Wednesday, September 30, 2009

A global arms bank as deterrence?

One of the most encouraging trends of the past few decades has been the remarkable decline in the incidence of wars between nation states, especially in comparison to even recent history. However, wars have been replaced with psychological battles of brinkmanship between nation states, resulting in the emergence of a new dimension to the relationship between nations - mutual deterrence. Such deterrence strategies too involve the same massive expenditures on procurement of sophisticated and hugely expensive weaponry as was the case with wars.

The only difference from the earlier era is that instead of using these weapons to actually fighting wars, weapons are now used to deter enemy nation states from any adventurism. In other words, weapons become a hedge against invasion.

In a world where financial market engineering concocts complex products to diversify and hedge against all kinds of risks, it may be appropriate to borrow some of those principles to design a market for achieving mutual deterrence in a more cost-effective manner. SO how about setting up a global arms bank. Here is how it will work.

This arms bank can be a depository of all kinds of weaponry. It can sell customized option products that enable nation states to purchase the right to own specific category of weapons. Like financial options, such options give purchasers the option, but not the obligation, to purchase the weapon products. The terms of delivery, of great importance in case of actual war breaking out, can be formulated in accordance with the requirements of the client. This would mean positioning arms at multiple arms depots, located at different locations across the globe. While this is likely to raise many problems, technological solutions can help overcome most of them.

Membership of this bank should be restricted to nation states, who can purchase the membership (for an annual fee) and buy options of their choice. Taking the model one step further, the arms bank itself can enter into forward contracts with weapons producers, so as to optimize on its own costs. Taking a leaf out of the Swiss banking model, all transactions (and even membership) in this global arms bank can be kept confidential. Since deterrence works by way of increasing the information asymmetry between antagonists, such secrecy will only enhance mutual deterrence.

Such an arms bank would help nation states avoid the massive and wasteful expenditures on amassing weapons to achieve deterrence against their enemies. It would ensure that nations do not spend huge resources to merely stock on weapons it is never likely to use. An arms bank like that envisioned above can be a global public good, in so far as it would help nation states avoid arms spending and divert resources towards development and welfare. Accordingly, a multilateral agency (similar to say, the IAEA) with equal stake for all member nations should administer the bank.

This proposal is never going to work to perfection. For a start, with a few initial credibility creating steps (or confidence building measures, CBMs) it will surely encourage some nations to cut back on their purchases and instead buy options from the bank. A global ban on arms trade will also go a long way in catalysing the development of this arms bank.

Capital markets policy

Standard theories on macroeconomic policy making have focussed on monetary policy, with its objective of controlling short-term interest rates, and fiscal policy, with its risk of impact on long-term rates. However, the present crisis, in which Central Banks and governments have resorted to widespread use of unconventional monetary policy responses (or quantitative easing) - liquidity injections and bank recapitalizations, loan guarantees, nationalizations, bank rescues, asset purchases, lowering of collateral standards etc - highlights the need to revisit academic research on macroeconomic policymaking.

For a start, Brad DeLong makes the distinction by lumping such unconventional responses under the rubric of "capital markets" policy. Broadly, all these actions are aimed at sending signals that alter the expected rate of future inflation and keep interest rates anchored between the short-term rates of monetary policy and the longer term rate expectations unleashed by fiscal policy. Prof DeLong makes the differentiates between monetary and capital markets policy,

"Normal monetary policy works by shifting the private sector's asset holdings toward assets that people spend more readily and rapidly, thus boosting spending. Quantitative easing at the zero bound does not do that: it simply exchanges one zero-yield government asset for another. What it does do is to change bond prices, rather by raising the safe short-term nominal interest rate and thus giving people an incentive to spend the money they already have more quickly."

And managing the exit from such expansionary policies would help anchor longer term expectations and keep the bond markets from tightening too much from a fear of inflation and large dficits.

Also, Paul Krugman's recent posts about the "crowding in" effect and lower real cost of the deficits of expansionary policies is relevant. The real costs of deficits in a recession or a zero-bound liquidity trap, are smaller than the nominal deficit incurred for two reasons.

First, as the spending finds its way into the economy, it has the effect of boosting aggregate demand and repaying itself partially through taxes and other government revenues (and lowering of expenditures on say, welfare measures, that government would otherwise have had to incur). It is for this reason that economists advocate that any such expansionary spending is done to get money in the hands of people who are likely to spend (andnot save or merely repay debts) it immediately. Krugman feels that the revenues cause something like a 40 percent offset, leaving the actual csots of fiscal stimulus to be only 60 percent of what it nominal cost.

Second, the expansionary policies boost aggregate demand and economic growth by hastening the return to normalcy and therefore lowers the real cost of both the debt and its servicing burden.

Tuesday, September 29, 2009

Designing incentives to improve teacher performance

How do teachers respond to financial incentives and contract tenures? Karthik Muralidharan and Venkatesh Sundararaman have examined the results of a randomized evaluation of various policy options to improve the quality of primary education implemented across a large representative sample (500) of government-run rural primary schools in five districts of the Indian state of Andhra Pradesh and found several interesting results.

They found that providing an extra teacher with fixed-term renewable contracts to a randomly-chosen subset of primary schools led to an improvement in student performance in math and language tests by 0.16 and 0.10 standard deviations (a treatment impact of 0.1 SD is equivalent to saying that an average child who received the treatment would have improved his/her rank by 4) respectively over the untreated control group schools after two years. The treatment effects were found to be the largest in remote schools and for students in the first grade. The contract teachers were significantly less likely to be absent than employee teachers, and more likely to be engaging in teaching activity when observed during unannounced visits to schools.

As the authors point out, unlike that of contract teachers, the wages of regular teachers are pushed up by their higher education qualifications and availibility of opportunities, premium to work in remote and rural locations, and the effect of unionization. The wage differential is often a multiple of more than five. The biggest criticism against the employment of contract teachers has been the on the grounds that it would lead to dilution of learning standards. Without claiming that a contract teacher is more effective than a regular teacher, they write,

"The combination of low cost, superior performance measures than regular teachers on attendance and teaching activity, and positive program impact suggest that expanding the use of contract teachers could be a highly cost effective way of improving primary education outcomes in developing countries... expensive policy initiatives to get highly qualified teachers to remote areas may be less cost effective than hiring several local contract teachers to provide much more attention to students at a similar cost... there may be an extent to which quantity can more than make up for the lower qualifications of contract teachers (especially for primary schooling) and do so in a cost-effective way."

In order to avoid the problems associated with mass recruitment of un-trained contract teachers and the resultant dilution of professional standards, the authors propose a performance-linked tenure track to integrate contract and regular teachers into a career progression. Under this arrangement, only contract recruitments are made and consistently high-performing contract teachers could be promoted to regular civil-service rank at the end of a fixed period of time.

Another policy experiment that involved providing bonus payments to teachers based on the average improvement of their students' test scores in independently administered learning assessments (with a mean bonus of 3% of annual pay) found that students in treatment schools performed significantly better than those in control schools by 0.28 and 0.16 SDs in math and language tests respectively at the end of two years. They found that the gains in test scores represented an actual increase in learning outcomes, and that the treated schools also performed better on subjects for which there were no incentives, suggesting positive spillovers. They also find that teacher incentive programs were three times as cost effective in raising test scores than unconditionally provide additional schooling inputs. The challenge with this is to arrive at the optimal level of bonus which incentivizes effort without creating distortions. Combining these two results, the authors suggest that

"there could be significant gains from moving to a system of hiring teachers on fixed-term contracts and then using performance measures to pay bonuses on an ongoing basis and to inform the tenure decision after a longer period of performance measurement. Such a system could both move the entire distribution of teacher effectiveness to the right (by increasing effort) and further increase average teacher effectiveness by not renewing the contracts of ineffective teachers... The use of teachers on fixed-term renewable contracts can be a highly cost effective policy for improving student learning outcomes, especially if placed in the context of a long-term professional career path that rewards effort and effective teaching at all stages of the teaching career."

