Palliatives will not address capitalism's problems

I had blogged earlier about Bridgewater's Ray Dalio's explanation of capitalism's problem as one of excesses that have built-up over the years,

Dalio's diagnosis is that capitalism's dynamics, especially since it has been taken to its extremes (say, in seeking profits, efficiency, productivity, market share etc) is now "producing self-reinforcing spirals up for the haves and dow for the not-haves, which are leading to harmful excesses at the top and harmful deprivations at the bottom". In effect, Dalio blames the dysfunctional nature of modern capitalism to an impersonal contributor, some inexorable dynamic of capitalism, say peak capitalism.

So there have been efforts from within in recent times to respond to these excesses. Innovations like the Universal Basic Income (UBI), impact investing, philanthro-capitalism, B-corporations, gender-lens investing, corporate social responsibility, responsible-sourcing, circular economy, carbon footprint tagging etc are examples. 

The use of environment, social, and governance (ESG) criteria in investing by financial institutions is another example. 

Businesspeople, being people, like to feel they are doing good. Until the financial crisis, though, for a generation or so most had been happy to think that they did good simply by doing well. They subscribed to the view that treating their shareholders’ need for profit as paramount represented their highest purpose... It is a view of the world... which has faced increasing pressure over the past decade. Environmental, social and governance (ESG) criteria have come to play a role in more and more decisions about how to allocate financial investment. The assets managed under such criteria in Europe, America, Canada, Japan, Australia and New Zealand rose from $22.9trn in 2016 to $30.7trn at the start of 2018, according to the Global Sustainable Investment Alliance... The discontent does not end with investors. Bright young workers of the sort businesses most desire expect to work in a place that reflects their values much more than their parents’ generation did...

On August 19th the great and good of ceo-land announced a change of heart about what public companies are for. They now believe that firms should indeed serve stakeholders as well as shareholders. They should offer good value to customers; support their workers with training; be inclusive in matters of gender and race; deal fairly and ethically with all their suppliers; support the communities in which they work; and protect the environment... Last year, employees at Google forced the firm to stop providing the Pentagon with ai technology for drone strikes and to drop out of the procurement process for JEDI, a cloud-computing facility for the armed forces. Google depends, perhaps more than any of its peers, on a smallish number of cutting-edge data scientists and software engineers; their views carry weight. Microsoft, despite similar misgivings from its employees, is still in the running for the JEDI contract. Amazon, for its part, is facing employee pressure over contracts with oil and gas companies.

For a start, it may be useful to scratch the surface and examine the ESG consideration details behind the trillions mentioned. Chances are that they would be so superfluous as to be meaningless.

This Harvard Business School case study and this discussion involving the professors concerned is a great example of how top-notch academic ideologues feel comforted by what are at best ultra-marginal tinkering on fund allocation processes of large investors. Such long-route to change can be interminably long. Most likely much ado about nothing!

In general, corporates have sought to deploy "virtue signalling" and initiated "feel-good" measures. These are not even token measures. In fact, they are perhaps downright disingenuous obfuscations. They are worse than band-aid on gangrene. Such song and dance at non-issues are on many occasions conscious efforts by the corporate elites and their ideological cheerleaders to distract attention from the core issue.

The Economist falls back on more of the capitalist medicine - accountability and competition. It proposes taking decision-making away from managers and vesting with shareholders even as shareholder base is broadened, on the grounds that this would bring in accountability and therefore demand for real change. And competition would help keep corporates honest in pursuing the interests of workers, consumers, and regulators. This is a great example of suggesting remedies, knowing fully well that they are both impractical and have little evidence of being effective.

Instead, a meaningful enough attempt will have to involve at least some corporate leaders showing the way with actions on issues like abjuring from tax avoidance, efficiency focused lay-offs and off-shoring, monopoly seeking or oligopolistic actions, providing decent wages and proportionate wage increases for workers, investing in and promoting the rights of lower level workers, ensuring adequate financing of pensions and other worker liabilities and so on. Now these would constitute real progress in addressing capitalism's excesses.

But then the argument would go that these are collective action or free-rider problems. No one corporate or group of corporates would want to pursue them since that would be shooting themselves in the feet. Never mind the reality of today's oligopolistic markets where just the 2-3 leaders could take the lead and show meaningful impact without compromising significantly on their commercial interests. 

Anyways, the collective action problem presents a convenient fig-leaf for liberal opinion makers blame the favourite whipping boy, government, for not putting in place appropriate policies. But if some government tries to engage with the problem, the same liberals accuse governments of meddling with markets or favouring one group over other. The lack of any broad-based ideological support and hair-splitting among opinion leaders (including The Economist) for the actions on European Union in the direction of anti-trust (whatever their real intentions) is a case in point. 

I think we need paradigm shifts. And these shifts are unlikely to emerge from within. The house has to burn down. 

Reforming the global monetary and financial system

It is gratifying when no less a person than the Governor of Bank of England Mark Carney breaks ranks from orthodoxy and summarises our book, The Rise of Finance. The core of the speech goes to the heart of what we have argued in our book. The global financial and monetary system is broken and the role of dollar is central to the problem.

In his speech at the annual Jackson Hole gathering of central bankers, Carney highlighted the problems associated with the world's reliance on the US dollar and spillovers especially on emerging economies from US monetary policy actions. He questioned the macroeconomy stabilisation orthodoxy on flexible inflation targeting and floating exchange rates. He advocated the creation of a new international monetary and financial system (IMFS) based on many more global currencies, where IMF could play a role to avoid having countries self-insure themselves against sudden-stops and capital flight by the inefficient and wasteful hoarding of US dollar assets, and greater global monetary policy co-ordination.

On the problems with the prevailing system,

Globalisation has steadily increased the impact of international developments on all our economies. This in turn has made any deviations from the core assumptions of the canonical view even more critical. In particular, growing dominant currency pricing (DCP) is reducing the shock absorbing properties of flexible exchange rates and altering the inflation-output volatility trade-off facing monetary policy makers. And most fundamentally, a destabilising asymmetry at the heart of the IMFS is growing. While the world economy is being reordered, the US dollar remains as important as when Bretton Woods collapsed. The combination of these factors means that US developments have significant spillovers onto both the trade performance and the financial conditions of countries even with relatively limited direct exposure to the US economy.

He argues that these developments have lowered the global equilibrium interest rates, which in turn influences domestic monetary policy actions, which in turn become a bigger problem when the US economic conditions warrant tightening by the UD Federal Reserve even as economic condition elsewhere are weakening. The result is a structural disinflationary bias in the world economy.

Greater cross-border trade, growth of global value chains, and globalisation in general have synchronised producer prices globally and also introduced a disinflationary bias on the world economy. This increase in global trade has been accompanied by the DCP or trade invoicing in dollars even when the trade does not involve the US, thereby weakening the automatic (external side) stabilisation effects of a floating exchange rate.

