More on the secular stagnation debate

The main argument in favor of the extended period of extraordinary monetary accommodation has been that it would provide the space for balance sheets to heal and the economy to get back to pre-crisis growth trajectory. Now, what if a return to the pre-crisis growth path may no longer be possible, for whatever reasons?

Economists like Robert Gordon have for some time now been cautioning about a productivity growth slow-down. Tyler Cowen had popularized this trend in his book "Average is Over", claiming that all the low-hanging fruits of recent technology revolutions have been plucked and actual productivity enhancing innovation has reached a plateau. Larry Summers has sought to provide a theoretical framework to the underlying trends by resuscitating Hyman Minsky's 'secular stagnation' hypothesis. Essentially, declining investment demand, induced by a variety of long-term structural factors, have forced down the Wicksellian natural interest rate to historic low levels, with limited prospects of a recovery for the foreseeable future. 

The supporters of unconventional monetary policy responses, led by Paul Krugman, have argued that such policies will not only help repair distressed household and corporate balance sheets, but also stoke the inflationary expectations required to restore consumption and an exit from the liquidity trap. They have claimed that central bankers could "credibly promise to be irresponsible" and unhinge inflationary expectations. While they also support fiscal policy measures, all those are made conditional on the persistence of monetary accommodation.

In this context, a recent dialogue between Larry Summers and Paul Krugman is instructive. Krugman, one of cheer-leaders of ever more monetary accommodation, assumes a return to pre-crisis growth path. But Summers describes the belief in pre-crisis recovery taking hold as a 'deus ex machina' event, and writes,

The essence of the secular stagnation and hysteresis ideas that I have been pushing is that there is no assurance that capitalist economies, when plunged into downturn, will, over any interval, revert to what had been normal. Understanding this phenomenon and responding to it seems the central challenge for macroeconomics in this era... I suspect it will lead to more emphasis on fiscal rather than monetary actions in depressed economies.

Krugman has grudgingly accepted the possibility that a return to pre-crisis normalcy may not be possible, thereby making policy response that much harder. If we agree to Summers' point that pre-crisis growth may not be a possibility, then low interest rates are here to stay, thereby making government borrowings, especially to finance much-needed investments in infrastructure in the US less of a problem. But the flip side of this argument is that this too may have limited traction as a growth driver and may end up down a slippery slope, as Japan is today. While the US does not face as bad a demographic headwind, Japan's struggles with the use of fiscal expansion in triggering growth draws attention to the limitations of fiscal policy itself in such circumstances. 

In any case, all this would also mean that the US has followed Japan and, possibly, Europe, into a long period of low growth rates, with attendant drag on the emerging markets and the world economy itself. 

The challenge with early restructuring of debts

Indebtedness and deleveraging have been an important global economic concern in recent years. Several Eurozone countries, none more than Greece, suffer from massive debt burdens. The Chinese economy is struggling on the back of heavily indebted corporates and local governments. Closer home in India, the fate of "House of Debt" companies are just a more high-profile reflection of broader corporate indebtedness. In all three cases, creditors, primarily banks, are the obvious counterparties suffering the losses. 

There is little prospect of any satisfactory denouement to this problem. Worse still, the policies being followed do not appear to be doing much good. Currently, in all these cases and more, the strategy has been to reschedule loans in the hope that with time recovery will take hold and deleveraging will happen through growth. This assumes that the debt troubles are essentially a liquidity problem - either firms have illiquid assets or the asset revenue streams are further in time - and not one of solvency. 

But what if the latter were true? What if a large proportion of the underlying assets have negative values and the debts cannot be serviced under any circumstances? This assumes significance since it is now widely accepted that the Greek debt burden is just unsustainable and increasingly evident that the same is the case with Chinese local governments and many large infrastructure projects in India. In this case, rescheduling would not only be kicking the can down the road but also increasing the final tally of losses - interest, cost escalation, partial default provisioning etc. In the circumstance, the best approach would be to strip shareholders and have creditors take haircuts. 

Economists have accordingly advocated that the Eurozone debts should have been restructured with haircuts and forgiveness. In fact, economists like Ken Rogoff argue that the Great Recession should have been countered with not just quantitative easing but more importantly, policies that nudged governments into buying back risky debts and lenders into writing-off some part of their loans. The conventional wisdom is that this is an ideological battle between those advocating the wait-and-watch and restructuring strategies. 

Maybe, but for the political decision makers, there is another important consideration. Governments would find it difficult to offer taxpayer's money to bailout bad investments and their respective promoters, investors and lenders. The lurking feeling would be that these reckless and greedy stakeholders are being bailed out. Also baked into this dynamic is the moral hazard associated with bailing out bad investments. 

