Tuesday, May 31, 2011

The derivatives contract in slum housing!

Slumania is a squatter slum in the Urbania Municipality of Corruptionland. It houses nearly 500 families in 3 acres of government land. Like other such slums, it has all the features of un-planned growth - small and irregular lanes, no side drains and sewerage network, leaking water lines, unhygienic surroundings etc. The election promise of Aya Ram, the local MLA, was to get a multi-storied housing colony sanctioned with roads, water and sewerage lines.

Finally, thanks to the his efforts, as part of the National Urban Development Mission (NUDM), the Government have sanctioned multi-storied (G+3) housing units with all infrastructure facilities. The Urban Community Development wing of Urbania Municipality does the Socio-Economic Survey (SES) to document the list of beneficiaries. Possession Certificates (PCs) of all beneficiaries are prepared and kept ready for distribution.

Simultaneously, Aya Ram's cronies swing into action. They demand that Rs 10000 be paid by each household to ensure registration. This is despite their name already having been cleared in the SES conducted by the Municipal authorities. Now, Rs 10,000 is not a small amount for the beneficiaries. Most of them already face an uphill struggle to pay the Rs 10000-20000 beneficiary contribution required to get the house sanctioned. Despite this, they immediately pay Aya Ram's extortionary tribute.

Why do people pay the premium despite their name finding place in the SES list and the assurance of a formal government mandate, the PC? This requires an examination of the post-sanction risks faced by the PC holder. After the sanction, the processes of tender finalization and completion of work, would take atleast 12-18 months. Even the process of physical allotment has numerous uncertainties associated. This is a long enough window for several risks to surface - the local muscleman may arm-twist the beneficiary off his PC, Aya Ram's cronies may collude with officials to issue duplicate certificates on the same house (thereby robbing the beneficiary off his allotted house), and so on. So here is the economic rationale behind the exorbitant premium,

1. The premium is a hedge against these risks. It is the cost of buying protection against these uncertainties. The contract is a form of derivative - beneficiary being the protection buyer, Aya Ram the protection seller, and protection against dispossession is the risk being purchased! The payment made to Aya Ram's cronies is proportional to the perceived risks to obtaining final possession of the house. In many respects, it is the simplest of insurance contracts.

2. The willingness of the beneficiaries to pay an exorbitant premium, despite possessing a government issued and legally valid certificate (the PC), is a reflection of the credibility deficit of government contracts. In other words, the premium is a measure of the cost of the contract (even government ones) enforcement in such environments. Higher the premiums, greater the institutional credibility deficit or weaker the contract enforcement conditions.

Sunday, May 29, 2011

Taming the traffic snarl

Here is my op-ed in Mint today which argues that effective traffic management requires going beyond conventional solutions like road widenings and fly-overs and "requires demand-side measures that encourages public transport usage, discourages private vehicles, and enables human beings to make rational decisions about their travel plans and road usage". The material data used in the article are available here.

The challenge of traffic management

One of the biggest concerns with traffic management in urban centers is the explosive growth in vehicle population, far outpacing the growth in road network expansion.

The standard bureaucratic solution to addressing this challenge is to widen roads and build fly-overs. This is understandable, since it is the easiest solution to implement and generates immediate benefits, atleast for some time. In fact, it is even necessary, since it is important to realize the fullest available carriageway. However, on a longer-term perspective, such measures are only kicking the can down the road.

As has been the experience from across the world and in our own cities, any road expansion triggers off the cliched Parkinson's law. Supply creates its own demand. More carriageway immediately attracts more vehicles.

Any sustainable solution to traffic management requires demand-side measures that encourages public transport usage, discourages private vehicles, and enables human beings to make rational decisions about their travel plans and road usage. An appropriate mixture of these interventions can improve traffic management.

The first requires massive investments in public transit systems and their careful integration with all other modes of transport, public and private. It is as much an exercise in urban planning as transport management. In this context, it is also important to bear in mind that, as experience from across the world shows, such investments have to be heavily subsidized. Most importantly, a good public transit system is a pre-requisite for the success of all other demand side interventions.

Across the world, a large number of countries have experimented with a slew of initiatives to discourage the usage of private vehicles. They have included measures to both make vehicle ownership and usage expensive. For more than two decades, Singapore has a policy that mandates that all vehicle owners have a Certificate of Entitlement (COE). As part of this policy, quotas restrict the number of new cars (to maintain only a certain level of vehicle growth) and vehicle owners have to buy COE permits in auctions. The high COE permit auction rates act as a prohibitive tax on vehicle ownership.

Similarly, in China, faced with exploding vehicle population, Shanghai has for several years now been conducting monthly "license plate auctions". In a reflection of the growing demand for vehicles, bid rates have averaged a record 46,000 yuan ($6,900) in recent times.

Buoyed by Shanghai's success, Beijing recently adopted a lottery system to issue car license plates. It even goes beyond Shanghai and mandates that new registrations are only being given to only those who have paid tax and social insurance in the city for more than five years. Further, cars licensed in other parts of China are now forbidden from driving during peak hours in the capital’s main urban area. All this will restrict registrations to just 240,000 additional vehicles in 2011, a third of the current annual level, and is estimated to take 10 m potential buyers out of the market.

Singapore, London, and a few other European cities have sought to levy congestion charges in certain high traffic density areas to dis-incentivize vehicle usage there at certain times. Many Chinese cities like Guangzhou, Shenzhen and Hangzhou are now toying with congestion charges. Policies that seek to internalize the parking charges are another approach to limit vehicle usage, atleast in certain areas and certain times. Cities like London, Hong Kong, and New York, with their heavy parking fees, impose a huge premium on private vehicle usage. Some Chinese cities like Ningbo are even considering forcing citizens to own a parking space before they can buy a car.

Some of the Latin American cities have experimented with barring odd and even-numbered vehicles on designated week-days. Car-pooling has for long been a favorite in many parts of the US (though it is now going out of favor in many areas).

Finally, it is important to provide people with information about traffic conditions in the most readily usable manner. This will help them make rational decisions on effective road utilization. In many respects, road traffic has striking similarities with a free market. Consumers base their decisions to purchase goods and services based on price, quality, and some other parameters. Similarly, people make their travel plan, route and vehicle usage choices, subject to certain constraints - parking charges, vehicle usage costs, traffic intensity at the time etc.

Like in the free-market, it is possible to generate more efficient traffic outcomes, if people are provided with traffic-related information in the most appropriate manner. This does not mean flooding people with all available information, but channeling it in a cognitively salient and easy-to-use manner. This makes easy for people to make choices that can optimize on their travel times and therefore improve traffic management.

Intelligent traffic management systems, that use technology-intensive devices, which are integrated to each other, can be very effective in effective rendering such information.

Government spending Vs public debt

Conventional wisdom attributes the massive public debts that many developed countries face today to a legacy of large government spending. In this context, Lane Kenworthy points to an insightful graphic that matches net government debt in 2010 to government expenditures (as a % of GDP) over the 1990-2010 period, and finds no co-relation whatsoever.



His conclusion is spot on,

"A high level of government spending doesn’t necessarily produce heavy government debt. Nor does low spending guarantee low debt. Debt levels are a function of government expenditures and revenues and economic growth."


As Mark Thoma has written, the conservatives have tried to sell their "shrink the government" agenda by arguing that expenditure cuts are the only way out of the huge public debt. Raising taxes, the other side of the fiscal balance equation, is opposed on ideologically spurious supply-side (being on the other-side of the Laffer curve) arguments.

This conservative ideology has exercised a firm grip on politics in even many developing economies. The high rates of economic growth have been responsible for keeping the fiscal status of these governments on the balance.

