Sunday, August 31, 2008

Financial market regulation and Munis in US

Amidst the carnage wreaked by the sub-prime mortgage crisis, one of the calmer areas of the financial system has been the $2.6 trillion (2007) Municipal Bond (Munis) market in the US. Most of this debt issued by cities and local governments, are held by individual investors. But now here comes revealing reportsthat the disclosure standards and requirements followed by many of Munis issuers suffers from several deficiencies.

Surveys and reports indicate numerous and increasing detection of lapses and omissions in both annual filings of financial statements and other reports of material changes that are of concern to investors. In 2006, Munis that had raised approximately $350 billion upon issuance were found to be delinquent in disclosure. The enormity of the regulatory problem is highlighted by the fact that there are roughly 54,000 municipal issuers with debt outstanding, and 25,000 of those issue debt about every two years, in comparison with shares of just under 4,000 companies trading on the New York Stock Exchange.

While the historic default rates in Munis is a very low 1.5%, these disclosure deficiencies could show up in times of financial turmoil and credit squeeze, as is the case now. What exacerbates the situation is the fast surfacing problems with urban and transport infrastructure in the US, which has increased the demands on investments in these areas, thereby creating greater demands on municipal tax revenues.

Munis may only be the latest example of the failure of the financial market to regulate itself, and yet another example of the need for stronger financial market regulation. A meltdown in the Munis market would be catastrophic for the real economy, with devastating impact on the local governments.

Saturday, August 30, 2008

Latest world poverty estimates

One of the more interesting findings from the World Bank's latest estimates on global poverty (calculated based on Purchansing Power Parity (PPP) exchange rates), is the fact that in India poverty appears to have declined faster in the eighties, than in the "post-liberalisation" nineties and beyond. The proportion of people living under $1.25 per day for the country came down from 59.8% in 1981 to 51.3% by 1990 or 8.5 percentage points over nine years. Between 1990 and 2005, it declined to 41.6%, a clearly much smaller drop of 9.7 percentage points over 15 years.

Here are a few snippets from the report of relevance to India(abstract available here).

1. Around 42% of the Indian population or 456 million people live below the revised $ 1.25 per day international poverty line. It was 421 million in 1981.

2. The number of Indian poor also constitute 33% of the global poor, which is pegged at 1.4 billion people.

3. India also has 828 million or 75.6 % of the population living below $2 a day. Sub-Saharan Africa is better with only 72.1% living below $2.

4. Even in China, 208 million people or 16 per cent of the population live below $1.25 a day. East Asia recorded the sharpest decline in poverty from 79% of the population in 1981 to 18% in 2005

The rise in absolute numbers in India is in contrast with the figures across the developing world, where 1.4 billion people (one in four) were living on less than $1.25 a day in 2005, down from 1.9 billion (one in two) in 1981. These figures are an upward revision from previous estimates since recent research and statistics reveal that cost of living is higher in the developing countries than thought of.

Figures also reveal that the extent of poverty reduction shows wide variation. Poverty in East Asia, the world’s poorest region in 1981, has fallen from nearly 80% of the population living on less than $1.25 a day in 1981 to 18% in 2005 (about 330 million), largely owing to dramatic progress in poverty reduction in China.
The results have been less dramatic for South Asia and least for sub-Saharan Africa.

The latest poverty estimates draw on 675 household surveys for 116 developing countries, representing 96 percent of the developing world, done as part of the International Comparison Program (ICP), in 2005. The survey interviewd 1.2 million randomly sampled households, and the new international poverty line is $1.25 per day at 2005 prices.

Friday, August 29, 2008

Status report on SEZs in India

Though the Government of India have been sanctioning SEZs at a breakneck pace in the last couple of years under the SEZ Act 2005, it well known that the sanctions have not been translating into action on the ground. Now, the Commerce Ministry has acknowledged the same in a first of its kind status report on industrial units within SEZs. The report says that only 343 industrial units are presently working in the 253 SEZs (56 in 2006, 133 in 2007, and 64 so far in 2008) notified so far. Of the 253 notified, only 90 SEZs have become operational.

More on the Indian SEZs is available in an earlier post here.

Thursday, August 28, 2008

India in Olympics

India may have had its best ever Olympic performance, winning onen gold and two bronzes. But in terms of per capita gold medal count, it comfortably comes last!

The heroics of Usain Bolt led team of sprinters bolted Jamaica to the top of this table. While smaller nations occupied the top four positions, the more significant achievement was that of Australia, which came in fifth, with 0.69 gold medals per million population, a confirmation of the widely acknowledged fact that Australia is easily the most sporting nation in the world.

Infrastructure financing in the US

Over the last few years, a popular perception has gained ground in India that the private sector can take over the dominant share of the massive investments required in meeting our infrastructure requirements. The few and scattered examples of successful private particiapation in power generation, minor ports, airport terminals, BOT roads under the Golden Quadrilateral Project, and especially development of commercial and residential real estate, have strengthened this impression. This has also been used to explain away the lower than required Government investments in these critical sectors.

But the experience so far from this reliance on private sector and that from other countries would appear to contradict this belief. Even the aforementioned successful cases of private participation, except maybe in roads, have taken inordinately long times in even achieving financial closure. The example of China in the build up to the recently concluded Olympics, for which spent nearly $43 bn over a seven year period, with very limited private participation, is only another example of the fact that, across the world, governments have been the primary investors in infrastructure. It is true that private sector has played an important role, but mainly in managing O&M concessions on already created assets, and at best being JV partners with the Government.

Contrary to popular perception roads and bridges, airports, ports and most other infrastructure assets in the US had been built, operated and maintained by federal, state or local governments either from taxes, user charges or debt raised from the market. Traditionally, the federal government played a major role in developing American infrastructure: Thomas Jefferson built canals and roads in the 1800s, Theodore Roosevelt expanded power generation in the early 1900s. In the 1950s Dwight Eisenhower oversaw the building of the interstate highway system. The role of private sector, either by way of ownership or maintenance, has hitherto been minimal.

The collapse of the Minnesota bridge last year focussed attention on the poor state of the American roads and bridges. The American Society of Civil Engineers estimates that the United States needs to invest at least $1.6 trillion over the next five years to maintain and expand its infrastructure. Last year, the Federal Highway Administration deemed 72,000 bridges, or more than 12 percent of the country’s total, "structurally deficient". But the funds to fix them are shrinking: by the end of this year, the Highway Trust Fund will have a several billion dollar deficit.

The Dulles Greenway, a 12.53 mile highway connecting the Dulles Toll Road to the Leesburg Bypass, constructed in 1995, is one of the first fully privately owned toll roads in the US. It was built by a private consortium, Toll Road Investors Partnership II (TRIP II), owned by the Bryant/Crane family and the private equity group Kellogg, Brown and Root (KBR).

