longer protects property rights. Cartels which were impossible to form earlier are now rampant. When you meet Modi, Swamy and Kejriwal, please ask them to abolish this law as well. I doubt they will listen to you because the license holders have become very wealthy and have close friends in the government. But since you are going to meet them, there is no harm in trying”

Before 1971, and more so before 1934, one could go to a bank in the U.S., produce a dollar bill on the counter, and demand the amount of gold promised on the note. With the Gold Reserve Act of 1934, the U.S. changed the nominal value of the U.S. dollar from 1.505 grams of gold to 0.888 grams of gold. With a single stroke, the U.S. government slashed in half the amount of gold the Federal Reserve owed to the world. Finally in 1971, after printing an enormous amount of dollars without any backing of gold, the U.S. completely de-pegged the dollar from gold and defaulted on its obligations. Since 1971, the Federal Reserve has had the liberty to print as many dollars as it wants. The Federal Reserve is printing more and more and more.

In 1926, Montagu Norman, head of the Bank of England and Benjamin Strong, Governor of the Federal Reserve Bank of New York, used all the resources at their disposal to defeat Basil Blakett’s plan to establish a full gold standard in India. After the push from the U.S. for central banking in India, the RBI was established on April 01, 1935; perhaps the biggest April Fool of the Indian population. Later in 1944 at the Bretton Woods agreement, the U.S. dollar was accepted as the reserve currency. However, in 1947, the British, lacking resources after they were brutally hammered by the Axis powers all over the globe, relinquished their influence over the subcontinent to their war ally, the Soviet Union. Under the Soviet influence, the RBI did not collect the notes printed in the U.S. After the collapse of the Soviet Union in 1991, the RBI started collecting dollars as reserves. The U.S. printed the dollars, and the RBI collected them from exporters, transferring the wealth of savers and producers (weavers and fishermen) in India to consumers in the U.S. (people of Atlanta) and a few exporters (masseurs) in India. Strange as it may sound but it is true: The foreign exchange reserve policy of India subsidizes consumption in the U.S.

The foreign fiat reserves with the RBI is the cumulative purchasing power stolen from the poorest in India to benefit essentially two set of people, exporters in India and consumers outside India; both enjoy at the expense of the poorest in India. Total foreign reserves stand at more than $300 billion. That is about Rs. 15,000 for every man woman and child in India. That is somebody’s education you stole. That is somebody’s healthcare you stole. That is someone’s new born child’s milk you stole. Can there by anything more insidious than that? Can there be anything more foolish than collecting fiat notes of a foreign country? The saddest part is that politicians come on national television and brag about how sound our foreign reserves are.

When you see a Rs.120 crore fancy BPO or IT building in a city in India, don’t delude yourself by calling it development. It is just that the building is visible and the mechanism with which Rs. 1 was stolen from each of the 120 crore poor Indians is not.

Export is not an end in itself. It is a means to import goods and services that are produced more efficiently elsewhere. Printing notes to collect foreign fiat currencies does not create employment. It only changes the pattern of employment. It might look like a virtuous cycle of investment, employment and demand creating prosperity for all, but that is far from true. Visible is the employment in sectors that benefit (masseurs and eucalyptus farmers). What is not easily visible is the misery brought by the devaluation.

Also killed in the process is a genuine price discovery, the soul of free market, that enables people who provide value ride up the ladder. A masseur suddenly becomes valuable for the society and a farmer toiling in heat and dust is forced to commit suicide.

Confront an exporter and he will start squawking like a parrot “If we don’t export, the foreign businessmen will import/invest and take all our money. China also collects reserves. How will we buy oil? The interest rates in the U.S. are so low; it is an unfair competition for our businessmen who don’t have access to cheap capital, so we should at least give them this cushion. The income of the poor has risen because of the note collection policy.”

What will the foreigners do with our currency notes? Eat them?  No, they won’t eat our money. They will use it to buy something of value that we create for them. And when they spend the money they earn, productive and valuable jobs will be created in sectors that are truly valuable. Collecting reserves is one wrong thing that the Chinese have done; they have started realizing their mistake and are moving away from their peg. A country does not buy oil, the people of the country do. Except for strategic defense purposes, it makes no sense for the government to collect fiat reserves to secure future purchases of oil. If the Federal Reserve is printing notes and keeping their interest rates low, an inflow of dollars will make the rupee rise against the dollar (demand and supply). Foreigners will find it difficult to purchase the rupee. In other words, the amount of FDI will be driven by what is valued by the 1.2 billion people of India and not a few bureaucrats in the government. “The income of the poor has risen because of the note collection policy.” Really? Tell that to the weaver who is not able to afford milk for her new born child. Tell that to the rice farmer who is not able to afford medical care for his mother.

The fear of the foreign investor, the government is trying to lure, is not unfounded. The state of our judicial system is not the best. The government is more than $1 trillion in debt and there is nothing stopping the government from simply taking on more debt and monetizing it (printing notes). It is natural for the investor to expect some form of solace from the government. It is natural for a foreign investor to expect it, but is criminal for the government to grant it by collecting reserves.

Investors are better attracted by rule of law and a reliable judicial system that resolves conflicts efficiently. Majority of the resources available to the government should be dedicated to that cause. Confidence in the rupee ought to be restored by a prudent fiscal policy (possibly a constitutional amendment that does not allow the total government debt to exceed 10% of the GDP in the future i.e. post a default which is likely imminent if the government does not pick the road to hyperinflation, killing the economy once and for all) and a reliable monetary policy (limiting the ends towards which the RBI can carry out open market operations, preferably limiting its mission to being a lender of last resort). And finally, the RBI should return the purchasing power stolen from the poorest in India by selling its fiat reserves in a time bound fashion.

Yes, fiscally responsible road is not an easy one to tread on. Yes, a reliable monetary policy calls for restraint and patience. Yes, it is a mammoth task to achieve rule of law and establish an efficient judicial system.  But an “easy way out”, which is not even a way out is simply criminal.

Akin Culprits

It is time for another flashback. During the free market regime in Ghaziabad, Shyam lent out money at an interest rate that was determined by the level of savings and the demand for credit in Ghaziabad. When people saved more and the demand for credit was low, Shyam loaned out notes at lower interest rates. When people saved less and the demand for loans was high, he increased the interest rates. Shyam evaluated all the loan applications thoroughly and charged a premium for projects with high risk. He did not “decide” the interest rate. It was determined by the demand and supply of notes and credit risk of projects. When interest rates were high, it meant that there was less to be loaned out for investment. “That makes sense.” Shyam explained “Only something that is saved can be invested. When savings are low, only businesses that are the healthiest, i.e. businesses that people value the most, are able to pay back a high rate of interest. Other businesses, that don’t provide as much value, are automatically culled out. There are no experts who determine lending targets or impose priority sectors upon us. Every transaction that occurs on this island is reflective of the will of the people of Ghaziabad.”

Not all people came to the bank at once to get their saved goods. So Shyam could loan out more notes than what he could issue directly against the goods people saved with him. But he could issue new notes only to the extent that the people of Ghaziabad didn’t lose confidence in his bank. He could not print notes out of thin air; depositors kept a check on where and how much Shyam was investing. A sound fractional reserve banking system was born.

With genuine healthy credit backed by sound savings, the economy of Ghaziabad started growing at a rapid pace. Two wheat farmers in Ghaziabad, Ashok and Kamal, applied for credit in Shyam’s bank; both wanted to buy an ox. Shyam investigated the creditworthiness of Ashok and Kamal and found that Ashok was more productive than average farmers in Ghaziabad, whereas Kamal was not creditworthy and might have run away with the money. Shyam decided to give a loan to Ashok and turned down Kamal’s application. Ashok used the notes to buy an ox. He also offered to purchase Kamal’s land. Kamal found the price offered by Ashok to be very attractive, as he could not even dream of making that much amount of money farming on the land his entire life. Ashok could offer such an attractive price for the land as he was more productive than Kamal, and therefore could get more out of the land. Ashok bought Kamal’s land and started cultivating it. As a result of these two transactions, more land came under productive cultivation.

Note that no land acquisition act was required to bring the land under more productive private uses. Repeat: private uses.

Kamal used the money he got from Ashok to open a samosa shop. On her death bed, Kamal’s mother had whispered a secret samosa recipe into his ears. He bought potatoes grown in one of Ashok’s farms, added value to them using the secret recipe and sold the samosas to the people of Ghaziabad. One of Kamal’s sons started tilling the land for Ashok and learned valuable farming skills in the process. Ashok’s nephew, who was unemployed before, started frying samosas at Kamal’s shop. Even Rahul got a job; he became a sign spinner for the samosa shop; Kamal gave him a samosa every day for spinning a sign for an hour. All of them, Ashok, Kamal and Shyam and their families were better off. The people of Ghaziabad got cheaper food grains and an option to purchase delicious samosas. Numerous such transactions took place in Ghaziabad opening new opportunities for the people of Ghaziabad to add value to the economy.

