David Leonhardt has an interesting article on what has to be done to transform and even reconstruct the US economy. He draws attention to the fact that two of the primary engines of recent American growth - the explosion in consumer debt and spending, which lifted short-term growth at the expense of future growth, and the great Wall Street boom, which depended partly on activities that had very little real value - are no longer active, thereby casting serious doubts about the economic growth prospects of the US.
His prescriptions for the transformation of the American economy include - greater government investments in infrastructure and research; cleaner energies and fuel consumption technologies; health care reforms; reforming education, especially high schools and upwards ( educating more people and educating them better) etc.
But he draws attention to one of the more important, but less focussed, requirements for any long-term and sustainable transformation - institutional changes in the socio-economic balance of power. Mancur Olson's seminal work on the decline and rise of nations had spotlighted attention on the role of interest groups in deciding the fate of nations. Olson had claimed that as economies grow, interest groups that accumulate more and more influence over time, at the expense of others and even stifling long term economic growth propsects.
Taking cue, Leonhardt writes, "This country’s long period of economic pre-eminence has produced a set of interest groups that, in Olson’s words, 'reduce efficiency and aggregate income'. Home builders and real estate agents pushed for housing subsidies, which made many of them rich but made the real estate bubble possible. Doctors, drug makers and other medical companies persuaded the federal government to pay for expensive treatments that have scant evidence of being effective. Those treatments are the primary reason this country spends so much more than any other on medicine. In these cases, and in others, interest groups successfully lobbied for actions that benefited them and hurt the larger economy." The biggest, most powerful and most debilitating was Wall Street."
Even as the Obama administration starts work on an agenda to end the economic crisis and reconstruct America, it will have to face "opposition from a murderers’ row of interest groups: Wall Street, Big Oil, Big Coal, the American Medical Association and teachers’ unions".
In this context, of equal relevance is the work of people like Frank Levy (and Peter Temin, and Robert Reich), who argues how the traditional institutions – unions, the minimum wage, the tax system, accounting conventions and ultimately the tone set by the government – have the power to either moderate or reinforce the underlying vagaries of the market. And how "U.S. institutions abandoned a moderating role sometime after 1975, when market forces were already tending toward greater inequality."
Leonhardt also points attention to the fact that governments have always had the most critical role to play in genrating the momentum for rapid economic growth - the GI Bill created a generation of college graduates; the Interstate System of highways made the entire economy more productive; and the Defense Department developed the Internet, which spawned AOL, Google and the rest.
Saturday, January 31, 2009
Friday, January 30, 2009
Obama's fiscal stimulus
The much awaited Obama fiscal stimulus plan, christened the American Recovery and Reinvestment Act (ARRA) - 2009, amounting to $819 bn, has been finally approved by the US House of Representatives. The plan consists of direct spending by way of cash transfer payments (UI, medicare etc) and government purchases of goods and services, both amounting to $604 bn, and revenues foregone over the next ten years by way of tax cuts, amounting to about $215 bn.
The Obama administration describes the proposal as "the first crucial step in a concerted effort to create and save 3 to 4 million jobs, jumpstart our economy, and begin the process of transforming it for the 21st century with $275 billion in economic recovery tax cuts and $550 billion in thoughtful and carefully targeted priority investments with unprecedented accountability measures built in."
The plan contains targeted efforts in - energy efficiency and renewable energy ($54 bn); R&D in science and technology ($16 bn); modernizing roads, bridges, transit systems, waterways and public buildings ($90 bn); education infrastructure including classrooms, labs, and libraries ($141.6 bn); reducing health care costs ($24.1 bn); helping workers hurt by the economy (UI, food stamps, health care, training etc)($102 bn); aid to states to save public sector jobs and protect vital services ($91 bn); tax cuts to workers and spur investment and jobs. The proposal is to spend $20 bn over 5 years on additional food stamps and $43 billion over two years to extend and increase unemployment benefits (adding as much as 33 weeks of benefits). The signature tax cut proposal seeks to provide a credit of up to $500 for individuals and $1,000 for couples, by reducing the amount of money withheld from paychecks.
Discussions on how fast each item in ARRA will take effect is available here, here, here, and here.
Mostly Economics draws attention to useful links on the ARRA - Obama's own outline of the proposal, Christina Romer and Jared Bernstein's analysis of its job creation impact, CBO's cost estimate (full details here). David Leonhardt and Phineas Baxandall raises well founded concerns about how the stimulus spending in infrastructure, especially transportsation, could end up being frittered away. The CBO Director Douglas Elmendorf's testimony before the Congress on fiscal stimulus is available here, and CBO's forecast of the US Budget and Economic outlook for 2009-19 is available here. NYT has discussion on the stimulus bill by some economists here. Romer and Bernstein's analysis of the impact of the stimulus on employment generation is represented below
A few broad observations
1. The CBO estimates that that about 64% of the money, or $526 billion, would be spent by September 2010, the first 18 months, which is the expected trough of the recession. This leaves us still with 36% which would not be spent in achieving the immediate purpose.
2. For all talk of investments in public transport infastructure, less than 5% of the stimulus goes into roads and bridges.
3. The tax cuts dimension is substantial, and extending to well into the next decade.
4. Health and education get a huge boost, at $127 bn and $150 bn respectively. The allocations for education include new buildings, school renovation, special education, scholarships and grants to needy college students, expansion of the federal student aid programs etc. The health insurance proposal covers all those getting unemployment insurance, irrespective of their incomes (ie, without any means-testing), with Medicaid (which is normally for low-income people, and for decades it has been financed jointly by the federal government and the states, with the federal share averaging 57% of costs). This would be the closest to a universal health insurance program in the US.
5. There is a prominent emphasis on assistance to states and local governments, especially in health (increases federal government share in Medicaid), education (larger share of student loans and construction of school infrastructure), and public transit systems. This assistance are on the presumption that states would find it difficult to sustain their spending on these programs and would thereby leave the most vulnerable and affected to fend for themselves.
6. There is little mention of an fiscal exit strategy. Nor is there any attempt to tie-up the program to some form of cost/expenditure recovery plans, so that atleast a portion of the stimulus spending is directly recovered when the economy returns back to normalcy.
Update 1
Economix has this graphic about how much is proposed to go to each state.
Update 2
Susan Woodward and Robert Hall analyzes the Obama plan here.
Update 3
David Leonhardt tracks the debate about the amount required for an effective fiscal stimulus. There are those like Mark Zandi and Jan Hatzius at the Goldman Sachs who estimate that the recession is likely to idle almost $2 trillion of resources — buildings, equipment and people — this year and next, and argue for atleast $1 trillion.
Meanwhile, people like Martin Feldstein have instead of across-the-board tax cuts, been calling for targeted tax cuts that people will receive only by spending money, on a new house or other items.
Update 4 (9/10/2011)
Arguably the most controversial prediction of the sub-prime crisis is the Romer-Bernstein estimate of US unemployment rate with and without ARRA. Here is how it stacks up against the actual unemployment rate till date.
The Obama administration describes the proposal as "the first crucial step in a concerted effort to create and save 3 to 4 million jobs, jumpstart our economy, and begin the process of transforming it for the 21st century with $275 billion in economic recovery tax cuts and $550 billion in thoughtful and carefully targeted priority investments with unprecedented accountability measures built in."
The plan contains targeted efforts in - energy efficiency and renewable energy ($54 bn); R&D in science and technology ($16 bn); modernizing roads, bridges, transit systems, waterways and public buildings ($90 bn); education infrastructure including classrooms, labs, and libraries ($141.6 bn); reducing health care costs ($24.1 bn); helping workers hurt by the economy (UI, food stamps, health care, training etc)($102 bn); aid to states to save public sector jobs and protect vital services ($91 bn); tax cuts to workers and spur investment and jobs. The proposal is to spend $20 bn over 5 years on additional food stamps and $43 billion over two years to extend and increase unemployment benefits (adding as much as 33 weeks of benefits). The signature tax cut proposal seeks to provide a credit of up to $500 for individuals and $1,000 for couples, by reducing the amount of money withheld from paychecks.
Discussions on how fast each item in ARRA will take effect is available here, here, here, and here.
Mostly Economics draws attention to useful links on the ARRA - Obama's own outline of the proposal, Christina Romer and Jared Bernstein's analysis of its job creation impact, CBO's cost estimate (full details here). David Leonhardt and Phineas Baxandall raises well founded concerns about how the stimulus spending in infrastructure, especially transportsation, could end up being frittered away. The CBO Director Douglas Elmendorf's testimony before the Congress on fiscal stimulus is available here, and CBO's forecast of the US Budget and Economic outlook for 2009-19 is available here. NYT has discussion on the stimulus bill by some economists here. Romer and Bernstein's analysis of the impact of the stimulus on employment generation is represented below
A few broad observations
1. The CBO estimates that that about 64% of the money, or $526 billion, would be spent by September 2010, the first 18 months, which is the expected trough of the recession. This leaves us still with 36% which would not be spent in achieving the immediate purpose.
2. For all talk of investments in public transport infastructure, less than 5% of the stimulus goes into roads and bridges.
3. The tax cuts dimension is substantial, and extending to well into the next decade.
4. Health and education get a huge boost, at $127 bn and $150 bn respectively. The allocations for education include new buildings, school renovation, special education, scholarships and grants to needy college students, expansion of the federal student aid programs etc. The health insurance proposal covers all those getting unemployment insurance, irrespective of their incomes (ie, without any means-testing), with Medicaid (which is normally for low-income people, and for decades it has been financed jointly by the federal government and the states, with the federal share averaging 57% of costs). This would be the closest to a universal health insurance program in the US.
5. There is a prominent emphasis on assistance to states and local governments, especially in health (increases federal government share in Medicaid), education (larger share of student loans and construction of school infrastructure), and public transit systems. This assistance are on the presumption that states would find it difficult to sustain their spending on these programs and would thereby leave the most vulnerable and affected to fend for themselves.
6. There is little mention of an fiscal exit strategy. Nor is there any attempt to tie-up the program to some form of cost/expenditure recovery plans, so that atleast a portion of the stimulus spending is directly recovered when the economy returns back to normalcy.
Update 1
Economix has this graphic about how much is proposed to go to each state.
Update 2
Susan Woodward and Robert Hall analyzes the Obama plan here.
Update 3
David Leonhardt tracks the debate about the amount required for an effective fiscal stimulus. There are those like Mark Zandi and Jan Hatzius at the Goldman Sachs who estimate that the recession is likely to idle almost $2 trillion of resources — buildings, equipment and people — this year and next, and argue for atleast $1 trillion.
Meanwhile, people like Martin Feldstein have instead of across-the-board tax cuts, been calling for targeted tax cuts that people will receive only by spending money, on a new house or other items.
Update 4 (9/10/2011)
Arguably the most controversial prediction of the sub-prime crisis is the Romer-Bernstein estimate of US unemployment rate with and without ARRA. Here is how it stacks up against the actual unemployment rate till date.
D Grade for US infrastructure
The American Society of Civil Engineers (ASCE) in its annual Report Card for 2009 has given a D (poor) grade for America's public infrastructure, another indicator of the widespread refrain that it is crumbling. The Report Card, an assessment by professional engineers of the nation's status in 15 categories of infrastructure, point to "an infrastructure that is poorly maintained, unable to meet current and future demands, and in some cases, unsafe". The Report estimates an investment requirement of $2.2 trillion over the next five years. A few salient features are as follows:
1. Of the 15 sectors, there are 4 C's and 11 D's. Bridges, solid waste and rail get C, whereas roads, aviation, school, energy, dams, public transit and even drinking water gets D.
2. The Eisenhower Interstate Highway System is more than 50 years old and is badly in need of both repairs and new investments. Poor road conditions cost motorists $67 billion a year in repairs and operating costs, and cost 14,000 Americans their lives. One-third of America's major roads are in poor or mediocre condition and 36% of major urban highways are congested.
3. The national power grid has seen 25% more demand since 1990, with little meaningful upgrade in its overall capacity, and peak deficits are reaching alarming levels. Without a projected electric utility investment of $1.5 trillion by 2030, brownouts and even blackouts will be routine occurrences.
4. More than 26%, or one in four, of the nation's bridges are either structurally deficient or functionally obsolete
5. Aging pipeline and treatment facilities that are near the end of their useful life means that an estimated seven billion gallons of clean drinking water is lost every day.
The report also lists out its suggestion for improving the infrastructure. One of the most important of the five suggestions is leadership by the Federal Government. The poor state of American public infrastructure is in many ways an indictment of the ideology that the development (and even maintenance) of public infrastructure can be left largely to the workings of the market and the private sector. This belief, is clearly at odds with all standard economic principles which define many of these infrastructure facilities as public goods, which the market will invariably under-supply and therefore requires the government to step in.
David Leonhardt draws attention to the relative spending on capital investment and research by the public and private sectors over the years. He finds that instead of increasing and occupying a much larger share, the private sector spending has remained constant at about 17% of GDP over the past 50 years. This itself is bad enough, but is compounded by the fact that spending by the government — federal, state and local — has dropped from about 7% of GDP in the 1950s to about 4% now.
1. Of the 15 sectors, there are 4 C's and 11 D's. Bridges, solid waste and rail get C, whereas roads, aviation, school, energy, dams, public transit and even drinking water gets D.
2. The Eisenhower Interstate Highway System is more than 50 years old and is badly in need of both repairs and new investments. Poor road conditions cost motorists $67 billion a year in repairs and operating costs, and cost 14,000 Americans their lives. One-third of America's major roads are in poor or mediocre condition and 36% of major urban highways are congested.
3. The national power grid has seen 25% more demand since 1990, with little meaningful upgrade in its overall capacity, and peak deficits are reaching alarming levels. Without a projected electric utility investment of $1.5 trillion by 2030, brownouts and even blackouts will be routine occurrences.
