Saturday, July 31, 2010

Nudging to keep restaurants clean?

In an interesting experiment, drawing on insights from behavioral psychology, and whose outcome will be widely watched, New York city public health department has launched a program to grade all the 24000-odd restaurants across the city A, B or C on their respective cleanliness.

The officials hope that issuing restaurant letter grades will help consumers make informed choices about where to eat out and the resultant consumer awareness would create a powerful new incentive for restaurants to maintain the highest food safety standards. In the language of behavioural economics, the grading system, by generating public pressure, is expected to nudge the restaurants into improving their cleanliness.

Restaurateurs will be required to to post the 8-by-10-inch placards prominently on a front window, door or exterior wall within five feet of the main street entrance, from four to six feet in height. Failure to do so will be punishable by a $1,000 fine, with additional penalties for counterfeiting.

The ratings will be phased in, with only the A grade restaurants required to post their grades. Restaurants that receive a lower grade will automatically be inspected again at a later date and their grades reviewed, and if they are still unhappy with their grade, they have the right to seek an administrative hearing. A black-and-white "grade pending" sign will be posted in restaurants that are appealing their scores.

Incidentally a number-based grading system, based on points for violation of specified parameters, is already in place and the grades are displayed on the health and mental hygiene department website. Now the blue A card will correspond to 0 to 13 points under the old system, while the green B will designate a less sanitary 14 to 27 points, and an orange C will represent 28 points or more.

Inspections are unannounced and done atleast once a year. An inspector, equipped with hand-held computers to fill and calculate scores, examines the establishment’s sanitary conditions and then give the operator a printed report listing the violations observed, the points for each violation, and the total number of points.

Expectedly, the decision has evoked strong opposition from the restaurant owners and the New York State Restaurant Association has already sent a letter to some 3,500 eating establishments, rallying opposition and raising money for a possible legal challenge.

The challenge to replicating this experiment in countries like India would, apart from the political opposition it would invariably provoke, be in maintaining the purity/sanctity of the grading system. Though, to some extent more objective measures of hotel-cleanliness and food-safety can help address this problem, a large element of subjectivity will continue to remain. The likelihood of the administrative machinery being subverted to dilute the grading system will be very high.

A comparison of the supervisory bureaucracy in New York and a typical Indian city is instructive. In New York, the department is adding 23 more inspectors to its existing 157 to conduct annual visits that are now expected to rise by more than one-third, to 85,000 from 60,000. This translates to almost 130-150 restaurants for each inspector and 450-500 inspection visits each inspector in an year.

In comparison, a similarly large city like Delhi would have more than a lakh restaurants whose regulation is monitored by a handful of food inspectors. It becomes practically impossible for even a food inspector working exclusively on monitoring grading (they typically have a host of other activities) to just visit all the restaurants in his jurisdiction once a year.

An alternative would be to have grading agencies, similar to the ISO certification firms, who can be entrusted the task of evaluating restaurants on a few clearly defined parameters. While this too is vulnerable to being subverted, it stands a more realistic chance of succeeding than any government run certification and grading arrangement.

Friday, July 30, 2010

Labor market in the Great Recession

Arguably the biggest immediate economic challenge facing developed economies is that of lowering their unemployment rates. In the US, despite the unexpectedly strong economic recovery, equity market rise, and surges in corporate profits, unemployment rate has been stubbornly sticky.

In fact, in his semi-annual monetary policy report testimony to the Congress, Fed Chairman Ben Bernanke even opined that it will take at least three or four years for employment to return to its long-run sustainable level and the economy to recover the 8.5 million jobs lost in 2008 and 2009.

Assuming that the recession in the US officially ended in the summer of 2009, after adjusting for inflation, the economy grew 2.2% in 2009 Q3, 5.6% in 2009 Q4, and 2.7% in 2010 Q1. However, despite three quarters of output growth, the unemployment rate has remained stubbornly high, rising from 9.5% in June 2009, to 10.1% in October 2009, before falling back to 9.5% in June 2010, identical to the rate when growth restarted 12 months earlier.

Admittedly, the well-established lag between output growth and rise in job-hirings is a partial explanation for this stickiness. In the circumstances, there has been an interesting debate about the surprising rigidities in the labor market that are delaying labor market adjustments in the aftermath of the Great Recession.

Conservatives had attributed the persistently high unemployment rates among many European economies through much of the last two decades to the moral hazard induced incentive distortions generated by the continental economies' generous social welfare nets. It was argued that those out of jobs found it more convenient to live-off benefits than search for jobs.

However, the same argument can be hardly applied to the US economy, with its bare-minimum of social security benefits and flexible labor markets. In fact, the US Congress even voted early this month to not continue unemployment insurance benefits to long-term unemployed beyond 52 weeks (originally, it was 26 weeks but was extended once). However, early this week the Senate approved the extension of unemployment benefits for those out of work for more than 26 weeks for another six months till November 2010.

In the US, the search for structural causes for the persistent high unemployment rate has received much attention. They include skills mismatch, workers geographically "stuck" in place by negative housing equity, and the reduced employability of the long-term unemployed.

Automation and off-shoring has meant that it becomes possible for employers to lay-off workers performing manufacturing and low-end mangerial jobs and certain high-skill service sector jobs. As Daron Acemoglu argues, this along with the reluctance of men previously performing relatively well-paying manual tasks, manufacturing jobs and lower-end managerial jobs being unwilling to take lower paying service jobs means that structural unemployment will remain high for some time, atleast till recovery takes firmer roots and/or expectations of the workforce about job propsects change.

In other words, as Gilles Saint Paul writes, unemployment will persist "because of the reduced employability and job search intensity of the long term unemployed". He also cautions against "political hysteresis", or the possibility of those who have kept their jobs (the insiders) supporting tighter labour regulations (once the recession is past) that would increase their bargaining power in order to take advantage of the recovery to get higher wages, at the expense of new hires.

