Back to square one - financial market regulation?

The bitter lessons of the sub-prime crisis appears to be slowly receding away from memory and the unhealthy practices that inflated the sub-prime bubble era are returning back with vengeance. Now that the markets are back to normal, atleast in appearances, the urge to return to the boom days is proving irresistible.

The latest evidence comes from the US Federal Reserve’s recent decision to allow major banks to increase their dividends and to buy back shares. The decision comes in the aftermath of the Fed's Comprehensive Capital Analysis and Review (CCAR), a cross-institution study of the capital plans of the 19 largest US bank holding companies.

In an excellent post, Simon Johnson has strongly contested this decision and the validity of the CCAR to reliably assess the strength of banks

"The Fed’s decision on dividends effectively lets the banks pay out shareholder equity, making the banks more highly leveraged... Bank executives and other key personnel are paid on a "return on equity" basis, so this increases their upside — that is, what they will make as long as the economy and their sector does well... Any individual bank will want to keep its equity levels low, because its executives and owners are not worried about system-wide spillover costs, such as what happens to other banks when one bank fails."

The failure risk for big banks is mitigated by the blanket insurance provided by the too-big-to-fail problem - governments cannot allow such institutions to sink for fear of a financial market meltdown. The bank executives, creditors, and even shareholders, all suffer from the moral hazard problem arising from this.

In a letter to the Financial Times, Anat R Admati and her colleague financial academics, had this to say about dividend payouts and share buybacks,

"A dollar paid out to shareholders through either dividends or share repurchases is a dollar that would not be accessible to creditors in a situation of financial distress. For this reason, and to prevent the shifting of value from debt holders to equity holders, debt covenants typically restrict dividend payments when leverage is high... taxpayers should be concerned when banks pay dividends and remain thinly capitalized, because, as we have seen, taxpayers are the ones who are likely to end up covering the banks' liabilities in a crisis... retaining earnings is generally viewed as the least costly way to raise funds and build capital, as it avoids the transactions costs associated with new equity issuance."

This debate revolves around one of the most fundamental problems in modern financial markets - who will bear the cost of addressing the systemic risks (with its massive negative externalities) that are generated by certain actions of banks, what should be that cost, and in what form should it be levied?

The sub-prime crisis has drawn attention to the dangerous consequences of excessive risk-taking and leverage, and the systemic risk created by too-interconnected to fail big financial institutions (the TBTF problem). The tax payers had to bear the burden of the massive amounts required to bailout financial institutions in the aftermath of the bursting of the mortgage bubble. It is therefore universally accepted that these financial institutions have to internalize the cost of addressing the systemic risks generated by their actions.

It is widely acknowledged that adequate equity capital and reasonably high enough counter-cyclical risk weighted capital reserves are necessary to meaningfully resolve these problems. The global banking regulators recently announced the Basel 3 regulations in an effort to mitigate the systemic risks that arise in the financial markets. However, a large number of influential financial economists have argued that the capital reserves required to address such risks are much higher than what is proposed under the Basel 3.

In an excellent NYT article Gretchen Morgenson points to a few other instances of attempted regulatory dilution as the Dodd-Frank Law becomes operational. These measures are being pushed by taking the cover of getting the securitization, derivatives and the mortgage market moving again and to buoy falling home and other asset prices.

One of the biggest achievements of the new legislation was to route all derivative trades through clearing houses and exchanges. However, now bankers are calling for exempting currency swaps from Dodd-Frank citing a provision that permits the Treasury secretary to exempt foreign-exchange swaps from the regulation. Foreign exchange swap trades are in the range of about $4 trillion a day, and trading in foreign-exchange contracts generated revenue of $9 billion in 2010 in the top five US banks, more than was produced by any other type of derivative.

Critics say that the only the only reason this market did not seize up like others during the meltdown was that the Fed lent huge amounts — $5.4 trillion — to foreign central banks through so-called swap lines during the fall of 2008. However, the Treasury Secretary Tim Geithner looks inclined to providing the exemption.

There are details of interpretation of specific provisions in the Dodd Frank law that could determine whether the relevance or otherwise of the regulation. One concerns how regulators define a 'qualified residential mortgage'. Morgenson writes,

"Issuers of asset-backed securities that are made up of such loans needn’t keep any credit risk of those securities. But sellers of loan pools that don’t consist of qualified mortgages are required to retain some of the risk in them. This provision was meant to eliminate the perverse incentives of the mortgage boom, when packagers of loan pools were encouraged to fill said pools with toxic waste because they had little or no liability for the deals once they were sold.

What constitutes a qualified mortgage has become a battleground issue because of the risk-retention rules under Dodd-Frank. Qualified mortgages should be of higher quality, based upon a borrower’s income, ability to pay and other attributes to be decided by financial regulators... Among the questions to be considered is how much of a down payment should be required in a qualified loan, and whether mortgage insurance can be used to protect against the increased risks in loans that have smaller down payments.

The use of mortgage insurance during the boom effectively encouraged lax lending. Investors who bought securities containing loans with small or no down payments were lulled into believing that they would be protected from losses associated with defaults if the loans were insured. But when loans became delinquent or sank into default, many mortgage insurers rescinded the coverage, contending that losses were a result of lending fraud or misrepresentations. When they did so, the insurers returned the premiums they had received to the investors who owned the loans.Lengthy litigation between the parties is under way but has by no means concluded.

Clearly, for many mortgage securities investors, this insurance was something of a charade. So any argument that mortgage insurance can magically transform a risky loan into a qualified residential mortgage should be laughed off the stage. And yet, mortgage insurers are making those arguments vociferously in Washington."

She also points to the battle to re-open trade on covered bonds - pools of debt obligations that have been assembled by banks and sold to investors who receive the income generated by the assets, while the issuing bank retains the credit risk. The problem with this is that since the investors who bought the covered bonds would have first call on the banks' assets (over that of the FDIC), this would wind up bestowing a new form of government backing (FDIC's deposit insurance) to the major banks issuing the bonds.

And confirmation that things are indeed getting back to normal comes from the graphic below of financial sector (it accounts for less than 10% of the value added in the economy) profits, which have regained its pre-crisis share and is back to more than 30% of all domestic US profits



Felix Salmon should have the last word,

"Banks are still extracting enormous rents from the economy, and profits which should be flowing to productive industries are instead being captured by financial intermediaries. We’re back near boom-era levels of profitability now, and no one seems to worry that the flipside of higher returns is higher risk. Any dreams of seeing a smaller financial sector have now officially been dashed. And the big rebound in corporate profits since the crisis turns out to be largely a function of the one sector which we didn’t want to recover to its former size."

Why letting off the bribe-giver will not reduce corruption?

The Chief Economic Advisor to Government of India, Prof Kaushik Basu has an interesting paper (via Mostly Economics) where he advocates that the act of giving harassment bribes (bribes that people often have to give to get what they are legally entitled to) be made legitimate. He writes,

"In other words the giver of a harassment bribe should have full immunity from any punitive action by the state. It is argued that this will cause a sharp decline in the incidence of bribery. The reasoning is that once the law is altered in this manner, after the act of bribery is committed, the interests of the bribe giver and the bribe taker will be at divergence. The bribe giver will be willing to co-operate in getting the bribe taker caught. Knowing that this will happen, the bribe taker will be deterred from taking a bribe... this entire punishment should be heaped on the bribe taker and the bribe giver should not be penalized at all, at least not for the act of offering or giving the bribe... such a change in the law will cause a dramatic drop in the incidence of bribery"

I could only say, "If only it were this simple"! Consider these,

1. Prof Basu's arguement makes the same mistake as other standard models that explain corruption. It overlooks the supply-side (bribe-giver) incentives and remains confined to the demand-side (bribe-taker). It needs to be borne in mind that apart from officials demanding bribes, harassment bribes are also paid because people are willing to pay a higher price (than the official fees) to access the service at their convenience.