4. More than 26%, or one in four, of the nation's bridges are either structurally deficient or functionally obsolete
5. Aging pipeline and treatment facilities that are near the end of their useful life means that an estimated seven billion gallons of clean drinking water is lost every day.
The report also lists out its suggestion for improving the infrastructure. One of the most important of the five suggestions is leadership by the Federal Government. The poor state of American public infrastructure is in many ways an indictment of the ideology that the development (and even maintenance) of public infrastructure can be left largely to the workings of the market and the private sector. This belief, is clearly at odds with all standard economic principles which define many of these infrastructure facilities as public goods, which the market will invariably under-supply and therefore requires the government to step in.
David Leonhardt draws attention to the relative spending on capital investment and research by the public and private sectors over the years. He finds that instead of increasing and occupying a much larger share, the private sector spending has remained constant at about 17% of GDP over the past 50 years. This itself is bad enough, but is compounded by the fact that spending by the government — federal, state and local — has dropped from about 7% of GDP in the 1950s to about 4% now.
Thursday, January 29, 2009
CCTs and winning elections
Here comes fairly compelling evidence to show that Conditional Cash Transfer (CCT) schemes are not only efficient means of transferring development assistance but are also vote-winners! Chris Blattman points to a fascinating study of CCT schemes by Marco Manacorda, Edward Miguel, and Andrea Vigorito, which finds evidence that such programs generate greater political support than other welfare spending programs.
They studied the impact of the Uruguayan PANES CCT program, consisting mainly of a monthly cash transfer for a period of roughly two and half years, on political support for the government that implemented it. Their findings include
1. Beneficiary households are 21 to 28 percentage points more likely to favor the current government (relative to the previous government).
2. The impact of the same nominal cash transfer is "larger among poorer households and for those near the center of the political spectrum", consistent with the "probabilistic voting model in political economy" and the fact that "the marginal utility of consumption is highest for this group".
3. The "effects persist after the cash transfer program ends".
4. They estimated that the "annual cost of increasing government political support by 1 percentage point is roughly 0.9% of annual government social expenditures".
Intutively too, cash transfers, being more direct and salient, are more likely to catch the immediate imagination of its beneficiaries than the more indirect methods like subsidies or in kind assistance. Surely, it provides more direct exposure for the politician to deliver the subsidy for fertilizers or crop price support or health insurance as direct cash transfers instead of the regular method providing poor quality seeds or fertilizers or health care.
In fact, one of the greatest attractions for politicians (and Governments) in promoting Self Help Groups (SHGs) and micro-finance in states like Andhra Pradesh, has been the symbolic political value attached to the regularly held loan disbursement melas. The flagship poverty alleviation programs of both the previous (Velugu program) and present (Indira Kranti Pathakam and Pavala Vaddi loans) governments in Andhra Pradesh have revolved around direct cash transfers in the form of micro loans to SHG members.
Many shrewd politicians have realized that they derive more political mileage from these direct cash disbursements than the old IRDP-style asset distribution! CCTs are only a small step ahead from the SHG loan disbursements. Now, atleast this should spur some of our own politicians to embrace them!
They studied the impact of the Uruguayan PANES CCT program, consisting mainly of a monthly cash transfer for a period of roughly two and half years, on political support for the government that implemented it. Their findings include
1. Beneficiary households are 21 to 28 percentage points more likely to favor the current government (relative to the previous government).
2. The impact of the same nominal cash transfer is "larger among poorer households and for those near the center of the political spectrum", consistent with the "probabilistic voting model in political economy" and the fact that "the marginal utility of consumption is highest for this group".
3. The "effects persist after the cash transfer program ends".
4. They estimated that the "annual cost of increasing government political support by 1 percentage point is roughly 0.9% of annual government social expenditures".
Intutively too, cash transfers, being more direct and salient, are more likely to catch the immediate imagination of its beneficiaries than the more indirect methods like subsidies or in kind assistance. Surely, it provides more direct exposure for the politician to deliver the subsidy for fertilizers or crop price support or health insurance as direct cash transfers instead of the regular method providing poor quality seeds or fertilizers or health care.
In fact, one of the greatest attractions for politicians (and Governments) in promoting Self Help Groups (SHGs) and micro-finance in states like Andhra Pradesh, has been the symbolic political value attached to the regularly held loan disbursement melas. The flagship poverty alleviation programs of both the previous (Velugu program) and present (Indira Kranti Pathakam and Pavala Vaddi loans) governments in Andhra Pradesh have revolved around direct cash transfers in the form of micro loans to SHG members.
Many shrewd politicians have realized that they derive more political mileage from these direct cash disbursements than the old IRDP-style asset distribution! CCTs are only a small step ahead from the SHG loan disbursements. Now, atleast this should spur some of our own politicians to embrace them!
More banking sector observations
In continuation to the previous post, here are a few more observations on the banking sector
1. The graphic below indicates that the private sector and foreign banks have been more reluctant to pass on the benefits of the RBI rate cuts. Interestingly, the domestic private banks are more conservative in their lending rates than even the foreign banks, whose reactions may be partially explained by the problems faced by their parent banks in US. Further, the lending-deposit rate differentials for private banks is 6.75-8%, almost double that of the 3.75-4% for public sector banks. If despite these margins and cushions, the private sector banks have seen higher growth in NPAs relative to the public sector banks, then it raises questions about their competitiveness and operational performance. Does it mean that the public sector banks in India are more efficient, atleast to the extent of the core banking activity of managing lending and deposit taking?
2. The foreign and domestic private sector banks also appear to have suffered a crisis of confidence among depositers. This is indicated by the sharp drop in growth in their deposits compared to their public sector counterparts. The deposits grew by just 12.1% and 13.4% for foreign and private banks respectively in 2008, as against 34.1% and 26.9% repsectively for 2007. In contrast, the deposit grew at the same 24.2% in both years for public sector banks. Does this mean that like in the US, when the times were good, the former engaged in less than prudent practices like offering more than sustainable deposit rates to attract deposits?
3. There is some validity in the reasoning by banks that they are constrained in their ability to lower depsoit rates, especially given the need to shore up reserves in these uncertain times. Banks can lower their lending rates only if they lower their deposit rates commensurately. However, the prevailing high interest rates on small savings instruments like Public Provident Fund (PPF), at 8%, puts a clear floor on lowering deposit rates. In the circumstances, if banks lower deposit rates more aggressively, there could be a flight of deposits from banks to these instruments and similar others like post office savings accounts.
4. Announcing the quarterly credit policy review, the RBI Governor made a direct mention of the fact that the "transmission of the policy interest rate signal" while effective in the money and government securities market, has failed in the credit markets. Since October 2008, the RBI has reduced repo rate from 9% to 5.5%, reverse repo rate from 6% to 4%, and CRR from 9% to 5%, all of which coupled with liquidity injections have released Rs 3,88,045 Cr into the banking system. Despite such extraordinary measures, the credit markets remain trapped in the high rate vortex.
Update 1
The Businessline reports that banks have delivered impressive profit growth in the December quarter, with the average net profit growth for the top-20 banks standing at 58% and a median net profit growth standing at 44%, riding on higher treasury income (as yields fell, bond portfolios appreciated in value and mark to market losses were written back), higher margins (due to the CRR cut and lower provisions, which are freed up for lending), and still high lending rates. Further, the Net Interest Margins (NIMs) of these banks are also at a very healthy, even unsustainably high, range of 3-4%. These figures would appear to indicate considerable comfort and cushion for these banks to lower their lending rates.
The one standout looks to be ICICI. Despite profitting from a sharp boost in their treasury income (it rose to Rs 976 crore against Rs 282 crore last year), the Y-o-Y profits grew just 3.4%, against the sector average of 58%. Add in the fact that its NIM is also relatively low at 2.4%, and the NPAs have registered a relatively larger increase. Do we have some cause for concern?
1. The graphic below indicates that the private sector and foreign banks have been more reluctant to pass on the benefits of the RBI rate cuts. Interestingly, the domestic private banks are more conservative in their lending rates than even the foreign banks, whose reactions may be partially explained by the problems faced by their parent banks in US. Further, the lending-deposit rate differentials for private banks is 6.75-8%, almost double that of the 3.75-4% for public sector banks. If despite these margins and cushions, the private sector banks have seen higher growth in NPAs relative to the public sector banks, then it raises questions about their competitiveness and operational performance. Does it mean that the public sector banks in India are more efficient, atleast to the extent of the core banking activity of managing lending and deposit taking?
2. The foreign and domestic private sector banks also appear to have suffered a crisis of confidence among depositers. This is indicated by the sharp drop in growth in their deposits compared to their public sector counterparts. The deposits grew by just 12.1% and 13.4% for foreign and private banks respectively in 2008, as against 34.1% and 26.9% repsectively for 2007. In contrast, the deposit grew at the same 24.2% in both years for public sector banks. Does this mean that like in the US, when the times were good, the former engaged in less than prudent practices like offering more than sustainable deposit rates to attract deposits?
3. There is some validity in the reasoning by banks that they are constrained in their ability to lower depsoit rates, especially given the need to shore up reserves in these uncertain times. Banks can lower their lending rates only if they lower their deposit rates commensurately. However, the prevailing high interest rates on small savings instruments like Public Provident Fund (PPF), at 8%, puts a clear floor on lowering deposit rates. In the circumstances, if banks lower deposit rates more aggressively, there could be a flight of deposits from banks to these instruments and similar others like post office savings accounts.
4. Announcing the quarterly credit policy review, the RBI Governor made a direct mention of the fact that the "transmission of the policy interest rate signal" while effective in the money and government securities market, has failed in the credit markets. Since October 2008, the RBI has reduced repo rate from 9% to 5.5%, reverse repo rate from 6% to 4%, and CRR from 9% to 5%, all of which coupled with liquidity injections have released Rs 3,88,045 Cr into the banking system. Despite such extraordinary measures, the credit markets remain trapped in the high rate vortex.
Update 1
The Businessline reports that banks have delivered impressive profit growth in the December quarter, with the average net profit growth for the top-20 banks standing at 58% and a median net profit growth standing at 44%, riding on higher treasury income (as yields fell, bond portfolios appreciated in value and mark to market losses were written back), higher margins (due to the CRR cut and lower provisions, which are freed up for lending), and still high lending rates. Further, the Net Interest Margins (NIMs) of these banks are also at a very healthy, even unsustainably high, range of 3-4%. These figures would appear to indicate considerable comfort and cushion for these banks to lower their lending rates.
The one standout looks to be ICICI. Despite profitting from a sharp boost in their treasury income (it rose to Rs 976 crore against Rs 282 crore last year), the Y-o-Y profits grew just 3.4%, against the sector average of 58%. Add in the fact that its NIM is also relatively low at 2.4%, and the NPAs have registered a relatively larger increase. Do we have some cause for concern?
Wednesday, January 28, 2009
Latest Big Mac Index
The latest edition of the Big Mac index, created by The Economist magazine, to compare the relative values of currencies with respect to the US dollar, by comparing the market prices (at market exchange rates) of Big Mac burgers in the respective currencies, is out. According to the index, if the price of a Big Mac translated into dollars is above $3.54, its cost in America, the currency is dear and if it is below that benchmark, it is cheap.
If the index is any indicator, the Yen and Pound are close to their fair values, while Chinese Yuan is under-valued by nearly 50% and Euro is over-valued by over 25%. The index survey does not include India, presumably since the Macs made their entry into India only recently. But now that there are 132 McDonalds restaurants in the country, it may be time for The Economist to include India. Till then, in a more crude manner, a Big Mac (if I am not wrong), costs Rs 85, which translates to $1.73 at an exchange rate of Rs 49 for a dollar, meaning that the rupee is under-valued by 51%!
If the index is any indicator, the Yen and Pound are close to their fair values, while Chinese Yuan is under-valued by nearly 50% and Euro is over-valued by over 25%. The index survey does not include India, presumably since the Macs made their entry into India only recently. But now that there are 132 McDonalds restaurants in the country, it may be time for The Economist to include India. Till then, in a more crude manner, a Big Mac (if I am not wrong), costs Rs 85, which translates to $1.73 at an exchange rate of Rs 49 for a dollar, meaning that the rupee is under-valued by 51%!
Observations on Indian Banks
Businessline draws attention to the non-performing assets (loans not serviced - either the principal or interest or both - within 90 days of due date) of eight of the largest Indian banks, five public and three private sector. A couple of preliminary observations
1. The NPAs when seen in their true perspective is reasonable, even healthy. Over the last year, even as lending increased by Rs 2.6 lakh Cr, gross NPAs rose by just Rs 7,218 Cr, a clear sign of the relative calm in the Indian banking sector. Even this too can be, atleast partially, attributed to the interest rate hikes in response to inflationary pressures, and the recent rate cuts are likely to act in the opposite direction. In the circumstances, the credit squeeze (or more specifically, the reluctance of banks to lower their lending rates despite the steep rate cuts by RBI) in India is more likely a case of psychological contagion effect of the widespread couter-party risk induced collpase of the credit markets in the US. Or is it a case of banks being stretched out in servicing their costly liabilities run up during the rate increases early this year? Or more likely both.
2. If we take the second quarter of 2008 (ie. March 2008) as a reasonable approximation of the beginning of the credit squeeze, then all the three private sector banks appear to have slipped up in relative terms whereas the public sector banks appear to have held up well. The relative increase in NPAs of private sector banks is also much larger given the relatively smaller increase in their credit growth when compared to public sector banks (public sector banks saw an increase of 28.6% in credit flow in 2008 as against 19.8% in 2007, whereas the figures for the private banks were 11.8% and 24.2%). If this is true, then can we say that private banks in India would have gone the same way as their US counterparts, but for the "heavy hand" of RBI regulation under YV Reddy?
