On Manmohan Singh, Ruchir Sharma - and what I think India needs to be a "Breakout Nation"

I found absolutely nothing even remotely worthwhile in prime minister Dr. Manmohan Singh’s public address on India’s 65^th Independence Day. On the contrary, to me it seemed that he was just repeating the same old tired lines we have all stopped believing long, long ago – from promising that every villager will get electricity within 5 years to “education” for all poor kids and all the rest, including better pensions for retired personnel of the socialist State (a promise that drew very loud cheers from the crowd!).

“Where’s the money?” someone ought to have asked this “economist.”

Or, better still, “What is ‘sound money’?”

As far as electricity for villagers is concerned, the combined losses of all the State Electricity Boards exceeds Rs. 2,00,000 crores (1 crore = 10 million) – and these losses are growing.

Ruchir Sharma heads Morgan Stanley Asset Management, specializing in “emerging markets,” which means countries like India, Brazil, China, Malaysia, Indonesia and so on. I got to meet him and occasionally interact with him a full 15 years ago, in 1998, when I began my brief stint as an editorial writer and columnist with The Economic Times in Delhi. He was one of our columnists – and he held the same job that he holds today. His columns were very well written, with insights from other emerging markets, with cutting humour sometimes, and perhaps they ruffled feathers within the Establishment – but that, in my view, was a very good thing to do. I myself did that every single day! And continue to do so.

Ruchir is now in the news because of a book he has authored titled Breakaway Nations. I am yet to read it – but I did read some reviews, which were favourable.

I quite enjoyed reading his column in the ToI yesterday – especially after hearing the PM’s "predictably boring" speech.

Ruchir has made two “economic policy prescriptions”: the first, rapid urbanization; and the second, reducing the fiscal deficit. He has also made one “political prescription.” This is based on his own prediction that the next government at the Centre will comprise a coalition of regional parties. Thus, it follows for him that strong State-level governments – a New Federalism, perhaps – will rescue India from its current doldrums. And then, we might well become one of those “breakaway nations” he has written about.

Allow me to now say a few words on the vast gulf that separates an “economist” – that is, one who studies market phenomena in terms of abstract theory – and one who is a “market player.” The former is an armchair philosopher at best; the latter is himself engaged actively in what is best described as “perpetual forecasting.” Ruchir, as a successful professional managing the assets of extremely wealthy clients, must speculate on the future values of the various assets he invests in; that too, in various geographical locations, each with its own political uncertainties.

This difference between the theoretical economist and the practical businessman is best brought out in the following extract from Margit von Mises’ Memoirs. They have only just arrived in New York City, their ship docking in on August 2, 1940. What follows describes events of December the same year.

On December 5 we went to Cambridge, where he delivered a lecture at Harvard’s Littauer Hall, arranged for him by his brother Richard, who since 1938 had been professor of mathematics and aviation at Harvard.

During our stay in Cambridge I met, for the first and only time, Professor Joseph A. Schumpeter, who had just been married for the third time. His new wife was an elegant and intelligent American. They kept a lovely, well-run home. The discussion at lunch was lively but careful, both men aware of their parts as host and guest. Schumpeter knew of course that Lu did not agree with many of his views.

This might be a good opportunity to mention a little story that Joe Keckeissen, a former student of Lu’s and now a professor at the University Francisco Marroquin in Guatemala, has told me and that is corroborated by Bettina Bien-Greaves through her shorthand notes. One night in his seminar, Lu was commenting on the late Professor Schumpeter. “There are many people,” he humourlessly disclosed, “who stand steadfastly by the social doctrines of Professor Schumpeter. They do not seem to remember that when the great professor was minister of finance he was not able to protect Austria against the most disastrous inflation in its history and that, when the great professor was president of a bank (Biedermann Bank), the bank failed.”

As far as Ludwig von Mises, theoretical economist and armchair philosopher is concerned, I have only just reported, from the same memoirs, how he did not accept a high position in a bank – and how he flatly stated that he preferred “writing about money” and was not interested in earning money. Indeed, he was quite happy to predict that he would “never have much of it”! This was in the year 1928. He died in 1973 – and this prediction proved to be completely accurate.

It is from his armchair that Mises thought out all that was necessary to pen his authoritative Theory of Money and Credit, a treatise currently celebrating the centenary of its publication.

Practicing bankers and central bankers ought to carefully study this treatise - for they could never ever write it. They do not study anything other than their balance sheets. The theoretical economist studies, thinks, and writes. This was the difference between Schumpeter and Mises - and it always continue to hold between the "doer" and the "thinker." 

I am mentioning this only because Ruchir Sharma has specifically indicated INFLATION to be a very big problem for India; one that is harming the future prospects of this nation; and it is only to “tame” or “control” this beast that he has arrived at his prescription – one that seems to be “folk wisdom” these days – that the fiscal deficit must come down.

So, let us look at the matter from the point of view of abstract economic theory – and that too, the theory that Ludwig von Mises was the first to fully elaborate.

