Wednesday, October 31, 2018


As PPPs face an existential crisis, Philip Hammond's budget speech in UK had this,
I remain committed to the use of public-private partnership where it delivers value for the taxpayer and genuinely transfers risk to the private sector. But there is compelling evidence that the Private Finance Initiative does neither... I have never signed off a PFI contract as Chancellor... and I can confirm today that I never will. I can announce that the Government will abolish the use of PFI and PF2 for future projects.
So the country which pioneered the use of PPPs in health, education, and infrastructure sectors through its Private Finance Initiative (PFI) has come the full circle. I have blogged on numerous occasions outlining the reversing momentum on the use of PPPs in infrastructure sector across Europe and US (See the latest herehere, here, here, here, here, and here). UK had done 716 PFI projects with a capital value of £60 bn and with future charges amounting to £199 bn over the next three decades.

The FT had this to say,
Nearly 30 years after the private finance initiative was born as a means of paying for the construction of hospitals, schools and roads, the chancellor sounded the death knell for the contentious funding mechanism — saying he had never “signed a PFI contract as chancellor” and never would.
One of the major triggers was this report of the National Audit Office (NAO) which demolished the claims of PPP supporters and found that PFI projects had much higher life-cycle costs than their public sector comparators. Schools built with private money was found to be 40% more expensive and hospitals 60% more!

More than even "value for money and risk transfer", the real reason for doing PPPs should be realisation of true efficiency gains. In fact, risk transfer should not be the primary consideration at all since it generally leads to public sector transferring excessive risks to the private sector, which in turn bids aggressively to assume the risks in the full knowledge that having won the bid they can always come back and renegotiate favourable terms. 

And the most appropriate way to do PPPs should be to unbundle construction and operation risks, use public money for arms-length construction contracting, and then concession out operation and maintenance to private providers where efficiency gains are to be had. 

Time for policy makers in countries like India who are steaming ahead with PPPs across sectors to take note!

Saturday, October 27, 2018

Some thoughts on central bank "independence"

Viral Acharya, the Deputy Governor of the Reserve Bank of India (RBI) has this speech where he makes a very strong case for central bank independence. He argues that it is in the government's self-interest to allow autonomy to central banks since refusal to do so would be catastrophic in terms of market reactions and its impact on the economy.

One can appreciate the underlying larger point about the need for central bank autonomy. Also, especially in the context of recent history of disputes between the government and the Reserve Bank of India, the need for governments to exercise restraint is undoubtedly greater.

But there is a tendency to take such arguments about central bank independence to excessive extremes. It only amplifies the narrative about dispassionate and wise central bankers trying to protect the economy from the capriciousness and corruption of governments. Viral Acharya's speech is not immune from playing to this tune. But global experience shows that this is far from true.

In this context, it is worth stepping back and placing his claims in some perspective. This is also the subject of my forthcoming book with V Ananthanageswaran.

Some observations in this regard.

1. The point about markets punishing governments which threaten central bank autonomy has its origins in one of the most dominant narratives of our times - markets are an efficient aggregator of information and therefore know what is best for the economy, and therefore policy should follow market signals. While this may be right on some occasions, it is also wildly off-mark on several others.  The events leading up to the sub-prime mortgage meltdown and in its aftermath are only the latest manifestation of the reality that markets are not only not efficient and self-correcting but also engenders deeply destabilising distortions. This, thisthis, this, this and this are only the latest posts in this blog alone on the issue. 

Unfortunately, this has become an article of faith among opinion makers, financial market participants, and central bankers, thereby limiting their ability to appreciate pervasive market failures.  In fact, central banks have taken "following market signals" to its extremes. The market's "confidence fairy" rules the roost. A growing body of research appears to indicate (see this and this) that monetary policy decisions, especially in developed economies, have become captives of financial market dynamics. Talk about putting the cart before the horse!

2. The recent ring-side accounts by insiders like Yanis Varoufakis and Paul Tucker gives the lie to the conventional wisdom about central bankers as independent and objective technocrats selflessly pursuing public interest and broader macroeconomic concerns. While the former indicates how the European Central Bank (ECB) was a captive of political interests, the latter exposes the belief about the superior wisdom and expertise of central bankers and experts in general. 

There have also been numerous recent instances of practices ranging from border-line compromised accommodation to wholesale information leaks involving central bankers and preferred financial market participants. In fact, just in the last five years, there have been high profile examples of culpability and corruption from US (Jeffrey Lacker, President of Federal Reserve Bank of Richmond) UK (Charlotte Hogg, Deputy Governor of Bank of England), Switzerland (Philip Hildebrand, Governor of Swiss Central Bank) and ECB (Benoit Coeure, ECB Board member). The first three were forced to quit once the scandals surfaced. 

With great power comes great responsibility and accountability as well as the need to exercise restraint. In democracies, despite all its flaws, political leaders face checks and balances which significantly limits the degrees of freedom available for excesses. Unfortunately, the experts in central banks neither have anything similar in terms of the accountability nor the restraints. Like with executives who have reached the C-suite of the largest financial institutions, central bank leaders are largely impervious to reputational considerations. A revolving door with financial institutions and high-paid speech circuits raises serious concerns about objectivity and fairness, not to speak of malafide actions. 

3. Since the nineties, aided by the Goldilocks global macroeconomic conditions, central banks have assumed an aura of competence and credibility. These conditions have had their origins in several factors,  of which central bank actions are but just one. But given the amorphous and diffuse nature of the other factors (globalisation, liberalisation and deregulation, technology revolutions, financialisation, emergence of China etc) and the growing omnipresence of a few individual central bankers, a narrative around the superior wisdom of central banks has taken hold. It can also be argued that the conditions too allowed governments leave central banks to their domain and ignore the emerging narratives. In any case, when the going is good, the policy challenges for all concerned are that less demanding. 

Once the global financial crisis struck, faced with their own limited fiscal space as well as the difficulty of mobilising political consensus, governments in the developed world left their central banks to do the heavy lifting. Central banks went the full hog into uncharted territories with quantitative easing and extraordinary monetary accommodation. It gave the impression of central banks being the only game in the town. In the guise of transparency and central bank communication, some central bank governors merrily assumed the status of populist media darlings. 

While it may have perhaps helped avert another Great Depression, nearly a decade of such policies has not succeeded in restoring balanced growth and macroeconomic stability. In fact, it is now certain it has engendered several distortions. And, in the thrall of their theoretical frameworks and captives of market confidence fairies, central banks appear to have lost sight of the emergent distortions. 

Consequently, it is no surprise that governments have sought to wrest back control. In recent years, governments have not shied away from taking on central banks. The actions of Presidents Trump and Erdogan in the US and Turkey respectively are only high profile examples of such actions. And such trends are likely to become more frequent going forward. 

