Saturday, August 31, 2013

The efficiency improvement role of insurers

The organizational efficiency of retail product and service delivery chains in the US and elsewhere is truly impressive. I am referring to the remarkable ease with which large retail chains - whether selling consumer durables, or burgers, or hair cuts - run their business, many of which span across hundreds, even thousands, of locations spread over a continental geography.

A simple standard answer is that these private firms are very efficient. But I think that a more accurate explanation would be that the transactions undertaken within each location of a retail chain are embedded in a highly incentive compatible eco-system. Let me explain.

Consider McDonalds. There are many moving parts within the black-box. Each location has an elaborate mechanized kitchen and a few other equipments. It employs a few people. It receives a daily stock of cooked and uncooked food intermediates that go into making the burgers and other items. It delivers both the physical burger and associated service delivery environment, all with a remarkable, even boring, degree of standardization in both quality and appearance. 

In other words, stripped to its basics, these locations appear just like the mid-day meals kitchens in Indian public schools. Like them, here too a number of things could go wrong - a kitchen oven could stop working, the sanitary fitting in the restroom could fail, one of the employees could fail to turn up that day, one of the food intermediates could go bad, or the truck bringing the day's meat stock could get delayed early morning. But these problems appear to have been surmounted. It is too much of a stretch to believe that the management (or franchise owner) has anticipated every eventuality and planned for them.  

I think there is one important factor that may have played an important role in aligning incentives in this giant exercise at logistics and work-flow management - insurance. The conventional wisdom is that insurance cushions the buyers (of the insurance) from unexpected and one-off high expenditure incurring events. But insurance may also have an operational efficiency enhancing feature.

Insurance services force providers to clearly defining service and product standards, besides putting in place adequate redundancies and slack to cover for various exigencies. Therefore once all the transactions involving equipments, man-power supply, trucking, etc are insured, it aligns incentives among all sides to a contract.

The flip side is that it piles on layers of costs, which ultimately get reflected in the high price of many services. There is also the possibility that distortions will creep in, especially if sellers of services can pass-on the high cost of insurance to willing buyers, like with health care in the US.

In any case, it will be interesting to examine the respective contributions of these less-discussed environmental factors as against the internal management effectiveness of firms to improving their operational efficiency?

This may also partially explain why it is difficult to establish such large supply chains in countries like India. The development of a similar eco-system will be constrained by the price-sensitive nature of these markets. 

Sunday, August 25, 2013

Observations on India's currency crisis

The rupee's slide continues. Apart from adverse global headwinds, triggered off by the uncertainty associated with a tapering of the quantitative easing in the US, the Indian economy has been battered by three weaknesses - persistent high inflation, large fiscal deficit, and unsustainable current account deficit. It was natural that, atleast in the short-run, the value of rupee decline since it was losing competitiveness both internally (due to inflation) and externally (due to greater demand for foreign currency).

In this context, I have three observations.

1. One of the most worrying things about the crisis is the potential adverse impact of a falling rupee on the external debt sustainability of Indian corporations. They have raised $ 50 bn in loans over the past four years, buoyed by the ultra-low interest rates abroad and an environment which favored large capital inflows into emerging economies. Many commentators had strongly supported such capital financing, on grounds of cost efficiency and others, and the RBI too had successively eased external commercial borrowing restrictions. Since most of these borrowers had their revenues in rupee, any depreciation of rupee was certain to adversely affect them. Interestingly, the raising of external debt continues unabated, and no body appears to be calling for some restraints on it.

This should be a strong reminder to the advocates of unhindered capital flows about its potential dangers. Market participants, in this case our corporations, swim with the tide and rarely exercise rational restraint when the times are good. Regulators should exercise caution and refrain from pro-cyclical measures, even in the face of vociferous support for such measures, when the markets are on the upswing. This is only the latest episode of private corporations running up large external debts in a capital flow cycle, only to endanger their country when the cycle reverses. And we still learn nothing from such recurrent episodes.

