Of Thought & Action

The 2011 Economics Nobel - Christopher Sims

2011-10-11T22:48:00.003+05:30

(Note : This was earlier written as part of the previous post, so it begins abruptly where that one leaves off. It got so long that I split the post into two. I am beginning to think that even very knowledgeable economists may have fundamentally mischaracterized Sims when they see him as someone primarily useful for empirical techniques)

I found Chris Sims much more exciting - digging into his work was a whole new level of education. This dude should really have been blogging! First of all there is the fact that his VAR, SVAR models and techniques require as few structural assumptions about the economy as needed. This I now believe is an important objection to all mainstream/blogosphere macro that tackles policy issues - why the need to presume unidirectional causality arguments? (If logical causality was to become the dominant paradigm in macro, shouldnt we all be Austrians by now?)

Indeed, Scott Sumner's critique of VAR as possibly misidentifying nominal shocks and reversing causality looks exactly wrong at first cut - that's precisely the kind of pitfall that VAR models seem to be trying to avoid. Second, and more importantly, Sims is almost wholly free of policy and worldview biases in the issues that he tackles. This is absolutely remarkable - almost unique - in a macroeconomist who writes most frequently on monetary issues. Lastly, Sims is about so much more than the empirical techniques! Reading even 2 or 3 of his papers is proof enough.

Here are a few gems I found in Sims's research:

1) Limits to inflation targeting - "Inflation targeting may do more harm than good if there is a substantial chance that the central bank cannot in fact control inflation. .........These considerations suggest that in those countries where inflation control has in the past been most difficult, inflation targeting may be least useful......."

2) Central banks are not really independent, sometimes not even monetary in countries with structural deficits

3) IS/LM critique (this one actually has several great sections worth reproducing in full)-

"Since the equations he wrote down did not include an explicit role for

expectations, the ISLM codification of Keynesian orthodoxy could plausibly ignore

them, and did so. This not only distorted Keynes’s thinking, it ironically weakened

Keynesian orthodoxy in the face of the rational expectations critique"

"A coherent Keynesian approach, accounting for endogenous expectations, implies very

strong effects of monetaryand fiscal policy and leads to greater attention to the

role of the government budget constraint in making the effects of monetary policy

conditional on prevailing fiscal responses, and vice versa"

"If money illusion, lack of foresight, and decision-making inertia are important

in macroeconomic dynamics, it seems more likely that they are important in labor

markets than in the majority (value-weighted) of investment and savings decisions"

"It is useful to recognize where we are introducing non-neutrality into a model and to bear in mind the limitations of non-neutrality assumptions. But it was one of Keynes’s central

insights that in this respect a little ad hockery is not too high a price to pay for

maintaining a model’s grip on reality"

"That an interest rate increase engineered by the central bank could exacerbate rather than reduce inflation, is commonly recognized in current policy discussions ... " (Is this mechanism at work in India these days?)

4) The price level in an open economy depends on the level of government debt

5) When does monetary policy determine the price level, when does fiscal policy. What to do at the zero lower bound.

6) Government bonds are like equity; TBTF bonds are almost like government bonds; Berkshire Hathaway is almost like a government

7) The biggest risks that the European Monetary Union faces : this one is beyond outstanding. It has so many great ideas that I can't even select properly. It describes most mechanisms at work in the Eurozone today, comprehensively. Oh, and it's written in 1999. Which makes it single best macro prediction I have encountered yet.

Phew, that's not a few, that's a lot. And there are many more. Chris Sims has basically tackled almost every major macro/monetary policy and theory conundrum head on in his career, and has outlined mechanisms that almost completely describe the macroeconomic funk (he does abstract out of finance and default) that developed economies find themselves in these days. He's done this about 10-15 years ago. He handles fiscal & monetary policy symmetrically, recognises the areas of overlap between the two, handles disequilibrium as well as rational expectations with equal ease, creates models that have monetary as well as fiscal non-neutralities, looks at open economy dynamics and explicitly recognises and models various deficit financing as well as budgetary constraint choices. Most importantly, he twists theories to suit facts.

And you're telling me that he is a VAR technician?

I feel almost obliged to link to an early 90's critique by Larry Summers of empirical macroeconomics, of exactly the kind of epitomised by Sargent & Sims. Summers is more appreciative of Sims's VAR models than of Sargent's 'deep parameter estimations'. I had enjoyed reading the piece earlier, agreeing with the basic philosophy though I had no real idea about the details. But I now think that Summers critique is basically summarized as 'empirical macroeconomics has not been useful yet' and I am less convinced. 'Yet' can be key. And as Noah Smith says here, the lack of conclusions from VAR models may be a feature not a bug. Could it be that the theoretical as well as 'pragmatic empirical' macro that Summers prefers pretends to tell us more than it really does?

I read one criticism somewhere that VARs are models with linear dynamics and as such may be unhelpful in describing the fundamental non-linearity of the macroeconomy. This sounds more reasonable to me. But then what do I know.

Either way, I found digging into Sims's work a mind-opening, nearly mind-bending endeavour. I invite everyone interested to do the same. You can begin with this interview here.

(Update : Have corrected some formatting/typo issues in this post as well as the previous one. )

The 2011 Economics Nobel

2011-10-11T18:09:00.005+05:30

Thomas Sargent & Christopher Sims have received the 2011 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. Tyler & Alex posted some excellent summaries (1, 2, 3, 4) over at Marginal Revolution. Others (Krugman, Sumner, Noah Smith) posted their own sets of congratulations, inferences & comments.

I'd heard of both but was until yesterday extremely unaware of the work of either, barring a faint memory of having read something (by Robert Hall, perhaps) about Sargent's place on the freshwater - saltwater spectrum and knowing the full expansions of VAR and SVAR. So yesterday was a day of great education. It is noted that this was a prize for 'empirical macroeconomics' or even 'macroeconomic empiricism'. Everyone also made amply clear that as true blue empiricists, both Sargent and Sims hold views and have published papers that sit uneasy with almost all ideological and policy camps. I found that the theory and policy implications, as well as the historical context, were often more revealing than the sophistication of the techniques, which I'm ill equipped to comment on.

Tyler linked to two of Sargent's most influential papers (1, 2). While the broad takeaway from both seems to be that monetary policy and fiscal policy must usually act together for either to be really effective in a business cycle, it was interesting that Scott Sumner linked approvingly to a paper titled "Some Unpleasant Monetarist Arithmetic" which claims that monetary authorities may be powerless in managing the price level and open market operations may end up achieving the reverse of what they intend to. On reading the paper, you understand why - Sargent's paper is about the importance of expectations in general and uses ratex (though he doesn't assert or necessitate that ratex is the right way to model expectations). Sargent also uses definitions of 'tight money' and 'easy money' that belong to a different era and that Scott has completely disavowed. But I still find it a little bit of a cheat that Scott doesn't mention the government debt mechanism for this counterintuitive result (more on this later), nor does he so much as nod to the later introduction that this result may hold even in the short run and thus monetary policy effectiveness is fundamentally contingent on accommodation by fiscal policy.

Tyler also linked to this interview with Sargent that I did not enjoy much - he defended the 'state of modern macro' by essentially saying that macro researchers are more nuanced than they are being given credit for. This is true but it is a truism. Almost every academic worth talking about is more nuanced than popularly characterized - this does not tackle the basic substance of the critique. I also found it a bit disappointing that Sargent didn't subject his hypothesis on the Eurozone (pages 10,11 of 14) to his own strict empirical standards, otherwise he would have easily noticed that the default risks are better correlated with the size and volatility of the capital account surplus than the fiscal deficits. One interesting bit was when he talks about the Kareken-Wallace model of banks and bank runs as an alternative to the more popular Diamond-Dybvig. He compares the basic features, assumptions and gaps in both models and I recommend reading that section (pages 5,6 of 14) in detail. Noah Smith's take on Sargent is charming and well worth reading - he calls Sargent a 'badass' whose research sometimes proved too hot to handle for theorists who would have wanted him to side with them. (The last link is a rather damning indictment of Lucas & Prescott if meant in all seriousness and not as an exaggeration).

Update : There was a part on Chris Sims written earlier for this post. But as I kept discovering more while writing it, I realised it deserved a separate post.

The 'Old Keynesian' deceit, the crisis & Europe

2011-09-29T11:35:00.004+05:30

Paul Krugman, on Ireland. "And I have, of course, written repeatedly — both informally and in actual papers with diagrams and Greek letters — that in a deleveraging, liquidity-trap economy, wage reductions would reduce, not increase, employment "

Paul Krugman, on Ireland. "Look, standard Keynesian models, open-economy version, tell a very clear story about what happens when a country pegs its exchange rate at a level that leaves its industry uncompetitive. The country doesn’t stay depressed forever: high unemployment leads to actual or at least relative deflation, which gradually improves cost-competitiveness, which leads to rising net exports and gradual expansion. In the long run, full employment is restored; it’s just that in the long run we’re all, well, you get the picture"

So Professor, which is it? Does deflation reduce employment or increase employment? I know, I know. Reduce in the short run, increase in the long run. The challenge, is to tell us when the short run transforms into the long run in a deflationary economy without a change in the macroeconomic policy regime. When does the inflection point occur? What causes it?

The biggest empirical challenge to the Keynesian (ala Hicks, Tobin, Krugman) theories of the business cycle is not stagflation, as was earlier presumed. It is the paucity of the deflationary wage-price death spirals of the kind that you may expect or predict from these theories. Hyperinflations and sovereign defaults are much more common.

And if I understand my IS-LM (and I think I do), 'deleveraging' is not part of it. IS-LM is a plausible theory of the price of debt (of a very ideal, 'no credit risk' kind) , but it does not even begin to touch the level of debt, esp. risky debt. Among the many intellectual conceits of the Krugman/ De Long band in the past two years has been to casually add 'deleveraging' to the more standard terms of 'liquidity trap' and 'deflation'. I have nothing against adding to your intellectual repertoire. Indeed, it is the only way to approach anything even remotely complex. But to speak of deleveraging as if it has been part of their intellectual framework all along is just cheating.

For the past couple of years, the old macroeconomic camps and opponents have been mostly heat and very little light, with everyone either dropping their heads or dropping their pants. Initially, the finance and banking experts (Raghuram Rajan, Gary Gorton) were the ones to turn to. But now that the focus is back on the broader macroeconomy, I find it most edifying to turn to Ricardo Caballero & Ken Rogoff.

Among the bloggers, Scott Sumner remains the most consistently interesting, policy recommendation-wise. And the recently created David Glasner blog is just a goldmine. (Incidentally, has anybody else noticed that the RBI seems to be living a Sumnerian dream, by design or by default? India's annual NGDP growth for the past 4 odd years has consistently been stable in the whereabouts of 16-17%. 6% inflation, 10% growth ; 10% inflation 7% growth, etc.)

But the most radically simple and brilliant policy recommendation for 'balance-sheet-weakness-inducing-deficient-demand' type recessions has to be the modified 'helicopter drop' proposed by Steve Waldman here. He talks about the Fed, but there is nothing in that recommendation that can't be replicated elsewhere in the world. Or at least in India, should we need to.

The presumption, of course, is that there isn't a looming sovereign debt crisis. And that there is monetary independence. And enough fiscal consolidation to ensure that there is treasury's blessing for the central bank to undertake a quasi-fiscal action. Europe, therefore, is as a nice gentleman told me recently, quite 'shafted'.

Of Op-Eds

2011-08-16T15:25:00.003+05:30

Recently, Ravikiran blogged after a long time. Reading his post took me to the days about 4-5 years back when I had just started blogging, and the 'Indian blogosphere' (or at least the part of it that I engaged with) was a virile, juvenile and occasionally illuminating virtual space that had not yet been neutered by Facebook, Twitter, work and maturity. Out of nostalgia, I browsed some of his older posts. Among the most recent ones was a link to an editorial by Shruti Rajagopalan. It caught my eye due to the recent controversy over the sponsorship of the London Olympics by Dow Chemicals, the company acquired Union Carbide, which was responsible for modern India's worst industrial disaster.

It's a piece worth discussing for two reasons. One, it is very well written, concisely argued, compact yet forceful. Two, and more importantly, it is an excellent demonstration of the sheer futility of the op-ed as a non-fiction form of great merit.

Shruti argues that by preventing American tort lawyers from doing their customary ambulance-chasing out of an intuitive, paternalistic yet misguided and ill-informed sense of protecting the Bhopas Gas Tragedy victims from exploitation, the Indian government actually ended up causing them (the victims) more harm. The civil lawsuit was settled for the presumably low sum of $470 Mn; the criminal charges took more than two decades to process and ended in ridiculously lenient sentences.

Ravikiran talks about strict liability and judicial reform in his post linking to that piece. I don't have any good conceptual framework to analyse strict liability, so I won't go there. The need for judicial reform in India is a no-brainer, so I won't go there either. But the specific claim that Shruti discusses at length in her op-ed, the value of the civil settlement, is worth discussing. For this discussion, please bear in mind that Shruti's argument is explicitly utilitarian in a rather precise sense - she is making the claim that the Bhopal Gas tragedy victims were stiffed of just compensation, monetarily.

Shruti mentions that American tort lawyers typically charge one-third as commission fees from any legal settlement. Thus, a $470 Million pay-out would have needed to be $705 Million or above for the America-tort-lawyer way to be more successful than the Indian-government way. (Losses due to the leaks in the government distribution mechanism can be assumed to be the same in either case, and so are not material to this analysis).

So what would have made the payout $705 Million or more? Shruti claims that bureaucrats underestimated the fatality and injury rate, partially because of incompetence, partially because their incentives were not aligned with correctly estimating the right numbers. She does not charge (or even insinuate) outright corruption, but one may well imagine that to be a third source of error and manipulation. Hence, Shruti concludes that the Bhopal Gas victims were stiffed.

But wait, wasn't that conclusion contingent on the American tort lawyers being able to extract $705 Million or more? Do we have any evidence on whether that would have been achieved? We have some clue - she mentions that estimates of the death toll range from 4000 to 15000 (though she doesn't mention the sources of those estimates - if the bureaucratic estimate was 3000, the range should have been 3000 to 15000, at the very least). If it is 15,000 and the government was off by 5x, $470 million is rather obviously a prima-facie rip-off. If it is 4000, then maybe not, because the pay-out also includes injuries etc.

So what is the convincing evidence in the op-ed that the American tort lawyers would have been able to extract $705 million? None, actually. And that is the fundamental problem with a policy op-ed. Even the best ones are arguing from assertion, at some level or the other. Some are more nuanced than others, take longer time to figure out, but they all suffer from this same fatal flaw. Shruti believes (more or less correctly) that the bureaucrats' incentives are not properly aligned, and this leads her to believe and argue the result of their actions was necessarily sub-market-optimal. She doesn't feel the need to investigate the evidence required to go from the premise to the conclusion, or at the very least, doesn't feel the need to present it.

Data-based argumentation in policy is difficult. There is only one history. There are way too many variables to consider. There isn't enough data. You can't set up Monte Carlo simulations. You're not even sure if those would be useful at all. And in any case, if you were pursuing any of the above for writing something, that would be a PhD paper, not an op-ed. Shruti could have tried to collect data or evidence on the average pay-outs in cases argued by private tort lawyers in the US vs those argued by government counsel. Or in some comparable legal systems. But would she have found comparable or useful data? Would she have been able to draw any meaningful patterns? Most importantly, was it worth her time to do any of this for a thousand word essay?

And that's the thing about op-eds. They leave your posterior belief distribution almost exactly where your prior was. If you agreed more or less with Shruti's point of view, you would have found yourself nodding along, relishing the forceful prose, being appalled by the sheer injustice of government action and inaction. If you didn't and thought hard enough, the sheer lack of facts being used to argue her case (as opposed to simply the facts of the case) would become apparent. And you would dismiss the article as yet another speciously argued anti-government piece.

And if you were sitting somewhere on the fence, like I was, you would swing from this view to the other. Many times. And then wonder about the futility of the op-ed.

Of Light Bulbs

2011-06-11T16:18:00.002+05:30

Tyler Cowen gets one wrong. He approvingly refers to this article by Virginia Postrel. Ms Postrel's point, most generally, is that taxes or other commercial incentives are better solutions than regulatory bans. To the first degree, I agree. However, it is interesting to see how frequently she is wrong about the specifics that she is using/referring to while making the general point.

Ms Postrel is referring to the impending ban on incandescent light bulbs (called GLS in the lighting industry). She quotes Instapundit's dissatisfaction with the non-reduction in his electricity bills even after switching over to CFLs (compact fluorescent lamps). Okay. So? Controlling analysis for other variables, anyone? She believes GLS is a low margin commodity while CFLs are 'high margin specialty wares'. Are you freakin' kidding me? What are the odds that Ms Postrel has never read even a rudimentary analyst report on the lighting industry?

She refers to the American unwillingness to shift out of incandescent bulbs into CFLs. Okay. For the longest time, Bengal did not vote the CPM out. People are inertial. In this inertia, they make stupid decisions. Like not going to that expensive gym they have just taken membership of. Or not paying their taxes/credit card bills on time though these days, those payments are often just a click away.

She talks about the moral hazard problem makes this rule inefficient - about how people who know that CFLs consume less electricity are no longer incentivized to be careful about electricity usage and may end up leaving the bulb on for longer hours. Right. CFLs are about 5-6 times as energy effective as incandescent bulbs. The average American leaves the light on in his house for 6-8 hours typically (standard assumption in lighting calculations). If he shifts to CFL, Ms Postrel posits that he may be likely to leave the light on for more than 36-40 hours every day.

But the funniest part is reserved for the last. "The bulb ban makes sense only one of two ways: either as an expression of cultural sanctimony, with a little technophilia thrown in for added glamour, or as a roundabout way to transfer wealth from the general public to the few businesses with the know-how to produce the light bulbs consumers don’t really want to buy."

(emphasis mine)

Yes, apparently CFL manufacturing technology is one of the best kept secrets in the industrial world.

I invite Ms Postrel to read just one industry report on lamp margins by category. Or to visit one of the many CFL assembly operations around the world (mainly in China) to figure out exactly how high tech they are. Or, to just do some simple arithmetic before making claims on inefficiency.

Ultimately, she has exactly one point in her favour. That of the freedom of consumer choice. Usually, it's strong enough, but in this particular case, it doesn't seem so compelling to me. Else, you will soon see big protests or an active underground market in incandescent bulbs. (After all, marijuana has been illegal since forever, hasn't it?) I don't see that happening anytime soon.

As an aside, the US is a funny country. CFL is 3x the price of GLS and the adoption rate is just 25%. In India, CFL is 10x the price of GLS and the adoption rate is already 20%. And remember the fact that India is a fundamentally cash constrained economy, and the levels of electricity theft render the energy saving proposition useless in a few regions. For most Indians, the abiding value of GLS is not in its ability to light up fancy restaurants, but rather its promise of the being the only lamp you can buy with exactly one ten-rupee note in your pocket, the lamp that you grudgingly buy because paying up a 100 Rs. upfront is just not a viable option now, whatever its benefits in the future.

So tell me, have you also experienced Gell-Mann amnesia recently?

(Full disclosure : I work in the lighting industry, and my job is such that broadly, I'm happier when CFL sales increase. If you ask me personally, the tube-light remains lighting wise the best solution before the recent advent of LEDs, for many reasons. But then the upfront cost can be nearly Rs. 500 if you're also buying the ballast, and it's not a bulb-retrofit. )

Bad books - bleg

2011-06-03T23:56:00.003+05:30

One kid from the insti on an internship wanted some help on his project. He is supposed to recommend how to improve demand forecasting in one of our businesses. He has a recommendation, which is simple, intuitive but assumptive. He tests it on one data point. It works. He tests on another. It doesn't. He wishes away the evidence. I don't let him move on. He finally says something to the effect of - 'it's a theory, I studied it at the insti.' I don't remember studying anything of the sort, so I ask him where he read this theory. He whips out a book. International authors, fancy cover. 10 pages devoted to A/F ratio (the theory). I skim through it. It's 10 pages of tables with lots of data points, calculations of the mean and standard deviation of those data points, celebrating the normal curve and devotedly explaining why 99.8% may not be very different from 100% but 90% is (I'm not kidding).

Then, somewhere in between, there's one little sentence. 'Since the forecasting bias (A/F) of last season was x, we can assume that maybe it will be the same this season'. That's it, that's all. The entire model, the entire meat and juice, apologetically assumed way, to devote 10 pages to arithmetic, banal arithmetic at that.

I fancy a job as an editor sometimes.

To keep it alive

2011-03-06T17:10:00.000+05:30

Say you're researching/writing an article about the 'demographic dividend'. Say you're hypothesizing that it is the single biggest factor in India's recent economic growth. Say your evidence is the differences in inter state growth rates and inter-state working age population, between those states are doing well and those that aren't doing so well. Say your evidence shows you that the working age population in UP/MP/Bihar actually *declined* between 1991 and 2001.

