Framing the inequality debate

Widening inequality is arguably one of the most important socio-economic challenges facing societies, rich and poor, across the world. Unfortunately, despite the steep widening of inequality in recent years, it has not generated the anticipated level of social outrage.

In a recent article in the NYT, Ian Ayres and Aaron Edlinn, had called for a Brandeis tax, as a tax directly on inequality. The Brandeis Ratio is the average income of the richest one percent of household to the average median household income. This ratio has risen alarmingly from 12.5 in 1980 to 36 by 2006. The Brandeis tax be an automatic extra tax on the income of the top 1 percent of earners — a tax that would limit the after-tax incomes of this club to 36 times the median household income. It would therefore be an inequality capping tax.

In a series of posts in Freakonomics, they take their argument one step ahead and advocate that the debate on income inequality be framed in terms of "medians". They write,

"Framing income inequality in terms of "medians" is also part of a larger goal of making the median household incomes more salient... Part of our goal is to change the way politicians speak about income equality. Framing the income of the wealthy in relation to the median income will help us all keep in mind the relative success of the middle class.

It might even be useful to describe other things in terms of medians. A new Cadillac Escalade will run you 1.4 medians. A year’s tuition at Yale Law School is about .88 medians. We might even restructure government salaries so that they automatically adjust with the median... To raise the prominence of the median measure, government could standardize a "mi" symbol."

Behavioural psychologists have long pointed to the power of framing in re-orienting the human mind. In the instant case, absolute income numbers are not very effective in signalling about the degree of inequality. However, when the same is framed in terms of "mi", the extent of inequality becomes cognitively striking.

Similar framing can be an effective strategy in the various conservation (water, electricity etc) and environmental awareness campaigns. Water closets could be rated based on the number of buckets of water used. Air conditioners can be rated by describing their energy consumption as a multiple of that of a fan. In all these cases, the message is framed in a language that is readily graspable and therefore cognitively salient.

In this context, economist Robert Frank has constructed a Toil Index to more evocatively highlight the middle-class squeeze. It represents the number of monthly hours of work required to rent a house in an area served by a school of average quality. And it has just shot up vertically since the last decade.

Improving learning levels - what delivers bang for the buck?

I blogged yesterday about the student learning levels crisis in India. In this context, as the search for solutions and policy approaches to improving learning levels are in progress, this graphic from Andrew Fraker (report not online) and colleagues of IDInsight provides valuable and credible enough clues.



The graphic, which presents the evidence from 34 rigorously evaluated studies from 9 countries (19 of them from India) on strategies to improve student learning outcomes, clearly points to the superiority of remedial education. In fact, he finds that interventions that combine remedial education and increasing accountability are the most effective strategy to improve learning outcomes. Interestingly, it also finds that interventions that focus on inputs and technology have very negligible or even negative effect.

Another less obvious point from the graphic is the wide dispersion in outcomes within the remedial education sample. It just shows that while, on the average, remedial education is very effective, its success lies in getting the design and implementation strategy right. Unfortunately, this is where we struggle to get the mix right and fail with the implementation. And this in turn brings undeserved discredit to remedial education itself.

The influence of Prospect Theory mapped

Mostly Economics points to a fantastic graphic that maps the spectacular growth in "scholarly influence" of Prospect Theory, which examines decision making in conditions of uncertainty and risk, as measured by Journal citations and references in different fields. Daniel Kahneman and Amos Tversky published their landmark paper on Prospect Theory in 1979.



This visualization is also an example of the power of graphically illustrating concepts like growth in influence of ideas and trends.

The student learning deficit crisis

It should not come as a surprise to anyone that student learning levels in our schools are abysmal. Numerous reports, most notably the annual ASER reports, have confirmed that our schools system is in a serious state of disrepair.

But two studies, highlighted in Mint over the past one week, point to a malaise that is much deeper, universal, and shocking in its magnitude. Our school education system is a national crisis, one that most seriously threatens our future economic growth prospects. The human resource plumbing of our economy needs immediate fixing.

First, the Quality Education Study (QES) 2011 conducted by Wipro and Educational Initiatives in some of the "best" private schools in five metropolitan cities show that learning levels of their students are way behind global averages. It finds that the outcomes are depressing even in issues like civic responsibility, sensitivity towards differently able, and acceptance of diversity. Anurag Behar's conclusion is striking,

Actual learning levels of students in our best schools are below global averages. Our students did well in areas that required memorization and procedural skills, but are way behind when it came to understanding, conceptual clarity, thinking and application...

India’s school education is in bad shape, not just the government- and low-fee private schools, but even the 'best schools' that are the exemplars for all other schools to emulate... These schools, where the students come primarily from upper middle-class homes, reflect significant gender and community bias and low social sensitivity.