In what has been described as the first instance of privatization of an existing toll road in the US, in early 2005, the City of Chicago entered into a $1.83 billion, 99 year lease concession with a private consortium, the Skyway Concession Company, LLC (SCC) (a joint-venture between the Australian Macquarie Infrastructure Group and Spanish Cintra Concesiones de Infraestructuras de Transporte SA), entrusting the operation and maintenance of the 7.8-mile Chicago Skyway Bridge. SCC will be responsible for all operating and maintenance costs of the Skyway but has the right to all toll and concession revenue.

This was followed by another high-profile case of privatization of major highways when, in June 2006, Indiana received $3.8 billion from the same consortium made up of Cintra and the Macquarie Infrastructure Group (MIG), and in exchange the state ceded operation of the 157-mile Indiana East-West Toll Road for the next 75 years. The consortium would finance their investments by collecting all the tolls.

Another eagerly awaited test case for highway privatization in the US is the Pennsylvania Turnpike. As recently as May 2008, the Spanish firm Abertis Infraestructuras, SA and Citi Infrastructure Investors of New York City submitted a record $12.8 billion proposal to lease the Pennsylvania Turnpike. The proposal is facing approval in the State legislature.

As can be seen, there are very few examples of fully privately constructed toll roads even in the US. It is in this context that the NYT reports that major Wall Street firms and private equity funds like Goldman Sachs, Morgan Stanley, Credit Suisse, Kohlberg Kravis Roberts, and the Carlyle Group have amassed an estimated $250 billion war chest — much of it raised in the last two years — to finance a tidal wave of infrastructure projects in the United States and overseas.

But it cannot be denied that given the relative weakening of many sectors from the ongoing financial turmoil, the emergence of highly versatile structured financial instruments in the recent years, the utility of modern technology in quantifying outcomes and facilitating cost recovery, and the massive infrastructure requirements, both in the developed countries and more importantly the emerging economies, there are plenty of interesting opportunities available for private participation in infrastructure creation. But even in the more developed markets with more depth in their private infrastructure markets, the results so far have been limited.

Tuesday, August 26, 2008

Schooling and domicile in the US

Education upto the high school in the bastion of the free market is a predominantly government monopoly. Public schools in the US provide free education and generally maintain very good standards, whereas private schooling is very expensive and most often inferior to the public schools. Local governments spend considerable resources and attention towards maintaining standards and infrastructure in these schools. Public schools are therefore the preferred schools of choice for both rich and the poor.

In contrast, public schools in India are epitomes of neglect and apathy. The rich and even the middle class have fled government schools leaving only the children from poor families, and that too out of compulsions arising from the high costs of private education. It is ironical that in a developing country like India, basic education is increasingly being dominated, atleast in the urban areas, by private schools, whereas public schools are the overwhelmingly dominant service providers in the US.

The public schools in the US are run by the local town councils, and financed by the property and other local government taxes. These schools are also accountable to very active Parent Teacher Associations (PTAs). Admission in these public schools are restricted to the local tax paying residents. Unlike in India, it is not possible for residents of one town to send their children to the neighbouring town which has a better public school. Public school admission is therefore determined exclusively by the place of residence. In other words, the sole criterion for admission to a public school is local domicile.

With public school standards varying across towns, school quality becomes one of the most important (in some cases the most important) determinant of domicile. Localities with good quality public school becomes an attractive location for prospective home buyers, and this demand in turn bids up land and house values in these areas. The higher property values translates into higher property taxes, which in turn generates more money for the school, thereby further improving the school quality. It also sets in motion a virtuous positive feedback on the quality of education, as these parents are more likely to be demanding on school quality standards.

There is a flip side to this arrangement. The higher property values attracts the richer and more well off and makes the area unaffordable for the poorer. So we have school choice driven agglomeration economics, which results in socio-economically segregated areas. This emergent phenomenon is discussed in an earlier post here.

Sunday, August 24, 2008

Prospects for the US economy

In the latest NYT Economic View column, Tyler Cowen argues that the distortions and excesses that bedevil the US economy today can be resolved only if there occurs a fundamental shift in the spending habits of American consumers.

But any such changes at this point of time may be easier said than done, and may even rebound badly. As the economy falters and threatens to slip into a recession, any dramatic change in the consumption (or saving) habits carries major risks. As the graph below shows, consumption is far and away the major determinant of the US economic growth, contributing 72% to the GDP growth in 2007-08.

With business investment weak, inventories falling and the housing market continuing to fall, the only hope lies in exports and government spending. The weak economies in US and Europe, are likely to have knock on effects on growth in the emerging economies. This will adversely affect one of the last remaining engines of US economic growth, exports, and leave government spending as the single most important determinant in the fortunes of the US economy in the immediate future. Here too, the signals are not encouraging given the less than desired (or expected) results from the first round of fiscal stimulus. In any case, there are many contrasting views on the efficacy of any fiscal stimulus led demand management and government spending led pump-priming.

As Cowen argues, the age profile of the American population will come in the way of increasing savings. In other words, thanks to an aging population, the US economy is today at the other end of the savings-consumption cycle. The solvency induced credit squeeze will ensure that lending institutions will be wary of counter-party risk and therefore not effectively allocate investment resources. The American economy is more deeply integrated with the financial markets than other economies, and is therefore most vulnerable to any solvency induced liquidity-trap that would starve the corporate sector off credit.

As the Economist points out, there are also significant similarities between the US situation today and the Japanese economy in the early nineties. Average house prices nationwide rose by 90% in America between 2000 and 2006, compared with a gain of 51% in Japan between 1985 and early 1991, when Japanese home prices peaked.

The similarities do not end there. Like the Fed, the Bank of Japan too cut interest rates aggressively in response to the crisis, reducing it from 6% in July 1991 to 1.75% by the end of 1993. Two years after American house prices started to slide, the Fed funds rate has fallen from 5.25% to 2%. The cyclically adjusted budget deficit (which excludes the automatic impact of slower growth on tax revenues) increased by an annual average of 1.8% of GDP in 1992 and 1993—similar to America’s budget boost this year. Like Japan, US is also on negative real interest rate territory, leaving little room to manouevre with monetary policy.

Though there are significant differences, including major mistakes made by Japan like raising taxes that nipped off any recovery, there exists a real threat of a Japan style economic downturn.

The best that can be done is to buy time (by a mix of monetary loosening and targetted fiscal stimulus) and then use it productively to quickly wring out the excesses in the financial system and piggyback on hopefully robust enough economic growth in China led emerging economies, while at the same time praying that commodity and energy prices fall and stabilize at lower levels (so that inflation does not open up another battlefront). In otherwords, avoid a hard landing by forcing a softer landing!

