Thursday, June 28, 2007

The Savings Paradox

Savings and Investment are two sides of the same coin. Though saving money is considered desirable, it has its costs. While savings are necessary to sustain investment in an an economy, consumption is necessary to make the same investments profitable. We have heard of the huge domestic savings of East Asian economies, and especially China. In January 2005, the present US federal Reserve Governor, Ben Bernanke alluded to a "savings glut" in the world economy.

East Asian economies are interesting examples of the complex interplay of savings and investment. Historically, most of these countries have been huge savers, with small consumption growth. Some Asian economies, especially Japan, even suffer from acute demand compression. Consumers are not willing to spend as much as their incomes would afford. There could be many reasons for this. First, historically in many closed economies like India and many in the East Asia (remember that most East Asian economies were heavily import protected till very recently), in the absence of choice, the consumers had limited spending options. Second, culturally many Oriental and South Asian countries encourage thrift to conspicuous consumption. Third, the higher interest rates afforded numerous lucrative investment options (though this cannot be said about Japan). Fourth, the low inflation in many East Asian economies also meant that spending was not that attractive an option, as people could afford to postpone spending. Fifth, all these economies have massive young population who tended to over-save to improve their future prospects. Finally, Japan suffered from deflation in the late nineties and early years of this millennium. People started postponing their purchases in anticipation of further falling prices. A vicious cycle got precipitated and the deflation worsened.

Savings also depends on the rational expectations of the consumers. If the Government is running higher deficits, citizens generally respond by cutting down on present consumption and starts saving in anticiaption of future tax increases.

Economic history teaches us that high domestic savings are essential in generating the investment required for high economic growth rates in any country. The huge 35-45% savings rates of the East Asian economies during the decades of sixties to nineties, played a critical role in sustaining the East Asian economic miracle. The domestic savings rate of China, recently crossed 50% of the GDP. The proactively interventionist Government bureaucracies in Japan, Singapore, Malaysia, South Korea, and Taiwan channelled these huge savings towards priority sector investments, that sustained the export led economic growth model. Besides supporting investment spending, savings also lubricates and adds liquidity to the financial system, thereby strengthening and deepening it. A robust financial sector is vital to the long term economic prospects of any economy.

What are the deficiencies of a savings driven economy? Savings yield high returns only if there is demand for investment spending. Investment spending in turns depends upon consumption demand. Till recently, the East Asian economies were able to sustain investment spending by maintaining huge exports. But now, with currencies appreciating and faced with the prospect of falling demand in US, these economies have to look internally for sustaining their economic growth. Further, excessive savings can also increase inequality in an economy. The rich generally save more than the poor and in a context of excess savings, the rich over-save, thereby deepening the inequality gap. This is increasingly evident in all the economies of East Asia. In contrast, increase in consumption can contribute directly to the economic growth, which has a direct multiplier on the incomes of all the people.

How do we generate consumption demand? One way to get people to start consuming more and saving less is to generate inflation. During times of inflation the purchasing power of our investments decreases and the costs of borrowing fall. It will encourage people to pull out their savings and start spending. (Paul Krugman famously advocated that Japanese Central Bank should signal inflation to get Japan out of the liquidity trap in the nineties) Opening up the economy will surely help broaden the market and increase choice, thereby giving a filip to consumer spending. We need to look no further than what happened to the Indian consumer durable goods market after liberalisation. Lower interest rates will also be an incentive for people to curtail investments and encourage borrowings. South Korea has been a successful example in generating a consumption boom by among other things lowering interest rates, encouraging borrowing, and the use of credit cards.

What are the consequences of low savings or dis-savings? The United States, since the late nineties, has been experiencing the biggest consumption boom in history. It has been fuelled by a massive rundown on domestic savings, with household savings recently moving into the red. The "wealth effect" generated first by the Information Technology (IT) and the telecoms bubble in the share market, and later by the rising real estate market, has empowered the American consumer to throw caution into the wind and spend as though there is no tommorrow. The historically low interest rates generously contributed towards the growth of both these bubbles. The weak dollar which made the cheap East Asian and Chinese imports even cheaper, only multiplied the wealth effect. But this massive run down on somestic savings has spectacularly distorted the American macro-economic picture. Its impact will be felt for many years to come.

Wednesday, June 27, 2007

China and the world's best

I was reading a news that China has built a 36 km bridge across the sea, linking Shanghai and Ningbo, the world's longest sea crossing structure. The six lane, cable-stayed structure was built at a cost of $1.42 bn, in less than 5 years.

This is only one among the many construction achievements that the great Chinese economic factory keeps churning out with a frightening regularity. The massive 2.3 km long, Three Gorges Dam, completed in 12 years, one year ahead of schedule, is the world's largest hydel power dam, five times larger than the next. The 1118 km Tibetan Railway link connecting Qinghai and Lhasa, completed in six years and well ahead of schedule, is the highest railway link in the world. The 2.4 km Beijing-Kowloon (or Jingjiu) Railway line, one of the largest single railway expansion in the world, was completed in just three years. Now comes news that China is going to build a 100 km road link connecting its Himalayan frontiers, in time for the 2008 Olympics. The list of such impressive Engineering achievements goes on!

The contrast with India could not have been starker. I can't think of a single major construction activity in India over the past 30 years, which can match any of these. The Delhi Metro is undoubtedly a mjor achievement, but surely not an Engineering marvel. The Golden Quadrilateral Project is impressive by Indian standards.

The lag is confined not just to the Government, but extends into the private sector too. There are atleast a hundred high-rise buildings in Shanghai, which are bigger than the biggest in any Indian City! If we are thinking of competing with China, we better know fast where we stand and what we are aspiring to!

Monday, June 25, 2007

Justifying American Foreign Policy

American Foreign Policy suffers from the impossible balancing act between Wilsonian Idealism and Kissingerian Realism. In their idealist garb, the Americans consider themselves as the progenitors of freedom, democracy, liberalism, and capitalist market economy. But realism demands that foreign policy be tailored to meet the specific geo-political imperatives and economic compulsions. This necessitates compromises and even deceptions, that may strike at the heart of the ideological facade. It is this contradiction that confuses and outrages other countries, and severely undercuts American claims to any moral superiority.

The contradictions in Policy become evident as actions do not match words. You cannot stand for promoting democracy, while sabotaging popular democratic process in Latin America, Algeria and Palestine. American cannot sing the virtues of free speech even as it is supporting Television channels like RCTV which openly incites violent overthrow of a democratic government, and placing restrictions on the operations of hugely popular channels like Al Jazeera. How can you preach the virtues of free trade and capitalism, while indulging in blatant protectionism in agriculture? How can you talk about free movement of capital, when you cite national security to disallow any major FDI from a nation called China? America cannot talk about saving the environment when it is standing in the way of implementation of the universally accepted Kyoto Protocol. How can you selectively sing the tune of multilateralism, when your country stands out among civilized nations, in not having signed a host of UN Conventions on basic civil rights and repeatedly mocks at the United Nations by unilateral actions in Iraq, Afghanistan, Palestine, and many others? How can a country whose Middle East policy is controlled with a very tight leash, by the zealots in the extreme right-wing American Israeli Public Affairs Committee (AIPAC), be considered a honest mediator in the Middle East? How can a Government which is effectively a captive of powerful pharmaceutical companies, with the sole objective of keeping even life-saving drugs expensive at the cost of millions of African lives, be a reliable and sympathetic partner for African countries? How can you talk about human rights, while maintaining Guantanamo Bay and tolerating war crimes like Abu Ghraib?

Harvard Professor, Joseph S Nye had coined the term "soft power" to highlight the difference in American influence from that exercised by leading powers in history. He emphasised that "soft power" has its roots in American democratic political culture, free-market economy, liberal social values, ideals like free speech etc, besides the various visible embodiments of American style capitalism like McDonald, Mickey Mouse, Hollywood, CNN, Nike and Gap.

This claim for a superior moral ground and being the torch-bearer of all that is good and desirable in this world, was irreparably tarnished in the developing world, due to the actions during the cold war period. The open support for Israeli genocide and blatant violations of UNSC resolutions, had destroyed all credibility in the Arab world. The invasion of Iraq with fabricated claims of presence of Weapons of Mass Destruction (WMD) and the subsequent events during the occupation, the rampant cronyism in international oil contracts and UN assisted rehabilitation projects in Iraq, have all contributed towards eliminating any vestiges of moral authority in Europe and rest of the developed world.

The State Department outlines that one of the major objectives of US foreign policy is "to create a more secure, democratic, and prosperous world for the benefit of the American people and the international community." This is fine as a normative framework to hang your foreign policy initiatives. But in the final analysis, any decision will have to be taken based on national interest. If any of the ideals conflict with national interest, the later will have to prevail. Therefore the problem starts the moment you start justifying all your actions based on these ideals.

