Weekend reading links

1. The new Labour government in UK wants to close down the "carried interest tax" loophole that Private Equity firms enjoy - it allows them to pay 28% instead of the regular 45% rate. Patrick Jenkins has a good article that examines the issue and proposes a compromise.

First, they make a principled point — that carried interest is not really income as reformers argue, but a genuine reward for executives, dubbed general partners in the industry, taking investment risk. If GPs invest alongside third-party investors — so-called limited partners (or LPs) — in a deal, any gain (or “carried interest”) they make should be treated as a capital gain because that is what it is. Second, the sector insists that implementing the policy as outlined would drive wealth creators and growth generators — key to Labour’s agenda of economic revival — out of the country... 

There are clear flaws in the industry’s arguments. Tax changes and differentials in this sector have not led to an exodus in the past. In 2017, Italy introduced a new regime, taxing carried interest at 26 per cent, instead of the 43 per cent of higher-rate income tax. Ireland taxes carried interest at barely half the UK rate. So far neither country has made huge inroads in attracting private equity executives... The more substantive point of principle is also moot. In many cases a private equity manager is not actually investing any of their own money, but is being gifted the “right to carry” by their employer, in much the same way as a banker might be gifted shares as part of a bonus (which is liable to income tax). There is no requirement to actually invest your own money in order to benefit from the carried interest tax break...

Reform is clearly needed, but with a spirit of pragmatic compromise. First, Reeves should follow through on her instinct that individuals must actually invest, say at a level equivalent to 1 per cent of the fund, as similar regimes in France and Italy already dictate. This would tighten the alignment between GPs and LPs, which is in everyone’s interest. Second, in order to qualify for carried interest taxation, the investment should genuinely be putting capital at risk. At present, CVC is one of very few firms where executives on a bad deal can actually forfeit money, even if the fund overall succeeds. Third, tax rates should be calibrated smartly. For cases where the threshold for real investment is met, a rate of, say, 33 per cent could be levied; if the threshold is not met, the rate would be 45 per cent. This would still be within the range of competitor jurisdictions, albeit towards the upper end. (France charges up to 34 per cent.)

2. The Skills Ministry appears to have bitten off more than it can chew with its target of having the country's top 500 companies providing internships to 10 million youth over the next five years. 

In the five years from 2019-20 to 2023-24, India added 4.47 million people to the salaried workforce, which stood at a little over 90 million in 2023-24, according to the Centre for Monitoring Indian Economy's consumer pyramids household survey. The salaried class includes managers, supervisors, white-collar professionals, clerks, industrial and non-industrial workers, and support staff. Offering internships to 10 million people in the next five years in India's top 500 companies will mean more than doubling the total employment generated across the salaried class in the past five years, or 11% of all the people employed under this category... According to Mint's study of annual reports of 94 companies on the BSE 100 index, there were 3.83 million employees at BSE 100 firms as of 31 March 2023. The data included both permanent and non-permanent employees, and excluded workers (in some cases, only permanent employees were considered due to unavailability of data)... 

As per the Union budget's announcement on Tuesday, the interns will be paid ₹5,000 per month along with a one-time assistance of ₹6,000. Companies will be expected to bear the training cost and 10% of the internship cost from their corporate social responsibility funds. The emphasis on skilling comes at a time when the Economic Survey for 2023-24 found that about one in two graduates straight out of college is not employable. “Estimates show that about 51.25% of the youth is deemed employable. In other words, about one in two are not yet readily employable, straight out of college," the Economic Survey, unveiled on 22 July, said. "However, it must be noted that the percentage has improved from around 34% to 51.3% in the last decade."

The scheme is part of five DBT schemes aimed at education, skilling and employment with an outlay of Rs 2 trillion over five years, to benefit 41 million youth. 

The difference of this scheme from the apprenticeship promotion efforts should be noted.

An apprenticeship is a structured system of training where individuals, known as apprentices, learn a trade or profession through a combination of on-the-job training and classroom instruction. Apprentices can be both graduates and non-graduates. Students who turn apprentices can also use the stipend to fund their education. The stipends depend on whether the candidate has been picked up under the NAPS (National Apprentice Promotion Scheme) or NATS (National Apprentice Training Scheme) programme. The former is meant for all trades and may take non-graduates, while the latter is largely for engineers and technical apprentices.

3. Nice snapshot of the budget numbers.  

This is the break-up of the capital expenditure proposals

I'm ambiguous on the Rs 1.5 trillion interest-free 50-year loans. State governments which had negligible or no liabilities to the central government over the years have become indebted to the central government through this scheme. It also means that the states are now ever more obliged under Article 293(3) of the constitution of India to the central government. 