Saturday, August 23, 2008

Central Banks and co-ordinated policy

This blog had been arguing for sometime that given the global nature of inflation today, independent actions of Central Banks on the monetary policy front will provide limited or only temporary relief. A previous post had even suggested that Central Banks across the world should co-ordinate and raise domestic interest rates uniformly, not to combat inflation but to slow down growth. (Kenneth Rogoff had been advocating the "forced slowdown" hypothesis for sometime)

Now Adam Posen and Arvind Subramanian have called for a joint approach by global Central Banks to reducing global inflation, centred on a common public commitment to tighter monetary policies. They compare the strategies of Central Banks to a game of "chicken", wherein each Bank is attempting to duck the pain of monetary contraction, hoping that others will bear the burden of adjustment.

Though ECB and some of the major emerging economies having tightened policies, the desired impact will not be achieved without similar action by the US Fed and the People's Bank of China. Such co-ordinated action will send a strong signal and thereby anchor market expectations on inflation. The extent of monetary tightening of course should and can be left to the individual Central Banks.

Incentive system facing IAS officers

It has been a widely held view for a long time that the highest bureaucracy in India, represented by the Indian Administrative Service (IAS), has become captive to the political system, thereby adversely affecting the morale of the service and the efficiency of public service delivery. It is no secret that politicians use posts
of varying importance to motivate bureaucrats, who respond by investing in political loyalty or (in fewer cases) skill to get important posts. The most visible manifestation of this phenomenon is the now commonplace large numbers of transfers that takes place when governments change after elections.

However, a fascinating BREAD paper by Lakshmi Iyer and Anandi Mani, which explored the relationship between IAS officers and the political system, arrives at a few interesting (and heartening) conclusions:
1. High-skilled officers face less frequent transfers and lower variability in post importance due to political change.
2. There is no robust evidence of a negative impact of such politically-induced transfers on district-level policy implementation outcomes.

The analysis is from a simple principal-agent framework, where the politician's (principal) electoral success is a function of the bureaucrat implementing policies effectively and bureaucrats (agent) aspire to hold important posts. In the absence of direct control over the bureaucrats, the politicians respond by using transfers and postings as a leverage over their agents. The bureaucrats respond very early in their career, either by developing a reputation for expertise in a specific sector, or more commonly by pitching their loyalties to one or a group of politicians or political party.

The article validates the following hypotheses empirically, by tracking the careers of over 4000 IAS officers across India over the 1980-2004 period
1. If the electorate cares not just about efficiency, but also about redistribution issues, political change will result in reassignments (transfers) of bureaucrats across posts.
2. Junior bureaucrats with high initial ability are more likely to invest in developing expertise as their route to career success.
3. High-skilled bureaucrats are less likely to be reassigned to new posts as a result of political turnover than bureaucrats who develop a reputation for loyalty to particular politicians.
4. Political change will cause less variability in the importance of posts held by these high-skilled officers, relative to loyal bureaucrats.
5. Since politicians main motivation for such transfers is to influence their re-election prospects, political change is more likely to result in transfers among posts which a¤ect a greater number of voters.
6. Political change is less likely to result in bureaucratic turnover if alternative means of controlling bureaucratic outcomes are available.

The other empirically validated findings of the study, many of them very obvious, include the following
1. The study also finds that that those with high initial ability are more likely to be recommended for senior positions in the central government in New Delhi, suggesting the Central Government bureaucracy is more professionally competent than the State Government one.

2. The finding that officers who develop professional competence are no more likely to get better postings (over an entire career) than those pitching their tents behind political leaders or parties, is an incentive to officers to take the more easier route to "success" (high-profile postings) by investing in political loyalties.

3. Officers who belong to the same caste as the Chief Minister's party base are more likely to be appointed to important positions.

4. District Collector and other district level positions that directly impinge on the interests of the local politicians and parties, are more vulnerable to transfers when governments change. More populous districts are more likely to witness bureaucrat transfers following political change, consistent with the politician's motivation to use bureaucrat reassignments to inflence a larger number of voters.

5. Bureaucrats in districts where the local politicians belong to the same group (in the party) as the incoming Chief Minister are less likely to be reassigned by the latter. This is consistent with the model's prediction that the availability of alternative means of control over bureaucrats lowers the politician's incentive for transfers. In other words, this suggests that the Chief Minister regards local politicians and bureaucrats as substitutes for exerting their influence at the district level.

My strong contention is that the bivariate (loyalty and ability) analysis is simplified in considering the two variables as mutually exclusive. The game becomes fiendishly complex, once we have loyal officers also being capable and vice-versa, as is increasingly the case. This deserves more anlysis and will be the focus of more posts in coming days.

Urban Competitiveness Report

A recently released Global Urban Competitiveness Report 2007, which ranks 500 cities across the world on seven parameters of competitiveness, has ranked New York as the most competitive city in the world, followed by London, Tokyo, Paris and Washington DC. The report has been released since 2006 by the Chinese Academy of Social Sciences after analyzing major cities' industries, people, multinational cooperation, as well as living, social and business environments.

Urban competitiveness is defined as a city’s ability of creating more wealth in a faster and better manner than other cities in the world. The report measures the comprehensive competitiveness of 500 cities around the world in terms of 9 indexes, namely GDP, per capita GDP, per unit area GDP, labor productivity, number of multi-national enterprises settled in the city, number of patent applications, price advantage, economic growth rate and employment rate.

The report finds that good performers in the world are making the following efforts in order to compete with their global rivals:
1. Outlining development strategies and providing guidance in planning;
2. Improving business environment to support small and medium-sized enterprises;
3. Promoting industrial upgrade’; achieving the transformation of the city;
4. Offering life-long education to citizens and encouraging the inflow of talents;
5. Paying attention to environment protection and pursuing sustainable development;
6. Designing city brand and marketing the city;
7. Building service-oriented government by implementing enterprise management model in city management;
8. Fostering city’s special characteristics and cultivating diversified cultures.

The report urges that with a growing urbanization, government should attach greater importance to the sustainable development of economy, society, environment and culture, promote urban competitiveness and build their cities into the nicest home for people. To achieve that goal, government officials have to deal with the following 10 issues:

1. Giving local government larger autonomy, and properly handling the relationship between central and local governments;
2. Creating a better environment for businesses, and engaging market forces into government policy making;
3. Maintaining local features while expanding communications with the world; providing life-long education to the public to facilitate industrial upgrade; promoting innovation and entrepreneurship;
4. Balanced development of economic and social development; promoting integration of city and region;
5. Developing multiple industries;
6. Preserving and inheriting historical culture;
7. Balanced development of business environment and residential environment.

