Wednesday, February 29, 2012

What's common between the PIIGS and India's electricity utilities?

For a start, both are deeply in the red and require debt restructuring programs that need to go beyond mere rescheduling or re-packaging. Further, both need fundamental reforms that the respective policymakers and governments appear unwilling to embrace! And finally, in both cases, so far governments have been interested in merely kicking the can down the road.

Both governments appear to be treating the symptoms instead of the underlying problems. The Eurozone needs to face up to the reality that its peripheral economies' debt problems can recede only if their economies grow fast enough to bring down the debt-to-GDP ratios. This would require abandoning the current austerity programs and embracing policies that address fundamental issues like competitiveness problems (Ken Rogoff says wages should be halved), banking solvency, and fiscal transfers from the core economies.

In Eurozone, everyone realizes that the immediate problem is the resolution of the massive debt overhang faced by governments and financial institutions in many peripheral economies. After having exhausted all the conventional interest rate monetary policy tools and faced with ballooning debt finance costs by countries like Greece, the European Central Bank (ECB) first introduced a bond-purchase program in May 2010. After it failed to unfreeze the credit markets and lower yields and when fears of defaults mounted, threatening even Italy and Spain, in August 2011 the ECB announced a three-year concessional long-term capital provision program for Eurozone banks.

Some of those banks in turn used the money to buy higher-yielding government bonds, facilitating governments’ access to affordable credit without violating a legal ban that prevents the central bank from financing governments. The first infusion involved provision of of €489 billion (or $642.5 billion at the current exchange rate) in low cost three-year loans to 523 banks. The second round is slated for February 29, 2012.

In case of India's mostly state-owned distribution utilities, faced with an estimated losses (or non-performing loans) worth nearly Rs 70000 Cr over the last five years (since 2006) and a possible cumulative losses of over Rs 1.75 lakh Cr, the Government of India (GoI) is training its energies on a way out of this massive debt gridlock. A Planning Commission report has suggested that these loans be ring-fenced into special purpose vehicles guaranteed by the state government.

However, any sustainable solution would need both GoI and the state governments to implement policies that dramatically lower the shamefully high distribution losses, increase tariffs periodically to bring it in line with cost of service, and reduce the haemorrhage due to the free power for agriculture. A report released by credit rating agency Crisil estimated the gap between the average cost of supply per unit of power and the realization per unit was as high as 86 paise.

All stakeholders would do well to remember that such debt restructuring is not new to the electricity sector. Early last decade, before the current wave of deregulation and liberalization in the sector started, the accummulated losses of the State Electricity Boards (SEBs) were hived off their balance sheets and the SEBs were unbundled. Ten years down the line, nothing much appears to have changed as the next round of debt restructuring looms large.

In conclusion, both Eurozone countries and distribution utilities need to not only shake-away their debts but also undertake fundamental structural reforms. In the former, it will have to involve policies that sets the stage for recovery and economic growth, which in turn will reduce the debt-to-GDP ratios. The latter will have to follow a two-pronged approach of atleast partially off-loading their debts and simultaneously embracing all the earlier mentioned reforms.

Tuesday, February 28, 2012

India's non-inflationary growth rate

The RBI Governor D Subba Rao candidly admitted that India's non-inflationary economic growth rate was 7%. In other words, in order to grow beyond 7% without stoking high inflation, India should take steps to ease supply-side constraints like infrastructure bottlenecks, food production deficiency, labour supply shortages and so on.

In this context, a linear extrapolation of India's GDP growth rates since 1951 reveal that the current trend growth rate may be at about 7%. It is obvious that the economy has been growing above the trend growth rate for a some time now, thereby stoking the inevitable inflationary pressures.

If this trend growth rate has to move upwards, it is important to increase the productive capacity of the economy. This can be achieved only with increased investment activity, especially in fixed capital formation. However, on both counts, investment rate and gross fixed capital formation, the Indian economy has been doing badly since the onset of the recession.

Monday, February 27, 2012

Why redistribution matters?

John Sides in The Monkey Cage has an excellent post that points to the distinction between the progressivity of taxation and the level of inequality.

This paper by Moinca Prasad and Yingying Deng has an excellent graphic of the progressivity of direct taxes, as measured by the Kakwani index of taxation (a measure of the progressivity in the distribution of taxes among different categories that controls for the impact of income concentration on the concentration of the tax burden), in many advanced countries.

However, given its relatively higher Gini coefficient, America's progressivity of taxation does not translate into lower income inequality. So what gives? The aforementioned paper shows that the high progressivity in America's taxation system is matched by the low level of income redistribution through welfare policies. In simple terms, it is America's welfare policy that needs immediate attention than its taxation policy. The graphic below highlights the role played by income redistribution in lowering inequality.

The Scandinavian countries achieve twice as much inequality reduction (as measured by the lowering of their respective Gini coefficients) by redistributive policies than the Anglo-American nations. It is not a coincidence that these countries have much higher levels of taxation as measured by their higher tax-to-GDP ratios. It appears that higher redistribution goes hand-in-hand with higher levels of taxation.

Interestingly, the association between tax progressivity and overall re-distribution through taxation across countries is negative.

Though the study speculates on several political economy reasons, none of them are satisfactory enough to provide a good explanation for this surprising inverse correlation.

These graphics are an excellent empirical illustration of the importance of enlightened public policy in lowering inequality and poverty. It is also a strong reminder to free-market evangelists that unfettered markets fail to achieve the desired conditions necessary to promote growth and reduce poverty and inequality.

Sunday, February 26, 2012

Future of grocery shopping!

How about being able to make your grocery purchases using your mobile phone while waiting for your bus or metro train and having them delivered home? This is what Tesco has been pioneering, with great success, in South Korea by plastering subway station walls with facsimiles of groceries, labeled with a unique code for each product.

Shoppers waiting at sub-way stations can do their home grocery shopping using their mobile phones. A mobile phone application enables people to click/scan the QR code on any displayed product in virtual storefronts at select locations. The product will then get pushed into your virtual shopping cart and get delivered when you get back home. Waiting times get converted into shopping times!

Saturday, February 25, 2012

Assualt on incentives - the case of farm loan waivers

Talking of assault on incentives and the moral hazard concerns arising from loan waivers, Mint writes,

The loan waiver announced in February 2008 had a cut-off date of December 2007. The general elections were held about 18 months later. It seems likely that farmers are now anticipating that the next election will be held sometime in the middle of 2014; so it is a good time to begin defaulting.