However, the search for explanations for the high unemployment in structural causes may be a red-herring. For a start, structural unemployment refers to those long-term unemployed that would be without jobs even if aggregate demand was on target, an extremely dubious assumption now. As Scott Sumner points out, the decline in nominal GDP has been so large (in 2009 nominal GDP in the US fell at the fastest rate since 1938) that "there is nothing at all surprising about the steep rise in unemployment during 2008-09". And after the ARRA expired, since nothing really effective is being done to nullify the effects of the lingering nominal GDP shock, the high rate of unemployment persists. He writes that the focus on structural causes "takes the pressure off policymakers to deliver adequate nominal GDP growth".

Richard Koo tool feels that the search for structural causes is diverting attention from attending to the real problem of reviving depressed aggregate demand. He argues that in a balance sheet recession the private sector minimizes its debt instead of maximising profits so as to repair their battered balance sheets. In the circumstances, governments need to step in and fill the deficit or risk letting the economy dip into a deflationary spiral with persistent and rising unemployment rates. He writes,

"When the deficit hawks manage to remove the fiscal stimulus while the private sector is still deleveraging, the economy collapses and re-enters the deflationary spiral. That weakness, in turn, prompts another fiscal stimulus, only to see it removed again by the deficit hawks once the economy stabilises. This unfortunate cycle can go on for years if the experience of post-1990 Japan is any guide. The net result is that the economy remains in the doldrums for years, and many unemployed workers will never find jobs in what appears to be structural unemployment even though there is nothing structural about their predicament. Japan took 15 years to come out of its balance sheet recession because of this unfortunate cycle where the necessary medicine was applied only intermittently."

Paul Krugman points to the interesting differences in the labor market outcomes in the recessions before nineties, which were due to real economy shocks and resultant macroeconomic policy actions, and those in the nineties and beyond, which have been induced by financial market crashes. He points to the variations in productivity across recessions in these two periods and writes

"(B)efore 1990, recessions were generally accompanied by a fall in productivity, mainly because businesses would hang on to workers, so as to be prepared to ramp up production quickly once recovery got underway. After 1990, this 'labor hoarding' effect basically vanished; if anything, productivity growth seemed to accelerate in times of weak demand. Partly this may have reflected structural changes in the economy; it might also reflect the (correct) perception that recovery from financial-crisis-induced recessions is much slower than recovery from recessions created by tight money, imposed by the Fed to control inflation."

In a much discussed recent post, Tyler Cowen felt inclined towards the view that "many previously employed workers simply have a current marginal product pretty close to zero". His reasoning is based on the fact that the economy produces much the same amount of goods with the reduced number of labor, without any major new technological breakthroughs. In other words, since a lesser number of workers are now producing more than earlier, the marginal product of those now laid-off workers had to be zero. See also Arnold Kling here.

Further, examination of the US labor market reveals that the unemployment rate is very low for highly-educated workers but very high for those at the other end of the spectrum (in the US, 34.7% of the labor force is college graduate and above, whereas their share of the long-term unemployed, more than six months, was just 18.7%). Similarly, lower-income Americans are affected greatly by the current recession while people at the top of the pyramid have almost negligible unemployment rates.

However, among the long-term unemployed, those with more education tend to have longer length of unemployment, while those with less education are more likely to find another quickly. This is understandable given the fact that more educated are more likely to wait for an appropriate opening before they re-join the labor market, whereas those at the other end are most likley to join the first opportunity that comes their way.

Greg Mankiw points to the steep rise in the median duration of unemployment and feels that traditional unemployment-output-inflation relationships like Okun's law, Phillips Curve, NAIRU etc may be due for revision.

On the shift in NAIRU, he also points to recent research findings that the "long-term unemployed put less downward pressure on inflation" and argues that therefore "the increase in long-term unemployment may mean that we will see less deflationary pressure than we might have expected from the high rate of unemployment".

Interestingly, Paul Krugman draws attention to a paper by Laurence Ball who points to the strong tendency of high unemployment to become permanent. Those out of work for a long enough period become permanently unemployable (or atleast less productive and less competitive in the job market), both psychologically and in terms of their skill-erosion. Ball provides compelling evidence that weak policy responses to high unemployment tend to raise the level of structural unemployment, so that inflation tends to rise at much higher unemployment rates than before.

Krugman also points to the possibility that the Beveridge curve — the relationship between job vacancies and the unemployment rate — already seems to have shifted out dramatically, signaling a worsening of the NAIRU. David Altig writes that the "most tempting explanation for the seeming shift in the Beveridge curve relationship is a problem with the mismatch between skills required in the jobs that are available and skills possessed by the pool of workers available to take those jobs".

Heidi Shierholz explains away the falsehood in the five big unemployment myths - unemployment benefits make people less likely to find jobs (since there are now roughly five unemployed workers for every available job, simply searching for jobs won't help you find one!); unemployment insurance doesn't contribute to economic recovery (see this); we can't afford to do this right now (see this, primary causes of US long-run deficits are rising health-care costs and low revenues and the stimulus is responsible for no more than 1 to 2% of US's long-run fiscal gap); private sector can take care of unemployment on its own (to get down to the pre-recession unemployment rate within five years, the labor market would have to add an average of roughly 280,000 jobs every single month between now and then); and unemployment rate gives us a good sense of how many people are affected by the downturn (the underemployment rate which includes jobless people who have given up looking for work and people who are working part time but want full-time jobs stands at 16.5%).

Tim Duy has this excellent summary of the debate in the blogosphere about the possibility of NAIRU having risen.

Update 1 (1/8/2010)
Minneapolis Fed has a series of superb graphics that highlights the magnitude of the Great Recession in relation to previous ones in terms of changes is employment and output.

Update 2 (8/8/2010)
Mark Thoma argues that irrespective of whether the unemployment is structural or cyclical, governments have a major role to play in lowering it, especially in deep recessions like the current one. Mark Thoma also argues that governments should intervene with fiscal support even with structural unemployment.

