Economic impact of Railways in India

In an earlier post, I had outlined the dramatic impact of investments in all-weather connecting roads in improving the economic prospects of any area. In fact, it is possible to argue that big-ticket investments in transportation infrastructure offer the biggest bang for the buck among any public investments. And more remote and backward the area connected, the higher the benefits.

In this context, a new NBER working paper by Dave Donaldson assesses the economic benefits of large transportation infrastructure by examining the development of the vast railway network in colonial India. He uses archival data from the times and compares the impact on areas where these lines were built and those where, though sanctioned, it was never built, and found that

"railroads reduced the cost of trading, reduced inter-regional price gaps, and increased trade volumes..., when the railroad network was extended to the average district, real agricultural income in that district rose by approximately 16%."

The economic impact apart, there are several social and political consequences of enabling physical transport connectivity. It immediately opens up the area, thereby potentially weakening political insurgency (through both economic development and reducing the cover offered by inaccessibility). The resultant opening up has the potential to create a powerful force of modernization that can erode regressive social and political traits, and empower the residents of the area. It also increases the efficiency of labor markets - the Bihar worker who was getting Rs 35 per day working in his village in Motihari now finds it convenient to migrate to work for Rs 200 a day in Mumbai - and promotes economic growth.

As an afterthought, and with reference to SR's SMS, the impact of light-rail networks could be even more dramatic. For a peek into the benefits, just look north of the border to China, which has already developed 7431 km of light-rail network. An ambitious 1,318-km high-speed rail line linking the country's two most important cities — Beijing and Shanghai - at a cost of $33-billion line will open in 2012, and reduce travel time in half, to just five hours.

Why French resist raising retirement age?

Over the past few days, France has been experiencing paralysing protests against a decision to raise retirement age and reduce benefits for the old-aged. The French Parliament has approved a bill that would raise the minimum age for reduced French retirement benefits to 62 from 60, and raise the age to collect full benefits to 67 from 65. Though all the major European economies have initiated similar measures over the past year or so, nowhere has it generated this intensity of opposition.

An explanation for the strong French reaction can be obtained from a comparison of the labor force participation rate, or the percentage of people in each age category who are working or seeking employment, of France with that of the other major economies.



As can be seen, in the 60-64 age-group, the French have the lowest labor force participation rate. In 2009, only one Frenchman in five of this age-group was in the work force, to 61% of Americans, three-quarters of Japanese, and over half of Germans. The same pattern follows for all higher age-groups. To be French and to be old is very heaven!

Europe's Tea Party activists - fiscal austerians?

The belief that fiscal austerity in a recession will generate market confidence and lift the economy from its depths counts along with the equally evangelical supply-side belief that tax cuts will always increase revenues as touchstones of conservative economic ideology. As the Congressional elections in the US draws near and with economy floundering at the door-step of a double-dip, the Tea Party activists are waging a vigorous battle for ideological and political dominance.

Across the Atlantic, in some respects, the austerians have emerged as the Tea Party activists of Europe. An austerity fever, nay epidemic, appears to have gripped the continent. In the face of already high and continuously rising double-digit deficits, and weak macroeconomic conditions - stagnant or dedlining output and high unemployment rates - Europe has collectively embraced a policy of re-balancing government finances. Even a cursory examination of the fiscal deficit reduction targets which have been announced by all the economies exposes them as an exercise in deception and dishonesty.

Across the peripheral economies, all the leading economic indicators look dismal, with forecasts for further reduction in output and growth in unemployment. This in turn means sharp declines in tax revenues and rise in deficits. More worryingly, the lack of private demand and near-certainty of corporate spending not being able to bridge the output deficit created by fiscal austerity, means that these economies are perched at cusp of a potentially catastrophic downward economic spiral from which recovery could be long and tortuous.

Following the recent upward revision of its 2009 deficit from 13.5% to 15.5%, Greece looks almost sure of not only not staying close to its targeted budget deficit of 8.1% for 2010 but also overshooting by some wide differential. This would not only require further debt restructuring, following the earlier $150 bn EU-IMF package, but also force more spending cuts thereby increasing the downward pressure on output and tax revenues. In the meantime the mountain of debt will grow, drawing in bond-vigilantes who will drive up the cost of financing that debt, thereby adding to the debt stock and deficits. The result of all this is predictable - sovereign defaults, deep recession (the economy has contracted 4% so far this year), and rising unemployment.

Ireland, which is set to experience its third consecutive year of economic contraction in 2010, is undertaking the most ambitious, almost unreal, deficit reduction program - to cut fiscal deficit from a whopping 32% in 2009 of GDP to a saintly 3% by 2014. Portugal is struggling to meet its deficit target of 9% of GDP, even as the economy continues to weaken. Spain faces the difficult task of slicing its deficit to 6% by 2011 from 11% in 2009 in the face of a slumping economy and the largest unemployment rate in continental Europe. Britain too has implemented unprecedented spending cuts, which look set to tip the economy into a long period of stagnation.

The fiscal austerity prescription in the face of a slumping economy and rising unemployment defies all logic and history is replete with examples that illustrate its folly. The most recent high-profile example was the IMF-driven fiscal contraction that was forced on the East Asian economies in the aftermath of the 1997 regional currency crisis. Then the austerity medicine had devastated these economies and only those like Malaysia, which went against the prevailing consensus, escaped relatively unscathed. Subsequent studies and the IMF itself have on occasions acknowledged the folly of forcing down such policies.

Paul Krugman points to another example from history, post-Depression US, when sustained public spending through the New Deal and other programs drove up government expenditures and the debt stock. However, the resultant economic growth boosted tax revenues and thereby lowered the deficits. Thanks to the recovery, even as the debt stocks rose, the deficits plunged.

More on the Chinese growth model

One of the distinguishing characteristics of China's economic growth, across sectors, has been the willingness to encourage development on a global-scale, even at the risk of generating substantial excesses.

Accordingly, in core-infrastructure sectors like railways, power generation - thermal, nuclear, solar, and wind - telecommunications and green technology automobiles, it encouraged the development of massive domestic manufacturing capacities. Originally intended to meet its own huge demand, these manufacturers were simultaneously encouraged to explore and capture the global markets. Since the demand - both domestic and external - was spectacularly humunguous and apparently without any bounds for the foreseeable future, anybody willing to set up facilities were encouraged with attractive incentives - tax breaks, cheap loans, subsidized utility tariffs, linkage infrastructure, and often cheap/free land.

Much the same has characterized real estate development. Mirroring the spectacular growth of cities like Shanghai, massive satellite townships were developed in many areas across the country. These developments, supported with cheap loans, far from being constrained by any bureaucratic speed-breakers, were positively encouraged by policymakers intent on developing cities that can help achieve their rural-to-urban population transfer ambitions.

The incentives of all stakeholders were aligned in the direction of such unrestrained development. Since land auctions were the major share of local government revenues, they had a vested interest in encouraging these development which would in turn boost land values in the surrounding areas. Further, these developments and the economic activity and revenues that came with it, signalled favorably about the local party and government officials to the authorities in Beijing and paved the way for their rise up the party ladder. Finally, these developments, most of which involved partnership with the local establishment, either directly or indirectly, provided ample opportunities for rent-seeking and enriched those belonging to the ruling establishment.

