Why and how Finance sucked up (or, sucks up) engineering talent

I had posted the following comment in response to this article in FT:

Much of the comments on this article focused on the micro behaviour of individuals who chose to join financial institutions and hence were, for the most part, defensive about their behaviour and hence, critical of the article. But, that lens is the wrong one.

The article points to a paper that highlights the attractiveness of finance to engineers as opposed to other jobs that were more suited to their education. It is a social phenomenon and the responses have to be in the policy domain, if it is established that there has to be a policy response. As individuals, engineering graduates who joined the banking industry were doing the sensible thing for themselves and their families. This commentator and Andrew Hill would have done the same, in all likelihood. But, we need to move away from that frame.

Why did finance attract so much talent? A corollary question that poses itself is why was finance able to pay so much that talent flowed to it? Well, finance made so much of profits that it was able to pay. Actually, the attraction of talent, high wages and profits became mutually reinforcing trends later. But, what was the source of profits?

Finance, in modern times (post-1980s because that is when financial liberalisation, de-regulation and liberalisation of capital flows started in right earnest), has not been doing anything unique in comparison to the past.  It facilitated much secondary trading of financial securities. But, the compensation for it has come down considerably and the fees for active asset management have, for the most part, proven to be wasted and wasteful compensation. So, what was the source of it?

Andrew Haldane, in his contribution to the volume, ‘The Future of Finance’ published by the London School of Economics in 2010 (‘Contribution of the Financial Sector: Miracle or Mirage’) has pointed out that finance generated extraordinary profits because it wrote deep out of the money options (think Credit Default swaps and sub-prime securitisation). Deep out of the money options earns premium for the writer but once in a while these options get in the money and the writer has to pay up to the options owner. That is what happened in 2008.  Second source of profits was that much of the profits were risk-unadjusted. One source of risk is that many assets were valued as per models and hence shown at fair value. Second source of risk is high leverage ratios in investment banks’ balance sheets. The third arose out of creating products that, willy-nilly, drew the buyers into the web of financial leverage. In fact, that is where the engineering talent was needed.

High profits were required to maintain stock valuation in deference to the pressures exerted by institutional investors. Second, compensation of higher executives was linked to stock price performance. Hence, showing consistently rising profits was an obligation. That required generation of complex financial products which, though based on complex mathematics, were essentially built on unsuspecting clients assuming financial leverage. Developing these products required engineering talent. Ergo, the phenomenon that the paper and the article cover.

Now, the question for policymakers is whether any of this is welfare enhancing. Evidently, they are not. Their welfare-destruction was evident in the crisis of 2008. Have the policy responses changed the demand for engineering talent and the attraction of finance to such talent? Not much, if at all.

So, this is a socially negative phenomenon even though it is positive at the personal level, somewhat like the paradox of thrift that Keynes had discussed, in a different context.

In this context, it is worth noting that Bloomberg reported last evening that bonuses in Wall Street reached their highest level since 2006.

To be or not in the B-Index

It is difficult to keep up with Andy Mukherjee. At the rate at which he is writing, he might give Amol Agrawal of ‘Mostly Economics’ a complex with his prolificity of writing. In the last twenty-four hours alone, I have counted three Andy pieces – joining the Bond index, on the lone SELL rating on ICICI Bank and on Uber selling out to GRAB in SE Asia.

We shall focus on the column on China joining the Barclays-Bloomberg Bond index with India an onlooker. Andy thinks that India should be less fussy about foreigners holding its sovereign debt issued in Indian rupees. After all, the country runs a current account deficit and it can do with some foreign savings. Once you are in the index, index tracking funds will be invested, no matter what the fundamentals are. Of course, they can go underweight but they won’t sell and scoot fully. That is the sum and substance of his argument, if I understood them correctly.

I do not disagree with the logic. There is something to be said in its favour. Andy’s points are well made. But, on balance, I think India is not ready for it and I am not sure it will be ready in the very near future. India lacks the governance and discipline required for sustained macroeconomic stability. China can and will brazen it out. It is ‘Too big to fail’. India is not.

Whether most investors stay invested or not because of index tracking requirements, what matters to asset prices is the behaviour of the marginal investor.

Whether the debt held by foreigners is denominated in local currency or in foreign currency matters little in the end. If investors whose reference currency is not INR decide that they wish to get rid of INR risk, then the foreign exchange risk comes into play fully, regardless of the currency of denomination of the Indian debt.