What would your reaction be?

Option A. "Oh dude, I forgot. Migration. Let's dig deeper. and re-hypothesize."

Option B. "Uh-oh. Nevermind, who's gonna get that anyway. Let's publish."

Option C. "Damn! That's like the last piece in this tremendous body of evidence. Brilliant, let's publish!".

If your response is B or C, congratulations! You are now fit to write for Mint Lounge's economics coloumn.

http://www.livemint.com/articles/2011/03/04224138/Demographic-dividend-eases-dis.html

Forgive the vitriol, it's been very long.

Women's Reservation Bill & Socio-Political Policy

2010-03-08T15:51:00.006+05:30

A bill proposing 33% reservation for women in India's national parliament and state legislatures was tabled by the ruling Congress Party in the Rajya Sabha (upper house) today. Currently, it is in the process of being stalled in decidedly uncivil ways by those opposed to the bill, some elected representatives of dubious history. For today, I am cheering on the goons. Let me explain why.

My political philosophy is utilitarian. With the assumption of the zeroth law of all modern political philosophy - that political rights to all the governed will be equal - a version of preference utilitarianism comes closest to describing an ideal social objective. Give the people what they want, but don't privilege anyone's wants over anybody else's.

To a first approximation, people want to be rich and productive, to own territory, to be free and yet safe (from the territorial ambitions of others) and to not be very disadvantaged compared to others. 'Sovereignty' best describes the combination of liberty, safety and territory. 'Dignity' best describes the combination of relative and absolute aspects of the egalitarian ideal (nobody should die of starvation, nobody should be *very poor* compared to others). Prosperity, sovereignty, dignity - these are the sometimes conflicting objectives of an ideal social utility or welfare function.

An existing social order or legal status quo may be discriminatory. Women may be discouraged from ever thinking about a business or public career - some of them may be much better at the job than the present incumbents. Talented children of a disadvantaged background may never speak English as well as many urban nincompoops, curtailing their career options as well as national productivity. A legitimate farmer may have been dispossessed of his land to benefit an incapable land-owner two centuries ago by a foreign sovereign that is no longer recognized in the country. These are all impediments not just to the dignity of the people concerned (share of the pie), but also the prosperity of the entire society (size of the pie). Correction of a discriminatory social order can thus be a justified goal of policy for the purpose of both prosperity and dignity. The question is - what needs to be corrected and how best to do it?

Most discriminatory social orders manifest themselves as endowment failures. A policy that attempts to correct such an order while maximizing the combination of prosperity and dignity must aim at removing the relevant endowment failure, setting the equilibrium of the outcomes to be determined freely. Top-down reservations, of the kind embodied in the women's reservation bill, attempt to directly force outcomes - assuming that the endowment failures will then auto-correct. They end up maximizing neither prosperity nor dignity.

The most pervasive endowment failure is being born in poverty. Correcting for that - in the form of transfers and subsidies or economic status based reservations and affirmative action - is the highest RoI policy that one can have. This is a good case to support economic status based policy as opposed to caste based or gender based reservations, but it is not complete. Discriminatory social orders can often lead to significant endowment failures beyond poverty. A poor 'forward caste' student is much more likely to have indirect endowments - wealthy, well-educated, networked relatives or friends - than a poor 'backward caste' student. A poor boy will probably get to study in that good college away from home, a poor girl will be asked to drop out of school.

A case can thus still be made for reservations on the basis of gender or caste. Especially, if the reservation is in the law-making body of a representative democracy, where one can argue that the aim itself is 'representation' and not just efficient law-making. It's not a clinching argument, but it is one worth considering. And one must remember that the correct axis of representation is political aspiration, not any other part of your identity.

This argument thus does not really work for gender. Whatever is your preferred level of governance - the nation, the state, the local administration - geographical proximity is the best proxy we have for maximum shared political interests. Caste is rather strongly correlated with geography in India, but gender is obviously not. The constituencies that are reserved for SC/ST candidates are constituencies that have a significant majority of SC/ST population. That is clearly not the case with men and women. It has been proposed to select the reserved constituencies on a rotational basis, but that simply reduces the incentive to get re-elected (and hence to work in the constituency at all).

The fundamental problem with the endowment and representative aspects of the bill then is two-fold - gender is a good proxy neither for poverty nor for shared political aspirations. Moreover, the extremely top-down nature of the proposed reservations means that the new equilibrium will be a classic case of the somewhat disadvantaged crowding out the very disadvantaged. Most of the women who will get to compete on the reserved tickets will be those that are already politically well-off. Men and women will become more equal, but currently powerful women and currently powerless women will become even more inequal. A similar thing happened with caste based reservations. Top down forcing of outcomes does not level the playing field - it actually degrades the most disadvantaged even further.

And until now, we haven't even considered the fact that just as many women who are not given a shot at a career must be abler than many men who are, many men may be better representatives of the political aspirations (of both men and women) of a reserved constituency than all the women candidates. There is a loss to the dignity of these men, and there is a loss of national prosperity. What is more, just like with caste based reservations, the issue will later become part of the entrenched politically correct 'non-partisan' consensus in the country with no hope of being eased out.

The long term solution to the endowment failure of Indian women is surely a general fall in poverty and a more equal social outlook. That is however a long term outlook. Even in the short term, however, there are many better ways - even within the flawed ambit of quantity reservations - to implement a more equal polity and social order. One of the best ones is to reserve not constituencies but electoral tickets : empower women through a chance at political success, don't assure them of the result.

Reservation of seats in the national and state legislatures is a step that improves dignity of some people (currently powerful women) at the expense of many others (currently powerful men, currently powerless women). The effects on national prosperity are equally questionable. The bill must not pass and some uncivil representatives, abhorrent as they may be, are currently our best hope.

p.s: What confuses me, though, is what is the political benefit that Sonia Gandhi sees from such a move. Even if women were to prefer women over men as their representatives, why will women in a reserved constituency vote for a Congress woman over women from the competing parties? Does Sonia Gandhi really believe that such a policy has net positive social gains and is acting upon that? Is she obsessed with the legacy of her dead husband, who first introduced such a proposal in the parliament? Will Congress gain a significant number of votes by being remembered as the party that empowered women? I highly doubt that.

p.p.s: As I finish writing this, it seems that the goons have succeeded, at least for now. Bravo!

On Buiter and the Crisis

2010-02-19T18:26:00.003+05:30

In August 2008, a month before Lehman collapsed, Willem Buiter presented what he light-heartedly called the "longest paper ever" at the Jackson Hole Symposium. The paper made waves around the world for primarily two things. The first was its length, a staggering 141 pages. The second, and more substantive was its criticism of the handling of the crisis (until then) by the three main central banks in developed nations (the Fed, ECB and BoE).

I finished reading the paper two days back. For me, the best and the most striking parts of the paper were not those that dealt with a judgement on how the central banks had been handling the crisis. They were the connections that he makes between macroeconomic (output, price, inflation) stability, financial stability and the central bank's role in binding the two.

Buiter begins with the premise that in any financial crisis, the job is two-fold. First, the immediate damage to the economy at large has to be minimized. Next, the probability of occurrence of future such crises has to be minimized and better tools to deal with them have to be developed. He then offers (or borrows form others and integrates) several great insights on the linkages between macroeconomic and financial stability.

1) The short term interest rate is a blunt and indirect measure suitable for macroeconomic stability but not for financial stability.

2) Reserve requirements (or Cash Reserve Ratios) are a quasi-fiscal tax on banks when they offer no interest. When they offer interest, they can be used as tools of financial stability.

3) Asset price booms and busts are always asymmetric. So is the leveraging and de-leveraging of the financial system. Booms and leverage ratios always build gradually, though they can reach monstrous proportions. Busts and de-leveraging are much more rapid.

4) Asset price bubbles are driven, by definition, by non-fundamental factors. The short term interest rate is a fundamental determinant of asset prices and is thus too insensitive to be used to prick such bubbles.

5) It is not just huge commercial banks that are 'too big to fail' . Any reasonably large or inter-connected institution that has considerable leverage and the majority of its assets as financial assets are 'too systemic to fail'.

6) Two different but inter-connected kinds of liquidity crises can lead to and feed from a system-wide solvency crisis. One is funding liquidity, which occurs on the liability side. Here, a financial institution is not able to borrow overnight or short term to meet certain regulatory or business requirements. The other is market liquidity, which occurs on the asset side. Here, a financial institution is not able to sell an asset on its books in the market to get cash as the market for that asset has frozen. Clearly, the two kinds of liquidity are inter-connected.

7) The central bank has two functions in such a situation: as a lender of last resort (LLR) to solve a funding liquidity crisis, and as a market-maker of last resort (MMLR) to solve a market liquidity crisis.

8) A special resolution regime with prompt corrective action (PCA) measures is required to ensure that fundamentally insolvent financial institutions are allowed to fail (as solvency is a private good) without damaging the rest of the financial system and the economy.

9) In the LLR function and MMLR functions, central banks should be willing to accept as collateral and/or purchase and hold on their books large varieties of assets that may not be good today but will be good of held to maturity. The discount/lending rates on such lending and purchases should be punitively high.

10) Such lending and purchases have to be buck-stopped by the treasury, ideally by an immediate exchange of risky assets with sovereign debt between the central bank and the treasury. This is to ensure that the central-bank is not abused as a quasi-fiscal institution and the risk is undertaken on the books of an institution answerable to the democratically elected legislature.

11) The secured overnight inter-bank lending market (call money market in India or the Federal funds market in the US) exists mainly due to bizarre central bank procedures and is rather redundant. To set a truly effective official policy rate, central banks must be willing to borrow and lend any amount at that rate. Because central banks have punitive rates or quantity caps on the overnight lending and borrowing that they do from banks, effective risk free rates often diverge from policy target rates. (A good example of this is the call rate in India, which has been hovering between 2% to 3% for the last few months even though the reverse repo rate is 3.25% and repo rate is 4.75%.)

12) Any financial system has inside assets (where the asset and the liability are both financial in nature) and outside assets (where the asset is in the real economy and the liability is financial). Home equity and stocks are outside assets while home mortgages and debt instruments are inside assets.

13) The modern financial system has many layers and a majority of its assets are inside assets. Even a rapid de-leveraging of such a system can be sustained if it can be ensured that the effects don't spill over into outside assets. More importantly, the counter-cyclical policy measures to flood the markets with liquidity in a crisis need to be tempered by the fact that a lot of de-leveraging may simply involve inside assets.

14) Monetary and credit aggregates are important tracking tools and obsession with the short term interest rate is counter-productive.

Apart from these, he makes some other key points as well.

1) Lack of transparency in the pricing of illiquid collateral creates moral hazard problems. When coupled with the in-built adverse selection in the way the Fed prices these collaterals - it accepts the pricing of a clearing bank that is typically that is typically a business associate of the broker-dealer in question - the US had created the mother of all moral hazard problems even before Lehman went under.

2) Due to its failure to differentiate between inside assets and outside assets, the Fed reacts far too strongly to weak asset prices. Or, it has been 'cognitively captured' by Wall Street.

3) There is a structural break in the relationship between core inflation (doesn't include energy and food prices) to predict future headline inflation (includes everything). This is due to increased consumption by India and China. As a result, Fed's monetary policy has been too loose and as the financier of the world and the dollar-country, the US has been exporting this inflation elsewhere.

4) The US and UK have current account deficits as well as low-interest bearing assets. What this means is that the US and the UK are living on borrowed consumption being financed at effectively negative nominal and real interest rates! This won't continue for a long time. A massive outbreak of inflation will follow in the middle run (2-3 years) unless there is a structural change in the ratio of consumption to savings.

5) With foreign assets and liabilities at 500% of GDP, the UK is almost like a giant hedge fund.

Buiter also shows remarkable foresight when he contends that the fed funds rate (which was 2% then) might hit the zero lower bound soon enough, and that the worst is not over. He also makes the interesting proposal of de-linking reserves from currency, arguing that bank reserves kept with the central bank can pay a positive as well as negative interest (storage costs and security costs of cash will ensure that banks will not mind paying a small interest to the central bank to keep reserves). This could then free up the policy option to actually have a negative nominal interest rate to counter deflationary pressures.

Where I fail to understand Buiter is if he supports or opposes counter-cyclical capital requirements for financial institutions (which go up in times of plenty and down in times of crisis). Early on in the paper, he recognizes leverage as the key villain and endorses the Goodhart-Persaud proposal of counter-cyclical capital and liquidity requirements and extends it to all large leveraged financial institutions from just commercial banks. He also argues that such requirements should be based on rapid leveraged balance sheet growth of the institution in question and that national regulators can and should go beyond Basel II in ensuring this. Not much later, however, he takes his oft-repeated stance of 'liquidity is a public good, solvency is a private good' and argues that any extra liquidity requirements during good times to provision for the bad times is a privately and socially inefficient waste of liquidity. He also makes the same case in this blog-post, where he trashes precisely the kind of move by the FSA that he seemed to be supporting early on in the Jackson Hole paper. If his point is that liquidity provisioning in bad times cannot solely be a private endeavour then I agree, but he seems to be making the case that liquidity provisioning in bad times should be completely a public endeavour undertaken by the central bank which can create new liquidity almost costlessly. It is hard to understand how such a view reconciles with a support for counter-cyclical capital and liquidity requirements.

Nevertheless, this is probably the only paper in which one economist manages to form a coherent whole of a wide variety of divergent thoughts on the crisis. Read it at your own leisure. It will continue to be relevant long after this crisis is gone.

Macro Cube - 5

2010-02-15T17:37:00.002+05:30

By the last post, we were done with all vertices, edges faces and even a diagonal of the macro cube.

The interesting faces were

1. Social Democrat (SD) : SF - NK - DK - PK

2. Wicksellian / New Keynesian (WNK) : NK - NMC - MD - DK

3. Walrasian / Classical Liberal (WCL) : NC - NMC - MD - NA

4. Disequilibrium : NA - MD - DK - PK

I had said my own view of the macro-economy and understanding resonates and draws most heavily from the Disequilibrium and the WNK views. Let me explain why.

Based upon whatever little I have understood, there seems to be a case for :

1) Privileging money over other goods, but only just.

2) Privileging aggregate demand in the short run, but only just.

3) Privileging the banking and financial system as having special properties, but only just.

4) Privileging disequilibrium and non-optimization as the usual state of the economy, but only just.

5) Being wary of excessive leverage and short-term debt, but only just.

6) Healthy trust of the markets and skepticism of the government, without giving into the temptation of policy nihilism.

I find this set of principles best satisfied in the Disequilibrium and WNK versions of the economy. For a near- compulsive centrist and a non-believer in ideas in that try to re-invent the wheel (like me), this view presents two additional advantages. One, it is just the right distance of right from centre. Two, trying to incorporate it into the mainstream should not be too difficult - one needs to begin with the saltwater orthodoxy and infuse it with heavy dollops of disequilibrium and the financial system.

I believe that the economist who best represents such a school of thought is Willem Buiter. Buiter wrote a set of four essays (1, 2, 3, 4) in September last year that anyone interested in solutions to the crisis must read. Buiter's classifies his recommendations for fiscal stimulus into a broad framework of 'equitization of debt', a set of strategies that boosts aggregate demand while reducing leverage. Apart from Buiter, the ones that make most sense to me in the crisis and in general are - Raghuram Rajan, Barry Eichengreen, Kenneth Rogoff, Janet Yellen, Tyler Cowen and Rajiv Sethi.

Rajan was among the initial advocates of the brilliant solution of systematically important financial entities being partially financed by securities that convert automatically from debt to equity when there is substantial systemic risk. There's a fabulous interview here. Eichengreen's coverage of the crisis as well as his take on the gold standard as the proximate cause of the great depression are terrific. Rogoff has co-authored the book that is now almost universally considered the bible on financial crises and is the most reasonable among those that warn of sovereign defaults due to fiscal profligacy. Yellen was Buiter's favourite for the Fed Governor post and has a series of excellent thoughts/ speeches on the crisis. Tyler Cowen's macro is as eclectic and delightful as the rest of his thoughts and Rajiv Sethi is the most financially nuanced of those who try to model the economy as a non-linear dynamical system.

There are some common frameworks that unite and inform the macroeconomics of this seemingly disparate set. One is a keen understanding of banks and financial markets. The other is a habit of looking at international capital flows and political economy while analysing and recommending policies. The third, and most important, is a commitment to policy centrism and epistemic openness.

The cube has helped me place the confusing views of a large number of economists that I read in a somewhat more cogent framework. Scott Sumner, for example, is a monetary disequilibrium (MD) theorist who believes in rational expectations. I think it's rather impossible to be any kind of a disequilibrium theorist with a belief in ratex so I bump him up to Mo (Monetarist) from MD. Bryan Caplan's macro is a Disequilibrium/WCL mongrel that will resonate with that of Prof. J R Varma. If you're concerned how the Paul Krugman who recommended inflationary expectations as a way out of the Japtrap is now such an avowed fiscalist, you need only to realise that the macro of Krugman the MIT-trained theorist is WNK but that of Krugman the political polemicist is firmly SD - overall, he is simply a Keynesian (K).

And if you read and find both Krugman and Caplan persuasive, may I suggest the Disequilibrium - WNK space that I place myself into?

Macro Cube - 4

2010-01-23T00:46:00.008+05:30

At the end of all the heavy-duty categorising of the last three posts, this is what the modified Macro Cube looks like. It is now labelled at the vertices and edges with the theories that they represent. These are

NC: New Classical ; NCh: New Chicago

NMC: New Monetary Consensus

NW: Neo-Wicksellian ; NK: Neo-Keynesian

FK: Folk Keynesian ; SF: Socialist Fiscalism

SS: Supply Side ; A: Austrian ; NA: Neo-Austrian

OC/FB: Old Chicago, Free Bankers

MD: Monetary Disequilibrium Theory

Mo: Monetarist ; MK: Monetary Keynesian

DK: Disequilibrium Keynesian ; K: Keynesian

MPK: Minsky-like Post Keynesian ; PK: Post Keynesian ; FF: Functional Finance Theorists

RFD: Real & Financial Disequilibrium

Now there's only the faces and one rather interesting diagonal to go. The faces are easier : these are a collection of theories that a very broad view/consensus represents and not any one theory.

1) SF - NK - DK - PK : This face has Keynes written all over it, and the unifying factor is their fondness for fiscal solutions. This is a left-of-centre view that has a few things going for it. I will call it Social Democrat (SD) macro. The leading theorist would be Joseph Stiglitz and the leading practitioner, Gunnar Myrdal.

2) NK - DK - MD - NMC: These theories are a collection of Neoclassical and Keynesian views of the economy that assign a special role to money and prefer monetary solutions to crises, but are ok with fiscal ones too. I will call it Wicksellian/New-Keynesian (WNK) macro, for a variety of reasons.

Knut Wicksell was the first modern macro theorist, and he tried to assimilate a wide range of the prevailing macro thoughts of his era into a cohesive framework, while coming up with the ideas of a natural rate of interest (through which he integrated the real sector and the monetary sector) and even endogenous money creation. He was inspired by the Austrian and the Ricardian views of the economy, but yet ended up influencing both Keynes and Schumpeter. Endogenous money seems to place him close to the Post Keynesians, while a focus on the short term interest rate places him firmly in Neo-Classical category. His debate with Fisher seems to indicate a Keynesian view of the economy, while his fondness for Walras indicates a Classical view. I have no doubt that had he followed rather than predated Keynes and modern central banks, he would be trying to come up with a theory that is in equal parts equilibrium and disequilibrium, equal parts Neoclassical and Keynesian. Hence, Wicksell.

The New Keynesians - I have struggles to place them somewhere. Everyone post Samuelson who may focus on aggregate demand - from Joseph Stiglitz to Michael Woodford - are called New Keynesians. I believe that's not a helpful way of looking at things. I understand New Keynesian theory as one that tries to integrate the Neo-Classical view of the economy with the Keynesian view. The equilibrium and rational expectations based efforts resulted into the neo-Wicksellian framework. But there are others, who modify these efforts in many interesting ways. Ben Bernanke and Mark Gertler, with their financial accelerator and credit channel view of monetary policy. Robert Gordon, with his distinctions between markets that approximate Neoclassical auction markets and those that don't. And Edmund Phelps, the granddaddy of them all, with his adaptive expectations view of multi-period optimization by economic actors. Even Greg Mankiw, who in this excellent essay expresses dislike for the complete markets and rational expectations view of the world. Phelps, Gordon, Bernanke, Mankiw - these are the true New-Keynesian theorists. And they lie in the middle of that MD-NMC-NK-DK face of the cube.

So, I will call this the Wicksellian/New-Keynesian (WNK) macro theory. I am also convinced that a less sophisticated version of WNK is the macro of my favourite political philosopher John Stuart Mill, as evidenced by his stance in the Bullionist controversy.

