Thursday, January 31, 2008

Monetary policymaking

Forget the finance ministries of the world, the new power centers are the boardrooms of the Central Banks. Like Kremlin watching during the Cold War, scrutinizing and analyzing every move of these Central Banks and their powerful Chairmen have become the latest fad. Every statement is dissected and vivisected to glean out some underlying message about the policy trends of these Banks. Based on these perceptions, the financial markets and following them the economy at large, form expectations about the future monetary policy actions. And in an increasingly complex and integrated global financial markets, where market sentiment and confidence is of critical importance, the importance of expectations cannot be over-emphasized.

On 29th January, 2008, the Reserve Bank of India (RBI) came out with the annual credit policy review and on 30th January, 2008, the Federal Open Market Committee (FOMC) of the US Federal Reserve had its regular periodic meeting. Both these pre-designated events are forums where the RBI and the Fed are expected to announce the latest interest rates. Predictably, both were preceeded by massive and frenzied media speculation, flying in all directions, about the possible interest rate decisions. The speculative excesses, focussed on the decision expected to be taken on a fixed day and time, had started a good 2-3 weeks ahead. It also generated a whole spectrum of expectations among the market participants, revolving around the likely consequences of whatever decision was taken. It may not be incorrect to even claim that the market had travelled well in advance of the decision.

In many respects, it can be argued that the market speculation had foreclosed the options available before the Fed. For example, following the un-scheduled and dramatic 75 basis points cut of the Federal Funds rate by the Fed on 22 January, 2008, the markets had jumped to the conclusion that come the FOMC meeting on 30th, January, another 50 basis points cut was inevitable. These expectations effectively tied the Fed's hands. If contrary to the market expectations, it did not lower rates by 50 basis points, the markets would in all probability have reacted negatively. The financial markets had already betted so heavily in favor of a 50 points rate cut, that any other alternative would have triggered off a crisis.

Further, by providing the build-up time, the Fed may have even defeated many of its own objectives. In times of a liquidity and solvency crisis, one of the important objectives of monetary policy is to provide some time-cushion for the affected market participants to get their balance sheets into some semblance of order. However, speculative excesses that invariably get formed during the build-up time may outweigh the likely benefits of any monetary easing. The FOMC meeting on January 30, provided an anchor for the market to pre-empt the Fed, thereby reduce the impact of the January 30th rate cut and also effectively present a fait accompli to the Fed. Instead of providing cushion-time, it becomes an opportunity for more speculation.

Any policy decision, more so the monetary policy, will achieve its desired objectives only if the market reacts to it. If on the contrary, the market is allowed to form expectations of such decisions, which in turn determines the policy itself, then we have the recipe for bad policy making. While the present dispensation of announcing interest rate changes may have been suitable previously, it no longer appears the most ideal way of announcing interest rate decisions.

In light of the aforementioned, a few questions are in order. Has monetary policy emerged to such pre-eminence as to over-ride all other macro-economic policy levers? Are interest rates, such a critical macroeconomic variable, to the near total exclusion of all others? If yes, is this a desirable or healthy outcome? Given the extremely volatile and fluid nature of the global financial markets, are fixed and pre-specified meetings like the FOMC or annual credit policy statements, the appropriate forums to announce interest rate decisions? Does it not leave the Central Banks vulnerable to being pre-empted by the financial markets? Are we not experiencing an increasingly media dictated monetary policy? Is all the media attention and speculation surrounding interest rate reviews good for monetary policy? Or is the "wisdom of the crowds" beneficial in arriving at the right interest rates? Is interest rates driving inflationary expectations or the other way round?

In any case, I am convinced that like Sun Tzu's description of a good general, "An effective Central Bank should be felt and not seen!"

Tuesday, January 29, 2008

Mint article on risk in financial markets

Here is my Mint article on two rapidly emerging trends from the global financial markets that are a cause for deep concern—a widening returns gap between categories of investors, and increasing difficulty in locating and pricing risk.

Where do risks go?

Standard financial theory suggests that risks should be borne by those who understand it best (and are hence able to take steps to hedge for it or mitigate it). But reality, as is borne out by the sub-prime crisis, seems to suggest exactly the opposite!

The latest annual report of the Bank for Internatonal Settlements (BIS) says, "By the time crisis hits it is far too late. It is well before then that people make mistakes. Usually, moreover, it is not those responsible for the mistakes who suffer, but everybody else."

The BIS notes: “There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking...Moreover, should liquidity dry up and correlations among asset prices rise, the concern would be that prices might also overshoot on the downside.”

Modern financial theory also claims that diversification of portfolio results in the reduction of risk. There can be no better example of portfolio diversification than some of the marvellous products of financial engineering like Collateralized Debt Obligations (CDOs). But despite the proliferation of such instruments, instead of reducing it, systemic risk in the global financial system appears to have increased.

Modern banks have also learned to hide away their risks in off balance sheet entities like Special Purpose Vehicles (SPVs) or Structured Investment Vehicles (SIVs), hedge funds, private equity funds etc. These off-balance sheet entities take on the loans issued by banks, and thereby free them to do more lending and assume ever more risk. This cascade of increasing risk is compounded by the fact that the banks are supported by very little equity capital, or very thinly capitalised, much less than that owned by many private equity firms.

About how the financial innovations of recent years has landed the entire financial system in a soup, Paul Krugman writes, "The innovations of recent years — the alphabet soup of C.D.O.’s and S.I.V.’s, R.M.B.S. and A.B.C.P. — were sold on false pretenses. They were promoted as ways to spread risk, making investment safer. What they did instead — aside from making their creators a lot of money, which they didn’t have to repay when it all went bust — was to spread confusion, luring investors into taking on more risk than they realized."

Gillian Trett writing in the FT, Draining away: four problems that could beset debt markets for years, argues that contrary to popular belief, the financial engineering of the past decade has not done much to diversify risk. He writes, "But the feverish financial innovation seen this decade has enabled banks to turn corporate and consumer loans into securities that have then been sold all over the world. Until recently it was presumed that this innovation had made banks stronger than before, because they had passed credit risk on to others. Consequently, regulators and investors tended to presume that the main threats to stability in the modern financial world came not from banks but risk-loving players such as hedge funds. Recent events have, however, turned these assumptions on their head. Although some hedge funds have run into problems, their losses have generally not posed any wider systemic threat. Instead, share prices of the banking groups have slid as it became clear that banks had offloaded less risk from their books as investors and regulators had presumed. Indeed, the interbank market is gripped by fears that more banks could soon tumble into crisis, as they run out of capital with which to write off loans. Sectors that had been widely ignored in recent years because they seemed utterly safe and dull - such as bond insurers, money market funds and structured investment vehicles - are also beset by a loss of confidence."

Nouriel Roubini, in an article, The Dark Matter of Financial Globalization, has blamed securitization for the increase in risk. Securitisation is the process by which lenders pool their loans into shares with or without structured tranches, and raise money in the capital markets. The banks and other lending institutions are therefore able to take out the credit risk from their books. They are backed by assets like mortgages, commercial and retail loans, credit card debt etc. Mortgage backed securties form over 80% of the market in asset backed securities.

It allows banks to remain in the mortgage business as originators and intermediaries without taking too much of the interest-rate, term and liquidity risks on to their own highly leveraged books. These risks are in turn transferred on to those investors who want longer-term, higher-yielding assets. By increasing liquidity it ensures that the riskier borrowers have access to more credit than before.

It sought to shift the risk of term-transformation (borrowing short to lend long) out of the fragile banking system on to the shoulders of those best able to bear it. What happened, instead, was the shifting of the risk on to the shoulders of those least able to understand it. What also occurred was a multiplication of leverage and term-transformation, not least through the banks’ “special investment vehicles”, which proved to be only notionally off balance sheet.

Despite the complexity of securitization transactions and instruments, the two fundamental concerns are the same - the quality of the underlying loan collateral and the pricing of this risk. Securitization, by transferring the loans from the balance sheets of the originating banks, encourages moral hazard by way of irresponsible lending. This can be reduced only by an incentive structure which prices the risk accordingly.

A paper by Robert Van Order, On the Economics of Securitization: A Framework and Some Lessons from U.S. Experience, offers a detailed analysis of the securitization market. The article puts the issue in perspective thus,
"Broadly speaking there are two models for funding loans: the portfolio lender model, which typically involves banks or other intermediaries originating and holding the loans and funding them mainly with debt, most often deposits, and the securitization model, which involves tapping bond markets for funds, for instance by pooling loans and selling shares in the pools. A central issue with securitization is that while securities markets are efficient sources of funding, they also involve agency costs because bond market investors are often at an informational disadvantage relative to other traders."

The risk transfer chain for securitization works something like this. The ability to transfer instead of holding risks, coupled with assymmetric information, increases the moral hazard of irresponsible lending. Unlike in the past when the extent of risk and the bearer of risk was easy to identify, complex financial instruments like CDOs have dispersed risk deep and across the system, making identification impossible. This makes it difficult to restructure or reschedule debt, thereby restricting one of the main levers of managing financial meltdowns.

