The health care problem for the US economy

The President Obama's Budget proposals has generated an intense debate about how to rein in America's deteriorating fiscal balance. The Republicans are expectedly talking about cutting wastage and big government, and training their guns on Social Security and non-defence discretionary spending. But where do the real problems lie? The CBO's long-term Budget Outlook summed up the public debt challenge facing the US economy thus,

"At the end of 2008, that debt equaled 40 percent of the nation’s annual economic output (as measured by gross domestic product, or GDP), a little above the 40-year average of 36 percent. Since then, large budget deficits have caused debt held by the public to shoot upward; the Congressional Budget Office (CBO) projects that federal debt will reach 62 percent of GDP by the end of this year—the highest percentage since shortly after World War II. The sharp rise in debt stems partly from lower tax revenues and higher federal spending related to the recent severe recession and turmoil in financial markets. However, the growing debt also reflects an imbalance between spending and revenues that predated those economic developments."

The CBO projects that if current laws (including the recent Affordable Health Care Act) do not change, federal spending on major mandatory health care programs will grow from roughly 5 percent of GDP today to about 10 percent in 2035 and will continue to increase thereafter.



In contrast, the CBO projects that Social Security spending will increase from less than 5 percent of GDP today to about 6 percent in 2030 and then stabilize at roughly that level. This means that health care, and not social security, should be the primary focus of initiatives aimed at balancing the budget.



As Ezra Klein perceptively indicated, the US Government could easily be mistaken for an insurance conglomerate protected by a large, standing army. Atleast that is what the graphic below points to. Left unattended, Medicare and Medicaid alone are projected to double in size over the next 30 years, from the current 20% of the budget.



Paul Krugman highlighted the critical role of Government in health care. In 2009, 71% of total US health care spending was through some form of health insurance provider. And of this, 68% came from the various government health care providers.



Paul Krugman has this and this to say about the futility of cutting the bloated defense budget and thereby addressing the fiscal deficit. He is spot on with his conclusion, "Even a drastic cut in military spending wouldn’t release enough money to offset more than a small fraction of the projected rise in health care costs."



And, as the graphic from Free Exchange indicates, the search for a solution to balance the budget by cutting non-defence discretionary spending is "madness". It was equal to 3.6% of GDP in 2008, the same as in 1963, and forms just 12 % of the current budget. It is also not projected to rise substantially in the future. The room for manoeuvre with budget balancing by cutting this looks very marginal, hardly enough to make a meaningful dent.



Paul Krugman argues that any serious effort to address the deficits should involve health care reforms and some increases in taxes so as to bridge the revenue gaps. About the types of health care reforms he writes,

"It might include things like giving an independent commission the power to ensure that Medicare only pays for procedures with real medical value; rewarding health care providers for delivering quality care rather than simply paying a fixed sum for every procedure; limiting the tax deductibility of private insurance plans; and so on."

See also this excellent post on the fiscal crisis facing America by Simon Johnson.

Widening income-productivity growth gap and inequality

I have blogged earlier about the concerns posed by widening inequality across the world. Conventional wisdom on widening inequality has attributed it to the explosive growth in incomes at the top of the distribution. It is argued that there has been a sharp increase in the returns on higher education, manifested in the spectacular incomes of financial sector workers and corporate executives. They claim that while incomes elsewhere have increased, it is just that those at the top of the pyramid have increased much faster.

This argument overlooks another important trend at the other end of the income spectrum. It now emerges, from the latest figures released by the BLS in the US, that changes in workers real hourly compensation has been lagging labor productivity growth. This effectively means that in relative terms, workers are getting squeezed from both side. On the one side, incomes of those at the top are exploding. On the other hand, their own incomes are not even keeping pace with productivity growth.



The graphic above, of growth of productivity and real hourly compensation in the nonfarm business sector, is striking for atleast couple of reasons. One, the gap between labor productivity and real wages of workers has been widening since the eighties. Two, even as productivity growth has been sharply rising over the past three decades, wage growth has remained small. In fact, even as productivity growth rate increased from nineties to the first decade of this millennium, the wage growth rate declined.

An excellent essay by BLS provides more interesting insights into the reasons for the widening compensation–productivity gap. This gap is a function of two trends - the growth rate of prices and the labor's share in output. If the price deflator rises faster than the income growth, then the purchasing power falls and the compensation-productivity gap grows. The same outcome occurs if the share of the total output accounted for by workers compensation falls.

As indicated earlier, the compensation-productivity gap has widened sharply since the eighties in the manufacturing sector, in a sharp break from the trend earlier.



The consumer prices have grown much faster than implicit price deflator of manufacturing output since early eighties.



Finally, labor's income share of manufacturing sector output has been in constant decline since the seventies.



Update 1 (7/3/2011)

From mid-2009 through the end of 2010, output per hour at US non-farm businesses rose 5.2% as companies found ways to squeeze more from their existing workers. But the lion’s share of that gain went to shareholders in the form of record profits, rather than to workers in the form of raises. Hourly wages, adjusted for inflation, rose only 0.3%, according to the Labor Department. In other words, companies shared only 6% of productivity gains with their workers. That compares to 58% since records began in 1947. Only in the recovery from the deep recession of the early 1980s, when inflation-adjusted hourly wages fell 0.4%, did workers do worse than they have in this recovery.



Update 2 (14/1/2013)

Nice graphic that captures how the productivity gains have been captured by capital at the cost of labor.

Emmanuel Saez has found that the top 1% of households captured 65% of all the American income growth in the 2002-07 period. Another study has found that 1/3rd of the overall increase in income going to the richest 1% has resulted from the surge in corporate profits.

Is free trade efficient and/or good?

Greg Mankiw's recent column in the NYT praising international trade, where he urged Americans to see emerging economies as trade partners and not competitors, has generated an interesting debate about the costs and benefits of international trade.

Uwe Reinhardt highlighted the difference between the way non-nationalistic economists and nationalistic citizens view the issue of gains and losses from trade,

"Many Americans might balk at the lower-priced scarf if it were offered not by an American but by a low-cost manufacturer in Shanghai or Bangladesh... Whether a fellow American gains from a trade or someone in Shanghai does not make any difference to most economists, nor does it matter to them where the losers from global competition live, in America or elsewhere."

He also points to the controversial work of Alan Blinder (see pdf here and here), where he questioned the wisdom of the theory that "every country gains by unfettered international trade" in the context of the threat to American jobs posed by off-shoring of services to emerging economies. Prof Blinder had estimated that 30-40 million jobs in the US are potentially off-shorable and this "may pose major problems for tens of millions of Americans over the coming decades". He also raised the concerns about how America would be able to cope up with its impact, especially given its tattered social safety net.

In this context, David Autor, David Dorn and Gordon H. Hanson (via Mike Konczal) explored the impact of import competition on US local labour markets that were differentially exposed to the rise of trade with China in the 1990-2007 period due to differences in their initial patterns of industry specialization. Controlling for various external factors, they found,

"Increased exposure of local labor markets to Chinese imports leads to higher unemployment, lower labor force participation, and reduced wages. While the employment reduction is concentrated in manufacturing, wage declines occur in the broader local labor market, and are most pronounced outside of manufacturing. Growing import exposure spurs a substantial increase in transfer payments to individuals and households in the form of unemployment insurance benefits, disability benefits, income support payments, and in-kind medical benefits. These transfer payments are two orders of magnitude larger than the corresponding rise in Trade Adjustment Assistance benefits. Nevertheless, transfers falls far short of off-setting the large decline in average household incomes found in local labor markets that are most heavily exposed to China trade."

