Deregulation gone rogue in airline industry

When FT or Economist writes about the harms inflicted by deregulation, it's a good time to start taking it seriously.

The deregulation of the US airline industry and the breaking of the US air traffic controllers strike by Ronald Reagan are considered seminal moments in the triumph of the free-market orthodoxy in the late seventies and early eighties. 

However, that wave of deregulation and privatisation has since played itself out with its problems and failings being exposed. I have blogged earlier on the roll-back of railways privatisation in UK, the problems with water privatisation, and the general reversal of the trend towards private participation and PPPs in infrastructure in Europe. 

The recent disruptions from mass cancellations in the US airline industry has drawn attention to the problems associated with excessive deregulation and the absence of adequate investments in capacity. In a recent article, the FT wrote thus,

Is this period of disruption for America’s air travel industry a short-term consequence of the pandemic or the culmination of long-term under-investment and shortcomings in regulatory scrutiny... A Gallup poll in August found that 37 per cent of Americans held a negative view of the airline industry, compared with 27 per cent who held a favourable impression... Despite widespread customer dissatisfaction, the three major companies — United Airlines, American Airlines and Delta Air Lines — reported combined fourth-quarter net profit of $2.47bn on revenues of $39bn... Passenger yield — the revenue from each person flying one mile — was higher in 2022 than in 2019... “The US [has] the largest, most complex air system in the world,” says Joe Rohlena, an airline analyst with Fitch Ratings. “Like it or not, when something goes wrong in one part of this system, it’s going to have relatively large effects. Without improvements that need to happen, it’s not going to run flawlessly.”

The roots of the current malaise can be traced back to the era of deregulation,

The roots of the current US aviation system spring from the 1978 Airline Deregulation Act. In the four decades prior, the US government was responsible for regulating the air service. Prices and routes were set by the Civil Aeronautics Board, which based fares on airline costs plus a 12 per cent profit. Republican President Gerald Ford began the push towards deregulating the industry, a mission later championed by Democratic Senator Ted Kennedy, who argued it would lower fares and allow more people to fly. Airlines themselves were among the most vocal opponents, saying the shift would destabilise the industry... When President Jimmy Carter signed the bill in 1978, it allowed airlines to fly any route they wanted, charging any price the market would bear. Dozens of new airlines formed, paying their crews lower wages than the established players. Labour unrest gripped the industry, and fares plummeted as airlines battled for market share. Many adopted the hub-and-spoke model, using major airports as a central hub for connecting flights, allowing airlines to maximise efficiency but eliminate many nonstop routes.

The new world order toppled titans Pan American World Airways and Trans World Airlines (TWA), which filed for bankruptcy in the 1990s. United Airlines filed in 2002, in the aftermath of the 9/11 terrorist attacks, and Delta Air Lines followed three years later. It has been reported that, years later, Kennedy cornered Phil Bakes, the man who persuaded him to champion deregulation, at a Democratic Party event and chastised him for misleading him about its effects. The bankruptcies led the airlines to fixate on cost-cutting and to avoid investing in their operations, including expensive but necessary IT infrastructure... In the next decade, airlines rewarded shareholders with stock buybacks instead of improving their services, resulting in the zero-slack system infuriating customers today. As airlines sought to increase revenue, they downsized seats and introduced fees for services previously included in the airfare. Planes have grown increasingly crowded, with the load factor inching upward from 72 per cent in 2002 to 83 per cent last year. 

The FAA, too, has struggled to invest in infrastructure and operations. The agency now has fewer employees to manage airspace that has grown more crowded from both commercial flights and the proliferation of drones. It also has suffered from precarious Congressional funding. Only once since 1982 has it received funding for a five-year period, making long-term planning difficult. Instead, the agency has been plagued by continuing resolutions on Capitol Hill that force it to plan how air traffic control will operate if federal employees are forced to stop working due to a government shutdown. The trend accelerated when a wave of candidates from the Tea Party, a one-time anti-government faction within the Republican Party, were elected to Congress in 2010. Temporary reauthorisation had been extended 23 times from 2007 until Congress voted in favour of the FAA Modernization and Reform Act of 2012.

The consequences of deregulation has not been benign,

The concerns raised by opponents of deregulation came to pass: the airline industry has increasingly consolidated. Between 2008 and 2013 there were a series of megamergers in which United, Delta and American Airlines each swallowed a similarly sized competitor. The four major US carriers and their affiliate regional airlines now control 80 per cent of the routes in the United States, says William McGee, senior fellow for aviation at the American Economic Liberties Project, an anti-monopoly think-tank. Unlike the glut of new competitors that flooded the market in the 1980s, only two new airlines have launched in the past 16 years. Average airfares adjusted for inflation have fallen since 1978, but the benefits are spread unequally among customers. Heavily trafficked routes or those where low-cost carriers operate do offer lower fares, while prices have risen on routes to smaller cities. Passengers also typically face extra costs, such as bringing luggage — a move that has paid off for carriers. US airlines derived less than three-quarters of their operating revenue from fares in the first nine months of 2022, compared to 89 per cent three decades ago.

The fundamental problem that needs to be highlighted is that deregulated free market competition invariably results in a race to enhance efficiencies primarily by cutting costs, limiting investments, and maximising profits. The incentives of private participants get distorted big time. The outcome in the medium term is higher prices, asset stripping, and reduced service quality. This is the iron law of deregulation.

It's important here to make two points. One, the baseline of regulation is important. The problem is less with deregulation per se, but with excessive deregulation of the kind mentioned above. It's the ideological belief, instead of practical choices, that's the problem. Unlike developed markets which are typically already deregulated for private participations in most sectors, many developing countries could do with greater deregulation. An example is that of power generation in Africa where the entire sector is government owned and heavily regulated. It could do with deregulation. 

Two, the success of deregulation depends on the capability to regulate. Given the innate incentives of the private sector, deregulation should be accompanied by strong capacity to monitor and enforce the existing regulations and private contracts. This depends on state capability, which is unfortunately acutely deficient in most developing countries. In its absence, deregulation is a recipe for state capture and crony capitalism.

Weekend reading links

1. Market concentration fact of the day - English Premier League edition

During a frantic January transfer window in Europe, English clubs spent €830mn, almost double the previous record. Chelsea alone spent more than all the top-tier clubs in Italy, Spain, Germany and France combined, a sign of the Premier League’s increasing financial dominance over the world’s most popular sport. Of the top 10 biggest spenders in Europe this season, all but one play in England... Deloitte’s league table of the 20 wealthiest teams in Europe now includes 11 English clubs, up from seven a decade ago...  Only one French team and three Italian clubs make it into the top 30 clubs by revenue, according to Deloitte...

Javier Tebas, chief of Spain’s La Liga, accused the Premier League of allowing its wealthy club owners — from Middle Eastern petrostates to US private equity billionaires — to weather “barbaric” losses, which put the health of the broader game at risk by driving up costs for everyone else. “It is quite dangerous that the [transfer] markets are doped, inflated, as has been happening in recent years,” he said. “That can jeopardise the sustainability of European football.” 

This comes even as a recently released report of a four year investigation by EPL found that Manchester City, the current champions and the richest club, and owned by the Abu Dhabi royal family since 2008 had indulged in more than 100 breaches of the League's financial rules. This adds more fuel to the perception that English clubs have enjoyed an unfair advantage due to light-touch regulation, which allows it to attract wealthy Middle Eastern and American owners who have the deep pockets to absorb large losses. 

Club owners include a Serbian-born media tycoon, a Greek shipping magnate, the Saudi sovereign wealth fund, and several American billionaires, making ownership something of a status symbol for the mega-rich. “Owning shares in IT companies and property in Manhattan is not as sexy as owning a Premier League club,” says Francis. Without billionaire benefactors, other leagues in Europe have chosen to implement stricter financial standards. The idea is to stop teams living beyond their means in pursuit of glory. In Spain, La Liga’s economic controls require clubs to submit regular updates on their revenue, which the league then uses to calculate pre-determined spending limits. Last summer, those rules briefly barred FC Barcelona from registering new signings, before the Catalan club used asset sales to boost its balance sheet. The league has since tweaked its controls to make that harder to do. In Germany, ownership of clubs is guarded by the so-called 50+1 rule, which prevents outside investors from acquiring controlling stakes in most teams, leaving clubs to rely on their own income to fund themselves. The Bundesliga says these rules help protect German football from “reckless owners”.