In the absence of a social safety net, the common citizens were forced into saving a larger share of their increased incomes. And without alternative sources of investment for these savings, they flowed into the tightly regulated banking system despite the very low interest rates offered.

Since alternative financial investment opportunities were scarce and given the apparent commercial attractiveness and large returns promised by real estate investments, banks loaned out massive sums to real estate developers. These state-controlled banks were also encouraged to lend at lower rates and seek a share in returns from the developments.

This arrangement, common in most parts of Japan and East Asia, offered considerable attractions to real estate developers. Lured by the attraction of rising real estate prices and the possibility of making windfall returns, coupled with the absence of similarly attractive investment avenues, buyers flocked into the market. These large numbers of potential buyers provided the demand-side thrust. With incentives of all important stakeholders aligned, the real estate bubble frothed, got inflated and continues to grow.

I have already blogged about one such development - the Tianjin Eco City. Now the NYT has an excellent account of one such city, Kangbashi New Area, in north China’s sparsely populated Inner Mongolia region, which it describes as a "ghost town", replete with completed residential and commercial accommodation and all other community assets and infrastructure which are used by only a handful of people. This 12 square mile township has been built from scratch on a huge plot of empty land 15 miles south of the old city of Ordos which has a population of 1.5 million.

Apart from its mostly unoccupied residential and commercial areas, it also contains a 500000 sq ft convention center and a $450 million financial district. Projected to have 300000 residents by now, even official estimates put the current occupancy at 28,000, though the real figures would be much smaller.

Kangbashi is no exception and is reminiscent of dozens of similar townships across the country. As the Times report says, in the southern city of Kunming, a nearly 40-square-mile area called Chenggong has raised alarms because of similarly deserted roads, high-rises and government offices. And in Tianjin, in the northeast, the city spent lavishly on a huge district festooned with golf courses, hot springs and thousands of villas that are still empty five years after completion.

The aforementioned account of scale-driven sectoral growth explains why, unlike India, China is able to construct massive projects, well within time. The sizes and numbers of the projects being planned and the perception of firm commitment from the government towards the almost un-restrained development of the sector, provide the depth and security required for markets to develop around them.

Accordingly, developers have the flexibility to think about procurements on massive scale, manufacturers can plan and set up facilities that will cater to the huge anticipated demand, governments and private institutions have the incentive to train large numbers of skilled manpower to provide workforce for these sectors, and potential employees/labor in turn respond to these industry signals when they make their career choices. And the inevitable by-product of all this are the excesses at the margins (and resultant wastages), which get amplified at the first signs of any slow-down.

In India, such real estate development can take place only after the proposal passes a long-list of due-diligence screenings - demand survey, land acquisition, open competitive bidding, departmental clearances, and financial closure. At each-level there would have been questions raised, by multiple stakeholders (who are not always the government or developers), about the commercial or socio-economic rationale for the development. High-profile investments in any sector, which are in any case far and few in between, would attract close scrutiny and this serves as systemic inhibitors on inflating bubbles.

More fundamentally, the uncertainties associated with all these processes and multiplicity of sources from which they can emerge means that private participants cannot plan ahead without any ambiguity and carry considerable risks with their investment decisions. Further, the prevarications of governments, state and central, with the implementation of stated policy, creates apprehensions about their commitment itself. In simple terms, the environment does not generate the level of confidence required for investors to take the plunge.

Unlike China's bubble, India appears to be stuck in a low-equilibrium trap, which prevents the swift and unrestrained development of various infrastructure sectors.

Dilemmas in administration

Here is a parable that illustrates the complexity of emergent scenarios at the intersection between politics, public policy and social objectives.

The Government of Corruptionland decides to build a world-class highway road which would function as a ring road to its capital city of Metropolis. The economic benefits of the road are considerable, immediate, well-established and not disputed.

However, complicating matters is the fact that the proposed alignment comes in the way of land owned by Mr Pirate Ram, one of the most powerful political leaders of Corruptionland. In the prevailing political circumstances, it is impossible to build the road along the proposed alignment against the wishes of Mr Pirate Ram.

The Principal Secretary of Roads Department proposes an alternate alignment which skirts the lands owned by Mr Pirate Ram (note the slippery slope in this line of thinking). Though it does not compromise on the larger alignment and broader objectives of the road, the new alignment would involve displacing considerable numbers of poorer people, besides affecting other people.

Once the new alignment is proposed and some insider brokers access the critical information that Mr Pirate Ram would never permit acquisition of his land, they sense rent-seeking opportunities. They open negotiations with the other land owners along the original alignment offering to save their lands in return for some gratification. In an environment of information asymmetry, the land owners are most likely to agree. This coalition, bound together by a mutually beneficial financial transaction, gathers a momentum of its own, and multiplies the opposition hitherto led by only Mr Pirate Ram.

What are the choices facing the bureaucrat? Wait for the next elections to see out the current government and hope that Mr Pirate Ram's powers would have waned? Or accept the new alignment and structure a generous enough compensation package for the poor land losers? Also ignore the rent transactions that inevitably follows the change in the alignment?

The former would involve many costs - loss of the benefits that would have accrued by way of the road coming in early, higher construction costs, and the considerable risk that the same politician would be able to stall the road even with the new government (money knows no political boundaries!).

Let me therefore situate the problem facing any decision maker.

1. A good quality road has to be built.
2. In its present alignment, the road is a non-starter.
3. An alternate alignment, which does not compromise on the broader objectives, is a reasonable second-best alternative.
4. This new alignment entails loss of property for considerable numbers of poor people.
5. Accepting the alternative alignment creates rent-seeking opportunities.

The alternate alignment would result in Mr Pirate Ram's land being saved and its values rocketing up, the poor beneficiaries would be adequately compensated (if a satisfactory rehabilitation is done), the entire rent-seeking chain would feed on the transactions, and a world class road would get built.

In the second-best world, the Principal Secretary's priorities would appear to revolve around ensuring that

1. the second-best alternative does not compromise on the broader objective.
2. the poor people who lose their lands are appropriately compensated, not only for the loss of property, but also livelihoods (if required). In any final costing, in case of most projects this would be a minor blip.
3. the road is built professionally, within time and with good quality.

The slippery-slope hazard with accepting the new proposal is that it opens the door for similar demands from others whose lands fall along the alignment. And this will inevitably be followed by rent-seeking from those sensing an opportunity to make a quick buck by taking up the cause of the land losers. Sensing the distinct possibility of saving their lands, the land losers too gravitate towards fixers and local middlemen who step in with offers to save their lands in return for a fee. A rent-seeking network develops.

Note: I thought about the possibility of some publicity about the fraudulent activities bringing in judiciary and civil society organizations and getting the road built along the original alignment. The inevitable result would be delays and cost over-runs, even cancellation of the project. It appears that whichever way we see it, the net economic benefits of a good quality road constructed in time exceeds its costs.

And now, negative yield bonds!