Now we come back out of the flashback to the period when the economy of Ghaziabad had started tottering under the new government. Modi, Swamy and Kejriwal were initially blinded by the prosperity of masseurs and eucalyptus farmers. They were busy celebrating the success of Rahul’s genius idea of collecting Atlanta notes. “Look at the wealth around you. Look at the growth rate. Look at the reserves. Look at the massaging skill sets our masseurs have developed” they boasted. However, after about a year, the reality started setting in. They could not understand why there was so much price rise and why so many farmers and weavers were protesting.

Modi, Swamy and Kejriwal went running to Rahul’s house and prostrated before him. Rahul nodded his head with reproach as he spoke “You guys just don’t get it. It is simple. The banks are not giving credit to the poor. Besides that, you are charging a very high rate of interest on loans. It is impeding investments. I am going to give you two solutions. Lower the interest rates by issuing more notes and give credit to the poor. Problem solved. And for the last time, just don’t barge into my house when I am reading.” Rahul then got back to reading his favorite book ‘Chacha Chaudhary aur Raka ka Intakaam’.

Modi, Swamy and Kejriwal started giving loans to farmers. Unlike Shyam who had an incentive to investigate the creditworthiness of the farmers who applied for loans in his bank, the government gave credit to just about anybody who cared to apply for a loan. The bank gave credit to both Ashok and Kamal. Even Rahul applied for a loan to buy an ox. “I want to milk it every day for breakfast.” he wrote in his loan application. His loan was approved.

When Ashok went to purchase an ox, he could not find one. Kamal and Rahul had bought the ox Ashok had planned to purchase. Ashok had to spend more money to buy an ox from a nearby village. Kamal and Rahul stopped paying back their loans after about six months. The bank raised the interest rates to make up for the bad loans, making credit expensive even for productive farmers like Ashok. The productivity of the labor in Ghaziabad started stagnating. When people started worrying about whether they will get their deposits back, the government guaranteed their deposits (DICGC). The guarantee was essentially meaningless as the government could simply print notes and devalue the savings to pay back the depositors. As a result, the depositors stopped caring where their money was being invested.

Despite an increase in the number of bad loans, the bank employees demanded an increment in their wages. The wage hike was approved by the government. “It is somebody else’s money” Modi, Sawmy and Kejriwal thought. So they stole more wealth from the poor (printed more notes) and gave it to the bank officials. A note in retrospect – When Shyam owned and operated the bank and his customers stopped paying back their loans, his bottom line took the hit.

When the interest rates started rising, the bank printed more notes to create an artificial supply of savings and lowered the interest rates for priority segments determined by a committee of experts in the bank. The recipients of the new notes (created out of thin air) started bidding up the price of goods in Ghaziabad. The weaver was doomed twice, once by the note-collection policy and then by a suppressed interest rate.

The government was one of the biggest beneficiaries of low interest rates; it could borrow and spend an unlimited amount of money on salaries of government officials. Everybody started desiring government jobs where one could get notes printed by the government and enjoy a secure life at the expense of the producers and savers in Ghaziabad.

The downward spiral did not stop. In one of the local elections, Rahul suggested to the government “If you waive off my friend Kamal’s loan, he and his family will give you their vote.” The government, unlike Shyam, did not care if the notes lost their value. So they printed more notes and waived off many such loans. Ashok who was sincerely paying back his loan felt cheated and stopped making the payments; many hard working farmers followed suit. Due to a significant rise in the number bad loans, the bank stopped lending to farmers altogether. The farmers in Ghaziabad started borrowing from ruthless local lenders (Sahukars). With the government spending only a fraction of its budget on maintaining law and order and judiciary, the local lenders felt confident threatening the farmers and harassing them for money. Many farmers decided to commit suicide instead of facing the ordeal. In the past, when the government spent almost all its resources on maintaining a rule of law, local lenders had access only to the collateral posted by the farmers, and not their life or liberty.

Financial inclusion is a symptom of wealth that comes with a free market. You cannot force financial inclusion and expect wealth creation for the poor.

Businesses that people value will thrive when the banks are not owned and operated by the government and when the RBI is not allowed to interfere with the interest rates. Stealing the savings of the hard working poor in India by artificially decreasing the interest rates (printing notes) to achieve what might look like development in the short run is as heinous a crime as a terrorist attack.

And lastly, except for an emergency of war, the RBI and nationalized banks should not be allowed to purchase government bonds enabling the government to spend poor people’s money on salaries of government officials and wasteful schemes. That is one change in the policy of the RBI that can constrain the governments guided by Rahul Chidambaram from becoming a burden on the society.

If you are deluded into thinking that there is an arcane science behind monetary policy, or if you are befuddled by some “economist” regurgitating terminologies, I would encourage you to read the most definitive paper on monetary policy by Milton Friedman published in 1968: The Role of Monetary Policy. Monetary policy cannot be used to stimulate growth. Milton Friedman’s last recommendation, after he saw what happened in the three decades post 1971, was a return to gold standard. As regards to fiscal policy, Dr. Friedman believed that J.M.Keynes, before his demise in 1946, was about to come out in public with a paper criticizing the ridiculous extent to which his disciples had applied his theories, that were more relevant during the preceding wartime, to please government officials who were desperate to be seen in public as trying to do something to solve the “problem”. Unfortunately, he passed away before he could do so. Today, all you need to be recognized as an economist is a PhD degree and an ability to squawk “Lower the interest rates”, “Spend more on infrastructure.”

Yes, establishing a healthy system of private credit is an enormous task that cannot be completed overnight. Yes, prohibiting the central bank from interfering with the interest rates can cause some pain in the short term. Yes, maintaining law and order and establishing a sound judicial system, to deter local lenders from harassing poor farmers, is difficult to achieve. But an “easy way out” which is far from a way out is simply criminal.

Side note: No land acquisition was required to facilitate the transaction that took place in Ghaziabad between Ashok and Kamal, to bring the land under a more productive private use. If the government acquires land for projects (freeways, new cities etc.), it should be auctioned, so that entrepreneurs can compete with each other to purchase the land and use it for most productive businesses/infrastructure. Complex ‘public private partnerships’ that force the taxpayers to bear the risk of such projects do not make any economic sense.

The government “help”

Government is good at one thing: It knows how to break your legs, hand you a crutch, and say, “See, if it weren’t for the government, you wouldn’t be able to walk.” – Harry Browne

When elected men with immaculate virtue use eminent domain to determine the greater good, you can be assured of one thing – The end result will not be good, let alone greater. Banks nationalized for the greater good? Collecting fiat foreign currency reserves for the greater good? Regulations on businesses for the greater good? APMC Act for the greater good? Sale of acquired land at throw away prices for the greater good? Interfering with interest rates for the greater good? Oh no, your greater good is bad. My greater good is actually good. Isn’t it? Do you think the banks were nationalized for the greater bad? Do you think the enormous regulations on businesses were put in place for the greater bad? It is always something that is done for the greater good that further traps our nation into poverty because strangled in the process is the spirit of free market. Good institutions are the ones that don’t rely on virtuous men running them. Governments are not an exception.

Unfortunately, there is always someone in the government yearning to pull a Rahul Chidambaram. More often than not these ideas are endorsed by our “economists”. The irony is exacerbated by a scarcity of recognized genuine free market economists in economies that were once the bastions of free market. In the United States, where free market was embraced more than two hundred years ago, the current state of affairs is such that economists are acclaimed only if they don’t know, or pretend not to know, anything about economics; mindless cheerleaders of regulation and big governments are decorated for their brilliance in economic thinking. Again, no one other than Milton Friedman, who won the Nobel prize in economics in 1976, admitted that he could come out openly against big governments only at the end of his career when he had very little to lose. The U.S. government did not listen to him at the time and now, three decades later, the country is on the brink of an economic collapse that many free market economists believe will dwarf the 2008 meltdown. (You can read about the dynamics of the imminent economic crisis in the U.S. in my article ‘The Changing Game of Ben Bernanke‘ published in 2013)

Our nation needs genuine free market economists to put down ideas proposed by Rahul Chidambaram before they do any damage, and to redirect all the resources at the disposal of the government towards its three responsibilities: External security (defense), internal security of life and property (police), and an efficient judicial system to resolve conflicts. Our nation cannot afford to invest in anything but these three tried and tested foundation stones of a Republic that have produced the nations that we call superpowers.

