Thursday, May 31, 2007

US Current Account Deficit

There as been an interesting debate going on for the past decade about the burgeoning US current account deficit. Even as the world is accumulating savings at a frenetic pace, America is busy consuming it. In March 2005, Ben Bernanake, famously suggested that the world was suffering a "global saving glut". Asian Central Banks have been buying into dollar assets, especially US Treasury Bonds, with a voracious appetite. Ken Rogoff of the Harvard University called this massive influx of funds from the emerging economies as the "biggest foreign-aid programme in world history", with Asian Central Banks subsidizing American consumption and housing boom. How do we explain this twin phenomenon of "savings glut" across the world and the run down on savings in the USA? (the American household now saves less than 1% of their disposable income)

The US current account deficit stood at a very high 6.1% of the GDP or $856.7 bn for 2006-07. In fact, the trade deficit for 2006-07 stood at $827 bn. In contrast Japan had a current account surplus of $181.5 bn or 4% of GDP, China $249.9bn or 8.1%, Germany $165 bn or 4.9%, and Saudi Arabia $95.4 bn or 18.2%. The entire South East Asian bloc, excluding China and Japan, had current account surplus of over $150 bn for the period. The oil exporters have been running up surplus of over $500 bn annually. Execpt for Britain, France and Spain, every other major economy was running current account surpluses. The Euro area has also been continuosly running current account surplus. Trade surplus is the norm across the world.

Consequently, the Chinese foreign exchange reserves touched $1.2 trillion in April 2007, while Japan's reserves were $916 bn, Euro Zone had $451 bn, Russia $267 bn, South Korea had $247 bn, and India $204 bn. At the end of 2004, of the official foreign exchange reserves of all the countries, 66% were denominated in dollars, and 25% in euros.

Except for a couple of East Asian and Latin American economies, the consumer price inflation was at a historic low of 1-3% range. Unemployment figures have varied between 4-5% for the US over the past couple of years. Except for Japan, the 10 year Government Bond rates have been in the 4-5% range in all major developed economies, in the recent few years, the lowest since the 1960s. The global economy has been also growing in the 4-5% every year for the past few years.

We therefore have a high savings, high surplus, high growth Asia excluding Japan; high savings, high surplus, but low growth Japan and Germany; and a low saving, high deficit, and robustly growing America. The "savings glut" of Bernanke has coincided with a drop in investment across the world, except China, all the more surprising given the historically low interest rates and high economic growth rates.

China is in a league of its own. It has grown at around 10% annually since 1990. Its Gross Domestic Investment rate at 46% in 2006 is phenomenal and its Gross Domestic Savings rate at 50% is unprecedented, and continues its growth unabated. The Yuan, despite a slight relaxation in the band in July 2005, continues to be heavily supported with open market intervention by the Central Bank, and is undoubtedly under valued.

The other major story has been the oil exporters. Buoyed by the steep rise in oil prices and chastened by their reckless spending spree from previous oil booms, the oil exporters have been investing this windfall to form an oil stabilisation fund and the like. The growing savings in other emerging economies like India is understandable given the robust economic growth and productivity gains seen in the past decade.

Where have all these savings been going? The world has huge savings to invest, and America wants those savings. Ideally, I would like my investments to fetch good rates of returns and also be protected from any exchange rate risks. But these savings are going into the cheap US Treasury Bonds which are at historic lows, and faced with the spiralling current account deficit the dollar has been sliding, thereby further reducing the returns. But the massive flows from the rest of the world to the US continues, turning conventional economic wisdom on its head.

The Asian Central banks have been liberally deploying these huge savings to hold down their currencies by buying huge amounts of US Treasury Bonds.The windfall from the rise in petrol prices has also found its way into the US T-Bonds. Further, faced with the "savings glut", these economies have realised that their financial systems do not have the breadth nor the depth required to effectively manage these huge amounts. In the circumstances, emerging market Central Banks naturally find the US Government securities the safest bet, even with its low returns. Also dollar assets have another advantage in that they are much more liquid. As on March 2007, foreigners held US T-Bonds worth $2.2 trillion, of which China held $420 bn Japan $612bn, and oil exporters $113 bn.

There is a substantial body of opinion in the US that lays the blame for the deficit problem on China and its policy of deliberately holding down the yuan. They point to the huge Chinese trade surplus with the US and how it is causing a weakening of the dollar. The supply siders also blame the stagnant consumption, especially in Japan, Germany and parts of Euro zone. Bernanke himself subscribes to the view that the American deficit problem is not "made in the USA" and therefore has to have solution externally, in its originators. This supply side argument has its weaknesses. China and Japan account for less than 40% of the US current account deficit. Further, US takes only one-fifth of the Chinese exports. The US current account deficit has grown by more than five times the growth in the Chinese current account surplus. In fact, in pure numbers alone, the oil exporters have contributed a much larger share to the growth in the US deficit than the Chinese. Ultimately the fact remains that the massive inflow continues because there is an insatiable demand from the US consumers, and it will continue as long as that is not satiated. The "not made in the USA" logic is something akin to controlling prostitution by banning prostitutes without simultaneously addressing the demand.

The more interesting explanation for the rising deficit is the demand side one. The past couple of decades have seen historically low interest rates, unprecedented trade liberalisation, and active use of expansionary monetary and fiscal policy by the Government. All this has led to a massive spurt in imports from not only China but also from other East Asian economies. The historically low interest rates, coupled with low inflation and the huge variety of easy money generating financial instruments like flexible mortgage loans and its aggressive marketing by finacial institutions, sparked, in Greenspan's words an "irrational exuberance", spawning massive asset bubbles, first in shares and then in real estate. Unlike previous bubbles, which were confined to only certain sections of the society, these bubbles attracted a significant share of the population, and generated an "income effect" for them. Buoyed by this "wealth effect", the people started running down their savings and indulging in a huge spending spree, thereby generating the consumption boom. With interest rates at a historic low and housing equity liquid and easily accessible, Americans have completely given up saving on current incomes.

The massive tax cuts of George Bush in the early years of the millennium, the largest post-war fiscal largesse, and the decade-long loose monetary policy of Alan Greenspan meant that the Government policies were actively feeding the binge boom. In fact the irresponsible tax cuts of the Bush administration has compounded the problem by turning the budget from a massive surplus to ever growing deficits. The end result is that except for the private sector, all other sectors of the American economy are running growing deficits.

There is another school which interestingly finds nothing wrong with the rapidly growing deficit. They see it a sign of America's strength that foreigners want to have a share in the world's greatest economic machine. They even consider that this deficit has been the engine that has kept the world economy afloat at a time when the Japanese and European economies were in recession. They contend that without the generosity of the American consumers, China could not have sustained its spectacular boom and the East Asian economies could not have so quickly emerged from the crisis of the late nineties. They also point out that the US annual borrowing of $850 bn is nothing compared to the American household wealth of over S35 trillion. But this household wealth itself is built on the dubious and illusory foundations of a stock and real estate bubble.

They also say that American borrowing is unlike those of others, given the unique status of dollar, as the world's reserve currency. In contrast to other countries who borrow externally, America can issue bonds on its own currency. All its external liabilities are dollar denominated, whereas the major share of its assets are foreign currency denominated. at a time when dollar is weakening with respect to other currencies, the Americans would enjoy double benefit from both falling real value of its debt and rising dollar value of its assets.

So where does this all this leave us? It is only a matter of time before the Asian and the oil exporting countries start looking for higher returns on their investments. (In fact, China recently entered into an agreement with Goldman Sachs, paying it $3 bn, for managing a part of its massive foreign exchange reserves) But given the deep legacy of the recent stock and real estate bubbles, driven by massive borrowings, America cannot hope to raise its interest rates to provide higher returns, without creating a serious run on its over-loaned financial system. It is also clear that the East Asian and oil exporting nations cannot easily pull out their huge investments from US T-Bonds without huge repercussions, which will primarily hurt them. Any frenzied withdrawal could send the dollar into a tailspin and lead to huge fall in the values of these investments. For the US economy itself, this would spark off interest rates hikes and a meltdown. We could then have a classic Ponzi scheme unravelling, with both the US and the global economy tanking into a recession or even worse. The best that the Federal Reserve can hope is to manage the financial system for a soft landing.

In fact, faced with depreciating dollar, the Central Bankers have already realised the need to slowly reduce their exposure to the US market, and consequently the pace of reserve accumulation has already started slowing down, except with the Bank of China. China will also have to slow down its purchases of dollar, as inflationary pressures mount. The strengthening Euro has become an attractive investment option for many Asian Central Banks. The rebounding Japanese economy has also attracted investments in Yen denominated assets. Further, with the rapid evolution of the financial sector in these emerging economies and the arrival of sophisticated and safe financial instruments, these countries will no longer need to look outside for parking their burgeoning savings.

The unfortunate thing about the massive influx of foreign money is that it has gone into financing America's consumption and housing boom and its reckless fiscal bonanazas for the rich, rather than into any productive investments. The private sector investment has not grown at the rate necessary to offset the profligacy at the other side. Chastened by the massive investment binge in the 1990s, the corporate spending as a share of GDP is at its lowest in a quarter century, thereby keeping the exports sector dull.

So what is the outlook? It looks bleak to say the least, and we will need a miracle to prevent a hard landing. With net external debt of nearly $4 trillion at the end of 2006-07, America will eventually have to generate more internal savings and/or run up external surpluses to pay off its huge outstandings. This will require Americans to sharply cut down their consumption (which in turn poses other risks) and also increase savings. The private sector will have to increase the historically low investment rate, so that exports can be boosted. Given the grim deficit scenario, it is a fait accompli that America will need its exports to grow steeply to start repairing the damage. And it will have to start immediately. The depreciating dollar will surely help.