Friday, May 27, 2011

The global food loss and wastage problem

This story provided lighthearted amusement for some time recently, though its underlying message did not generate much debate. However, there are some interesting findings from a study released by the Food and Agriculture Organisation (FAO) on trends in food loss and wastage across the world,

"Roughly one-third of food produced for human consumption is lost or wasted globally, which amounts to about 1.3 billion tons per year... Food wasted by consumers in rich countries (222m tonnes) is roughly equal to the entire food production of sub-Saharan Africa (230m tonnes)."


The report makes the distinction between food loss - occurring at the production, harvest, post-harvest and processing phases - and wastage - retailers and consumers throwing perfectly edible foodstuffs into the trash. The study finds that though industrialised and developing countries waste or lose roughly the same amount of food each year – 670 m and 630 m tonnes respectively - there are important differences.

Rich countries waste food primarily at the level of the consumer and at the retailer level, especially for fruits and vegetables, by often unreasonable quality standards that over-emphasize appearance instead of safety and taste. For developing countries, the major concern is food loss due to weak infrastructure – including poor storage, processing and packaging facilities that lack the capacity to keep produce fresh. Further, on a per-capita basis, the per capita food waste by consumers in Europe and North-America is 95-115 kg/year, while this figure in Sub-Saharan Africa and South/Southeast Asia is only 6-11 kg/year.



Apart from strengthening food supply chains (by investing in storage, processing, packaging, and transportation), the report also advocates reducing reliance on retailers like big supermarkets, promotion of direct sales of farm produce to consumers, encourages retailers and charities to work together to distribute unsold but perfectly edible food that would otherwise go to waste.

These findings come at a time when the food prices have been soaring (overall cost of food in April was 36% higher than in 2010). Last month, the World Bank said that rising food prices had pushed 44 million more people into extreme poverty, and an additional 10 million people live at the margins of falling into poverty. There are two observations in this context,

1. It is ironical that while public policy explicitly tries to lower electricity transmission and distribution losses, we are, at best, ambivalent about reducing food wastage. This is despite, food wastage being a much bigger problem than the former. More unfortunately, this issue gets even less attention than issues like energy and water conservation.

2. There is some food for thought for behavioural economists and psychologists here. Apart from the hard policy and investment-driven (more storage facilities etc) choices required for cutting down on food loss, can we also nudge people into reducing their food wastage? Such subtle nudges could be incorporated into the processes undertaken at every level in the production-marketing-consumption chain, so as to reduce the likelihood of food being wasted.

For example, one way to nudge people into lowering food consumption wastage is to encourage the purchases of smaller packets of food materials from stores. Another option is some form of restrictions on promotional offers that encourage people to buy more food than they need. Given the amounts of food wasted in hotels, are there some nudges or strategies that could enable hotels more effectively manage their cooking demand schedules? In particular, what are the strategies that enable hotels to minimize wastage from buffet spreads?

But this nudge (or shove) may be one step too far!

Thursday, May 26, 2011

A market solution to child malnutrition problem?

Poor households in big city slums invariably live in unbelievably cramped single room accommodation, with access to limited civic amenities like water supply and sanitation. Furthermore, both parents generally have to work to earn atleast food for the family.

In the circumstances - strapped for time, space, and resources - women make do with cooking simple, but unhealthy, carbohydrate heavy meals (say, rice/roti and curry), which are filling and keeps away hunger. The women do this despite being aware of the importance of nutritious food and what constitutes such foods. The higher cost of nutrient-rich foods is just another reason for this, though this is debatable.

Policy makers have long debated various strategies to improve the nutrition status of atleast the children living in slums. The Anganwadi centers are among the most visible of such interventions, and have had considerable successes in some areas. However, the overall nutrition of the family remains elusive. The large numbers of small eateries - women squatting on street margins, push carts, road encroachment stalls etc - in slums too provide much the same carbohydrate and fat heavy foods.

Faced with similar circumstances in the over-crowded slums of Jakarta, an NGO Mercy Corps started a healthy street food business for children called Kedai Balitaku, or My Child’s Café in April 2009. It started with a $120,000 donation, has since spun off into a for-profit company. The idea was that once people have access to healthy foods at very cheap prices (same as those of the unhealthy foods available elsewhere), they will prefer such foods over their traditional ones, atleast once a day. Creating a buzz around such foods, by careful marketing helps. An article by Tina Rosenberg in the Times describes KeBal,

"KeBal sells niche street food. Its clientele is children — and it focuses on those 5 years old and younger. The most popular meal is a chicken, rice and vegetable porridge, which costs the going rate of 20 cents. The leading snack is a 10 cent gelatin pop. Such pops are a common snack but they are almost always made with artificial fruit flavors; KeBal’s are made with real mango, strawberry, melon or other fruits. The menu also includes meatballs, macaroni and cheese and shu mai dumplings. The carts use food-grade materials and vendors get regular health inspections from KeBal’s management.

Nutritionists designed the menu, but just as important as what went into the food was convincing mothers to buy it and children to eat it. The advertising firm Saatchi & Saatchi donated the design of the visual brand and a marketing strategy aimed at children. The carts have bright colors and play music. Four dolls on the cart represent different food groups and are named for benefits of good nutrition — Strong, Smart, Lively and Taller. The cart also has built-in toys teaching shapes or colors that kids can play with while they wait. They display hand-washing messages and have jugs of water with soap so vendors can wash dishes and children can wash before they eat. The food is displayed at a child’s eye level. The Times column writes,

The food is prepared by KeBal employees in a cooking center, which starts work just after midnight to make food to sell to eight vendors, who begin their routes around 5 AM. The vendors take the risks and keep all the profit on the food they sell. KeBal is about to open a second cooking center, and is planning to have six by the end of the year, each providing food to at least eight vendors. Next year, as soon as Indonesian franchise law allows, KeBal will also start selling cooking center franchises. By 2013, the company hopes to own 21 cooking centers and have 10 more owned by franchisees. That will allow it to feed 6,000 children daily and take in projected revenue of at least $2 million a year."


An approach that mirrors KeBal, catalyzed with initial government or some non-government foundation support, and initiated in different cities across the country, has the potential to be a major intervention to improve nutrition levels in countries like India. The menus will have to be customized to meet local food requirements and locally available healthy foodstuffs.

China graph of the day

The spectacular growth of electricity consumption across China over the past-decade and half.



(Click to enlarge)

(HT: NYT)

Wednesday, May 25, 2011

Poverty and vulnerability in India

One of the most interesting graphics in the recently released World Bank report on poverty in India is one that highlights how much vulnerable are a large proportion of the non-poor to aflling into poverty. Vulnerability is defined in terms of the threat of the family falling into poverty in future. It is a measure of the volatility of household incomes and exposure to various external risks.

The graphic below captures the clustering of rural, urban, and mega-urban populations around the poverty line. The intensity of clustering has hardly changed over the decade.



I can think of four implications for poverty eradication and development policy-making from this finding

1. It is as much important to monitor and support those who have moved into poverty (from being non-poor) as it is to assist those who are below the poverty line. In other words, the poor are a dynamic population, more so in rural India. People continuously move in and out of poverty, possibly with seasonal periodicity. Given the close clustering of people around the poverty line, especially in rural areas, large numbers of people are likely to fall into poverty in times of economic uncertainty (in rural areas mainly, weather related shocks, say, a poor monsoon).

2. Targeting those below the poverty line becomes a near impossible task given this close clustering, especially in rural areas. Even if we are able to narrowly and quantitatively measure those below and above the poverty lines, it is impossible to qualitatively assess, with any reasonable degree of satisfaction, whether their lives correspond to those of the poor or non-poor.

