Monday, January 31, 2011

The unintended consequences of road widening

Road widenings are commonplace across cities in many developing countries. Cities in these countries are a work in progress, the chaotic and unplanned result that emerges from a series of piece-meal developments. The need for road widenings are the inevitable result of such development.

Among all the major Indian cities, Hyderabad has been at the forefront of road-widenings. All the major city roads have been subjected to atleast one, sometimes multiple rounds, of widening. The state and local governments have innovated on several approaches to obtaining the consent of land losers and acquiring land.

However, there are a few unintended consequences of such widenings. I am inclined to the argument that unwittingly road widenings have turned Hyderabad into a city without footpaths and where hawkers run riot on road margins.

1. Public perceptions of road widenings are restricted to widening of the carriage-ways. However, such widenings are accompanied by a series of other actions - construction of drains and footpaths, and shifting of utility services (water, sewerage, telephone, and electricity lines). In fact, carriage-way expansion forms only a small share of the total cost of widening. All these accompanying activities involve co-ordination across numerous departments and therefore take time.

However, local governments start on road widenings with limited resources, most often only enough to cover the carriage-way and at the most, drains. Further, given the long drawn out nature of the work, the carriage-way is laid over the utility lines (and this explains the frequent cuttings on newly laid roads!). Footpaths are invariably given the short shrift.

It is therefore no surprise that in comparison to cities with less road widenings like Chennai and Bangalore, Hyderabad roads suffer from lack of footpaths. In fact, Hyderabad could count as one of the most pedestrian unfriendly cities.

2. Another feature of road widenings is the irregular nature of the widened roads. This is a result of the refusal of certain individuals along the alignment to part with their lands and the court litigations that invariably follow. The non-shifting of electricity poles and lines, coupled with the aforementioned problems with land acquisition ensures irregularly developed carriageways. In the absence of footpaths, these irregular spaces (which cannot be used as carriage-way) get occupied by street hawkers.

This problem of under-utilized carriage-ways is also a result of way in which road widenings are carried out. Urban planners frame the issue as one of expanding width instead of adding lanes. Width becomes the negotiating point, thereby creating roads with anomalies like 2.5 and 3.5 carriageways. I have blogged earlier about the implications of such framing.

Saturday, January 29, 2011

Changing people's behaviour

"In the long term, willpower alone won’t work for difficult behaviors. You need to take a different approach, such as changing your environment, removing triggers and taking baby steps."

How do we get people to not litter? How do we get people to switch off bulbs and air conditioners when they leave? How do we get people to brush without leaving taps open or use water more optimally when bathing or turn-off taps after use? How can we get people to avoid fats and eat more healthy food or even switch to a vegetarian diet?

How can we encourage people into installing energy conservation devices whose benefits are not immediate? How can we nudge people into planting more trees? How can we get people to give up smoking or drinking or taking drugs? How do we get people to stop picking their noses or biting their nails? How do we get people to control their anger? How can we turn people away from gossiping?

These are some classic examples of behavioural changes that have remained elusive to any standard prescriptions. Conventional approaches to resolve these problems have ranged from awareness creation to promulgation of regulations and invocation of conventions to use of incentives and dis-incentives. However, even the strictest regulations, most carefully designed incentives, and most intrusive of awareness campaigns have failed to deliver desired results.

Why have these approaches failed? Where did they fall short? It is now becoming increasingly clear that getting people to know about something does not automatically translate into actually doing it. In other words, while conventions, regulations, awareness, and incentives may get people to know and even commit them to do something or change their behaviour, it is not enough to actually complete the task. There are several cognitive biases that come in the way of fully-aware people fulfilling their commitments.

It is in this context that several interesting findings from recent research in the field of Behavioural Psychology has generated much interest. The field achieved prominence through the best selling work of Richard Thaler and Cass Sunstein, Nudge. They used insights from behavioural psychology to develop a "libertarian paternalistic" framework that could be used to design public policies that overcome cognitive biases that afflict human beings.

On similar lines, Dean Karlan and Ian Ayres have designed "commitment contracts" that attempt to "commit" people into doing certain things or behaving in a specific manner. Dan Ariely and others have proposed using "trigger factors" that would trigger at an appropriate time to get people into acting as required.

Behavioural psychologists study why people behave the way they do and what can be done to change behaviours. The Stanford University's Persuasive Technology Lab has been at the forefront of using computing products (from websites to mobile phone software) "to change what people believe and what they do". The website defines the new science as

"Captology is the study of computers as persuasive technologies. This includes the design, research, and analysis of interactive computing products created for the purpose of changing people's attitudes or behaviors... captology describes the area where computing technology and persuasion overlap."

Prof BJ Fogg, the Director of the Lab, has organized the various psychological theories that explain behavioural changes into a Fogg Behavioural Model (FBM). The FBM model requires the simultaneous convergence of three elements - motivation, ability, and trigger - for any behaviour change to occur. It shows that "behavior is the result of three specific elements coming together at one moment". Trigger a behaviour change after increasing the motivation and ability.

Motivation comes from three core motivators which appear in the form of pleasure or pain, hope or fear, social acceptance or rejection. Ability depends on six simplicity factors - time, money, physical effort, brain cycles, social deviance, and non-routine. The three types of triggers are facilitator, spark and signal.

Dr Fogg also has the Behaviour Grid which "describes 15 ways behavior can change". He has also created a Behaviour Wizard that "can help you design for successful behavior change".

See also this presentation on the ten mistakes people make when they attempt to achieve behaviour change.

Top 10 Mistakes in Behavior Change

Friday, January 28, 2011

Governments and innovation

Industrial policy evokes immediate scorn and arguments that it promotes inefficiency and wastage. Even liberal economists and policy makers shy away from support for any form of industrial policy. They argue that the market place is too complex for governments to pick winners.

I have blogged extensively about the role of benign industrial policy in the promotion of economic growth objectives. China is the best and recent example of such policies.

Economix points to an excellent report by the Breakthrough Institute that uses several case studies to highlight the critical role played by American governments in promoting several seminal technologies. It writes,

"The history of American innovation shows that an active partnership between the public and private sectors has been key to developing breakthrough technologies, which have driven generations of economic prosperity."

Government support, by way of conscious and not so conscious, inducstrial policy has played a major role in the success of almost all the major technologies that are ubiquituous in our daily lives today,

"Driving directions from your iPhone. The cancer treatments that save countless lives. The seed hybrids that have slashed global hunger. A Skype conversation while flying on a Virgin Airlines jet across the continent in just five hours... Our gratitude at being able to video chat with our children from halfway around the world (if we feel gratitude at all) is directed at Apple, not the Defense Department. When our mother's Neupogen works to fight her cancer, we thank Amgen, not NIH or NSF."

It traces two channels through which governments have promoted new technologies,

"First, the government has long acted as an early funder of key basic science and applied research and development. So it was in agriculture, when the government created new land-grant colleges and expanded funding for agricultural science, leading to the development of new and better crops. In medicine, many of today's blockbuster drugs can trace their existence to funding from the National Science Foundation (NSF) and the National Institutes of Health (NIH).

