For the love of left or right

One of the biggest lessons (learnt rather rudely though and still not perfectly) of my trading days was that conviction behind a trade is essential. But being in love with it is suicidal. For the love of the trade often makes one blind even to the clearest of writings on the wall. Today I trade no more, but I read various economists – both leftists and rightists… And I see many of them making the same mistake, falling in love with their ideologies to the point of making arguments which simply run contrary to the basic principles of economics.

I would take up here 3 recent proposed reforms… (1) Direct Cash / Benefits Transfer. (2) Abolishing Securities Transaction Tax. (3) Port Charges Reforms. While each of these have many points in favor or against of them, I would simply confine myself here to the points which I think are against basic economics.

1. Direct Cash / Benefits Transfer
This means giving money directly to the people in lieu of say food subsidy. Currently food is supplied at highly subsidized rates through PDS or ration shops. Now our leftist economists criticize the change saying it would fuel inflation. Their reasoning is simple – more money in the hands of poor means more demand and hence higher inflation. Higher prices of food all around again meaning higher inflation.

I don’t think this makes sense. Why? Because the total amount of subsidy doesn’t change! Earlier the government was paying the wheat traders say Rs. 100 per kg. Then assume it sold the wheat to the poor free of cost. So the subsidy, and hence the fiscal deficit was Rs. 100. This deficit fueled inflation to the extent of Rs. 100 in the economy. Now in the new system, the government will again pay the wheat trader Rs. 100. So a deficit of Rs. 100 arises. Next, it sells the wheat to the poor at Rs. 100. So it gets back Rs. 100 and now deficit becomes Rs. 0. Finally it transfers this Rs. 100 in the bank account of poor directly. So deficit again becomes Rs. 100. Thus the deficit remains unchanged and hence no inflation.

Consider the argument that now there will be additional demand from poor in the market and hence higher food inflation. Agree the demand of food at market rates would increase. But so would the supply! For earlier what was sold ‘off-market’ to the poor by the government, would now come in the market. And thus the increase in demand and supply will match out each other. Where is the additional inflation?

2. Abolishing Securities Transaction Tax (STT)
This time the rightist economists like Ila Patnaik propose that we should abolish this tax. Simply put, STT is a tax imposed when one buys / sells a share in the stock market. They argue that due to this tax, trading Nifty in India will become more expensive. So foreign investors would instead begin to trade Nifty futures (a kind of derivative) in Singapore. So India’s business will go abroad and India would lose. Now consider this…

Lets say STT is 10%. Now a foreigner wants to buy Nifty which is at say 1000. If he buys in India, he will have to pay 1000 + 100 = 1100. But if he buys Nifty in Singapore, he doesn’t have to pay this tax, so he would have to pay only 1000. Naturally he would prefer to buy in Singapore, correct? But here is a problem… He can buy in Singapore only if there is someone in Singapore to sell it! Now typically what happens is that there are people who would be willing to provide the other side of the trade i.e. they would be willing to sell Nifty in Singapore. And to offset their risk, they would buy Nifty in India. They are called arbitrageurs and because of their operations liquidity is maintained in Singapore. If they were not there, Nifty market in Singapore would become too illiquid to trade. Now in our example, for our arbitrageur to not to lose money, Singapore Nifty has to be at least at 1100! Why? Because he would sell Singapore Nifty at 1100 and buy India Nifty at 1000 to offset his risk … but he would also have to pay tax of 100 in India and thus total he has to pay 1100 in India. So if Singapore Nifty is anything below 1100, he would not do the transaction. And if he doesn’t do this transaction, there will be no liquidity. If there is no liquidity, there is no risk of ‘India losing its business to Singapore’.

Now in market there are always people trying to buy and sell. Singapore Nifty cannot go above 1100 otherwise the arbitrageurs will sell Singapore Nifty and buy India Nifty. Similarly Singapore Nifty cannot go below 900 because then the arbitrageurs will buy Singapore Nifty and sell India Nifty. So Singapore Nifty will oscillate between this large range. And within this range, arbitrageurs will not operate and hence no liquidity! Thus instead of losing business, higher STT will only bring more business to India, keeping all other things constant. (Of course I am aware that a higher tax will reduce the overall market and in the final analysis India’s market share may reduce. But the point is that the argument of India losing market to Singapore is wrong.)

3. Port Charges Reforms
India needs to develop its ports. But government doesn’t have money. So it needs private participation via PPP. But the private player would only invest if he can make money. He can make money by charging a ‘port fee’ to all the users of the ports (exporters and importers). Currently this port fee is fixed by the government. Obviously it is less and hence no incentive for private players to invest. So the rightists propose (and the shipping department has agreed) to let the private port developers decide the port fee. They can then charge a higher port fee and make money and so will be eager to invest now. Fair enough?

But here comes the problem. Ports are a monopoly! An exporter in Bombay has no choice but to export his stuff through the Bombay port. True he can ship it out through Chennai port if the charges at Bombay port are too heavy, but shipping stuff to Chennai will entail higher costs. So so long as charges in Bombay port are lower than charges in Chennai port + the transport costs from Bombay to Chennai, the Bombay port is a monopoly. And basic economics tells us that monopolies lead to market failures. And so the government must intervene to correct this market failure.

Agree, the current fixed port fee regime is counterproductive. But by letting the port developer fix the fee, we are simply moving from one type of market failure to the other. Why can’t we seek a solution somewhere in the middle? Say in the bidding process for the development of the port, why can’t we award the project to the private party who agrees to charge the lowest? This would take care of the monopoly part assuming the bidding is competitive and so the lowest bidder would win and thus any monopoly profits would be wiped out. Of course I don’t know the details of the process, but in principle, something like this should work.

Funny enough, in its defence in the coal scam the government took the opposite position. It said a competitive bidding would only mean coal prices would go up and thus the electricity prices. That is why it went ahead to give away the mines for free. But there too why couldn’t we have a competitive bidding where the coal mine would be allocated to the person who would be willing to sell the coal (or the electricity) at the cheapest price?

Anyways, the love of ideology has made these economists blind to the extent they forget basic economics.