Origins of the US public debt

These are tumultuous times on both sides of the Atlantic. Public debt and economic weakness is the common factor in both stories.

The beginning of next week will determine whether the US will have to officially default on its debt commitments. On August 2nd, the $14.294 trillion threshold at which by law America can no longer borrow money, will be reached. In a speech last month Ben Bernanke outlined the consequences of a failure to raise the debt limit. He said,

"Failing to raise the debt limit would require the federal government to delay or renege on payments for obligations already entered into. In particular, even a short suspension of payments on principal or interest on the Treasury’s debt obligations could cause severe disruptions in financial markets and the payments system, induce ratings downgrades of U.S. government debt, create fundamental doubts about the creditworthiness of the United States and damage the special role of the dollar and Treasury securities in global markets in the longer term. Interest rates would likely rise, slowing the recovery and, perversely, worsening the deficit problem by increasing required interest payments on the debt for what might well be a protracted period."

The debt-limit debate has highlighted attention on the origins of the US public debt. Times has an excellent graphic that shows who the US government owes its $14.3 trillion debt and the respective contributions of various Presidents.



In 2001, George Bush inherited a surplus, with projections by the Congressional Budget Office for ever-increasing surpluses. But every year starting in 2002, the budget fell into deficit, and when Bush left office it stood at $1.2 trillion in deficit for 2009. The graphic below shows the damaging effect of Bush tax cuts, all of which if allowed to expire by end-2012 would cut deficits by about half. President Obama’s policies, a fait accompli given the circumstances when he took over, did not add much to deficits.



The Economist has this graphic that shows the evolution of the official debt limit under various US Presidents. The US Congress has acted a total of 91 times since June 1940 to either raise, extend or alter the definition of the debt limit—36 times under Democratic presidents.



See also this Q&A on the US debt ceiling debate.

Update 1 (12/2/2012)

Ezra Klein has this excellent graphical illustration of the origins of America's current debt woes.

On rights-based development and populist quick-fixes

Pranab Bardhan has a brilliant essay in Boston Review that strikes an immediate chord with development discourse in India. Instead of commenting, let me reproduce portions.

He appreciates the concern among civil society groups and activists at the extreme poverty and vulnerability of the marginalized and their enthusiasm for a rights-based approach (as against the dole-based approach of traditional welfare state). However, he cautions against the prevailing craze for it,

"It (rights-based approach) serves to raise consciousness among the poor and the vulnerable about their entitlements, and remind them that they are not mere supplicants to politicians and bureaucrats. In a weak administrative and institutional context, however, the NGO approach of uncompromising support for citizen’s rights can cause more harm than good. If the structure for implementing some of these rights is weak and corrupt, then the rights are hollow and promoting them breeds cynicism."

In the context of India where courts have joined civil society groups in taking up the cause of the poor and vulnerable, he strikes a much-needed but politically incorrect note of caution,

"India is already littered with hundreds of unenforced or spasmodically enforced court injunctions, some of them on the implementation of rights. This proliferating judicial activism, egged on by the rights-based movement and the media, may end up, for all its good intentions, undermining the credibility and legitimacy of the judiciary itself."

Prof Bardhan hits the nail on its head when identifying the real limitation of civil-society activism driven rights-based approach to development in societies where the ability of governments to deliver is severely constrained. He writes,

"The social activists share with left-wing unions a preoccupation with redistribution, and a lack of concern for generating enough surplus to enable it. There are obvious trade-offs here between incentives for private enterprise and the need for social justice... When real capacity to create wealth is missing, social activism is often reduced to mere populism, which in the long run can be wasteful and counterproductive."

This is the biggest problem with the dominant development policy discourse in India - too much of wealth re-distribution and too little of wealth creation!

Again, in light of the political drama surrounding anti-corruption activists and their populist quick-fixes, Prof Bardhan questions their right to appropriate the mantle of popular legitimacy in democratic societies,

"In the policy arena... such non-party organizations cannot and should not threaten to replace the role of traditional party organizations in a democracy. Voluntary groups, as single-interest advocacy lobbies, lack the mechanism of transactional negotiations and give-and-take among diverse interest groups that large party organizations, representing and encompassing those varied interests, possess.

