Managing the Impossible Trinity

I had blogged earlier about the challenges faced in managing the impossible trinity - the impossibility of simultaneously having capital mobility coupled with stable (fixed or an adjustable peg) exchange rates and interest rate autonomy.

The increasingly inter-twined nature of the financial markets and the economy and the rapid global financial market integration over the past two decades poses formidable challenges to Central Banks in managing their monetary policies and the external sector. This challenge is amplified in case of emerging economies where Central Banks do not enjoy the same level of credibility among market participants and the transmission channels for various monetary policy signals remain heavily clogged.

Unlike Central Banks in many developed economies which have, atleast till recently, been more or less focussed on managing price stability and controlling inflation, Central Banks in emerging economies shoulder the additional responsibility of promoting economic growth. But these two objectives occasionally appear to conflict, especially when inflation rears its head as the economy shows signs of overheating, forcing the central bank to step in to tighten policy rates and cool the economy. This often goes against the wishes of their political masters.

The trend of massive foreign capital inflows, with the attendant risk of sudden capital flight, is another risk that has to be carefully managed by these Central Banks. Rapid surges in capital inflows, most often the result of global economic momentum shifts, unsettles the real exchange rate and also the current account balances. On the one hand these capital inflows boost the local equity market, brings in Foreign Direct Investments (FDI) and external commercial capital for businesses, while on the other hand they have the effect of boosting the local currency against the dollar.

The RBI's challenge is to maintain the "Goldilocks" economy, "neither too hot nor too cold", using all the instruments at its disposal. It has to manage high economic growth rates and foreign capital inflows, while containing both inflationary and currency appreciation pressures, and all this with a "light-touch" approach on monetary policy. In India, the RBI is not only the custodian of the monetary policy but also supervises banks and other finciancial institutions and is the primary regulator of the financial markets.

Since the turn of the decade, the Indian economy has been growing at a very rapid pace and attracting foreign capital in large amounts. Though inflation has been kept under control, inflationary pressures remain very real and rears its head recurrently, forcing Central Banks to aggressively intervene. The same problem is confronted when rupee appreaciates with respect to dollar, forcing pressure from exporters to indulge in open market operations to manipulate the currency markets.

As Rakesh Mohan and Muneesh Kapur point out in a working paper, managing the impossible trinity is a delicate balancing act, which requires a careful and calibrated deployment of the full spectrum of policy options, depending on the specific and varying conditions in the real economy and the financial markets. There are no readily available policy prescriptions that can be taken off the shelf and applied to optimally manage both the monetary policy and the exchange rates, even while keeping inflation under control, growth robust and capital inflows welcome.

The RBI has used multiple instruments and a menu of options to manage the external sector and the monetary policy - active management of the capital account, especially debt flows; within debt flows, tighter prudential restrictions on access of financial intermediaries to external borrowings vis-a-vis nonfinancial corporate entities; flexibility in exchange rate movements but with capacity to intervene in times of excessive volatility along with appropriate sterilisation of interventions; associated building up of adequate reserves; continuous development of financial markets in terms of participants and instruments; strengthening of the financial sector through prudential regulation while also enhancing competition; pre-emptive tightening of prudential norms in case of sectors witnessing very high credit growth; and refinements in the institutional framework for monetary policy.

In this context, the authors also favor a carefully sequenced movement (which is also dependent on the developments in both the real economy and financial markets) towards capital account convertibility and controls on debt flows - both private and inflows into risk-free sovereign debt instruments to take advantage of interest differentials (carry trade). They write,

"Capital controls have to be a part of an overall package comprising exchange rate flexibility, the maintenance of adequate reserves, sterilisation and development of the financial sector... During periods of heavy inflows, liquidity is absorbed through increases in the cash reserve ratio and issuances under the market stabilisation scheme. During periods of reversal, liquidity is injected through cuts in cash reserve ratio and unwinding of the market stabilisation scheme. Overall, rather than relying on a single instrument, many instruments have been used in coordination."

Their summary is very appropriate,

"As a result of this approach, growth in monetary and credit aggregates could be contained consistent with the real economy undergoing growth, structural transformation and financial deepening. Inflation was contained even as growth accelerated. Overall, financial stability was maintained even as the global economic environment was characterised by a series of financial crises. The impossible trinity was managed by preferring middle solutions of open but managed capital account and flexible exchange rate but with management of volatility. Rather than relying on a single instrument, many instruments have been used in coordination. This was enabled by the fact that both monetary policy and regulation of banks and other financial institutions and key financial markets are under the jurisdiction of the Reserve Bank, which permitted smooth use of various policy instruments.

Key lessons from the Indian experience are that monetary policy needs to move away from narrow price stability/inflation targeting objective. Central banks need to be concerned not only with monetary policy but also with development and regulation of banks and key financial markets – money, credit, bond and currency markets. Given the volatility and the need to ensure broader stability of the financial system, central banks need multiple instruments. Capital account management has to be countercyclical, just as is the case monetary and fiscal policies. Judgements in capital account management are no more complex than those made in monetary management."

Update 1 (11/7/2010)

Greg Mankiw explains the three different ways in which China, US, and Europe manage the impossible trinity. The first restricts capital inflows, the second permits exchange rate volatility, and the third has given up monetary policy autonomy.

Fiscal contraction during recessions?

It is widely agreed that an economy facing a deep recession and massive unemployment has to indulge in fiscal stimulus expenditures by way of direct government spending and/or tax cuts to stimulate the economy out of the trough. Accordingly, economies of the world, both developed and emerging, have resorted to generous fiscal stimulus spending during the current Great Recession.

Spain, one of the worst hit by the property bubble, has apprently decided to take a contrarian route. Spain's economy is staring deep down the barrel, as this Times report indicates

"The International Monetary Fund said this week that it expected Spain to be the only country in the euro zone to remain in recession this year. It forecast a contraction of 0.6 percent in 2010, then growth of 0.9 percent in 2011. The national statistics office in Madrid said that unemployment was 18.8 percent in the fourth quarter, up from 17.9 percent in the previous period. According to Eurostat, the European Union’s statistics agency, 44.5 percent of people under 25 in Spain were without work at the end of 2009."

In order to combat the deep recession and unemployment, what has the Spanish government decided

"The Spanish government said that it would cut spending by almost 50 billion euros, or $70 billion, to help bring its budget deficit down to 3 percent of gross domestic product by 2013, from 11.4 percent last year. Lowering the deficit to 3 percent would be in line with European Union’s limit on national deficits... the spending cuts would spare only a few areas — education, antiterrorism, research and development, pension payments and unemployment assistance. Total spending cuts for public employees will amount to a reduction equivalent to 0.3 percent of G.D.P. through 2013, taking into account reduction measures like hiring freezes."

This contrarian budget balancing approach is what economists like John Cochrane and Eugene Fama have been advocating. Spain's path towards recovery with this contrarian approach is an experiment to be evaluated. Let us wait for 2013 or 2014 to judge who was right!