“There are four ways in which you can spend money. You can spend your own money on yourself. When you do that, you really watch out what you’re doing, and you try to get the most for your money. Then you can spend your own money on somebody else. For example, I buy a birthday present for someone. Well, then I am not so careful about the content of the present, but I am very careful about the cost. Then, I can spend somebody else’s money on myself. And if I spend somebody else’s money on myself, then I am sure going to have a good lunch. Finally, I can spend somebody else’s money on somebody else. And if I spend somebody else’s money on somebody else, I am not concerned about how much it is, and I am not concerned about what I get. And that’s government.” – Milton Friedman

The government has racked up Rs. 50,000 of debt for every man, woman, and child in India. Yes, you read it right, the total government debt is $1 trillion. The government has spent all this money on us for our greater good. Can you even begin to imagine how much we would have gotten for ourselves if each one of us was given Rs. 50,000 in cash? And this is just the portion of the government spending that was financed by debt. The total money the government has spent on us is several folds higher.

If the government has surplus money it gets from the sale of natural resources, it should be given to her in cash so that she can get the most out of it. Don’t take away from her the power to decide how she wants to spend her own money. Don’t take the liberty to overpower her will. Don’t spend her money on building toilets for her. Don’t spend her money by buying LED bulbs for her. Don’t spend her money by purchasing electricity for her. Don’t spend her money by securing insurance for her. Don’t spend her money by building schools for her child. Don’t spend her money by selling a natural resource at a low price (on an assumption by some expert in the government that she needs to buy the cheaper goods produced using the natural resource). Don’t waste her money on welfare bureaucracy. Let her decide if she wants to build a toilet, buy LED bulbs, purchase milk for her newborn child or do anything else with her money. She will definitely get the most out of her money, and when she spends it, free market, if not stifled by the government, will work to produce what she demands much more efficiently. When she and many other women like her demand toilets, entrepreneurs, without any government support, will compete with each other to build cheaper and better toilets. If she decides to spend her money on healthcare, somebody will decide to pursue a career in healthcare and become a doctor and someone will open a health insurance company. When she demands skill development for her child, somebody will open a school to provide exactly the skills that she demands for her child (and not some worthless skills determined by bureaucrats sitting in Delhi). That is power to the people. Stealing her money and then giving it back to her in terms of what a bunch of experts in the government deem fit is no less cruel than a terrorist attack.

Don’t Bailout The Banks – An Email To The Finance Minister Of India

Honorable Finance Minister of India,

On Tuesday, June 10, 2014 prominent bankers in India met you to lobby for a National Asset Management Company (NAMC). If this proposal, or anything even closely resembling it, goes through, it will break the backbone of the Indian economy.

Three years ago, when I wrote an email to the then Finance Minister of India, I anticipated this moment. At that time, almost all the economists and bureaucrats, oblivious to the fundamentals at play, were hailing the ~9% rate of “growth”. Below is an excerpt from one of my emails I wrote on August 3, 2011 to Pranab Mukherjee warning him about an impending slow down in the economy and a subsequent banking crisis:

“Up until this point, everything will go as it should but then our government will feel the pressure to intervene and, might deviate the economy from the path to correction. This is where India would need a strong political will and a strong Finance Minister to take the right steps and steer us through the crisis, not out of political expedience but for the nation’s interest.

The pressure will come from a choice between the interest of the party, which is re-election, and that of our nation, which is a sound economy. India is financing its current account deficit with its capital account surplus. Revenue from 3G license auction enabled the government to finance the spending for one year and kept the fiscal deficit close to 5%. Amount of short term debt and debt to foreign countries are at unprecedented levels. The collapse will result in a reduced tax base and the government will not be able to meet its fiscal commitments. Going bank on these commitments will jeopardize its re-election. On the other hand, there will be banks crying SOS. In these banks the government might find an accomplice. Instead of cutting spending, allowing the banks to fail and seizing the opportunity to disinvest, the government might relent to the pressure and take steps that will increase its chances of re-election. It might be tempted to reduce the interest rates, bail out the banks and borrow more, from people and from the banks. In the worst case scenario, the government will pursue quantitative easing and increase spending to spur growth. This might keep a temporary lid on interest rates and allow the government to borrow more. However, this will result in more inflation, and eventually inflationary expectations and a downgrade will increase the interest rates triggering the ultimate inflationary collapse leaving the Indian economy paralyzed.

Paying taxpayers’ money to the banks for the risks they have taken is the worst mistake the government can make. It is like giving a gambler money to play in a casino with a condition that profits will belong to the gambler, and losses to the tax payers. The government should not follow this path under any circumstances.”

[The full email is pasted post script.]

As expected, NPAs of the 40 listed banks have swelled to more than $40 billion with more than 40% increase in 2013 alone. These banks are now lobbying with the Finance Ministry to set up a NAMC, a government sponsored enterprise, to use public money to pay for their private mistakes. If the government surrenders to these lobbying efforts, it will not only create a moral hazard but will also worsen inflation in India.

The government, already more than a trillion dollar in debt, is running a massive fiscal deficit, so in effect, what the banks are proposing is an Indian version of Quantitative Easing (QE) i.e. printing money to buy bad assets from the banks. Emulating the QE program of the U.S. is not pragmatic; the QEs that the Fed has been pursuing since November of 2008 have already started backfiring. I have discussed the dynamics prevailing in the U.S. economy in my article “The Changing Game of Ben Bernanke“. When you read this article, please keep in mind that, unlike the U.S. dollar, the Rupee does not enjoy a reserve currency status. So any QE by the RBI is going to have very quick repercussions.

Governments all over the world want to be seen as trying to do something. However, any form of government intervention to come out of this situation will only worsen it. Why? Because what is happening is not a problem; it is a solution, and the most efficient one. Market forces are working to liquidate the malinvestments of the past several years and put the freed resources to more efficient uses. An intervention by the government will only prolong the painful period of recovery our economy must go through.

Let us take an example to understand the implications of a government bailout of banks. A samosa maker applies for a $10,000 loan from a bank to invest in a state of the art machine that makes spherical samosas. The bank makes an assessment of his ability to pay back the loan using the revenue from his business and extends him a line of credit against the machine as collateral. Unfortunately, customers did not appreciate spherical samosas any more than they did the regular ones, and the smell of the oil the machine used for lubrication became a cause of concern for some of the customers. As a result, the samosa maker incurs losses and is not able to pay back the loan. The loan becomes a non performing asset for the bank. The bank confiscates the machine but is unable to sell it in the market even at a high discount. Free market is working to liquidate the malinvestment, i.e. investment that people do not value.

The bank now goes to the Finance Minister and asks for money to cover its losses. The banker knows that the government has a lot of money it collects from hard working individuals, many of whom are very poor. It is a myth that the poor in India don’t pay taxes. The price poor people pay for goods would have been much lower if the government did not collect taxes on just crude oil for example. In fact, the poor might be paying a higher percentage of their income in taxes, as a greater portion of their income goes into consuming artificially high priced goods. “Subsidies” in India are not subsidies, they only reduce a fraction of the tax burden imposed by the government.So the banker in effect asks the Finance Ministry to give him poor people’s money to cover for his mistake.

The government is running a fiscal deficit, so to pay the bank, it “borrows” from the RBI. The RBI prints money out of thin air and gives it to the bank. More money pours into the market. More money chasing the same amount of goods (remember there are no additional goods in the form of spherical samosas in the market) causes more inflation, which hits the poor the hardest as they are the last recipients of the new money supply. In short, the bank and the borrower benefit at the expense of the poorest in India. The bailout also creates a moral hazard; with the government’s put option, the bank is now encouraged to make even riskier loans to more samosa makers. Similarly, when the government goes into debt to pay the salaries of an ever increasing army of government officials who don’t produce anything, it creates inflation as there are no goods to back up the additional money supply. Even if a state government is not able to pay its debt, it should be allowed to default, so that it is not able to raise money for unnecessary projects in the future.

 

If there is something the Finance Ministry can do, i.e. if it prioritizes strengthening of the fundamentals of the Indian economy over short term alleviation of banks and malinvested borrowers, it is using this opportunity to sell off government’s stake in banks and completely deregulate the banking industry. I have made the case for privatizing the banks in layman’s language in my article “Republic of Ghaziabad“.

I hope you don’t fall for fear mongering, which might ensue if you don’t bail out the banks, and take the right steps.

 

Sincerely,

Shubhendu Pathak
shubhendu.pathak@gmail.com
202-770-9483

Email 2/5

Sub: Indian Economy and Our Last Hope
Date: August 03, 2011

Honourable Finance Minister,

It is with sincere regard for your service to the nation and trust in your will to solve the problems in India that I am sharing this concern and analysis with you. This email is in continuation of my previous email titled ‘Economy of India and Our Fight Against Corruption’ dated June 16, 2011 in which I described the odds stacked against the Indian economy. I have attached that email post script. As you might have noticed, many events I had described in the email have started playing out.

In this email I discuss the recent steps taken by the government and the pitfalls that the government should avoid when our economy starts shrinking in the coming months.

