Wednesday, June 30, 2010

Observations from liquor license auctions

The Andhra Pradesh state government raised a massive Rs 6904 Cr in the recently conducted auctions for two-year liquor retail sales licenses for 6596 retail outlets across the state from a record 48600 bids. This is in comparison to the Rs 3200 Cr received for the 2008-10 auctions from 20000 bids.

This means that, coupled with the excise and sales tax receipts on the liquor sold, which is estimated to be double the auction amount, the excise department is expected to be the highest revenue earner for the state government topping the traditional commercial taxes department. These auctions have highlighted several interesting examples of economic incentives at work.

1. Under the existing state government policies, the number of retail licenses have remained frozen at 6596 for almost a decade now. The geographical distribution of these licenses are such that while the towns and cities can have more than one shop, based on the population and some other parameters, only one license is issued in each mandal (the small administrative unit in the rural areas with a population of about 40000 to 1 lakh, of which there are nearly 1100 in the state).

The single license holder in each mandal assumes all the characteristics of a classic monopoly. This automatically contributes towards increasing the premiums on bagging license rights, especially for rural areas. This is borne out by the fact that the rural areas witnessed the most intense competition, evidenced both in the numbers of bidders and the amounts bid. In fact, the higest bid of Rs 5.21 Cr came for a shop in Nadikudi village of Dachepalli mandal in Guntur district and several other bids for mandals were higher than Rs 3 Cr.

In these areas, given their monopoly character, these outlets become the single point dispensing counter for the numerous illegal outlets that invariably dot the rural landscape. Further, given the intimate relationship between crime, liquor, and political power, a successful bid confers on the license holder a powerful source of patronage.

2. Apart from licenses for retail sales outlets, the excise department also issues license for serving liquor - bars in urban areas and permit rooms in rural areas. These license fees are fixed by the government and its revenues are a small percentage of the collections from retail shop auctions. In the rural areas, the successful bidders for retail sales are provided the choice to bid for one permit room (attached to the license holding retail outlet) on payment of some small additional amount. In other words, while there are multiple (though restricted) serving centers in each urban area, there is only one legally permissible serving center in each mandal.

The aforementioned architecture makes retail liquor sales business very constricted, especially at its downstream end. While the outflows (from the retail outlets) are massive and growing, the consumption end is serviced by a limited number of bars and permit rooms. In the absence of adequate numbers of institutionalized formal centers for serving the massive quantities of liquor flowing in, informal centers inevitably spring up. This restriction opens up another parallel market - in illegal "serving rooms" (attached to both licensed retail outlets and the numerous illegal ones). It is an open secret that most, if not all, the retail outlets and their numerous illegal off-springs function as sales-cum-serving centers.

3. In many respects, liquor retail licenses and bar/permit room licenses are complementary goods. Every few retail outlets have to be serviced by some legal serving rooms. A market design where there are downstream restrictions on the numbers of bar/permit room licenses (even as consumption is increasing) is only bound to increase the premium on upstream retail sales licenses.

In other words, the retail license bidders have internalized the (the one legal permit room and illegal serving rooms) benefits that accrues from their ownership of a retail license, and have priced that into their bids.

4. Though the permit room licenses are obtained relatively cheap at the margins (for a few lakhs of rupees in comparison to the crores paid for shop license), it is commonly found that less than half the license holders prefer to take them. Since all of them invariably end up serving liquor in their outlets, those without permit room licenses presumably do so because the cost of evading detection of their illegal activity is less than the price of the permit room license. In other words, especially given the fact that the permit room license itself is relatively cheap, the enforcement officials of the Prohibition and Excise Department are selling themselves too cheap!

5. Interestingly, another contributory factor to the over-sized bids may have been the economic recession which has had the effect of depressing the real-estate market and leaving builders and developers in the search for alternative remunerative investment opportunities. Further, the very large parallel economy resulting from the aforementioned monopoly characteristics offers them an added attraction of acting as an outlet to funnel the massive amounts of black money that had been sloshing around the real estate sector.

Tuesday, June 29, 2010

Scoring a self-goal to win!

More on the law of unintended consequences. Marginal Revolution points to an unusual match between Barbados and Grenada.

"Grenada went into the match with a superior goal difference, meaning that Barbados needed to win by two goals to progress to the finals. The trouble was caused by two things. First, unlike most group stages in football competitions, the organizers had deemed that all games must have a winner. All games drawn over 90 minutes would go to sudden death extra time. Secondly and most importantly, there was an unusual rule which stated that in the event of a game going to sudden death extra time the goal would count double, meaning that the winner would be awarded a two goal victory.

Barbados was leading 2-0 until the 83rd minute, when Grenada scored, making it 2-1. Approaching the dying moments, the Barbadians realized they had no chance of scoring past Grenada's mass defense, so they deliberately scored an own goal to tie the game at 2-2. This would send the game into extra time and give them another half hour to break down the defense. The Grenadians realized what was happening and attempted to score an own goal as well, which would put Barbados back in front by one goal and would eliminate Barbados from the competition.

However, the Barbados players started defending their opposition's goal to prevent them from doing this, and during the game's last five minutes, the fans were treated to the incredible sight of Grenada trying to score in either goal. Barbados also defended both ends of the pitch, and held off Grenada for the final five minutes, sending the game into extra time. In extra time, Barbados notched the game-winner, and, according to the rules, was awarded a 4-2 victory, which put them through to the next round."

Monday, June 28, 2010

Two-handed economist

Two economists proposing diametrically opposing policy choices for the same problem is one of the defining characteristics of the profession. The latest example comes in the form of the policy choices presented by James Galbraith and Jeff Miron on addressing the problem of persisting unemployment in the US in a NYT Room for Debate.

First, James Galbraith on the need to create jobs by shrinking the labor force,

"Reducing the eligibility age for Medicare to 55 would allow older workers to opt into early retirement. Eliminating the early retirement penalty in Social Security for, say, five years — and, yes, we can afford that — would open up jobs for young people. More money for community colleges, technical schools and universities can help: more students means fewer unemployed."

Second, Jeff Miron's approach to pursue jobs growth,

"Phasing in a higher age of eligibility for Social Security and Medicare, to slow the growth of entitlement spending. This would signal markets, at home and abroad, that the US can balance its budget over the longer term. If this occurs, capital will come flooding in, along with talented labor if immigration policy permits. This influx would spur investment and subsequently job growth."

Both are understandably incomplete and clear representations of ideological positions. I am inclined to the view that such issues cannot be argued and resolved at an intuitive or theoretical level, especially since a small change of even one or two years (to the Medicare eligibility norms) can have massive implications on the fiscal balance and its beneficiaries. An objective assessment should require filling in the numbers and doing a cost-benefit analysis of the balance sheet, duly internalizing costs like those inflicted on the laid-off and older workers who now lose their Medicare protection (due to increase in age floor).

Sunday, June 27, 2010

US and Europe - different fiscal challenges?

The build-up to the G-20 summit has featured an interesting trans-Atlantic debate on the relative merits of continuing with or exiting the expansionary fiscal and monetary policies of the past three years.

President Obama has cautioned his colleagues against any premature exit from stimulus spending. However, the "austerians" appear to have won over in Europe, with the new British government already announcing unprecedented spending cuts and tax increases in an emergency budget.

