India's growth dilemma in a graphic

I am labouring this point. Cities are already India's economic growth engine. In the years ahead, they are estimated to contribute 70% each of the national economic growth and all new jobs created. But rural India, where 65% of the population lives, takes up the major share of public spending and administrative energies. The graphic below summarizes India's public policy priorities.



This skewedness may be guilty of killing the goose that lays the golden eggs. India needs to grow near the double digit rate so that its tax revenues and new jobs created grow fast enough to meet the massive and growing demand. Higher tax revenues would provide governments with the necessary resources to expand public investments, both in rural and urban areas. Faster pace of job creation would provide adequate opportunities to accommodate the rapid additions to the workforce. It would ensure that the danger of our demographic dividend turning sour is averted. And, as I have blogged earlier, transfers are a function of tax revenues. Higher the tax revenues, more the resources available to reduce poverty and mitigate any rise in inequality through effective redistribution policies.

Unfortunately, both state and district-level public policy and public spending (investments and welfare spending) are disproportionately focussed on rural India. Much more needs to be done for rural development. But a more effective strategy to achieve that objective would be to strengthen the urban growth and job creation engine and then utilize the resultant growth in tax revenues to promote effective rural development.

Counter-cyclical Fed communication strategy

When the history of central banking is written, historians will surely devote a substantial part of the book to the aftermath of the bursting of the sub-prime mortgage bubble. As financial markets veered at the edge of precipice and the Great Recession took hold, and fiscally constrained and politically paralyzed governments largely abdicated the policy making space, central banks were left with the onerous task of stabilizing financial markets and restoring economic growth.

Central banks, led by the American Federal Reserve and the Bank of England, have deployed a wide range of monetary policy tools to stabilize markets and boost aggregate demand. These unconventional monetary easing approaches like quantitative easing policies have contributed to a dramatic ballooning of the balance sheets of central banks across the developed world.

In keeping with such changes, central banks have also sought to make more effective use of their communication strategies to anchor market expectations. One of the most important instruments of central bank communication has been the publicly announced commitment to keep interest rates low for extended periods of time. The Federal Reserve in the US had very early in the crisis announced its commitment to keep interest rates low for "and extended period of time". Subsequently, it went further in providing greater clarity to this phrase by announcing in August that it planned to keep rates near the zero bound till atleast the summer of 2013. The objective is to firm expectations among various market participants and reduce uncertainties about consumption and investment decisions.

Now, the NYT reports that the Fed is planning to make publication of interest rate forecasts a permanent feature of its monetary policy communication strategy. The Times writes,

"Forecasting policy is part of a broader set of changes that the Fed is considering to improve public understanding of its methods and goals. The Fed’s chairman, Ben S. Bernanke, and other officials say that improved communications could deliver a modest boost to the economy with relatively little risk. None of their other options for additional action are nearly so appealing...

Such a forecast likely would cover the expected path of policy over the next three years, including information about the range of predictions. The Fed already publishes similar predictions about economic growth, inflation and unemployment four times a year."

While the attempt to shape longer-term expectations to revive the "animal spirits" is understandable during such recessionary times, there will be questions raised about the wisdom of such upfront commitment during upturns in the business cycle. For example, during an economic recovery when financial markets are booming and inflationary pressures are rising, such upfront commitment to keep interest rates low would, instead of leaning against the wind, be amplifying the market exuberance. It would run contrary to the conventional wisdom on central banking - "take the punch bowl away when the party gets going".

Such upfront commitment could also restrict the central banks' freedom to manoeuvre. Economic headwinds can change unexpectedly. A commitment to follow a particular policy stance would limit the central bank's ability to change track in response to emergent trends. Any such abrupt deviation from its pre-announced policy stance would erode the credibility of future announcements by the central bank.

In other words, while anchoring expectations by announcing a commitment to maintaining interest rates during recessionary and uncertain times may be desirable, it may not be wise to institutionalize such medium to long-term commitments into the monetary policy framework of central banks.

Stylized Facts on Indian Economy

Arvind Subramanian and Utsav Kumar have certain stylized facts about recent economic growth trends in the Indian economy.

1. Putting to rest the debates and concerns about economic growth in an open and liberalized economy, economic growth was faster in the 2000s than the 1990s in most states. Rajasthan, West Bengal, and Himachal Pradesh were the only laggards. The growth rates in many of other states more than doubled in the 2000s.