India frequently gets into situations in which foreigners would want out. Despite its savings rate at a low 30%  (given its growth ambitions), India has not given up the ambition to become a high growth nation.  Governments feeling shaky politically – that may be a reality after 2019 elections – might want to go for high growth and do so via fiscal populism something that India did, not so long ago (2009 to 2011) and that is recipe for disaster for debt and for the currency because with a savings rate of 30% and low capital and labour productivity, high growth can come only via a ramp-up of aggregate demand and that would blow out the current account deficit.

The bond market – rational as they are with respect to emerging markets (only) – would administer tough love. Sometimes, it is too tough.

Bond markets are far more sanguine with respect to fiscal profligacy and debt accumulation by advanced nations. Indeed, over the last thirty five years, bond investors have rewarded advanced nations’ public debt accumulation with ever-lower interest rates. So much for market discipline!

Therefore, all told, if one is not sure of self-control and discipline and would likely binge, it is better not to look at the plate of delicious sweets.

So, India is better off not regretting missing out on the bond index membership.

The Indian banking purgatory – policy proposals – 3/3

I wrote part 2 on March 10. I have been wanting to excerpt Dr. Y.V. Reddy’s extarordinarily candid lecture on February 1st. It contained some definitive recommendations. I copy and paste them below.

In addition, he has spoken about the proximate and underlying causes of India’s bad debts problem in the banking system, etc. He is even questioning if the leitmotif for nationalisation of banks remains relevant nearly fifty years later. You should read the full speech if you are interested in Indian banking.

  1. The first step for improving our banking system is a commitment to reduce SLR and CRR to global levels as soon as possible. We cannot have a globally competitive economy with an over-burdened banking system.
  2. The current policy of ownership and governance in banking needs to be reviewed urgently to correct the outdated and distorted policies. This should be done before our banking system passes on to foreign owners, irrevocably.
  3. A high level internal enquiry within the RBI should be undertaken to fix the responsibility for excesses in NPAs in recent years and, more important, to suggest and adopt measures to improve the system as a whole.
  4. In view of the large amounts of public money involved, the government may put in public domain action taken on Fourteenth Finance Commission’s recommendation for improving the financial system with economical use of tax payer’s money.
  5. A White paper on the future of Public Sector banking may be placed before the Parliament at the earliest in view of their criticality for efficiency in financial sector as a whole, to be able to serve a globally competitive economy.
  6. In brief, the current approach of treating Banks as special and bank depositors as special must be continued, and an assurance to this effect may be extended by the Government.
  7. In view of global developments and emerging Indian economy, there is a case for RBI to internally review the current policy of annual transfer of surplus after determining the needs for addition to reserves and adopt a new policy after due consultation with Government.

The first two parts on Indian banking are here and here.

Getting off the arm-chair

These two articles remind us of where our utility as public policy commentators lies.  Real (intellectual) discoveries (epiphanies, in a way) await us when we dig deeper. The first article tells us of the author’s discovery that gun control is probably not the answer to the United States’ gun related violence.

The second story is about a Harvard Medical School study that looked into U.S. health care that is much derided.

It is a coincidence that these wo articles came into my space on a day when my column in MINT dealt with the real issue behind India’s declining Gross Fixed Capital Formation to GDP ratio. It is not, as we think, because of businesses not investing. It is because, as per official data, household capital formation has stalled. Household capital formation has stalled because household savings rate has really dropped from 25.2% in 2008-09 to 16.3% in 2016-17.

That does merit a proper investigation as to the causal factors. In my column, I allude to one: failure of the governments to provide public goods necessitating private expenditure on them. So, household savings and GFCF failure is governance failure and not ‘jobs’ failure. The column is here.

Labour intensive sectors – post-GST blues and other links

Incisive analysis but a troubling story on the woes of labour intensive sectors post-GST.

Job creation in the corporate sector – not a good story too

Government allows fixed term employment for all sectors. An interesting and, may be, even a futuristic development. Even workers might need to be flexibly moving from one project to another in the decades to come.

Home sales in the seven biggest metros drop 40% in 2017 from their levels in 2013-14.

A good RBI (brief) analysis on affordable housing and housing affordability in India. It ws part of the January 2018 RBI Monthly Bulletin.

Mohandas Pai and S. Krishnan on ‘tax terrorism’ running amok in the country – not good at all.

Rohit Saran on state failure crimping household budgets. Good piece.

