Economics 1 - How to approach Economics

Economics for Non Economists 5 – Inflation - Why is the government’s inflation rate lower than my personal experience?

By Girish Menon

Some of you would have realised that in the China virus season the supermarkets have raised prices and stopped offering discounts on many goods. As a result you would have experienced rising food bills which according to layman knowledge should translate into inflation*. At the same time, you may have read many economists predict a period of recession, deflation** and high levels of unemployment. So how is it that when you are experiencing inflation personally, economists predict the existence of deflation?

It all depends on the way the inflation rate is calculated.

The UK government uses the Consumer Price Index (CPI) to estimate the inflation rate in the British economy. It works like this:

1. Every year a few thousand families are asked to record their expenditure for a month. From this data the indexers estimate the types of goods and services bought by an average household and the quantity of their income spent on these goods.

2. With this information, surveyors are sent out each month to record prices for the above mix of goods. Prices are recorded in different areas of the country as well as in different types of retail outlets. These results are averaged out to find the average price of goods and this is converted into index numbers.

3. Changes in the price of some goods are considered more important than others based on the proportion of the income spent by the average household. This means that the above numbers have to be weighted before the final index is calculated. 

---Topics covered earlier

Relation between Debt and Profit

Explaining GDP and Economic Growth

Quantitative Easing

What is a Free Market

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Consider this example:

Assume that there are only two goods in the economy, food and cars. The average household spends 75% of their income on food and 25 % on cars. Suppose there is an increase in the price of food by 8% and of cars by 4% annually.

In a normal average calculation, the 8% and 4% would be added together and divided by 2 to arrive at an average inflation of 6%

However, this provides an inaccurate figure because spending on food is more important in the household than spending on cars. Food is given a weight of 75% and cars are given a weight of 25%. So the price increase of food is multiplied by ¾ (8*3/4 = 6) and added to the price increase of cars which is multiplied by ¼ (4*1/4 =1) which will result in an inflation of 7%.

Therefore if the inflation index was 100 at the start of the year then it will read 107 at the end of the year.

The accuracy of inflation calculations

As the example makes clear this calculation is based on an imagined average family’s spending patterns. There maybe only a few families in the UK that have the exact same spending patterns as imagined by the government.

Theoretically, different rates of inflation could be calculated within an economy by changing the consumption patterns or weightings in the index. This will explain why the inflation that you experience may be higher or lower than the government’s inflation rate.

* Inflation is an average increase in price level compared over a previous period.

** Deflation is an average decrease in price level compared over a previous period.

Disinflation means the inflation in the current period is lower than the earlier period.

Economics for Non Economists 4 - The Marriage of Debt and Profit in Capitalism

 by Girish Menon (Adapted from: Talking to my Daughter about the Economy by Yanis Varoufakis)

How does a new entrepreneur start?

 Let’s call her Indira. Indira will need some money (capital) to hire the factors of production i.e. to pay wages, for raw materials, machines and for rent to start her business. Since she will only get money after she has sold her goods, she has to take a loan to get started and the loan taken to get started is called Debt.

 Also, since the amount of wages, raw materials and rent are decided in advance the only person who does not know what she will end up with at the end of the process is Indira the entrepreneur. Hence achieving a profit becomes the most important goal for Indira in order to survive and not to end up with unpayable debt.

---For earlier articles

Explaining GDP and Economic Growth

Quantitative Easing

What is a Free Market

---

 Entrepreneurs as time travellers

 When Indira takes a loan to get started, what is she actually doing? In the format of a sci-fi movie, she is looking into the future through a semi-transparent membrane. Sensing an opportunity, she then pushes her hand into the future and grabs the revenue she will make and pulls her hand back into the present.

 If Indira has discerned the future accurately, then she will be successful and will earn enough to repay the loans that she borrowed to start with. However, if she has predicted the future wrongly then her business will fail and she will be unable to repay her loan and become bankrupt.

 Bankers as time travel agents

 Nowadays bankers create money out of thin air. Yes, they have the power to type the numbers in your bank account and money is created. Since bankers have very few constraints on the amount of money they can conjure, they have great incentive to lend money and earn interest and other fees. After all the more money they create and lend in an economy the greater the profits for themselves.