As I have blogged earlier, this willingness to pay is manifested either in the higher direct bribes paid by those applying for government services or the payments made to middlemen who help procure the service. Merely addressing the demand-side incentives, while over-looking (and in this case, maybe, even furthering) the supply-side ones, is not likely to deter bribery.

2. Any amendment to the Prevention of Corruption Act (PCA) 1988 by repealing Section 12 (which defines the punishment to abettors) should have no effect on the incentives of those bribe-givers who bribe with an intention to trap the official. This category of bribe-givers are already protected by Section 24 read with the Supreme Court judgements (Bhupinder Singh Patel v. CBI, 2008 (3) CCR 247 at p. 261 (Del): 2008 Cri LJ 4396) indicated in Prof Basu's paper. This protection comes if the bribe-giver is able to establish that "the bribe was given unwillingly and in order to get the public servant trapped".

This is all the more easier to prove in case the bribe-givers are planning to trap the official with help of the local anti-corruption agency. In such cases, the entire bribe-giving process, though done secretly, is done with the assistance of the agency. And all this is in addition to the specific protections given under the respective state legislations to people approaching anti-corruption agencies to trap those demanding bribes.

Even without any amendment, the bribe-giver has the freedom to complain before the anti-corruption agency and lay a trap to catch the bribe-taker. In the circumstances, the amendment, atleast theoretically does not change the incentives of the bribe-givers.

3. The model suggested by Prof Basu gives excessive weight to incentives and assumes that changing those incentives will alter the bribe taking and giving environment. I am inclined to argue that this overlooks the critical role of enforcement.

There is nothing secretive about corruption in most government offices. It is part of the local gossip - who takes money, how much, through which channel, and so on. All anti-corruption agencies are well aware of this. It is only that they choose not to act unless prodded by a specific complaint.

In the circumstances, merely changing incentives will change nothing in the game. As already indicated, the incentives are already there (all the more so with sting operations by television channels etc). It is just that enforcement is abysmally weak.

4. There is the challenge of reforming a system where deviance is the norm. Standard models of addressing corruption works under the presumption that corrupt practices exist at the margins or are not widely prevalent. In such circumstances, the fear of being caught is large enough to deter bribe-taking at the margins.

However, when the practice is so widespread as to be a norm (as is the case with say getting a certificate from a Land Revenue official), conventional regulatory and incentives driven solutions become toothless. The deterrent effect of being caught is attenuated when the bribe-taker realizes that his actions are similar to that of the majority of his colleagues.

What will you do when the same corrupt practice bedevil most of the offices? How effective is the deterrent effect of being caught when the practice is widespread and the anti-corruption agencies are over-stretched (and in any case do not have the commitment to pursue such cases)?

In such a milieu, for "bribe-giver trapping bribe-taker" (and thereby deterring the "bribe-taker") strategy to be effective, there will have to be such incidents on an unimaginably massive scale. As we know, sending everyone to jail or suspending/trapping a considerable majority of officials is simply unrealistic.

5. Finally, there are perverse incentives associated with such changes, which are likely to harm the morale and fabric of the bureaucracy. It would come as a surprise to many readers to know that a not insubstantial number of such trappings across all states are motivated by work-place rivalries and social factors (caste politics). In fact, in many departments, threat of trappings are used as an instrument by local politicians to control officials. (None of this is to condone such corruption nor claim that such victims are innocent)

In fact, at the lower levels of the bureaucracy in rural areas, such threats are used to blackmail officials indulging in petty corruption. In fact, more often than not, those trapped are amongst the least venomous. The influential and the most corrupt have their strategies to manage the anti-corruption agencies and avoid being caught. This strategy also suits the officials of the anti-corruption departments who can meet their annual targets by targeting these lower-level officials.

In conclusion, for any anti-corruption (to contain harassment bribes) strategy to be effective, the bribe-taker and bribe-giver have to be respectively deterred from taking and giving bribes, and the enforcement machinery has to be responsive to those complaining to them and actively pursuing those suspected of taking bribes. Piece-meal administration of elements of this complex strategy is certain to fall flat, far from causing any "dramatic drop in the incidence of bribery".

PS: There are many real world issues I have not even mentioned - the difficulty of proving in a court of law that bribe was taken and the money has to be returned, the natural reluctance of citizens to be entangled in court litigation and being perceived as on the wrong side with government officialdom etc.

Update 1 (9.4.2011)

There is another reason why the bribe-giver-trapping-the-bribe-taker arrangment will not find too many takers. In a game theorey perspective, the bribe-giving citizen is not playing an one-off game. He plays repeated games with his bribe-taking interlocutors and their partners in the government. Accordingly, if a bribe-giver has a reputation for trapping officials, then he faces the strong possibility of being harassed (or atleast deeply inconvenienced) by the bribe-taking community. Therefore, when weighing the costs and benefits of trapping against not-trapping, the citizen feels it prudent to go along with the latter.

The impossibility of policing "insider information"

The investigations surrounding the Galleon hedge fund insider-trading scandal has provided an opportunity to observe the backroom activities that often underpin the actions of financial market traders and analysts.

In particular, of interest to readers in India, have been the revelations (transcript here and podcast here) that the former Chairman of McKinsey, Mr Rajat Gupta, was constantly passing on critical insider information to Galleon founder Mr Raj Rajaratnam, about investment decisions of firms on whose Mr Gupta was serving. The SEC, as part of its largest insider trading investigations, have found evidence that Mr Gupta passed on information to Mr Rajaratnam immediately after Goldman Sachs board meetings he attended and Mr Rajratnam in turn made investments based on that information.

The investigations have thrown up several examples of such practices. Mr Anil Kumar, a McKinsey director, put his own reputation at risk, and passed insider information about Goldman's clients, in return for $2.6 m. Mr Rajiv Goel, an Intel Manager, has testified that he passed on advance information about the semiconductor group’s earnings to Mr Rajaratnam. There are surely more skeletons that will come tumbling down as the trial progresses.

It is inevitable that insider information on business dealings will be shared during socializing within a closed friendship network of financial market executives. Such information transfers can be either part of party gossip or deliberate leakages. It is inconceivable that atleast some of this information will not be used by some members of the group to make beneficial financial investments (directly or indirectly, through their partners). Since most of these executives are also investors in these markets, the incentive to profit from such opportunities are often irresistible.

In this context, Luigi Zingales points to a working paper by Andrea Frazzini, Christopher J. Malloy, and Lauren Cohen who find that college friendship ties generate a considerable premium. They find that portfolio managers place larger bets on firms that have directors who are their college mates, earning an excess 8% annual return. He writes,

"A benign interpretation of these results is that college mates know each other better; thus, a portfolio manager has an advantage in judging the quality of the CEO better if they spent time with him or her in college. But this benign interpretation is difficult to reconcile with the finding that these positive returns are concentrated around corporate news announcements."

In simple terms, it is almost impossible to police insider information sharing within small friendship networks and investment transactions based thereon. Criminalizing such information disclosure and moral suasion to encourage executives to keep such information confidential, while partially effective, have their limits. In fact, I would be surprised if insider trading were not rampant within corporate circles. The incentives are simply too attractive for atleast a substantial numbers of actors to forego. Only those with the strongest moral character can be relied upon to constantly resist the allurements from such information sharing.

Much the same conflicts of interest entangle government officials. They come from the same stock and faced with similar incentives are likely to react no differently. Consider this. Mr Babu Ram is the official who heads the Industries Development Corporation of Briberonia. The Government of Briberonia decides to set up an ambitious Special Economic Zone (SEZ) in about 100 Acres, about 25 km away from Metropolis, its capital city. Mr Babu Ram also heads the Committee that is to soon finalize the SEZ proposal.

Mr Realtor Ram is one of Mr Babu Ram's closest friends. During one of the regular family dinners, Mr Babu Ram mentions about the SEZ proposal. Mr Realtor Ram realizes the significance of this in terms of its potential impact on land values around the proposed SEZ location. He suggests that they buy a few acres at the prevailing cheap rates in anticipation of prices rising manifold once the SEZ is developed in a few years. Accordingly, Mr Babu Ram and his friends make considerable investments in the area.

