Analyzing RBI's Monetary Policy

True to its conservative Central Banking style and hawkish policy stance on inflation, the RBI has followed the Australian Central Bank (and alongside Norway) in initiating a cautious exit from the expansionary monetary policy of the past twelve months. The RBI's caution is understandable given the classic dilemma on the trade-off between exiting too soon (and thereby adversely affecting fledgling growth prospects) and staying on for too long (thereby unleashing inflationary pressures).

Though the RBI left the policy rates and the CRR in tact, its decision to raise SLR to 25% of Net Demand and Time Liabilities (NDTL), lower export credit refinance amounts, increase the provisioning requirement for advances to real estate sector and close certain temporary liquidity windows are clear declaration of intent that a calibrated and sequenced exit from the loose money policy is underway. Many of these decisions, including the SLR increase (the actual investments in government securities is beyond 26%), is likely to have minimal effect on the actual liquidity situation and is more a signal to anchor inflationary expectations.

Further, as the RBI Governor pointed out, even without any further repo rate cuts, the banks have enough room to lower their lending rates. An indicator of the delayed transmission of credit policy signals is the continuing reduction in lending rates by many banks.



However, the practice of sub-BPLR lending (to preferred and larger clients), unchanged higher small savings rates, and the high cost of old deposits will continue to hold back banks from responding effectively to monetary policy signals.

Credit growth indicators appears to show that demand-pull inflation should not be a worry. As the RBI's weekly statistical statement released on October 23 says, bank credit growth fell to a 12 year low of 10.8% as on October 9, sharply down from 29.5% in the same period last year. Even assuming a pick-up in credit growth in the next few busy season months, the credit growth rate for 2009-10 is going to fall well short of the 23% for last fiscal, and even short of the RBI's revised figure of 18% for 2009-10. Further, private consumption spending shows no signs of picking up despite the recent lowering of lending rates. Interestingly, food credit has contracted so far this fiscal compared to last year.

Credit demand continues to remain subdued among both businesses and consumers. And interest rate hike expectations appear to have already taken hold of businesses. In expectation of higher interest rates, businesses have been trying to trim their bank loan liabilities and thereby ease their future interest costs.

However, in an encouraging sign and an indicator of the increasing breadth of the Indian financial markets, while bank credit growth remains subdued, normalcy appears to have been restored in the larger market for financing business investments. The buoyant equity markets have contributed substantially to this improvement. Businesses have been relying on non-bank sources - mutual fund redemptions, equity market placements, CP etc - to raise funds - raising Rs 1,21,158 Cr through corporate bonds and equities in April-August 2009, against Rs 41,270 Cr in the same period last year. However, many of these sources are unlikely to remain active once the investments parked in these instruments by businesses are drained off.



The uptick in inflation is driven by an increase in food prices, which are a manifestation of the supply-side constraints arising from the delayed and poor monsoon and global demand-supply imbalances. In any case, as the graphic below indicates, the volatility in headline weekly WPI-based inflation (as opposed to core inflation, which strips out the food and fuel components) cannot become the basis for any meaningful monetary policy decisions.



Raising rates will do little to achieve the objective of lowering foodgrain prices. They will require deploying a variety of other policy instruments, including increasing imports and more aggressive declogging of the social safety net delivery mechanisms. In so far as inflation is concerned, in a cost-push inflation scenario, monetary policy can at best help in anchoring inflationary expectations and preventing them getting embedded too deeply into the economy.

Inflation concerns (RBI expects inflation to be 6.5% by March 2010) alone cannot dictate interest rate decisions now. The RBI cannot afford to keep ignoring the substantial appreaciation (against the dollar) that rupee has undergone in the past few weeks and its impact on the competitiveness of Indian exports. The surge in capital inflows ($42 bn so far, against $9.1 bn for the entire last fiscal) into our equity markets over the past six months too has contributed to making the rupee dearer.



In the circumstances, any increase in rates now will only increase the inflows (a possible dollar carry trade) and the upward pressure on rupee. As a recent Financial Express op-ed explained, the RBI will be forced into making the Impossible Trinity trade-off if it has to maintain monetary policy autonomy.

The RBI Governor has recently stressed that the Bank remains committed to pursuing a three-pronged strategy of aiming at price stability, economic growth, and financial stability. The combination of a massive surge in capital inflows, a banking sector awash with liquidity and low interest rates are a recipe for resource mis-allocation and development of asset bubbles (as experienced by the equity markets since March and is beginning in the real estate market). In the circumstances, while balancing the need to keep the economy recovery intact without stoking off inflationary rpessures, it is also important that the RBI pay attention to financial market stability in its monetary policy decisions. The second quarterly credit policy review may be seen as a step in this direction.

Analyzing government corruption

Some time back Andrei Shleifer and Robert Vishny examined the dynamics of government corruption (they defined it as "sale by government officials of government property for personal gain") and found that weak governments which do not exert control over its institutions and processes leads to ultra-high corruption levels and that the illegality and secrecy associated with corruption made it more distortionary and costlier than taxation.

Shleifer and Vishny make the distinction between corruption without theft (as in the case when a driving license is issued by collecting a bribe, where the official actually turns over the official price of the good to the government even as he charges his bribe) and that with theft (as in the evasion of income tax, where the government gets nothing even as the official collects his bribe).

In another excellent analysis of corruption, Jakob Svensson describes public corruption as "the misuse of public office for private gain". He differentiates between corruption and rent-seeking, with the former being a straight resource transfer while the latter manifests as a private extraction of benefits (or rents) at the cost of the society, and arising from the opportunities created by government interventions.

Using a framework borrowed from the afore-mentioned lines of analyses, I will classify all government corruption and rent-seeking into four categories.

1. Public services delivery based corruption - Involves the collection of bribes to deliver individual goods and services, use or own public property or access civic utility services out-of-turn or at a cheaper rate, and use community assets without paying (or under-paying) for it. Examples include the payouts made to get certificates on birth, death, land ownership etc, documents like passports and driving licenses, utility services like water, electricity, and property tax assessments etc, and community assets (this is rare and consists of bribing officials and politicians to sanction such assets) like roads or community halls.

The demand for such services is almost perfectly inelastic, and most often the citizen applicants are left with no choice but to pay the bribes sought. The forced extraction of the bribes and its universal impact, indifferent of the citizens' ability to pay, means that this is the most inefficient form of corruption. Apart from the fact that it affects the most basic of government services which are universally accessed, individual officials exercise a near monopoly (the presence of single delivery/access channel, adds a monopoly dimension to its delivery) in the deliver of these services. The absence of competition and alternatives to access these services, coupled with the inevitable nature of its demand, implies that its impact on society is most debilitating.