I am inclined to believe that the performance-based pay system being proposed may be more difficult to scale up than anticipated. While it may have succeeded in the limited context and time over which it was implemented, it may not yield the desired results with a more ambitious scope and larger area of implementation. As the program is expanded to cover all the teachers, the incentive award risks becoming an routine entitlement and getting diluted.

There are likely to be four major problems associated with the determination of bonuses. First, what would be the most optimum bonus? It should neither be too small as to have limited incentive effect nor too large as to waste scarce resources and generate incentive distortions. Second, as the program coverage expands, it will become difficult to cover all the teachers under a single bonus formula with broad acceptance among the stakeholders. Third, there will be increasing conflict between the search for accuracy of the formula in approximating the actual impact of teacher efforts and its transparency so as to generate broad-based acceptance. Finally, and most crucially, there will always be the problem with administering accurate data collection on such a massive scale. How do we guard against potential problems like grade inflation and data manipulation?

Efforts to incentivize teachers with performance based-pay and choice in transfers have been attempted in many states across India, albeit on smaller scales, with not so satisfactory results. The problem ultimately boils down to administering such massive programs and guarding against the dilution of its standards as it expands to cover all the schools. Given the standards of school supervision that prevails and the massive numbers of supervisors at different levels involved, it will be a major challenge to ensure the quality of data collection even for a district, leave alone a state. It will be very difficult, even with extensive computerization to effectively address this challenge. Once the programs are institutionalized, there is an ever-present danger that the performance incentive system loses its sanctity.

Further, in the absence of a sunset clause, these incentives are liable to be distorted. With time, there is the imminent danger, especially given the influence wielded by unions, that the incentives could become internalized as part of the salary structure. Ultimately, this could merely add to the substantial premium that government teachers enjoy over private school teachers.

Since behavioural economists have shown that people are more averse to losses than attracted to similar sized gains, penalties are more likely to be effective than incentive rewards. However, penalties raise opposition from the unions and would therefore be difficult to implement.

The policy of renewable fixed-term contract appears more practical and easier to implement. It opens up the possibility of a tenure track for newly recruited teachers that incentivizes them to perform and not shirk work. But the challenge with this approach would be to actually fire or discontinue the contracts of the poor perfroming contract teachers.

There is already a provision in the existing teachers' recruitment process in many states, that takes in these teachers initially as probationers whose services will be regularized after two or three years on receipt of a "satisfactory service certificate" issued by their supervisory officer. It is therefore legally possible to discontinue the probations of poor perfroming teachers. But there have been no or very few instances of such terminations, so much so that the process of declaration of probations has become superfluous and degenerated into a routine activity.

One way to overcome this problem is to keep the contract periods relatively short, two or three years, so as to leave the discharged candidates enough time to seek an alternative career. A policy on the recruitment process assumes significance in view of the current proposals in a number of states to recruit teachers in large numbers.

Tobin Club - tax financial transactions

In the aftermath of the sub-prime mortgage crisis, James Tobin's proposal for a tax to deter speculative short-term cross-country currency transactions, is finding increasing support among economists, regulators and policymakers. In fact, they have gone further ahead and proposed taxes on various other forms of financial transactions, including the likes of "bailout" and "too big to fail" taxes.

The fundamental rationale behind such taxes is that many types of financial transactions, especially those involving complex financial instruments whose risks are both difficult to locate and assess, generates negative externalities. In similar circumstances, taxes have been found to be more effective than regulation in internalizing the external costs by aligning private incentives with social costs and benefits, with the least distortions and the greatest efficiency. Apart from restraining undesirable complex and high-risk financial transactions, such taxes would also raise revenues to finance the enactment of measures to more effectively regulate such transactions and build up an account to fund bailouts when required.

Edward Glaeser is the latest addition to the Tobin Club by favoring the imposition of a tax on banks which would be based on their respective systemic risks. He feels that such taxes are easier to administer and superior to regulations,

"Slapping an appropriate tax on these entities would have generated revenue and limited their desire to impose extra risks on the American taxpayer... Calculating such a tax may seem incredibly hard, but well-designed regulations require even more knowledge. Consider the proposal to ban certain firms from trading in derivatives. To determine whether this ban makes sense, we would need to know both the impact of such trading on expected bailout costs and the private benefits that such trading yields for each firm. To micromanage a firm’s trading strategy, a regulator needs to know private benefits and social costs. Designing a sensible tax just requires knowing the costs to the taxpayer.

A tax is also less likely than regulation to stifle innovative activity. Giving a firm the option to act, for a price, is less intrusive than banning actions altogether. Regulations have often served industry insiders by creating barriers that prevent the entry of smaller competitors. An appropriate systemic-risk tax would have no such effect, since new firms would usually be small enough to fail...A tax also generates revenues, which offset the cost of future bailouts."

Monday, September 28, 2009

Evaluating bank balance sheets

In the aftermath of the sub-prime mortgage crisis and the consequent financial market meltdown, there has been considerable debate about the failure of banking regulators to accurately assess institutional and systemic risks. There have been demands to identify and use more representative and accurate parameters that adjust for the inherent solvency risks and toxic assets that are present in the banking sector.

The conventional parameters for evaluating the soundness and strength of banks have been Capital Adequacy Ratios (CAR) and Non Performing Assets (NPAs). The former, also called Capital to Risk Weighted Assets Ratio (CRAR), is the ratio of a bank's capital (equity plus reserves) to its risk weighted credit exposures or risk weighted assets, and is a measure of the "ability of the bank to withstand losses before its ability to pay off its liabilities starts getting compromised" or how much the bank's "assets could fall in value by upto and still it would be able to pay back its depositors". The latter is measured as the percentage of its assets (lendings) which are classified as sub-standard or doubtful of repayment.

However, as Madan Sabanvis writes in a Mint op-ed, looked independently, these two ratios alone can provide misleading indications - a bank with low CAR can show a low NPA ratio and a bank with high CAR may have built up toxic assets. He therefore proposes a "knockout ratio" ("how much of capital would be erased by NPAs", measured as ratio of gross NPAs to capital), by juxtaposing the contaminated part of the portfolio (or NPAs) with the available capital that belongs to the bank. The objective is to arrive at the true extent of capital, or free capital, that the banks actually own, after adjusting for the NPAs. As he writes, "This gives the extent to which the bank’s own capital is being blocked by its impaired assets."

The adjusted CARs for 39 major Indian banks for the fiscal 2009, by extrapolating how the CAR would look like in case NPAs were deducted from the capital of the bank, reveals serious concerns about the capitalization of our banks.

The average "knockout ratios" for these 27 public sector and 12 private banks was quite high at 20.4%; under the concept of adjusted CAR, six banks now slide below the 9% mark that Basel II stipulates; whereas while only one bank had a single-digit conventional CAR, there are now 17 with adjusted CAR less than 10%; the median decline from conventional to adjusted CAR was 2.42 and the average decline was 2.6. The balance sheets of some of the public sector majors like SBI, Syndicate Bank, Union Bank of India, and Indian Overseas Bank, suddenly becomes less flattering. In a further confirmation of the widely held fears about the strength of the ICICI Bank, it emerges with the largest "knockout ratio" among the major private sector banks. Axis Bank, Indian Bank, HDFC, Bank of Baroda, Andhra Bank are among those who emerge with low knockout ratios.

