Tuesday, November 30, 2010

The case for labor mobility

Here is my Mint op-ed today that points to an underlying suspicion of migration in our development discourse and explains why we need to overcome it.

Monday, November 29, 2010

More on hospital corruption

Here is the science and psychology behind hospital corruption. As can be seen, the very low government hospital user fee, the huge differential between it and private consultation fee, and the substantial un-captured higher willingness to pay (WTP), provides for considerable rent-seeking opportunities (shaded area in graph below). The WTP is amplified by the vulnerability of a patient fighting for his/her life.

Elimination of bribery by raising user fees to match that of the private hospitals is politically unfeasible. The logistics of managing reimbursement of the higher fees to the poor (to UID-linked bank accounts) is simply too complex. Standard prescription like more rigorous regulations - anti-corruption agencies, exemplary punishments, transparent recruitment process, etc - while essential, are not likely to make much head-way given the huge numbers (of officials and offices) involved, the vast spread, effective monopoly of service provision (atleast to the poorest), and entrenched and commonplace nature of such rent-seeking. In fact, the challenge is to resolve corruption given the aforementioned existing factors.

Simple and cliched as it sounds, the reasons for keeping consultation fees low in government hospitals is worth repeating. Basic health care services are a public good - not supplied by private sector and the preserve of governments. Pricing up the access to the service so as to capture the full WTP, will naturally end-up denying the service to the poorest. However, they are precisely those who cannot access private health care and who are among the most certain beneficiaries of such government welfare programs. Any attempt to increase consultation fees in government hospitals and reimburse the subsidy will be too complex to administer, even with enabling systems like the UID.

In any case, market efficiency is not the issue here, as one of the comments (KP) nicely put it, "If the government steps in to provision and deliver a service, it is invariably a question of satisfying un-met demand because of market failure, its logic is not to capture the consumer surplus in entirety". Further, comparison with the US is irrelevant for the two reasons - cultural and law-abiding nature of citizens - which are not applicable, atleast for now, to India. And, as POM graphically and brilliantly highlights, capturing consumer surplus by higher pricing is no insurance against rent-seeking or other forms of exploitation. It simply morphs and emerges in an even more difficult-to-address form! Outsourcing, especially to SHGs and NGOs, while theoretically appealing, have been found to deliver much the same, even worse, outcomes.

Even raising the wages of the street-level bureaucrat is likely to do little to limit rent-seeking. In view of many of the aforementioned factors, the rents are likely to be inelastic in relation to the salaries. In other words, the increased salaries, without addressing the WTP and other contextual factors, will do little to depress the bribes.

I cannot but completely agree with KP that it is "perverse" to apply the WTP principle and maximize consumer surplus while designing public policies (that too on supply of public goods) in an environment of huge unmet demand. Fortunately, our sense of right and wrong have not degenerated so much that we are forced to deny a person an opportunity to save his life because he cannot afford the required treatment.

The challenge, and the problem I posed in the earlier post, is to design implementation strategies for delivering health care services in government hospitals, given all the adversities of the environment.

Here my understanding of the problem. The last-mile issue here is the multiple interfaces between officials and the patient. We cannot avoid them, but we can minimize them and even create conditions to limit the chances of bribe-transactions. The challenge then is to structure an implementation environment that will nudge/coax/deter/condition officials so as to mitigate or even eliminate the rent-seeking opportunity. And these environmental framing can be done in different ways, taking into account the specific cultural and functional factors.

At a more generic level, is it possible to have a single-window type interface? Can all the tests be done at one location so as to eliminate multiple interfaces? Can tests be carried out at the bedside? Is it possible to issue tokens with clear timings to each patient to access these services? What are the different means of corrupt practices at each interface, and can we do something to deter them? Can we rotate officials at the cutting edge with some periodicity? Answers to all these and more would be determined by the micro-environments of the rent-seeking action and how we can re-frame them to dis-incentivize corrupt practices.

Or, on a more unconventional manner, can we have a system wherein, no in-patient can keep possession of any money? And even if they want, the notes should be dipped in a powder that dis-colors water? Or we can even borrow this from Kathmandu airport - pocket-less employee uniforms!

Saturday, November 27, 2010

More on the Celtic crisis

Paul Krugman makes an interesting comparison between the relative paths adopted by Iceland and Ireland when faced with similar financial crises. He describes the relative success, till now, of Iceland and the disaster looming on Ireland, as the triumph of heterodoxy over orthodoxy in economic policy making.

In both cases, the crisis could be traced to irresponsible lending by banks and borrowing by real estate and other businesses. And businesses and borrowers in both ran up massive amounts of external debts. When faced with their respective decision-moments, the responses could not have been starker.

Nearly 18 months back, Iceland responded by making "foreign lenders to its runaway banks pay the price of their poor judgment, rather than putting its own taxpayers on the line to guarantee bad private debts". The result was a number of private sector bankruptcies, which also "led to a marked decline in external debt". It also introduced capital controls to prevent sudden capital flight by foreign and domestic investors. It refrained from destabilizing its Nordic social welfare model with the standard fiscal austerity measures like spending cuts.

In contrast, faced with the prospect of huge losses for banks and their irresponsible foreign lenders, the "Irish government stepped in to guarantee the banks’ debt, turning private losses into public obligations". The result is that the debts got transferred from the banks to the Irish Government's balance sheet. At the first signs of trouble, it imposed a series of "savage fiscal austerity" measures in order to restore "market confidence". And followed it with more doses of the austerity medicine.

The "confidence fairy" has responded in the most unexpected manner to the actions of both governments. If the supporters of the "confidence fairy" hypothesis were correct, Iceland should have been ravaged by the bond-vigilantes and Ireland should have been ovewhelmed by a rush in market confidence. The results have been exactly the opposite. The bond markets continue to savage Ireland, whose bond yields and CDS spreads continue to rise steeply despite nearly three years of austerity. However, Iceland has made a smart recovery, both its economy and the financial markets, winning praise from even the IMF.

Its CDS spreads have fallen from 800 to less than 300, whereas Ireland's cost of insuring debt has risen precipitously from less than 200 to over 500 points.

In fact, a testament of its success and the problems of the EU peripheral economies is the fact that Iceland's CDS spreads have fallen below that of even Spain.

And, unlike Ireland, being out of the single currency zone meant that Iceland could indulge in significant currency devaluation to increase the competitiveness of its exports.

In this context, Simon Johnson points to the odds stacked against Ireland being able to emerge out of its debts any time in the foreseeable future. He points to the fact the fact that atleast 20% of Irish GDP is from 'ghost corporations', attracted by Ireland's 12.5% corporate tax rate, that have little or no real activity in Ireland. This effectively means that the real debt burden of Ireland is more than 100% of the GNP and could rise to 150% of GNP in the next few years.

The steep fiscal contraction by way of spending cuts, especially at a time when the economy is set to contract for the third year in a row, will amplify the real debt burden. In the absence of a national currency, it cannot even devalue and increase the competitiveness of its exports. And given the extraordinary rise in asset valuations - property prices rose four times - any chances of asset prices rising to reduce the real debt burden is remote.

Further, this year, the government will run a deficit of 15% GNP, and with nominal GNP falling, it could well remain that high next year, even if the government cuts spending by the 2 to 3% of GNP currently envisaged. In other words, Irish economy would have to grow at close to its highest ever growth rates just to ensure that its debt share stays the same.

In the circumstances, it is certain that Ireland cannot resolve its debt crisis without some form of debt restructuring that forces lenders to take substantial haircuts. But coming in the way of this is the significant exposures of European banks to Irish debt.