Friday, August 22, 2008

School education and CCTs

Conditional Cash Transfer (CCT) programs have been the latest step in poverty eradication strategies. One of the popular CCTs have been that involving transfer of cash to students (or their parents) to incentivize school attendance and performance. Many initiatives have begun over the past year or so, especially in New York, and while the early indicators have been mixed, it may be too early to pass any definitive judgements. Such programs have been discussed earlier here and here.

New York city has been test ground for a number of such programs, run by different private foundations. The NYT reports a mixed verdict from the results of the first year of one such program for students appearing in the Advanced Placement exams, wherein students in 31 New York high schools were offered upto $1000 for improved performance. At the 31 schools, the number of students taking exams rose to 4,620 from 4,275. Students involved in the program, financed with $2 million in private donations and aimed at closing a racial gap in Advanced Placement results, posted more 5’s, the highest possible score. That rise, however, was overshadowed by a decline in the number of 4’s and 3’s. Three is the minimum passing score.

In New York, in addition to the privately run Advanced Placement program, Roland G. Fryer, a Harvard economist who is serving as the Department of Education’s chief equality officer, is leading the school system’s effort to give middle school students prizes of up to $50 per test (and cellphone minutes for good behavior, attendance and homework along with test scores) for taking and passing other standardized tests. Test scores of the nearly 6,000 students who participated in Dr. Fryer’s program, which distributed $1.1 million in private donations, would be released in October.

The largest such CCT program is set to start later this year. In it, corporations and foundations have pledged $79 million over five years to pay 13,000 students and their teachers in 67 high schools in six states $100 for each passing score on the math, science or English Advanced Placement test.

Marketing cricket

My first experience of watching a baseball match (between Durham Bulls and Buffalo Bisons, at the Durham Bulls Stadium - neither of them being a big team) has convinced me that Lalit Modi and Co still have a lot more juice to squeeze out from marketing cricket (especially the one day and 20-20 variants). Here are a couple of immediately evident examples of money still lying on the table

1. How about a celebrity compere/anchor, livening up the minute or so, between overs and during drinks/luncheon intervals? The commercial opportunities available lying untapped are huge. Right now, apart from the cheer-leaders and the advertisements on the big screens, there is no side event that keeps people entertained.

2. More professional franchising out of food business within the stadium. How about differential pricing of food business in different sectors of the stadium?

Thursday, August 21, 2008

Corporate sector and the Indian economy

With inflation continuing its upward climb and commodity and energy prices ruling high, it is now well accepted that the Indian economy is set for a slowdown. But the quarterly revenue (Q1 2008-09) figures for India Inc bears out no signs of any slowdown in economic growth or any relation to the weak industrial output (IIP) figures. The revenues of the Rs 4000 Cr plus club have grown by 33% this quarter, as against 24% last year, while that of a sample of over 4000 companies (analyzed by the Economic TImes) was 24% (against 16% last year). The performance was the best among the last four quarters.

However, the inflationary pressures and rising interest rates have squeezed the bottomlines. While net profit growth for the large firms fell from 30% last year to 10%, it was much weaker for the entire sample at a mere 6%. Raw material costs surged 26% in the quarter (against 13% in Q1 2007-08), while interest costs rose 34% (against 25% last year).

These figures highlights the robust demand in the economy, and signals that the conditions for sustaining the high economic growth rates continue to exist. The overflowing work orders of the infrastructure and construction equipment makers is another encouraging factor. No Indian corporate group has deferred or cancelled new investments plans due to the weak economic conditions.

Recent trends appear to indicate that commodity and energy prices may have touched their peaks and are on their way down. The economic slowdown and consequent weak demand in US and Europe, will surely reduce imports from emerging economies, thereby lowering the demand for commodity inputs. With the commodity and energy prices stabilizing and even falling, inflation too may have touched its peak, and there may be no further need for monetary tightening.

In the context of strong domestic demand, the corporate sector will do well to heed the aforementioned signals and tide out the temporary difficulties by going ahead with their investment plans. The present difficulties are the result of global economic conditions (demand-supply mismatches and financial market crises) and are not a reflection of the economic fundamentals of the Indian economy.

Power sectors in China and India

The Businessline has an article comparing power sectors in India and China, with suggestions about sectoral reforms, especially in generation.

In 2006, the China's energy generation grew by 13.5% to 283 million kW. The output touched 147 million kW in the first six months of 2007, 15.9% higher than in 2006. More than 80,000 MW of generating capacity was added by end-2006, of which, more than 52,800 MW using coal. The country’s total power generation capacity rose to 6,22,000 MW up from 5,37,000 MW in 2005 and in 2007 it touched 7,31,000 MW.

India and China were adding capacity at almost the same pace even as late as the eighties. In the late 1980s, India was adding about 4,500 MW a year. In the Seventh Plan, about 21,400 MW was added to take the total capacity to 63,985 MW. In the same period, China, whose grid size was twice ours, was adding around 9,000 MW a year — that is, a rate of growth more or less similar to India. But though during the Eighth, Ninth and Tenth Plans India doubled its capacity — 1,44,500 MW as on date — it was still only about 20% of China’s capacity.

The article traces this massive spurt in capacity addition to three factors
1. Bulk ordering of capital equipment - boilers, turbines etc - and standardization of equipment design
2. Indigenisation of the capital equipment by insisting on technology transfer, given the massive volumes being procured.
3. On the supply side, greater focus on long-term import of coal as well as developing coal mines within China.

Debate on lowering corporate taxes

A recent Washington Post article about the relatively high marginal corporate tax rates in the US has sparked off a heated debate. Paul Krugman responded (here and here) by claiming that the 35% statutory (maximum) corporate tax rate in the US means very little, given the large numbers of potential deductions available which ensures that the effective rates are far lower.

Dean Baker puts the record straight using data from the OECD and the Congressional Budget Office to show that in the average member country corporate taxes are equal to about 3.5 percent of GDP, whereas in the United States, corporate taxes have generally been between and 1.5-2.5% of GDP over the last two decades.

A NYT editorial highlighted the deep problem of corporate American evading taxes utilizing the large number of deductions. An investigation by the Government Accountability Office found that almost two-thirds of companies in the United States usually pay no corporate income taxes. Corporations have become increasingly skilled at tax-avoidance strategies, including transfer pricing — overcharging their American units for products and services provided by subsidiaries abroad to artificially reduce their profits here.

The article claims that while corporate profits have soared — reaching a record of 14.1% of the nation’s total income in 2006 — the percentage of these profits paid out in taxes is near its lowest level since the 1930s. It writes, "This country’s corporate tax rates are among the highest in the industrial world, yet the taxes that corporations pay are among the lowest."