Update 3 (1/9/2010)

During the 2007-09 recession, middle income jobs were the worst hit, while lower paying jobs have been recovering faster than higher paying ones.

David Autor of the MIT also writes that from 2007 to 2009, the paper said, there was relatively little net change in total employment for both high-skill and low-skill occupations, while employment plummeted in so-called middle-skill occupations.

Update 4 (20/9/2010)

Mike Konczal (also this) and Paul Krugman point to evidence that it is weak aggregate demand and not skills mismatch that is driving the high unemployment rates in the US.

Update 5 (11/11/2010)

A San Francisco Fed working paper questions the structural reasons are causing high unemployment hypothesis. They write that "analysis of data on employment growth and jobless rates across industries, occupations, and states suggests only a limited increase in structural unemployment, indicating that cyclical factors account for most of the rise in the unemployment rate".

Update 6 (5/12/2010)

The structural or skills-mismatch hypotheisis of Kocherlakota et al (with its attendant claim that government cannot do anything) is not borne out by the across-the-board nature of job losses. As Matt Yglesias points out, it looks like a "massive and largely avoidable plague of idless in which the country is producing far fewer goods and services than it is capable of producing".

Update 7 (12/3/2011)

Economix (from Cleveland Fed report) points to an excellent graphic that highlights how "America’s most educated workers have been blessed with significantly lower unemployment rates and higher wages gains than their less-educated counterparts".

Thursday, July 29, 2010

Explaining India's inflation story

Just as unemployment is the defining macroeconomic challenge of the era across developed economies like the US, persistently high inflation has assumed centerstage as the central economic policy challenge in India. Worryingly, inflation in India has been following a trend different from other emerging economies where, as the graphic below indicates, inflation rates have moderated.

Standard explanations of India's inflation story has focussed mostly on foodgrain prices and specific supply and policy shocks. Besides conventional monetary policy responses, the immediate prescriptions to the problem have revolved around government buffer-stock operations, increasing imports and other efforts to increase foodgrain supplies. However, I have blogged earlier here and here that India's inflation story may be far more complex and go beyond these issues.

In this context, the RBI has used the occasion of its first quarter monetary policy review to expectedly hike the repo and reverse repo rates by 25 and 50 basis points, respectively, to soften persistent inflationary pressures in the economy. The fourth hike in the key policy rates in the current calendar year will increase the repo rate to 5.75% and reverse repo rate to 4.50%, while the CRR will remain at 6%. In a deficit liquidity mode, the repo rate under LAF (Liquidity Adjustment Facility) is the effective operating policy rate. See this and this excellent posts by Amol Agarwal.

The larger hike in the reverse repo rate was to narrow the corridor for short-term money market rates and thereby reduce interest rate volatility. Since the WPI-based inflation, recorded at 10.6% for June, has been in double-digits since February and was getting generalized across sectors, the RBI has raised the baseline projection for WPI inflation to 6% for FY 2011 from 5.5% earlier. Primary article (basically food, minerals and non-food crops) prices rose by 16.3% in June, fuels by 14.3% and manufactured goods by 6.7%.

The quarterly policy review document points to the demand-side pressures (increased pricing power) and capacity constraints generating inflationary forces and elevating inflation expectations. Non-food items like fuel products, iron ore and electricity contributed 70% to the WPI inflation in June compared with nil last November, indicating that food was no longer the dominant factor for speeding the rate.

In what is surely the most convincing analysis of India's stubbornly persistent inflation scenario I have come across, Arvind Subramanian draws attention to fundamental structural issues - overheating and cost-push inflation induced by rising land prices - that may satisfactorily explain India's inflation problem.

He does not subscribe to the standard explanations like weak monsoons and resultant fall in agriculture production or policy-shocks like fuel price and MSP hikes. He also doubts the utility of conventional monetary policy tools in addressing this inflation challenge.

Instead he feels that "the economy’s current growth rate of 7-8 per cent is above its potential or trend growth rate" and is causing the economy to overheat. Exacerbating the problem is weak agriculture productivity growth and increased purchasing power due to programs like NREGS. In particular, the unintended stimulative impact of NREGS on aggregate demand in rural India may be one of the under-appreciated contributors to inflationary pressures. He argues that the supply capacity of the economy is simply unable to match the demands on that capacity,

"We do not know for sure what the bottlenecks are in the rest of the economy. They could be inadequate investment in infrastructure, inadequate supplies of skilled labour (always a possibility in India because its growth model is so skills-reliant), slow total factor productivity growth or some combination of all the three."

There is no official measure of potential output levels for the Indian economy. Though, accurate approximations of potential output growth rate is difficult, the RBI research itself estimates the potential output growth rates in the 6.8-7.4% range for the 2000s decade. In fact, in view of the infrastructure bottle-necks that seriously constrain the capacity of the economy to meet the much faster growth in aggregate demand, a liberal approximation of the potential output will be in the range of 8-8.5%.

In a recent article in the Economic Times, B Kapali raised much the same issue while pointing to the persistent underlying inflationary pressures in the Indian economy over the past decade,

"A wide range of goods, services and assets have experienced some of the sharpest price increases we have seen in recent memory. Very high inflationary pressures have been built into the overall macro economy in the past 7 or 8 years even as real growth shifted into a higher gear. Between 2000 and 2010, while real GDP rose 100%, nominal GDP increased 260%. This indicates that prices have risen close to 300% in this period — a CAGR of nearly 12%. (This is the price level increase in overall GDP including services)...

After a decade of rapid output growth but equally rapid (or even larger) increases in prices, the basic questions (going beyond the tyranny of the present) are: what is the Indian economy’s potential growth rate? Has monetary policy been too accommodative in the past 10 years in relation to the level of potential output?"

