It is estimated that in the US, an average of $150bn is spent on gifts every year during the year-end holiday season (though this year, it may be far less!). It is estimated that the Indian consumers splurged over Rs 40000-45000 Cr this year on various categories of gifts - mithai and dry fruits, garments, consumer durables, gold, silver, automobiles, electronic goods, and ofcourse crackers - in the period between Dussehra and Diwali.
But gifts throw up a major, albeit hidden, economic problem. Eco 101 teaches us that a transaction is efficient if the total economic surplus is maximized. In other words, both the producer and consumer surplus should be maximized. In the case of gifts, the respective surpluses of the gift giver and the gift recipient should be maximized. While the gift givers are naturally happy with the gifts they are gifting, the gift recipients are less likely to be as happy. This arises because of the varying preferences of individuals and the information asymmetry prevalent between the donor and the recipient.
This problem is widely prevalent in the commonest of gifts - toys, clothes, shoes, bags, jewellery, books, consumer durables etc. Given the vast variety available and the equally numerous tastes of individuals, unless the gifter is aware of the specific preference of the recipient, there is a strong probability of gifting some thing that does not maximize the utility of the recipient. In fact, with many of the aforementioned items, the probability of a sub-optimal utility transaction is very high.
With food gifts, there is an additional health risk. The most frequently gifted food items are sweets and dry fruits, whose consumption imposes significant health costs on the recipients. Typically the higher end gifts like automobiles and expensive ornaments do not suffer as adversely from this problem. Despite the possibility of lower total surplus, the deadweight loss is likely to be smaller.
Corporate gifts are a different matter altogether. In such gifts, the utility to the gift giver is much higher than the utility to the recipient. In fact, these transactions can be justified solely in terms of the utility derived by the giver. Further, the types of items given as corporate gifts is more impersonal, standardized, (like diaries, pens etc) and only rarely individual-specific. But despite this, here too the deadweight loss is significant.
In 1993, Prof Joel Waldfogel wrote a very influential paper on The deadweight loss of Christmas. He estimated that the typical $50 Christmas gift is valued by the recipient at between $35 and $43 due to the deadweight loss arising from differences in the respective tastes of the donor and the recipient. He had however specifically excluded sentimental value from his calculations.
One way of reducing the deadweight loss is by making the gift fungible, so that the recipient can transact it if he finds a better choice. This can be achieved if the shops take back sold goods, or if the gift is a shopping coupon or voucher in your favorite shop. In fact, gift vouchers and its electronic version, gift card, have become a very popular method of gifting materials, and has been aggressively promoted by major retail stores. Tim Harford offers his tips on buying Christmas gifts. There are even websites that sells gift cards and also helps swap different types of gift cards.
More than $25bn worth gift cards were sold in the US in the last season, up 34% from the previous year, thereby making gift cards rival apparel as the most popular present. Retailers like gift cards because they see it as an interest free loan from the customers and also because it has been found that the recipients usually spend more than the amount on the card ("uplifting" spending). In fact, of the total of $70 bn spent by consumers on gift cards in 2007, 58% said they spent more than the gift card amount when they used it.
But doubts remain about its effectiveness. According to a new survey, a quarter of all gift vouchers are never used by the recipients - providing windfall profits for the stores. In 2007 alone, one US chain, Best Buy, has chalked up a profit of $19m (£9.5m) from unclaimed gift cards. However, the economic slowdown which has opened up strong possibility of issuing retailers going under, thereby defaulting on their gift cards, poses a problem for the gift cards market this year.
The most ideal solution to eliminating any deadweight loss would be to gift money! But here we are likely to run into social mores and offend cultural sensibilities. In case of corporate gifts, cash gifts will be tantamount to open bribery! Or else, the gifter should be asking the recipient about their choice, in which case it loses the significant characteristic of a gift.
The silver lining in this mad gift race is that the economy benefits by way of increased consumption and hence production, and so on. Whether the total utility is increasing or not is a different matter. Gifts are therefore an example of increasing deadweight losses contributing to the economic growth!
Update 1
See also this from Joel Waldfogel.
Wednesday, December 31, 2008
Tuesday, December 30, 2008
Sub-prime crisis explained
The wizards of Wall Street brew the "sub-prime" broth...
The broth finally boils over...
Meanwhile, after a futile search for WMD in Iraq, the Bush administration finally realized they were looking at the wrong place...
After the WMDs implode, comes the bill...
Unable to foot the bill, the "bread lines" start to form ...
Since those impoverished are "too big to fail", the Government steps in ...
Hanky Panky is given a blank cheque...
To be encashed from the tax payers account...
"Helicopter" Ben and the Fed are not to be left behind...
Bailout ATMs make their appearance...
Public debt mounts ...
Joe Six-pack groans...
The epitaph is written...
And the wheel turns the full circle - circa 1917...
Or... business as usual?
More of these can be seen here and here. An excellent cartoon primer on the crisis can be seen here.
The broth finally boils over...
Meanwhile, after a futile search for WMD in Iraq, the Bush administration finally realized they were looking at the wrong place...
After the WMDs implode, comes the bill...
Unable to foot the bill, the "bread lines" start to form ...
Since those impoverished are "too big to fail", the Government steps in ...
Hanky Panky is given a blank cheque...
To be encashed from the tax payers account...
"Helicopter" Ben and the Fed are not to be left behind...
Bailout ATMs make their appearance...
Public debt mounts ...
Joe Six-pack groans...
The epitaph is written...
And the wheel turns the full circle - circa 1917...
Or... business as usual?
More of these can be seen here and here. An excellent cartoon primer on the crisis can be seen here.
Monday, December 29, 2008
Urban terrorism Vs Naxalism
The Mumbai terrorist attacks, and recent Delhi and Assam bomb blasts, like the greatly increased number of other recent incidents of urban terrorism, have coalseced and strengthened the collective anger and hatred being felt across the country against terrorism and militancy. The Mumbai attack, in particular, appears to have jolted the Government into action for setting up an institutional architecture that would work towards preventing such incidents.
In a different context, rural terrorism, in the form of naxalite attacks in remote and interior areas of many states, has been going on for many years. Major incidents of naxalite attacks are becoming increasingly commonplace, taking the lives of large numbers of innocent and poor villagers, and policemen on duty.
However, naxalite activities have never caught the imagination of the national public consciousness as urban terrorism, and has therefore not been the focus of any sustained and co-ordinated actions of the state and central governments. This despite the fact that the former has been a much older problem, claimed many times more lives, and has been more debilitating in ao far as it has contributed substantially to these areas being perpetually trapped in poverty and under-development.
To the extent that terrorism is part of an effort by its perpetrators to focus the attention of the state and its citizens to the cause espoused by them, from the perspective of its perpetrators urban terrorism has surely been much more successful than rural terrorism. It is also understandable that this should be so, given the fact that the majority of our opinion makers (media, academia, commentators, bureaucrats, and political class) and their targets (upper and middle class) live in cities and towns. There is therefore an immediacy and closeness to terrorist incidents in their backyards, which they can easily identify with. In contrast, the naxalite incidents take place in the back-of-beyond, isolated from the consciousness of these opinion makers and the middle class.
Without any intention to incite naxalite terrorism in cities, this difference in responses in the public consciousness does raise a few interesting questions of academic interest. Does it mean that naxalite planners should re-think their strategies? Would a naxalite group which focuses on urban terrorism be more successful? What effect will a shift in strategy have on their rural support base, since they rely on such incidents to re-affirm their strength and hence support among rural poor? Will this change also isolate the naxalite movement from its roots and prevent them from claiming moral legitimacy? Will a shift to urban terrorism, force governments to give more attention to the long pending problems of these areas?
However, the aforementoned shift can also be counterproductive for naxalites, given the possibility of increased attention generating more aggressive counter insurgency response by the government, thereby sowing the seeds for the end of such naxalite activites.
In a different context, rural terrorism, in the form of naxalite attacks in remote and interior areas of many states, has been going on for many years. Major incidents of naxalite attacks are becoming increasingly commonplace, taking the lives of large numbers of innocent and poor villagers, and policemen on duty.
However, naxalite activities have never caught the imagination of the national public consciousness as urban terrorism, and has therefore not been the focus of any sustained and co-ordinated actions of the state and central governments. This despite the fact that the former has been a much older problem, claimed many times more lives, and has been more debilitating in ao far as it has contributed substantially to these areas being perpetually trapped in poverty and under-development.
To the extent that terrorism is part of an effort by its perpetrators to focus the attention of the state and its citizens to the cause espoused by them, from the perspective of its perpetrators urban terrorism has surely been much more successful than rural terrorism. It is also understandable that this should be so, given the fact that the majority of our opinion makers (media, academia, commentators, bureaucrats, and political class) and their targets (upper and middle class) live in cities and towns. There is therefore an immediacy and closeness to terrorist incidents in their backyards, which they can easily identify with. In contrast, the naxalite incidents take place in the back-of-beyond, isolated from the consciousness of these opinion makers and the middle class.
Without any intention to incite naxalite terrorism in cities, this difference in responses in the public consciousness does raise a few interesting questions of academic interest. Does it mean that naxalite planners should re-think their strategies? Would a naxalite group which focuses on urban terrorism be more successful? What effect will a shift in strategy have on their rural support base, since they rely on such incidents to re-affirm their strength and hence support among rural poor? Will this change also isolate the naxalite movement from its roots and prevent them from claiming moral legitimacy? Will a shift to urban terrorism, force governments to give more attention to the long pending problems of these areas?
However, the aforementoned shift can also be counterproductive for naxalites, given the possibility of increased attention generating more aggressive counter insurgency response by the government, thereby sowing the seeds for the end of such naxalite activites.
Sunday, December 28, 2008
Stimulating corporate India?
There is a striking difference between the fiscal stimulus debates in India and in the US (and most other countries). In the US and elsewhere, the stated objective of a fiscal stimulus is to manage the demand side by bringing unemployed resources back to work and by increasing the disposable incomes of people who are more likely to spend (Within this there are differences about which strategies - tax cuts or government spending - is the more effective option). In contrast, in India the stimulus measures appears to be aimed at managing the supply side, and consists of direct benefits and incentives to the producers and suppliers.
Econ 101 tells us that a fiscal stimulus works by leaving more money in the hands of people to spend, whose spending sets in motion a multiplier effect that in turn increases aggregate demand and the virtuous cycle gets initiated and sustained. There are two ways of managing this aggregate demand. The more direct way is to transfer money to consumers by way of tax cuts or tax credits, increase welfare support through enhanced unemployment insurance and food vouchers, and sustain and even increase employment by bringing the unemployed (or to be laid-off) resources to work. The indirect strategy is to cut duties and taxes so as to incentivize businesses to lower prices and maintain investments. This indirect strategy is a version of the trickle down economic policy making, so entrenched in India.
The stimulus measures announced by the Government of India, except some decisions on the real estate side (and here too the benefits are aimed more at builders than home buyers), have been mostly by way of cuts in duties and taxes aimed at either lowering the prices or propping up corporate bottom-lines. This strategy works on the premise that during a slowdown, lower prices will sustain demand and corporate tax benefits will incentivize businesses to continue their investments and keep capacity fully utilized.
Both these are questionable assumptions. I have blogged extensively (here and here) about the difficulty in passing on the benefits of such duty and tax cuts to the final consumers. Even recent examples do not give much faith for optimism. This is especially so in developing markets like in India where the prices are stickier and the price signal transmission belt is not very efficient and has many distortions. Second, as examples of Japan in the nineties and US recently shows, tax concessions to incentivize corporate investments will come up against the "rational expectations" on depressed economy which would induce businesses to postpone investments. In simple terms, these supply side measures end up stabilizing the profitability of corporate India, which claims to be have been badly affected by the downturn.
I am inclined to believe that one of the reasons why this strategy has assumed dominance (in the public realm and among policy makers) arises from the imperfections in the manner in which economic and financial market information is disseminated in India. The financial media (especially the electronic variants) and corporate opinion makers have been purveying this line of thought, to the near total exclusion of all else, because it benefits all of them directly. In fact this is a logical extension of the increasing belief among corporate India that the Government should directly intervene in their favour in the markets when faced with adverse economic headwinds (like currency appreciation, equity market declines, export drops, or other cyclical global economic trends), so as to bailout the industry.
