India Growth Model 03: Fix-Contest-Leapfrog-Prepare Growth Model for India

Indian growth model must have various components addressing local AND global demand. The window of opportunity is short, we need to develop faster. The growth needs to come from both public and private sector and must utilize the Indian human resources. I propose a four-way Fix-Contest-Leapfrog-Prepare model for growth.

Fix

For basic infrastructure and basic capacity building there is enough capital available globally and that capital is seeking low returns which is good.

We need to continue to fix basic infrastructure, from ports, roads, power, housing, etc. to law and legal systems, education, defense to modern infrastructure like telecom and digital infrastructure etc.

We need to continue the cleanup that began in 2014 which mean reformative laws need to be cleaned and reworked for example, Insolvency and Bankruptcy Code, GST Act, etc. needs to be shepherded through the legal institutions that are trying to muzzle it.

However, the most important part of this strategy is to create a proper social security framework. What demographic dividend we envisage, will turn into a demographic nightmare in about 40 years. The problems faced by pensions, medical insurance, health insurance etc. In the developed countries like US, Japan, Europe etc. Signal potential pitfalls for the Indian economy.

The Fix strategy focusses mostly on government action. While there is ample scope for Public-private participation or for divesting government created infrastructure to investment vehicles, the central focus of this strategy will be driven by government. It requires high quality last mile delivery. The strategy will depend on known and innovative models of government action.

Contest

The Contest strategy is relevant for industries operating currently. The catch-up will involve penetration, locally by global companies and globally by Indian companies, of known business models. It is spread of McDonalds and Sushi across the Indian hinterland. It is also the spread of Vada Pav and Fish curry across the remote corners of the world.

This strategy portends that we will liberalise and open the economy. At the time when trade wars are looming large, this will mean global corporates will focus on India intensifying the competition in the domestic space. This will be quick win for consumers and job creation but a difficult time for domestic industry. However, it is not all bad, things will improve for domestic industry also. Something similar to what we say between 1992-1994 and between 2002-2005 we can hope to achieve. This is domestic battle. Battle for Indian consumers by Indian and global companies.

However, we need to prevent the mistakes and learn from the experience of the world when we liberalise. Thus, we may want to regulate the propogation of Genetic modified foods, or hormonally treated meats etc.

The contest strategy focusses on private players and known business models. The role of government shall remain limited to regulation and monitoring. Coordinated export development strategy is required. This means industrial policy will be as important as Fiscal policy.

Leapfrog

Generating, lasting, fast paced private growth is quite difficult. Particularly at the time when trade wars are looming large where economies will try to protect their jobs and therefore their markets. It will come from those industries where we India can deliver susbtantive and impossible to replicate advantage that will remain exclusively tied to India. This will be the focus of the Leapfrog strategy.

The Leapfrog strategy will focus on IT/ITES, Food, Fashion, Jewellery, Movies, Music, Entertainment, Culture, medicine, among other sectors.

Leapfrog strategy will be driven by innovative private players. The role of government will be limited but innovative interventions. We also need champions for each of the industry clusters working in this area. Dewang Mehta is the name that immediately comes to mind.

Prepare

At the time we are developing this strategy, we need to keep an eye on emerging trends in distributed manufacturing, robotics, artificial intelligence, advances in biology, etc.

These opportunities are for the private sector. In this report we focus on what private sector can do to address these opportunities in the economy and market place and create value. This participation by the private sector will entail some innovative groundwork by the government. We highlight that in later section.

Model in summary

The Fix-Contest-Leapfrog-Prepare Model is meant to limit the role of the Government. It also recognizes that Government is also necessary and required to deliver certain services. Thus, the model is centrist in terms of economic leanings. It is meant to clarify the necessary reform that government needs to undertake and to underline its urgency.

It is also the aim of this model to enumerate some of the many opportunities open for private sector in India. It is the private sector that will create those jobs. The model is meant as a treasure map that hopes to inspire many private sector treasure hunters to go forth and seek this treasure of growth and prosperity for the economy.

It is also important for this model to highlight the nature and extent of coordination that will be required between government and private sector. Both these entities will be required to complement each other so that India can address these opportunities before us. Coordination is more important because, unlike between 2002-2007, the macro environment is volatile.

The Fix-Contest-Leapfrog-Prepare Model will be explained in detail in subsequent sections.

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India Growth Model 02: India needs a new Growth Model

India needs growth at a time when global growth is sluggish, globalization of trade and supply chains has plateaued and is likely to reverse. These headwinds are challenging for any economy. Therefore, the Indian model of growth has to be substantially different.

Proven business models are broken

Across times countries have deployed similar models for growth. They are based on trade to places that have demand for goods / skills available in your economy. This demand emanates from cost arbitrage or availability arbitrage. 

Early Europeans were seeking spices available only in the tropical Asia. At that point in history they did not have much to trade with Asia but Industrial Revolution changed all that. With use of force they were able to maintain demand side and supply side in control and make neat profits. This enrichment of Europe came at the expense of Asia and Africa. The armed control over markets and suppliers allowed Europeans to run a level of protectionism that is unparalleled and hopefully will never be repeated. Nevertheless it represents one model of growth.

In the pre-war era, America developed exporting to war torn Europe. Taking advantage of wage differential, higher risk tolerance thanks to innovative risk mitigation mechanisms, and a healthy domestic demand augmented by immigration, Americans were able to enrich themselves both at the expense of Europe in some cases and also in cooperation with Europe in others. American protectionism was more from the cost side. Using slave labor and forcibly usurping the land and other resources Americans were able to create value. The American growth model was thus based on military industrial complex.

The Post World War II development of Europe was entirely based on exploiting American demand augmented by domestic demand from rebuilding initiatives supported by low cost capital. This time, Europe was not able to run the kind of protectionism that had benefited them earlier. However, they benefited from twin protectionism. Europe enjoyed fortuitous financial protectionism based on low cost of capital thanks to Marshall Plan. It also engaged in currency management to help sustain the development. There were other factors allowing faster growth in Europe - lower population in all of West, new technologies from war for productivity enhancement and solid demand from rebuilding.

The Japanese growth which partly overlaps with European growth was also based on the same premise. Japanese fine-tuned this strategy by self-deprivation and focusing on exports to the West turning it into a protectionist advantage. Japan had another advantage, it did not need to spend on military and defense.

However, this dependency of Japan and Western Europe became unbearable for United States which was operating under the Gold Standard. It lead to abolishing of Gold Standard and start of modern finance driven development era. This is the time when John Connally made his two famous statements - “Dollar is our currency and your problem” and the ever prescient and my favourite “My philosophy is that all foreigners are out to screw us and it’s our job to screw them first.”

East Asian tigers and then China were the first to take advantage of the growth unleashed in this period. Using essentially the same model, these countries relied on pegged exchange rates and export demand to move out of poverty. By the time India joined the party in 1991, this model was quite well understood. The initial quirks were exposed during the South East Asian Crisis. The crisis led to refinement rather than correction of the model.

By 2002-03 this model became so well understood that most of the developing countries started using this model. Over-reliance on consumers from developed world and excessive constraints on domestic demand were norms of the day. This old model of development has finally broken or is in the process of breaking. In effect we will need a new model for growth.

Indian model of growth has to be substantially different. It has to withstand competitive forces right from the word go. India will not have any advantage of protectionism except what naturally accrues to it. Indian model must take advantage of the uniqueness of Indian demand in comparison with other countries. Given that Indian markets are not exactly uniform, India can become the hotbed for innovations that can be exported to the whole world.

The future is hypercompetitive

In the next phase of globalization, we are likely to encounter countries defending their domestic consumer. India has to withstand competitive forces right from the word go. India will face stiff competition winning in the markets outside India. India will not have any advantage of advantages except what naturally accrues to it.


Thus, India will have to fight for the global consumer,  some times on unfavorable terms, other times with entrenched players. India will face technological gridlock making innovation costly and product development long drawn. India will also have to face adverse tacit protectionism in the form of unreasonably demanding product/service quality or unreasonable punitive damages from product/service failure.

