The savings rate de-regulation

The decision by the RBI to deregulate bank savings rate in its second quarter monetary policy review is one of the most progressive and efficiency increasing reforms in recent years. All banks are currently mandated to pay an interest of only 4% on savings account deposits.

In one stroke it eliminates one of the last remaining glaring incentive distortions in India's banking sector. With 26% of the total bank deposits (as on June 2011) being in the current and savings bank accounts, banks hitherto benefited hugely from an artificially lower cost of funds.

It is expected to increase depositors’ interest income by around Rs 9000 Cr. The Businessline reports that assuming the savings bank deposit rates of banks rise by 1 percentage point, profits before provisions and taxes will be lower by 9.3 per cent (based on FY-11 profits) if they do not pass on the deposit rate hikes to borrowers.



This decision increases competition, lowers entry barriers, encourages savings, and contributes to strengthening the financial markets and increasing the effectiveness of the monetary policy transmission channels. In simple terms, it is one of the rare policy decisions which aligns incentives of all stakeholders and increases overall efficiency of the system. Here is a summary of its benefits.

1. It will increase competition among banks and thereby increase all round efficiency in the sector. Banks will be forced into raising deposit rates so as to attract depositers and also allocating their lendings into the most profitable avenues.

2. It lowers entry barriers by working to the advantage of smaller banks and newer entrants. They have hitherto suffered from a system where location of branches conferred an unfair first-mover advantage. Now with the freedom to price their depsoit rates, these banks can hope to attract accounts by signalling with more competitive rates. This was evident in the immediate aftermath of the decision, with Yes Bank announcing hiking its deposit rates by 200 basis points.

3. It will force banks into diversifying into other transaction and advisory services which will in turn enhance the breadth of India's financial system. This will be felt with much greater force by the public sector banks who have a higher exposure to low cost savings bank deposits. Hitherto, the ceiling on deposit rates had provided banks with a large easy source of money and comfortable assured profits from it (SBI alone loses Rs 1500 Cr for every 50 basis points increase in deposit rates). To this extent, the incentives were not aligned towards getting banks to search for alternative sources of revenues.

4. On the consumers side, given the dominant role of banks in household savings, especially of savings bank accounts in case of the poorer people, this deregulation will enable them to get higher returns on their deposits. This will in turn boost household savings and also encourage people in rural areas to utilize bank accounts to channel and save their incomes. Banks too are certain to come up with more differentiated savings products.

5. It increases the effectiveness of monetary policy transmission mechanisms. As deposit and lending rates are arrived through a competitive process, any changes in the repo rates will, in normal times, is more likely to be transmitted quickly into the financial system and the economy.

The largest income transfer in history?

I have blogged here, here, and here with graphics about the alarming concentration of wealth in the US. But this superb graphic series in Mother Jones is simply outstanding and cognitively striking.

This graphic compares how much various income groups make today versus how much they would be making if everyone's incomes had grown at similar rates since 1979. By 2005, the bottom 80% were collectively earning about $743 billion less per year while the top 1% were earning about $673 billion more.



Over the past three decades, the US economy has become the classic winner takes all economy. Even as incomes of all others have remained more or less stationary, those of the top 1% have ballooned.



Productivity has increased, but income and wages have stagnated for all Americans, except those at the top one percentile.



Despite all these, why do Tea Party activism generate front page news? It can atleast partially be attributed to ignorance, as this cognitively striking graphical representations of actual distribution of income and wealth conveys.



I would not be surprised if this would constitute the largest income transfer ever in history anywhere in the world from one income category to another. The public policy dynamics of these three decades in the US has facilitated this widening of inequality. On similar issues, see the comparison of the US with Canada, Germany and Sweden.

Would be great to have such graphical representations of income distribution and other inequality determining aspects in India. The importance of such information in awareness creation and contributing to the depth of public debates on issues of popular concern is underestimated. If the rich data collected by state and central government departments, including the census office, on various sectors is made freely available in readily usable formats, it would be picked up by various advocacy groups and researchers, to generate such striking graphics. Public debate would be the richer for that.

Debt restructuring or default - Is it enough?

Call it whatever you like, Greece has effectively defaulted on its sovereign debt, atleast half of its private external debt. The agreement that private investors will take a 50% haircut on their bonds constitutes a virtual default. The agreement reached to resolve Eurozone crisis contains this restructuring of Greek debt, a bank recapitalization plan, and an expansion of Eurozone bailout fund.

The agreement to restructure Greek debt also includes a new €130 bn bail-out of Greece by the European Union and the International Monetary Fund and is estimated to reduce Greek debt levels to 120% of GDP by end of the decade. The deal includes a decision to force the continental banks to raise new capital amounting to a total of €106 bn ($150 bn) by June 2012 to raise their Tier I capital ratio to 9% of total capital so as to provide them with greater cushion against potential losses on loans to the PIIGS.

They also agreed to increase the firepower of the remaining amount in the €440 bn ($610 bn) European Financial Stability Fund (EFSF) (estimated to be about €250bn after the proposed new Greece debt deal) by providing "risk insurance" to new bonds issued by struggling eurozone countries, especially Italy. This would limit bondholder losses by guaranteeing a portion of potential losses - EFSF effectively offers credit protection on Greek debt. It is hoped that this would increase the size of the EFSF by 4-5 times to about €1,000bn. Efforts are also on to get outside investors like sovereign welath funds from China, Russia and others.

Though any agreement is welcome, there are several doubts about whether this is a case of too little too late. Critically, even after the haircuts and bailout, Greece will still have a debt-to-GDP ratio of 120% even in 2020. This raises questions about its effectiveness and increases the possibility of more write-downs and bailouts. This would mean complete wiping out of private bondholders and even write-downs by official lenders (who will be the last to suffer any haircuts). Of the 340 billion euros in Greek government debt, only about 200 billion euros is owed to private creditors and therefore covered by the restructuring plan. The rest of the debt is controlled by the European Central Bank, the International Monetary Fund and other institutions that have said they would not participate in a debt restructuring. FT Alphaville has several interesting questions here about the details of the three-pronged bailout plan.

In addition there are more fundamental issues. Eurozone countries' economic stagnation which is driven by a combination of declining economic competitiveness, huge sovereign debts, and difficulty in financing government deficits. The beleaguered peripheral Eurozone economies are handicapped by the unavailability of all the remedies traditionally used by countries facing recession and sovereign debt crisis - inability to indulge in fiscal and monetary expansion, reflate their economies, or devalue their currencies. Though notionally a currency union with a harmonized monetary policy, it does not have any central fiscal authority nor does it have a monetary authority willing to assume its traditional role. In simple terms, Eurozone is a monetary union without a fiscal federation or a full-fledged central bank.

The better placed economies like Germany are strongly opposed to fiscal transfers to bail out their reckless peripheral partners. The European Central Bank (ECB) has refused to lend to its struggling member states. It has preferred to let the newly created and limited European Financial Stability Fund (EFSF) assume the responsibility of lending to those countries and stabilizing the financial markets.