2. Commentators have been accusing the government for not doing much to escape the crisis. While the government undoubtedly bears the major share of the blame for having allowed things to get this worse, there is little that it can do now to avoid some period of suffering. Those who call on the government to "do something path-breaking and far-reaching" do not realize that there are no such silver-bullets. The deep structural problems of the Indian economy have been exacerbated by a self-fulfilling downward spiral of negative sentiments that have gripped the perceptions of Indian economy.  

The former is a very serious battle to be fought later, though reforms have to be initiated now. And backstopping the downward spiral and reshaping expectations is a not a matter that is easily addressed, even by the most proactive of governments, leave aside governments with deeply eroded credibility. In any case, even the most appropriate policy measures start impacting with a reasonable lag, which is often time enough for the economy to spiral further down. It is evident that we over-estimate the ability of the government to do much in the short-term, though this is no excuse for the government to delay taking steps to lay the foundations for a sustained medium-term recovery.

Further, as I had blogged earlier, all talk of letting the rupee find its fair value, betrays a failure to appreciate the complex dynamics of international foreign exchange markets.

3. I also feel that the criticism of the RBI for its failure to stay the course with monetary tightening may be a bit unfair. It is in effect blaming the RBI for the government's failures. It was a big step of independent decision making, even by the standards of any central bank, for the RBI to so decisively raise rates in July defense of the rupee. It had to overcome stiff resistance from its own government which faces an election and private corporations who were badly hit by the rise in rates. I see nothing wrong with a three-steps forward and one-step backward strategy, where a very decisive intervention is followed up with small compromises. It is of course a matter of debate as to what degree of back-tracking is tactically sound.

Monetary policy making in such times is about pragmatism and consensus building, and not pursuing the ideal or even the second best alternative. A too independent and theoretical a central bank runs the risk of allowing an Abenomics style take-over. After all it is not too much of a stretch to imagine that the government would have made the environment impossibly difficult for the RBI if it stayed its ideal course too far. In this context, it will be interesting as to how an untested Raghuram Rajan will navigate the crisis. 

Saturday, August 24, 2013

What Anna Hazare, Kejriwal, and Co should have pushed for?

I strongly believe, like most others, that there are no magic bullets to address complex issues like corruption or development. Having said that, there are interventions which are likely to have substantially large impact on the problem. 

The civil society movement in India been very vocal in recent months on the establishment of a strong ombudsman, the Lok Pal, as the most important instrument to combat corruption. I think that if it did want to raise the pitch on one issue, a more effective choice would have been to force the government to promulgate a Manpower Deployment Act. 

Frequent and completely discretionary, most often whimsically so, transfers are a feature of personnel management within governments in India. It is an open secret that in many states, most of the influential local officials are brought (or bought!) in by the local legislator and function at their behest. It has become arguably the most important cause for politicization and corruption in the administrative system, from the lowest to the highest levels. 

The state and central governments would have to promulgate their own legislations. Individual departments, in turn, should frame rules that govern their employees transfers, in accordance with their state or central legislation. It should clearly define those eligible, the criterion, and the process for transfers. Further, all transfers should be done only in a small, preferably two-week window, in the summer each year. All transfers done in violation of these rules should be explicitly recorded with reasons, and be subject to an appeal process. Furthermore, these deviations should be compiled by the Department and placed before the state Assembly or Parliament in their respective annual reports on the Manpower Deployment Act. Transfers done in case of exigencies like vaccancies arising due to retirements and promotions too should be covered by a transparent and rules-based regime. 

Apart from minimizing corruption, this will go a long distance towards promoting good governance too. Stability of tenure, by itself, brings in a tremendous amount of accountability. Short tenures are inefficient for many reasons. Primarily, it takes a few months for any official, howsoever experienced, to become familiar with their operational jurisdiction. Further, when officials are transferred once a few months, they have no incentive to plan and implement programs. More importantly, it becomes easy for them to shift blame on their predecessors or on some extraneous factors. But if an official has been in place for atleast two years, he cannot either feign ignorance or evade responsibility about problems in his jurisdiction.