What will America need to stave off a hard landing? Internally, American households will have to start saving more and its corporates will have to start investing more, especially for the export sector. Exports will have to start growing. Inflationary pressures will have to be kept under check, so as to contain interest rate rises and further fall in dollar. The Government will have to repsond with fiscal rectitude and turn around to a surplus and immediately at that. The irrepsonsible tax cuts will have to be rolled back and pork-barrel curtailed. The real estate bubble will have to be deflated so as to achieve a soft landing that would not adversely affect the financial sector. This in turn again requires the interest rates to not harden too much.

Externally, continuing cheaper imports of manufactured goods from China and the rest will be of great help in keeping prices under control. Japan and Germany will have to start consuming more and saving less, so as to provide market for US exports. Hopefully the dollar continues to remain weak, without however precipitating any drastic fall in confidence or run downs on the dollar. The Asian and Middle Eastern Central Banks will have to remain persuaded to not start withdrawing their investments in a frenzy at any time. The exit will have to be managed carefully. The financial sector in the emerging economies have to develop quickly in its breadth and depth.

Now in real life, common sense dictates that however credit worthy I am, there is a limit to how much I can borrow or will be lent by bankers. In other words, I cannot live beyond my means for long periods of time. With great luck, I may be able to fool all my creditors for some time, but only for some time. Then the chickens come home to roost! It will require a near miracle for both the US and the rest of the world to come out of this mess!

Public Utility Test in Media Relations

One issue that has confused me repeatedly and has led me through the entire gamut of options and has not left me any the better, is on how we bureaucrats should be dealing with the Fourth Estate. Bureaucrats are traditionally seen as the behind-the-scenes executioners of Government Policy. In fact, it is even considered a virtue for bureaucrats to remain invisible from the glare of the media. I am a supporter of the invisible bureaucrat school, but with certain reservations. These reservations arise from the fact that we are today living in a changed world with diverse challenges, each requiring different solutions and options.

What is the context? There are a multiplicity of news channels active today. Newspapers which hitherto were confined to mostly global concerns, have now become more local-centric, with tabloid editions for each district and even cities. The plethora of television channels, especially the 24 hour news channels, with their ubiquitous continuous scrolls, have brought debate on public issues straight to people's living rooms. Within cities too, the cable operators have all started local news channels, which bring visuals about local issues.

The Fourth Estate, consisting of the print and the electronic audio and visual media (the internet media are yet to start playing any role) are important stakeholders and increasingly influential partners in the public domain in which we operate. In the league of opinion makers, the media have always been influential players, but their importance has increased manifold in the past few years.

So what should be the yardstick for our relationship with the media? There is no dispute on the fact that we ought to share information, especially those which are necessary for the citizens to be informed participants in debates about public issues. We are living in an age when massive changes are taking place, radically altering the fabric of our society, economy and polity, and exposing all of us to its consequences in our daily lives. It is therefore imperative that all citizens are informed about these issues, and we as bureaucrats have surely a major role to play in this.

We also have a critical responsibility in making citizens aware about social and civic issues. We need to make people aware about changes that are taking place around them and how best they can themselves or we can help them confront these changes. We need to spread awareness about reforms in the functioning of Government and how the citizens can better use or adopt these reforms. Citizens need to made aware about how they can adapt modern technology and processes to facilitate accessing public services.

I will stick my neck out and argue that the touchstone for our relationship with the media should be promotion of this objective. Any message should primarily focus on promoting these issues, which increase public utility, instead of projecting individual achievements. It is not out of place to remind ourselves that in so far as these achievements are all the policy objectives of the Government, there are other participants in the system who have have the specific mandate of promoting these successes.

Thus, instead of giving far disproportionate importance to press conferences held to proclaim 90% Property Tax payments, we ought to be showcasing those methods adopted to recover tax dues from longstanding defaulters. While the former will only serve to promote the achievements of the individual concerned, the later will surely send a strong deterrent message to would be defaulters. Instead of diverting attention away from the parking problems by giving disproportionate focus on a cellar demolition drive, we ought to be paying more attention to publicize the magnitude of parking problem and the options available for citizens to address this challenge.

Another example, instead of parading the master car thief, with the entire fleet of recovered cars, before the glare of camera, we ought to be showcasing methods and technologies that can help the police pre-empt such theft or catch such criminals. The former has little utility value to the public except satiating the immediate and trivial curiosity surrounding the event, but will have significant personal value to the police officer in showcasing his achievement. Some may argue that it reassures the public about the effectiveness of the police machinery. I seriously doubt it, but even granting that, it still is no explanation for the disproportionate share of such media interactions. In fact, even if such interactions have to take place, it should primarily seek to communicate some strong deterrent messages to other car thieves. (A universal message that they will be caught if stealing cars is of no deterrent value to them for obvious reasons. If it were, no body would be stealing cars!)

But showcasing methods and technologies that help pre-empt car thefts and even help catch criminals have tremendous utility value. For example, a press conference to showcase a device like the Lojack, which would help us trace out stolen cars using a radio transmitter with a GPS device fitted randomly at different locations in cars, will go a long way in spreading awareness among the public about how to protect their cars from theft and a strong deterrent on the criminals from indulging in car thefts.

It implies that instead of catching and parading offenders and criminals, or those pilfering civic services and claiming the credit for the one-off success (invariably we are catching and displaying, maybe one-in-ten such offenders), we ought to be highlighting the mechanisms in place to control such offences.

To conclude, it is safe to say that the focus of our interaction with the media should not be the outcomes of our actions, which rarely have more than limited public utility, but should if any, be on the methods adopted to achieve the outcomes. The later, besides making people more aware of what they should be knowing about that particular issue, would also be strong deterrent message to those lurking offenders, defaulters and criminals within the audience.

So next time, we hold a press interaction, focus on the issue not the outcome! The sole yardstick should be, does my message promote public utility? If of course my objective is different, then the test naturally fails!

Wednesday, May 30, 2007

Littering and the decentralised solution

One of the biggest sanitation problems facing our cities is that of littering of drains and roads with garbage and waste. The enormity of the problem cannot be over empahsised. In fact a large proportion of our public health problems can be traced back to this. Drains clogged with garbage leads to overflow of the drainage water, breeding of mosquitoes, and general unhygenic environment leading to various epidemics.

Apart from its obvious public health related problems, there are serious financial implications. The Vijayawada Municipal Corporation (VMC) spends about Rs 1.2 Cr a month or Rs 14.4 Cr a year, on sanitation personnel. A significant proportion of the sanitation personnel are involved in cleaning drains and sweeping roads. If we could control littering and dumping of garbage on drains, it is estimated that we can easily reduce the number of staff by atleast half. This would translate into savings worth Rs 7 Cr and above every year.

How do we solve this problem? I am a strong believer in the failure of regulatory solutions to socio-economic problems. Regulatory solutions bring in a number of exogenous variables, including rent-seeking, which invariably dilutes the focus from the task at hand. Solutions which depend on incentives and dis-incentives can better achieve our objectives. Littering is clearly a social problem, arising from a lack of civic sense. We need to have market or society inclusive solutions to such social problems.

One way is to fine those littering streets and drains and get it enorced through private citizens and Resident's Welfare Associations (RWAs). The Corporation can empower citizens or RWAs to fine people littering the streets. The RWAs can even be empowered to use the fine proceeds to maintain cleanliness and take up other development activities in their area. Even private individuals can be permitted to retain the amounts so collected, as a reward for undertaking a socially valuable action. The fine amounts can be kept at a minimum. It is observed that even a minimum fine, when collected by their neighbours or fellow citizen, has a powerful symbolic value and is a strong deterrent on errant behaviour.

Critics may scoff at this and declare this a recipe for lawlessness and describe it as government shirking its responsibility. I differ. After all in the developed countries and especially in places like Singapore, there exists a tacit understanding that if I litter the road, I am likely to be reported for the same by other citizens and hence anyway fined. It is this implicit vigilance in the civil society which has played a significant role in ushering in civic sense and controlling littering. In the absence of effective reporting and compliance mechanisms, it may be better to directly empower citizens to levy and collect these fines.

Similar approach could be adopted in controlling electricity or water pilferage. By delegating enforcement and fine collection powers to RWAs, if not individuals, we can contain the thefts. It is anyway an idea worth pursuing.

Tuesday, May 29, 2007

Long ques and economic inefficiency

At some time or other, most of us would have been part of long ques to access some service. Most commonly we would have spent long agonising waiting time in ques for buying cinema ticket, and railway or bus tickets. We in Andhra Pradesh can more easily relate such experience with the long ques for having darshan (glimpse) of Lord Venkateswara in Tirupati.

I am sure nobody will dispute my claim that these ques are responsible for huge loss of economic efficiency and do not serve any meaningful purpose. For a start, these ques do not discriminate between the repective urgency and needs of those standing in it. By treating all those standing on equal terms, it ignores the differential willingness to pay among them. Some of the people, faced with an urgency or who attach more value for their time, will obviously be willing to pay a premium to access the service at the earliest.