Spain's problems is only the latest manifestation of the need to bring in some form of flexibility to the EU's very rigid (on macroeconomic parameters) Stability Pact given the wide diversity among member economies. One way of accomodating the rigid norms of the Pact is to have an EU-wide fiscal balancing fund that bails out economies like Spain and Greece which face severe debt crisis.

Liberalize labor regulations

The biggest labor market and employment generation challenge faced by policymakers in India is to expand the base of the disproportionately miniscule organized (or formal) sector and manage a smooth and swift transition of the more than 340 million un-organized (or informal) sector employees into the formal sector.

The commanding presence of the heavy hand of government regulation has been the major institutional cause for the emergence of the massive informal sector. Deregulation and better regulatory frameworks will help partially address this challenge. The more immediate cause for the stunted growth of the formal sector and outsized proliferation of the informal sector has been the lack of adequate flexibility in labor hiring and firing policies. This has had the effect of distorting incentives by discouraging firms from hiring employees and growing their businesses, while "crowding-in" employment into the informal economy.

An OECD Economic Survey of India 2007 found that

"Although regular employment has risen, it still represents only 15% of total employment and its growth has been almost exclusively in the smaller, least productive enterprises. Employment in firms with more than ten employees accounts for only around 3.75% of total employment (one quarter of regular employment) and has been falling... India has a much smaller proportion of employment in enterprises with ten or more employees than any OECD country. The number of workers has also fallen in the manufacturing sector where the share of labour income in value-added is low compared to other countries and capital-intensity is relatively high. Such developments indicate that India is not fully exploiting its comparative advantage as a labour-abundant economy."

It also finds that laws governing regular employment contracts in India are stricter than those in Brazil, Chile, China and all but two OECD countries.



Measure of restrictions on indefinite contracts in the formal sector (Regular employment)

Its conclusion about India's labor market is instructive,

"In labour markets, employment growth has been concentrated in firms that operate in sectors not covered by India’s highly restrictive labour laws. In the formal sector, where these labour laws apply, employment has been falling and firms are becoming more capital intensive despite abundant lowcost labour. Labour market reform is essential to achieve a broader-based development and provide sufficient and higher productivity jobs for the growing labour force."

The difficulty of assessing peak power deficit

One of the more widely accepted proxies for economic growth is the growth in electricity consumption, especially for developing economies. However, there may be reasons to doubt the direct co-relation between electricity and GDP growth rates. In fact, for much the same reason, it may not be possible to assess with any reasonable degree of correctness the actual electricity demand in these countries where recurrent load reliefs or power cuts are a characteristic of daily life.

It is estimated that India has electricity supply deficit, both during normal (base) and peak times, in the range of 10-20%. A recent KPMG report has forecast the peak deficit for 2010 at 12.6%, up from the 11.9% for 2009. However, it is extremely difficult to make reasonably accurate approximations of supply deficits, especially in the context of developing countries like India where demand is suppressed in many dimensions.

For a start, the practice of load reliefs (or power cuts) - scheduled and unscheduled - are so widespread that even the first level of approximation of demand cannot be made with any confidence. Then there is demand, mainly industrial, which is suppressed by way of consumption being curtailed, postponed or even cancelled due to the problems with reliability and availability of supply.

In view of the substantial suppressed demand, electricity (in countries like India) is an excellent example of supply creating its own demand, Say's law. The mere availability of adequate and reliable supply will increase consumption by releasing the pent up demand among existing consumers and encouraging more energy-intensive industrial and commercial activity, especially in the suburban and rural areas.

Once the supply increases, a large share of pent-up demand, being currently met (fully or partially) through diesel and other generator sets gets shifted into grid electricity along with the regular domestic demand (suppressed due to load relief). However, this consumption does not add substantially to the GDP, in so far as it only results in greater capacity utilization and people using more electricity. In the circumstances, not all the electricity supply growth will contribute to increase in GDP.

Rural schooling reality check - ASER report

The 2009 edition of the Annual Status of Education Report (ASER), brought out by Pratham, that covers private and government schools in the rural areas of 575 out of 583 districts in the country is out (full pdf here and abstract here).

As Wilima Wadhwa makes out in a Mint op-ed, the findings of the report indicates that despite private schools’ perceived superiority, they do not show much learning difference from government ones after controlling for characteristics other than the type of school (ie parental incomes etc). The report finds that two-thirds of the learning differential between government and private schools can be attributed to factors other than the type of school. Here are a few graphics from the report.

The percentage of children out of school, while small for both boys and girls in the 7-10 age group, continues to remain at about 7% for girls in the 11-14 age group.



About 30% of the children aged 3 do not attend pre-school and this share has been growing. Among those aged 4, 20% do not attend pre-school and there has been no improvement in this over the past four years



The share of children in private schools in rural areas remain relatively stable, albeit with small increases, over the last four years. However, at the all-India level, private school enrolment increased from 16.3% in 2005 to around 22.6% in 2008—a rise of around 40%, with most of the increases coming in the urban areas.



The share of private schools remain around 20% across all school levels - primary, upper-primary and high-school. The shares reach 25% for high schools.



The most dismal picture is in the abysmal learning levels. There have been only modest improvements in learning levels over last year across all classes.







Among other highlights

1. Andhra Pradesh recorded an increase in the percentage of 11-14 year old girls out of school from 6.6% in 2008 to 10.8% in 2009.
2. Interestingly, the numbers and percentage of students going to private tuition's are on the rise for students attending both private and government schools. Among government school children, the percentage going to tuition class increases steadily as children move into higher classes - from 17.1% in Std 1 to 30.8% in Std 8. Among children attending private schools, almost a quarter (23.3%) take private tuition from Std 1 onwards. In West Bengal, more than half of all Std 1 students and almost 90% of all Std 8 government school children take some kind of paid tuition.
3. School attendance figures vary widely across states, with less than 60% of enrolled children attending in states like Bihar, compared to southern states where average attendance is well above 90%.

Unconventional monetary policy responses

In an earlier post, I had blogged about the challenges facing monetary policy in the aftermath of the sub-prime mortgage crisis and the Great Recession. In this context, the debate about unconventional monetary policy also assumes significance in view of widespread concerns that central banks cannot exit from their prevailing loose interest rate policies (as and when inflationary pressures mount) without first contracting their massively expanded balance sheets.

Monetary policy hitherto was confined towards achieving primarily price stability (while balancing economic growth considerations), and interest rates were considered its primary tool. However, in the aftermath of the sub-prime bubble bursting, and the global credit markets virtually freezing and plunging into terminal declines, Central Banks across the world were forced to step in with extraordinary measures like quantitative easing.

Claudio Borio and Piti Disyatat draw the distinction between such "balance sheet policies" and "interest rate policy" and define unconventional monetary policy as falling under the broader category of balance sheet policy (similar to open market operations in the forex market to achieve a desired exchange rate), whereby the central bank uses its balance sheet to affect directly asset prices and financial conditions beyond the short-term, typically overnight, interest rate (or interest rate policy). In other words, balance sheet policies involve efforts to expedite the effectiveness of interest rate policy signals by changing the profile of central bank's balance sheet in terms of size, composition and risk profile.

