Public Debt

The Indian budget was unveiled recently. Amongst other things, it talks about reducing the budget deficit from 6.9 percent of the GDP to 5.5 percent of the GDP.

This is heartening. The budget deficit essentially refers to the balance between spending and earning by a country in a fiscal year. So the less the deficit, the better it is. However, another parameter called the public debt is another matter altogether.

The public debt, also expressed as a percentage of the GDP, is the overall debt the country is in. The figure on the left indicates the public debt of the world. I have little respect for the fiscal policies of the US and the UK. Which is why, their public debt of close to 60% doesn't surprise me. However, what worries me is the stark difference between India and China. Our public debt is close to 40 percent whereas China is sitting comfortably at 10-20 percent.

The good thing about percentages is that they hide the reality a little. In absolute money terms, with a GDP 3 times as that of India, a ten percent deficit of China is almost similar to a 40 percent deficit of India. However, that shouldn't be a reason for joy.

I also noticed the grey colors in the map. Either they have non-existent GDP, no public debt or the data is not available. Considering that the countries seem to be West African ones or Mongolia, it seems to be a valid question :)

One-tenth of the real money

Banks issue much more money than they have in reserve. However, the central banks play a central role in developing the illusion that all is well.

Money used to be the overall sum of goods and services put together, remember. How does more and more money come to represent the same amount of goods and services then? Well, because at the heart of the problem is the allowance of fractional-lending, where banks can lend much more than what they have in reserve. This reserve is not the reserve in their own bank but the reserve they maintain in the Central Bank of the land they operate in.

Banks are required to make an initial deposit to the central bank when they start operations. Lets say $1000. By the allowance of fractional-lending, the bank can now loan a maximum of $10000 to someone (the maximum ratio being 10:1). Lets say Adam gets that loan. Adam buys a car from Ann for $10,000 and Ann goes off and deposits this in another bank. Yes, the new bank has $10,000 now. But (and thankfully) the new bank cannot apply fractional-lending on this sum. It cannot give a loan of $100,000 based on this $10,000. In fact, the deposit of $10,000 is 'divided' by the fractional-lending ratio and reduced to two parts - $909 and $9090 (the sum coming to $10,000). The balance-sheet for the new bank will show the complete $10,000, but it can loan money only over the $909 dollars now. The next maximum loan is, hence $9090. This is an important step. To take a step back, in the first loan, $1000 was inflated to $10,000 but as soon as it was deposited, it was deflated back to $909 for the purposes of providing loans. In-spite of this 'deflation', each bank will earn interests on each successive loan, even if it is of a slightly lesser amount (first $10,000, then $9090 and so on). If this series keeps going on, and we add the maximum successive loans, they add up to $100,000!

There are two take-aways. The first is that fractional lending allows banks overall to earn interests on loans of money that is 100 times that is deposited in the central reserve. Also, that the money in circulation is 10 times what is deposited with the central reserve.

Hence, go open a bank. And remember that a new car is really worth just 1/10th.

House ownership across Britain and the US

Property ownership was a British concept to begin with. Not that people didn't own property other than the British but the association of strength and power with ownership of property was something of very British origin. In the 1700s, the power to vote resided with the wealthy land-owning aristocrats, the people who came to occupy the House of Lords in the parliamentary system later.

But as with any financial tale, this one did not have a very happy ending. These men-to-the-manor-born borrowed heavily to pay for their extravagant lifestyles, with their land and the agricultural revenues as collateral. However, come mid-1800s, as the prices of agricultural produce went down, so did the backing for these loans. As these aristocrats put their heads together to sort out finances, most of them realized that their borrowings were way more that the worth of their estates and their agricultural revenues put together. Most of the houses were acquired by the lenders and several of the rich elite had to move into rented houses, a big step down considering the opinions of those times.

That was Britain. Now the US.

Owning a house makes sense. It gives you security and ownership. However, before the great depression, only two-fifths of the US population owned their own homes. As the great depression struck, the few home owners there were, were also forced out of their homes for lack of mortgage payments. So how did this miserable situation turn around? The New Deal! Mr. Roosevelt took several steps to encourage people to invest money in house ownership. The government ensured that the money invested by the public to a bank as part of mortgage payments would be ensured by the government even if the bank went bust. A federal housing administration was setup to offer longer, larger and lower interest loans (20 to 30 years). And it also setup the 'Federal National Mortgage Association' which goes by the famous nickname - Fannie Mae - to stimulate the mortgage market.

Well all of that seems about right. What went wrong then? Well, the way it began was that these mortgages were not given out to any tom, dick and harry. They were only given to 'prime' candidates. The rest you probably know ....

Bonds and the American civil war

Then came the bonds. Bonds are not the most popular of financial instruments. The returns are low and there is always the risk of inflation catching up or overtaking their rate of return.

However, bonds are no small time contenders. The bond market is many times the world's stock markets put together. Moreover, they have been an instrumental tool for governments in times of economic strife. Cotton backed bonds were the main source of money for the Confederates, the southern US government, to get money to finance the war against the North. These bonds promised interest like any other bond. However, they went a step further. In case the interest could not be paid by the government, these bonds were exchangeable for cotton! Cotton, a rich cash-crop was an excellent backing to these bonds. Several people became interested and bought the bonds.

With money sourced from these bonds, the war dragged further. Finally, the North, understanding the importance of this crop in the scheme of things, played a master-stroke. Devoting a large section of their military strength to it, the North secured the port of New Orleans. New Orleans was the main exit point for all the cotton the south exported. With the port under northern control, the promise of cotton in exchange for the southern bonds to the bond-holders went down the drain. Their value plummeted and so did the source of money for the South contributing greatly to their defeat in the end.

The Medici

To look back at the ascent of the concept of modern day money, we need to take notice of Italy in the 1200s. Money, in token form, had come into being by then. However, lending was still not a profession of good standing. Christianity forbade usury, the practice of charging interest on the loan doled out. However, if a money-lender didn't charge interest, how would he make a living? How would he cover the defaults?

Jews were the answer to this riddle. A different religion allowed them a different set of rules. In Florence, sitting behind their benches, they gave loans without compunction or fear of the after-life. Dealing with numbers for generations on an end has clearly made them a smart bunch of fellows. The Christians could only sit in the side-lines, working away at their 'legitimate' professions.

This changed in the latter part of the 1300s. Giovanni de Medici, of the notorious Medici family in Venice, rose to clear his family of their stamp of infamy. Using his sharp intellect, he hit upon an ingenious way of tapping into the money business, and still remaining within the remit of the Christian laws. He started to work on Forex! There was no low forbidding a commission on changing currencies at the time. The commission, after all, was not interest. It was just a commission. And once this happened, there was no stopping the Medici family. By spreading their services far and wide in Italy, they grew in scale, allowing lower operating costs. Low costs and higher profits - the family became richer and more powerful. Two (three) queens and a pope eventually came from this family.

The masters of money ...

I have come across some fascinating documentaries tracing back the history of money and how economics had a major role to play in world affairs since the beginning of organized society. I might dedicate a few blogs to how things were ...