2.  FT writes how the B Corp, an ESG certification benchmark widely recognised as the gold standard, is being abused in the form of green washing. In order to achieve B Corp status firms have to ostensibly "meet high levels of overall social and environmental performance, public transparency and legal accountability to balance profit and purpose". 

There are now over 6400 companies across 158 industries certified as B Corp, including several multinational companies with deeply questionable ESG claims. The certification is done by a non-profit network B Lab Global and its national chapters. 

There are limits to the certification. A company may commit to paying its own employees a fair wage but there is no requirement to extend this further down the supply chain. If a company makes increased profits, how it deploys those funds is not for B Lab to dictate. It could invest in growers or farms, increase staff wages, install solar panels — or just ramp up dividends or executive pay. For these and other reasons, questions linger over whether B Corps are enacting truly meaningful change internally and whether the effects of that change is being felt more widely. Another UK executive says that while the certification helped show the company in a good light when pitching business to clients, beyond that he does not really think about the larger purpose of the movement. “Companies are keen to say we have a social purpose, therefore we have a good company,” says Mark Goyder, a corporate governance expert and founder of business think-tank Tomorrow’s Company. “But they don’t emphasise the how. Here are the ways we underpin this, how do you ensure values are upheld and how do you govern things like culture?”...

Companies gain B Corp status based on how they score out of 200 on a variety of metrics across governance, treatment of workers and customers, community and the environment. The process can be long and expensive — anywhere between $500 and $50,000 each year — and this has to be reappraised every three years. Companies, which have to get at least 80 points, are also required to legally cement the B Corp commitment into the mission statement of their company... the points system allows companies to pick and choose which criteria apply to them, usually with the help of sustainability consultants, and focus on meeting them.

3. Supply chains relocating out of China

The shift away from mass textile production in the country, albeit still in its early stages, marks the reversal of years of outsourcing to a region that has come to dominate the textile supply chain. Big names such as Mango and Dr Martens have recently cut or signalled their intention to shift manufacturing out of China or south-east Asia... Dr Martens (the bootmaker) has moved 55 per cent of its total production out of the country since... 2018. Just 12 per cent of its production for the 2022 autumn/winter collection was manufactured in China compared with 27 per cent in 2020 and it estimated this will drop to 5 per cent this year... The relocation was also being driven by stricter laws being introduced in the US and Europe against labour abuses, she added, following the alleged use of forced labour in the cotton-rich territory of Xinjiang in China... According to statistics from China’s National Bureau of Statistics, the average factory wage doubled between 2013 and 2021, from Rmb46,000 ($6,689) per year to Rmb92,000.

For all such talk China remain the export behemoth in sectors like textiles  

4. McKinsey is the latest to announce mass layoffs. 

McKinsey & Co. plans to eliminate about 2,000 jobs, one of the consulting giant’s biggest rounds of cuts ever... Under a plan dubbed Project Magnolia, the management team is hoping the move will help preserve the compensation pool for its partners, the people said, asking not to be identified discussing non-public information... Companies in industries from finance to technology to retailing are reducing staff amid a slowdown in demand and predictions of a looming recession. Tech giants including Amazon.com Inc. and Microsoft Corp. have announced plans for deep cuts, and Goldman Sachs Group Inc., Morgan Stanley and other top banks have been eliminating thousands of positions.

I have been thinking about this. I wonder how much of the spate of layoffs in corporate America has been triggered by Elon Musk. Musk culled the vast majority of Twitter workforce after takeover and that does not, at least till now, have had any major adverse impact on the company. For businesses waiting to seize any opportunity to cut costs, this would have been the trigger. Besides, they could use the excuse of the pandemic hirings etc to justify the layoffs. 

5. Good FT article on how Apple has hooked Gen Z consumers and entrenched itself

Gen Z users — those born after 1996 — make up 34 per cent of all iPhone owners in the US, versus 10 per cent for Samsung, according to new data from Attain, an adtech data platform... As Gen Z is the most online of any age group — spending up to six hours a day on their smartphones — the iPhone’s dominance is shaping the social circles of young Americans... The propensity of Gen Z to purchase iPhones — or convince their parents to — comes even as the average price of an iPhone approaches $1,000, roughly three times the average Android device globally, according to Counterpoint. The Gen Z preference for iPhone is more pronounced in the US than elsewhere, but when market intelligence group Canalys did research in western Europe it found that 83 per cent of Apple users under 25 years of age planned to keep using iPhone. The percentage of Android users of the same age who plan to stick with Android was less than half that.

6. Andy Mukherjee has two excellent graphics that shows how the Adani Group companies differ from the remaining companies of corporate India. 

The sharp difference between return on capital employed and stock market returns over the last three years

And that over this year till date

7. In the context of talking about Elon Musk, Palanivel Thiagarajan, the Finance Minister of Tamil Nadu, has this piece of eternal wisdom,

"... if you get successful very quickly, and very successful, it's a very dangerous thing because it starts putting the notion in your head, that somehow you exist in a different plane than the rest of us. And I don't mean that in terms of racism and classism. I mean, you start thinking that you're such a genius that you can't get anything wrong... that you have this unique ability to always see everything perfectly, and predict and manage and run all the stuff. And I've seen it before in large hedge funds, in large banks, in fact at Lehman, we saw some of that. And that almost always ends one way. Or, in fact, every time it ends one way. The only question is how long. It ends with you getting way ahead of your abilities. Because the reality is, and I'll say this in a very very important message to the youth. The reality is that you could be successful 100 different ways through a different combination of circumstances, and you could lose or fail at something a 100 different ways. So it's very hard when you're successful to either assume that you are very smart or very good or uniquely qualified. And the same way just because you fail at something you shouldn't let that failure determine your self worth or your self understanding or realisation... Everything is redeemable. All failures are redeemable, all success is temporary. There is no guarantee of any of this stuff. But most people who get really successful really fast forget that."

I'm also reminded of this in the context of this article in The Economist about the new tech and self-centric worldview of the technology billionaires of Silicon Valley. 

8. The Ken examines the economics of fashion e-commerce sites in India (Mantra, Flipkart, Amazon, Jabong etc) and finds that their commercial viability is questionable.

These companies have done almost everything they can to squeeze profits. They’ve created private labels, resorted to favourable terms of sale, and achieved reinventorisation. Most recently, they’ve even started charging some customers for returns—something unheard of so far. And yet, profits continue to elude them. So it’s time to ask—will profitability ever come?

Despite the much higher margins of 35-40% these sites demand from sellers, the biggest challenge for fashion e-commerce sites comes from the very high percentage of sale returns. Typically fashion and apparel have return rates of 35-40%. This from an article in The Economic Times

There’s bad news for fashion retailers hoping to cut real estate expenses by venturing into ecommerce — running an apparel business online is almost just as expensive as running a brick-and-mortar store in any mall... Some fashion brands that entered the online space in the past five years claim to be paying 30-40% commission to ecommerce platforms such as Jabong, Flipkart, Amazon, Myntra and Koovs for sales and product delivery... This is almost as much as they would pay to run a physical retail store, which includes costs like rental (15%), staffing and utilities (8-10%) and maintenance and discounts (5-6%), according to Arvind Singhal, chairman of retail consultancy firm Technopak Advisors.

9. Some snippets on bank credit growth which points to the lop-sided nature of India's economic growth

Six of every ten personal loans were for homes and vehicles as of 31 January 2023, according to the RBI’s latest bank credit data. The two categories combined have surpassed the loan amount given to the entire agricultural sector. The real-estate sector is also observing some unprecedented developments: residential properties priced above Rs 1.5 crore (~US$181,300) accounted for ~30% of total sales—the highest ever proportion—across the country in 2022, according to a 2023 report by Knight Frank, a global property consultancy. This share was ~23% in 2021, similar to pre-pandemic levels... Overall, the launch of luxury properties priced above Rs 2.5 crore (US$302,000) doubled in 2022, said Mumbai-based real-estate-services company Anarock Property Consultants in its report... “Sales of apartments priced over Rs 1.5 crore (US$181,300) doubled in 2022 in India. Luxury projects priced above Rs 2.5 crore (US$302,000) in tier-1 cities are getting sold out at the pre-launch stage. Inventory overhang for such projects is at a decadal low,” said a senior employee at JLL India, a real-estate services company. 