The resulting stickiness of import prices in dollar terms means exchange rate pass-through for changes in the dollar is high regardless of the country of export and import, while pass-through of non-dominant currencies is negligible. As a result, import prices do not adjust efficiently to reflect changes in relative demand between trading partners, in part because expenditure switching effects are curtailed, and global trade volumes are heavily influenced by the strength of the US dollar.

It has been shown that, controlling for the global business cycle, a 1% appreciation of the dollar against all other currencies leads to a 0.6% contraction in trade volumes in the rest of the world within one year.

In addition to trade invoicing, dollar is also the dominant currency in the financial markets, and all this creates a self-reinforcing spiral that predominates dollar ever more,

As well as being the dominant currency for the invoicing and settling of international trade, the US dollar is the currency of choice for securities issuance and holdings, and reserves of the official sector. Two-thirds of both global securities issuance and official foreign-exchange reserves are denominated in dollars. The same proportion of EME foreign currency external debt is denominated in dollars and the dollar serves as the monetary anchor in countries accounting for two thirds of global GDP. The US dollar’s widespread use in trade invoicing and its increasing prominence in global banking and finance are mutually reinforcing. With large volumes of trade being invoiced and paid for in dollars, it makes sense to hold dollar-denominated assets. Increased demand for dollar assets lowers their return, creating an incentive for firms to borrow in dollars. The liquidity and safety properties encourage this further. In turn, companies with dollar-denominated liabilities have an incentive to invoice in dollars, to reduce the currency mismatch between their revenues and liabilities. More dollar issuance by non-financial companies and more dollar funding for local banks makes it wise for central banks to accumulate some dollar reserves. 

And the net result is that actions of US government and the Federal Reserve have enormous spill-overs on the world economy, even in countries which have limited US exposure. Helene Rey has described the global financial cycle as a dollar cycle. Carney points to evidence on the harmful effects of spillovers,

For EMEs, this manifests in volatile capital flows that amplify domestic imbalances and leave them more vulnerable to foreign shocks. One fifth of all surges in capital flows to EMEs have ended in financial crises, and EMEs are at least three times more likely to experience a financial crisis after capital flow surges than in normal times. While the typical EME receiving higher capital inflows will grow 0.3 percentage points faster, all else equal, the typical EME with higher capital flow volatility will grow 0.7 percentage points slower... Bank research suggests that the spillover from tightening in US monetary policy to foreign GDP is now twice its 1990-2004 average, despite the US’s rapidly declining share of global GDP. Financial instability in advanced economies also causes capital to retrench from EMEs to ‘safe havens’, as it did during the 2008 financial crisis and the 2011 euro-area crisis. Connally’s dictum “our dollar, your problem” has broadened to “any of our problems is your problem”... Bank of England work finds that redemptions by EME bond funds (with large structural mismatches) in response to price falls are five times those for EME equity funds (with lower structural mismatch). In turn, EME equity funds are twice as responsive as advanced economy equity funds.

So what does he suggest? In the short-run he suggests transparent pursuit of flexible inflation targeting, with focus on trading off domestically generated inflation and output volatility, as well as co-ordination with fiscal and regulatory policies, at both national and international levels.

In the medium term, policymakers need to reshuffle the deck. That is, we need to improve the structure of the current IMFS. That requires ensuring that the institutions at the heart of market-based finance, particularly open-ended funds, are resilient throughout the global financial cycle. It requires better surveillance of cross border spillovers to guide macroprudential and, in extremis, capital flow management measures. And it underscores the premium on re-building an adequate global financial safety net... EMEs can increase sustainable capital flows by addressing “pull” factors including... expanding the scope and application of their macroprudential toolkits to guard against excessive credit growth during booms. Bank of England research finds that tightening prudential policy in EMEs dampens the spillover from US monetary policy by around a quarter... At the same time, it is in the interests of advanced economies to moderate push factors, including risks in their markets and institutions... Pooling resources at the IMF, and thereby distributing the costs across all 189 member countries, is much more efficient than individual countries self-insuring. To maintain reserve adequacy in the face of future larger and more risky external balance sheets, EMEs would need to double their current level of reserves over the next 10 years – an increase of $9 trillion. A better alternative would be to hold $3 trillion in pooled resources, achieving the same level of insurance for a much lower cost.

In the longer term, we need to change the game. There should be no illusions that the IMFS can be reformed overnight or that market forces are likely to force a rapid switch of reserve assets... Any unipolar system is unsuited to a multi-polar world. We would do well to think through every opportunity, including those presented by new technologies, to create a more balanced and effective system... Multiple reserve currencies would increase the supply of safe assets, alleviating the downward pressures on the global equilibrium interest rate that an asymmetric system can exert. And with many countries issuing global safe assets in competition with each other, the safety premium they receive should fall. A more diversified IMFS would also reduce spillovers from the core and by so doing lower the synchronisation of trade and financial cycles. That would in turn reduce the fragilities in the system, and increase the sustainability of capital flows, pushing up the equilibrium interest rate.

Weekend reading links

1. Very good article on India's dairying sector by Chandramogan, the founder of Hatsun Agro Products. This about the importance of milk production to India's agriculture,

The CSO’s national accounts statistics shows that 26.15% of the GVA from India’s agricultural sector in 2016-17 was constituted by livestock. Further, 66.93% of the value of livestock output was from milk. It implies that roughly every fifth rupee in Indian agriculture comes from dairying. This is because practically every farmer produces milk, irrespective of what his/her “main” crop is. Unlike the main/principal crop that is marketed once or twice a year, milk brings in income on a daily basis. Also, its prices are less prone to volatility and there is no other crop where the Indian farmer realises roughly two-thirds of the rate paid by consumers (that ratio is one-third in the US). Organised dairies in India have evolved a unique procurement-cum-marketing system, wherein Indian farmers get 60 to 65% of the value of retail price paid by the consumer. Milk is a source of liquidity, predictability and stability in rural incomes. Moreover, for every eighth or ninth farmer producing milk, there is a mom-and-pop store retailing the same. Again, there is no product that is as fast-moving as milk, allowing the small retailer to rotate capital 365 times a year. In short, in India, in spite of paying approximately 25% higher a price to the farmers compared to US, consumers get it at two-third of the price consumers in the US pay.

And its growth has been impressive,

Our milk output more than doubled from 79.66 mt in 2000 to 176.27 mt in 2017, when the same for the world increased by just 42%, from 579.31 mt to 824.80 mt. In 2000, India produced 79.66 mt of milk versus the rest of the world’s 499.65 mt. 17 years later in 2017, India produced 176.27 mt versus the rest of the world’s 648.53 mt. India’s milk grew by 109% against 30% in rest of the world in the last two decades. India’s contribution to the entire world growth is 35% versus 65% of all countries put together... India, in the last 10 years or more, has been a net exporter rather than importer of dairy products.

If only we had more opeds by people who actually are doing what they are writing about!