They also write about the distributional consequences of trade - while it lowers incomes for workers in industries or regions exposed to import competition, gainers include consumers who have increased product variety and industries and regions with expanding exports have higher income growth. They find that the gains from trade with China are between $32 and $61 per person, whereas the deadweight losses are estimated at $52 from the transfer mechanisms in place.

This analysis does not fully capture the benefits. As the article itself mentions, while the benefits of trade are permanent, the deadweight losses of transfers are temporary. More importantly, it does not include the benefits of trade by way of exports (after all, we cannot assess the impact of trade by merely valuing only one side of the equation!).

The critical issue here is not whether free trade is beneficial or not. On the net, it is hard to argue that free-trade is not beneficial and harder still to prove it. But, as the aforementioned study acknowledges and we all know, the benefits and costs of free-trade are not evenly distributed. It is natural that the gainers are happy and the losers are disgruntled and oppose free-trade. The important issue therefore is how the gains and costs are distributed among different people and regions and whether governments can have any role in that.

This raises questions about the relative gains and losses, both in terms of amounts lost and gained and the numbers of people on both sides of the equation. It is here that there is a growing belief, among a larger number of people and regions, that they are being forced to take a disproportionate share of the costs of trade. They accuse a few of disproportionately benefiting from trade. Economics has little to teach us about how to resolve such distributional issues. That is the realm of politics.

The politics of fairness and the sustainability of Pareto optimizing trade demands that the losers be appropriately compensated for their losses. The compensation is usually in the form of some type of transfers from the government to these losers. However, this raises the issue of where the government can find the resources to finance such transfers.

Since the gainers benefited disproportionately, it is only natural that some portion of their excess gains be appropriated by way of say, taxation. In other words, re-distribute a share of the (disproportionate) benefits obtained by the gainers from trade to the losers. This will buy the support of the losers and ensure the sustainability of the Pareto improving trade.

Now free-market economists would argue that this raises questions of how much to re-distribute and to whom. How do we redistribute? Who are the gainers and how much did they gain? Who are the losers, and how much should they be compensated? Yes, the answers to these and more are not simple. But they are not insurmountable.

But the alternative is to accept the losers argument that they do not deserve to lose because of trade and therefore all trade should be stopped (in any case, once you oppose some types of trade, a slippery slope appears, where trade in general gets questioned). After all, and economists understand it better than anyone else, any transaction is economically efficient (and Pareto optimal) only if it makes people better off without making anyone worse off. Free-trade, minus re-distribution, clearly leaves the losers worse off and is both inefficient and not a Pareto improvement.

Such re-distribution can be made less distortionary and with minimal deadweight losses if it is structured so as align the incentives of all the parties. The losers, getting the transfers, should have incentives in place to search for newer jobs and acquire new skills that can help them find a job quickly or recover their income losses. Similarly, the gainers should be taxed for the disproportionate gains, arising from easy arbitrage opportunities, so that their incentives are not distorted badly.

The important take-away from all this is simple. Free trade is good, but only if it is supplemented with transfers that cushion the losers. Put differently, sustenance of free-trade makes the strongest case for social safety nets. In fact, losers from free trade are just another example of market failures (in so far as an "efficient outcome generates "bad" results). A social safety net can address all these problems, not just those arising from trade failures. And Econ 101 teaches us that social safety nets are in place precisely to resolve such failures. William Polley is spot on

"You see, it is the potential for a Pareto improvement that makes free trade desirable. There are winners and losers. But the winners gain more than the losers lose. So effect a transfer from the winners to the losers that still allows the winners to gain but compensates the losers for what they lost. Only then can you really say that free trade (with the compensating side payment) benefits everyone. If the compensation is not there, then I cannot unconditionally advocate free trade. I must call attention to the fact that some will lose."

See also Mark Thoma (also here), Tim Worstall, and Free Exchange debate the issue.

Crime data visualization

Interactive graphics, especially those based on geographical visualization, have the potential to revolutionize decision-support in public policy. Crime detection and prevention is an area where such data can be extensively used.

The Guardian newspaper teamed up with Doug McCune to illustrate the street-wise crime information released by the British Government Police Department using vivid interactive geographical visualization. Apart from helping police officials with their crime detection and prevention activities, this also enables people to examine different types of crime levels in their areas and compare it with those elsewhere.



(click here to play the graphic)

The data representation is made using a geographical data visualization software, SpatialKey. It is the next generation location intelligence solution that enables interactive analyses and reports to be created and shared by business decision makers in minutes.

I had blogged earlier about Doug McCune's spectacular representation of San Francisco's crime levels as elevations on the city map.



See also this link to 20 visualizations of crime data from across the world.

More on redefining the role of central banking

This is carrying forward from my earlier blog post on the re-definition of the role of central bankers. The Economist has an interesting debate on the issue. Its Economists by invitation column recently discussed the changing role of central banks.

John Makin and Michael Bordo argue that central banks return to a focus on their primary goal of maintaining price stability. They also advocate a separation of price and financial stability functions.

Hyun Song Shin argues that the big failure of the pre-crisis monetary policy was a neglect of the macroeconomic importance of financial stability. He writes that the central banks either hived off the "unglamorous business of financial stability" to a separate microprudential regulator or neglected it. The central bankers sought to specialize in the technical details of core monetary policy.

Markus Brunnermeier advocates that central banks should use more of the available tools to maintain financial stability. He also suggests that "central banks should lean against imbalances preventively", instead of just cleaning up after crisis strikes. Takatoshi Ito impresses on the importance of central banks to coordinate closely with fiscal and regulatory authorities in managing the financial markets and during crisis management.

Avinash Persaud feels that the effective divorce (in many countries) between central bank and regulatory agency, or monetary policy and regulatory policy, was a fatal mistake. He writes, "Monetary policy was deliberately oblivious to the asset price boom — that was somebody else’s problem. Regulatory policy was oblivious to macro risks — that was the central bankers job."

An excellent article in the same magazine chronicles the changing face of central banking and examines the dilemmas facing central bankers in the post-sub-prime crisis era. One of the concerns that was raised relate to the perception that, with quantitative easing, central bankers are treading into fiscal policy. In particular there are influential voices that claim that central bank purchases of government bonds, in the hope of lowering long-term interest rates, are tantamount to fiscal policy. They also argue that such policies were responsible for generating and sustainaing several macroeconomic imbalances in the global economy. Further, they also contend that such policies also end up bailing out greedy and irresponsible bankers.

In addition to the issues discussed in the earlier post, there are growing voices that central banks should take on more responsibility for the supervision of banks, especially with respect to the stability of financial systems. This effectively means more macro-prudential regulation, in addition to their existing responsibility for micro-prudential (bank-specific) regulation. This would involve assessing the systemic risk of the actions of individual institutions and different financial instruments.