The debate has strong echoes in India too, where the large numbers of exemptions available have opened up numerous avenues for corporate tax evasion. The corporate sector is at the forefront of calls to lower taxes, alleging that the high corporate tax rates are lowering the competitiveness of Indian companies. Taking advantage of various exemptions and rebates, the corporate sector paid taxes at the rate of 20.60% in 2007-08, substantially lower than the statutory tax rate of 33.66%.

Interestingly, public sector companies paid taxes at the rate of about 23% while private sector paid at the rate of about 20%. Private sector companies earned Rs 5,56,190 crore as profits before taxes, but declared taxable income of Rs 3,41,606 crore only, or only 60% of their profits, during the financial year 2006-07, thereby getting total tax concessions worth Rs 58,655 crore, an increase of 30% over the previous year. IT companies and ITes and BPO firms pay some of the lowest tax rates anywhere in the world, at 6% and 7% respectively. This issue has been discussed in detail in an earlier post here.

Wednesday, August 20, 2008

Electricity prices on the way up in US

The high coal and natural gas (which powers 70% of US power plants) prices have driven up electricity costs in the US. The typical residential consumer paid about $100 per month for electricity in 2007. Rates have climbed by 24% since 2000 to a national average of 10.2 cents per kilowatt hour (unit), and this is predicted to grow another 15% by end of 2009. But the higher prices have made the lower cost nuclear-powered and hydro-electric plants more profitable.

Tuesday, August 19, 2008

Oil companies and their profits

Econ 101 teaches us that as bottomlines improve and demand increases, private companies plough back their increasing profits into newer investments in upgradation and capacity expansion. By this logic, the oil companies should have been funneling back their windfall profits of recent years into exploration and refinery capacity expansion. But statistics for the top five oil companies reveal that in the last five years, while profits have soared production has remained stagnant.

Compared with 1994, these big five have been spending a much smaller proportion of profits on exploration and instead have been splurging the windfall on share buybacks that would enrich the existing shareholders without adding any value to the economy. In other words, the high oil prices may be one of the largest single transfers of wealth from the ordinary citizens to the some of the richest people in the world. It is a virtual tax imposed by the rich on everybody else. (And it is in this context that the proposal by Barack Obama to impose a windfall profit tax on oil companies can be seen.)

The NYT's arguement that the fall in global oil production is the result of reduced influence of the oil companies is misleading. Its contention that from the Caspian Sea to South America, Western oil companies are being squeezed out of resource-rich provinces and are being forced to renegotiate contracts on less-favorable terms and are fighting losing battles with assertive state-owned oil companies, is an indicator of the oil market finally showing signs of becoming competitive.

For decades, oil companies have been biggest beneficiaries of mercantilism, exploiting apprehensions on energy security and controlling massive oil assets in many developing countries with little or no accountability. This led to massive profits which enriched the shareholders of these companies. But now, led by the likes of Hugo Chavez and Co, many of the oil rich areas are asserting themselves and scrapping or re-negotiating heavily one-sided contracts with the big oil firms.

Faced with this reality of being forced to share a more justified share of their massive profits with the resource owners, thereby resulting in smaller and realistic bottomlines, the big oil firms appear to be digging their heels in and cutting back investments and maximizing their returns from the high energy prices.

As late as the 1970s, Western corporations controlled well over half of the world’s oil production. These companies — Exxon Mobil, BP, Royal Dutch Shell, Chevron, ConocoPhillips, Total of France and Eni of Italy — now produce just 13%. Today’s 10 largest holders of petroleum reserves are state-owned companies, like Russia’s Gazprom and Iran’s national oil company.

Many of these state owned firms, who have access to increasingly large quantities of oil, do not have access to the latest technologies or are hindered by bureaucratic inefficiencies to ramp up production quickly. It is imperative that they collaborate with the private oil majors to boost oil production in response to the growing demand. But this would require the oil companies to reconcile themselves to more realistic profits and forego the the exploitative profits of past decades.

Monday, August 18, 2008

Evolution of world records

The NYT has this excellent interactive graphic depicting the evolution of World Records in many Olympic events over the past century.

Saturday, August 16, 2008

Return of the big Government?

The political and economic history of the past quarter century has been dominated by an ideology that sought to roll back big government and placed a fundamentalist faith in the notion that markets are self-correcting, allocate resources efficiently, and serve the public interest well. These ideas had also underpinned the infamous "Washington Consensus" bouquet of policies - privatization, liberalization, balanced budget, capital account covertibility, independent Central Banks, and inflation fighting to the exclusion of all else - that was the basis of many of the policies of multi-lateral institutions like the World Bank and IMF.

This ideological thrust, influenced by the free-market and neo-liberal ideologies of economists like Ludwig Von Mises, Friedrich Von Hayek and Milton Friedman, started with the Thatcher and Reagan administrations of the early eighties. Now, almost forty years later, after a series of market failures, the curtain appears to have definitively come down on this experiment. The blind trust on the self-correcting abilities of the market has completely disappeared from the mainstream, and there are loud calls to bring back the much-maligned Government.

Today, it is widely acknowledged that there are too many market failures, lingering on for too long, for the government to not intervene. Here are five areas where Government is making a big comeback

1. Financial Markets - It is now official - the big bang of financial market reforms of the nineties has failed, and failed with disastrous consequences. In the aftermath of the bursting of the sub-prime mortgage bubble, moral hazard concerns are thrown out of the window and bailouts are the norm. Bear Stearns, Northern Rock, Fannie Mae and Freddie Mac, the list of bailouts is impressive an continues to grow. It is estimated that the sub-prime losses and bad loan write downs will easily cross $1 trillion.

The unregulated financial markets have done an excellent job in repeatedly distoritng incentives and misallocating financial resources, thereby building up bubbles, first in tech stocks and recently in housing mortgages. It is feared that there are more bubbles in credit card debt, education loans etc, which are waiting to erupt in the US financial market.

These recent events have starkly highlighted the massive failures of the unregulated financial markets. It is clear that there are too many and too complex conflicts of interests and moral hazard concerns, and markets cannot account for them. Unregulated financial markets are designed to privatize gains and socialize losses. Financial markets have become too large and integrated, intertwined with the real economy, and dominated by behemoth investment banks, that problems in one institution invariably affects the others and threatens to drag the real economy down.

2. Social Security in an age of widening inequality - The rising food prices and inflation, and the clear inability of governments to control them, has exposed massive numbers of people, especially in the developing world, to issues like food security. A decade back, opinion makers were basking in the glory of a world economy that was growing as though there was no end. It was even proclaimed that we had entered an age of prosperity!

Even in that bastion of limited government, the biggest social security debate is about health insurance, and there is an increasing convergence of opinion about a single-payer, universal health insurance. It would not be an exageration to argue that health care insurance and social security reform have been one of the two or three major issues in the ongoing US Presidential campaign.