The second study, PISA 2009+, evaluated 15-year-olds’ skills in overall reading, mathematical and scientific literacy on a comparative basis across 10 countries. Himachal Pradesh and Tamil Nadu, which are thought to be the best performing school systems in India, were part of the survey. Both came at the bottom, on par with Kyrgyzstan in all the three parameters.



Comparing with the full PISA 2009 study of 74 nations, Tamil Nadu ranked 72 and Himachal Pradesh 73, just ahead of Kyrgyzstan in mathematics and overall reading skills. Shanghai in China topped the PISA rankings in all three categories. Its findings brought out in Mint are shocking,

"In Tamil Nadu, only 17% of students were estimated to possess proficiency in reading that is at or above the baseline needed to be effective and productive in life. In Himachal Pradesh, this level is 11%. This compares to 81% of students performing at or above the baseline level in reading in the OECD countries, on an average... In other words, only a little over one in six students in Tamil Nadu and nearly one in 10 students in Himachal Pradesh are performing at the OECD average...

Only 12% of students in Himachal Pradesh and 15% in Tamil Nadu were proficient in mathematics against an OECD average of 75%; when it came to scientific literacy among students of class X, the proficiency level in Tamil Nadu was 16% and in Himachal, 11%, as against an OECD average proficiency of 82%. In Malaysia, 56% of students were proficient in reading and 41% in mathematics. Similarly, in the United Arab Emirates, the mathematics proficiency levels was estimated at 49% and for reading, 60%. Like India, both countries participated for the first time."

The key to improving learning levels in our schools is to improve the quality of classroom transaction. This demands replacing rote learning with instilling conceptual understanding in students. Teacher initiative and headmaster leadership are critical to achieving this transformation. However, the difficulty lies in achieving this transformation on the humunguous scale that India requires.

The real challenge is to do this in an environment where the odds are heavily stacked against such quality improvements - demotivated and disinterested teachers, headmasters without any initiative, students from adverse socio-economic backgrounds, deficient infrastructure, an eco-system which favors rote learning, and so on. Putting learning levels at the center of the agenda would be a good place to start the process of repairing our school education system.

India's software sector and exchange rate fluctuations

In the second half of 2010, spurred by capital inflows, the rupee appreciated substantially against the dollar. Infosys CFO V Balakrishnan then called for urgent intervention by the RBI to stabilize the currency,

"The RBI should intervene right now to halt heavy speculative inflows through the FII (foreign institutional investments) route to reduce the currency volatility, which is currently ranging from 10-15 percent... With a trade deficit of $13 billion, such a wide currency fluctuation is unsustainable for the country as well as the software services sector, which depends largely on export revenues. We hope the central bank (RBI) will step in to ensure the quality of inflows."

Now, with the opposite trend playing out and rupee falling sharply, thereby boosting the rupee value of software exports, Narayana Murthy finds nothing amiss and finds it a general phenomenon,

"Value of rupee keeps fluctuating. This is normal. At some point of time value of Rupee was at 39 against a dollar."

The two contrasting, or opportunistic, remarks provide an insightful peek into India's software industry. The software sector, while undoubtedly globally competititive, benefits from substantial government support. It continues to enjoy most of the benefits extended to it as a sunrise industry in the nineties. The industry has lobbied intensely to retain the tax breaks given to exporters located inside the Software Technology Parks. The sector has the lowest effective tax rate of 15-18%, compared to the statutory corporate tax rate of 34%, and lobbies hard against removing tax exemptions.

Used to double digit growth rates for decades now, it is important that India's software sector adjust to the vagaries of global market place. Instead of relying on free lunches resulting from cheap labour, low tax rate or weak currency, the industry should seek to raise its competitiveness by increasing productivity and moving up the value chain.

The banking sector bailout debate resurfaces

In a recent post, Felix Salmon had a bleak assessment of the Eurozone crisis,

"In every crisis there’s a point of no return — if you don’t do XYZ in time, it’s too late, and the crisis is certain to get out of anybody’s control. I’m increasingly convinced we’ve already passed that point of no return in Europe. The banks won’t lend to each other, the Germans won’t do Eurobonds, and the ECB won’t act as a lender of last resort. The confidence fairy has left the continent, and she isn’t about to return. Which means, as we used to say in 2008, that things are going to get worse before they get worse."

As the increasing bond yields and CDS spreads indicate, the European credit markets are pretty much freezing up. As reflected in the dismal response in recent auction, even the Teutonic credibility of the German bund has taken a dent. Governments are finding that debt refinancing has become very expensive. Banks, with heavy sovereign debt exposures, have become averse to lending anymore, not only to sovereigns but also to each other. Further, they also face rising margin calls due to heightened sovereign debt default risks. The risk of assets turning sour and demand for increased capital requirement (from margin calls), is turning an initial liquidity crisis into a solvency crisis for the banking sector.