3) NC - NMC - MD - NA: This is a bunch of people united by their distrust of fiscal policy and in general the government, though they may approve of judicious monetary policy. I will call this Walrasian/Classical Liberal (WCL) macro. This is more or less the 'Classical' view that Keynes disapproved of and that forms the most direct political opposition to a social democrat system. For the most sophisticated macro-model of this view - one that tries to incorporate asset prices into general equilibrium - we have to turn towards Fischer Black. This paper summarizes some of more important ideas of Black's magnum opus, which has been referred to approvingly recently by Tyler Cowen. Margaret Thatcher would be the leading politician whose government had a WCL approach to the economy.

4) NC - NA - PK - SF: This divergent group of theories is united by a distrust of expansionary monetary policy, a focus on production and supply rather than consumer demand, and not much else. I am going to call them Non-Monetary theorists and leave it at that.

5) NC - NMC - NK - SF: A group of theories with widely divergent politics but united by the model-simplification of equilibrium and optimization. Various versions of freshwater, saltwater and socialist thoughts keep indulging into such models but if we are to truly make sense of the world economy, equilibrium must go.

6) NA - MD - DK - PK: The best for the last. How does one unite Hayek and Keynes? Or listen to Bill Woolsey and Steve Keen at the same time? Or indeed, Schumpeter and Patinkin? Well you drop the assumption of equilibrium, open your mind to monetary aggregates, interest rates and credit risk at the same time, and try to incorporate balance sheets and the financial system into your version of the macro-economy. Incredibly difficult to formalize, but incredibly fruitful to conceive and follow. The disequilibrium dudes, of all hues, are the ones you turn to in a crisis in the modern financial economy.

And on this face, there is a very interesting diagonal: the one that leads us from Hayek (NA) to Minsky (DK). Along the diagonal, from Hayek(right) to Minsky(left of cente), you will successively find - Hayek, Arnold Kling (Recalculationist), Tyler Cowen (Austro-Keynesian), Willem Buiter (the golden mean), Axel Leijonhufvud (Keynesian) and then Minsky. Oh, and somewhere between Leijonhufvud and Minsky, I suspect, you will find Keynes himself.

Arnold has been arguing for some time that markets are self-correcting but they are slow adaptive systems, that monetary policy is useless in what is essentially a sectoral adjustment following over-investment into some sectors, and that inflation is round the corner. Tyler sympathises with Arnold's view but is less convinced about the ineffectiveness of monetary policy and generally less skeptical of government intervention.

Buiter is essentially a monetary theorist, but one who balances his fondness for monetary aggregates and interest rates with a keen understanding of the banking system, a deep respect for moral hazard problems and a healthy deference to the 'financial instability due to leverage' view of Minsky. To top it all, unlike most macro theorists, he never forgets to consider the international political economy when he makes a theoretical point or a policy recommendation. He also wrote the definitive essays on what I believe is the best way out of the current crisis, but more on that later.

Leijonhufvud proposes a 'corridor hypothesis' view of things in which the markets and the financial system self-correct if disturbances are small but can go out of range when exposed to large disturbances with no surety of coming back on their own. He was among the initial Keynesian theorists who expressed a dissatisfaction with the 'equilibrium' version of things. Not surprising then, that he has been appropriated both by Arnold Kling (of the real-disequilibrium story) and Nick Rowe (of the monetary disequilibrium story).

So that's it, the faces are all done. One could make a couple of further groups. If you combine Wicksellian/New-Keynesian macro with Social Democrat macro, you get Aggregate Demand (AD) macro. The single greatest insight of Keynes was to introduce and privilege demand in macro discussions, and Keynes is what SD and WNK macro have in common. AD macro abhors the gold standard and endorses the modern banking system with regulations. Unsurprisingly, if you combine Non-monetary and WCL macro, you get Aggregate Supply (AS) macro. AS macro is sympathetic towards either the gold standard, or full-reserve banking with no lender of last resort or deposit insurance, or free banking. Or all.

And finally, if you combine WCL and WNK macro, you get the old Classical view of the economy, which Keynes mis-characterized somewhat. Jean Baptiste Say did not believe in the Say's Law, David Ricardo disagreed with Ricardian equivalence and David Hume can be thought of as the first monetarist. The Classicals were skeptical of fiscal actions but not monetary, and had a more sophisticated (or paradoxically, more intuitive) understanding of disequilibrium than many modern mainstream macroeconomists.

I agree most with Disequilibrium and WNK macro, and in the next and final post of the series I will explain why.

Macro Cube - 3

2010-01-22T18:31:00.005+05:30

In the last post, I covered 6 of the 12 edges of the macro cube. These were:

1) AB : Folk Keynesian (FK)

2) BC : Keynesian (K)

3) CD : Minsky-like Post-Keynesian (MPK)

4) DA : Functional Finance (FF)

5) BQ : Neo-Wicksellian (NW)

6) QR : Monetarist (Mo)

Let's cover the other 6 now.

7) CR : This is a set of theories that shares its preference for monetary solutions over fiscal ones in most cases with the neo-Wicksellian orthodoxy. However, some new dimensions are introduced. Some versions try to consider credit and the financial system; at any rate cash is an explicit feature of the economy. Money is thought to be especially privileged and could be exogenous or endogenous. Some versions of the theory have money as privileged as it is a medium of exchange/store of value (Nick Rowe, here and here). Others privilege it as it a medium of account (Bill Woolsey, here - though he is an MD theorist proper) or a numeraire. Some, like Brad De Long, worry about liquidity traps that may render monetary policy ineffective in extreme cases. Others, like Willem Buiter, worry that the tying up of a medium of exchange with a numeraire (or a 1 to 1 conversion between reserves and currency) unnecessarily curtails monetary policy options. At all times, the attempt is to merge Keynesian and Neoclassical views of money and the economy with heavy doses of disequilibrium. I will call these guys the 'Monetary Keynesians' (MK). The intellectual fountainheads of this theory are surely Irving Fisher (in the post-depression era) and Don Patinkin.

Now you may wonder how one can place an avowed monetarist like Nick Rowe in the same theory as an unabashed Keynesian like Don Patinkin. They are united, I believe, with their 'disequilibrium' and Keynesian approach to money. Remember, that the Keynes of 1930 was somewhat different from the Keynes of 1936. And of course, we have a spectrum - one third of the way from C to R is Patinkin, a further one-third away is Rowe. De Long is somewhere in between. This set of theories is very interesting and intellectually very attractive, though it may privilege money by just a tad too much.

8) RS: Alright, another interesting set of people and ideas. They treat the economy as if it is in disequilibrium, treat people as making sub-optimal choices and will yet not trust the government with fiscal stimulus, and only grudgingly with monetary actions. These have to be theorists who are skeptical of the government on not just utilitarian, but also moral grounds. Two distinct set of theories and theorists fit the bill almost perfectly - the Old Chicago (OC) school and the Free Bankers (FB). What I call Old Chicago is a set of people who had a unique and divergent take on the economy, but who were at the University of Chicago between the wars and formed one side of the intellectual opposition to Keynes - Frank Knight, Jacob Viner and Henry Simons. This forms the first wave of the Chicago-School, before the Friedman-Stigler era. They insisted on analytical rigour, yet regarded the future as inherently uncertain and volatile and defended capitalism on moral grounds.

The free bankers are a set of theorists who believe that private banks should have the right to have their own currencies and should operate with the minimal but hard constraint of full-reserve banking. Not only does this make money 'free' and 'sound', it also decentralizes monetary policy in a way that no central bank could hope to achieve. While some of the free bankers are general anarchists (Rothbard, David Friedman), the one I'm really looking at for the purpose of macro theory is George Selgin. He merged his understanding of Hayek and Leland Yeager to privilege money, but only just, and tried to show the tenuous links between 'free money' and 'sound money'. OC/FB theorists are sometimes likely to recommend a gold standard.

9) SP: Now, we have the Austrians (A). They understand that the economy may sometimes be in disequilibrium, but absolve such disequilibria of any great damages. They warn instead of greater future damages if credit bubbles are not allowed to die their natural death. Credit bubbles and the ensuing recessions are thought to arise from irrational investment decisions in the real sector and considered non-monetary, but may be stoked or aggravated by an irresponsible central bank. Deflations are not feared. Money is neutral for all practical purposes - though again, a central bank might create unnecessary illusions. This is a 'liquidationist' view of recessions - which prevents moral hazard problems but takes no account of the loss of social welfare and wealth, considering it a necessary readjustment. Governments and central banks don't have much of a role in such readjustments - though they can make it worse by unnecessarily stoking inflation through monetary and fiscal measures. Hence, neither are recommended. This is a quirky, consistent, far-right view that is unnecessarily fearful of government action and does not consider the demand-side at all. The Austrian theory of heterogeneous capital, sectoral re-adjustment and government skepticism has a ring of truth to it. But worrying about inflation in a crisis might just be akin to - as Robert Skidelsky put it - crying 'Fire' in Noah's flood, and adherence to the gold-standard is too deflationist.

Krugman blames them for much of the damage caused by the Hoover-Mellon administration in the Great Depression. Though that might be uncharitable, the Austrians are far too right for my liking, despite some interesting ideas. Rothbard and Bohm-Bawerk are the canonical Austrians. Hayek, I would place at vertex S, as a Neo-Austrian.

10) PQ : What lies between the New Classicals and the New Monetary Consensus? Why, the New Chicago (NCh) guys, of course. By this, I refer to Robert Lucas, Robert Barro, John Cochrane and everyone else who believes that markets almost always self-correct, fiscal policy is useless due to corruption and/or Ricardian equivalance and monetary policy may be used, but only judiciously. These are essentially the third generation of Chicago economists - the first being Knight et al, the second being Friedman-Coase-Stigler et al. As theorists who refuse to leave rational expectations and optimization, and would rather treat recessions as some "episodes" (Lucas) or "residuals" (Barro) they are far-right, far too theoretical and seemingly more concerned with precision than relevance. Though they are far too trusting of the efficiency of markets, some of their more sombre ideas have meat - as can be witnessed in this recent interview, for example.

11) AP: Between socialist fiscalism and the New Classicals - the most left-wing and the most right-wing of our theories here - there can't be any one cogent theory. So, I will use the 'spectrum' view of things one more time. As we move from left to right, on a path that eschews monetary policy and doesn't have a good disequilibrium theory of the economy, we will first meet some naive centrists who would think of deficit spending in crises but not of interest rate cuts. There aren't many academics who would hold this view, but enough laymen. They are fiscalists, but trust markets to do the job in normal times. They aren't very interesting.

But further down right, there's a set of theories that is very non-monetary and equilibrium-driven in its approach but favours fiscal policy, albeit not deficit spending. Yes, we are talking about the 'cut-taxes-please' Supply Siders (SS) - people like Jude Wanniski and Arthur Laffer. Krugman once called them snake-oil theorists, and I am tempted to agree. We should remember, though, that when times are good focusing on the productive capacity of the economy as opposed to simply consumer demand might be important. In a crisis, this theory has nothing to add.

12) SD: This is a rather broad spectrum too, with the Neo-Austrians on the right and the Post-Keynesians on the left. But there are many common themes that unite them. One is surely the idea of heterogeneous capital that makes monetary aggregates irrelevant and credit risk important. The other is a distrust of the financial sector, as well as of monetary policy's effectiveness in solving problems arising out of the financial or the real economy. The result - you often see these theorists worry about excessive credit, moral hazard, big banks and inflation expectations. For this crisis, whether they blame the government or the financial sector is more or less a question of political ideology rather than theory, for the theory is often the same. Apart from the Austrians and the Old Chicago school, this is also the set of people most likely to recommend the gold standard as a way to prevent the potential debauchment of the price level by central banks. If you begin from S and start moving to D, you might first encounter Joseph Schumpeter, then someone like V Anantha Nageswaran and further to the left, Simon Johnson and James Kwak of the Baseline Scenario blog. It's a very interesting set of theories, but one that I find most useful when I consider them along with the Monetary Keynesians.

I don't really know what to call them - Real & Financial Disequilibrium (RFD) theorists is the best I can come up with.

Phew, all edges done. The faces for the next post.

Macro Cube -2

2010-01-22T14:07:00.004+05:30

Ok, let's begin with a quick recap of the last post. I tried to categorize macro theories along three axes -

1. Does the theory use/believe in equilibrium and optimization? (E/O)

2. Does the theory recommend monetary stimulus in abnormal times? (M)

3. Does the theory recommend fiscal stimulus in abnormal times? (F)

Then, on the (E/O, M, F) co-ordinate space, I placed the 8 vertices of the resultant cube as follows

A (1,0,1) : Socialist Fiscalism (SF)

B (1,1,1) : Neo-Keynesian (NK1)

C (0,1,1) : Disequilibrium Keynesian(DK)

D (0,0,1) : Post-Keynesian (PK)

P (1,0,0) : New Classical (NC) Q (1,1,0) : Neoclassical/ New Monetary Consensus (NMC)

R (0,1,0) : Monetary Disequilibrium (MD) S(0,0,0) : Neo-Austrian (NA)

Let's begin with the edges of the cube now.

1) AB : Between the Neo-Keynesians and the socialist fiscalists, we have people who may or not recommend central bank action but definitely recommend fiscal initiatives to boost consumer spending and reduce unemployment, in good times and bad. This is a left-of-centre view that that Arnold Kling calls 'Folk Keynesian' and Paul Krugman once disparagingly called 'Vulgar Keynesian'. I will go with the Arnold Kling nomenclature (FK). It does not have much currency among academic scholars, though it is often the dominant popular view of the macro-economy. It strives for the right aims, but recommends the wrong policy actions and has confused theoretical underpinnings. Unfortunately, if you hold such a view in India, you would be considered 'centrist'.

2) BC : Recommend strong government action of monetary and fiscal kinds in crises, mild government action otherwise. Since I am running out of various prefixes, I am going to simply call it Keynesian (K). Jim Tobin and his brand of Keynesian teaching at Yale in the 70s is the best example of such a theory. Tobin was also the flag-bearer of the Keynesian defence against the Monetarist onslaught and made the first concerted efforts at integrating asset markets with macro-economic theory. More recently, Christy Romer & George Akerlof can be said to be of a true Keynesian persuasion. It is a comprehensive, coherent and attractive theory, but one that was surely called into question during the stagflation of the 70s (though the Keynsians would like to attribute that to the one-time but significant oil supply shock of the era) .

3) CD : Minsky inspired Post-Keynesian theorists. They try to integrate the financial instability hypothesis with the theory of endogenous money. I don't know what to call them but I can think of no better example than Steve Keen, who blogs at Debtwatch. Keen goes one step further than incorporating Minsky, Graziani and Moore into Keynes. He also tries to incorporate the debt-deflation hypothesis of Irving Fisher and Schumpeter's non-linear dynamical version of the economy. It is a difficult, perhaps fruitless research program but one that resonates with economic reality often enough to not be discarded. Keen is more left-wing than I think he should be, but there is no denying that his insights are ignored by the mainstream macro to its own disadvantage. This, actually, is about as left as I am willing to go.

4) DA : Functional Finance (FF) Theorists. This is the view that combines Chartalism (government deficits are necessary for the existence of a monetary economy) and strong fiscal dominance (Treasury >> Central Bank) with the notion of boosting consumer demand for employment and as a result asks for the government to do whatever it can fiscally to keep the economy up and running and happy. Abba Lerner is its foremost theorist and he summarized the view most succintly when he asserted that balanced budget constraints apply to individuals, not governments. More recently, one can find something similar espoused by Joseph Stiglitz when he recommended that the way out of the Asian crisis was more, not less, government spending. It is the policy proposition that resulted when a Machiavellian Republican president arm-twisted a reputed Keynesian/monetary theorist. It usually results in consumer profligacy, and has been strongly criticized in various ways by many scholars, including Ken Rogoff here (his open letter to Joe Stiglitz following the latter's book Globalization And Its Discontents).

5) BQ : This is the equilibrium theory that keeps an open mind to fiscal stimulus in bad times, but prefers monetary methods a lot more as it asserts that fiscal policy multipliers may be minimal due to a multitude of reasons. It is perhaps the dominant graduate school orthodoxy, and I will call these theorists neo-Wicksellian (NW) - as Nick Rowe does - for its obsession with the short-term interest rate. Inflation and output targeting is the goal, through rule-based or discretionary methods. The leading theorists are pretty much the who's who of modern monetary macroeconomics. One third of the way from B to Q, you will find Stan Fischer and Olivier Blanchard. A further one-third and you have John Taylor and Jordi Gali. ( I was a little off in saying that John Taylor was at vertex Q - Robert Hall is probably a better bet for that slot.) Somewhere in between, you will find Alan Greenspan's policies as the Fed chair. Though it is not an obnoxiously free-market-supporting theory as some like to characterize it, it has rightly taken a hit in this crisis for its predilection with equilibrium and the risk-free rate. Abstracting out of cash, credit risk and the financial system are model-simplifications that this theory needs to abandon.

6) QR : Finally, the Monetarist (Mo) view. Economy may be in equilibrium or disequilibrium, but central banks can always do enough to render fiscal policy unnecessary. The velocity of money (V) is either a constant, or increases in the money supply (M) and/or quantitative easing can always overcome a drop in the V so that the nominal GDP (M*V) can always be targeted and stabilized. Since discretionary policy may be subject to various errors and political pressures, a pre-announced targeted path of nominal expenditure or monetary aggregates is the best central bank policy. Money is exogenous, non-neutral in the short run but neutral in the long run. I probably shouldn't even bother to say it, but Milton Friedman is the canonical Monetarist. It is an attractive, theoretically sound view but one that was called into question in the Volcker recession. It's main problem is that it too abstracts away from credit risk (and hence does not pay enough attention to V).

Let me stop here and leave the other 6 edges and the 6 faces for the next couple of posts.

The Macro Cube - 1

2010-01-21T19:26:00.007+05:30

After a long time, back to macro. Even the most cursory of observers of the recent macroeconomic debates must have noticed that the field is far from settled. Some debates are academic, some political, some on theory and others on applications of that theory. How is one to make sense of all the theories and opinions flying past us? How does one decide, if one can't catalogue?

Allow me to present the completely new and original (and hopefully useful) Macro-Cube. This is also my first attempt at having anything remotely pictorial on this blog - hope it goes well.

Right, so let's get down to business. What is this cube? Very simplistically, it tries to catalogue theories (and the ideologies they entail) along three axes. These axes are each represented by a question.

1. Does the theory depend on/utilize equilibrium and optimization as major tools/concepts? (Equilibrium/Optimization)

2. Does the theory recommend monetary policy/stimulus in abnormal times? (M recommended)

3. Does the theory recommend fiscal policy/stimulus in abnormal times? (F recommended)

Why these three? Well, the first because of all methodological simplifications used by economists, equilibrium and optimization are the ones that seemingly introduce the greatest distortions from reality, and the ones that look most disposable in non-normal times. The second and the third are obvious - the macroeconomics of business cycles would have little relevance to the general society if it were not for the policy implications/ predictions that it makes. These policies usually stack up along the broad lines of fiscal or monetary initiatives, and the major macro theories also diverge along these lines.

Now, what do we do about these axes? Along each axis, a binary answer of 1 or 0 answers each of the above questions in a yes or no. This gives us a total of 8 polar points, or the 8 vertices of the cube. The resultant truth table is drawn in a manner that will be familiar to anyone conversant with boolean logic. For example, if your theory says that economic actors can be assumed to optimize and the economy is usually in equilibrium, and you strongly recommend both fiscal and monetary correctives anyway, you are a (1,1,1) or you lie on vertex B of the cube - and so on.

Clearly, various points within the cube, on each edge or face or even inside, represent points of view and theories that are somewhere in between the polar theories. What are the vertices and where do the more prominent theories fall?

A (1,0,1) : Theory that utilizes equilibrium and optimization, and recommends fiscal actions but not monetary. I understand it as a set of various theories that don't think a central bank or monetary policy is too important independently, recommend its subservience to the finance ministry or the treasury, want this treasury to run a bunch of fiscal initiatives in good times and bad, and think that the economy will be on track - if only the government is allowed to micromanage the macro-economy. From the description itself, this is a rather non-coherent theory - perhaps an unfair characterization on my part. Forgive this as a model simplification - I am less convinced of the existence of this vertex than any other. Let's call this vertex Socialist Fiscalism and move ahead after noting that sensible theorists and practitioners should have nothing to do with this rather naive view of the economy.

B (1,1,1) : Theory that utilizes equilibrium and optimization, and recommends both fiscal and monetary policy when times are non-normal. This should not be hard to guess. This is the classic Neo-Keynesianism of Solow, Samuelson and Modigliani and the IS-LM cross. It was the dominant paradigm for a long time and it is what introductory macro courses in most business schools still teach. One might wonder why the theory recommends strong government action though its methods of equilibrium and optimization entail self-correcting and complete markets. Well, the trick that the Neo-Keynesians used was to take sticky prices and wages from Keynes and use it to explain recessions and justify government action. As a result, this theory suffers from some incoherence due to a lack of micro-foundations but still has a lot of offer by way of policy recommendations in bad times.

