Sunday, November 10, 2013

On political freedom versus economic freedom

(This is an e-mail I wrote out to a group of friends some time back, so dives into content without giving much prior context. Hopefully it still makes sense. I have blanked out the names used with 'xxxx'.)

I thought xxxx made an interesting claim the other day, which diverged somewhat into a discussion of how best should government pursue its activities of commercial service provision. Laying out my thoughts on the initial question at hand. 

I saw xxxx as making a statement about the respective behaviours shown by people when exercising economic freedom vs political freedom. There's a fair bit of political science research into how people vote, which mostly concludes that the rational voter hypothesis and the self-interested voter hypothesis are both false. People vote largely to signal group affiliation and are usually too ignorant to put in place a government that acts to maximize their well-being. One chief reason why this is so is because there isn't much of a premium from selecting the 'right' government or a disadvantage from selecting a 'wrong' one , directly, to the populace at large. The benefits or harmful effects of governance performance seep in over long periods of time and very indirectly, so closing the rationality loop is hard. On the other hand, with economic decisions, people have relatively good and quick feedback mechanisms - they start losing money if they're stupid - which promote rational i.e. sensible decision-making. 

Note that this is at odds with the standard MIT-NeoKeynesian econ literature which assumes away the government as a benevolent and competent dictator which can step in every time there is an externality that the market fails to internalize or solve.

Thus, some have claimed that the presence of economic freedom is actually more liberating and optimal than the presence of political freedom - for example, we shouldn't really care if our political landscape is dominated by the same party/ same people  as long as the govt gets out of the citizens' everyday lives and lets them set up shops, businesses, pursue economic choices, etc. without much ado. Economic choice might be more important than having the vote. I thought this was the claim that xxxx was initially making.

It's an interesting, radical, powerful claim with more than a kernel of truth to it. I still disagree. 

My contention was that it is the claim of a deracinated individual, who begins with the individual as the unit of analysis, ends with the individual as the unit of analysis and thus reaches this conclusion. It could indeed be true for most of *us* . But it is not true for the world at large, especially in large, heterogeneous societies with tons of social correlations with existing opportunity. 

My contention is that the loop of feedback between your representative and you might be broken for geographically neutral, globalized individuals, but it is plenty strong for people in the 'hinterland'. They exercise choice through their representatives, quite frequently so, and multiple times even between the exercising of their vote. 

Why through your representative and not through individual economic decisions? The answer lies in what xxxx suggested was the issue with government - so many things happen in the background that affect/constrain your choices without your knowledge or control. This is true. And yet, it is as true of individual economic decision making as of the government, if not more.

I'll start with something quasi-financial in nature. Individual credit risk. Economic decisions can be financially optimized assuming away the cost of capital, which is often very *systemic* and beyond anyone's control. Consider the practice of bonded labour - now outlawed - in India, where failure to repay a money lender led to indentured servitude for the borrower for life. What is this transaction, financially? It is secured lending, collateralized by human capital. It seems like a terrible thing, but economically, it is about as free a system you're likely to see. The fact that modern systems with egalitarian sensibilities do not allow people to offer their human capital as collateral leads to restricted choices where the incumbent owners of financial capital - which *can* be offered as collateral - stand to borrow cheap and gain disproportionately. So why was this old system of securing borrowing through collateralized labour not successful? Why did it not lead to a reduction of credit rates across the board? Why was this near-risk-free borrowing extended at rates as high as 60% per month? 

The answer, perhaps, is that the borrowers were caught in a bad political equilibrium, where the exercising of economic choice did not - indeed, could not - liberate them. Their micro-economic decisions were overwhelmingly constrained by their macro-institutional exclusion. The market could not wrench them out of it, though political inclusion could.

Similarly, consider the perpetuation of influence through networks, politely called 'social capital'. This is again problematic for the brand of analysis that treats individuals in an ahistorical, arms-length fashion. Our lived experience, daily, reminds us that we are not so much as individuals as somebody's son, somebody's daughter, somebody's friend, part of some elite/not-so-elite cohort etc. Again, *our* experience might be somewhat different, as we operate in highly sanitised, almost game-like environs where a basic level of social capital has been accumulated, and hence assumed away. The rest depends on the individual and so we tend to observe and place greater weight on individual-centric explanations of opportunity, success, achievement. But this is simply not true for very vast sections of very large societies, where there is tons of path-dependent baggage to be utilised or shed away before one can even begin to make use of any little bit of economic freedom. 

Nevertheless, it is interesting that though my own country operates on a belief much similar to mine - political empowerment first, before economic freedom - the results have not been too good. This is probably because political empowerment, through its very nature, is handed out in a 'group' fashion, and the result in India has been that while many groups do indeed  reach better political equilibria, they often do so only at the expense of pushing another, worse-off group down below them. The scarcity of economic opportunity no doubt plays a part in creating this scarcity of political opportunity as well - so xxxx may have a strong point despite my arguments to the contrary. But not for the reason he thinks.

