Sustainability of Debt

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For economies with fractional reserve-generated fiat money, balancing the budget is characterized by an exponential growth D(t) ≈ D0(1 + r)t of any initial debt D0 subjected to interest r as a function of time t due to the compound interest; a fact known since antiquity. At the same time, besides default, this increasing debt can only be reduced by the following five mostly linear, measures:

(i) more income or revenue I (in the case of sovereign debt: higher taxation or higher tax base);

(ii) less spending S;

(iii) increase of borrowing L;

(iv) acquisition of external resources, and

(v) inflation; that is, devaluation of money.

Whereas (i), (ii) and (iv) without inflation are essentially measures contributing linearly (or polynomially) to the acquisition or compensation of debt, inflation also grows exponentially with time t at some (supposedly constant) rate f ≥ 1; that is, the value of an initial debt D0, without interest (r = 0), in terms of the initial values, gets reduced to F(t) = D0/ft. Conversely, the capacity of an economy to compensate debt will increase with compound inflation: for instance, the initial income or revenue I will, through adaptions, usually increase exponentially with time in an inflationary regime by Ift.

Because these are the only possibilities, we can consider such economies as closed systems (with respect to money flows), characterized by the (continuity) equation

Ift + S + L ≈ D0(1+r)t, or

L ≈ D0(1 + r)t − Ift − S.

Let us concentrate on sovereign debt and briefly discuss the fiscal, social and political options. With regards to the five ways to compensate debt the following assumptions will be made: First, in non-despotic forms of governments (e.g., representative democracies and constitutional monarchies), increases of taxation, related to (i), as well as spending cuts, related to (ii), are very unpopular, and can thus be enforced only in very limited, that is polynomial, forms.

Second, the acquisition of external resources, related to (iv), are often blocked for various obvious reasons; including military strategy limitations, and lack of opportunities. We shall therefore disregard the acquisition of external resources entirely and set A = 0.

As a consequence, without inflation (i.e., for f = 1), the increase of debt

L ≈ D0(1 + r)t − I − S

grows exponentially. This is only “felt” after trespassing a quasi-linear region for which, due to a Taylor expansion around t = 0, D(t) = D0(1 + r)t ≈ D0 + D0rt.

So, under the political and social assumptions made, compound debt without inflation is unsustainable. Furthermore, inflation, with all its inconvenient consequences and re-appropriation, seems inevitable for the continuous existence of economies based on fractional reserve generated fiat money; at least in the long run.

Political Ideology Chart

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It displays anarchism (lower end) and authoritarianism (higher end) as the extremes of another (vertical) axis as a social measure while left-right is the horizontal axis which is an economic measure.

Anarchism is about self-governance, having as little hierarchy as possible. As you go to the left, the means of production are distrubuted more equally; and as you go to the right, individuals and corporations own more of the means of production and accumulate capital.

On the upper left you have an authoritarian state, distributing the means of production to the people as equally as possible; on the lower left you have the collectives, getting together voluntarily utilizing their local means of production and sharing the products; on the lower right you have anarchocapitalists, with no state, tax or public service, everything operated by private companies in a completely free and global market; and finally on the top right you both have powerful state and corporations (pretty much all the countries).

But after all, these terms change meanings through history and different cultures. Under unrestrained capitalism the accumulation of wealth both creates monopolies and more importantly political influence. So that influences state interference and civil liberties also. It also aspires for infinite growth which leads to the depletion of natural resources which is another diminishing fact for the quality of living for the people. At that point it favors conservatism rather than progressive scientific thinking. Under collective anarchism, since it’s localized, it is quite difficult to create global catastrophes, and this is why in today’s world, the terms anarchism and capitalism seems as opposite.

Techno-Commercial Singularity: Decelerator / Diagram.

H/T Antinomia Imediata

If the Cathedral is actually efficient, the more it happens, the less it happens. Decelerator.

  1. taxation: this deviates resources from capital and buries them into the consumption of the tax-receivers (namely the Cathedral bureaucracy). trash and shit.
  2. regulation: there are various ways this could work, insofar as regulation is very inventive. but the main pattern has to do with deviating capital from the most rentable (i.e., (self-re)productive) investments, into those that are most likely to become un-recyclable trash, at least in the long run.
  3. politicization: this deviates brain-power from technological producing theories into, well, bullshit research departments, especially through politicization of academic funding of hard sciences.
  4. protectionism: since this protects technical developments from properly feeding back into the commercial cycle, it breaks the link between technical advantage and capital accumulation, leading lots of resources into stupid gadgetry.

all these being forms of fucking up the incentive structures that allow the accelerative cycle to be. in diagram form:unnamed (2)

 

 