In other words, accuracy in targeting, even with technologies like bio-metric identification, will come up against the difficulty of cracking the eligibility criterion. The fact is that, atleast in rural areas, most people are either poor or run the risk of falling into poverty. This also means that strategies that seek to leverage self-selection (the non-poor will naturally de-select themselves from accessing the benefits, and therefore enable more effective targeting) becomes relatively ineffectual.

3. In view of the tight clustering of the overwhelming share of the population around the poverty line, is there a case for universal subsidy transfers, especially in rural areas? Why not subject the same flawed below poverty line (BPL) figures in various states to more rigorous analytics to identify the degree of clustering, and decide on making subsidy universal if the numbers of poor exceed an agreed cut-off parameter? The transaction costs and inefficiency distortions associated with targeting (and a dual-price regime) would far outweigh the additional expenditure required for the expansion.

4. Addressing this type of pervasive poverty may require going beyond the prevailing development paradigm in India that seeks to overcome poverty through wealth re-distribution (welfare programs, self-employment and livelihood programs, etc) instead of wealth creation (rapid and equitable economic growth, and massive job creation).

Welfare enhancing policies cannot address the issue of development when poverty is so widely pervasive. It works best when poverty exists at the margins, and that too only to the extent of providing welfare support. It is growth promoting policies that are required to pull an entire population out of poverty, as is the case with the widespread poverty in India.

This is not a call to junk all welfare programs, but only a reminder that welfare policies cannot achieve the objective of poverty eradication. That requires policies that promote growth and create jobs. Welfare policies can at best provide the cushion or platform on which wealth creation policies can be sustained (or its risks mitigated).

Tuesday, May 24, 2011

More on macroeconomic policy arguments during the Great Recession

The Great Recession has become a fertile ground for considerable analysis of the prevailing conventional wisdom macroeconomic policies. The relative merits of contractionary and expansionary monetary and fiscal policies are at the heart of all ideological battles.

Conservatives fret at the inflationary effects of expansionary conventional (zero-bound interest rates) and unconventional (quantitative easing) monetary policies and call for tightening monetary policy or atleast oppose any further monetary expansion. They also point to the unsustainable public debt and fiscal deficit and argue any fiscal expansion. Some even argue that all this is crowding out private spending, despite the overwhelming evidence of massive idling resources and capacity in the US economy. Their general belief is that hard money and sound government finances are necessary for a robust recovery to take hold.

Paul Krugman has been the strongest proponent of the view that when faced with a liquidity trap, increases in the monetary base (which includes bank reserves as well as currency) doesn’t cause inflation, or even a rise in broader definitions of the money supply. Faced with a recession and the zero-bound, businesses postpone investments and consumers their spending, thereby forcing banks to hold on to their reserves. This propensity to hold on to reserves is amplified by the fact that under such conditions, cash and T-Bills become near perfect substitutes, and the Fed cannot therefore expand M2.

Krugman points to the evidence from old and recent history to highlight this. At the onset of the Great Depression, though the Fed expanded the monetary base considerably (admittedly this may have been smaller than was required), it did not result in the expected increase in money supply and inflation remained muted.



Much the same happened in Japan. Despite a dramatic expansion in the monetary base by the Bank of Japan, prices kept falling.



Since the beginning of the Great Recession, the US Federal Reserve has been quick in dramatically expanding its balance sheet and increasing the monetary base. The result - M2 money supply and consumer prices have hardly budged.



However, even among those who favor monetary expansion, there is one group who argue that the Federal Reserve could have done more to avert a deep recession in 2008 and 2009 if it had indulged in much more aggressive monetary expansion. Scott Sumner, David Beckworth and others argue that the central bank using monetary policy tools can do more, even when faced with a zero-bound in interest rates, to stimulate aggregate demand and expand the economy.

They advocate setting an explicit nominal GDP target (or nominal GDP growth path) to shape future market expectations about current and future nominal spending and thereby boost economic growth or prevent aggregate demand crashes. This, they argue, can be done by purchasing assets other than Treasury Bills, like longer-term securities, to lower long-term rates and thereby incentivize investment and consumption spending so as to reach the nominal GDP target. David Beckworth writes,

"Set an explicit nominal GDP level target so that expectations are appropriately shaped. If such a rule were adopted expectations of current and future nominal spending would be anchored around the level target... Even if a spending crash did occur the catch-up growth needed to return nominal spending to its level target would most likely imply an expected path of short-term real interest rates consistent with restoring full employment...

if the monetary base and t-bills became perfect substitutes because the 0% bound is reached the Fed should buy longer-term treasuries or foreign exchange... The 0% bond for us really is not a big deal, but simply an artifact of monetary policy using a short-term interest rate as the targeted instrument."


As David Beckworth acknowledges, this understanding is not that different operationally than a New Keynesian invoking a higher inflation target to lower the expected path of real interest rates or the portfolio channel to drive down the term premium on long-term bonds.

Paul Krugman points to evidence from Japan to question the quasi monetarist position on the utility of monetary policy during such liquidity trap crises. In this context, he also draws attention to the views of the late Milton Friedman who had advocated that the central banks push more reserves into the banking system through monetary expansion. In fact, Friedman had famously blamed the Fed's unwillingness to indulge in sufficient monetary expansion as the major contributor towards the Great Depression.

However, unlike the Fed in the 1930s, the Bank of Japan indluged in massive monetary expansion. However, this did not result in the expected rapid growth in the money supply or monetary base.



Paul Krugman concludes that "in the face of a really big shock, which pushes the economy into a liquidity trap, the central bank can’t prevent a depression". In the circumstances, the only option left is fiscal policy. Here Krugman points to the critical role that the government borrowing and spending played in making up for the steep decline in private consumption.



Update 1 (28/10/2011)

FT Aplhaville points to a Goldman report which advocates nominal GDP targeting for the US.

"For the US, we advocated a shift to nominal GDP targeting, backed up with asset purchases, as the best of these options if further easing is needed. We think nominal GDP targeting probably provides the best way of communicating a credible intention to deliver a more aggressive easing without taking risks on long-term inflation. First, the framework is simple and transparent and avoids the complications of choosing a particular price index. Second, it deals directly with the problem of large excess capacity in the economy and focuses on a variable that is more directly linked to the ability to cope with debt contracts that were mostly made on the assumption that nominal income would be much higher than it currently is. Extending the price level trend for the US or UK would not deliver as strong a case for easing (and in the UK may argue for tighter policy). Third, it does not focus directly on generating inflation, which may make it more palatable to the public, or on the exchange rate, which could raise international tension. Fourth, it defines a clear exit strategy for policy and so minimises the risk of runaway inflation. Other policy options meet some of these criteria, but we think overall score less well."

Monday, May 23, 2011

The LinkedIn IPO scam?

Was thinking of writing on this a few days earlier. The spectacular doubling of the share price of LinkedIn from its IPO offer prices as it debuted on public trading at the NYSE has had investors and financial media gushing about a possible new wave of IPOs by social media start-ups. However, there has been little discussion about how the investment banks that managed this IPO shafted and scammed LinkedIn.

For the record, LinkedIn's IPO managers, Morgan Stanely and Bank of America (Merrill Lynch division), fixed its offer price at $45 per share to sell 7.84 million shares, raising $352.8 m for LinkedIn, and valuing the firm at $4.3 bn. The share debuted on NYSE at $83, or 84% higher, touched $120, before closing at $94.25 on the opening day, a gain of almost 110%.

