Real Life Lessons that Economics Can Teach Us All

I often find people dismissing Economics as being "impractical", 'unscientific" or "idealistic", and when I try to debate otherwise, I get some heated arguments, most of them being along the lines of its inability to 'truly reflect the reality'. Considering that economic theories are formulated with a peculiar assumption of Ceteris Paribus, a Latin phrase that translates to 'holding all other factors constant', I do not blame the skeptics. Regardless, I believe that Economics is still a science, which emerged from the notion of scarcity, and I think it teaches some important lessons on life. Let me mention some of them. 

1. Expectations: Expectations about the future causes businesses and households (participants of the economy) to adjust their consumption, saving, investment and expenditure patterns accordingly, and these subsequently influence economic variables.

Let’s look at an example, within the Indian context to see how this works. In an inflationary environment, expectations of future inflation could become a self-fulfilling prophecy. For instance, if workers expect future inflation, they are more likely to demand higher wages to compensate for the increased costs of living. If their management gives in to their demands, the higher wages would increase the cost of the product / service that the firm sells. Moreover, the firm, in anticipation of higher inflation will increase the costs further to maintain adequate profit margins. Essentially, the higher costs will be passed on to the consumers causing what is known as Cost-Push Inflation. On the other hand, the workers who now have more disposable income will demand for more (or higher quality) goods and services. If the supply remains at the same, the prices will go up thereby causing inflation of a different kind – Demand-Pull Inflation.

Key Lesson: Expectations influence Actions, and hence Outcomes. If you believe you will succeed / fail at any endeavor, chances are, you're making another self-fulfilling prophecy. Thus, as the spiritual gurus say, stay positive !

2. Externalities: Externalities are spillover consequences (often non-monetary) of a transaction, experienced by unrelated 3^rd parties. These could be positive (read: social benefits) or negative (read: social costs), and could potentially lead to market failure if the social costs are not compensated for. On the other hand, social benefits tend to add to the business' goodwill. 

For example, schools, universities and research institutes emit positive externalities as education generates social benefits in addition to the profits for the institute selling the service (of education). Therefore, it’s a common feature in advanced economies for governments to either subsidize education or give incentives to education providers for the social benefit they bring about. On the other hand, large investment banks have been heavily criticized for taking on unsustainable amounts of debt leading to the Global Financial Crisis of 2007-08, and also amplifying the systemic risk in the overall banking system. These actions of investment banks (due to poor regulation) had brought about severe negative externalities that have now triggered in widespread social unrest (read: Occupy Wall Street).

Key Lesson: Your actions always have unintended consequences. Well-intended actions can sometimes have unintended ill side-effects too, and vice-versa. You can never be cautious enough. 

3. Dead-weight Loss: Dead-weight loss (DWL) refers to the monetary/welfare costs to society that are caused by market inefficiency, mostly arising due to poor policies or misallocation of resources. When a market is in equilibrium (i.e. demand = supply), there is no DWL. However, when price controls (minimum wage, subsidy, etc) are introduced, the demand & supply dynamics change and the new equilibrium point create a dead-weight loss. 

For example, imposing taxes on any particular product / service would not only reduce the seller's profits, but also cause some customers to shy away from making that purchase due to a higher price, thereby further reducing the profitability of the seller. In another scenario, imposing price controls (such as minimum wage & price ceilings) tends to restrict the businesses from functioning optimally, and creating DWL in the process. This loss of efficiency is then passed on to the consumer in the form of higher prices. In both cases, there is deadweight loss arising in terms of the monetary loss of profit for the seller, and in terms of the loss of utility derived from that particular product to the customer. 

Key Lesson: Let nature take its course, and only intervene when those forces are on a collision course, and external action is a must. Natural forces have a way of finding their own equilibrium.

4. Opportunity Cost: Opportunity cost is the cost of the action that has to be forgone, when opting for an alternative action, thereby highlighting the relationship between 'scarcity' and 'choices'. It is important to understand that the underlying assumption is that resources (time/money/labor) are limited and therefore there is always a trade-off on how to deploy those resources at any given point in time. One must note that the opportunity cost of an action may not necessarily be monetary in nature.