The Mint report points to a working paper by Martin Kanz (see presentation here) which examined the impact of the 2008 farm loan waiver and found that "debt relief does little to improve the fi nancial position of benefi ciary households" but has strong eff ects on expectations of the beneficiaries. About the material impact of debt relief, he writes,

"Debt relief does not lead to a measurable increase in investment, an improvement in the productivity or a reduction in the variance of realized returns to agricultural investment among households that had their debt cleared under the program."

About its impact on shaping expectations, he writes,

"Households in the treatment group state that they would be much more likely to default on cooperative bank loans in the future, and this propensity is increasing in the amount of debt relief they received. Similarly, recipients of full debt relief are signi cantly less concerned about the reputational consequences of defaulting on bank debt, which suggests that debt relief removes much of the social stigma associated with nancial distress...

the finding that households that had a higher total amount of debt cleared report that they would be more likely to default on cooperative bank debt in the future appears to con firm fears that debt relief is detrimental to the culture of prudent borrowing."

Friday, February 24, 2012

Indian economy - A status report

The good news first. India's 10 year bond yields have started falling since November 2011 in anticipation of lower inflation and reduction in repo rates.

Since later December 2011, the equity markets have staged a smart rally. The volatility indices like the India VIX too appears to be moving towards the trend rate.

Another sign of the stability returning to the markets is the exchange rate. After its steep decline since March 2011, the exchange rate has been appreciating since the second half of December 2011.

The bellwether HSBC Purchasing Manager's Index (PMI) has been improving since November 2011. The composite index for January which covers both the manufacturing and service sectors rose from December’s 54.7 to 59.6 to signal the sharpest increase in activity in nine months.

However, there are certain disturbing signals. Though India's core inflation rate (Thanks Mostly Economics)appears to be trending downwards, it is well above the comfortable 4% range.

The overall economic outlook, while looking up, is some distance away from normalcy. India appears to have had a double-dip economic slowdown since the Great Recession struck the world economy. Starting 2008, the economy has declined twice and the last quarter of 2011 may be the second trough.

Industrial production too has mirrored the fate of the GDP with two troughs during the same period.

Of greatest concern, as highlighted in the recently released report of the Prime Minister's Economic Advisory Council is the declining rate of investment, savings and gross domestic fixed capital formation. None of these important indicators have recovered from the 2008-09 slowdown.

Thursday, February 23, 2012

Too much of a good thing is bad!

Arguably the most famous debate in economics is between those advocating unfettered free markets and those proposing regulatory restraints and proactive government actions to address market failures.

The former claim that free-markets reduce market frictions and promote competition, which in turn generates efficient outcomes. They argue that the ability of markets to lower frictions and promote competition is a function of the degree of its liberalization. Unfettered free markets, they say, produces the most efficient outcomes.

The latter argue that market failures like externalities (both positive and negative), information asymmetry, moral hazard, unequal playing field among market participants etc can be addressed only with government action. Such actions take the shape of regulation, redistribution through taxation and subsidies, and sometimes even direct participation (like running schools and hospitals). In other words, public policies rectify market failures and strengthen free-market.

However, an examination of real world events reveals that markets fail and often fail spectacularly and with devastating consequences. A short history of the past two decades shows numerous examples of greater deregulation, in the direction of unfettered free markets, have failed miserably. Here are six examples of how lowering market frictions results in the reduction of market efficiency or does not lead to the desired outcomes.

1. Free market enthusiasts advocate policies that promote economic growth on the grounds that it can by itself contribute towards increasing incomes and reducing poverty. They see frictions caused by government regulations and restrictions on doing business as being responsible for lower incomes and poverty in many developing countries. However, there is increasing evidence from across the world that poverty and inequality reduction is better achieved by proactive government redistributionary policies and transfers than by mere economic growth.

2. Conventional wisdom would have it that greater choice reduces market frictions and increases efficiency. However, there is ample evidence, from a number of fields, that an excess of choices induce decision paralysis among human decision makers. Human beings are apparently not the objective and rational utility maximizing individuals.

3. Central Banks across the world have been pursuing greater transparency in their communication strategies, so as to bridge the market friction arising from information asymmetry. However the argument that this will promote more efficient shaping of market expectations may not turn out as expected. As I have blogged earlier, extreme transparency in central bank communcation need not always result in efficiency.

4. The wave of financial market deregulation and financial innovation across the world in the second half of nineties and in the last decade were supposed to lower market frictions and thereby increase financial market efficiency. It was believed that the light-touch regulation of financial market participants would facilitate more effective risk diversification and resource allocation and thereby lower both systemic risk and boost economic growth. However, as events of the past five years have shown, it has spawned several market failures - risk mis-pricing, resource mis-allocation, opaque financial instruments, systemic risks like too-big-to-fail and too-interconnected-to-fail, emergence of massive financial behemoths whose activities constrain market competition, and so on.

5. Theoretically atleast, arbitrage opportunities in financial markets arise from the presence of residual market frictions. Therefore, if any privileged information that becomes available were quickly traded away, that would increase the market efficiency. If this logic were correct, high frequency trading (HFT) would have improved market efficiency. However, there is enough evidence that HFT lowers market efficiency, distorts market incentives, and destabilizes markets.

6. Conventional wisdom would have it that completely free trade (which creates frictionless transactions) is the most efficient order. However, as Dani Rodrik has shown in his excellent recent book on globalization, as trade becomes freer and freer, its distributional effects loom larger and larger. In the context of the need to redistribute from the winners to compensate the losers, he shows that at very low tariff levels (as is the case with many countries in the post-WTO era), the marginal gain (say, increase in incomes or GDP) is dwarfed by the degree of redistribution required (from winners to losers). As trade gets more open, the redistribution-to-efficiency gain ratio shoots up. He writes, "It is inherent in the economics of trade that going the last few steps to free trade will be particularly difficult because it generates lots of dislocation but with little overall gain".

In all these cases, from hindsight it is not difficult to rationalize that the incessant pursuit of reduction of frictions contributed significantly to the failures. It removed the systemic checks and balances, institutional and psychological, that aligns incentives among all participants. Further, it also elbowed out the government from stepping in to mitigate markets failures.

Even assuming theoretically that frictionless systems generate efficient outcomes, there is the issue of whether it is possible to reach this state. If left to itself, after an infinite period, any market system may reach its equilibrium when all the ideal conditions hold. However, in the real world, we do not have the luxury of such timeframes and are therefore concerned in dealing with partially distorted markets. As the aforementioned examples illustrate, in such circumstances, there is the need to achieve a delicate balance of frictions.

