Brijesh - Economics Made Easy

BRIJESH JANARDHANAN

AN EASY LOOK @ ECONOMICS AND MONETARY ECONOMICS

The Rich Man’sStory

2005 Brijesh Janardhanan

You have permission to post this, email this, print this and pass it along for free to anyone you like, as long as you make no changes or edits to its contents or digital format. In fact, I’d love it if you’d make lots and lots of copies. The right to bind this and sell it as a book, however, is strictly reserved. Please quote the book and/or source when used.

B l a n k p a g e

Of all the liars in the world, sometimes the worst are your own fears. - Rudyard Kipling

T H E R I C H M A N ’ S S T O R Y

Created by Blue Crush 1

Introduction

CONOMICS is such an important part of our lives. If the nightmarish scenario continues as it is unfortunately continuing everybody in the room will need to know how it impacts them, irrespective whether they care about the policies behind it. The Rich Man’s story came out of my efforts to explain

my family the impact of economics and how it is going to affect us in future. Wanting to keep all the text book jargons out, I tried to make it as easy as possible to understand. Of course, easy way of reaching out is to tell a story, give a situation and build characters. That’s what I tried to do in The Rich Man’s story.

I also had to keep it very short to capture the short attention span. Therefore this was broken down in to 7 easy pieces.

I think the main purpose of writing was served in many ways. First of course, my family understands the economics much better. And having sent to my friends many found it useful in understanding. This was in 2005 and early 2006, and many of us pretty much knew what to expect in future. It unraveled in form of credit crisis.

Once I had it written it I put this on my blog (http://surff.blogspot.com), and remains my most favorite post till date. I have not updated these parts in any way as the basic remains relevant.

I would love to receive your feedback. Please drop a message at [email protected].

Wishing you all the best,

Brijesh Janardhanan

Dec 2008, New Delhi.

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http://surff.blogpsot.com 2

PrefaceHi

HIS is an attempt explain few things in a simple manner. But economics is not a simple cake. It has been made tough as hell by the jargons that keep sprouting. It tough also because, every event is viewed differently by different people. What is income for somebody is somebody else’s' expense. What is

demand for one is somebody's supply. But it is an important part of life. Having knowledge of economics will sure not hurt. It may just help. This attempt, is by no way the most "correct" method. I mean the terms may not be exactly defined as such. But it is close. My only attempt is to create interest and make aware of few things. I hope is simple enough for you consider starting reading economics in detail.

If there is a central theme you must remember at all the times while reading these passages, then it is this: The Party is still on, enjoy the Party. Don't worry too much about the future, live the present. But plan, who will drive you to home when you have finished partying. Plan, how you will manage the hangover effect.

PARTY HARD, JUST KEEP YOUR HEAD ON YOUR SHOULDERS. [I hope I am able to keep it too :)]

Tip 1: This is a story, only that it deals with economics. You would have to go through the sequential parts, other wise much of the continuity, the "process" will be missed.

Tip 2: Many times I have included some texts in the [ ] which just help you out, in visualizing the contexts and interpretations. You can skip them, if you find it difficult, and still not loose anything.

Best wishes,

Brijesh

November 2005

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The Rich man’s story

HIS is a story that happened in a small village. About 200 families made it their home. There was a rich man in that village. The rich man was the head of the village also. And there was a hard working but poor merchant there.

Our story begins long back, when the grandfather of the Merchant decided that he has to break some rules. The Merchant was poor because he was in the habit of trading with the people he knew well. He did not sell his merchandise to any body else other than, selected few people of his community. Grandfather decided that it would be better for his family, if he began trading with the Rich Man. Grand father was very respected in the household and hence there was no opposition to what he said. The family was strict and respected its elders. Merchant met the Rich Man for the first time after many years and expressed his wish to sell his merchandise to him. Rich Man agreed because the Merchant had very good wares and sold it for a small profit only. Rich Man was very happy.

Their dealings started and both were happy. There were other traders in the village as well. Some of them like Albert, Louis and his friends were not happy that Rich Man was buying his needs from the Merchant. So they convinced the Rich Man, that he should not buy his entire requirement from the Merchant, and he is obligated to buy the merchandise of Louis, Albert and his friends. Rich Man agreed to that, even though the prices of these groups of people were much higher than the Merchant. It was a good policy for the Rich Man, because the Grand father had just died, and his sons were unpredictable. Rich Man did not want to depend on Merchant for everything; he wanted his supplies to be met properly. In return for his favor, Rich Man took the same promises from Louis, Albert and friends.

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The poor merchant protested against this arrangement of Rich Man. He said that he had a big family, and he will remain poor if the Rich Man did not buy his goods. Rich Man convinced the poor Merchant after some time, he will buy all the necessities from Merchant, if he can sell cheaper than others. Poor Merchant having no other choice, agreed.

As the time progressed, the trade between the Rich Man and the Poor Merchant grew. They were small because of the Rich Man's agreement. But it was a big improvement in their relationships.

At first the Poor Merchant gave cheap and best prices to the Rich Man, which he bought against the cash. As the trade between them grew, the Rich Man was not able to pay the full amounts and the Poor Merchant also agreed to carry some credit. The trade grew and knew no bounds.

