Friday, October 31, 2008

Fiscal stimulus options

A study by the Economic Policy Institute (EPI) shows that tax cuts are among the least effective and most economically inefficient of fiscal stimulus strategies. Food stamps deliver the greatest bang for the stimulus buck, followed by unemployment insurance (UI), infrastructure spending, and assistance to states. The crucial determinant for the success of any fiscal stimulus is that it should be spent immediately and not saved. This means that the benefits should be targetted at those people who are most likely to spend it fully. Unlike taxes, which are more likely to be saved or repay off old debts, the other aforementioned stimulus reach the most in need and therefore involve immediate consumption spending.

The first round of fiscal stimulus in the US, worth $145 bn announced in January 2008, focussed on tax rebates for families and incentives for businesses, and was therefore relatively ineffectual in benefitting the economy. I have posted previously on these issues in detail here and here.

(HT: Economix)

Thursday, October 30, 2008

Liquidity trap in the US?

The comparisons with Japan of the nineties and early part of this decade look increasingly appropriate for the US economy. By cutting the Federal funds rate, the rate which banks charge each other on overnight loans, by 50 basis points to 1%, the Fed has opened up strong possibility of a zero rate scenario, commonly called "Zero Lower Bound".

The Japanese Central Bank had kept interest rates at zero for five years from 2001 to 2006, in an effort to combat persisting deflation and to stimulate an economy that tanked into recession in the aftermath of the bursting of the property and financial market bubbles. Like Japan’s, American banks have become so decimated by losses in real estate that they are either unable or unwilling to resume normal lending.

However, the rate cuts may not mean much as the economy’s problems have less to do with interest rates than the reluctance of banks and financial institutions to lend money. Even though the Fed has lent almost $600 billion to financial institutions in the last month alone, banks are still reluctant to lend to businesses or consumers. Since the credit crisis began in August 2007, the Fed has slashed the overnight lending rate from 5.25%. But interest rates for 30-year fixed-rate mortgages are about 6.3%, roughly where they were when the credit crisis began.

The prospect of zero rates will limit the traditional monetary policy options. The remaining options would involve "quantitative easing" by effectively printing more money and injecting it into the eocnomy. The Fed could start buying Treasury securities with longer maturities, which would push up their prices and drive down longer-term interest rates. If that didn’t work, the Fed could start buying up privately-issued debt, like corporate bonds. All these options have adverse long term implications on the macroeconomic balance, if they fail.

If the Fed funds rate did drop to zero, it would not mean free money for consumers or businesses. The zero rate would only apply to the reserves that banks are required to maintain and that they lend to one another. Customers would still have to pay some interest, but the rates could be extremely low for some business borrowers.

The rate cut comes even as the Fed acknowledged that the economy had lost steam on almost every front — consumer spending, business investment, financial markets and even exports, which had been the one bright spot recently. Further, so early in a downturn, the US economy has shed more than 700,000 jobs so far this year, and the unemployment rate has climbed to 6.1%, from 5% in January, and is estimated to reach atleast 8%. Credit card companies, facing sharp increase in defaults, have made sharp cuts in their lending.

Interestingly, with rates approaching zero, it is important that the US economy experience some amount of inflation, or else fall into a liquidity trap similar to the one that Japan faced. Some amount of inflation is desirable under such low interest rate conditions, so as to both encourage spending and give enough room for flexibility in case of rates being forced down further. But the falling commodity prices may have exactly the opposite effect, stoking off deflationary pressures.

Update 1
Now comes the first statistical confirmation of a recession, with personal consumption falling at an annual rate of 3.1% in the third quarter of this year, its biggest drop since 1980, when the economy was in a deep recession. The last quarter in which consumers reduced their spending came in 1991. All this translates into an annualised shrinkage of the economy by 0.3%, a figure that is certain to worsen as the recession deepens.

Update 2
Mostly Economics explains Zero Interest Rate Policy (ZIRP), deflation and the liquidity trap.

Wednesday, October 29, 2008

World housing prices

The size of each territory shows the total value of all housing, adjusted for local purchasing power. Western Europe contains the most expensive housing, while Africa and South Asia has the cheapest, even after allowing for the fact that money goes further here. Good news for Indian real estate market?

(HT: The Telegraph)

World rail, moped and motorcycle footprint

Moped and motorcycle usage map of the world

Rail usage map

The maps appear to indicate that India may be the most mobile country in the world!

(HT: The Telegraph)

World wealth map

1 AD

2015 AD

(HT: The Telegraph and Chris Blattman)

Why India and China may be less affected?

Here are a few more reasons why Asia may be relatively less affected by the financial market crisis in the US and Europe
1. Mortgages are new to the emerging economies of Asia. Home loans represent only 19% of GDP in Japan, 12% in China, and a mere 5% in India, according to CLSA figures for 2007. In contrast they form 105% of GDP in the US.
2. Very few mortgages have been securitized and sold as mortgage backed securities. Other complex securities like CDOs and CMOs are yet to make their entry into the Asian markets.
3. Asian banks were much more conservative in their mortgage lending, limiting loans to a maximum of 70% of the home price. In the US, mortgage lenders loaned anything from 80% to even 100% of the home price.
4. Real estate related exposures of Indian and Chinese banks are relatively small. In India, HDFC, Axis Bank, and Yes Bank have the biggest exposure to property developers, at about 12% of loans.

External trade accounts for over 70% of China's GDP and 40% of India's GDP, and is much higher for many of the smaller East Asian economies. While it is true that many Asian economies are heavily export dependent, more than half of the their exports are among themselves.

For the past two decades, the high domestic savings and investments of Asian economies has been the engine of global economic growth. Their cheap exports have gone into triggering and then sustaining a global "savings glut" and a "consumption boom" in the US. With the export market now drying up, the time may have now come for the emerging economies of Asia to stoke their hitherto suppressed domestic consumption.

None of this can save Asia from the contagion effects of the financial market Tsunami that originated in the US financial markets. However, in these extraordinary times, a decline of growth rate from 12% to 9% for China and from 9% to 7% for India, are exceptional and enviable achievements. Both are more than double the most optimistic assessment of the global economic growth rate!

Update 1
Economist has this article explaining why contrary to popular perception, China may not be that closely dependent on exports.

Headline figures show that China's exports surged from 20% of GDP in 2001 to almost 40% in 2007. However, in value-added terms, by stripping out imported components, and then converting the remaining domestic content into value-added terms by subtracting inputs purchased from other domestic sectors, we find that the "true" export share is just under 10% of GDP, making China slightly more exposed to exports than Japan, but nowhere near as export-led as Taiwan or Singapore. At first glance, that second step seems odd: surely the materials which exporters buy from the rest of the economy should be included in any assessment of the importance of exports? But if purchases of domestic inputs were left in for exporters, the same thing would need to be done for all other sectors. That would make the denominator for the export ratio much bigger than GDP.

African governance scorecard

The Mo Ibrahim governance index, which ranks 48 sub-Saharan African countries by five criteria - safety and security, the rule of law, transparency and corruption, participation and human rights, sustainable economic opportunity and human development - finds Mauritius as the best governed country in Africa. Interestingly, the smaller countries occupy the top positions, while the biiger, resource-rich ones make up the rear. Yet another affirmation of the "resource curse"?

