Friday, June 8, 2018

RBI’s Interest Rate Manipulation

Finally after a gap of 4 years the Indian central bank RBI raised its interest rate – the repo rate – by mere 25 basis points to 6.25% yesterday. RBI cited a concern for rising price inflation in the form of oil price shock as a major reason for hiking the interest rate. They said, while hiking rate will combat price inflation, its policy stance remains “neutral” i.e., it is ready to lower rate again if the hike in interest rate starts to hurt economic growth.

The mainstream view of the role of the central banks in the economy and society is that they are the monetary institutions that stabilize the economy and help it grow. But the reality is exactly opposite to this mainstream view. RBI is the main source of all kinds of instabilities in India. Its policy of interest rate manipulation, via creation of money out of thin air, is the source which creates major problems like inflation, boom and bust cycles and the inequality of income and wealth.

Inflation
Modern mainstream macroeconomics defines inflation as a rise in general price level, for which they blame sometime supply shortages (cost push inflation) and sometime rise in demand (demand pull inflation). The original and correct definition of inflation was an increase in the quantity of money and credit. The modern mainstream definition focuses on the effects of inflation, which is wrong. The right way to look at inflation is to focus on its cause rather than effect. This is because only then we can truly eliminate inflation from our economy. Once we clearly see that inflation is an increase in the quantity of money and credit, the next logical question is, who is responsible for this increase? The answer is easy: RBI, the central bank which has monopoly over the supply of money and credit in India. Only RBI can create money (rupees) in India. Only they can print it. If you and I will print our rupees at home then we will go to jail. It is a crime of counterfeiting. RBI is the official counterfeiting institution! Thus only RBI can increase the quantity of money and credit, and so it is solely responsible for creating inflation. When it prints currency notes to lower the interest rate, it increases the quantity of rupees in the market. This is inflation. And this inflation lowers rupee’s purchasing power. Looking from the goods side, it looks like their prices are going up. In reality, the purchasing power of rupee is going down. What 100 rupees used to buy in 2017, it no longer buys in 2018.

Boom Bust Cycles
RBI is also the sole cause of business cycles (boom and recession) in India.

The mechanism through which RBI tries to increase or lower the supply of money is via its monetary policy of interest rate manipulation (other two ways are: CRR (cash reserve ratio) and purchase or sale of government bonds (OMO: open market operations)). Interest rate is a price of time. It is determined by the societal time preference of how much resources people want to consume today or save and invest for tomorrow. The consumption and saving  habits of people determine the supply of loanable fund, and the demand for this fund comes from the businessmen (entrepreneurs) side. This demand and supply of loanable fund is what determines the market rate of interest. If supply goes up, while demand is constant, then the interest rate will come down and vice versa. And when the demand goes up, when supply is held constant, the interest rate will rise and vice versa. Without the RBI, the supply of loanable fund (money) comes from the real saving of people. This saving in turn comes from prior production. But RBI distorts this whole mechanism by artificially creating the supply of money from thin air. When it prints money (without any prior production and saving), it increases the supply of money in the market which lowers the interest rate. This RBI determined monetary rate of interest is different from the market determined originary rate of interest. Interest rate is a price of time and it is used by entrepreneurs to make decisions about how much resources to allocate for producing goods for immediate consumption in present and how much to devote to capital projects for future production and consumption. When RBI artificially lowers the interest rate, it gives a false signal to entrepreneurs about the availability of saved resources. They start borrowing to start long term capital projects. These projects are inherently unsustainable because the real pool of savings to support these projects is not available. As they start spending the borrowed money, in the form of giving wages to their workers etc., their spending starts to lift prices of various producer and consumer goods. This is the beginning of the boom. But because this boom is unsustainable, it will end in a final bust and ensuing recession and depression. When prices will rise so much that it threatens the ruling government, for which the central bank is working as a banker, RBI will start to increase the interest rate (like what it is now doing). But this sudden increase in the interest rate creates problems for businessmen who borrowed money thinking interest rates will remain lower for long time period for them to realize profits from their long term capital projects. They suddenly find that they all made an error. And they have to suddenly stop their projects. This is the bust and beginning of a recession or long depression. This bust now results into mass unemployment and halting of production processes hurting economic growth.