2. Livemint points to a CAG report that highlights concerns about India's revenue collection system. For the quarter ending June, gross tax revenue collection grew at the slowest pace in 10 years. The shortfall in central GST collection for 2018-19 was 22%. The report also draws attention to tax compliance not having improved significantly post-GST. The complexity of GST structure has made automated invoice matching difficult to implement, thereby creating opportunities for tax leakages and calculation errors.

A summary of the CAG report findings

3. Nice article on the perils of commercialisation of higher education. The UK's higher education market has been transformed over the past decade by market-based reforms which allowed for-profit colleges. In 2018, the Office for Students (OFS) was set up as the higher education regulator. Higher education institutions have come to rely increasingly on student fees than government grants.

Some of the providers are owned by private equity investors. The OFS requires all universities and colleges to register in order for their students to be eligible for government loans. The OFS has recently allowed private institutions to fail, which in turn raises the concerns about what will happen to the students admitted.

More signatures of distortions and problems,

Universities lower down the pecking order have fared less well... Universities are keenly aware that they are mostly competing with a handful of rivals for students, and that geography plays a big role in determining who those rivals are. Exeter, in south-west England, has commissioned research which shows it attracts students who live near the m5 motorway that runs into town, and struggles to recruit from anywhere north of Birmingham, in the Midlands... Universities not attracting enough students have to adapt. Since the new system was introduced, almost all have charged the maximum allowed—now £9,250 ($11,250) a year. Since students are entitled to government loans, which they don’t have to repay until they earn more than £25,725 a year, they are relatively unfussed by upfront costs. But price competition has begun to emerge in the form of hefty scholarships. A more common way to appeal to students is to lower the grades for entry. At its most devious, this takes the form of offers which do not require the applicant to achieve any grades at all, provided they make the university their first choice.

4. A very good description of today's start-up and technovation world,

WeWork tries to “elevate the world’s consciousness”. Or the company’s claim that it has a market opportunity of $3tn. This is precisely the sort of overconfidence that led Lyft to claim it was part of one of the biggest societal shifts since the invention of the car, and Uber to say flying taxis will soon be in the air, while suggesting it was targeting a $12tn market, including the money consumers spend in restaurants. Hype is one of the tech sector’s most magical qualities. Why under-promise when the financial success of the best bets has been so extraordinary? Tesla’s prediction of robo-taxis has the added bonus of making its forecast for driverless cars seem achievable. Uber’s gargantuan addressable market makes its own valuation look more sane. Much is made of the fact that Lyft and Uber shares trade below the price at which they listed. Less about the fact that two lossmaking companies with no clear path to breaking even are still valued at $16bn and $59bn, respectively. True believers are not limited to start-ups. At an Amazon conference earlier this year, I sat beside a man whose business card told me that he was chief evangelist of Amazon Web Services. Grandiosity makes sense in an industry that often has to generate excitement and funding before products even exist.

5. Interesting inferences here and here on Reliance Industries decision to pare down all its debts. In its latest AGM, the company announced the end of its 7 year $100 bn investment cycle in refining, petrochemicals, telecoms, and retail and a commitment to become a zero-debt company in 18 months.  Andy Mukherjee asks very relevant questions,

While a breather after such frenzied activity may be understandable, why does he want Reliance to be a zero-net-debt company in 18 months? What will it mean for the more than 100 banks and financial institutions around the world that provide India’s largest company and its subsidiaries with billions of dollars – and yen, and rupees – in financing and refinancing? Above all, what will Reliance’s deleveraging mean for India?... in October 2016 Reliance was shouldering 13% to 14% of the entire investment by India’s top 1,250 listed companies as well as Indian Railways and state-owned electricity boards... The rest of India Inc. is paralyzed by debt and self-doubt; consumers are overstretched; and so is the government. A holiday for Reliance would remove from play the only domestic balance sheet with unspent firepower.

Whatever the motivations and reasons, it will clearly take out one of the biggest sources of investment demand away from the market exactly at a time when the economy needs it the most.

6. This blog has long held the view that technology firms benefit from regulatory arbitrage that allows them to socialise a significant share of their costs, which normal brick-and-mortar firms are expected to internalise. 

Sample this from a WSJ investigation,

Many of the millions of people who shop on Amazon.com see it as if it were an American big-box store, a retailer with goods deemed safe enough for customers. In practice, Amazon has increasingly evolved like a flea market. It exercises limited oversight over items listed by millions of third-party sellers, many of them anonymous, many in China, some offering scant information. A Wall Street Journal investigation found 4,152 items for sale on Amazon.com Inc.’s site that have been declared unsafe by federal agencies, are deceptively labeled or are banned by federal regulators—items that big-box retailers’ policies would bar from their shelves. Among those items, at least 2,000 listings for toys and medications lacked warnings about health risks to children. The Journal identified at least 157 items for sale that Amazon had said it banned, including sleeping mats the Food and Drug Administration warns can suffocate infants. The Journal commissioned tests of 10 children’s products it bought on Amazon, many promoted as “Amazon’s Choice.” Four failed tests based on federal safety standards, according to the testing company, including one with lead levels that exceeded federal limits. Of the 4,152 products the Journal identified, 46% were listed as shipping from Amazon warehouses...

Amazon’s struggle to police its site adds to the mounting evidence that America’s tech giants have lost control of their massive platforms—or decline to control them. This is emerging as among the companies’ biggest challenges. Amazon, Facebook Inc., Twitter Inc., Alphabet Inc. ’s YouTube and others are under scrutiny over how they wield their dominance in booming internet markets while their forums are used for fraudulent listings, offensive content and misinformation—including some spread during America’s 2016 elections... Amazon’s common legal defense in safety disputes over third-party sales is that it is not the seller and so can’t be responsible under state statutes that let consumers sue retailers. Amazon also says that, as a provider of an online forum, it is protected by the law—Section 230 of the Communications Decency Act of 1996—that shields internet platforms from liability for what others post there. This is similar to a common defense by internet companies faced with complaints about content or services offered on their platforms. Courts and regulators have largely agreed—until recently...

Third-party sellers are crucial to Amazon because their sales have exploded—to nearly 60% of physical merchandise sales in 2018 from 30% a decade ago, Amazon says. The site had 2.5 million merchants with items for sale at the end of 2018, estimates e-commerce-intelligence firm Marketplace Pulse. Amazon doesn’t make it easy for customers to see that many products aren’t sold by the company. Many third-party items the Journal examined were listed as Amazon Prime eligible and sold through the Fulfillment by Amazon program, which generally ships items from Amazon warehouses in Amazon-branded boxes. The actual seller’s name appeared only in small print on the listing page...

In contrast, Walmart Inc. requires all products on store shelves be tested at approved labs, company documents show. Target says it requires suppliers of store-branded products to undergo additional inspections and testing beyond government standards. Target and Walmart have created online marketplaces for third parties to sell directly to consumers. Target’s site, launched earlier this year with several sellers, is invitation-only. Walmart had around 22,000 sellers at the end of 2018, according to Marketplace Pulse. It requires an application that can take days for approval, and only a fraction of merchants applying make it through the vetting, says a person familiar with Walmart’s policy.