NB. Note that none of this has to do with the 'service delivery' aspects of governance, which is where the conversation turned the other day. For the record, I do believe that cash transfers done right go a longer way than direct provision for most goods or services. Development economics research consensus (to the extent that there is one) seems to be that the only interventions where in-kind benefits consistently outperform cash transfers seem to be health interventions (ORS/ mosquito bed nets) - but for everything else, cash works better. Education in India is a primary example, with a plethora of cheap private schools cropping up in cities - schools that we would be horrified by from a 'quality' perspective - but which still deliver better learning results than government schools.

Monday, April 29, 2013

A typology of monetary theories - II

Carrying on from where I stopped last time on the monetary typology

5. Henry Thornton : I sometimes like to think that macroeconomics - or at least modern monetary economics - began with Henry Thornton. During the Bullionist controversy, he wrote his magnum opus at the start of the 19th century. The text, revived in the economic literature through the efforts of Jacob Viner in the 1930s, reads more modern than a majority of contemporary monetary discussions. Thornton's work is possibly the first successful marriage of the currency and the banking principles (see pg 296 onwards here for more reference on the difference between the two). Schumpeter considered it the best theoretical monetary performance of the 1790-1870 era in his HEA (pp 657-658). Thornton anticipated Wicksell's cumulative process of the expansion or contraction of the economy, in what was a bid to explain the observed regularity  between issue of central bank liabilities and the nominal economy, which is simply assumed by the quantity theory of money (QTM).  As Schumpeter notes (HEA, pp 676-677, 702-703), only Ricardo and a few of his closest associates ever believed in the "strict" (we would today call it "naive") form of quantity theory. Thornton, though he was on Ricardo's side in the Bullionist controversy, sought to explain it using processes and phenomena that he saw in the 'real world', rather than posit it as a matter of logic, as Ricardo did. In all, Thornton represents the centre in the theory of monetary policy - comfortable with currency and credit, with quantities and rates, with a belief in the power of central banks, though acting through private financial agents.

6. Schumpeter : I label this cell with Josef Schumpeter's name borrowing from Ashwin, who describes endogenous money creation through banks' extension of credit as an idea that is first/best explained in Ch 3 of his book Theory of Economic Development. I haven't read it, so I will defer to Ashwin's judgement, with the caveat that Schumpeter was an unbelievably wide scholar of the history of economic thought, and it is my prior that someone so widely read is unlikely to hold 'polar' positions. So, Schumpeter himself might have been a 'Schumpeter-ian centrist', somewhere between the Thornton & Schumpeter cells in my typology. However, we are more concerned with what the cell signifies rather than the views of Schumpeter himself - so what makes for a Schumpeterian theory of monetary actors and mechanisms?

In short, this is a view that infuses the financial/banking system with a lot of autonomy, through both prices (interest rates) and quantities and thus renders the central bank a relatively smaller player in the purely monetary scheme of things. The endogeneity of money (supply) is a common heterodox position and a large number of theorists with widely divergent policy prescriptions - Austrians, Real Bills theorists, Post Keynesians, etc. - hold views on it which seem remarkably similar. I submit that what would be specifically *Schumpeterian* is the view that the financial system leads/should lead credit and money creation rather than responding passively to consumer or investor (real economy investors, i.e. businesses) demand. The argument is definitely a claim about how the world works but is perhaps also normative, enshrined in Schumpeter's twin views - as Ashwin describes it - of money creation through elastic credit as the differentia specifica of capitalism, and of the banker as the capitalist par excellence. This is in some contrast to the real bills view (banks/central banks *should* extend money only against safe, short term collateral) as well as the canonical Post Keynesian 'horizontalist' view that even privately created endogenous money is merely 'accommodative' i.e. responding passively to exogenous money demand. However, the monetary views of some notable 20th century empirical theorists - particularly John Gurley and Edmund Shaw - are of a Schumpeterian nature and the approach also resonates with Post Keynesians of a more 'Structuralist' persuasion - witness Thomas Palley or Bob Pallin.

7. Woodford/New View : In 2003, Mike Woodford wrote what continues to be the benchmark monetary theory text in graduate macroeconomics. Woodford visualized a "cashless", or more precisely a currency-less economy where monetary policy is focused on price stability and is conducted using just the short rate, with the rest of the yield curve taking care of itself through financial equilibrium. While this has been seen as a modern take on a Wicksellian 'pure credit' economy, Woodford's attempt should also be seen as the proper development of the 'New View' of monetary economics that began with Jim Tobin's explorations of monetary economics in a world of modern financial internediaries and assets in the early 1960s. As Perry Mehrling notes, Woodford's work should be seen not simply as a New Keynesian reponse to the rational expectations revolution, but also as an initial attempt by modern macroeconomics to rise to the challenge of modern finance.