(I use the last three links for my MINT column this coming Tuesday. Watch out for it)

The Thiruvadanthai trilemma

Although my friend Srinivas Thiruvadanthai did not mean to pose the question as such, I thought I would credit him with a ‘Trilemma’ that, I hope, will remain for posterity! His blog post triggered the following thoughts:

Another thoughtful and thought-provoking post as usual, Srini. The last paragraph of the post has been the rallying cry of BIS economists from White to Borio (including Cecchetti or not?).

I found the paragraph on the ‘ex-post criticism’ of the Fed not being easy enough in mid-2008 to be particularly insightful. Hindsight is a gift for critics that is denied to policymakers in real time!

The blog post can be considered a formulation of ‘Thiruvadanthai Trilemma’ between free-market finance, financial stability and economic stability. You can have two of the three but not all of them.

Notice that I have taken interest rates out of this trilemma. That is deliberate. In other words, the problem that there is no one single interest rate that stabilises the financial economy and the real economy at the same time disappears if (a) we remove the paradigm that ‘markets know best’ particularly for the financial sector and for financial markets (in a sense, I believe, the comments by Ms. Carolyn Sissoko reflect that) and if (b) the relevant horizon to evaluate the correctness of the monetary plolicy setting was long enough.

Let me take up my point (a) above. The question is whether regulating finance alone is both necessary and sufficient to enjoy both financial and economic stability at the same time. Yes, some would say.

That is what Ms. Caroline Sissoko has said in her coments on his post. But, is that really the case? We will never know because two things were at work in the post-Great Depression period and, in particular, in the post-WW II period. Economic growth was a low-hanging fruit. Therefore, it is possible that, regardless of how the financial sector or financial markets behaved, sustained high growth would have washed away all sins – with or without tight regulation. We will never know.

Therefore, it logically follows that in the era of slower growth that we face now, the case for financial sector and financial market regulation becomes stronger and not weaker.

Critics would object that this would further jeopardise the already lower growth. Well, the IMF has the answer. In a paper that is now a book, ‘Too much Finance’, the authors argue that financial development in advanced nations has already crossed the theshold at which it is beneficial for economic growth.

So, financial sector/financial market regulation will take care of the ‘Thiruvadanthai Trilemma’.

Fortifying that will be a monetary policy setting that chooses its relevant horizon more carefully than what central bankers have done in the last three+ decades. It should be longer than the business cycle so that it encompasses the financial cycle. I am merely paraphrasing the arguments made regularly by BIS economists. That is my point (b) above.

In a long enough time horizon, the dilemma, of fixing a high enough rate that handles financial market exuberance without hurting real economic activity or a low enough rate that allows financial intermediation to repair or to resume while the economy is overheating, solves itself.

In recent times, I beleive that the former dilemma has imposed much bigger long-run costs on the economy and on the society than the latter dilemma, in the above paragraph.

If unelected and technocratic policymakers optimise their decision over a reasonably long time frame, then the need for (or, the impossibility of) multiple policy rates is avoided or obviated.

If they cannot do that in practice that easily, then another approach is to have the domestic economy counterpart of ‘unremunerated reserve requirements’ that is applied to regulate capital flows. There can be a counter-cyclical credit surcharge (or discount) that the central bank, in its capacity as a banking regulator, prescribe for credit allocation, on the top of the policy rate. There can be times when this surcharge (negative or positive) can be zero. In that case, the policy rate works both for the financial economy and for the real economy. This can be on top of (and not in lieu of) countercyclical capital buffers that regulators now want to impose on banks.

Gross confusion here

At least, as reported by Reuters, Bill Gross appears to be all over the place. If global economies are leveraged to the hilt and if that means that intrest rates cannot go up without causing big dislocation/disruption/pain, then it risks adding to the pile of debt. This is a Catch-22 situation that Jerome Powell’s predecessors had landed him in. For the future of his country and for the future of the rest of the world too, some beginning has to be made somewhere.

If Powell is to be counselled against raising rates as indicated by him and his fellow FOMC members – 6 to 8 rate hikes of 25 basis points each in 2018 and in 2019 – then it is a counsel to allow more debt creation and a bigger eventual and inevitable pain.

This is what he had written, from which Reuters has written its report:

I write this – not in support of low interest rates and financial repression – indeed I have argued for the necessity of an eventual normal rebalancing if small savers and financial institutions such as pension funds and insurance companies are to continue to perform their critical capitalistic role. But I believe, as does Fed Governor Neel Kashkari, that our financial systems’ excesses cannot be expunged quickly by “liquidating assets” à la Andrew Mellon in the 1930’s, but by a mild and gradual re-entry back to privately influenced, as opposed to central bank suppressed, interest rates. 2% Fed Funds in a 2% inflationary world is the current limit in my opinion. [Link]

I am not sure I buy it fully. But, that does not mean that his point of view is any less valid than mine.