C (0,1,1) : Alright, things get interesting here. Now we have a theory that discards equilibrium and optimization and hence recommends both monetary and fiscal initiatives depending on the conditions. I will call this 'Disequilibrium Keynesianism'. I can think of no better example of such a theory than Hyman Minsky's financial instability hypothesis, which Minsky proposed after extensive study of Keynes's General Theory and the financial system. It is the most 'left-wing' theory that I find myself in strong agreement with. In a financial crisis this theory looks very attractive but what one must keep in mind is - do we have reason to be so trustful of the government and so distrustful of markets on the average (or even in a crisis).

D (0,0,1) : Disequilibrium, monetary initiatives not useful in a recession, hence fiscal stimulus. This is classic Post-Keynesianism. Keynes's chief rationale for a fiscal stimulus was the liquidity trap argument. Post-Keynesians are wont to believe either that the economy is frequently in a liquidity trap or, more subtly, that money is endogenous and hence exogenous monetary actions by the central bank are useless. Or both. Paul Davidson, the Circuitists, and the Chartalists are good examples. On the left-right spectrum, these guys fall slightly left of Minsky and though they have several good and arguable ideas, they are more skeptical of the market economy than they should be.

P (1,0,0) : Equilibrium, self-correcting and optimizing markets, government policy either ineffective or actively damaging and hence not recommended. Right, we're talking about the New Classicals here. To me, this is a theory that prefers theoretical coherence over correspondence with reality. Money is thought to be neutral even in the short-run. Recessions are either sudden large vacations or real-sector phenomena that will correct soon enough or something equally implausible. Of course, most of the big names associated with New Classical macro are more moderate and nuanced in their thought but I think Thomas Sargent and Ed Prescott can still be placed firmly on vertex P. This is the most right-wing of our theories here, and the one most sanguine about markets - I don't find most of its views attractive.

Q (1,1,0) : The economy is mostly in equilibrium, economic actors optimize, monetary policy can be effective in the short run, but fiscal policy almost certainly isn't. This shouldn't be hard to guess either. This is the standard Neo-Classical view of the economy. This is the view of the first ever macro-model of the economy, of Irving Fisher before the Great Depression and before the debt-deflation hypothesis. This is also the theory of Taylor-rule based inflation targeting monetary policy that resulted from the uneasy truce between New Classicals and the New Keynesians. Following the good people of the Levy Institute, I will call it the New Monetary Consensus. Examples? None better than John Taylor and Michael Woodford. Closer to home - Ajay Shah. This is the standard macro-view backing mainstream capitalist thought, though a lot of its assumptions and conclusions are quite questionable. This is as right-wing as I get.

R (0,1,0) : The economy could be in disequilibrium, this disequilibrium is fundamentally monetary in nature and hence the solution is monetary, not fiscal. This is another interesting point of view and one that I would have been unexposed to had I not been following some blogs. These are the Monetary Disequilibrium theorists, and their fountainhead should surely be Leland Yeager. Yeager combined the fiscal suspicion of Hayek with the monetary theory of Keynes and created a new theory that is rather attractive and woefully under-explored by the mainstream. Money is thought to be completely exogenous, and the central bank can always help things by slashing interest rates, quantitative easing or by de-linking reserves and currency.

S (0,0,0) : Ladies and gentlemen, welcome the Neo-Austrians. I take the name from one of the various terms that Arnold Kling has used for his rather novel take on things. It says that the economy is frequently in disequilibrium, but that these disequilibria are the natural process of the evolution of the economy and government tinkering is either ineffective or damaging. Money is neither neutral, nor privileged - for what good does monetary policy do when the adjustment is hypothesized to be inter-sectoral and in real (not just monetary) terms? Fiscal policy can be subject to corruption, or can stoke and aggravate moral hazard or inflation problems. It is an interesting proposition, though I find it most useful when considered together with the Disequilibrium Keynesianism of vertex C.

So there you have it - descriptions of the 8 polar cases. I thought of such a cube for the first time about two months back but only now have been able to comprehensively place theories and theorists along the proper vertices, edges and faces of the cube. And if you found the vertices interesting (or are wondering just where the hell Friedman and the Monetarists went), wait for the next post which will be about these in-between theories.

Two quick notes on epistemology/philosophy of the mind

2009-11-30T12:39:00.005+05:30

1. Steven Landsburg has come out with a book that seems rather promising. There is a blog too.

There is this one post in which he takes Richard Dawkins to task about the latter's insistence that evolution by itself destroys the idea of a God. I don't care much about the post itself, but one paragraph caught my eye.

That, however, is just wrong. It is not true that all complex things emerge by gradual degrees from simpler beginnings. In fact, the most complex thing I’m aware of is the system of natural numbers (0,1,2,3, and all the rest of them) together with the laws of arithmetic. That system did not emerge, by gradual degrees, from simpler beginnings.
If you doubt the complexity of the natural numbers, take note that you can use just a small part of them to encode the entire human genome. That makes the natural numbers more complex than human life. Unless, of course, human beings contain an uncodable essence, like an immortal soul—but I’m guessing that’s not the road Dawkins wants to take. (emphasis mine)

Has there ever, ever been a case where this phrase has been more applicable? A small part of the set of natural numbers can be used to represent the genome, not to encode it in the sense that gene encoding is commonly understood. Protein molecules can not be created out of natural numbers.

Landsburg's definition of complexity of genome in terms of encoding the genome is essentially an information-theoretic one. The main idea here is that of Kolmogorov complexity. It is the right approach, of course, but it is essential to remember just what the base information is. The genome itself is not a sequence of non-random and finite set of ACTGs, only its representation is.

Of course, there is a more fundamental though more subtle issue. Kolmogorov complexity proceeds by assuming arithmetic, which assumes the set of natural numbers. To talk of the complexity of the set of natural numbers itself is completely meaningless. It is like saying that the set of alphabets of the English language is more complex than any arbitrarily complex philosophical idea (for e.g. - the map is not the territory) because the idea can be expressed by a small, finite and non-random subset of the alphabet.

Does this mean that I'm opposing Godelian platonism by comparing a mathematical set to a human construct like an alphabet? Not really. I hold an information-theoretic view of the universe. Math is the closest we get to a system that captures the fundamental notion of information.

2. On EconLog, Bryan Caplan responds to Robin Hanson in the latest Caplan-Hanson debate (on philosophy of the mind, this time). He links to an old paper by him on why he is a dualist (mind and matter/body are different - mental phenomena can not be reduced to physical ones) and not a monist/reductionist (all things are made of matter, there is no mind beyond the body, mental phenomena are completely reducible to physical ones). He refers to John Searle approvingly before critiquing him. That's for later though.

What is striking is - Caplan claims to be neither a substance dualist (that the mind is a separate substance than the body) nor a property dualist (the mind is an emergent property of the brain that is not reducible to anything simpler). Substance dualism is rather naive and uninformed by anatomy and neuroscience. Property dualism, however, is an extremely attractive position to adopt if you're going to be a dualist. Why then does Caplan reject it? He explains -

"Neither is my view property dualism; for the essence of a property is that it could not   even be conceived as existing apart from something else.    For example, "whiteness" could not even be imagined to   exist all by itself; the reason is that it is a property, not an   independent thing.  But we can conceive of the mind all by itself; hence it is not a property. "

It is an old paper, so maybe Caplan has not reviewed it in quite some time, but it is rather unbelievable that he ever used/convinced himself of the trickery of 'whiteness' (as opposed to white) and the ambiguity of 'conceive' to dismiss property dualism.

I can absolutely conceive of 'white' by itself. You can argue that this is false, and that my conception of white will be a white wall, a white board, white cloth, brilliant sunlight or something physical that possesses the property of 'whiteness'. You will be right. But then, you can't genuinely believe that you can conceive of a mind independently. You can only conceive of mental phenomena - desire, choice, anger, pain. And even then, you can only conceive of how you/other sentient beings perceive these phenomena or how they are transient properties of sentient beings. And there's no reason to assume that something physical (the brain) cannot possess the properties implied by mental phenomena. That, in fact, is the very premise of substance dualism.

Which is to say, Caplan rules property dualism out either by naivette or by assumption,  in very simple and direct language that makes the mistake rather obvious.

On Rand and Ethics

2009-11-04T14:27:00.005+05:30

At Marginal Revolution, Alex Tabarrok has a post on Ayn Rand's relevance and her philosophy, prompted by the recent flurry of activity around the release of two new biographies of her. He links to almost 5-yr old pieces on her by himself, Tyler Cowen and Bryan Caplan.

In his 2005 post, Tabarrok argues that Rand is a lucid, prominent and the first modern proponent of virtue ethics. Now I had no clue what virtue ethics was, so I decided to check it up. The wikipedia entry for virtue ethics says this

Virtue theory is an approach to ethics which emphasizes the character of the moral agent, rather than rules or consequences, as the key element of ethical thinking. This contrasts with consequentialism, which holds that the consequences of a particular act form the basis for any valid moral judgment about that action, and deontology, which derives rightness or wrongness from the character of the act itself rather than the outcomes

Here is the wikipedia article, which I believe is rather muddled. A clearer and crisper explanation of the differences between the three main strands of normative ethics(systems of distinguishing the right from the wrong - deontology, consequentialism, virtue ethics) can be found in this sentence from the wiki article on deontological ethics.

Deontological ethics or deontology (from Greek δέον, deon, "obligation, duty"; and -λογία, -logia) is an approach to ethics that determines goodness or rightness from examining acts, rather than the consequences of the act as in consequentialism, or the intentions of the person doing the act as in virtue ethics.

This is a very good summary of the critical difference and it enables further analysis. A lot of people will consider a 'It was never my intention to hurt you, I just ended up doing something stupid' explanation as legitimate if it comes from a romantic partner or a child. It is difficult for a legal system to adopt such a view in a case of, say, drunken driving. (Most legal systems actually hold such a view partially - we will come to that a little later.) To the extent that you can only infer a person's motives and moral character from their actions, it seems that either virtue ethics is completely subsumed under deontology or the distinction is too subtle for the gross sieve of my comprehension. In any case, though intention and action can be separated, repeated action is the surest indicator of intention that there is - you may not forgive the same mistake thrice even in a partner or a child.

I have never found deontology particularly illuminating beyond the insight that every system of normative ethics will require certain axioms. Deontology's way to distinguishing the right from the wrong is to check if the act conforms to a certain set of pre-decided rules, the moral axioms. It is easy to see that if you allow these rules to be long enough and complex enough and democratic enough, deontology collapses into consequentialism. Kant, for example, is led to conclude that lying is always bad only because he insists on working with the simple and singular predicate of 'lying'. If you allow for more complex and more numerous predicates, it is easy to accommodate lying in those situations where it creates more favourable social outcomes without explicitly mentioning that you are trying to improve the net social outcome. If you do not allow for such predicates, you are asking for the reality to conform to your thoughts, which is not a useful way to approach a theory of practical reason. Ironically, due to simpler and fewer predicates, a functioning large-scale deontological system will necessitate a much larger, more confused and less universal set of moral axioms.

Drunken driving and injury caused under the influence of alcohol is an interesting illustration. The chain of reasoning that outlaws drunken driving appears to me to be this:

1) It is wrong to cause death or injury to other people.

2) Drunkenness leads to significantly reduced motor control which is very likely to cause uncontrolled driving.

3) Uncontrolled driving is likely to cause death or injury to other people on the road for no fault of theirs.

4) Hence, drunken driving should be illegal.

A 'pure' deontological framework will find 'injury caused' a difficult concept to punish as it is a consequence and not an act itself. Thus in a deontological framework, all instances of drunken driving will appear as equal evils to you. You will not be able to engage in the kind of probabilistic reasoning I mention above, as it is fundamentally consequentalist, with the one simple moral axiom of 'don't cause death or injury to other people'.

In fact, since the intention/moral character and the consequence of an act are mutually exclusive and completely characterize the act, consequentialism and virtue ethics are better compared with each other than either with deontology. Most functioning legal systems require the establishment of both actus reus (that the act happened) and mens rea (the intention behind the act) to establish a crime. A distinction is made between drunken driving that caused injury and drunken driving that didn't, and between murder (intended, planned homicide) and the common 'culpable homicide not amounting to murder' used if a car runs over and kills someone when the driver was inebriated. Thus, we see a combination of consequentialism and virtue ethics pervading most modern legal systems.

As Tabarrok says, Rand's ideal of the virtuous man is rational, independent and productive. The insertion of rationality is brilliant stroke to achieve consistency within virtue ethics without sacrificing common wisdom, for it removes the dichotomy between evil acts and evil intents. Competence as morality brings morality closer to a folk reality. If you cause me hurt by being stupid rather than malicious, you are still in the wrong. This makes it possible to scale Rand's system up to the social level - otherwise it would remain stunted to a set of personal ethics (e.g. "yes, Salman Khan ran over and caused the death of n pavement dwellers, but he didn't want to do that any more than you or I did, so I can still think he is not a bad person and like him").

Till this point, Rand seems not only correct but also very original. However, while the moral axioms of rationality, independence and productivity are in consonance when evaluating the individual, they are less helpful in guiding a social framework. First, notice that of the three, only independence truly scales up. As Caplan points out, Rand thought that a large number of people were fundamentally irrational and led themselves to near-slavery (by supporting socialism when a 'superior, more rational, more moral' brain could see that it was doomed). She sure wouldn't want these people to be punished for being thus incompetent and immoral (beyond the market forces). It's virtuous to be rational and productive, ok to not be so competent and evil to be impinging upon somebody else's attempt to be so. And one doesn't have the moral obligation to try and make someone else rational and productive. How different is this from the concept of negative liberty, an idea that has had currency at least since the time of Thomas Hobbes?

Therefore, I believe Tabarrok missed the point when he asserted that Rand's moral defence of capitalism on the basis of selfishness is spot on, for a much more satisfying defence is the simple and older idea of negative liberty. Rand was also neither unique nor the first in requiring that there be a moral defence of capitalism - this had already been done explicitly by Frank Knight, and implicitly by others who identified as classical liberals. Tabarrok was also grossly unjust to every single political philosopher of the modern times when he says that "the modern literature lags behind Rand in connecting ethics and politics". All political philosophers are first moral philosophers. It is impossible to try to create a coherent governance framework without first privileging certain social conditions and outcomes as moral 'goods'. Political philosophers don't make their ethics explicit, because they are usually building upon or deconstructing the politics (and hence ethics) of older political philosophers. Isn't the Hobbesian Leviathan predicated upon the assumption that human life should be neither nasty nor brutish nor short?

It is because of all this that I tend to judge Rand's moral philosophy rather unfavourably. Her insistence on selfishness and egoism as opposed to mere negative liberty opens weak holes in what is otherwise a sound philosophy. Her insistence on evaluating the individual and then creating a society that best aids the most perfect individual lays her philosophy open to the charge of ignoring the social reality and of not being universal enough to merit a discussion as a political system. If you respect the political equivalence of all individuals (everyone must have the same rights as I do) it is disingenious and contradictory to arrive at that set of rights based upon your preference and your own ideals without even considering the preferences and ideals of those whom you want to grant those rights. It is difficult to see what Rand had to offer that may be relevant to any scaled-up political discourse that Thomas Hobbes, John Locke or John Stuart Mill did not.

And it is the intuition that democratic rights be democratic in nature that makes consequential and utilitarian ideas so attractive. You don't need to have a personal ideal of the perfect man as independent and productive and rational to arrive at a political system. You only need the intuition that the average man desires to be free, to be materially prosperous and to be able to make a better decision to arrive at the notion of a social utility function. It is only a small step from there to the idea that a political economy and a legal system that makes decisions that maximize the social utility is the ideal system. And some more small steps with mathematical reasoning will take you to Pareto optimality and Kaldor-Hicks efficiency.

Of course, the version of utility and efficiency that we have right now is very broad - it includes the human preference for liberty and even the human aversion for inequity. Therefore, modern political and economic philosophy explicitly recognises the trade-offs between efficiency, liberty and equality. As an illiberal society is also usually an inefficient society and as the preference for equality can be accommodated to a broad extent in macro aggregates (Gini coefficient, Human Development Indices) it is eminently possible to zero down upon a political system that is quite close to maximizing social utility - the modern liberal democracy, capitalism with a few rules. The debate then becomes about how many of those rules should be there and what those rules should be. Rand doesn't have much to add there.

Of course, in the last two paragraphs I have casually slipped in the idea of positive liberty through efficiency and equality arguments. You can disagree. However, if you must try to create a grand theory to back your belief in laissez-faire, you are much better off looking towards negative liberty and the classical liberals than selfishness and Ayn Rand.

p.s. On epistemology, though, Rand is surprisingly good. From Caplan's post

"We know that we know nothing,' they chatter, blanking out the fact that they are claiming knowledge–"There are no absolutes," they chatter, blanking out the fact that they are uttering an absolute–'You cannot prove that you exist or that you're conscious,' they chatter, blanking out the fact that proof presupposes existence, consciousness and a complex chain of knowledge: the existence of something to know, of a consciousness able to know it, and of a knowledge that has learned to distinguish between such concepts as the proved and the unproved.

If you forgive the subtle fallacy of recursion without base class in the first two sentences (it is perfectly logical, for example, to say that you believe in tolerance and hence are intolerant of intolerance), this is a brilliant paragraph. The "proof presupposes ...." part is sheer genius in its clarity and delivers a short yet fatal blow to a lot of Cartesian and Humean skepticism.

p.p.s My bias towards efficiency and utility, while sympathizing with negative liberty and the human aversion for inequity at the same time may seem contradictory. It is. I have the broad framework clear, and this framework is essentially that of John Stuart Mill. Within that, I prefer to think about the specific tradeoffs on a case by case basis and using inductive logic. If you insist that a social system be logically consistent and yet be able to handle all 'truths' that intuition and reality will throw at it, you have missed Godel's fundamental insight.

Liquidity Trap, Banks & Fiscal Policy

2009-10-06T13:00:00.007+05:30

Monetary policy is usually considered potent enough to cure all evils. If the economy is not growing fast enough - the central bank buys treasuries for cash from banks, thus releasing more money into the system for circulation. The economy is overheating, it does the reverse. Equivalently, it can also lower or hike interest rates by fiat. A decision by the central bank to buy treasuries for cash or to decrease interest rates has the same effect - it increases the price of the treasuries and makes it desirable for banks to sell them and invest the proceeds elsewhere.

All this assumes a normal economy where a bank has no incentive to hold reserves in excess of what it is legally required to do and where treasuries and cash are not good substitutes for each other. In a crisis, the economy is not in a normal situation. Interest rates could be touching zero (as they are now) and treasuries and cash become almost substitutable. If the central bank now starts buying treasuries for cash from banks, the banks will happily take the cash and sit on it. They will keep reserves much in excess of what they are required to, as they don't have confidence in private assets, treasuries are equivalent to cash and the possibility and fear of a bank run (or a loss of confidence in the banks' assets) makes it prudent to keep more reserves than is mandatory.

The part where banks consider the excess cash as a substitute for treasuries and hold on to it (just like they were holding on to treasuries) is the liquidity trap. The part where banks hold excess reserves due to fear, let's call that a 'solvency trap'.

To get past this situation, Keynesians recommend fiscal stimulus. The government issues new treasuries, this increases the interest rate on treasuries, people buy treasuries (through banks) and the government has cash to burn. Of course, some of the excess cash will also be used up to buy existing treasuries from the central bank itself, i.e fiscal stimulus will also have the effect that a mild monetary contraction in the form of an interest rate hike does. This can be avoided by concurrent monetary expansion by the central bank.

Irrespective of any such concurrent monetary policy measure, fiscal expansion ensures one critical thing at least - the government borrows from lenders because the private sector is not able to. The average willingness to spend cash has increased. The government can then spend the money in various ways. It can choose to invest in infrastructure and aim at the positive network effects to boost the economy. It can reduce the debt burden of households and businesses by re-capitalizing them. Or, it can decide that it has no competence in choosing and privileging specific households and businesses and instead just aim at getting the stimulus to work through the banking system by giving cash back to the banks.

But lack of cash with banks was never the problem - the willingness to get it moving was! And the government is not going to just make a donation to the banks. So what happens in a fiscal stimulus that operates through banks anyway?

Well this is what I think happens. Government issues new debt, lenders of all hues move cash from banks to treasuries. The balance sheet of the banking system shrinks. The banks also buy up some more treasuries from the central bank. Now the government is going to give this cash back to the banks in exchange for something. What is this something?