Tuesday, January 27, 2009
Euro and the crisis
As the twin dangers of recession and deflation stalks the European economies, questions are inevitably being raised about the role of Euro in containing the crisis. It is being speculated that one or more of the 16 Euro currency area countries, especially the weaker ones (Greece, Ireland, Italy, Portugal and Spain), their creditworthiness now downgraded, may default and declare bankruptcy and/or be forced out of the Euro zone, or the European Monetary Union (EMU), thereby deeply damaging the confidence in Euro.
The Euro was introduced as a single currency from January 1, 1999, to foster greater monetary and economic co-ordination between the economies of the European Union and reduce transaction costs. In order to participate in the new currency, member states had to meet strict criteria such as a budget deficit of less than 3% of GDP, a debt ratio of less than 60% of GDP, low inflation, and interest rates close to the EU average. Since inception, despite early weakness and doomsday warnings, the Euro had fast emerged as a worthy challenger to dollar global supremacy, even becoming the largest single currency area, overtaking the US. Though it had grown in strength in recent years, critics had always argued that the acid test will come when the Euro area faces a recession, a reality that now beckons.
With the present economic crisis requiring dramatic monetary and fiscal loosening, the aforementioned strict Euro conditionalities are clearly coming in the way of the ability of the individual Euro nations to respond aggressively. Conventional responses out of such economic downtruns like currency devaluations, slashing interest rates, increasing government expenditures etc are all constrained by these restrictions. This has left them with ineffectual and crisis-exacerbating approaches like wage reductions and lay-offs to combat the downturn.
While the stronger ones have been enacting large fiscal stimuluses to shore up their economies and protect their banks, the weaker ones, with growing deficits and debts, are experiencing a skyrocketing of the yields on their debts, thereby steeply increasing the premiums they have to pay on their public borrowings. This has constrained their ability to indulge in expansionary fiscal pump priming and capital injections for recapitalizing their ailing banks. As the NYT writes, "the widening gap between the interest rate that Greece and larger economies like Germany have to pay to borrow reveals the first cracks in what so far has been a fairly solid fortress Europe".
However, any attempt at leaving the Euro will only make matters worse as experience, including recent ones, show that investors would flee en masse from the banks and markets of a country that contemplated abandoning the Euro thereby wrecking the bond and equity markets and the banking system in that country. The major Euro economies and the ECB have so far been reluctant to make aggressive monetary and fiscal interventions, especially to bailout failing banks and other financial and corporate institutions. But the closely knit and effectively irreversible natire of the Euro zone means that the stronger economies will have to share the burden of bailing out those faced with bankruptcy, like especially Greece.
Barry Eichengreen argues that though the financial shocks have been asymmetric, with the weaker economies facing problems arising from their mounting deficits and debts (like Greece and Italy) and bursting of big housing bubbles (like Ireland and Spain), the entire Euro area is slowly being engulfed by a symmetric economic shock. In all the mainland European economies, growth is collapsing in the face of declining economic activity, slumping exports, and growing unemployment. He therefore proposes a swift and "common monetary policy response by (the ECB, thereby abandoning its single minded fixation with inflation) way of cutting interest rates to zero, moving to quantitative easing, and allowing the euro exchange rate to weaken... complemented by fiscal stimulus". Those with limited fiscal space, will have to be assisted from the outside, especially from their stronger partners like Germany.
The crisis facing Euro also highlights attention to the fact that most of these weaker economies had not undertaken any of the important and painful structural reforms that are necessary to bring in domestic economic and financial discipline. Many of these economies were already suffering from large current account deficits and unsustainable public debts. The calmness provided by the entry into EMU, coupled with the availability of the easy credit, thanks ironically to the success of the ECB in maintaining inflation at just 2.1% annually for the past decade and Germany's stagnation, had helped gloss over the structural weaknesses and fed the housing and other asset bubbles in Euro land.
Therefore, as Zsolt Darvas argues, the need to expand the EMU to cover its EU non-members should not be used as an excuse to relax the strict entry rules, and thereby postpone the necessary structural reforms, the absence of which have been the primary contributor to the extent of the crisis in many of these economies, both from the euro zone and outside. Further, the success of the Czech Republic and Slovakia, in maintaining high growth, low inflation, and staving off the contagion of the crisis, is a testimony to the policy reforms initiated by both these.
Interestingly, despite all the problems being faced by the Euro, the troubles being experienced by those EU countries outside the Euro zone are even greater, and could have been mitigated if they were part of the Euro zone. Zsolt Darvas and Jean Pisani-Ferry have drawn attention to an "asymmetry between the countries who benefit from the shelter effect of the euro and those who do not". The asymmetry in the monetary policy responses and the access to euro liquidity between the EMU economies and the non-EMU members of EU, especially the emerging economies of Eastern Europe, have adversley affected the latter. The authors claim that "being inside a large currency area considerably helps small open economies in times of crisis", and therefore makes the case for a swifter expansion of the EMU to include the other non-euro EU memebers.
They also suggest a few interim measures, that would help the non-euro members tide over the crisis - swap agreements between ECB and non-euro member Central Banks; dilution of collateral standards by ECB for for its repurchase transactions with counterparties local currency denominated government bonds; avoidance of asymmetric credit constraints by euro area banks in the non-euro members; and monetary and fiscal loosening by the affected non-euro members.
Mostly Economics draws attention to a speech by the Governor of the Denmark Central Bank, Nils Bernstein, where he made a strong case for Denmark joining the EMU, especially in view of its stabilizing influence at times of economic crisis. He said, "The single currency and single monetary policy are stabilising factors that prevent the individual member states from seeking their own – often mutually competitive – monetary solutions to the crisis." It also draws attention to a pamphlet by William Buiter et al, who make a strong case for Britain joining the EMU.
The Euro was introduced as a single currency from January 1, 1999, to foster greater monetary and economic co-ordination between the economies of the European Union and reduce transaction costs. In order to participate in the new currency, member states had to meet strict criteria such as a budget deficit of less than 3% of GDP, a debt ratio of less than 60% of GDP, low inflation, and interest rates close to the EU average. Since inception, despite early weakness and doomsday warnings, the Euro had fast emerged as a worthy challenger to dollar global supremacy, even becoming the largest single currency area, overtaking the US. Though it had grown in strength in recent years, critics had always argued that the acid test will come when the Euro area faces a recession, a reality that now beckons.
With the present economic crisis requiring dramatic monetary and fiscal loosening, the aforementioned strict Euro conditionalities are clearly coming in the way of the ability of the individual Euro nations to respond aggressively. Conventional responses out of such economic downtruns like currency devaluations, slashing interest rates, increasing government expenditures etc are all constrained by these restrictions. This has left them with ineffectual and crisis-exacerbating approaches like wage reductions and lay-offs to combat the downturn.
While the stronger ones have been enacting large fiscal stimuluses to shore up their economies and protect their banks, the weaker ones, with growing deficits and debts, are experiencing a skyrocketing of the yields on their debts, thereby steeply increasing the premiums they have to pay on their public borrowings. This has constrained their ability to indulge in expansionary fiscal pump priming and capital injections for recapitalizing their ailing banks. As the NYT writes, "the widening gap between the interest rate that Greece and larger economies like Germany have to pay to borrow reveals the first cracks in what so far has been a fairly solid fortress Europe".
However, any attempt at leaving the Euro will only make matters worse as experience, including recent ones, show that investors would flee en masse from the banks and markets of a country that contemplated abandoning the Euro thereby wrecking the bond and equity markets and the banking system in that country. The major Euro economies and the ECB have so far been reluctant to make aggressive monetary and fiscal interventions, especially to bailout failing banks and other financial and corporate institutions. But the closely knit and effectively irreversible natire of the Euro zone means that the stronger economies will have to share the burden of bailing out those faced with bankruptcy, like especially Greece.
Barry Eichengreen argues that though the financial shocks have been asymmetric, with the weaker economies facing problems arising from their mounting deficits and debts (like Greece and Italy) and bursting of big housing bubbles (like Ireland and Spain), the entire Euro area is slowly being engulfed by a symmetric economic shock. In all the mainland European economies, growth is collapsing in the face of declining economic activity, slumping exports, and growing unemployment. He therefore proposes a swift and "common monetary policy response by (the ECB, thereby abandoning its single minded fixation with inflation) way of cutting interest rates to zero, moving to quantitative easing, and allowing the euro exchange rate to weaken... complemented by fiscal stimulus". Those with limited fiscal space, will have to be assisted from the outside, especially from their stronger partners like Germany.
The crisis facing Euro also highlights attention to the fact that most of these weaker economies had not undertaken any of the important and painful structural reforms that are necessary to bring in domestic economic and financial discipline. Many of these economies were already suffering from large current account deficits and unsustainable public debts. The calmness provided by the entry into EMU, coupled with the availability of the easy credit, thanks ironically to the success of the ECB in maintaining inflation at just 2.1% annually for the past decade and Germany's stagnation, had helped gloss over the structural weaknesses and fed the housing and other asset bubbles in Euro land.
Therefore, as Zsolt Darvas argues, the need to expand the EMU to cover its EU non-members should not be used as an excuse to relax the strict entry rules, and thereby postpone the necessary structural reforms, the absence of which have been the primary contributor to the extent of the crisis in many of these economies, both from the euro zone and outside. Further, the success of the Czech Republic and Slovakia, in maintaining high growth, low inflation, and staving off the contagion of the crisis, is a testimony to the policy reforms initiated by both these.
Interestingly, despite all the problems being faced by the Euro, the troubles being experienced by those EU countries outside the Euro zone are even greater, and could have been mitigated if they were part of the Euro zone. Zsolt Darvas and Jean Pisani-Ferry have drawn attention to an "asymmetry between the countries who benefit from the shelter effect of the euro and those who do not". The asymmetry in the monetary policy responses and the access to euro liquidity between the EMU economies and the non-EMU members of EU, especially the emerging economies of Eastern Europe, have adversley affected the latter. The authors claim that "being inside a large currency area considerably helps small open economies in times of crisis", and therefore makes the case for a swifter expansion of the EMU to include the other non-euro EU memebers.
They also suggest a few interim measures, that would help the non-euro members tide over the crisis - swap agreements between ECB and non-euro member Central Banks; dilution of collateral standards by ECB for for its repurchase transactions with counterparties local currency denominated government bonds; avoidance of asymmetric credit constraints by euro area banks in the non-euro members; and monetary and fiscal loosening by the affected non-euro members.
Mostly Economics draws attention to a speech by the Governor of the Denmark Central Bank, Nils Bernstein, where he made a strong case for Denmark joining the EMU, especially in view of its stabilizing influence at times of economic crisis. He said, "The single currency and single monetary policy are stabilising factors that prevent the individual member states from seeking their own – often mutually competitive – monetary solutions to the crisis." It also draws attention to a pamphlet by William Buiter et al, who make a strong case for Britain joining the EMU.
Overpaid financial sector employees
NYT draws attention to a new NBER working paper by Thomas Philippon and Ariell Reshef, that used detailed information about wages, education and occupations to shed light on the evolution of the U.S. financial sector over the past century, and found that financial workers are hugely overpaid.
Their findings include that "financial jobs were relatively skill intensive, complex, and highly paid until the 1930s and after the 1980s, but not in the interim period (the skill intensity and the complexity of jobs in the financial sector relative to the nonfarm private sector exhibit a U-shape from 1909 to 2006); financial deregulation and corporate finance activities linked to IPOs and credit risk increase the demand for skills in financial jobs while computers and information technology play a more limited role; and that wages in finance were excessively high around 1930 and from the mid 1990s until 2006".
They estimated that though the changes in the relative wage of finance employees is partially the result of an "efficient market response to a change in the economic environment", "rents accounted for 30% to 50% of the wage differential between the financial sector and the rest of the private sector". These rents, which measures the excess payments made, largely explains the flow of talent into the financial sector.
They draw attention to a less discussed dimension to regulatory failure to anticipate and prevent these crises - the absence of the required quality of human capital within regulatory institutions needed to keep up with, understand, and effectively regulate the innovations in the financial industry. They claim that given
the "wage premia" offered by private financial institutions, it is impossible for regulators to attract and retain highly-skilled financial workers. So one immediate regulatory recommendation would appear to be to offer the sector-compatible salaries to regulators, atleast those at the cutting edge.
They also claim that "a good chunk of (financial market) innovation has to do with tax and regulation arbitrage. That is really a waste for the society".
Update 1
Maureen Dowd has this stinging evisceration of the habits of the Wall Street bankers. NYT points attention to the fact that despite all the turmoil around them, financial institutions based in New York alone, including many who accepted tax payer financed bailout assistance, paid out $18.4 bn in bonuses for 2008, more than even 2004 and the sixth largest ever. The most shocking was Merrill Lynch's $4 bn bonus payout, even as the failing firm was up for sale and being bought by Bank of America. Joe Nocera has this to say on bonuses.
Update 2
Thomas Philippon has this article in the Vox, elucidating the same views as above.
Their findings include that "financial jobs were relatively skill intensive, complex, and highly paid until the 1930s and after the 1980s, but not in the interim period (the skill intensity and the complexity of jobs in the financial sector relative to the nonfarm private sector exhibit a U-shape from 1909 to 2006); financial deregulation and corporate finance activities linked to IPOs and credit risk increase the demand for skills in financial jobs while computers and information technology play a more limited role; and that wages in finance were excessively high around 1930 and from the mid 1990s until 2006".
They estimated that though the changes in the relative wage of finance employees is partially the result of an "efficient market response to a change in the economic environment", "rents accounted for 30% to 50% of the wage differential between the financial sector and the rest of the private sector". These rents, which measures the excess payments made, largely explains the flow of talent into the financial sector.