We're all Japan now!

As the bond market rally continues unabated, yields are touching historic lows. The yields of Bloomberg Barclays Multiverse Index, the broadest bond market gauge that tracks more than $58 trillion of debt is nearing the all-time low of 1.4% touched in 2016.

The FT also has this nice graphic that points to a bond market "yield drought"!

Underlining the trend, Germany just sold 30 year bonds at slightly negative yield - it sold €824 million ($914 million) worth bonds that pay no interest, at slightly above face value, so when they mature in 2050, Germany will pay back €795 million. The logic as an FT editorial writes is pretty compelling,

Buying longer-dated, negative-yielding debt makes sense for pension and insurance funds matching assets to future liabilities. Paying to lend money to governments is also profitable — if a year later investors pay even more for the privilege. Thirty-year Bunds bought 12 months ago have generated returns totalling more than 30 per cent. Returns on Amazon shares were flat in euro terms over the same period. The German Dax share index lost 5 per cent. Repeating that performance would require a further percentage point fall in 30-year yields, says Bank of America. Scarily, that is not ridiculous. US president Donald Trump wants the US Federal Reserve to slash its benchmark interest rates. Other central banks would have to follow. Global trade wars and Brexit could give them cover. Supplies of German Bunds are limited, pushing prices up and yields down.

In many ways, the global bond market mirrors what Japan has been going through for the past two decades - howsoever low it gets, it never ends. We're all Japan now!

Update 1 (24.08.2019)

The upshot of this is also the massive risks it poses to the financial system from a future rise in bond yields, the duration risk. Sample this FT assessment,

Diversified investment portfolios have benefited from the tailwinds of the bond rally. A global index of government bonds, for example, has returned some 8 per cent over the past 12 months, compared with a drop of 2 per cent for the FTSE All World stock index. An index of US Treasury bonds with a maturity of more than 20 years has appreciated by more than one-fifth this year alone, with price performance enhanced by the August grab for long-dated paper... "At ultra-low bond yields, the risk of owning bonds converges with the risk of owning equities. The short-term potential for capital appreciation — nominal or real — diminishes, while the potential for vicious losses increases dramatically.’’ The financial system is thus left exposed to any abrupt rise in bond yields while having little scope for strong price appreciation, given the extreme moves that already reflect plenty of bleak growth and inflation data down the road. What should really worry people is how a prolonged episode of negative and lower-yielding government bonds intensifies the challenges facing bank profitability. There are also red flags fluttering over valuations for pension funds and the viability of insurers, as bond coupons shrink. Herein resides ammunition for the next episode of financial market distress, which played a major role in torpedoing the global economy in 2001 and 2008.

NEXT and outcomes-based policy making

The recently passed National Medical Commission (NMC) Act in India has an interesting provision for a common National Exit Test (NEXT) to certify medical students for successful completion of their basic graduation course and license them to practice medicine as well as admission to post-graduate courses. The government also claims that the Act will dispense with the elaborate system of regulations and inspections that the Medical Council of India (MCI) undertakes that had become a source of rampant corruption.

The underlying presumption is that instead of validating  adherence to procedural requirements by medical colleges, focus on certifying the quality of graduates being trained. In other words, focus on capturing the outcomes. Why fuss on regulations and inspections with their messy administration and governance challenges when we can just monitor the quality of exiting students?

This resonates strongly with the logically appealing narrative of outcomes-based policy making, one of the prevailing fads in international development. There is something neat about this - just define outcomes, and leap-frog the messy procedural and governance challenges that have bogged us down for decades.

My own thinking on it has evolved considerably over the past decade or so, and today I am less convinced about neat outcomes-based policies. Accordingly, I have blogged earlier about why outcomes-based policies, especially on complex issues, while deceptively alluring, but are most likely to disappoint. See this, this, this and this.

The stakes are too high, the political economy too complex, and the eco-system constraints too onerous for a NEXT to achieve its desired objective in such a simple manner. For a start, the nature of NEXT itself poses massive implementation challenges. For NEXT to be meaningful, it will have to go beyond the easily administrable Multiple Choice Questions (MCQs) and involve qualitative assessment, including for clinical judgement skills. Unlike MCQs, such testing has too many moving parts, thereby, increasing the likelihood of subversion, even with use of the best technologies. 

If the fidelity of the exam processes itself is not illegally subverted, then the nature of questions or the manner of its administration (the rules of the game) will be legally compromised. And if neither happens and NEXT forces the closure of many medical colleges, or results in failures of large numbers of students (especially those who have paid massive sums under the management quota), or abruptly denies the several influential people who want their children as doctors, then vulnerabilities will only accumulate inexorably. 

In any case, it is naive to expect a simple outcomes-tweak, howsoever rigorously monitored, to force the managements and systems of the 536 medical colleges to start adhering to all requirements in a manner that enables high-level graduate instruction. For there is also the issue of supply-side requirements. We under-estimate the physical infrastructure and personnel quality requirements as well as pedagogy approaches that are critical to ensuring quality in medical graduate instruction.  

Then there is the student feedstock quality itself - we have seen how NEET or JEE have been distorted by the entrance coaching institutions, thereby seriously undermining the quality of entrants into professional courses. NEXT coaching centres will inevitably spring up. Finally, there are the likely serious emergent anomalies and problems (say, those related to reservation etc) which are not easily addressed. Resolving all these take time and persistent effort.

This is not to reject NEXT, but only to qualify the requirements to achieve the objective. For the NEXT to stand any chance of success in ensuring good quality of medical graduates, the exit test has to be complemented with all the governance requisites - basic and easily verifiable eligibility requirements for the institutions (entrance examination, its physical and personnel infrastructure, and course modules), transparent and arms-length accreditation and periodic certification/ranking mechanism, and a light-touch regulator. There is no substitute for these latter requirements. And more than NEXT, it is this that would still remain the biggest challenge.

Admittedly, the details of the regulations on the NMC Act and its operationalisation, and how the NMC itself would acquit itself as a regulator are what would matter. The battle has only started. In many ways, even with NEXT, the main challenges to be overcome are pretty much the same that the erstwhile Indian Medical Council (IMC) failed to administer - governance and regulation.

The worst outcome would be to gloss over the more persistent governance and regulation battles and prematurely declare victory in the belief that the mere introduction of NEXT (even if implemented with high fidelity) would help achieve the objective of quality in medical graduation in India.

The Great Saudi Arabian fiction?

No, this is not from any fiction book. It is about Neom, the brand new city of the future being constructed at a cost of $500bn and covering 10,000 square miles of unknown and neglected rocky desert and empty coastline in north-west Saudi Arabia. It is the vanity project of the de facto ruler of the country, Mohammed Bin Salman (MBS). 