It won't be treasuries, that will just be a monetary expansion and fiscal contraction. It won't be true short term debt - that's just cash back to the bank and all that has happened is that the bank owes money to the government instead of investors and the government in turn owes money to the investors. It can, however, be long-term debt, or short term debt with the surety that it will be rolled over (which is just cheap long-term debt) or equity. If it is long term debt, the asset liability mismatch of the bank is corrected to an extent. If it is equity, the bank is unlevered a little without a shrinking of the balance sheet. In either case, fiscal stimulus that operates through the banking system fundamentally improves the capital structure and hence the solvency of the banking system. This is bound to reduce the tendency to hold excess reserves and get the money circulating faster.

Conventional monetary policy then just involves a shift between two safe assets of the banking system - it cannot be expected to work when there is substitutability between these assets. Unconventional monetary policy, in which the central bank buys private assets from banks in exchange for cash, also exchanges one asset for another but these are not substitutable. It can, in principle, work.

Bank-driven fiscal policy effectively involves tinkering with the liability structure of the banking system. It can be a way out of the liquidity trap as well as the solvency trap. In fact, it can help the economy escape out of the liquidity trap precisely by getting out of the solvency trap.

Promised Econ Link Fest

2009-09-22T12:57:00.001+05:30

1) The Blog Wars : De Long & Krugman vs. the New Classicals

Krugman's main salvo

John Cochrane's reply (reproduced on Karl Smith's site)

Nick Rowe points out Cochrane's mistake

De Long takes apart the New Classical case: here, here and here

David Levine replies to Krugman

De Long replies to Levine

De Long summaries his pet peeves with the New Classicals

Krugman offers a historical sketch

2) Nick Rowe explains why money is not like other goods and assets and hence, not neutral in a non-barter economy, here and here.

3) Steve Keen

Keen is a Minsky style Post-Keynesian. He has written a book called Debunking Economics, which is highly critical of neoclassical economics.

He laments the usual equilibrium analysis of the economy in the mainstream and tries to model the economy as a non-linear dynamical system using differential equations. He argues that money is endogenously created (money is there iff. there is debt). He also sees the modern capitalist economy as inherently unstable (which ties up with the dynamical model) because of the financial fragility hypothesised by Minsky.

4) Barry Eichengreen and Kevin O Rourke on the comparison between this depression and the original great depression.

5) Janet Yellen on what central bankers can learn from Minsky

Yellen is the governor of the Federal reserve of San Francisco. She argues that there is a pressing need to incorporate finance into mainstream macro, that there indeed are asset price bubbles and it may be desirable for a proactive central bank to deflate them. She also says that not all bubbles are equal, and that credit market bubbles and deleveraging need more proactive intervention than equity market booms and busts. She is however skeptical about how a central bank can go about doing it, and suggests countercyclical capital requirements (which go up in times of liquidity and go down in times of distress) as a robust policy measure.

6) 2006 paper by Alan Blinder on the main monetary policy challenges faced by central banks everywhere.

Blinder's only blind spot in the paper was his strong assertion on the issue of asset price bubbles. He asserts that central banks should not be concerning themselves with such bubbles, and gives the example of the tech bubble and bust to demonstrate how asset price fluctuations can be effectively handled post facto. In the light of recent events, it is a particularly bad example. Oh well, hindsight is perfect.

The insights on exchange rate interventions (intervene in extreme volatility), transparency of output and unemployment objectives (its necessary) and bank supervision (it may be required), and the deliberations on interest rate are quite brilliant. Do read the whole thing though - it's clear, smoothly written and really gives the lowdown on the practice of central banking.

7) Minsky & Minsky-like

Financial instability hypothesis

What can I say that hasn't been said before? From wiki,

Dr. Minsky proposed theories linking financial market fragility, in the normal life cycle of an economy, with speculative investment bubbles endogenous to financial markets. Minsky claimed that in prosperous times, when corporate cash flow rises beyond what is needed to pay off debt, a speculative euphoria develops, and soon thereafter debts exceed what borrowers can pay off from their incoming revenues, which in turn produces a financial crisis. As a result of such speculative borrowing bubbles, banks and lenders tighten credit availability, even to companies that can afford loans, and the economy subsequently contracts.
This slow movement of the financial system from stability to crisis is something for which Minsky is best known, and the phrase "Minsky moment" refers to this aspect of Minsky's academic work.

Paul McCulley's Minsky inspired take on the 'shadow banking system', a term that he coined. Incidentally, Janet Yellen also refers to McCulley approvingly in her address. Oh well, PIMCO is just a great bond fund.

8) The history, development, state and relevance of macro (the non-vitriolic not-just-post-crisis series),

David Laidler, among the original monetarists, on Lucas, Keynes and macro.

Robert Gordon, on why 1978 era macro might be the best guide to the crisis. Some insightful ideas about the differences in goods that have 'auction markets' (like oil) and others that don't and what that means for macroeconomic theory.

Greg Mankiw, 2006 paper on theory vs. policy in macro. Excellent stuff!

Arnold Kling, in a smart little piece about how shortage of data affects macroeconomic debates of all hues, as a small review of Mankiw's paper.

Michael Woodford, papers on revolution and evolution in 20th century macro (1999), and a somewhat ill-fated celebration of a then new neoclassical 'consensus' in macro. (2007)

Robert Lucas, asserting that smoothening short run demand flucatuations ought to be subservient to looking at long term supply driven growth. This address forms the basis of part of the analysis in the Laidler paper. Recent events don't bear him out too well either.

Have fun!

Money, Macro & the Crisis

2009-09-19T20:55:00.002+05:30

Recently, I've found myself reading a lot on the crisis, monetary policy and macroeconomics. This includes the usual suspects, some newly discovered stuff and a book. But most of all, I've been reading research papers, including some that were published a few decades ago. Some sort of clarity and a framework have begun to emerge and I'm now finally able to get the drift on some of the more technical discussions on the relevant issues. There are two prominent themes in these readings that emerge often and that I find myself agreeing with most strongly.

The first is that there is a pressing need to incorporate finance and into macroeconomics. Earlier, this incorporation had stopped at understanding the role of money in the economy with a cursory glance at the banking system. The basic channel that unifies money, the banking system and the real economy is credit and credit has never really been incorporated into mainstream macro. If there is only one thing that we learn from Minsky, it should be this: incorporate credit as the concept and the financial sector as the context to inform macroeconomic policy.

The second theme is that dynamic monetary disequilibrium is a consistent feature of the modern credit economy. If you take a look at the criticisms of the New Classical school (esp. John Cochrane) coming from De Long and Krugman and many others in the recent online economic wars, there is one constant refrain: the New Classical school has failed to grasp the role that money can play in the modern economy. The New Classical school has an implicit belief in the Say's Law, and thus believes that there can be no general supply glut, that excess supply in one sector is offset by excess demand in another, that savings always equal investment and hence recessions are temporary readjustments in overall social preference from some goods and sectors to other. It thus believes in the 'neutrality of money', i.e the idea that money only functions as a medium of exchange, that investment and consumption decisions are made in real terms and hence the only source of demand for money is the 'transactions demand'. As many have pointed out, this is a model that could perhaps accurately describe a barter economy, or to a monetary economy where the velocity of money is a fixed technological constant subject only to exogenous shocks and thus behaves as if it were a barter economy.

While the barter system has not existed for a long time now, the relatively simpler economy of the past, say until the 19th century, could perhaps be approximated by such a model. In an explicitly monetary economy, however, money also seems to perform the function of a store of value and thus there could be disequilibrium, especially a monetary disequilibrium. A fully fledged 'finance economy' has since become the reality in the 20th century, and such a finance economy seems to have the ability to magnify and reinforce the monetary disequilibriums.

There are, of course, a number of people and streams of thought that have tried to incorporate credit into their understanding of macroeconomics and business cycles. Apart from Minsky, the Austrian Business Cycle theory is one such. Broadly, it says that money is easy in good times due to actions of market participants and artificially low interest rates set by the central bank. This excess money causes businesses to over-invest, thus temporarily causing a bubble. Ultimately this bubble bursts, resulting in a temporary under-investment that brings the economy back to its 'normal' state. Central banks should not try to increase liquidity during such a crisis, for that will just create another such bubble. Murray Rothbard's version of the business cycle also has people over-inesting irrationally only in the presence of the central bank!

Because of the resemblance of the boom-bust hypothesis to the technology bubble to mortgage bubble shift of the past decade, and because of its incorporation of credit, this theory has gained some credence in the past year. It has however, been criticized on various grounds at various times by several economists, including both Keynes and Friedman. The central issue with the theory is that it also seems to believe in the neutrality of money. Moreover, the theory seems to treat irrational over-investment as a moral evil and recessions are seen as having the salutory effect of bringing people back to the preferred state of rationality. This can seem as a Great Depression-apologist stance and Krugman has indeed attributed part of the blame for the broad-based central bank failures during the depression to the Austrians.

Apart from the Austrians and Minsky, there was at least one other economist whose ideas seem strikingly close to the events unfolding of the crisis, but who doesn't seem to have gotten much attention. Henry Simons is considered one of the founders of the Chicago school. Simons recognised and distrusted the high volatility of the liquidity demand of money and believed that the credit cycle and short term debt issued by banks and corporations exposed any financial system built on it to severe fluctuations through asset liability mismatches, which could then spread the fluctuation to the real sector. He was also concerned a lot about maintaining the price level. In one theory, we see the amalgamation of several strands of thought that have come to dominate academic thought in the crisis.

Though Simons's understanding of the inherent fragility and positive feedback of the financial system is similar to Minsky's and Bernanke's, his policy prescriptions differ. He recommends full reserve banking, the gold standard, the complete absence of short term debt, and strict monetary management by the government. If these frameworks are in place, it seems to me that the rest of the economy starts resembling an 'as if' barter system and his favoured policy stance of laissez faire becomes workable.

A full reserve banking solution has also been provided by others wary of the financial system or the government, including Rothbard and intermittently, Friedman. The causes of course, differ. The generation of money through fractional reserve banking has been compared to counterfeiting by more than a few respected economists, including Maurice Allais. The debate is not only interesting (though perhaps lop-sided), it is critical to understanding the tenuous relationship between money and credit in the financial economy.

Credit is endogenous, it comes about from the interaction of the financial and the real sectors. Indeed, it is also the main channel of transmission between the two. Proponents of fractional reserve banking argue that it is just the way to implement the 'monetization' of credit. Proponents of full reserve banking are concerned either about the supposedly illusory money (Rothbard, Allais) or about financial fragility (Simons).

Of course, even within the 'monetization of credit' philosophy, one can ask where does the money itself come from. While the monetarists and many Keynesians believe that money, though inevitable, is still exogenous and comes from the government and the central bank as a way to monetize the credit, the circuit theorists argue that money is an endogenous property of a credit economy itself. Indeed, in their view, credit IS money. Of course, there are the agnostics in between these two views.

We can thus summarize the broad ways of looking at the theory and concept of money, arranged in a roughly free market to interventionist order.

1) Money is neutral and always in equilibrium.

2) Money is neutral but there are temporary, required credit disequilibria.

3) Money is not neutral and sometimes in disequilibrium, but exogneous.

4) Money is not neutral and often in disequilibrium, and may be exogenous or endogenous.

5) Money is not neutral, often in disequilibrium and endogenous.

My own views are closest to 4.

(This post has left out several contextually required links. The next one is going to be a mega link fest)

RBI and central banking

2009-09-13T13:38:00.003+05:30

If you read Ajay Shah's blog, you will notice that he is an ardent supporter of inflation targeting, rule based central banking and by and large critical of RBI's policy actions. Specifically, he believes that in an emerging country likely to have weak institutions, like India, the central bank has no business using discretion, that currency depreciation should not be fought using fx reserves, that modern academic macroeconomic insights (of the Monetarist-New Keynesian variety) like inflation targeting are widely used and widely effective and that RBI's heavy handed approach to regulation has drastically stunted financial markets and innovation and thus stunted entrepreneurship and growth. Ila Patnaik, with whom he has collaborated on several papers and other research initiatives, has more or less similar positions. I refer to the two of them because of two recent pieces - this op-ed by Dr Shah in FE and this one by Dr. Patnaik in the Indian Express.

Before we turn to the op-eds in question, it is interesting to explore each of the broader positions in some detail. Rule based central banking is thought to stabilize market expectations and prevent the central bank from committing policy mistakes which it might otherwise do on account of insufficient data, incompetence or vested interests. However, it also takes away some important tools that central banks have to fight pro-cylicality. Dr. Shah is however ok with de facto if not de jure central bank positions, but seems to insist that India cannot afford de facto positions because our institutions are weak. This characterization of Indian institutions, while broadly correct if we were only talking in generalities, fails as a logical argument when one specific institution is being discussed, whether the RBI or any other. Rule based central banking could be a great idea if there was sustained evidence of RBI policy failure, otherwise there is no specific need for us to be pessimistic about RBI simply because on the average, Indian institutions are weak. And how has the RBI done? We'll turn to that in some time.

The specific measures of inflation targeting and using fx reserves to fight currency depreciation are trickier issues. Basically, as this article by Raghuram Rajan points out, the two objectives cannot be managed well together with a single instrument - interest rate - at your disposal and currency defences are widely thought to be ineffective at best (as in the case of England, 1992) and ruinous (Indonesia & Malayasia, 1997) at worst. Combine that with the hypothesized effectiveness of the Taylor Rule in combating stagflation, and we seem to have a no-brainer: open capital account completely, let the currency fluctuate and manage the price level through inflation targeting. Broadly, this makes complete sense. However, there are important nuances that are probably being missed out in such a simplified narrative.

For one, emerging market currencies tend to be strongly correlated with all other asset markets in the country. Most capital inflow into emerging markets is on the basis of perceptions of macroeconomic and political risks and stability. In India, the situation is further complicated by the fact that foreign institutional investors are not allowed to buy and sell rupees in the spot (cash) market, unless it is for the explicit purpose of buying equities or some other assets. Now anyone who has any knowldge of trading desks will tell you that such correlations are often speculated on, or other speculations are often based upon assumptions of such correlations. In a crisis, when there is sudden asset deleveraging, such speculations can form a strong postive feedback looop, further aggravating the deleveraging. It is futile to try to establish the cause and effect chain in such feedback cycles - to counter them, one or both the legs of the cycle may be attacked, and this could be the fx market or the correlated asset market (equity, for example). It is interesting to note that the darling of the free market, Hong Kong, had managed to avert the 1997 crisis to a great extent through such operations. The nature of the operations may be different for an economy like India, for the degree and even the direction of the correlations may run different, but point is - it is possible and perhaps desirable to defend a currency provided one does so judiciously. And without discretionary monetary policy, such actions are impossible.

What of inflation targeting? Though the evidence has been mixed, IT gives a robust way to achieve price stability, which is key in an economy with fiat currency, fractional resevrve banking and credit. The question is not whether IT is a worthy goal - it surely is. The question is - should IT be the only focus of the central bank, or are there other objectives just as worthy? Specifically, should the central bank pro-actively intervene in asset price bubbles? This paper by Janet Yellen (governor of Federal Reserve of SSan Francisco and one of the economists touted as Bernanke's successor) discusses the issue in great detail. Yellen notes that not all asset price fluctuations are created equal and broadly says that while equity market booms and busts may be left alone, credit markets deserve a deeper look as credit is the main mechanism of transmission between the financial and the real economy. In either case, praising and echoing Minsky, she emphasizes the need to bring the financial sector and financial stability as explicit constructs in macroeconomics and monetary policy.

Next, what about capital account liberalization? Let's treat the restrictions on corporate debt investments later. First, let's recall what exactly is forbidden in the Indian currency market - FIIs are not allowed to speculate on the spot value of the rupee. They can buy and sell NDFs (non-deliverable forwards) though, and these are short-dated enough to be considered close proxies for the spot market by most trading desks. What this ensures, however, is that the very short term rupee liquidity in the market is insulated from manpulation, allowing RBI greater room to act as a manipulator itself. Raghuram Rajan, whose committee has recommended full capital account convertibility, himself finds in this paper that

Cross-country regressions suggest little connection from foreign capital inflows to more rapid economic growth for developing countries and emerging markets. This suggests that the lack of domestic savings is not the primary constraint on growth in these economies, as implicitly assumed in the benchmark neoclassical framework.

and goes on to suggest a 'pragmatic' way for the process of capital account liberalization. In another paper, he and his co-authors conclude that

even successful developing countries have limited absorptive capacity for foreign resources, either because their financial markets are underdeveloped, or because their economies are prone to overvaluation caused by rapid capital inflows.

seemingly confirming some of the common sensical arguments around the 'hot money' of capital inflows.

Now finally, we turn to the recent critiques that Dr. Shah and Dr. Patnaik have dished out to the RBI. Dr. Patnaik asserts that India is not the only country that has remained relatively unscathed in the crisis and hence there is no evidence that RBI has done a spectacular job and that the world has nothing to learn from RBI. She criticizes the self-praise that some recent RBI establishment people have heaped upon themselves (perhaps Dr. Y V Reddy) and points to the micro and macro-prudential frameworks of east Asia as being worthy of emulation. She concludes memorably

A villager with no roads may foolishly boast of having no accidents, but he cannot teach people how to regulate traffic on busy intersections. It is important for policy makers to remember that India has no lessons to offer to regulators operating in the sophisticated world of finance, and proposals suggesting that they should learn our style of regulation only makes us look foolish.

Let's take a look at what RBI and Dr. Reddy have praised themselves for. This NY Times article provides a clue.

One of the first moves he made was to ban the use of bank loans for the purchase of raw land, which was skyrocketing. Only when the developer was about to commence building could the bank get involved — and then only to make construction loans.
...
Then, as securitizations and derivatives gained increasing prominence in the world’s financial system, the Reserve Bank of India sharply curtailed their use in the country. When Mr. Reddy saw American banks setting up off-balance-sheet vehicles to hide debt, he essentially banned them in India. As a result, banks in India wound up holding onto the loans they made to customers. On the one hand, this meant they made fewer loans than their American counterparts because they couldn’t sell off the loans to Wall Street in securitizations. On the other hand, it meant they still had the incentive — as American banks did not — to see those loans paid back.

Seeing inflation on the horizon, Mr. Reddy pushed interest rates up to more than 20 percent, which of course dampened the housing frenzy. He increased risk weightings on commercial buildings and shopping mall construction, doubling the amount of capital banks were required to hold in reserve in case things went awry. He made banks put aside extra capital for every loan they made. In effect, Mr. Reddy was creating liquidity even before there was a global liquidity crisis.

Now, if these aren't micro and macro-prudential measures, I don't know what are. I fail to see why Dr. Patnaik feels that these measures are something that no one can learn from. Interestingly, Yellen also notes that a way for central banks to induce financial stability is to manage liquidity requirements

Capital requirements could serve as a key tool of macro-prudential supervision. Most proposals for regulatory reform would impose higher capital requirements on systemically important institutions and also design them to vary in a procyclical manner. In other words, capital requirements would rise in economic upswings, so that institutions would build strength in good times, and they would fall in recessions. This pattern would counteract the natural tendency of leverage to amplify business cycle swings—serving as a kind of “automatic stabilizer” for the financial system."

Now compare this with D V Subba Rao's speech, the one that has come under fire from Dr. Shah. Subba Rao, outlining the measures that the RBI recommends to stave the crisis, says

24. It may be relevant to highlight some of the specific features of our system that have contributed to financial stability:
• Banks are required to hold a minimum percentage of their liabilities in risk free government securities under the statutory liquidity ratio (SLR) system. This stipulation ensures that banks are buffered by liquidity in times of stress.
• We managed the capital account actively. In the face of large capital inflows during 2006-08, we sterilised the resultant excess liquidity through calibrated hikes in the cash reserve ratio (CRR) and issue of market stabilisation scheme (MSS) securities. When the flows reversed during the last quarter of 2008, we reversed the measures too. We cut the CRR and bought back the MSS securities to inject liquidity into the banking system.

Seems like Subba Rao and teh RBI, through design or default, have integrated Minsky and Yellen's insight into the system already. He also outlines the fundamental philosophy of RBI's monetray policy and management

20. In contrast to the minimalist formula of ‘single objective, single instrument’, the conduct of monetary policy by the Reserve Bank has been guided by multiple objectives and multiple instruments. In general, our three main objectives have been price stability, growth and financial stability, with the inter se priority among the objectives shifting from time to time depending on the macroeconomic circumstances.

The RBI's philosophy then, is nothing more than what Minsky suggests in his financial instability hypothesis. It is ahead of its time in explicitly recognizing the importance of financial stability as a goal beyond price stability, though I consider Yellen's skepticism about central bank intervention in asset price bubbles healthier than Subba Rao's conviction.

By stark contrast, Dr. Shah's and Dr. Patnaik's op-eds seem like rants that assert what they want to argue. They smirk at RBI's gloating, but this is what Subba Rao says

Sure, we have been hurt by the crisis, but much less than most others. It will be a folly though to let that lull us into complacency and to believe that there is something inevitable about India’s financial stability.

