"Normalcy" restored in the US economy?

Interesting graphic by Floyd Norris, which appears to indicate the US economy returning to normalcy, with some of the standard indicators of economic and financial volatility becoming subdued.



Fundamentally, these charts only indicate that the worst may be over and further declines are not likely. However, they do not make a quick recovery inevtiable. In fact, they tell very little about any recovery, except the optimism that a recovery could be round the corner. And L-shaped recovery is still possible. And there is also the possibility that the stimulus contributed to bringing in "normalcy", and now that is tapering off (federal government hirings continue to grow whicle local governments continue to shed payrolls), there could be further volatility.

The February labor report indicates that though the economy lost only about 36,000 jobs in the month, the unemployment rate remained unchanged at 9.7%, lending credence to the impression that the economy is getting "worse much more slowly".





There are enough signs in the job report to indicate that the recovery may even be losing steam. See this graphic that puts the post-war recessions in perspective



With nearly 15 million Americans unemployed in February, four in 10 unemployed for six months or longer, and the so-called underemployment rate (which counts people whose hours have been cut along with those working part time for lack of full-time positions) at 16.8% (up from 16.5% in January), current growth and recovery trends will do little to make a serious dent in the unemployment situation for many years. See also this and this. Mark Thoma has this link summary.

The CBO's analysis of the Budget and Economic Outlook (presentation here) reveals the following (unemployment rate first and potential-actual GDP output gap next)




See also a nice interactive graphic of the projections of government deficits under different scenarios here.

Update 1 (10/3/2010)
See this presentation by the CBO director on the fiscal policy options for the US. It projects that the public debt is on a trajectory that poses significant economic risks and becomes unsustainable and the key choices for medium-term and long-term policy are how quickly and in what way to restrain federal borrowing. It also forecasts a slow economic recovery due to financial market fragility, restrained increase in household spending, and declining support from monetary and fiscal policy as the stimulus wears out.

Update 2 (1/6/2010)
The recession has taken a much greater toll, in general, among the black population, as reflected in the much larger extent of job losses.



A recent Federal Reserve study estimated that for every dollar of wealth owned by a white family, a black or Latino family owns just 16 cents. The Economic Policy Institute’s forthcoming "The State of Working America" analyzed the recession-driven drop in wealth and found that as of December 2009, median white wealth dipped 34 percent, to $94,600 while the median black wealth dropped 77 percent, to $2,100.

Why PDS should continue to remain disbursed through FPS

The Public Distribution System (PDS) which distributes food rations among those classified Below the Poverty Line (BPL) in India deserves every ounce of the criticism heaped on it for being the embodiment of corruption, inefficiency, and political patronage in the delivery of welfare benefits. Not only does it not meet its desired objectives, but it also ends up very badly distorting market incentives. In this context, over the years, there have been numerous efforts to reform it ranging from re-surveys, vouchers, bio-metric validations, smart cards and so on.

Now, in view of the possibility of a unique identification (UID) number and a Total Financial Inclusion (TFI) bank account becoming available for all citizens, there is a theoretical possibility of even eliminating the Fair Price Shops (FPS) that deliver PDS rations. It can be argued that the BPL beneficiaries could purchase their rations from the market by paying the PDS prices and then the shops could get their subsidy reimbursed on production of proof (bills/vouchers) of their BPL sales. I am inclined to argue that this arrangement will fail for the following reasons

1. Unlike petrol, diesel or LPG prices, food grains are decontrolled and their prices vary widely across markets, often within the same city. Further, there are numerous varieties of rice, wheat, sugar etc. Even within the same variety, there are considerable variations in quality. All these makes standardization (across the state or country) and quantification of the extent of subsidy difficult and therefore its administration near impossible.

2. Food prices are subject to wide fluctuations, often within a short time. Further, the same variety of food grains undergoes different price changes at different places at the same time. There is no reliable and universal index that reflects these variations. In the circumstances, the volatility in food prices and the need for dynamic adjustment of the proportionate subsidies becomes a herculean administrative task.