The Poor Merchant faced the first economic paradox. As the trade grew, Merchant became Rich. But if he became Rich, we would not be able to sell the merchandise at low prices like he was doing. So, the paradox was, he had to stay poor so that he can become rich. This is how the paradox worked. As the Merchant became rich, his reputation and credibility in the market will increase. Because of this his value in the market will increase in the market and there will be lot of people willing to trade with him. If he traded more with them, and because he was a good trader, the value was bound to increase more. Finally there will be a stage where no body would be able to afford his merchandise and he will become poorer!

Now the primary concern for the Merchant was that his value should not increase more than the Rich Man. That was because, if his value increased a lot more than the Rich Man, Merchant would not be able to sell the goods at low prices as he was selling. Since the Rich Man bought most amounts of goods, if the Rich Man did not buy them, the Merchant would naturally be poor again.

Nobody wants to be poor not even the Merchant. So he decided to follow the clever middle path strategy. He decided that he will trade with anybody who is willing to trade with him, whether it is Albert, Louis, Steve or others. But he will see to it that he will be able to sell to the Rich Man at same prices. How was he going to do that? This way. Now suppose that Rich Man buys a table from merchant presently he pays 100 gold coins to the Merchant. Now with increased trading with others, when the value of the same table is bid up by the Louis or Steve to 125 gold coins, it is not wise for the Merchant to sell the same table to Rich Man at 100 gold coins. The clever way he


thought out was, sell the table to the Rich Man at 125 gold coins and lend the Rich Man back his extra 25 gold coins for a very low rate of interest.

This scheme was very good for the Rich Man because he could buy 125 Gold coins worth of produce and yet pay only 100 gold coins. This will help him to maintain his consumption at very low prices and he will be able to consume more. For the Merchant, it allowed him to trade with other people as he chose fit and increase his value, but yet not loose his prime customer the Rich Man.

This scheme of things progressed well. The produce of the Merchant was very good and they were snapped up by the Rich Man in large quantities, because they were cheaper than others and were of better quality.

Rich Man grew richer by the day, because he was buying the goods cheaper. So he had a lot of money left over to buy other things from others. Rich Man bought many other things from Steve, Louis etc. The Rich Man was truly happy and his household flourished.

Rich Man conveniently forgot about the credit the poor merchant was giving him. He was too happy. Until finally he realized the debt he owed to poor merchant was Huge. Rich Man was now hopelessly dependent on the Merchant to maintain and grow his standard of living. Even the Merchant was beginning to realize that he was giving too much credit to the Rich Man indirectly. He was worried because he also realized that Rich Man had taken too much debt. Moreover there was lot of opposition from the Merchant's sons that a lot of money was given as a debt to the Rich Man at a very low interest rates and helping the Rich Man enjoy the luxuries. The Merchant though became richer by many folds, was still poor as his family was a big family. The sons were correct in saying that there was lot of expenses in the house itself, which had to be met first. As mentioned earlier the household, was a strict place, and nobody complained severely.

Not only Merchant, but also others in the village like Louis, Albert and others knew the debt position of the Rich Man. Some people like Albert almost entirely stopped trading with the Rich Man or charged a higher premium for his produce. Rich Man was finally feeling the pressure of the debt he had built up. He decided to ask the Merchant to reduce the value of the goods he had bought, a kind of bargaining. The only difference this time was it was bargaining for the goods Rich Man had used for years. The Merchant was perplexed; he was confused and obviously resisted any move by the Rich Man to reduce its value. Remember, the prices offered by the Merchant


were already low. And if the Rich Man's argument was to be taken, then the entire history will be re-written. This is how it works.

Rich Man had bought the table from the Merchant several years ago for 125 gold coins. The Merchant gave back 25 gold coins to Rich Man at very low interest rates. Now, if the bargain of Rich Man was taken, there are two ways of doing it. For example if the Rich Man is asking for 5 gold coins lower, the table will be worth 95 gold coins. This will hit the profits of the Merchant. This was not much of a problem as the trade was already completed.

But the real problem was the Rich Man was asking Merchant to lower the value of debt given. Therefore of the 25 gold coins that Merchant had given the Rich Man, only 20 Gold coins will be returned!

There was a huge debate in the Merchants house of how to do this. There was no question of challenging the Rich Man, as he still was the Richest Man in the village, though had taken a huge debt. The debate was not even about the Merchant whether he should have given the part of the money back, at that point in time, Merchant needed somebody to buy many things he produced and the Rich Man was a logical choice. The debate was weather the Merchant should have overlooked his own family for the trade reasons. Now the Rich Man wanted a discount for the things he had consumed. The same produce the Merchant could have sold it to others at higher price. Made a lot more profit. Merchant also gave back a major portion of the profits back to the Rich Man as loans at very less interest rates. The money which Rich Man used to consume more luxurious items. The money that Merchant will loose if he accepts Rich Man's proposals could have been gainfully used for the benefit of the family. Now it would so seem the Merchant and his family worked hard so that the Rich Man could consume luxurious items. Now by giving discounts to Rich Man, out of their savings [profits] the family has to pay so that the Rich Man and his family could enjoy. This is a classic case of make the cake, let Rich Man eat it and pay his bill too!