And this on the important rural schemes

4. One area where India has trumped China is in its equity markets.

India formed just 6-7% of the MSCI ten years back. It has now risen to near 20%, whereas over the same time China has shrunk from over 40% to around 25%. But Indian stocks are clearly overvalued, trading at 24 times their expected earnings next year against 10 for China. 

5. Daron Acemoglu and James Robinson have an excellent article that articulates the need for the Democratic Party in the US to free itself from its current elite capture. 

When monarchies ruled... they had an elaborate justification for their legitimacy. In early modern England, it was the “divine right of kings.” In China, it was the “mandate of heaven.” It’s not just autocratic regimes that rely on such philosophies. The move toward greater popular participation also required legitimation and a new social contract. In England, that was articulated by philosophers such as John Locke, who provided the foundation of “popular sovereignty.”... That trust is largely lost. Center-left parties, which used to get a significant fraction of their votes from blue-collar workers and citizens without college degrees, now increasingly rely on votes (and money) from college graduates, professionals and managers.

That is all the more so in the United States, where the Democratic Party has gradually become associated with the preferences of the well-educated and urban voters. Democratic politicians often shy away from policies such as job guarantee programs, trade protection and stronger unions... Center-left parties need to lead the way in breaking this mold. This must start by the severing ties with tech billionaires, pharmaceutical giants and Wall Street tycoons. It is difficult to believe that a party that gets funding and ideas from the very wealthy will work hard for the well-being of the most disadvantaged. They must promote to leadership people with a background in manual work and from different educational paths. One visible and symbolic way of achieving this is to reserve a fraction of candidacies and leadership positions to individuals without a college degree. Similar strategies have been successfully used by Swedish social democrats and local governments in India... Campaign-finance reform would help, including public money for candidates that refuse support from big donors. There is also a case for introducing proportional representation voting, which can allow new parties to take up the mantle of working-class causes if the two major parties cannot get their act together. 

Note the point about severing ties with elite interests and promotion of people with a background in manual work and from different educational paths. In other words, return to truly representative governments.

6. The findings of a 3 year RCT study on unconditional income transfer among 3000 adults in Texas appears to pour cold water on UBI enthusiasts. 

The trial recruited 3,000 people in Texas and Illinois on the basis that they would be in a study receiving $50 a month or more for three years. Then a third of them were unexpectedly told they would instead receive $1,000 a month with no effect on any of their other income. The results definitively show that receiving more money provides a better life. Spending and saving rises... Time at work went down for both the recipients of the $1,000 and their partners, replaced by more leisure... The big question for the dynamic benefits of a universal income was what people would do with their additional time. Would they invest in their education, upskill, get better jobs or start businesses? The short answer was no. The findings ruled out “even small improvements” in the quality of employment and upskilling. The most that could be said was that the recipients spent some of their extra leisure time thinking about starting a business without actually doing it... Did universal support make recipients healthier than the control group? Again, the answer was no. Surveys and blood tests of recipients and the control group shows no improvement in physical health, and mental health improved only in the first year. There were more visits to medical facilities and more alcohol consumed, although also less problematic drinking.

7. Solar industry globally is facing a massive glut created by China that's driving down prices and destroying domestic solar industries in many countries, including in Europe. 

According to BloombergNEF, panel prices have plunged more than 60 per cent since July 2022. The scale of the damage inflicted has sparked calls for Brussels to protect European companies from what the industry says are state-subsidised Chinese products. Europe’s solar panel manufacturing capacity has collapsed by about half to 3 gigawatts since November as companies have failed, mothballed facilities or shifted production abroad, the European Solar Manufacturing Council estimates. In rough terms, a gigawatt can potentially supply electricity for 1mn homes. The hollowing out comes as the EU is banking on solar power playing a major role in the bloc meeting its target of generating 45 per cent of its energy from renewable sources by 2030.

The Chinese prices are so low that it requires very high tariff to level the playing field, besides constant surveillance to see whether the exports are being routed through third countries.

The Inflation Reduction Act.. has spurred almost $13bn of investment in solar manufacturing, more than six times the amount committed in the five years before the legislation... In May, it removed a tariff exemption for double-sided panels and lifted levies on Chinese imports of solar cells from 25 per cent to 50 per cent. Chinese companies now also face penalties if they are found to have dodged tariffs. US imports of Chinese polysilicon for solar panels had already been hit by a 2021 ban on products made or sourced from China’s Xinjiang because of concerns over the use of forced labour. Nevertheless, America’s solar power companies warn that the steps taken by the Biden administration this year will fail to provide enough protection... Chinese solar companies... dumping cells in south-east Asia, the source of the bulk of US imports. A solar panel manufactured in America using US-made cells costs 18.5 cents a watt, compared with 15.6 cents for a panel sourced in south-east Asia and just over 10 cents for one produced in China, according to estimates from BloombergNEF. 