There are three eaxmples which highlight how the financial complex transactions and sophisticated instruments, actually gave only an illusion of risk transfer. One, is the complex inter-relationship between the Wall Street Banks and the hedge funds and other alternative investment strategy vehicles. In the US, three investment banks - Goldman Sachs, Morgan Stanley, and Bear Stearns - dominate the prime brokerage, which provides hedge funds their finance (raised from high net worth individuals and other institutions) and also lend them shares for shorting. The fact that these three act as brokers for 60% of all the hedge fund assets is itself a cause for concern arising out of lack of diversity. What is more disconcerting is that these banks may actually be taking back all the risks they purport to sell away. Consider the example of credit derivatives. Banks owning corporate bonds buy credit default swaps (CDS) to hedge against defaults. But if the swap is purchased from a hedge fund, which itself depends on the Bank for loans, then we have effectively no transfer of risks!

Second example of risk not adequately hedged is the potential conflict of interest between the regular trading desks of the investment banks and the prime brokerage arms. The prime brokers who work closely with the hedge funds, are likely to have valuable information about the positions taken by the hedge funds. This leaves the door open for the prime brokers to share this information with the trading desks.

The third example of risk being scattered within the same organization, while giving the impression of diversification, was the Kilo Funding, pioneered by Bear Stearns. Kilos were CDOs issued by Bear Stearns, which sought to tap the short term money market funds, by offering higher than regular interest, and a "liquidity put" guaranteeing the full repayment, issued through a Wall Street Bank. The money was in turn used to provide cash for the hedge funds owned by Bear Stearns and also buy ABS from the Bank itself and the hedge funds. The entire risk was localised within Bear Stearns and the Wall Street Bank!

Andrew Leonard highlights the role of hedge funds, with limited expertise in insurance and risk management, in selling Credit Default Swaps on everything from corporate default swaps to subprime CDOs, as insurance against defaults. Even worse, the hedge funds were selling protection to investment banks that were their own sources of credit. In other words, they were borrowing money from the same banks that they were insuring against bond default. So if the default occurred, they'd have to make good their own lender.

Andrew Leonard also makes a very forceful case for regulating financial markets, so as to limit the uncontrolled dissemination of risk, "The events of the past year have demonstrated precisely what can and will happen when you don't have well-regulated markets. Left essentially to themselves, the best and brightest of Wall Street proved that they were unable to properly price or manage risk, and instead, through their incessant striving for higher yields created massive incentives for all kinds of irresponsible behavior, from the borrower who lied about their income to the bank that repackaged loans into fancy new securities to the agencies that rated those securities."

The last word on risk management in modern financial markets should go to Frank Partnoy (agains thanks to Andrew Leonard), "In the long run, "risk" is being sold off by people who know best how to evaluate it to people who don't know what they're in for."

Update
Ben Stein has a trenchant critique of the way short sales and traders have wreaked havoc on the financial markets. He writes, "The losses in United States markets alone are on the order of about $2.5 trillion in recent weeks. How can a loss of roughly $100 billion on subprime — with some recoveries sure to come as property is seized and sold — translate into a stock-market loss 25 times that size?"

Efficient markets and widening inequality

What do you make of this scenario? Imagine this middle class employee, who has invested his hard earned pension contributions in a Pension Fund, which in turn invests the same in complex and high yielding financial instruments, rated AAA+ by the major credit rating agencies. But unknown to the employee and the Pension Fund, the high profile investment bank which peddled those instruments, was also shorting the same instruments. Then one day disaster strikes, the markets crash, and his hard earned pension savings disappear.

Ladies and gentlemen, welcome to the spectacular world of modern financial markets, with its alphabet soup of exotic financial instruments, assortment of Nobel laureates, mathematicians and financial whizkids, and those wonderfully versatile off-balance sheet entities called Special Investment Vehicles (SIVs). Move over Harry Potter. Read on.

There are two observations on the recent trend in global financial markets that are a cause for concern. They relate to who are the major beneficiaries of financial innovation and how risks get transferred.

Thanks to the financial innovation of the last few years and the broadening and deepening due to integration of global markets, it is now widely acknowledged that markets are becoming more and more efficient. All the information available in the markets is increasingly being reflected in the prices of financial instruments. In the circumstances, the major source of profits are just two:
1. Arbitrage opportunities across time, areas, and instruments.
2. Multiplication of small margins by trading in volumes.

In an increasingly efficient market, all the easy and obvious arbitrage options get quickly traded away, and only the more latent and complex opportunities remain. Taking advantage of these fleeting profit opportunities requires complex financial models and an assortment of PhDs and MBAs, armed with sophisticated software programs based on models devised by Nobel Prize-winning theoreticians. This only the high net worth individuals and their hedge fund and private equity The later requires large investment requirements, either own capital or debt. Both these requirements are beyond the reach of the regular investors.

It is claimed that the complex products of financial engineering have helped diversify risk and make the financial system safe. It was hoped that securitization of liabilities would help take out and disseminate risks across a large number of investors, who are best suited to bear it. Asset Backed Securities (ABS) like Credit Derivatives, CDOs, CMOs, CDS etc and off-balance sheet entities like SPVs and SIVs have emerged with the objective of transferring and diverisfying risks.

But the reality has been somewhat different. The most fundamental principle of risk management is that risks have to be allocated in such a manner that they are borne by those best able to bear it. But recent events have clearly shown that the complex ABS have been "sold off by people who know best how to evaluate it, to people who don't know what they're in for." By being able to transfer their loans and receivables through securitization, lenders suddenly realized that they no longer had to be concerned with the quality of the loans. This moral hazard led them to maximize their loans by lending to anybody willing, and even some unwilling, to borrow.

Further, as Frank Partnoy has shown in his insightful book, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets, "complex financial instruments are designed not so much for the purpose of reducing risk as for skirting laws or accounting rules and providing a source of windfall profits to Wall Street's traders and brokers.". Complexity and sophistication of financial instruments has been a convenient shield for obscuring risk and confusing unsuspecting investors.

Standard financial theory claims that risk and return have a directly proportional relationship. These complex securities help high risk investors take positions that offer the potential of very high returns. But it also creates distortions like low risk investors ending up with very high risk securities. (Standard & Poor's downgraded credit rating for the bond insurer ACA Financial Guaranty Corp from Aaa to CCC "junk" status in December 2007)

In this context, it is also important to note that risk itself needs to be re-defined. The levels of risk assumed for identical investment positions, varies for different categories of investors. What is very risky for one category of investors may not be so for another group. Unlike the small investors, the hedge fund and private equity firms, supported their battery of mathematical and financial wizards and number crunching supercomputers with access to real time information, are better able to locate and price risk.

With the credit ratings providing inadequate, even misleading, information about the levels of risk embedded in various financial instruments, and the price itself not fully reflecting the inherent risks, the small and regular investors were left with no means of identifying risk. This market failure was exacerbated by the absence of adequate regulatory controls to locate and price securitization risks.

The risk pricing models used contained the usual flaws and discrepancies, which continues to get ignored or glossed over depsite numerous bitter experiences. The regular suspects of Bell curve and CAPM apart, risk rating models assumed that mortgage defaults are independent of each other thereby permitting the use of the "Law of Large Numbers" to discount the probability of default of more than 20% of the principal. Further, in the absence of any acceptable liquidity valuation method, the risk pricing models did not account for the risks associated with market liquidity.

For the high net worth investors, hedge funds and private equity firms, it is "heads I win, tails you lose"! A blunt, but more accurate description of most of what pases on as financial innovation, would be cheating!

Saturday, January 26, 2008

Structuring a fiscal stimulus

With monetary approaches like lowering interest rates and multiple, co-ordinated fund infusions having little impact on the ever worsening sub-prime crisis, the US Government is considering a series of fiscal policy measures, aimed at boosting economic activity by increasing short term aggregate demand.

As a first step, President George Bush announced about $145 bn worth tax rebates for American families and incentives for businesses to provide “a shot in the arm to keep a fundamentally strong economy healthy” and avert a slide into recession.

Drawing parallels from the 2001 tax cuts which is claimed to have pushed the US economy into the consumption boom trajectory after the bursting of the tech stock bubble, the Bush administration is contemplating tax rebates to spur consumption and investment. This claim is not backed by both theory and facts, given that the consumption boom was well underway and can be attributed more fundamentally to the historic low interest rates and the "income effect" generated by the real estate bubble that followed. Further, a study of the 2001 tax rebates of $300-600 by Joel Slemrod and Mathew D Shapiro, of the University of Michigan showed that only 22 percent of taxpayers surveyed spent their rebates.

They write, "Instead, they would either save it or use it to pay off debt. This very low rate of spending represents a striking break with past behavior, which would have suggested a much higher rate of spending. The low spending rate implies that the tax rebate provided a very limited stimulus to aggregate demand."

In recent years, especially the two terms of George W, fiscal stimulus has been an alibi for doling out generous tax concessions. And these tax breaks, invariably benefit the rich immediately, while generating deficits that are again used as an excuse to cut down on Government expenditure, especially on welfare.