Stimuluses and asset bubbles

Nouriel Roubini (also here) on the need to devise effective exit strategies from the expansionary fiscal and monetary policies of the past few months, so as to prevent igniting inflationary pressures and a fresh round of asset bubbles, without snipping out the nascent "green shoots" of economic recovery.

Sunday, September 27, 2009

Global structural imbalances and monetary policy autonomy

In earlier posts here, here, here, and here, I have blogged extensively about the importance of rectifying the global macroeconomic imbalances, if we are to avoid the recurrance of the sub-prime mortgage crisis and the recession that followed.

An excellent guest post in Baseline Scenario adds more to the list of reasons to remedy these imbalances. It argues that "structural problems – like trade imbalances, inadequate capital ratios, and weak financial regulation – severely constrain Fed monetary policy options by impacting currency flows and the value of the dollar". This leads to situations like the present one, when pressure mounts on the Fed to raise rates to quell inflationary fears even when unemployment is rising, capacity utilization is declining, and potential output gap is widening.

Baseline Scenario points to unaccounted for (in conventional macroeconomic models) leakages in the monetary stimulus - "to large financial institutions with asymmetric reward functions (aka, government owns the downside) and government guarantees (Too Big To Fail) that give them cheap access to credit" (and blowing up newer bubbles) and outflow of capital from the country "through dollar hedging mechanisms (into commodities, foreign assets, and an anti-dollar carry trade)" - that takes away from the expansionary impact of a cheap money policy. And there is also the leakage due to the liquidity depressing effect arising from decreased money velocity of circulation due to the reluctance of businesses and households to invest and spend.

In the circumstances, the Fed's monetary policy can be effective only if complemented with "financial regulation (to avoid new liquidity being channeled into bubbles instead of real investment), better capital asset ratios (to help moderate moral hazard and asymmetric risk), and limited expectations of future dollar devaluation (which currently result from our huge debts, and China’s continued mercantilist policies that keep the dollar propped up)".

In the absence of these set of policies and effective regulation ("due to regulatory capture or because financial innovation has outpaced the political system's willingness to extend regulators' reach"), the Fed will be forced into taking away the punchbowl during booms and giving it back during busts, with the attendant risk of getting the timing wrong - "taking away the punchbowl too fast and give it back too late, due to poor regulation and dollar instability, and its own anti-inflation intellectual bias and obsession with its credibility". And recent history shows that the timing is most often likely to be wrong and rarely right! Brad DeLong's blog describes this as "second-best punchbowlism"!

In this context, it is important that we revisit the conditions of the Mundell-Fleming Impossibility Theorem. In an earlier post, I had blogged about the challenge of the Impossible Trinity - it is impossible for a Central Bank to simultaneously achieve capital mobility coupled with stable (fixed or an adjustable peg) exchange rates and interest rate autonomy. Under any macroeconomic circumstances, only two of these objectives could be simultaneously met.

In view of the aforementioned reasoning, to the list of conditions under which Central Banks can maintain interest rate autonomy, we must now add effective financial market regulation (of which higher capital asset ratios are just one of the desirables). In its absence, even with floating exchange rates and free capital mobility, Central Banks will be unable to respond to a downturn with the necessary loose monetary policy.

Saturday, September 26, 2009

The great divide in macroeconomics

Paul Krugman's NYT Magazine essay on a crisis facing modern macroeconomic theories has provoked an intense debate in the blogosphere. Mark Thoma has captured this in two exhaustive lists here and here.

The ongoing economic crisis has exposed the inadequacies of both the saltwater (who, in Keynesian tradition, think that monetary and fiscal policy interventions can mitigate or even prevent recessions) and freshwater (who, following Milton Friedman and the Chicago School and Real Business Cycle school, claim that recessions cannot occur without government interventions and even if they occur monetary policy is adequate to generate recovery) schools of economics. Apart from this, it has also exposed the sharp cleavage between these two, with the former having supported the aggressive monetary and fiscal policy actions of the last twelve months and the latter continuing to believe that economies work best when markets operate freely, with limited government participation.

More fundamentally, neo-classical and Keynesian economists differ about how quickly and whether wages and prices adjust in response to demand-supply mismatches. The former have built their macroeconomic models on the assumption that wages and prices are flexible and that prices 'clear' markets, and balance supply and demand, by adjusting quickly. In contrast, the latter believe that markets do not clear automatically and can remain stuck in a deficit equilibrium and also argue that the neo-classical models cannot explain the peristent and repeated short-run economic fluctuations.

A bit of wikipedia to fill up details (and refresh my own memory!) of the great divide that came to the fore sharply in the early seventies. Keynesian economics, that gained ascendancy in the aftermath of the Great Depression, argued that fluctuations in the business cycle due to a decline in aggregate demand (due to a fall in money supply or economic recession) would lead to a (not temporary) fall in employment and output and it requires Central Bank and government interventions, through monetary and fiscal policy actions, to stabilize the cycle. In contrast, the neo-classical school had focussed on market-based (through supply-demand balancing) determination of prices, output, income distribution and resource allocation, arrived at by the interaction of individuals who have rational preferences, maximize utility and act independently based on full information and firms whose objective is to maximize profits. They emphasize equilibria as solutions of agent maximization problems, and see limited role for governments in addressing economic fluctuations and crises.

The neo-classical assault on Keynesian economics in the early seventies, led by Milton Friedman's monetarism, put monetary policy at the center of the debate ("inflation is always and everywhere a monetary phenomenon") on addressing macroeconomic crisis and general deviations from the potential output. It rejected fiscal policy and other demand management policies as leading to the crowding out of private investments and inefficient allocation of resources. This was reinforced by the rational expectations theory, pioneered by Robert Lucas, which assumes that individuals take all available information into account in forming expectations and that though agents' expectations are wrong at every one instance, but is correct on average over long time periods.

Therefore, for example, attempts to lower unemployment through expansionary monetary policy economic agents will fail (after an initial fall in unemployment) because people and firms will anticipate the effects of the change of policy and raise their expectations of future inflation (and interest rate hikes) accordingly, which in turn will counteract the expansionary effect of the increased money supply. Stagflation will result and the events of late seventies and early eighties appeared to vindicate this.

And this meant that anticipated policies (monetary and fiscal) have no effect on employment and cannot stabilize the economy, as expectations nullify the gains from expansionary policies. Only surprise changes in, say, the money supply matter. This Edmund Phelps-Robert Lucas analysis appeared to have weathered the Keynesian attack on the neo-classical paradigm by explaining the evidently Keynesian behaviour of the economy in terms of imperfect information and the rational expectations formed from that. However, as Paul Krugman has argued, such rational expectations based models (which assumed that people had to form expectations about the future based only on price signals) "broke down as soon as you let people have access to any other information – say, by looking at interest rates, or reading a newspaper".

This limitation of the rational expectations led neo-classical revival along with the Lucas critique, led to another split, between the New Keynesians and the Real Businsess Cycle (RBC) schools, which has since manifested as the freshwater-saltwater divide. The Lucas critique argued that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data. Models constructed based on historical information may not yield accurate predictions because the predicted co-relations can be expected to change when new policies are introduced. Instead, Robert Lucas claimed that it was important to model atleast the fundamental parameters that govern human (and firms) behaviour - preferences (objectives of agents), technology (productive capacity of the agents), and institutional (mainly resource) constraints - in response to (and in anticipation of) policy changes and then aggregate the effects of the resultant individual decisions to calculate the macroeconomic effects of the policy change.