Weekend reading links

1. The Economist makes a very important point in explaining the productivity slowdown in developing countries,

Half of the slowdown in labour-productivity growth in recent years reflects not a failure to imitate but a failure to accumulate: weak investment has left labour with too little capital to work with. This shortfall in investment explains all the productivity slowdown in South Asia, the Middle East and north Africa, and two-thirds of that in Europe and Central Asia.

And this cautionary note about focusing excessively on the magnitude of the productivity slowdown,

In a World Bank publication 25 years ago Lant Pritchett, now at Oxford University, emphasised that catch-up growth was historically quite rare. Yes, imitation should be easier than innovation (and returns to investment should be high where capital is scarce). But other factors often got in the way. After all, if poor countries reliably grew faster than rich ones, there would not be so many poor countries still around. The “dominant feature” of modern economic history was not convergence between rich and poor countries, wrote Mr Pritchett, but “divergence, big time”.

2. In the context of the problems with bailing out IL&FS, TT Rammohan makes a very important point about how media trials have fuelled decision paralysis,

The moment something goes wrong with a company, especially in the financial sector, or in government, there are allegations of a “scam.” The government and public sector agencies go into a deep freeze. Nobody wants to take decisions for fear of the political fallout and reprisal from investigating agencies but the economy ends up paying a hefty price. The need to insulate the functioning of the financial sector from the “scam” mentality is surely one of the important challenges for the Indian polity.

Sample two examples of this in the case of IL&FS,

In 2015, when IL&FS faced problems of refinancing loans, it had proposed a merger with the Piramal group, which has a strong presence in the financial sector. The merger was expected to result in funds of ₹ 8,500 crore in the merged entity. Life Insurance Corporation (LIC), one of the principal shareholders of the IL&FS, did not agree with the valuation proposed. Worse, the LIC sat on the proposal for a long time. As a result, the standstill agreement with the Piramal group of three to four months got extended to nine to ten months. Under the agreement, the IL&FS could not raise debt or equity from any source until the standstill period was over and this worsened its liquidity situation.

The IL&FS has said that it has arbitration claims on National Highways Authority of India (NHAI) worth over ₹ 7,000 crore. These claims relate to payments on various infrastructure projects. Given that it is a government organisation, the NHAI often prefers to opt for litigation in relation to such claims instead of settling these through discussion. This, in turn, creates problems for infrastructure companies that have agreements with the NHAI.

3. Malappuram, Kozhikode, and Kollam figure among the top ten fastest growing cities in the world for 2015-20, with Malappuram being the fastest. Livemint has a very good analysis.

This once again raises questions about the manner in which urban areas are notified in India. Apart from notified towns and cities, the census also identifies areas as census towns with population more than 5000, density above 400 per sqkm, and with more than 75% male non-agrarian workforce. Further, there is another category of areas with population more than 5000. These throw up wide variations,

A 2019 paper (bit.ly/2019paper) in the Journal of Asian Economics shows that if we use a population threshold of 5,000, that is, if all areas having more than 5,000 people are classified as urban, India will be 47% urban. And Kerala? It goes from 16% administratively urban as per the 2011 Census to almost 100% urban by this definition.

And the difference matters because,

ULBs and RLBs provide very different kinds of goods, services and management. The 73rd and 74th constitutional amendments contain the XIth and XIIth Schedules listing the powers, authority and responsibilities of Panchayats and ULBs, respectively. Items listed for ULBs and not RLBs include: town planning, slum improvement, public amenities including street lighting, parking lots, bus stops, solid waste management, building regulations and fire services. An urban area governed by a ULB rather than an RLB could potentially benefit from a 147% increase in road length per sq. km, a 128% increase in water storage capacity in kilolitres per capita, a 25% increase in the probability of establishing a higher education institution, and an 11% increase in hospital beds per capita. 

Even when amenities and services are available in de facto urban areas, the quality may be worse than it would have been under a ULB. Roads are a good example. The NYU-UN Habitat Atlas of Urban Expansion measures the quality of roads in several Indian cities in the pre-1990 period compared to peri-urban expansion areas between 1990 and 2014. The quality drops off sharply due to the unplanned nature of the growth in the peri-urban areas. For instance, the average road width in the Kozhikode 1990-2014 expansion area was 4.03 metres, compared to 9.84 metres in its pre-1990 area (which was within the municipal boundaries)... A 2011 report on India’s municipal finances estimated that ULBs raised about 8.5 times more tax revenues than Panchayats.

4. Important point made here about also focusing on revenue deficit in discussions on the Fiscal Responsibility and Budget Management (FRBM) Act.