Inequality of Income and Wealth
RBI also creates and increases the income and wealth inequality. Because RBI prints money, to whomsoever it will give this money he/she will become rich. Those people who get this freshly printed money from RBI first can claim and buy scarce goods at lower prices. Once they spend this printed money, it starts to slowly raise prices. Those people who receive this money last, will face higher prices, lower purchasing power and lower standard of living i.e., poverty. Now who are going to receive freshly printed money first? Obviously those who are well connected with the government and its bureaucracies. Politicians, bureaucrats, big businesses who receive big loans from commercial banks (people like Ambanis, Adanis, Tatas, Birlas, Mallayas, Modis etc.) and anyone with a political clout. Who will receive this money in the end? Common people. In this way the rich become rich and poor become poor in India.

Conclusion
RBI is not a messiah who is going to stabilize or grow the Indian economy. It is the very cause of all our miseries. If people of India want to see inflation, business cycles and inequality of income and wealth being eliminated then they must demand that the Indian central bank RBI be dismantled as soon as possible. As long as RBI is in place, it will continue to destabilize the Indian economy. It will also continue to print money for the government so that its political masters can continue to control the lives of Indian people; so that they can continue to wage bloody wars. For the cause of peace and prosperity it is necessary that RBI be dismantled.

Wednesday, May 30, 2018

Rising Oil Price and Weakening Rupee

Since coming to power the Narendra Modi government, in the economy sector, was helped by one big factor i.e., the low international crude oil price. Helped because crude oil import represents top import bill for the Indian government. Being the only major source of conventional energy, without which the economy cannot work, oil is the most crucial product for India. As India produces very little of its oil, it is mainly reliant on crude imports from the Middle East. And the Middle East is again facing Gulf war type of prospects after the US President Donald Trump pulled out of the Iran nuclear treaty.

Instead of passing the benefit of this low international crude oil price, the Modi government pocketed all the profit in the form of higher excise duty on petrol and diesel. Thus the Indian consumer was deprived of low petrol and diesel prices. The excuse for this policy was to use this siphoned-off money for so-called “welfare” activities. Now with rising oil price, petrol and diesel prices have hit their highest levels in India. Despite this, the government is in no mood of reducing and repealing the excise duty on these products.

It now seems that the big benefit of low international crude price that the Modi government enjoyed is going to turn into big cost. The price of crude oil in international market is steadily rising since last year or so. It has hit its highest of recent years of about US$ 71 per barrel. This is going to put immense pressure on the already strained fiscal deficit of the Indian government. The Modi government cannot afford to let lose its purse anymore, which it very much wants to lose to win elections, because that will result into credit rating agencies  downgrading the rating of Indian government bonds, which is already of lower medium grade. If that happens then it will stall investment in the Indian market by foreign and local investors. This will dampen the future growth prospect bringing further downgrades. If the oil price continues to rise and the Indian government doesn’t tighten its purse then a repeat of 1990s crisis also cannot be ruled out.

Not only the rising price of crude oil can give immense headache to Modi government, but also tumbling rupee. Rupee has hit its lowest level in last couple of years of 68.52 rupees against 1 US$. Depreciating rupee will also cause import bill to soar. It will also lift the inflation level making life of ordinary Indians even more difficult than what it is right now. In the aftermath of US Fed’s policy of raising its interest rates, the Dollar is strengthening. This strong dollar can cause immense problems in the so-called emerging market economies which includes India.

This double whammy of rising crude oil price and weakening rupee is soon going to confront Modi and his government. It has to be seen how he tackles it. Looking at the past evidence of Modi government’s handling of the economy, we should not expect much.

Friday, May 18, 2018

Arvind Kejriwal’s Unemployment Guarantee Scheme

The Arvind Kejriwal government in New Delhi has just guaranteed unemployment for many unskilled, semi-skilled and skilled workers by passing a tough minimum wage bill recently. As newspapers reported, President Ram Nath Kovind has given his assent to the Delhi government’s Bill to amend the Minimum Wages Act under which employers violating labour rules in the city will now face fine ranging from Rs 20,000-50,000 and jail term between one to three years. Last year the Kejriwal government increased the minimum wages of unskilled, semi-skilled and skilled workers by 37%. According to this new Act, for an unskilled worker, the minimum wages is Rs 13,350 per month while for semi-skilled, it is Rs 14,698. The minimum wages for skilled persons is Rs 16,182 in the national capital. 