In simple terms, the LinkedIn offer price was hugely under-valued. At the advice of its IPO underwriters, LinkedIn sold itself too cheap. Its investors gains were LinkedIn's loss. And for this rip-off, it paid its IPO managers a cool 7% of the deal as their fee! Furthermore, the IPO gave its managers the perfect opportunity to gift their preferred institutional and other high-value investor clients some easy money (and more business from them in the future). And all this at LinkedIn's expense!

This illustrates the deep malaise with Wall Street and financial markets across the world - limited or no accountability and badly mis-aligned incentives. Where else can you get away with a cool $28 m and assured future business deals, for basically short-changing your employer? Where else are the remuneration structure so completely de-linked from the outcome of the activity? If your remuneration is fixed (at 7% here), irrespective of what happens to the IPO, where is the accountability?

Henry Blodget, who knows as much about these things as anyone around, estimates that the fair offer price should have been $60 per share and therefore LinkedIn lost around $175 m. See also this excellent op-ed by Joe Nocera. See also this Blodget article on how ZipCar's IPO underwriter's Glodman Sachs and JP Morgan screwed the company off $50 m.

Sunday, May 22, 2011

The crowds are not always wise!

James Surowiecki's best selling book, The Wisdom of Crowds, popularized the belief that the collective wisdom of a group of people was superior to the individual wisdom of even experts. It has generated considerable interest in the design of systems that seek to channelize the knowledge of large groups of people to say, predict events and prices. See Justin Wolfers' paper on prediction markets here.

It is based on the statistical phenomenon by which individual biases cancel each other out, distilling hundreds or thousands of individual guesses into uncannily accurate average answers. However, it assumes that the members of the crowd have a variety of opinions, and arrive at those opinions independently.

A new study of this phenomenon by Jan Lorenz and Heiko Rahut finds that contrary to conventional wisdom, groups insights could go awry if participants were influenced by the guesses of their peer group. They found that though groups are initially wise, "knowledge about estimates of others narrows the diversity of opinions to such an extent that it undermines” collective wisdom". Moreover, they found that "even mild social influence can undermine the wisdom of crowd effect". In this context, as the Wired article points out, computer modeling of crowd behavior also hints at dynamics underlying crowd breakdowns, with the balance between information flow and diverse opinions becoming skewed.

The authors recruited 144 students from ETH Zurich, made them sit in isolated cubicles and asked them to guess various indicators like Switzerland’s population density, the length of its border with Italy, the number of new immigrants to Zurich and how many crimes were committed in 2006.

At the end of each round of questioning, they were given small payments for coming close to the actual answer (signified by the gray bar). At left is the range of responses among participants who received no information about others. The findings of the study participants who were asked how many murders occurred in Switzerland in 2006 is shown in the graphic below.



The Wired article concludes,

"As testing progressed, the average answers of independent test subjects became more accurate, in keeping with the wisdom-of-crowds phenomenon. Socially influenced test subjects, however, actually became less accurate. The researchers attributed this to three effects. The first they called "social influence": Opinions became less diverse. The second effect was "range reduction": In mathematical terms, correct answers became clustered at the group’s edges. Exacerbating it all was the "confidence effect", in which students became more certain about their guesses."


As the authors claim, such false beliefs are commonplace in society, politics and markets. The herd behaviour of investors in financial markets is driven by excessive confidence generated by social influences. Opinion polls and the mass media largely promote information feedback and therefore trigger convergence of how we judge the facts and potentially create overconfidence in possibly false beliefs. Social fads and beliefs, some of which are of questionable value, become popular for no apparent reason.

In all these areas - markets, society, and politics - there are people and groups with an interest in influencing the beliefs of participants. They are vulnerable to being manipulated to suit the requirements of these vested interests. Such dissonances constitute failures in markets, politics and society.

Europe and China - trade deficits widen

One of the most contentious issue in international trade is the unabated growth in trade imbalances between China and its trading partners. Most major economies, except, a handful like Germany, have large and growing trade deficits with China. The graphic below shows that exports from most European countries to China are rising faster than imports from China.



If this trend continues, protectionism is not far behind. The US has repeatedly accused China of unfair trade practices, artificial currency manipulation being the most oft-repeated.

Last week, the European Commission imposed its first ever antisubsidy tariffs against imports from China accusing China of unfair trade practices. It accused the country of "significantly subsidizing its coated fine-paper industry by giving cheap loans, allocating land below market value and granting various tax incentives", and imposed duties of up to 12 percent on imports of high-quality paper used for magazines and brochures.

Friday, May 20, 2011

End of fertilizer price decontrol?

It was with great fanfare that the Government of India launched the Nutrient Based Subsidy (NBS) regime for fertilizers in April 1, 2010. It effectively dismantled the administrative control over fertilizer prices. The subsidy was to be fixed, based on the nutrient content of each fertilizer, and then transferred as a back-end subsidy to the manufacturing companies. It gave companies full freedom to fix Maximum Retail Prices (MRPs), though there was an informal understanding to keep price hikes within 'acceptable' limits.

It went off relatively well in its first year, raising hopes of further reforms in the subsidy regime. However, following the steep increases in global petroleum prices in recent months, the wheels seem to be coming off the NBS regime. The manufacturers have been left with no option but to increase the MRP to cover for the increased import prices. As I have blogged earlier, in response the government has been forced into revising the subsidy for 2011-12 three times already.

Faced with continuing rise in fuel prices, the Government has issued directions to the fertilizer companies to restrict the MRP increases to a band. The Businessline points to a recent circular issued by the Department of Fertilisers asking firms to limit the increase in the MRP of di-ammonium phosphate (DAP) to Rs 600 a tonne for the kharif season ahead. It writes,

"Since the MRP, prior to April 1, averaged Rs 10,750 a tonne, a Rs 600 rise works out to Rs 11,350 a tonne. To this, if the 1.03 per cent excise-cum-education cess imposed in the 2011-12 Union Budget is added — this is recoverable from farmers — the new admissible MRP would be roughly Rs 11,470. Against this, companies like Coromandel International, Indian Farmers Fertiliser Cooperative and Zuari Industries have already declared MRPs of Rs 11,700 to Rs 12,000 a tonne, exclusive of State-level and local levies. It remains to be seen if they will now have to roll back their MRPs to the May 5 circular-prescribed levels."


The NBS regime for fertilizers is a test case for cash transfers with PDS. It highlights the challenges in subsidy administration posed by price volatility. However, unlike the fragmented food grains markets, fertilizer market is more integrated. Therefore it is possible to develop an index, also linked to global crude prices, that is a reasonable reflection of fertilizer prices. The subsidy payable to manufacturers or distributors could be calibrated with respect to this index, so as to avoid the repeated ad-hoc revisions. This does create a slight fiscal uncertainty, though the variation is not likely to be so much as to imbalance government finances.

Thursday, May 19, 2011

More highways and flyovers do not solve traffic problems

The commonest solution to addressing urban transport problems is to expand the road space - either build new roads or widen them or construct fly-overs and elevated express-ways. Planners project it as neat and logical, politicians see it as populist, consultants and contractors view them as cash-cows and people find it sexy. Everyone loves it, atleast in its immediate aftermath.

However, as this post points out, there are serious limitations to this approach. Matthew Philips writes,

"Studies over the last decade (like this one, this one, and this one; plus the book Suburban Nation) have pretty much dismantled the theory that more roads equal less traffic congestion. It turns out that the opposite is often true: building more and wider highways can increase traffic congestion."


