The dangers of more monetary accommodation

Over the past few days, monetary authorities on both sides of the Atlantic have announced further extraordinary monetary accommodation policies. 

In Europe, the ECB finally bowed to pressure and announced  an ambitious program, dubbed "outright monetary transactions”, to purchase an unlimited amount of eurozone sovereign debt with maturities of between one and three years. The ECB's bond buying program, though conditional on governments signing up to a European Financial Stability Facility or European Stability Mechanism programme for fiscal and structural reforms, comes despite strong opposition by the German Bundesbank. Further, the ECB would not be treated as a preferred creditor in the event of default, thereby signalling to investors that the ECB purchases will not subordinate their own holdings of peripheral country bonds. This is part of ECB's determined effort to do "whatever it takes" to save the Euro. 

In the United States, spurred into action by the persistent dismal unemployment figures, the Federal Reserve announced its third round of quantitative easing program, QE3. It has decided to inject an extra $40bn into the economy each month through purchases of mortgage-backed securities for an unlimited time till the labour market improves. The FOMC reported, 

The Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative... the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

As the FT reports, this marks a significant strategic shift in the Fed's policy stance. It has now, for the first time tied policy to developments in the economy – and promised not to shift policy until it succeeds.

For the record, the QE1 in 2008-09 involved purchases of $600 bn in mortgage backed securities and agency debt, $1.25 trillion of agency MBS, $200 bn in agency debt, and $300 bn in Treasuries.  The QE 2, from November 2010 to July 2011, involved purchases of $600 bn in similar securities. The most recent Operation Twist in September 2011 involved a swap of $400 bn of Treasuries to achieve maturity transformation and lower long-term rates.

The underlying premise behind both these actions in the US and Europe is the belief that liquidity injections will somehow help address the underlying problems and help the respective economies back on recovery path. In other words, this view sees the current problems as mainly liquidity problems, which can be tided over by an extended period of monetary accommodation.  

Unfortunately, this view may be deceptively misleading and could lead us down the path of even more pain. The best that can be said in favor of this policy is that monetary accommodation will help buy the time required to address the fundamental structural and fiscal problems. Though extraordinary monetary accommodation has been going on for nearly 5 years now, governments have done precious little to address the fundamental problems in the real economy. Nor is any inclination on their part to do anything different. And all along, things may have steadily gotten worse.

Europe's problems, certainly that of Greece, cannot be addressed by merely buying time and hoping that the denominator in the debt-to-GDP calculus improves with time. Fiscal austerity has already deepened it to a level from where all the possible options may have been shut off. In case of the US, while financial institutions' balance sheets have been repaired, very little has been done to address the balance sheet problems of the households. Further, no amount of central bank aggression will address the real problem of persistent unemployment rate and output gap, as well as the longer term debt problem arising from health insurance expenditures.  

And associated with any cheap money policy is the resource mis-allocation dangers, both domestically and globally.  Ruchir Sharma summed it up nicely,

The Fed can print all the money it wants - but it cannot dictate where it will go. The frst two rounds of quantitative easing fuelled a commodity bubble, increased income inequality and set a bad example for the rest of the world. During the 16 months of round one, up to March 2010, the CRB commodity price index rose 36 per cent, while food prices rose 20 per cent and oil prices surged 59 per cent. During round two, in the eight months up to June last year, the CRB rose 10%, with food up 15%, while oil prices rose a further 30%... Now, there is a tight link between stocks and commodities, with prices rising and falling in lockstep. This link neuters monetary policy makers, because rising commodity prices negate the stimulative impact of looser credit... a third round of quantitative easing... could be more counterproductive than the first two, since oil and food prices are now dangerously close to levels that have acted as a tipping poing for the global economy in the past.

Financial market distortions caused the sub-prime crisis and if conditions of extended accommodation persist for too long another bubble may get inflated somewhere in the wide markets. More worryingly for the developing countries, in a world awash with liquidity in search for returns, their economies offer attractions for speculators looking for quick bucks. This is all the more so given the diminishing investment options in the developed economies. Such capital flows, as we already know from several recent experiences, can have damaging consequences. In the circumstances, from the perspective of developing economies, is some form of capital controls desirable?

Climate change and traffic congestion

What's common between addressing climate change and traffic congestion? Disincentivizing private vehicle usage will help mitigate carbon emissions and control traffic congestion. As the graphic below shows, transportation is a large contributor to global carbon emissions.

Happily for environmentalists, the sheer immediacy of the problem of traffic congestion, makes it an issue demanding urgent attention for policy makers. In simple terms, climate change advocates stand a greater chance of succeeding in their fight against carbon emissions by joining hands with urban transport managers in addressing traffic congestion.