For example, instead of reading this post, you could have been baking a cake, washing your car, shopping, working, etc. Here, your opportunity cost is in terms of time (scarce resource), which could have been used for many possible activities (choice), and in the trade-off, you chose to read this post (excellent choice). In another instance, an investor decides that investments to make based on his capital and the available opportunities (both being scarce resources), and his decision (trade-off) is based on the pay-offs of each investment opportunity (returns, risk levels, etc). At the end of the day, one can use a $ 1 million to deploy at the stock markets, a new house, at a new business venture, or be used up for buying flashy goods, or be given to charity, etc.

Key Lesson: Our lives are determined by the choices we make, and while our options may seem limited, we must compare their Opportunity Costs to make the right decisions. 

5. Diminishing Marginal Utility: The Law of Diminishing Marginal Utility, in simple words, says that as an individual consumes more and more units of a product/service, the utility (read: satisfaction) derived from each consecutive unit, after a certain number of units, tends to decline. This concept applies to a production setting to, and a manufacturer may find his marginal utility diminishing by producing more units.

For example, Toyota currently manufactures 1000 cares a day. But to manufacture more cars per day, it will need to hire more workers, which will require more space to work, and also more wages to pay out. This may no longer be efficient because it may raise the average cost of producing one car. Hence producing more than the 1001^st car (and every car after that) will have diminishing marginal utility.  Similarly, consider a situation where you are very thirsty, and you drink water. Your 1^st glass will be very satisfying, but your second glass, though much needed, will not offer the same satisfaction as the 1^st one, and hence, will have lower marginal utility.

Key Lesson: More isn’t always better. Excessive quantity more often than not tends to defeat the purpose and backfire. This also applies to things such as hard work and happiness, where excess can lead to health problems and therefore, a natural decline in efficiency.

6. Fiat Money: It is currency that has been declared by the government to serve as legal tender, but is not backed by any physical commodity such as gold, copper, grains, etc. Therefore, its value is not intrinsic, but based solely on the premise that the counterparty would accept it as means of payment for goods, services and debt (or taxes in case of the Government).

As most of you know (I hope) transactions historically were made using the Barter System. This evolved to using commodities (grains, precious metals) as currency, until the 11^th century China, where the Yuan and Ming dynasties became pioneers of fiat currency. That being said, after the Nikon Oil Shock in 1971, almost all currencies in the world have been flat currencies. The problem with this is that since currencies are legal tenders backed solely by trust, it can become worthless due to hyperinflation if there is a loss of public confidence on owing to incessant printing of paper currency (the most recent victim of this was Zimbabwe).

Key Lesson: Always Have Faith. The moment you lose confidence, even the most prized assets – whether it is a skill, a person, or an object – become worthless.

Time for RBI to smell some Coffee

Inflation in India now has been stubbornly hovering close to 10%, and RBI's attempts to tame it have been nothing but counterproductive for the Indian economy. Despite 12 hikes (350 basis points) since March 2010, inflation still remains high. The RBI's "hawkish stance" on monetary tightening has won Governor Dr. Subbarao very few admirers. Corporate leaders voiced their disappointment and the Financial Markets did not hide their dismay either.

It is a well-known notion that every Central Bank's biggest challenge is to balance the trade-off between Economic Growth and Price Stability (Inflation). Also, economic theory tells us that conventionally, the level of economic activity in a country can be adjusted by adjusting Interest Rates, which determine Aggregate Demand.

Increase in Interest Rates = Decrease in Aggregate Demand

Decrease in Interest Rate = Increase in Aggregate Demand 

For example, increase in interest rates will cause the interest on loans, credit card debt, EMIs, etc. to rise. Other things equal, this would make people use their credit cards less, and cut discretionary spending to meet the rising interest payments. Overall there will be a slowdown in economic activity. Conversely, when the level of economic activity is low to begin with, and the central bank needs policy action to stimulate it, it would lower interest rates. By doing so, it would encourage people to borrow more (take more business loans, shop more) and hence increase economic activity.