In fact, Nobel laureate James Tobin, while advocating his famous Tobin Tax on cross-border short-term capital flows, argued about the need "to throw some sand in the wheels of our excessively efficient international money markets". Too little frictions and the resultant excessive efficiency is clearly bad for the system.

In this context, as Barry Schwartz explains in an excellent op-ed in the Times, frictionless free markets are akin to a "too much of a good thing" and they invariably result in sub-optimal outcomes. As the most recent example of reduction in market frictions by way of financial market deregulation and innovation has shown, far from increasing efficiency, such policies are likely to result in market failures and distortions. He writes about the benefits of the less efficient counterfactual,

If loans weren’t securitized, bankers might have taken the time to assess the creditworthiness of each applicant. If homeowners had to apply for loans to improve their houses or buy new cars, instead of writing checks against home equity, they might have thought harder before making weighty financial commitments. If people actually had to go into a bank and stand in line to withdraw cash, they might spend a little less and save a little more. If credit card companies weren’t allowed to charge outrageous interest, perhaps not everyone with a pulse would be offered credit cards. And if people had to pay with cash, rather than plastic, they might keep their hands in their pockets just a little bit longer. These are all situations in which a little friction to slow us down would have enabled both institutions and individuals to make better decisions.

Wednesday, February 22, 2012

Eurozone crisis in graphics

A series of excellent graphics from Paul Krugman that points to the underlying causes behind Europe's current crisis.

Contrary to conventional wisdom, surging public debt and fiscal irresponsibility was not the cause for the current problems, even among the peripheral economies. Greece was the only exception. The graphic shows how public debt to GDP ratios continued to decline across the PIIGS throughout last decade till the crisis struck.

However, in the aftermath of the Eurozone integration, there was a sharp surge in capital inflows from the core to the peripheral economies. Both demand and supply side forces drove these flows. On the demand side, the single currency and the resultant sharing of sovereign risk lowered the cost of capital for all these economies, thereby making debt available at cheap rates for the domestic industry.

On the supply side, this capital flow bubble was induced by the sudden decline in the sovereign risk of the peripheral economies (given their integration into a single currency union), the bright economic prospects and the potential for higher returns. Investors assumed that the biggest supporters of European integration, Germany and France, would never let a weaker eurozone country default on its obligations, for fear of derailing the political union of Europe. This belief enabled precisely such countries and their private financial institutions to borrow heavily at cheap rates. Predictably, these flows led the emergence of large current account imbalances.

The sudden influx of easy money led to a sharp increase in price levels and wages across the PIIGS economies. The economic competitiveness of these economies took a hit, especially in relation to the core area economies.

Despite the austerity programs under implementation in these economies, the debt-to-GDP ratios are not expected to come down anytime soon. The shrinking economies have contributed to the declines in interest rates.

Update 1 (28/2/2012)

Paul Krugman on what caused the Eurozone crisis,

At root, their problems are primarily caused by balance-of-payments rather than sovereign debt issues; they had huge capital inflows between 1999 and 2007, which led to inflation, and now they need somehow to regain competitiveness. But overlaid on this is a sovereign-debt crisis, which has forced them to seek aid — and the lenders are demanding harsh austerity in return, which is further depressing economies already suffering from severe overvaluation.

See also this set of graphics from Krugman. This shows the impact of austerity on Greece.

Another Governance Failure?

India’s income per head grew more than fourfold between 1990 and 2010; yet the proportion of underweight children fell by only around a quarter. By contrast, Bangladesh is half as rich as India and its income per head rose only threefold during the same period; yet its share of underweight children dropped by a third and is now below India’s... Brazil cut the number of underweight people by 0.7% a year between 1986 and 1996 and reduced stunting by 1.9% a year. Bangladesh reduced both rates by 2% a year in 1994-2005...

... better nutrition can be a stunningly good investment. Fixing micro-nutrient deficiencies is cheap. Vitamin supplements cost next to nothing and bring lifelong benefits. Every dollar spent promoting breastfeeding in hospitals yields returns of between $5-67. And every dollar spent giving pregnant women extra iron generates between $6-14. Nothing else in development policy has such high returns on investment.

(HT: The Economist)

Tuesday, February 21, 2012

Central Bank Communication and Financial Stability

Central Banks across the world are racing to go transparent. In United States, the Federal Reserve has raised transparency to new levels by publishing the long-term policy rate forecast and the next rate hike expectations of the individual members of the Federal Open Market Committee (FOMC). The Reserve Bank of India too has not remained unaffected by this trend as its minutes now reveal the individual opinions of its Monetary Policy Committee members.

The argument behind this transparency is that it minimizes information asymmetry and helps shape policy expectations among all market participants more effectively. However, it is far from certain that such transparency is beneficial in the long-term or any more efficient than the current strategy of relative opacity.

For example, in the instant case of the Fed, the longer-term forecasts of the individual members, albeit appropriately qualified, helps bake in expectations of longer-term policy direction among market participants. Though qualified with assumptions and conditions, this fine print is most likely to be overlooked, especially when there is a sustained period of upswing in various growth indicators. As the actions of Alan Greenspan and Co. over the first half of the past decade shows, the members are themselves likely to be blinded to the various cognitive biases that influence their decisions when the economy is either doing well or badly.

The resultant "irrational exuberance" is certain to bias the decisions of a large number of market participants. In these circumstances, the longer-term forecasts act as pro-cyclical amplifiers. In the absence of such forecasts, the market participants would atleast have been that less certain about the economic trends. And given the formidable reputation that central banks have assiduously built-up over the past few years, these forecasts are likely to carry much greater punch than other sources of information.

Therefore, such transparency enhancing forecast publications, tend to make the market participants lean more towards the wind than would have been the case in their absence. Perversely enough, a dose of uncertainty may have diminished the "irrational exuberance" and herd mentality and made market participants more guarded in their economic decisions. In simple terms, instead of improving market efficiency, the reduction of information asymmetry has the potential to lower market stability.

Update 1 (24/2/2012)

It appears that the Fed's push to reduce frictions in one area is complemented by increased frictions in other areas. Simon Johnson detects a very clear bias in the meetings held by the Fed officials on the Dodd Frank legislation,

Just on the Volcker Rule — the provision in Dodd-Frank to limit proprietary trading and other high-risk activities by megabanks — Fed board members and staff members apparently met with JPMorgan Chase 16 times, Bank of America 10 times, Goldman Sachs nine times, Barclays seven times and Morgan Stanley seven times...

