When oil prices rise, Americans drive less!

NYT has this graph, which is an excellent example of how consumers respond to variations in prices. With gasoline crossing $4 a gallon, and the rising price acting as a tax on consumers, Americans appear to be cutting down on their drives.

Administrative Reforms - I

"Administrative reforms" (AR) is one of the most widely debated phrases in public policy circles. No discussion about governance is complete without AR. It is often seen as the one magic wand that can solve many of the governance ills that bedevil our polity. Numerous commissions have been appointed by successive governments to study AR, and the contents of these reports get dusted up with the same frequency as the change in Governments.

The main recommendations of these AR reports are the same - transparency, accountability, decentralization, changes in recruitment process etc. AR initiated so far have sought to either reduce the bureaucracy (a hiring freeze on central government bureaucracy since 2001), decentralization of authority and devolution of powers through the 73rd and 74th amendments to the Constitution in 1992, bringing in transparency in administration by promulgation of the RTI in 2005 etc.

These are all undoubtedly important reforms, critical to infusing a spirit of responsiveness in the bureaucracy, and will surely have some impact on the larger society and polity. But beyond addressing the issues at a superficial level, they fail to contextualize the reforms and appreciate the need to link with specific outcomes. They do not address critical operational challenges faced at the cutting-edge of service delivery. Therefore, by themselves these macro-level reforms are not likely to achieve much.

Popular (and even among more informed citizens) stereotype of the reasons for the inefficiencies in our bureaucracy and polity focus only on corruption and venality of the functionaries - bureaucrats and politicians. It has been widely argued that once we bring in transparency and accountability to the system, many of these problems will get resolved by themselves, and our administration will become more efficient. But experiences from across the world would indicate that such simplified diagnosis and prescription for improving administrative effectiveness may not be fully correct. For example, the Chinese (and previously the East Asian economies) bureaucracy and polity has none of these aforementioned desirables, but is still very effective.

Recently The Economist carried an article about the Indian civil service which captured a few interesting facets of our bureaucratic system, and in particular the work of a typical District Collector. It raised a very pertinent question, "India has some of the hardest-working bureaucrats in the world, but its administration has an abysmal record of serving the public".

The Economist paints the picture of the District Collector as a very hardworking officer, struggling with the diverse and complex challenges facing his district. As the most popular chronicler of rural poverty and development in India, P Sainath informs in his popular book, "Everyone loves a good drought", though many of India's most backward districts have been administered for long years by some of the best officers of the Indian Administrative Service (IAS), they continue to remain backward. It is clear that the outcomes have not been in proportion to the efforts and expectations.

Describing the work schedule of the District Collector of Jalaun district in Uttar Pradesh, The Economist writes, "Mr Samphel reckons he spends 60% of his time dealing with individual supplicants—also outside the collectorate. As the Ambassador turns back on to the road, it is waylaid by a tractor bringing a cartload of petitioners in from a distant village. Then one of Mr Samphel's three mobile phones bleeps. Someone wants firewood; Mr Samphel calls a forestry official to relay the request. It is a hugely impressive performance. Mr Samphel works 16 hours a day, seven days a week, and reckons he has had two days off since 2003. But this is hardly an efficient way to minister to a needy population almost half the size of New Zealand's!"

Yes, that surely is not the way Helen Clark administers New Zealand. Over the coming weeks, I will attempt to capture a few vignettes of the problems and challenges facing our governance systems. The first will be about the institution of the District Collector.

Amartya Sen on food crisis

In a NYT op-ed Amartya Sen describes the ongoing food crisis in terms of the tale of two peoples,

In one version of the story, a country with a lot of poor people suddenly experiences fast economic expansion, but only half of the people share in the new prosperity. The favored ones spend a lot of their new income on food, and unless supply expands very quickly, prices shoot up. The rest of the poor now face higher food prices but no greater income, and begin to starve.

There is also a high-tech version of the tale of two peoples. Agricultural crops like corn and soybeans can be used for making ethanol for motor fuel. So the stomachs of the hungry must also compete with fuel tanks.

He writes that the present crisis is caused not so much as a result of falling production, but accelerating consumption.

Incentivizing school attendance and performance

I have argued earlier here and here that conditional cash transfer (CCT) is a more economically efficient way of transferring welfare benefits to the poor. The latest post of Gary Becker and Richard Posner debate on paying children to attend school.

As Prof Posner writes, Milton Friedman was one of the earliest proponents of direct cash transfers to replace welfare programs. His contention being that people have a better sense of their needs than government bureaucrats, so that if the government simply gave poor people money they would allocate it more efficiently than the welfare bureaucracy would do. This is the philosophy underlying the US Government's program of Earned Income Tax Credit. Any moral hazard concerns can be taken care by making the cash transfers conditional to the recipients achieving certain pre-specified outcomes.

The Mexican Government's Progressa (and Oportunidades) program of mid-nineties sought to reduce child labour and improve school enrollment rates by paying poor parents to keep their children in school and to take them for regular health check-ups. It was argued that if the children remain in school and performs well instead of going to work, the families could be compensated for the loss in their children's earnings by direct cash transfers. Studies by economists in the United States and elsewhere clearly show that Progressa has succeeded in inducing the mainly rural parents in the program to keep their children in school longer than they would have.

Taking cue from the Progressa experience, private foundations and individuals have started experimental programs in New York (New York City Opportunity program) and few other American cities that directly pay poorly-performing, older children (and not parents) to incentivize them to remain in school and improve their performance.

As Prof Becker writes, "Rewarding these poor students for better performance is similar to the tuition scholarships and stipends that colleges award to students with good grades. To earn the "pay" offered, students involved will skip school less often. They will also pay closer attention to their teachers during classes and do more homework, so that they can do better on the standardized tests that are being used to judge their performance."

The moral hazard concern with such conditional cash transfer programs is that it will encourage some children who have been doing well to lower their school performance, so that they can qualify for the program. The program therefore ends up rewarding even those children who would have achieved good performance even without the cash incentive. Therefore the challenge with administering such programs would be to identify the right target group of children.

Prof Posner sees significant incentive distortions, in both parents and children, arising from such cash transfer schemes. He claims that such programs will continue the neglect of public schools, which may be the cause of the poor performance and drop-outs. He also foresees substantial transaction costs associated with implementing and monitoring such programs. Further, such programs do not mandate any sunset clauses which will end the cash support to the child.

However, these cash transfer programs can be more effective in promoting education in socio-economic contexts like in many Indian states, without stoking off incentive distortions. In many parts of the country, especially among specific communities, girl children drop out from schools very early. Further, during the harvest season, the parents have an incentive to take their children out of school so as to work in the fields. It is also true that many of these practices and trends cover the major portion of children in such areas that it may not be worth the transaction costs to target and exclude the small minority who attend school.

