Milton Friedman has famously claimed once - inflation is everywhere and without exception a monetary phenomenon. Many have agreed, many have disagreed and a small subset on either side have understood. I don't know which group i belong to!
In theory, it is quite straightforward to understand that if the money supply in the economy is growing at the same rate as the output, the average price level in the economy will be constant - zero inflation. Hence any economy wide price increase has to be attributed to the prevalence of more money than that is needed to buy all the goods and services produced. The issue becomes perpelxing when one thinks of the so-called supply side inflationary shocks. If the oil price goes through the roof, prices of most things tend to go up. This is also easy to understand and in fact to see in practice. What happens to money supply in this case? As in, if money supply were constant and the price of a key commodity went up due to supply side issues, what explains the resultant inflation?
One can go back to first principles and device a thought experiment. Say a closed economy has wheat as the primary commodity and a host of manufactured goods and services. For simplicity let us assume that the economy is not growing in real terms and has constant money supply. Hence one can effectively point to the total amount money in the market (including notes, coins and bank deposits). Now if the wheat harvest of one year turns out to be quite bad and the stocks dwindle. The demand for wheat has remained same and hence by the laws of supply and demand, the price of wheat will go up. Insofar as there is no change in the money supply, one would expect a deflationary pressure on the price of other commodities. As in the haircuts and electricity should become cheaper since more money is now being sent the way of purchasing wheat. Would it happen in real life? If not, where would the excess money to pay for more wheat come from?
In a real life scenario, there might be a linkage to the asset markets and credit generation. Ultimately money supply is primarily affected by the rate of credit growth in the economy. If the supply shock leads to change (effectively increase) of the credit in the economy, it can lead to inflation through a forced change in money supply. Forced in the sense that it comes from outside the monetary policy controller of the economy (central bank). In this sense Friedman may be right in the final observation - it is through the money supply route that the supply shocks also get to increase inflation. But the statement has been often abused by monetary policy critics who directly translate that statement into a blame for all inflation onto monetary policy. That is clearly not the case.
One can only say that supply side or demand side, inflation comes through increase of money supply. Not always can the increased money supply be attributed to the monetary policy. However only active monetary policy can quell the increased money supply.
Another important factor in considering the impact of money supply on inflation is the growth rate in asset markets. It is not only goods and services that are purchased with money. Equities, bonds and real estate are as well. Hence the linkage of money supply to inflation is not complete without understanding the balancing figures of asset price changes. More on that later.
Sunday, August 08, 2010
Wednesday, July 21, 2010
Sovereign defaults - the next big thing!
Much of 2008 was marked by a speculation about which big company was to fail next! After the Bear Sterns rescue, people started guessing who was next to disappear - through failure or takeover. Citi, UBS, AIG, Lehman, Merrill were all in the fray. Finally Lehman went bankrupt and Merrill was acquired while the rest survived to see another day. As the fears of a catastrophic global meltdown receded, a certain optimism justifiably took root amongst investors. Not too long though! As Euro area problems boiled over through the PIIGS and a few others, a new specter has started to hang over the global economy - sovereign defaults.
In short sovereign defaults are failures of a government to repay its debt obligations. It is not new to the modern global economy. Argentina defaulted in the 90s, several smaller countries defaulted through second half of 20th century and so on. However it is probably the first time since second world war that some of the developed economies are the candidates for default - in this case most notably Greece and Portugal and to a lesser extent Spain, Italy and Ireland.
Sovereign defaults are imminent when the government of a country runs into debt trap - a state of affairs when one needs to keep borrowing ever increasing debts to simply keep repaying the earlier ones. The obvious reason this starts to happen is because the governments in question spend more than they earn - leading to budget deficits. But then that is the modus operandi of most governments in the present world. Why the sudden change of fortunes? The problems arise when the deficits grow too large for the government's current and expected income as well as when the interest payments go up as the investors in that government's debt start demanding a higher interest rate on their lending. Unfortunately most often these two trends coincide. Investors start to get wary of spendthrift governments - especially those with economies growing slowly or not at all. The increase interest payments on the debt then pushes these governments to start borrowing more, which further unnerves the investors and the cycle continues. Often it is broken in its early stages by belt tightening by government thereby reducing actual deficits as well as by creating more faith amongst investors - thus reducing interest payments on further borrowings.
