Modi comes to Sydney, brings a civilisation with him

Sydney and its Indian community were treated to a masterful display of oratory yesterday by Indian Prime Minister Narendra Modi, who delivered an electrifying speech in Hindi to Australian members of the Indian diaspora.

His mesmerising Sydney performance was an emphatic celebration of brand Modi and of a positive patriotism not seen in the West in many decades. The stadium was reportedly at full capacity of 16,000, with a several thousand more following the event on giant screens outside the venue. Particularly noteworthy was a strong, visible and enthusiastic Muslim contingent in the crowd dressed in traditional attire carrying a large Indian flag, mocking the leftist myth of Modi being a divisive Hindu fascist.

Hot on the heels of his successful New York tour where he delivered a similar performance, Modi seems to have innovated a novel and somewhat mystifying brand of diaspora politics. It is not easy to see how endearing himself to overseas Indian crowds who cannot vote serves his political self-interest. Yet it is consistent with the unique interpretation that Modi seems to have brought to the Indian Prime Ministership. Unlike other PMs who are mere heads of the government of the Republic of India, Modi appears to see himself as a leader of Indian Civilisation itself. It explains why he spends hours courting the ‘children of Mother India’ in faraway places who will never be able to vote for his party. These performances are closely followed by the Indian media and help present Modi as a leader bringing Greater India back to its rightful place in the world order. The diaspora helps to set the global context of his vision as well as highlight India’s global soft power.

It is a mark of the oratorical skills of Modi that he succeeds in rousing and inspiring foreign Indians’ patriotism and makes them feel part of the story of the rise of modern India. Most of the young people in the Allphones Arena are unlikely to ever return to live in India, yet listened with rapt attention to Modi explaining his policies and plans to improve their ancestral homeland. They would have left with a strong sense of connection to India and Modi. He noted, “these days it takes an overnight flight to reach Australia from India, yet it took an Indian Prime Minister 28 years”, before declaring “my countrymen living here have the same right (to me) as Indians in India”.

Despite playing up the audience's ties to India, Modi also strongly emphasised the importance of their loyalty to their adopted country. Reflecting the integrated world of the 21^st century, he emphatically stated that according to Indian philosophy, it is their biggest duty to be devoted to serving their adopted countries, their karmabhumi (land of their karma or efforts). Recounting the contribution of prominent Indo-Australians in ‘brightening Australia’s name’, he praised such achievement as the strength of the Indian diaspora.

Never before has the Indian diaspora had an Indian Prime Minister who understood their unique position so perfectly – loyalty and gratitude to their new country mixed with an emotional and cultural attachment to their native country. He won the night when he articulated that feeling:

“I know that in the recent Indian election you did not have a vote, yet you followed every second of it, staying up the night before the results were out… I know that for the global Indian your interest was not in the politics but stemmed from an anguish, a fire burning in your heart that “when will my country become like the country I’m living in?’”

The secret to Modi’s almost universal appeal is in the way he has managed to internalise the past, present and future of Indian civilisation and is able to personify the culture, heritage, frustrations, dreams and aspirations of an entire civilisation of 1.2 billion people.

Modi brings an unapologetic Hindu nationalism, but in an appropriate, unifying dose. Just like the West undeniably has a Christian heritage, India’s heritage is Hindu. Neither heritage needs to alienate members that have left the religion, yet their cultural references uniquely express the civilisation’s identity. Thus Modi invokes the patriot saint Swami Vivekananda, who sought to galvanise an enslaved India to awaken to its heritage, quoting his patriotic calls: “I have faith in Swami Vivekanada’s dream of seeing my Mother India once again reigning as the world’s guru, leading the world in fulfilling its aspirations.”

Modi is gifted in mixing grand civilizational ambition with the small practical problems that still plague tens of millions of Indians. In his speech, he deftly translated partriotism to community service in one sentence, saying, “The meaning of ‘Hail Mother India’ is in uplifting the millions of Indians still living in abject poverty, without clean water, electricity and even toilets. Some people have big ambitions, but I want to achieve small things for small people and help them become big people.” He then talked about his efforts to improve government efficiency and getting rid of unnecessary red tape, as well as his signature if unusual national campaign to clean up India, which saw him sweeping a street with a broom.

