Monday, November 30, 2009

Inequality and India's economic growth

Here is my Mint op-ed on the challenge posed by widening inequality and opportunity presented by urbanization on India's economic growth.

Sunday, November 29, 2009

Situation (not character) maketh the man?

Chris Dillow points to Thierry Henry's now famous "hand of god" goal in the recent World Cup qualifier against Ireland and argues that instead of being a "cheat" as he is accused of, Henry's may be a case of an "ordinary guy who found himself in a position where there was an overwhelming incentive to act dishonestly". He points to a recent study of the "dictator" game to analyze the role of personal identity and altruism, which finds that we should be cautious about "attributing identities to people and attempting to explain economic conduct in terms of these identities" ("fundamental attribution error" at work).

Two issues here

1. It is not that self-perception of character does not matter, but the extent of its influence may not be as large as thought of. In particular, when the situation posits an overwhemlimg incentive to act contrary to character, the average indivdual invariably ends up deviating. As Dillow himself says in the context of the Dictator game, "subjects who say they believe in fairness tended to give away a similar large sum" - character does exhibit a positive co-relationship with many of their behavioural outcomes, though the extent of this is mitigated or enhanced by circumstances. This critical role of situations only underlines the importance of incentives (that distinguish situations) that can make human beings act one way or the other.

2. We may not have given enough allowance for instinct. As people who have played football will acknowledge, instinct does play a critical role in many of the split-second reactions of players on the field. But the difficulty is to find out how much of Henry's reaction was a result of instinct than of volition? In any case, it cannot be denied that instincts do play an important role in many decisions taken by human actors. And are instincts a reflection of character?

Friday, November 27, 2009

Anchored inflation expectations

Antonio Fatas sees the strongly coupled inflation trends in the emerging and developed economies since 1996 as a "reflection of the strong anchoring of inflation expectations". Interestingly, inflation has remained tightly under control despite a few instances of major economic and finacnial market shocks.

Given the fact that the immediate history will surely exert a powerful influence in forming inflation expectations, it will require a shock of extraordinary proportions to break out of the anchored expectations. And with every passing day, as the green shoots of recovery takes hold (albeit ever so slowly), and the financial markets get back to normalcy, the extraordinary circumstances required for anchored expectations to get disengaged will recede faster into the pages of history. And this may a silverlining of hope for the world economy.

Wednesday, November 25, 2009

Central Bank independence in peril?

One of the major, if not the biggest, casualties of the sub-prime crisis and the economic recession, with its resultant fiscal expansion driven increase in public debt, could well turn out to be increased oversight of Central Banks across the world and stronger curbs on Central Bank independence. The primacy of Central Bank monetary policy making in controlling inflation has been so much taken for granted that we may now be unwittingly dissipating it in the guise of exercising greater political oversight over all financial market regulators.

On the one hand, political executives have realized the critical role of Central Banks in reflating a depressed economy and may feel that they should exercise greater control over this function. On the other hand, the question marks over the failure of Central Bankers (especially the Greenspan Fed in the US) to "take away the punch-bowl as the party got going" (by say, raising interest rates), and the resultant asset price bubbles have raised a chorus of opinion that Central Banks themselves need to be more closely regulated.

In the circumstances, as Free Exchange noted, albeit in a different context, the challenge is to "influence the Fed, while simultaneously keeping it independent". Unfortunatley, it is increasingly becoming clear that in order to achieve the former, the later is being compromised.

It therefore comes as no surprise that the US Congress is debating controversial proposals with far-reaching implications on the Federal Reserve's independence, to clip the Fed's regulatory authority, to change the selection process to key posts in the Federal Reserve system, and to audit its monetary policy decisions and dealings with foreign central banks.

The always incisive Mark Thoma expresses the concern that dilution of Central Bank independence and greater control by the political executive could seriously compromise the only credible policy instrument available to address inflation and unleash "political business cycles". There are three ways to finance deficits - government raising taxes, government issuing debt, and the Central Bank printing money. Of the three, the first is politically suicidal, especially when the economy is not doing well (precisely when such deficits are likely to be large), the salience of the second option invites policy criticism (on grounds that it would drown the future generations in debt, and also crowd out private investments by sucking in all available savings). Governments, especially those facing elections in the immediate future therefore prefer not to exercise these two policy choices.

This leaves printing money as the most attractive option, since its immediate impact could be positive on the output. This option, popularly called debt monetization, takes place outside public glare and its immediate implications are benign and longer term consequences not easily evident. Since inflation takes effect with some lag, there is no immediate adverse impact from injecting money supply into the economy. Printing money also offers the superficial attraction that the expected inflation would erode off the burden of debt and depreciate the currency, all the more attractive given the burgeoning public debts and intense trade competition posed by China with its weak-currency policy.

Under this, the Central Bank prints money and then offloads it into the market by purchasing long-term government securities. The net result is that instead of the government (or Treasury in the US), the Central Bank now holds the debt, and it pays for its operations from its earnings on these bonds and remits the remainder to the government. Further, the purchases of government securities pushes up their yields (lowers their prices) and puts upward pressure on interest rates. And as the increased money supply finds its way into the market, inflationary pressures soon get triggered off.

Anil Kashyap and Frederic Mishkin argue that any audit of the Fed's monetary policies would cripple policy making on inflation. They also feel that the publication of the minutes of the interest rate setting committee (the FOMC) meetings, periodic reports and often gruelling testimonies of its officials ensures adequate transparency in Fed's policy making, besides giving the executive enough supervisory control.

Alan Blinder feels that Central Bank independence has "enabled the long time-horizons of technocrats to triumph over the short-term perspectives of politicians", and kept inflation under control over the decades. He argues that any dilution of this independence would result in political monetary policy prevailing over technocratic monetary policy with disastrous long term consequences.

Many prominent economists have expressed firm support for the policies of the Fed and feel that its aggressive and unconventional monetary policy actions saved the economy from slipping into a repeat of the Great Depression. However, the Fed's concerns with inflation and reluctance to indulge in more monetary easing in the face of soaring unemployment is causing atleast some consternation and the voices would grow louder as the economy worsens, even if slowly.

Free Exchange echoes the views of those who favor some controlled dose of inflation as a means towards a counter-cyclical reflation of the economy. They argue that in the face of a zero-bound liquidity trap, the Fed should consider abandoning its obstinacy with the 1.7-2% inflation target and explicitly target a higher, say 4%, inflation target to bring in some traction into the floundering economy.

Tim Duy has an excellent summary of the existential dilemma facing the Federal Reserve in the US. In light of the events of the past decade, amplified by the high-profile moral hazard creating bailouts of the last twelve months, a strong and difficult to erase impression has gathered ground that the Fed works for Wall Street and not the Main Street, leave alone Joe and Jane. Restoring even a small sliver of faith, atleast among the public and threreby warding off attacks and encroachments from the public representatives, would require a leap of faith and an explicit declaration of concern about the problems created by unregulated financial markets, its various incentive distortions and other systemic failures. Paul Krugman too feels surprised by the Fed's reluctance to support junking shadow banking and returning to traditional banking.