This generally involves bribery without theft, in so far as the user charges are mandatory and the service issued without collecting them will fall outside the legal net and therefore become useless. To this extent, in simple terms, the citizen ends up paying more than what he is required to pay.

2. Revenue loss-based corruption - This arises from the government's power to levy and collect taxes and duties of various kinds so as to raise revenues to finance public expenditures. They include evasion of all kinds of taxes imposed by different levels of governments - property tax, sales and excise taxes, income and corporate taxes, and customs duties. This is an example of corruption with theft, with the government made to forego the revenues. This type of corruption imposes the heaviest economic cost and needs to be addressed with the firmest hand of the government

3. .Regulatory rents - They arise from the monopoly privilege of the government in issuing permissions for and imposing standards on certain activities. For example, permissions and licenses for starting and exiting businesses, approvals of building plans and land-use changes etc.

This is more a process of rent extraction than direct bribe-route corruption. Buildings get constructed without parking areas and following the mandatory set-back provisions. Real estate activity gets permitted in flood plains or public property. Industries get built and run without required environmental clearances or following required labor permits.

It imposes entry barriers, in so far as it results from the monpolist power of government officials in delaying or denying permissions or imposing restrictions on activities of citizens and businesses. However, it has also been argued that this corruption expedites processes ("lubricates the bureaucracy") and saves valuable time which would otherwise have been taken up by bureaucratic procedures.

4. Public works based rent-seeking - This works as a rent-seeking arrangement, where officials and politicians (and many others including the media) seek to extract their share from various government interventions like public works and government procurements. Subversion of the process of allotment of works or procurement of materials and dilution of quality in execution of works or the procurement of public goods and services are classic examples of this type of corruption. Robert Wade has documented how this rent-sharing chain works its way right up to the top of the administrative and political hierarchy and the inherent difficulty in eradicating it.

However, direct or indirect stakes (by political representatives) in contract works or procurements, is by itself not necessarily a bad outcome, provided the quality of work is not diluted. It can be argued that such involvement by the local political establishment in contracts, expedites the execution process and ensures faster delivery of projects. The savings from cost-over runs arising from delays itself is substantial enough to overlook the distortions resulting from such direct of indirect stakes. This has been explored at length in earlier posts here, here and here.

The "biophysical economics" arguement

Energy-centric "biophysical economics" is the latest in the series of inter-disciplinary invasions of the narrowly defined field of economics in the past few decades. Putting a doomsday spin to the "dismal science", they contradict the conventional wisdom of constant long-term economic growth, and argue that the diminishing supply of world's energy resources raises serious concerns about the "limits to growth" and the future of mankind.

Their arguement revolves around an "understanding that the survival of all living creatures is limited by the concept of energy return on investment (EROI) - that any living thing or living societies can survive only so long as they are capable of getting more net energy from any activity than they expend during the performance of that activity". This understanding is to be read with the Second Law of Thermodynamics, which postulates that all energy systems have a tendency to increase their entropy (or the state of disorder) rather than decrease it.

The most obvious battle-ground for the two is the debate about global energy reserves. While conventional economic theories see no limits to the availability of energy resources, and claim that at an appropriate market price (equal to the marginal cost of production) supply will always meet the demand. In contrast, echoing peak-oil (or peak-coal and peak-gas) hypothesis, bio-physical economists analyze historical production data, and claim that petroleum sector's EROI in the US has steadily declined from about 100-to-1 in 1930 (meaning one had to burn approximately 1 barrel of oil's worth of energy to get 100 barrels out of the ground) to less than 36-1 by the 1990s and further down to 19-to-1 by 2006.

Single stop and SHGs

This post is in continuation to the issued raised here about the need to revise our paradigm on Self Help Groups (SHGs) and widen their scope of activities by interventions like this.

I had blogged earlier about the activities of pioneering NGO, SingleStop USA, a poverty fighting startup, which seeks to "connect the working poor in New York with government funds and services intended for them". SHGs and their federations, with the required training and other support from government, could emulate the role of SingleStop USA and provide such one stop services on various issues to both its own members and others requiring such services. Here are a few possible areas of such intervention

1. Assist in accessing various available government welfare benefits. It is well acknowledged that one of the main obstacles to the effective delivery of welfare services to the poorest is the lack of awareness about the myriad welfare programs and schemes among the target groups. These exchanges can become one-stop facilitation centers for poor people to access all the benefits they are eligible for. These centers can help map an individual with the various benefits he or she is eligible to avail, help them fill up the applications and then get the benefits sanctioned and released.

2. Help poor people in getting sanctions, clearances, payment releases, mistake rectifications, and even information from government departments. Such agencies can volunteer to liaison with government departments and help the poor applicants access services and resolve their grievances.

3. Provide assistance with backward and forward linkages for those SHG members who have availed loans for opening new business or expanding an existing one. These agencies can help procure raw materials and intermediate goods at cheaper rates by bundling together the requirements of large numbers of buyers. They can also play an important role in linking up with potential buyers elsewhere and thereby maximize the returns to the SHG member. They can also be assisted with trainings on accounting practices and other specific business needs.

4. Match poor citizens, especially those with medical problems and requiring resources for educational purposes of children, with prospective donors and agencies, government and non-government, willing to support them financially.

5. Provide information and even tie-up educational scholarships and cheap loans for students seeking admission to professional courses.

6. Can provide legal and financial counselling to low-income families, especially those affected by some recent turmoil. Legal advice is valuable to such people in view of the problems faced by them with evictions, land disputes, criminal charges on family members, and so on.

7. Counselling and assistance in helping people addicted to drugs and alcohol. Social workers can also give help on issues including domestic violence and problems at school.

8. Co-ordinate with job placement agencies (and local maistries) to match the unemployed with prospective employers. The agency can establish contact with all the local hiring agents and supply workers to them. They can also provide career counselling.

9. These single stop agencies can maintain a comprehensive database of all its customers and use the same for providing more effectively targeted services to its members.

An agency similar to SingleStop, and located within each federation of SHGs in a block or tehsil, would go a long way towards improving the effectiveness of welfare programs by both facilitating access and improving the delivery mechanisms. It will also help leverage the opportunities available elsewhere to help those in need.

European sugar subsidies

Europe's Common Agriculture Policy (CAP), which lavishes mroe than 50 bn euros in subsidies, has for long been the embodiment of market distortions that marks much of government support for agriculture. Such subsidies, with its resultant market distortions, is glaringly evident in the case of sugar, where European domestic consumers have been paying roughly double the world market rate for almost two decades. The graphics below captures some of the distortions.