They draw attention to a less discussed dimension to regulatory failure to anticipate and prevent these crises - the absence of the required quality of human capital within regulatory institutions needed to keep up with, understand, and effectively regulate the innovations in the financial industry. They claim that given
the "wage premia" offered by private financial institutions, it is impossible for regulators to attract and retain highly-skilled financial workers. So one immediate regulatory recommendation would appear to be to offer the sector-compatible salaries to regulators, atleast those at the cutting edge.
They also claim that "a good chunk of (financial market) innovation has to do with tax and regulation arbitrage. That is really a waste for the society".
Update 1
Maureen Dowd has this stinging evisceration of the habits of the Wall Street bankers. NYT points attention to the fact that despite all the turmoil around them, financial institutions based in New York alone, including many who accepted tax payer financed bailout assistance, paid out $18.4 bn in bonuses for 2008, more than even 2004 and the sixth largest ever. The most shocking was Merrill Lynch's $4 bn bonus payout, even as the failing firm was up for sale and being bought by Bank of America. Joe Nocera has this to say on bonuses.
Update 2
Thomas Philippon has this article in the Vox, elucidating the same views as above.
Monday, January 26, 2009
PPP in urban mass transit systems
The debate surrounding the proposal for a Metro-rail project for Kochi in Kerala has thrown up several interesting issues. None more important than whether the project should be done as a Public Private Partnership on a BOT or a as a purely government enterprise. It was originally proposed that the 25 km, Rs 3048 Cr project would be executed on PPP on a BOOT/BOT model. But now the Planning Commission of India wants it to be a PPP, while the Ministry of Urban Development prefers government funding, as a joint venture between the Central and State Governments.
The Ministry argues that a comparison of the only two PPP Metros in the country - Bombay (Reliance) and Hyderabad (Maytas) (both not yet operational, with the latter in serious dount now) - and the fully Government driven Metros - Delhi, Chennai, Calcutta, and Bangalore - shows that the latter is a more cost-effective and superior model. They rest their arguement on the grounds that the commercial viability of Metros is questionable and experience from across the world shows that such projects will need heavy Government patronage.
The Secretary, Urban Development, Government of India, has said that PPP model for Metro may fail not only because of the commercial unviability of such projects, especially in its initial years, but also because of the near certain possibility that "the terms and conditions in (any such) agreement would in all likelihood be in favour of the private firm and might not accord priority to public interest".
I am inclined to the Ministry's view that atleast the construction should be funded by the Government, for the following reasons
1. World over, including in developed economies, mass rapid transit systems, are constructed by Government funds and publicly owned, either through local governments, transit authorities or by national governments. The operation & maintenance (O&M) can be performed by the owner or entrusted to a private company through a concession agreement.
The massive up-front investments costs coupled with the complusion to keep mass transit fares cheap and affordable, means that such projects are invariably of questionable commercial viability. Further, the operational effectiveness of mass rapid transit systems depend strongly on the close co-ordination with other public transport modes, especially buses, which are run by the government in most of our cities.
2. In any case, the Indian market and its commuter base may not be able support the high user charges needed to make a BOT project viable. It is difficult and even impossible to reconcile the twin objectives of affordable fares and commercial viability in a purely BOT model. Further, the legacy of cheap public transport fares makes it a political hot potato to revise fares in any meaningful manner.
3. The cost of capital raised for infrastructure projects by the private sector is invariably more than that for the government. This assumes critical importance in view of the massive capital costs and the long term nature of such finacing. Interestingly, the US Congressional Budget Office (CBO), in a testimony before the US Congress last year, had favored raising money, mainly from the market through sovereign guarantee, and then fund public and even private investments in infrastructure.
4. The construction risks associated with transport projects, especially within cities, especially those arising from problems in land acquisition and co-ordination with various utility providers, are substantial. These problems have been the major contributors to project compeletion delays and attendant cost over-runs. Government is best positioned to bear these construction risks. It may be more effective to lease out the facility after construction.
5. PPP projects in infrastructure carry huge moral hazard concerns, in view of the precedent of re-negotiations of contracts in large numbers of such projects. The sanctity associated with contracts and concession agreements have eroded substantially due to these examples. In the circumstances, the doubts expressed by the Secretary UD is more likely to be borne out.
6. The Planning Commission's bias for PPP models is understandable given the widespread impression that private sector can play a critical role in the provision of infrastructure. While the importance of private sector in infrastructure cannot be underplayed, its utility has to be seen in the specific context.
Infrastructure is not a homogenous group. Sectors like ports, airports, and power generation, all of which involve single location activities, are inherently suited for private management. But water, sewerage, solid waste, electricity distribution and public transport services are still heavily subsidised and will continue to be so, making them more suitable for government instead of private investments.
As an afterthought, we seem to have missed another more important issue. Does Kochi really need a metro? It has a population of just 6 lakhs and a small area of 95 sqkm - not even remotely suggesting the need for a metro! A more ideal solution would appear to be to re-model, expand and make investments in the existing rail network passing through the city and connecting its suburbs and the surrounding towns. Incidentally, metros are fast becoming the new fashion (Patna is also proposing one), another example of major infrastructure white elephants.
In fact, the debate has already become a sensitive political issue, with the Kerala state government firmly pitching itself behind the Ministry of Urban Development, and making its sanction an indicator of the Central Government's commitment to the development of the State! A live example of how politics, and not more objective considerations, decide the fate of major infrastructure projects! Let us wait and watch how this climaxes.
The Ministry argues that a comparison of the only two PPP Metros in the country - Bombay (Reliance) and Hyderabad (Maytas) (both not yet operational, with the latter in serious dount now) - and the fully Government driven Metros - Delhi, Chennai, Calcutta, and Bangalore - shows that the latter is a more cost-effective and superior model. They rest their arguement on the grounds that the commercial viability of Metros is questionable and experience from across the world shows that such projects will need heavy Government patronage.
The Secretary, Urban Development, Government of India, has said that PPP model for Metro may fail not only because of the commercial unviability of such projects, especially in its initial years, but also because of the near certain possibility that "the terms and conditions in (any such) agreement would in all likelihood be in favour of the private firm and might not accord priority to public interest".
I am inclined to the Ministry's view that atleast the construction should be funded by the Government, for the following reasons
1. World over, including in developed economies, mass rapid transit systems, are constructed by Government funds and publicly owned, either through local governments, transit authorities or by national governments. The operation & maintenance (O&M) can be performed by the owner or entrusted to a private company through a concession agreement.
The massive up-front investments costs coupled with the complusion to keep mass transit fares cheap and affordable, means that such projects are invariably of questionable commercial viability. Further, the operational effectiveness of mass rapid transit systems depend strongly on the close co-ordination with other public transport modes, especially buses, which are run by the government in most of our cities.
2. In any case, the Indian market and its commuter base may not be able support the high user charges needed to make a BOT project viable. It is difficult and even impossible to reconcile the twin objectives of affordable fares and commercial viability in a purely BOT model. Further, the legacy of cheap public transport fares makes it a political hot potato to revise fares in any meaningful manner.
3. The cost of capital raised for infrastructure projects by the private sector is invariably more than that for the government. This assumes critical importance in view of the massive capital costs and the long term nature of such finacing. Interestingly, the US Congressional Budget Office (CBO), in a testimony before the US Congress last year, had favored raising money, mainly from the market through sovereign guarantee, and then fund public and even private investments in infrastructure.
4. The construction risks associated with transport projects, especially within cities, especially those arising from problems in land acquisition and co-ordination with various utility providers, are substantial. These problems have been the major contributors to project compeletion delays and attendant cost over-runs. Government is best positioned to bear these construction risks. It may be more effective to lease out the facility after construction.
5. PPP projects in infrastructure carry huge moral hazard concerns, in view of the precedent of re-negotiations of contracts in large numbers of such projects. The sanctity associated with contracts and concession agreements have eroded substantially due to these examples. In the circumstances, the doubts expressed by the Secretary UD is more likely to be borne out.
6. The Planning Commission's bias for PPP models is understandable given the widespread impression that private sector can play a critical role in the provision of infrastructure. While the importance of private sector in infrastructure cannot be underplayed, its utility has to be seen in the specific context.
Infrastructure is not a homogenous group. Sectors like ports, airports, and power generation, all of which involve single location activities, are inherently suited for private management. But water, sewerage, solid waste, electricity distribution and public transport services are still heavily subsidised and will continue to be so, making them more suitable for government instead of private investments.
As an afterthought, we seem to have missed another more important issue. Does Kochi really need a metro? It has a population of just 6 lakhs and a small area of 95 sqkm - not even remotely suggesting the need for a metro! A more ideal solution would appear to be to re-model, expand and make investments in the existing rail network passing through the city and connecting its suburbs and the surrounding towns. Incidentally, metros are fast becoming the new fashion (Patna is also proposing one), another example of major infrastructure white elephants.
In fact, the debate has already become a sensitive political issue, with the Kerala state government firmly pitching itself behind the Ministry of Urban Development, and making its sanction an indicator of the Central Government's commitment to the development of the State! A live example of how politics, and not more objective considerations, decide the fate of major infrastructure projects! Let us wait and watch how this climaxes.
Alan Blinder lists six sins that landed the US (and the rest) in mess
Princeton Professor Alan Blinder argues that the ongoing crisis is the result of "a series of avoidable human errors... recognizing and understanding (which) will help us fix the system so that it doesn’t malfunction so badly again... and we can do so without ending capitalism as we know it". He has outlined six sinful choices that contributed to building up and exacerbating the obngoing crisis
1. Wild and unregulated derivatives trading magnified the losses several times over and deepend the shocks on the financial markets.
2. Sky-high leverage, thanks to the permission accorded to securities firms by the SEC in 2004 to raise their leverage sharply. "Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1... under 33-to-1 leverage, a mere 3% decline in asset values wipes out a company"!
3. The sub-prime mortgage lending surged spectacularly in the 2004-07 period, as the bank regulators slept and more dangerously, "many of the worst subprime mortgages originated outside the banking system, beyond the reach of any federal regulator".
4. Failing to act on the early flood of home foreclosures on grounds of "free-market ideology, denial and an unwillingness to commit taxpayer funds".
5. Letting Lehman Brothers collpase, especially after Bear Stearns, half its size, was rescued, was a "collosal error". "After Lehman went over the cliff, no financial institution seemed safe... lending froze, and the economy sank like a stone."
6. The deviation of the TARP, from its original proposal to buy the troubled assets of banks, to recapitalize them by direct cash injections, was the last major sin. He draws parallels with the markets for mortgage backed securities and commercial paper, both of which revived, atleast partially, in response to the Fed's direct purchases of these and the relaxation of lending standards against these assets.
For an alternate economic history of the world, as Prof Blinder writes - "if derivatives were traded on organized exchanges, if leverage were far lower, if subprime lending were smaller and done responsibly, if strong actions to limit foreclosures were taken right away, if Lehman were not allowed to fail, and if the TARP funds were used as directed"!
1. Wild and unregulated derivatives trading magnified the losses several times over and deepend the shocks on the financial markets.
2. Sky-high leverage, thanks to the permission accorded to securities firms by the SEC in 2004 to raise their leverage sharply. "Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1... under 33-to-1 leverage, a mere 3% decline in asset values wipes out a company"!
3. The sub-prime mortgage lending surged spectacularly in the 2004-07 period, as the bank regulators slept and more dangerously, "many of the worst subprime mortgages originated outside the banking system, beyond the reach of any federal regulator".
4. Failing to act on the early flood of home foreclosures on grounds of "free-market ideology, denial and an unwillingness to commit taxpayer funds".
5. Letting Lehman Brothers collpase, especially after Bear Stearns, half its size, was rescued, was a "collosal error". "After Lehman went over the cliff, no financial institution seemed safe... lending froze, and the economy sank like a stone."
6. The deviation of the TARP, from its original proposal to buy the troubled assets of banks, to recapitalize them by direct cash injections, was the last major sin. He draws parallels with the markets for mortgage backed securities and commercial paper, both of which revived, atleast partially, in response to the Fed's direct purchases of these and the relaxation of lending standards against these assets.
For an alternate economic history of the world, as Prof Blinder writes - "if derivatives were traded on organized exchanges, if leverage were far lower, if subprime lending were smaller and done responsibly, if strong actions to limit foreclosures were taken right away, if Lehman were not allowed to fail, and if the TARP funds were used as directed"!
Graphic on how US dealt with previous recessions
NYT has this excellent interactive graphic about how successive US governments have dealt with the past seven recessions, including commentatries by Jeffrey Frankel, Mark Gertler and Glenn Hubbard.
Wonder, why the websites of Indian financial dailies do not have good graphics on the analysis of the domestic economic situation, as opposed to routine graphs comparing economic indictors?
Wonder, why the websites of Indian financial dailies do not have good graphics on the analysis of the domestic economic situation, as opposed to routine graphs comparing economic indictors?
Sunday, January 25, 2009
Taylor Rule
Taylor Rule, formulated by Stanford economist John Taylor in 1993, stipulates how much the central bank should change the nominal interest rate (say, federal funds rate in US) in response to divergences of actual GDP (or employment level) from potential GDP and of actual inflation rates from a target inflation rates.
It provides a guide for Central Banks to "set short-term interest rates as economic conditions change to achieve both its short-run goal for stabilizing the economy and its long-run goal for inflation". It identifies three determining factors for the "real" short term interest rate
1. where actual inflation is relative to the targeted level that the Fed wishes to achieve
2. how far economic activity is above or below its "full employment" level
3. what the level of the short-term interest rate is that would be consistent with full employment (Taylor assumed this to be 2% for the US economy).
Part of the reason for Greenspan's apparent success, atleast till the sub-prime crisis blew the cover, with monetary policy was the close adherence to Taylor Rule.