BRICS Bloc, New Development Bank and Where the Heck is it

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Some of this post is a bit dated, as this was meant to be written as an editorial for a BRICS Journal way back towards the fag end of 2015, and a lot of water has flown under the bridge ever since, with India holding the BRICS Summit in October last year in Goa, which also saw parallel sessions being organized by Peoples’ BRICS Forum, a conglomerate of civil society organizations from BRICS member countries raising concerns over the possible funding patterns the Bloc would be undertaking at the expense of environmental degradations and human rights violations. So, let us get on with it:

The BRICS bloc, a conglomerate of five of the biggest emerging economies is home to 43% of the world’s population with a share of 22% of the global GDP. These staggering statistics make Brazil, Russia, India, China and South Africa truly a force to reckon with. The bloc’s initiative to erect a development finance institution in the form of New Development Bank (NDB), is often attributed in the West as a reaction to the institutional sclerosis of Washington-DC-dominated World Bank and the International Monetary Fund (IMF), whereas it is a catalyst complementing rather than challenging the Bretton Woods institutions or the Asian Development Bank in fighting poverty in the emerging economies. Whatever be the attributions, the logic of fighting global poverty is itself steeped in controversies ranging from applying mathematical and statistical juggleries to determine the number of poor according to standards that are a far cut from realities on ground, to economic measures built upon the plinth of models that on many occasions forgo the human capital in a relentless pursuit of development agenda, which is meaningless if only persevered in concentrating on the extreme poverty and purblind to the gap yielding inequalities.

The world is watching with keenness on the mushrooming of New Development Bank, which was officially launched in Shanghai in July, 2016. What would be the underlying rationale of this model? How and where would the finances flow? If the investments were complemented to fill a vast infrastructural gap, how would the safeguards be architected to prevent socio-economic and environmental violations on ecologies? What of the democratic set-up that underlies the formation of this bloc and subsequently of NDB getting hijacked by the political and economic clout and prowess of China? These have been some of the pressing and contentious questions that could either derail the rationale behind this initiative or leave no stone unturned in replicating the western-dominated financial institutions that find themselves increasingly in the eye of the storm for fostering irreversible violations and damages. Aside from that, China’s growing eminence in G20 is a step to rival G8’s macroeconomy, international trade and energy capitalisation lending it legitimacy for a foreign policy geared towards a north-south dialogue in addition to the south-south dialogue efficacious through BRICS and G20. Moreover, China views G20 as an economic platform with other emerging countries on board for a resolve on international affairs. G20 along with BRICS Bank is a contrivance for a financial architecture that focuses on development issues on the one hand, and internationalising its currency on the other. Clearly, it is not a case of what Deng Xiaoping called for “China keeping a low profile”. So, is it merely a speculative materialism that is the engine behind China’s true intentions?

The Asian Development Bank has calculated an infrastructural gap worth $8 trillion in the Asia Pacific needing to be filled by 2020. This is where NDB would cash-in most, and likely create a polarity between infrastructural funding and other developmental concerns. But, what is infrastructure is as hazy as the fuzzy logic of the calculated gap. It is a prerogative to continuously industrialise the BRICS, of building and upgrading ports, gateways, intelligent transportation and communication, power generational and distributional capabilities to augment developmental agenda, which incidentally sets parameters for economic prosperity, the fruits of which permeate to the hitherto-considered peripheries in a fight against poverty. However, the Articles, according to NDB President KV Kamath have a purpose sketched out for the Institution, “To mobilise resources for infrastructure and sustainable development projects in BRICS and other emerging economies, complementing the existing efforts of multilateral and regional development banks.” This is imperative of sustainability, pragmatism, innovation and speed of execution, of which the last could accelerate in a more experimental manner. The speed could pierce through bureaucratic red tapes, blunt operating procedures, and intensify delivery of massive infrastructural projects. Dang Xiaoping, in a rather philosophically pensive manner referred to reform as a process of feeling stones while crossing the river. Although, this should be the dictum NDB needs to seriously gravitate to, dangers of transgressions are lurking heavily.

The BRICS economies are undergoing economic upheavals, and China, the second largest economic power in the world with a nominal GDP more than the rest of bloc’s combined GDP is seeing NDB along with the Asian Infrastructure Investment Bank (AIIB) and Shanghai Cooperation Organisation (SCO) as cardinal tools of its foreign policy initiatives. All of the three have a vision to revive China’s economic might through One Belt One Road (OBOR) and Silk Route through regional collaboration on the one hand and transcending state boundaries for facilitating trade links on the other. How would this augur for India is as important a question as how would the Government in India prioritize its policies for the NDB to plug in? The Government has sockets in place to provide the necessary plug ins, be they in the form of new tax allocations providing more funding for the states in order to empower growth, set budgetary allocations in order to expedite transport, communication and power capacities, proposal to create National Investment in Infrastructure Fund with a base capital of $3.25 billion, to planning and implementing regulatory reforms keeping a steady eye on growing influx of private capital and associated technologies to finally expunge bottlenecks to growth-led development model as a result. This is crucial, not just for India but for the entire bloc as a whole, since NDB’s priorities will be in line with the national development banks of member countries in effectuating the removal institutional roadblocks to growth. With a stated lending of up to $34 billion every year to begin with for filling up the huge infrastructural gap, NDB will act as an additional source of funding for India where the estimated gap in infrastructure is up north of $500 billion till 2020.