(HT: The Economist)

Tuesday, October 28, 2008

Marx and the financial crisis

Chris Dillow feels that the ongoing crisis, with its origins in the financial markets, makes Marxian explanations of the crises facing capitalism, which are based on the real economy, less relevant. To Marx, crises in capitalism originated in the real economy. Recessions occur when an over-accumulation of real capital equipment combine with a lack of demand to cause a falling rate of profit and then capital-scrapping, job cuts and slump. This could atleast partialy explain the previous major recessions.

Interestingly, as Dillow argues, Marx showed that capitalism was micro efficient but macro inefficient - individual capitalists, each pursuing profit maximization, could produce an outcome that was bad for capitalists in general (falling profits and crisis). He seems to have taken for granted that individual capitalist enterprises were rationally organized - an assumption clearly belied by the recent happenings in the financial markets.

However, on a broader canvas, as the cataclysmic recent events highlight, Marx was right to show that capitalism was a force for great growth and great instability; right to show that profits arose from exploitation; right to stress that technical progress determines social conditions; right on alienation and primitive accumulation.

But where Marx, and his classical predecessors and even neo-classical successors, failed was in drawing conslusions from these underlying developments. Much before Marx, Malthus had already postulated that the supply of labour would rise to offset increasing demand, keeping real wages down (theory of the "increasing misery" of the working class), and Ricardo (and Smith) had prophesied that the law of diminishing returns would cause the rate of profits to fall thereby leading to a "stationary state" in which economic growth ceased. But they all, including the neo-classical exogenous growth theories, failed to appreciate the importance of technological progress. Explaining how capitalism continues to survive, Dillow writes, "Economic growth is a race between technical progress and diminishing returns. And technical progress has won."

Starbucks theory of international economics!

Daniel Gross proposes the "Starbucks theory of international economics", which postulates - the higher the concentration of expensive, nautically themed, faux-Italian-branded Frappuccino joints in a country's financial capital, the more likely the country is to have suffered catastrophic financial losses!

The author draws parallels between the "irrational exuberance" that blew the sub-prime mortgage bubble and the sectacular proliferation of Starbucks coffee outlets in many major global financial centers. He writes,
"The Seattle-based coffee chain followed new housing developments into the suburbs and exurbs, where its outlets became pit stops for real-estate brokers and their clients. It also carpet-bombed the business districts of large cities, especially the financial centers, with nearly 200 in Manhattan alone. Starbucks' frothy treats provided the fuel for the boom, the caffeine that enabled deal jockeys to stay up all hours putting together offering papers for CDOs, and helped mortgage brokers work overtime processing dubious loan documents. Starbucks strategically located many of its outlets on the ground floors of big investment banks."

However, beyond the obvious ancedotal appeal, the "Starbucks theory", like the "Golden Arches" theory of international relations of Thomas Friedman, may have only limited analytical utility. The massive spurt in Starbucks stores were only one of the many economic and commercial developments that piggy backed on the sub-prime boom. In other words, Starbucks formed a part of the inevitable froth that accompanies such bubbles!

Making sense of derivatives

Over the counter derivatives market, one of the biggest contributors to the ongoing financial crisis, had an estimated size of about $596 trillion by end of 2007. In contrast, the value of the world's financial assets—including all stock, bonds, and bank deposits—was pegged at $167 trillion.

But the numbers may be deceptively high as there are often multiple derivative contracts on the same underlying asset, not all contracts involve actual delivery of the asset or culminates in a transaction, and since many contracts hedge risks they essentially cancel one another out. So a more meaningful way of measuring the size of the derivatives market is to calculate the instruments' market value — which refers to how much they would be worth if the contracts had to be settled today. Gross market value of all outstanding derivatives was $14.5 trillion at the end of 2007, less than one-fortieth of the $596 trillion estimate. That number shrinks to about $3.3 trillion once you take into account contracts that directly offset one another.

Update 1
Gretchen Morgenson has this account of how the complex derivatives borught about the downfall of the likes of Merrill Lynch.

Update 2 (7/3/2010)
Gretchen Morgenson on swap contracts entered into by Greece and municipal bodies in the US that hugely benefitted the advisors and banks that arranged those deals.

Monday, October 27, 2008

Emerging markets balance sheet

The decoupling arguement appears to be surely settled, as the butterfly flapping its wings in New York is shaking up the airwaves in Shanghai and Mumbai! The contagion effect on the emerging economy financial markets, exchange rates and the monetary policy, has been significant. Now the real economy too in these countries are feeling the effects of the recessionary conditions in US and Europe.

Here is an attempt to tally the pluses and minuses facing emerginge conomies. The negative side first.

1. Many of the emerging economies, especially in the East Asia, are export driven and will feel the pinch from reduced consumption and imports by the developed economies. Both the manufacturing exporters, like China and ASEAN, and the services sellers, like India and Phillipines, will be adversely affected.
2. The commodity exporters, like oil producers and many Latin American and African countries, will find their windfall profits from the commodities price boom, suddenly disappear. Brazil’s commodity exports amount to 9% of its GDP and its commodity firms, such as the oil giant Petrobras, account for over 40% of the stockmarket.
3. The falling asset prices and resultant unwinding of positions from emerging economies, and the decline in corporate investment resources of multi-national firms, will squeeze the availability of external funds through both Portfolio (FPI) and Direct Investment (FDI) inflows.
4. The unwinding of positions by US and European financial institutions to shore up the reserves of the distressed parent firms, has put downward pressure on the domestic currencies. The falling currencies could substantially offset the advantage gained from declines in commodity prices.
5. The low US interest rates and the absence of adequate depth in domestic financial markets, will mean that the massive foreign exchange surpluses invested in US Treaury Bonds will continue to yield only nominal returns. These investments will remain as one of the largest foreign aid programs in world history.
6. The exports of many of the East Asian economies contain significant import content. The depreciating local currencies make import more expensive, and thereby forcing some amount of pass through into the export prices.
7. The depreciating local currency will make the dollar-denominated loans taken by private firms and governments more expensive. Besides increasing the interest burden and cost of capital, it also opens up the possibility of defaults.

On the positive side
1. The cheaper commodity prices will ease inflationary expectations and give the Central Banks more room to manouvre with monetary policy, besides easing the price pressure on the poor population.
2. By making exports more competitive, the cheaper currencies, could help ease current account deficits in countries like India, and boost exports everywhere.
3. The crisis provides an ideal opportunity to spur domestic consumption growth in many of these economies, which is vital to ensuring the sustenance of the high economic growth rates of recent years. A strong domestic demand can help insulate economies to some extent from such global turmoils.
4. The substantial domestic savings, in the range of 30-50%, will, once the apprehensions (arising mostly from the Wall Street and its linkages with the domestic markets) about credit quality eases, help keep open the tap for investment capital.
5. Unlike the Wall Street and increasingly, the European financial markets, which are facing a solvency crisis, the emerging economy financial markets are only experiencing a liquidity crisis. The crucial difference is that a solvency crisis has to ultimately climax in massive losses, a liquidity crisis can ease if confidence is restored back into the market.

Sunday, October 26, 2008

Do newspapers make politicians more responsive?

Over the last decade or so, Andhra Pradesh has seen a spectacular growth in local editions of Telugu language newspapers. There are atleast eight news dailies, with district tabloid editions, covering all the 23 districts in the State. Other states too are undergoing a similar revolution in information dissemination and opinion making, albeit at a slower pace and smaller scale.