Fed Governor Ben Bernanke has this to say, "when output is above its potential or inflation is above the target, the Taylor rule implies that the federal funds rate should be set above its average level, which (all else being equal) should slow the economy and bring output or inflation back toward the desired range."
More discussion on Taylor Rule is available here, here, here, and here. Econbrowser has a discussion on Prof Taylor's simple model to try to predict housing starts on the basis of past values of interest rates.
Paul Krugman points to a Goldman Sachs estimates of the potential output, whose comparison with the Taylor Rule, would appear to predict that the Fed would have to cut rates to minus 6% by 2010, a clear indicator of deflation and a liquidity trap.
It provides a guide for Central Banks to "set short-term interest rates as economic conditions change to achieve both its short-run goal for stabilizing the economy and its long-run goal for inflation". It identifies three determining factors for the "real" short term interest rate
1. where actual inflation is relative to the targeted level that the Fed wishes to achieve
2. how far economic activity is above or below its "full employment" level
3. what the level of the short-term interest rate is that would be consistent with full employment (Taylor assumed this to be 2% for the US economy).
Part of the reason for Greenspan's apparent success, atleast till the sub-prime crisis blew the cover, with monetary policy was the close adherence to Taylor Rule.
Fed Governor Ben Bernanke has this to say, "when output is above its potential or inflation is above the target, the Taylor rule implies that the federal funds rate should be set above its average level, which (all else being equal) should slow the economy and bring output or inflation back toward the desired range."
More discussion on Taylor Rule is available here, here, here, and here. Econbrowser has a discussion on Prof Taylor's simple model to try to predict housing starts on the basis of past values of interest rates.
Paul Krugman points to a Goldman Sachs estimates of the potential output, whose comparison with the Taylor Rule, would appear to predict that the Fed would have to cut rates to minus 6% by 2010, a clear indicator of deflation and a liquidity trap.
Poverty and the education gap
A UNESCO study claims that in India, a 17-22 year old in the richest quintile has had an average of 11.1 years in education, compared with only 4.4 years for those in the poorest quintile. The study concludes that inequality - based on wealth, gender, location, ethnicity and other markers - is the biggest barrier in achieving the goal of universal primary education for all (EFA) by 2015. It also draws attention to the fact that the quality of education received by children is so poor that many of them leave school without basic literacy and numeracy skills. The report emphasises the need to link up national EFA plans with wider strategies on nutrition, health and poverty.
It affirms that market solutions (vouchers, PPPs, government support for low-fee private schools etc) that works by expansion of choice and competition can only be a marginal supplement to functioning public schools. It also finds that several popular ideas like hiring contract teachers (instead of regular employees), performance related pay for teachers, and decentralization of authority - financial and functional - to local agencies/institutions, are effective only under certain conditions.
(HT: The Economist)
It affirms that market solutions (vouchers, PPPs, government support for low-fee private schools etc) that works by expansion of choice and competition can only be a marginal supplement to functioning public schools. It also finds that several popular ideas like hiring contract teachers (instead of regular employees), performance related pay for teachers, and decentralization of authority - financial and functional - to local agencies/institutions, are effective only under certain conditions.
(HT: The Economist)
Saturday, January 24, 2009
Africa need not despair!
Chris Blattman has an excellent post, that appears to convey that there is light at the end of the tunnel for Africa!
The painting below is that of a swampy settlement beside a river, painted in 1832.
On January 20th, 2009, the same site, now called the National Mall in Washington, was the venue for the inagural ceremony of the 44th President of the United States.
He also draws attention to the case of Zachary Taylor, 12th President of the United States, three of whose five children died of malaria and who himself died 16 months into his term of gastroenteritis!
The painting below is that of a swampy settlement beside a river, painted in 1832.
On January 20th, 2009, the same site, now called the National Mall in Washington, was the venue for the inagural ceremony of the 44th President of the United States.
He also draws attention to the case of Zachary Taylor, 12th President of the United States, three of whose five children died of malaria and who himself died 16 months into his term of gastroenteritis!
Friday, January 23, 2009
How to make banks solvent - Nationalization?
Bailouts have become the defining feature of the global economic landscape in the past few months, as a deepening recession leaves an ever increasing number of victims wayside. The debate now appears to have reached its climax, with a growing number of voices now calling for going the full hog - Government take-over!
The whole credit squeeze triggered off by the sub-prime mortgage defaults, assumed alarming proportions with the attendant flight to liquidity by the financial institutions. The massive leveraging (Morgan Stanley boasted $33 of assets for each dollar of capital) during the bubble years magnified the impact of this crisis. The unwinding of positions, with banks scrambling to shore up their steeply depleted reserves, led to massive sell-offs of securities, thereby driving them to bottom levels and leaving many of the asset backed securities virtually worthless and illiquid, without an active trading market. The deleveraging also left borrowers with a shrinking supply of credit and that too accessible at exorbitant prices. This left many of the biggest financial institutions vulnerable to being wiped out and necessitated the government to step in with bailouts.
The original $700 bn Troubled Assets Relief Program (TARP) had sought to identify and then auction the impaired assets on the banks' books and thereby establish a clearing price for them. It was soon abandoned in favour of direct cash injections, in return for some equity stake, so as to enable the banks to recapitalize and then use it to buy some of these impaired assets at a steep discount. With even this not being enough the Fed and Treasury took the extraordinary step of direct interventions of "quantitative easing" through direct purchases of distresed assets and guarantees for deposits and assets, and has so far committed more than $8 trillions for it.
But these bailouts ran into problems on many fronts, none of which were addressed by these bailouts. For a start, the deleveraging and the resultant plummeting of asset prices, had left many assets worthless, illiquid, and with no buyers. It did nothing to alleviate the masive credit and counter-party risks that had frozen the credit markets. Though it had hoped that the bailouts would recapitalize the banks and thereby encourage them to buy up the distressed assets on the cheap, this hope did not materialize as the extent of crisis was much deeper than anybody had fathomed.
In this context, three broad models for taking out distressed assets and bailing out weakened financial institutions have emerged. Let us examine the details of all three.
1. Citibank and Bank of America (BoA) model
This arrangement seeks to inject capital into the distressed banks, in return for some form of stake and commitments on dividend payout and executive compensation, and also provide a sharing (between the bank and government agency) of guarantees for the non-performing or illiquid assets.
The Citigroup bailout provides $40 billion in fresh capital and capital relief (in return for preference shares), and it ring-fences $306 billion of illiquid assets on Citi’s $2 trillion balance-sheet. The bulk of any losses on these, beyond the first $29 billion, will be borne by government agencies.
In the $118 bn BoA deal, the US Government decided to supply BoA with a fresh $20 billion capital injection and absorb as much as $98.2 billion in losses on toxic assets, including residential and commercial real estate and corporate loans. BoA will be responsible for the first $10 billion in losses on a pool of $118 billion in illiquid assets, while the Treasury Department and the Federal Deposit Insurance Corporation will take on the next $10 billion in losses. The Fed will absorb 90% of any additional losses, with BoA responsible for the rest.
In both cases, the Fed will buy up the distressed assets by creating specifically funded entities, which will in turn buy up the mortgage backed securities. This will effectively turn the Fed into a direct lender to homeowners.
In both cases, the equity infusion will be in return for preference shares and commitment to cut back its dividend payout, accept a loan-modification program and put more stringent restrictions on executive pay. The preference share route, instead of taking ordinary common stock shares, was to minimize risk (preference share holders come before common stock holders) and avoid playing a role in the day-to-day management of the banks so assisted. In contrast, the British bailout plan sought to take direct equity stake and ownership of the banks assisted, often majority control. However, in both cases, the bad assets will continue to remain in the balance sheet of the banks.
The problem with this model is that it does little to ally investor fears about the health of the bank, since the distressed assets, whose value is itself uncertain, continue to remain within te books of the bank. Further, it also does nothing to establish a clearing price for the impaired assets on banks’ books nor facilitate its trading. Finally, such bailouts, as in the case of the Citigroup, covers only a portion of the distressed assets, mortgage backed securities here, but leaves out the other similarly dubious assets like its huge credit-card and overseas-loan portfolios, and the numerous off-balance sheet exposures. Its piecemeal approach also creates dangerous moral hazard concerns.
2. Bad bank model
Ring fence all the troubled and non-performing assets of each bank separately and set up a "bad bank", a separate entity which takes ownership of these assets and then manages them in order to maximise their value. This is being tried out in UBS now.
The generic variant of this is to set up a universal "bad bank", which would 'buy up' the non-performing assets from different banks at "fair value", and thereby hope that
a) the uncertainty surrounding counter-party risk is eliminated and buyers know what they are buying
b) a price discovery mechanism for distressed assets is established
c) provide liquidity to a market for trading these assets
This example was successfully tried out in Sweden in the early nineties, and its efforts to restructure and resell distressed loans has been acclaimed a success. This cleaning up the books of banks is likely to restore some semblance of normalcy and thereby make it easier for these banks to raise capital or attract buyers. It is thought that this will have a huge psychological impact on the markets, in so far as it signals a clean break with the past.
In the US, it is now being proposed to set up a similar bad bank, or "aggregator banks", created and capitalized by the federal government, with the sole purpose of buying up bad assets and warehouse them in one place. The precedent cited is the Resolution Trust Corporation (RTC), set up in the aftermath of the Savings & Loans banks in the eighties.
The problem with this model of valuing and isolating bad assets, is what assets to be separated and how to value them. Assigning a "fair value" is an almost impossible task. Unlike the earlier precedents, this time we are dealing with fiendishly complicated structured mortgage assets with risks dispersed far and wide, even identifying and locating their risks, leave alone valuing them is virtually impossible. Since many of these assets are not traded in exchanges and others have been not traded for months and are illiquid, there is no way of valuing them with any sense of accuracy.
Any attempt to buy them by assigning them some valuation, will most likely end up adversely affecting the interests of tax payers, as the government is more likely to end up over-paying. Further, since it is not proposed to seize the distressed banks before the "bad bank" is set up (unlike in case of RTC), such bailout will reward the current owners and shareholders, by offering them the possibility of future gains in the good bank, besides encouraging moral hazard concerns. Paul Krugman has described this proposal "Hankie Pankie II" and compares it to the once abandoned Super-SIV plan.
3. Temporary Nationalization
To the extent that the purpose of all these bailouts is to get the distressed assets off the balance sheets of banks, and thereby re-establish normalcy in the credit markets, there are very serious problems with all these proposals. Stripped off all jargon, the simple reality is that the assets of many major banks are much less than their liabilities. In the circumstances, the only way for the Government purchases to make the banks solvent again is to pay much more than what private buyers are willing to offer (so as to atleast cover up the differential) and also take huge risks on board with the attendant possibility of even more cost for the tax payers.
Paul Krugman has argued that the least painful way to get this done is for the banks themselves to either write them off to zero or to sell them off at whatever price they get. This will penalize greedy shareholders and owners who are likely to get wiped out or have to exit at huge losses.
He has cited the example of the RTC, wherein the Government seized the defunct banks, cleaned out the shareholders, transferred their bad assets to RTC, paid off enough of the banks’ debts to make them solvent and sold the off to new owners. In Sweden, the Government took over whole banks, and then hived off the bad stuff without any kind of valuation at all, and then left them to sit for a while before selling them off. In Ireland in the nineties, the Government had taken over all the bank liabilities, by guaranteeing their unsecured debts, while leaving the assets on the banks' balance sheets, thereby bailing out the debt/bond holders in a massive way. However, the FDIC guarantees in the initial bailouts, along similar lines, was alleged to have been too favourable to bondholders.
All this brings us to probably the bailout of last resort - nationalization! The benefits are many - minimized moral hazard, cheaper cost of capital for the new banks, transparent, least cost to the tax payer, etc. Many influential voices, including even The Economist, have added their weight to nationalization. Awkward Corner and FT Alphavile points attention to the debate on nationalization with links.
Chris Dillow clarifies on the conventional responses against nationalization here. Of all these, Felix Salmon offers the most convincing case in two brilliant posts, where he gets most of the points right
And more here
Update 1
NYT makes an interesting point, that nationalization has to be an either-or solution - you nationalize all the banks or none at all - since given the wobbly state of all major banks, any nationalization of a few, would see the floodgates open for the others as investors and depositers exit from them.
Update 2
Free Exchange has a nice summary of the two fundamental problems associated with any apprioach that involves asset purchases or ring-fencing off assets, like a "bad bank" - which assets are distressed and how to value them? The closer they get to transparent market pricing, the bigger the capital shortfall in the system will look! The narrower the scope of any bail-out, the smaller the up-front bill, but the greater the risk that more will be needed later—and thus the greater the market uncertainty!
Update 3
The NYT has this article which sums up the central debate in bailing out distressed financial institutions - how to value bad assets?
Update 4
Nouriel Roubini too feels that nationalization is the only meaningful way forward to clean up bank balance sheets without compromising the interests of the tax payers. He has calculated that they need $1.4 trillion in new cash to return their capital levels to where they were before the crisis began.
Update 5
William Buiter, Paul Romer and James Kwak discuss the "good bank" solution - instead of creating a government entity to buy toxic assets from existing banks - or nationalizing existing banks, removing their toxic assets, and then reprivatize them - create brand new, good banks with the same government money, enabling them to lend money unencumbered by previous bad decisions, and then privatize them. David Warsh sums up this debate here.
Update 6
An analysis of the Swedish model here. The authors argue that the Swedish model followed the principles of transparency of asset losses up-front, and honest communication about the extent of public intervention; politically and financially independent receivership; maintenance of market discipline; and restoration of credit flows.