The changing role of central banking

Standard economic models define the role of central bankers as managing price stability, as manifested by inflation rates, through the conventional interest rates-based monetary policy actions. Accordingly, inflation targeting has been the guiding monetary policy framework for a generation of central bankers.

The sub-prime crisis and the Great Recession has naturally raised questions about this strategy. On the one hand, it has brought to the fore the issue of financial stability, while on the other, it has also raised questions about the importance of economic growth itself. What can central banks do to promote these objectives?

Whatever the earlier reluctance, the dilemma about whether central banks should go beyond inflation targeting appears to have been settled. Some central banks, like the US Federal Reserve and the Reserve Bank of India, have always explicitly considered the promotion of economic growth as part of their objective (though others like the ECB have not been sure). However, the big change has been in the embrace of financial stability as an important objective of central banking policies.

Hitherto central banks have been concerned about the prices of goods and services. The prices of financial and other tradeable assets have remained outside their surveillance radar. The sub-prime mortgage bubble (and the financial market bubbles of the last two decades) with its several incentive distortions and its disastrous contagion effects on the real economy have highlighted the importance of monitoring the prices of financial assets. It is now clear that macroeconomic stability is a function of both price and financial stability.

This expansion in the scope of central banking has naturally raised questions about the instruments in their armoury to address the three-fold challenge of price stability, financial stability, and output stabilization. Financial stability is a much deeper issue than the other two, and requires that central banks go beyond their traditional micro-prudential regulation of individual banks. They have to assess the systemic risk impact of individual banks through macro-prudential regulation.

The current crisis has also seen central banks in the developed economies deploying a variety of often extraordinary measures to get their financial markets and economies back on the recovery path. The most important of these unconventional policies have been quantitative easing, which has been embraced by many central banks. Broadly, quantitative easing refers to the generic set of policies that involved direct credit injections, liberal credit access windows, near blanket credit guarantees, collateral standard expansions/dilutions, and outright asset purchases. The result of all this, coupled with the zero-bound in interest rates, has been dramatic credit expansions with explosive growth in the balance sheets of the central banks.



In the aftermath of the sub-prime meltdown, the US Federal Reserve and Treasury responded swiftly and pumped massive amounts to bailout Wall Street. Apart from lowering interest rates to the zero-bound, these measures also included credit guarantees and unconventional quantitative easing through direct credit injections and asset purchases. The Fed emerged as an effective lender, buyer and insurer of last resort.

It is difficult to estimate the exact impact of such policies. The counterfactual is one of the most difficult riddles. All the more so when the policy itself has not delivered its ultimate objective but merely prevented the situation from getting worse. How do we know what would have been the situation now without all these extraordinary policies? How do we know that these policies, tried out in desperation, have not prevented a repeat of the Great Depression? Or how do we know what could have been, as Paul Krugman and some others have claimed, with a stronger dose of quantitative easing?

There are other equally importat issues. For long time now, economic stability has meant targeting an inflation rate of around 2%. Accordingly, central banks across the developed world have successfully managed monetary policies over the past two decades and kept inflation expectations under control. In fact, it was even being suggested that central banking has slayed the inflation demon. All the major developed economies had low inflation rates and inflation expectations when the sub-prime bubble burst.

However, that in turn posed a problem of a different kind. The low inflation also mean that the interest rates were at already low levels. This also meant that the real interest rates were at ultra-low levels. Once the bubble burst and the Great Recession took hold, the central banks aggressively cut rates even further, and the interest rates touched the zero-bound. With inflation rates remaining low and even falling further, the real interest rates fell into the negative territory. All this meant that conventional monetary policy and its primary instrument, interest rate changes, had become blunt.

This naturally raised questions about the inflation and monetary policy decisions of the pre-crisis era. What is the optimal inflation rate? Should inflation rates be targeted a little higher, so as to enable governments and central banks to have some room to maneouvre with interest rates when downturns strike? What should be the ideal interest rates during the good times?

Almost exactly a year back, the IMF Chief Economist, Olivier Blanchard waded into this debate with a landmark paper. In a major U-turn from the standard IMF orthodoxy on inflation, he advocated a higher inflation target for economies during good times. He argued that economies should target a higher inflation rate, preferably 4% (against the standard 2%), so as to leave enough room for monetary policy actions to work when recessions and downturns strike.

At a 4% inflation rate, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.

However, the challenge with higher interest rates lies in balancing the central bank credibility associated with a rigid and well-communicated low inflation policy and the difficulty of anchoring inflationary expectations at a higher level of inflation. The Blanchard paper has several other important suggestions, some of which are of importance to central bankers. I have discussed them here.

More fundamentally, the recent crisis has certainly highlighted the importance of central banks, especially in crisis situations. The technical nature of their work and their ability to act immediately and without much lag, unlike their political counterparts, make them important institutions. In fact, given the centrality of the economy and the increasing importance of the central banks in macroeconomic management, it is important to re-assess the role of central banks.

Their over-sized role, even in developing economies, raises the inevitable questions about the type of over-sight that the political system should have on central banks. In the US itself there is a clear divide between those advocating much greater political control over the functioning of central banks and those demanding continuance of the central banks' autonomy.

Market for trading IIT JEE toppers!

The Times of India reports of a market in trading top rankers to coaching centers for the joint entrance examination (JEE) for the prestigious Indian Institutes of Technologies (IITs).

The intensely competitive IIT coaching centers have for some time been one of the most lucrative slivers of the education market. These centers compete fiercely to attract the best possible students in the hope that their success, especially in securing one of the top ranks, will attract more students next year. In fact, every year, after the JEE results are announced, the major centers try to outdo each other to advertise their success in capturing the top ranks.

This competition and the demand for having the top rankers on their rolls is classic free-market. It has spawned many healthy trends associated with such competition - focus on quality and outcomes, coaching fee waivers to lure good students and potential top rankers, and so on. However, it has also unleashed some unhealthy trends. The Times report describes the modus operandi of one such trader, Mr Vishnu Agarwal,

"He first zeros in on the brightest students from the best-known IIT coaching classes who are most likely to clear the JEE. He then approaches other coaching classes in Mumbai, Hyderabad and Delhi and offers them the opportunity to administer their test series to these students. Once the JEE results are declared, the coaching class can include those who appeared for their test series as part of the total number of students from their institute who made it to the IITs. The test series is free of cost for students, who are sometimes even paid to write these tests. The coaching class pays Agarwal for the service."

Apart from trying to capture potential toppers, some coaching centers also try to attract those top rankers who were not their students after results are announced. These students and their families are offered massive sums to declare that they have taken courses with the coaching center. All these activities do not generate any efficiency improvements and, if anything, creates perverse incentives.

Why Tendulkar's aborted gym makes a case for higher FSI?

I have written earlier about the need to raise the hugely restrictive and distortionary Floor Space Index (FSI) ratios applicable in Indian cities. FSI is the ratio of the total plinth area of the building to the total land area, and is typically in the 1.5-3 range for Indian cities. In contrast, FSI in most Asian cities varies from 5 to 15 and in many Western cities goes up to even 25. The low FSI is arguably the biggest factor that keeps urban housing prices unaffordable for the large majority of residents of any Indian city.