Though discretionary monetary policy decisions have more immediate impact than fiscal policy decisions, it has been observed that the proximate impact of fiscal policy is on the poorest and struggling families while that of monetary policy is on the financial institutions. Further, monetary policy is more likely to create long term distortions, by raising inflationary pressures and sustaining and even building up excesses. Lawrence Summers argues in favor of a fiscal stimulus, "Fiscal stimulus is appropriate as insurance because it is the fastest and most reliable way of encouraging short run economic growth at a time when a serious recession downturn would pressure American families, exacerbate financial strains, raise protectionist pressures and hurt the global economy."

In fact, the critical determinant of the success or otherwise of any temporary economic stimulus is in getting it spent immediately. Consumers tend to base their spending decisions on what is their "permanent income" or the income they expect to have over the long run, than what they get for one year or a few months. But the poorest, who don’t have a savings cushion, can’t borrow and spend less than what they’d like to given their permanent income, are most likely to spend all the money handed to them in a stimulus, and that too immediately. Another way to get the stimulus spent immediately is for government to spend the money directly or refrain from any spending cuts. State and local government who are most likely to cut their spending during recessions, need to be encouraged to not do so, by providing them assistance.

Eco 101 teaches us that fiscal policy measures during a recession includes supply side measures like corporate tax cuts, so as to incentivize private investment, and demand side steps like personal income tax cuts and Government spending programs. I have serious reservations on measures that seek to stoke demand and supply by reducing taxes, especially given the present context. The bursting of the real estate bubble and the resultant sub-prime mortgage loan crisis has highlighted serious solvency related problems. Such problems cannot be addressed with prescriptions which can solve liquidity related problems.

Personal income tax rebates work well when it puts money in the hands of people who are most likely to spend it. The rich and well off do not certainly belong to that category and will continue to spend, irrespective of any tax rebate. Personal tax rebates are intended to put cash in the hands of consumers, in the hope, and this is the critical determinant, that they will spend it immediately, giving a boost to retail stores, service providers and manufacturers of consumer goods. But history is replete with examples, most recently in Japan, when people facing recessionary expectations and possible interest rate increases, prefer to postpone their consumption and save the additional money put into their hands by the tax rebates or use it to repay debt.

Tax rebates generally benefit the rich disproportionately and becomes less a fiscal stimulus than a sop to the rich and well off - less bang for the buck. A rebate whose size increases for people with larger tax liabilities is likely to be less effective than a uniform refundable one. Further, this would do little to bring in more money into the economy, as the major beneficiaries are in any case indifferent to smaller recessions. In contrast, the lowest income household is most likely to spend all the additional money handed back to it by way of any rebates.

Tax concessions to incentivize business investment are intended to prompt companies to accelerate plans to buy new equipment and factories, and thereby forestall employment losses and even spur new hiring. But faced with a recession, the same devil of "rational expectations" on recession and interest rate increases rears its ugly head in the collective minds of the corporate sector. In any case, corporate sector investment has been already declining since 2004, and is at a historic low, and simple tax rebates will not be able to re-start that engine, without addressing other more deeper underlying causes.

The solvency problems can be ovecome only of the excesses of the bubble days are washed away, and that in turn requires somebody paying the price, most likely the home buyers and the financing institutions. Those bouyed by the "wealth effect" from real estate bubble were important participants in sustaining the consumption boom (even taking it to the high levels of the past 6-7 years) and are the ones most in need of cash. But this category, which is also the most likely group to have spent a significant portion of the rebates on consumption, is now left with no option but to spend the tax rebates in paying off their debts.

Even supply side conservatives, for long supporters ot monetary interventions and opponents of discretionary fiscal stabilizers, are now calling for active fiscal policy interventions. Martin Feldstein recommends a twin strategy of loose monetary policy and fiscal stimulus to reduce the risk of recession. He explains, "What's really needed is a fiscal stimulus, enacted now and triggered to take effect if the economy deteriorates substantially in 2008. There are many possible forms of stimulus, including a uniform tax rebate per taxpayer or a percentage reduction in each taxpayer's liability. There are also a variety of possible triggering events. The most suitable of these would be a three-month cumulative decline in payroll employment. The fiscal stimulus would automatically end when employment began to rise or when it reached its pre-downturn level."

He finds two benefits in such a stimulus, "First, it would immediately boost the confidence of households and businesses since they would know that a significant slowdown would be met immediately by a substantial fiscal stimulus. Second, if there is a decline of employment (and therefore of output and incomes), a fiscal stimulus would begin without the usual delays of the legislative process."

A Hamilton Project Strategy Paper by Douglas Elmendorf and Jason Furman defines three fundamental desirables in any fiscal stimulus - timeliness, well targeted, and temporary. Based on their respective macroeconomic impact, the authors draw distinction between "taxes and transfers" (eg tax cuts and unemployment insurance expansions) policies designed to increase disposable income and hence consumption, and "government purchases of goods and services" (eg. infrastructure spending) designed to increase spending directly. The authors list of fiscal stimulus options based on their respective bang for the buck

1. Most effective options
a) Extend uneployment insurance (and other) benefits temporarily
b) Temporary increase in food stamps to those already benefitting - would immediately free up incomes for the poor, which can (and most likely to) be then be used for consumption
c) Flat, refundable, equal-sized tax credits for all working households temporarily
d) Aid to local and State Governments, who tend to cut down their spending during recessions

2. Less effective options
a) Increase infrastructure investments - has limited short term impact
b) Temporary investment tax inecentives - has less short term impact, when compared to even individual tax rebates
c) Permanent reduction in tax rates

The Congressional Budget Office (CBO) has more or less the same bouquet of prescriptions on fiscal policy responses to a recession.

In any case, Keynesian demand side management policies may be making a 21st century comeback, and this time it appears to stay on for sometime!

Thursday, January 24, 2008

Fed rate cuts and monetary policy

The unprecedented decision by the Federal Reserve to cut the Federal funds rate by 75 basis points, the largest cut in over 21 years, to 3.5% has been not fully unexpected. It is now expected that the FOMC will further cut the rates to 3% at its next meeting on 30th January 2008.

An interesting reaction to the rate cuts has come from Paul Krugman. He has argued that the rate cuts may be a "pre-emptive" action by Ben Bernanke to not just ease credit supply, but also aimed at "maintaining a sufficient inflation buffer", if further cuts take the rates to the Zero Lower Bound (ZLB) and a possible "liquidity trap", a la Japan in 1990s. To that extent, some amount of inflation is desirable under such low interest rate conditions, so as to both encourage spending and give enough room for flexibility in case of rates being forced down further.

In a 2004 paper, Mr Bernanke had argued that the policy success in lowering inflation and interest rates, have increased the possibility of the nominal policy interest rate being constrained by the ZLB. This would limit the Central Bank's monetary policy options in stimulating aggregate demand.

The rate cut can restrict the Central Bank's ability to manouevre with monetary policy in other ways too. Coupled with falling confidence in the economy, it is likely to weaken the dollar and thereby makes imports more expensive. This in turn will stoke inflationary pressures, thereby limiting the Central Bank's freedom to use monetary policy, a vital economic policy tool to combate recessions.

The steep cut is also a very firm message from the Fed that the US Government that it will do everything possible to contain the financial market turmoil. It is a more effective response than small and repeated rate cuts, in so far as it reassures investors and shapes rational expectations. But on the flip side, it also reveals a sign of desperation and makes investors and lenders more wary, thereby exacerbating the credit crunch. It can give the impression that the Fed has played its final card and has now limited leverage in assuaging the markets.

There is also a concern that the rate cuts would paper over the deep rooted macro-economic imbalances that affect the US economy. Despite the recent declines, real estate and stock prices remain at historic highs and will need to undergo further correction. Even by the most conservative estimates, share prices will have to fall by atleast 10% and real estate by 20-40%, so as to reach normal levels. Such palliatives increases the probability of artificially glossing over the solvency problems facing many Financial Institutions and delays the inevitable hard decisions that are necessary for squeezing out the irrational excesses. As history shows, the more such things get delayed, the harder the landing.

Update
Martin Feldstein feels that the rate cuts may little to ease the credit markets given the deep rooted decline in confidence and absence of any mechanism to assess counterparty risks. He writes, "The lack of confidence in asset prices also translates into a lack of confidence in the creditworthiness of other financial institutions, impeding the extension of credit to those institutions. And because financial institutions do not even have confidence in the value of their own capital and in the potential availability of liquidity, they are reluctant to make new lending commitments."

He writes, "The current situation has the elements of a Catch-22: The credit flows needed for economic expansion require confidence in the values of existing financial assets, but market participants may not have such confidence while the risk of recession hangs over us."

Wednesday, January 23, 2008

Off balance sheet financing in Government

The triple effect of increasing oil prices, appreciating dollar and steeply rising demand are placing severe strains on the Government's subsidy burden and on the balance sheets of the oil and fertilizer companies. The problem is compounded by the inability (or unwillingness) of the Government to pass on the increase in market price to the consumers.

The subsidy component in the sales of petroleum products sold under the Administered Price Mechanism (APM) in July were Rs 5.90 per litre on petrol, Rs4.80 per litre on diesel, Rs 14.65 a litre on kerosene and Rs 189.15 per cylinder of LPG. These products account for around 50% of the oil companies’ sales, while the other 50% comprises products that do not come under the APM.