This is in sharp contrast to the policy followed by the US Treasury and the Federal Reserve when faced with similar (some would say, less severe) crisis in late 2008. The Government announced a massive stimulus package to stabilize the economy, while the Fed deployed extraordinary measures to emerge as the lender, buyer and insurer of last resort.

In fact, unlike the US and British bank recapitalization plans in which the respective central banks injected funds directly, the ECB has refused to do so. The banks are therefore relying on private investors to raise their capital so as to reach the 9% level. However, raising money from private investors will be difficult especially given the conditions.

The current conditions call out for proactive central bank leadership. No one seriously disputes that Spain and Italy, currently the biggest concerns, are solvent and are only experiencing a liquidity crisis. Such crises are best averted when central banks step in and open liquidity windows and function as lender of last resort. As Martin Wolf wrote recently, if sovereign default risk is addressed, it will "also automatically stabilise the banks, since it is fears of sovereign defaults that are driving worries over banking insolvency". See also this excellent paper by Paul De Grauwe. In light of all this, it remains to be seen whether the latest bailout will be effective.

Times, as always, has this nice graphic that captures the three prongs of the bailout plan.



The market reaction has be positive, with Greek CDS spreads nearly halving from 6000 to 3500.

Power sector reforms - farm power and tariff revision

The Business Standard reports that the Union Power Ministry have advised State Governments to transfer the massive losses, estimated at Rs 1.06 lakh Cr at end of 2009-10, off the balance sheets of state distribution utilities. It has also advised that states take action to ensure no further cash losses.



If the bailouts or restructurings happen, it will be the second time in almost a decade that state distribution utilities have received such help. At the turn of the century, as part of the first flush of reforms in electricity sector across the country, many state electricity boards were bailed with a Rs 41,400 Cr package. State governments assumed the debts and issued long-term bonds.

Like with the earlier bailout, the present need for bailout appears to have been triggered by similar reasons - the near inevitability of widespread defaults to central generating utilities by state and private sector distribution utilities. This is a clear sign that very little appears to have changed with the sector except in processes and formalities.

In fact, for all the structural reforms that have been enacted in the sector over the past decade, central and state governments have refrained from addressing the twin-elephants in the room - limiting free power for agriculture and regular increases in power tariffs. Unbundling, private sector participation in generation, liberalization of regulatory restrictions in transmission and distribution, and operational improvements like loss reduction, can only get you to the starting line.

Any earnest and meaningful effort to reform the sector has to place farm sector reforms and periodic tariff revision at its center. There is nothing secret nor mysterious about this. Any trading enterprise can survive only if its cost of purchase and service delivery matches its price of delivery. In simple terms, the power procurement cost plus the transmission and distribution cost have to match the aggregate tariffs.

In fact, its importance for the long term health of the sector itself cannot be over-emphasized. The problems faced by privatized distribution utilities in Delhi, who too have massive pending dues with generators, is a reflection of the magnitude of the problems. If the present trends are allowed to continue, it will adversely affect the prospects of private sector generation too. Unlike state generation utilities, private generators will not be able to manage their operations without regular payments on their power sales.

In many respects, the current sorry state of affairs is a serious indictment of the state and central power sector regulators. It is also a classic case of how easily important reforms can be subverted and given lip-service in implementation. It also drives attention to the important issue of tariff revision and the need for public conditioning to accept such revisions.

1. The Electricity Act 2003 and the various state regulatory acts clearly mandates that utilities should not bear state subsidies and state governments should transfer upfront (and not reimburse) the subsidy amounts to utilities for all subsidies being implemented by them. The regulators are supposed to safeguard the interests of the regulated utilities through the annual tariff revision filings. They are mandated to fix tariffs in a manner that reflects utilities' cost of power procurement, a reasonable level of operational efficiency improvements (read loss reduction), and required capital and operational expenditures.

But regulators across states have made a mockery of this, accommodating the interests of their paymasters, the state governments, at the expense of the utilities they were statutorily mandated to protect. Tariff filings in most states have been reduced to a charade, an academic exercise, and most often unprofessional at that, that has no relevance to realities in the field. Regulators, barring a few occasions, have failed to exercise their due powers and force states to bite the bullet on tariff and farm power related issues.

2. The policies of state governments since the reforms were initiated is a classic example of how easy it is to subvert well-intentioned and critical reforms. States have not raised tariffs on domestic consumers for many years now. Assuming inflation and the general increase in cost of procurement, the real subsidy has increased massively. Free power to farmers has remained a holy cow. Even the issue of mere metering of agriculture services raises unbelievable amount of passions.

Even with the latest crisis facing utilities, and despite being fiscally constrained, state governments are unlikely to take any meaningful steps to address this issue on a sustainable basis. It will require commitment at the highest levels to stand even a reasonable chance with pushing through such reforms.

3. Despite nearly two decades of liberalization, the one area where public debate, both in the political realm and in popular media, has remained entrapped in the mindset of the bygone era is that relating to cost-recovery and tariff revision. We cannot shy away for too long from the inevitable fact that consumers have to pay the full cost of any service consumed by them.

Public and political opinion needs to be conditioned into accepting the reality that there are no free lunches. Apparent free lunches are unsustainable and cause serious indigestion down the line. Reforms are not just cheap talk. For any meaningful reforms in sectors like utility and municipal services, important structural reforms have to complement with cost-recovery in service delivery. In simple terms, the culture of free or subsidized delivery has to end. At best, cost-recovery can be ensured in the aggregate through some form of cross-subsidization.

There can be a silver-lining to the crisis. If utilities are to be bailed out, it is a great opportunity for all stakeholders - regulators, state and central governments - come together and agree on some minimum steps with reforming farm power and tariff revision. This blog has always talked about scalable and practical steps in public policy reforms. However, the time may have come to stretch the definition of practicability given the serious magnitude of crisis facing power sector in India. I can think of three such minimal set of steps

1. All agriculture services should be metered. Leave alone bringing in efficiency and accountability in farm power consumption, this is an absolute essential requirement for many upstream reforms. For example, current estimates of distribution losses are badly flawed in the absence of any reliable estimate of agriculture consumption. It is common practice for utilities and regulators to use this as a sinkhole to doctor various operational efficiency and tariff figures that suit their respective agendas.

2. There is scope of considerable reforms with the terms of free farm power supply. To start with, free power supply should be restricted to only certain types of farmers, with the restriction being confined to easily enforceable or detectable parameters or proxy parameters. As I have blogged earlier, governments should move over to a system of fixed monthly units for agriculture consumption, to be reimbursed into the farmers accounts when they pay their monthly farm and domestic supply bills. Its benefits are manifold and the availability of Aadhaar, atleast in certain areas, makes the logistics simpler.

3. Periodic tariff revision, for all categories of consumers, must be made mandatory. In fact, even a simple, rule of thumb increase based on inflation or some other fixed parameter, will be one of the biggest boost for the sector. Just as was done to encourage unbundling of state utilities in the first generation of reforms, state governments should be directed to enter into MoUs or agreements with their utilities or mandate rules that define the terms for periodic tariff revisions. A mandatory and automatic requirement to periodically revise tariffs, agreed between all states and the centre can overcome, atleast partially, the political and collective action problems that accompany such hard reforms.