See these excellent posts on Central Bank independence here, here, here. See also this nice summary of Central Bank independence and the challenge facing the US Federal Reserve by Henry Kaufman.

Update 1
Mark Thoma has this superb explanation of the interaction between budget deficits and inflation and Central Bank autonomy. Central Banks can keep interest rates constant by monetizing the debt by expanding the money supply through open market operations - the central bank prints money and uses it to purchase government bonds held by the public causing the money supply to expand and the debt to contract.

Update 2
The House Financial Services Committee has passed a measure that would subject the Fed's interest-rate decisions to scrutiny by the Government Accountability Office.

See also this article that debates a change in strategy - from mopping up after a bubble bursts with lower interest rates to cushion the blow to the economy and restart growth, to one that identifies bubbles and takes action (raise rates) to prick it before it gets inflated. This proposed change comes against conventional wisdom, expemplified by Bernanke himself, who had argued in a famous 1999 paper that central banks should focus on controlling inflation and should desist from smoothing the booms and busts of business cycles and trying to prick bubbles.

Update 3
See this NYT article on the court case being pursued by Bloomberg News, which had filed a Freedom of Information Act request with the Federal Reserve Board seeking the details of its unprecedented efforts to funnel money to the collapsing banks of Wall Street, and which was rejected by the Fed.

Tuesday, November 24, 2009

Rise and rise of Asia

(HT: Greg Mankiw)

Public debt and inflation in US

In a series of excellent recent posts, Paul Krugman has nicely indicated why the US public debt and inflation are not the concerns, and unemployment and deflation is the more imemdiate challenge.

As share of GDP, while the US debt has been rising, it is still comfortably placed compared to the high rates the Japanese and Italian governments have been running for the past few years.

The chart below which shows the interest rate predicted by Taylor rule (minus 6.7% with the present inflation and unemployment) versus the actual rate on 3-month T-bills, clearly indicates that the economy is trapped in a protracted low interest zero-bound liquidity trap. The need of the hour is a commitment to more inflation than any increase in interest rates.

And worryingly, unemployment continues to rise unabated and given its lagging nature, is likely to keep rising.

The bond market worries about inflationary expectations due to rising debt, federal borrowing crowding out private borrowing and/or increasing doubts about US solvency, and the resultant apparent widening of yield spreads may not convey the full story, though it does convey market uncertainty. Interestingly, as the graphic shows, the nominal bond yield is about what it was in early September, while the real bond yield has fallen (due to weak expectations about the economy or some other reason).

Treasury Inflation Protected Securities (TIPS), whose payouts are indexed to consumer prices, give an objective, market-based measure of expected inflation (and therefore insure against inflation). The steep decline in TIPS in the aftermath of the failure of Lehman was a result of the Fed's aggressive market intervention to purchase more than $1.5 trillion worth of Treasury bonds and government-guaranteed securities linked to mortgages, so as to lower long term interest rates. The latest TIPS rates shows declines and that too at lower than trend rates, clearly reflecting deflation than any inflation.

The nominal rates too are stable at well below the pre-crisis levels.

In an uncertain economic environment, the risk-averse private sector is piling up on the liquidity of cash and short-term T-Bills, and the public sector is sustaining demand with deficit spending, financed by long-term debt. Some financial players are bridging the gap between the short-term assets the public wants to hold and the long-term debt the government wants to issue, through a form of carry trade.

It is felt, among others also by the bond markets, that these carry trade players who are borrowing cheap money short-term, and using it to buy long-term bonds, are badly vulnerable to interest rate increases. Higher rates will lower the prices of their long term bond investments (since their yields will rise) and leave them with losses and another vicious circle of collapsing balance sheets.

However, Paul Krugman describes this a 'maturity mismatch', and says that even if this happens, it would be a financial system problem and not a deficit problem, "It would basically be saying not that the government is borrowing too much, but that the people conveying funds from savers, who want short-term assets, to the government, which borrows long, are undercapitalized. And the remedy should be financial, not fiscal. Have the Fed buy more long-term debt; or let the government issue more short-term debt." And what is more, this carry trade is exactly what you would expect to see with undercapitalized financial market players who borrow short and lend long, even if fiscal policy were on a perfectly sustainable trajectory.

Brad De Long though feels that the thin nature of the long term Treasury market means that the price signals conveyed by it may not be an accurate reflection of market expectations and any unwinding of the carry trade could have very bad consequences. And as one of the comments makes the point, all financial institutions engage in some type of inter-temporal arbitrage using some form of carry trade, and any rate increase could therefore adversely affect all the financial market actors. This may have boxed the Fed into a debt-financed low interst rate environment.

Update 1
Mark Thoma has an excellent summary and status report on the problems facing the US economy on its burgeoning debt and possible inflation edxpectations by drawing a distinction between policies implemented by the Fed and Treasury in an attempt to bailout and stabilize the banking system, and the policies passed by Congress and signed into law by the president in an attempt to jump start the economy.

Update 2
The net interest payments as a percentage of GDP is no higher than during the eighties and nineties, even assuming the present burgeoning debt burden.

Update 3
An NBER working paper by Joshua Aizenman and Nancy Marion finds that despite the fact that shorter debt maturities reduce the temptation to inflate while the larger share held by foreigners increases it, in the years ahead, public debt in America is likely to be offset by inflation. They write about impact of a large nominal debt overhang on the temptation to inflate,

"When economic growth is stalled, the US debt overhang may trigger an increase in inflation of about 5 percent for several years. This additional inflation would significantly reduce the debt ratio, even with some shortening of debt maturities... a moderate inflation of 6 percent could reduce the debt/GDP ratio by 20 percent within 4 years."

However the unintended consequences of inflationary expectations getting out of control makes the strategy fraught with danger.

Update 4
Nouriel Roubini writes on the dangers of monetization induced inflationary pressures to erode public debt burden - inflation tax on lenders.

Update 5
Catherine Rampell points to Alan Auerbach who argues that since the major portion of US public debt is either indexed to inflation or is internally held within the government (e.g., the Social Security trust fund, etc), there is no possibility of inflating them away.

Update 6
Paul Krugman draws attention to the Cleveland Fed 'trimmed' inflation measures, which exclude outlying large price movements (the ultimate trim is the median, the rise in the price of the median category), which tells a story of dramatic disinflation in the face of a week weak economy.

Update 7 (23/3/2010)
Mark Thoma examines the possibility of various types of tax increases in the US in order to service the massive public debt burden and meet the growing expenditure requirements.

Update 8 (18/11/2010)

Core inflation — that is, the change in the cost of a basket of consumer goods, excepting the volatile categories of food and energy — was at its lowest level on record in October since the government began collecting such data in 1957.

Monday, November 23, 2009

Incentives matter, but are they enough?

For decades and centuries, countless economists and policy makers have searched for an answer to the proverbial gordian knot that challenges development policy making, "What makes nations rich and poor?". MIT's Daron Acemoglu is the latest to attempt to cut the gordian knot with this answer,

"Fix incentives and you will fix poverty. And if you wish to fix institutions, you have to fix governments."