It is in this context that the Government of India have decided to issue bonds to petroleum and fertilizer companies for securitizing the subsidy dues owed to them. Such bonds are interest-bearing IOU receipts issued in tranches by the Finance Ministry, that can be included in the balance sheet of oil companies. The bonds will be issued to these firms, and the finance ministry will organise payment of interest from the general budget and the principal on maturity. The PSUs can in turn sell them in the market at a discount to meet their cashflow requirements. The amount of bonds that these oil companies can sell in a quarter is also capped at 25 per cent of the total bonds in their portfolio. The main purchasers will again be other government insitutions, mainly the Life Insurance Corporation.

The investment of banks in these bonds will not be reckoned as an eligible investment in Government securities by banks and insurance companies for their statutory requirements. While the bonds will be transferable and eligible for market ready forward transaction (Repo), they will not be an eligible underlying security for ready forward transactions (Repo/Reverse Repo) with the Reserve Bank of India.

The Government of India have decided to issue fertilizer bonds of upto Rs 7500 to the fertilizer PSUs to compensate them for selling fertilizers at subsidized rates. In December 2007, the Government issued the first tranche of "8.30% Fertilizer Companies Government of India Special Bonds, 2023" for Rs 38.90 billion to 22 fertilizer companies. The fertilizer subsidy is expected to increase from Rs 11,835 crore in 2003-04 to an estimated Rs 47,979 Cr in 2007-08, including an Rs 8788 Cr carryover from last year.

The total petroleum subsidy in 2006-07 amounted to Rs 49,387 Cr (about $12.43 per barrel), or a cost recovery per barrel was $49.93 against an average cost for the year of $62.36. The subsidies are estimated to be Rs 54,935 Cr for 2007-08 and increase by Rs 2,200 crore for every one dollar increase in crude oil price. The Government is considering issuing petroleum bonds worth Rs 23,457 Cr in 2007-08, to partially compensate oil companies for their subsidy related losses. The Government has previously issued 7-year oil bonds amounting to Rs 9,000 crore on March 30, 2002, and 10 year Oil Bonds for Rs 24,000 Cr with a coupon rate of 7% in 2006-07.

The government does not account for these bonds in the fiscal deficit, or the gross borrowings target for the year, despite the bonds being a direct liability of the Government of India. This liability is also not covered under the Fiscal Responsibility and Budget Maintenance (FRBM) Act. This is virtually an off-balance sheet liability, and we have seen numerous examples in the private sector of how such financing could unravel.

There are many dangers associated with such financing. This could open up the floodgates for similar financing of other Government expenditures, involving food and other subsidies. The Prime Minister’s Economic Advisory Council, in its Economic Outlook for 2007-08, has highlighted such off-budget contingent laibilities, "Realistically, another 2% of GDP should be added to the reported revenue and fiscal deficits in order to get a more accurate picture of the state of government finances."

With the oil bonds a reality, the Government ought to atleast now put in place effective mechanisms to repay the same. The major share of oil is imported and is therefore paid for in dollars. It therefore makes sense to issue these bonds in dollars, so as to reduce the exchange rate risks and also make it more attractive for external investors. These bonds could be then sold externally by the Petroleum companies to even foreign investors and raise foreign exchange capital requirements for funding their purchases. This would also rule out any inflationary impact, which is likely to be generated by domestic transactions between the oil companies and the local FIs, and further on. With comfortable forex reserves, the RBI could afford to sell similar dollar-denominated bonds. This would also nicely set up the market for the inevitable future disinvestment of these oil companies. There is a precedent here.

The Venezuelan state-owned oil company, PetrĂ³leos de Venezuela, or PDVSA, sold $7.9 billion of dollar-denominated bonds in Latin America's biggest corporate bond sale ever. The sale was also partly designed to force down inflation and a falling currency. The PDVSA bonds were sold only to local investors, who could purchase them with bolivars and resell them to overseas investors for dollars.

Tuesday, January 22, 2008

Sensex and re-coupling

The carnage of the past two days has generated intense debate on what the Government should do to pacify the markets. There have been voices of concern from across the spectrum. But apart from the fact that any such precipitous decline calls for expressing concern, there appears very little we can do and should do about the events unfollding in the financial markets. Unlike in the US, the volatility in the financial markets does not call for much concern for the following reasons

1. Our markets were in any case over-valued, both in pure financial market terms and in relation to the real economy. At PE multiples of 22-27, we have the highest PE and PB values in the world, apart from China. PE multiples rose from 16 to 27 in the two year period of 2006 and 2007. The market capitalization to the nominal GDP ratio rose to 173% at the end of December 2007, a rise of 73% in the year. This is to be seen in light of the historical average M-Cap/GDP ratio of 37.5%, and an average ratio of just 47% for the entire 2004-07 bull run period. A correction was therefore long coming.

2. The economic fundamentals are strong - low inflation, strong currency, growing trade, rising savings and investment, robust demand, excellent corporate earnings, buoyant tax revenues etc. This is the ideal occasion for any equity market correction, in so far as we are better positioned to absorb the shocks.

3. Only 7% Indians own shares, directly or indirectly, compared to more than half all Americans. There is no substantial "wealth effect" due to shares that would now drag consumption down in India. The real economy is much less coupled to the financial markets than elsewhere. So less danger of a spill over to the real economy.

4. Unlike the US, we do not have any solvency problem with our financial sector. Banks have all posted record profits and robust top line growths. At worst, we could experience some form of liquidity problems.

5. A substantial contribution to the exit stampede has been due to margin pressures leading to brokers squaring off their positions. It has for long been a concern that the market had been over leveraged. This is reflected in the massive build up in the futures and options market, with repeated roll overs of leveraged long positions in expectation of windfall gains as the market keeps moving up. The average open interest position was Rs 1,31,000 Cr on 18 January 2008, as compared to Rs 92,538 Cr in October 2007.

6. The recent massive over-subscription for the Reliance Power IPO by retail investors, is an indicator of the huge liquidity available in the market. However, a more immediate contributor to the collapse could be the recent round of IPOs and NFOs, especially of the Reliance Power IPO, and the huge repsonses generated, which may have drained out liquidity from the markets. In fact the Reliance Power IPO drew about $190 bn worth bids for $2.9 bn worth shares, thereby draininng liquidity, forcing margin calls and thereby liqiudation of long positions.

7. One of the major contributors to the bull run over the last year has been the huge FII interest in emerging markets. Assets in emerging market funds doubled to $800 bn in 2007. FIIs pured $16.7 bn into India in 2007. The bullish outook of FIIs fuelled a similar, even more gung-ho sentiment among local institutions and investors.

8. There is very little we can do to control trends and forces, which have global dimensions. It is undeniable that the FIIs and events outside our country (like cuts in US interest rates and the arrival of emerging markets as attractive alternatives to the US and other developed markets) played a critical role in driving up Indian shares, and it is therefore understandable that they react to developments that have implications on their market positions, especially in the US market. Given the exceptional circumstances facing the global financial markets, and the large losses suffered by some of the biggest Wall Street Banks, it was only to be expected that the Indian markets get affected. We cannot enjoy the upside of the global financial markets, while not suffering the downside!

9. Such asset bubbles are not uncommon with economies growing at the pace at which India is. They rarely cause any lasting damage to the growth prospects.

Foremost, we should keep in mind the fact that the reasons for the declines in US and elsewhere are entirely different from that here. US is, to put it mildly, facing a dual crisis of a financial meltdown and an economic recession. The financial crisis may be accelerating the manifestation of fundamental demand side problems with the economy. On the contrary, the declines experienced in India are primarily a consequence of the deeply coupled nature of global financial markets. In other words, the reasons for the decline in Sensex are mainly exogenous.

We merrily shared in the "irrational exuberance" of the sub-prime lending and emerging market craze of global investors, and now as is the case with all such exuberances, reality has dawned. For the immediate, the declines present an excellent opportunity for investors to pick up shares on the cheap. In the long run, the events of the last two days will only be a blip in the horizon, an inevitable consequence of being active participants in the roller-coaster ride of the global financial markets! In fact, the unprecedented 75 basis points cut in the Federal Funds rate to 3.5%, could be just about enough to stem the tide and even reverse the bear run.

Update
It is business as usual at the markets, as the US rate cuts have provided the boost. With further rate cuts expected, both at home and the US, I have a feeling the events of past few days will soon be forgotten, only to be shaken up by another steep correction sometime later.

Markets in Everything and StickK

Here is a link to Marginal Revolution's markets in everything. The latest such market is StickK.com, launched by economists Ian Ayres and Dean Karlan, to facilitate personal commitment contracts to achieve a more healthier lifestyle.

If you want to quit smoking or reduce your weight and care ot able to do the same, no need to worry any longer. Enter into a contract with StickK, and pay some money upfront, with a contractual commitment to pay a fixed instalment to charity if you are unable to reduce and finally goive up your cigarettes or do fixed number of rounds or push-ups.

Update 1
NYT has this article on commitment contracts to reduce weights.

Oldest pin factory!

This post will quote extensively from two excellent articles on the changing nature of marriages and families in the modern economy.

