Markets in education - Growing too large and too fast is hard

The publicly financed but independently run Charter Schools are often thought as the solution to addressing quality in school education in the US. It was, therefore, with great expectations that Michigan embraced Charter Schools a few years back in an effort to improve its schools. As a Times investigation indicates, the results have been less than benign, with less than 10% of high school seniors being "college ready" on reading tests,

Detroit schools have long been in decline academically and financially. But over the past five years, divisive politics and educational ideology and a scramble for money have combined to produced a public education fiasco that is perhaps unparalleled in the United States. While the idea was to foster academic competition, the unchecked growth of charters has created a glut of schools competing for some of the nation’s poorest students, enticing them to enroll with cash bonuses, laptops, raffle tickets for iPads and bicycles. Leaders of charter and traditional schools alike say they are being cannibalized, fighting so hard over students and the limited public dollars that follow them that no one thrives. Detroit now has a bigger share of students in charters than any American city except New Orleans, which turned almost all its schools into charters after Hurricane Katrina. But half the charters perform only as well, or worse, than Detroit’s traditional public schools...

To throw the competition wide open, Michigan allowed an unusually large number of institutions, more than any other state, to create charters: public school districts, community colleges and universities. It gave those institutions a financial incentive: a 3 percent share of the dollars that go to the charter schools. And only they — not the governor, not the state commissioner or board of education — could shut down failing schools. For-profit companies seized on the opportunity; they now operate about 80 percent of charters in Michigan, far more than in any other state. The companies and those who grant the charters became major lobbying forces for unfettered growth of the schools, as did some of the state’s biggest Republican donors... Even as Michigan and Detroit continued to hemorrhage residents, the number of schools grew. The state has nearly 220,000 fewer students than it did in 2003, but more than 100 new charter schools. As elsewhere across the country, charters concentrated in urban areas, particularly Detroit, where the public schools had been put under state control in 1999. In 2009, it was found to be the lowest-performing urban school district on national tests... Detroit was soon awash in choice, but not quality.

It has this on the dynamics of choice, 

Nationally, some charter school groups praise Michigan for allowing so many institutions to grant charters. But the practice has also allowed bad schools to languish: When universities have threatened to close them, other universities have granted another charter. By 2015, a federal review of a grant application for Michigan charter schools found an “unreasonably high” number of charters among the worst-performing 5 percent of public schools statewide. The number of charters on the list had doubled from 2010 to 2014. “People here had so much confidence in choice and choice alone to close the achievement gap,” said Amber Arellano, the executive director of the Education Trust Midwest, which advocates higher academic standards. “Instead, we’re replicating failure.”

The campaign to attract students would not be out of place even in Kota in Rajasthan,

With all the new schools, Detroit has roughly 30,000 more seats, charter and traditional public, than it needs. The competition to get students to school on count day — the days in October and February when the head count determines how much money the state sends each school — can resemble a political campaign. Schools buy radio ads and billboards, sponsor count day pizza parties and carnivals. They plant rows of lawn signs along city streets to recruit students, only to have other schools pull those up and stake their own.

And about the inequitable effects of such unfettered markets and choice in Detroit,

Charter schools are concentrated downtown, with its boom in renovation and wealthier residents. With only 1,894 high school age students, there are 11 high schools. Meanwhile, northwest Detroit — where it seems every other house is boarded up, burned, or abandoned — has nearly twice the number of high school age students, 3,742, and just three high schools. The northeastern part of the city is even more of an education desert: 6,018 high school age students and two high schools to serve them. In a city of 140 square miles, transportation adds another layer to school selection. Few schools offer busing. And Detroit, long defined by the auto industry, never invested much in public transportation. A mile and a half to school can become an hour-and-a-half journey. 

 The verdict after nearly two decades of markets and competition,

For parents, the search remains for good schools — charter or public.

Several lessons from this excellent long form. The point that unfettered markets, or even any unregulated market, can help achieve learning outcomes is pure logical fantasy and does not need any reiteration. I have also blogged several times that over a long enough period, greater choice is more likely to generate sub-optimal outcomes. 

The more important point here is that Michigan tried to expand Charters across the State is quick time and it failed. Doubtless Michigan's already weak education system had made the original challenge even more daunting. But even good school systems will struggle to cope up with the scope of what Michigan did. 

This has great relevance to public policy at large. The challenge is not so much as to produce islands of excellence as to use public policy to improve the general standards across entire systems. And, as the example of choice and vouchers has shown, the two are not exactly similar, maybe even contradictory, set of challenges. Governments in many parts of the world, especially in developing countries, face the challenge of turning around poor performing education and healthcare systems. They are attracted by innovations like Charter schools, vouchers, capitation payment model, health insurance, PPPs and so on in the belief that such initiatives can quickly help improve general standards. But as the example of Michigan and several others from across the world and over time show, the desired transformations rarely ever happen. 

Thailand did not develop its capitation model of healthcare in a few years. It carefully built up its primary care and other public facilities over decades so that when it embraced the capitation model at the turn of the millennium, it had in place the foundations to support the model. Similarly, Finland developed its impressive school system over decades of effort. It struggled over generations to create the present eco-system which values education and teaching.

Transforming poor quality education and health systems take time and are generational projects. It requires careful design, persistent and laborious efforts, close engagement among stakeholders, flexibility in implementation that allows local initiative, enormous patience, and deep tolerance for failures. Unfortunately, the political and administrative dynamics of change are not readily amenable to such long drawn approaches. 

In the circumstances, the best that can be done is to understand the challenge in its true perspective. Then a two-track approach would have to be followed. At one level, the long-term enablers have to be gradually eased in to achieve the transformation. At the more immediate level, there has to be a steady stream of initiatives that respond to political and administrative exigencies and imperatives. I'll try to outline the specifics of such a strategy in coming posts. 

The Panama Canal Locks and perils of low-ball bids

As the new Locks to the 50 mile long Panama Canal, constructed at a cost of $5.4 bn, opened for traffic on Sunday, the Times has a fascinating account of the problems faced during construction, 

On July 8, 2009... after an intense two-year competition, a consortium led by a Spanish company in severe financial distress learned that its rock-bottom bid of $3.1 billion had won the worldwide competition to build a new set of locks for the historic Panama Canal... Disputes quickly erupted over how to divide responsibilities. Some executives appeared not to fully grasp how little money they had to complete a complex project with a tight deadline and a multicultural team whose members did not always see things the same way. Internal arguments soon gave way to bigger problems. There would be work stoppages, porous concrete, a risk of earthquakes and at least $3.4 billion in disputed costs: more than the budget for the entire project.