Econ 101 tells us that a fiscal stimulus works by leaving more money in the hands of people to spend, whose spending sets in motion a multiplier effect that in turn increases aggregate demand and the virtuous cycle gets initiated and sustained. There are two ways of managing this aggregate demand. The more direct way is to transfer money to consumers by way of tax cuts or tax credits, increase welfare support through enhanced unemployment insurance and food vouchers, and sustain and even increase employment by bringing the unemployed (or to be laid-off) resources to work. The indirect strategy is to cut duties and taxes so as to incentivize businesses to lower prices and maintain investments. This indirect strategy is a version of the trickle down economic policy making, so entrenched in India.
The stimulus measures announced by the Government of India, except some decisions on the real estate side (and here too the benefits are aimed more at builders than home buyers), have been mostly by way of cuts in duties and taxes aimed at either lowering the prices or propping up corporate bottom-lines. This strategy works on the premise that during a slowdown, lower prices will sustain demand and corporate tax benefits will incentivize businesses to continue their investments and keep capacity fully utilized.
Both these are questionable assumptions. I have blogged extensively (here and here) about the difficulty in passing on the benefits of such duty and tax cuts to the final consumers. Even recent examples do not give much faith for optimism. This is especially so in developing markets like in India where the prices are stickier and the price signal transmission belt is not very efficient and has many distortions. Second, as examples of Japan in the nineties and US recently shows, tax concessions to incentivize corporate investments will come up against the "rational expectations" on depressed economy which would induce businesses to postpone investments. In simple terms, these supply side measures end up stabilizing the profitability of corporate India, which claims to be have been badly affected by the downturn.
I am inclined to believe that one of the reasons why this strategy has assumed dominance (in the public realm and among policy makers) arises from the imperfections in the manner in which economic and financial market information is disseminated in India. The financial media (especially the electronic variants) and corporate opinion makers have been purveying this line of thought, to the near total exclusion of all else, because it benefits all of them directly. In fact this is a logical extension of the increasing belief among corporate India that the Government should directly intervene in their favour in the markets when faced with adverse economic headwinds (like currency appreciation, equity market declines, export drops, or other cyclical global economic trends), so as to bailout the industry.
Saturday, December 27, 2008
Friday, December 26, 2008
Chinese reserves and US savings
The story goes like this ... Attracted by the cheap Chinese imports, which in turn keeps US inflation down, US consumers throw caution to the winds and go on a consumption binge. Chinese trade surplus soars and the forex reserves build up spectacularly. Preferring the safety and liquidity of the US Treasury assets, the People's Bank of China channels the reserves into these assets (China owns $1 of every $10 of America’s public debt). The easy money keeps US interest rates down. This, coupled with the wealth effect from the real estate bubble (itself magnified by the inflows from China and other emerging economies), makes the American consumers borrow even more. Household savings trip into negative territory. The figures below captures the same sequence of events graphically
The populist rhetoric amongst the American conservatives now blames the Chinese for maintaining the renminbi under-valued and thereby keeping the American economy drugged on an unsustainable, high testosterone growth. This is something akin to blaming the drug peddler for my addiction or the prostitute for my licentiousness!
(HT: Chinese Pockets Filled as Americans’ Emptied)
The populist rhetoric amongst the American conservatives now blames the Chinese for maintaining the renminbi under-valued and thereby keeping the American economy drugged on an unsustainable, high testosterone growth. This is something akin to blaming the drug peddler for my addiction or the prostitute for my licentiousness!
(HT: Chinese Pockets Filled as Americans’ Emptied)
On learning economics...
On the question of debates on economic issues, Greg Mankiw writes,
"As you come to grips with (these) various points of view, you will be in a better position to judge which you find most cogent. But don't expect to reach unequivocal positions easily. It is best to consider all knowledge as tentative. The best scholars maintain an open-mindedness and humility about even their own core beliefs. Excessive conviction is often a sign of insufficient thought, which in turn may be derived from a certain pig-headedness. Intellectual maturity comes when you can maintain the right balance between informed belief and honest skepticism."
Managing Urban Transit Systems - A Case Study
An excellent case study about public transport systems in New York, especially important in view of the times we are living through.
There is an intense debate raging in New York over the decision by the Metropolitan Transport Authority (MTA) of New York to steeply raise base subway and bus fares, bridge and road tolls, and cut subway, bus and commuter rail services, in the face of increasing operating costs and declining revenues. Further, in the recent past, the metro has been the target of stinging public criticism on its poor maintenance of trains and stations.
In order to limit the fare and toll increases and service cuts, the MTA has appealed to the New York state government for a bailout plan. However, the ongoing recession may have tied Albany's hands on any fiscal hand outs. The MTA has therefore also proposed a modest payroll tax on businesses, unions and governments in the New York city area, and imposition of tolls on a couple of hitherto un-tolled bridges.
To summarize the learnings from this case study, especially relevant for many Indian cities which are moving towards modernizing their urban public transit systems:
1. Public transit systems like metros, being expensive, need some form of government subsidy or cross-subsidy with other transport systems. Forget the huge upfront investment required, even its operation & maintenance (O&M) costs are substantial. In the circumstances, it will have to be financed both by large enough user fees and government support.
2. Crucial decisions on bus and rail fares, tolls, etc have to be de-politicised, and taken on professional considerations. If the government so wishes to keep fares and tolls low, inspite of the need to raise them, it can subsidize the commuters by direct cash transfers (either to the operator or by vouchers to specific categories of commuters). Periodic raises in tolls and fares, atleast for the newer systems, should be a built-in feature when these systems are opened for use.
3. Urban private vehicle users, especially in major cities, have to be made aware of the cost of their convenience of using personal vehicles. Private vehicle road usage has a social cost (in terms of space occupation, reduced travel times, increased probability of accidents etc), which has to be internalized by way of user charges or road tolls. Public transit systems should be cross-subsidized with these user charges and tolls. Private vehicle owners can be weaned away to public transit systems like metros only if they are reliable, well-connected, stations have parking facilities and offer quality services.
4. Local public transport policy decisions have to be made from the systemic perspective, rather than as piece-meal solutions, so commonplace in India. The decisions affecting metro/train and bus fares, road and flyover tolls, restrictions on private vehicle entry (congestion charges), parking fees etc have to be taken keeping in mind an integrated perspective of the local urban public transit system. Most of our cities, despite clear directions of the Government of India, do not even have MTAs. Wherever these MTAs are present, their effectiveness and proficiency is questionable.
5. State and local Governments will continue to have a major role to play in the effective functioning of these systems. Appropriate regulatory interventions apart, financial support too will have to be a near permanent feature of the urban transport landscape. Given this context, the red herring of commercial viability raised by the ridiculous bid for the Hyderabad Metrorail Project, should quickly be set aside.
6. As the example of New York shows, structuring the O&M model for public transit systems is a complex challenge. These decisions have to be taken keeping in mind the specific character of the commuter bases, revenue streams from the different sources, availability of service providers in the local market, and the linkages between the different elements of the particular system and different systems.
7. In such weak economic times, the revenues of public utilities take a hit, investments in such public goods gets postponed or even cancelled, and the state government's ability to intervene and assist with bailouts become constrained. Therefore one of the more important fiscal stimulus strategies will be to transfer funds to cash-strapped local governments, who will otherwise cut down on their services, postpone investments, or raise user charges, all of which will affect the local economy even more adversely. The benefit transmission belt from assisting local governments is very obvious and delivers full bang for the buck.
There is an intense debate raging in New York over the decision by the Metropolitan Transport Authority (MTA) of New York to steeply raise base subway and bus fares, bridge and road tolls, and cut subway, bus and commuter rail services, in the face of increasing operating costs and declining revenues. Further, in the recent past, the metro has been the target of stinging public criticism on its poor maintenance of trains and stations.
In order to limit the fare and toll increases and service cuts, the MTA has appealed to the New York state government for a bailout plan. However, the ongoing recession may have tied Albany's hands on any fiscal hand outs. The MTA has therefore also proposed a modest payroll tax on businesses, unions and governments in the New York city area, and imposition of tolls on a couple of hitherto un-tolled bridges.
To summarize the learnings from this case study, especially relevant for many Indian cities which are moving towards modernizing their urban public transit systems:
1. Public transit systems like metros, being expensive, need some form of government subsidy or cross-subsidy with other transport systems. Forget the huge upfront investment required, even its operation & maintenance (O&M) costs are substantial. In the circumstances, it will have to be financed both by large enough user fees and government support.
2. Crucial decisions on bus and rail fares, tolls, etc have to be de-politicised, and taken on professional considerations. If the government so wishes to keep fares and tolls low, inspite of the need to raise them, it can subsidize the commuters by direct cash transfers (either to the operator or by vouchers to specific categories of commuters). Periodic raises in tolls and fares, atleast for the newer systems, should be a built-in feature when these systems are opened for use.
3. Urban private vehicle users, especially in major cities, have to be made aware of the cost of their convenience of using personal vehicles. Private vehicle road usage has a social cost (in terms of space occupation, reduced travel times, increased probability of accidents etc), which has to be internalized by way of user charges or road tolls. Public transit systems should be cross-subsidized with these user charges and tolls. Private vehicle owners can be weaned away to public transit systems like metros only if they are reliable, well-connected, stations have parking facilities and offer quality services.
4. Local public transport policy decisions have to be made from the systemic perspective, rather than as piece-meal solutions, so commonplace in India. The decisions affecting metro/train and bus fares, road and flyover tolls, restrictions on private vehicle entry (congestion charges), parking fees etc have to be taken keeping in mind an integrated perspective of the local urban public transit system. Most of our cities, despite clear directions of the Government of India, do not even have MTAs. Wherever these MTAs are present, their effectiveness and proficiency is questionable.
5. State and local Governments will continue to have a major role to play in the effective functioning of these systems. Appropriate regulatory interventions apart, financial support too will have to be a near permanent feature of the urban transport landscape. Given this context, the red herring of commercial viability raised by the ridiculous bid for the Hyderabad Metrorail Project, should quickly be set aside.
6. As the example of New York shows, structuring the O&M model for public transit systems is a complex challenge. These decisions have to be taken keeping in mind the specific character of the commuter bases, revenue streams from the different sources, availability of service providers in the local market, and the linkages between the different elements of the particular system and different systems.
7. In such weak economic times, the revenues of public utilities take a hit, investments in such public goods gets postponed or even cancelled, and the state government's ability to intervene and assist with bailouts become constrained. Therefore one of the more important fiscal stimulus strategies will be to transfer funds to cash-strapped local governments, who will otherwise cut down on their services, postpone investments, or raise user charges, all of which will affect the local economy even more adversely. The benefit transmission belt from assisting local governments is very obvious and delivers full bang for the buck.
Thursday, December 25, 2008
Lessons from Micro-finance II
This is in continuation from an earlier post and also in response to the issue of microfinance "crowding out" local savings, as raised by Niranjan Rajadhyaksha.
Niranjan quotes Milford Bateman (in response to Tim Harford) and refers to the iron law of microfinance - "...to the extent that local savings are intermediated through microfinance institutions, the more that country or region or locality will be left behind in a state of poverty and underdevelopment". In other words, the microloans "crowds out" credit to the small and medium enterprises and "crowds in" credit to micro-businesses, mostly single employee businesses run by the owner.
However, the crowding out arguement may need to be qualified. Here is an intutive clarification. Most of the customers of micro-loans are the poorest of the poor. In any case, the amounts involved in such loans are very small and to that extent the savings "crowded in" are also likely to be small. More importantly, I am inclined to believe (no studies I could find out, only intutive arguement) that the savings of these people, especially in the context of the poorest in these developing societies, are in any case not (and cannot be) the source of funds for small and medium businesses.
