Divergence in the interests of Germany and Europe?

FT has this quote from German economist Hans Werner Sinn about how Germany managed to emerge from the problems related to re-unification and labour market rigidity in the nineties.

The demographic problem, the high costs in the new Länder [eastern Germany], are still there. But the problems of west Germany being too expensive, with wages too high, has been resolved . . . What helped was that other countries inflated away from Germany. That has contributed greatly to Germany’s success.

Werner Sinn also talks about how Germany benefited from the Eurozone crisis with German savings remaining in the country and boosting investment.

Capital markets have now understood that you can burn a lot of money in southern Europe. Germans’ savings, which previously drained to the south, often via the French banking system, now prefer to stay in the safe home haven, even if the rate of return is less. This has been the driving force behind Germany’s boom of the past two years. 

This German success has created problems elsewhere, especially among the peripheral economies. The single biggest challenge for these economies is to restore their external competitiveness. However, given the single currency, regaining competitiveness would require extended duration of inflation in Germany and deflation in periphery. This has to be coupled with fiscal loosening by both consumers and governments in Germany so as to provide demand for producers in the peripheral economies. Both look extremely difficult propositions.

Update 1 (12/5/2012)

The German government reported that the country’s trade surplus with the other 16 countries in the euro zone was 62.2 billion euros in the 12 months through March, down 29% from the level a year ago, and the lowest for any 12-month period since 2002.However, its trade surplus with countries not in the European Union has risen, offsetting the decline within the euro zone. That figure climbed to 62.9 billion euros, a record figure that is up 115% over the previous year. Germany’s overall trade surplus was at 162.7 billion euros, 3 percent higher than it was a year ago. 

And it appears that these trends will continue. German factories say orders continue to rise from buyers outside the euro zone, and continue to decline from companies within the zone.

Update 2 (26/6/2012)

Gunnar Beck strikes a contrarian note to the widely cited claim that Germany benefited enromously from the single currency and therefore ought to now be willing to take the losses, if any, to keep the eurozone in tact. He argues, pointing to a series of figures and Germany's less than impressive economic performance since 1995 (when EMU was launched), that Germany did not benefit much from the Eurozone. He writes,

Between 1998 and 2011, German exports grew by 117 percent, according to the Federal Statistical Office. But if the euro was so vital to Germany’s external trade, then the increase in exports to euro zone members would have been greater than the increase to other countries. In fact, the reverse is the case... German exports rose most — by 154 percent — to the rest of the world; by 116 percent to non-euro E.U. members; and least of all, 89 percent, to other euro zone members. In 1998 the euro zone still accounted for 45 percent of all German exports; in 2011 that share had declined to 39 percent...

Between 1995 and 2008, Germany saved more than most, yet it exhibited the lowest net investment rate of all O.E.C.D. countries. On average, from 1995 to 2008, 76 percent of aggregate German savings (private, governmental and corporate) were invested abroad. 

Eurozone's competitiveness crisis in a graphic

External competitiveness is the major problem facing the beleaguered Eurozone economies. Wages, prices, and production costs in these economies rose sharply during the binge years to destroy their competitiveness. The graphic below, from a speech by Swedish Finance Minister at the Peterson Institute, captures the problem starkly.

A National Health Insurance System

I have an op-ed in today's Mint on the principles of a national health insurance scheme for India.

The Swedish lessons for Europe

Fiscal austerity is the current buzzword in macroeconomic policymaking. Across Europe, despite very strong domestic political opposition, governments have embraced wildly ambitious fiscal adjustment targets in an attempt to rein in soaring public debts, restore market confidence, and thereby engineer economic recovery. 

However, evidence from nearly three years of such experimentation across Britain and the Eurozone economies has been dismal. Bond markets have remained unimpressed and sovereign bond yields continue to rise. Not only have the expected recovery not materialized, but these economies have slipped further down the abyss. And this has been the fate of economies within and outside the Eurozone. The latest casualty is Britain, which has officially slipped into a double-dip recession, its second recession in three years. It joins Belgium, the Czech Republic, Greece, Italy, the Netherlands and Spain who are already in recession.

As with Greece, Ireland, and Portugal earlier, Spain too is now experiencing the wages of the same austerity medicine. Amidst a contracting economy, its sovereign debt rating has been downgraded and cost of borrowing has been rising. One-in-four Spaniards are unemployed and half all Spanish youth are out of work, both the highest among advanced economies. Even with all the belt-tightening, Spain is expected to easily miss its target of lowering budget deficit from 8.5% of GDP to 5.3% in 2012 and do no better than 6.2% .   

As could have been anticipated, the blind embrace of austerity has had the effect of accepting the worst of all worlds. As economic growth has contracted, public debt-to-GDP ratios have gone up even higher and tax revenues have dipped sharply. In the absence of either the private sector or external sector stepping in top stanch the space vacated by public expenditures, it was natural that the economy would contract.

All this has raised unemployment rates and inflicted untold suffering on citizens across Europe. Economic hardship have triggered off pent-up social tensions. Political rebellions and protests have become commonplace in these countries. Many governments have lost power in the face of street protests and failures to push through the tough fiscal adjustment measures required to secure external funds. At last count governments in Greece, Ireland, Italy, Portugal, Spain, Netherlands, and now Romania have lost power due to the pains caused by spending cuts.     

In this context, it has become important that these economies abandon their dogmatic ideological embrace of austerity and fall back on policies that can get their economies growing. Robert Samuelson has a nice article which highlights the less-discussed economic turnaround of Sweden since its banking crisis induced economic recession in early nineties. In recent years, Sweden has emerged, along with Germany, as among the best performing developed economies.

