Calvinball and other links

I had forgotten to link Mr. Krugman’s (PK) post on Raghuram Rajan’s ‘Money Magic’. It is here. On top of that, he has taken a pot-shot at the latest recommendation of the Bank for International Settlements (BIS) recommendation that economic growth rate needed to slow. Well, I doubt if they make the point that rates need to go higher. Both are two different things.

I am yet to read the BIS annual report. I shall do so because I make the very same point (that they appear to have made) in my latest MINT column.

PK’s rejoinders to the BIS and to Raghuram Rajan are unsurprising. He belongs to the school that believes in giving more of the same medicine if it did not work the first time or the second time or the third time. It does not matter if, over the medium to long-run, the economic outcomes they seek do not fructify or that they fructify with enormous costs (moral hazard, inflated assets built on massive debt, etc.). That is a long-term problem. In the long-run, we are dead. So, argues the anti-Calvinists, as they claim to be. There is a moral superiority to their tone since they ostensibly root for the working class or the unemployed masses today.

Let us take a closer look at the two charts PK has produced in his blog post. The second chart has a different scale and the y/y change in Unit Labour Costs in the US is around 1%. No sign of wage pressures. In fact, I wonder why rates should always go up when ULC inflation is, say, above 3% or 4%. After all, why not let labour get, at least once in a while, a share of the productivity more than they should? 

In fact, that is the question I have, for PK and others: Who are benefiting from the zero interest rate cum loose money policy? Who benefited in 1998-99? In 2001-04 and now in 2007-11? It is an empirical question and the answers need to be found before either pouring more ‘liquidity’ medicine into the mouths of capitalists and speculators or before pouring scorn on those who espouse alternative view points.

If there is excess savings at nominal zero bound and if that means that the US potential GDP growth rate is probably close to 1% rather than 3%, then what the heck is the US stock market doing at 1300 points?  Who is propping it up and with what money and is that healthy? Debit balances in the NYSE Members’ Margin account was USD278.5 billions in March 2000 and it went up to 381 billion dollars in July 2007 and it stood at 315 billion dollars in May 2011. We all know what happened after March 2000 and after July 2007. Did that benefit the unemployed for whom the hearts of the anti-Calvinists bleed?

Something for the bleeding hearts to reflect on, here and here. Low interest rates combined with technological changes, compensation practices combined with short-term focus on stock prices by US corporate leaders and financial globalisation have boosted asset prices well beyond levels justified by fundamentals and have made those who are asset-rich, richer. Others have been immiserised. That is the path that America continues to walk on.

What if stimulus does not work?

When monetary and fiscal stimulus do not work, there are two possibilities. Either the stimulus is not enough – you increase it – or you look for explanations as to why they do not work as they were supposed to. May be, something else is at work. There are people – Krugman and de Long, to name just two – who think that if stimulus does not work, it simply was not enough. They want the Federal Reserve to get even more unconventional and the Obama government to run up a bigger deficit. There are those who argue that, may be, there are some reasons why even such an unprecedented stimulus did not work. Either it was wrongly applied or that the disease required a different remedy. Raghuram Rajan and Thomas Hoenig argued that way and the former is facing some stiff pushback now in the blogspace. See here and here, for example. For good measure, see Krugman’s speech too.

One of the commentators on the de Long post calls Raghuram Rajan a one-trick pony. That is, he did not do anything meaningful post-2005 after he warned of wrong incentives and risks in the financial system. I am not sure what else others have done.

The commentator had cited evidence from the Raghuram Rajan Committee report on the ‘Road map for financial sector reforms’ to prove his case that Raghu was a one-trick pony. I was not writing a blog then and hence did not comment on that report in a blog. But, I dug through emails that I had shared with my friend and I had expressed disappointment at that report, for its orthodoxy. It also omitted to mention the role and the importance of financial literacy. Otherwise, liberalised financial sector could play havoc with the rest of the economy. Information and incentives asymmetry is higher between vendors and consumers in this sector. But, in mitigation of the Committee, one could say that they wanted to start at the extreme end to arrive at the middle, given India’s political economy. Anyway, that is a digression.