A high-profile recent example of the colossal wastage and inefficiency of this comes from the Maharashtra Government's rejection of a request by Sachin Tendulkar to construct a gym on the top floor of his new house at Perry Cross Road, Bandra, Mumbai. The reason - the gym would mean that the FSI would exceed the maximum allowable FSI ratio of one.

Now, Tendulkar had purchased the 8998 sqft plot for Rs 39 Cr in 2008. In other words, every square feet of his house sits on some of the most expensive piece of real estate anywhere in the world. In per-capita land area terms, it will certainly be amongst the most under-utilized prime real estate in any of the major global cities. Further, the per-capita land area value occupied by Tendulkar and his family would be amongst the most expensive for any family across the world. Every strand of logical reasoning would support the argument that the draconian FSI ratio regulation of Mumbai is astonishingly inefficient.

It is a classic example of a loss-loss deal. Tendulkar and his family would obviously be dis-satisfied. The government gains nothing, and if anything has foregone a considerable future property tax revenue stream. Any possible economic activity or other benefits generated by way of the gym has been nipped off. (And, maybe Tendulkar would have been able to possibly exercise more with a gym at his house, and be able to extend his cricket career a few more months!!)

Consider this counter-factual. If FSI ratio was say, four, Tendulkar would probably have purchased say, 3000 sq ft of land. He would have spent say, Rs 20 Cr, and invested the Rs 20 Cr so saved in setting up a restaurant, which in turn would create jobs and other economic benefits. The remaining land may have been purchased by a real estate promoter to set up a mall, resulting in more economic activity. Or purchased by someone else - who would now be forced into buying a land that would otherwise have been used for multi-storied weaker section housing - to build his house.

All this would have been economically efficient outcomes. Tendulkar and family would have been happy to get a much larger house built at a lesser cost (in terms of land value). The valuable piece of real estate would have been more optimally utilized, instead of being locked up in a sub-optimal home investment (I am sure that not many economists would claim that building a house on a land worth Rs 39 Cr is efficient allocation of scarce resources!). The overall impact on the economy, in terms of jobs created, taxes generated, and resources more efficiently deployed, would have been substantial in comparison to the present outcome.

In fact, everybody would have been better off even if the government had declared that area a green zone or restricted area (or barred re-development). A park would have benefited large numbers of people and generated much higher utility and overall benefits. Sachin Tendulkar would have invested his Rs 39 Cr elsewhere with higher FSI ratios and built a house which atleast fully met his requirements. Scarce resources, money and land, would have been more optimally utilized!

New consumer price inflation measure

A new consumer price index (CPI), which uses calendar year 2010 as the base (100), has been released that "combines data from rural and urban areas and includes sectors that were not part of the existing consumer inflation measure". It will take atleast an year for the CPI inflation rate with the new index to become available, though the CPI index figures themselves will be released every month.

The objective is to obtain a more accurate consumer inflation measure that can be used to formulate policies. The four current consumer price indices (which offer data for industrial workers, agricultural labourers, rural labourers, and urban non-manual employees) are too narrowly targeted to be relevant for macroeconomic policy formulation.

The new consumer price index has five major groups - food, beverages and tobacco group (59.31% in CPI-R and 37.15% in CPI-U); fuel and light group (10.42% in CPI-R, and 8.40% in CPI-U); clothing, bedding and footwear group (5.36% in CPI-R, and 3.91% in CPI-U); housing group (0% in CPI-R, and 22.53% in CPI-U); and miscellaneous group consisting of education, medical care, transport and communication etc (24.91% in CPI-R and 28% in CPI-U).

The measures will be available as CPI-Rural, CPI-Urban, and CPI-combined, and reported state-wise and nation-wide every month. The national CPI will be obtained by merging CPI (Rural) and CPI (Urban) with appropriate weights, as derived from NSS 61st round of Consumer Expenditure Survey (2004-05) data. The weights for all have been derived from the results of the same NSS survey. Price data from 310 towns and 1181 villages across the country will be used to calculate the CPI-U and CPI-R respectively.

This follows measures taken last year to bring forward the base year of the Wholesale Price Index (WPI) from 1993-94 to 2004-05 and increasing its basket of commodities to 676 from 435. There are also plans to revamp the index of industrial production (IIP) to better reflect contemporary consumption and help policy makers take better-informed decisions.

The WPI, which does not fully reflect the actual price impact on consumers, is now used to formulate monetary and other policies. In most developed economies, the consumer price inflation measures are used to guide policy making. The WPI represents only 45% of the economy and largely excludes the dominant services sector, which contrubutes to nearly half the national GDP.

The current regime of one WPI and four CPI's introduce considerable ambiguity and has been one of the important factors in the way of the RBI embracing a full-fledged inflation targeting framework.

In this context, a paper by Ila Patnaik, Ajay Shah and Giovanni Veonese on behalf of the National Institute of Public Finance & Policy (NIPFP) qyestions the suitability of prevailing CPI measures and prefer that the CPI-Industrial Workers (IE) is the most accurate measure of the headline inflation rate.

An ode to cities!

I am waiting to read Edward Glaeser's new book. Till then, via Freakonomics, a few snippets

1. The density of cities generate network effects - "Being near smart people matters". Enrico Moretti has found that people’s wages typically rise by about 8 percent as the share of their fellow urbanites with college degrees goes up by 10 percentage points. He writes,

"I find that a percentage point increase in the supply of college graduates raises high school drop-outs’ wages by 1.9%, high school graduates’ wages by 1.6%, and college graduates wages by 0.4%. The effect is larger for less educated groups, as predicted by a conventional demand and supply model. But even for college graduates, an increase in the supply of college graduates increases wages."

Further, "globalization and new technologies have increased the returns to being smart, and we get smart by being around other smart people".

2. Educated cities grow faster and can better adapt to economic declines. Edward Glaeser and Albert Saiz write,

"Educated cities have grown more quickly than comparable cities with less human capital... We also find that skilled cities are growing because they are becoming more economically productive (relative to less skilled cities), not because these cities are becoming more attractive places to live. Most surprisingly, we find evidence suggesting that the skills-city growth connection occurs mainly in declining areas and occurs in large part because skilled cities are better at adapting to economic shocks."

A good school system that harnesses the urban advantages of competition and innovation adds to the strength of cities.

3. Cities with large numbers of smaller firms have become innovation hubs and have tended to create more jobs. Edward Glaeser, William Kerr, and Giacomo Ponzetto have written,

"Employment growth is strongly predicted by smaller average establishment size, both across cities and across industries within cities, but there is little consensus on why this relationship exists. Traditional economic explanations emphasize factors that reduce entry costs or raise entrepreneurial returns, thereby increasing net returns and attracting entrepreneurs. A second class of theories hypothesizes that some places are endowed with a greater supply of entrepreneurship. Evidence on sales per worker does not support the higher returns for entrepreneurship rationale. Our evidence suggests that entrepreneurship is higher when fixed costs are lower and when there are more entrepreneurial people."

4. Successful cities keep atrtracting migrants. One pre-requisite to keeping the flow of migrants going is to have affordable housing. As cities grow, vacant spaces get exhausted. In the circumstances, the only way for cities to keep housing affordable is to keep building vertically. As Ed Glaeser writes, "Chicago’s sea of cranes on Lake Michigan helps explain why average condo prices in the New York area are more than 50 percent more than condo prices in the Chicago area."