I am dismayed not so much at the civil society movement not reflecting this view, but at the failure of the opinion makers and media is channeling the movement's energy into more purposeful reforms like these.  

Thursday, August 15, 2013

A framework for classifying public officials

The suspension of a young IAS officer in Uttar Pradesh has generated considerable angst and indignation in India. Sub-divisional officers and town planners across the country demolish tens of compound walls each month, under much more communally sensitive conditions, and face commendation of their superiors. For those aware of the working of the bureaucracy, that this demolition has resulted in a suspension is more an indictment of the highest echelons on the bureaucracy (itself consisting of only IAS officers, albeit very senior ones) in the state than of its trigger-happy politicians.

But this incident, and the debate surrounding it, provides an appropriate context to examine the various management styles, personal preferences, and organizational impact of different kinds of officials. The simplest classification and description of officials is based on the honest/dishonest and effective/ineffective framework. I am inclined to believe that with small qualifications, the same holds for all kinds of public officials, not just in India but elsewhere. The matrix below tries to capture it, admittedly in a highly simplified manner, and is self-explanatory.

My three observations from this matrix. One, honest and ineffective officer is as much a liability as the honest and effective officer is an asset. Two, the dishonest and effective officer is the most difficult one to manage, since he is not only helpful and like-able at a personal level but is also growth promoting. Three, while in a second best world, stationary bandits may be the best we can hope for, the scarce positive externality generating official needs to be protected and promoted. 

Friday, August 9, 2013

What caused the decline in poverty in India?

The recently released figures by the NSSO shows that the percentage of population living below the poverty line in India declined by over 15 percentage points from 37.2% in 2004-05 to 21.9% in 2011-12. The poverty rate fell 9.8 percentage points to 13.7% in urban areas, and 16.3 percentage points to 25.7% in rural areas. In absolute terms, the number of poor declined by 33% from 407.2 million people to 269.7 million people in the same period.

The estimates are based on a percapita daily poverty line of Rs 27.2 and Rs 33.3 (2011-12 base year) for rural and urban areas respectively, which are higher than the equivalent World Bank standard for PPP-adjusted poverty line of $1.25 percapita per day. This translates to a monthly income of Rs 4080 and Rs 5000 respectively in rural and urban areas for a family of five. This poverty line was fixed based on the recommendations of the Suresh Tendulkar Committee which based its calculations on expenditures like food calorie intake, health, education etc.

Obviously some of these figures are suspect. But despite all debate about this and whether the reduction constitutes a significant achievement, it cannot be denied that the rate of poverty reduction has increased sharply in the last decade. Taking the same standard, the rate of decrease in poverty more than doubled from 0.74 percentage points annually in the 1993-94 to 2004-05 period to 2.08 percentage points in the 2004-05 to 2011-12 period. As the Business Standard reports, Indian economy grew at 6.2% in the former ten years and 8.4% in the latter eight.

The more interesting thing about this trend is what caused this reduction, or more specificially, what were the respective contributions of economic growth and redistributionary policies. While there have been conjectures and wild speculation about the possible causes, none of them are backed by any rigorous empirical evidence. Its exploration will be one of the more interesting academic research projects, with implications for development policy making itself.