Now let's be charitable and remove all the smirking and rhetoric in the op-eds and look at RBI's philosophy on the main issues - capital account liberalization, financial sector regulation, inflation targeting and currency defence. The RBI has a medium term inflation target of 5% and intervenes in the fx market only when there is "excess volatility'. RBI let the rupee fall from 40 to 52 against the dollar in the crisis, intervening only in most difficult phases. Fx reserves have not been depleted by any significant amount, and as Prof. J R Varma points out, the sterilizing of capital inflows that RBI did during the boom years meant that it was long US treasuries and short Indian equity, an immensely profitable trade in 2008. And this is what DVS says about the capital account liberalization process

We view capital account liberalisation as a process and not an event.

Indeed, this resonates with Rajan's paper. Where the RBI has really been messing up is the regulation of the corporate debt market, which irrespective of its relation to economic growth, is a trade that loses India lots of money, pointed out by Prof. Varma in the same post. This is also the ground on which Subba Rao's integration of financial stability into monetary policy objectives seems the weakest

The policy framework encourages equity flows, especially direct investment flows but debt flows are subject to restrictions which are reviewed and fine-tuned periodically.

If Dr. Shah and Dr. Patnaik were to restrict their critiques of the RBI on this account, and in a juicier more content-filled manner, one would feel bound to agree with them. However, they dilute their strong arguments with a plethora of weak ones, and rather than show some effects of the stunting of the corporate debt market (as Prof. Varma does), take potshots at the RBI's 'gloating'.

This is a classic policy debate situation. The central argument that Dr. Shah espouses is made to look weaker than it is by his undercooked takedown of his intellectual opponent.

What better way to break a long silence ..

2009-08-20T12:08:00.003+05:30

than linking to such utter idiocy as this. Can you count on how many levels the three levels of his argument are wrong?

Also, I have come to realise that it's immensely difficult to blog while working. Which explains why most bloggers are either students or don't have regular day jobs. To all those who blog regularly while working, respect.

Hinduism and I, part 1

2009-04-20T11:03:00.004+05:30

In the previous post, I offered four examples, all drawn from people I know, of how different people can have different ways of interpreting 'Hindu', unable to understand which ones Kupamanduka would be willing to include in the fold. My own thoughts on Hinduism are perhaps in order. Disclaimer : this is going to be long, personal and nostalgic. If you lose interest in between due to the egocentricity, my apologies.

I don't know what deeply religious exactly is, but you could say my family is deeply religious, or at least, they have become deeply religious as time has progressed. My parents both pray everyday, my mother for almost an hour. (The Sundarkaand of the Ramcharitmanas takes time, you know). Now parents always have this urge to ensure that the virtues they picked up anytime in their adult life be imbibed in their children at the earliest. That, coupled with the fact that I have a terribly sticky memory, meant that I was also doing pooja and reciting the Hanuman Chalisa, a few selected verses from the Ramrakhsa Stotra and the most popular hymns to Shivji, Durga and Saraswati by the time I was about 4. Though the reigning deities in my home are Ram, Krishna & Hanuman, I somehow always found the knotted-haired, earthly Shivji very interesting.

After some initial dabbling with Amar Chitra Katha versions, I had read the Ramayana and the Mahabharata, in Hindi, by the time I was 6. Of course, I did not read all of it, and of course I did not understand and grasp the import of the entire stories. In Mahabharata, for example, I would skip straight to the war after the initial background to the enmity between the Pandavas and the Kauravas had been established. I remember finding Mahabharata a lot more interesting than Ramayana, and when I went back to the epics a few years later (mid 90s) I remember wondering about the plausibility (or lack thereof) of things like the Brahmastra, an army of monkeys, a man with 10 heads, virgin births through the power of prayer and also about the ethics of Rama banishing Sita into exile on the hearsay of a deviant dhobi. The exalted status of Rama and Krishna in normal Hindu religious life and the non-committal idea of an 'avatar' also confounded me. Do bear in mind that I had yet to interact with or be brainwashed by the 'pseudo-secular' media ad intelligentsia - I guess a sense of the history of science and the prevailing common sense morality ofthe society around me were corrupting enough to breed a strong sense of skepticism.

In the 9th standard, I was intoduced to the Aryan Invasion Theory, which shook my confused understanding of Hindu historicity and mythology even further. I couldn't swallow it whole though, for I refused to accept that a story as elaborate as the Mahabharata didn't mention a merit in the discusison on the ancient history of India. Around the same time, I discovered that I was more interested in cricket, statistics and girls than in sitting and praying for 10 minutes everyday. I also started wondering about Karma and re-birth at about the same time. I had the good fortune of studying in a school run by the Bharatiya Vidya Bhavan trust. The trust was founded by K M Munshi, renowned freedom fighter, educationists and translator of religious texts. The school attempted to combine the British boarding school concept with the modern academic, scientific orientation and a commitment to the Indian and Hindu philosophies at the same time. One of the ays in which this balance manifested itself was Sanskrit classes from std. 6th to 8th, which consisted of basic gramar lessons followed by recitation of verses from the Bhagwad Gita in a metre, rhythm and style seen commonly in temples of the south. We didn't reach the last chapters, or cover the entire book, but we did cover suitable large portions of it. I remember being dissatisfied with the 'Karmanyevadhikarastu...' philosophy even then. This was definitely the begining of a new intellectual take I had developed on all things big and small, including religion and Hinduism.

Through 11th and 12th, I independently arrived at a 'first cause' defence of a belief in god. By this time, I had also become convinced that historical stories that were exaggerated by poets, priests and simple-minded devotees became mythologies, and that gods were either nature symbols or kings, or most likely, kings who had adopted nature symbols as their mascots or sources of strength. I also realised that many of the apparent contradictions in Hinduism and the Hindu beliefs are simply because there is no one definite book, prophet or origin of the religion. With a long, ancient and distributed lineage and an active approach to metaphysical and ethical inquiry, differing and competing views on what the world and the universe is and how to live your life are bound to come up. And I was extremely glad for that. But, my approach to religion had already become increasingly philosophical and intellectual and I did not really feel like taking much time out for praying.

In college, I furiously debated God, on the side of believers, against atheist friends. But that is tangential. I also read A L Basham's 'The Wonder That Was India'. Now Basham has his flaws, including a staunch belief in the Aryan Invasion Theory. But the largest section in this book consisted of his explorations of the religious philosophies of the Dharmic religions, especially Hinduism. I was absolutely hooked, and used to spend days poring and deliberating over the mass of information contained in that one section. (This was also the beginning of a somewhat strange habit of underlining, highlighting or bracketing sections in non-academic books with my thoughts and chess-inspired notes of ! and ? written in the margins) That, and Wikipedia, have also opened the door to quantum mechanics and Advaita Vedanta.

At the same time, I have developed an aversion to some of the more common ways of practising Hinduism, in my own hoouse and elsewhere. For one, I have a strong distaste for Brahmanical rituals like havans. I think it began with an innocuous dislike of fire and smoke, but I still used to take some kind of strange pride in things like knowing the correct way to do swaha (You have to hold the homa on the palm between the middle and ring fingers, and flick it straight with the thumb. The index and the pinky are extended lower and outwards, in an upturned and modified Metallica kind of way).

No longer. I am almost convinced now that the main techniques of the priest class in any relogion whatsoever, apart from soothsaying (which is good), are shame, guilt and fear. For example, the grihapravesh of my new house was a few months back. Among the many rituals that were done, one was to rid ourselves of the sin of destroying life in the process of building the house (say by destroying weeds on the plot of land or crushing ants through walking on them while constructing/overlooking the construction). So how could we rid ourselves of the sin? How else but by dropping some water here and there and by giving the main priest some gold, today substitued by cash - the priests have also moved to fiat currency from the gold standard. Mind you, this was for one rite, not for the entire ceremony. Such brokerage charges and commission reminded me of investment banking, with all the inbuilt perverse incentives and more.

Apart from priestly rituals, I also find myself irritated by the exaltation of every single virtuous character in the epics to a para-human status by devout Hindus. Yes, our minds are simple, but do they really have to be so simplistic? Kunti served sage Durvasa for a year, and he blessed her with a' mantra' that mistakenly gave her a child from the sun-god. Hello, take the hint. At least, don't get offended when others take the hint and say so. What's the point in taking this Christian virgin-birth morality and applying it to either our time or the Mahabharata time?

Having said that, I admire the prayer-based indiviudal relationships with the supreme that many devout Hindus build. For various reasons, I often feel that Shankaracharya was mistaken when he propounded the Gyaan marga as the one to moksha. The ability to go beyond intellectualising the religious and the metaphysical gladdens me, for I seem to have lost it.

This post is quite long already amd I have not yet spoken about Hindu political unity. That, and other more topical things in part 2.

On Hinduism

2009-04-18T10:50:00.003+05:30

Kupamanduka recently wrote a post that led to an acerbic reply form Ravikiran that led to further dicussion here. In a nutshell, Kupamanduka lamented the irreligiosity ( or at the very least, 'embarassed religiosity' ) of Hindus and asserted that there was nothing wrong with being more religious and more united with your fellow-reliogionists. In particular, he used the example of Islam and Pakistan (or more precisely, used somebody else's example of Islam and Pakistan) in an approving manner, though he made it clear that he doesn't admire Pakistan on the whole. He used parental love as an analogy, and also quoted this from Swami Vivekanada

"Then and then alone you are a Hindu when the very name sends through you
a galvanic shock of strength. Then and then alone you are a Hindu when
every man who bears the name, from any country, speaking our language or
any other language, becomes at once the nearest and dearest to you. Then
and then alone you are a Hindu when the distress of anyone bearing that
name comes to your heart and makes you feel as if your own son were in
distress. Then and then alone you are a Hindu when you will be ready to
bear everything for them."

Ravi took issue with the example of Pakistan, and I agreed whole-heartedly. He went on to theorise that excessive striving for unity is counterproductive, leads to narrow world-views and may even actively lead to disunity. I don't have an opinion on that yet, though I may just end up agreeing with him. Kupamanduka replied with a post that gave a ponderous justification of his stand using Hindu theological/ethical philosophy. Along the way, he wondered why people uninterested in Hinduism even bother about debates like these, dismissed the intersection of atheism and Hinduism as "non-sense" and most probably assumed that I am either unaware or uninterested in Hindu theology/philosophy.

So let's take this bit by bit. So who is a Hindu, and what is Hinduism? More precisely, on what basis can those who claim to be Hindus do so? Being born in a Hindu household is enough for the Indian legal system, but it does not seem to be enough for Swami Vivekananda and Kupamanduka. They are more concerned with an adult self-concept, a resonance and identification with either certain ideas or a common way of life, beliefs and culture. In the strong form, one also has to resonate not just with the ideas and the way of life, but also with everyone else who holds the same beliefs and practices the same way of life.

Consider Vievkanada's quote for example. The great man exhorts us to adopt a view of Hindu brotherhood that supercedes territorial boundaries and even a common way of life (language, etc.) Is this not at odds with the modern vitrue of patriotism? No, a cultural nationalist can easily retort. Why? Because according to one view, the identity of India cannot be derived from the modern European nation state alone, but has also to be derived from Hinduism, or at the very least, Dharmic religions. Thus, if you identify as Hindu, you cannot possibly be far removed from 'Indian'. ( I am not attributing to them the reverse implication, mind you).

Very well then, what is the problem? Well, at this moment, this definition of Hinduism is very political. Indeed, almost any definition that bases itself on a sense of non-intellectual peer-identification is bound to be political. The idea of 'Hindu unity' is thus by definition political. The political nature of unity is even more pronounced in our times, when the chief causes for Hindu anguish are not religious (like the plundering of the Somnath temple by Mahmud of Ghazni, or the Jaziya tax of Aurangzeb) but political (terrorist attacks, preferential treatment of Muslims by certain political parties, 'pseudo-secular, liberal' bias in the media, demographic change in Tripura, Bengal and Assam through illegal immigration from Bangladesh, distortion of History textbooks by leftist intellectuals).

Now, there's absolutely nothing wrong with a sense of political unity - the trouble comes when one tries to locate the basis of a political identity in philosophical inquiry. The trouble arises when an analogy is made with parental love, ignoring basic evolutionary biology. The trouble arises when Swami Vivekananda asks us to ignore geographic boundaries, which are the main source of political unity as they are the least suboptimal proxies for shared interests of utility. Most generally, the trouble arises when one constantly shifts from a reliogious/theological perspective of Hinduism to an intellectual/philosophical one to an identity/political one as per one's convenience in the argument.

Kupamanduka wonders about the disinterest in Hinduism, but he never makes it clear what view of a 'Hindu' is he referring to anyway? Take my mother for example. She is deeply religious, in the 'prayer and destiny' sense. She is also a staunch political Hindu, though she will never bother herself with Hindu philosophical thoughts on the absence/ flaws of free will as a justification for a sense of Hindu unity co-existing with an attempt towards universal love (as kupamanduka does). She is also probably unaware of and uninterested in the particular concepts he quotes in that post. Does she qualify? Or take the example of a deeply religious businessman who builds a temple worth a 100 crores, but couldn't care less about the suffering of fellow Hindus. Does he qualify? Take Vinayak Damodar Savarkar, an atheist who has even publicly lectured against the existence of God (by most accounts, though this is disputed) but who was the father of the modern Hindutva movement. Does he qualify? Or take any of a large number of young engineer kids (born in Hindu families) who are thrilled at the similarities between Advaita Vedanta and quantum mechanics and approach Hinduism through an extremely modern and scientific version of Shankaracharya's Gyan marga. Do they qualify?

Do notice, that until now, I have only latched on to the main problems in the broader reasoning that he tries to follow. My question about his particular argument of Islam and Pakistan being good exmaples of the unity borne out of religiosity remains over and above these arguments. Kupamanduka says that he will answer this in the next post, so let's wait.

In the next post, I will clarify my own world-view, my thoughts on the various differing conceptions of 'Hindu' and further outline my problems with the world-view espoused in the Vivekananda quote.

MBA

2009-03-29T09:19:00.001+05:30

I am now a post graduate.

Fundaes-2

2008-11-17T20:51:00.002+05:30

Claiming that the faults of big business are not the faults of capitalism is logically and morally equivalent to saying that the faults of big governments are not the faults of communism.

Last I heard, the modern corporation was defined by its system of distributing residual claims and the nature of those claims. Just as socialism is a definite system of governance and socialists should not be blurring it to simply mean anything that desires the greater benefit of the society, capitalism is also a very definite system of ownership and cannot be over-extended to mean just all the good things with the idealised free market. Corporatism is a stupid word.

So, stop with that argument already. It is tautological.

On Economic Thought - 6

2008-10-29T23:05:00.002+05:30

From behavioural finance, we move on to behavioural economics. The original and most pervasive idea in behavioural economics is that of bounded rationality. This simply means that contrary to the assumptions of neoclassical economics, human beings are not perfectly rational and often make errors in judgment, though full rationality could be a plausible first cut approximation. We do not optimize economic well-being functions like utility, because we lack the information processing capabilities required to optimize. Instead, we satisfice, i.e. we have certain targets in our mind that we set through a combination of experience, incomplete information and intuition, and then we work towards achieving those targets. We are happy with results that are sub-optimal but still good enough to meet the thresholds that we set for ourselves.

Computer engineers or others with some exposure to the field of artificial intelligence will recognise the difference between optimizing and satisficing to be exactly analogous to the difference between a best-result algorithm and a quickest/computationally easiest good-result heuristic. Thus, the central idea used to move from standard programming to AI is exactly the basis of the move from neoclassical to behavioural economics. It is no surprise then that Herbert Simon, the economist who introduced the idea of bounded rationality, was also a computer scientist. In fact, he is the only person ever to win both the Nobel in economics as well the ACM Turing Medal (possibly the highest recognition in the field of Computer Science). Herb Simon is probably the economist most under-explored by the mainstream, though he finds some pride of place in management literature.

Apart from bounded rationality, behavioural economics also makes some very interesting changes to neoclassical utility theory. Research by Kahneman and Tversky showed that people are not risk-averse, rather they are loss averse, i.e. they place higher weight on the possibility of losing some money as opposed to gaining the same amount. People also measure outcomes relative to some benchmarks that they set for themselves, and a typical example of this is an investor refusing to sell a stock at a loss in a market that is going downwards. Thus, if I have bought a stock at Rs 1000, I will refuse to sell it at 900, even if I believe that tomorrow the price is going to be 800 and rationally, I am better off selling today and holding cash. People value the same thing more once they posses it (status quo bias and endowment effect) and discount future cash flows by inordinately large discount rates (hyperbolic discounting). Importantly, people give different answers to questions that are logically equivalent depending upon the way they have been framed and give logically incorrect answers to seemingly simple rational choice questions if they are posed differently (framing). All this work led to what is known as cumulative prospect theory, which Avataram has sometimes written about. It is essentially an alternative to neoclassical utility theory.

Many of these assertions explain a lot of phenomena that we observe in practice to be near-ubiquitous. The endowment effect results in people demanding higher prices for houses they own than they would be wiling to pay themselves if they were customers, resulting in many unsold houses and reduced liquidity in the real estate market. Hyperbolic discounting means that people systematically err by saving too little for their retirement, something that we see rationalized away in the name of 'living for the moment'. Framing effects imply that people will respond to the exact same information and decision problem differently if the information is unstructured.

Behavioural economics has not only introduced new ideas, its central technique of conducting experiments with people to reveal utility preferences and cognitive biases is also very different from the largely arm-chair approach of mainstream microeconomics. It seems only intuitive that a science that is founded upon assertions of human behaviour follow this approach, but for some strange reason economists of the past have had a disdain for experimentation. The Austrian school was the epitome of such disdain. But more on the Austrian school later.

Back to experiments in economics. Enthused by what I read about behavioural economics, I tried conducting an experiment myself on the relevance of how decision problems are framed.

Consider the following question

There's a red-haired woman who is single. She plays tennis, is a feminist and a member of Greenpeace. What is she more likely to be ?
1) A newsreader
2) A lesbian newsreader

If you answered 2, you'd be in the majority but you'd be wrong. While this may seem to be an effort to illustrate the stereotypes and biases prevalent in society, it is actually nothing of the sort. Bias or no bias, the set of lesbian newsreaders is a subset of the set of all newsreaders. The probability that somebody is a newsreader is thus always greater than or equal to the probability of her being a lesbian newsreader. If you are a rational economic agent who makes the correct choices in decision problems, you would have chosen 1, irrespective of the mass of information presented to you and irrespective of any biases that you may have. However, the vast majority of people across levels of education, political beliefs and geographies pick 2.

I got this simplest of decision problems off something I was reading on the internet, and have posed it to many friends of mine, all MBAs from top institutes in the country. Barring one, every single one of them has given me the wrong answer. One of them (Frust), when offered the solution, suggested that the context matters - had the question been asked in a test measuring his quantitative abilities and knowledge, he might have given the correct answer. Over a dinner table conversation, he faltered. He may very well be right, and that only goes to illustrate the overarching importance of framing - the way and context in which information is presented to you may radically alter your decision. And we all know that real world information and decision choices resemble a dinner-table conversation far more than a probability test.

(You could also use this fact to infer that MBAs are stupid. That conclusion, however, will be dependent on your biases and has nothing to do with such googly-type solutions to decision problems.)

While Herb Simon would count as the big daddy of all behavioural economists, Richard Thaler is the one most prominent now. However, whenever I have read about Keynes and his theories, I have had a sneaking feeling that he may be the original behaviourist. The man who called the stock markets a beauty contest seemed unlikely to be anything else. Indeed, recent research into interpreting his works has followed that path, and the foremost researcher on that front happens to be George Akerlof.

Akerlof won the nobel for his seminal work on information asymmetry, which resulted in the formulation of the adverse selection problem. We don't need to go into the details but suffice it to say that his work introduces the last of the most significant tenets of behavioural economics. Not only are people incapable of processing large amounts of information and prone to multiple cognitive biases, they often do not even have the information rquired to make the requisite optimization or satisficing, and this leads to multiple complications. When this aspect is introduced, even Kenneth Arrow could be counted as a seminal behaviourist. Indeed, his 'learning by doing' model was probably the first endogenous model of growth.

The most interesting thing is that Akerlof has been looking at a theory of 'behavioural macroeconomics' by re-interpreting he works of John Maynard Keynes. He has been among the foremost New Keynesians with his efficiency wages theory that explains how people who get jobs during good times lock in higher-than-equilibrium salaries, and people who look for work during busts have to continue with lower-than-equilibrium salaries even when the times are good. His formal exposition of this intuitive idea has led to considerable new developments on the Phillips curve, the emprically known trade-off between reducing unemployment and reducing inflation. He has also been collaborating with Robert Shiller towards this goal of a theory of behavioural macroeconomics, which can be loosely described as the current New Keynesian macromodel with microfoundations explicitly in behavioural economics. Currently, the microfoundations of the New Keynesian macromodel are largely neoclassical, with a few market imperfections.

