Where did the "welfare dividend" go?

The Times of India reports that the NREGS program in Andhra Pradesh appears to have an unintended side-effect - "a record rise in the consumption of Indian Made Foreign Liquor (IMFL) among poor rural families, all thanks to the unprecedented sums of money that the scheme placed in their hands". This is borne out by record increases in liquor sales and illegal liquor outlets in the rural areas of the state in the past two years and the recent windfall returns from auctions of licenses to run liquor shops.

Over the past few years, the Government of Andhra Pradesh have introduced a series of welfare measures to benefit those below the poverty line (BPL). They include NREGS wage employment (Rs 135 per day), farm loan waiver, rice for Rs 2/kg, essential commodities at very cheap prices, free tertiary health care for all BPL families, scholarships for students from economically weaker sections, housing for all, free electricity for farmers and so on. They have been in addition to a virtual ban on raising water, sewerage and electricity tariffs and property taxes.

The net result of all this has been an increase in the disposable income available with these households, the "welfare dividend". This increase in disposable income has come from two sources - money saved from traditional expenditures on food, education, health care, and housing (due to the new schemes); and the fall in the relative prices (relative to the incomes, which have been rising) of civic services like water, electricity, and municipal taxes. This is in addition to the regular increases in income that comes with time. Where did all these savings go?

Econ 101 would have it that this additional income gets added to the pool of disposable income and becomes available for consumption expenditure (or for savings). The graphic below models the responsiveness of the consumption expenditures to increases in the supply of welfare goods/services



Let I1 be the indifference curve between two sets of goods - welfare goods and consumption goods. Thanks to increased incomes and income effect due to expanded set of welfare services/goods, the indifference curve shifts outwards to I2. Since welfare goods are inferior goods (whose consumption comes down as income rises), its uptake falls marginally (the income elasticity of uptake of welfare goods is small, since people retain many of the benefits despite increases in income) from Q(w1) to Q(w2). And consumption goods being normal good, their intake increases from Q(c1) to Q(c2), buoyed by the amounts saved from having to now spend less on those goods and services covered under the various welfare programs of the government.

The moot point is where did the "welfare dividend" go? Did it get spent on temptation goods like liquor or in capital investments and savings? The findings would make for a fascinating study and have important implications for public policy.

Update 1 (18/6/2010)
See Niranjan's superb op-ed that calls attention on the need for public policy to account for the behavioural decisions of individuals.

Marginal deterrence

Freakonomics draws attention to the concept of marginal deterrence, popularized by George Stigler, wherein "you set penalties such that, even if you can’t commit the criminal from carrying out a crime, he still has incentives to shift his criminal behavior toward less socially costly crimes". It quotes from Sir Thomas Moore's classic book Utopia,

And surely there is no one who doesn’t know how absurd and even dangerous for society it is to punish theft and murder alike. If the thief realizes that theft by itself carries the same peril as murder, that thought alone will encourage him to kill the victim whom otherwise he would only have robbed. Apart from the fact that he is in no greater danger if he is caught, murder is safer, since he conceals both crimes by killing the witness. Thus while we strive to terrify thieves with extreme cruelty, we really urge them to kill the innocent.

Update 1 (14/6/2010)

Niranjan Rajadhyaksha points to another example of marginal deterrence in the case of punishments for various crimes. If rapists and murderers are punished with the death penalty, what incentive is there for the rapist to leave the victim alive? He would have a strong incentive to kill his victim so as to snuff out all evidence!

Infrastructure finance reforms in India

Despite considerable progress with reforms in the sector, infrastructure financing in India has been constrained by the limited depth and breadth of the long-term debt markets. Despite widespread recognition of the need to create large enough debt markets to help support the country's massive infrastructure investment needs, success in pushing through the desired reforms has remained elusive.

The Planning Commission had targeted an infrastructure investment estimate of %514 bn for the Eleventh Five Year Plan (2007-12), and nearly a trillion dollars for the next Plan. It is also estimated that 70% of investments will come from private companies, in stand-alone investments and through partnerships with the government. However, unlike in other countries where insurance and pension funds are key buyers of long-term infrastructure bonds, both are expected to contribute less than 7% to the total infrastructure investment for the current Plan period.

