Infrastructure and Asian Infrastructure and Investment Bank. Some Scattered Thoughts.

What is Infrastructure?

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Infrastructure, though definitionally an elusive term, encompasses an economic standpoint consisting of large capital intensive natural monopolies. The term attains it heterogeneity by including physical structures of various types used by many industries as inputs to the production of goods and services. By this, it has come to mean either social, or economic infrastructure, wherein, in the former, are schools, hospitals etc, while in the latter are energy, water, transport, and digital communications, often considered essential ingredients in the success of the modern economy. Conceptually, infrastructure may affect aggregate output in two main ways: (i) directly, considering the sector contribution to GDP formation and as an additional input in the production process of other sectors; and (ii) indirectly, raising total factor productivity by reducing transaction and other costs thus allowing a more efficient use of conventional productive inputs. Infrastructure can be considered as a complementary factor for economic growth. How big is the contribution of infrastructure to aggregate economic performance? The answer is critical for many policy decisions – for example, to gauge the growth effects of fiscal interventions in the form of public investment changes, or to assess if public infrastructure investments can be self-financing.

Let us ponder on this a bit and begin with the question. Why is infrastructure even important? Extensive and efficient infrastructure is critical for ensuring the effective functioning of the economy, as it is an important factor determining the location of economic activity and the kinds of activities or sectors that can develop in a particular economy. Well-developed infrastructure reduces the effect of distance between regions, integrating the national market and connecting it at low cost to markets in other countries and regions. In addition, the quality and extensiveness of infrastructure networks significantly impact economic growth and affect income inequalities and poverty in a variety of ways. A well-developed transport and communications infrastructure network is a prerequisite for the access of less-developed communities to core economic activities and services. Effective modes of transport, including quality roads, railroads, ports, and air transport, enable entrepreneurs to get their goods and services to market in a secure and timely manner and facilitate the movement of workers to the most suitable jobs. Economies also depend on electricity supplies that are free of interruptions and shortages so that businesses and factories can work unimpeded. Finally, a solid and extensive communications network allows for a rapid and free flow of information, which increases overall economic efficiency by helping to ensure that businesses can communicate and decisions are made by economic actors taking into account all available relevant information. There is an existing correlation between infrastructure and economic activity through which the economic effects originate in the construction phase and rise during the usage phase. The construction phase is associated with the short-term effects and are a consequence of the decisions in the public sector that could affect macroeconomic variables: GDP, employment, public deficit, inflation, among others. The public investment expands the aggregate demand, yielding a boost to the employment, production and income. The macroeconomic effects at a medium and long term, associated with the utilization phase are related to the increase of productivity in the private sector and its effects over the territory. Both influence significantly in the competitiveness degree of the economy. In conclusion, investing in infrastructure constitutes one of the main mechanisms to increase income, employment, productivity and consequently, the competitiveness of an economy. Is this so? Well, thats what the economics textbook teaches us, and thus governments all over the world turn to infrastructure development as a lubricant to maintain current economic output at best and it can also be the basis for better industry which contributes to better economic output. Governments, thus necessitate realignment of countries’ infrastructure in tune with the changing nature of global political economy. Infrastructure security and stability concerns the quantity of spare capacity (or security of supply). Instead of acting on the efficiency frontier, infrastructure projects must operate with spare capacity to contribute to economic growth through ensuring reliable service provisions. Spare capacity is a necessary condition for a properly functioning system. To assure the level of spare capacity in the absence of storage and demand, the system needs to have excess supply. However, no rational profit-seeker will deliberately create conditions of excess supply, since it would produce a marginal cost lower than the average cost, and to circumnavigate this market failure, governments are invested with the responsibility of creating incentives ensuring securities of supply. This is seeding the substitutability of economics with financialization. 

So far, so good, but then, so what? This is where social analysts need to be incisive in unearthing facts from fiction and this faction is what constitutes the critique of development, a critique that is engineered against a foci on GDP-led growth model. This is to be done by asking uncomfortable questions to policy-makers, such as: What is the most efficient way to finance infrastructure spending? What are optimal infrastructure pricing, maintenance and investment policies? What have proven to be the respective strengths and weaknesses of the public and private sectors in infrastructure provision and management, and what shapes those strengths and weaknesses? What are the distributional consequences of infrastructure policies? How do political forces impact the efficiency of public sector provision? What framework deals best with monopoly providers of infrastructure? For developing countries, which have hitherto been plagued by weaker legal systems making regulation and enforcement more complicated, the fiscally weak position leads to higher borrowing costs. A most natural outcome is a systemic increase in financial speculation driven by deregulation transforming into financial assets. Contrary to common sense and what civil society assumes, financial markets are going deeper and deeper into the real economy as a response to the financial crisis, so that speculative capital is structurally being intertwined with productive capital changing the whole dynamics of infrastructure investment. The question then is, how far viable or sustainable are these financial interventions? Financialization produces effects which can create long-term trends (such as those on functional income distribution) but can also change across different periods of economic growth, slowdown and recession. Interpreting the implications of financialization for sustainability, therefore, requires a methodological diverse and empirical dual-track approach which combines different methods of investigations. Even times of prosperity, despite their fragile and vulnerable nature, can endure for several years before collapsing due to high levels of indebtedness, which in turn amplify the real effects of a financial crisis and hinder the economic growth. 

Role of Development Banks and AIIB

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Where do development banks fit into the schema as regards infrastructure investment? This question is a useful gamble in order to tackle AIIB, the new kid on the bloc. As the world struggles to find funds to meet the Sustainable Development Goals (SDGs), development banks could be instrumental in narrowing the gap. So, goes the logic promulgated by these banks. They can help to crowd-in the private sector and anchor private-public sector partnerships, particularly for infrastructure financing. However, misusing development banks can lead to fiscal risks and credit market distortions. To avoid these potential pitfalls, development banks need a well-defined mandate, operate without political influence, focus on addressing significant market failures, concentrate on areas where the private sector is not present, monitor and evaluate interventions and adjust as necessary to ensure impact, and, finally, be transparent and accountable. All of these are the ideals, which more often than not go the other way. China-led Asian Infrastructure Investment Bank (AIIB), despite having no track record still enjoys the highest ratings on par with the World Bank. This has fueled debates ranging from adding much-needed capital augmenting infrastructure to leniency in observing high standards of governance, and possibly ignoring environmental and societal impacts.