It is estimated that the claims of foreign banks on Ireland are at over $500 billion. German banks are owed $139 billion, which is 4.2% of German GDP British banks are owed $131 billion, or about 5% of Great Britain’s GDP, French banks are owed $43.5 billion, which is approaching 2% of French GDP, and Belgian banks are owed $29 bn, or 5% of its GDP. None of these countries are likely to support measures that would effectively force their own banks to take losses on their Irish exposures.

Update 1 (29/11/2010)
Ireland becomes the second country after Greece within the Eurozone to accept a bailout. The 85 billion euro ($112 billion) bailout plan, at an average interest rate of 5.83% (compared Ireland's 10 year bond rate of close to 10%), includes a contribution of 17.5 billion euros by the Irish government itself through money it has already raised. Of the rest, 22.5 billion euros will come from the International Monetary Fund. The remaining 45 billion euros will come from bilateral loans from European nations and two European Union rescue funds set up in the spring.

Of this €10 billion will be used to immediately to recapitalise the banks to bring them up to a core tier 1 capital ratio of 12%, with a €25 billion contingency. The remaining €50 billion will be used to meet the budgetary requirements of the State. Under the Plan, Ireland will reduce its budget deficit to 3% of GDP by 2015.

Update 2 (3/12/2010)
Barry Eichengreen has the best article on the prospects for the Irish economy. It is in one word - brilliant!

Friday, November 26, 2010

Transfers and poverty reduction

Lane Kenworthy has an excellent post on the dynamics of poverty reduction for the bottom percentile. The conventional wisdom that under-pin the trickle-down growth hypothesis places faith on employment creation and income/earnings growth (through both more work hours and higher wages) as the channel to reduce poverty. But Lane Kenworthy marshals an impressive array of statistics from across countries, albeit developed ones, to show that this argument breaks down for those at the bottom decile of income distribution. He writes,

"At higher points in the income distribution they do play more of a role. But for the bottom ten percent there are limits to what employment can accomplish. Some people have psychological, cognitive, or physical conditions that limit their earnings capability. Others are constrained by family circumstances. At any given point in time some will be out of work due to structural or cyclical unemployment. And in all rich countries a large and growing number of households are headed by retirees."

His analysis showed that in most countries, the earnings of low-end households increased little, if at all, over time. Instead, the reason for poverty reduction (or income growth) among the bottom percentile,

"It is increases in net government transfers — transfers received minus taxes paid — that tended to drive increases in incomes... Where economic growth has trickled down to the poor (households in the bottom income decile), it has done so mainly via government transfers rather than via earnings... Advances in real incomes for low-end households hinge on government efforts to pass on the fruits of economic growth."

In an earlier post, Kenworthy had argued that contrary to conventional wisdom with its emphasis on progressive taxation system, inequality reduction is achieved more by government transfers and better quality public services, both of which require higher quantity of taxes.

Wednesday, November 24, 2010

The Celtic Tiger is Museum piece?

Sample this paean about the Irish economic model (in the context of which model Europeans should follow) by the high-prophet of globalization and other global mega-trends, Thomas Friedman, in July 2005

"It is obvious to me that the Irish-British model is the way of the future, and the only question is when Germany and France will face reality: either they become Ireland or they become museums. That is their real choice over the next few years – it’s either the leprechaun way or the Louvre... As an Irish public relations executive in Dublin remarked to me: "How would you like to be the French leader who tells the French people they have to follow Ireland?" Or even worse, Tony Blair... the other day Mr. Blair told his E.U. colleagues at the European Parliament that they had to modernize or perish."

For some years now, the Irish economic model, the Celtic Tiger, had been lauded as the way forward for other Europeans. The three major strands on which the Irish model stood were - focus on higher education and attracting knowledge-based industries, ultra-low corporate tax rates (at 12.5%, it is the lowest in Europe - France 34%, Germany 30%, and Britain 28%!), and financial market liberalization that went beyond even the US.

However, from hindsight, as the ongoing events highlight, apart from the first, the other two were mis-guided policies that have played a major role in taking Ireland to the precipice. Banks, which issued loans recklessly during the real estate boom, have accumulated losses of about €70 billion, almost half the country’s economic output. The low corporate tax rate, which effectively turned Ireland into an on-shore tax haven, also meant a dramatic drop in the country's tax revenues when recession took hold. The country's fiscal deficit is now at a stunning 32% of GDP and public debt is set to cross 80% of GDP. Unemployment at 12% continues on its upward climb. The country is set to experience its third consecutive year of economic contraction in 2010.

The bursting of the sub-prime mortgage bubble in the US and the global financial market meltdown that followed have devastated the Irish economy. Its real estate market crashed in an even more spectacular manner than in the US, leaving the Irish banking system in shambles. It also triggered off an economic recession that ravaged the government's fiscal balance.

The Government first stepped in with a bailout, guaranteeing the debts of the bankers. When this appeared to have little effect, in order to impress the "confidence fairy", the Irish government announced a savage fiscal austerity program. However, after some initial enthusiasm among the bond-vigilantes, the reality set in. The bond-vigilantes have rewarded the Irish austerity programs with a resounding thumbs-down - Irish 10-year bond yield is at 8.35% and the spread with 10-year German bond is has been steadily widening 544 basis points, and the 5-year Irish CDS spread has shot up to 523 points.

Early this week, after its fiscal austerity program failed to rouse the "confidence fairy", Ireland followed Greece in formally applying for a rescue package. The EU and the IMF are working on a $109-123 bn package to help Ireland bailout its banks, reschedule its debts, and thereby prevent a sovereign bankruptcy. The funds will come from a rescue mechanism worth roughly $1 trillion that was set up in May by the EU and the IMF to help euro zone countries spiraling toward default.

The bailout is expected to support the failing Irish banks and also enable the Government to repay its debts and run regular activities without having to approach the ballooning bond markets for the coming three years. About €15 billion is likely to go to backstop the banks, while €60 billion would go to Ireland’s annual budget deficit of €19 billion for the next three years.

The bailout to reschedule Irish debts will invariably be criticised as merely delaying the inevitable default. Critics will point to Greece, whose bond yields and CDS spreads have continued to climb despite the bailout and measures to rein in government spending.

Adding weight to this view is the magnitude of losses suffered by Irish banks, most of which have been taken over by the Government. The gravity of the debt crisis being faced by the Irish Government is borne out by its staggering primary deficit in excess of 10% of GDP. This means that even without paying interest on their debt Ireland will still spend more than it collects in taxes.

In the absence of any of the traditional channels - currency depreciation or lowering interest rates or even inflation - to emerge out of a recession and sovereign debt-crisis, the propspects for the Irish economy looks bleak. The strong austerity dose and the prevailing economic weakness among its EU partners only amplifies the problem. All this means that growing or exporting its way out of debt looks remote and some sort of actual debt relief or reduction becomes the only sustainable option.

In the circumstances, a partial default, by way of an organized restructuring of debt would have forced bond-holders to accept a haircut on their investments and reduced the amount of money owed. Coupled with fiscal tightening, it would have stood a more realistic chance of success. However, this approach also carries with it considerable perceived dangers.

Primarily, the fears of investor panic and another round of financial market collapse is the biggest deterrent against traversing this path. The possibility that imposing bond haircuts can make future market access expensive or impossible for an extended time and can create serious contagion effects elsewhere is another reason to not embrace debt-restructuring.

Finally, the fact that creditors are banks belonging to the major European economies may also be another factor behind it. In the euro zone, more than 2 trillion euros in sovereign debt belonging to Greece, Ireland, Spain and Portugal is held largely by German, French, British banks and, in the case of Greece, local banks and pension funds.