Will Greece default? Will any of the other PIIGS default? The likelihood of Greece defaulting is low but not insignificant. The likelihood of any others defaulting is indeed quite low. Greece is a much more classic case than the rest, of a government spending too much for its own good with the hope that the buoyant global economy of the pre-2007 era would keep its problems under control. Thus the crisis hit it the hardest. The others are better managed in comparison - though no models of austerity!
While the world worries about the spendthrift governments in southern Europe, there are voices of concern over a frugal Germany as well! It might almost sound contradictory to see experts crow over over-spending and under-spending at the same time for countries in the same monetary union. There is some merit to it, but there are deeper questions raised about the structure of global economy in the process. The rabit-hole may indeed go much deeper, but more on that later!
In short sovereign defaults are failures of a government to repay its debt obligations. It is not new to the modern global economy. Argentina defaulted in the 90s, several smaller countries defaulted through second half of 20th century and so on. However it is probably the first time since second world war that some of the developed economies are the candidates for default - in this case most notably Greece and Portugal and to a lesser extent Spain, Italy and Ireland.
Sovereign defaults are imminent when the government of a country runs into debt trap - a state of affairs when one needs to keep borrowing ever increasing debts to simply keep repaying the earlier ones. The obvious reason this starts to happen is because the governments in question spend more than they earn - leading to budget deficits. But then that is the modus operandi of most governments in the present world. Why the sudden change of fortunes? The problems arise when the deficits grow too large for the government's current and expected income as well as when the interest payments go up as the investors in that government's debt start demanding a higher interest rate on their lending. Unfortunately most often these two trends coincide. Investors start to get wary of spendthrift governments - especially those with economies growing slowly or not at all. The increase interest payments on the debt then pushes these governments to start borrowing more, which further unnerves the investors and the cycle continues. Often it is broken in its early stages by belt tightening by government thereby reducing actual deficits as well as by creating more faith amongst investors - thus reducing interest payments on further borrowings.
Will Greece default? Will any of the other PIIGS default? The likelihood of Greece defaulting is low but not insignificant. The likelihood of any others defaulting is indeed quite low. Greece is a much more classic case than the rest, of a government spending too much for its own good with the hope that the buoyant global economy of the pre-2007 era would keep its problems under control. Thus the crisis hit it the hardest. The others are better managed in comparison - though no models of austerity!
While the world worries about the spendthrift governments in southern Europe, there are voices of concern over a frugal Germany as well! It might almost sound contradictory to see experts crow over over-spending and under-spending at the same time for countries in the same monetary union. There is some merit to it, but there are deeper questions raised about the structure of global economy in the process. The rabit-hole may indeed go much deeper, but more on that later!
Sunday, July 13, 2008
The society defining forces
Several things have shaped human societies over time. There have been a few regular themes and then a few which came and went. What we need to understand from here on is which are the drivers now and how do we manage them for a better tomorrow.
In the past religion, natural resources and land have been almost constant drivers of social structure and restructuring. Periodically there have been special themes. The racial anger before WWII or industrial revolution in 19th century imperialism or the outcry against imperialism in 20th century or the rise of nationalism in western world political revolutions in 17th and 18th centuries.
The social structure is built and altered by some of these inherent forces as also some upheavals like war, disease or large scale migration. In the modern times, the drivers shaping us have been predominantly emergence of a new global military order, fossil fuels, international mobility of capital/goods/labor, religion and finally technology.
How the society will evolve from here with the pushes and pulls of these factors is not an easy thing to imagine. Harder still is an attempt to shepherd the course of events in the desired direction - if at all we know what that is.