Instead of being wedded to ideology-driven policies, Sweden embraced prudent policies that combined both the conservative and liberal social and economic agendas. For a start, it did not bail out its banks but forced them to take massive losses and virtually nationalized its banking sector. The real estate bubble that was inflated by the financial deregulation of the 1980s deflated in 1991-92. As pressure mounted on the krona, overnight interest rates spiked to 500%, and the Swedish economy contracted steeply and unemployment quadrupled in three years to 12%. After a series of bank failures, the government moved in swiftly with a series of measures,

In September 1992... the government announced that the Swedish state would guarantee all bank deposits and creditors of the nation’s 114 banks. Sweden formed a new agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral. Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. Facing its own problem later in the decade, Japan made the mistake of dragging this process out, delaying a solution for years...

By the end of the crisis, the Swedish government had seized a vast portion of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.

This was followed with several far-reaching structural reforms that turned the largely statist economy into one of the world's most dynamic economies, without compromising on its social-democratic principles. The reforms drew from both the conservative and liberal playbooks,  

Sweden’s income tax base was broadened and tax rates were sharply reduced (marginal tax rates fell from 46% in 1996 to 33% in 2010). Spending was cut on old-age pensions, child allowances, unemployment benefits and housing subsidies. Union power over wages was reduced. Many markets (banking, air travel, telecommunications, electricity production) were deregulated. Low inflation and balanced budgets became broadly embraced popular goals...

Although Sweden trimmed social benefits, it hardly abandoned the welfare state. Overall government spending is still about 50 percent of the GDP, much higher than in the United States... To reduce income tax rates, the government raised other taxes. Gasoline and cigarette taxes were increased; so were taxes on dividends and capital gains, hitting the rich. Altogether, deficit reduction totaled a huge 12 percent of GDP from 1991 to 1998. Slightly more than a third of that came from higher taxes...

The aims were clear: to reward work by cutting income tax rates; to push people back into the labor market by reducing some government benefits; and to promote productivity by increasing competition. Productivity and “real” (after-inflation) wage gains improved markedly. Still, Sweden has less economic inequality than most advanced countries.

Sweden also benefited from favorable external economic conditions. Its recession coincided with a sustained period of economic strength across much of the world. Sweden could therefore export its way out of recession. A 25% devaluation of the krona boosted exports. Unfortunately, none of the peripheral European economices today can afford this luxury. None of the Eurozone economies have the freedom to undertake this policy route. See also this excellent presentation by Swedish Finance Minister Anders Borg.

The choices facing Eurozone governments are stark. Currently the austerity policies are merely pushing their economies down the hill, with no hope of finding an anchor that can drive economic recovery in the foreseeable future. It is necessary for all the Eurozone economies to start regaining their economic competitiveness for any sustained recovery to take hold. This can happen only with either a Eurozone exit and/or fiscal transfers from the Eurozone's center. There has to be some period of fiscal accommodation in the periphery and consumption increase in the center.

This is an opportunity to push through the tough labour market liberalization and industry dergulation policies that have for long contributed to sclerosis in Europe. More than that it is an opportunity for the Europen monetary union to become a loose political union, a necessary requirement for the continent to stave off similar situations in future, leave alone escape the current mess.   

Banking in developing countries

Conventional wisdom would have it that one of the important obstacles to surmounting poverty is lack of access to formal banking services. It is assumed that once people are given access to bank accounts, they will manage their finances more efficiently, save more, and also leverage it to raise capital for their self-employment and other entrepreneurial needs.

However, as I have already written here, this may only be a partial interpretation. There is mounting evidence to show that conditional on access to a bank account, the majority of people use their bank accounts sub-optimally, most often as a mere storage for their cash balances. The Economist, which points to a newly released World Bank report (pdf here) on banking services usage across the world, writes,

The vast majority of people in developing countries - 88% - say they use banks solely for personal use. The commonest reason for taking out a loan, for example, is to pay for family emergencies (typically someone falling ill). That is followed by school fees, home construction and the expenses of a wedding or funeral. In Africa, 38% of those with bank accounts say they use them to receive remittances from family members abroad. One particularly important reason for having an account in Europe, Central Asia and Latin America is to bank money from the government, either salaries or benefits. In comparison, banks do not seem to be used so much for what seems like a basic purpose: saving money. More than a third (36%) of adults said they had saved some money last year. But only a fifth (22%) said they used a bank or other formal financial institution to do it; 29% saved, but not at a bank (presumably they put the money under the mattress or used it to buy jewellery).

 A few graphics from the report highlights these findings. Accounts penetration is very low in South Asia.



Even among those saving money, banks have not been able to marginalize the informal sources.

Further, a majority of those with bank accounts did not save.

Loans were mostly drawn for personal consumption than for business purposes. 

 Purchases of insurance products for health and agriculture is minuscule.
 

China moves up the value chain

From being the consumer goods factory of the world, China is fast becoming the infrastructure contractor to developing countries. As domestic wages increase and labour market diversifies, China is ceding ground to other lower-cost consumer goods manufacturing countries and moving over to heavy equipment, especially infrastructure-related, manufacturing.

The massive domestic infrastructure investment boom of the past decade-and-half has equipped many Chinese firms, public and some private, with expertise in heavy equipment manufacturing and construction of huge infrastructure projects. The FT describes this push and its implications

Between 1998 and 2010, consumer goods exports from China to the rest of the world grew at a rate of 13 per cent a year. Heavy industry exports to the developing world, by contrast, grew by 25 per cent annually over that period... Chinese companies have had difficulty adding value in high-end consumer products (that) require a complex mix of design, branding and marketing skills that are in short supply in a relatively low-income country like China. On the other hand, using the huge construction boom for the past couple of decades as a training ground for selling excavators and bulldozers to the rest of the world at lower prices than their developed world competitors is easy enough...

The so-called China price now applies to industrial goods, not just consumer goods. Cheap China exports could provide a boost to investment in the developing word, just as they once did to consumption in the developed world... This ought to be a near unalloyed positive for the developing world, except that financing may prove more difficult as the developed world’s banks retreat from lending overseas.