Consider the evidence from the US. A 1998 Surface Transportation Policy Project titled "If you Built it, They Will Come: Why We Can’t Build Ourselves Out of Congestion" found that 90 percent of new urban roadways in America are overwhelmed within five years. Another study of 70 urban areas across 15 years concluded,

"Metro areas that invested heavily in road capacity expansion fared no better in easing congestion than metro areas that did not. Trends in congestion show that areas that exhibited greater growth in lane capacity spent roughly $22 billion more on road construction than those that didn’t, yet ended up with slightly higher congestion costs per person, wasted fuel, and travel delay... On average the cost to relieve the congestion reported by TTI [Texas Transportation Institute] just by building roads could be thousands of dollars per family per year."


Another study on the possible impact of the expansion of Washington's highway network finds it unlikely to result in a significant reduction in congestion on the state's roads.


"Academic research and practical experience have demonstrated that increases in highway capacity lead to increases in vehicle travel-reducing, or in some cases negating, the congestion-fighting benefits of the projects."


It suggests increasing investment in transit services and other transportation alternatives, improving the efficiency of existing highways and removing bottlenecks, and ultimately reducing the growth in vehicle-miles traveled (VMT) on the highways. A study by the Texas Transportation Institute finds,

"The effect of lane mile additions on VMT growth is forecast and found to account for about 15% of annual VMT growth with substantial variation between metropolitan areas. This effect appears to be closely correlated with percent growth in lane miles, suggesting that rapidly growing areas can attribute a greater share of their VMT growth to growth in lane miles."


See more evidence from the US on the futility of building (by roads) your way out of congestion in this exhaustive op-ed. This video is an excellent summary of the impact of fly-over demolitions on traffic

Moving Beyond the Automobile: Highway Removal from Streetfilms on Vimeo.



None of this is to argue against road widenings and fly-overs. Given the population sizes involved, municipal governments will be forced to maximize on road carriage-way through widenings and fly-overs. However, as these examples show, we have to be wary of seeing them as part of long-term urban transport problems. A fresh supply of road carriage-way, it appears, creates its own demand!

Wednesday, May 18, 2011

India's trade liberalization story in a graph

This graph (via this Vox post) captures the decline in average tariffs in the major US export markets. As can be seen, India's unilateral reduction of its applied tariff average from 40% in 1995 to about 10% today, is the most aggressive trade liberalization by any country, even discounting for the fact that it had the highest tariffs to start with.



Note the significant progress in the initial years of the Doha Round and the relative stalemate in recent years.

Inequality and public debt in the US

Arguably two of the biggest challenges facing the US economy are widening inequality and unsustainable deficits and debts. The CBPP has some excellent graphics on both problems.

First, the graphic below highlights the explosive growth in after-tax incomes at the very top of the income ladder since the eighties. Among the OECD countries US has the highest income inequality after taxes and transfers. Its taxation and transfers system does very little to lower income inequality, with its social security benefits being among the least effective.



The gap between the top 1 percent and the poorest fifth of Americans widened sharply - more than tripling from 22.7 times to 74.6 times in the 1979-2007 period.



And one of the most important driving forces behind this widening - declining tax rates at the top, even as incomes balloon. With an average income of $270 million in 2008, the typical household in the Top 400 made 4,700 times as much as the average American filing a 1040 form. This CBPP chart shows that between 1992 and 2008, the average share of their incomes that these households paid in federal taxes dropped from 26 percent to 18 percent, while their annual incomes shot up by over 700 percent, after inflation.



It is widely believed that the fiscal stimuluses and financial bailouts are the major culprits for America's massive public debts. However, the CBPP graphic shows that they form a very minuscule share. The economic downturn (and consequent reduction in revenues), President Bush’s tax cuts and the wars in Afghanistan and Iraq explain virtually the entire deficit over the next ten years.



Update 1 (29/8/2011)

Excellent link to articles on inequality in the US here.

Monday, May 16, 2011

How the rich and poor benefit from government

I had blogged yesterday on the critical role played by governments in the effective functioning of free markets. I also pointed out that despite being more critical of governments than the poor, the rich benefit disproportionately from government and its activities.

Here is a Venn diagram that captures the relative shares of rich and poor in both private and public provisions of physical infrastructure and rule of law.



The circle (B+E+C) represents government provision of physical infrastructure and rule of law. The remaining part of the square represents private provision of infrastructure and social and private capital driven contracts.

The rich rely on the governments to provide a major share (C) of both these - physical and social/economic - infrastructure. The rely on private provisioning only where governments fail. In contrast, the poor rely mostly on private provisioning of all infrastructure (A) and have a limited uptake of public infrastructure (B). The intensity of government provisioning of both types of infrastructure is much more in cities than villages, where most of the poor live. Even in case of the urban poor, they work mostly in the un-organized sector and transact in the parallel un-regulated economy.

So, despite the very evident benefits that the rich derive from the role of governments, why are they and the middle class the most vocal critics of governments? Why do they want to down-size the very agency whose activities underpin their own success? There are obviously many reasons, ideological and non-ideological. However, I have three fundamental explanations that come to mind

1. There are a few related cognitive biases at play here. Human blindness to availability bias means that they easily recall the high-profile failures of governments (and there are no dearth of such ones) while over-looking the several government-driven provisions that are taken for granted. Their vulnerability to representativeness bias means that they over-estimate the probability of government failures instead of using a Bayesian calculation to weigh the relative successes (or benefits) and failures (or losses) of governments.

2. On a more material dimension, human beings naturally prefer to partake of benefits without having to pay for it. Public provision of physical and social-economic infrastructure is expensive and requires that people pay substantial taxes. Who likes to pay taxes? It must be one of those rare things which though everyone dislikes, is essential to maintain a functional society and economy.

3. People find government a convenient "other" that can be blamed for everything that is wrong with the economy and society. Government (by implication politicians and officials) is responsible for corruption, inefficiency, poor quality of service delivery, poverty and under-development, deficient infrastructure. Though the blame is richly deserved, it is not their exclusive preserve. It should be apportioned among the larger society itself, its populist opinion makers, our own disinclination to pay taxes, free-ride on public infrastructure, and so on.

Sunday, May 15, 2011

Why governments are important in a market economy?

Wish I had written this! Dani Rodrik has a superb explanation of the role of governments in the successful functioning of modern markets.

"Modern markets need an infrastructure of transport, logistics, and communication, much of it the result of public investments. They need systems of contract enforcement and property-rights protection. They need regulations to ensure that consumers make informed decisions, externalities are internalized, and market power is not abused. They need central banks and fiscal institutions to avert financial panics and moderate business cycles. They need social protections and safety nets to legitimize distributional outcomes.

Well-functioning markets are always embedded within broader mechanisms of collective governance. That is why the world’s wealthier economies, those with the most productive market systems, also have large public sectors."


Once we recognize this, a few things naturally follow

1. Markets require basic physical infrastructure and rule of law to be effective. Regulation is necessary to correct market failures. In other words, Governments underpin markets.

2. This, as Prof Rodrik writes, also raises the issue of who makes the rules that govern this system and then administer them. Democracy and politics inevitably follow.

3. Development of good quality infrastructure and establishment of effective administrative and governance systems do not come cheap. People need to pay taxes in return for enjoying these services. And given the low tax base, especially in countries like India, those at the top of the income ladder need to pay more.

4. Ironically, and contrary to conventional wisdom, the rich and well-off benefit disproportionately from government and its activities than the poor. They use the physical infrastructure directly and derive much greater benefits from its use than the poor. Similarly, contractual regulations and rule of law undepin much of the transactions made by the rich. In fact, in countries like India, the transactions carried out by the poor are mostly done outside the formal government institutional channels.