I identify the critical element of this view as the attempt to infuse the monetary sovereign with full policy control through a monetary instrument, even in a world of entirely interest-bearing money. Money is the numeraire, and the main monetary channel is expectations of future monetary action. In developed economies with elaborate forward-looking financial markets, in a world of treasury ETFs, money market mutual funds, zero-cost sweeps between demand deposits and time deposits etc. - the Woodford-ian schema seems entirely reasonable as the default prior to begin working with.

Rest to follow in parts III and IV.

Friday, April 19, 2013

A typology of monetary theories - I

As a much delayed follow up from my post proposing a top-level framework for thinking about business cycle macro, here's a framework for thinking about monetary theories.

Note that this is primarily about a theory of monetary mechanisms and propagation and thus corresponds better as a theory of monetary policy, rather than pure monetary theory, which would be more concerned with questions like 'why does money have non-zero value in equilibrium'. Yet, because of the centrality of the financial system in macroeconomic ups and downs and because of the growth of central banking with the urge to exert control over the financial system, arguably developments in the history of macroeconomic thought basically parallel developments in the history of central banking.

So here it is - a typology of monetary theorists and theories.

 Here, I've attempted to categorize monetary theories along two axes. The first axis deals with who is the primary monetary actor - central bank vs pvt banks & financiers. The second axis deals with what is the primary monetary mechanism - interest rates (real or nominal) vs the quantity of some monetary aggregates. Short notes on some of the cells follow :

1. Ricardo : As Schumpeter notes in his monumental History of Economic Analysis (Book III, Chapter 7, pp 657-719) the contemporary history of monetary theory goes back to the Bullionist Controversy in the early 19th century, and David Ricardo was the leading flag bearer for the currency school. Broadly speaking, a Ricardian monetary intuition involves a commitment to the quantity theory of money in some form or the other, a belief that 'outside' or central bank money is special, and that what is truly special about CB money is currency. As of today, Scott Sumner best represents Ricardianism in monetary thought. 

2. Old Monetarists : Old monetarists would broadly be people who focus on monetary aggregates, albeit both on base money (currency + reserves) and broad money (bank deposits etc.) aggregates. A classic tendency would be to focus purely on the liabilities of the banking system - as exemplified by Milton Friedman's contention that banks "also" have assets and that that's not quite important - and to infuse the central bank with a lot of control over the banking system. Nick Rowe would probably be a good example of a current theorist who is an old-style monetarist.

3. Real Bills Doctrine : This was the opposite side to Ricardo/Thornton in the Bullionist controversy, and this position has been revived a few times since. The basic contention is that 'money' - liquid media of exchange - is basically to be issued by pvt banks against high quality, short-term collateral. In old-school jargon, this went by the name of discounting against self-liquidating 'real' bills. Though this seems more like practical advice than monetary theory, the implied theory is easy to spot. Central banks are only supposed to respond to accommodate endogenous demand against specific, limited collateral, so that the primary monetary actors are private banks and financiers. Also, the restrictions on the quality and maturity of collateral to be admitted restricts interest rates to a rather narrow band - it is clear that quantities of collateral and exchange media issued are the main mechanisms here. As Perry Mehrling notes in his book on Fischer Black, Milton Friedman blamed this view for demanding that the central bank act in a pro-cyclical fashion and thus exacerbating business cycles.

4. Fisher : Irving Fisher created the first neoclassical macro model, and brought monetarist thought to the United States. He revived the quantity theory, but also brought to notice the monetarist paradox in interest rates - the observation that inflationary policies were associated with higher interest rates rather than lower. He conducted deep research into the construction of price indices and proposed that a monetary regime attempt to maintain price stability. It is clear that Fisher thought it was firmly within the remit and capability of central banks to maintain macroeconomic stability, through quantity mechanisms or rates mechanisms.

Descriptions of the other cells and some 'quadrant'-level aggregations will follow in the next post.

On Reinhart and Rogoff

If you follow macroeconomics or global economic policy, by now you'd be familiar with the recent blow-up over the so-called Reinhart-Rogoff (R-R) results. Carmen Reinhart and Kenneth Rogoff (R&R) have compiled and conducted some extensive research into the experience of countries following financial crises, which led to their book This Time Is Different. The central thesis of book was that financial crises have certain common, hence perhaps predictable, patterns, and among the biggest challenges in mitigating their occurrence or ensuing damage has been the tendency to believe that "this time is different". The book received plaudits when it was released - many have gone on to say that it's been their "bible" in the current global financial crisis.