A paper, titled “Fiscal Multipliers for India” by Sukanya Bose and N R Bhanumurthy shows, the multiplier is less than 1 for revenue expenditure and over 2.5 for capital expenditure. In other words, when the government spends Rs 100 on increasing salaries in India, the economy grows by a little less than Rs 100. But, when the government uses that money to make a road or a bridge, the economy’s GDP grows by Rs 250... The popular understanding of the FRBM Act is that it is meant to “compress” or restrict government expenditure. But that is a flawed understanding. “The truth is that FRBM Act is not an expenditure compressing mechanism, rather an expenditure switching one,” says Bhanumurthy, professor at National Institute of Public Finance and Policy (NIPFP).

5. George Soros has some very strong words on Facebook,

I repeat and reaffirm my accusation against Facebook under the leadership of Mr. Zuckerberg and Ms. Sandberg. They follow only one guiding principle: maximize profits irrespective of the consequences. One way or another, they should not be left in control of Facebook.

6. Even as housing affordability looms large as a public policy problem, the NYT reports of California Legislature's decision to reject an attempt to ease the problem,

A bill challenging California’s devotion to both single-family housing and motor vehicles by stripping away limits on housing density near public transit... On Thursday, one day before the deadline for action on the hotly debated bill, it failed to muster majority support in a Senate vote. In the end, in a Legislature where consensus can be elusive despite a lopsided Democratic majority, the effort drew opposition from two key constituencies: suburbanites keen on preserving their lifestyle and less affluent city dwellers seeing a Trojan horse of gentrification... Senate Bill 50, would have overridden local zoning rules to allow high-density housing near transit lines, high-performing school districts and other amenity-laden areas. Supporters portrayed it as a big but necessary step toward reducing the state’s housing deficit — and helping to curb carbon emissions from long-distance driving — by fostering development in dense urban corridors. Opponents decried it as state overreach into local land-use rules.

This is one more example of how progressive and democratic politics is coming in the way of addressing serious public policy challenges. 

7. Among the various possible drivers of economic growth in Africa, easing restrictions on internal trade is a surprisingly less discussed one.

Africa lags behind other regions in terms of internal trade, with intracontinental commerce accounting for only 15% of total trade, compared with 58% in Asia and more than 70% in Europe. As a result, supermarket shelves in cities such as Luanda, Angola, and Abidjan, Ivory Coast, are lined with goods imported from the countries that once colonized them, Portugal and France.

One of the reasons is the bureaucratic delays at border crossings, which can even run into 2-3 days on certain borders. In this context, the African Union-led new free trade agreement, AfCFTA, encompassing a combined economy of $2.5 trillion with 1.2 billion people spread over 54 countries, and to take effect in July 2020 and be fully operational by 2030 is a very promising development. 

The challenge will be its implementation. Many smaller countries rely on taxes on cross-border trade transactions for a significant share of the national revenues, whereas the bigger countries will gain from the easing of these restrictions.

8. Finally, nice article about Uralungal Labour Contract Co-operative Society (ULCS) in Vadakara, Kerala. Sample this

The 94-year-old ULCCS stands out from other cooperatives in many ways. For one, its size. It employs over 12,000 people, making it one of the largest labour cooperatives in Asia, saw revenue of Rs 1,100 crore in 2018-19, has projects worth Rs 2,700 crore on its books and assets worth a similar amount, from land and quarries to machinery. While it is headquartered in north Kerala, it undertakes infrastructure projects across the state, from flyovers to bridges and roads, aided by a reputation for completing projects punctually and maintaining high standards of work. Its biggest project is a Rs 450 crore road in Malappuram district. This is an extraordinary achievement in job-starved Kerala. It is also a model for the reinvention a cooperative has made. Then ULCCS also has generous employee benefits. “We give our workers a bonus twice a year apart from PF, ESI, holiday wages, pension, salary advance, interest-free loans and medical insurance of Rs 15 lakh,” reels off society secretary Shaju S. The bonus and medical insurance can be availed of by all workers while the rest of the benefits are only for society members, numbering 2,969. One can apply for membership after a year of working with the society. About half of the 9,000 non-members are migrant labourers.

Weekend reading links

1. A new study of 23 drugs, eight of which were under patents, reveals that while prices are highest in the US and lowest in India...

... their affordability is reversed.

2. FT points to the irony of Germany's fixation with Walter Eucken's Freiburg school's focus on balanced budgets,

Germany’s economy, despite its size, is extremely open. The ratio of exports to gross domestic product is 46 per cent. In Japan, the figure is 18 per cent and 13 per cent in the US. This openness allows Germany to pursue a passive macroeconomic policy at home and benefit from active demand-side policies pursued in other countries. About 60 per cent of the German current account surplus is with the US, the UK, France and Italy, which all have relatively high fiscal deficits. In short, Germany’s economy is supported by the demand management policies of countries that are heavily criticised by German academics and policymakers.