Stephen Gordon's graphic that highlights the relative changes in the employment rates between US and European economies over the last three years may carry some relevance in this debate. The US stands as the clear outlier among the major western economies in the extent of damage suffered by the labor market.

More than the anemic economic environment and weak growth prospects, it has been the sharp increase in the unemployment rate and the lack of any signs of a quick return to normalcy in the job market that has been the most important argument in support of continuing the expansionary policies. The labor market in the US has taken a much deeper hit than that of its European counterparts. To this extent, the amount of unemployed resources that need to be ploughed back into use through government intervention is far less amongst European economies than the US.

In this context, two other factors need to be considered. One, the lower baseline of unemployment rate and economic growth in Europe compared to the US means that the extent of stimulation required may be higher for the US. In other words, the US economy has deviated much more from its production frontier than the European economies, and would therefore require much more aggressive government intervention. Second, the European social security blanket and automatic fiscal stabilizers are much more generous and therefore more effective in cushioning those most adversely affected by the recession.

None of this is to support any fiscal tightening in Europe. Far from it, as the graphic below shows, the fiscal position of the major European economies is indeed better than that of the US. They have smaller primary deficits and require smaller fiscal adjustment to bring their public debts to within sustainable levels. This also means that they have greater fiscal space for stimulus spending than the US.

Continuation of the expansionary policies, atleast by the major economies of Europe, is important for both the world economy and (more importantly) the battered peripheral economies of Eurozone.

Saturday, June 26, 2010

Global debt situation

The Economist has a survey on the global debt situation that threatens to seriously imperil the global economic growth prospects for many years to come and demands radical changes from the way consumers, businesses, financial institutions and governments have behaved over the past few decades. It writes,

"(F)or the developed world, the debt-financed model has reached its limit. Most of the options for dealing with the debt overhang are unpalatable... The battle between borrowers and creditors may be the defining struggle of the next generation."

An interactive graphic, based on a survey by the McKinsey Global Institute, gives the details on the debt situation at 14 major countries with the respective shares of government, household, financial and non-financial corporate sectors.

The average total debt (private and public sector combined) in ten mature economies rose from 200% of GDP in 1995 to 300% in 2008, with even more startling rises in Iceland and Ireland, where debt-to-GDP ratios reached 1,200% and 700% respectively.

Interestingly, the aforementioned graphic has an encouraging picture of India, putting its fiscal position in the right perspective. Though it stands in the middle with its 70% public debt, it has the lowest share of household and financial sector debt and the third lowest share of non-financial sector debt. And as I have written earlier here, here, and here, even this 70% of GDP public debt is cushioned by the fact that more than 90% of its is domestically owed and the debt to exports ratio is close to its lowest in more than 75 years.

This graphic ranks countries in terms of their primary budget balance, debt-to-GDP ratios plus the relationship between the yield on their debt and economic growth (if the former is larger than the latter, the debt burden is getting steadily worse).

The expansion in the role of government over the past three decades, which was financed through borrowings and surging tax revenues is now showing signs of stress as the receession takes its toll on tax revenues. The debt-to-GDP ratio of the G7 group of nations is at its highest level for 60 years

Read the survey to explore the debate on debt burdens unsettling market confidence and upsetting the voters, how bankruptcy law has changed in favour of the corporate debtor (driven by the provisions of the Chapter 11 Bankruptcy law in the US which allows companies to continue operating and prevents creditors from foreclosing on the business), the unsustainable household consumption binge, corporate sector's appetite for debt, role of rating agencies.

See also interactive graphics on the interconnected web of Eurozone debt, the country-wide status of debt, and the macroeconomic situation of the EU economies.

Update 1 (15/5/2011)

The IMF staff has this nice video on public debt, which uses data from 174 countries over a period of 120 years, and will help policymakers understand the past and chart a future course to sustainable economic growth.

England Vs Germany in historical perspective

Marina Hyde points to a twitter message and puts the forthcoming England-Germany World Cup Football match in its right historical perspective

"This World Cup is exactly like the second world war. The French surrender early, the US turn up late, and we're left to deal with the bloody Germans."

She compares the performances of the two countries in major competitions (11 finals against two semifinals since 1966!) and describes their contests as an "ancient and hilariously one-sided blood feud",

"With his last minute, group-winning goal against Algeria yesterday, the USA's Landon Donovan effectively assassinated Archduke Franz Ferdinand and invaded Poland. England now face the old enemy – the old enemy being the one within, namely some people's pathological inability to view football games with Germany through any other prism than war. Yet if this enemy has an ally – an Axis buddy, if you will – it is the idea that our nation enjoys a serious football rivalry with Germany.

From the minute England's round of 16 destiny was clear, you will have heard much about this sainted antagonism with Germany. Yet the so-called rivalry is quite obviously an illusion, existing only in the minds of those wishful to the point of insanity – which is to say, the English. We are rivals with Germany in the same way Christine Bleakley is rivals with Oprah."

Friday, June 25, 2010

Calculating a bank tax

Among the proposals under consideration for financial market regulation reforms in the aftermath of the sub-prime crisis, have been those relating to placing limits on the size of TBTF institutions and raising resources to finance future bailouts. While the former has not made much headway, the later has received considerable attention in many countries in the form of bank taxes.

Like on many other initiatives during the recent crisis, Britain has been first off the block with the new coalition government's decision in its austerity budget to impose a levy on banks to raise £2 billion per year. The levy will start at 0.04% of banks’ riskier liabilities — excluding Tier 1 capital and insured deposits — in 2011, rising to 0.07 percent in 2012, and will be imposed on banks with liabilities of more than £20 billion. Following the British decision, France, Germany, and the EU too have thrown in their weight behind a bank tax with the "aim to ensure that banks make a fair contribution to reflect the risks they pose to the financial system and wider economy, and to encourage banks to adjust their balance sheets to reduce this risk".

In the US, President Barack Obama's proposed tax of 0.15% of net bank liabilities to raise up to $117 billion over 10 years, has met with stiff opposition and is not likely to sail through. However, one of the biggest challenges with these bank tax proposals has revolved around arriving at a widely acceptable approach/formula to decide on the optimal tax rates.

Calculating the appropriate tax for a financial institution with debt guarantees requires measuring the quantity of taxpayer risk and then pricing that risk. The latter can be accomplished through options markets designed specifically to price risk accurately. However, calculation of the former by regulators comes up against severe information asymmetry problems and other market failure risks.

In this context, Narayana Kocherlakota, President of the Minneapolis Fed proposes a new market-based method for determining the quantity of tax to be paid by financial institutions so as to internalize their risk externalities. He proposes that governments should provide debt guarantees to all firms in the financial sector and the resultant risk externality (created by this guarantee) be controlled by appropriate regulation should control. He writes,

"For a particular financial institution, the government should sell 'rescue bonds' paying a variable coupon linked to the size of the bailouts or other government assistance received by the institution or its owners. Coupon prices will reflect the market’s judgment of an institution’s risk profile and can therefore be used to set the tax.

... (say) the rescue bond pays a variable coupon equal to 1/1,000 of the transfers actually made from the taxpayer to the financial institution or its stakeholders. Much of the time, this coupon will be zero. However, just like the financial institution’s stakeholders, the owners of the rescue bond will occasionally receive a large payment. In theory, or in a perfectly functioning market, the price of this bond is exactly equal to the 1/1,000 of the expected discounted value of the transfers to the financial institution’s stakeholders. Thus, the government should charge the financial institution a tax equal to 1,000 times the price of the bond...