One of the distinguishing features of the real estate bubbles in many Indian cities is the close nexus between politicians, bureaucrats, and real estate developers. Property developers have made rampant use of insider information to purchase massive extents of land adjacent to upcoming (and unannounced) mega industrial and infrastructure projects.

There is a slippery slope with such information disclosures and consequent actions. Such information is often used to dispossess poor people off their lands at very cheap prices and leave them laborers on their own lands. Further, once the regulators (the officials and politicians) have themselves invested in lands surrounding a project area, they develop a stake in the project itself, which often ends up distorting the government decisions on the project itself.

Such conflicts of interest are not confined to land issues. There is the likelihood that officials administering tenders on huge infrastructure and IT projects share confidential information (again, deliberately or as party gossip) on either the tender details or rival bidders within a friendship network. This could in turn unfairly favor some bidders, often in return for some benefits for the officials. A college friendship network involving an official and a potential bidder is amongst the commonest channel for such insider information transfers.

Just as in the financial markets, the service rules of government officials specifically prohibit such information disclosures. However, like in the financial markets, this has not prevented officials from working closely with private business interests and striking mutually beneficial relationships that have caused loss to the public exchequer.

In any case, I am inclined to the belief that, contrary to the optimism of Luigi Zingales that only a small proportion of traders are rotten apples, such unethical practices are more widespread in both corporate and government circles than we would like to believe. And as simple Econ 101 would teach us, higher the stakes, greater the incentives, and greater the possibility of prevalence of such trends.

Free distribution or positive subsidized price?

Over the last few years, there have been a proliferation of field experiments across developing countries which have tried to examine the impact of pricing on the uptake of various health protecting products by poor people. What is the price (in terms of both incentivizing purchase and ensuring usage of the product) or subsidy that delivers the greatest bang for the buck?

The standard belief has been that people will not value products and services that are provided free. It is therefore most effective if these products and services are delivered at some small nominal cost, so as to foster a sense of ownership among the beneficiaries. People are more likely to use soap for cleaning their hands or chlorine for sanitizing drinking water or ITNs to keep-off mosquitos if these products are provided at nominal rates.

However, Randomized Control Trials (RCTs) in Kenya, Zambia and India have shown that uptake for products like insecticide treated bednets (ITNs), soaps, chlorine pellets, and de-worming tablets was highest when they were distributed free and uptake reduced exponentially when prices were raised even slightly. These findings are now being invoked to call for free distribution of health protecting, education improving and other welfare enhancing products and services to poor people across the world.



In fact, the RCT experiments have gone further and explored various other dimensions of usage. Pascaline Dupas and Jessica Cohen found several interesting results from their ITNs RCTs in Kenya - those who purchase ITNs are no more likely to be sick at the time of purchase (screening effect); those who are distributed free are no less likely to use it than those who paid (subsidized prices) and purchased nets (sunk-cost effect).

However, they found that subsidized positive prices dampens demand - ITNs uptake drops by sixty percentage points when its price increases from zero to $0.60 (or from 100% to 90% subsidy). Another study that provided un-subsidized ITNs with micro-consumer loans in India found that the uptake (usage the previous night) was just 16%, compared to 2% in control areas and 47% with free distribution.

There are several imponderables and mixed results that prevent drawing any generic inferences about pricing from these experiments. It is not possible to argue that free provision unambiguosly increases usage. Further, if a price is charged, it is even more difficult to arrive at a reasonably accurate price point where both purchases and usage is optimized for each product. Uncertainty on pricing can tip the scales either way. A few observations from these studies

1. It is premature to start generalizations from these results. I am inclined to believe that there may exist a trade-off between awareness and price that determines uptake of such products. Accordingly, the uptake is likely to be more even with positive subsidized prices if people are aware of its benefits (this does not equate to those who require such products more). Conversely, with lower awareness, free provision is likely to be more effective. It is however, difficult to draw a generic conclusion to this effect for all products and services.

2. Further, unlike non-acute care products like ITNs, critical care products are likely to exhibit lower price elasticity of demand (uptake). In other words, they are likely to be less sensitive to prices. This begs the question, what are non-acute care and which are critical care products?

3. The inferences from these studies are critically dependent on the contexts and varies across products. For example, while there is little evidence that those most in need of ITNs are more likely to buy and use it, the purchase (though not usage) of chlorine disinfectant liquid has been found dependent on need.

Another example of contradictory outcomes is with the provision of free school uniforms for children. Diana Hidalgo, Mercedes Onofa, and others found negative impact from a randomized experiment that provides free uniforms to primary school children in Ecuador. They found that "parents who pay for their children’s uniforms (the control group) feel more committed to the school than parents who got the uniforms for free (the treated) and therefore encourage their children to attend school". In contrast, a study in Kenya "found that providing a free school uniform increased attendance of young children by 6.4 percentage points".

4. In the final analysis, the purchase and use patterns of each of these products depend on a series of perceptions about its relative efficacy and utility for the consumer. In some cases, people are likely to show a reduced uptake when a product which was hitherto offered free was now offered for a small positive subsidized price, whereas in some others there would be no such effect. In some other cases, people are likely to see free products as signalling inferior quality and therefore show limited interest, whereas a high (but affordable) enough price would signal superior quality. In some cases, when people play a high enough price (how much is this "high enough" price?), the sunk-cost effects would take prominence and force people into using the product, while is cases like chlorine usage in Zambia showed no such effect.

5. Finally, to the extent that all such interventions are ultimately successful if they deliver on outcomes, there is no guarantee that such free supply will generate the intended results. A recent RCT of ITN usage in Orissa involving free distribution and purchase at unsubsidized prices with consumer micro-loans found little evidence of any "improvements in malaria and anemia prevalence, measured using blood tests". The authors attribute the failure to "insufficient ITN coverage" among the treatment villagers.

This debate again highlights the fundamental weakness with RCTs - the problem of generalizability. How and why do these interventions succeed? What processes and which environments are a pre-requisite for the success of a program? What is the role of cultural and other environmental issues on each intervention? Then there is also the limitation with how much can we generalize such results.

Update 1 (26/5/2011)

See this JPAL Bulletin explaining the benefits of free supply.

Electricity prices and elections

Summer time which coincides with elections is a sure-shot recipe for spot power prices in our power exchanges going over the roof. Two upward demand pressures on electricity consumption are at work - the seasonal cycle associated with higher consumption in summers and the pressure on governments facing elections to cut back on load reliefs.

This trend is playing out now, with Assembly elections due in many states. Businessline reports of day-ahead spot prices in the southern region zooming to over Rs 12 a unit in the last couple of days, over four times the price quotes for the rest of the country on the IEX — the country's largest power exchange (handles 80% of transactions). It writes,

"A key reason for spot electricity prices shooting through the roof in South India is the mad scramble among utilities in the region to arrange power to ensure zero power cuts before the polls in States such as Tamil Nadu, Kerala and Puducherry. Lack of adequate grid interconnection between the southern region and the rest of the country has compounded the problem."

The concern here is about the regulators staying away even in the face of such price volatility. There has been ample evidence of spot market prices inching upwards in anticipation of polls from January.



Being a regulated industry, it is natural that regulators step in whenever required to protect the interests of all stakeholders. It is therefore unfortunate that, depsite clear indications of surging prices and resultant profiteering at the expense of consumers, the regulators have stayed away.

It is all the more surprising since the the Central Electricity Regulatory Commission (CERC) had intervened to regulate prices before the Maharashtra Assembly elections in September-October 2009. The CERC invoked the proviso to Section 62 (1) (a)read with Section 66 of the Electricity Act of 2003 and imposed price ceiling on the purchase of electricity through bi-lateral agreements and power exchanges. In order to curb profiteering opportunities in response to a sudden surge in demand, the CERC announced a price band of 10 paise per unit to Rs 8 per unit to cover all inter-state day-ahead trades for a period of 45 days.