A graphical summary of the state of Indian Economy

Inflation has remained elevated at 8-10% range for more than 18 months since March 2010. Though the RBI and government have predicted the subsidence of headline inflation for many months now, it remains persistent at these high rates. The RBI's second quarter monetary policy review has projected baseline inflation to be 7% by end-March 2012.



Since February 2010, the RBI has increased rates 13 successive times, the largest such sequence of increases in its history. The repo and reverse repo rates have risen by 375 and 425 basis points respectively during this time.



Adding to the pressure is the steep recent depreciation in the value of rupee. While beneficial to exporters, it has the potential to add to inflationary pressures by making imports, espcially of oil, costlier.



In a reflection of the tightening monetary conditions, anchored inflation expectations, and increased government borrowings (government recently announced an increase in its 2011-12 fiscal borrowing by an additional Rs 52,872 Cr, taking it to a record Rs 4.7 trillion), long-term interest rates have been climbing. Into this milieu the announcement by the government The yields on 10 year government bonds have increased by more than 80 basis points since the beginning of the year.



As a measure of the growing global financial market instability, India VIX, the barometer of equity market volatility, has not only risen but has shown increased fluctuations over the past three months.

Are free markets in information flows good for stability?

Chris Dillow has an interesting post where he compares the role played by information cascades in triggering off stock market sell-offs and riots. In this context, in a recent paper Klaus Adam and Albert Marcet show that even a very small information cascade can generate significant asset price volatility. Can the same model of information cascades be extended to explain rioting?

Extending the same logic to social and political systems, there could be a strong argument that the latest communication technologies and information dissemination channels, which remove information market frictions, reduce their stability. In the circumstances, a familiar debate, similar to that between advocates of laissez faire and those favoring a more nuanced acceptance of free-markets, appears inevitable.

Laissez faire advocates would welcome the proliferation of these technologies as contributing to increasing the efficiency of information flows. They would argue that it will help people make more informed decisions and thereby reduce distortions and prejudices that are commonplace in social, political and economic markets. Is this assessment correct? Is unrestricted information flows and social networking platforms an unqualified good? Do market failures in financial and economic systems carry any relevance for information markets?

There are a few observations on this.

1. Information markets are vulnerable to atleast some of the same failures that characterize financial markets. Mere availability of information does not guarantee efficiency in decision making. As is the case with financial markets, thanks to the cognitive biases of human beings, the manner in which the information is presented or made available has important bearing on their individual response.

2. Social and economic systems straddle a fine line between stability and chaos. Unrestricted information flows often end up unsettling the delicate balance in such systems and chaos ensues. Without going into the merits of whether the delicate balance was sub-optimal or inefficient, it is often the case that stability is the casualty when the information market is unshackled. This assumes importance since socio-political stability is critical for any economic growth and development. The instability that followed the break up of countries like Yugoslavia is an example of this.

3. This brings us to an issue of whether some form of information latency is desirable for social and political stability. For example, in a highly heterogeneous society, democracy and the formal norms of democratic governance cannot be readily transplanted without having in place several other institutionalized checks and balances. Conventional norms of majority rule can be destabilizing in these countries, as evidenced by the civil wars in the aftermath of democratic elections held in a few African countries in the nineties.

4. As information flows unhindered and the communication channels become more active, the probability of even small events upsetting the balance is greater. Even small, often insignificant information flows, as the work of Klaus Adam and Albert Marcet shows, have the potential to generate considerable instability. A sharp increase in the quantity and velocity of information flows, as is happening now, significantly increases the probability of such dynamics being triggered off. This increases the social or political riskiness associated with traditionally unstable societies. This also means that instability mitigating institutional systems assume much greater significance in these countries.

5. Always-on and many-to-many communication channels like social networking sites amplifies the impact of free information flows. In all respects, these channels are much more disruptive of stability that mere information flows. Further, their stability creating aspects, most often end up being crowded out by the stability disrupting aspect. After all, do we not more often come across examples of an information flood clarifying issues instead of complicating them?

None of this is an argument in favor of placing restrictions on information flows and social networking sites. Far from it. It is only a note of caution and a pointer to possible triggers that can upset the stability of social, political and economic systems. It therefore becomes important that such information technology developments be accompanied by policies that mitigate the market failures that arise out of them.

Cost effectiveness and public service delivery

Any true test of a public policy intervention should involve not only an assessment of its defined program outcomes but also its cost-effectiveness in achieving those outcomes. In other words, assuming a set of desired outcomes, which policy approach generates the greatest bang for the buck?

I am inclined to accept the argument that in any real world development intervention, defining the outcomes is essentially a political decision, and therefore the preserve of the respective Department Ministers or the Cabinet. In contrast, structuring the policy design and implementation strategy for a chosen intervention is a bureaucratic/administrative and technical decision, the domain of officials and experts. It is their responsibility to help make an informed choice from among competing policy design alternatives. However, most often, in the real world of policy design and implementation, optimal policy design and cost-effectiveness takes the backseat.

Consider this example. The government of Populismland decides to provide free tertiary medical care and free secondary and higher education, including in private hospitals and colleges, for all those living below the official state poverty line, the BPL. The political objective is laudable. I have already written about the increasing importance of interventionist public policy in education and health care to address glaring market failures.

After the normal inter-departmental consultations, the bureaucrats of Health and Education Departments of Populismland draft their respective implementation strategies. The Health Department proposes the establishment of a government-run Trust to manage the tertiary healthcare program. In order to squeeze out the last ounce of populism, the program provides the ultimate choice to patients to take treatment in any hospital, public and private.

The Education Department too follows a similar script. To ensure that every student belonging to a BPL family gets all types of education for free, in private or government colleges, it formulates a policy that reimburses the full fees to all these students. Colleges fix fees, students apply and get admission, scholarships are sanctioned and disbursed. Simple!

In simple terms, in both cases, all the students belonging to the official BPL category, are offered the unparalleled choice of treatment and education in the best possible hospitals and colleges respectively. As indicated earlier, in both cases, the bureaucrats of Populismland have responded to the dictates of their political masters by tailoring simple but extremely expensive and unsustainable policy designs. How could the bureaucrats of Populismland have done better?

In simple quantitative terms, assuming the objectives, the single most important parameter is the expenditure per person per year for health care and education respectively. In commercial health care and education markets, this is determined by the insurance premium and the interest rate on education loans respectively. Optimal public policy design mandates that it be structured in a manner such that it is atleast as cost-effective as either of these.

Now, in most cases, and certainly with health and education, this would require drawing on professional expertise. The rote and unprofessional manner of policy formulation, commonplace with bureaucratic public policy designs, cannot achieve the objective of cost-effectiveness. So how can the bureaucrats of Populismland address the challenge of cost-effectiveness with its pre-defined healthcare and education interventions.