Slate has excerpts from Tim Harford's latest book, The Logic of life. In a rational analysis of the origins of marriage and family life, with its utility in distribution of household labor within family members in the old, self-contained societies, he calls family the "oldest pin factory of all".

Sample this, "Marriage used to be one of the fundamental ways to gain from division of labor. Before there were well-developed markets for anything much, and long before you could order a cappuccino, men and women were able to enjoy some of the gains from the division of labor by getting married, specializing, and sharing. Back on the Savannah, one might hunt and the other might gather. In the more recent past, one might be good at guiding a plough and sewing while another would specialize in cooking and household repairs. Nothing about Adam Smith's story suggests division of labor according to traditional sexual roles, but make no mistake: the family has rational roots. It is the oldest pin factory of all."

"By the 1950s, those traditional sexual roles were fundamental in the division of labor within marriage. The ideal husband specialized in breadwinning, getting an education, a good job, working whatever hours were necessary to win promotion, and earning ever more to supply the family with a car, a fridge, a nice house in the suburbs and frequent holidays. His adoring wife specialized in homemaking, cooking, cleaning, entertaining, bringing up the children to be smart and wholesome and taking care of her husband's emotional and sexual needs."

"Instead, the divorce revolution was driven by a more fundamental economic force: the breakdown of the traditional division of labor identified by Adam Smith. At the beginning of the 20th century, housework took many hours, and only the poorest and most desperate married women had jobs. As the decades rolled past, technological change made housework less time-consuming. It became easy—and quite common—for older women to enter the workforce after their children were grown and housework was easily manageable.

Once divorce rates first began to climb, it was no surprise that they increased dramatically. There was a rationally self-reinforcing loop at work: the more people divorced, the more divorcees—that is, potential marriage partners—you could meet. That meant that it was easier to get divorced yourself and find a new spouse."

Another interesting article on this is by Justin Wolfers and Betsey Stevenson. They write that families had played a crucial role in "flling in" where incomplete market institutions would otherwise have hindered economic development, "For example, even in the absence of well-functioning contract law, families found ways to enforce agreements among kin. This naturally gave the family a role as an organizing device for economic activity, and the limits of the firm often coincided with the limits of the family. Thus marriage also provided the key means to strategic “mergers” — a way to form alliances and boost the financial welfare of the household... prior to the expansion of the welfare state, the family had been a key provider of insurance, as spouses agreed not only to support each other “through richer, through poorer, in sickness and in health,” but also extended this guarantee to parents, children, and siblings. Before modern credit markets arrived, access to capital was often facilitated through family ties... A number of goods and services, such as freshly-cooked meals, or childcare, were historically not sold in the market sector. Thus, the family became the firm producing these household services."

"Just as Adam Smith observed that specialization by workers in the pin factory yielded more efficient production, so too families were organized so as to reap the benefits of specialization. Thus households came to involve the specialization of one spouse, typically the husband, in the market, and the other in the domestic sphere." But increasingly the market has developed and started to occupy more of the space traditionally held by the family, and the modern corporation has come to supplant the family firm as the key unit of production. Social insurance has provided social security, and other technological, legal and social changes have reduced the value of specialisation within families. Services previously produced in the home are now freely traded in the market.

Wolfers and Stevenson writes, "While the benefits of one member of a family specializing in the home have fallen, the costs of being such a specialist have risen. Advances in medicine have yielded rising life expectancy, ... thereby increasing the number of potential years in the labor force, and also the opportunity cost of women staying out of the labor market to be home with children."

They claim that the economic logic that drives modern marriages is "shared consumption", as opposed to "shared production" till now. They write, "Most things in life are simply better shared with another person: this ranges from the simple pleasures such as enjoying a movie or a hobby together, to shared social ties such as attending the same church, and finally, to the joint project of bringing up children. Returning to the language of economics, the key today is consumption complementarities — activities that are not only enjoyable, but are more enjoyable when shared with a spouse. We call this new model of sharing our lives “hedonic marriage”."

"Hedonic marriage is different from productive marriage. In a world of specialization, the old adage was that “opposites attract,” and it made sense for husband and wife to have different interests in different spheres of life. Today, it is more important that we share similar values, enjoy similar activities, and find each other intellectually stimulating. Hedonic marriage leads people to be more likely to marry someone of their similar age, educational background, and even occupation. As likes are increasingly marrying likes, it isn’t surprising that we see increasing political pressure to expand marriage to same-sex couples."

About the alleged rise in divorce rates they write, "Yet the high divorce rates among those marrying in the 1970s reflected a transition, as many married the right partner for the old specialization model of marriage, only to find that pairing hopelessly inadequate in the modern hedonic marriage. Divorce rates have actually been falling since reaching a peak thirty years ago. And those who have married in recent years have been more likely to stay together than their parents’ generation. These facts should be emphasized and bear repeating — divorce has been falling for three decades — since this important fact is often ignored in the discussion of the current state of the family."

About the changing demographics of marriage they write, "College-educated women used to be the least likely to marry, and today they are about as likely as those without a college degree to marry. Several decades ago, a woman earning a graduate degree was unlikely to find the old specialization model of marriage to be useful, and many therefore chose to remain single. But today’s hedonic marriage is likely more enticing for educated women.

On the flipside, the decline in marriage among less-educated women would be an important concern if we were still in the world where women needed a husband for financial security. Less educated women have their own market opportunities available to them and have less to gain from marrying today than in the past. The new hedonic model of marriage thrives when households have the time and resources to enjoy their lives. This suggests that increasing the financial stability of these households will lead to marriage rather than marriage leading to financial stability."

Monday, January 21, 2008

Irish Economic Miracle

Alone among the European economies, the Irish economy has for long distinguished itself as successful example of enlightened policy making by the Government. Especially after Ireland joined the EU in 1973, these policies have lifted the country from poverty and deprivation to one of the leading knowledge economies of the continent. These policies include
1. Attractive tax concessions for foreign investors.
2. All education, upto Unversity level, made free
3. An exclusive Public Private Partnership (PPP) initiative that has since bee replicated in many countries
4. Lower corporate and income taxes.

To this comes the latest initiative by Enterprise Ireland, an agency of the Irish government that gives fledgling small companies a helping hand. It proactively takes equity positions in start-up firms, leases space in Midtown Manhattan to provide accommodation for young Irish firms looking to expand in the US, helps set up operations in China by hooking up Irish firms with Chinese government officials, and finances R&D. Enterprise Ireland has also put up initial capital for venture investment funds and supports research and development at private companies and universities.

However, there is something interesting about the Irish tax rates. While corporate taxes are at a very low 12.5%, the income tax is 20% for the first $50000 and 41% on income above that. There are value-added taxes of 21 percent levied on all goods and transactions, with the exception of health and medical services, children’s clothing and food. While the corporate taxes are very low and are aimed at boosting private investment, the remaining taxes appear to be on the higher side.

Saturday, January 19, 2008

Radiohead phenomenon in school textbooks

Freeload Press (www.freeloadpress.com) have a catalogue of school textbooks and study material, which they have made available online, free of cost. Their business model relies on selling advertisement space on both the website and on the downloaded pages (the first few pages) of the free text book. It also sells advertisement-free, stripped down, black and white print versions of some of the downloadable textbooks, at a much lower cost.

The Freeload Press describes their mission statement thus, "We publish and distribute premium textbooks from the best authors in their respective fields. We then deliver our textbooks using an innovative combination of commercial support and direct fulfillment. This allows us to provide the textbook as a free e-book. Print versions are also available for reasonable prices – typically 65% less than competitive textbooks!"

School textbooks are typically very expensive, and retail at much higher prices than normal. (Though this is not much a problem in India now, it will soon become one as the copyright regulations get stringent in the coming years) The substantial secondary market, reliance on school library, and the limited market is repsonsible for this. The Free Exchange argues that, "Each year, students will find it easy to return to the download source for the text, thereby providing new revenue to the author--secondary markets become pointless. Lower prices should also increase consumption. Professors should feel no compunction about assigning students reading from multiple textbooks if the cost of each to the student is zero. This should provide some reinforcement to the free download model; since traffic to the download sites drives revenue, an overall increase in the average number of textbooks consumed by a student should improve the market for authors."

An advertisement-based, free online download model has the potential to unsettle the traditional textbook industry, just as Radiohead-like free downloads could do to the music industry. This model is also likely to generate demand for the really good textbooks, even by the less well known authors, thereby unsettling the "superstar effect", so widely prevalent in textbook retailing. However, it is also likely to generate a much higher degree of "network effect", as the well written books, become even more popular.

A few observations on this
1. The high cost of the most popular textbooks and the fixed cost arguement is much like the drugs industry with its high R&D costs for patents and the obscenely high drug prices. The numbers sold and the prices charged, do not square up, even assuming the most avaricious profit margins! A few explanations (thanks to Free Exchange, and some with less merit) that mitigate against the igh fixed costs and cost recovery hypothesis - disproportionately less price declines even after many editions, frequent revisions with little change in susbstance, small proportion of used books getting back to secondary market, poor production quality of such textbooks etc.