3. The latest BrandZ annual report on the value of brands finds that the top 100 global brands command a valuation of $3.4 trillion an increase of 133% over the past 10 years. The leader board, lead by Google, consists of mainly technology companies. Reflecting the churn, just 54 of the top 100 global brands ten years back are still there. 

4. I was waiting for someone to call this. Livemint says that with its 20 trillion long-term capital base, LIC has become the Indian government's lender of last resort.

It is popping up everywhere, so much so that I would not be surprised if whole Ministries (like Railways and Roads) see them as more important than the Union Finance Ministry and its Budget! Livemint writes, 

Where is the independence of LIC? If it is independent, why does it bail out the government through investments in bonds, equity or infra funds? Interest of the policyholders is key. They should get the best returns for their money... For instance, LIC picking up non-voting shares in banks at a price which was not discounted is not fair to the policyholders. In state-run banks, the voting rights are capped at 10%. So, in instances where LIC picked up more than 10% stake in state-run banks and is not getting voting rights, one can question why LIC did not purchase these shares at a discounted price..

5. Krishnamurthy Subramanian lifts the veil on conflicts of interest among Indian credit rating agencies who offer non-rating services 

The study employs data on the rating and non-rating activities of all CRAs in India from 2010 to 2015. It finds that a CRA that provides non-rating services to an issuer provides higher ratings (designating lower default risk) to that issuer when compared to the rating provided to the same issuer by other agencies... After controlling for various confounding factors, the distribution of ratings of issuers with non-rating services clearly dominates that of issuers without non-rating services. Additionally, the study examines the amount paid for consulting and finds that issuers obtain higher ratings the more (non-rating) revenue they generate for an agency.

The most uncomfortable evidence, which clearly suggests conflicts of interest, comes from comparing the defaults among issuers that pay for non-rating services and issuers that don’t. If higher ratings assigned by agencies to those issuers that pay for non-rating services are warranted, then default frequencies should be similar for firms within a given rating category, whether or not these firms have a non-rating relationship with the rating agency. If such issuers instead are treated more favourably, their ex-post default frequency would be higher than for other issuers with the same rating. The study finds support for the latter case... within a given rating category, firms that pay for non-rating services have higher one-year default rates than other firms. The fact that issuers that obtain non-rating services have higher ratings but higher default rates clearly points towards significant conflicts of interest despite claims of objectivity and independence by CRAs.

6.  Contract workers are an increasing share of the workforce even among India's leading IT companies,

Wipro, the country’s third largest software company, hired more contract workers than full-time employees in each of the past six years... Their number has increased from 70-odd in 2010 to more than 20,000 at the end of March.

7. Amazon announced an additional $3 bn investment in India last week, adding to the $2 bn made over the last two years. The major share of spending for e-commerce firms has been on marketplace discounting,

(Discount) sales and their accompanying ads are among the biggest sources of expenditure as well the biggest drivers of revenue for Amazon and the other online retailers... Amazon ran through nearly $2 billion in India in less than two years since its chief executive Jeff Bezos announced the investment in July 2014...

But such spending may no longer be possible given the new FDI rules which while allowing 100% FDI in online retail of goods and services under the marketplace model, prevents e-commerce firms from influencing the pricing of products, directly or indirectly, and limits a single seller's share to 25% of sales on any marketplace. Evidently, this leaves Amazon and others with limited flexibility to offer deep discounts and leaves warehousing and logistics management as the major investment avenues. But there is only so much you can invest in e-commerce logistics. 

I believe that the FDI guidelines are a good example of industrial policy. In so far as the overwhelmingly large share of FDI in e-commerce went into deep discounting in the race to acquire customers, it had no productivity enhancing role. The FDI policy now limits that option and encourages these firms to invest in their supply chain infrastructure. In this context, can policy go one more step in channeling some share of these investments into establishing agriculture logistics infrastructure like cold storages? It may even be prudent to increase the seller's share beyond 25% in case of farm products.

8. Fascinating graphic that captures how twitter reveals the ideological preferences of Democrat and Republican Congressmen. The graphic points to a study that captures the science-related engagement as reflected in their respective Twitter accounts

The study's findings offer mixed news,

While the Senate’s interest in science is generally quite low, Senate Democrats are three times more likely than Republicans to follow science-related Twitter accounts like NASA or the National Oceanic and Atmospheric Administration. Interest in science, the authors conclude, “may now primarily be a ‘Democrat’ value”... (But) among the ten most scientifically engaged Republicans on Twitter, half were willing to cross the aisle in January 2015 to vote in favour of an amendment declaring that “climate change is real” and that “human activity contributes to climate change”. With a greater understanding of science, leaders in Congress may be more willing to break party ranks and find common ground.