Why we are terming this minimum wage act as a guaranteed unemployment act for the workers? A little understanding of how market determines wages of workers will go in a long way to understand the reason.

In the labor market, the wages of workers are determined by the combined forces of their demand and supply. The supply of labor is mainly determined by workers’ choice between how much of their time to allocate to either work or leisure. The demand for labor is determined by workers’ discounted marginal value productivity i.e., how much value a labor can produce for the customer of the firm. This also means, how much extra revenue he can generate for the firm. This means, how much wage a worker will get in the labor market is determined by his productivity. Higher the productivity, higher the wage and vice versa. For example, before worker Crusoe started working in firm Acme, its revenue was 500 rupees. After his joining, we assume other things to remain unchanged, revenue goes up to 600 rupees; this means, the maximum wage that Crusoe can get is 100 rupees.

Equipped with this fundamental knowledge of economic science, we are now ready to analyze the impact of minimum wage on labor market.

Now enters the government with its minimum wage. Minimum wage is a government mandated wage, which means it is compulsory to implement and those who do not implement can go to jail as the Kejriwal act shows, which is set arbitrarily by the bureaucrats above the market clearing wage. It sets a floor price of labor below which no employer can pay their workers without facing government wrath. We have seen above that the market clearing wage of workers reflect their marginal contribution in firm’s revenue and profit. We also know that no firm can survive for long in the market without making profit. Setting of minimum wage above this market clearing wage by the government means now firms are forced to pay workers wages which are more than their marginal contribution in firm’s revenue and profit. This creates a survival issue for the firms. Let us take one numerical example to understand how minimum wage impacts firm’s cost of production and thus profitability. For the sake of simplicity we here assume that the only cost of production for a firm is its wage bill. Suppose, before the implementation of minimum wage act,  Acme firm employs 10 workers and pays them 500 rupees/labor annual wages. So its total production cost is 5000 rupees. Its total revenue is 7000 rupees. This means, its total profit is 2000 rupees (Total Profit = Total Revenue – Total Cost). The government then mandates a minimum wage of 800 rupees. Now firm’s total production cost goes up to 8000 rupees while its revenue stays the same at 7000 rupees. Remember, government’s minimum wage act only increases wages of workers, but not their productivity which can enhance firm’s revenue. Acme is now making a loss of 1000 rupees. As I said above, in loss making condition firm cannot survive in the market so it will try to reduce its production cost. The easiest way to do so is to fire some of the workers. In our example, Acme firm will fire 4 workers to bring its cost down to 4800 rupees. This will wipe out its losses and it will again start making 2200 rupees profit as before.

As we saw above, the end result of minimum wage act is unemployment for those 4 workers who got fired. When the government implements minimum wage, this is what happens. Every worker whose marginal value productivity is below prescribed minimum wage will find himself unemployed. No firm will be willing to hire them because their productivity cannot justify their wages.

Not only firms will fire their present workers, but they will also refuse to hire new workers because that will add in their production cost without increasing their revenue. Firms will have more incentive to instead start replacing their labor force with machines. Again the end result is unemployment for the workers!

As economic science tells us, the socialist measure of “minimum wage” is not a right means for increasing the welfare of workers as their proponents, like Arvind Kejriwal, tells us. This policy only hurts the very workers for whom it is designed. It is a policy of guaranteed unemployment. The only way in which we can increase the material standard of living and welfare of our workers is to help them increase their productivity via accumulation of both physical and human capital. Both these processes require an economic policy of laissez-faire Capitalism. As long as we do not have this economic system in place, workers’ lives cannot be changed for better no matter how much government increases their minimum wage!

Wednesday, May 9, 2018

Against the Grain and the State

James C. Scott has rewritten the history of the “civilization” in his recent book Against the Grain. He turns the mainstream narrative of civilization on its head with the help of evidences coming from various fields of sciences. In doing so, he rewrites the history of man himself. In rewriting  the mainstream narrative, Scott has twofold goals in his mind: first, the more modest one of condensing the best knowledge we have of these matters and then second, suggesting what it implies for state formation and for both the human and ecological consequences of the state form.