America would do well to refrain from its aggressive promotion of these lofty ideals, which it does not itself follow. The universal principles of democracy, freedom of expression, liberalism and free-markets can be the normative signposts shaping the broad contours of its foreign policy. These principles should not however become the primary determinant and the facade for the policy itself. National interest alone should fulfill that role.

Therefore, the Middle East Policy should be advocated in terms of American oil interests and domestic compulsions regarding Israel. The emergence of Hugo Chavez and Co could be resisted, not by invoking the name of democracy, but on the grounds of containing spread of revanchist Marxist ideologies in America's backyard. American Economic Policy should be conducted based on national economic interests and not on high principles of free-markets and free trade. America need not shy away from conceding that it supports the oil and pharmaceutical companies at any cost, because they are the largest political donors. There is nothing objectionable about holding the view that even democracy can and will be sabotaged, if it comes in the way of American national interests. But do not justify it by invoking a more holier and purer version of democracy and free speech, that America claims to espouse. There is no need to hide the fact that American environmental policy has to take care of the interests of its corporate citizens? Fine with multilateralism if we can, but we will act unilaterally if we should!

Realists proclaim that the ultimate test of the success of any policy is whether it enhances the national power or not. Given that American foreign policy has been in practice imbued more with realism than any idealism, it is only appropriate that this policy be underpinned by promotion of national power. This strategy will atleast ensure that America is not exposed to charges of hypocrisy and double standards.

It was Lord Palmerston who famously said, "There are no permanent friends and enemies in relations between nations, only interests". This has been the underlying theme in American Foreign Policy throughout the Cold War. The Unites States should embrace it again in the conduct of its foreign policy, thereby insulating it from the damaging charges of duplicity. The ideological strand for this policy can be derived from a methodology that relies on a rational and scientifically evaluated cost-benefit analysis of foreign policy alternatives, which would elevate any policy to a more objective plane. Maybe there ought to be more game theorists, behavioural scientists and economists at the Foggy Bottom!

Sunday, June 24, 2007

Sport and statistics

In the late nineties during his stint with the South Africans, the late Bob Woolmer brought the laptop into fashion for a cricket coach. In recent years, we have moved by leaps and bounds in employing statistical techniques for improving performance of sportsmen. In an age when professional sport at the highest level is exceptionally competitive and lucrative, and only a small difference separates the top few players and teams, it is understandable that sportsmen and their coaches try to squeeze out even the very minute marginal advantage.

By analysing the strokes of tennis players, we can gather a wealth of information about their styles of play. The service of a player can be studied to discern trends about when (different stages of the match) serves from deuce court (or advantage court) hits the tramline or centre line or the mid court. Other examples include, the probability of the player changing direction on a cross court rally by going down the line, the situations a player is likely to play drop shots, the general nature of service returns of a player on different angles of the serve etc

In football, both penalty kicks and freekicks, are fertile grounds for statistical analysis. An inventory of all Zinedine Zidane spot kicks may throw up interesting trends, including the direction he generally prefers - top left or right, bottom left or right, or centre top. Similar study of Oliver Kahn's movements may give some insights into the direction in which he prefers to move while defending spot kicks. We may even be able to discern interesting trends in the ball passing movements of individual players, as well the team. Thus a player marking Diego Maradona could gather useful information from the team statistician about his movements.

In cricket, one can possibly draw interesting conclusions about a batsman's response to different types of deliveries, not just short rising deliveries. It is possible that a particular batsman will get targetted by a specific category of bowlers with a particular type of delivery. Similarly with bowlers, detailed analysis may reveal specific trends in their deliveries. A Stuart Clarke may prefer to not follow up a nasty bouncer with a yorker, but with a loose half volley inviting an indiscretion from the shaken up batsman. There are many other insights that can be drawn by studying statistics - how a batsman tries to get off the mark, how he reacts to balls outside the off stump etc

Similar statistical analysis have substantial role to pay in most team games. Table Tennis, Hockey, Baseball, Rugby, Badminton are some of the game likely to be enriched by the use of statistical techniques. The coaches will have to identify those vital parameters or variables in their sport and then analyse it for useful information.

These statistics reveal a lot about the mental make-up of players and how they respond to different situations. We are not far from the day when a statistical analyst could program a ball-by-ball strategy for an innings which the captain could execute with the help of a PDA. Of course we will never have a Plan executed to clockwork precision. (A Sachin Tendulkar or a Brian Lara can, on their day, easily destroy any plan. But most journeymen cricketers can be constrained) These methods are only aimed at enhancing performance outcomes by optimizing our repsonses to different situations, players and teams.

The purists will be shocked by these developments and there will be heated debates about whether it is for the long term good of the game. But sport is after all entertainment in its different dimensions, and nothing else. To the extent that these techniques have made modern day sport more competitive than ever before, we should have no dearth of entertainment. An example is Chess, which in contrast to a decade back is today far more technically analysed with sophisticated software, but none the less popular.

This provides a sliver of opportunity for our perpetually losing sportsmen. Get some of our accomplished software talent into analysing sport!

Friday, June 22, 2007

Encouraging Positive Externalities

I have already written about externalities in previous posts. Externalities are outputs or outcomes which are borne by the system external to the agent doing the activity. These external impacts can be either detrimental or beneficial to the society at large. Those which impose a cost on the external environment is called a negative externality and those which confer benefits on it are called positive externality. Positive externalities are good for the society and have to be therefore encouraged. However, since it does not confer any benefit on the generator of the activity, positive externalities will be under supplied, if left to the market.

Therefore, just as negative externalities have to be penalised and taxed, positive externalities have to be incentivised or subsidised. When your actions make strangers better off, you should be encouraged to do more of the same and maybe even given tax relief. The Marginal Social Cost (MSC) of positive externalities is less than the Marginal Private Cost (MPC), and the Marginal Private Benefit (MPB) is less than the Marginal Social Benefit (MSB). Under any circumstances, the private individual bears greater cost and gets lesser share of the benefit than the society at large. Positive externalities confer benefits to the society, while incurring little or no cost. In short, it is a free lunch! But in the absence of clearly defined property rights, the agent doing the activity cannot capture the financial benefits of the externality.

What are the examples of positive externalities in urban areas? Health Care, Education, gardens and green belts, keeping surroundings clean, maintaining pet dogs (pet dogs deter crime in the neighbourhood), parking lots etc.

Education and health care are popular and standard examples of positive externalities. Vaccination taken by an individual not only helps the individual, but also reduces the chances of the neighbour contracting the disease. An unhealthy individual inflicts a negative externality on the environment, in so far as he is a health risk for his neighbours. Education helps in building up the knowledge base of the population and development of its citizens. An uneducated person causes negative externality, by being a burden on the society and a potential recruit or prey for some anti-social activity. We need to encourage private agencies coming forward to provide health care and education, especially in the slums and other poor localities, by incentivizing them.

Residents Welfare Associations (RWAs) who keep their areas clean are generating a positive externality, in so far as they are not only directly enjoying its benefits, they are also passing on the benefits to the neighbouring areas. They also end up fostering a healthy competition, by encouraging the neighbouring and other RWAs to keep their surroundings clean. It may be appropriate to reward such RWAs by taking up civil works or trying to solve their long standing problems on priority.

Green belts and parks are evidently good for the environment, and people who adopt them need to be encouraged. In fact, we need to encourage residents to plant trees in their areas, and shops to adopt trees in fron of their shops, wherever possible. These shops should be incentivized by giving, say, Property Tax relief to the extent of trees planted and maintained. Given the massive parking problem facing our cities, any development of private parking lots would have benefits beyond that accruing to the individual, and hence should be encouraged.

We can even add philanthropy as an example of positive externality. Philanthropic donations confer huge social benefits and hence ought to be ecouraged. In fact, our Income Tax Act confers certain tax exemptions on donations for certain causes. Extending this, local bodies may be given the freedom to accord privileged status to such individuals or provide them certain tax or other concessions.

Thursday, June 21, 2007

Rent seeking in civic services

The ingenuity of rent-seeking channels never ceases to amaze! Sample this latest discovery. Before I venture into it, let me confess that I stumbled upon this by sheer accident. I can imagine each of us monitoring numerous such processes on a daily basis, while continuously missing the minutiea which conceals such impressive inventory of best practices in rent-seeking!

The Citizen Charter of the Vijayawada Municipal Corporation (VMC) outlines the following well established procedure for the sanction and execution of new water and Under Ground Drainage (UGD) connections.
Step 1. The house owner makes an application at the Citizen Charter Counter.
Step 2. The application is referred to the Assistant Engineer (AE) concerned, so as to verify whether connection can be given (to verify the availability of network in the area and feasibility of giving connection immediately).
Step 3. After verification the applicant has to remit the requisite connection charge, and the connection is sanctioned.
Step 4. The Engineering section then gives the physical connection from the existing distribution line.

