Since starting of this blog, I have tried to cover the topics for the people like myself, those who understand only basics of finance and not the luscious terms like hedge funds, leveraged buy outs, mortgage funds etc.

Banks fulfill a very important role in the economy by matching borrowers and lenders. When we deposit $100 in a bank, the bank keeps, at most, two to three dollars in its vaults (in fact the money is often in the central bank), the remaining $98 or so is lent to a borrower.

Most businesses require loans for their normal operations. When the banking sector does not work properly, businesses cannot get loans and they have to curtail their production and lay off workers. As they curtail production, they demand fewer products from their suppliers and therefore their suppliers have to reduce their output and fire workers. If manufacturers cannot sell their goods because the firm downstream does not need as many products as before, they cannot generate enough revenue to repay their earlier loans. Businesses go bankrupt and banks experience further problems as their balance sheet deteriorates due to non-performing loans. At this point, banks want to lend even less because of the uncertainty generated from bankruptcies. As they lend less, the vicious circle continues – with producers cutting production and firing workers.

On the top of this, depositors start worrying about their deposits because the non-performing loans have made some banks go belly up – your bank has lent out your money to borrowers who cannot return it. Depositors start withdrawing their cash and banks have even fewer possibilities for lending as they have to hoard cash in case there is a run on the bank. If the financial sector does not work, the real economy can go into a deadly spiral and shrink by 30 per cent as during the Great Depression.

Last four weeks have sent the financial world in a full carnage, as bear guzzled up the giants who had been on bull rampage for quite some time now.

We are sure you would have read about what happened, how it happened and what can happen further, so here are some links to just epitomize the blood bath.
(All of these are either interactive or images)

But then there are many ways of doing a non cash transaction these days: Credit card, Debit Card, Prepaid Card, PayPal/Google Checkout or Mobile payments...

The snapshot below lists the approximate processing fees charged by each major player in various payment instruments (ranging from Cash/Check to Credt & Debit Cards and Mobile Payments).

The markets have been giving shudders to the investors for a long while now, most have lost faith in Sensex, while most have become skeptical. The 'Relationship Managers' (RM) are after every person who seems to smell of cash. Mutual Funds, Insurance, ULIPs, loans are all being coaxed using telemarketing. The advisors and RMs would suggest that this is the time to actually invest in market as you will lose the opportunity once its up and appealing but the fear of losing always above then the lust for more, keeping the public away. So for risk averse people what are the investment options available right now.

For a risk averse investor the main aim is to save the assets from monetary erosion. So the investment options to be evaluated are the ones having low risk of erosion and almost gurantee of full cash back (atleast) in event of further weakening of economy. There are many instruments for investing where the return is more or less guranteed. The top choice these days is Fixed Deposits (as evident on the billboards). Bank deposits are the safest investment after Post office savings because all bank deposits are insured under the Deposit Insurance & Credit Guarantee Scheme of India. With effect from A.Y. 1998-99, investment on bank deposits, along with other specified incomes, is exempt from income tax up to a limit of Rs.12, 000/- under Section 80L. Also, from A.Y. 1993-94, bank deposits are totally exempt from wealth tax. The 1995 Finance Bill Proposals introduced tax deduction at source (TDS) on fixed deposits on interest incomes of Rs.5000/- and above per annum. But banks are not the only option for FD, you can go for post offices FD and FD given by the companies.

Another option that has got very popular recently is Fixed Maturity Plan (FMP). In FD, said above, your return is taxable in case interest is more than Rs. 5000 per annum (per FD). Thats where FMP starts shining in investors eyes. FMPs, as they are popularly known, are the equivalent of a fixed deposit in a bank, with a caveat. The maturity amount of a fixed deposit in a bank is 'guaranteed', but only 'indicated' in the FMP of a mutual fund.

FMPs are debt schemes, where the corpus is invested in fixed-income securities. The tenure can be of different maturities, from one month to three years. They are closed-ended in nature, which means that once the NFO (new fund offer) closes, the scheme cannot accept any further investment. The magic is in the tax treatment of a mutual fund FMP. FMPs are classified under the debt scheme category and enjoy certain tax benefits, such as:

So going for a long term FMP (more than one year) the return on the FMP will be say 10% - .14025(10%); while that in FD will be 10%-.33(10%) essentially giving a return of 8.5975 - 6.6667 = 1.93%

The distribution of income is central to one of the most enduring issues in political economics. On one extreme you will find the communists who argue that all incomes should be the same, or as nearly so as possible, and that a principal function of government should be to redistribute income from the haves to the have-nots. On the other extreme are those who argue that any income redistribution by government is bad. They argue that income redistribution makes people lazy and gives them incentive not to work, it favors the free riders and punishes the hard workers.