Any effort to reduce carbon emissions has to involve aggressive action by US, China, and India. Given the magnitude of the problem - deteriorating traffic and air quality - it is therefore unsurprising that in recent weeks all three have initiated policies aimed at restricting vehicle usage and/or reducing the carbon footprint from vehicular emissions.

Following Shanghai and Beijing, Guangzhou, the third largest Chinese city, has embraced license plate auctions and lotteries to restrict the growth of vehicles. It is estimated to halve the number of new vehicles entering the market. Even the usually lethargic Indian government has been spurred into action and is contemplating urban transport tax to discourage vehicle ownership and congestion pricing to disincentivize vehicle use. In the US, President Obama recently announced stricter energy efficiency standards which are expected to nearly double the average fuel economy of cars and light trucks to about 54.5 miles a gallon by 2025.

However, as the Times points out in a recent article, a more effective way to address this challenge may be by simply taxing carbon fuels. This blog has consistently argued in favor of carbon tax as the preferred strategy to achieve carbon abatement, based on considerations of both economic efficiency and practical implementation challenges. This graphic from the Times article highlights the potential gains from a carbon tax in the US.

Nevertheless, as this McKinsey report shows, improvements in emission standards is one of the cheapest carbon abatement options.

But with the issue of discouraging vehicle use, we need to realize that we can make a meaningful dent only by simultaneously deploying all the three policy options available - making vehicle ownership costly (vehicle tax, license plate auctions etc), internalizing the social costs of vehicle usage (carbon tax, congestion pricing, high parking fees etc), and encouraging the use of public transport. In countries like the US, among these options, carbon tax, despite its certain political opposition, is likely to be the least distortionary and most effective way to address both traffic congestion and climate change.

The dismal economic landscape on both sides of the Atlantic

The FT has a nice graphic of output gap that captures the dismal economic situation on both sides of the Atlantic.

The coming Wednesday is important on many counts. The German constitutional court will determine whether it is right for German public funds to be contributed to the European Stability Mechanism, which underpins the ECB's recently announced short-term unlimited government bond buying program. The Bundesbank has already criticized the move "as being tantamount to financing governments by printing banknotes". The same day, voters in Netherlands could give a signal of their commitment to stay on or leave Europe in the country's national polls. Finally, in light of Chairman Bernanke's pessimistic comments on the US economic prospects, the Fed will decide on whether or not to go ahead with another round of quantitative easing.

"Spectrumgate" Vs "Coalgate"

Corruption in the allotment of coal mine blocks is the latest in India's season of auditor-exposed scams. The Times of India reports that Jindal Power Limited (JPL), a subsidiary of Jindal Steel and Power Limited (JSPL), owned by a Congress MP, benefited by way of accessing captive coal mine block for its 1000 MW merchant power project in Chhattisgarh's Raigarh district. 

The project which turned fully operational in 2008 and is the first merchant power plant in the country (which can sell power at spot rates to any buyer, instead of being bound by tariffs fixed through long-term power purchase agreements) got coal at a concessional rate. The report writes,

Over the next year, it sold power at an average price of more than Rs 6 per unit. By 2010, the high returns had not only covered its running costs but also investments of Rs 4,338 crore. According to infrastructure experts, it takes a minimum of 5-7 years to repay debt incurred for capital investment in power projects... Jindal Power has become debt-free within two years of operation due to strong cash flows on account of low cost. A big component of the low cost was cheap coal obtained from its captive coal mine just 10km away — Gare Palma IV/2 and IV/3 with combined reserves of 246 million tonnes of coal...

The Jindal Group is the largest beneficiary of coal block allocations. It has reserves of 2,580 million tonnes of coal, while the second largest beneficiary in the private sector has just 1,500 million tonnes...  The problem is not that the company got access to massive reserves of coal. The issue is that it uses cheap coal to sell power at prices much higher than the others... documents show that JPL sold 22 million units of power last October for a price as high as Rs 5.47 per unit.

The Times's comparative analysis of three power projects in north Chhattisgarh — Sipat project of NTPC, Amarkantak project of Lanco group, and JPL's Raigarh project - which came into existence around the same time makes for compelling reading. The difference in coal prices could not have been starker, 

Lanco Amarkantak and NTPC Sipat buy coal from South Eastern Coalfields, a subsidiary of Coal India. JPL mines its own coal. NTPC's average fuel cost last year came to Rs 1,200 per tonne while Lanco's cost worked out to an average of Rs 1,020 per tonne. Jindal officials refused to share the company's coal cost figures. But sources in Chhattisgarh's mining industry said JPL's cost could not exceed Rs 300-400 per tonne as it extracts coal from an open cast mine for which it had bought land at low prices. Taking an even broader estimate of Rs 500 per tonne of coal, based on Coal India's current margins, would still leave JPL with half the coal cost of its competitors...