Let us try to conceptualize the problem. As mentioned earlier, the long ques do not take into account the willingness to pay of certain people. Economists would see this as a clear case of economic inefficiency and deadweight loss. Further, the one-size-fits-all arrangement of que results in substantial loss of revenue to the service provider. In our quest for a solution to this, we need to keep in mind that in any solution to this problem, some people will always lose out either by not getting the service at all (not getting the cinema tickets) or being the last to access the service (Tirupati darshan). So our limited objective should be to put in place an arrangement that would optimize the time spend by different individuals after taking into account their preferences.

How will this que arrangement work? For the simpler public service ques, each category of que can be divided into two, say equal, parts. One part, consisting of those unwilling to pay the additional premium, can continue to be part of the line and access the service in a que. The other part can assemble in an auction hall for a multiple-bid Dutch auction. In such auctions, the auction prices start high and then keeps dropping till all the units are sold out.

The details of the auctions can vary widely. The offset rate at which the auction starts can be determined by the auctioneer. In fact for non-public service items like the cinema tickets, even all the tickets can be sold through these auctions. Maybe some part of ticket can be sold through online auctions, and the rest by auctions, say half hour before the show starts. The auctions can even be held in smaller groups, so as to reduce the typical confusion that surrounds them.

The solution for the famous Tirupathi darshan ques is more complicated. Besides serving a public service function and unlike the cinema ticket ques which are static, the Tirupathi ques are in a constant state of flux, with people pouring in regularly. Tickets are issued for different categories of darshans, based on the distance of the darshan. A separate que can be formed for each category for all those unwilling to pay any additional amount. Periodic auctions, can then be held for those willing to pay the darshan premiums. With time the general market rates in auctions would become public knowledge and only those willing to pay those sums will attend the auctions. In order to ensure that those standing in the que are not greatly disadvantaged and do not get pushed back significantly, we can control the periodicity of auctions. The periodicity of auctions can also vary based on the pilgrims rush at any time. We would thereby have two sets of ques for each category, based on the need and urgency of the people, measured in terms of their willingness to pay - the general que and those who have paid the premiums (maybe these ques can merge into one at the entrance). In order to deter all those who would be willing to pay only small premiums of say, one or two rupees, the auctioneer can fix a minimum initial differential of say, Rs 5.

What are the benefits of this intervention? This auctioning would not only reduce the economic inefficiency, it would also help in significantly controlling the black market in these services. It is common practice in cinema theatres for touts to sell these tickets at a huge premium in the black. This not leads to huge loss of unaccounted for revenue, it also engenders a culture of fraud and even violence. Its benefits on the larger economy - cinema theatre owners will get more money and hopefully set up more theatres, railway and bus operators get more money and will operate more services, and total opportunity costs of waiting times will be reduced.

There is one thing which bothers me about this arrangement. Economists make a huge assumption by reducing each individual's utility to his or her willingness to pay. This is a highly debatable assumption. For example, I am waiting in a long que to buy ticket for the next India-Australia cricket Test, but cannot afford the auction premium. I pride myself as an inveterate cricket fan and tries to go and see matches whenever possible. There are others in the que, part of a large corporate group out to have some fun, not especially interested in the game and in fact seeing a cricket Test at the ground for the first time. But they are willing to pay the auction premium and thus pip me to the match. Except by the economists' definition of utility, the marginal utility gained by me in seeing the match is obviously bigger than that of the group.

These auctions are obviously not the ideal solution to the que problem. There are also certain other solutions worth trying. They may fail or succeed. There is an interesting article by Steven Landsburg in the Slate "The First One Now Will Later Be The Last". But I suppose till we come up with a better solution to quantifying utility (say a utilometer, which measures our hormone secretion while we are standing on the que!), we may have to settle for the next best solutions.

Sunday, May 27, 2007

Negative Externalities in Cities

Externalities are outputs or outcomes which are borne by the system external to the agent doing the activity. These external impacts can be either detrimental or beneficial to the society at large. Those which impose a cost on the external environment is called a negative externality and those which confer benefits on it are called positive externality. The benefits of a negative externality goes to the agent producing it, while the costs are invariably borne by the society at large. Obviously, negative externalities ought to be contained and penalised, while positive ones have to be encouraged and incentivized. Economics teaches us that for efficiently managing these externalities, its costs and benefits have to be internalized.

Externalities suffer from what are called market failures, and hence demands some form of government intervention. Left to themselves, the market will undersupply positive externalities and oversupply negative externalities. We will thus have unhindered and unregulated activity, inflicting huge social costs. In the absence of Government intervention, those deriving the benefits of the activity ill not compensate those bearing the costs of the activity.

All externalities have private costs and private benefits, accruing to the agent doing the activity causing it, and social costs and benefits impacting the external environment and society. In all the negative externalities, the Marginal Private Benefit (MPB) of consumption is more than the Marginal Social Benefit (MSB) of consumption, and the Marginal Private Cost (MPC) less that the Marginal Social Cost (MSC), thereby leading to an over supply of the activity with increasing costs on the society.

There are a number of negative externalities in cities, and many major urban problems and issues can be traced back to the presence of externalities. Apart from the usual accused like pollution from vehicles, we have costs imposed on the society and environment by actions like dumping garbage or litterring on roads and drain, parking vehicles on road margins, house extensions encroaching public spaces, occupation public spaces in shopping complexes, hawkers on road margins, constructing steps and ramps over drains and onto the road, using motors to draw water from the network, letting out sewerage into side drains, growing cattle in residential areas, violating zoning regulations and housing commercial and institutional establishments in residential areas, traffic congestion arising from using personal vehicles and not using public transport etc.

It is commonplace in cities to have frequent media reports lamenting about the losses incurred by way of Property Tax evasion, loss of Non Revenue Water, and various other inefficiencies. By reasonable approximation, the total evasion of Property and Vacant Land Taxes in Vijayawada Municipal Corporation (VMC) area would be at the most Rs 4-5 Cr, the loss due to NRW would be about Rs 4 Cr (taking 50% NRW), and losses from other inefficiencies would be another Rs 5 Cr. Thus all these conventional inefficiencies cost the VMC about Rs 15 Cr every year in revenues.

In constrast, let us try to quantify the costs incurred in Vijayawada due to some of the aforementioned negative externalities. We will try to quantify the cost by way of the willingness to pay principle, the incomes foregone, direct cost inflicted, opportunity cost, cost that would have to be incurred by the individual to eliminate the problem, or other means. It does not include certain other more difficult to capture costs like inconvenience and health hazard caused to the general public etc. All the costs indicated are annual
Unauthorised Parking - Rs 55 Cr
Hawkers on road margins - Rs 15 Cr
Building extensions on road margins - Rs 10 Cr
Steps and drains covering drains and public roads - Rs 3-5 Cr
Litterring of streets and drains - Rs 4-5 Cr
Using motors to draw water - Rs 12-15 Cr
Letting out sewerage into open drains - Rs 3 Cr
Violating zoning regulations - Rs 10-15 Cr
Traffi congestion - ?
Cumulatively the cost of all the aforementioned extenalities alone on the external environment and society come in the range of Rs 112-123 Cr. (The details of all these calculations are available)

Readers may dispute the standards and the assumptions used in some of these calculations, and I will not argue on that. But even considering half this amount, there is still is no competition! Unfortunately we have not even woken up to addressing this problem, leave alone solving it. We clearly have our priorities misplaced, at least economically.

Many of these problems have limited practically enforceable regulatory solutions. We will ultimately need to develop civic responsibility in our citizens to have any sustainable long term solution to these problems. But how do we go about inculcating civic responsibility itself? Information Education Campaign (IEC) and massive awareness generation is necessary for sure. That is a long campaign and will take time. Till then the only other way to address them is by internalizing these external costs. This will incentivize agents towards finding alternative solutions that will reduce or eliminate costs inflicted on the environment and the society.

All the aforementioned are serious problems whose collective costs on the society are enormous and are increasing with the trend of rapid urbanization. If we are to ensure that there is no further deterioration in the quality of urban life, leave alone improve it, it is necessary to start making those agents causing these negative externalities pay for their actions.

In all these cases, not only do the users not pay for the damage inflicted on the environment and society by their actions, there is also a resigned acceptance of these costs by the public at large. Sociologists may diagnose this as arising from lack of civic repsonsibility, and may advise development of social capital for containing these problems. But economists see them as problems of failure in internalising costs. Whatever the diagnosis, it is undoubtedly a problem that has to be addressed with the same seriousness we attach to other issues like global warming or climate change. And addressed immediately too.

Saturday, May 26, 2007


I was watching Sachin Tendulkar labour his way through to his 37th Test century against Bangladesh at Dhaka today. It was painful to see him struggling to avoid the gentle bouncers of Mashrafe Mortaza and repeatedly failing to read and barely surviving the innocuous left arm spin of veteran Mohammed Rafique. What made it even more excruciating was the realisation that the Tendulkar of old, even at 50% of his self, would have toyed with both these bowlers. In an age of attacking batsmanship, when the one-day run rates of 1980s and early 1990s are the norm in test cricket, when batsmen take audacious liberties with technique and strokeplay, Sachin Tendulkar was content at patting back half volleys and pushing full tosses for singles. For a man with text-book technique and fluid grace, which made Mark Nicholas describe his bat as "an extension of his body and hands", this has been some fall from the pedestal.