Similar trends of higher growth at the premium segments are visible in vehicles market. 

... domestic sales of utility vehicles outpacing that of passenger vehicles (PVs) by more than 185,000 was witnessed in 2022, showed data by the Society of Indian Automobile Manufacturers (Siam)... A Siam official broke down the data. “While compact SUVs (sport utility vehicles) were the go-to option in 2021 and for the most part of 2022, cars priced well above Rs 15 lakh (~US$18,000) drove the growth in the later half of the year and the first month of 2023.”... Audi reported a 27% year-on-year (y-o-y) sales growth in 2022 on the back of newer launches. Meanwhile, Mercedes Benz and BMW have registered a y-o-y growth of 41% and 37%, respectively, largely driven by the demand in tier-1 cities... outstanding car loans have spiked by ~25%, according to the RBI’s data.

Another aspect of the credit growth story is this

In the one year from 30 December 2021, retail loans grew over 20%, while trade advances rose ~14%. During the same period, loans to industries grew by ~9%.

10. An example of the hypocrisy on climate change is the passenger vehicle ownership and usage patterns in the US. 

The average new American car purchased in 2021 weighed 1.94 tonnes, fully half a tonne more than the European average. Purchases of SUVs and “light” trucks together now account for four out of every five new vehicles bought in the US, up from one in five 50 years ago. The pattern of car purchasing maps on to the US political divide. Republicans are more likely than Democrats to buy a new vehicle of any kind, and vastly more likely to buy a big one. About 65 per cent of buyers of the largest pickup trucks, utility vehicles and SUVs last year were Republican, compared with just 15 per cent bought by Democrats, according to a survey by the research company Strategic Vision. And this isn’t driven by America’s political geography. Whether you look at buyers in dense urban centres or isolated rural areas, trucks and SUVs are red, small hybrids blue. The divide becomes even more stark when Americans are asked to pick which attributes they look for in a new car: “aggressive”, “powerful” and “rugged” all rank among the top five selected by Republican-leaning purchasers. The US fleet of huge vehicles is down to identity, not necessity: individualism on wheels.

The heavy vehicles coupled with excessive individualism also takes its toll in the form of accidents,

Almost one in 10 drivers and passengers in the front seat of US cars do not wear a seatbelt, and 45 per cent say they often drive at least 15 miles per hour above the speed limit on motorways. In the UK, both measures are way lower, at 3 per cent. The grim result is that half of the car occupants killed in the US in 2020 were not wearing seatbelts vs 23 per cent in the UK. Speeding is implicated in 30 per cent of fatal crashes in the US but just half of that in Britain. All told, 43,000 people died on America’s roads in 2021, the highest mortality rate in the developed world by some margin. By my calculations, a fifth of those could be averted every year if rates of speeding and seatbelt-wearing matched peer countries.

Some thoughts for philanthropic donors working with governments in India

This final post draws on two earlier posts this week on the value of evidence and the role of innovation  in development. 

Given these observations, how should philanthropic donors and the organisations they support engage with governments to maximise their effectiveness? I'm specifically talking about support to implement ongoing programs, enhance state capabilities etc. 

For a start, it's worth always keeping in mind that in the Indian context most persistent public policy challenges are too complex for the marginal philanthropic funding to make a meaningful difference within reasonable time. The objective then should be to identify the highest leverage in terms of the activity or intervention, implementation unit, and the process proposed. 

This identification is a critical aspect whose importance is not adequately recognised. It demands a discovery process which donors and non-profits generally overlook. Even when they undertake some embedded initial exploration, it's soon becomes a routine and opportunistic engagement. For donors and implementation partners, this discovery process demands their highest level engagement for some period of time. It has to be also borne in mind that even when discovered, the scope and outcomes from such engagements will be modest and not as grandiose as the donor/partner may want. 

I believe the biggest challenge comes from the ideological priors of the donors or their implementation partners. Most donors come with their priors about the theory and process of change. As I have blogged on numerous occasions, these perceptions are deeply flawed and does not reflect the messy realities of development and public administration. 

In fact, this ideological cloud results in atleast two important distortions among the donors (and their partners).

1. They start to look for problems and solutions which fit into their priors. So they tend to look for those issues and solutions which are amenable for reasonably quick resolution. But these are often marginal to the larger problem, and/or not the priority of the government, and/or detracts from scarce administrative bandwidth. 

2. Strong priors marginalise the requirements of the government stakeholders. It's not uncommon for donors and their partners to pay lip-service to the requirements of the government agency and pursue their agendas. The absence of clear articulation of their objectives and priorities by the government stakeholder is often the convenient excuse. The result is limited government participation, interest, and ownership in the outcomes of the intervention. This problem is exacerbated by many donor/partner's proclivity to engage at their highest levels with only the political and bureaucratic leadership and not cultivate mid-level officials (the actual permanent implementers) within their government department partners. 

In this context, I can think of four common mistakes that donors make while engaging with governments:

1. There are very few important public issues where governments would require external support and which can be resolved in finite time. It's therefore important to be cautious on guarding against confusing psychological satisfaction at the appearance of having solved a problem without actually having solved it. Donors should shape their expectations about the ambiguities and uncertainties associated with their engagements and what can be achieved from them. This would also influence their own shaping of the expectations of their government partners from the engagement. 

It's easy to confuse and/or delude yourself into believing that you've made a difference when all you've done is staged an event or put a nice looking band-aid. Or done a small pilot. This is what most philanthropic interventions end up doing. 

2. A few high level photo-ops should not be mistaken for genuine government interest in the partnership. If someone offers support in addressing a complex public issue, then very few governments are likely to refuse it. The government has nothing to lose and no skin in the game. But getting important government leaders actively engaged and owning up the partnership is very hard and demands immense effort. The form of top-level ownership should not be confused with the substantiveness required. 

3. While top leadership engagement is important, the sustainability and success of any intervention is critically dependent on ownership by the Department or implementing agency. This requires active engagement and ownership of the senior and middle-level Departmental officials. They are the internal champions of change. Donors and their partners rarely spend the required efforts to cultivate Departmental officials. 

4. Most often, the external support ends up doing hygiene activities that are a source of nagging irritation for the primary stakeholder - like routine program/project management, recording meeting minutes and other documentations, preparing presentations etc. These routine things crowds out change requirements on serious issues. 

In light of all the above, I'll prescribe four essential requirements for any engagement by a philanthropic donor with governments (nothing new, but just putting it out there nevertheless)

1. Identify a stakeholder who is committed to the cause and has the administrative agency to decide and execute the decisions that emerge from the intervention. It's no good to have a high level approval of the Chief Minister or some high functionary who's not the Head of the administering Department. In fact, I'll venture that an engagement led by the Chief Minister's Office is most likely to fail for several reasons. Nobody wants to give up a photo-op on being seen to be doing something new, though very few are committed to actually being engaged actively in doing it. 

2. Let the stakeholder articulate the problem statement with hypotheses, about issue(s) agitating him/her and for which she/he wants external support. It's important that the individual concerned goes through the struggle of articulating the problem statement. Many times, the stakeholders themselves are not clear on what they want. Even more problematic is that (due to incentive compatibility issues) most often the researchers/donors have priorities which are marginal to the concerns of the stakeholder. 

Even if the donor/partner identifies a problem and solution through embedded or other exploration, it has to necessarily be validated as being a felt-need of the government leader. This is hard and requires conscious and intense effort. It's required to directly or through a very high quality consultant engage intensively with the individual leader to elicit and articulate the problem statement and hypotheses. Donor's should eschew the temptation to identify the problem and formulate the hypotheses for the government leader. 

3. The government leader should be actively engaged throughout the process with ideation and co-creation of the intervention. In simple terms, the successful implementation of the intervention is closely correlated with the intensity of engagement by the government leadership. This can be hard given the scarce time available for top officials for active engagement in such marginal partnerships. 

4. Finally, it's important for the partner to embed within the government agency and work with a team of officials identified by the government to execute the intervention/plan. In course of the engagement, donors and their partners would do well to keep in mind the four common mistakes outlined above and avoid them. 

Needless to say, like with any generalisations as above, there will always be exceptions. And it's also possible that I'm using too high a standard in making these suggestions.  