All this encouraged the Keynesians to revisit the microfoundations of their models. The New Keynesian school that sought to build microfoundations for Keynesian economics, agree with the neo-classicists about the rational expectations among businesses and individuals but differ in that it provides for a variety of market failures (atleast in the short run) - prices and wages are "sticky"; monopolistic competition; credit market imperfections; co-ordination failures among market participants, leading to aggregate demand multipliers and possible multiplicity of equilibrium; unemployment caused by moral hazard and matching frictions etc. Since these failures (especially that relating to price and wage stickiness) lead to an economy stagnating at less than full employment, they argued that macroeconomic stabilization by the government (using fiscal policy) or by the central bank (using monetary policy) can lead to a more efficient macroeconomic outcome than a laissez faire policy would.

The New Keynesian models with 'sticky' wages and prices rely on the stickiness of wages and prices to explain why involuntary unemployment exists and why monetary policy has such a strong influence on economic activity.

However, the New Keynesians have focussed attention mainly on the role of monetary policy, especially when both inflaiton and output are down, in which case expanding the money supply (by lowering interest rates) helps by increasing output while stabilizing inflation and anchoring long term inflationary expectations. They have paid limited attention to the role of fiscal policy, though they acknowledge its utility in stabilizing output.

The neo-classicists responded to the deficiencies pointed out by Robert Lucas and Co by formulating their RBC Theory models in which business cycle fluctuations, to a large extent, can be accounted for by real (in contrast to nominal) shocks. They see recessions and slowdowns as the efficient response to exogenous changes in the real economic environment and hold that the level of national output necessarily maximizes expected utility. Accordingly, they feel that governments should concentrate only on the long-run structural policy changes and not intervene through discretionary fiscal or monetary policy designed to actively smooth economic short-term fluctuations. In other words, unlike other theories of the business cycle (including Keynesianism and monetarism), the RBC school see such cycles as "real", in so far as they do not represent a a failure of markets to clear but reflects the most efficient possible operation of the economy, given its specific structure.

Further, in response to the Lucas critique, both the aforementioned groups went about constructing their own versions of macroeconomic models (different from the earlier static and deterministic general equilibrium models) based on the micro-foundations of agent behaviour. Since macroeconomic behavior is derived from the interaction of the decisions of all these players, acting over time (dynamic), in the face of uncertainty (probabilistic) about future conditions, these models are classified as dynamic stochastic general equilibrium (DSGE) models. The DSGE models accordingly attempts to explain aggregate economic phenomena, such as economic growth, business cycles, and the effects of monetary and fiscal policy, on the basis of macroeconomic models derived from microeconomic principles.

The RBC theory based DSGE models, formulated by Fynn Kydland and Edward Prescott assumes flexible prices to study how real shocks to the economy might cause business cycle fluctuations. In contrast, the New Keynesian DSGE models assume that prices are set by monopolistically competitive firms, and cannot be instantaneously and costlessly adjusted.

To locate the debate about the state of macroeconomcis in the present generation and the latest research, Justin Wolfers draws attention to a paper by Narayana Kocherlakota who analysed the works of the latest generation of tenured macroeconomists in the top 15 American university economics departments and is cautiously optimistic about the future of macroeconomics. He does not find any saltwater-freshwater divide among them and finds that they do not ignore heterogeneity nor frictions nor bounded rationality, and their models incorporate a role for government interventions. However, as Wolfers points out, unlike their predecessors, being more interested in economic theorizing they have not been active participants in current economic policy debates nor are they engaged with issues of the real world.

The ongoing crisis appears to have decisively, atleast for the time, shifted the upper hand to the Keynesians. Paul Krugman has been at the forefront of those leading the backlash agianst the free-market monetarist ideologues who opposed the government fiscal stimuluses and aggressive unconventional monetary policy responses by the Federal Reserve during the present crisis. He has even lamented that it is the "Dark age of macroeconomics"!

All this has expectedly generated a very shrill reaction from Chicago School, with John Cochrane leading the charge. However, as Bradford Delong illustrates, with this excellent compilation, the Chicago School is clearly on weaker wicket in this battle, atleast for now. They appear more like Ostriches burying their head in the sand when their favorite theories and holy cows seem like crumbling in the face of the overwhelming evidence of reality, instead of rationally and objectively responding to their critics. See also this, this and this by Paul Krugman, Nick Rowe, and Mark Thoma respectively.

Update 1
What's wrong with modern macroeconomics? - Conference papers by Mark Thoma.

Update 2
Alan Kirman has this critique of modern macroeconomics and financial market theories and argues that the economy is complex adaptive system and advocates making the analysis of the structure of interaction between agents more central to our models.

Update 3
Charles Kindleberger's anatomy of a bubble, which draws heavily from Hyman Minsky is available here. John Quiggin on what next for macroeconomics.

Toxic asset auction design

One of the biggest challenges that Central Bankers and policy makers faced in their efforts to administer the TARP and similar toxic asset purchase schemes during the sub-prime mortgage crisis was the problem of valuing these assets and desinging an efficient price discovery mechanism. Now, Oxford Professor Paul Klemeper (of the European telecom spectrum auction fame) has proposed a new auction design, called "product-mix auction" (more details in pdf here), that can be used for toxic asset purchases and central bank liquidity auctions in a credit crunch.

Simultaneous multiple-round auctions are infeasible in financial market auctions because of the transaction costs and incentive distortions they are likely to impose. He therefore proposes a "simple-to-use, sealed-bid, auction that allows bidders to bid on multiple differentiated assets simultaneously, bid-takers to choose supply functions across assets", and one that makes it harder for bidders to collude or exercise market power in any unfair manner. He desribes his auction design thus,

"Each bidder can make one or more bids, and each bid contains a set of mutually exclusive offers. Each offer specifies a price (or, in the Bank of England’s auction, an interest rate) for a quantity of a specific "variety". The auctioneer looks at all the bids and then selects a price for each "variety". From each set of offers in each bid, the auctioneer accepts the one that gives the bidder the greatest surplus evaluated at the selected prices or no offer if all the offers would give the bidder negative surplus. All accepted offers for a variety pay the same (uniform) price for that variety.

The idea is that the menu of mutually exclusive bids allows each bidder to approximate a demand function, so bidders can, in effect, decide how much of each variety to buy after seeing the prices chosen. Meanwhile the auctioneer can look at demand before choosing the prices. (Allowing the auctioneer to choose the prices ex post creates no problem here because it allocates to each bidder precisely what that bidder would have chosen given those prices in the environments for which the auction is proposed.) Importantly, offers for each variety provide a competitive discipline on the offers for the other varieties, because they are all being auctioned simultaneously."

To clarify, "each bidder can make any number of bids and each bid specifies a single quantity and an offer of a per-unit price for each variety. The offers in each bid are mutually exclusive. The auctioneer looks at all the bids and chooses a minimum "cut-off" price for each variety, consistent with both market demand and its own supply curve. The auctioneer accepts all offers that exceed the minimum price for the corresponding variety, except that it accepts at most one offer from each bid. If all the price-offers in any bid exceed the minimum price for the corresponding variety, the auctioneer accepts the offer that maximizes the bidder’s surplus, as measured by the offer’s distance above the minimum price. All accepted offers pay the minimum price for the corresponding variety – that is, there is 'uniform pricing' for each variety."

Friday, September 25, 2009

US government debt

Floyd Norris has a nice graphic which illustrates how the US national debt, at $7.2 trillion as on June 30, 2009, has grown by more than a third over the past year, as the US Government has borrowed massively to finance its financial and economic stimulus policies.