Conversely, this also meant that these state economies were more exposed to the global economic factors. Therefore when the world economic slowdown struck, the faster growing and more globalized states were more adversely affected.

2. One of the common features of economic growth is that as economies liberalize and growth picks up, a trend towards covergence takes hold. The poorer states, by virtue of growing faster than the richer states, start catching up with the latter’s level of income. This convergence is also critical towards promoting a consensus on liberalization and reforms and also sustaining the high growth rates.

Unfortunately, a regression of the average annual growth rates across all states and initial percapita income of 2001 reveals little convergence. In fact, it shows that richer states on average grew faster so that the inequality across states is actually increasing. This relationship holds for different time periods and different state sample sizes. It should sound a note of caution for policy makers that the robust growth in the traditional laggard states in the last decade is not enough to promote the much-needed convergence.



3. The biggest concern is the possibility that one of India's greatest strength, its young workforce (demographic dividend), could also turn out to be its biggest problem. In the last decade of 20th century, this beneficial impact of this favorable demographics was favorable in the economic growth trends as seen from the graphic below.



However, the picture appears to have reversed in the first decade of the new millennium. Economic growth has been found inversely correlated with the working age population growth rates among the various Indian states.



The biggest concern states in this regard are Rajasthan, Bihar, UP, Assam, and Madhya Pradesh where the demographic dividend is in serious danger of turning sour. In many respects, this reversal of trend over the last decade is one of the biggest challenges facing India. Unfortunately, the policy paralysis of recent years means that it is in serious danger of being overlooked.

Lessons from the German Health Insurance Model

Uwe Reinhardt has an excellent summary of the oldest national health insurance system in the world. Germany has a statutory, mandatory, community rated health insurance system which provides a prescribed basic package of benefits to nearly 88% of population through 154 private, non-profit, sickness funds. In addition there are 46 private health insurers operated on commercial principles which provide comprehensive coverage to the remaining 11% of the population (including civil servants) and also top-up supplementary coverage, if demanded, to those on statutory insurance.

Employees and pensioners pay 8.2% of their gross wages/pensions, while employers/pension funds must contribute 7.3%, for a total contribution of 15.5% of gross wages/pensions upto a maximum wage of (or pension) of 44,550 euros. Unemployed people pay premiums in proportion to their unemployment compensation, and for the long-term unemployed the government pays the sickness fund a fixed per-capita payment. The coverage is for the entire family. Insurance is tax-financed for children. Employees/pensioners earning above 49,500 euros (in 2011) are free to opt out of the statutory system and purchase private, commercial coverage, but if they do, they cannot ever return to the statutory system unless they are paupers.



In order to equalize actuarial risk among the competing sickness funds, all premium payments go into a national risk-equalization fund, from where a capitation (that is risk-adjusted for the employee/pensioner and dependents) is paid out to chosen sickness fund of the employee/pensioner. Recent federal legislation has forced private insurers to levy on younger people higher premiums than their actuarial risk can justify to build up an old-age reserve, thus preventing premiums from climbing too rapidly with age.

In countries like India, where health insurance market is in its nascent stages and state and central governments have been experimenting with various models, the German model is instructive. The most important attraction of the German model is its offering of community-rated universal coverage for a basic prescribed package of benefits. This arrangement minimizes actuarial risks and keeps down both premiums for the insured and administration costs for the insurers.

Currently in India a number of states and the Union Government are rolling out independent insurance schemes, each for different categories of citizens within the same geographic area. Such fragmented schemes, by concentrating risks, run contrary to the principles of optimal risk management and increases the costs for all sides. Since most of those covered in such schemes are subsidized, the governments end up paying the higher premiums. Insurers hedge for both the higher risk and the actuarial uncertainties associated with such specific and concentrated risk pools by demanding higher premiums.

An ideal system would be for the Government of India to bring together all state governments on board in a national health insurance scheme which is universal for a basic package of benefits. The scheme should be community rated and opened to all insurers, public and private. An Aadhaar-complaint database can be maintained to administer this scheme and subsidize premiums for certain categories of citizens. All citizens should be mandatorily covered under the scheme, and those requiring additional coverage be permitted to buy supplementary insurance (additional benefits) from the market.

See this excellent comparison of health insurance systems from fourteen countries.

