World faces a more serious problem than high debt - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster
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World faces a more serious problem than high debt 

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In this issue:
» Ireland starts printing its own currency
» A scam that would put 2G to shame
» Labour unrest plagues yet another company in India
» Gold MFs are outshining equities
» ...and more!


00:00
 
In October 2009, a few months after the debt induced crisis brought down the global financial markets, a small group of people in the US met for some serious soul searching. The group comprised of scholars not just from the field of economics but from fields as diverse as ecology, engineering and several other disciplines. One would wonder what experts from other fields had to do with a problem that was purely economical in nature. The crisis, it was presumed, was nothing but a result of a reckless borrowing binge and overleveraged balance sheets.

Experts from other fields however, did not see it this way. They argued that debt, whether it be private or public, is nothing but a demand on the future productivity of a nation and its people. Thus, if increase in productivity grows at a slower pace than increase in debt, ability to pay is hindered and events like the subprime crisis take place. Therefore, productivity or the lack of it is believed to be the main culprit.

Now, what causes the drop in productivity? Well, there are many reasons behind this. The most important though is believed to be something called as the energy return on investment. This is nothing but the units of energy required to extract one unit of energy. Why energy should hold so much importance one would wonder? This is because it is not the demand-supply curves but energy that lies at the heart of economics. Everywhere you see, you will notice things and objects transformed into useful forms by the use of energy. Thus, the real wealth in an economy is nothing but products derived from using energy. It is therefore of great concern to us when experts point out to the fact that energy return on investment is on a downward path.

As per data from the Scientific American magazine, petroleum sector's energy return on investment was as high as 100 times in 1930, implying that one had to burn just one barrel of oil to get 100 barrels out of the ground. And what is the ratio now? Well, by 2006, the ratio had fallen to low as 19 times. Thus, it is quite clear that if more and more energy is diverted towards extracting energy, that much less is available for economic growth and hence, output suffers a steep fall.

Not all are convinced though. These people argue that technology will certainly come to the rescue. However, even with technology growing by leaps and bounds, the drop in productivity has not been averted. Thus, there is no guarantee that technological breakthroughs can overcome the problem. Furthermore, other sources of energy have not been proven both safe as well as economically viable yet. It does look like the growth in economic output will run into energy related speed breakers.

Do you think mankind's ingenuity will be able overcome the problem of falling return on energy investments? Share your views with us or you can also comment on our Facebook page

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01:40  Chart of the day
 
The realty sector never fails to surprise us. Or rather shock us. Take today's chart of the day for instance. It highlights the demand supply scenario in the affordable housing space in the five major cities of India. As shown, the demand far outstrips the supply for affordable housing. This state of affairs should certainly raise questions about why developers seem to ignore the opportunity that is present in plain sight and instead, opt to build premium projects. If a leading daily is to be believed, it has to do with the cost of the land and the long gestation periods that affordable housing projects usually take. Little wonder, the sector is in a state of complete mess as the safe haven for developers during a slowdown has hardly been a viable undertaking.

Source: LiveMint
*NCR - National Capital Region
** MMR - Mumbai Metropolitan Region

02:17
 
While Greece is struggling to remain solvent, the European Union is striving hard to keep the debt contagion from spreading. After Greece, the next most vulnerable candidate would be Ireland. Rumours are making the rounds that the Irish central bank is already printing its old currency just in case it leaves the Eurozone. We are not certain if the rumours are true. But one thing is certain; the case for the eventual collapse of the euro is gaining momentum.

From a long term perspective, it makes absolute sense for Ireland to go back to the punt, its old currency. The country could not only lighten its debt burden but also boost up its exports by devaluing the currency. But the intervening process would indeed be very painful. And why not, creating a currency takes years of planning. So disintegrating it would also be a complex and painful process.

02:47
 
If you thought that the 2G spectrum scam was the worst that India got to see of corruption, think again. Besides the precious telecom spectrum, there is yet another natural resource that has been exploited to make illegal gains. And we will not be surprised if some more skeletons tumble out. The size of iron ore mining scams in states like Karnataka, Goa and now Orissa threaten to top even the size of the 2G scam. According to newspaper reports, the illegal mining of iron ore in Karnataka has cost the exchequer Rs 162 bn. The one in Goa has cost Rs 120 bn. But Orissa that houses a third of India's iron ore deposits seems to be the victim of a mining scam to the tune of Rs 3 trillion!

There are supposedly 243 mines in Orissa where work had been suspended in 2009. But thanks to strong political connections, the mining companies have been able to sidestep the law. Clearly, the rate at which the nation's precious resources are being plundered, we could run out of virtually everything in a few years time.

03:24
 
Legendary investor Warren Buffett made a statement some time back about how the Obama government should tax the rich people more, much to the chagrin of the latter. But while he claims that his federal taxes in 2010 amounted to 17.4% of his taxable income, many of the Americans especially those belonging to the rich set would love to see the details of Buffett's tax returns.