For a start, in both cases, there should be serious debate about what constitutes eligibility. In some respects, this is the most important determinant of total cost of such programs. In health care, the challenge lies in designing the cheapest and least distortionary insurance scheme. I have blogged earlier here and here about the principles that should underpin such schemes.

In education, the issues are more complex. The challenge would be to provide affordable and good quality college education, in both private or public institutions, at the lowest cost, without creating systemic distortions. A robust mechanism for scholarship sanction and rigorous monitoring its utilization should be established. Incentives that relate sanctions and disbursal to the performance of both students and colleges are an essential requirement. Critical to keeping costs down is a rigorous process of fixing the fee amounts for various college degrees to be reimbursed for those covered under the scheme.

Alternatively, is it possible for public policy to catalyze a carefully regulated but efficient market in education scholarships. Enabling policy framework can be established to encourage banks and other financial institutions to offer student loans. Subsidies, both on interest and principal, of varying amounts, can be offered to students depending on their family incomes. The institutions eligible to be part of any government subsidized loans should be rigorously screened. The exact design of each student loan, and the extent of government support can vary depending on the type of courses.

For example, those studying in professional colleges, and getting placed should take over atleast some portion of their loan. Similarly, those performing poorly in certain school courses should be permitted to avail scholarships only for certain categories of subsequent courses.

In conclusion, any policy which simply doles out assistance, either directly or indirectly, without aligning incentives and preventing systemic incentive distortions, is a recipe for disaster. More importantly, it is a clear case of abdication of their responsibilities by administrators.

Global economy's external debt tangle

Excellent graphic in Times that captures the web of debt exposures among all major global economies. As the graphic shows, the consequences of a cascade of adverse events - defaults, contagion, credit contraction, and collapse of economic activity - can be potentially catastrophic.



(Click on the graphic to enlarge)

See also this interactive graphic.

Update 1 (24/12/2011)

An analysis of the age of debt.

Commodity bonds to hedge price volatility

Commodity exporters have always been vulnerable to the vagaries of global commodity price volatility. Jeffrey Frankel suggests the use of commodity bonds by both commodity exporters and their buyers to hedge against price risks.

Exporters of a particular commodity would issue debt denominated in terms of the price of that commodity (say Aluminium bonds by Jamaica), rather than dollar or any other currency. The interest rate paid on this debt will increase or decrease depending on whether the commodity prices are rising or falling respectively. This will ensure that the cost of debt service adjusts automatically (and debt-to-export ratio does not rise) in case of a decline in the price of the underlying commodity. The purchasers of this debt could include the major buyers of these commodities, whose (price increase) risk can be mitigated by the increased returns from higher commodity prices. He writes,

Instead of denominating a loan to Nigeria in terms of dollars, the Bank would denominate it in terms of the price of oil and lay off its exposure to the world oil price by issuing that same quantity of bonds denominated in oil. If the Bank lends to multiple oil-exporting countries, the market for oil bonds that it creates would be that much larger and more liquid. This pooling function would be particularly important in cases where there are different grades or varieties of the product (as with oil or coffee), and where prices can diverge enough to make an important difference to the exporters.

Why has rent-seeking increased?

Corruption is arguably the dominant public policy issue being debated in India today. The popular lament is about an alarming increase in corruption. The graphic below highlights a part-philosophical, part-economics explanation.



The dynamics of philosophy and economics have combined to mis-align incentives badly to favor those seeking rents. The returns from rent-seeking have surged, whereas the risk of getting caught has come down. Therefore, naturally, the rate of return, per unit of risk assumed, has exploded. Further, the self-respect quotient among public officials has declined precipitously (partly because the strong stigma associated with rent-seeking has long since disappeared and also since rent-seeking has got closer to the norm). So is there any surprise at the dramatic increase in corruption?

The psychology of poverty

Conventional wisdom on poverty has been that poor remain poor because of low incomes and their certain lifestyle and behavioural traits - lack of cleanliness, limited self-control, wasteful expenditures, idling away time etc. While incomes are not within their control, it has been argued that the poor could be encouraged to change certain behavioural traits that could increase the likelihood of their overcoming or atleast mitigating poverty.

This post is a summary of considerable research that appears to point to a significant role of behavioural psychology in determining the behaviour of the poor.

1. I had blogged earlier about the bee-sting theory of Charles Karelis.

When we're poor our economic worldview is shaped by deprivation, and we see the world around us not in terms of goods to be consumed but as problems to be alleviated. This is where the bee stings come in: A person with one bee sting is highly motivated to get it treated. But a person with multiple bee stings does not have much incentive to get one sting treated, because the others will still throb. The more of a painful or undesirable thing one has (i.e. the poorer one is) the less likely one is to do anything about any one problem. Poverty is less a matter of having few goods than having lots of problems. Poverty and wealth, by this logic, don't just fall along a continuum the way hot and cold or short and tall do. They are instead fundamentally different experiences, each working on the human psyche in its own way.

Karelis argues that poverty introduces a diminishing marginal utility to putting in effort, "One doesn't have enough money to pay rent or car insurance or credit card bills or day care or sometimes even food. Even if one works hard enough to pay off half of those costs, some fairly imposing ones still remain, which creates a large disincentive to bestir oneself to work at all."

2. Conventional wisdom would have it that people exercise their free willpower to resolve conflicts among competing choices and demands on their scarce resources (be it money, time, space, attention, affections etc) and make decisions in a rational manner and in their best interests. In other words, these decisions are thought to be under the control of the respective individuals.

A recent New Republic article points to the pioneering work of researchers from Case Western Reserve University, Roy Baumeister, Ellen Bratslavsky, Mark Muraven, and Dianne Tice, who found that an individual’s capacity for exerting willpower was finite. Their experiments found that self-control was depletable - exerting willpower in one area makes us less able to exert it in other areas subsequently in the immediate future.

They had food-deprived subjects sit at a table with two types of food on it: cookies and chocolates; and radishes. Some of the subjects were instructed to eat radishes and resist the sweets, and afterwards all were put to work on unsolvable geometric puzzles. Resisting the sweets, independent of mood, made participants give up more than twice as quickly on the geometric puzzles. Resisting temptation, the researchers found, seemed to have "produced a 'psychic cost'".

In another experiment, participants were asked to remember a number – the number was randomly selected to either be a short two digit number or a seven digit number – and then to walk down a hallway to another room for an interview. As a seeming afterthought, they were told there is a snack cart in the hallway and to help themselves to one of the snacks. The snack choice was either fruit salad or chocolate cake. The subjects asked to remember the two-digit number selected the fruit salad in equal proportions to the chocolate cake. The subjects tasked with remembering the longer seven digit number overwhelmingly chose the chocolate cake. The authors attribute this to depletable self-centrol - when attention is focused elsewhere, such as on retaining a long number, there is less of this resource available to guide the decision over snack choice.

In another experiment in rural Rajasthan by Dean Spears, people were, in random order, offered to purchase a well-known brand of soap at a highly discounted price and they were also asked to squeeze a mildly resistant handgrip for as long as possible (handgrips are common way to measure cognitive control, with the duration determined by mental will power). He found that if the hand grip came before the offer of discounted soap, both poor and rich respondents squeezed the grip for an average of two minutes. But if the decision to purchase soap was taken before the hand grip exercise, the rich respondents still held the handgrip for an average of two minutes, while the poor gripped for a full 40 seconds less. He found that by making economic decision making more difficult for the poor, poverty depletes cognitive control.