The AIIB was officially launched in Beijing on January 16th, 2016, with 57 founding members, including 37 in Asia and 20 non-regional countries. Being the largest shareholder of the AIIB, China has an initial subscription of $29.78 billion in authorized capital stock in the AIIB out of a total of $100 billion, and made a grant contribution of another $50 million to the AIIB Project Preparation Special Fund on January 16th, 2017. India is the second-largest shareholder, contributing $8.4 billion. Russia is the third-largest shareholder, contributing $6.5 billion, and Germany is the largest non-regional shareholder (also the fourth largest shareholder), contributing $4.5 billion. While being open to the participation of non-regional members, the AIIB is committed to and prioritizes the ownership of Asian members. This is reflected in the capital structure requirement and the requirements for the composition of Board of Governors in the AIIB’s Article of Agreement (AOA), which requires no less than 75 percent of the total subscribed capital stock to be held by regional members unless otherwise agreed by the Board of Governors by a Super Majority vote. The AOA also requires that 9 out of the AIIB’s 12 members be elected by the Governors representing regional members, and 3 representing non-regional members. The prioritization of Asian-members’ ownership of the AIIB does not necessarily mean that the AIIB’s investment is restricted only to Asia. According to its AOA, the AIIB aims to “improve infrastructure connectivity in Asia,” and it will invest in Asia and beyond as long as the investment is “concerned with economic development of the region.” The bank currently has 64 member states while another 20 are prospective members for a total of 84 approved members. 

The AIIB’s EU/OECD members potentially could have some positive influence over the institutional building and standard setting of the young institution. The European Commission has recognized that an EU presence in China-driven institutions would contribute to the adoption of best practices and fair, global standards. Adherence to such standards will be promoted by the AIIB entering into partnership with existing Multilateral Development Banks. It has also been argued that joining the AIIB would give the European countries access to the decision-making process within the AIIB, and may even allow the European countries to play a role in shaping the AIIB’s organizational structure. As an example of EU/OECD members’ activism in monitoring the AIIB’s funds allocation, both Denmark and the UK, who are AIIB’s OECD members, proposed that contributions to the AIIB would qualify as official development aid (ODA). After a thorough review of AIIB’s AOA, mandate, work plan and other available materials, the OECD’s Secretariat of the Development Assistance Committee (DAC) recommended including AIIB on the List under the category of “Regional development banks,” which means the OECD would recognize the AIIB as one of the ODA-eligible international organizations. Once approved, the Secretariat of DAC will be able to “monitor the future recipient breakdown of the AIIB’s borrowers through AIIB’s future Creditor Reporting System and thereby confirm that the actual share of funds going to countries on the DAC List of ODA Recipients is over 90%.” That is to say, if approved, there would be additional external monitor to make sure that the funds channeled through the AIIB to recipient countries are used properly. 

The AIIB’s initial total capital is $100 billion, equivalent to about 61 percent of the ADB’s initial total capital, 43 percent of the World Bank’s, 30 percent of the European Investment Bank’s (EIB), and more than twice of the European Bank for Reconstruction and Development’s (EBRD). Of this $100 billion initial capital, 20 percent is to be largely paid-in by 2019 and fully paid-in by 2024, and the remaining 80 percent is in callable capital. It needs to be noted that according to the AOA, payments for paid-in capital are due in five installments, with the exception of members designated as less developed countries, who may pay in ten installments. As of any moment, the snapshot of AIIB’s financial sheet includes total assets, members’ equities and liabilities, the last of which has negligible debt at the current stage since the AIIB has not issued any debenture or borrowed money from outside. However, to reduce the funding costs and to gain access to wider source of capital, the AIIB cannot rely solely on equity and has to issue debenture and take some leverage, particularly given that the AIIB intends to be a for-profit institution. In February 2017, the AIIB signed an International Swaps and Derivatives Association (ISDA) Master Agreement with the International Finance Corporation (IFC), which would facilitate local currency bond issuance in client countries. Moreover, AIIB intends to actively originate and lead transactions that mobilize private capital and make it a trusted partner for all parties involved in the transactions that the Bank leads. In the long term, the AIIB aims to be the repository of know-how and best practices in infrastructure finance. 

It is widely perceived that the AIIB is a tool of Chinese foreign policy, and that it is a vehicle for the implementation of the Belt and Road (One Belt, One Road) Initiative. During a meeting with global executives in June 2016, the AIIB President Jin Liqun clarified China’s position, saying the AIIB “was not created exclusively for this initiative,” and that the AIIB would “finance infrastructure projects in all emerging market economies even though they don’t belong to the Belt and Road Initiative.” It is worth pointing out that despite the efforts on trying to put some distance between the AIIB and the Belt and Road Initiative, there is still a broad perception that these two are closely related. Moreover, China has differentiated AIIB projects from its other foreign assistance projects by co-financing its initial projects with the preexisting MDBs. Co-financing, combined with European membership, will make it more likely this institution largely conforms to the international standards” and potentially will steer the AIIB away from becoming solely a tool of Chinese foreign policy. This supports China’s stated intention to complement existing MDBs rather than compete with them. It also means that the AIIB can depend on its partners, if they would allow so, for expertise on a wide range of policy and procedural issues as it develops its lending portfolio.

Although AIIB has attracted a great number of developing and developed countries to join as members and it has co-financed several projects with other MDBs, there is no guarantee for any easy success in the future. There are several formidable challenges for the young multilateral institution down the road. Not all the infrastructure investment needs in Asia is immediately bankable and ready for investors’ money. Capital, regardless it’s sovereign or private, will not flow in to any project without any proper preparation. Although Asia faces a huge infrastructure financing gap, there is a shortage of ‘shovel-ready’ bankable projects owing to the capacity limitations. The young AIIB lacks the talent and expertise to create investor-ready bankable projects, despite that it has created a Project Preparation Special Fund thanks to $50 million by China. The AIIB aims to raise money in global capital markets to invest in the improvement of trans-regional connectivity. However, infrastructure projects are not naturally attractive investment due to huge uncertainties throughout the entire life cycle as well as unjustified risk-profit balance. Getting a top-notch credit rating is just a start. The AIIB has to find innovative ways to improve the risk-adjusted profitability of its projects. This issue itself has been a big challenge for many MDBs who engage in infrastructure financing for a long time. It is uncertain if the AIIB could outperform the other much more matured MDBs to find a solution to tackle the profitability problem in infrastructure financing. The highest rating it has received from ratings agencies could pose a challenge in itself. The high rating not only endorses the bank’s high capital adequacy and robust liquidity position, but also validates the strong political will of AIIB’s members and the bank’s governance frameworks. A good rating will help the AIIB issue bonds at favorable rate and utilize capital markets to reduce its funding costs. This certainly will contribute to AIIB’s efforts to define itself as a for-profit infrastructure investment bank. However, there is no guarantee that the rating will hold forever. Many factors may impact the rating in the future, including but not limited to AIIB’s self-capital ratio, liquidity, management, yieldability, risk management ability, and its autonomy and independency from China’s influence. 