The RBI recently took the right step of increasing the interest rates to slow down inflation in India. The ensuing effects of this step i.e. a slowdown in the economy will put tremendous pressure on the government to steer away from the current stance. The following analysis suggests that the government and the RBI should not move away from the current stance of increasing interest rates under any circumstances, and should take additional steps to move away from the dollar to solve the inflation problem in India.

The government’s current step of increasing the interest rates to control inflation, although correct, is only a part of the solution of the inflation problem in India. The argument that inflation in India is due to global increase in commodity prices and supply side pressures is a complete nonsense. The inflation is occurring in India primarily due to two reasons. Cheap dollars available to investors abroad are being used to pump up a speculative bubble in India. The government is buying these dollars and expanding its dollar reserves, and printing rupees out of thin air, by encouraging new loans, to maintain the currency peg. The U.S. is printing the dollars into oblivion and we are bearing the brunt. This same mistake, called sterilization in China, is driving inflation in their country. There are many lessons to learn from China; this is definitely not one of them. In addition to the government reserves, there are illegitimate dollars, either bought in exchange for rupees or deposited directly, which many allege are more than the reserves, that are being stacked in Swiss banks. The other reason of inflation is the indiscriminate spending by the government. The government has raised the salaries of government officials and waived off loans of farmers, with a complete disregard of their productivity.

All the recipients of this newly issued money, i.e. people employed by the service sector and the government now have more money to bid for the goods available in the market. This is driving the prices higher in India.

On top of this problem, the goods available in the market are reducing because the economy is shifting away from manufacturing. The industrial sector growth is waning at an alarming rate; it slowed to 5.6% in May compared to 8.5% a year ago. Trade deficit is about 7% of GDP. Majority of our imports are consumed and do not contribute to capital formation. We are now importing more than we are exporting, consuming more than we are producing. The question is ‘Where are the dollars to finance the trade deficit coming from?’ They are coming from investors who are selling dollars to buy rupees to speculate in the Indian market. Why are they selling their dollars? They are selling their dollars because they are available to them at a very low, and manipulated, interest rate.

The inflation is wiping out the savings of hard working Indians, and transferring the wealth to recipients of the new credit supply. These recipients are people working in the Finance, Insurance and the Real Estate sector (also known as the FIRE sector for understandable reasons), and other service sectors that are essentially exchanging debts, speculating and not adding much value to the economy.

Although increasing interest rates will restrict the money supply and strengthen the rupee, speculation encouraged by the rupee purchased by dollars will be hard to curb. The cheaply available dollars will keep on pouring. In addition to increasing the interest rates, the government will have to stop purchasing more dollars or dollar denominated assets, and move away from the policy of pegging the rupee to the dollar. Unless, the government does so, inflation will continue to rise. An interest increase without stemming the root cause will not curtail inflation.

The rupees purchased with the dollars are primarily being invested in the FIRE sector. The U.S. has become a net consumer of the world, and by buying these dollars, we are not only feeding it, but are allowing growth of a little parasite, the speculative service sector, within our economy. It is like the big parasite has infected our economy with a baby parasite which is growing every day. High interest rates and a diversification away from the dollar will kill this parasite and we should allow that to occur.

Confused economists will cry that we need dollars to buy oil, so we should devalue the currency so that we can export enough to get the required dollars. The fact is that market forces are much more efficient in deciding how much oil our economy actually needs, and will drive the valuation of the rupee in accordance. Any manipulation leads to misallocation of resources; a pertinent example of this misallocation is that of the employees in the FIRE sector buying bigger and bigger cars and using them to commute to and fro office every day. These people add little value to the economy by exchanging debts, but are able to buy big cars that consume oil and jam the roads of Indian cities. When this phony service sector collapses, we would not need the oil that is currently being wasted by these commuters, and the resources that are currently being used to manufacture big cars will be available for use in areas that make meaningful contributions to the economy. People will start buying efficient cars like Alto and Maruti 800 instead of gas guzzlers, and the Indians driving the cars would be the ones who are earning money via addition of value.

Economic virtues suggest that the correct way to encourage exports is to become efficient in production so that prices decrease and our products become competitive even with a strong currency. This will take time but it is exactly what we need. Expanding credit supply to devalue a currency only transfers wealth from hard working individuals to speculators.

Although increasing the interest rates is the right step, it is what will follow that will determine whether we emerge out of this ‘manthan’ with a weak or a strong economy. The inflation, lagged by an increase in credit supply which has taken place over several years, will continue to rise, and the RBI should continue to increase the interest rates, not slowly but at a very rapid rate regardless of the slowdown in the economy. This will trigger a deflationary collapse of the phony service sector economy we have built over the past few years. This is good as it is the service sector that is responsible for inflation, both because it is the channel via which new money is being sprinkled on the economy, and because the sector is not producing any goods people can buy. No matter how bad the collapse may look, this would be the healthy approach and will allow our economy to recover after a couple of years.

However, governments all over the world are known for taking the wrong decisions, and I hope that you do not relent to the pressure of following the confused herd when our economy slows down. With rising interest rates, many businesses will fail and the speculative bubble will burst. The double whammy for the Indian economy will come from the collapse of the U.S. economy. This is tied to the propped up demand in the U.S., some of which has found its way to the Indian economy in the form of service sector jobs. When the interest rates rise and/or U.S. economy collapses the resulting urban army of unemployed people will default on their home and car loans adding to the bank losses. Indians who were feeling wealthy due to their high home prices and spending a little more than they otherwise would have spent will reduce their discretionary spending. Manufacturing sectors will not be spared as the phony demand evaporates leading to more layoffs. Reduced demand for homes due to high interest rates, and a high inventory in the market will drive the house prices further down leading to more defaults.The banks will have to book massive write downs.

Up until this point, everything will go as it should but then our government will feel the pressure to intervene and, might deviate the economy from the path to correction. This is where India would need a strong political will and a strong finance minister to take the right steps and steer us through the crisis, not out of political expedience but for the nation’s interest.

The pressure will come from a choice between the interest of the party, which is re-election, and that of our nation, which is a sound economy. India is financing its current account deficit with its capital account surplus. Revenue from 3G license auction enabled the government to finance the spending for one year and kept the fiscal deficit close to 5%. Amount of short term debt and debt to foreign countries are at unprecedented levels. The collapse will result in a reduced tax base and the government will not be able to meet its fiscal commitments. Going bank on these commitments will jeopardize its re-election. On the other hand, there will be banks crying SOS. In these banks the government might find an accomplice. Instead of cutting spending, allowing the banks to fail and seizing the opportunity to disinvest, the government might relent to the pressure and take steps that will increase its chances of re-election. It might be tempted to reduce the interest rates, bail out the banks and borrow more, from people and from the banks. In the worst case scenario, the government will pursue quantitative easing and increase spending to spur growth. This might keep a temporary lid on interest rates and allow the government to borrow more. However, this will result in more inflation, and eventually inflationary expectations and a downgrade will increase the interest rates triggering the ultimate inflationary collapse leaving the Indian economy paralyzed.

Paying taxpayers’ money to the banks for the risks they have taken is the worst mistake the government can make. It is like giving a gambler money to play in a casino with a condition that profits will belong to the gambler, and losses to the tax payers. The government should not follow this path under any circumstances.

The scenario described above has already started playing out. The banks have purchased about $ 39 billion worth of SLR securities since April, double the amount of loans issued during the period. Another gimmick that banks might try when the interest rates rise further is that of holding securities under the HTM category so that they don’t have to mark them to market. Efforts like these are like manipulating a thermometer when it reads a higher temperature. Please kick them out of your office when they give you this argument.

One advantage that India has over other economies is the massive holdings of gold with the families. Some people might make the mistake of not defaulting due to social taboos and pay for their loans from their family savings or holdings of gold. Although, the likeliness of this happening is less, the government should discourage this as it is tantamount to stealing hard earned money from people and giving it away to speculators. This gold will help India recover in later years.

In the Ponzi scheme of the U.S. dollars, as with all the Ponzi schemes, the last ones out will suffer the most. China has already started making its moves. Let us not be the last ones to move away from the dollar. We can use the reserves to buy gold and future contracts of oil. We can also make efforts to trade with the OPEC in their own currencies or a basket of currencies and export agricultural commodities to these countries. This will need a lot of guts and efforts from our politicians, but it will be worth the effort.

I sincerely hope that you take the right steps in the coming months, and that history looks back at you as the captain who steered India through the crisis.

I would greatly appreciate a reply/acknowledgement from you.

Sincerely,
Shubhendu Pathak

CC: Dr. D. Subbarao, Honourable Governor, RBI
BCC: Dr. Manmohan Singh, Honourable Prime Minister

Republic of Ghaziabad – Part I

“The nine most terrifying words in the English language are: I’m from the government and I’m here to help.” – Ronald Reagan

“Help the poor”. Wherever on the planet and whenever in the history these words have come from a government, a social and economic disaster has followed. If we focus on the lessons from East Germany – West Germany, South Korea – North Korea or even the current state of the U.S. to illustrate the point, the economically literate will get a chance to confuse us with terminologies they themselves don’t understand. Economy is not a controlled experiment where data can be used to validate a theory. The validity of a theory in economics is better established by how well it explains the relationship between cause and effect. It is not a rocket science. So let us build up from the axioms and corollaries of economics to understand how a help promised by the government not only makes no economic and social sense but is also morally corrupt.