Part of the reason that Buffett's tax rate was quite low was on account of much of his income coming from capital gains and dividends. Plus, it is assumed that he took significant deductions for charitable donations. Interestingly, Buffett's statement to increase taxes for high earners does not include taxes on dividends paid by his own company, Berkshire Hathaway.

There is another aspect to be considered. US corporations are subject to a top federal income tax rate of 35%, which is the second highest in the world. But if one considers Berkshire's investment in Bank of America for instance, Buffett and the Berkshire investors will not have to pay anything close to that because corporations can exclude from taxation, 70% of the dividends they receive from an investment in another corporation. Little wonder then that many of the rich in the States will not see eye to eye with Buffett as not all are on the same boat.

04:09
 
India's labour problems continue to mount. First Maruti Suzuki and now Voltas (Tata Group Company) is facing the problem of labour unrest. Workers of Voltas are protesting against the company's recruitment policy and wages. The main demands of protesting workers are, hiring more permanent employees and equal pay for permanent and contract workers. They claim that the company has hired workers only on contract basis for the last 15 years. At present Voltas employs 8,000 contract workers, 3,000 management staff and only 600 permanent workers. Out of 3,000 management staff, more than half of them perform the work of ordinary workers, but they are paid a salary 3 times more than ordinary workers. This violates the basic principal of equal pay for equal work. While the management has been quick to rebuff charges, it highlights yet another instance of growing tensions between the Have and Have-nots.

04:38
 
Meanwhile, indices in the Indian stock market moved into the negative after opening the day on a positive note with the Sensex trading lower by around 70 points at the time of writing. Heavyweights like L&T and ICICI Bank were seen driving most of the decline. Most other Asian markets closed mixed today whereas Europe is trading mostly in the negative.

04:52  Today's investing mantra
"Narrow-minded economists emphasize 'production' and virtually ignore what happens to the source of nature's resources, as well as to nature's sink, which has to absorb the unwanted, so-called 'by-produces' or 'production." - Garrett Hardin
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6 Responses to "World faces a more serious problem than high debt"

J Jeyaseelan

Sep 29, 2011

Let us now look at the question of declining productivity.

In order to understand productivity properly, we must first understand the difference between economic (physical and emotional productivity)which might be computed on the basis of 'Values' and financial productivity calculated with the help of 'prices'.

There are only three sources of economic productivity: nature, technologies and managerial/governance innovations. Adequate and properly distributed rainfall results in higher output per unit of physical labour, energy and materials expended on cultivation. A new technology might result in greater output per unit of total inputs utilised in the production process. An innovative management procedure might help reduce the time and motion required by people to complete a job than before. Every improvement in economic productivity is very important for making economies viable. Any fall in economic productivity would lead to disastrous consequences in the future.

However, financial productivity is more important in the immediate context. If for example, the higher agricultural output resulting from good monsoon caused a more than disproportionate fall in the prices of the concerned farm output, the much needed gain in economic productivity would be translated in to a loss in financial productivity. In fact this is one of the reason why in countries like the US excess milk or food grain is destroyed. It is a case where an economy lacks mechanisms to translate rise in economic productivity in to overall economic growth.

Lesson Number 1 therefore is to closely watch the trends in both economic and financial productivity and ensure that there exists a mutually beneficial linkage between the two.

Equally important is the difference between micro and macro productivity. Usually when we compute micro productivity, overheads in general and rent in particular is kept out of the calculations. While micro productivity ratios are important to understand the viability of a specific process of production macro productivity is important to the gauge the feasibility of such production processes within the overall framework of any organisation or economy.

In the case of a company for example, a particular production process which might be economically productive by itself, might not be productive enough as compared to the macro productivity it might generate inside another company. Every productive process gains or loses value, based on advantageous synergies or disadvantages provided by the rest of activities within any organisation or economy. This is the reason why companies are advised to focus on core competencies, which help enhance collective efficiency or macro productivity of all the activities of an organisation taken together.

Let us now turn to the example of oil. The example deals only with micro level economic productivity which is well stated in the Malthusian theory of marginal productivity. As demand for grain keeps increasing farmers would be forced to till more and more of land that yields less productivity.

But then there is more to the oil example. Prices of oil have not risen in proportion to the increase in costs but because of the higher rent sought by the owners of oil resources. When we are paying for oil, we are not only paying for the higher cost of oil production but also a huge overhead cost by way of rent. We are actually supporting the profligate lifestyles of the oil producers just because they have been able to cartelise the oil market through OPEC

Recession is the result of higher rent pay outs that cannot be absorbed by the extant productivity levels of the ongoing production and consumption processes. An example would help understand this predicament better. Assume that there is a cartelised shortage in the market for rented homes. If your landlord were to double the rent to support his profligate lifestyle and you have no option to find a cheaper alternative, you would be forced to cut down all your other expenses. When people are forced to do such things en masse recession is the inevitable result.