Experience from across the world indicates that long-term debt forms the major share of infrastructure finance. Banks and in recent years IIFCL, have been the biggest sources of domestic funds for the sector. However, the limitations of banks based financing has been exposed repeatedly, most recently with the luke-warm response to the "take-out financing" scheme announced in the 2009-10 budget. Long-term debt funds are therefore vital to ensuring that India achieves its ambitious infrastructure investment targets.

In this context, the recommendations of the Deepak Parekh Committee on India Infrastructure Debt Fund (IIDF), which submitted its report early this week, assumes significance. The central thrust of its recommendations are towards regulatory changes to permit foreign insurance and pension funds to invest in the proposed IIDF. Prevailing restrictions on capital inflows through external commercial borrowings (ECB) restricts the inflow of foreign debt. Apart from recommending a relaxation of this restriction (if need be by creating a special window for inflow of foreign debt with tenor of more than 10 years), the report also suggests that investment in IIDF should not form part of existing limit prescribed by SEBI for FII investment in corporate bonds.

It proposed that the IIDF be set up and managed as a trust, with an intial corpus of Rs 50000 Cr, approved and regulated by SEBI under the modified venture fund guidelines, and managing debt with tenor of more than 10 years. The report suggests that the debt fund should be set up by one or more sponsors - the major existing infrastructure financiers or investment banks or multilateral lending agencies (to increase the attractiveness for foreign investors) - who will have to invest atleast 10% of the total investment in the form of subordinated debt, and act as the General Partners (GP). It also recommended that the country's foreign exchange reserves may be used to source up to $ 2 billion for the Fund.

The report also recommends that the Fund refinance up to 85% of the outstanding debt from senior lenders, thereby enabling the project companies to substitute debt with long term bonds at comparatively lower interest rates. It is hoped that this restructuring of project debt will release a large volume of present lending capacity of the commercial banks, thus enabling them to lend more to new projects.

The recommendations are in line with similar practices for financing infrastructure assets across the world. The US recently set up three institutions - National Infrastructure Bank (NIB), a National Infrastructure Development Corporation (NIDC) and a subsidiary National Infrastructure Investment Corporation (NIIC) - to raise money, mainly from the market as long-term debt, through sovereign guarantee, and then fund public and private investments in infrastructure. The logic being that government sponsored entities are better positioned to raise capital in larger amounts and at lower cost than the private sector.

In the US, most of the federal government’s programs for surface transportation are financed through the Highway Trust Fund, about 90% of whose revenues come from two taxes on motor fuels.

Football World Cup curtain raiser

"Five days shalt thou labour, as the Bible says. The seventh day is the Lord thy God’s. The sixth day is for football."

Anthony Burgess

The World Cup Football starts today and Goldman Sachs has just brought out a booklet, World Cup and Economics 2010, for this edition, which seeks to go beyond the football field and explore statistical relationships and causal explanations between football performance and national economic growth.

The report finds a relationship between the improvement in FIFA ranking since the last World Cup and the improvement in GES scores over the same period, particularly for developing countries. This correlation is 0.28 if we include all the participating countries (except North Korea); without Brazil and Argentina, it is even higher at 0.34; the relationship gets stronger at 0.51 if we look at the developing countries only; and without Brazil and Argentina, the correlation for emerging markets is even higher at 0.64. This suggests that improvements in GES "could conceivably be associated with better infrastructure and funding facilities for football", which in turn contributes to improving football performance.



The annual Growth Environment Scores (GES) brought out by Goldman Sachs measures the prospects for sustainable growth and productivity improvements across nations. The GES rank is from 0 to 10, with 10 being the highest, and the higher the score, the more likely the country is to be successful in terms of wealth.

Update 1 (14/6/2010)
Nice graphic that captures the economics of the World Cup.

The case for more stimulus

This is a long post... a sort of summary of the debate surrounding continuation of expansionary policies. With the US economy getting better much slower than required (especially to get normalcy restored in the job market), the debate about further expansionary stimulus measures has picked up.

The deficit hawks point to the burgeoning public debts and raise the spectre of sovereign defaults (made more salient by the problems facing the PIIGS in Europe) and unhinged inflationary expectations. They call for an immediate end to all stimulus spending and initiation of measures to rein back the deficits through spending cuts and interest rate increases to pre-empt inflation.

