Consider this. The cash flow projections in the project report spout numbers that are fit to rank as ‘rich beyond the dreams of avarice’. The sensitivity analysis for all kinds of ‘what if’ scenarios come up with an Internal Rate of Return (IRR) that is well above the threshold rate. The only fly in the ointment, as it were, is that the project is so huge that it would guzzle all the resources the firm can command, and some more. So much so, should the project fail to deliver on its promises, the firm’s viability itself would be seriously undermined.
What should the CEO do? Should he give the go-ahead for the new project? Common sense tells us that the firm would be better off jettisoning the project, no matter how good the projections are, as the risks simply don’t warrant putting the entire cash flows on the line. But business history is replete with examples of companies biting off more than they can chew, only to end up with fractious litigations with bankers and other creditors as they face imminent bankruptcy. Vijay Mallya is only the latest in a series of such misadventures on the part of promoters. Nor will he be the last. Such, indeed, is the nature of the beast.
But it is not just industrialists. Politicians too, it would seem, are prone to the affliction of throwing away their entire accumulated wealth of political legitimacy in a last-throw-of-the dice kind of gamble, only to come up a cropper in the end.
Why the Referendum at all?
The fate that befell British Prime Minister David Cameron as the British public voted to pull Britain out of the European Union (EU) was one such. In over 100 years, he was the first Conservative party Prime Minister to return to power with a larger percentage of popular votes than the first time. He was next only to Margaret Thatcher to have returned to power after completing a full term in office as PM. With everything going in his favour and no immediate threat to his leadership, he staked his reputation and the entirety of his political capital on the possibility that Britain would want to remain within the EU.
True, he had to call for a referendum in keeping with his election promise. But the larger question to be asked is this: was it at all necessary for him to have conceded to this demand in the first place? No doubt, there were rumblings of dissent within the Conservative party regarding continued membership of the EU. These were dictated by fears among some leaders that they might lose their parliamentary seats to rivals from United Kingdom Independent Party, which had professed a strong anti-EU line before the voters. But Cameron’s own leadership position was really not under any threat. Yet, he chose to give in to the demand for a referendum in 2013, to appease a section of the old-guard in the Conservative party.
Again, having beaten back what little threat such leaders posed, he could have mounted a campaign in the General Election of 2015 on broader development issues confronting the British economy instead of making the EU membership the central theme of the campaign. If the British people really thought that the EU membership was the core election issue, they would most certainly have voted for the UKIP, which displayed better credentials on the subject. As it happened, the Independent Party was soundly defeated in that election. In the circumstances, there was no need for Cameron to have rushed into the referendum in 2016, especially when he had given himself time until 2017 to call for such a move.
Dictates of economic theory
What is ironic is that Cameron himself had warmly endorsed a principle of Conservative political philosophy in a book review published by The Guardian back in 2005. This principle holds that the concrete benefits of an existing society must be taken more seriously than potential abstract benefits that could be gained through applying a new social theory. https://www.theguardian.com/books/2005/jan/22/politicalbooks.highereducation
Substitute for the phrase, ‘concrete benefits of an existing society’ the words, ‘concrete cash flows from an existing business must be taken more seriously before venturing upon any new business’, and the analogy to the world of business is very clear.
The drama of Britain exiting the EU is an apt example of yet another principle, this time from the world of economic theory. A nation is confronted with policy choices involving three key variables that affect its economic performance. These are exchange rate (for the local currency), capital flows from abroad and domestic interest rate or its proxy, price stability. Economic theory postulates that a country can choose to control, at best, two of these three variables, never all the three at the same time.
A country’s monetary authority can choose to free capital flows and also fixed exchange rate but must be prepared to give up on controlling interest rates in the economy and, through it, price stability. Or it can choose to have price stability and exchange rate stability but then must be prepared to impose stringent controls on capital flows. It is not difficult to see why this must be so.
Two out of three
Let us take the first scenario, where the country allows free inward movement of international capital. All other things remaining constant, this must inevitably result in the local currency strengthening against an international reserve currency such as the dollar. Now, the monetary authority can intervene in the currency market and buy up such fresh flows of dollars and release domestic money in the economy. The resultant excess supply of money would not only trigger a spike in demand for goods, pushing prices up, in general, but it could also lead to a rise in interest rates in the economy through the medium of policy rates.
In other words, the monetary authority has lost control over the interest rate in the economy. But this scenario can be avoided if the inflow of capital from abroad is somehow plugged. The economy will then enjoy not only a stable exchange rate but also a stable monetary policy (interest rate). But that is possible only if the monetary authority imposes stringent controls on capital flows. So it is back to controlling only two of the three variables in what is often called the ‘Impossible Trinity’.
An ‘Impossible Trinity’ of a slightly different kind is at play in Britain’s exit from the EU — something of relevance to other countries as they grapple with policy choices that confront them when they sign a global trade arrangement. A society can have democracy and national sovereignty. But then, it cannot have globalisation, the third element of the Trinity.
Britain, which had signed up for membership of the European Union, had already surrendered some of its national sovereignty for the privilege of being part of a larger globalised community. In other words, it had the advantages of globalisation and some kind of pan-European democracy. It now wants national sovereignty and local democracy but must, of necessity, give up on globalisation. The rule of the ‘Impossible Trinity’ would not have it any other way.