In any case, contrary to Thomas Friedman's prediction, after two years of financial and economic tumult and untold social suffering, it is the Celtic Tiger economic model, along with its current Government, that looks set to join the collection at the National Museum of Ireland! Ireland today looks like a Paradise Lost or a miracle turned mirage!

Update 1 (26/11/2010)

Portugal passes a fiscal austerity plan to bring down its deficit and reassure the debt markets. The budget plan for 2011 is aimed at re-assuring nervous lenders that the country could avoid a bailout by meeting its deficit-cutting targets. The plan is expected to cut Portugal's budget deficit from 9.3% of GDP last year, to 7.3% this year, and 4.6% in 2011.

Spain, with a budget deficit of 11.1% of GDP last year, too has pushed through austerity measures including spending cuts. However, given its size, Spain has emerged as Europe's "too-big-to-fail" country.

Meanwhile, Ireland has successfully resisted pressure from other EU members on any increase in its ultr-low corporate tax rate of 12.5%. The country is heavily dependent on foreign direct investments (FDI). About 70% its exports and 70% of business spending on research and development comes from FDI. Foreign-owned firms pay workers about $7.1 billion each year and provide one in seven of the country’s jobs, either directly or indirectly. Multinationals paid about 5 billion euros in corporate tax to Ireland last year, more than 50% of all corporate tax receipts.

Tuesday, November 23, 2010

How do we address hospital corruption?

I recently came to know that it is not government offices or police stations that have the widest prevalence of corruption. That distinction surprisingly belongs to government hospitals, the larger referral centers. And unlike corruption in other establishments, this one is deeply entrenched and not easily resolved. Here is why.

The patient is normally greeted at the registration counter itself with attendants offering a swifter route to access the doctor in return for some "speed-money". And the ordeal continues till they approach the medicine issue counter, where a "fee" is demanded for provision of medicines. In between, the patient is forced to pay bribes at every location he/she visits for a diagnostic service - laboratory, X-ray center, dressing center, injection room etc.

For the in-patient, the experience follows an even more elaborate work-flow. Apart from all the aforementioned, "user rents" are extracted from them by the sanitation workers (sweepers and cleaners), nurses, food contractor, and so on. The single biggest payout is reserved for the operation theatre attendants. Their extortionary power gets amplified by the psychological vulnerability of a patient bound for the operation table.

Here are a few features of this hospital rent-seeking network

1. There are multiple rent-seeking interfaces within a hospital. Each bribe-taker serves an independent rent-center within the hospital. It is not possible to offer a one-time bribe and then pass through the entire chain of services unrestricted.

2. The psychological vulnerability of a patient visiting a doctor makes them easy prey to the extortionary impulses of the bribe-takers. The demands are likely to be met without much resistance and there is little likelihood of anyone openly complaining. No where is this more evident than patients being taken to the operation theater. In fact, atleast some of them pay up as an insurance against life-threatening negligence during the operation.

3. Most worryingly, hospital rent-seeking is completely institutionalized. Almost every staff member is partakes of the spoils. In fact, it has become so closely enmeshed into the work culture that at least some of them rationalize it without any remorse and view it as normal. In other words, the intrinsic deterrent against this practice has severely diminished.

4. The bribe transactions are between two individuals, neither with an incentive to make it public, and take place in relative privacy. Further, the odds-stacked against the patient are so formidable that there is little chance of him complaining. Adding to the challenge is the rapid flow of these transactions within the system.

5. There is an important supply-side willingness to pay dimension that makes the task of controlling hospital corruption even harder. For example, it is almost a cultural norm to gift the nurse delivering the new-born baby. Similarly, patients coming out of a successful operation reward their attendants as a token of appreciation and expression of their happiness.

Regulatory strategies, by way of improved supervisory systems while important, are not likely to make much head-way. A near universal and deeply institutionalized phenomenon cannot be satisfactorily tackled with supervisory oversight. How can we punish everyone? When everyone breaks the law, it no longer remains a crime, atleast in the popular psyche!

The deterrent effect of punishments on individuals caught indulging in taking bribes is not likely to remain for too long. Soon the positive feed-back generating (it collectively emboldens everyone) environmental effect arising from everybody taking bribes will prevail and the deterrent fear will fade out.

In view of all the aforementioned, how do we control corrupt practices in our referral hospitals? In general, how do we control a form of corruption which has become so pervasive as to be the norm and not the exception?

Monday, November 22, 2010

The "slippery slope" with financial incentives

Econ 101 teaches us that incentives matter and that rational economic man responds predictably to incentives, especially financial ones. However, recent research from behavioural psychology shows wide variations, often contrary to standard model predictions, in the responses of real world human beings to financial incentives. This has naturally generated an interesting debate about the pros and cons of using financial incentives to instill habits.

Health care has been at the forefront of efforts to use incentives to generate socially desirable health outcomes in individuals. Studies show that 50-70% of the health care costs in the US are preventable. Accordingly, realising the financial benefits associated with better preventive care, health insurers have used financial incentives to encourage people to stay healthy - exercise more and eat healthier foods. They have found that even modest financial incentives up-front to encourage people to remain healthy can save the much larger costs of hospitalization (and insurance payouts).

Health service providers and even employers (who pay the health care premiums) incentivize physical activity, which is measured using web-enabled pedometers, accelerometers or heart-rate monitors. Personal activity data is uploaded from the activity-tracking devices into an individual’s account on the Web. Health insurance premium payments drop by some specified amounts if the individual attains his/her activity goals. This trend has even led to the emergence of health-incentive management companies.

Similarly, it has been found that one-third to one-half of all patients in the US do not take medication as prescribed, and such lapses fuel more than $100 billion dollars in health costs annually because those patients often get sicker. In response, insurers, doctors and pharma companies have been toying with paying people money to take medicine or to comply with prescribed treatment.

Behavioural economists like Uri Gneezy have studied the use of financial incentives to promote habit formation in different walks of life. Gneezy and Gary Charness have found that "even though personal incentives to exercise are already in place, it appears that the financial incentive serves as a catalyst to get some people past the threshold of actually getting started with an exercise regimen".

More controversially, similar line of reasoning have been invoked to get children to study or even behave properly, people to exhibit civic responsibility (like to pick up litter or not litter), and so on.

There is a slippery slope with taking the application of incentives to its extremes, especially when it involves getting people to do what is obviously in their own interest and what they ought to be doing in the normal course. Here is a list of examples of such slippery slope outcomes.

1. It has been found that such incentives may create self-doubts about the true motive for which good deeds are performed. This in turn could crowd-out, even destroy, the inherent pro-social attitudes in human beings. Children paid to study are amongst those most vulnerable to such incentive distortions.

2. Incentives could result in market failures or bad market outcomes. For example, paying for organ donations could end up creating a black market in organ transfers.

3. Financial incentives could create hysteresis effects, especially for pro-social behaviours. This could manifest in two forms. One, pro-social attitudes would not be regained once the incentives are withdrawn. Second, it will take much greater effort to generate the same level of outcomes after incentives are removed. Therefore children exposed to financial incentives to study or help in household chores, could end up not responding once those incentives are withdrawn.

4. Financial incentives can dilute pro-social motivations. Accordingly, payment for volunteering under certain conditions end up reducing effort - people do less work than would have been the case without the incentives.

5. The use of financial incentives opens up possibilities of distortions or sub-optimal outcomes if the magnitude of incentive is either too small or too large. For example, failure to strike the right balance on inncentives to reduce health risks can result in worse performance than not paying at all.