Based on what is in the public domain on the Fed’s Web site, my assessment is that people opposed to sensible financial reform — including but not limited to the Volcker Rule — have had much more access to top Federal Reserve officials than people who support such reforms. More generally, it looks to me as though, even by the most generous (to the Fed) account, meetings with opponents of reform outnumber meetings with supporters of reform about 10 to 1.

Monday, February 20, 2012

Eurozone debt sustainability

The most important question surrounding the Eurozone crisis is about the sustainability of the current debt levels, especially given each country's economic prospects.

The simple reality, stripped off all economic theory, is that the debt-to-GDP ratios can come down only if the GDP growth rate (the denominator) is faster than that of the growth in debt stock (the numerator). In other words, so long as the economy declines, even if the debt stock remains the same, the debt-to-GDP ratio will increase.

In this context, even as European economies implement severe austerity policies of wage freezes, government spending cuts, and tax increses, the biggest casualty appears to be growth itself. But for Germany, Eurozone would have been already deep in the red. Eurostat has reported that for the last quarter of 2011 GDP in the 17-nation euro area fell 0.3% from the prior three months, the first drop since the second quarter of 2009. Greece’s GDP slumped 7% in the fourth quarter from a year earlier.

The British economy shrank 0.2% in the last quarter of 2011 and unemployment rate is now at 8.4%, the highest since endd-1995 and is forecast to rise through 2012. In fact, the British National Institute of Economic and Social Research (NIESR) has warned about the country slipping into recession in 2012 and has forecast that the UK economy will contract by 0.1% this year. It has urged the government to loosen its fiscal stance and shore up faltering demand.

The debt-to-GDP ratios of all the peripheral economies have risen sharply since the onset of the Great Recession. They have continued to rise through all of 2011 and are expected to sustian the trend through 2012.

The best indicator of the prospects of a country emerging out of a sovereign debt hole is its primary fiscal balance, which is a measure of the fiscal balance excluding debt service. The Kiel Institute barometer of public debt calculates how much debt countries can bear in the long term by examining the primary surpluses of countries. It is based on the assumption that the ratio of the primary surplus to GDP (the primary surplus ratio, PSR) must be equal to or greater than the debt ratio (S) times the difference between the nominal interest rate (i) and the nominal growth rate (g) if the debt ratio is to remain stable.

PSR ≥ S(i – g)

It maps the primary supluses required by the Eurozone economies to sustain their current debt levels based on the aforementioned assumption. The growth rates, optimistic and pessimistic rates, are long-term rates and the interest rates are the 10 year long-term bond yields. Greece and Portugal face extraordinary challenges even with very optimistic long-term growth scanarios.

In the circumstances, the only way appears to be an early debt restructuring. However, even with this, the extent of haircuts required on Greek debt would almost wipe out its creditors. Portugal, and to a lesser extent Ireland, too would require some form of debt restructuring deals. Fortunately, the bigger economies of Italy and Spain look relatively safe.

See also these stories that chronicle the austerity miseries of Britain, Portugal, and Greece.

Modern Macroeconomics Family Tree

Dylan Matthews (via MR) provides a short history of modern macroeconomics and this nice family tree of the subject.

Sunday, February 19, 2012

The wages of "contractionary expansion"

This quote by an unemployed British youth may be an appropriate reflection of the mood of the moment across much of Europe as governments pursue "contractionary expansion" - aggressive austerity campaign in an effort to lower public debt and fiscal deficit, and thereby boost growth.

"If you are not working, in training or in college, you might as well be a thief — employers just do not take you seriously. At some point, you just say, 'I’m stuck and I will never find a job.'"

Though most Eurozone economies are purusing austerity policies to boost growth, the evidence so far is dismal. Unemployment rates, especially among the youth, have risen sharply across most of Europe.

Saturday, February 18, 2012

Examining Spain's twenty-plus unemployment rate

Among all the dismal macroeconomic indicators pouring out from the peripheral Eurozone economies, the biggest concern is the high unemployment rates. In an environment of fiscal austerity, high rates of unemployment rates have the potential to severely destablize the society. Nowehere is this a bigger concern than in Spain, which has the highest unemployment rate.

Though, this graphic from Zero Hedge is scary, as Ezra Klein points out, it may not be as depressing as it appears. The vast majority of kids in this age group are in school and therefore should not be considered as part of the workforce.

Historically Spain has had extrteme volatility in its labour market. Its unemployment rate surged since early 2008, mirroring its rise in the first half of the nineties. Ezra Klein writes,
Construction in Spain was a whopping 13 percent of employment during the housing bubble — far bigger than even the United States — which led to an especially big crash. Also, it’s much harder to fire workers in Spain (which in turn makes jittery employers more reluctant to hire in the first place) and much easier to use temp workers.
Temporary workers form 33% of the total employees in Spain, the highest among all major economies. A CEPR study of the labour markets in Spain and France finds that in case of the former, the cost of firing temporary labour is minimal whereas the cost of firing the permanent labour is very high. This temporary-permanent labour contract costs is an important structural imbalance in the Spanish labour market. It has echoes in India's own labour market policies.

Spain's problems can be traced to a real estate bubble and a private consumption boom. Paul Krugman captured Spain's problems succinctly,
There was a huge boom in Spain, largely driven by a housing bubble — and financed by capital outflows from Germany. This boom pulled up Spanish wages. Then the bubble burst, leaving Spanish labor overpriced relative to Germany and France, and precipitating a surge in unemployment. It also led to large Spanish budget deficits, mainly because of collapsing revenue but also due to efforts to limit the rise in unemployment.
An examination of the macroeconomic indicators highlights Spain's vulnerability. Since the mid-nineties, the Spanish debt-to-GDP ratio has declined gradually to just 36.1% in 2008. However, it has since ballooned to 60.1% in 2011. Gross capital formation has declined from 29% of GDP in 2008 to less than 23% in 2010. Tax revenues as a share of GDP has fallen from slightly below 14% in 2007 to just above 8% for 2009. Since 2007, the structural balance, or output gap, has widened from just above 1% to more than 7% in 2011. Strained by the depressed economy and the resultant fall in revenues, the fiscal balance slipped from a surplus of nearly 2% of GDP in 2008 to a deficit of 9.3% in 2011. If macroeconomic indicators are any reflection, since 2009, the Spanish economy has fallen off the cliff.

The austerity is likely to worsen the situation. However, given its high unemployment rates and the adequate fiscal space available, Spain should be following expansionary policies till recovery takes firm hold.

Update 1 (25/6/2012)

FT has an article that questions the basis of measurement that projects these very high youth unemployment rates in Europe. These unemployment rates are obtained by dividing the number of unemployed youth by the total number of youth in the workforce. The denominator excludes those attending university and also those undergoing job training. This number is therefore likely to be very high.