Some recent very good reads on China

(1) On Thursday, U.S. time, the Trump administration raised tariffs on China goods. Whether the tariffs amount to USD50.0bn or that they were being levied on USD50bn worth of Chinese imports is not yet clear.

An investment bank wrote the following, this morning, in its daily missive:

Our economists note that news reports differ on whether the tariffs would apply to $50bn of Chinese imports, or whether they aim to raise $50bn in revenue. If it is the latter then they would apply to $200bn, or about 40%, of Chinese good imports. The only thing the USTR (US Trade Representative) mentions is that the unfair Chinese trading practices are estimated to cost the US economy at least $50bn / year. The extent of the tariffs is one uncertainty, another is the extent of the response by the Chinese.

The same research note made the remarks below:

Although the US decision elicited consternation abroad and calls from allies not to escalate to a trade war, Trump’s decision received cross-party support in the US from Senate Democrat Leader Chuck Schumer, who said Trump is “exactly right” and “I’m very pleased that this administration is taking strong action to get a better deal on China.” White House trade adviser Peter Navarro meanwhile told reporters the measures are a “seismic shift from an era dating back to Nixon and Kissinger, where we had as a government viewed China in terms of economic engagement… That process has failed”. This suggests that the decision has the weight of the US policy / geopolitical strategy establishment behind it, especially after Trump purged his advisors of pro-free trade voices and replaced them uniformly with China hawks, and is not simply a political tactic ahead of midterms or a Trump-specific impulse.

In a way, it made me think of how much Trump, the outsider, has managed to thumb his nose at conventional wisdom that binds both the major political parties in the United States. He is governing, for better or worse, as a true outsider. In India, in some respects, that is still missing despite the election of Mr. Modi in 2014 who, in a way, overcame the established leadership in his own Party to become its national leader but yet, he has not stamped his authority on policy.

(2) Only this morning, I managed to read the ‘Executive Summary’ of the report of the US Trade Representative on China’s WTO compliance. Of course, the media had featured this comment prominently. But, it is worth putting it out all over again:

Given these facts, it seems clear that the United States erred in supporting China’s entry into the WTO on terms that have proven to be ineffective in securing China’s embrace of an open, market-oriented trade regime. [Link]

Again, this is in line with what many sensible observers have written in the last two to three years.

(3) Notwithstanding the cop-out/finessing in the last paragraph of their article, Kurt Campbell and Ely Ratner, pretty much, vindicate Trump and they are also extremely consistent with the message of John Pomfret in his wonderful book, ‘The Beautiful Country and the Middle Kingdom’. The article could be behind a paywall.

Very brief extracts:

Nearly half a century since Nixon’s first steps toward rapprochement, the record is increasingly clear that Washington once again put too much faith in its power to shape China’s trajectory. All sides of the policy debate erred: free traders and financiers who foresaw inevitable and increasing openness in China, integrationists who argued that Beijing’s ambitions would be tamed by greater interaction with the international community, and hawks who believed that China’s power would be abated by perpetual American primacy. ……..

…….. Washington now faces its most dynamic and formidable competitor in modern history. Getting this challenge right will require doing away with the hopeful thinking that has long characterized the United States’ approach to China.

(4) A good friend had sent a speech delivered by Kevin Rudd, former Australian Prime Minister to the students at the U.S. military academy at West Point, earlier in March. It is worth the investment of time going through that speech. My reactions are as follows:

(1) Clearly, it is a Master class that the Indian political establishment needs to hear.

(2) Do Indian political leaders know the kind of intellectual concepts or are they capable of the intellectual thinking that Kevin Rudd attributes to Xi Jinping?

(3) Why has NITI-Aayog idea of inviting international experts to address Indian parliamentarians stopped? Was there anyone after DPM Tharman and Bill Gates? (Yes, there was Michael Porter on competitiveness of nations and states in May 2017)

(4) I was struck by his penchant for numerically layered arguments: Three characteristics, three aspects of the economic transformation post-2013 (or lack thereof) esp. with respect to private sector and then seven concentric circles.

(5) His explanation of how China chose to pursue the path that it is currently pursuing after deliberating upon alternative models is fascinating but equally it is silent on the contradictions and vulnerabilities of the model chosen eventually – single party dominance and encroachment.