In this context, Pronob Sen, Chairman of the National Statistical Commission, had this to say about the debate between growth and redistribution,
The growth acceleration certainly was a major factor, but it would not have had this kind of impact if two other developments had not occurred. The first is that there was a terms of trade shift in favour of agriculture, which began in 2004 and continued to gain strength thereafter. Over the period, my rough estimate is that the terms of trade improvement added somewhere between 3 to 4 percentage points annually to real agricultural income growth.  The second is that rural wages rose rapidly, indeed faster than agricultural prices, which led to a distributional shift away from land owners towards landless labour.  As a result of these two factors, the high GDP growth rate “trickled down” to the poor, especially the rural poor, much faster and to a larger extent than would have been the case otherwise.
The genesis of the terms of trade shift appears to be the large increase in minimum support prices by the UPA government, but its continuation, and indeed acceleration, is a more complex story. The distributional changes certainly increased the marginal propensity to consume of the country as a whole, but also appeared to have triggered off an unprecedented change in dietary patterns... The rural wage increases, I believe, are due substantially to the implementation and roll-out of Mahatma Gandhi National Rural Employment Guarantee Scheme (MNREGA) since 2006, but other factors have also played a part. In particular, the rural roads programme -- Pradhan Mantri Gram Sadak Yojana (PMGSY) has opened up rural work opportunities which simply did not exist earlier. 
Now let me indulge in my two cents of speculation. Economic growth, at least in the short to medium-term, can result in poverty reduction by two channels - trickle down growth and redistribution policies. Trickle down growth, or rising tide lifting all the boats, is build on the foundation that the overwhelming majority of the poor are equipped with the human capacity to access the opportunities that arise from economic growth. But it is well known that the typical poor Indian, especially in rural areas, suffers from both human resource capability deprivation - education and health standards, and livelihood skills - and physical infrastructure deficit that are essential to make use of the opportunities presented by growth. In fact, even among its emerging market peers, India comes out very poorly in its human resource development scores.

In recent years, there have been a sharp increase in redistribution policies like NREGA, minimum support prices, public distribution system, social welfare pensions, and so on. Massive amounts have been spent and its coverage has expanded as state governments have diluted the eligibility requirements to increase its electoral appeal. It is inevitable that, even with all its leakages, these transfers contribute towards income growth and therefore poverty reduction. The fact that poverty fell much steeper in rural areas and in the poorest states, even discounting for the base effect, may lend some credence to this view. In the circumstances, the argument that Pronob Sen makes about the redistribution policies having hastened the process of economic growth tricking down to reduce poverty appears compelling.

What should be a matter of concern is whether the reduction is sustainable. It needs answers on two dimensions. One, will those who have come out of poverty continue to remain so once they lose access to the redistribution programs? Two, have the dynamics of this poverty reduction process (productivity increases, changes in consumption patterns etc) created the conditions to move the economy into a high growth trajectory?

I am inclined to answer in the negative on both. And this is an indictment of the particular nature of the redistribution policies we have been following. It has been like band-aid on a gangrene. We need to be discussing and debating such second-order issues of growth instead of arguing over the relative merits of non-issues like the relative superiority of growth and redistribution. What should be the design of redistribution policies that ensure sustainable poverty reduction? What structural reforms are necessary to make economic growth more inclusive and thereby sustainable?      

Thursday, August 8, 2013

Economic counter-factuals - Norway and Britain

From Justin Fox,
As Thatcher took office as Prime Minister in 1979, booming oil revenue from the North Sea offered big opportunities and posed big decisions for the UK and Norwegian governments. Under Thatcher, the UK chose to spend the windfall as it came in and cut other taxes — a policy that her successors didn't really alter. Norway started out on a similar track, albeit using the money more to prop up its increasingly expensive welfare state than to cut taxes, but in 1990 established what was then called the Petroleum Fund, now a $720 billion sovereign wealth fund with significant global influence and hugely positive implications for the country's fiscal present and future. Now, not surprisingly, some in the UK are saying that's an alternative they should have considered.
The Norwegian Sovereign Wealth Fund is indeed one of the most visionary policies by any government in history. There is a limit that no more than 4% of the funds capital be spent in one year. It is estimated to top a trillion dollars in the foreseeable future and currently "owns an estimated 1p in every £1 of world equity, which is a colossal stake in the global economy from such a small base, and is reckoned to be the largest owner of stock in Europe". Its interest and dividend returns are estimated to be around 14.3 bn pounds. 

Monday, August 5, 2013

On monetary and fiscal policy dilemmas

Two sets of articles on monetary and fiscal policies highlight the dilemmas policy makers face when making a decision to choose between competing policy alternatives. As both cases highlight, a very good appreciation of economic history and local political economy can be invaluable in increasing the likelihood of getting decisions right.