Indecent Bazaars. Thought of the Day 113.0

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Peripheral markets may be defined as markets which generate only a small proportion of their financial inflows from local business and investors, but which attract the interest of ‘global’ investors. Emerging markets and markets for financial exotica such as financial derivatives are examples of such peripheral markets. Because emerging markets are largely dependent upon attracting international funds in order to generate increases in securities prices and capital gains which will attract further funds, they are particularly good examples of the principles of Ponzi finance at work in securities markets.

A common characteristic feature of peripheral markets is that they have no history of returns to financial investment on the scale on which finance is drawn to those markets in a time of capital market inflation. Such returns in the future have to be inferred on the basis of conjecture and fragmentary information. Investment decisions are therefore more dependent on sentiment, rather than reason. Any optimism is quickly justified by the rapid increase in asset prices in response to even a modest excess net inflow of money into such a market.

Emerging markets illustrate this very clearly. Such markets exist in developing and semi-industrialized countries with relatively undeveloped pensions and insurance institutions, principally because only a small proportion of households earn enough to be able to put aside long-term savings. The first fund manager comes upon such a market in the conviction that a change of government or government policy, or some temporary change in commodity prices, has opened a cornucopia of profitable opportunities and therefore warrants the dismissal of a history of economic, financial and political instability. If he or she is able with buying and enthusiasm to attract other speculators and fund managers to enter the market, they may drive up asset prices and make the largest capital gains. The second and third fund managers to buy into that market also make capital gains. The emulatory competition of trading on reputation while competing for returns makes international investment managers especially prone to this kind of ‘herd’ investment.

For a while such capital inflows into the market make everyone happy: international fund managers are able to show good returns from the funds in their care; finance theorists can reassure themselves that greater financial risks are compensated by higher returns; the government of the country in which the emerging market is located can sell its bonds and public sector enterprises to willing foreign investors and use the proceeds to balance its budget and repay its debts; the watchdogs of financial prudence in the International Monetary Fund can hail the revival of finance, the government’s commitment to private enterprise and apparent fiscal responsibility; state enterprises, hitherto stagnating because of under-investment by over-indebted governments, suddenly find themselves in the private sector commanding seemingly limitless opportunities for raising finance; the country’s currency after years of depreciation acquires a gilt-edged stability as dollars (the principal currency of international investment) flow in to be exchanged for local currency with which to buy local securities; the central bank accumulates dollars in exchange for the local currency that it issues to enable foreign investors to invest in the local markets and, with larger reserves, secures a new ease in managing its foreign liabilities; the indigenous middle and professional classes who buy financial and property (real estate) assets in time for the boom are enriched and for once cease their perennial grumbling at the sordid reality of life in a poor country. In this conjuncture the most banal shibboleths of enterprise and economic progress under capitalism appear like the very essence of worldly wisdom.

Only in such a situation of capital market inflation are the supposed benefits of foreign direct investment realized. Such investment by multinational companies is widely held to improve the ‘quality’ or productivity of local labour, management and technical know-how in less developed countries, whose technology and organization of labour lags behind that of the more industrialized countries. But only the most doltish and ignorant peasant would not have his or her productivity increased by being set to work with a machine of relatively recent vintage under the guidance of a manager familiar with that machine and the kind of work organization that it requires. It is more doubtful whether the initial increase in productivity can be realized without a corresponding increase in the export market (developing countries have relatively small home markets). It is even more doubtful if the productivity increase can be repeated without the replacement of the machinery by even newer machinery.

The favourable conjuncture in the capital markets of developing countries can be even more temporary. There are limits on the extent to which even private sector companies may take on financial liabilities and privatization is merely a system for transferring such liabilities from the government to the private sector without increasing the financial resources of the companies privatized. But to sustain capital gains in the emerging stock market, additional funds have to continue to flow in buying new liabilities of the government or the private sector, or buying out local investors. When new securities cease to attract international fund managers, the inflow stops. Sometimes this happens when the government privatization drive pauses, because the government runs out of attractive state enterprises or there are political and procedural difficulties in selling them. A fall in the proceeds from privatization may reveal the government’s underlying fiscal deficit, causing the pundits of international finance to sense the odour of financial unsoundness. More commonly rising imports and general price inflation, due to the economic boom set off by the inflow of foreign funds, arouse just such an odour in the noses of those pundits. Such financial soundness is a subjective view. Even if nothing is wrong in the country concerned, the prospective capital gain and yield in some other market need only rise above the expected inflation and yield of the country, to cause a capital outflow which will usually be justified in retrospect by an appeal to perceived, if not actual, financial disequilibrium.

Ponzi financial structures are characterized by ephemeral liquidity. At the time when money is coming into the markets they appear to be just the neo-classical ideal of market perfection, with lots of buyers and sellers scrambling for bargains and arbitrage profits. At the moment when disinvestment takes hold the true nature of peripheral markets and their ephemeral liquidity is revealed as trades which previously sped through in the frantic paper chase for profits are now frustrated. This too is particularly apparent in emerging markets. In order to sell, a buyer is necessary. If the majority of investors in a market also wish to sell, then sales cannot be executed for want of a buyer and the apparently perfect market liquidity dries up. The crash of the emerging stock market is followed by the fall in the exchange value of the local currency. Those international investors that succeeded in selling now have local currency which has to be converted into dollars if the proceeds of the sale are to be repatriated, or invested elsewhere. Exchange through the local banking system may now be frustrated if it has inadequate dollar reserves: a strong possibility if the central bank has been using dollars to service foreign debts. In spite of all the reassurance that this time it will be different because capital inflows are secured on financial instruments issued by the private sector, international investors are at this point as much at the mercy of the central bank and the government of an emerging market as international banks were at the height of the sovereign debt crisis. Moreover, the greater the success of the peripheral market in attracting funds, and hence the greater the boom in prices in that market, the greater is the desired outflow when it comes. With the fall in liquidity of financial markets in developing countries comes a fall in the liquidity of foreign direct investment, making it difficult to secure appropriate local financial support or repatriate profits.