Axioms are simple. Parallel lines do not intersect. At least one human has to work to produce a good or service that can be consumed by someone. In mathematics, complex theorems are built on axioms. Governments, banks, insurance companies, the concept of a contract etc. are built on axioms in economics.

This story is of a small island called Ghaziabad. It was located in the Indian ocean and had a population of 50, 25 males and 25 females. There were five tasks each individual on the island performed to survive 1. caught fish 2. cultivated land 3. cut wood for fuel 4. made clothes 5. brought water from a waterfall 5 km from the dwelling place. Each island dweller carried out these five tasks during the day to survive, went to sleep at night to recover from fatigue and woke up in the morning to carry out the same five tasks the next day. There was no holiday in Ghaziabad. Everybody worked every day just to survive. Nobody had time to enjoy luxuries of life or even to take care of someone who fell ill.

One day a dweller who was better than others at catching fish suggested to his friend – “It takes me a lot of time to cut wood. I have a good spear I made and my aim is pretty accurate but I don’t have arms as strong as yours. I will catch some fish for you tomorrow. Can you get me some wood?”. His friend agreed – they entered into a contract. The next day, the fisherman saved the energy he used to waste cutting wood and the lumberjack was glad not chasing fish with his broken spear. Happy with the outcome of this arrangement, the two men started doing it every day. They spent their saved time and energy in luxury activities, climbing trees, swimming in the ocean, looking for lice in each other’s hair and what not. When other people saw them spend quality time, they got motivated and followed suit. Specialization of labor, the premise of the modern economy, was born.

The benefits of specialization of labor were so intuitive that after about a year the village had each individual performing just one task the individual was good at. 10 people caught fish, 10 cultivated land, 10 cut wood for fuel, 10 made clothes, and 10 brought water from the waterfall. As a result, production in the island increased significantly and the fruits of labor were enjoyed by all.

However, there were a few growing concerns in Ghaziabad. The word about the prosperity of the island had spread and there were rumors that people from a neighboring island were planning to plunder some of the houses. The dwellers also suspected that one of the lumberjacks had turned into a thief and was stealing goods from their houses. When the dwellers went out to work, they were worried about the safety of their assets back at home. In addition to this problem, one contract between a lumberjack and a fisherman was violated. The fisherman refused to give the lumberjack the fish due for the day claiming that he did not receive any wood; the lumberjack insisted that he had left the wood in front of the fisherman’s house. This had led to tension between the two families. Afraid that their contracts might be violated, some of the lumberjacks started fishing again.

The productivity of the island started falling. The seniors in the island became concerned about the future of Ghaziabad and held a meeting. It was decided that three people will be appointed to protect the life and personal property of people and to ensure completion of contracts between individuals on the island. One person would guard the beach from potential external attacks, one would guard houses during the day, and one would resolve conflicts whenever a contract was violated.

To ensure that the appointed individuals can focus on their jobs, they were not required to produce anything for themselves. It was decided that fishermen will give them two fish every day, cloth makers will give them one pair of clothes every two months, farmers will give them an adequate quantity of grains and someone will bring them drinking water. Consensus on who to appoint for the job could not be reached so it was decided that people who had the maximum number of island dwellers supporting them will hold the position. Elections were held and a team of three credible individuals was appointed. In the island of Ghaziabad, government was born.

The role of this government, which people felt was necessary, was to create an environment conducive for efficient production and trade. It was not formed to help the poor, it was not formed to provide education, it was not formed to provide water, it was not formed to control the prices of essential goods. It was formed so that people could do what they did more efficiently.

With an assurance that their assets were in safe hands, people started going to work. Fishermen and lumberjacks started exchanging goods again as there was someone reliable to resolve conflicts. The economy of Ghaziabad was back on track.

One more prosperous year passed by. Some interesting developments took place on the island. Four cloth makers thought – “People spend so much time in the evening to start a fire, why not make something that will make it a little easier to create fire.” They saved some extra clothes during the year and started working on a process to manufacture matchsticks from locally found chemicals. They exchanged the clothes they had saved during the year for fish and grains to survive while they worked on this new venture. After a few months of hard work, the team found success. The product became popular overnight. Matchsticks saved everybody so much time that lumberjacks were willing to give ten days of wood supply and fishermen were willing to give ten kg of fish in exchange for just one pack of matchsticks.

Note that the fishermen and lumberjacks were willing to pay so much not because they were forced to do so but because they felt that one pack of matches was worth that value. The fishermen could catch more fish and the lumberjacks could cut more wood in the time they saved every day by using the matchsticks they purchased. The value of matchsticks was measured by the amount of goods (money) people were willing to pay for them. The engineers had anticipated the needs of the people of Ghaziabad and had assumed a certain amount of risk; they could have lost all their savings had their venture been unsuccessful. Looking at how the risk was rewarded, other people were motivated to take similar risks to build new things and to produce existing goods more efficiently.

One of the lumberjacks called Shyam had a groundbreaking idea. He had a credible image in Ghaziabad and his ability to evaluate the risk of new ventures was well known. He asked his friends to save their extra clothes, wood, fish and matchsticks with him for a year. He promised to give back the savers more than they saved with him after a year. He then identified islanders trying to create new things or working on producing existing things more efficiently and gave them clothes to wear and fish to eat till the time they were working on their initiatives. If the initiative was successful, Shyam was paid back more than what he invested. Some of the dwellers were not successful and were not able to pay back but Shyam got enough from the successful ones and became wealthy. Before people of Ghaziabad gave Shyam their savings, they did a lot of research to make sure that he was trustworthy and competent, and that he was investing their savings responsibly. After making this assessment about him, they made the decision to invest their own hard earned goods. The savers were rewarded for the risk they took when Shyam paid them back more than they saved with him. Bank was born.

Let us not go into fiat money, central banking, or the fractional reserve banking system. In fact, let us not even go into money, as that will again give the economically literate a chance to confuse us. Money was invented only to reduce the complexities of the barter system. Let us keep our resolve to stick to the basics.

The island economy started growing at a very rapid pace as people working on ideas had easy access to savings. A farmer borrowed savings from Shyam and worked for four months to develop a process to produce fertilizers from bat droppings he collected from the floor of a nearby cave. The yield of his farmland increased so much that he was able to sell his grains for much less; he could exchange four month’s supply of wheat for just a couple of clothes. Cloth makers now had more grains they could save with Shyam. A sixteen-year-old child prodigy invented a barrel with wheels using which he was able to bring water from the waterfall for ten people at once. Women who earlier spent most of their time bringing water from the waterfall started weaving clothes and exchanged them for water. The women became so efficient at making clothes that they not only made a lot of extra clothes but the clothes they made were of a much higher quality. They used extra clothes to buy matchsticks and saved even more time.

Did the sixteen year old prodigy’s tanker make the women unemployed? (Will FDI in retail increase unemployment of shopkeepers? Did metro, cars, buses and auto-rickshaw drivers make men running horse-carts unemployed?)

A fisherman had spent sleepless nights making a bigger and stronger fishing net. He caught so much fish every day that it became difficult for him even to unload and pack them. He offered one fish to any dweller willing to help him for an hour to unload and pack the fish in banana leaves. Employment was born.

Note that the fisherman did not force employment upon the employee. He offered him an opportunity to exchange his labor for fish. The employee accepted the employment because he thought that he would not be able to catch or earn one fish in an hour anywhere else using his current level of skills. It was a win-win for both of them.

On the other side of the island, lumberjacks were facing a problem. The name of the problem was Black Recluse, a spider common in the woods of Ghaziabad. The spider bite was so poisonous that any lumberjack bitten by it had to take bed rest for at least a month. This had put some of the lumberjacks in a very difficult situation as they could not support their families during the recovery period. To solve this problem, lumberjacks of Ghaziabad formed an association and built a huge storage facility. Every lumberjack who stored one log of wood in this facility every month could use the wood in the facility in case he was bitten by a spider. Insurance was born.

Government, banks and finally insurance. These institutions provided so much stability to Ghaziabad that it became an ideal economy for neighboring islands. There was so much production in the island that charity was common. Women gave extra fish to people who could not afford them. Cloth makers gave clothes to people who could not temporarily work due to bad health. The system nurtured the inherent human nature to indulge in charity and to treat fellow islanders as brothers. Civilization was at its peak.