Conventional economics teaches us that loans come at a cost. In an inversion of this universal reality, an interesting auction of five-year US Treasury Bonds has resulted in investors paying $105.50 to buy $100 bonds, thereby "agreeing to pay the government for the privilege of lending it money".

These bonds, Treasury Inflation Protected Securities (TIPS), attracted investors since they offer a guaranteed protection against inflation. Though TIPS have been yielding negative yields for some time now, it is the first time since the government began selling these them in the 1990s that new ones were sold at a negative yield.

These bonds will have the same final payout, irrespective of the inflation, and in the meantime their prices will increase if inflation soars. In simple terms, "the investors who took part in the $10 billion auction are betting that inflation, now at about 1% annually, will rise to a level that more than compensates for the premium they paid". In an indication of the investor interest, the $10 bn auction attracted $28 billion worth of bids.

This negative yields for five-year TIPS, reflect the investors hope, in the light of expectations of a second round of quantitative easing in the US, that the Fed will succeed in generating inflation, thereby making their investments remunerative. Though, deflation is the short-term trend, they hope that in the medium-term, as the economy starts recovering, inflationary pressures will get unleashed.

Nudging into healthy eating!

Excellent interactive graphic in the Times of the layout of a school cafeteria designed by Brian Wansink, David R Just, and Joe McKendry, that seeks to employ techniques from behavioural psychology to nudge children into more healthy eating. Their smart lunchroom is a classic exercise in structuring the environment and framing choices in a manner so as to get children to make more healthier eating decisions.

Here is their list of a dozen strategies, arrived at from experiments done in cafeterias at different schools, to coax children into more healthy eating.

1. Creation of a speedy "healthy express" checkout line at the entrance for students not buying desserts and chips, doubled the sales of healthy sandwiches.

2. A "cash for cookies" policy forbids the use of lunch tickets for desserts increased the up-take of fruits by 71% and reduced that of desserts by 55%.

3. Pulling the salad bar away from the wall and placing it in front of the checkout register nearly tripled the sales of salads.

4. When cafeteria workers asked each child, "Do you want a salad?", salad sales increased by a third.

5. Putting oranges and apples in a fruit bowl instead of a stainless steel pan, more than doubled the fruit sales.

6. Moving the chocolate milk behind the plain milk led students to buy more plain milk.

7. Decreasing the size of cereal bowls from 18 to 14 ounces, reduced the size of average cereal serving at breakfast by 24%.

8. Requiring the use of trays increased vegetable consumption - students without trays ate 21% less salads but no less ice-cream.

9. Keeping ice-cream in a freezer with closed and opaque top significantly reduced ice-cream sales.

10. Students offered a choice between carrots and celery were much more likely to eat their vegetables than students forced to take only carrots.

11. Giving healthy food choices more descriptive names, like "creamy corn" rather than simply "corn", increased their sales by 27%.

12. Placing nutritious food like broccoli at the start of the lunch-line, instead of the middle or end, increased the amounts students purchased by 10-15%.

Ironically, much the same techniques are employed by shopping malls, in exactly the opposite direction to lure shoppers into buying more expensive and often un-necessary products. Structuring the shopping environments and choices appropriately can enhance the shopping experience for the buyers. But, unlike in case of school lunch-rooms, the obvious conflict of interest between the shoppers and vendors (shop owner wants people to buy, irrespective of whether the people really need it or not, whereas the rational buyer wants to get value for money from their purchases) may prevent any such reconciliation.

Update 1 (19/2/2011)

Trayless food services in college canteens has resulted in as much as 25 to 30% less wasted food, according to a 2008 study of 25 campuses by food services provider Aramark.

The "confidence fairy" trumps Keynes in UK!

Even as a fierce debate rages about the policies required to address the Great Recession across the developed economies, among the major economies Britain has made a decisive choice to embrace fiscal austerity to restore market confidence. The land of Keynes appears to have blinked on the face of massive fiscal strains and chosen to break with Keynesian policies and follow the path of balancing government finances to revive economic growth.

In recent days, France has decided to raise the minimum retirement age to 62 from 60 and the age for a full pension to 67 from 65. Earlier Greece, Spain, and Ireland had embraced deep spending cuts in an attempt to avoid sovereign bankruptcies.

The Conservative Government in Britain last week followed its other European partners by annoucing the country’s steepest public spending cuts in more than 60 years in an effort to eliminate government deficits by 2015. This comes as Britain faces one the worst public debt problems among all developed economies - 11.5% public deficit and 61% public debt. It is hoped that these steep cuts will repair government's fiscal balance, improve market confidence, stimulate the private sector and restart growth.

The proposed measures include a reduction of expenditures in government departments by an average of 19% (£83 billion or about $130 billion) by 2015, sharp cuts in welfare benefits, increase in the retirement age from 65 to 66 by 2020 (saving $ 8 bn a year), and elimination of 490,000 public sector jobs (out of a total of 6 million jobs or 8% of the total) over the next four years. Further, payments to the long-term unemployed who fail to seek jobs will be cut saving $11 billion a year, and a new 12-month limit will be imposed on long-term jobless benefits, and measures will be taken to curb benefit fraud.

This follows an earlier decision to stop paying its hitherto universal child benefit payments ($32 a week for a first child and $21 for each subsequent one) to people earning more than around $70,000 a year. There is also a proposal to accept the findings of the Browne Review on subsidies for university education, which suggests dramatic cuts on university education spending.

The Browne review advocates scrapping of the present system that caps a year's tuition fee at £3,290 ($5,275) in favor of a free-market approach paid for by the students themselves — but only after they graduate and are earning more than £21,000 a year. It is being suggested that the government could then cut about 80% of the current $6.2 billion it pays annually for university teaching, and about $1.6 billion from the $6.4 billion it provides for research. To make up for the shortfall, universities would have to raise tuition to an average of more than $11,000.

On the revenues front, the British Government has already announced plans to levy a one-time 50% marginal tax on bankers' bonuses of more than £25,000 ($40,700). This would be levied not only British banks but also the London subsidiaries of Wall Street giants. The move is more symbolic than substantial since it would raise only £550 million.

Such a hair-trigger alarmist repsonse from Britain is surprising, and far from engendering market confidence may end up rousing market anxiety and even panic. Unlike fellow Europeans like Greece and Ireland, despite its high 11.5% fiscal deficit, Britain is nowhere close to bankruptcy or reeling from any bond-vigilantes. There were no bond-market panics and inteerest rates have remained low. Public debt at 61%, while high, is not so large as to press the panic button. And all these macroeconomic indicators are similar to that in the US (fiscal deficit of 10.7%), which is debating the extent of accommodation - monetary and fiscal - required. Further, there will be serious questions about the need to eliminate government deficits at all, and that too within such a short-time and starting from an aggregate demand shrinkage driven recession.



These dramatic measures carries with it considerable risks and even goes against the grain of historical record of countries which faced similar situations. In simple terms, the spending cuts are made on the assumption that the private sector will be able to able to make up for the 19% and 8% cuts in government spending and employment respectively, over the next four years.