Update 1 (9/3/2012)

Conservatives in the US have for long advocated consumer-driven health plans (CDHPs) which combine high-deductible health plans (HDHPs) with Health Savings Accounts (HSA). The HDHP's have low premiums, out-of-pocket payment caps, no co-payments, but high deductibles. The consumer desposits a fixed amount each year into the HSA, which is tax-deductible and gets carried forward, and which can be used for regular out-patient medical expenses and for payment of deductibles.

It is argued that since consumers make the payments (of deductibles and other regular medical expenditures) directly and are therefore responsible for their health care purchase decisions, they are more likely to optimize on their treatment options. In regular health insurance models, the consumer is completely divorced from the payment decisions, thereby generating several incentive distortions.

Critics see this as part of efforts to introduce more private participation into health insurance and make consumers responsible for their health care plans. They also see this, along with the Republican supported plans to replace Medicare with vouchers that can be used to purchase health insurance plans from private insurers. The rising health care costs, asymmetric information problems in health care, and the lack of expertise in consumers to shop for the best possible insurance alternative, and so on make such consumer-choice plans inefficient and burdensome for consumers. See Paul Krugman's critique here.

See this Youtube video on CDHPs. See this excellent paper comparing helth insurance systems from across the world. See this account of the Swiss health insurance model.

The sources of European sovereign debt crisis

The graphic below which highlights the sources of public debt in Europe since 2007 for Germany, Italy, France, and the UK offers several insights.



1. Stagnant or declining economy is understandably a large source of growth in the debt-to-GDP burden. As I have blogged earlier, this is true of America's current deficit. The graphic shows the same of France, and in particular UK. UK, which has had the largest austerity drive, has also had the largest increase in debt-to-GDP ratio. Conversely Germany's robust growth has kept its deficit from being higher than it would have been without.

2. As the debt burden crosses the unsustainable mark, two effects are likely to kick in. One, the absolute value of debt repayment increases. Two, the cost (interest rate) of debt service (rescheduling and raising new debt) rises and this feeds into the first. Italy, with its 120% of GDP debt stock and bond yields which touched 7%, is clearly the example of this.

3. As Matt Yglesias writes, the graphic also shows that Italy's major problem is a liquidity crisis which threatens to drive the country insolvent. It even has a primary surplus and its debt problems are a direct result of exploding debt service costs. The graphic also highlights how all the other standard factors driving up debt are absent. With the ECB refusing to act as a lender of last resort, Italy is facing a "national-level bank run"!

4. As Brad Plumer writes, Germany has had the largest fiscal stimulus and spend the most bailing out banks. The result has been financial stability and growth, though both are now threatened by a pan-European contagion from the PIIGS.

Inequality and the "Big Sort"

Peter Orszag has a scholarly op-ed in Bloomberg where he points to the pernicious consequences of widening inequality,

"To a stunning degree, Americans are increasingly moving into neighborhoods with other people who have similar incomes and share their political views. Bill Bishop and Robert Cushing... and others have documented the way Americans increasingly live near people with similar political views. This residential sorting by political party has occurred despite an ongoing overall decline in housing mobility."

He points to a new study by Sean Reardon and Kendra Bischoff who find that Americans are increasingly choosing to live near people in their own income bracket. They find that whereas almost two-thirds of American families lived in middle-income neighborhoods in 1970, it declined to just 44% by 2007. Further, the share of those living in a poor neighborhood, in the same period, more than doubled, from 8% to 17%, and those living in an affluent neighborhood rose from 7% to 14%. Another study by Tara Watson concluded that trends in income inequality can fully explain recent increases in economic segregation.

More worryingly, these trends are also impacting voting patterns. Orszag points to Andrew Gelman who has shown how "within any given state, higher-income people are much more likely to vote Republican". Orszag writes,

Gelman finds that although, in any state, higher- income people are more likely to be Republican, the link between income and party affiliation in blue states is less dramatic than it is in red ones. In other words, as you move up the income scale in a Democratic state, the proportion of Republicans rises, but not as much as it does in a Republican state. That higher-income people in red states are so much more likely to vote Republican helps explain the blue state-red state conundrum. My personal experience is consistent with this: It is rare to meet a high-income Democrat in a red state.

His conclusion is instructive,

Residential segregation by income has been increasing markedly, and since income is strongly related to voting patterns, this phenomenon may help explain the rise in residential segregation by political party. As we surround ourselves with people like us, we reinforce our own views, and the result is a more polarized population.

Doubling per capita incomes

This graphic in The Economist highlights how average incomes in developing economies are growing more quickly than at any previous time in history.