These results have been corroborated in more than 100 experiments, where researchers have found that exerting self-control on an initial task impaired self-control on subsequent tasks - consumers became more susceptible to tempting products; chronic dieters overate; people were more likely to lie for monetary gain; and so on. In addition to self-control decisions, these researchers have expanded the theory to cover tradeoff decisions - like choosing between more money and more leisure time. They have found that tradeoff decisions require the same conflict resolution as self-control decisions and appears to similarly deplete our ability to muster willpower for future decisions.

In all these cases, willpower can be understood as the capacity to resolve conflicts among choices as rationally as possible, and to make the best decision in light of one’s personal goals. And, in all of them, willpower seems to be a depletable resource. The Development Impact blog writes,

"The conditions of poverty exact a heavy toll on cognitive resources through the everyday challenges of scarcity. The repeated trade-offs confronting the poor in daily decision making – i.e. "should I purchase a bit more food or a bit more fertilizer?" – occupy cognitive resources that would instead lay fallow for the wealthy when confronted with the same decision. The rich can afford both a bit more food and a bit more fertilizer, no decision is necessary...

My impulsive desire may prefer the consumption good in front of me, but my cognitive control can resist that impulse and select the alternative investment good if it hasn’t already been depleted through recent repeated usage. If my control resource has been depleted through earlier use, then the conditions of poverty can induce behavior that in turn prolongs poverty... because cognitive control is a depletable resource, the higher frequency of difficult economic decisions confronting the poor takes a toll on subsequent decisions."

Dean Spears did field experiments in India and analysed the American Time Use Survey and found that poverty is responsible for lower performance and control.

3. The theory of declining temptations says that the fraction of the marginal dollar that is spent on temptation goods decreases with overall consumption. Sendhil Mullainathan and Abhijith Banerjee argue that "declining temptations can help to explain a large range of phenomena, from poverty traps to credit and investment behavior". They argue that this "has a number of striking implications for the investment, savings, borrowing and risk-taking behavior of the poor".

They advocate using these insights to design commitments savings products (that both force savings and limit withdrawals) for poor people. Nava Ashraf, Dean S. Karlan, and Wesley Yin designed commitment savings products for a Philippine bank and found that those who opened the account increased savings by 192% and 337% over 6 and 12 months respectively relative to the control group.

4. Lack of control

Psychologist Martin Seligman has propounded the concept of "learned helplessness", as a "condition of a human person or an animal in which it has learned to behave helplessly, even when the opportunity is restored for it to help itself by avoiding an unpleasant or harmful circumstance to which it has been subjected". It follows that clinical depression and related mental illnesses may result from a perceived absence of control over the outcome of a situation.

Accordingly, when we don't feel we have some level of control over our lives we get depressed. And when we feel we have no control for a long time we stop trying to improve a terrible situation because we don't think it's possible anymore. Eric Barker writes about the story of taming elephants - after being leashed by a chain and realizing that they cannot break-free, elephants stop trying to get free even if the chain is replaced with a rope. Such feeling of lack of control, arising from factors like unfair workplaces, bad bosses, and unemployment, have been found to lead to poor health. It is therefore natural for a poor person, who faces a series of continuous struggles on even the most mundane and basic of things, to feel that things are mostly out of his control and accordingly feel depressed and unproductuive.

5. Decision fatigue

I have blogged earlier about a study by Shai Danzigera, Jonathan Levavb and Liora Avnaim-Pessoa of the changes in the nature of decision-making by eight experienced parole judges in Israel during a court session. They found that the prisoners appearing for parole were "anywhere between two and six times as likely to be released if they are one of the first three prisoners considered versus the last three prisoners considered".

The larger message sought to be highlighted by this experiment is that human beings are vulnerable to decision fatigue - the ability to discriminate and make objective decisions get depleted as the session or day (or even life?) progresses. Jon Tierney sums it up nicely,

"No matter how rational and high-minded you try to be, you can’t make decision after decision without paying a biological price. It’s different from ordinary physical fatigue — you’re not consciously aware of being tired — but you’re low on mental energy. The more choices you make throughout the day, the harder each one becomes for your brain, and eventually it looks for shortcuts, usually in either of two very different ways. One shortcut is to become reckless: to act impulsively instead of expending the energy to first think through the consequences... The other shortcut is the ultimate energy saver: do nothing. Instead of agonizing over decisions, avoid any choice. Ducking a decision often creates bigger problems in the long run, but for the moment, it eases the mental strain. You start to resist any change, any potentially risky move — like releasing a prisoner who might commit a crime. So the fatigued judge on a parole board takes the easy way out, and the prisoner keeps doing time."

This analysis is similar to the arguement above that people have a finite store of mental energy, which enables them to exert self-control. Therefore, once they indulge in activities that require utilization of this self-control (like decision making), their reservoir of mental energy is depleted, and they are likely to show less mental commitment in subsequent activities. This phenomenon manifests itself in people making irrational and often impulsive choices and decisions when their mental energy level gets depleted.

Extending this analysis to poor people could help throw light on some of the elements that characterize people living in poverty. Experiencing scarcity in everything (time, money, space, jobs, physical strength etc), more than any others, poor people have to constantly make decisions involving trade-offs. This depletes their pool of mental energy faster, leaving them to either act impulsively or not act at all. The popular caricatures of poor people with different manifestations of these attributes can atleast partially be attributed to decision fatigue and depleting mental energy.

Tierney offers a neat summary of all these new behavioural psychology theories of poverty,

"This sort of decision fatigue is a major — and hitherto ignored — factor in trapping people in poverty. Because their financial situation forces them to make so many trade-offs, they have less willpower to devote to school, work and other activities that might get them into the middle class. It’s hard to know exactly how important this factor is, but there’s no doubt that willpower is a special problem for poor people. Study after study has shown that low self-control correlates with low income as well as with a host of other problems, including poor achievement in school, divorce, crime, alcoholism and poor health."

Labor market matching problems

Conventional public policy on employment generation is limited to the creation of new jobs and training to equip job seekers with requisite skills to compete in the job market. Since the former is directly related to the larger issue of economic growth, the focus of government driven employment generation programs have been largely confined to the later.

However, this approach, while a necessary requirement in any employment generation policy, may be a limited view of the dynamics of labor markets. I can think of atleast two dimensions of labor market inefficiency that keeps employment market at a sub-optimal equilibrium.

1. Matching unemployed labor to employers - At any time there are unemployed people looking for jobs and buyers of this labor searching for sellers. The problem is how to match them. This is a big challenge with un-skilled and semi-skilled service sector jobs. How do we match demand for specific jobs at a specific location and on specific terms, with sellers who meet all these requirements?

