Aarogyasri is a hugely popular health insurance program initiated the Government of Andhra Pradesh. Administered by a government-run Aarogyasri Trust, it covers all the below poverty line (BPL) citizens, and provides for pretty much the entire spectrum of high-value tertiary treatments. In the language of insurance, the Aarogyasri is a single-payer (government), mandatory coverage (for all BPL families), pure community rated (same insurance rate for all those covered) insurance scheme.
Its supporters point to four features of the program as proof of its widespread appeal. One, it covers all the major medical conditions, with a generous coverage of upto Rs 2 lakh per family every year. Two, it provides un-paralleled choice to patients, giving them the freedom to choose any hospital, government or private, for their treatment. Three, it provides for completely cashless treatment in any of the empaneled hospitals. Four, the scheme incentivizes government doctors by earmarking a share of the payments recieved by their hospital for treating Aarogyasri cases to the doctors and staff.
However, it is precisely these four attractions that form the basis of concerns about its long-term sustainability.
1. The universal coverage is a red herring. In reality, the supply-side is severely constricted by the available treatment facilities. In fact, even with the spurt of private hospitals in the wake of the program, less than a quarter of patients suffering from a covered medical condition are likely to be treated under the scheme.
Herein lies one of the biggest challenge for the scheme. If the present trend continues, more private hospitals will crop up, if only to exclusively service patients covered by the scheme. This will in turn increase the available treatment facilities and thereby the actual claims processed by the insurer. It is inevitable that premiums will keep going up for years to come, merely due to the addition of new treatment facilities.
As the numbers of private hospitals increase, there will also be increased pressure to expand the pool of covered procedures. This too will drive premiums north. Adding to all this will be the universal trend of rapidly increasing medical treatment costs. Will the government budget prove deep and resilient enough to meet all these upward pressures?
2. The level of patient choice in Aarogyasri is simply unprecedented, a luxury not available to even patients in many developed economies. Given the state of government hospitals and the incentives of private and government hospitals (the former have no incentive to chase patients), patients are more or less certain to prefer the former. This would be a shame since most government secondary and tertiary care hospitals have well qualified doctors and adequate diagnostic and surgical devices, though the quality of service delivery is questionable. Questions will invariably have to be asked about whether it is possible to leverage the Aarogyasri program to improve the quality of service delivery in government hospitals.
3. Related to the previous point, the prevailing government policy on secondary and tertiary healthcare provides for no synergy between the government's own single-payer Aarogyasri health insurance program and its existing secondary and tertiary care facilities. In fact, they are each considered distinct and mutually exclusive. This is unlike the health insurance model in most western countries, where there are strict protocols for referrals, with cases being referred to private hospitals only when government hospitals are unavailable.
An application of the same model would have brought in the government hospitals as a major health service providers in the Aarogyasri scheme through a similar protocols-based sharing of cases between them and private hospitals. It would also have enabled resource-strapped Government hospitals to access payments from the Aarogyasri program. This cash flow becomes all the more important since the state government reduced its budgetary allocation to all these hospitals in lieu of the Aarogyasri allotment. In simple terms, the budgetary allocations to Aarogyasri and existing government hospitals being a near zero-sum game (net allocation being more or less the same), the private hospitals benefitted at the cost of the government hospitals.
4. Further, once the patient is admitted by the private hospital, given the pay-per-intervention payment system, their incentives are strongly aligned towards over-treatment. Since the treatment is cashless, the incentives of the patient are aligned towards accepting the "best" available treatment. Unfortunately, in the prevailing model, the incentives of the doctors are aligned towards projecting expensive invasive surgical procedures as the "best" option. For example, irrespective of the medical condition and the age profile of the patient, irradiation therapies are generally preferred (by both doctors and patients) over medication. In simple terms, the most aggressive treatments have become the standard of healthcare.
In standard insurance schemes, insurers have to keep a strict vigil on the pre-authorization process (when the tests are done and the patient is screened for a particular surgery/therapy) so as to minimize over-treatment. This is all the more so since the payments to health service providers (doctors and hospitals) are on a pay-per-procedure/intervention basis, as against the less distortionary fixed payment for treatment of a medical condition.