The real action however takes place somewhat like this.
Step 1. The owner applies at the Citizen Charter Counter.
Step 2. The application along with the applicant, is referred to the Assistant Engineer concerned.
Step 3. Rent seeking starts. The AE or his sub-ordinate insists on speed money to expedite the physical inspection. The first transaction is direct and the report is sent to the Counter.
Step 4. The connection charges are paid and the sanction order is issued at the Citizen Charter counter. The applicant feels relieved at having got his connection sanctioned. But wait, the ordeal has only started!
Step 5. The sanction letter is given to the AE, who directs the applicant to a particular plumbing contractor for executing the connection. The contractor demands Rs 2500 for the work. Suspicious, the applicant enquires elsewhere and finds out that it costs only Rs 1000, and confronts the AE. The AE responds that only his contractor is accredited to work on the municipal distribution lines! Resigned to his fate, the applicant then purchases the required plumbing material only to be told that he ought to be purchasing a different brand of material from a particular shop. On enquiry, he is told it costs two or three times as much! The poor citizen finally ends up paying Rs 1000-Rs 2000 more for the connection.

The existing process contains all the trappings of transparency and accountability. But as is the case elsewhere in public service delivery, the processes have been badly subverted by entrenched vested interests. In fact rent-seeking behaviour has been effectively institutionalized.

Instead of direct bribe payments, the rents have been costed into the legal transactions. The chances of detection is minimized, and all the stakeholders (officials, plumber, and the materials supplier) have been co-opted into a tightly knit arrangement. The incentive structure could not have been better designed. An economist would therefore, conclude that market distortions have been minimized! Given that there are 40-60 applications received daily by VMC, we are looking at a susbtantial remuneration. Even at an average of 50 connections daily, with a rent of Rs 1000 per tranasction, we have a Rs 1.3 Cr to Rs 1.5 Cr economy!

Interestingly, there is a simple solution to this. Outsource the process of executing connections, while more intensively monitoring the processes at the Citizen Charter. The citizen would apply at the Citizen Charter Counters, then come back after two days and make the payment, and the outsourced contractor will then execute the work for a flat rate. The interface with the AE or other Muncipal officials is restricted to that at the Citizen Charter Counter. In fact, it can be a simple thumb rule of governance, that reducing rent-seeking requires minimizing citizen-official interfaces and interactions.

Monday, June 18, 2007

Describing "Life"

My shortest post yet, but the sweetest!
"Life is understood backwards, but must be lived forwards", 19th century Danish philosopher, Soren Kierkegaard, on how historians explain events only after they unfold. How I wish, I could have have said this!

Sunday, June 17, 2007

Bestseller Lists

I assume that the purpose of publishing a Bestseller List is to help readers make informed choices about their next purchases, much like the stock market prices claim to indicate the underlying fundamental value of shares. But I am afraid, like in the stock market, here too the customers end up making uninformed choices. Here is why.

The Best Seller Lists are normally prepared based on the sales information of books in that particular week. Some of them may have been released before the week and some released in that particular week. The Non-fiction top five in a leading newspaper today read like this: India's Unending Journey (Mark Tully), Confessions of a Swadeshi Reformer (Yashwant Sinha), India After Gandhi (Ramachandra Guha), India, The Next Global Super Power (Namita Bhandare), and Discordant Democrats (Arun Maira). Now, I will stick out my neck and say that I have serious objections with atleast three of the books finding a place in this list. But given the publishing houses and the specific nature of each of the three books, I am not surprised. I am also confident that, except for maybe two, none of the rest will find place in the list two weeks hence.

Does this list give the potential buyer any valuable insights into his next purchase? I do not think so. In fact, I will claim that given a list of all the releases for the past 4 weeks, the list could have been predicted, and with some luck even the order of sales. Mark Tully and Ram Guha are predictable, though their presence in the list only reinforces their already considerable star power and says little about the quality of the book. (The other three are also predictable, for other reasons) It is also interesting to note that three of the books were released in June and two in the second half of May.

The popularity of a book in the immediate aftermath of its release is undoubtedly a wrong barometer for judging the quality or standard of the book. It is something similar to the first day or week, of the latest blockbuster movie release. Have we not seen numerous blockbuster movies run out of steam within the first week itself? Unlike movies, book demand is more inelastic or sticky, and therefore takes a longer time for the market forces to play itself out and adjust to the real demand. It is understandable that a new book by Gabriel Garcia Marquez or Bill Gates or Manmohan Singh,would jump straight into the Best Seller list. (In fact if Indra Nooyi or Lakshmi Mittal or even Shilpa Shetty wrote a book, all of them would have to be in the Best Seller List, if only for a week or a month!) We ought to be surprised if it did not. Such a launch would only be a testament to the publisher's marketing skills rather than a judgement on the inherent substance of the book. Therefore, it may not be wrong to say that the Best Seller list ends up distorting the buyers preferences.

In fact, I am inclined to believe that such best seller lists are another marketing tool which helps the publisher drive home a book's instant popularity even higher. (One can argue that there is no contradiction between the publisher's marketing objective and the reader's right to read the "best" book. The publisher knows best, and marketing is anyway all about helping people make the right choices. The only problem with this line of thought is that what is right for the marketer is not always the best option for the customer!) It is also useful for potential publishers about the insights it gives them about the market of book readers.

However, these lists can still be useful for the buyer, in so far as it gives a list of those books we ought to be wary of purchasing! It is similar to the stock market, where we ought to be cautious of over-valued or bubble shares. In light of the above, we can conclude that though the bestseller list can contain the good books, thanks to the nature of the modern marketing machinery it is also likely to contain the not so good ones.

How do we make the Bestseller List more reflective of what is inside the book, so that it can help readers make informed choices? One way is to take into account the sales information for longer periods of say, three months and more, for listing out the Bestseller. Another, is to include only books with a publishing time lag of say, one month, in the list. (This of course has obvious disadvantages, but still helps the buyer) I am sure there are other parameters which can directly measure or atleast be a proxy for the quality of the latest book releases.

Friday, June 15, 2007

Democracy in the Middle East

The latest battle in the never ending Middle Eastern saga is unfolding in all its ferocity. Only difference is that this time the battle lines have been redrawn, the combatants are both Arabs and for a change, the fighting does not involve Israel. Yesterday, the split between Hamas, the militant Islamist group fighting for an independent Palestinian State, and the Palestinian Authority (PA) got formalized with the Hamas seizing control of the Gaza Strip. This appears to be the final nail in the coffin of the Government of National Unity. The dismissal of the Hamas led Government of Prime Minister Ismail Haniyeh by the Fatah leader and Palestinian President Mahmoud Abbas, precipitated this final act in the tussle between Hamas and Fatah.

With this denouement, the Hamas controls Gaza and the Fatah exercises its control over the West Bank. So, finally instead of a single independent Palestinian State, we may end up with two beseiged and moth eaten Palestinian entities, fighting each other instead of Israel. Or, more comically, we could climax with a three state solution - Israel, Gaza and West Bank! It will become another addition to the overflowing cupboard of half-truths and ironies, that is the trademark of Middle Eastern politics.

This is the latest twist to this round of peace moves between Israel and the Palestinians, initiated in Oslo in 1993. The 2006 elections to the Palestinian Authority, widely hailed as the first ever peaceful exercise of democratic rights in the Arab world, saw Hamas emerge as the victor, much to the chagrin of the Fatah, which controls the Palestinian Liberation Organization (PLO). The rampant corruption and lawlessness which marked the rule of Fatah, was considered responsible for their electoral defeat.

This dissolution of the National Unity Government is tantamount to a coup d' etat on a democratically elected government, one elected with a majority that George Bush and co can only dream about. And predictably, the great upholders of democracy in the world have responded to this "murder of democracy" by cutting off all humanitarian aid supplies to the Gaza Strip! This was the reward to the 1.5 million resident of Gaza for not opposing the Hamas takeover! There was not a word of concern at the blatant dismissal of a democratically elected government.

This policy is in line with the glorious tradition of American support for "democracy" in the Arab world. Democratic process is initiated, elections are held, an "untouchable" group emerges as the winner, then the US gets restless, get the army or some renegade right wing element to sabotage the process, finally dismiss the democratically elected government, democratic process gets initiated again....! In Algeria in the late nineties, the Islamic Salvation Front threatened to win a reasonably free and fair elections, and the army stepped in. History is repeating itself in Palestine, with the "dangerous" and "terrorist" Hamas being kicked out of a democratic office by undemocratic means. And George W nods in approval of Mahmoud Abbas' actions.