On a similar note, financial penalties on deviations from social norms can take the stigma out of non-conformity. Therefore penalties for turning up late for classes will end up increasing late-coming as people rationalize away their late arrivals on the penalty payment.

Update 1 (12/12/2010)

A neuroeconomics study of human brain activity shows that each brain responds differently to incentives, and reward-related brain activity can predict the undermining effect (the person is less likely to voluntarily engage in a task after performing that task for some sort of extrinsic reward) within an individual. This means that removing extrinsic incentives to engage in an activity can have damaging effects on the desire to voluntarily engage in that activity.

This is particularly interesting because it shows that not all individuals should be treated as equal in economic models of decision-making and incentive-driven. behaviour.

Saturday, November 20, 2010

Bush tax-cuts and supply-side economics

The most enduring dogma in economics is the belief that tax cuts always pays for itself. The latest example of this, for which evidence is out, is the Bush-tax cuts of 2001. And what is the evidence?

David Leonhardt examined the evidence on growth rates, for both ten and five-year periods, from recent American economic history and found that the last decade was the worst. The growth from 2001 through the third quarter of 2010 averaged 1.66%, comfortably lower than the second-worst decade - average growth rate for 1971-80 was 3.21%. The five-year comparison produced the two worst periods.

The evidence becomes even more clinching when we compare the labor market outcomes of Bush-era, with its tax-cuts, and Clinton-era nineties, characterized by tax increases. The labor force participation rate has declined continuously throughout the decade to touch its lowest ever employment-to-population rate of 58.4%.

The total non-farm payroll has remained stationary during the Bush decade. This is in sharp contrast to the sharp spike during Clinton era, despite the tax increases.

One of the strongest arguments in favor of tax cuts is the claim that it encourages business investments. But, belying this claim, the total private industry payroll has remained the same for an entire decade, in comparison to the sharp rise during the Clinton era.

Another arguement punctured by a comparison of the two periods is the claim that it promotes entrepreneurship. David Leonhardt points to BLS figures that clearly shows that these tax cuts did not lead to entrepreneurship and innovation. In fact, the rate at which start-up businesses created jobs fell during the past decade.

On the fiscal balance front, its impact has been in one word, disastrous. When Bill Clinton left office in 2001, the budget for 2009-12 was forecast to have an average surplus of almost $854 bn. The actual budget deficit for 2010 is forecast to be in excess of $1.3 trillion!

Update 1 (16/4/2011)

Here is a graphic that captures the impact of Bush tax cuts on US deficit.

Update 2 (1/6/2011)

Excellent post by Bruce Bartlett that makes the point that the high statutory corporate tax rates in the US masks the numerous exemptions, credits, and deductions, that are enjoyed by corporates in the US. This ensures that the effective corporate tax rate is among the lowest in the world. In fact, as a share of GDP, it is the lowest among all OECD countries.

Update 3 (8/6/2011)

Excellent CBPP graphics that highlights the perverse effects of the 2001 Bush tax cut law.

Friday, November 19, 2010

The economic growth way out of debt trap?

The Great Recession continues to ravage the US economy. The unemployment rate remains stuck at a very high rate; inflation continues on its downward trend and deflation looks round the corner; aggregate demand shows no signs of any rebound; corporates, sitting on record cash surpluses and experiencing prductivity surge, look disinterested in new investments.

The recent Congressional election results which saw Republicans making gains, has brought debt and deficit reduction to the forefront of economic policy debate. It appears that the Age of Austerity is about to begin. This despite clear warnings and much evidence from history that stabilization of economic growth and lowering of unemployment (instead of debt reduction) should be the immediate priority of any Government faced with such a deep recession. If the "pain caucus" pushes ahead with their spending cut plans, it is inevitable that the economy will slip deeper into deflation and recession. It is possible that when the history of the Great Recession is written, historians will point to the Congressional ballot as a defining event in US history.

Debt reduction can be achieved through four methods - spending cuts, tax increases, inflation, and economic growth. The Tea Party activist led "pain caucus" in the US are propogating spending cuts-based approach. However, as I have blogged earlier, fiscal austerity during an aggregate demand slump recession will only deepen recession. One only need to look at evidence from America's own Depression-era history or Japan since the nineties. Or the fate of austerity poster-child Ireland which is today tethering at the precipice of a sovereign default. The extent of tax hikes required to make a meaningful dent on the US public debt appears politically not feasible. Inflating away debt carries its own risks and will erode the long-term economic credibility of the US economy.

In the circumstances, economic growth driven debt-reduction looks a win-win strategy. However, given the massive size of the current US debt and future liability additions, economic growth alone will not be able to address the problem. Any meaningful attempt to reduce the debt will have to involve a combination of growth, spending cuts and tax increases. Ideally, given the persistent recession, both spending cuts and tax increases should be deferred till the economy starts on the recovery path. Growth should take immediate priority.

In this context, David Leonhardt has an excellent article in the Times which argues that if the US economy grows "one half of a percentage point faster than forecast each year over the next two decades... the country would have to do roughly 40 to 50 percent less deficit-cutting than it now appears". He points to the experience of the debt-laden post-War US economy to drive home the effectiveness of growth-led debt reduction.

When World War II ended, the federal government had debt equal to a whopping 122% of GDP. But in the 1950s and 1960s, the economy grew at an average rate of 4.3% a year, and the debt steadily dropped, falling to to just 38% of GDP in 1970. In contrast, the CBO forecasts the public debt of the US Government to be 94% of the GDP or $1.4 trillion at the end of 2010. See also this post (and its graphics) about the importance of growth for debt reduction.

Times recently initiated a discussion on US government deficit reduction with a nice interactive feature on the topic which carries the work done by economists Alan Auerbach and William Gale on federal deficit reduction. Auerbach and Gale study three fiscal scenarios for the US economy over the next decade - the CBO Baseline (which assumes no change in current law - or all tax cuts expire etc - and projects deficits declining sharply to 2.3% of GDP by 2014 and remaining below 3.0% through 2020), future Congresses will act like the previous ones and extend expiring provisions, and the Obama Administration's current policy stance. They write,

"Under either the extended policy or the Obama policy scenarios, deficits are high and rising over the second half of the decade, despite the assumption that the economy is in full employment. In 2020, the deficit is projected to be between 5 and 7 percent of GDP and the debt/GDP ratio is projected to exceed 90 percent. These figures only deteriorate with the passage of time. The long-term fiscal gap - the size of the immediate and permanent change in spending or taxes needed to keep the long-term debt/GDP ratio at its current level - is in the range of 6-9 percent of GDP. Further health care reform can be an important part of reducing the fiscal gap, but the problem is far too large to be solved by plausible reductions in health care spending alone. Postponing the onset of a fiscal package will make the problem even harder: even just a 5-year delay in implementation would raise the required fiscal adjustment by about 0.4 percent of GDP, or almost $60 billion per year."

The immediate trigger for the US public debt crisis is the deficits created by the Iraq and Afghanistan wars, the 2003 Medicare drug plan, the Bush tax cuts, the recession and the government’s responses, like the stimulus. Assuming all the current policies continue, the deficit in 2015 will be about $400 billion larger than the level that economists consider sustainable.

However, in the long-term, the health of America's finances will be determined largely by Medicare, Medicaid, and Social Security, both of which face the pressure from the retirement of the baby boom and the aging of the population. The baby boomers will pay far less in taxes than they will draw in benefits. Steep cuts in the other areas, including on discretionary spending, will not generate the required amounts to make a meaningful dent on the national debt. The importance of health care reforms should be seen in this context, as the single biggest contributor to improving America's long-term finances.