2. It is hugely distorted by "network effects". The text books prescribed by instructors and more popular in the better and bigger schools, drive out the others from the market. (This is especially true in the IITs where the overwhelming bias in favor of foreign textbooks, tend to leave the students unexposed to some better textbooks by Indian authors.) In a field like education, especially graduate, where conceptual clarity is no more important than exposure to the full spectrum of views and positions, reducing the available repertoire to a few superstar books, can affect the balanced development of the students and the field itself. This is something similar to the trends in the media industry with its increasing mergers and industry consolidation, that seek to monopolise and thereby limit the public dissemination of ideas and opinions.

3. It is easier for the publishers to get this model through because the peculiar nature of textbook market. Again like what role the doctors do for drug industry, the instructors play a crucial role in prescribing textbooks and influencing the purchase decisions of the sutdents. And the instructors, in turn are influenced by the "superstar instructors", who invariably have their own "superstar textbooks" to push through. The instructor-publisher relationship suffers from the same well documented problems that afflict the doctors-pharmaceutical companies relationship in teh drug industry. Further, instructors like to prescribe textbooks that reduce their workload and let students rely more on the textbooks. There is clearly a form of "principal-agent" problem, as what is best for the instructors is not necessarily good for the students.

4. Another distortion arising due to the superstar effect. Due to the overwhelming importance of the superstar textbooks, the slightly less well written, but more than adeqaute and very cheap textbooks do not get a look in. This is an economically inefficient outcome, as the students pay disproportionately higher prices for a textbook, even as only a slightly inferior standard book is available at a much cheaper price, for only a slightly more utility. (Note: Standard is generally inferior only in relation to the presentation of the matter, and not on the substance.)

5. Textbooks, especially the basic and introductory ones, have very long shelf lives. Unlike the R&D costs for drug discovery, human capital cost forms the overwhelming share of the fixed development cost. Also, unlike the music industry, it does not depend on a grand collaborative effort of different individuals. In fact, basic course textbooks rely on a lot of free lunches from the Research Associates, PhD students and others who assist in the development of the book and who do not get remunerated (proportionately) for the same.

6. The example of textbook industry in countries like India is instructive. Textbooks, even the superstar ones, are not expensive. This is despite the market suffering from a massive problem with pirating and photocopying. A few characteristics of this market - publishers are not as powerful, textbooks are sold directly to the students, reading material is prescribed in the syllabus/curriculum and not by teachers, multiple textbooks are prescribed thereby providing choice and eliminating the monopoly problem etc. Therefore in a market not distorted by publisher power, indirect sales, and principal-agent problem, the high fixed costs argument breaks down.

7. The publishers tend to cream off a disproportionately high share of the margins. (I do not have figures on this, but this is a suspicion)

Clearly we have a market failure. Solutions to the same invariably involve regulation (whether we like it or not). Some of these solutions include
1. All textbooks should be published by Government or by some independent, non-profit agency. As an alternative, like some suggestions that prescribe Governments buying patents, the copyrights on the more profitable books can be purchased and brought to public domain.
2. Textbooks should be prescribed along with the curriculum and should involve choice. Don't leave textbook choice to teachers
3. Or else go to the other extreme and make certain textbooks mandatory for the course and let the universities/colleges negotiate with the publisher and get it at lower costs. This approach, while lowering the costs, will create other distortions.
4. Regulatory restrictions on new editions.
5. Wiki textbooks or Opensource textbooks! A whole market could develop around them, like the Linux versions, thereby profitting the major contributors.
6. Encourage the Freeload Press model, with free downloads.
7. More copies made available in libraries. Or copies given along with the course materials after collecting a fixed user fees, and taken back after the course.
8. Making available cheaper, stripped down, black and white versions.

Thursday, January 17, 2008

Job creation and Government policies

The Indian Prime Minister's Economic Advisory Council (EAC) today called for lowering indirect taxes, so as to boost consumption and thereby sustain the high econommic growth in the face of weakening external demand. The EAC has also asked for a relief package for labour intensive industries, so as to tide over the rising rupee. But are these suggested measures the most ideal fiscal policy measures to sustain economic growth, while at the same time facilitating job creation?

The failure of the "India Shining" campaign of the BJP in the 2004 elections, is an excellent example of how high GDP growth do not automatically translate into increased individual welfare. In other words, India may be shining, but were Indians doing great? While there has been a great deal of debate about the issue of job creation, statistics paint a picture of job creation not being proportional to economic growth.

The forces of globalisation and liberalisation have changed the character of the employment markets and more importantly of jobs themselves. We live in an age when the job market is undergoing rapid transformation. The fixed time, fully insured, jobs are being replaced with McJobs. These McJobs are characterized by their temporary and flexible nature, and have fewer promotions or raises and fewer benefits. While the uncertainty associated with jobs have been increasing, the compensation has stagnated and for many categories even declined in real terms.

NYT contributor, David Leonhardt, has written about how the American economy has been experiencing a slowdown in job creation in recent years. He describes the job market thus, "The biggest problem with the job market isn’t the jobs that are being eliminated, shipped overseas or filled by temporary workers. The biggest problem is on the other end of the equation. There are far fewer jobs being created by new or expanding companies than there were throughout the 1990s." Drawing on recent job statisitcs, he argues that job elimination and creation in the US are at its lowest in many decades.

For long, it has been part of economic orthodoxy that economic growth would automatically take care of jobs also. Numerous studies and the post-1990s econommic growth have shown that this may not be the case, and there is the possibility of "jobless growth". Traditional explanantions for jobless growth like linking it to productivity does not stand the test of close scrutiny. All models link productivity growth to investment, and private sector investment has been declining since 2004. Has the time come for reevaluating our economic policies, keeping in mind the specific job creation objective? Has the time come to concentrate on better targetting of fiscal policies?

Many economists argue for the need to concentrate government stimulus in areas that produce a high number of well-paying jobs. These include capital spending and many Government programs, from education and health care to infrastructure, as well as the tax concessions given to different income groups to stimulate growth.

Many people criticized President Bush's "growth" policies - mostly tax cuts on income and dividends weighted toward the well off - for providing too little bang for a buck's worth of stimulus. Such policies, weighted towards the rich and towards boosting consumption growth, has been found to be less likely to create jobs. The objective of the policy should be to create more jobs, if necessary by boosting consumption, and not the other way round.

The NYT reports about a study by Harvard economist, James Medoff, about the job creation potential of different categories of investments. Mr. Medoff created a measure that included the number of jobs produced by a dollar of spending and the level of pay and benefits those jobs provided. Combining the two resulted in a labor market 'score.' He then examined how highly capital investment, consumption and various government spending programs scored by adding good jobs to the economy.

Mr Medoff found that while private investment in durable goods did very well in creating jobs, investment in education did even better. As the report says, "It created many more jobs per dollar spent, and they paid fairly well, if not as well as jobs derived from capital spending. Government health care spending also produced many well-paying jobs. Other government spending programs conducive to good job growth were for highways, water and air facilities, and police and firefighters. Military spending also added good jobs, but not at an equivalent rate."

It found that the weakest job creation spending was consumption, which the Bush tax cuts stimulated and which has been the undoubted engine of recent economic growth in the US. In fact, given the overwhelming role of Chinese and other imports in consumption, a tax stimulus ends up transferring American tax payers wealth to China and other emerging world exporters.

The NYT article's recommendation is simple, "A sensible new economic program, therefore, would reject individual tax cuts and emphasize government spending that creates jobs. This could include adequate transfer of money to the states - as much as $100 billion. It could also include seriously financing the president's new education bill, which has been neglected; a drug prescription plan for Medicare that is more generous than what Congress is considering; new ideas about providing health insurance to those who have none; and innovative investment in transportation infrastructure."

The findings of the Medoff study and the trends from the US economy, has clear learnings for other economies. This assumes much significance for India, especially at a time when its economy is expanding rapidly, and an important objective is to ensure that this growth is inclusive. The aforementioned studies underline the importance of health care and education investments, apart from basic infrastructure investments. Fiscal policy has to lay more emphasis on Government spending as opposed to individual tax cuts, that spur consumption, so as to optimize job creation. All this is of critical importance in developing countries like India, where double digit economic growth which do not translate into large number of jobs, may not be sustainable and win elections. India's economic growth has to positively rub off on Indians!

Update
Arvind Panagariya has an interesting explanation about why Indian manufacturing sector has not take off as China's and why labor intensive industuries have not made a similar mark in India. He writes, "In the late 1960s, India had also adopted the policy of reserving labour-intensive manufactures for the exclusive production by small-scale enterprises. Even after years of steady relaxation, the small-scale enterprises face a ceiling of 50 million rupees (approximately $1.25 million) on investment in plant and machinery. The small-scale industry list grew over time and by the late 1980s came to include virtually all labour-intensive products. As long as this reservation was in force, high-quality labour-intensive manufactures that could compete on the world markets had no chance of emerging in vast volumes. The bulk of the small-scale enterprises operated in the protected domestic market."