The instruments of balance sheet policies include inter-bank market conditions through modification of discount window facility, exceptional long-term operations, broadening of eligible collateral and of counter-parties, inter-central bank FX swap lines, introduction or easing of conditions for securities lending; and influencing non-bank credit market through CP funding/purchase/ collateral eligibility, ABS funding/purchase/collateral eligibility, corporate bond funding/ purchase/collateral eligibility, and purchases of other securities. They also include purchases of government bonds and foreign currency securities, and changing targets for bank reserves.

Bank reserves are the sum of a banks' holdings of deposits in accounts with their central bank and the currency that is physically held in its vaults (while central banks do not pay any interest on reserves, as a result of a legislative change in the US in October 2008, the Fed can pay interest at the Federal funds rate for excess reserves). All banks are required to hold a share of their deposits as mandatory reserves, and this helps central banks establish a target (short-term) interest rate. If the reserve ratio drops below the legally required minimum, a bank must add to its reserves by borrowing the requisite funds from another bank that has a surplus of reserves in its account with the central bank. If the Central bank wants a higher federal funds rate, it drains reserves and if it wants a lower rate, it adds reserves till the desired interest rate is achieved in either case.

By virtue of its monopoly over reserves, the central bank can set the quantity and the terms on which it is supplied at the margin, and if need be buy and sell unlimited amounts to achieve the chosen price (which would be the opportunity cost on excess reserves). This also means that "the same amount of bank reserves can coexist with very different levels of interest rates and conversely, the same interest rate can coexist with different amounts of reserves" - ie. interest rates and reserves are decoupled.

Of relevance is only how the reserves are remunerated relative to the policy rate. Central banks typically remunerate excess reserve holdings (over and above any minimum requirements) at a rate that is below the policy rate, leaving banks with little incentive to keep excess reserves (and get rid of unwanted balances by lending in the overnight inter-bank market). This also means that once the demand for mandatory bank reserve requirements have been met, the central bank can set the overnight rate at whatever level it wishes by signaling the level of the interest rate it would like to see, and without indulging in any open market operations (or liquidity management operations) on reserves.

The central bank can also decide to remunerate the excess reserves at the policy rate, especially when it wants to expand liquidity to affect broader financial market conditions. In such conditions, the the opportunity cost of holding reserves for banks becomes zero so that the demand curve becomes effectively horizontal at the policy rate, and the central bank can then supply as much as it likes at that rate. Therefore by paying interest on reserves at the policy rate banks would be indifferent about the amounts held, and interest rates and reserves stand decoupled. Either way, interest rates and reserves are decoupled giving banks the freedom to manage the size and structure of their balance sheets separate from the policy rate targeted.

As Borio and Disyatat write,

"Monetary policy can, and often is, implemented without calling for significant changes in the size of the central bank’s balance sheet. Given a policy that is exclusively focused on setting a short-term interest rate, the overall size of central banks’ balance sheets will be primarily driven by exogenous (autonomous) factors, such as the demand for cash by the public, government deposits, and reserve requirements...

The decoupling of interest rate from balance sheet policy means that unwinding balance sheet policy and shrinking the central bank’s balance sheet are not preconditions for raising interest rates. For example, central banks that pay interest on excess reserves simply have to raise this rate along with the policy rate to implement an interest rate tightening without changing the outstanding amount of bank reserves... Since excess reserves are very close substitutes with short-term claims on the central bank or the government, what the central bank buys and the credit it extends are more important than how these operations are financed...

Discussions of exit strategies can also be delineated along two separate dimensions - the appropriate level of interest rates, on the one hand, and the desired central bank balance sheet structure, on the other. The former is likely to be dictated exclusively by considerations about the traditional inflation output trade-off; the latter is likely to be influenced also by considerations about market impact, including the potential disruptions that an unwinding might cause."

Apart from signaling intent like interest rate policy, balance sheet policies help bring about desired changes in balance sheets of private financial institutions which face liquidity constraints and are saddled with illiquid assets. Central bank actions to acquire illiquid (risky and toxic) assets, or readiness to buy or accept them as collateral, increases the liquidity of the portfolios of the holders of these assets. As the authors write,

"The removal of risky assets off banks’ balance sheets obviates the need for distress sales to comply with risk-based capital constraints and frees up capital (that is, raises the ratio of capital over risk-weighed assets), which can help support credit growth. The combination of stronger balance sheets, higher collateral values and higher net worth, may help loosen credit constraints, lower external finance premia and revive private sector intermediation."

However, it needs to be emphasized that unconventional monetary policy responses should be resorted to under extraordinary circumstances and should not become a part of the Central Bank's armory of regular monetary policy activities. Borio and Disyatat write,

"As central banks move away from the simplicity and well-rehearsed routine of interest rate policy, they face much trickier calibration and communication issues. As they substitute for private sector intermediation, they may favour some borrowers over others, tilting the level playing field, and could risk making the private sector unduly dependent on public support. As they purchase government debt, they come under pressure to coordinate with the public sector debt management operations. And as their balance sheets expand and they take on more financial risks, central banks risk seeing their operational independence and anti-inflation credentials come under threat in the longer term.

As a result, questions about coordination, operational independence and division of responsibilities with the government loom large. These costs suggest that unconventional monetary policies should best be seen as special tools for special circumstances. The costs also point to the need for appropriate governance arrangements, designed to limit the risk that the central bank anti-inflation priorities are undermined in the medium term. And they put a premium on early exits, as soon as economic conditions permit."

Update 1
Ricardo Reis has an NBER working paper that reviews the unconventional US monetary policy responses to the financial and real crises of 2007-09, by dividing them into three groups - interest rate policy, quantitative policy, and credit policy.

Update 2 (24/7/2011)

Excellent FT interactive graphic on the debate surrounding QE.

To raise rates or not : RBI's monetary policy review dilemma

The build-up to the third quarter review of the monetary policy later this month has naturally re-ignited the inflation-growth trade-off debate. Should interest rates be raised in light of the recent spurt in inflation to 7.31%, well above RBI estimates?

Those advocating raising rates point to the rise in inflation and the need to exit the unprecedented monetary loosening of the past eighteen months. Opposers point to the supply-side reasons for food and fuel inflation and argue that any increase in rates would nip in the bud the fledgling signs of economic recovery. This blog has consistently taken the latter position though the argument gets more complex with every passing day.

In an excellent op-ed in Mint, Renu Kohli draws attention to the falling real interest rates on various instruments. The real policy repo rate is in negative territory at minus 3.79% and the real yield on 10 year securities is close to zero. These rates have dropped by half over the past three months.



As she writes, the growth signals are mixed. However, she does point to certain real inflationary concerns - annualized, three-month moving average of manufacturing inflation in the range of 4.5-6% since August; rise in long-term interest rates by a full two percentage points in the year to January 2010 despite the loosening; widening nominal spreads between short term T-Bills and long-term G-Secs indicate inflationary expectations etc. Coupled with the negative real policy rate, these signals will surely increase the pressure on RBI to act to raise rates and re-align interest rates.