Jindal sold power at the highest prices — Rs 3.85 per unit in 2011-2012, compared to Lanco's Rs 3.67 and NTPC's Rs 2.20. The previous year, JPL had sold power at an even higher rate of Rs 4.30 per unit. The combination of cheap coal and high power prices explains why Jindal posted Rs 1,765 crore as profits, or 60% of its income, while Lanco made a profit of just Rs 155 crore, just 12% of its income. 

Now, if the figures in the ToI report are correct, this is a classic example of private gain at public cost. It is also here that the parallels with the other major scandal of our times, telecommunications spectrum allotment, ends. In case of telecoms, a significant share of the gains from discretionary low cost acquisition of the spectrum was passed on to the consumers in the form of high quality services delivered at very low cost. In other words, the rent-seeking involved in the spectrum allotments generated certain positive externalities. The competitive pressures created subsequent to the allotment process, by design or otherwise, contained incentive compatibilities that forced the companies to share their excessive gains.

However, in case of the mining blocks, despite its fundamental similarity with telecom spectrum, the winners have sought to corner all their disproportionate gains. They have, as the Jindals have done, sought to take advantage of the market structure (the freedom to sell the power so produced on a merchant power route). Or, as most others have done, they have sought to keep the allotted blocks undeveloped, assured by the belief that they were sitting on potential gold mines. In fact, it is a damning indictment of the whole policy framework that barring a few, most of the mines have been allowed to keep them undeveloped despite being allotted at extremely concessional rates.

In other words, unlike the telecom spectrum, where market competition and a policy framework kept the spectrum owners honest and thereby forced them to share the benefits arising from low capital costs, the coal block owners were not constrained by any policy framework.

Update 1 (12/9/2012)

Between June 2004 and 31 March 2011, the coal ministry allocated 194 coal blocks on a nomination basis to various firms for captive use. Mint unpacks more skeletons,

Between 1996 and 2009, JSPL and its unit JPL were allotted nine coal fields in the mineral-rich states of Orissa, Chhattisgarh, Madhya Pradesh and Jharkhand, translating into reserves of 2.59 billion tonnes, or 5.97% of the 43.35 billion tonnes doled out by the Centre... The coal blocks allocated to JSPL on its own and as part of a partnership were Gare Palma IV/1 (1996), Gare Palma IV/2 (1998), Gare Palma IV/3 (1998), Gare Palma IV/6 (2006) in Chhattisgarh, Utkal B-I (2003), Ramchandi Promotional (2009), Urtan North (2009) in Orissa, and Jitpur (2007) and Amarkonda Murgadangal (2008) in Jharkhand.

The mis-directed debate on Aid

Whether external aid is effective or not is arguably one of the most controversial topics of debate. Critics point to the several examples of corrupt and under-developed aid recipient countries, especially in Africa, and argue that aid programs have been ineffective. Some go further and argue that aid has positively damaged governance systems in these countries by, among other things, increasing rent-seeking opportunities and thereby increasing corruption and promoting governance failures.

I am inclined to believe that the critics of aid miss the point on the following counts

1. Failures in aid utilization are no different from the inefficiencies (and wastage and corruption) that characterize the regular public programs in these countries. An appropriate comparison would be the relative performances (in terms of achievement of outcomes) of similar programs in a sector in different parts of a country (after controlling for the regional differences) run with aid and domestic finances. My feeling is that the externally funded program, despite all its failures, would have been more effective than the domestic program.

There cannot be any absolute touchstone for measuring the effectiveness of aid utilization. Its effectiveness has to be seen in light of the general governance standards of the recipient country.

2. It may not be appropriate to paint all aid with the same brush. There exist wide variations across countries and programs/sectors. A more helpful and serious criticism would be to identify areas or regions/countries where aid may not be having the desired effect and similarly where they are successful. In countries like India, which have received huge amounts of aid, there is little to show that aid money has been less efficiently spent than the domestic government funds nor has it failed to achieve substantial (albeit less than would have been originally hoped) gains. 

3. Considering that aid is an external cashflow aimed at supplementing the local government finances, it is no different from any other sudden one-time domestically generated cashflow. Extending the logic that aid corrupts polities, one could as well argue that these countries should be denied access to any lumpy finances. The same logic underlies the "resource curse" faced by countries with huge natural resource reserves. Again extending the logic, we would have to argue that since the resource stocks are harmful to that country (by corrupting its polity), it should be deprived off those resources.

Apart from these there are several other more commonly argued responses in support of aid. If we are to make an meaningful dent in addressing the issue of effective aid utilization, it may be more appropriate to focus on identifying areas and sub-sectors where the marginal returns from such funds can be very high. Most of the aid falls into a general routine pattern across the world, flowing into health, education, and livelihood creation. Such programs, however well-crafted, are likely to get subverted as it winds its way through the domestic bureaucratic systems.