I suppose there must be a form of informal "savings pyramid", which outlines the flow of savings of the different categories of people based on their incomes. The savings of the poorest is invariably too small, the transaction costs too high, and the marginal utility benefits for these poor savers too meagre, for these savings to find their way into the pool of formal lending institutions. It therefore stands to reason that the bottom most rung of the "savings pyramid" that feeds the formal sector are the lower middle class, and not the poor or the poorest.
This strand of analysis may be slightly corroborated by the World Bank study on the sources of credit mobilization across 45 countries. The study finds that the "share of household credit in total credit increases as countries grow richer and financial systems develop". It finds that it is socio-economic trends that determine credit composition. All this sits nicely with the aforementioned "savings pyramid" hypotheis.
By logical extension of the Bateman arguement - the former (small and medium businesses) being in the organized sector and the latter (micro-businesses) part of the informal economy, microfinance ends up promoting the unorganized parallel economy. It may therefore be more relevant to link up the expenditures on these micro-loans to the formal sector. But such arrangmeents, with its attendant bureaucracy and transaction costs, has its own pitfalls.
Niranjan quotes Milford Bateman (in response to Tim Harford) and refers to the iron law of microfinance - "...to the extent that local savings are intermediated through microfinance institutions, the more that country or region or locality will be left behind in a state of poverty and underdevelopment". In other words, the microloans "crowds out" credit to the small and medium enterprises and "crowds in" credit to micro-businesses, mostly single employee businesses run by the owner.
However, the crowding out arguement may need to be qualified. Here is an intutive clarification. Most of the customers of micro-loans are the poorest of the poor. In any case, the amounts involved in such loans are very small and to that extent the savings "crowded in" are also likely to be small. More importantly, I am inclined to believe (no studies I could find out, only intutive arguement) that the savings of these people, especially in the context of the poorest in these developing societies, are in any case not (and cannot be) the source of funds for small and medium businesses.
I suppose there must be a form of informal "savings pyramid", which outlines the flow of savings of the different categories of people based on their incomes. The savings of the poorest is invariably too small, the transaction costs too high, and the marginal utility benefits for these poor savers too meagre, for these savings to find their way into the pool of formal lending institutions. It therefore stands to reason that the bottom most rung of the "savings pyramid" that feeds the formal sector are the lower middle class, and not the poor or the poorest.
This strand of analysis may be slightly corroborated by the World Bank study on the sources of credit mobilization across 45 countries. The study finds that the "share of household credit in total credit increases as countries grow richer and financial systems develop". It finds that it is socio-economic trends that determine credit composition. All this sits nicely with the aforementioned "savings pyramid" hypotheis.
By logical extension of the Bateman arguement - the former (small and medium businesses) being in the organized sector and the latter (micro-businesses) part of the informal economy, microfinance ends up promoting the unorganized parallel economy. It may therefore be more relevant to link up the expenditures on these micro-loans to the formal sector. But such arrangmeents, with its attendant bureaucracy and transaction costs, has its own pitfalls.
Governments and support for entrepreneurship
Dani Rodrik is right in claiming that in developing economies entrepreneurial activity, whose social value is much more than private costs, comes up against the issue of "first mover disadvantage" arising from uncertainty about the underlying cost structure - what can and cannot be produced profitably.
He writes about such entrepreneurs, "If they succeed, much of the gains are socialized through entry and emulation, whereas if they fail, they bear the full costs... One must presume that there are many more (discovery efforts or entrepreneurial activities) that could be taking place, but which are not, because it is difficult for pioneers to capture a large enough part of the social surplus they generate, even with the subsidy programs in place."
So how do we enable the pioneers to internalize a greater share of the social surplus? We cannot provide exclusive rights, like patents, because many of these are not patentable. Governments cannot assume the role of a venture capitalist of last resort. How can governments distinguish between "good" and "bad" ideas and entrepreneurs, and support the "good" ones? Can Governments avoid the moral hazard associated with picking winners, especially given the numerous examples of subsidies ostensibly given to support entrepreneurship, but plainly doled out to cronies and favorites? Nor can we expect the markets to step in and single-handedly perform the role of supporting entrepreneurship and picking winners.
There are those, like William Baumol and Co, who will say that Governments can play an in-direct role in enabling the development of entrepreneurial culture - lowering entry and exit barriers (start-up registration, flexible labour markets, accessing finance); institutional framework that rewards entrepreneurial activity (property and contract rights); discourage destructive entrepreneurship that divides the pie than increase its size( corruption, crime, excessive taxation, subsidies etc); and winners should be incentivized to continue their innovation and not stagnate (anti-trust laws, and openness to trade). But these are the necessary, but not sufficient, conditions for entrepreneurial activity and economic development.
Scanning the economic landscape of the past few decades, it is difficult to come across examples of such market driven rise of entrepreneurship in the developing economies. On the contrary, one can cite numerous examples of "guided bureaucratic" entrepreneurial activity - East Asia, China, India, the flower industry in Ethiopia etc. Even the economic history of Japan, US and Europe bears this out.
Take the example of the first flush of flower exporting entrepreneurs in Ethiopia. There was no way they could have emerged endogenously, through the dynamics of the market forces, given the inherent economic, commercial and technical uncertainties (not even "risks" - remember the "known unknowns and unknown unknowns"). An exogenous intervention, by way of subsidy through cheap land and tax holidays, was necessary to discover the underlying cost structure and break open the market. As Dani says and as the theory about positive externalities affirms, private sector will always be reluctant to step in where social benefits exceed private costs.
Given the crucial role of the Government in picking winners, the importance of a committed bureaucracy and enlightened political administrators assumes significance. This institutional framework, probably the most critical determinant, is rarely a consideration in standard economic principles of policy making for promoting entrepreneurship. Wherever acknowledged, it gets grudgingly marginalized into a corner, clubbed as part of the now fashionable "good governance".
I had blogged earlier on the similar chicken and egg problem facing the market for infrastructure financing and government sector software applications in India. Both remain trapped in a stalemate, and will continue to be so in the absence of active external (read government) intervention to break the dead-lock.
He writes about such entrepreneurs, "If they succeed, much of the gains are socialized through entry and emulation, whereas if they fail, they bear the full costs... One must presume that there are many more (discovery efforts or entrepreneurial activities) that could be taking place, but which are not, because it is difficult for pioneers to capture a large enough part of the social surplus they generate, even with the subsidy programs in place."
So how do we enable the pioneers to internalize a greater share of the social surplus? We cannot provide exclusive rights, like patents, because many of these are not patentable. Governments cannot assume the role of a venture capitalist of last resort. How can governments distinguish between "good" and "bad" ideas and entrepreneurs, and support the "good" ones? Can Governments avoid the moral hazard associated with picking winners, especially given the numerous examples of subsidies ostensibly given to support entrepreneurship, but plainly doled out to cronies and favorites? Nor can we expect the markets to step in and single-handedly perform the role of supporting entrepreneurship and picking winners.
There are those, like William Baumol and Co, who will say that Governments can play an in-direct role in enabling the development of entrepreneurial culture - lowering entry and exit barriers (start-up registration, flexible labour markets, accessing finance); institutional framework that rewards entrepreneurial activity (property and contract rights); discourage destructive entrepreneurship that divides the pie than increase its size( corruption, crime, excessive taxation, subsidies etc); and winners should be incentivized to continue their innovation and not stagnate (anti-trust laws, and openness to trade). But these are the necessary, but not sufficient, conditions for entrepreneurial activity and economic development.
Scanning the economic landscape of the past few decades, it is difficult to come across examples of such market driven rise of entrepreneurship in the developing economies. On the contrary, one can cite numerous examples of "guided bureaucratic" entrepreneurial activity - East Asia, China, India, the flower industry in Ethiopia etc. Even the economic history of Japan, US and Europe bears this out.
Take the example of the first flush of flower exporting entrepreneurs in Ethiopia. There was no way they could have emerged endogenously, through the dynamics of the market forces, given the inherent economic, commercial and technical uncertainties (not even "risks" - remember the "known unknowns and unknown unknowns"). An exogenous intervention, by way of subsidy through cheap land and tax holidays, was necessary to discover the underlying cost structure and break open the market. As Dani says and as the theory about positive externalities affirms, private sector will always be reluctant to step in where social benefits exceed private costs.
Given the crucial role of the Government in picking winners, the importance of a committed bureaucracy and enlightened political administrators assumes significance. This institutional framework, probably the most critical determinant, is rarely a consideration in standard economic principles of policy making for promoting entrepreneurship. Wherever acknowledged, it gets grudgingly marginalized into a corner, clubbed as part of the now fashionable "good governance".
I had blogged earlier on the similar chicken and egg problem facing the market for infrastructure financing and government sector software applications in India. Both remain trapped in a stalemate, and will continue to be so in the absence of active external (read government) intervention to break the dead-lock.
Wednesday, December 24, 2008
Mother of all moral hazards!
Hyman Minsky brilliantly captures the world view in this age of 'irrational exuberance',
To the list we can also add stock analysts, fund managers, investors, home buyers, and most of the others who participated in the market orgy. This is the "mother of all moral hazards"!!
(HT: Martin Wolf)
"A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him."
To the list we can also add stock analysts, fund managers, investors, home buyers, and most of the others who participated in the market orgy. This is the "mother of all moral hazards"!!
(HT: Martin Wolf)
War and fiscal stimulus
Martin Feldstein proposes a temporary rise in defense spending on supplies, equipment and manpower, as part of any fiscal stimulus package. Military procurement is a classic fiscal stimulus measure, the most famous example being the role of World War II spending in decisively pushing the American economy into a high growth trajectory.
This has resonance for India too, especially through investments in an one-time catch up for the resource-strapped defense forces. It is also likely to bring political points, especially in light of the Mumbai attacks and the sabre-rattling with Pakistan. By logical extension of this argument, a war with Pakistan has the potential to be the ideal fiscal stimulus! Wonder why the Pakistani Government is not using this to buttress their claims of Indian war mongering!!
This has resonance for India too, especially through investments in an one-time catch up for the resource-strapped defense forces. It is also likely to bring political points, especially in light of the Mumbai attacks and the sabre-rattling with Pakistan. By logical extension of this argument, a war with Pakistan has the potential to be the ideal fiscal stimulus! Wonder why the Pakistani Government is not using this to buttress their claims of Indian war mongering!!
Markets and negative externalities
A generous description of any commonplace urban public marketplace in India (or for any developing country) would be that of disorder and melee. Such public grocery, vegetable, fish and meat markets attract large numbers of hawkers selling a whole variety of regular consumption items. Exacerbating the disorder and confusion created by the hawkers are the riotously parked bicycles, motorcycles, and cars belonging to the customers. Most often the area becomes a traffic nightmare and inconveniences everybody. Unfortunately, we see this problem as a regulatory failure and continue to set up such markets across our cities on this assumption.
These markets draw in predominantly poor, lower-middle and middle class consumers, whose general propensity is to make their purchases of basic kitchen and other household necessities during their market shopping trips. Further, they make their purchases of these items typically from small hawkers and roadside stores. This incentivizes hawkers peddling these regular consumption items to set up shop around the public market. Besides, these markets and its immediate surroundings also provide a focal point for those traders who have missed out getting a stall or shop allotted in the public market. In fact, a significant proportion of the hawkers around such markets belong to the aforementioned category.
Thus it is inevitable that vegetable markets get swamped with still more vegetable vendors and fruit hawkers. Policy makers and planners fail to recognise the reality that these public markets become market organisms whose utility and importance goes much beyond the mere supply of the designated specific commodities. They become the pivot around which an entire set of unorganized commercial activity gets developed, which can neither be prohibited or disincentivized. This is much like the village shandy, which hosts the entire spectrum of small commercial activity, covering all the basic household goods. And I am inclined to believe that it is desirable that these public market places develop like the shandies, encouraging small traders and entrepreneurs, while meeting consumer demand for a one-stop shopping convenience for middle class households.
Urban planners need to be receptive to the fact that any urban public market place comes as a package - hawkers, mobile vendors, parking etc. In many respects these elements form a negative externality imposed by the market. It is important that we factor in this reality in planning our market places. This implies that we locate our public market places in areas where there exists enough space for parking and the other informal commercial activity, besides being away from major traffic areas. Even if this means inconveniencing the customers by their having to travel farther, instead of the convenient walk down to the next street!