The Obama administration had appointed a bipartisan Fiscal Commission, chaired by Erskine B. Bowles and Alan K. Simpson, which recently submitted its proposals. It includes cuts to the pay of federal workers over the next several years, closure of military bases, reduction in foreign aid, elimination of tax breaks so that income and corporate tax rates could be reduced across the board, a gradual 15-cents-a-gallon increase in the federal gasoline tax, expansion of the payroll tax, cuts to Social Security benefits for high earners, and increased retirement age for Social Security. Some conservatives have criticized that plan for raising taxes at all, and some liberals dislike its emphasis on spending cuts and eliminating middle-class tax breaks.

The most stunning statistic about the US government finances is its dramatic turnaround in less than a decade. When Bill Clinton left office in 2001, the budget for 2009-12 were forecast to have an average surplus of almost $854 bn. But the early 2000s downturn, Bush tax cuts, Afghanistan and Iraq wars, Bush-era expansion of Medicare prescription durg coverage, and the sub-prime mortgage and Great Recession bailouts and stimuluses have pushed the budget to a $1.3 trillion deficit for 2010. See also the CBO's latest long-term Budget Outlook here, here, and here. See this and this for how the trillion dollar deficits were created.

Wednesday, November 17, 2010

The market incentive problem with smart meters

There is a fundamental incentive mis-alignment problem with any smart meter installation program. In order to realize their full benefits, smart meters need to be able to service both consumers and the utility through the price and consumption signals respectively. The utility should be able to effectively allocate supply and consumer be able to optimize usage.

However, while the former is easily achieved by mere installation of smart meters, the later requires going beyond. In fact, from the consumer's side, the inevitable last mile gap emerges. Though, they have access to consumption and price signals, they neither have the infrastructure to make it cognitively salient nor act on them.

Consumers can respond to the price signal and manage consumption only if they have the systems to track their consumption. They should have access to devices with real-time displays of not only total consumption (and pricing), but also those of their appliances. Further, they should have systems that enable them to automatically respond to higher consumption or prices by disconnecting part of their load.

Therefore, the smart meter becomes meaningful for the consumer only if the displays, network software, and internal wiring are made available. But the meter manufacturer does not supply these devices nor do the utilities have any direct interest in providing them. And, in view of the expenditures involved, the consumers will rarely install on their own.

In fact, smart meters without its accompaniments leaves the consumer as the loser. The meter manufacturer sells his product and the utility improves its grid-management efficiency. The consumer is left with higher bills!

In the absence of effective policies to address this market failure, we can be sure that the initial rounds of smart meter installation programs will not yield the desired results. While helping utilities with supply allocation, it will do little towards demand management. In the absence of consumer support, given the expenditures involved (front-loaded costs and back-ended systemic benefits), smart grid projects will come up against the usual opposition to any new intervention.

What are the possible solutions? Just as energy efficiency ratings have now become commonplace with electrical appliances, it is imperative that newer generations of equipments come with real-time power consumption displays. Smart meters could be bundled with consumption and pricing display LEDs. Over time, the home electricity wiring should be configured and attached to the smart meter with default provisions that trips-off one or more phases when either the consumption or the price breaches a pre-defined threshold.

Tuesday, November 16, 2010

Nudge to reduce rash-driving by RTC bus drivers

I have blogged earlier about the fundamental urge of a policymaker to regulate when faced with a problem. Rash driving by the government-run public transport system drivers creates a major road safety problem across India. Confronted with this problem, the regulators step in - fines and other punitive actions, coupled with awareness creation and sensitization. And as we all know, these solutions while easy to announce are difficult to enforce into outcomes.

Therefore, more sustainable and readily implementable policies may be more effective in addressing such problems. How do we get those drivers into driving safely by encouraging them, nudging them, to do so? Is it possible to either align incentives or structure an appropriate environment that nudges them into compliance?

In this context, there are atleast two examples, which all Road Transport Corporation's (RTC's) in India would do well to emulate. I had earlier blogged about minibuses in Kenya with posters that told passengers to speak up if the driver drove dangerously, which resulted in significant reduction in accidents. Meru cabs, one of India's largest Radio taxi services, have automatic speed control alert systems that warns "Please slow down you are crossing the speed limit" on a voice-over and nudges the driver to slow down.

A combination of both, deployed across all RTC buses in the country, may have the potential to dramatically reduce driver rage related accidents involving these buses. A bulb, prominently displayed, and a voice-over mocking/chiding the driver (say, using a dialogue from a popular movie and imitating the voice of a vernacular movie star!), both connected to the speed control governor, can be a cheap and much more effective substitute for blunt regulations.

On similar lines, other road safety related problems like drunken-driving, helmet usage, and driving while using cell-phone may be more effectively tackled using insights from behvioural psychology operationalized using technology and process innovations. Deterrent regulations involving fines and other punishments are difficult to enforce, especially when the volumes being regulated are far beyond the capacity of the regulatory system. In fact, such solutions may be more relevant and useful for countries like India than developed countries (with their smaller population densities and relatively more disciplined regulatory systems, both on the side of regulators and the regulated).

Monday, November 15, 2010

Smart meters and cognitive biases

The Obama administration's $787 bn stimulus plan contained $3.4 bn to modernize America's electricity grid, including the installation of smart meters. It is estimated that by 2020, there could be as many as 65 million smart meters in the US.

Smart meters have the potential to revolutionize electricity usage and grid management by enabling more efficient, demand-based allocation of power to end-users. They are bi-directional meters that transmit real-time consumption data which can be used by utilities to manage demand using time-of-day pricing and consumers to optimize consumption based on the price signals.

However, the roll-out of smart meters in the US has been accompanied with widespread criticism of inaccuracies in billing. Customers have complained of excess billing and class-action suits have been initiated in a few states. This mirrors similar complaints when Indian utilities replace older meters with the latest digital meters, especially those which have infra-red port-based readings.

I am inclined to the view that such complaints are a result of a cognitive bias called availability heuristic. Consumers' minds have been anchored to a range of values for many years and even decades. Suddenly, when their billed units go up, they struggle to mentally accept it. The availability bias continually draws the old billing pattern to their minds.

In any case, the transition period from one metering system to another will naturally generate discrepancies arising from a variety of commonplace administrative and technical problems. However, in case of smart meters, they are likely to be more significant for the following reasons

1. Smart meters have higher billing accuracy than conventional meters. So it is but natural that input fractions and connection losses at the consumer end that generally get added to utility losses now get, right fully, billed on the consumer.

2. A significant number of old meters will certainly be defective. Their defects range from being sluggish and under-recording units to being stuck-up (and therefore being billed based on average consumption of earlier months). In countries like India, the proportion of such meters can be as high as 60-70%, and even more in utilities where old meters have never been replaced. In one stroke, a smart meter brings out all these suppressed readings.

3. If meters are replaced during summer, then the inevitable seasonal variations (consumption rises in summer) get attributed to the changed meters and its deficiencies.

4. Finally, why should consumers be surprised that their billed units have suddenly increased? The very objective of smart meters is to capture the hidden commercial losses. It is natural that all those charged higher units with the old meters would have had their meters tested and replaced. This only leaves the remaining meters, consisting of the normal ones and the under-recording ones. Their replacement will naturally result in a rise in billed units.

All this only highlights the importance of awareness campaigns to sensitize consumers about the reasons for possible higher billing on installation of smart meters.

Update 1 (16/11/2010)

One of the comments pointed to the concerns over radio frequency radiation arising from smart meters. Green blog points to a new study that compares the radiation levels from various devices and finds out that smart meter radiations are tens of thousands of times smaller than even cell-phone radiations.