Another factor which contributes to the fragility of peripheral markets is the opaqueness of financial accounting in them, in the sense that however precise and discriminating may be the financial accounting conventions, rules and reporting, they do not provide accurate indicators of the financial prospects of particular investments. In emerging markets this is commonly supposed to be because they lack the accounting regulations and expertise which supports the sophisticated integrated financial markets of the industrialized countries. In those industrialized countries, where accounting procedures are supposed to be much more transparent, peripheral markets such as venture capital and financial futures still suffer from accounting inadequacies because financial innovation introduces liabilities that have no history and which are not included in conventional accounts (notably the so-called ‘off-balance sheet’ liabilities). More important than these gaps in financial reporting is the volatility of profits from financial investment in such peripheral markets, and the absence of any stable relationship between profits from trading in their instruments and the previous history of those instruments or the financial performance of the company issuing them. Thus, even where financial records are comprehensive, accurate and revealed, they are a poor indicator of prospective returns from investments in the securities of peripheral markets.

With more than usually unreliable financial data, trading in those markets is much more based on reputation than on any systematic financial analysis: the second and third investor in such a market is attracted by the reputation of the first and subsequently the second investor. Because of the direct connection between financial inflows and values in securities markets, the more trading takes place on the basis of reputation the less of a guide to prospective returns is afforded by financial analysis. Peripheral markets are therefore much more prone to ‘ramping’ than other markets.

Why would such a crisis of withdrawal not occur, at least not on such a scale, in the more locally integrated capital markets of the advanced industrialised countries? First of all, integrated capital markets such as those of the UK, and the US are the domestic base for international investors. In periods of financial turbulence, they are more likely to have funds repatriated to them than to have funds taken out of them. Second, institutional investors tend to be more responsive to pressure to be ‘responsible investors’ in their home countries. In large measure this is because home securities make up the vast majority of investment fund portfolios. Ultimately, investment institutions will use their liquidity to protect the markets in which most of their portfolio is based. Finally, the locally integrated markets of the advanced industrialized countries have investing institutions with far greater wealth than the developing or semi-industrialized countries. Those markets are home for the pension funds which dominate the world markets. Among their wealth are deposits and other liquid assets which may be easily converted to support a stock market by buying securities. The poorer countries of the world have even poorer pension funds, which could not support their markets against an outflow due to portfolio switches by international investors.

Thus integrated markets are more ‘secure’ in that they are less prone to collapse than emerging or, more generally, peripheral markets. But precisely because of the large amount of trade already concentrated in the integrated markets, prices in them are much less likely to respond to investment fund inflows from abroad. Pension and insurance fund practice is to extrapolate those capital gains into the future for the purposes of determining the solvency of those funds. However, those gains were obtained because of a combination of inflation, the increased scope of funded pensions and the flight of funds from peripheral markets.

Ramping the Markets: Banking on Ponzi Finance. Thought of the Day 112.0

China Minsky

When funded pension schemes were first put forward at the beginning of the 1970s as a private sector alternative to state earnings-related pensions, the merchant (investment) banks and stockbroking firms that promoted them did not anticipate how successful they would become in that, by the following decades, pension schemes and allied forms of life assurance would come to own most of the stocks and shares quoted on the world’s stock markets. When pension funds held a minority of stocks, the funds could altogether put money into stock markets by buying stocks, or withdraw it by selling, without significantly affecting prices or the liquidity of the market as a whole. Now that pension funds and allied life assurance and mutual funds constitute the majority of the market, it is not possible for them to withdraw funds altogether without causing a fall in prices, or even a stock market crash.

Because of their success, pension funds have become the newest and possibly the most catastrophic example of Ponzi finance. The term Ponzi finance was invented by the American economist Hyman P. Minsky as part of his analysis of financial market inflation. It describes a form of finance in which new liabilities are issued to finance existing liabilities. According to Minsky, financial crises are caused by the collapse of ‘financial structures’ whose failure is precipitated by their increasing ‘financial fragility’. Financial structures are simply commitments to make payments in the future, against claims that result in incoming payments in the future. For Minsky, the characteristic feature of financial markets and financial speculation is that they afford opportunities for economic units to enter into future financial commitments, in the expectation of gain. In this respect, at least, they are similar to fixed capital investment. Success in securing gains persuades speculators to enter into further commitments, which become more ‘fragile’, i.e., more prone to collapse because future commitments become more speculative and less covered by assured financial inflows.

Minsky identifies three types of financial commitments, which are distinguished by the different degree of financial risk that they entail. In hedge finance, future commitments are exactly matched by cash inflows. A common example is the practice in banking of lending at variable or floating rates of interest. In this way, if a bank has to pay more interest to its depositors, it can recoup the increase by raising the interest rates that it charges to its borrowers (assuming that its depositors cannot withdraw their deposits before the term of the loan expires).

Speculative finance is characterized by certain commitments which have to be covered by cash inflows which may rise or fall, or uncertain commitments against a fixed cash inflow. If a bank lends money at a fixed rate of interest it is engaging in speculative finance, because it is running the risk that it may have to pay a higher rate of interest to depositors if interest rates rise. However, to set against this risk it has the possibility that the interest rates paid to depositors may fall, and it will thereby make additional gains from a wider margin between lending and borrowing rates.

Ponzi finance, in Minsky’s view, is a situation in which both commitments and cash inflows are uncertain, so that there is a possibility of an even more enhanced profit if commitments fall and the cash inflow rises. Against this has to be set the possibility that commitments and the cash inflow will move together so that only a minimal profit will be secured, or that commitments will rise and the cash inflow will fall, in which case a much more serious loss will be entered than would have occurred under speculative finance.