Within Indian markets too there will be intense competition. There is shortage of consumer demand globally. All the top companies will look to gain from addressing the Indian demand. This competition will be both - an opportunity and a threat. If this competition for domestic market creates jobless profitability then it is threat. If it creates vibrant ecosystem then it is an opportunity. Indian model must take advantage of the uniqueness of Indian demand in comparison with other countries. Given that Indian markets are not exactly uniform, India can become the hotbed for innovations that can be exported to the whole world. Thus, the ecosystem will create competency to win across the world.

In short, while other countries grew by looking outwards, India should grow looking inwards AND outwards. But, how will India grow? 

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India Growth Model 01: Introduction

Two forces help the arduous journey of a nation towards progress. The How force makes us confident to embark on the journey and reduces the risks associated with it through sheer details. The second force is the Where force. It is the lure of the dream of a new tomorrow. That dream makes us turn, it gives us energy, carries us through the tough times and gives our life meaning. A nation that knows its WHERE can bear with any HOW! (1)

I was a bit disappointed with the Niti Ayog released their report titled “Strategy for New India @75”. [Here is the the accompanying presentation.] It was a very detailed HOW. The WHERE is missing - not just from the report but even from discussions, research papers, media. It is as if our WHERE has not been conceived. And that is a problem as the “how” depends on WHERE you are and WHERE you want to go. Without the WHERE, everything seems important and when everything is important, nothing is.

Even now the Where is missing. What does this India of 2050 look like? What do people do in this developed India? Where do they work? Where do they live? What do they wear? What things do they buy? What is their relationship with their government? What is their relationship with other countries? What are they worried about? How are the cities? How is the countryside? We can imagine many questions and paint a picture of India at 2050. It is here we want to go. This is our WHERE.

When we know the WHERE, our entrepreneurs will start gearing up for the challenge. When we know the WHERE, we will know what to prioritise, what to speed up, where can we go easy.

In my mind, I have a WHERE and hence my HOW is a little different. So this effort is to paint a detailed picture of the WHERE and augment the picture of the HOW we have already seen.

This series of posts details my thoughts on vision of new India and how to get there. These thoughts I will compile into a report at the end. At present time, the thoughts come from a broad based thinking on the topic, the final report will differ from this but hopefully not by much.

Notes:

1. Alluding to the quote “Those who have a 'why' to live, can bear with almost any 'how'.” ― Viktor E. Frankl, Man's Search for Meaning

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Comments on Ray Dalio's post on Monetary Policy 3 and MMT

Ray Dalio's comments are always well researched and interesting. For starters, I think, Principles for navigating Big Debt Crises is must read. (Its free PDF). His recent post on his LinkedIn blog is about Monetary Policy 3.0 and MMT. 

Some fundamental comments about present crisis:

1. QE only creates a space for fiscal response: Central banks and governments alike misunderstood the role of monetary policy in the 2008 financial crisis. The crisis was different than others we have faced since Great Depression. Per my reading of Keynes (which seems to different than Keynesians and neo-Keynesians both), in such crises, the proper response has to be from fiscal side. The monetary policy merely creates space for the fiscal response or accommodates the fiscal response preventing untoward consequences. The response had to be holistic - a coordinated and sustained monetary and fiscal policy response.
2. Fiscal policy amplification mechanism is broken: Broken may be a harsh word, we may choose "has become messy" in its place. The point is, fiscal policy needs an amplification mechanism. When government starts infrastructure spending, it needs some real value-creating sector to take it from there and start driving the economic engine. At present we do not have such "real value-creating sector" that can boost employments and wages generally. In 1980s we had tech, in 2000s we had internet, now we need something. In absence of a big driver, we need many small ones. If such capability is difficult to create in one sector it is quite difficult to create in more than one sectors too. The solution is to let inherent advantages play out.
3. Inherent advantages are muzzled: Inherent advantages have stopped driving international trade since east asian crisis, and at a larger scale with China's entry to WTO. Instead, we have pegged exchange rates (soft/hard/overt/covert), manipulated tariff and non-tariff barriers, and, in general, non-transparent trade policy. Until that is fixed we cannot have trade based on pure competitive advantage.
4. Small business innovations are indefensible: When people talk of China usurping Intellectual property they usually talk about submarine plans etc. But I am talking of something very basic. Check out new funding projects on kickstarter - innovative shoes, innovative bags, innovative pens, anything that takes your fancy. Just search on alibaba or just wait for few months you will see some products like those (invented by kickstarter entrepreneurs) in the market on mass scale. These products are not sold by those companies who invented them on kickstarter or such platforms. This is IP theft that hurts the most. It removes new business competitiveness right at its infancy.
5. Trickle-up always works; trickle down some times: Monetary policy practitioners and academic economists in general prefer trickle down economics. But empirical evidence says reverse is true. Trickle-up works all the time. Thus, when there is a choice of bail out, we must lean to lower strata. (A) It is more fair and just, (B) better optics and (C) right incentives. But MAIN reason it works because it balances the bargaining power of both sides. Bail out the top and they lean on to regulation to prevent or constrict trickle down stifling the economy. Bail out the bottom and lo and behold all the incentives align beautifully.
6. Certainty of employment and wages is the one super-indicator: The best solution to any crisis is to get certainty of employment and wages going, rest follows from that. Today we have almost full employment but it is uncertain. Wage predictability is also uncertain. That's why the lack of demand is so persistent.
7. Interest Rates are like friction: Too much and too little friction are both bad. Sames goes for interest rates too much is bad, too little is ALSO bad.

Some comments about Monetary Policy 3:

1. Debt financed Fiscal spending financed by QE: I don't agree with Ray Dalio that this was pursued after 2008 financial crisis. The fiscal spending was essentially going to the same group who could access the QE funds. Yes, there was fiscal deficit and increased fiscal spending and yes there was QE to finance it. But this is exactly the wrong kind of stimulus as I have written since 2009 itself.
2. Giving $10,000 to one person Vs $100 to 100 persons Vs $1 to 10,000 people: Helicopter money is not easy to design. The behavioral response in each of three cases varies drastically.The range of outcomes possible is mind boggling.
3. Spending conditions interfere political rights: If I am tasked to spend $10,000 can I give it to someone from my family to pay down her loan? Does that amount to spending? Should I buy something? What thing? These questions are difficult to answer, monitor and control. 
4. A little inflation is necessary: People will spend when they can surely afford it (condition above - certainty of employment and wages) and it will get costlier tomorrow. Inflation is important, zero inflation may not be that great.

The examples of Monetary policy 3.0: 

The best part of the analysis is the historical perspective Ray Dalio gives. Sharp readers of this blog will immediately note that there are fundamental differences between the conditions in various situations described and those existing now. That is acceptable difference.

Particularly interesting is the Roosevelt response in 1930s. It still forms the basic template for solution today. However, we are at a slightly different position today than in 1930s. So we have to make more adjustments than Dalio may seem to suggest. [Dalio is NOT suggesting it - it appears simple but it is incredibly complex - politically, fiscally and economically]

In Sum

Do not understand these comments as put down of Ray Dalio (as if he cares what I think!). I admire the man because he is being honest and creating a framework to solve the crisis. Good intentions and honest efforts deserve praise - even if the guy making those efforts is one of the richest.

From my side, I solved this crisis puzzle back in 2009 itself.

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About Australian banks and Australian property

John Hempton highlights something interesting today about resignation of top Australian Bankers.

Back in 2016 John Hempton and Jonathan Tepper of Variant Perception conducted research by personally meeting with the real estate brokers and seeking apartments to buy. In a sort of reply of scenes from the Big Short, they found banks wanting on the paperwork, mortgages being sold to those with questionable ability to repay. You can read some media reports about this here, here or here.

Today John Hempton wrote about recent firing in light of the final report of the Royal commission into banking and detailed allegation therein. John Hempton says:

Anyway come the Royal Commission Dr Henry talked to the Commission in a frank and open way about the problems. It was Dr Henry being Dr Henry: honest, competent, and realistic.