I was just checking the income distribution change in India with respect to the other nations. The rise of Indian middle class is so so evident here, and at the same time one can see how China's middle class gave in to a better distribution of money. Number of higher income people are much higher in China and Brazil than India, their BRIC partner. You can check these graphs from the website http://www.gapminder.org

Income Mobility
Another factor to consider when studying the degree of inequality in a society is the amount of income mobility. Income mobility refers to the ease with which workers can move up and down in the hierarchy of earning power. If the rich always stay rich and the poor always stay poor, then an unequal income distribution is a permanent and serious problem. But if they can move then it is much better for national economy.

Zimbabwe's economy spiraled downward from Second Congo War, leading to food and oil shortages, hyperinflation, and massive emigration. During this recent period Zimbabwe's President Robert Mugabe's policies have been denounced in the West and at home as racist against Zimbabwe's white minority.

Until 2000, Zimbabwe was the 'breadbasket of Africa', exporting wheat, tobacco, and corn to the rest of the continent and beyond. Zimbabwe contains the most fertile farmland on the continent, and until recently was a tourist Mecca, home of Victoria Falls, one the seven natural wonders of the world, and numerous game reserves, now nearly emptied by poachers and starving peasants. It’s hard to comprehend exactly what living within such a catastrophic economic crisis actually means. Imagine going to the pub buying a drink and then two hours later returning to the bar to order the same drink again but only to learn that the prices have now doubled – would you pay?

Quantum Theory is one of the most bizzare yet fascinating theories. You can read volumes about it and yet still be in the dark about it. It is truly weird and amazing and applicability to practical life seems unfathomable.

On the other hand Game Theory which was once an economic theory has now been expanded and is being used in all aspects of our lives. From bidding in auctions to deciding geo-political balances of power.

Q) So what do we get when we add these 2 ingredients in a recipe for Science ?
Ans.) The death of Game Theory ( in practice at least).

Let me propound this grave statement by talking about a cat. Schroedinger's Cat.
Let us find a small kitten and put him in a box. And put the lid on. Add in the box a tiny capsule of cyanide gas, which breaks when the cat steps on it and kills the cat. Now close the lid of the box.

After the lid has been shut we have no way of knowing whether the cat is alive or dead as we can't see the cat. So quantum theory states that the cat is both alive and dead in a weird superposition of states. The moment we close the box , the cat moves into 2 parallel states of universe ; One in which it is dead and one in which it is alive. Opening the box superposes the 2 universes back together and the cat appears as dead or alive.

Now what is the implication for game theory. Game theory tries to pre-empt the actions of opposing parties by finding out what will logically due to happen. But in games where one does not know for sure what the opposing action will be and there is a play of probability ( eg Say Company A , decides to launch a product. Now Company B , may or may not decide to play a price war on it. Company A can never know this and must assume probabilities) .

We see that whenever there is a probability component because we cannot see the state of a system ( as in the cat) there are multiple possibilities and they all exist at the same time. Hence game theory cannot predict the action as all actions are equally likely and hence there can be no best strategy for player A, based on decisions for player B.

BUT, this is not seen to be true, Why ? Because the theory implies that the state of the system is not visible to the observer. But in Reality, in all cases the observer has an idea of the system state at all times and hence Quantum States is not true and Game Theory still is Alive and Kicking !!!

When the inflation is on a rise world over, the largest economy in the world is looking the face of recession and the food prices are rising on global level its all natural for a specialists like Amartya Kumar Sen to put forward their arguments on all this. And as judgmental creatures we are, we end up criticizing present rather than propose a future in form of a action.

For introduction, Amartya Kumar Sen is an Indian economist, philosopher, and a winner of the Bank of Sweden Prize in Economic Sciences (Nobel Prize for Economics) in 1998, "for his contributions to welfare economics" for his work on famine, human development theory, welfare economics, the underlying mechanisms of poverty, and political liberalism.

In his blog post he has explained the food mismatch citing example of a country with a lot of poor people who suddenly experience fast economic expansion, but only half of the people share in the new prosperity. The favored ones spend a lot of their new income on food, and unless supply expands very quickly, prices shoot up. The rest of the poor now face higher food prices but no greater income, and begin to starve.