3. The number of outlets/shops vending these products are too many. Therefore the logistics of administering them becomes extremely difficult. Many of the retailers, especially in rural areas and in smaller towns, work outside the formal economy and bringing them into a formal UID-linked subsidy reimbursement channel poses a whole new set of challenges.

4. FPS are the primary outlet for government's buffer-stock and open-market operations to stabilize food prices at times of shortages and price spikes. In its absence, governments will have to off-load stocks in the open market, which could end up being hoarded and thereby put upward pressure on prices. Private retailers could game the market by driving up the prices to pocket ever larger subsidies. Such price gouging can be even more pronounced in certain areas, especially with a few monopoly/oligopoly retailers/traders. Food security could be seriously compromised.

In view of all the aforementioned, it is inevitable that FPS's remain the outlets for delivering PDS rations. The objective should be to ensure that the delivery of rations from these shops are done after due validation checks, so that pilferage of rations by way of bogus cards and without the presence of the actual beneficiary is eliminated. This can be done in both on-line (the database is hosted elsewhere and real-time validation of all accounts and identities are carried out) and off-line (the database is hosted in the systems at the FPS and is updated with some periodicity over a dial-up connection) environments using biometric or iris-based smart cards, depending on the local conditions (electricity supply/telephone services).

Delivering welfare benefits

Here is my Mint op-ed on using UID-linked TFI bank accounts to deliver CCT-based welfare assistance. See also this.

CCT, UID, and TFI

Recent government initiatives on total financial inclusion (TFI) and unique identity number (UID) makes it possible to design a strategy that unties the gordian knot on effective delivery of goverment's welfare programs to intended beneficiaries.

The leakages in government welfare programs for the economically deprived are mainly two-fold - targeting of beneficiaries and pilferage in the actual delivery of benefits. The former gets manifested in the form of ineligible, duplicated and even fictitious beneficiaries, and the latter in the form of beneficiaries getting less than their actual benefits.

Administering the delivery of welfare benefits in a massive and complex country like India poses enormous challenges. Policy makers designing programs for the entire country are faced with conflicting choices and a difficult trade-off between ensuring efficiency in delivery and minimizing corruption. In an effort to eliminate leakages and target the delivery, they design programs with multiple layers of monitoring mechanisms, uniform standards for beneficiary selection and strict guidelines outlining the process of delivering benefits to the consumers. Unfortunately, the result is a tangle of bureaucracy that ironically enough increases inefficiency and spawns both rent-seeking and wastage, broadly in the form of the aforementioned leakages.

Designing a program that avoids getting entrapped in the bureaucratic tangle of norms, components and guidelines, while preserving the basic administrative requirements to effectively monitor and ensure that the program meets its objectives, is one hell of a challenge. Simplistic prescriptions like people's participation and local decision-making, while easy to preach are very difficult to implement.

A paradigm shift in the delivery of welfare benefits can be achieved with a combination of unique identity and bank account for each citizen, and delivery of welfare benefits in the form of cash transfers. Fortunately, recent developments make it possible to implement all three policy alternatives and realize the expectedte benefits in effectively targetting social welfare programs.

The government have already initiated a high-profile Unique Indentification (UID) project to allot a unique number to all citizens over five years. The equally ambitious Total Financial Inclusion (TFI) project seeks to provide access to formal credit mechanisms by giving them a bank account to everyone below poverty line. The missing piece is conditional cash transfer (CCT) programs that directly transfers cash to the recipients, conditional to their achieving certain health, educational land nutritional outcomes.



CCT schemes are based on the premiss that each family knows what is best for them, what are their needs and wants and how the money can be most effectively spent. They are already the most discussed idea in development policy making, rising to prominence with its considerable successes in Brazil and Mexico during the last decade. Nancy Birdsall of the Center for Global Development has described CCTs as the "closest you can come to a magic bullet in development" and they are gaining widespread acceptance as the most effective poverty-fighting strategy.

A UID number is the most fool-proof method of ensuring targeting of beneficiaries and would also save the massive transaction and administration costs associated with the process of selecting beneficiaries. The various welfare benefits - from CCT programs, pensions, NREGS wages, interest and other subsidies, loans etc - can be directly transferred into the respective accounts of beneficiaries and thereby eliminate pilferage of benefits.