For the vast number of Indians, reality is far from development modelled on growth as envisaged by the political machinery at the centre. Growth forecasts have been revised downwards fearing a significant deceleration in exports and a capital flight from the country, courtesy unfavourable investment climes and a pitiable ease of doing business standards. While the Index of Economic Freedom ranks the country at 128 on a scale that defines the economy as situated in a mostly “unfree” zone, socio-economic concerns like malnutrition, falling public health indices, extreme poverty and growing inequality continue to plague the country. NDB’s role will be put under an intense scanner in addressing such internal contradictions of a magnitude that cannot be resolved merely by an external makeover tied to a growth that belittles its own citizenry. Unless Human Development Index, which emphasises life expectancy, education and income and GINI Coefficient Index, which measures inequality representing income distribution to country’s citizens are brought to affect the rating agencies’ take on India’s investment climate, Government’s relentless pursuit of developmental ends would never reach the multitude of people caught between the scylla and charybdis of regimental vagaries.

(DATED) With the upcoming India-Africa Summit to be hosted by New Delhi in October, there is a likelihood of trade relations between the two regions getting an uplift. Not only are India-Africa relations much softer compared to China’s scrambling for the African continent, it could also signal the way NDB gets projected by India in tune with its own foreign policy and diversify trade patterns seeking inroads into natural resources rich countries to augment a new investment destination for the increasing global profile of Indian corporate sector. As the Bank’s focus is concentrated on private investments, this gears in well with India’s investment in Africa in services and manufacturing sectors, roping in a vast population of non-resident Indians on the continent in a drive to foster economic regionalism on the one hand and throw around diplomatic weight on the other in a benign manner underlying India’s unique power equations. NDB could be a strong node bringing these realities to fruition, by promoting a reform in global economic governance with far-reaching significance and consequences. What remains to be seen is how much the NDB will abide by operation guidelines and procedures to see itself as not only different from other multilateral development institutions in terms of expediency, but also hold true to safeguards that protect vulnerabilities rather than exploiting and expropriating them. The latter is still a desiderata!!

Where is it all headed now?

The bank is planning to raise funds by issuing bonds in India, denominated in the local currency, the rupee, after to issued renminbi-denominated bonds in China in 2016. “In 2017, predominantly we’ll aim at taking up more lending tools to raise another $2.5bn for projects spreading over our member countries that are sustainable and do economic good. Virtually, we will try to double the lending of 2016 this year. What we are doing here at NDB is only a fraction of the need. Beyond lending, we would like to act as a catalyst, to get more parties involved in the lending process for projects that contribute to economic growth and sustainability,” said Kamath.

Major challenges for the bank lie in the changing global economic situation, which is seeing interest rates rise in developed countries. But, developing countries’ fast economic growth will help offset the effects, said he. Kamath also called the China-led OBOR a sound initiative that would bring benefits across several countries by investing in a significant way and creating economic momentum. “The program also brings synergy, making regions come together all along the Belt and the Road,” he said. Further he called, “We see it as something that will clearly spur economic activity in the region, and we think that the program is going to succeed.” On to renewable energy, where the focus seems to be concentrated….

In October last year, a new strategic report was produced by the Institute for Energy Economics and Financial Analysis (IEEFA), reviewing how successful the NDB has been so far. The report looked both at the increased renewable capacity of all five BRICS countries, but also the economic strain of such an ambitious project, a strain that is clear from the funding gap already present.

The NDB set targets tailored to each of the BRICS countries, taking into account their plans and their existing renewable capacity. The bank is designed to offer loans quickly and flexibly to the BRICS countries to make achieving these possible. “They had financed about $911m and that they had declared intent to finance or increase their loan by about $1.2bn every year,” says IEEFA consultant and the report’s author Jai Sharda. “So [the NDB is providing] about 11% of the public capital required.”

The report uses the concept of blended finance to work out the progress made and the progress required by the BRICS countries. “The concept of blended finance is basically built on the idea that when there is public money going into a sector it draws private money into that sector,” Sharda explains. “For every one dollar of public finance – the sort of finance being provided by the New Development Bank – it is estimated that it will make four dollars more of private money. So we built our estimations on that basis.”

Developing countries are some of the biggest consumers of energy in the world, as expanding a country’s infrastructure is energy-intensive. Economic development often requires large-scale industrialisation, such as we have seen in China, which has led to a more prosperous economy but also meant that China is the largest producer of CO2 in the world. All five of the BRICS countries rank in the top 20 polluters.