 Bankers - Heads I win and tails you lose

 Earlier, bankers would lend to entrepreneurs like Indira if they trusted her to able to repay her loan in the future. But nowadays banks have found a way to insulate themselves from Indira’s failure. For example, once a bank has given a loan of say £400,000, then the bank would chop up this loan into little pieces and sell it on to others i.e. in return for lending the bank £100 each; four thousand investors would each be given a share in the £400,000 loan. Thus the bank has already recovered the loan and will make a profit when Indira repays her loan. If Indira goes bankrupt then the four thousand investors will lose their money.

Positive Multiplier

 Suppose Indira is successful, she will hire workers, buy raw materials… these factor suppliers will receive wages and rents and buy more goods and the process of recycling goes on a positive and upward scale increasing GDP, more employment, more new businesses etc.

 The Crash

As the economy grows, banks will lend even larger amounts of loans until it reaches a point when the loans they have made are so vast that the economy cannot keep pace. At this point realization dawns that the large loans will not be repaid and the economy crashes.

 Due to the bank’s enthusiastic lending the once successful Indira may now find it difficult to repay her loan. She will now have to close down her business and the workers and suppliers will no longer get wages or rents. This may affect other businesses and a downward spiral starts resulting in bankruptcies, lower GDP, unemployment….

Debt, Profits and Crashes

Thus debt is indispensable in capitalism. There can be no profit without debt. However, the very same process that generates profits and wealth also generates financial crashes and economic crises.

Economics for Non Economists 2 – Quantitative Easing Explained

by Girish Menon

Pradhip, you have asked for an ‘Idiot’s guide on Quantitative Easing and how it affects the economy’. Let me try:

The Bank of England (BOE) has been practising Quantitative Easing (QE) since 2009. The amounts are:

Time	Amount in £ Billions
Nov. 2009	200
July 2012	375
Aug. 2016	435
Mar. 2020	645
June 2020	745

Ref – The Bank of England

What exactly did the BOE do when they said they were doing QE?

The BOE created additional digital money and used it to buy financial assets (especially government bonds) which were owned by the privately owned banks, pension funds and others.

How did they create this additional money?

Unlike you or me who would be arrested if we did this; the BOE has been conferred with monopoly powers to conjure up any amount of money from thin air by typing the necessary numbers into its bank accounts. It’s as simple as saying, ‘Let there be £745 billion and it appears in the bank’s accounts.

Why do they do QE?

Post the 2008 financial crisis there was a liquidity crisis (see below for explanation of liquidity crisis). The BOE by buying the government bonds from local banks transferred cash to them thus enabling them to start their lending activities in the economy.

In 2020 too they have done the same, but this time I suspect that even if the commercial banks are willing to lend there may not be enough borrowers and so this policy may not have the intended effect of stimulating economic growth.

How does QE affect the economy?

The dominant worldview is that debt drives the world. So QE ensures that lenders have enough money to lend to prospective borrowers. Borrowers borrow money to produce and sell goods at a profit; enabling them to repay their loans with interest while creating jobs in the economy.

The above borrower will use his loan to buy machinery, employ labour…. One man’s spending is another man’s income, so the money begins to circulate among citizens in an economy and a positive spiral will push economic growth and create employment.

However, all this theory hinges on the citizens’ confidence about the future. In the current Covid climate, with firms downsizing at will and people worried about their future, I doubt if there will be a critical mass of borrowers to re-start the stalled economic activity.

Pradhip, thus the BOE does indeed have a magic wand to create money out of thin air. You may ask why is it that in a free market I am not allowed to create my own money? Now that question will be considered seditious!

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What Is a Liquidity Crisis?

A liquidity crisis is a financial situation characterized by a lack of cash or easily-convertible-to-cash assets on hand across many businesses or financial institutions simultaneously. In a liquidity crisis, liquidity problems at individual institutions lead to an acute increase in demand and decrease in supply of liquidity, and the resulting lack of available liquidity can lead to widespread defaults and even bankruptcies. (Ref Investopedia)

---Also watch

Economics for Non Economists 1: What is a free market economy?

by Girish Menon

Suma, you have asked a really fundamental question and I will try to answer it in two parts viz;

-         What is a market economy?

And

-         What does free mean in the context of free market economy?

So let’s start with the first aspect – What is a market economy?

The activity of buying or selling a good is called a market transaction or a market activity. Thus a market is a set of arrangements where goods are exchanged for money.

Today most countries in the world adopt the market model for the production and consumption of goods and services. They believe in the Adam Smith quote, ‘It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.’