The whole credit squeeze triggered off by the sub-prime mortgage defaults, assumed alarming proportions with the attendant flight to liquidity by the financial institutions. The massive leveraging (Morgan Stanley boasted $33 of assets for each dollar of capital) during the bubble years magnified the impact of this crisis. The unwinding of positions, with banks scrambling to shore up their steeply depleted reserves, led to massive sell-offs of securities, thereby driving them to bottom levels and leaving many of the asset backed securities virtually worthless and illiquid, without an active trading market. The deleveraging also left borrowers with a shrinking supply of credit and that too accessible at exorbitant prices. This left many of the biggest financial institutions vulnerable to being wiped out and necessitated the government to step in with bailouts.
The original $700 bn Troubled Assets Relief Program (TARP) had sought to identify and then auction the impaired assets on the banks' books and thereby establish a clearing price for them. It was soon abandoned in favour of direct cash injections, in return for some equity stake, so as to enable the banks to recapitalize and then use it to buy some of these impaired assets at a steep discount. With even this not being enough the Fed and Treasury took the extraordinary step of direct interventions of "quantitative easing" through direct purchases of distresed assets and guarantees for deposits and assets, and has so far committed more than $8 trillions for it.
But these bailouts ran into problems on many fronts, none of which were addressed by these bailouts. For a start, the deleveraging and the resultant plummeting of asset prices, had left many assets worthless, illiquid, and with no buyers. It did nothing to alleviate the masive credit and counter-party risks that had frozen the credit markets. Though it had hoped that the bailouts would recapitalize the banks and thereby encourage them to buy up the distressed assets on the cheap, this hope did not materialize as the extent of crisis was much deeper than anybody had fathomed.
In this context, three broad models for taking out distressed assets and bailing out weakened financial institutions have emerged. Let us examine the details of all three.
1. Citibank and Bank of America (BoA) model
This arrangement seeks to inject capital into the distressed banks, in return for some form of stake and commitments on dividend payout and executive compensation, and also provide a sharing (between the bank and government agency) of guarantees for the non-performing or illiquid assets.
The Citigroup bailout provides $40 billion in fresh capital and capital relief (in return for preference shares), and it ring-fences $306 billion of illiquid assets on Citi’s $2 trillion balance-sheet. The bulk of any losses on these, beyond the first $29 billion, will be borne by government agencies.
In the $118 bn BoA deal, the US Government decided to supply BoA with a fresh $20 billion capital injection and absorb as much as $98.2 billion in losses on toxic assets, including residential and commercial real estate and corporate loans. BoA will be responsible for the first $10 billion in losses on a pool of $118 billion in illiquid assets, while the Treasury Department and the Federal Deposit Insurance Corporation will take on the next $10 billion in losses. The Fed will absorb 90% of any additional losses, with BoA responsible for the rest.
In both cases, the Fed will buy up the distressed assets by creating specifically funded entities, which will in turn buy up the mortgage backed securities. This will effectively turn the Fed into a direct lender to homeowners.
In both cases, the equity infusion will be in return for preference shares and commitment to cut back its dividend payout, accept a loan-modification program and put more stringent restrictions on executive pay. The preference share route, instead of taking ordinary common stock shares, was to minimize risk (preference share holders come before common stock holders) and avoid playing a role in the day-to-day management of the banks so assisted. In contrast, the British bailout plan sought to take direct equity stake and ownership of the banks assisted, often majority control. However, in both cases, the bad assets will continue to remain in the balance sheet of the banks.
The problem with this model is that it does little to ally investor fears about the health of the bank, since the distressed assets, whose value is itself uncertain, continue to remain within te books of the bank. Further, it also does nothing to establish a clearing price for the impaired assets on banks’ books nor facilitate its trading. Finally, such bailouts, as in the case of the Citigroup, covers only a portion of the distressed assets, mortgage backed securities here, but leaves out the other similarly dubious assets like its huge credit-card and overseas-loan portfolios, and the numerous off-balance sheet exposures. Its piecemeal approach also creates dangerous moral hazard concerns.
2. Bad bank model
Ring fence all the troubled and non-performing assets of each bank separately and set up a "bad bank", a separate entity which takes ownership of these assets and then manages them in order to maximise their value. This is being tried out in UBS now.
The generic variant of this is to set up a universal "bad bank", which would 'buy up' the non-performing assets from different banks at "fair value", and thereby hope that
a) the uncertainty surrounding counter-party risk is eliminated and buyers know what they are buying
b) a price discovery mechanism for distressed assets is established
c) provide liquidity to a market for trading these assets
This example was successfully tried out in Sweden in the early nineties, and its efforts to restructure and resell distressed loans has been acclaimed a success. This cleaning up the books of banks is likely to restore some semblance of normalcy and thereby make it easier for these banks to raise capital or attract buyers. It is thought that this will have a huge psychological impact on the markets, in so far as it signals a clean break with the past.
In the US, it is now being proposed to set up a similar bad bank, or "aggregator banks", created and capitalized by the federal government, with the sole purpose of buying up bad assets and warehouse them in one place. The precedent cited is the Resolution Trust Corporation (RTC), set up in the aftermath of the Savings & Loans banks in the eighties.
The problem with this model of valuing and isolating bad assets, is what assets to be separated and how to value them. Assigning a "fair value" is an almost impossible task. Unlike the earlier precedents, this time we are dealing with fiendishly complicated structured mortgage assets with risks dispersed far and wide, even identifying and locating their risks, leave alone valuing them is virtually impossible. Since many of these assets are not traded in exchanges and others have been not traded for months and are illiquid, there is no way of valuing them with any sense of accuracy.
Any attempt to buy them by assigning them some valuation, will most likely end up adversely affecting the interests of tax payers, as the government is more likely to end up over-paying. Further, since it is not proposed to seize the distressed banks before the "bad bank" is set up (unlike in case of RTC), such bailout will reward the current owners and shareholders, by offering them the possibility of future gains in the good bank, besides encouraging moral hazard concerns. Paul Krugman has described this proposal "Hankie Pankie II" and compares it to the once abandoned Super-SIV plan.
3. Temporary Nationalization
To the extent that the purpose of all these bailouts is to get the distressed assets off the balance sheets of banks, and thereby re-establish normalcy in the credit markets, there are very serious problems with all these proposals. Stripped off all jargon, the simple reality is that the assets of many major banks are much less than their liabilities. In the circumstances, the only way for the Government purchases to make the banks solvent again is to pay much more than what private buyers are willing to offer (so as to atleast cover up the differential) and also take huge risks on board with the attendant possibility of even more cost for the tax payers.
Paul Krugman has argued that the least painful way to get this done is for the banks themselves to either write them off to zero or to sell them off at whatever price they get. This will penalize greedy shareholders and owners who are likely to get wiped out or have to exit at huge losses.
He has cited the example of the RTC, wherein the Government seized the defunct banks, cleaned out the shareholders, transferred their bad assets to RTC, paid off enough of the banks’ debts to make them solvent and sold the off to new owners. In Sweden, the Government took over whole banks, and then hived off the bad stuff without any kind of valuation at all, and then left them to sit for a while before selling them off. In Ireland in the nineties, the Government had taken over all the bank liabilities, by guaranteeing their unsecured debts, while leaving the assets on the banks' balance sheets, thereby bailing out the debt/bond holders in a massive way. However, the FDIC guarantees in the initial bailouts, along similar lines, was alleged to have been too favourable to bondholders.
All this brings us to probably the bailout of last resort - nationalization! The benefits are many - minimized moral hazard, cheaper cost of capital for the new banks, transparent, least cost to the tax payer, etc. Many influential voices, including even The Economist, have added their weight to nationalization. Awkward Corner and FT Alphavile points attention to the debate on nationalization with links.
Chris Dillow clarifies on the conventional responses against nationalization here. Of all these, Felix Salmon offers the most convincing case in two brilliant posts, where he gets most of the points right
"Since the government has an interest in protecting its own liabilities, rather than maximizing shareholder value, the chances of crazy gambles will be minimized. In any case, since the government is taking virtually unlimited downside, it should by rights have all the upside as well - i.e., ownership. It's (nationalization) transparent and easy to understand: if a bank is insolvent (and the FDIC is good at making those determinations), then simply nationalize it. That's what the Swedes did, and that's what we should do too."
And more here
"Nationalization is what the Nordics successfully did in the early 1990s; it can work here, too. The only real question is how much to pay: my gut feeling is that shareholders should get nothing, holders of preferred stock should take a serious haircut, and that if there aren't very many of those, then unsecured senior creditors should take a modest haircut too. The point of the exercise is to minimize the degree to which the banks' bondholders are bailed out, while at the same time minimizing the systemic consequences of a massive bond default by the likes of Citigroup and Bank of America.
But that decision is secondary. The big decision is whether or not to nationalize - or, rather, whether to nationalize now, and get it over and done with, or to continue to construct ad hoc responses in a desperate and probably doomed attempt to avoid having to nationalize at all. Surely we can all agree that if it's going to happen, it's better it happens sooner rather than later."
Update 1
NYT makes an interesting point, that nationalization has to be an either-or solution - you nationalize all the banks or none at all - since given the wobbly state of all major banks, any nationalization of a few, would see the floodgates open for the others as investors and depositers exit from them.
Update 2
Free Exchange has a nice summary of the two fundamental problems associated with any apprioach that involves asset purchases or ring-fencing off assets, like a "bad bank" - which assets are distressed and how to value them? The closer they get to transparent market pricing, the bigger the capital shortfall in the system will look! The narrower the scope of any bail-out, the smaller the up-front bill, but the greater the risk that more will be needed later—and thus the greater the market uncertainty!
Update 3
The NYT has this article which sums up the central debate in bailing out distressed financial institutions - how to value bad assets?
Update 4
Nouriel Roubini too feels that nationalization is the only meaningful way forward to clean up bank balance sheets without compromising the interests of the tax payers. He has calculated that they need $1.4 trillion in new cash to return their capital levels to where they were before the crisis began.
Update 5
William Buiter, Paul Romer and James Kwak discuss the "good bank" solution - instead of creating a government entity to buy toxic assets from existing banks - or nationalizing existing banks, removing their toxic assets, and then reprivatize them - create brand new, good banks with the same government money, enabling them to lend money unencumbered by previous bad decisions, and then privatize them. David Warsh sums up this debate here.
Update 6
An analysis of the Swedish model here. The authors argue that the Swedish model followed the principles of transparency of asset losses up-front, and honest communication about the extent of public intervention; politically and financially independent receivership; maintenance of market discipline; and restoration of credit flows.
Behavioural models in finance
That market failure is not the only justification for government intervention in the marketplace is made abundantly clear by recent research in behavioural economics. Behavioural models have sought to replace the homo economicus model of utility maximizing rational agents with a more realistic concept of "bounded rationality", where agents, though on average rational, act based on their specific preferences.
Mark Thoma draws attention to a Vox article by Leigh Caldwell, which points to a few behavioural and psychological considerations that may have contributed to the present economic crisis, analyzes a few of these models and suggests more sophisticated policy responses that could break the crisis’s psychological hold on markets. Here is a list of these bounded rationality models that relaxes some of the standard theoretical assumptions
1. Utility is discounted in a time inconsistent manner - Experiments show that people apply a high discount on utility in the present, but a lower one in the future. This partially explains the recent huge variances between overnight and three-month interest rates. The "trust deficit" in the financial markets exacerbates this short-long time frames imbalance.
2. People do not have access to all relevant information - Financial markets are characterized by "information asymmetry" and therefore require "enforced transparency". This explains why many agents who in the absence of crucial information, were forced to make guesses in their investment and trading decisions, with catastrophic results.
3. All relevant information is not expressed through market prices - markets are efficient, reflecting the full value in prices, only when there is sufficient liquidity and when there are no moral hazard problems. In its absence, the price signals break down, and investment and resource allocation decisions are made based on non-price signals.
4. People cannot instantly weigh up the change in utility in any buying or selling decision - they rely on familiar choices to avoid the mental effort and risk of picking alternatives (anchoring or habit). Further, anchoring creates a tendency to fixate on one option too long when we might profitably switch to another –it limits the effects of all kinds of quantitative changes in policy.
5. People do not act to maximise their utility - alternative models of decision making include multi-dimensional ("vector") utility functions, value modelling, psychological attempts, and "local utility gradient" to understand subconscious mental drivers.
All these deviations from the standard financial market models, highlight the discepancies in our conventional policy responses, and needs to be taken into account when formulating regulatory policies.
Update 1
Chris Dillow lists out more cognitive biases - availability heuristic, self-serving bias/wishful thinking (people start risky projects), bandwagon effect (momentum investing), focussing effect (looking at one piece of data and under-rating others), status quo bias, gambler's fallacy (we’ve had a run of reds, so black must be due!), hot-hand fallacy, base-rate fallacy (ignoring prior probabilities) etc.
Mark Thoma draws attention to a Vox article by Leigh Caldwell, which points to a few behavioural and psychological considerations that may have contributed to the present economic crisis, analyzes a few of these models and suggests more sophisticated policy responses that could break the crisis’s psychological hold on markets. Here is a list of these bounded rationality models that relaxes some of the standard theoretical assumptions
1. Utility is discounted in a time inconsistent manner - Experiments show that people apply a high discount on utility in the present, but a lower one in the future. This partially explains the recent huge variances between overnight and three-month interest rates. The "trust deficit" in the financial markets exacerbates this short-long time frames imbalance.
2. People do not have access to all relevant information - Financial markets are characterized by "information asymmetry" and therefore require "enforced transparency". This explains why many agents who in the absence of crucial information, were forced to make guesses in their investment and trading decisions, with catastrophic results.
3. All relevant information is not expressed through market prices - markets are efficient, reflecting the full value in prices, only when there is sufficient liquidity and when there are no moral hazard problems. In its absence, the price signals break down, and investment and resource allocation decisions are made based on non-price signals.