As such, the NDB has set goals to reduce the BRICS environmental impact while increasing the amount of energy they produce through renewable energy sources. Brazil is arguably in the best position to do this, as in 2015, 74% of its energy came from renewable sources. According to the IEEFA’s report, “Brazil’s 2024 Energy Plan envisages an increase in total installed renewable capacity, including large hydropower, from 106.4GW in 2014 to 173.6GW in 2024.”

India, China and South Africa have all set impressive targets, and have begun work to reach them. India intends to increase its renewable energy production by 40% by 2030, as well as reducing emissions intensity by 33%-35% over 2005 levels. China’s targets are even greater, as it plans “to reduce emission intensity by 60%-65% over 2005 levels”, the IEEFA report says. “China is estimated to increase its solar capacity to 127GW by 2020 from 43GW at the end of 2015, and wind capacity from 145GW in 2015 to 250GW by 2020.” South Africa has the furthest to go of the BRICS, as at present it gets 94% of its energy from fossil fuels but has plans to install a further 17.8GW of renewable energy capacity by 2020.

Russia is slightly different to the other BRICS countries as it has technically already met its target. Russia’s target was to reduce emissions by 25%-30% over 1990 levels, and emissions are currently around 40% lower than 1990 levels. However, the country is planning a 4.5% increase in the amount of renewable energy it produces by 2020.

All five BRICS countries have made progress, although to different extents. Brazil currently produces the most renewable energy, with 74% of its energy coming from renewable sources, the vast majority coming from large hydroelectric plants.

Sharda suggests that Brazil’s current success is, in part, due to its long-standing history of renewable projects, necessitated by a lack of coal: “I think Brazil has been better off than especially China and India in implementing more renewable energy because they lacked fossil fuel alternatives.”

Despite their fast-growing economies, India and China have historically been slower to develop their renewables sectors. “India and China have massive amounts of coal deposits, similarly Russia has large amounts of oil and gas deposits, and South Africa is one of the biggest exporters of coal,” Sharda says. “All of these countries have had a traditional, natural advantage.”

But things are beginning to change for both China and India, and they are expected to see the biggest boom in renewable energy of any of the BRICS countries in the next few years. “China led the coal and thermal power boom, they didn’t have an issue with dealing with worsening environmental conditions at a national level then,” Sharda says. “But the government and policy makers have actually become very sensitive to environmental issues which are why they are focusing a lot on renewable energy now.”

There is a massive trend moving towards renewable energy sources in China so, despite the fact that 74% of its energy came from fossil fuels in 2015, the IEEFA report estimated that China would increase its solar capacity to 127GW and increase its wind capacity to 250GW by 2020. However, in January, China increased its targets and its spending on renewable energy, and now plans to invest at least $360bn by the end of 2020, solidifying its position as a global leader on clean energy. Meanwhile, India increased its renewable capacity to 225GW by August 2016, a huge leap from 97GW in 2005. This is predominantly from using hydro.

Russia and South Africa are making slower progress. South Africa still relies on fossil fuels, increasing its renewable capacity to just 2.1GW in March 2016 from 1.8GW the previous year. Russia is making small progress predominantly due to a lack of investment from the country itself, only allocating $1bn for renewable technologies in all 17 Russian states in 2014.

Despite rapid development in the BRICS countries, for Brazil, China, India and South Africa there is a long way to go for any country to meet its targets. There is a funding gap which the NDB, among others, need to fill to help stimulate the development of the renewable energy industries in each country. The IEEFA estimates that “meeting these targets would require an annual investment of around $177bn. In comparison, the investment in the renewable sector in BRICS countries in 2015 was $126bn, leaving an average shortfall of $51bn.”

It is clear, therefore, that a vast increase in investment is needed. “Brazil’s renewable capacity expansion plans would require an investment of $86bn, or 85.2% of overall electricity generation capacity investment,” the IEEFA report states. This is despite Brazil’s impressive hydroelectric infrastructure. Meanwhile Russia would require an investment of $44bn, India will require $128bn, China $254bn and South Africa $30bn.

Whilst these figures are for varying timescales and some countries, China in particular, are likely to be able to channel enough money to meet their targets, it is clear that a much greater and more sustained investment will be needed if the BRICS countries as a whole are to achieve their goals. Furthermore, these figures do not include the knock-on infrastructure upgrade costs that renewable energy generation will create. India alone will need a further $26bn over the next ten years to update its grid.

But more is going to be done, starting with an announced increase in the loans available from the NDB. “The development bank has actually declared that they were targeting to expand and increase their support of energy development this year,” Sharda says. “Their target is actually about 35% percent of the overall public capital required.” This large increase could make all the difference.