Lesson to be learnt. It is fine with democracy so long as you kow-tow our line. If you decide to act in the genuine interests of your country, and in the Middle East that invariably means against the interests of the US and Israel, then you are an outcaste. If in the process democracy is the casualty, then who wants democracy!!

Thursday, June 14, 2007

A case for Water Meters

Vijayawada has been witnessing a compelling and heated debate about whether to install water meters for individual household water connections. I am convinced that the case for water meters is a no brainer. Here is why.

Before, I venture any further, a few lines about how water reaches your homes. The raw water is taken from Prakasam Barrage and subjected to rapid gravity filtration and chemical treatment at the KL Rao Head Water Works. The treated water is pumped using high power motors, through huge iron pipes, to the over 50 reservoirs at different locations in the City. The water is then released into the distribution network according to a fixed time schedule, wherein each area gets supply at a specific time. The topography of the city necessitates using booster motors at a number of locations to pump water up the hill slopes. (About __ lakh people reside on hill slopes) The entire process from treatment of raw water to delivery at household is very expensive, with electricity cost alone coming to nearly Rs 6 Cr every year.

The basic minimum requirement of any quality urban water supply system is that it should supply adequate, un-polluted, leakage free, uniform pressure, and of course affordable water, to its consumers. From the service providers' perspective, it is necessary that the system have minimum unaccounted for water and the least Operation & Maintenance (O&M) cost. Let us visit each of these desirables and analyse them.

Adequacy is linked not only to quantity, but also time. The network may be supplying more than adequate water over a two hour period, but when the householder may be at work or away. This is typically the case in urban households. The opportunity cost incurred in waiting for collecting water is considerable. This also necessitates setting up storage sources, with all its attendant health risks. In fact, one of the major causes of mosquito breeding in the hill slopes of Vijayawada is residual water in the many storage vessels in each house. It of course too obvious to state that with every additional hour of supply, the adequacy problem gets solved automatically.

In a regime of intermittent supply, the distribution lines are empty or not fully filled at any time. Further, it is commonplace to see water supply lines going under culverts or laid alongside side drains. Therefore, any leakage at such locations makes the distribution line vulnerable to ingress of water from these drains or other external sources. The potential for such contamination is significant when the distribution pipeline is not fully filled. In contrast, if the supply is continuous, there is positive pressure inside, thereby preventing inflow of water into the pipes.

Intermittent supply means different areas are supplied water at different times, with the areas loosely separated by a number of manually operated valves. In a labyrinthine network as in any urban water supply network, it is impossible to do this in any scientific manner, and is often operated in response to temporary shortfalls and demands. We therefore have hugely varying pressure distribution across the network. In fact, if one street gets water with 7m head for 2 hours, don't be surprised to see supply in the neighbouring street with 3m head for just 30 minutes. In the absence of adequate delivery pressure, over three-quarters of households, especially the multi-storied ones, in Vijayawada use motors to increase the delivery pressure. It has been found that the approximate cost of running an 1 HP motor everyday for just an hour, comes to Rs 250, whereas the maximum water bill is only Rs 80!

Intermittent supply also imposes heavy demands on the maintenance of the network, especially at the numerous joints, bends and valves. When water is suddenly released into the network, it impacts on these parts with considerable force. Such repeated pressure invariably leads to their dislocation and unravelling, thereby causing leakages. However, if the supply is continuous, there is no pressure on these vulnerable parts of the network, thereby minimizing the chances of leakages. Further, being a significant source of O&M costs, any reduction in leakages will bring down these costs substantially. By minimizing our O&M costs, we can make the system more sustainable and even pass on the savings to the consumers. Besides all this, it is unarguable that intermittent supply inflicts more costs on the poor than the rich.

As you can see, things start becoming more clearer now. If we are to achieve all the aforementioned, desirables in urban water supply system, it is now universally acknowledged that we need to move from intermittent to continuous supply. But continuous supply means, magnification of the present wastages, over the 24 hour period. It therefore becomes imperative that we measure consumption at all levels and eliminate unaccounted for water losses. This will in turn again cut down our expenditure and help us pass on the savings to consumers. As you can see, it is a virtuous cycle all the way!

I have heard a number of arguments against meters, which can at best be attributed to ignorance. Some argue that nobody wants continuous 24 hour supply. But they miss the point that everybody want pollution-free, leakage proof, and high pressure supply, which can come only if supply is continuous! Others argue that meters get spoiled too frequently or show wrong readings. Another justification for having continuous supply, since the intermmitent nature of supply means water suddenly hitting the meterscausing damage, air circulating in the network causing wrong readings, and the need to use motors. Some others argue, with more justification, that meters can cause higher water tariffs. This can and should be addressed by an appropriate system of Increasing Block Tariffs (IBT), so as to assure a reasonable quantity of water at the minimum cost to citizens.

Far from being a cause for burden on the poor, meters can be a powerful instrument in ensuring equitable distribution of water supply. It is well documented from experiences across the globe that in an intermittent supply regime, the richer households consume much more water, at the expense of the poor. In Vijayawada too, while people living in slums struggle with 5 to 10 buckets of water daily, those in other localities have enough water to clean their cars and water their lawns. In the absence of meters, both pay the same amount. We therefore have an interesting irony, with the poor subsidising the rich!

Numerous studies show that an average middle class household can consume no more than 8 to 10 kilolitres a month, for all their basic needs. We could fix this as some sort of a benchmark requirement, to be supplied at the minimum tariff, with additional amounts supplied with escalating tariffs. The number is beside the point, the important thing is that a more serious and informed debate should start atleast now.

As you can see, opposing water meters is something akin to opposing the messenger, while accepting the message. We fail to realise that water meter is only a device used for measuring consumption, and not the demon that it is made out to be.

Tuesday, June 12, 2007

Rawlsian Test for Policy Making

How does the Government make decisions and policies affecting its citizens? What are the motivations behind policy makers favoring one set of alternatives over another? Are there any specific normative guidelines or thumb rules to which these decisions or policies are subject to? This assumes great importance given the profound impact of even minor policy decisions of the Government on the lives of many people.

Former Harvard Professor, the late John Rawls, outlined an interesting principle in his famous book, "A Theory of Justice". Rawls' concern was with the rules governing the distribution of what he called "the primary social goods" in any society. Primary social goods consist of the basic civic rights and the minimum socio-economic advantages necessary for a citizen to start his life at an equal footing with anybody else. He defines an "original position", before the rules and conventions governing our society were formulated, from where individuals have to make a decision about the distribution of the primary social goods.

"No one knows his place in society, his class position or social status, nor does anyone know his fortune in the distribution of natural assets and abilities, his intelligence, strength, and the like. I shall even assume that the parties do not know their conceptions of the good or their special psychological propensities. The principles of justice are chosen behind a veil of ignorance." (Rawls)

From behind the "veil of ignorance", the individual in "original position" would necessarily select two principles of justice which would create the structure of the society - Liberty Principle and Difference Principle. Under the Liberty Principle, "each person is to have an equal right to the most extensive scheme of equal basic liberties compatible with a similar scheme of liberties for others". The Difference Principle postulates that social and economic inequalities are to be arranged in such a way that
a) there should be a "fair equality of opportunity" for all citizens in access to offices and positions
b) they should be inclined towards the least-advantaged members of society (maximin rule)

The "maximin" rule (maximizing the minimum gain), advocates that given the choice of defining the rules that would govern the socio-economic structure of the new society, every individual would make a choice that produces the maximum gain for the worst off. This is understandable since the individuals in the "original position", behind the "veil of ignorance", would not be aware of even their own strengths and weaknesses. They would therefore have to hedge themselves against the worst possible eventual ordering of individual attributes and the society.

To the extent that the forces of naure will anyway favor those already endowed, with more advantages, our concern should be with trying to take care of those lesser advantaged and those disadvantaged. This can be met only by providing equality of opportunity for all individuals at any point of time, or atleast at the beginning, so that anybody disadvantaged due to factors beyond his control, is also given an opportunity to overcome his handicap and achieve any status he aspires to. This is the basic minimum requirement for any individual in the society to strive for improving his condition. In its absence, the privileged becomes more privileged and the under-privileged become worse off, and in the process the society stagnates.

Any Government policy on education, health care, land reforms, or other welfare and development issues should necessarily be subjected to this test. In a world where every individual has varying natural and social endowments, it is only natural that there should be serious problems with access to basic opportunities. It is therefore the cardinal principle of natural justice and good governance that all the citizens should have equal access to every service and facility offered by the Government. The maximin rule in the difference principle, is the ideological justification for government interventions like subsidies, affirmative action, progressive taxation etc, which are essential for ensuring equality of opportunity. It is the only way of ensuring that government policy does not get captured by vested interests.