This kind of give-and-take is particularly important when resolving controversial issues and requires complex trade-offs and balancing of diverse interests. Those who speak for the poor usually underplay the diversity among the poor and sometimes romanticize their traditional way of life. A dam may benefit thousands of small farmers in hitherto parched land, even as it displaces thousands of others; a development project may displace some from their ancestral land but provide jobs and more productive livelihoods for others; and so on. Each such case involves complex trade-offs and demands negotiated compromises and compensations across groups and over time. Such deliberations should take place within a party forum where diverse interests and stakeholders are represented."

Finally, this message for those opposing capitalism on the grounds that capitalist exploits the poor, is extremely relevant,

"Activists who romanticize the pristine life of the poor and the indigenous, and ignore a great deal of misery and stagnation, should keep in mind that the horrors of capitalism fade in comparison with the horrors of pre-capitalism."

The populist assualt on incentives - MFI loan defaults

I had blogged earlier about a study by Citigroup economists Willem H. Buiter and Ebrahim Rahbari where they identified factors that could affect future global economic growth. One of the more interesting factors pointed out was the dangers to growth genereated by "the populist assaults on the incentives to work, save and invest". Here is one such example.

Mint quotes Vijay Mahajan of Basix who claims that, thanks to the state-wide default on Microfinance Institution (MFI) loans by self-help groups (SHGs) in Andhra Pradesh, there could be "92 lakh households in Andhra Pradesh who are appearing on the defaulters list of the National Credit Bureau".

Even assuming an element of exaggeration in the figure, it is an extraordinary situation. As far as I can remember, this is the first truly big example of a full-scale debt default by a large section of population. Unlike the loan waivers, where governments decree to write-off loans, here is an example of borrowers deciding to collectively and unilaterally extinguish their debt obligations, without abrogating their loan contract with the MFIs.

First, there is the legal-technical issue of these defaulters, forming a major share of SHGs and women in Andhra Pradesh, losing their credit-worthiness in a single stroke. How would the banks classify or risk-weight future loans to this massive category of borrowers?

More importantly, the larger message that would have been internalized by these women and their communities is that their contractual obligations to their lenders is no longer sacrosanct. The hitherto entrenched belief among borrowers that their private debt will always have to be re-paid is now shaken (the loan waivers have long since shaken this belief on government debts).

Similarly, lenders, of all kinds (who lend to these people), will now be aware that the credit risk of their borrowers have suddenly spurted. Markets will price it accordingly, with higher rates and stronger conditions, which in turn will adversely affect access and hurt borrowers. Unfortunately, this moral hazard is not limited to just borrowers and lenders. It covers all forms of contracts, and this is an even bigger concern.

As standard economic theories have taught us, a market economy is underpinned by bonds of loyalty and trust which facilitates contracts that form the basis of most market-driven transactions. There are a number of studies which have shown that developing countries have weaker contract obligation and enforcement capital and they are binding constraints on economic growth in these economies. The MFI default would surely have diminished the already limited contract capital available in such societies.

In this context, governments need to ensure that their policy decisions do not distort incentives. In the instant case of MFI loan defaults in Andhra Pradesh, even if the government wanted to punish the MFIs, it would have been appropriate if it was done without distorting incentives.

One approach would have been to, in some form, recover the loans through the regular government SHG institutions, with or without interest. The recovered amounts could then have been returned back to the banks that financed the MFIs. This would have punished the MFIs, who would have been deprived off their profits and would suffer credibility loss, without distorting borrower incentives nor causing loss to the financial institutions that funded the MFIs.

Globalization and American economy

The impact of globalization has been one of the most controversial topics of debate in macroeconomic policy making for nearly two decades now. However, for most part, the debate has been partisan and driven by ideological considerations (free-marketers Vs protectionists). In this acrimony, important issues about how the dynamics of globalization affects economic output, employment, trade and inequality have not got the deserved attention, atleast among policy makers.

In this context, Michael Spence and Sandile Hlatshwayo have an excellent working paper on the impact of globalization on employment, economic value-added, and value-added per employee across various sectors of the US economy. The deeply empirical paper has several interesting findings.