If Sydney in 2004 saw Tendulkar abstain from all shots outside the off stump, then today he had obviously made up his mind to duck under anything that was bounced at him. Sunil Gavaskar in the second half of his career had completely avoided certain strokes like the hook and the pull, which were a regular part of his repertoire. When asked about it, Gavaskar once said that he did that since the team was then so dependent on him that he had to cut down all risks. That logic does not extend to Tendulkar and the present Indian batting line-up. Watching him over the past few years, one gets the impression of an obstinate man, unmindful of any advice, who has made up his mind that whatever the circumstances, safeguarding his wicket is the only objective. There have been numerous occasions in the recent past when Sachin's extra cautious approach has been a big drag on the team's scoring rate and victory pursuit. But then I suppose, Tendulkar should know more than anyone else, what he is doing.

Besides his obvious technical excellence, Sachin was blessed with a great eye sight and balance, and extraordinary hand-eye co-ordination. At his pomp, Tendulkar had, as they say, five or six shots for every ball and could conjure up boundaries of even the very good balls. Remarkably, he could play the most unorthodox of shots, requiring exceptional hand-eye co-ordination, with the minimum of risk while making it look aesthetic and technically correct. In this he was unique from any other batsman of his age, including Brain Lara. But these talents decay with time, and decays very fast indeed.

The king has been reduced to a pauper and is eking out his livelihood! It is time for the curtain to come down on the final Act!

Friday, May 25, 2007

Livelihood Insurance and Macro Markets

I have been reading Robert Shiller's book, "The New Financial Order:Risk in the 21st Century". As with the previous "Irrational Exuberance", this one is also a very interesting read. It contains some very serious insights and ideas about financial risk mitigation. Shiller proposes six ides for a new financial order - Macro Markets, Livelihood Insurance, Income linked loans, Inequality Insurance, Intergenerational Social Security, and International Agreements for Risk Control.

Macro Markets could easily follow in the footsteps of equity markets, derivative markets, and commodity markets, in the coming years. We could have a market for trading in the economic health of different countries. While the stockmarket represents only a portion of a country's economy, the macro markets can represent the country's economy itself. Its performace can be a predictor of the future expectations of investors and other stakeholders about the prospects of the country's economy.

Macro securities on the GDP of a country would be like any other share, with its value determined by the expected revenue streams or economic growth potential of that country. These securities would give out dividends in proportion to the performance of the country's GDP, reflected in the value of the security. These securities could be issued either by the Government or by private financial Institutions accredited by the country. Macro securities on GDP will thus enable investors to invest directly in the country's economy and its price will represent the value of a claim on the economy. These securities will not have any expiration dates and will be similar to perpetual futures on the index. Apart from national incomes, other macro securities could be issued to cover prices of different categories of real estate in a City or Country, incomes of different occupations etc.

Institutions issuing the security can "invest the proceeds in macro markets representing the national incomes of other countries", thereby "effectively swapping the risk of its national income for the better diversified portfolio of national incomes all over the rest of the world". By selling the security on GDP of a country to foreigners, we would be effectively selling the risk on our economy to a foreigner, thereby facilitating massive risk diversification and risk sharing.

Robert Shiller and Allan Weiss patented macro securities in 1999. To quote from the book about the details of these securities, "These securities are issued and redeemed on demand by a stock exchange or by financial institutions, but only in pairs - an "up macro" designed so that its price moves up when the GDP moves up and a "down macro" whose price moves down when the GDP moves up and vice-versa. Though issued and redeemed in pairs, these securities are traded separately and each finds its own price in the market. Each member of a pair has a separate cash account adjusted according to the specified economic index (eg GDP) being traded, by re-allocating across accounts. Each macro security pays dividend equal to the interest on its cash account."

"Suppose a pair of securities is issued for $200 when the index is 100. The account of the up macro is initially credited with $100 and the account of the dowm macro is also credited with $100. If the index rises to 102, the custodian of the cash account takes $2 from the down macro account, reducing it to $98 and puts them up in the up macro account, so that the balance in the up macro account again equals the index at $102. This action means that, subsequently, the dividends on the up macro security will be higher, and the dividends on the down macro security will be lower. In this way, through subsequent dividends, the holder of the up security will be rewarded by the rise in the index. By anticipating higher dividends, the investors in the up macro security will bid up its price. If on the contrary, the index falls, the investors will quickly bid down the price of the up macro and bid up the price of the down macro, anticipating the changed future dividends. The price of the security need not track the index, but will anticipate the index."

"The price of the up macro will represent a long-term claim on the index, much as a stock is a claim on the future earnings of the company. People wanting to invest in the index can buy the up macro, and those wanting to protect themselves against any risk on the index can buy the down macro. In macro-securities, for every "long" there is a "short". The "shorts" are those exposed to a risk on the index, while the "longs" are the international investors."

A market portfolio consisting of macro securities on the GDPs of all the countries will represent a claim on everything of economic value and would be the "ultimate diversified portfolio".

Similar macro markets can come up for real estate prices for a particular city, wherein homeowners or mortgage lenders can hedge their risks by buying securities for individual cities and home equity insurers will use the markets to offer policies to homeowners.

Another risk mitigation instrument is the Livelihood Insurance. In an age of proliferating technologies and related jobs, there is a need to hedge against any risks posed by the maket to these very specialized livelihoods. This insurance will be vital towards encouraging development of these virgin fields by attracting fresh talent. An individual seeking to make a career in a particular field can purchase livelihood insurance issued for that field, which would insure him against any decline in incomes in that field. The risks he would have had to bear otherwise would now be borne by the insurance company. "The policy would pay him a regular income over the years in the event of a decline. He would pay for this policy by committing to pay as an insurance premium a fraction of his future income over the future years, or by committing to pay a fixed indexed sum per year over the years, or by committing to pay a combination of these two." The investors in the insurance company will of course hold the security so as to profit from any upside in the profession.

Livelihood insurance could cover all the jobs or careers. The employers could issue the insurance as an employee benefit or the unions could issue it for their members. For example, in a market for incomes of medical doctors, those starting out on the profession could be sold insurances by the livelihood insurers and the medical schools or medical associations (who have an interest in the prospering of this profession) could make investments in these markets by buying these macro securities issued by the insurers.

Examples of such risk hedging tools include the $1.865 loan arranged in 1994 by Citibank for Bulgaria, with an interest rate tied to the growth rate of its economy. Higher the growth rate, higher the interest that would have to be paid by Bulgaria. Bulgaria thus managed to transfer some of its economic risks to the diversified portfolio of individual and institutional investors.

The day is not far when kids seeking a career in cricket will venture out into the cricket pitch, armed with an insurance on income from cricket. We could see African countries benefitting enormously from external income linked loans, or Goldman Sachs issuing bonds insuring the future income of celebrities, or Income Tax Act being replaced with an Inequality Insurance Act to usher in a progressive taxation schedule whenever the present inequality levels threatens to get worse. All these will enable risk diversification on a hitherto unimaginable scale besides adding huge liquidity to our financial system.

Thursday, May 24, 2007

New Job for Wolfowitz!

If ever there was a perfect resume for any job, then Paul Wolfowitz is the man with the ideal credentials. So says Maureen Dowd, in an excellent New York Times op-ed, appropriately headlined "An Experienced Destroyer". Starting with Wolfie's CV,in an article dripping with sarcasm and vitriol, Ms Dowd tears into Wolfowitz, a man widely acknowledged in a bipartisan consenus, to being singulalry responsible for much of America's present foreign policy muddles.

President of World Bank : 2005-07
Responsibilities : Reining in European lefties, raining tax-free money on Arab girlfriend, and giving anti-corruption efforts in bad name.
Achievements: Paralysed the international lending apparatus to the point where small countries had to max out their Visa cards to pay for malaria medicine. Learned the traditions of many cultures, including those of Turkey, where you apparently are not supposed to take off your shoes at mosques to reveal socks so full of holes that both big toes poke blasphemously through.
Deputy Secretary of defence for President Bush : 2001-05
Responsibility : Starting a war.
Achievements : Mismanaged the world’s most powerful army. Shattered the system of international diplomacy that kept the peace for 50 years. Undermined the credibility of American intelligence operations. Needlessly brought humankind to the brink of nuclear war. Destroyed Iraq.
Demented Visionary : 1993- 2001
Responsibility : Concocting a delusional plan for regime change in Iraq with pals like Shaha Riza, Ahmad Chalabi and his merry band of Iraqi exiles who conjured up phoney intelligence about Saddam’s WMD.
Achievements : Imagining an Iraq that didn’t exist.

Having Wolfie back on the job market is a tremendous opportunity. What do we want next destroyed? Could this walking curse on the world run Halliburton into the ground? At the Pentagon, Wolfie tried to help the Vice get rid of anything multi-multilateral treaties, multilateral institutions, multilateral alliances, multiculturalism. Multi, to them, meant wobbly, caviling, bureaucratic and obstructionist. Why be multi when you can be uni?"

So what is Wolfowitz waiting for. There is the big job up for grabs, come November, 2008, for the President of the United States. It will be an ideal stage for Wolfowitz and his neo-con cronies to do an Attila makeover of the rest of the world. Further, the Americans themselves can have a taste of the Wolfie medicine which both Iraq and the World Bank have been privileged to have received. Till then, as a build up and to perfect his already considerable skills for the job, Dick Cheney could think of letting Wolfowitz loose on Halliburton!!

Move over Hillary Clinton, Barack Obama, and Rudy Guiliani! Let's roll out the carpet for Paul Wolfowitz as the 44th and the last President of the USA!! Hail the neo-conservative movement!