More on innovations and the role of governments

This is revisiting an old debate, thanks to the excellent Chris Dillow. Daron Acemoglu re-examines the classic claim that producers capture only a tiny fraction of the full benefits of any innovative activity and research and development activity should therefore be catalyzed by governments.

Analysing the incentives that drive investments in innovative activities by private firms and the direction (or areas) of those investments when the market is dominated by a particular technology or strategy, he writes,

"This paper... shows that equilibrium technological progress may exhibit too little diversity (too much conformity), in particular, foregoing socially beneficial investments in 'alternative' technologies that will be used at some point in the future. The presence of future innovations that will replace current innovations imply that social benefits from innovation are not fully internalized. As a consequence, the market favors technologies that generate current gains relative to those that will bear fruit in the future; current innovations in research lines that will be profitable in the future are discouraged because current innovations are typically followed by further innovations before they can be profitably marketed...

The recognition that there will be further innovations (in the prevailing technology or strategy) will discourage research in areas that will generate new products or technologies for the future relative to improving currently used products, processes, or technologies. Consequently, in equilibrium, too much research will be devoted to currently successful product and technology lines...

A social planner would choose a more diverse research portfolio and would induce a higher growth rate than the equilibrium allocation. The diversity of researchers is a partial (imperfect) remedy against the misallocation induced by the market. Researchers with different interests, competences or ideas may choose non-profit maximizing and thus more diverse research portfolios, indirectly contributing to economic growth."


In this context, Chris Dillow points to three reasons why this finding assumes even greater significance. He writes,

"1. If there is a danger of catastrophic climate change, then there is a need for new green technologies. But the danger that producers won’t get the fruits of such innovations - as they’ll be usurped by future better innovations - can lead to under-investment in them.
2. Capital spending and productivity growth have been weak for years. This might be a symptom of a decline in useful innovations. Maybe capitalism has picked the low-hanging fruit.
3. Many innovations (pdf here) since the 1980s have had the effect of increasing inequality. They’ve benefited capitalists and/or bosses at the expense of workers."

Saturday, May 14, 2011

Global unemployment challenge

The biggest immediate problem facing the developed economies is arguably the persistence of high unemployment rates. As the graphic below reveals, among the major economies, apart from Germany, unemployment rate remains well above the level before the onset of the Great Recession in September 2008.



Its innovative short-work scheme that encouraged companies to keep workers on reduced hours rather than let them go and the strength of its exports sector played a major role in limiting the impact of the Great Recession on the German labor market. Labour market reforms initiated in the last decade too helped Germany retain its competitiveness during the Great Recession.

In the circumstances, contractionary fiscal and monetary policies, driven by fears of burgeoning deficits and inflationary pressures, are only likely to further shrink these economies. This danger is all the more so since aggregate demand is very weak and the private sector is in no position to lead the recovery.

Anemic economy will only exacerbate the debt crisis and increase the debt-to-GDP ratios. As to inflation, given the considerable idling resources in all these economies, it looks like a phantom menace. The immediate challenge should be to get these economies back on some stable recovery path, so that jobs are restored and created, by continuing the expansionary policies for some more time. Or else, we could be staring at a lost decade for developed economies.

Westward shift in US population center of gravity

Interactive graphics can convey complex issues in a cognitively striking manner. Economix points to a US Census Bureau interactive map showing the shifting center of the country's population - defined as "the place where an imaginary, flat, weightless and rigid map of the United States would balance perfectly if all residents were of identical weight".



(click this for full image)

Like in the US, India's decennial census figures too are out now. Since census figures are a wealth of statistical information, its utility lies in the ease with which potential users can extract (it baffles me as to why GoI Departments do not provide for downloading their data in atleast Excel format) and render this data. Compare the respective efforts of the Census Commissionerates from the United States and India in this regard. The Census Commissionerate could take a leaf out of this when presenting its final 2011 census data.

Friday, May 13, 2011

Most educated religious group in the US?

Hindus again, followed by Jews!

More importantly, David Leonhardt finds a very strong relationship between education levels and incomes across all religious groups and within each of them. He analyzed the data in different ways and comes to the same conclusion - "more affluent people tend to produce more educated children, and more educated people tend to earn much more than less educated people".

The chart below shows the percentage of people with a four-year college degree and the percentage of people with family income of at least $75,000 a year, using data from Pew. Note the near tight upward correlation between education levels and household incomes.



Interestingly, as David points out, the Protestants, who form the largest religious group in the US, are poorer than average and poorer than Catholics, thereby calling to question Max Weber's famous theory that Protestant nations are generally richer than Catholic nations.

I had blogged earlier about the fact that Hindus formed the richest religious group in the US.

Update 1 (25/1/2014)
From a Times oped,
Indian-Americans earn almost double the national figure (roughly $90,000 per year in median household income versus $50,000). Iranian-, Lebanese- and Chinese-Americans are also top-earners. In the last 30 years, Mormons have become leaders of corporate America, holding top positions in many of America’s most recognizable companies... Although Jews make up only about 2 percent of the United States’ adult population, they account for a third of the current Supreme Court; over two-thirds of Tony Award-winning lyricists and composers; and about a third of American Nobel laureates.
The remarkable rise of Asian immigrants is captured by this anecdote,
Take New York City’s selective public high schools like Stuyvesant and Bronx Science, which are major Ivy League feeders. For the 2013 school year, Stuyvesant High School offered admission, based solely on a standardized entrance exam, to nine black students, 24 Hispanics, 177 whites and 620 Asians. Among the Asians of Chinese origin, many are the children of restaurant workers and other working-class immigrants. 

The BRTS capital of the world faces a reality check?

Last decade, many Latin American cities, led by Bogota in Colombia, had successfully pioneered the use of innovative bus transit systems that have been catalysts for the economic transformation of these cities. The Bus Rapid Transit System or BRTS, with dedicated bus lanes, became the rage of urban planners across developing countries. It was held up as an environment friendly model to address the chronic urban traffic problems of the exploding cities in developing countries. And it was far cheaper than the fancy subway systems. The Times describes the BRTS,

It is more like an above-ground subway than a collection of bus routes, with seven intersecting lines, enclosed stations that are entered through turnstiles with the swipe of a fare card and coaches that feel like trams inside... To create TransMilenio, the city commandeered two to four traffic lanes in the middle of major boulevards, isolating them with low walls to create the system’s so-called tracks. On the center islands that divide many of Bogotá’s two-way streets, the city built dozens of distinctive metal-and-glass stations. Just as in a subway, the multiple doors on the buses slide open level with the platform, providing easy access for strollers and older riders. Hundreds of passengers can wait on the platforms, avoiding the delays that occur when passengers each pay as they board.


Bogotá’s TransMilenio BTRS has been central to a dramatic transformation of Colombia's once drug-war torn capital city. In 2009, the TransMilenio was used for an average of 1.6 million trips each day, and has allowed the city to remove 7,000 small private buses from its roads, reducing the use of bus fuel — and associated emissions — by more than 59% since it opened its first line in 2001. In fact, thanks to its extensive route system, TransMilenio moves more passengers per mile every hour than almost any of the world’s subways.

Apart from its affordable and easy to implement nature (Subways cost more than 30 times as much per mile to build than BRTS, are three times as much to maintain, and can be built more quickly), the BRTS is the most environment friendly of transport interventions. As the graphic below shows, it has the lowest per capita emission rate, and can make a serious dent on the smog that envelopes most major cities across the developing world.