This "magic bullet" triptych of UID-TFI-CCT would considerably enhance the ability of governments to assist specific categories of economically and socially deprived citizens with customized welfare programs. A whole series of assistance measures, hitherto thought difficult or even impossible to administer, can be delivered easily and effectively. Instead of messing with prices through the plethora of market distorting price controls (for food, fertilizers, seeds, kerosene, petrol and diesel), it becomes possible to deliver subsidies as direct cash transfers to respective individual accounts. Similarly, tax credits can be provided to specific categories of people.

This triptych also enables the economically deprived people to more easily access the wider market and private businesses to penetrate the massive market at "the bottom of the pyramid". It increases the efficiency and reduces the costs for private businesses to deliver certain services, especially to economically deprived people who were most likely to have been denied access to this market.

The UID number, with related bio-metric identification mechanism, will ensure that only the intended beneficiary avails of the benefits. With time and the network effect arising from the expansion in the use of UID database for delivery of different welfare and other (even private) services, it also becomes possible to means test and screen beneficaries for their eligibility to access various benefits.

The TFI bank account will ensure that payments are delivered directly to the individual, cutting through the different layers of bureaucracy, without pilferage at any level.

CCT programs, by directly transferring money, will ensure that the commonplace wastages associated with government procurements and service delivery are avoided or atleast minimized. More importantly, direct transfers through CCT programs involving cash or vouchers (for say education, housing, health care, food grains, employment training etc) minimize market distortions arising from practices like dual pricing, with its resultant corruption and emergence of parallel markets.

Taken together, TFI and CCT enables the government to deliver a wider range of welfare assistance - interest subsidies, matching contributions, tax credits, lump sum transfers, externality credits etc - in addition to the regular types of subsidies. It also helps the use of technologies like mobile phones and internet to be more widely used to target and deliver assistance to the target beneficiaries.

This tryptich will radically enhance the effectiveness of delivery of the myriad government programs like delivery of pensions, self-employment benefits, PDS, education loans, health insurance, farm subsidies, and so on. They deliver much greater bang for the development buck by lowering transaction costs, ensuring better tragetting, removing ineligible beneficairies, and minimizing the costs arising from market distortions due to direct government interventions that tinkers with prices.

With such policies it becomes possible to deliver subsidies without tinkering with the price signals and distorting incentives. The government can deliver subsidies directly into the TFI bank accounts of the beneficiaries after validating their UID numbers. The subsidy can be for a fixed quantity of the product or service at a pre-defined flat rate on its price. The beneficiary will purchase the product or service from the market by paying the regular market price. This subsidy can be redeemed either by presenting vouchers or consumption bills. In order to account for inflation, the subsidy rates can be benchmarked to the Consumer Price Index (CPI) or some other price index.

While the PDS will continue to deliver foodgrains, fuels like kerosene and LPG can be delivered using vouchers. These vouchers can be used to purchase kerosene and LPG from the retail market, then produced at the Fair Price Shops (FPS) and redeemed after UID validation of the smart card. The subsidy can be transferred directly to the UID-linked bank account.

This approach can address the problems posed by free-power to farmers. A fixed amount of electricity can be given to farmers at subsidized rates by transferring the subsidy into their bank accounts after validating their UID numbers and their consumption bills. This arrangement give the flexibility to target the amount of subsidies for specifically the harvest period and deny the same for off-seasonal activities. The same approach can be adopted to deliver subsidies for water and various agricultural and industrial equipments and inputs. Fertilizer subsidies too can be delivered through this arrangement.

Update 1
Interesting figures from here. Responding to a Parliamentary Question in December 2009, the Minister of State for Consumer Affairs, Food and Public Distribution revealed that 2006, 5,300,000 bogus ration cards had been identified in West Bengal, 1,046,000 in Andhra Pradesh. Orissa was amongst the lowest at 250,000. A recent UN Population Agency (UNPA) found that a mere 8% of beneficiaries under the Janani Suraksha Yojna (JSY) - a program that entitles pregnant women with a cash transfer (at the time of delivery) if they undergo an institutional delivery - in Bihar received their money when discharged while Orissa topped the list at 20%.