The mainstream narrative of civilization that James Scott turns on its head goes like this:
  • Domestication of plants and animals led directly to sedentism and fixed-field agriculture.
  • Sedentism and the first appearance of towns were typically seen to be the effect of irrigation and of states.
  • Sedentism and cultivation led directly to state formation.
  • Agriculture, it was assumed, was a great step forward in human well-being, nutrition and leisure.
  • The state and early civilizations were often seen as attractive magnets, drawing people in by virtue of their luxury, culture, and opportunities.
  • People living outside the urban city state centers were barbarians and their lives were horrible compared to the lives of city dwellers.
Scott takes these mainstream narratives in turn and reexamines them under the light of evidences from various fields of research. I will review this reexamination in brief here. In his reexamination exercise, the main focus area of Scott is the cradle of civilization i.e., the ancient Mesopotamia (the region between two rivers Euphrates and Tigris. A place also known as ‘the fertile crescent’). Whenever needed Scott also uses evidences coming from the Americas, Europe as well as South East Asia for this purpose.

Domestication of plants and animals led directly to sedentism and fixed-field agriculture
As Scott examines the evidence against the above claim he reaches a very different and opposite conclusion. The evidences suggest that, in fact, it turns out that sedentism long preceded evidence of plant and animal domestication and that both sedentism and domestication were in place at least four millennia before anything like agricultural villages appeared on the land of ancient Mesopotamia. Scott discusses this paradox of state and civilization narrative:
A foundational question underlying state formation is how we (homo sapiens sapiens) came to live amid the unprecedented concentration of domesticated plants, animals, and people that characterize states. From this wide-angle view, the, the state form is anything but natural or given. Homo sapiens appeared as a subspecies about 200,000 years ago and is found outside of Africa and the Levant no more than 60,000 years ago. The first evidence of cultivated plants and of sedentary communities appears roughly 12,000 years ago. Until then – that is to say for ninety-five percent of the human experience on earth – we lived in small, mobile, dispersed, relatively egalitarian, hunting-and-gathering bands. Still more remarkable, for those interested in the state form, is the fact that the very first small, stratified, tax-collecting, walled states pop up in the Tigris and Euphrates Valley only around 3,100 BCE, more than four millennia after the first crop domestication and sedentism. (emphasize added)
This evidence suggests that the whole civilization narrative that naturalizes the state form and assume that once crops and sedentism, the technological and demographic requirements, respectively, for the state formation were established, states/empires would immediately arise as the logical and most efficient units of political order. Nothing like this happened in the past. What actually happened was that 4000 years before any state arose, people domesticated plans and animals and were living a sedentary life in and around the Tigris and Euphrates rivers. If the rise of state is so natural, and a sign of progress for human beings, then why did it not arise for 4000 years after we decided to settle down? It didn’t rise among us because the conditions for its rise were very different from what the civilization narrative tells us.

Before we discuss these conditions, it is better to examine the reasons that made humans settle down and live a sedentary life. We will see below that our ancestors were not living only one type of, hunter-gatherer or sedentary, life.     
Sedentism and the first appearance of towns were typically seen to be the effect of irrigation and of states
It turns out that this claim is also not correct. Instead of both sedentism and the first appearance of towns typically a product of irrigation and states, they were usually the product of wetland abundance.
People started to settle down in one area to live sedentary lives millennia before any state arose amidst them. The reason for sedentism turns out to be the availability of wetland areas. Scott throws light on this issue:
What might have been an earlier trend toward population growth and settlement in the Fertile Crescent owing to warmer and wetter conditions ended abruptly around 10,800 BCE. A millennium-long cold snap that followed is believed by some to have been caused by a massive pulse of glacial melt from North America (Lake Agassiz) suddenly draining eastward into the Atlantic through what we now call the Saint Lawrence River. Population receded, the remainder shrank back from marginal highlands to refugia where the climate, and therefore the flora and fauna, were more favorable. Then, around 9,600 BCE, the cold snap broke and it became warmer and wetter again – and fast. The average temperature may have increased as much as seven degrees Celsius within a single decade. The trees, mammals, and birds burst out of the refugia to colonize a suddenly more hospitable landscape – and with them, of course, their companion species, Homo sapiens.
… As we shall see, the earliest large fixed settlements sprang up in wetlands, and not arid settings; they relied overwhelmingly on wetland resources, not grain, for their subsistence; and they had no need of irrigation in the generally understood sense of the term. Insofar as any human landscaping was necessary in this setting, it was far more likely to be drainage than irrigation. The classical view that ancient Sumer was a miracle of irrigation organized by the state in an arid landscape turns out to be totally wrong.              
This means, the state didn’t organize agriculture and started civilization. Exactly opposite happened in the past. People were already living a sedentary life in wetlands which were teeming with rich resources of all kinds. Instead of simply living on agriculture grain diet, people had very varied diet of fruits, nuts, river fishes, turtles, tubers etc. etc. These people also domesticated some of the wild plants, like wheat, barley and maize that we state subjects heavily rely on today, as well as animals like goats, sheep, mules, chicken etc. well before any state came into being.