In such circumstances, it is important that the incentives be structured appropriately to meet the objectives. There are many different ways in which the cash transfers can be structured. The amount of cash transferred can increase with every class, and can culminate as a scholarship to attend professional courses. The cash transfer can be graded into a few categories, so as to incentivize children to perform well. Therefore while the best performers get the maximum cash transefr, the worst get the least. It may also be worth increasing the cash incentives for the worst performers in each class, so as to incentivize them to perform better in the next higher class. Further, in many backward areas of certain states, the enrollment rates are so low that merely keeping children at school is itself a challenge.

The transaction costs associated with such programs can be minimized by involving the women Self Help Groups (SHGs). Apart from the child attending school and performing well, such cash transfer can also be made conditional to the mother being a member of an active SHG. The cash transfer can then be made to the bank account of the SHG. This transfer can be made quarterly, based on the attendance and test results of the child. In order to avoid incentive distortions like grade inflation, there should be relative grading of the performance of children.

Such policies will have to be formulated by carefully analyzing the statistics available and tailoring programs to suit the specific local requirements. For example, the cash transfer can kick in at those classes where girl children normally drop out or for those months when children drop out for harvest. But given the different social context, unlike the New York program, all the cash transfers should be made to the parents.

Case for Gasoline Tax

Robert Frank makes out an excellent theretical case for taxes in general under certain circumstances, and gas tax in particular. Quoting Adam Smith, he argues that Smith understood that the invisible hand is often benign, but not always.

The exceptions occur when the costs incurred by the producers are not the only costs and/or the benefits enjoyed by the consumers are not the only benefits. In other words there are significant externalities, and especially negative ones. In such cases, the Marginal Social Cost (MSC) is not equal to Marginal Cost (MC) for the producer and the Marginal Social Benefit (MSB) is not equal to the Marginal Benefit (MB) for the consumer. Though equilibrium is reached when the MC equals MB, it is not an efficient equilibrium. He writes,

"The market reaches equilibrium when the cost of producing the last pound is exactly equal to its value. If the costs incurred directly by sellers are the only relevant costs of expanding potato production, and if the benefits to potato buyers are the only relevant benefits, the invisible hand gets things just right. The production and consumption of many other goods, however, generate costs or benefits that fall on people besides buyers and sellers. Producing an extra gallon of gasoline, for example, generates not just additional costs to producers, but also pollution costs that fall on others.

As before, market forces cause production to expand until the seller’s direct cost for the last unit sold is exactly the value of that unit to the buyer. But because each gallon of gasoline also generates external pollution costs, the total cost of that last gallon produced is higher than its value to consumers. The upshot is that gasoline consumption is inefficiently high. That simple example captures the classic breakdown in the invisible hand when a product’s market price doesn’t reflect all its relevant social costs and benefits. In such cases, the simplest solution is to discourage consumption by taxing it...

That the invisible hand often breaks down is actually good news. After all, we need to tax something to pay for public services. By taxing forms of consumption that generate negative side effects, we could not only generate enough revenue to eliminate budget deficits, but also help steer resources toward their most highly valued uses.

Because such taxes make the economy more efficient, it makes no sense to object that they impose hardships on low-income families. Again, an efficient policy is one that maximizes the size of the economic pie. And with a bigger pie, it’s always possible for everyone to get a bigger slice."

Comparing housing markets

The Economist's house price indicators (measured as % change) for 1997-2008, for the first quarter of 2007, and the latest is shown below.



It seems to suggest that house prices are still climbing, except in the US and a couple others. In any case house prices in Japan and Germany have been falling for more than a decade now. As The Economist points out, the worst excesses of the housing boom may have been played out in Spain and Ireland. According to Goldman Sachs, construction and housing-related employment in both countries made up 13% of all private-sector jobs at the end of last year, against 9% in America and 5% in Germany. Meanwhile, nominal residential investment was 11% of GDP in Ireland and 9% in Spain, against 6% in America. That has caused a glut. The Economist feels that New Zealand and Australia are the other vulnerable markets.

'The Economist' calls for monetary tightening

The Economist feels that inflation is a cause for greater concern for developing countries and estimates that more than two-thirds of world population may be struggling with double-digit inflation by mid-summer. Inflation has touched highs in Russia, Indonesia, China, India, Thailand and many other emerging economies.



That this inflationary surge has been driven by oil and food prices is the major concern for the developing economies, and especially the poor. Food accounts for 30-40% of the consumer-price index in most emerging economies, compared with only 15% in the G7 economies.



The Economist feels that though supply side shocks were the initial cause for food price rises, if monetary conditions were tighter, rises in food prices might have been offset by declines elsewhere thereby keeping inflation under control. It also argues that since general inflationary pressures, including wage demands, are more closely dependent on food prices in developing countries, monetary policy may have a greater role in anchoring inflationary expectations. The prescription is therefore to tighten monetary policy and raise interest rates.

For long, it has been thought that inflation should be primary concern of Central Banks in developed economies, whereas emerging economies' Central Banks have to strike a balance between inflation and growth. It is one of the interesting ironies that influential opinion makers like The Economist are now advocating that growth should be the central concern for economies like the US (and hence the need for lowering interest rates, which was being advocated till some time back), while inflation should be the primary concern of Central Banks in emerging economies.

It is well established that businesses in developing economies face higher cost of capital, which reduces their competitiveness. This is all the more so since bank loans are still the major source of financing in these countries. A more intergrated and globalized economy makes the businesses more un-competitive in the face of higher domestic interest rates. The consequent reliance on External Commercial Borrowings (ECBs) is a more dangerous solution, with the attendant risks of exchange rate appreciation and inflation pressures.

At a time when interest rates in the developed economies are at historic lows, with the real rates being in negative territory in the United States, any raising of interest rates in the emerging economies may generate undesirable incentive distortions. It could set in motion active carry trade channels between emerging and developed economies. This in turn will force up the exchange rates of the emerging market currencies, thereby lowering their export competitiveness, and also stoke inflationary pressures arising from the massive inflows of foreign capital. Besides it would also add to the debt service burden as emerging market Central Banks would then be forced to release market sterlization bonds to mop up the excess liquidity, and pay the higher rates.

The emerging economies like India now face the twin challenge of sustaining the growth of their interest rate sensitive industrial and service sectors, while at the same time insulating the large number of poor people from the high foodgrain and energy prices. On the face of it these are contradictory challenges, which require diametrically opposite solutions. Sustaining high growth rates requires keeping rates low, whereas inflationary pressures forces up the interest rates.

Faced with high commodity and input prices, appreciating currencies, and weakening demand in the US and other developed markets, many emerging economies are experiencing downward growth pressures. In the circumstances, high interest rates will only exacerbate the situation and potentially choke off the fledgling growth. In any case, the high foodgrains and energy prices are not the result of any loose monetary policy but the result of supply failing to keep up with a rapidly growing demand. This rise in demand is itself the inevitable consequence of the spectacular economic growth in these economies this decade. It is therefore highly unlikely that monetary tightening will help control this cost-push inflation scenario.

