Thursday, September 30, 2010

Capital controls to call the Chinese bluff?

China's persistent currency manipulation to keep the renminbi under-valued has been one of the biggest global economic concerns for some time now. This has acted as an effective export subsidy cum import tariff, a job sucking machine, that has served to artificially boost China's export competitiveness vis-a-vis developed economies and other competing emerging economy exporters.

Any efforts at direct action by way of sanctions and coercing China into revaluing its currency, besides being legally untenable, is bound to fall short politically. In the circumstances, Daniel Gros proposes capital controls on Chinese purchases of US debt through reciprocity arrangements,

"The US (and Japan) could easily prevent the Chinese Central Bank from continuing its intervention policy without breaking any international commitment. The US and Japan only need to invoke the principle of reciprocity and declare that they will limit sales of their public debt henceforth to only include official institutions from countries in which they themselves are allowed to buy and hold public debt... the Chinese authorities would just be told that they can buy more US T-bills Japanese bonds only if they allow foreigners to buy domestic Chinese debt... in contrast to the area of trade, there are no legal constraints on the impositions of capital controls."

This would leave the Chinese government without avenues for investing its massive reserves. The euro option looks unlikely given the current risks associated with those assets and the possibility that euro members would retaliate with their own reciprocity arrangements. For the same reason, in the absence of meaningful currency alternatives, any threat to dump its dollar reserves would leave China with no alternative but store its reserves as cash deposits. And given the investments in scale required to manage the massive reserves, the possibility of Chinese investments in US private assets look remote.

In any case, as Paul Krugman has vociferously argued, any Chinese hair-trigger fire-sales of its trillion dollar hoard of US Treasuries would actually rebound on China and generate a win-win outcome for the US. Such forced sales and capital flight would knock the value of Chinese investments by both lowering the prices of those assets and leading to the depreciation of the dollar (unless the Chinese step in with even more dollar purchases, leaving them with the problem of finding a source to invest them or risk leaving them under the cushions!). And, the resultant depreciation of the dollar would end up increasing the competitiveness of US exports.

As Daniel Gros says, any US imposition of a reciprocity arrangement, with the attendant possibility of drying up of the Chinese channel to finance US deficits, would constitute a test of the US commitment to rein in its burgeoning deficits and massive public debt. This would also be the most effective strategy to call the Chinese bluff and ensure that the chimera of Chinese boycott of US debt is quietly buried.

Jailhouse USA?

Economix draws attention to a stunning statistic from a new report from Pew’s Economic Policy Group and the Pew Center on the States,

"Young black men who dropped out of high school are more likely to be incarcerated than employed."

Incarceration rates in the United States has risen dramatically since 1980, and more than one in three young black men without a high school diploma are currently behind bars. With 2.3 million people behind bars, the United States houses more inmates than the top 35 European countries combined.

Wednesday, September 29, 2010

This one for the Tea Party activists!

Deeply insightful graphic from Chuck Marr (via Mark Thoma) highlighting the "stunning shift in income" has taken place in US, "from the middle class to those few at the very top of the income scale".

Inequality in US has widened so dramatically that in comparison to the 1979 income distribution, the average middle-income American family had about $9,000 less after-tax income in 2007, and an average household in the top 1 percent had $741,000 more.

In 1979, the middle 20% of Americans had more than twice as large a share of the nation’s total after-tax income as the top 1%, whereas by 2007, the top 1%'s slice of the economic pie had more than doubled and in fact exceeded the middle class’s slice, which had shrunk. Fully two-thirds of the income gains in the last economic expansion (2001-2007) flowed to just the top 1 percent.

The US Census Bureau reports that the top-earning 20% of Americans (those making more than $100,000 each year) received 49.4% of all income generated in the United States, compared with the 3.4% earned by those below the poverty line. That ratio of 14.5-to-1 was an increase from 13.6 in 2008 and nearly double a low of 7.69 in 1968. It also found that the international Gini index for the US income inequality was at its highest level since the Census Bureau began tracking household income in 1967.

As Mark Thoma asked, "Is it possible for an outcome to be equitable when, as in recent decades, nearly all of the gains from growth accrue to one class?". In the face of such overwhelming evidence, the advocacy of Tea Party movement to lower taxes is at best dubious.

Monday, September 27, 2010

Poverty eradication through wealth redistribution or wealth creation?

There is an interesting paradox about India's administrative architecture. It is widely acknowledged that the most critical (in terms of program implementation and organizational importance) administrative unit in the country is the district, headed by a District Collector. But the irony is that this administrative unit is barely involved (and informed) in all major economic growth promoting activities of that area.

To the extent that districts are the cutting edge of governance in India, what happens there is a reflection of the priorities of the government of the time. So what does the district administration in a typical Indian district focus on? In the present context, the list would include - NREGA; functioning of schools, hospitals, and ration shops; response to disasters (specifically, floods and droughts); managing food price rises; procurement of grains; pensions; SHG activities; self-employment activities under various programs etc.

The list of what is not among its priorities include industrial growth; pro-active facilitation of industrial ventures; attracting investments; planning the expansion of road, water and electricity networks; planning and implementing other infrastructural facilities; monitoring the quality of engineering works; preparing and implementing macro-plans on district's overall economic development (not village-level micro-plans) etc.

The two groups of administrative priorities distinctly get divided into welfare enhancing and growth promoting policies. Whenever the focus of district collectors fall on infrastructure, it rarely goes beyond irrigation, school buildings, and small rural roads. Involvement in infrastructure and industry is most often confined to land acquisition.

The Government of India recently invited bids for the city gas distribution network in many districts across the country, including four districts of Andhra Pradesh. How many of these district network plans were prepared in consultation with the respective district level stakeholders, including officials? What are the chances that the district administration will be involved in the execution of the project (apart from the issue of land acquisition)? Both answers will unfortunately be in the negative.

It is well-established that local participation (in planning, finalization, implementation and monitoring) at the level of all stakeholders is a sine-qua-non of any successful sustainable economic growth model. However, to the extent that districts are the cutting edge of implementation and have some of the best officials in the bureaucracy, it is indeed surprising as to how little they are involved in the vital economic growth generating policies.

In simple terms, those with the least knowledge of an area are driving the growth of that area. It is as though the mandarins in Beijing drove the Chinese economic growth miracle of setting up millions of Town and Village Enterprises (TVEs) without any involvement of the local bureaucrats and party apparatchiks.

All this gives the unmistakable impression that India's poverty eradication strategy, indeed even its politico-economic governance strategy, revolves around targeted welfare programs. Increasing economic growth, while important, does not form a major part of the immediate poverty eradication calculus. The energies of the major share of its bureaucracy are not utilized into the big issues that determine economic growth. The focus is clearly skewed towards wealth redistribution than wealth creation.

All this is unfortunate. History is replete with examples from across countries which conclusively show that sustained periods of high economic growth rates is the only path out of poverty. Targeted poverty reduction programs involving redistribution of wealth, while important, are only instruments of poverty mitigation not poverty eradication.

The relationship between economic growth and poverty reduction is well-documented and there is considerable debate about which way the causation runs. However, it cannot be denied that any poverty reduction can come only by expanding the pie. This is especially true of the remote and backward areas of the country, untouched by even the basic infrastructure investments and bereft of any industrial activity.

