Banking and Lending/Investment. How Monetary Policy Becomes Decisive? Some Branching Rumination.

the-state-of-global-monetary-policy-in-a-chart-and-a-map

Among the most notoriously pernicious effects of asset price inflation is that it offers speculators the prospect of gain in excess of the costs of borrowing the money to buy the asset whose price is being inflated. This is how many unstable Ponzi financing structures begin. There are usually strict regulations to prevent or limit banks’ direct investment in financial instruments without any assured residual liquidity, such as equity or common stocks. However, it is less easy to prevent banks from lending to speculative investors, who then use the proceeds of their loans to buy securities or to limit lending secured on financial assets. As long as asset markets are being inflated, such credit expansions also conceal from banks, their shareholders and their regulators the disintermediation that occurs when the banks’ best borrowers, governments and large companies, use bills and company paper instead of bank loans for their short-term financing. As long as the boom proceeds, banks can enjoy the delusion that they can replace the business of governments and large companies with good lending secured on stocks.

In addition to undermining the solvency of the banking system, and distracting commerce and industry with the possibilities of lucrative corporate restructuring, capital market inflation also tends to make monetary policy ineffective. Monetary policy is principally the fixing of reserve requirements, buying and selling short-term paper or bills in the money or inter-bank markets, buying and selling government bonds and fixing short-term interest rates. As noted in the previous section, with capital market inflation there has been a proliferation of short-term financial assets traded in the money markets, as large companies and banks find it cheaper to issue their own paper than to borrow for banks. This disintermediation has extended the range of short-term liquid assets which banks may hold. As a result of this it is no longer possible for central banks, in countries experiencing capital market inflation, to control the overall amount of credit available in the economy: attempts to squeeze the liquidity of banks in order to limit their credit advances by, say, open market operations (selling government bonds) are frustrated by the ease with which banks may restore their liquidity by selling bonds or their holdings of short-term paper or bills. In this situation central banks have been forced to reduce the scope of their monetary policy to the setting of short-term interest rates.

Economists have long believed that monetary policy is effective in controlling price inflation in the economy at large, as opposed to inflation of securities prices. Various rationalizations have been advanced for this efficacy of monetary policy. For the most part they suppose some automatic causal connection between changes in the quantity of money in circulation and changes in prices, although the Austrian School of Economists (here, here, here, and here) tended on occasion to see the connection as being between changes in the rate of interest and changes in prices.

Whatever effect changes in the rate of interest may have on the aggregate of money circulating in the economy, the effect of such changes on prices has to be through the way in which an increase or decrease in the rate of interest causes alterations in expenditure in the economy. Businesses and households are usually hard-headed enough to decide their expenditure and financial commitments in the light of their nominal revenues and cash outflows, which may form their expectations, rather than in accordance with their expectations or optimizing calculations. If the same amount of money continues to be spent in the economy, then there is no effective reason for the business-people setting prices to vary prices. Only if expenditure in markets is rising or falling would retailers and industrialists consider increasing or decreasing prices. Because price expectations are observable directly with difficulty, they may explain everything in general and therefore lack precision in explaining anything in particular. Notwithstanding their effects on all sorts of expectations, interest rate changes affect inflation directly through their effects on expenditure.

The principal expenditure effects of changes in interest rates occur among net debtors in the economy, i.e., economic units whose financial liabilities exceed their financial assets. This is in contrast to net creditors, whose financial assets exceed their liabilities, and who are usually wealthy enough not to have their spending influenced by changes in interest rates. If they do not have sufficient liquid savings out of which to pay the increase in their debt service payments, then net debtors have their expenditure squeezed by having to devote more of their income to debt service payments. The principal net debtors are governments, households with mortgages and companies with large bank loans.