5. Densified and vertically growing cities are more environment friendly than suburban sprawl. Building up is also an environmentally sensitive alternative to building out. Edward Glaeser writes,

"People who live in cities do tend to emit significantly less carbon than people who live in the country... That’s coming mainly from driving, from the fact that there’s just a lot fewer carbon emissions associated with dense living. It’s not just the move to public transportation; it’s also the drivers within cities — they’re just driving much shorter distances. And then, of course, it’s because of much smaller homes. The higher price of urban space means that people are living in smaller homes, even with the same family size. And that leads to lower electricity usage, lower home heating usage — and those are the facts that I think make cities seem, at least to my eyes, significantly greener."

See this excellent article on skyscrapers.

Update 1 (8/3/2011)

A person’s earnings rise by more than 7 percent as the share of people in his or her metropolitan area with a college degree increases by 10 percent, holding that person’s own level of education constant. Educated neighbors are particularly valuable in dense cities, where contact is more common. Edward Glaeser writes,

"Before the industrial revolution, cities were centers of small, smart companies that connected with each other and the outside world. Small companies and smart people are the sources of urban success today. The industrial city now seems like an unfortunate detour during which cities exploited economies of scale but lost the interactive exchange of ideas that is their most important asset...

A great paradox of our age is that despite the declining cost of connecting across space, more people are clustering together in cities. The explanation of that strange fact is that globalization and technological change have increased the returns on being smart, and humans get smart by being around other smart people. Dense, smart cities like Seattle succeed by attracting smart people who educate and employ one another."

Generators should respond to market signals

One of the last remaining relics of central planning that persists in Indian economy is in power generation. State-owned generators continue to set up high-cost power plants on considerations other than economic efficiency and viability and leaves the state distribution utility with no option but to purchase the power at whatever tariff. The generator's inefficiencies and resultant higher cost of power purchase is passed on to the consumers and tax payers.

In this context, without the usual fanfare associated with important policy decisions, the Ministry of Power, Government of India recently started implementing one of the most progressive reforms in power sector. As part of the National Tariff Policy, it has mandated that from January 5, 2011, all power purchases by distribution utilities should be only through tariff-based competitive bidding. As I have blogged earlier, the tariffs in competitive bids have been generally much lower than that arrived at through cost-plus tariff based PPAs.

It now emerges that, despite the clear mandate of Para 5.1 of the National Tariff Policy, several state government are trying to get round this decision on competitive tariff-based power purchases. They are taking the plea that this would not apply to them without the state regulator's approval. And given the evident lack of autonomy of most state regulators, it is almost certain that most of them will not notify this provision.

Given their high cost of power generation, the mandatory requirement for competitive bids would have effectively shut the door for state-owned generators. Instead of setting up power plants and then thrusting it on utilities, generators would now have to participate in open-competitive tenders and win the right to sell their power. Their high cost of power means that they are most likely to be priced out in any competitive bidding process and even from the short term markets.

Accepting such reforms would require generators to abandon their current supply-driven investment strategies and adopt capacity addition strategies that are demand-based. Generators would have to calibrate their investment decisions to the market signals and not invest in new plants based on extraneous considerations.

More on the China effect on the US Economy

The NYT has a nice summary of America's reliance on China to finance its massive current account deficits and public debts,

"For eight years after the United States resumed running large budget deficits in 2002, China was the largest lender, buying a fifth of the new Treasury securities sold during that span — an expenditure of more than $900 billion. During 2006, China financed more than half the American deficit. When the financial crisis struck hardest, China spent more than $100 billion on Treasuries over the two-month period of September and October 2008."

However, there has been a dramatic shift in the capital flows from China since early last year. The US Treasury Department has estimated that for the 12 months through November, China reduced its holdings of Treasuries by more than $36 billion. In the eight years from 2002-09, the total US Government debt rose by $4.4 trillion to $9.3 trillion, of which China financed a fifth, other foreign countries two-fifth, and Americans the rest.

Further, since the Chinese central bank indulged in massive purchases of dollars to keep the renminbi from appreciating, somebody has been purchasing those Treasuries. These purchases could have been by fund managers from other countries acting at the behest of China or currency traders and investors who arbitraged dollar with other currencies.

In another context, surrounding the Chinese President Hu Jintao's visit to the US, commentators have been comparing the threat posed by Chinese firms to that of Japanese firms in the eighties. Unlike the case with Japan, American firms have much greater exposure in China for a variety of factors. This they claim may make them more vulnerable to Chinese manipulation. They point to the US quarterly current account deficit with the US of $89.2 bn, which is four-and-half times more than that of Japan.



Japan sharply limited direct investment by foreign companies, while China welcomed it with the result that all major US companies have substantial investments there. Like Japan, the Chinese government too has insisted on technology transfers. They demand technology transfers and setting up of manufacturing plants in joint ventures for preferred access to the domestic market.

The Chinese government has been more aggressive with its industrial policy, outlining a lengthy list of industries where it has long-term ambitions - commercial aircraft, telecommunications equipment, high-speed trains, clean-energy goods like solar panels and wind turbines, and even automobiles. Finally, the Chinese domestic market is much larger than anything Japan could offer.

Update 1 (8/5/2011)

Laura Tyson argues that the demand for tough action on renminbi revaluation by American policy makers fails to recognize that the renminbi has already appreciated significantly relative to the dollar, exaggerates the benefits of a stronger renminbi for the United States and overlooks the benefits of a stronger renminbi for China itself.

She points to calculations by The Economist, since 2005, when China adopted its managed-band system, the renminbi has appreciated about 24 percent in nominal terms and about 50 percent in real terms relative to the dollar. An appreciation of the renminbi vis à vis the dollar would help China combat imported inflation, especially for oil and commodities whose world prices are denominated in dollars.

Men can make history...

.... all the more so in the age of Facebook and YouTube! There is recent evidence to this effect.

The pent-up discontent against the government of President Zine al-Abidine Ben Ali in Tunisia was unleashed into a street rebellion with the self-immolation of a 26-year old fruit vendor, Mohamed Bouazizi. This was in response to being slapped by Faida Hamdy, a 45-year-old municipal inspector in Sidi Bouzid.

He immediately became the hero and she the villain in a rebellion that resulted in President Ben Ali fleeing to Saudi Arabia on Jaunary 14 after 23 years in power. His suicide, the symbol of daily humiliations and petty corruption by low-level officials, was the catalyst for protests that spread from the countryside to the capital and then on to Egypt and across the Arab world.

One of the rallying points for Egypt’s revolution was the beating to death by the police in Alexandria last year of Khaled Said, a 28-year-old Egyptian businessman. He was pulled from an Internet cafe in Alexandria last June by two plainclothes police officers, who witnesses say then beat him to death in the lobby of a residential building. Human rights advocates said he was killed because he had evidence of police corruption.

A Facebook memorial dedicated to him, We Are All Khaled Said, maintained by a Google marketing executive named Wael Ghonim, evolved into an anti-torture site followed by hundreds of thousands of users on Facebook. Ghonim himself was kidnapped off the street in Cairo, blindfolded and held for 12 days. After his release, he gave an emotional television interview about his detention and the government’s brutal attempt to stop the protests that helped to add momentum to the movement.