He cites the successes of the American states along its Mexican border, Singapore, China, Botswana, and so on, relative to the poverty and failure of their respective immediate neighbours to justify this claim. Echoing of the institutionalists, he claims that all of them enjoy law and order, implicit or explicit private property rights, and dependable government services, and their citizens can go about their daily activities and jobs without fear for their life or safety or property rights. He therefore advocates promotion of greater transparency, more openness, and greater democracy, among the poorer nations.

I am not quite convinced whether Prof Acemoglu is not treading the same path of "sweeping explanations" that those he accuses others - Montesquieu (people in hot places are inherently lazy), Max Weber (Protestant ethic), Jeff Sachs (geography and weather), and Jared Diamond (advancement of technology) - of doing.

Enabling citizens to own property and carry out contractual transactions, and live without fear of crime or graft (or atleast unpredictable graft!) is a fundamental pre-requisite for the effective functioning of a modern economy. The recent success of the South East Asian economies and China, with their focus on economic freedom over democratic rights, has highlighted attention on the importance of the certainty inherent in rule of law (however flawed the law be). This disciplines society and administration - creates the enabling environment for individuals and businesses to conduct their business without assuming completely unpredictable and uncertain risks, and assures citizens of living their lives free from fear of crime.

The discipline and certainty provided by the traditional institutional arragements - tribal (as in case of Botswana), cultural (British colonial) and religious (Confucian in case of the Chinese and East Asians) - have played a critical role in their respective successes. This cultural-political milieu, often a legacy of historical evolution, are not easily replicable and often unique to societies. Pakistan is a neighbourhood example of the difficulty of putting in place stable governance structures that help institutionalize the incentives necessary to address poverty. Within India itself, the experience of different states offers a dazzling spectrum of diversity in outcomes in addressing development and poverty.

Further, the soundness and transparency of government institutions that underpin the success of nations - as the recent example of Iraq and the historical litter of long drawn out experiments with democracy from Asia and Africa conveys - is itself not something that can be easily transplanted into polities and societies. In other words, even assuming that fixing institutions will help rid off poverty, how do we fix governments that can align the incentives?

Assembling the right mix of ingredients required to fix institutions is the biggest challenge - one that can rarely be overcome with quick-fixes like transplanting or grafting institutions. It often requires the measured march of history to evolve organically, a process that can at best be expedited. And expediting this should be our effort.

In this context, a new paper by Lisa Chauvet and Paul Collier (full paper here) find that free and fair elections in developing countries improve economic policy by disciplining governments, though infrequent or uncompetitive elections may actually make things worse.

Sunday, November 22, 2009

Decline of empires

Superb graphical illustration of the decline of the Spanish, British, Portuguese and French colonial empires during the course of the nineteenth and twentieth centuries by Pedro M Cruz (via Economix).

Visualizing empires decline from Pedro M Cruz on Vimeo.

Such visualizing graphics are brilliant tools of illustration. See this one about Brownian motion, the scientific basis for Random Walk hypothesis that underpins much of modern finance.

Brownian motion with processing from Pedro M Cruz on Vimeo.

Saturday, November 21, 2009

Capital controls are back?

The Brazilian government's decision last month to impose a 2% tax on all capital inflows into equities and fixed income instruments to slow the appreciation of its currency, the real (which has gained 36% against the US dollar this year), has re-opened the debate on capital controls and proposals like Tobin tax on cross-border capital flows. Apart from containing the appreciation of the real, it is hoped that the tax will also prick any asset bubbles building up in the financial markets due to the mis-allocation of resources from the massive capital inflows of the past few months.

The markets reacted with dismay at the Brazilian decision, and opponents, which includes the IMF (see this response to the IMF's position by Dani Rodrik), immediately claimed that the tax would end up being circumvented and the capital flows continue unabated. They point to the examples from even recent times that appear to indicate that in the absence of a blanket ban on all capital inflows, it is almost impossible to control capital inflows, and that such selective controls may only end up generating distortions in the financial markets.

The recent turmoil in the global financial markets in the aftermath of the bursting of the sub-prime bubble and its disastrous impact on national economies has naturally heightened the apprehensions surrounding financial market events and the build-up of systemic risks. Since March, buoyed by signs of strong recovery in the emerging economies and continuing economic weakness among the developed economies, and to take advantage of a weakening dollar, there has been a massive inflow of capital into the emerging economies.

These inflows flows into emerging economies, which have nearly doubled their equity markets, have also contributed to appreciation of the domestic currencies against the US dollar. The continued weakness of the US economy, its bleak short to medium-term prospects, and the near certainty of a loose monetary policy for the foreseeable future by the Fed means that the dollar looks set to decline further. The resultant appreciation of their currencies, coupled with the Chinese refusal to let the renminbi find its value against the dollar, will adversely affect the export competitiveness of emerging economies (especially against the Chinese exports). This will invariably put pressure on these countries to intervene in the forex markets with dollar purchases to stem the appreciation of their currencies. This forex market intervention would necessitate sterilization measures to keep the money supply and inflationary pressures under control. The additional burdens on fiscally strained governments would be considerable.

In this context, it would be instructive to take a look at a growing chorus of opinion that appears to favor some form of controls on cross-border capital flows. As Arvind Subramanian and John Williamson have written in a brilliant article, the Brazilian decision may be "signaling an end to an era in which emerging markets were enamored with foreign finance, and in expressing willingness to take action to moderate inflows of foreign finance". Accordingly, they advocate "a less doctrinaire approach to foreign capital flows", one that abandons "sanctifying, implicitly or explicitly, foreign finance" and acknowledging the seriousness of the problems posed by surges in capital flows.

They feel that instead of blindly opposing all capital controls (as was the response of IMF to the Brazilian decision), these countries, with help of agencies like the IMF, should look at the "best ways of designing these measures (Should they be price-based or quantity-based? What kinds of flows are best addressed, debt or portfolio? Over what duration are limits most effective? When should they be withdrawn?) so that the benefits are maximized and risks minimized".

They argue that while pursuit of more open capital flows should be a long-term, structural objective of all economies, it needs to be recognized that surges in capital inflows can pose serious macroeconomic challenges that may require a different cyclical response. They write, "For emerging markets, the policy arsenal against future crises must cover measures to restrict credit growth and leverage countercyclically, notably surging capital flows."

They also call on the IMF to accept such measures so as to eliminate the stigma associated with such actions, which in turn adversely affects the market confidence and credibility of the nations introducing such controls. They write, "By recognizing that in some instances sensible curbs on inflows might be a reasonable and pragmatic policy response, the Fund can eliminate the market-unfriendly stigma that actions of the Brazilian type might otherwise risk incurring."

In a blog post, Arvind Subramanian even calls for co-ordinated restrictions on capital flows by a set of emerging markets. He writes that since "the cause of the increased flows is common to all countries, namely Fed policy, it will be a policy challenge not just for individual countries but for emerging markets as a group".