All these monetary policy driven analysis of inflation in emerging economies also misses the fact that they have been growing at very high and possibly unsustainable rates for some time now, and overheating was inevitable. It was only time before inflationary pressures became evident. Historically (as in Japan and East Asia in the seventies and eighties), similar situations in growing economies have been better managed by keeping interest rates low, even at the cost of slightly higher inflation.

The higher food and energy prices will need to be managed by strenthening and better targetting of social security measures. Governments will have to pay more attention to issues of food security and providing basic foodgrains to the poorest at affordable prices, thereby insulating them from the inflation concerns.

As the graph indicates, foodgrains contributes about 60% of the consumer price basket in India, and to that extent the inflation figures are a skewed representation. The situation is the same for most emerging economies. To that extent the core inflation (stripped off food and energy prices) may be much lower.

The advocacy of tighter monetary policies in emerging economies now only highlights the fact that the old-style "Washington Consensus" policy-mix is still alive and ready to be dusted up whenever developing economies face a crisis. It was the same during the East Asian crisis in late nineties, as is now. The Economist was at the forefront of the monetary tightening movement then and so are they now. As they say, some things never change!

The challenge of transport planning

The roll-out problems faced by three recent big urban tranpsort projects only highlights the fact that such projects, especially on their implementation side, can be fiendishly complex. The first example is the major overhaul of the public transport system in Santiago, Chile, which was launched in February 2007. The Transantiago scheme involved some 200km (125 miles) of dedicated bus lanes, and the wholesale reorganisation of bus routes to integrate them with the city's metro.

But immediately on commissioning all hell broke loose, and the Transantiago came to be known as a model of how not to reform public transport. It brought misery for commuters: more changes to complete typical journeys, long queues for full buses and gross overcrowding of the metro. There were many reasons for the failure - imposition of arbitrary routes that took little account of passengers' habits, rigid bus routes, inadequate number of buses, inadequate use of pre-paid smart cards, problems with the satellite technology to control bus movements.

In Jnauary 2008, the 28 km Gurgaon-Delhi expressway was opened amidst much fanfare, being projected as a showpiece of Indian urban transportation. The project soon became a commuter's nightmare, as commute times actually increased. The independent consultant to the Project, RITES, got its traffic projection numbers badly off the mark, and the actual traffic on the very first day turned out to be what was projected for 2013. While DPR, prepared in 1998, estimated traffic in the first year at 80,000 vehicles a day, the actual average daily traffic is now being estimated at 140,000 vehicles. Contrary to the 5% annual traffic growth projected, the actual growth has been more than 9%. With the majority of users not moving into pre-paid cards, the toll gates could not cope up with the huge traffic.

And now comes the pilot Bus Rapid Transit (BRT) corridor in New Delhi, which degenerated into chaos immediately after being launched. The 5.8km-long corridor—constructed on a pilot basis between Ambedkar Nagar and Moolchand in South Delhi, resulted in massive traffic congestions and increase in commute times, thereby inviting public wrath. A whole debate got initiated on whether public transport systems like BRT were suitable for Indian conditions.

The interesting thing about all the three aforementioned examples, at least the first two, is that these massive engineering projects appear to have failed not in their engineering but on their transport planning side. Now transport planning is an extremely complex task, complicated not so much by its technical dimension, but by its social dimension. It requires in-depth understanding of the specific economic and commercial context of the city, the local transport mix and passenger habits. Apart from factoring for these major and most obvious stumbling blocks, it is impossible to account for the numerous contingencies that can arise when such massive projects get rolled out.

It is also not incorrect to argue that we, including our private sector, lacks adequate expertise, in planning and executing such massive projects. Having been closely involved with the BRT project in Vijayawada, from preparation of Detailed Project Reports (DPRs) to initiating the project execution, I am convinced that we still have a huge distance to cover. There are only a handful of consultants who have any expertise on BRT or other multi-modal transport systems. And their expertise too is mostly confined to one or two individuals, and limited to the engineering side.

In fact, major infrastructure projects invariably face starting troubles. The problems being faced by the new Hyderabad international airport, and the new terminals at London Heathrow and Beijing, are only major recent examples of this reality. People marvel at the engineering dimension of the infrastructure project, without realising that the operational dimension is even more difficult and often impossible to successfully plan and execute.

But the initial implementation period is an excellent opportunity to closely study the operational dynamics and get emergent problems remedied. It is critical that all such project management teams have adequate and professionally competent support staff in place during the initial period of implementation of the project. In fact, the success of such grand projects depends on how quickly and effectively we can respond and solve the emergent problems.

Over use of health care

That the American health care system is a dream for insurers and doctors, and a nightmare for patients is well documented. Sample the latest chronicle by Dr Sandeep Jauhar in the NYT,

"I recently took care of a 50-year-old man who had been admitted to the hospital short of breath. During his month long stay he was seen by a hematologist, an endocrinologist, a kidney specialist, a podiatrist, two cardiologists, a cardiac electrophysiologist, an infectious-diseases specialist, a pulmonologist, an ear-nose-throat specialist, a urologist, a gastroenterologist, a neurologist, a nutritionist, a general surgeon, a thoracic surgeon and a pain specialist. He underwent 12 procedures, including cardiac catheterization, a pacemaker implant and a bone-marrow biopsy (to work-up chronic anemia)."

Dr Jauhar blames over-utilization and over-treatment for the aforementioned state of affairs. Overutilization is driven by many factors - "defensive" medicine by doctors trying to avoid lawsuits; patients’ demands; a pervading belief among doctors and patients that newer, more expensive technology is better. Over consultation and over testing arise from the perverse financial incentives that face doctors.

Contrast this with the present situation in India, despite its rapid convergence to the American situation. Medical diagnosis in the US is largely an exercise in technology based, mechanistic filtration, while in countries like India it still is a function of the doctor's professional judgement and clinical skills. Patients in the US are, for a variety of reasons, subjected to all possible diagnostic tests before finalizing the prescription. In contrast, doctors here rely on a few basic diagnostic tests and then rely on their experience and clinical skills to make the prescription.

The American medical care system addresses treatment in terms of a theoretical outlook that seeks to rule out all possibilities, thereby explicitly minimizing the role of doctor's judgement. In contrast, the Indian medical treatment approach looks at the symptoms and then tries to rule out the dominant possibilities through a few basic diagnostic tests. This method places considerable importance on the professional expertise and experience of the doctor. It works on the basis of preponderance of probabilities as the basis for making the diagnosis.