In this context, a closer examination of the credit markets is on order. One of the most salient features of banks across the world over the past year or so has been their persistent reluctance to lend. In India too, the massive liquidity injections and monetary easing by RBI have not translated into expansion in the credit markets and the broad money supply has been steadily declining since the middle of last year. The year-on-year growth in M3 supply as on 22.1.2010 was 17.1% compared to 20.2% at the same time last year. Bank credit to the commercial sector has been very weak at 13.4% compared to 22.3% for the same period last year. Encouragingly there are signs that this may be picking up since November, driven in part by the festival season and year end lending and spending.



Credit to the government sector has been declining and stabilizing to its normal levels after the massive borrowings of the last year. Bank credit to government has been growing at an y-o-y rate of 32.8%, lower than last year's 33.7%. The inflationary impact due to the government borrowings may not be as high as feared, though there is always the danger of the lagged impact of inflationary forces due to the massive spurt in government borrowings.



These aforementioned money market indicators appear to point to the credit markets continuing to remain subdued. Banks continue to park their excess reserves in the safety of government securities, as evidenced by the sustained daily reverse repo transactions in the range of Rs 90,000 - 100,000 Cr. Far from the economy showing any signs of over-heating, the credit markets appears to indicate cautious optimism.

It is an altogether different matter that the larger businesses have fortunately been able to mobilize resources through the non-bank sources. The Commercial Paper market has rebounded nicely with declining spreads and increasing issues. However, credit support from the non-bank sources have largely eluded the medium and small scale industries who continue to remain dependent on banks for meeting their credit requirements.

There is no denying the fact that the RBI has to exit its monetary loosening. Asset bubbles may be in the process of getting inflated in the equity markets. Real estate markets too shows signs of rebounding. It is clear that instead of investments and consumption, a substantial portion of the credit unleashed by the RBI may have found its way into the asset markets.

Draining off this excess liquidity is important and it is reasonably clear that this exit, which already started with the increase in the SLR by 100 basis points late last year, can proceed apace. This would mean increasing the CRR from 5%. In fact, a series of increases in CRR over the next six months is almost inevitable.

About the repo rates, it needs to be borne in mind that though the WPI-based core inflation is in the range of 4.5-6%, it remains within acceptable range in comparison to the historic levels for the Indian economy. It is amply clear that the rise in food prices cannot be controlled by raising rates or other demand side interventions. It is arguable that the fiscal stimulus spending measures have contributed substantially towards the nascent signs of economic recovery. It is important that all policy measures necessary to strengthen this recovery be in place. Increasing rates would adversely affect investments which are already constrained by the weakness in the economic environment.

However, it is important that RBI reiterate its commitment to aggressively fighting inflation when the need arises. This would re-assure the markets and investors, and to that extent keep a lid on inflationary expectations. This may be appropriate and even adequate for this time.

Update 1
As expected, the RBI left the repo and reverse repo rates untouched.
The RBI Governor's statement on the Third Quarter Review is available here. The CRR was raised by three-quarters of a percentage point, to 5.75%, to become operational in two stages, a move that is expected to drain off Rs 360 billion (about $7.8 billion) from the Indian financial system. See this excellent summary of the situation by Tamal Bandyopadhyay.



The RBI raised the baseline GDP growth projections to 7.5% from the 6% forecast made in October 2009, by assuming a near zero growth in agricultural production and continued recovery in industrial production and services sector activity. The baseline projection for WPI inflation for end-March 2010 was raised to 8.5% from 6.5% made in October. It also revised downwards the non-food credit growth projection for 2009-10 to 16%, and based on this projected credit growth and the remaining very marginal market borrowing of the government, the projected M3 growth in 2009-10 was reduced to 16.5%.

Incentives matter!

China retreats from US securities?

The inevitable Chinese retreat from US securities appears to be on the way. Even as the US Treasury indulged in its biggest borrowing binge ever last year, China has been cutting back on its exposure. The latest statistics released by the US Treasury claims that in the first eleven months of 2009 China raised its holdings (both private and government, but in China's case it is mostly government) of Treasury securities by just $62 billion, less than 5% of the money raised by Treasury.



Though China continues to be the largest foreign holder of US Treasury securities at $790 bn (followed by Japan at $757 bn and Britain at a distant $278 bn), its holdings have been falling since last July, the first such six-month decline since 2001. This decline comes despite the fact that during 2009 the volume of outstanding Treasury securities owned by the public (as opposed to United States government agencies like the Federal Reserve or the Social Security Administration) rose 23% by $1.4 trillion to $7.8 trillion, the largest annual increase ever. This means that China lend just 4.6% of the money the government raised during the year, compared with 20.2% in 2008 and a peak of 47.4% in 2006.

In another indicator of the future, foreign purchasers financed only 39% of the borrowing in the 11 months, leaving American investors to purchase the remaining secutrities. This is in stark contrast to as recent as 2007 when foreigners were buying more Treasuries than the government was issuing, enabling Americans to reduce their Treasury holdings even as the government borrowed hundreds of billions of dollars.

Update 1
Chinese holdings of Treasury bills fell by $34 billion in December 2009, at $755.2 bn, dropping behind Japan (Japan’s holdings rose 1.5 percent in December to $768.8 billion) as the largest holder of US Treasury debt. China's forex reserves stood at $2.4 trillion.

Update 2
"Foreign official" owners own $2.374 trillion in US Treasuries at the end of 2009. This is just under one-seventh of all American government securities outstanding ($7.27 trillion, of which $3.614 trillion was held by all foreign owners, official and private, at the end of 2009).

Modelling asset bubbles caused by low interest rates

I have blogged extensively about the classic dilemma facing central bankers as they face an inflating bubble - whether to ex-ante take away the punch-bowl as the party gets going or post-facto clea n up after the bubble bursts. The challenge as Joseph Gagnon writes is "how to walk the fine line between easing too little to fight unemployment and easing too much to cause a new and harmful bubble".



Brad DeLong explained the situation with a simple model of a bubble caused by a central bank holding interest rates below its long-run equilibrium so as to boost aggregate demand and thereby fight an economic slowdown. He describes such bubbles as being caused by a "carry trade" (income earned over their cost of borrowing) arising from speculators borrowing at the low short-term interest rate to purchase a long-term asset at a price above its long-run expected value. Despite being aware of the risk of an asset price crash when the central banks reverses its loose money policy, they are confident of timing their exit with their profits before the prices of the long term assets starts declining. The moral hazard arising from the now near certainty of a bailout only adds to their confidence and adventurism about taking deep speculative positions. He writes,

"The more speculators ex ante expect bailouts and the more speculators are impressed with their own cleverness, the more hesitant should the central bank be about providing monetary accommodation. William McChesney Martin said that the job of the Federal Reserve was to take away the punchbowl before the party got rolling. Alan Greenspan thought that as long as there was an Okun gap and no sign of inflation the Federal Reserve should spike the punchbowl with the grain alcohol of low interest rates because it could, if necessary, serve as designated driver to get everybody home safely. In this finger exercise it is William McChesney Martin who is right. And how right he is depends on the vulnerability of the market—on speculators’ expectations of rescue (the 'Greenspan put') and on speculators’ confidence in their own expertise."