At present, despite impressive advances in renewable capacity in the BRICS countries, some look set to miss their targets. If the NDB and other multilateral development banks and financial institutions manage to increase investment, the BRICS could have a massive effect on the environmental damage currently being created by their energy systems. Their success will be evident across the next ten years and beyond, and will be keenly anticipated around the world.

Debt versus Equity Financing. Why the Difference matters?

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There is a lot of confusion between debt and equity financing, though there is a clear line of demarcation as such. Whats even more sorry as a state of affair is these jargons being used pretty platitudinously, and this post tries to recover from any such usage now bordering on the colloquial, especially on the activists’s side of the camp.

What is Debt Financing?

Debt financing is a means of raising funds to generate working capital that is used to pay for projects or endeavors that the issuer of the debt wishes to undertake. The issuer may choose to issue bonds, promissory notes or other debt instruments as a means of financing the debt associated with the project. In return for purchasing the notes or bonds, the investor is provided with some type of return above and beyond the original amount of purchase.

Debt financing is very different from equity financing. With equity financing, revenue is generated by issuing shares of stock at a public offering. The shares remain active from the point of issue and will continue to generate returns for investors as long as the shares are held. By contrast, debt financing involves the use of debt instruments that are anticipated to be repaid in full within a given time frame.

With debt financing, the investor anticipates earning a return in the form of interest for a specified period of time. At the end of the life of a bond or note, the investor receives the full face value of the bond, including any interest that may have accrued. In some cases, bonds or notes may be structured to allow for periodic interest payments to investors throughout the life of the debt instrument.

For the issuer of the bonds or notes, debt financing is a great way to raise needed capital in a short period of time. Since it does not involve the issuing of shares of stock, there is a clear start and end date in mind for the debt. It is possible to project the amount of interest that will be repaid during the life of the bond and thus have a good idea of how to meet those obligations without causing undue hardship. Selling bonds is a common way of funding special projects, and is utilized by municipalities as well as many corporations.

Investors also benefit from debt financing. Since the bonds and notes are often set up with either a fixed rate of interest or a variable rate with a guarantee of a minimum interest rate, it is possible to project the return on the investment over the life of the bond. There is relatively little risk with this type of debt financing, so the investor does not have to be concerned about losing money on the deal. While the return may be somewhat modest, it is reliable. The low risk factor makes entering into a debt financing strategy very attractive for conservative investors.

What is Equity Financing?

Also known as share capital, equity financing is the strategy of generating funds for company projects by selling a limited amount of stock to investors. The financing may involve issuing shares of common stock or preferred stock. In addition, the shares may be sold to commercial or individual investors, depending on the type of shares involved and the governmental regulations that apply in the nation where the issuer is located. Both large and small business owners make use of this strategy when undertaking new company projects.

Equity financing is a means of raising the capital needed for some sort of company activity, such as the purchase of new equipment or the expansion of company locations or manufacturing facilities. The choice of which means of financing to use will often depend on the purpose that the business is pursuing, as well as the company’s current credit rating. With the strategy of equity financing, the expectation is that the project funded with the sale of the stock will eventually begin to turn a profit. At that point, the business not only is able to provide dividends to the shareholders who purchased the stock, but also realize profits that help to increase the financial stability of the company overall. In addition, there is no outstanding debt owed to a bank or other lending institution. The end result is that the company successfully funds the project without going into debt, and without the need to divert existing resources as a means of financing the project during its infancy.

While equity financing is an option that is often ideal for funding new projects, there are situations where looking into debt financing is in the best interests of the company. Should the project be anticipated to yield a return in a very short period of time, the company may find that obtaining loans at competitive interest rates is a better choice. This is especially true if this option makes it possible to launch the project sooner rather than later, and take advantage of favorable market conditions that increase the projected profits significantly. The choice between equity financing and debt financing may also involve considering different outcomes for the project. By considering how the company would be affected if the project fails, as well as considering the fortunes of the company if the project is successful, it is often easier to determine which financing alternative will serve the interests of the business over the long-term.

In summation, equity financing is the technique for raising capital organization stock to speculators whereas debt financing is the technique of raising capital by borrowing. Equity financing is offered forms like gained capital or revenue while debt financing is available in form of loan. Equity financing involves high risk as compare to debt financing. Equity holders have security but debt holders don’t have. In equity financing, entrepreneurs don’t need to channel benefits into credit reimbursement while in debt financing, entrepreneurs’ have to channel profit into repayment of loans.

Is Indian GDP data turning a little too Chinese? Why to be Askance @ India’s Growth Figures?

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India defied expectations on Tuesday to retain the title of the world’s fastest growing major economy, despite the pain caused by Prime Minister Narendra Modi’s shock crackdown on cash.