In principle, the government need not figure out in advance which institutions are systemically important and which are not. Instead, the market would provide this information through the pricing of rescue bonds... A well-designed tax system can entirely eliminate the risk externality generated by inevitable government bailouts."

Thursday, June 24, 2010

More debates on timing the exit from monetary accommodation

As the sub-prime crisis unfolded, the US Federal Reserve initiated a series of extraordinary "unconventional" monetary policy interventions to unfreeze the credit markets and inject ample liquidity. They included special liquidity injection facilities, reductions (to zero-bound) in the short-term interest rates, and increases in the Fed’s balance sheet (through purchases of longer-term securities). Fed emerged as the lender (to cash-strapped firms), buyer (of illiquid securities) and insurer (of all loans) of last resort.

Now with the green shoots of recovery on the landscape and fears about inflationary pressures taking hold, calls for exiting from the loose monetary and credit policy has been gathering steam. Those advocating an end to monetary accommodation point to the splendid recovery in the financial markets - so much so that the equity markets now appear to exhibit much of the same signs of irrational exuberance that was its characteristic throughout much of the last decade.

Raghuram Rajan recently wrote about the need to raise interest rates in the US from its current "ultra-low to low" so as to prevent the build-up of several possible incentive distortions. He argues that the ultra-low rates could bring about "dangerous financial imbalances, such as asset price mis-alignments, bubbles, or excessive leverage and speculation".

However, in an insightful recent post, Glenn Rudebusch (also here) of the San Francisco Fed differed with Raghu Rajan and wrote that if the economy will take years to return to full employment, "it seems likely that the Fed’s exit from the current accommodative stance of monetary policy will take a significant period of time". He points to a statistical regression of the funds rate over the past two decades on core consumer price inflation and on the gap between the unemployment rate and the CBO's estimate of the natural, or normal, rate of unemployment, captured in the graphic below.

Since the nominal rates touched the zero-bound in late 2008, this regression rule would indicate that the rate will have to remain lower than zero for many months to come,

"The dashed line combines the benchmark rule of thumb with the Federal Open Market Committee’s median economic forecasts (FOMC 2010), which predict slowly falling unemployment and continued low inflation. The dashed line shows that to deliver future monetary stimulus consistent with the past—and ignoring the zero lower bound—the funds rate would be negative until late 2012. In practice, this suggests little need to raise the funds rate target above its zero lower bound anytime soon."

After the rates reached the zero-bound the Fed turned attention towards driving down the long-term bond yields with its massive program of purchasing securities (long-term Treasuries and agency debt). This unconventional monetary stimulus would presumably have had the impact of further loosening the monetary policy and thereby ensuring that the appropriate level of short-term interest rates would be higher than that shown in the earlier graphic.

Rudebusch points to findings that the changes in long-term interest rates have much larger effects on the economy than equal-sized changes in short-term interest rates. The output sensitivity to movements in the 10-year yield have been estimated to be quadruple the output sensitivity to a short-term interest rate. He incorporates this effect into the above interest rate graphic by drawing from a study by Joseph Gagnon and others, which estimates that the Fed’s announcements in late 2008 and early 2009 of future securities purchases caused 10-year yields to fall by about ½ to ¾ of a percentage point.

"If the Fed’s purchases reduced long rates by ½ to ¾ of a percentage point, the resulting stimulus would be very roughly equal to a 1½ to 3 percentage point cut in the funds rate. Assuming unconventional policy stimulus is maintained, then the recommended target funds rate from the simple policy rule could be adjusted up by approximately 2¼ percentage points... and the recommended period of a near-zero funds rate would end at the beginning of 2012."

He also addresses the concerns about financial market mis-allocations by pointing to the example of Japan for the decade and half when despite short-term rates remaining essentially zero, there was no build-up of financial imbalances. He therefore argues that "the linkage between the level of short-term interest rates and the extent of financial imbalances is quite erratic and poorly understood" and prefers prudential financial regulation to restrain excessive financial speculation.

The more widely-used Taylor Rule too predicts (using the FOMC 2009 forecasts) that the interest rates should be ruling in the negative territory and not likely to return to the zero-bound till well into 2012.

Incidentally, the Mankiw Rule (also here) which put forward another simple rule for setting the federal funds rate (rate = 8.5 + 1.4 (Core inflation - Unemployment)) too suggests that except for dramatic changes in the inflation and/or unemployment rates, the interest rates will remain at zero-bound for quite some time. Andy Harless points out that "if the core inflation rate remains near 1%, the unemployment rate will have to fall to 7%" and "if the core inflation rate rises to 2%, the unemployment rate will still have to fall to 8%", both not likely to happen anytime soon.

Andy Harless also has this post which constructs the Mankiw Rule by taking into account the impact of the unconventional monetary easing of 2009 and finds much the same result. See also Ben Bernanke on the Fed's exit strategy here.

Wednesday, June 23, 2010

Governments and urban development

My recent Mint op-ed that advocated re-development of slums by in-situ multi-storied housing instead of granting property rights has generated some strong (dare I say, bigoted) comments from the extreme-right. Without getting into the merits and details of any government role in slum re-development, the general underlying premise (of these comments) is that once property rights are given, the dynamics of the market will take care of all infrastructure development.

In the circumstances it is only appropriate that we read what one of the most influential urban economists has to say about the same issue. Edward Glaeser has a superb post explaining how cities turned from being "killing fields – places where proximity led to death and disease" (mainly due to the pollution of the water supply) to healthy locations. He claims that far from this happening automatically as cities grew larger and richer, "urban disease was reduced only with massive public intervention". For those advocating reliance on the free-market to address the urban infrastructure challenges, he has this powerful message,

"By 1896, there were almost 1,700 public water systems in the United States, and municipalities were spending as much on water as the federal government spent on everything except the military and the postal service... this spending was only possible because municipal debt markets had matured to the point where cities could borrow vast sums...

Big waterworks weren’t the only example of big government reducing urban disease. In 1896, George Waring attacked the waste on New York City’s streets with a lot of spending and a uniformed corps of cleaners... the downsides of proximity, be they cholera or crime, have never been solved with laissez-faire. Costly, often intrusive public action has often been needed to manage the negative externalities associated with urban density."

And nobody can accuse Ed Glaeser of being a supporter of bureaucratic central planning and not having an understanding of economics!

Monday, June 21, 2010

Do private schools improve public schools?

More evidence that competition can improve public school performance. A just released NBER working paper by David Figlio and Cassandra Hart (pdf here) examined the impact of private school competition on public school students’ test scores based on the experience of Florida’s Tax Credit Scholarship program (FTC) which offered scholarships (through vouchers) to eligible low-income students to attend private schools.

It offered assistance to students with family incomes below 185% of the federal poverty line to attend private religious or non-religious schools in Florida. The vouchers cover only part of the costs of attending private schools, and parents were free to send their children to any private school regardless of the share of tuition and fees covered by the voucher. They explored whether students in schools that were exposed to a more competitive private school landscape saw greater improvements in their test scores after the introduction of the scholarship program than did students in schools that faced less competition and found

"...that greater degrees of competition are associated with greater improvements in students’ test scores following the introduction of the program; these findings are robust to the different variables we use to define competition. These findings are not an artifact of pre-policy trends; the degree of competition from nearby private schools matters only after the announcement of the new program, which makes nearby private competitors more affordable for eligible students.