What has been the impact of this development on local politics? Has it made local politicians more responsive? Have these local editions succeeded in highlighting the major issues of public concern? Has this surge in local information made people more aware and stoked their civic sensibilities? What has been their role in fuelling the "competitive populism" that is sweeping politics today?

An NBER working paper by David Stromberg and James M. Snyder Jr. have found that congressmen in the US from districts with newspapers that aggressively cover local politics tend to work harder to represent the interests of their constituents. Such congressmen are more likely to break with their parties, more likely to bring home pork-barrel projects, and more likely to participate actively in committee hearings than congressmen from districts without a strong local press.

An intutive assessment would appear to answer in the affirmative to all the aforementioned questions. The polity in a hitherto semi-feudal society like Andhra Pradesh has undoubtedly become much more responsive since the early nineties. Crucial development issues like education and health care has been brought to the forefront of government interventions and electoral debate, especially in local elections. Social and economic empowerment has occured at an unprecedented pace during this period. Electoral politics has become much more intense and competitive, with candidates trying to outdo each other in their promises to constituents.

This surge in awareness has been most marked in villages and mofussil towns. Electoral turnout in local body elections, one of the simplest barometers of civic involvement, has increased substantially in these areas, whereas it has declined in urban centers like Hyderabad. Interestingly, the penetration of these local editions has been least effective in cities like Hyderabad, where the English dailies (with their more state and national focus) have crowded out the local issue oriented vernacular dailies.

(HT: Freakonomics)

Hedge funds next?

One of the most remarkable features of the ongoing crisis has been its relative lack of impact on the $1.7 trillion hedge funds industry. The dot com bust and weakness of the equity markets at the turn of the century, pushed institutions like pension funds, foundations and endowments, into hedge funds which promised attractive returns. Given their risky investment strategies, high leverage and large exposure to mortgage backed securities, it was natural to expect these private partnerships to be adversely affected by the crisis.

Steve Levitt thinks the good news may not last for too long and their weak balance sheets are obscured by lack of regulation and "lock-in" periods on investments. The "lock-in" periods vary from a quarter to a few years, though generally with quarterly opt-out provisions. The unregulated nature means that hedge funds are not governed by "mark to market" regulations that necessitates margin calls and capital ratio requirements. As the "lock-in" periods expire and redemptions start, Levitt predicts "a string of huge hedge fund failures".

And the signs are unmistakable. Globally the number of hedge funds are shrinking, retrenchments have started in some of the biggest names, and losses are mounting as wealthy investors start heading for the exits. The current year is on the way to becoming the worst ever since the industry erupted into prominence in 1990. However, even as the average hedge fund was down 17.6% during the year till early this week, it performed far better than most other investment avenues.

The falling markets, bans on short trading, tightened standards on prime brokers (who lend shares for short selling, offer advise and assist hedge fund maangers), and the rising tide of regulation, has made many traditional strategies of these "omnipotent vanguard of financial capitalism" unworkable or illegal. The crisis facing the hedge funds lends credence to the long held view by sceptics that far from any special set of trading strategies, these funds just used cheap money to amplify mediocre returns and are simply another cog in the massive debt-dependent financial ecosystem that has emerged in the recent years.

But the extent of their leverage, at three to five times, is far less than the 20 to 30 ratios that investment banks had run up. Given this, the major concern arises from any possibility of a stampede to the exit doors by its high net worth investors and institutions, in particular who face pressures to raise their surpluses and margin calls. In the days ahead, only a spectacular rebound by the financial markets can save runs on many hedge funds.

Update 1
Hedge funds have performed badly in 2008, as indicated by the graph below.

Getting people to vote! has started commitment contracts to incentivize voters to vote in their local elections. As Dean Karlan writes in an FT op-ed,
"StickK can verify (using publicly available data) whether people fulfill their commitment to vote. If they do not, StickK e-mails their friends or charges their credit card as punishment for failure. If money, individuals choose where the money gets sent; but most choose to send it to a charity (chosen by stickK, so the individual gets no specific pleasure from knowing where the money goes), or even harsher, to an 'anti charity', a politically polarizing charity such as the Bill Clinton Presidential Library or the George W. Bush Presidential Library."

(HT: Freakonomics)

Low savings and the financial crisis

David Leonhardt and Ben Stein feel that the virtual lack of savings among American households has been instrumental in creating the crisis. The net result of the past two decades of financial engineering has been a proliferation of financial instruments, promising (and delivering for some time) spectacular returns, that enticed investors and savers away from regular deposit insured savings avenues. The "wealth effect" and "irrational exuberance" generated by the sustained boom in equity and real estate markets, gave currency to an impression that asset markets can only go up. The result was a steep fall in the household savings rate, which even fell into negative territory.

Ironically, the low savings may have played a significant role in containing the ongoing crisis by limiting the runs on bank deposits. If people do not have enough savings account deposits to pull out, then there cannot be bank runs! Atleast the markets do not have to contend with a rush to pull out deposits!

Update 1
Daniel Gross highlights how institutional factors (like aggressive credit-card solicitations, ubiquitous casinos, state lotteries, and payday lenders, which "outnumber McDonald's franchises in four out of five of the nation's most populous states") and macroeconomic developments (increasing cost of goods and services, while incomes stagnate or even decline) have contributed to keeping savings down.

According to the Federal Reserve, the net worth of households and nonprofit organizations soared from $39.2 trillion at the end of 2002 to $58.7 trillion in the third quarter of 2007, a 50% increase. This came at a time when real personal savings were miniuscule: $174.9 billion in 2003 and just $57.4 billion last year.

But with consumer spending forming 70% of economic activity, Americans need to spend more at this time of economic crisis.

Global electoral college!

If the whole world could vote in the US Presidential elections, Barack Obama would obliterate John McCain 9009 to 278! So says The Economist. Does it say anything about how much the Repblicans have alienated the international community and what the world's perception of the GoP?

Puzzles quiz!

1. No ticket wins? Imagine a 1000-ticket lottery with one winning ticket. It's possible that Ticket 1 will not win. This is applicable to Ticket 2, and Ticket 3 ... and Ticket 1000 too. But, seen this way, it entails the impossible conclusion that "one ticket wins and no ticket wins". Who described it?

2. Razor's edge. In a town, there is only one barber. Every male shaves himself or goes to the barber. From this it follows that the barber shaves only those who don't shave themselves. So far so good, but we land in a mess when we ask the question "Does the barber shave himself? If the barber does not shave himself, then he must shave himself; but if he does shave himself, then he will not shave himself. Who mentions the barber's paradox in a song?

3. End of head. A trickster god makes a bet with some dwarfs. Should he lose the wager, the price would be his head. The dwarfs win and come to collect his head. He says it's alright, but they have absolutely no right to take any part of his neck. So, where does the head end and the neck begin. The debate is still on, and the god retains his head. What's the term for the logical fallacy involved?

4. Going to Abilene. "Are we going to Abilene?" Yes, that's the decision of a group of people. Nobody actually wanted the trip, but nobody said "No", because everybody mistakenly believed that all the others wanted to go to Abilene; saying "No" would create a conflict. This happens often in all societies, in collective decisions. Who described it?

5. A poll plot. In a voting situation, individual preferences pose a conflict when taken together. Imagine three candidates, A, B and C, and three voters with the following preferences (in decreasing order). Voter 1: ABC. Voter 2: BCA. Voter 3: CAB. Now, if C is chosen as the winner, you can argue B should win instead, since two voters prefer B to C. But by the same argument, A is preferred to B, and C is preferred to A. What's the situation called, and who noted it first?