Update 2 (26/6/2010)

The penetration levels and access to finance across the country are quite meager - six out of 10 Indians do not have access to a bank account; home mortgage as a proportion to GDP stands at barely 7%; and insurance penetration is under 4%.

The minimum wages and government hirings

Many state and central governments in India have imposed restrictions, even bans, on the recruitment of typists and computer operators and advocate using contract personnel (hired through manpower contractors) for these services. However, the regulatory fiat that classifies all computer operators into a single minimum wage bracket that rises every year may actually be an example of how such minimum wage laws can seriously distort market incentives and efficiency.

Econ 101 tells us that the government mandated minimum wage floors drive a wedge between the quantity of labor supplied and that demanded, thereby leaving productive labor resources unemployed. Supporters of minimum wage though argue that in the absence of collective bargaining power for labor, such wage floors are necessary to ensure that labor are not exploited by capital owners.

I am inclined towards the view that both these explanations simplify matters considerably and do not wish to take a generic position on this issue, atleast for now. However, it is undeniable that in the real world, labor markets respond to minimum wages in different ways. And there are problems when the minimum wages are rising at a rate faster than inflation and with the indiscriminate application of minimum wages to workforce in the semi-skilled services sector.

In recent years, a substantial wedge has developed between the minimum wage for certain categories of labor and their prevailing market prices. I can think of two reasons for this, though there are surely more. One, the minimum wages have been increasing at a rate faster than the prevailing market wages as government labor departments stick to their weighted formulas to mark up minimum wages every year, independent of prevailing market rates. Second, in keeping with the expanding youth workforce, the supply of un-skilled and semi-skilled labor has been increasing at a very rapid clip. This abundance has had the effect of depressing market prices.

The poorly regulated vocational skill development sector (eg. proliferation of largely unregulated private computer training institutes) means that there exists vast variations in the quality of education imparted by different institutions. Except for a few institutions, students from the vast majority of such schools are poorly trained and therefore have a very inferior skill set. A highly differentiated market emerges for these semi-skilled people, with a small minority of employable labor and the large majority who are unemployable.

The minimum wage, by dictating a flat rate for everyone in the same labor category (say data entry operators), irrespective of the actual skills they possess, seriously distorts incentives among both employers and employees. The employers cannot discriminate among their employees depending on their relative abilities and skill endowments. Safe in the assurance that the critical determinant of their wages is acquisition of a certificate and everyone with that qualification will get the same wage, students' incentives to put in efforts to actually acquire the desired skills get skewed. Further, the employees have no incentive to improve their skills even after getting into their jobs.

The extent of incentive distortions, especially in the quality of work output, due to minimum wages is larger with semi-skilled services than with agriculture and factory labor. Take the case of computer operating personnel in government offices. There is scope for considerable variations (a full spectrum in variations) in both skill endowment and ability within each category. It is plain inefficient to sweep all computer operators under one generic, single salary slab arrangement. Government employers are forced to pay the same flat rate to all operators, irrespective of their relative abilities.

Macroeconomic stability and the challenge of financial market regulation

The primary objective of all central banking is to control inflation and promote economic stability. While much has been written about the former, the latter, which consists of both preventing (or mitigating/cushioning) volatility in aggregate demand (or output) caused either by macroeconomic shocks and/or financial instability (of which banking crises form a major share), has often not attracted the same level of attention among central banks. The sub-prime crisis and the Great Recession has surely changed this. I am inclined to argue that the various dimensions of financial market vulnerabilities and the inherent difficulty of market regulation will continue to strain the resources and skills of central bankers in maintaining macroeconomic stability.

More than even monetary policy management, increasingly it is evident that the greatest challenge facing central banks is in maintaining financial market stability. On the one side, the central bank has to encourage financial market innovations that promote economic growth, while on the other hand prevent these innovations from inflating asset bubbles and other market distortions. As the events of the last decade have shown, central banks are still unsure about how to achieve this twin objective. They face the following problems during the boom times

1. Identifying what constitutes a bubble. Relevant proxy parameters, with their boundary limits, that most accurately reflects the build up of bubble is important to monitor this.