Even small investments in these have the potential to yield immediate and substantial direct and indirect impact on rural incomes and thereby poverty reduction. Imagine the job creation potential of a medium-scale manufacturing facility or the considerable and immediate economic multiplier benefits from an all-weather road or electrification of a remote village.

What is more, to the extent that all major issues relating to development are still being planned and decided exclusively by the state capitals and in New Delhi, Indian economic growth bureaucracy retains distinct features of the old command and control regime. And volumes have already been written about the failures and deficiencies of such command and control approaches to economic growth.

None of this is to elevate nominal GDP growth rates to a pedestal of sacrosanct nature. The argument is only that District Collectors should do all that they are doing now, but should be playing a central role in the development of infrastructure and industries, and enabling linkages between them in their respective districts.

There are risks associated with more active participation of district administration - decentralization of corruption, lack of requisite capacity at district levels, dilution of professional standards deficient understanding about the macro-growth picture etc. However, the beneficial effects more than off-sets the aforementioned negative effects, especially if the scope of involvement of district level stakeholders is clearly defined to exclude technical decisions and bid-related financial issues.

To conclude, instead of spending all their scarce energies with directing poverty mitigating welfare programs and fighting meaningless battles with price rises and labor migration, district officials should be more actively involved in the process of economic growth creating path towards poverty eradication.

Saturday, September 25, 2010

Professor Bernanke Vs Chairman Bernanke

Facing its lost decade in the nineties, Princeton professor Ben Bernanke advocated that the Bank of Japan Governor Masaru Hayami indulge in aggressive monetary loosening, including signaling a higher inflation target. He even went on to describe the Japanese monetary policy timidity as a "Case of Self-Induced Paralysis".

"Krugman and others have suggested that the BOJ quantify its objectives by announcing an inflation target, and further that it be a fairly high target. I agree that this approach would be helpful, in that it would give private decision-makers more information about the objectives of monetary policy. In particular, a target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the 'price-level gap' created by eight years of zero or negative inflation...

BOJ officials have strongly resisted the suggestion of installing an explicit inflation target. Their often-stated concern is that announcing a target that they are not sure they know how to achieve will endanger the Bank’s credibility; and they have expressed skepticism that simple announcements can have any effects on expectations.

With respect to the issue of inflation targets and BOJ credibility, I do not see how credibility can be harmed by straightforward and honest dialogue of policymakers with the public. In stating an inflation target of, say, 3-4%, the BOJ would be giving the public information about its objectives, and hence the direction in which it will attempt to move the economy. But if BOJ officials feel that, for technical reasons, when and whether they will attain the announced target is uncertain, they could explain those points to the public as well. Better that the public knows that the BOJ is doing all it can to reflate the economy, and that it understands why the Bank is taking the actions it does."

Now, faced with similar macroeconomic environment and prospects of a similar deflation-induced lost-decade in the post-Great Recession US, the Federal Reserve opposition to higher inflation target mirrors the policy "paralysis" that Prof Bernanke accused the BoJ of. Ironically, the same Ben Bernanke, currently Chairman of the Federal Reserve differs with Professor Bernanke, and lays out much the same reasons for opposing a higher inflation target.

"Such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability. In this context, raising the inflation objective would likely entail much greater costs than benefits. Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed's hard-won inflation credibility. Inflation expectations would also likely become significantly less stable, and risk premiums in asset markets--including inflation risk premiums--would rise. The combination of increased uncertainty for households and businesses, higher risk premiums in financial markets, and the potential for destabilizing movements in commodity and currency markets would likely overwhelm any benefits arising from this strategy."

Private sector efficiency in perspective

Maxine Udall provides a much-needed sense of perspective to the private vs public sector debate, and claims of private sector's inherently superior efficiency,

"... concentrated economic and political power in the private sector is as much a "problem" as an ineffective, inefficient guvment especially one that has been deprived of the funds needed to regulate a complex capitalist society based on commercial exchange and characterized in some sectors (like health and finance) by several types of market failure...

It's a problem when guvmint is always and everywhere perceived to be the problem. It makes it difficult to pass legislation that would protect homeowners, borrowers, small businesses, renters, consumers (all the people who fuel and benefit from economic growth and prosperity) from corporate abuse of political and economic power...

Just ask yourself, as I often do, was your last unpleasant encounter with a cell phone company, a cable television company, a credit card company, or a bank or was it with a government agency? In my case, I'm sorry to say that some of the larger, more powerful parts of the private sector lose hands down."

Friday, September 24, 2010

The global macroeconomic rebalancing challenge

The events of the last three years have ignited intense debate about the prospects for the world economy and the policy measures that need to be taken globally and across individual economies to improve them. Global macroeconomic re-balancing has been a constant theme in all these debates. I have blogged about them here, here, here, here, here, here, and here.

The fundamental global imbalance is that the emerging economies are saving too much (and consequently spending too little), while the developed economies are spending beyond their means (and by corollary saving too little). Apart from manifesting in their current account surpluses/deficits and foreign exchange surpluses, these imbalances have important secondary influences on the development of manufacturing sectors and financial markets across the developing economies.

Further, as Stephen Roach recently pointed out, until developing Asia is able to shift its reliance from exports and external demand to private consumption and internal demand, Asia may not be in a position to take the baton of global leadership from the developed world. Nor will China be able to chart a growth trajectory that is decoupled from the fortunes of the developed economies, especially the US. In fact, currently, the US and China appear locked into a "mutually assured economic destruction" battle.

The East Asian currency crises of 1997-98 and its bitter lessons have had a profound impact on policy-makers across much of the emerging economies, especially those in Asia. And the Great Recession of 2008-09 may only have served to reinforce those lessons. Policy makers had responded with a renewed focus on the export-led growth strategy and accumulating foreign exchange surpluses and consumers moved towards saving even more. It actually increased its dependence on external demand, boosting the export share of pan-regional GDP from 35% in 1997 to 45% by early 2007.

Unfortunately, the lessons learnt, while important at that point in time, may now be coming in the way of the much-needed global macroeconomic re-balancing. China's imminent rise up the value-addition ladder and resultant increase in labor wages may be only another reason for these changes.

The prevailing global economic balance can continue only if the developed economies continue to exhibit the same insatiable appetite for imported goods from the emerging economies. In the absence of any such demand, the balance breaks down. Most worryingly for the emerging economies, their economies get imperiled if their major export market suddenly decides to take a holiday.

But re-balancing will require going beyond merely consuming more and saving less. Fundamentally, people will have to be convinced that they should spend more and save less. This becomes difficult, both on social-historic and economic grounds. Historically, people have been brought up in a culture of thrift and savings. Further, the deep uncertainty surrounding economic prospects in an increasingly globalized economy, without adequate social safety nets, only increases the urge among consumers to spend less and save more.

However, governments could help facilitate this process in many directions. Like with most issues affecting the world economy today, the major role has to be played by China. If China takes or is forced into taking three important steps, the world economy would have travelled a long distance in the path towards rebalancing.

1. Utilize a share of its massive "growth dividend" (taxes and other growth related revenues) to establish a comprehensive social safety net to cushion its vulnerable citizens. It would provide a boost to domestic consumption and lower the country's reliance on exports for growth. In fact, the recent fiscal stimulus was an excellent opportunity to establish this safety net.

2. Permit foreigners to invest in Chinese financial markets. This would immediately broaden and deepen the Chinese financial markets, thereby providing Chinese people themselves with a remunerative and diversified savings source. Besides, it would establish a channel for foreigners to take a share in China's massive foreign exchange reserves, thereby also ensuring diversification away from dollar-denominated assets and US Treasury Bonds.