From the armchair Hindu nationalist living in the West, to the struggling urban Indian middle classes, to the utterly impoverished and downtrodden, Modi is able to reflect the aspirations and frustrations of every strata of his broad constituency.

For a country that knew nothing other than an asphyxiating socialist economy until the early 90s, Modi brought a refreshing dose of libertarian doctrine in his speech. Turning the third world electioneering rulebook on its head he declared, “Governments cannot and should not try to build nations. People build nations. Governments should only do so much and step aside. Unlike other politicians who boast of making laws, I enjoy revoking laws. Governments have created such a burden, it feels suffocating. Open the windows, let the people live! The nation will progress due to the people, not because of governments. This is my philosophy.”

It is also emblematic that almost all of Modi’s speeches are delivered in Hindi. Modi makes much of the fact that he is the first PM to be born in an independent India. In Sydney, he repeated the poignant line from his first speech in Parliament, “We did not have the honour of dying for our nation, but we do have the opportunity to live for our nation!” He is the first PM who does not belong to the anglicised Delhi elite that ruled India after the end of the Raj. He rose from the grassroots, starting life as a humble tea seller and has a special connection to the masses which previous PMs lacked. He symbolises the end of India’s cultural cringe, and its emergence as a self-confident nation speaking its own language.

As the euphoria of Sydney’s Modi mania wears off, we are left hoping that Modi can succeed in converting his inspirational rhetoric into real development. With the West still grappling with the rise of an authoritarian China, and struggling to contain a newly assertive Russia, the free world needs a strong India to fly the flag of democracy. A strong prosperous India will show the rest of the developing world that that democracy, economic prosperity and human rights need not be mutually exclusive.

The rise of India goes beyond improving the destiny of 1.2 billions Indians, and is tied to the continuing struggle against tyrannical ideologies. It is thus appropriate that Modi continues to host events such as the Sydney gala, and cultivate his international image. 

Housing overvalued, but savings overtaxed: buying may still make sense

It was an unusual but welcome move by the RBA to weigh into the popular debate on whether the Australian residential housing market is overvalued. In publishing a research discussion paper titled “Is Housing Overvalued?”, it took the rare step of explicitly trying to answer the big economic question on everyone's mind.

While the RBA’s research papers can sometimes be esoteric, its foray into more topical economic issues should be welcomed. It injects rigour into the debate, which can sometimes be driven by less informed research or by participants with an agenda. It not only helps inform ordinary citizens on the big issues affecting them, it is also useful for markets to understand what is informing the central bank’s views.

Given the unsuccessful attempts by the RBA to talk down the value of the dollar, one wonders if a paper called “Is the Australian dollar overvalued?” is forthcoming.

This paper was unique in that it used a new dataset that used matched data of prices and rents of properties, whereas previous research relied on separate series of rents and prices, assuming there was no difference in quality of houses for rent and those for purchase. 

The paper’s approach is to directly compare the costs of renting and buying a house, and use the difference as an indicator of whether houses are overvalued. It neatly breaks down the different components of home ownership and compares them to rental yields. 

The components are: real interest rate, running costs, annual average transaction costs, depreciation, and most importantly, expected capital appreciation. A simple equation that results is

The only real unknown in the equation is pi, the expected capital gain. A useful way of answering the question of whether housing is overvalued is to consider the expected capital gain that will cause the equation to balance.

On this basis, the key finding of the report is that the housing market is fairly valued if house prices continue to grow at their historical 49-year average of 2.4% p.a in real terms, but 19% overvalued if they grow at the 10-year average of 1.7% p.a. Tellingly, the RBA points out that 1.7% “currently may be closer to a consensus assumption”. Adjusting for the inflation assumption, the capital appreciation rates are 5.2% and 4.5% p.a in nominal terms. In other words, if you’re happy to live in a house for 10 years and are confident house prices will grow by at least 5.2% p.a on average over that period, go for the great Australian Dream.