Sedentism and cultivation led directly to state formation
The evidence suggests that states pop up only long after fixed field agriculture appears.

As we have seen above, for four millennia and more there was no state to be seen among our ancestors who were living a sedentary life. So, naturally the question arises that why after four millennia delay the state finally arose? We now turn to answer this question.

Scott looks at the evidence and provides the answer:
If civilization is judged as an achievement of the state, and if archaic civilization means sedentism, farming, the domus, irrigation, and towns, then there is something radically wrong with the historical order. All of these human achievements of the Neolithic were in place well before we encounter anything like a state in Mesopotamia. Quite the contrary. On the basis of what we now know, the embryonic state arises by harnessing the late Neolithic grain and manpower module as a basis of control and appropriation. The module was, as we shall see, the only possible scaffolding available for the design of the state.
Settled populations growing crops and domesticated grains, and small towns with a thousand or more inhabitants facilitating commerce, were an autonomous achievement of the Neolithic, being in place nearly two millennia before the appearance of the first states, around 3,300 BCE.
… This complex, however, represented a unique new concentration of manpower, arable land, and nutrition that, if “captured” – “parasitized” might not be too strong a word – could be made into a powerful node of political power and privilege.
This finding is in line with other important works re the origins of the state like that of the German sociologist Franz Oppenheimer. He divided the means of sustenance into two categories: first, economic means where people sustain their lives by producing goods and selling the surplus in the market in exchange for other goods that they want, and second, the political means where people live their lives by appropriating goods produced by others i.e., parasitism.

The domus complex i.e., sedentary human settlements with their domesticated flora and fauna, as well as accompanying unique diseases like plague, cholera etc., which came into existence when humans started living in crowded towns with their domesticated animals, were already in place which the state appropriated for itself using coercive methods. Scott explains this history of origins of the state:
If state formation depends on the control, maintenance and expansion of the concentrations of grain and manpower on the alluvium, the question arises how the early state could have come to dominate these population-and-grain modules. The would-be subjects of this hypothetical state, after all, had direct, unmediated access to water and flood retreat agriculture as well as a variety of subsistence options beyond cultivation. One convincing explanation for how this cultivating population might have been assembled as state subjects is climate change. Nissen shows that the period from at least 3,500 to 2,500 BCE was marked by a steep decline in sea level and a decline in the water volume in the Euphrates.
… The shortage of irrigation water confined the population increasingly to well-watered places and eliminated or diminished many of the alternative form of subsistence, such as foraging and hunting.  
… Climate change, then, by forcing a kind of urbanization in which 90 percent of the population lived in settlements of thirty hectares or more, intensified the grain-and-manpower modules that were ideal for state formation. Aridity proved the indispensable handmaiden of state making by delivering, as it were, an assembled population and concentrated cereal grains in an embryonic state space that could not, at that epoch, have been assembled by any other means.
… The state form colonizes this nucleus as its productive base, scales it up, intensifies it, and occasionally adds infrastructure – such as canals for transport and irrigation – in the interest of fattening and protecting the goose that lays the golden eggs. (emphasize added)
Once the state came into existence in this way, it added extra dangers in already problematic crowded domus complex. The crowded settlements were suffering from natural disasters like droughts and diseases, and the state added more layers of insecurity of taxes and warfare over those dangers.   