... the government has also routinely helped develop new industries by acting as an early and demanding customer for innovative, high-risk technologies that the private sector was unable or unwilling to fund. Military procurement during and after World War I helped America catch up to its European rivals in aerospace technology and was key to the emergence of the modern aviation industry. Decades later, the modern semiconductor and computer industries were created with the help of government procurement for military and space applications...

The microchips powering the iPhone owe their emergence to the U.S. military and space programs, which constituted almost the entire early market for the breakthrough technology in the 1960s, buying enough of the initially costly chips to drive down their price by a factor of 50 in a few short years."

Update 1 (13/2/2011)

See this and this for the role of Public-Sector Research in the Discovery of Drugs and Vaccines.

Thursday, January 27, 2011

Applying statistical techniques to lower health care costs

I have blogged earlier about the use of statistical techniques to identify high intensity locations of road accidents and malaria incidence and then intervene with greater focus to address the problem.

In a recent New Yorker article (gated), Atul Gawande points to the application of the same techniques - focus on the most expensive patients ("super-utilizers") to lower health care costs. A physician in Camden, New Jersey, Jeffrey Brenner, found that one per cent of patients are responsible for thirty per cent of medical costs. These patients were subjected to an intensive treatment regime to both treat and undergo prevention regimes,

"Brenner’s team, which includes a nurse practitioner and a social worker, make regular home visits and phone calls to check in about new and existing complaints, unfilled prescriptions, and other complications that could land them back in the hospital. They help apply for disability insurance and fill out paperwork for state-run housing where their medication can be overseen. They encourage these super-utilizers to improve their lives with steps like quitting smoking, cooking more, joining Alcoholics Anonymous—even going to church."

The results have been dramatic. Brenner found that his first 36 patients saw a 40% reduction in average monthly hospital and emergency room visits, and 56% reduction in average hospital bills—savings. A similar intervention in Atlantic City found that after 12 months, the first 1200 patients had 40% fewer emergency-room visits and hospital admissions, 25% fewer surgical procedures, and 25% reduction in treatment costs. Gawande writes,

"An important idea is getting its test run in America: the creation of intensive outpatient care to target hot spots, and thereby reduce over-all health-care costs. But, if it works, hospitals will lose revenue and some will have to close. Medical companies and specialists profiting from the excess of scans and procedures will get squeezed. This will provoke retaliation, counter-campaigns, intense lobbying for Washington to obstruct reform."

In this context, a recently released report (pdf here) by the British Government's Behavioural Insight Team draws on insights from behavioural science to show that significant health improvements can be achieved with a series of nudge-based interventions. These nudges can be applied to get people to give up smoking and drinking, get them to exercise more and turn up for routine periodic check-ups and so on. Atleast some of the same techniques could be applied to these "super-utilizers".

Tuesday, January 25, 2011

More on India's volatile inflation story

For more than a year now, India has been grappling with high inflation, especially in foodstuffs, even as most other emerging economies had stable inflation rates. Now however, with steadily rising petroleum prices, food and oil inflation is fast becoming a global worry. There is therefore the added worry that rising global commodity prices will spill-over into India and amplify inflationary pressures.

An extraordinary confluence of bad weather across many exporting countries have affected supply of many agricultural commodities crops and the resultant supply-constraints might help keep prices high over the next several months. However, unlike the steep food price spikes of 2007-08, there are adequate global supplies of grains like rice and wheat, and their prices too are much below those peaks. The supplies of sugar, meat and oils remain close to their highs.

Further, there is strong enough evidence in favor of more structural-demographic factors for India's food inflation. The rising per-capita incomes are naturally accompanied by shifting consumption patterns. People increase their consumption of high-protein meats and pulses, oils, vegetables and fruits.

It may therefore be no coincidence that the prices increases have been steepest in these categories. At a compounded annual growth rate (CAGR), the price of a basket of vegetables has increased 21.26% in the last five years, compared to the WPI for all commodities rising by around 5%. In simple terms, the increased supply (and the acreage, production and productivity of vegetables have risen) has not been able to keep pace with the increase in demand.

In this context, it is also important to bear in mind the specific nature of inflation in India. Deepak Mohanty's excellent speech which examined nine instances of long-enough double digit inflation episodes since independence, describes India a "moderate inflation country". Further, though inflation trend has been downward sloping, it has been characterized by the sharp volatility. This volatility, especially in food and fuel inflation, can be attributed to supply-constraints. The Free Exchange has an excellent summary of India's volatile inflation path,

"So rather than call India a persistently high-inflation economy, it may be better to think of it as a country where inflation is relatively more volatile through the business cycle than in other countries... It doesn’t help that Indian agricultural output is very volatile, partly because of poor infrastructure, bad supply chains, poor storage facilities, and the like. This means that changes in weather conditions or other factors affecting output can lead to really large price fluctuations."

The wholesale price inflation always lags behind the consumer price inflation, with its greater focus on food and fuel prices. In fact, as the graphic below indicates, the relative weights attached to food and fuels in the consumer price index basket is amongst the highest for India. This too contributes to the abnormally high recorded rates of inflation for India.

Pressure is mounting on the Reserve Bank to rein in rising inflation by raising interest rates. However, as the aforementioned factors indicate, merely tinkering with monetary base when the supply-side constraints are driving inflation may not yield the desired results. Rapid expansion in supply - especially those of vegetables, fruits, sugar, pulses and oils - is the only sustainable way to address inflationary pressures in India. Monetary policy actions can, at best, contain core inflation and prevent food inflation spilling over into the rest of the economy.

Finally, as I had blogged earlier, it will be intriguing to find out the contribution of NREGA to higher food prices in India. There are two clear channels through which higher NREGA wages could spill-over into the price system. One, higher NREGA wages increases the cost of production by bidding up farm wages. And this impact could be susbtantial, given the fact that NREGA wages are more than double the prevailing agriculture labor wages in atleast some states. Second, higher NREGA wages places greater disposable incomes in the hands of rural consumers, which increases the demand for the higher value foods. The near universal nature of NREGA means that the demand-side pressures are substantial.

Update 1 (8/2/2011)

After a record heat wave and drought in Russia last summer, which pushed Moscow temperatures above 100 degrees for the first time ever (half the global decline in wheat production has been in Russia); dry weather in Brazil; and biblical-proportion flooding in Australia in November-December 2010, here comes more trouble from China. A severe drought, the driest winter in 60 years, is threatening the wheat crop in China, the world’s largest wheat producer.

The FAO has said that 5.16 million hectares, or 12.75 million acres, of China’s 14 million hectares of wheat fields had been affected by the drought, and that 2.57 million people and 2.79 million head of livestock faced shortages of drinking water. However, China had about 55 million tons of wheat in stockpiles as of last summer, equal to about half the annual harvest. It is self-sufficient in most foodgrains, and imports only soyabean and corn, mainly for animal feed (as the Chinese diet shifts towards meat)

See this on rising food prices across the world since last summer due to declining production. Paul Krugman sees no signs of any speculation, as manifested in inventory build-up.