On the other side are those who point to the bitter decade-long experience of Japan with deflation and economic stagnation in the nineties, and caution against any premature exit from the expansionary stimulus policies of the last two years. They worry that the household and business balance sheets are so badly damaged and the unemployment rates too high that any fears of "crowding-out" of private investments and inflation are unfounded. They advocate continuation of the expansionary fiscal policies to boost aggregate demand and create jobs (and also prevent lay-offs) and further loosening of monetary policy to keep credit flowing, longer-term interest rates low, and even stoke some inflation. They point to the declining trend in prices and stable long-term bond yields to justify their claim.

However, the debate on the relative effectiveness of fiscal and monetary policies, continues to rage unabated. I have already blogged about the problems faced by monetary policy when facing the zero-bound in nominal interest rates. Economists like Joseph Gagnon, advocate further monetary easing in Japan, euro-zone and US through large purchases of long-term bonds (pdf here) by the central banks to reduce long-term interest rates. He points to the extremely anemic economic environment and the very low inflation rates in these countries to argue for such expansionary policies.

Unlike normal times, increasing the monetary base when faced with the zero-bound in nominal interest rates will have an expansionary impact only if "people believe it signals higher inflation later". However, as Mark Thoma writes, the Fed's carefully constructed, stellar inflation fighting reputation raises serious doubts on its credibility to commit itself to future inflation. People are most likely to think that the Fed will pull the levers at the first signs of inflation gathering steam. Politically too, the paranoia about inflation, active even when deflation is staring us, cannot be avoided when prices start to rise.

All this means that fiscal policy becomes the preferred option, especially when interest rates have lost traction. However, as Mark Thoma explains, during normal times, with both full-price adjustment classical models and sticky-price New Keynesian models and an inflation targeting central bank, fiscal policy generates multipliers less than one,

"When government spending goes up during normal times, inflation increases, and sharp increases in the real interest rate are needed to return inflation to its target value. The sharp increase in the real interest rate offsets the increase in output brought about by the increase in government spending, and this is what makes the multiplier small in this case. Under reasonable parametrizations, there "really isn’t much fiscal policy can do."

More particularly, with strict inflation targeting, the multiplier is less than one. When the Fed follows a Taylor rule instead of strict inflation targeting, the multiplier is larger, but still less than one (though not always, it could even be less than the multiplier for strict inflation targeting under some conditions). If monetary policy maintains a constant real rate instead of following a Taylor rule, the multiplier is equal to one. This means that during normal times, sticky price models predict fiscal policy multipliers of a magnitude less than or equal to one, with the exact magnitude depending upon the rule the Fed follows, i.e. how the real interest rate responds to fiscal policy changes."

However, as Micheal Woodford and others have found, things change when the interest rate is touching the zero-bound. As Mark Thoma writes, this happens because the expectations of increase in fiscal spending raises inflationary expectations and thereby lowers real interest rates,

"In general, at the zero bound fiscal policy multipliers are greater than one, and this remains true under strict inflation targeting... The larger multiplier occurs because the increase in government spending increases inflation (more precisely it reduces the rate of deflation). If the crisis is expected to last another period with some probability, as it will in the model, then government spending is expected to persist as well and expected inflation will rise. The increase in expected inflation lowers the real interest rate when the zero bound is a constraint (even with strict inflation targeting), and the lower real interest rate generates additional economic activity.

Note that the source of the increase in expected inflation is the expected increase in government spending in the next time period. All that's required for expected inflation to rise is that fiscal policy is expected to persist another period. However, the Fed won't do anything in response to the rise in inflation expectations because under the assumptions of the model the target interest rate remains negative."

The case in favor of fiscal policy (over monetary policy) is explored in detail with numerous links here and here. The IMF too recently examined the impacts of fiscal policy across economies, under various conditions, and came to favorable conclusions about the effectiveness of fiscal stimulus spending policies. The IMF's latest fiscal monitor too captures the favorable impact of the stimuluses.

Among fiscal policy options tax cuts and direct spending have been amongst the most popular. This is despite the fact that welfare spending through automatic stabilizers like food stamps, unemployment insurance, and nutritional support for children, may be more effective in containing the most debilitating effects of a recession. As the length of the slowdown increases and unemployment rates remain stubbornly high, assistance to state and local governments are fast emerging as an important source of fiscal policy intervention.