Annual gross domestic product (GDP) growth for the October-December period came in at 7.0 per cent, a tad slower than 7.4 per cent in the previous quarter but much faster than the 6.4 per cent expansion forecast by economists in a Reuters poll. Economists are scratching their heads its almost seen for the economy is untouched by demonetisation now you are one of the strongest defendant of demonetisation. Would you agree that the economy was almost left untouched by demonetisation some pain was warranted was it not?

Shaktikanta Das: As we have explained earlier, we have to go by real statistics. Now, when the Q2 figures where the second quarter figures for the current year released the advanced estimates were released that time also we had explained that we have to go by real statistics and not by anecdotal evidence.

Being the fastest-growing large economy in the world is India’s destiny, and even the most poorly conceived economic policy imaginable can’t stop destiny….To say the data is startling is an understatement. The IMF had predicted that India would grow at around 6 percent in the half-year after “demonetisation,” as it’s called. Most independent economists forecast GDP growth would come in somewhere between 6 and 7 percent. Those economists naturally assumed that withdrawing 86 percent of the country’s currency and reducing access to bank accounts would dampen private consumption.  

Yet if one believes the government’s numbers, taking away most of India’s cash overnight didn’t hurt private spending at all. In fact, private consumption rose by 10.1 percent over the quarter. That’s the highest growth in spending in over five years, and it came at a time when consumer confidence was falling sharply. 

My take on the statistics:
Well, this is a simple tweaking of the equations that differentiate the growth curve. In short, we have all been a part of exams where 9/10 is different from 99/100, even if just one number distances the actual score from the maximum one could score. On similar lines, the crimes of growth are factored in on growth year/base year. This is mathematical jugglery narrowed in on political ends. Whichever way one looks at the data, some of the indicators are still found lagging the composite growth, thereby dumbing down the economists when the growth curve mandates a pattern recognition.
GDP, when calculated at Factor Cost is related with GDP at Market Price, and written as an equation of the form,
GDP (FC) = GDP (MP) – indirect takes + subsidies
While, Gross Value Added,
GVA (basic prices) = Sum (net of production taxes & subsidies) to GDP (factor cost)
Stamp duties and property taxes make up the production taxes, whereas labour, capital and investment subsidies are the other half. Why is this done? To inflate GDP after it starts representing the GDP of a country in terms of total GVA, i.e. without discounting for depreciation. Moreover, GDP at market price adds taxes and deducts subsidies on products and services to GDP at factor cost. The sum total of the GVA in various economic activities is called the GDP at factor cost. With a change in method and a subsequent change in base year, India has increased or rather expanded its manufacturing base in the sense of capturing it.  This has also enabled the country to include informal sectors, which hitherto had not found its true manifestation. This is mere adherence to standards that become internationalized.
Now, what happens in India’s case is the part subsidies, which has been the fixed denominator for our GDP, unlike most of the developed world, or even the developing economies. So, our GDP hitherto had largely been GDP (FC). After rearranging the equation above, GDP (FC) would have subtraction of the subsidies part, and yield GDP (MP), thus changing the base completely, and giving a large share of the economy as growing, rather than the dismal one predicted in the wake of demonetization. This has been effectuated since 2012 implying that whatever happens after demonetization, the growth period would project only redundant figures. Slip that into the quarterly period, and yes, the new base would indicate a growing economy, as used by the WB/IMF to forecast India growing more than China. So, there is nothing really dastardly an act here, but more about how to integrate the parts into the composite to yell at the world, we are growing.

How Permanent Income Hypothesis/Buffer Stock Model of Milton Friedman Got Nailed?

Milton Friedman and his gang at Chicago, including the ‘boys’ that went back and put their ‘free market’ wrecking ball through Chile under the butcher Pinochet, have really left a mess of confusion and lies behind in the hallowed halls of the academy, which in the 1970s seeped out, like slime, into the central banks and the treasury departments of the world. The overall intent of the literature they developed was to force governments to abandon so-called fiscal activism (the discretionary use of government spending and taxation policy to fine-tune total spending so as to achieve full employment), and, instead, empower central banks to disregard mass unemployment and fight inflation first. Wow!, Billy, these aren’t the usual contretemps and are wittily vitriolic. Several strands of their work – the Monetarist claim that aggregate policy should be reduced to a focus on the central bank controlling the money supply to control inflation (the market would deliver the rest (high employment and economic growth, etc); the promotion of a ‘natural rate of unemployment’ such that governments who tried to reduce the unemployment rate would only accelerate inflation; and the so-called Permanent Income Hypothesis (households ignored short-term movements in income when determining consumption spending), and others – were woven together to form a anti-government phalanx. Later, absurd notions such as rational expectations and real business cycles were added to the litany of Monetarist myths, which indoctrinated graduate students (who became policy makers) even further in the cause. Over time, his damaging legacy has been eroded by researchers and empirical facts but like all tight Groupthink communities the inner sanctum remain faithful and so the research findings haven’t permeated into major shifts in the academy. It will come – but these paradigm shifts take time.