Sunday, November 14, 2010

Separating "physique" and "skill" effects

Sometime back, I had posted on the impact of Sachin Tendulkar's reputation on his opponents. In that context, I had argued that the physical size and on- and off-field behaviours (in addition to their obvious skills) of players like Hayden and Richards may have contributed substantially to the overall reputational intimidation (or mental disintegration) exercised on their opponents.

Amol Agarwal had mailed me an interesting question about how to separate the relative contributions of individual skill and physical factors towards intimidating opponents. In other words if...

Net intimidation, I = intimidation due to "skill-effect", I(s) + intimidation due to "physique effect", I(p)

I, say, for a superstar batsmen, is a function of the difference in the performances (in terms of runs per over or strike rate or even bowling averages) of the opposing bowlers against the superstar and the other regular batsmen. But the big challenge is how to separate I(s) and I(p)? For simplicity, let us also assume that I(s) also includes the contribution of skill-itself (in addition to intimidation due to the over-sized skill).

I have thought long and hard and have not been able to come with a satisfactory enough solution. But any answer(s) would surely be interesting. Are there any instrumental variable that can be used to separate the two effects?

What the UID will not do

I have blogged earlier about the numerous exciting possibilities offered by the UID project in radically enhancing the ability of governments to effectively deliver the myriad government welfare programs and subsidies.

The importance/uniqueness of the UID is in vastly expanding the ability of governments to more accurately target and deliver a much wider range of subsidies. More specifically, UID-linked bank accounts create the channel to deliver subsidies as a cash transfer directly to the individual. However, it needs to be clearly borne in mind that the UID is not a panacea for every welfare benefit delivery problem. It is only an improvement, albeit a major one, on the existing welfare delivery channels.

This message assumes importance in view of the increasing number of articles that have been appearing expressing apprehension at the persistence of delivery channel failures even after the UID is implemented. It needs clarification that these peristent failures are less an indictment of any inadequacy of the UID number and more a testament to the complexity of delivering welfare assistance in such massive scale and under complex socio-economic environments as we have in India.

In any case, here are a few major generic problems that will persist even after the implementation of the UID project.

1. It will not, atleast in the initial stages, contribute much to the accurate identification of beneficiaries (or means-testing). The list of beneficiaries eligible to receive the benefits will have to be determined following a purely administrative process. So, even after implementation of the UID project, the problem of ineligible beneficiaries availaing of welfare benefits will remain.

However, as the database grows and becomes more universal, it becomes possible to leverage the network effect (arising from membership of larger numbers of specific categories of programs) and screen out atleast the ineligible applicants.

2. As a corollary, the UID can be of only limited use in covering all the excluded eligible beneficiaries, which is a major problem with programs like the PDS.

3. UID will not address the last-mile leakages. Thus the leakages by way of under-weighment at the fair price shop of the distributed rations or reductions in the amounts paid out as welfare pensions or NREGS wages (at the cash disbursal point by the Business/Banking Correspondent, BC) cannot be avoided.

4. It cannot certify the quality of works carried out under wage-employment programs like the NREGS. Further, it cannot also address leakages by way of, say, man over-reporting (extra man-days claimed), unless the attendance at the work site is taken by UID authentication.

5. Even if the dual-price mechanism is dismantled for foodgrains, petrol, diesel, and fertilizers, and an arrangement to transfer the subsidy to the UID-linked bank account of the individual is introduced, the possibility of market manipulation by wholesalers and retailers to restrict supplies and/or increase the prices for fertilizers and food grains will remain.

Saturday, November 13, 2010

Known unknowns - impact of QE?

The debate about the likely economic impact of quantitative easing (QE) is another example of how the final outcome of any economic decision can go any which way, depending on the specific confluence of factors.

In this case, the magnitude of stimulus boost to the US economy provided by the QE will depend on the changes brought about in long-term interest rates, value of the dollar, and equity market valuations. This impact will be felt through three channels

1. Encouraging business investments (by way of lower bond yields and higher share prices)
2. Favoring household consumption (through wealth effect caused by lower debt service costs and higher asset prices)
3. Increasing exports (by way of weaker dollar)

Chris Dillow feels that "investment isn’t very responsive to asset prices, nor exports to exchange rate". The final outcome will be a function of the interaction of all these with the "confidence fairy" effects. The strength of the "confidence fairy" is determined by the "animal spirits" manifested in business confidence and consumer beliefs, tempered by the activism of "bond-vigilantes" and the business investment inertia of the real option theory (wherein, when faced with uncertainty, people have more incentive to hold onto the option to invest rather than to exercise it).

As can be surmised, there are too many imponderables in the aforementioned equation for anyone to confidently predict the final outcome of a related policy prescription. What would be the respective impacts of interest rate decline on business investments, domestic oncumption due to asset market increases, and exports because of declining dollar? How active (or inactive, as is the case now) will be the "bond-vigilantes"? What will be the combined interaction effect of the macroeconomic factors with the "confidence fairy"? Given the uncertainty and the multiple actors involved (other countries, especially China, EU, and other major emerging economies), it may not be possible to answer these questions a degree of assuredness ex-ante.

In the circumstances, the best possible option is to evaluate the costs and benefits, risks of doing and not-doing, and taking decision accordingly. Given the perilous state of the US economy, the risks of not conducting monetary accommodation appear to far out-weigh the risks of doing so.

QE will have an impact of raw material prices too. Commodity prices will be affected through three channels

1. The possibility of inflationary pressures being created by expansion of the monetary base and consequent money supply growth.

2. A share of the money finding its way into the commodity markets and increasing commodity derivatives market speculation. This will surely have some impact on the actual commodity prices.

3. The weakening dollar will exercise an upward pressure on raw materials since their international market prices are generally denominated in dollar values.

In an excellent recent post, James Hamilton cautioned against QE by pointing to a close co-relation between monetary expansion and commodity prices. He feels that "there is a pretty strong case for interpreting the recent surge in commodity prices as a monetary phenomenon". He writes that even as Fed attempts to forestall a Japan-style deflation, it also "needs to watch commodity prices as an early indicator that it's gone far enough in that objective". He claims that his point of costs exceeding benefits would be when oil prices move above $90 a barrel.

On a related context, Nick Rowe has a nice post on Tobin Q, and how its rise would boost economic activity. Tobin Q, named after James Tobin, is the ratio of the market value of a firm's assets, as measured by its stock and bond prices, divided by the (actual) replacement cost of those same assets. Businesses invest if "buying one extra bulldozer adds more to the financial value of the firm than it costs the firm to buy it". Prof Tobin had argued that loose monetary policy would boost share and bond prices and thereby raise Q, and so make new investments attractive.

Thursday, November 11, 2010

Morality play and probability in development discourse

This post will highlight two strands of the prevailing development discourse in India which, I am inclined to believe, comes in the way of effective public policy formulation and implementation.

1. Development is not morality play. Any discussion on a development issue is generally overlaid with powerful moral overtones. Accordingly, policies fail to yield the desired results for a variety of moral failures - officials and politicians easily fall prey to corrupt practices, capitalist businessmen exploit ignorant consumers, bureaucracy does not empathize with the plight of the poor, supervisory officials lack character, and so on.

This normative discourse suffers from a serious disconnect with the dynamics of the real world in which the policy has to be implemented. In simple terms, it refuses to acknowledge the reality of the world-as-it-exists. The challenge then is to design a policy implementation environment for a world which is characterized by some or all of the aforementioned moral failings. How do we structure the incentive framework so as to align the preferences and urges of the various (corrupted, partly or fully) stakeholders towards achievement of the desired objective?

