Friday, September 10, 2010
Third party assessment in government
Here is my Mint op-ed that makes the case for using third party agencies to provide feedback on the quality of public service delivery and thereby improve the effectiveness of our supervisory bureaucracy.
Detectives to supervise service delivery
It is widely acknowledged that the biggest failure of our government bureaucratic machinery lies in its inability to ensure the effective implementation of the myriad welfare and development programs.
Traditional supervisory mechanisms within the government suffer from numerous deficiencies. Apart from the badly mis-aligned incentive structure, dys-functional chain of command, and poorly motivated individuals, existing supervisory architecture is inherently over-burdened and over-stretched in many dimensions. Field supervisors invariably have too many locations, spread over too large an area, with a vast variety of activities, and all this without adequate training, logistics and resources.
In this context third party assessment, by a professionally competent and independent agency, has the potential to improve the quality of public service delivery and program implementation.
The theoretical case in favor of an external assessment is unexceptionable. It flies against any logic to have a supervisory mechanism constituting the very same people whose services are being monitored. Such independent monitoring is all the more important given the unmistakable shift in focus from a merely quantitative to a qualitative assessment of government's activities.
One of the biggest breakthroughs in improving the quality of public construction works in recent years have come from the introduction of mandatory third party quality control checks. Typically government departments call open competitive tenders and contract out engineering works - roads and drains, water and sewerage, buildings, etc - for execution through contractors and then the regular department officials supervise the quality of execution.
However, this arrangement posed the inevitable conflict of interest, wherein the supervisory engineers often colluded with the contractors to dilute the quality of works. In the circumstance, third party quality audits, consisting of random and surprise inspections of works at each stage, by competitively selected external agencies, emerged as a preferred strategy to elicit an independent feedback about the quality of works. In recent years, this has become a mandatory requirement in all projects being implemented by both central and most state governments.
Extending the logic of TPQC beyond engineering works, it is natural to deploy it in an independent assessment of various government programs. The services of independent agencies can be utilized to obtain feedback about the functioning of institutions like schools, hospitals, and even various government offices, apart from the quality service delivery in various government programs. They can range from the specific - which teacher, doctor or official is taking bribes or irregular in work or ineffectual, quality of a work or service delivered etc - to the general - sources of leakages or bottlenecks or delays in the delivery of a service, inefficiencies within the system, and so on.
Instead of the third party assessment duplicating the existing regular supervisory mechanism, a mandate involving randomly sampled inspections may be adequate. The certainty of follow-up action, punitive or remedial, on its findings will be powerful enough deterrent to ensure its effectiveness.
The critical ingredient for success in this market is integrity and credibility of the agency. In other words, third party assessment agencies are in the business of selling integrity. In complex socio-political environments, where the avenues for incentive distortions are numerous and mostly unanticipated, managing such a business can be a herculean task.
Most often, a successful engineering TPQC agency, which starts off as a team of a handful of committed people with exceptional integrity, loses the way as it expands to take in more work. In a rapidly emerging market, where success immediately begets more success, with a resultant proliferation of business opportunities, firms often bite off more than they can chew and in the process end up diluting their standards and ultimately losing credibility. With time, many of these firms end up being indistinguishable from the government supervisory mechanism.
Rigorous internal quality controls are therefore fundamental to success in this business. Once lost, credibility is very difficult to recover. The general lack of qualified professionals, coupled with the need to attract people with integrity and keep them honest, would require the development of a robust business model.
All this of course assumes that the head of the institution is himself committed towards improving the system, an itself often debatable premise. However, it cannot be denied that third party assessment equips officials with a hitherto unavailable and powerful force multiplier that dramatically increases their span of control and thereby supervisory effectiveness. In other words, all things being equal, effective use of third party assessment has the potential to considerably improve the quality of government service delivery channels.
Critics would surely allege that this is a back door entry of private agencies into the basic governance functions itself. However, it needs to be borne in mind that the success and widespread adoption of TPQC with engineering works has not generated voices calling for scaling back the regular engineering supervision.
However, it is important to be clear about their scope of work and objectives, so as to ensure that it does not become an excuse and cause for further erosion of the already weak regular supervisory systems. Fundamentally, the outputs of the third party agency should be a feedback for only the highest level of administration, preferably only the Head of Department, and should complement, not supplement, the role of the regular supervisory architecture. A third party assessment service would differ from a regular survey (or opinion poll), in the continuing and qualitative nature of the engagement with the agency.
For all those venture capitalists, in search of an idea to fund, partnership with the government in the creation of a competitive market for independent service quality assessment would do more than any other innovation to atleast partially address the persistently stubborn implementation failure of Indian bureaucracy.
Traditional supervisory mechanisms within the government suffer from numerous deficiencies. Apart from the badly mis-aligned incentive structure, dys-functional chain of command, and poorly motivated individuals, existing supervisory architecture is inherently over-burdened and over-stretched in many dimensions. Field supervisors invariably have too many locations, spread over too large an area, with a vast variety of activities, and all this without adequate training, logistics and resources.