For these reasons, the simplest entry-point for donors/partners lies with supporting the implementation of specific programs. The task is clear and ring-fenced. The platform offered by these programs can then be used to consciously prioritise the building of implementation capacity in a purely opportunistic manner. 

Some thoughts on government interventions to prevent recessions

Ruchir Sharma points to a very important point about government interventions to prevent or mitigate recessions and its moral hazard and cushioning effect,

Faith in government as a saviour in recessions has been worming its way into people’s minds for most of their lifetimes. Since 1980, the US economy has spent only 10 per cent of the time in a recession, compared with nearly 20 per cent between the end of the second world war in 1945 and 1980, and more than 40 per cent between 1870 and 1945. One increasingly important reason is government rescues. Combined stimulus in the US, the EU, Japan and the UK, including government spending and central bank asset purchases, rose from 1 per cent of gross domestic product in the recessions of 1980 and 1990 to 3 per cent in 2001, 12 per cent in 2008 and a staggering 35 per cent in 2020. Though the 2020 recession was sharp, it was the shortest since records begin, lasting just two months. Government bailouts in the pandemic came so fast and large that it felt to many people, particularly white-collar employees working from home, as if the recession never happened. Their incomes and credit scores went up. Their wealth exploded with rising stock and bond markets. Now this experience of recession as a non-event seems baked into the professional psyche.

The article also points to the likelihood of a period of higher inflation,

The most lasting legacy of Covid may be its impact on work and wage inflation. One in eight people say they plan “no return” to pre-pandemic activities, including work... In conversations I hear chief executives saying that they have “pricing power” for the first time in decades... Meanwhile, the world is changing in fundamentally inflationary ways: birth rates have been falling for years but are now rapidly shrinking working-age populations. Countries are retreating inward, offshoring to the nearest and most friendly nations rather than to the least costly. The pressure from demographics and deglobalisation will push the new normal for inflation higher, closer to 4 than to 2 per cent.

Some observations

1. On the point about government interventions over the years leading to the build up of excesses, I am reminded of a Howard Marks newsletter (which I blogged here),

In the forestry business, if there's a small fire they let it occur and sometimes they even cause some small fires to burn up the fuel that lies on the forest floor. And if you don't permit any small forest fires, when you finally have one that you can't put out right away, you're going to have a doozy because of all the accumulated fuel on the forest floor.

I believe that if they prevent every recession, that will give rise to such excesses on the high side, it will be, as I say, unsustainable and will cause a recession and that's going to be a doozy. So it just seems to me that if I were running Fed, which I'm absolutely unqualified to do, I would opt for leaving it alone most of the time, the economy, and having it do what it does naturally...We're all in the investment business because we believe in the efficacy of the free market as an allocator of resources. So if you do, then shouldn't you leave the economy and the capital market alone as much as you can so that it can freely allocate resources?

Excessive interventions invariably come in the way of the self-correcting mechanisms of the market, of which recessions are one. However, no matter the logical arguments against such interventions, the political economy of the times cannot help avoid such interventions. In the circumstances, there is little to be done except to endure and face up to the reality. 

2. The normalisation of the resolve (and public acceptance) to undertake such massive interventions by governments also means that they could in theory pull some more cards out to backstop and cushion the next recession, even as more excesses (in the form of debts, zombie companies, financial market distortions etc) build up. Further, the powers and instruments available with governments today (combined with the willingness to use them) to mitigate recessions are more than ever. It may require the later recession to bring the house down. The can could be kicked down the road. 

3. The forces pulling in the direction of higher inflation will have to be seen against those pulling in the other direction. I had blogged here about how the period of low interest rates may continue for long into the foreseeable future. 

4. Besides, I think a steady state inflation of 4% should not be seen as the arrival of a period of higher inflation. Instead it should be seen as a return to more normal times. Instead, the last two decades and more of 2% and below inflation have been an aberration.

Update 1 (28.03.2023)

Ruchir Sharma has more on the culture of reflexive bailouts

In stark contrast to the minimalist state of the pre-1929 era, America now leads a rescue culture that keeps growing to new maximalist extremes... A restrained government was a key feature of the industrial revolution, marked by painful downturns and robust recoveries, resulting in strong productivity and higher per capita income growth. Right into the 1960s and 1970s, resistance to state rescues still ran deep, whether the supplicant was a major bank, a major corporation or New York City. Though the early 1980s is seen as a pivotal moment of broader government retreat, in fact this era was marked by the rise of rescue culture when Continental Illinois became the first US bank deemed too big to fail. In a move that was radical then, reflexive now, the Federal Deposit Insurance Corporation extended unlimited protection to Continental depositors — just as it has done for SVB depositors... In each crisis, rescues held down the corporate default rate to levels that were unexpectedly low, compared with past patterns. They are doing the same now even as rates rise and bank runs begin... The rescues have led to a massive misallocation of capital and a surge in the number of zombie firms, which contribute mightily to weakening business dynamism and productivity. In the US, total factor productivity growth fell to just 0.5 per cent after 2008, down from about 2 per cent between 1870 and the early 1970s. Instead of re-energising the economy, the maximalist rescue culture is bloating and thereby destabilising the global financial system. As fragility grows, each new rescue hardens the case for the next one... constant rescues undermine capitalism. Government intervention eases the pain of crises but over time lowers productivity, economic growth and living standards.

When innovation in development is a distraction

It has become a fad to pursue innovation in development. It's not that innovation is bad, but just that in many areas it's becoming a serious enough distraction from serious engagement with development. 

I have therefore come to the view that it would do development a lot of good if we eschew the out-sized importance given to innovation and instead focus on just executing better what's been going on. After all there are only so many ways in which teaching, diagnosing and treating, skilling, farming etc can be done. And the search for innovation has become an end in itself, detracting from the main purpose. 

Let me point to a few common examples where innovations replace priorities, displace effort, and often leave the system worse-off than before the innovation's introduction. 

1. In the last two decades the use of incentives to encourage people to do certain tasks which they ought to be doing (send children to school, do ante-natal checkups, immunise their children, for delivery at institutions, undergo skilling, segregate garbage at source etc) has become acknowledged as innovative. In other cases, people are incentivised to do what are their social responsibilities - keeping environment clean etc. 

The problem is that the effect of such incentives decay over time and they come to be seen as an entitlement. In the absence of such incentives, or (more likely) without periodic increases in the incentive, people feel discontented, thereby reducing off-take. In other words, the cognitive focus of the individual shifts from the primary task to the incentive, and changes in their perception of the incentive determines the fulfilment of the task.

More importantly, the introduction of the incentive has also the effect of taking away the collective focus  of the public system from governance improvements that are critical in public services delivery. The attention on implementation of the incentive displaces effort from the regular service delivery and its monitoring, and collectively the system feels a lesser need to prioritise delivery and supervision. The net result is a system which often delivers less than before. 

2. Information Technology interventions have become common place. And they have brought about dramatic improvements in service delivery in many areas. However, it's also the case that people have come to believe that IT solutions can address most problems in development. So, the entire process of painstaking inspections and supervision, granular monitoring, and intense high-level periodic reviews have all come to be marginalised by the presence of ubiquitous Dashboards. Or simple analysis of administrative data is displaced by search for hifalutin solutions involving AI/ML and Random Forest algorithms. Or, the accountability of ensuring eligibility or qualification has been dispersed by excessive reliance on technology-based work-flow processes and validations. Or a smart electricity meter ends up eliminating the requirement of painstaking energy audits and field inspections. 

There is also the psychology of IT interventions. Everyone is looking for solutions to persistent problems. Once a technology solution is presented as a panacea, alongside the psychological drive to ensure its quick implementation there's also a lurking belief that officials would henceforth be freed of their current drudgery of physical monitoring. Further, once implemented, the lurking belief takes over and the officials relax their attention on their original governance and oversight roles. 

3. Process re-engineering is a management fad that has found its uses in public systems. The idea of eliminating redundant processes is unexceptionable. But going beyond and introducing innovations like deemed approvals or eliminating supervisory layers can be counterproductive in weak capacity systems. So, for example, deemed approvals of building plans or statutory certificates without the necessary safeguards (which are very difficult) can result in emergence of abusive practices, which worsens the problem.