It came off badly. I remember the grilling he got from the Royal Commission and understood what was happening. It was clear that what was required from the Royal Commission was kowtow, rather than honest frank discussion. Dr Henry looked bad even though he was probably the single most reliable and honest witness the banks put up.

The Royal Commissioner made specific findings against Dr Henry and Andrew Thornburn. This surprised me because on my research National Australia Bank was the best of a bad lot, both in absolute level of moral decay and in direction.

The report quotes Dr. Henry and Thorburn in many places. The transcripts do not show Dr. Henry in good light. The transcript indicates that possibly Dr. Henry took this too lightly. He did not do any homework. A deposition once you are sworn in is a serious business. I do not sympathize with Dr. Henry.

The transcript of some others reveal that they kept repeating from jargon books and PR manuals. To that extent whatever their deep rooted ills did not come out. 

Implication for property market

There are two fundamental issues with the housing and mortgage markets. 

First the search for yields and the quantum of capital available makes real estate the best asset class to absorb the QE effects. It is doing precisely that. So some of the price appreciation is attributable to this. The macro policies have created this asset builders boom - create an asset and sell it to REIT type holders at ludicrous cap rates without any regard to final consumer.

Second, the problems in mortgages are of banks creation. As banks search for return in a tight market they have crossed the limits. The crisis in Australian banks is part of continuum that includes Wells Fargo opening accounts for customers to US sub-prime crisis. It may not be as acute but it is part of the same class.

Learnings for Commissions in India

The commission for banking has its website and documentation spot on. I urge Indian commissions to maintain such kind of records open for public scrutiny.

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Questionable Promoters' action

Deepak Shenoy from CapitalMind has an excellent blog and website. His post today titled Jubilant Backtracks From Paying Promoters For Brand They Don’t Really Use deals with some questionable actions by the Bhartias. Below are edited quotes from that article.

Jubilant Foodworks and Jubilant Life Sciences in a board meeting, they proposed a 0.25% royalty on consolidated sales for using the “Jubilant” name , to each of the companies.

To give you a perspective Jubilant Foodworks is franchisee operator for Dominos and Dunkin Donuts both well known US brands. Jubilant Life Sciences is a pharma company in generics and contract manufacturing.

The article further details various business groups doing this activity in some form or other. The two prominent ones that are missed in that discussion are the Aditya Birla Group and Kingfisher. Here are some from the article:

• Royalty from listed companies - 
• Colgate from Colgate India (4.8% of turnover) 
• Unilever from HUL (3.15%), 
• Dominoes from Jubilant Foodworks (~3%), 
• JSW Steel to Wife of Promoter (INR 1.25 billion)
• Tata from Tata companies using Tata name (0.25%) 
• Tata from Tata companies not using Tata names (0.15%)
• Muthoot group
• Shriram group
• Wadias (intending) from Britannia Industries
• Loans to promoters later written off
• Network 18
• DHFL (Alleged)
• Merging promoter companies with listed ones at unclear valuations
• Satyam
• JPAssociates
• LEEL
• Eon electric (attempted)
• Vedanta
•  
• Financing Promoter lifestyle
• Raymond - maintaining Raymond House

I do not like these kinds of "promoter earnings". You are either a promoter or an employee - don't be both. These should come within the purview of related party transactions irrespective of their materiality.

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Jobs/Employment and Growth

Why are incomes not picking up even when the unemployment rate is at its lowest and profits are rising?

The first phase of automation focussed on improving productivity. So skill requirement of workers goes up and hence their pay goes up.

In present phase of automation, the skill requirement of worker operating the equipment is going down and hence their pay is going down.

Thus, if you replace the spade with earth moving equipment, you need to pay the worker more for the higher skill requirement. But when you replace an expert barista with a coffee-maker machine then you need to pay less to the operator of that machine. 

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Knowledge improves Risk Mitigation

Improved knowledge of business domain: A person who has better knowledge of the nature of risk is better placed than person without any knowledge.  What you want to know is - where are the bargaining power centres, do you understand them and who owns them and whether you can change those. Given my knowledge of pharma and allied sectors, I do not invest in pharma.

Improved knowledge of parties involved: If you know the founders well, you may be able to take higher risks than otherwise. You may also "know" competitive landscape - what they think, how they act.

Mechanisms to hedge risks are available and known: Hedging mechanisms are not always obvious. Not always "options" will solve your problem. Your knowledge must be comprehensive enough to determine what are the hedging mechanisms involved. Sometimes you can create an alternate product line to improve your bargaining power. 

With knowledge, you can better understand the risks. For you, the risks will be lower than others.

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Farmer suicides and loan waivers - can we solve it?

Farmer suicides have brought the problems facing the farmers to the fore. Indebtedness has been highlighted as one of the dominant problems for suicides. As a corollary, governments have taken populist turn towards loan waivers. This is not the first time the farm loans have been waived. But can we do something to make it the last?

I reviewed the research on this topic and summarised them in my paper. I found there are a lot of problems facing agriculture. To put it succinctly, Indian agriculture suffers from: i) poor productivity, ii) falling water levels, iii) expensive credit, iv) a distorted market, v) many intermediaries who increase cost but do not add much value, vi) laws that stifle private investment, vii) controlled prices, viii) poor infrastructure, and ix) inappropriate research. 

These are basically symptoms of two fundamental issues with agriculture. First, farm risk management has gone wrong. Second, there is lack of coordination between various parts of agricultural value-chain. Thus, farmers do not respond to changing prices and market dynamics pro-actively. They also bear higher costs for post-harvest coordination in the value-chain like transportation, packaging, etc. 

Farmers needed to become better at risk management. They should use futures prices at the crop planning stage itself. At harvest stage a mix of contracted sales, and spot sales to can maximise realisations. They also needed more reliable availability of inputs, of credit etc. All this meant we need information – different types and large quantum of information like futures prices, weather forecasts, demand estimations, pesticide usage guidance, seed knowledge, planting knowledge, etc. AND, this information had to be available to farmer when he/she needs it.

But information is only ONE part of the problem. Farmer also needs physical inputs to reach at his remote farm. So, fertilizers should be delivered on time. Farm insurance should approved. Seeds, pesticides should reach the farmer on time. It means the value-chain partners must be available and acting reliably consistently. It meant the value-chain participants need the farming process to be visible.

There is universal agreement about risk associated with dealing with commodities. It means despite much effort many times farmers will fail. The question is then – can they fail safely? 

The corporate world has solved this issue through use of limited liability vehicles. So can we apply that to the farmers? I believe, a limited agricultural bankruptcy mechanism should act like a safety net for farmers. However, we don’t want farmers to hide personal failures within agricultural risks. Hence, we want farmers to separate personal and agricultural assets for this purpose of limiting liability.

I think we can fix these using an information system –an ERP-like solution for agriculture to help assist the farmers. Such system will reduce the coordination costs, improve information availability and increase the scale of operation allowing formal economy to step in and help farmers. With ring-fencing of risks, low cost collaboration, timely information, we can help farmers into a positive spiral of profits-investment-productivity. I sketch out the schematic of such a system called Smart Agriculture Management System (SAMS) in my paper.

This issue is important. Please read the paper, I tried to keep it as short as possible. Please make suggestions for improvement. If you think SAMS will work then do spread the word.

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Black Money & Demonetization

The Government of India announced that the Rs 500 and Rs. 1000 denominated currency notes will cease to be legal tender. The move was targeted towards tackling black money, corruption and terrorism. After initial euphoria, questions began to emerge. What are the costs of this demonetization? Will it be effective if people can still create new black money thereafter? Will it increase the GDP? Will it increase inflation? What about tax revenues? We look for answers.

Black money and demonetisation

To start off, black money is a wider societal ill and demonetisation is but one step in the war against black money.

Black money and black economy are also two different constructs. The terms shadow economy and underground economy are also used as synonyms for black economy. 

Black money is the currency of black economy. It refers to illegal money earned from illegal sources which has not been disclosed to the government. The advantage of black money is that it links into the legitimate economy, uses the advantages of the legitimate economy but does not pay the costs.