He also takes a dig on the use of ethanol as fuel. Produced mainly from corn in US, it routes the food production for different consumption, and its the poor who has to pay for it. Logic is simple, countries like India, China, Vietnam and Argentina are experiencing rapid development; people move up to better and processed food; the food consumption per person rises and the food export which was coming from these nations earlier lessens or stops. The inflation rises and food prices shoot up, the poor who already were surviving on cheap and small food quantity are forced to hunger. The world’s poor are themselves divided between those who are experiencing high growth and those who are not; and the number of the latter is quite high.

This reminds me of a small game every new batch in FMS, Delhi (India) was made to play in Induction session by the faculty of organizational behavior. Crux of the game was that you may register a high growth or spikes of it in short run on your own. But to maintain growing in the long run, you need the co operation from all others. Same holds true for global economy and with more and more countries on development phase, it is going to hold more and more true for the world economy.

As project syndicate reports, Russia’s economic success is partly attributable to high oil and commodities prices. But oil is not the whole story. The tax reform of 2001 improved incentives to work and decreased tax evasion by introducing a flat 13% income tax – one of the world’s lowest. Liberalizing the procedures for corporate registration and licensing, and limiting inspections, improved the climate for small businesses and entrepreneurs. Conservative macroeconomic policy and financial-sector reform lowered interest rates and fueled an investment and consumption boom. Real wages tripled, and poverty and unemployment fell by half.

Inequality and corruption are going to be the main obstacles now. Despite Russia’s recent economic achievements, both remain at alarmingly high levels. According to Forbes magazine, there were 87 Russian billionaires, with combined wealth of $471 billion, a figure second only to the United States. Yet their net worth accounts for roughly 30% of Russia’s GDP, whereas America’s 469 billionaires are worth only about 10% of US GDP.

More importantly, inequality of opportunity is very high as well. According to a recent survey, a majority of Russians believes that acquiring wealth requires criminal activity and political connections. Only 20% believe that talent matters. These beliefs are self-fulfilling prophecies.

Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was 2 dollar as there were only two pieces of 1 dollar coins circulating around.

1) There were 3 citizens living on this island country. A owned the land. B and C each owned 1 dollar.

2) B decided to purchase the land from A for 1 dollar. So, A and C now each own 1 dollar while B owned a piece of land that is worth 1 dollar.
The net asset of the country = 3 dollar.

3) C thought that since there is only one piece of land in the country and land is non productive asset, its value must definitely go up. So, he borrowed 1 dollar from A and together with his own 1 dollar, he bought the land from B for 2 dollar.
A has a loan to C of 1 dollar, so his net asset is 1 dollar.
B sold his land and got 2 dollar, so his net asset is 2 dollar.
C owned the piece of land worth 2 dollar but with his 1 dollar debt to A, his net asset is 1 dollar.

The net asset of the country = 4 dollar.

4) A saw that the land he once owned has risen in value. He regretted selling it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollar from B and and acquired the land back from C for 3 dollar. The payment is by 2 dollar cash (which he borrowed) and cancellation of the 1 dollar loan to C.
As a result, A now owned a piece of land that is worth 3 dollar. But since he owed B 2 dollar, his net asset is 1 dollar.

B loaned 2 dollar to A. So his net asset is 2 dollar.
C now has the 2 coins. His net asset is also 2 dollar.
The net asset of the country = 5 dollar. A bubble is building up.

(5) B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 dollar. The payment is by borrowing 2 dollar from C and cancellation of his 2 dollar loan to A.

As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 dollar.
B owned a piece of land that is worth 4 dollar but since he has a debt of 2 dollar with C, his net Asset is 2 dollar.
C loaned 2 dollar to B, so his net asset is 2 dollar.

The net asset of the country = 6 dollar. Even though, the country has only one piece of land and 2 Dollar in circulation.

(6) Everybody has made money and everybody felt happy and prosperous.

(7) One day an evil thought came to C's mind. "Hey, what if the land price stop going up, how could B repay my loan. There is only 2 dollar in circulation, I think after all the land that B owns is worth at most 1 dollar only."
A also thought the same by now.

(8) Nobody wanted to buy land anymore. In the end, A owns the 2 dollar coins, his net asset is 2 dollar. B owed C 2 dollar and the land he owned which he thought worth 4 dollar is now 1 dollar. His net asset become -1 dollar.