Mortgage rate is not equal to investment return 

While the conclusion thus far is sound, there is one simplifying assumption which limits the practical use of this paper for individuals considering whether to buy or rent. It also likely overstates the level of overvaluation of housing. 

This is the assumption made that there is no difference in the mortgage rate and the post-tax opportunity cost of owner’s equity. The authors claim that this assumption is applicable to those with little investible financial wealth, and that buying a home is comparable in riskiness to investing in assets such as shares, which have a real historical pre-tax return of 6.9% since 1979 or 7.3% since 1883. 

In the first instance, neither of those rates are equal on a post-tax basis to the assumed mortgage rate of 6.2%, which is paid out of post-tax income. The pre-tax investment return needed to be equivalent to the mortgage rate is a heady 9.4% for income earners in the 34% tax bracket, and an even higher 10.2% if they are in the 39% tax bracket. Thus even if we use shares as a proxy to the opportunity cost of owner’s equity, we find their long run post-tax return is significantly lower than the mortgage rate. 

Furthermore, the opportunity cost is usually far lower than the mortgage rate, since no renter is likely to place all of his investable funds in risky assets. Cash, term deposits and lower-risk assets are likely to make up a significant portion of an average renter’s portfolio. 

In the equation below, the authors state that the mortgage rate component R is actually a weighted average of the opportunity cost of owner’s equity and the mortgage rate. e is the proportion of equity in the owner’s home, r^m is the mortgage rate, and r^alt is the opportunity cost of owner’s equity.

Hence, as an owner’s equity in his/her home grows, the mortgage rate component of the equation shrinks, reducing the cost of home ownership compared to renting.

Imputed rent and Tax
The cost of housing tends to be the biggest barrier to achieving financial freedom, given its large. Being able to live in your own home without having to work to pay the rent or mortgage is an approximate definition of financial freedom.

Theoretically, this financial freedom should be achievable whether one buys their home or accumulates enough savings that the income generated pays for the rent. But in reality, there is a tax distortion that makes it far easier to achieve financial freedom by buying your own home. 

This is because investment earnings are taxed at the full marginal rate while the benefit derived from living in your own home (what economists call ‘imputed rent’) is tax-free. 

This pushes up the required rate of return one needs to earn on investments before it equals the rental yield. It also slows down wealth accumulation for renters, since their surplus savings are taxed at their marginal rate while homeowners’ savings are funnelled into tax-free imputed rent. In other words, over the long run, an individual with a steady income is likely to be better off buying a house than renting the same house. The key caveat is that they have to live in it long enough to ride out the volatility of house prices. 

While house prices can drop 40% over the next 1-5 years, they are less likely to do so over 10, and have a very small chance of not holding their value of 20. Hence, the longer you are happy to live in a particular house, the higher your chances of being better off over that duration.

This is why the Australian middle-class formula for wealth creation by getting on the property ladder as soon as possible tends to work. 

Net Worth Projection 

Another way of looking at whether to buy or rent is to project an individual’s net worth in each scenario. A simple scenario for an ordinary individual looking to buy a modest house worth $400,000 is instructive. 

Let’s say this person has saved up the 20% deposit for the house. We use the RBA’s variables for interest rate and running costs of ownership of 6.2% and 1.5%, but slightly more realistic assumptions for rent (say $380/week vs RBA’s 4.2% yield assumption which would imply a rent of $320, a dream for any Sydneysider). We use a generous investment return of 5% pre-tax, much higher than most term deposit rates available at the moment, and a free cashflow of $3,500. This should reflect the situation for most ordinary Australians in metropolitan areas.

The chart above shows the net worth projections for that individual if he rented or bought, with no capital gain, and with a capital gains equal to inflation of 2.8%.

As can be seen, the average punter is far better off buying even if house prices only keep pace with inflation. Indeed, the required capital gains to break even in 3, 5 and 10 years are 3.1%, 1.5% and 1.1% p.a. In other words, over ten years, it is better to buy even if the house depreciates 28% in real terms over that period! Even if they don’t grow at all (and hence effectively depreciate in real terms), he will be better off buying if he holds on to it for 23 years. Note the assumption of 0% nominal growth over this period is extremely conservative and implies a real depreciation of around 76% over that period. 