The debate was silent, it was a strict household.

The smart strategy of the Merchant didn't look that smart now. But looking at the trade consideration it was a good strategy. But strategy itself began to loose value after a certain point in time. The Law of Diminishing effect.


In the real world the Rich Man is USA and the Merchant is China. The trade between US and China got the real impetus in late 1970's when Deng Xio Pang liberalized the economy. The trade was good for the 80's. But in the beginning the Early 90's China was beginning to accumulate the US treasury bills. This accumulation was very much legitimate at first. US is one of the richest countries and it is a good policy to invest its proceeds into the good asset which in this case was US treasuries. This was legitimate and advisable.

Chinese were facing problems with the export competitiveness in the mid 90's as the competition form Malaysia, Philippines etc increased. It was then, they accidentally fell into the trap of pegging of their currency. By pegging, you do not allow the Dollar-Yuan [Chinese currency] to move. So no matter what the amount of trade, the value of the Merchant remains the same. But this was still not a policy, it is just something that they happened to do. The South-east Asia crisis in 1997, when there was a large scale outflow of the foreign investors from this region began to hurt, was the point where this pegging was made a policy. From then on till now, the Yuan has been pegged at one rate. 8.28Yuan for a dollar.

How can a country keep its currency pegged? Simply put, by not allowing the currency not to go down or go above a fixed level in the base currency. This is how it works.

Trade involves two things, inflows of money and outflows of money. When one currency is more in demand than the other currency of the trading nations, the fluctuations happen. The US-China trade, has almost been one sided, with China receiving money and US giving money. The inflows into a country can happen because of two reasons. One is, when the US importer pays Chinese exporter with Yuan. The other way money comes into China, is when the US companies open their factories, offices and other investments in China. The dollar is of no use in China, whose official currency is Yuan. Therefore, ultimately all the inflows are converted into Yuan either by the exporter or the multinational that is opening the offices in China. Since, the China has been exporting huge amounts of goods to US and the foreign multinationals have been investing in China heavily, the demand for Yuan [for the conversion reasons] is very high. Naturally, since the demand is high, the Yuan's value will go up.

But if the value of Yuan goes up, the exports of China becomes costlier for the US citizens.


This is how it works. For example, if a Chinese exported shoe costs 80 Yuan in China and if the exchange rate was 8 Yuan per dollar; the US citizen will pay $8 [80Y / $8] for a pair of shoe. Now, with increased trade, if the exchange rate goes up to 5 Yuan per dollar, the US customer will have to pay $16 [80Y / $5] for a pair of shoe. So, naturally the demand for this product goes down. That is simple economics.

China faced the same problem highlighted in the Story above. If it exports more to US, and if the US MNC's invest more in China, the demand for Yuan will be up and export will be hurt. Why will MNC invest in a country from where it cannot export? So the country as such, will be worse off. To peg the China had to create an equal and opposite force to the Yuan demand. That is, they had to create a demand for the Dollar. Whenever the Yuan faced lot of pressure for appreciation, the Chinese government created an equal pressure on Dollar and therefore their values dint change. Thus the Yuan was pegged.

For the dollar demand to be created, Chinese government was routinely buying dollars from the MNC's and the exporters. Dollar, is just a currency and is of no use by itself. Therefore the Chinese government used these dollars to buy the US government bond [US treasury bills]. Buying was good because, it gives them some interest rates, even though it was very low. And thus the accumulation began. Government bonds are the means by which government borrows money from financial markets. Thus started the vicious cycle of funding the US government.

And what was the effect of Rich Man's bargain on China.

Beginning from early 90's China had accumulated nearly $500bn of US treasury bills. The bills whose real interest rates [interest rates after adjusting to inflation] were in the region of 0.75-1.5%. $500bn that could have been invested in the country health, education, illiteracy, infrastructure, housing etc, was blocked in US treasuries. US was having a party with Chinese money while the Chinese themselves were dying of starvation and disease.

A few days back the Chinese government agreed to remove its pegging to dollar. This was done on "international pressure". International pressure = Rich Man's pressure. They revalued it by about 2%. In other words, 2% of $500bn - $10bn gone up in smoke. Rs 45,000Crores. Just like that. The money that could have been used for the Social welfare for the poor Chinese citizens - gone. The market expects Yuan to go up by about 10% in a year’s time. Put that in numbers, $50bn is going to go up in smoke, in a year’s time.


And $50bn is a huge sum of money. India's entire planned infrastructure expenditure for the next 20 years is just $30bn. US had a party right through the 90's and all these years. A booming stock market, a booming IT industry, a booming housing sector etc. The bill is to be paid by the poor Chinese who works 12-14 hours a day, to make enough sum of money the US citizens spend on dog food.

This is the story of the Rich Man and the Poor Merchant.