From whatever little sense I have been able to make of economics, George Akerlof happens to be my favourite economist. Robert Shiller is another one to watch out for, and let me predict here that he may get the Nobel soon enough, in 2009 or 2010. Shiller correctly called the dot com and the real estate bubbles, but more on him later.

On Economic Thought - 5

2008-10-27T06:16:00.003+05:30

Last time, I asserted how financial markets and securities help cut out the tautological subjectivity of value. Well, they go further. The idea of 'rationality' is well defined. 'Efficiency of a market' can be tested sharply because the implication of an 'efficient' market is very objective and can be checked for against market prices. There is a tremendous amount of high quality data available. Finally, even information has some precise definitions in the field of finance.

Among the most celebrated and debated ideas in finance is the efficient market hypothesis (EMH). What does it say? Well simply, that financial markets are rational and hence stocks are fairly priced all the time. In case there is a move away from this ideal equilibrium, it adjusts back to the stable equilibrium state fast enough.

But isn't that absurd? To assume that investors are always rational? Well, that's the catch. The rationality of a market on the whole (or indeed, of the entire economy) has very little to do with the rationality of every individual participant. You see, for the market to be rational, it is not necessary for every, or indeed, even most investors to be rational. All that is needed is that
1) The 'irrationality' is randomly distributed across people and has a mean of zero.
2) There are a reasonable number of 'arbitrageurs' who have the capital and the freedom to make use of those opportunities in the market when stocks are incorrectly priced.

Thus, when Ravikiran asserts here and here that retail investors in India are stupid and hence the EMH may not hold for India, it makes me wonder if he understands the EMH at all. As long as the idiot retail investors in India (or elsewhere) are idiotic in their own randomly distributed ways, the EMH would still hold. The argument is simple - the overestimations of the positive idiots will cancel out the underestimations of the negative idiots. The only problem arises when idiocy is systemic - when idiots make mistakes that are very similar to each other.

Even if the mistakes are systemic, the EMH may not be affected. If there are some few rational people working for a few hedge funds or investment banks who spot these systemic mistakes, they will use their money to capitalize on it to make riskless profits, or arbitrage. These smart guys will make the EMH work by two means
1) The mispricing will correct immediately.
2) If the mispricing does not correct, the arbitrageurs will keep making money and over some time drive out the idiot investors who will be losing their shirts.

Thus, any reasonably mature financial market should be efficient. In this fully developed form, the EMH was among the technically soundest theories to have propped up. It ruled out the efficacy of either technical or fundamental analysis, and implied that your best bet in investing was to buy an index fund, or to passively replicate the benchmark index.

The theory was especially popular in the Chicago School tradition. It fit beautifully with the idea of rational expectations and other such tenets of neoclassical economics. Opposition to this theory has come from various quarters. One of them has been the value investors - the supremely successful stock pickers of the Warren Buffet mould. They rubbish the idea of the market always being fairly priced, buy when things are cheap, sell when they are expensive, and generally make millions doing this. However, it must be noted that they are only aghast at the claim that markets are always efficient. Because, this strategy of buying low and selling high makes money only if prices will someday be correctly priced in. In this manner, the value investor is only performing the role of the rational, efficiency-inducing arbitrageur of the EMH. The value investing school thus quarrels with the more extreme conclusions of the EMH, but has no strong theoretical model to oppose it.

The real challenge to the EMH has come from behavioural finance. Now Avataram probably believes that he has introduced the Indian blogosphere to the existence of Daniel Kahneman, but I stumbled upon these theories while preparing for my summer internship interviews last year. Behavioural finance hit the EMH on its two most important pillars - on the assumption of irrationality being random instead of systemic, and on the assumption of the possibility of profiteering from riskless arbitrage.

Multiple experiments have shown that people across levels of education make choices that are wholly inconsistent with the idea of risk-averse expected utility maximization. The Ellsberg paradox and the Allais paradox are two illustrations of that. More importantly, arbitrage is never truly riskless. There are limits to arbitrage, and the most important one is capital preservation. Arbitrageurs can be driven out of business if the mispricing that they are trying to take advantage of deepens and does not correct as quickly as they'd want to. Their trades will keep losing money, and they run the risk of getting fired for losing money or underperforming their benchmarks. About 50 years before behavioural finance became en vogue, this idea was captured beautifully by Keynes in the quote that I'm sure many have heard - "Markets can stay irrational longer than you can stay solvent". Indeed, if there is one adage that you should know and remember about the financial markets, it is this one. The most striking example of the risk of arbitrage preventing a rational outcome in the markets has been the celebrated case of Royal Dutch and Shell, where stocks of the exact same company split in a 60:40 ratio refused to trade in that ratio for elongated periods of time.

Research into behavioural finance and behavioural economics has over the years produced a rich body of evidence of the systemic cognitive biases that individuals have. The idea of the importance of market microstructre has also gained relevance. I have long believed that if mathematics is at the base of the natural sciences, and philosophy is at the base of the humanities, then psychology is definitely at the base of the social sciences. Since economics is a somwhat scientific social science, I should probably say that cognitive science is at the base of all economics. Some of the ideas presented by the behavioural economists are easily among the most compelling arguments on economic activity that I have come across. But more on that later.

On Economic Thought - 4

2008-10-25T22:56:00.004+05:30

We spoke of the Neoclassical theory of prices being hit by the New Keynesians. But what exactly is this theory of price? A theory of prices and values is nothing more than an attempt to answer the questions - 'what is this good actually worth?', and 'why should it be worth that much?'. The analysis could be both descriptive (or as economists would like to call it, positive), or judgmental (normative).

When younger, I often wondered why SRK gets Rs. 2 crs for hamming through a steaming pile of rubbish like KKHH, while the guy who builds your house has no place to sleep once he is done building your house. Needless to say, these were just ponderings over the theory of prices and values. A belief that there is some 'true' value of a product or service is a very intuitive thought and is known as the intrinsic theory of value. In this case, the price of the good may be very different from its perceived value. This belief has a normative bias, for it asserts what a good should be worth, and thus lends itself very easily to adjectives like 'overpriced', 'too cheap', 'unjustified' and 'exploitative'.

On the other hand, the belief that a product or service is worth whatever its user is willing to pay for it is called the subjective theory of value. It thus converges the theory of value and the theory of prices into one. This idea is also known as utility theory and came to the forefront during the marginalist revolution, which is more or less the genesis of neoclassical economics as we know it today. It is somewhat unintuitive, and the fact that it can escape common intuition is one of the main reasons why people are often unwilling to place faith in the market system. It is also ostensibly descriptive in nature - it doesn't say what goods should be worth, just explains why they are priced the way they are.

Before the neoclassicals came along, there were, unsurprisingly, classical economists. I believe that there are three main strains of classical economics, i.e economics of the 18th and 19th centuries. The fountainheads of these strains are Adam Smith, David Ricardo and Karl Marx respectively. One could argue about this point forever, but let's accept the current categorisation as an easy rule of thumb. All three strains have similar, yet subtly different theories of value. They are similar in the sense that all three believed in the intrinsic theory of value. However, while Adam Smith proposed that the 'natural price' of a good is its cost of production, Marx asserted that the true value of a good should be the amount of labour that goes into producing it. Ricardo's ideas were somewhere in between, and he believed that while the labour theory of value is inherently wrong, it can serve as a good approximation. All three agreed, of course, on the fact that market prices can be widely different from this intrinsic value. However, while Smith believed that prices would tend to converge to the intrinsic value, Marx saw the difference between market prices and intrinsic values as another fault of the capitalist system.

Marx, of course, was uneasy with the importance of capital in the first place. But Smith was vindicated to an extent later when neoclassical economists showed that in a competitive market, prices should converge to the cost, albeit the marginal cost. Ricardo's ideas were resurrected later by Pierro Sraffa, but more on Sraffa and his followers later.

The neoclassical idea of the utility theory of value is an extremely powerful concept. However, I think that its claim of being descriptive and not judgmental is somewhat misplaced. If you make the ideas of price and value converge by asserting that a good is worth whatever its user is willing to pay, you are indulging in a tautology. The normative bias in this idea is the inbuilt implication that nothing is ever mispriced. The argument then becomes circular.

This is where the financial markets come in. Unlike, say a shirt, a stock is difficult to fall in love with. The idea of subjective values hardly makes sense when one talks of financial instruments. Thus, while the market price of a financial instrument is dependent upon the actual demand and supply, it is possible to arrive at a 'true intrinsic value' on the basis of a theoretically consistent system of valuation. This true value may differ, sometimes widely, from the market price and thus the financial markets provide a brilliant opportunity to test many of the assumptions and conclusions of neoclassical economics, including rationality and efficiency of markets and market participants. But more on the the financial markets later.

On Economic Thought - 3

2008-10-24T23:56:00.005+05:30

So, I happen to be excited about the New Keynesians these days. But before we latch on to the New Keynesians, a little background on Keynesians themselves may be in order.

Everyone has heard of John Maynard Keynes. But what many people do not know or realise is, none of the Keynesian macroeconomic models that economists quibble and debate about ad-infinitum were actually drawn by him. The IS/LM was formalised by John Hicks and Alvin Hansen. The Phillips curve, of course, came later. Keynes himself, wrote his magnum opus and a few other books, debated with intellectual rivals, and became a policy adviser. But much of post World War 2 macroeconomics was dominated by his thought, or more precisely, by various interpretations of his thought. If there is a single important takeaway from Keynesian economics, it is that government policy has the ability to manage aggregate demand (of goods, money and labour) and that demand is the key factor, supply will adjust. This is in opposition to the Neoclassical (or Classical, as Keynes chose to call it) view of aggregate supply being the key factor. The government could manage this demand through deficit spending or interest rates. Thus, it affords ample scope for both monetary and fiscal policy, though the reconstruction efforts after the Great Depression and after World War 2 largely focussed on fiscal initiatives.

The standard textbook interpretation of Keynes is what is called Neo-Keynesian macroeconomics. Paul Samuelson, Robert Solow, Franco Modigliani, John Hicks and James Tobin are probably the most important figures of Neo-Keynesian economics. At its core, it is a marriage of the Neoclassical macromodel of old to the insights from Keynes's opposition to it. Crudely, economists agreed that Keynesian insights were more relevant in the short-run, while the Neoclassical model held in the long run. Whenever assertions about human behaviour had to be made, the Neo-Keynesians turned to standard Neo-Classical microeconomics. In fact, on some important counts (growth theory, for example) Neo-Keynesian macroeconomics had almost nothing to do with the original Keynesian theory. Thus, there was a synthesis of the Neoclassical and the Neo-Keynesian view of markets and the economy. This combination is what introductory courses in economics at most places teach. It is also the academic thought underpinning mainstream right-of-centre capitalism, which supports freedom and efficiency at the individual market level, while allowing an important role for government intervention when dealing with aggregate variables and special situations.

The problem with this synthesis is, it can sometimes be ad-hoc and inconsistent. It talks of microeconomics when it wants to, else it ignores microfoundations. More pertinently, some of the Keynesian conclusions that it draws are logically at contradiction with the assumption of rationality in neoclassical economics. Plus, the demand boosting goverment initiatives that neo-Keynesians speak of are typically inflationary. The stagflation of the early 70's called into question the implied positive correlation between inflation and economic growth.

New Classical Economics arose as a result of these inconsistencies. Robert Lucas and Thomas Sargent insisted that macromodels be formed on grounds that are consistent with microeconomic foundations. They emphasised rational choice, rational expectations and real business cycles. They arrived at some pretty unbelievable conclusions, including one that crudely put, asserts that unemployment is always voluntary. In their view, in a recession, people are basically taking a vacation. There was bound to be some academic backlash to these outlandish theories. Enter the New Keynesians.

The New Keynesians tried to integrate most of the tenets of Keynesian, or neo-Keynesian economics with the neoclassical microfoundations, making room for some more market imperfections than traditional neoclassical economics allowed, while still allowing people to be rational in the long run (Actually, the idea of 'rationality' needs to explored in greater detail, but more on that later).

The details can be left for the serious academic, but one feature of New Keynesian economics (other than DSGE) needs to be talked about. The single most consequential market imperfection that the New Keynesians introduce is the idea of 'sticky' wages and prices. In short, this is the theory that when there is a supply-demand mismatch, it is the quantity rather than the prices that change. Neoclassical theory argues that if for some reason the supply of some product exceeds its demand, its price will drop, and there will be a supply-demand equilibrium at the new price. New Keynesians argues that these hardly happens in practice, and that it is much more common for the suppliers to re-adjust their supply, keeping the prices at their original level. This downward 'stickiness' of prices can be due to a multitude of reasons, from psychological resistance against revision of prices to the costs that are incurred in making this revision. Nowhere is this concept more beautifully illustrated than in the real estate market, where sticker prices continue to be the nearly the same though the developers have lost more than half of their market value.

So what's the big deal, you ask? There is a supply-demand equilibrium anyway, right? So where's the imperfection? Well, the informative role of prices is lost. At an elementary level, this is the single biggest takeaway from the idea of sticky wages and prices. Prices may no longer be indicative of true supply and demand scenarios. There could be extended booms and busts. Thus, while accepting most of the tenets of neoclassical microeconomics, it delivers a blow where it matters the most - on the theory of prices. But, more on the theory of prices and values later.

Prominent New Keynesians include Greg Mankiw, Michael Woodford, Jordi Gali, George Akerlof, Stanley Fischer & Olivier Blanchard.

On economic thought - 2

2008-10-24T05:14:00.004+05:30

So I mentioned last time that microeconomics involves much less math than macro does. Well, let me make a qualification to that. There is an important field of microeconomics that is very math heavy - general equilibrium theory. Mainstream economics of the past 200 years owes a lot of techniques and terms to physics for its mathematical analysis. The idea of 'equilibrium' is thus deeply embedded in economics. In microeconomics, the most commonly encountered equilibrium is that between the supply and demand of any product or service. This is referred to as a partial equilibrium - it says nothing about the supply demand relations of other products, and how they affect the equilibrium under consideration.

General equilibrium theory refers to the attempt to bring together the equilibria of all or most of the products and services in the marketplace. Its earliest proponent was Leon Walras, followed a little later by Vilfredo Pareto. Both these economists belonged to the 'Lausanne School', and were highly mathematical in their thought and approach. The Walrasian and the Paretian ways differed in some details, and were brought together int a more general, more refined and highly mathematical neoclassical general equilibrium theory by Kenneth Arrow and Gerard Debreu. Dynamic programming, comparative statics - the modern GET has it all. Unsurprisingly, GET is considered tough and beyond the scope of introductory courses. As a result, I have very little exposure to it. Why do I speak of it then?

Well, even though it's categorised under micro, and uses microeconomics techniques and variables, the level of analysis in GET is very macro. Crudely, while macroeconomics typically tries to analyse aggregate variables in the economy from a top-down perspective, GET tries to aggregate them from their microeconomic components. If you're talking about all product markets inside the economy, you are pretty much talking of the entire real economy (assuming a closed economy - no currency transactions). It is not surprising that the first true macroeconomic model was more or less a scaled up general equilibrium model with some additions. Irving Fisher's neoclassical macromodel draws heavily from the mathematics and analysis of Walras. GET thus forms an interesting bridge between micro and macroeconomics, and a refined GET could be considered one legitimate way of looking at economics in an integrated fashion.

The importance of such an integrated approach cannot be over-emphasized. Indeed, the most technically sound and scathing criticism of Keynesian macroeconomics came from Robert Lucas, who insisted that macroeconomic models be necessarily founded upon and consistent with microeconomic foundations. A branch of macroeconomics that arose as a response to this critique is called New Keynesian Economics. Essentially, it tries to provide Keynesian macroeconomics with consistent and complete microeconomic foundations. But more on that later.

The thing I want to highlight now about New Keynesian Economics is, it uses something called a Dynamic Stochastic General Equilibrium. This is a GE model that attempts to remove some of the more central flaws of the Neocalssical GE model. It is dynamic, instead of static. It allows room to make technology endogenous. It models transitions between equilibira as stochastic processes, and hence it must be cool.

Basically, DSGE models are the high point economics has yet reached in general equilibrium theory. I don't know much about DSGE models, but they excite me. And they are only one of the many things that get me excited about New Keynesian Economics.

On economic thought - 1

2008-10-20T00:20:00.003+05:30

(Finance will come soon enough, but for now, economics)

Most introductory courses in economics split the discipline into microeconomics and macroeconomics. Very crudely, microeconomics deals with markets, while macro deals with the entire economy. Government policy spans the entire spectrum, for eg. product market regulations on the micro front, fiscal and monetary policy on the macro.

Microeconomics is a set of assumptions, assertions, observations and models on which the foundation of economic thought is built. While a fair bit of it (especially in its mainstream form) is mathematical, it is essentially just a modeling of human behaviour, action and interaction. On the other hand macroeconomics is highly mathematical, deals with huge amounts of data, employs complicated econometric models and often deals at an uncomfortable level of abstraction. To be sure, there are assumptions, assertions and comments on human behaviour galore. However, at all points of time, the attempt is to analyse the cumulative sum of all agents in a given economy.

Therefore, microeconomics tends to be easier and much more intuitive than macro. For example, to assert that 'government inspection of schools is debilitiating' requires only a certain level of knowledge and competence. To claim that 'the correct way for India to fight inflation is to sell its dollar reserves' takes a wholly different level.

Most non-academic thinkers and commentators miss this fact. As ordinary citizens, what influences us most is government policy, and that straddles both micro and macro. Somehow, the average commentator on economic policy tends to assume that if he is able to, say, critically evaluate the regulatory aspects of tax, he is also able to make very informed comments about the ideal fiscal policy. In the past, it has often amused as well as irritated me to see inflation-is-a-monetary-phenomenon-explained-for-dummies type of posts floating around in the blogosphere. However, I have always reserved comment, for I was one of the dummies myself.

To be sure, the basic relationships between macroeconomic variables can be broadly understood by a single course in macro, or even casual reading. What I am refering to here are the prominent macroeconomic debates. Many of these tend to very fine-grained and extremely non-trivial in nature. While one side of the debate may seem intuitively more appealing if explained properly, criticism of the other side should typically be left to the experts. Most dilletante commentators are only projecting their policy biases when they take sides. Uninformed macroeconomic analysis mixed with policy bias makes for a terrible concotion.

Another key point that we often miss out is that many economic (micro and macro) debates are academic in nature, centred on a theoretical contention or on interpretation of avaliable data, and may not have any policy or ideological implications. For example, neo-classical economics (mainstream microeconomics as it is taught at most places) assumes that technology is exogenous to all firms in the economy. The macro-level implication is that technology can be treated as an exogenous variable to the economy and changes in technology lead to 'shocks' or transitions between different 'equilibrium' states of the economy (more on equlibriums later). I find this assertion to be patently absurd on the micro-level. Of course, no neoclassical economist lives or dies by this theory and it is only a model-simplification. However, I find this simplification extremely distortionary. Sure enough, it has been criticized on many fronts by many economists who also find it absurd. But does this criticism have any policy implications? Most probably not.

If I was to argue that this flaw in neoclassical economics means that the capitalist economic system that it serves as the foundation of is principally flawed, it would be a stupid argument. Yet, often enough, people believe that by finding out one flaw with a system of economic theory they have destroyed the credibility of the policy implications of that system. More commonly, one finds people trying to place their own understanding of a purely academic debate on a simplified policy spectrum of left and right, socialism and capitalism.

Of course, there are many other tenets of economic theory that have direct policy implications. A blow to one of these tenets would lead to genuine policy debates. One prominent example is that of the ridiculous idealization of perfect competition. But more on imperfect competition and other such things later.

(this is the part 1 of an n-part series, n is as yet undecided)

Of blogging and finance

2008-10-16T02:20:00.003+05:30

Tanuj (or as we call him here, Bhaiyya) brings to my notice that every post of mine on the first page of my blog is a criticism of someone. He is quite pleasantly amused by this fact, but I will have to disappoint him by saying that of late I have developed an aversion of this tendency of mine, and not only for what it implies abut my behaviour and nature.

You see, criticism bores me now. I refuse to criticise the commies, because their arguments are not worth criticising. Ditto for religious / political hawks and fundamentalists. Libertarians were a prime target earlier, but India Uncut has stagnated remarkably and Sabnis doesn't blog any more. Ravikiran came back on the scene and some new juice was offered, but I have noticed that my arguments with him often become too defensive and pedantic - of the 'no, I never said this' and 'yes, you did' type. (Was he also a debator in a previous avatar?) That stuff bores me much faster now than it did earlier.