The Aarogyasri program too makes payments to hospitals based on a pay-per-procedure basis. In fact, the tender premiums quoted by the insurers are based on this premise. The Trust prefers this approach since it believes that its in-house pre-authorization process is rigorous enough to effectively screen patients and prevent over-treatment. In fact, effective pre-authorization is the forte of the best Third Party Administrators (TPAs) hired by the insurers. If the Aarogyasri Trust does this effectively, then it has to be counted among the most effective TPAs. In any case, as the program expands, maintaining such rigorous pre-authorization process will become difficult.
However, unless it moves away from the in-house pre-authorization process to a purer insurance model, it may not be possible to change the payment model. A medical condition based payment approach is much more complex to administer and riskier too and may not be possible with an in-house model of pre-authorization.
5. In simple terms, the incentives under the Aarogyasri scheme offered a cash reward top-up to doctors for doing much the same procedures which they were doing through their regular hospital in-patient channel. This has the potential to create a moral hazard - the doctors who internalize the incentive and do these procedures come to slowly view these incentives as entitlements.
This turn of events can damagingly distort the incentives facing doctors, especially if at some point in time the government decides to abandon Aarogyasri and decides to revert back to the old model of government institutions based health care. Further, it cannot be denied that atleast some doctors are likely to be disincentivized in taking proper care of patients not covered by Aarogyasri. Also, what about the cash incentive crowding out intrinsic motivation?
Aarogyasri incentive structuring is a powerful example of the need to exercise great caution when we introduce performance-based pay systems into government bureaucracies. Unless carefully structured, cash incentives not only distorts the current implementation, but it also generates adverse expectations which come in the way of future implementation of performance based pay. In some ways, this is similar to a situation where a doctor abruptly replaces a commonplace but effective drug with a powerful new medication against a particular virus/bacteria, only to find after some time that the second generation drug too is losing sting, leaving us with limited available options to effectively treat the microbe.
So what can be done to make the Aarogyasri program more cost-effective without radically tinkering with its existing model?
For a start, it is imperative that there be a clear protocols-based system of referrals, so that the existing government facilities are more closely integrated into the Aarogyasri scheme. The government hospitals benefit by way of accessing more funds and thereby better diagnostic and surgical facilities. It will also help the government accommodate the massive budgetary support that is inevitable in the coming years as the scheme grows.
A treatment facility wise mapping of government hospitals can help route Aarogyasri patients to those hospitals for specific medical conditions. Only those cases which cannot be treated in these hospitals (for either lack of bed space or lack of required facilities) should be referred to private hospitals. Simultaneously, there should be a vigorous campaign to improve service delivery standards in secondary and tertiary hospitals.
The incentive system for government doctors provided for under the Aarogyasri scheme has to be either dismantled or be made more nuanced. If the later is preferred, the incentives should kick-in only after a certain performance benchmark is breached.
Under the Aarogyasri scheme, the insurance premium quoted by the insurer is a function of the number of procedures/therapies covered, N, the respective price (to be paid to the hospital) fixed for each surgery/therapy (or medical condition) i, Pi, the number of empaneled hospitals (or number of available treatment beds for each surgery/therapy i), Ei, and the disease incidence risk among the population pool insured for each medical condition i, Ri.
In other words, Premium, Pr = f(N)+g(Pi)+h(Ei)+q(Ri)
Insurers seek to ensure that their expenditure due to claims and administration costs is lower than the premiums collected.
Of these, the most important parameter is the prices of procedures. Neither the insurer nor the health service providers have an incentive to control it. The health service providers are the direct beneficiaries of higher procedure rates and therefore lobby hard for maximizing procedure prices. The insurers merely pass on these higher prices on to the consumers by way of higher premiums.
The insurer seeks to minimize his claim outgo either by limiting the number of empaneled hospitals (so that the numbers of cases that can be treated is controlled) or turning away (on some pretext or other) those who claim treatment. Both these problems can be addressed. The former can be mitigated by defining the list of empaneled hospitals in the tender itself, including those which are likley to be added each year and details of when they will become operational. Since the premiums are revised each year and it takes atleast an year for establishing any hospital, such up-front disclosure is not likely to create any problems. The later can be overcome by making it mandatory to treat all the patients pre-authorized by the Aarogyasri Trust.