The argument that better grid inter-connectivity of the eastern region with the northern and western regions is responsible for the absence of similar price spikes in the NEW grid is a straw man. Neither Assam nor West Bengal are in the market making purchases similar in magnitude to Tamil Nadu. West Bengal is amongst those with the lowest deficits. In any case, as the example with Maharashtra in 2009 shows, when the bigger states enter the market, the demand pressures show up and forces prices upwards.

Revamping urban housing policies

A McKinsey Report (summary here) in 2010 estimated that 25 million urban households cannot afford housing, and estimates the demand to rise to 38 million by 2030. The Government of India have estimated an additional housing requirement of 26.53 million during the 11th Five Year Plan (2007-12).

Bridging this deficit is one of the biggest challenges facing urban administrators and infrastructure specialists in the country. Further, in view of the growing importance of urban growth (urban areas contributed 58% of GDP in 2008 itself), this is critical to sustaining our economic growth itself.

State governments across the country have adopted several policy variations to address this. The commonest strategy has been direct construction of housing units, either on vacant lands or on existing slums (by in-situ development). State governments have dovetailed funds from various Central Government schemes and bank loans to develop large numbers of housing units.

Another increasingly important approach has been to develop slums on public-private-partnerships (PPPs). The most popular form is one where developers are permitted to commercially develop a portion of government land allotted to them in return for constructing a defined number of dwelling units for the poor in the remaining land.

Other strategies include earmarking a portion of a layout or built-up area being developed for urban poor. The private developers would then sell these houses to the targeted category at prevailing market rates. It is hoped that this would both open up scarce urban land for housing and also cross-subsidize weaker section housing. As part of efforts to acheive the goal of "Affordable Housing for All", the National Urban Housing and Habitat Policy, 2007 (NUH&HP) mandates the reservation of "10-15 percent land in new public/ private housing projects or 20-25 percent of FAR (whichever is greater) for EWS/ LIG housing through appropriate legal stipulations and special initiatives".

The Andhra Pradesh Government has become only the latest state to notify guidelines making it mandatory to reserve 20% of developed land in all urban housing projects to the economically weaker sections (EWS) and Lower Income Groups (LIGs). This is in addition to 15% of built-up area being reserved for EWS and LIG in housing projects.

For the layouts, the maximum plot size for EWS is to be 35 sq.mts and 55 sq.mts for LIG. The plots are to be disposed to registered weaker section societies or to public agencies at prevailing market rates as per the Registration Department. Such societies should develop them as group housing schemes and not plotted development. The policy also provides for complete exemption on stamp duty, non-agriculture conversion charges, and development charges for one time registration of EWS/LIG and 50% of development charges and other fees for LIG plots.

I am afraid that such policies, while populist and logically appealing at first view, do not pass muster on rigorous analysis. For a start, they are cosmetic exercises and will do little to address the urban housing problem. Even if all the several formidable implementation problems are overlooked, the houses that can be built under this will be minuscule in comparison to the requirements, especially in the larger cities.

The fundamental objective of all these interventions should be to ensure that it increases the supply of urban housing stock with the least possible market distortions. However, such policies will not only fail to meet its objective, but will also generates market inefficiencies that can create other problems.

There are two categories of consumers who face massive urban housing shortages. The economically weaker sections, consisting mainly of migrant labor, exert the largest demand on the market. The lower-income and middle-income groups too form large shares of the demand for urban housing.

In fact, such strategies overlook the multiplicity of categories within urban poor themselves. At one end are those, primarily the LIG, who can possibly afford to buy these houses with a bank loan. At the other end of the spectrum are the largest numbers, especially the poorest, who cannot afford these houses and will be reliant on heavily subsidized housing.

More importantly, this will adversely affect the general housing market itself and conflict with the primary objective of making housing affordable for the non-poor. From the perspective of the private developer, earmarked development will effectively reduce the amount of land available for full realization of commercial opportunities.

The developers would naturally pass on this additional cost (by way of incomes foregone, the opportunity cost) to purchasers through higher prices. In other words, the buyers of the original housing units (who are not always the economically well-off) end up paying higher prices. And this too without the LIG and EWS necessarily getting houses at a low price (even if they get at low price, the government pays a very high subsidy).

In other words, the earmarking serves as a tax on home buyers. The middle-income group (MIG), themselves a large customer group and the engine that drives urban economic growth, will be the worst affected by this. Similar attempts to get developers part with a share of their housing, say by offering a share of developed space for social housing in return for additional FAR also translates into higher prices for buyers of the original units.

In any case, the extent of land that is likely to be made available through such interventions is too small to impose such a large cost on the general market itself. Finally, there is also the administrative nightmare of enforcing such programs. The wide variations in land values, itself non-transparent, complicates matters. Who are the LIG and EWS? How do we monitor the allocation process? Even if state governments agree to provide the subsidy, how will the price discovery happen and what will be subsidy? How do we ensure that these housing units are not captured by middlemen who in turn will rent it out to beneficiaries?

At a more fundamental level, the massive demand can be met only with a mix of policies that increase the supply of vacant lands and encouragess vertical growth. Since most cities have already run out of their stock of vacant and un-allocated government lands, it is important to tap the massive extents of un-utilized lands available with various government departments.

Another source for unlocking land is to re-develop the squatter settlements on government lands, both notified and un-notified slums, with multi-storied housing units. It is here that we run into the highly regressive regulatory restrictions on built-up area that can be developed in any land.

There are regulatory and infrastructural limits on vertical growth in our cities. Indian cities have amongst the lowest Floor Area Ratios (FAR), ranging from 1-3. In contrast, FSI in most Asian cities varies from 5 to 15 and in many Western cities goes up to even 25. However, such vertical expansion would also require investments in the appropriate enabling utility infrastructure.

Restrictive Floor Area Ratios (FAR) are the single biggest impediment to unlocking the potential of urban housing market in India. Among all the bigger economies, India has the lowest FAR, which restricts the amount of built-up area that can be constructed on a land. The commonplace manifestation of this is the absence of high-rise buildings in our cities. I have blogged earlier about the need for Indian cities to go vertical and infrastructure facilities to be planned to accommdate vertical growth.

As a recent World Bank paper points out, all these policies are a legacy of an era when the objective was to discourage urban migration and distribute growth to smaller cities and villages.

There are also other stifling policy restrictions. The McKinsey report found that state and central governments impose a total tax of 27% on housing. This is in addition to the several regulatory conditions that are also de-facto taxes that increase the real cost of urban housing.

Update 1 (30/6/2012)

The Andhra Pradesh government has modified its earmarking requirements government order by replacing it with some form of fee equivalent. Now, if the project area is over five acres, the builder has to provide 10 per cent of the total built-up area for the economically weaker section or they can reserve some units. Further, developers taking up projects above 3,000 sq.m. and up to five acres have to pay shelter fee to the respective municipal bodies. The builders have to pay a shelter fee of Rs 400 per sq.mt metre up to 750 per sq.mt depending upon the project location.

Pros and cons of bio-fuels

Via: Online Schools

(HT: Eco-politology)

Free trade and social safety nets - two sides of the same coin?

Uwe Reinhardt has a series of superb posts defending free trade and advocating social safety nets. This is appropriate at a time when both are under attack from ideologues and opinion makers on both sides of the political spectrum. About the benefits of free-trade, he writes,

Relative to a status quo of no or limited international trade, permitting full free trade across borders will leave in its wake some immediate losers, but citizens who gain from such trade gain much more than the losers lose. On a net basis, therefore, each nation gains over all from such trade.

The objections to this has both external and domestic dimensions. Externally, critics argue, and rightfully too, that countries apply these principles selectively and breach them through a variety of trade restrictions. This needs to be addressed through mutually agreeable international trade negotiations. While progress on this has been halting, it is the lesser challenge.

More importantly, and of immediate concern to politicians across the world, is the fact that free trade creates losers. The uncertainty that comes with being vulnerable to such disruptions amplifies the opposition. Further, the losers are much larger in number than the winners.