We also... find that schools that we would expect to be most sensitive to competitive pressure see larger improvements in their test scores as a result of increased competition... Both greater ease of access to private school options (measured by the distance and density measures) and the variety of options that students have in terms of the religious (or secular) affiliations of private schools (measured by the diversity and concentration index measures) are positively associated with public school students’ test scores following the introduction of the FTC policy."

The flip-side to this finding may be that it may have a more nuanced relevance to countries like India because this study is set in an environment where state funds are tied to student enrollment and losing students to private schools therefore constitutes a financial loss (and even a possible closure by merger with a nearby school if the strength declines precipitously). In countries like India this fear may have no deterrent effect since even if schools lose students (so much so that they have to close down), teachers cannot be fired. In such environments, as this and this posts have explored, such competition may end up further impoverishing government schools.

Sunday, June 20, 2010

Incentivizing teachers or schools?

Incentivizing teachers and students with cash payments for improving the quality of education imparted and learning outcomes achieved forms a highly controversial area of education reforms across the world.

Edward Glaeser points to an interesting assessment of such programs for teachers under implementation in 26 US states by Stuart Buck and Jay P Greene of University of Arkansas, who find that standard implementation problems that bedevil reforms in all sectors come in the way of the success of merit-pay projects. They claim that entrenched vested interests work towards "blocking, diluting or co-opting" the program by either preventing its enactment and diluting the focus or evaluation methods or outcome standards.

They write that in the absence of competition, "even if wise and benevolent state actors manage to get the incentives right at a particular moment in time in a particular place, their actions can always be undone by immediate successors" under the influence of powerful vested interests,

"With greater educational competition, however, state bureaucracies, local school boards, and building principals face a sharpened incentive to figure out how to structure their own pay systems so as to extract excellent performance from their employees. If they fail to do so, students may be more likely to leave the state school system altogether, thus diminishing the public schools’ budget... As a result, competition enhances the possibility that merit pay could reach its full potential, rather than being co-opted by interest groups whose goal is to reward whatever it is that they already happen to be doing. Put another way, competition between schools diminishes the political power of interest groups that are dedicated to undermining merit pay."

Their concluding comments about the problems faced with successful implementation of merit-pay is strikingly appropriate about many public institutions

"Public schools are not primarily educational institutions where policies are organized around maximizing student achievement. Instead, public school systems have to be understood as political organizations organized around the interests of their employees, their union representatives, and affiliated politicians and other interest groups... difficulty with attempting merit pay in education is that it consists of imposing a market-based practice in a non-market environment. None of the forces that cause organizations to seek effective merit pay systems, as well as maintain and alter them effectively over time, exist in public education. Established interests will forcefully resist and undermine merit pay, making its success doubtful."

However, it may not be correct to read this as a general endorsement against designing public policies with built-in performance-based incentives in non-market based environments. It only cautions about the presence of numerous adversarial factors which need to be mitigated when implementing such policies. I am skeptical of the success of teacher-based incentive pay, especially in developing country environments, for the following reasons

1. In many schools, the baseline is so low that even small interventions can make a dramatic difference in performance. For example, ensuring higher teacher and student attendance, teachers attendance for trainings, systematic syllabus coverage, periodic homework assignments, conduct of examinations and prompt evaluation of examination papers will all by themselves contribute substantially towards improving school performance. Compliance with these basic requirements, a function (and basic pre-requisite) of routine supervisory over-sight, is poor due to the virtually non-existent field presence of the administrative machinery.

The logic behind performance-based financial incentives is to kindle the inner competitive/motivational urge within teachers to improve their productivity and thereby increase performance outcomes. In an environment with such low baseline, which can be raised with small and routine administrative interventions, the incentive would then get inefficiently frittered away. It would be the equivalent of using powerful antibiotics on common-cold.

2. This can have many perverse consequences. For example, it could end up diverting attention from critical administrative deficiencies and ensuring that adherence to even routine duties and responsibilities are now made dependent on financial incentives. Taken to its logical conclusion, these incentives become an extension of salaries and lose their productivity improvement value.

These incentives could also end up generating perverse "entitlement effects", where teachers could start demanding incentives for even complying with their routine duties and responsibilities (for which they draw their salaries in the first place). While this would generate perceptible improvements in the immediate period, the medium and long-term moral hazard effects could be detrimental to the system as a whole.

3. In view of the aforementioned low-hanging fruits, did the mere fact that the schools were being treated for merit-pay based performance improvements itself contribute to actual performance improvements? In contexts where the baseline is itself very low, even small and cosmetic steps towards improving monitoring and supervision can yield substantial results. Merely being part of an experiment, where performance would be monitored more closely than in the business as usual case, is itself likely to shake-up the establishment and ensure better performance outcomes. Further, the nature of the experiment means that it is not possible to have double-blind treatments to control for the Hawthorne effect. Therefore, it may not be correct to conclude that the same outcomes would result when the policy is implemented on scale.

4. Even assuming the effectiveness of merit-pay, how do we know what is the optimal incentive amount. The wide variations in the socio-economic environments of different schools means that the optimal incentive structures are like to vary vastly. Given the aforementioned politics of such decisions, there exists the strong possibility of over-paying for achievement of sub-optimal results (which would have been achieved even without any incentives).

5. Crowding-out effect - Only the good (or already motivated) teachers are likely to be influenced by incentives. They enroll (or "crowd-in") for the incentive programs. This has the perverse effect of further widening the standards between the good and poor teachers, thereby causing even more distortions within the school system.

6. Incentives without disincentives - All existing merit-pay systems involve one-way incentives with no disincentives. Even if implemented, assured of their monthly salaries, a large share of teachers are not likely to respond to any of these incentives. Given the large salaries drawn by teachers, the quantum of incentives is not likely to be large enough to make substantial cognitive impact on the entrenched inertial psyche of majority of the teachers.

I am inclined to the opinion that financial incentive structures that reward improvement in school (as against teacher) performance may be more effective than teacher-based incentives. However, this too comes up against formidable challenges like the wide variations in socio-economic environments that determine performance outcomes. Further, the challenge with designing such incentive structures is to identify quantifiable and objective parameters that are reliable indicators of school performance outcomes.

But with appropriate normalization among the few commonly observed determining factors, it may be possible to normalize and arrive at an appropriate measure of the true base-line for all schools. In any case, financial incentives for school performance is easier to implement for the following reasons

1. It is likely to face less political opposition since it does not directly target teachers at an individual level.
2. By not directly focusing on individual teacher-specific outcomes, it does not create much of the aforementioned incentive distortions.
3. School-based incentives creates a great opportunity for schools to access funds for meeting their infrastructure and other requirements. This is likely to increase its popular acceptability.
4. School-level outcomes can be measured with much less distortions and are a more accurate reflection of student learning outcomes. Such macro parameters are also less vulnerable to being manipulated and subverted.
5. Involving the local community, an important factor in ensuring political acceptability and sustainability, is easier with such macro-level interventions.
6. Given the vast differences in school backgrounds, a school-level incentive program gives each school the flexibility to tailor school-specific incentives targeted at teachers and others.