However, this private sector growth in output and job creation to cover up for the government's exit would have to be a top-up on the regular growth. And regular growth itself will have to be large enough to bridge the yawning output gaps that shows no signs of narrowing. In simple terms, Britain will have to grow at its highest rate in the post-war era, close to double digits, just to return to normalcy. What makes this even more formidable is the fact that this momentum will have to get generated immediately and there appears nothing in the horizon among the private sector that could trigger off such a dramatic spurt in growth.



And all this has to start immediately, since any delays would only end up pushing the can further down the road and widening the output and employment gaps, necessitating even more higher rates of growth and job creation. There are serious and well-grounded fears that such optimism may be misplaced.

It is also hoped that these measures will restore market confidence and encourage the private sector to come forward with their investment and spending plans. However, as the evidence so far from Ireland, which has been similarly savage with its spending cuts, shows, such assumptions may fall through. After its initial round of spending cuts failed to enthuse the markets and trigger any recovery and make any dent on its stupendous budget deficit of 32% of GDP, Ireland is set to announce another round of cuts, which would take the total cuts to 14% of its GDP.

As Joseph Stiglitz wrote in response to the British decision, the excessive faith in the confidence fairy and attendant spending cutbacks "will weaken Britain, and even worsen its long-term fiscal position relative to well-designed government spending". He wrote,

"There is a shortage of aggregate demand – the demand for goods and services that generates jobs. Cutbacks in government spending will mean lower output and higher unemployment, unless something else fills the gap. Monetary policy won't. Short-term interest rates can't go any lower, and quantitative easing is not likely to substantially reduce the long-term interest rates government pays – and is even less likely to lead to substantial increases either in consumption or investment. If only one country does it, it might hope to gain an advantage through the weakening of its currency; but if anything the US is more likely to succeed in weakening its currency against sterling through its aggressive quantitative easing, worsening Britain's trade position...

The few instances where small countries managed to grow in the face of austerity were those where their trading partners were experiencing a boom... Lower aggregate demand will mean lower tax revenues. But cutbacks in investments in education, technology and infrastructure will be even more costly in future. For they will spell lower growth – and lower revenues. Indeed, higher unemployment itself, especially if it is persistent, will result in a deterioration of skills, in effect the destruction of human capital, a phenomena which Europe experienced in the eighties and which is called hysteresis. Lower tax revenues now and in the future combined with lower growth imply a higher national debt, and an even higher debt-to-GDP ratio."

It is being argued in some circles that the apprently contrasting responses (atleast till now) on both sides of the Atlantic to addressing the Great Recession comes from their respective different historical experiences and the attendant institutional memories. The memories of the Great Depression and the human sufferings and long-term damage inflicted to the economy is thought to inform the relative acceptance of fiscal and monetary accomodation in the US. In contrast, Europeans are driven by even more recent experiences with government deficits that have resulted in sovereign defaults and episodes of run-away inflation. In particular, it is being claimed that the Conservative Government's decision now is grounded in memories of Britain’s economic collapse in the 1970s, when the International Monetary Fund had to come to the rescue just as it has done recently in Greece.

Joe Stiglitz should have the last word,

"Austerity converts downturns into recessions, recessions into depressions. The confidence fairy that the austerity advocates claim will appear never does... Consumers and investors, knowing this and seeing the deteriorating competitive position, the depreciation of human capital and infrastructure, the country's worsening balance sheet, increasing social tensions, and recognising the inevitability of future tax increases to make up for losses as the economy stagnates, may even cut back on their consumption and investment, worsening the downward spiral...

Britain is embarking on a highly risky experiment. More likely than not, it will add one more data point to the well- established result that austerity in the midst of a downturn lowers GDP and increases unemployment, and excessive austerity can have long-lasting effects... it is a gamble with almost no potential upside. Austerity is a gamble which Britain can ill afford."

Google and the art of "tax arbitrage"!

In the aftermath of the sub-prime mortgage crisis, with its numerous examples of executive excesses and corporate greed, corporate governance issues among businesses have assumed critical importance. It is universally agreed that for all the regulatory oversight, markets cannot be made to run efficiently and fairly without appropriately addressing important corporate governance issues.

One of the most controversial of such concerns revolves around the complex accounting strategies that businesses adopt to avoid taxes. Corporates point to the fact that they are not doing anything illegal but only exploiting a legally available provision to maximize their bottom-lines and thereby shareholder value. Critics argue that such actions, while technically legal, blurs the boundaries between the legal and dishonest, and engenders a culture of opacity and much else.

In this context, it cannot be denied that even as tax authorities across the world focus their energies on curbing domestic tax evasion, there have been very little attention paid on evasion through shifting of incomes and expenditures across national boundaries. Global economic liberalization and closer integration of national economies, coupled with the dramatic expansion of global financial markets, have empowered businesses to indulge in "tax arbitrage".

Businessweek has an excellent account of how Google, which tells employees "don’t be evil" in its code of conduct, employs a strategy to avoid US corporate taxes, that while being legal appears suspicious at best and plain immoral at worst. It is clear that Google is not only a leader in technology but also in its ability to evade taxes!

Google, which has cut $3.1 bn from its tax bill since 2007, pays an effective corporate tax of 2.4% on its overseas profits, the lowest corporate tax rate on overseas profits among the top five US technology companies by market capitalization. It utilizes provisions in US and Irish tax laws to allocate income to tax havens and attribute expenses to higher-tax countries ("transfer pricing"). See this superb interactive guide.

1. US law allows companies to license to a subsidiary the offshore rights to its intellectual property for undisclosed fees. If this fee is kept low (despite the requirement that subsidiaries pay "arms length" prices for technology rights), their taxable income at home becomes less. In Google's case, its deal is with a subsidiary called Google Ireland Holdings.

2. This Dublin-based subsidiary , in turn takes advantage of an Irish law ("Double Irish") that exempts taxes for companies which claim to have their management based elsewhere. Google Ireland Ltd - which employs about 2000 people, gets credit for about 88% of the company's overseas sales (total of $12.5 billion in non-US sales in 2009) - reported a pre-tax profit of less than 1% of sales in 2008 since it paid out $5.4 bn in royalties to its management vested in a Bermuda-based company.

3. The royalty payments from Google Ireland Ltd. in Dublin then takes a quick detour to the Netherlands ("Dutch Sandwich") to avoid triggering an Irish withholding tax. Irish tax law exempts certain royalties to companies in other EU-member nations. In Amsterdam, Google Netherlands Holdings BV, which does not have a single employee, paid out 99.8% of the $5.4 billion it received from Dublin to the unit managed in Bermuda.

4. Bermuda, being an off-shore tax-haven, does not impose any corporate tax. More perversely, the Google's subsidiary (management center) in Bermuda changed legal form in 2006 to become a so-called unlimited liability company, so as to take advantage of another Irish law that permits such firms to not disclose such financial information as income statements or balance sheets. This meant that it became impossible to track its balance sheet.

It is estimated that the US alone loses $60 bn annually due to such "transfer pricing" of taxes. Such international income-shifting helped cut Google’s overall effective tax rate to 22.2% last year, against the US corporate tax rate of 35%. It is also estimated based on a rough analysis that if the company paid taxes at the 35%rate on all its earnings, its share price might be reduced by about $100 from its current $600 plus.