Google Dictionary defines self interest (own interest) as ‘one's personal interest or advantage, especially when pursued without regard for others.’ Some economics texts assume that the self interest of a goods producer is to earn profits whereas the self interest of a consumer is to maximise her happiness by paying for goods she requires.

Adam Smith’s theory expects citizens in an economy to be both producers and consumers of goods. As a producer you are expected to generate a profit from your toils. You, as a consumer, are expected to use the profits to buy other goods to live your life.

Based on the above logic, market theory predicts that if all the citizens of an economy are left to pursue their self interest then it will result in the automatic production of all goods and services that citizens require in order to be happy.

Though Adam Smith preferred the word ‘invisible hand’, I have used the term automatic. Google dictionary defines automatic as ‘working by itself with little or no direct human control’. In other words producers make and sell goods which they think will be demanded and hope to profit from it. There is no authority other than their anticipation of consumer needs that guide their decision to produce and sell goods. Similarly, consumers pay for a good because they think it will make them happier and there is nobody telling them what to buy and consume.

Thus, a market economy would be an economy where the production and consumption of all/most goods and services is determined by the self interest of its producers and consumers. This system is also known as capitalism.

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So, what is a free market economy?

These days it’s not only the UK, USA etc. but many other countries who call themselves free market economies. But are they truly free market economies where the production and consumption of all goods are determined automatically with its citizens unabashedly following their self interest?

I notice that you seem to be shaking your head. Especially in this Covid climate you will have noticed the role that the UK government has played in your life and the way it has affected your pursuit of self interest and happiness. So what I will now do is list the conditions necessary for Adam Smith’s theory of the invisible hand to work:

1. There are many buyers for a good in the market and no buyer is large enough to get a discount on the price.
2. There are many small sellers of a good in the market and no seller is large enough to set its own price.
3. The goods produced and consumed are identical or homogeneous. In other words a consumer cannot recognise the producer of the good.
4. There must be freedom of entry to the market – or no barriers that prevent a potential producer from entering the market.
5. There must be freedom of exit from a market – if a producer wishes to quit a market then s/he should be able to do so freely and without any sunk costs.
6. There must be perfect knowledge. Producers must have full knowledge of the technologies used by its rivals and consumer preferences. Consumers must be aware of the short and long term benefits and costs from consuming a good.
7. The factors of production must be mobile. It means that the land, workers, machines used for producing a good should be easily redeployed to producing any other good when demand changes,
8. There must be no transport costs.
9. There must be independence in decision making. No external forces affect the decision making ability of producers and sellers.
10. No externalities. The act of production and consumption based on self interest should not result in benefits or costs to third parties.

I am sure that after you have read the above conditions you will agree that neither the UK economy nor for that matter the Indian economy is anywhere close to being a free market economy. I don't think there is a single economy in the whole world that satisfies most of the conditions of a free market.

I will now let Ha Joon Chang have the final word on free markets:

“The free market (economy) does not exist. Every market has some rules and boundaries (by governments) that restrict freedom of choice. A market looks free only because we so unconditionally accept its underlying restrictions that we fail to see them. How ‘free’ a market is cannot be objectively defined. It is a political definition. The usual claim by free market economists that they are trying to defend the market from politically motivated interference by the government is false. Government is always involved and those free-marketeers are as politically motivated as anyone. Overcoming the myth that there is such a thing as an objectively defined ‘free market’ is the first step towards understanding capitalism.’

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• When I presented this article to Suma she said, 'Girish, you have not understood my question. I meant where can I find the free goods that should by definition be there in a free market?' 

Failing the Tebbit test - Difficulties in supporting the England cricket team

by Girish Menon





The article by second generation British writer Kishan Koria applying the 'cricket test' to examine the behaviour of Britons of Asian origin was interesting and revelatory but it may be a case of blaming the victim and not the perpetrator. So, I am going to raise some issues which are never raised in the politics of Tebbit's followers. 

Firstly, why should it be a natural assumption that if you have resided in England for years you must support the English cricket team? If England's home advantage against India is reduced to fixing the pitch to suit its bowlers then so be it. The English cricket team must earn the support of the ticket buyers with its acts on and off the pitch.

The spectator in a cricket match has paid a high price to be there. That s/he should cheer for the England cricket team was never a condition of the contract. She is a free agent and can support whoever she pleases. 