4. Unfortunately the issue of central bank independence gets framed on an absolute basis, whereby any policy action by a government that intersect with the domain of central banking is viewed as a threat to its autonomy. In fact, central banks react sensitively to even perfectly legitimate public statements by governments indicating their preference for particular monetary policy actions, say lowering of rates or exchange rate interventions. 

There is nothing absolute about the issue of central bank independence. Its separation from the government cannot be absolute. Instead, a more appropriate question should be about what is the right level of independence or autonomy for central banks, consistent with its role in a democratic polity and the need for an integrated and comprehensive macroeconomic perspective. 

The argument that central bank actions are purely technocratic and therefore apolitical, and therefore demanding absolute independence, is deeply flawed. This all the more surprising since we are only just emerging from the decade-long extraordinary monetary easing, whose effects are now a matter of intense debate. Central banks are not just technocratic bank regulators. Their actions have deep distributional consequences. There is a growing pile of evidence about the adverse distributional consequences of quantitative easing. This goes beyond just the issue of penalising savers and benefiting borrowers, and in contributing to important structural shifts in the nature of modern capitalism itself. 

Further, the idea central bank autonomy is not sacrosanct and is a relatively new trend, with its origins in the inflationary episodes of seventies and early eighties. In fact, there are serious question marks about the real extent of central bank independence. But things have changed dramatically over the last three decades. In fact, The Economist, no less, recently advocated revisiting the notion of central bank independence in light of the declining interest rates and persistent low inflation.   

5. About most things in life, there are no clear answers and second-best approaches may actually be the best approach. It applies as much to the mechanics of the relationship between central banks and governments. Some amount of creative tension, even played out in the public domain, may be not just unavoidable but even desirable. 

Consider the present situation in India. With banks already under ailing and the non-banking financial institutions squeezed in the aftermath of the IL&FS crisis, the credit markets have frozen up, thereby dampening economic activity. But this co-exists with signatures of rising inflationary and exchange rate pressures. The central bank justifiably feels that it is not an appropriate time to accommodate. The government equally justifiably feels that the economy could do with some monetary accommodation. 

Only the naive would argue that monetary policy is the rote application of some complicated formula. And we are not even talking about the limitations of monetary policy in demand-pull conditions, especially in supply-constrained developing countries like India. In the circumstances, how can the government be blamed for demanding lower rates, at the least politically not to be seen demanding so? In fact, such creative tensions are perhaps desirable in so far as it keeps central banks too anchored around real world considerations and not be guided solely by straitjacket mandates and disconnected expertise.  

Having said all this, I am inclined to be sympathetic to the Deputy Governor of RBI. In case of India, unlike many developed economies, the RBI would come out in much more favourable light when we examine the balance sheet of the last ten years. This coupled with the lack of maturity of institutional practices within the government is perhaps reason enough to give the benefit of doubt to the RBI over the government. But the notion of absolute independence of central banks should not be entertained.

Update 1 (06.05.2020)

This about the blurring of lines between the monetary and fiscal policy in the context of the pandemic is illuminative,
Steve Mnuchin, America’s treasury secretary, has said that on some days he has spoken to Jerome Powell, chairman of the Federal Reserve, more than 30 times. The Bank of England has co-ordinated interest-rate cuts with Britain’s treasury and recently agreed to increase the government’s overdraft. The Bank of Japan has long been an enthusiastic partner in the economic agenda of Abe Shinzo, the prime minister.
The Governor of the Bank of England, Andrew Bailey, wrote an oped in FT reassuring investors just before the Treasury announced its decision to temporarily monetise its deficit.

Imagine the reaction in India if the government and the central bank worked with such co-ordination. It would have been branded as the central bank having sold out to the government or the government having subjugated central bank independence.

Update 2 (23.05.2020)

In the backdrop of the debate around the German Constitutional Court's questions on ECB's bond buying program, Adam Tooze questions the myth of central bank independence,
In the paradigm that emerged from the crises of the 1970s, independence meant restraint and respect for the boundaries of delegated authority. In the new era, it had more to do with independence of action and initiative. More often than not, it meant the central bank single-handedly saving the day... Rather than obstreperous trade unions and feckless politicians, what central bankers have found themselves preoccupied with is financial instability. Again and again, the financial markets that were assumed to be the disciplinarians have demonstrated their irresponsibility (“irrational exuberance”), their tendency to panic, and their inclination to profound instability. They are prone to bubbles, booms, and busts. But rather than seeking to tame those gyrations, central banks, with the Fed leading the way, have taken it on themselves to act as a comprehensive backstop to the financial system—first in 1987 following the global stock market crash, then after the dot-com crash of the 1990s, even more dramatically in 2008, and now on a truly unprecedented scale in response to COVID-19. Liquidity provision is the slogan under which central banks now backstop the entire financial system on a near-permanent basis.
This about the opponents of the ECB's actions is important,
For them, the ECB serves as a lightning rod for their grievances about the changing political economy of the last decade. They blame it for victimizing savers with its low interest policy. They blame it for encouraging the debts of their Southern European neighbors. Exponents of the old religion of German free market economics regard cheap credit as subversive of market discipline. All in all, they suspect the ECB of engaging in a policy of redistributive Keynesianism in monetary disguise, everything that Germany’s national model of the social market economy was supposed to have ruled out. For these Germans, the ECB is an opaque technocratic agency arrogating to itself powers that properly belong to national parliaments, barreling down the slippery slope to a European superstate. And, for them, it is anything but accidental of course that it is all the creation of a Machiavellian Italian with trans-Atlantic business connections, Mario Draghi. For the body of opinion that had always been suspicious of the euro, Draghi’s commitment to do “whatever it takes” in 2012 was the final straw. The Alternative for Germany (AfD) emerged in 2013 not originally as an anti-immigrant party but as a right-wing economic alternative to Berlin’s connivance with the antics of the ECB. 
The Karlsruhe based German Constitutional Court plays an activist role, and has been a check on unfitted expansion of European power on the grounds of defending democratic national sovereignty. The Court's lates ruling is that the German government failed to supervise the ECB's largescale bond-buying program of 2015 to push inflation to 2%, which, it ruled, overstepped its monetary policy realm and strayed into economic policy which is that of national governments. The German government and ECB have three months to respond.

Update 3 (11.09.2021)

Fed officials market trading activities raises questions,
Federal Reserve officials traded stocks and other securities in 2020, a year in which the central bank took emergency steps to prop up financial markets and prevent their collapse — raising questions about whether the Fed’s ethics standards have become too lax as its role has vastly expanded. The trades appeared to be legal and in compliance with Fed rules. Million-dollar stock transactions from the Dallas Fed president, Robert S. Kaplan, have drawn particular attention, but none took place when the central bank was most actively backstopping financial markets in late March and April. However, the mere possibility that Fed officials might be able to financially benefit from information they learn through their positions has prompted criticism of perceived shortcomings in the institution’s ethics rules, which were forged decades ago and are now struggling to keep up with the central bank’s 21st-century function...