Further, as China continues to increase its investments in global financial markets, it is important that foreign investors exposed to Chinese investments have access to appropriate instruments to hedge their China-related exposures. Foreign investments in yuan-denominated assets and yuan borrowings are therefore necessary requirements for the stability of the global financial system. This will also increase the global importance of the renminbi and enable China to play a greater strategic role in the world economy.

3. Permit a phased and calibrated re-valuation of the renminbi. Apart from rectifying the market distortions which adversely affect global trade, the benefits to China itself from this are manifold. It will immediately make imports competitive and benefit Chinese consumers and contribute towards lowering the emergent inflationary pressures. Chinese manufacturers will be encouraged into moving higher up the value chain and into more technology intensive goods, thereby increasing both their profits and critically labor wages. It will be a major step in the direction of boosting Chinese domestic consumption share and reducing the excessive export-dependence.

Interestingly, among all these emerging economies, India may be among those requiring the least amount of macroeconomic re-balancing. Its exposure to external markets, while significant, is more than off-set by its large share of domestic consumption, among the highest for emerging economies. However, a comprehensive social safety net, especially a national health insurance scheme, would be an example of both good social and economic policy.

Update 1 (29/9/2010)

Stephen Roach has these pro-consumption structural policies for China,

"These policies should include an expanded social safety net, with a public retirement program, private pensions and medical and unemployment insurance. China should also provide major support for rural incomes through tax policy and land ownership reform, as well as enhanced initiatives to encourage rural-urban migration. And it should encourage the creation of service-oriented jobs in industries like retail and wholesale trade, domestic transportation, leisure and hospitality."

China’s gross domestic saving rate is 54% of national income, the highest in the world for a major economy, whereas its consumption share of GDP is only about 36%, the lowest for a major economy.

The incentive mismatch with private donations

Just thinking. There is a fundamental incentive mis-alignment with philanthropic donations in general. The lion's share of the donor's personal satisfaction comes from the act of giving. Once the personal moment is past and the major portion of happiness is dissipated, the donors have limited interest in the subsequent outcomes. The graphic below captures the donor's satisfaction profile with respect to time.

In simple terms, since the act of giving is separated from the achievement of the outcome, and since the donor's interest is mostly concentrated at the former, there exists a strong likelihood that the latter could fall short on the original (for which the donation was made) objective. This may, atleast partially, explain why so much of private donations and aggregated private aid is mismanaged and often wasted.

Thursday, September 23, 2010

Charter cities for rural India

A version of Paul Romer's charter cities may offer interesting possibilities for the development of rural India. The proposal outlined is in its first draft and should undergo considerable fine-tuning before implementation. Sceptics are advised to step back and reflect on the broader idea before unsheathing their knives.

The proposal is to lease out large tracts of government lands in rural India, at very cheap rates or even free of cost, in return for development along broadly defined lines. The defined objective could be to set up a large enough manufacturing facility, which employs a number of people (not necessarily locals) and generates more than a quantified amount of economic activity. In other words, charter out parcels of land in remote locations, in the hope of creating substantially large enough non-farm economic activity.

The only pre-requisite would be that a failure to set up the manufacturing facility within the specified time will entail restoration of the allotted land. If only a partial extent of land is developed, then the remaining extent will be resumed. The bids can be evaluated and allotted based on the attractiveness of the commercial proposal - in terms of its potential impact on the local economy. While, this does raise genuine concerns about unhealthy practices, greater clarity on the terms of reference, phasing, and condition for restoration can considerably mitigate them. In any case, if the desired project is established on ground, its benefits would more than off-set any losses incurred by doling massive land parcels to favorites.

The underlying logic is that any private investment (and presumably, any private investor putting his money on the block would channel investments to those sectors that would enable him leverage the strengths of the area), especially in virgin locations like these remote areas, will have a dramatic impact on the local economy. Apart from providing jobs, mostly indirect, it will boost economic activity and form the threshold for further development. No government action can realistically be a substitute for one big-ticket private investment.

The private investments and its multiplier on the local economy (direct and indirect jobs, and the substantial other economic opportunities) have the potential to serve as the anchor for a broader set of other economic activities. This approach works on the assumption that the only sustainable way in which these remote geographic areas can move into the next growth trajectory is through manufacturing or services-led economic growth.

The proposed lands should be in remote enough locations (and there is no scarcity of such areas), which are deficient in both infrastructure and any off-farm economic activity, and which would otherwise not have developed on its own or even with government support in the foreseeable future. Further, in order to ensure that such efforts do not get cannibalized into small-time land grabs, it should be mandatory that the allotments be of large enough tracts.

A credible enough threat of taking back unused extents of land should serve as an adequate incentive for businesses to fully implement their investment proposals. Though current concession and other contract agreements provide for penalty clauses, including resumption of the allotted lands, the provisions are often drowned in impenetrable legalesse. This effectively nullifies the force of these provisions and emboldens the private developer to deviate from contractual provisions and hoard land.

In the circumstances, it would be required to explicitly link development (along pre-defined lines and within schedule) of the area to the threat of resumption or dispossession. In simple terms, development along the pre-defined lines within the specified time should be the only scope of work (or terms of reference) for the private developer.

In order to discourage developers from sitting on undeveloped land, contracts or concession agreement many be explicitly structured (while this provision is present in present-day contracts, they are most often qualified to the extent of dilution) to resume government possession of those extents which have not been developed within the scheduled time.

I would call such land transfers Pareto improvement decisions for the following reasons

1. It is difficult to achieve success with government-led economic growth interventions in remote locations. Private business investments go to either already established industrial locations or areas surrounding urban centers. Without government support, to the extent of it being perceived as overtly generous, business investments are not likely to materialize even in the long-term in such remote locations. This proposal would be an example of benign industrial policy, which while guiding investments into certain specific locations, does not micro-manage by defining the type of business activity.

2. Government-directed capital investments are a very remote possibility. And prospects of government investments - in the scale and comprehensive nature - required to improve local physical infrastructure too are bleak. In any case, the number of such locations are far too large for government investments, even assuming it to be in scale and comprehensive, to make any meaningful dent on the overall requirements.

3. The spill-over effect or positive externalities on the locality due to the private investments, especially in areas untouched by any economic activity, are likely to be substantial. Even if the investment is limited, it can provide an anchor to catalyze further economic activity. For example, a business investment in a remote location will suddenly bring in a large number of people into one location and involve transportation of inputs and products into and from the area. These activities will invariably generate linkages with the local economy by creation of jobs, newer business opportunities, and awareness about the potential/opportunities for human improvement (that comes with the introduction of such types of growth activities into virtually time-warped societies).

4. The private entrepreneur has the incentive of capitalizing on a potential first-mover advantage into such virgin territories/markets. This is especially true if the entrepreneur views his investment in such locations with a longer time horizon. The potential benefits from a successful intervention are huge and provides him a head-start, over all other later entrants, in establishing all linkages and making use of the local strengths. The cheap or virtually free availability of land and cheap unskilled labor (for all non-critical activities) will contribute towards keeping production costs low, especially since land values are an increasingly large share of investment cost.

5. Private business investment is the best bet for bringing in basic infrastructure investments, either through government (to incentivize these investments) or by the private investor(s), into these remote areas. Some level of basic investments on connecting roads, electricity, and telecommunications will inevitably follow, either from the government or the private developer himself. In fact, given the dynamics of the prevailing political system, more than the local political representatives, a big enough private developer stands a better chance of bringing in even government investments into public infrastructure in such areas.