The recent rise in foodgrain prices and inflation, has adversely impacted the poorest and most under-privileged. In such situations, it is imperative that governments step in and provide basic minimum social safety cushions to these poor people. Such times are therefore strong reminder of the continuing importance of social safety nets. Sample this debate about wage insurance.

3. Environment - In the past quarter century, neo-liberal economic thinking had scorned on any proposal for raising taxes. In keeping with the belief that the tax payers knew best how to spend their taxes, tax cuts had become the order of the day. Today we have widely co-alescing opinion among major economists that carbon taxes should be introduced to control emissions and thereby prevent global warming.

There is across the board support in all countries that carbon emissions should be capped and then reduced, either through the European style cap-and-trade system of emission permits or through carbon taxes.

4. Global trade - The post-WTO era of globalization and off-shoring, coupled with the impressive trade assisted global economic growth over the last 15 years, had instilled a widespread belief that free trade could be the magic pill to eradicating poverty in developing world. Trade barriers were pulled down and tariffs were lowered on an unprecedented scale, and the vision of a "flat world" dictated trade policies.

The massively subsidised agriculture exports from US and Europe have had the effect of devastating agriculture in many developing countries, especially in Africa. Agriculture investments have declined and the results are to be seen in the rising foodgrain prices.

This has now given way to misgivings about whether free trade has created deep distortions in the global and national economies. Free trade and globalization are now being blamed for everything from widening inequality in the US to rising commodity and energy price inflation to displacement of labour in Africa. It is now widely acknowledged that trade needs to be regulated. This debate has been discussed in this blog here and here.

5. Fiscal Policy - Demand management policies are back. We only need to witness the almost across the board clamour for fiscal stimulus to prop up a diving US economy. Despite the not so encouraging outcomes from a first round of fiscal stimulus in te US, a second round of fiscal stimulus is on the horizon and appears to enjoy bi-partisan support. After a brief flirtation with Friedman and self-correction, it has now become universally accepted that governments need to step in at times of market failure, so as to pump-prime recessionary or failing economies.

In addition, there are economic cycle problems like rising energy and commodity prices, that have highlighted market failures which demand government intervention. For example, it is argued that governments will have to proactively participate in addressing the issue of food and energy security, and in finding alternative energy sources. Barack Obama, the leading presidential contender in the US, has proposed imposing a windfall tax on oil companies and use the proceeds to fund research in alternative energy technologies.

Many influential economists have called for government intervention to address the issue of widening income inequality in the US. Numerous studies have blamed the erosion of countervailing checks and balances as the primary reason for this widening inequality and have warned of serious consequences if the decline is not stemmed. This debate has been discussed by this blog here, here and here.

In all these aforementioned areas, market failures affect the poor and underprivileged very adversely. Further, for too long, the brunt of market failures was borne by the poor and the rich had been spared its consequences. The difference today is that the extent of market failures have become too large to be confined to a small portion of the economy and is adversely affecting the entire economy.

Update 1
The FT has this comment describing the increasing tension between politics and the market, and the global trend towards increasing role for government. Particularly scathing is the doubts expressed about the present state of financial markets by former Fed Chairman Paul Volcker, "Simply stated, the bright new financial system – for all its talented participants, for all its rich rewards – has failed the test of the market place."

The article also highlights the growing influence of the "libertarian paternalism" school of behavioural economics that Cass Sunstein and Richard Thaler's new book, Nudge, promotes. This view of Government as Platonic Guardians, approves of governments nudging citizens to act in accordance with (pre-defined) public policy goals.

Friday, August 15, 2008

Drunkard's walk

I have been reading Leonard Mlodinov's book "Drunkard's Walk" which describes how randomness rules our lives. Here are a few examples of cognitive biases described in the book.

1. Pascal's Triangle - Has applications wherever you need to know the number of ways in which you can choose some number of objects from a collection that has an equal or greater number. Each number in the triangle is claculated by adding the numbers to the left and right of it in the previous (above) line.

2. Monty Hall Problem. Suppose the contestants on a game show are given the choice of three doors: Behind one door is a car (something valuable); behind the others, goats (less valuable). After a contestant picks a door, the host, who knows what's behind all the doors, opens one of the unchosen door, which reveals a goat. He then says to the contestant, "Do you want to switch to the other unopened door?" Is it to the contestant's advantage to make the switch?

Let us assume the initial guess, Lucky Guess scenario, was correct. The probability of it initially is 1/3 (since behind only one of the three doors is the valuable object). On the contrary, the probability of the initial guess being wrong, Wrong Guess scenario, is 2/3. Now, if the contestant's initial guess was wrong, which is twice as likely as he was right, with one of the two doors in the Wrong Guess scenario being opened and found to reveal a goat, it is guaranteed that the car will be behind the other door. So the choice for the contestant is to decide between the two scenarios. Since the Wrong Guess scenario is twice as likely as his initial Lucky Guess scenario, it makes logical sense to switch his choice.

3. Regression to the mean, an extraordinary event (or a major deviation from the mean) is most likely to be followed by a more ordinary/average event. Daniel Kahneman, while lecturing to a group of Israeli air force flight instructors at the Hebrew University, found that his students felt that punishing/scolding pilots for their mistakes was very effective, whereas rewarding them was counter-productive.

All the pilots had a certain ability to fly, and while their skills were incrementally improving due to the training, it would be impossible to notice massive/spectacular improvements from one manouver to the next. So it would be natural that if a pilot made an exceptionally good manouver - one far above his normal level of performance - then the odds would be that he would perform more closer to his norm, or a worser level, the next day. Similarly, a pilot who performed very badly today, is most likely to perform closer to his norm, or big improvement, tommorrow! The flight instructors' penalties and rewards hardly made a difference. Kahneman's contention is that rewarding positive behaviour is more effective than punishing mistakes.

Thursday, August 14, 2008

Urban local government in India and the US

This post will try to examine some reasons why civic services and amenities are much more efficient in the US than India.

The local government (and other government agencies) in an Indian city delivers the following services directly using its own personnel
1. Sweeping of roads; cleaning drains; and collection, treatment and disposal of solid waste
2. Provision of water supply and maintainance of sewerage facilities
3. Supply of electricity
4. Streetlighting
5. Maintenance of local roads
6. Community amenities like parks, libraries and community halls
7. Schools, hospitals and anganwadi (nutrition) centers
8. Fire Services
9. Maintenance of law and order
10. Regulatory services like town planning, commercial licenses, and birth and death registration

In contrast, in the US the services from Sl Nos 1 to 4 are outsourced (sanitation and streetlighting) or are supplied by private providers (water, sewerage, and electricity). Therefore, while all the major civic services in any Indian city are provided directly by the government, they are delivered by private operators in the US. This frees up the local government to concentrate on more effectively delivering the services from Sl Nos 6 to 10.