With or without capital market inflation, higher interest rates have never constrained government spending because of the ease with which governments may issue debt. In the case of indebted companies, the degree to which their expenditure is constrained by higher interest rates depends on their degree of indebtedness, the available facilities for additional financing and the liquidity of their assets. As a consequence of capital market inflation, larger companies reduce their borrowing from banks because it becomes cheaper and more convenient to raise even short- term finance in the booming securities markets. This then makes the expenditure of even indebted companies less immediately affected by changes in bank interest rates, because general changes in interest rates cannot affect the rate of discount or interest paid on securities already issued. Increases in short-term interest rates to reduce general price inflation can then be easily evaded by companies financing themselves by issuing longer-term securities, whose interest rates tend to be more stable. Furthermore, with capital market inflation, companies are more likely to be over-capitalized and have excessive financial liabilities, against which companies tend to hold a larger stock of more liquid assets. As inflated financial markets have become more unstable, this has further increased the liquidity preference of large companies. This excess liquidity enables the companies enjoying it to gain higher interest income to offset the higher cost of their borrowing and to maintain their planned spending. Larger companies, with access to capital markets, can afford to issue securities to replenish their liquid reserves.

If capital market inflation reduces the effectiveness of monetary policy against product price inflation, because of the reduced borrowing of companies and the ability of booming asset markets to absorb large quantities of bank credit, interest rate increases have appeared effective in puncturing asset market bubbles in general and capital market inflations in particular. Whether interest rate rises actually can effect an end to capital market inflation depends on how such rises actually affect the capital market. In asset markets, as with anti-inflationary policy in the rest of the economy, such increases are effective when they squeeze the liquidity of indebted economic units by increasing the outflow of cash needed to service debt payments and by discouraging further speculative borrowing. However, they can only be effective in this way if the credit being used to inflate the capital market is short term or is at variable rates of interest determined by the short-term rate.

Keynes’s speculative demand for money is the liquidity preference or demand for short-term securities of rentiers in relation to the yield on long-term securities. Keynes’s speculative motive is ‘a continuous response to gradual changes in the rate of interest’ in which, as interest rates along the whole maturity spectrum decline, there is a shift in rentiers’ portfolio preference toward more liquid assets. Keynes clearly equated a rise in equity (common stock) prices with just such a fall in interest rates. With falling interest rates, the increasing preference of rentiers for short-term financial assets could keep the capital market from excessive inflation.

But the relationship between rates of interest, capital market inflation and liquidity preference is somewhat more complicated. In reality, investors hold liquid assets not only for liquidity, which gives them the option to buy higher-yielding longer-term stocks when their prices fall, but also for yield. This marginalizes Keynes’s speculative motive for liquidity. The motive was based on Keynes’s distinction between what he called ‘speculation’ (investment for capital gain) and ‘enterprise’ (investment long term for income). In our times, the modern rentier is the fund manager investing long term on behalf of pension and insurance funds and competing for returns against other funds managers. An inflow into the capital markets in excess of the financing requirements of firms and governments results in rising prices and turnover of stock. This higher turnover means greater liquidity so that, as long as the capital market is being inflated, the speculative motive for liquidity is more easily satisfied in the market for long-term securities.

Furthermore, capital market inflation adds a premium of expected inflation, or prospective capital gain, to the yield on long-term financial instruments. Hence when the yield decreases, due to an increase in the securities’ market or actual price, the prospective capital gain will not fall in the face of this capital appreciation, but may even increase if it is large or abrupt. Rising short-term interest rates will therefore fail to induce a shift in the liquidity preference of rentiers towards short-term instruments until the central bank pushes these rates of interest above the sum of the prospective capital gain and the market yield on long-term stocks. Only at this point will there be a shift in investors’ preferences, causing capital market inflation to cease, or bursting an asset bubble.

This suggests a new financial instability hypothesis, albeit one that is more modest and more limited in scope and consequence than Minsky’s Financial Instability Hypothesis. During an economic boom, capital market inflation adds a premium of expected capital gain to the market yield on long-term stocks. As long as this yield plus the expected capital gain exceed the rate of interest on short-term securities set by the central bank’s monetary policy, rising short-term interest rates will have no effect on the inflow of funds into the capital market and, if this inflow is greater than the financing requirements of firms and governments, the resulting capital market inflation. Only when the short-term rate of interest exceeds the threshold set by the sum of the prospective capital gain and the yield on long-term stocks will there be a shift in rentiers’ preferences. The increase in liquidity preference will reduce the inflow of funds into the capital market. As the rise in stock prices moderates, the prospective capital gain gets smaller, and may even become negative. The rentiers’ liquidity preference increases further and eventually the stock market crashes, or ceases to be active in stocks of longer maturities.