The Swedish lessons for Europe

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Fiscal policy Rules - Chilean experience

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

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

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

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

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

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

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

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

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

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

Highlights of Budget 2011-12

1. Budget at a glance - how money comes and where it is spent?





2. Expenditure control is one of the highlights of the budget, especially with decreases in all major subsidy categories. Further, the budgeted net borrowing of Rs3.4 trillion for this fiscal is Rs 40,000 crore less than market expectations. However, it remains to be seen whether the targets will be met.



3. The landmark decision of the budget was arguably the one to replace fertiliser, fuel and LPG subsidies with direct cash transfers from March 2012. Interestingly, the size of the subsidy bill, including for food, for the year 2011-12 has been reduced by 12.5% from the current year’s revised estimates to Rs 1.4 lakh crore.



4. On infrastructure, the FII limit for investment in corporate bonds, with residual maturity of over five years issued by companies in the infrastructure sector, was increased four-fold from the current $5 bn to $25 bn, albeit with a minimum lock-in period of five years. This is not likely to have any immediate impact as only half-a-billion dollar out of the existing limit of $5 billion has so far been utilised.



The allocation for infrastructure sector was increased by 23.2% to Rs 2,14,000 Cr, which is about 48.5% of the gross budgetary support to plan expenditure. To attract foreign funds for financing of infrastructure, special vehicles can henceforth be created in the form of infrastructure debt funds; interest payments on the borrowings of these funds will be taxed at 5% instead of the current 20%; and the income of the fund will be exempt from tax.

Since infrastructure companies are usually organized as SPVs, FIIs would also be permitted to invest in unlisted bonds with a minimum lock-in period of three years and will also be allowed to trade amongst themselves even during the lock-in period.

5. Overall social sector spending goes up 17%. Education and healthcare will get 24% and 20% more respectively. However, NREGA spending, a large part of whose allocation was unspent this fiscal, has remained same.



6. To address the critical issue of supply-side constraints in agriculture, there were a number of initiatives. The interest subvention subsidy on farm loans repaid on time was increased from 2% to 3%. The target for agriculture sector credit has been raised by Rs 1 lakh crore to Rs 4.75 lakh Cr. Further, allocation under the Rashtriya Krishi Vikas Yojana(RKVY), which incentivises states to invest in the farm sector, was raised to Rs 7,860 crore from Rs 6,755 crore in the current fiscal. Another Rs 2200 Cr was earmarked to improve productivity and boost production of vegetables, pulses, oilseeds, millet and fodder.



It was also decided to grant 'infrastructure sector' status to cold storage facilities and exempt cold chain equipment from excise duties. Further, capital investment in the creation of modern storage capacity would be eligible for a viability gap funding scheme from the Finance ministry.

It was also announced that 2 mt of storage capacity would be created in the coming fiscal under the Public Entrepreneurs Guarantee (PEG) Scheme. It is estimated that there is a shortage of agriculture storage capacity of 32 mt, which would require investments in excess of Rs 10000 Cr.

7. Tax to GDP ratios are rising again, though much remains to be done.



8. Corporate tax surcharge on domestic companies has been cut from 7.5% to 5%. The rate of Minimum Alternate Tax (MAT), levied on developers of Special Economic Zones as well as units operating in SEZs, has been raised from 18% of book profits to 18.5%. For the year 2011-12, dividends received by an Indian company from its foreign subsidiary will be taxed at a lower rate of 15%, to provide these funds an incentive to flow to India.

9. Interesting graphic on the sector-wise effective corporate tax rates.



10. The aforementioned graphic highlights the critical role of exemptions or "subsidy to preferred tax payers". In 2010-11, the central government lost potential tax revenue worth a staggering Rs.5.7 lakh crore due to the various exemptions, concessions and rebates it gave. These concessions, which form about 80% of the total tax expected to be collected in the period, are given to corporate and personal income tax payers, and excise and customs duty payers. After deducting export credit related concessions, the revenue foregone amounts to Rs 5.1 lakh crore.



Excise and customs duty rebates form about 39% and 34% respectively of the total revenue foregone, while personal income tax formed just 10% and corporate tax 17%. However, such revenues foregone has been increasing over the years, more than doubling from about Rs 2.4 lakh crore in 2006-07 to the present Rs 5.6 lakh crore. with the proportion increasing from 50% to 80% of total tax collections. The effective tax rate on the 4.27 lakh corporate returns filed by end of December 2010 was 23.53% as against the statutory tax rate of 33.99%.

Obama Budget proposals

President Obama's ten year budget proposals reveal the true extent of America's government debt crisis. As the Times reports, by President Obama’s own optimistic projections, federal government's budget deficit will peak at 11% of GDP in 2010 and will not return to what are widely considered sustainable levels (3% of GDP) till next ten years.