Both the aforementioned conditions, coupled with upfront disclosure of number of surgeries/therapies, transparent fixation of prices for each procedure, and government-run pre-authorization can substantially align the incentives of all parties. If these conditions are fulfilled, the insurer's bid would be determined purely based on his actuarial risk calculation for the insured risk pool and their administration costs. Such bids are more likely to generate efficient outcomes, since it increases the likelihood of the successful bidder also being the most efficient insurer.
Wednesday, October 5, 2011
Tuesday, October 4, 2011
How much difference does two decades make - India Vs China?
The graphics below highlight China's spectacular growth over the past two decades with respect to India. Given the fact that the major share of this explosive growth took place in the last eight years, it is truly an awesome story!
The global share of India and China's manufactured exports were more or less the same in 1985.
Fast forward to 2008, and China has raced away spectacularly in every manufacturing sector.
(HT: Will India overtake China in the next decade?)
The global share of India and China's manufactured exports were more or less the same in 1985.
Fast forward to 2008, and China has raced away spectacularly in every manufacturing sector.
(HT: Will India overtake China in the next decade?)
Taxes and growth/incentives
The central tenet of supply-side economics has been the argument that higher taxes disincentivizes human effort and therefore a reduction in taxes will increase effort and total tax revenues. Paul Samuelson called this "snake oil economics" and it has been repeatedly exposed as being based on questionable assumptions.
Here are two latest examples that contradict this claim. One, Antonio Fatas (in response to Robert Lucas's claim that higher marginal tax rates in Europe discourage married women from working) posts a chart of marginal tax rates and female employment to population ratio for the 25-54 age range for 2010. It shows that countries with high taxes show higher level of efforts as measured by employment to population ratios, whereas the US, with its low taxes, also has low levels of effort.
Second, the CBPP blog points to the respective impacts on output and employment of the Clinton tax increases in the nineties and the Bush tax cuts in the last decade. Both job creation and economic growth were significantly stronger in the recovery following the Clinton tax increase than they were following the 2001 Bush tax cut.
Update 1 (7/10/2011)
Matt Yglesias points to the fact that the late Steve Jobs, despite being a more successful businessman than Bill Gates or Larry Page, has a modest share of Apple's massive market capitalization. He writes,
Here are two latest examples that contradict this claim. One, Antonio Fatas (in response to Robert Lucas's claim that higher marginal tax rates in Europe discourage married women from working) posts a chart of marginal tax rates and female employment to population ratio for the 25-54 age range for 2010. It shows that countries with high taxes show higher level of efforts as measured by employment to population ratios, whereas the US, with its low taxes, also has low levels of effort.
Second, the CBPP blog points to the respective impacts on output and employment of the Clinton tax increases in the nineties and the Bush tax cuts in the last decade. Both job creation and economic growth were significantly stronger in the recovery following the Clinton tax increase than they were following the 2001 Bush tax cut.
Update 1 (7/10/2011)
Matt Yglesias points to the fact that the late Steve Jobs, despite being a more successful businessman than Bill Gates or Larry Page, has a modest share of Apple's massive market capitalization. He writes,
"It’s worth thinking about this kind of thing when trying to consider the impact of financial incentives at the margin for high-achievers. Greg Mankiw and others, I think, want us to believe that the ups-and-downs of the estate tax were an important driver of the quantity and quality of entrepreneurial effort undertaken by these guys. That doesn’t seem even remotely right to me."
Monday, October 3, 2011
Impact of cash transfers in an economy with large fiscal transfers
For its extraordinary, almost global size, India's flagship National Employment Guarantee Scheme (NREGS) remains one of the least evaluated of anti-poverty programs anywhere in the world. For example, how has the massive NREGS cash transfers to rural consumers affected wages and local price levels? More generally, what is NREGS contribution to India's persistent food inflation? Or more specifically, how is the additional disposable income generated by NREGS being spent?