6. The elevator paradox. Two famous observers in a multi-story building. The one with an office near the bottom thought the first elevator to stop at his floor was most often going down. The one with an office near the top thought it's quite the other way round. This gives the impression that elevator cars are mantled in the middle of the building and sent upwards or downwards to be dismantled, which is not true. Who were the observers?

7. Buttered cat. Cats always land on their feet; buttered toast always lands buttered side down. So, what would happen if you drop a cat from a good height with a piece of toast attached on its back, butter side up? This is the "buttered cat paradox". Who won a Student Academy Award for a film based on a high-school friend's paper on the topic?

8. The same axe. The paradox in "George Washington's axe" revolves around the question whether the axe remains the same axe if it were fitted with a new head and later with a new handle. Sometimes it's called "My Grandfather's Axe", as referred to in a historical novel: "This is my grandfather's axe: my father fitted it with a new stock, and I have fitted it with a new head." Who was the author?

9. Room for you. Hilbert's paradox (after German mathematician David Hilbert) presents a hotel with infinitely many rooms -- all occupied! As the new arrival, you get Room 1. And for that, the staff have to move the current occupant of Room 1 to Room 2, the occupant of Room 2 to Room 3 and so on. What movie expresses it best with the slogan "We're always full, but we always have room for you"?

ANSWERS 1. Henry E. Kyburg (philosopher, computer scientist) 2. Chip Hop (rap) artist MC Plus in "Man Vs Machine" 3. Loki's Wager (Loki is that god, in Norse mythology) 4. US management expert Jerry Harvey in 'The Abilene Paradox' 5. The voting paradox / Marquis de Condorcet (18th century) 6. Physicist Marvin Stern and the very famous George Gamow 7. Kimberly Miner for her 'Perpetual Motion' (2003) 8. Robert Graves in 'The Golden Fleece' (1944) 9. 'Hotel Infinity' by Amanda Boyle (writer/director)

(HT: The New Indian Express)

Friday, October 24, 2008

Food security interventions in developing countries

The effect of the ongoing global economic crisis, especially that arising from the increased food prices, and its impact on the poor, has been the focus of intense debate. Apart from its obvious impact on those already poor, the steep rise in foodgrain prices has also had the effect of making food unaffordable for more than a 100 million people, especially in the least developed countries. Which type of social safety nets are the most effective and least distortionary ways of delivering assistance to these people?

Nora Lustig is spot on in describing the global food crisis as one involving a price increase rather than reduced supply, and therefore the most appropriate safety net is to compensate the affected population - both the 'old' and 'new' poor - for their loss in purchasing power. She analyses four categories of social safety net programmes - direct cash transfers, food for work, food rations/stamps, and school feeding - and finds that 19 out of 49 low-income and 49 out of 95 middle-income countries do not have any such programme.

For any of these programs to successfully address the issue of 'food security', not only does it need to effectively bridge the reduced purchasing power, but also have mechanisms to select the 'new' poor. Further, it is also important to deliver the assistance without much time lag. School feeding programs, with their universal nature, are an excellent option for all times. Food for work is mainly an employment generation activity, and does not address the issue of decreased purchasing power. It may be more effective as a demand management response, but not as food security initiative.

Both cash transfer and food stamps are more effective ways of delivering assistance to those hurt by reduced purchasing power. Cash transfer programs though an economically efficient way to transfer assistance, is difficult to administer, especially in assisting the 'new' poor. However, this may be appropriate for middle income and developed countries, where financial inclusion is achieved (people have access to formal bank accounts) and beneficiary information in accurately captured.

In the least developed countries, food vouchers/stamps, though less efficient than direct cash transfers, may be faster to implement and much easier to administer. Selection of the 'new' poor is always going to be a huge challenge, especially given the short response time available, in these countries. Further, except for a small minority, the ovewhelming majority in these countries are likely to be affected by reduced purchasing power. Therefore a strong case can be made out for a universal public distribution system for distribution of the basic foodgrains. Any program that seeks to screen out a small minority will have unaccpetably high transaction costs and the market distortions. Multi-lateral and bilateral aid to these countries should be aimed at assisting such programs.

However, as the graphic shows, food for work has become the most popular food security intiaitive in the low income countries. Unfortunately food stamps are the least favored policy response even among the least developed countries.

The crisis is also a timely reminder about the importance of subsistence farming and increasing farm productivity, especially for the rural poor. Since most rural families have access to atleast some small plot of farming land, it may be important to ensure that this land is brought under cultivation and productivity on that land is increased. This may be one of the most fundamental and effective food security initiatives.

Tuesday, October 21, 2008

Falling commodity prices

Reflecting record world-wide harvests, the latest FAO estimates show that world cereal output touched 2.2 billion metric tonnes, a new record, and 5% more than last year. Rice production increased 2% over last year's record harvest, and wheat production increased by about 11%, fed by a phenomenal 25% rise in Europe.

Declining demand and recessionary expectations may lie behind the steep decline in global oil and commodity prices. Copper rose to $8443 pmt in the second quarter this year, but it is now selling at $6991, a decline of over 17%. While iron ore prices have largely remained static this year at around $140 per dry metric ton, this actually represents a slowdown in a six-year long price surge. The World Bank’s steel products price index rose continuously over the year to a high of 342 in August but dipped marginally to 338 in September.

Effect of deleveraging

The ongoing de-leveraging has driven the PE valuations of equity markets in the emerging economies down by 40-70%. At a PE multiple of 13.2, the Indian market may be the closest to historical PE standard of 15 to 17. Does it mean the Nifty has bottomed out?

Monday, October 20, 2008

Land reforms in China

In another major step in its transition to a capitalist economy, the Chinese government has announced that it will permit farmers to to lease or transfer land-use rights on the small land plots assigned to them under the existing system of collective village ownership of lands. Under the new policy, the government will establish markets where farmers can 'subcontract, lease, exchange or swap' land-use rights or join cooperatives, thereby opening up the possibility of consolidation of farms and more efficient farm activity.

This comes on the 30th anniversary of the first generation of land reforms initiated by Deng Xiaoping, that broke up the collective use, if not ownership, of land and created a household registration system that assigned land to individual families to use as they saw fit. Those reforms enabled farm incomes to rise sharply during the early 1980s, even as incomes of city dwellers remained mostly stagnant.

What should the RBI do?

The Reserve Bank of India (RBI) has been on a mission to inject more liquidity into the financial markets, especially through sharp cuts in Cash Reserve Ratio (CRR) and increased exercise of its Liquidity Adjustment Facility (LAF) window. All these are extraordinary monetary policy steps by the RBI.

The CRR, the proportion of their deposits that banks have to maintain in cash with the RBI, has been cut thrice from 9.5% to 6.5%, including one cut by 150 basis points. Statutory Liquidity Ratio (SLR), the share of assets kept in government securities, has been cut by 50 basis points. Besides this, the RBI has agreed to provide Rs 25,000 Cr to banks that have participated in the agriculture debt relief and waiver scheme.

Apart from the LAF auctions that permit banks to borrow from the RBI in return for government securities, the RBI has also decided to open a Rs 20,000 Cr credit window for banks to borrow from it in order to lend to mutual funds. All these have had the effect of releasing atleast Rs 1,45,000 Cr of lending resources to banks. Amidst all this action, the RBI has been conspicuously silent about the premier monetary policy lever - interest rates.