The sharp contrast between the winners - with the over-sized gains of a handful of mostly high-profile individuals and businesses - and losers - deprived off their livelihoods and left to fend for themselves - provides fuel for political backlash. In the circumstances, it is reasonable that the losers are adequately compensated or atleast cushioned against their vulnerabilities. And it is only right that winners give up a share of their gains to assist their less fortunate brethren, who have been made to suffer losses due to factors beyond their control. He writes,

Suppose the Jones family is hurt financially by low-cost imports from abroad, while the Smith family is hurt equally by home-grown disruptive innovation – such as the displacement of travel agents by online booking of airlines and hotels or of airline ticket-counter personnel by online check-in. Should only the Jones family be compensated for its loss because it involves foreign trade?

A far better approach would be to have in place a solid, general economic safety net that helps all families whose economic base is disrupted through forces beyond their control, whether such disruptions originate in foreign trade or domestic developments. Unfortunately, too many economists decry that approach as a welfare state – and that makes selling the case for free trade that much harder.

Who should be compensated and by how much? Who should pay for compensating the losers and how much? While economists can help answer these questions, the larger decisions are essentially political in nature. Economists would do themselves, their profession, and the issue of free-trade itself a lot good if they realize this and not stray deep into such re-distribution debates. Efficiency is a question of economic analysis, while fairness is a matter of moral and political judgement.

Paradox of household and corporate savings

Paradox of savings is a fallacy of composition where the perfectly virtuous habit of increasing savings when embraced by everyone generates negative outcomes for the economy as a whole. This is amplified when the economy is facing a recession and aggregate demand is falling. In such circumstances, it is in the interest of the economy if people spend more to shore up the declining aggregate demand.

During the Great Recession, debt-laden households in developed economies, in particular the US, cut back sharply on expenditures and boosted their savings to repay debts.



In response, businesses too have been postponing investments. This coupled with the general trend of businesses to indulge in cost-cutting, mainly through lay-offs, during recessions (so as to, in the main, keep their bottom-lines in tact) means that businesses are sitting on hoards of cash surpluses. At 7% of all their assets, non-financial corporations’ cash and other liquid assets reached $1.9 trillion at the end of 2010, the highest level in the US since 1963.



In the final quarter of 2010, capital expenditures amounted to $975 billion, or 6.6% of gross domestic product — up from a low of 5.4% in 2009 but still well below the 10-year average of about 8%. The non-residential private fixed investments dropped precipitously during the recession.



All this highlights the pro-cyclical nature of their basic economic activities for the two critical stakeholders. When faced with uncertainty, consumers save and businesses postpone investments. In contrast, when the economy is on the up, consumers spend as though there is no tomorrow, while businesses borrow recklessly and over-invest.

Recessions are marked by declines in aggregate demand. Households and businesses shutting-off their spending taps compounds the problem. It is possible, as the East Asian economies and Germany have done on occasions, to export your way out of a downturn. Further, if the recession is not very deep, it is possible to indulge in monetary accommodation and encourage businesses to bring forward investments.

But these were not available options for the US economy at the peak of the Great Recession. Under such circumstances, there is no choice left but for governments to step in and provide a temporary boost to aggregate demand.

Who are the eligible beneficiaries?

In my previous post, I had drawn attention to the debate about whether the Aadhaar identity would help more effective targeting of welfare beneficiaries. I had argued that Aadhar-based identification would not help screen out those beneficiaries who do not meet the eligibility requirements.

In this context, one of the comments pointed to the psychological deterrent effect of any Aadhaar-based identity in screening out the ineligible. This works on the presumption that since Aadhaar localizes the identity and makes it easy to trace individuals, the possibility of being noticed when drawing benefits would deter the ineligible from accessing those benefits.

I am not sure about the effectiveness of such deterrent for two reasons. First, the margins between the eligible and ineligible are never cut-and-dry. For example, it is impossible to accurately avoid inclusion errors (ineligible getting included) when identifying people below or above the poverty line based on the standard income parameter. What should be the cut-off income? How do we quantify that income? Second, given the widespread poverty in the country, the numbers of people who straddle the blurred boundaries of eligibility are considerable.

In other words, a large number of people face the ambiguity about whether they are eligible or not to receive certain welfare benefits. In the circumstances, the deterrent effect gets considerably diluted. Where is the need to fear when many of your neighbours belong to the same category? In any case, given the difficulty with income quantification, how can anybody establish that you are not income poor (especially when the major share of incomes of those under scrutiny generally comes from the informal sector)?

This challenge will remain with or without Aadhaar and raises the question of what is the most appropriate method to identify welfare beneficiaries. In this context, I am reminded of George Akerlof's famous paper that advocates the use of "tagging" - which tags (identifies) people and then makes specific transfers (or concessions) to them - in taxation. Tagging eliminates the ambiguity arising from eligibility parameters (like income) and enables easier differentiation of the eligible from the ineligible.

What are the most effective tags to identify poor people eligible to receive welfare benefits? The commonest tags are height, weight, looks, gender, age, educational qualifications etc. These are all, for obvious reasons, unsuited for identification of the income poor.

Among the more effective likely tags could be the nature and/or size of ones house. For example, a person living in a temporary or semi-permamnent house could be treated as income poor. Alternatively, the carpet area of the house, discounting for locations, could be used as tags for income levels. Either way, it becomes possible to verify and mark out a person who claims benefits despite failing the eligibility norm. Though administration of house-type based tags too raises concerns, it does look a more promising approach to screen beneficiaries than the current practice of identification based on incomes.

It is possible there are more effective tags, especially for certain subsidized products. In any case, irrespective of whether Aadhaar is used or not, the problem of beneficiary identification, with a reasonable degree of accuracy, has to be satisfactorily resolved.

Pitfalls in cash transfer implementation

The decision by the Union Government to replace the current subsidy regime in fertilizers, cooking gas and kerosene with a system of cash transfers in a phased manner has triggered off an intense debate about cash transfers. This post will summarize the most relevant and common objections to cash transfers and critically examine each of them.

1. It does not resolve the targeting problem

The biggest criticism of Aadhaar is that it leaves the critical issue of beneficiary identification, or targeting, unresolved. The Aadhaar identification merely validates whether the particular individual has come to receive his welfare benefit. It does not say anything about whether the individual is, in the first place, eligible to receive the benefit itself. The means testing of the beneficiary for his or her eligibility is essentially an administrative process.

There are four possible sources of leakages in any welfare program – beneficiary impersonation, ghost, duplicate, and ineligible beneficiaries. Aadhaar-based identification can easily eliminate the first three possibilities. It ensures that benefits are transferred only to the registered beneficiaries. However, ineligible beneficiaries cannot be immediately addressed with Aadhaar. The concern about failure to ensure targeting is therefore only partially correct.

Aadhaar-linked processes are a definite and significant improvement on the prevailing system of beneficiary identification and benefit disbursement. Its effectiveness will improve incrementally as Aadhaar is adopted by a critical mass of user departments so that databases can be shared to screen out the ineligible. In any case, Aadhaar cannot be a substitute for the administrative failure in keeping the beneficiary selection process honest.

It also provides governments an excellent second-best tool to effectively target benefits on petroleum products like cooking gas and fertilizers that are currently universally subsidized. Any such change in regime will be a qualitative and substantial improvement on the current universal subsidy regime.

2. Cash transfers cannot factor in price volatility

The most serious concern about cash transfers, one that deserves the strongest consideration, is on the issue of price volatility. Critics point to the possibility of sharp and sudden price fluctuations, especially for food grains, and argue that this would adversely affect the consumer’s purchasing power. They argue that unless subsidy amounts are calibrated real-time to in response to local market price, a virtually impossible task given the diverse and fragmented nature of rural markets, the cash transfers will fail to achieve its objective.

It is undeniable that prices of commodities, especially food-grains, fluctuate sharply across regions (even within districts, between the head quarters and rural interiors) and over even small time-periods. I have blogged about this here and here. To the extent that the ultimate objective is food or fuel security, or making available these commodities at affordable prices, price volatility poses serious problems.