6. Most often, such areas, apart from being economically backward, are also socially regressive (with caste and feudal social attributes). These external investments bring in outsiders and modern ideas to these villages. These coupled with the social empowerment dimension of access to newer (different from the cultural strait-jacketing types of livelihoods) and more remunerative business opportunities unsettles established orders and become a powerful source of social change for the better.

So how about this advertisement!

"The Government of Backwardland (GoB) invites Expression of Interest (EoI) from reputed manufacturing firms who are willing to invest in any manufacturing activity in its remote Timbuktu area. The GoB will provide 1000 acres land free of cost in the area. The developer would be required to develop the entire area with manufacturing related activity within three years from handing over possession, failing which the unused land will be immediately resumed back to the government."

Update 1 (9/12/2011)

The Economist reports on Paul Romer's proposal to set up a charter city in the northern coast of Honduras. The city will have its own government, write its own laws, manage its own currency and, eventually, hold its own elections. The proposal has found favor in Honduras and some constitutional changes too have been carried out.

Wednesday, September 22, 2010

Nudging on how often and how long people exercise

The newest addition to the list of iPhone-based nudges is NudgerSize, developed by Keystone Insights, LLC, that seeks to get people into exercising and also calibrating how often and how long we exercise.

The "Nudge-Your-Size-Back" iPhone application uses multiple voice reminders or pop-up messages or sound alerts to encourage users to exercise and increase their exercise productivity. It even has customizable voice nudges - friendly, supportive, humorous or aggressive - depending upon personal needs.

A recent WSJ article had pointed to a Stanford University study of 218 people, which found that "small amounts of social support, ranging from friends who encourage each other by email to occasional meetings with a fitness counselor" can help people break out of physical inactivity. The study had divided people into three groups - first and second received periodic calls from a trained health educator and an automated computer system respectively, while the third control group received only initial health education tips but no follow-up calls.

It found that after 12 months, participants receiving calls from a live person were exercising an average of about 178 minutes a week, a jump of 78%. Exercise levels for the group receiving computerized calls doubled to 157 minutes a week. But for the control group of participants, who received no phone calls, exercise levels rose up only 28% to 118 minutes a week.

Update 1 (23/2/2011)

Alan M Garber and Jeremy D Goldhaber-Fieber have this post in Vox about the behavioural psychology way to get people to exercise more.

Monday, September 20, 2010

Efficient subsidy transfers - cash transfers Vs dual pricing/price controls

In a recent post explaining the unique nature of the market for health care services, Prof Uwe Reinhardt draws attention to Kenneth Arrow's seminal work on welfare economics. Professor Arrow had argued that for any given initial distribution of income and wealth, a perfectly competitive market (full information among sellers and buyers about price and quality, no entry barriers for sellers, and no single buyer or seller can influence the market) will settle down at a unique equilibrium, a state from which no potential buyer or seller would want to move.

The First Optimality Theorem claims that in such equilibriums, the traded good or service is allocated among buyers in such a way that it would be impossible through any reallocation to make someone happier without making someone else less happy. In other words, such allocations are Pareto efficient.

The Second Optimality Theorem states that "any particular Pareto optimum can be achieved through competitive markets by simply prescribing an appropriate initial distribution of factor ownership and a price vector". In other words, specific politically desired social/economic outcomes can be achieved in a welfare-maximizing manner using the market mechanism by an appropriate initial distribution of incomes and wealth. In Prof Reinhardt's words,

"If on ethical grounds society wished to distribute a good or service (for example, education or health care or food or beach houses) among people in a particular way — like egalitarian principles — it need not have government directly involved in producing or distributing that good or service. The desired distribution could be attained by redistributing income and wealth among the citizenry in a way that would drive the perfectly competitive private market to achieve the desired allocation of the good or service among the people. Better still, it would do so in the welfare-maximizing way."

Let me illustrate this by taking the classic example of a market for any goods/service which is regulated - either in the form of dual-pricing (food grains through PDS) or price controls (petrol or diesel). The incentive distortions and inefficiencies in such markets have been discussed in earlier posts. Prof Arrow's theorems would have it that the specific social/political objectives (say, food security) can be achieved through the market mechanism and by transferring the proportionate cash subsidy directly into the hands of the targeted beneficiaries.

Such subsidies are ubiquitous in India - public transport, public utility services, farm inputs, weaker section housing etc. Assuming Arrow's theorem to be correct, then the way forward would be to dismantle the price controls and target the equivalent subsidies directly to the bank accounts of the intended beneficiaries.

The benefits would be two-fold. One, the market distortions caused by price controls would immediately disappear and the suppliers (including private ones) could compete to deliver services efficiently. Second, benefits would now be more effectively targeted, thereby avoiding much of the wastage and pilferage that characterize the current arrangement.

However, I foresee two major problems with this approach - one on the implementation side and the other on more theoretical considerations.

1. Targeting presumes perfect knowledge about the identity of the beneficiaries. Maintaining the accuracy of beneficiary identification has traditionally been the 800-pound gorilla in India's welfare administration. The complex nature of India's society and polity, heavily politicized welfare administration, and widely-pervasive and excruciating poverty exacerbates the beneficiary identification challenge.

2. The assumption of competitive markets in these sectors is questionable. Many infrastructure segments are classic monopolies and capital intensive and therefore not easily amenable to efficiency promoting competition. Further, given the under-developed markets, the often weak supply-side may not be able to always match up to the massive and increasing demand.

However, there are answers to such challenges. If the UID/Aadhar gets rolled out according to plan, then targeting suddenly becomes easier. In fact, UID-linked bank accounts have the potential to be a game-changer in the transfer of subsidies directly as cash. Further, the only thing worse than a market with monopolistic structure is one that is not only monopolistic but is also inefficient (due to price controls). To that extent, there is a very strong case to be made that the subsidies should be reimbursed to the targeted beneficiary instead of having a dual-price market. In any case, cushioning supply shocks will always require governments to often step-in with an active role with various policies, including maintenance of buffer stocks and aggressive open market operations on it.

Let me describe the current subsidies-based arrangement as S and the proposed cash-transfer based one as C. The balance sheet for S is that while it is easy to implement, it creates considerable market distortions and massive pilferage/wastage. In contrast, though C is difficult to implement, it avoids many of the market distortions, besides being more cost-effective in terms of the net public expenditure. On the balance, it cannot be denied that C produces far less incentive distortions than S. In simple terms, C is superior to S if its net benefits exceeds that of S.

Let C(d) be the incentive distortions caused by C and S(d) that caused by S.
Let C(w) be the wastage/pilferage generated by C and S(w) that by S.
Le C(i) be the measure of logistics of implementation of C, and S(i) that of implementation of S.

On the balance, the net cost of implementation of S is a measure of S(d) + S(w) + S(i), and that of C will be C(d) + C(w) + C(i). Further, as is clear from the aforementioned reasoning, C(d) < S(d), C(w) < S(w), and C(i) < S(i). Adding them

S(d) + S(w) + S(i) > C(d) + C(w) + C(i)

(S(d)+S(w)+S(i))-(C(d)+C(w)+C(i)) > 0

Therefore, the total cost of S will always be larger than C for any S or C interventions.