Starbucks and globalization

(HT: Marginal Revolution)

Status of dollar - an update

One of the biggest talking points in recent discussion about global economy has been the speculation about the dismal prospects for the US Dollar. However, such doomsday predictions may be premature and a more balanced assessment is required.

Since March, with uncertainty about the US economy, the dollar has been on a continuous decline against all the major currencies, except the Chinese renminbi.



The US Fed's loose money policy and swollen balance sheet, coupled with the ballooning government debt and record budget deficit, have only fuelled the speculation that the age of dollar as the dominant global reserve is over.



Conventional wisdom would have it that a declining dollar would put upward pressure on long term US Treasuries and widen the spreads on riskier dollar assets. However, bond market trends reflect the opposite, though the risk of a medium to longer term rise is yields looks possible.





Further, the US public debt (at 56% of GDP), while alarming in its rise, in absolute numbers, and in the share of short-term debt maturing in one year, appears to be on the lower side in comparison with that of other major economies, especially Japan.



And, thanks largely to the enormous size and credibility of its financial markets and economy (both of which will require some recurrances of the recent events to dissipate away) and the inherent advantage of having a domestic currency which is also the preferred global reserve currency, its sovereign bond rating remains as strong as ever. However, further slippages in public debt, beyond the 100% of GDP mark, could force ratings downgrades and raise the borrowing costs and debt-service burdens.



The one big concern for the US economy and dollar would have come from a possible rise in interest rates in the face of inflationary pressures. However, as Paul Krugman, has argued here, in all likelihood, deflation will be the much bigger concern for US policy makers and the need for raising interest rates looks remote.



The biggest plus from the declining dollar is that it would enable the US to bridge its trade deficits and thereby contribute, atleast partially, towards remedying the global macroeconomic imbalances. And indications are that the US trade deficit is shrinking in response to the depreciating dollar.



A weaker dollar is primarily a reflection of the weak US economy, especially in relation to the emerging economies. Further, given the ongoing recalibration of the global economic balance of power due to the stunning rise of the China-led emerging economies and the serious loss of credibility suffered by the US financial system from the sub-prime mortgage crisis, the dollar's decline from its preminence of the last fifty years was inevitable. Though it will remain the biggest global reserve currency, there will be much greater competition from the other major currencies in the years ahead.

Here too, the relative economic weakness of Euro zone and Japan, will leave a vacuum that may leave the forex markets in a state of flux for the foreseeable future. Interestingly, though dollar's share of global forex reserves fell to 63% in mid-2009 from 72% in 2001, most of it was due to decline in its value, not reduced demand. Ironically, a cheap dollar will incentivize Central Banks to buy more dollars in expectation of increase in domestic currency returns from dollar assets.

See this Economist article on the varied set of responses to the declining dollar from Japan, EU, China and other emerging economies. And Krugman points to another reason for having a depreciated dollar to remedy the global macroeconomic imbalances.

Update 1
Christian Broda, Piero Ghezzi, and Eduardo Levy-Yeyatiit claim that the dollar may strengthen in 2010 if the Federal Reserve exits quantitative easing sooner than its counterparts and the US economy enjoys a strong rebound.

Update 2
Paul Krugman points to the trend decline in the value of dollar since 2002, and feels that any CHinese dumping of dollar (or selling its Treasury holdings) would only mean that the Chinese do quantitative easing on behalf of the US.

India's China policy should move beyond the traditional paradigm

Even as public opinion in India gets driven into a crescendo over Chinese incursions into Arunachal Pradesh and its aggressive comments at the Prime Minister's visit to the state, and India's loud protestations, a more immediately damaging event may be unfolding on the trade front in the form of ballooning Chinese trade surplus with India.

I feel that the border dispute, while being important, is more a red-herring, a mis-guided (because it sustains and amplifies China's aggressive and not-so-pleasant external image that will surely block its entry into the leadership platform of the "modern democratic" world) Chinese habit (whether it is deliberate and part of a larger plan or a legacy of history and China's internal politics is a matter of debate) of keeping the borders with all its neighbours unproductively active. It would be unfortunate and playing straight into Chinese hands, if we fritter away our scarce energies and resources to match the Chinese rhetoric and build up our military arsenal strength to match the Chinese, and in the process overlook more urgent and important issues.

The immediate and more important concern for the world with China is not its aggressive foreign policy posturing. The real problem is its obsession with keeping the renminbi under-valued, so as to keep its exports competitive, and its refusal to take pro-active steps to address the massive global macroeconomic imbalances that contributed to triggering off the sub-prime crisis and the resultant economic recession. Given the profile of Chinese trade, a policy to keep the Chinese currency under-valued adversely affects other developing countries, especially given the global recession and slump in global aggregate demand, by keeping out their exports to China, pricing out their exports elsewhere (to developed economy markets), and making their domestic markets a dumping ground for cheap Chinese exports.

The under-valued renminmbi is an effective import tariff cum export subsidy, and therefore a back-door attempt to subvert the spirit of the World Trade Organization and principles governing global trade. In plain language, shorn of all trade jargon, it is the "mother of all protectionist policies"!

In the context, taking a leaf out of the Chinese foreign policy book, with its efforts to keep India's foreign policy establishment busy with neighbourhood politics (Pakistan, Arunachal border issue, and even support for Maoist insurgencies), it may be prudent long term strategy to align with the US on issues like the currency manipulation and international macroeconomic imbalances to keep the Chinese on the economic backfoot. India (and its influential opinion makers across the world) should play a more subtle role in exposing China's duplicity in pretending to assist in the development of poorer countries of the world, like in Africa, even as it keeps its currency over-valued and thereby harming their domestic economy and long-term economic growth prospects.

India should play its role in making China's conscious beggar-thy-neighbour policy more salient in international foreign policy debates and thereby lock China's government into fending off this charge. The near universal adverse impact of China's currency policy and suppressed domestic demand would make this a powerful and damaging challenge for the Chinese government. And in the process, it would also highlight attention on one of the most important global economic challenges - restructuring global macroeconomic imbalances - in the coming years.

Lord Palmerston famously said, "nations have no permanent friends or allies, they only have permanent interests". Following this acknowledged lesson in realpolitik, India should seek to go beyond the traditional paradigms of Hindi-Chini bhai bhai and evolve a more multi-dimensional approach in its China policy. While acknowledging the shared interests as developing countries and the persisting border dispute, we should seek to build issue-specific positions (that may conflict or agree with the respective Chinese positions) on issues that impinge on our national interests.