The article also highlights the potential for trade disputes that could arise from this aggressive push with heavy equipment exports. Countries like India, which have their own fledgling heavy equipment industries, are more likely to resist this Chinese push. 

Leverage and executive compensation

FT quotes Andrew Haldane's work that shows how the increased focus on return on equity (as against return on assets) as the metric for measuring executive performance drove executives into over-leveraging and thereby amplifying risk,

For most of the 20th century the long-run return on equity in UK banking moved in line with the underlying growth rate of the UK economy. Then from 1986 to 2006 the return on equity jumped from 2 per cent to an annual average of 16 per cent. Yet the return on assets was largely stagnant over the period. In effect, the managers of banks took to the roulette wheel. They juiced up rotten returns by shrinking their equity capital and taking on more risk. This pattern was repeated across much of the developed world.

More on India's urbanization challenges

Frank Muraca has a nice post on possible reasons for India's slower pace of urbanization. He points to a recently released report on American cities by the McKinsey Global Institute (MGI), which has a couple of interesting graphics relating to India's urbanization trends.

The graphic below shows that urbanization is in its initial stages in India, especially when compared to China. It has 234 cities with population above 200,000 (as on 2010), which are estimated to contribute 49% to GDP growth in the 2010-25 period. Only 20% of population currently live in these 234 cities. In contrast, China's 710 such cities are estimated to contribute 90% to GDP growth in the same period. The report describes the scale of China's urbanization as unprecedented.

In fact, unlike the other major emerging economies, India has not experienced an urbanization boom of comparable proportion. The decadal growth in urban population has not shown any appreciable increases.

The report attributes India's slower pace of urbanization to two factors. One, state borders limiting mobility and resulting in "urban economic concentration in state hubs rather than city clusters across the nation". Two, policies that have traditionally "favored small-scale production and discouraged larger-scale operations in cities".

Another graphic points to the population and GDP of large cities, small cities and rural areas, in India and elsewhere. The contrast is obvious. As on 2010, 81% of its population and 61% of GDP came from the smaller cities (population below 200,000 and rural areas). 

Further, in comparison to other countries,the contribution to GDP of cities outside its top two metropolises is small. In fact, the share of its Tier III cities is smaller than even that of its Tier II (28 cities). This is a reflection of the low priority that urban development holds in India's development paradigm. As Frank posts, quoting an MGI report on India,

India spends only $17 per capita annually on urban capital investment, compared with $116 per capita in China and $391 in the United Kingdom. In addition, India's current urban spending varies dramatically according to the size of city. Tier 1 cities spend an average of $130 per capita each year, with 45 percent of this total on capital spending. However, owing to high general and administrative costs, most Tier 3 and 4 cities support per capita capital spending of only $1 currently.

One of the biggest takeaways for India from these cross-country comparisons on urbanization and economic growth trends is to dramatically increase the focus on urbanization, in particular, the growth of its Tier III and smaller cities. While many of the top 30 cities may or will, in near future, have access to several sources of capital to trigger the civic infrastructure investments required to support their growth (both by attracting populations and investments), the same cannot be said about the Tier III and the smaller cities. Nearly 40% of the urban population is located in 4728 smaller cities with population less than 100,000. These cities will require massive public investments from the state and central governments before they can start thinking about sustainable growth.

Markets in everything - internalizing expenses due to misconduct as the cost of doing business

Since the disastrous oil spill from its Deepwater Horizon oil rig in April 2010, British Petroleum (BP) has apparently spent nearly $30 bn in clean up costs, civil damage claims, and restitution to businesses and residents along the Gulf of Mexico. The incident, which involved a spillage of 200 million gallons of oil, resulted in the death of 11 workers and a massive environmental disaster. However, despite the huge price tag of the oil spill, $30 bn and climbing, BP's commercials appear unaffected. It collected more than $375 billion in 2011, pocketing $26 billion in profits.

While criminal prosecution charges were framed against the executives of BP and its contractors, nobody has been prosecuted till date for these damages. This has important moral hazard implications. Though BP has been involved in similar safety failures earlier, when they paid huge fines, they have moved on without addressing the underlying safety related issues. In fact, as Times writes, "without personal accountability, the fines become just another cost of doing business".

Much the same story can be said about the several cases of financial market irregularities, bordering on criminal misconduct, that played a major role in blowing the sub-prime mortgage securitization bubble. Several financial institutions, including its leading lights, have been found guilty of practices that involved making money by betting against their own clients. These firms peddled unsuspecting clients securities that they themselves were betting against (say, shorting). They made money from fees as well as being the counterparty in the trade.

In most of these cases, the financial institutions have settled the malpractice suits and even the criminal prosecution by making huge compensation and fine payments. However, not one top executive has been convicted on criminal misconduct. Most of these institutions have weathered the worst of the sub-prime meltdown, paid their fines, and are back to making profits by indulging in the same practices. They have come to see the fines as another "cost of doing the business".

In his best selling book, Predictably Irrational, Dan Ariely has written about the changed behaviour of parents when a kindergarten moved from a regime of mandatory pick-up as soon as school closes to a regime that charged for additional hour spent beyond the school hours. They found that in the former regime parents generally came to pick-up their children within time, whereas parents preferred to pay and pick up their children at their convenience. He argued that in the first regime, social norms kept parents from tardiness in pick-ups. However, in the second regime, introduction of a penalty increased tardiness. A fine becomes the price (pdf here) of the violation or deviation. The same motivations lie beneath the moral hazard described in the first two examples.

Such trends are not confined to high-finance and business, but pervasive in modern-day lives. Old-fashioned virtues of equality (of people standing in a que to access a service) have given way to opportunity-cost driven conventions (rich people pay to access the service out of turn). The implications of this gradual shift have been far-reaching and is surely a major contributor to the widespread widening of inequality across societies. It is obvious that there is a slippery slope associated with these trends. Traditional mores slowly get replaced with market-based morality, with all its attendant consequences.