Unfortunately, there is no rigorus enough empirical study of the impact of world's largest cash transfer program on rural wages and resultant inflation. In a related context, Jesse M. Cunha, Giacomo De Giorgi, and Seema Jayachandran compared the relative local price effects of cash and in-kind transfers by studying a large food assistance program in Mexico that randomly assigned villages to receive boxes of food (trucked into the village), equivalently-valued cash transfers, or no transfers and found,
The study also finds that price effects were particularly pronounced for very geographically isolcated villages, where the most impoverished people live. This is consistent with the fact that these villages are less open to trade and have less market competition, and are therefore more likely to be supply constrained in case of cash transfers. In these cases, the in-kind transfers actually increases supply and lowers prices.
The authors point to two issues that needs to be factored in while calculating the price benefits. One, their study does not look into what kind of effect is generated in the long-term, when the higher prices would signal to increase local production, thereby easing supply constraints. In fact, its long-term benefits are far more than that arising from external in-kind supply.
More importantly, there is the issue of how much does in-kind transfers constrain households' choices or conversely how much does cash transfers increase households' choices. As the authors point out, it is quite possible that an efficient private sector would create more surplus than if the inefficient government were the supplier. So they suggest that the best alternative would a mixture of cash transfers and policies to ease supply-side constraints.
Extending this analysis to NREGS and India will yield interesting possibilities. In India, we currently have a deeply supply constrained market where inflation expectations are on the rise. In such markets, any cash transfer would do little to increase supply. It increases the cash available with consumers, without doing much to boost supply, atleast in the short- to medium-term. Increased prices are inevitable. This increase in prices affect both the specific commodity being subsidized and the general price level.
Consider a cash transfer in place of rice supply through the Public Distribution System (PDS). Assume a family requires 60 kg of rice per month and gets cash equivalent of 35 kg of rice. Let us also assume that the subsidies are calibrated to price variability. Let us assume that there is only one variant of rice available in these remote markets and its price is Rs 15 per kg before the new cash transfer scheme is introduced. In supply-constrained markets (and remote interiors are classic examples of supply-constrained markets), which also experience government fiscal spending, prices generally increase and the following two effects are observed.
1. The beneficiary gets only a portion of his rice through the PDS. He has to purchase the rest from the market at market prices. In this case, he purchases 25 kg from the open market. After the cash transfer scheme is introduced, the price of rice increases to Rs 20 per kg (since the PDS supplies, which is not an insignficant share of total supply in such small markets, is now not available and has to come from the general market supply). He still continues to get cash equivalent to 35 kg. But now he has to shell out an extra Rs 125 per month for the same amount of rice the family was consuming before the program was introduced.
In contrast, with in-kind transfer, let us assume that the price falls (or it could remain the same) by say Rs 2 per kg after its introduction. This in turn leaves the farmer with a savings of Rs 50 per month. The difference between the two programs, with these assumptions, is therefore Rs 175.
2. There is also the likely spill-over effect on the general price level due to the increase in the price of rice. Further, the additional disposable incomes generated by way of NREGS and the resultant higher rural wages, will increase the demand for other items, mainly meat and other protein foods. Econ 101 would tells us that, when supply remains the same (which is likely to be the case with most products, atleast in the medium term), additional incomes (or higher aggregate demand) will have the effect of increasing the general price level.
All this in turn increases the burden on the family by say, Rs 100. Taken together, both these effects have the effect of reducing the real income of rural household by Rs 225 per month. The combined effect of cash transfers in an NREGS context is captured in the graph below. Note that it is possible that even the actual aggregate consumption could fall, rather than increase, especially if inflationary pressures get out of hand.
This highlights the importance of easing supply-side constraints in ensuring the effectiveness of any cash transfer scheme. In fact, taken together with NREGS, cash transfers could, without policies to increase supply, exacerbate inflationary pressures. Whatever the analysis, India's biggest obstacle to growth and successful implementation of process reforms that can increase growth, is a deeply supply-constrained economy. Its inflation problems too are just a symptom of supply bottlenecks.
Unfortunately, there is no rigorus enough empirical study of the impact of world's largest cash transfer program on rural wages and resultant inflation. In a related context, Jesse M. Cunha, Giacomo De Giorgi, and Seema Jayachandran compared the relative local price effects of cash and in-kind transfers by studying a large food assistance program in Mexico that randomly assigned villages to receive boxes of food (trucked into the village), equivalently-valued cash transfers, or no transfers and found,
"Both types of transfers increase the demand for normal goods, but only in-kind transfers also increase supply. Hence, in-kind transfers should lead to lower prices than cash transfers, which helps consumers at the expense of local producers...
