The need for fiat currency
In a recent post, I'd expressed concern that the current economic slowdown is a symptom of structural issues, rather than just a liquidity crunch. My main argument is that, the slowdown we are seeing, is actually a result of the massive economic growth we saw in the last few years leading to increased capability for value addition, and a resultant increase in demand for money supply.
Money supply is not the same as liquidity crunch. In the latter, there is enough money in the system to cater to its demands, but the money is not "flowing" (probably due to hoarding and distrust). But, money supply scarcity is an even more fundamental problem. It refers to the dearth of money itself, to meet the growing demands of the economy.
There is a recent video (in Kannada) on social media, that makes a pretty convincing case that the current slowdown is not due to structural issues with the economy. The speaker likens the slowdown to us deciding to walk for 15 kms and taking a rest after about 8 kms. He also provides a very convincing argument that the slowdown is not in all sectors, by noting that sales of smartphones, refrigerators and AC units have actually gone up. He then goes on to end in an optimistic note that the current trade war between US and China, may mean that more manufacturing jobs will now come to India.
The arguments are very well made, but not convincing enough to dispel my misgivings about the structural issue itself.
Let me give another analogy about the problem. The growth of an emerging economy like India, is not so much like us walking for 15 kms, but somewhat more like a child growing up into a teenager. This transition from a developing and largely impoverished economy, to a potential economic leader, requires several structural evolution along the way to manage growth pangs. There is not enough evidence that we are recognising this.
Money supply reserves in India, are largely based on valuation of our foreign exchange and gold reserves. What this means is, the amount of money that is there in the system is proportional to the amount of stuff we can buy from other countries, and the amount of gold we can pay for it. Our capability for meeting demand and supply within the economy itself, has no say in the amount of money in the system.
So what do we do if we need more money in the system? We either flagellate ourselves to go and meet economic needs of other economies to increase our foreign exchange reserves, or try and dig up more gold-- either from our mines, or from the lockers of families. None of it results in an economic incentive for citizens to solve our problems first.
The "gold standard" for money supply primarily came to vogue a couple of centuries ago, when inter-currency trade took centerstage as a result of industrial revolution. However, the gold standard has been obsoleted for "fiat" currency (or currency minting by decree), by several major economies of the world. There are several examples of "economic skew" that happens when money supply is based on very narrow criteria like gold reserves. For example, in the Irish potato famine of the 19th century, the government decided to export food to buy gold reserves (and hence mint more money), than reduce its food exports and feed its own people. Similarly, during the California gold rush, a bottle of water costed as high as $140-- because everyone was trying to figure out how to mine more gold, rather than how to harvest water. Because, gold meant money.
These problems are well known, and most major economies around the world, have put mechanisms in place to mint money by governmental fiat (decree), rather than base it solely on foreign exchange or gold reserves. The fiat is not arbitrary of course-- and not every fiat would result in hyperinflation. It is possible to implement fiat models that makes a fairly accurate estimate of money supply demand in the system.
Finally, the "optimism" about manufacturing jobs coming to India is not really optimistic. Given the fact that Indian diaspora are all over the world, India does have the knowledge and capability to build its own industries in just about all hi-tech sectors like semi-conductors, hi-res optics, etc. However, it is still so difficult to get anything built in India. Flawed money supply models (coupled with liquidity and trust issues), make it a herculean task to convert our theoretical knowledge into practice. Even today for example, opening a high-end hotel requires about 156 different kinds of permits! The licence and permit raj was supposed to have ended long ago?
So even when multi-national companies come to invest in India, they only outsource some low-end work to India and keep all the necessary intellectual property and competitive advantage to themselves.
And it goes without saying that, basing our economic growth on the arrival of multinationals, only increases the disparity between the market exchange rate of the dollar to its relative purchasing power. What we can buy for 1 dollar in the US, on an average, we can buy for 15 rupees in India. But, if we exchange 1 dollar in currency markets, we get about 74 rupees per dollar! What this means is that there is no incentive for educated professionals to take up any of our own country's problems and solve it, when they can instead solve somebody else's problem and earn more money for the same or lesser amount of effort.