A bailout becomes possible only when the costs of the stand-off become egregiously damaging to the economy. A settlement, with losses imposed on the stakeholders, then becomes politically less unacceptable. 

Accordingly, though many of the stressed projects are insolvent and cannot be revived without haircuts and contract renegotiations (extend tenure or raise tariff or viability gap funding), it is unlikely to happen till something definitive happens. This includes the developer defaulting completely or going bankrupt, or creditors offering haircuts, or the cumulative drag of all the projects on the sector becomes unbearable. Till then, the promoters and creditors invariably hold out, in the expectation that things will improve or the government will blink. 

Not only would the total cost of a final settlement be much higher, the private benefits from the bailout would outweigh the private costs due to the delay for all the private stakeholders. Coupled with the taxpayer-financed bailout, everyone is left worse off,  similar to a game of Prisoner's dilemma with its inevitably sub-optimal outcome. This is the insurmountable transactional challenge with political and social bargaining in any such situations. 

More on conflicts of interest in investment banking

Interesting article in the FT on how Goldman Sachs is courting Silicon Valley unicorns in the hope of winning transactions advisory business (on future IPOs etc). It also exposes certain underlying conflicts of interest and interpretation of existing rules like the Volcker Rule, the thin line that investment banks like Goldman have navigated with much success, 

As fast-growing tech companies such as Uber and Airbnb stay in private ownership for longer, bankers must come up with more ways to ingratiate themselves in advance of a public stock offering... A case in point is a $1.6bn private debt raising that Goldman ran for Uber earlier this year, giving its private clients access to equity in Uber in advance of an IPO. They paid a 4 per cent fee for debt that converts to equity at an 18 per cent discount to the IPO price, if the IPO occurs within one year. The discount grows more generous with time, rising to 30.5 per cent if the IPO happens after three and a half years.

Goldman has also been investing small amounts of its own money in tech start-ups, and it is a small shareholder in Uber after participating in the company’s 2011 fundraising. The bank has made about 50 investments in start-ups so far this year, or double the number it made during the same period in 2012... Goldman says its activities are compliant with the Volcker rule, which curbed proprietary trading and placed limits on banks’ investments in in-house private equity and hedge funds. Under the rule, banks were allowed to continue using their own money to buy stock in private companies, so long as they planned to hold the investments for more than 60 days.

Two things stand out. One, the pricing of such issuances give Goldman ample flexibility to curry favor with their unicorn clients at the cost of its investors. And we know that Goldman is not averse to doing so. During the sub-prime mortgage boom, it sold the infamous Abacus 2007-AC1 synthetic collateralized debt obligations of mortgages to its investors even while using its proprietary capital to bet against the same mortgages. And the favors can cut in the other direction, benefiting preferred institutional investors and high net worth investors, as ZipCar and LinkedIn found out during their IPOs. Second, the concern about proprietary trading, which was sought to be curtailed by the Volcker Rule, also underlines the limitations of prescriptive rules in regulating such trades. 

Such conflicts of interest are likely to deepen in the years ahead as Goldman's (and others) traditional cash driver, fixed income sales and trading, looks set to decline on the face of the bottomed-out bond yields, and financial advisory (advising companies on mergers and acquisitions and fundraising) becomes an increasingly important contributor to revenues.

Weekend reading links

1. Polio is the new cross-border threat for India from Pakistan,

Experts warn that neighboring India, which succeeded in shedding its label as a polio-endemic nation three years ago, could face serious cross-border infection.

As immunization efforts flounder in Taliban-controlled northwest regions, the number of Polio cases reported have been growing, thereby raising the specter of cross-border infection. Yet another reason why India needs a stable and developing Pakistan.

2. Livemint has a graphic on judicial vacancies and case loads.

3. Arguably one of the most important macroeconomic debates in recent years has been over the relative superiority of fiscal austerity or expansion in combating economic weakness in developed economies. Two contrasting tales from both sides of the Atlantic.

In Spain, the Conservative Popular Party has pursued a vigorous austerity policy, slashing public spending in the middle of a recession and pushing through a series of labor reforms to improve external competitiveness. It has achieved internal devaluation through wage compression - wages have fallen in nine of the last fourteen quarters since the PP government assumed power. These measures appear to have succeeded, with output estimated to grow by 3% this year, Spanish exports have grown fastest rising from a share of 17% of GDP in 2007 to 23% in 2014, the number of Spanish companies selling abroad has risen 50% in the same period, and unemployment though still high has been declining. In contrast, in Canada, the center-left Liberal Party of Justin Trudeau recently won elections on an avowedly Keynesian platform.