The choice of policy alternatives becomes very clear with this formulation. With UID-linked bank accounts, C(i) stops being a major problem, and to that extent the cost differential between S and C widens. As already discussed, the incentive distortions and wastage/pilferage is much less with cash transfers than with subsidized regimes. On the balance, cash transfers score over price controls and dual-pricing.

Sunday, September 19, 2010

Is Ireland heading for default?

Amidst all the attention on Greece, Ireland had fallen off the radar, especially after its much-praised embrace of fiscal austerity. However now, raising questions about the effectiveness of the austerity medicine, there are unmistakable signals from the Bond and CDS markets (via CR) that Ireland may be hurtling into sovereign default territory.

Markets appear clearly unimpressed by Ireland's very harsh fiscal austerity measures. As the Irish book closes, we may not need to wait three years to find out the outcome of Ireland's experiment with fiscal austerity.

The fiscal austerity debate in perspective

Unemployment is the biggest short to medium-term challenge facing the US economy. The San Francisco Fed has a summary of the projections by different agencies for monthly net job creation required to bring down unemployment rate to 8% by June 2012. All estimates point to the need for creating a minimum of 225,000 jobs every month, and even with that unemployment will remain well above the desirable 5-6% rate.

Complicating matters, forecasts from the CBO, the BLS, and the Social Security Administration (SSA) suggest that, absent cyclical movements, labor force participation will trace a downward course driven by the aging of the baby boom generation. Also worryingly, average job growth during the last economic expansion was just about 142,000 per month.

In this context, how have been the recent labor market trends? The last three months have witnessed net job losses.

Even the private sector job market shows no signs of buoyancy.

In the circumstances - prevailing job market environment, aging labor force, precedent of job creation during upturns, and the requirement to return close to normalcy - without additional external resources, the economy looks unlikely to return to normalcy any time for the foreseeable future. Do we need any more justification for another round of stimulus? Take the pick - high unemployment rates for the foreseeable future or short-term deficits?

Friday, September 17, 2010

The diversification of Chinese currency manipulation

The big story in the global foreign exchange markets for the past few years has been China's brazenly mercantilist policy of keeping exchange rates artificially under-valued and the reluctance of US and others to squarely call Beijing's bluff. Now, in an interesting twist, there is increasing evidence that China may be pursuing a different strategy with its exchange rate policy - diversification away from its hitherto dollar-centric purchases and investments into other currencies, mainly yen.

In this context, Japan's decision early this week to prop up the dollar and weaken its currency by intervening in international currency markets through sales of yen and purchases of dollars, assumes significance far beyond its immediate impact on the dollar-yen exchange rate. This intervention, the first since 2004, comes on the face of mounting pressure from export businesses who have been bruised by a surging yen which touched 83.66, the highest level since 1995. Faced with an economy fighting deflation and recession, the Japanese government is naturally concerned that the engine of its economic growth, exports, are being adversely affected by the strengthening yen.

This surge has coincided with China investing its massive dollar reserves into buying large amounts of yen-denominated Japanese bonds for the past few months, acquiring a net 583.1 billion yen ($6.97 billion) in July and more than $27 n so far this year. At $2.45 trillion (as on June), China possesses the world’s largest foreign-exchange reserves, mostly held in dollar assets, while Japan has the second-largest reserves at $1.01 trillion.

Interestingly, the Chinese purchases of Japanese bonds have been mostly of short-term instruments. This suggests a tactical approach, as China buys yen-denominated instruments in anticipation of a strengthening yen (which benefits the foreign investor, as he gets back more dollars for every yen invested). It leaves them with the flexibility to exit once the yen starts weakening.

The circumstances - both Japan and China wanting to keep their currencies from appreciating, and China wanting to diversify its forex holdings - provide for a convergence of interests of both China and Japan. Japan buys dollars and sells yen, while China offers a share of its massive dollar reserves and buys yen, which it in turn invests in Japanese bonds. In other words, China is using Japan as a proxy to invest its dollar reserves, and US currency market diplomacy gets diverted to Japan.

The Chinese yen purchases also contributes to the rising yen, thereby forcing Japan into buying even more of dollars so as to keep its currency from appreciating. In fact, China has gone beyond Japan, and has been also purchasing South Korean and Malaysian debt, in an effort to reduce its dollar exposure and also deflect attention from US criticism that it is manipulating its currency and building up dollar reserves that is weakening the US economy. And underpinning all these foreign currency debt incursions is the policy of keeping yuan pegged to a depreciating dollar (which ensures greater returns from investments in those appreciating currencies).

But within Japan there are concerns about the Chinese policy, especially its reluctance to permit Japanese and other foreign investors make purchases in its domestic financial market. This would enable Japan and Japanese borrowers exposed to Chinese investments hedge against sudden shocks (of say, yen depreciation, that can precipitate capital flight from yen) by taking corresponding yuan investment positions.

In recent months, the People's Bank of China has talked in favor of overseas financial institutions investing in Chinese bond market so as to promote greater use of the yuan in global trade and finance. But with China, such announcements mean little. In the last instance, since its high-profile announcement in June signaling that it would let the exchange rate start to reflect market forces, the yuan has risen exactly 1% against the dollar!

Thursday, September 16, 2010

What does Apple sell?

Not iPhones and iPods, but "pricing" (via Freakonomics)! So says a Businessweek article that examined Apple's strategy of using "pricing decoys, reference prices, bundling and obscurity" to increase the attractiveness of its products.

The iPod Touch media player has been revamped at three price points - $229, $299, and $399 - all costing more than the iPhone (iPhone 4 with more features comes at a much lower price of $199), which does everything the Touch can plus make phone calls. The $399 and $299 price models serve as decoys, to be used as reference points, to increase the attractiveness of the cheaper version.

Another application of a high reference point is the strategy of launching products at an artificially high price (to capture the initial burst of consumers with higher willingness to pay) and then rapidly lowering that price - iPhone cost $599 when it first hit the streets, while today at $199 it appears like a steal.

Clearly distinguishing itself from the rest of the market makes it difficult to establish an external price reference point for any Apple product, at least in the immediate aftermath of its launch, and thereby makes it possible to push through the price premiums. Obscurity of the product therefore makes it easier for customers to embrace Apple's prcing.

Finally, an Apple product is never an one-off buy, but is followed by a series of downstream expenditures - data and voice phone contracts, song purchases, video rentals, and advertising clicks. These services are bundled into the original purchases with a back-loaded payment structure.

More illustrations of price referencing (all from Freakonomics). First, decoys

Reference point pricing...

... and more reference point pricing

And the increasingly popular pay-what-you-wish!

Update 1 (19/9/2010)

Tim Harford has this nice summary of different pricing strategies that exploit various cognitive biases - endowment effect, anchoring, social approval, bundle freebies etc. He points to infomercials - "The TimCo smokemaster doesn’t retail for £200; it doesn’t retail for £100; it doesn’t retail for £50... (anchoring to a price of £200)... if our lines are busy, please try later” (social approval)... the smokemaster is not available in regular stores (loss aversion)... but wait! When you buy the TimCo smokemaster you get the TimCo soup knife absolutely free (complex pricing and use of 'free')". He also points to drip pricing which combines many of these effects,

"Customers agree to pay a price only to discover that there is a charge for delivery; another charge for paying by credit card, and another for insurance. Drip pricing taps into the endowment effect, because customers feel that they have already made the decision to purchase; it creates loss aversion because customers commit time and effort to the search before being hit with extra charges; and it is a form of complex pricing which makes it hard to compare offers."