Ponzi finance lies behind the view that is no less erroneous for being widely repeated, that a higher return reflects the ‘greater risk’ of an enterprise. This is exemplified in the practice of banks charging higher rates of interest for what they perceive as greater risks. Behind this view lies the Austrian tradition, from Böhm-Bawerk onwards, of regarding economic outcomes as analogous to the gains and lotteries obtainable from repeated routine games, such as the tossing of a dice. The certain pay-off (or ‘certainty-equivalent’) is held to be lower than some possible pay-off. The association of the greater payoff with its lower probability then leads to a presumption that the latter ‘causes’ the former. However, the profits of companies and financial institutions are not the proceeds of gaming, however much enterprise in an unstable market system may appear similar to gambling. In fact, these profits are the outcomes of financial flows that ebb and progress through the economy, propelled by actual expenditure and financing decisions. The systems of financial claims and liabilities arising from those decisions become more fragile, as first speculative and then Ponzi financing structures come to predominate, and larger gains and larger losses may then be made. But the possibility of extraordinary profits or losses in Ponzi financing structures in no way means that realization of such profits is caused or justified by the possibility of the losses. Ponzi finance arises out of objective contractual obligations. The ‘greater risk’, which is held to justify a higher cost of finance, may be entirely subjective or a cover for monopoly profits in finance.

The simplest example of Ponzi finance is borrowing money to pay interest on a loan. In this case, the financial liability is increased, with no reduction in the original loan. Pyramid bank deposit schemes were the schemes after which this phenomenon is named, and they are perhaps the most extreme example of such financial structures. In a pyramid deposit scheme, the financier might take, say, Rs. 100 from a depositor, and promise to double this money after a month if the depositor introduces two new depositors at the end of that month. The two new depositors get the same terms and when they pay in their Rs. 100 respectively, Rs. 100 goes to double the money of the first depositor, and the other Rs. 100 is the financier’s profit. The two new depositors get their profit at the end of the next month from the new deposits paid in by the four new depositors that they introduce to the scheme, and so on. Initially, such schemes promise and deliver good profits. But their flaw lies in the fact that they require deposits to rise exponentially in order to pay the promised rewards to depositors. In the example that is described above, deposits have to double each month so that after one year, the scheme requires Rs. 409,600 in deposits just to keep solvent. After the thirteenth month, Rs. 819,200 would need to be deposited to keep up promised payments to depositors. Such schemes therefore usually collapse when they run out of gullible people to deposit their savings in them. While their life can be briefly extended by persuading depositors not to withdraw their profits, this cannot work for more than one or two payment periods, because such schemes are so dependent on increasing amounts of additional money being paid into them in each successive period.

Ponzi schemes are named after Charles Ponzi, an Italian immigrant who swindled Boston investors in 1919 and 1920 with a pyramid banking scheme. Minsky noted that Ponzi’s scheme ‘swept through the working classes and even affected “respectable” folk’. Because they prey on the poor and the ignorant, Ponzi schemes in banking are usually banned, although this does not prevent them from occurring in countries where it is difficult to regulate them. In Minsky’s view, financial collapses occur because booms in financial markets result in sufficient profits for speculative and Ponzi finance to induce a shift from hedge finance to speculative and Ponzi finance.

Ponzi finance in securities markets is much more common than in banking. Indeed, it is arguable that such finance is essential for the liquidity of markets in long-term securities: if a security is bought, it may have an assured ‘residual liquidity’ if it is a bond in that, when it matures, the money will then be returned to the investor. If, however, the security is a share which is not repaid by the issuer except on liquidation of the company, then it has no assured residual liquidity. Its liquidity depends on some other investor wishing to buy it at a reasonable price. If the share is to be sold at a profit, then the condition for this to happen is that demand for it has risen since it was bought. In this respect, liquidity and capital gains in the markets for long-term securities depend on Ponzi finance.

Ponzi finance was present at the very inception of modern stock markets. The South Sea Company and the Mississippi Company, whose stocks featured in the first stock market collapse of 1720, both ended up issuing stocks to raise finance in order to buy stocks to keep the market in their stocks liquid and stable. In modern times, this is a common feature of merger and takeover activity in capital markets. Corporate takeovers are frequently financed by issuing securities. The proceeds of the new issue are used to buy in the target company’s stock ‘at a premium’, i.e., at a price that is greater than the pre-takeover market price. The money raised by issuing the new stocks is used to pay the higher return to the stock-holders of the company being taken over. In this case, issuing new stock is exactly equivalent to the pyramid banking practice of taking in new deposits in order to pay an enhanced return to older depositors, which is the premium on the target company’s stock. The main difference between the two types of operation is that, during such takeover activity, the stock market as a whole functions as a pyramid banking scheme. However, precisely because it is the market as a whole which is operating in this Ponzi way, the pyramid nature of the venture is less obvious, and the gains are greater, because more and wealthier contributors are involved. Since this is an outcome of the normal functioning of the market, which may hitherto have been acting in a perfectly proper and respectable fashion, raising finance for industry and providing for widows and orphans, it is not possible to ‘finger’ the perpetrator of the pyramid scheme.

A more obviously controversial kind of Ponzi finance is the practice known as ‘ramping’ the market. A financier discreetly buys up a particular stock over a period of time, and then announces with great fanfare that he or she is buying in the stock. There are few markets in which emulatory competition is as strong as financial markets, where being conservative in practice and faddish in innovation are preconditions for a ‘sound’ reputation. The ‘sounder’ that reputation, the more likely it is other investors will imitate the buying strategy. Indeed, there is an element of compulsion about it, depending on the reputation of the investor. Those investors without reputation must follow for whatever reasons the investment direction signalled by investors with reputation, or else languish among lower-growth stocks. As the price of the stock rises due to the increased demand for it, such reputable financiers quietly sell out at a profit to their imitators, thereby confirming their reputation for financial ‘soundness’. Obviously, the better the reputation of the financier, the greater the gain from such an operation. To support such a reputation and legitimize the profits from trading on it, financiers will obviously attribute the gains from this practice to their own financial acumen, rather than confessing to having ramped the market.

The almost instantaneous dissemination of relevant information on which modern financial markets pride themselves (and which many financial economists believe makes them near perfect), also facilitates this kind of market manipulation. In securities markets, the investors emulating the financier are the equivalent of the new depositors. They too may make money, if they too can persuade subsequent new investors to buy at higher prices. As with the pyramid banking case, ramping markets depends on increasing interest by additional investors. Because in practice it is indistinguishable from normal trading (unlike pyramid banking, which is rather more obvious), and because any losers usually have other wealth to fall back on, such practices are frowned upon in securities markets, but cannot be eliminated. However, in the case of pension funds, the eventual losers will be ordinary working people, who will only have a minimal state pension in the future to fall back on. This makes it all the more important to understand how a reputable system for financing pensions has become a Ponzi finance scheme which will in future collapse.