Joe Gagnon feels that the De Long model overstates the welfare costs of bursting bubbles by assuming that "all declines in long-term asset prices are costly even if they are not associated with bubble-like behavior" and by ignoring "the role of unleveraged or partially leveraged investors". He feels that in the process the model places an excessive importance on the role of monetary policy without consideration for other critically important factors like leverage. He therefore differs with De Long's assumption that apart from the cost of any bailouts, the welfare cost of a bursting bubble is an "amount proportional to the squared losses of the investors" and points attention to the important role played by leverage. He writes,

"This welfare cost, however, implicitly assumes that investors are fully leveraged and thus are forced to default on their short-term loans whenever long-term asset prices fall, even when there is no bubble. This feature of the model is clearly unrealistic... In a world of unleveraged (or lightly leveraged) investors, falling asset prices would not bankrupt anyone and thus would not raise fears of bankruptcy. In such a world, there are no welfare costs of a bursting bubble, at least as long as the central bank acts nimbly to keep the economy on track. It is true that investors suffer a decline in wealth, but only from a level that was not fundamentally correct to begin with."

Coming to the present, given the strong and bitter memory of the events of recent past, he feels that strong leverage driven increases in asset prices are not likely now. He therefore argues in favor of monetary policy actions to support and even increase the prices of long-term assets now to speed economic recovery and avoid deflation. He also feels that the possibility of a sustained low interest rate driven bubble in commodities is remote due to problems in storability, and points to the sharp rise and decline of oil prices in 2008 as an example of this.

However, there is increasing evidence to the contrary that such optimism about any salutary effects of the Great Recession (on investors and bankers) may be misplaced and that the age of leverage may be far from over.

About the fundamental lesson from the recent crisis, he writes,

"The global financial crisis demonstrates the need for reforms to greatly reduce the leverage of financial institutions and to make that leverage respond to the credit cycle in a stabilizing manner... linking property-related taxes to property prices in order to damp their swings... regulators need to be vigilant in maintaining the process of deleveraging and preventing any new buildup of leveraged asset purchases, including for commodities. In the long run, we need to greatly reduce the degree of leverage in our financial system and it may be a good idea to make leverage respond inversely to asset prices and to put stabilizing mechanisms in the tax system."

The more relevant lesson from Gagnon is that when the leverage is minimal, as was the case when the technology bubble of 2000 burst with no apparent ill effects, loose monetary policy may be an option.

However, more fundamentally, it cannot be denied that the moral hazard arising from the inevitability of bailouts (one which has been amplified many times over by the very open willingness of governments to bailout the fnancial markets and the TBTF actors) will always incentivize financial institutions and players to over-leverage and run up unsustainably high risks. The need for stricter and automatically kicking in regulatory policies to control the build-up of leverage assumes greater significance.

Job creation policies that deliver bang for the buck

Paul Krugman draws attention to the CBO report (pdf here) that examines the job creation potentials of various fiscal stimulus spending measures.

In an earlier report, the CBO had defined three key criteria for judging policy options for spurring economic growth and increasing employment - timing (providing help when it is needed most); cost-effectiveness (providing the most growth and employment per dollar cost to the federal budget); and consistency with long-term fiscal objectives (preventing the short-term deficit increase due to stimulative policy from adding excessively to federal debt in the long run).

CBO examined the effects on output and on employment of a number of policies. The effect of a policy on employment is measured by the cumulative effect on years of full-time-equivalent employment for each dollar of total budgetary cost (a year of full-time-equivalent employment is 40 hours of employment per week for one year). By focusing on full-time equivalents, the calculations include increases in hours among people in part-time employment and possibly some overtime for full-time employees.

To account for uncertainty, the analysis includes both a 'low' estimate and a 'high' estimate for the effect of each policy. For the range of policy options considered, the figure below shows the range of low to high estimates of the cumulative effects on employment in 2010 and 2011, when CBO expects that the economy will still be in the early stages of the recovery.



Increased aid to the unemployed, reducing employers payroll taxes so as to incentivize them to hire, additional social security payments, and aid to states are among those delivering the biggest bang for the stimulus buck in generating employment.

Update 1
Alan Blinder proposes implmenting both the two main options specifically aimed at job creation - direct public-service employment and a new-jobs tax credit. He feels that if most of the new public-service positions are low-wage jobs, and if the tax credit is designed well, the per-job costs of these policies are comparable at $30,000 to $40,000. He recommends doing both, targeting roughly a million new jobs with each program, at a budgetary cost of perhaps $70 billion.

Update 2 (24/02/10)

The US Senate approved a $15 billion plan to spur job creation that would give employers a temporary exemption from payroll taxes for hiring people who had previously been out of work for at least 60 days.



Update 3 (17/3/2010)
Casey Mulligan has this analysis of the trade-off between moral hazard of continuing unemployment benefits and the need to continue benefits so as to stimulate aggregate demand in a recession.

This study finds that longer-term Unemployment Insurance (UI) entitlement leads to longer unemployment duration and indicate that the adverse effect of longer entitlement changes relatively little in response to variation in demand conditions.

Update 4 (20/6/2010)

List of policy options to create employment for the growing army of long-term unemployed - offer bonuses for long-term unemployed persons who find work; offer bolstered work-search help for the long-term unemployed; expand retraining programs and increase outreach; expand relocation allowances; encourage self-employment; expand work-sharing programs; and provide generous tax incentives for employers to hire the long-term unemployed.

A debt threshold for India

I blogged earlier about India's public and external debt positions and had argued that India may have a debt tolerance threshold which is closer to many of the developed economies and higher than most emerging economies. However, that analysis was mainly from the perspective of India's external debt scenario and had also not considered the public debts of state governments and also the considerable amount of off-balance sheet liabilities of the Central Government.

Now, in an IMF working paper, Petia Topalova and Dan Nyberg feel that a debt ratio in the range of 60-65% of GDP by 2015-16 (from the present total public sector debt, including states and off-balance sheet liabilities, of 78% of GDP in 2008-09, which is also one of the highest among all emerging economies) might be suitable for India. They feel that it would provide room for counter-cyclical fiscal policy and contingent liabilities and also send a strong signal of the government’s commitment to fiscal consolidation by making a clear break with the past.



Their debt simulation forecasts to achieve the 60-65% target would require substantial subsidy reform (fuels, fertilizers and food) to contain current spending, efforts to improve tax administration (GST, elimination of exemptions etc)and widen the tax base to raise revenues, and disinvestment of public assets to lighten the debt burden.



Under their baseline scenario, without any of these reforms, they estimate the total public sector debt to decline to 74% by 2015-16. Under the best case scenario, with a combination of subsidy reform, revenue reforms and partial privatization of public enterprises, the public debt level could decline to 59.5% of GDP.