4. People cannot instantly weigh up the change in utility in any buying or selling decision - they rely on familiar choices to avoid the mental effort and risk of picking alternatives (anchoring or habit). Further, anchoring creates a tendency to fixate on one option too long when we might profitably switch to another –it limits the effects of all kinds of quantitative changes in policy.
5. People do not act to maximise their utility - alternative models of decision making include multi-dimensional ("vector") utility functions, value modelling, psychological attempts, and "local utility gradient" to understand subconscious mental drivers.
All these deviations from the standard financial market models, highlight the discepancies in our conventional policy responses, and needs to be taken into account when formulating regulatory policies.
Update 1
Chris Dillow lists out more cognitive biases - availability heuristic, self-serving bias/wishful thinking (people start risky projects), bandwagon effect (momentum investing), focussing effect (looking at one piece of data and under-rating others), status quo bias, gambler's fallacy (we’ve had a run of reds, so black must be due!), hot-hand fallacy, base-rate fallacy (ignoring prior probabilities) etc.
Thursday, January 22, 2009
Real business cycle theory rebutted
Joseph Schumpeter had argued that a "perennial gale of creative destruction" is an inevitable requirement for any advance in human condition and this in turn can take place only in the context of a cycle of boom and bust. New technologies and inventions arouses a wave of optimism and entrepreneurial spirit, leading to over-investments, funded by credit made available by banks eager to partake of a share in the boom. Then reality dawns and the bubble bursts, leading to banks exiting in the same irrational manner, which only exacerbates the crisis. But the reality of such a "creative destruction", with its attendant bad times, is an inevitable fact of such cycles. This in turn calls for government intervention to to smooth the rough edges of the "destruction" arising from the replacement of the old capital.
Robert Skidelsky takes up arguement against the contemporary "real business cycle" theories which claims that efficient markets, which always clear, will smooth over and minimize the "destructiveness" of the "creation" in any boom and bust, and therefore any government intervention will be counter-productive. He rejects their contention that the markets will clear by themselves, and argues that the non-intervention arguements of the "real business cycle" theorists is misplaced. However, he argues that unlike even the dot-com bubble, this time there was no positive technological shock and the easy credit financed only a massive house of financial innovation built on shaky and often illusory foundations.
Robert Skidelsky takes up arguement against the contemporary "real business cycle" theories which claims that efficient markets, which always clear, will smooth over and minimize the "destructiveness" of the "creation" in any boom and bust, and therefore any government intervention will be counter-productive. He rejects their contention that the markets will clear by themselves, and argues that the non-intervention arguements of the "real business cycle" theorists is misplaced. However, he argues that unlike even the dot-com bubble, this time there was no positive technological shock and the easy credit financed only a massive house of financial innovation built on shaky and often illusory foundations.
Unconventional monetary policy responses
As the sub-prime meltdown has progressed and as the interest rates have been driven down to the zero-bound and the credit squeeze has shown no signs of loosening, the Federal Reserve and the Treasury in the US has come up with a series of extraordinary and unconventional monetary policy measures. These responses effectively mean that the Government has become the lender, investor and insurer of last resort in the financial markets, in a last gasp effort to restore normalcy of credit flow in these markets. The government has so far guaranteed almost $ 8 trillion in investment, loans and deposits.
The NYT captures these responses in the excellent graphics shown below.
These responses are collectively called "quantitative easing", "which means having the Fed pump staggering amounts of money into the economy by buying up a wide range of debt instruments", all in an attempt to unfreeze the credit markets. Here is a brief of the $8 trillion plus guaranteed (but not fully spent) by the Government.
a) Insurer - Government has committed $3.2 trillion as guarantees to investors and depositers against default. These include the FDIC's insurance of senior-subordinated debt issued by banks till June 2009, and similar guarantees to money market funds, non-interest bearing deposit accounts, besides that provided to the distressed assets of Bear Stearns, Morgan Stanley, Freddie Mac/Fannie Mae, Citigroup and Bank of America (BoA).
b) Investor - Government has committed $3 trillion in cash in return for stakes in financial institutions. This includes, the Fed's role as buyer of last resort in the Commercial Paper (CP) markets, direct investments in financial institutions through the TARP, purchases of debt and mortgage bascked securities (MBSS) from the likes of Fannie Mae and Freddie Mac, and the direct stakes taken in AIG, Citigroup and BoA.
c) Lender - Government has committed $1.7 trillion in low interest loans to large financial institutions. This includes, the low interest loans using an expanded base of collateral, including asset backed securities, through the Term Auction Facility (TAF); and lending to investors holding securities backed by consumer and small business loans through the Term Assets Backed Securities Loan Facility (TALF).
d) Forex market - $755 bn as guarantee for currency swaps with Central Banks of other countries.
Update 1
Mostly Economics summarizes the Fed's credit easing responses here. A St. Louis Fed primer is available here.
Update 2
Quantitative easing basically means that the Fed is selling Treasury bills or their equivalent (interest-paying excess bank reserves are essentially the same thing), while buying other assets - mortgage-backed securities; securities backed by credit-card debt; longer-term government debt etc - expanding its balance sheet enormously in the process.
Update 3
Claudio Borio and Piti Disyatat have this nice summary of unconventional monetayr policy responses.
The NYT captures these responses in the excellent graphics shown below.
These responses are collectively called "quantitative easing", "which means having the Fed pump staggering amounts of money into the economy by buying up a wide range of debt instruments", all in an attempt to unfreeze the credit markets. Here is a brief of the $8 trillion plus guaranteed (but not fully spent) by the Government.
a) Insurer - Government has committed $3.2 trillion as guarantees to investors and depositers against default. These include the FDIC's insurance of senior-subordinated debt issued by banks till June 2009, and similar guarantees to money market funds, non-interest bearing deposit accounts, besides that provided to the distressed assets of Bear Stearns, Morgan Stanley, Freddie Mac/Fannie Mae, Citigroup and Bank of America (BoA).
b) Investor - Government has committed $3 trillion in cash in return for stakes in financial institutions. This includes, the Fed's role as buyer of last resort in the Commercial Paper (CP) markets, direct investments in financial institutions through the TARP, purchases of debt and mortgage bascked securities (MBSS) from the likes of Fannie Mae and Freddie Mac, and the direct stakes taken in AIG, Citigroup and BoA.
c) Lender - Government has committed $1.7 trillion in low interest loans to large financial institutions. This includes, the low interest loans using an expanded base of collateral, including asset backed securities, through the Term Auction Facility (TAF); and lending to investors holding securities backed by consumer and small business loans through the Term Assets Backed Securities Loan Facility (TALF).
d) Forex market - $755 bn as guarantee for currency swaps with Central Banks of other countries.
Update 1
Mostly Economics summarizes the Fed's credit easing responses here. A St. Louis Fed primer is available here.
Update 2
Quantitative easing basically means that the Fed is selling Treasury bills or their equivalent (interest-paying excess bank reserves are essentially the same thing), while buying other assets - mortgage-backed securities; securities backed by credit-card debt; longer-term government debt etc - expanding its balance sheet enormously in the process.
Update 3
Claudio Borio and Piti Disyatat have this nice summary of unconventional monetayr policy responses.
Wednesday, January 21, 2009
Lighter side of the economic meltdown!
This, from my email inbox, are are a set of hilarious anecdotes which pretty accurately caricatures the present times.
1. The US has made a new weapon that destroys people but keeps the building standing. It's called the stock market - Jay Leno
2. Do you have any idea how cheap stocks are? Wall Street is now being called Wall Mart Street - Jay Leno
3. The difference between a pigeon and a London investment banker. The pigeon can still make a deposit on a BMW.
4. What's the difference between a guy who lost everything in Las Vegas and an investment banker?
A tie!
5. The problem with investment bank balance sheet is that on the left side nothing's right and on the right side nothing's left.
6. I want to warn people from Nigeria who might be watching our show, if you get any emails from Washington asking for money, it's a scam. Don't fall for it - Jay Leno
7. Bush was asked about the credit crunch. He said it was his favorite candy bar - Jay Leno
8. The rescue bill was about 450 pages. President Bush's copy is even thicker. They had to include pictures - Jay Leno
9. President Bush's response was to meet some small business owners in San Antonio last week. The small business owners are General Motors, General Electric and Century 21 - Jay Leno
10. What worries me most about the credit crunch is that if one of my cheques is returned stamped 'insufficient funds', I won't know whether that refers to mine or the bank's.
1. The US has made a new weapon that destroys people but keeps the building standing. It's called the stock market - Jay Leno
2. Do you have any idea how cheap stocks are? Wall Street is now being called Wall Mart Street - Jay Leno
3. The difference between a pigeon and a London investment banker. The pigeon can still make a deposit on a BMW.
4. What's the difference between a guy who lost everything in Las Vegas and an investment banker?
A tie!
5. The problem with investment bank balance sheet is that on the left side nothing's right and on the right side nothing's left.
6. I want to warn people from Nigeria who might be watching our show, if you get any emails from Washington asking for money, it's a scam. Don't fall for it - Jay Leno
7. Bush was asked about the credit crunch. He said it was his favorite candy bar - Jay Leno
8. The rescue bill was about 450 pages. President Bush's copy is even thicker. They had to include pictures - Jay Leno
9. President Bush's response was to meet some small business owners in San Antonio last week. The small business owners are General Motors, General Electric and Century 21 - Jay Leno
10. What worries me most about the credit crunch is that if one of my cheques is returned stamped 'insufficient funds', I won't know whether that refers to mine or the bank's.
Most expensive real estate in Asia
Here is the list of the ten fastest growing retail zones in Asia. India has six of these ten. This survey was done in June 2008, since when as the travails of Jet Airways indicate, the real estate market has been tapering off.
(HT: Businessline)
(HT: Businessline)
Tuesday, January 20, 2009
Tax cuts Vs infrastructure spending
This post is in continuation to an earlier post on the two big macroeconomic debates of the present times. The first one had explored the debate between fiscal and monetary policies, while this one seeks to explore the debate within fiscal policy itself between tax cuts and government spending on public infrastructure.
Among the advocates of fiscal policy, there have been interesting debates about which among the various spending options are more effective - direct spending on infrastructure and works, tax cuts (and here to specific categories, especially those aimed at the poor and middle income than the rich and businesses), welfare assistance for the poor like food stamps and unemployment insurance, grants assistance for states etc.
However, on the larger canvas, this debate has become confined to a battle for supremacy between tax cuts and government spending on public infrastructure. It is argued that tax cuts are more likely to be saved or used to pay off debts, than spent. In contrast, infrastructure spending pushes money into the economy, with all its multiplier effect, besides creating public assets which in any case the government has to supply. The debate on this has revolved around the respective economic multipliers of these two stimulus alternatives.
Though tax cuts are a significant part of the proposed Obama fiscal stimulus, forming $150 bn each to businesses and individuals, its efficacy is extremely questionable, especially given the failure with the even the most recent experience with such tax cuts - the $146 bn tax cuts in February 2008 by the Bush administration (which was mostly saved or used to pay off debt).
The Romers (again!) are in the thick of this debate, having (allegedly) claimed in a recent NBER working paper that tax cuts have a multiplier of 3, as against the multipliers in the range of 1-2 for other fiscal spending alternatives (full article by Valerie A Ramey, whose research suggests a 1.4 multiplier for government spending, is available here).
Greg Mankiw makes out a list of all major citations that favour tax cuts as the most effective fiscal policy option, the most prominent being Andrew Mountfod and Harald Uhlig. Mankiw himself favours monetary policy over fiscal policy, but within fiscal policy prefers tax cuts over direct spending.
However, Nate Silver analyzed the Romers' position by drawing the distinction between two types of tax cuts - "exogenous" (one designed not to counter business cycles, but done under relatively healthy economic circumstances) and "countercyclical" (done in an unhealthy economy and designed to return the economy to normal growth) - and argues that the Romers were referring to the former, whereas the need of this hour is the latter.
Brad DeLong clarifies further on the differences between the two sets of figures. He writes that Ramey's study understates the spending multiplier, since it does not account for the inevitable increase in tax revenues from the spending. Krugman illustrates this effect nicely here, and Andy Harless here. WSJ's Real Time Economics, draws attention to an analysis by the forecasting firm Macroeconomic Advisers, which claims that the $775 bn Obama fiscal stimulus plan could "pay for up to 40% of itself via higher tax revenue over the next five years".
Interestingly, in an analysis of the employment creation potentials of the different stimulus programs of the US Government, Christina Romer and Jared Bernstein estimated (with "considerable uncertainty") the multipliers of government purchases (spending) and tax cuts at 1.57 and 0.99 respectively. It has to be said that with the available instruments and models, it is not possible to very accurately predict the multipliers associated with various policy alternatives. However, the weight of evidence clearly points towards government spending having a higher multiplier than tax cuts, especially when the economy is facing a recession.
There have been many other distinguished voices of support for government infrastructure against tax cuts. Paul Krugman (and here and here), Mark Thoma, Robert Skidelsky, Economic Policy Institute (EPI), Joseph Stiglitz - all have made strong cases against tax cuts and in favour of direct government spending.
Paul Krugman feels that those favoring tax cuts over government spending do so on ideological grounds, than based on any raitonal understanding of the issue. He lists out the opponents, all of whom are also incidentally political conservatives. He also clarifies on Gary Becker's support for monetary policy giving the example of the recession of early 1980s, arguing that unlike then, now we are kissing the zero-bound, where monetary policy becomes superfluous.
The other major issue between tax cuts and government spending is that the process of selecting the projects for fiscal spending may degenerate into a process of dispensing pork barrel, and hence deliver little bang for the buck. It may be questionable to reject an otherwise effective remedy just on the grounds of apprehension of being captured by vested interests. In any case, tax cuts too are vulnerable to similar inefficiencies, with the likelihood of dispensing tax cuts to those not in need of the same, who then end up saving it.