It prefers using another indicator, the unemployment ratio, which is measured by dividing the number of unemployed youth with the total population of young people under 24. Interestingly, when measured this way, the figures drop sharply. For example, the youth unemployment rate for Spain is 48.9 per cent, but the youth unemployment ratio is only 19 per cent. The youth unemployment rate in Greece is 49.3 per cent; its youth unemployment ratio is only 13 per cent. In both Ireland and Italy, the rate is 30.5 per cent, but the ratio is only 11.7 per cent and 8 per cent respectively. For the eurozone, the youth unemployment rate is 20.8 per cent but the ratio only 8.7 per cent. In fact, while the eurozone’s youth unemployment rate has increased since 2009, the youth unemployment ratio has stayed the same.

Update 2 (3/7/2012)

FT has a section on youth unemployment and its long-term consequences. The graphic below captures some of the stark figures associated with yout unemployment.

Friday, February 17, 2012

India's WTO challenge

Here is my op-ed with Srikar on the need to align national economic policies with our WTO commitments.

Thursday, February 16, 2012

The "drugs test" for financial products

Steve Levitt points to this paper by Glen Weyl and Eric Posner who aadvocate that all financial instruments should be rigorusly screened for their social utility before they can be traded. They claim that enhanced discolusre and the use of exchanges and clearinghouses, which form the centerpiece of most financial regulation proposals, will not achieve the objective of stabilizing financial markets. They write,

"We argue that disclosure rules do not address the real problem, which is that financial firms invest enormous resources to develop financial products that facilitate gambling and regulatory arbitrage, both of which are socially wasteful activities. We propose that when investors invent new financial products, they be forbidden to market them until they receive approval from a government agency designed along the lines of the FDA, which screens pharmaceutical innovations. The agency would approve financial products if and only if they satisfy a test for social utility. The test centers around a simple market analysis: is the product likely to be used more often for hedging or speculation? Other factors may be addressed if the answer is ambiguous."

The challenge with this proposal would be the definition of social utility. There is a thin line between gambling and hedging, especially with complex derivative instruments. I am not sure whether it is possible to draw any clear distinction between the two. In the circumstances, there is likely to be litigation and lobbying, which will generate incentive distortions that will benefit lawyers, lobbyists, and unscrupulous regulators.

However, a test to verify the exploitation of regulatory arbitrage stands a good chance of success and may also be socially and systemically desirable. After all, any regulation is put in place to address market failures. If market players are allowed to skirt around those regulations, it does not bode well for the stability and health of that market.

Another touchstone could be an examination of the possible conflicts of interest. This should determine who can buy and sell these products. As the events of the past few years show, regulators failed to control even basic, first-level conflicts of interests. Financial institutions like Goldman were peddling derivative products to unsuspecting clients, even as they themselves were shorting the underlying assets. Is it possible to have a code of conduct underlying the transactions for each product?

Wednesday, February 15, 2012

Nudging to reduce fraud, error and tax defaults

The British Cabinet office's Behavioural Insights Team recently released a research study on the application of insights from behavioral psychology to (pdf here) reduce fraud, debt and error within public systems. The report points to seven behavioral insights that can enhance public policy and help achieve desirable outcomes.

The Behavioural Insights Team conducted RCTs on these eight interventions and found impressive results. They are summarized below.

The British government's taxation department, HMRC, sent out letters with a range of different messages to 140,000 taxpayers. Residents received either a control letter (which contained no social norm) or one of a number of different social norm messages. All of the social norm letters contained the statement that '9 out of 10 people in Britain pay their tax on time', but some also mentioned the fact that most people in the recipient’s local area (or postcode) or town had already paid.

The graph shows that there was a 15 percentage point increase from the old-style control letter which contained no social norm and the localised social norm letters. In fact, the phrasing of the letter is of great relevance. Saying that '9 out of 10 people pay their tax on time' is more effective if it is followed by 'you are one of the few people who have not paid yet'. Simply including a phrase with both these elements raised the payment rates achieved by a single letter from 36.8% to 40.7%.

The studies of the Team also found that letters which contain simple, clear messages about the issue at the beginning of the letter, clearly spell out the actions required (by underlining it or highlighting it) and underline implications of noncompliance, increases the likelihood of favorable responses.

As I blogged earlier, another study involved sending out SMS messages to defaulters on court fines. Personalized text messages were sent out to defaulters with varying messages - general message to pay the fine, message indicating the person's specific fine amount, and those giving his/her name. The results have been quite impressive.

This strategy poses two challenges for policy makers contemplating the same in developing countries like India.

1. Since compliance with rules are low and defaults very high, the marginal impact of these interventions could be considerable.

2. However, on the flip side, given the weaker social norms, the nudging impact of the messages could be attentuated in these social contexts. Since in many groups, deviation is the norm, the messages may not carry the same weight.

The ultimate effectiveness of these interventions in these societies will depend on the emergent dynamics of these two forces. If the former prevails, the intervention will be a success.

Tuesday, February 14, 2012

Income inequality and educational outcomes

Widening income inequality is arguably one of the biggest challenges facing the economy and society in both developing and developed countries. Addressing it assumes greater significance given the dynamics of forces shaping global economic trends. For a variety of factors, these forces institutionally favor children from families with higher incomes.

Children from more well-off families have numerous socially institutionalized advantages that put them well-ahead of those from poorer families. One, they are most likely to attend the best or better schools. Two, their parents can afford to spend more time and resources with them and show much greater interest in their education. Three, their social and family environment is much less likely (than that of children from poorer backgrounds) to be detrimental to the child's learning process. Four, they attend good early childhood education centers and other learning institutions, which gives them a head start when they join school. Finally, they are more likely to have exposure to various other non-school based, formal and non-formal literacy related platforms.

The Times has an excellent article that points to a sharp spurt in learning achievement gap over the past few decades between children from rich and poor family backgrounds.

A Stanford University study has found that the gap in standardized test scores between affluent and low-income students had grown by about 40% since the 1960s, and is now double the testing gap between blacks and whites. It analyzed 12 sets of standardized test scores starting in 1960 and ending in 2007 and compared children from families in the 90th percentile of income and children from the 10th percentile. It highlights the increased role of family incomes in determining children's learning levels,

"The relationship between parental education and children’s achievement has remained relatively stable during the last fifty years, whereas the relationship between income and achievement has grown sharply. Family income is now nearly as strong as parental education in predicting children’s achievement... a given difference in family incomes now corresponds to a 30 to 60 percent larger difference in achievement than it did for children born in the 1970s."