The presence of social networking sites and video sharing channels like YouTube are extraordinarily powerful force multipliers for such revolts. An impassioned speech on human rights by Egyptian activist Asmaa Mahfouz, widely circulated on YouTube and Facebook, played an important part in mobilizing thousands of protesters to gather in Cairo's Tahrir Square on January 25, sparking off the rebellion that ultimately overthrew President Hosni Mubarak.

Shareholder capitalism under threat?

Stock markets, one of the bedrocks of modern capitalism, are supposed to ensure efficient allocation of financial resources by both providing a platform for businesses to raise investible funds and an outlet for investors, big and small, to invest their savings. However, there is an increasingly evident trend that questions whether either objective is being met.

On the one hand, businesses, atleast the best-performing ones, are raising an increasing share of their financial needs privately. On the other hand, the sharp market volatility of recent years, coupled with pervasive regulatory failures, mean that equity markets are no longer as safe and attractive an investment option for the small retail investor as earlier.

In an excellent NYT op-ed, Felix Salmon brilliantly captures the "noisy sideshow" that stocks markets have become in the US. He writes about the equity market trends in the US,

"The stock market is becoming increasingly irrelevant — a trend that threatens the core principles of American capitalism. These days a healthy stock market doesn’t mean a healthy economy, as a glance at the high unemployment rate or the low labor-market participation rate will show... What’s good for Wall Street isn’t necessarily good for Main Street... the glory days of publicly traded companies dominating the American business landscape may be over. The number of companies listed on the major domestic exchanges peaked in 1997 at more than 7,000, and it has been falling ever since. It’s now down to about 4,000 companies, and given its steep downward trend will surely continue to shrink... Put another way, as the number of initial public offerings steadily declines, the stock market is becoming little more than a place for speculators and algorithms to compete over who can trade his way to the most money."

He writes that the shares of innovative listed companies like Google and Apple "are essentially speculative investments for people making a bet on how we’re going to live in the future". Further, attractive technology firms like Facebook and Twitter raise resources privately and are therefore out of bounds common investor public. The insulation from regulatory oversight, investor accountability, and the pressures to match market expectations, mean that companies prefer it that way. His conclusion raises serious concerns,

"Only the biggest and oldest companies are happy being listed on public markets today. As a result, the stock market as a whole increasingly fails to reflect the vibrancy and heterogeneity of the broader economy. To invest in younger, smaller companies, you increasingly need to be a member of the ultra-rich elite."

Stock markets continue to be important sources of raising business capital in countries like India. However, like in the US and other developed markets, derivative operations have assumed an increasing share of equity markets in India.

An examination of the records on capital raised by private firms through private placement and public market offerings throws up interesting results. As can be seen, private placement remains the overwhelmingly major route for private firms to raise fresh capital and the preference is increasing.




Even after deducting the share of private financial institutions share in the private placement market, the figures remain heavily skewed in favor of the private placement route.

Given all this, primary market remains a small investment channel for retail investors. Most retail investor activity is confined to the secondary markets, and as mentioned above, increasingly to the derivative markets.

Data visualization charts of the day

1. Superb illustration of the widening income inequality in the US, using data put together by Emmanuel Saez, from the EPI website. Between 1917-2008, average incomes in the US grew by $38,216 (in 2008 dollars). The richest 10% got 51% of that increase and their share in the growth has been rising since the eighties.

2. Excellent visualization of President Obama's Budget proposals for 2011-12. New York Times has another superb spending category-wise visualization of how the $3.7 trillion is proposed to be spent, with changes from last year. Such graphics help sift through the avalanche of budget related data and informs at one glance the areas where spending cuts can make a difference to the overall budget deficit.

The iPhone success in perspective

Nothing captures the essence of Apple's overwhelming success with smart phones better than the graphic below comparing the trends in market and profit shares of all global cellphone makers. Apple has virtually decimated the field by capturing more than half the market profits since iPhone was launched in 2007, and that too with just 4% market share.



It sure helped that Apple could make a super-normal profit of $360 from an iPhone 4 which retailed for $600.

This market share is certain to fall. But it should take nothing away from Apple's spectacular success in such a competitive, dynamic and technology-intensive market.

Nudging with mobile phones on behaviour change

One of the important requirements for achieving behaviour change is the salience of behaviour change causing triggers. Information, presented in the most cognitively salient manner and with some close-enough periodicity, can be a powerful trigger to achieving behaviour change.

Mobile phones, thanks to their near universal coverage even in many developing countries and ubiquitousness in daily lives of citizens, have the potential to delivering such information. They are an excellent channel for doctors and health care professionals to maintain a continuous dialogue with the patients.

In recent years there have been numerous studies on experiments that have used mobile phones to both generate optimal treatment response and more effectively manage disease incidence. They have relied on using reminders to people about medication and treatment schedules and management of their eating and lifestyle behaviours.

A randomized control study on adherence to antiretroviral therapy (ART) for AIDS using mobile phone SMS reminders in Kenya among 431 adult patients over 48 weeks found that "weekly text reminders increased antiretroviral drug adherence from 40% to 53% of participants". The authors write,

"In intention-to-treat analysis, 53% of participants receiving weekly SMS reminders achieved adherence of at least 90% during the 48 weeks of the study, compared with 40% of participants in the control group (P = 0.03). Participants in groups receiving weekly reminders were also significantly less likely to experience treatment interruptions exceeding 48 h during the 48-week follow-up period than participants in the control group (81 vs. 90%, P = 0.03)."

In a study about application of sun protection creams to reduce the risk of developing skin cancer, 70 patients in the 18-72 age group were sent cell phone text messages (along with weather report, at 7 AM) reminding them to apply their sunscreen daily for six weeks. The patients’ adherence to daily sunscreen usage was evaluated with a novel electronic monitoring device, which was strapped onto the tube of sunscreen - when the cap of the sunscreen tube was removed, the device sent a text message to researchers that was then recorded as evidence of sunscreen use.

The study found that text reminders increased the proportion of people who applied sun protection from 30% to 56%. Specifically, the 35 subjects who received daily text message reminders to apply sunscreen had a mean daily adherence rate of 56 percent compared to a mean daily adherence rate of only 30 percent by the 35 subjects who did not receive reminders.

A review of 12 RCT studies which examined the use of text messages to promote weight loss, get people to stop smoking and manage diseases like diabetes and asthma, found evidence to support text messaging as a tool for behavior change in eight of nine 'sufficiently powered studies'. The authors write,

"Twelve randomized controlled trials published between 2005 and June 2009 of interventions for disease prevention and management using text messaging were reviewed. Nine countries were represented, only one of which is a developing country. The majority of the studies (8) found evidence of a short-term effect regarding a behavioral or clinical outcome related to disease prevention and management. Of those that found no evidence of effect, only one had sufficient power to detect an effect in the primary outcome. Evidence for text messaging in disease prevention and management interventions was observed for weight loss, smoking cessation, and diabetes management. Effects appeared to exist among adolescents and adults, among minority and non-minority populations, and across nationalities."