The new nutrient-based fertilizer subsidy regime overcomes the problem of price volatility by providing a large enough subsidy to act as a buffer against reasonably large manufacturing cost increases. The subsidy transferred to the manufacturers, which is fixed once a year, is deliberately kept high so as to discourage manufacturers from indulging in any market manipulation. It is also hoped that with this subsidy, even if costs increase, the subsidy will cover the increased costs and keep fertilizer prices affordable. However, it has to be admitted that this approach may not be practical for products like food grains and other products.

In the circumstances, at least in the initial phases, it may be more appropriate if cash transfers for products like food grains are restricted to areas where the volatility is least. Urban markets experience less price volatility and they are also more closely integrated into each other. Therefore, an arrangement where the subsidy amount is indexed to the relevant inflation measure is likely to address most of the concerns on price volatility. It has to be admitted that this strategy does not address local price shocks and sudden spikes which cannot be accurately captured on a pan-Indian inflation index.

3. The cash transferred will be frittered away on wasteful expenditures

One of the long-held opposition to cash transfers revolves around the premise that recipients are likely to fritter away their cash on wasteful expenditures. This is all the more so in rural areas, where men are more likely to manage household finances. The widespread self-control problems that bedevil human beings, as highlighted by research in behavioral psychology, adds credence to this claim.

Consider the case of a beneficiary who receives cash transfers on fertilizers and cooking gas into his account, besides NREGA wages and other welfare transfers. There is the possibility that these multiple and often lumpy inflows into a single account would be diverted for other purposes, especially on wasteful expenditures, thereby defeating the purpose of such transfers.

Such concerns can be effectively addressed through vouchers, smart cards, and structured savings bank accounts. The retailers can be reimbursed their subsidy on production of the vouchers for the subsidized product received from the beneficiaries. Debit cards with purchases restricted to only the prescribed commodities can also be used to administer cash transfers. Transfers to the account of the woman family member can also help address such concerns to some extent.

Finally, there are multi-tier savings bank accounts. Insights from recent research in behavioral economics show that use-directed sub-accounts within the main account, designed to take into consideration people’s "mental accounting choices", may be more effective at optimal management of multiple inflows. Accordingly, savings accounts, with say, food or fertilizer sub-accounts, can combat people’s behavioral urges to spend their cash transfer incomes on other expenditures.

In any case, there are doubts on the assumption itself. A study of unconditional cash transfer schemes in 15 Eastern and Southern African countries by S Devereux, J Marshall, J MacAskill and L Pelham indicates that the fungibility of cash transfers does not necessarily undermine the intended outcomes. They also found that recipients used the freedom of choice provided by unconditional cash transfers in a wide range of ways that directly or indirectly benefited children, from purchase of food, groceries, health and education services to investments in farming or small enterprise.

4. It does not address the issue of consumer choice

Another serious objection comes from those pointing to the limited consumer choice in most Indian markets. Since cash transfers are meaningful only when citizens have choice, what use is this cash when people have little or no choice with schools or hospitals? It is a reality that many parts of the country and millions of people have no access to hospital facilities. Further, such presentation of choices, far from creating competition among service provides, only adds to the rent-seeking opportunities. It amplifies the power of the entrenched sub-optimal interests.

Similarly, in most parts of rural India there are typically just one or two retailers for any product. The resultant lack of competition renders any claims of choice disingenuous. If the exclusive government outlets, say ration shops, are closed down, the possibility of price gouging (atleast on certain occasions) by the local kirana shop owner cannot be ruled out.

This concern loses its relevance outside the rural context. Even the smaller cities offer enough choice with retailers, schools and hospitals. Urban residents, who enjoy such choices, can therefore benefit from cash transfers. In any case, given the widespread prevalence of predatory practices like hoarding among retailers even in the smaller towns, such policies will have to be complemented with strong administrative actions to curb these practices.

5. It is a smokescreen to roll-back Government

The strongest critics from the left view a "roll-back the government" agenda behind the cash transfer movement. They see cash transfers as the first step in a systematic campaign to divert attention from more fundamental issues. They express the fear that the focus on cash transfers would slowly displace critical basic welfare issues like investments in primary education and health care, food and fuel security, and so on.

They portray cash transfers as a convenient excuse for governments to abdicate on their responsibilities, "We have done our side of the bargain. We provided you cash, now you go and buy whatever you want". Governments, they argue, will transfer cash to students, patients, and farmers, and leave investments in schools, hospitals, and irrigation to the vagaries of market forces. Similarly, cash transfer in place of food grains, run the risk of seriously imperiling food security. Such ideological arguments are never easy to refute. It may be more effective to tackle them on similar ideological grounds, though its success is not assured.

In conclusion, the concerns of price volatility and choice are not easily refuted. They also remain formidable obstacles to widespread adoption of cash transfers. However, urban markets, which are less susceptible to random and local price shocks and may offer adequate choice, are best placed to receive cash transfers.

Accordingly, it is preferable that the first phase of cash transfers be implemented in towns and cities and for products with less price volatility and choice problems. Food grains distributed through PDS are vulnerable to sharp price fluctuations. The concerns of food security raised by skeptics are not easily refutable. Besides, any failures arising from cash transfers in food grains could become a rallying point for opponents calling for aborting the cash transfer scheme. Cooking gas and fertilizers, and less so kerosene, with their centralized distribution network, are less vulnerable to these concerns.

It is undeniable that urban areas are more suited for cash transfers in all these products. However, this dual subsidy regime, wherein city residents get cash transfers whereas villagers continue to receive subsidies through the conventional channels, may generate its set of problems.

This will be all the more so for food grains and kerosene, and especially during periods of price volatility. In this context, it is important that subsidy benefits are disbursed to consumers in all areas through an Aadhaar-linked system, irrespective of whether they receive cash or not.

Counterfactuals and economic analysis

As the debates on monetary and fiscal policy options during the sub-prime crisis and Great Recession have shown, macroeconomic theories can rarely explain with certainty whether one set of policies are superior to another or are certain to succeed in a given circumstance.

For every example of success with a certain set of policies, opponents are quick to show failures with them. They also point to apparent successes with an alternative set of policies. And in any case, no two situations are the same. Such debates usually end in a stalemate over the relative merits of two opposing theoretical and ideological positions. Further, in such ideological battles, even blatantly untenable views have remarkable persistence. Ideologies are not easily buried.

Since successes or failures with a specific set of policies are rarely cut-and-dry, post-mortems of economic policies too are never non-controversial. For example, despite overwhelming evidence about how TARP and ARRA prevented a complete financial meltdown, created employment and off-set deeper output contraction, sceptics refute the evidence.

Supporters who claim success with a set of policies would face opposition from those arguing that an alternative approach would have yielded better results. Even more, they would argue that conditions would have been better off without those policies - Wall Street would have recovered faster and stronger if there were no bailouts.

Supporters will counter by saying that the recovery would have been more swifter and stronger if their prescriptions were applied in full. For example, economists like Paul Krugman have long argued in favor of much stronger fiscal stimulus measures to mitigate the hardships of the Great Recession. Counter-factuals can only be debated about, never satisfactorily, leave alone conclusively, proven.

The NYT reports of the latest example with such from Europe.

Another missed opportunity for Europe? Over the last year, the European Union and the International Monetary fund have pledged 640 billion euros ($890 billion) to bail out distressed economies on the Continent’s periphery. Yet the interest rates on benchmark bonds in Greece, Ireland and Portugal remain at or near their record highs.

Critics of the bailout will surely see the persistent high interest rates as arising from an inability to convince the confidence fairies and a failure of the policy itself. Supporters would argue that there would have been sovereign defaults from Greece and Ireland in the absence of such bailout backstops.

In simple terms, economic policy are equally handicapped in explaining their policies both ex-ante and ex-post.

Update 1 (28/9/2011)

Paul Krugman has this excellent description of the counterfactual debate on stimulus spending in the US.