A subset of the themes that R&R covered in their book was the dynamics between growing public debt and growth. This evolved into an independent line of published research, from which the 'headline' take-away was that countries with public debt/GDP ratios of over 90% experience strikingly slow growth, and thus the 90% level might be an intuitive tipping point beyond which may lie treacherous territory for sovereign borrowing. This argument, though made with suitable academic precaution, has been used or at least invoked by several influential policy-makers in developed economies with debt/GDP ratios exceeding the 90% level, as reason to impose a cutback in fiscal spending immediately. It is obviously at the centre of some of the most important global policy debates of our debates.

Now two days ago, Rortybomb (Mike Konczal) posted research from three University of Massachusetts economists (Herndon, Ash, Pollin) that tried to replicate the Rogoff-Reinhart results but could not. They found that the R-R results resulted from a rather messy combination of an excel code error, choosing to exclude certain data points, and devising a schema of weighting that seemed to skew the results and did not seem intuitively defensible. Unsurprisingly, the microcosm of the online world that cares about these things more or less exploded, first with schadenfreude, then with appeals to subtle readings, and very quickly, as is the wont of online discourse, to more systemic and 'meta' things like the central lessons to be learned from the debacle, the incentives facing economists, etc.

For a quick update on what has been happening, Felix Salmon has a good round-up and Tyler Cowen continues to act as a conscientious and indispensable clearing-house.

A short summary of just what has happened may be useful. First of all, though the schadenfreude is directed mostly at the Excel error, that error itself does not drive the biggest magnitude change in the result at hand. It pushes the growth experienced by countries with debt in excess of 90% of GDP from -0.1% to merely 0.2%. But removing the asymmetric weights and including all episodes changes it further to 2.2%, and that's really where the meat and juice of the debate lies. Rortybomb has further posted analysis by U-Mass economist Arin Dube that shows that the debt-slow growth correlation actually shows reverse causality, i.e. it's the slow growth that causes high debt ratios, rather than vice versa.

The economists themselves responded remarkably fast, and were forthcoming about accepting the code error. However, they insisted that firstly, they had only claimed association, not causation and secondly, at ~2%, growth for countries with public debt more than 90% of GDP was still a full 1% lower than that of countries with public debt less than 90%. The first is the plausible deniability of every sophist's argument - after all who gets global fame for simply showing that a high ratio is "associated with" a low denominator. It was always the potential causation hinted at which mattered and the op-eds that Rogoff and Reinhart wrote for popular audiences seemed to unambiguously hint at implied causation. The second may still be relevant, but ~2% vs ~3% simply lacks the jaw-drop value of less than 0% vs ~3%, and is actually not even statistically significant.

But the R&R defence wholly skipped over the deeper issues around including and excluding data points and arbitrary weighing schemata. On this, others have risen, not to their defence per se, but to shift focus and draw attention to the larger issues at hand. I have now seen a bunch of these arguments, and none of them are very convincing.

First up, let's get the 'any data analysis exercise will have to make these choices' bit out of the way. This is true, and for precisely this reason data analysis exercises offer, or should offer, at the very least, footnotes or explanatory pieces detailing these choices and a short note on why they were preferred to other choices. Investment banking analysts are routinely laughed at for having plucked out of the air assumptions about projections of growth, industry growth, market share etc. and yet any half decent analyst would not dare offer his or her work without detailing qualitative reasons for the quantitative assumptions being made and a list of sensitivities. Arguably, the former is more important and should be dealt with at depth by an academic - especially if the choices being made are not prime-facie intuitive (like, say, removing a 10 sigma outlier). It is worth pointing out that the main reason R&R come up with the 90% figure is because their intervals are of 30% i.e. they split the data into buckets of 0-30%, 30-60% and so on. This is purely a modelling choice artifact, and the actual tipping point, assuming any exists, may be 80% or 110% or 93.7%.

Here, a good way of going about it might be to to set up a graph and see if there are any natural 'inflection points' and if the simple graph between the two variables won't do, consider natural transformations like time-derivatives or logarithms until you get a graph with an inflection point. Ultimately, your data range choices have to make intuitive sense to numerate people. If you have to torture the data too much, it's quite possible you're looking at a very banal reality.

Another set of defences underscores the point that the episode mostly shows the pitfalls of macro analysis owing to the small data sets available. While true, this is inapplicable to the issue at hand. This is a problem with all data sets that show structural transformation, even if they go back a long time, and so with all data sets that concern themselves with the socio-commercial reality of our society. R & R stand questioned not because they made a prediction using analysis that came unhinged because the original analysis suffered from a small data set. Given the small data set, they chose to transform it in such a manner that very different conclusions were reached than if those transformations were eschewed. These transformations are reminiscent of the sham that passes off for the concept of risk-weighted assets when calculating capital ratios for banks - I contend that the fineness achieved was outweighed by the robustness lost due to it, and that this would have been true even ex-ante.