The graphic also shows how the outstanding debt of all the other economic actors - businesses, households and even state governments - has fallen off a cliff, leaving the US government to stand in for this collapse in private demand. The other relief amidst this spectacular explosion in national debt has been the historic low interest rates that have kept debt financing at very cheap levels.

During the current crisis, the government was forced into the role of a financial intermediary between the credit markets on the one side and the private financial institutions and businesses on the other. It borrowed on the behalf of the latter to bridge their liquidity squeeze, restore market confidence and spur aggregate demand.

The graphic also points to another indicator of the recent dominance of the financial services sector. While twenty years ago, non-financial businesses in the United States borrowed $1.70 for every dollar borrowed by the financial sector, government-guaranteed or not, the figure today is down to just 68 cents. Of concern is the fact that most of the debt incurred by the financial services sector was not based on any real economic activity, but from securitization and debt generated from derivative securities.

Update 1
Japan's massive public debt, touching 200% of its GDP, and bloated by the stimulus spending during the current recession has raised fears of a sovereign debt default and massive debt sell-offs.

However, Japan is rich in personal savings and assets, and less than 10% of its debt is held by foreigners, compared to 46% of America's public debt. Further, half of Japan’s government bonds are held by the public sector, while government regulations encourage long-term investors like banks, pension funds and insurance companies to buy up the rest, effectively meaning that the government is just borrowing from one pocket and putting it in the other.

Finally, as Paul Krugman writes, Japan has the lowest long term bond yields, a bell-weather of inflationary pressures and debt default risks, among all major economies, and if anythin pointing to a long period of deflation.

Update 2
Paul Krugman puts the US public debt in perspective and argues that its public debt as a share of GDP has not reached unsustainable levels.

Larry Summers feels that even with the big recent increase in government debt, the total amount of debt generated by the United States economy has not been growing especially fast and that the total level of borrowing in US economy is actually lower than in normal times, not higher. David Leonhardt claims that the declines in private borrowings may have partially off-set the increase in government borrowings.

Update 3

Obama's Bush inheritance will be felt for many years to come

Update 4
Excellent editorial in the Times that examines the issue of burgeoning US government deficits and traces it to the Bush era profligacies and the recession.

Update 5
Menzie Chinn finds that the US public debt ratio and budget imbalance might not be as bad in comparison with other major developed economies.

Thursday, September 24, 2009

McDonaldization and Wal Martization of the US

Nice graphic (from Economix, via Felix Salmon) that maps how far any given point in the US is from the nearest McDonald’s is an excellent illustration of the "McDonaldization" of the US.

An even more fascinating and must see Wal Mart growth video about the WalMartization of the US is available here. I visualize a distinct tipping point effect at work in the growth of these stores.

See also this graphic about the growth of Target super stores.

Predicting banking crisis

When the asset bubbles were building up, the common refrain was that it would be unwise to deflate bubbles because we are not sure whether it is a bubble and the costs of such actions can be substantial. It was argued that departures of the market values (itself a tricky valuation exercise) of assets from its fundamentals was difficult to predict and therefore it was preferable to clean up after the bubble burst.

Bharat Trehan of the San Francisco Fed claims that "simple indicators based on asset market developments can provide early warnings about potentially dangerous financial imbalances", and suggests that departures of credit levels and asset prices from their historic threshold levels are good predictors of an imminent banking crisis.

Trehan points to multi-country studies by Claudio Borio and Philip Lowe and Graciela Kaminsky and Carmen Reinhart (and also this) which examined three different measures - asset prices, credit, and investment - and found that increase in credit levels above a certain threshold (they called it "credit gap") is the best predictor of a banking crisis. They defined the credit gap as the difference between the current ratio of credit to GDP and a slowly changing measure of the trend value of this ratio. They found that with a credit gap of 5% as threshold, we would be able to predict 74% of the crises that occurred subsequently.

Asset (stock and property markets) prices are the other indicator that can best approximate the imminence of a banking crisis. After examining a sample of 15 countries, Bordo and Jeanne declare an asset market to be in a boom or bust if the three-year moving average of the growth rate of the inflation-adjusted asset price falls outside a specified range, whose width is defined taking into account the historical average growth rate and volatility of the asset price. This analysis is more accurate for property than for equity markets.

As Trehan writes, the purpose is not to zero in on the ideal set of indicators, but to identify simple indicators that "would have signaled impending trouble prior to the current crisis"... simple indicators can be useful, not to fine-tune policy during normal times, but as signals of rising levels of risk in the economy."

Protectionism update

I had blogged earlier about the rise of creeping protectionism among G-20 countries in the aftermath of the global economic recession. Simon J Evenett examined the findings of the latest report of the Global Trade Alert (GTA) that examined such measures initiated by G-20 members since Novemeber 2008 (when they committed themselves to a no protectionism pledge) and finds an increase in trade-distorting protectionist measures among these countries.

He writes that the "overwhelming picture is one of planned and implemented state initiatives that reduce foreign commercial opportunities and reverse the 25-year trend towards open borders". He also finds that worldwide, the number of discriminatory measures being implemented outnumbers the liberalising measures by five to one and there are a large number of such measures on the pipeline and set to come into effect over the next six months. A small snapshot of the biggest offenders, ranked by four parameters, are shown below

And the graphic below represents the almost global-reach of the targets of protectionist measures imposed by G-20 nations.

Wednesday, September 23, 2009

Industrial policy and power equipment industry

I had blogged earlier, here and here, about the continuing relevance of government guidance by way of effective industrial policies to promote economic development, especially in the emerging economies. Government of India's policies on procurement of boiler, turbine and generator (BTG) equipments for power generation units may be the latest example of the utility of "industrial policy".

Faced with achieving a massive generation capacity target of 78,500 MW during the Eleventh Five Year Plan, Indian generators, both private and state-owned, have been grappling with the challenge of sourcing power equipment. With overflowing order books and limited capacity (about 6000 MW per year), the sole Indian power equipment manufacturer, BHEL, has been unable to meet the huge requirements. The Chinese power equipment suppliers have seized the opportunity by leveraging their massive capacities and resultant economies of scale to promise delivery of these equipments at competitive prices.

Private generators have been sourcing most of their equipments from China, despite the concerns with the effectiveness of Chinese equipments with India's high ash content coal and their lower PLFs. The Chinese BTG equipments are 10-15% cheaper and are delivered well in time, compared to the persistent delays that plague the over-burdened BHEL's delivery schedules.

The major Chinese equipment makers - Dongfang, Harbin, SEPCO, CMEC and SEC - have emerged as among the largest and lowest cost manufacturers of BTG equipments required for thermal power generating plants across the world. Interestingly, government policies like standardization of equipment sizes (which has also enabled freezing of the critical and time-consuming task of plant designs) and bulk procurements for the huge domestic generation capacity additions, assisted by the country's galloping economic growth over the past two decades, have propelled these firms to the top of the global league, competing with the likes of established players like Alstom, Siemens, and Hitachi. China is not alone in having achieved success with such policies. Earlier, the Korean government had promoted Korea Electric Power Corporation (KEPCO), which after having successfully assisted in boosting domestic generation capacity is now seeking out markets elsewhere.

Taking cue from the Chinese experience and its own huge projected capacity additions and resultant equipment needs in the coming years, the Government of India has been making efforts to catalyze the development of a vibrant domestic industry in power equipment design and manufacturing. It has barred its generation projects (mostly NTPC) and advised state government generators from sourcing equipments from China and is insisting that prospective sellers, both Chinese and others, form joint ventures with Indian partners and set up manufacturing facility in India.