The unprecedented nature of the response, with the slew of measures to inject liquidity into the banking system, gives the impression of a crisis ridden banking sector. However, I am inclined to believe that both the diagnosis and the prescription may be a case of mistaking the trees for the woods. While an adequate CRR response was urgently warranted, the more important monetary policy exercise has to be by way of cuts in the interest rates. Unfortunately, action in this direction has not been forthcoming and delay may yet cost us dearly.

The liquidity problems facing the Indian financial markets and banks are not solvency related, but more a manifestation of the contagion effects from the global crisis. The global financial meltdown has triggered off massive unwinding of positions or deleveraging by FIIs as they repatriate capital to shore up the reserves of their embattled parents in US and Europe. This pullout and the apprehensions it generated has had a cascading downward effect on our equity markets. These investors have withdrawn more than $10 bn from the Indian equity markets in the past few days.

The effect of all these were amplified by the steep rise in margin and other prudential requirements imposed on financial institutions by mark to market (MTM) accounting procedures used to value the financial transactions they had indulged in. While such MTM accounting procedures had inflated the holdings during the bubble, they have had the opposite effect when the markets were falling. The result of all this was to have institutions scrambling to shore up their liquidity positions and reserves.

Further, the demand for dollars from FIIs pulling out their investments and oil importers looking to fund their oil purchases, has had the effect of temporarily putting upward pressure on the dollar. In other words, the Indian markets have not been spared the inevitable contagion effects of the turmoil in the global financial markets in the aftermath of the bursting of the sub-prime bubble in the US.

Unlike the US and European banking system, Indian banks do not suffer from any solvency crisis. The exposure of Indian banks to real estate and home mortgages is minimal when compared to those in US and Europe. Further, the capital adequacy ratios (CAR) of all the major Indian public and private sector banks are higher than the Basel II requirement of 12%. Therefore, at worst, we have a temporary liquidity crisis created by the sudden exodus by the FIIs and the contagion effect of the global financial market turmoil. The fundamentals of the real economy is sound and in any case has not deteriorated significantly over the past few weeks to merit any dramatic response.

The Indian corporates are facing a credit squeeze not because of any lack of adequate liquidity, but because of unaffordably high cost of capital. The pall of gloom hanging across the global economy and the expectations of an impending slowdown in the Indian economy, have exacerbated the investment climate. In this environment, the high interest rates act as a sure shot tranquilizer.

The steep falls in global energy and commodity prices and the attendant declines in domestic inflation removes the only remaining rationale for keeping interest rates high. Our interest rates are one of the highest among all major economies, and we are the only one to have not loosened monetary policy in the past few days.

The huge off-balance sheet deficits, in the form of oil and fertilizer bonds, limits the ability of the government to indulge in any fiscal pump priming, either by way of infrastructure spending or tax concessions. Fiscal policy becomes constrained under the conditions, leaving monetary policy to shoulder the responsibility.

Sunday, October 19, 2008

Demand-supply dynamics at work in oil markets

From $147 per barrel on July 11, 2008, to below $70 now, the fluctuations in oil prices are a reasonable representation of the volatility and uncertainty facing the global economy today. Roger Lowenstein has an excellent exploration in the NYT of the happenings in the oil industry in the lead up to recent dramatic events. The reasons for the volatility predictably appears to be a mixture of speculative interest, declining production and spare capacity, reduced investments, civil and political conflicts, and increased demand from emerging economies.

While speculative interests may have had a role in driving up prices, it may not be a adequate enough explanation for the large volatility. Approximately 500,000 crude-oil futures contracts, representing 500 million barrels, trade on the New York Mercantile Exchange alone each day, whereas the world uses only 86 million barrels of oil daily, and the overwhelmingly major portion of these trades are settled in cash before the contract expires and do not involve taking any physical deliveries. The lack of build up of inventories and the close links with the real economy by way of actual deliveries of these trades, limits the amount by which prices can increase.

Even as oil prices rose this decade, big oil companies — still responding to the price signal of an earlier period — plowed most of their cash flow into dividends and stock repurchases rather than risk it on exploration, and there was a lull in building critically needed refineries. By the middle of this decade, various big oil regions — Mexico, Nigeria, the North Sea, Colombia, Venezuela — were experiencing production declines.

Many older wells are declining in their outputs and merely maintaining the output levels require investments, some thing many producers are not willing to do without the incentive of higher prices. The marginal barrels today are found in remote and costly terrain, like the Canadian tar sands or off the coast of Brazil under 7,000 feet of seawater and more than 10,000 feet of ocean floor.

The expectations of a double squeeze on capacity from declining production and increased demand was enough to set in motion a series of forces that signalled to both producers and consumers and drove up prices. The present decline in oil prices is of significance in so far as the final (medium-term) floor price will determine the viability or otherwise of alternative options like natural gas and renewable energy sources.

Goldman Sachs administration!

It is no secret that the axis of power in the Treasury Department is decisively tilted in favour of Goldman Sachs, through its ex-employees led by Henry Paulson and the culture and linkages they bring into the administrative machinery. The NYT has this description of the role being played by Goldman Sachs employees in administering the financial crisis and the bailout plan.

Given the central role played by firms like Goldman Sachs (ie, thier bankers and fund managers) in inflating the sub-prime mortgage bubble, using their services to administer the bailout program raises serious concerns on conflict of interests. As the report highlights, there are already allegations that by not allowing Lehamn Brothers become a bank holding company and letting it to fail, the Treasury and the Fed were favoring Goldman Sachs. In other words, this has the potential to turn out to be the mother of all moral hazards!

Kenneth Arrow on financial markets

Kenneth Arrow is spot on about the possibility of market failures in the financial markets,

There have been two developments in the economic theory of uncertainty in the last 60 years, which have had opposite implications for the radical changes in the financial system. One has made explicit and understandable a long tradition that spreading risks among many bearers improves the functioning of the economy. The second is that there are large differences of information among market participants and that these differences are not well handled by market forces. The first point of view tends to argue for the expansion of markets, the second for recognising that they may fail to exist and, if they do come into being, may fail to work for the benefit of the general economic situation.

There is obviously much more to the full understanding of the current financial crisis, but the root is this conflict between the genuine social value of increased variety and spread of risk-bearing securities and the limits imposed by the growing difficulty of understanding the underlying risks imposed by growing complexity.

Daniel Alpert on homeowner relief

Amidst all the discussion about bailing out the financial institutions, there has been little attention paid to addressing the fundamental issue behind the crisis, what Glenn Hubbard calls "the elephant in the room" - declining home values! Now, Daniel Alpert of Westwood Capital has come up with a Freedom Recovery Plan (FRP) to exchange interest between homeowners and mortgage lenders, without creating moral hazard.

The declining home prices have left homeowners holding a pile of debt which is higher than the value of the collateral it supports. Since mortgage loans are unsecured loans with liability limited to the housing collateral, in the aforementioned circumstances the mortgage holders are better off by just walking away leaving their homes and renting home elsewhere. Such foreclosures will in turn generate a downward pressure on home prices and exacerbate the downward spiral in the housing market.

Home values become all the more important given the fact that the success or otherwise of the financial institutions bailout plans depends on stemming the declines in home prices and stabilizing these values so that the recoveries from the bailouts investments are maximized. If home prices continue to decline and foreclosures mount, the values of the underlying mortgage backed securities will fall even more, thereby further squeezing the asset base of these institutions. The result of all this could be a deleveraging spiral cum liquidity trap and more bank failures, and a case of good money thrown after increasingly worthless and bad assets!