The Rich man’s storycontinues

e will continue our story of Rich Man and the Merchant. Since now you know who they are, please do not confine your self to thinking about the two characters only. I write these pieces, because I want to communicate

the economic issues and concepts underlying. Rich Man and Merchant are just players in our game. Though very much factual players. I would like you to look at the broader issue, while understanding the concepts. Much of this Part and the rest are imaginary, only using the foundations built on the Part 1, to explain some economic concepts.

At the ending of Part 1, we saw how the Rich Man put much pressure on the Poor Merchant to reduce its debts. But, the Poor Merchant cannot give the discounts and forgive all or even most of the debts. After all he is under no obligation to do that. But Merchant understands one important matter that, if the Rich Man is not able to buy much, then Merchant will loose more than just his future business, he would also loose much of the money the Rich Man owes him. Therefore, the Merchant is ready for a compromise. Rich Man meanwhile is searching for a way out.

Rich Man finally strikes gold. He finally hits upon the idea, what if he could give the Merchant "I Owe You [IOU] notes" or "Promissory Notes" in return for the consumption, past and future. The advantage for the Rich Man is he would not have to bring up the money to pay the merchant in full. Technically, the Rich Man buys himself some time before he can make the payment to the Merchant. The advantage for the Merchant is that he can transfer IOU notes given to him by Rich Man, to others like Albert, Louis and other merchants and buy his needs. This frees all the

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blocked debts owed by the Rich Man, and Poor Merchant too has opportunity to be rich.

An agreement is reached. Whenever the Rich Man, buys the merchandise from Merchant and other merchants too, Rich Man writes out a Promissory Note for the difference he has to pay [remember the Rich Man also sells goods to others]. In the Promissory note he states that he will pay the bearer of the Promissory note certain sum of gold coins, which is equal to the difference he has to pay. This arrangement is prosperous and liked by everyone. Because none of the merchants have their capital and profits locked up. For example, if Albert gets a Promissory note for 100 gold coins, he does not have to wait for Rich Man to pay at the end of tenure; he can simply buy the goods from other merchants and pay them with this IOU note. Merchants, are happy because their trading turnover increases, increasing their wealth, personal consumption and happiness.

But then, good times never last for ever. The problem in this arrangement is: after sometime, the consumption of the Rich Man grows so much [taking a particular rate of growth in his standard of living], that he has to finally start a printing press to print the IOU notes. This goes on for some time. May be a couple of years. Finally, slowly but surely, it dawns upon the Merchants of the village, that If all the merchants went one day together with the Promissory notes, Rich Man would not be able to pay for them in gold as promised in the note. The Rich Man simply did not have that much of gold.

The slow realization of the value of Promissory notes sinks in amongst the Merchant community. Slowly, but surely, Merchants one by one, start to attach more risk if the merchandise is paid for by the Rich Man's Promissory notes. In other words, the Promissory notes loose their value in the eyes of these men. But inspite of their caution, the Merchants cannot stop trading with the Rich Man; after all he is the biggest consumer in their village. And more trading is also bringing these Merchants more wealth that which they are able to enjoy.

The summer does not last for ever. The Rich Man cannot buy for ever. Other merchants cannot also stop selling to Rich Man, because if they do most of their families will be idle, as there is no one other than Rich Man to buy such huge quantities. The cycle has to come to an end. Let us assume, the entire market now realizes the Rich Man's IOU is lesser worth than stated. Trades people stop taking the Promissory notes. They know if they exchange the merchandise for the Notes then they may not be able to exchange the notes for their requirement. That is, they know


the value of the Notes will become lesser and lesser in future. So why take it. But, what about them who are holding large amounts of gold coins in the form of Promissory notes, like our Poor Merchant [China man]. The large holders initially hold off against selling the notes for lesser value, as it will bring down the value of their total worth! Merchants like our Poor Merchant cannot even sell part of it, because if the market comes to know they are selling, the panic will start and which in turn will lessen their worth. They are kind of trapped. Their greatest benefit is in helping the Rich Man stabilize and not go down. By helping the Rich Man, again by selling products to him, in exchange of Notes that are loosing value every day.

[You may say, we are at this present juncture in the world economy. It must be remembered, this is Part is fake, but the underlying economic assumptions and concepts are in working order.]

From here on the story becomes complex, as every section of the society in the village is affected. The possibilities of what can happen are also enormous.


Luxury and consumption

e will take the possibilities and their impact in different sections, so that we can clearly segregate the scenarios.

Let us, in this Part see what will happen if the Rich Man's friends are successfully able to bring out a transformation and help Rich Man out of the situation.

All the Merchants who have traded with the Rich Man are trapped. They cannot sell and convert the Promissory notes into the gold because there is not enough gold in the whole village!!! [We will see how this happened later on] The value of the Notes in the eyes of the Merchant community is falling rapidly, and with it the total net worth of the Merchants to whom the Rich Man owes large sums of gold.

One of the ways of helping out the Rich Man is to continue selling to the Rich Man in exchange of Promissory notes, until the Rich Man's consumption equals or is lesser than production. In other words, the Rich Man has to maintain a position wherein his production exceeds his consumption. This is a tough and hard for both parties involved. The Rich Man, suddenly decreasing the amount of buying will leave many Merchant families idle and will decrease their wealth and happiness.