Another alternative is to start with incentives for principals than teachers, as suggested by Jim Stergios, the executive director of the Pioneer Institute, a public-policy research organization in Boston (via Ed Glaeser). This arguement works on the assumption that school performance could improve dramatically if highly motivated principals had the resources to attract the best teachers and the strength to move the worst ones into other sectors. Even intutively, a large enough incentive for principals, could have the potential to get principals to manage their schools optimally and generate greater bang for the buck.

Good news from China?

After all the brouhaha surrounding China's beggar-thy-neighbor weak-yuan policy, there have been some sprinkling of good news out of China in recent weeks.

The latest was the announcement by the People's Bank of China, that it would allow greater flexibility in the value of renminbi in relation to an unspecified basket of currencies, the clearest sign yet that China would allow its currency to appreciate gradually against the dollar and other currencies. However, in a note of caution, it warned explicitly that "the basis for large-scale appreciation of the RMB exchange rate does not exist". This raises doubts about the extent of re-balancing and apprehensions that it would be similar to that was done in 2005 when the renminbi was allowed to appreciate slightly (from 8 to 6.83 yuan) and then re-pegged.

Apart from the mounting pressure not only from the US, but also from other emerging economies like India, the announcement may have also been triggered off by the steep rise in renminbi (along with the 15% rise in the value of dollar) against the euro in the last two months. As the Times reported, that has made Chinese officials nervous about the future competitiveness of Chinese sales to Europe, the biggest market for Chinese exports.

This exchange rate decision comes in the wake of mounting labor unrest in Chinese factories, especially in the auto industry, demanding higher wages. Poor and deteriorating work conditions and standards of living have been attributed as the reasons behind this unrest among industrial workers. A report in the Times writes about conditions at a Honda factory in Guangdong province,

"Workers at the factory here said that their jobs required them to stand for eight hours a day at their posts, and that pregnant women were allowed to sit only in their last trimester. Workers also complained that they were not allowed to speak while working — a common requirement in Chinese factories — and that they had to obtain passes before going to the bathroom. They said they were criticized if managers thought they took too long getting a drink of water."

The workers are also demanding the right to form trade unions separate from the government-controlled national federation of trade unions, which has long focused on maintaining labor peace for foreign investors and acted as a vent for pent up frustrations over pay and work conditions. The Chinese government has so far not allowed unions with full legal independence from the national, state-controlled union, though it has permitted workers choose their factories’ representatives of the national union and allowed the creation of "employee welfare committees" in parallel with the official local units.

Most of these strikes are led by migrant workers from the hinterland, who accuse the local governments of not doing enough to regulate work and living conditions. Unlike their parents who formed the first wave of migrant factory labor, the new generation are motivated less by the poverty of the countryside than by the opportunity of the city, and therefore are not averse to demanding atleast living urban wages.

As Yasheng Huang points out about China's spectacular emergence as the factory of the world in the last 20 years, through the creation of tens of millions of jobs in the export sector, in relative terms the Chinese labor has been the big loser. He writes,

"The labor income share of Chinese GDP declined from 57% in 1983 to only 37% in 2005, and the ratio has stayed at that level since then. This is to say that hundreds of millions of Chinese workers have lost relative to government and corporations, which, in terms of head counts, represent a tiny fraction of China’s massive population... Now labor wants its legitimate due from economic growth and workers have every right and the moral high ground to demand it."

Strengthening the workers hand is the resurgence of economic growth after a brief lull in 2007-09, which in turn has increased demand for labor and exposed labor shortages. This has increased the leverage of industrial workers whose salaries have not kept pace with inflation and soaring food and housing costs.

There have been an eruption of strikes in many locations across the country. Recent strikes at Toyota and Honda factories follows those at suppliers to consumer electronics makers Apple and Dell. Foxconn Technology, maker of products that include Apple iPhones and Dell computer parts, announced plans to raise the salaries of its 800,000 workers in China, beginning in October, by 33%. It also decided to double the salaries of some of them to a monthly average of 2,000 renminbi ($300). Thanks to these interventions, the basic salary for an assembly line worker in Shenzhen is expected to rise from 900 renminbi ($132) a month to atleast 1,200 renminbi ($176).

Honda has agreed to give about 1,900 workers at one of its plants in southern China raises of 24 to 32%. Further, in response to the labor unrest and offset inflation and rising food, energy and housing costs, Beijing has directed local governments early this year to raise the minimum wage in the regions — which is set locally and is around $130 to $150 a month in big coastal cities. Many cities have already responded by raising the minimum wage by about 10 to 15%, to about 750 to 1,100 renminbi. The average hourly wage in southern China is only about 75 cents an hour and the minimum monthly wage in Shenzhen is 900 renminbi, about 83 cents an hour. China has the world’s largest manufacturing workforce - more than 112m people at the end of 2006, and this workforce is still cheap, costing $0.81 an hour, or just 2.7% of the cost of their American counterparts.

The combined effect of a revalued renminbi and increased wages would certainly lower the competitiveness of Chinese exports and increase that of imports. The rise in wages and cheaper imports would have the effect of increasing the purchasing power and thereby the consumption demand among Chinese consumers. Besides, it would also help contain inflationary pressures (which have been surfacing in recent weeks) arising from decades of China's export-driven growth. It will also encourage the penetration of development from the coastal provinces to the still-backward hinterland areas.

For the world economy, it would help economic growth among China's trading partners - by increasing opportunities in the Chinese domestic market (especially in the high-end consumer goods sector) - and competitors (especially other emerging economies) - by helping them mitigate the unfair competitive advantage enjoyed by Chinese exports. This would go a long way towards re-balancing the prevailing unsustainable global macroeconomic imbalances.

Additionally, it would help China manage the build-up of massive foreign exchange reserves more effectively. The Times reports that China has been "spending nearly one-tenth of its annual economic output to buy Treasury notes and bonds and other foreign securities while printing and selling renminbi, all in an effort to prevent the renminbi from rising against the dollar".

Update 1 (21/6/2010)

The renmibi strengthened to the highest level in nearly two years in the biggest one-day move since 2005. More evidence of rising labor unrest. But Tim Duy is not sure whether real change is underway and feels it may be more "smoke than fire".

Update 2 (13/7/2010)
In a reflection of the growing supply squeeze for workers, factories are now competing to attract workers.

Update 3 (1/8/2010)
Excellent articles in the Economist tracking the latest emerging trends in the Chinese labor market and its implications for the world economy.

Update 4 (6/8/2010)
At $0.81 an hour, the cost of Chinese workers is just 2.7% that of their American counterparts.

Saturday, June 19, 2010

Awesome China!

One of the most awe-inspiring aspects about the last quarter century of Chinese economic growth has been its amazing ability to exponentially scale up growth on almost all observable parameters, almost ad infinitum. This statistic via Marginal Revolution is astonishing.

China now exports every six hours as much as it did in the whole of 1978!

Update 1 (4/8/2010)

Over the past 30 years, its 10% growth rate has lifted 566 billion people over the $1.08 "extreme poverty" threshold set by the World Bank. Yilmaz Akyuz, chief economist of the South Centre, estimates that close to 60% of China's imports are used in the export sector and only 15% of imports are for domestic consumption and exports may have contributed to 50% of China's pre-crisis growth.

Friday, June 18, 2010

Dominant strategy for strikers - shoot to the center?

I had blogged earlier that despite the dominant strategy for football goalkeepers facing a penalty strike was to stay at the center, keepers preferred to dive randomly to the right or left since they feel greater regret at letting a goal in after standing still in the centre compared with jumping either side.