4. Times points to this paper that evaluated the impact of seven cash transfer programs in Mexico, Morocco, Honduras, Nicaragua, Philippines, and Indonesia and found "no systematic evidence that cash transfer programs discourage work" and thereby promote lazy behaviors.

5. Business Standard points to another price transmission problem in India, in piped natural gas (PNG) distribution in cities. An 18% recent reduction in the regulated (by indexation) upstream price of natural gas (from $4.66 mBtu to $3.82 mBtu due to fall in global oil prices) translated to a mere 3% cut in the PNG price for consumers. As of June 2015, India had 2.8 PNG consumers in 11 states. 

The Indian Supreme Court had in July 2015 ruled that the Petroleum and Natural Gas Regulatory Board (PNGRB) had no powers to regulate transmission through CGD network and could only determine tariff for gas transmission through common or contract carrier pipelines. It, therefore, rejected PNGRB's claim to fix retail city gas prices. City gas distribution (CGD) firms are, therefore, currently monopolies and enjoy freedom from price regulation. They have marketing exclusivity for the first five years of their operations. Subsequently, the CGD network would be on "open-access", available to third parties to supply gas as a "common carrier", thereby ushering competition in the closed market. Once they become "common carriers", the PNGRB would have the regulatory powers to fix tariffs. However, the challenge then would, in all likelihood, be to get the incumbent network owners to not sabotage the open access arrangement. 

6. The digital traces left by mobile phones have emerged as one of the most exciting areas of studying human behavior in real-time, with the potential to frame public policy accordingly. Here are a few applications. 

LogAnalysis software developed by Emilio Ferrara and Co of Indiana University analyzes social networks developed from telephone calls (chiefs of gangs makes a few calls to trusted lieutenants who in turn disseminate the same widely and repeatedly) and compares them with crime data to identify (and pre-empt) criminals and crime locations. Adeline Decuyper and Co in Belgium monitored food consumption patterns by superposing an FAO household survey data with mobile phone calls data from Rwanda and found that airtime top ups correlated with purchases of high-value food items. Kevin Kung and Co at MIT used data from Ivory Coast, Portugal, and Boston and found that humans spent an hour daily commuting, independent of distance or mode of transport or the country, thereby validating the old Marchetti's constant (they assumed people's homes as where they made calls in the night and office as the location of calls during working days). Vasyl Palchykov and Co use the duration and frequency of telephone calls from a database of nearly 2 billion calls (age and sex of the callers were available) to tease out the changing patterns of relationships between men and women at different ages. Jameson Toole and Co use mobile data to study the economic and social impact of mass lay-offs by analyzing the changes in people's social networks. 

7. Andres Velasco points to the findings of Tulane University's Commitment to Equity Institute, which examined the impact of various fiscal policy instruments (direct taxes, indirect taxes, direct transfers, indirect subsidies like food and energy prices, and in-kind transfers like education and health care services) on inequality and poverty for Brazil, Chile, Colombia, Indonesia, Mexico, Peru, and South Africa,

The largest income redistributive effect is in South Africa and the smallest in Indonesia. Success in fiscal redistribution is driven primarily by redistributive effort (share of social spending to GDP in each country) and the extent to which transfers/subsidies are targeted to the poor and direct taxes targeted to the rich. .. South Africa’s result can be attributed to the combination of a large redistributive effort with transfers targeted to the poor and direct taxes targeted to the rich... While fiscal policy always reduces inequality, this is not the case with poverty. Fiscal policy increases poverty in Brazil and Colombia (over and above market income poverty)... meaning that a significant number of the market income poor (nonpoor) are made poorer (poor) by taxes and transfers. This startling result is primarily the consequence of high consumption taxes on basic goods... 

The marginal contribution of direct taxes, direct transfers, and in-kind transfers is always equalizing. The marginal effect of net indirect taxes is un-equalizing in Brazil, Colombia, Indonesia and South Africa. Total spending on education is pro-poor except for Indonesia, where it is neutral in absolute terms. Health spending is pro-poor in Brazil, Chile, Colombia and South Africa, roughly neutral in absolute terms in Mexico, and not pro-poor in Indonesia and Peru.

They calculate the marginal contribution of a tax or transfer (as the difference in inequality gini with and without the intervention) and the total redistributive effect (difference between market income gini and disposable or post-fiscal (disposable income plus indirect subsidies minus indirect taxes) incomes gini). 

Several counter-intuitive findings stand out - regressive taxes in Chile and South Africa are equalizing or neutral; the marginal contribution of contributory social security old-age pensions is un-equalizing in Chile, Mexico and Peru. 