Our policymakers, both politicians and bureaucrats, ought to keep this vital principle in mind while formulating any policy or taking a decision. They ought to be asking the question, "Does this policy (or decision) promote the maximin principle"? In fact, this principle should be a necessary condition for any policy or decision.

Monday, June 11, 2007

Corrupt Individuals and the Lifestyle Paradox

There is an interesting characteristic about rent seeking individuals in Government. If one were to closely observe the lifestyles of the majority of our protagonists, it is common to see a near total lack of any display of ostentation. In fact, most of the corrupt individuals would surprise us with their remarkable material simplicity. I have seen numerous individuals, who by any yardstick would have earned enough to afford very comfortable lives, with extremely spartan sartorial sense, and without even a minimal display of a good lifestyle.

Let me explain with a couple of examples. There was this Town Planning Building Inspector, caught by the Anti-Corruption Bureau, with assets worth above Rs 4 Cr, whose physical appearance and lifestyle would embarrass a pauper. Another observation, I am sure you will agree with me that middle class families can easily afford atleast the smaller cars. So it is all the more surprising to find even higher level officials using the ramshackle Mahindra jeeps of decades vintage used in Government, for taking out their families. Faded and old shirts, fraying collars, repeated use of the same dress, torn sandals, use of old and ramshackle vehicles etc are some common distinguishing features of such individuals.

The common argument is that by deliberately avoiding any signs of conspicuous consumption, these individuals are trying to deflect any attention from themselves. But ironically, by consciously downplaying their incomes and trying to give an exaggerated impression of penury, the more corrupt individuals may actually be unwittingly signalling themselves out in the crowd! What makes this even more stark is the contrast with the less corrupt or honest officials. The majority of these individuals lead normal lifestyles, commensurate with their incomes.

Taken to its conclusion this argument would make it impossible to spend money on anything. Though this consideration would be certainly working in any individual's mind, the extreme frugality exhibited by some individuals goes beyond any reasonable yardstick. In any case, the behaviour of these individuals clearly appear to deviate from Thorstein Veblen's universally applicable Theory of Conspicuous Consumption.

My observations are confined to those I have seen and interacted with in my eight years in Government. However, I think it is a big enough sample to form certain hypotheses, which need to be then tested more rigorously against available data. Do we have a lead for anti-corruption agencies? I am inclined to believe that we do have one. How about targetting the more suspiciously under-dressed and those consciously displaying a lack of ostentation in their lifestyles? You will agree that instead of the more difficult task of going after those with incomes disporportionate to their known sources of income, it would be much easier to target those with lifestyles disproportionately lower than those with similar incomes. My guess is that both would be the same!

Saturday, June 9, 2007

Targetting Subsidies

That subsidies suffer from a major targetting problem is widely acknowledged. The former Prime Minister of India, the late Mr Rajiv Gandhi famously said that only 15 paise of the rupee spend as subsidies actually reaches the intended beneficiary. A Planning Commission report bemoans that only Rs of the Rs 3.65 spent on food subsidy actually reaches the beneficiaries. It is also well acknowledged that a significant proportion of any subsidy is either skimmed away by those who are not eligible for the assistance or lost through rent seeking activities or frittered away in the bureaucratic maze.

A subsidy is intended to either boost consumption or to boost production, ie it should facilitate either an upward shift in the demand curve or a downward shift in the supply curve. It is introduced by the Government to take care of market failures. Classical economic theory teaches us that any subsidy should, to the extent possible, be directly delivered to the end user. Therefore for a service subsidised by way of lower prices, it is most efficient if the government directly pays the subsidy differential to the beneficiary, instead of artificially keeping the prices low.

These direct payments to the beneficiaries would reduce the massive market distortions that creep in by way of lower prices. These lower prices distort the market in more ways than one. It causes skewed consumption patterns (power, diesel, fertilizers), adulteration and fraudulent practices (kerosene), pilferage (PDS), unaccounted for consumption (water supply), and ineligible beneficiaries (housing). By transferring the subsidy directly as cash payments to the beneficiaries, wherever and to the extent possible, we are eliminating market distortion problems and reducing the problem to one of identification of the subsidy beneficiaries.

What are the major subsidies of the State and the Central Governments? The Public Distribution System, Welfare Pensions, input subsidies to farmers, procurement subsidies for agriculture commodities by way of Minimum Support Prices, subsidised rural and urban housing, subsidised urban civic services, public transport, self employment, kerosene and petroleum products.

Agriculture input subsidies and the Minimum Support Price on procurement are classic examples of wrongly directed subsidies, which not only suffers from huge leakages but distorts the market for agricultural commodities. It causes overuse of certain categories of fertilizers and under use of certain others, and similarly skewed production patterns among agricultural commodities. Instead if these price support and other subsidies can be delivered directly to the beneficiaries by way of direct payments, we can susbtantially reduce its ill-effects. In fact these direct payments in turn can be delivered to the farmer by bundling it with some other public service accessed by the farmer (by way of reduced cost on that public service). With the extensive use of kisan credit cards, we can even think of transferring payments directly to the farmers, as is done in the US.

What are the urban civic services, which can be better targetted by direct subsidy payments to the beneficiaries? Public taps are located in certain poor locations on the pretext that those people cannot afford the connection charges and the monthly tariffs. But these taps suffer from the problem associated with any common resource - overuse. A more economically efficient way of delivering this subsidy would be to identify the three or four houses in the locality requiring such support and providing them individual household connections. The connection charges can be lowered (there is more economic logic in even giving them connection without connection charges!) and the monthly tariffs can be subsidised and this subsidy amount can be delivered back to them through lower bi-annual property tax assessment. This will eliminate the problem of overuse and capture by ineligible beneficiaries. The same logic can be extended to other utility serices like electricity, sewerage etc.

As a corollary, we can collect different user charges through established revenue streams like Property Tax. Electricity charges are another well established revenue stream, which can be utilised for bundling other revenue streams. Though there is a provision of collecting user charges from bulk garbage producers like hotels, hospitals, vegetable shops, auditoriums, schools and colleges etc, it has proved very difficult to collect the same. Instead, the average user charges, quantified for different categories of generators, can be factored into the Property Tax of these bulk garbage generators. For those very big generators, who are smaller in number, we can continue to collect user charges based on the quantity.

Lower prices for diesel and kerosene distorts the market in more ways than one. Kerosene subsidy can be delivered directly to the consumer, by say again, lower property tax on the house or some other means. Diesel subsidy can be directly delivered to the vehicle owner by lower Motor Vehicle Tax or susbidising his vehicle loan repayments. The subsidy on public transport tickets can be delivered directly to say children, through say, lower school fees.

This arrangement of direct payments requires extensive monitoring mechanisms and database management. At a time when e-Governance infrastructure is developing rapidly, we ought to be initiating these interventions in such important process areas. This is not to claim we can do this everywhere. But wherever we can, we ought to be delivering subsidies through direct payments than by tinkering with the price mechanism. Indeed the first option for us to deliver subsidised services should be through direct payments. It will go a long way in eliminating, market distortion, pilferage and wastage, and free-riding on public resources.

Friday, June 8, 2007

Are we missing the most corrupt?

Classical economics assumes all individuals are rational economic agents. It is presumed that all our actions are taken based on a logical and rational cost-benefit analysis and considerations of the environment in which we operate. The rational economic agent has also been the basis of many traditional analysis of bureaucracy. This world-view has however been fiercely disputed by economists of different ideological shades.

I have been for the past eight years, an interested and an increasingly curious observer of the very vibrant corruption market in Government. This experience has exposed me to certain characterisitcs of this most universal and ubiquitious of social practices, which defy rational explanation. I will briefly outline two of them which I have observed, and try to analyse what any rational individual ought to have done under the circumstances.

Before I venture any further, I must make it clear that all my observations are of the general and may deviate significantly from the particular. In the light of even my limited experience, given the diversity of human behaviour I am convinced that corruption market cannot be fitted into the neat Bell Curve analysis that is characteristic of classical economic systems. In fact there could be many instances of large and unpredictable deviations in behaviour from the norm, ie, the long tail. I have myself observed unpredictable abberations from the norm on numerous occasions with many officials.

First, it is clear that any rational individual ought to be making as limited transactions as possible, so as to minimize the chances of being caught. Given that every transaction carries the imminent threat of being caught, it would make great sense to do as few transactions as possible, and make each transaction count. But I have observed that many of the transactions are sub-optimal (ie, the agent does not realise the full willingness of the victims to pay for the act), and the agents generally do not discriminate between opportunities (we thus see attempts to make money in every opportunity). For example, I have seen Engineers and Town Planners, with plethora of opportunities, biting off more than they can chew by claiming shares in even sub-optimal (smaller amount and the inherent danger) transactions. We can probably explain this in terms of avarice, which unlike other attributes, does not obey the traditional law of diminishing returns.