Steven Levitt and Stephen Dubner examined the same psychology from the perspective of the penalty strikers and found that they "are generally reluctant to aim penalty kicks at the center of the goal even though the data show that is the most effective spot". And their explanation is on similar lines,

"He may think that if he kicks down the centre and the keeper does manage to stop it, the kicker will look like an utter fool... A penalty kick down the middle has the same private benefit as a goal to the left or the right, but a miss down the middle has a greater private penalty: it may well define a player’s career. And so he acts according to his own private benefit, not the greater good, and fires away to the left or the right. If he misses there, the moment will be remembered more for the keeper’s competence than the kicker’s ignominy."

Snapshot of global imbalances

The role of global macroeconomic imbalances, manifested most saliently in the current account surpluses and deficits of the emerging and developed economies respectively, has been discussed extensively here, here, here, here and here. A recent Vox article by Kati Suominen has a superb graphic that captures global build-up of imbalances for the 1996-2015 period, with respective contributions of the major economies. The graphic projects that the imbalances are set to persist, albeit at a slightly lower level.

The US, UK, Canada, Australia, India, Turkey, France, and southern European nations form the deficit side of the global macroeconomic balance, while China, Japan, emerging East Asia, Germany, and oil producing nations form the surplus side.

Thursday, June 17, 2010

Case for in-situ slum development

Here is my Mint op-ed today which argues that instead of granting property rights, slums should be redeveloped in situ using, say, multi-storeyed housing

Wednesday, June 16, 2010

Fiscal austerity is not the answer

Sparked off by belt-tightening in Euro-zone, the calls for fiscal austerity elsewhere (especially the US) has grown louder. These voices (Paul Krugman calls them the "Pain Caucus") point to the burgeoning public debt burdens and the possible unraveling of inflationary expectations, and are now even advocating increasing interest rates.

The OECD set the pace in its latest Economic Outlook by suggesting that the US Fed raise the benchmark federal funds rate by 350 basis points by end-2011, even though its own forecast says that unemployment then will still be 8.4% and inflation under 1%. It also advocated an early exit from exceptional fiscal support, preferably now or atleast by 2011, in view of the "unfavorable government debt dynamics".

Raghuram Rajan has raised doubts about the effectiveness of accommodative fiscal and monetary policies and argues against both any more stimulus, including a jobs bill, and favors raising interest rates. He feels that such policies fuel inflationary pressures, endangers fiscal balance, creates asset bubbles not only in the US but in developed economies, and all this with little beneficial effects.(However, as this later post appears to indicate, his argument is for raising rates from ultra-low to low, so as to prevent the build-up of systemic-risk generating distortions)

Jeff Sachs points to the harmful effects of unsustainable debt burdens and calls for cutting spending. He argues that fiscal policy, at least in the US now, cannot credibly manage expectations to raise growth and lower unemployment.

And all this despite the fact that unemployment is still very high in all developed economies, decrease in unemployment rates far too slow to make any meaningful impact, and economic growth environment remains subdued. Moreover, both prices and long-term bond yields show no signs of inflationary expectations becoming entrenched. As Glenn Rudebusch pointed out in a superb recent article, even the doubling of the Fed’s balance sheet has had no discernible effect on long-run inflation expectations measured in the Survey of Professional Forecasters, consistent with Japan’s decade-long spell of price deflation.

Mark Thoma has this point to point answer to Raghuram Rajan's article, where he points to the CBO's assessment, consistent with a wide range of estimates, of the Obama administration's fiscal stimulus program. Brad De Long has this superb post on Jeff Sachs' argument by pointing to the lack of any signs of inflationary pressures building up and of prospects of higher interest rates that could result in "crowding-out" of private investments. Paul Krugman has this response to the OECD's recommendations.

Krugman has been amongst the most strongest critics of those calling for fiscal austerity and raising interest rates. As he and others have argued, the immediate macroeconomic problem is lack of demand, and not inflation or rising debt burden. Any contraction now, fiscal and monetary, at a time when some recovery is taking hold, is certain to end up stifling those green shoots of economic recovery. Instead of enacting contractionary policies, the objective now should be to tailor targeted stimulus policies that would specifically address the unemployment problem, boost aggregate demand and smoothen the recovery path.

And it is not as though any exit from stimulus is going to dramatically alter the fiscal balance of the US economy. Krugman points to a rough estimate (of US economy) that cutting spending by 1 percent of GDP would raise the unemployment rate by .75 percent compared with what it would otherwise be, yet reduce future debt by less than 0.5 percent of GDP.

Further, as the graphics below points out, the fiscal position has been compromised not by stimulus spending, which forms a surprisingly small share of the overall debt burden, but by other more important issues. The OECD's own estimates indicate that of the 35.5% increase in debt burdens across developed economies in the 2007-14 period shows, only 3.5 percentage points will come from fiscal stimulus, and the rest will come from other sources, most notably from revenue losses due to the drops in asset prices. At the current long-term inflation-protected securities rate of 1.75%, the long-term cost of servicing an extra trillion dollars of borrowing is $17.5 billion, or around 0.13 percent of GDP.

The IMF too estimates that of the almost 39 percentage points of GDP increase in the debt ratio in 2008-15 period, about two-thirds is explained by revenue weakness due to the adverse impact of recession. Interestingly, the IMF report estimates that the fiscal stimulus contributed to only one-tenth of the increase in debt.

In the US, the contributions to the increase in debt stock due to stimulus spending dwarfs those due to other fundamental factors like health care and social security spending. As the graphic below illustrates, the ARRA related deficits and debt stock is very small compared to those brought about by Bush era tax cuts and other aforementioned structural problems.

See also this post which puts the current stimulus spending in historical perspective.

In fact, lessons from a very recent precedent makes a strong case for continuing the expansionary policies. The Japanese government indulged in massive fiscal pump-priming throughout much of the nineties in response to the recession brought about by the property market crash in the early part of the decade. However, as the debt burdens grew, much like the present situation in countries like US, the Japanese government reacted by raising interest rates in 1998 and 1999. The economy, which was showing definite signs of recovery, plunged back to recession and deflation trap and a lost-decade ensued which carried well into the last decade.

The work of economists like Adam Posen have subsequently shown that the Japanese policy makers erred by raising rates mid-way and snuffing out recovery. The long-term fiscal costs of the entire process for Japan has been much larger than could have been the case without the mid-term contraction. The Americans and others could face much the same outcome if they exit prematurely from expansionary policies. See also Paul Krugman here highlighting the lack of any adverse inflationary impact in Japan due to its extraordinary expansion of the monetary base.

And a co-ordinated global fiscal austerity movement could be devastating for the world economy as a whole. As Krugman again points out with the case of Europe, the Mundell-Fleming model informs that "fiscal contraction in one country under floating exchange rates is in fact contractionary for the world as a whole. The reason is that fiscal contraction leads to lower interest rates, which leads to currency depreciation, which improves the trade balance of the contracting country — partly offsetting the fiscal contraction, but also imposing a contraction on the rest of the world." And now if the US too joins the fiscal contraction bandwagon, we will most certainly have global contraction all-round. Who will then act as the buyer of all these goods?