In all these things, a common feature is the displacement of bureaucratic effort. In weak capacity public systems, the administrative bandwidth of officials is heavily constrained. There are only a few things that they can concentrate and do well at any time. The introduction of the innovation adds to the already big list of priorities they are supposed to implement and/or supervise and/or monitor. Besides, any innovation being new, there will always be greater uncertainties in its implementation which in turn demands greater administrative attention in implementation. The net result is that the attention bestowed on the innovation will displace that given on the original task.

A good example of this is the emerging body of evidence which shows that the implementation of Edtech interventions in schools end up lowering the time teachers spend on classroom instruction, thereby reducing learning outcomes.

In conclusion, we should prioritise governance of implementation and monitoring of development interventions. Innovation should be about tinkering at the margins to improve governance. It should not become the central focus in addressing the development problem. 

Examining the theory of change of evidence in development

I'll do three posts this week on development. The first will focus on the value of evidence in development. The second will examine the value of innovation. The final post will draw from the first two and posit an agenda for philanthropists to engage with governments, in the specific context of India. 

This post will examine the premiss behind the conventional wisdom on the value of evidence in development. As I have blogged several times (here, here, here, here, here, here, here, here, here, here and here), this premiss arises from simplistic mental models about how stuff happen in the real world. 

In the theoretical world of development, the theory of change on evidence in development can be summarised in terms of two possible pathways. One, if we are able to establish evidence that an ongoing program is not having impact, then it can be discontinued. Two, if we can demonstrate impact in a pilot, then it can be scaled up. 

However, in the real world of development, neither of these hold. 

1. Contrary to logic, it's very difficult impossible for a full government program, even a critical feature of a program, to be canned just because some evidence has emerged about its ineffectiveness. There are at least three reasons. One, the emergent evidence will always be rationalised away as either being not credible, or by pointing to unique contextual factors, or due to some confounding factor. Two, the absence of impact will be rationalised away as being a temporary phenomenon (say, once teachers and students learn how to use technology Edtech will start showing results). Three, there are only so many ways in which you can do the fundamental things in education, health, skilling, agriculture etc, which are captured in these programs and therefore canning them does not arise as a possibility.  

2. Again contrary to logic, there are very few altogether new scalable ideas (apart from specific products/drugs or IT solutions) in major development sectors (health, education, nutrition, livelihoods, skills, agriculture etc) which can be converted into a program. In some variant or the other, all these have been tried out somewhere sometime. Or are parts of an ongoing program somewhere. Or have marginal impacts as to merit the considerable bandwidth of an acutely capacity constrained public system. Deworming pills, nifty nudges, and information disclosures are examples. And in any case, successful pilots mean little in the complex world of public policy making. 

Actually, I'll go further. Even if there are innovations, they get adopted not because of evidence but because they have become part of a powerful narrative, to which evidence is only one of the contributors. As I blogged earlier, paraphrasing Lant Pritchett, development is a faith-based activity, where the value of incremental evidence is marginal and primarily in hastening the formation of a narrative strong enough to tip the balance in favour of the change.  

In the circumstances, what's the value of evidence?

I can see one important use - to ensure execution fidelity. To ensure that the program gets implemented as per its prescribed design and guidelines. Here administrative data generated by the processes and transactions involved in government programs assume significance. Data analytics can be used to generate actionable and relevant insights about deviations, abuse/manipulation, ineffectiveness, inefficiencies etc. Unfortunately, in a world enamoured by innovations, too few people want to engage on this unsexy, painstaking, and less-innovative endeavour. 

And even when they engage, they prefer to focus on distracting issues like AI/ML or technology solutions and management-speak whose actual value in addressing the development issue at hand is deeply questionable.  

On a related note, in some cases, evidence can also be used to iterate and improve the design of a program. But this requires such high capacity that its application will be very rare in weak state capacity environments. But for policy makers and academic researchers engaged with bringing evidence to bear in public policy, use of administrative data should be the gold-standard in the application of evidence in policy making. 

Weekend reading links

1. Noah Smith has a good compilation on the application of industrial policy in over a dozen developing countries. He's sympathetic to the Joe Studwell-Ha Joon Chang school which strongly believes in the use of industrial policy in achieving economic growth. This blog has been a staunch advocate of the same for a long time. 

Smith points to an IMF paper which is a definitive call for industrial policy, albeit with some cautions

We suggest three key principles behind their success: (i) the support of domestic producers in sophisticated industries, beyond the initial comparative advantage; (ii) export orientation; and (iii) the pursuit of fierce competition with strict accountability.

This is essentially a summary of Studwell.

2. Adani too important to fail facts of the day,

It accounts for 7% of the capital spending of India’s 500 biggest listed firms. The group has promised to spend $70bn by 2030 on green investments—part of a cherished government plan to make India a green superpower. The Centre for Monitoring Indian Economy (cmie), a research firm, keeps a database of big current and planned capital expenditures in India, both public and private. Adani accounts for 3% of the full pipeline of projects by value, but almost 10% of the newer projects, announced in the fiscal year that ended in March 2022...

Its seven airports handle 23% of India’s passenger traffic; its dozen ports receive or dispatch around 30% of India’s international freight; its recently acquired cement business churns out 14-20% of India’s total; its warehouses hold 30% of Indian grain; it is the country’s biggest private generator of electricity from fossil-fuel plants (and a big one from renewables) and so on.

3. Ruchir Sharma points to the remarkable stability of the Thai Baht since the 1998 crisis as a case study in the success of economic orthodoxy. The country was the epicentre of the East Asian financial crisis, which was triggered by the implosion of the baht, resulting in contraction of the economy by nearly 20%, collapse of stocks by more than 60%, and devaluation of baht against the dollar by more than half. 

The baht trades at 33 to the dollar, not much lower than 26 before the crisis. Yet Thailand hardly feels expensive: a foreign visitor can find a 5-star hotel room for under $200 a night, a fine dinner in Phuket for $30. Despite the strong baht, Thailand is globally competitive... After 1998, many emerging societies turned financially conservative, especially those hardest hit in south-east Asia... nowhere in the region did a government turn more economically orthodox than in Thailand, avoiding the excesses that can scare off outsiders and tank currencies... Since 2000, Thailand’s government deficit has averaged 1 per cent of gross domestic product, less than half the average for emerging economies. Its central bank has been similarly cautious, keeping rates relatively high and broad money supply growing at 7 per cent a year, third lowest among major emerging economies. The ultimate pay-off for orthodoxy is low inflation. Thai inflation has averaged just over 2 per cent, the same as the US, a rare feat for an emerging country. Among other emerging economies, only China, Taiwan and Saudi Arabia have had lower inflation than Thailand since 1998... 

Thailand remains among the most open emerging economies. Trade has risen from 80 per cent of GDP in 1998 to more than 110 per cent today. The external deficits that foretold the crash gave way to surpluses, as Thailand built on its strengths in tourism and manufacturing, which generates a quarter of GDP... Since the crisis, tourism has more than doubled as a share of GDP to 12 per cent, becoming an unusually large source of foreign exchange... its per capita income has more than doubled to nearly $8,000, up from $3,000 before the crisis. Moreover, Thailand has achieved financial stability despite constant political upheaval, including four new constitutions in the last 25 years... the Thai baht has sealed its unlikely claim to be the world’s most resilient currency — and a case study in the upsides of economic orthodoxy.

4. Germany's tri-party coalition government of Social Democrats, Greens, and liberal Free Democrats which assumed power in December 2021 is a great example of political accommodation,

Lars Klingbeil, SPD chief, has driven the SPD to acknowledge the flaws of its Russia policy in a recent policy paper. Berlin suspended the Russian gas pipeline Nordstream 2 two days before the invasion. Shortly after, it lifted a legal ban on sending weapons into war zones. Germany now is the third-largest supplier of weapons, valued at €2.3bn, to Ukraine. Standing up to the Kremlin came more naturally to the human rights-minded Greens, headed by foreign minister Annalena Baerbock and economics minister Robert Habeck. Decoupling from Russian fossil fuel was a welcome step towards the transition to renewables — astonishingly, completed in less than a year. Yet it came at a steep price to their principles: a return, albeit temporary, to coal mining and nuclear power, and begging trips to Qatar and Saudi Arabia for liquid natural gas. The free-market, debt-hating FDP, who secured the powerful finance ministry for Christian Lindner, their leader, found themselves signing off on immense emergency spending bills: a €100bn special investment fund for the armed forces, and a €200bn offset package for German industry and consumers to buffer the impact of the Russian energy cut-off.