Research on tackling black money

The issue of black money has been well-explored. The National Institute of Public Finance and Policy has been active in research about black money. Their 1983 survey of estimates of Black Money[1] led to a report on Aspects of Black Money[2] in 1985. The Report of 2012 titled Measures to tackle Black Money in India and Abroad[3] and the 2012 White Paper on Black Money[4] by Ministry of Finance covers the various research studies and updates them. These studies however have not been able to determine a consistent estimation of the black economy. The estimates, including from other sources, vary from 15% to 45% of the total economy. The papers, however, give a broad spectrum of mechanisms to deal with black money.

Apart from the above Indian initiatives, there have been global initiatives to tackle “underground economy” or “shadow economy”. Primarily, the principles remain the same. Internationally, I find, they focus more on facilitating voluntary compliance than enforcement. Maintaining trust and confidence in tax system takes precedence[5]. They also recommend risk based monitoring mechanisms, coordination amongst revenue departments and education among other things[6].

Principles of tackling black money

The first principle is that remove the systemic pain that leads to creation of black money in the first place. Blame lies with the tax department. Black money is nothing but money generated in legitimate transactions which are hidden from government so as to avoid paying the transaction cost (usually tax) in the legitimate economy[7]. This is usually done by using physical cash. This cash thereafter must be processed to convert into consumption or investment. Black economy refers to various activities, transactions etc. that help process this physical cash, create returns on this cash, facilitate consumption using this cash etc. 

The second principle has two parts. First, not all cash transactions are necessarily black money transaction. They become black money transactions only if they are hidden from the legitimate economy. Thus, a shop-keeper who does not give receipt but declares the sale (it’s only hypothetical) does not create black money. Conversely, a shop-keeper who gives a receipt but discloses other receipt book to the tax authorities (happens all the time) creates black money transaction. Second, the black money must at some time or other be plugged into legitimate economy. Thus, it cannot be done using user-created currency that cannot be exchanged with local currency. So it depends on legal tender. It means somewhere down the chain there must exist a person for whom part of this black money is legal cash income which he can use for his own consumption in legitimate channels. Usually, this is the construction worker, or other poorest of the poor who will give certain services and his income will remain under the government radar. It can also be illegal traders in gold or diamonds etc. who can convert this into precious items that have quasi-legal tender status. 

The third insight is that black economy is continuously fed by parts of white economy that go underground. Quite a few people who do not want to promote black money contribute to it. They are either coerced – say developer forcing buyer to pay him in cash or government officer seeking bribes in cash. Therefore, preventing white money from becoming black the starting point. The recommendations of Report titled Measures to tackle Black Money in India and Abroad describe some strategies. The core principle is to increase the cost of converting legitimate money into cash (wherein government loses ability to track it) and reducing the cost of electronic transfer also promotes electronic transactions. 

Black money flows through a separate channel. Such channel has infrastructure to handle black money. The fact is black money seldom remains in cash. It moves into high value items like real estate, diamonds, gold, films etc. The people involved in these sectors have well-evolved mechanisms to absorb black money. One way is to create entire value chains that use only cash. It is easy in sectors where workers/suppliers are unorganised, contract workers – e.g. Construction, films production etc. Bringing systematic regulations that make it easy for the participants in the value chain to accept electronic payments will curb black money.

Black economy depends on black money financiers. These are money lenders earning like 2% per month on their investments for financing the activities in black money friendly sectors. Film financing, construction financing, financing retailers, dance bars, alcohol, etc. These financiers also need enforcement mechanism to ensure their money is safe. Naturally they ally with criminal elements. Al Capone, the famous Chicago mobster, was previously an enforcer but later a financier. 

Black money faces the same invest or consume choice as legitimate money. On the investment side, it seeks sectors that are friendly for black money. So those people who buy many apartments from developers and developer later sells these for profit, are contributing to investment side when their agreements are not registered and do not pay stamp duty. Jewellers and traders of precious stones also contribute helpfully in this area.

On the consumption side, black money seeks to buy three things legitimate goods that can be consumed openly (i.e. normal things in abnormal amounts – say many shoes, many suits etc.), illegitimate goods that can be consumed secretly (banned or imported exclusive foods – caviar or expensive wines, expensive furnishings, home decorations etc.) or stored secretly (high-end safes, etc.). Within these sectors there exists trails that lead to the people hoarding the money.

Black money is also used in legitimate investments. Foreign channels play critical role. Quite substantial investments in P-Notes is actually round-tripped black money. The key aspect of these instruments is create anonymity by being away from arms of the laws of the country from where income can be fed into the legitimate hands. In such cases, the source of income is illegal. Thus, many businesses in tax-havens such as Mauritius, Cayman Islands etc. exist to convert illegal money into legal money. Many of these investments come under the purview of money laundering.

Incentives for electronic transactions help prevent use of cash. Income tax deductions on credit cards or e-payments up to a certain limit can incentivise electronic transfers. South Korea used credit card income deduction experiment has been hailed as a success by OECD.

Strategies for tackling Black Money

The distillation of various approaches can be summarised as under:

1. Establish identity of persons (through PAN Card, Aadhar Card etc.) operating in the country – citizens and foreigners.
2. Enable low the cost direct bank transfers (Implementation of NEFT/IMPS/RTGS and other formats) including direct transfers of subsidies to the beneficiaries under the Aadhar scheme.
3. Enable electronic register of assets (Underway through electronic land records, digitisation of revenue records)
4. Reform tax system so that cost of compliance is lower than cost of tax evasion. (through initiatives such as Saral forms, e-filing, self-declaration etc.) Indirect tax system through simplification (GST).
5. Widen the net for disclosure by filing Income Tax return. (auto-processing returns for tax refunds)
6. Regulations that increase costs for black money creating activities. (Prevention of Corruption Act etc.)
7. Create attribution chain for funds entering and exiting the country (such as through P-Notes, FDI, Prevention of Money Laundering Act etc.)
8. Create e-trails of both incomes and expenditure.
9. Control on holding of cash and physical money including Indian and foreign money. (FEMA, recent demonetisation)

It is clear that black money clean up is underway on many fronts. Many of the pieces of puzzle have been put in place.

Semantics of the current demonetisation

Demonetisation is the mechanism by which the government states to withdraw the money which is current legal tender. The government being sovereign can take such decision. The effect of this announcement is that the currency notes in circulation will now cease to be valid tender and can only be exchanged at the banks. Demonetisation of higher denomination notes as an idea has been around[8].

There are two important issues with respect to the present demonetization. First, that the notes ceased to be legal tender from midnight of 8th November just 4 hours after announcement. So in effect the only places where they will be accepted will be banks. Second, even the banks have been given time until when they can accept the notes – 30th December. Third, the cash swap carries restriction. Thus, in effect the announcement forces these notes into the banks deposits within a short period of time.

As per RBI estimates[9], 15billion notes of 500 denomination (approx. Rs. 7853.75 billion) and 6 billion notes of 1000 denominations (approx. Rs. 6325.68 billion) exist. In addition, RBI estimates that fake 0.2 million notes of Rs. 500 and 0.15million notes of Rs. 1000 were discovered. The actual number of fake notes in circulation will be higher. These will be worthless from 09 November 2016 but you can get the credit for the money held as these notes in the form of bank deposit. Naturally, those who can disclose deposits equal to the amount they hold in cash will have no problem.

Hasn’t it been done before?

Indeed, it has. The first demonetization took place in 1946 and Rs 1000 and Rs 10,000 notes were demonetized. Later in 1978, Rs. 1000, Rs. 5000 and Rs. 10,000 were demonetized. This is the third time demonetization has taken place. 

The critical difference is in the quantum however. The first and second demonetisations effected really high value notes which formed a small part of notes in circulation. We can arrive at the estimates by comparing the denomination of the note with the annual per capital GDP. In 1960, India’s per-capita GDP was Rs. 400 (then currency), in 1978 per capita GDP was Rs. 1722/- whereas today it is Rs. 103,000/- (today’s currency). [10]Thus in 1960, a 1000 Rupee note was 2.5X and in 1978 it was 0.5X per capita GDP, considerably easy to withdraw. The second aspect is that today the 500/- and 1000/- currency notes represents ~85% of physical money in circulation. At that time, it was considerable less[11].