As the article writes, Neom involves several "leaps of faith", 

“This should be an automated city where we can watch everything,” Neom’s MBS-led founding board said, according to the documents—a city “where a computer can notify crimes without having to report them or where all citizens can be tracked.”... Neom aims to have “zero work/stress-related diseases,” with residents working at startups or companies like Amazon.com Inc., which Saudi officials are trying to lure with incentives like free energy and subsidized labor, according to the planning documents... Residents’ children would be schooled in the “leading education system on the planet,” with innovations like "hologram faculty"... Though Neom is surrounded by desert, it will have many farmers markets. Temperatures will be cooler than Dubai, the documents say, and moderated by “cloud seeding” to make it rain. Because they live in the city with the “highest GDP per capita,” the documents say, a resident could indulge in a fancy dinner; Neom aims to have the “highest rate of Michelin-starred restaurants per inhabitant.” To keep Neom safe, cameras, drones and facial-recognition technology will let Saudi intelligence services track everyone... Neom in a statement said the project is about “technology in all sectors such as mobility, livability, health and medical, all of which will ensure we are providing the most attractive living environment on the planet. Earlier this year, MBS issued a decree about an area called Silver Beach. “I want the sand to glow,” he said, according to two people familiar with the project. Engineers haven’t figured out a safe way to do it. Each night, he told underlings, a fleet of drones should create the illusion of a rising moon—crescent, half, full. “That’s what he wants this future to be,” a former executive said.

It is understandable to promote grandiose projects with some hyperbole. But this, even by any standards of grandeur, looks just plain ridiculous. The only beneficiaries from this would be western financiers, consultants, and construction contractors.

Is it the modern reprise of the historical tales of foolish king and conman/thief who try to trick him?

Negative yield facts for the day

After a brief lull, negative interest rates are back in the news with a vengeance. This should make us sit up and wonder,

Bonds worth $15tn — roughly a quarter of the debt issued by governments and companies around the world — are currently trading with negative yields. That means prices are so high that investors are certain to get back less than they paid, via interest and principal, if they hold the bond to maturity. They are, in effect, paying someone to look after their money. 

In fact, yields on 10 year bonds of nine countries are now in the negative territory.

The spread of the negative yield phenomenon is a very good illustration of how interconnected and footloose global capital has become. What started out as a developed country phenomenon - low inflation and weak economic prospects - has driven capital into searching for yields thereby dragging down borrowing costs everywhere. In fact, yields on German bunds are trading below zero for upto 15 years.

It has created oddities everywhere,

Danish lender Jyske Bank last week issued a 10-year mortgage bond at an interest rate of minus 0.5 per cent, meaning homeowners are being paid to borrow. Meanwhile, Swiss bank UBS is planning to charge its super-rich clients for holding on to cash... Bonds issued by Poland, the Czech Republic and Hungary have joined the club.

Ananth points to the stunning inversion of logic from fact that Greek 5Y is 1.27% and US 5Y is 1.5%! Greece recently received orders of more than €13bn for the seven-year bonds, well above the €2.5bn on offer, at 1.9% below the 2.1% expected. Yields on even 10 year bonds of Greece breached the US level recently. As to the reasons, sample this,

The dramatic fall in Greece’s borrowing costs is a testament to how much it is now considered a stable member of the European Union, especially given that as recently as 2018, total Greek government debt was calculated at 181% of the country’s gross domestic product. It could also be a sign of desperate investors who are hungry for yield in a low-return world. Negative returns on core euro zone debt have pushed bond buyers to look at riskier sovereign debt from countries like Italy and Greece. Last Tuesday, Greece sold 2.5 billion euros of seven-year notes, attracting more than four times the bids needed to fulfil the sale.

Needless to say, the reason is most likely the latter. 

And underlining the lesson of traditionally very short investor memories and why this time is no different, Argentina, among the beneficiaries of the low-rate world, is bracing for its latest round of debt restructuring and/or default. The Peso tumbled by over 25% early this week and public debt has risen from 86% to 100% since 2018, 24 percentage points more than the 2019 IMF target as per the Fund's $56 bn restructuring program. Market participants expectations of a sovereign default over the next five years is put at a whopping 75%! The much hyped century bonds of the country is trading at a massive discount.

Clearly investors are betting on the very short-term when they are buying bonds at these yields. They are completely speculative search for yield bets. And the public resolve of governments and central banks to keep rates down only seems to anchor expectations among investors accordingly and keep inflating this bubble.

The only question is how much longer can the rates keep falling before investors and savers realise that the costs are simply unacceptable.

Update 1 (02.09.2019)

Thanks to the spectacular rise in central bank holdings and regulatory requirements, the volume of tradeable German bunds has shrunk, driving yields into the negative territory across all tenors. 

In fact, the volume of freely traceable Bunds are expected to drop below €70bn by 2024 down from more than €600bn a decade earlier.

Public policy to promote Innovation

Noah Smith points to the new paper by Nick Bloom and Co on policies to promote innovation. In the context of the US, they explore the relative efficacy of various innovation policy levers - tax policies to favour R&D, government research grants, policies aimed at increasing the supply of human capital focused on innovation, intellectual property policies, and pro-competition policies. 

Their conclusion is in the form of table which they call "a toolkit for innovation policymakers",

In the short run, research and development tax credits and direct public funding seem the most effective, whereas increasing the supply of human capital (for example, through expanding university admissions in the areas of science, technology, engineering, and mathematics) is more effective in the long run. Encouraging skilled immigration has big effects even in the short run. Competition and open trade policies probably have benefits that are more modest for innovation, but they are cheap in financial terms and so also score highly. One difference is that R&D subsidies and open trade policies are likely to increase inequality, partly by increasing the demand for highly skilled labor and partly, in the case of trade, because some communities will endure the pain of trade adjustment and job loss. In contrast, increasing the supply of highly skilled labor is likely to reduce inequality by easing competition for scarce human capital.

The effect of immigration is very interesting

Immigrants make up 18 percent of the US labor force aged 25 and over but constitute 26 percent of the science, technology, engineering, and mathematics workforce. Immigrants also own 28 percent of higher-quality patents (as measured by those filed in patent offices of at least two countries) and hold 31 percent of all PhDs. A considerable body of research supports the idea that US immigrants, especially high-skilled immigrants, have boosted innovation. For example, Kerr and Lincoln (2010) exploit policy changes affecting the number of H1-B visas and argue that the positive effects come solely through the new migrants’ own innovation. Using state panel data from 1940 to 2000, Hunt and Gauthier-Loiselle (2010) document that a 1 percentage point increase in immigrant college graduates’ population share increases patents per capita by 9 to 18 percent, and they argue for a spillover effect to the rest of the population.

Their conclusion is to favour three policies - government funding, tax credits, and skilled immigration. Interesting how some of the staples of free-market ideology like intellectual property protection and pro-competition policies fall short on evidence of impact.