C has a loan of 2 dollar to B. But it is a bad debt. Although his net asset is still 2 dollar, his Heart is palpitating.

The net asset of the country = 3 dollar again.

Of course, before the bubble burst B thought his land worth 4 dollar. His net asset is still 2 dollar, his heart is palpitating.

The net asset of the country = 3 dollar again.

(9) B had no choice but to declare bankruptcy. C as to relinquish his 2 dollar bad debt to B but in return he acquired the land which is worth 1 dollar now.

A owns the 2 coins, his net asset is 2 dollar. B is bankrupt, his net asset is 0 dollar. ( B lost everything ) C got no choice but end up with a land worth only 1 dollar (C lost one dollar) The net asset of the country = 3 dollar.


There is however a redistribution of wealth. A is the winner, B is the loser, C is lucky that he is spared.

A few points worth noting -

(1) When a bubble is building up, the debt of individual in a country to one another is also building up.
(2) This story of the island is a close system whereby there is no other country and hence no foreign debt. The worth of the asset can
only be calculated using the island's own currency. Hence, there is no net loss.
(3) An overdamped system is assumed when the bubble burst, meaning the land's value did not go down to below 1 dollar.
(4) When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the loser. The asset could shrink or in worst case, they go bankrupt.
(5) If there is another citizen D either holding a dollar or another piece of land but refrain to take part in the game. At the end of the day, he will neither win nor lose. But he will see the value of his money or land go up and down like a see saw.
(6) When the bubble was in the growing phase, everybody made money.
(7) If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A ) and take part in the game. But you must know when you should change everything back to cash.
(8) In addition of land, the above applies to stocks as well.
(9) The actual worth of land or stocks depend largely on psychology.

Source: Anonymous mail forwards

A day back I was going through the blog of Greg Mankiw, an economics professor at Harvard University. His yesterday's post talks about two articles he read giving him two hypothesis:

What he derives out of these two hypothesis is a a new piece of the monetary transmission mechanism: The Fed's monetary expansion reduces interest rates >> low interest rates drive up commodity prices >> high commodity prices make OPEC rich >> and finally OPEC uses its new wealth to recapitalize our struggling financial institutions.

Jeffery Frankel, a former member of the White House council of economic advisers, points out at a flawed growth explanation. It has been said since 2003 that the growth of Asian countries and new economies have been deriving the resources consumption. As these countries were running full engines to grow at enormous rate so, the resource consumption was too high. More money after fewer resources -> prices rose higher. Now he observes that in its most recent forecast, the IMF World Economic Outlook revised downward the growth rate for virtually every region, including China. The overall global growth rate for 2008 has been marked down by 1.1 percent (from 5.2 percent in July 2007, just before the subprime mortgage crisis hit, to 4.1 percent as of January 29, 2008). And prospects continue to deteriorate. Yet commodity prices have found their second wind over precisely this period. Up some 25 percent or more since August 2007, by a number of indices. So that rebuffs the given justification.

So he comes to a conclusion: real interest rates are an important determinant of real commodity prices. He puts it like this, the monetary expansion temporarily lowers the real interest rate (whether via a fall in the nominal interest rate, a rise in expected inflation, or both — as now). Real commodity prices rise until commodities are widely considered "overvalued" so overvalued that there is an expectation of future depreciation (together with the other costs of carrying inventories: storage costs plus any risk premium) that is sufficient to offset the lower interest rate (and other advantages of holding inventories, namely the "convenience yield"). Only then do firms feel they have high enough inventories despite the low carrying cost. In the long run, the general price level adjusts to the change in the money supply. As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were.

But the events since August 2007 provide a further data point, he observes. As economic growth has slowed sharply, both in the United States and globally, the Fed has reduced interest rates, both nominal and real. Firms and investors have responded by shifting into commodities, not out. This is why commodity prices have resumed their upward march over the last six months, rather than reversing it.

That all brings me to a question, where is the problem exactly? As I see it, the problem entirely lies with the domestic consumers of US. Problem is that this consumption is so high that US consumer is also the world's largest consumer in entirety. So if they decrease consumption, every big nation feels the burnt on fiscal revenue. Also due to the transaction base being dollar, even monetary health suffers for all nations (even though their own currency gets strengthened!). Fed rate cuts brings the liquiidity in the system, which already is facing the inflation. Now how to make sure that the excess money is going in paying off debt rather than higher consumption level? or should it actually go to consumption to make world stable? Shouldn't the FD interest rates be increased to suck off the excess of 'luxury' money?