Second, like any other market, corruption too depends on certain exogenous variables. It is to be expected that rational individuals respond to the external system and adapt their behaviour. But I have seen numerous instances where greed gets the better of the individual and he carries out transactions under extremely dangerous and unfavourable conditions, thereby exposing him to a greater than acceptable risk. There seems to be a general reluctance among officials to wait and see how the environment develops before taking the plunge. Thus we see sub-ordinate officials unwilling or unable to bide time till say, a very strict Head of Department gets transferred or a period of heightened vigilance passes off.

So how does a typical corruption market play itself out? It would seem that when faced with the lure of money, most agents seem to give a go by to rationality. Do we conclusively presume that while indulging in corruption, officials do not function as rational agents and are captives of avarice, capriciousness and opportunism? Assume Mr Superior and Mr Subordinate, who are working in the Department for Prevention of Corruption. Mr Superior is the Head of the Section where Mr Subordinate and his numerous other colleagues are working. We can also safely presume that the Department is fairly representative of corruption in Government.

My experience has convinced me that multiple and sub-optimal transactions are more common among Mr Subordinate and his colleagues, who also believe in not discriminating between situations and prefers a continuous cash flow. This should come as no surprise, since the potentially smaller amounts in each transaction at this level would necessitate regular and greater number of transactions. Given these multiple transactions by each individual, there is naturally a very high probability of getting caught. Further, since there are larger number of sub-ordinate staff, a greater proportion of transactions which get detected ought to involve them.

What skews this distribution even further, is the entirely opposite nature of observed corruption at the level of Mr Superior. The potential reward from each transaction is much higher for Mr Superior. This may partly explain why he and his ilk are generally selective about their opportunities and are willing to wait for the opportune moment before striking gold. His defence becomes even more impregnable if he starts to act like a rational agent and decides to carefully select his opportunities and minimize his transactions while optimizing the returns from each transaction.

Mr Subordinate and his friends therefore get a raw deal on two counts. They become vulnerable not only due to the higher number of transactions and their impatience to wait for the right opportunities, but also due to the ability of Mr Superior and his colleagues to evade more intense focus on their activities. This coupled with the much smaller number of officials in the category of Mr Superior ensures that Mr Subordinate and friends gets caught a disproportionately higher number of times. I have done some calculations of the typical corruption economy in Engineering and Town Planning Departments in Municipal Corporations. The higher level officials have only a one-fifth chance of getting caught and indulge in transactions that are atleast ten times bigger than that done by those at the lower levels.

It is therefore reasonably safe to conclude that those few individuals operating rationally by transacting fewer and only the bigger opportunities and adapting to the environment, have considerably lesser probability of getting caught in the act. It may also not be incorrect to presume that such clinically executed and and bigger transactions generally evade the radar of detection agencies. If this is true, then there is a bigger category of the really corrupt, but rationally operating officials whom or anti-corruption agencies have not yet focussed on in the manner they ought to be doing. In fact does it meant that our anti-corruption wings are unaware of the actual extent of problem? Don't you think our anti-corruption agencies are barking down the wrong tree? These are important lessons to be learnt for the vigilance and other anti-corruption agencies.

Sudhir Venkatesh of Columbia University has done a pioneering study of the drug peddlers of Chicago and New York by embedding himself in that undergorund economy for nearly a decade. The study revealed a number of fascinating insights about the mind and motivations of drug peddlers. Someone ought to do a Sudhir Venkatesh and study the corruption market by emebedding himself in it. I am sure it will help us draw more definitive conclusions about the workings of this economy - the motivations driving its actors, the success and failure ratios, failure costs and success windfalls, the nature of interactions between actors, potential limit of transactions, limits where rationality breaks down, cost benefit analysis of transactions etc. In particular, I am interested in finding out what percentage of officials and what category of them do get caught,and what proportion of transactions are successful.

Tuesday, June 5, 2007

Government and Communication Strategy

We have all seen Governments grappling with the challenge of selling an agenda to its citizens. There are numerous instances of governments unable to push through serious reform agendas and perish in the process. Whether it be hiking tariffs and user charges or increasing any kind of taxes, or cutting costs by introducing newer technologies or pruning bureaucracy, or initiating collaboration with the private sector by privatization or outsourcing, we face a very serious problem in communicating the message to the stakeholders. In its absence these reforms invariably remain still-born or meanders along directionless.

Governments need to be in continuous communication with its citizens on every issue of governance - service delivery standards, effective utilisation of civic assets, reforms and changes, and developing civic repsonsibility in citizens. This assumes greater importance in view of the emergence of the forces of globalisation and liberalisation, which have led to massive changes in service delivery and governance. It is necessary that citizens are aware of the challenges facing them due to these changes and reforms and they need to be better informed about how to adapt to this changing environment. If the citizens are not properly equipped in dealing with these changes and new technologies, both the city and the citizen, in particular, risks falling behind, with serious medium and long term socio-economic and political consequences.

Let me try to run through some of these issues. One of the biggest and ever enduring problems facing our cities is that arising from severe deficiency or even absence, in many cases, of civic responsibility among our citizens. Our urban governance priorities also find no place for proactively inculcating this softer and much more important issue of developing urban social capital. Urban administrators focus immense amounts of energy on infrastructure development and service delivery issues. If we could devote even a small percentage of this time and priorities in developing civic sense among our citizens, it would be an invaluable multiplier on ensuring more effective utilization of these assets and efficient delivery of civic services.

I can list out a number of infrastructure assets and civic services that are inefficienctly utilized due to the scarcity of social capital. In Vijayawada, for the past year or so, we have introduced door-to-door basket collection across the City, and have been encouraging people to collect all their daily garbage in a basket ever morning, so that a tricycle can come and pick up the same. Despite tremendous energy spent at all levels of the sanitation machinery in implementing this, we continue to have serious littering problems. In many residential areas, garbage and waste continue to be thrown into drains and roads. I can't think of any reason other than lack of even the basic civic sense for this persistance with littering despite the introduction of door-to-door basket collection.

Our water supply systems suffer from a chronic problem of wastage, reflected in our high Non Revenue Water (NRW) ratios. By any reasonable approximation at least 15-25% of our water is wasted by the citizens themselves. Similar figures apply for electricity consumption too. Our newly laid Under Ground Drainage (UGD) networks get immediately clogged with household waste and clothes and start overflowing. Even in areas with UGD network despite repeated efforts, people connect only their latrines to the sewerage line, and continue to let out their kitchen, toilet, and other waste water into the open drains. We encroach into the smallest available road margin and cover the drains with our steps, thereby prevent its proper cleaning.

Less said about our traffic sense the better. Each one of us seem to think that the road space is our sovereign right and we are operating in a vacuum around us. We do not even remotely realise the consequences of our actions on our co-road users. We are loath to follow even the traffic signals, cut across lanes as per our wish, and want road cuttings on dividers at every imaginable location which makes you wonder why have the divider at all.

Urban governance and service delivery is undergoing massive changes, and it is imperative that we take along all the stakeholders with us in this journey. We need huge resources to fund our massive infrastructure requirements. Funding agencies are understandably concerned that these resources be spent most efficiently and we get value for money from these investments. Naturally the focus has been turned on the inefficiencies and wastages in our system - low tax collection, massive free-riding on services, poorly targetted subsidies, huge NRW in water supply, sub-optimal utilization of assets etc. We need to embrace newer technologies, and work and service delivery processes like outsourcing and water meters; newer financing models like Build-Operate-Transfer (BOT) and Public Private Partnership (PPP); work in greater collaboration with private agencies through Partnerships and Privatization; put in place mechanisms to ensure sustainability of systems through adequate cost recovery and user charges.

I have not seen Government at any level, except for a few departments like Tourism, take communication strategy with any seriousness. The traditional Public Relations Officer (PRO) arrangement, whose only expertise lies in circulating dry and unreadable press notes about the routine activities of the Government, is not suited for modern day public communication challenges. In an age of diverse and rapidly growing communication channels, it is necessary for Governments to have a serious look at its communication policy. Routine and simple advertisements will not help us in keeping our surroundings clean, or reduce water or electricity wastage, or drain off our sewerage into the UGD network, or follow our traffic rules or help citizens understand the changes sweeping the world and how they should be adapting to those changes.