The difference in quality is very evident. By outsourcing and privatizing certain services, not only is the delivery of civic services improved, but also the effectiveness of the local government and its agencies in delivering the remaining services. In contrast to India where the local government has spread itself out too thin, in the US it is much more focussed on its core competency.

I am convinced that if the local Government in the US were delivering these basic civic services and utilities, they would do just as bad a job as their Indian counterparts have been doing. It is just that these services are too large and complex to be managed efficiently by the distorted incentive systems of Government agencies. The efficient delivery of these services is to a great extent dependent on the direct accountability of the service providers to the consumers.

Another important reason why civic services are excellent in the US is simply the fact that Americans pay many times more local tax and user charge than Indians do. A comparison of the property tax (assume a 1500-2000 sqft house) and user charges on civic services in Hyderabad and Boston is interesting
Hyderabad suburbs
Property Tax Rs 2000-2500 (annual) ($50-60)
Water and sewerage - Rs 100-200 (monthly)
Electricity - Rs 1000 (monthly)
Cooking gas - Rs 700 (monthly)
Total user charges per month - Rs 2000 (or $50)

Boston suburbs
Property Tax - $4000-5000 (annual) (PPP equivalent of $800-1000)
Water - $20 (per month)
Sewerage - $40-50 (monthly) (note that sewerage is more costlier than water)
Electricity - $100-150 (monthly)
Gas (cooking and heating) - $200-300 (monthly)
Snow removal, cleaning and solid waste collection - $150-200 (monthly)
Total user charges per month - $500-700 (PPP equivalent of $125-175)

Adjusting for PPP (assume conversion factor of 5), the property tax in the US is still 16 to 20 times Indian rates. In other words, the property tax on a 1500-2000 sqft house in the suburbs of Hyderabad will have to be increased from Rs 2000 to atleast Rs 32000 to become equivalent with rates in the US. Interestingly, this would be about 1% of the market value of the Hyderabad house. It is true that police and fire services are not under the local body in India, and teachers salaries are paid by the state government in many states. On the other hand Indian cities do not maintain good libraries and other community amenities, and their civic infrastructure, schools and hospitals are in a bad state of disrepair.

The limited focus of local body functions, private delivery of utility services, and the large property tax rates atleast partially explain the greater efficiency and effectiveness of local governments in the US.

Wednesday, August 13, 2008

Why foreigners invest in the US?

One of the most important contributors to the robust economic health of the US economy for most of the past two decades, despite the rising trade and current account deficits, has been the continuing willingness of emerging market Central Banks to invest a large part of their burgeoning foreign exchange surpluses in the low yielding US Treasury securities. Over $2 trillion dollars has been flowing into the US every year, sustaining a spectacular consumption boom that has been the engine of US economic growth.

Over the five years from 2002 through 2006, gross capital flows into the United States totaled $6.2 trillion. Foreigners invested an average of over $5 billion in the United States every day, despite relatively low returns compared to investments in other countries and the widespread expectation of continued dollar depreciation. Why have these investors foregone large returns and invested in the low yielding US government securities?

This is the subject of an NBER working paper by Kristin Forbes, which argues that the absence of adequate depth and maturity in the domestic financial markets is the major reason for this capital flows. Countries with less developed financial markets invest a larger share of their portfolios in the United States and the magnitude of this effect decreases with income per capita. The inference from this finding is that lower levels of financial market development in other countries will continue to support capital flows into the United States, thereby supporting the US current account deficit and large global imbalances without major changes in asset prices.

Forbes writes, "Indeed, they (foreginers) may choose to purchase U.S. portfolio investments in order to benefit from the highly developed, liquid, and efficient US financial markets, and from the strong corporate governance and institutions in the United States - although both of these perceived strengths of the United States have shown some vulnerabilities during the recent financial market turmoil. Foreigners also may invest in the United States in order to diversify risk, especially if returns in US financial markets have little correlation with returns in their own country's domestic financial markets. Or, investors outside the United States may put their money here because of their strong linkages with the United States, through trade flows or such measures of "closeness" as distance, inexpensive communications, or sharing a common language."

"Second-best" solutions to resolving civil wars

In a world of "best practice" models, it has long been the acknowledged wisdom that civil conflicts in developing countries, especially in Africa, can be solved only by encouraging democratic exercise of power and eliminating despotic warlords who have seized power. This poses problems in finding solutions to many of the sub-national strifes in Africa, where local warlords carve out their exclusive jurisdictions and exploit the area and its people, plundering their rich natural resource base.

The international community has consistently refused to recognize the reality of these strong local centers of power, represented by the victorious warlords, and have responded by imposing economic sanctions. This stalemate in turn benefits and most often ends up strengthening the warlord's position (they manage to focus local discontent on the hardship caused by the sanctions), while causing severe hardship and deprivation for the poor residents of the area.

Now Chris Blattman makes a bold suggestion that the relationship between a local warlord and his exploited local residents be formalized through a legal arrangement, wherein the illegitimate enterprise be converted into a legitimate economic activity. The economic activity would then be regulated and subjected to all the regular checks and controls and taxes. Such a "second-best" arrangement acknowledges the reality of the warlord's de-facto authority, but tries to incentivize him to exercise internationally accepted norms of ruler-ruled relationship.

The warlord benefits by way of international (and formal domestic) recognition for his authority over the area, in return for adhering to responsible norms of governance and repsect for democratic rights. The local residents therefore escape exploitation by their rulers. The warlord trades his exploitative policies for domestic and international legitimacy.

As the example of Uganda shows, over time the remaining traces of exploitative practices recede and the residents gain enough power to even remove their rulers, mostly through democratic process. This sets the platform for the development of more organic and accountable governance structures.

There is atleast one precedent in history for this arrangement. This is something similar to the dilution of the Mughal empire by the jagirdari system (the local Mughal generals were granted revenue collection jurisdiction over their areas, as jagirs) in India of the eighteenth and nineteenth centuries, which may have played a significant role in expediting the transition from monarchy to democracy in the country.

An extension of this logic would be to recognize victorious warlords, but only under certain conditions, wherein they agree to abide by international conventions on civilized behaviour and adherence to basic human rights. It is surely an experiment worth attempting.

Tuesday, August 12, 2008

Debates on globalization

The ongoing commodity and energy price spikes and the recessionary pressures facing developed economies, has generated an intense debate about globalization and global free trade. The atmosphere of unqualified acceptance of globalization that prevailed in the nineties and early part of this decade, has given way to a more nuanced view. There is enough evidence to indicate that the outcomes from two decades of globalization and falling trade barriers may have been mixed, and may even have contributed to widening inequality across the world. This debate has been the subject of previous posts in this blog here and here.