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

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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.

Open Market Operations. Thought of the Day 93.0

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It can be argued that it would be much more democratic if the Treasuries were allowed to borrow directly from their central bank. By electing a government on a program, we would know what deficit it intends to run and thus how much it will be willing to print, which in the long run is a debate about the possible level of inflation. Instead, it has been argued that decisions made on democratic grounds might be unstable as they are affected by elections. However, the independence of central banks is also serving the interest of commercial bankers as we argue now.

In practice, the central bank buys and sells bonds in open market operations. At least it is always doing so with short term T-bonds as part of the conventional monetary policy, and it might decide sometimes to do it as well with longer maturity T-bonds as part of the unconventional monetary policy. This blurs the lines between a model where the central bank directly finances the Treasury, and a model where this is done by commercial banks since they result in the same final situation. Indeed, before an open market operation the Treasury owes central bank money to a commercial bank, and in the final situation it owes it to the central bank itself, and the central bank money held by the commercial bank has been increased accordingly.

The commercial bank has accepted to get rid of an IOU which bears interest, in exchange of a central bank IOU which bears no interest. However the Treasury will never default on its debt, because the state also runs the central bank which can buy an infinite amount of T-bonds. Said differently, if the interest rates for short term T-bonds start to increase as the commercial banks become more and more reluctant to buy these, the central bank needs to buy as many short-term bonds as necessary to ensure the short term interest rates on T-bonds remain at the targeted level. By using these open market operations a sovereign state running a sovereign currency has the means to ensure that the banks are always willing to buy T-bonds, whatever the deficit is.

However, this system has a drawback. First when the commercial bank bought the T-bond, it had to pretend that it was worried the state might never reimburse, so as to ask for interests rates which are at least slightly higher than the interest rate at which they can borrow from the central bank, and make a profit on the difference. Of course the banks knew they would always be reimbursed, because the central bank always stands ready to buy bonds. As the interest rates departed from the target chosen by the central bank, the latter bought short term bonds to prevent the short term rate from increasing. In order to convince a commercial bank to get rid of a financial instrument which is not risky and which bears interest, the only solution is to pay more than the current value of the bond, which amounts to a decrease of the interest rate on those bonds. The bank thus makes an immediate profit instead of a larger profit later. This difference goes directly into the net worth of the banker and amounts to money creation.

To conclude, we reach the same stage as if the Treasury had sold directly its bond to the central bank, except that now we have increased by a small amount the net worth of the bankers. By first selling the bonds to the commercial banks, instead of selling directly to the central bank, the bankers were able to realize a small profit. But this profit is an immediate and easy one. So they have on one side to pretend they do not like when the Treasury goes into debt, so as to be able to ask for the highest possible interest rate, and secretly enjoy it since either they make a profit when it falls due, or even better immediately if the central bank buys the bonds to control the interest rates.

The commercial banks will always end up with a part of their assets denominated directly in central bank money, which bears no interest, and T-bonds, which bear interest. If we adopt a consolidated state point of view, where we merge the Treasury and the central bank, then the commercial banks have two types of accounts. Deposits which bear no interests, and saving accounts which generate interests, just like everybody. In order to control the interest rate, the consolidated state shifts the amounts from the interest-less to the interest-bearing account and vice-versa.

Credit Bubbles. Thought of the Day 90.0

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At the macro-economic level of the gross statistics of money and loan supply to the economy, the reserve banking system creates a complex interplay between money, debt, supply and demand for goods, and the general price level. Rather than being constant, as implied by theoretical descriptions, money and loan supplies are constantly changing at a rate dependent on the average loan period, and a complex of details buried in the implementation and regulation of any given banking system.

Since the majority of loans are made for years at a time, the results of these interactions play out over a long enough time scale that gross monetary features of regulatory failure, such as continuous asset price inflation, have come to be regarded as normal, e.g. ”House prices always go up”. The price level however is not only dependent on purely monetary factors, but also on the supply and demand for goods and services, including financial assets such as shares, which requires that estimates of the real price level versus production be used. As a simplification, if constant demand for goods and services is assumed as shown in the table below, then there are two possible causes of price inflation, either the money supply available to purchase the good in question has increased, or the supply of the good has been reduced. Critically, the former is simply a mathematical effect, whilst the latter is a useful signal, providing economic information on relative supply and demand levels that can be used locally by consumers and producers to adapt their behaviour. Purely arbitrary changes in both the money and the loan supply that are induced by the mechanical operation of the banking system fail to provide any economic benefit, and by distorting the actual supply and demand signal can be actively harmful.

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Credit bubbles are often explained as a phenomena of irrational demand, and crowd behaviour. However, this explanation ignores the question of why they aren’t throttled by limits on the loan supply? An alternate explanation which can be offered is that their root cause is periodic failures in the regulation of the loan and money supply within the commercial banking system. The introduction of widespread securitized lending allows a rapid increase in the total amount of lending available from the banking system and an accompanying if somewhat smaller growth in the money supply. Channeled predominantly into property lending, the increased availability of money from lending sources, acted to increase house prices creating rational speculation on their increase, and over time a sizeable disruption in the market pricing mechanisms for all goods and services purchased through loans. Monetary statistics of this effect such as the Consumer Price Index (CPI) for example, are however at least partially masked by production deflation from the sizeable productivity increases over decades. Absent any limit on the total amount of credit being supplied, the only practical limit on borrowing is the availability of borrowers and their ability to sustain the capital and interest repayments demanded for their loans.

Owing to the asymmetric nature of long term debt flows there is a tendency for money to become concentrated in the lending centres, which then causes liquidity problems for the rest of the economy. Eventually repayment problems surface, especially if the practice of further borrowing to repay existing loans is allowed, since the underlying mathematical process is exponential. As general insolvency as well as a consequent debt deflation occurs, the money and loan supply contracts as the banking system removes loan capacity from the economy either from loan repayment, or as a result of bank failure. This leads to a domino effect as businesses that have become dependent on continuously rolling over debt fail and trigger further defaults. Monetary expansion and further lending is also constrained by the absence of qualified borrowers, and by the general unwillingness to either lend or borrow that results from the ensuing economic collapse. Further complications, as described by Ben Bernanke and Harold James, can occur when interactions between currencies are considered, in particular in conjunction with gold-based capital regulation, because of the difficulties in establishing the correct ratio of gold for each individual currency and maintaining it, in a system where lending and the associated money supply are continually fluctuating and gold is also being used at a national level for international debt repayments.