Their debt simulations are based on the assumption that real GDP growth will return to its potential rate of 8% by 2013-14, the GDP deflator stabilizes at 4% per annum, and the real effective interest rate on government debt remains close to its historical average at 4%. This in turn means that the interest-growth differential contributes about an average of 3-percentage points of GDP reduction in debt per annum.

Framing tax policies

That taxes incite passions and fears of big government among conservatives and generates instinctive opposition in politicians is well known. I have blogged earlier about how it is possible to collect the same amounts more easily without generating the same opposition, by either minimizing the salience of the tax or by re-designating the tax as a user fee or by promising to use the proceeds of the fee in some specific and tangible, preferably local, activities.

Economix points to an article by Bradford Plumer in the New Republic which draws attention to a new study by David J. Hardisty, Eric J. Johnson, and Elke U. Weber of Columbia University that finds substantial impact of framing in the way taxes are perceived and received.

"Test subjects were broken up into two groups, and each group was allowed to pick between pricier and cheaper versions of various items like airline tickets. Group A was told that the more expensive items included the price of a 'carbon tax', whose proceeds would go toward clean-energy development. Group B was told that the costlier items included the price of a 'carbon offset', whose proceeds would go toward clean-energy development. Exact same policy, just different names for each.

You can guess what happened next. In the 'offset' group, Democrats, Republicans and independents all flocked toward the pricier item. They were perfectly happy to pay an extra surcharge to fund CO2 reduction — even Republicans gushed about the benefits of doing so. Not only that, but most of the group supported making the surcharge mandatory. In the 'tax' group, however, Democrats were the only ones willing to pay for the costlier item. Republicans in this group were much more inclined to grumble about how much more expensive the tax made things. Labels really do matter."

It is in this context that the Obama administration has preferred to call its bank tax proposals as a "fee". It is also a compelling enough reason to frame any carbon emission tax as an "offset fee" so as to pre-empt the predictable anti-tax opposition.

Return of Glass-Steagall?

The Obama administration's proposals (as part of the comprehensive financial market reform Bill currently in the Congress) to impose stricter limits on the size and scope of trading activities of big banks to prevent excessive risk taking marks atleast a partial return to the era of Glass-Steagall and is a clear acknowledgment of the fact that the decision to repeal the Chinese wall between commercial and investment banking activities of financial institutions did contribute to the sub-prime crisis.

Last week the administration had announced plans to recover atleast a part of the costs incurred in the TARP bailout with something similar to a bank tax. This renewed vigor on fighting the big banks comes as President Obama said,

"My resolve to reform the system is only strengthened when I see a return to old practices at some of the very firms fighting reform; and when I see record profits at some of the very firms claiming that they cannot lend more to small business, cannot keep credit card rates low, and cannot refund taxpayers for the bailout. It is exactly this kind of irresponsibility that makes clear reform is necessary."

The Obama administration proposals include

1. Limit the Scope - No bank or financial institution that contains a bank (taking federally insured deposits) should own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit.

2. Limit the Size - Limit the consolidation of financial sector by placing broader limits on the excessive growth of the market share of liabilities at the largest financial firms, and to supplement existing caps on the market share of deposits. Since 1994, the share of insured deposits that can be held by any one bank has been capped at 10% and it is now proposed to expand that cap to include all liabilities, so as to limit the concentration of too much risk in any single bank.

Despite small concessions like payment of bonuses by deferred stock instead of cash, the remaining Wall Street majors have all announced record bonuses on the back of a resurgent equity markets and a market depleted of competition. Despite its less-than-stellar year (in fact, the first annual loss in its 74 year history in 2009), Morgan Stanley earmarked 62 cents of every dollar of revenue for compensation ($14.4 billion for salaries and bonuses), an astonishing figure, even by the gilded standards of Wall Street. Goldman, which made record profit of $13.4 billion for 2009 on revenue of $45.2 billion, has set aside $16.2 billion (or 35.8% of its revenues, lower than previous years) to reward its employees (or an average of $498,000 for its 32,500 employees). However, there remain doubts about later and backdoor payments that would boost the share of bonuses.

What has also raised popular outrage comes from the fact that most of the profits of these large firms have come from obscure and largely socially not-beneficial (some would say socially costly, given the excessive risk taking and inevitable bailouts) trading activities and not retail or commercial lending that directly contributes to economic growth. In fact, it is clear that these institutions cornered most of the benefits from the unprecedented quantitative easing measures, blanket debt guarantees and low interest rate policies of the Fed and the Treasury, which were originally meant to restore confidence in the financial markets and get banks to re-open their credit taps for cash-strapped businesses and individuals. However lending remains constrained with banks keeping their credit taps dry, under the excuse of counter-party risks, and are instead using the cheap money to play and drive the equity markets and their bottom-lines.

In this context, Simon Johnson (echoing Krishna Guha in the FT and the famous Pecora investigations into the causes of the Wall Street crash of 1929) has called for broad anti-trust investigations into some of the big firms. He sees "definite elements of oligopoly in wholesale markets, underwriting new issues, and mergers and acquisitions both in the United States and around the world", which has contributed to the very high profits in big banks over the past decade. He asks the question

"Is there evidence that our leading banks have used their pricing power or other aspects of their market muscle to keep out competition or otherwise distort behavior in very profitable arenas, like over-the-counter derivatives?"

Prof. Johnson also raises concerns about the dramatic increase in the share of assets in the largest six US banks that now stand around 60% of GDP, up from around 20% in the early 1990s, a level of concentration that increased during the crisis and bailout of the past two years. Among the regulatory steps proposed to address the problems generated by this concentration includes "raising capital requirements steeply, as well as a size cap on biggest banks to rein them in".

Apart from these, as Goldman Sachs CEO Lloyd Blankfein himself acknowledged in his recent Congressional testimony, there is an immediate need to bring the shadow banking system, consisting mainly of the unregulated over-the-counter (OTC) derivative products, under stricter supervision. Paul Krugman too has argued about the need to rein in the shadow banking system.

Update 1
Nice Economix post places the new plan, described the "Volcker Rule" by Obama himself, in historical perspective with respect to the Glass-Steagall Act.

Update 2
Viral Acharya and Matthew Richarson have this article commenting on Obama administration's bank reform - financial crisis responsibility fee and limit on the size and scope of trading activities - proposals. They write, "President Obama’s plans – a fee against systemic risk and scope restrictions - seem to be a step in the right direction from the standpoint of addressing systemic risk, if their implementation is taken to logical conclusions."

Update 3
Bank of England Governor Mervyn King argues "that big banks must separate their higher-risk trading and investment banking businesses from their core deposit-taking functions". He said, "After you ring-fence retail deposits, the statement that no one else gets bailed out becomes credible".

Unlike the US with its Glass-Steagall Act which was repealed in 1999, there have been no legla separation of investment banking functions for deposit taking bank holding companies.