They divided the economy into two buckets - tradeables and non-tradeables - and examined what happened in them during the high-noon of globalization, the 1990-2008 period. Tradeable sectors' output is traded across national borders and include manufacturing, agriculture, mining, technical services, financial services etc. Non-tradeables include government services, health care, retailing, transportation, construction, restaurants, legal services etc.

Their main findings, based on examination of historical time series data from US BLS and BEA, drawing on aggregate and particular industry level data for employment and value-added, include

"Value added grew across the economy, but almost all of the incremental employment increase of 27.3 million jobs was on the non-tradable side. On the non-tradable side, government and health care are the largest employers and provided the largest increments (an additional 10.4 million jobs) over the past two decades... without fast job creation in the non-tradable sector, the United States would already have faced a major employment challenge."

And about the underlying forces driving these trends and future prospects, they write,

"The trends in value added per employee are consistent with the adverse movements in the distribution of US income over the past twenty years, particularly the subdued income growth in the middle of the income range. The tradable side of the economy is shifting up the value-added chain with lower and middle components of these chains moving abroad, especially to the rapidly growing emerging markets. The latter themselves are moving rapidly up the value-added chains, and higher paying jobs may therefore leave the United States, following the migration pattern of lower-paying ones."

And about the implications of this trend, they point to long-term structural challenges with respect to the quantity and quality of employment opportunities for Americans, especially with respect to income distribution

"... almost all incremental employment has occurred in the non-tradable sector, which has experienced much slower growth in value added per employee. Because that number is highly correlated with income, it goes a long way to explain the stagnation of wages across large segments of the workforce."

More critically, they point to the impact of this trend on the US labor market, which assumes greater significance in view of the prevailing unemployment gloom,

"The expanding labor force was absorbed in the non-tradable sector (roughly 26.7 out of a total of 27.3 million net new jobs), government and health care leading the growth (10.4 million incremental jobs between them). In our view, it is unlikely that this pattern will continue. Chances are good that the pace of employment generation on the nontradable side will slow. Fiscal conditions, the costs of the health-care sector, a resetting of real estate values, and the elimination of excess consumption all point to the potential for a longer-term structural employment problem. Expanding employment in the tradable sector almost certainly has to be part of the solution. Otherwise, the United States will have a longer-term employment problem."

In other words, the authors make the point that while globalization has made goods and services less expensive for Americans (and kept a lid on inflation), it has also diminished employment opportunities for Americans at the lower and middle parts of the value chain, besides leaving open the danger that the higher-paying jobs at the top end of the value chain too may follow lower paying jobs in leaving American shores.

They also claim that the two contrasting trends across the tradeable and non-tradeable sectors - the former growing in terms of income (higher wages and profits) but not jobs and the latter growing in terms of jobs but not income (stagnant wages and benefits) - is a recipe for increasing inequality and social and political polarization.

Their prescription for the American economy is simple - boost the tradeable sector. Without dramatic increases in the size and scope of the tradable sector, the US economy will face an extended period of slow job growth and rising inequality. Arguing against protectionism, they advocate policies that incentivize businesses to invest in the physical and human capital necessary to make American workers more productive, rather than simply outsourcing work overseas.

See also this from Michael Spence and this from Uwe Reinhardt.

The "framing effect" and monetary policy

In its quarterly monetary policy review, the Reserve Bank of India (RBI) has raised its benchmark repo rate (the rate at which it lends money to commercial banks) by 50 basis points to 8%, its 11th successive increase since October 2009.

In the accompanying statement, the RBI expressed heightened concerns at inflationary expectations getting unleashed. It argued that inflation was a far bigger concern than any slowdown in economic growth. In simple terms, as the RBI Governor's press statement indicates, the main thrust of the interest rate decision was to "moderate inflation and anchor inflation expectations".

Given this "inflation targeting" based paradigm in central bank communication, the rate hike has expectedly raised concerns about its adverse impact on economic growth. It is argued that the increased cost of borrowing would discourage investments and slow down growth. Further, they also claim that since the inflation is driven by supply-side causes, monetary policy actions will have little impact on the final outcomes. This view is based on the valid assumption of an inflation-growth trade-off.