Of course, the numbers will vary with every circumstance, but the point is that wealth creation is faster when you don’t pay almost half your investment earnings in tax, and instead pay to own the home you live in. 

Conclusion 

The conclusions to draw from all this are: 

·       The housing market is 20% overvalued based on what the RBA calls consensus capital growth rates;
·       But it’s probably not as overvalued as that given the lower opportunity cost for most individuals, and the unseen tax benefit on imputed rent.
·       If you  can see yourself living in a house for 10 or 20 years, chances are you’re better off buying it than renting it.
·       This does not constitute financial advice. Do your own numbers. 

WWI Centenary as India comes of Age: Time to Renew the Commonwealth

The centenary of the First World War comes at a time of great generational change, as the millennials and the first digital natives come of age. Coinciding also with the start of the Asian century, this presents a perfect opportunity to rejuvenate the Commonwealth. 

Democratic institutions are threatened around the world. As the free world faces fundamentalist Islam, and a rising authoritarian China and Russia, there is an urgent need to focus on and assert the values of the free world. A great mass of the population of free countries belongs to the Commonwealth of Nations. With Europe in structural decline and the US turning inwards, it is vital that the Commonwealth takes up the fight for democratic and liberal values.

The rise of the British Empire changed the world forever. No other historical force has shaped the modern world to such an extent or touched as many people on such a scale. It is the reason that I, an ethnic Indian am writing this in English, the language I am most familiar with, in Australia, a country I easily assimilated into. 

In what Daniel Hannan has described as 'Anglobalisation', the British Empire and later the Commonwealth has left behind a global community sharing a common language, legal system, academic culture, and to a lesser extent a cultural milieu.  Yet the predominant emotion associated with the British Empire over the last hundred years have been acrimony, resentment and betrayal. This has translated into apathy for the Commonwealth. 

This is not terribly surprising. The last hundred years witnessed the worst excesses of British imperialism. India was rewarded for its loyalty and bravery in World War I not with self-government but with a brutality that dwarfed the worst caricatures of the Kaiser. For sacrificing hundreds of thousands of its sons, the Punjab was rewarded with martial law and the slaughter of Jalianwala Bagh, where hundreds of unarmed men, women and children were enclosed and shot dead in cold blood by an unrepentant General Dyer. To rub salt in Indian wounds, Dyer received little formal reprimand, and was hailed as a hero by sections of British society, with the Morning Post collecting the equivalent of a million pounds to present to him. Britain snubbed Indian demands for dominion status on par with the white realms, ultimately losing the goodwill of its Indian subjects.

In the rest of the Anglosphere, the last hundred years witnessed Britain abandoning its family to cosy up with its neighbours, when it joined the EU and abandoned its trade links with Australia and New Zealand, who could not compete with the generously subsidised agricultural industry of Europe. 

It is therefore not surprising that there is little love for the Commonwealth and the soul of the old British Empire that it embodies. The decolonisation process happened relatively recently, and there are still many who remember life in the shadows of a Union Jack. Singapore and Malaysia only became independent 57 years ago. It is understandable that the views of that generation and those that followed them are shaped by the struggle against a foreign imperial power, often with a racial dimension.

My grandparents lived in a world where the white man literally ruled. My parents grew up in the shadow of colonialism, where the white man no longer ruled, but towered as a superior wealthy caste that ruled in all but name. Theirs was the first generation of the great Indian diaspora, which fought racism to give their children a better future in faraway lands.

Generation Y is really the first to be born unburdened of this history. This generational change coinciding with the centenary of World War I presents a unique opportunity to rejuvenate the Commonwealth. For the first time, all the descendants of the British Empire can genuinely count themselves as beneficiaries of that historical phenomenon which has forced us into a common patrimony. Regardless of the horrors and injustices our ancestors inflicted or suffered, we are today fortunate to be born in the Anglosphere- a loose, informal community of free countries which offers us a gateway into every continent on Earth and almost every major culture.

For the first time, a generation can look back at the remarkable events of the First World War without being influenced by personal experiences of colonialism or its aftermath. We can objectively see the diverse peoples of the Anglosphere coming together to defend an empire that although imperfect, was the genesis of our modern lives.