It has also outlined clear norms stipulating that bidders for all ultra mega power projects (UMPPs) would be entitled to source equipment only from equipment suppliers who provide upfront commitment for progressive indigenisation of technology or a phased manufacturing programme (PMP). While this may have been motivated more by an old-fashioned protectionist desires to keep out the Chinese from capturing the Indian market and also protect the local manufacturers (mainly BHEL), it has the potential to pave the way for strengthening the country's heavy and capital equipment industry and its ancillaries.

Early indications are that this policy has already started bearing results. L&T and Mitsubishi have formed a joint venture and set up a manufacturing facility which has already bagged a number of orders. Other Indian firms too have tied up with global majors like Alstom, Siemens, Hitachi etc, to set up equipment manufacturing facilities in India, including for boilers with advanced super-critical technology.

While this policy of a phased manufacturing programme for foreign equipment suppliers may have been partially responsible for the delays in meeting the generation capacity addition targets, it also lays the foundation for a swifter pace of capacity addition once the critical threshold of domestic manufacturing facilities are established. Further, the presence of domestic expertise and facilities also enables more effective servicing and maintenance support for the installed units.

However, such industrial policy to promote the development of heavy equipment sector cannot stop with merely banning the sourcing of equipments from outside and the insistence on domestic production. It will have to be complemented with efforts to hasten the actual capacity addition projects (so that the industry expands and matures by feeding on the increased capacity addition) by standardizing equipment design, expediting site clearances and environmental approvals etc. In the absence of the latter, industrial policy will end up as another example of the autarkic import-substitution policies of an earlier era, and benefiting a few firms and lining the pockets of decision makers and hangers on.

Financial literacy may take some time to achieve

In the aftermath of the sub-prime mortgage crisis, there have been a chorus of voices for greater awareness creation and protection to ordinary consumers about the dangers and risks inherent in complex financial products. Financial literacy has taken the front seat in most of the financial market reform proposals under consideration across the world.

An NBER working paper by Annamaria Lusardi, Olivia Mitchell, and Vilsa Curto (via Zubin Jelveh) draws attention to the shockingly poor financial literacy among the young - "fewer than one-third of young adults possess basic knowledge of interest rates, inflation, and risk diversification". They advocate that providing financial education in high school may be particularly beneficial to children from disadvantaged backgrounds. They write,

"We found that most young adults are not well equipped to make financial decisions: only 27% of young people in our sample possessed knowledge of basic financial concepts including inflation and risk diversification and could do simple interest rate calculations. Financial illiteracy is not only widespread but is particularly acute among specific groups, such as women, Blacks, Hispanics, and those with low educational attainment."

However, Jelveh claims that we have not reached the level of financial maturity required to get people to think about "interest rates and inflation the way they think about, say, calories or the price of gas", and therefore a consumer financial protection agency may only "give people a false sense of security".

Tuesday, September 22, 2009

"Sin" taxes Vs "Yuck" ads!

Public health experts across the world have been concerned at the increasing consumption of sugary soft drinks and holds it partly responsible for the increased incidence of obesity, high blood pressure and heart diseases. Accordingly, policy makers have been relying on two main approaches to reduce the consumption of these beverages - awareness creation through ("Yuck") advertisement campaigns and soda (or sin) taxes.

I have already posted earlier here and here about the benefits of an obesity tax on such foods. The New York City has been running high-visibility anti-soda advertisements that repulsively illustrates the harmful effects of these sugary beverages. And taking cue from how cigarette taxes have helped curb smoking, the Obama administration is considering imposing a soda tax on soft drinks, energy drinks, sports beverages and many juices and iced teas.

While public health specialists support these efforts, economists have been more ambivalent in their responses. Liberatarian paternalists, following the lessons from behavioural psychology, strongly advocate such ad-campaigns and taxes as efforts to nudge people away from consuming these beverages. There are others who argue that taxes will help internalize the external costs imposed by obesity and other harmful effects on health - increased burden on government health care systems (Medicare/Medicaid), social contagion effects of obesity etc. However, libertarian opponents, who favor respect for individual decision-making, argue that people drink beverages because of the utility and pleasure they derive from its consumption. Accordingly, they strongly oppose any government intervention in advising them about what is good for their health.

The case in favor of atleast some form of restraints on consumption of beverages is well established and needs no reiteration. In any case, whatever the arguements against public paternalism and protection of individual's right to indulge himself (to destruction and death if he so desires), the net economic cost inflicted on the society by these individual actions are too large to be ignored. One man's liberty stops where it starts adversely affecting another man's (or society's) liberty.

In the scale of liberty, awareness campaigns are surely on the liberatrian side while taxes would appear to verge on paternalism. However, I am inclined to side with Edward Glaeser in favoring paternalism as the more efficient form of controlling consumption of sugary beverages. Both taxes and instrusive and unpleasant ads seeks to internalize the external costs of consuming these beverages by making it costlier for the consumer. But while the former involves collection of the costs in the form of tax revenues, the latter option ends up dissipating the costs.

In other words, as Prof Glaeser writes, "An effective ad that makes drinking soda less psychologically pleasant is essentially a tax without revenues... The case for taxes and against ads is that if we are going to impose costs on cola drinkers, it is better to get some revenue back." And also, from the experience of the efforts to curb smoking, the "bigger decreases in smoking followed big increases in the tax on cigarettes".

Carbon sequestration in power plants

Amidst all focus on carbon taxes and cap-and-trade approaches to control carbon emissions, carbon sequestration has hitherto taken a back-seat. Now the Virginia based Mountaineer power plant in the US is all set to become the world’s first coal-fired power plant to capture and bury deep inside earth some of the carbon dioxide it churns out. The hope is that the gas will stay deep underground (around 8000 ft), squeezed into tiny pores in the rock by displacing the salty water there, for millennia rather than entering the atmosphere as a heat-trapping pollutant.

The success of this experiment assumes significance in view of the fact that the overwhelming majority of power plants are coal or fossil-fuel based and retrofitting them could prove far more feasible than building brand new, cleaner ones.

Opponents claim that the cure could turn out far worse than the disease. They point to the possibility of pollution of water suplies (the carbon dioxide could mix with water underground and form carbonic acid which could leach poisonous materials from rock deep underground that could then seep out) and the substantial energy consumption in the process ofcapture and sequestration itself.

Update 1
See also this post.

Sunday, September 20, 2009

SHG membership as a signalling mechanism

In the last two decades, Self Help Groups (SHGs) and the micro-finance movement have emerged as one of the most important, if not the dominant, platform for addressing the challenge of eradicating poverty in many developing countries. The penetration of SHGs have been especially strong in many parts of India. However, there is a growing danger that these SHGs are becoming an end in themselves, rather than be instruments in fighting the scourge of poverty. I have blogged about this in an earlier post here.

These groups which started out as a means of empowering and inculcating thrift among women continue to remain stuck with the same paradigm and objectives. At best, the existing sets of policies have helped these groups start and expand on small, livelihood-based business activity. However, even in the specific activity of accessing formal sources of financing (for various purposes), the SHGs have not gone beyond traditional bank-loan driven group borrowings.

This post will seek to make a case in favor of a signalling role for SHGs in helping their individual members (and not as a group) access the broad spectrum financing options in the market. I will flag off one dimension - accessing all available formal financial/financing markets - in which SHGs, especially those with adequate capacity, can be invaluable in spurring more macro-level economic activity.

Now, a large number of these groups have gathered substantial capacity to deliver on outcomes beyond those intially envisaged. With some assistance and a different set of policy tools, many of them are capable of leveraging their capacity and built-up strengths in moving up into a higher trajectory of growth. More specifically, those SHGs can enable the transition of the SHG and micro-finance movement from addressing poverty alleviation to promoting vibrant entrepreneurship and economic development.