One more year passed by and the next election was upon Ghaziabad. The incumbent government decided to fight the election. Their campaign pitch was – “We carried our responsibilities diligently. We protected life, prevented theft and made sure that transactions were carried out properly. Vote for us and we will continue our sincere service to the people of Ghaziabad” Another team of three individuals Arvind Modi, Narendra Swamy and Subramanian Kejriwal was planning to fight the election and was rapidly gaining popularity in Ghaziabad. (The names are purely coincidental.) They were proposing a plan where every unemployed dweller on the island will get free fish and clothes. “We should at least provide basic livelihood to everybody on the island. It is their right” they said. People were initially confused. They asked – “We have not seen you guys produce a thing in your life. How are you going to give clothes and fish to these dwellers?” To this, they answered – “We will collect it from cloth makers and fishermen. We will make this collection mandatory.” Cloth makers and fishermen were furious at this idea and started a campaign against the team.

Legend has it that it was all Rahul’s idea. There was a village fool in Ghaziabad, his name was Rahul Chidambaram. He lived in a world of his own – talking to himself, running after kids who teased him and making various types of sounds from his armpits. He used to intentionally burp very loudly whenever anyone asked him his name. One day Modi, Swamy and Kejriwal were walking on the beach when they saw Rahul at a distance playing a game of ‘who can pee the farthest’ with kids. Kejriwal said to him jokingly – Will you vote for three for us if we fight the election. Rahul thought for a few minutes then said – “only if you give me some clothes and fish”. Kejriwal, Modi and Swamy looked at each other and thought – “What a great idea? Forget about all the responsibilities, protecting property and life and yada yada. We will just promise fish and clothes to people. We will make the rules of the game. We will rule.” And they decided to fight the elections.

The team won with an overwhelming majority. Even some of the fishermen and cloth makers who did not feel like working anymore voted for them. Under the new government, hard working cloth makers and fishermen saw their produce being taken away against their will. Many fishermen closed their operations. People of Ghaziabad now had an incentive not to work and live off of the production of others. Youngsters were not motivated to gain fishing and cloth making skills; they thought it was government’s responsibility to feed them.

The team announced new job vacancies in the government. They needed someone to collect fish and cloth from fishermen and cloth makers. When people asked how they will pay the employees, they said – “We will collect more fish and clothes from the fishermen and the cloth makers”. More fishermen closed their operations after this announcement. As a result, fish became so scarce that lumberjacks had to cut wood for an entire day just to pay for one fish.

Next election came and Swamy, Kejriwal and Modi with the best of their intentions announced “Fish are scarce. We don’t want anybody to die of hunger. How can you ask a hungry man to work? We need to put price cap on fish. We need to collect more fish from these fishermen.” The team further deviated from their initial responsibility to protect the life and personal property of people and to ensure completion of contracts between individuals on the island.

Running out of fish and clothes to fulfill their promises, the team overtook Shyam’s bank (nationalized it) and started giving saved clothes and fish to people. When the savers asked “Shyam paid us back if the investments were successful. We don’t trust your investment skills. What if our savings are invested in ventures that are not successful”. The team said “Don’t worry about it. We will collect more from people and give it to you. We will sell the resources on the island and cover the losses.” They “guaranteed” their savings.

The guarantee purportedly devised to prevent run on the banks, that are essentially nationalized, is a part of an insidious arrangement. The RBI printing money out of thin air to “lend” to the government or to pay the savers is even more insidious. It devalues the savings. The power given to the RBI to lend to the government and to carry out open market operations is one of the root causes of the evil. Governments and friends of governments can destroy an economy via inflation with this unnecessary power.

It can get a bit confusing when money is involved in transactions – “The government pays the farmer with money, the government pays the doctor for his services with money, the government pays teachers for education with money.” The government does not produce anything. Money is title to goods or services; it does not come out of thin air. Neither do savings. Someone has to work hard to create savings. The one who saves has the right to invest her/his savings where he/she feels the reward is worth the risk. In a true republic, the saver has this basic right. When people gave their savings to Shyam, they did their research on his credentials and kept a check on where their savings were being invested. People now with “guaranteed” savings stopped researching before they gave their savings to the team. Kejriwal, Modi and Swamy neither had the competence nor was there any pressure from the savers to invest in the right areas. The trio started giving money to their friends who could convince them easily. When they lost money, they just increased the tax.

They also started making new rules – who can sell fish, what price can one charge etc. They appointed a planning commission to suggest areas where people should invest. The experts in the commission said – “Fishermen have become very wealthy. Only fishermen who will manufacture salt will be allowed to fish. The people of island need salt. There is a very high demand for it.”

If people need something, they pay for it, be it water, electricity, education or salt. Profit is a measure of value addition. If a business is not making a profit producing a good or service, it means that people do not appreciate the value addition the business is offering. When a third party applies its mind and forces a business to invest somewhere, it essentially overrules the will of the people. Without exception, such an application of mind leads to misallocation of resources.

What about national highways? What about water? Let us take national highways as an example as it seems most intuitive that they are a government responsibility. If people of Delhi say that red light should mean stop and people of Haryana say that red light should mean go, there is going to be a lot of confusion, so rules that fall under this category can be made by the government such as town planning (so that someone does not open a loud factory in the middle of a residential area), road maps (so that people don’t build roads every which way) etc. But whether to build a national highway should be a decision made by the people. How? Build-Own-Transfer model has the answer. Highways’ value should, like any other good or service, be measured by users’ willingness to pay for it. Entrepreneurial individuals will assess this value and decide whether to build the road. An entrepreneur will build a road if he/she feels that its value will be appreciated by people i.e. people will pay for it. The resources the entrepreneur will use will be commensurate to the value of the road as measured by people’s willingness to pay for it. If the entrepreneur builds a bad road, people won’t pay to use it. The highway will be transferred as a national asset after a certain period of time.

Governments are known to build roads to nowhere i.e. roads that provide no value. Government’s sole responsibility in commerce is to provide an environment conducive to trade, not to apply its mind to interfere in it. No matter how intuitive it may sound, it should never be decided by a third party what goods or services people want to consume or what might benefit them. It takes a strong resolve and character to leave this power with the people. We will discuss one such resolve displayed by one of the 19th-century presidents of the U.S. For now, let us return to the island of Ghaziabad.

To cover for bank losses and to fulfill the promises given to the people of Ghaziabad, the government started collecting even more tax. With 40% of their catch being taken away by the government, even more fishermen stopped fishing. The sixteen year old prodigy who could earlier eat healthily by working for a few hours could only get one fish in exchange of a tank of water and was forced to stop his operation. By the time he came home after pulling the tanker all day, he was so hungry that one fish was not sufficient for him. Women started going to fetch water from the waterfall. As a result, clothes they made became scarce. Rape and theft were common as the team lost focus on its primary responsibility of ensuring the safety of life and property. Very few people entered contracts as the authority to enforce them had weakened. Nobody wanted to produce so the team started giving perks to individuals to set up big production facilities. As a result, wealth disparity started increasing.

The fabric of human nature that inspires every human to take care of others started deteriorating. People stopped charity as they thought it was government’s responsibility to take care of “them”. “Them” vs. “Us” was born. The “We” started deteriorating. Attitude of people changed to align with the existing set of incentives. Earlier hard work and risk was rewarded and ‘Power’ was defined as “The ability to help others by producing things that they needed”. The new system rewarded connections with the government. The definition of ‘Power’ changed to “The ability to create problems for others”. The national character started shaping up in accordance. Everybody thought that everybody else is corrupt by nature. The death spiral had begun. In a few years, the economy of Ghaziabad resembled that of India.

This question from the bleeding hearts always seem to touch a nerve – “But then what will happen to the people dying on streets? Who will take care of them? Only a person who has not seen hunger can ignore their plight.”

When the government decides to help the poor with someone else’s money, is essentially weakens the fabric of human nature; it doubts the inherent nature that inspires every human to indulge in charity, to treat a fellow national as his own brother and to take individual responsibility. It does not only make no economic sense but is also morally corrupt to the core. It takes a strong resolve and character to resist the temptation to help the dying with somebody else’s money.

Economists continue to cite what the U.S. government is doing today to defend welfare policies. What made the U.S. a wealthy nation is not what it is doing today. Today, it has picked up a road to collapse. The U.S did not have income tax prior to 1913 (only profits were taxed). Income tax was unconstitutional before the 16th amendment. Similarly, the Fed was not allowed to buy the U.S. treasuries. It was only during the crisis of World War I that an exception was made to finance the war. Unfortunately this power given to the Fed was never reverted.

The nation was built on sound principles. There is a very famous example from the glorious days of the U.S., the days that made the country a superpower. Members of the congress wanted to pass the Texas Seed bill in 1887 to help the farmers suffering from drought in the state of Texas. President Grover Cleveland vetoed the bill. The excerpt below from his reply to the congress summarizes his thinking.