1. Charles Plosser, the President of Philadelphia Fed, has been one of the strongest voices within the US Federal Reserve system against the quantitative easing policies that have seen the Fed's balance sheet balloon past $3.5 trillion. He has consistently argued that the Fed's extraordinary monetary policy measures have blurred the lines between monetary and fiscal policies, and thereby the roles of central banks and governments. He feels that it has politicized the Fed's mandate and laid it open to pressures to pursue similar policies in future. This, he feels, would take away from the central banks' primary mandate of maintaining the purchasing power of the national currency unit.

In this essay, he lays out a very compelling case to exercise caution on unconventional monetary policy actions like purchases of non-Treasury securities and lending to "insolvent" institutions which clearly are on credit policy territory. He calls for re-establishment of the boundaries between monetary and fiscal authorities and urges governments to take measures to address structural deficits,
Once a central bank ventures into fiscal policy, it is likely to find itself under increasing pressure from the private sector, financial markets, or the government to use its balance sheet to substitute for other fiscal decisions. Such actions by a central bank can create their own form of moral hazard, as markets and governments come to see central banks as instruments of fiscal policy, thus undermining incentives for fiscal discipline. This pressure can threaten the central bank’s independence in conducting monetary policy and thereby undermine monetary policy’s effectiveness in achieving its mandate...
Congress has mandated the goals of monetary policy to promote price stability, maximum employment, and moderate long-term interest rates. Asking monetary policy to take on ever more fiscal responsibilities undermines the discipline of the fiscal authorities and the independence of the central bank. Central banks and monetary policy are not and cannot be real solutions to the unsustainable fiscal paths many countries currently face. The only real answer rests with the fiscal authorities’ ability to develop credible commitments to sustainable fiscal paths. It is a difficult and painful task to be sure, but a monetary solution is a bridge to nowhere at best, and the road to perdition at worst — a world of rising and costly inflation and a weakening of fiscal discipline.
These concerns are very real. It surely is a judgement call between supporting unconventional monetary policies, and in the process running the real risk of distorting the incentives of stakeholders and risking the institutional credibility of central bank, and adhering to a conventional monetary policy stance, and being blamed for not having done enough to restore economic normalcy despite having some firepower to have done so. I guess this is where a good grasp economic history and local political economy assumes critical significance.

2. The Economist points to the latest addition to the debate on the magnitude of the fiscal multiplier. IMF's Olivier Blanchard and Daniel Leigh argue that the strong fiscal consolidation in many advanced economies has resulted in lower economic growth than expected, suggesting that fiscal multipliers were higher than originally assumed. By backing out the multiplier from the actual fiscal consolidation and growth rates, they find that it substantially above 1 early in the crisis. Clearly the amount of slack created by the Great Recession was much higher than estimated.

The article also points to another IMF paper by Ethan Ilzetzki and Co which examined the effects of fiscal policy in 44 developed and developing economies. They find that the fiscal multiplier of government consumption is higher in developed economies while that of government investment is higher in developing countries and is well above one; is relatively large in countries with fixed exchange rate and almost zero in countries with flexible exchange rate (where the effects of fiscal expansion leaks out, by way of both higher imports and depreciating currency); is lower in open economies than closed ones; and is zero in high-debt countries. Furthermore, they argue that the multipliers of government investments by developing countries may rise as their governments learn to more effective manage the exchange rate, thereby reducing the leakage of fiscal policy through the exchange rate channel.

Menzie Chinn has an excellent paper where he examines the effect of fiscal policy under various macroeconomic conditions - slack in the economy, monetary policy path, and public debt shares. As the graphic below shows, fiscal multipliers in the US have been found to be highest during recessions, exactly the time when they are needed.