One of the trends emerging in recent times is the reestablishment of population as a driving force of prosperity. Before the industrial revolution, GDP was almost linearly linked to the number of people a region had. That in turn was driven by resources, rivers and trade along with government spending on massive projects. Post industrial revolution, mass manufacturing enabled the societies with fewer people to catch up and leave behind those with more people. With an edge in military technology of the western powers imperialism followed. Long after the dark age experienced by the colonies is over, these economies are still reeling under the impoverishment suffered during the colonization.
Slowly the things are coming a full circle though. Technology improved so much more in the interim that the mass manufacturing became commoditized, the western world itself is trying to move up the value chain into services economies and outsourcing manufacturing to cheaper locations. Once again population is coming back to the centre of economic activity. The demographic dividends that the populous countries are looking to reap is an evidence of that. As for the western economies, the declining population has started to ring alarm bells leading to all sorts of desperate efforts to get women to have children. The worry is very real.
Where are we headed from here. For more than 3-4 decades the populous countries will probably continue to play catch up on the standards of living of the west. However, post that the populous countries will appear lot mightier than the sparse west. Just as Europe went to the sidestage of the global arena to make way for US, the western world will make way for the populous countries. Once again the world will look more balanced - more prosperous than it was in 1st century, but with pretty much the same relative relevance of various regions.
As an Indian, I am not worried whether India will grow big mighty and prosperous. I would however, like to ensure that the process is smooth and does not encounter the special obstacles of the prevalent times. To do so, the most crucial three things are ensuring access to credit, education and healthcare to the near poverty line people of the country. Else much of the demographic dividend could turn into demographic liability.
In the past religion, natural resources and land have been almost constant drivers of social structure and restructuring. Periodically there have been special themes. The racial anger before WWII or industrial revolution in 19th century imperialism or the outcry against imperialism in 20th century or the rise of nationalism in western world political revolutions in 17th and 18th centuries.
The social structure is built and altered by some of these inherent forces as also some upheavals like war, disease or large scale migration. In the modern times, the drivers shaping us have been predominantly emergence of a new global military order, fossil fuels, international mobility of capital/goods/labor, religion and finally technology.
How the society will evolve from here with the pushes and pulls of these factors is not an easy thing to imagine. Harder still is an attempt to shepherd the course of events in the desired direction - if at all we know what that is.
One of the trends emerging in recent times is the reestablishment of population as a driving force of prosperity. Before the industrial revolution, GDP was almost linearly linked to the number of people a region had. That in turn was driven by resources, rivers and trade along with government spending on massive projects. Post industrial revolution, mass manufacturing enabled the societies with fewer people to catch up and leave behind those with more people. With an edge in military technology of the western powers imperialism followed. Long after the dark age experienced by the colonies is over, these economies are still reeling under the impoverishment suffered during the colonization.
Slowly the things are coming a full circle though. Technology improved so much more in the interim that the mass manufacturing became commoditized, the western world itself is trying to move up the value chain into services economies and outsourcing manufacturing to cheaper locations. Once again population is coming back to the centre of economic activity. The demographic dividends that the populous countries are looking to reap is an evidence of that. As for the western economies, the declining population has started to ring alarm bells leading to all sorts of desperate efforts to get women to have children. The worry is very real.
Where are we headed from here. For more than 3-4 decades the populous countries will probably continue to play catch up on the standards of living of the west. However, post that the populous countries will appear lot mightier than the sparse west. Just as Europe went to the sidestage of the global arena to make way for US, the western world will make way for the populous countries. Once again the world will look more balanced - more prosperous than it was in 1st century, but with pretty much the same relative relevance of various regions.
As an Indian, I am not worried whether India will grow big mighty and prosperous. I would however, like to ensure that the process is smooth and does not encounter the special obstacles of the prevalent times. To do so, the most crucial three things are ensuring access to credit, education and healthcare to the near poverty line people of the country. Else much of the demographic dividend could turn into demographic liability.
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