Monday, January 24, 2011

More on the labor market in the Great Recession

There is an interesting debate in the blogosphere exploring the reasons for the persistent high unemployment rates in the US and elsewhere. Conservatives lay the blame on the structural skills mismatch and argue that this cannot be resolved through any stimulus spending measures. Liberals claim that the massive slump in aggregate demand from the boom, means that there are massive idling resources which can be brought to work with an appropriately structured stimulus program.

Okun's law (for every percentage increase in the unemployment rate, GDP will fall by an additional roughly two percentage points) also means that productivity falls during recessions. Labor economists attribute this to labor hoarding - firms except recovery any time and therefore keep workers on their rolls despite not needing since it might be both difficult and costly to find workers when needed. Therefore conventional wisdom would have it that firms hoard labor during recessions in expectation of a quick recovery.

In an excellent post, Nick Rowe compares the peculiar dynamics of unemployment and GDP growth rates of the major economies and finds that the US economy violated Okun's law during the Great Recession. Further, instead of declining during a downturn, labor productivity in the US actually rose during the Great Recession. In contrast, the labor productivity in Europe has been pro-cyclical, as conventional wisdom would have expected. The GDP fell a little over 4%, peak to trough, and employment fell nearly 6%, so the GDP/employment ratio increased by over 1%.

To explain this deviant behaviour, Rowe makes the distinction between general and firm-specific human capital (which is useful at one firm), and argues that firms prefer to lay-off the former and retain the latter (since both finding and training them when recovery returns will be costly). He attributes the observed deviation from Okun's law to the specific nature of the booms in countries like US, Spain, and Ireland, driven as they were by real-estate and construction bubbles. When the bubble burst, a disproportionate share of the job losses were concentrated in the construction sector.

He writes, "the construction trades require a lot of general human capital and very little firm-specific human capital. Two building sites can swap bricklayers easily, with minimal re-training." Further, given the magnitude of the bubble, firms also realize that normalcy is not going to return anytime soon, thereby reducing the need to keep workers on rolls.

The diminished incentive for labor hoarding has initiated an argument that the US labor market suffers from a problem with the productivity of the unemployed instead of any fundamental issues with the economy itself. Since less number of workers in the US are producing the same output, Tyler Cowen has raised the issue of zero marginal product (ZMP) workers. He suggests that unemployment rate has not returned to earlier levels despite the output being restored because those workers did not add any value. Paul Krugman answers him here by examining evidence from the recovery in early eighties. See also Scott Sumner here explaining much of the higher unemployment as result of trend-productivity growth over the past two-and-half years.

Alex Tabarrok cites many reasons for firms being labor disgorging in recent recessions, thereby causing labor productivity to be mildly pro-cyclical than counter-cyclical. They include the structural nature of the recession, due to which many firms may not need the same workers anytime; expectations are for a long, flat U shaped recession, thereby eliminating any incentive to hoard; competitive labor markets; and severe competitive pressures on firms. He also clarifies on the issue of sticky wages,

"The problem of sticky wages is often misunderstood. The big problem is not that the wages of unemployed workers are sticky, the big problem is that the wages of employed workers are sticky. This is why stories of the unemployed being reemployed at far lower wages are entirely compatible with the macroeconomics of sticky wages."

Also coming against the ZMP hypothesis are findings that unemployment rate pretty much doubled across all groups of labor. Charlie Eisenhood has found a rough doubling across groups with different ages and education levels. Mike Konczal and Arjun Jayadev have found that under-employment (people working involuntary part-time jobs) too doubled in every occupation and in every career. All these lend ample weight to the demand-side explanations of persistent unemployment rates.

Moreover, unlike others, though the US GDP recovered back quickly the unemployment rate has remained high. In fact, the US unemployment rate is amongst the highest in the world. Paul Krugman, Christina Romer and David Leonhardt explore the possible reasons for the persistence of the high unemployment rates in the US. See also this earlier post on the labor market during the Great Recession.

Paul Krugman points to three possible reasons for the persistence of unemployment in the US. One, unlike the earlier recessions, recent ones have been caused by private-sector over-reach (through rising debt and/or asset values) and not by monetary policy actions of Fed to tame the cycle. Recoveries from these tend to be "long flat U's rather than the V-shaped recoveries of yore". And to the extent that firms know this, they have less reason to hoard labor; they’re not going to need those laid-off workers for a long time.

Second, the weakness of private-sector labor unions (unlike Europe) has eliminated a powerful obstacle to mass lay-offs. Finally, competition at the top means that businesses cannot afford to retain slack, for however small a period, and survive, especially in such uncertain times. Put together, all the three have reduced the incentive to hoard labor during uncertain times.

In any case, the final word should go to Economix,

"Solving the structural issues — such as slow-growing educational attainment — will take years. In the meantime, we could make a whole lot of progress by focusing on the cyclical problems."

Update 1 (8/3/2011)

David Leonhardt points out that while those at the higher end of the income ladder and those with four year college degrees have performed well during the Great Recession, those at the middle levels have done better than those at the bottom.

This runs contrary to the hypothesis, pioneered by David Autor, that the middle of the US job market is hollowing out. He has characterised the US job market as one "with expanding job opportunities in both high-skill, high-wage occupations and low-skill, low-wage occupations, coupled with contracting opportunities in middle-wage, middle-skill white-collar and blue-collar jobs".

Update 2 (28/7/2011)

Economix points to a new report that concludes that the great bulk of new jobs created since the economic recovery began are in lower-wage occupations, paying $13.52 or less an hour. It finds that while 60% of the jobs lost during the downturn were in midwage occupations, 73% of the jobs added since the recession ended had been in lower-wage occupations, like cashier, stocking clerk or food preparation worker.

It points to "The Good Jobs Deficit", wherein the number of jobs in midwage and high-wage occupations remains significantly below the prerecession peak, while the number of jobs in lower-wage occupations has climbed back close to its former peak. The report divides the nation’s occupations into equal thirds: lower-wage, midwage and higher-wage. It found that during the downturn, the nation lost 3.9 million jobs in midwage occupations, while losing 1.4 million in lower-wage occupations and 1.2 million in higher-wage ones.

The report said that of the net employment losses during the recession, 60 percent were in midwage occupations, while 21.3 percent were in lower-wage occupations and 18.7 percent in higher-wage ones. Since the recession ended, there had been a 1.7 million increase in the number of jobs in low-wage and midwage occupations, with low-wage jobs accounting for nearly three-quarters of that. But the number of jobs in high-wage occupations has declined by 461,994 since the recession ended (from first quarter 2010 to first quarter 2011).

Update 3 (4/6/2012)

Mike Konczal and Arjun Jayadev has this nice paper on the US labour market in the Great Recession. See also Mike's blog posts here and here.