The focus on Commonwealth contributions to the World War I in Britain this year has dusted off sepia-tinged, forgotten stories from a period of the British Raj, when the Indian Independence movement was still a struggle within, not against the system. A time when there was a degree of respect and good faith between the British rulers and their Indian subjects, who like Gandhi were proud subjects only demanding their right of self-rule. We see photos of letters sent by Queen Mary to her “Indian sisters” who had been widowed by the War, and hear BBC programs of a hospital at the Royal Pavilion in Brighton set up for wounded Indian soldiers, where the British were most careful with dietary requirements (having learnt their lessons from the 1857 mutiny).[1]

India comes of Age

As the western world succumbs to its demographic and fiscal deficit, it is India’s moral duty to carry the torch of the Anglosphere into this century. After a thousand years of subjugation, its time has come. The election of Narendra Modi could prove to be a turning point in Indian and world history. Modi, the first PM to be born in independent India, embodies the optimism and confidence of India’s burgeoning, aspirational youth.

At first sight, the election of a man who shuns English in favour of Hindi and the first PM from outside the anglicised Delhi elite would appear to be bad news for the Anglosphere. However, this would be taking a myopic view. Modi’s Hindu nationalism is necessary to allow India to shrug off its last vestiges of colonial complex and come to its own in the eyes of the world.

While India may have won freedom, it has remained culturally colonised. English trappings such as a convent education and fluency in English are still viewed as social status symbols. The higher up you climb in Indian society, the more anglicised you need to be. This was so ingrained that it showed until recently even in the Hindu nationalist Bhartiya Janata Party, where senior leaders such as LK Advani belonged to what author Tavleen Singh has described as the elite world of the ‘Delhi Durbar.’ Modi is the first politician from the grassroots of the real India to shatter the glass ceiling to high office.

India can best contribute to the Anglosphere if she rediscovers her place there as a self-confident nation true to herself and her ancient, diverse and pluralistic Hindu civilisation. India has always been its own civilisation, but it was brought into the modern age by the Raj, and will continue to have a natural affinity to the Anglosphere.

When Modi first entered Parliament as the PM, his first act was replete with accidental symbolism. As he approached the steps of the Central Hall of Parliament, Modi went down on his knees and touched his head to the sacred temple of democracy, in the manner Hindus enter a temple. It was a humble tribute to the voters who put him there and encapsulated a beautiful cross-cultural acknowledgement of universal truths. Here was the personification of Hindutva (Hindu nationalism) paying homage in the most Indian way to Westminster democracy.

That act was symbolic of the exciting potential India has in store if it takes up the torch of righteousness and liberty in the international community.  The most precious values of the Anglosphere are universal in nature. A true statesman like Modi steeped in the Hindu tradition of dharma (righteousness) should quickly find common ground with the Anglosphere and its allies in pursuit of the common values of democracy, religious freedom and liberalism. While liberal values have not been especially prevalent in modern India, they do have deep roots in Indian culture and civilisation, as discussed in Amartya Sen's The Argumentative Indian.

A resurgent, newly confident India can put its unique cultural stamp on the universal values that have been borne by all progressive societies in human history. Perhaps the best way for India to get back at Britain for the Raj would be to remind an ailing Britannia of what Anglosphere values really are, and what she has lost.

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[1] http://www.telegraph.co.uk/history/world-war-one/11026562/How-Brighton-Pavilion-became-a-temporary-hospital-for-Indian-soldiers-in-WW1.html 

India: Libertarian Utopia or Anarchist Dystopia?

India can be described as a giant living experiment of a society with minimal government. Theoretically, India has a Westminster system of government with all the accompanying civil institutions. In reality, however, these institutions are weak, underfunded and often effectively non-existent in many spheres of Indian life. The resulting dynamics of Indian society can give us a glimpse into a stateless society.

While elements of Indian life seem to echo libertarianism, India overall cannot be described as a libertarian paradise, due to the absence of certain fundamental freedoms.