These markets draw in predominantly poor, lower-middle and middle class consumers, whose general propensity is to make their purchases of basic kitchen and other household necessities during their market shopping trips. Further, they make their purchases of these items typically from small hawkers and roadside stores. This incentivizes hawkers peddling these regular consumption items to set up shop around the public market. Besides, these markets and its immediate surroundings also provide a focal point for those traders who have missed out getting a stall or shop allotted in the public market. In fact, a significant proportion of the hawkers around such markets belong to the aforementioned category.
Thus it is inevitable that vegetable markets get swamped with still more vegetable vendors and fruit hawkers. Policy makers and planners fail to recognise the reality that these public markets become market organisms whose utility and importance goes much beyond the mere supply of the designated specific commodities. They become the pivot around which an entire set of unorganized commercial activity gets developed, which can neither be prohibited or disincentivized. This is much like the village shandy, which hosts the entire spectrum of small commercial activity, covering all the basic household goods. And I am inclined to believe that it is desirable that these public market places develop like the shandies, encouraging small traders and entrepreneurs, while meeting consumer demand for a one-stop shopping convenience for middle class households.
Urban planners need to be receptive to the fact that any urban public market place comes as a package - hawkers, mobile vendors, parking etc. In many respects these elements form a negative externality imposed by the market. It is important that we factor in this reality in planning our market places. This implies that we locate our public market places in areas where there exists enough space for parking and the other informal commercial activity, besides being away from major traffic areas. Even if this means inconveniencing the customers by their having to travel farther, instead of the convenient walk down to the next street!
Tuesday, December 23, 2008
Design of financial systems
Robert C. Merton and Zvi Bodie have an interesting article that proposes a functional approach to designing and managing the financial systems of countries, regions, firms, households, and other entities, by a synthesis of the neoclassical, neo-institutional, and behavioral perspectives.
Their Functional and Structural Finance (FSF) theory seeks to combine the traditional neo-classical theories on frictionless markets, rational agents, and efficient outcomes with two additional attributes - an institutional approach (see here) that focus on the structural aspects of the financial system that introduce friction and may lead to non-efficient outcomes; and a behavioural approach (here, here, here, and here) that focuses on the ways in which and the conditions under which economic actors are not rational.
This approach recognizes the fact that neo-classical models cannot satsifactory predict or explain the institutional structure of financial systems, or how specific types of financial intermediaries, markets, and regulatory bodies will or should evolve in response to underlying changes in technology, politics, demographics, and cultural norms.
(HT: Baseline Scenario)
Their Functional and Structural Finance (FSF) theory seeks to combine the traditional neo-classical theories on frictionless markets, rational agents, and efficient outcomes with two additional attributes - an institutional approach (see here) that focus on the structural aspects of the financial system that introduce friction and may lead to non-efficient outcomes; and a behavioural approach (here, here, here, and here) that focuses on the ways in which and the conditions under which economic actors are not rational.
This approach recognizes the fact that neo-classical models cannot satsifactory predict or explain the institutional structure of financial systems, or how specific types of financial intermediaries, markets, and regulatory bodies will or should evolve in response to underlying changes in technology, politics, demographics, and cultural norms.
(HT: Baseline Scenario)
Monday, December 22, 2008
The economic crisis in plain English
Oportunidades and the role of CCTs
Tina Rosenberg has this excellent article in the NYT about the hugely successful anti-poverty program of the Mexican governments, Oportunidades (earlier Progressa). Oportunidades has now become the de facto welfare system in Mexico.
The program gives the poor cash, but unlike traditional welfare programs, it conditions the receipt of that cash on activities designed to break the culture of poverty and keep the poor from transmitting that culture to their children. Its success has catapulted Conditional Cash Transfer (CCT) schemes to the forefront of poverty fighting strategies throughout the world.
Oportunidades focuses on providing cash grant to parents for sending children to school (and maintaining good attendance); basic food grant if children and ante-natal women attend regular health checkups, take nutrition supplements, besides attending a monthly workshop on a health topic, like purifying drinking water. The cash payments are made to the women, and surveys show that 70% of Oportunidades’ payment is spent on food — mostly fruit, vegetables and meat - and much of the rest goes to kids’ shoes and clothing and home improvements.
Beneficiaries are selected using the census data to find the poorest rural areas and urban blocks, and within those areas, by giving out questionnaires about people’s income and possessions. The families must be re-certified every six years. The criteria apply nationally — the program allows for no local discretion. Local political leaders have no influence and so cannot use the payments to extort political support. Oportunidades staff members do not handle money — local banks hand out the envelopes of cash, and recipients are encouraged to open bank accounts to receive direct transfers. It has limited infrastructure and bureaucracy, and is relatively cheap, costing Mexico only about $3.8 billion annually, of which an estimated 97% of the budget goes directly to the target group.
The criticisms are mostly about the programs design, about how the conditions should be structured. It is argued that the conditions should be made more stringent - that student achievement, not just attendance, should be rewarded. But these are part of the process of evolution of any welfare program. Another criticism is that the payments are too small to make any significant dent in poverty.
As Rosenberg says, the CCT model is an attempt to reconcile the traditional stalemate between conservatives and liberals (right and left), who attributed poverty to the poor themselves (with its attendant implication that they are impervious to external support) and capitalism (with its low wages, institutionalized discrimination, and widening inequality), respectively. It forces the poor to imbibe many of the structural and behavioural traits that the middle class takes for granted. It seeks to offer the "new paternalism" of the State in the form of "tough love", instead of unconditional love of the old nanny state. It enforces outcomes and dispenses off with targets and impersonal subsidies.
CCT offers an excellent model for delivering individual welfare benefits in India. It can be neatly fitted into the paradigm of competitive populism driven proliferation of individual beenfit schemes in India. Even if the Governments want to provide specific benefits, instead of cash, the benefits can be made conditional to fulfilling certain desirable social goals. Thus, the Rs 2 kg rice can be linked to say, school attendance of the children of the household.
The free television and other individual benefits given to poor families can be moneized and the cash transferred directly, ideally in instalments, conditional to their achieving certain desired social goals. This would considerably reduce the cost of the program, by eliminating the transaction costs and pilferage inherent in the procurement and distribution process. As the success of cash payments for NREGS and old age pensions, through bank and post office savings accounts have shown, the logistics of these cash transfers can be easily managed. Further, the strong roots established by the women Self Help Group (SHG) movement in many states, enables easy integration of CCT programs into the rural society. Besides, by bringing the poor into the ambit of the formal banking and credit mechanisms, it would also achieve the objective of Total Financial Inclusion (TFI).
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Fifty years back Mexican anthropologist Oscar Lewis published a book called "Five Families: Mexican Case Studies in the Culture of Poverty", detailing a single day in these families’ lives, where he singled out elements of a culture that, he argued, keep those socialized in it mired in poverty - machismo, authoritarianism, marginalization from organized civic life, high rates of abandonment of illegitimate children, alcoholism, disdain for education, fatalism, passivity, inability to defer gratification and a time orientation fixed firmly on the present.
The program gives the poor cash, but unlike traditional welfare programs, it conditions the receipt of that cash on activities designed to break the culture of poverty and keep the poor from transmitting that culture to their children. Its success has catapulted Conditional Cash Transfer (CCT) schemes to the forefront of poverty fighting strategies throughout the world.
Oportunidades focuses on providing cash grant to parents for sending children to school (and maintaining good attendance); basic food grant if children and ante-natal women attend regular health checkups, take nutrition supplements, besides attending a monthly workshop on a health topic, like purifying drinking water. The cash payments are made to the women, and surveys show that 70% of Oportunidades’ payment is spent on food — mostly fruit, vegetables and meat - and much of the rest goes to kids’ shoes and clothing and home improvements.
Beneficiaries are selected using the census data to find the poorest rural areas and urban blocks, and within those areas, by giving out questionnaires about people’s income and possessions. The families must be re-certified every six years. The criteria apply nationally — the program allows for no local discretion. Local political leaders have no influence and so cannot use the payments to extort political support. Oportunidades staff members do not handle money — local banks hand out the envelopes of cash, and recipients are encouraged to open bank accounts to receive direct transfers. It has limited infrastructure and bureaucracy, and is relatively cheap, costing Mexico only about $3.8 billion annually, of which an estimated 97% of the budget goes directly to the target group.
The criticisms are mostly about the programs design, about how the conditions should be structured. It is argued that the conditions should be made more stringent - that student achievement, not just attendance, should be rewarded. But these are part of the process of evolution of any welfare program. Another criticism is that the payments are too small to make any significant dent in poverty.
As Rosenberg says, the CCT model is an attempt to reconcile the traditional stalemate between conservatives and liberals (right and left), who attributed poverty to the poor themselves (with its attendant implication that they are impervious to external support) and capitalism (with its low wages, institutionalized discrimination, and widening inequality), respectively. It forces the poor to imbibe many of the structural and behavioural traits that the middle class takes for granted. It seeks to offer the "new paternalism" of the State in the form of "tough love", instead of unconditional love of the old nanny state. It enforces outcomes and dispenses off with targets and impersonal subsidies.
CCT offers an excellent model for delivering individual welfare benefits in India. It can be neatly fitted into the paradigm of competitive populism driven proliferation of individual beenfit schemes in India. Even if the Governments want to provide specific benefits, instead of cash, the benefits can be made conditional to fulfilling certain desirable social goals. Thus, the Rs 2 kg rice can be linked to say, school attendance of the children of the household.
The free television and other individual benefits given to poor families can be moneized and the cash transferred directly, ideally in instalments, conditional to their achieving certain desired social goals. This would considerably reduce the cost of the program, by eliminating the transaction costs and pilferage inherent in the procurement and distribution process. As the success of cash payments for NREGS and old age pensions, through bank and post office savings accounts have shown, the logistics of these cash transfers can be easily managed. Further, the strong roots established by the women Self Help Group (SHG) movement in many states, enables easy integration of CCT programs into the rural society. Besides, by bringing the poor into the ambit of the formal banking and credit mechanisms, it would also achieve the objective of Total Financial Inclusion (TFI).
--------
Fifty years back Mexican anthropologist Oscar Lewis published a book called "Five Families: Mexican Case Studies in the Culture of Poverty", detailing a single day in these families’ lives, where he singled out elements of a culture that, he argued, keep those socialized in it mired in poverty - machismo, authoritarianism, marginalization from organized civic life, high rates of abandonment of illegitimate children, alcoholism, disdain for education, fatalism, passivity, inability to defer gratification and a time orientation fixed firmly on the present.
Sunday, December 21, 2008
YV Reddy Vs Alan Greenspan...?
... and the winner is YV Reddy, so says Joe Nocera in NYT and Dean Baker! Nocera even describes Dr Reddy as "anti-Greenspan".
Even as Greenspan, endowed with oracular powers by the Wall Street and their trumpet bearers in the financial media, got swept away by the "irrational exuberance" accompanying the real estate and sub-prime mortgage bubble, Dr Reddy went the other way and tightened lending standards, curtailed securitization and derivative products, and increased risk weightings on commercial buildings and shopping mall construction, as a similar real estate bubble took shape in India. As early as December 2007, even before the crisis had erupted, the US Federal Deposit Insurance Corporation (FDIC) reported that 28% of the banks had an exposure to construction lending that exceeded their capital.
But the moot point, as Mark Thoma raises, is not whether Central Bank Governors or Chairmen should have rung the alarm bells and taken away the punch bowl as the party got going. It is the need to put in place rules that move automatically to cool rising asset prices, and thereby avoid having to depend on the discretion of individuals, with the attendant dangers of flawed judgement.
Update 1
Joe Stiglitz approves of YV Reddy's handling of the RBI during the real estate bubble.
Even as Greenspan, endowed with oracular powers by the Wall Street and their trumpet bearers in the financial media, got swept away by the "irrational exuberance" accompanying the real estate and sub-prime mortgage bubble, Dr Reddy went the other way and tightened lending standards, curtailed securitization and derivative products, and increased risk weightings on commercial buildings and shopping mall construction, as a similar real estate bubble took shape in India. As early as December 2007, even before the crisis had erupted, the US Federal Deposit Insurance Corporation (FDIC) reported that 28% of the banks had an exposure to construction lending that exceeded their capital.