The settlements under the FRP would involve homeowner/borrowers, with impaired mortgage loans (mortgages exceeding home values), voluntarily surrendering the deeds to their homes to their mortgagees in consideration of the right of continued occupancy, as tenants, for a period of five years. After five years, the homeowner-turned-renter would have the right to buy the home back, at fair market value, from the lender.

The FRP minimizes the moral hazard by making the homeowner losing his equity on his house, albeit temporarily, and the lender taking a loss by way of reduced rents (which would be only 60-70% of the mortgage payments). Five years may be an adequate enough time to stabilize the housing and also the financial markets. The FRP does not involve any tax payer bailout and also seeks to give all existing homeowners a chance to get back into the ownership of their homes when they’ve gotten their financial houses in order. More analysis of the FRP is available here.

Update 1
Luigi Zingales has another plan.

Update 2
Jim Grosfeld has another plan which seeks to provide interest subsidy so as to reduce the interest burden on the most distressed mortgages.

Estimating the sub-prime losses

There have been numerous estimates of the ultimate cost to the tax payer of the massive bailouts that have been announced by governments across the world. NYT estimates the total funds committed for everything from the bailouts of Fannie Mae and Freddie Mac and those of the Wall Street firm Bear Stearns and the insurer American International Group, to the financial rescue package approved by Congress, to providing guarantees to backstop selected financial markets is a very big number indeed - $5.1 trillion, more than a third of the US economy! How much of this will be recovered and how much lost to the tax payer? How the bailout plan is administered and its details will ultimately determine the final cost to the economy.

This post had been written and got lost somewhere amidst the drafts. It is published without making changes and it captures how most of the predictions made by people like Nouriel Roubini have been proved right.

Calculated Risk claims that in nominal terms, the [Case-Shiller] index is off 8.9% over the last year, and 10.2% from the peak. However, in real terms, the index has declined 12.9% during the last year, and is off 14.6% from the peak. About the extent to which housing prices can fall, it writes, "If prices will eventually fall 30% in nominal terms, then we are only about 1/3 of the way there. But if the eventual decline is 30% in real terms, then we are about half way there."

Ben Bernanke estimated the sub-prime losses at just $100bn last July. On March 7, 2008, Goldman Sachs economists published an even higher estimate of mortgage-related losses, at $500bn, along with $656bn in other losses, for a total of $1,156bn. In reaching its conclusion, Goldman estimated a peak-to-trough house price fall of 25 per cent. Martin Wolf analysed that the aggregate financial sector losses amount to $1,000bn. He also claimed that this would be manageable, if painful, for an economy as big and a government as creditworthy as that of the US.

Prof Nouriel Roubini of New York University’s Stern School of Business argues that financial losses might amount to $3,000bn. Prof Roubini notes that a 10 per cent fall in house prices (relative to the peak) knocks off $2,000bn (14 per cent of gross domestic product) from household wealth. The first 10 per cent fall has already happened. What he sees as a likely 30 per cent cumulative fall would wipe out $6,000bn, 42 per cent of GDP and 10 per cent of household wealth. Already, falling prices are showing up in declining net household wealth. Prof Roubini also talks of a $5,600bn decline in the value of stocks and the possibility of additional trillions of dollars in losses on commercial property. Total losses might even equal annual GDP.

Martin Wolf argues that "the principal direct effect of such losses will be on spending, particularly residential investment and household consumption. In the third quarter of last year, personal savings were a mere 2.4 per cent of GDP, while the financial balance of the personal sector (the difference between its income and expenditure) was minus 2.1 per cent. These patterns do not make sense when asset prices are falling. But a sharp rise in household savings would ensure a deep and durable recession."

Worse, the bigger the damage to the financial sector, the more credit-fuelled personal spending is going to dry up. So what might such overall losses mean for financial intermediaries. In Prof Roubini’s 12 steps to meltdown, discussed here on February 20, 2008, he assumed that their losses on mortgages would be $300bn-$400bn, while losses on other assets (consumer debt, commercial real estate loans and so forth) would be another $600bn-$700bn, for a total of $1,000bn.The mainstream has caught up. But Prof Roubini has moved on.

In his comments on the FT’s forum, Prof Roubini suggests that, after price falls of 20 per cent from the peak, losses on mortgages could be as much as $1,000bn. With a 40 per cent fall, they could be $2,000bn. He adds another $700bn for other losses, to reach total financial sector losses of close to $3,000bn, or about 20 per cent of GDP.

So how does Prof Roubini reach these much higher figures? The difference between him and Goldman is not so much in assumptions about the house price fall: 25 per cent for Goldman Sachs and 20-40 per cent for Prof Roubini. Both also estimate that lenders would lose half of the loan value after repossession. But Goldman believes that just 20 per cent of households in negative equity would default, while Prof Roubini believes 50 per cent might do so.

For people with poor credit ratings and few assets, apart from their house, walking away does seem to make disturbingly good sense (“Jingle-mail rings alarm bells for lenders”, Financial Times, March 7). Buyers with no equity had an option to walk. Now they are exercising it. This was demented finance. Yet, so long as the economy remains reasonably robust, highly indebted people with good career prospects would surely not wish to wreck their credit rating. Nevertheless, markets are pessimistic: the prices of even AAA tranches of securitised loans are collapsing.

Suppose, then, that Prof Roubini were right. Losses of $2,000bn-$3,000bn would decapitalise the financial system. The government would have to mount a rescue. The most plausible means of doing so would be via nationalisation of all losses. While the US government could afford to raise its debt by up to 20 per cent of GDP, in order to do this, that decision would have huge ramifications. We would have more than the biggest US financial crisis since the 1930s. It would be an epochal political event.

Yet, Goldman argues that, after allowing for loan-loss provisions, the proportion of loss-making loans advanced by the non-leveraged sector and the ability to write off losses against tax, its $1,156bn comes down to $298bn. If a similar magic could be worked on the Roubini numbers, the effective losses to the leverage sector would fall to less than $750bn – huge, but more manageable.

Much will depend on what happens to the economy. Unfortunately, the effectiveness of monetary policy is constrained when the worries are more about insolvency than illiquidity. Concern about credit quality is rampant, not least in the resurgent spreads on interbank lending. Monetary policy is further constrained when lower short-term interest rates fail to translate into long-term rates, partly because of worries about inflation.

Alas, worries are understandable. There are two ways of adjusting the prices of housing to incomes: allow nominal prices to fall or raise nominal incomes. The former means mass bankruptcy and a huge fiscal bail out; the latter imposes the inflation tax. In extreme circumstances inflation must be attractive. Even if it is not the Fed’s choice, it is what a reasonable outsider might fear, with obvious consequences for all asset prices.

I suspect Prof Roubini’s latest estimates are excessively pessimistic. But I am not certain this is so, given his record: just look at the vicious interaction between falling asset prices, financial stress and spending. We must pray that the Fed can clean it all up, without excessive collateral damage. Unfortunately, such prayers often go unanswered.

Saturday, October 18, 2008

Parking charges in cities

As expected, parking is a premium service in the major western cities, while it is relatively cheaper in the developing country cities.
(HT : The Economist)

Thursday, October 16, 2008

Is Main Street following Wall Streeet?