Dani Rodrik neatly sums up the growing body of critical opinion against any unrestrained acceptance of globalization. He writes, "So we have Paul Samuelson, the author of the post-war era's landmark economics textbook, reminding his fellow economists that China's gains in globalisation may well come at the expense of the US; Paul Krugman, today's foremost international trade theorist, arguing that trade with low-income countries is no longer too small to have an effect on inequality; Alan Blinder, a former US Federal Reserve vice-chairman, worrying that international outsourcing will cause unprecedented dislocations for the US labour force; Martin Wolf, the Financial Times columnist and one of the most articulate advocates of globalisation, writing of his disappointment with how financial globalisation has turned out; and Larry Summers, the US Treasury chief and the Clinton administration's "Mr Globalisation", musing about the dangers of a race to the bottom in national regulations and the need for international labour standards."

A few months back, University of California's Graduate School of Business (GSB) professors, Christian Borda and John Romalis, had argued in an NBER working paper that trade with China may have had the impact of lowering the prices paid by the poorer Americans for their daily consumption needs, thereby mitigating the effects of widening inequality. They wrote, "Since Chinese exports are concentrated in low-quality non-durable products that are heavily purchased by poorer Americans, we find that about one third of the relative price drops faced by the poor are associated with rising Chinese imports".

This and an NYT column by Tyler Cowen, reiterating his belief that globalization produces net benefits for everyone, triggered off an interesting debate in the blogosphere. Cowen had argued that the pace of globalization should not be linked to issues like strengthening social safety nets etc. He wrote that instead of worrying about globalization America should focus on getting its schools, health care and banking systems right.

Mark Thoma differed by claiming that the net impact of globalization and increased trade on the middle- and lower-income households is more negative than is commonly projected. He also wrote that "maintaining political support for increased openness will require that the gains from trade and technological change be shared more equitably, and that economic risk be dispersed across a much broader swathe of the population through risk transfer mechanisms such as enhanced social insurance".

Brad DeLong waded into the debate by claiming that globalization and trade were bit players in reasons for widening inequality within the US, and argues that the conclusions of Stolper-Samuelson hypothesis may be not correct.

Dani Rodrik has consistently argued that the benefits of free trade may have been wildly over-estimated. Using standard models, he claims that the net benefits from free trade may be less than 1% of GDP for the US economy.

The theory of comparative advantage claims that free trade lowers relative prices and not the general price level. Therefore, when a country opens up to trade (or liberalizes its trade), it is the relative price of imports that comes down; by necessity, the relative prices of its exports must go up! If the consumption basket of the majority of people are weighted in favor of the importables, the consumers are better off. But if the basket is in favor of exportables, then the consumers are worse off.

However, none of the leading opponents of unfettered globalization, including the most extremist voices like Jospeh Stiglitz, are against turning back on globalization. What they want is the creation of new institutions and compensation mechanisms – domestically and internationally – that will render globalisation more effective, fairer, and more sustainable. But their appears no single universally acceptable consensus about what sets of policies to follow to achieve these objectives and make globalization more acceptable. As Dani Rodrik writes, at a time of extreme global economic uncertainty, the world economy desperately awaits the new Keynes.

Inflation and wage-price spiral

One of the more important reasons for containing inflationary pressures using a tight monetary policy has been that of the wage-price spiral. It had been argued that higher prices would set in motion an offsetting upward pressure on wages, which in turn would drive up inflationary expectations. But since the wage-price spiral led double-digit inflation of the seventies, figures from atleast the last two decades appear to indicate that the American Government has conquered the spiral.

As Louis Uchitelle argues, the driving force behind this spiral, workers leverage, has diminished substantially, atleast in the US. Unions have declined, except in small sectors, to the point of being virtually irrelevant; cost-of-living adjustments, once commonplace, have disappeared; companies are not creating jobs; and the threat posed by off-shoring has conditioned workers to not even ask for a raise. The trend of falling real wages for atleast three decades now has also contributed to keeping the wage-price spiral down, leading to a resigned acceptance of lower living standards than to expectations of higher wages.

Unlike America where only 7.5% of workers are unionized, more than 25% of employees in the European Union are members of trade unions and in some EU countries the wages set in union contracts are automatically extended to other companies in the same industry. Martin Feldstein therefore reasons that the stronger possibility of wage-price spiral is one of the reasons for the more hawkish monetary policy stance of the European Central Bank.

This "anchoring of inflationary expectations" among workers has kept a lid on the wage-price spiral by persuading workers that inflation would be controlled. The need to "anchor inflation expectations" has been the justification behind the tight monetary policy stance of the Federal Reserve.

Paul Krugman feels that the current round of inflationary pressures are under control, wages aren’t taking off, the labor market is weak, and the one-time oil and food price spikes will end in a deflationary environment. He therefore finds no need to tighten monetary policy. Free Exchange too seems to think that food price inflation is set to fall.

Update 1
Paul Krugman has this graph indicating the diconnect between wages and consumer price index. He argues that with commodity prices falling, inflation may be on its way down.

Update 2
Here is more indication that wages are indeed not rising as fast

Slowdown in China?

The NYT carries a story quoting weaker Chinese economic indicators and forecasts a post-Olympics slowdown of the economy.

The article alludes briefly to the "enormous investments in new roads, ports, rail lines and other transportation networks are starting to show productivity gains that could help the country weather a global economic downturn better than most". It is this legacy of the two decades of booming infrastructure investments that could end up saving the Chinese economy.

Wednesday, August 6, 2008

Rogoff again on slowing global growth

For sometime now, this blog had been advocating here and here that it is necessary to slowdown global demand, so as to stave off the dark clouds encircling the global economy. Ken Rogoff has been the most prominent advocate of this school of thought.

Now Rogoff has reiterated his logic behind this reasoning. Except for Europe, all regions of the world have or are in the process of embracing some form of fiscal stimulus plan to pump-prime demand. He writes,

"Individual countries may see some short-term growth benefit to US-style macroeconomic stimulus, albeit at the expense of loosening inflation expectations and possibly paying a steep price to re-anchor them later on. But if all regions try expanding demand, even the short-term benefit will be minimal. Commodity constraints will limit the real output response globally, and most of the excess demand will spill over into higher inflation."

The whole debate ultimately boils down to which of the costs is higher - temporarily managing demand and thereby sustaining growth while re-anchoring higher inflationary expectations, against letting the excesses and distortions in the real economy and the financial markets be subjected to the process of "creative destruction" playing themselves out, thereby temporarily slowing down economic growth. I am inclined to believe that the later may be a more prudent choice, especially given the reasonably higher growth cushion available for many of the emerging economies. In fact, we should consider it a good fortune that the real economies in many emerging (and developed) countries are in good enough health, with bouyant aggregate demand growth, to take any demand slowdown in their stride.