Recently, another of Milton’s legacy bit the dust, thanks to a couple of Harvard economists, Peter Ganong and Pascal Noel, who with their paper “How does unemployment affect consumer spending?” smashed to smithereens the idea that households would not take consumption decisions with discretion, which the Chicagoan held to be a pivot of his active fiscal policy. Time traveling back to John Maynard Keynes, who outlined in his 1936 The General Theory of Employment, Interest and Money a view that household consumption was dependent on disposable income, and, that in times of economic downturn, the government could stimulate employment and income growth using fiscal policy, which would boost consumption.

In Chapter 3 The Principle of Effective Demand, Keynes wrote:

When employment increases, aggregate real income is increased. The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by so much as income …

The relationship between the community’s income and what it can be expected to spend on consumption, designated by D1, will depend on the psychological characteristic of the community, which we shall call its propensity to consume. That is to say, consumption will depend on the level of aggregate income and, therefore, on the level of employment N, except when there is some change in the propensity to consume.

Keynes later (in Chapter 6 The Definition of Income, Saving and Investment) considered factors that might influence the decision to consume and talked about “how much windfall gain or loss he is making on capital account”.

He elaborated further in Chapter 8 The Propensity to Consume … and wrote:

The amount that the community spends on consumption obviously depends (i) partly on the amount of its income, (ii) partly on the other objective attendant circumstances, and (iii) partly on the subjective needs and the psychological propensities and habits of the individuals composing it and the principles on which the income is divided between them (which may suffer modification as output is increased).

And concluded that:

1. An increase in the real wage (and hence real income at each employment level) will “change in the same proportion”.

2. A rise in the difference between income and net income will influence consumption spending.

3. “Windfall changes in capital-values not allowed for in calculating net income. These are of much more importance in modifying the propensity to consume, since they will bear no stable or regular relationship to the amount of income.” So, wealth changes will impact positively on consumption (up and down).

Later, as he was reflecting in Chapter 24 on the “Social Philosophy towards which the General Theory might lead” he wrote:

… therefore, the enlargement of the functions of government, involved in the task of adjusting to one another the propensity to consume and the inducement to invest, would seem to a nineteenth-century publicist or to a contemporary American financier to be a terrific encroachment on individualism, I defend it, on the contrary, both as the only practicable means of avoiding the destruction of existing economic forms in their entirety and as the condition of the successful functioning of individual initiative.

For if effective demand is deficient, not only is the public scandal of wasted resources intolerable, but the individual enterpriser who seeks to bring these resources into action is operating with the odds loaded against him …

It was thus clear – that active fiscal policy was the “only practicable means of avoiding the destruction” of recession brought about by shifts in consumption and/or investment. That view dominated macroeconomics for several decades.

Then in 1957, Milton Friedman advocated the idea of Permanent income hypothesis. The central idea of the permanent-income hypothesis, proposed by Milton Friedman in 1957, is simple: people base consumption on what they consider their “normal” income. In doing this, they attempt to maintain a fairly constant standard of living even though their incomes may vary considerably from month to month or from year to year. As a result, increases and decreases in income that people see as temporary have little effect on their consumption spending. The idea behind the permanent-income hypothesis is that consumption depends on what people expect to earn over a considerable period of time. As in the life-cycle hypothesis, people smooth out fluctuations in income so that they save during periods of unusually high income and dissave during periods of unusually low income. Thus, a pre-med student should have a higher level of consumption than a graduate student in history if both have the same current income. The pre-med student looks ahead to a much higher future income, and consumes accordingly.Both the permanent-income and life-cycle hypotheses loosen the relationship between consumption and income so that an exogenous change in investment may not have a constant multiplier effect. This is more clearly seen in the permanent-income hypothesis, which suggests that people will try to decide whether or not a change of income is temporary. If they decide that it is, it has a small effect on their spending. Only when they become convinced that it is permanent will consumption change by a sizable amount. As is the case with all economic theory, this theory does not describe any particular household, but only what happens on the average.The life-cycle hypothesis introduced assets into the consumption function, and thereby gave a role to the stock market. A rise in stock prices increases wealth and thus should increase consumption while a fall should reduce consumption. Hence, financial markets matter for consumption as well as for investment. The permanent-income hypothesis introduces lags into the consumption function. An increase in income should not immediately increase consumption spending by very much, but with time it should have a greater and greater effect. Behavior that introduces a lag into the relationship between income and consumption will generate the sort of momentum that business-cycle theories saw. A change in spending changes income, but people only slowly adjust to it. As they do, their extra spending changes income further. An initial increase in spending tends to have effects that take a long time to completely unfold. The existence of lags also makes government attempts to control the economy more difficult. A change of policy does not have its full effect immediately, but only gradually. By the time it has its full effect, the problem that it was designed to attack may have disappeared. Finally, though the life-cycle and permanent-income hypotheses have greatly increased our understanding of consumption behavior, data from the economy does not always fit theory as well as it should, which means they do not provide a complete explanation for consumption behavior.

