Are these economists the biggest threat to the world?

Aug 3, 2011

In this issue:
» Staggering size of India's lost tax receipts
» Outsourcing not as lucrative as before
» India can have its worst growth in 3 years
» Don't bet on a significant decline in gold prices
» ...and more!
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No other report has perhaps received as much publicity in recent times as the one written by two economists called Carmen Reinhart and Kenneth Rogoff. Infact, their book, which is based on the same topic as the report has also become a huge hit. So, what is the report as well as the book all about? Well, these two gentlemen have studied financial crises going back as much as 800 years and have come to one important conclusion. The conclusion being that once the debt to GDP ratio of a country touches 90%, the economy reaches a sort of a tipping point. In other words, at this ratio, the GDP growth starts slowing down fast.

This ratio has gained so much popularity that policymakers across the globe are using it as some sort of a reference point. It is being argued that this ratio has been instrumental in Greece being asked to cut down spending and control deficits. Amazingly, even the US congressmen used this number to force the Government to curb its spending spree. Thus, while the debt ceiling has been raised, it has come with a strict rider that deficits will have to be reduced over the course of the next decade.However, not everyone is in agreement with the findings of Reinhart and Rogoff. Infact, one press report has even gone to the extent of calling them the two most dangerous economists in the world today. The 90% figure, argue critics, has been arrived at just arbitrarily. And there is nothing sacred about it. Infact, cutting debt at a time when the private sector is also reducing debt may backfire as per them.

One such criticism has come from none other than Robert Shiller, one of the most astute observers of financial markets. He has argued that investors are overreacting to debt to GDP ratios. And hence are demanding programs that cut spending at a time when recovery is still weak.

We agree that debt to GDP ratio of 90% may not be sacred. But we are also in disagreement with Mr Shiller and others with viewpoints similar to his. We don't think that Governments should increase debt as well as spending during times of economic weaknesses. This just postpones the problems according to us. Just as companies with high debt are assumed to be risky, we don't see any reason why it should be different for economies. Infact, the sooner the crisis is allowed to play out and taken out of the system, the faster will a ground be laid for renewed growth. Do not believe us? Just ask Japan.

What do you think? Do you think Governments should increase debt when private sector is reducing its own or leave the correction process to itself? Share your views with us or you can also comment on our Facebook page.

 Chart of the day
If the world gold council's latest data is to be believed, India is the 11th largest holder of official gold reserves in the world. At around 558 tonnes, its holdings are just 7% of the biggest holder in the world, the USA. However, it should be noted that the data takes into account just the official gold holdings. We are certain that once all sorts of holdings are taken into account, India's standing is likely to improve a great deal.

Source: World Gold Council

A major part of the fortunes of the Indian IT industry has been driven by the flow of outsourcing. Companies worldwide realized that they could get work done at cheaper rates by simply outsourcing the work to countries like India. This helped them in reducing their costs. But the growth has now started to ebb away. As per the TPI index of outsourcing that measures commercial contracts of over US$ 25m, the total value of such contracts has fallen by 18% YoY in June 2011. One of the reasons for this has been the fact that the industry has become more mature. But another reason for this has been the hassle involved in outsourcing.

As per an article of Economist, companies have faced serious issues with regards to quality as well as timely delivery. There have also been cases wherein the delivering company has overpromised to bag the order but under-performed when it came to delivery. This has led several companies to rethink their outsourcing strategy. While they still agree that outsourcing can help in saving costs, however they are now looking at outsourcing only the non-core activities. This will help the Indian IT industry with continued order flows. But it is unlikely to give them the huge push in margins that they are all eyeing as the margins lie in the higher end work. To get that, the IT industry needs to spruce up its act. It needs to concentrate more on the quality of people they hire rather than just looking at the quantity of hires. It is time to start balancing the quantum with the quality.

Already 15% up in the year, gold seems well set to make new highs. Its demand as a safe haven is gaining momentum as the global economy is on the verge of another crisis. The global investors are losing faith in key global paper currencies on account of mounting debts and excessive money printing. Raising the U.S debt ceiling will be no consolation for investors as rating agencies can see through the ineffective cosmetic treatments to patch up a failing economy. With other signals showing the world economy in doldrums, gold continues to remain in demand.

It's not just Europe and US, the rising inflation concerns in China and the need for other countries to diversify their foreign reserves is pushing up the gold prices as well. Its use as a safe haven has lured even the Bank of Korea that is making its first gold purchases in more than a decade. With so many factors working in its favour, there seems to be nothing that can pull gold significantly back any time soon.