The budget projects that the deficit will peak at nearly $1.6 trillion in the current fiscal year (2009-10), a post-World War II record, and then decline to $1.3 trillion in the 2010-11 fiscal (starting October 2010), but will remain at economically troublesome levels over the remainder of the decade. Over 10 years, the budget is expected to save an estimated $1.2 trillion, mainly by ending the Bush tax cuts for the richest Americans and freezing some domestic spending for three years.

Obama's $3.8 trillion budget for fiscal year 2011 incorporates proposals to overhaul the health care system and energy policies, which are languishing in Congress. It also contains a $266 billion proposal on tax credits for hiring and new job-creation investments, and on other short-term stimulus including extended unemployment compensation.

As the Times writes, it does not make the really hard choices about entitlement programs — Medicare and Medicaid, especially — and about taxes that are essential to cut annual deficits and to begin paying down an accumulated debt (both domestic and foreign), which is forecast to equal 77% of GDP by 2020, the highest since 1950. The President has already proposed a widely criticized three year freeze on all non-defense discretionary spending to rein in the spiralling federal debt.

The real deficit picture is likely to turn out to be far worse, as this graphic shows, since in the last 30 years, about 80% of four-year budget forecasts have been too optimistic.

The budget has also been criticized for not doing enough to address the steep unemployment challenge and trying to put deficit reduction (through spending freeze) over short-term fiscal support to pull the economy out of the bottom. In fact, the budget proposals forecast the unemployment rate to be 9.8% at the end of 2010, 8.9% at the end of 2011, and 7.9% at the end of the Presidential election year of 2012.

Economix points to the figures on US government revenues and expenditures recently released by the Office of Management and Budget. Interestingly, even as the shares of individual income tax has remained stagnant, excise and corporate taxes have declined, payroll taxes (which includes Social Security and Medicare taxes) have become a much larger source of revenue for the federal government over the years.



On the expenditure side, the decline in defense has mirrored the worrying increase in health care expenses.



This superb graphic, courtesy Brad de Long, captures the reasons for the steep deficits. The Bush era tax cuts and its impact tower over all others, including the impact of the current recession. The Iraq and Af-Pak wars too have contributed substantially. In contrast and surprisingly, the fiscal stimulus appears to have had very limited impact, adding credence to the increasingly widespread belief that the Obama administration got too much caught up with barking down the wrong tree and not expanding the ARRA for fear of increasing the deficit.



As this excellent editorial in the Times points out, to seriously address the debt problem, President Obama will have to fix health care, broaden and raise taxes and reform social security. It estimates that given the rising health care costs and an aging population (and its impact on Medicaid, Medicare, and Social Security) without these serious reforms, federal debt in the United States would grow from 53% of GDP in 2009 to more than 300% by 2050.

The graphic above also clearly indicates that the stimulus spending has contributed only a miniscule share to the increased public debt burden. This also goes against the growing chorus that another round of stimulus spending will be suicidal in the efforts to unwind the debt burdens. As Joseph Stiglitz recently wrote, "The US economy needs another stimulus, and it needs it now."

Mark Thoma draws the distinction between the need for a short-run deficit to boost demand and reduce unemployment now, with the need to implement health care reforms to address the long-run imbalance in the budget. He writes, "Whether we spend more or less to fight the employment problem that exists right now has little to do with solving this (health care and long run imbalance) problem, and there's no reason at all for concern about the long-run problem to stop us from doing more now. No reason except deficit fetishness that refuses to separate the long-run health care cost problem from the largely independent short-run needs of those who are struggling to find employment in an economy that is still losing jobs."

Paul Krugman points to the annual President's Economic Report which shows that the stimulus fades out fast starting in fiscal 2011 (which starts in October 2010), even as unemployment being around as high as it is now. He feels that a premature stimulus exit (or not having another round of stimulus) has the danger of repeating 1937 when the FDR administration exit the stimulus when the economy had barely started to recover, thereby deepending the recession.



Update 1
The San Francisco Fed's economic outlook forecasts the persistence of economic output gap well into 2012.



Unemployment and GDP forecasts for the next two years are also available.

Update 2 (7/3/2010)
CBO report on the Budget and Economic Outlook is available here (see also a presentation here, pdf here)

Update 3 (17/3/2010)
David Leonhardt has an excellent summary of the need to balance between increasing taxes (increasing marginal tax rates etc) and cutting expenditure (health care reforms etc) in order to meet America's unsustainable public debt. Taxes fell from 21% of GDP in 2000 to a 60-year low of 15.1% in 2009.



This superb graphic clearly captures the difference between expenditure and revenues with projections for the next fifty years. As can be seen, the solution has to necessarily involve Medicare and Medicaid.