The price increase caused by cash transfers, based on the point estimates, offsets the direct transfer by 6 percent for recipients who are consumers of these goods. Meanwhile, for in-kind transfers, the price effects represent an indirect benefit to consumers equal to 5 percent of the direct benefit. Thus, choosing in-kind rather than cash transfers in this setting generates extra indirect transfers to the poor equal to 11 percent of the direct transfer. Of course, the welfare implications are reversed if transfers recipients are producers rather than consumers.
We also find that agricultural profits increase in cash villages, where food prices rose, more so than in in-kind villages where prices fell. These effects are due both to the change in the price of goods sold, but also to households responding by producing more (less) when the price of what they produce increases (decreases)."
The study also finds that price effects were particularly pronounced for very geographically isolcated villages, where the most impoverished people live. This is consistent with the fact that these villages are less open to trade and have less market competition, and are therefore more likely to be supply constrained in case of cash transfers. In these cases, the in-kind transfers actually increases supply and lowers prices.
The authors point to two issues that needs to be factored in while calculating the price benefits. One, their study does not look into what kind of effect is generated in the long-term, when the higher prices would signal to increase local production, thereby easing supply constraints. In fact, its long-term benefits are far more than that arising from external in-kind supply.
More importantly, there is the issue of how much does in-kind transfers constrain households' choices or conversely how much does cash transfers increase households' choices. As the authors point out, it is quite possible that an efficient private sector would create more surplus than if the inefficient government were the supplier. So they suggest that the best alternative would a mixture of cash transfers and policies to ease supply-side constraints.
Extending this analysis to NREGS and India will yield interesting possibilities. In India, we currently have a deeply supply constrained market where inflation expectations are on the rise. In such markets, any cash transfer would do little to increase supply. It increases the cash available with consumers, without doing much to boost supply, atleast in the short- to medium-term. Increased prices are inevitable. This increase in prices affect both the specific commodity being subsidized and the general price level.
Consider a cash transfer in place of rice supply through the Public Distribution System (PDS). Assume a family requires 60 kg of rice per month and gets cash equivalent of 35 kg of rice. Let us also assume that the subsidies are calibrated to price variability. Let us assume that there is only one variant of rice available in these remote markets and its price is Rs 15 per kg before the new cash transfer scheme is introduced. In supply-constrained markets (and remote interiors are classic examples of supply-constrained markets), which also experience government fiscal spending, prices generally increase and the following two effects are observed.
1. The beneficiary gets only a portion of his rice through the PDS. He has to purchase the rest from the market at market prices. In this case, he purchases 25 kg from the open market. After the cash transfer scheme is introduced, the price of rice increases to Rs 20 per kg (since the PDS supplies, which is not an insignficant share of total supply in such small markets, is now not available and has to come from the general market supply). He still continues to get cash equivalent to 35 kg. But now he has to shell out an extra Rs 125 per month for the same amount of rice the family was consuming before the program was introduced.
In contrast, with in-kind transfer, let us assume that the price falls (or it could remain the same) by say Rs 2 per kg after its introduction. This in turn leaves the farmer with a savings of Rs 50 per month. The difference between the two programs, with these assumptions, is therefore Rs 175.
2. There is also the likely spill-over effect on the general price level due to the increase in the price of rice. Further, the additional disposable incomes generated by way of NREGS and the resultant higher rural wages, will increase the demand for other items, mainly meat and other protein foods. Econ 101 would tells us that, when supply remains the same (which is likely to be the case with most products, atleast in the medium term), additional incomes (or higher aggregate demand) will have the effect of increasing the general price level.
All this in turn increases the burden on the family by say, Rs 100. Taken together, both these effects have the effect of reducing the real income of rural household by Rs 225 per month. The combined effect of cash transfers in an NREGS context is captured in the graph below. Note that it is possible that even the actual aggregate consumption could fall, rather than increase, especially if inflationary pressures get out of hand.