2. How much to "lean against the wind" to deflate the bubble. Acting too quickly and too aggressively risks sacrificing the beneficial effects of a boom, while the costs of being too slow and being light-touch were there to see after the sub-prime bubble burst.

3. Which instruments to deploy, so as to minimize the impact of intervention. Interest rate and other conventional macroeconomic parameters impact on the entire economy, not just those parts of the markets which have been distorted.

4. Automaticity of regulatory provisions to address the bubble. Policies that soften any bout of "irrational exuberance" will generate strong opposition from all stake holders and run the risk of being politicized. It is therefore important to have atleast some first level of self-acting regulatory requirements that kick-in as soon as the "green shoots" of a bubble appears. The more intrusive policies can then follow with the inevitable lag.

Charles Goodhart writes that "it should be possible to construct a more counter-cyclical, time-varying regulatory system in such a way as to mitigate these problems, so long as the regulations are relaxed in the downturn after having been built up in the boom". He captures this twin-dilemma nicely

"There is a tension between trying to get banks to behave cautiously and conservatively in the upswing of a financial cycle, and being prepared as a central bank to lend against whatever the banks have to offer as collateral during a crisis. Again, the more that a central bank manages to constrain bank expansion during euphoric upswings, e.g. by various forms of capital and liquidity requirements, the greater the disintermediation to less controlled channels. How far does such disintermediation matter, and what parts of the financial system should a central bank be trying to protect? In other words, which intermediaries are 'systemic'; do we have any clear, ex ante, definition of 'systemic', or do we decide, ex post, on a case-by-case basis?"

The Basel II norms had created a feeling of false comfort among banks and their regulators across the world. While it laid out quantitative risk-weighted capital adequacy requirements for banks, it left the details of what constitutes capital and risk to individual national banking regulators. Banks, often in collusion with their local regulators, gamed the system and rendered this ratio an ineffectual instrument to monitor individual bank risk. More fundamentally, this increased emphasis on risk unwittingly lent a pro-cyclical dimension to banking regulation - conventional measures of risk decline during a prolonged boom and this in turn frees up banks to ramp up leverage.

Further, it was all along presumed that firm or bank-focussed financial regulation was adequate to control systemic risks. Accordingly, macro-prudential regulation of the financial sector itself was largely ignored on the belief that regulating the institutions was sufficient. This presumption failed on two grounds

1. Individual and systemic risk do not always coincide. There are two common examples from the events of the recent past. One, while actions in the aftermath of a financial crisis to cut lending and increase liquidity is prudent and risk-lowering for individual banks, it amplifies risks for the system as a whole. Second, the now infamous "too-big-to-fail" financial institutions exert a disproportionately large adverse impact on the financial market itself.

2. The rapid emergence of the largely unergulated shadow banking sector. This meant that the conventional risk monitoring parameters, which was confined to covering the regulated banking sector, became largely superfluous as the most aggressive risk-taking was concentrated in the shadow banking sector.

Apart from the conventional credit risk arising from the quality of its assets, banks increasingly face balance sheet risks due to two factors - excessive leverage and maturity mis-match between assets and liabilities (especially significant during low interest rate cycles).

Another big challenge with financial market regulation is about getting the micro-prudential (or bank-level)and macro-prudential (or system-wide) regulation of banking and financial sector respectively right. There are those like Markus Brunnermeier and Hyun Song Shin, who advocate separate regulator for both - a Financial Services Authority tasked with the former and central banks doing the latter. They write,

"Macro-prudential regulation in particular needs reform to ensure it countervails the natural decline in measured risk during booms and its rise in subsequent collapses. "Counter-cyclical capital charges" are the way forward; regulators should adjust capital adequacy requirements over the cycle by two multiples - the first related to above-average growth of credit expansion and leverage, the second related to the mismatch in the maturity of assets and liabilities. Changes to mark-to-market procedures are also needed."