At this point, the minimal or negative prospective capital gain makes equity or common stocks unattractive to rentiers at any positive yield, until the rate of interest on short-term securities falls below the sum of the prospective capital gain and the market yield on those stocks. When the short-term rate of interest does fall below this threshold, the resulting reduction in rentiers’ liquidity preference revives the capital market. Thus, in between the bursting of speculative bubbles and the resurrection of a dormant capital market, monetary policy has little effect on capital market inflation. Hence it is a poor regulator for ‘squeezing out inflationary expectations’ in the capital market.

Why Should Modinomics Be Bestowed With An Ignoble Prize In Economics? Demonetization’s Spectacular Failure.

This lesson from history is quite well known:

Muhammad bin Tughlaq thought that may be if he could find an alternative currency, he could save some money. So he replaced the Gold and Silver coins with copper currency. Local goldsmiths started manufacturing these coins and which led to a loss of a huge sum of money to the court. He had to take his orders back and reissue Gold/Silver coins against those copper coins. This counter decision was far more devastating as people exchanged all their fake currency and emptied royal treasure.

And nothing seems to have changed ideatically even after close to 800 years since, when another bold and bald move or rather a balderdash move by the Prime Minister of India Narendra Modi launched his version of the lunacy. Throw in Demonetization and flush out black money. Well, that was the reason promulgated along with a host of other nationalistic-sounding derivatives like curbing terror funding, expanding the tax net, open to embracing digital economy and making the banking system more foolproof by introducing banking accounts for the millions hitherto devoid of any. But, financial analysts and economists of the left of the political spectrum saw this as brazen porto-fascistic move, when they almost unanimously faulted the government for not really understanding the essence of black money. These voices of sanity were chased off the net, and chided in person and at fora by paid trolls of the ruling dispensation, who incidentally were as clueless about it as about their existence. Though, some other motives of demonetization were smuggled in in feeble voices but weren’t really paid any heed to for they would have sounded the economic disaster even back then. And these are the contraband that could give some credibility to the whole exercise even though it has turned the world’s fastest-growing emerging economy (God knows how it even reached that pinnacle, but, so be it!) into a laughing stock of a democratically-elected dictatorial regime. What is the credibility talked about here? It was all about smashing the informal economy (which until the announcement of November 8 contributed to 40% of the GDP and had a workforce bordering on 90% of the entire economy) to smithereens and sucking it into the formal channel through getting banking accounts formalized. Yes, this is a positive in the most negative sense, and even today the government and whatever voices emanate from Delhi refuse to consider it as a numero uno aim.

Fast forward by 3 (period of trauma) + 8 (periods of post-trauma) months and the cat is out of the bag slapping the government for its hubris. But a spectacular failure it has turned out to be. The government has refused to reveal the details of how much money in banned notes was deposited back with the RBI although 8 months have passed since the window of exchange closed in January this year. Despite repeated questioning in Parliament, Supreme Court and through RTIs, the govt. and RBI has doggedly maintained that old banned notes were still being counted. In June this year, finance minister Arun Jaitley claimed that each note was being checked whether it was counterfeit and that the process would take “a long time”. The whole country had seen through these lies because how can it take 8 months to count the notes. Obviously there was some hanky panky going on. Despite statutory responsibility to release data related to currency in circulation and its accounts, the RBI too was not doing so for this period. They were under instructions to fiddle around and not reveal the truth. Consider the statistics next:

As on November 8, 2016, there were 1716.5 crore piece of Rs. 500 and 685.8 crore pieces of Rs. 1000 circulating the economy totaling Rs. 15.44 lakh crore. The Reserve Bank of India (RESERVE BANK OF INDIA ANNUAL REPORT 2016-17), which for a time as long as Urjit Patel runs the show has been criticized for surrendering the autonomy of the Central Bank to the whims and fancies of PM-run circus finally revealed that 99% of the junked notes (500 + 1000) have returned to the banking system. This revelation has begun to ricochet the corridors of power with severe criticisms of the government’s move to flush out black money and arrest corruption. When the RBI finally gave the figures through its annual report for 2016-17, it disclosed that Rs. 15.28 lakh crore of junked currency had formally entered the banking system through deposits, thus leaving out a difference of a mere (yes, a ‘mere’ in this case) Rs. 16,050 crore unaccounted for money. Following through with more statistics, post-demonetization, the RBI spent Rs. 7,965 crore in 2016-17 on printing new Rs. 500 and Rs. 2000 notes in addition to other denominations, which is more than double the Rs. 3,421 crore spent on printing new notes in the previous year. Demonetization, that was hailed as a step has proved to be complete damp squib as the RBI said that just 7.1 pieces of Rs. 500 per million in circulation and 19.1 pieces of Rs. 1000 per million in circulation were discovered to be fake further implying that if demonetization was also to flush pout counterfeit currency from the system, this hypothesis too failed miserably.