There is enough evidence now, in light of the forex market crises of the past two decades, to question the utility of removing all capital controls, especially in case of developing countries. Eswar S. Prasad, Raghuram G. Rajan, and Arvind Subramanian find that there is enough evidence to "suggest that insofar as the need to avoid overvaluation is important and the domestic financial sector is underdeveloped, greater caution towards certain forms of foreign capital inflows might be warranted". They write,

"Contrary to the predictions of standard theoretical models, non-industrial countries that have relied more on foreign finance have not grown faster in the long run. By contrast, growth and the extent of foreign financing are positively correlated in industrial countries... the reason for this difference may lie in the limited ability of non-industrial countries to absorb foreign capital – especially because of the difficulty their financial systems have to allocate it to productive uses, and because of the proneness of these countries to exchange rate appreciation (and, often, overvaluation) when faced with such inflows... there is no evidence that providing additional financing in excess of domestic savings is the channel through which financial integration delivers its benefits."

They however underline the importance of financial integration and ensuing competition to spur domestic financial development. They therefore suggest an approach that involves providing "a firm commitment to integrate financial markets at a definite future date, thus giving time for the domestic financial system to develop without possible adverse effects from capital inflows, even while giving participants the incentive to press for it by suspending the sword of future foreign competition over their heads".

In another paper, Dani Rodrik and Arvind Subramanian too come to much the same conclusions. They find that the "benefits of financial globalization are hard to find", "financial globalization has not generated increased investment or higher growth in emerging markets", and that the "countries that have grown most rapidly have been those that rely less on capital inflows". They also find that "financial globalization has not led to better smoothing of consumption or reduced volatility". They write, "Depending on context and country, the appropriate role of policy will be as often to stem the tide of capital flows as to encourage them. Policymakers who view their challenges exclusively from the latter perspective will get it badly wrong."

Interestingly, evidence from Chile's experience with capital controls in the form of "imposition of reserves requirements on capital inflows", indicates that "while they have allowed the Central Bank to have a greater degree of control over short term interest rates, they have failed in avoiding real exchange rate appreciation". This brings us to Mundell's impossible trinity which claims the impossibility of simultaneously having a policy mix of free capital inflows, stable (fixed or an adjustable peg) exchange rates and interest rate autonomy.

Under any macroeconomic situation, only two of these objectives can be met simultaneously. In the circumstances, especially in light of the events of the past few months, conventional wisdom would dictate that the choice for Central Banks is easy. Selective capital controls would give Central Banks and governments, much needed room to manouvre with their interest rates and foreign exchange rates in an uncertain environment.

The ET has a nice graphic which captures the dilemma facing the RBI and policy makers in India on the issue of capital controls.

As part of its capital controls policy and in the face of a flood of capital inflows ($16 bn in FPI till date against $20 bn for full 2007, $17.74 bn for H1 2009-10 against $35.2 bn for 2007-08), the Indian government is working on a proposal to auction corporate entitlements to make external commercial borrowings (ECBs).

Update 1
An IMF working paper has advocated that capital controls are a "legitimate" tool in some cases for governments facing surges in external investments that threaten to destabilize their economies. It writes, "Even when flows are fundamentally sound, it is recognized that they may contribute to collateral damage, including bubbles and asset booms and busts... Capital controls on certain types of inflows might usefully complement prudential regulations to limit financial fragility and can be part of the toolkit... If the economy is operating near potential, if the level of reserves is adequate, if the exchange rate is not undervalued, and if the flows are likely to be transitory, then use of capital controls - in addition to both prudential and macroeconomic policy - is justified as part of the policy toolkit to manage inflows".

Simon Johnson draws attention to Lord Adair Turner's lecture at the RBI where he argued that "the case that short term capital liberalization is beneficial is... based more on ideology and argument by axiom than on any empirical evidence" and implicitly favored the use of capital controls when situation warranted.

Eye of the beholder!

The same photograph can be propaganda, journalism, art or any combination of the three, depending on "our beliefs about them", says Errol Morris.

"We see a photograph based on our beliefs – what we believe about the photographer’s intentions, our political beliefs, and the context in which the photograph appears. Think of all the ways the meaning of a photograph can change. The photographer takes a picture; a journalist writes a caption; the picture appears in an article; it is cropped or appears with other images (which skew the meaning); or it appears in a publication with known (or suspected) political sympathies; often photographs that seemingly express a point of view that we don’t like are seen as propaganda. And photographs that seemingly express a point of view that we do like are seen as journalism. People rarely find fault with photographs that accord with their own beliefs."

Friday, November 20, 2009

IMF on economic recovery

Free Exchange points attention to IMF's updated economic outlook for Asia and the Pacific (full paper here) which forecasts output in the area to grow by 2.8% in 2009, up from 1.2%, and by 5.8% in 2010, up from 4.3%, and credits this rebound to trade normalization. India's gorwth for 2009 and 2010 are also revised upwards to 5.4% and 6.4% respectively. Interesting set of "heat maps" on global growth momentum...

On Asia's growth momentum...

And on recovery in advanced economies.

See also IMFs WEO for global growth prospects.

Thursday, November 19, 2009

Collapsing bank credit growth

One of the biggest concerns for India's immediate economic prospects is the precipitous and continuing collapse in credit growth, which fell to a 12-year low of 9.7% year-on-year as of October 23, 2009, down from close to 30% for the same period last year. As Chetan Ahya of Margan Stanley points out in an ET op-ed, the bank credit to GDP ratio (12 month trailing) has dropped to below 4% in November 2009, from a peak of 11.6% of GDP in October 2008.

The bank balance sheets are almost back to normalcy and the banking system is flush with liquidity as evidenced by the larger than required investments in government securities (it is above 27% against the SLR requirement of 25%) and the low yielding reverse repo and T-Bill transactions. Even liquid mututal funds have been attracting bank reserve investments. The 19% year-on-year growth in deposits against the 9.7% growth in credit for the same period, is only adding to the excess liquidity. The incremental credit-deposit ratio at 38% is currently close to 2001 lows.

An indication of the rebound of demand and expectations has been the surge in commercial paper issuance by businesses and the revival of the IPOs in the equity markets. External commercial borrowings too have been on the rise. In fact, the bigger firms have been raising capital at much lower cost than the prevailing commercial bank lending rates through their Commercial Paper (CP) offerings. As I have blogged earlier, the fact that banks too have been lending to their favored clients at large discounts on the BPLR also means that the BPLR may have lost its effectiveness as an interest rate signalling mechanism.

In many respects, this ability of businesses to raise capital despite bank credit ruling at historic lows is also a measure of the increasing depth and breadth of India's hitherto bank-dependent credit markets. Further, the price signals conveyed by the debt markets - commercial paper and other medium and long term debt offerings - have been more reflective of the monetary policy signals conveyed by the Central Bank's repo rate changes.

In a banking system flush with so much liquidity and demand being comfortably met from alternative sources of credit, even if the RBI were to raise rates, we may not see any immediate rise in the lending rates. The same inertia that we saw with monetary policy transmission when repo rates were on their way down will be witnessed when the rates are now hiked.