On a substantive note, I am not so much concerned with the arguement about cheap Chinese exports destroying our industry as with China's policy to keep the renminbi artificially undervalued and thereby effectively pursue a beggar-thy-neighbour policy.



The contribution of the artificially weak renminbi towards subsidizing Chinese exports and taxing Indian imports should be of concern to India, not only in our bilateral trade but also in the larger competition in global trade.

Stocks Vs Bonds

Contrary to conventional wisdom, which gives the impression that stocks being riskier yield greater returns in the short run, the graphic below appears to clearly show that it is only in the much longer run that stocks score over bonds.



As the Times reports, "the stock market underperformed important bond categories over the 10 years through September — with an annualized loss of 0.2 percent for the Standard & Poor’s 500-stock index, versus annualized gains of 8.1 percent for long-term government bonds and of 7.8 percent for long-term corporate bonds". The trend reverses only for investments of 30 years and more only.

However, ironically enough, the recent decade of weakness in the equity markets, also means (thanks to the law of averages) that the equity markets may be in for good times in the coming decade. As Prof Jeremy Siegel says, "Historically, whenever you’ve had long periods when bonds outperform stocks, that sets up an excellent time to invest in stocks. So looking forward, things look very favorable for stocks and not favorable for bonds, certainly not Treasury bonds."

Poverty Reduction in India, China and Brazil

In a World Bank working paper comparing poverty reduction efforts across China, Brazil and India, Martin Ravallion finds that the Chinese success, while substantial is characterized by rising inequality, whereas India, while being more successful in economic growth than Brazil, has been the poorest in achieving poverty reduction outcomes.





He attributes China's greater success to "growth promoting policies" and the "relatively low inequality in access to productive inputs (land and human capital), which meant that the poor were able to share more fully in the gains from growth". The high initial inequality in Brazil retarded both economic growth and constrained more widespread sharing of the benefits of economic growth. However, in the past two decades, it has been successful in poverty reduction due to "its greater macroeconomic stability" and "more effective and pro-poor social policies". As Prof Ravallion writes,

"Combining China’s growth-promoting policies with Brazil’s social policies would surely be a good formula for any country".

Prof Ravallion feels that India's income inequality (as opposed to consumption inequality which is low) and more damagingly its human development inequality have come in the way of more effective access to opportunities and sharing of the benefits of the economic growth, especially non-farm rural growth.

Interestingly, he argues that the secondary (industrial) sector played a less important direct role in poverty reduction in all three countries. In China, the growth in the output of the primary sector (mainly agriculture) was the main driving force in poverty reduction, whereas in Brazil and India, the tertiary (services) sector was more important.

He also finds that "Brazil (since the mid-1990s) and India (going back to the 1970s) have clearly been more aggressive than China in their efforts to attack poverty through direct interventions, such as using (conditional or unconditional) transfers".

Like the other studies on poverty reduction, Prof Ravallion also stresses on the importance of delivering better education and health care to India's poor (and thereby address the human development inequality), so as to equip them to "participate more fully from the opportunities unleashed" by economic growth.

Prof Ravallion concludes with two parameters to assess the relative success with poverty reduction in these three countries - pro-poor growth and pro-poor social policies. He writes,

"China clearly scores well on the pro-poor growth side of the card, but neither Brazil nor India do; in Brazil’s case for lack of growth and in India’s case for lack of poverty-reducing growth. Brazil scores well on the social policies side, but China and India do not; in China’s case, progress has been slow in implementing new social policies more relevant to the new market economy (despite historical advantages in this area, inherited from the past regime) and in India’s case, the bigger problem has been the extent of capture of the many existing policies by non-poor groups."

Update

Martin Ravallion mailed me his response to Matt Berkely's comment

"Matt Berkley’s (cryptic) concerns appear to be baseless. If he had consulted the source paper, he would have found out that all the inter-temporal poverty comparisons being made in the study in question are real, i.e., they are assessed by deflating standard (comprehensive) measures of nominal spending or income by the most appropriate price indices available (including food prices, but not just food, since even poor people do not consume food alone)."

Income transparency and nudging on payment of taxes

One of the most effective nudges to get people to pay taxes (of all kinds) is to make public and disseminate widely their annual incomes, tax assessments, and their actual tax payments.

In this context, Norway shows the way, by becoming the first country to make public the official records - "skatteliste" or "tax list" for 2008 - showing the annual income, overall wealth, and tax assessment of nearly every taxpayer in the Scandinavian country. While Norway may not have a major problem with tax evasion and the tax list may be aimed at increasing transparency, such public disclosures may be more effective in countries like India, where tax (income, corporate, property and other local taxes) evasion and payment default is rampant.

Update 1 (12/3/2010)
See this on the impact of shaming campaigns acrosz US to nudge people into paying their taxes.

Nudging on climate friendly food

Swedish companies have started labelling farm produce with its carbon foot-print to illustrate the impact of its production of distribution, and thereby "nudge" consumers into choosing more climate-friendly food products.



It is estimated (a 2005 study by Sweden’s national environmental agency) that about 25% of the emissions produced by people in industrialized nations can be traced to the food they eat. The Swedish government have already in place regulations that seek to provide preferential treatment or impose regulatory conditions to promote such food products. Don't be surprised if, after suggestions for an obesity tax, proposals for a climate change tax on food products, based on their carbon footprint, gathers steam!

Climate Change consensus

My Mint op-ed on climate change challenge is available here.

Costs of greenhouse gas emission reductions

The build-up to the much awaited UN Convention on Climate Change at Copenhagen in December has re-ignited with much greater vigour, the classic debate between those who feel that emission reduction policies will impose unacceptable burdens on economic growth and those who feel that countries can cut emission without hurting economic growth. In a Wall Street Journal Report on Environment, Steven Hayward makes the case that carbon energy use is central to the world economic prospects and emission reductions are too expensive, while Robert Stavins argues that gradual reductions are both possible and affordable. Paul Krugman has elaborated on why the costs of achieving emission reductions are not as scary as opponents project and very much affordable.

Though I am inclined to side with Professors Stavins and Krugman, there are important issues to be addressed before developing countries like India can take the plunge and embrace the emission reductions bandwagon.

While it is true that developed economies have been responsible for most of the damage inflicted on the environment by way of carbon emissions, it cannot be denied that it is only a matter of time before the rapidly growing emerging economies catch up. In the circumstances, if is a foregone conclusion that the developing countries have to be active partners in any effort to control greenhouse gas emissions. The only question remains what should be the extent of their initial commitments.