Wednesday, May 23, 2007

Artificially Scarce Goods

Goods and services are classified based on two characteristics - excludability and rivalness in consumption. A good or service is excludable if the supplier can prevent those who do not pay from consuming it, while non-excludable goods cannot be prevented from being consumed by anyone. A good or service is rival in consumption if the same unit cannot be consumed by more than one person at a time, non-rival if it can be consumed by many simultaneously. Non-rival goods therefore have the unique characteristic that the additional cost of adding one more consumer is . Private goods are the only goods and services that can be efficiently produced and consumed in a competitive market.

All private goods are obviously excludable and rival in consumption, whereas all public goods are non-excludable and non-rival in consumption. I am interested in the category of goods and services which is excludable and non-rival in consumption. These goods and services are called "artificially scarce goods". Though the marginal cost of allowing an additional consumer for such such goods and services is zero, they are always supplied at a cost to the consumer (probably to recover atleast part of the initial investment costs). These goods and services however suffer from difficulty in fixing their prices, due to which they are plagued by a problem of inefficiently low level of consumption. The most common text book examples of such goods are computer software and pay-per-view television.

Access to water and sewerage distribution networks, and by implication acccess to water supply and sewerage services, are also examples of excludable and non-rival services. These services are delivered through distribution networks, laid along road margins. The individual households take their connections by payment of some fixed connection charges to the utility service provider. They also pay a monthly tariff as consumption charges for the service.

However, there is one thing about these services that strike me as interesting and unfortunate. It is the inability of a large proportion of people to access these services, despite the presence of the distribution network in front of their homes. The connection charges necessary to gain access to a water connection, limits the uncontrolled access to these distribution networks. All the households in a street use the same distribution line to gain access to water connections. Once the network is laid, the marginal cost of any new connection is zero. However, the marginal returns are equal to the monthly water tariffs.

Connection charges are undoubtedly necessary to help regulate access to these services and ensure its long-term sustainability. But by restricting access, we are creating an economically inefficient outcome, both in terms of sub-optimal utilization of an infrastructure asset and also foregoing the monthly tariff revenue stream. Besides, we are also denying citizens access to basic civic services.

There are those who argue that by lowering access charges, we are foregoing a substantial one-time connection charge revenues. I am not even remotely going to dispute that this revenue is indeed susbtantial, but it will be revenue only if it is realised! And I have serious reservations about what portion of this unrealised amount can be collected, especially in the not so well off areas of the City. Experience shows us that in such areas once a utility network line is laid, on an average nearly half the population take connections immediately, while another 10-20% take connections within a few months, while the rest continue to refrain from accessing the service. The inefficiently low level of consumption therefore get frozen. In fact there are numerous streets in Vijayawada where a significant proportion of residents have not taken connection even years after the line was laid, due to prohibitive connection charges.

In fact, a significant portion of them access the service through illegal connections, public taps, technological spill overs etc. It has been found across all our cities that it is very difficult or even impossible to control these factors beyond a point. We therefore need to lure this residual category of consumers into leagally accessing the service. The challenge is to do this without distorting the incentive structure for the others. Have we not seen this before? Cell phone companies routinely offer many connection packages, some with lower access charges. This is done to capture certain categories of consumers who otherwise would not have taken the connections, thereby resulting in sub-optimal utilization of the network and loss of potential revenues. The central fact remains that we cannot expect the residual consumers to take connections with the prevailing connection charges. The problem we need to address is how much to lower and when.

Access to some of these services can and should be subsidised for certain category of consumers. A differential access charges policy can be introduced and the subsidy can directly cover the revenue foregone by the service provider. This would atleast bring the system to an efficient level of asset utilization, besides adding to the monthly revenue stream, and all this without any additional cost. To sceptics who doubt the ability of these residual consumers to pay even the monthly tariff charges, my contention is that most of these services are very reasonably priced and are even subsidised for certain categories of consumers. For example, the monthly water tariffs in Vijayawada is Rs 40 for the Below Poverty Line (BPL) households, while it is Rs 80 for the others.

All the other utility services - electricity, telephone, cable TV - suffer from this problem. All of them are examples of economically inefficient systems and are provided by both Government and private service providers. It may be appropriate for the governments and private service providers to have a re-look at how access to these civic services can be increased to its optimal level. Further, as we have already seen, eliminating or reducing bariers to access can be a helpful policy tool in even containing pilferage of these services.

Monday, May 21, 2007

Universal Health Insurance

Many State Governments as well as the Union Government in India have recently initiated programs offerring health insurance for farmers and other poor people. In this context, here have been voices calling for the Government to diversify its health insurance options by roping in private insurers. They argue that these private insurers, including the foreign insurance multinationals who have entered after the liberalisation of the insurance market, can offer cheap and good quality health insurance for farmers and the poor.

However, experiences from across the world, and in particular from the USA, shows that we should be wary of such prescriptions. It is now widely acknowledged internationally that till we come up with something better, Governments are the most efficient providers of any universal health insurance program. At best,certain services can be outsourced to private insurers. But then we in India are used to a time lag in accepting and rejecting trends. We tend to adopt practices and policies only as they start going out of acceptance in the west. (Remember how in the early nineties, the Government adopted the then discredited Laffer Curve theory, which argued that indirect tax revenues could always be increased by lowering the marginal tax rates). The same could be happening with this advocacy for private health insurance.

The need for Health Insurance assumes importance in light of the astonishing advances in medical technology. While these advances have undoubtedly saved many lives, these newer operations and surgeries, involving sophisticated instruments and procedures are very expensive. Experience from across the globe indicate that instead of reducing costs, technological advances have actually led to a steep rise in medical costs. It is therefore important to cover individuals, especially the poorer sections, with some form of insurance so as to hedge their health risks.

But insurance markets have certain very peculiar characteristics. It is plagued by the famous "adverse selection" problem, first conceptualized by the 2001 Economics Nobel Prize laureates George Akerloff and Joseph Stiglitz. Adverse selection arises from the inability of the market to recognise "lemons". A lemon refers to a defective item put up for sale. The presence of lemons throws up interesting possibilities in certain markets like those for used cars and insurance. Both these markets suffer from what economists call "assymmetric information" related problems. The sellers in these markets - used car owners and insurance claimants - have more information about the commodity on sale, than the buyers. For example in a used car market, in the absence of full information about the quality of the car, the buyer will be unwilling to pay the full price for even a good condition car. Similarly, sellers of good cars will be hesitant to put up their cars for sale since even good cars are likely to trade only at a discount. This dual effect is likely to see the market being occupied more by lemons than good quality products, thereby further deepening the information assymmetry problem.

A solution to this stalemate is setting up effective signalling mechanisms whereby the better quality product, whether used cars or individual insurance applicants, can differentiate themselves. But this is easier said than done and herein lies the problem with insurance market. The healthier individuals may be unwilling to pay the higher premiums charged by the insurance companies, who will therefore be left with the less healthier applicants. This in turn makes the insurance companies either hike up the premiums or put in place mechanisms to screen the medical histories of individuals. They try to screen out the lemons and keep only the healthy individuals. But this screening exercise is no mean task, requiring multiple levels of testing and monitoring. A bureaucracy then develops.

Private insurers spend significant resources screening out lemons. Is is estimated that in the US, these bureaucratic transaction costs account for upto 20% of the insurance costs for private insurers. In contrast the Government insurance programs like Medicare and Medicaid spend a mere 2% of the cost on administration, leaving the remaining 98% to be spent on medical care.

Further, rigorous screening procedures defeat the very purpose of providing insurance. It ensures that all those urgently and most necessarily in need of insurance are kept out of the insurance net. It reduces insurance sector to a mere profit making industry, with the provision of providing insurance being only incidental. We thus have an industry which seeks to provide health insurance ending up insuring all the healthiest and least needy customers for insurance, while eliminating all those most needing that insurance!

In view of the adverse selection problem and the need to have efficiency in delivery, it may be appropriate for any health insurance system to have the following three characteristics. One, any health insurance should be universal for the particular category proposed for. Second, people should buy insurance from the Government. Third, the actual delivery of medical service can be outsourced to multiple private health insurers.

By making health insurance universal and by getting government to sell insurance, we eliminate the costs incurred in fighting adverse selection. This will go a long way in bringing down the transaction costs. The core objective of providing health services can be outsourced to the private insurers, who will compete in Government run "Health Markets" (Senator John Edwards, Democratic Party Presidential nomination contender, has proposed something similar in the US) to sell insurance bouquets. The private insurers will sell insurance in these Health Markets to the Government, which in turn will sell it to the individuals. To be competitive in this market, the private insurers will have to reduce their overheads, and strike bargains with drug companies and medical service providers for reducing service cost. Here larger insurance providers like Government have an advantage in that they have significant bargaining leverage.

The insurance premiums will obviously have to be fixed taking into account the medical histories of individuals and will be calibrated in proportion to the market cost of delivering those services. Wherever the individual is unable to afford the premium, the Government can subsidise the individual to the extent required. The subsidy can be directly paid to the private insurance supplier. The element of subsidy, which in any case would be required, will therefore be beter targetted and utilized.

Health Insurance has generated a great amount of debate in the US since the nineties and is one of the most serious public finance concerns of the Federal Government. The Congressional Budget Office have repeatedly come up with figures explaining the serious budgetary implications associated with steeply rising health care costs. The contender for Democratic Party nomination for the US Presidential elections, John Edwards has outlined a similar plan, which envisages significant role for the Government.

As we have seen, insurance sector is an example of market inefficiency arising from assymmetric information. This requires Government intervention to bridge the information gap and reduce the attendant transaction costs. But the delivery of actual insurance service can be efficiently delivered by private insurers.