This highlights the importance of easing supply-side constraints in ensuring the effectiveness of any cash transfer scheme. In fact, taken together with NREGS, cash transfers could, without policies to increase supply, exacerbate inflationary pressures. Whatever the analysis, India's biggest obstacle to growth and successful implementation of process reforms that can increase growth, is a deeply supply-constrained economy. Its inflation problems too are just a symptom of supply bottlenecks.
Sunday, October 2, 2011
The Future of School Education?
"By 2015, all South Korean students will be issued tablet computers instead of paper textbooks. Homework will be uploaded rather than carried in back-breaking backpacks."
(HT: NYT)
Saturday, October 1, 2011
Does Europe needs its version of TARP/TALF?
It is increasingly evident that the Eurozone stands at the precipice, with the serious danger of carrying the world economy down with itself.
The combined ECB-IMF bailout, operated through the European Financial Stability Fund (EFSF) appears too little to make any meaningful dent on Europe's growing list of problems. In simple terms, Europe is facing its Lehman moment. The markets are clearly unimpressed by the amounts provided under the EFSF and are ratcheting up the pressure on the peripheral economies. In recent weeks, the cost of insuring Greek and Italian debts have exploded, as have their bond yields and spreads with German bund. Europe clearly needs much more ammunition in its armoury to come out of this with the Eurozone intact and without suffering massive economic damage.
The obvious risk is the catastrophic cascading effect a sovereign default can have on the global financial markets, leave alone the European markets. More immediate danger, and one which is already playing itself out, is the credit squeeze being felt by most European financial institutions, as wary lenders from across the Atlantic and elsewhere are working out ways to pare down their Eurozone exposure.
A sovereign default by Greece, while theoretically manageable, is certain to amplify market uncertainty and risks across the financial markets, and thereby increase the pressure on countries like Italy. A run on Italy, leave alone a full-fledged default, will be well-neigh unmanageable. The European financial markets are most certain to seize as these dangers start showing up in the aftermath of a Hellenic default. And the impact of all these on the global financial institutions, on both sides of the Atlantic, including Germany, will be very damaging for their balance sheets.
The need of the hour then, as US faced in the aftermath of the Lehman default, is to immediately address the solvency and liquidity crisis that is brewing and threatening to go out of hand. The former requires a massive banking recapitalization program, while the later demands opening an expansive liquidity injection window. The Euro 440 bn EFSF, intended to inject capital into distressed banks and purchase sovereign bonds so as ease the pressure on their yields, may be too little too late to serve the purpose.
The EFSF will be able to lend up to 440 billion euros, or about $600 billion, and issue guarantees for 780 billion euros. However, a more realistic requirement is estimated at nearly 2 trillion Euros. Given the politics of Eurozone, this looks clearly unrealistic. Though announced more than three months back, the EFSF is yet to get approval in all member Parliaments, highlighting the difficulties of decision making in the Eurozone area. Even otherwise, with a total Eurozone GDP of 9.5 trillion euros, this would be more than 25% of the total GDP.
In the US in 2008, as part of the TARP and the TALF, the Treasury and the Fed carried out both operations, with the former in massive scale. Liquidity windows were opened, blanket credit guarantees provided, collateral standard relaxed, and the Fed even carried out massive purchases of certain failing assets in order to backstop the markets. The Fed almost tripled its balance sheet to emerge as an effective lender, insurer and even buyer of last resort to prevent the markets from fully seizing up.
Such aggressive actions may be required to soothen the markets somewhat and weaken the grip of widespread panic. If the liquidity infusions are in sufficient size and done without much delay, it may be possible to buy enough time for the beleaguered institutions to recover some lost ground, and bring some semblance of normalcy back to the markets, thereby preventing a full meltdown. One of the big policy successes, atleast in terms of its immediate objective, of the past four years has been the US financial market bailout initiated in late 2008. Addressing the deeper and fundamental issues of individual bank solvency and economic and financial market restructuring can be taken up once this stage is surmounted.
But there are serious doubts about the effectiveness of such policies in stemming the panic. The assumption is that equity injections and credit infusions will buy enough time for the Eurozone economies to restore market confidence, lower the cost of financing their sovereign debt, bring debt servicing burden under control, and put the economy back in a robust growth path. But critics have raised doubts about this optimism.