Finally, some have made the point that R&R are simply reacting to the incentive system in academic economics and popular commentary. Economics, it turns out, is a discipline that does not prize replication of results the way hard sciences do, and prizes novel insight more so that the errors of the type of R&R are rife through the profession. R&R might actually be ahead of the curve by engaging with the criticism so openly. Further, popular commentary obviously rewards strong claims more than agnostic and possibly sterile data inference exercises. Ergo, the choices that R&R made follow. Even if these arguments are true, one is forced to ask - should we then resist the urge to trash R&R or simply add the urge to trash the entire economics profession to the mix? Moreover,  is it alright to apply the leeway in standards that we may be able to afford an up and coming popular essayist or a graduate student seeking a job and tenure to Kenneth Rogoff and Carmen Reinhart. Rogoff has been the chief economist of the IMF, is a member of the super-elite Group of 30 and was a student of Rudiger Dornbusch (who advised several LatAm governments in the '80s) and Stanley Fischer (possibly the macroeconomist with the most star studded policy experience ever) during the phase at MIT which has produced some of the most prominent international macroeconomists of our era (Bernanke, Obstfeld, Krugman, Frankel). He is a plausible contender for the topmost policy jobs in a Republican administration. Reinhart is somewhat less entrenched, but is also a tenured professor at Harvard, a top-10 authority on sovereign debt and default especially in emerging nations, and brought the term 'financial repression' into the modern macro lexicon. By any stretch, they are as about as elite as the academic macropolicy elite gets, and remember that these are days when macroeconomists are disproportionately at the centre of the global policy elite.

No, this defence from diminished expectations won't cut it. To check how diminished our expectations may have become, see this otherwise brilliant Neil Irwin piece where he seems thankful to R&R for simply compiling and collating the data that backed their broader research.

Reinhart and Rogoff did a shoddy job and deserve most of the ridicule coming their way. 

Saturday, February 02, 2013

Reductio ad absurdum - an inefficient technique?

Reductio ad absurdum is the Latin term for a common device of rhetorical debate - the proof by contradiction. In high school mathematics, proof by contradiction was one of top few tools or methods employed to prove theorems. As a younger man, less comfortable with ambiguity and less familiar with probabilistic reasoning, I was absolutely in love with the device. You assumed that what had to be proved was not in fact true, deduced from it a result that was clearly absurd. Since the absurdity could not be true, the initial assumption must have been flawed and the proof inexorably followed. The result was clear, simple, strong, elegant and inescapable. Marvellous platonic beauty.

Proof by contradiction at its core relies on a simple but powerful element of formal logic that students of philosophy or computer science should instantly recognise - the equivalence of the contrapositive. Formally, this is stated as 

A -> B = ¬B -> ¬A, or 

If (the truth of) A implies (the truth of) B, then not B (the falsehood of B) implies not A(the falsehood of A), where A and B are both statements which could be true or false.

Perhaps all that sounds excessively jargon-y or convoluted, but the chain of reasoning is simple and essentially the same as that employed in high school math

1) Assume that statement A is true.
2) From that, deduce that statement B must be true.
3) Show (or it is perhaps common knowledge) that statement B is false.
4) Hence, statement A is false.

But  reductio ad absurdum isn't just about high school math. We often hear the distinction between necessary and sufficient arguments being made in less formal, verbal debate. Well, A -> B is the same as saying that the truth of A is sufficient (but not necessary) to show the truth of B, and the corollary that the truth of B is necessary (but not sufficient) to show the truth of A. And knowingly or unknowingly, we make a number of arguments and critiques that rely on embedded reductio ad absurdums.

A couple of recent examples have made me wonder if this is indeed a good way to make a point. My hypothesis is, reductio ad absurdums are likely to be misinterpreted even by intelligent people who are not sympathetic to your stand. Of course, that's plausibly true for all arguments, but the trouble with reductio ad absurdums is that you can be (mis)interpreted to be saying the exact opposite of what you set out to say. Let me illustrate using the two examples, from 'opposite' sides of a rather contentious issue in India, that are currently on my mind.