The experience in health insurance from across the world and in particular from the US, is a strong reminder to us about the continuing importance of government role and the deficiencies of the private sector in atleast certain markets. It reiterates the limitations of the market in delivering certain services, and the need for Government interventions during such market failures.

Sunday, May 20, 2007

Employees Motivation

One of the interesting differences in perception between the private and Government sectors is that the private companies see their employees as assets whereas Government employees are seen as liabilities! The consequences are evident in the low productivity and poor quality of work output, and the shockingly low levels of motivation.

In order to encourage employee motivation, the Vijayawada Municipal Corporation (VMC) decided to honor best performing officials in each wing. It was decided to select the best performers by conducting election among each category of employees. We thought that peer election was the surest indicator of the performance of an official, and peer recognition (more than even recognition by superiors) the most satisfying achievement for an employee. However, in order to ensure that it didn't become a popularity contest, it was decided to give 30% weightage in votes to the Head of the Department (HoD).

The voting was conducted for slection of the best three officers in ten categories, including ministerial staff. Besides them, voting was organised for the categories of Revenue Inspectors, Bill Collectors, Assistant Engineers, Work Inspectors, Building Inspectors, Sanitary Inspectors, and Social Workers. In this election experiment, each employee was to be a voter as well as to be voted on. The employee could however vote only in the election to his or her category of employees. Like the preferential voting arrangement, the voter had an option of selecting the best three officials in his or her opinion in that particular category. The first option was given three marks, the second two marks and the third option one mark. The marks were then added to arrive at the total marks polled by each employee. The marks secured in this was given 70% weightage and was added to the marks given by the HoD.

Over 800 employees exercised their franchise through secret ballot. The entire voting and counting process was according to the guidelines of the Election Commission of India for regular elections. The elections drew unexpectedly huge repsonse and excitement, and a turnout of over 95%. It was also decided to give handsome cash compensations to all the three winners in each category.

That the elections generated a lot of anticipation can be gauged from the fact that a good number of employees, who obviously were very confident of their abilities, came to me after the results and tried to justify as to how they were atleast as efficient as the winners. That to me was clear sign that we had succeeded in igniting the fire of competition among these employees.

When we thought about this initiative, one of the major stumbling blocks was how to get across the general difficulty in sanctioning financial incentives, over and above their regular allowances, to employees. I faced great reluctance and opposition from within the system to spend a mere Rs 2,50,000 for monetary awards to these best performing employees. (It is relatively easier in Corporations and the like, but very difficult in Government Departments to overcome the procedural limitations and then to get the money for these incentives.) I am convinced that these awards have done more for employee motivation and competition in the VMC than any other initiative (of which there are only a handful) in the recent past. I would strongly recommend that Heads of Departments be given certain budgetary allocation, for such HR related initiatives. It will do more good in improving employee motivation levels than any number of superfluous additional increments granted routinely to anybody who ages naturally within the organization. We are, as they say, penny wise and pound foolish. Always! But now we better change, at least slowly!

A few learnings from this experiment. One, we have yet to realize how poor the motivation levels of government employees are, leave alone initiating steps to remedy the situation. From what I can see by scanning around, there seems to be little stirring in this direction. Second, more generally, we care very little for human resources management. Indeed, beyond the usual routine training programs, which invariably are so poorly tailored to meet even the basic functional requirements, we pay no attention to managing our employees. We do not have any manner HR concept ingrained in the system. Third, we need to spare resources for HR initiatives, over and above the routine trainings. Budgetary allocations need to be made for this. Finally, during the process of this election, I have been awakened to the potential utility of the concept of peer selection. We should be applying this extensively elsewhere.

Saturday, May 19, 2007

Giffen Goods

At the outset, let me confess to being slightly apprehensive about this post, which maybe treading a bit too far than I have ventured till date! But ...

Normal goods are characterised by negative price elasticity of demand. However, in case of Giffen Goods, the rise in price of the good results in increased demand. It is believed that there are no actual Giffen goods, though certain inferior goods, without close susbstitutes, exhibit under certain circumstances the characteristics of Giffen goods.

However, I have long been puzzled by two examples which seem to exhibit Giffen good characteristics. First, any market which is developing a bubble - stocks, property, currencies, etc - exhibit Giffen features. As the price of the asset rises, a self-fullfilling prophecy cycle is initiated and the asset prices go up, and the bubble builds up. The asset displays Giffen characterisitcs during its build up, and regardless of the rapidly increasing prices, the demand goes over the roof.

Primary Health Care is another good exhibiting Giffen features. How? If the cost of primary health care goes up, it is natural for people to cut back on their visits to clinics or hospitals. People respond by improvising with traditional home remedies or quack prescriptions. The result is that the disease or illness is mis-diagnosed or not properly attended to. This in turn aggravates the condition and in more cases than not, the patient needs the services of a doctor and often admission to hospitals. The patient ultimately ends up spending more that he would have in the first place, if proper treatment was given. (I am sure there are empirical studies bringing this out in clear quantitative terms) Interestingly, this is another reason why the Government ought to be subsidizing primary health care.

Primary Health Care meets the basic tests for Giffen goods. Primary Health Care is an inferior good, in so far as its consumption decreases with rising living standards. Rising living standards are associated with better nutrition and hygiene levels, thereby reducing the chances of primary health hazards. Also Primary Health Care cannot be susbstituted.

I have only drawn attention to two examples which have been rankling in my mind for sometime.

Friday, May 18, 2007

Housing Rental Market

Shelter for all is among the Millennium Development Goals (MDGs) enunciated by the United Nations. Urban Housing is one of the major challenges facing administrators and policy makers across the globe. It is also unfortunately one of the issues trapped in the gridlock of outdated policy prescriptions and bureaucracy.

The Union and State Governments in India have over the years taken up housing as a priority welfare activity and programs like the Indira Awas Yojana (IAY) and the Valmiki Ambedkar Away Yojana (VAMBAY) have gone a long way towards addressing housing problems in many states. The IAY and its other variants have dovetailed Government of India and State Government finances, with a small beneficiary share, to construct basic housing units. A few States like Andhra Pradesh have recently started leveraging institutional finance from Nationalised Banks and thereby expanded the coverage.

A time has now come to have a serious re-look at this model, especially with respect to urban areas. I have a few reasons as to why we need to move beyond this model and look at other options. Foremost, with increasing urbanization, the demand for housing in urban areas has far outstripped the supply and the deficit is widening sharply. Land is an extremely scarce commodity in our cities, and it is imperative that we make the most optimal use of this resource. Further, the urban poor have certain unique characteristics, which mark them out from the rural poor. Migration is one of the important characteristic traits among urban poor and it is necessary for any urban housing model to take this into account.

We need to construct our urban housing model by taking into account the specific context, the profile of the beneficiaries, their requirements, and then integrate this with our broader socio-economic goals vis-a-vis economic development in urban areas. We need to ask these questions before framing the answers.

In the present arrangement, it is commonplace to find people selling away their housing units, and moving again into squatter slums. In a VAMBAY settlement of 3372 houses in Vijayawada, it was observed that in 3 years about 850 have sold away their houses and about 500 have rented out their houses. Of those who purchased the houses, more than 60% have made substantial changes to the old, Government constructed houses, and some have reconstructed better houses and converted them partly into commercial units. This VAMBAY Colony is surely representative of Government sponsored Urban Housing Projects across the country. This can be partially controlled by building only multi-storied tenaments.

It is important that housing policies meet our broader economic objectives. Urban Housing should seek to cover those sections of the economy who are essential foot soldiers in the urban growth engine. Policy makers need to be sensitive to the need for regulated and controlled development of urban centers. Our rapidly growing cities, severely constrained by lack of basic civic infrastructure, should not be strained to its seams by massive influxes from rural areas. We need to leverage the economic growth in our cities to reducing poverty by expanding opportunities for the poorer people, but also be aware of the dangers posed to the sustenance of this growth. Ultimately our poverty elimination and other objectives will be achieved only if the City continues to remain vibrant and grow. If we do not wake up to this challenge, we could end up killing the proverbial goose that lays the golden eggs.

The primary objective should be to provide housing for a specific category of poor, who are vital contributors to urban growth. Otherwise, it will only serve as one of the many ill-directed incentives, which end up promoting indiscriminate urban migration. Instead of adopting a one-size-fits-all approach in equally subsidising all the urban poor, the Government may consider providing differential subsidies to various categories of urban poor, based on the larger development objectives. For example, semi-skilled or self-employed urban poor who are vital to driving urban growth, need to be incentivised, as opposed to unskilled and un-employable poor migrating from rural areas, whose services are more immportant and can be better utilised in a rural economy.

What is then the policy solution to Urban Housing? I believe that we can better address these concerns if instead of allotting houses, we create a market in rented government housing for the poor. Instead of transferring ownership to the inhabitant, a pool of such housing units can be constructed and made available in the market. A seniority list of beneficiaries can be prepared and they can be allotted rent vouchers. These vouchers can be allotted for a year at a time, and can then be renewed, thereby keeping a check on fraudulent practices like sales and sub-leases by the original allottees. As an incentive, the house can be finally transferred to the tenant after a certain period of responsible habitation, under certain conditions.

To those who will claim that the rents will be an additional burden on the poor, my answer is that they are already paying atleast Rs 500-1000 as monthly rents for squatter huts in slums, without access to any basic civic facilities. In contrast to this, in such housing colonies they would no longer have to suffer from problems associated with uncertainty in tenure, and will have access to all the basic civic facilities. In any case all Government Housing schemes today have a significant bank loan share, which the beneficiary has to repay through monthly instalments. Rental vouchers would only be substituting the payments to the bank with the private developer, while ensuring far better quality in construction and in maintenance.