However, given the inherent difficulty of "taking the punch bowl away as the party gets going" and the empirical observation that "countries which allow a less regulated, and more innovative and dynamic, financial system grow faster than their more controlled brethren, despite being more prone to financial (boom/bust) crises", there may be an arguement in favor of having in place effective policies to quickly respond and pick up the pieces after a bust. And given the political difficulty in pushing through meaningful financial regulation plans, it may be prudent to drawn on lessons from the sub-prime mortgage bubble and its aftermath and put in place atleast an efficient crisis-management architecture.

Update 1 (20/3/2010)
Alan Greenspan blames the crisis on the dramatic decline and convergence of global real long-term interest rates in the last two decades which in turn engendered "a dramatic global home price bubble heavily leveraged by debt and a delinking of monetary policy from long-term rates". See Greg Mankiw's comments on the Greenspan paper here.

He offers three suggestion for making the financial system more crash proof. One, given the strong moral hazard of bailouts unleashed by the actions of the Fed and Treasury during the sub-prime crisis, it is important to have higher capital requirements. Otherwise, creditors to the big institutions will view them as too safe, and will lend to them too freely, and the financial institutions, in turn, will be tempted to respond to their low cost of debt by leveraging to excess.

Two, he proposes "living wills" for all financial intermediaries where they publicly disclose (thereby pre-empt counterparties from complaining after the fact that they thought they had more legal rights in the event of liquidation than they do) their own plans to wind down in the event that they fail, thereby leaving policymakers with a a game plan in hand if these instiutions fail.

Third, he also proposes contingent debt that will turn into equity when some regulator deems that a firm has insufficient capital. This debt would become a form of pre-planned recapitalization in the event of a future financial crisis, and the recapitalization would be done with private rather than public money. Since the financial firm would pay for the cost of these funds, rather than enjoying taxpayer subsidies, it would be incentivized to make itself less risky, for instance, by reducing leverage. The less risky the firm, the less likely the contingency would be triggered, and the lower the interest rate the firm would need to pay on this contingent debt.

Update 2 (29/3/2010)
Greg Mankiw favors banks and financial institutions selling contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital. He feels that this would be s form of crisis insurance and a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds.

He also supports the Greenspan idea of financial firms writing their own "living wills", describing how they would wind down in the event of an adverse shock to their balance sheets.

See this excellent summary of the challenges facing financial market regulation by David Leonhardt. Mike Konczal has a superb analysis of all the financial market regulation proposals under circulation in the US.

Corruption at checkpoints

Benjamin Olken and Patrick Barron examined the bribe payments made by truck drivers at military and police checkpoints and weigh bridges in two Indonesian provinces and unearth some interesting parallels between the behaviours of the corrupt officials and the standard industrial organization theory. They find an average of 20 illegal payments per trip, totalling about 13% of the cost of each trip.

They find that the illegal nature of these payments does not prevent corrupt officials from extracting additional revenue using complex pricing schemes, including third-degree price discrimination (at checkpoints) and a menu of two-part tariffs (at weigh bridges).

Evidence of price discrimination comes in the form of differential bribes charged on truckers based on observable characteristics like the age of the vehicle and type of cargo carried, both of which may indicate greater willingness-to-pay. Bribes paid per checkpoint increases as the trip nears its destination, consistent with ex-post hold-up along a chain of monopolies.

They find that after the military withdrew from the Aceh province in the aftermath of a peace agreement with local rebels, forcing the closure of the military checkpoints, the bribes at the remaining police checkpoints went up to capture the "peace dividend". This also indicates that decentralization may not necessarily lower corruption since the local market forces calibrate themselves, by marking prices upwards accordingly.

Regulatory solutions to addressing checkpoint collection will invariably fail. So any efficient policy that addresses checkpoint corruption should involve either some or all of these below

1. Minimizing the number of checkpoints.
2. Regulatory checks like weighment should be done at only one place, preferably at the entrance and done on computerized weighbridges genreating computer weighment recipt. Ideally, weighment checks should be dispensed off.
3. Automating toll collection so as to make the toll amount salient and the process transparent.
4. Outsourcing toll collection after fixing up toll rates