One of the most important dimensions of the utility of SHGs is in their role as an effective signalling mechanism. The poorer borrowers suffer from an especially acute risk aversion among lenders arising from the greater probability of adverse selection. The peer-pressure driven compulsion among SHG members to repay bank loans has become an effective credit guarantee for banks in making group loans to the SHGs. A logical extension of this argument would be to use the same credit-worthiness signal arising from SHG membership (atleast in the case of the stronger groups) to leverage loans for individual group members.

This would enable individuals to use their group membership to access/draw individual loans from banks for specific productive investments like business expansion or starting new businesses, constructing homes, purchasing consumer durables and automobiles, loans for education and health care, and so on. Presently, individual group members who want to make these purchases or investments access credit through the group loans, and then use it to incur their expenditures, thereby causing considerable transaction costs and duplication of activities.

Further, group loans generally involve equal distribution of the loan amounts among all group members. However, within a group, different members have varying levels of credit thresholds. Members use these loans for different purposes, move along varying growth trajectories, and have non-uniform credit needs and repayment abilities. In the circumstances, it becomes likely that those members who are more enterprising and have higher credit appetite gets constrained (in access to more credit) by their laggard compatriots. All these only highlight the importance of enabling individuals to access loans at their terms.

Here are a few examples of how this would work. Retailers (or their partner financing institutions) selling consumer durables on EMI can lend directly to poor customers, without the standard collateral requirements, by banking on the implicit guarantee provided by the individual's group membership. Typically, in the rural areas and smaller towns, there are likely to be only a handful (even only two or three) of retailers in the local market selling consumer durables or automobiles. It is easier and more efficient for them to administer these EMI sales of consumer durables and automobiles to the small numbers of local customers.

Poor people, looking to construct their homes, face numerous problems in accessing home loans in the regular financial markets. Given the large demand for home loans and the massive government spending on providing housing to the poor, it is natural that it offers ample mutually beneficial opportunities for both banks and the poor customers. The regular government housing programs for the economically weaker sections can be dove-tailed with direct bank lending to individual members of good SHGs, either by government providing the interest subvention subsidy (soft loans to beneficiaries) directly to the bank or the individual leveraging bank loan to top up the government assistance and construct a larger house with an additional loan.

Similarly, individual members should be able to access education loans by leveraging their membership of the SHGs, especially for higher education in professional courses. Here too, the regular government interest subsidies can be transferred directly to banks, thereby minimizing transaction costs and effectively addressing the targeting problem.

By encouraging the banks to lend directly to individuals using the signalling platform of SHG membership, and then transferring the interest subsidy directly to these banks, the government can reduce the considerable transaction costs and other numerous distortions associated with government subsidies.

It is true that there is nothing that prevents bankers today from providing loans to credit worthy individuals who are members of SHGs. But a formal recognition of provision of individual loans to the members of SHGs with good track record on the back of an implicit (not explicit) guarantee as a component of priority sector lending of banks, would go a long way in boosting the demand for such loans. It would encourage bankers to lend and borrowers to access formal financial institutions to meet their financial requirements. Bankers do not bear much additional substantive risks. Afterall, loans provided to SHGs were done so without any collateral backing and have borne impressive returns till date.

In the absence of credible signalling mechanism about the credit-worthiness of these individuals, such transactions would not have materialized. The banks benefit by increasing their loan portfolio without a disproportionate increase in the risk assumed, while the poor consumer gains access to the formal sources of credit provisioning, and government becomes able to more effectively target and deliver its assistance. We have a clear Pareto improvement, brought about by the signal emanating from membership of a credit-worthy SHG.

In order to avoid any moral hazard arising from this, it may be prudent to limit such lending to only those groups which have availed of and repaid atleast one or two tranches of loans in the recent period. The lending should be done strictly only after a resolution has been passed by all the members of the group permitting the specific individual to access the loan. Further, such lending can start off with small loans and the credit limits can be progressively loosened, both among group members and specific individuals availing of the loans. Also, the initial rounds of such loans can be limited to specific categories of expenditures like purchases of consumer durables, automobiles, student education loans etc.

Saturday, September 19, 2009

The relevance of industrial policy

World Bank's Chief Economist Justin Yifu Lin has kicked off a debate with his version of new-structuralist economics that favors an active role for governments in promoting industrial policies that works with a country's comparative advantage. Critics like William Easterly, who favor the markets and entrepreneurs to do the job of allocation of scarce resources and industrial development, feel that governments cannot identify the sources of comparative advantage and even if they do cannot have in place the incentives to support those sectors.

Justin Lin argues that "comparative advantage should drive policy. The optimal economic structure is endogenously determined by the endowment structure - resources, labor, capital, and hard and soft infrastructure - and differs for each country at different stages of development." He claims that the role of the state is to "develop the required infrastructures and use industrial policy to facilitate the upgrading to industries that are consistent with the country’s comparative advantages". He feels that the market can handle static efficiency, but can’t handle the transition from one stage of exporting to another, like from lighter to heavier industry. Under such circumstances, governments can be guided by following those countries ahead of it on the technological ladder and put in place policies to achieve those objectives. I am inclined to favor Justin Lin for a number of reasons.

First, it is not as simple as merely identifying the comparative advantage and then promoting it by supporting government and private firms in the identified sector. The East Asian economies had in place a comlementary set of policies - education, health care, infrastructure, etc - which addressed the backward and forward linkages that are necessary to sustain any industrial policy. These policies and resultant institutional structures and ancillary markets underpinned the East Asian success story. Unfortunately, most developing economies are sorely deficient in these basic pre-conditions.

Second, even if the basic pre-conditions in terms of development of human resources are met, in the absence of pro-active government interventionary support it will be difficult for the fledgling domestic industries to survive the onslaught from the more efficient and cheaper external competitors. Such support through an effective industrial policy is important to establish a level playing field, especially in the inital few decades of industrial development till a threshold of economic maturity and development is reached. The industrial and economic development paths of all the major economies of the world across history, without exception, has followed this trajectory.

Third, identifying comparative advantage is not about picking specific products and services (like women’s cotton suits or ceramic toilets or building a national car), but locating borader areas of competence and advantage like labor intensive manufactures in the first stage among East Asian economies and subsequent movement up the production chain. Similarly, the Indian government realized the comparative advantage conferred by its large pool of skilled and English speaking manpower and put in place policies, however flawed, to promote sectors like software and bio-technology. Countries at different stages of development will have industries locate at different segments in the spectrum.

Industrial policies are about promotion of savings, provision of access to timely and adequate finance, policies to develop human resources and endow them with requisite technical skills, facilitate easy access to capital goods, judicious use of export subsidies and other support to provide a level-playing field against foreign competitors, atleast till the domestic firms find their foot-hold.

Finally, there is a thin line that differentiates good and beneficial industrial policy from protectionism. However, this cannot be held against industrial policies, since protectionist barriers have been a constant in the economic landscape of even market-friendly developed economies like the United States. Protectionism has never been the exclusive preserve of governments.

In the circumstances, it endows on economists to help policy makers design appropriate policies that take into account each nation's comparative advantage. They can help stitch together the most effective and least distortionary set of policies and construct the institutional architecture that aligns incentives with the achievement of the pre-defined policy objectives. They should also study the conditions under which such industrial policies are likely to be successful in different economies.

Prof Easterly's example of the corruption in giving driver's licences in India is surely irrelevant to the debate about government's role in initiating industrial policies. Inefficiencies and distortions in the implementation of policies, which are not uncommon even in the developed economies (witness the extent of inefficiency and incentive distortions in the US health insurance market), cannot be taken to abandon government intervention of any kind.