However, a different, "over-heating economy" paradigm based central bank communication could give a different spin to this interest rate decision. It is common knowledge, and the RBI statement reiterates this, that inflation in India is caused by supply constraints. The growth on the supply-side of the economy is simply unable to keep pace with demand growth. These constraints include infrastructure bottlenecks, slow growth in manufacturing production capacity and agriculture production etc.

In the circumstances, there are only two options - ease supply-side constraints and/or slow down demand growth. Since the former is a medium to long-term challenge, the only alternative is to cool-down the economic growth. In this context, the objective of the RBI's rate hike decision becomes one of deliberately cooling down an over-heating economy. The interest rate hike has the desired contractionary effect on the economy. In this monetary policy communication paradigm, lowering growth, and not inflation, is the direct objective. If this is the objective, then the inflation-growth trade-off loses its relevance, with the balance tipping decisively in one direction.

This debate is a classic case of what behavioural economists call "framing effect". Substantively, both "inflation targeting" and "cooling the overheating economy" based monetary policy decisions amount to the same. However, when framed in terms of the former, concerns about growth come to the fore, forcing governments into criticising the central bank. In contrast, when framed in terms of the latter, where slowing down growth is the explicit objective, the criticism of the central bank is likely to be more muted.

The need to regulate consumer finance

One of the most important lessons to be learnt from the sub-prime crisis is the need for better consumer protection in financial markets. In particular, given the shockingly abysmal level of financial literacy among consumers, it was important to provide atleast the most basic level of protection against predatory practices by financial institutions.

In recognition of this imperative, the Dodd-Frank Bill in the US, last year established the Consumer Protection Bureau within the Federal Reserve Board to write and enforce rules protecting consumers of financial products and also increases the authority of state regulators to enforce protections. It would require lenders and sellers of financial products to provide plain-English disclosures, price comparisons with alternative products and clear tripwires before fees are assessed.

This issue assumes much greater relevance in developing countries where financial liberalization of recent years has brought in its wake a proliferation of attractively packaged financial products. The widespread consumer financial illiteracy coupled with skeletal regulation provides fertile ground for predatory lending practices by unscrupulous financiers to unsuspecting borrowers.

A Times article points to the havoc being wreaked by credit card debts, which have also contributed to the extensive economic growth of recent years, in some Latin American countries .

"It has also opened the door to abuses, as credit issuers have used predatory techniques to lure customers, particularly young and less affluent ones, in countries where regulation is scant, annual interest charges can top 220 percent and consumers cannot seek bankruptcy protection, economists and consumer defense groups say... troubling undercurrents in the South American economic boom: indiscriminate lending, lax regulation and ballooning over-indebtedness of large parts of the population, especially those with lower incomes."

And it points to practices that are reminiscent of those of the sterotype of unscrupulous moneylenders, used by certain retailers in Brazil and Chile who peddle consumer durables on credit,

"... among 418,000 clients (of La Polar) in Chile who fell behind on their payments and had their debts repackaged by the retailer La Polar, which raised interest rates and extended loan terms without their knowledge. In early June, it came to light that executives at La Polar had been unilaterally renegotiating clients’ debts for more than six years... The widespread proliferation of credit has been both rapid and relatively recent, developing over the past decade and spurring a consumer revolution across South America. Retail chains like La Polar in Chile and Casas Bahia in Brazil, which sell electronics and housewares, have thrived by offering relatively low-priced goods and extending easy credit terms to entire classes of people who had never had access to it."

While bank-issed credit cards have been regulated, cards issued for in-store use by retailers have enjoyed "light-touch" regulation, thereby setting the stage for a rapidly emerging household indebtedness problem in these countries.

This issue is all the more dangerous for countries like India with a history of extremities of political populism. Credit-driven financial growth has the potential to be the most dangerous form of populism. Unlike conventional electoral populism, involving handing out doles to the electorate which bankrupts the state, credit-driven populism could first bankrupt the households and then the state (in the process of bailing out the banks and the households). This danger is amplified in countries which are in the nascent stages of their financial market growth, where the major share of financial institutions are government owned and financial illiteracy is the norm.