Another study by University of Michigan researchers that uses data from nearly 70 years finds the imbalance between rich and poor children in college completion — the single most important predictor of success in the work force — has grown by about 50 percent since the late 1980s.

"Wefind growing gaps between children from high- and low-income families in college entry, persistence, and graduation. Rates of college completion increased by only four percentage points for low-income cohorts born around 1980 relative to cohorts born in the early 1960s, but by 18 percentage points for corresponding cohorts who grew up in high-income families. Among men, inequality in educational attainment has increased slightly since the early 1980s. But among women, inequality in educational attainment has risen sharply, driven by increases in the education of the daughters of high-income parents. Sex differences in educational attainment, which were small or nonexistent thirty years ago, are now substantial, with women outpacing men in every demographic group."

Times points to the critical importance of early childhood education which gives children from better economic circumstances a head-start in the education race.

"Meredith Phillips, an associate professor of public policy and sociology at the University of California, Los Angeles, used survey data to show that affluent children spend 1,300 more hours than low-income children before age 6 in places other than their homes, their day care centers, or schools (anywhere from museums to shopping malls). By the time high-income children start school, they have spent about 400 hours more than poor children in literacy activities."

Economix points to this intuitive explanation from a behavioural psychology perspective about the relationship between income deprivation and parenting outcomes. The implication is that well-off parents, being less likely to be hassled by their daily chores, are therefore more likely to have enough emotional energies to concentrate on their child's educational needs. They write,

"Good parenting requires psychic resources. Complex decisions must be made. Sacrifices must be made in the moment. This is hard for anyone, whatever their income: we all have limited reserves of self-control, and attention and other psychic resources... Low-income parents... face a tax on their psychic resources. Many things that are trifling and routine to the well-off give sleepless nights to those less fortunate."

Greece in two graphs

From the excellent Floating Path comes two graphics that capture the true magnitude of Greece's problems. Over the past three years, its public debt has ballooned even as the economy has contracted.

The graphic below captures the distrubution of its 355 bn Euro debt.

Monday, February 13, 2012

Potential for high speed rail corridors in India

FT charts the high-speed rail (HSR) networks across the world. China is the runaway leader with 37% of the total global operational HSR track. However, if its pipeline of projects under construction are added, it will have more HSR track length than all other countries combined! Among HSR under construction, EMs count for over 60% of the total track being built.

India does not have any HSR track under construction, nor anything in reasonably advanced stages of planning. Rail transit policy making in India, it appears, is taken up with metro rail systems, with even small cities preparing grandiose projects for metro-rail systems.

In this context, HSR offers exciting possibilities for promoting economic growth and laying the foundations for the creation of large growth corridors. Despite the significant successes achieved by the National Highways Authority of India (NHAI) with the construction of the Golden Quadrilateral road network in the past decade, roads cannot form the basis for integrating regional growth clusters.

Ahmedabad-Mumbai-Pune, Delhi-Lucknow-Patna, Delhi-Chandigarh-Amritsar, and Chennai-Bangalore-Hyderabad are four promising HSR corridors. HSR services in these routes, which connect important industrial and commercial centers, have the potential to underpin economic growth by harnessing the increasing returns from geographic integration. The HSR will provide greater integration among the large population clusters in these corridors. It will integrate labour markets and strengthen the existing manufacturing and services base in these corridors.

In this context, the Kerala's government's proposed 580 km, Rs 1.18 lakh Cr HSR corridor between Thiruvananthapuram and Mangalore, which would reduce travel time more than four-fold to around three hours, is an excellent proposal. Instead of wasting its scarce resources pursuing a metro-rail link for Kochi, the Kerala government would do well to vigorously pursue this by upgrading the existing rail network into HSR in a phased manner. Given its narrow-strip geography and urban demographics, Kerala would stand to benefit immensely from such rail links.

The Apple effect on equity markets

Zero Hedge points to the astonishing impact of the performance of Apple Inc on the technology sector stocks. The graphic captures the earnings per share of S&P 500 technology firms with and without Apple.

Tyler Durden is spot on in his assessment of the concern arising from this graphic,
While ignoring Apple as a provider of 'wealth' is akin to Monty Python's "What Have The Romans Ever Done For Us?" comment, we worry that so much 'expectations' burden should fall on the shoulders of a company that relies on constant 'successful' innovation and constant low cost wages (no growth) to merely maintain current growth and earnings while facing constant and massive competitive threats from every side of its business.
Update 1 (29/1/2015)

WSJ has this summary of Apple's mind numbing results for the last quarter of 2014. Barry Ritholtz writes,
Apple’s net profit of $18 billion is an astonishing gain of 38 percent over the already-huge $13.1 billion in the same quarter last year... Earnings per share rose 48 percent on revenue of $74.6 billion, up a staggering 30 percent... the company’s flagship product, the iPhone sold an astonishing 74.5 million of them in the quarter, a gain of 46 percent from the same quarter a year earlier. What's more, the phones sold for an average of $687... Apple sold 34,000 phones an hour, 24/7. Revenue in China rose 70 percent to $16.1 billion, making it Apple’s third-largest market by sales, after the U.S. and Europe.
See also this article on how Apple has managed to create an eco-system of innovations around the iPhone.

Sunday, February 12, 2012

Tax and transfer to reduce inequality

I have blogged repeatedly about the critical role played by government transfers in reducing inequality and the unsustainability of economic growth in conditions of high inequality. However, transfers require tax revenues. This highlights the importance of taxation in addressing poverty and creating conditions for sustainable economic growth. The graphic below from The Economist draws attention to this.

In most European nations, the poverty rates are lower only because of the significant role played by government transfers. Transfers nearly halve poverty rates in these countries. Contrast this with the United States where the lower extent of transfers are responsible for keeping poverty rates high.

The role of taxes and transfers is even more pronounced with inequality measures. Similar trans-Atlantic trends persist with inequality reduction due to taxes and transfers. In case of many developing countries, as the cases of Mexico, Brazil, and Chile show, the low levels of transfers contribute towards their poverty and high inequality rates.