The supporters of fiscal austerity base their argument on the implicit premise that China and other emerging economies will provide the engines - either through their cheap exports (that would contribute to keeping domestic inflation in check) or by acting as robust markets for the developed economy exports (and thereby provide a boost for economic growth). However, as this and this shows, even China may not be immune to the inevitabilities of the economic growth cycle, and not be able to shoulder the burden. And even assuming that all these fears do not materialize, will China permit a large enough devaluation of the renminbi and will its consumers start loosening their purse-strings?

The parallels with Eurozone and invoking the threats of sovereign defaults there as a justification for fiscal austerity in the US may not be appropriate since the problems and prospects facing these economies are vastly different. The fundamental problem with Eurozone economies, like the PIIGS, are that in the absence of the conventional macroeconomic adjustment tools (currency devaluations, interest rate independence, stoking inflation etc), these economies are left with limited policy options to manage a reasonably painless transition to normalcy. See this, this, and this on the problems facing Euroland.

Finally, there is little evidence to show that fiscal austerity is, leave alone actually generate economic growth, even restore market confidence. Paul Krugman points to the examples of Canada and Ireland to show that it is wrong to conclude that fiscal austerity brought economic growth there. He also points to the recent example of Ireland's large fiscal austerity campaign, which does not appear to have had much real impact, as evidenced by the CDS spreads, in restoring market confidence.

In the absence of policies that boost aggregate demand and with a strong dose of fiscal austerity, the long-run fiscal and economics costs could far outstrip the short run fiscal benefits. As Krugman has said, the movement in favor "fiscal consolidation" can only be explained as a manifestation of the ideological position on fiscal discipline and a desire to be seen to be being fiscally tough.

Update 1 (20/6/2010)
Paul Krugman lists out the fiscal contraction in recent times and shows that they did not depress the economy since the "depressing effects were offset by huge moves into trade surplus and/or sharp declines in interest rates", both of which are impossible now.

Brad Delong shows how the adjustment of microeconomic imbalance is far different from that of macroeconomic imbalances.

Update 2 (21/6/2010)

Nouriel Roubini favors c-ordinated policy measures to answer to avoid a double-dip global recession - "deleveraging by households, governments, and financial institutions should be gradual—and supported by currency weakening—if we are to avoid a double-dip recession and a worsening of deflation. Countries that can still afford fiscal stimulus and need to reduce their savings and increase spending should contribute to the global current-account adjustment—through currency adjustments and expenditure increases—in order to prevent a global shortage of aggregate demand."

Paul Krugman writes, "Spend now, while the economy remains depressed; save later, once it has recovered".

See David Leonhardt on the perils of an early exit from monetary accommodation. Ben Bernanke himself is deeply aware of the huge challenge with unemployment, especially the nearly half share of those who have been unemployed for more than six months. See also this post on the consequences of the early exit in 1937, which led to the double-dip.

Update 3 (23/6/2010)

The new British coalition government unveiled the most severe package of spending cuts and tax increases since the early days of Margaret Thatcher’s era and the steepest fiscal spending reductions since the 1930s. They include average budget reductions of 25 percent for almost all government departments over the next five years, and will make Britain a leader among European countries, including Ireland, Greece and Spain, competing to show they can slash spending and appease investors worried about surging $1.4 trillion national debt.

It would cut the annual government deficit by nearly $180 billion over the next five years, shrinking Britain’s public sector and instituting tough reductions in public housing benefits, disability allowances and other previously sacrosanct aspects of the country’s $285 billion welfare budget. Also announced was a two-year wage freeze for all but the lowest paid among Britain’s six million public servants and a three-year freeze on benefits paid to parents for rearing children, in addition to new medical screening for people claiming disability benefits, part of a bid to cut $16 billion from the annual welfare budget.

A raft of tax increases were also announced - an increase next year to 20 percent from 17.5 percent in the value-added tax on most goods and services, and an increase in the capital gains tax, to a new high of 28 percent. At the same time, changes in income tax will remove nearly 900,000 of Britain’s poorest people from the income tax system altogether, and corporate taxes will also be reduced over a five-year period, to 24 percent from 28 percent.

Update 4 (25/6/2010)

Martin Wolf

"A reduction in the fiscal deficit must be offset by shifts in the private and foreign balances. If fiscal contraction is to be expansionary, net exports must increase and private spending must rise, or private savings [must] fall. Thus, experience of fiscal contraction is going to be very different when it occurs in a few small countries... when the financial sector is in good health... when the private sector is unindebted... when interest rates are high... when external demand is buoyant... and when real exchange rates depreciate sharply..."

Brad Delong wonders why it is so difficult to understand the merits of fiscal expansion, especially now.

Update 5 (29/6/2010)

In many ways Ireland is a classic example of the failure of the austerity medicine. Nearly two years ago, an economic collapse forced Ireland to cut public spending and raise taxes (by upto 20%), the type of austerity measures that financial markets are now pressing on most advanced industrial nations. Lacking stimulus money, the Irish economy shrank 7.1 percent last year and remains in recession, jblessness among its 4.5 million population is above 13 percent, and the ranks of the long-term unemployed — those out of work for a year or more — have more than doubled, to 5.3 percent. The budget went from surpluses in 2006 and 2007 to a staggering deficit of 14.3% of GDP last year, and continues to deteriorate and its once ultra-low debt could rise to 77 percent of GDP this year.

But the rewards to austerity remain invisible. Ireland’s risk spreads are worse than Spain’s, even though Ireland wasted no time on self-flagellation while Spain hesitated. It now pays a hefty three percentage points more than Germany on its benchmark bonds, in part because investors fear that the austerity program, by retarding growth and so far failing to reduce borrowing, will make it harder for Dublin to pay its bills rather than easier.

And all this despite Ireland being a classic case of growth by adopting neo-liberal policies. Its labor market is one of Europe’s most open and dynamic. After its last major recession in the 1980s, it lured knowledge-based multinationals like Intel and Microsoft — and now Facebook and Linked-In — with a 12.5% tax rate, giving Ireland one of the most export-dependent economies in the world, and massive investments in higher education.

Update 6 (30/6/2010)
David Leonhardt feels that relying on private sector to pull the world economy out of recession may fail. He draws attention to the thirties when between 1933 to 1937, the United States economy expanded more than 40 percent, but the recovery was still not durable enough to survive Roosevelt’s spending cuts and new Social Security tax. In 1938, the economy shrank 3.4 percent, and unemployment spiked.

Update 7 (6/10/2010)

Alberto F. Alesina and Silvia Ardagna examined the evidence on episodes of large stances in fiscal policy, both in cases of fiscal stimuli and in that of fiscal adjustments in OECD countries from 1970 to 2007, and found that

"Fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases. As for fiscal adjustments, those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions."

Robert Barro argues against fiscal expansion describing the impact as "voodoo multipliers". Paul Krugman critiques Alesina and Ardagna study. And the IMF too finds flaws in Alesina study and argues that fiscal austerity during a crisis will only exacerbate the crisis. See a summary here.

Tuesday, June 15, 2010

Data representation as a nudge

In line with the "nudge" thesis, I am a strong believer in the use of innovative data representation techniques as decision support tools for officials at various levels. Apart from their functional utility (for example, a 'GIS map' gives the impersonal numbers a more easily identifiable geographic identity, and a 'heat map' is much more effective in illustrating the intensity of the activity being studied), they also have a pronounced cognitive impact on its audience.

The newest version of such maps comes in the form of this superb representation of various types of crimes in San Francisco in 2009 as laid out on the city map.