Ricardian equivalence in insurance

Ricardian equivalence refers to the argument that consumers internalize the government's borrowings by cutting back on their spending (or increasing their savings) in anticipation of higher taxes in future. Conservative economists have invoked this to argue that government deficit spending cannot stimulate aggregate demand.

The NYT has an article raising the issues concerning insurance industry in the aftermath of the Japanese earthquake and tsunami,

"Moody’s said ratings for all of the major reinsurers were stable, and many reinsurance analysts said they saw one bright spot in the disaster: prices for reinsurance have been declining for several years, and while the earthquake will hurt the results of companies for one quarter, it might spur new demand and higher prices.

Reinsurance contracts are often renewed in April, and Keefe, Bruyette & Woods issued a report on Tuesday suggesting that losses from the earthquakes in Japan and, recently, New Zealand would lead to firmer prices on California earthquake and Florida hurricane insurance."

This is classic rational expectations (or cognitive biases) operating from both ends of the market. Property owners, atleast in earthquake prone and coastal areas, swayed by the availability bias generated by events in Japan, will be more inclined to insure their assets in a more comprehensive manner. Similarly, insurers would increase the actuarial risks associated with such events and price their premiums upwards.

Assuming that the actual risks remain the same (taken on a historic scale), the insurer can therefore hope to claim higher profits in future (though this is partly reduced the higher premiums that re-insurers are themselves likely to charge). To this extent, insurers will be able to recover a large portion of the current payouts from these higher future premiums. This begs the accounting question about what is the real long-term impact of such earthquakes on the insurance industry.

China embraces next stage of reforms

Even as India debates and prevaricates on its next generation of reforms, China appears to have taken the plunge with its next stage of reforms and growth. The latest Five year Plan (2011-15), unveiled recently, seeks to address some of the fundamental imbalances within the domestic economy. It may mark the first major step in a fundamental course correction to the Chinese economy - the shift from an imbalanced export-driven growth to more balanced domestic consumption centered economic growth.

For some time now, critics have accused Beijing of promoting a policy of export-driven economic growth that in many respects run counter to balanced development at home. They point to China's massive current account surpluses (now at 5% of GDP) and $3 trillion plus forex reserves (most of which is inefficiently deployed in low return assets) which stand in stark contrast to its extra-ordinarily low household spending of 36% of GDP.

They also claim that internally the Government favors businesses and discriminates against its own workers. This is evidenced by the poor working conditions, low wages and almost non-existent social safety net. In contrast, businesses benefit by their low cost of labor and subsidized inputs.

Critics are right to argue that while Beijing buys billions of dollars (with its attendant cost of carrying) to manipulate the renminbi's exchange rate and favor exporters, it is loath to spend small amounts to increase the purchasing power of the vast majority of its citizens. Such policies are unsustainable and forces China into problems externally and internally.

It is these imbalances that the 12th Five Year Plan seeks to atleast partially address. It is estimated that these measures would raise household spending to a range of 42-45% GDP by 2015 from 36% now. One of the biggest components of this plan is the proposal to build 10 million affordable homes this year and 36 million units (enough to house the combined populations of France, Australia and Canada) over the five year period. As the Times writes, "In theory, millions of Chinese will no longer have to save for an exorbitant, market-priced home, leaving more spending money in their pockets."

The Plan also contains proposals to gradually raise the proportion of national income going to labor,broadening pension and health insurance coverage, especiaally in private sector, and lowering taxes. Social outlays are projected to increase by 14% this year. Among the reforms will be tax policies aimed at boosting rural purchasing power, measures to broaden rural land ownership, and technology-led programs to raise agricultural productivity. Stephen Roach of Morgan Stanley Asia claims that it could "spark the greatest consumption story in modern history".

Apart from providing housing, this will also help sustain China's voracious appetite for cement, steel, copper, and other commodities, and also prop up its spectacular investment rate of 48% of GDP. The overall boost to the economy from the wealth effect and resultant increased purchasing power of especially the nearly 50% of Chinese living in cities, could provide a powerful boost to the economy. Given the scale associated with China, it could easily help replace exports as the new growth locomotive for China's economic growth.

And all this could have a salutary effect on China's external policy and the larger issue of global macroeconomic imbalances. It would reduce Beijing's incentives to indulge in aggressive currency manipulation. More importantly, it would focus the Government's energies on improving the internal vibrancy and breadth of the Chinese economy. And for China's trading partners, it could provide a double boost - fairer competition with Chinese exporters and the alluring prospect of accessing the massive Chinese domestic market.

While these are far from adequate, they are a belated and welcome acknowledgement of a fundamental challenge facing the Chinese economy. And given the reputation of policy makers in Beijing to execute once the agenda is set, it is not out of place to expect these targets to be easily met and exceeded. The Chinese consumer, it appears, may finally be woken up! Are policy makers in New Delhi listening?

Re-thinking macroeconomic policies - a graphical summary

The sub-prime mortgage crisis and the Great Recession have questioned several underlying assumptions of modern macroeconomics. Paul Krugman famously called it the "Dark Age of Macroeconomics" and many standard macroeconomics text books are currently undergoing wholesale revisions in the light to these experiences.

What should be the role of Central Banks, especially in ensuring financial stability? What are the policies and instruments that can be deployed by central banks? What should be the optimal inflation target? What are the exit routes available for central banks from extraordinary monetary accommodation? Do central banks have a role in stabilizing output, that goes beyond interest rate changes, especially when faced with deep recessions?

What regulations are required to ensure greater stability and improve the crisis-resilience of banks? What can be done to contain the build up of systemic risks and limit the contagion effects of deleveraging and resultant liquidity crisis? How do we mitigate the moral hazard concerns arising from financial bailouts? What type of financial market regulations are required to limit the possibility of asset bubbles?

What are the fiscal policy options for governments faced with an economic recession and zero-bound in interest rates? How should fiscal policy be organized during such recessions? Which policies deliver the greatest bang for the buck? How can we swiftly deploy stimulus measures in the face of political paralyses and gridlocks? Should governments restrain from stimulating the economy, when faced with zero-bound recessions, with short-term fiscal measures for fear of deficits and debts?

What is the role of global macoreconomic imbalances in causing and sustaining asset bubbles? What is required to prevent the build up of such imbalances? How should cross-border financial flows be regulated? What is the optimal capital account policy for emerging economies? What sort of international monetary system is required to satisfactorily resolve cross-national financial crises?

I have tried to consolidate the learnings from events of the last three years and the post-mortems and other research that has gone into more satisfactorily understanding and explaining macroeconomic policy making. The result is this graphic. While I must admit that it is highly simplified (all such beautiful flow-charts are meant to simplify complex policy eco-systems), it only seeks to broadly highlight all the different elements of a post-crisis macoreconomic policy framework.

It is clear that the mandate of central banks have to expand beyond inflation targeting and include financial market stability. And when faced with deep recessions, central banks have a credit policy role, whence it could become a lender, buyer, and insurer of last resort. Fiscal policy becomes critical when monetary policy loses traction and when interest rates are at the zero-bound. Its main instruments are automatic stabilizers and discretionary spending measures. The specific instruments of each policy, as indicated in the chart, are illustrative and is meant to merely guide discussion.



(Please click on the graphic to enlarge)

In fact, the IMF recently brought together some of the world's leading economists to a conference where the Fund and participants urged a wholesale re-examination of macroeconomic policy principles. See also this concise presentation by Olivier Blanchard.

Quote for the day

"Solutions for great and complex societal problems are rare. There’s no guarantee that local successes can be replicated. But our best strategy is to look for ideas that work on a small scale and try to figure out how to make them work on a larger one. The right spirit is empirical: try things out, learn what you can, adjust, and try again. There are no foregone conclusions — except that we’ll fail if we don’t even try."

Dr Atul Gawande (via The Gold Standard) discussing the application of statistical techniques that focus on the most expensive patients ("super-utilizers") to lower health care costs in Camden, New Jersey. The gated article is now available free here.

The trans-Atlantic debate on igniting economic recovery

When history of the Great Recession will be written, among the primary issues for discussion will be the relative impacts of recovery policies followed across countries.