In this context, Michael Sandel's new book, What Money Can't Buy: The Moral Limits of Markets, provides an excellent perspective on how pricing human behaviour and responses runs the risk of crowding out other values. Jonathan Last has an excellent review of the book, where he writes,

Today you can purchase your way out of waiting in line for rides at many amusement parks. There are express lanes that allow us to buy our way out of traffic. Many schools now "incentivize" performance, paying students if they read books or do well in school; some schools now sell ads on children's report cards. Cities routinely sell advertising space on public property, ranging from parks and municipal buildings to police cars. In each of these cases, long-held ideas about inherent worth and common ownership have been displaced by the simple morality of the market. 

He quotes Sandel's assessment of market driven morality,

Markets don't only allocate goods, they also express and promote certain attitudes toward the goods being exchanged... When we decide that certain goods may be bought and sold, we decide, at least implicitly, that it is appropriate to treat them as commodities. 

Prof Sandel raises questions about the effect of such marketization on democracy itself,  

At a time of rising inequality, the marketization of everything means that people of affluence and people of modest means lead increasingly separate lives. We live and work and shop and play in different places. Our children go to different schools. You might call it the skyboxification of American life. It's not good for democracy, nor is it a satisfying way to live. Democracy does not require perfect equality, but it does require that citizens share in a common life. What matters is that people of different backgrounds and social positions encounter one another, and bump up against one another, in the course of everyday life. For this is how we learn to negotiate and abide our differences, and how we come to care for the common good.

The issues raised by Prof Sandel have enromous significance for our society today. If the creeping influence of markets and its touchstone of utility maximization crowds-out individual values and social norms, then we are not far from an age where man would move from being a "social" to a "monetary" animal. Its aggregate consequences would be far from benign.

Votes would be bought and sold, criminals would purchase their way out of jails, college seats would be auctioned off, policy decisions would be purchased based on donations made to parliamentarians and ministers, and so on. Further, it would be no longer anathema to let the poor suffer or even die for lack of access to medical care, or keep lowering taxes on the rich, or provide tax concessions to businesses while loathing welfare subsidies to the indigent, and so on. 

Fiscal policy Rules - Chilean experience

Arguably the biggest short-term challenge facing the Government of India is to get its fiscal balance in order. With elections due in two years, the propsects of any significant roll-back on subsidies, the major contributor to the fiscal imbalance, appears bleak. However, at a policy level what are the options available for the government to address this challenge?

The ultimate objective of any fiscal policy framework is to maintain long-term budget balance. In the long-run this can be achieved only by running up surpluses during the good times so as to build up the buffer to draw upon when the economy hits rough weather. But real world implementation of such counter-cyclical fiscal policy is difficult in democracies. As the good times arrive and tax revenues soar, pressure inevitably builds to spread it around. Not many countries have successfully managed this challenged.

The most famous experiment with fiscal policy rules is the European Union's Stability and Growth Pact, which defined a budget deficit target of 3% of GDP, beyond which defaulters could attract steep fines. It was thought that the clear target and the severity of the fines would deter countries from defaulting. But as we have seen over the past decade, this target was rarely met, even by its more fiscally prudent members.

Closer home, India's own experiment with fiscal policy rules has been disappointing. The Fiscal Responsibility and Budget Management (FRBM) Act was enacted in 2003 with the objective of eliminating revenue deficit and bringing down fiscal deficit to 3% of GDP by March 2008. However, the sub-prime crisis and the global economic slowdown resulted in the suspension of its implementation in 2009. In the context of India's dismal fiscal balance, there have been calls from within the government for reviving the FRBM.

However, Chile, as in many other cases of macroeconomic policy making, stands out as an excellent example of successful fiscal management. Since 2000, Chile has managed a truly counter-cyclical fiscal policy through a set of very clearly defined fiscal policy rules. At the heart of its fiscal policy framework is a clear budget target. The budget target was originally set as a surplus amounting to 1% of GDP, but was lowered to 0.5% in 2007 and to 0% in 2009. The government is permitted to run a deficit larger than the target only if the output falls short of its long-run trend (say, in a recession) or if the price of copper (it accounts for 16% of government's income) falls below its medium-term (10 year) equilibrium. Jeffrey Frankel writes,

The key institutional innovation is that there are two panels of experts whose job it is  each mid-year to make the judgments, respectively, what is the output gap and what is the medium term equilibrium price of copper. The experts on the copper panel are drawn from mining companies, the financial sector, research centers, and universities. The government then follows a set of procedures that translates these numbers, combined with any given set of tax and spending parameters, into the estimated structural budget balance. If the resulting estimated structural budget balance differs from the target, then the government adjusts spending plans until the desired balance is achieved.

He writes about how the government of Michelle Bachelet (2006-2010) instututionalized the structural budget rule (it was initially followed voluntarily by the government of Ricardo Lagos) into a Fiscal Responsibility Bill 2006 and resisted the temptation to indulge in public spending when copper prices boomed. 

The real test of the policy came during the latter years of the copper boom of 2003-2008 when, as usual, the political pressure was to declare the increase in the price of copper permanent thereby justifying spending on a par with export earnings. The expert panel ruled that most of the price increase was temporary so that most of the earnings had to be saved. This turned out to be right, as the 2008 spike indeed partly reversed the next year. As a result, the fiscal surplus reached almost 9% when copper  prices were high. The country paid down its debt to a mere 4 % of GDP and it saved about 12 % of GDP in the sovereign wealth fund. This allowed a substantial fiscal easing in the recession of 2008-09, when the stimulus was most sorely needed.