Economic Freedom

Due to weak governmental structures, private property rights are not adequately protected in India. Land owners risk encroachment and even expropriation from land mafias. There is corruption in the police force, and while the courts are fair and free from corruption, they are underfunded, and it can take more than a decade for justice to be served. Needless to say, justice delayed is justice denied.

Officially at least, India is very far from a libertarian paradise as far as economic freedom is concerned. It is consistently ranked amongst the bottom in international economic freedom. For example, starting a business in India is a bureaucratic nightmare and can take a month on average. India’s socialist past still heavily influences its labour laws.

In reality however, many small businesses operate without being registered, with off-the-book employees, sometimes including child workers. They rely on good relations with the local law enforcement community, occasionally resorting to bribery to circumvent the law. Approximately 85% of the total workforce is estimated to work in the informal sector.

There is certainly something libertarian about a community consensus which turns a blind eye to market interventions and labour regulations. For example, auto-rickshaw fares are supposed to be set by the government, but they never keep pace with inflation, and are ignored. No customer expects to go by the meter, which only serves an ornamental purpose, and fares are agreed laissez faire by bargaining.

While there are many episodes of abuse, child labour is also used in mutually beneficial situations. It is common for local grocery stores to hire poor children to run the shop and small errands, and for middle class homes to hire teenagers to clean their homes and wash their dishes. As poverty rates reduce however, more poor parents are sending their children to school and this practice is thankfully becoming less prevalent. Middle India is suffering from a shortage of domestic workers similar to England during the Victorian era.

It can be argued that India’s informal labour market shows that unregulated labour markets can function relatively well and meet the needs of society. Of course, an unregulated market leads to many more instances of abuse than would occur in a regulated one, and critics could claim an anarchist dystopia of sorts. However, the free market largely sorts itself out. A natural minimum wage is one whereby less energy is expended than justified by the wage being offered. Similarly, reputational damage tends to limit the worst excesses of unscrupulous employers.

India is also a bit of an unofficial libertarian paradise in its widespread tax evasion. While India has an elaborate tax code, only about three percent of Indians pay any tax. Considering a large part of their taxes will mostly be siphoned off to line the pockets of corrupt politicians and public officials, it is not difficult to sympathise with this attitude. 

However, unregistered small businesses are exposed to harassment by law enforcement authorities and often need to offer bribes to stay in business. In such a quasi-libertarian society, the public generally tries to avoid any interaction with the authorities, especially the police, who can be a law unto themselves.

However, given the police are also badly under-resourced, there is a mutual dependency. Some police stations have to rely on the goodwill of local communities to function, and some give-and-take thus ensues.

India’s illiberal economic framework affects big businesses most, as they are most visible and have to abide by the red tape. This leads to lower rates of investment and job creation than would otherwise be possible. It also helps to entrench existing big businesses by raising barriers to entry for serious entrepreneurs. It is noteworthy that many of India’s biggest businesses are those which flourished under the crony socialism of the pre-liberalisation Licence Raj. 

In that era of economic stagnation, a nexus of politicians and businessmen had connived to create a cosy oligopoly closed to competition. So badly was innovation stifled that Indian roads saw no significant change in car design until 1993, with the now iconic Ambassador cars being continuously produced in almost the same form for decades on end.

Combined with low tax receipts and a dysfunctional public sector, India is strangled by a lack of investment in vital infrastructure. Its vast economic potential remains latent as opportunities to trade are squandered because goods and services cannot be moved efficiently from supplier to customer.

Freedom of Speech and Individualism

A big stain on India’s libertarian credentials is its poor record on freedom of speech. Riveted by caste and minority religious politics, the Indian government censors opinions which may offend minority communities. India was one of the few non-Muslim countries to ban Indian-born author Salman Rushdie’s Satanic Verses. It even effectively barred him from visiting the country to attend the Jaipur literary festival, when the government publicly declared it would not provide him security to protect him from Islamic fundamentalists who have placed a bounty on his head. A few Indian states banned public screenings of The Da Vinci Code, when Christian groups complained it was offensive. A few months ago, controversy erupted when Hindu groups legally pressured publishers to recall and cease publishing Wendy Doniger’s book The Hindus, complaining it offended Hindu sentiment.