(6) He has completely underplayed any discussion of China’s vulnerabilities or weaknesses or limitations. I would not say that it is due to a certain veneration or that he is in awe of China but, may be, because he believes that it is good to over-estimate an adversary rather than do the opposite.

(7) His discussion on the method that Xi has chosen to accommodate (or, suppress or ignore) the demand for political freedom after economic freedom is too thin or weak or almost non-existent. He says that Xi’s answer to that is ‘ideology’. Does not elaborate as much as he could have or should have.

(8) In the same breath, I can also add that his discussion of China’s economic limitations is too weak. May be, that is not his forte. He assumes that China will overtake American GDP and also mentions a time frame. But, risks to such a facile view are not mentioned, let alone discussed.

(9) What is clear to India is that there are no easy ways with China. In fact, I might even say that, in a sense, Xi’s ‘Presidency without limit’ makes many things clear. There is no equality or parity with China. They do not want India to have its own sphere of influence. They scoff at it. They may, at one stage, come to that understanding with the U.S. and that too, on their terms, later. But, they could rather have India as a supplicant and not as a strategic adversary or a partner.

India, proud of its civilisational past, now should know what its path is. It has to be prepared to confront and be prepared for confrontations through many flanks – economic, diplomatic and military and not be squeamish about its alliances with other democracies in the region and the USA – ‘the dance of the democracies’.

(5) Separately, I went through the testimony given by John Garnaut, former journalist and advisor to Prime Minister Malcolm Turnbull to the U.S House Armed Services Committee on March 21, 2018 although the document puts the date wrongly as March 21, 2008 (I wonder). That speech which comes with his article in ‘Foreign Affairs’ attached is, in some ways, a good counterpoint to the somewhat relatively benign way in which Kevin Rudd has painted the developments in China.

From mining bitcoins to Qatari hostages to the tyranny of convenience to opoids – recent great reads

Andrew Sullivan’s piece in ‘New York Times Magazine’ on the Opoid crisis in America made for grim and sad reading. Of course, some of the causes he alludes to strike a chord even if it is hard to empirically verify them or establish them. You can read the article here.

A British-American friend responded thus:

It’s difficult to analyse how the US has got itself into this position. There are many factors, including a collective cultural desire to be anaesthetised from whatever is disturbing or difficult. That’s been made easier by having a medical profession that’s symbiotically in cahoots with the insurance industry, making the feeding of addictions a win-win situation for both sectors.  The human fallout is horrifying and there is probably not a family in the country that does not have someone who has been affected by this.

Reading this article (ht: Rohit Rajendran) in the ‘Politico’ magazine made me recall the movie, ‘It is a mad, mad, mad world’.  I think the movie came in the Sixties. The extent to which electricity is consumed to ‘mine’ bitcoins boggles the mind. More fascinating are the quarrels and the social effects it has caused. It is a good piece of journalism.

The article does a very good job of explaining what ‘mining’ bitcoins is about and what forms a block and a blockchain, etc. I get it (kind of). But, I really wonder if it can ever threaten the monopoly of the State on money. If it does, its issuers become an alternative State. If it does not, it is a fad and a bubble. As long as the number of bitcoins does not exceed 21 million of them, its artificial scarcity value can be maintained. If it is increased, then it would begin to create doubts in the minds of authorities. Read it here.

Srinivas Varadarajan shared the link to a very thoughtful article on the ‘Tyranny of convenience’. Some sentences that stood out for me:

Particularly in tech-related industries, the battle for convenience is the battle for industry dominance.

Convenience and monopoly seem to be natural bedfellows.

Today’s technologies of individualization are technologies of mass individualization.

Convenience is all destination and no journey.

Struggle is not always a problem. Sometimes struggle is a solution. It can be the solution to the question of who you are.

We give other names to our inconvenient choices: We call them hobbies, avocations, callings, passions. These are the noninstrumental activities that help to define us.

Rajesh Raman shared the link to a long story in New York Times on how members of the Qatari royal family were taken hostage and the dizzy geopolitical calculations behind it. Worth reading, if only to understand a bit of the conflicts between nations (or, tribes) in the Arab Peninsula.

I liked this blog post of MarkGB on the demonisation of Putin. There are no villains nor heroes but only an understanding of high stake games that nations play. I am yet to figure out why the West is hellbent on driving the Russians into the hands of China.

Soeren Kern has a detailed blog post on the political correctness behind unreported rape and assault cases in Germany. What is the rationale for the political correctness or squeamishness?