The NYT reports of a mobile phone messaging service in the US, text4baby, "that sends free text messages to women who are pregnant or whose babies are less than a year old, providing them with information, and reminders, to improve their health and the health of their babies". Registration can be done from your cell phone by simply texting the word BABY (or BEBE for Spanish) to 511411. The sender will be asked to enter the baby’s due date or baby’s birthday and zip code. Once registered, the sender will start receiving free messages with tips for pregnancy and caring for baby. These messages are timed to the due date or the baby’s birth date.

Iceland Vs Ireland?

Almost alone among those who faced the depths of the financial crisis, Iceland refused to bailout its financial institutions. It placed its biggest lenders in receivership and chose not to protect creditors of the country’s banks, whose assets had ballooned to $209 billion (11 times GDP). In other words, the creditors, not the taxpayers, shouldered the losses of banks.

The krona lost 58% of its value by the end of November 2008, inflation spiked to 19% in January 2009 and GDP contracted by 7% that year. The Prime Minister Geir H. Haarde resigned after nationwide protests.

As a Bloomberg report argues, if early signs are any indicator (with economy projected to grow 3% in 2011), then Iceland’s decision to let the banks fail is looking smart and may provide important lessons for others. The GDP grew for the first time in two years in the third quarter, by 1.2%, inflation is down to 1.8%, the cost of insuring government debt has tumbled 80%, and banks have bounced back into the profitability.

The three biggest Icelandic banks - Kaupthing Bank hf, Landsbanki Islands hf and Glitnir - who had indulged in the spectacular lending spree at home and overseas were seized by regulators on October 6, 2008. The Bloomberg report writes,

"The government negotiated with the creditors, almost all of them outside the country, including mutual funds and hedge funds in the US and the UK and European banks and pension funds. Kaupthing’s creditors agreed to take an 87% stake in Arion, and Glitnir’s creditors now own 95% of Islandsbanki. Glitnir’s biggest creditor as of June was Dublin- based Burlington Loan Management Ltd., followed by Royal Bank of Scotland and DekaBank Deutsche Girozentrale, the fund manager for Germany’s state-owned savings banks.

Glitnir’s 8,500 creditors and Kaupthing’s 28,000 expect to get about 30 cents on the dollar for their claims, based on secondary-market prices of the banks’ debt and asset valuations by the resolution committees. About half of Kaupthing’s creditors are German depositors who had Internet accounts, have gotten their principal back and are seeking interest payments.

Landsbanki’s creditors opted for a promissory note from successor NBI hf instead of a stake in the new bank. Landsbanki had collected about $5 billion of overseas deposits through branches in the U.K. and the Netherlands. Iceland didn’t guarantee those deposits at the time it seized the bank, as it did for domestic customers, leading to a dispute with the British and Dutch governments. In December, Iceland agreed to compensate the U.K. and the Netherlands in full for their payments to Icesave depositors, as the Landsbanki accounts were known. Payment, including interest of about 3 percent, will be made over 35 years."

In contrast, Ireland guaranteed all the liabilities of its banks when they ran into trouble and has so far injected 46 billion euros ($64 billion) as capital so far to prop up these banks. The result is an unsustainable debt burden that could swell to twice its GDP, up from 94% now and the near certainty of a sovereign debt default. It is a widely held feeling in Icleand that if it had guaranteed all the banks’ liabilities, they would have been in the same situation as Ireland.

See this Vanity Fair article by Micheal Lewis on Ireland. Micheal Mandel has an excellent series of graphics that puts the role of external sector, exports/imports and financial profit repatriations, on Ireland's economic fortunes in perspective.

The M-PESA success story

It is undoubtedly true that the mobile phone is one of the really revolutionary inventions of our times, with the potential to transform human lifestyles and the way we even do business. Fundamental to its success is its ability to bridge the last-mile connect and deliver numerous services.

I have already blogged about its potential to revolutionize the way people manage their finances. The most famous example of this is the M-PESA - an SMS-based money transfer system that allows individuals to deposit, send, and withdraw funds using their cell phone - that was launched in March 2007 by the Kenyan cell-phone company Safaricom. Today M-PESA reaches approximately 65% of Kenyan households. Similarly, in the Philippines, Globe Telecom operates GCASH, and in South Africa WIZZIT facilitates mobile phone‐based transactions through the formal banking system. An excellent working paper by William Jack and Tavneet Suri documents the rise of M-PESA.

M-PESA is not a banking service. It does not pay interest on deposits nor make loans. It allows users to deposit money into an account stored on their cell phones, to send balances using SMS technology to other users (including sellers of goods and services), and to redeem deposits for regular money. In this sense, M-PESA transfers fungible cellphone talk time.

In exchange for cash deposits, Safaricom issues a commodity known as e-float or e-money, measured in the same units as money, which is held in an account under the user’s name. E-float can be transferred from one customer’s M‐PESA account to another using SMS technology, or sold back to Safaricom in exchange for money. Charges, deducted from users’ accounts, are levied when e-float or e-money is sent, and when cash is withdrawn.

Originally, transfers of e-float sent from one user to another were expected to primarily reflect unrequited remittances, but nowadays, while remittances are still a very important use of M-PESA, e-float transfers are often used to pay directly for goods and services, from electricity bills to taxi-cab fares. To facilitate purchases and sales of e-float, M-PESA maintains and operates an extensive network of over 23,000 agents across Kenya. M-PESA agents hold e-float balances on their own cell-phones, purchased either from Safaricom or from customers, and maintain cash on their premises. They only have to predict the time profile of net e-float needs, and maintain the security of their operations.

M-PESA caters to a specific category of small transactions. The paper finds that the volume of transactions effected between banks under the RTGS (Real Time Gross Settlement] method is nearly 700 times the daily value transacted through M-PESA, and the average mobile transaction is about a hundred times smaller than the average check transaction (Automated Clearing House, or ACH), and even just half the size of the average Automatic Teller Machine (ATM) transaction.

The paper documents many advantagees of mobile phone money transfers. They include facilitation of trade, making it easier for people to pay for, and to receive payment for, goods and services; provide a safe storage mechanism, and thereby increase net household savings; facilitates inter-personal transactions and thereby improve the allocation of savings across households and businesses by deepening the person-to-person credit market; by making transfers across large distances trivially cheap, it improves the investment in, and allocation of, human capital as well as physical capital (say, promote migration); it enhances the ability of individuals to share risk; it enables timely money transfers and thereby provides always-on access to money; empower women, and so on.

Three examples on the Laffer Curve canard

One of the fundamental tenets of supply-side economics invokes the Laffer Curve to argue that we stand on the downward sloping side of the curve and therefore tax cuts will increase revenues. I have blogged earlier to show how it does not square up with recent historical experiences with tax cuts.

Chris Dillow points to three examples that show the economy on the positive (rising) side of the Laffer Curve.

1. Henrik Kleven, Emmanuel Saez and Camille Landais study the response of professional footballers in Europe to tax rates and conclude that the revenue-maximizing tax rate upon them in England is over 80%. This would easily put the current tax rate at the left of the Curve.