Although India's growth slowed down in FY09 at the height of the crisis, the economy recovered strongly in the subsequent couple of years to post a healthy growth in GDP. But now, there is a possibility that India's GDP growth may revert to what we had seen in FY09. And some economic data released over the past 3-4 months could be said to support this. For starters, there have been clear signs of a slowdown in car and two-wheeler sales and modern format retail sales. On top of that, investment and construction spending appear to be moderating due to lack of demand visibility and policy paralysis. That is not all. High inflation has been a bane for quite some time now and the RBI has responded to this by gradually hiking interest rates. This in turn has hampered demand and profitability of India Inc.

Further, the government has also not spent much on developmental activities. One reason for this being the high fiscal deficit, which has not given much headroom to the government to spend. All of this has then put a question mark on whether India will be able to grow at the same pace as it had in the last two years. Indeed, the Prime Minister's Economic Advisory Council (PMEAC) also cut estimates for growth to 8.2% from 9% earlier. Slowdown in economic growth could translate into lower jobs and salary cuts, which in a high inflationary scenario would act like a double whammy. All in all, quite a few headwinds for the Indian economy in the months to come.

Few readers may have had the experience of being amongst those in the highest tax bracket way back in 1971. But those belonging to that generation can tell you what it meant paying 97.5% of income as taxes to the government. Since then, several tax reforms and incentives to liberalise the economy has made tax payouts in India substantially lower. Individual income tax rate of 30% makes India's effective tax rates competitive amongst developing economies. The tax cuts that started since 1991 onwards may have certainly paved the way for individual and corporate prosperity. But several loopholes have meant a huge dent in government's tax receipts and a ballooning deficit. These if not corrected on time could be fatal for the economy's future prospects.

As per Bloomberg Businessweek, the report - The Black Economy in India - estimates India's annual loss of tax receipts at Rs 14 trillion! Also, the Indian government's tax revenue is an estimated 18% of India's US$ 1.5 trillion GDP, the lowest among the four BRIC nations. Tax holidays in economically backward states and fiscal exemptions on agricultural income have been the bane of contention for several years. Most often these have been used by the rich to evade taxes. A double tax treaty with Mauritius is a favourite with companies wanting to evade taxes on investment gains. Despite this, the government continues to turn a blind eye to most corrective proposals. After all, the black money is a major source of election funds too! With such conflicting interests, we wonder if the Indian government will ever be in a position to keep its deficit cut promises.

Meanwhile, indices in the Indian stock market continued to inch lower today as well with the Sensex more than 150 points down at the time of writing. Heavyweights like L&T and ICICI Bank were seen driving most of the losses. While Asian indices also closed lower today, Europe too was seen submerged in a sea of red.

 Today's investing mantra
"Wide diversification is only required when investors do not understand what they are doing." - Warren Buffett

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12 Responses to "Are these economists the biggest threat to the world?"

S N Rao

Aug 3, 2011

To me no ratio is sacred. Yet too much of debt is risky just like it is flor companies. So why not Govt. increase debt in recession & reduce when the trade cycles are reversed. The debt can be reduced during bloom period, Only financial discipline is required.



Aug 3, 2011

How intelligent is the idea for borrowing against your future probable income? One may argue that borrowing money can help expanding resources that would generate future income enough to pay off the debt and add to book value as well- a real gain. The private sector uses this concept quite well and the better ones arrive at some healthy productive debt-equity ratio that would maximise the gains. Any attempt to over stretch the debt can have disastrous implications on the coporation and its future viablitiy.

However the countries do not seem to have been following this mantra. The government tend to act in short term by using debt as means of creating mass welfare schemes which,to me, most of the time is ill conceived. The financial crises in the last three decades, beginning with Japan Bank sector debacle, has provent this point. These countries and their governments need to do some mathematics and understand the economics that mass welfare need always be fruitful for the country because of free rider problem. I won't be surprised if even after a few decaded Indian continues to live with high fiscal deficits.

and yes, if the debt goes beyond a certain limit the capacity of the economy to service this debt declines; its like the patient is so used to asteroids that any natural recovery and stability looks miles away,what do you do? take more of the asteroids or let the condition cause pain for some time and then a natural course of recovery.

Any kind of debt is at roots of all financial pains. I beleive if we demand a lower growth rate for a few years, a double digit growth would naturally occur in future. Patience and not the debt is the key.


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