The problem with more and more stimulus is that we enter into the realm of the unknown and hence, as Raghuram Rajan mentioned in a subsequent piece, it is about risk management.

Similarly, let me concede that I have been a votary of ‘expansionary austerity’ – i.e., the belief that austerity could restore confidence and credibility in policy and thus prove to be expansionary. This ‘Free Exchange’ blog post makes an important point and that, I admit, is a valid angle:

Britain counted on “confidence” to lift the economy amid austerity and has been sorely disappointed, despite an accommodative central bank. The literature on expansionary austerity suggests that it’s not an impossibility, but that it nearly always occurs in countries where high debt levels have produced high interest rates. [More here]

There are some academic papers cited in support of the argument on the limitations of expansionary austerity. I have not read them. They can be seen here and here. Bradford de Long advocates the US government borrowing more because it is in a position to borrow more as the ‘market’ has not protested. After all, the 10-year nominal Treasury yield is below 3.0% when the headline inflation rate is 3.6%.

My problem with this argument is how do we know that the market is correct? Many of these folks have argued, in other contexts, that financial markets are not efficient. After all, just about three years ago, the yield on the 10-year Greek sovereign paper was trading at 20-40 basis points above the yield on the German 10-year government paper. Japan is still able to borrow at around 1% for 10 years. Was the market pricing in the risk of Greek debt correctly then? Or, is it pricing Japanese debt correctly now?

So, I probably err on the side of those advocating making haste slowly at the minimum when stimulus does not work, instead of advocating more stimulus. At the same time, I realize that this debate is impossible to settle. That is the beauty and frustration of economics, given the impossibility of constructing counter-factual scenarios.

A new definition

A quick one on the FT news item on the Reliance Industries’ angry missive against the Comptroller and Auditor General Office in India on their allegations against private sector oil companies. I have not gone into it in detail and hence this post is not about the substance of the charges made by the CAG against the private oil companies that they inflated the capital expenditures incurred by them so that the Government of India shelled out more than what it would have. What caught my attention, however, was this novel definition of an auditor that the Congress spokesperson Digvijay Singh gave for the role of a CAG:

Digvijay Singh, a senior Congress party politician and close ally of the Gandhi family, has tried to diminish the CAG’s findings, saying the agency’s purpose was not to act as an anti-corruption watchdog.

“I am very surprised that senior parliamentarians have not understood the role of the CAG,” he said. “The role is that of an auditor. [A] CAG report is not a report on corruption. It is not an investigative agency but a bookkeeping agency.”

Since when did an auditor become a book-keeper?

Coming to think of it, this gentleman was the toast of the intelligentsia and the chattering classes some years ago as a Chief Minister who provided good governance.

Supply and prices rise!

Ok, I was taking some liberties with the header. I meant that the International Energy Agency (IEA)  – through its member countries – decided to release more crude oil (or products) into the market and the Indian government finally raised the price of kerosene, diesel and cooking gas slightly. But, the Government of India did not release the price of diesel and cooking gas from its discretionary control. That is disappointing. Although it is not that surprising that the Opposition parties cried foul, knowing the history of Opposition reactions to such moves no matter which party or coalition was in power, it is still disappointing not to see some display of political maturity at least somewhere. We are far removed still from having a mature and intellectual discourse on our formidable economic problems.

In the meantime, the decision of the IEA to release crude oil and/or petroleum products was a smart tactical move. It is a tacit admission by the Federal Reserve (or, the US administration) that further monetary stimulus could actually achieve the opposite result. That is, it might push commodities prices higher. In other words, the Federal Reserve has finally admitted that easy monetary policy and liquidity could be aiding speculative demand and boost to the prices of commodities. You will also be excused if you interpreted the move as a show of empty hands by policymakers. They realize that they cannot do more. Let us rephrase it. They can do more. The Federal Reserve can always print dollars to buy up all assets – shares and what else – but they appear to realize that such measures have unforeseen consequences or that the costs of such measures might exceed the benefits.

There is a lively debate going on in the blogsphere on Raghuram Rajan’s piece, ‘Money Magic’. I have blogged on it here. Raghuram Rajan has followed up with a clarification. The key points he makes are these and I broadly agree with him:

I would be wary of pushing any policy too hard, especially if there is little evidence that it is working — the unintended consequences could outweigh the meager benefits, if any.