Professional communication strategy needs to be in place for communicating both the softer issues relating to developing civic repsonsibility and those relating to reforms and changes. We need to leverage the strengths of all the different channels of communication - electronic visual and audio media, newspapers, Internet, billboards etc. The content of the message has to be prepared keeping in mind the different audiences and their repsective access to the different media. In short, we need a full time communication strategy team in place. This is especially important in Urban Local Bodies, where massive urbanization, the huge infusion of funds and the tide of reforms under implementation, necessitates mandatory stakeholder participation and therefore the need for being in constant communication with them.

If we are to successfully address these challenges, we ought to dispense with our routine PRO and outsource our communication strategy to a professional agency. Even then it will be one hell of a task, but one which is one of our most demanding challenges. Unfortunately we still have not woken up to this challenge.

Saturday, June 2, 2007

Bureaucracy and adverse selection

Observing layers on layers of procedures and formalities in government bureaucracy for the past 7-8 years, I have often wondered as to why it needs to be so rigid to the point of being stifling. (I have limited experience of private bureaucracy to comment on it) All of us are aware that procedures and processes are only the operational infrastructure for achieving certain specified objectives of the Government. But bureaucratic systems often tend to elevate and see the means as ends in themselves, thereby defeating the very purpose of having in place those rules and regulations.

There are a number of theories which seek to explain and analyse the functioning of any bureaucratic system. These theories range from those of Karl Marx to Max Weber, Rational Choice to Public Choice schools, and the more recent ones invloving interest groups and pressure groups. Into this multi-dimensional debate, my personal experiences suggest that the "adverse selection" analysis is appropriate. It will highlight the crucial adverse selection problem in the interaction between the layers of the bureaucracy. This problem breeds suspicion and apprehension among agents, thereby necessitating and even justifying the mitigating mechanisms of the rule-book.

Nobel Prize winning economists George Akerloff and Joseph Stiglitz, conceptualized the "adverse selection" problem as arising from an inability of the market to recognise "lemons". A lemon is a defective item put up for sale. The presence of lemons throws up interesting possibilities in certain markets like those for used cars and insurance. Both these markets suffer from what economists call "assymmetric information" related problems. The sellers in these markets - used car owners and insurance claimants - have more information about the commodity on sale, than the buyers. For example in a used car market, in the absence of full information about the quality of the car, the buyer will be unwilling to pay the full price for even a good condition car. Similarly, sellers of good cars will be hesitant to put up their cars for sale since even good cars are likely to trade only at a discount. This dual effect is likely to see the market being occupied more by lemons than good quality products, thereby further deepening the information assymmetry problem.

A bureaucracy too suffers from an acute problem of this adverse selection. Government transactions are institutionalised by way of layers of procedures and processes, and elaborate file work to capture the same on record. Among other things, this is necessary to ensure consistency in policy and decisions, reduce subjectivity and individual biases, facilitate monitoring and supervision, maintain records for future reference and limit rent-seeking opportunities. They help protect the system from both the willful and involuntary actions of the lemons or rogue individuals.

Let us imagine every transaction in government - file approvals, decisions etc - as an interaction between two layers of the bureaucracy, involving sub-ordinates and the supervisor or the principal and agent(s). Like in the case of insurance, where the presence of lemons increases the transaction costs, in bureaucracy lemons contribute towards making it more rigid and rule oriented. Lemons act with different motivations - malafide intentions, ignorance of rules and processes, over-enthusiasm and haste, and even plain incompetence. Given the presence of lemons, prudence demands that the principal and the agents look at every transaction with great caution. This atmosphere of suspicion, necessitates the validation of processes and actions at every step.

In fact, one could say that the most immediate and in many ways the most important concern for any official is the need to protect himself from the consequences of actions of other agents in the system, especially those with suspect intentions. This caution gets institutionalized and translated into a set of formal procedures and processes, captured typically in a set of file notings. In a way, this standardization tries to bridge or mitigate the assymmetry in information betwen the official and the lemon. In the absence of any mechanism to screen the lemons, agents see a potential lemon at every step, and see all transactions with the same level of caution. Once caution becomes the by-word, procedures and formalities come to fore, as individuals try to hedge their risks by submerging the process in a sea of bureaucratic procedures and formalities. Therefore one could even say that in the absence of adverse selection, a significant rationale for inflexible bureaucratic procedures would cease to exist.

Since adverse selection is a reality, we need take steps to limit the problems arising from it. Akerloff and Stiglitz argue that this requires reducing the assymmetry in information. This in turn calls for putting in place effective signalling mechanisms which can eliminate or atleast bridge this information gap. The agents (sub-ordinates) ought to be looking for every opportunity to signal their intentions and message to the principal (supervisior), who in turn should be receptive to the signals coming from the agents. These signalling mechanisms should work continuously and on multiple channels within the system. It should involve a mixture of both the formal and the informal.

The informal channels rest mainly on the bonds of trust and reciprocity in relations between individuals in each layer. The principal should be accessible to the agents at all times. Healthy work place relationships between the principal and agent, regular informal briefings, mentoring programs, etc can contibute susbstantially towards developing mutual trust. It is necessary to actively promote development of social capital within the organization or department.

The formal channels, consisting of institutionalised networks have an equally important role in eliminating this information assymmetry. Regular meetings, standardizing reporting formats and information flow, and inspections can go a long way towards bridging any gaps between layers. Internet and its numerous social networking technologies like bulletin boards and blogs are also powerful tools in facilitating free flow of information and reducing the assymmetry. For example, regular interactions through a common website can help agents in different layers understand each other better and help disseminate information across large sections of the system.

It is only by keeping open vibrant and continuosly active interaction channels across bureaucratic layers that the information assymmetry can be bridged and trust developed. This can then be leveraged by both the principal and agents to cut through the bureaucratic maze and expedite service delivery. At least wherever the interaction is free from adverse selection, the red tape can be curtailed. I am sure many of these channels are active and vibrant in corporate bureaucracies, and it may be a partial explaination for the lower level of red tape.

My objective by way of this analysis was only to highlight a critical area of concern in the interactions between the principal and agents in a bureaucracy and why we need to contain this. If we are to overcome this red tape we need to get beyond this mind-set and set up multiple signalling mechanisms, both informal and formally institutionalized, within the bureaucratic system. This will assure and comfort principal and agents in a system about the intentions behind each others actions. Ultimately each interaction has to find its mutually comfortable level of working relationship, which in turn will have to be adapted to the existing bureaucratic environment.

Friday, June 1, 2007

US Current Account Deficit

There as been an interesting debate going on for the past decade about the burgeoning US current account deficit. Even as the world is accumulating savings at a frenetic pace, America is busy consuming it. In March 2005, Ben Bernanake, famously suggested that the world was suffering a "global saving glut". Asian Central Banks have been buying into dollar assets, especially US Treasury Bonds, with a voracious appetite. Ken Rogoff of the Harvard University called this massive influx of funds from the emerging economies as the "biggest foreign-aid programme in world history", with Asian Central Banks subsidizing American consumption and housing boom. How do we explain this twin phenomenon of "savings glut" across the world and the run down on savings in the USA? (the American household now saves less than 1% of their disposable income)

The US current account deficit stood at a very high 6.1% of the GDP or $856.7 bn for 2006-07. In fact, the trade deficit for 2006-07 stood at $827 bn. In contrast Japan had a current account surplus of $181.5 bn or 4% of GDP, China $249.9bn or 8.1%, Germany $165 bn or 4.9%, and Saudi Arabia $95.4 bn or 18.2%. The entire South East Asian bloc, excluding China and Japan, had current account surplus of over $150 bn for the period. The oil exporters have been running up surplus of over $500 bn annually. Execpt for Britain, France and Spain, every other major economy was running current account surpluses. The Euro area has also been continuosly running current account surplus. Trade surplus is the norm across the world.

Consequently, the Chinese foreign exchange reserves touched $1.2 trillion in April 2007, while Japan's reserves were $916 bn, Euro Zone had $451 bn, Russia $267 bn, South Korea had $247 bn, and India $204 bn. At the end of 2004, of the official foreign exchange reserves of all the countries, 66% were denominated in dollars, and 25% in euros.

Except for a couple of East Asian and Latin American economies, the consumer price inflation was at a historic low of 1-3% range. Unemployment figures have varied between 4-5% for the US over the past couple of years. Except for Japan, the 10 year Government Bond rates have been in the 4-5% range in all major developed economies, in the recent few years, the lowest since the 1960s. The global economy has been also growing in the 4-5% every year for the past few years.

We therefore have a high savings, high surplus, high growth Asia excluding Japan; high savings, high surplus, but low growth Japan and Germany; and a low saving, high deficit, and robustly growing America. The "savings glut" of Bernanke has coincided with a drop in investment across the world, except China, all the more surprising given the historically low interest rates and high economic growth rates.