Though carbon taxes, emission fees, cap-and-trade in emission permits coupled with carbon off-sets, and carbon sequestration are the favored means of emission reductions, there are sharp differences among experts about their relative effectiveness.



Recently, the US House of Representatives passed the Waxman Markey Bill, HR 2454, on climate change that seeks to cut emissions to 80% below 2005 levels by 2050 by following a cap-and-trade regime. The emission allowances, which would start with more liberal allocations, would grow tighter over the years, pushing up the price of emissions and presumably driving industry to find cleaner ways of making energy. The reduction target envisaged would seek to stabilize atmospheric concentrations at 450 ppm in CO2 equivalent terms, as against the growth trend of potentially catastrophic (would lead to rise in temperature of atleast 6 degrees Celsius and output loss worth 2-5% of global GDP every year) 1000 ppm by the end of the century.

Formidable as they are, these targets are not as insurmountable as they appear. For a start, Prof Stavins points to the fact that "from 1990 to 2007, while world emissions rose 38%, world economic growth soared 75% — emissions per unit of economic activity fell by more than 20%". Interestingly, this was despite the fact that most of the economic growth during this time, especially in China and emerging Asia, was environmentally irresponsible and damaging.

Prof Stavins advocates internationally co-ordinated efforts at emission reductions and immediate action to move towards cleaner technologies in the newer plants and activities in energy intensive industrial activity and power generation. The public good nature of such reductions, in so far as the costs are borne by the emission reducing industry while benefits are diffused across the society, means that no one country will come forward to incur the costs of emission reductions with reciprocating efforts from all others. And, since plants built today will determine emissions for a generation, there is need for immediate action to adopt clean technologies for the new plants in high emission industrial sectors - steel, cement and manufacturing plants - and power generators.

The effectiveness of cap and trade, especially on the monitoring of adherence to the emission reduction targets, has been the subject of some controversy. Both the EU ETS and the US emissions reporting have been the target of attacks on these grounds. Apart from the initial problem of arriving at the most efficient allocation of allowances (permissible emissions) among emitters, there is the much bigger challenge of monitoring emission reductions. This becomes an all the more greater challenge in developing countries where even enforcement of basic environmental safeguards are doubtful. Therefore, any emission reduction trade, involving the sale of emission reduction commitments by industries in developing countries, will be extremely difficult to monitor.

Also, cap-and-trade regimes are vulnerable to mis-directed subsidies. Under this, projects in developing countries, which use clean technologies and practices, become eligible to avail Certified Emission Reduction (CER) permits, which can then be sold in exchanges like the EU's Emission Trading System (ETS) to those who have exceeded their emission allocations. In other words, the ETS ends up subsidizing such projects. The problem with this arrangement is that it fails to discriminate between those green projects which require these subsidies (to incentivize the developers to adopt clean technologies, like say a scientific landfill) and those which would have any way come up on its own.

Further, global co-ordination of policies, at best a very difficult and complex challenge, may be even more difficult to achieve with a complicated cap-and-trade regime. In view of the vast variations among nations in their respective stages of economic development and costs of emission reductions, it is impossible to have a uniform policy on initial emission allowances and targets for reductions. In the circumstances, carbon taxes emerge as an effective and more practical approach towards emission reductions. It is both easier to co-ordinate such policies across nations and effectively implement and monitor their compliance. And also, carbon taxes generates revenues for the government, which in turn can be used to fund the research and development efforts to develop cleaner technologies.

There are two suggestions on the way forward. Since the primary requirement for emission reductions is the use of cleaner and environment friendly technologies, it is imperative that the access barriers to these technologies are lowered. This means that, for example, emissions generating steel or cement or power plants being set up across the world have access to these cleaner technologies. In other words, these technologies should become some sort of public good, made readily available for all such investments across the world. This presents an opportunity for the developed countries to assuage and overcome the deep suspicion among developing countries to binding emission targets.

The Economist points to a suggestion by the World Economic Forum about how private investments from developed countries in green technologies in developing countries could be protected against currency and political risk. It proposes that development banks — the World Bank or regional ones like the Asian Development Bank — would use public funds from the rich world to guarantee investors against these sorts of country risks. There are also proposals for government-guaranteed bonds for climate-related investment, as well as more direct public support for specific green funds, in the form of loss-sharing agreements and debt guarantees.

It is therefore appropriate that the developed economies, being responsible for most of the greenhouse gas emissions and damage inflicted on the environment, finance the development of clean technologies in industrial activity, manufacturing, transportation and other carbon emitting activities and share them with developing countries. A global clean technologies exchange can be established under the aegis of the UN Framework for Climate Change (UNFCC) which can collect such knowledge from across developed world. This exchange can purchase such technologies from private firms and developers on payment of a mutually beneficial and negotiated royalty.

In order to ensure that the costs of the transition are staggered over the entire transition period and thereby made affordable for all the stakeholders, it may be more effective to declare up-front gradually tightening emission standards on various emission sources like automobile, construction and industrial activities. This would save firms and investors the uncertainty and steep costs associated with sudden and one-time interventions and policy changes. This would also go a long way towards easing the opposition to emission reduction targets arising from the fear that it would impose unacceptably high costs on the economy.

Mostly Economics points attention to an speech by William Nordhaus who too feels that a "harmonized international carbon tax is likely to be a more effective" instrument to address climate change. Paul Krugman has this excellent post (and this) explaining why cap-and-trade keeps the Harberger triangles small and the net economic benefits to the society at large are considerable. See this Times article outlining the problems associated with calculating carbon emissions.

Update 1
Ed Glaeser feels that China and India holds the key on climate change reduction efforts.

Update 2
Under the Kyoto Protocol, members of the EU-15 had agreed to cut their greenhouse-gas emissions 8 percent below 1990 levels by 2012, and to get there, the EU set up its Emissions Trading System, which first got underway in 2005. Now, the EU-15, on the whole, is expected to cut emissions 13% (and 8.5% excluding all suspect measures in allowance allocations etc) below 1990 levels by 2012 just through existing and planned energy measures — including the cap-and-trade system. According to new data from the European Environment Agency (EEA), all of the EU-15 members except Austria are now on track to exceed their Kyoto obligations. See also this graphic from Economist



Update 2
Arvind Subramanian and Nancy Birdsall advocates that the developed countries abandon, or at least postpone, the primacy accorded to emissions reduction targets by developing countries, and help them obtain those at the lowest possible cost in the greenest possible way. In return, China, India and other developing countries should adopt, and be encouraged to adopt, internationally verifiable national targets for emissions-intensity, which could also be the basis for technology and other transfers from industrial to developing countries.