Saturday, January 22, 2011

Encouraging news from Africa

Earlier I had blogged about the economic resurgence of Africa over the past decade. Maxim Pinkovskiy and Xavier Sala-i-Martin have three graphics which reinforces the impression about an African resurgence.

There is a clearly evident connect between rising per capita incomes and declining poverty rates since the mid-nineties.

Much the same trends come from measurements of African welfare, using Amartya Sen’s index of GDP-per-capita x1 minus the Gini coefficient. It shows that African welfare declined substantially between 1970 and 1995, but the trend was reversed dramatically between 1995 and 2006.

All this has been accompanied by falling inequality, including after mid-nineties when economic growth rates rose steeply. This proves that growth was not confined to a narrow elite and was more broad-based.

Their main conclusion is that "Africa is reducing poverty, and doing it much faster than many thought", especially in the 1995-2006 period. More encouragingly, they also find that "growth from the period 1995-2006, far from benefiting only the elites, has been sufficiently widely spread that both total African inequality and African within-country inequality actually declined over this period".

Further, they also write that "African poverty reduction cannot be explained by a large country, or even by a single set of countries possessing some beneficial geographical or historical characteristic". All classes of countries, including those with disadvantageous geography and history, experience reductions in poverty.

All this raises the question, is Africa today at the same stage East Asia and Asia Pacific were in the seventies?

Friday, January 21, 2011

Nudging on organ donation

The British Government has decided to introduce a system of "prompted choice" on organ donor registration when people apply online for driving licenses from July 2011. Under this, applicants will be prompted to say "yes", "no", or "I do not want to answer this now" to a question about whether they want to donate their organs. It is believed that by prompting people into making a choice, more people can be made to register for organ donations.

In contrast to "prompted choice", under the "presumed consent" policy, all people are assumed to be willing to donate their organs unless they specifically choose to opt out. Experience from many countries and some US states shows that either types of policies have significantly increased the number of organ donors. Prompted choice schemes in US states like Illinois, for example, have increased donor registrations from 38% to 60% of the population. Spain, Austria, and Belgium have presumed consent organ donation legislations, which have yielded higher donor rates.

Organ donation policies in India revolve around awareness creation and piecemeal campaigns to enrol signatures from potential donors. For example, the National Blindness Control Program has a campaign to get people to donate their eyes. These programs are marked by meaningless campaigns (because these consents have no legal standing) to enlist signatures of potential donors. Celebrities are enlisted and substantial amounts spent, without any tangible results.

It is time that the Government of India embrace either prompted or presumed consent policies, with specific variations to suit our requirements. This would be an example of moving beyond conventional regulations, incentives and awareness-based policy-making to one that applies insights from behavioural psychology.

Thursday, January 20, 2011

A new tax slab for the uber-rich?

Fascinating graphic from the Economix which highlights the magnitude of income differentials at the highest income levels. As can be seen, for the bottom 90 to 95 percent of Americans, the income distribution is relatively flat, whereas at the mid-90s, the line suddenly kinks upward.

Brad DeLong has a log income distribution which Paul Krugman compares to "a long street running up a hill, in which rising altitude goes along with rising income".

The emergence of this distribution has important consequences. Conventional income profiling which classified people into categories of the poor, rich and middle-class is no longer relevant. A fourth category of the uber-rich has emerged at the highest income level, distinct from the mere-rich. This category, a small percentage of the total population (most often no more than 5%), earn several times more than the mere-rich and own a staggering share of the national wealth.

This has profound implications for all social, political and economic policy making. This massive income differentials at the top and the resultant concentration of wealth has dramatically altered power equations within societies. The mere-rich have been replaced by the uber-rich as the power-elite.

The incentives and the psychology that drives the uber-rich are different from those of the mere-rich when the latter formed the power-elite. This has implications for economic policy making. For example, there arises the issue of a separate higher tax bracket for the uber-rich and other changes to the taxation system. Currently, the uber-rich are enjoying the taxation rate that was designed for the mere-rich.

This assumes greater significance in view of the major share of the incomes of the uber-rich coming from financial markets through some form of capital-gains. It cannot be any coincidence that in the US, such incomes are taxed at a marginal rate of 15%, compared to wage and other incomes which are taxed at 39.6%.

Further, as Paul Krugman writes, "if you’re in the middle of the income distribution, your uphill neighbor is about as much richer than you than your downhill neighbor is poorer, but in the upper reaches that’s no longer true". Psychologically, the fact that the mere-rich have been superseded by the uber-rich in such a short time would have a profound impact on their psyche and the relationship between these two groups at the top of the income distribution. Will this lead to a social consolidation between the mere-rich and the middle-class to form the countervailing elite? How will this impact political power equations and relationships at the top of the income distribution?

Income distribution trend follows the same pattern every where. The graphic below illustrates India's income distribution of more than ten years back, which shows a gradually rising graphic. The income distribution today would be strikingly similar to that of the US.

Update 1 (12/4/2011)

Nancy Folbre makes the case for a higher and separate tax rate for the millionaires. As she shows, high marginal tax rates have been the historical norm. She also finds limited historical evidence to support the view that tax increases dampen economic growth.

Update 2 (1/5/2011)

Paul Krugman points to newly released IRS documents which show that the top 400 income tax payers had an average tax rate of less than 17% in 2007. Further, they accounted for more than 10% of all capital gains income in America. Krugman writes,

"Conservatives often try to sell the notion that reducing the capital gains tax is about helping small business people. But you really want to think of the fact that a significant chunk of that tax break is going to just 400 people.

And when you think about financial regulation, you similarly want to bear in mind that when asset prices rise, a tiny handful of people get a large chunk of the gains; I don’t know this for sure, but I’d bet that they somehow end up bearing a much smaller share of the losses when the bubble bursts."

Another reason for a higher tax slab for the uber-rich?

Update 3 (18/5/2011)

One of the most important driving forces behind widening income inequality - declining tax rates at the top, even as incomes balloon. With an average income of $270 million in 2008, the typical household in the Top 400 made 4,700 times as much as the average American filing a 1040 form. This CBPP chart shows that between 1992 and 2008, the average share of their incomes that these households paid in federal taxes dropped from 26 percent to 18 percent, while their annual incomes shot up by over 700 percent, after inflation.

Update 4 (26/5/2011)

Economix draws attention to the latest figures released by Tax Policy Center on income distribution in the US for 2011.

The difference in income between a household at the 50th percentile and a household at the 51st percentile is $1,237 ($42,327 versus $43,564). But the difference in incomes between a household at the 98th percentile and the 99th percentile is $146,118 ($360,435 jumps up to $506,553). The gaps become even wider at the extreme top of the income ladder: A family at the 99.5th percentile makes $815,868; its neighbor at the 99.9th percentile makes more than double that, at $2,075,574 a year.

Tuesday, January 18, 2011

Rebalancing global current account imbalances

The biggest medium-term concern for the world economy is the management of the global macroeconomic (specifically, current account) imbalances - getting the deficit countries to save and the surplus generators to spend more.