This brings us to the question of how does Interest Rates affect Inflation? The answer to this is pretty straightforward on the surface of things. Low interest rates give more borrowing power to consumers & businesses, which gives them more spending power. With the increased spending, the economy gets stimulated and Inflation is a natural by-product of this growth. Hence, at lower levels, inflation is actually encouraged as it’s a sign of economic growth.

Now that our basic understanding of economic theory has been refreshed, lets get back to the situation on hand. Over the last decade, the developed economies have led themselves in hot soup. Loose policies (low interest rates & low poor supervising) encouraged the use of debt, but the scale became enormously reckless. In 2008, we saw corporations grappled with high debt being unable to repay and had to be rescued by their Governments. The situation this time around is somewhat similar, but the culprits are not corporations, but rather sovereign nations. So obviously, now the severity of the situation is much higher.

While the scope of this issue is exceptionally broad, I will try to stick with events in India in this blog. Now then, having laid the backdrop, lets address the key issue: The RBI, the interest rate hikes, and the impact on GDP growth & the common man (who does not understand economics).

With access to dozens of economics PhDs in his advisory group, one would expect that he would have got the point by now. I’m not sure if Dr. Subbarao cannot see, or doesn’t want to admit, that his monetary tightening has not been working, and has only been hurting growth. It’s time he has to think outside the box. I admit that the situation is tricky, and political agendas only make decision making harder. However, sometimes one needs to stop over-analyzing things to tackle core issues.

India’s GDP growth rate is 2nd only to China, and this comes despite the global slowdown, political & bureaucratic hindrances, and infrastructure bottlenecks. With such economic growth, some inflation is inevitable. Especially considering that India imports its oil, most cars on the streets are imported brand names, as are our electronics, thereby making India a deficit nation too (More on fiscal deficits later).

To simplify our focus on inflation, lets take a closer look at its components. In doing so, one can see that the biggest components of Indian Inflation are rising Food & Energy prices. While energy prices are more a global factor and there is little we can do to drastically change its impact on the common man, the blame for food inflation can be put on inept Government Policies entirely. Over the years, enough has been talked about the country’s infrastructure bottleneck. Broken roads, rusted railways, poor warehousing facilities and outdated logistics, coupled with shortage of trained semiskilled labor, widespread corruption, a log jam of pending legal cases; the list is endless. The 2010 Commonwealth Games held in New Delhi was a showcase of all of the above-mentioned problems to the world. Oh the shame!

Such issues do not enjoy the press coverage as Bollywood parties do, for obvious reasons. But some research and dirt-digging led me to find out that roughly 40% of our agricultural harvests end up rotting due to bottlenecks in supply-chain. Oh the waste! If you think about it, the solution to most of India’s problem seems simple. Stimulate investment in infrastructure and we minimize the wastage too! Right? 

This is the point where I highlight what is in my opinion, the key difference between Indian and Chinese way of reforms. Indian infrastructure investments are usually too little too late. We make our roads long after the point where we absolutely cannot function without them anymore. Then too, the quality is so poor that less than 1 year into it, and heavy maintenance and repair work is required. On the other hand, China builds roads in advance, anticipation future needs. Infrastructure investments in India, much like any other investments, require ROI to be delivered as quickly as possible. In contrast, Chinese infrastructure investments assume this same ROI delivery period to be closer to 15-20 years, and hence the infrastructure is made to last, with minimal maintenance and repair. 

So wrapping it all up, all I'd like to say is this: 

• Despite all the above mention issues, India IS growing. 
  
• So some inflation is inevitable. 
• But 10% is a bit too high and is hurting the common man.  
  
• To lower it in a sustainable fashion, traditional monetary policies (of raising interest rates) will not help.  
  
• What will help is removal of wastage from the system. 
• This can be achieved by investing in 2 key spaces:  
• The Supply Chain Infrastructure  
• Bureaucratic hindrances