In this context third party assessment, by a professionally competent and independent agency, has the potential to improve the quality of public service delivery and program implementation.
The theoretical case in favor of an external assessment is unexceptionable. It flies against any logic to have a supervisory mechanism constituting the very same people whose services are being monitored. Such independent monitoring is all the more important given the unmistakable shift in focus from a merely quantitative to a qualitative assessment of government's activities.
One of the biggest breakthroughs in improving the quality of public construction works in recent years have come from the introduction of mandatory third party quality control checks. Typically government departments call open competitive tenders and contract out engineering works - roads and drains, water and sewerage, buildings, etc - for execution through contractors and then the regular department officials supervise the quality of execution.
However, this arrangement posed the inevitable conflict of interest, wherein the supervisory engineers often colluded with the contractors to dilute the quality of works. In the circumstance, third party quality audits, consisting of random and surprise inspections of works at each stage, by competitively selected external agencies, emerged as a preferred strategy to elicit an independent feedback about the quality of works. In recent years, this has become a mandatory requirement in all projects being implemented by both central and most state governments.
Extending the logic of TPQC beyond engineering works, it is natural to deploy it in an independent assessment of various government programs. The services of independent agencies can be utilized to obtain feedback about the functioning of institutions like schools, hospitals, and even various government offices, apart from the quality service delivery in various government programs. They can range from the specific - which teacher, doctor or official is taking bribes or irregular in work or ineffectual, quality of a work or service delivered etc - to the general - sources of leakages or bottlenecks or delays in the delivery of a service, inefficiencies within the system, and so on.
Instead of the third party assessment duplicating the existing regular supervisory mechanism, a mandate involving randomly sampled inspections may be adequate. The certainty of follow-up action, punitive or remedial, on its findings will be powerful enough deterrent to ensure its effectiveness.
The critical ingredient for success in this market is integrity and credibility of the agency. In other words, third party assessment agencies are in the business of selling integrity. In complex socio-political environments, where the avenues for incentive distortions are numerous and mostly unanticipated, managing such a business can be a herculean task.
Most often, a successful engineering TPQC agency, which starts off as a team of a handful of committed people with exceptional integrity, loses the way as it expands to take in more work. In a rapidly emerging market, where success immediately begets more success, with a resultant proliferation of business opportunities, firms often bite off more than they can chew and in the process end up diluting their standards and ultimately losing credibility. With time, many of these firms end up being indistinguishable from the government supervisory mechanism.
Rigorous internal quality controls are therefore fundamental to success in this business. Once lost, credibility is very difficult to recover. The general lack of qualified professionals, coupled with the need to attract people with integrity and keep them honest, would require the development of a robust business model.
All this of course assumes that the head of the institution is himself committed towards improving the system, an itself often debatable premise. However, it cannot be denied that third party assessment equips officials with a hitherto unavailable and powerful force multiplier that dramatically increases their span of control and thereby supervisory effectiveness. In other words, all things being equal, effective use of third party assessment has the potential to considerably improve the quality of government service delivery channels.
Critics would surely allege that this is a back door entry of private agencies into the basic governance functions itself. However, it needs to be borne in mind that the success and widespread adoption of TPQC with engineering works has not generated voices calling for scaling back the regular engineering supervision.
However, it is important to be clear about their scope of work and objectives, so as to ensure that it does not become an excuse and cause for further erosion of the already weak regular supervisory systems. Fundamentally, the outputs of the third party agency should be a feedback for only the highest level of administration, preferably only the Head of Department, and should complement, not supplement, the role of the regular supervisory architecture. A third party assessment service would differ from a regular survey (or opinion poll), in the continuing and qualitative nature of the engagement with the agency.
For all those venture capitalists, in search of an idea to fund, partnership with the government in the creation of a competitive market for independent service quality assessment would do more than any other innovation to atleast partially address the persistently stubborn implementation failure of Indian bureaucracy.
Thursday, September 9, 2010
Institutionalizing fiscal policy
Historically, while there has been a well-established architecture, both in terms of institutions and formal rules, for taking monetary policy decisions, none exists for fiscal policy actions. Interest rates are set by Central Banks (and their Monetary Policy Committees) using the standard Taylor Rule framework, or one of its variants, with reference to prevailing macroeconomic parameters like inflation and unemployment rates.
While price stability, embodied in low long-run inflation rates, is more or less an accepted part of public debates, debates about an acceptable level of public debt and deficits raise several controversies. Further, the re-distributional side of fiscal policy and its attendant political dimensions introduces a strong political economy aspect into fiscal policy decisions. Unlike the largely apolitical interest rate decisions, those on whom or what to tax (and their respective rates of taxation) and what and where to spend or cut expenditures are of deeply political nature.
The Great Recession and the resultant need for fiscal expansion, at a time when economies across the world are fiscally strained with massive and unsustainable debt burdens, has spot-lighted attention on the inadequacies of the standard fiscal policy toolbox. Unlike monetary policy, apart from being deeply political, fiscal policy decisions are mostly ad-hoc and piecemeal, with rarely any objective and independent assessment of future costs and returns.