Agriculture, it was assumed, was a great step forward in human well-being, nutrition and leisure
This claim is ubiquitous. Agriculture revolution is generally seen as a great leap forward for the humanity, which before that was living a life of uncivilized hunter gatherer barbarian! Something like the opposite was initially the case.

The precise reason for the start of the so-called “agricultural revolution” is not yet pinned down by the researchers, but once cultivation started and grains like wheat, barley and maize etc., with animals domesticated, it transformed the cultivars, livestock and the soils and fodder on which they depended, and, most importantly, homo sapiens themselves. Scott explains,
The domus was a unique and unprecedented concentration of tilled fields, seed and grain stores, people and domestic animals, all coevolving with consequences no one could have possibly foreseen. Just as important, the domus as a module of evolution was irresistibly attractive to literally thousands of uninvited hangers-on who thrived in its little ecosystem. At the top of the heap were the so-called  commensals: sparrows, mice, rats, crows, and (quasi-invited) dogs, pigs, and cats for which this new Ark was a veritable feedlot. Each of these commensals in turn brought along its own train of microparasites- fleas, ticks, leeches, mosquitoes, lice and mites –  as well as their predators; the dogs and cats were there in large part for the mice, rats, and sparrows. Not a single critter emerged from its sojourn at the late-Neolithic multispecies resettlement camp unaffected.
This multispecies resettlement camp brought behavioral and physiological changes in the domesticated species. The hallmark behavioral differences between domesticated animals and their wild contemporaries is a lower threshold of reaction to external stimuli and an overall reduced wariness of other species – including Homo sapiens. The shorthand that we use today to describe these behavioral traits is “sheepish herd behavior” i.e., cowardly crowd behavior and a lack of individuality. The physiological changes were, the reduction in male-female differences (sexual dimorphism), higher fertility rate, reduction in brain size etc. The reduction in brain size, particularly the limbic system, resulted into general reduction in emotional reactivity. The crowded living space also meant deteriorated health among these domesticates. Various pathologies like weaker bones due to reduced quality of common agriculture diet, gum diseases as well as far higher mortality rate was the result.

All these changes that we see in domesticate animals are also seen in humans who are coevolving in this multispecies camp. The spread of sedentism transformed Homo sapiens into far more of a herd animal than previously. With this sedentary lifestyle,  Homo sapiens traded a wide spectrum of wild flora for a handful of cereals and a wide spectrum of wild fauna for handful of livestock. Scott sees this late Neolithic revolution as something of a deskilling. The agricultural revolution contracted our living space, our diets, our attention to and practical knowledge of the natural world and the breadth of our ritual life.

The state and early civilizations were often seen as attractive magnets, drawing people in by virtue of their luxury, culture, and opportunities
This is also not true. The early states had to capture and hold much of their population by forms of bondage and were plagued by the epidemics of crowding. The early states were fragile and liable to collapse, but the ensuring “dark ages” may often have marked an actual improvement in human welfare.  

People living outside the urban city state centers were barbarians and their lives were horrible compared to the lives of city dwellers
We, who live in cities, always think or actually are made to think that those people who live in forest areas away from urban city state centers are tribal and primitive. They are somehow the lesser beings. But the facts are actually the opposite. As Scott shows, that life outside the state – life as a “barbarian” – may often have been materially easier, freer, and healthier than life at least for nonelites inside civilization.

The fragility of the states
Once the states came into being via the use of coercive means, it was very difficult for them to survive and thrive. These early states, and the modern ones too, face multiple on-going problems that threaten their existence. We have seen that for continual existence the state requires huge amount of settled population with its agricultural domus complex. Without these conditions, it cannot survive. Depopulation is the biggest danger that the state faces. When the host becomes smaller than the parasite, the parasite dies. The earliest, and modern, states faced many issues which resulted into their subjects exiting their territories making them vulnerable and liable to “collapse”. These issues are, epidemics, crop failures, floods, salinization, taxes, war and conscription. These factors provoke sometimes steady leakage of population from the state boundaries and sometimes mass exodus e.g., thousands of uber rich Indians have left the Indian nation state in last few years due to heavy taxes and other such burdensome governmental policies.