I have tried to list out the incetives and disincentives that face each stakeholder in the Indian and American medical care protocols. The American system first.
Doctors
1. Threat of lawsuits - the doctor decides to play safe and minimize his judgement, and therefore prescribes the full protocol of tests.
2. Reimbursement of treatment by insurance companies - As reimbursement rates have declined in recent years, most doctors have adapted by increasing the quantity of services. So patients get subjected to more number of tests.
3. Patients demand comprehensive care - leaves the doctor with little option but to conduct the full spectrum of diagnostic tests.
4. High cost of testing facilities - Doctors try to recover their high investment costs on diagnostic equipments by maximizing on the numbers of tests.
5. Piecemeal payments - Doctors get reimbursed for whatever they bill, thereby incentivizing them to over test and over consult.

Patients
1. Payment detached from treatment - Patients do not pay separately for each diagnostic test, making them unaware of the actual cost of their treatment and tests.
2. Feeling that technology and comprehensive testing is better - Increases the pressure on doctors to do the full spectrum of tests.
3. Ease of access to testing facilties - incentivizes the demand for testing, leading to over-testing.

Insurance companies
1. Threat of lawsuits - insurance companies insist on the full spectrum of diagnostic tests, so as to minimize the role of discretion and judgement.
2. Moral Hazard concerns - transaction costs go up, reflecting in higher premiums.

Contrast this with the Indian system where the major share of patients do not have any insurance cover.
Doctors
1. Get paid by the patients - incentive to minimize costs.
2. Patients demand more personal care - incentivizes doctors to trust their clinical skills and judgement.
3. High costs of diagnostic tests - incentivizes doctors to minimize tests.
4. Predominance of single doctor hospitals/clinics - minimizes over-consultation.
5. Not very active medical litigation market - encourages doctors to make diagnosis and make prescriptions trusting their judgement.

Patients
1. Demand for personal care - patients have to trust the doctors
2. Patients choose their doctors, and makes direct payment to the doctor - this introduces competitive pressures and lowers costs

Health care is very unlike any other service delivered in the market, which obeys the traditional principles of economic analysis. In the final analysis, any health care system can be efficient and effectively deliver its desired objectives, only when the patients have adequate faith in the doctor's diagnosis and the doctors have enough trust in their own clinical skills and experience to make definitive judgements on the final diagnosis. Health care policies need to have incentives and disincentives that promote this re-establishment of trust and belief. Ironically enough, the spiralling health care costs may just about be getting out of control, thereby providing a very strong reason for patients to go back to trusting the judgement of their doctors.

The Slate has an article by Dr. Darshak Sanghavi who argues that doctors in the US are simply not focussed on treating the disease. He adduces two reasons for this deficiency
1. Clinical training in primary care excessively focuses on the diagnostic hunt rather than the more routine rounds of treatment that follow. Medicine is about the exciting search for a diagnosis, and any old doctor can write a prescription once the real work is done.
2. Medical education today fixates on acquiring knowledge that is largely unrelated to patient care. The sheer abundance crowds out an important—in fact, the only—skill that matters in treating a patient: how to critically appraise published clinical trials. Few doctors ever read them. In effect, medicine has become a priesthood of practitioners who never review or learn to interpret the Bible to minister to their flock; they instead rely on secondhand wisdom.

Therefore, as Dr Sanghavi says, "the average internist can describe the branching patterns of the major coronary arteries but not the primary clinical trials assessing how much, if at all, various cholesterol-lowering agents cut heart-attack risks. Or, for that matter, whether the trials were soundly conducted."

Food crisis in a graph

The NYT has this excellent graphic to illustrate the food crisis we are facing now.



Consider these figures
1. Adjusting for inflation and exchange rates, the wealthy countries, as a group, cut donations to agriculture in poor countries roughly in half from 1980 to 2006, to $2.8 billion a year from $6 billion. The United States cut its support for agriculture in poor countries to $624 million from $2.3 billion in that period.

2. Adjusted for inflation, the World Bank cut its agricultural lending to $2 billion in 2004 from $7.7 billion in 1980.

Default taxes

Here is a common paradox. Numerous willingness to pay studies in cities show that most urban residents are more than willing to pay higher than prevailing user charges for efficient delivery of civic services. But the moment the Urban Local Body (ULB) raises the user charges or tariffs, protests break out, invariably forcing the ULB to either backtrack or considerably dilute the increase. How do we bridge this paradox?

ULBs (or for that fact, any Government agency) find it difficult to impose fresh or even raise taxes or user charges on various civic services. One of the biggest challenges is that of collecting user charges on garbage collection, transportation and disposal, from our city residents. In this context, how about a flexible system that imposes a specified amount of default user charges for solid waste collection, but leaves the option for payment on the individual citizen?

It can be argued that this is an effective way of stimulating the civic sensibilities of any citizen. I will argue that there is a strong case for experimenting this approach despite its "slippery slope" nature, provided there is enough evidence of willingness to pay among certain categories of consumers. Fortunately, as mentioned earlier, numerous studies have shown significant willingness to pay among garbage generators and regular citizens, provided the quality of service is good.

It can be made even more effective if a flat default payment is fixed and an option given to the consumer to voluntarily pay the default amount or any other amount he is willing to. This is a more economically efficient arrangement to elicit the full value from the willingness of citizens to pay for the service delivered. This arrangement can be initially tried out in some of the more well off colonies and then extended to other areas.

In an age where taxes and user charges are fast becoming an anathema, default payments can become a useful strategy to efficiently draw out the consumer willingness to pay.

Government policies and outcome uncertainties

Peter Bernstein argues in favor of pro-active Government policy intervention to stabilize aggregate demand and employment, instead of standing by and letting the market forces play themselves out.

In many ways, it is as much a challenge managing prosperity as it is managing an economic crisis. As the recent famous example of the "Greenspan put" highlights, it is almost impossible to know the right time and extent of policy intervention required (in this case lowering interest rates), that while sustaining the economic growth would not cause the economy to overheat. Did Greenspan cut the rates too low and hold it low for too long, and thereby let the financial market bubble grow out of control? Is Bernanke making the same mistake now, albeit in a crisis?

Opponents of intervention to stabilize an economy argue that "creative destruction" is necessary to weed out the excesses and inefficiencies. Further, government intervention policies are fraught with information assymetry problems and have the potential to generate moral hazard problems. They therefore favor a policy of letting the market dynamics work themselves out.

Mark Thoma makes out a case for government intervention to stabilize the economy. He argues that the challenge is to identify the economy's natural rate of output (its normal production possibility frontier) and unemployment rate, so as to tailor policies to bridge the deficit. Worse still, since policies generally realize their full impact with a time lag, we need to estimate what would be the natural output rates two or three years down the line.

He describes this situation as being similar to "shooting at a moving target with very slow bullets, and the movements in the target aren't always easy to predict". What makes this even bigger challenge is the fact that "not only does the target move, output moves on its own as well".