This will have a very damaging effect on the Rich Man and his family, because after years of luxury, they have to work to pay the price of that luxury. This is an interesting result because, when the Rich Man reduces the consumption and increases the production, the other parties like Poor Merchant, Albert and others will pay back the excess amounts to the Rich Man with his own Promissory note. Rich Man will now have to work hard to pay back what he owes to the society. Rich Man will have to work hard to earn back the pieces of paper he called "Promissory Notes". He has to finally fulfill his promise. This best illustrates "There is no free lunch" philosophy.

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This is hard on other helping Merchants too because, they have to be patient until the Rich Man is able to take back all the notes with them or for his debt to come to manageable proportions. Until then, they also have to forgo the pleasure and wealth.

There is another method, by which the Merchants will be able to help Rich Man. That is by the simply increasing their consumption to such an extent that Rich Man inspite of his large consumption is able to produce more. It is not easy ways too; there are some problems that crop up. For that to happen there has to be a cultural change in among the merchants. For example, the hard working and thrifty Poor Merchant will have to spend lavishly on consumption. And Rich Man must also be able to increase his production capacity quickly and rapidly to fulfill the requirements. This is least hurting process among the two.

Finally, when the Rich Man is able to pay off the debt, and hopefully having learnt the lesson, things become normal again.

The points mentioned here may sound simple, with little hurt, but when taken in the context of nations, the accompanying social upheaval is enormous. The adversity faced by the people on both sides of trade is enormous. In other words, the Rich Man's actions even in its most positive light are capable of cause severe hard ships.

There are obviously many more problems and many more solutions, I have just looked two here.


Promises…

N this part let us take the negative possibilities, if Rich Man's friends and investors are not able to help him out.

One way of trying to help the Rich Man is for his loyal friends to buy up all the Promissory notes issued by the Rich Man, thereby increasing the credibility of the Rich Man's Notes, and supporting their own wealth, in exchange of some concessions and security conditions from Rich Man. In effect, the Merchants would have successfully "colonized" the Rich Man, or bought large pieces of land and revenue. Rich Man, anyway you look at it, has to pay.

There are many possibilities, of how things can go out of control. Some are here.

If the Merchants decide to encash their Promissory notes, Rich Man will loose all its richness. Because, as pointed out, there is not enough gold in the entire village. This is because of Inflation. Rich Man may have to sell off many assets to repay the creditors. This would be a disastrous consequence. It seems unlikely any country would fall like this. But there is an unfortunate precedence of Fall of Rome in ancient days. Meaning, one of the most powerful nations can fall, if due caution is not exercised. Suffice to say, it will hurt ALL.

Another method is to write down the value of the Promissory notes. This is otherwise called as "Devaluation". What this means, is the Rich Man may decree since he is not able to pay all the creditors/ Merchants in full, he will pay them in lesser value for Promissory notes. Meaning, if the Rich Man had to give 100 gold coins on a Promissory note, then he may decide to pay only 90 coins or 80 coins or any number

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as he may deem fit. This "Devalues" the promissory note [which in economic parlance is called "Currency Devaluation"].

In the practical world, the devaluation is not simple, especially the "mark down" part, as lot of people's wealth is concentrated in these promissory notes. They won’t take the bullet easily. This method does not solve the problem 100% but gives the Rich Man another opportunity to set things right. [Another method of buying time, refer Part 2. Hopefully this time he has learnt his lessons] Creditors in the end, will end up paying more, like the Poor Merchant [China Man] in end of Part 1. Merchants do not have much bargaining power in these situations because if they let the Rich Man go under, they won’t get Anything back [except for the secured loans]. All the unsecured loans become bad debts. It is similar to killing the hen. So it better to get 80 coins in place of 100, rather than not get anything at all.

Just to make a point. Is Rich Man justified in "devaluing" his Promissory notes? It is after all going back on his promise! In a way, Yes, he is justified. After all it was the foolishness [or whatever you may call] of the Merchants in the first place to lend [buy promissory notes] so much money to a person, who may not be able to give it back. It was Merchants greed of rise in his turnover, income, wealth and happiness that made him accept the Promissory notes either out of negligence of Rich Man's creditworthiness or greed to "keep the engine going" [Refer Part 1]. As they say "There is no free lunch". It is pay back time for the Merchants.

I will take another negative possibility in another part. Because it deals with an interesting concept as well as being very important.


Money

HE scenario that is being described here, has happened many times in past world history. It is nothing new. It is a possibility. Understanding it is important. Because it is painful. To talk from an economist point of view always sounds like a robot talking, so inhuman. But to understand some concepts we have to take non-partial look.

I am sorry I have to do this. I have to stop the story, and take a big tour. We will first try to understand some concepts we have discussed, and then come back to our story. I hope you find the journey interesting.