To answer Prof Easterly, poor country governments certainly have a comparative advantage, atleast over its its nascent or under-developed private sector and its market structures, in discovering their comparative advantage.

Update 1 (18/4/2010)
Dani Rodrik on the return of industrial policy, "British Prime Minister Gordon Brown promotes it as a vehicle for creating high-skill jobs. French President Nicolas Sarkozy talks about using it to keep industrial jobs in France. The World Bank’s chief economist, Justin Lin, openly supports it to speed up structural change in developing nations. McKinsey is advising governments on how to do it right."

He has three important pre-requisites for a successful industrial policy.

1. Industrial policy is a state of mind rather than a list of specific policies. Its successful practitioners understand that it is more important to create a climate of collaboration between government and the private sector than to provide financial incentives. Through deliberation councils, supplier development forums, investment advisory councils, sectoral round-tables, or private-public venture funds, collaboration aims to elicit information about investment opportunities and bottlenecks. This requires a government that is 'embedded' in the private sector, but not in bed with it.

2. Industrial policy needs to rely on both carrots and sticks. Given its risks and the gap between its social and private benefits, innovation requires rents – returns above what competitive markets provide. That is why all countries have a patent system. But open-ended incentives have their own costs: they can raise consumer prices and bottle up resources in unproductive activities. That is why patents expire. The same principle needs to apply to all government efforts to spawn new industries. Government incentives need to be temporary and based on performance.

3. Inustrial policy’s practitioners need to bear in mind that it aims to serve society at large, not the bureaucrats who administer it or the businesses that receive the incentives. To guard against abuse and capture, industrial policy needs be carried out in a transparent and accountable manner, and its processes must be open to new entrants as well as incumbents.

Capture of regulatory and policy-making instruments?

The debate on financial market regulation proposals have focussed attention on procedural and structural issues like capital adequacy requirements, systemic risk regulation, caps on executive compensation, and so on. However, the equally important role of personal conflicts of interests inherent in policy makers and market regulators appears to have been confined to the sidelines.

The back and forth movement of bankers and financial market actors to prominent policy making and regulatory positions is widely acknowledged and the numerous instances of very strong and immediate conflicts of interests, at the very highest levels of decision making, has been adequately documented. It is surprising that a political and administrative system like that in the US which pays attention to disclosure requirements and potential conflicts of interests, has virtually ignored these massive moral hazard generating situations. Even more surprising has been the lack of public indignation and outrage at this serious problem.

Imagine the public outcry it would have generated in India if Vijay Mallaya was made our Civil Aviation Minister or Chanda Kochar was made the RBI Governor or any of the Ambani brothers were made the Petroleum Minister! Given the overarching role of the financial markets in the overall American economy, it is no stretch to compare the aforementioned Indian scenarios with the elevation of the likes of Robert Rubin, Hank Paulson and Co to important public policy making positions.

In an excellent op-ed in the Times, Simon Johnson and Peter Boone examine this issue and writes,

"Since our top regulators are political appointees, it should be no surprise that, in the face of heavy lobbying by the financial sector, they often turn out to be regulatory doves. We’ve permitted our mid- and high-level regulators to revolve between jobs in finance and officialdom. To name just two examples, during the Clinton administration, Robert Rubin left Goldman Sachs to become secretary of the Treasury, then returned to the industry to take an oversight role at Citigroup, while Henry Paulson, the secretary of the Treasury during the last years of the George W. Bush administration, came straight to government from Goldman Sachs.

A high-level position at the Federal Reserve, the Treasury, the White House National Economic Council or at a Congressional committee overseeing banking can be a ticket to riches when public service is done. The result is that our main regulatory bodies, including the Fed, are deeply compromised. Rather than act as the tough overseers of the public purse that we need — and that we had before 1980 — they have become cheerleaders for the financial sector. These cheerleaders, in turn, generate financial cycles by letting our financial system grow too fast, with far too little capital for the risks it takes."

And they write on the need to prohibit such movements of personnel and favor the development of career regulators to man such important positions,

"We should prohibit companies and senior managers in regulated financial industries from making donations to political campaigns. We should also restrict public employees involved in regulatory policy from working in those industries for five years after they leave office. And we should prohibit people who move to government from the finance sector from making policy decisions on bailout and regulatory-related matters for a minimum of five years.

Our regulators need to be smart people who understand finance, but they don’t need to be drawn from the upper echelons of the financial industry. There are many proven, dedicated professionals in our regulatory agencies today, and we should support the development of an even stronger cadre of career regulators. It should be up to the financial sector to make its practices clear and simple enough for these professionals to understand, and any that are too complex should not be approved."

Internalize energy efficiency costs

The proliferation of consumer electronic devices over the past few years has considerably increased electricity usage in houeholds across the world. It is estimated that Americans now have about 25 consumer electronic products in every household, compared with just three in 1980, and that consumer electronics which now represents 15% of global household power demand is expected to triple over the next two decades.

This dramatic increase in the use of electricity consuming devices makes it imperative that there be stricter energy efficiency standards on newer electrical devices. Presently, many of the newer generation of electronic products like flat screen TVs and video game consoles, which are energy guzzlers, have no efficiency standards anywhere.

These are examples of classic negative externalities - in so far as these new generation devices impose a disproportionately larger burden on global energy reserves and the environment. In the absence of regulatory controls, such devices will continue to proliferate and expand at the same or faster pace. Therefore, as with any such negative externality, the solution lies in getting the producers to internalize the full external costs of these devices.

Manufacturers of these devices, who oppose stricter standards on the grounds that it would increase costs and stifle innovation, and its users should be made to fully internalize the external costs by spending resources to improve the energy efficiency and by paying higher prices comensurate with use of cleaner technologies, respectively.

Friday, September 18, 2009

Taxation and behavioural economics

I have blogged in earlier posts about the relevance of behavioural psyhology in formulating tax policies. Now, in a Brookings working paper, William J. Congdon, Jeffrey R. Kling, and Sendhil Mullainathan (via Freakonomics) explore the implications of deviations from the rational and self-interested utility maximizing agent of neo-classical economics due to cognitive biases and time-inconsistency problems, on tax policy.

They argue that imperfect rationality of human beings means that they choose sub-optimally, bounded self-control comes in the way of their realizing their intentions, non-standard preferences means that they care about the welfare of others and fairness and form their preferences around reference points (both in time and space).

Contrary to convetional wisdom that advocates simplicity in tax policy, behavioural psychology leads us to favoring certain types of nuanced complexity, especially in promoting welfare and fairness. For example, sales taxes (which are not posted on the good sold) and electronic toll fees (through E-Z Pass) are not salient and therefore pass through un-noticed, separately identified taxes to fund specific benefits are easier to levy, tax credits enable targetting and thereby optimize provision of subsidies.

They also point to the possibility of leveraging the automaticity inherent in tax administration (like deduction at source, and simplicity of tax filing channels) especially to take advantage of the imperfect rationality of tax payers. This can be used to facilitate automatic access to transfers and certain types of direct subsidies along with tax filings, encourage retirement and personal savings (eg channel tax refunds into default savings accounts), and have opt-out insurance policies.

About the relevance of such behavioural deviations from standard assumptions for fiscal policy, they argue that tax cuts presented as "bonus" might be more likely to be spent than tax cuts presented as a "rebate", since when individuals perceive the tax cut as a gain (a 'bonus') rather than as a foregone loss (a 'rebate'), they are more likely to spend the tax cut. Further, there is evidence that tax cuts delivered through reduced (monthly) withholding, as against lump-sum rebate or bonus, is more likely to be spent.