Such first level of matching immediately adds people to the workforce and reduces job-search inefficiencies. Businesses benefit by way of lower search costs for employing required labor (firms incur expenditures varying from 1-3 months salary as the cost of locating the right labor pool). People stay out of workforce for longer than necessary. Can public policy lower this inefficiency?

2. Optimal matching of under-employed labor - This involves matching employed people with jobs appropriate for their skill and capability level. In other words, it enables efficient matching of labor supply and demand.

Consider the case of Ramu, working with a small, single employee mom-and-pop clothes retailer in a city. After two years in the job, Ramu acquires enough skills to assume more demanding responsibilities. He can easily fit into the role of a lower manager in a shopping mall. His place can in turn be taken by a semi-skilled or even unskilled new addition to workforce, Ravi, who recently migrated from the neighbouring district in search of jobs. Everyone benefits - Ramu benefits by way of higher wages, Ravi gets employment, mom-and-pop retailer gets employee at lower cost, and the mall gets an employee with skills and experience. Most importantly, the economy benefits by way of productivity enhancing efficient matching of two people with varying skills with jobs that are most appropriate for them.

When several millions of such matching takes place, the efficiency gains are massive. It translates into the mom-and-pop shops expanding and hiring more labor, the mall increasing its sales, consumption by the new additions to the workforce adding to aggregate demand, and so on. In other words, the removal of such inefficiencies sets the stage for a virtuous circle of economic growth and job creation. How can public policy enable the removal of these inefficiencies and facilitate efficient matching of labor supply and demand?

In both these cases, the fundamental issue is a matching problem - how do we match unemployed or under-employed workers with their potential employers? Left to itself, for various reasons, the markets cannot enable efficient matching, especially in developing economies. Therefore, what role can governments play in facilitating such matching?

I had blogged earlier about the possibility of governments facilitating this by establishing and adding value to a dynamic meta-labor supply database. This would serve as a database for individual employers or placement agencies to locate job seekers who meet their requirements, thereby benefiting both sides.

I am strongly inclined towards the view that public policy has an important role to play in facilitating this matching process. The debate should be about how to achieve it without creating any major labor market incentive distortions.

China and US - Contrasting paths to structural imbalances?

In many ways, China and US are classic examples of how both free-market capitalism and statist capitalism, through contrasting routes, have produced severe macroeconomic imbalances that have brought the later to its knees and threatens the former. The graphic below insightfully captures the respective problems of the American and Chinese economies.



It was unbridled financial market liberalization and sustained expansionary monetary policy, which fuelled massive property and financial asset bubble and debt-financed household consumption binge, that is the source of much of America's current woes. Notional household income share of the GDP rose on the face of the twin bubbles. Households spent as though there was no tomorrow, running savings down to the bottom. Finally when the bubble burst and the recession took hold, households faced the brunt of the slowdown and even after four years, recovery remains uncertain.

In China, the policies enacted in late nineties, in response to bankruptcy problems facing state-owned companies and banks, looks set to have much the same impact in not the distant future. Beijing assumed tighter control over interest rates and exchange rates, keeping them artificially low to finance cheap loans to businesses and government agencies and increase external competitiveness so as to drive its preferred export-led and infrastructure investment driven economic growth model. This period also coincided with the government abandoning the communist era policies of life-long employment and liberal social safety nets, thereby forcing households to increase their savings to meet educational, health care and housing needs for themselves and their children.

These policies amounted to a huge transfer of wealth from the households to businesses, both government and private, and government agencies. Banks and state-owned companies staged excellent recoveries. But all this was at the cost of households - household consumption, already among the lowest at 45%, fell to just 35%, and savings rate rose sharply to about 40%.



As the Times and the FT point out in two excellent essays, this model worked well so long as the export markets were vibrant and the infrastructure deficit was filled, and the government was able to control the supply and price of credit and thereby keep cost of capital artificially low. As the two primary growth drivers weaken, as is happening now, and the unregulated shadow banking system assumes an increasingly dominant role (it now supplies more credit to the economy than the formal banking system) thereby weakening Beijing's ability to control credit, the sustainability of this growth model becomes doubtful. The sliding property market which financed a major share of the investment spending, especially by local governments, is yet another source of concern.

George Magnus writing in the FT has this to say about China's rebalancing strategy from an investment-centric and credit hungry model to one built around consumption,

"It involves a redistribution of income from capital and profits to labour and wages; radical changes in the role of the exchange rate, interest rates and capital markets; and strategies to counter the high propensity to save by households, corporates and central government. It is also politically divisive because power and economic privilege have to be wrested from party elites, state enterprises and banks, and given to new beneficiaries such as private companies, households, college graduates and rural migrant workers."

It is increasingly inevitable that China can sustain its high growth rates only if its domestic consumers can step into the space being vacated by the traditional growth engines. The question is whether Beijing has the stomach to embrace the required structural reforms to enable this transition?

Benford's Law in accounting

Tim Harford, Mark Thoma and Marginal Revolution have interesting posts on Benford's Law, which in essence states that in contrast to the statistically irregular manipulated data, "real" data in any type of data distribution have some statistical regularity.

Tim Harford writes,

"Benford’s Law was discovered in 1881 by the astronomer Simon Newcomb, and then again by Frank Benford, a physicist at General Electric, in 1938. The law is a curious one: it predicts the frequency of the first digits of a collection of numbers. For example, measure the lengths of the world’s rivers, and see how many of the digits begin with “one” (184 miles; 1,543 miles) versus “three” (3,022 miles) or “nine” (985 miles). Newcomb and Benford discovered that the first digit is usually a “one” – fully 30 per cent of the time, over six times more common than an initial “nine”. And the result is true whether one counts the numbers on the front page of The New York Times or leafs through baseball statistics."

And he gives an example of how manipulated data fails the Benford test,

"A manager who must submit receipts for expenses over £20 may end up filing claims for lots of £18 and £19 expenses – and the data will then contain too many ones, eights and nines. A forensic accountant can easily check this, and while not an infallible check, it’s an indicator of possible trouble."

Marginal Revolution draws attention to a post by Jialan Wang who shows how Benford's law reveals possible manipulation of corporate accounting statements.

"So according to Benford’s law, accounting statements are getting less and less representative of what’s really going on inside of companies. The major reform that was passed after Enron and other major accounting standards barely made a dent... deviations from Benford's law are compellingly correlated with known financial crises, bubbles, and fraud waves... Accounting data seem to be less and less related to the natural data-generating process that governs everything from rivers to molecules to cities."

Can analytics software developed based on Benford's Law be of practical use in monitoring public policy? For example, can it be used to detect cheating in performance reporting among all types of officials, say, students academic performance reported by teachers?

Nudging to stay healthy!

As health care costs ratchet upwards, insurance companies have been experimenting with various strategies to keep them under control. The most interesting approaches involve the use of insights from behavioural psychology to nudge people into staying healthy so that their treatment expenditures are minimized.

The Economist points to the success of South African insurer, Discovery Group, with its "Vitality" program that applies the "air miles" model to health care. Discovery has risen from obscurity to become South Africa's largest health insurer in less than two decades.