Seven years later, and nearly two years late, the locks have finally been declared ready to accept the new generation of giant ships that carry much of the world’s cargo but cannot fit in the original canal. To mark the occasion, Panama has invited 70 heads of state to watch on Sunday as a Chinese container ship becomes the first commercial vessel to attempt the passage from the Atlantic Ocean to the Pacific through the larger locks.

The bid process that led to the developer selection appears to have been flawed,

Three consortiums — including one led by Bechtel, an American company with an international reputation for taking on big, difficult projects — pursued the contract. The financially weakest consortium was led by a Spanish company, Sacyr Vallehermoso, which American officials called “nearly bankrupt” in one cable and “technically bankrupt” in another. Sacyr’s consortium included a Panamanian company owned by the family of the canal administrator at the time, Alberto Alemán Zubieta. The company, Constructora Urbana, in which Mr. Alemán himself previously owned stock, had already done millions of dollars in business with the canal. The other two members were Impregilo, a large Italian contractor, and Jan De Nul, a Belgian company that specializes in dredging and excavation. In March 2009, after 15 months of contentious negotiations, the three consortiums submitted their sealed bids... That July, with the nation watching on television, the bids were opened, and the result was a shocker: The underdog Sacyr group had won... When one of the bidders makes a bid that is a billion dollars below the next competitor, then something is seriously wrong

And the rock-bottom bid has thrown up the expected deficiencies,

In simple terms, to be successful, the new canal needs enough water, durable concrete and locks big enough to safely accommodate the larger ships. On all three counts, it has failed to meet expectations, according to dozens of interviews with contractors, canal workers, maritime experts and diplomats, as well as a review of public and internal records. The low winning bid, a billion dollars less than the nearest competitor’s, made “a technically complex mega-project” precarious from the outset, according to a confidential analysis commissioned by the consortium’s insurer, Hill International... 

Among the biggest risks is the concrete that lines the walls of the six mammoth locks punctuating the path between the seas. Last summer, water began gushing through concrete that was supposed to last 100 years but could not make it to the first ship. The Hill analysts had warned that the consortium’s budget for concrete was 71 percent smaller than that of the next lowest bidder. The budget also allotted roughly 25 percent less for steel to reinforce that concrete. Then there is the lock design. Tugboat captains say they cannot safely escort the larger ships because the locks are too small with too little margin for error, especially in windy conditions and tricky currents. In fact, in a feasibility study... the Panama Canal Authority had earlier concluded that the tugs needed significantly more room. The tugboats themselves are a problem, especially the 14 new boats purchased from a Spanish company, mostly for the expanded locks. To maneuver safely, they must be precisely controlled, but according to captains, they are so unstable that they operate best going backward, something that cannot be done while towing ships through the canal... the canal authority bought the tugboats for $158 million from a company later represented by the son of Jorge L. Quijano, the canal’s administrator.

The new locks exist for one reason: so that huge “neo-Panamax” ships can move far greater quantities of cargo through the canal. For them to do that, the waterway must remain deep enough so that fully laden ships do not hit bottom. But canal officials discounted warnings that they needed new sources of water, and during a recent drought, shippers had to significantly lighten their loads. Canal officials had assured the country that no new reservoirs were needed.

Poor quality of concrete and other materials, skimping on standards, and cronyism appear pervasive in the project. And then there are the standard issues of emergent project risks, like water availability in the Gatun Lake which supplies water to the Locks and design challenges with the size of locks, numbers of tugboats, and so on.

This is yet more evidence that in large infrastructure projects, it is always better to structure the bid process in a manner that emphasizes the importance of technical proficiency and financial capability of the bidder over merely the lowest bid amount. In fact, in mega projects like the Panama Canal extension, with several unknown unknowns, and where cost over-runs are inevitable, it may even be appropriate to have internal benchmark pricing for major components and disqualify bids that low-ball estimations below a certain floor threshold on each of those major heads. 

Liberal democracy in the age of globalization

The Times has this assessment of Brexit,

Since the fall of the Berlin Wall in 1989, politics and economics have mostly moved in one direction, with the elites on both sides of the Atlantic favoring policies like the North American Free Trade Agreement with Canada and Mexico, the introduction of the European currency and the entry of China into the World Trade Organization. Business has applauded these moves, but voters are not necessarily on board as they once were... The Brexit vote... reflects a deep distrust of the benefits of the global economic system among a wide swath of voters in Europe and the United States, and a broadly held view that government institutions — whether in Washington or Brussels — are calcifying and don’t work well.

As more analysis of Brexit pours in, I am reminded of Dani Rodrik's "inescapable trilemma". It claims that "democracy, national sovereignty and global economic integration are mutually incompatible: we can combine any two of the three, but never have all three simultaneously and in full."

As I argued yesterday, in the case of Britain, increased integration with Brussels unleashed both economic and political insecurities. At the economic level, the competitive pressures engendered by migration and imports hurts at least some sections of both labor and capital. Politically, the erosion of "the symbols and benefits of national citizenship" amplifies the adverse effects of economic competition. Democratic governments will invariably feel the backlash from this constituency.

Assuming that democracy is a non-negotiable attribute, we are left trading off national sovereignty and economic integration. It is here that the broad sweep of time and historical perspective assumes significance. The trade-off is done most seamlessly if economic and political integration happens gradually over a few generations. But such scripts rarely pan out as planned in the real world. Instead, such transitions are invariably a series of back-and-forth movements between progress and setbacks. And Brexit is no more likely to be one more such setback in the sixty year European Project.

One could argue whether the single currency was introduced too soon. Could they not have waited longer for the norms of economic integration to have become more internalized? Should the forces of financial market integration have been allowed to play out more before the currency union was introduced? Should greater fiscal integration have preceded a currency union? Should Europe have waited for its political institutions to attain more credibility before its push forward with monetary union?

I would be inclined to answer in the affirmative to all these questions. But the political dynamics of European integration expedited the transition. The push-back was therefore inevitable. The supporters of the European Project will now have to assess their failings, address them, and resume the path towards integration. 