Update 4
Simon Johnson has an incisive critique of the "Volcker Rule" on two grounds - the limit on scope rule can be overcome by banks that will immediately shed all their banking activities in the firm belief that they will be bailed out irrespective of anything; the limit on size rule applies only to future growth of bank and therefore ignores the problem of size among the incumbents.

He proposes some cap on the size of banks at some low level related to the real economy. He favors a cap on bank assets and liabilities as not more than a small percentage of Gross Domestic Product, and set that percentage so the banks go back to the size they were in the early 1990s, when the banking system worked fine and we didn’t have anything like our current levels of systemic risk.

Update 4
Daniel Gross has an excellent article that explores why the big five investment banks got too big, too greedy, too risky, and too powerful.

Update 5
Paul Volcker makes the case for financial market overhaul.

Update 6
Hank Paulson and Alan Blinder call for creation of a single systemic risk regulator (both prefer the Fed for this role because the responsibility for identifying and limiting potential problems is a natural complement to its role in monetary policy) and a resolution authority to impose an orderly liquidation on any failing financial institution so as to minimize its impact on the rest of the system.

Prof Blinder also advocates setting up a Consumer Financial Protection Agency (CFPA) to help unwary consumers from being duped into investments in risky financial products and restrictions between proprietary trading and trading, hedging, and market-making on behalf of clients, though he feels that the latter is very difficult to structure.

Update 7
Wall Street elders too call for more effective regulation of financial markets, with some going beyond the Volcker Rule and advocating banning any deposit taking commercial bank from indulging in any trading activity (not just proprietary), even for its clients - questioning whether trading operation should even exist under the same roof as a standard commercial bank.

Update 8 (22/5/2010)
The US Senate passes its version of the financial market regulation bill. See details of the comparison with the House version here and here.

India needs to increase investments substantially

PSD blog draws attention to an article by Rebecca Wilder which highlights the need for India (and Brazil) to increase its savings rates in order to boost overall investment and, in turn, worker productivity. This assumes importance if India is to capitalize on its large, young, and rapidly growing (adding 13 m workers every year) workforce.

In an FT blog post, Shankar Acharya has argued that the restrictive labour laws (especially on hiring and firing them), and preferential treatment and reservations for small scale industries encourage Indian manufacturing units to "stay small". A multiplicity of labor laws (46 central and over 200 state labor laws) only adds to the problems of the businesses. Further, indirect tax regimes favoring the small enterprise have suppressed scale and encouraged firms to remain small.

Difficulty in accessing capital and poor infrastructure facilities - especially in access to transport, electricity and water - only exacerbates the problems. This prevents them from taking advantages of the classic industrial economies of scale and scope and also keeps productivity enhancing capital investments at a minimum. Further, many of these regulations and controls also disincentivizes businesses from coming into the formal sector and thereby avoid conforming to the restrictive regulations, especially on hiring labor.

It is therefore no surprise that the capital stock per worker is much lower for India (and Brazil) in comparison with China. Given its low productivity base, even incremental increases in investments will lead to dramatic improvements in productivity.



Though investment spending as a share of GDP has been growing...



... it is increasingly coming from the sharp rise in FDI inflows.



It is therefore important that India increase its domestic savings substantially, so as to boost capital investments and increase its capital stock, which would in turn increase labor productivity.



While there have been improvements, the household savings have been relatively stagnant for the past few years. In fact the increases in savings have been due to the increase in public sector savings, something which is likely to be adversely affected by the economic slowdown.

Making financial inclusion morew effective

My Mint op-ed on designing financial instruments for the poor that take into account their spending patterns and cognitive biases is available here. The links for the article is available here.

Financial engineering for the poor

The last two decades have seen a proliferation of financial instruments that have had a dramatic impact on the global financial markets. While many of these instruments of financial engineering have played critical contributory roles to the current crisis, it cannot be denied that they have had considerable beneficial effects.

In the circumstances, it may be appropriate to borrow atleast some of the more obviously beneficial initiatives and instruments of financial engineering and use them to help the poor and lower middle class save more and efficiently and control their expenditures. Unlike the profit-driven nature of conventional financial market interventions, financial innovation for poor people should draw in on insights from behavioral psychology that point to numerous cognitive biases that forces them into sub-optimal spending and saving decisions.

Instead of providing inefficient direct assistance through revolving funds, interest subsidies and plain vanilla bank loans, it may be more effective to take a leaf out of behavioural economics and design instruments that incentivize savings, optimize consumption expenditures, and more effectively manage income flows for poor people.

In view of the large number of competing immediate consumption needs and their limited income, poor people experience very high opportunity costs on their savings. They also face self-control problems with managing their incomes and expenditures due to their dynamically inconsistent inter-temporal preferences. Recent research in behavioural economics have shown numerous examples of the aforementioned problems and offered suggestions on overcoming them.

In this context, in a classic paper, Shlomo Benartzi and Richard Thaler have advocated the use of instruments like "Save More Tomorrow", that commit savers in advance to allocate a portion of their future salary increases toward retirement savings.

In the present arrangement, the SHGs leave their thrift savings in the group savings bank account, which yields meager returns. Savings accounts, similar to the Corporate Liquid Term Deposit (CLTD) accounts offered to corporate clients, that automatically sweeps all the balances in the account into short term (say, money market) instruments and gives higher returns can optimize returns on their savings.

Apart from the issue of large numbers of competing needs, it is also commonly observed that a large share of the savings get dissipated in expenditures during festival seasons on "temptation goods". In order to overcome the self-control problem and disincentivize wasteful consumption expenditures, restrictions can be imposed on the periodicity and amounts (minimum balance requirements etc) that can be withdrawn at any time from an account.

Any exception to this should require an elaborate application process, including possibly multiple visits to the bank. Higher premiums (interest rate discounts or flat penalties) can be placed on withdrawls during a specific period, timed to coincide with, say festival season, or higher interest rate return for savings during that particular period ("festival offer" of higher rates for specified periods, complements nicely with the demand-supply dynamics, given that people tend to withdraw their savings in larger quantities during such times).

Savings instruments that combine features of a lottery (which are manifestly attractive for low income people) can be used to incentivize people to both save and keep their savings locked in for longer periods. Peter Tufano of HBS has designed premium savings bonds, that come with a lottery option, in which the buyer can particiapte only if he remains invested for a certain period of time. The Irish government has a unique form of tax and risk-free, state guaranteed savings instrument, Prize Bonds, offering people the chance to win big cash prizes in a weekly lottery.

There is also evidence to suggest that use-directed accounts, that are designed based on people's mental accounting choices, are effective at promoting savings. Accounts designed with pre-defined and use-directed escrows, can therefore be a very effective instrument in nudging people to both making savings for specific needs and limiting withdrawls from specific escrows. Further, sub-accounts like "education accounts" or "bike accounts" can be used to channel specific subsidies like student scholarships or even be linked up with commercial EMI based schemes for consumer durables.