On an optimistic note, Chetan Ahya feels that the sequential figures on credit growth and the rebound in industrial production (credit growth lags behind IIP figures) means that credit growth will start "recovering from December 2009 to reach 16% by March 2010 and further to 22% by end-2010". He writes about the expectations that,

"The WPI non-food inflation rate to rise sharply to 4.7% year-on-year by March 31, 2010, compared with –2.9% year-on year during the week ended October 17, 2009. Moreover, with rising oil prices, the working capital demand of oil companies is also likely to pick up to the extent the government refrains from increasing domestic fuel prices. Recovery in corporate capital expenditure will also support the credit demand over the next 12 months. Early signs from fund-raising activity of the corporate sector indicate that capital expenditure is about the bottom. With industrial production growth likely to remain, increased capacity utilisation will mean higher investments by the corporate sector supporting the recovery in credit growth."

Update 1
See this for a summary of the reasons for low credit growth - recoveries after downturns can proceed without credit growth (firms use up inventories, have lower cost of financing etc), access to non-bank sources of finance, access to working capital through money market MFs and overnight debt issuance etc.

Wednesday, November 18, 2009

Commodity prices - role of speculative activity?

James Hamilton points attention to the sharp, across the board rise in global commodity prices and questions the popular perception that weakening dollar has been the main contributing factor. He argues that the magnitude of movements in commodity prices greatly exceeds the size of changes in the exchange rate - since the start of this year oil prices have increased five times as much as the dollar price of a euro. He attributes three reasons for the

1. The resurgence in real economic growth among the emerging economies, whose contribution to global economic growth have been growing, has increased demand for commodity prices and thereby driven up their prices and also put strengthened their currencies against the dollar.

2. Investors are making increasing use of commodities as an investment class to hedge against risks in equities and a depreciating dollar. Further, the low interest rates have also provided an incentive to hoard physical commodities as an investment vehicle.

He points to a paper by Ke Tang and Wei Xiong, which finds that contrary to the unrelated movements in oil and other commodity prices a decade ago, there is an increasing tendency for commodity prices to move together over the last few years. They attribute this to co-relation to "the increased use of commodities as a financial investment".

Correlation (using a rolling sample beginning one year before indicated date) between returns on oil and specified commodity. Source: Tang and Xiong (2009).

In this context, I had blogged earlier that the speculators driving up commodity (mainly oil) prices was not borne out by the inevitable increase in storage and inventories (since speculators are not end-users of the commodity, atleast a share of the commodities under speculation has to find its way into some form of rolling storage).

However, Jim Hamilton now points to the graphic below which shows considerable increase in oil inventories and also reports of speculation in commodities from different parts of the world. This appears to point to the growing influence of speculative activity on global commodity prices.

Weekly U.S. crude oil ending stocks, excluding SPR, in thousands of barrels, from EIA. Black line: average over 1990-2007. Red: 2008. Green: 2009.

Update 1
Moneywatch explains the reasons for oil price volatility.

Tuesday, November 17, 2009

Chimerica and China's weak currency policy

In the backdrop of a global economic recession and a world economy plagued with fundamental macroeconomic imbalances, as President Obama embarks on his maiden visit to China, the elephant in the room is clearly China's weak currency policy. China's obstinacy to use it massive forex reserves to keep the renminbi pegged (After letting the renminbi appreciate gradually against the dollar from 2005 to 2008, the government has kept the renminbi at about 6.83 to the dollar since July 2008, with aggressive currency market interventions) to a declining dollar so as to artificially boost its export competitiveness, would not only be tantamount to a beggar-thy-neighbour policy affecting its own developing country counterparts, but would also postpone any re-calibration of the global macroeconomic imbalances that are fundamental to sustainable global economic growth prospects.

As Paul Krugman writes, the Chinese currency market policy is "siphoning much-needed demand away from the rest of the world into the pockets of artificially competitive Chinese exporters". The IMF too have called for a stronger yuan and more Chinese consumer spending to help ease global economic imbalances and assure healthy growth. While the current recession and slump in global trade has slightly narrowed the global imbalances, there is increasing concern that this may be "mostly illusory – the transitory side-effect of the greatest trade collapse the world has ever seen" - and as the economies recover, the US, Germany, China and others will return to their old paths.

However, the more salient feature of the visit will be the fast closing gap (see graphic below) between China and the US on various economic and political parameters, and the US efforts to reassure its primary banker about its burgeoning deficit that threatens to drag the dollar on a downward spiral!

Interestingly, China's weak renminbi policy has played a major role in most of the changes in the aforementioned graphic. Niall Ferguson and Moritz Schularick have this excellent chronicle of the Chimerica relationship between the US and China in this decade and explores the challenges ahead.

Interestingly, China's massive long position on dollar assets will be one of America's most important bargaining points in its relationship with Beijing. As the saying goes, "when you owe a bank $1000 you have a problem, but when you owe $10 million then the bank has a problem"!

Update 1
Tyler Cowen describes the China-US trade relationship thus, "China uses American spending power to enlarge its private sector, while America uses Chinese lending power to expand its public sector."

Update 2
Helmut Reisen uses the Balassa-Samuelson effect to measure the currency undervaluation of the renminbi and finds that the renminbi is undervalued by only 12%. He also argues that "a gradual renminbi appreciation will be sustained only if Chinese corporate and public savings are lowered".

Update 3
Paul Krugman feels that Chinese mercantilist policy of keeping renminbi devalued could trigger off protectionist sentiments and damage the world economy. He also feels that the threat of Chinese government dumping their dollar reserves and diversifying into other currencies is overblown, especially in a world awash with cheap capital, and will end up hurting China and beenfitting the US.

Update 4
Paul Krugman feels that it is inevitable that prices rise in China.

"Consider the real exchange rate, defined as RX = EP*/P, where E is the exchange rate measured as the domestic currency price of foreign currency (so an appreciation of the renminbi is a fall in E), P* is the foreign price level, and P the domestic price level. Basic international macro says that there is a "natural" level of the real exchange rate, determined by trade competitiveness and international capital flows. And the economy "wants" to get to that real exchange rate. If you have a floating exchange rate, you get there via a rise or fall in E. But if you have a pegged rate, there's pressure on prices instead. By deliberately keeping E higher than it would be under floating, China is creating pressures for P to rise; the inflationary pressures are directly related to the exchange rate policy."

James Hamilton feels that the prices may already be rising.

Update 5
Mohamed Ariff makes the important point that China’s exchange rate policy has implications for global trade and particularly other East Asian nations and advocates that, given China’s fixation on the dollar peg, countries such as Thailand and Malaysia may have no choice but to peg their currencies to China’s yuan.

Update 6
Simon Johnson argues that the renminbi is 20-40% under-valued and makes the case for pressing the Chinese to revalue their currency. He also argues that far from having any adverse impact on the US economy, this would boost the US economy.

Update 7 (16/3/2010)
Paul Krugman proposes imposing a 25% surcharge on Chinese exports to offset the impact of China's weak renminbi (estimated to be 20-40% under-valued) policy. He rubbishes concerns that it would lead to China dumping US assets, saying that it would be good for the US - given the weak economy, US interest rates will remain rock-bottom for the foreseeable future; Fed can easily intervene to keep long-term rates under control, if need be; the depreciating dollar will boost export competitiveness; and declining dollar liabilities will lower the real debt burden.