Mr. Kaplan was buying and selling oil company shares just as the Fed was debating what role it should play in regulating climate-related finance. And everything the Fed did in 2020 — like slashing rates to near zero and buying trillions in government-backed debt — affected the stock market, sending equity prices higher... Mr. Kaplan’s financial activity included trading in a corporate bond exchange-traded fund, which is effectively a bundle of company debt that trades like a stock. The Fed bought shares in that type of fund last year.

Thursday, October 25, 2018

More noise on outcomes-based financing

Owen Barder and Andrew Rogerson critique a proposal to use donor guarantees to increase the supply of loans to finance education investments by developing country governments. They question the supply-side response and argue for the need to increase the demand for education finance. They propose the use of outcomes-based financing in this regard.

They posit three factors a limiting education finance,
  • long time horizons for at least some of the benefits of education;
  • lack of certainty about fiscal returns; and
  • lack of certainty that more money will result in better education outcomes.
Now there are two very distinct issues here that need to be disentangled. One, governments realising the value of spending more on education. Two, governments being able to spend more on education. 

The former is a necessary but not sufficient condition for the latter. Even if governments strongly believe in the former, it is very unlikely to have any impact on the latter. In fact, there are hard fiscal constraints that limit the ability of governments to spend more on education. And these constraints are unlikely to go away anytime for these countries at their current stage of development. 

Government budgets, are for most part, contrary to conventional wisdom, an exercise in tinkering at the margins. The major lines of spending are already pre-defined, irrespective of governments on items like salaries and establishment costs, defence, interest payments, and allocations for ongoing programs. This leaves governments in developing countries with hardly anything to make meaningful enough choices, including on new capital expenditures etc. When faced with choices of allocating this money, governments invariably prefer areas where the political market is higher - infrastructure, populist welfare, and so on. Services like health and education come much behind in the political market choices.

For example, the Government of India has perhaps little more than a percentage of GDP available each year (from the 12-13% of GDP revenues) for discretionary spending. In the circumstances, all talk of increasing the spending on health, education, agriculture etc by 2-3 percentage points of GDP each is just that, mere talk.   

So the main constraint limiting greater expenditure on education is simple - governments just don't have the money to be able to spend more on education. Neither making loans available at cheaper cost nor making education financing outcomes-based will help governments spend more on education. The fact remains that only so much fiscal space is available for all kinds of spending. Financial engineering of any kind, including monetisation of education outcomes and quicker fiscal returns, cannot make "education more investible for governments". 

In the circumstances, not only do we need to improve the quality of aid spending but also need more aid spending. 

The only benefit with outcomes-based financing of education is that it can theoretically help governments realise greater value for money from ongoing expenditures. But as I have written  here and here,  this too is deeply questionable with the case of student learning outcomes. However, it undoubtedly has its value in many areas. 

It is logically appealing for armchair thinkers to think of addressing complex development challenges (like poor student learning outcomes) by using the disciplining force of finance to overcome weak state capacity constraints. Unfortunately, finance can only do so much. In case of such intractable challenges like poor student learning outcomes, we need to address more directly the underlying problems. Outcomes financing can help, but at the margins.

At a meta-level, these arguments are coming from a particular world view - hey, we've tried everything to address this problem; we just don't know what works; we've no way to know what works; so give them money, tied to outcomes, and let them figure out what works and spend accordingly; and we hold them accountable for agreed outcomes!

Naivety Ignorance dressed up as intellectual sophistication!

Wednesday, October 24, 2018

Greater Bay Area - feeling the stones while crossing the river

The world's longest sea-bridge has opens for traffic today. The 55 km bridge, connecting Zuhai on the mainland with Hong Kong and Macau, cost $15 bn to construct. It is part of the governments plan to develop the southern region involving Guangdong's nine cities, Hong Kong, and Macau, as a Greater Bay Area to rival the Silicon Valley.

The Pearl River Delta was the origin for China's spectacular economic performance over the past three decades. If Xi Jinping has his way, it may well turn out to be the engine that drives the shift in the Chinese economy from manufacturing and exports towards high innovation, services, and consumption. 

The Greater Bay project covers an area containing nearly 70m people with a $1.5tn economy... HSBC expects the region’s economy to nearly double to $2.8tn by 2025... The idea behind the Greater Bay Area plan is to capitalise on the region’s impressive infrastructure and expertise in finance, manufacturing and technology by dropping trade barriers, promoting cross-border business and eventually creating a single market... Guangdong, which contains the nine mainland cities involved in the plan, is the workshop of the world, exporting $670bn of goods last year, more than any other province in China. Its economy is more driven by private enterprise than any other in the country and is home to the most billionaires. It incorporates sprawling industrial centres like Dongguan and Foshan, home to many of the region’s factories, and Shenzhen, China’s Silicon Valley and the base for technology giants from dronemaker DJI to telecoms equipment producers Huawei and ZTE to Tencent, which operates the WeChat app. The region boasts an impressive logistics network, with three of the world’s 10 busiest container ports — in Hong Kong, Guangzhou and Shenzhen — and thriving international airports in all three cities, as well as the new bridge and high-speed rail links. Hong Kong and Shenzhen are major financial centres... Economists at HSBC say that the Greater Bay Area is a “compelling example of how the clustering of talent, capital and industries will drive higher value-added production and fuel consumption to secure long-term sustainable growth”.
But how to go about such a cross-national project? The FT article points to lack of clarity that is apparently worrying investors,
The toughest challenge is how to integrate Hong Kong, a free port with its own customs regime and a semi-democratic system, into mainland China, where Mr Xi has been cracking down hard on critics and intensifying capital controls for fear of financial instability... Beijing was supposed to release guidelines on the integration of the Greater Bay Area last year but officials are struggling to come up with concrete proposals to drive the economy forward without upsetting the delicate political balance in Hong Kong... this ad hoc approach may not be enough to convince many investors to part with their cash. “Companies are interested in the potential of the Greater Bay Area project,” says Jens Hildebrandt, the head of the German chamber of commerce in China. “But they’re still missing specific plans and actions.”
It is impossible to have clarity upfront on many things with such complex and ambitious projects. This is all the more so since the Greater Bay Area project is much more than a massive capital investment and area development project. It is also about the integration of the very different social and political systems of Hong Kong and Macau into that of the mainland. So the typical Chinese "crossing the river by feeling the stones" approach is perhaps best suited,  
The project is similar to the Belt and Road and other grand Communist party initiatives, which Yu Jie, a China expert at the London School of Economics, calls “fluid in nature, opaque in implementation and flexible in the measures used to deliver projects”. “Crossing the river by feeling the stones”, as Deng Xiaoping called this approach to economics, has worked for China in the past. But it is harder to improvise as the scale of the economic and political “contradictions”, as the Chinese Communist party likes to call them, increase.
The challenge is to have the feet firmly on the river-bed, feel the stones, and respond accordingly.