But the moot point, as Mark Thoma raises, is not whether Central Bank Governors or Chairmen should have rung the alarm bells and taken away the punch bowl as the party got going. It is the need to put in place rules that move automatically to cool rising asset prices, and thereby avoid having to depend on the discretion of individuals, with the attendant dangers of flawed judgement.
Update 1
Joe Stiglitz approves of YV Reddy's handling of the RBI during the real estate bubble.
Economics of oil production
I had blogged earlier on the debate surrounding the spectacular increase in petroleum price, which had reached $147 in July 2008, only to fall below $40 recently. Oil Drum now feels that the prospects of prices rebounding are bleak, especially given the weakness of the economy and the massive debt accumulated by households.
There are three popular explanantions for the volatility in oil prices - multiple equilibria, importance of the marginal barrel and Hotelling principle.
First, unlike other commodities, oil is characterized by three factors - it is an exhaustible resource, production is controlled by national governments, and for the major oil exporters oil is the overwhelmingly dominant source of national income. Paul Krugman therefore feels that oil exporters respond to high oil prices in three ways - engage in real investment at home, which is subject to diminishing returns; invest abroad, which carries dangers (or frozen accounts etc) for many Middle Eastern oil producers; or "invest" by cutting oil extraction or leaving more supply under the ground for future extraction, and hence reduce supply.
So there is a definite chance that over some range higher oil prices will lead to lower output, which given highly inelastic demand opens up the possibility of multiple equilibria (as proved by Cremer et al). This is corroborated by the history of yo-yo swings in oil prices. The presence of such multiple equilibria leaves the market vulnerable to being tipped from one equilibrium to another even by small events - small production cuts in a tight market, political events, changes in expectations etc - thereby magnifying the volatility.
Calculated Risk finds another inflexion point in the massive increases in recent years in government spending in the major oil producing nations. It therefore follows that if the oil prices decline, the need to maintain these high expenditures (in grandiose projects and benevolent welfare largesse) will force many of these producers to increase their production, thereby leading to further falls in prices.
Second, the oil market cares about the marginal barrel and the immediate situation. Oil and natural gas are products that are unlike any other product in history that their use is pervasive and they need long lead times to create alternatives and restructure society around more local energy sources and smaller energy footprints. The high futures prices caused by production shortages or excessive financial ingress into commodities will slow economic activity, which will then reduce demand for oil and prices will plummet and overshoot on the downside, only to bounce back (and overshoot on the upside) when the economy rebounds.
Third, Harold Hotelling in 1931 had suggested that any exhaustible mineral resource under the ground has the same significance as a bond, and is in some sense interchangeable with such a financial instrument. Hotelling Rule states that the unit price of an exhaustible resource less the marginal cost of extracting it will change exponentially over time at a rate equal to the return on comparable capital assets, say interest rates or exchange rates.
As the resource is depleted, the price rises and as the price rises the demand, and hence the consumed quantity, falls. This continues until a price, the backstop price, is reached where an alternative technology or a substitute for the resource becomes economically viable. At this point, the resource is said to be economically exhausted, even though there is some amount of the resource remaining in the ground. Since there is always a backstop technology at a sufficiently high price, it follows that no exhaustible resource can ever be completely extracted. That means that in some sense, exhaustible resources aren't exhaustible.
Interestingly, the steeply declining prices may contain within itself the seeds of future increases. The lower prices have already induced many oil companies to postpone or even cancel exploration projects. The high oil prices had given a filip to oil exploration, making even Canadian tar sands or deep sea reserves off the coast of Brazil attractive options. If the lower prices make these marginal barrels unremunerative, firms are likely to increasingly back off even committed investments, leave alone newer ones.
Standard economic theory says that when demand drops and prices fall, companies curb their investments, leading to lower supplies. When demand recovers, prices rise again and companies start to invest in new production, starting another cycle. It is more pronounced with the oil market. Given the time lag between exploration and getting oil to the pumps, future supplies are strongly co-related with investments made now. Lower prices now therefore appear to be a recipe for higher prices in future, especially when after the economic activity rebounds back and supply is not able to keep pace with demand.
There are three popular explanantions for the volatility in oil prices - multiple equilibria, importance of the marginal barrel and Hotelling principle.
First, unlike other commodities, oil is characterized by three factors - it is an exhaustible resource, production is controlled by national governments, and for the major oil exporters oil is the overwhelmingly dominant source of national income. Paul Krugman therefore feels that oil exporters respond to high oil prices in three ways - engage in real investment at home, which is subject to diminishing returns; invest abroad, which carries dangers (or frozen accounts etc) for many Middle Eastern oil producers; or "invest" by cutting oil extraction or leaving more supply under the ground for future extraction, and hence reduce supply.
So there is a definite chance that over some range higher oil prices will lead to lower output, which given highly inelastic demand opens up the possibility of multiple equilibria (as proved by Cremer et al). This is corroborated by the history of yo-yo swings in oil prices. The presence of such multiple equilibria leaves the market vulnerable to being tipped from one equilibrium to another even by small events - small production cuts in a tight market, political events, changes in expectations etc - thereby magnifying the volatility.
Calculated Risk finds another inflexion point in the massive increases in recent years in government spending in the major oil producing nations. It therefore follows that if the oil prices decline, the need to maintain these high expenditures (in grandiose projects and benevolent welfare largesse) will force many of these producers to increase their production, thereby leading to further falls in prices.
Second, the oil market cares about the marginal barrel and the immediate situation. Oil and natural gas are products that are unlike any other product in history that their use is pervasive and they need long lead times to create alternatives and restructure society around more local energy sources and smaller energy footprints. The high futures prices caused by production shortages or excessive financial ingress into commodities will slow economic activity, which will then reduce demand for oil and prices will plummet and overshoot on the downside, only to bounce back (and overshoot on the upside) when the economy rebounds.
Third, Harold Hotelling in 1931 had suggested that any exhaustible mineral resource under the ground has the same significance as a bond, and is in some sense interchangeable with such a financial instrument. Hotelling Rule states that the unit price of an exhaustible resource less the marginal cost of extracting it will change exponentially over time at a rate equal to the return on comparable capital assets, say interest rates or exchange rates.
As the resource is depleted, the price rises and as the price rises the demand, and hence the consumed quantity, falls. This continues until a price, the backstop price, is reached where an alternative technology or a substitute for the resource becomes economically viable. At this point, the resource is said to be economically exhausted, even though there is some amount of the resource remaining in the ground. Since there is always a backstop technology at a sufficiently high price, it follows that no exhaustible resource can ever be completely extracted. That means that in some sense, exhaustible resources aren't exhaustible.
Interestingly, the steeply declining prices may contain within itself the seeds of future increases. The lower prices have already induced many oil companies to postpone or even cancel exploration projects. The high oil prices had given a filip to oil exploration, making even Canadian tar sands or deep sea reserves off the coast of Brazil attractive options. If the lower prices make these marginal barrels unremunerative, firms are likely to increasingly back off even committed investments, leave alone newer ones.
Standard economic theory says that when demand drops and prices fall, companies curb their investments, leading to lower supplies. When demand recovers, prices rise again and companies start to invest in new production, starting another cycle. It is more pronounced with the oil market. Given the time lag between exploration and getting oil to the pumps, future supplies are strongly co-related with investments made now. Lower prices now therefore appear to be a recipe for higher prices in future, especially when after the economic activity rebounds back and supply is not able to keep pace with demand.
More criticism of the Paulson bailout plan
Pietro Veronesi and Luigi Zingales accuses that the revised Paulson bailout plan ($125bn equity infusion in the nine largest U.S. commercial banks, in return for preferred equity with a nominal value equal to the amount invested, and a three year Government, through FDIC, guarantee on all new bank debt issues), with its emphasis on equity injections, creates no value to the banking system, amounts to a massive redistribution from taxpayers to bondholders, and enriches Wall Street cronies!
They write that the plan "increased the value of banks’ financial claims by $109 billion at a taxpayers’ cost of $112 -135 bns, creating no value in the banking sector. The biggest beneficiaries of this massive redistribution were the debtholders of financial institutions, especially those of the three former investment banks and of Citigroup. The equity holders just broke even."
Luigi Zingales suggests that the channel for equity injections should have been different. He feels that a better option would have been for the FDIC to take equity stakes in the borrowing banks, by swapping their debts as equity.
Alan Blinder is equally scathing in his indictment, arguing that the preferred stocks, with no control rights, were puchased often at above-market prices and with no public-purpose strings attached. He writes, "The 5% dividend rate that taxpayers will generally receive is half what Warren Buffett got from Goldman Sachs. Banks receiving capital injections through the front door are generally allowed to pay dividends out the back door. And there are no public-purpose quid pro quos, such as a minimal lending requirement. So banks can just sit on the capital, which is what most of them have done, or use it to make acquisitions, as a few have."
He feels that the crisis cannot be settled without addressing the issue of mounting foreclosures. This would require re-financing home mortgages (so that foreclosures that destroy real estate values and force fire sales of homes are contained) and buying "illiquid and now worthless" troubled assets (so that these assets start getting traded and their valuations get established).
They write that the plan "increased the value of banks’ financial claims by $109 billion at a taxpayers’ cost of $112 -135 bns, creating no value in the banking sector. The biggest beneficiaries of this massive redistribution were the debtholders of financial institutions, especially those of the three former investment banks and of Citigroup. The equity holders just broke even."
Luigi Zingales suggests that the channel for equity injections should have been different. He feels that a better option would have been for the FDIC to take equity stakes in the borrowing banks, by swapping their debts as equity.
Alan Blinder is equally scathing in his indictment, arguing that the preferred stocks, with no control rights, were puchased often at above-market prices and with no public-purpose strings attached. He writes, "The 5% dividend rate that taxpayers will generally receive is half what Warren Buffett got from Goldman Sachs. Banks receiving capital injections through the front door are generally allowed to pay dividends out the back door. And there are no public-purpose quid pro quos, such as a minimal lending requirement. So banks can just sit on the capital, which is what most of them have done, or use it to make acquisitions, as a few have."
He feels that the crisis cannot be settled without addressing the issue of mounting foreclosures. This would require re-financing home mortgages (so that foreclosures that destroy real estate values and force fire sales of homes are contained) and buying "illiquid and now worthless" troubled assets (so that these assets start getting traded and their valuations get established).
Saturday, December 20, 2008
PPP models in advertisement rights
Foot-over-bridges or sky-walks are increasingly becoming commonplace in many metropolitan cities as a means of facilitating pedestrian crossings at busy traffic junctions. Apart from this functional utility, these bridges provide vantage locations to display advertisements, and advertisement agencies naturally find these bridges a good source of raising revenue.
The Mumbai Metropolitan Region Development Authority (MMRDA) proposes to erect 50 sky walks or foot-over-bridges with modern designs to facilitate pedestrian crossings at busy traffic junctions. These bridges will be built with its internal funds, at a cost of over Rs 600 Cr. The MMRDA will then bid out advertisement rights on them.
Cities like Hyderabad have opted to follow another business model to finance such bridges. They have bidded out the construction-cum-maintenance of these structures for a specific period of time (usually the bid parameter) to advertisement agencies who would finance them by raising revenues from advertisements.
The same two models are possible in other similar projects like construction of toilets and bus bays. In the MMRDA model, the construction risk is borne by the Government, while in the Hyderabad model the construction, operation and commercial risks are borne by the private agency.
It has been found from experience across the country that the later (Hyderabad model) is a better option for more mature markets where price discovery mechanisms are in place, while the former (MMRDA) is more suited to emerging and developing markets.
Apart from the strong possibility of not finding suitable bidders (as many cities who have followed it have found out, and Hyderabad itself found out with its failed experiment with bidding out toilets and bus bays), the Hyderabad model leaves the Government vulnerable to being left with a bad deal (both in financial terms and in terms of the concession period) as the private agency hedges its risks in an uncertain market. Given the state of the market, from both supply and demand side, in most Indian cities, the MMRDA model may be a more appropriate model.