In his blog post, Krugman also makes the point that during the crisis the US private sector has gone from being a huge net borrower to being a net lender (the lending being to the US government), whereas the government borrowing has surged, but not enough to offset the private plunge. Therefore the US dependence on foreign loans is way down, and the surging deficit is, in effect, being domestically financed. The bottom line is that if China decides to pull back, what they’re basically doing is selling dollars and buying other currencies — and that’s actually an expansionary policy for the United States.

Paul Krugman estimates that by running an artificial current account surplus that is 1 percent of the combined GDPs of liquidity-trap countries, China is in effect imposing an anti-stimulus of that magnitude — which plausibly means 1.5 percent of GDP. See video here.

Update 8 (20/3/2010)

Paul Krugman points to the fact that it is China's export of capital, and not eh value of renminbi per se, that is the problem. Though China's capital account (FDI+ FPI + other investments, including capital flows into bank accounts or provided as loans + reserve account) has received massive foreign investments over the last two decades, it has been more than offset by the massive export of capital (by way of purchases of foreign assets, mainly US Treasuries and agency assets). The net result is a negative net capital account. More importantly, these purchases have been large enough to even balance out the large current account suprluses (balance of trade or exports minus imports of goods and services + net factor income from abroad, including interest, dividends, and remittances + net unilateral transfers from abroad, like aid receipts) arising from China's export machine.

As Krugman argues, China is able to maintain this massive capital account deficit (or export capital) because capital controls inhibit offsetting private capital inflows and the de facto policy of forcing capital flows out of the country. Further, by creating an artificial capital account deficit, China is, as a matter of arithmetic necessity (since Capital account + Current account = 0 and Current account = Domestic savings – Domestic investment), creating an artificial current account surplus. And by doing that, (given the absence of adequate safe and liquidi financial investments opportunities in the local market) it is exporting savings to the rest of the world.

In a paradox of thrift world (economies hit by recession and weak demand) anyone who tries to save more reduces demand, reduces employment, and – because investment responds to excess capacity – ends up actually reducing investment. By exporting savings to the rest of the world, via an artificial current account surplus, China is making all of us poorer. A weak renminbi is only the mechanism through which China’s capital-export policy gets translated into physical exports of goods.

Update 9 (22/3/2010)
Paul Krugman estimates that China’s aggressive exports and reluctance on imports could lower global world production by 1.4 percent and cost Americans 1.4 million jobs.

Update 10 (2/4/2010)
Tyler Cowen and Ryan Avent do not agree with the taxing China policy.

Update 11 (10/4/2010)
NYT Room for debate on China's weak currency policy.

Update 12 (17/11/2010)

Excellent article that highlights the tensions between exporters (who stand to benefit) and importers (who lose) from weaker dollar.

Instruments to optimize on private vehicle use

A few days back, I had blogged about California's plans to implement pay-as-you-drive insurance policies that allow motorists to buy insurance based on the miles they drive.

Now the Dutch government has announced plans to introduce a miles driven based "green" road tax from 2012 by equipping each vehicle with a GPS device that would track how many kilometres are driven and when and where and use it to calculate the net tax payable. The proposal, aimed at cutting the carbon dioxide emissions by 10%, seeks to scrap ownership and sales taxes, about a quarter of the cost of a new car, and replace them with the "price per kilometre" system. The tax for a standard family saloon would start at 3 euro cents per kilometre (seven US cents per mile) in 2012 and would increase to 6.7 cents (16 US cents per mile) in 2018.

Per-mile pricing of auto insurance and road tax are aimed at optimizing on private vehicle use and more effectively internalizing externalities. It is hoped that such marginal pricing will increase the efficiency in private vehicle usage, relieve traffic congestion and increase road safety, besides reduction in carbon emissions.

(HT: Greg Mankiw)

Monday, November 16, 2009

Regulating TBTF banks - Cocos and ABRR

In the aftermath of the sub-prime mortgage induced financial market meltdown, there have been numerous suggestions to prevent the build-up of sytemic risks, in particular those posed by the "too big to fail" (TBTF) financial institutions. The latest prescription to the TBTF problem among banks comes in the form of "contingent convertible bonds" (CoCos).

James Kwak has describes CoCos as, "a contingent convertible bond is a bond that a bank sells during ordinary times, but that converts into equity when things turn bad, with 'bad' defined by some trigger conditions, such as capital falling below a predetermined level." This will enable banks to assume more leverage and increase their profits, while leaving open the possibility of converting this debt into equity if things went bad.

However, opponents have rejected CoCos on grounds of difficulty in defining the trigger point, uncertainty about the extent of a crisis and the amount of capital conversion required to avert a bank-killing panic, finding people willing to buy these things, and the impact on the market of triggering a conversion.

Another suggestion is to deploy automatic stabilizers like asset based reserve requirements (ABRR) which would extend differential margin requirements to a wide array of assets held by financial institutions and thereby directly target financial market excesses and the build-up of systemic risks. The regulator (often the Central Bank) would set adjustable reserve requirements (to be held as non-interest-bearing deposits with the central bank) for each asset class, based on its concerns with inherent riskiness, blowing up of an asset price bubble, unsustainable expansion in the asset outstanding, and so on.

Update 1
Paul Volcker calls for dismantling the TBTF banks.

Update 2(1/4/2010)
Simon Johnson and James Kwak, who have been amongst the most consistent supporters of splitting up the TBTF instituions, argue that capital requirements for TBTF firms are not likely to succeed since it would require knowing how much capital would be needed to withstand what a rare financial storm ("tail event"). They therefore support a standard capital requirement for all banks, and make sure that none of those banks are too big to fail.

They also point to the example of Lehman Brothers (which gamed its accounting books and showed Tier 1 capital of 11.6% shortly before it went under in September 2008) and show how capital requirementsare an unreliable measure of strength of banks. Like other regulatory refinements, they depend on the ability and motivation of regulators to rein in financial institutions that have clear incentives to evade them at every opportunity.

They therefore propose strict asset caps (as a percentage of gross domestic product, i.e., relative to the size the overall economy) on financial institutions that are adjusted for the types of assets and obligations held by those institutions.

Central Bankers like Paul Volcker, Mervyn King, Thomas Hoenig, and Richard Fisher have all favored either breaking up TBTF banks or having caps on their size, so as to limit the systemic risk they can have.

Europe's sub-prime mortgage loans - shipping loans?

The over $350 bn in loans advanced by European banks to the shipping industry threatens to become the Europe's version of America's sub-prime mortgage loans. The collapse of global trade in the current recession and the resultant plummeting charter rates (45% plunge in freight rates for container ships) have devastated the values of shipping assets and rocked banks with shipping industry exposure. This coupled with a glut of previously ordered ships have left many banks clutching negative equity on their shipping industry investments.