Elinor Ostrom and decentralized governance

In the aftermath of Elinor Ostrom winning the Nobel Prize in Economics for studying issues relating to economic governance (resource allocation issues) of the commons, there have been a number of commentaries claiming her theories as a vindication of the decentralized and traditional governance approaches to managing community resources. However, such sweeping generalization and reliance on community-based decision making does not do justice to Prof. Ostrom's work and is a gross simplification of complex socio-economic and socio-political challanges in addressing such issues.

It is undoubtedly true that, absent institutional constraints and transaction costs, community management of resources like canal water for irrigation, forest resources, and even common civic assets is the most fair, economically efficient, and sustainable means of managing such resources. However, in many developing countries where effective management of such common resources is a major challenge, the socio-political environments are riddled with institutional constraints and substantial transaction costs.

Further, many of the traditional governance arrangements are driven by unfair and inequitable decision making structures, most often dominated by kinship and ethnic loyalties. As Gadde Swarup pointed out in one of the comments, "some of the laws of common resource governance has caste elements in it (like fishing, temples etc) and these implicit understandings of the past may not be desirable or viable now".

In the very recent past, many Indian states like Andhra Pradesh have experimented extensively with the community management model for common resources and assets and even delivery of public services. Accordingly, utilization of irrigation water and forest products; management of schools, health sub-centers, and anaganwadi centers; maintenance of village drinking water schemes etc, were all handed over to the local community stakeholders. However, the results have not been very encouraging, and many of these internventions have subsequently been abandoned or scaled back. Admittedly, many of these decisions were with constraints attached (eg. no control over teachers) and with a thin veneer of democracy (elections to select the monitoring group etc) that may not have been conducive to the local socio-political environment.

The cap and trade Vs carbon taxes debate revisited

Outside the mainstream of economic policy making, dominated as it is by the more glamorous issues like financial market regulation and macroeconomic policy making, one of the biggest areas of ideological and academic divide is over policies on greenhouse gas emissions reductions to address the climate change challenge. While everyone agrees that fundamental to addressing this issue is raising the price of carbon and ensuring universal participation, there is a sharp divide over which of the two alternatives - cap-and-trade and carbon taxes - is superior.

One group of environmental economists, led by the likes of Robert Stavins of Harvard, favor cap-and-trade, while the other group, led by William Nordhaus of Yale, pump for globally harmonized carbon taxes to combat carbon emissions. While conceding the relative superiority of cap-and-trade on grounds of economic efficiency, this blog has consistently argued in favor of carbon taxes as a superior alternative, only on the basis of its ease of administration and implementation. The fact that any meaningful emission reduction plan has to involve all the countries of the world, gives added importance to harmonization of policies across nations. Carbon content based taxes may be easier to harmonize than cap-and-trade.

This debate also carries relevance on a deeper public policy making canvas, on the issue of trade-off between policies which generate the greatest economic efficiency but face implementation challenges on the one hand, and those that are slightly less efficient but are easier to implement on the other hand. Cap-and-trade appears to be belonging to the former camp while carbon taxes to the latter.

Cap-and-trade permits those who can reduce their emissions at the least cost to sell their saved carbon credits (or certified emission reductions, CERs) to those facing higher marginal costs, and thereby achieves economic efficiency - lowest cost and least distortions. Unlike any other form of emission reduction policy, as Robert Stavins points out, cap-and-trade differentiates among emission sources and confers a compliance flexibility which can be used to cut emissions at the lowest cost.

The economics of both are captured in the two graphs below. First, Paul Krugman models the deadweight loss to emitting businesses and the economic benefits to both emitters and consumers of their products.



The carbon tax imposes a deadweight loss indicated by the red triangle.



Here is a list of possible implementation problems associated with cap-and-trade that can come in the way of achieving the desirable objectives.

1. Difficulty in selection of projects eligible for issuance of carbon credits by the UNFCC. Projects which use clean technologies or those which reduce greenhouse gas emissions cannot become the sole criterion, since there are many such projects which would in any case have come up because of their lower life-cycle costs. Even these projects now become eligible for carbon credits and the resultant subsidy.

To take just one example, all solid waste management projects or lighting energy saving projects, which would have come up in any case, are now eligible for carbon credits. These CERs are a straight subsidy to these projects. The only reason why there has not bee a flood of such projects from developing countries is lack of awareness and the bureaucratic barriers to entry (hiring of consultant, host government certification, and then approval by the UNFCC, and then finding a buyer).

2. In developing countries, where adherence to even basic and visible environmental safeguards are at a premium, it may be extremely difficult, well-neigh impossible, to monitor greenhouse gas emissions. Therefore, it will be difficult to monitor the compliance of projects eligible to sell carbon credits. And enforcement will be an even bigger challenge.

3. National governments, especially from developing countries, have a greater incentive in imposing carbon taxes, in view of its assured revenue stream, whereas the cap-and-trade regime, will provide any substantial revenues only many years latter.

4. Increasingly, CER sales have become an important source of financing such projects. In fact, they have become a sort of viability gap funding source for these projects. In other words, project promoters see CERs as part of a project financing option and less part of an emission reduction plan. This results in incentive distortions by way of efforts to game the achievement of emission targets.

Further, the market volatility associated with the prices of CERs leads to uncertainty in revenue streams for these projects and increases the risks associated with them.

5. National governments in many developing countries cannot be relied upon to effectively administer a cap-and-trade regime. Such regulatory interventions are likely to spawn corruption and defeat the purpose. An international bureaucracy can be of limited utility in monitoring adherence to standards which require invasive inspections.

6. The politics of formulating an internationally acceptable cap-and-trade regime may make it a non-starter. How do we harmonize cap-and-trade policies across nations states - the emission reduction targets, initial allocations of emission allowances and the details of tightening standards? Will the old bogey of "why should we pay for the costs of your pollution with our economic prospects" not derail any effort to impose meaningful emission caps?

7. Cap-and-trade does not address emissions from sectors like transportation and usage of electronic devices. Transportation in particular is an increasingly dominant source of greenhouse gas emissions and cannot be kept out of the ambit of any serious policy proposal to reduce greenhouse gas emissions.

8. In developing countries, the politics and lobbying surrounding the issue will ensure that the initial allocations will be very liberal and the standards will be kept deliberately loose to minimize the costs on the domestic industries.