Weekend reading links

1. Arguably the story of the week has been the Renminbi breaching the psychologically important 7 per dollar mark, for the first time since 2008. The decision to not intervene to prop up the currency, which has been over-valued for a long time now, is also a retaliation to President Trump's latest announcement slapping tariffs on another $300 bn worth Chinese exports. Further, with economic activity slowing down, the weaker currency will boost Chinese export competitiveness.

Incidentally, the Government also issued an order to state-owned companies to stop Chinese purchases of US agricultural products.

2. More from FT on the ongoing turmoil in the world of auditing, one of the most important watchdogs of capitalism. Sample this defence by Grant Thornton boss David Dunckley when probed by UK MPs on the firm's audit of scandal-hit cafe chain Patisserie Valerie,

“We are not giving a statement that the accounts are correct... We are saying they are reasonable... We are not looking for fraud.”

And about the egregious accounting misdemeanours of KPMG,

Accounting rules do not stop auditors signing off on numbers divorced from reality. They allowed Carillion to treat £1.6bn of goodwill from acquisitions as permanent assets — 35 per cent of its total — and not write down any of the value despite signs the businesses were struggling. One, Eaga, had its goodwill valued at an unchanged £329m even as losses mounted and it was only kept solvent by Carillion’s financial support. Similarly, accounting rules allowed too much contract revenue to be recognised, profit from partnerships and joint ventures to be consolidated as the company’s own and early payment facilities to inflate cash inflows while obscuring true levels of debt. Auditors’ roles still do not include challenging a company more strongly on its ability to continue operating — new proposals are only being worked on. Nor are auditors’ roles any more separate from their employers’ consulting arms, which can earn big fees from audit clients — again, removing these conflicts are still only proposals.

3. What if there is a trade-off between the effectiveness of the roll-out of 5G spectrum and the government's revenues maximisation policy from spectrum auctions? FT points to a very interesting angle to the global 5G race - cost of ownership of spectrum.

Chinese operators have picked them up for free — part of Beijing’s attempt to have a national rollout of 5G. Yet in parts of Europe recent auctions have been so expensive that at least one company has had to cut shareholder dividends. In the US — where President Donald Trump has declared that “the race to 5G is a race that America must win” — spectrum licences are being sold at historically low prices... For the telecoms operators the licences are the “ticket to ride” — access to the infrastructure that will be critical to their future success, even existence. For governments they are no less important yet some cash-strapped administrations have been sending out mixed signals over how to strike a balance between raising billions from a sector already straining to reduce costs while stimulating investment in the rapid deployment of 5G services... China granted its spectrum licences to the country’s telecoms networks in June rather than selling them off. The US then unveiled its biggest ever sale of spectrum in July boasting of a plan to auction off, by the end of the year, more airwaves than the country’s combined mobile industry currently employs. It has set the bidding for some of the very high frequency bandwidth at a value of one 10th of a cent per megahertz per capita making those airwaves some of the cheapest ever sold.

This has strong resonance in India where telecom operators are struggling to make investments on the face for an ultra-competitive market coupled with exorbitant prices paid for spectrum ownership. But it is unlikely to stop the government in India,

Other governments see spectrum — the airwaves used to carry mobile phone and other electromagnetic signals — as a cash cow. India’s telecoms regulator has just proposed selling blocks of spectrum for 5G at a price that is 40 per cent above what was charged in other Asian markets. Auctions in Italy and Germany have raised huge sums. Vodafone was forced to cut its dividend for the first time in its history following the German sale, amid industry warnings that the more they spend on spectrum, the less they have to spend on building the network via new masts, servers and base stations.

For a country whose telecoms sector is struggling, an expensive 5G spectrum auction can be one too far. But will the government, equally struggling to balance the fisc, realise this and exhibit some temperance?

4. Eswar Prasad has a very good article which summarises the costs of currency wars. For the US, it is hard to imagine any scenario where the US Dollar would end up depreciating,

The US has shown little interest in any fine distinctions between market-driven currency depreciations versus targeted policy-driven devaluations, viewing all currency depreciations relative to the dollar as hostile economic acts. A currency war would do little to boost US growth prospects. It is much harder for the US to push down the value of the dollar, ironically because of the currency’s dominant presence in global financial markets. It would be difficult to engage in unilateral intervention on a scale sufficiently large materially to affect the dollar’s value against other major currencies — especially if the Federal Reserve stayed on the sidelines in such an endeavour. Besides, such a move would incite a broader currency war, with other countries stepping up their own retaliatory intervention. The resulting turmoil in financial markets could actually firm up the dollar’s value if investors turn to it for safety.

5. Daron Acemoglu has the best summary of the case against UBI that I have read,

UBI, which is parachuted from above as a way of placating the discontented masses. It neither empowers nor even consults the people it aims to help. (Do workers who have lost their middle-class jobs want government transfers or an opportunity to get another job?) As such, UBI proposals have all the hallmarks of the “bread and circuses” used by the Roman and Byzantine Empires – handouts to defuse discontent and mollify the masses, rather than providing them with economic opportunities and political agency. By contrast, the modern social welfare state that has served developed countries so well was not handed down by tycoons and politicians. It aimed to provide both social insurance and opportunities to people. And it was the result of democratic politics. Ordinary people made demands, complained, protested, and got involved in policymaking, and the political system responded. The founding document of the British welfare state, the World War II-era Beveridge Report, was as much a response to political demands as to economic hardship. It sought to protect the disadvantaged and create opportunities, while encouraging civic engagement.

The whole argument in favour of ideas like UBI and (certain forms of) direct cash transfers is lazy, and borne out of ignorance, a naive belief in the value of efficiency over other considerations, and lack of any understanding of how the real world works. 

6. FT has this on rising elderly bankruptcy in the US,

The elderly are far more visible in US bankruptcy courts these days than in previous generations. Baby boomers aged 65 and older are racking up far higher levels of debt than their parents, who were raised during the Great Depression, and a growing minority are finding themselves tipping over from desperate financial trouble into bankruptcy. The culprits are vanishing pensions, soaring healthcare costs and tens of thousands of dollars in unpaid student loans for themselves, their children and even their grandchildren... In 1991, over-65s made up only 2 per cent of bankruptcy filers, but by 2016 that had risen to more than 12 per cent... Over the same period, elders grew as a percentage of the US adult population too, but only from 17 per cent to 19.3 per cent... In 1989, only one in five Americans aged 75 or older were in debt; by 2016, almost half were, according to the most recent US Federal Reserve survey of consumer finances.

7. Finally, Noah Smith on how the rules of the game can be tweaked to bring greater role for workers in wage setting. Proposals include multi-employer or sectoral wage bargaining, wage councils or wage boards, German-style industry and regional level collective bargaining through worker's councils etc. 