Consider a scenario where the central bank liberalizes (or is forced into) lending regulations on consumer financing (both credit cards and for EMI-based purchases). Predatory lending is never far away and even state-owned banks too enter the fray with several easy-credit schemes. A consumer debt-bubble gets inflated in which a large number of people, especially from the lower middle-class, become exposed. Come elections and the demands start for some form of loan waiver by an electorate socialized into feeling nothing unethical about such demands. It only requires one unscrupulous political party, and there is no dearth of them, to promise write-offs on all consumer debt owed to PSU banks, to force everyone else to follow suit.

That this is not a far-fetched scenario is borne out by the numerous precedents in our history. Loan waivers have been a common feature of our political landscape for decades now. The recent state supported forced write-offs of MFI loans in Andhra Pradesh is a reminder of the vast possibilities of such a trend.

Further, apart from the political populism associated with write-offs, there are factors which strongly encourage such credit growth. For a start, such credit growth drives economic growth. Businesses make profits, consumers are happy borrowing and spending at apparently easy terms and without any hassles, policy makers are satisfied with business investments that create jobs, and bankers are thrilled at the rapid growth of their business (and lending excesses are inevitable). Most importantly, politicians benefit by keeping all these stakeholders satisfied. So where is the incentive to take away the punch-bowl?

It is in this context that more prudent regulation of the sector assumes significance. Such regulation is required to align the incentives of all stakeholders into driving the overall objectives of consumer credit flow. As the experience of Chile and Brazil shows, with increasing financial liberalization, it is only a matter of time before such practices start showing up.

Issues from urbanization trends in India

The latest figures released from India’s Census 2011 shows that for the first time ever India added more people to cities than rural areas. Cities and towns added 91 million people to 90.4 million by villages in the 2001-11 period. The decadal population growth rate for urban India was 31.8%, while for rural India it fell to 12.2%.

It also found that 31.2% of the total population lives in urban centres compared with 27.8% in 2001 and 25.5% in 1991, with South Indian states leading the urban charge. Cumulatively, of the 1.21 billion population, 833 million live in rural India while the remaining 377 million reside in urban India.



The number of towns in the country rose 53.74% to 7,935 between the last two census. However, this conceals an interesting division - the number of statutory towns (notified as a municipality or corporation) rose by 242 to 4,041, while census towns (officially gram panchayats, but have large populations) almost trebled to 3,894. The emergence of such small and informal census towns, especially in states like Kerala (where urban population share nearly doubled in the last decade), is a cause for concern.



As Mint reports, the residents of these census towns benefit from all government benefits that go to rural areas and also lower property taxes and other permit fees. The tax revenues foregone aside, more worryingly, these areas are currently being administered (or not administered) by gram panchayats with limited expertise in managing governance and infrastructure service delivery for larger population centers. This administrative deficit is likely to have adverse long-term consequences for these cities, especially since they are experiencing rapid pace of expansion and development.

These census towns, which are in the early stages of their development, do not have the infrastructure nor the governance capabilities to absorb the sudden influx of migrants from neighbouring villages. Adhoc and chaotic growth in residential settlements and commercial establishments and deficient or absent civic infrastructure are inevitable. The unplanned layouts which emerge from such growth resemble squatter settlements, and leave little scope for future growth and severely constrains the subsequent establishment of standard civic infrastructure facilities.

This failure to plan urban development is a classic case of policy paralysis that characterizes much of policy making in India. In most of these cases, political considerations take precedence over objective requirements. The local panchayats in most cases oppose merger into the neighbouring city or notification as a municipality. Panchayat members risk losing power and play up local resident's fears over higher taxes. Finally, when the merger or notification comes, it is too late. The city's broad topographical layout is already in place, leaving little room for any planned expansion.

On the positive side, in a reflection of the growing political prominence of cities, the number of urban Lok Sabha seats increased from around 70 to at least 100. This growing political influence of urban India will help correct the skewed nature of governance bandwidth in the country. However, since nearly 70% of Indians continue to live in rural areas, the compulsions of electoral politics dictates that rural issues will get priority over urban ones.