Prof Stavins may be right in claiming that "the best (and most likely) approach for the short to medium term in the United States is a cap-and-trade system", where the monitoring and enforcement costs may be manageable. However, if we are looking at an internationally applicable uniform policy for lowering emissions, then carbon tax looks more attractive for all the aforementioned issues of the real world.

It may also be possible to have an international climate change policy that draws both approaches and standardizes them to arrive at an acceptable mix of emission reduction policies. And as this Hamilton Project paper, pointed out by Prof Stavins, indicates, governments should be presented with both alternatives, and left to choose that policy option which generates the least political opposition and which imposes the least short and medium-term costs on the economy (or that which has the least painful transition costs).

Update 1
See this graphical analysis of the Waxman Markey Bill's cap and trade proposals.

Update 2
See this chronological sequence of the evolution of the concept of cap-and-trade.

Update 3 (18/6/2010)

Report on the success of the 1990 Clean Air Act Amendments in the US to contain sulphur-di-oxide emissions from coal-fired power plants that caused acid rain. See also this video on cap-and-trade and this article on the Climate Change Bill before US Congress.

Update 4 (22/6/2010)

Free Exchange lays out the case here and here for carbon taxes over cap-and-trade.

China's dollar reserves dilemma

China's massive accumulation of dollar reserves, now more than $2 trillion, has been the focus of much attention and speculation abouts its possible impact on the world economy. The expanding trade surplus coupled with the Chinese Central Bank's dollar purchases to keep the renminbi from appreciating have contributed to this accumulation of reserves.



Chastened by the bitter experience of the East Asian currency crisis of late nineties and in the absence of sufficient depth in the dometic capital markets, the Chinese Central Bank has preferred to plough these massive reserves into the safety and liquidity of US Treasuries, despite their relatively meager returns. However, this massive dollar reserves have become a major source of concern for the Chinese, especially in view of the cloud hanging over the fortunes of the US Dollar. To re-phrase the old adage, this massive Chinese loan to finance America's deficits is now more China's problem than America's!

With the renminbi tied to the dollar, China remains stuck with these dollar investments. If they exit now, apart from the problem of finding appropriate alternative investment avenues, they also run the risk of unleashing a downward spiral in these markets thereby bringing the value of their investments crashing down. Repatriation of capital on such large scale would also bring deep instability to the forex markets.

Paul Krugman makes the interesting point that any Chinese recalibration of portfolio from US Treasuries into other currency holdings (say, Euro or Yen) "would, in effect, be engaging in quantitative easing (QE) on behalf of the Fed" and "doing the Europeans and Japanese a lot of harm"! The classic QE would consist of the Fed selling Treasury bills, while buying other assets (mortgage-backed securities; securities backed by credit-card debt; longer-term government debt etc), and expanding its balance sheet enormously in the process. Now instead of the Fed, the Chinese would be indulging in QE by selling US Treasuries. And the flight of such huge quantity of capital over a short time from dollar into another currency would certainly put upward pressure on it.

Paul Krugman argues that China's weak currency, beggar-thy-neighbour policy is "siphoning some of that inadequate demand away from other nations, which is hurting growth almost everywhere".

Update 1
The Peterson Institute estimates (pdf here) that the renminbi is 40% under-valued against the dollar. Simon Johnson also points to the proposect facing forex speculators - the inevitability of renminbi rising against the dollar, coupled with the low interest rates in US and China's rapid rates of growth, means that capital inflows into China and long positions in renminmbi assets are a one-way bet!

Update 2
Martin Feldstein too argues in favor of CHina letting the renminbi rise in value to redress the global macroeconomic imbalances.

Another bubble blows up - regulators should stand up

Economists advocating tightening of monetary policy and ending the period of cheap money, besides opposing any more stimulus spending, base their claims on the burgeoning government deficits that could unleash inflationary pressures. While the merits of this claim is debatable, there is another way in which the cheap money could be harming the economy - by generating mis-allocation of resources into the financial markets and blowing up asset bubbles.

Just as the capital markets were overlooked by the mainstream academia and policymakers in the build-up of the sub-prime mortgage bubble, it may be that the same mistake is being repeated with the present bull run in equity markets across the world. Whereas every major indicator of economic growth show at best the initial stirrings of a recovery, the financial markets have been galloping on an upward incline, threatening to inflate another asset bubble.

It is clear that even as the credit markets remain constrained despite the banking sector being awash with liquidity, the excess liquidity is finding its way into the financial markets. The unconventional monetary policy actions like quantitative easing, dilution of lending standards, government debt guarantees, etc, have had the effect of creating a "wealth effect" among financial institutions that has in turn found its outlet in the capital markets.

In an excellent article in FT, Wolfgang Munchau points to two equity market metrics - Cape (invented by Robert Shiller), which stands for the cyclically adjusted price/earnings ratio and measures the 10-year moving average of the inflation-adjusted p/e ratio, and Tobin Q, a metric of market capitalisation divided by net worth - both of which agree that US equity markets are overvalued by some 35-40%. Further, in another indication of froth returning to the financial markets, home prices have been making a surprising rebound, even as foreclosures show no signs of easing off.

Munchau, like a growing number of economists, attribute this asset market rally to the cheap money policy being pursued by the Fed to support the recession-hit and slowly recovering economy. The Fed has been unwilling to raise rates for fear of nipping out the nascent "green shoots" of economic recovery. He therefore predicts a period of dangerous tight-rope walking and inevitable economic instability,

"Once perceptions of rising inflation return, central banks might be forced to switch towards a much more aggressive monetary policy relatively quickly – much quicker than during the previous cycle. A short inflationary boom could be followed by another recession, another banking crisis, and perhaps deflation. We should not see inflation and deflation as opposite scenarios, but as sequential ones. We could be in for a period of extreme price instability, in both directions, as central banks lose control...

Our present situation can give rise to two scenarios – or some combination of the two. The first is that central banks start exiting at some point in 2010, triggering another fall in the prices of risky assets. In the UK, for example, any return to a normal monetary policy will almost inevitably imply another fall in the housing market, which is currently propped up by ultra-cheap mortgages. Alternatively, central banks might prioritise financial stability over price stability and keep the monetary floodgates open for as long as possible. This, I believe, would cause the mother of all financial market crises – a bond market crash – to be followed by depression and deflation."

All this comes even as an intense debate rages on about the inadequacy of modern macroeconomic models to account for capital market events in predicting or explaining macroeconomic events and outcomes. Further, the events of the last eighteen months have spotlighted attention on the need for Central Banks to look beyond mere aggregate price levels and focus on financial asset price trends while formulating monetary policy. Financial market stability has assumed equal importance alongside economic stability in interest rate decisions. And it now appears that both these objective may be in conflict at this point in time, when the economy is poised on recovery path after a deep recession and the financial markets indicate a bubble blowing up.