Brexit explained in graphics

Correlation is not causation. But this set of graphics from FT (HT: MR) may be a good place to look for the underlying factors that contributed to the victory of Leave. Analysis of data from the UK's 382 counting areas (local government districts) revealed that there were five strongly correlated indicators.

The areas with large proportion of degree-educated voters and jobs requiring degrees were the biggest votaries of Remain. In contrast, those who had never left UK, were among the strongest supporters of Leave, 

In the recent London Mayoral Election, we carried out a similar analysis and found that areas where many people did not hold a passport — indicating they would not have been abroad recently — tended to yield high votes for the far-right Britain First party. The same pattern emerges here. After education and occupation, the share of people not holding a passport was the next most strongly correlated characteristic with the Leave vote.

And going against the conventional wisdom that economic integration is the path towards political integration, the Leave vote was strongest in those areas which were economically most dependent on EU, in terms of economic output exports.

Analysis of British Election Survey found that the strongest predictor of this counter-intuitive result comes from the attitudes towards immigration. Very interestingly, these are also the regions where immigration is perceived as most damaging. 

Citizens of regions where immigration is perceived as damaging are much more likely to vote for Brexit. Presumably, the unifying forces of economic dependency are more than offset by those of competition for jobs from migration and by more latent suspicions of immigration (the Survey question was "‘Do you think that immigration undermines or enriches Britain’s cultural life?")

I am inclined to agree with David Goodhart that the persistent economic weaknesses, widening inequality, and the "disappearance of a once familiar industrial working class culture and the declining status of much non-graduate employment" may have increased the attachment to the symbols and benefits of national citizenship. This squares up with much of the public commentary on the support base of Donald Trump, Front National, Five Star Movement, and others across Western Europe. 

This goes back to a theme that I have written about on numerous occasions. A robust national social safety net which assures a basic dignified human life consistent with the country's economic and social development is an absolute necessity to pacify the losers from globalization and liberalization and thereby prevent populist backlashes. This is as much sound politics as it is economics. And there are very few such areas where there is political and economic convergence. 

Weekend reading links

1. On the US Pharma industry,

A recent Plos One study found that about 36 percent of all new drugs approved in the United States between 1988 and 2005 were protected solely by secondary, or trivial, patents.

2. The arms ocean that US is,

There are as many as 8.2m assault-style weapons at large in the US, which almost certainly exceeds that of any uniformed armoury in the world, barring the Russian and Chinese militaries. That is without mentioning the more than 300m estimated smaller firearms in US homes.

3. Is Uber leading a race to elimination in the car aggregator market? The company plans to undertake more fund-raising, bringing its total mobilization to $15 bn since starting out in 2009 and its valuation to $68 bn, and it has no plans in the foreseeable future to go public. To put this in perspective, when Amazon went public in 1997, it raised $54 million and was valued at $438 million! So what is the game plan?

Every time Uber raises another $1 billion, venture capital investors and others may find it less attractive to back one of Uber’s many rivals: Didi Chuxing, Lyft, Gett, Halo, Juno. In other words, Uber’s fund-raising efforts have seemingly become part of the contest: It’s not just a rivalry over customers and drivers; it’s a war of attrition, a mad scramble to starve the competition of cash. At the moment, Uber’s success has had the opposite effect: It has spawned a long list of rivals, big and little guys who say, “We can do it too.” But over time, as the smaller competitors run out of cash — after heavily subsidizing riders in an effort to steal business from Uber — venture capitalists should be less inclined to put up even more cash to go up against Fortress Uber. 

Uber’s fund-raising arms race comes against the backdrop of falling valuations for many Silicon Valley unicorns — private companies worth $1 billion or more. So there’s clearly a rush to take the money while it’s still available... So far, Uber is clearly winning the valuation game: It is worth more than virtually all of its rivals combined... Uber is currently on track to lose about $2 billion annually in China and India as it heavily subsidizes customers and drivers to gain market share.

This is clearly a race to the bottom, where only those with enough firepower will survive. But the end game could turn out different than anticipated, especially if the markets itself shrinks considerably once the subsidies are removed. 

4. More on this from this fascinating essay on Uber's challenges in China, where Didi Kuadi dominates, and where ride-sharing apps and aggregators are still not fully legal, and Uber China is an independent entity,

Typically, Uber takes a cut of about 25 per cent of the passenger’s fare and passes the rest of the fare on to the driver. Costs are kept low because Uber doesn’t employ the drivers, or own the cars. However, in China, Uber pays drivers a multiple of the passenger’s fare, meaning that the company loses money on most rides. Other Chinese ride-hailing companies employ a similar strategy... Many drivers for Uber say they would not be driving if it weren’t for the bonuses, while passengers also say they would ride less if the services became more expensive... While Uber’s services include luxury cars, cheaper rides are a bulwark of Uber’s business in China. Uber’s carpool service, with fares as low as Rmb2 (21 pence) accounts for more than half of rides in several key cities... removing subsidies altogether will not be easy. Examples from other markets show that heavily subsidised businesses sometimes just evaporate once the subsidies disappear. The taxi-hailing business of Didi and Kuaidi, which was initially fuelled by subsidies, is now a tiny fraction of their merged business and generates no revenues. Smaller ride-hailing companies in other markets, such as EasyTaxi in Jakarta, found that their business dried up completely when subsidies ended.

5. Livemint points to an India Ratings report on the asset quality of the country's top 500 corporate borrowers. It classifies their loans into four categories - stressed, elevated risk of refinance (ERR), medium ease of refinance (MER) and high ease of refinance (HER). The stressed loans form a counter-party to the Rs 5.8 trillion stressed loan book of the country's banks as on end-March 2016. The report says,

240 of the top 500 borrowers belong to the stressed and ERR (elevated risk of refinance) categories and will remain exposed to significant refinancing risk during FY17. These 240 borrowers hold about 42% of the total outstanding debt of Rs.28.1 trillion i.e. Rs.11.8 trillion, of which Rs.5.1 trillion is stressed and another Rs.6.7 trillion falls in the ERR (elevated risk of refinance) category

 And the larger share of refinancing requirement in 2016-17 is for stressed and ERR loans.

6. Livemint, again, points to the elevated debt to equity ratios and decadal low of return on equity on 303 manufacturing firms in the BSE 500.