"You earn points by exercising, buying healthy food or hitting certain targets. You rise through various levels, from blue to gold, as you accumulate points (rewards are adjusted to your starting level of fitness to give everybody a chance of making progress). And you are given a mixture of short- and long-term rewards ranging from reduced premiums to exotic holidays.

Discovery has formed alliances with a host of companies to provide rewards linked to your 'vitality level'. Pick ’n’ Pay, a South African grocery chain, provides discounts of up to 25% on 10,000 'healthy foods'. Airlines such as Kulula offer discounted flights. Discovery can measure whether people actually go to the gym, rather than just join, by swiping their membership cards. It says it has solid evidence that participation in the programme more than pays for the rewards: active participants are less likely to fall ill and, if they do, they spend a shorter time in hospital."

The "air miles" model of incentivization has been deployed in other industries, "including a credit card that offers discounts linked to well-being and car insurance that offers cheaper petrol to people who drive safely (a telemetric device installed in your car monitors aggressive driving, like harsh acceleration or sharp cornering)".

Corruption and growth

Tim Harford points to this insightful joke which captures the difference between the roving bandit and the stationary bandit, about which I had blogged earlier.

"A bureaucrat from Sani Abacha’s Nigeria visits a bureaucrat in Suharto’s Indonesia and is impressed that his Indonesian counterpart lives in a nice house and drives a Mercedes. "Do you see that road? Ten per cent," the Indonesian explains.

A couple of years later the visit is reciprocated. Suharto’s man finds the Nigerian civil servant in a palace with a pair of Ferraris. "Do you see that road?" says the Nigerian, gesturing at virgin rainforest. "One hundred per cent.""

He explores the challenge of reconciling the incentives of the inevitable corruption among politicians and bureaucrats with those of promoting national economic growth. He points to the success as countries like South Korea, which despite close and corrupt nexus between businessmen and the ruling elite, managed to escape being grid-locked in corruption and stagnation by focusing on export-driven growth. This focus on export markets and the need to be competitive ensured that corruption did not compromise on productivity and quality.

Similarly, the spectacular Chinese economic growth story conceals rampant corruption involving close relationship of politicians, bureaucrats and businessmen. However, certain systemic incentives sought to mitigate the adverse consequences of such corruption and align incentives of all sides towards promoting growth. The export driven growth model, which underpinned the success of town and village enterprises (TVEs), and the informal economic performance based promotions of local party apparatchiks contributed in no small measure to China's success.

In all these models, the ruling establishment, wilfully or otherwise, succeeded in putting in place mechanisms that incentivized economic growth and more critically linked the flow of corruption benefits itself to this growth. In other words, these systems ensured that corruption was sub-ordinated to the achievement of the broader macroeconomic and growth objectives. As the economic growth increased, all stakeholders realized the benefit of nurturing the goose that lays the golden egg, a virtuous cycle of growth and corruption got entrenched. I have two observations about this.

1. Is it possible to replicate this model in countries like India? I am inclined to believe that there are a few ingredients that served to sustain this model, which may be missing in countries like India. The most important ingredient is literacy. I believe that high-levels of literacy exposed all stakeholders to the benefits of sustainable economic growth. Most often, as is evident in the lower level corruption in countries like India, where illiteracy is widespread, the extent of corruption is not dis-similar to Abacha's Nigeria. Though I am not aware of any empirical validation, I believe that there could be a positive correlation between stationary bandits and literacy, and vice-versa between roving bandits and literacy.

Another factor that could possibly come in the way of the formation of such mutually-beneficial coalitions in India may be democracy itself. Does the inevitable lack of discipline of democratic politics erode the stability of such coalitions? Does the lack of continuity in multi-party democracies hamper the establishment of a stable elite?

2. An important point about state-driven industrial policy that is often missed in standard debates about its pros and cons is its role in building and sustaining such coalitions. Supporters point to its role in effective allocation of resources in developing economies. However, they overlook its equally important role in sustaining the careful equilibrium among a set of stationary bandits.

The industrial policies followed by countries like South Korea and China have for long been accused of having engendered a system of crony capitalism. However, the redeeming feature of this capitalism, appears to have been that these capitalists were interested in first expanding the pie and then nibbling the expanded pie!

In other words, East Asian industrial policy not only allocated resources efficiently, but also did so in a manner that reconciled the apparently contradicting need to appease the rent-seeking inclinations of the ruling elites and maintain economic growth.

Mathew Effect in Poverty

The experience from Great Recession has once again conclusively shown that as the economy weakens, the under-privileged and disadvantaged are the most vulnerable. It is doubly ironic that these people are suffering in a recession caused by those at the top of the social and income ladder, most of whom have been spared the worst and many are even prospering. Clearly, the poor are paying for the sins of somebody else!

Consider these three graphics from the impact of the Great Recession on the American society. People with a four-year degree — who have an unemployment rate of just 4.3 percent — are barely experiencing an economic downturn. It should come as no surprise that not only were the least educated most vulnerable during the plunge into recession but also the least successful during the recovery. In fact, those with the best education levels enjoyed an increase in employment rate during the recession.



Among all industries, those with lower than high school education performed much worse than those at the higher end.



This graphic captures the magnitude of the disparity



A more rational analysis would explain this irony as the natural order of things in a modern economy. Not only are those at the lower end of income ladder more vulnerable to recessions and slowdowns, they are also among the least likely to benefit from any booms or upturns.

For a start, those at the lower end of the income ladder obviously do not have the wealth to cushion them from any dips in their incomes, just as those at the other end can draw down from their pots. But more critically, the dynamics of modern economies - education-premiums, skill-bias etc - militates against those initially disadvantaged or under-privileged. A form of Mathew Effect - "For to all those who have, more will be given, and they will have an abundance; but from those who have nothing, even what they have will be taken away" - is a distinguishing characteristic.

Therefore, as economies globalize, the case for a strong, universal, and dynamic social safety net becomes ever more relevant. People are more exposed, often directly, to global economic forces, many of which may adversely affect their livelihoods and push them into poverty or deepen their existing poverty-stricken condition. Further, unlike earlier times when economic mobility was mostly upwards and at a slower pace, such mobility is becoming increasingly rapid and also involves two-way movements.

In the circumstances, if economies are to cushion their vulnerable sections of population to the vagaries of these global economic forces, a social safety net should be a priority. This comfort is also necessary to increase the political acceptability of policies that involve trade liberalization and making labour markets more liberal and flexible.

The dynamic nature of these changes in income status also means that increasingly social safety entitlement programs should have an automatic entry and exit provisions. Those who suddenly fall into poverty (by say, an easily identifiable event like job loss or migration back into his village etc) should be able to avail of the social safety benefits just as those who experience an increase in incomes should drop-off. This automaticity, like with unemployment benefits in the US, will minimize the role of governments, with all its political dimensions, and make these programs more efficient and less distortionary.

At some time, when Aadhhar becomes more universal, and integrated national databases are available, it may be possible to have such dynamic poverty programs in India too. For example, those who get a government job could be declared ineligible for food rations with immediate effect. This will address one of the current biggest problem with entitlement programs in India - absence of sunset clauses.