The other causal factor mentioned by Arvind Subramanian is the increased activity in the real estate market on the back of strong economic recovery. The resultant surge in capital inflows into real estate and housing has led to sudden increases in the price of land and related inputs, raising the cost of production in the economy as a whole. He writes,

"A whole range of services, such as retail, construction, entertainment, education and finance — which account for progressively larger shares of the economy — use significant amounts of land as an input, a fact that gets overlooked in inflation discussions, which tend to focus on agriculture and manufacturing... Generalised cost-push inflation could then be a natural consequence with the push resulting from the interaction between a pre-existing microeconomic distortion and a macroeconomic factor that serves to aggravate this distortion, converting a price-level effect into an inflation effect."

He proposes taking immediate steps to eliminate the land market distortions and dampening credit flows, both external and domestic, into the real estate sector. This would help contain the real-estate driven cost-push inflation pressures. While it may be possible to take immediate steps to address this challenge more effectively, the expansion of the production possibility frontier of the economy would surely take time.

Neither of these causes can be directly addressed with standard monetary policy tools and would require resolving more fundamental structural challenges being faced by the Indian economy. In other words, the persistently large inflation is the most immediate and salient question mark on India's ability to sustain near double digit rates of economic growth. Does this also mean that Indian economy looks will face consistently high inflation rates alongside high economic growth rates for atleast the foreseeable future?

Update 1 (4/8/2010)

Niranjan has this op-ed pointing to the over-heating story.

Tuesday, July 27, 2010

How can foodgrains be "off-loaded"?

The persistently high food inflation has triggered off calls for more aggressive and direct government intervention in the foodgrain markets, especially by off-loading some share of the massive buffer stocks, in order to increase the supply and thereby lower prices.

Adding weight to this are reports that more than 10 mt of rice and wheat, stored in the open across the country by the Food Corporation of India (FCI), are at risk of (or already are) rotting. Of the 59 mt of grain stored by FCI and state agencies across India, 42 mt is in covered buildings, while the remaining 17.8 mt is stored in the open under tarpaulins.

Now, assuming the government decides to off-load these stocks, what are the channels to do so without any major market distortions? Unlike conventional open-market operations of the government in the financial markets, it is not possible to simply off-load massive stocks of food grains directly into the market, even accepting the distortion effect on the market prices. In the absence of trading in rice and wheat futures, the commodities market too lose relevance (it is a moot point as to whether manipulating this market can translate into lower market prices).

The only available channel for the government to off-load such massive quantities of stocks is the existing public distribution system (PDS). Here too, it can be done either by improving the efficiency of drawls (given the dysfunctional nature of the PDS in many North Indian states) or by increasing the allocations itself. Any improvements in the efficiency of PDS system is too complex an issue to be addressed immediately, which leaves increasing allocations as the only alternative. In fact, the proposal under the Food Security Act to distribute atleast 35 kgs of rice or wheat to BPL families at Rs 3 per kg in 150 of India’s poorest districts, is a good place to start.

But such actions would only cause small quantities to be released into the market and would not make any meaningful dent on rotting stocks or the larger issue of lowering prices. Further, it would take care of only food grains like rice and wheat, and still leave the major contributors to food inflation like pulses, oil-seeds, vegetables, etc unaddressed.

In this context, food-for-work programs, dove-tailed to the NREGS program (with some share of the wages given as food stamps), can be the most effective channel to off-load the massive food stocks and thereby bring down prices. This would enable the expansion of the scope of NREGS to more explicitly include infrastructure asset creation, besides wage employment assurance. Many much-needed infrastructure/community asset works that would other-wise have not been done, can now be covered under this. Moreover, from the experience of previous food-for-work programs, it can also have a depressing effect on food grain prices.

Another alternative would be to issue time-dated food vouchers, especially in rural areas. These vouchers could be redeemed through the regular PDS shops and other pre-defined/certified retail outlets. Though this would certainly carry the risk of market incentive distortions, if structured carefully and done in sufficiently large enough quantities it can achieve both the stock-disposal and price lowering objectives. And finally, there is the option of helicopter drops!

Monday, July 26, 2010

Social empowerment and economic growth

More evidence in support of the argument that economic growth is the most sustainable route to social empowerment comes from the example of women working in the growing garment industry in Bangladesh.

This Economix post points to how "by giving women an independent source of livelihood, Bangladesh’s garment industry has changed this conservative Muslim country’s society in immeasurable ways". An yet to be released study finds that "a doubling of garment jobs causes a 6.71% increase in the probability that a 5-year-old girl is in school". It has also been found that girls who live in villages with garment factories tend to marry later and have children later than the girls who grow up in villages.

More than 80% of the three million people who work in the industry are girls, who migrate to cities to work in these factories when they are in the 16-19 age group. Bangladesh with annual garment exports worth $ 7.1 bn, is already the world's second largest garment exporter. With the lowest factory wages in the world, the country is slowly emerging as the preferred outsourcing location for western apparel retailers and brands, who are exiting China due to rising wages there.

In this context, a study of the software industry in India by Emily Oster and M. Bryce Millett has found that the introduction of one ITES center increases school enrollment by 5.7% in its surroundings, an effect driven almost entirely by English language schools.

The results from the software and the garment industry are consistent with the claim that social empowerment impacts are driven by changes (or perception of changes) in returns to schooling. Such inherent incentives-driven forces have to complement (and beyond some level - say, secondary and tertiary education - even dominate) the role of government welfare interventions in achieving social goals like education.

They also underline the fact that the most effective - in terms of sustainability, ease of implementation, and most importantly, magnitude of the impact - means of social empowerment and poverty reduction is through economic growth.

Targeted welfare programs and focused poverty-reduction initiatives like micro-finance and SHGs, while important, have serious limitations in their ability to translate destitution-support led social empowerment into meaningful long-term economic empowerment. If there is any more evidence required, just look northwards to China!

Sunday, July 25, 2010

Where is the evidence of inflation?

While following the debate on exiting fiscal expansion in the US, I thought of listing out all available graphics on inflation based on different types of indices and expectations to see where does the evidence point to. As can be seen below, all of them point unmistakably southwards.

The 12-month percentage change in core inflation has been going downhill...

... as is the CPI for all urban consumers stripped off food and energy components. Core inflation has fallen from more than 2 percent to less than 1 percent.