What is Money? What is that we understand by the term money? Do you think the notes you carry around in your pockets is money? Do you think the zeros you have in your bank is money? So so wrong. They are not money. They are just "currency". They are simple "papers". And if you are using the 'plastic money', then you only have the notion of money. It is ridiculous to think that we slog 24 hours a day, so that at the end of the month somebody gives us few slips of paper, wherein some body simply promises us to pay us that much of money. Just like our Rich Man, a promissor. It is hard to explain now, hope you catch the concept later on. There is a whole band ofeconomist, intellectuals who band this as the "Greatest Swindle of the Man-kind".

Let’s begin, where it all began. Let us begin by understanding how the trade began.

Deep in the pre-historic ages, there might have been two individuals who were good at something. One may have been good in hunting and other good in fruit gathering. So, in the pitch darkness, when they came back to their caves, they shared their produce with each other. This was Barter. You give me this much; I will give you this much. We

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may assume, if the hunter dint get any hunt for the day, he may have manage some other way, or borrow some fruits from his friend or friend will give the hunter out of sympathy and friendship. This is a simple transaction.

As the time progressed and the communities increased, the sympathy level would have come down. Because people not knowing each other that well. Therefore, producing was crucial. It was the livelihood. Something you did for living. But how do you know how much Oranges does it require to buy the deer meat or the meat of a wild boar. Certainly, hunting these would have involved different levels of difficulty. How do you also know what the value of Orange is when it is off season? Certainly, the value of fruits would have changed from season to season. There is a big problem fixing the price, when transactions with added complexities are involved. They needed a common cause. That common cause is what is called as Money.

Money had its own intrinsic worth. It would on any day, come rain or shine, summer or winter, stand on its own. It could buy its owner its value of goods, no matter the time or day. Money was pure.

Money was also money because everyone in the society agreed that it had value. Humans have experimented with wide range of money. They differed from conch shells, stones, wooden sticks, bones to metals like gold, silver, copper etc. We will use only gold in the discussion for the sake of ease.

Now let us assume a society of 100 people, where 1 gold coin buys you the goods worth 1 gold coin. Let us assume they transact once every month. Therefore, the turnover [the GDP] of the society will be [100 people x 12 months=] 1200 gold coins per year. This will be the same, no matter what the progress made by the society. If we change one variable, say one transaction per day. Then the GDP becomes [100 people x 365 days=] 36,500 Gold coins. We can see, there is an intrinsic "brake" in this type of dealing. You cannot go too fast, no matter how many deer you have hunted, or what amount of bumper crop you have produced. This "brake" has been the big weakness of the "Gold Standard".

What is Gold Standard? Simply, it means every economic unit of money, is backed up by equal amount of economic value. 1 gold coin = 1 gold coin. [This is carrying the meaning to little extreme but understanding is useful]


To progress, societies either needed more people to deal with or transact more and more frequently. Both of which had limitations. The clever way to by pass this "brake" and increase the GDP was as follows. To illustrate, simply, make two unit of economic money equal to one gold coin. If we take this example, then the achievable GDP of the society doubles overnight. [2times x 100people x 365 days = 73,000 gold coins]. This meant more transactions and more wealth. People would be happier. This process, of increasing the value on an economic unit, while maintaining/ decreasing the value of economic value, is similar to "inflation". [The term Inflation would be understood much better when included under the discussion on banking]

Now let us progress into the future, and bring in the interesting character of Angel and the Devil. The Banker. Bankers were originally goldsmiths. To be a banker in the earliest days needed only one qualification, to have a "Locker". In the earliest days, people would come to the Banker-goldsmith, who was a person of highest integrity, to keep their valuables with him, namely gold and gold coins. In return, the Banker would give them a promissory note for that particular value. With the permission of the "Depositors" the banker would lend the gold and gold coins to the needy. Thus the banker earned his living. In the earliest days, it was the necessity of the “depositors" to keep their belongings safe. But competition would soon arise, for the "depositors" valuables. Bankers started offering, an incentive called as "Interest" whenever a depositor deposited the money with them.

Now, somebody smart enough to safe guard the money was smart enough to use it. It would not have taken long for the Banker to see, that depositors "Save" the money. That is, they do not use part of it. And from Banker's point of view, they are not "Withdrawn". So, no matter the circumstance, there was some money always with the banker. To illustrate, if the Banker had 1000 gold coins as deposit, and banker thinks 900 gold coins will not be withdrawn within a month, Banker can lend 900 gold coins easily for a month. Up until here, we are safe [gold standard]. But it is another practice that led to something more useful as well as devious.

The amounts loaned out were put back in as a deposit, and were used for further loans. For example, if 900 gold coins were lent out to 9 people at 100 coins each and each of these "debtors" put back 50 coins for safekeeping until required. The banker, had [9people x 50 coins=] 450 coins more to lend. He could lend 100 coins each to 4 more people. From the simple 1000 gold coins in deposit, by using the "credit" based system of accounting, the Banker increased the "Money Supply" to [1000+900+450+....=]2350 coins. From just 1000 gold coins, an extra 1350 coins were


created, with no increase in the "Redeemable Economic Value". In other words, 1350 coins of value were created out of thin air. Just like magic. This created "Inflation". This method of banking is also called "Fractional Reserve Banking", because the actual reserves with the Bankers are just a tiny fraction of the 'money' lent out.