Joseph Gagnon feels that current account imbalances are likely to return to record levels over the next five years and the recent narrowing of imbalances was almost entirely a result of the global recession and that global recovery will unwind this effect. About the fundamental reason for the continuing build up of these imbalances, he writes,

"The primary culprit, in my view, is the development strategy increasingly being adopted by emerging markets — most notably China — of deliberately undervaluing one’s currency by official purchases of foreign assets in order to get net-export-led growth. Most developing economies are now piling onto this strategy in a big way (hence the currency wars), and it is a major problem for the U.S. We all want net exports to grow but we cannot all get it."

About the way ahead, he writes,

"To avoid a return of large global imbalances, economies with current account deficits should cut fiscal deficits more than is currently projected and economies with current account surpluses should reduce official financial outflows and allow their currencies to appreciate as well as take steps to boost domestic demand.

Fiscal consolidation in surplus economies — though necessary in some cases — is detrimental to rebalancing and should proceed at a slower pace and to a lesser degree than in deficit economies. Even in deficit countries, the pace of fiscal consolidation should be slower in economies where the recovery from the crisis remains weak.

Monetary policy should remain accommodative and even ease further in economies where output remains below potential and inflation threatens to fall below desired levels. In developing countries in which inflationary pressures are rising, a tighter macroeconomic policy stance is indicated. However, the form of the tightening should differ based on country circumstances: Surplus economies should tighten via exchange rate appreciation, whereas deficit economies should tighten via fiscal policy."

I am not sure whether Gagnon's assessment of the reasons and the possible solutions captures the full picture. While he offers clarity on the measures to be undertaken by the surplus generators, there is ambiguity about policies to be adopted by the deficit countries. He under-estimates the contribution of the extraordinary monetary accommodation (by way of quantitative easing) in the US to sustaining the imbalances. The resultant capital flows into emerging economies have played an important role in fuelling financial market excesses and over-heating there.

Monetary accommodation, while required to mitigate the adverse impact of the recession, cannot be a substitute to avoid the hard choices required. Given the extraordinary structural imbalances that had crept into the domestic economy (eg, the out-sized prominence of the financial markets), economies like the US cannot restore normalcy without undergoing considerable pain and implementing policies that can reform the domestic structural imbalances.

For a start, debt-laden household and business balance sheets have to contract considerably for any recovery to be sustainable. Currently, apart from boosting aggregate demand and investment, policy-makers are adopting an ultra-accommodative monetary policy for three reasons. One, keeping real interest rates low so as to lower the interest burden. Two, buy time for recovery to take hold by allowing businesses and households to re-schedule their debts. Three, hope that asset values will regain a major share of their values, so that some of the notional balance sheet debts will disappear.

However, all these assumptions may not stand closer scrutiny. Asset values are far down from the boom peaks and are not likely to return to anywhere near those values anytime in the foreseeable future. Further, buying time while keeping an ultra-accommodative monetary stance, may as Raghuram Rajan and others have argued, fuel other bubbles and even more asset mis-allocation. All this would be pumping more steroids on a patient already pumped up with an over-dose of them!

America's persistence with more quantitative easing in the name of expanding credit and lowering real long-term rates (and thereby raise asset values and boost consumption) is similar to China's policy of keeping the renminmbi under-valued so as to keep exports competitive. The Americans say that without this, the economy risks tipping into a deeper recession. The Chinese fear that currency revaluation will reduce Chinese exports, weaken economic growth, and generate social tensions. Both sides are grossly over-estimating the relative impacts and their policies are playing an important role in sustaining the current account imbalances. Further, both are band-aid policies that reveal a reluctance to embrace more fundamental changes required to remedy deeper domestic structural problems.

Micheal Spence has a few excellent suggestions, which may be germane to a more effective resolution of the imbalances. He advocates a pull-back from the quantitative easing policies and policies that increase the share of America's tradeable sector. He writes about,

"... a pull-back from quantitative easing in the US, which is subjecting the emerging economies to a flood of capital, rising commodity prices, inflation, and asset bubbles. Intervention may be needed in fragile sectors of the US economy, like housing, where faltering performance could produce another downturn. But such intervention can and must be far more precisely targeted than QE2. America’s reluctance to target areas of weakness or fragility leaves the impression externally that QE2’s real goal is to weaken the dollar...

global economy will be out of balance so long as the US runs large current-account deficits... that gap needs to be filled by higher foreign demand and increased export potential... The tradable sector accounts for just 30% of the US economy (by value added), and employment growth in the tradable sector is negligible... If exports are to grow substantially, the scope of the tradable sector must expand."

He also makes a subtle point about China's internal re-balancing,

"In the case of China, a key part of its 12th five-year plan is to shift income to the household sector, where the savings rate is high but still lower than the corporate rate. The economy can then use household savings (with appropriate financial intermediation) to finance corporate and government investment, rather than the US government."

Such internal re-balancing can be done only if China liberalizes its labor markets so as to remove restrictions on wage increases and puts in place a social security system to cushion workers against rising uncertainty (and this is one of the major causes for higher savings rate). It has to be hoped that such policies will encourage the Chinese consumers to loosen their purse strings.

Monday, January 17, 2011

The transformation of NREGS!

The Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS) was launched in 2005 as a social security mechanism that provided every rural poor household a right to a minimum of 100 days employment. In simple terms, it was the classic unemployment insurance scheme.

Several changes to the nature of the programs have transformed it from an insurance scheme to an entitlement scheme. The most definitive signal of this change was the latest decision to index wages to inflation. In the revised structure, the wages under MNREGA will go up between 17 to 30% on the base of Rs 100 for the present. The revised wages came into effect from January 1 and will keep the index in Consumer Price Index (CPI) as the basis. It means an additional expense of Rs 3,500 crore for the last quarter of 2010-11.

In fact, an even more conclusive proof of its transformation is the formation of NREGS workers unions in union-friendly Kerala. Besides, higher wages and more guaranteed days of work every year, these unions are demanding a pension scheme, a healthcare scheme, provision for the education of their children, and housing and welfare schemes for MGNREGS workers. I have already blogged about the possible incentive distortions of NREGS here, here and here.

In this context, Harsh Gupta offers a nudge that would reconcile the employment creation and asset creation imperatives without creating incentive distortions. He proposes that all rural poor be given an "opt-out" clause of getting, say, half the wage by not working at all. By making this opt-out clause contingent of fulfillment of certain conditions (like sending children to school, vaccinated etc), this would become a form of conditional cash transfer. Since the poor are most likely to accept this, it will provide them the safety net while enabling governments to concentrate on those areas where infrastructure assets need to be created.

Angela Merkel's Eurodenial?

Any country is, among other things, also a currency union. But a currency union can succeed only when complemented with some other factors. Consider this.

Imagine if the city of Bombay (or the state of Maharashtra), which contributes an over-sized share to India's gross tax revenues, refuses to share the taxes collected within its territorial jurisdiction. Or the central government at New Delhi refuses help to beleaguered wheat farmers of Punjab devastated by floods. Or Tamil Nadu restrains Telugu speaking people from Andhra Pradesh working in Chennai and elsewhere in the state.