David Beckworth shows thee steeply declining trend in inflation expectations as reflected in the difference between 5 year treasury yields and 5 year TIPS for the
January 4, 2010 - July 15, 2010 period.

Menzie Chinn
finds no signs of inflation with either annualized 3 month changes in price indices...

... inflation expectations from either Survey of Profession Forecasters...

... or from market-based measures of inflation expectations.

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.69%, or in other words, the public currently expects the inflation rate to be less than 2% on average over the next decade. This is borne out by the expected inflation yield curve.

On a historical perspective too nothing appears to have badly unsettled the inflation trend.

Paul Krugman points
to the 10 year TIPS spreads (difference between the interest rate on ordinary government bonds and bonds indexed to inflation), which is a measure of the inflation rate, and finds much the same declining inflation trend

And Rebecca Wider finds that the trend is global, atleast among the developed economies. She illustrates using the respective inflation-indexed bond markets that the 10-yr break-even expected inflation rates for the UK, Germany, Canada, Italy, and the US are falling.

See also this and this by James Hamilton.

Update 1 (1/8/2010)
More evidence from Free Exchange which points to the continuously declining trend on the interest rates on 10 year US government debt.

Update 2 (3/8/2010)
University of Michigan estimates (survey-based) of inflation expectations appear to indicate that they are currently well anchored. Indeed, except the early 1980's which experienced a period of rapid disinflationary expectations, expectations have been relatively stable.

Financial market inflation expectations, as manifested in the difference between 5 year Treasuries and 5 year TIPS fell slightly in recent months, but nothing like the clear taste of deflationary expectations at the end of 2008. It too appears to be well anchored.

Update 3 (4/8/2010)
David Beckworth has a series of graphs on falling inflation expectations.

Update 4 (10/8/2010)
Menzie Chinn finds that over certain horizons, we already have deflation; and for certain segments of the population, inflation has been at zero for a year already.

US economic situation in graphics

Mark Zandi's testimony before the House Budget Committee contains several superb graphics that can be used to nicely reconstruct the state of the US economy today.

The LIBOR-Treasury spreads clearly reflect the strains experienced by the US economy over the past three years.

The federal debt-to-GDP ratio, while not alarming when seen in historical perspective, is estimated to reach its highest level in more than half-a-century.

As the recession deepened, state and local government revenues have fallen precipitously.

The impact of ARRA spending will disappear from the third quarter, leaving the corporate sector to shoulder the burden.

Stripped off the census hirings, the labor market shows no signs of any recovery despite the recession getting over.

A reflection of the deep uncertainty about economic prospects is the anemic job hirings in the private sector, which has acted to amplify the unemployment problem.

Despite a surge in corporate profits, jobs have been hard to come by, as most of the profits have been saved or used to pay-off debts.

Consumer sentiment is stuck at a low plateau.

Business confidence, like consumer confidence, is at its lowest level in the last three decades.

Despite the rebound in equity markets and bottoming of the real estate market, foreclosures show no signs of falling.

The spectacular de-leveraging by households and financial and non-financial firms has driven down the credit markets and there is no evidence of any recovery.

The news from Europe is not encouraging as the sovereign debt spreads (with respect to 10 year German government bonds) remain high.

Update 1 (19/8/2010)

Superb series of graphics on the US economic situation.

Saturday, July 24, 2010

Software industry and engineering colleges

Interesting NBER working paper by Ashish Arora and Surendra K. Bagde that examines the causal role of state-level undergraduate engineering baccalaureate capacity (engineering college seats) on the development of local software industry (specifically software exports) across 14 major Indian states over the 1990-2003 period (which coincides with the rise of India's software industry). They write,

"We find that differences in software exports by states are related to the supply of human capital even after controlling for factors such as how rich or large the state is, and measures of industrial production, electronics production or telecommunication investment."

The graphic below shows the state share of software exports and engineering baccalaureate capacities for the 1990-2003 period. The clear positive co-relation points in favor of the aforementioned reasoning.

And given the almost similar presence (in proportion) of state-funded engineering colleges in all states, the role of private engineering colleges assume significance,

"It is the role of private engineering colleges which is the key the puzzle. Simply put, states which allowed private engineering colleges to enter early were able to get a head start and, this early advantage has persisted for nearly a decade and a half."

The changes in software exports and engineering baccalaureate capacity over the 1990-2003 period was the largest in Karnataka, Maharashtra, Tamil Nadu and Andhra Pradesh which had the largest increases in private engineering college seats, which points to a broad causal relationship.

They conclude,

"In other words, states were favored locations for software development because they had higher stocks of human capital, and they had higher stocks of human capital because they allowed private engineering colleges to operate earlier than other states... a key source of variation (in software exports) is that some states in India allowed the entry of private engineering colleges much earlier than the rest. These tend to be the states that also subsequently became the major poles of software exports... Permitting privately financed colleges helped mitigate the adverse effects of the lack of public investments in higher education."

For the record, the number of engineering colleges in India increased from 246 in 1987 to 353 in 1995 and over 1100 in 2003, with private sector forming 80% of new colleges added in the 1987-95 period and 94% in the 1995-2002 period. Further, during the 1985-2003 period, undergraduate engineering baccalaureate capacity increased ten-fold from about 45,000 (59 per million) to about 440,000 (405 per million).

Experience-stretching and the income-happiness paradox

It is by now widely acknowledged that once people achieve a basic minimum income level, further increases in individual incomes do not automatically translate into increases in happiness. In fact, a study by David G. Blanchflower and Andrew Oswald has even claimed that in the United States despite rising incomes, "the well-being of successive birth-cohorts has gradually fallen through time".

In this context, Jonah Leherer points to a new study by Quoidbach J, Dunn EW, Petrides KV, and Mikolajczak M, that draws from the experience-stretching hypothesis (that an over-dose of a happy experience lowers the marginal utility associated with an additional unit of the activity) of Daniel Gilbert, and concludes that money does not always make people happy.