Update 1 (10/5/2014)

Jared Bernstein uses data from a CBO report to show that,
For middle-income households, transfers and lower taxes explain the vast majority of their income growth in recent decades. Their earnings have declined in real terms 7 percent from 1979 to 2010, but Social Security, Medicare, unemployment insurance and lower taxes have more than made up the difference... After accounting for taxes, middle incomes rose about 36 percent, from 1979 to 2010. But here’s the kicker: 90 percent of that increase came from higher transfers (74 percent) and lower taxes (16 percent). And remember, we’re talking middle-class families here, not poor ones... The share of comprehensive income going to the top 1 percent grew 6 percentage points before taxes and transfers from 1979 to 2010, and 5.4 points after taxes and transfers. (If one stops at 2007, before the recession, the same comparison yields an increase of 9.8 points before tax and 9.3 after).

Update 1 (18/11/2014)
Times has a nice story that points out that before taxes and transfers, the US does no worse than its western counterparts. Once taxes and government transfers are factored in, the US rises to the top in the inequality ladder. 
Total taxes as a share of GDP is among the lowest in the US.

Nudging on enforcement

How do we get traffic offenders and other rule violators who have been delivered fine slips to pay up their fines? More importantly, how can we increase the likelihood of getting people to pay their taxes in time?

Tim Harford draws on the findings of the research studies conducted by the UK Cabinet Office's Behavioural Insights Team,

Let’s say somebody has been fined in court but has not paid. You could send in the bailiffs. Or you could send a text message explaining that if the fine isn’t paid quickly, the bailiffs will be on their way. The Behavioural Insight team and the courts service ran a randomised trial, sending no text message to some people and a variety of text messages to others to see which approach works best. It turns out that text messages are highly effective and even more effective is a text message that mentions the miscreant’s name. The difference between no message and a personalised message is that instead of one in 20 people immediately paying up, one in three people do. That adds up to 150,000 occasions on which the bailiffs need not be called in.

This is an excellent example of how small nudges can go a long way towards improving compliance with rules. Similar interventions that leverage the cognitive impulses of human beings can be powerful facilitators in increasing supervisory effectiveness and enabling adherence to prevailing rules.

Saturday, February 11, 2012

Why consultants?

Robin Hanson, via MR, has this explanation for paying exorbitant amounts to hire reputed management consultation firms with inexperienced but smart consultants,

Firms often have big obvious misallocations of resources, where lots of folks in the firm know about the problems and workable solutions. The main issue is that many highest status folks in the firm resist such changes, as they correctly see that their status will be lowered if they embrace such solutions.

The CEO often understands what needs to be done, but does not have the resources to fight this blocking coalition. But if a prestigious outside consulting firm weighs in, that can turn the status tide. Coalitions can often successfully block a CEO initiative, and yet not resist the further support of a prestigious outside consultant...

Yes the information contained in consulting advice can be obtained elsewhere at a lower cost. Firms could hire most any smart independent folks, or set up a prediction market. But alas those sources don’t have the raw strength of status to cow opponents into submission, opponents who in practice can block changes no matter what a CEO declares.

I will add four more reasons

1. Most often, the leadership (or atleast critical parts of the leadership) knows what is wrong. However, any major transformation cannot be done based on hunches or anecdotal evidence. The consultant provides the convenient cover for the executives to push through the transformational changes. The consultant's report provides the gravitas and credible justification for the reforms proposed.

2. A reputed external consultant, specifically hired to develop and/or manage a transformation program, has significant symbolic value. This can provide the required change momentum and discipline to push through the proposed reforms. The transformation blue-print prepared by a reputed external consultant after a "stakeholder consultation" (and this jargon is important) process, provides a platform to galvanize the entire organization into embracing change.

3. The organization generally contains the knowledge for its failings, its prospects, and an idea of its road map. However, the transformation blue-print is never available in one place and in an implementable format. The consultant talks to all stakeholders and puts together everything in an implementable shape.

If the organization does not have an idea of its broad failings and its future direction, then it is an indictment of the management itself. Such organizations require a change in their management, instead of consultant quick-fixes. If the management is not revamped, such organization cannot turn-around or achieve its objectives even with the consultants' advise.

4. Apart from the broad transformation components, the consultant's transformation blue-print contains certain details (like the sequence of changes, its pace, etc) which are not always evident and does require some basic information collection and problem solving. Ultimately, this may be the biggest substantive value addition by the consultant.

Which country offers the cheapest labour?

FT charts the minimum wages in all the major economies, adjusted for purchasing power parity.

Friday, February 10, 2012

Industrial Policy in the US

Faced with a jobs crisis, the Obama administration is proposing a wide-ranging package of policies to revive the manufacturing sector in the US economy. This interest in reviving manufacturing comes on the back of a three-decade long decline of jobs in American manufacturing - US manufacturers produced roughly the same amount of goods in 2010 as they did a decade before, but they did so with six million fewer employees on their payrolls.

The Times summarizes the proposals which include using taxes, tariffs, and other policies to favor domestic manufacturers over their foreign competitors,

The administration has put together a far-ranging set of proposals: cutting taxes for manufacturers that produce goods in the United States, taking away tax breaks for businesses that move jobs offshore, doubling a tax deduction for makers of high-tech goods, providing support to businesses investing in areas where factories are closing, expanding worker training programs and creating a new task force to better enforce trade rules and intellectual property rights. Closing a loophole that allows companies to shift profits abroad would pay for the tax credits.

This is classic industrial policy. However, instead of directly picking winners, the government is putting in place a framework which would enable the most competitive firms in particular sectors to flourish and develop strength. The ultimate objective of the policy is to increase local job creation and boost economic activity in manufacturing sector.

The big challenge for governments pursuing industrial policy are three-fold. One, which industries (within manufacturing) to favor with industrial policy? Two, what should be the type and extent of industrial policy instruments deployed to support each industry? Three, the need for sunset provisions so that the concessions and preferential policies are not permanently baked in.

It is a very real danger for governments to be misled into either supporting inefficient and flagging industries or deploying the wrong set of instruments (eg, like ones that discourage foreign technology transfers) under pressure of lobbying from industry interest groups. This is all the more a problem in democracies since these industry groups are more often massive contributors to the political parties. The difficulty faced by the Government of India in withdrawing the tax concessions granted to IT firms operating within the software technology parks established by the government is a classic example of the problems with exiting such policies.

Thursday, February 9, 2012

India's economic challenges

Martin Wolf has an excellent op-ed in FT, which highlights how India and China have decoupled from the developed economies during the Great Recession.

He makes the point that, even with possible future global shocks, the biggest challenges to India's growth remain internal.

Thoughtful Indian observers are well aware that the principal obstacles to rapid economic development are internal, not external. Among obvious constraints are failures of governance, including wasteful spending on subsidies at all levels of government, a dire record on the provision of education and health to the bulk of the population, rigid labour laws, inadequate infrastructure and costly restrictions on efficient use of land.