5. On the regeneration of Eindhoven, the base for ASML, the world's most advanced chip etching machines,

Eindhoven’s tech sector has attracted EU commissioners, who routinely visit in an effort to understand how a place hit by industrial decline in the early 1990s transformed into a regional tiger economy, expanding by 8 per cent annually. Its companies and academics file almost 500 patents per 100,000 inhabitants annually, one of the highest rates in the world. And a quarter of Dutch private sector research and development, €3bn a year, is spent here. A big chunk comes from ASML, Europe’s most valuable semiconductor company with a market capitalisation of €250bn. Signify, the former Philips lighting division, chipmaker NXP and truckmaker DAF are also innovators based in Eindhoven... ASML’s unique extreme ultraviolet (EUV) lithography machines could not have been built without VDL, a local family-owned company that focuses on solving complex engineering challenges... The most advanced machines are worth about $170mn each and, since 2019, their export to China has been banned by the Dutch government... The company still has a €40bn order backlog and is hiring around 250 people a month in the city and enlarging its factory to meet demand.

Eindhoven's revival is a tribute to the Dutch Polder model of government which brings politicians, companies, and unions together to find joint solutions

By the early 1990s, big employers such as Philips and DAF were shutting factories in the face of cheap competition from Asia. Mayor Rein Welschen invited the head of the local employers’ association, the technical university and business leaders to his home and they came up with a plan to fight back. When Philips shifted its headquarters to Amsterdam in 2001, public and private sectors worked together to repurpose the labs and retained the staff... Another Philips research base became the High Tech campus, home to more than 260 companies including TomTom, Siemens and Huawei. US investment fund Oaktree bought it in August 2021. Companies there are developing artificial intelligence, quantum computing and photonics — microchips powered by light rather than electricity. “This is the smartest square kilometre in the world,” said Johan Feenstra, chief executive of Smart Photonics. It has taken advantage of old Philips clean rooms to set up a production line for photon chips. They can cut power use by data centres and be deployed in remote areas...

Eindhoven University of Technology is one source of recruits. Robert-Jan Smits, the president, said the institution believed in the virtue of involving students in practical projects, such as the world’s longest 3D-printed bridge at Nijmegen. “Eindhoven is unique. Myself, the CEOs and politicians, we see each other often. On my bicycle I can get to ASML, Philips and NXP in no time,” Smits said. “We are for the region, with the region and by the region. Our job is not to make ASML bigger. It is to create more ASMLs.”

6. As Air India does a 470 aircraft order with Airbus and Boeing, it's interesting that all the top 3 and four out of top 10 aircraft orders in the last decade have come from Indian airline operators. 

Some serious diplomatic capitalisation appears to have happened around this deal, which is a welcome change in India's foreign policy management.

7. R&D spending facts of the day,

The world invests a little over 2 per cent of gross domestic product (GDP) in R&D. This spending is hugely concentrated. Of the $2 trillion spent on global R&D, the top five (of over 180) countries — the US, China, Japan, Germany and South Korea — account for three-quarters. In-house spending by industry accounts for a little over two-thirds of all R&D investment, with the balance split 60:40 between higher education and government laboratories. Within industry, the top five industries — pharmaceuticals, automobiles, technology hardware, software and electronics — account for 73 per cent of all industrial R&D. And within those industries, it is highly concentrated in a few companies, with the top 20 companies accounting for 22 per cent of global industrial R&D.

And India's R&D expenditures,

In total R&D investment India rank 16th, below Israel, a country with a GDP one-sixth ours, and a population under one-hundredth of ours. In-house R&D by industry lags even further behind, with $7 billion in investments and ranking 22nd between Poland and Singapore. The net effect is that Indian firms invest 0.3 per cent of GDP in in-house R&D, compared to a world average of 1.5 per cent. The European Commission each year gives us a very helpful table that lists the top 2,500 investors in R&D worldwide. These firms account for around three quarters of the global industrial R&D, so are representative of the complete picture. India has 24 firms among the 2,500, against 822, 678, 233 and 114 from the US, China, Japan and Germany, respectively. Considering the Centre for Technology, Innovation and Economic Research (CTIER) list of top 100 R&D spenders, there would be 31 Indian firms in the global 2,500 R&D spenders...

India has no firms in five (technology hardware, electronic equipment, aerospace, general industrials, construction materials) of the 10 top industrial sectors, and just one firm in two (chemicals and industrial engineering). We have a limited presence in three of these 10 sectors (pharmaceuticals, software and auto). Second, and most strikingly, we are missing even one giant investor in in-house R&D. Our top ranked firm, Tata Motors, with an annual R&D spend of $3.5 billion globally, clocks in at number 58 ($400 million of this is in India). The most telling comparison is that each of the top seven firms invests more than all of India (every firm, university and government laboratory put together). And even firms #24 (Honda), #25 (Qualcomm) and #26 (Bosch) each invest more in R&D than all Indian industry combined at over $7 billion each... In software, we have some of our most prominent and profitable companies, but seriously lag in R&D, investing 1 per cent of sales to a global average of 10 per cent. One often hears the argument that our software firms are service firms to the world’s product firms. But most of the top 10 Chinese software firms are also service firms. Our top 10 software firms invest 1 per cent in R&D to 8 per cent in China.

8. A summary of the soft landing case,

Supply chains are operating much more normally, inflation has come off the boil, the Fed is dialling interest rate rises down in size, rather than up, and, on a related note, corporate America is no longer saddled with such an outlandishly strong dollar. The data on employment may also be a little funky, but the direction of travel is clearly positive. Add into the mix: China is emerging from Covid lockdowns and Europe seems to have dodged a frigid and punishingly expensive winter.

9. Are young people falling out of love with driving cars?

By 1997, 43% of America's 16-year-olds had driving licences. But in 2020, the most recent year for which figures are available, the number had fallen to just 25%. Nor is it just teenagers. One in five Americans aged between 20 and 24 does not have a licence, up from just one in 12 in 1983. The proportion of people with licences has fallen for every age group under 40, and on the latest data, is still falling. And even those who do have them are driving less. Between 1990 and 2017 the distance driven by teenage drivers in America declined by 35%, and those aged 20-34 by 18%. It is entirely older drivers who account for still increasing traffic, as baby-boomers who grew up with cars do not give them up in retirement.

In Britain the proportion of teenagers able to drive has almost halved, from 41% to 21%, in the past 20 years. Across the countries of the European Union there are more cars than ever. Yet even before the covid-19 lockdowns emptied the roads, the average distance travelled by each one had fallen by more than a tenth since the turn of the millennium... Even in Germany, where the internal-combustion engine is an economic totem, drivers are pushing the brakes. The trend is especially strong in big cities. One study of five European capitals—Berlin, Copenhagen, London, Paris and Vienna—found the number of driving trips made by working people was down substantially since a peak in the 1990s. In Paris the number of trips made per resident has fallen below the levels of the 1970s.

10. Is there a case for bringing back money supply into the central banks' models for rate setting,

Since the 1980s central banks have generally focused on interest rates rather than trying to fix the amount of money in circulation. Money does not even feature in most state-of-the-art models of inflation, which are focused on interest rates, the real economy and inflation expectations. Yet money supply was one of the few indicators to provide advance warning of inflation: across the oecd, a broad measure of it rose by 12% in just six months after February 2020. A recent study by economists at the Bank for International Settlements finds that countries with stronger money growth saw markedly higher inflation, and that incorporating money growth into inflation forecasts would have improved their accuracy.

Proponents of this view feel that inflation may taper off.

Yet this sort of “immaculate disinflation” is possible, claim one group of economists: those who study money. In 2020 they were among the few to worry about a burst of inflation. Today they are among the most open to the idea that inflation—of both prices and wages—could go away relatively painlessly. Their argument is that the world economy has been suffering what used to be called a “monetary overhang”, in which it must work off a one-time change to the supply of money caused by a burst of stimulus. Once that overhang has dissipated, things should return to normal, argues Chris Marsh of Exante Data, a research firm. Monetary overhangs, which were experienced after the second world war in the rich world and in many post-Soviet economies in the 1990s, have not typically led to persistent inflation.