RBI earlier removed pre-2005 notes of all denominations from circulation as they have fewer security features compared with subsequent notes. The process of removing the older notes from circulation continued for nearly one year. The deadline was extended till December 2015 and those notes continued to remain legal tender till November 8. This was not exactly demonetisation but removing from circulation and has now subsumed into the present demonetisation.

Why attack the cash?

First, who holds black money in cash? Mostly corrupt people. Their pay-offs are in suitcases and hoarded in their houses. These are balances held till they find their target investments. A lot of black money itself is mainly held in gold and land. 

As explained earlier, cash, i.e. black money is the currency of black economy. The government cannot do much about black money that remain stagnant if it remains a legal tender. But remove the legality of it and the government is able to alter the cost-benefits equation of corruption. Demonetisation attacks the currency supply of the black economy. But removing the cash available to buy these gold and you affect the supply chains in black economy. When the flow gets interrupted the cost of corruption increases and payoff reduces dramatically. Such action attacks the chain that processes black money.

It is possible that as a result land prices and gold prices will fall. If land prices fall, middle class will be able to purchase land. If gold purchases are reduced, the forex pressure on INR will ease a bit. Thus, legitimate money which was being priced out of the economy gets an opportunity. Further, it prevents the black money processing chains from forcing white money into black.

Inflationary or Deflationary 

Firstly, part of the actual money in circulation is never recovered. Depending on various conditions, at least 20% of this paper money will never reach banks. This stock of money is lost. Many believe this to be deflationary. It isn’t. Since this money was never within the legal purview it was meaningless anyways. From government’s point of view, it was like the money we forgot in an old diary and the diary was lost. This money did contribute to the economy but to smaller extent.

Some say “but this money was being used to buy Audis and other luxury goods”. This is weak argument. Audi as a company does not receive unaccounted money (if they do that is criminal as well). The black money chain in such cases effectively starts with the dealers who game the system by discounting the vehicle or by making the vehicle pre-owned, prior owner being the dummy person. In either of these cases the black money is circulating to other illegal users. If such deals are curtailed it is good – not bad. In any case a black money purchaser who pays Rs. 2.5 million to buy Rs. 4 million Audi then can buy a Skoda legitimately. 

Will it work?

One argument is we tried it in 1978 and failed. Of course we failed. First the notes demonetized were too large for the size of the economy. Second, we can fairly estimate that the black economy may not have used the super high value notes as much too. The present action has better chance of success as it proceeds logically. First, people across India were given an Identity card (Aadhar), then bank accounts were opened for them (Jan-Dhan), and people across India can transfer money using SMS today. No strategy can succeed without proper systems in place. This time there are better mechanisms that people can switch to.

Another argument is that people can deposit the money now and withdraw cash five months later for black money transactions. Of course they can. But there are various laws in place that track the cash withdrawer. These guidelines were framed for Prevention of Money Laundering Act. As per RBI rules under that, every withdrawal needs a PAN card reference. Further, every branch manager is required to file detailed statement of weekly/monthly cash transactions. The cost-benefit for legitimate fellows becomes high. It is easier to monitor for the tax authorities. One person claims to have sent his 200 or so employees to convert old currency into new currency. Thus, per day at Rs. 4000/- per person he is converting Rs. 0.8million into cash. So has the system failed? The answer is no. It appears from the logical approach followed by the government that this is merely the beginning of effort against black money. I suspect these two mechanisms will be taken care of in subsequent actions. 

The more fundamental answer is that black money is not a pool but a chain. Break the chain or make the chain costly and you inconvenience the poor who did not have access to bank systems. But with Jan-Dhan accounts, poor have ready access to banking channels (though not credit). So if you are law-abiding citizen then you can sail through mostly unscathed no matter how poor you are.

Black money in real estate gold etc. 

Usually, black money is used to purchase the following items – gold, precious metals, precious stones, real estate, high end consumer goods, high-end liquor, drugs, and entertainment. The total quantity of Gold, precious metals, precious stones, liquor and certain high end consumer goods in the market that is disclosed and purchasable is unknown. Their price is reasonably known. The quantity of real estate, entertainment etc. is known but their prices are not known to the government. For high-end alcohol, drugs and other items, both quantity and price are unknown to the government. 

This sort of black-money driven consumption is out of purview of the legitimate formal economy. The effect of demonetization on such consumption will be positive. Either this spending will cease thus reducing illegal imports of gold, precious metals, stones, liquor, drugs, entertainment of certain types (dance bars for example) etc. Other parts will integrate into the formal system thus prices of real estate, entertainment will generate legitimate revenue for government.

In short, the demand for these items will not be affected that much in short term and definitely not in long term. There is no denying that the contours of demand will shift from shadow economy to formal economy.

No magical government windfall gain

One argument goes that if a certain portion of the cash does not get deposited then RBI will no longer have to be liable for those notes. That reduced liability will be transferred to Government. If you estimate that about 30% of the currency notes will not come back, Government could be receiving about 30% of Rs. 14 Trillion is more than Rs. 4 Trillion. Such gains will be a game changer. Such arguments are naïve as they come from misunderstanding of how central bank balance sheet works[12] and also how money is created. 

One must remember that Balance sheet is an accounting construct to understand the capital deployment. Destruction of soiled notes, removal of older notes and other activities also do not create any income for government. Such activities merely adjust the balance-sheet on the liability side only. Simply put, there will be no gain to the government if RBI’s liabilities are written off. 

The issue in present case is the quantum of readjustment. If RBI balance sheet shrinks by 30% one fine day, there will be panic. But this effect can also be muted by writing down in phased manner while keeping the liability alive on paper. If this was possible you could have seen demonetization every 5 years. The only effect is that it will improve the quality of RBI balance sheet but no further.

The second part of the argument is that such a windfall need not wait for demonetization. The windfall is nothing but quantitative easing. That has consequences and is a well debated concept. 

Do Terrorists carry money in trunks?

One of the stated aims of the demonetization was to tackle terrorism. It has met with lot of ridicule. People are asking if terrorist do carry money in suit cases while coming across the borders. Again these people are missing the point. 

In fact, money laundering is one of the most important financing mechanism for terrorists. It was after 9/11 that the US initiated substantial push towards enacting of anti-money laundering laws to prevent financing of terrorists. The anti-money laundering investigations fails when the money trail leads to cash. In India the terror-finance trail starts and ends with cash making it impossible to get early alerts of terrorist active in the country. Demonetisation will upset the financing chain for the terrorists.

As noted, black money is the currency of black economy. It is the black economy, including financiers that need extra-judicial enforcement mechanisms. The terror groups are at the apex of criminal elements that provide this enforcement mechanism. If film producers do not pay their financiers, they get call from D-company – in effect an enforcement call. The black economy is also as innovative as any other. The criminal elements then seeking alternative revenue streams indulge in various terror activities. The terror finance chain comprises gold, diamonds and counterfeit currency. The counterfeiters don’t keep the money in cash but quickly convert it into legitimate, legal bank accounts through SMEs and other small businesses. Using these fronts these terrorists use this money to buy information and access. The actual terror attack is only the “last-mile” effect. The ultimate “attackers” are usually pawns without any knowledge of systems.

Yet, the main effect of demonetisation and subsequent introduction of new notes will be to increase the costs of the counterfeiters. It will serve to shock this supply chain.

The unscrupulous SMEs

The biggest elements in the black money creation chain are the SMEs. SMEs are flexible entities like sponges when it comes to cash. The question of scale of SMEs in the black money chain is mind boggling. Over years I come to believe that at least 30% of SMEs exist solely for serving the black money chains and about 80% contribute to the black money chain (many don’t have a choice). 

Their modus operandi is thus. SMEs themselves exist so as to help tax management. I refrain from using tax evasion because many of these acts are in fact legal and encouraged by law. Next, using a complicit banker the SME’s get loans. Their auditors are complicit in the process too. Now, unscrupulous promoters siphon cash away from these entities and fund private gains/marriages etc. Banks lending to SMEs are left holding the bag. This has also caused substantial stress in the bank balance sheets. Many of these SMEs are quite lax about filing financial statements with the authorities.