Google's success has encouraged other technology firms to adopt the same model and license the foreign rights to their intellectual capital to subsidiaries in countries with low tax rates, while retaining the expenditures on their balance sheets. Microsoft employs a "Double irish" strategy to avoid tax payments on part of its external income.

This example illustrates the negative externalities generated by Ireland's policy of keeping tax rates low to attract investments. Coupled with its leaky taxation laws, this strategy not only does not benefit Ireland, but also ends up transmitting very costly incentive distortions across the global economy. In other words, Ireland's liberal taxation rules are classic examples of beggar-thy-neighbour policies, which, as the country's recent fiscal crisis shows, does not benefit even Ireland.

This example highlights the need for harmonization of tax policies across economies. Its importance will increase in the coming years with greater global economic integration and as companies start exploiting such tax arbitrage opportunities to minimize their tax payments. In the absence of reasonably uniform standards, such beggar-thy-neighbour policies could end up triggering "tax wars" among the major economies.

Update 1 (20/12/2011)

The Times reports that GE, America's largest corporation, reported worldwide profits of $14.2 billion in 2010, and said $5.1 billion of the total came from its operations in the United States. But it paid no American taxes and even claimed a tax benefit of $3.2 billion. Times writes,

Its extraordinary success is based on an aggressive strategy that mixes fierce lobbying for tax breaks and innovative accounting that enables it to concentrate its profits offshore. G.E.’s giant tax department, led by a bow-tied former Treasury official named John Samuels, is often referred to as the world’s best tax law firm. Indeed, the company’s slogan "Imagination at Work" fits this department well. The team includes former officials not just from the Treasury, but also from the I.R.S. and virtually all the tax-writing committees in Congress.

Though corporate tax rate is 35%, effective tax rates are much lower and corporate share of the nation’s tax receipts have fallen from 30 percent of all federal revenue in the mid-1950s to 6.6 percent in 2009.

Update 2 (29/4/2012)

Times has this story of how Apple uses the same strategy to avoid payment of taxes. For the record, Apple paid cash taxes of $3.3 billion around the world on its reported profits of $34.2 billion last year, a tax rate of 9.8 percent.

This graphic captures the Double Irish tax arbitrage strategy nicely. Apples treats its domestic profits as royalties payable to an Irish subsidiary on patents it owns, so as to avoid paying the 35% corporate tax on its profits. And in Ireland, if the Irish subsidiary is controlled by managers elsewhere, like the Caribbean, then, after paying Irish tax rate of 12.5%, the profits can skip across the world to the tax-free haven in the Caribbean.

When the same product is sold overseas, profits go to a second Irish subsidiary. And because of Irish treaties that make some inter-European transfers tax-free, the company can avoid taxes by routing the profits through the Netherlands. The profits then flow back to the first Irish subsidiary, which sends the profits to the overseas tax haven.

 

The QE 2 debate in perspective

Ben Bernanke's recent speech has set-off heightened speculation about a second round of quantitative easing (QE) being round the corner in the US.

The debate about QE represents the classic economic problem. On the one hand, the supporters point to an economic environment with idling resources - both capital (cash surplus businesses postponing investment decisions) and manpower (unemployed labor) - and weakened animal spirits. In the circumstances, restoration of market confidence can be done only through government interventions, either by way of direct government spending or incentives to encourage businesses to change their investment and consumers their consumption decisions.

On the other hand, such interventions result in increased deficits and debt stock. And this is where opponents draw attention to the danger of stoking inflationary pressures, which in turn puts upward pressure on interest rates. They also point to government borrowing ultimately (and through different channels) crowding out private borrowers and investments. And we know that all this will end up tipping the economy back into recession.

The supporters counter by arguing that all the aforementioned "Treasury View" arguments do not apply when the economy is facing the nominal zero interest rate and resultant liquidity trap. When faced with the zero bound and pervasive gloom, all conventional approaches loose traction, and only governments have the firepower to lift the economy back into a sustainable growth path.

They claim that the danger of doing nothing for fear of inflation and debt spiral is the real possibility of a long-drawn out deflation-induced recession, even a depression. And they highlight the case of Japan and the striking pre- and post-crisis similarities between the US now and Japan of the nineties. They say that Japan's nearly two-decade long troubles underlines the fact that a deflation-induced stagnation is much worse than an inflation induced recession.

Opponents see a slippery slope in this argument. They question the benefits of the earlier round of quantitative easing. They allege that far from saving the economy from any collapse, the TARP doled out tax payer money to bailout greedy bankers and their financial institutions, which they argue should have been allowed to fail. They also point to the fact that even after the $787 bn fiscal stimulus, unemployment rates and output gaps remain at historic highs.

They also argue that any further monetary accommodation and credit expansion will only exacerbate the process of resource mis-allocation in the financial markets, already evident from the rising stock markets. The QE way of stimulating recovery, they caution, carries the considerable risk of inflating another bubble with all its attendant market distortions. It only postpones the inevitable and necessary rebalancing required to wring out the excesses that had got built into the world economy. They therefore not only oppose further QE, but also calls for exiting monetary accommodation.

So who is correct? I am inclined partially to both sides. The fiscalians are correct that there exists the possibility of a long-drawn equilibrium of stagnation, which can be averted only with government intervention. The austerians are correct about the slippery slope and the dangers of a new bubble. The difficulty, even impossibility, of separating cause and effect (like in so many other areas of economic policy making) means that we will never be able to satisfactorily resolve the dispute about whether TARP and ARRA succeeded or failed, leave alone how much they contributed towards the present employment and output conditions.

As Nobel laureate Myron Scholes recently pointed out, a decision to proceed with expansion through policies like the QE has uncertain consequences. Though it lowers the uncertainty associated with government's commitment to keep interest rates low and stimulate the economy, going ahead it also engenders uncertainty about the economy, especially about the problems with exiting from QE and the possibility of inflationary pressures taking hold.

On the policy makers' third-hand, the challenge then is to reconcile these two apparently contradicting yet plausible positions and tailor policies that mitigate dangers without sacrificing the benefits of fiscal and monetary expansion. For a start, they could begin with interventions that deliver the greatest bang for the buck with the least macroeconomic distortions and adverse long-term consequences. Continuation of the automatic stabilizers and interventions like assistance to states are the least controversial of such policies.

The fears about crowding out and inflation taking hold are easily dismissed. Deflation and not inflation looks like the more important concern. The fears about crowding out looks positively out of place in an environment where business expectations are anemic and the credit markets are flush with funds.

Also, the fears of stimulus spending rocketing up deficits and debt stock are not borne out by facts. The stimulus expenditures - even with a large third round of stimulus - a very small proportion of the long-term debt projections. The deficits have exploded due to a stagnating economy and reduced revenues, and even without any spurt in government expenditures.

The more pertinent dangers are with resource mis-allocation. Is it possible to structure expansionary policies which have minimal resource mis-allocation possibilities? Should we raise sectoral capital adequacy ratios and their risk weights so as to disincentivize and limit resource flows into those sectors? Ultimately, debates about macroeconomic balancing reverts back into issues of appropriate regulation of the financial markets.