Simple savings instruments that make annuity payments for children's educational purposes are effective means of chanelling savings for specific purposes. Besides, public policy can promote them by making matching or some pre-defined contributions to such accounts. The periodic (monthly/quarterly) contribution can be transferred by default from the savings bank account. Like Save More Tomorrow, the contributions can even be increased every year, in small increments, as a default option.

Appropriately customized (varying subsidies, depending on the size of house to be constructed), easy to access home loan products for the poor, can be designed and offered through private banks at varying commercial terms (tenor, rates and so on). The subsidies - direct cash, interest rate subsidy, etc - can be directly transferred into the account of the individuals.

Similarly, specific business investment products can funnel savings and government subsidies (like those under various self-employment schemes) to make capital investments in starting new or expanding existing businesses. Government support can be made conditional on achieving certain levels of savings, and can also be used to leverage further private bank loans.

In view of the volatile nature of inflation in developing countries, inflation-indexed savings products, especially those with longer tenor, can help mitigate inflation-induced erosion of the value of savings.

Agricultural income comes as harvest-time windfall inflows, which, given the self-control problems that afflict human beings, are liable to be inefficiently frittered away. It is therefore only appropriate that this one time inflow be converted into a stable revenue stream so that the farmers have access to an assured income every month. So how about a "harvest plan" annuity product offering by banks to attract these amounts as term deposits with gradual draw down? Such annuity plans can be offered to farmers groups, so that the banks can attract large deposits from the incomes of a group of farmers.

A share of these deposits can then be channeled into some of the various other savings products, including as default options. Payments on procurements by the FCI can be funneled into these accounts by default, including into a "fertilizer account", which can in turn be drawn down to make payments for fertilizer purchases for the next season. Such instruments can be used to make more efficient use of the proposed nutrient-based direct cash transfer fertilizer subsidy regime.

Or the subsidy can be given as dated vouchers which expire within specific period, timed to coincide with the mid-season, when application of fertilizers is most optimal.

Apart from promoting savings and containing excessive and even wasteful expenditures on "temptation goods" and immediate gratification, such financial instruments also help to more optimally and efficiently target beneficiaries with various direct and indirect subsidies. It also creates signalling platforms that simultaneously enables private companies to tap into the "fortunes at the bottom of the pyramid" and those consumers to access the products of this market.

The global safe-asset imbalances and the sub-prime crisis

A large number of the explanations for the Great Recession have blamed the global imbalances - savings glut in the emerging economies and voracious appetite for debt in developed economies - and the (forced) need for their re-adjustment for creating the conditions of financial market instability that triggered off an economic recession.

However, as the crisis unfolded, instead of capital rushing away from the deficit laden US economy and dollar assets (if the aforementioned explanation were true), the capital flight was in the opposite direction. The US did not end up experiencing a deficit funding problem, as the global imbalance school would have predicted.

A more complete understanding of the crisis would have to look beyond the simple savings-deficit imbalance and explain the micro-dynamics of the capital flows. In this context, in earlier posts I had blogged about the role of demand for safe and liquid assets among emerging economy governments and investors (especially in light of their bitter experience with the currency crisis of the late nineties), which the domestic equity and debt markets could not satisfy.

Ricardo Caballero (the full paper here) attributes this phenomenon to another imbalance, one arising from an "insatiable global demand for safe debt instruments" which put great "pressure on the US financial system and its incentives". The bitter experience of the currency crisis of the late nineties and the relative lack of depth of their financial markets meant that the emerging economy markets could not meet the demand for safe assets and had to rely on external markets, of which the US markets were unquestionably superior and safer.

In fact, the demand for safe assets went beyond what was available even in Wall Street and other developed economy markets. The capital flight to safety and liquidity of US assets, and the resultant abundance of liquidity, therefore set in motion perverse incentives to re-package, securitize and sell riskier assets and payment streams as AAA-rated securities (with help from the rating agencies) by creating complex instruments that sought to hide the various risks. The largest re-allocation of funds (from the emerging to developed economies) matched the downgrade in perception of the safety of the newly created triple-A securitization based assets. He writes,

"The surge of safe-asset demand was a key factor behind the rise in leverage and macroeconomic risk concentration in financial institutions in the US as well as the UK, Germany, and a few other developed economies. These institutions sought the profits generated from bridging the gap between this rise in demand and the expansion of its natural supply... the safe-asset shortage was also a central force behind the creation of highly complex financial instruments and linkages, which ultimately exposed the economy to panics triggered by Knightian uncertainty.

This is not to say that the often emphasized regulatory and corporate governance weaknesses, misguided home-ownership policies, and unscrupulous lenders played no role in creating the conditions for the surge in real estate prices and its eventual crash. Instead, these were mainly important in determining the minimum resistance path for the safe-assets imbalance to release its energy, rather than being the structural sources of the dramatic recent macroeconomic boom-bust cycle."

And about how the various credit market mechanims worked to both trigger off and then amplify fear and panic to spread through the markets, he writes

"The triggering event was the crash in the real estate 'bubble' and the rise in subprime mortgage defaults that followed it... The global financial system went into cardiac arrest mode and was on the verge of imploding more than once. This seems hard to attribute to a relatively small shock that was well within the range of possible scenarios.

The real damage came from the unexpected and sudden freezing of the entire securitization industry. Almost instantaneously, confidence vanished and the complexity which made possible the 'multiplication of bread' during the boom, turned into a source of counter-party risk, both real and imaginary. Eventually, even senior and super-senior tranches were no longer perceived as invulnerable.

Making matters worse, banks had to bring back into their balance sheets more of this new risk from the now struggling ‘Structure Investment Vehicles’ and conduits. Knightian uncertainty took over, and pervasive flights to quality plagued the financial system. Fear fed into more fear, causing reluctance to engage in financial transactions, even among the prime financial institutions.

Along the way the underlying structural deficit of safe assets worsened as the newly found source of triple-A assets from the securitization industry dried up and the spike in perceived uncertainty further increased demand for these assets. Safe interest rates plummeted to record low levels.... Widespread panic ensued and were it not for the massive and concerted intervention taken by governments around the world, the financial system would have imploded."

He feels that addressing these issues would require governments to "explicitly bear a greater share of the systemic risk". This would in turn need the savings surplus countries to re-balance their portfolios toward riskier assets, apart from increasing the depth and breadth of their financial markets. The governments of the developed economies would have to either itself supply much of the triple-A assets or let the private sector take the lead role in supplying them with government support only during extreme systemic events.

Caballero argues that the most efficient approach would be a balance between government and private sector option, which would more effectively manage the systemic risk created through the private sector supplied triple-A rated securities. He writes,

"It is possible to preserve the good aspects of this process while finding a mechanism to relocate the systemic risk component generated by this asset-creation activity away from the banks and into private investors (for small and medium size shocks) and the government (for tail events). This transfer can be done on an ex ante basis and for a fair fee, which can incorporate any concerns with the size, complexity, and systemic exposure of specific financial institutions. There are many options to do so, all of which amount to some form of partially mandated governmental insurance provision to the financial sector against a systemic event."