Another key element of a libertarian society is being treated as an individual, and India fails abysmally on this score. The historical social rigidity caused by the caste system needs no introduction. But even after millennia of judging individuals on their birth, modern Indian society decided to continue the same approach, but just reverse the direction of discrimination.

In India today, the vast majority of jobs in the public service are reserved for members of backward castes and religious minorities. Even university entrance scores are determined by an individual’s caste. Nowadays, this can sometimes mean a wealthy lower caste student can be given preference over a poor Brahmin student. 24% of seats in the national parliament are reserved for low-caste members.

The government has even mooted plans to force private schools and universities, as well as privately-owned businesses to implement caste-based quotas! 

Verdict           

India's problems are too intractable to be solved by altering the influence of government.

Overall however, India is probably closer to an anarchist dystopia than a libertarian utopia. It is how the world's citizens would have seen the country as they heard of the ghastly gang rapes that plagued the nation's capital. It is the world of hundreds of millions of Indians struggling below the poverty line fending for themselves, and that of middle-class Indians who do daily battle with corrupt public officials for basic tasks like receiving birth certificates and driver's licences. 

Nonetheless, in the economic sphere, India's laissez-faire small business scene shows the world doesn't end without government. 

Is all that glitters gold?

The performance of gold as an asset class is usually assessed in US dollar terms. This approach overlooks differences in currency performance over time, which can significantly distort returns. For example, gold would have been a much better investment in a high-inflation country with a depreciating currency than in a country with low inflation and a stable currency. 

An examination of the gold price over the last 30 years would call into question gold’s largely unquestioned status as a store of value.

This study looks at the Australian dollar gold price, using data from the Perth Mint[1].

Exchange rates and inflation are two big factors that obfuscate the true underlying performance of gold. As the chart below shows, the stellar performance of gold we hear so much about loses a bit of its lustre once exchange rates and inflation are taken into account.

In Australian dollar terms, gold has proven to be quite a volatile commodity over the last 39 years. The chart below shows the inflation-adjusted gold price since the days of the Whitlam prime ministership, with prices rebased to Sept 2013 levels using the ABS inflation series and interpolating inflation rates between quarters.

The most noticeable fact from this chart is that despite the decade-long bull market, we have nowhere near approached the highest recorded modern price of gold when inflation is taken into account. The short, sharp spike in 1980 is generally explained as occurring due to a confluence of extraordinary geopolitical events, such as the Soviet invasion of Afghanistan and the storming of the US embassy during the Iranian revolution.

Looking through this one-off spike and rebasing the series to an index where the gold price on 2 January 1975 is set at 100, the chart below emerges.

This chart makes it easier to see the long periods over which gold did not hold its real value. When the series falls below the x-axis, gold was worth less than its 1975 value. The choice of starting point does not make a big difference. The real gold price at the start of 1975 would be witnessed again in 1979, 1989, 1993, and 2006. Other than the period between 1979 and 1989, gold did not hold its value between those points in time.

The longest such interval is the 13 years someone who bought gold in 1993 would have had to wait for his investment to merely recover its original value. If we ignore the rally in the preceding years, this bear market lasted almost two decades, from 1990. This long underperformance is partly explained as caused by the offloading of gold by central banks. Another likely explanation is that the economic boom that arose off the back of the IT revolution made gold a relatively unattractive investment option. 

Nonetheless, this chart should help dispel the mystical aura that seems to surround gold and its status as a safe haven. An investment that can take up to 16 years to become positive and can fall by up to 30% in a matter of months is not low-risk in my book.

30 years would usually be considered to represent the ‘long term’, as it spans the majority of most people’s working lives. Yet as the chart above shows, since the abandonment of the gold standard, there have been several points when gold investors would not have maintained their initial investment after inflation, even after holding gold for 30 years. Buying and holding gold up to today would have proved very costly if it was bought at one of the peaks in the 80s, especially when opportunity cost is taken into account. 

Of course, historical performance is no guide of future performance, and it is possible that gold may hold its value better in future. But the historical data we have so far from the end of the gold standard is not encouraging. It is also interesting that the volatility of gold has not affected its status as a safe haven.   