What should be the policy transmission channels and how should the recovery look like? The ideal outcome would be for the expansionary policies to stimulate aggregate demand without generating financial market distortions. Fiscal policy should employ idling labor resources and government spending should put money in the hands of people who are likely to spend and thereby boost aggregate demand. This in turn should increase business confidence and encourage businesses to go ahead with their investment and hiring decisions.

The unconventional monetary expansion should lower the cost of capital, especially long-term capital, for businesses and governments, and thereby encourage and bring forward business investment decisions and lower the real cost of the public debts run up to finance the fiscal stimuluses. It should also provide the time and opportunity for businesses and households to repair their badly bruised balance sheets. All the while, the aforementioned specific regulations should play their role effectively in preventing the build-up of financial market imbalances.

In other words, instead of debating the relative merits of the respective positions of fiscalians and austerians and fighting fictitious (and ideological) battles against inflation and debts, we ought to be discussing about having in place approppriate regulations to address the possibility of market distortions arising from the expansionary policies.

Update 1 (24/10/2010)
Paul Krugman questions the effectiveness of QE 2, since the net risk remains within the government. He writes that "QE2 amounts to a decision by the US government to shorten the maturity of its outstanding debt, paying off long-term bonds while borrowing short-term".

Taking the Treasury and the Fed as a single entity, any quantitative easing would merely involve redemption of long-term debt (through re-purchases by the Fed) using money generated by expanding the monetary base. sales of new short-term debt instruments. Given the fact that at close to the zero-bound, cash and T-Bills are close substitutes (both pay nearly zero interest rates), it is just as if Treasury sold 3-month T-bills and used the proceeds to buy back 10-year bonds.

Update 2 (17/11/2010)

Mark Thoma has an excellent post on QE II. He describes QE II as, "It is conventional monetary policy that operates at the long end of the yield curve through the buying and selling of long-term financial assets rather than through the more traditional buying and selling of short-term assets. The need to operate at the long end of the yield curve presently is not because the Fed has lost control of long-term rates... it’s because the Fed can no longer move rates at the short-end."

More on the Japan then and the US economy now

Via Mark Thoma, from Mary C Daly of San Francisco Fed, comes a graphic that compares core-inflation trend in the US with Japan of the nineties, and the similarity is striking. A long-term deflation trap is a real possibility.



The deflation trend accompanies a steady slide in GDP growth rates, after a brief recovery. Real GDP growth trajectory has already been revised downwards thrice this year.



The worries about deflation coupled with stagnation comes even as the potential output crossed more than a trillion dollars and is estimated to persist well into the next few years.



Update 1 (30/10/2010)

Excellent Times article that compares Japan and US. The interesting thing is that US may be worse off than Japan in so far as it cannot draw on a large domestic savings pool to finance stimulus spending like Japan. See also this article about the problem faced by the Japanese policy makers and central bank on the financial market mess.



Update 2 (5/11/2010)

Bernanke now feels that the US economy faces the prospect of undergoing the Japan experience.

Analyzing interest caps on MFIs

The Government of Andhra Pradesh's proposed interest rate cap on rates charged by micro-finance institutions (MFIs) will in all likelihood, like similar price control decisions, generate its set of incentive distortions. I can think of three, as illustrated graphically.



1. A lowering of interest rates from the Re to Rc immediately reduces the number of people getting credit from Qe to Qs (this is indicated by the shaded triangle II).

2. However, the numbers willing to access credit at Rc increase from Qe to Qd (this is indicated by the shaded traingle III). In other words, Qd minus Qs is the number of people left without credit supply at Rc.

3. More worryingly, people accessing credit when the rates fall to Rc are most likely to be those with the highest ability to pay (those lying alongside the shaded area I) and also those more likely to have access to other channels of credit. This is because, those MFIs who are willing to provide credit at lower rates are likely to have better due diligence procedures that minimize their transaction (read recovery) costs. This ensures that those in the shaded area I are more likely to end up being given loans. Further, they also have the choice of picking from a large enough pool (demand is from Qd, whereas the supply is only for Qs) and hence are more likley to choose only the most credit-worthy of borrowers.

Prioritizing within the target group of borrowers for the provision of any subsidized credit, those people who are the most credit-worthy are also the least vulnerable and would therefore have to come last in any preference scale. However, assuming all the Qd are needy and willing to borrow at Rc, those lying in the shaded areas II and III are more vulnerable and are more likely to be prized out for all the aforementioned reasons and also not have access to alternative channels of credit. In Econspeak, the more credit-worthy and richer borrowers crowd out the less-credit worthy and poorer borrowers.

If a bank were to be in a position to be able to screen its borrowers and filter out the least credit-worthy and most vulnerable, then it would be operating in a seller's market and consider itself lucky. The MFIs (or atleast some of them) are in a similar market, thanks to the interest rate caps. Instead of helping the poor borrowers in dire need for credit, the interest rate cap ends up benefiting atleast some of the MFIs while helping none of the poor (irrespective of all this, the more credit-worthy ones would have anyway accessed their loans)!

Great Recession and the world economy

As history is written, the Great Recession may come to be defined as the first pan-global economic event of the post-modern era, one spanning countries across the world. A study of its pervasive and enduring impact by the Brookings Institution compared (after adjusting for price changes) the difference between today’s projections (based on the IMF's World Economic Outlook) of 2013 GDP per capita income and pre-crisis estimates (WEO of October 2008) for various countries of the world.



It writes,

"The thick concentration of dark red throughout Eastern Europe and the former Soviet Union, where for many countries 2013 incomes will be 15 to 20 percent lower than had been previously expected, illustrates where the crisis has done the greatest and most lasting damage. Conversely, developing Asia—including the large economies of China, India, Indonesia and Vietnam—escape virtually unscathed. The advanced economies of Western Europe and North America fall in the middle of this range, with downward revisions of around 5 percent. In Africa, Latin America and the Middle East, meanwhile, the picture is much more mixed: each region is home to both star performers and countries devastated by the crisis, evidence of the regions’ low levels of economic interdependence. All told, 154 economies are now anticipated to be poorer in 2013 than had been thought two years ago, while only 25 are expected to be richer."

World trade trends update

Times has a chart showing the dollar volume of monthly exports reported by 16 major countries since world trade peaked in July 2008, and the change in value of each currency against the dollar, comparing the average currency value in July 2008 to the average value in August of this year.



On the trade front, the developed economies have to travel a long distnance before they can claim some semblance of normalcy. Even the big emerging economies, used to fast-paced export growth have only recovered to where they were when the crisis erupted (July 2008). And dollar has appreciated against all currencies, thereby affecting US export competitiveness.

The last-mile gap with microfinance and the way ahead for MFIs

In a country full of paradoxes, it should have come as no surprise that one of India's most profitable business sectors is also one that claims to provide a platform to lift its millions out of grinding poverty.

After a brief lull, microfinance institutions are back in the news with a big bang. First came the spectacular $354 million IPO of SKS Microfinance followed by an ongoing debate about the ethical concerns with making profits out of poor people. Then came the acrimonious ouster of the CEO of SKS under mysterious circumstances.