In this context, at the Federal Reserve Bank of Kansas City’s annual Jackson Hole Symposium, Eric M. Leeper argued about the need for both fiscal research and fiscal policy practice to becoming more scientific. He makes the striking point that while "the macro policy dimensions of monetary policy — output and inflation stabilization — have been largely depoliticized, virtually no aspect of fiscal policy is insulated from politics".
Leeper draws the distinction between micro fiscal decisions (that are ground out by the give and take of politics) and macro fiscal issues (that can be treated as primarily scientific matters), and argues that once the overarching macro issues are settled, the politically determined micro questions would be constrained. He poses a series of questions that fiscal policy makers should address in their quest to making their task more objective and scientific
Nominal fiscal rules that place targets on fiscal deficits and public debts are amongst the commonest and simplest form of scientific fiscal policy practice. Many countries, notably Chile, Sweden, and New Zealand have nominal targets on these fiscal parameters. The most famous example of such fiscal rule is the European Union's Growth and Stability Pact that prescribed clear fiscal deficit and public debt targets for members.
India too adopted the Fiscal Responsibility and Budget Management (FRBM) Act in 2004, aimed at disciplining government expenditures. The FRBM mandated elimination of revenue deficit (by reducing it by 0.5% of GDP every year for five years beginning 2004-05) and fiscal deficit be lowered to 3% of GDP by 2008-09 (by annual reduction by 0.3% of GDP). The FRBM rules have mid-year targets for fiscal and revenue deficits, at 45% of budget estimates by the end of September each year. In case of a breach of either of the two limits, the Finance Minister will be required to explain to Parliament the reasons for the breach, the corrective steps, as well as the proposals for funding the additional deficit. See this excellent analysis of India's FRBM Act.
Fiscal councils are the other preferred institutional answer to the conduct of fiscal policy. Simon Wren-Lewis (via Amol Agarwal), who has an excellent website on Fiscal Councils, writes that such councils, which though funded by the government are independent, and provides macroeconomic policy advice, especially on the likely course of national budget deficits. They make the budget more transparent and credible, by providing independent analysis of the budget numbers, and checking the Government’s policy, budget projections, and growth assumptions for consistency.
It is believed that an independent fiscal council would promote counter-cyclical fiscal policies and reduce the deficit bias that governments are vulnerable to. They could provide independent and accurate (eliminating window dressing through off-balance sheet accounting) assessment of the current and future deficit projections implied by current policies. It would act as a possible restraint, working through public pressure and moral suasion, on the spending-happy, short-term biased populist governments. Further, it could also act as a "co-ordination mechanism that forces individual spending ministers to recognise the overall budget constraint".
Sweden, Hungary and Netherlands are among those with relatively well-functioning councils, though the US CBO has some of its features. Sweden has an independent fiscal policy council whose chair testifies before the Parliament, which in turn has succeeded in generating productive public debate about the trade-off between sustainability and fiscal stimulus, which the Swedish government and most others have been facing. In Netherlands, the government-run Central Planning Bureau (or Bureau for Economic Policy Analysis) has sufficient credibility as an independent evaluator that political parties feel compelled to have their fiscal plans vetted by the Bureau.
On similar lines, Tim Besley and Andrew Scott (via Amol Agarwal) have advocated setting up "independent fiscal policy committees to institutionalize fiscal transparency and restore credibility to governments’ long-term public finances", especially given the legacy of current expansionary policies and unsustainably large debts across many countries.
In the context of India, Niranjan Rajadhyaksha has argued for the establishment of a fiscal council, similar to the CBO, given the political difficulty of setting up any independent fiscal authorities. For a start though, the Finance Ministry would do well to try answering Eric Leeper's aforementioned set of ten questions.
Update 1 (22/4/2011)
Lars Calmfors and Simon Wren-Lewis argue that, with the right guarantees of their independence in place, independent fiscal councils can make a significant positive contribution to fiscal policy.
While price stability, embodied in low long-run inflation rates, is more or less an accepted part of public debates, debates about an acceptable level of public debt and deficits raise several controversies. Further, the re-distributional side of fiscal policy and its attendant political dimensions introduces a strong political economy aspect into fiscal policy decisions. Unlike the largely apolitical interest rate decisions, those on whom or what to tax (and their respective rates of taxation) and what and where to spend or cut expenditures are of deeply political nature.
The Great Recession and the resultant need for fiscal expansion, at a time when economies across the world are fiscally strained with massive and unsustainable debt burdens, has spot-lighted attention on the inadequacies of the standard fiscal policy toolbox. Unlike monetary policy, apart from being deeply political, fiscal policy decisions are mostly ad-hoc and piecemeal, with rarely any objective and independent assessment of future costs and returns.
In this context, at the Federal Reserve Bank of Kansas City’s annual Jackson Hole Symposium, Eric M. Leeper argued about the need for both fiscal research and fiscal policy practice to becoming more scientific. He makes the striking point that while "the macro policy dimensions of monetary policy — output and inflation stabilization — have been largely depoliticized, virtually no aspect of fiscal policy is insulated from politics".
Leeper draws the distinction between micro fiscal decisions (that are ground out by the give and take of politics) and macro fiscal issues (that can be treated as primarily scientific matters), and argues that once the overarching macro issues are settled, the politically determined micro questions would be constrained. He poses a series of questions that fiscal policy makers should address in their quest to making their task more objective and scientific
1. Should there be a long-run target for the debt-GDP ratio? What should it be?
2. Are there circumstances under which deficits (surpluses) should be permitted to permanently raise (lower) the debt-GDP ratio or should debt always be retired back to some long-run target?
3. Should government spending, taxes, and monetary policy be adjusted to stabilize debt?
4. How rapidly should the debt ratio be retired back to the target ratio?
5. What are the macroeconomic effects of certain government spending and tax changes in well-specified thought experiments?
6. What are a country’s fiscal limits and how much government debt can it support before markets deem the debt to be risky?
7. What happens as the economy approaches its fiscal limit?
8. What policies can keep the economy well away from its limit?
9. What are the are the macroeconomic consequences of alternative policy responses to the era of fiscal stress?
10. Should monetary and fiscal policy behave in fundamentally different ways in an era of fiscal stress than they do in normal times?
Nominal fiscal rules that place targets on fiscal deficits and public debts are amongst the commonest and simplest form of scientific fiscal policy practice. Many countries, notably Chile, Sweden, and New Zealand have nominal targets on these fiscal parameters. The most famous example of such fiscal rule is the European Union's Growth and Stability Pact that prescribed clear fiscal deficit and public debt targets for members.
India too adopted the Fiscal Responsibility and Budget Management (FRBM) Act in 2004, aimed at disciplining government expenditures. The FRBM mandated elimination of revenue deficit (by reducing it by 0.5% of GDP every year for five years beginning 2004-05) and fiscal deficit be lowered to 3% of GDP by 2008-09 (by annual reduction by 0.3% of GDP). The FRBM rules have mid-year targets for fiscal and revenue deficits, at 45% of budget estimates by the end of September each year. In case of a breach of either of the two limits, the Finance Minister will be required to explain to Parliament the reasons for the breach, the corrective steps, as well as the proposals for funding the additional deficit. See this excellent analysis of India's FRBM Act.
Fiscal councils are the other preferred institutional answer to the conduct of fiscal policy. Simon Wren-Lewis (via Amol Agarwal), who has an excellent website on Fiscal Councils, writes that such councils, which though funded by the government are independent, and provides macroeconomic policy advice, especially on the likely course of national budget deficits. They make the budget more transparent and credible, by providing independent analysis of the budget numbers, and checking the Government’s policy, budget projections, and growth assumptions for consistency.
It is believed that an independent fiscal council would promote counter-cyclical fiscal policies and reduce the deficit bias that governments are vulnerable to. They could provide independent and accurate (eliminating window dressing through off-balance sheet accounting) assessment of the current and future deficit projections implied by current policies. It would act as a possible restraint, working through public pressure and moral suasion, on the spending-happy, short-term biased populist governments. Further, it could also act as a "co-ordination mechanism that forces individual spending ministers to recognise the overall budget constraint".
Sweden, Hungary and Netherlands are among those with relatively well-functioning councils, though the US CBO has some of its features. Sweden has an independent fiscal policy council whose chair testifies before the Parliament, which in turn has succeeded in generating productive public debate about the trade-off between sustainability and fiscal stimulus, which the Swedish government and most others have been facing. In Netherlands, the government-run Central Planning Bureau (or Bureau for Economic Policy Analysis) has sufficient credibility as an independent evaluator that political parties feel compelled to have their fiscal plans vetted by the Bureau.
On similar lines, Tim Besley and Andrew Scott (via Amol Agarwal) have advocated setting up "independent fiscal policy committees to institutionalize fiscal transparency and restore credibility to governments’ long-term public finances", especially given the legacy of current expansionary policies and unsustainably large debts across many countries.
In the context of India, Niranjan Rajadhyaksha has argued for the establishment of a fiscal council, similar to the CBO, given the political difficulty of setting up any independent fiscal authorities. For a start though, the Finance Ministry would do well to try answering Eric Leeper's aforementioned set of ten questions.
Update 1 (22/4/2011)
Lars Calmfors and Simon Wren-Lewis argue that, with the right guarantees of their independence in place, independent fiscal councils can make a significant positive contribution to fiscal policy.
Tuesday, September 7, 2010
MFIs and their higher interest rates
In the past two decades, micro-finance (and self-help groups) has almost acquired a reputation of being the closest to a magic bullet in development policy-making. One of the distinguishing features of microfinance is the higher interest rates charged by microfinance institutions (MFIs). Esther Duflo and Abhijit Banerjee have an article in the Journal of Economic Perspectives that highlights this,
The sequence of events goes something like as follows
1. The lender has to incur a fixed cost on maintaining a large recovery machinery and general administration of the loan. In view of the large numbers of these borrowers and the specific nature of such loans (no collateral loans to those without any prior credit history), the fixed enforcement costs (due to more enforcers, need to collect information on a larger number of people etc) are likely to be large. The larger fixed costs coupled with smaller loan amounts means higher interest rates.
2. Higher the interest rates, the less credit-worthy borrowers will "crowd-out" the more credit-worthy ones, and an adverse selection effect will be generated. The higher interest rates would attract borrowers who are intrinsically more likely to default. This too adds to the administration cost at the margins.
3. Higher interest rates will naturally lower the size of loans. This also means that the absolute interest repayments will form a larger percentage of the loan principal. In other words, smaller loans means that the fixed costs as a percentage of the loan amount will be higher, thereby driving the interest rates even higher up.
Here is a graphical illustration of how the high administration charges of micro-loans drives up the rates, crowds out the best borrowers, lowers average loan amounts, and thereby forces rates even further up.
The moral hazard is amplified by the presence of multiple and competing lenders. The cost of a likely default is often lowered by the possibility of another lender waiting in the wings to step up when the need arises again. In this context, it would be interesting to examine the moral hazard effect on private micro-lenders arising from the presence of government micro-finance (if they default there, they can always fall back on the government)?
The cost of default has to be higher than the interest payment so as to minimize the possibility of default. As Banerjee and Duflo point out, the incentive of a continuous relationship with the bank/micro-lender often provides the deterrent against default.
The fundamental issue being raised here is this. Micro-finance has emerged as one of the major sources of channeling credit to poor people. It is arguable that even as micro-finance has grown in importance, it may have had unintended effect of taking away the focus from penetration of conventional banking into rural areas and among the poor.
However, as the aforementioned reasoning/modelling suggests, micro-finance services only a specific category of customers among the poor. While regular consumption needs and business working capital requirements (with their focus on adequacy and timeliness) are optimally serviced by micro-loans, small-business capital investments (which need larger and longer tenor loans) would require conventional banking.
Conventional banking will always be the preferred choice for customers borrowing higher amounts with longer tenors. Further, there will be a large share of the poor who cannot afford the higher rates charged by the micro-financiers. Under the circumstances, the total consumer welfare among the poor can be maximized only if micro-loans complement, and not substitute, conventional banking sources.
"These fixed costs of administering a loan can explain why interest rates for small loans are so high, why they vary so much across borrowers, and why the poor pay higher interest rates. Since borrowers with little wealth must get small loans, the fixed administrative cost has to be covered by the interest payment, which pushes the interest rate up. But high interest rates exacerbate the problem of getting borrowers to repay. Total lending therefore shrinks further, pushing up interest rates even more, and so forth, until the loan is small enough and the interest rate high enough to cover the fixed cost for even a small borrower. In other words, the presence of fixed costs introduces a kind of multiplier into the process of determining the amount lent and the rate charged... And if the borrowers are poor enough or the fixed administrative cost is high enough, the interest rate could become infinite: these borrowers will be unable to borrow at all."
The sequence of events goes something like as follows
1. The lender has to incur a fixed cost on maintaining a large recovery machinery and general administration of the loan. In view of the large numbers of these borrowers and the specific nature of such loans (no collateral loans to those without any prior credit history), the fixed enforcement costs (due to more enforcers, need to collect information on a larger number of people etc) are likely to be large. The larger fixed costs coupled with smaller loan amounts means higher interest rates.
2. Higher the interest rates, the less credit-worthy borrowers will "crowd-out" the more credit-worthy ones, and an adverse selection effect will be generated. The higher interest rates would attract borrowers who are intrinsically more likely to default. This too adds to the administration cost at the margins.
3. Higher interest rates will naturally lower the size of loans. This also means that the absolute interest repayments will form a larger percentage of the loan principal. In other words, smaller loans means that the fixed costs as a percentage of the loan amount will be higher, thereby driving the interest rates even higher up.
Here is a graphical illustration of how the high administration charges of micro-loans drives up the rates, crowds out the best borrowers, lowers average loan amounts, and thereby forces rates even further up.
The moral hazard is amplified by the presence of multiple and competing lenders. The cost of a likely default is often lowered by the possibility of another lender waiting in the wings to step up when the need arises again. In this context, it would be interesting to examine the moral hazard effect on private micro-lenders arising from the presence of government micro-finance (if they default there, they can always fall back on the government)?
The cost of default has to be higher than the interest payment so as to minimize the possibility of default. As Banerjee and Duflo point out, the incentive of a continuous relationship with the bank/micro-lender often provides the deterrent against default.
The fundamental issue being raised here is this. Micro-finance has emerged as one of the major sources of channeling credit to poor people. It is arguable that even as micro-finance has grown in importance, it may have had unintended effect of taking away the focus from penetration of conventional banking into rural areas and among the poor.
However, as the aforementioned reasoning/modelling suggests, micro-finance services only a specific category of customers among the poor. While regular consumption needs and business working capital requirements (with their focus on adequacy and timeliness) are optimally serviced by micro-loans, small-business capital investments (which need larger and longer tenor loans) would require conventional banking.
Conventional banking will always be the preferred choice for customers borrowing higher amounts with longer tenors. Further, there will be a large share of the poor who cannot afford the higher rates charged by the micro-financiers. Under the circumstances, the total consumer welfare among the poor can be maximized only if micro-loans complement, and not substitute, conventional banking sources.
Monday, September 6, 2010
Debts, unemployment, deflation and recovery - lessons from history
The logic in favor of fiscal expansion when faced with a recession, in which aggregate demand has tanked precipitously, unemployment is high, business investments have dried up, and debt-to-GDP ratio is rising (and when monetary policy has run into the zero-bound) is that it utilizes idle resources (labor and capital), sustains (and even boosts, depending on the size of the stimulus) demand, and prevents government revenues from declining (and thereby increasing the debt/GDP ratio). It also provides the required traction for the economy to climb the steep slope of recession and return to normalcy.
Temporary deficit-financed, fiscal expansion, has been opposed by the "austerians" on the grounds that it would amplify the already large debt stock and deficits, drive down market confidence, crowd-out private spending, and finally unleash an inflationary spiral that would only serve to worsen the precarious economic prospects of an economy fighting a recession. These posts - here, here, and here - are among those replying to this argument.
However, as with all economic theories, the true test of its utility lies in its application to real world events/issues. In this case, what has been the historical experience with countries facing similar macroeconomic conditions? The two big comparable events are the post-Depression (including wartime) US and Japan during the nineties. I have already blogged about them here.
This comparison of the total US debt (public plus private) from 1929 to 1948 in billions of dollars and the total debt as a percentage of GDP shows how a robust economic recovery can quickly wind down the debt/GDP ratio and lower the real debt burden. While from 1929 to 1933 when everyone was trying to pay down debt, the debt/GDP ratio skyrocketed thanks to contraction and deflation, whereas during and immediately after WWII, despite the massive borrowing the GDP grew faster than debt, and the debt burden ended up falling.
As a recent WSJ article opined, the persistence of decade-long fall in consumer prices in Japan had raised questions about the dynamics of deflation. The inflation-adjusted Phillips curve predicts not just deflation, but accelerating deflation in the face of a really prolonged economic slump.
However, though standard Phillips curve models claim that falling inflation results in rising unemployment, the experience of Japan with rising unemployment in the nineties led to a surprisingly mild, long drawn-out deflation instead of the expected deep, destructive and concentrated (depression-style) deflationary spiral. Japan's bitter and frustrating experience with economic stagnation and slowly falling prices since the early nineties raises fears that the US too could be stuck in the groove of sustained gradual deflation.
There is also mounting evidence that "prolonged periods of economic weakness are, with almost no exceptions, associated with falling inflation rates". Further, as the inflation rate goes toward zero, it seems to get "sticky", and as in the case of the US now, slight positive inflation persists in the face of an obviously depressed economy. Krugman has written that this slow movement towards deflation is also in keeping with theories of downward nominal wage rigidity (probably due to bounded rationality, there’s some downward inflexibility in prices and wages even after expectations have had time to fully adjust).
See also this episodic comparison of recessions in the US which shows that inflation falls with rising unemployment. However, as the aforementioned nominal wage and price stickiness theory would suggest, the decline in inflation (or disinflation) has been muted when the core-inflation rate has been low.
Update 1 (14/10/2010)
Jon Hilsenrath has this excellent account comparing Japan and the US.
Temporary deficit-financed, fiscal expansion, has been opposed by the "austerians" on the grounds that it would amplify the already large debt stock and deficits, drive down market confidence, crowd-out private spending, and finally unleash an inflationary spiral that would only serve to worsen the precarious economic prospects of an economy fighting a recession. These posts - here, here, and here - are among those replying to this argument.
However, as with all economic theories, the true test of its utility lies in its application to real world events/issues. In this case, what has been the historical experience with countries facing similar macroeconomic conditions? The two big comparable events are the post-Depression (including wartime) US and Japan during the nineties. I have already blogged about them here.
This comparison of the total US debt (public plus private) from 1929 to 1948 in billions of dollars and the total debt as a percentage of GDP shows how a robust economic recovery can quickly wind down the debt/GDP ratio and lower the real debt burden. While from 1929 to 1933 when everyone was trying to pay down debt, the debt/GDP ratio skyrocketed thanks to contraction and deflation, whereas during and immediately after WWII, despite the massive borrowing the GDP grew faster than debt, and the debt burden ended up falling.
As a recent WSJ article opined, the persistence of decade-long fall in consumer prices in Japan had raised questions about the dynamics of deflation. The inflation-adjusted Phillips curve predicts not just deflation, but accelerating deflation in the face of a really prolonged economic slump.
However, though standard Phillips curve models claim that falling inflation results in rising unemployment, the experience of Japan with rising unemployment in the nineties led to a surprisingly mild, long drawn-out deflation instead of the expected deep, destructive and concentrated (depression-style) deflationary spiral. Japan's bitter and frustrating experience with economic stagnation and slowly falling prices since the early nineties raises fears that the US too could be stuck in the groove of sustained gradual deflation.
There is also mounting evidence that "prolonged periods of economic weakness are, with almost no exceptions, associated with falling inflation rates". Further, as the inflation rate goes toward zero, it seems to get "sticky", and as in the case of the US now, slight positive inflation persists in the face of an obviously depressed economy. Krugman has written that this slow movement towards deflation is also in keeping with theories of downward nominal wage rigidity (probably due to bounded rationality, there’s some downward inflexibility in prices and wages even after expectations have had time to fully adjust).
See also this episodic comparison of recessions in the US which shows that inflation falls with rising unemployment. However, as the aforementioned nominal wage and price stickiness theory would suggest, the decline in inflation (or disinflation) has been muted when the core-inflation rate has been low.
Update 1 (14/10/2010)
Jon Hilsenrath has this excellent account comparing Japan and the US.
Sunday, September 5, 2010
Fiscal multipliers for tax cuts and spending
I have blogged here and here about fiscal multipliers for different policy choices. Among the different fiscal stimulus spending choices, there is heated debate on the relative effectiveness (in terms of its bang for the buck or fiscal multiplier) of tax cuts and direct spending.
In the US, with the controversial Bush original tax cut in place since June 2001, set to expire by end of this year, there is an intense debate raging about its future. Republicans expectedly want them to continue and made permanent, whereas Democrats are broadly converging to the view that it should expire for those with incomes beyond $250,000.
Mark Zandi has this revised and latest examinaton of the fiscal multipliers of various stimulus measures.
As can be seen, direct government spending - through unemployment benefits, food stamps, work sharing or infrastructure spending - top the list, giving more than a dollar's worth of stimulus for a dollar's worth of spending, while cuts to taxes affecting businesses and upper-income individuals - such as the corporate, dividend, capital gains and alternative minimum taxes - gives much less.
However, since tax cuts are politically easier to push through, tax rebates aimed at those likely to spend (as against save it), jobs tax credit to spur investment and hiring, and cuts in payroll tax (which finances Social Security and Medicare and is paid by both businesses and workers) may be the most effective.
See also this paper by Alan Auerbach and Yuriy Gorodnichenko who find that "large differences in the size of fiscal multipliers in recessions and expansions with fiscal policy being considerably more effective in recessions than in expansions" and that "controlling for predictable components of fiscal shocks tends to increase the size of the multipliers".
Update 1 (25/9/2010)
Analysis show that the 2008 Bush tax cuts failed.
In the US, with the controversial Bush original tax cut in place since June 2001, set to expire by end of this year, there is an intense debate raging about its future. Republicans expectedly want them to continue and made permanent, whereas Democrats are broadly converging to the view that it should expire for those with incomes beyond $250,000.
Mark Zandi has this revised and latest examinaton of the fiscal multipliers of various stimulus measures.
As can be seen, direct government spending - through unemployment benefits, food stamps, work sharing or infrastructure spending - top the list, giving more than a dollar's worth of stimulus for a dollar's worth of spending, while cuts to taxes affecting businesses and upper-income individuals - such as the corporate, dividend, capital gains and alternative minimum taxes - gives much less.
However, since tax cuts are politically easier to push through, tax rebates aimed at those likely to spend (as against save it), jobs tax credit to spur investment and hiring, and cuts in payroll tax (which finances Social Security and Medicare and is paid by both businesses and workers) may be the most effective.
See also this paper by Alan Auerbach and Yuriy Gorodnichenko who find that "large differences in the size of fiscal multipliers in recessions and expansions with fiscal policy being considerably more effective in recessions than in expansions" and that "controlling for predictable components of fiscal shocks tends to increase the size of the multipliers".
Update 1 (25/9/2010)
Analysis show that the 2008 Bush tax cuts failed.
Saturday, September 4, 2010
China's forex management and RMB revaluation imperative
The last decade has seen spectacular growth in China's external trade, and the ballooning trade surplus has resulted in an exponential growth in its foreign exchange reserves. Management of this, now more than $2.5 trillion, has been a source of much controversy and one of the biggest challenges for policy makers in Beijing.
What makes the management of its forex reserves an even bigger challenge is the expectation of the inevitable renminbi (RMB) appreciation, which while making foreign investors loath to borrow in RMB and invest abroad (for fear of losses when the RMB eventually appreciates) also encourages hot money inflows into China for investing in RMB assets (in expectation of higher returns when RMB finally appreciates).
As Ronald McKinnon writes, China has used four strategies to manage its forex reserves - liquid official reserves in the State Administration of Foreign Exchange (SAFE); sovereign wealth funds (like the China Investment Corporation) which invests overseas in bonds, equities, or real estate; encouraging Chinese state-owned firms to invest abroad in oil, power, rail, or other construction sectors; and quasi-barter aid programs in developing countries which generate a return flow of industrial materials.
In managing its forex reserves, China has taken lessons from Singapore, whose own currency is not used for international lending and whose government tightly controls overseas financial intermediation. Its large savings and foreign exchange surpluses are lent to two giant sovereign wealth funds - the Government Overseas Investment Corporation (GIC), which invests in fairly liquid overseas assets, and Temasek, which is more of a risk taker in foreign equities and real estate - who minimize systemic currency risk from international investing.
Being government government owned and therefore backed by large forex reserves, these agencies are best positioned to cushion any currency shocks. Further, since the foreign assets are held by the government agencies, the possibility of capital flight when the currency appreciates is ruled out. Also, the Singapore Dollar is managed through a gentle "float" against the US Dollar, whose stability anchors Singapore's national price level.
With dollar prevailing as the global currency of choice, China, despite being the world's largest creditor nation, cannot use its own currency to finance foreign investments. Apart from the fact that dollar is the universal currency of clearing international payments, what makes China an "immature creditor" nation is the fact that the Chinese domestic financial markets are not fully developed, have interest rate restrictions and residual capital controls.
In view of all this, foreigners prefer not to borrow from Chinese banks in RMB or issue RMB denominated bonds in China. Therefore, apart from Chinese corporations investing abroad, the only way in which foreign private investors take shares (or buy into) in China's massive forex surplus is through Chinese banks, insurance companies and pension funds' acquisition of dollar-denominated liquid foreign exchange assets.
But this generates a currency mismatch risk for Chinese investors - their domestic liabilities (bank deposits, annuity, or pension liabilities) are all RMB denominated while foreign assets are dollar denominated. The threat of a dollar devaluation (or RMB appreciation), which is inevitable, therefore carries considerable risks for these Chinese investors. Private Chinese investors would therefore find it unattractive to hold dollar assets, thereby leaving the central government to do the financial intermediation of China's massive foreign exchange surpluses in the global markets.
While this hedges against any risk of capital-flight induced by currency appreciation, it hinders the deepening and diversification of the Chinese financial markets. In other words, so long as the RMB remains over-valued, or atleast the perception persists, Chinese private investors would be deterred from investing abroad and private foreign investors would think twice before raising debt in China. Yet another reason to get done with revaluation of the RMB.
What makes the management of its forex reserves an even bigger challenge is the expectation of the inevitable renminbi (RMB) appreciation, which while making foreign investors loath to borrow in RMB and invest abroad (for fear of losses when the RMB eventually appreciates) also encourages hot money inflows into China for investing in RMB assets (in expectation of higher returns when RMB finally appreciates).
As Ronald McKinnon writes, China has used four strategies to manage its forex reserves - liquid official reserves in the State Administration of Foreign Exchange (SAFE); sovereign wealth funds (like the China Investment Corporation) which invests overseas in bonds, equities, or real estate; encouraging Chinese state-owned firms to invest abroad in oil, power, rail, or other construction sectors; and quasi-barter aid programs in developing countries which generate a return flow of industrial materials.
In managing its forex reserves, China has taken lessons from Singapore, whose own currency is not used for international lending and whose government tightly controls overseas financial intermediation. Its large savings and foreign exchange surpluses are lent to two giant sovereign wealth funds - the Government Overseas Investment Corporation (GIC), which invests in fairly liquid overseas assets, and Temasek, which is more of a risk taker in foreign equities and real estate - who minimize systemic currency risk from international investing.
Being government government owned and therefore backed by large forex reserves, these agencies are best positioned to cushion any currency shocks. Further, since the foreign assets are held by the government agencies, the possibility of capital flight when the currency appreciates is ruled out. Also, the Singapore Dollar is managed through a gentle "float" against the US Dollar, whose stability anchors Singapore's national price level.
With dollar prevailing as the global currency of choice, China, despite being the world's largest creditor nation, cannot use its own currency to finance foreign investments. Apart from the fact that dollar is the universal currency of clearing international payments, what makes China an "immature creditor" nation is the fact that the Chinese domestic financial markets are not fully developed, have interest rate restrictions and residual capital controls.
In view of all this, foreigners prefer not to borrow from Chinese banks in RMB or issue RMB denominated bonds in China. Therefore, apart from Chinese corporations investing abroad, the only way in which foreign private investors take shares (or buy into) in China's massive forex surplus is through Chinese banks, insurance companies and pension funds' acquisition of dollar-denominated liquid foreign exchange assets.
But this generates a currency mismatch risk for Chinese investors - their domestic liabilities (bank deposits, annuity, or pension liabilities) are all RMB denominated while foreign assets are dollar denominated. The threat of a dollar devaluation (or RMB appreciation), which is inevitable, therefore carries considerable risks for these Chinese investors. Private Chinese investors would therefore find it unattractive to hold dollar assets, thereby leaving the central government to do the financial intermediation of China's massive foreign exchange surpluses in the global markets.
While this hedges against any risk of capital-flight induced by currency appreciation, it hinders the deepening and diversification of the Chinese financial markets. In other words, so long as the RMB remains over-valued, or atleast the perception persists, Chinese private investors would be deterred from investing abroad and private foreign investors would think twice before raising debt in China. Yet another reason to get done with revaluation of the RMB.
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