In order to dovetail resources from other sources, we need to extensively encourage Public Private Partnership (PPP) in this sector. Given the booming construction market, huge demand for poor and lower income housing, and the plethora of long-tenor financing options available, these ventures offer tremendous potential for real estate developers. Fifteen to twenty year Build-Operate-Transfer (BOT) contracts can be an attractive business proposition for developers, who can collect pre-determined rents from the tenants. The rental subsidy offerred by the Government can be directly transferred to the private builder. This would ensure better targetting of the subsidies and its more efficient utilisation. Further, instead of the single size homogeneous housing units, the private builder can be given the freedom to construct units with small variations in plinth area and amenities.

While issuing the vouchers, the Government can give beneficiary the freedom to choose between the many available private and Government housing units. While the Government will only provide the basic minimum of subsidy, the beneficiary should be free at any time to move to a higher category of housing by paying the differential over the subsidy. All these will generate a healthy competition between private builders and ensure quality in construction and maintenance.

Rent vouchers will also help us utilise our scarce subsidy resources more effectively. Instead of spending the subsidy upfront for construction, it can now be drawn down over a longer time frame. This will help cover greater number of beneficiaries than would have been possible by constructing houses and directly transferring ownership. Thus, instead of covering 1 million beneficiaries over 15 years, we can now cover all of them over a couple of years.

The rental vouchers are an economically efficient system of targetting subsidies and meeting the welfare objectives. By encouraging competition among private builders, it ensures good quality of construction and more efficient utilisation of resources. It also reduces the market distortions like sale or lease of housing units and allotment to the less needy and denying those urgently and most badly in need of housing. By giving the beneficiaries the freedom to choose their housing locations and categories, rent vouchers will make urban housing program for the poor more demand driven. An efficient system should be able to self-select its target beneficiaries, while screening out the ineligible. In the absence of any better alternative, rent vouchers look the best bet yet.

Edward Glaeser and Joseph Gyourko present a road map for a new Housing Policy for the US, with strong emphasis on vouchers. The full policy text is available here.

Wednesday, May 16, 2007

Corruption and High Value Customers

The Municipal Corporations are concerned with delivery of a variety of civic services to citizens - building plan approvals, birth and death registrations, tax assessments, property title transfers, water and sewerage connections etc. Though the Citizen's Charter has specified fixed time schedules for the delivery of these services, it is followed more in its breach than observance. It is normal practice for citizens to be harassed by making them run around the respective offices for these services. The more resourceful individuals however manage to get their work expedited by bribing the officials. This arrangement suits the rent-seeking establishment as well as those willing to pay the additional rent for these services.

My prescription to solve this problem is to formalise and then institutionalize this rent-seeking. How do we do that? The Municipal Corporation needs to put in place a mechanism for identifying all those who would be willing to part with this additional charge (which they pay by way of rents) for receiving these services. One way is to enlist certain high value citizens who need regular interface with the Corporation, as premium customers of the Corporation, on payment of a fixed yearly subscription amount. May be the Corporation can issue an "Edge Card" to these premium cusotmers, which will enable all members to access VMC services through a fast-track mechanism. The subscription amount should be decided by the market populated by such high value customers.

Another option is to have differential pricing for these services. Those who are ready to wait and get these services delivered within the time period specified in the Citizen Charter will continue to pay the normal fees. But those who require the services urgently can be charged certain amount, depending on how quickly they need it. Indeed we can even have across the counter delivery of most services, with all the verification and scrutiny done in an hour or so, but at a high premium. I am sure it is a premium those in need will readily pay for.

The solution is an economically efficient one, in fact it is a Pareto optimal one. Many citizens are in any case accessing and getting their work done through back-door and informal channels. The cost of the services delivered by this route went towards enriching individual officials as a form of speed money, without any way benefitting the Corporation. This payment of speed money generated an unhealthy environment within the Corporation, wherein all the citizens were harassed in expectation of some illegal gratification. There was no way for the official expecting the rent to differentiate between those who were willing and capable of paying and those who were not. In the end, both categories ended up harassed. Now the Corporation would be able to capture the cost of the services, and even develop a market in such services. The "Edge Card" may also emerge as a sort of status symbol for its holders, and may help attracting a significant number of the rich and wealthy of the City. In fact, it can even become an effective instrument in channelizing philanthropic efforts towards the city's development.

Suppose A and B apply for a building plan, under normal circumstances both plans have to go through the same scrutiny and approval process. The process does not account for the premium attached by any of the applicants in getting the plan cleared at the earliest. If A urgently needs the plan and is willing to pay additional fees to expedite its approval, then the existing process does not take into account this willingness to pay. An economically efficient market in municipal services will calibrate price of services against demand, so as to minimize any deadweight losses. Differential pricing for services will enable A to get his Plan approved earlier than B, but for a cost which A is willing to bear. B will in any case get his Plan approved within the statutorily mandated time period. This arrangement is a Pareto optimum when compared to the previous one-price-for-all system, since we are now making both A and the Corporation better off, while B is no worse off.

What is the flip side to this arrangement? Critics may say that it is pandering to elitism in delivery of even basic civic services. My counter would be that it would only be formalising an existing arrangement, which cannot be wished away nor can be controlled beyond a point, without in any way affecting the mandated schedule of delivering services. It would make a significant dent on rent-seeking behaviour, in fact even questioning the very need for such payments. It would also bring in much greater transparency to the delivery of such services. For the moralists among us, the downside by way of commercializing even basic government services, is more than counteracted by the upside in containing corrupton which was eating away the fabric of our society.

I have tried to address only a certain category of corruption in this post. Economics as they say is the study of how "agents respond to incentives". By that yardstick alone corruption is an interesting field for application of economic principles.

Why is it difficult to spend money?

Before joining government service, I could never understand when news reports at the end of a financial year informed that our Government and its agencies had failed miserably to meet its spending targets. It was impossible for me to believe that agencies could not spend money. I thought getting money was the problem and spending it the easier bit! After all, I had struggled (and continues to struggle) with the meager pocket money allocated to me all my childhood! Whatever money I got, disappeared within a week or even less. I had thought, may be they should try out people like me in Government!

Now, years later, in Government I have a different prespective on this issue. The Vijayawada Municipal Corporation (VMC) has recently been the recipient of a wind fall from the Government of India's Jawaharlal Nehru National Urban Renewal Mission (JNNURM). We have been sanctioned Projects worth $200 million (Rs 800 Cr) for providing water supply and sewerage, roads and public transport, and housing and slum development. We have been implementing this Project since the past year and I will recount some of my frustrations in this thankless exercise.

The problems span the entire process of Project execution, starting from selection of a consultant, tendering and bid process management, finding a contractor itself, to monitoring the project execution.

Our Engineering procedures are an anachronism in a market booming with construction activity. The tenders for all engineering works are prepared using the Standard Schedule of Rates (SSR), which gets revised annually in July or August. The SSR list was itself formulated decades back and so does not incorporate the costs for many of the more recent additions. Further, the rules prohibit awarding any tenders for a premium of beyond 5%. The technical qualification criterion for contractors have been formulated keeping in mind civil contractors and does not factor in the requirements for selecting contractors for modern electro-mechanical systems and Operation & Maintenance (O&M) of such systems. These guidelines and procedures were in short perfectly suited the bygone era when they were formulated.

Now, in a more liberalised era, when market determined rates are the norm and outsourcing the accepted practice, these are serious constraints and limiting factors. The SSR rates need to be either indexed to the market or need to be revised more frequently. The newer work components have to be incorporated into the SSR or maybe guidelines iussued for standardising their rates. Most importantly, the limits on tender premiums have to be scrapped. The water-tight one-size-fits-all approach to technical evaluation needs to be dispensed off, by giving more flexibility to the tendering agencies in defining such criterion.

The implementation machinery itself suffers from a severe lack of capacity. At a time when we take pride in our country being at the fore-front in the use of Information Technology and computers, we are seriously deficient in using these technologies for monitoring work implementation in Government. The execution and monitoring of these big infrastructure projects can be facilitated and considerably speeded up by using customized project management software. However these techniques and systems have yet to make any in roads into Government bureaucracy. Given the enormity of the tasks, without using them, it is impossible to execute these projects in any reasonable time period.

Forget control systems and automation, there are glaring inadequacies even in the basic processes and technologies we employ in construction. For example, we continue to do on-site preparation of the concrete mix for the majority of our civil constructions without employing technolgies like Ready Mix Concrete (RMC). Early morning today, I was inspecting a Rs 4.5 Cr or $1.1 million work involving construction of a 2.4 km long storm water drain. This work would use 12000 cubic metres of 1:3:6 cement concrete or 52800 bags of cement. Even with RMC, it would need 2000 loads, and will take atleast 2-3 months. But our Engineers are presently doing this work by on-site mixing of these 50,000 odd cement bags, and it would take some effort if this work were to get completed atleast this year. (This is something similar to an ant climbing Mt Everest!) Why then are we using RMC? My Engineers say there is just one RMC plant in the area, including in all the neighbouring districts, and that is working at full capacity and is unable to meet the requirements (as they say in finance, oversubscribed many times over!).