The Mumbai Metropolitan Region Development Authority (MMRDA) proposes to erect 50 sky walks or foot-over-bridges with modern designs to facilitate pedestrian crossings at busy traffic junctions. These bridges will be built with its internal funds, at a cost of over Rs 600 Cr. The MMRDA will then bid out advertisement rights on them.
Cities like Hyderabad have opted to follow another business model to finance such bridges. They have bidded out the construction-cum-maintenance of these structures for a specific period of time (usually the bid parameter) to advertisement agencies who would finance them by raising revenues from advertisements.
The same two models are possible in other similar projects like construction of toilets and bus bays. In the MMRDA model, the construction risk is borne by the Government, while in the Hyderabad model the construction, operation and commercial risks are borne by the private agency.
It has been found from experience across the country that the later (Hyderabad model) is a better option for more mature markets where price discovery mechanisms are in place, while the former (MMRDA) is more suited to emerging and developing markets.
Apart from the strong possibility of not finding suitable bidders (as many cities who have followed it have found out, and Hyderabad itself found out with its failed experiment with bidding out toilets and bus bays), the Hyderabad model leaves the Government vulnerable to being left with a bad deal (both in financial terms and in terms of the concession period) as the private agency hedges its risks in an uncertain market. Given the state of the market, from both supply and demand side, in most Indian cities, the MMRDA model may be a more appropriate model.
Causes of conflicts
The Heidelberg Institute for International Conflict Research (HIIK) recently released the latest issue of its Annual Conflict Barometer 2008, which describes recent trends in conflict development, escalations, settlements. The HIIK defines "conflicts as the clashing of interests (positional differences) over national values of some duration and magnitude between at least two parties (organized groups, states, groups of states, organizations) that are determined to pursue their interests and achieve their goals".
The report documents nine wars and almost 130 violent conflicts across the world in 2008 and classifies conflict broadly to include peaceful disputes over politics or borders (low intensity), as well as those involving sporadic or constant violence (medium or high intensity). It finds that though ideological change is both the most common cause of conflict and the root of most wars, but there is rarely only one cause of dispute. The other commonest causes include self-determination, national control, and control of resources and territory.
(HT: The Economist)
The report documents nine wars and almost 130 violent conflicts across the world in 2008 and classifies conflict broadly to include peaceful disputes over politics or borders (low intensity), as well as those involving sporadic or constant violence (medium or high intensity). It finds that though ideological change is both the most common cause of conflict and the root of most wars, but there is rarely only one cause of dispute. The other commonest causes include self-determination, national control, and control of resources and territory.
(HT: The Economist)
Friday, December 19, 2008
Corporate Governance and Ethics in India
Two recent events have focussed attention on the issues of Corporate Governance and Corporate Ethics among private sector firms in India. First, Satyam Computer Services had to beat a hasty retreat from its outrageous decision to acquire Maytas Properties and take a 51% stake in Maytas Infra for $1.6 billion, in the face of strong shareholder opposition.
Second, in another less discussed incident, Rajya Sabha member and Chairman of the Bajaj Auto Ltd, Rahul Bajaj, in an obvious case of conflict of interest, blatantly used the question hour in the Parliament to campaign for sops to the auto industry to tide over the economic slowdown.
In this context comes the Transparency International’s 2008 Bribe Payers Index (BPI), which explores the degree to which companies from 22 of the world’s wealthiest and economically dominant countries are likely to engage in bribery when doing business abroad. And, expectedly, Indian companies comes out as the third most bribery prone. Russian firms leads the pack.
It appears that despite all high-minded talk and wailing about lack of leadership (including by the aforementioned worthy) among the political class in television channels in the aftermath of the recent Mumbai terror attacks, substantial sections of coporate India are in many ways sailing in the same boat as the very politicians they accuse with righteous indignation!
(HT: The Economist)
Update 1
Siemens pays $1.6 bn in fines, the largest such payout, after pleading guilty of corrupt practices involving bribing foreign governments. The company had creatively itemized these expenditures in its balance sheet.
Second, in another less discussed incident, Rajya Sabha member and Chairman of the Bajaj Auto Ltd, Rahul Bajaj, in an obvious case of conflict of interest, blatantly used the question hour in the Parliament to campaign for sops to the auto industry to tide over the economic slowdown.
In this context comes the Transparency International’s 2008 Bribe Payers Index (BPI), which explores the degree to which companies from 22 of the world’s wealthiest and economically dominant countries are likely to engage in bribery when doing business abroad. And, expectedly, Indian companies comes out as the third most bribery prone. Russian firms leads the pack.
It appears that despite all high-minded talk and wailing about lack of leadership (including by the aforementioned worthy) among the political class in television channels in the aftermath of the recent Mumbai terror attacks, substantial sections of coporate India are in many ways sailing in the same boat as the very politicians they accuse with righteous indignation!
(HT: The Economist)
Update 1
Siemens pays $1.6 bn in fines, the largest such payout, after pleading guilty of corrupt practices involving bribing foreign governments. The company had creatively itemized these expenditures in its balance sheet.
State of Indian infrastructure
The Economist puts the Indian Infrastructure sector in perspective. Sample these dismal stats
1. Only 13% of the sewage prduced by the 1.1 billion people is treated, and an estimated 700m Indians have no access to a proper toilet. The result - 1,000 children die of diarrhoeal sickness every day!
2. It takes an average of 21 days to clear import cargo in India; in Singapore it takes three.
3. India’s urban roads are choked: the average speed in Delhi has fallen from 27kph (17mph) in 1997 to 10kph. In 2007, 130,000 people died on India’s roads, 60% more than in China, which has four times as many cars. By the end of 2007 China had some 53,600km of highways with four lanes or more, India had just 8000 km of dual carriageways.
4. Peak power demand outstripped supply by almost 15%, distribution losses are 35%, 9% of potential industrial output in India is lost to power cuts, and some 600m Indians have no mains electricity at all.
5. In the next five years the government plans to increase India’s generating capacity by an annual 14%, or 90,000MW (China added 100,000MW in 2007), but it added only 7000 MW in 2007, itself a record!
6. Though primary school enrolment rate is 96%, the quality of education on offer is abysmal. Half of ten-year-olds cannot read to the basic standard expected of six-year-olds, over 60% could not do simple division, and half the children leave school by the age of 14. One reason is that only half of Indian teachers show up to work.
7. NASSCOM reckons that of the 350,000 engineering graduates who emerge each year, mostly from private colleges, 25% are unemployable without extensive further training, and half are just unemployable!
8. Though the Planning Commission estimates India'a infrastructure investment requirement over the next five years to be $475 billion or about 8% of GDP a year, this year’s investment is likely to be only around 4.6% of GDP!
1. Only 13% of the sewage prduced by the 1.1 billion people is treated, and an estimated 700m Indians have no access to a proper toilet. The result - 1,000 children die of diarrhoeal sickness every day!
2. It takes an average of 21 days to clear import cargo in India; in Singapore it takes three.
3. India’s urban roads are choked: the average speed in Delhi has fallen from 27kph (17mph) in 1997 to 10kph. In 2007, 130,000 people died on India’s roads, 60% more than in China, which has four times as many cars. By the end of 2007 China had some 53,600km of highways with four lanes or more, India had just 8000 km of dual carriageways.
4. Peak power demand outstripped supply by almost 15%, distribution losses are 35%, 9% of potential industrial output in India is lost to power cuts, and some 600m Indians have no mains electricity at all.
5. In the next five years the government plans to increase India’s generating capacity by an annual 14%, or 90,000MW (China added 100,000MW in 2007), but it added only 7000 MW in 2007, itself a record!
6. Though primary school enrolment rate is 96%, the quality of education on offer is abysmal. Half of ten-year-olds cannot read to the basic standard expected of six-year-olds, over 60% could not do simple division, and half the children leave school by the age of 14. One reason is that only half of Indian teachers show up to work.
7. NASSCOM reckons that of the 350,000 engineering graduates who emerge each year, mostly from private colleges, 25% are unemployable without extensive further training, and half are just unemployable!
8. Though the Planning Commission estimates India'a infrastructure investment requirement over the next five years to be $475 billion or about 8% of GDP a year, this year’s investment is likely to be only around 4.6% of GDP!
Thursday, December 18, 2008
Most promiscuous nation is...?
... Finland, so says a survey of 48 countries by researchers from the Bradley University.
(HT: The Economist)
(HT: The Economist)
Steve Levitt clarifies Giffen goods
Giffen goods are those products whose demand, contrary to normal goods, increases with price - an upward sloping demand curve. Steve Levitt has an excellent post clarifying the recent claims that rice in rural China (peasants buy more of rice as its price rises) and prostitutes (types of customers preferring more expensive prostitutes) are examples of Giffen goods, may be off the mark.
Levitt writes, "When we talk about the demand curve for a good, what we mean is how the quantity consumed for that exact same good changes with the price of that good while holding everything else constant (such as the consumer’s income, the price of other goods, etc) and vice-versa."
In case of prostitutes, cheaper and more expensive prostitutes are two types of "goods", serving two different categories of consumers. Therefore the customer who purchases the high-price prostitute would demand just as much or more of her services if she were willing to do all the same things but at half the price.
Rice is the staple diet in rural China, whereas meat is a luxury diet, and people prefer to substitute rice with more meat (substitution effect) as they become richer. However, as the prices of commodities rice (or inflation takes hold), peasants face reduced real incomes (income effect of a price change) which turns them away from consuming luxury food items like meat and towards consuming basic staple like rice. For staples like rice, the substitution effect and the income effect push in opposite directions, and when the income effect is bigger than the substitution effect (the relative rise in price of rice is smaller than that of meat or the difference between the prices of the two products are too high), higher rice prices lead the peasants to feel so poor that they end up consuming more rice.
Levitt writes, "When we talk about the demand curve for a good, what we mean is how the quantity consumed for that exact same good changes with the price of that good while holding everything else constant (such as the consumer’s income, the price of other goods, etc) and vice-versa."
In case of prostitutes, cheaper and more expensive prostitutes are two types of "goods", serving two different categories of consumers. Therefore the customer who purchases the high-price prostitute would demand just as much or more of her services if she were willing to do all the same things but at half the price.
Rice is the staple diet in rural China, whereas meat is a luxury diet, and people prefer to substitute rice with more meat (substitution effect) as they become richer. However, as the prices of commodities rice (or inflation takes hold), peasants face reduced real incomes (income effect of a price change) which turns them away from consuming luxury food items like meat and towards consuming basic staple like rice. For staples like rice, the substitution effect and the income effect push in opposite directions, and when the income effect is bigger than the substitution effect (the relative rise in price of rice is smaller than that of meat or the difference between the prices of the two products are too high), higher rice prices lead the peasants to feel so poor that they end up consuming more rice.
Wednesday, December 17, 2008
Moral hazard and unemployment benefits
For a long time conservative and free-market economists, especially in the US, have opposed unemployment insurance on the grounds that it promotes moral hazard and disincentivizes people from hunting for jobs and even shirk work. In the face of this spirtited opposition, successive governments in the US has cut back on unemployment benefits and its duration. But two studies - in the UK and US - come up with interesting findings to the contrary.
Chris Dillow draws attention to a study by Barbara Petrongolo, which uses data from the Jobseekers Allowance Program in the US and finds that though "tougher search requirements did succeed in getting people off unemployment benefits initially, it was not successful in getting people into new, lasting jobs". She found that the people subjected to the tougher rules worked fewer hours 12 months later, and those that were in work earned less than those who had been subject to the less stringent Unemployment Benefit rules. Stricter beenfit regimes tempted people to take the first job that came along, rather than wait for ones for which they were more suited. The upshot was that people went into low-earning work, or jobs that didn’t last. Also, many of those who left unemployment either went onto incapacity benefit or into the black economy.