The debt to money imbalance created by the widespread, and global, sale of Asset Backed securities may be unique to this particular crisis. Although asset backed security issuance dropped considerably in 2008, as the resale markets were temporarily frozen, current stated policy in several countries, including the USA and the United Kingdom, is to encourage further securitization to assist the recovery of the banking sector. Unfortunately this appears to be succeeding.

A Monetary Drain due to Excess Liquidity. Why is the RBI Playing Along

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And so we thought demonetization was not a success. Let me begin with the Socratic irony to assume that it was indeed a success, albeit not in arresting black money for sure. Yes, the tax net has widened and the cruelty of smashing down the informal sector to smithereens to be replaceable with a formal economy, more in the manner of sucking the former into the latter has been achieved. As far as terror funding is concerned, it is anybody’s guess and so let them be with their imaginations. What none can deny is the surge in deposits and liquidity in the wake of demonetization. But, what one has been consciously, or through an ideological-driven standpoint denying is the fact that demonetization clubbed with the governmental red carpet for foreign direct investment has been an utter failure to attract money into the country. And the reason attributed for the same has been a dip in the economy as a result of the idiosyncratic decision of November 8 added with the conjuring acts of mathematics and statistics in tweaking base years to let go off the reality behind a depleting GDP and project the country as the fastest growing emerging economy in the world. The irony I started off with is defeated here, for none of the claims that the government propaganda machine churns out on the assembly line are in fact anywhere near the truth. But, thats what a propaganda is supposed to doing, else why even call it that, or even call for a successful governance and so on and on (sorry for the Žižekian interjections here).

Assuming the irony still has traces and isn’t vanquished, it is time to move on and look into the effects of what calls for a financial reality-check. Abruptly going vertically through the tiers here, it is recently been talked about in the corridors of financial power that the Reserve Bank of India (RBI) is all set to drain close to 1.5 lakh crore in excess liquidity from the financial system as surging foreign investments forces the central bank to absorb the dollar inflows and sell rupees to cap gains in the local currency. This is really interesting, for the narrative or the discourse is again symptomatic of what the government wants us to believe, and so believe we shall, or shall we? After this brief stopover, chugging off again…Foreign investments into debt and shares have reached a net $31 billion this year, compared with $2.7 billion in sales last year, due to factors including India’s low inflation and improving economic growth. This is not merely a leap, but a leap of faith, in this case numerically. Yes, India is suffering from low inflation, but it ain’t deflation, but rather disinflation. There is a method to this maddening reason, if one needs to counter what gets prime time economic news in the media or passes on as Chinese Whispers amongst activists hell-bent on proving the futility of the governmental narrative. There is nothing wrong in the procedure as long as this hell-bent-ness is cooked in proper proportions of reason. But, why call it disinflation and not deflation? A sharp drop in inflation below the Reserve Bank of India’s (RBI’s) 4% target has been driven by only two items – pulses and vegetables. the consumer price index (CPI), excluding pulses and vegetables, rose at the rate of 3.8% in July, much higher than the official headline figure of 2.4% inflation for the month. The re-calculated CPI is based on adjusted weights after excluding pulses and vegetables from the basket of goods and services. The two farm items – pulses and vegetables – have a combined weight of only 8.4% in the consumer price index (CPI) basket. However, they have wielded disproportionate influence over the headline inflation number for more than a year now owing to the sharp volatility in their prices. So, how does it all add up? Prices of pulses and vegetables have fallen significantly this year owing to increased supply amid a normal monsoon last year, as noted by the Economic Survey. The high prices of pulses in the year before and the government’s promises of more effective procurement may have encouraged farmers to produce more last year, resulting in a glut. Demonetisation may have added to farmers’ woes by turning farm markets into buyers’ markets. Thus, there does not seem to be any imminent threat of deflation in India. A more apt characterization of the recent trends in prices may be ‘disinflation’ (a fall in the inflation rate) rather than deflation (falling prices) given that overall inflation, excluding pulses and vegetables, is close to the RBI target of 4%. On the topicality of improving economic growth in the country, this is the bone of contention either weakening or otherwise depending on how the marrow is key up.

Moving on…The strong inflows have sent the rupee up nearly 7 per cent against the dollar and forced the RBI to buy more than $10 billion in spot market and $10 billion in forwards this year – which has meant an equivalent infusion in rupees. Those rupee sales have added liquidity into a financial system already flush with cash after a ban on higher-denomination currency in November sparked a surge in bank deposits. Average daily liquidity has risen to around Rs 3 lakh crore, well above the RBI’s goal of around Rs 1 lakh crore, according to traders. That will force the RBI to step up debt sales to remove liquidity and avoid any inflationary impact. Traders estimate the RBI will need to drain Rs 1 lakh crore to Rs 1.4 lakh crore ($15.7 billion to $22 billion) after taking into account factors such as festival-related consumer spending that naturally reduce cash in the system. How the RBI drains the cash will thus become an impact factor for bond traders, who have benefitted from a rally in debt markets. The RBI has already drained about Rs 1 lakh crore via one-year bills under a special market stabilisation scheme (MSS), as well as Rs 30,000 crore in longer debt through open market sales. MSS (Market Stabilisation Scheme) securities are issued with the objective of providing the RBI with a stock of securities with which it can intervene in the market for managing liquidity. These securities are issued not to meet the government’s expenditure. The MSS scheme was launched in April 2004 to strengthen the RBI’s ability to conduct exchange rate and monetary management. The bills/bonds issued under MSS have all the attributes of the existing treasury bills and dated securities. These securities will be issued by way of auctions to be conducted by the RBI. The timing of issuance, amount and tenure of such securities will be decided by the RBI. The securities issued under the MSS scheme are matched by an equivalent cash balance held by the government with the RBI. As a result, their issuance will have a negligible impact on the fiscal deficit of the government. It is hoped that the procedure would continue, noting staggered sales in bills, combined with daily reverse repo operations and some long-end sales, would be easily absorbable in markets. The most disruptive fashion would be stepping up open market sales, which tend to focus on longer-ended debt. That may send yields higher and blunt the impact of the central bank’s 25 basis point rate cut in August. The RBI does not provide a timetable of its special debt sales for the year. and if the RBI drains the cash largely through MSS bonds then markets wont get too much impacted. This brings us to close in proving the success story of demonetization as a false beacon, in that with a surge in liquidity, the impact on the market would be negligible if MSS are resorted to culminating in establishing the fact that demonetization clubbed with red-carpeted FDI has had absolutely no nexus in the influx of dollars and thus any propaganda of this resulting as a success story of demonetization is to be seen as purely rhetoric. QED.