A pre-requisite to effectively answering this question is the acceptance of the reality of a world with pervasive moral failures. The policy environment has to be then micro-founded by borrowing insights from the fields of public choice theory, behavioral psychology, micro-economics, and political economy. The framework so arrived can be effectively translated into action using the latest developments in Information Technology.

For example, setting up an effective framework for supervisory officials has to acknowledge the reality of the lowest common denominator - corrupt, inefficient, apathetic and truant official. They have to be incentivized into working towards achievement of the desired objective by appropriate structuring of their work environment. This can range from carefully designed reporting formats to innovative use of IT tools, all of which liberate the official from diversionary and routine activities and converge his energies on his critical responsibility.

2. Binary evaluation of policies and implementation strategies. The prevailing discourse on development policy-making is shaped, almost exclusively, in terms of achievement of the final policy objective. Framing the terms of the debate on the outcome of a policy in such restrictive manner has important pitfalls.

Policy interventions or development strategies get judged on a binary scale - success or failure in achievement of the final goal. This means that the full-spectrum of possibilities between success and failure gets edged out from this binary evaluation framework.

The science of behavioural psychology informs us that framing of questions and its terms of reference play a crucial role in determining the course of debate about any issue. A binary evaluation framework therefore restricts policies to the standard straitjacket of solutions and strategies.

This is unfortunate since social policy interventions are inherently unsuited to such binary evaluation and are more accurately judged on a probabilistic scale. Accordingly, a more appropriate method to assess the effectiveness of a particular strategy could be in terms of how far it has increased the chances of achieving the pre-defined objective. What is the probability of achieving the objectives with this strategy? Has the strategy increased the likelihood of success? If so, by how much?

In other words, the touchstone for the acceptance of a particular implementation strategy would require a subtle re-formulation of the question. Today we ask whether the proposed strategy would ensure achievement of the objective? As we know, generally the answers to such sweeping questions in social sector, whatever be the policy objective, are in the negative. Instead, the query should be whether the proposed implementation strategy (or policy itself) significantly improves the likelihood of achievement of the objective?

Yes, a new approach will increase the likelihood (than is the case now) of the ANM or teacher attending to hospital and school respectively. But it will still leave open the possibility that some of them will game the new system and continue to play truant. But the net increase in the probability of achieving the objective, weighed against the relative increase in cost, merits adoption of the new strategy.

Both these biases in the development discourse have profound impact on policy-making and implementation. They exert a strong influence on the minds of the decision makers at all levels. The result is that the choices tend to get restricted to the already existing set of strategies. As a corollary, innovative or different approaches get crowded-out. Taken to extremes, they breed a culture of cynicism and status quo preference.

It is therefore important that any evaluation of available choices on development policies and their implementation strategies be made on a stochastic scale and without morality overtones.

Wednesday, November 10, 2010

Analysing trends in India's macroeconomic policy

The Great Recession has accelerated several changes already underway in the world economy for the past few years. Arguably the most significant development has been the emergence of developing countries as engines of global economic growth. It has also exposed several deficiencies in the dominant Washington Consensus model of economic growth. So much so that, faced with its deepest economic downturn since the Great Depression, the US itself is reassessing many of the sacred tenets of the Washington Consensus.

The spectacular rise of China and the increasing certainty of India emulating China have meant that Beijing Consensus and now, the "Mumbai Consensus", are slowly gaining wider acceptance. In a recent speech in Mumbai, Lawrence Summers coined the phrase "Mumbai Consensus" to describe the nature of India's economic growth model which has seen the country's chart the troubled sub-prime waters relatively trouble-free.

The Indian model is characterized by "a reliance on domestic consumption rather than exports, services rather than manufacturing, and private enterprise rather than state-led companies and investments". It bears striking similarities with America's own growth history and trajectory, and unlike the Chinese model, revolves around private-sector driven growth and democratic pattern of development. Further, India's response to several important global macroeconomic issues has generated the impression that the Mumbai Consensus is closer to an open-market economy driven approach. This feeling gets amplified when seen against diametrically opposite reactions among other developing economies and even developed economies.

India's willingness to allow both capital unfettered access into equity and debt markets and the exchange rate to strengthen stands against reluctance among others, both developed and developing, to do the same. These have been part of a remarkable trend where Indian economy charts a path at variance from the rest of the world, one which appears to put India to the right of the economic spectrum. Here are a few examples.

1. The aftermath of the sub-prime meltdown has engendered deep financial market uncertainty. However, despite the Great Recession in the developed economies, the global financial markets have recovered smartly since March 2010. This has been characterized by sharp spurt in capital flows into the emerging economies, whose equity markets are clearly showing signs of froth.

It is in this context that, early this year, the IMF broke with its long-held ideological position, and said that capital controls are a "legitimate" tool in some cases for governments facing surges in external investments that threaten to destabilize their economies. There have been an increasing chorus of voices calling for capital controls for developing economies. The World Bank is the latest to advice Asian economies of temporary and targeted controls to contain asset bubbles in the region’s stock, currency and property markets.

Before and after the IMF's change in stance, countries like Brazil and Thailand have announced policy measures to limit capital flows. Brazil imposed a 2% tax on foreign portfolio inflows last October. Thailand has imposed a 15% withholding tax last month on interest and capital gains earned by foreign investors on Thai bonds issued by the government, central bank and state enterprises, and is contemplating more controls. Earlier in June, Indonesia introduced "quasi-capital control measure" by making short-term investment less attractive to foreign funds. A few days back, the South Korean government moved to stabilize the won by limiting assets accessible to foreign capital, while Taiwanese officials made some bank deposits off limits to foreign investors.

However, despite itself experiencing a steep rise in foreign capital inflows into its equity markets which recently breached its highest ever mark and shows signs of a bubble getting inflated, India has so far refrained from any talk of capital controls. The FIIs have pumped in a massive $26.7 bn into Indian equities till October end. In fact, just a few days back, even as some other economies were contemplating introduction of capital controls, the Indian government again reiterated its resolve to not impose capital controls. Instead it has preferred sector-specific selective credit controls to prevent the build-up of asset bubbles.

India's tolerance for higher capital inflows stem partly from the realization that it requires foreign capital to bridge the widening current account deficit (CAD) and to fund its huge infrastructure investment needs.

The strong economic growth and its import-intensity, coupled with a not-so-strong export growth and relatively stagnant domestic savings rate, makes foreign capital critical to sustaining high growth rates.

In view of all the aforementioned, the RBI and the Government appear to have informally agreed to raise the tolerable level of net capital inflows to $150 billion, up from the earlier figure of around $110 billion.

2. China's policy of keeping its currency pegged to a steadily declining dollar confers significant advantages on Chinese exporters. This has raised concerns among its trade competitors, especially those from other emerging economies. Atleast some of them have already started open-market operations to buy up dollars, and more look likely to follow.

Recently, after many years, the Bank of Japan carried out foreign exchange market interventions to keep the yen from appreciating any further. The central banks of Brazil, Thailand and South Korea have also been active in the foreign exchange markets to limit the appreciation of their respective currencies.

The Rupee has appreciated strongly against the dollar. Led by the export-dependent software industry, Indian exporters have been mounting pressure on the government to take action to stem the appreciation. However, the RBI has been remarkably reluctant to buy this line and has steadfastly refused to intervene. The exporters have been advised to become more competitive to respond to such market pressures, instead of relying on government crutches.

In fact, the RBI appears to have taken a measured and long-term view of the rupee appreciation. In a recent speech, the RBI Governor even said that "currency interventions should be resorted to not as an instrument of trade policy but only to manage disruptions to macroeconomic stability" and cautioned about the costs of such interventions.