Thanks to the demonetization, some of these SMEs will be used to convert the black money from promoters’ holdings into the SMEs holdings. Conversely, those having illegal cash can push it into the SME balance sheet and “make it legal”. Readers may have guessed that banks will benefit from this when their bad loans suddenly start turning good. The net effect, I suspect, will be positive. 

It is clear that the next element in the fight against black money should be SMEs. These entities are critical elements and cannot be missed for this fight to succeed.

Other black money creators

There are other critical elements in black money chain or black economy. These elements represent turning smaller amount of white money into black by aggregation and misrepresentation.

For example, take NGOs. Some of the NGOs existing only on paper. Their model is thus. These NGOs collect legitimate amounts from citizens and push it into causes like animal shelters, girl child, medical aid to needy etc. The main problem is that the costs of these NGOs is unreasonably high. They also commit fraud by misrepresenting number of animals and kind of facilities etc. creating a source of black money for the promoters who get salary and or benefits like cars and drivers from the NGOs.

Cooperative banks are another piece of the puzzle. These accept smaller deposits from individuals and loan to founders and directors. The process is illegal and escapes the law only because it is not regulated by the RBI but by Politicians who are themselves directors in such institutes.

Government aided/recognized schools, colleges and institutions which look innocuous and have no actual teachers, students or infrastructure but simply using approvals from complicit education officers create a chain wherein legitimate money turns into black money. Others institutes have proper systems but use management quota to pool students’ money into black money pools for the founders. Some use both mechanisms.

Such entities are inherently different from SMEs which exist to service the needs of a wealthy black money holder or create black money through banks. These elements will be hit substantially by the demonetization and their promoters will be forced to declare these amounts or destroy them. However, the issue is that they can continue to create black money sources since their model has not been dismantled.

Role of Religious and other public trusts

The model of trusts is a little different but they are as important elements in processing black money as SMEs and others listed above. The trusts are both receptacles and users of black money. They are not creators.

Some allow devotees to make small but numerous donations while spending substantial amounts on expenditures related to their promoters. Others are created out of anonymous black money donations with specific beneficiaries. Their nature makes them a hot-potato issue where they seem to be untouchable by any government, religious entities being protected by constitution. 

These trusts will die over time as their feeder mechanisms are constrained. Yet, the reason they are highlighted here is because within the next two months we will see a lot of trusts being formed with weird articles of constitution that violate the basic premise of laws on public trusts. 

So will demonetisation eliminate black money?

Not by itself. It is just one move of one piece in the chess board of black money. To check-mate the black money king, you have to win the board. There are various steps required as detailed above. Government can play all these moves and still fail if they play improperly. All we can say is that Government is playing well. But will it succeed? The efforts will bring massive amounts of cash into the banking system – a benefit in itself. Once the money is in the legitimate channels, it should be better utilized and revenue will be generated from its use. If that is success enough then yes. 

Then again the government has tackled GST which represents 2/3rd of its revenues. It has tried to increase the size of the pie on which taxes are imposed by forcing the transactions into formal economy. The next part is reform of Income Tax which will tackle the remain 1/3rd of the revenue. Then will come loophole plugging. There seems to be well thought out method to this madness. Rest time will tell.

Notes and links

[1] http://www.nipfp.org.in/publications/working-papers/1509/ 

[2] http://www.nipfp.org.in/book/927/ 

[3] http://dor.gov.in/sites/upload_files/revenue/files/Measures_Tackle_BlackMoney.pdf 

[4] http://finmin.nic.in/reports/whitepaper_backmoney2012.pdf 

[5] Comparing how some tax authorities tackle the hidden economy by UK National Audit Office Rand Europe 2009 

[6] Reducing opportunities for tax non-compliance in the underground economy – Information Note dated January 2012 

[7] The Shadow Economy Friedrich Schneider & Colin C. Williams, Institute of Economic Affairs, 2013 

[8] Proposed by various people such as Arthakranti and also by Peter Sands in essay titled Making It Harder for the Bad Guys: The Case for Eliminating High Denomination Notes, M-RCBG Associate Working Paper Series | No. 52 in February 2016 and later discussed by Lawrence Summers and others. 

[9] https://www.rbi.org.in/scripts/AnnualReportPublications.aspx?Id=1181 

[10] World Bank data in currency of respective year. Earliest data available is 1960 so we have used 1960 data. Devaluation was in 1946 which was way before this year. 

[11] The numbers based on estimates by various agencies. 

[12] For basics refer to Centre for Central Banking Studies Handbook – No. 32 Understanding the central bank balance sheet by Garreth Rule.

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Why does Lloyd Blankfein's interview with Fareed Zakaria sounds weird to me?

Fareed Zakaria interviewed Lloyd Blankfein, CEO of Goldman Sachs, for his GPS program. Here is the video. There are so many weird things with this one. But I came away ith a feeling that if Elizabeth Warren were to cross-examine him in Court, Lloyd Blankfein would be toast. But first watch this (transcript of full show here):

The interview basically talks about few key concepts:

1. State of the Economy
2. Accountability of top management of Banks - context of Wells Fargo scam.
3. Closeness with Clintons
4. Why wouldn't Hillary Clinton release the transcripts of the talks at Goldman Sachs

I found many weird things. Let us look at the interview in detail (highlights and in-quote comments are all mine).

I start from first question leaving hi's and hello's out.

ZAKARIA: From your vantage point, what does the economy look like? You know, how strong is growth? Because it still seems steady but tepid. 

BLANKFEIN: Well, it feels steady but tepid. But that being said, it is steady and there are a lot of advantages that the U.S. economy has. So for example, the consumer has deleveraged banks -- the banking system is in excellent shape. If you look at energy, there's a lot of tailwind in the U.S. economy and the fact of the matter is, we went through a big trauma, which included a banking system trauma and it took a while to work itself through. So the answer is, it's tepid but we're definitely growing and it's established, and the latter point is the more significant point. 

This is the first question. Nothing special here. Though as a CEO of Goldman Sachs I would have expected Blankfein to be sharper about his analysis. Instead he comes across as pedestrian.

"Banking is in excellent shape" is the wrong thing to say if you ask me, particularly in the world which wants your head. He could have said Banks are in much better position to support entrepreneurial activity - small businesses and the like, than the time just after the crisis. That will kickstart recovery.

Look at this first part:

ZAKARIA: A lot of people say, though, there's a lot of economic anxiety. People don't feel like these numbers are right, that unemployment is down, but at the same time, you know -- so for some reason, they remain as great sense of economic anxiety, what do you attribute that to? 

BLANKFEIN: Well, I'd say, there's economic anxiety but I'd say there's a more generalize anxiety and a very negative sentiment and I think it's fed and feeds into the political cycle. I have trouble explaining. If you look at the metrics, you talk about unemployment -- unemployment is not just down, we're virtually at full employment.   

Now, you'd say that there's some degree of underemployment or wage (earning) that was always the case. 

I'm not minimizing the consequence to people who should have -- who feel their jobs should be higher paid and legitimately so, and the legitimate issues about minimum wages, but at the end of the day, these problems always existed to some extent. They're less -- people should feel better than they may actually do. I'm not saying they should feel good or there aren't challenges to try to surmount or other objectives to strife for. But the sentiment is a lot worse than the economy.  [Mr. Blankfein, you just trivialized the problems facing normal people across the world who have never felt this way before]

If you knew all the numbers and you are teleported here from two years ago or three years ago and you're told where employment was, where the price of energy was. What the federal deficit was looking like is a percentage of GDP, the strength of the consumer, a lot of other metrics and you heard that. You would think that sentiment would be a lot better than it is today. 