Example 1- Rajdeep Sardesai vs Swapan Dasgupta

First, we have Rajdeep Sardesai (RS), editor in chief of CNN-IBN, being accused of calling Dawood Ibrahim, India's most wanted criminal and terrorist, a patriot. The basis of this claim is an op-ed he wrote about a month after the Mumbai blasts of 1993. The op-ed is reproduced here. RS's article is a critique of the statements and politics of the now-deceased Shiv Sena chief Bal Thackeray and an impassioned plea that all Muslims must not be tarred by the same brush. The relevant controversial passage is this:
Indeed, the loyalty test is so patently superficial that it is bound to be exposed sooner or later.  For example,  Mr. Thackeray has always seen support for the Indian Cricket Team when it is playing Pakistan to be a mark of a true patriot.  He might be intrigued to learn that during the one-day internationals in Sharjah, one man who speaks fluent Marathi has been spotted waving the tricolour and vociferously cheering the Indian Team.  His name is Dawood Ibrahim."
The accusation started with people picking up on what another prominent journalist Swapan Dasgupta (SD) wrote on his blog after the Mumbai blasts of 2006. 
Working in the Times of India during those turbulent days, I recall the editorial savagery which greeted the suggestion that the ISI and Dawood Ibrahim had anything to do with the blasts. Rajdeep Sardesai even wrote an edit page article regretting that Dawood’s patriotism was being questioned by nasty saffronites
See what I'm driving at? RS's argument is of the type:

Statement A : (The Bal Thackeray Test) Those who support the Indian cricket team against Pakistan are true patriots.

Statement B: Dawood is a patriot.

Given the information that Dawood flies the tri-colour and cheers for India vs Pakistan in cricket, A -> B. But since we know that ¬B (it is common knowledge that Dawood can't possibly be a patriot). Ergo, ¬A. The Bal Thackeray test is false. QED. Proof by contradiction.

This is a correct and strong argument, almost trivially so. Yet, SD accused RS of implying that Dawood was a patriot. Of course poor RS says, directly, "the loyalty test is so patently superficial", so one would have thought that things would be clear. Apparently not. If someone doesn't share your politics or worldview, your reductio ad absurdum will be made to look like the exact opposite of what you're trying to say.

Example 2 - Meenakshi Lekhi vs Aakar Patel

Recently, NDTV had a panel debate on the implications of the Gujarat chief minister Narendra Modi's possible rise as the BJP's Prime Ministerial candidate for the 2014 general elections. Six panelists discussed and argued about a lot of things, especially around politics of development vs politics of identity. The video of the debate is here

Prof Najib Jung, the vice-chancellor of Jamia Milia Islamia made the claim that the BJP is likely to lose a significant share of the Muslim vote were Narendra Modi to ascend. BJP's representative on the show, Ms. Meenakshi Lekhi (ML) inferred this as saying that with Mr. Modi at least, the politics of identity is likely to overpower the politics of development in Muslim voting patterns. She counters this by saying (beginning at about the 27 minute mark in the video)
ML : I have a question for Mr. Najib, what does the Muslim want? Does the Muslim want to be.. going to Pakistan? Does the Muslim not have the same nationalistic fervour as anybody else? Does he not want his children to be going to the same schools as others? 
(interruptions)..This is a highly insulting....(interruptions)
ML: That's exactly my point, it's not insulting,'re insulting the intelligence of the common Muslim...
(interruptions and cacophony)
Aakar Patel (AP), another prominent journalist and a keen analyst of Narendra Modi, took strong exception  to ML's argument on the show and was driven enough to pen his coloumn in the Pakistani daily Express Tribune slightly ahead of his normal schedule, where he claimed that the Indian Muslim "lives on sufferance". He had this to say about the show in question
On Nidhi Razdan’s show on NDTV on the night of January 29, I was on a panel, discussing Narendra Modi as a prime ministerial candidate. In the Bharatiya Janata Party (BJP) corner was a woman called Meenakshi Lekhi. Midway through the discussion, she asked a soft-spoken man, Najib Jung, vice chancellor of Jamia Millia Islamia, if he thought Indian Muslims wanted Pakistan.
Why did she bring this up? I don’t know, and there was no occasion to. But it was dropped in casually because it’s the natural thing to say to a Muslim here — hey, are you guys Pakistan-lovers? Tell us the truth, now. 
Again, see where I'm driving at? The structure of Ms Lekhi's argument was :

Statement A : (Najib Jung's implicit contention) The Indian Muslim will relate more with religious identity than nebulous notions of development.

Statement B: The Indian Muslim relates with Pakistan , wants separate (religion-specific) schools.

Since Pakistan was a nation formed on the basis of religious identity and religion-specific schooling is again a question of prioritising religious identity over other things, A -> B. However, it is assumed to be common knowledge that B is not true. ¬B. Ergo, ¬A. Proj Jung's contention falls. QED. Proof by contradiction.

Now, the validity of parsing of Prof Jung's views may be questionable, but the argument as made by ML stands. It is logically correct. Yet, AP interprets it to mean that ML is calling into question the motives of Indian Muslims, while her argument stands precisely if one assumes that the motives of Indian Muslim are not based on religious identity and are above question.