In countries with high inflation, the perennial depreciation of the domestic currency makes gold look like a good investment and works as an effective inflation hedge. For example, the Indian rupee has moved in only direction since independence. It has gone from parity with the US dollar in 1947 to more than 60 rupees to a dollar today. Assets priced in foreign currencies, such as gold, have thus held their value, and delivered big returns in local currency terms.

However, simply holding foreign currency may be a safer strategy. Given the difficulty in obtaining and storing foreign currency and the traditional attraction to gold, it is not difficult to see the preference for gold as a popular store of value in countries like India. In the absence of a stable fiat currency, gold continues to play its ancient role as a store of value. In China, negative real returns on savings increase the relative appeal of gold as an investment. Together, India and China represent half of the world's demand for gold.

It could be argued that such monetary settings will provide a support for real gold prices as these countries continue to industrialise. As their populations become wealthier, they may continue to store their wealth in gold. However it should be noted that the Indian government recently slapped a tax on the importing of gold, as it was being blamed for its ballooning current account deficit. It is also questionable whether such monetary settings would be consistent with China’s stated aim of increasing consumption and reducing reliance on exports.

Another important question facing Australian gold investors is gold’s relationship with the exchange rate. Gold is priced in US dollars, which means that movements in the exchange rate can lead to a significantly different investment return in Australian dollars, compared to the underlying movement in the gold price. As the first graph reveals, the significant appreciation of the Australian dollar significantly cut the peaks of the gold price bull markets. If two investors in Australia and America had each bought a gold bar in June 1991 in their home currencies, at the peak of the gold bull market, the American would have enjoyed a nominal price appreciation of more than 5 times his initial investment, while the Australian’s return in his home currency would have been well under 4 times.

A study of Australian dollar gold prices and the exchange rate shows that there is a negative correlation between the two, meaning that they tend to move in opposite directions. The monthly return of gold has a correlation coefficient of -0.4 with the change in the exchange rate. This seems logical – being priced in US dollars, all else being equal, the AUD value of gold should rise when the Australian dollar falls and vice versa.

Finally, in exploring gold’s ability to preserve wealth, a logical point of comparison would be the share market. Another tenet amongst investors is that equities outperform other asset classes in the long run. 

A look at the All Ordinaries accumulation index from 1984 shows that shares soundly beat gold as a store of value over the last three decades, despite the 1987 Wall Street crash and the 2007 financial crisis. A dollar invested in the share market was mostly able to hold its real value over extended periods of time. Even if you had bought at the peak just before the Wall St crash in 1987, you would have recovered the purchasing power of your initial investment by 2005, and it would be worth roughly the same today. Of course, we don't know yet how long investors who bought at the 2007 peak will have to wait to recover their investment. 

Yet again, the numbers are sobering when inflation is taken into account. While the All Ords with dividends reinvested is a staggering 7.4 times its 1984 level in nominal terms, in real dollar terms that performance is whittled down to a more modest but still impressive 2.6 times.

The volatility of the All Ords dwarfs the movement in the gold price. A casual observer will be able to notice the daily swings and hence conclude that shares are risky. Yet the graph above indicates that over the long run, the share market is better as a store of wealth. This should not be surprising considering that the sharemarket is an aggregation of an economy's companies, which are generally able to reflect inflation in the prices they charge their customers. 

Fundamentally, economic value arises from the profitable provision of goods and services that are in demand, which is precisely what listed companies do. It is hence empirically sensible that investing in a diversified group of companies providing a strong proxy to economic activity is likelier to be a good store of value. On the other hand, the demand for gold is driven largely by investors and speculators, and its total supply is determined by mining activities. New engineering and scientific breakthroughs may make it easier to mine and refine gold, leading to an increase in supply. 

In conclusion, this short study goes some way in showing that in Australia at least, recorded history in the age of fiat currency does not suggest that gold is a safe store of wealth. It also illustrates just how powerful inflation can be in masking true investment performance.

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[1] http://www.perthmint.com.au/investment_invest_in_gold_precious_metal_prices.aspx