Any currency union immediately takes currency and monetary policy autonomy out of the equation. You sink or swim along with all others within the union. The problem arises when different areas within the union are at different stages of the business cycle.

Denied off the freedom to lower interest rates (and thereby stoke inflation and lower the real domestic debt burden) or devalue the currency (and thereby increase competitiveness and lower the real external debt burden), the struggling areas need help from outside. They need fiscal transfers from elsewhere to cushion the impact of reduced output and lower tax revenues and there should also be freedom for labor migration that would take the load off the local job market.

The first requires fiscal integration and the second political union. This does raise questions about the difficulty of sustaining a currency union without greater political and financial integration. Bombay or Tamil Nadu cannot have the benefits of a national economy without the costs imposed by fiscal transfers and labor mobility. Similarly, Eurozone economies cannot enjoy the benefits of a currency union without greater political and economic integration.

Fiscal federalism and (less so) labor mobility are the fundamental attributes of any national economy or any successful optimal currency area (OCA). The critical component of fiscal federalism is the transfer of resources across areas - from the well-off (or resource-rich or economically vibrant) to the poorer areas - and to those experiencing output declines and job losses during downturns.

In the circumstances, the intransigence of Angela Merkel on any efforts towards stronger fiscal integration of Europe is baffling. A case of Eurodenial?

Update 1 (25/1/2011)

French finance mininster Christine Lagarde too is not too keen and sure about closer fiscal integration within Eurozone.

Sunday, January 16, 2011

The ASER report 2010

The Annual Status of Education Report (ASER) 2010 (highlights here), prepared by the NGO Pratham, and covering 7 lakh children in 14,000 villages across 522 districts, was released on Friday. It reported a substantial increase in school enrolment figures but no visible improvement in the quality of education.

The trend for enrolment has been encouraging, with continuous decline in the out of school children, both boys and girls, and of all age groups. Only 3.5% of children in the 6-14 age group are out of school.

Private school enrolment has been continuously rising, increasing from 16.3% in 2005-06 to 24.3% in 2010 for all children in the 6-14 age group, with southern states leading the way.

A considerable share of children in the 3-5 age groups do not attend either the angawadis or the LKG/UKG.

Interestingly, a larger share of government school students attend private schools than those from private schools. The need for external tuition is also a reflection of the quality of these schools. Since the tuitions are invariably private, the effective reliance on private teaching centers is higher. There is a clear decrease in the incidence of tuition among children enrolled in private schools across all classes till Std VIII.

The learning outcomes remain very dismal, even declining in certain areas. Nationally there is not much change in reading levels as compared to last year. Nearly half the students in Class V cannot read even the Class II text.

Only 65.8% of children in Class 1 can recognize numbers 1-9, down from 69.3% in 2009. The percentage of students in Class 3 who can solve two-digit subtraction problems has fallen from 39% in 2009 to 36.5% in 2010. The percentage of Class 5 children who can solve simple division problems has fallen from 38% in 2009 to 35.9% in 2010. Across the country, the ability of children to deal with elementary arithmetics has declined. A large percentage of middle school children struggled in their everyday dealings with numbers, such as reading a calendar, estimating volume or calculating area.

Rated on seven infrastructure parameters they are required to meet under the RTE Act, only 3% schools were found satisfactory on all. The parameters included buildings including classrooms and a boundary wall, drinking water, toilets, girls' toilets, teaching and learning material, libraries and the availability of mid-day meals. Only 53% of all schools surveyed across India were found compliant with the pupil-teacher ratio (PTR).

Though RTE mandates all schools have drinking water facilities, nearly 30% schools don’t have it while around 50% don’t have usable toilets. While teacher absenteeism was almost 45% in the 13,000 schools visited, student absenteeism was almost half in these primary schools across the country.

More evidence of global warming

NYT points to recently released reports by the NASA and the National Oceanic and Atmospheric Administration which indicate that 2010 was the wettest year in the historical record. Further, the global average surface temperature for 2010 had tied the record set in 2005 (record-keeping began in 1880).

The 2010 temperature was 1.12 degrees Fahrenheit above the average for the 20th century, which is 57 degrees. It was the 34th year running that global temperatures have been above the 20th-century average; the last below-average year was 1976. The new figures also show that 9 of the 10 warmest years on record have occurred since the beginning of 2001.

In India too, as the Indian Meteorological Department announced recently, 2010 was the warmest year ever in India since weather records began in 1901. The mean annual temperature in the country during 2010 (at 24.64 degrees C) was as much as 0.93 degrees Celsius higher than the long term (1961-1990) average.

Saturday, January 15, 2011

Paul Krugman on the Euromess

It has become the convention that Paul Krugman sets the standard on most major issues on our times with his incisively brilliant essays in the Times. His columns heralding a Dark Age in Macroeconomics and Building a Green Economy generated intense debates on the state of economics and environmental policy making respectively.

Now, comparing the current Euro-zone crisis to a Greek tragedy, Paul Krugman has a superb essay on the origins and evolution of the Union, reasons for the crisis, and the prospects facing Europe. He sets the stage nicely,

"The tragedy of the Euromess is that the creation of the euro was supposed to be the finest moment in a grand and noble undertaking: the generations-long effort to bring peace, democracy and shared prosperity to a once and frequently war-torn continent. But the architects of the euro, caught up in their project’s sweep and romance, chose to ignore the mundane difficulties a shared currency would predictably encounter — to ignore warnings, which were issued right from the beginning, that Europe lacked the institutions needed to make a common currency workable. Instead, they engaged in magical thinking, acting as if the nobility of their mission transcended such concerns.

The result is a tragedy not only for Europe but also for the world, for which Europe is a crucial role model. The Europeans have shown us that peace and unity can be brought to a region with a history of violence, and in the process they have created perhaps the most decent societies in human history, combining democracy and human rights with a level of individual economic security that America comes nowhere close to matching. These achievements are now in the process of being tarnished, as the European dream turns into a nightmare for all too many people."

Krugman points to the most important and fundamental challenge facing the peripheral European economies - increasing their competitiveness. He writes,

"Imagine that you’re a country that, like Spain today, recently saw wages and prices driven up by a housing boom, which then went bust. Now you need to get those costs back down. But getting wages and prices to fall is tough: nobody wants to be the first to take a pay cut, especially without some assurance that prices will come down, too... If you still have your own currency, however, you wouldn’t have to go through the protracted pain of cutting wages: you could just devalue your currency — reduce its value in terms of other currencies — and you would effect a de facto wage cut... by giving up its own currency, a country also gives up economic flexibility... adjusting your currency’s value solves the coordination problem when wages and prices are out of line, sidestepping the unwillingness of workers to be the first to take pay cuts."