Now, following a number of high-profile suicides allegedly driven by harassment from usurious micro-lenders and mounting opposition, the Andhra Pradesh (AP) government has cracked the whip on microlenders. An ordinance has been promulgated capping the interest rates charged by micro finance institutions (MFIs) and introducing stronger regulatory requirements. In AP alone the MFIs are estimated to have given loans worth Rs 3500 Cr so far this year, against Rs 2358 Cr given by government banks (against annual target of rs 7500 Cr).

On the face of it, there should not have been any competition between MFIs and government-financed SHGs, especially in AP. The SHGs financed by the government of AP receive considerable interest subsidy, leaving them to pay an interest of just 1% if the group maintains regularity in repayment for six months continuously. The linkage amounts too are large, Rs 75000 for the first linkage (given to groups after six months of satisfactory thrift activity), Rs 2-4 lakhs for the second linkage, and so on.

In contrast, the MFI groups recieve smaller amounts and at usurious annual interest rates of 24-60%. The repayment terms are much more onerous - weekly repayment (as opposed to monthly for government SHGs) and the threat of force and public humiliation for recoveries. Despite these obvious disadvantages and attractions of the other side, women groups prefer MFIs in large numbers. What are the last-mile gaps that force poor people into making such apparently irrational choices?

Unlike the bureaucracy-layered loans grudgingly given by the scheduled banks as part of their priority sector lending to government managed SHGs, MFI loans come with the red-carpet rolled-out. While the group members are forced into making multiple visits to bank branch, the MFIs offer loans at the door-step. And the paper-work and other procedural formalities are minimal with MFI micro-loans. The repayment procedures too are convenient. The always-available nature of these MFI loans as opposed to the still-distant nature of bank microloans, also ensures that they fulfill the critical timeliness requirements of poor people.

There are also the attractiveness conferred by way of lack of regulation and absence of standard due-diligence requirements. MFIs encourage formation of groups followed by immediate sanction of loans, whereas the government banks insist on six months of continuous thrift activity to become eligible for the first round of loan linkage. The same group can access loans from multiple MFIs, without any questions raised about repayment capabilities.

In simple economic terms, thanks to all the aforementioned last-mile deficiencies, the opportunity cost of accessing micro-loans offered by government banks is much larger than the cost of the MFI loans, even with their usurious interest rates.

My argument that follows is neither in favor nor against MFIs. On the one hand, there is ample evidence that most MFIs indulge in unhealthy business practices that ends up exploiting the very people whom it intends to help. It is by now widely-known that apart from the downright illegal strong-arm tactics to recover defaulting loans, they also employ unethical practices that conceals the true cost of loans from their unsuspecting borrowers.

On the other hand, it is undoubtedly true that MFIs are only the latest in the long-line of businesses that have seized the opportunity to exploit the massive profits that characterize virgin markets. The only difference being that unlike their predecessors, MFIs have been making their super-normal profits even as they maintain pretensions of helping the poor and complementing the efforts of the government in lifting people out of poverty.

In simple terms, it cannot be denied that the MFIs are merely exploiting an extra-ordinary business opportunity. However, it can be argued that they are free-riding on public externalities (tapping into the existing SHGs and the social capital and trained field personnel created by the government microfinance movement) to run an exceptionally lean and low-cost business model. In the purest capitalist language, any business enterprise which, notionally atleast, purports to play by the rules of the game, and generates a return on investment far in excess of 50% is arguably efficient.

It cannot also be overlooked that MFIs, like money lenders, play an important role in meeting credit requirements of the poor. In recent years, MFIs have proliferated in response to the realisation of huge un-met credit demand among the poor, arising partially from the government's own inability to provide universal access to formal credit mechanisms. In other words, MFIs are a form of the cliched "necessary evil".

The challenge now is to ensure that the MFIs contribute towards meeting the credit requirements of poor people, without compromising on the their undoubted capitalist efficiency and entreprenurial drive. In other words, how do we get MFIs to shed their predatory and unethical business practices and start to function like normal businesses? The instinctive answer to such questions is stringent regulation - interest rate caps, severe punishments and so on.

I am inclined towards a more nuanced position. While regulations are essential, it needs to be borne in mind that they can be successful only if the state has the capability and commitment to enforce them. As is the case with similar regulations on a host of other sectors and activities, neither pre-requisites are available. In the circumstances, regulations have to be supplemented with strategies that can re-align the profit-maximizing incentives of micro-lenders with achievement of the desired public-policy objective of expanding access to formal credit mechanisms.

One way to achieve this is to formulate the market for micro-loans in a manner that makes borrowers effectively sub-ordinated equity partners in the enterprise. Profits beyond a pre-defined bound, and after accounting for the regular shareholder dividends, could be ploughed back into the respective accounts of the borrowers as bonuses that effectively lowers the final interest rates. This would enable an efficient form of price-discovery on interest rates which reconciles both the commercial imperatives of the MFI and the reasonableness of the interest rate borne by the poor borrower.

Another approach would be to have a sliding scale for appropriating some of the super-normal profits. In simple terms, a graduated system of taxation can be introduced that internalizes some of the earlier mentioned public externalities that have been captured free by the MFIs. Governments could then reimburse this as an interest subsidy to the borrowing groups.

The administration of both these strategies could become dramatically simpler with the coming of UID and the introduction of UID-linked bank accounts. It also becomes easier to enforce regulatory requirements on capacity-related eligibility norms for groups, on the number of separate loans a group can hold, and other factors.

In conclusion, MFIs may or may not have succeeded in their ostensible mission as social enterprises. It may also be debatable as to whether their activities will be to the benefit and long-term good of their customers. However, it is undoubtedly true that they have enormously enriched their promoters.

Analysing inflation trends in India

A recent speech by Subir Gokarn, RBI Deputy Governor, (via Mostly Economics) sheds interesting light on the growth-inflation dynamics of the Indian economy and the "policy commitment to maintain a balance between growth and inflation in the short run, while fostering faster growth with lower inflation over long periods of time".

In another speech, Deepak Mohanty, Executive Director at RBI, examined the nine incidents of double-digit inflation since 1954, and argued that "volatility as well as incidence and duration of double digit inflation has reduced over time". He points to the fact that despite the recent rise in food prices, inflation rates have been on a downward trend in India in recent decades.



That there is nothing simple about the causes of recent inflation is borne out by the near-uniform increases in inflation rates across all categories and on both supply and demand-sides. As the graphic below shows - now and in earlier instances of high inflation - both food and fuel prices (reflecting supply-side forces) and the prices of manufactured goods (reflecting demand-side ones) have been on the rise. This raises doubts on the utility of monetary policy alone in addressing these inflation episodes.



Historically too, periods of high inflation has coincided with demand and/or supply-side shocks, with food (mostly internal, monsoon failures etc) and fuel supply (mostly external) shocks being the most persistent. However, unlike demand-side ones, supply-side shocks are not amenable to being addressed with conventional monetary and even fiscal policy responses. This raises the need for automatic fiscal stabilizers and long-term efforts to improve farm productivity, besides more effective counter-cyclical macroeconomic management.