Conclusion
James C. Scott by turning the whole civilizational narrative upside down thus does a great job of making us aware about what is going on in present. The nation state that we see today are parasitic organizations, and these parasites are vulnerable to collapse. When they collapse, life outside and without them becomes much more easier and better. The so-called dark ages are actually an improvement in standard of living for millions of people. As I have mentioned somewhere else, today’s nation states are also collapsing. Once they are gone, life for billions of people will surely improve.

Monday, April 23, 2018

RBI Should Make the Cash Crunch Permanent

Many states of India are again experiencing situation like demonetization of 2016. ATMs all across India are running dry and we are seeing long lines outside banks. The finance minister Mr. Arun Jaitley said that this shortage of cash is because of unusual sudden spike in the demand for money. Newspapers are citing causes related with supply where RBI failed to print enough currency notes despite warnings from the commercial banks. A cash crunch like this is surely a combined effect of both demand and supply side factors.

Government has asked RBI to ramp up printing of currency notes in the aftermath of this cash crunch. According to the latest report, RBI is gearing up to print up to 1 lakh crore new notes to plug the cash gap. This is a big mistake. This cash crunch can be a boon in disguise. If this crunch continues then, in the long run, it can result into lower prices of all consumer and producer goods, which will increase the standard of living of Indians. How? Let us see.

The price of any commodity is determined by four factors combined together. Two factors are from the commodity side and two from the money side. These four factors are: 1) demand for and supply of commodity, and 2) demand for and supply of money. Price of any commodity is an exchange ratio of that commodity with the other commodity with which it is exchanging e.g., if Crusoe exchanges 2 fish for 4 coconut of Friday then the price of 1 fish is 2 coconuts and the price of 1 coconut is half fish. When we are in the indirect exchange money economy the one common commodity exchanging against all other commodities is money commodity (historically gold and silver). The price of every commodity in money economy is thus expressed in terms of money commodity e.g., if 2 fish are exchanging against 20 rupees then the price of 1 fish is 10 rupees.

The laws of demand and supply tell us what the price of any commodity will be. Other things being constant, when demand will increase, price will increase and vice versa; and when supply will increase price will decrease and vice versa.

Now as I said above, the price of any commodity, say like an apple or an orange, is determined by four factors: demand for and supply of commodity and demand for and supply of money commodity. Let us use an example of an apple here. Other factors remaining unchanged, rise in the demand for apple will lead to rise in the price of apple. Fall in the  demand for apple will lead to fall in the price of apple. Increase in the supply of apple will lead to fall in the price of apple, and fall in supply of apple will lead to rise in the price of apple. Similarly, rise in the demand for money (people keeping more cash balance in home), while other three factors remaining unchanged, will lead to fall in the price of apple. This because increased demand for money increases its price i.e., its purchasing power in terms of other commodities like apple. We have to remember here that the money commodity also has a price like other commodities, and that price is its purchasing power i.e., how much other commodities it can buy. A fall in the demand for money will lead to rise in the price of apple. A fall in the supply of money will lead to higher purchasing power of money and lower price of apple. An increase in the supply of money will lead to lower purchasing power of money and higher price of apple.

The on-going cash crunch means two things: One, higher demand for money, in the form of people hoarding more cash balance, and two, reduced supply because RBI is not printing fresh currency notes. And both things mean, as we have seen above, higher price of money i.e., higher purchasing power and conversely lower prices of consumer and producer goods. If the cash crunch continues for long then, under the assumption that other three factors do not change drastically, slowly the prices of all other consumer and producer goods will start to fall in the market. If RBI is not printing fresh currency notes and people continue to hoard cash then the purchasing power of rupee notes in the market must rise i.e., the prices of other commodities must fall. Of course, this effect will only be seen under the given assumption of other factors not changing drastically. If they change drastically then prices may either rise or fall. We need concrete data of the rate of rise and fall in those factors to decide the end effect on consumer and producer good prices.

Notwithstanding the change in other factors, one thing is certain that if RBI stops printing any more currency notes and people continue to hoard cash then prices of consumer and producer goods will fall. This fall in prices will be a boon for Indians. Falling prices means higher real income i.e., a person either needs less rupees to buy the same amount of goods that he was previously buying or with the use of same rupee notes that he holds he can buy more goods. In either case Indians will become truly rich.