Wednesday, September 15, 2010

Basel III norms

The Basel III banking norms, intended to make the global banking industry safer and protect economies from financial meltdowns, has been finally agreed to by central banks and banking regulators from 27 major countries. The culmination of the two-year long process, undertaken by the Basel Committee on Banking Supervision, comes after intense debate between those demanding tougher reserve requirements and their opponents arguing that such norms would adversely affect banks' profitability and stifle financial innovation.

Fundamentally, the new standards will considerably strengthen the reserve requirements, both by increasing the reserve ratios and by tightening the definition of what constitutes capital. It will more than triple the amount of capital that banks must hold in reserve to absorb losses, in order to force them to maintain a larger cushion against potential losses.

The proposals increase the common equity reserve (or Core Tier 1 capital, calculated as a percentage of risk-weighted assets), the least risky form of capital, from 2% to 7% of their risk-weighted assets. Add in a 2.5% conservation buffer, banks will need 7% common equity, 8.5% Tier 1 capital, and 10.5% Tier 2 capital reserve. Further, there is also a counter-cyclical buffer of 0-2.5%, to be set by individual national regulators, which accounts for any irrational exuberance during the good times. This means a potential loss-absorbing capital requirement of upto 9.5% common equity, 11% Tier 1 capital, and 13% Tier 2 capital.

The new norms also introduce a Tier 1 leverage ratio of 3%, which would limit banks to lending 33 times their capital, which represents a cap on bank risk irrespective of the impact from the higher capital numbers. Though this ratio, intended as a backstop to the risk-based measures, is targeted to be achieved only by 2018, the banks will need to disclose their leverage ratios from 2015.

However, as the timetable below shows, banks have been provided a lengthy transition period, nearly a decade, to adjust to these tougher norms. Some of the provisions do not take full effect until the beginning of 2019, so as to comply with some of the strictest rules. January 1, 2013, has been set as the deadline for member nations to begin to phase in Basel III rules.

Mark Thoma has this nice analysis of the the new norms. Simon Johnson advocates the Hanson-Kashyap-Stein view that banks should be required to hold enough capital at the peak of the cycle so that when they suffer losses they still have enough capital (and are not forced into distress sales) so that the markets do not think they will fail. This points toward at least 15 percent Tier 1 capital being required in good times; the most forward-looking officials in Group of 20 countries may aim for closer to 20 percent.

Update 1 (18/9/2010)

Felix Salmon writes that Basel III does "a bad job of reducing unforeseeable risks", with the result that "banks are incentivized to load up on the kind of securities which can blow up in unforeseeable ways". And one of the ways in which it causes this is by continuing up the possibility of gaming risk measures. Like Basel II, the proposed arrangement too leaves risk measurements to the discretion of individual banks. As Noah Millman writes, "Since taking any additional measurable risk is now stigmatized, the game becomes how to increase returns without increasing measurable risk".

Update 2 (19/9/2010)

Economist points to analysis by Credit Suisse which shows that all but the shakiest European banks will meet these requirements by 2012, with many of them already meeting them.

Monday, September 13, 2010

The economics of bribing and what to do about it

Been sometime before I blogged about one of my favorite topics - the dynamics of corruption! Here is an attempt to answer the most persistently frustrating of socio-economic problems - why do people pay bribes and how can we restrain such payments?

The story goes like this. Buyers of the myriad government services, like those of any other product in a market, face similar demand-supply curves. As evident from the figure, those buyers above A in the demand curve (numbering Q1) are willing to pay more than the price fixed for the service/product, P1. This willingness to pay at the margins opens up opportunities which middle-men and bribe-takers exploit.

Citizens (buyers) lying on the upper-side of the demand curve are willing to pay more than the government prescribed user fee of P1. Therefore the area of triangle ABP1 (shaded) constitutes the full rent market.

Here is an attempt to apply the principles of economics to address the problem of bribe payments. While these suggested solutions will not in anyway eliminate rent-seeking, they will align incentives for all stakeholders in a manner so as to certainly reduce the likelihood of rent-seeking behavior. The first approach addresses the demand-side (rent-givers) and the second manages the supply-side (rent-seekers).

One, Econ 101 teaches us that markets do a good job of price discovery and too low a price causes incentive distortions. For various reasons, the prices fixed by governments are most often too small, leaving rent-seekers with ample opportunity to exploit (as indicated in the graphic above). For example, electricity connection charges are very low and government machinery is invariably over-stretched. Buyers (with a much higher willingness to pay) are therefore incentivized to pay a rent-premium to access the connection faster and without any inconvenience.

The solution is to have a differential pricing mechanism (a two-price arrangement), with a higher priced premium service delivery channel that would seek to capture higher willingness to pay consumers. They would pay double or triple the amount (to be fixed based on the demand for the service and the ability of the system to deliver the premium service) to have the same service delivered at their door-step and within 24 hours. This hassle-free window would cater to those citizens with higher willingness to pay. It reduces the possibility of rent-seeking by institutionally capturing the higher amounts that people are willing to pay. See this and this.

Two, Econ 101 also tells us that markets provide competition which arbitrages away certain types of inefficiencies. So if one supplier provides widgets at $5, whereas the others are willing to sell it for $3, the former will be priced out of the market. Since government is the monopoly supplier of these products, direct external competition is impossible. The solution is therefore to have multiple channels (within government itself and also outsourced alternatives) to deliver the service so as to generate some level of competition.

Multiple channels within the same department - either at different locations or at different levels - provides citizens with a choice. The dynamics of this choice is often adequate to arbitrage away rent-seeking opportunities. Outsourcing (see this example) also helps avoid the critical citizen-government interface which is most often the origin of corrupt practices.

If the sale of all government services/products are subjected to this twin test, it would considerably lower the likelihood of rent-seeking behaviour - both eliminating it in some places or atleast minimizing the amounts extracted.

Sunday, September 12, 2010

Household balancesheets in the Great Recession

Richard Koo, an analyst with the Nomura Securities, has argued that the the current recession is characterized by a combination of falling asset prices with high indebtedness among both businesses and households, which in turn forces them to stop borrowing and pay down debt. In such "balance sheet deflation", which is strikingly similar with Japan's experience in the nineties, the economy plunges into virtual bankruptcy as borrowers start defaulting, the government inevitably emerges as borrower and spender of last resort. He has argued that the battered balance sheets of businesses and households can be repaired only with fiscal policy, especially since monetary policy has lost traction.

A nice graphics (via Mark Thoma) captures the extent of damage suffered by household balance sheet during the current recession in comparison with earlier ones. In both the 2000 and current recessions, while asset prices dropped (due to stock market and real estate collapses respectively), liabilities have remained constant, thereby battering the balance sheets.

As can be seen, household balance sheets suffered the worst damage in the past two recessions, which were asset-bubble crash induced ones. In both cases, the declines were much larger and more long-drawn out. This also means that unlike earlier recessions the quick V-shaped recovery is less likely since the households have to spend time repaying debts and repairing their balance sheets (through higher savings) before consumption can return to normalcy.

In this context, Mike Konczal points to the distributional dimension of this balance sheet crisis that clearly indicates that unlike those at the top and bottom (whose debt burdens have not changed much), those at the 20%-90% range of household income range have been badly bruised, both in terms of debt as a share of assets and incomes.