While ship owners continue to service their debt, there is growing fears that as the competition for business drives cargo revenue well below what it costs to send a ship across the ocean, ship owners may soon be the next group of borrowers unable to manage their debts. The anxiety generated by the recent collpase of Eastwind Maritime, a medium-size carrier company, underscores the dangers lurking in the shadows, especially if global trade does not recover soon.

Sunday, November 15, 2009

Misplaced sympathies and collateral damage

One state government has a program to assist Self Help Groups (SHGs) and their federations start small co-operative stores selling various household provisions. These stores are provided stationary and provisions at concessional rates by absorbing massive subsidies.

While this has partially achieved the intended result of providing remunerative self-employment opportunities for SHGs and also provisions for consumers at lower cost, it has had some very damaging consequences. Apart from the now commonplace pilferage and diversion of the subsidized provisions, this policy has adversely affected the businesses of small shop owners and traders, especially in the rural areas of the state.

In such areas, one SHG run co-operative provision store (which would cater to a few villages) can potentially price out all the private small traders and shop-keepers and sound their death knell. All the hard work and effort that went into gradually building up private businesses is laid waste. Besides, such policies have a very profound and adverse long term effect on entrepreneurial spirit and private economic activity in those areas. It also generates a very harmful dependency syndrome among its beneficiaries. Such policies are therefore unsustainable and the fiscal burdens it imposes on the governments are considerable.

A more effective, less distortionary and sustainable way to achieve the desired objective of assisting these groups is to provide them all required forward and backward linkages (from training to accessing finances to sourcing intermediates and raw materials to marketing final products) to compete more effectively in the existing market. In other words, to borrow the cliched phrase, help and teach a man how to fish instead of giving him the fish!

Even a cursory reading of basic economic principles and countless examples from across the country and elsewhere (over time) have repeatedly shown that any government strategy to lower prices for consumers by market intervention is likely to come up short. This (particular) intervention is too small to make any meaningful dent on prices, and in any case, the government already has in place a policy instrument, the Public Distribution System (PDS), to address precisely this objective. And the most conclusive judgement against the program is that its subsidies place too large a burden on the state finances and therefore is unsustainable.

This example neatly illustrates the complex challenge of designing effective public policies to address poverty and social welfare. I am inclined to accept the view that the state government (and its policy makers, both political leadership and bureaucrats) initiated this program with the objective to "help the poor". But all such programs are generally designed assuming the target group in isolation without considering its impact on the rest of the economy or society. Accordingly, in many cases, its impact taken as a whole tends to be minimal or even negative, thereby causing considerable medium and long-term damage to the economy and the cause of economic development.

Worse still, such programs tend to create large groups of vocal and influential vested interests, who benefit by either pilfering or being part of its contracting chain. These groups invariably co-opt powerful sections of the political class and bureaucracy as rent-seeking stakeholders, and entrenches themselves against any changes to the status quo. Add the weight of the direct beneficiary class (here, the SHGs and their co-operatives), and it requires going against the grain of political correctness to question such popular programs.

Unfortunately many popular welfare programs suffer from precisely this malady. Opponents and critics (especially among the political class and bureaucracy) get immediately branded as anti-development and effectively silenced, even when questioning anything about its implementation, leave alone the outcomes. Debates in the print and electronic media rarely goes beyond the gaggle of general criticisms of populist programs and political expediency. They neither spotlight attention on the adverse consequences of such programs (apart from the rent-seeking and resource drain aspects) nor suggest different designs for the same program nor lay out alternative approaches to achieve the same objectives. Economists and professional public policy academics in India are yet to emerge as an important source of opinion makers on government policies. Neither do they have much influence in policy formulation.

In the circumstances, these programs, with all their attendant flaws, get perpetuated ad nauseum.

Seven "best buys" of poverty eradication

Didn't quite notice it. Mostly Economics points attention to Poverty Action Lab's seven "best buys" of rigorously evaluated, cost-effective and practical policy initiatives to reach the United Nations Millennium Development Goals (MDGs). Esther Duflo has a nice presentation here.

1. For as little as 50 cents per child per year, deworming of children through mass school-based programs can cut school absenteeism by a quarter.

2. It costs no more than $2.25 per child per year to provide remedial education to children who lack basic reading skills.

3. Doing away with small user fees on bednets to make them available for free to pregnant women and mothers in health clinics costs less than $5 per net and can increase uptake by 75 percent.

4. Quotas for women in politics costs practically nothing. Yet, it increases women’s political participation and shift spending towards women’s priorities, such as clean water.

5. It costs $4 per girl per year to provide free primary school uniforms that help keep girls in school and reduce teen pregnancies by 9 percent.

6. Smart subsidies to farmers boost technology adoption, farm productivity and income. Time-limited offers to purchase fertilizers in the harvesting season, with free delivery in the planting season, can massively increase uptake and usage of fertilizers.

7. Small incentives - such as a bag of lentils per shot - can be a minor additional price to pay to get children immunized.

Intutively too, there cannot have been any arguement about the efficacy of the aforementioned seven "best buys", and the evaluations only confirm it. These seven program components, if effectively implemented, can go a long way in achieving the MDG objectives. There are though a few uncovered and very important areas, like promoting institutional deliveries, getting children to school (and not merely keeping them there), improving learning and health care outcomes, which can also be added to the list (will think of a few and post later).

However, I am deeply suspicious of neat policy prescriptions that give the appearance of simplicity to complex social challenges. Given the variations in socio-economic contexts, it may be more appropriate to claim these as "good buys" (as against "best buys"), lest they get rammed down into their target population as non-negotiable components of multi-lateral lending programs, often to the exclusion of other even more effective local-specific solutions (or "buys").

Interestingly, from the context of India, except for the smart subsidies, all the remaining six interventions have been initiated (in some form or the other) in atleast some areas. For example, in the Integrated Tribal Development Agency (ITDA) areas of Andhra Pradesh, these programs have been in place for many years now. In fact, de-worming, remedial education (or bridge courses), mosquito nets (free in tribal areas), student uniforms (in the ashram schools and residential hostels), and incentivizing immunization are always among the top priority for any PO of an ITDA.

I distinctly remember having administered all the aformentioned components (except the subsidies) as a Project Officer of ITDAs, though I haven't come across any evaluation of the impact of these initiatives. However, there are serious implementation challenges with even simple things like deworming or provision of uniforms.

Deworming, quotas, and uniforms are relatively easy to implement, in so far as they have minimal administration (or transaction) costs. Mosquito nets and immunization incentives too can be implemented, especially if its coverage in the village (or the target habitation) is universal. All the aforementioned involve a single transaction between the government provider and the recipients.

However, remedial education and smart subsidies pose substantial challenges. Remdial education involves continuous engagement between teachers and students and the outcome depends on the quality of the interaction, monitoring which poses the usual difficulties. Smart subsidies are likely to pose considerable administration challenges, especially given the huge monies involved and the need to target the benefits.

It needs to be borne in mind that while these may "best buys" may achieve specific outcomes defined by the MDGs, they are small steps in the process of achieving the desired overall quality and outcomes in health care, education, women's empowerment, increasing agricultural productivity etc. There are no magic pills or short cuts to achieving them.