More generally, risk management in policy making might suggest not going to extremes when policy makers are faced with high levels of uncertainty about policy effectiveness (this is common sense, I don’t have a model here).

I will have more to say on this and on the notion of ‘expansionary austerity’ in a separate post.

Return to Seventies

MINT has an excellent EDIT and that is worth reproducing in full. I do so  here. This Edit needs to be read in conjunction with this blog post by Gulzar in ‘Urbanomics’ .

(Disclosure: I am a weekly columnist in MINT on Tuesdays)

Posted: Wed, Jun 22 2011. 9:36 PM IST  

Return to rent-seeking  

India needs economic reforms as never before. They are unlikely anytime soon  

Twenty summers ago, in the middle of a balance of payments crisis, India carried out far-reaching economic changes. Within years of a round of unshackling the economy, growth rapidly shifted to a high gear. Poverty began a climb down, the first time at a fast-enough pace. Today, it is considered to be within running distance of surpassing the growth rate seen in China in recent years.   Like all foundational myths, there is a kernel of truth in this story. Economic freedom did lead to growth. It also holds a lie: That these changes were initiated and carried on willingly. That is, at best, a partial truth. It would be more accurate to say that reforms since then have either been executed in the face of a crisis or have been carried out in sectors where there were no special interests or incumbents who blocked them. Two examples— one success and one failure— are illustrative. If telecom is a success story today, it is because there were no incumbents to battle. Today there are many firms in this sector and if anything, cut-throat competition in the sector that has led to consumers enjoying services that are cheapest in the world. In contrast, 20 years ago, consumers had to virtually beg for phone connections and the Jurassic sized state-owned firms couldn’t care less.  

The failure, too, is instructive. Agriculture is a good example. The costs of not liberalizing agriculture are there for all to see. As income of individuals has gone up so has the demand for food. Unlike telecom, agricultural commodity markets remain regulated. From farm gate to retailers, the government controls every single step: prices are “advised” by the commission for agricultural costs and prices and “set” by a cabinet committee. There is little scope for price discovery by economic agents. The results are in marked contrast: telecom services are dirt cheap; food is often so expensive that the poor have to go without it.

This story of failure is repeated in sector after sector. Perhaps, the biggest victim is industry where labour laws have ensured that manufacturing remains concentrated in very small firms that employ less than 25 persons. Big industries that can suck out unemployment have, at best, a scattered presence. The government has, now, proposed a solution: a manufacturing policy replete with incentives to be administered by bureaucrats. Were it not for the calendar, one could have mistaken the year as 1948 when the government embarked on a similar misadventure.  

This holds a clue on why reforms have seldom been carried out by choice. The fact is that India’s political class as a whole never believed in them. And this includes Prime Minister Manmohan Singh in his new, post-2009 avatar—something intriguing as he was instrumental in undertaking a bout of liberalization earlier. This is not a problem of knowledge. At the highest level of government, decision makers know the benefits of running a market economy. After all the 8%-plus growth for many years now is a result of that. The problem exists at a different level.  

It makes much sense, as does politics everywhere, to create vote-fetching schemes. In most democracies, there are institutional mechanisms to limit such schemes. In India there are a few countervailing institutions that impose such limits. In the end, matters boil down to the complexion of the government in power. If anything, an incumbent government can do pretty much what it pleases with markets.  

What this does is to keep the balance between free markets and statism quite fluid. The period from 1998 to 2004, by and large, witnessed a tilt in favour of markets. Since 2004, the balance has yanked dramatically on the other side. It is very easy to create a symbiotic relationship between politicians and the electorate. There is, always, demand for “free” stuff. Our system is more than happy to provide it: free power, free food and free travel are there for a large number of citizens.  

This trend has accelerated since 2009—almost a return to the 1970s when India was caught in a wave of populism. The bargain, outlined above in crude terms, has now been finessed. Politically, it is acceptable that 1% of the gross domestic product is spent in populist schemes to maintain a favourable political equilibrium.  