One observation from this is that indebtedness is pervasive among the country's corporate and not the exclusive preserve of infrastructure firms.

7. Livemint feels that the "key to affordable and egalitarian housing ought to unlock India’s vacant houses first". As per census 2011, there were 2.47 vacant houses in India, or 90% of the number of rented houses in the country.

8. The Times points to the latest EPI study of income inequality in the US. The picture is very alarming.

Between 2009 and 2013, for example — a period that encompasses most of the post-Great Recession era – the top 1 percent captured all of the income growth in 15 states (Connecticut, Florida, Georgia, Louisiana, Maryland, Mississippi, Missouri, Nevada, New Jersey, New York, North Carolina, South Carolina, Virginia, Washington and Wyoming)... In all, the top 1 percent in the United States captured 85.1 percent of total income growth from 2009 to 2013. In 2013, the 1.6 million families in the top 1 percent made 25.3 times as much on average as the 161 million families in the bottom 99 percent. Those and other figures are reminiscent of conditions in the Roaring Twenties. In 1928, the peak year of that decade’s boom, the top 1 percent took home 24 percent of the nation’s income. In 2013, the top 1 percent nationally took home 20.1 percent of all income, while in five states (New York, Connecticut, Wyoming, Nevada and Florida) the income share for the top 1 percent exceeded the peak from 1928.

9. Bloomberg points to the shifts in the source and volume of US oil imports.

While Canada has become the country's largest source of oil imports, Middle East continues to play an important role.

10. The World Bank's latest report on Private Participation in Infrastructure (energy, transport, and water projects) in low and middle-income countries reveals that total investment in 2015 was $111.6 bn, compared to $111.7 bn in 2014 and $124.1 bn over the previous five years. Transportation and energy, as usual, dominated the investment destination by sector. Excluding Brazil, China, and India, investment rose 92%, on the back of Turkey’s US$35.6 billion IGA Airport (New International Airport) investment commitment. Solar energy investment rose 72% over the previous five-year average to reach US$9.4 billion and renewables captured nearly two-thirds of energy investments with private participation.

11. Ian Bremmer has this nice illustration of the web of geopolitical relationships in the Middle East.

12. Finally, on the Brexit vote, one commentator in the FT draws attention to the class divide by arguing that "the lower down the social and educational ladder you descend the greater likelihood that someone will have voted to Leave, while the best markets for Remainers is having a degree and being aged 18-29". This class divide largely replicates itself in the rise of people like Donald Trump and anti-Establishment and Far Right parties across continental Europe. But the British vote must be among the most surprising outcomes of the populist backlash against globalization, cross-national integration, and economic liberalization.

In any case, now the challenge would be about firming up the British relationship with the EU. In order to send out a strong signal to potential similar exits, the EU leaders would want to ensure that the costs of an exit are prohibitive enough. An accommodative exit for UK could encourage similar movements in other member countries. Here is a good graphic of the options available.

Another concern would be the dynamics of independence movements in Scotland, surely, and maybe Northern Ireland. The Brexit vote could well be the starting of the dissolution of the United Kingdom.

While the British exit would undoubtedly set back the European project, if the continent can weather it without further member exits or substantive reversals, it may well strengthen the Project's multi-track pathway towards integration.

Smell test for why "this time is any different"

It is commonplace for new governments and policy makers across developing countries to claim that they have a plan to address complex social problems - learning outcomes, sanitation, financial inclusion, improve health care, increase agricultural productivity and so on - whose resolution have elided their predecessors for decades. 

Almost always such intent comes wrapped in the form of a more vigorous profession of commitment and a new program, the primary differentiator most often being the scale of the ambition in terms of targets and time within which it is sought to be achieved. This alone, supporters tend to believe, would ensure success of the endeavor.

I am not sure. Instead, I'll go by a two-part smell test to assess whether this time is any different.  

1. What is being done now that was not part of earlier efforts and how will it increase the likelihood that this time is different?

2. What has been done to improve state capability in the execution of the program?

It is most likely that a vast majority of public policy interventions in these areas by governments across the world would fail the two part smell test. Development is really hard.

Convergence, Small Time?

The World Bank's latest Global Economic Prospects, apart from lowering global growth estimates from 2.9% to 2.4%, has an analysis which confirms a slow down or even a reversal of the economic convergence between rich and developing countries. The FT has this summary of the report,

Last year just 47 per cent of 114 developing economies tracked by the bank were catching up with US per capita gross domestic product, below 50 per cent for the first time since 2000 and down from 83 per cent of that same sample in 2007 as the global financial crisis took hold... But over the past three years, as major emerging economies such as Brazil, Russia and South Africa have slowed or fallen into recession, the slower average growth means the number of years it would take to catch up with the US has grown to 67.7 years. For frontier markets, those more fragile economies further down the development scale, such as Nigeria, the catch-up period more than doubled from 43.1 years to 109.7 years.

This also means that the number of years necessary for these countries to catch up with the US economic output level has increased.

This comes on the back of a recent report by Capital Economics which highlighted the challenge with maintaining the same pace of convergence as economies develop. The period since 2000 has been undoubtedly the high watermark of convergence,

But, as graphic below shows, going forward, convergence will slow down as per capita incomes in countries like China and India increase, and their respective potential growth rates decline. It also shows that for its economic size, and despite the high growth episode of 2003-08, India has grown at atleast four percentage points below its potential rate in the 2000-14 period.

Adding to the problems, as an OECD report highlights, is the slow pace of global trade, which has been declining continuously since the crisis. 

But, in light of the larger size of the emerging economies, the Capital Economics report argues that their growth will matter even more for the world economy,

EMs now account for about 60 per cent of global GDP, compared with 40 per cent in 2000. If developed economies grow at the 1.9 per cent annualised rate the IMF predicts in the coming five years, this suggests global growth could even be stronger with EMs growing at 4.5 per cent (but accounting for 60 per cent of the global economy) than when they expanded by 5.5 per cent but accounted for only 40 per cent of it.

It may be presumptuous to draw too many conclusions from such cyclical trends in emerging economy growth. The pre-eighties period of the last century was associated with sustained high growth among developed economies, leading some economists to describe it as a period of "divergence, big time". Since the eighties, led by the East Asian economies and China, the developing countries have grown at a much faster rate, again leading some others to describe it as "convergence, big time". Statistically, at least, for the respective periods, both were largely correct. 