The biggest structural problem facing many of these economies, especially Greece, Portugal, and Italy, is the need to reduce their cost of production and regain competitiveness. This is traditionally done by devaluing domestic currency or cutting wages. The former is not an option as long as they remain within Eurozone, while the later will in all probability exacerbate the problem and push the economy further down. This could in turn trigger off a debt spiral, further increasing the debt-to-GDP ratio and sovereign debt servicing costs.
In any case, given all the aforementioned, if the Euro experiments has to survive, it is inevitable that the core economies step in with more explicit and larger support for the beleaguered peripheral ones. That support has to come either in the form of direct fiscal transfers or some mixture of monetary expansion, including some way using the Eurozone's combined balance sheet to finance the debt of the weakened economies, and partial defaults or haircuts. Preferably all of them. Further, the more this intervention is delayed, the steeper will be the recovery path and higher will be the price to be paid.http://www.blogger.com/img/blank.gif
Update 1 (6/10/2011)
The ECB and Bank of England announced measures to support the financial markets. ECB said it would start offering banks unlimited loans (banks have to put up collateral like bonds or other securities) at the benchmark interest rate for about one year, up from the previous six months. The ECB also said it would resume buying so-called covered bonds, which are a form of debt secured by packages of loans and guaranteed by the issuing bank. Covered bonds are one of the main ways that banks raise money.
The Bank of England decided to retain interest rates at 0.5% and also announced the decision to widen its so-called quantitative easing program to £275 billion, or $425 billion, from £200 billion.
Update 2 (13/10/2011)
On what needs to be done for Europe, Martin Wolf writes,
But he identifies the formidable challenge of making crisis management compatible with fiscal adjustment,
The combined ECB-IMF bailout, operated through the European Financial Stability Fund (EFSF) appears too little to make any meaningful dent on Europe's growing list of problems. In simple terms, Europe is facing its Lehman moment. The markets are clearly unimpressed by the amounts provided under the EFSF and are ratcheting up the pressure on the peripheral economies. In recent weeks, the cost of insuring Greek and Italian debts have exploded, as have their bond yields and spreads with German bund. Europe clearly needs much more ammunition in its armoury to come out of this with the Eurozone intact and without suffering massive economic damage.
The obvious risk is the catastrophic cascading effect a sovereign default can have on the global financial markets, leave alone the European markets. More immediate danger, and one which is already playing itself out, is the credit squeeze being felt by most European financial institutions, as wary lenders from across the Atlantic and elsewhere are working out ways to pare down their Eurozone exposure.
A sovereign default by Greece, while theoretically manageable, is certain to amplify market uncertainty and risks across the financial markets, and thereby increase the pressure on countries like Italy. A run on Italy, leave alone a full-fledged default, will be well-neigh unmanageable. The European financial markets are most certain to seize as these dangers start showing up in the aftermath of a Hellenic default. And the impact of all these on the global financial institutions, on both sides of the Atlantic, including Germany, will be very damaging for their balance sheets.
The need of the hour then, as US faced in the aftermath of the Lehman default, is to immediately address the solvency and liquidity crisis that is brewing and threatening to go out of hand. The former requires a massive banking recapitalization program, while the later demands opening an expansive liquidity injection window. The Euro 440 bn EFSF, intended to inject capital into distressed banks and purchase sovereign bonds so as ease the pressure on their yields, may be too little too late to serve the purpose.
The EFSF will be able to lend up to 440 billion euros, or about $600 billion, and issue guarantees for 780 billion euros. However, a more realistic requirement is estimated at nearly 2 trillion Euros. Given the politics of Eurozone, this looks clearly unrealistic. Though announced more than three months back, the EFSF is yet to get approval in all member Parliaments, highlighting the difficulties of decision making in the Eurozone area. Even otherwise, with a total Eurozone GDP of 9.5 trillion euros, this would be more than 25% of the total GDP.
In the US in 2008, as part of the TARP and the TALF, the Treasury and the Fed carried out both operations, with the former in massive scale. Liquidity windows were opened, blanket credit guarantees provided, collateral standard relaxed, and the Fed even carried out massive purchases of certain failing assets in order to backstop the markets. The Fed almost tripled its balance sheet to emerge as an effective lender, insurer and even buyer of last resort to prevent the markets from fully seizing up.