Now obviously, there's a huge amount of meta-knowledge here about Rajdeep Sardesai, Swapan Dasgupta,  Meenakshi Lekhi & Aakar Patel that followers of the Indian political scene will be familiar with, that explains their statements and interpretations. But deconstruction is not what I'm interested in here.

My limited point is - even within the overall futility of trying to convince those that disagree, the reductio ad absurdum is particularly inefficient. People will either not pick it up, or interpret it to mean the exact opposite of what you intended. I will certainly try to avoid the proof by contradiction in informal debate.

Thursday, January 24, 2013

The Tax/GDP ratio and Mr. Subramanian's strange contention

Arvind Subramanian, has written a curious op-ed yesterday in which he tries to judge the performance of the state of Gujarat vis a vis other states through its ability to generate tax revenues as a % of its GDP. This is a slightly unconventional metric, and Mr. Subramanian lays out the philosophical justification for it early on. He says
Historically, institutional development has been associated with effective taxation. Taxation is the glue that binds the rulers and the ruled; fact that they are taxed gives citizens an incentive to hold rulers accountable, and this in turn helps to ensure that the latter deliver value for money by way of efficient services to citizens. “No representation without taxation” is, thus, one of the key insights of political and economic development. A corollary is that reasonable (but not onerous) taxation ensures that good governance will be durable, outlasting individual leaders
This sounds reasonable in so far as it goes. Mr. Subramanian makes both a cross-sectional as well as longitudnal comparison, i.e. between states as well as across time. Globally, cross-section tax/GDP ratios have a debatable relation with state capacity but the time-series shows the Wagner law - increasing prosperity is strongly correlated with an increasing tax/GDP ratio in most nations. So far so good.

But the leap that Mr. Subramanian makes from there, into positing that the own tax revenues (OTR)/ gross state domestic product (GSDP) ratio for Indian states is an operationalization that accurately captures the letter and the spirit of the above philosophy and empiricism, is unwarranted. India's highly centralized fiscal framework means that states collect only a limited set of the taxes that its consolidated governments impose on its citizens and firms. Broadly, these include goods/consumption taxes (state VAT and excise), stamp duties, registration taxes, motor vehicle taxes, tolls, etc. Income taxes, corporation taxes, central excise, service taxes etc. are controlled by the centre and then evolved to the states through finance commission recommendations. It's not at all clear why a taxation schema that is entirely devoid of direct taxes can be considered a good guide to the fiscal or development capacity of a particular state government in India. In other words, even if one accepts Mr Subramanian's philosophy, his key metric does not necessarily follow.

So what does the OTR/GSDP represent? Mr. Subramanian subjects it to a smell test - we 'know' that AP, Karnataka, TN are governed well and they seem to have high OTR/GSDP and we 'know' that West Bengal is governed poorly, and it has low OTR/GSDP, so surely we must have picked the right metric. But this smell test raises more questions than it answers.

1) Good governance was supposed to be important for economic development - where is the proxy for economic development? Is it per capita GSDP and we're just supposed to 'know' it?

2) Even so, why would a schedule of indirect taxes and stamp duties that are not progressive in rates (for a given state, Rs.100 spent on a certain commodity or transaction attracts the same rate of tax as Rs. 10,000, unlike, say, for income taxes) display progressive properties and be increasing in economic development?

3) If consumption taxes in India are indeed highly progressive through qualitative differences - e.g. essential products are charged at 0%, while non essentials variably between 4%-5% and 12.5% - do the differing tax/GDP ratios simply reflect differential consumption mixes across states rather than any governance attributes? Does this have development or state capacity implications?

4) Even beyond a general progressive effect in consumption, do the differential OTR rates simply indicate one or two critically divergent sources of sales and excise revenues? To give one example, the states of AP, TN & Karnataka all collect own tax revenues of the order of Rs. 400 billion every year, of which nearly 50 billion each year comes from liquor sales, which are banned in Gujarat. This is about 1% of the GSDPs of these states. Is that all there is to the inter-state comparisons? Does a divergence between states in liquor revenues over the last 20 years mostly explain the time-series divergences?

5) If the consumption patterns aren't very different, does the OTR/GSDP simply reflect differential tax rates for similar commodities or transactions? If so, does it show up in the price levels between the states and has this been controlled for? Should it be controlled for? Do inter-state price differences have consumption implications, controlling for wealth and income?

It is far from obvious that OTR/GSDP is a measure of anything that proxies well for the development capacity of a state.