But now, as the major developing countries, outside Africa, approach lower middle-income status, the pace of convergence will, not surprisingly, decline. But the overall trend towards convergence cannot be denied. We are more likely to have "convergence, small time". The final verdict belongs to the always incisive Dani Rodrik,

It’s also interesting to see how the bounce back from a former, overstated conventional wisdom generates its own exaggerations. Contrary to much grumbling at the present, I do not think economic convergence is dead. I continue to think that developing countries as a whole will grow more rapidly than the advanced economies. But some of this will be due to a trend decline in the growth rate of the advanced economies. And the rate of convergence will not be nearly as rapid as what we have seen over the last two decades.

On premature deindustrialization and other things

Tyler Cowen peeks into the economic prospects of a world buffeted by declining productivity, secular stagnation, stagnating global trade, premature deindustrialization, increasing automation, and so on.

On how little of the world economy is connected with trade,

Only a small fraction of firms export or even consider trying to export; the actual percentage of exporting firms is estimated at eighteen percent. Most firms which do export are selling a single product to a single country, and even the average magnitude here is to sell to only 3.5 countries. Most nations are not active competitors in most global economic sectors... We see also that exporting firms are much larger than nonexporting firms – 4.4 times larger as measured by sales – and that fact is consistent with the notion of a relatively high fixed cost to trading internationally.  

On the importance of manufacturing,

The lack of manufacturing exports for an economy also may feed into domestic growth by taking away potential economies of scale. Without the chance to export Toyotas, Japanese domestic cars probably would have been more expensive and of lower quality. Internally-driven growth would have less of a jump start from the export sector and also less of an ongoing surplus to draw from for future domestic investment. Manufacturing appears to create strong backward and forward linkages, whereby one set of successful manufacturing companies helps to fund input sectors and complementary sectors, also full of middle class jobs. For the United States, for instance... manufacturing accounts for about seventy percent of the country’s business research and development.

Cowen points to a "cell phones instead of automobile factories" growth path, wherein increasing returns to scale activities like IT, where research and innovation are increasingly focused, though largely produced in developed countries, will diffuse quickly and widely across developing countries, and become the drivers of economic growth there,

The new imbalance would be based on increasing returns to scale goods, which would trickle down to poorer countries, vs. constant and increasing cost goods, which would not trickle down. Developing nations thus would be very well supplied with (cheaper versions of) increasing returns to scale goods, but have relatively stagnant supplies of constant and decreasing returns to scale goods. In practice this would mean that cell phones, software, web sites, movies and television shows, pharmaceuticals, and ideas more generally would be plentiful in developing nations. Similarly, housing and many basic foodstuffs will have higher relative prices. “Living in the past,” so to speak, will become increasingly expensive, and living on or near the technological frontier may become relatively cheap, even in countries which are not thought of as especially technologically advanced. This probably would mean that younger individuals would gain more from economic growth than would older individuals, at least relative to a model of balanced growth; the younger individuals are more likely to use the newer technologies.

On the enclaves model of economic and social development, with the attendant implications for inequality,

Indian outsourcing activities, as practiced in Bangalore, Chennai, or Hyderabad, are examples of enclave construction. The outsourcing centers typically produce much of their own infrastructure, including electricity, water, web connections, and even roads. The goal is for the environment inside the firm, often set in walled-off medieval-style compounds, to approximate that of a fully developed nation. At the same time, the enclave is set in India and takes advantage of the lower wages there. It is another way of blending developed and developing country features, and future development models likely will involve a good deal of such blends, rather than the more straightforward construction of middle class societies as we have witnessed in South Korea, Japan, and Taiwan.

On India's growth prospects,

India is a striking example of a country which has been underinvesting in manufacturing. As we have seen in section two of this paper, the likely implication is that India will fail to develop a large (in percentage terms) middle class and thus will continue to develop along a path of extreme income inequality, with gains unevenly distributed and to the long-run detriment of the nation... India is not a natural candidate to succeed China as the world’s low cost manufacturing center. 

The world economy, especially for emerging economies, is at an intriguing point in their development trajectory. Apart from premature de-industrialization, there are several forces with very uncertain dynamics at play. The increasing use of robots and attendant automation of economic activities is likely to disrupt the labor market. The dynamics of modern capitalism, with skill-biased technologies and wage premiums for the higher income levels, appears to support widening inequality. 

Similar trends are visible within countries too. Consider urbanization. In contrast to the gradual and planned urbanization in developed countries, cities are developing countries are undergoing very rapid and massive, but extremely chaotic growth. This has had the effect of engendering sprawls and gentrification, both of which threatens to leave such cities with pockets of affluence and modernity in a sea of less than desirable living conditions. It is possible that most cities in developing world will never achieve the quality and vibrancy of cities like London and New York even if incomes reach the same levels.

The Emperor returns!

This progression of headlines in the French newspaper Moniteur in March 1815 tracking the return of Napoleon from exile at Elba is stunning by any standards.

China higher education story of the day

Times has a very interesting article on how China is trying to redistribute the benefits of higher education across the country. The annual nation-wide Gaokao examinations which determine admissions to college seats is now widely seen as reinforcing urban-rural, coastal-hinterland, and rich-poor disparities. A recent decision, therefore, reserves a certain number of seats in all the major colleges to students from less developed regions. The decision has resulted in widespread protests across the coastal areas from parents of local children. 

Top schools are concentrated in big prosperous cities, mostly on the coast, and weaker, underfunded schools dominate the nation’s interior. Placement is determined almost exclusively by a single national exam, the gaokao, which was administered across China starting on Tuesday. The test is considered so important to one’s fate that many parents begin preparing their children for it before kindergarten... The exam gives the admissions system a meritocratic sheen, but the government also reserves most spaces in universities for students in the same city or province, in effect making it harder for applicants from the hinterlands to get into the nation’s best schools.

The authorities have sought to address the problem in recent years by admitting more students from underrepresented regions to the top colleges. Some provinces also award extra points on the test to students representing ethnic minorities. 

This spring, the Ministry of Education announced that it would set aside a record 140,000 spaces — about 6.5 percent of spots in the top schools — for students from less developed provinces. But the ministry said it would force the schools to admit fewer local students to make room... 