Blankfein sounds like he meant people should stop whining. They are whining for no reason. The people are unhappy because their jobs (a) don't pay them as much as they think they deserve, (b) their jobs cannot be counted on as stable for forseable future, (c) they do not see Government or policy makers doing anything to help the situation AND more importantly (d) they see policy makers going to great lengths in aiding bankers to create more profit through dubious policies when they don't seem to need any help. In this context, Blankfein comes across very insensitive.

Under-employment was always the case? Really? Not correct! It is one thing to argue that the wages were unreasonably high and they have come to normal or that there was over-employment and now it has reverted to mean. But this plain denial. 

To how many did the comment "and I think it's fed and feeds into the political cycle" sounded like he started to blame the US FED and then turned it elsewhere? It did to me. I know it is sly to infer that. But if he wanted to say "anxiety is fed by the political cycle and also feeds the political cycle" then he should have been more clearer. He is CEO of Goldman Sachs, you should speak deliberately and precisely, and more so when you speak to the media. Didn't he get media training? He can't give excuses.

We continue:

ZAKARIA: The one thing that people are sure of still is that they are suspicious of the banks. If you listen to Donald Trump, you know, he varies on lots of different things but the one consistent thing he keeps hitting is that the banks are bad, that they're in cahoots, that they're -- you know, the big banks are part of the group of things he attacks, big media, big government, you know, the Clinton machine, the banks and he always gets wild cheers.   

BLANKFEIN: Well, I think you're being generous. I think it's not suspicious, it's outright accusations and it's not just Donald Trump, you know, frankly. I mean, I don't like telling -- I don't like the fact that I don't like saying it to you but, you know, we're not -- at times, people think of us as, you know, bankers is tone deaf. Believe me, I read the papers everyday and I hear it.  [what are you so stressed about? There is nothing you can't like telling the media that they are unfairly targetted]

Look, variety of reasons. Let me just start out. One of which is, I think, some of the behaviors that have been, you know, highlighted and visited, you know, are real and justify some negative response. And then, other parts of it are just a general -- and I don't want to minimize it so let me pause for a second and say, there has been -- bankers have played an important role in the system, generally, get rewarded for the risks they take. And some of those risks were poorly managed and some of the behaviors were not, you know, recorded as bad behavior. And so, there's a legitimate reaction to that, full stop.
[Ok, Good! That is true - good to admit it.]

Other things also -- let me tell you, bankers are no better at predicting the future than anybody else. And most of what we do are trying to get the future right, trying to make good decisions of how to allocate capital, trying to lend money to people who pay you back, trying to finance winners and not finance losers and guess what, you don't always get it right and you get drawn into the same mistakes and the same confusion that anybody would and everybody does in connection with their efforts to try to figure out what the future is going to be. [This has been debunked, ridiculed so many times cannot believe Blankfein is using this defence.]

So, good to have Blankfein admit that there are bad apples. These bad apples should be punished heavily - in accordance with law. That is where a leader would take it. Blankfein could also say because it is such a complex system ascribing blame is very difficult and it takes time. But Banks don't want bad apples in their system as much as the general public does. 

But then for weird reason, he starts defending bad behaviour. I doubt people think the "bad apples" Blankfein referred to were only people making mistakes. People know you are talking of the cheats. People simply want you to say "we are finding the cheats and sending them to jail". To the lawyer in me, this volunteering of information looks suspicious.

ZAKARIA: One of the criticisms people make about the banks which is playing itself out with this Wells Fargo affair is banks make mistakes. They do bad things. They do things they shouldn't have done and they pay fines in a sense admitting the wrongdoing, whether or not technically they do but nobody at the top gets held accountable. Goldman Sachs has paid fines. Do you think that's a fair criticism? 

BLANKFEIN: I would -- well, let me just say, first of all, I can't own or comment on Wells Fargo situation, you know, I could apply it in abstract. Everyone is looking for someone to hold accountable but sometimes -- the answer is -- look, the short answer is you would like to ascribe malevolence to everything that goes wrong. 

Now there is bad behavior. Someone has cheated or this fraud, well, that's the remedies for that and people go to jail for that. [Para added by me] 

But sometimes, people are just wrong. And they're wrong about things within their area of expertise because I may be in finance and you may be a political scientist but I have views about political science and I may be right, you may have views about where the financial markets are going, you may be right. You just don't know.  

And sometimes, what's going on here is that people are trying to prescribe malevolence for people who were wrong and the evidence that they were simply wrong is look how much money they lost. And at the end of the day, if you still think that their behavior was off, to be punished the way people are saying they should be punished, you still have to find some kind of a criminal intent. 

You know, to this day maybe the law shouldn't be this way. But stupidity is not a crime. Sometimes it's even a defense because if you're merely wrong and you didn't get it right, it's hard to ascribe criminality.

ZAKARIA: But some of the cases -- and again, I know you can't comment about Wells Fargo particularly but there are some cases where it wasn't just being wrong. 

BLANKFEIN: Sure. If there's bad behavior, then bad behavior should be punished. Look, there was nothing -- it was not criminality but there were civil wrongs in Goldman Sachs which we, you know, paid fines with respect to which we paid fines. And so that punishment -- but you're asking something different. You're asking -- 

ZAKARIA: I'm saying that the public sentiment seems to be and you see in the words of Elizabeth Warren which is why the people at the top not held accountable.  

BLANKFEIN: Well, I think people should be held accountable for what they're responsible for. In other words, if somebody has a duty and they didn't fulfill their duty, well, that's a civil wrong.  [Legally correct - but wrong context]

You can fine somebody. The idea, going further and saying there should be criminality, you still have to -- you still have to commit a crime to be a criminal. And to commit a crime, you still have to have some level of intent for what you're doing. So we're talking very abstractly here.  [Legally very smart]

And so I'm not saying look, I'm a citizen, also. Any time there's some malfeasance, I would love to see a head roll, but you have to -- can't -- but once the head starts to roll, it's no longer an abstraction for the person whose shoulders it was on. They have to really have -- there has to be a crime. [Para added here] 

And I -- listen, we were investigated. The people who investigated us, and others, presumably, you know, we were very, very -- a subject of a lot of focus. I would have to say that people looked at a lot of behaviors. And if there was no -- and I'm not talking about myself in particular; [Why did Blankfein want to add this disclaimer] I'm talking about the group -- and the outcome was, was there were people who -- who -- people in the community of people who -- in the enforcement community -- were not going easy. If they failed to bring a case, they felt that there was no case.

This is the part that stumped me. First Blankfein would have done well if he was legal expert. For someone who could't explain why growth is tepid or there is economic anxiety, he breezes through the legal minefield with remarkable ease. He could put a lawyer to shame with his precision. Yes, Mr. Blankfein, people make mistakes and no one in America is against mistakes. 

"People are prescribing malevolence for people" this statement is so ambiguous that it could be a a part of a master confession. It can leave the jury in the "did he or didn't he" zone. Let me clarify what people think. When people see toddler using a semi-automatic gun and kill 20 people, they don't blame the toddler, they blame the parents and the pro-gun lobbies blame the gun manufacturers. So when a whale trader makes $1billion wrong bets, they blame his supervisors and may not necessarily blame him. This is not negligence but criminal negligence and repurcussions are dire - jail. This is not a civil liability but a criminal one. And frankly US Justice Department has dropped the investigations of criminal liability for civil penalties. That looks dubious to people.

Blankfein uses the stupidity argument without being provoked. My ears pricked up when he volunteered that one.

What Blankfein is saying is, in law, called the difference between misfeasance and malfeasance. Misfeasance means a mistake, trying to do the right / acceptable thing but making a mistake leading to a loss. Malfeasance is trying to do the wrong / unacceptable thing and doing it well. Now it may so be that your law and your work are such that they look awfully similar. That is, a mistake while doing normal thing and well-executed bad /wrong thing looks the same. The question then is how to determine which is which. 

Or, it could be so that banks may be trying to do something bad/unacceptable AND made mistake  and thus blew up the system. In this case the liability is not only criminal but also vicarious - i.e. Firm is also liable. The behaviour of Justice Department let the banks off the hook on this major issue. Clearly, banks were doing something unacceptable - Goldman's internal emails themselves said that in so many words while shorting the derivatives.