Though the number of reserved items fell from 821 in 1998-99 to 114 in March 2007, the draconian labor laws ahve prevented the de-reserved sectors making much headway. Panagariya writes, "Under these laws, it is virtually impossible for a firm with 100 or more employees to fire the workers even in the face of bankruptcy. It is equally difficult for the firms to reassign the workers from one task to another. These provisions impose very low worker productivity or a high real cost of labour. Large-scale capital-intensive sectors such as automobiles, where labour costs are a tiny proportion of the total costs, can profitably operate in such an environment. But the same is not true of large-scale labour-intensive sectors labour. Few foreign manufacturers are willing to enter India outside of a small subset of capital- and skilled-labour intensive sectors."

He also dwells on two other constraints - expensive power and poor transport infrastructure, "Not only do firms pay a much higher price for power in India than elsewhere in the world, they also face much greater uncertainty of supply. Likewise, despite considerable improvement, the transportation network in India remains unreliable and inefficient. The time taken to clear the goods entering and existing the ports and to move the goods between ports and manufacturing sites, which is so critical for assembly and processing activities, is much higher and more variable in India than in the competing countries such as China."

Wednesday, January 16, 2008

New disease on the horizon - fibromyalgia!

Move on Prozac and depression, here comes Lyrica and fibromyalgia! This is the latest attempt by the big pharamceutical companies to first create and then capture the market in combating the new category of diseases - lifestyle diseases. The latest in the line of man made, life-style diseases is fibromyalgia, which apparently affects middle-aged women and is characterized by chronic, widespread pain of unknown origin. Pfizer has betted on a drug Lyrica, which has recently become the first US FDA approved drug for treating fibromyalgia, which is expected to follow Prozac and become the newest blockbuster drug. Other drug companies have also jumped the fray, with Eli Lilly and Forest Laboratories, asking the FDA to let them market drugs for fibromyalgia.

However, there is a furious debate raging about the disease itself. The supporters hope that Lyrica will legitimize fibromyalgia, just as Prozac brought depression into the mainstream. But opponents say that the disease does not exist and is only a physical response to stress, depression, and economic and social anxiety. They do not consider fibromyalgia a medically recognizable illness and say that diagnosing the condition actually worsens suffering by causing patients to obsess over aches that other people simply tolerate. They fear that Lyrica will be taken by millions of people who do not need them.

Tuesday, January 15, 2008

Empirical Analysis in anti-malaria activities

I am an ardent advocate of applying the Freakonomics methods in analysing public issues and in policy making. This post is a very strong live example of the utility of statistical analysis in governance. In one of my earliest posts, I had outlined how the Vijayawada Municipal Corporation (VMC) had initiated an anti-malaria drive in the city by utilizing certain simple techniques of statistical analysis. Without focussing on the details of how the success was achieved, I will merely flag off the utility of data analysis in addressing the malaria incidence.

Briefly, Vijayawada city is highly malaria endemic, and there used to be 5000 to 6000 positive cases detected in the City every year. The Malaria circle in VMC was divided into 53 sections which were serviced with equal intensity (or lack of it) by the Malaria Wing. But a close scrutiny of the Malaria trends in the 53 sections over a five year period, revealed certain startling conclusions.

It was found that a major proportion of the positive cases came from 10 sections. Within these 10 sections too, colony and street wise analysis was done to localize the prevalence. It was therefore decided in 2006 to give specific focus to anti-malaria activities in these 10 sections. A range of activities were initiated in these areas to address the problem. The next year, following the success of the experiment in these 10 sections, it was decided to give similar focus for the next vulnerable 12 sections.

Spurred by the success of these methods, which were first initiated in September 2005, a major Malaria Free Vijayawada 2011 campaign was launched in August 2007. The objective was to focus the application of these successful methods to cover the entire city and eradicate Malaria from Vijayawada. As a result, in addition to the original 22, another 8 vulnerable sections have been identified for intensified anti-malaria activities. These 30 sections constitute more than 90% of the positive cases in the 53 sections of the City.

The results have been nothing short of spectacular. While the number of positive cases detected were 6271 in 2005, it fell 53.4% to 2921 in 2006, and 40.15% to 1748 in 2007. In the 10 most endemic sections where these methods were initiated in mid-2005, it fell 54.4% from 2652 in 2005 to 1129 in 2006, and 28.6% to 805 in 2007. In the 12 next vulnerable sections where the campaign was initiated in January 2007, it fell 34.4% from 752 to 493. During the tree years, the blood smear collection samples too increased.

All this was achieved at reduced cost, compared to the previous years. The focus of anti-malaria activities was shifted to anti-larval and other preventive activities. Hitherto anti-malaria activites focussed heavily on Malathion fogging, which despite being found to be both ineffective and harmful to public health, continues to be the predominant focus in many areas. There are strong vested interests in ensuring its continuation, given the relatively higher costs of such activities. Malathion consumption fell from 9580 litres in 2005 to just 299.5 l in 2007. In contrast, reflecting the increased focus on anti-larval activities, the consumption of chemicals like Baytex, Pyrethrum, and Abate increased.

The aforementioned example is a simple illustration of the efficacy of data analysis in solving local problems. This approach can be an invaluable tool in identifying and then tackling many local problems and deficiencies in health and education sectors, especially given the wealth of information available with the respective departments.

Wednesday, January 9, 2008

A recession in the rent seeking economy

It is not hyperbole to suggest that the corruption economy is the largest and most widely pervading sectors of the Indian (or any developing country) economy. With everybody talking of a recession in the US, I thought it an appropriate occasion for highlighing the situations under which the rent services economy goes to recession. What determines the price of rent seeking services? What are the distortions in the rent seeking market?

Unlike other sectors of the economy, the rent services sector has certain unique characterisitics. In fact, it would not be incorrect to even claim that the rent market has inherent monopoly characteristics. This is especially true of the more narrow market in the delivery of public services. The monopoly character is given by the fact that Government is the sole provider of such services, and the issuing official the sole authority designated with dispensing it. This makes it all the more vulnerable to price gouging.

Imagine this scenario. There is Department of Poverty Eradication, which is concerned with all the anti-poverty programs of the Government. It is led by a Minister and Heads of Department at the State level, and has tens of thousands of field functionaries, allocated across all the districts. Assume also that the major source of conventional rent seeking in this Department are from procurement and works, and from transfers of officials. The rent seeking chains are multiple and operate across many levels, and often leads upto the highest level. A typical rent chain works its way through different levels of the bureaucracy, bottom-up, (so rent seeking economy exhibits bottom-up characteristics!) and culminates at the decision making level. Given the inherent hierarchical nature of bureaucracy, this in turn means that the individual preferences of the particular decision making authority assumes great importance.

In such an arrangement, the price of the rent is invariably proportional to the rent charged by the highest link in the chain. In some ways this link becomes the price setter. If the highest link charges a high premium, there is a cascading effect across the entire length of the chain, thereby benefiting all the participants in the chain. But if the price charged is too high, there is the distinct possibility of pricing out potential customers. In contrast, if the highest link charges at a discount, it dampens the market and causes discontent among the participants. (Though not always true, generally the rents charged declines in value down the chain) In fact, there is a serious danger of the market itself drying up. Participants may find the price too low to compensate them for the risk undertaken, and may drop out, if only temporarily. In both scenarios, there is the potential for a recession in rent services. There are therefore inherent problems with both the rapacious and the more easily satifsied links.

But of the two scenarios, the former possibility is remote given the low price elasticity of demand for such services. This is especially true of the transfer market, where the depth and breadth, in terms of competing claimants, is often very small and the stakes too high. This ensures that the participation does not vary. Most participants in the rental market for transfers see the high rent values as something similar to making an investment in a high return capital asset, that keeps yielding handsome returns.

There are also situations where the rents have been hard wired into the architecture of the rent seeking economy - an economist would describe the rents as sticky - that it does not change with the official holding the postion. This is true especially at the lower levels of the bureaucracy, where the rents do not vary with changing officials. Such arrangements are likely to continue even if the cumulative rent price is higher than the price normally expected by the buyers. Recession also sets in when a more strict and incorruptible official assumes charge.

It often requires market intervention to stabilize the rent services market and take it out of recession. And this is precisely what actually happens. It is in the interest of the other participants in the chain, or the other stakeholders, to intervene and rectify the distortions. Interest groups soon develop to oust the rapacious or easily satisfied senior official, whose selfish actions have depressed the market and ushered in a recession. The same is true when there is an incorruptible official at the highest link. As is the case with all commodities and services traded in the economy, there is an equilibrium with rent services too, which is neither too high nor too low!

Crime and violent films

Economists Gordon Dahl of the University of California, San Diego, and Stefano Della Vigna, of University of California, Berkeley, have presented a paper at the annual meeting of the American Economic Association, in which they have claimed that the proliferation of violent films have contributed towards making the streets safer by keeping violence prone individuals inside film theatres. This conclusion goes against conventional wisdom, which argues that the brutal and gory violence depicted in cinemas contribute towards making the society more aggressive, violent and crime prone.