The debate between tax cuts and spending has overshadowed consideration of the other equally important fiscal policy options. Since recessions increase the numbers of those below the poverty line, increases in welfare assistance, by way of expanded coverage of food stamps and unemployment insurance, should ideally be one of the automatic fiscal stabilizers in the economy. It will improve the incomes of the poorest and leave them with cash to spend on other essentials. Stepped up assistance to states (who generally cut back on spending), increased allocation for ongaoing government infrastructure and other useful spending programs, release of money for delayed-but-in-progress works, and increase in easy to kick-start infrastructure projects.
There has also been the other big debate about how much fiscal stimulus is necessary to get normalcy restored as early as possible. Economists like Paul Krugman and Ben Stein have described that it is not possible to "nickel and dime our way" through the crisis facing us and have argued that normal rules do not apply during such extraordinary times. They claim that the output gap, between actual and potential GDP, is too high to be bridged with small or even medium tinkering, but requires shooting the biggest cannon with fiscal policy.
Adding his voice to this debate is Ben Bernanke, who in a recent speech, claimed that there was a need to pour billions more in cash infusions, over and above the $700 bn already committed in bailing out the financial markets, "to stabilize the financial system and restore normal flows of credit". He said that, atleast during extraordinary recessions, both monetary and fiscal policy responses converge on the need for a "surge" of infusions and government spending to even stand a semblance of chance to restore normalcy. But how much is needed appears to be far from settled.
Now after all this monetary and fiscal stimuluses, the economies show no signs of recovery. It is therefore not surprising that Ben Bernanke has now voiced his concerns that monetary policy should continue to go hand in hand with fiscal policy as desired policy response to such crises (he also dwelled on the need to strengthen regulatory over-sight immediately and co-ordinated action by nations in economic, financial and regulatory policies). A combined monetary-fiscal push, with the fiscal dimension assuming the lead, especially when we are well into a recession and when the zero-bound is on us (at zero-bound, the "crowding-out" from higher interest rates argument against fiscal policy loses steam), appears to be a more sensible way ahead. Bernanke had in a seminal speech in 2002, in response to the deflationary spiral that had trappen Japan, had argued that monetary policy still has an important role in a "deflation scenario", even when the interest rates hit the zero bound.
Update 1
Lawrence Mishell points to a study by Matthew D. Shapiro and Joel Slemrod (and here), which claim that only one-third of the $300 given back in tax credit early last year, as part of President Bush's $146 bn exclusively tax break fiscal stimulus, was spent, with the remaining having been saved or used to pay off debts. Mark Thoma too weighs in here.
Bruce Bartlett and Hal Varian make the case for a stimulus to boost private investment through tax concessions, which Mark Thoma counters.
Update 2
Edward Glaeser pumps for greater infrastructure spending.
Update 3
Justin Wolfers draws attention to a paper by Gauti Eggertsson of the New York Fed, which argues that at zero short-term nominal interest rate, tax cuts increase deflationary pressures and thereby reduce output. He reckons that tax cuts, by acting on the supply side (incentivizing them) by increasing labour supply and investments without simultaneously addressing the demand side, could actually exacerbate the crisis. So he prefers policies aimed at stimulating aggregate demand - a temporary increase in government spending and a commitment to inflate.
He writes, "The multiplier of tax cuts goes from positive at positive interest rates to negative once the interest rate hits zero, while the multiplier of government spending not only stays positive but becomes many times larger at the zero bound."
Justin Wolfers has this to say about tax rebate checks.
Update 4
Greg Mankiw compares the opposing views of Richard Clarida (Lower multipliers) and Christina Romer (higer multipliers) on fiscal stimulus measures.
Update 5
Greg Mankiw, quoting from the research by John F. Cogan, Tobias Cwik, John B. Taylor, and Volker Wieland, claims that government spending multipliers are much smaller in New Keynesian modesl than in the older ones. Menzie Chinn replies here.
Update 6
CBOS estimates of the impact of the February 2008 tax cuts is discussed here.
Update 7
More on the debate here and here.
Update 8
If you want to cut taxes, cut them immmediately, and pre-empt anticipation effects that drags down economic activity.
Update 9
Robert Barro and Charles Redlick prefers tax cuts over government spending and finds that the multiplier of defence spending falls in a range of 0.6 to 0.8 and argues that non-defence multipliers are unlikely to be larger.
Alberto F. Alesina and Silvia Ardagna examined the evidence on episodes of large stances in fiscal policy, both in cases of fiscal stimuli and in that of fiscal adjustments in OECD countries from 1970 to 2007, and find that - fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases; fiscal adjustments based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases; adjustments on the spending side rather than on the tax side are less likely to create recessions.
Update 10
Mankiw points to papers that find tax cuts superior to direct spending to combat recessions - Christina and David Romer, Alberto Alesina and Silvia Ardagna, Olivier Blanchard, Andrew Mountford and Harald Uhlig.
Among the advocates of fiscal policy, there have been interesting debates about which among the various spending options are more effective - direct spending on infrastructure and works, tax cuts (and here to specific categories, especially those aimed at the poor and middle income than the rich and businesses), welfare assistance for the poor like food stamps and unemployment insurance, grants assistance for states etc.
However, on the larger canvas, this debate has become confined to a battle for supremacy between tax cuts and government spending on public infrastructure. It is argued that tax cuts are more likely to be saved or used to pay off debts, than spent. In contrast, infrastructure spending pushes money into the economy, with all its multiplier effect, besides creating public assets which in any case the government has to supply. The debate on this has revolved around the respective economic multipliers of these two stimulus alternatives.
Though tax cuts are a significant part of the proposed Obama fiscal stimulus, forming $150 bn each to businesses and individuals, its efficacy is extremely questionable, especially given the failure with the even the most recent experience with such tax cuts - the $146 bn tax cuts in February 2008 by the Bush administration (which was mostly saved or used to pay off debt).
The Romers (again!) are in the thick of this debate, having (allegedly) claimed in a recent NBER working paper that tax cuts have a multiplier of 3, as against the multipliers in the range of 1-2 for other fiscal spending alternatives (full article by Valerie A Ramey, whose research suggests a 1.4 multiplier for government spending, is available here).
Greg Mankiw makes out a list of all major citations that favour tax cuts as the most effective fiscal policy option, the most prominent being Andrew Mountfod and Harald Uhlig. Mankiw himself favours monetary policy over fiscal policy, but within fiscal policy prefers tax cuts over direct spending.
However, Nate Silver analyzed the Romers' position by drawing the distinction between two types of tax cuts - "exogenous" (one designed not to counter business cycles, but done under relatively healthy economic circumstances) and "countercyclical" (done in an unhealthy economy and designed to return the economy to normal growth) - and argues that the Romers were referring to the former, whereas the need of this hour is the latter.
Brad DeLong clarifies further on the differences between the two sets of figures. He writes that Ramey's study understates the spending multiplier, since it does not account for the inevitable increase in tax revenues from the spending. Krugman illustrates this effect nicely here, and Andy Harless here. WSJ's Real Time Economics, draws attention to an analysis by the forecasting firm Macroeconomic Advisers, which claims that the $775 bn Obama fiscal stimulus plan could "pay for up to 40% of itself via higher tax revenue over the next five years".
Interestingly, in an analysis of the employment creation potentials of the different stimulus programs of the US Government, Christina Romer and Jared Bernstein estimated (with "considerable uncertainty") the multipliers of government purchases (spending) and tax cuts at 1.57 and 0.99 respectively. It has to be said that with the available instruments and models, it is not possible to very accurately predict the multipliers associated with various policy alternatives. However, the weight of evidence clearly points towards government spending having a higher multiplier than tax cuts, especially when the economy is facing a recession.
There have been many other distinguished voices of support for government infrastructure against tax cuts. Paul Krugman (and here and here), Mark Thoma, Robert Skidelsky, Economic Policy Institute (EPI), Joseph Stiglitz - all have made strong cases against tax cuts and in favour of direct government spending.
Paul Krugman feels that those favoring tax cuts over government spending do so on ideological grounds, than based on any raitonal understanding of the issue. He lists out the opponents, all of whom are also incidentally political conservatives. He also clarifies on Gary Becker's support for monetary policy giving the example of the recession of early 1980s, arguing that unlike then, now we are kissing the zero-bound, where monetary policy becomes superfluous.
The other major issue between tax cuts and government spending is that the process of selecting the projects for fiscal spending may degenerate into a process of dispensing pork barrel, and hence deliver little bang for the buck. It may be questionable to reject an otherwise effective remedy just on the grounds of apprehension of being captured by vested interests. In any case, tax cuts too are vulnerable to similar inefficiencies, with the likelihood of dispensing tax cuts to those not in need of the same, who then end up saving it.
The debate between tax cuts and spending has overshadowed consideration of the other equally important fiscal policy options. Since recessions increase the numbers of those below the poverty line, increases in welfare assistance, by way of expanded coverage of food stamps and unemployment insurance, should ideally be one of the automatic fiscal stabilizers in the economy. It will improve the incomes of the poorest and leave them with cash to spend on other essentials. Stepped up assistance to states (who generally cut back on spending), increased allocation for ongaoing government infrastructure and other useful spending programs, release of money for delayed-but-in-progress works, and increase in easy to kick-start infrastructure projects.
There has also been the other big debate about how much fiscal stimulus is necessary to get normalcy restored as early as possible. Economists like Paul Krugman and Ben Stein have described that it is not possible to "nickel and dime our way" through the crisis facing us and have argued that normal rules do not apply during such extraordinary times. They claim that the output gap, between actual and potential GDP, is too high to be bridged with small or even medium tinkering, but requires shooting the biggest cannon with fiscal policy.
Adding his voice to this debate is Ben Bernanke, who in a recent speech, claimed that there was a need to pour billions more in cash infusions, over and above the $700 bn already committed in bailing out the financial markets, "to stabilize the financial system and restore normal flows of credit". He said that, atleast during extraordinary recessions, both monetary and fiscal policy responses converge on the need for a "surge" of infusions and government spending to even stand a semblance of chance to restore normalcy. But how much is needed appears to be far from settled.
Now after all this monetary and fiscal stimuluses, the economies show no signs of recovery. It is therefore not surprising that Ben Bernanke has now voiced his concerns that monetary policy should continue to go hand in hand with fiscal policy as desired policy response to such crises (he also dwelled on the need to strengthen regulatory over-sight immediately and co-ordinated action by nations in economic, financial and regulatory policies). A combined monetary-fiscal push, with the fiscal dimension assuming the lead, especially when we are well into a recession and when the zero-bound is on us (at zero-bound, the "crowding-out" from higher interest rates argument against fiscal policy loses steam), appears to be a more sensible way ahead. Bernanke had in a seminal speech in 2002, in response to the deflationary spiral that had trappen Japan, had argued that monetary policy still has an important role in a "deflation scenario", even when the interest rates hit the zero bound.
Update 1
Lawrence Mishell points to a study by Matthew D. Shapiro and Joel Slemrod (and here), which claim that only one-third of the $300 given back in tax credit early last year, as part of President Bush's $146 bn exclusively tax break fiscal stimulus, was spent, with the remaining having been saved or used to pay off debts. Mark Thoma too weighs in here.
Bruce Bartlett and Hal Varian make the case for a stimulus to boost private investment through tax concessions, which Mark Thoma counters.
Update 2
Edward Glaeser pumps for greater infrastructure spending.
Update 3
Justin Wolfers draws attention to a paper by Gauti Eggertsson of the New York Fed, which argues that at zero short-term nominal interest rate, tax cuts increase deflationary pressures and thereby reduce output. He reckons that tax cuts, by acting on the supply side (incentivizing them) by increasing labour supply and investments without simultaneously addressing the demand side, could actually exacerbate the crisis. So he prefers policies aimed at stimulating aggregate demand - a temporary increase in government spending and a commitment to inflate.
He writes, "The multiplier of tax cuts goes from positive at positive interest rates to negative once the interest rate hits zero, while the multiplier of government spending not only stays positive but becomes many times larger at the zero bound."
Justin Wolfers has this to say about tax rebate checks.
Update 4
Greg Mankiw compares the opposing views of Richard Clarida (Lower multipliers) and Christina Romer (higer multipliers) on fiscal stimulus measures.
Update 5
Greg Mankiw, quoting from the research by John F. Cogan, Tobias Cwik, John B. Taylor, and Volker Wieland, claims that government spending multipliers are much smaller in New Keynesian modesl than in the older ones. Menzie Chinn replies here.
Update 6
CBOS estimates of the impact of the February 2008 tax cuts is discussed here.
Update 7
More on the debate here and here.
Update 8
If you want to cut taxes, cut them immmediately, and pre-empt anticipation effects that drags down economic activity.
Update 9
Robert Barro and Charles Redlick prefers tax cuts over government spending and finds that the multiplier of defence spending falls in a range of 0.6 to 0.8 and argues that non-defence multipliers are unlikely to be larger.
Alberto F. Alesina and Silvia Ardagna examined the evidence on episodes of large stances in fiscal policy, both in cases of fiscal stimuli and in that of fiscal adjustments in OECD countries from 1970 to 2007, and find that - fiscal stimuli based upon tax cuts are more likely to increase growth than those based upon spending increases; fiscal adjustments based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based upon tax increases; adjustments on the spending side rather than on the tax side are less likely to create recessions.
Update 10
Mankiw points to papers that find tax cuts superior to direct spending to combat recessions - Christina and David Romer, Alberto Alesina and Silvia Ardagna, Olivier Blanchard, Andrew Mountford and Harald Uhlig.