As indicated, the critical innovation in Chile was the clear identification of budget-relevant macroeconomic variables (output gap and copper prices), entrustment of its estimation to independent panels, and the fortification of this framework as a statutory mandate. This approach to fiscal policy making has the twin-benefits of letting a technocratic agency determine the outer boundaries of the fiscal balance at any time, while leaving elected governments with the freedom to allocate spending among competing claims. However, as is the case with all such neat solutions, the challenge lies with its political acceptability.

One encouraging sign as we set out in this pursuit of fiscal policy rules comes from the evolution of central banks and their monetary policy making role. We often take for granted the independence and objectivity of monetary policy decisions. This glosses over the fact that independent, target-focussed and rules-driven monetary policy decisions by central banks is, even in developed economies, a recent phenomenon. In countries like India, central banks have gained tremendous authority and credibility in their interest rate decisions over the past decade or so. Governments have exercised great caution and restraint in promoting central bank autonomy. There is some reason to hope that fiscal policy rules too could similarly evolve and gain strength over a period of time.

Comparing neo-natal care options

Mint has an excellent graphic that highlights why home-based neo-natal care is an extremely cost-effective approach to addressing India's shockingly high Infant Mortality Rate. It chronicles the success of NGOs in the extremely backward Gadchiroli district of Maharashtra in lowering IMR and improving infant health through neo-natal care delivered at their homes by local community health workers.

The graphic below compares the cost per DALY (disability adjusted life years) saved for different types of interventions. As can be seen, home-based neo-natal care and zinc fortification deliver very high bang for the buck. The Gadchiroli-type initiative costs just $7 per DALY saved.























All this assumes much greater significance in view of the lates UNICEF estimates which show that  deaths in the neonatal period or first four weeks account for roughly 40% of all under-five deaths and their proportion has grown by 10% since 1990.

Traffic management explained

(HT: Atlantic Cities)

The politics of the monetary policy debate

The Reserve Bank of India (RBI) has finally succumbed to the increasingly mainstream demand for lowering interest rates. In its mid-quarterly monetary policy review, it has lowered the repo rates by a substantial margin of fifty basis points.

Conventional wisdom would have it that the RBI makes its interest rate decisions on objective considerations based on clearly defined parameters. Even assuming the inevitable discretionary judgement that goes with such decisions, the broadly technocratic nature of such decisions are widely accepted. It is also assumed that these decisions stabilize the economy as a whole. The twin objective is to keep inflation anchored and boost economic growth.

However, a closer analysis of this decision reveals a deeply institutionalized political and social bias. Two observations from the debate that preceded and also followed this decision.

1. In recent months, there has been a growing belief that the RBI holds the key to restoring India's economic growth. In fact, this belief has come to dominate opinion makers across the world. The apparent simplicity of tweaking a single number, the repo rate, to alter the fortunes of the economy has obvious attractions to all parties - academicians, businesses, governments, and media. It provides an easy opportunity for all and sundry to weigh in with their two ounces of wisdom. Unfortunately, it also takes away from focussing on the real issues at hand and holding governments accountable for their role in restoring economic growth. It takes the pressure off from governments in having to deal with more fundamental structural distortions and need for more reforms.

This impression is also reinforced by a cognitive bias, the availability heuristic. The RBI's interest rate decisions are discrete and high-profile events, very frequently deployed (especially in the past few years), and is associated with clear economic growth implications. Rate hikes increase the cost of capital while reductions have the opposite effect. It therefore becomes very easy for everyone to associate a tight monetary policy stance with growth suffocation.

2. The inflation Vs growth trade-off in monetary policy management, in the Indian context, has critical political overtones. Corporate India is directly and immediately hurt by the high interest rates. It therefore becomes natural for them to lobby aggressively to lower interest rates. They argue that the downside risks to economic growth associated with higher rates are much higher than its corresponding inflation risks.

However, monetary loosening, especially when inflationary forces remain unhinged and the economy is running at its potential output frontier, poses significant inflation risks. And inflation, as the episodes of runaway spikes in food prices in recent years indicate, can very adversely affect the poor. They disproportionately bear the costs of inflation compared to the non-poor and corporates.

In simple terms, leave alone its technical merits, a rate cut now reflects a conclusive preference for one political view over another. The balance sheet squares up clearly - high interest rates increases the cost of production for corporate India, while inflation has only marginal immediate impact; inflation hurts the poor directly while the effect of high interest rates is negligible. In terms of the magnitude of short to medium-term effects, lowering of interest rates and a possible rise in inflation will impact the poor more adversely than corporates and non-poor.     

3. Finally, as I have blogged earlier, RBI's recent tight monetary policy stance goes much beyond inflation control. In recent years, the Indian economy has been growing at a rate much higher than its potential GDP growth rate. In the absence of policies and investments that ease supply-side bottlenecks, this potential growth rate has remained stagnant. Therefore, it became necessary for the RBI to cool down the economy, so as to prevent the build up of inflationary pressures. However, popular debates and mainstream discussion on monetary policy have tended to gloss over this and focus on the growth inhibiting role of high interest rates.    

In the final analysis, these prejudices and biases are reflective of the dynamics that skew the priorities in the formulation of public policies and their implementation in India.

Postscript - I missed linking to this post by Daron Acemoglu and Simon Johnson which highlights how monetary policy in the US too appears to have become beholden to the interests of Wall Street. 

Inequality and taxation in the US

America's deep fiscal hole and spectacular income growth at the top of the income ladder has ignited a debate on increasing the marginal tax rates, especially for the richest.

This striking graphic from Thomas Piketty and Emannuel Saez brilliantly captures the stunning magnitude of concentration of wealth at the top over the past quarter century. In order to mitigate the effects of this, they propose a "much higher top marginal tax rates on the rich, up to 50 percent, or 70 percent or even 90 percent, from the current top rate of 35 percent". Peter Diamond and Emmanuel Saez have estimated that the optimal tax rate on the highest earners is in the vicinity of 70%.