The difficulty with raising interest rates leaves the Central Banks to focus attention on rolling back some of the uncoventional policy responses which may have had the effect of generating the "wealth effect" among financial isntitutions and channeling funds into the capital markets. However, this is a difficult balancing act and would require judgement calls that would require making trade-offs between the relative impacts on the real economy and financial markets. Apart from adversely affecting economic activity, any event (not just direct rate hikes) that would put an upward pressure on interest rates now could devastate the weak balance sheets of a majority of the banks and a large portion of mortgages, both of whom are effectively surviving by clutching on to the sliver of hope provided by the ultra-low interest rates.

However, many emerging economies like India, whose banking sectors have been relatively unaffected by housing mortgage and derivative based on them, and who are also experiencing the same twin dilemma of containing an equity market bubble without nipping off the first signs of economic recovery, may have some room to manouver with their monetary policy. They can rein in the non-interest rate instruments of expansionary policy without adversely affecting the financial markets. Thus the Reserve Bnak of India could slowly drain off the excess liquidity by raising the various mandatory provisions like the CRR and SLR, so as to shrink the excess bank reserves which are presently finding its way into the capital markets, either directly or indirectly.

It is in this context that aggressive and intrusive financial market regulation to prevent the build up of firm-specific and systemic risks assumes great significance. It is now very clear that a massive resource mis-allocation is underway into the capital markets. The conventional policy instruments to control such situations have become ineffectual due to the specific economic conditions being faced. In the circumstances, there is no alternative but for the regulators to step in and exert the regulatory hand to contain the unrestrained build-up of asset bubbles. Unfortunately, governments across the world do not appear to have the stomach for any such adventurism. The lessons of the past few months appear not to have been learnt.

Global agriculture graphs

Two excellent graphics, comparing the cereal yields per hectare and percapita cereal production, shows that, despite Green Revolution, India has been, in most charitable terms, a laggard.

Even Bangladesh appears to have done far better than us in both counts - productivity and total production. Interestingly, the biggest productivity improvements in India have come in the last two decades and not during the green revolution decades of 60s to 80s. Does this mean that the Green Revolution era increases in agriculture production were mostly due to increase in acreage (due to more land being brought under cultivation and increase in irrigation - do figures bear it out?) than improved productivity?

More on vouchers and school choice

I have blogged earlier about the utility of vouchers as a means to promote school choice for students and thereby increase competition among schools and improve educational standards. Economists like Gary Becker have claimed that vouchers are more efficient and effective alternative to subsidized public schools. Karthik Muralidharan has this excellent articulation of the effectiveness of the voucher program in improving educational outcomes.

However, evidence from the evaluations of school voucher programs in Latin America suggests that the verdict is far from conclusive. Further, it can also be argued that school choice and vouchers, while improving choice for children, is less likely to improve the general educational standards.

Theoretical analysis of social and public interventions by governments, with its defined set of various logically consistent outcomes, will tend to exclude those outcomes that are an unpredictable (or unexpectedly emergent) result of the multi-dimensional interaction between the myriad agents, institutions, and the larger environment. There are far too many factors (to always accurately factor in), whose complex interaction unleashes unpredictable dynamics that tend to deflect outcomes from those expected or forecast.

In the case of voucher interventions, it may be too facile to assume that once we provide choice, parents - rich and poor - will send their children to the better schools (private or public) and in the process incentivize schools to remain competitive and also have a mix of rich and poor children. This works on the assumption that parents school choice decision is a function of only school quality (defined mainly by student performance records) and affordability (in terms of fees) is the only constraint facing them.

However, in practice it has been found that there are a myriad other constraints facing parents when they make school-choice decisions. For example, some of the commonest entry barriers to private schools, faced by children from poor families include large and unaffordable expenditures on school uniforms and books, extra-curricular activities and so on. Then there are the institutionalized social and cultural constraints associated with studying in such environments, that are more debilitating on children from underprivileged families. Geography, in so far as the good private schools are likely to be situated closer to or within richer areas and away from the poorer areas, may also play an important role in determining school choice.

These socio-economic environment specific constraints exhibit varying strengths, which in turn plays a crucial role in determining outcomes. In the real world, they can even dwarf the beneficial effects of school choice. Here is just one illustration of how these factors interact to produce sub-optimal or even adverse consequences.

In an environment where government schools are impervious to competitive pressures (say teachers have assured employment and schools cannot be closed down) and where societal forces (say, caste or religion) exert considerable influence, vouchers may achieve limited success and could even be detrimental. It could end up "crowding out" the best and brightest among the poor children in the locality away from the government schools and into the private school, thereby depriving these government schools off the valuable positive externalities generated from the presence of these children. (Note: In case of these children, some of the aforementioned constraints are overcome through scholarships, the positive externalities enjoyed by the private school due to their presence etc).

The government school would therefore be deprived off its best talents and the resultant positive externalities on the remaining children. In the circumstances, the vouchers could end up making private schools more competitive and leave the government schools even more impoverished. The private school, by attracting the best talent, becomes even more segregated (performance-wise) from the government schools, and a two-track schooling system, with even greater outcome disparity, emerges.

The result is that the final outcomes mirror the different versions of Schelling's chessboard experiment, with its distinct pattern of segregation. The good private schools will end up cherry-picking from the full range of students, rich and poor, and thereby benefit from the presence of good students and good teachers, while the government schools, especially in the poorer areas, will be left with the remaining students.

The aforementioned example is yet another instance of market failure that leads to outcomes that lets efficiency trump over fairness. In the process of allocating schools based on individual choice, it is presumed that the most efficient set of outcomes emerge. However, this efficiency overlooks the strong possibility of unfairness in the emergent outcome, an eventuality which often leaves government schools and its students short-changed.

All this does not mean that vouchers are ineffective, but only highlights the importance of socio-economic constraints that play a vital role in determining the final outcomes. It is therefore important that the socio-political and economic environment in which vouchers are implemented is carefully analysed and factored into any such policy decision. In other words, vouchers require a complementary set of policies for their success.

As I have blogged earlier, urban areas, with its more competitive government schools, smaller geographical limitations, favorable communal and racial mixtures, and much larger spectrum of choice, are a more likely context for successful implementation school vouchers. The costs associated with the possible failure of a voucher program (in improving standards in government schools) is far smaller in urban environments than in rural areas.