In the context of the debate between fiscal expansion and consolidation, this speech by Jens Weidemann, President of the Bundesbank makes a cogent case for consolidation in view of the adverse public debt ratios in many Eurozone economies. Supporters of fiscal austerity, like Wiedemann, see the current problems as a "crisis of confidence in the sustainability of public finances" and claim that a "credible commitment to sound public finances", despite its short-term growth dampening effect, will inspire confidence and improve long-term growth prospects.

Again any clear cut view on either position is a judgement call that balances two sets of risks. Supporters of fiscal expansion run the risk of losing an opportunity to force governments to address their long-term fiscal problems besides not getting the menu, magnitude, and timing of fiscal policy instruments right, thereby worsening the fiscal balance when expansionary policies fail to yield the desired results. Similarly austerity advocates risk pushing the economy down a deep trough by not doing enough to get economic growth back on track when expansionary policies could have restored normalcy and then left governments to concentrate exclusively on getting the fiscal balance in order. A good understanding of economic history and political economy can increase the likelihood of getting the judgement right.

Friday, August 2, 2013

The limits to "talking up" the markets

Lots of activity on economic reforms front in recent weeks coming from New Delhi. The Finance Minister has led the way in talking up the markets with high-profile visits to global capitals. Just in the last couple of days the Union Government has liberalized the caps on foreign direct investments (FDI) in telecom, defence, and insurance sectors, and relaxed the conditions of retail trade liberalization. Further, there are also attempts to kickstart the disinvestment and privatization process.

It would be very naive to believe that any of these measures will do much to address the deep-rooted structural problems facing the Indian economy. Even if the Indian industry and even influential opinion makers feel that the second round of reforms have been re-started, the Finance Minister and his officials are smart enough to realize that this is just "damage control".

Their hope would be that these measures would reverse the process of erosion of confidence that had gripped investors and businesses over the past couple of years. It would revive the animal spirits and boost investor confidence so that private investments, especially by foreign capital, will increase, and capital flight will be reversed. This, in turn, would help bridge the country's unsustainable current account deficit. In other words, this is just "talking up" a weak and uncertain market.

But as a holding measure, it is very important. In terms of global investor confidence, India appears to stand on a slippery slope, maybe even a precipice. The immediate trigger may have less to do with fundamentals than a stream of bad news about the Indian economy, amplified by global factors, which have shaken investor confidence and business sentiments. Foreign investors are taking flight, prompted also by events elsewhere. The rupee has been falling. Bond yields have surged precipitously. And now the equity markets have joined the downward slide. In the circumstances, a self-fulfilling negative cascade can always be round the corner. "Talking up" the business sentiment with high-profile expectations-shaping measures is the urgent need of the hour.

But didn't someone say that "talk is cheap". It can backstop an imminent crisis, but will only kick the can down the road unless supplemented with more fundamental reforms. I'll have something to say about that in the days ahead.

The futile search for quick-fixes

Most often the long-term economic health of nations is about getting several basic things right. But unfortunately, when in trouble, the search is invariably for innovative and big-bang solutions. James Surowiecki sums up this dilemma in the context of the criticism of President Obama's recent speech that laid out the challenges facing the US economy and what needs to be done. He writes,
Obama’s speech was, in a sense, the equivalent of saying that if you want to lose weight, you need to eat better and exercise more. And demanding that he offer up some “big, bold, and new” idea (as Milbank, for instance, did) is like asking for a fad diet—lose thirty pounds in thirty days while eating only muffins! If we’re really serious about the long-run performance of the economy, we need to abandon the quest for short-term fixes and radical solutions, all of which steal from, rather than enhance, the economy’s still-enormous strengths.
I could not agree more. This is also the problem with popular narratives on what needs to be done to get India out of its current economic weakness. There are no quick-fixes nor "big, bold, and new" solutions. It needs to get the boring basics right - sustainable growth happens when the consumption base expands, encouraging investors to lend capital and businesses to invest, thereby creating more jobs and increasing the base further, and this entire process is facilitated by macroeconomic and social stability, an enabling regulatory framework, and good quality human and physical infrastructure.