In fact since the mid-eighties, income gains at the topmost part of the income ladder dwarf those elsewhere. As the after-tax incomes of the top 1% households rose 277% in the1979-2007 period, those of the bottom quintile just nudged up 18%.

An important contributory factor to this rise in income inequality has been the declining marginal tax rates. As David Leonhardt points out, the effective tax rates - including income, payroll, and all other federal taxes - have declined dramatically in the last 50 years for the very rich. The US tax code while still progressive, is not nearly as progressive as it used to be.

See also this excellent series of graphics from Derek Thompson.

Update 1 (29/4/2012)

The Times has this graphic which shows how as corporate profits have exploded, effective tax rates have fallen. 

 Update 2 (13/5/2012)

Top marginal tax rates from Visualizing Economics.

India's most important structural imbalance in a graphic

A report by Deloitte has this graphic which captures the essence of India's most worrying economic-demographic imbalance.

An oversized 58% of the workforce involved in agriculture contributes just 15% to the GDP. India's biggest challenge in the coming years will be to manage the transition of a large share of this 58% into manufacturing and services. Given the already large share of services sector, manufacturing may have to absorb the major share of those moving out of agriculture.

Where is global oil demand coming from?

The graphic below from Barclays Research, via Floating Path, captures the sources of global oil demand growth. As can be seen, Brazil, India, China, and Saudi Arabia (BICS) have been collectively responsible for most of the global demand in the past few years. In fact, almost the entire demand growth in 2011 and 2012 is estimated to come from them.

Eurozone's rebalancing challenge

Regaining external competitiveness dented by a decade of massive external capital inflows, asset price bubbles, and investment booms, is arguably the biggest challenge facing many of the beleaguered Eurozone economies. Martin Wolf, quoting two Goldman Sachs research papers, “Achieving fiscal and external balance”, points to the magnitude of this re-balancing challenge facing the peripheral economies.

To achieve a sustainable external position, Portugal needs a real depreciation of its exchange rate of 35 per cent, Greece one of 30 per cent, Spain one of 20 per cent and Italy one of 10-15 per cent, while Ireland is now competitive. Such adjustments imply offsetting appreciation in core countries. Moreover, with average inflation of 2 per cent in the eurozone and, say, zero inflation in currently uncompetitive countries, adjustment would take Portugal and Greece 15 years, Spain 10 years and Italy 5-10 years. Moreover, that would also imply 4 per cent annual inflation in the rest of the eurozone.

But the danger is that even if the required inflation environments can be sustained for long periods, the austerity policies being followed by these economies could choke off any growth and push them down a contractionary spiral. Spain's targeted fiscal correction by 5.5% of GDP over two years, with 3.2% adjustment proposed for 2012, from its fiscal deficit of 8.5% of GDP for 2011, is one of the biggest fiscal adjustments ever attempted by a large industrial country. Such severe austerity threatens economies with large unmeployment rates, debt-ridden banks, and fiscally constrained governments. Predictably, as with the case of Spain, the markets have reacted with alarm driving up Spanish bond yields and CDS spreads.

The regulation Vs subsidy debate and international trade law

Consider the three scenarios.

In the first, the government of Regulationland promulgates a law that prescribes certain domestic content requirement for equipments used in domestic solar power generators. It ensures that the local manufacturers are directly favored over imports under all conditions. It involves no direct subsidy by the government, though the entry barrier erected is an implicit subsidy protection. This is the classic pre-WTO domestic industry protection strategy.

In the second, the government of Subsidyland provides a large direct subsidy to its equipment manufacturers. This enables these manufacturers to beat off competition from their external competitors and imports. Alternatively, it also helps them outbid foreign manufacturers in their own markets. This strategy requires that the government of Subsidyland incur huge subsidy expenditures. China has been following this policy in many sectors, including renewables.

In the third, the government of Tariffland offers to purchase the output from the solar industry - generated solar power - at a (higher) concessional tariff, provided the generator meets certain local equipment sourcing requirement. This indirectly promotes local manufacturers over their external competitors. This approach is a mix of regulation and subsidy, and it reduces the huge upfront subsidy burden on governments. Canada has adopted this strategy under its FIT Program and India under its Jawaharlal Nehru National Solar Mission.

Substantively, in all the three cases, the issue involved is the same. National governments have deployed various strategies to favor their domestic solar equipment manufacturers over their foreign competitors. The objective is to promote domestic industry and prevent them from being swamped by foreign competition. Any international trade law that seeks to promote trade discrimination has to necessarily address the issues raised by all the three strategies in an equitable manner.

Why do countries adopt these different strategies? Individual nations adopt these strategies based on their respective national strengths and weaknesses - fiscal balance, strength of local industry, nature of national renewables program etc. Those unwilling or unable to spend public resources prefer the first, while those with deep pockets prefer the second. The third alternative is deployed by countries with limited fiscal space.

The international trade law provisions that regulate such measures by national governments are covered in the Article III: 4 of Trade Related Investment Measures (TRIMS). This "national treatment" rule prohibits protectionism and discriminatory treatment against imported products and in favour of domestic products. This effectively means that the regulatory restrictions of Regulationland and Tariffland are illegal.

However, and very interestingly, Article III 8 allows for payments of subsidies to domestic producers and consumers. This means that it is permissible for governments to subsidize their manufacturers by offering them direct subsidies or to subsidize consumers by providing power at concessional rates. Accordingly, the action of the government of Subsidyland and that of the Tariffland authorities in providing tariff concessions are permissible. Now there is something clearly amiss with this differential treatment.

The principle of fairness in any law demands that for any particular objective, the law should not be path dependent and should constrain or promote all sides equally. In other words, the mechanics of its implementation should not favor one country over another. In this case, given the specific objective of ensuring that foreign manufacturers of solar equipments are not discriminated against, any law should ensure that none of the three - Regulationland, Subsidyland, and Tariffland - are discriminated against or left less well-off than the others.