Money supply is not the same as liquidity crunch. In the latter, there is enough money in the system to cater to its demands, but the money is not "flowing" (probably due to hoarding and distrust). But, money supply scarcity is an even more fundamental problem. It refers to the dearth of money itself, to meet the growing demands of the economy.
There is a recent video (in Kannada) on social media, that makes a pretty convincing case that the current slowdown is not due to structural issues with the economy. The speaker likens the slowdown to us deciding to walk for 15 kms and taking a rest after about 8 kms. He also provides a very convincing argument that the slowdown is not in all sectors, by noting that sales of smartphones, refrigerators and AC units have actually gone up. He then goes on to end in an optimistic note that the current trade war between US and China, may mean that more manufacturing jobs will now come to India.
The arguments are very well made, but not convincing enough to dispel my misgivings about the structural issue itself.
Let me give another analogy about the problem. The growth of an emerging economy like India, is not so much like us walking for 15 kms, but somewhat more like a child growing up into a teenager. This transition from a developing and largely impoverished economy, to a potential economic leader, requires several structural evolution along the way to manage growth pangs. There is not enough evidence that we are recognising this.
Money supply reserves in India, are largely based on valuation of our foreign exchange and gold reserves. What this means is, the amount of money that is there in the system is proportional to the amount of stuff we can buy from other countries, and the amount of gold we can pay for it. Our capability for meeting demand and supply within the economy itself, has no say in the amount of money in the system.
So what do we do if we need more money in the system? We either flagellate ourselves to go and meet economic needs of other economies to increase our foreign exchange reserves, or try and dig up more gold-- either from our mines, or from the lockers of families. None of it results in an economic incentive for citizens to solve our problems first.
The "gold standard" for money supply primarily came to vogue a couple of centuries ago, when inter-currency trade took centerstage as a result of industrial revolution. However, the gold standard has been obsoleted for "fiat" currency (or currency minting by decree), by several major economies of the world. There are several examples of "economic skew" that happens when money supply is based on very narrow criteria like gold reserves. For example, in the Irish potato famine of the 19th century, the government decided to export food to buy gold reserves (and hence mint more money), than reduce its food exports and feed its own people. Similarly, during the California gold rush, a bottle of water costed as high as $140-- because everyone was trying to figure out how to mine more gold, rather than how to harvest water. Because, gold meant money.
These problems are well known, and most major economies around the world, have put mechanisms in place to mint money by governmental fiat (decree), rather than base it solely on foreign exchange or gold reserves. The fiat is not arbitrary of course-- and not every fiat would result in hyperinflation. It is possible to implement fiat models that makes a fairly accurate estimate of money supply demand in the system.
Finally, the "optimism" about manufacturing jobs coming to India is not really optimistic. Given the fact that Indian diaspora are all over the world, India does have the knowledge and capability to build its own industries in just about all hi-tech sectors like semi-conductors, hi-res optics, etc. However, it is still so difficult to get anything built in India. Flawed money supply models (coupled with liquidity and trust issues), make it a herculean task to convert our theoretical knowledge into practice. Even today for example, opening a high-end hotel requires about 156 different kinds of permits! The licence and permit raj was supposed to have ended long ago?
So even when multi-national companies come to invest in India, they only outsource some low-end work to India and keep all the necessary intellectual property and competitive advantage to themselves.
And it goes without saying that, basing our economic growth on the arrival of multinationals, only increases the disparity between the market exchange rate of the dollar to its relative purchasing power. What we can buy for 1 dollar in the US, on an average, we can buy for 15 rupees in India. But, if we exchange 1 dollar in currency markets, we get about 74 rupees per dollar! What this means is that there is no incentive for educated professionals to take up any of our own country's problems and solve it, when they can instead solve somebody else's problem and earn more money for the same or lesser amount of effort.
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