China is in a league of its own. It has grown at around 10% annually since 1990. Its Gross Domestic Investment rate at 46% in 2006 is phenomenal and its Gross Domestic Savings rate at 50% is unprecedented, and continues its growth unabated. The Yuan, despite a slight relaxation in the band in July 2005, continues to be heavily supported with open market intervention by the Central Bank, and is undoubtedly under valued.

The other major story has been the oil exporters. Buoyed by the steep rise in oil prices and chastened by their reckless spending spree from previous oil booms, the oil exporters have been investing this windfall to form an oil stabilisation fund and the like. The growing savings in other emerging economies like India is understandable given the robust economic growth and productivity gains seen in the past decade.

Where have all these savings been going? The world has huge savings to invest, and America wants those savings. Ideally, I would like my investments to fetch good rates of returns and also be protected from any exchange rate risks. But these savings are going into the cheap US Treasury Bonds which are at historic lows, and faced with the spiralling current account deficit the dollar has been sliding, thereby further reducing the returns. But the massive flows from the rest of the world to the US continues, turning conventional economic wisdom on its head.

The Asian Central banks have been liberally deploying these huge savings to hold down their currencies by buying huge amounts of US Treasury Bonds.The windfall from the rise in petrol prices has also found its way into the US T-Bonds. Further, faced with the "savings glut", these economies have realised that their financial systems do not have the breadth nor the depth required to effectively manage these huge amounts. In the circumstances, emerging market Central Banks naturally find the US Government securities the safest bet, even with its low returns. Also dollar assets have another advantage in that they are much more liquid. As on March 2007, foreigners held US T-Bonds worth $2.2 trillion, of which China held $420 bn Japan $612bn, and oil exporters $113 bn.

There is a substantial body of opinion in the US that lays the blame for the deficit problem on China and its policy of deliberately holding down the yuan. They point to the huge Chinese trade surplus with the US and how it is causing a weakening of the dollar. The supply siders also blame the stagnant consumption, especially in Japan, Germany and parts of Euro zone. Bernanke himself subscribes to the view that the American deficit problem is not "made in the USA" and therefore has to have solution externally, in its originators. This supply side argument has its weaknesses. China and Japan account for less than 40% of the US current account deficit. Further, US takes only one-fifth of the Chinese exports. The US current account deficit has grown by more than five times the growth in the Chinese current account surplus. In fact, in pure numbers alone, the oil exporters have contributed a much larger share to the growth in the US deficit than the Chinese. Ultimately the fact remains that the massive inflow continues because there is an insatiable demand from the US consumers, and it will continue as long as that is not satiated. The "not made in the USA" logic is something akin to controlling prostitution by banning prostitutes without simultaneously addressing the demand.

The more interesting explanation for the rising deficit is the demand side one. The past couple of decades have seen historically low interest rates, unprecedented trade liberalisation, and active use of expansionary monetary and fiscal policy by the Government. All this has led to a massive spurt in imports from not only China but also from other East Asian economies. The historically low interest rates, coupled with low inflation and the huge variety of easy money generating financial instruments like flexible mortgage loans and its aggressive marketing by finacial institutions, sparked, in Greenspan's words an "irrational exuberance", spawning massive asset bubbles, first in shares and then in real estate. Unlike previous bubbles, which were confined to only certain sections of the society, these bubbles attracted a significant share of the population, and generated an "income effect" for them. Buoyed by this "wealth effect", the people started running down their savings and indulging in a huge spending spree, thereby generating the consumption boom. With interest rates at a historic low and housing equity liquid and easily accessible, Americans have completely given up saving on current incomes.

The massive tax cuts of George Bush in the early years of the millennium, the largest post-war fiscal largesse, and the decade-long loose monetary policy of Alan Greenspan meant that the Government policies were actively feeding the binge boom. In fact the irresponsible tax cuts of the Bush administration has compounded the problem by turning the budget from a massive surplus to ever growing deficits. The end result is that except for the private sector, all other sectors of the American economy are running growing deficits.

There is another school which interestingly finds nothing wrong with the rapidly growing deficit. They see it a sign of America's strength that foreigners want to have a share in the world's greatest economic machine. They even consider that this deficit has been the engine that has kept the world economy afloat at a time when the Japanese and European economies were in recession. They contend that without the generosity of the American consumers, China could not have sustained its spectacular boom and the East Asian economies could not have so quickly emerged from the crisis of the late nineties. They also point out that the US annual borrowing of $850 bn is nothing compared to the American household wealth of over S35 trillion. But this household wealth itself is built on the dubious and illusory foundations of a stock and real estate bubble.

They also say that American borrowing is unlike those of others, given the unique status of dollar, as the world's reserve currency. In contrast to other countries who borrow externally, America can issue bonds on its own currency. All its external liabilities are dollar denominated, whereas the major share of its assets are foreign currency denominated. at a time when dollar is weakening with respect to other currencies, the Americans would enjoy double benefit from both falling real value of its debt and rising dollar value of its assets.

So where does this all this leave us? It is only a matter of time before the Asian and the oil exporting countries start looking for higher returns on their investments. (In fact, China recently entered into an agreement with Goldman Sachs, paying it $3 bn, for managing a part of its massive foreign exchange reserves) But given the deep legacy of the recent stock and real estate bubbles, driven by massive borrowings, America cannot hope to raise its interest rates to provide higher returns, without creating a serious run on its over-loaned financial system. It is also clear that the East Asian and oil exporting nations cannot easily pull out their huge investments from US T-Bonds without huge repercussions, which will primarily hurt them. Any frenzied withdrawal could send the dollar into a tailspin and lead to huge fall in the values of these investments. For the US economy itself, this would spark off interest rates hikes and a meltdown. We could then have a classic Ponzi scheme unravelling, with both the US and the global economy tanking into a recession or even worse. The best that the Federal Reserve can hope is to manage the financial system for a soft landing.

In fact, faced with depreciating dollar, the Central Bankers have already realised the need to slowly reduce their exposure to the US market, and consequently the pace of reserve accumulation has already started slowing down, except with the Bank of China. China will also have to slow down its purchases of dollar, as inflationary pressures mount. The strengthening Euro has become an attractive investment option for many Asian Central Banks. The rebounding Japanese economy has also attracted investments in Yen denominated assets. Further, with the rapid evolution of the financial sector in these emerging economies and the arrival of sophisticated and safe financial instruments, these countries will no longer need to look outside for parking their burgeoning savings.

The unfortunate thing about the massive influx of foreign money is that it has gone into financing America's consumption and housing boom and its reckless fiscal bonanazas for the rich, rather than into any productive investments. The private sector investment has not grown at the rate necessary to offset the profligacy at the other side. Chastened by the massive investment binge in the 1990s, the corporate spending as a share of GDP is at its lowest in a quarter century, thereby keeping the exports sector dull.

So what is the outlook? It looks bleak to say the least, and we will need a miracle to prevent a hard landing. With net external debt of nearly $4 trillion at the end of 2006-07, America will eventually have to generate more internal savings and/or run up external surpluses to pay off its huge outstandings. This will require Americans to sharply cut down their consumption (which in turn poses other risks) and also increase savings. The private sector will have to increase the historically low investment rate, so that exports can be boosted. Given the grim deficit scenario, it is a fait accompli that America will need its exports to grow steeply to start repairing the damage. And it will have to start immediately. The depreciating dollar will surely help.

What will America need to stave off a hard landing? Internally, American households will have to start saving more and its corporates will have to start investing more, especially for the export sector. Exports will have to start growing. Inflationary pressures will have to be kept under check, so as to contain interest rate rises and further fall in dollar. The Government will have to repsond with fiscal rectitude and turn around to a surplus and immediately at that. The irrepsonsible tax cuts will have to be rolled back and pork-barrel curtailed. The real estate bubble will have to be deflated so as to achieve a soft landing that would not adversely affect the financial sector. This in turn again requires the interest rates to not harden too much.

Externally, continuing cheaper imports of manufactured goods from China and the rest will be of great help in keeping prices under control. Japan and Germany will have to start consuming more and saving less, so as to provide market for US exports. Hopefully the dollar continues to remain weak, without however precipitating any drastic fall in confidence or run downs on the dollar. The Asian and Middle Eastern Central Banks will have to remain persuaded to not start withdrawing their investments in a frenzy at any time. The exit will have to be managed carefully. The financial sector in the emerging economies have to develop quickly in its breadth and depth.

Now in real life, common sense dictates that however credit worthy I am, there is a limit to how much I can borrow or will be lent by bankers. In other words, I cannot live beyond my means for long periods of time. With great luck, I may be able to fool all my creditors for some time, but only for some time. Then the chickens come home to roost! It will require a near miracle for both the US and the rest of the world to come out of this mess!