So the current recession is not the result of fall in the marginal productivity in the oil sector but the higher rent component to be paid to the owners of the oil resources. They are the profligate landlords of the modern world

Lesson Number 2 is that we need to watch trends in micro and macro productivity levels and try and avoid higher rents that might affect macro productivity very adversely

That is however, not the end of the story. Increasingly governments are joining the ranks of landlords thanks to the backdoor revenue mopping mechanisms like public debt. Governments are indeed landlords who take direct rent with the help of taxes and much more rent through public debt and deficit financing.

There is certainly a reasonable rent that we need to pay to the government for the common services like security and infrastructure. Just like there is a level of rent that you can afford to pay without upsetting the apple cart, any higher rent demanded by the governments either directly by way of more taxes or indirectly through public debt or deficit financing will inevitably lead to reduction in your ongoing consumption patterns which start the recessionary process.

Sometimes, governments walk in to wars without realising that it would affect the normal consumption patterns on which economy depends. Sometimes citizens are also foolish enough to demand things from governments that cannot be done without debilitating the economy. One such area is internal / homeland security. The growing menace of terrorism has forced many governments to sink large investments and take on huge revenue expenditure additionally. But the returns from such expenditures in terms of economic productivity is very insignificant.

Lesson Number 3 is that we cannot force governments to do everything for us unmindful of the economic consequences. Wars waged in Afghanistan and Iraq as well the huge homeland security burden have siphoned of purchasing power that would have otherwise supported the usual consumption pattern in the US and averted some of the heavy burdens of the current recession. The ultimate moral of the story is that we cannot get things done at any cost just because they are good for us. We would have to always find more and more economic ways of doing good things to avert tragedies like the current recession.

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J Jeyaseelan

Sep 29, 2011

I am often amazed the very little attention being paid such vital issues like public debt. Who cares about growing public debt? Our perspectives have become so short term based, most of us do not even think of our own future.

So solution Number 1 should be to teach people about longer term implications of their actions. This would help create a moderated mindset that would not be overtaken by instant gratification but is very willing to weigh objectively future happiness of our actions with some degree of patience.

The second reason for the prolific rise in public debt is the licentiousness with which governments are able to mop up resources through domestic and foreign debt. Public debt is considered to be the most convenient since it obviates the need for raising taxes. The foolish public is always very happy with governments that do not raise taxes. They hardly bother to know if the government had resorted to using more of public debt instead of raising taxes through higher taxes. What people forget is the fact it translates in to heavier but invisible taxes on their future incomes. In addition governments that resort to public debt find this as the most convenient route since they don't have to think about repayment. As a result, very considerable extent of tax revenues are now required to be allocated interest and debt repayments. There could be nothing more perverted than this in public finance.

Solution Number 2 would be to empower the central banks to carry out a due diligence on the requests for raising resources through public debt, the same way as the banks are required to do while approving corporate or personal loans. Governments must provide adequate information about how it hopes to generate future revenues to meet interest commitments and repayment of the principal.

This is not to say the fall in productivity is not a major concern. But there is also an indirect link between the manner in which governments are able to float debts and the drop in productivity, It is equally important let me deal with it separately

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Babu1950

Sep 28, 2011

I always thought that development index using per capita consumption of energy, plastics etc was faulty & infact unsustainable.
In fact the UN model of happiness index, seems more rational, justified & sustainable. In the last survey Bhutan was at the top.
Gandhian model of self sustaining village economy is also worth revisiting, for civic planning.
In nut shell, Governments are the biggest perpetrator of the misery on common people.

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Ramanand

Sep 28, 2011

The energy extracted to energy spent ratio can go back to 100 if we start using oxen/mules/human muscle to pump oil. Another part of the problem of the reducing ratio is that it now needs to be extracted from one place and shipped to another corner of the world.
And no, human ingenuity will not come to our rescue. Human ingenuity cannot overcome massive social/economic infrastructure that has been structured such that it is viable only in a "growth" scenario. Once growth stops, the whole of existing socio-economic fabric will tear up. Significant population reduction will happen as part of this soon to come collapse, expect lower strata of the society to initiate the aggression as they start to lose everything they hold dear.

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Gopal Kalpathi

Sep 28, 2011

Well, as usual the western mind (both scientific as well as economics) is bent towards inventing newer and newer terminology and causes. The simplest of the thing is to reduce consumption. The whole economic slowdown is a natural process of cutting consumption. If only man learns to live with in the available means (read natural resources) we will be lot better and will do a lot of good to the planet Earth.

Man had always prided himself in destroying (An atom Bomb can destroy a whole city in seconds, cutting down of trees can be achieved in seconds) but ask him to do make things as fast and we will have the answer to all our problems not just this economic slowdown.

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G Rai

Sep 28, 2011

It has also to do with the greedy O&E companies of today!

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