Were it just a matter of numbers that are replicated constantly, year after year, it would inflict damage, but not of the kind that would mar the country’s fortune. Alas, that is not the case. This equilibrium is unstable as economic data points out: growth is slowing even as inflation remains high. Demands for money in welfare schemes continue to rise.  

Many decades earlier, the economist Anne Krueger said something wise about the political effects of such intervention: “If the market mechanism is suspect, the inevitable temptation is to resort to greater and greater intervention, thereby increasing the amount of economic activity devoted to rent-seeking. As such, a political ‘vicious circle’ may develop. People perceive that the market mechanism does not function in a way compatible with socially approved goals because of competitive rent-seeking. A political consensus, therefore, emerges to intervene further in the market, rent-seeking increases, and further intervention results.” India today is well into the vicious circle she described. Under such circumstances, it is wishful to expect meaningful economic reforms. Twenty years after a bout with “reforms”, India is in a rent-seeking mood.   Economic reforms in India: a forlorn hope? Tell us at  

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The Hellenic noise

Too much ink has been shed on Greece, Portugal, Ireland and Spain. A friend had once told me that the philosopher-guru JK had said that progress was man’s innate ability to complicate simplicity. Perhaps, it has never been truer than in the case of the European debt problem. When some one borrows too much, either the borrowers seize the assets or they declare bankruptcy. Or, they are able to refinance their borrowings at much cheaper rates and continue to survive for some more time.

The question is who is willing to lend to them/help them refinance at cheaper rates? Is that enough? It might help the ‘flow’ (interest burden) problem but what about the stock of debt that they have? If the stock of debt is to be cut, it is some one else’ asset. What happens to their balance-sheets? The borrowings are made not just by the Greek and other sovereigns. Private sector entitites – banks, corporations, etc., – too have borrowed from overseas.

Then, there is the contagion effect because investors are fraught and are living in a world where public and private men and women in authority have been parsimonious with truth. Once Greece does or is forced to do something that investors have not anticipated, they would not ask questions but shoot first. Morever, how do we even know about how much we know about Spanish banks’ and saving banks’ asset quality? That is why unlike Stuart Staniford, I have no problem in believing that there will be a contagion effect if Greece engages in a unilateral act (default or restructuring of its debt obligations or leaving the Euro!).

Yes, there is the additional complication that Greece belongs to a club and if it chooses to leave the Club, no one knows what happens to the Club afterwards. The Club has no rules for dealing with this. Second, if weak members of the Club leave, the strong members of the Club might become too strong for their own good!

Further, in the case of sovereigns is that they need to keep borrowing as they have obigations to fulfil. Of course, just as in the case of individuals, sovereigns cannot and should not endlessly (often, the same as ‘needlessly’) run fiscal deficits. That is why, a cyclically adjusted neutral fiscal policy makes sense. That is, the government runs surpluses in good times to use them in lean times.

The question is how to ensure good times for countries like Greece? Where is growth going to come from? Savings? Investment via lower interest rates? Competitive manufacturing and services via lower wages and a cheaper currency? Who will ensure that the Euro climbs down from 1.43 to 1.13 or 0.93 vs. US dollar? What does America do in that case? Will the Greeks accept a lower standard of living and for how long, to restore economic growth and to sustain it?

Now that I have listed down all the questions that are pertinent (in my view,  of course!), any Op-ed that deals with the subject should be deemed useless unless it sheds light on these questions. Clever solutions that would legally allow Greece (and others) to default without defaulting and that would allow banks to carry the loans on their books as if they are good and current are not necessarily useful and do not put a closure to the issue.

The inflation strawman

Surjit Bhalla sets up a few strawmen to knock them down while lending his thoughts and voice to the RBI Governor. Economists working for investment banks would, perhaps, be happier to see the stock market surging so that there are more equity listings, IB mandates, active secondary trading and broker commissions than to bet on a CARRY TRADE in Indian rupee which has underperformed other Asian currencies quite substantially. Many of us – for the record, I do not work for an investment bank and do not have any product to sell to clients  – have been advocating rate hikes not just for India but also for Indonesia, China, South Korea, etc.

On the Indian inflation challenge, these posts in ‘Urbanomics’ are worth reading. FT has a bizarre edit on India’s inflation.