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.

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.

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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”.

Hyman Minsky, Karl Polanyi, Deleterious Markets and if there is any Alt-Right to them? Apparently No.

Karl Polanyi has often highlighted on the insight about the predicaments of the market. these perils realize that when the markets are left to their own devices, they are enough o cause attrition to the social relations and fabric. However, the social consequences of financial instability can be understood only by employing a Polanyian perspective on how processes of commodification and market expansion jeopardize social institutions. For someone like Hyman Minsky, equilibrium and stability are elusive conditions in markets with debt contracts. His financial instability hypothesis suggests that capitalist economies lead, through their own dynamics, to “the development over historical time of liability structures that cannot be validated by market-determined cash flows or asset values”. According to Minsky, a stable period generates optimistic expectations. Increased confidence and positive expectations of future income streams cause economic actors to decrease margins of safety in their investment decisions. This feeds a surge in economic activity and profits, which turns into a boom as investments are financed by higher degrees of indebtedness. As the economic boom matures, an increasing number of financial intermediaries and firms switch from hedge finance to speculative and Ponzi finance. Minsky argued that economists, misreading Keynes, downplay the role of financial institutions. In particular, he argued that financial innovation can create economic euphoria for a while before destabilizing the economy and hurling it into crises rivaling the Great Depression. Minsky’s insights are evident in the effects of innovations in mortgages and mortgage securities. Actors using speculative and Ponzi finance are vulnerable to macroeconomic volatility and interest rate fluctuations. A boom ends when movements in short-term and long-term interest rates render the liability structures of speculative and Ponzi finance unsustainable. The likelihood of a financial crisis (as opposed to a business cycle) depends on the preponderance of speculative and Ponzi finance in the economy under question.

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Minsky regularly criticized economists for failing to grasp Keynes’s ideas. In his book Stabilizing an Unstable Economy Minsky argued that while economists assimilated some of Keynes’s insights into standard economic theory, they failed to grasp the connection between the financial and real sectors. Specifically, he argued that finance is missing from macroeconomic theory, with its focus on capital structure, asset-liability management, agency theory, and contracts. He wrote:

Keynes’s theory revolves around bankers and businessmen making deals on Wall Street … One of the peculiarities of the neoclassical theory that preceded Keynes and the neoclassical synthesis that now predominates economic theory is that neither allows the activities that take place on Wall Street to have any significant impact upon the coordination or lack of coordination of the economy…

Minsky’s work on financial crises builds on Keynes’s insights, using terms such as “euphoric economy”, and “unrealistic euphoric expectations with respect to costs, markets, and their development over time”. Yet Minsky considered the issues of rational prices and market efficiency as only the tip of an iceberg. His broad framework addresses issues related to the lending practices by financial institutions, central bank policy, fiscal policy, the efficacy of financial market regulation, employment policy, and income distribution. Financial institutions, such as banks, become increasingly innovative in their use of financial products when the business cycle expands, boosting their leverage and funding projects with ever increasing risk. Minsky’s words on financial innovation are striking, as if foretelling the recent crisis.

Over an expansion, new financial instruments and new ways of financing activity develop. Typically, defects of the new ways and the new institutions are revealed when the crunch comes.

Commercial banks sponsored conduits to finance long-term assets through special purpose entities such as structured investment vehicles (SIVs), something similar to the Indian version of Special Purpose Vehicles (SPVs). These were off balance sheet entities, subjecting them to lower regulatory capital requirements. Special purpose entities used commercial paper to raise funds they then used to buy mortgages and mortgage securities. In effect, banks relied on Minsky-type speculative and Ponzi financing, borrowing short-term and using these borrowed funds to buy long-term assets. Wrote Minsky,

The standard analysis of banking has led to a game that is played by central banks, henceforth to be called the authorities, and profit-seeking banks. In this game, the authorities impose interest rates and reserve regulations and operate in money markets to get what they consider to be the right amount of money, and the banks invent and innovate in order to circumvent the authorities. The authorities may constrain the rate of growth of the reserve base, but the banking and financial structure determines the efficacy of reserves…This is an unfair game. The entrepreneurs of the banking community have much more at stake than the bureaucrats of the central banks. In the postwar period, the initiative has been with the banking community, and the authorities have been “surprised” by changes in the way financial markets operate. The profit-seeking bankers almost always win their game with the authorities, but, in winning, the banking community destabilizes the economy; the true losers are those who are hurt by unemployment and inflation.

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Combining Hyman Minsky’s insights on financial fragility with a Polanyian focus on commodification offers a distinct perspective on the causes and consequences of the foreclosure crisis. First, following Polanyi, we should expect to find commodity fiction applied to arenas of social life previously isolated from markets to be at the heart of the recent financial crisis. Second, following Minsky, the transformations caused by novel uses of commodity fiction should be among the primary causes of financial fragility. Finally, in line with a Polanyian focus on the effects of supply-demand-price mechanism, the price fluctuations caused by financial fragility should disrupt existing social relations and institutions in a significant manner. So, how does this all peter down to alt-right? Right-wing libertarianism is basically impossible. The “free” market as we know it today needs the state to be implemented – without reading Polanyi, you just know for example that without the force of the state, you just can’t have private property or all the legal arrangements that underpin property, labour and money. So it wouldn’t work anyway. Polanyi’s point is that if we want democracy to survive, we need to beware of financial overlords and their ideological allies peddling free-market utopias. And if democracy even stinks of stability, then stability is destabilizing as Minsky would have had it, thus corroborating the cross-purposes between the two thinkers in question, at least to the point of a beginning.