The thing is if bad behaviour is being displayed repeatedly, you benefit from bad behaviour (get a bonus) when it doesn't explode into a crisis then you are part of the system when it does explode. So you go to jail along with the perp as a co-accused. Now imagine a series of mistakes leading all the way to the top, taking place repeatedly and all those making mistakes are getting rewarded . This is a conspiracy - the burden of proof shifts from prosecution to the accused. How many times will Blankfein say he made a mistake. At the end it will appear he was only making mistakes at Goldman Sachs - wonder why he kept getting all those bonuses.

ZAKARIA: I have to ask you about the relationship of Goldman Sachs to the Clintons. There was a front-page story in the New York Times alleging that there are very close connections, that Goldman Sachs has done all kinds of things, from give money to the Clinton Global Initiative to creating a partnership between the -- your foundation and the State Department when Hillary Clinton was in office, to, of course, holding fund-raisers for both Clintons at various points. 

How do you respond to that charge?  

BLANKFEIN: Well, Hillary Clinton was the -- was our -- was a New York senator. [Trying to avoid the usage of the word "our" ;)] We're largely a -- well, we're certainly a New York- headquartered firm. The -- when -- when Bill Clinton was in office, obviously, he was the president of the United States -- we're one of the larger banks; we have influence in the financial system; of course we engage. We engage with Senator Schumer. We engage with Governor Cuomo.  

I don't know how to -- we could have -- I know that, you know, in the conspiracy world -- theory-driven world in which we live in, you connect data points, but, heck, [hmm?] I have -- I go out and I meet with editors of newspapers. I meet with Republicans, leaders. I -- we -- it's necessary for us to do that. Part of what we do is -- part of our role requires not just that we're committed to [the word Blanfein used was "permitted" to not "committed to]-- our sense of duty requires that we explain the financial system and the ramifications of what official action would be. And of course we engage our political leaders.  [Finally he found the right angle to give the meeetings]

ZAKARIA: But the implication is that there was a tighter connection. Do you -- do you... 

BLANKFEIN: Well, I'll give you -- I'll give you an example of a tighter part of a connection. In the '08 political cycle, I held a fund-raiser for Hillary Clinton. And I could tell you, throughout our firm and other firms, so did a lot of people and so did a lot of people in our firm hold fund-raisers for people running against her. We had no -- I mean, you can -- you can go on and trace it. [No need to trace it but it would have been better to state this upfront] But, listen, if the fact is that we're identified with Hillary Clinton, who, as we say this, you know, the election is coming up and I'm sure this will -- this conversation will survive that moment, but as we sit here now, we don't know who will win the election. But it looks like the odds are favored Hillary Clinton. If the worst thing was that we had a history of having engaged positively with Hillary Clinton, that's not going to annoy me. [Fair point]

ZAKARIA: But do you personally support and admire Hillary Clinton?  

BLANKFEIN: Well, I've -- I'm supportive of Hillary Clinton, and I certainly -- yes, I do -- yes. So, flat out, yes. I do. That doesn't say that I agree with all her policies. I don't. And that doesn't say that I adopt everything that she's done in her political career or has suggested that she might do going forward. [Fair point]

But in terms of, you know, her intelligence, her, I think, her positioning not only in terms of her ideology but what I regard as a certain -- as a pragmatism that I saw demonstrated when she was our senator and in earlier stages of her political career, when she could cross the aisle and engage other people to get things done, I admire that, and it stands out a little today because it's a little -- because it's a little -- that kind of -- that kind of willingness to engage and compromise -- but let's just stop at engage -- that willingness to engage is a scarcer commodity these days. [Again a fair point]

This was a rather innocuous topic. The way Blankfein answers raises suspicion rather than questions themselves. The way to answer it was first admit there is a connection. Personally, raising funds and so forth, then talk about regular interaction with politicians to put forth our understanding of financial system and so on. Blankfein answers weirdly. I felt he was trying to avoid using the word "our" senator - when referring to Hillary. Why? I wonder.

I was surprised by his use of word "permitted". Clearly Fareed did not imply that he cannot meet Clinton. And Fareed probed rightly. So then comes the issue that Blankfein personally held fund-raiser for Hillary. Fareed says both but Blankfein admits only Hillary. Now if I was asked - this relationship would be the first thing to disclose. Also ties between Goldman (the firm) and the Clintons. Blankfein avoided the question on the Clinton foundation and his own foundation.

By the end though he is comfortable talking about general stuff - why I support Hillary and general stuff like that.

ZAKARIA: Why won't she release the transcripts? 

BLANKFEIN: OK, well, you'll have to ask her -- you have to ask her that. I would say -- and the answer is I don't know. [Why so defensive] 

But if it were me in her position, I would have wanted to reveal -- I'm not sure what she's afraid -- you know, these transcripts were her -- somebody who had left office as secretary of state giving a tour of her impressions of the world. They weren't given to Goldman Sachs -- you know, the press talks about Goldman Sachs partners. She spoke at our client meetings. These were meetings with -- with hundreds of people. Believe me, she was not saying -- I didn't think she was saying anything untoward. I don't recall specifically. [Again a hedge - hmm] But nothing that she said would have jarred me that she was going into some impermissible or revealing some secrets. I don't know what secrets she would have had about the financial market that she could have revealed.  [So myopic is Blankfein, doesn't think Hillary may be more smart than he understands]

ZAKARIA: There's a poll out, I think, a couple of months ago. Sixty percent of Americans worry that Hillary Clinton would not be able to properly regulate the financial industry because of her ties to it. What do you say?  

BLANKFEIN: You know, I don't know how to -- I don't know how to -- I'm not sure how to respond to that. People say that. I would say that the financial system today is so much more tightly regulated. The regulators in their seats are so vigilant and so tough and their reputations depend on that toughness. Everyone is -- it's not a place where everybody is disarmed; everybody is armed. And the consequences of any kind of breach are so severe, I think -- I think we've -- I think we've handled that aspect of it. [This is a repeated many times by bankers]

I think -- look at the, you know, it's something I -- you know, frankly, I'm scared to death of mistakes that are made in my organization, and guess what? The world wants me to be scared to death of that and they want me to be vigilant at the end of the day. And they've accomplished their purpose. They have me on edge all the time. [So you weren't vigilant? Weren't scared? And if you have confidence in your risk management systems then why should you be scared?]

My biggest -- I am not -- I don't live in fear that I'll do something wrong. I know I won't. Of course, there are accidents can happen, but I know I'll never do something wrong intentionally. [Again hedging himself] I live in fear that one of my tens of thousands of employees -- and for other people who run big companies, it's hundreds of thousands of employees -- will do something wrong and their bad behavior will be ascribed to me, not simply because I failed to supervise, but in this current milieu, it will be ascribed to me as if I intended that act that was accomplished by somebody in the organization, or even if it's multiple people in the organizations. 

And that's a very -- that's a very hot -- we're talking about an anxious economy. Guess what? You have an anxious industry. And guess -- you know, and I'll say, go further, I'm sure that people are happy that it's that way. [Interesting victim's position he is taking]

These were fairly innocuous questions to which parrotted answers were expected. But Blankfein is unbelievably circumspect. In the entire interview the tone of Fareed Zakaria is quite neutral. Fareed doesn't seem to incite anything. Yet, voluntarily Blankfein is quite shaken up. Why? So if this is the case now, imagine what will happen if Blankfein were to be interrogated (i.e. cross examined) in Court by Elizaebth Warren. She will roast him alive. No before the senate/congress because there he is not obliged to share everything. But in court where adverse inference can be drawn.

I thought for CEO of Goldman Sachs, Lloyd Blankfein did not look one bit of the industry captain he should have been. He looked like a normal trader opining on various things. This opinion I deduce from watching John Mack, CEO Morgan Stanley, in the teeth of the crisis, or Jamie Dimon during his various media interviews since the crisis. He sounds more like a lawyer - which itself makes me suspicious.

Time and again words of Peggy Noonan - protected and unprotected ring in my mind. These people do not have any sense of ground reality. That is both sad and catastrophic.

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Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms".