Package of interventions and poverty elimination

Sometime back, I had blogged about the work of Charles Karelis of Colgate University who had, with his "bee-sting" theory, argued that poverty introduces a diminishing marginal utility to putting in effort.

The underlying premise is that while a person with one bee sting is highly motivated to get it treated, one with multiple bee stings does not have much incentive to get one sting treated, because the others will still throb. In other words, more of a painful or undesirable thing one has (i.e. the poorer one is), the less likely one is to do anything about any one problem. Or poverty is less a matter of having few goods than having lots of problems.

For example, randomized control trials around the world on improving learning outcomes have found that stand-alone interventions fail to deliver desired results. Researchers from MIT's Poverty Action Lab have found that reduction in class size not complemented with other measures like school committee empowerment and performance tracking of students, fails to yield any significant results.

If this insight is assumed true, then there are formidable limitations on the relative effectiveness of specific policy interventions in achieving their objectives. It may also help partially explain the less than satisfactory response from poor people to individual social policy interventions that encourage people to improve cleanliness and hygiene (use community toilets) or parents to send children to school or vaccinate infants or poor manage their finances optimally.

What is the incentive to overcome the inertia and expend effort to keep toilets clean when the entire neighbourhood is dirty? Where is the motivation to immunize the child when he/she is living amidst unhygenic surroundings and falls sick every week? Where is the motivation to use mosquito bed-nets when if mosquitoes do not catch you, bacterial infections will lay you down? What is the incentive to eat more expensive healthy food, when disease vulnerability is very high and incidence so commonplace?

In other words, a package of policies that incentivize use of mosquito bed-nets, construction of individual toilets, immunization, awareness creation on child nutrition and personal hygiene, and so on may be more effective than piece-meal health and sanitation interventions. Or a bundled financial product that combines savings account with health insurance, education scholarships, and pensions may generate greater savings outcomes than separate products.

Further, if the bee-sting theory reasoning is assumed to hold, there is a strong likelihood that the amount of incentives required to produce a desired behavioral change would be much larger with a single intervention than with a package of interventions. For example, the financial incentive to get children to school or parents to immunize children would be much larger if these interventions were made separately than if made as part of a bouquet. Therefore, an economically efficient approach may be to bundle a number of interventions together and incentivize them with a large enough cash transfer (which would be less than the sum of all the individual incentives).

All this means the likelihood of considerable variations in the relative effectiveness of individual policy interventions when implemented separately and when done as part of a package. Therefore, poverty eradication policies may be more effective if they address the challenge on multiple dimensions instead of piecemeal and one-off affairs. All this point towards the need for a "big push" in poverty eradication, including close co-ordination across departments.

An ideal opportunity to assess this hypothesis was the Millennium Villages Project (MVP) experiment. Unfortunately, as the recent controversy surrounding Michael Clemens and Gabriel Demombynes questioning the effectiveness of MVP in the absence of rigorous impact evaluation indicates, that opportunity may have been lost. They write,

"Comparing trends at the MVP intervention sites in Kenya, Ghana, and Nigeria to trends in the surrounding areas yields much more modest estimates of the project’s effects than the before-versus-after comparisons published thus far by the MVP. Neither approach constitutes a rigorous impact evaluation of the MVP, which is impossible to perform due to weaknesses in the evaluation design of the project’s initial phase. These weaknesses include the subjective choice of intervention sites, the subjective choice of comparison sites, the lack of baseline data on comparison sites, the small sample size, and the short time horizon."

They oppose the wisdom of spending huge amounts and expanding MVP without having access to objective evaluation of the its impact. See Jeff Sachs response here and a summary of the debate here.

Behavioural economics and human culture

At a time when behavioural economics has assumed centerstage as one of the most discussed areas in economics, Chris Dillow points to two papers that caution against indiscriminate generalizability of findings about human psychology and behvaiour based on narrow samples from Western societies. Both papers draw attention to the considerable variations in human nature on various basic domains across cultures that have the potential to generate different equilibriums when economics and psychology intersect.

Joseph Henrich, Steven J. Heine, and Ara Norenzayan, reviewed human responses to visual perception, fairness, spatial reasoning, moral reasoning, thinking‐styles, and self‐concepts, and finds "substantial variability in experimental results across populations" in these domains. For example, results of ultimatum game experiments differ hugely across tribes, with Americans making much higher offers than the Hadze in Tanzania or Tsimane in Bolivia.

Roberta Dessi and Xiaojian Zhao examined numerous studies in behavioural psychology that contrasts North Americans to Japanese and found that while North Americans value self-esteem and are prone to overconfidence, the Japanese are much less so to both. In contrast, shame appears to play a much more important role among Japanese than North Americans. It means that Americans and Japanese will respond differentially to incentives that plays on self-esteem and shame. Americans are more likely to respond positively to incentives that are tailored around promotion of self-esteem whereas Japanese are likely to react similarly to incentives structured around avoiding shame.

Does this mean that, fundamentally, all cognitive biases will have to be filtered through the lens of human cultural traits before proclaiming their universal applicability? Many commonplace cognitive biases do have a universal resonance. Human beings are not known for their ability to correctly predict what we would want in the future; are subject to self-control problems; are more averse to losses than attracted to similar sized gains; have problems evaluating complex choices; struggle to take decision when faced with an over-load of choices, and so on.

However, there are other findings which could end up going awry when filtered through certain cultural environments. One possible area relates to the outcome of the interaction between incentives and human behaviour, especially in the magnitude of incentives required to generate the desired outcomes. The outcome of monetary incentives for kidney donations could vary widely depending on respective cultures. Similarly, incentives to reward pro-social behaviour (like getting children to help at home) could generate a broad spectrum of outcomes based on the host cultural environments.

On same lines, studies have found that human response to financial incentives for behavioural changes vary depending on their respective socio-economic backgrounds. Jo Phelan and Bruce Link have found that those in lower socio-economic classes have poorer smoking cessation rates when responding to financial incentives.

Bootleggers, Baptists, and MFIs

A few years back, the now Clemson University Professor Bruce Yandle, wrote a famous paper that provided a crude theory of the demand for and supply of social policy regulation by invoking the parable of Bootleggers and Baptists.

Fervently supported by Baptists, early last century, some American states promulgated laws to ban Sunday sales of alcoholic beverages at legal outlets. Surprisingly, the biggest supporters of this legislation were the Bootleggers, who benefitted from the reduced availability and the opportunities to black market. In simple terms, Baptists demand prohibition to make alcohol illegal, while the criminal Bootlegger wants it to stay illegal so he can stay in business! And what's more, the Bootleggers even came to rely on the Baptists to monitor enforcement of the restrictions that benefit them!

Much the same framework can be used to analyse the current strident demand for strong regulation of the micro-finance institutions (MFIs) in India. Instead of alcohol, MFIs are the target of regulation. The Government has suddenly emerged as the moralizing Baptist in support of the exploited borrowers.

Who are the Bootleggers? In so far as the direct competitors of MFIs are the moneylenders, they stand to gain the most from any action that curtails the activities of MFIs. I cannot but avoid the feeling that the good old Shylocks are laughing all the way to the bank!

The dangers of QE 2.0 for the world economy

Even as President Obama suffered losses in the Congressional elections, the Federal Reserve voted in the opposite direction to move ahead with further monetary accommodation through a second round of quantitative easing.

As expected, the Federal Open Market Committee (FOMC) decided to go ahead with a $600 m monetary expansion through asset purchases. The FOMC outlined the reasons

"(T)he pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters."

And then the proposal to expand the Fed's holding of securities so as to promote a stronger pace of economic recovery and lower the elevevated unemployment rate,

"The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month."

About the economic prospects for the days ahead,

"The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period."

This action will further increase the Fed's already swollen balance sheet and is expected to lower the rates on long term securities (and consequently coporate and mortgage bonds), thereby encourage business investment related borrowings. Coupled with the Fed's ongoing program, started in August, of using proceeds from its mortgage-related holdings to buy additional Treasury debt (at a rate of about $35 billion a month, or $250 billion to $300 billion by the end of June), the total Fed QE expansion will be $850 billion to $900 billion.



Economix has a list of economists who have supported and opposed such monetary expansion. WSJ described it the "riskiest chapter yet in (Fed's) attempt to lift the U.S. economy out of its toughest economic environment in generations". Reactions here.

It is undoubtedly true that the US economy needs more monetary accommodation now. And economic growth in the US and other developed countries is critical for the world economy. However, the monetary expansion in the US could generate potentially harmful and even disastrous consequences for the world economy due to certain actions and trends elsewhere.

Monetary accommodation in the US will have two important and immediate external effects - put downward pressure on the value of dollar and amplify the current trend of capital flows into emerging economies. Both in turn have the potential to exacerbate already serious economic distortions, especially when it interacts with policies followed by other countries.

China's refusal to let its currency appreciate in relation to the dollar ensures that renminbi will also go down with the dollar. This will adversely affect the competitiveness of other emerging economies - who compete directly with China in many export markets - and force them into intervening more aggressively in the currency markets.

This will in turn exacerbate the current alarming capital flow trends into emerging economy financial markets. Further, any reduction in long-term Treasury rates coupled with the recent increases in interest rates across many emerging economies will widen the interest rate differential and add to the forces driving capital inflows into those economies. Such inflows, in turn, generate upward pressure on the local currencies.

The closed positive feedback loop arising from the interaction of these two trends can generate other distortions. For fear of unleashing inflationary pressures from such massive inflows, emerging economy governments would be forced into sterilizing the inflows. This in turn will increase the supply of their Treasuries, with attendant cost of holding them.

More damagingly, such inflows, especially at a time when these economies are back to their pre-crisis growth rates, have the potential to generate asset mis-allocation problems. Equity markets, most certainly everywhere, and real estate, in many emerging economies, are showing enough signs of froth and bubble. All such distortions are of greater concern given the uncertainties that surround growth in the developed economies and its close relation with the economic fortunes of many export-dependent emerging economies.

A damaging intersection of all these trends, especially if the underlying forces build-up to a critical mass, have the potential to trigger off currency and trade wars, marked by protectionist and retaliatory actions between countries. It also has the potential to unleash a movement towards imposition of capital controls, all of which could set-back the process of economic liberalization and global financial market integration many years back.

Since monetary accommodation in the US is essential for the US to give itself a fighting chance for recovery, the only chance of limiting the adverse impact from the aforementioned scenarios is for sensible and far-sighted macroeconomic policies from countries across the world. Most importantly, China will have to drop its weak-yuan policy and let its currency appreciate with respect to the dollar. More than the positive impact on US-China economic balance sheet, it will be more beneficial for the rest of the world, especially the other emerging economies. In the absence of any erosion of trade competitiveness, they will have no reason to intervene in the currency markets with its attendant dangers.

Equally important, emerging economies should engage in counter-cyclical macro-prudential regulation to stabilize their financial markets. Such regulation, especially on the real estate and equity markets, are likely to be more effective than knee-jerk capital controls. Such actions will mitigate the potential asset mis-allocation problems that could arise from massive hot-money flows and dampen the resultant financial market cycles. Unfortunately, the possibility of these aforementioned steps looks remote.

Update 1 (4/11/2010)

As expected, some emerging economies have reacted with dismay to the Fed decision and criticised it as endagering them.

Update 2 (6/11/2010)

With some signs of recovery taking hold, the Bank of England and ECB have decided to leave their record low interest rates in tact. The British bank left its bond purchasing program at £200 billion, or $322 billion, and its main interest rate at 0.5%, while the ECB left the rate at 1%.

Update 3 (11/11/2010)

Primer on QE from Felix Salmon.

Carbon price Vs government funded research - climate change debates

The failure of the US Congress to arrive at an agreement on a climate change bill, has generated another debate about the way ahead with addressing the problem.

The dominant consensus approach to combat climate change have revolved around putting a price to carbon, through carbon tax or cap-and-trade, that would encourage people and businesses into embracing cleaner energy technologies. They advocate this in view of the impossibility of internalizing the significant amount of negative externalities generated by carbon fuels and the prevailing higher prices of cleaner energies.

However, a recent proposal by Michael Shellenberger and Ted Nordhaus of the Breakthrough Institute, takes a different path and argue in favor of greater government funding for clean-energy research. They make three points in support of their claim. One, as the US Climate Change Bill shows, the political economy of raising the price of carbon is difficult, even impossible. Second, the results of the biggest experiment with increasing the price of carbon, the European Union Emission Trading System (EU ETS), have been disappointing. Third, given the impossibility of privately capturing all the benefits of any major innovation, history shows that major technological breakthroughs in all sectors have come through government support for research. They call for

"...increasing federal innovation investment from roughly $4 today to $25 billion annually, and using military procurement, new, disciplined deployment incentives, and public-private hubs to achieve both incremental improvements and breakthroughs in clean energy technologies."

In the circumstances, I cannot but agree completely with David Leonhardt that "in the long term, a carbon price and more research funding are both important parts of the response to climate change". Or to quote Prof Robert Stavins,

"Carbon-pricing – whether carbon taxes or cap-and-trade – will be an essential part of any truly meaningful national climate policy. Likewise, to address the "R&D market failure", direct technology innovation policies will also be required. Both are necessary. Neither is sufficient. These are complements, not substitutes."

Or from Michael Shellenberger and Ted Nordhaus themselves,

"A technology-first strategy is not a technology-only strategy. Cheaper and better clean energy technologies are not a substitute for pricing, regulatory, public procurement or other policies that will be necessary to make a full transition from fossil fuel based technologies to low carbon technologies."

As an aside, the new report points out that, after accounting for macro-economic factors, the trends in European emissions are nearly indistinguishable from business-as-usual emissions. They use this to question the efficacy of carbon pricing strategies to addressing climate change. Two observations on this

1. Like the case with the debate surrounding the economic impact of the fiscal and monetary expansion in the US (the austerians point to the high unemployment rate and weak economy to claim that it had no impact), the results of the EU ETS cannot be easily isolated. Given the difficulty of accurately measuring emissions, there are several questions that have to be answered before we can make the claim that EU ETS has had no impact. For example, it is very much possible that without the EU ETS, the emissions would have been even higher.

2. A failure of EU ETS cannot be extrapolated to declare the failure of all carbon-pricing, even all cap-and-trade, systems. It is now well-established that the EU ETS contained several distortions, including the initial generous allocations of allowances and the liberal standards for evaluating projects eligible to receive carbon permits.

Such claims are an example of a cognitive bias called representativeness heuristic - people judge the probability or frequency of a hypothesis by considering how much the hypothesis resembles available data as opposed to using a Bayesian calculation. The high-profile nature of the EU ETS and it close attachment with the cap-and-trade movement meant that its failure (or even allegations) naturally led to questions being raised about the movement itself.

Regulating MFIs

Sriram and me have an article in this month's edition of Pragati that examines the issue of regulating micro finance institutions and its larger implications on the future of "social enterprises".

Will QE work?

With the Fed set to announce a second round of quantitative easing (QE) early next week, there have been intense debate about its potential effectiveness. I have blogged a few days back about the merits of both sides in the debate. There are two plausible arguements that could lower the effectiveness of any quantitative easing

1. Since, as Paul Krugman has written, any QE only involves a maturity transformation of outstanding debt by "paying off long-term bonds (using money generated by expanding the monetary base) while borrowing short-term (through sales of new short-term debt instruments)", the net risk remains with the government (Treasury or the Fed). Further, since at close to the zero-bound, cash and T-Bills are close substitutes (both pay nearly zero interest rates), it is just as if Treasury sold 3-month T-bills and used the proceeds to buy back 10-year bonds.

One channel through which QE can positively influence the financial markets is by way of large-scale purchases of illiquid private financial instruments which would have the effect of repairing the battered balance sheets of those institutions holding such assets. However, the success of this channel would depend on whether the Fed purchases such assets and the quantity it purchases.

2. The other question mark is about whether a mere expansion of monetary base will automatically expand money supply. In other words, will a greater monetary base actually result in banks lending more and people borrowing (and spending) more? Though Milton Friedman had argued that quantitative easing will expand money supply and address Japanese deflation in the nineties, the actual experience was conclusively to the contrary.



The graphic above shows that even after Bank of Japan engineered a huge increase in the monetary base post-2000 (Krugman calls it "the original quantitative easing"), the money supply hardly budged. This calls to question the hypothesis that monetary expansion in liquidity trap conditions would automatically result in broad money expansion, economic growth, and even inflation. Krugman invokes the same precedent to question the oft-repeated claim that the Fed's refusal to indulge in monetary accommodation caused the Great Depression - "Why should we believe that the Fed had any more control over M2 in the 30s than the BOJ had over M2 more recently?"

This experience once again highlights the importance, even pre-requisite, of revival in aggregate demand for monetary expansion to produce the desired results. If demand is frozen and attendant expectations get anchored, no amount of QE will be able to get businesses to bring forward their investment decisions and consumers to engage in consumption, leaving banks with more cash reserves which does not leave their vaults.

See also this excellent article by David Wessel in WSJ that considers both sides of the monetary policy arguments on QE and pumps for another roaund of QE in the US. He looks at the declining money supply velocity (or lower "oomph" for each unit of dollar), declining incomes, and declining bond-market expectations to justify another round of QE.