Update 1 (6/4/2012)

A Times article writes, "Two economists, Michael Kremer of Harvard University and Edward Miguel of the University of California, Berkeley, found that deworming reduced school absenteeism by 25 percent in a sampling of schools in Kenya and that regular treatment could lead to an additional year of attendance — all for  $3.50 per student, far less than subsidies, meals, free bicycles or other incentives to keep kids in school.

Children who are regularly dewormed earn over 20 percent more as adults and work 12 percent more hours, while those infected are 13 percent less likely to be literate."

Saturday, November 14, 2009

Failure of the rational economic agent?

The search for an explanation for the sub-prime mortgage bubble led financial and economic crisis leads us to debates about whether it was a failure of forms of ownership and control mechanisms - private ownership (and capitalism) Vs public ownership, markets Vs government regulation etc.

One of the arguments being made is that the crisis has exposed the weaknesses inherent in the "efficient markets" hypothesis, that underpins both modern financial and real economy markets. That the markets cannot always efficiently allocate resources among competing investment alternative, is amply demonstrated by the sub-prime mortgage bubble. But, as Chris Dillow points out, this line of reasoning runs into problems with the recent happenings in the financial markets - you can't beat the market on a consistent basis (thereby confirming EMH), but prices deviate massively away from "fundamentals" (or the presence of fat tails, going contrary to EMH).

In another post, Dillow points to two specific reasons for banks failure to self-regulate - rational self-interest led individuals to create and hold "toxic assets" that jeopardized the interests of banks’ owners, and chief executives lacked the knowledge (or ability or incentives) to control a complex sprawling bank. Interestingly, these reasons are the same as that we commonly attribute to government failures - bureaucrats failing to act in the public interest, and central planners lacking the knowledge (or ability or incentives) to control the economy!

I am inclined to go with Dillow's argument that the only way to explain this is by reasoning that markets and institutions, both public and private, are populated by individuals, who are themselves constrained by "bounded rationality" and often prisoners of their own vested interests. In the first case, even if markets are not efficient, bounded rationality constrains traders from profiting from small and minuscule mis-pricings and profiting from fleeting opportunities.

There is another argument that the financial crisis is an indictment of traditional capitalist ownership structures and not free markets. This is explained by the moral hazard and information asymmetry inherent in the principal-agent model modern financial institutions, and the difficulty in managing complex financial instruments and markets. While the former is related to the conflict between the self-interest of the managers and that of shareholders, the latter is a natural consequence of the bounded rationality of human beings.

Friday, November 13, 2009

India's post-reform business landscape

An NBER working paper by Laura Alfaro and Anusha Chari that examined publicly-listed and unlisted firms in manufacturing and services industries has found that contrary to expectations, there have been very few dramatic structural changes in Indian business (private and public) landscape in the post-reform period.

Exploring how industrial concentration, number, and size of firms evolved between 1988 and 2005 they find that "the economy is still dominated by the (larger) incumbents (state-owned firms) and to a lesser extent, traditional private firms (firms incorporated before 1985)" and their respective shares of assets, sales and profits continue to persist. The exception to this broad pattern being the post-reform period emergence of new private firms in the services sector.

Another interesting finding from the statistics, though not highlighted in the study, is the contrasting fortunes of public and private sector firms with their firm profitability (measured by the average return on assets). While public sector firms have steadily increased their profits, the private firms established after 1985 have seen eroding profits. In fact, despite a small decline in the relative share of their assets (among public, pre-1985 and post-1985 private, and foreign firms) and almost constant share of sales, public sector firms' share of the total net profits has not only withstood private competition but also actually increased slightly.

The authors do not give explanations for this relative stasis. Has de-regulation not gone far enough to lower the entry barriers for newer firms? Have the larger firms indulged in monopolistic or oligopolistic strategies to keep out competitors? Does corporate India not have the required depth, both financially and technically, to catalyze newer entrants? Has increased external competition (due to lower tariffs and the process of globalization) adversely affected Indian privte firms?

Thursday, November 12, 2009

Anchoring interest rate expectations

In uncertain times like the present, where interest rates are ruling at historic lows, government deficits are mounting, and inflationary pressures (atleast in the medium to long term) remain a strong possibility, one of the more important goals of monetary policy making is to remove uncertainty about interest rate (and inflation) expectations. Central Banks have tried to approach this goal by making public statements to guide expectations about future short-term rates, with and without specifying clear time lines and/or rates (or rate ranges).

US Federal Open Market Committee meeting of August 12, 2009

"The Committee... continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

Bank of Canada's interest rate meeting on April 21, 2009

"Bank of Canada lowers overnight rate target by 1/4 percentage point to 1/4 per cent and, conditional on the inflation outlook, commits to hold current policy rate until the end of the second quarter of 2010."

Two economists from the San Francisco Fed have compared the experiences of both Canada and the US and find no evidence that market participants make distinctions between these statements and expectations generated by their respective policy implications. One of the fundamental challenges of central banking, especially in uncertain times, is to provide clear communication about "the expected path of short-term interest rates, which influences long-term interest rates today", which in turn plays a crucial role in investment and spending decisions. As the authors write, "the ability of central banks to influence the economy today depends upon their ability to shape market expectations about the path of policy rates in the future".

However, Central Bankers face a dilemma with their interest rate communications,
"Make an explicit statement that may have a substantial impact now with the risk of problems in the future, or avoid the risk and make a more cautious statement that may have only a marginal impact".

The authors compared the forward rates on interest rates of both US and Canada and assessed the two contrasting interest rate communication policy stances adopted by the respective Central Banks,

"We find little to suggest that the announcement of a fixed end date has significantly affected expectations of future monetary policy in Canada. It seems that market participants see little difference between the US phrase "extended period" and Canada's conditional commitment to keep rates fixed for a specified period."

In any case, both Central Banks' strong and explicitly made commitment to "promote economic recovery and preserve price stability", coupled with their strong credibility, may have had the effect of marginalizing the subtle differences in their interest rate communications. However, this may not be the case with other Central Banks who do not enjoy similar credibility and autonomy. In case of these Central Banks, the markets may find positive signals in more explicit targets during uncertain times.

Update 1
Nick Rowe has a nice analysis of the dilemmas facing Central Banks when they promise to keep nominal interest rates low for too long to escape a liquidity trap - output today Vs inflation in the future. He feels that a public policy communication to create a higher inflation (than what is the normal, and which in turn is clearly defined) in the future than it would want in future, in order to buy higher inflation, lower real interest rates, and higher output today may be more explicit than one that promises to keep the overnight rate near zero for an extended period, conditional on the outlook for inflation.

Update 2
Brad De Long suggested that the Fed fix an explicit inflation target of 3%, so as to lower the real interest rate and boost investment and consumption in the economy. Ben Bernanke replied by pointing to the "risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward".

Paul Krugman feels that the Fed should real interest rates by either itself buying long-term assets, driving down the wedge between short and long rates, or raise expected inflation, or do both.