On the question of drains itself, the VMC has been sanctioned over 400 kms of storm water drains of various sizes. A drain work is very simple, but one of the more laborious categories of civil works. It involves laying different concrete beds, raising centering, and then filling body walls, all of which requires long curing periods. The long duration of the work, especially in thickly inhabited areas, invariably affects the quality of the work and causes enormous inconvenience to the public. Given this major constraint, I cannot imagine why a market for pre-cast structures has not developed so far. In fact, pre-cast structures have their utility not only in drains, but in most other civil works, including roads and housing. There isn't a single established pre-cast civil contractor in the entire State. We are still waiting for these developments.

One thing is for sure, these problems will be solved with time. But their resolution can be significantly expedited if the Government takes intiative and addresses them directly, rather than letting the market take its sweet time in finding solutions. Governments need to pro-actively promote and even create these markets, streamline and liberalise procedures, and incubate and spread basic technologies. Until we are able to solve these problems, we will continue to stumble along by miserably failing to achieve our spending targets.

I have only read about the Chinese economic boom. I am told they laid more than 20,000 kms of highways and more than 10,000 km of railway lines, including those supporting high speed trains, just last year alone. Infrastructure activity and its multiplier on the economy has contributed significantly towards the Chinese economic miracle. While we struggle to achieve even modest spending targets, the Chinese economic system seems to have no problems guzzling hundreds of billions of dollars. What is the difference? Maybe we can draw some useful lessons from them.

I have only outlined some of the demand side bottle-necks. There are many more such examples. There are of course the supply side constraints, involving the inability of the system of contractors and service providers, to soak up this investment and deliver services. That will be the concern for a later posting.

Tuesday, May 15, 2007

End of America!

There is an interesting debate in the Guardian, triggered off by an excellent article by Naomi Wolf "Fascist America, in 10 easy steps"..

Lord Byron it was who said, "Eternal vigilance is the price of liberty". That there has been a breakdown in this vigilance is brought out brilliantly, though sometimes with a little hyperbole, by Ms Wolf, "Because Americans like me were born in freedom, we have a hard time even considering that it is possible for us to become as unfree - domestically - as many other nations. Because we no longer learn much about our rights or our system of government - the task of being aware of the constitution has been outsourced from citizens' ownership to being the domain of professionals such as lawyers and professors - we scarcely recognise the checks and balances that the founders put in place, even as they are being systematically dismantled." Ms Wolf has alerted us to the creeping dangers of such totalitiarian tendencies in American political institutions.

It is indeed staggering to realise how far the Bush administration has fallen. The list of administration idealogues and cronies under scanner for corruption and other fraudulent practices is growing - Paul Wolfowitz, Alberto Gonzales and the Federal Prosecuter Gate, Lewis Libby, Conrad Black, the Halliburton gang, Texan oil groups ...

I can't imagine many Governments, even in some of the more dubiously democratic countries, surviving this relentless carnage of character and integrity, which the Bush administration has been facing every day for the past two years. Are the American people turning a blind eye, or are they simply ignorant of this orgy of malfeasance and fraud? If it is the later, as I am inclined to belive, then there is a major problem with the media establishment in that country. How can so many intelligent people be continued to be fooled for so long a time? Where have all the upholders of truth and justice in the Fourth Estate disppeared to? Amira Hass, writing in the Israeli newspaper Haa'retz, spoke about the role of media as "questioning the centres power". But by that standard, the media has long since abdicated its responsibilities. As an outsider following US mainstream media closely through the major newspapers and magazines, I am struck by this self-censorship and the lack of outrage or even concern about this state of affairs in a country which prides itself as the fountainhead of democracy and good governance.

Next time US Human Rights watchdog Freedom House rates countries on various indices of freedom, it may do better to take a pause and do some introspection. To re-phrase Mao Zedong, "let a million Naomi Wolfs and Noam Chomskys bloom"!

Sunday, May 13, 2007

Random Walks and Fractals

There is an article by Benoit Mandelbrot and Nassim Nicholas Taleb, which is a superb explanation of the deficiencies in modern financial theory "How the Finance Gurus Get Risk All Wrong". It is also a reminder to all of us that we are captives to the ebbs and flows of the major academic trends of the time. As Keynes had said, " Practical men, who believe themselves quite exempt from any intellectual influence, are usually slaves of some defunct economist".

Despite its proven obsolescence, standard measures of risk are still holy cows in the corridors of modern finance. Power Laws have yet to make any dent in the Gaussian Distribution dominated world of modern finance. Classical economics, revolving around concepts of equlibrium and the utility maximizing rational economic man with access to perfect information, continues to hold sway in Eco 101 courses across the globe. Business Cycles and other major events continues to be explained by the exogenous shock theory. No where is this disconnect more stark than in the practical world of equity markets. Mandelbrot and Taleb says:

"Your mutual fund's annual report, for example, may contain a measure of risk (usually something called beta). It would indeed be useful to know just how risky your fund is, but this number won't tell you. Nor will any of the other quantities spewed out by the pseudoscience of finance: standard deviation, the Sharpe ratio, variance, correlation, alpha, value at risk, even the Black-Scholes option-pricing model. The problem with all these measures is that they are built upon the statistical device known as the bell curve. This means they disregard big market moves: They focus on the grass and miss out on the (gigantic) trees."

The same applies for our regard and the importance attached to stock analyst valuation of equities. The fundamental parameters necessary for valuation of any asset are its projected cash flows and the rate at which these flows are discounted, besides the other environmental factors like inflation, taxes etc. But there are no fail-proof methods for calculating the afore-mentioned two parameters. Despite this, stock valuation and stock picking are the accepted norms in modern finance theory. Instead of asset allocation and portfolio diversification strategies, investors are lured straight into the glitz of stock-picking. As they say "never have so many intelligent people been all chasing such completely false theories". For more on this, Henry Blodget has an excellent piece in the Slate, "Stop Picking Stocks - Immediately!".

Update 1
Nassim Nicholas Taleb excoriates the portfolio theory, law of large numbers, and the pervasive use of statistics in finance, while Harry Markowitz mounts a defence of MPT, distinguishing it from financial engineering.

Saturday, May 12, 2007

Public Discourse in the Age of 24X7 TV News Channels

I have often wondered at the contribution of the media, especially the now ubiquitous electronic media and the news channels, in setting the public agenda and in generating discourses on important issues of public concern. It is common place to find any political or social event succeeded by a series of analyses on different TV channels, dissecting and vivisecting the minutae of the issue.

However, having seen numerous such programs on issues varying from politics to social issues, business to science, and arts to sports, I have often been left wondering, "where is the beef?" . This uncanny knack of invariably overlooking or missing the substance is one of the chief characteristics of modern day television news reporting. Any event is immediately characterised as the greatest, worst, defining point, or water-shed or in some other superlative. However this superlative remains only till the next event happens. If somebody from Mars were to arrive on earth (or someone were to resurrect from 18th century) and watch the Television footage of news channels over the past one year, he would consider it his good fortune to be part of a period where so many definitive events have all happened.

I was seeing a program on the UP election results telecast by the ND TV on Saturday night. The Program was titled, "Is this (UP election result) a turning point in caste politics in India?".
I was struck by the sheer profoundity of the question and its use in this context.
Yes, Mayawati had won a landslide. Yes, it was an apparently irreconcilable dalit-brahmin platform that saw her through. Yes, Uttar Pradesh continues to be the most critical determinant shaping Indian politics. Yes, it was the first time in over a decade that a party had emerged so triumphantly in UP elections. Granted all this and even more, but does the vedict merit asking a question as profound as this?

We have had innumerable twists and turns in Indian (more specifically North Indian) caste politics. It has been a series of commas but never a full stop, as it should be on such issues. There has been the Reservation Bill for SC and ST; the Mandal movement and the OBC reservations; the definitive emergence of sectarian parties like the Samajwadi Party, the Bahujan Samaj party (BSP) and the like; numerous Supreme Court and High Court verdicts that have then threatened to tilt the balances in caste politics. But the issue unfolds and plays out like the Hegelian dialectic - the thesis, followed by the anti-thesis, and then the synthesis, and the cycle starting again...

It speaks of nothing short of ignorance to even ask such a question for a serious debate. UP has had numerous elections in the past two decades (I guess, more than it has ever had). Each election has seen an emergence of a unique socio-political coalition which represented the balance of forces at that time. What is it that is so different this time that makes us confidently predict that the balance of forces and the issues will not be different five years hence? Even assuming that this election has definitively changed the social equations in UP, is it even sensible to suggest that it has also changed the caste equaltions in Indian politics? I leave it to readers to make their judgements. But mine is clear.

I got the distinct impression that the question was aimed more at sustaining the program than based on any merits of the issue. The questions in the debate also seemed to convey a desperate attempt at justifying its labelling. In teh face of sustained competition and with viewers spoiled for choice (or the lack of it!), the TV channel had to come up with a rabbit off its hat, to wean away the viewers from its competitors and towards itself. What better way than through such grandstand debates?

One of the more common forum of indiscriminate use of superlatives and display of ignorance and hubris is sports telecasts, especially cricket. We see usages like great, best, finest, and so on being liberally thrown about in every other sentence uttered by our celebrity television commentators and sports analysts. Thus today we have Sachin Tendulkar as the best batsman of all time, to be replaced tomorrow by Brain Lara, and the day after that by Ricky Ponting.

The power of television, especially in an age of more passive reception, in shaping public discourses cannot be over-emphasized. The unfortunate thing with such programs is that it obfuscates the real issues and takes public debates on very important issues, off the track. In all this grand drama, the casualty has been our inability to see things in perspective. Our perspectives are so blinded by the immediate, that we lose sight of the history.