Given this heterogeneity, to the question of whether direct taxes or indirect taxes and direct transfers or in-kind transfers are more effective at lowering inequality or reducing poverty, one can only say that "it depends" on its interaction with the other fiscal policy instruments already in operation. 

More on India's GDP growth rates

Much has been said about the last revision to the India's official economic growth statistics. To the extent that an economy's strength is reliably reflected in the underlying contributors, the graphic below raises more concerns about its veracity.

Clearly, since 2013, there is a distinct divergence in the trends between GDP growth and that of some of the important underlying contributors.  

Indian economy reading links

1. More confirmation that India's middle class may be much smaller than originally thought comes from the latest Credit Suisse Global Wealth Databook 2015. It finds a middle class of just 24 million adults, less than a fourth of China. This is confirmed by findings of recent Pew survey, the Government of India's own socio-economic and caste census, and by the income tax assessee base.

The report also finds disturbing trends on wealth dispersion, with the richest 1% and 10% Indians respectively owning 53% and 76.3% of the country's wealth, far more unequal than the US where the top 1% own 37.3% of the total wealth.

Highlighting the rapid widening of inequality, even as the national wealth rose by $2.284 trillion in the 2000-15 period, the richest 1% and 10% respectively claimed 61% and 81% of the increment.

2. More dismal news from Credit Suisse through the latest version of its status report on the debt levels of India's ten most indebted infrastructure firms. Their cumulative debt has risen seven-fold over the past eight years to reach 12% of all bank loans and 27% of all corporate loans, with debt levels rising for all the ten groups. Their interest cover dropped to 0.8 in 2014-15 from 0.9 in 2013-14, despite a significant share of interest being capitalized, and debt/EBITDA rose to 7. 

While the loans are standard in the bank books, 35-65% of the debt of four groups have been downgraded to default by rating agencies. In fact, the report points to auditor findings that 48% of the total debt, or $53 bn, was in some form of default, with $37 bn for 0-90 days and $16 bn for more than 90 days. It also estimates that 20-90% of the loans for some groups, aggregating to $48 bn or equivalent to declared banking sector gross NPAs, may be under severe stress. Taking all these into the count, the report estimates that the total NPA of India's banking system could be close to 17%.

Some of the groups have sold away their better-performing assets to raise capital, leaving them with an even greater struggle to repair their balance sheets. Faced with such levels of balance sheet problems, these firms have cut back on capital expenditure by 20-70%. Most worryingly, many projects have 20-70% cost over-runs, thereby pushing capital costs beyond their pre-loss replacement costs and leaving the projects unviable. 

It is most certain that many of these projects will have to be restructured with large haircuts and/or further equity infusions, maybe even public support. The aggressive traffic forecasts and tariff estimates that formed the basis of financial closure in road and power projects respectively may be impossible to realize. This coupled with the accumulated interest during construction and construction cost escalation may have made many projects insolvent. Any simple rescheduling of loans may be merely kicking the can down the road. 

3. Rajan Govil joins those questioning the GDP growth numbers based on underlying indicators. He points out that nearly three-quarters of August's 6.4% annual IIP growth are explained by four items - gems and jewelry, insulated rubber cables, heavy commercial vehicles, and electricity - whose out-sized growth rates are simply unsustainable. He also points to the unabated trend of declining credit growth - non-food credit growth was 8.4%, and that to industry and services was 5-6%. 

4. A new report by Bain and Co estimates private equity (PE) investments in India to touch $22.3 bn in 2015, exceeding the previous record of $17.1 in 2007. With this, PE would make up more than half the FDI into India.  

While this is an encouraging trend, its details need to be carefully parsed. Investments in consumer technology (e-commerce, aggregators, and other sharing economy firms), real estate, and financial services collectively made up 65% of all inflows and those into manufacturing is marginal. By its very nature, PE investors generally take positions in existing firms. A few large deals make up a disproportionate share of all PE investments - the top 25 deals made up 49% of 2014 PE investments. Finally, as the graphic below shows, the potential inflows from such sources is very small.

In any case, as I have blogged earlier, all such sources are a rounding error when compared to the country's credit needs, the overwhelming majority of which is met by the banking sector. 

Comparing urban footprints

A fascinating graphic of city sizes, to scale, and their respective populations.

Another graphic compares the respective sizes of Atlanta and Barcelona, which both have the same populations. 

Note the comparison between the respective sizes of similarly populated cities like New York and New Delhi or even Tokyo and Dhaka. In this context, it is worth recollecting that both Delhi and Dhaka have stringent height restrictions, as reflected in their low floor area ratios (FARs), which are orders of magnitude lower than those in New York or Tokyo. This naturally translates into low per capita space availability for residents of these cities, which is reflected in their large shares of slum populations.