Opposition was quick to seize on the data with the former Finance minister P Chidambaram tweeting:

Untitled

He further lamented that with 99% of the currency exchanged, was demonetization a scheme designed to convert black money to white? Naresh Agarwal of Samajwadi Party said his party would move privilege motion against Urjit Patel for misleading a Parliamentary Panel on the issue.

But, what of the immense collateral damage that the exercise caused? And why is the government still so shameless in protecting a lunacy? Finance Minister Arun Jaitley on asserted that any attempt to measure the success of the government’s demonetization exercise on the basis of the amount of money that stayed out of the system was flawed since the confiscation of money had not been the objective. He maintained that the government had met its principal objectives of reducing the reliance on cash in the economy, expanding the tax base and pushing digitisation. Holy Shit! And he along with his comrades is selling and marketing this crap and sadly the majority would even buy into this. Let us hear him out on the official position:

Denying that demonetisation failed to achieve its objectives, Finance Minister Arun Jaitley said the measure had succeeded in reducing cash in the economy, increasing digitisation, expanding the tax base, checking black money and in moving towards integrating the informal economy with the formal one. “The objective of demonetisation was that India is a high-cash economy and that scenario needs to be altered,” Jaitley told following the release of the Reserve Bank of India’s (RBI) annual report for the last fiscal giving the figures, for the first time, of demonetised notes returned to the system. The RBI said that of the Rs 15.44 lakh crore of notes taken out of circulation by the demonetisation of Rs 500 and Rs 1,000 notes last November, Rs 15.28 lakh crore, or almost 99 per cent, had returned to the system by way of deposits by the public.”The other objectives of demonetisation were to combat black money and expand the tax base. Post demonetisation, tariff tax base has increased substantially. Personal IT returns have increased by 25 per cent,” the Finance Minister said. “Those dealing in cash currency have now been forced to deposit these in banks, the money has got identified with a particular owner,” he said. “Expanding of the indirect tax base is evident from the results of the GST collections, which shows more and more transactions taking place within the system,” he added. Jaitley said the government has collected Rs 92,283 crore as Goods and Services Tax (GST) revenue for the first month of its roll-out, exceeding the target, while 21.19 lakh taxpayers are yet to file returns. Thus, the July collections target have been met with only 64 per cent of compliance. “The next object of demonetisation is that digitisation must expand, which climaxed during demonetisation and we are trying to sustain that momentum even after remonetisation is completed. Our aim was that the quantum of cash must come down,” Jaitley said. He noted in this regard that RBI reports that the volume of cash transactions had reduced by 17 per cent post-demonetisation. A Finance Ministry reaction to the RBI report said a significant portion of the scrapped notes deposited “could possibly be representing unexplained/black money”. “Accordingly, ‘Operation Clean Money’ was launched on 31st January 2017. Scrutiny of about 18 lakh accounts, prima facie, did not appear to be in line with their tax profile. These were identified and have been approached through email/sms. “Jaitley slammed his predecessor P. Chidambaram for his criticism of the note ban, saying those who had not taken a single step against black money were trying to confuse the objectives of the exercise with the amount of currency that came back into the system. The Finance Ministry said transactions of more than three lakh registered companies are being scrutinised, while one lakh companies have been “struck off the list”. “The government has already identified more than 37,000 shell companies which were engaged in hiding black money and hawala transactions. The Income-tax Directorates of Investigation have identified more than 400 benami transactions up to May 23, 2017, and the market value of properties under attachment is more than Rs 600 crore,” it said. “The integration of the informal with the formal economy was one of the principle objectives of demonetisation,” Jaitley said. He also said that demonetisation had dealt a body blow to terrorist and Maoist financing that was evident from the situation on the ground in Chhattisgarh and Jammu and Kashmir. One thing is for sure: more and more of gobbledygook is to follow.