3. The recent second round of quantitative easing announced by the US Federal Reserve has been met with strong criticism across the world. The German finance minister denounced it as "undermining the credibility of US financial policy". Many emerging economies too have criticized the move, describing it as postponing structural adjustments in the US economy and exacerbating the global macroeconomic imbalances.

India has been the only major economy to support US QE. It has acknowledged the importance of monetary accommodation for economic recovery in the US and the importance of a healthy US economy to global economic prospects.

4. In a classic inversion of roles, India today appears on the free-market side of the globalization debate more than even many developed economies. Apart from certain controls on food-grain exports, it has been continuously liberalizing its economy, albeit at a slow pace. This trend has been in contrast to protectionist sentiment on the rise elsewhere, including the US.

In response to the outsourcing bogey, the US has tinkered with various measures like limits on visas for IT personnel from abroad and restrictions on firms receiving stimulus assistance outsourcing work abroad (discriminatory tax treatment based on whether the firms create jobs at home or abroad). It recently imposed fee hikes of $2,000 or more on H1-B and L-1 visas for highly-skilled foreign workers at firms employing more than 50 workers, with half or more of their workers on H1-B visas.

Realizing the benefits of an open economy and expanding international trade, India has been steadily opening up its economy. This stands in contrast to the continuing reluctance of the East Asian countries to open their economies to trade. India has gone far ahead of even OECD economies like South Korea in liberalizing both its real economy and financial markets to international competition.

5. The contrasting fortunes of the developed economies and India to the sub-prime mortgage crisis has drawn attention to the role of regulators on all sides. How did India and its financial institutions, despite its relatively open financial markets and conventional regulatory architecture, escape the fate of counterparts elsewhere?

The RBI has used multiple instruments and a menu of options to manage the external sector and the monetary policy both before and in response to the sub-prime crisis. It has followed a carefully sequenced movement (which is also dependent on the developments in both the real economy and financial markets) towards capital account convertibility and controls on debt flows - both private and inflows into risk-free sovereign debt instruments to take advantage of interest differentials (carry trade). And all this has been backed up with strict enforcement of regulations.

6. India has contributed its fair share to addressing the global macroeconomic imbalances - skewed trade, savings, consumption, and investment preferences. In stark contrast to countries like China which implicitly suppresses local consumption, India has one of the largest shares of domestic consumption. Its domestic savings rate at around 35%, which while not adequate, has grown significantly over the past decade.

At a time when the developed economies are attempting to export their way out of recession and emerging economies want to continue with their export-dependent growth model, India is one of the handful of major economies willing to provide aggregate demand. Unlike, the closed and export-oriented East Asian economies, India has steadily liberalized its economy and is an increasingly significant market for global exporters.

A recent speech by the RBI Governor conveyed a great sense of maturity about the way India conducts its macroeconomic policy. He described the dilemma facing the Central Bank
"The biggest problem thrown up by capital flows is currency appreciation which erodes export competitiveness. Intervention in the forex market to prevent appreciation entails costs... If the resultant liquidity is left unsterilized, it fuels inflationary pressures. If resultant liquidity is sterilized, it puts upward pressure on interest rates which, apart from hurting competitiveness, also encourages further flows."

He had more wise words for Central Banks and governments across the world,

"In as much as lumpy and volatile flows are a spillover from policy choices of advanced economies, the burden of adjustment has to be shared. It’s unrealistic to expect emerging market economies to carry the full burden of lifting global growth... Managing currency tension will need shared understanding on keeping exchange rates aligned to economic fundamentals and an agreement that currency interventions should be resorted to not as an instrument of trade policy but only to manage disruptions to macroeconomic stability."

And about what the world needs now, he said

"The surplus economies will need to mirror these efforts — save less and spend more, and shift from external to domestic demand. They need to let their currencies appreciate."

Are US, China, and Germany listening?

Update 1 (13/11/2010)
Among the major economies, India has the lowest exports to imports ratio.

Monday, November 8, 2010

Package of interventions and poverty elimination

Sometime back, I had blogged about the work of Charles Karelis of Colgate University who had, with his "bee-sting" theory, argued that poverty introduces a diminishing marginal utility to putting in effort.

The underlying premise is that while a person with one bee sting is highly motivated to get it treated, one with multiple bee stings does not have much incentive to get one sting treated, because the others will still throb. In other words, more of a painful or undesirable thing one has (i.e. the poorer one is), the less likely one is to do anything about any one problem. Or poverty is less a matter of having few goods than having lots of problems.

For example, randomized control trials around the world on improving learning outcomes have found that stand-alone interventions fail to deliver desired results. Researchers from MIT's Poverty Action Lab have found that reduction in class size not complemented with other measures like school committee empowerment and performance tracking of students, fails to yield any significant results.

If this insight is assumed true, then there are formidable limitations on the relative effectiveness of specific policy interventions in achieving their objectives. It may also help partially explain the less than satisfactory response from poor people to individual social policy interventions that encourage people to improve cleanliness and hygiene (use community toilets) or parents to send children to school or vaccinate infants or poor manage their finances optimally.

What is the incentive to overcome the inertia and expend effort to keep toilets clean when the entire neighbourhood is dirty? Where is the motivation to immunize the child when he/she is living amidst unhygenic surroundings and falls sick every week? Where is the motivation to use mosquito bed-nets when if mosquitoes do not catch you, bacterial infections will lay you down? What is the incentive to eat more expensive healthy food, when disease vulnerability is very high and incidence so commonplace?

In other words, a package of policies that incentivize use of mosquito bed-nets, construction of individual toilets, immunization, awareness creation on child nutrition and personal hygiene, and so on may be more effective than piece-meal health and sanitation interventions. Or a bundled financial product that combines savings account with health insurance, education scholarships, and pensions may generate greater savings outcomes than separate products.

Further, if the bee-sting theory reasoning is assumed to hold, there is a strong likelihood that the amount of incentives required to produce a desired behavioral change would be much larger with a single intervention than with a package of interventions. For example, the financial incentive to get children to school or parents to immunize children would be much larger if these interventions were made separately than if made as part of a bouquet. Therefore, an economically efficient approach may be to bundle a number of interventions together and incentivize them with a large enough cash transfer (which would be less than the sum of all the individual incentives).

All this means the likelihood of considerable variations in the relative effectiveness of individual policy interventions when implemented separately and when done as part of a package. Therefore, poverty eradication policies may be more effective if they address the challenge on multiple dimensions instead of piecemeal and one-off affairs. All this point towards the need for a "big push" in poverty eradication, including close co-ordination across departments.

An ideal opportunity to assess this hypothesis was the Millennium Villages Project (MVP) experiment. Unfortunately, as the recent controversy surrounding Michael Clemens and Gabriel Demombynes questioning the effectiveness of MVP in the absence of rigorous impact evaluation indicates, that opportunity may have been lost. They write,

"Comparing trends at the MVP intervention sites in Kenya, Ghana, and Nigeria to trends in the surrounding areas yields much more modest estimates of the project’s effects than the before-versus-after comparisons published thus far by the MVP. Neither approach constitutes a rigorous impact evaluation of the MVP, which is impossible to perform due to weaknesses in the evaluation design of the project’s initial phase. These weaknesses include the subjective choice of intervention sites, the subjective choice of comparison sites, the lack of baseline data on comparison sites, the small sample size, and the short time horizon."

They oppose the wisdom of spending huge amounts and expanding MVP without having access to objective evaluation of the its impact. See Jeff Sachs response here and a summary of the debate here.