Monday, October 22, 2018

Construction industry fact of the day

From the FT, on the need for a modular revolution in construction industry,
Nine out of 10 buildings worldwide run over budget and the average cost overrun is 51 per cent, said Bent Flyberg, professor of construction at Saïd Business School. “The construction-site has to become an assembly-site,” he said. “Until this happens, construction will be stuck in the Stone Ages as regards productivity.”... The off-site model not only halves the build time but leads to an 80 per cent reduction in waste, encourages a 95 per cent recycling rate, and produces higher quality buildings because it’s “easier to impose strict controls on the factory floor than on a building site”.

Balance sheet of financial market liberalisation

Ryan Avent in The Economist,
According to the Behavioural Finance and Financial Stability project at Harvard University, an average of four countries a year suffered a banking crisis between 1800 and 2016. From 1945 to 1975, when the global financial system was tightly controlled, most years were entirely free of banking crises. Since 1975, however, an average of 13 countries have found themselves in the throes of one each year. Since the 1970s, the deregulation of national banking systems and the lifting of constraints on the global flow of capital ushered in a new era of financial boom and bust. Re-regulation since 2009 has not fundamentally changed this picture. The current value of outstanding cross-border financial claims, at $30trn (and growing), is below the peak of $35trn reached in 2008, but well above the 1998 level of $9trn.

Saturday, October 20, 2018

Weekend reading links

1. Noah Smith has some graphics which capture some disturbing long-term trends in the US. The first is on economic mobility, which has continued to decline alarmingly.
The next concerns the fact that the sub-prime crisis and the Great Recession has completely wiped out the household wealth gains made by the bottom half of the population.
Finally, the real median personal incomes, after rising steadily through till nineties has plateaued off.
2. Nice pictorial essay of Rungis, the world's largest wholesale food market in Paris.
Spread over 573 acres, with 13,000 employees, 19 restaurants, banks, a post office and even its own police force, Rungis is a city within a city, and a global gateway to the Continent and beyond for millions of tons of fresh gastronomic fare... Rungis is an ultramodern market, generating nine billion euros in annual sales (about $10.4 billion). With pavilions divided among the four major food groups, a system for recycling biowaste and a global platform for e-commerce, the operation is so efficient that Moscow, Abu Dhabi and other capitals are recasting their food markets on the Rungis model.
Even Rungis has not been spared the effects of modern trends,
But as competition from Amazon, Google and other online food shopping conglomerates grows, the state-backed company that runs the market, Semmaris, wants wholesalers to move more of their business into the cloud.
3. Share buybacks fact of the day,
Companies are on track to repurchase more than $770 billion in their own stock this year, according to research from Goldman Sachs. That’s more than twice the size of the next largest source of demand, exchange-traded funds, which last year bought $347 billion in shares.
Another risk factor lurking around the stock markets!

4. FT points to the example of BlackRock to highlight the travails of fund management industry. In particular, this graphic about the declining average fee of BlackRock's $6.44 trillion AUM.
More broadly across the industry,
The average cost of US bond and equity funds has slipped from 0.76 per cent and 0.99 per cent of the investment respectively in 2000 to 0.48 per cent and 0.59 per cent last year, according to the Investment Company Institute.
5. Saudi Arabia and the power of business interests,
In the last decade, Saudi Arabia was awarded $138.9 billion in potential military contracts under the United States’ Foreign Military Sales rules, according to the Congressional Research Service... Companies like BAE and Thales of France have also profited handsomely, as European defense companies exported €57 billion worth of armaments to Riyadh between 2001 and 2015... The kingdom bought around $20 billion worth of American products last year, including Ford autos and Boeing jets. Riyadh also sealed $15 billion in deals with General Electric for goods and services in areas like power generation, mining and health care. And the oil giants can’t possibly walk away from one of the world’s biggest producers...

Saudi Arabia became the biggest source of capital for American start-ups last year. Saudi Arabia’s Public Investment Fund recently invested $1 billion in Lucid, a competitor to Elon Musk’s Tesla car company, and $3.5 billion in Uber. Crown Prince Mohammed bin Salman has pledged $45 billion to Japan’s SoftBank Vision Fund for technology investments intended to help modernize the oil-dependent Saudi economy by 2030. The kingdom has been signing deals for futuristic buildings, AMC movie theaters and swank French hotels as part of a $500 billion blueprint for Neom, a modern city to rise from the desert by 2025. Riyadh is exploring nuclear energy deals to help power it all in anticipation of the day when the oil wells run dry... The kingdom has generated about $1.1 billion worth of fees for banks since 2010 in a variety of deals, including mergers and acquisitions and the arranging of loans and bonds, according to data from Dealogic. The biggest quarry is Saudi Aramco, the world’s largest oil producer, as it prepares to list itself on public stock markets in anticipation of raising over $100 billion... Saudi Arabia has also showered billions of dollars on private equity firms so they can strike deals. The kingdom has pledged to provide up to $20 billion for a $40 billion infrastructure investment fund run by Blackstone, which had its first deal close this year.
6. Signatures of Chinese growth slowdown?
China’s government on Friday reported that the economy grew by 6.5 percent over the three months that ended in September compared with a year ago. While fast by global standards, the pace is China’s slowest since early 2009, during the depths of the global financial crisis... The currency has weakened and is hovering near a 10-year low against the American dollar... In a report this week, S&P Global estimated that China’s local governments are carrying as much as $6 trillion in shadowy debt off the books. That is equivalent to roughly three-fifths of China’s entire economic output... Officials are beginning to encourage new investment. They have added more money to the financial system. To reduce the bill, they are asking the private sector to help out. This week it announced that 1,222 infrastructure projects worth $362 billion would be financed by private companies... The trade war could shave as much as 1.6 percent off China’s economic growth figures next year, according to a recent report from the International Monetary Fund. 
The restrictions placed recently on the shadow banking sector, a critical contributor to credit growth, does not help with economic growth.

All this comes on top of the battered stock markets, where the Shanghai Composite has plunged to a four-year low. And if the renminbi touches 7 to a dollar in the coming weeks, like with the Indian Rupee after it breached 70 to a dollar, there could be rapid subsequent declines.