Deepak Lal on China hubris

Professor Deepak Lal has pooh-poohed claims of ‘Beijing consensus’ or Beijing model of  State Capitalism. Rightly so. But, pretty much all the criticisms levelled at Beijing model apply to the ‘Washington consensus’.  Both proponents made and make the mistake of generalising from a context specific approach to eocnomic growth that worked. Both have or should have  SELL BY and  ”Not to be sold here’  warnings.

This key observation of his on whether China is in danger of becoming a Japan deserves to be taken note of:

So, is the latest adherent to the “Asian” model likely to meet the same fate as its parent? I do not think so. This is because China, unlike Japan in the eighties, is still in the “catch-up” phase of economic growth. And with savings rates remaining high, until the “demographic dividend” ends in 2025, with an elastic labour supply in relatively free labour markets, and abundant industrialisation opportunities for expansion beyond the coast, China should be able to maintain high growth rates in the next decade.

The dangers are longer term, once the catch-up phase ends.

On whether Indian growth model is superior to that of China  – as he seems to be alluding to here – this blogger thinks that Professor Deepak Lal needs to update his views. India’s growth of the 1992-2002 years  (with some years of middling growth during this period excluded) was not due to a full State-led capitalism model nor a genuine grassroots devolution model that China practised in the 1980s as Yasheng Huang narrates in his book.

It was not deliberate but accidental because policy did not do much to get the State  further out of the way of bottom-up, entrepreneurial growth. That is evident in the acts of policy omission and commission in the decade to 2010, including that of the NDA rule up to 2004.

The growth rate of the period 2002-07 owed itself largely to the global boom and low commodity prices up to 2004.  Further, it was low interest rates globally that kept domestic interest rates low. But, it fostered mostly an unsustainable investment boom. It was growth alright but not healthy growth.

Hence, China’s model may be flawed now or might become increasingly inappropriate for China but India has not got it right either. In fact, there are many things that need fixing in India now. For a list of things that are languishing for want of attention, see here and here.

Stanley Fischer and Moral Hazard

Felix Salmon has a good post on why Stanley Fischer is not the right guy for the post of the IMF Chief. Even though it is now irrelevant because he is overaged, it is good to recall the orthodox approach that Mr. Fischer took when he was the first deputy managing director of the Fund between 1994 and 2001. Recently, I had the opportunity to go through his speech at the III  Brahmananda Memorial Lecture in February 2011 in India. It is worth going into. I have only one comment on one of the nine lessons that he drew for central bankers, from the global crisis:

After having had to decide how to deal with moral hazard issues in a variety of financial crises, I have arrived at the following guide to conduct: if you find yourself on the verge of imposing massive costs on an economy – that is on the people of a country or countries – by precipitating a crisis in order to prevent moral hazard, it is too late. You should not take the action that imposes those costs. Rather in thinking through how a system will operate in a crisis, you need to take into account the likelihood of facing such choices, and you need to do everything you can in designing the system to keep that likelihood very small.

Very well. But, one small counter-question: By taking action to prevent moral hazard, a central bank might impose current costs but what about the future benefits that arise to the country or countries by the signalling effect that it sends to those whose conduct might create ‘moral hazard’ situations in future? In other words, what is the relevant time horizon to chalk up the costs and benefits?

Rejoinder to Jamie Dimon

Prof. Anat Admati takes the fight to Jamie Dimon of J. P. Morgan. She has written an open letter to the Board of J. P. Morgan asking them to do the right thign by their own bank, by the sector, by the nation and by the world. This is admirable. She is logical. She correctly says that whether the funding is through equities or through loans, it does not affect one bit what the banks do with the funds on their asset side. She is right. But, a higher E in the E+D mix means a lower leverage ratio and that means lower profits. She is also right to say that risk-adjusted profits are, perhaps,  the same or better. But, the bankers are paid in risk-unadjusted dollars and to them, the nominal value of earnings matters and not risk-adjusted earnings. Until Boards wake up to that aspect in the matter of compensation, the Dimons of the world would keep complaining about higher capital and lower leverage ratios.

While you are at it, pl. check out this Felix Salmon blog post on Dimon and Geithner.