In other words, the "consumer debt problem in the economy really is a debt problem for the middle class", one that has the potential to "sap middle-class families’ spending power for perhaps years to come".

Further, the middle-class has suffered more than the wealthy from the housing crash because middle-class families tended to rely more on their homes to build savings through rising equity, whereas the wealthier had a much larger and more diverse portfolio of assets — stocks, bonds, etc. — which have mostly bounced back significantly this year.

In the circumstances, and I am inclined to Konczal's arguement in favor of lien-stripping - "the most sensible way to get through this debt is to have well designed mechanisms for writing down housing debt, where homeowners take a penalty and creditors get an excessively large claim on future housing price appreciation". Such measures are more effective than tax cuts in so far as tax cuts in repairing the balance sheets in so far as it directly addresses the debt problem. Mark Thoma points to Joseph Stiglitz who has advocated mortgage write-downs,

"For one out of four US mortgages, the debt exceeds the home’s value. Evictions merely create more homeless people and more vacant homes. What is needed is a quick write-down of the value of the mortgages. Banks will have to recognize the losses and, if necessary, find the additional capital to meet reserve requirements."

And as Mark Thoma writes,

"Japan made the mistake of allowing balance sheet problems for both households and banks to linger and the result was a prolonged recession. We seem to have gotten the message about banks... but the message that households need just as much attention seems to be harder for policymakers to get. We need policies to stimulate demand, and on top of that, we also need policies that accelerate balance sheet repair. One without the other gives up important synergies, and prolongs either the length or the depth of our problems."

Konczal also makes the case that since the upper 10% of income earners do not face such problems (in fact, their leverage and income-debt ratios appear to have improved), they could provide the spending power to help fuel an economic recovery. It also means that any tax cuts for them would only provide benefit them without any incremental benefit for the economy.

Update 1 (18/8/2011)

Household balance sheets remain over-leveraged in the US, indicating that it will be some time before recovery can really kick-in.

More on US income inequality

Several fascinating graphics in Slate illustrating the Great Divergence of widening income inequality in the US. The economic history of the US over the past seventy years is the "Great Convergence" (1940-73, coined by Claudia Goldin of Harvard and Robert Margo of Boston University) of incomes of the first forty years, followed by the "Great Divergence" (1979 onwards, coined by Paul Krugman) of the past thirty years.

In 1979 the top quintile's income share was eight times that of the bottom quintile, while it rose to 14 times by 2007. The top quintiles share increased only slightly relative to the middle quintile, rising from three times in 1979 to four times by 2007. These trends reflect in large part a growing "college premium." Since 1979 the income gap between people with college or graduate degrees and people without them has grown. The moderately skilled middle class is hollowing out.

Among all developed economies with income inequility problems, the US easily tops the list in being the most unequal economy. This chart shows select nations where the income share of the top 1 percent was highest in 2005.

Update 1 (19/10/2010)

Chad Stone writes, "the average middle-income American family had $13,000 less after-tax income in 2007, and an average household in the top 1 percent had $782,600 more, than they would have had if incomes of all groups had grown at the same average rate since 1979".

Update 2 (7/11/2010)

Nicholas Kristof says that inequality in the US has reached a "banana republic point where our inequality has become both economically unhealthy and morally repugnant". The richest 1% of Americans now take home almost 24% of income, up from almost 9% in 1976. The CEO’s of the largest American companies earned an average of 42 times as much as the average worker in 1980, but 531 times as much in 2001. From 1980 to 2005, more than four-fifths of the total increase in American incomes went to the richest 1%.

A recent paper by Robert H. Frank of Cornell University, Adam Seth Levine of Vanderbilt University, and Oege Dijk of the European University Institute found that inequality leads to more financial distress. They looked at census data for the 50 states and the 100 most populous counties in America, and found that places where inequality increased the most also endured the greatest surges in bankruptcies.

Update 3 (30/3/2011)

Economix writes that the top 1 percent of earners receive about a fifth of all American income; on the other hand, the top 1 percent of Americans by net worth hold about a third of American wealth.

Update 4 (16/4//2011)

Series of graphics from CBPP on income inequality in the US and the role of taxation system.

Update 5 (7/6/2011)

The chart below shows how far things have moved off their traditional ratios in terms of US incomes. The top 1% are earning more income, and keeping more of it, than anytime since the roaring 1920s.

Friday, September 10, 2010

Third party assessment in government

Here is my Mint op-ed that makes the case for using third party agencies to provide feedback on the quality of public service delivery and thereby improve the effectiveness of our supervisory bureaucracy.

Detectives to supervise service delivery

It is widely acknowledged that the biggest failure of our government bureaucratic machinery lies in its inability to ensure the effective implementation of the myriad welfare and development programs.

Traditional supervisory mechanisms within the government suffer from numerous deficiencies. Apart from the badly mis-aligned incentive structure, dys-functional chain of command, and poorly motivated individuals, existing supervisory architecture is inherently over-burdened and over-stretched in many dimensions. Field supervisors invariably have too many locations, spread over too large an area, with a vast variety of activities, and all this without adequate training, logistics and resources.

In this context third party assessment, by a professionally competent and independent agency, has the potential to improve the quality of public service delivery and program implementation.

The theoretical case in favor of an external assessment is unexceptionable. It flies against any logic to have a supervisory mechanism constituting the very same people whose services are being monitored. Such independent monitoring is all the more important given the unmistakable shift in focus from a merely quantitative to a qualitative assessment of government's activities.

One of the biggest breakthroughs in improving the quality of public construction works in recent years have come from the introduction of mandatory third party quality control checks. Typically government departments call open competitive tenders and contract out engineering works - roads and drains, water and sewerage, buildings, etc - for execution through contractors and then the regular department officials supervise the quality of execution.

However, this arrangement posed the inevitable conflict of interest, wherein the supervisory engineers often colluded with the contractors to dilute the quality of works. In the circumstance, third party quality audits, consisting of random and surprise inspections of works at each stage, by competitively selected external agencies, emerged as a preferred strategy to elicit an independent feedback about the quality of works. In recent years, this has become a mandatory requirement in all projects being implemented by both central and most state governments.

Extending the logic of TPQC beyond engineering works, it is natural to deploy it in an independent assessment of various government programs. The services of independent agencies can be utilized to obtain feedback about the functioning of institutions like schools, hospitals, and even various government offices, apart from the quality service delivery in various government programs. They can range from the specific - which teacher, doctor or official is taking bribes or irregular in work or ineffectual, quality of a work or service delivered etc - to the general - sources of leakages or bottlenecks or delays in the delivery of a service, inefficiencies within the system, and so on.

Instead of the third party assessment duplicating the existing regular supervisory mechanism, a mandate involving randomly sampled inspections may be adequate. The certainty of follow-up action, punitive or remedial, on its findings will be powerful enough deterrent to ensure its effectiveness.

The critical ingredient for success in this market is integrity and credibility of the agency. In other words, third party assessment agencies are in the business of selling integrity. In complex socio-political environments, where the avenues for incentive distortions are numerous and mostly unanticipated, managing such a business can be a herculean task.

Most often, a successful engineering TPQC agency, which starts off as a team of a handful of committed people with exceptional integrity, loses the way as it expands to take in more work. In a rapidly emerging market, where success immediately begets more success, with a resultant proliferation of business opportunities, firms often bite off more than they can chew and in the process end up diluting their standards and ultimately losing credibility. With time, many of these firms end up being indistinguishable from the government supervisory mechanism.