In conclusion, I am inclined to believe that the rightful indignation at the perceived shortcomings of aid programs is rooted in its obvious failure to achieve the desired objectives. But the moot point is whether the objectives were themselves too unrealistic, given the governance standards in the recipient countries. 

Unintended consequences of financial repression

In the context of China's still inflating property bubble, Yichuan Wang has an interesting post where he attributes the housing boom to an absence of alternative investment opportunities. He writes that housing has become a "savings vehicle" for ordinary Chinese citizens,

Chinese citizens face a severe shortage of effective ways to save money or preserve value. Bank deposit rates consistently run below the rate of inflation. When better investment opportunities come along, those deposit rates don't necessarily rise. There are securities companies, but it's very difficult for the people to trust them... The stock market is seen as a capricious creature...

Housing is special because it is much more concrete than other investments. It depreciates relatively slowly and is easy to verify; this is unlike many other investment opportunities such as equities or securities. It is useful, because you can immediately start to live in it or rent it out. Also, because of rising incomes across China, it seems very reasonable that demand for housing will increase and therefore building a house will have a high return.

In other words, China's financial market repression - artificially low interest rates, capital controls, strongly regulated capital markets etc - has been fueling the residential property bubble. He sees this as a constrained revealed preference,

Large scale housing investment is not necessarily a neutral “revealed preference”. Rather it can be a dangerous “constrained preference”. Given the option between negative real rates in a bank account or housing, Chinese citizens choose housing. But if they had the option of higher deposit rates, we might have seen a shift away from housing towards regular bank deposits. This is very similar to the problem developmental economists face when discussing whether people in poor countries have too many children. While parents might prefer to take care of fewer children, they choose to have more children so that enough of them survive to take care of their elderly parents. So similarly, poor people choose to have a lot of children given their constraints, but with enough financial innovation they would consider having fewer children.

In fact, I am inclined to argue that this preference for housing investment as a savings vehicle may be also contributing to keeping savings very high and consumption suppressed. The large amounts required to buy housing, as opposed to other smaller but diversified investment alternatives, increases the need to save more. The rising property values exacerbates this trend. And this in turn is keeping consumption heavily constrained. This is one more reason for Beijing to start addressing the underlying causes for the disproportionately large propensity among households to save. See this and this for an analysis of the underlying reasons.

In this context, it is tempting to draw parallels with Indian households' attraction to investment in gold. In the absence of adequate, easily accessible, low-risk, and liquid enough investment opportunities, they find gold a very good investment opportunity. In terms of gold imports adding to the country's unsustainable current account deficit and the gold stocks locking up a significant share of savings, its dead-weight loss and larger economic cost is clearly bad for the economy. The financial market uncertainty in the aftermath of the sub-prime crisis and the surge in gold prices has only amplified the resource mis-allocation problem.

A recent report by Macquarie (via FT) found that India's net gold imports worth $23 bn (1.3% of GDP) in 2011-12 was almost half of its $44bn current account deficit. It wrote,

Our estimates suggest that net gold imports alone have contributed nearly 40bps to the 130bps widening in India’s current account deficit between FY08 and FY11 (from 1.3% to 2.6% of GDP).

Both these examples of resource mis-allocation which are directly related to financial market repression is a reminder about its adverse consequences on the national economy. 

Time to do away with hourly billing

The persistence of hourly billing in many knowledge-based service professions comes across as an anachronism in this age of outcome-focused work ethics. Many of the leading consultancies and professional service providers, who lose no opportunity to drive home the critical importance of outcome-focus to their clients, bill them in terms of the man-hours of work done.

The idea of hourly billing has its roots in the manufacturing shop floor. Here the highly specialized work output was clearly defined (or definable), with each employee being expected to deliver a certain work output each hour for a specified number of hours each day. It was also important to quantify this given the widely prevalent practice of over-time work done by factory workers.

However, in modern knowledge based sectors, where team-work and individual effort are equally important and their interaction affects the quality of their output, hourly billing has the potential to severely distort incentives. The absence of clearly defined work output and time schedule for each individual worker only amplifies this risk. Primarily, hourly billing ends up distorting incentives and encouraging the employee or hired worker to bill excessively.

For example, in software and consulting, it incentivizes professionals to shift work (otherwise doable during regular office hours) to off-time hours (such as weekends), so that they can claim the much higher hourly rates during such times. Similarly, the leading management consultants bill exorbitant rates for the hours devoted by their top executives. But the terms of reference of this time is only defined very vaguely and often generates limited marginal value addition. Such pricing enables these firms to justify the huge rates they charge their clients.

The time may have come to debate the need to junk hourly billing and embrace the more efficient outcomes-based billing route in all knowledge-based sector labor markets.