Over the past two decades, the government has opened hundreds of new institutions of higher education, and university enrollment surged to 26.2 million in 2015 from 3.4 million in 1998, though much of the growth has been in three-year polytechnic programs. At the same time, job prospects for college graduates in China have dimmed in recent years. That has left parents worried about wasting their life savings on substandard schools and even more desperate to get their children into the better ones.

Dissatisfaction with the gaokao is also rising. The test, modeled after China’s old imperial civil service exam, was intended to enhance social mobility and open up the universities to anyone who scored high enough. But critics say the system now has the opposite effect, reinforcing the divide between urban and rural students. The top universities in big cities like Beijing, Shanghai and Nanjing are the most likely to lead to jobs and the hardest to get into. Students from less developed regions are vastly underrepresented at these colleges. That is because they attended schools with less money for good teachers or modern technology and because the admissions preference for local applicants means they often need higher scores on the gaokao than urban students.

This is a dynamic that echoes with India's own reservation and other affirmative action programs, both in terms of the specific actions as well as the popular emotions it generates. At a more fundamental level, this is one more story of how extreme forms of competitive pressures (a merit based selection exam), which initially have a benign nature, accumulates anti-competitive strains (the better off have access to the resources necessary to compete on equal terms), and ends up being captured by the beneficiaries. 

Weekend reading links

1. Ajay Shah has an excellent column examining the issue of unbundling of commercial activities,

Consider the New Pension System (NPS). Project OASIS, saw that the overall pensions problem contained three distinct industries: managing money, owning customers, and record-keeping. It suggested an unbundled architecture, where pension fund management was separated from interaction with customers. Record-keeping was centralised to harness economies of scale and ensure that it was easy for consumers to switch from one pension fund manager to another. This design caters to heightened competition. On the strength of better fund management, a new pension fund manager can steal customers, as switching is always possible. Similarly, the front end firms would live or die based on their friendliness to customers, and not on the quality of their fund management. In the conventional world, finance professionals generally focus on the deal-making required to get a new product to the customer. These finance professionals are a little shocked when, in the NPS environment, incumbent manufacturers do not control the distribution. All distributors are equally keen to push all products; all manufacturers have equal access to all distributors.

Though Shah sees unbundling as having worked in only NPS, electricity, and net-neutrality, I am inclined to cast the net wider. In particular, one could think of looking at many financial market activities in this way.

The only observation is that with the emergence of IT solutions, the entry barriers from an incumbent's entrenched presence in the downstream side of selling a service may not be as important as earlier.

2. The underlying signatures of Indian economy continue to remain weak. The capex index from IIP data comes in at the lowest since April 2010.

The RBI's latest Industrial Outlook Survey shows that the business expectations index is lowest since at least 201-11

Much the same story about expectations on industrial production, order books, and job creation. Not a happy picture at all.

3. Mexico City's air pollution levels fall back to the nineties. This stat about its vehicle population is stunning,

Developers erect skyscrapers with a dozen floors reserved for parking. The Mexican Institute for Competitiveness, an economic think tank, estimates that 42 percent of space in new developments built between 2009 and 2013 was designated for parking.

4. Livemint points to BIS data for the 2007-15 period for 18 countries which finds that housing prices in India rose the highest at 72.3%.

As the article points out, for whatever reason, housing market in India does not respond to over-supply and piling inventory by price corrections. Developers prefer to hold tight. It may just be that the margins are large enough (or supply small) to provide them the comfort to hold on to vacant units long enough.

5. Very good analysis of India's new Bankruptcy Code here. This is more likely to be an evolutionary process where the fruits will start appearing only 5-8 years hence. A very important reform though.

6. When in China Capitalists sing the Chinese tune! Consider the example of Disney. Disney opened its $5.5 bn Shanghai Disney Resort, its first facility in China, a joint venture with Shanghai Shendi Group. Times has a nice essay, which describes what Aswath Damodaran calls the "China trade-off",

In addition to handing over a large piece of the profit, the control-obsessed company would give the government a role in running the park. Disney was also prepared to drop its longstanding insistence on a television channel... Disney is sharing the keys to the Magic Kingdom with the Communist Party. While that partnership has made it easier to get things done in China, it has also given the government influence over everything from the price of admission to the types of rides at the park...

The partnership structure puts Disney in a complicated spot. Shendi is really a consortium of four powerful government-owned companies: the Shanghai Radio, Film and Television Development Company; Jin Jiang Hotels; Bailian retail shops; and a property developer, the Lujiazui Group. And each of those companies has separate business ties to Disney’s new resort. The Jin Jiang Group has a contract to provide tourism services for the park. The Lujiazui Group helped develop the world’s largest Disney Store. The Shanghai Media Group, a division of the development company, is positioned to capture a big share of the park’s television and advertising budget, since it controls the city’s biggest television stations, as well as major newspapers, magazines and radio properties.

7. Germany followed Japan and Switzerland into having its 10 year sovereign bond yield slip into negative territory. It is estimated that 40% of the $6.4 trillion Euro region debt is now trading below zero, which as one analyst said,  

Nobody buys bunds at these yield levels thinking they are attractive. Demand for haven assets is being driven by fear of Brexit and growth concern. Investors are buying bunds as a hedge against uncertainty.

Another analyst had this to say,

Every day you own a bond like that you compound a loss, and the only way to make money is when someone else is willing to pay a higher price. As a store of value I don’t see it as a very good investment.

Former PIMCO head, Bill Gross has already described negative bonds as a "supernova that will explode one day". Since retail deposit rates have not become negative anywhere, the direct impact of negative rates is not being felt by citizens. Also, since yields have been continuously on the decline, prices have been rising and investors have been making profits.

8. More evidence that we may have reached "peak ship size". With 18% of world's container capacity anchored and idled, and global shipping capacity rising by 7% last quarter even as demand grew by 1%, the shipping industry is staring down the barrel,

A study last year by the OECD found that economies of scale from today's mega-boats are four to six times smaller than those in previous periods of up-sizing. Around 60 percent of cost savings now comes from engine technologies. In other words: Building smaller boats with better engines would offer more savings than going bigger. Then there's risk. Today's largest container vessels can cost $200 million and carry many thousands of containers -- potentially creating $1 billion in concentrated, floating risk that can only dock at a handful of the world's biggest ports. Such boats make prime targets for cyberattacks and terrorism, suffer from a dearth of qualified personnel to operate them, and are subject to huge insurance premiums. 