With the bailouts out of the way and credit tap re-opened for banks, the focus of attention now shifts from Wall Street to Main Street. However, the now continuous stream of bad news trickling out on the economy is likely to impact on the financial markets, thereby adversely affecting the dynamics of the bailout plans.

Many negative feedback loops are getting activated. There is a deep-seated fear that the financial rescue will add to an already-swelling federal budget deficit and force the Treasury to borrow heavily in the capital markets, thereby "crowding out" private investment besides forcing up interest rates and Treasury yields. Further, the recessionary expectations and weaker profits will discourage investment decisions and make companies postpone new hirings, thereby bringing down economic growth and forcing up unemployment.

The "negative wealth effect" due to declining values of real estate and shares coupled with the credit squeeze, will keep consumer spending, which has been the engine of recent economic growth at over 60% of the US GDP, very weak. The fall in retail sales is a confirmation of this trend. With Europe too experiencing similar economic environment, prospects for one of the larger remaining engines of economic growth, exports, too look very bleak.

With credit scarce, private firms are not the only ones getting squeezed. Cities, states and other local government agencies are facing problems in accessing the debt markets as the Municipal Bond market is almost frozen. Yields on municipal bonds jumped to 6.74%, up from 5.44% a month earlier.

Adding to these woes, David Leonhardt feels that income for the median household will be lower in 2010 than it was a full decade earlier. Falling pay will weigh on living standards, consumer spending and economic growth.

In keeping with the anemic global economic environment, demand has been declining, thereby driving commodity prices down. From late 2001 until mid-2008, the price of oil rose 800%, copper rose 700% and wheat rose 400%, whereas the decline of recent weeks has taken virtually every major commodity more than halfway back to its late 2001 price, adjusted for inflation. Wheat prices are down to $6 a bushel from $13 in March 2008, soya bean has fallen to $9 a bushel from $16 in July, and since the spring and early summer, oil has dropped 44%, while metals like aluminum, copper and nickel have declined by a third or more.

In many ways, the falling commodity prices may be the one silver lining in the dark clouds gathering on the horizon. It is likely to ease inflationary fears and help Central Banks keep interest rates low, besides increasing the real incomes of consumers. But the decreases may not be much if the Chinese and other emerging economies continue to grow even at a slightly reduced pace.

Update 1
Anil Kashyap and Doug Diamond in an FAQ about the financial crisis here.

Wednesday, October 15, 2008

Bailout action starts

Following in the footsteps of the British government, (Q&A here, and analysis here) the US and many European governments have announced their bailout plans. All the plans broadly seek to recapitalize the banks by capital infusion in exchange for equity stakes, extend some form of guarantees for deposits and on inter-bank lending, and impose restrictions on executive compensation on the firms availing the assistance. The American plan is more liberal in terms of the conditions imposed on the firms participating in the program.

Under the US plan, the Treasury would make $250 billion available to banks — nine have already been identified — in order to help recapitalize those banks and to get them lending again, among themselves and to businesses and consumers, besides guaranteeing new debt issued by banks for three years. The Federal Deposit Insurance Corporation (FDIC) would also offer an unlimited guarantee on bank deposits in accounts that do not bear interest — typically those of businesses — bringing the United States in line with several European countries, which have adopted such blanket guarantees. And the Federal Reserve would start a program to become the buyer of last resort for commercial paper, a move intended to help businesses get the money they need for day-to-day operations and act as a back stop for a $1.6 trillion market.

Of the $250 billion, which will come from the $700 billion bailout approved by Congress, half is to be injected into nine big banks, including Citigroup, Bank of America, Wells Fargo, Goldman Sachs and JPMorgan Chase, officials said. The other half is to go to smaller banks and thrifts. The investments will be structured so that the government can benefit from a rebound in the banks’ fortunes. All these investments and guarantees would be for a period of three years, thereby fixing an exit time for the government commitments. An analysis of the plan is found here.

These interventions to prop up banks large and small — along with recent bailouts as well as guarantees to support business loans, money markets and bank lending — mark a dramatic change in the global financial landscape and makes the national governments the ultimate guarantor for banks, something unimaginable till a few weeks back. The markets have so far responded positively to these interventions, with share prices rising across the world.

British bailout plan

US bailout plan

Update 1
Reactions of economists to the new plan here.

Update 2
Gretchen Morgenson feels that the restrictions imposed on executive pay in the bailout plan are important since the nine banks participating in the capital infusion program paid their former and current chief executives a total of $231 million last year.

Update 3
Here is an article on how the Europeans were swifter off the mark in responding to the financial market crisis.

Monday, October 13, 2008

Return of the public intellectual!

My favorite political economist, Paul Krugman, has won The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2008. He wins the Prize for his "analysis of trade patterns and location of economic activity". As Justin Wolfers rightly points out, Krugman is a "true public intellectual", unafraid of real-time policy advice, with its attendant risks of being proved wrong.

I am not surprised by the choice, especially given the ongoing financial crisis, and the active role that Paul Krugman has played in forming and shaping opinions, both through his NYT op-eds and his blog.

Links here, here, here, here, here, here, here, here, and here.

Update 1
Paul Krugman explains "New Trade Theory" here. The full paper on increasing returns and economic geography and scale economies and product differentiation are found here and here.

Update 2
Avinash Dixit describes Krugman's contributions and predicts that Paul Romer, Grossman and helpman will win the Nobel next year for their endogenous growth theory.

Update 3
Nobel lecture slides available here. Nobel lecture here.

Update 4
Nobel lecture available here.

Update 5
New Yorker profiles Paul Krugman.

"PURA will not work"!

So says Singapore's Lee Kuan Yew, referring to former Indian President APJ Abdul Kalam's development model of Providing Urban Amenities in Rural Areas (PURA). And, while appreciating the idealism inherent in the approach, I am inclined to go with Lee's arguement that given the Indian context, with its far-flung and sparsely populated villages, it may be impossible and economically inefficient to take urban amenities to rural areas.

A more appropriate and realistic model would be to have separate strategies for development in general and infrastructure development in particular, for both rural and urban areas. In urban areas, the focus should be on a gradual and planned expansion of the urban coverage, by improvements in the suburban civic infrastructure and establishment of effective linkages with the downtown areas, and in parallel develop integrated residential and industrial settlements. In rural areas, the strategy should be centered around the development of a basic minimum of physical infrastructure and civic and welfare services.

The demographics of Indian villages, especially in the more remote backward and tribal areas, is very unique. Such areas are characterized by small habitations, consisting of anywhere from 5 to 50 families, with the houses often randomly scattered or laid out in three or four small streets, and separated from the next habitation by atleast a few hundred meters. A few such habitations form a gram panchayat (GP), and ten to twenty GPs (or more) form a tehsil (or block or mandal). And there are millions of such habitations!

In this broad geographical context, and given scarce resources and competing demands, our development strategy for such areas will have to be confined to covering the essential civic and welfare services. Physical infrastructure like internal roads and drains, connecting roads, assured and safe drinking water supply, school, hospital, and anganwadi buildings should be developed in all these habitations. Civic and economic welfare services like basic education, health care, nutrition, assistance to disabled and old-aged, and food security should be assured, and delivered with adequate quality.

Achievement of even this limited goal, one which has so far eluded the Indian state, would itself be a great challenge. The effort and resources required of the government machinery to achieve them will be monumental. For a start, as Lee Kuan Yew asks, where do we get the doctors, teachers, nutritionists, and other professionals to service the millions of such habitations. Given this geographical context, it may be almost impossible to provide anything beyond basic education and health care to the residents of these hamlets.