This effectively means that the law should equally neutralize the ability of governments to either regulate or subsidize away foreign competition. Regulation and subsidy are two sides of the same coin - a regulation is a negative subsidy (or tax) on the foreign competitor while a fiscal concession to domestic manufacturers are direct positive subsidy to them. In other words, any WTO regulation to restrict trade discrimination can itself be fair only if the degree of restraints imposed on regulation is the same as that imposed on subsidies.

India and emerging Asia compared

The annual Asian Development Outlook 2012 (pdf here), which talks about rising inequality in Asia, has some interesting graphics about the Indian economy, especially in comparison to its counterparts in emerging Asia.

Note the sharp fall in investment as a contributor to GDP growth in 2011. Though government consumption has contracted, so has private consumption. Interestingly, the share of private consumption has risen in China.  

The Reserve bank of India (RBI) has been easily the most aggressive Asian central bank. It cut interest rates vigorously when the recession struck and raised rates with similar aggression when inflationary pressures became unhinged. On the positive side, there exists considerable cushion for monetary easing if the RBI feels inflation is under control.

But inflation in India has been a persistent problem for the past four years. India's current inflation rate is more than twice that of any other major Asian economy. This means that the RBI will remain reluctant to indulge in any significant monetary easing anytime in the immediate future. At best, it is not likely to raise rates any further.  

I have blogged earlier that the inflationary pressures were clearly the result of an overheating economy. As the graphic shows, the Indian economy's scorching pace of growth in the mid-2000s blazed the economy well beyond its potential output frontier. Though growth has slowed, it is now merely at its potential output frontier. This is yet another reason why the RBI may desist from moving down the path of monetary accommodation. Massive investments to ease the supply side is the need of the hour.

However, the government appears to have limited fiscal space to play an aggressive role in any supply side easing. India is easily the most fiscally constrained country among all major Asian economies. This means that two things will have to happen simultaneously. One, fiscal spending on subsidies will have to be reined in and the savings routed into infrastructure, agriculture, human resource development and so on. Two, private investments will have to be catalyzed in large amounts. Foreign capital investments will have to supplement the domestic private partners in boosting private investment in the economy.
  

The graphic below highlights the nature of distribution of gains between labour and capital. In the period 1990-2007, while real wage rate did not even double, labor productivity increased three-fold, from about 80,000 to about 250,000 rupees. In fact,  the average annual growth rate of labour productivity was 7.4% during 1990–2007, while the average annual real wage growth rate was only 2%. This implies that gains in productivity were not passed on to wages and, consequently, the labor share of India’s organized manufacturing sector declined significantly.

More on China's macroeconomic imbalances

Much has been written about China's economic policies that sought to boost exports at the cost of everything else. It is now very clear that it has come with significant costs and serious external and internal macroeconomic imbalances. Externally, Beijing has aggressively intervened in the market to keep the renminbi undervalued. Internally, it has kept interest rates artificially low which in turn has resulted in severe financial repression and suppressed domestic private consumption.

Economix has an interview with Nicholas Lardy who outlines why these two imbalances, external and internal, are closely linked,

The government adopted a low-interest-rate policy at that time. Deposit rates were held down so that the after-inflation return on bank deposits for savers turned negative. That reduced household income below the path it otherwise would have achieved, leading to a slowdown in the rate of growth of household consumption expenditure. Since most households lack adequate health insurance and retirement programs, they also responded to lower deposit rates by saving even more, so as not to be delayed in reaching their savings goals. That put further downward pressure on private consumption expenditure.

China has adopted a low-interest-rate policy as a mechanism to reduce the costs of simultaneously maintaining price stability and an undervalued exchange rate. The central bank intervened massively in the foreign exchange market to moderate the pace of appreciation of the renminbi, China’s currency. And that intervention led to a large, ongoing increase in the domestic money supply, which the central bank had to offset by the sale of central bank bills and requiring banks to increase their reserves deposited at the central bank. The central bank had to pay interest on these bills and reserves, and the low-interest-rate policy made the cost of these operations less than it would have been had interest rates been market determined.

One could add several other consequences of the low interest rate policy. While it has been a major contributor to the promotion of China's investment driven economic growth strategy, it has also generated distortions in resource allocation, the most prominent and of greatest concern being the real estate bubble.

Stripped off all its macroeconomics, China's investment and export based economic growth strategy has been underpinned by massive government inflated bubbles, in multiple sectors. And for much more than a decade now, the country has managed to successfully carry on the strategy. The government kept interest rate and exchange rate suppressed so as to boost investment and exports. Coupled with capital controls, low interest rates, boosted the coffers of the country's public sector banks with cheap capital, which they on-lend to businesses at low rates. Real estate market boomed, which amplified the finances of state entities and local governments which owned all the land. These agencies leveraged the high real estate values to raise resources to finance their massive infrastructure investments. On the external side, the low exchange rate raised export competitiveness, which in turn encouraged massive inflows of foreign direct investment. A sustained period of widespread global economic growth provided all the favorable conditions for China to pursue this export strategy uninterrupted.

There are several dangers associated with this strategy. Lardy himself points to one such transmission channel,

Urban households have piled into property investment in part because of negative real interest rates on bank deposits, and capital controls that prevent most households from investing abroad. The property boom is based on the widespread assumption that property prices will continue to move upward with only brief and shallow price corrections. If this expectation changes, investment demand in residential property could evaporate. Demand for output of steel, cement, copper, aluminum and many other products is driven largely by residential real estate, so if that sector slumps it could usher in a long period of much slower economic growth.

While the rulers in Beijing certainly deserve their share of compliments for the country's spectacular economic growth, it cannot be denied that China has enjoyed more than its fair share of luck and benefited from favorable external circumstances. Now that the consequences of the imbalances, especially the internal ones, are becoming ever more apparent, Beijing ins being forced to re-evaluate its options. Low interest rates are becoming unsustainable for a variety of reasons, making over-reliance on the investment-driven growth strategy unsustainable. Propsects of anemic economic conditions in much of developed world for the foreseeable future puts question marks on the export-led growth approach.