Mark Thoma describes the problem thus, "Even if there is no policy intervention at all, eventually output would recover to the natural rate. So if policy is relatively slow as compared to the self-healing process, then policy is likely to do more harm than good. This is why we devote so much energy to trying to find out how much time it takes for policy to impact the economy, and to determining how fast the economy can overcome frictions that prevent it from staying at full employment continuously."

Even if it is clear that the economy would recover faster with policy interventions, the challenge remains to determine the exact size and timing of the policy intervention, besides the policy diagnostics themselves. He sums up the dilemma, "Give the economy too much of a policy shock and you overshoot causing inflation, too little and output will be too low leaving people unemployed. Further, it's hard to readjust and fine tune as you move forward due to the lags and moving targets, and this often results in a fairly conservative intervention, one that attempts to avoid making big mistakes."

This is the dilemma facing Central Banks in a slowing economy (and even a booming economy) which is experiencing inflationary pressures. The question is whether to raise interest rates, and if so when and by how much? Similarly, faced with a cost-push inflation scenario, Governments have to make the choice of fiscal concessions (among other policy choices) - lowering import and raising export duties - so as to ease supply side constraints and increase supply. Again the dilemma is by how much and when? That these are difficult judgements to make does not mean that we abstain from making the decision itself. If that were the logic it would be impossible to exercise fiscal and monetary policy choices at any time!

The challenges facing Indian corporate sector

The honeymoon with globalization is slowly fading into the mists of time. For the last decade, we had been luxuriating in the after-glow of the spectacular economic growth, burgeoning trade and foreign exchange reserves, booming consumer market, and rising stock markets. Our knowledge professionals were in great demand from Tokyo to Texas, software and biotech companies had become the trendsetters in their fields, and a new breed of outwardly oriented corporate groups, with world beating ambitions were scouting abroad for good buys. Inflation was low, fiscal deficits brought under control and our macroeconomic policies were being applauded by multi-lateral agencies for bringing about stable and broad-based economic growth.

But in the space of a few months, sensex has tumbled, rupee has appreciated, export growth has declined, economic growth is facing strains, and inflation has reared its ugly head. We are now facing the first cyclical downturn of the global business cycle after we integrated with the global economy in the nineties. Questions are now being asked, as we face a reality check. Price controls, export bans, lowering import duties, input subsidies, tax concessions and so on are now being dusted up from the cupboards and placed at the policy making tables. The whole spectrum of economic regulation is coming back with a vengeance.

It was not so long ago that commodity producers used to complain about the terms of trade weighted against them, and manufacturers were enjoying the benefits of low input costs. Now the pendulum has swung to the other extreme, and manufacturers are complaining about high input costs.

The software exporters bemoan their falling competitiveness in the face of sharply appreciating rupee, rising wages, and ending of the STPI tax concessions. Textile and other manufacturers despair that the rising rupee has taken away their markets. Real estate developers who were hitherto wallowing in the spectacular "unearned land value increments", brought about by the booming economy, are now wailing about high steel and cement prices.

The software companies, manufacturers, textile exporters, builders all have joined a bandwagon calling for government intervention to save their respective sectors from marauding external forces. Patriotism and every other tool of expedience has became an ally in mobilizing Government intervention.

For far too long, our businesses have enjoyed massive and unprecedented growth rates, with apparently little cost and effort. Little did they realize that these bloated profit margins were built on the plentifully available natural profit opportunities - cheap labour, less demanding domestic market, too few suppliers and manufacturers, pent up demand, booming equity markets, cheap land values, weak environmental and labour standards, arbitrage opportunities etc. There were inefficiencies everywhere to be exploited and too few competitors to take advantage of them. In many ways these distortions were a form of internalized hidden subsidies, whose benefits were shared among the businesses and their consumers. It was also a natural consequence of the sudden opening up of a massive economy, shackled with restrictions and regulations for decades.

This good fortune was magnified by benign external conditions - an era of robust global economic growth, a US consumption boom, global savings glut induced low interest rates, weak rupee, massive capital flows into the emerging markets. All this was superimposed on a global economy where trade in goods and services were expanding and in which individual economies were liberalizing and globalizing.

This natural process of development was similar to that experienced by many countries in their respective growth phases. The large and very obvious inefficiencies and latent profit opportunities were exploited by the eneterprising early movers, who made massive capital investments and deployed the plentiful supply of skilled human resources. Indian corporate sector, especially in knowledge based services, enjoyed explosive growths, and many of them emerged as world beaters.

This fortunate coincidence of circumstances was too good to last and had to end. The crisis in the global financial markets, rising commodity prices and the US recession have combined to bring an end to the good times. Industrial production slowed, inflation rose, software profits fell, and predictions of economic growth rate falling to 7-7.5%. The cassandras of doom started singing and the backlash started.

We cannot always have competitive export environment and cheap imports, low inflation and low interest rates, fixed exchange rate and autonomy in monetary policy. Our skilled manpower cannot enjoy ever higher wages without their employers parting with a greater share of their profits, and thereby taking a cut in their bottomlines. The farmers cannot hope to get better returns on their produce, without the consumers having to pay a higher price. The demand for consumer durables and other manufactures cannot be sustained without the manufacturers passing on a part of their profits by way of lower prices.

These trade-offs are a part and parcel of any open, competitive economy, much less a global market economy. There are no free lunches! The good comes with the bad as a package in an open economy. The cheaper rupee and low wage skilled labor force were the foundations on which the recent successes of our knowledge based and other manufacturing industries were built.

Where are the profits now going to come from? While newer markets and new products and services will always keep becoming available and continue to provide high margins, the more sustainable basis for growth has to come from productivity improvements, process upgradation, embracing latest technologies, lean inventories, and investments in Research & Development. In the fast changing global economic landscape, firms will have to be nimble enough to adapt effortlessly to the changing market preferences and expectations. More importantly, our corporates, especially in the knowledge based space, have to realize that the age of the stratospheric 30-40% growth in profits are a thing of the past. We are moving into an age of more realistic growth rates.

Mukesh Kacker has an excellent analysis of the real estate market in the ET, where he writes, "Surely, if a sector makes 65-80% profits while other sectors are happy to make 25-30%, there is something amiss. So what makes this sector and its players so stupendously efficient? Have they unveiled new, path-breaking managerial practices or just serendipitously stumbled upon the elixir of eternal profit-making at super-normal levels? "

We cannot remain immune from the global trend of rising commodity, energy and foodgrain prices. Some commentators argue that we can keep food prices under control only if we invest heavily in agriculture and attain self-sufficeincy in foodgrain production. While the presciption is surely desirable and even necessary, I am not sure we will be able to achieve our objective of controlling prices even with this.

In the final analysis, we need to make a choice. Do we deviate from the inexorable global trend and remain as a closed autarkic economy, and be satisfied with the cliched Hindu rate of economic growth? Or, do we open our economies, albeit at our pace and sequence, and share in the massive wealth creation that is happening across the world, and thereby continue to enjoy the near double-digit growth of the past decade?