All the people are happy because the increase in the money supply has improved the standard of living. They "think" they are now richer because last summer they had 25 gold coins and this summer they have 50 gold coins. Now let us assume the angel, the much blessed, magician banker continues his magic trick for years. Now, on books of record there are so much money created [including the drafts, negotiable instruments, promissory notes etc] that the "Money Supply" increases enormously. We must realize, increase in money supply is a spiraling effect. More money supply, leads to much more money supply. The cycle does not end. It would end only if no new money was created using the Credit based system.

But does the paddy field's yield, for example, match up with the pace of growth in money supply. Unfortunately not, the real world grows much slower than else. [That is why you will see the financial sector or any other sector without "brakes" like software growing faster than say agriculture, in an inflationary climate. Simply, because people have more money- don’t know what to do and this leads to a situation where there is more to invest in companies, stocks, real estate, cars, vacations, parties etc. You see everyone opening a company or producing a film. Or giving Rs100 for a coffee which is worth only Rs5. You see rich becoming richer. The stock market booms. Real estate goes sky high. Credit cards are everywhere. Loans are a joke. Cars and obnoxious wealth populate. People are simply rich, with no Jesus idea what to with the money. Or are they really "Rich". Even our Rich Man was rich. Back to the story.]

But does the paddy field's yield, for example, match up with the pace of growth in money supply. Unfortunately not, the real world grows much slower than else. In effect, this means the production of paddy remains same but the money supply has increased a lot. Therefore by simple demand-supply economics, the price of the paddy goes up. Why, because just like coffee, people are ready to give Rs40 for a rice that is worth Rs20. The commodity price increases. All the real world prices increases, because they cannot increase the production at the same pace as the money supply. Don’t forget, Money supply is a spiraling effect. [There is a common mis-perception that increase in prices is inflation. Actually, increase in prices is the 'result' of inflation. Many economists call this "increase in prices" theory as cheating. That is because; any


government can control the prices of commodities to a large extent. Take the case of onion imports or petroleum imports. Back to story]

It is not long then that Money supply has grown to such an extent that, even the simplest commodity cost HUGE sums of money. You may have to carry a truck load of "currencies" to buy a bagful of necessities. It is surely cheaper, to burn the money than pay for gas. It would be easier to sleep on the Currencies than buy a mattress.

From the conventional point of view, the money has lost value. How? For example, a cup of coffee that cost Rs5 now would cost say Rs100. So therefore [Rs5 yesterday = Rs100 Today]. This gives us another impact of inflation, and sometimes considered [wrongly] as the definition of inflation.

Not to mention, there will be a class of society, which will be caught totally off guard. They would never have imagined, what they bought for Rs10 would be Rs30, in just a few days.

The worst part of the story is that there is no end in sight. It is just spiral effect. In this environment, billionaires will be middle class, may be even lower. Why? Because even the simplest thing can cost Trillions!!! These are the facts. In 1913 Germany, a pair of shoe would cost 13 marks. By 1923, the same pair of shoes cost about 32 Trillion Marks!!!! [32,000,000,000,000 marks for a shoe!]

This period when the money supply is very very high, and increasing at a very sharp rate [because of compounding effect] and when the prices double almost every week [a day] is called "Hyper inflationary" period. This phenomenon is called "Hyper-Inflation".

Let’s get back to the village of the Rich Man. Now, since the Rich Man's Promissory notes have been used by the Merchants among themselves to trade, the notes become equivalent to money. Now, the Rich Man has printed out so much of Promissory notes, that actual amount of Gold in the entire village is just a tiny fraction of the "Money supply". [Fractional Reserve] That is why Rich Man can never hope to buy back the entire Promissory notes with the gold. But, he still has one way of protecting his loyal Merchants. Rich Man simply prints out more Promissory notes, to cover for the short fall. For Example, if one promissory note promising 100 coins is worth only 80 coins in the eyes of trades’ people, then Rich Man will simply print another Promissory note for the shortfall of 20coins. It does not take long to realize this is a spiral effect, just like our tour above. More the Rich Man prints the notes, more the


value decreases, and more he has to print again to keep the sum of the notes equivalent to 100. What will result is hyperinflation. Rich Man, will end up giving 32 trillion coins for a shoe, which initially cost just 12 coins.

There is a widespread poverty during these times. Not to say, things are expensive. The 'Notes' by themselves have no meaning or intrinsic worth. The Poor Merchant and his family who worked hard, for number of years, to save some coins/notes, now find even the simple necessities out of reach. He would be lucky if the hard earned money could buy his family enough bread and medicines.

[So, what is the value of the money we carry around, and for which we struggle and slog day and night. The Money retains its value as long as there is value for it in the market. If the value goes down, naturally the employers will give more 'money'(salary) just to compensate. And we end up thinking, we have become richer. This is where, in my opinion, the jobs in "non-brake" industries like Financial sector, software, BPOs, Call centers etc [Especially BPOs and Call centers] carry biggest risk. When the time comes, we are very much incapable to translating our knowledge and experiences into "real world" production.]