The new study argues that money's ability to allow us to enjoy the best things in life (like great vacation or food) also, ironically enough, ends up decreasing our ability to enjoy the mundane joys of everyday life (like sunny days, cold beers, and chocolate bars, happy home life etc) which is the source of most of our joys in daily lives. This is because experience stretching (by way of cognitive comparison between the limited time on the "best things in life" to the remaining times on the "mundane things in life") ends up diminishing the relative (and by extension, the absolute) values of the subsequent less pleasurable experiences. They write,

"This study provides the first evidence that money impairs people's ability to savor everyday positive emotions and experiences. In a sample of working adults, wealthier individuals reported lower savoring ability (the ability to enhance and prolong positive emotional experience). Moreover, the negative impact of wealth on individuals' ability to savor undermined the positive effects of money on their happiness.

We experimentally exposed participants to a reminder of wealth and produced the same deleterious effect on their ability to savor as that produced by actual individual differences in wealth, a result supporting the theory that money has a causal effect on savoring. Moving beyond self-reports, we found that participants exposed to a reminder of wealth spent less time savoring a piece of chocolate and exhibited reduced enjoyment of it compared with participants not exposed to wealth. This article presents evidence supporting the widely held but previously untested belief that having access to the best things in life may actually undercut people's ability to reap enjoyment from life's small pleasures."

Update 1 (27/7/2010)

Daniel Sgroi finds that happiness raises productivity by increasing workers' effort and concludes that economists may need to take the emotional state of economic agents seriously.

Friday, July 23, 2010

US financial market reforms signed into law

Finally, after nearly an year of debate and acrimony, President Obama has signed into law a sweeping expansion of federal financial regulation, one that "subjects more financial companies to federal oversight and regulates many derivatives contracts while creating a consumer protection regulator and a panel to detect risks to the financial system".

The financial regulation reform bill (the Dodd-Frank bill) has tried to address seven major issues - regulation of the shadow banking system, limiting conflicts of interests, steps to limit the build-up of systemic-risk, consumer protection measures, internalizing the externalities imposed by systemic risks (costs of the inevitable bailouts), a resolution authority to dissolve failed large institutions, and regulator to monitor systemic macro-prudential risks. And needless to say, it is incomplete on all of them.

Shadow banking and limits on using derivatives

It expands federal banking and securities regulation from its focus on banks and public markets to a much wider range of financial companies, including those trading in credit derivatives. However, the legislation leaves regulators with broad leeway to shape its meaning and its impact.

The legislation establishes federal oversight of derivatives and requires most deals to be insured by a third-party clearinghouse and traded on public exchanges. In other words, henceforth standardized derivatives contracts will be traded on an open exchange, with prices and volumes reported publicly, and the contracts must also be cleared through a third party, an intermediary who guarantees that if one party defaults, the investor holding the other side of the trade will still be paid. The shift to clearinghouses will turn derivatives trading from a highly profitable niche to a more volume-based business, in which banks will have to compete on customer service and price.

But trading in credit-default swaps referencing lower-grade securities, like subprime mortgages, will have to be run out of bank subsidiaries that are separately capitalized. These subsidiaries may have to raise capital from the parent company, diluting the bank’s existing shareholders. Non-financial corporations would be allowed to set up their own financial affiliates to create and trade derivatives related to their businesses.

However, the bill permits banks to conduct trades for customers in interest rate swaps, foreign currency swaps, derivatives referencing gold and silver, and high-grade credit-default swaps. Banks will also be allowed to trade derivatives for themselves if hedging existing positions.

The legislation leaves to the discretion of regulators about which derivatives are to be traded on exchanges and how long traders can wait to disclose pricing information (so as to encourage competition). The important exclusions in the bill would only ensure that these trades would now shift to the hedge funds and special purpose vehicles outside the regulatory over-sight.

Systemic risk limiting measures

A large part of the debate on financial market regulation reforms have focused on the importance of having robust and self-acting mechanisms to address the build-up of systemic risk arising from concentration of risks within a few large firms - the too-big-to-fail (TBTF) problem.

A number of influential voices have argued that the only meaningful way to address this is to break-up the large financial institutions. They had argued that given the political power wielded by the large banks, the difficulty of regulators staying one-step ahead, and the moral hazard unleashed by the sub-prime bailouts, a repeat of the events that led to the sub-prime meltdown was inevitable.

However, it contains nothing on breaking up the big financial conglomerates nor limiting their size. Nor is there any action on stronger capital requirements. Further, it does not cover the large foreign banks, which in the absence of comparable restrictions will face a competitive advantage and resultant skewed incentives to continue these undesirable practices. In conclusion, the bill fails completely on the issue of limiting systemic risks arising from TBTF firms and their inter-connectedness.

The legislation restricts banks from making speculative investments with their own money, a provision known as the Volcker Rule, but allows banks to take small stakes in investment funds including hedge funds and private equity funds. This in turn dilutes the rigor of Volcker Rule type restrictions. It also authorizes regulators to impose restrictions on large, troubled financial companies.

Consumer protection

It creates a Consumer Financial Protection Bureau within the Federal Reserve Board (with separate financing and an independent director), to be appointed by the president, to write and enforce rules protecting consumers of financial products like checking accounts, mortgages and payday loans and also increases the authority of state regulators to enforce protections. Lenders would now be required to provide plain-English disclosures, price comparisons with alternative products and clear tripwires before fees are assessed. Banks may cut back on free checking as they spread costs more evenly across the customer base, rather than relying on a minority of customers to make bad choices.

However, it exempts loans provided by auto dealers from the Bureau’s oversight. If the super-regulator feels that if a consumer protection measure threatens the soundness or stability of the financial system (read "threatens bank profitability"), they can override the consumer protection bureau’s rules.

The legislation establishes a Financial Stability Oversight Council, as an ├╝berregulator, to be led by the Treasury secretary and made up of top financial regulators, to coordinate the detection of risks to the financial system. With the objective of giving the Congress more oversight of the Fed, the legislation also provides for audits of the Fed's Fed Special Lending Facilities, Open Market Operations, Discount Window Loans.