See also this NYT graphic and article on how the trillion dollar deficits were created during the last decade.

Update 4 (16/4/2010)
Via Mark Thoma




Update 5 (29/9/2010)

David Leonhardt summarizes the fiscal situation facing the US, "The bulk of the deficit problem instead comes from three popular programs, Medicare, Social Security and the military, and they happen to be the ones the Republican pledge exempts from cuts. But it’s impossible to fix the deficit without making cuts to these programs or raising taxes. To suggest otherwise is to claim that 10 minus 1 equals 5."

Lessons from Chile and Canada

Amidst the ruins of the sub-prime crisis and the Great Recession, two shining examples of good governance in administering the economy and financial markets stand out. I had blogged earlier about the role of the Reserve Bank of India (RBI) in keeping a lid on "irrational exuberance" in the credit and asset markets. Canada and Chile are two other examples worthy of emulation.

Fiscal prudence dictates that governments run counter-cyclical fiscal policy where they reduce overall debt when the economy is operating above its average growth trend and run up debts when the economy is running at below average growth so as to smooth over declines in aggregate demand. Jeffrey Frankel draws attention to Chile's achievement in effectively managing its long-term budget balance by resorting to prudent counter-cyclical fiscal measures.

At the risk of lowering its popularity, the government of Michelle Bachelet had resisted intense pressure to spend the soaring receipts from increases in copper exports and steep rises in their prices on populist expenditures. However, when the recession stuck and despite the fall in copper prices, the government drew down the assets that it had acquired during the copper boom and increased spending sharply, and thereby succeed in moderating the downturn.

This classic case of successful implementation of counter-cyclical fiscal policy was underpinned by the presence of the required institutional framework and strict fiscal rules (target for the overall budget surplus at 0.5% of GDP). The government introduced a Fiscal Responsibility Bill in 2006, which gave legal force to the role of the structural budget, and created a Pension Reserve Fund and a Social and Economic Stabilization Fund, the latter a replacement for the existing Copper Stabilization Funds. As Prof Frankel writes, under the Chilean rules, the government can run a deficit larger than the target to the extent that

1. Output falls short of potential, in a recession, or
2. The price of copper is below its medium-term (10-year) equilibrium

Interestingly, there are two institutionalized panels of experts whose job it is each mid-year to make the judgments, respectively, what is the output gap and what is the medium term equilibrium price of copper. This effectively de-politicized the decision to run large fiscal deficits. The panels rightly ruled during the copper boom of 2003-08 that most of the price increase was temporary so that most of the earnings had to be saved.

Prof Frankel suggests that countries, especially commodity producers, could apply variants of the Chilean fiscal device. He writes,

"Given that many developing countries are more prone to weak institutions, a useful reinforcement of the Chilean idea would be to give legal independence to the panels. There could a requirement regarding the professional qualifications of the members and laws protecting them from being fired, as there are for governors of independent central banks. The principle of a separation of decision-making powers should be retained: the rules as interpreted by the panels determine the total amount of spending or budget deficits, while the elected political leaders determine how that total is allocated."

Mark Thoma compares such institutional interventions to a form of Taylor Rule for fiscal policy. See also Mostly Economics.

The second shining example throughout the ongoing turmoil has been Canadian financial markets. As Paul Krugman argues, Canada faced much the same domestic and external environments in the lead up to the crisis as the US - loose money policies and robust economic growth at home and a "flood of cheap goods and cheap money from Asia". Like the six "too-big-to-fail" financial firms in the US, the Canadian financial market landscape is dominated by five banking groups. But when the bubble burst, unlike the US, in Canada mortgage defaults did not soar, major financial institutions did not collapse, and there were very few bailouts.

Canada's success lay in more effective regulation which included "much stricter limits on leverage, much stricter limits on unconventional mortgages, and an independent consumer protection agency for borrowers" and its adherence to "boring banking" to keep bankers honest. Canada's independent Financial Consumer Agency had sharply restricted subprime-type lending and its bank regulators had placed well-defined limits on securitization by requiring that lenders hold on to some of their loans.

Update 1
See also this post on the parallel between the long-term unemployment in the US now and "unpleasant parallels to Canada's experience of the 1990's".

Update 2 (25/3/2010)
Simon Johnson and Peter Boone disagrees that Canada provides an example of better regulation. Canada has five mega TBTF banks who ran up higher leverage (average of 19 times levered) than the big six US TBTF banks. Their capital requirements - both Tier One capital and tangible common equity ratios - were lower than US banks and were therefore less capitalized. However, all of them enjoyed guarantees provided by the government of Canada (over half of Canadian mortgages are effectively guaranteed by the government), especially on their mortgages (just like Fannie Mae & Co, who however did relax their lending standards and slipped into trouble).