US and China - the Trump re-set

Ananth points to the nice article by John Pomfret justifying a re-set in US-China policy from the conventional wisdom of co-operation and friendship (or "shape what China does") that has been followed for decades. He argues that such a policy disregards the underlying intentions of the Chinese Communist Party,

Since the financial crisis of 2008 and the rise of President Xi Jinping, China has stopped market-oriented economic reforms, launched a massive crackdown that has resulted in the incarceration of more than 1 million Uighurs in Xinjiang, ramped up efforts to steal Western technology, broken a promisemade to a U.S. president not to militarize the South China Sea and tried to export its system abroad. It has squeezed aspirations for democracy in Hong Kong and launched a campaign to undermine the democratic system in Taiwan.

And this is the nub of the matter and what is required,

The Trump administration is the first one in decades to tell China that the status quo is broken. What China watchers should be doing is building on that insight, and not returning to promises of a kinder, gentler policy that wouldn’t have worked in the 1940s and won’t work today.

The Scholar's Stage blog places the evidence on record about how US miscalculated on China and offers this summary,

The sad truth is that the Party has a say in its own fate. We moved. They countered. They took decisive measures, some quite costly, to ensure that the West's attempt to peacefully liberalize their regime would not succeed. They loudly proclaimed their intention to do this all the way back in 2008; this resolution was aggressively translated into policy between 2010 and 2014. The decision to tighten the screws under Hu Jintao and Xi Jinping was openly articulated as a direct response to Western attempts to change China and liberalize the Party... The tragedy of American policy making in the 2010s is that we refused to recognize what they were doing. Our politicians and pundits discoursed on the "choice" the Chinese faced before them long after they had made it. The gambit had failed. We were slow to recognize it. Eventually a rough national consensus that engagement was no longer a winning strategy came about, though it came seven years too late. Now that this consensus has been reached and a clearer-eyed vision of the Communist regime finally lies before us, panicked notes of the departed are heard again. "Trust us!," go their nervous murmurings. "This is how we wanted it to be!" 

From hindsight it is a compelling argument that the US committed the mistake of not engaging more actively with the Russia of Mikhail Gorbachev and Boris Yeltsin in the post-Cold War nineties and disbanding the NATO (or at the least not expanding NATO to include the Eastern Bloc nations). Clearly the scars of the Cold War were so strong that it was unrealistic to expect the US foreign policy establishment to be able to seize the moment and pivot in the opposite direction. When the raison d'être of too many parts of the establishment was anti-Soviet activities, it would have been foolish to expect them to do so. And in the absence of top quality political leadership, the status quo prevailed. This Keith Gessen essay is a revealing exploration of America's Russia policy.

In case of China, the miscalculation has similarly been on the other direction. While the post-USSR Russia policy of the US establishment was encumbered by the Cold War experiences, the China policy appears to have been excessively influenced by the post-Nixonian ideological consensus amplified by the economic partnerships that the US economic elites entered into with China in the globalisation era. Both proved impervious to history, facts and logic. 

For India, there is no denying the appeal of Trump's policy on China. This blog has consistently argued in favour of President Trump's policy on China, even with all the very frequent whimsical actions and flip-flops. 

Let me also clarify one thing to avoid any moralising on the issue. There is no point adjudicating on whether the US or the Chinese economic model is superior. Or even whether the US has been more benign that China will be - remember that for all of nineteenth and large parts of twentieth century, the US was hardly benign, and everything can suddenly appear benign after the "war" has been "won". China is perhaps only doing what any large emerging power would have done, though, as I have blogged earlier, the Xi Jinping turn is doing itself more harm than good. 

Weekend reading links

1. Cash surpluses mount across corporate America. Berkshire Hathaway's cash pile jumped to $122 bn amidst the rising stock markets,

Mr Buffett has struggled to clinch a significant takeover in recent years. In a letter to shareholders in February he warned that prices for businesses were “sky-high” and that the group is likely to invest in stocks as it hopes for an “elephant-sized acquisition”... “The inability to identify attractive operating companies to acquire…that is a problem that has persisted for a long time,” James Shanahan, an analyst with Edward Jones said. “This cash balance growing out to a new record level is frustrating to a lot of investors, but they have been taught over decades to appreciate the management team will be cautious and wait for opportunities.”

Google's parent Alphabet has overtaken Apple to hold the largest cash pile in corporate America, touching $117 bn. Faced with pressure from activist investors, Apple has had to pare down its surplus to $102 bn from $163 bn at end of 2017. Google's rising pile is despite spending $25 bn last year, much of it on real estate - office holdings in cities and data centres. Since the end-2017 US tax reform lowering the tax rate on US companies' overseas cash reserves, 

Apple has responded to the change by spending $122bn on buying back stock and paying dividends in the past 18 months. Other companies to dig deep include Cisco Systems, which has cut its cash holdings from $35bn at the time of the new tax law to only $11bn. Alphabet’s stock buybacks, by contrast, have been paltry. In the nearly four years since it began repurchasing its own stock, it has spent an average of only $1.7bn a quarter.

2. Very good profile of Annagret Kramp-Karrenbauer, the Secretary General of the ruling Christian Democratic Union (CDU) in Germany and the new Defence Minister, and also the women tipped to replace Angela Merkel as German Chancellor.

“I don’t know what she stands for,” says Christoph Hartmann, a former liberal politician who was her deputy prime minister in Saarland. “[Former chancellor Helmut] Kohl stood for German reunification, [Gerhard] Schröder for welfare reform, [Willy] Brandt for rapprochement with the Soviet bloc. But AKK — she has no vision. She is like Merkel — a person without qualities.”

3. FT has a fascinating article at how Russia is using cutting-edge technology to track and tax transactions in real time, thereby dramatically lowering leakages in VAT,

To address the leakage, Russia built two huge data centres and legislated so that companies had to submit every invoice between businesses. It also mandated every retailer to buy new cash registers that were linked securely and directly to the data centres. In real time it can now check every invoice to ensure VAT refunds it pays are linked to invoices where companies have remitted the same money to the authorities. Then using artificial intelligence, it can quickly find patterns in the data and companies which have many broken links, allowing the authorities to target certain companies for a tax audit. Since everything is linked, it can also spot tax officials with a low collection rate from the companies for which they are responsible... The authorities receive the receipts of every transaction in Russia, from St Petersburg to Vladivostok, within 90 seconds... The 20 per cent VAT gap has now fallen to 1 per cent and, as collection has become more efficient, receipts have soared. Between 2014 and 2018, the money collected from VAT rose 64 per cent, compared with a 21 per cent increase in nominal household consumption over the same period...The VAT tax gap between revenue due and revenue collected was about 20 per cent in Russia before its reforms, according to Mr Mishustin, and in a mature economy such as the UK, HM Revenue & Customs estimated it at 9.1 per cent in 2017-18.