And we have no idea how the debt overhang will play itself out. Sample this,
Chinese corporations now hold dollar-denominated debt of roughly $450bn, compared with almost none in 2009. A more hawkish Fed means trouble for such borrowers. Since 2014 the dollar has risen by nearly 25%, on a trade-weighted basis, buoyed by a stronger American economy and rising interest rates. A dearer dollar makes life difficult for those with local-currency assets and dollar debts.
7.  How the world's richest companies are fighting to avoid paying taxes to local governments and discharge their civic obligations.
For months, technology companies in San Francisco have fought a local ballot proposition that would impose taxes on corporations to fund initiatives to help the homeless... The extra money from the proposition could total $300 million a year and would effectively double the city’s budget for addressing homelessness... The measure is designed to fund short-term shelters, permanent housing and mental health services for the homeless with a gross receipts tax and a payroll tax on companies above a certain size. The city estimated that nearly half of the businesses that would be affected by the tax are in tech and finance... In Seattle, Amazon objected in May to a city tax that would have funded services for the homeless. After intense opposition, Seattle officials scuttled it... In San Francisco, some tech companies, including Mr. Dorsey’s Twitter, used tax breaks in 2011, which the city offered to keep them from moving away. In 2012, San Francisco also adjusted its tax code by switching from a payroll tax to a gross receipts tax, a change that favored the tech industry, which spends extravagantly to recruit top engineers.
Many leading Tech companies and their executives have pledged donations to the campaign to defeat the Proposition C vote in San Francisco. 

8. Bloomberg points to the real currency manipulators,
9. Ananth sends link to this article in Atlantic about the world of dynamic pricing in online shopping that is verging on Heisenberg's uncertainty principle!
The right price—the one that will extract the most profit from consumers’ wallets—has become the fixation of a large and growing number of quantitative types, many of them economists who have left academia for Silicon Valley... The price of a can of soda in a vending machine can now vary with the temperature outside. The price of the headphones Google recommends may depend on how budget-conscious your web history shows you to be, one study found. For shoppers, that means price—not the one offered to you right now, but the one offered to you 20 minutes from now, or the one offered to me, or to your neighbor—may become an increasingly unknowable thing.
About Amazon's software engine,
It’s built to manage consumers’ perception of price. The software identifies the goods that loom largest in consumers’ perception and keeps their prices carefully in line with competitors’ prices, if not lower. The price of everything else is allowed to drift upward... In one instance, Boomerang monitored the pricing shifts of a popular Samsung television on Amazon over the six-month period before Black Friday. Then, on Black Friday itself, Amazon dropped the TV’s price from $350 all the way to $250, undercutting competitors by a country mile. Boomerang’s bots also noticed that in October, Amazon had hiked the price of some HDMI cables needed to connect the TV by about 60 percent, likely armed with the knowledge, Hariharan says, that online consumers do not comparison shop as zealously for cheaper items as they do for expensive ones.
The article also highlights how one-price (instead of price haggling at each transaction) was one of the major innovations of our times which dramatically transformed the efficiency of retail and its scalability. Discounts and coupons offered a way for consumers to still be able to retain the sense of getting a "better value".

10. The Economist on the China-US relations. This is the important thing,
America is undergoing a deep shift in its thinking about China on right and left alike. There is a new consensus that China has a deliberate strategy to push America back and impose its will abroad, and that there needs to be a strong American response. The coalition takes in conventional free-traders in the White House as well as the zero-summists in Team Trump and the national-security hawks in Congress. Pentagon chiefs and the bosses of spy agencies have framed China as the greatest threat to America’s security, requiring a “whole of government” response. In civil society, the coalition includes religious conservatives, human-rights advocates, labour unions and old-school protectionists.
11. Finally, in the backdrop of low-inflation and low interest rate world, The Economist calls for a revisit of the dogmatically followed thinking about central bank independence! 

Friday, October 19, 2018

How the IAS contributes to the 'flailing state'

The Indian Administrative Service (IAS) receives a lot of flak for everything that is dysfunctional about public systems in India. Much of it can be traced back to a psychological urge of opinion makers and critics to identify a specific cause (and therefore solution) and absolve oneself of any responsibility. For several reasons, the IAS is a very convenient punching bag.

But some of the blame is rightly deserved. From reflection, there is perhaps nothing more debilitating than its role as a banyan tree stifling leadership and initiative within line departments. Remember Lant Pritchett famously described India as a "flailing state" - a strong "head" (the IAS) which is very loosely connected to its very weak "limbs" (the field officials). 

Young IAS officers posted in various field positions - Sub Collectors, Project Officials of various agencies, Municipal Commissioners, CEOs of Zilla Panchayats, District Collectors etc - possess unparalleled authority. In a global perspective, there is perhaps no example of such across-the-board power. 

For sure, given the extremely weak state capacity, things work reasonably well on the average due to the enormous energy and commitment of young officers working in these posts. But this is like band-aid on gangrene. 

In the process, these officers centralise authority and exercise them aggressively. Most often they function effectively as the head of the department and directly exercises line departmental authority. It is a very rare officer who steps back and empowers the line department heads or who respects their views. Rarer still are those who allow departmental heads to take critical decisions and stand by them in goods times and bad. Public upbraiding of departmental heads, often in front of their own subordinates, and those below them is common place. The result is an enfeebling of important line department bureaucracies. Taking cue from the Collector, political representatives too follow suit. This, is not to gloss over the self-inflicted apathy, ineptitude, and corruption among departmental officials themselves.

It does not help that there is some crises or the other all too often within each department and the Collector's active engagement becomes critical to defuse the situation. The campaign mode of program delivery of both central and state governments centralises authority even more in the hands of the District Collector. Realising the enormous convening power of the District Collector, departments at state level prefer to engage with them rather than their own line department heads on important issues. 

Consider a District Education Officer or District Health Officer. Each have the responsibility of managing a geography with population ranging from 1-10 million and thousands of teachers and health personnel. They are the equivalent of Permanent Secretary of Education of a small country. How many of them are empowered to act independently? After a career of subservience and taking orders, how many of them still retain the initiative to act independently even if empowered?

And we are not even talking about the Block Education and Health Officers, not to mention the field inspectors or supervisors in either departments. 

This is not to blame young officers for their initiative. Their immense energies and intent to do good cannot be doubted. The challenge is to channel this appropriately to realise the government's objectives.

This practice is not confined to the young officers or for field departments. It applies as much to state level and central Ministries and agencies. 

So what can be done?

To the extent that any meaningful attempt to address our chronic state capacity problems have to start with strengthening frontline functionaries within various departments, it is critical that its leadership be nurtured to find their feet, become empowered, and lead and not follow (the IAS officer). The young IAS officers posted in the field should be made to realise the importance of this. It is for training institutions like the LBSNAA and the State Administrative Training Institutes (ITIs) to help officers internalise this insight.

Collectors, for example, should refrain from becoming de-facto heads of line departments. They have to realise their role should be to support heads of departments perform their functions. They should be leaders of a team, stepping in as required to guide, capacitate, co-ordinate, and monitor. This requires a very different mindset from the current direct execution approach.

Thursday, October 18, 2018

History repeats itself - the time for a new synthesis?

A recurring theme of this blog has been the trend, now quite egregious, of capture of political institutions by financially well-off elites. And interestingly, for various reasons, the intelligentsia have played along.

We have enough evidence today to argue that deregulation, excessive financialisation and privatisation, business concentration, de-unionisation, and skill-biased technologies have all led to a weakening of labour's influence and a corresponding dominance of business interests in both the economy and the polity. 