As is expected and can be seen from previous experiences, high inflation periods have coincided with increases in government borrowings. However, over the past few decades, inflation has remained relatively indifferent of the broad money growth rate. Dr Gokarn attributes this stability to the increased depth of Indian money markets which have been able to absorb the volumes and mitigated the potentially inflationary pressures.



Interestingly, inflation rates have been stable over the past two decades, with inflation volatility coming down sharply. Dr Gokarn also points to a "universal correlation between the level of the inflation rate and its stability" and the fact that the "reduction in the average inflation rate over the years has been accompanied by a sharp reduction in the volatility of that rate".



And he holds out hope about inflation prospects in the prevailing high inflation environment. The clearest indicator that the inflation is on its way down comes from the month-on-month rates of inflation which gives a sense about the momentum of inflation. Since early 2010, the momentum has clearly been on the negative.

Africa in perspective

Africa is larger than China, US, India, Japan, and all of Europe combined!

School grades inflation

For some years now, New York has been a national model in the US for education reforms, and much of its success was attributed to the system of standardized English and Math tests, whose results also formed the basis for evaluation of schools and teachers, apart from students. New York Mayor Mike Bloomberg, who has been its biggest supporter and driving force, had made test results central to all his educational initiatives.

Schools were graded (A-to-F grading) on how much their scores rose and threatened with being closed if they did not. The scores dictated which students were promoted or left back, and which teachers and principals would receive bonuses. Teachers and principals earned bonuses of up to $25,000 if their schools’ scores rose. This year, they were even used to help determine which teachers should receive tenure.

Since its introduction in 1999, which revealed massive deficiencies in learning outcomes across classrooms, the state has made impressive progress as evidenced by these test results. However, in recent times, there have been serious doubts raised about whether these gains reflected actual learning outcome gains or manifested grade inflation. Following widespread criticism that its standardized tests contributed towards keeping grades artificially inflated, New York state introduced tougher tests this year, causing proficiency rates to plummet and deflating the achievement balloon.



The high stakes attached to these standardized tests inevitably unleashed forces that would slowly undermine the system itself and made the exams too easy to pass. Schools got fixated on how to raise scores, instead of looking for more authentic learning. Research has shown that when educators are pressured to raise scores on conventional achievement tests, some improve instruction, while others turn to inappropriate methods of test preparation that inflate scores.

The short, narrow and predictable nature of the exams, coupled with the fact that results were released publicly immediately, meant that teachers began to know what was going to be on the tests. It also made coaching easy and deprived test creators much needed flexibility and variety in setting questions. Students were preparing and writing exams by merely following examination papers for the previous three to four years.

Test designers like to insert questions that do not count in the score (though the students does not know this) but might be used in a future test. This allows them to create tests with a mix of easy, moderate and difficult material that is constant — or standardized — from year to year, so that administrators can compare one year’s performance with another’s. Public release of test results meant that test designers could no longer rely on this strategy to mitigate the predictability of question papers.

One way to audit exam results for grade inflation, proposed by harvard and CUNY researchers, is to insert some questions that would not resemble those from previous years. If a class performed well on the main section of the test but poorly on the added questions, that would be evidence that scores were inflated by test preparation. If on the contrary, a class performed well on both that teacher might have methods worth emulating.

The experience of New York mirrors that of tenth class results across many Indian states. Over the past decade, with the emergence of private schools and intense competition to attract and retain students, a trend has emerged where schools signal their superiority through tenth class exam results. Further, among government schools, with tenth class pass matric being the only universal basis available for inter-school comparison and consequent importance of it, administrators and teachers were incentivized to game the examinations to boost their respective results.

The experience of New York and those Indian states is not an argument against standardized tests. Far from it. Standardized tests, administred in an objective manner and with questions that are not predictable, are the only means to assess student learning outcomes. However, extreme care should be taken to design and manage these tests, especially over time and if they form the basis for high stakes decisions. This should be complemented with dynamic third party auditing to continuously assess (and maybe control for) the extent of grade inflation present in the test results.

Nobel Prize for the times

This year's Nobel Prize in Economics could not have been given to a more appropriate set of people (my prediction notwithstanding!). The persistent high unemployment rates in the US during the Great Recession raises serious questions about classical theories which predict that the labor market will clear automatically (by way of wages falling thereby enabling labor supply to match with demand automatically).

The "austerians" have been attributing the persistently high unemployment rates to structural factors associated with changes in the economy in recent years, and feel that the high rates are only a manifestation of a "new normal". The implication of this is that any effort to boost demand by way of additional government spending would have no effect. In contrast, their opponents see this as a manifestation of weak demand and anemic investment environment. They therefore advocate more stimulus spending and monetary accommodation to enable effective utilization of idle manpower and encourage businesses to proceed with their regular investment decisions.

Professors Peter A Diamond of the Massachusetts Institute of Technology, Dale T. Mortensen of Northwestern University and Christopher A. Pissarides of the London School of Economics won the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel "for their analysis of markets with search frictions" where buyers and sellers do not match themselves automatically. Specifically, they "spent decades trying to understand why it takes so long for people to find jobs, even in good economic times, and why so many people can be unemployed even when many jobs are available".

They argue that it takes time for unemployed workers to be matched with the proper opening, since neither people nor jobs nor employers are identical. These findings are relevant for markets with differentiated products — like labor and housing - which do not fit into the classic supply-demand equalizing paradigm. In these markets, "heterogeneous sellers confront heterogeneous buyers, and it takes time and effort to find appropriate matches".

On a broader canvas, their work is an important component of "search theory", which has been applied to many other areas, like money systems and venture capital markets. Labor economists talk about firing costs, family economists talk about divorce costs, and housing economists talk about shifting costs, all of which comes in the way of automatic market adjustments. Their findings also point to the possibility of unintended consequences like unemployment benefits ending up prolonging joblessness by making it less costly to be without work.

As NYT reports, Prof Diamond said that one of the implications of his work was the fact that more fiscal and monetary stimulus was probably necessary to speed up job growth, "The slower it happens, the more workers lose their skills and stop searching, and so the process goes more poorly after that". Rejecting the "new normal" unemployment rate hypothesis, Prof Diamond says, "Workers and employers will adapt to what will make the economy function. I see no reason why, once we get fully over this, we won’t go back to normal times".

Professor Mortensen argues in favor of additional measures to get credit functioning more normally, and in particular to make it easier for small businesses to get loans, were crucial to reducing unemployment, "From my perspective the problem right now is not the labor market. What’s happening in the labor market is a symptom of more complicated problems with the financial market".

In many respects, this prize may also be seen as the final triumph of Keynesianism itself. While Keynes had generically argued that economies need not automatically recover from a recession, this year's winners have shown that much the same applies to the labor market for varying reasons. Edward Glaeser who has this excellent summary of their research, also has the most appropriate tribute,

"Rarely has the prize committee been better able to match the honored work with the moment."

See Mostly Economics for a nice summary and and excellent graphical explanation by Econospeak of the Beveridge curve relationship and the difficulty of assessing any equilibrium unemployment rate.