One of the major offshoots of the demonetisation drive was a push towards a cashless, digital economy. Looking at the chart below, where there is presented the quantum of cashless transactions in some of the major economies of the world…one could only see India’s dismal position. Just about 2% of the volume of economic transactions in India are cashless.

12052016-Volume-equitymaster

Less cash would mean less black money…less corruption…and more transparency. Is it? Assuming it is, how far the drive would go on driving? But was India really ready to go digital? There were 5.3 bank branches per one lakh Indians in rural India 15 years ago. On the eve of demonetization, the figure stood at 7.8 bank branches per one lakh Indians. This shows that a majority of rural India has very little access to banks and the organized financial sector. They rely heavily on cash and the informal credit system. Then, we have just 2.2 lakh ATMs in the country. For a population of over 1.2 billion people, that’s a very small number. And guess what? A majority of ATMs are concentrated in metros and cities. For instance, Delhi has more ATMs than the entire state of Rajasthan. Given the poor penetration of banks and formal sector financial services in rural India, Modi’s cashless economy ambitions were always a distant dream. Then there are issues of related to security. Were the banks and other financial institutions technologically competent to tackle the security issues associated with the swift shift towards a digital economy? Can the common man fully trust that his hard earned money in the financial system will be safe from hackers and fraudsters? And the answer does not seem be a comforting one!

“Those dealing in cash currency have now been forced to deposit these in banks, the money has got identified with a particular owner” So surveillance was the reason. Makes sense why they are so desperate to link aadhaar to bank accounts. Some researchers have considered couple of factors which have actually caused demonetization in India. First one includes the refinancing of public sector banks in India. 80% of banks in India are run by government, during the last two decades these banks have been used to lend out loans to corporations which stink of cronyism. These politically-affiliated businesses did not pay back their money which has resulted into the accumulation of huge amount of non-performing assets (NPAs) within these banks. From last three years warning signals were continuously coming about their collapse. Through demonetization millions of poor people have deposited their meagre sums within these banks which have resulted into their refinancing, so that they can now lend the money to the same guys who earlier do not paid back their loans. sounds pretty simplistic, right? Sad, but true, it is this simple. The second factor is the influence of technological and communications companies on the government, as these companies are among the fastest growing ones during the last two decades. Making payments through digital gate ways will be very beneficial for their growth. They can expand their influence over the whole human race. The statements from technological giants like Apple, Microsoft, MasterCard, Facebook, Google etc. clearly shows their intentions behind cashless society. Tim Cook the chief executive of Apple said that “next generation of children will not know what money is” as he promotes “apple pay” as an alternative. MasterCard executives consider apple pay as another step towards cashless society. MasterCard is mining Facebook users data to get consumer behaviour information which it can sell to banks. Bill gates said India will shift to digital payments, as the digital world lets you track things quickly. The acquisition of artificial intelligence companies by Google, Facebook and Microsoft is also on its peak. Over 200 private companies using AI algorithms across different verticals have been acquired since 2012, with over 30 acquisitions taking place in Q1 of 2017 alone. Apple acquired voice recognition firm “Vocal IQ and real face Google has acquired deep learning and neural network, Facebook acquired Masquerade Technologies and Zurich Eye. So what is actually going on, as private corporations and governments are desperate to introduce cashless economy through biometric payment system.

No black money was unearthed by Modi’s historic folly. Terrorism has also not gone down after demonetization and neither has circulation of counterfeit currency. So, it was a failure on all counts, a point that has been predicted by economists worldwide. What the note ban did was cause untold suffering and misery to common people, destroy livelihoods of millions of wage workers, caused bankruptcy to farmers because prices of their produce crashed and disrupted the economic life of the whole country. The only people who benefited from the note bandi were companies that own digital payment systems (like PayTM, MobiKwik etc.) and credit card companies. It also seems now that ultimately, the black money owners have benefited because they managed to convert all their black wealth in to white using proxies.