As the Times pointed out, TransMilenio success came with several important complementary policies,

"The negative stereotypes about bus travel required some clever rebranding. Now upscale condominiums advertise that they are near TransMilenio lines. People don’t say, ‘I’m taking the bus,’ they say, ‘I’m taking TransMilenio'... Free shuttle buses carry residents from outlying districts to TransMilenio terminals... Bogotá removed one-third of its street parking to make room for TransMilenio and imposed alternate-day driving restrictions determined by license plate numbers, forcing car owners onto the system."


However, underlining the complexity of the challenge facing urban transport planners, a recent Times article points out that TransMilenio may have become a victim of its own popularity. It is now hobbled by long waiting lines, overcrowded buses and delays and corruption in building new routes, and has also become a setting for armed robberies and violent protests. Most critically, it faces the challenge posed by the exploding private vehicle population of the city. Vehicle sales in Bogota surged to 25,527 in February, a 51% jump from the same month a year earlier, worsening its traffic jams.

Bogota is only the latest example of cities which have struggled with the complex challenge of urban transport despite apparently successful transport policy interventions. Many emerging economy cities build fly-overs, widen roads, by-passes, establish meto-rail lines, or improve traffic signalling integration that provide immediate relief. However, it is rarely long before the same problems re-surface. It is therefore worth reiterating for the upteemth time that any sustainable solutions to urban transport has to involve a comprehensive package of interventions as highlighted above.

Tuesday, May 10, 2011

Winner's curse and market failures in resource allotments

One of the most controversial areas of public policy in recent years has been that involving allotment of public resources to private interests. As the role of the private participation in the economy expands, many hitherto public assets - land, mines, telecom spectrum, municipal infrastructure, etc - are increasingly being operated by private participants.

In light of the numerous resource allocation scandals in recent months, a debate has been generated about what is the most effective strategy to allot public resources. Though competitive allocation of resources appear to be the best strategy for such allotments, there are very valid enough reasons to be sceptical. Critics point to the need for governments to be flexible and retain discretion in such allotments in the larger public interest. Let us examine both sides and see how the balance sheet squares up.

Conventional wisdom would have it that competitive markets always result in efficient allocation of scarce resources. However, real world experience reveals that competition also has the potential to generate market failures that create inefficient outcomes. In particular, all sides in the bargain are vulnerable to the winner's curse - over-paying for your purchases. This happens irrespective of whether the allotments are done in a transparent and competitive manner or by discretionary allotments. So what is the most efficient method to allot public resources to private interests?

The most famous recent example of winner's curse is the 3G spectrum auctions in Europe at the turn of the century. Telecom operators who bid fantastic sums to claim 3G licenses soon realized the folly of their excessive commitments. It had a devastating impact on their balance sheets and adversely affected the sector itself. Subsequently, the subject has generated considerable research and analysis and many prescriptions have been offered on efficient auction designs (see Paul Klemperer here).

However, nothing seems to have been learnt from the European debacle by both policy makers and the industry itself. Though it is a little early to tell, there is enough evidence to suggest that most of the telecom operators in India over-bid during last year's 3G spectrum auctions. The poor latest quarterly results of these operators are an indicator of the strains imposed by their excessive bids.

All these represent classic market failures. It is astonishing that professionally competent managers who run these telecom operators could not have learnt the bitter lessons from the European auctions. Equally baffling is the failure of financial institutions that supported the respective bidders to exercise the required due diligence that would have exposed the risks inherent in such irrationally exuberant bidding. Policy makers too should take the blame for failing to take into account the inevitability of winner's curse in such auctions and their inability to design the auction so as to mitigate these risks.

However, one of the critical, albeit less-discussed, reasons for such exuberance in bidding could be attributed to the moral hazard arising from the increasing trend of contract re-negotiations. The number of recent precedents of governments permitting such re-negotiations on very specious and flimsy grounds, after the completion of a competitive price discovery process, has considerably eroded the sanctity of contracts. Bidders realize this and rationalize that they could bid on the higher side and mitigate any risk of winner's curse by lobbying to re-negotiate away the unpalatable terms and conditions. And when all bidders play the game on the same assumptions, then winner's curse becomes superfluous.

There is another side to the debate. Economies in transition, especially in a closely integrated world, face an interesting dilemma. On the one hand, they have to compete with others to attract investments and engender business confidence. This competition exists among nations and within them between regions. Governments therefore have to accommodate the requirements of this competitive environment and tailor policies that encourage investors. This often demands discretion-based decisions that appear to favor or provide preferential treatment to certain private groups or firms.

Consider this. A state government faces stiff competition from other states to provide additional incentives to lure say, an IT company, to prefer the state over competitors to set up its new development center. Apart from standard infrastructure sops (like assured quality of power, good connectivity etc), such incentives typically include fiscal concessions, exclusive infrastructure, and additional land. Over the past few years, states have wooed such investors with huge land allotments, far in excess of the specific investment requirements.

Arriving at the right type and degree of incentives is at best of times a very difficult exercise. There is a fundamental information asymmetry in this process. The private firm has clear information of what are the respective offers of individual states and can make its decision based on them. However, the state governments work in an environment of information asymmetry. Unaware of the promises and intentions of their competitors, a state government is forced into marking up its offer on the higher side so as to pre-empt its competitors. The private firm is fully aware of this game and contributes more than its fair share to exacerbating the information asymmetry and trying to bargain the best possible deal from its interlocutor states. The net result is that the successful government invariably ends up with a winner's curse by offering excessive concessions.

Since the environment in which these decisions have to be taken is bedevilled with information asymmetry, it is no surprise that preferential offers made to attract individual investments are mostly controversial and involve some form of corruption.

More worryingly, this challenge has to be managed by public institutions and a civil society that are rarely strong enough to exercise the vigilance required for ensuring fairness in such decisions. Most often, the public institutions are captured by the private firm and the terms of the bargain severely compromised against public interest.

The civil society and its opinion makers mistake the trees for the woods by falling prey to the attraction of a public media trial of a few scapegoats. The public debate gets circumscribed and rarely tries to address the problem with systemic solutions.

Given the prevalance of winner's curse with both strategies, how do we address the problem of public resource allotments? In an ideal world, the benevolent and wise ruler would negotiate with the best interests of his citizens at heart and commit just enough concessions to tip the investment in their favor. But as discussed, the real world is rife with information asymmetry, moral hazard, and winner's curse. Besides there are real-people (read officials and politicians) prone to colluding with unscrupulous investors and a public who are either powerless or distracted by media trials and the lure of instant justice.

Allotments of public resources by way of both competitive bidding and discretionary approaches face the problem of winner's curse. In the former, the private firms end up over-paying and ultimately ending up defaulting or atleast compromising on its commitments. In case of the latter, public resources get allotted on the cheap to private interests.

So the issue boils down to which approach is likely to work best, given these circumstances? Alternatively, which risk - winner's curse for bidders or governments - is less difficult to mitigate? Here, I am inclined to hold that ensuring transparency in the process of allotments of public resources on a discretionary mode, even through empowered committees of eminent people (who are the eminent people and how honest are they), is an almost impossible task in most developing countries, including India. Institutional mechanisms to minimize corruption is difficult to implement for a variety of reasons.

However, markets are versatile enough to mitigate the adverse consequences of winner's curse. After all, the fundamental ideological issue here is over whether the individual wisdom and knowledge of government (and a few of its officials) is superior to the collective wisdom of the market in both ensuring most efficient price discovery and in mitigating the effects of possible incentive distortions like winner's curse. This debate has been settled for some time now.

However, if markets are to determine the allotment process, it is important to structure its institutional design details by taking into account the specific issues related to the sector and lessons from failures across the world. Besides trying to resolve any winner's curse, the design should also address the other sector-specific problems that come in the way of success with such allotments. This not only ensures transparency and efficiency, it can also mitigate the consequences of the market failures that result from various incentive distortions.