Mark Thoma points here and here to the problem posed by the deteriorating fiscal positions of state and local governments in the US that reflects in the rising job losses in those areas. The expansionary impact of federal fiscal stimulus is being countervailed by the contractionary impact of spending cuts by state and local governments.



In the search for swift-acting fiscal stimulus interventions with large multipliers (and socio-economic impact), assistance to state and local governments would surely be amongst the most effective.

And as Brad De Long writes, when faced with high unemployment rates, weak investment and spending environment, and anemic growth expectations, short-run deficits may be more expansionary and beneficial in the long run and belt tightening contractionary and harmful. In these times, he calls for prescriptions suited for "depression economics", wherein the beneficial effects of government spending and tax cuts will more than off-set the harmful effects of increased debt burden.

He compares the arithmetic of the relative costs of fiscal expansions during normal times and during the present times (where rules of "depression economics" applies) and finds that while "expansionary deficit-boosting fiscal policy is simply a non-starter in normal times", it generates "more income and employment now... in return for sacrificing only a tiny bit of production each year in the future, when we believe that we will be richer and will mind the reduction significantly less".

This is because, unlike normal times, more government spending now will not lead the Federal Reserve to raise interest rates to fight inflation, there is no "crowding out", boost to production (from a spending program) creates a substantial reflow in taxes that makes the spending program a bargain, and the government can borrow at "uniquely favorable terms" and thereby keep debt serrvice burdens manageable. His conclusion

"Each dollar of missing production and each unemployed worker right now is much, much more painful to the country and a much greater loss to human welfare than a dollar of missed production and an unemployed worker in normal times."

Tyler Cowen writes that reduction in real interest rates will not make much of a difference in investment decisions of businesses since the investment determining constraint is the "hurdle rate", which does not change by much despite the recession. He points to the fact that the "hurdle rate" in investments is in the range of 20-30% (to account for agency problems and related transaction costs) and therefore small reductions in interest rates have limited impact. In Econ 101 terms, real interest rates become a largely non-binding constraint since the elasticity of new projects to changes in real interest rates is very low (at the prevailing hurdle rates).

However, a logical extension of this line of arguement would mean that interest rates are always a non-binding constraint on investment decisions. Since the "hurdle rates" are in the range of 20-30% even during normal times, any small interest rate changes (and rate changes will always be small, a few tens of basis points, when compared to the "hurdle rate") will have no impact on the investment decision.

In another post, he also feels that the real issue is lack of trust, which has forced businesses to under-invest and households to under-spend. This lack of trust causes consumers, companies and financial firms to be more cautious than they’d otherwise be, and results in sub-par growth and occasional market frights. This is what economists like Robert Shiller have been pointing to for some time now, and what Keynes himself alluded to when he referred to the depressing role of "animal spirits".

And since the challenge is to get the "animal spirits" active and market-confidence restored, as is increasingly becoming evident (especially when faced with the zero-bound), aggressive fiscal policy interventions are required, irrespective of the what the short-run deficit. The alternative to this is the strong possibility of slipping ever deeper into recession and thereby increasing the costs (and deepening the fiscal strains) of recovery.

See also David Leonhardt here and here.

Nudging to keep meetings short

An old wag has it that meetings are where minutes are recorded and hours wasted. The effectiveness of administration (and management) in both public and private sectors is to a large extent dependent on the clarity and focus of the frequent meetings at different levels. Most often, meetings meander along for a long time, and ends with considerable opportunity cost bill.

In this context, the Nudges blog points to a clock that tells you how much your office meeting is costing (number of people in the meeting x average hourly wage). All you need is to simply enter the number of people in the room, ballpark an average hourly wage, and press the start button for the clock to start ticking on the cost of the meeting.



Wonder whether there is a clock which can measure the level of restlessness (or declining attention spans) among participants (using camera-based sensors) and trigger the closure of meetings when it crosses a threshold?

America in the Red?

Estimates indicate that by September 30, 2010, the total national debt of the US is set to reach $13.79 trillion (94.3% of GDP), with $9.3 trillion (63.6% of GDP) held by the public and $4.49 trillion (30.7% of GDP) held by federal government accounts.



(Click on the graphic to enlarge)

At the end of 2009, $ 7 trillion worth US Treasury securities were outstanding, of which $3.6 trillion was owned by foreign investors ($877.5 bn by China, $768.5 bn by Japan). The interest burden on this was $383.1 bn at the end of 2009.