It creates a process for the government to liquidate failing companies at no cost to taxpayers, which is similar to the FDIC process for liquidating failed banks. Regulators believe they now have the authority to force troubled banks into a resolution process, something they didn't have before, and that they can do so in a way that won't disrupt the banking sector and create even bigger problems. However, as Mark Thoma has written, "regulators won't know if this will actually work until they try it, and that's the problem".

See assessments of the bill by Gretchen Morgenson, Simon Johnson, and Tobin Harshaw. See also this and this on the evolution of the Bill across the House of Representatives and the Senate. See this excellent description of the variouys components of the Bill by Mark Thoma.

Robert Reich has this assessment,

"(T)he legislation does nothing to diminish the economic and political power of these giants. It does not cap their size. It does not resurrect the Glass-Steagall Act that once separated commercial (normal) banking from investment (casino) banking. It does not even link the pay of their traders and top executives to long-term performance. In other words, it does nothing to change their basic structure. And for this reason, it gives them an implicit federal insurance policy against failure unavailable to smaller banks — thereby adding to their economic and political power in the future...

Customized derivates can remain underground. The consumer protection agency has been lodged in the Fed, whose own consumer division failed miserably to protect consumers last time around. On every important issue the legislation merely passes on to regulators decisions about how to oversee the big banks and treat them if they’re behaving badly."

James Henry and Laurence Kotlikoff describes this law as like being "invited to dinner and served pictures of food". More debate on the Dodd-Frank bill here.

Martin Wolf answers austerians

Martin Wolf has the best answer to 'austerians' advocating immediate tightening of fiscal policy in response to burgeoning deficits and debts across much of developed world and fears of bond-vigilantes, so as to restore "market confidence" in the country's commitment to maintain fiscal discipline over the long-run,

"Let us translate this proposal into ordinary language: 'If you are unwilling to starve yourself when desperately ill, nobody will believe you would adopt a sensible diet when well.' But might it not make sense to get better first?"

Thursday, July 22, 2010

More evidence on default savings options

I have blogged earlier here, here, here, here, and here about the effectiveness of default options in savings bank accounts and retirement plans to get people to save more and more efficiently.

More evidence of the effectiveness of default options in retirement plans come from an NBER working paper by Gopi Shah Goda and Colleen Flaherty Manchester who studied the impact of a particular firm's transition from a defined-benefit (DB) to defined-contribution (DC) retirement plans.

The transition offered existing employees a one-time opportunity to make an irrevocable choice between plans, and employees who did not make a choice were defaulted to switch to the DC plan if under age 45 or remain in the DB plan if age 45 or older. They then used a regression discontinuity framework to estimate the causal effect of the default rule and found

"Using a regression discontinuity framework, we estimate that the default increased the probability of enrolling in one plan over the other by 60 percentage points... Our simulations show that for a broad range of levels of risk aversion, allowing the default for the choice between pension plans to vary by age can substantially improve outcomes relative to a uniform default policy. Our results suggest that considerable welfare gains are possible in our model by varying defaults by observable characteristics."

Analyst estimates - reality check!

Economix points to McKinsey research which highlights the wildly over-optimistic nature of earnings-growth estimates of equity analysts for the past quarter century - ranging from 10-12% annually, compared with actual growth of 6%!

Only in years of strong growth, such as 2003 to 2006, when actual earnings caught up with earlier predictions, do these forecasts hit the mark.

Wednesday, July 21, 2010

More on the need for labor market flexibility

Much of the discussion about economic reforms remain confined to financial markets, infrastructure and agriculture. Labor market reforms tend to get overlooked, both because they are politically sensitive and there is a lack of understanding of its potential impact.

This is especially important given the widely acknowledged positive role that flexibility with labor migration across geographies and industries can play in promoting economic development. I have blogged about the need for labor market reforms in India here, here and here.

Our labor market suffers from numerous distortions both due to absence of appropriate incentives and presence of disincentives - lack of incentives for migration in search of better opportunities and disincentives against hiring and movement across jobs. In fact, these restrictive labor market regulations play no small role in the development of the massive black economy in the country. The challenge for policy makers will be to structure reforms that unshackles the market while providing some form of cushion to the workers against the uncertainty created and vulnerabilities introduced by these reforms.

Consider this example. Wages, for both unskilled and skilled labor, in Kerala are amongst the highest in the country. In fact, the unskilled labor wages are 3-4 times higher and skilled ones 2-3 times more than in neighboring Tamil Nadu. This is an absolutely staggering situation and highlights attention on the huge inefficiencies and rigidities that bedevil the labor market across the country.

Even though there are no legal restrictions on migration within India, internal labor movements remain sub-optimal within the country. Apart from the cultural and social issues that inhibit migration there are several institutional factors that come in the way of internal migration.

Fundamentally, migrants cannot access any of the welfare and other government benefits that the local residents enjoy. This is true not only of commonplace subsidies like rations, pensions, weaker section housing etc, but also of more critical benefits like access to local government employment openings, educational scholarships for children, health insurance, and self-employment scheme benefits. (In fact, another advantage of the UID/Aadhar is that it would provide portability of benefits and thereby help overcome many of these institutional obstacles to increased migration).

It is a reflection of the institutional bias against such internal migration that many state governments have policies in place specifically intended at discouraging migration. Further, the well-intentioned actions of state governments on various issues like housing end up with unintended adverse consequences. I have already blogged about the unintended incentive distortions caused by provision of housing units (linked to bank loans) in anchoring potential migrants to their villages thereby generating inefficient labor market outcome.

In this context, it would be interesting to study the role of NREGS in "crowding-out" beneficial rural to urban migration. It is possible that the NREGS will have disincentivized migration by a number of potential semi-skilled rural-to-urban migrants whose migration would have generated more efficient long-term labor market and economic outcomes. For example, rural-to-urban migrants would have a much greater chance of deploying their skills and even upgrading them, besides being a source of skilled labor supply for industries, than those who choose to remain in their villages.