He advocates a cautious opening up of the financial markets,

First, the financial system is capable of generating huge instability and needs to be watched. Second, the integration of India into the global financial system has to be managed carefully. Huge crises may be socially and economically manageable for high-income countries. They would be grossly irresponsible for a country like India.

Wednesday, February 8, 2012

Policy making and accountability

Consider this. The national economy is liberalizing and individual states are competing with each other to attract private investments. They try to out-bid their competitors by offering attractive concessions - tax breaks, concessional utility services, land at lower rates or even free, and so on - to external investors.

It is that early phase of liberalization and economic growth when investors are uncertain of the area's economic potential and pro-active industrial policy is required to incentivize them. In these circumstances, any policy that seeks to attract investors through open-competitive bidding or auctions are not likely to have many takers.

In many states, the industrial or investment promotion policy itself explicitly provides policy makers the flexibility to offer concessions depending on the competition. The state governments (and its political leaders and officials) exercise discretion, on case-by-case basis, to attract investors. While there are broad guidelines, many of the decisions on concessions and preferential allotments are made based on estimates of what would be required to incentivize the investor prefer this state over its competitors. In the process, as is inevitable with such discretionary policies, especially when the stakes are massive, there are instances of excesses, corruption and nepotism in the concessions offered.

Now fast forward ten years. Large investments have flowed in, the state industrial sector has much greater depth and breadth, and its economy has taken off. The conditions that necessitated the promotional policies have changed and the state has established itself as an attractive investment destination. Many of the same promotional policies, while still in force, stand out as obvious anachronisms.

Concurrently, a few sordid tales of discretionary policy corruption emerge, wherein politicians, officials, and corporate groups colluded to cause loss to the state exchequer. The popular outrage leads to an acrimonious post-mortem and revisit of all the industrial policy decisions taken ten years back. Investigations begin and many of the discretionary policy decisions taken to attract investments, including those done in good faith, are called to question on the grounds that it caused loss to the public exchequer and therefore get attributed with malafide intent. So what gives?

Any post-facto assessment, especially given the passage of time and the dramatically changed economic environment, of such decisions are liable to be flawed unless carefully done. Most importantly, it needs to avoid getting entrapped into examining the policies and resultant decisions against the backdrop of the prevailing macroeconomic environment and the lens of regulatory governance. Such cognitive biases and investigation norms are most often difficult to side-step.

The investigations have to draw the clear distinction between the discretionary investment promotion policy decisions taken on behalf of democratically elected sovereign governments in good faith and those taken with malafide intent. Further, the malafide intent has to be established by deep scrutiny of the facts and circumstances surrounding the allotments, instead of the automatic presumption from the (now) apparent excessively generous nature of the concessions allotted.

I will go even further. If the due process has been followed and the democratically elected government has, in its wisdom (or lack of it), granted concessions to a corporate group, howsoever generous, then the investigations should be confined to examining the evidence of any malafide intent behind the decision or failure to adhere to the procedure established by law in its implementation. As to the magnitude or extent of concessions or the policy paradigm (say, auctions against the discretionary allotments) followed, I strongly believe that its adjudication should be left to an appropriate forum, say, the judiciary or the respective appellate tribunals. Atleast in democracies, any investigation by any subsequent governments, should adhere to the aforementioned principles.

In the absence of such protection, any exercise of judgement, on the part of an official or political leader, however well-intentioned, can be questioned subsequently on grounds of having caused loss to the public exchequer. All such decisions, by their very nature, incentivize and provide preferential treatment to one investor, so as to encourage them to invest in the state. Perforce they involve immediate loss to the exchequer. The trade-off is the expectation that it will set the platform for industrial growth and the recovery of the short-term loss through longer-term gains from economic growth.

If this subtle dimension to policy making is not appreciated in any post-mortem, the moral hazard generated by the apprehension of a possible future implication, will restrain policy makers from making judgement calls on such policies. An environment of decision paralysis will result.

Unfortunately, as this environment of suspicion and media trial gets entrenched into the psyche of civil society and defines the agenda of mainstream debates, policy making that involves any exercise of judgement will become a minefield. It will handcuff even those officials whose intentions are in the larger public interest.

This argument is not in anyway an approval or condonation of the obvious irregularities and corruption that have been a characteristic feature of investment promotional policies in many states and at the center in the past decade or so. Those responsible for the malafide actions and administrative irregularities that caused loss to the public exchequer should be punished and the deterrent against such actions strengthened.

However, this should not be at the cost of simplistic appraisals of complex decision-making environments that can only end up paralysing decision-making at all levels and turning the country into a banana republic. It is also pertinent to point out that the propensity for such excesses and corruption are an inevitable accompaniment to economic development in emerging markets.

Tuesday, February 7, 2012

China fact of the day

If you thought that the China story was all about manufacturing exports, here is a reminder about its consumption market

In 2010, Chinese consumers purchased 19 percent of all PCs sold throughout the world, 18 percent of the LCD TVs, 14 percent of the mobile phones, and 26 percent of the automobiles (all by unit volume).

Why Facebook is going public?

The Economist has an excellent graphical representation of Facebook's market reach and commercial prowess. The firm is seeking to raise $5 billion from its initial public offering, which would give it an estimated market capitalisation of $80-100 billion. It employs only around 3,000 staff, giving it an average revenue of $1.2m per person in 2011.

In this context, John Gapper has an interesting op-ed in FT where he questions the rationale behind Facebook's decision to go public. The company's free cash flow rose from $190m to $470m between 2010 and 2011, while its shareholders’ equity increased from $2.2bn to $4.9bn, leaving it with no immediate need for any additional capital.

It intends to put the cash into US government bonds and savings accounts, and perhaps use some to pay the tax due on converting into shares the "restricted stock units" it has given to its 3,200 staff... Its sole tangible purpose for the IPO proceeds is to meet a tax obligation that will be triggered by going public. Welcome to the Catch-22 world of the venture capital liquidity event...

Apart from meeting US regulations for a private company to go public when it gains more than 500 investors, Facebook’s motivation is clear: to gratify its venture capital investors and employees... a quote from Mr Zuckerberg’s letter to new shareholders, "We’re going public for our employees and our investors... We made a commitment to them when we gave them equity that we’d work hard to make it worth a lot and make it liquid, and this IPO is fulfilling our commitment".

In terms of Silicon Valley’s logic, it makes sense. The returns from occasional winners such as Facebook make up for venture capitalists’ losing bets on thousands of other start-ups – provided the winners are sold either to other companies or to the public markets.