The result has been widening inequality and the emergence of a group of super-wealthy elites. The signatures, with evidence, of the dynamics that have contributed to this state of affairs have been piling up - increasing business concentration across sectors, declining labour's share in national income, booming executive compensation, soaring profits, growing entry barriers and anti-competitive practices, slackening anti-trust enforcement, rising prices and stagnant productivity following mergers, business investment declines associated with rising market power, higher price mark-ups, disproportionate benefit from monetary policy, and so on. 

But we are still debating this. Isn't all this adequate to connect the dots? What more evidence do we need to call out the problem? 

One could argue that even these signatures, damning as they are, would have been a matter of concern but not alarm if this were all and, importantly, the safety valves of democratic politics were active and healthy. But the aforementioned dynamics have been accompanied by an increasing trend to use the resulting economic dominance to capture the process of making the rules of the game in society, polity, and economy and use them to favour the dominant group at the cost of all others. When this happens, the social contract starts breaking down. And we may now be staring at an advanced state of break down. 

A rich body of recent research points definitively to capture of politics and institutions responsible for laying down the rules of the game. Business executives have unprecedented access to the highest political levels, some even averaging one White House meeting a week, and that access translates into decisions which unfairly favour them over others. Stock market returns, and not real world concerns, "cause Fed policy". 

And what if Federal Reserve Governors selectively leak insider information to benefit their favourites? Since 1994, the average excess return on stocks over Treasury Bills, or equity premium, was earned entirely in weeks 0, 2, 4, and 6 in Federal Open Market Committee (FOMC) cycle time, where the cycle starts on the day before each of the scheduled eight annual FOMC meetings. But disturbingly, these returns appear to be caused by systematic unofficial communication with selective market participants (or insider information leaks) from Fed Governors who meet bi-weekly after the FOMC meeting. And what if there is evidence of increased opportunities for such informal leaks after such meetings from analysis of taxi trip data into and from New York Fed. The FOMC is open, but it seems only for a privileged few!

These look like simple misdemeanours when compared with the actions of those who caused the "Made in Wall Street" global financial crisis. Wall Street firms have since been charged with misleading clients, selling dodgy securities, deceiving and mis-selling to customers, rigging bids and interest rates, foreclosure abuses and mortgage misrepresentations, market manipulation, predatory sales, fraud cover-ups, and so on. In sum, the full spectrum of white collar crimes, many with outright criminal liabilities. And those at the receiving end included both retail customers, regular investors and high-net worth ones, and institutional investors, including public pension funds. Not one senior Wall Street executive has been charged with criminal liability, much less sentenced. Worse still, much the same character cast are now back to enjoying fat bonuses and lobbying to chip away at even the weak regulatory oversight on their activities put in place by the Dodd-Frank legislation. 

Then there are the authoritative ringside expositions of the capture from, among others, Yanis Varoufakis, William Buiter, and Paul Tucker. Paul Tucker has even gone to the extent of pleading for the retreat of technocracy and more space for politics, and cautioning central bankers from attending Davos!

And these trends have become so egregious that what would have been considered scandalous in public life a few decades back is today passé. When immediately after demitting office, a President of the United States and a Chairman of Federal Reserve, the premier executive and regulator respectively in the world's largest economy and most powerful nation, nonchalantly accept handsomely compensated speaking tours sponsored by the very same interests who benefited the most from their policies and are arguably at the vanguard of political capture, then it cannot be denied that there is something seriously wrong!  

Leave aside all such research and just consider the short history of the last decade. On the one hand, the rich have benefited immensely from the ultra-low interest rates and booming stock markets, even as the middle-class and the less well-off have seen their wealth erode due to the low rates and the tanking of the housing market. Businesses and the richest individuals have been the biggest beneficiaries of tax favours of all kinds, even as public debt soars into unsustainable terrains. 

On the other hand, the non-elites have borne the brunt of the austerity policies that governments have pursued either on their own volition or been forced to do so. Consider the direct squeeze on funding for local governments and their increasing indebtedness, pervasive and sharp across the US and UK; the pruning down of welfare programs; the creeping privatisation of essential public services and their transfer to private interests with questionable intents. While the richest benefit by way of even tax exemptions on their bloated (so call "Cadillac") medical insurance policies, the poorest are left to fend for themselves by shopping for insurance policies from the market. 

Or consider the behaviours of the corporate titans of tech America. They incorporate subsidiaries in off-shore tax havens, vests intellectual property rights in them, transfers almost all profits to those subsidiaries, and thereby "avoid" paying taxes; thanks to the low interest rates they are able to borrow cheap in the US, use the money raised to finance share buy-backs, and boost their own wealth and payout massive dividends; and as if all this were not enough, claim tax exemption on the interest expenses for the debt raised, thereby avoiding paying even less of the already meagre tax dues.

In the US, in the immediate aftermath of the bursting of the sub-prime mortgage bubble, each one of the major actors - households, corporates, and financial institutions - were left with massive debt overhang. The US Government and the Federal Reserve reacted with alacrity and a slew of initiatives to bail out the same financial institutions, who bore the primary responsibility for inflating up the bubble. Then the extraordinary persistence with low interest rate was justified as necessary to repair corporate balance sheets and encourage investment. As regards households, somewhere in the fine print of these measures was a small program to help those struggling with foreclosures. 

While behemoth corporations were too big to fail, households had to be disciplined with foreclosures. It was as though the free-market principles of competition and moral hazard applied only to the latter and not the former. 

The result is to see. Even as the top 1%, even the top 10%, have seen their wealth rocket upwards on the back of the stock market boom, the bottom half has seen a steep fall in their wealth. For the richest, it is a case of sow the wind and let others reap the whirlwind, all the while sitting in a comfortable place and enjoying life!

Stunningly, the elites have drawn strength and credibility from the ideological and intellectual underpinning provided by the US academic establishment (barring a few honourable exceptions) and reputed institutions like the IMF in support of their actions. Free trade, liberal immigration, global citizenry, unfettered individualism, deregulation, globalisation, and so on have found ideological justification in their works. Even when some of the concerns like widening inequality have been surfaced by the likes of Thomas Piketty, these intellectual forefathers have sought to distract with obfuscation and arcane and superfluous digressions. Needless to say, these eminence grise have, in their own differing ways, benefited from the same trends.

The flag-bearers of the Fourth Estate have played a prominent role in distilling and disseminating these ideas and the narrative. They have helped establish a Gramscian hegemony to rationalise and drive these trends. The mutually beneficial partnership which emerged has been sustained under the veneer of a noble sounding "liberal democratic and free-market consensus".

Even enlightened self-interest has disappeared from the playbook of the elites. Clearly, they have become so emboldened with hubris as to eschew even pretensions of propriety and fairness in their actions. Again, history repeating itself. 