Mr. Subramanian is upfront about some challenges that he sees could be offered to his thesis, including what he describes as the ideological right-of-centre argument of low taxes = private sector led growth. Surprisingly, he offers no counterpoint of his own to this challenge - having seen the opponent's move, why does he not think ahead and play his next one? But this line of argument is not central in my view, given that direct taxes on personal income and corporation income have simply been excluded from the states' tax schema and thus this analysis by construction.

A typical critique of Mr Subramanian's has been made by R Jagannathan at Firstpost. In his usual style he packs one or two good arguments with a set of weak and annoying assertions. Mr Jagannathan rightly takes Mr Subramanian to task for speculating on Gujarat's development performance as a function of its OTR/GSDP ratio without considering Kerala, typically offered as the anti-dote to the 'Gujarat model'.

However, he goes on to make some rather strange assertions. He talks about Gujarat's agricultural spike that yields no income taxes, but this is neither here nor there - an explosion of skilled salaried professionals in Bangalore will similarly increase Karnataka's GSDP but not so much its OTR because they pay the their income taxes to the centre, not the state.  He argues that stable and increasing tax/GSDP ratios are a function of political stability. Sorry, what? Political stability helps tax revenues grow as a % of GDP how exactly? Can we atleast have a bare-bones argument to place our faith upon? He also seems to believe that since Gujarat focuses on infrastructure and the other states on services, which are inherently 'profitable', the other states have an advantage in revenue collection. Again, how exactly? What taxes do these non-infrastructure corporations pay to their respective state governments out of their outstanding profits? He goes on to allege Gujarat's neighbouring states for its failure to draw more revenues from infrastructure. Umm, ok. These are shallow speculations, excusable in a reactive casual conversation, but not worth a place in what is supposed to be an analytically founded editorial response. (To be fair to him, the greater disappointment is that Mr Subramanian chose to make this about Narendra Modi's performance)

Another more interesting challenge is further offered by Mr Subramanian himself - again surprisingly without a counter-point of his own - where he sees Gujarat as offering a different set of tax vs service trade-offs to its inhabitants than other states, akin to a differentiating strategy in the classic Tiebout model of competitive taxation. But we come back to the same question - what really are the tax benefits being offered by the state of Gujarat to lure private investors that are differential? Stamp duty removal, capital returns for investments over a certain limit, exemption of electricity duties for SEZ units - these are bog standard sops offered by all industrial states to investors. Compare, for example, Gujarat's industrial policy strategy with Karnataka's and tell me if they're not both bending over backwards to exempt stamp duties, offer interest subsidies, re-imburse this duty and that. Not so long ago, we had articles arguing that other states may offer more sops, but Gujarat's development model was more sustainable. No, fiscal competition does not quite cut it.

Ultimately, we're left with the same fundamental dilemmas on the use of OTR/GSDP that we started with:
1) Given that ALL direct taxes are excluded, is the pure theory of taxation and state capacity even applicable to the OTR/GSDP ratio?
2) What is the underlying model and cause of progressivity here? OTR/GSDP is progressive as a function of what exactly? Is that something a good proxy for of a state's fiscal capacity?

A couple of other, minor points are also in order. It doesn't help that Mr. Subramanian words a key sentence rather poorly. Speaking of Gujarat's decline in the OTRGSDP ratio over the last 20 odd years, he says:
This decline is actually dramatic — because this was a period during which Gujarat grew very rapidly, which should have elevated its tax collections
As can be expected, this statement can be read as a schoolboy mistake, confusing absolute numbers and percentages, which I don't think he's guilty of. He's most likely making a point conditioned on the assumption of progressivity of OTR/GSDP, which goes horribly wrong exactly because he has not elsewhere given evidence that he has handled the question of progressivity.

Further, the data that he offers in his charts and tables - though I think they're only tangential to the key issues here - look somewhat strange. The average OTR/GSDP seems overstated by more than a percentage point, going by this data from RBI which is referred to as a source by Mr Subramanian's charts. Perhaps I'm looking at the wrong set of figures - the main RBI report is close to 400 pgs and I've not had the chance to go through it in detail. Still it would have been nice to be able to easily reproduce Mr Subramanian's data at source.

To conclude, it is unfortunate that Mr. Subramanian chose to use his preliminary findings to make what is a weak and unfounded political point, because the pure analytics of the line of research he's pursuing is important, interesting and prima-facie, deleteriously stunted. The business of comparing this chief minister with that and speculating on comparative development performance with one unsettled metric is best left to political dilettantes, available a dime a dozen in the edit pages of our main broadsheets. I would have expected Mr Subramanian to offer insight, and engage in a deeper meditation on refining precisely what measure of fiscal capacity might indicate development ability, and why. His academic work on this with Utsav Kumar is still forthcoming, and one can only hope that in its more developed form, it will grapple honestly with the sort of questions that I've raised here.