Monday, May 9, 2011

Greece at the doorstep of default?

It was an year ago when Greece accepted a 110 billion Euro EC/IMF bailout that was expected to restore market confidence and set the country back on the recovery path. So what is the verdict after a year?

For a start, Greece’s economy shrank 6.6% in 2010, far more than the 1.9% decline in 2009, thereby amplifying the debt-GDP ratio. The yield on 10 year Greek government bonds have rocketed to 15.5% from just over 7% in early May 2010.



The cost of insuring 5 year bonds have nearly tripled from just above 500 basis points to 1400 basis points.



The eagerly anticipated "confidence fairy" expected from the bailout announcement also appears to have eluded the peripheral economies. The peripheral European bond spreads (over German bonds) have surged continuously and those of Greece, Ireland, and Portugal have all set record highs.



Apart from Greece, the CDS spread on Portuguese and Irish debt too have widened since.



The yelds on three-year bonds have surged spectacularly across all the three major peripheral economies. It stands at an exorbitant 23% for Greece.



These strong contra-indications of market scepticism is despite the fact that the bailout has been going on below the surface. The European Central Bank has been lending money to Greek banks, accepting Greek bonds as collateral on loans to other banks, and even buying bonds, all in the hope of buying time so that market confidence would be restored and the economy will be back on recovery path with time.

However, as I have blogged earlier, this arguement is based on the assumption that Greece and others face a liquidity crisis, not a solvency problem. If, as is increasingly being felt, this diagnosis is wrong and there is a solvency problem, then a sovereign default or atleast restructuring of debt, with creditors taking haircuts, is the only way out. Delaying it will have the danger of transmitting the risks to the other vulnerable economies, especially Spain and Italy. Further, uncertainty on sovereign debt also increases market volatility, thereby affecting the economy itself in many ways.

In any case, it does look increasingly likely that Greece will be the biggest sovereign default or atleast restructuring since Argentina's $81.8 bn sovereign default of December 2001. For the record, it has been locked out of international capital markets ever since. The rating agencies too appear to think the same.

Update 1 (14/5/2011)

Excellent NYT editorial highlighting the challenge facing EC on Greece. With no private lender wanting to finance its debts and more than $400 bn in debts coming due for repayment by next year, further assistance to both private and public lenders from EC is inevitable. And this has to be followed up with restructuring of these massive debts. The editorial writes about the prospects,

"Greece’s economy shrank 4.5 percent last year and is projected to fall an additional 3 percent this year. Average salaries are down roughly 10 percent. Those grim numbers have translated into shrinking tax revenues and bigger budget deficits. Greece’s national debt, now just over 140 percent of gross domestic product, is on track to rise to 160 percent next year, and keep rising."


The prescription could not have been more appropriate,

"No serious banker any longer believes Greece can pay all that it owes on time. Greece got itself into this mess. But Europe will have to help it get out. It will become even harder the longer Europe waits and pretends."

Sunday, May 8, 2011

Mental fatigue and decision-making

One of the less understood and least discussed areas of public policy is the influence of psychological and behavioural motivations in determining the actions and decisions of human beings. Conventional wisdom on this has relied on the assumption that human beings are rational and respond to incentives (rewards and punishments) and regulations (rules). But this approach overlooks the critical influence of cognitive biases on human behaviour.

An excellent post in Economix draws attention to the critical role of extraneous, human behaviour-related factors in deciding outcomes in public administration. It points to a recent paper by Shai Danzigera, Jonathan Levavb and Liora Avnaim-Pessoa who analysed the changes in the nature of decision-making by eight experienced parole judges in Israel during a court session.

They examined more than 1,000 rulings made by them in 2009 found that the probability of favorable decisions declined dramatically as the session progressed. They write,

"Are judicial rulings based solely on laws and facts? Legal formalism holds that judges apply legal reasons to the facts of a case in a rational, mechanical, and deliberative manner. In contrast, legal realists argue that the rational application of legal reasons does not sufficiently explain the decisions of judges and that psychological, political, and social factors influence judicial rulings. We test the common caricature of realism that justice is “what the judge ate for breakfast” in sequential parole decisions made by experienced judges. We record the judges’ two daily food breaks, which result in segmenting the deliberations of the day into three distinct “decision sessions.” We find that the percentage of favorable rulings drops gradually from ≈65% to nearly zero within each decision session and returns abruptly to ≈65% after a break. Our findings suggest that judicial rulings can be swayed by extraneous variables that should have no bearing on legal decisions."




A Guardian report quotes one of the authors, Jonathan Levav,

"You are anywhere between two and six times as likely to be released if you're one of the first three prisoners considered versus the last three prisoners considered."


This finding resonates with studies elsewhere and in other areas. Behavioural economists like Dan Ariely have found that making successive decisions depletes a limited mental facility. As people get tired, they look for shortcuts, and one of the easiest shortcuts is to uphold the status quo – in this case, denying parole. As the Economix report writes about its implications elsewhere,

"This suggests that college admissions committees are more likely to accept the first applicants they consider after a lunch break. Or that quality-control officers may be more likely to ignore possible flaws in products as a long day drags toward its close."


As the Economix post argues, while food and rest are imperfect solutions to overcome mental fatigue related problems, checklists may be more effective in addressing them. In fact, Prof Levab points to the extensive use of checklists by professionals like pilots as an acknowledgement of the reality of mental fatigue.

Update 1 (7/6/2011)

The idea of depletable self-control - that an individual’s capacity for exerting willpower was finite (or exerting willpower in one area makes us less able to exert it in other areas) has been gaining currency in recent years. In 1998, researchers at Case Western Reserve University published some of the young movement’s first returns. Roy Baumeister, Ellen Bratslavsky, Mark Muraven, and Dianne Tice set up a simple experiment. They had food-deprived subjects sit at a table with two types of food on it: cookies and chocolates; and radishes. Some of the subjects were instructed to eat radishes and resist the sweets, and afterwards all were put to work on unsolvable geometric puzzles. Resisting the sweets, independent of mood, made participants give up more than twice as quickly on the geometric puzzles. Resisting temptation, the researchers found, seemed to have "produced a 'psychic cost'".

Over the intervening 13 years, these results have been corroborated in more than 100 experiments. Researchers have found that exerting self-control on an initial task impaired self-control on subsequent tasks - consumers became more susceptible to tempting products; chronic dieters overate; people were more likely to lie for monetary gain; and so on.

In addition to self-control decisions, researchers have found the same problem with tradeoff decisions - where w resolve conflicts among choices as rationally as possible. Any decision that requires tradeoffs - like choosing between more money and more leisure time - require the same conflict resolution as self-control decisions and seems to deplete our ability to muster willpower for future decisions.

Princeton economist Dan Spears has found that such self-control and trade-off decisions are more pervasive for poor people, with the result that they make a large number of sub-optimal subsequent decisions. For example, if you have enough money, deciding whether to buy the soap only requires considering whether you want it, not what you might have to give up to get it. However, many of the tradeoff decisions that the poor have to make every day are onerous and depressing - whether to pay rent or buy food; to buy medicine or winter clothes; to pay for school materials or loan money to a relative - are weighty, and just thinking about them seems to exact a mental cost.

Mullainathan and Banerjee too found that given their scarce incomes, the same self-control or trade-off decision problem is more consequential for the poor than the rich. These findings bring in a new dimension to poverty - "poverty doesn’t simply reduce freedom by constraining an individual’s choices, but that it may actually alter the nature of freedom by reducing an individual’s willpower".