Such aggressive actions may be required to soothen the markets somewhat and weaken the grip of widespread panic. If the liquidity infusions are in sufficient size and done without much delay, it may be possible to buy enough time for the beleaguered institutions to recover some lost ground, and bring some semblance of normalcy back to the markets, thereby preventing a full meltdown. One of the big policy successes, atleast in terms of its immediate objective, of the past four years has been the US financial market bailout initiated in late 2008. Addressing the deeper and fundamental issues of individual bank solvency and economic and financial market restructuring can be taken up once this stage is surmounted.
But there are serious doubts about the effectiveness of such policies in stemming the panic. The assumption is that equity injections and credit infusions will buy enough time for the Eurozone economies to restore market confidence, lower the cost of financing their sovereign debt, bring debt servicing burden under control, and put the economy back in a robust growth path. But critics have raised doubts about this optimism.
The biggest structural problem facing many of these economies, especially Greece, Portugal, and Italy, is the need to reduce their cost of production and regain competitiveness. This is traditionally done by devaluing domestic currency or cutting wages. The former is not an option as long as they remain within Eurozone, while the later will in all probability exacerbate the problem and push the economy further down. This could in turn trigger off a debt spiral, further increasing the debt-to-GDP ratio and sovereign debt servicing costs.
In any case, given all the aforementioned, if the Euro experiments has to survive, it is inevitable that the core economies step in with more explicit and larger support for the beleaguered peripheral ones. That support has to come either in the form of direct fiscal transfers or some mixture of monetary expansion, including some way using the Eurozone's combined balance sheet to finance the debt of the weakened economies, and partial defaults or haircuts. Preferably all of them. Further, the more this intervention is delayed, the steeper will be the recovery path and higher will be the price to be paid.http://www.blogger.com/img/blank.gif
Update 1 (6/10/2011)
The ECB and Bank of England announced measures to support the financial markets. ECB said it would start offering banks unlimited loans (banks have to put up collateral like bonds or other securities) at the benchmark interest rate for about one year, up from the previous six months. The ECB also said it would resume buying so-called covered bonds, which are a form of debt secured by packages of loans and guaranteed by the issuing bank. Covered bonds are one of the main ways that banks raise money.
The Bank of England decided to retain interest rates at 0.5% and also announced the decision to widen its so-called quantitative easing program to £275 billion, or $425 billion, from £200 billion.
Update 2 (13/10/2011)
On what needs to be done for Europe, Martin Wolf writes,
"The broad consensus of the world’s policymakers and commentators is that the eurozone must now do the following: divide countries in difficulties into the insolvent and the illiquid; restructure the debts of the former and provide unlimited, but temporary, support for the latter; and recapitalise banks, after stress tests that allow for losses on sovereign debt, either from national treasuries or from the European financial stability facility, in accordance with the flexibility given by the decisions taken in July 2011."
But he identifies the formidable challenge of making crisis management compatible with fiscal adjustment,
"... there is an opposing risk, that forcing adjustment on the weak will fail, because of a lack of offsetting adjustment in the strong. That would not be a huge problem if those forced to adjust are small. It is a vast problem if they are large. The risk is of a downward spiral as austerity is exported and re-exported.
No doubt, a way must be found to deal with the immediate crisis that does not allow another panic. But that would not be a solution if it merely led to indefinite financing of fundamentally uncompetitive economies. At the same time, one-sided and unduly hasty adjustment would exacerbate the downturns in the eurozone and world economies. What is needed is financing and adjustment. Unless and until that difficult combination is achieved, we are delivering first aid not a cure."
Euro distress signatures
Here is a comparative assessment of the panic affecting Greek, Portuguese, and Italian government debt instruments. The spreads between the 10 year sovereign bonds of each of these countries and the German Bund had started widening since April and has gathered momentum since July.
The yields on ten year sovereign bonds too have increased sharply over the past month or so.
The cost of insuring Greek, Portuguese, and Italian debt, reflected in the 5 year CDS spreads, too have followed much the same pattern, exploding in the past two months.
The yields on ten year sovereign bonds too have increased sharply over the past month or so.
The cost of insuring Greek, Portuguese, and Italian debt, reflected in the 5 year CDS spreads, too have followed much the same pattern, exploding in the past two months.
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