If our choice is the later, then we need to be prepared to compete in an extremely competitive global economy. Every participant in this economy - firms, employees, farmers, traders, artisans, investors, borrowers, and governments - should appreciate the reality that there is a complex interplay of market forces in process that are beyond the control of any individual country or even groups of countries. Governments have an important role to play in sequencing and phasing the opening up of their economies, but also suffer from severe limitations about their powers.

In such a context, the role of the Government should be to give each participant every opportunity to compete on an equal footing in the global economy, and also provide a basic social safety net to cushion those losers and victims of this process from the adverse impact of this opening up. The later is especially important in the case of countries like India with our large numbers of poor citizens, who are ab-initio dis-enfranchised form competing in the global wealth creation machine, for various reasons like deficiencies in education, health care, and skill development trainings. The Government has an important role in insulating them from the sharp shocks and dislocations that are a consequence of such movements of the global economic cycles and also providing them with the access to all the basic opportunities necessary to compete in the global economy.

Given the events of the recent past, the Government also has a critical role to play in easing supply side constraints in agriculture and infrastructure, so as to create the enabling environment for sustaining economic growth. But there is precious little governments can do to reverse cyclical global trends, especially in an increasingly integrated global economy. Governments can only ride the business cycle, it is powerless to drive it!

Steel market parable

Econ 101 teaches us that in an open global economy, if there are world-wide supply side constraints on commodities and rising demand, their prices should rise. As prices go up, consumers will cut down their consumption and look for substitutes, while producers will look to increasing their production. Over time, the twin effects of these two actions will shift the supply curve up and the demand curve down, thereby lowering prices. This is all the more true in markets with multiple suppliers, where monopoly behaviour is less likely. We are told that there is little that governments can do with monetary or other policy levers to lower prices. And so the story goes.

Now consider this sequence of events. First, led by high global iron ore and commodity prices, domestic steel prices rise to historic highs, touching Rs 58000 per tonne in April. Second, inflation figures touch an all-time high of 7.6%, threatening India's economic growth. Third, the Government of India intervenes with a slew of measures, including export bans and reduction in import duties, so as to ease supply side constraints and lower prices. Fourth, steel prices continue to remain up, as producers refrain from lowering prices, citing high global prices. In fact, the steel producers increase prices in two phases in April by including a raw material surcharge of Rs 5000 per tonne.

Fifth, though the Government had talked tough all the while, producers refuse to back down. Sixth, then the Prime Minister of India holds a meeting with all the major steel producers. Finally, an agreement is announced wherein, the steel producers agree to slash prices of flat steel by Rs 4000 per tonne, with immediate effect.

What prompted the steel producers to lower prices? I will not buy the arguement that the steel producers agreed to lower prices because Government agreed to keep export duties in abeyance for two reasons - exports form a small share of the total production and not all steel producers benefit from the non-imposition of export duties. In any case, the total revenues foregone by steel producers by way of lowering prices is much more than the marginal incomes gained by the postponement of export duties.

I cannot agree with the contention that high global commodity prices are behind high steel prices and therefore prices cannot be lowered without a fall in global prices. If that were so, then steel and commodity prices have not changed much in recent days to merit a reconsideration in prices now. Further, there are enough producers in India (I could count atleast 14 of them) for our steel market to be classified as competitive. Also, it strains credulity to hope that our steel producers would give in and lower prices even if it meant unacceptably large hits on their bottom-lines.

Where did the Econ 101 story go wrong? What is to be inferred from the aforementioned sequence of events? Did the steel producers indulge in cartel behaviour in the first instance? Did they lower the prices out of altruism (public interest) or in response arm-twisting by the Government? If it were the former, would the producers have lowered prices without any Government intervention? If they lowered prices in reponse to Government arm-twisting, will it not adversely affect the bottom-lines of these companies? Did Government intervention succeed where the market mechanism failed? Will the steel producers have lowered prices if there was no Government intervention?

I am inclined to believe that national Governments continue to have an important role in such crisis situations, in bargaining and wresting out concessions from producers, especially in more organized markets like that for steel and cement. This is despite the emergence of an increasingly integrated global market place. Fiscal and monetary policy measures which are not supplemented by government guidance (read hard talk) is less likely to have the desired impact, especially in very tight market conditions.

Higher energy prices and changing incentives

Even as politicians are doing everything possible to make an ongoing gas price surge even worse, Ken Rogoff finds a silver lining in the high prices. He argues that "high fuel prices are the best way to inspire energy conservation and innovation".

He writes, "High prices for commodities today mean more supply for future generations, while at the same time creating an incentive to develop new ways to conserve... Again, high prices are helping in ways that Western politicians seem afraid to contemplate."

Proof that this may actually be happening is available here in a NYT article. With gasoline approaching $4 a gallon, people are increasingly abandoning their private vehicles and moving to using mass transit systems. Proof of this are the sudden surge in passenger traffic in bus and metro lines.

The article finds that "the biggest surges (in ridership) - of 10-15 percent or more over last year — are occurring in many metropolitan areas in the South and West where the driving culture is strongest and bus and rail lines are more limited". With the national average for regular unleaded gasoline reaching $3.67 a gallon, up from $3.04 a year ago, car buyers too are gravitating towards smaller vehicles and per capita average gas consumption by Americans is expected to decline for the first time since 1991.

It writes that other incentives may only be adding to the attraction of public transport, "Wireless computers turn travel time into productive work time, and more companies are offering workers subsidies to take buses or trains. Traffic congestion is getting worse in many cities, and parking more expensive."

Higher prices, especially energy prices, are a form of Pigou tax on gas consumption, something which politicians across the world have not had the courage to impose. It is the ideal incentive to reduce our unsustainable gas and energy consumption, vital to sustaining our environment and even our long-term economic growth. There is an excellent wrap-up of the sustainability problem and the solution (reduce consumption) here, here, here and here

Update 1
Richard Posner roots for $200 per barrel oil, since it would lower consumption and expedite the process of search for cleaner fuels. Gary Becker too feels that higher gas prices will nake the oil extraction industry and oil use more efficient.

Update 2
Paul Krugman gives the comparative example of Europe and US on fuel consumption. He writes that higher oil prices have incentivized Europeans to shift to more fuel-efficient vehicles and cut down usage of private cars. Krugman feels that the more definitive shift towards reducing oil consumption in the US will come only if America moves from its car-dependent suburbia culture to more densified population centers with adequate public-transport facilities.

Update 3
Here are five good outcomes which have resulted due to higher gasoline prices - mass transit boom, lower obesity rates, shorter commutes, fewer accidents, and biofuels caze.

Inefficiencies in government procurement

I am firmly convinced that we are wrong in believing that in general, inefficiency and wastage in government procurement is more the result of conciously driven rent-seeking actions than incidental corruption arising out of the incentive structure created by the procurement bureaucracy. While it is undoubtedly true that there is no dearth of active and conciously corrupt actions, the inefficiency and wastage generated by bureaucratic red tape provides more than ample incentives to sustain a massive rent-seeking economy.