It was no surprise that things started to go wrong and wheels started coming off the apparent Goldilocks economy. The global financial crisis may have been a trigger, in so far as it exposed all the cracks that had hitherto been papered over by favourable forces like rising property markets, policies that allowed gorging on debt, globalisation and the rise of China, and the flush of productivity gains and opportunities that emerged from the new technologies. But after a few moments or months of sobriety and right rhetoric, things have gone right back to where they were, before 2007. May be, worse.

This is history repeating itself big time. Across societies and polities over time, economic elites have exercised their dominance over political power and control over decision making processes. And always the dominance has spilled over into excesses, provoking rebellions and revolutions, and sometimes assimilations, that resulted in regime shifts. We are seeing our own version of this dynamic. 

Hegel, though in the context of abstract ideas, described this in terms of an inexorable dialectic - thesis, anti-thesis, and synthesis. Accordingly, any state of the world, or thesis, generates its own opposition, or anti-thesis. The contradictions are resolved through a new state of the world, or a synthesis. In some sense, humans need the ‘other’; so do nations, institutions and ideologies to sustain themselves and to hold themselves from slipping into ‘excess’ mode.

Adam Smith cautioned about such capture and excesses. Karl Marx adapted Hegel to the material world and made it his central thesis - "the history of all hitherto existing society is the history of class struggles"! In more secular terms, Vilfredo Pareto and Gaetano Mosca claimed this as an immutable law, though in an acknowledgement of the dialectic, Pareto wrote about the "circulation of elites" and described "history as the graveyard of the elites". C Wright Mills wailed at the "power elites" from political, economic and military establishments who had usurped power from elected representatives and the resultant erosion of democracy. A host of others in recent times from James Burnham to Robert Putnam have written about the ceding of decision-making power by democratic institutions to managers and technocrats. Notice the striking similarity here with the prevailing central bank dominance over economic policy making.

But democracies, over the past century or so, have sought to address this problem through sufficient institutional checks and balances against egregious excesses by the dominant classes. These institutions and channels of engagement and negotiations have served as safety valves. John Kenneth Galbraith described them as institutions of "countervailing power", necessary to attenuate excesses. Over the past century, faced with the onslaught from communism, these same institutional systems have helped capitalism and liberal democracy survive by giving birth to the likes of labour unions and collective bargaining, consumer organisations, welfare state, social democracies, and so on. It is not incorrect to say that capitalism co-opted elements of communism to fend off the latter.  

But that was then. Unfortunately, if we accept the aforementioned dynamics on both the economic and political realms, the space now available for such safety valves to defuse may have shrunk and even disappeared. The populist backlash of recent times is a manifestation of this disturbing reality. And the response of the liberals is even more disconcerting. 

Instead of realising the enormity of the problem facing us and the near complete breakdown of the social contract, and advocating measures to address it, the liberal intellectuals and opinion makers have acquiesced with the elites by going after the convenient straw man in Donald J Trump (DJT). Even with all his flaws, DJT is merely a transient phenomenon, the sort of which is very likely when the social contract is tattered. 

It is not DJT that is the real problem, it is the elite capture of the rules of the game and the near complete marginalisation of the voices of labour and the economically disenfranchised. The "thesis" is no longer sustainable, and the "anti-thesis" is chaotic and deeply uncertain. In the circumstances, history teaches us that all we can expect is a tumultuous synthesis. Unless we act now to achieve a more orderly synthesis. 

Tuesday, October 16, 2018

The Sears bankruptcy and asset stripping

I have blogged several times in the recent past about asset stripping and corporate conflicts of interest. Sample this, this, this and this

The latest is Sears, the original big retailer, mail-order catalogs to brick-and-mortar chain, which has today filed for bankruptcy under Chapter 11 in the US. 

The company, formed in 1886, and was most recently purchased by hedge fund  owner Edward Lampert in a $11 bn deal in 2005 and merged with Kmart, which he already owned, has since seen its market capitalisation fall from nearly $30 bn to around $40 million. The bankruptcy trigger was a default on a $134 million debt repayment. If liquidated, the company will end up laying-off its 68,000 workers.

The dominant narrative in the post-mortems that will invariably follow will be that of a company which was slow to innovate and which was among those disrupted by the Amazon juggernaut. While these were undoubted contributory factors, a potentially equally important contributor appears to have been the financial engineering asset stripping practices employed by its billionaire owner. Sample this,
He has spun numerous assets off from the retailer into separate companies that his hedge fund invests in. As many of these spinoffs flourished, Sears slid toward insolvency. Over the past five years, the company lost about $5.8 billion; over the past decade, it shut more than 1,000 stores. Many of the 700 stores that remain have frequent clearance sales, empty shelves and handwritten signs... Its total bank and bond debt stood at about $5.6 billion in late September... Sears remains a publicly traded company, but Mr. Lampert exerts an enormous amount of control. He orchestrated a series of deals that generated cash for Sears in the near term, but sold off many of the company’s most valuable assets — creating entities that he also has a stake in. Sears’ shares, which topped $120 as recently as 2007, closed on Friday at 40.7 cents. Sears spun off Lands’ End, the preppy clothing brand, into a separate company, which Mr. Lampert’s hedge fund took a large stake in. The market value of Lands’ End now dwarfs that of Sears. In 2015, Sears sold off stores worth $2.7 billion to a real estate company called Seritage. Mr. Lampert is a big investor in that company as well as its chairman. Seritage is converting many of the best locations into luxury offices, restaurants and apartments. Mr. Lampert is also seeking to buy the Kenmore brand from Sears for $400 million. Even in bankruptcy, Mr. Lampert will have great sway over the company’s fate. His hedge fund owns about 40 percent of the company’s debt, including about $1.1 billion in loans secured by Sears and Kmart properties. As a result, he could force Sears to sell the stores or transfer them to him to repay that debt. “Lampert will make out,” said Mr. Olbrysh, the retired Sears worker. “There is no question about that.”
These practices are perfect examples of asset-tripping. I struggle to understand why this is not criminal misconduct. In any case, given the pervasive nature of such practices, especially in the private market, it is imperative that some very strong prohibitive action be initiated to rein in such stigmatised capitalism before the whole house is brought down by one of such failures. But how can we shape expectations given that the regulators chickened-out when faced with indicting Goldman Sachs for its infamous Abacus engineering.  

In simple terms, as Sears slid down the bankruptcy path, Lampert was busy enriching himself! And one of Lampert's partners in this process and one-time Yale-roommate was one Mr Steven Mnuchin, the current US Treasury Secretary!

Update 1 (17.10.2018)

An FT columnist writes,
Mr Lampert’s commitment to Sears seems genuine.