INFLATION:

Like many, many words, the precise meaning of the word “inflation” – which is a technical term used by economists – has changed over the past few centuries. Originally, the word referred to “increases in the supply of money” – while it was universally understood that the “general rise in prices” that inevitably followed was a consequence of inflation; i.e. of the increase in the money supply. In other words, the “cause” and the “effect” were both clearly understood in earlier times, unlike today. Thus, right now, we in India have many expressing the completely erroneous and utterly misleading view that errant monsoon rains will cause inflation.

There is nothing mysterious about inflation. It is not caused by any act of god, or of nature.

Inflation is DELIBERATE POLICY. This becomes obvious when we consider the original meaning of the word itself. Today, since it is State control over the supply of money, we know who is responsible for the consequences of their deliberate policy of increasing money supply. The “money” is only irredeemable paper, anyway. There is no “commodity” backing it. Its supply can be increased at will – and used to finance the State.

There are winners and losers in inflationary conditions. Savers lose; borrowers gain. Incentives are also altered when “administered” interest rates are artificially lowered, ostensibly to “stimulate the economy.” Companies then prefer debt to equity. Shareholders lose say in company policies; bankers rule. And bankers, in a central bank controlled “fractional reserve system” are nothing but an organized “cartel,” who with a very small quantity of actual deposits can lend out vast amounts, while being able to rely on the State’s central bank to bail them out whenever they require a “lender of last resort.” This injects what is nowadays known as a “moral hazard” into banking – for bankers must be “prudent,” while under such a centralized and cartelised organization with the full backing of the State, they are actually encouraged to take on more risks than they would have otherwise.

It is also this very same artificial lowering of interest rates, which reduces the costs of borrowing capital, that is the primary cause of “business cycles” – the repeated and seemingly endless cycles of “boom-and-bust” that have been plaguing all economies ever since central banking has been established. The US Federal Reserve, for example, was established in 1913 or thereabouts. And the Great Crash of 1929 – which Mises predicted, and who’s Institute for Business Cycle Research was established a full two years earlier, in 1927 – soon followed.

Let us now pause to understand how and why these booms-and-busts occur: The root cause is nothing but the artificially low rate of interest, which “distorts economic calculation.” As I explained the other day:

The Misesian paradigm focuses on monetary calculation using actual market prices as the necessary precondition for the rational allocation of resources within an economic system featuring specialization and the division of labour.

A “promoter-entrepreneur” examines two figures: the first of these is “concrete,” and reflect the actual costs he will have to incur in order to produce whatever he has in mind; the second of these is but a “forecast” – he "hazards a guess" rather than makes an "informed guess" – and this guess concerns only what the future price of whatever he produces will fetch. On the basis of these figures, he will “decide” – and, thus, he will make “bids” for all that he will require to produce whatever he has decided to produce. Thus, if he invests in real estate, say, he will bid for construction workers, for cement, for steel, and so on. Things go wrong for hordes of such promoter-entrepreneurs only because the artificially lowered costs of borrowing capital distort their vision of the future.

A “boom” occurs not because one or two such promoter-entrepreneurs get it wrong. The boom occurs when entire hordes of them get it wrong. This is what Mises and his followers call “malinvestment.” We can actually “see” it today, in India, in real estate – by which I mean all these high-rise apartments being built all over the place for the better-off, who are also offered generous loans to buy them. The regular full-page advertisements in newspapers, always by completely unknown, new firms, give the game away. And, if you actually tour one of these areas to see the situation on the ground for yourself, you will surely predict that much of what has been built will lie unsold. But bank managers have the land as collateral from the builders. And they have the apartments as collateral from the final buyers, who have also borrowed from them. And so, this “game” goes on and on – with everybody singing “It’s boomtime, folks!” – till the inevitable bust comes. For it is not a "boom" at all; it is only a "bubble" - and when the bubble bursts, prices crash, and the entire house of cards collapses. Borrowers default - and since the value of their collateral has crashed as well, the banks ultimately have to take the hit. And so the cry goes out to recapitalize them.

Today, it is my firm belief that it is really “bust-time” for such real estate investments in Indian cities. Indeed, I recently read that quite a few, newly established cement factories are shutting down!

There is thus only one solution to this recurring malady: The malinvestments must be liquidated. Further, all “human interference” – be that of the State or that of private bankers – in manipulating interest rates or altering the supply of money must be completely eliminated, once and for all.

Let me now turn to Joseph T. Salerno’s paper “Mises and Hayek De-Homogenised” once again, this time with particular reference to the third and final section in which he discusses the article by Lawrence White. In this article, White’s contention that Mises somehow supported fractional reserve-based “free banking” is comprehensively demolished; and Mises’ actual views on the matter very clearly stated. I particularly liked the closing sentence of Salerno’s paper: “I still insist that the homogenization of the views of two brilliant but very different thinkers [Mises and Hayek] serves no purpose today but to significantly impede the quest for knowledge and truth among those working within the Mengerian tradition.”