In the circumstances, re-balancing will have to involve nudging the Chinese consumers to play a more central role. This will require rewarding and incentivizing them with higher interest rates and more diversified and remunerative investment alternatives for their savings (read greater financial liberalization). Further, manufacturing wages will have to become more market determined, so that people's purchasing power increases proportionately with the economy's growth. Both these will have to be accompanied by domestic policies that establish a comprehensive social safety net and enabling greater access to affordable urban housing, tertiary education, and so on.

America's income inequality in a graphic

The graphic strikingly captures the nature of income growth and resultant contribution to widening inequality in the United States. Though median income grew from $8,734 in 1970 to $49,445 in 2010, almost all the real income gains were captured by those at the top 10%. The contrast with economic growth in the previous half-century could not have been starker.

In fact, as Emmanuel Saez has documented, during the 2010 recovery, the top 1 percent captured 93 percent of the income gains, while the incomes of the 99 percent essentially remained flat.

Evidence of sticky wages

Econ 101 teaches us that prices adjust to clear supply and demand. Accordingly, in the aftermath of an economic boom when wages have risen, as recessions strike and unemployment rates climb, businesses lower wages which in turn lowers production costs and boosts investment and further hiring. In other words, high unemployment rates do not persist since wages fall proportionately to clear any labour market over-supply.

This has been used as a justification to oppose any government intervention to clear markets suffering from recessions. If the markets clear by themselves, it is argued, then where is the need for any discretionary fiscal policy intervention by governments. Though markets may deviate from the equilibrium, it is only a matter of time before the aforementioned dynamics takes over and restores stability.

However, as we have seen with the Great Recession and persistent high unemployment rate in the US, labour markets are not so accommodative. It is obvious that labour market does not clear so easily. In fact, the New Keynesian schools have long talked about "frictions" and "stickiness" with wages and prices which come in the way of markets regaining their earlier equilibrium. Economists like George Akerlof have pointed to downward wage rigidities, especially in conditions of low inflation.

In this context, an excellent study by researchers from the San Francisco Fed highlights the magnitude of this problem. They used individual-level survey data from 1980-2011 from the Current Population Survey (CPS), the monthly survey conducted by the Bureau of Labor Statistics used to measure the unemployment rate, to demonstrate the salience of downward nominal wage rigidity. They write,

Despite a severe recession and modest recovery, real wage growth has stayed relatively solid. A key reason seems to be downward nominal wage rigidities, that is, the tendency of employers to avoid cutting the dollar value of wages. This phenomenon means that, in nominal terms, wages tend not to adjust downward when economic conditions are poor. With inflation relatively low in recent years, these rigidities have limited reductions in the real wages of a large fraction of U.S. workers. 

In the current American context, since inflation is low and therefore keeping wages constant cannot reduce real wages, the only way for employers to lower wages is to actually cut nominal wages. The graphic below is an excellent illustration. The dashed black line shows a symmetric normal distribution, while the blue bars plot the actual distribution of nominal wages in 2011. The blue bar that spikes at zero shows that a large number of workers report no change in wages over a year. The prominence of this psike shows that disproportionately large numbers of employers simply kept wages fixed over the year. This proposition is also supported by the fact that the gap in the normal distribution and the actual wage distribution is much higher on the left side. This gap suggests that the spike at zero is made up mostly of workers whose wages otherwise would have been cut.

Similarly, the researchers also compare the trends in such wage rigidity over the past 30 years. They compared the proportion of workers in the same job who report no year-over-year wage change and find that their share rises in recessions and persist well into the recovery. Further, this proportion has risen sharply in the Great Recession for all categories of workers. They find that from 2007 to the end of 2011, the fraction of workers experiencing no yearly wage change rose to 16% from 11.2%. This is five percentage points higher than the average size of the spike at zero from 1983 to 2007.

The same trend is observed among all categories of workers.

See also Paul Krugman (also here) and Mark Thoma. 

India's urbanization trends

Excellent graphics from the recently released IIHS report (pdf here) on Urban India 2011. If we take into account larger villages, half of India's population is already living in urban areas or in areas with similar conditions.

Contrary to conventional wisdom, natural urban gorwth and not migration from rural areas is the major cause of urban population growth.

Despite the increasing importance of cities, urban development remains someway off from the mainstream development radar. The graphic below accurately captures the development priorities of governments in India. The Eleventh Plan (2007-12) allocation to various sectors reveals the low priority for urban development.

Cars and two-wheelers constitute 86% of all vehicles on the road, while accounting for just 29% of all trips. Walks and public transport together form 54% of all trips made. The case for massive investments in public transport is most compelling.

The High Powered Expert Committee (HPEC) appointed by the Planning Commission to estimate the financial requirements of cities has estimated that transportation requirements would form the major share of funds requirement for our cities in the 2012-31 period. However, the major focus of JNNURM has been on water supply and urban housing. In some sense, this is encouraging since it means that the funds requirement for providing the basic non-transport urban infrastructure - sewerage and water supply, solid waste management, and storm water drains - is a small share of the total estimated requirement.

Excellent snapshot (click to enlarge) of the cornucopia of urban social safety programs.

 

Despite the increased pace of urbanization over the past two decades, the share of informal employment as a share of total urban employment has remained stable in the 80% range. Jobs in trade and surprisingly, manufacturing, have been largely confined to the informal sector. 

Spatial clustering is defined as the ratio of the share of employment of a sector in an area divided by the national share of employment of that sector. Values greater than one signifies a relative clustering of that particular sector's employment in the particular region. The graphic below reveals a spatial clustering in the metros and million-plus cities for ICT services, high-tech industries, and fast-growing export sectors.