“I can find no warrant for such an appropriation in the Constitution, and I do not believe that the power and duty of the general government ought to be extended to the relief of individual suffering which is in no manner properly related to the public service or benefit. A prevalent tendency to disregard the limited mission of this power and duty should, I think, be steadfastly resisted, to the end that the lesson should be constantly enforced that, though the people support the government, the government should not support the people.

The friendliness and charity of our countrymen can always be relied upon to relieve their fellow citizens in misfortune. This has been repeatedly and quite lately demonstrated. Federal aid in such cases encourages the expectation of paternal care on the part of the government and weakens the sturdiness of our national character, while it prevents the indulgence among our people of that kindly sentiment and conduct which strengthens the bonds of a common brotherhood.”

Following this veto, President Cleveland donated his personal money to the farmers of Texas.

There is a radical difference between a Democracy and a Republic. In a Democracy a government does what the majority wants. In a Republic the power of the government is limited and cannot be increased even if majority wants it. India calls itself a Republic but operates like a Democracy. We adopted this form of government in 1947 and picked up the road to collapse. We will become a true Republic when 1.2 billion people are free to choose how they want to serve each other.

“I will give you a talisman. Whenever you are in doubt, or when the self becomes too much with you, apply the following test. Recall the face of the poorest and the weakest man whom you may have seen, and ask yourself, if the step you contemplate is going to be of any use to him. Will he gain anything by it? Will it restore him to a control over his own life and destiny? In other words, will it lead to Swaraj (rule of the self) for the hungry and spiritually starving millions? Then you will find your doubts and your self melt away.” – Mohandas Karamchand Gandhi

The poor woman who walks for miles every day to get water does not need help from the government; she needs Swarajya. Links to Part II  Republic Of Ghaziabad – Part II and Part III: Republic Of Ghaziabad – Part III.

An email to Arvind Kejriwal

Dear Mr. Kejriwal,

I hope you remember my last email. My name is Shubhendu Pathak. I graduated from IIT Delhi in 2006 and am currently working in the U.S.

In this email I will discuss the misdirection of your movement in your stance against Ambani brothers and other industrialists in India. I feel that your angst against the industrialists in India is misdirected and will lead to unproductive results.

I will discuss a simple example as I feel that it is, in this case, a more efficient way of describing how your stance against industrialists in India will harm the economy and is principally misdirected. The example centers on a small entrepreneur, say Ramu, who sells Samosas (Momos for non Indian readers) in Rajnagar, Ghaziabad. Don’t yet start criticizing that a Samosa wala cannot be compared with the billionaire Mukesh Ambani/Tata. I will come to that point later. This Samosa wala has a small shop in Ghaziabad. He buys potatoes, spices, LPG cylinder, oil, refined flour, cauldron(s) etc. and rents a space. He incurs some cost to buy all of this. Ramu has the recipe (Intellectual Property) and skills and invests his labor to add value to the ingredients to prepare Samosas. Now remember he is taking a risk when he makes this investment, because he is anticipating that his Samosas will be bought by the residents of Raj Nagar. If he prepares the ingredients in the morning, and nobody buys them during the day, he will have to throw away some of the ingredients at night and incur losses.

How does he make profit? People buy his Samosas at a price which is greater than the sum of the costs he incurred to prepare them. So the price P is greater than the cost incurred C. Why do the customers pay a price P>C? After all, the Samosa wala did not force them to buy his Samosas at gun point. The customers with their own individual discretion decided to pay an extra amount P-C, as that is what they believed was the value the Samosa wala added to the ingredients. Profit P-C is the additional value he added, as measured by the customer’s willingness to pay the extra amount. Profit is not insidious, it is decided by YOU and I. So Ramu adds value to society, and people with their own choice reward him for this value addition. This is true power with the public; public decided who is adding value and who should be rewarded. Now Ramu anticipates more demand from Kamla Nehru Nagar, a nearby locality, and makes additional investment in a machine that can make more Samosas in less time. His anticipation turns out to be correct. Kamla Nehru Nagar residents are pleased with the taste of his Samosas and are willing to travel to Raj Nagar to buy them. Remember here again, he is not forcing anybody to buy his Samosas, neither he is forcing anyone to sell him the ingredients. YOU and I, at every instance, are deciding how much value he is adding. Also recognize the risk he took when he made that investment in the machine. Now YOU and I are rewarding him for that risk.

Now, another Samosa wala in Kamla Nehru Nagar called Suresh is also trying to expand his business. His Samosas are not that tasty and he abuses (verbally) his customers every now and then. Slowly his business starts shrinking due to competition from Ramu. Again, it is every individual’s personal decision that Suresh loses his business. YOU and I decided that we don’t want to be abused and that he deserves not to make any profit. This is free market and it is one of the tenets of a Republic.

Now we come to the second part of the story, after which I will transition to how your protests are misdirected. Suresh is now very angry and tries something that is against free market principles. He reaches out to the MLA of Ghaziabad to strike a deal. He tells him that he wants to see a regulation that allows only one Samosa wala for the region of Kamla Nehru Nagar and Rajnagar, and that the government will provide a license to sell Samosas in the area. Of course Suresh will get the license in the 2-G spectrum type “auction”. In return, the MLA will get 5% of shares in his Samosa shop. The MLA agrees to the deal. Now Suresh knows that the MLA is in his pocket, so he strikes another deal. Now he wants the government to pass a regulation that will bar farmers to sell potatoes in the free market (welcome the insidious APMC act). Then he collaborates with the MLA to acquire land (“auction” of natural resources) to grow his own potatoes. After a few years, he becomes the Samosa king of Ghaziabad. Ramu on the other hand is forced to work as a bonded labor in Suresh’s shop, and after a while he commits suicide.

You are protesting against this Samosa king Suresh. Is he wrong? I think it is an irrelevant question. Most of the humans will happily take any undue favor they can get from the government. It is not an attitude problem. It is human nature, it exists everywhere in the world, and you cannot change it. The Samosa wala is not at fault. He is doing what he is expected to do. He is not responsible to protect the Republic of India. YOU and I did not elect him. We elected the MLA. And he is the one at fault. The regulatory regime is at fault. Big unnecessary government is at fault.

There is more to it. There is one example that might help you understand this concept better. You might know that in India when they have to reduce the population of stray dogs in an area, the municipal authorities have a choice to either castrate the dogs or the bitches in that area. Which method do you think is more effective? Intuitively, everybody would say that one should castrate the bitches, because if you castrate a dog, some other dog will do the job (have sex and impregnate the bitch). Same is true with the government. If you castrate Suresh, Samosa wala no. 1024 will do the job. The impregnable government needs to be castrated. Also, people did not elect Suresh, but they elected the MLA. Suresh is not responsible for their well-being. The MLA is.

The industrialist you are targeting, although have taken undue favors from the government to make their samosas, they have done so under a reasonable presumption that if they don’t do it, somebody else will because unfortunately the bitch is always on heat. Nevertheless, these industrialists have added value to our economy and you cannot discredit that. YOU and I willingly paid for the samosas (cars, cell phones etc.) they have made. They now have the labor and capital that will allow India to excel in the next century. Just castrate the government so that the Ramus don’t commit suicide.

The big question is why in the hell would they help you, as they seem to be the beneficiaries of this mess? Well not all of them are beneficiaries. If Suresh gets undue favors, other industrialists suffer. Collectively, all industrialists would want this system cleaned because now it is a mess even for Suresh, because the bitch has gone berserk.

I would request you to reconsider your strategy of targeting the industrialists in India.

Best Regards,
Shubhendu Pathak

Their Grievances Justified – A Case in Defense of Capitalism and Paul Krugman

The dynamics of greed, or a milder version of it called ‘pursuit of wealth’, has favored the rich over the poor in the past few decades. The norm of greed, nevertheless, was and has been equally endorsed by both the classes. Greed is not only supposed to make you wealthy. It can also make you poor, not because of the underlying risks, but due in part to the dynamics of the new economic model. Failure to comprehend this model can grossly misdirect grievances of both the 99% and the 1%.

During the last few decades, and more so in the last fifteen years, the rich became rich by earning what was spent by the poor. What the 99% spent by selling the claims on their future earnings, the 1% earned by selling them goods and services. When it became clear that there were no future earnings to claim, the stakeholders should have taken the losses. At least that is what the virtue of capitalism suggests: risk controls greed.

Missing or obscured in the equation, however, was the risk. An examination of how and where the risk was placed and how the steps taken to “solve” the situation guided the distribution of claims can help us better judge whether the responsibility lies in mere deviation from rectitude of the 100%, or a criminal offence on the part of the 1%, or a little less than 1% to be precise.