11. Finally, the reinvention of malls in the US, which have been losing business and declining,

During the pandemic, malls found themselves suddenly having to fill thousands of square feet left vacant by struggling retailers like J.C. Penney and Gap. Others realized too much space was allocated to their parking lots. Since the internet disrupted consumer shopping habits, malls have been trying to make a case for their existence. As old anchor stores have downsized, closed or filed for bankruptcy, malls have made space for grocery-store chains, climbing gyms, Covid-19 vaccine sites and dialysis centers in an effort to increase foot traffic and give shoppers a reason to stay longer... mall owners face challenges, including evolving consumer tastes, zoning changes and local resistance... 

The combination of malls and apartments is not a new concept, but more landlords across the country are rethinking their use of space in this way. The strategy builds on the live-work-play communities that are built to accommodate the needs of its residents and have been become popular in the past decade with young adults seeking amenities within walking distance... The addition of medical services within shopping centers is a popular trend as well.

This is a testament to the strength of the American market and its signals that businesses can reinvent themselves in response to changing market conditions.  

More on management consultants in government

I look forward to reading Mariana Mazzucato's just to be released critique of the work of consultants in public sector. FT has an interview here. 

From my own experience of watching consultants in several departments for nearly 25 years, I cannot but very strongly agree with her central premise that management consultants have "no expertise in the areas they're advising" and their role has weakened governments. I have blogged here, here, here, here, here and here about the problems with the use of consultants by governments, and co-written in the latest book State Capability in India. 

As a phenomenon, the use of management consultants by governments is a culmination of a long period of application of theories of public choice and new public management, coupled with value for money and other costs-benefits assessments of government interventions which have been spearheaded by economists. The role of consultants can be described as that of evangelising and diffusing these ideas within governments. 

I can think of some reasons why the now pervasive use of consultants by government agencies is detrimental to public good. (As a disclaimer, none of this should be seen as an argument that government knows best and consultants are always bad. Instead, these should be seen as generally observed problems with the role of consultants in governments. The objective is to drive home a point that goes against prevailing conventional wisdom.). 

1. Simplifies responses to complex challenges and detracts from serious introspection and engagement within governments. Their engagements has also contributed to simplification of public debates on these issues. 

Politicians, bureaucrats, and public want neat and elegant solutions to problems. But, as H L Mencken said, for every complex problem there is an answer that is clear, simple, and wrong. And consultants, by nature of their expertise and business models, are primed to provide such clear and simple solutions. 

This is especially so, but not only, in social sector areas like education, health, agriculture, and skilling. I cannot imagine how management consultants can help with persistent and complex development challenges like improving learning outcomes, poor sanitation and nutrition, low agricultural productivity, and pool quality of technical skills. Especially since the solution to none of these problems lies primarily in technical fixes and involves areas like state capacity improvements, account-based accountability, behavioural changes, social mobilisation, community engagement etc. 

The most famous examples of such "cons" are the vision 20X0 documents, Dashboards, War Rooms, Delivery Units, Data Analytics Units etc. I have come across several of these and have not found even a single one of them which have "delivered" anything even remotely close to their big promises and large costs. In fact, someone should do an objective assessment of all such projects (in say, India) that evaluates the achievements against the promises. In terms of value generation promised against actual achievement, I'm sure all these would count among the biggest failures in any sector. But the myth endures with same intensity. These ideas and their peddlers appear teflon coated. 

Even on areas like public private partnerships in infrastructure or outsourcing of public services delivery, or the use of technology in addressing chronic problems like low property tax demand or high electricity distribution losses or reducing traffic congestion, consultants have been central in simplifying the issues and considerably reducing the effectiveness of these ideas in implementation. In all these cases, the shiny solution seriously detracts attention from also attending to basic governance failures which are critical for any meaningful attempts to address these problems. 

An area where consultants exercise complete control is with industrial policy formulation across state governments in India. Consultants are a very important contributor to locking state governments into a very expensive race to the bottom with fiscal concessions, input subsidies, and marketing and branding. None of these have any evidence basis either from developed or developing countries. Amidst all this, the real issues of handholding and facilitation over the long-term to create genuinely hassle-free business environment gets overlooked. Even the Ease of Doing Business (EoDB) engagements have been reduced to an exercise in documentation, branding, and self-perpetuation. 

2. Enfeebles governments by taking over their core-functions and making them dependent on such consultants. It's increasingly the case that all thinking and analysis within the government is being outsourced to consultants. Consultants frame agendas, steer important policy making activities, moderate decision making, prepare important documents like file notings, Government Orders, and Cabinet Notes. 

So much so that it has become common for political and senior bureaucratic leaders to instinctively dismiss ideas and documents from subordinate officials with derision. The impact on morale within the bureaucracy has been devastating. This is despite the presence of at least a handful of officials in most Departments with the kind of expertise which even the best consultant can match.

The result is that the skill of preparing good GOs, Policy Briefs, Cabinet Notes etc has almost disappeared from several Departments. The reliance on consultants for performing core function of the government is near complete in these Departments.   

The most disturbing trend is in engineering departments, which not so long ago prided themselves in their  technical expertise. Such expertise has been rapidly disappearing, as engineering departments have progressively outsourced their design, project report making, estimates preparation, bid process management, contracting, and even work monitoring roles to consultants. The reality of a State Public Works Department without the expertise to even prepare an estimate or undertake execution management for reasonably large projects is not too far ahead in future.

The most pernicious forms of consultant engagements with governments is the use of the now common Program Monitoring Units (PMUs). These PMUs are the proverbial thin end of the wedge entry points for consultants in embedding themselves within governments long-term. It's not uncommon for the same consultant, including the same individuals, remain on the project for years, with the contract itself getting extended almost interminably. The PMU becomes the extended arm of the government. In reality, all it does is record minutes, prepare briefs and shiny presentations which keeps the show going (for the higher officials) while little happens on the field. 

These PMUs are now like the relationship between companies and their auditors. However, while corporate governance laws globally now mandate auditors have to be changed every five years, no such laws exist for consultants in governments. 

3. Is a very important entry point for regulatory and bureaucratic capture by commercial interests and fuels corruption. In commercially driven sectors like infrastructure, IT, urban development etc, consultants serve two roles. 

One, at best, they are the market makers for technology solutions, business solutions, new kinds of products etc. In the guise of thought leadership, the McKinsey knowledge insights about areas like smart cities, transportation, artificial intelligence, construction etc are good examples of sophisticated corporate lobbying to evangelise shiny  ideas with questionable value (for their contexts) and catalyse markets. Two, at worst, they are the backdoor for original equipment manufacturers (OEMs), contractors, and solutions providers to push through specifications and standards which favour certain vendors over others. 

In large PPP and other projects, consultants are also entry points for financial market intermediaries. There are informal relationships between consultants and the financial institutions which drive such engagements. All such engagements invariably distorts incentives within the bureaucracy and breeds corrupt practices.

In general, consultants have been the most important reason for transforming infrastructure projects and public procurements in general from being need-based and context-specific to being supply-based and vendor driven. 

4. Infuses a transactional and free-market ideology which elevates efficiency, value for money, and revenues maximisation over all else. In the process, other important considerations like social capital, local contextual factors, public demand, aspirational considerations, fairness, equity, and so on are marginalised. Most importantly, the work of consultants shrinks the space available for public debates that reflect political choices and factors. 

So, for example, investments in schooling or health care get evaluated based on narrow evidence frameworks of costs-benefits or value for money assessments. A school building or teachers may not translate into student learning outcomes, but schooling cannot happen without a school building or adequate teachers. Similarly road and electricity connectivity may not yield immediate outcomes, but no development can happen without road and electricity.

Or smart city projects becomes reduced to the implementation of a set of smart technology solutions with limited attention paid to smart community adoption, smart individual engagement, smart market integration, and smart policy alignment of the elements of these projects. These are value-free technical projects foisted on complex values-based communities and systems. Failure is baked ab-initio into the design. 

5. Provides the cover for promotion of questionable interests within governments. Apart from their own agendas, consultants also provide the cover for questionable policies and decisions which the executive wants to implement. Their reports are used by these governments to push through their own questionable agendas in project selection, financing models, land and resource allotments, and procurements. 

Consultants prepare conveniently framed project reports and financial viability models on projects which have limited public good basis or are poor value for money. Governments turn around and justify these projects citing the reports/models as having been prepared by a reputable consulting firm.