The idea of a propensity to consume, which had been formalised in textbooks as the Marginal propensity to consume (MPC) – which described the extra consumption that would follow a $ of extra disposable income, was thrown out by Friedman.

The MPC concept – that households consume only a proportion of each extra $1 in disposable income received – formed the basis of the expenditure multiplier. Accordingly, if government deficit spending of, say $100 million, was introduced into a recessed economy, firms would respond by increasing output and incomes by that same amount $100 million. But the extra incomes paid out ($100 m) would stimulate ‘induced consumption’ spending equal to the MPC times $100m. If the MPC was, say, 0.80 (meaning 80 cents of each extra dollar received as disposable income would be spent) then the ‘second-round’ effect of the stimulus would be an additional $80 million in consumption spending (assuming that disposable and total income were the same – that is, assuming away the tax effect for simplicity). In turn, firms would respond and produce an additional $80 million in output and incomes, which would then create further induced consumption effects. Each additional increment, smaller than the last, because the MPC of 0.80 would mean some of the extra disposable income was being lost to saving. But it was argued that the higher the MPC, the greater the overall impact of the stimulus would be. Instead, Friedman claimed that consumption was not driven by current income (or changes in it) but, rather by expected permanent income.

Permanent income becomes an unobservable concept driven by expectations. It also leads to claims that households smooth out their consumption over their lifetimes even though current incomes can fluctuate. So when individuals are facing major declines in their current income – perhaps due to unemployment – they can borrow short-term to maintain the smooth pattern of spending and pay the credit back later, when their current income is in excess of some average expectation.

The idea led to a torrent of articles mostly mathematical in origin trying to formalise the notion of a permanent income. They were all the same – GIGO – garbage in, garbage out. An exercise in mathematical chess although in search of the wrong solution. But Friedman was not one to embrace interdependence. In the ‘free market’ tradition, all decision makers were rational and independent who sought to maximise their lifetime utility. Accordingly, they would borrow when young (to have more consumption than their current income would permit) and save over their lifetimes to compensate when they were old and without incomes. Consumption was strictly determined by this notion of a lifetime income.

Only some major event that altered that projection would lead to changes in consumption.

The Permanent Income Hypothesis is still a core component of the major DSGE macro models that central banks and other forecasting agencies deploy to make statements about the effectiveness of fiscal and monetary policy.

So it matters whether it is a valid theory or not. It is not just one of those academic contests that stoke or deflate egos but have very little consequence for the well-being of the people in general. The empirical world hasn’t been kind to Friedman across all his theories. But the Permanent Income Hypothesis, in particular, hasn’t done well in explaining the dynamics of consumption spending.

Getting back to the paper mentioned in the beginning, it finds deployment of a rich dataset arguing to point where the permanent income hypothesis of Friedman is nailed to the coffin. If the permanent income hypothesis was a good framework for understanding what happens to the consumption patterns of this cohort then we would expect a lot of smoothing going on and relatively stable consumption.

Individuals, according to Friedman, are meant to engage in “self-insurance” to insure against calamity like unemployment. The evidence is that they do not.

The researchers reject what they call the “buffer stock model” (which is a version of the permanent income hypothesis).

They find:

1. “Spending drops sharply at the onset of unemployment, and this drop is better explained by liquidity constraints than by a drop in permanent income or a drop in work-related expenses.”

2. “We find that spending on nondurable goods and services drops by $160 (6%) over the course of two months.”

3. “Consistent with liquidity constraints, we show that states with lower UI benefits have a larger drop in spending at onset.” In other words, the fiscal stimulus coming from the unemployment benefits attenuates the loss of earned income somewhat.

4. “As UI benefit exhaustion approaches, families who remain unemployed barely cut spending, but then cut spending by 11% in the month after benefits are exhausted.”

5. As it turns out the “When benefits are exhausted, the average family loses about $1,000 of monthly income … In the same month, spending drops by $260 (11%).”

6. They compare the “path of spending during unemployment in the data to three benchmark models and find that the buffer stock model fits better than a permanent income model or a hand-to-mouth model.”

The buffer stock model assumes that families smooth their consumption after an income shock by liquidating previous assets – “a key prediction of buffer stock models is that agents accumulate precautionary savings to self-insure against income risk.”

The researchers find that the:

the buffer stock model has two major failures – it predicts substantially more asset holdings at onset and it predicts that spending should be much smoother at benefit exhaustion.

us_pih_study_2016

7. Finally, the researchers found “that families do relatively little self-insurance when unemployed as spending is quite sensitive to current monthly income.” Families “do not prepare for benefit exhaustion”.