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Economy Feb 12, 2013

Why Chidu and Subbu do not have much control over fiscal deficit

By Vivek Kaul

In the past few pieces I have written about the huge amount of money being printed by central banks and governments all across the developed world.

The Federal Reserve of United States, the American central bank, has expanded its balance sheet by 220% since early 2008. The Bank of England has done even better at 350%. The European Central Bank came to the party a little late and has expanded its balance sheet by around 98%. The Bank of Japan has been rather subdued in its money printing efforts and has expanded its balance sheet only by 30% over the last four years. But is now joining the money printing party and is looking to print as many yen as required to get an inflation of 2% going. Read more here.

The idea as I have mentioned in a couple of earlier pieces is to create some consumer price inflation to get consumption going again. As a greater amount of money chases the same amount of goods and services, the hope is to create some inflation. When people see prices going up or expect prices to go up, they generally tend to start purchasing things. This helps businesses as well as the overall economy. So by trying to create some inflation or at least create some inflationary expectations, the idea is to get consumption going again.

But this trick practised by central banks hasn't worked. Inflation has continued to elude the developed world.

Central bank governors and governments when they decide to print money are essentially following the Chicago university economist Milton Friedman. Friedman had even jocularly suggested that a recessionary situation could be fought by printing and dropping money out of a helicopter, if the need be, to create inflation.

The idea behind this assumption is that just by dropping money out of a helicopter there will be an increase in money supply and inflation will be created. So in that sense it did not really matter who is standing under the helicopter when the money is dropped. But French economist Richard Cantillon who lived during the early eighteenth century showed that money wasn't really neutral and it mattered where it was injected into the economy. In the modern sense of the term, it matters who is standing under the helicopter when printed money is dropped from it.

Before we get back to Cantillon, let me deviate a little.

Christopher Columbus wanted to discover the sea route to India. He went on his first journey to find India on the evening of August 3, 1492. Before that he had managed to negotiate a contract with King Ferdinand and Queen Isabella of Spain, which entitled him to 10% of all the profit.

But he ended up somewhere else instead of India. An island he named San Salvador, which the locals called Guanahani. The question though is why did he want to go to India? It seems he had read the published accounts of Marco Polo and was very impressed by the wealth that lay in store in India.

Columbus made three more journeys in search of a sea route to India, but never found it. In the end, it didn't really matter, because the Spaniards found what they were looking for: gold and silver, in ample amounts. Though not in India, as was the original plan, but in what came to be known as the "New World" immediately and South America a little later. Within half a century of Columbus' first expedition, the Spaniards had found most of the treasure that was to be found in the New World.

With all this silver/gold coming into Spain from the New World there was a sudden increase in money supply and that led to inflation in Spain. Richard Cantillon studied this phenomenon and made some interesting observations.
What he said was that when money supply increased in the form of gold and silver it would first benefit the people associated with the process of money creation, the mining industry in general and the owners of the mines, the adventurers who went looking for gold and silver, the smelters, the refiners and the workers at the gold and silver mines, in particular. These individuals would end up with a greater amount of gold and silver i.e. money, before anyone else. This money they would be spent and thus drive up the prices of meat, wine, wool, wheat etc. This new money would be chasing the same amount of goods and thus drive up prices.

This rise in prices would impact people not associated with the mining industry as well, even though their incomes hadn't risen like the incomes of people associated with the mining industry. As Dylan Grice an analyst formerly with Societe Generale told me a few months back "The problems arise for other groups. Anyone not involved in the production of money or of the goods the newly produced money purchased, but who nevertheless consumed them - a journalist or a nurse, for example - would find that the prices of those goods had risen while their incomes hadn't."

This is referred to as the Cantillon effect.

A higher fiscal deficit means that the government has had to borrow more and that in turn has meant higher interest rates as well. Reuters

A higher fiscal deficit means that the government has had to borrow more and that in turn has meant higher interest rates as well. Reuters

Cantillon, writing before the days of Adam Smith, was the first to articulate it. I find it very puzzling that this insight has been ignored by the economics profession. Economists generally assume that money is neutral. And Milton Friedman's allegory about the helicopter drop of money raising the general price level completely ignores the question of who is standing under the helicopter," said Grice.

The money printing that has happened in recent years has been unable to meet its goal of trying to create consumer price inflation. But it has benefited those who are closest to the money creation like it had in Spain. In the present context, this basically means the financial sector and anyone who has access to cheap credit (i.e. loans).
Institutional investors in the developed world have been able to raise money at close to zero percent interest rates and invest that money in financial assets all over the world, and thus driven up their prices.

As Ruchir Sharma writes in Breakout Nations - In Pursuit of the Next Economic Miracles:

"What is apparent that central banks can print all the money they want, they can't dictate where it goes. This time around, much of that money has flown into speculative oil futures, luxury real estate in major financial capitals, and other non productive investments...The hype has created a new industry that turns commodities into financial products that can be traded like stocks. Oil, wheat, and platinum used to be sold primarily as raw materials, and now they are sold largely as speculative investments. Copper is piling up in bonded warehouses not because the owners plan to use it to make wire, but because speculators are sitting on it...figuring that they can sell it one day for a huge profit."

Other than this all the money printing has also led to stock markets across the world reaching levels they were at before the financial crisis started. Investment banks and hedge funds have borrowed money at very low interest rates and invested it all over the world. This has led to an increase in price of oil as well, something that impacts India majorly. Currently one basket of Indian crude costs around $108 per barrel. The Indian government hasn't passed on this increase in oil prices to the Indian consumer and sells products like diesel, petrol, kerosene and cooking gas at a loss. The losses thus faced by the oil marketing companies on selling diesel, kerosene and cooking gas are compensated for by the government. This means increased expenditure for the Indian government and thus a higher fiscal deficit. Fiscal deficit is the difference between what the government earns and what it spends.

The other impact of this money printing has been an increase in price of gold. Investors all over the world have been buying gold as more and more money is being printed. The Indian investors are no exception to this rule. India produces very little gold of its own. Hence, most of the gold being bought in India needs to be imported. When these imports are made India needs to pay in dollars, because gold is bought and sold in dollars internationally. In order to pay in dollars, India needs to sell rupees and buy dollars. This means that there is an increase in the supply of rupees in the market, and the rupee loses value against the American dollar. A little over a year back one American dollar was worth Rs 49. It touched around Rs 57 by the middle of 2012. Currently one dollar is worth around Rs 53.5.

When the rupee loses value against the dollar it means that India has to pay more in rupees for its imports. India's number one import is oil. Hence, with the rupee losing value against the dollar over the course of the last one year, India has been paying more for oil being imported in rupee terms. This has in turn led to increasing government expenditure and therefore a higher fiscal deficit. A higher fiscal deficit means that the government has had to borrow more and that in turn has meant higher interest rates as well. This explains to a large extent why the government has in recent times tried to control the import of gold by increasing the duty on it and thus control the value of the rupee against the dollar.

What this entire story tells us is that the likes of P Chidambaram and D Subbarao have far lesser control over the Indian economy and the fiscal deficit of the government, their attempts to prove otherwise notwithstanding.

So as long as the Western world continues to print money, prices of oil and gold will continue to remain high. Hence, Indians will continue to buy gold and the oil bill will continue to remain high.

by Vivek Kaul

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