The height of the peaks in the graphic is a measure of the intensity of the particular type of crime in that area. This most easily identifiable and ready-to-use data representation can help channelize focus (especially in those at the cutting-edge level) on activities that can prevent these crimes. Imagine the cognitive impact of similar data representation that highlights the tenth class performance or learning outcomes in their respective areas among school supervisors. Statistics combined with maps is a very powerful nudge!

World oil consumption

The latest figures from BP's annual Statistical Review of World Energy show that world oil consumption fell by 1.2 mbpd in 2009 to 84.77 mbpd and production dropped by 2 mbpd, both declines being the largest since 1982. India's consumption was 3/.183 mbpd, China's 8.625, and US 18.686 mbpd.

Sunday, June 13, 2010

Where did the "welfare dividend" go?

The Times of India reports that the NREGS program in Andhra Pradesh appears to have an unintended side-effect - "a record rise in the consumption of Indian Made Foreign Liquor (IMFL) among poor rural families, all thanks to the unprecedented sums of money that the scheme placed in their hands". This is borne out by record increases in liquor sales and illegal liquor outlets in the rural areas of the state in the past two years and the recent windfall returns from auctions of licenses to run liquor shops.

Over the past few years, the Government of Andhra Pradesh have introduced a series of welfare measures to benefit those below the poverty line (BPL). They include NREGS wage employment (Rs 135 per day), farm loan waiver, rice for Rs 2/kg, essential commodities at very cheap prices, free tertiary health care for all BPL families, scholarships for students from economically weaker sections, housing for all, free electricity for farmers and so on. They have been in addition to a virtual ban on raising water, sewerage and electricity tariffs and property taxes.

The net result of all this has been an increase in the disposable income available with these households, the "welfare dividend". This increase in disposable income has come from two sources - money saved from traditional expenditures on food, education, health care, and housing (due to the new schemes); and the fall in the relative prices (relative to the incomes, which have been rising) of civic services like water, electricity, and municipal taxes. This is in addition to the regular increases in income that comes with time. Where did all these savings go?

Econ 101 would have it that this additional income gets added to the pool of disposable income and becomes available for consumption expenditure (or for savings). The graphic below models the responsiveness of the consumption expenditures to increases in the supply of welfare goods/services

Let I1 be the indifference curve between two sets of goods - welfare goods and consumption goods. Thanks to increased incomes and income effect due to expanded set of welfare services/goods, the indifference curve shifts outwards to I2. Since welfare goods are inferior goods (whose consumption comes down as income rises), its uptake falls marginally (the income elasticity of uptake of welfare goods is small, since people retain many of the benefits despite increases in income) from Q(w1) to Q(w2). And consumption goods being normal good, their intake increases from Q(c1) to Q(c2), buoyed by the amounts saved from having to now spend less on those goods and services covered under the various welfare programs of the government.

The moot point is where did the "welfare dividend" go? Did it get spent on temptation goods like liquor or in capital investments and savings? The findings would make for a fascinating study and have important implications for public policy.

Update 1 (18/6/2010)
See Niranjan's superb op-ed that calls attention on the need for public policy to account for the behavioural decisions of individuals.

Saturday, June 12, 2010

Marginal deterrence

Freakonomics draws attention to the concept of marginal deterrence, popularized by George Stigler, wherein "you set penalties such that, even if you can’t commit the criminal from carrying out a crime, he still has incentives to shift his criminal behavior toward less socially costly crimes". It quotes from Sir Thomas Moore's classic book Utopia,

And surely there is no one who doesn’t know how absurd and even dangerous for society it is to punish theft and murder alike. If the thief realizes that theft by itself carries the same peril as murder, that thought alone will encourage him to kill the victim whom otherwise he would only have robbed. Apart from the fact that he is in no greater danger if he is caught, murder is safer, since he conceals both crimes by killing the witness. Thus while we strive to terrify thieves with extreme cruelty, we really urge them to kill the innocent.

Update 1 (14/6/2010)

Niranjan Rajadhyaksha points to another example of marginal deterrence in the case of punishments for various crimes. If rapists and murderers are punished with the death penalty, what incentive is there for the rapist to leave the victim alive? He would have a strong incentive to kill his victim so as to snuff out all evidence!

Infrastructure finance reforms in India

Despite considerable progress with reforms in the sector, infrastructure financing in India has been constrained by the limited depth and breadth of the long-term debt markets. Despite widespread recognition of the need to create large enough debt markets to help support the country's massive infrastructure investment needs, success in pushing through the desired reforms has remained elusive.

The Planning Commission had targeted an infrastructure investment estimate of %514 bn for the Eleventh Five Year Plan (2007-12), and nearly a trillion dollars for the next Plan. It is also estimated that 70% of investments will come from private companies, in stand-alone investments and through partnerships with the government. However, unlike in other countries where insurance and pension funds are key buyers of long-term infrastructure bonds, both are expected to contribute less than 7% to the total infrastructure investment for the current Plan period.

Experience from across the world indicates that long-term debt forms the major share of infrastructure finance. Banks and in recent years IIFCL, have been the biggest sources of domestic funds for the sector. However, the limitations of banks based financing has been exposed repeatedly, most recently with the luke-warm response to the "take-out financing" scheme announced in the 2009-10 budget. Long-term debt funds are therefore vital to ensuring that India achieves its ambitious infrastructure investment targets.

In this context, the recommendations of the Deepak Parekh Committee on India Infrastructure Debt Fund (IIDF), which submitted its report early this week, assumes significance. The central thrust of its recommendations are towards regulatory changes to permit foreign insurance and pension funds to invest in the proposed IIDF. Prevailing restrictions on capital inflows through external commercial borrowings (ECB) restricts the inflow of foreign debt. Apart from recommending a relaxation of this restriction (if need be by creating a special window for inflow of foreign debt with tenor of more than 10 years), the report also suggests that investment in IIDF should not form part of existing limit prescribed by SEBI for FII investment in corporate bonds.

It proposed that the IIDF be set up and managed as a trust, with an intial corpus of Rs 50000 Cr, approved and regulated by SEBI under the modified venture fund guidelines, and managing debt with tenor of more than 10 years. The report suggests that the debt fund should be set up by one or more sponsors - the major existing infrastructure financiers or investment banks or multilateral lending agencies (to increase the attractiveness for foreign investors) - who will have to invest atleast 10% of the total investment in the form of subordinated debt, and act as the General Partners (GP). It also recommended that the country's foreign exchange reserves may be used to source up to $ 2 billion for the Fund.

The report also recommends that the Fund refinance up to 85% of the outstanding debt from senior lenders, thereby enabling the project companies to substitute debt with long term bonds at comparatively lower interest rates. It is hoped that this restructuring of project debt will release a large volume of present lending capacity of the commercial banks, thus enabling them to lend more to new projects.

The recommendations are in line with similar practices for financing infrastructure assets across the world. The US recently set up three institutions - National Infrastructure Bank (NIB), a National Infrastructure Development Corporation (NIDC) and a subsidiary National Infrastructure Investment Corporation (NIIC) - to raise money, mainly from the market as long-term debt, through sovereign guarantee, and then fund public and private investments in infrastructure. The logic being that government sponsored entities are better positioned to raise capital in larger amounts and at lower cost than the private sector.

In the US, most of the federal government’s programs for surface transportation are financed through the Highway Trust Fund, about 90% of whose revenues come from two taxes on motor fuels.