In the circumstances, there are two options. The interventionists advocate aggressive measures to restore credit markets (through rate cuts, liquidity injections, credit guarantees, and asset purchases) and bank recapitalization with stringent conditions attached. This is effectively a call to the central bank to step in as a lender, buyer, and insurer of last resort. It would also involve governments taking stakes in banks. Felix Salmon too prefers intervention. His prognosis about the fate of Eurozone is based on this assumption. He believes that the ECB's intransigence and failure to act has driven away the confidence fairy.

The sceptics counter that such measures are likely to be futile. They oppose such bailouts as rewarding reckless and greedy bankers. They also argue that it would merely postpone the hard decisions and belt tightening that are necessary to remove the excesses and distortions created by the skewed pre-crisis growth. Finally, they associate it with trying to restore growth in the aftermath of an asset bubble by inflating another bubble. They point out that the extraordinary monetary easing and liquidity support has the potential to amplify distortions and destablize global financial markets. It would also come in the way of the much needed croeconomic rebalancing among economies of the developed and emerging world.

In this context, as Christina Romer points out, the nature of the response matters critically with any interventionist approach. She points to the contrasting experiences of Sweden in 1991 and Japan in 1992 after their respective banking crises. The former nationalized its banks, recapitalized with public funds, and then returned to private control, with the result that the country returned to its pre-crisis trend within three years. In contrast, Japan refused to clean up its banks, rolling over loans to failing companies, with the result that it continues to grapple with anemic growth and deflation for almost two decades.

It is difficult to make a satisfactory enough judgement call on either position from merely theoretical principles or historical experiences. Both sides could be right and wrong in different ways. In simple terms of a cost-benefit analysis, which option generates higher net benefits? Alternatively, which option would generate the least costs or the less worse set of distortions? Unfortunately, these questions do not have convincing enough answers.

But it is undoubtedly true that bailouts generate moral hazard by taking away the biggest disciplining factor of capitalism. And, as the recent evidence has shown, such bailouts, perversely enough, end up concentrating risk by making the TBTF institutions even bigger.

Update 1 (21/12/2011)

In its role as lender of last resort to banks, the ECB allocated 489.2 billion euros, or $644 billion, to 523 institutions through its longer-term refinancing operations, or LTROs. The loans are for three years and will be at the benchmark 1% interest rate. This is the largest amount ever allocated in a single ECB liquidity operation and first time ECB has extended loans for maturities beyond one year. ECB had started the liquidity operations in the aftermath of the Lehman collapse. It announced that another LTRO will be held in February 2012.

The three-year loans are designed to compensate for a dearth of longer-term market funding, at a time when banks are facing the need to roll over an extraordinarily high amount of their own debt. Banks in the euro zone must raise more than 200 billion euros in the first three months of 2012.

The cheap loans issued by the ECB may also indirectly help governments like Spain and Italy that have faced higher borrowing costs. Spain paid sharply lower interest on debt it auctioned early this week, as banks appeared to use cheap ECB money to buy the bonds, profiting from the difference in interest rates. However, the proceeds could also be used to re-finance existing assets as they become due in the months ahead.

The ECB, as part of its effort to prevent a credit crunch, also broadened the collateral it will accept in return for loans. It is even accepting outstanding loans as security, a measure designed to help smaller community banks that may lack conventional forms of collateral like bonds.

Income inequality and sustainable growth

Eduardo Porter points to the work of IMF economists Andrew Berg and Jonathan Ostry that questions the sustainability of economic growth in conditions of widening inequality. They argue that "sustainable economic reform is possible only when its benefits are widely shared".

They found that in high-inequality nations spurts of growth ended more quickly, and often in painful contractions. They find that a 10 percentile decrease in inequality (represented by a change in the Gini coefficient from 40 to 37) increases the expected length of a growth spell by 50 percent.





They also found that income distribution contributes more to the sustainability of economic growth than does the quality of a country’s political institutions, its foreign debt and openness to trade, the level of foreign investment in the economy and whether its exchange rate is competitive.



The graphic below highlights why widening inequality is a much greater cause for concern in the US



Extreme inequality and its rapid widening is especially bad for developing economies like India, which are even otherwise vulnerable to supply and demand-side business cycle shocks. As Porter briefly mentioned, such widening inequality has implications which go beyond economic stability. It threatens political stability and forces democratic governments down the slippery slope of political populism.

I am inclined to believe that the rapid explosion of competitive populism in India in recent years is in no small measure due to the rapid rise in income inequality and the perceived need for governments to placate increasingly alienated and disgruntled voters who have come to believe that they are being short-changed in the sharing of benefits of liberalization and globalization. As the inequality gap widens further, the propensity for competitive populism will only increase.

This creates a policy gridlock, a low-level equilibrium, from where governments find it difficult, fiscally constrained, to meaningfully address the critical issues that determine sustainable economic growth. Among other things, it contributes to the stifling of reforms and the weakening of governance.