On the one hand, countries like England, Estonia and Ireland have responded with savage fiscal austerity by cutting wages, spending, and even raising taxes. Across the Atlantic, the US has responded with multiple fiscal stimuluses and continuing monetary accommodation. The major European economies like Germany and France too reacted with stimulus measures, albeit much less muted. Which of these two opposing fiscal policy stances succeeded?

There are two undoubted distinguishing features of the Great Recession. One, aggregate demand has slumped as evidenced by persistently weak consumer spending and the rise in unemployment rate. Second, the balance sheets of households and businesses have been battered by the bursting of the asset bubbles.

Both require different policy prescriptions. An aggregate demand slump would require fiscal policy interventions that would provide money to those people who are likely to spend them. Direct spending measures (like infrastructure works and transfers to local governments) and social safety cushions (like unemployment insurance and food stamps) are ideal for boosting aggregate demand.

Repairing battered balance sheets require policies that help pay off debts or lower its burden or atleast reschedule them. Monetary accommodation for an extended period will lower the debt service burden. Additional credit lines will help mitigate the inevitable liquidity contraction after a financial market meltdown. Since large numbers of people are left with negative housing equity, policies that restructure mortgage debts will help repair household balance sheets. Stimulus spending by way of tax cuts will leave people and businesses with more money which can be used to repay debts.

However, balance sheets cannot be repaired in a hurry. In fact, it will take long for households and firms to shake off the massive debts accummulated. It can only be hoped that some or all of the aforementioned policies work towards helping regain much of the lost ground in asset values. In other words, policies aimed at repairing balance sheets will involve both direct efforts to reduce debt burden and indirectly buy time so that recovery will itself contribute to rebuilding balance sheets.

Both features weigh heavily on the US, British, and Irish economies - aggregate demand is weak and balance sheets of both households and financial institutions are bruised. In addition, government debts too have crossed sustainable levels. But the situation is different with much of continental Europe. They did not experience the same sort of property market bubbles like in the US or Ireland. Accordingly, household balance sheets are less a problem. Their problems lie in financial institutions with massive exposure to their own peripheral economies (the PIIGS).

In case of the PIIGS, all the three - governments, businesses and financial institutions - face deep struggles. All of them borrowed and splurged heavily during the boom and are now facing pay-back time. There is limited fiscal space available for any meaningful stimulus spending. The fiscal austerity, under implementation in some form of the other in all of them, is taking its toll on citizens.

Whatever the specific details of the policies being followed, an immediate return to robust economic growth is critical to the fortunes of all these economies. Strong growth is necessary to not only reduce the high unemployment rates, but more importantly to ensure that the share of public debts do not explode and trigger sovereign defaults.

In the circusmtances, fiscal austerity will leave the entire recovery burden on the private sector. It will have to generate enough growth to not only kick-start growth, but also cover for the loss in GDP due to fiscal contraction. And it will have to achieve this in conditions marked by persistent financial market uncertainty (with resultant high cost of capital), bruised (business and banking) balance sheets, and citizens who will face the brunt of the government's spending cuts. The odds of succeeding against these very formidable obstacles are minimal.

The initial indications from the British experience with fiscal austerity has been disastrous. After four consecutive quarters of modest growth, the economy experienced a contraction in the last quarter of 2010, declining 0.5%. This comes in the back of an extraordinary $128 bn four-year program of spending cuts and tax increases, including an across-the-board reduction of 20% in the budgets of most government departments. Ireland's two year fiscal austerity appears to be leading the country firmly down the sovereign default path. If that is any indicator, England faces a very long and painful struggle ahead.

However, there is one area where the debate about policy responses appears to have been settled. In the aftermath of the sub-prime meltdown, the US Fed and Government responded with great speed and pumped in massive amounts of liquidity to bailout the affected financial institutions. Apart from lowering interest rates to the zero-bound, these measures also included credit guarantees and unconventional quantitative easing through direct credit injections, banking reserve expansions, and asset purchases.

The Fed emerged as an effective lender and insurer of last resort. A massive $750 bn financial market bailout was followed by two rounds of quantitative easing. More than $3 trillion have beeen injected into the financial markets to drive Wall Street's recovery. And the results have been spectacular, though confined to corporate America.

Simon Johnson places the recovery in Wall Street and corporate profits in the US in perspective by comparing with recoveries in earlier recessions. The last quarter saw Wall Street back to pre-crisis levels of profits and executive compensation. The bailouts and implicit government guarantees saved the day for Wall Street. The fiscal stimulus backstopped corporate profits from falling too much. The ultra-low interest rates have kept the debt service burdens low and bought time to heal the debt-laden balance seets. He writes,

"Profits for the private sector... in the third quarter of last year... were back at the level of 2006. After the deep recessions of the early 1980s, it took at least three times as long for profits to come back to the same extent."

He also writes,

"In the back-to-back recessions of 1980-82, real non-financial sector profits dropped about 30% (from 1977-78 to 1980) and struggled to rebound for most of the decade. This same measure of profits did not surpass its level of the late 1970s until the early 1990s... during that same cycle... real profits in the financial sector fell 50% from 1979 to 1980, regaining the level of the late 1970s by 1987...

In contrast, over the finance-led boom-bust-bailout cycle of 2007-2010... profits have proved much more resilient. In real terms, the financial sector earned record profits in 2005 (and accounted for an eye-popping 30% of total corporate profits in that year). These fell sharply, to be sure, but only really for one quarter at the end of 2008. Financial sector profits have been running at around 90% of their pre-crisis level since early 2009."

Sharing network infrastructure - way forward for telecommunications?

South East Asian countries like Hong Kong and South Korea are leaders in the provision of ultra-high speed (in the range of giga bit) broadband services, and that too offered at exceptionally cheap rates. In fact, South Korea has a plan to connect every home in the country to the Internet at one gigabit per second by the end of 2012. This is in stark contrast to elsewhere even in developed economies, where broad band services are limited to a few megabits and exorbitantly expensive.

In the US, the fastest service of Verizon, the leading provider of fiber-to-the-home service, is only 50 megabits a second and it costs $144.99 a month. In contrast, Hong Kong Broadband Network offers one gigabit per second service for less than $26 a month, and it operates profitably. Similarly, a pilot gigabit project initiated by the South Korean government with 1,500 households in five South Korean cities costs 30,000 won a month, or less than $27, for a connection.

Broadband service providers in Hong Kong and South Korea undoubtedly enjoy the benefits of high population density of these countries. They also have a critical mass of consumers for these services.

A NYT article argues that in the United States, "costs would come down if several companies shared the financial burden of putting fiber into the ground and then competed on the basis of services built on top of the shared assets. That would bring multiple competitors into the picture, pushing down prices." Most broadband markets in the US have one dominant cable and phone company each.

Another reason for the lack of interest in ultra-broadband services in the US is the absence of services that require such high speeds. Uncompressed, broadcast-quality HD video, for example, uses 23 megabits a second. High speed services include those requiring two-way video-feeds like those used for tele-medicine and other services requiring video-conferencing, require software applications and service providers, apart from customers.

I am not upto speed with the latest regulatory provisions in telecom sector in India. However, the same approach could be adopted in India too where several telecom operators have already laid vast fibre optic backbone networks. In fact, fibre optic networks are today available across the length and breadth of the country, even in rural interiors. In many places, these are adequate to deliver even utlra-broadband services.

With appropriate regulatory changes, similar to the open access arrangements in electricity, telecom service providers can share their networks. The electricity distribution and transmission utilities are obliged to permit anyone to transfer electricity using their networks for payment of a fee.

In the absence of such regulatory enablers, telecom companies would be get locked up in an expensive and inefficient battle to lay competing network lines. This would crowd-out investments in content development and prevent the realization of the full potential of broadband-based service delivery. This is all the more unfortunate since unlike South Korea and other smaller developed countries, distances and problems posed by it are stumbling blocks to India's development. Education, health care, employment skills development and many other areas could be transformed if the infrastructure and softare platform to deliver broadband-based services is available.