Yet the biggest costs associated with these floating behemoths are on land -- at the ports that are scrambling to accommodate them. New cranes, taller bridges, environmentally perilous dredging, and even wholesale reconfiguration of container yards are just some of the costly disruptions that might be needed to receive a Benjamin Franklin and service it efficiently. Even when taxpayers foot the bill for such upgrades, the costs can be passed on to vessel operators in the form of higher port fees. In recent years, mega-vessels have caused traffic jams in the water and on-shore as overwhelmed ports struggle to offload thousands of containers. The expense in worker overtime and cargo delays can be significant. Making matters worse, the bigger ships make fewer port visits, leaving operators wondering if they should invest in costly renovations for what would amount to infrequent stopovers.

9. Business Standard chronicles Lavasa, the five-town smart city complex being developed independently by Hindustan Construction Company (HCC), on the foothills of the Western Ghats in Maharashtra. The project which was launched in 2004 and has so far incurred a cost of Rs 6600 Cr in the partial development of two towns (on 8000 and 2400 Acres respectively) follows the pattern of a very dense central core with sparse radial developments.

Despite the investments made, Lavasa continues to be largely a holiday destination with limited investments in services employment and other non-recreational commercial investments. Lavasa is a test case for the belief, which underpins a large part of Chinese urbanization, that "build it and they'll come". I am inclined to believe that Lavasa will be a success in the next 8-10 years and a great example for planned urbanization in India. And if that happens, the reasonable sizes of each development (a few thousand acres), will have had no small a role to play.

10. Finally, Goldman Sachs has been all over the news this week with two scandals. First, came news that Goldman Sachs advised the 2014 sale of BHS, the UK Department store chain, for £1 to Retail Acquisitions, a group of investors led by Dominic Chappell, an ex-bankrupt with no retail experience. Now with BHS with its 11000 odd employees facing bankruptcy amidst allegations of swindling and fraud, the ex-BHS chairman Sir Phillip Green has effectively blamed Goldman for clearing the sale to a person like Chappell. 

If the first was not scandalous enough, the second would put even the most unscrupulous corporates to shame. The Libyan Investment Authority (LIA), the country's sovereign wealth fund (SWF), has initiated a $ 1bn suit for damages on Goldman at London. It accuses Goldman of exploiting its limited experience in 2008 to sell nine risky derivative trades that ultimately lost the SWF $ 1.2 bn, by using "undue" influence over LIA's own employees, including delivering the services of prostitutes and providing luxurious hospitality. Goldman is accused of using one of its executives, Youssef Kabbaj, to lobby and dine LIA officials concerned to purchase the products. The description of the trial here is downright lurid and despicable. 

These come as Goldman is recovering from its role in raising upto $3 bn money for 1MDB, the Malaysian state fund at the center of a corruption scandal involving the country's Prime Minister. Goldman apparently received $300 m for this and $200 m for the LIA purchases. 

Denmark and negative rates

Bloomberg has an article on negative interest rates in Denmark. Unlike others who use negative rates as a tool of monetary accommodation to restore economic growth, the country had embraced negative rates as early as 2012 to maintain the kroner's peg against a depreciating euro.

Apart from highlighting the apparent normalcy associated with negative rates, the article points to atleast two interesting features of the Danish economy that goes against the grain of orthodox Econ 101. One, high taxation and high minimum wages may not always be bad,

Despite a minimum wage not far below $20 an hour and some of the world’s steepest taxes, unemployment is almost the lowest in Europe.

Second, despite the persistent low rates, the country's real estate market has suffered only a "froth" and not "bubbles" as would have been expected. Strict mortgage lending regulations may, after all, be effective

the country regulates the housing market to a degree unimaginable in the U.S. It’s nearly impossible for a foreigner with no connection to Denmark to buy property, preventing inflows of overseas money. Banks apply stringent financial criteria to mortgages for buy-to-let properties; it’s hard for Danes to purchase homes they don’t intend to live in. Regulatory guidelines require minimum down payments of 5 percent and stress tests of borrowers’ finances against runups in rates. With the encouragement of regulators, banks have hiked fees on flexible-rate loans, nudging buyers into fixed-rate mortgages. The rules are even tighter for properties in Copenhagen... Compared with New York, London, and even Stockholm, Copenhagen real estate is still a bargain: $500,000 buys a decent two-bedroom.

However, it should not be construed that such policies can be replicated to similar effect elsewhere. Denmark's unique social and political history and their attendant forces have undoubtedly played a critical role in the apparent relative lack of problems, maybe even success, with negative rates. But a more definitive conclusion is that this is yet more evidence that countries need to embrace a more heterodox approach and carefully select policies keeping in mind their local context and requirements. This, more than blind administration of economic orthodoxy, even with negative rates, is more likely to help economies forge successful growth paths.

As to negative rates itself, in a week when Germany joined Japan and Switzerland with negative rates on 10 year sovereign bonds, its future may well depend on the answers to at least five questions.

1. How much low can the rates fall? Beyond a point, the transmission of rates into retail and all other parts of the economy will be felt, with potentially very disruptive consequences. Fundamentally, at a certain point, the negative rate would exceed the cash storage cost.

2. How much longer can the banks hold out? Apart from having to pay the central bank for holding their reserves, banks have been constrained from passing on negative rates to depositors. This has been eroding their profitability as reflected in declining Net Interest Margins (NIMs).

3. How much long will it be before the savers revolt? These low rates are exacerbating the woes of the already insolvent pension funds in many parts of the world. Insurers are struggling for returns on their investments and asset managers are fighting to retain their investors. And, coupled with negative retail deposit rates, the cumulative effects low rates may become onerous enough to force savers out into the streets.

4. How much more skewed can the risk allocation become? As returns on conventional assets decline, it is only natural that investors move into newer and riskier areas in search for yields. But this in turn invariably amplifies risk by inflating bubbles. The more time markets stay in these regions, the steeper the fall.