There is an excellent CEPR paper by Oriana Bandiera, Andrea Prat, and Tommaso Valletti, Government spending in Italy - inefficiency vs. corruption, which seeks to clear some of the widely held misconceptions about corruption and inefficiency in government.

The authors use a dataset of procurement prices paid by Italian public bodies to disentangle the effect of active waste (overpricing that benefits the decision-maker directly, like bribing) and passive waste (overpricing due to sheer inefficiency). They find that passive waste, and not corruption-led active waste, accounts for 83% of the total estimated waste.

They find that some public bodies appear to pay systematically more than others for the same type of goods, with the central administration paying on average 22% than health authorities and universities (local government is in between). The differences appear to be due to passive waste rather than active waste, suggesting that sheer inefficiency is an important component of government waste.

The typical procurement policies of Government agencies are cast in stone and this inflexibility makes them economically inefficient. The lack of flexibility means that the procuring agencies cannot factor for local conditions and requirements. All the procurement parameters - specifications of the items, technical and financial qualifications of bidders, bid process management and bid finalization conditions - are laid out in the form of guidelines and frozen. This becomes a major handicap given the large variety and choice now available, disaggregated nature of the market, difficulty (and even desirability) in standardizing specifications of materials to be procured, and role of informal practices like sub-contracting, ring-formation etc.

The main objective of these guidelines is to standardize procurement rules, so as to eliminate the role of human discretion and the attendant possibilities of corruption and nepotism. This rigidity in the rules means that any deviation from these procedures - even when it would very obviously benefit the Government financially or when the specifications need to be modified to optimally suit local requirements - renders the officials vulnerable to disciplinary action.

The incentive structure is therefore clearly established. In most cases, the guidelines specifically prohibits economically efficient alternative price discovery arrangements like post-bid negotiations between say, the lowest two bidders, on the grounds that it opens up the door for corrupt practices. In other cases, the guidelines specifically fix quarterly quantities of different materials to be procured, leaving the local offices with no discretion to change them to suit varying local requirements. Therefore we end up having scarcity of certain materials and abundance of others.

Even those officials genuinely interested in reducing inefficiency and procuring the right kind and quantity of materials, and at the least cost, are disincentivized from using their subjetive discretion. The procurement process is thereby reduced to a set of guidelines to be applied mechanistically, without any application of mind with regard to local requirements and econommic efficiency.

The findings of the study that the wastage is maximum with central government procurement is understandable. Centralized procurement guidelines try to formulate a single set of rules for the entire country, which are invariably oblivious to local requirements and conditions.

The results are - procurement at higher prices than local market rates, delays, sub-optimal and inefficient inventory management, materials not suiting local requirements etc. In any case, with the bidders having internalized the processes, the inevitable corruption associated with bureaucracy remains. Further, with limited attention generally paid to the quality of the procured materials, the major source of rent-seeking and inefficiency lies in the quality.

There is therefore a risk that policy measures aimed at reducing corruption, like additional administrative hurdles or external controls, may increase passive waste. At the risk of sounding cliched, we end up being "penny wise and pound foolish". I am inclined to the arguement that procurement process should be more flexible, giving greater discretion to the local officials, while being unwaveringly strict on the quality of materials procured.

Yes, this will lower the control exercised by the central bureaucracy and increase the discretion of local officials, with all its perceived deficiencies (though I am again strongly inclined to believe that it will be no worse). But on the positive side, the procurement process will surely become more efficient, less wasteful, cheaper prices, better inventory management, superior quality, and thereby better value for money.

Violence and social cultures

How do violence and civil strife influence a country's social culture and vice-versa? Edward Miguel, Sebastián M. Saiegh, and Shanker Satyanath have an NBER paper, National Cultures and Soccer Violence, that seeks to give some explanations.

The authors study the behavioural patterns of the thousands of international players playing in the common institutional environment of the European professional soccer leagues and finds, "a strong relationship between the history of civil conflict in a player's home country and his propensity to behave violently on the soccer field, as measured by yellow and red cards but not other dimensions of play, such as regular (no-card) fouls or goals scored".

They find that this link is robust to region fixed effects, country characteristics (e.g., rule of law, per capita income), player characteristics (e.g., age, field position, quality), outliers, and team fixed effects.

Summers rephrases the case for globalization and trade!

Lawrence Summers acknowledges the well-known secret that after-all, in a world where emerging economies are booming, un-adulterated free-trade as we commonly refer to, may not be fully in America's interests. In two FT articles, he sounds a refreshingly welcome note of caution, on the gung-ho march of globalization and free-trade. He lists out three reasons why American workers may not buy the arguement that globalization improve economic welfare.

1. Developing countries increasingly export goods such as computers that the US produces on a significant scale, putting pressure on wages. While workers disproportionately bear the brunt of the competition induced higher wages, the consumers benefit from cheaper and better quality products. At the same time, rising global prosperity increases the rewards accruing to the already highly paid producers of intellectual property goods such as films, where the US has a comparative advantage.

2. The growth of countries such as China raises competition for energy and environmental resources, raising the price for Americans.

3. Growth in the global economy encourages the development of stateless elites whose allegiance is to global economic success and their own prosperity rather than the interests of the nation where they are headquartered. The older "what is good for America is good for GM" is now being replaced by "what is not good for America is no
longer necessarily not good for GM"! He claims that "a decoupling of the interests of businesses and nations may be inevitable"! Companies have less of a stake in the quality of the workforce and infrastructure in their home country when they can produce anywhere.Businesses can use the threat of relocating as a lever to extract concessions regarding tax policy, regulations and specific subsidies. Inevitably the cost of these concessions is borne by labour.

He writes, "When other countries develop, American producers benefit from having larger markets to sell into but are challenged by more formidable competition. Which effect predominates cannot be judged a priori."

Prof Summers argues that any policy promoting globalization should be accompanied by domestic policies that seeks to address "inequality and insecurity". This is precisely what many of the left leaning globalization sympathizers have long been advocating. While globalization is bound to expand the pie and more efficiently allocate resources across the global economy, it will cause significant labor dislocation and hardships in individual countries besides increasing uncertainty in many areas. This can be addressed only through policies aimed at substantially cushioning the poorest and providing everyone with all the basic opportunities for competing in this global economy.

He also highlights the need for harmonization of tax and regulatory policies across nations, so as to avoid competitive policies in these sectors that engenders both protectionism and an unhealthy race to the bottom. He writes, "There has been a race to the bottom in the taxation of corporate income as nations lower their rates to entice business to issue more debt and invest in their jurisdictions. Closely related is the problem of tax havens that seek to lure wealthy citizens with promises that they can avoid paying taxes altogether on large parts of their fortunes." I am not sure whether any voluntary tax agreement can be achieved among nations, and whether they are even desirable.