In many respects, states like Kerala should learn from the bitter experiences of PIIGS economies in Europe who too face the formidable challenge of higher wages lowering their economic competitiveness in relation to their EU partners. Kerala's labor market is surely a major handicap for the state in its efforts to attract industrial investments, in the face of competition from other states, due to its uncompetitive labor rates.

Lack of adequate labor market integration across Europe means that the PIIGS economies have to take regulatory measures to address the issue of high labor wages. This naturally comes up against considerable political opposition and stands less chance of success. A more practical and efficient method to address this issue is to design policies that promote internal migration that arbitrages away such labor market distortions.

Monday, July 19, 2010

Markets are inefficient because they are efficient?

The Efficient Market Hypothesis (EMH) and market efficiency in general has been the subject of much debate in the aftermath of the sub-prime meltdown. Popular conception of EMH has it that asset prices cannot deviate significantly from its fundamentals, an untenable hypothesis given history and especially the recent events.

In this context, a more nuanced understanding of the concept of efficiency may help us appreciate the issue in its right perspective. Efficiency has two dimensions - market prices reflect all publicly available information about the fundamentals and the prices are fundamentally unpredictable. The popular inferences from these two dimensions are that they ensure that "prices are always right" and "it is impossible to beat the market on a sustained basis" respectively.

However there are enough reasons to believe that such highly simplified inferences may not be correct. It needs to be borne in mind that prices reflect only the "publicly available" information, and not "private" (or insider) information that is inevitable in such complex systems. Even more importantly, it also does not reflect the information about small and fleeting mis-pricings that are used by the likes of high-frequency traders. There have been even recent examples of wild market fluctuations largely attributable to the actions of such traders.

Further, as I have blogged about earlier, systemically too prices are extremely vulnerable to even small shocks administered through the random actions of noise traders/trading. Therefore deviations from the fundamentals will be a commonplace feature of equity markets.

In this context, Chris Dillow points to a new working paper by Brock Mendel and Andrei Shleifer where they claim that "rational but uninformed traders occasionally chase noise as if it were information, thereby amplifying sentiment shocks and moving price away from fundamental values". They show that even without large numbers of noise traders and significant sentiment shocks, a small numbers of these noise traders can have an impact on market equilibrium disproportionate to their size in the market. They write about how sophisticated but uninformed investors learn from prices,
"... such investors may entertain more complicated models and use other public information, such as bond ratings, in forming their demands... If ratings agencies usually do a good job of assessing the riskiness of bond offerings, it may be rational for uninformed traders to use these ratings as a rule-of-thumb to assess underlying value. On those occasions when the ratings agencies are wrong, this will induce correlated mistakes among the mass of uninformed traders, which will overwhelm the price impact of any better-informed traders in the market. It is only when the direct news about valuations reaches the uninformed investors that the market would correct itself. In this example, uninformed traders would rationally end up chasing noise thinking that it reflects information."
In other words, markets go wrong because sometimes rational but uninformed traders mistakenly believe that a price rise is driven by informed traders and not by noise traders and these noise traders, however small, occasionally carry enough momentum to tip the scales in favor of their trend. But as Chris Dillow rightly points out, this deviation from fundamentals "is only possible because very often prices really are right and do embody genuine information" and therefore "markets are occasionally inefficient precisely because they are so often efficient".

Interestingly, in view of the considerable range of non-fundamental information on market psychology (animal spirits of the market participants) that prices reflect, Rajiv Sethi has written that EMH be renamed as the invincible markets hypothesis (IMH)!

Update 1 (18/10/2013)

John Cassidy has a nice article that debunks the notion of efficiency with financial markets.

Sunday, July 18, 2010

A nudge to decide!

Even as Goerge Loewenstein and Peter Ubel urge caution, Dan Ariely has more of nudge-based solutions to everyday real-life problems. Procrastinator is an iPhone application, developed by the Duke Center for Behavioral Economics, that "aims to help take the pain out of making big decisions in your life"!

As all of us know, "when choosing between two or more very similar options, we tend not to take into account the consequences of not deciding" and experience a "decision paralysis". This is where Procrastinator steps in. It allows you to set deadlines for your hard decisions so that when time is up, if you haven’t chosen an option, Procrastinator chooses for you, much like Octopus Paul! And he seems to have gotten it right always!

Saturday, July 17, 2010

Do tax cuts pay for themselves?

One of the most fundamental tenets of supply-side economics is the entrenched belief that tax cuts pay for themselves. This ideological belief, which is unsupported by empirical facts, forms the cornerstone of conservatives' advocacy of tax cuts to boost economic growth. Paul Krugman has three excellent graphics that are self-explanatory.

Despite the higher tax rates, the Carter era saw a steady growth in revenues. In contrast, the Reagan era, with its tax cuts, saw permanent reduction in revenues relative to what they would otherwise have been. As Krugman writes, the Reagan tax cuts saw "a drop in revenues, then a resumption of growth, but no return to the previous trend". Below is the real federal revenue, in 2005 dollars, from 1970 to 1990.

The Clinton and Bush administrations were two two-term administrations, one of which raised taxes, while the other cut them. But the graphics below - of federal revenues and total non-farm payrolls for the respective periods - do not lend support to the claims of supply-siders. In fact, despite the tax cuts, the Bush era federal revenues and employment rate never touched the Clinton period growth trends (despite its tax increases).

This explains why Paul Samuelson described such reasoning "snake-oil economics"!

Update 1 (27/7/2010)

Excellent post in FT by Martin Wolf about the political psychology behind supply-side economics.

Update 2 (1/9/2010)
David Leonhardt writes, "... even Ronald Reagan’s much-lauded 1981 tax cut doesn’t appear to have worked. After he signed it, the economy lost jobs for 16 straight months. It didn’t start gaining jobs until after he had raised taxes, to reduce the deficit, in late 1982."