The Gold Effect

Gold. That shiny, yellow, malleable and ductile metal. Not much use to a chemist – it is very unreactive in the lab, but place it in the Indian economy and it has the effects of a catalyst gone wild – the ultimate symbol of wealth and power and prestige for many Indians and the Finance ministry’s excuse and reason for everything that is wrong with the Indian economy. Money, in its conventional form, has an opportunity cost.

This means that there is a price for holding money against rising or falling interest rates. If you do not put money in the bank you stand to lose out on the interest being paid by the banks. It does not matter whether the interest rates are high or low, as long as it is not zero, you always stand to lose. The Indian recognizes this and thus concludes (falsely, of course) that the accumulation of gold, as opposed to money, will provide a safe store of value. They refuse to believe that it has an opportunity cost – it does. And, and this point is very important, they can wear the gold.

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They can show it off. In fact, people vie each other at this. The euphoria over Gold in India is so large that recently, a ‘guru’ in a remote Indian village dreamed of hundreds of tonnes of buried gold under an old maharaja’s palace. Instead of dismissing it as pure fantasy, or better, not giving it the attention it did eventually get, the Indian Government plunged into it. They dug for the gold! Yes, gold reserves are essentisial for a nation but it is also a fact that more than half the world gold holdings are in jewellery while the central banks hold a dismal fifth of the reserves.

India, together with China, is responsible for around 56% of the world’s total gold demand. Gold has been a part of the Indian culture and ethos for centuries and, if we go by the current trend, is likely to be so for more to come. But gold, like coal and petroleum, is limited in supply. It is a scarce resource. Granted that we are not going to consume every bit that is mined, we must concede that India does not produce enough gold to meet its domestic needs. This results in an increased demand of gold in a market where the supply is limited, which leads to a surge in imports.

And the demand is so great that it takes its toll on the exports. That is when calculating net export the difference between exports and imports is taken and the huge import of gold to meet the ever-increasing demand weighs this quantity down. As Keynes tells us, when this happens it results in the total output of the economy (GDP) going down. Now we must understand one more point, the Indian voter’s and to a larger extent the lesser economically inclined world’s measure of how well an economy is doing is the growth in its GDP. And in an economy of India’s size, we expect nothing sort of, say, 5% growth on a quarterly basis and not yearly.

That again is an important point because it means that the Indian Government is in trouble every 4 months, not 5 years; which is generally good. It has to explain why the economy is doing badly without inviting our wrath, that is, without telling us that we are responsible for it. It must be a feat of diplomacy. The new trend in the Indian middle class, again less economically inclined, is to look at the CAD or the current account deficit. For them, a surplus is good whereas a deficit is bad. Even a very small amount in either purse is enough to tilt the political balance.

And this is not good news for the ruling party or coalition (varies seasonally).What follows is a slew of “measures” and “reforms”. These are code words for inviting more corporations and ‘attracting’ foreign funds. They are shameless appeasements meant for the MNC’s to exploit India’s resources for private gain. An East India Company was not enough for us; of course, they were a mercantile capital and not industrial, but the idea is the same. What we fail to understand is the there are two accounts for a nation, and not one.

They are the current account (the one we love so much) and capital account (the one we conveniently ignore). The former measures all transactions related to goods, services and transfer payments while the latter is a measure of the nation’s transactions in financial assets. Every time we import goods, it counts as a deficit on the Current Account and surplus on the capital account. Being the happy economists that we are, we see the former sliding down and not the latter going up, that is to say, in a balance sheet we are looking at only one column while choosing to forget the other. But here is the punch – while we do this most of us have no clue why the CAD is widening or shrinking (this rarely happens).

What is more baffling is the Indian government’s response to this – to increase the duty on gold imports. On the surface, this is a standard measure – which is another fancy way of saying that it comes straight out of an Economics textbook. It has done pretty well in terms of controlling short term fluctuations but while we are dying, the argument already lies dead. The argument goes that higher the duty on gold, greater the import cost, greater the import cost, higher the price of gold, higher the price of gold, viola, lower the demand. It is all very good. The problem comes when we think that the textbook are always right.

Now, there are reasons why sometimes certain things are written in textbooks is precisely why they should be avoided. The argument presented above and the method that was subsequently followed rests on a wrong premise, the same wrong premise that Adam Smith and Ayn Rand fell victim to : it assume that Human Beings are rational, that they are influenced by reason and not emotion. They make the mistake of substituting a dynamic psychological process with a clockwise physiological process. If they had been around long enough to witness the Wealth Effect, they probably would have given up on their arguments. Here is what actually happens when the imports duty is increased – people demand more ! I do not have a rational explanation for this.

The most plausible explanation was given by The World Gold Council, according to which, “Demand was further stimulated […] by expectations (which were subsequently proven to be well-founded) that the government would again increase the import duty on gold. This encouraged stock-building by bullion dealers and jewellers alike ahead of the duty hike, and consumers who had planned to buy gold in the near future brought forward their purchases to avoid paying higher duties”. Many other attempts to explain this phenomenon have resulted in Economists switching over to behavioural psychology and even sociology.

I am not an expert at either and therefore I am not going to pretend to be one. Instead, if we assume that humans are not rational beings, this ‘phenomenon’ does not lead us to a contradiction in terms. Like the Wealth Effect we seem to have stumbled upon the Gold Effect, whereby, the standard assumptions of Economics break down. This though, does not mean that Economics breaks down. It just means that we need to restate our assumptions and work from them towards a better theory. Economics, after all, is a science.

It is not absolute. It relies on ever changing theories which are better than their predecessors. There is no right ‘theory’ or ‘field’. It is all an experiment. For this experiment to succeed we have only one pre-requisite- that of not being too rigid with our assumptions.