Rigorous internal quality controls are therefore fundamental to success in this business. Once lost, credibility is very difficult to recover. The general lack of qualified professionals, coupled with the need to attract people with integrity and keep them honest, would require the development of a robust business model.

All this of course assumes that the head of the institution is himself committed towards improving the system, an itself often debatable premise. However, it cannot be denied that third party assessment equips officials with a hitherto unavailable and powerful force multiplier that dramatically increases their span of control and thereby supervisory effectiveness. In other words, all things being equal, effective use of third party assessment has the potential to considerably improve the quality of government service delivery channels.

Critics would surely allege that this is a back door entry of private agencies into the basic governance functions itself. However, it needs to be borne in mind that the success and widespread adoption of TPQC with engineering works has not generated voices calling for scaling back the regular engineering supervision.

However, it is important to be clear about their scope of work and objectives, so as to ensure that it does not become an excuse and cause for further erosion of the already weak regular supervisory systems. Fundamentally, the outputs of the third party agency should be a feedback for only the highest level of administration, preferably only the Head of Department, and should complement, not supplement, the role of the regular supervisory architecture. A third party assessment service would differ from a regular survey (or opinion poll), in the continuing and qualitative nature of the engagement with the agency.

For all those venture capitalists, in search of an idea to fund, partnership with the government in the creation of a competitive market for independent service quality assessment would do more than any other innovation to atleast partially address the persistently stubborn implementation failure of Indian bureaucracy.

Thursday, September 9, 2010

Institutionalizing fiscal policy

Historically, while there has been a well-established architecture, both in terms of institutions and formal rules, for taking monetary policy decisions, none exists for fiscal policy actions. Interest rates are set by Central Banks (and their Monetary Policy Committees) using the standard Taylor Rule framework, or one of its variants, with reference to prevailing macroeconomic parameters like inflation and unemployment rates.

While price stability, embodied in low long-run inflation rates, is more or less an accepted part of public debates, debates about an acceptable level of public debt and deficits raise several controversies. Further, the re-distributional side of fiscal policy and its attendant political dimensions introduces a strong political economy aspect into fiscal policy decisions. Unlike the largely apolitical interest rate decisions, those on whom or what to tax (and their respective rates of taxation) and what and where to spend or cut expenditures are of deeply political nature.

The Great Recession and the resultant need for fiscal expansion, at a time when economies across the world are fiscally strained with massive and unsustainable debt burdens, has spot-lighted attention on the inadequacies of the standard fiscal policy toolbox. Unlike monetary policy, apart from being deeply political, fiscal policy decisions are mostly ad-hoc and piecemeal, with rarely any objective and independent assessment of future costs and returns.

In this context, at the Federal Reserve Bank of Kansas City’s annual Jackson Hole Symposium, Eric M. Leeper argued about the need for both fiscal research and fiscal policy practice to becoming more scientific. He makes the striking point that while "the macro policy dimensions of monetary policy — output and inflation stabilization — have been largely depoliticized, virtually no aspect of fiscal policy is insulated from politics".

Leeper draws the distinction between micro fiscal decisions (that are ground out by the give and take of politics) and macro fiscal issues (that can be treated as primarily scientific matters), and argues that once the overarching macro issues are settled, the politically determined micro questions would be constrained. He poses a series of questions that fiscal policy makers should address in their quest to making their task more objective and scientific

1. Should there be a long-run target for the debt-GDP ratio? What should it be?
2. Are there circumstances under which deficits (surpluses) should be permitted to permanently raise (lower) the debt-GDP ratio or should debt always be retired back to some long-run target?
3. Should government spending, taxes, and monetary policy be adjusted to stabilize debt?
4. How rapidly should the debt ratio be retired back to the target ratio?
5. What are the macroeconomic effects of certain government spending and tax changes in well-specified thought experiments?
6. What are a country’s fiscal limits and how much government debt can it support before markets deem the debt to be risky?
7. What happens as the economy approaches its fiscal limit?
8. What policies can keep the economy well away from its limit?
9. What are the are the macroeconomic consequences of alternative policy responses to the era of fiscal stress?
10. Should monetary and fiscal policy behave in fundamentally different ways in an era of fiscal stress than they do in normal times?

Nominal fiscal rules that place targets on fiscal deficits and public debts are amongst the commonest and simplest form of scientific fiscal policy practice. Many countries, notably Chile, Sweden, and New Zealand have nominal targets on these fiscal parameters. The most famous example of such fiscal rule is the European Union's Growth and Stability Pact that prescribed clear fiscal deficit and public debt targets for members.

India too adopted the Fiscal Responsibility and Budget Management (FRBM) Act in 2004, aimed at disciplining government expenditures. The FRBM mandated elimination of revenue deficit (by reducing it by 0.5% of GDP every year for five years beginning 2004-05) and fiscal deficit be lowered to 3% of GDP by 2008-09 (by annual reduction by 0.3% of GDP). The FRBM rules have mid-year targets for fiscal and revenue deficits, at 45% of budget estimates by the end of September each year. In case of a breach of either of the two limits, the Finance Minister will be required to explain to Parliament the reasons for the breach, the corrective steps, as well as the proposals for funding the additional deficit. See this excellent analysis of India's FRBM Act.

Fiscal councils are the other preferred institutional answer to the conduct of fiscal policy. Simon Wren-Lewis (via Amol Agarwal), who has an excellent website on Fiscal Councils, writes that such councils, which though funded by the government are independent, and provides macroeconomic policy advice, especially on the likely course of national budget deficits. They make the budget more transparent and credible, by providing independent analysis of the budget numbers, and checking the Government’s policy, budget projections, and growth assumptions for consistency.

It is believed that an independent fiscal council would promote counter-cyclical fiscal policies and reduce the deficit bias that governments are vulnerable to. They could provide independent and accurate (eliminating window dressing through off-balance sheet accounting) assessment of the current and future deficit projections implied by current policies. It would act as a possible restraint, working through public pressure and moral suasion, on the spending-happy, short-term biased populist governments. Further, it could also act as a "co-ordination mechanism that forces individual spending ministers to recognise the overall budget constraint".

Sweden, Hungary and Netherlands are among those with relatively well-functioning councils, though the US CBO has some of its features. Sweden has an independent fiscal policy council whose chair testifies before the Parliament, which in turn has succeeded in generating productive public debate about the trade-off between sustainability and fiscal stimulus, which the Swedish government and most others have been facing. In Netherlands, the government-run Central Planning Bureau (or Bureau for Economic Policy Analysis) has sufficient credibility as an independent evaluator that political parties feel compelled to have their fiscal plans vetted by the Bureau.

On similar lines, Tim Besley and Andrew Scott (via Amol Agarwal) have advocated setting up "independent fiscal policy committees to institutionalize fiscal transparency and restore credibility to governments’ long-term public finances", especially given the legacy of current expansionary policies and unsustainably large debts across many countries.

In the context of India, Niranjan Rajadhyaksha has argued for the establishment of a fiscal council, similar to the CBO, given the political difficulty of setting up any independent fiscal authorities. For a start though, the Finance Ministry would do well to try answering Eric Leeper's aforementioned set of ten questions.

Update 1 (22/4/2011)

Lars Calmfors and Simon Wren-Lewis argue that, with the right guarantees of their independence in place, independent fiscal councils can make a significant positive contribution to fiscal policy.