Further, I am not sure whether this would serve the larger (and more important) objective of providing better economic and livelihood opportunities for the residents of these habitations. The scattered nature of these habitations works against exploitation of any economies of scale, and thereby makes most economic activities unsustainable. It becomes all the more challenging given India's minimal non-farm sector and manufacturing base, and our increasing reliance on a services-led growth strategy, which requires leveraging network and densification effects.

Taking examples from across the world, it is difficult to foresee much relevance for a development model that seeks to deliver these basic physical infrastructure and welfare services, while at the same time keeps these people in the existing widely spread out habitations. The alternatives are difficult and complex, and cannot be seen as a simple issue of increasing urbanization. In this context what should be the objective of our rural development policies? More about this in a later post.

Sunday, October 12, 2008

How rich are you?

You can find your position of the global rich list here.

Measures of globalization!

First, global coverage of Blackberry email device.

Second, the extent of blocking of social content on Internet.

(HT: The Economist)

Realists Vs Fundamentalists

Paul Romer has an excellent post here, highlighting the growing divide between fundamentalists, with their reliance on models, and realists, with their focus on empirical research.

Fundamentalists (like the "dynamic stochastic general equilibrium" modelers in financial markets, and the "stabilize, liberalize, privatize" ones in development policy) have an unswerving faith in models, and feel that policies should always be derived from the best available model and data filtered through this model. And, if an observation does not fit within the context of a model, it should be excluded from consideration. Realists, conscious of the limits of abstract models which filter out potentially important complexity, discounts for the flaws in the models and are more comfortable with a division of labor between the researcher who constantly refines and improves the models and the clinician who makes policy decisions.

As Prof Romer says, leave alone outliers, models cannot explain many events and actions that diverge even slightly from the norm.

Income inequality and bubbles

Mark Thoma, drawing from data collected by Emmanuel Saez and Thomas Piketty, finds striking relationship between income concentration and development of bubbles. The concentration of incomes increased even as the dot com and then the housing bubbles got inflated, leading Prof Thoma to infer that it is more probable that income concentration caused bubbles.

Update 1
Justin Fox feels that "the rise in income inequality over the past 30 years has to a significant extent been the product of a series of asset-price bubbles".

Saturday, October 11, 2008

The financial crisis in perspective!

These graphs appear to indicate that, despite all the ongoing tumult, there has been dramatic calming down of the business cycle since the Great Moderation (the period in the aftermath of the oil crisis, starting from about 1983). Quarter-to-quarter changes in GDP are closer to average, the frequency of recessions has gone down, the severity of recessions has become less, and the volatility in risk premiums have decreased.

(HT: Mark Thoma, Macroblog)

Lessons from Japan!

(HT: Steve Hsu)

Friday, October 10, 2008

What should be done?

With the markets, in both US and elsewhere, responding to the series of individual bailout plans and co-ordinated interest rate cuts with even more steeper declines, Paul Krugman feels that the only way forward would appear to be a co-ordinated British type bailout plan.

The British Plan seeks to recapitalize the banks by direct infusion of about 50 bn pounds, in return for Government stake taken through issuance of preferred shares, and providing guarantees for inter-bank lending and banks issuing short and medium term unsecured debt. Until markets stabilise, the Bank of England would continue to conduct auctions to lend sterling for three months and also to lend US dollars for one-week periods against a wider range of collateral. The Bank would also provide at least £200bn under its special liquidity scheme – under which banks can swap illiquid loans for risk-free government securities.

Barry Eichengreen and Richard Baldwin, sums up the recommendations of thirteen economists (full pdf here) commissioned by VoxEU
1. A quick bank recapitalisation with global coordination
2. A guarantee of deposits and/or loans with global coordination
3. Co-ordinated macroeconomic stimulus.

Bradford DeLong calls for immediate and co-ordinated monetary and fiscal expansion with banking sector recapitalizations, and in the long term, policies to make executive compensation incentive-compatible and a more progressive tax system.

As can be seen, the international finance multiplier makes co-ordinated action pre-requisite for any effort to restore confidence in the global financial markets.

However, Casey Mulligan thinks there is no need to panic and the economy really does not need any saving. since we are only in a "financial crisis" and not an "economic crisis", and the economy is resilient enough to tide out the financial turmoil. The basis for this optimism is that the real economy market equivalent of PE multiple for financial markets, marginal product of capital employed, was at a historic high of 10% (profit per dollar of capital invested) in the first half of 2008, and the third quarter profits reports of the non-financial sector private firms are encouraging.

Laurence Kotlikoff and Perry Mehrling argue that with the US Government assuming the role of a unversal banker and insurer of last resort, the worst may yet be over, and most of the physical and human capital are still intact.

But such optimism may be misplaced given the fact that it does not take much for the real economy to get trapped in a stagnant or low growth and jobless equilibrium. The credit squeeze coupled with the recessionary expectations will surely dry up corporate investments, and lead to postponement of hiring decisions. Consumers, facing a "negative wealth effect" will in all likelihood sharply cut back and even stop spending, and use any fiscal stimulus or tax credits to repay their debts. This will impact demand, which will remain weak, and this in turn further depress investment. We have seen it before in the late nineties and early this decade in Japan. No amount of human and physical capital could prevent the financial crisis becoming an economic crisis!

Marc Faber's advice to Americans!

Fund manager Marc Faber had this advice for Americans about how to spend the $145 bn fiscal stimulus, involving tax credits, announced by the Government in April this year.

"The federal government is sending each of us a $600 rebate. If we spend that money at Wal-Mart, the money goes to China . If we spend it on gasoline it goes to the Arabs. If we buy a computer it will go to India . If we purchase fruit and vegetables it will go to Mexico , Honduras and Guatemala . If we purchase a good car it will go to Germany . If we purchase useless crap it will go to Taiwan and none of it will help the American economy. The only way to keep that money here at home is to spend it on prostitutes and beer, since these are the only products still produced in US. I've been doing my part."

(HT: From an email message)

Crisis of capitalism, not failure of government!

Richard Posner makes an excellent point that the ongoing crisis should be seen as a "crisis of capitalism" than as a "faliure of government". He writes,

"Bernanke and Paulson are neither politicians nor civil servants; Bernanke is an economics professor and Paulson an investment banker. Their principal advisers are investment bankers rather than Fed and Treasury employees. Even the prohibition of short selling, which seems like a product of the kind of mindless hostility to speculation that one expects from politicians, has been strongly urged by Wall Streeters, including the CEO of Morgan Stanley. The White House, the Congress, and even the SEC have been only bit players in the response to the crisis. In effect, the government's power to repair the crisis that Wall Street created has been delegated to Wall Street."

Further, it is now well acknowledged that the real estate and the sub-prime mortgage bubbles which tirggered off this present crisis, were the makings not of Government, but Alan Greenspan, with his unflinching faith that markets can regulate themselves.

As an afterthought. It is now widely accepted that years of historically low interest rates fuelled and sustained the loose borrowing and investing practices of Wall Street. However, this reality is clearly at variance with standard economic models, which proclaim the primacy of prices as the most fundamental signalling and allocative mechanism. If this were true then interest rates should have corrected itself upward as the bubbles got inflated!

Update 1
Paul Volcker weighs in, "In the U.S., the market took over. The market has flopped."