In fact, it may not be incorrect to describe crony capitalism as the relationship between politicians and bureaucrats on one side and contractors/vendors and financiers on the other side, mid-wifed by management consultants. 

6. Lack of any performance accountability. It should count as the biggest irony that the biggest proponents of the new public management theories refuse to hold their own work accountable to the principles of the same theories. Have you ever heard of an outcomes-based consulting contract? 

Consultants argue that they are only advisors, and are not in control over the implementation of their advice and plans. Never mind, if you propose unimplementable solutions, they'll never get implemented. And if you have not implemented what's been proposed, how can you be held accountable?

As I wrote earlier, "In a fair world, if these consultants are held to account for the value for money from their such advice to governments, then it will most likely figure among the greatest value destruction ideas in the history of development."

Update 1 (08.05.2023)

See this and this on the work of management consultants in India. 

A few more thoughts on central bank independence

As central banks have assumed a critical role in macroeconomic management, the issue of central bank independence has emerged as an important areas of public debates. I have blogged on multiple occasions, latest here, here, and here. 

A CEPR working paper examined whether central bank governor appointments have over the years become more or less political and its impact on monetary policy outcomes. The paper uses perception surveys to identify politically motivated governor appointments (in terms of whether the governor is more loyal to the executive or the central bank mandate).

The authors used information on 316 central bank governor appointments in 57 countries between 1985 to 2020, drawing on biographical information on relationships with the executive and perception surveys of international press and independent academic experts. They combined this information into an index, Governor Appointment Index (GI), of whether the governor was more or less independent of the executive. They then compared it with three canonical models of de jure independence like specific institutional reforms targeting appointments, terms of office, and dismissal of governors. 

The figure below shows no discernible relationship between the GI and measures of de cure independence in models which control for country fixed effects.

Clearly de jure independence does not translate into de facto independence.

The authors also find,

Not only have central bank governor appointments not become more independent on average, but our results further show that they may have become more political as central banks are given more operational independence. The relation between our governor appointment index and legal reforms that aim to insulate the governor from political interference turns strongly negative when central banks are given more policy or financial independence, and their operations become less transparent... Our results illustrate that legal independence is not sufficient to guarantee that the central bank is not captured by political interests... As central bank powers increase, it is likely that incentives to appoint political allies, with the explicit or implicit aim to affect future central bank policies, will increase.

Some observations:

1. This is a great example of what Lant Pritchett has described as isomorphic mimicry. It's one more addition to the long list of best practice reforms where transplantation of the form of reform does not translate into actual outcomes. The de-jure and de-facto diverge. 

2. The construction of the GI is most certainly flawed. For example, while prior employment in executive is a negative for central bank independence, the opposite can be argued in many contexts. The perceptions of international press and western academics are invariably prejudiced and cannot be a reliable measure of actual independence. The example of The Economist's derisive ad hominem about the current Governor of the Reserve Bank of India as a "pliant insider" is only an illustration of ignorance and prejudice. 

3. There is a more important aspect of central bank independence that the paper glosses over. As much as independence from the executive, the governor (and members of the rate setting committees) also need to have independence from market vested interests and should be free from personal conflicts of interest. Unfortunately regulatory capture and personal conflicts of interests are not uncommon, especially in  the western economies. In an earlier post here I had illustrated on some of these problems. 

4. Given the nature of their role and critical importance of central bank decisions on the economy as a whole, it's only natural that central banks are accountable to the political executive. After all, especially in democracies governments are elected and reposed the ultimate responsibility of managing the economies. 

However, there is an endogeneity between the institutional independence of the central bank and its political accountability. The former is critically dependent on the latter. The problem is that the latter is difficult to define or prescribe in clear terms for the activities that engage central banks. 

In democracies, central banks are ultimately accountable to the legislatures, and therefore to the executive, albeit within the boundaries of their statutory mandates. This becomes especially relevant as most central banks have the dual mandate of inflation control and economic growth. Given the difficult to comprehend and even more difficult to manage trade-off between inflation and growth, monetary policy responses in all but a few occasions of rising inflation is not about application of models but an exercise of human judgement. And academicians and technocrats do not have any superior expertise or exposure to be able to exercise better judgement on such trade-offs. 

There is also the issue of real-world imperatives of governments in democracies which cannot be glossed over. It's true that governments generally don't prefer restrictive monetary policy because output collapse appears more politically unpalatable than higher inflation (which experience tells that even when high will generally be in the high single digits or low teens). Central banks should be cognisant of their government's concerns and accommodate where possible, but only where possible. However, in cases where there is a strong belief that accommodation is counter-productive, the central bank should be firm in politely declining the government and proceeding with its preferred course of action. Accommodate if you can, but proceed if you cannot. 

5. Given the difficulties of managing the relationship between central banks and governments even with just two variables, the problems get compounded if central banks are entrusted other mandates. Consider the scenario where central banks have a role in mobilisation of climate finance and regulation of digital currencies. In both areas, democratically elected or otherwise sovereign governments can have legitimate preferences that can conflict with narrow technocratic considerations in both realms. Issues of inter-generational equity and national security are best left to sovereign governments than unelected technocrats. It's therefore important to be clear about the expectations from central banks if they are entrusted these additional responsibilities. 

6. The onus is as much on the central bank as on the government in managing the relationship between central banks and the executive. This means communication between the two sides is as much important as the central bank's forward guidance communications. In case of difficult decisions, it's always useful for  central bank governors to actively engage and communicate informally with the political and bureaucratic leadership in the executive about their reasons. 

In some respects, I would argue that the most important relationship in central banking is that between the Governor and the political and bureaucratic leaders in the Finance Ministry. Most often, it's not the decision per se that generates discontent in the executive but the manner in which it was taken and the general breakdown of relationship between the two sides. A good relationship and effective communications can most often (not always) de-risk even harsh and politically unpalatable decisions, and thereby central bank independence itself.

7. It has been the practice in recent years to bring outsiders, mostly academicians, as central bankers. A narrative has been created that the markets will perceive the central bank insiders or bureaucrats as pliable and therefore not likely to be independent. This practice comes from the belief that central banking is a technocratic activity and academicians are the best possible technocrats. Both these assumptions are questionable. 

Central bank rate setting decisions are hardly about models, but an exercise of judgement. And even among technocrats, economists working with financial institutions are likely to possess the required combination of practical experience and technical expertise than academic economists. But they come with the general conflicts of interest problems associated with revolving doors. 

I'll therefore argue that, in general, insiders and bureaucrats with technical expertise and integrity are more likely to be effective than either academic or market economists. Apart from their technical competence, they also have the attributes of experience of being associated with the management of such situations which enhances the quality of their judgement, and their superior ability at effective but credible informal relationship management. 

8. Finally, central bank independence is endogenous to political accountability in so far as antagonisation of the political executive will invariably result in a backlash where the political executive will generally prevail. This is a hard reality of life. I know this can appear to be a condonation of the political executives, but the idea is to be aware of this reality and exercise judgement accordingly. Carry the executive with you if you can, but proceed with firmness if you cannot.  

In other words, central bank independence depends on the nature of the relationship between the two sides. If the latter becomes strained, it's more likely that the former will become compromised. Given the importance that the central banks associate with the former, it's only natural that it works extra hard to ensure the latter is harmonious. 

Update 1 

The political consequences of Fed's actions are enormous. A good example is, as this NYT article writes, the outcome of the next US Presidential election which could depend very deeply on Fed's actions and their outcomes. It points to the assessment of Ray Fair, a Yale Professor who has been predicting presidential and congressional elections for decades. He writes, 

An optimistic story is that the Fed will raise interest rates a little more, thus contracting the economy some, but by the end of 2023 inflation will be back near 2 percent and the Fed can ease off. This is a positive story for the Democrats retaining control of the White House in 2024. Going into 2024 inflation will have been licked and output growth will have started to pick up. By November 2024 the economy will have been growing for three quarters and inflation will be under control. A pessimistic story is that inflation will not go gently and the Fed will have to keep interest rates high and possibly rising into 2024. Inflation might still be higher than the Fed wants in the summer of 2024 and the Fed will still be tightening or at least not easing off. Output growth in 2024 might be sluggish because of the Fed’s tightening. This is, of course, negative for the Democrats: high inflation and low growth... The Fed’s main goal at the moment is to get inflation down to 2 percent, not to help one political party. But the political consequences of its actions are huge.