Are we there yet?

O, has the time come for such a situation as yet. No. Not at all. But we are getting there somewhat closer every passing month. It could be years before we see some bad situations or we may never even see them in our life times at all. Hopefully so. But does that mean we can party hard and forget the hangover? That would not be prudent.

One of the smartest investor explains the risk management like this. Suppose you have to cross a street every day. Initially, you check out if there are any vehicles approaching, and carefully cross the street. And every time you find that there are no vehicles approaching, so does that mean the next time you are crossing the street you need not be careful. 'That' crossing perhaps could end up being the last crossing.

So let the party continue, enjoy, just be aware what you have to do, when the party is over.

What should we do? Here I would not like to make any suggestions, for no matter, I am still do not know enough to suggest that. There are many books that deal with these issues that should help.

P a r t

S


To sum it up…

have given some concepts of economic term in previous Parts. Now I will try to put together, a story of the where we are in present situation.

We will begin our story from the beginning of the last century. One significant event in the beginning of the twentieth century was the World War I. And the war is the serious consumer of money. It sucks in money from all corners. It puts so much of money into the economy that it prospers, even after the war is over. This global/country prosperity has always taken place when the wars have been waged. And they have been great tools for Bankers to earn significant sums of profits.

World War I began in 1914. So, how can the country finance its military adventures? Simple, print the money. There is nothing more easy in the world than printing your own money and buy whatever that would be required. Rich Man did that. [But, you know the price he paid.] Most of the Europe was engaged in bloody war. To finance this all the countries involved, be it Germany or England, simply printed the money. And money was used to fund the war purposes. US, was not involved in the first War. But, in order to assist England to win the war, it started its won printing program.

Germany hyper inflated around 1923 [32 trillion for a pair of shoe! Refer Part 5]

To understand something more, let us add a twist. Let us take production into account. The main role of US in World War I was as a supporter to England. In order to finance the England's war plans, US began printing money [Financing England]. But the clever US did not help much in the term of cash in the term of war goods. For example, they built ships, automobiles, guns, steel for England. Therefore much of the money printed was gainfully put into expansion of the economy and building of assets.

P a r t

I


Since, US was exporting more rather than importing [that is producing more, than consuming] and because they were gainfully utilized, US did not hyper inflate. But itwent on to face another problem.

The decade after the war became to be known as "The Roaring Twenties" in US. The War had just ended. The increase in money supply had placed lots of money with the people, who used it for lavish consumption. The times were generally good and it was a jolly good time to have fun. But after the War and after few years of reconstruction of England, and reconstruction loans to other countries, the US dint have much incentive to increase the money supply. [Remember, the money supply is spiral effect. The money retains value as long as the new money is coming in. Refer Part5] Once the money supply tap was turned down, the consumption levels dropped. The demand dropped.

Soon, after the war, major requirements from the war front had stopped. But this had led to excess capacity created in US to be idle. Many of the factories were converted for civilian purposes. [For the employment sake] The competition and production capacity increased and the prices began to fall. Factories produced so much that many factories had to close. Because of better management, efficiency, large production economics the prices kept on falling and the other business were closing. All the while demand was decreasing as the money supply came down. Finally, the unemployment rate was so high, that the demand for the products virtually diminished. In order to survive, the surviving businesses cut down the prices further to stimulate sales. All these led to cascading fall in prices. This was "Deflation". The period became famous in economic history as "The Great Depression".

There is a heart rending story that explains a lot. The father used to work in collieries and had lost his job,

Child: Mother, Why don’t we have enough coal to heat?

Mother: Because we do not have the money

Child: Why don’t we have the money?

Mother: Because your father does not have a job

Child: Why doesn’t father have a job?

Mother: Because there is too much coal!


[It was poverty amongst the plenty.]

In the decade following the recovery, the World War II started. And as always, war eats up the money. So, it leads to more money creation and more fun for people. The after war period saw great growth in the US economy. Partly fueled by increase in money supply and partly by genuine demand and progress. It must be mentioned, that up until that time, the Dollar bills [notes] were freely convertible in gold. But US was major exporter at that point with great industrial strength, therefore Money [convertible into Gold, therefore Gold] kept coming into the US.

But in the late 60's the tide changed. Japan began exporting to US in a big way. And for first time in a long period, the Gold was going out of the country [US imports from Japan were more than exports. So, had to pay Japan in gold-convertible money] US later adopted the policy that was landmark. It totally delinked the Dollar from the gold. From now on, Dollar holders could not claim the equivalent value of Gold. In effect, US threw off the "brakes". Earlier, there had to be some basis [linked to Gold] in order to print or issue money, but with the "brakes" off, it could print any amount it wanted. The market will decide what the value of the dollar bills was. [Just like in the case of Rich Man's Promissory notes]

From then to now, the Fed has been printing money, for every reason it deems fit. Iraq war. Homeland security. The rate of money creation increased in the mid 90's. Now, the US owes the foreign countries Trillions of dollars. Just like our Rich Man.


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Brijesh - Economics Made Easy