Financial sector and widening inequality

(HT: New York State Comptroller’s Office, via Economix)

Update 1 (15/3/2012)

Times writes,

Before 1990, pay for the chief executives of financial firms were on par with those of chief executives of the largest traded companies, or even slightly lower. By 2005 the pay was roughly 250 percent bigger on average, said Ariell Reshef, a professor of economics at the University of Virginia. Broadly speaking, between 1980 and 2005, bonuses and salaries in finance increased 70 percent more than average pay elsewhere.

The desirability of an expansionary credit-driven recovery?

Even as the debate rages about how best to achieve recovery, there is the issue of what should constitute recovery. Though there cannot be much argument about the need to bring down unemployment rates to the pre-recession lows, the need to restore the other macroeconomic parameters (notably those related to financial sector and household consumption) to its pre-recession peak is questionable.

Roger Farmer, an ardent advocate of the superiority of quantitative easing over fiscal expansion and a strong believer of the self-fulfilling effect of market confidence, writes,

"Housing wealth in the US has fallen by 34% since its peak in 2006, and is still declining. The stock market fell by almost 50% from its 2007 peak and remains down by nearly a third. This enormous loss of wealth caused a large and persistent drop in consumption demand, which has led to an increase in unemployment... A quantitative-easing policy in which a central bank buys risky assets can prevent price fluctuations and restore the value of financial wealth...

My work provides a new and coherent approach to macroeconomics that explains how a lack of confidence can lead to persistent unemployment. It supports the purchase of equities by central banks to reduce asset-price volatility, restore the value of wealth, and prevent a future market crash...

The Great Recession did not turn into Great Depression II because of coordinated action by governments around the world. Although fiscal expansion may have played a role in this success, central bank intervention was the most important component by far. Quantitative easing works by increasing the value of wealth."

The underlying assumption behind Prof Farmer's hypothesis is that normalcy can be achieved only with a restoration of the pre-crisis financial asset values. The same assumption drives the logic of those advocating expansionary policies - somehow consumers will start to buy, businesses will invest, and banks will lend, thereby restoring normalcy in economic growth, and this in turn requires adequate time so that market confidence will revive and asset values will regain their old highs.

The logic behind monetary accommodation is to buy some time so that the forces of economic growth can be catalyzed into action. It is hoped that if market expectations can be shaped, it could pave the way for growth - investments, jobs, and consumption - which in turn would restore asset values to the pre-recession era standard.

Expansionary policies, especially on the monetary side - like maintaining ultra-low interest rates for an extended period of time - have the potential to generate and amplify existing distortions. One manifestation of this is the deepening divide between the bigger firms and the small and medium businesses in the US. While the former have continued to access credit at ultra-low interest rates and pile on record profits, the later have been badly squeezed in the credit markets. Risk averse banks have been wary of lending to these companies, who are the predominaty actors in creating jobs in the US economy. The result

Another example is the phenomenon of the existing TBTF institutions getting even bigger and more riskier riding on the back of the favorable policy regime. In fact, as Nassim Nicholas Taleb and Mark Spitznagel have argued persuasively in a recent article, the US Treasury and the Fed, as part of TARP and the numerous other unconventional monetary policies, have transferred an astonishing $2.2 trillion to the major American banks and this figure is estimated to reach $5 trillion by end of the decade. They write about how banks, despite their recklessness, were bailed out by the US government.

"Banks take risks, get paid for the upside, and then transfer the downside to shareholders, taxpayers, and even retirees. In order to rescue the banking system, the Federal Reserve, for example, put interest rates at artificially low levels; as was disclosed recently, it also has provided secret loans of $1.2 trillion to banks. The main effect so far has been to help bankers generate bonuses (rather than attract borrowers) by hiding exposures.

Taxpayers end up paying for these exposures, as do retirees and others who rely on returns from their savings. Moreover, low-interest-rate policies transfer inflation risk to all savers – and to future generations. Perhaps the greatest insult to taxpayers, then, is that bankers’ compensation last year was back at its pre-crisis level."

Banks benefitted immensely from the prolonged period of access to ultra-low interest rates, blanket credit guarantees, collateral standards dilution, and massive capital injections. At the height of the crisis, the Fed backstopped bank losses by becoming the lender, insurer and even purchaser (buying up illiquid and risk-filled mortgage backed securities to prevent values plummeting) for the entire financial system.

As the crisis expanded and the strains started showing on some of the largest financial institutions, it became increasingly evident that their failure would have catastrophic consequences on the economy. So the momentum gathered to provide all possible liquidity support and even direct bailouts, if need be, so as to contain the spread of systemic risks. The underlying premise was that it was mainly a liquidity crisis (and not a solvency one), and if the banks were given enough time, market confidence would be restored, asset values would recover, and balance sheets will be repaired.

It can be safely argued that this strategy worked, and the balance sheets of the biggest banks have recovered considerably from the depths of 2008-09. However, unfortunately, this relatively quick recovery has blanked out all institutional memory of the lessons from the sub-prime crisis. Apart from some cosmetic changes, financial markets continue merrily with limited regulation.

The same old unhealthy practices, ones that led to the build-up of systemic risks in the first place, are back along with the driving force behind these trends - distorted incentives of traders, executives and managers. Executive compensation is back to the halcyon days of the pre-crisis era. The big financial institutions have gotten bigger and enjoy the benefits of a market place where even as their smaller competitors are credit constrained, they themselves have access to capital at utlra-low rates for an extended period of time. It clearly appears as though nothing has changed, and the cycle looks set to repeat, with the markets in wait for the next bubble to inflate.

In a recent post about the Eurozone crisis, Tyler Cowen had written that though the Eurozone governments had on paper a balanced budget, their commitment to a single currency was a massive naked put, relative to their GDP, which was not internalized into the national budgets. Similarly, the growing sizes of the TBTF institutions and the resultant concentration of risks, is a very large naked put by the US government in favor of its TBTF institutions, one which is unfortunately not reflected in the US government's fiscal balance. Only when disaster strikes and the bailout checks have to be signed, the true magnitude of the fiscal commitment becomes obvious.

Finally, there is the impact of the extraordinary monetary accommodation in the US on the world economy, especially the emerging economies. The massive stocks of easy money sloshing around poses great threats to financial market stability. For a start, it can trigger off destabilising capital inflows into emerging economies and undesirable sharp currency appreciation. However, these flows can quickly reverse, leaving currencies and equity markets battered.

The aftermath of the sub-prime mortgage crisis presented a great opportunity for regulators to clamp down on the several unhealthy business practices in financial markets that were primarily responsible for the mess. However, that window of opportunity is almost gone. And more worryingly, the market conditions that has emerged in the aftermath of the crisis may be perpetuating or even amplifying many of the worst offending excesses.

We appear to have been left with the worst of all worlds. The regulators have failed to seize the opportunity. The market conditions in the aftermath of the crisis works towards making the big institutions even bigger. And amidst all this, the credit markets remain seized up and the economy continues to show no signs of any recovery.