Update 2 (18.10.2018)

More here
Many Wall Street analysts and investors have speculated that Mr. Lampert’s primary interest in Sears was its real estate. The retailer had hundreds of stores in prime malls and shopping plazas across the United States. These properties could be sold to more profitable retailers or become something else entirely, like movie theaters, condominiums or offices. That was the idea behind Seritage Growth Properties, a publicly traded real estate company Mr. Lampert helped to establish in 2015 to acquire 235 stores from Sears. ESL invested $745 million, and Mr. Lampert became Seritage’s chairman. Its share price has soared 45 percent since its initial public offering and prominent investors like Warren E. Buffett have bought into the company. Mr. Lampert’s stake in this business is now worth approximately $1.1 billion.
Also this

Monday, October 15, 2018

Thoughts on innovation

John Cassidy credits the Nobel Prizes in Economics to William Nordhaus and Paul Romer as an acknowledgement of market failures (it is deeply disturbing that it required Nobel Prize worthy works for economists to realise this!).

He writes,
Take the development of transistors. Scientific researchers at Bell Labs invented them in the late nineteen-forties, and Western Electric started manufacturing them for commercial use in 1951. The customers who purchased the products that incorporated these early transistors, such as hearing aids and radios, presumably got their money’s worth. But that was only the beginning: once the basic knowledge of how to create a transistor existed, other businesses could use it to make different and better products, a process that Romer likened to creating new recipes. “By now, private firms have developed improved recipes that have brought the cost of a transistor down by a factor of 1 million,” he noted in a 1993 essay. “Yet most of the benefits from those discoveries have been reaped not by the innovating firms, but by the users of the transistors. Just a few years ago, I paid a thousand dollars per million transistors for memory in my computer. Now I pay less than a hundred per million, and yet I have done nothing to deserve or help pay for this windfall.”
Implicit in this line of reasoning is at least the following assumptions

1. It is private firms and markets which drive innovations,

2. therefore innovators deserve the high mark-ups they charge, 

3. innovators also deserve to appropriate all (or at least the major share of) the benefits from an innovation,

4. but innovators cannot appropriate benefits since it is relatively easy to copy innovations and commercialise them,

5. those who follow reap most of the benefits from those discoveries and the innovators reap disproportionately lower benefits, 

6. in the absence of such incentives businesses would not innovate, whereas presented with them they would do so, and 

7. consumers deserve nothing for the lower prices.

It is indeed striking that none of the seven assumptions would hold in many, if not the vast majority, of the cases involving commercial innovations. Marianna Mazzucato has documented it here and here

But the hegemony exercised by this narrative is striking. How about the following alternative narrative?

1. Private firms and markets drive commercial innovations which are built on decades of fundamental research financed largely by governments. Innovations are generally built sequentially on each other.

2. It is therefore only appropriate that the benefits of the commercial innovations that emerge from the foundations of public financed R&D be distributed proportionately and not allowed to be privately appropriated by just the last innovator. 

3. Very few innovations are truly path-breaking in so far as they emerge from first principles - general purpose technology innovations. It would be a mischaracterisation to claim that Facebook or Google or Amazon or Uber or AirBnB would not have emerged without those respective entrepreneurs. In each of these cases, a correct characterisation would be that each of those enterprising entrepreneurs and their respective companies were lucky enough to be at the right place at the right time in the path of technological evolution to be able to seize the breaks that came their way. 

4. Innovators are incentivised by a patent regime which is increasingly skewed in their favour. This allows them a monopoly market power which translates invariably, even in the hands of the best intentioned people, into high mark-ups and even price gouging. 

5. There are considerable entry barriers into copying - not only do you need to copy the innovation itself, it also necessary to copy/develop a business model. In case of knowledge innovations, barriers like network effects can be almost insurmountable. And now with the political capture of the institutions that makes the rules of the game, the entry barriers are institutionally entrenched. 

6. There is now a growing pile of evidence that businesses, despite sitting on massive cash surpluses, prefer not to invest in R&D and spend money on share buy backs and the like. 

7. Consumers are also taxpayers who underwrote the overwhelming share of the ultimate cost of bringing these innovations to them.

Wednesday, October 10, 2018

The case of agriculture crop insurance

Consider the challenges faced by a weather index insurance agency. It has to cover for an episode which has a high frequency but is completely uncertain, ensure the data is credible and minimises basis risks (affected farmer not eligible for claim because the index trigger was not hit), and pay out an amount which is commensurate to the damage suffered. It also has to keep the premiums affordable for the poor farmers, ensure that pay outs are done within a reasonable time, and genuine victims are not excluded. And it has to do all this with poor quality of index data and very patchy actuarial data, not to mention very unreliable crop damage models built on the index data.

A viable insurance model assumes reasonable premiums, diversified risk pool, and low frequency of insured episode incidence. But in case of crop insurance for the poor, the actuarial model has to support ultra-low premiums even with the constraints of high (and increasing) frequency of index triggers being hit, highly correlated insured pool (weather is the same over reasonably large areas or regions), and significant enough reimbursements required to make this meaningful enough for the farmers.

If we try doing the math, we will soon realise in no time that self-financed micro-insurance for the poor is an impossible proposition. In fact, it is no surprise that even the most efficient and largest crop-insurance scheme in the developing world enjoy over 80% premium subsidy support. India’s new massive nation-wide crop insurance program, Pradhan Mantri Fasal Bima Yojana (PMFBY), has premium subsidy of a whopping 97%! Even by squeezing out all the efficiency gains from financial engineering and technology, the commercial viability frontier will still remain very distant. In any case, whatever the insurer will pay out has to come from what is remaining after covering their costs – a claim ratio above 100% is not sustainable.

In simple terms, index insurance tries to do both financial engineering and weather modelling to address a complex development challenge. This is a double challenge. One, the actuarial models have to support affordable premiums. Two, the index data model that underpins the premium calculation is robust enough to minimise basis risks and ensure that the development objectives are met. The first suffers historical data deficiencies and the second is an emerging area of research fraught with deep uncertainties. 

In contrast, a direct payment to identified victims does not involve any of the risk mitigation and transaction costs associated with managing an insurance. However, it does involve the challenge of assessing damages and their validation, whereas an index insurance only requires more easily verifiable (though less directly linked to the desired outcome) index triggers. But it eliminates the significant basis risk faced by farmers and ensures that the desired development objectives are realised. Besides, it also captures the true cost of crop damage mitigation in a clean, direct, and efficient manner. 

In light of the above, the most efficient crop risk mitigation strategy would be direct income payments and not heavily subsidised insurance.

If we are engaging on a truly evidence-based policy making mode, the focus of innovation should be on helping governments make accurate assessments of crop damages in quick time. The one area where significant efficiency gains can be realised is from optimising the process of data collection and its validation. And this could be outsourced to a competent agency. But is anyone even talking about this?

Update 1 (19.12.2018)
Underlining the point made above, crop insurance subsidies are massive even in the US
The National Agriculture Insurance Scheme (NAIS) under implementation in India since 1999 and covering over 25 million farmers had an average claims multiple of over 3.5 times the premium payment for the 2000-08 period. See also this, this and this on crop insurance.

Update 2 (21.02.2020)

Good explainer about India's PMFBY crop insurance scheme here.