The manner in which the English cricket establishment has treated players like Pietersen and Panesar gives the outsider an impression that they don't care about the views of their followers in any case. I'm sure even Bopara may be surprised at the number of times he has been in and out of the England team. 

The cricket blog The Full Toss has often highlighted the uncaring way the ECB deals with the supporters of the English cricket team. So, will it not be natural for cricket lovers to express their disgust in manifold ways? 

As far as citizenship in a land goes so long as residents pay taxes and obey the laws of the land then they are free to do what they like with the rest of their lives. This is usually the argument of free marketers like Tebbit, so why then do they wish to deny choice to these consumers of cricketainment with the nanny state telling them who to support in a cricket match? 

So, the likes of the ECB should be happy that it is the English citizens of Indian origin who are putting the bums on stadia seats and the brown pounds in their coffers. Many English bums (pun unintended) stay away from cricket stadia for a variety of reasons  including ticket prices, poor team selection policies etc. Hence the ECB should not further risk their luck by telling these high fare paying spectators who to support. Instead they should earn their support by fair minded policies and listening to the voices of their dwindling support base.

Personally, I fail the Tebbit test every time England play India and I have been unable to understand why. This is funny because in my growing years I supported the Mumbai team against other Indian teams even though my parents were immigrants from the state of Kerala (far away from Mumbai), and despite there always existing  a violent campaign against immigrants in Mumbai. 

It maybe out of alienation in a land where me and my family's future fortune lies. It maybe the jingoism in the highly conservative media. It maybe the 'institutional racism' referred to in the Macpherson report. It may be the 'barging of Gavaskar by Snow'; the negative lines bowled by Giles; the Zaheer Khan jelly beans incident; the failure to criticise Anderson for his foul mouthed pronouncements in the quest for victory; the failure to understand the invalidity of the predicted path in a DRS while castigating the non believer as a Luddite; or invoking the spirit of cricket argument selectively.  As for the booing of Moeen Ali, a fine prospect, to my mind this appears to be a continuation of the Indo-Pak rivalry which has been carried forward by the diaspora. 

However, I have also noticed periods when I begin to like the English team but then something happens and the old English superiority biases surface in the commentariat and I am driven once again to dislike the team, probably wrongly, probably not due to the players' actions. But, most importantly, the overriding reason is the brand of cricket the team plays. I have for long been a fan of the Pietersen, Botham and Gower brand of English cricket. But, so long as the clones of Boycott and Tavare dominate the approach to batting it is a trifle difficult to stay awake let alone support the England team. 

Dhoni's Revenge

By Girish Menon

As the brickbats from aficionados of Test cricket kept piling on the abject Indian cricket team at the Oval yesterday, I was pleasantly amused by Dhoni's comment at the press conference following the Indian surrender. He stated, as quoted on Cricinfo, "Don't be so jealous of IPL". It made me ponder if Dhoni and his teammates have affected their revenge in such a cold blooded and undetectable manner.

Australia and England along with purists and other conservatives in cricket have for the past so many years been shouting that India did not care for Test cricket. The ICC however predicted that the new power structure in the ICC would restore Test cricket to its halcyon days. And this five Test series with India would showcase the new superpower's commitment to the 'soporific' game. Yet, by ending the Oval and Old Trafford Tests in three days Dhoni's men have put paid to such plans.

Given India's quick and abject defeats in two consecutive series in England, which county chief will have the gumption to bid   to host India's next Test match. The ECB have been running an auction and handing out Tests to the highest bidder. County grounds like the Oval hoped to attract the 'brown pound' in order to make a profit. With India's capitulation I doubt if future visits by the Indian team will attract the demand that we have seen recently.

The counties may hope to attract the 'white pound' to compensate for the Indian diaspora's absence. But cricket as a sport is dwindling in popularity as the coffers of most counties will reveal.

Indian advertisers might also be mad at the team's performances as the 'brown eyeballs' would be switching channels to avoid the shambles put up by Dhoni's men. They may henceforth demand the negation of 'home advantage' and creation of pitches that suit Dhoni's men. Thus match fixing, frowned upon by the ICC, may make a re-entry in the form of scripted matches all in the name of entertainment.

In the process, Dhoni's men would have wreaked sweet revenge not only on the lovers of Test cricket and the ICC but also on Andersen. For after all, what will his record as England's highest wicket taker be worth, if Test cricket is dead and the only records worth mentioning are set in the IPL?