About the reasons why a currency union cannot survive without other complementary institutions and policies, he writes,

"When the single European currency was first proposed, an obvious question was whether it would work as well as the dollar does here in America. And the answer, clearly, was no... Europe isn’t fiscally integrated: German taxpayers don’t automatically pick up part of the tab for Greek pensions or Irish bank bailouts. And while Europeans have the legal right to move freely in search of jobs, in practice imperfect cultural integration — above all, the lack of a common language — makes workers less geographically mobile than their American counterparts...

Robert Mundell of Columbia stressed the importance of labor mobility, while Peter Kenen, my colleague at Princeton, emphasized the importance of fiscal integration. America, we know, has a currency union that works, and we know why it works: because it coincides with a nation — a nation with a big central government, a common language and a shared culture. Europe has none of these things, which from the beginning made the prospects of a single currency dubious."

The lead-up to and aftermath of a single currency zone resulted in a dramatic convergence of government bond yields and widespread euphoria and hope,

"By the middle of the 2000s just about all fear of country-specific fiscal woes had vanished from the European scene. Greek bonds, Irish bonds, Spanish bonds, Portuguese bonds — they all traded as if they were as safe as German bonds. The aura of confidence extended even to countries that weren’t on the euro yet but were expected to join in the near future: by 2005, Latvia, which at that point hoped to adopt the euro by 2008, was able to borrow almost as cheaply as Ireland...

As interest rates converged across Europe, the formerly high-interest-rate countries went, predictably, on a borrowing spree. (This borrowing spree was, it’s worth noting, largely financed by banks in Germany and other traditionally low-interest-rate countries; that’s why the current debt problems of the European periphery are also a big problem for the European banking system as a whole.) In Greece it was largely the government that ran up big debts. But elsewhere, private players were the big borrowers. Ireland, as I’ve already noted, had a huge real estate boom: home prices rose 180 percent from 1998, just before the euro was introduced, to 2007. Prices in Spain rose almost as much. There were booms in those not-yet-euro nations, too: money flooded into Estonia, Latvia, Lithuania, Bulgaria and Romania."

He finds striking similarities between the economies on both sides of the Atlantic and their respective contributions to the global economic crisis of 2008,

"This was, if you like, a North Atlantic crisis, with not much to choose between the messes of the Old World and the New. We had our subprime borrowers, who either chose to take on or were misled into taking on mortgages too big for their incomes; they had their peripheral economies, which similarly borrowed much more than they could really afford to pay back. In both cases, real estate bubbles temporarily masked the underlying unsustainability of the borrowing: as long as housing prices kept rising, borrowers could always pay back previous loans with more money borrowed against their properties. Sooner or later, however, the music would stop. Both sides of the Atlantic were accidents waiting to happen."

About the dilemma facing the peripheral economies - regain their competitiveness while also paying off their massive debts - he writes,

"Membership in the euro means that these countries have to deflate their way back to competitiveness, with all the pain that implies... Even when countries successfully drive down wages, which is now happening in all the euro-crisis countries, they run into another problem: incomes are falling, but debt is not.

As the American economist Irving Fisher pointed out almost 80 years ago, the collision between deflating incomes and unchanged debt can greatly worsen economic downturns. Suppose the economy slumps, for whatever reason: spending falls and so do prices and wages. But debts do not, so debtors have to meet the same obligations with a smaller income; to do this, they have to cut spending even more, further depressing the economy. The way to avoid this vicious circle, Fisher said, was monetary expansion that heads off deflation. And in America and Britain, the Federal Reserve and the Bank of England, respectively, are trying to do just that. But Greece, Spain and Ireland don’t have that option — they don’t even have their own monies, and in any case they need deflation to get their costs in line."

He sees four possibilities for Europe - toughing it out; debt restructuring; full Argentina; and revived Europeanism. Toughing it out is classic "internal devaluation" to restore competitiveness, where economies reassure their creditors by enduring pain (by cutting wages, prices, and government spending) and thereby avoid default or currency devaluation (similar to what the small Baltic nations appear to be doing, despite their Depression-type declines in output and employment). This would require time and dollops of good fortune.

Debt restructuring would immediately ease the debt burden, though the economies would still need to slash spending and raise taxes to balance its budget, besides suffering the pain of deflation to regain competitiveness. Krugman feels that this is inevitable, atleast for Greece and Ireland,

"A debt restructuring could bring the vicious circle of falling confidence and rising interest costs to an end... I find it hard to see how Greece can avoid a debt restructuring, and Ireland isn’t much better. The real question is whether such restructurings will spread to Spain and — the truly frightening prospect — to Belgium and Italy, which are heavily indebted but have so far managed to avoid a serious crisis of confidence."

The policies of the peripheral economies are strikingly similar to that of Argentina since 1991 when it embraced a "currency board" with a rigid peso-dollar peg to ward off a debt crisis. This disastrous experiment, which involved fiscal austerity and tax increases to regain market confidence and IMF bailout to buy time for the austerity to work, collapsed in 2002. Peso-dollar peg was abandoned, peso plunged by more than two-third, and Argentina defaulted on its debts, eventually paying only about 35 cents on the dollar. Since 2003, Argentina experienced a rapid export-led economic rebound. Krugman writes about Iceland's combination of default and devaluation,

"The European country that has come closest to doing an Argentina is Iceland, whose bankers had run up foreign debts that were many times its national income. Unlike Ireland, which tried to salvage its banks by guaranteeing their debts, the Icelandic government forced its banks’ foreign creditors to take losses, thereby limiting its debt burden. And by letting its banks default, the country took a lot of foreign debt off its national books. At the same time, Iceland took advantage of the fact that it had not joined the euro and still had its own currency. It soon became more competitive by letting its currency drop sharply against other currencies, including the euro. Iceland’s wages and prices quickly fell about 40 percent relative to those of its trading partners, sparking a rise in exports and fall in imports that helped offset the blow from the banking collapse."

The most desirable outcome would be greater fiscal union between members. Krugman refers to the proposal (Juncker-Tremonti plan) mooted last year of "E-bond". They would be issued by a European debt agency at the behest of individual European countries, and guaranteed by the European Union as a whole. Germany has rejected this as a "transfer union", where the irresponsible economies would be subsidizied by the responsible ones.

Currently Europe has decided to stick with "tough it out" policy stance, and Paul Krugman feels that this policy may not succeed,

"Governments that can’t borrow on the private market will receive loans from the rest of Europe — but only on stiff terms: people talk about Ireland getting a “bailout,” but it has to pay almost 6 percent interest on that emergency loan. There will be no E-bonds; there will be no transfer union... In any case, the odds are that the current tough-it-out strategy won’t work even in the narrow sense of avoiding default and devaluation — and the fact that it won’t work will become obvious sooner rather than later. At that point, Europe’s stronger nations will have to make a choice."

See also this assessment of Estonia's progress with toughing it out, even as it joined the eurozone early this year.

Thursday, January 13, 2011

Managing public resources

Here is my Mint op-ed that talks about allotment of natural resources to private interests only after a competitive price-discovery mechanism.

Analyzing China's savings paradox

The persistent reluctance of Chinese consumers to spend their incomes, especially when they are experiencing unprecedented prosperity (average annual household income almost tripled from 1989 to 2006) has been puzzling.