Regulatory policies should involve a global consensus on the right amount of regulation in each sector. This is a highly contentious area, and there is considerable distrust among developing countries that, in the guise of standardaization and harmonization of regulatory policies, the developed economies have been trying to foist favorable regulatory standards that are widely perceived as being inimical to the interests of the former. The negotiations on labour, investments, phytosanitary conditions etc under the WTO have clearly highlighted the divisions. The challenge here lies in arriving at a mutually acceptable consensus on regulatory standards.

Mint article on rating NGOs

Here is the link to my latest Mint op-ed, Aiding donors for more charity, which appeared today. It argues that rating the effectiveness of NGOs will generate healthy competition and help potential donors choose better.

Pragati article on inflation

Here is my article in the May edition of Pragati, on inflation, Pressed by Inflation (has to be dowloaded).

Dowry Inflation in India?

Raj Arunachalam and Trevor Logan conclude in an NBER working paper that there is no evidence to prove that "real dowry amounts have systematically increased over time in South Asia".

Whatever be the sociological reasons, and there are a number of them, from an economic point of view, the major incentive that drove the dowry market was an economy in which women were not formal participants. The increasing role of women in workplaces should by itself ensure a significant drop in the dowry rates.

At the risk of being politically incorrect, the economic rationale for this decrease would be that the Net Present Value (NPV) of the future revenue streams of all literate and employed women is most often likely to be much more than any one time marriage pay-off. It may also be true that male literacy may have an attenuating effect on dowry amounts, though I am inclined to beleive that this may be a small effect!

In fact, it may be a good idea to have studies that control for certain parameters, so as to bring out trends, if any, indicating this aforementioned hypothesis. Such studies should involve time series data on dowry trends across categories like
1. States where women's literacy and employment rates have been increasing with those where these rates have been relatively stagnant.
2. States where men's literacy rates (here more focussed search could go on to secondary and higher education figures too) have been increasing with those where it has been stangnant (this addresses the demand side dimension)
3. Similar studies can also be carried out across certain castes/communities where the propensity to give dowries is especially high.
4. Proportion of women who are employed but have not given dowry.
5. Average dowries given by educated (and employed) and uneducated (and unemployed) women.
6. Average dowries received or taken by educated and uneducated men.
7. Differences in the dowries paid by the differently employed (or unemployed) daughters of the same family. It is logical that the employed daughter pay (or not pay) a much smaller dowry than the unemployed.
8. This analysis can be extended to cover all the married daughters of an extended family, so as to control for other sociological foctors.
9. Dowries given can be traced against the incomes of employed women, controlling for parameters like community, regions/states, and socio-economic backgrounds.

I am more inclined to believe that social empowerment of women, by itself, will not be enough to significantly reduce or eliminate dowries. More so in societies like ours with its deeply entrenched customs and social mores. If social empowerment were enough, then the average dowries should have decreased dramatically in states like Kerala and among the Self Help Group (SHG) members of Andhra Pradesh and Kerala. But there is little indication that this has happened.

It would therefore appear that economic empowerment of women is a sine qua non for ensuring that dowries become a thing of the past.

Food Security and Financial Markets

This post is in continuation to my previous posts on rice trade, and will seek to examine the possible long term solutions to combating foodgrain inflation.

In the period from March 2007 to March 2008, the average world price for corn increased 30%; for rice, it increased 74%; for soybeans, 87%; and for wheat, 130%. In India, the prices of oils and fat have gone over the roof - vanaspathi by 41.15%, mustard oil by 58.2%, groundnut oil by 24.7%, milk by 11.1%, and potato by 12.5% in the March 2007-March 2008 period. The BBC has this on the rising food prices.

Rising food prices hurt net consumers, while benefiting producers. In developing countries, the major share of poor consumers are the urban poor and the landless agriculture labour, who spend upto 70% of their incomes on food. And this category is a major share of the consuming population, and are most vulnerable to price volatility.

The volatility in foodgrain prices highlights the volatility associated with commodity prices in an integrated global economy. It also underlines the importance of adequate measures to cushion atleast the poorest and most under-privileged from such uncertainties. It is in this context that the much derided Public Distribution System (PDS) of India and the role of the Food Corporation of India (FCI) in maintaining adequate buffer stocks of foodgrains, assume significance as vital componenets of a comprehensive food security policy.

What are the policy prescriptions available? The world of financial markets may interestingly enough, have a lot to offer to our food security policies. In the recent years, the financial markets have seen a proliferation of instruments that are aimed at hedging against financial risks, besides enhancing global financial liquidity. Similar interventions aimed at hedging commodity price risks and increasing availability are necessary.

The existing commodities exchanges and trade in commodity derivatives, are more concerned with non-foodgrain commodities, and are populated more by private sector participants. Nation states or their representatives, especially from the developing world, are not participants in these exchanges. Further, the financial instrument dimension of commodities trading is increasingly overtaking its commodity price hedging dimension.

Madan Sabnavis of the National Commodities Exchange (NCDEX) of India argues for the establishment of a World Agricluture Bank (WAB) to address global demand supply mis-matches in agriculture commodities. He proposes that the WAB, build up a buffer stock of foodgrains, by procuring at the prevailing market price, to be used in times of crisis. This global FCI(!) would allow its contributing members to buy a certain multiple of their contribution or quotas, at a predetermined price, which may be announced at the beginning of the year. The members would therefore be hedged against abnormal price rises.

A more effective alternative than a WAB would be to have a global commodities exchange, trading in agriculture commodities, and with national economies or their representatives being the traders. There can be an international commodities trading market in which individual countries or their representatives are the traders. Therefore, a rice consumer like Senegal could enter into a futures contract for purchase of rice from a rice producer like Vietnam. This would ensure that both the producers and consumers get insulated from the vagaries of global commodities market preferences. In fact the numerous private commodities exchanges could get linked to this massive global commodities exchange (GCEX).

Another alternative would be, as Esther Duflo suggests, to create an international market in providing foodgrain price insurance for the poor. She writes, "Countries that are neither net sellers nor net buyers could do this internally, and countries that are either net sellers or net buyers should be able to sell this insurance on the world market."

Prof Robert Shiller had sometime back conceptualized macro-markets, which can be created to trade in macro-securities of various agriculture commodities. These macro-securities, linked to both global market prices and individual national production figures, will insure producers and consumers against agriculture price volatility.

Macros are twin-securities - up and down macros - issued on an index, which move up and down, in response to the movements in the value of the index. The macros give dividends, with the holder of the up macro being rewarded when the index rises, and the holder of down macro when the index falls. Individual nations, (or their food trading agencies, like the FCI in India) can buy the down-macros, while regular investors can buy the up-macros. There can be international macro-securities to hedge against the volatility in rice, wheat, corn and other foodgrain prices.