The difference between Mises and “modern free bankers” like White is most clearly brought out by Salerno in this paragraph:

Unlike our modern free bankers, Mises emphatically did not foresee the free banking system evolving towards a miniscule reserve ratio of gold to demand liabilities and the progressive transformation of gold into a practically demonetized interbank “clearing asset.” For Mises, rather, evolution was all in the opposite direction, with initial entrepreneurial ignorance precipitating an early splurge in the creation of fiduciary media and the resulting cyclical fluctuations leading slowly back to a system of marginal 100 percent reserves while painfully renewing awareness among the public that bank notes and deposits are not money per se but merely claims to and substitutes for money, i.e., gold.

What is “fiduciary media”? It is “money based on trust.” It means that, if a banker has in his vaults, X quantity of physical gold, he may happily issue paper notes to, say, his borrowers, as loans, knowing full well that these notes increase his liabilities beyond his stock of gold. He will then collect “interest” by lending out mere paper, unbacked by any real capital. Of course, if all private bankers do the same, the interest rate will fall below its “natural rate” – and thereby distort economic calculation and cause business cycles. Further, banks could even go bust if there are “runs.”

Salerno’s detailed presentation of Mises’ actual views as they evolved, from the 1912 publication of Theory of Money and Credit all the way to Human Action in the 1940s, including some important papers on the Manipulation of Money and Credit in between make it abundantly clear that “one of Mises’ most famous contributions to economic theory is his demonstration of the causal link between fiduciary media and the business cycle.”

Salerno has two long quotes from Mises, quotes from two different books, and the following extracts from these are, in my opinion, of vital importance in today’s world, for informing public opinion as to what is right and what is wrong, in the true "public interest":

It would be a mistake to assume that the modern organization of exchange is bound to continue to exist. It contains within itself the germ of its own destruction; the development of fiduciary media must necessarily lead to its own breakdown…. It will be a task for the future to erect safe guards against the inflationary misuse of the monetary system by the government and against the extension of the circulation of fiduciary media by the banks.

The most important prerequisite of any cyclical policy, no matter how modest its goal may be, is to renounce every attempt to reduce the interest rate, by means of banking policy, below the rate which develops on the market.

Finally, Salerno says that White is guilty of an “unwarranted, if unintentional homogenization of Mises and Adam Smith.” 

Here, what I must mention is that Adam Smith changed his views on free banking and fractional reserves when many big Scottish banks crashed, and among those who lost fortunes was his most famous pupil, the young Duke of Buccleuch. With his prestige hugely diminished, Adam Smith then made inquiries about the Bank of Amsterdam – because, for reasons that will soon be clear, it was the one bank in the whole of Europe that enjoyed the most rock-solid reputation. Finally, he found out about an Englishman settled in that Dutch city – and wrote to him asking how this bank functioned. The reply he received became the reason why he had to issue a fourth and final edition of The Wealth of Nations, in which he came out in full support of the Bank of Amsterdam and its policy of maintaining a 100 percent reserve in gold against all note issue.

Indeed, when my column advocating “A Return to the Gold Standard” was published in Mint, a comment from Lawrence White soon made its appearance, accusing me of “not having read Smith properly.” In my terse reply, I told White about the fourth edition, and how and why Smith’s views had changed. Unfortunately, Mint subsequently changed the software used for recording comments – and all these older comments have disappeared.

As for Ruchir’s political prescription regarding a New Federalism, and a new coalition at the Centre comprising regional parties – all I can say is that what we Indians first need to “breakout” of, as a “nation,” is this MINDSET that insists on telling us that without politicians and bureaucrats “looking after us and our affairs,” we are doomed.

If we want to be free, if we want to individually prosper, take individual responsibility for accumulating capital through our own, private and honest efforts, and if we want to freely select honest and capable public officials for looking after common interests in each of our cities and towns (and Ruchir calls for "rapid urbanisation"), paying taxes to them that are agreed upon, and which are then fully accounted for – in short, if we want to fix not only our economic but also our political affairs, then it is this MINDSET that must go.

The "political order" we need is nothing but "civic order" - which means the proper running of each of our cities and towns, and may there be hundreds of new ones. Today, each and every city and town throughout India is a MESS. Centralised throwing of funds at them - as in the case of the Jawaharlal Nehru Urban Renewal Whatchamaycallit (JNURRM) from a Central Ministry of Urban Development is worse than nonsensical. 

What we need is REPUBLICANISM. And not FEDERALISM. It means free-trading and self-governing cities and towns, each with its own mayor, accountable to its own citizenry, who own property, who run businesses, who pay taxes, and who have to ensure that their civic order as well as civic independence are well-guarded.

Thus, to BREAKAWAY, we need a NEW MINDSET.

We need to think in terms of FREE PEOPLE - and not RULERS.

Because the fact remains – and this is precisely where I left off at the end of my last post – it is this socialist, centralized State that is the real problem, while the people, including the numberless, unlettered, but honest and hard-working poor who are the Ultimate Resource.