The study claims, "We find that violent crime decreases on days with larger theater audiences for violent movies. The effect is partly due to voluntary incapacitation: between 6PM and 12AM, a one million increase in the audience for violent movies reduces violent crime by 1.1 to 1.3 percent. After exposure to the movie, between 12AM and 6AM, violent crime is reduced by an even larger percent. This finding is explained by the self-selection of violent individuals into violent movie attendance, leading to a substitution away from more volatile activities. In particular, movie attendance appears to reduce alcohol consumption. Like the laboratory experiments, we find indirect evidence that movie violence increases violent crime; however, this effect is dominated by the reduction in crime induced by a substitution away from more dangerous activities. Overall, our estimates suggest that in the short-run violent movies deter almost 1,000 assaults on an average weekend. While our design does not allow us to estimate long-run effects, we find no evidence of medium-run effects up to three weeks after initial exposure."

Using a decade of national crime reports, cinema ratings and movie audience data to examine what has happened to rates of violent crime during and immediately after violent films are shown, they say, "Instead of fueling up at bars and then roaming around looking for trouble, potential criminals pass the prime hours for mayhem eating popcorn and watching celluloid villains slay in their stead. You’re taking a lot of violent people off the streets and putting them inside movie theaters. In the short run, if you take away violent movies, you’re going to increase violent crime." Their analysis of the vast data revealed that “on days with a high audience for violent movies, violent crime is lower.” They also claim that over the last decade, the showing of violent films in the United States has decreased assaults by an average of about 1000 a weekend, or 52,000 a year.

Describing these findings as the latest in a series of such studies in the "Freakonomics era", the NYT says, "Practitioners of the dismal science are transcending traditional subjects like labor and markets, and are now crunching numbers to evaluate matters like cheating among sumo wrestlers or the effects of a crackdown on cocaine."

The study is an excellent illumination of the fact that "if you can incapacitate a large group of potentially violent people, that’s a good thing." However, there are a number of other issues that remain unaddressed. How does the violence in the movies influence or impact on the audience, especially those already prone to violence? Does it sow seeds of violent conduct in otherwise non-violent and law abiding youth? Do viewing these movies make potential violent youth or individuals more violent? Do they go out and vent out their impulse for self-realization by indulging in more violent crime than they would otherwise have done?

Tuesday, January 8, 2008

Fibonacci ratios and the Sensex

The ET carries Sensex 2008 target estimates made using the Fibonacci ratios - 0.382, 0.618, 1.618, and 1. The estimations of the yearly closing target, done based on the difference between the lowest and highest monthly closes, multiplied by the Fibonachi ratios, and then added to the highest monthly closing of the previous year, revealed striking similarity with the actual performance for four years from 2004 to 2007. In fact, at least one among these Fibonacci ratios has given a target that is in a range of +/- 5% of the final realised value of the Sensex for the next year.The table below reveals the similarity



The graph below charts the highest-lowest monthly closing trends for the past four years.



With this method of technical analysis, the Sensex 2008 is estimated to be 23094.27, 24828.61, 27635.89 and 32177.51 respectively, for the four Fibonacci ratios. Let us revisit this post on 31, December 2008!

Sunday, January 6, 2008

A case for easing monetary policy in India

In a meeting with all bank chiefs last week, the Finance Minister requested them to soften interest rates, so as to maintain the current growth rates. The economic conditions present an interesting picture. While oil prices continue to move upwards, the inflation trends are more benign. Central Banks have to exercise their monetary policy levers by keeping a balance between the two, at times competing, concerns - growth and inflation. There are opinions both in favor and against easing the monetary policy. I will list out a few reasons as to why monetary policy should be eased.

In early 2007, with inflation threatening to touch 7% and beyond, and the Government facing coalition uncertainty, RBI was facing a difficult situation. The rising inflation in the early part of the year, coupled with the surge in foreign investments, both FDI and FPI, resulting in rising forex reserves raised major concerns within both the RBI and the Government. The RBI responded with a series of monetary tightening measures. The repo rate (at which RBI lends to banks) rose to 7.75% in three instalments, starting October 2006, the CRR went up to 7.5% in the same number of instalments from April 2007. It also raised the limit set on the amount of money that could be removed from the system by short-term (reverse repo) and long term (market stabilization) borrowing.

This monetary tightening has yielded results in the last six months, as WPI inflation has been brought down below 4%. With inflationary concerns allayed, the time has certainly come for growth concerns to take over. This means the RBI should ease the monetary controls and encourage investment. It is the time for aggressively cutting rates.

Monetary policy decisions are increasingly dependent on the global macroeconomic picture. Monetary policy autonomy has diminished to the extent that Central Banks have to factor in the fundamentals and the expectations in the global economy, atleast in the major economies of the world. It is in this context that India may be standing at a favorable position in the global growth cycle.

The US and Europe are easing their monetary policy out of compulsions arising from the sub-prime mortgage related credit squeeze and the imminent dangers of a recession. In contrast, India can afford to loosen monetary policy from a position of strength. A loose monetary policy is critical for continuing the rise in investment rates, at 35% of GDP, which is essential for sustaining the high 9-10% growth rates. In an increasingly integrated global economy, any US recession and low interest rates presents a great opportunity for India to sustain high economic growth without inflationary pressures.

A hard landing in the US and recession elsewhere in the developed world, will cause a fall in global aggregate demand, which will adversely affect the export-led growth economies. The high degree of integration between US and the Asian economies will only exacerbate any consequences of recession in the former, thereby triggering off a global slowdown. This will in turn dampen global oil, energy, food, and other commodity prices, and force down inflationary trends and lower import costs. Though these external shocks will definitely have an impact on our economic growth, India is uniquely positioned among the major economies to ride out this tide. Its low trade dependence, forming 23.5% of GDP, as compared to 36.6% for China and 72% for the ASEAN countries, and a large and fast growing domestic economy, ensures that the Indian economy will continue to remain largely decoupled from rest of the world. Its growing domestic savings rate, at 34% of GDP, and robust financial markets will only increase its ability to withstand external shocks.

There are no dangers of a credit flight or out of control inflation for the foreseeable future. A balanced play of the Impossible Trinity, by way of stable exchange rates and a gradual easing of capital mobility controls, will ensure that we are able to maintain interest rate autonomy.

I will list out a few reasons as to why monetary policy should be eased.
1. Low interest rates are critical for sustaining the rapidly increasing investment rate. It stood at 35% of GDP for 2006-07. Apart from reducing the cost of capital, it will also contribute towards sustaining the bull run in the equity markets.
2. Indian economic growth is extremely interest rate sensitive, given the large number of small and medium businesses, who depend heavily on bank credit. Further, the limitations imposed on accessing external borrowings, also increases the dependence on local bank credit.
3. A recession in the US and elsewhere will reduce consumption demand and hence lower aggregate demand, which in turn is likely to put downward pressure on import prices. A fall in global aggregate demand, is likely to also depress energy, commodity and foodgrain prices, thereby further lowering inflationary pressures.
4. The WPI is already at a very low 3.65% for the first week of December, and declining. Given that CPI follows the WPI, with a lag, the CPI is also set to fall in the coming weeks. Inflationary pressures are therefore well under control.
5. With declining rates elsewhere, prompted by the credit crunch, higher rates in India will open up carry trade like arbitrage opportunities, which are not necessarily desirable.
6. In the event of a recession in the US causing drop in FII inflows into emerging markets, a loose monetary policy could help provide the internal thrust to sustain and stabilize the stock markets.
7. In contrast, in the event of a capital flight into emerging markets, the low interest rates will reduce the incentives for financial market distortions that could encourage undesirable, hot money inflows.
8. By making rupee investments less attractive compared to the other currencies, low interest rates will reduce capital inflows and thereby control the exchange rate appreciation of rupee.
9. A low rate will leave the RBI with enough flexibility to manoeuvre without compromising on growth concerns, when the economy starts overheating, as it will frequently do.
10. The prevailing high interest rate regime had crowded in the overwhelming share of domestic savings into bank deposits, and crowded out the development of alternate investment avenues in the financial markets. The result is that such investments, including the equity markets (only 7% of population invest in shares), lack from adequate depth and breadth. A low rate regime could provide the opportunity for development of such market.
11. A lower rate will ease the demand for External Commercial Borrowings, which crossed $30 bn in 2007. India has emerged as the largest issued of foreign currency convertible bonds (FCCBs) in Asia, outside of Japan. While ECBs are to be welcomed as a source of investment alternatives, an over reliance on them, especially on certain categories, can have harmful medium and long term implications. We only need to look back at the East Asian currency crisis of 1997.
12. The low interest rates will give a filip to consumption growth as hire purchase and home loan markets will go up. The importance of the consumption driven growth multiplier for the economy is enormous.

More fundamentally, for far too long, interest rates in India have remained higher than the global average. It was understandable given the developing and closed nature of our economy, and high inflation rates. But these high rates had introduced many distortions into the economy. Now with economy opening up, financial markets getting integrated with the global markets, capital mobility restrictions being slowly eased, inflation coming under control despite the galloping oil prices, and global interest rates being eased, it is natural that our monetary policy be eased at the slightest opportunity.

As it is our interest rates are high enough to make the cost of capital for our corporates higher than their global competitors. At this stage of our economic growth, when we are stabilizing the high growth trajectory, it is important that we use every opportunity to lower the cost of capital for our corporates. Besides the immediate advantages, it also expedite the painless convergence of our economy with the global financial markets and also provide the Central Banks with greater flexibility to manoeuvre in times of inflationary pressures, economic downturns and financial crisis.