Tim Harford points to a recent NBER working paper by Raj Chetty which claims that more generous unemployment insurance appears to lead to greater unemployment not due to moral hazard and people ducking work, but because the beenfits give a cushion to those looking for jobs from having to rush into an unsuitable job. His research suggests that those without their own cash reserves are using unemployment benefits to buy themselves time to find the right job. Therefore, while unemployment benefits do encourage unemployment in the short term, that may not be a bad thing!
Chris Dillow draws attention to a study by Barbara Petrongolo, which uses data from the Jobseekers Allowance Program in the US and finds that though "tougher search requirements did succeed in getting people off unemployment benefits initially, it was not successful in getting people into new, lasting jobs". She found that the people subjected to the tougher rules worked fewer hours 12 months later, and those that were in work earned less than those who had been subject to the less stringent Unemployment Benefit rules. Stricter beenfit regimes tempted people to take the first job that came along, rather than wait for ones for which they were more suited. The upshot was that people went into low-earning work, or jobs that didn’t last. Also, many of those who left unemployment either went onto incapacity benefit or into the black economy.
Tim Harford points to a recent NBER working paper by Raj Chetty which claims that more generous unemployment insurance appears to lead to greater unemployment not due to moral hazard and people ducking work, but because the beenfits give a cushion to those looking for jobs from having to rush into an unsuitable job. His research suggests that those without their own cash reserves are using unemployment benefits to buy themselves time to find the right job. Therefore, while unemployment benefits do encourage unemployment in the short term, that may not be a bad thing!
US Fed shoots the big cannon!
Ushering in a historic era of monetary policy loosening, the US Fed has decided to cut the overnight federal funds rate, which affects how much banks charge when they lend their reserves to each other, to a range of 0-0.25% from 1%. This dramatic decision by the Federal Open Market Committee (FOMC) follows nine rate cuts in the previous 14 months and $1.4 trillion in emergency lending, all of which have failed to rein in the decline.
The rate cuts are largely symbolic, in so far as the funds rate had already fallen to nearly zero in recent days because the credit markets had frozen so much that the banks have been so reluctant to do any lending business. While the target fed funds was until yesterday still 1%, in the last few weeks — following the massive increase in liquidity by the Fed — the actual Fed Funds was already trading at a level literally close to 0%. The possibility of a Japan style liquidity trap with its attendant consequences now look real.
Though this historic low interest rate leaves the Fed with little room for conventional monetary loosening, the FOMC of the Fed still expressed its commitment to buy 'large quantities' of debt and mortgage-backed securities and debt issued by government-sponsored companies like Fannie Mae; commercial debt for businesses and consumer lending, and longer-term Treasury securities. These less conventional measures have meant that since September the Fed’s balance sheet has ballooned from about $900 billion to more than $2 trillion as the central bank has created new money and lent it out through all its new programs.
This open commitment now to even print money to keep credit flowing and prevent a deflation is in keeping with the well stated stance of Fed Governor Ben Bernanke (remember the parody of "helicopter Ben"). Martin Wolf has this excellent article about the dangers of deflation - higher real rate of interest, rising real value of debt as prices fall (debt inflation), and postponed conusmption and investments - and the comparisons with the Japanese crisis of the nineties.
Yields on Treasury debt, which have plunged this year as investors sought a haven for their money, fell to new lows after the Fed indicated it would buy long-term Treasury debt and promised to keep interest rates at "exceptionally low levels" for the foreseeable future. The yields on Treasury’s benchmark 10-year bill fell to 2.26% from 2.51% and the rate for a 30-year fixed-rate mortgage fell to 5.38% from 5.74% the previous day.
In order to revive corporate and consumer lending, from later this month the Fed will start purchasing $600 billion worth of securities that are backed by Fannie Mae, Freddie Mac and other government-sponsored entities, besides joining with the Treasury to introduce a joint program to buy up securities backed by consumer debt like automobile loans. All of these will take the Fed's balance sheet to beyond $3 trillion. The consequences of this massive build up of monetary base, which banks and other investors are essentially hoarding now, will be catastrophic if they are not destroyed once normalcy returns and banks start lending again.
The rate cuts follows a series of depressing news indicating that the recession is getting more severe than expected and has the potential to draw the economy into a depression. Unemployment figures for November have been dismal. In an increasing sign of deflation taking hold, consumer price index fell 1.7% in November, the steepest monthly drop since the government began tracking prices in 1947 as retailers have aggressively slashed prices in an effort to lure in Christmas shoppers. Home construction has skidded nearly 20% from October and 47% from the same time last year to its lowest levels in 50 years. Even the so-called core inflation rate, which excludes the volatile food and energy sectors, is essentially zero. Industrial production for November dropped 5.5% compared with November 2007 and 0.6% over the previous month, and manufacturing output declined 1.4% in November.
Meanwhile, despite a $ 5 bn cash infusion by Warren Buffet, with all its credibility spin-off (of immense value at such uncertain times), a corporate makeover into a universal bank, and a reputation for surviving many a crises, Goldman Sachs reported a quarterly loss of $2.12 bn, its first quarterly loss since it went public in 1999. The other big remaining investment bank turned universal bank, Morgan Stanley, too posted a $2.29 bn loss.
Update 1
Japanese Central Bank too follows suit and lowers rates to 0.1% from 0.3% and also announces its decision to buy up short term commercial paper to shore up the credit markets.
Update 2
Robert Lucas thinks that the Fed assuming the role of a lender of last resort at a time the markets are in a "flight to quality", has the potential to stumulate spending.
Update 3
The Economist reviews the Fed's unconventional monetary policy using quantitative easing.
Update 4
Janet Yellen of the Federal Reserve Bank of San Francisco summarizes the Fed's monetary policy response and compares the policies of the US Fed and Bank of Japan in the nineties. She makes the point that near the zero bound, short-term government securities and cash are almost perfect substitutes, and therefore simply expanding excess bank reserves by replacing G-Secs may have little effect on bank lending.
The rate cuts are largely symbolic, in so far as the funds rate had already fallen to nearly zero in recent days because the credit markets had frozen so much that the banks have been so reluctant to do any lending business. While the target fed funds was until yesterday still 1%, in the last few weeks — following the massive increase in liquidity by the Fed — the actual Fed Funds was already trading at a level literally close to 0%. The possibility of a Japan style liquidity trap with its attendant consequences now look real.
Though this historic low interest rate leaves the Fed with little room for conventional monetary loosening, the FOMC of the Fed still expressed its commitment to buy 'large quantities' of debt and mortgage-backed securities and debt issued by government-sponsored companies like Fannie Mae; commercial debt for businesses and consumer lending, and longer-term Treasury securities. These less conventional measures have meant that since September the Fed’s balance sheet has ballooned from about $900 billion to more than $2 trillion as the central bank has created new money and lent it out through all its new programs.
This open commitment now to even print money to keep credit flowing and prevent a deflation is in keeping with the well stated stance of Fed Governor Ben Bernanke (remember the parody of "helicopter Ben"). Martin Wolf has this excellent article about the dangers of deflation - higher real rate of interest, rising real value of debt as prices fall (debt inflation), and postponed conusmption and investments - and the comparisons with the Japanese crisis of the nineties.
Yields on Treasury debt, which have plunged this year as investors sought a haven for their money, fell to new lows after the Fed indicated it would buy long-term Treasury debt and promised to keep interest rates at "exceptionally low levels" for the foreseeable future. The yields on Treasury’s benchmark 10-year bill fell to 2.26% from 2.51% and the rate for a 30-year fixed-rate mortgage fell to 5.38% from 5.74% the previous day.
In order to revive corporate and consumer lending, from later this month the Fed will start purchasing $600 billion worth of securities that are backed by Fannie Mae, Freddie Mac and other government-sponsored entities, besides joining with the Treasury to introduce a joint program to buy up securities backed by consumer debt like automobile loans. All of these will take the Fed's balance sheet to beyond $3 trillion. The consequences of this massive build up of monetary base, which banks and other investors are essentially hoarding now, will be catastrophic if they are not destroyed once normalcy returns and banks start lending again.
The rate cuts follows a series of depressing news indicating that the recession is getting more severe than expected and has the potential to draw the economy into a depression. Unemployment figures for November have been dismal. In an increasing sign of deflation taking hold, consumer price index fell 1.7% in November, the steepest monthly drop since the government began tracking prices in 1947 as retailers have aggressively slashed prices in an effort to lure in Christmas shoppers. Home construction has skidded nearly 20% from October and 47% from the same time last year to its lowest levels in 50 years. Even the so-called core inflation rate, which excludes the volatile food and energy sectors, is essentially zero. Industrial production for November dropped 5.5% compared with November 2007 and 0.6% over the previous month, and manufacturing output declined 1.4% in November.
Meanwhile, despite a $ 5 bn cash infusion by Warren Buffet, with all its credibility spin-off (of immense value at such uncertain times), a corporate makeover into a universal bank, and a reputation for surviving many a crises, Goldman Sachs reported a quarterly loss of $2.12 bn, its first quarterly loss since it went public in 1999. The other big remaining investment bank turned universal bank, Morgan Stanley, too posted a $2.29 bn loss.
Update 1
Japanese Central Bank too follows suit and lowers rates to 0.1% from 0.3% and also announces its decision to buy up short term commercial paper to shore up the credit markets.
Update 2
Robert Lucas thinks that the Fed assuming the role of a lender of last resort at a time the markets are in a "flight to quality", has the potential to stumulate spending.
Update 3
The Economist reviews the Fed's unconventional monetary policy using quantitative easing.
Update 4
Janet Yellen of the Federal Reserve Bank of San Francisco summarizes the Fed's monetary policy response and compares the policies of the US Fed and Bank of Japan in the nineties. She makes the point that near the zero bound, short-term government securities and cash are almost perfect substitutes, and therefore simply expanding excess bank reserves by replacing G-Secs may have little effect on bank lending.
Tuesday, December 16, 2008
Fiscal policy debates
The economic crisis has initated an intense debate (Conservatives Vs Liberals, Monetarists Vs Keynesians) about whether monetary or fiscal policy are of greater significance during times of such turmoil. It has also re-kindled the old debate about the relative importance of the various fiscal policy options, especially the respective economic multipliers of tax cuts and government spending.
Mark Thoma and Robert Skidelsky weigh in on the importance of government spending led fiscal policy over tax cuts and monetary expansion. Paul Krugman writes that we have reached a world in which monetary policy, both in US and soon in Europe, has little or no traction, and therefore fiscal policy is the only option left. James Galbraith too appears to agree.
Greg Mankiw, invoking studies by Christina and David Romer, Bob Hall and Susan Woodward, and Valerie A Ramey, argues that the tax cuts offer a higher multiplier than government spending. He claims that unlike the later which works through increases in disposable income and consumption demand, the former also incentivizes more investment demand from businesses. However, Martin Feldstein, a doyen among conservative economists, broke ranks and declared that the $168 bn tax cut dominated US fiscal stimulus of February 2008 failed because people actually ended up saving and paying off debts instead of spending it on consumption.
Mark Thoma sums up the debate about the relative utilities of the various fiscal policy options, mainly between tax cuts and government spending. Catherine Rampell in the Economix blog of NYT has the recommendations of an exhaustive list of distinguished economists.
Update 1
Marginal Revolution draws attention to a recent NBER paper by Andrew Mountford and Harald Uhlig which finds that of the three fiscal policy options - deficit-spending, deficit-financed tax cuts and a balanced budget spending expansion - deficit financed tax cuts have the highest multiplier on the GDP. Free Exchange is not impressed and takes up issue here.
Update 2
The always insightful Mark Thoma has an excellent parable explaining how fiscal policy works during economic downturns and depressions. The commonest criticism against fiscal policy that it crowds out private investment may not apply to downturns and depressions, since at such times there are idle resources that are involuntarily unemployed and private investors are in any case unwilling to make any additional investments. So Paul Krugman is spot on in claiming that normal rules do not apply when the world is in depression.