Consider these - private consumption in China has fallen precipitously from 46% of GDP in 2000 to a measly 35%, the lowest among all major economies; urban Chinese household savings have doubled from 15% in the early 1990s to over 30% in recent year.

Rectifying these imbalances in the Chinese economy is critical to addressing the global macroeconomic imbalances that are atleast partially responsible for the current global economic crisis.

Economists Marcos Chamon, Kai Liu and Eswar Prasad studied Chinese statistical surveys of household incomes dating back to the 1980s and attribute the Chinese savings trend to the uncertainty Chinese feel about their income and the market-oriented nature of Chinese reforms. The heightened uncertainty forces the Chinese into saving a larger proportion of their income even in a rapid-growth economy.

They argue that the new nation-wide contributions-based pension scheme ('individual accounts' that hold retirement contributions from both employer and employee), introduced in 1997, replacing the companies' (mostly state-owned) based pensions scheme, has increased uncertainty among employees. Further, the economic reforms and the entry of multi-national firms have made the life of the average young Chinese worker riskier - private sector jobs do not guarantee job security. The proportion of workers employed in the state-owned companies fell dramatically from 81% in 1989 to 64% in 2006. And even for the state-employees, the terms of employment are not as secure as they used to be.

Accordingly, a U-shaped savings pattern has emerged - younger people save more to create a 'buffer' against greater income uncertainty and older folks save for their retirement. They write,

"Higher income uncertainty and pension reforms can together explain much of the rise in average savings among urban households in China…Moreover, the calibrated response to saving rates implies changes to the cross-section of savings over time that are sharper among households at the two ends of the age distribution of household heads. Even 10 years after the initial increase in uncertainty and pension reform, we estimate the youngest and the oldest households save 5 percentage points more than before those changes, compared to only 2.5-3.5 percentage points more for those in their late thirties-early forties."

The case for big cities

Mario Pol├Ęse makes the case for big cities with his Seven Pillars of Agglomeration

1. Economies of scale in production - large cities can support large factories and their upward and downward linkages and thereby makes manufacturing more efficient.

2. Economies of scale in trade and transportation - larger cities have access to larger airports or ports or railway stations, thereby making trade more cost-effective.

3. Falling transportation and communications costs - the steeper the drop in transportation costs and the greater the weight of scale economies in production, the greater the potential for centralizing production in one or two places.

4. The need for proximity with other firms in the same industry - face-to-face contact fosters trust; proximity generates network effects and amplification of knowledge and creativity; workers find it easy to move across firms and firms find it easier to locate workers; personal contact (and communication) is crucial in industries where creativity, inspiration, and imagination are vital inputs.

5. The advantages of diversity - the diversity of cities helps development of certain knowledge based industries, provide a variety of ideas, source a diverse pool of workers etc.

6. The quest for the center - firms want to locate in the geographic center of their markets. Centrality provides the customer-base.

7. Buzz and bright lights - city, being where the action is, attracts talented and ambitious people. Companies, in turn, can hire them. City is where ambition, dreams, the need for recognition meet each other.

Tuesday, January 11, 2011

More on the TBTF problem

Simon Johnson, one of the most vocal advocates of breaking up the big banks, lays out his case in this excellent analysis

"Today’s most dangerous government sponsored enterprises are the largest six bank holding companies: JP Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley. They are undoubtedly too big to fail – if they were on the brink of failure, they would be rescued by the government, in the sense that their creditors would be protected 100 percent. The market knows this and, as a result, these large institutions can borrow more cheaply than their smaller competitors. This lets them stay big and – amazingly – get bigger.

In the latest available data (Q3 of 2010), the big 6 had assets worth 64 percent of GDP. This is up from before the crisis – assets in the big six at the end of 2006 were only about 55 percent of GDP. And this is up massively from 1995, when these same banks (some of which had different names back then) were only 17 percent of GDP. No one can show significant social benefits from the increase in bank size, leverage, and overall riskiness over the past 15 years. The social costs of these banks – and their complete capture of the regulatory apparatus – are apparent in the worst recession and slowest recovery since the 1930s."

Arguably, the two biggest policy problems with modern financial markets relate to the nature of financial institutions - their size and their financing pattern. (Paul Krugman sees the shadow banking sector as another problem) Bankers point to the economies of scale benefits of large bank holding companies to refute the TBTF arguement. They also warn that increased equity requirements would restrict lending and impede growth.

As Simon Johnson pointed out, there is very little or no research evidence to support either arguments. The most pro-market of financial market economists, Eugene Fama has argued that too-big-to-fail (TBTF) is "perverting activities and incentives" in financial markets and is giving big financial firms "a license to increase risk; where the taxpayers will bear the downside and firms will bear the upside".

A number of the most distinguished American finance acedemics recently questioned the claim that greater equity requirements would adversely affect financial market efficiency,

"Using more equity changes how risk and reward are divided between equity holders and debt holders, but does not by itself affect funding costs. Tax codes that provide advantages to debt financing over equity encourage banks to borrow too much. It is paradoxical to subsidize debt that generates systemic risk and then regulate to try to limit debt...

Ensuring that banks are funded with significantly more equity should be a key element of effective bank regulatory reform. Much more equity funding would permit banks to perform all their useful functions and support growth without endangering the financial system by systemic fragility. It would give banks incentives to take better account of risks they take and reduce their incentives to game the system. And it would sharply reduce the likelihood of crises."

Mark Thoma attributes the persistence of TBTF institutions, despite the overwhelming evidence of their riskiness to regulatory capture. He writes,

"The potential costs of too big to fail banks are large and well known, and unless there are demonstrable benefits to offset the known costs, there is sufficient basis for breaking the banks up. But yet, with scant evidence of the benefits, but plenty of evidence about the costs, too big to fail banks not only persist, the banks are getting bigger. To me, that speaks directly too regulatory capture, and not in a kind way."

Update 1 (15/1/2011)

Simon Johnson has another excellent post on Goldman Sachs' denial of the TBTF problem. See this presentation and paper by Prof Anat Admati that clearly refutes the ("equity is expensive") notion that higher capital requirements will adversely affect banks competitiveness and innovation. She writes,

"We conclude that bank equity is not socially expensive, and that high leverage is not necessary for banks to perform all their socially valuable functions, including lending, taking deposits and issuing money-like securities. To the contrary, better capitalized banks suffer fewer distortions in lending decisions and would perform better. The fact that banks choose high leverage does not imply that this is socially optimal, and, except for government subsidies and viewed from an ex ante perspective, high leverage may not even be privately optimal for banks.

Setting equity requirements significantly higher than the levels currently proposed would entail large social benefits and minimal, if any, social costs. Approaches based on equity dominate alternatives, including contingent capital. To achieve better capitalization quickly and efficiently and prevent disruption to lending, regulators must actively control equity payouts and issuance. If remaining challenges are addressed, capital regulation can be a powerful tool for enhancing the role of banks in the economy."