And Russia and other countries are using nudges to get tax-payers to comply,

The Russian authorities are seeking to extend technology-led tax collection into the informal economy... Those that sign up to a new smartphone app pay 4 per cent of turnover, deducted automatically from their bank account, on services. Take-up so far this year has exceeded expectations since compliance guarantees the authorities will not chase people further for unpaid tax... Portugal, an early adopter, added an extra incentive for shoppers to pay VAT and ensure retailers did the same. If consumers add their personal tax number to an electronic receipt, the number is added into a monthly lottery for a substantial prize, such as a new car... consumers in areas that have seen high VAT evasion, for example restaurants, can get a 15 per cent deduction on the VAT paid from their annual income tax assessment... In many Nordic countries, Mr Sanger says, the authorities have sufficient verified data that they can hand out pre-filled tax returns and ask individuals to simply approve them.

Quite apart from its role in plugging leakages, given this, technology, by helping screen and zoom into the real evaders, may well turn out to be a big contributor to limiting harassment by tax authorities. 

4. The bidding for third round of India's toll-operate-transfer (TOT) concessions for India's national highway roads has been flagged off, with 27 companies showing interest. The TOT bundle comprises 9 stretches covering 566.27 km across four states, and has a reserve price of Rs 4995.48 Cr.

The first round in February 2018 saw Macquarie offer Rs 9691 Cr against the expectation of Rs 6258 Cr for 700 km, while the second bundle over 584 km was cancelled due to bids being far below expectation.

5. Simon Kuper advocates abolishing undergraduate teaching at Oxford and Cambridge to break down elitism in England,

Oxbridge recruits more pupils from eight schools (six of which are thought to be fee-paying) than from 2,900 British state schools combined, and spits them out at the other end as the proto-ruling class... After all, Canada, Australia and Sweden have private schools, but they also have above-average social mobility... That’s partly because private school in these countries doesn’t lead to a world-beating university, since Canada, Australia and Sweden don’t have world-beating universities. They just have lots of good ones, none of which confers a life-changing advantage... It’s similar in Germany, the Netherlands and the other Nordic states. You get a decent education, then have to prove yourself on the job market. Interestingly, all these countries are wealthier and almost all have better state schools than Britain. They also avoid many British nightmares: no doors closed at 17 to everyone who doesn’t get the letter from Oxbridge. No bitterness as the excluded are slow-tracked through their careers, overseen by an Oxbridge Brahmin caste... And in countries without elite universities, it’s rare for one class to capture the national heights: careers are decided more in adulthood, by which time people’s trajectories depend slightly more on their achievements than on their parents.

6. Yet more evidence of how closed a group the elite consensus in the US is, this time from the educational backgrounds, in terms of where they studied, of newspaper interns in the US,

65% of summer interns from a group of publications including The New York Times, the Washington Post, the Wall Street Journal, NPR and Los Angeles Times, came from among very selective universities in the nation. The New York Times, The Washington Post and Wall Street Journal especially recruited from the top 1% of schools ranked by selectivity.

7. Daron Acemoglu and James Robinson write,

In Why Nations Fail we argue that it is indeed differences in economic institutions that explain the comparative development of the Koreas, and the rest of the world. We make a distinction between inclusive economic institutions; which create broad based economic incentives and opportunities; and extractive economic institutions, which do not. The source of these institutions is political. They are chosen collectively as a consequence of social choices which are heavily shaped by political institutions. A society gets inclusive economic institutions because itís political institutions generate them as an equilibrium phenomenon. We call institutions which do this inclusive political institutions which have two dimensions; a broad distribution of political power and a strong (or effective or capable) state. When either condition fails, when power is narrowly concentrated or when there is a weak or ineffective state, we say there are extractive political institutions. In a nutshell, poor countries have extractive economic institutions as a consequence of extractive political institutions. Rich countries have the opposite combination, inclusive economic institutions underpinned by inclusive political institutions.

If we accept this argument, then the biggest danger of widening inequality is that it can lead to capture of the political institutions and their becoming extractive in nature. It is then only a matter of time before the economic institutions too become extractive.

8. Finally, an India NBFC fact of the day which underlines their importance and the impact of a liquidity squeeze among them,

In India, NBFCs have in recent years helped fund nearly 55-60% of commercial vehicles both new and used, 30% of passenger cars and nearly 65% of the two-wheelers in the country, according to rating agency ICRA.

The changed nature of infrastructure financing and its consequences

As we discussed in the oped, asset stripping has become a common feature of infrastructure PPPs. The story is same everywhere - water, railways, airports. It is true on both sides of the Atlantic, United Kingdom and United States. In fact, it is pervasive across the alternative investments world in general - Greybull Capital and British Steel, Carlyle and ManorCare nursing home chain, Thomas H Lee Partners and Simmons Bedding, Edward Lampert and Sears etc are only some of the recent examples.

It is instructive to look at the evolution of the global infrastructure financing market. Some time back, I had blogged describing its evolution,

The first phase was about simple long-term post-construction (with public finance) concessions, especially in countries like Latin America. Then countries like Australia, Canada, and England led with PPPs involving bundling of construction and O&M to initially construction contractors, then construction-cum-O&M consortiums, and finally finance-construction-O&M consortiums. The area of project finance and public bond issuances emerged to support PPPs. Then the likes of Macquarie created exit opportunities for construction contractors and a secondary market for infrastructure assets using privately raised infrastructure funds. Gradually, the private equity players found infrastructure assets a source of stable and reasonably attractive income stream, with ample opportunities for asset-stripping and pass-the-parcel game over the asset's long life-cycle. Now, there is a growing realisation in the developed economies, especially in Europe and the US that private participation is not only not cost-effective but also fraught with problems, and much greater public participation and strict regulation may be necessary in infrastructure projects. The full circle has been completed.

And in another context,

There is a growing trend of "pass-the-parcel" deal making (or secondary deals) in private equity space, where one PE firm sells stake to another. Last year the industry did a record 576 such deals. The trend has been associated with successive owners paying themselves large dividends, leveraging up, skimping on investments and maintenance, piling up unpaid pension obligations, and passing on to the next firm when they have squeezed out all the juice they can. In industry lingo, the existing owners "sweat" the asset as much as they can before passing it on.

There used to be a time when infrastructure projects were owned/operated by large infrastructure contractors/firms. They raised finance directly from banks and long-term or patient investors like pension funds and insurers who would subscribe to capital market issuances to finance infrastructure projects. The returns on these investments used to be moderate, the investments relatively illiquid, and the risk lower. Infrastructure was the boring, low-risk, and low-return area.

Then we had a period of financial innovation and engineering. When we look at PPPs in infrastructure today,  these assets are largely operated/owned not by infrastructure companies but by financial investors. The entities which operate/own and finance infrastructure investments are financial investors, alternate investment funds (AIFs) - infrastructure funds and private equity. The pension funds and insurance capital, instead of directly investing in bonds and the capital market, have come to channel their funds through the alternative investment vehicles.

This shift has had the perverse effect of distorting incentives in the market for infrastructure assets. By their very nature (and the examples from the mainstream PE world above illustrate this), the incentives of private equity etc are excessively aligned towards short-term and profiteering for their investors, and passing the parcel along.