Pure and simple trade is – I provide you with goods and services and hold claims on what you produce in the future. I take the risk and it is my loss if you don’t produce anything in the future. In the new economic model the claims on future earnings of the spender, the 99%, are not held by the producer, the 1%. The risk is held by “someone else”. The 1% keeps what it earns. This is why the 1% was happy when the welfare program was in effect replaced by a program meant to pander to the greed of the 99%. NINJA loans, LIAR loans and credit card loans financed all the spending and the 1% earned all that was spent with little or no risk.

Do the 99% deserve sympathy? Certainly not for the reasons they sight. The 99% were let off the hook for the risks tied to claims on their future earnings were grossly underestimated, thanks to both the government support for many of these debts and the alleged fraud perpetrated via the collusion of banks and rating agencies. Yes, the banks too helped the 99% spend at their will for it was the demand for MBSs and CDOs that was in effect encouraging the inordinate lending. A portion of the extra dollars that went abroad due to the continuing trade deficit was circulated back into these claims perpetuating a vicious cycle, amplified by various feedback loops, of borrowing and spending; the mighty ability of the United States to earn and pay back was undermined by this modern Opium. When the market forces started functioning and it became clear that the spender is never going to be able to pay back, the holders of the hyper-valued claims started to fail.

The 99% could just move away as they had no risks tied to the collateral, and that is exactly what they did. They walked away from the obligation and started saving, and the businesses that thrived on this spending started to fail. The Government shifted a portion of the debt on its balance sheet. The poor became less poor now that the debt was purchased by the government. The rich did not become less rich. People who became rich in the process of this debt financed spending remained rich, thanks to the anthropomorphic nature of corporations. Insider trading further stacked the odds against the 99% invested in stocks.

The banks were not allowed to fail. The government incurred debt to pick up the slack in spending, purchased much of the toxic assets and lowered interest rates to prop up the remaining collateral. So instead of the 99%, now the government will have to pay for the claims. The government will pay back this debt from tax revenues of future earnings. So in effect, the money that the 1% have is actually (a function of) the future earnings of taxpayers. How did the 1% earn this money? It depends on who are we talking about. Many corporations (employees and shareholders) provided goods and services to earn this money; that seems legitimate, for it might not be justified to expect them to evaluate the supposed risk the spenders, the 99%, were offering. That risk was not written on the dollar bills they were spending; the risk had been taken by the mythical “someone else”. Bank employees allegedly colluded with rating agencies, sold the claims on earnings, and took the cut; prima facie this is tantamount to criminal conspiracy and fraud.

Of course, we cannot ignore China, the elephant in the room, before discussing the fairness of the next steps. The Chinese situation is plain and simple trade – The producer (China) sells goods and bears the risk that the buyer (the United States) might not pay it back. So Chinese seem worse off than the rich in the U.S. who bore no such risk. On the brighter side, however, the Chinese gained enormously via access to capital goods that the Unites States, Germany, and Japan took decades to develop. Chinese now have all these capital goods and more than $ 3 trillion to spare. The moment the Chinese de-peg the Yuan, and start consuming the products they produce, the inflation that the U.S. has been exporting to China will start showing inside the U.S. The resulting spike in interest rates will both reduce the tax base and increase the costs to service the debt and will force either default or hyperinflation upon the U.S. So in effect, the steps Chinese, the primary financier, take in the near future will determine the fate of the 99% and the 1% in the U.S.

No signals from the government suggest that it wants to avoid the inflationary path. Spare a thought here for the Good Samaritan, who worked hard, spent responsibly, and saved for future consumption. Although a very rare species, he does deserve sympathy, as he now stands as the ultimate loser for he did not enjoy the “risk-free” exuberance back then and will now look at his savings wiped out as the government tries to inflate its way out of the mess.

Having said that, let us examine the other end of the spectrum advocated most fiercely by Peter Schiff. Taking a situation to an impractical level sometimes helps form rational perspectives, so let us do that here. What will happen if we bring capitalism back to the United States – say, as close as we can get to laissez-faire? – Stop all monetary and fiscal stimuli, allow the interest rates to rise, demolish the regulatory burden, reduce government spending and stop all forms of wealth redistribution. Not new to the Americans, this is the old American – Grover Cleveland style, a path strictly guided by the constitution. Of course, under such a scenario, the Chinese can just forget about all their claims on future earnings of Americans. Many businesses will close down as the spenders lose access to the debt they cannot pay back and the spending patterns readjust. Banks will fail, and will be allowed to fail. New healthy businesses and financial institutions will come up, and the entrepreneurial spirit of the mighty United States will spring back before anyone in the world can realize. However, the foundation of this resurgence would not be as sound as it seems. Under this reversion to capitalism, a portion of the wealth that the 1% own will effectively be what the debt holders around the world earned and will never be paid back. The 99% can live with that. However, not all the government debt is external. Internal debt represents money that future taxpayers will earn. The existing 1% possess some of this wealth as well. The 99% can object to that as they never voted for the government to take on the debt. It should have been the banks and holders of the debt that should have taken the losses. Even if we ignore the origin of the wealth of the 1%, wealth disparity under this transfer to capitalism will be enormous. While the wealthy will have the luxury of choosing between starting a business and enjoying their wealth, it will be a matter of survival for the 99%. A reasonable assumption that legitimizes sympathy for the 99% is that they could not have been expected to behave in any other way. Is a citizen of the United States expected to deny if he/she is offered a free lunch? How could he/she be expected to pay the price of the steps taken by the government and the banks? The disparity between competent and incompetent makes sense in capitalism where risk ensures fitness. It does not make any sense if some reckless intervention of the government leaves all the capital that engineers and scientists have developed over decades of hard work into the hands of a certain few. Who will answer the indebted generation some of who have not yet taken birth and whose wealth is already in the hands of the existing 1%?

Before discussing the merit of Paul Krugman’s argument, let us try to identify the root causes that led us into this mess. Intellectual tycoon, politician and economist Subramanian Swamy often discusses in his speeches the structure of society in ancient India as described in the scriptures. The model has an element of relevance here. The Varna Vyavastha (presently known as the caste system) was never meant to be hereditary as it exists in India today. Two great sages Maharshi Bhrigu and Maharshi Bharadwaja led a debate to decide the structure of the Hindu society. (You can imagine it as the greatest philosophers, psychiatrists, mathematicians, economists etc. of the time coming on a platform to discuss the structure of the society.) The outcome of the debate was that there should be four sections of society in alignment with inherent human nature.

Elements of power were recognized as knowledge, weapons, wealth, and land. To avoid centralization of power, any single person could hold only one of these elements. The highest and the most revered class was that of intellectuals. However, they were not allowed to hold wealth, weapons or land. Second in line were kings who had access to weapons. However, they were not allowed to take decisions without the approval of intellectuals. The third caste was that of businessmen, who did not have the intellectual ability to create, neither had the heart to defend their wife and children, but had the risk appetite (financial) and ability to execute businesses within the framework created by intellectuals. They possessed wealth but did not enjoy any social status. Their social status was determined by how much charitable they were. The last caste was that of labor. Transfer from lower to higher caste was a norm; in fact, some of the greatest intellectuals in India were born in low caste families.

There are many parallels that can be drawn from this model but let us focus on human motivations. Let us start with two basic primitive motivations: animals want to secure food to survive and want to pass their genes to the next generation. Recognition from other animals, power to control, and access to territory all help achieve these two objectives. Humans desire these same elements – social recognition, power, and access to wealth driven by these primitive instincts. These elements are not absolute, they are relative. So, a human driven by these elements cannot be satisfied with a finite amount of these elements. (I am not touching the spiritual realm which deals with the absolute and might not be applicable to the current scenario. Pursuit of knowledge is considered closest to the spiritual realm.)

If you create an environment where wealthy are revered and where they can influence decisions to control, you effectively give all the three elements of power to a few. This is the present situation in the United States. Access to capital (that was developed by scientists and engineers and proliferated by industrialists with decades of collaboration), social recognition (driven recently primarily by the media), and control of power via government (lobbying for unconstitutional favors) all belong to a few. This has enormous economic and biological ramifications for mankind. Distributing this power fairly will be impossible unless something unprecedented happens as it is human nature not to let go of what he/she has without resistance.

This brings me to the argument raised by Paul Krugman where he argues that a fake alien invasion can bring the economy out of the current slump in eighteen months. The idea of an alien invasion may seem dissociated from reality, but this argument is strongly rooted in the relationship between human motivations and economy. Under war-like situations, human motivations make a radical shift. During wars, a lower standard of living does not invoke frustration, it becomes a sacrifice. Massive build-up of capital takes place driven by the sacrifice of the poor and the rich alike. Wealthy become less wealthy as capital gets devalued. When the war is over, capital goods can be re-tooled for production. The fit regain control of this capital. Aligned human motivations and hard work can indeed bring back the economy on the right track very quickly. The merit of this argument cannot be discounted on the basis of its “impracticality”. If there is any argument that directs us to the virtues that can reinstate the health of the economy, its merit, at least in theory, should not go unappreciated.