5. How much longer can the markets sustain central bank purchases? The negative rates owe a lot to the massive sovereign bond (and now corporate too) purchases by central banks, especially the ECB and BoJ. But there are portfolio limits to how much of each category that the central banks can purchase. In Europe, since the ECB can buy no more than a third of any individual bond issue, there may be only 3 months worth of German bonds left to purchase at the current rate of nearly 20 bn euros a month. The Bank could be left owning a fifth of the sovereign bond market in Eurozone area by end-March 2017. In Japan, thanks to the BoJ's ETF purchases, the Japanese government is a top 10 holder in 90% of Japanese stocks.

How will Amazon spend the $3 bn?

I had blogged earlier raising doubts on how Amazon would be able to deploy the $ 3bn it proposes to invest in India, in addition to the $2 bn committed two years back. Now, $ 3 bn or Rs 200 bn is a huge amount of money.

It was easy to burn through $2 bn by offering heavy discounts to acquire customers. But now, with deep-discounts and all forms of indirect support to sellers off the table, the likes of Amazon will have to confine their expenditures to logistics management. But here the story may be different.

The IT applications in logistics management would largely be a replication of its proprietary solution and hardly cost much. This leaves them with investments in warehousing and building transportation fleet. It more likely that e-commerce firms would contract in transportation as a service and invest in warehousing. The former would therefore become part of the operating expenditure.

That leaves us with warehousing. But how much can this soak up? Consider this. There are currently just 5381 cold storages in India with a capacity of 24.45 MT. Assuming the average prevailing cost of cold storage at Rs 15 million per 5000 tonnes, the total investment made till date would be less than Rs 50 bn. In other words, the cumulative cold storage investment in the country is just a fourth of what Amazon alone proposes to invest in the country over the next few years!

One estimate of India's organized industrial and retail warehousing capacity in 2015 was 178 million sqft. This market has been growing at 25-30% or adding about 54 million sqft each year. Assuming a cost of Rs 1000 per sqft, organized retail capacity addition investment each year would be about Rs 54 bn. But e-tail formed just 1.7% of all retail sales in 2015 (or about 8-10 million sqft of warehouse space) and is expected to reach 4.4% by 2019. From this very low baseline, even with a 50% increase in e-commerce warehousing capacity (or 5 million sqft each year), the total annual investments would be about Rs 5 bn. All these figures are orders of magnitude off from what just Amazon alone proposes to bring in.

Am I missing something here? Or is it that for an economy of India's level of capital accumulation, Rs 200 bn is a huge amount? Is this then an opportunity to signal to investors like Amazon that India will allow unhindered automatic foreign investment in areas like farm produce retailing, where the likelihood of external sourcing is likely to be minimal?

Stalled projects graph of the day

Indian Express points to the lack of promoter interest and unfavorable market conditions as accounting for more than half the projects which were reported as stalled in 2015-16 according to CMIE. This was 19% last year and in single digits the previous year. 

Interestingly, since 2012-13, even as the share of projects stalled due to government related issues (clearances, raw material supply, land acquisition etc) have declined precipitously, those due to promoter's problems have risen. I am inclined to the view that this is a case of the deliberately suppressed real problems surfacing.  

In this context, I had blogged some time back arguing that a vast majority of stalled projects were ab-initio either fully unviable or had to be restructured significantly to regain commercial viability. The high proportion of projects which were shown as ostensibly stalled due to land acquisition and clearances would most probably not have gone ahead in any case for commercial considerations. Blaming site acquisition and clearances gave the promoters an excuse to absolve themselves and kick the can down the road in the expectation that something would happen to salvage the project. 

This also means that the bad loans and strained balance sheets faced by the country's banks and corporates respectively are not going to disappear anytime soon. Painful restructuring may be necessary with the majority of these projects, with both banks and promoters taking hits.

Stylized facts on public sector employment premium

Frederico Finan, Ben Olken, and Rohini Pande have an interesting paper on "personnel economics" which examined data from 32 countries. In particular, they find a significant wage premium associated with public sector employees, more so in developing countries, which have important implication on selection, incentive structures and monitoring. Some interesting graphics on premiums enjoyed by public sector workers.

1. The public sector pay premium is among the highest in India, at about 65%.

2. The public sector worker is 55% more likely to receive health insurance or other benefits, highest among all the sample countries.

3. The public sector workers are 48% more likely to receive pension benefits, again among the highest among all countries.

So here is the problem. The public sector employee in poorer countries enjoys a significant wage premium, is far more likely to enjoy health benefits and pensions, attracts the more educated, has a higher tenure. But this premium is not reflected in their performance outcomes. 

The paper discusses the usual stuff about using screening applicants, and using incentives and monitoring to improve outcomes. I've blogged about this on several occasions and am not very sure about sustainable gains from these attempts. 

Complexity theory and "New Economics"

Eric Beinhocker tries to go beyond the left-right distinction and economic orthodoxy to describe what he calls "economics for the real world". He describes the 'new economics',

Rather new economics is best characterised as a research programme that encompasses a broad range of theories, empirical work, and methods. It is also highly interdisciplinary, involving not only economists, but psychologists, anthropologists, sociologists, historians, physicists, biologists, mathematicians, computer scientists, and others across the social and physical sciences. It should also be emphasised that new economics is not necessarily new. Rather it builds on well-established heterodox traditions in economics such as behavioural economics, institutional economics, evolutionary economics, and studies of economic history, as well as newer streams such as complex systems studies, network theory, and experimental economics... The common thread running through this broad research programme is a strong desire to make economic theory better reflect the empirical reality of the economy. New economics seeks explanations of how the economy works that have empirical validity. Thus behavioural economists run painstakingly crafted experiments to explain actual human economic behaviour. Institutional economists conduct detailed field investigations into the functions and dysfunctions of real institutions. Complexity theorists seek to understand the dynamic behaviour of the economy with computer models validated against data.

He points to the use of the likes of agent-based models to analyze various markets. On policy making, he advocates eschewing the traditional mechanistic approaches (incentives, interventions to correct market failures, costs-benefits analysis etc) and embrace an approach that accommodates complexity, unpredictability, and reflexivity.

He outlines three principles of this approach. One, instead of going in with one design, experiment with multiple approaches and iterate and refine the ones that work best. Second, policies and institutions should be as adaptable as possible. Third, instead of being policy engineers, policy makers need to see themselves as stewards who "create the conditions in in which interacting agents in the system will adapt towards socially desirable outcomes". This would involve an evolutionary approach to execution. 

This is an addition to a growing body of literature that advocates an experimental and iterative approach to program design and implementation.