2. Orley C. Ashenfelter, Kirk B. Doran, and Bruce Schaller examined a panel dataset of New York City taxi drivers and the impact of permanent fare increases on their number of hours worked. They found a negative elasticity, of around minus 0.2 - a 10% rise in cabbies' revenue per mile caused them to work 2% less. This points to the income effect outweighing the substitution effect in the long run labor supply of males.

On similar lines, if what’s true of cabbies is also true of bankers, higher taxes on the rich will reduce their incomes. And if the income effect dominates, they will work harder to recoup the money. Chris Dillow also points to higher earners having a stronger taste for income than other people - this is why they are high earners. But this increases the chances of them working harder in response to higher taxes.

3. Pierre Cahuc and Stéphane Carcillo examined the impact on labor supply of the detaxation of overtime hours (exemption on the income tax and social security contributions that applied to wages received for hours worked overtime) introduced in October 2007 to allow individuals in France to work more so as to earn more. They found that it was costly for the public purse and did not have any significant impact on hours worked.

Conversely, it has had a positive impact on the overtime hours declared by highly qualified wage-earners, who have opportunities to manipulate the overtime hours they declare in order to optimize their tax situation, since the hours they work are difficult to verify. This again confirms Dillow's point about higher earners having a stronger taste for income than other people.

I cannot but not agree with Chris Dillow's conclusion,

"Now, this is not to deny that Laffer curves exist. No doubt, there is a point at which higher taxes would be counter-productive and tax cuts would pay for themselves... But where is the hard evidence that, at tax rates around current levels, there are such effects?"

Outcome-based venture capital financing of social policy

Imagine this social policy experiment. Crimeland prison has among the highest prisoner recidivism rate (prisoners are convicted of another crime within one year of release) in Globonia. Then World Without Crime Foundation (WWCF) comes up with a proposal that commits to lower recidivism rate by atleast 50% (after adjusting for the national average decline) over three years. It would cost $50000 to implement the program over its three years.

So WWCF offers to finance the entire upfront investments in return for being given Prison Improvement Bonds. These Bonds would have 4 year maturity and would be redeemed with returns which are based on the percentage of reductions (over and above the promised 50% minimum) achieved with recidivism. However, if the experiment fails to yield the expected minimum returns, the investors get nothing and lose their principal.

David Leonhardt points to a real-world experiment with such bonds in Britain. The British Government has initiated a program at Her Majesty’s Prison Peterborough, where 60% of the prisoners are convicted of another crime within one year of release. A nonprofit group named Social Finance has raised about $8 million from investors and is implementing, in collaboration with the prison authorities, a program to help former prisoners find work, stay healthy and the like. Some 3000 prisoners are being covered under this, which started last year.

Investors will get their money back starting in 2014 — with interest — if the recidivism rate falls at least 7.5%, relative to a control group. If the rate falls 10%, the investors will receive the sort of return that the stock market historically delivers.

They form part of the emerging category of social policy financing - social impact bonds. It has also been called payment-by-performance by the British government officials. Non-profit groups like foundations pay the initial money for a new program and also oversee it, with government approval. The government will reimburse them several years later, possibly with a bonus — but only if agreed-upon benchmarks show that the program is working. If it falls short, taxpayers owe nothing. It is hoped that success with a few initial interventions could help build a mainstream social investment market that attracts financial institutions and retail investors.



The British government is also planning to raise about £5m to develop a further package of two or three more social impact bonds. These bonds could fund programmes reducing the number of children going into care, working with children in pupil referral units, diverting persistent women offenders from prison, and developing more effective drug rehabilitation projects. Schemes to tackle long-term health problems in the community, such as diabetes and asthma, could also produce big savings in acute hospital bills.

In the US, David Leonhardt also reports that the Obama administration is set to shortly propose seven pilot programs, costing up to $100 million, along these lines. The financing mechanism will be described as pay-for-success bonds. They are set to broadly focus on increase kindergarten readiness among low-income children; increase college completion rates; reduce criminal offenses and incarceration rates among minority youth; raise the future earnings of laid-off workers; reduce hospital readmissions among patients with chronic illness etc.

What are the advantages with such social policy venture capital funds? One, most importantly, it will bring in a culture of outcome evaluation into social policy spending. Two, governments can hedge against the downside risk of the intervention failing. It will ensure much greater bang for the buck with social policy spending. Three, the hedging against downside risks also makes it easier for governments to embrace innovative programs that would otherwise have not found the light of day for risk aversion and status quo bias.

Four, Governments strapped for cash would not need to cough-up resources upfront, especially for programs whose returns are likely to show-up only after a few years. They would need to make payments only on the successful implementation of the intervention. Five, non-government agencies, non-profit and for-profit, get the platform (with all the attendant logistical support) of government agencies to experiment on their initiatives. This would marry the professional expertise and commitment of the non-government agencies with the existing government systems. Six, it will enable more effective utilization of non-government funds. Today, much of these funds are frittered away on piecemeal interventions that have little policy value.

However, there are several formidable challenges that need to be surmounted before this approach can achieve its desired objective. Which interventions to select? Which outcomes to measure, with what parameter, and how do we benchmark them? What should be the baseline and expected outcome scores? What should be the appropriate control group?

There is the possibility of external agencies being entrusted perfectly doable projects and walking away with assured returns. Ensuring the selection of parameters that, with a reasonable degree of accuracy, measures outcomes is a difficult task and one that can be very easily subverted. Both the baseline calculation and the final outcome fixation should be done with adequate care and after rigorous due diligence. The final outcome should be adjusted for changes that would have taken place even without the intervention. In the absence of clear definition of the target population, the external agency will have an incentive to cherry-pick and present a distorted picture of its achevements. Finally, the control group should be selected with appropriate care so as to be representative with the treatment.

In fact, the details of such initiatives should be arrived at only through a rigorous professional exercise carried out by competent agencies, and devoid of political and anecdotal judgements. On a note of caution, atleast for the initial set of such financing interventions, it may be better to leave out economic cost-benefit analysis (and focus on the financial benefits by way of budgetary savings) from calculations of return on investment. It may be advisable to focus on interventions (or outcome measurement parameters) where the benefits are more easily quantifiable by comparison with a relevant control group. Further, decentralized interventions are more likely to succeed, at least in the initail stages, with such financing programs.

Update 1 (22/6/2012)

Nice Fixes column on social impact bonds. It points the work of an organization One Service, which has brought together four social service groups to provide comprehensive assistance to men released after serving short-term jail sentences at Peterborough Prison near London. It informs that the idea of social impact bonds originated from various thinkers, social service experts and captains of industry in Britain who formed a group called Social Finance to build a social investment market there.

One Service raised £5 million — about $8 million — from 17 investors in Britain and the United States, and the investors will get their money back only if One Service succeeds. The bondholders are mostly charitable groups who would normally give money away. Over the next six years, the recidivism rates of men released from Peterborough will be compared to the recidivism of a matched group of prisoners elsewhere. If Peterborough’s re-conviction rates are 7.5 percent less than the control group,the British government will repay the bondholders with interest. If that threshold isn’t met, investors lose their money, which means that technically it is not a bond. The better the recividism rates, the larger the payout for investors, which is capped at the equivalent of 13 percent per year over an eight-year period.

See also this McKinsey report on Social Impact Bonds.