Update 3
The most definitive proof that monetary policy can save the economy in times of economic slowdown comes from the present crisis. Unlike the Great Depression, nobody can accuse the Central Banks across the world, individually and collectively, of not doing enough and quickly at that. We have seen the Fed and others summon all the monetary policy levers - lower rates aggressively to the zero bound; capitalize banks and financial institutions with the most liberal terms; inject liquidity through their discount windows by relaxing all lending standards; act as a market maker of last resort by purchasing troubled assets and commercial papers; and provide blanket guarantees to deposits. The amounts involved have been mind boggling - more than $1.3 trillion in the US alone, and counting!
Apart from a few hours (in a few cases, a couple of days) of market rally, the financial markets and the economy appears to have hardly acknowledged these interventions. If anything, Central Banks, and not the Governments, have been the primary players in the drama so far.
However, despite the overwhelming proof, apologists of Monetarism, will surely claim that had the Central Banks not intervened so aggressively, the situation could have been much worse!
Update 4
Gary Becker takes a historical perspective, of the past fifty years, and restrains any knee-jerk aggressive government regulatory interventions that may have adverse long term consequences.
Update 5
Paul Krugman draws attention to the work of Adam Posen who finds evidence that the Japanese fiscal stimulus in 1995 did actually work and increase economic growth rate. However, Tyler Cowen debates the reliability of the Japanese example, given other factors involved.
Update 6
Paul Krugman gets to the basics of Eco 101 in favour of stimulus in the form of infrastructure spending and providing public goods, as opposed to stimulus in the form of tax cuts. A marginal dollar spent on public goods is worth more than a marginal dollar spent on private consumption, because in any case these are goods that a functioning society and market requires and will be under-supplied by the private sector.
Update 7
Bloomberg has this excellent article tracing the roots of the Monetarist take-over of economic policy making since the seventies. And Barry Ritholtz writes the obituary for Chicago School.
Update 8
Paul Krugman uses numbers to prove that the multiplier is much higher for public spending, by way of the increase in taxes ploughed back to the economy. The net stimulus is therefore smaller, or there is more bang for the buck.
Update 9
Daniel Gross sums up the debate between fiscal and monetary policy and favours using both in such extraordinary times.
Update 10
Here is the famous NBER working paper of 1994, at the center of debate now, by David and Christina Romer that claims that in post-war recessions, monetary policy has been more effective in the early stage of recoveries. They write, "We find that the Federal Reserve typically responds to downturns with prompt and large reductions in interest rates. Discretionary fiscal policy, in contrast, rarely reacts before the trough in economic activity, and even then the responses are usually small. Simulations using multipliers from both simple regressions and a large macroeconomic model show that the interest rate falls account for nearly all of the above-average growth that occurs early in recoveries."
Update 11
Eugene Fama opposes fiscal stimulus on grounds that government debt only transfers burden from one generation to another.
Update 12
Brad Delong writes about the eclipse of the Chicago School.
Mark Thoma and Robert Skidelsky weigh in on the importance of government spending led fiscal policy over tax cuts and monetary expansion. Paul Krugman writes that we have reached a world in which monetary policy, both in US and soon in Europe, has little or no traction, and therefore fiscal policy is the only option left. James Galbraith too appears to agree.
Greg Mankiw, invoking studies by Christina and David Romer, Bob Hall and Susan Woodward, and Valerie A Ramey, argues that the tax cuts offer a higher multiplier than government spending. He claims that unlike the later which works through increases in disposable income and consumption demand, the former also incentivizes more investment demand from businesses. However, Martin Feldstein, a doyen among conservative economists, broke ranks and declared that the $168 bn tax cut dominated US fiscal stimulus of February 2008 failed because people actually ended up saving and paying off debts instead of spending it on consumption.
Mark Thoma sums up the debate about the relative utilities of the various fiscal policy options, mainly between tax cuts and government spending. Catherine Rampell in the Economix blog of NYT has the recommendations of an exhaustive list of distinguished economists.
Update 1
Marginal Revolution draws attention to a recent NBER paper by Andrew Mountford and Harald Uhlig which finds that of the three fiscal policy options - deficit-spending, deficit-financed tax cuts and a balanced budget spending expansion - deficit financed tax cuts have the highest multiplier on the GDP. Free Exchange is not impressed and takes up issue here.
Update 2
The always insightful Mark Thoma has an excellent parable explaining how fiscal policy works during economic downturns and depressions. The commonest criticism against fiscal policy that it crowds out private investment may not apply to downturns and depressions, since at such times there are idle resources that are involuntarily unemployed and private investors are in any case unwilling to make any additional investments. So Paul Krugman is spot on in claiming that normal rules do not apply when the world is in depression.
Update 3
The most definitive proof that monetary policy can save the economy in times of economic slowdown comes from the present crisis. Unlike the Great Depression, nobody can accuse the Central Banks across the world, individually and collectively, of not doing enough and quickly at that. We have seen the Fed and others summon all the monetary policy levers - lower rates aggressively to the zero bound; capitalize banks and financial institutions with the most liberal terms; inject liquidity through their discount windows by relaxing all lending standards; act as a market maker of last resort by purchasing troubled assets and commercial papers; and provide blanket guarantees to deposits. The amounts involved have been mind boggling - more than $1.3 trillion in the US alone, and counting!
Apart from a few hours (in a few cases, a couple of days) of market rally, the financial markets and the economy appears to have hardly acknowledged these interventions. If anything, Central Banks, and not the Governments, have been the primary players in the drama so far.
However, despite the overwhelming proof, apologists of Monetarism, will surely claim that had the Central Banks not intervened so aggressively, the situation could have been much worse!
Update 4
Gary Becker takes a historical perspective, of the past fifty years, and restrains any knee-jerk aggressive government regulatory interventions that may have adverse long term consequences.
Update 5
Paul Krugman draws attention to the work of Adam Posen who finds evidence that the Japanese fiscal stimulus in 1995 did actually work and increase economic growth rate. However, Tyler Cowen debates the reliability of the Japanese example, given other factors involved.
Update 6
Paul Krugman gets to the basics of Eco 101 in favour of stimulus in the form of infrastructure spending and providing public goods, as opposed to stimulus in the form of tax cuts. A marginal dollar spent on public goods is worth more than a marginal dollar spent on private consumption, because in any case these are goods that a functioning society and market requires and will be under-supplied by the private sector.
Update 7
Bloomberg has this excellent article tracing the roots of the Monetarist take-over of economic policy making since the seventies. And Barry Ritholtz writes the obituary for Chicago School.
Update 8
Paul Krugman uses numbers to prove that the multiplier is much higher for public spending, by way of the increase in taxes ploughed back to the economy. The net stimulus is therefore smaller, or there is more bang for the buck.
Update 9
Daniel Gross sums up the debate between fiscal and monetary policy and favours using both in such extraordinary times.
Update 10
Here is the famous NBER working paper of 1994, at the center of debate now, by David and Christina Romer that claims that in post-war recessions, monetary policy has been more effective in the early stage of recoveries. They write, "We find that the Federal Reserve typically responds to downturns with prompt and large reductions in interest rates. Discretionary fiscal policy, in contrast, rarely reacts before the trough in economic activity, and even then the responses are usually small. Simulations using multipliers from both simple regressions and a large macroeconomic model show that the interest rate falls account for nearly all of the above-average growth that occurs early in recoveries."
Update 11
Eugene Fama opposes fiscal stimulus on grounds that government debt only transfers burden from one generation to another.
Update 12
Brad Delong writes about the eclipse of the Chicago School.
Monday, December 15, 2008
Mint op-ed on fiscal stimulus
My op-ed piece on "Tailoring our fiscal stimulus" appears on Mint today.
Elections as a fiscal stimulus!
Any fiscal stimulus to be effective has to be timely, well targeted and temporary. If we go by this test, one of the most effective fiscal stimulus options is elections, especially in an Indian context!
Even with the most conservative estimates, election spending by both the political parties and the government runs into several thousands of crores of rupees. Unlike the conventional government fiscal stimulus, most of this spending will be in the unorganized sector and informal black economy, and will thereby impact the lives of millions of people in the most direct manner. Here is a list of the major election-related expenditure streams.
1. It is an open secret that a candidate spends anywhere between Rs 5 to 10 Cr for fighting a Parlaiment seat. This includes the payout to get the party nomination from the constituency to the actual election campaigning expenditure. For the 543 Parliament seats, assuming just two parties, and the lower bound of Rs 5 Cr, the total spending on Parliamentary elections alone works out to Rs 5430 Cr.
2. Add in assembly elections in a few states, say 1000 assembly seats. At Rs 3 Cr, and two candidates, this spending will work out to about Rs 6000 Cr.
3. It is estimated that the Election Commission will employ more than 4 million people to conduct the elections. Polling personnel at the rate of about 200 polling stations per Parliamentary constituency, 4 persons per polling station will have to be employed to conduct the poll. The payments to them and other officials, including the massive police and paramilitary personnel, involved in election process will be in the range of Rs 3000 - 5000 Cr. These payouts can be considered the equivalent of tax credit checks paid out to stimulate the economy.
4. The additional spending by way of procurement and logistics for election related activitities will be atleast Rs 2000 Cr.
The total spending on all these counts, at its most conservative estimate, will be a handsome Rs 15000 - 20000 Cr. A more realistic figure could be almost double this, a significant enough amount. Most of the campaign and election related spending will be on items which are produced and consumed locally. The multiplier effect on such spending is likely to be substantial and the benefits of the spending will accrue mainly to those most in need of the same. Further, the handouts will go to the hands of those who are more likely to spend rather than save it.
Finally, elections are a one-off event, and hence there is an inherent sunset provision to election spending. In the circumstances, the immediate need of the hour is - early elections!
Update 1 (28/101/2010)
The US Congressional elections in 2010 appears to have all the trappings of a fiscal stimulus. A new class of super-wealthy, self-funding candidates appears eager to spend their heirs' fortunes in the (often fruitless) search for thankless public office. The spending prowess of candidates like Meg Whitman in California and Mike Bloomberg in New York, have contributed substantially to stimulating the economy.
Even with the most conservative estimates, election spending by both the political parties and the government runs into several thousands of crores of rupees. Unlike the conventional government fiscal stimulus, most of this spending will be in the unorganized sector and informal black economy, and will thereby impact the lives of millions of people in the most direct manner. Here is a list of the major election-related expenditure streams.
1. It is an open secret that a candidate spends anywhere between Rs 5 to 10 Cr for fighting a Parlaiment seat. This includes the payout to get the party nomination from the constituency to the actual election campaigning expenditure. For the 543 Parliament seats, assuming just two parties, and the lower bound of Rs 5 Cr, the total spending on Parliamentary elections alone works out to Rs 5430 Cr.
2. Add in assembly elections in a few states, say 1000 assembly seats. At Rs 3 Cr, and two candidates, this spending will work out to about Rs 6000 Cr.
3. It is estimated that the Election Commission will employ more than 4 million people to conduct the elections. Polling personnel at the rate of about 200 polling stations per Parliamentary constituency, 4 persons per polling station will have to be employed to conduct the poll. The payments to them and other officials, including the massive police and paramilitary personnel, involved in election process will be in the range of Rs 3000 - 5000 Cr. These payouts can be considered the equivalent of tax credit checks paid out to stimulate the economy.
4. The additional spending by way of procurement and logistics for election related activitities will be atleast Rs 2000 Cr.
The total spending on all these counts, at its most conservative estimate, will be a handsome Rs 15000 - 20000 Cr. A more realistic figure could be almost double this, a significant enough amount. Most of the campaign and election related spending will be on items which are produced and consumed locally. The multiplier effect on such spending is likely to be substantial and the benefits of the spending will accrue mainly to those most in need of the same. Further, the handouts will go to the hands of those who are more likely to spend rather than save it.
Finally, elections are a one-off event, and hence there is an inherent sunset provision to election spending. In the circumstances, the immediate need of the hour is - early elections!
Update 1 (28/101/2010)
The US Congressional elections in 2010 appears to have all the trappings of a fiscal stimulus. A new class of super-wealthy, self-funding candidates appears eager to spend their heirs' fortunes in the (often fruitless) search for thankless public office. The spending prowess of candidates like Meg Whitman in California and Mike Bloomberg in New York, have contributed substantially to stimulating the economy.
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