Of course, criticising Avataram still remains fun, but the problem is that he blogs on The Maanga. Nilu has the attention span of a poodle if the discussion gets beyond his intellectual comprehension, as it frequently does. Which is why, often enough, a perfectly good rant-fest with Avataram is spoilt by his infantile posturing.

Basically, I am bored of criticising now. And hence, I will make a conscious attempt to shift the tone of this blog from critique to construction. In management jargon, I asked myself the question - what business am I in? And I discovered this.

So where does finance come in? Well Avataram seems to believe that blogging, and not finance, is my cobbling last. And I seem to think that I definitely understand finance better than I write on the blog. So how shall the twian meet? The answer, dear readers, is financial blogging, or more precisely, blogging on finance. Now don't run away - I am not going to write only on finance. In fact the non-financial posts will still greatly exceed the finance-related posts. Also, often enough, I will simply link to the efforts of my intellectual superiors rather than post myself. All I'm saying is, this blog will see more finance than it has seen in the past. Apart from all the stuff that I promised to write on some 2 years back.

Ajay Shah confounds me

2008-10-02T14:21:00.002+05:30

He links to this site, and claims that by one measure, the usage of IE and hence MS browsers has dropped below 50%. Then, on top of that he adds that the measure under-represents mobile phones and hence over-represents Microsoft.

Immediately below the statistics (which seemed to me to be fishy because they showed Chrome to have a 3% usage!), the developers of the website explicitly mention

W3Schools is a website for people with an interest for web technologies. These people are more interested in using alternative browsers than the average user. The average user tends to use Internet Explorer, since it comes preinstalled with Windows. Most do not seek out other browsers.

These facts indicate that the browser figures above are not 100% realistic. Other web sites have statistics showing that Internet Explorer is used by at least 80% of the users.

And yet, what Dr Shah infers from the site is that IE's usage may even be lesser than 49%. This absolutely confuses me. I am not even sure what the point of such selective representation could be. (I call it selective representation because I am ruling out incompetence and oversight) Is he cheer-leading for Mozilla? Is he anti-Microsoft? Or is he, in some perverse way, trying to argue that Microsoft's monopoly is not as much of a monopoly as it seems to be; that the web and hence the new information economy are wonderfully competitive and informative places and thus the relevance of free markets to the modern world is established.

There have been other such missteps in the past, which seem like subtle nuances at first but are quite shocking mistakes when evaluated to any depth. Using the SJTU ranking to rubbish IITs and thus establish the relevance of GARP- FRM is one such shocker in recent memory.

Dr Shah is a respected professor and wrote large chunks of what is one of the definitive studies and policy recommendations for the Indian financial landscape (Percy MIstry Report). Stuff like this just causes dissonance then.

Dear Mr Varma,

2008-09-21T17:25:00.003+05:30

Please stop. Your recent lack of activity had done you a lot of good. I was wondering if you really had found the good sense to not talk about stuff you don't know. But, you have risen to the occasion again.

The SEC has got it wrong time and again in this crisis. The failure of the regulator, however, is not adequate evidence for the failure of regulation, if you can make the distinction. Plus, this is finance. There is some math involved. There is some macro-economics involved. There are some accounting laws involved. Of all three things, I'm sure you have no effing clue. There are also many tenable conspiracy theories, but when one does not know the basic facts, indulging in conspiracy theories is the worst kind of arrogance that one can display.

Your interest and ideological grandstanding of policy prescriptions based on links and rhetoric (the Kashmir issue, and now this) with nearly zero knowledge of the underlying matter remind me more and more of the communists everyday. You share your predilection for ideology over issue and analysis with them. Which sort of confirms my longheld position that the world is round (yes, I translated from Hindi, I am a vernie) and the more extreme you get on either side of a divide, the closer you become to your ideological opposites in ways that you did not foresee. (You can call this Ritwik's theorem of the unintended consequences of ideology. )

The consistency with which you mange to sift out, read and link only the most half baked portions of non-representative analyses is amazing. So is your failure to perform even the most routine reserach on that which you wish to comment upon. There is Google, Bloomberg, the Yale law school online library (for Kashmir). You seem to be unaware of teh existence of these resources, and much worse, unwilling to fish them out.

I have to say - you were quite right when you said that when you try non-fiction, you end up repeating yourself. However,your diagnosis of things being cynically recurrent and non changig was not correct. Try this for an alternate hypethesis - you don't have much to say anymore. You have plateaued, stagnated. I wish you luck for the awards that you are competing in. I may even buy and read your novel, if I ever get the time. But for now, I have a sincere request. Please do stick to fiction. Invoking David Ricardo, Niranjan Rajadhyaksha and Ravikiran, that is your comparative advantage.

I must also thank you, though. For two thing. First, about three years ago, when I had just about discovered the world of blogs, you were thought provoking - infuriating at times, wonderfully insightful at others. I now realize that this was primarily because I was unexposed to the ideas that you hold, and some of them were very strong challenges to my world view. I don't know if it is result of my education in the last thre years or simply your stagnation, but you no longer have anything worthwhile to offer me as a reader. But let's give credit where it's due.

Second, I have been off the blogging scene for some 8 months now and I have a deadine to meet at 11 pm. Yet, your consistent piling up of rubbish has now broken my patience. I am back on my blog now, and I must thank you for that.

Thanks,
Ritwik

p.s I don't think I would be reading you much from now on. Ta-da. If you ever read this, you can use this as the perfect example of how the free-market system works. For a change, that will actually make sense.

I have to rush, but...

2008-01-25T20:10:00.000+05:30

Ok, I was holding out of doing this for various reasons. But this needs to be done, and hence yours truly shall go ahead. Read this. Especially this bit,

I’m not dissing the armed forces—they keep our borders and engineers safe—but there are better reasons to feel proud of being an army man than the power you have over people’s lives.

The other profession marked out by such lust for power is politics. How staggeringly sad.

Oh dear god! Such farce is not even funny.

Of momblogs, children and externalities

2008-01-13T14:18:00.000+05:30

Dear Mombloggers,

I don't read any of you. I know none of you read me either, but that's immaterial. It does surprise me that you would choose to share details of your life and your children with the world wide web, but I also know that I can't even begin to understand. We all write about what we like, so it's ok I guess.

I am, however, extremely surprised at the way you react to all the people who try to slag you on the blogosphere. It shows the great danger of being emotionally attached to what you write about. We all are, at some level. But when it's one's own children, it's a little too close for comfort. I am genuinely amazed at your willingness to read random people rant about children and be infuriated enough to even try to think of cyber-rebuttals. Feminists fisk stupid things all the time, but I see their point - it's an uphill battle when a large majority of the people don't even share some of your basic views on equality and don't realise that they are being bigoted. Libertarians fisk non-fisk-worthy commie arguments too, but I get their point as well - far too many people have notions of achieving great utopian equality without the slightest idea of how we're going to get there.

You, on the other hand, face no such uphill task. The world at large likes children. Since when did Nilu, Aadisht and Falstaff become representative viewpoint-holders on children? Their rants can be attributed to too much porn, too many graphic novels and too much poetry respectively. I don't agree with them, but I see the point in their rants (except for Nilu, in whose case having a point would defeat the entire point) - they are the ones who face an uphill task. Essentially, people with that extra bit of intelligence and a life that largely revolves around solitude and a computer develop slightly warped views of reality. You need not worry about them. You need to however, think about people like me.

You see, I too have a life that revolves largely around solitude and a computer. However, I am a country boy. I don't pontificate about the US presidential election - I frankly am more interested in the Bharat Ratna controversy. My intellectual rebellion developed much after my initial upbringing had grounded in me the virtues of appreciating the status quo and the constraints of decision makers. I am the one who you should be bothered about, for the majority of people with experiences similar to those three worthies turn out like me, and not like them. Country boys who hopefully understand economics but stop short of seeing Ronald Coase everywhere.

And you will be pleased to know - I don't dislike children. I don't necessarily like them either - but I know that they are going to happen in a few years and am absolutely ok with that. I think I'll like them once they are there, and I see the merits of the status quo. You will never hear me talk in appreciative terms about a growing population (oops, sorry, human capital base) and yet talking ill of children, because it appears terribly inconsistent to me. Don't be bothered yet, because people at large believe that it's not ok to be openly intolerant of children. Not yet.

So am I with you or against you? A bit of both. I sympathise with your predicament and yes kids are cute, but I wish that you'd display some more gravitas and sangfroid. Children rants are not to be replied to - it's a little like trying to beat children at their own game of not listening to reason. You fall into the trap by imitating them, only to realise that its not your core competence. And yes, some emotional distance from what one writes helps.

Thanks.

2) Which brings me to the question of negative externalities. Venu reminds me that to some people, children are akin to pets or smokers that impose negative externalities on other people. There are two questions here - one more fundamental than the other. We shall not even go into the 'pets' argument, for if you bring non-human life into the picture when we are trying to deal with human social systems, I am sorry to say that you've missed the point completely. However, the other aspect is worth examining.

There is obviously a negative externality when a smoker exhales fumes into a setting that involves non-smokers. There is also an obvious externality, though slightly intangible this time, when a child cries through what could have been a perfect rendition of a Mozart concerto. There is also an externality, intangible and not so obvious, to many devout Hindus when they so much as get news of an M F Hussain painting that shows a naked Sita on Hanuman's tail. Or to Muslims when they see their prophet depicted as a terrorist in a cartoon strip. You may want to brush the last two under the 'freedom of speech' carpet (and I would agree) but there's no denying the fact that there exists an externality - it is not for you to judge whether my mother should get angry at MFH or not, the fact that she does get genuinely disturbed is proof enough of the externality's existence. The question is, is the disturbance caused by the child's crying more similar to the MFH example, or more similar to the smoker example? The answer is quite obvious to me, but I would like to know your views on the issue.

Essentially, if you believe that a first principles based, non Coasian solution is the answer to the free speech issue, I fail to see why that should not be the case with children. However, even if you think a child is more analogous to a smoker than to MFH, there is another issue here. Am I the only one who sees the problem with trying to create an analogy between what is a choice, and what is a stage/fact of life that one does not really choose? Being of a particular age is far more like being a boy, a girl, a white or short than being a smoker. Coasian solutions for the gender and race issues as well, sirs?

Of course, private property rights are part of the solution - a theater owner would be well within his rights to ask the family of an unruly child to leave. Restaurants that an the entry of children could easily come up if it was a viable business model. But the point is not that - the point is, does there exist sufficient moral ground to ask for a Coasian solution at the society level?

Which brings me to the last, most confusing point. Is it correct for the government to have legislation that requires companies to have explicit no-discrimination policies? It is coercive, an infringement of absolute private property, and yet necessary if equity forms a reasonable chunk of the social welfare function. What are your views on this?

The value of human life

2008-01-03T13:06:00.000+05:30

We're fresh from a small round of blog discussions about the value of human life and the policy implications of executing murderers and executing 'vermiscripters' (computer virus writers). Steven Landsburg here and Ravikiran here assert that people who claim that a value cannot be attached to human life are making "invalid" and "wrong" statements. The crux of their argument is that we make choices about our lives and our safety all the time. So if I drive a bike at a 100 kmph for half an hour today, and that increases the chances of my death by .01%, then the fact that I am making this tradeoff means that utility (.01 % increased safety of life) = utility (driving a bike at 100 kmph for half an hour). It is easy to see that the RHS of this equation can be replaced in money terms - for e.g if I am willing to pay 1000 Rs to drive a bike for half an hour at 100 kmph, then utility (1000 rs) = utility (driving....half an hour) and by substitution, utility (.01% increased safety of life) = utility (1000 Rs). So far so good - the argument is flawless until here. But truth is a little more nuanced after this.

The flawed leap in the argument comes when people extend utility (1000 rs) = utility (.01% increased safety) to , say, utility (100000 rs) = utility (1% increased saftey). There are two assumptions underlying this extrapolation, both wrong, one more wrong than the other. The first assumtion is that utility (100000 rs) = 100 * utility (1000 rs). The second, and more incorrect assumption, is that utility (1% increased safety) = 100 * utility (.01% increased safety). (Of course, mathematically it is possible to come at the same conclusion without either fo the two assumptions, using a third more integrated one. But the decomposition into its parts will help illustrate the folly in logic better, and hence I take this route).

Let's deal with the first assumption. In classical analysis, goods are supposed to have diminishing marginal utility. Money is the one good that is exempted from this consideration - an extra buck is always as good as any other extra buck. It makes some amount of intuitive sense, plus it is necessary to exempt money from the concept of diminishing marginal utility if one is to compare the utility (and hence prices) of other goods. However, in decision analysis under uncertainity, things change a bit.

Rational people are risk averse. If I was to offer you a game where you could win 150000 rupees with 50% chance and win 50000 Rs with 50% chance, you would typically not accept this gamble at a price of Rs 100,000. The expected value of this game is 100000 - it has an expected return of 0 and it is irrational to take it up. You are bearing some risk, and hence would want a non-zero return. (In fact you would want a return above the risk free rate of interest, but lets not get into that). Mathematically, if U(x) is the utility function of money, U(50000) + U(150000) < 2 * U(100000). What kind of a function would U be? Concave to the x axis. Consider the simple example of U(x) = sqrt (x). It is easy to check that the inequality holds (in fact, it reduces to the RMS-AM inequality, or equivalently, to the statement that variance is non zero). Now, it's easy to see that with U(x) = sqrt (X), U(100000) = 10 U(1000) < 1000 U(1000). This is, of course, a cooked-up example that makes the inequality very strong, but it is easy to see that for any concave function, U(kx) < k*U(x). Hence, U(100000) < 100 * U (1000).

(Through all that not-so-fancy math, all that we're saying is that a 100 times more money will not make you a 100 times more happy. Which is something we all intuitively know. But since we are trying to counter some 'rational' arguments, we will stick with the math. )

The second assumption, and this is where the extrapolation gets hit very badly, can be invalidated by a simple thought experiment at the extreme. You make me two promises - one in which you promise to save me from near certain death, and another in which you promise to provide me with an extra .01% of safety. What is the worth of your first promise vis-a-vis your second promise to me? Is it worth 10,000 times more? Far from it. It is worth a whole lot more. I want to consume, I want to ride bikes, I want to do various things, but most of all, I want to live. I'd give you my entire wealth (everything above subsistence) if you saved me from near certain death. In fact, if someone was willing to take a leveraged position on my life, I'd be willing to give you a huge chunk of my future wealth as well. Put mathematically, the marginal utility of extra safety of life is increasing. U(1% safety) > 100 * U(.01% safety).

(Actually, it will not increase monotonically, for reasons that should be obvious. But we shall sacrifice behavioural assertions and mathematical rigour for the purpose of relevant analysis)

Now, if we put the mathematical formulations of our two intuitive results together, what do we get? U(1% safety) > 100 * U(.01% safety) = 100 * U(1000) > U(100000). The extrapolation of the 'value of life' from a single decision has been hit on two counts. Essentially, extrapolations like this will end up severely understating the actual value that we place on our safety and our lives. And therefore, the time frame of the analysis and the absolute numbers becomes of critical importance. It is useless to compare one exceution of a murderer with one execution of a vermiscripter if over my lifetime, many more than one executions take place.

Hence, dear economists and other rational type people - if you are going to estimate the value of my life by extrapolating from the value I place on .01% of my safety, say it like that. Because the answer that you will get will be different from your answer if you were to extrapolate it from the value I place on 1% of my safety. If you directly ask me the value of my life, I will refuse to put a figure to it. Not because I'm being a moralist. But because I am then thinking about the value of my entire life. 1 or 0. Life or death. Not 10000 times .01% or 100 times 1%. And I can genuinely not answer that, except for saying that my life is rather priceless. Not because I am irrational. But because I am rational and hence risk-averse. Because the marginal utility of money is diminishing while the marginal utility of safety is increasing. Because the way you frame a question will lead to a different answer.

The time frame of policy and an approximation of the utility of safety/life are of critical importance beofre one starts asserting things about the value of life and the costs and benefits of deterrence. If you are only going to multiply two numbers, don't bother. I learnt multiplication and pretty much mastered it when I was 7 years old.

Height of idiocy, really

2007-12-30T19:15:00.000+05:30

An economics professor argues that on the basis of economic logic and cost-benefit relationships alone, virus writers are more worthy of the capital punishment than murderers. Towards the end of the article, he accepts that some of the assumptions in his back-of-the-envelope calculations may be overly simplistic and incorrect, but defends himself saying this.

"But this essential point remains: Governments exist largely to supply protections that, for one reason or another, we can't purchase in the marketplace. Those governments perform best when they supply the protections we value most. We can measure their performance only if we are willing to calculate costs and benefits and to respect what our calculations tell us, even when it's counterintuitive. Any policymaker who won't do this kind of arithmetic is fundamentally unserious about policy."

There are multiple arguments for attaching and not attaching a cost to a human life. That is not what I am talking about here. I have only a couple of observations

1) Why is this man so happy about his ability to add and multiply numbers? Seriously,
everytime I read one of these ' lets do the math' rants I am left wondering about the sanity of the person in question. Dude, unless you're talking about partial differntial equations or probability distributions, you're not talking insight ok?

2) Witness this.

"Executing the murderer means giving you the safety. Executing the vermiscripter means giving you the cash. You'd rather have the cash than the safety. Ergo, executing the vermiscripter is better policy"

I would rather have lesser number of such coloumns than either safety or cash. Does it mean that executing the author is better policy?

A rambling monologue on worldviews

2007-12-30T11:54:00.000+05:30

(Or, whatever little sense I have been able to make of the world around me. In no particular order.)

1) When one thinks, one attempts to clear the clutter - grey is a colour that no one is truly comfortable with. The only sensible thing Deepak Chopra has ever said is when he asserted that mythological tales are powerful becuase they have well defined concepts of good and bad. At all points of time in my ruminations I am trying to judge correctness, to ascertain credit and to appropriate blame. Those who claim to not judge are either not thinking at all, or just being polite.

When thought does clear the clutter, it does so with with a brilliant sweep. Things fall into place - one knows exactly why one believes what one believes. Thought is nothing but self articulation. Given that a general proficiency in the tools of communication is achieved, it is easy to be articulate when one in clear.

The problem is that very often one has to make peace with the greys. It is difficult to be undecided when one is not indifferent. It is difficult, also, to be truly indifferent. Sometimes, it is fatal to be undecided. Very often, the clutter is not cleared, nor is there the hope that it will be cleared in the recent future. It is a painful state to be in. The only comfort is that most often, the Cartesian view on one's own existence is reaffirmed.

The single greatest advantage of thought is clarity. The single greatest disadvantage of thought is lack of clarity.

2) Just as mathematics is at the base of all natural sciences, and philosophy is at the base of all humanities, psychology is at the base of all social sciences. A priori enunciations of economic truths are nothing but claims that one has figured out the human mind. Adam Smith, Karl Marx and Ludwig von Mises are authors who fall in this category. It is no surprise that Friedrich Hayek went on to link spintaneous order with the connectionist hypothesis of cognition.

The validity of each enunciation lies in empirical evidence, and empirical evidence is temporal and contextual. What is contextual can never, by definition, be universal. The infinitely long run is an absurd idealization - it is of almost no use.

3) 'Universal human rights and values' is technically, a self-defeating concept. History shows as much. Universe has to be defined across space and time, and no set of human values has ever been consistent across time - not even the right to life. (I am not talking about violations of rights, only about the belief that these rights should exist in the first place. Weak newborns in Sparta were deemed to not have the right to life at all.) Does this mean that an axiomatic specification of a world view is impossible? Not really. One only needs to have the modesty to not pronounce it universal. The axioms of choice are dynamic - a recognition of this is enough.

People, most notably Murray Rothbard, have tried to argue that the right of 'self-ownership' is the one necessary and sufficient human right. Everything else follows. There is, of course, the disclaimer that self-ownership has no meaning unless we respect the self-ownership of others. This is not entirely true. Self-ownership as a concept can exist independent of the equivalence of political rights. There is the more fundamental assertion here, that my political system, whatever it is, will not indulge in any a priori discrimination. This is the zeroth law implicit in almost all political debates of today, and it is also independent of self-ownership or any other such rights. The zeroth law has profound implications. Socio-political equivalence of all citizens is by itself not a very ancient idea. It seemed abhorrent to Locke and Paine that a charter may determine basic rights, and it is extremely seductive to indulge oneself in the concept of natural and universal rights. Yet, a question worth asking is - if these rights are indeed so universal and natural, why did we chance upon them so late? It is a little strange to accept a prophet of human rights.

I am enchanted by the enlightenment age views on liberalism. John Locke was a phenomenal man. But, he was not a prophet. He was a change-maker, one of many. 'Universal human rights' before him and 'universal human rights' after him are different sets, and this difference renders the term 'universal human right' an oxymoron.

4) 3 above forms the basis of one of the strongest arguments in the defence of the communismt end that I have ever heard. I believe that an ideal system will try to ensure, non-coercively, that station in life is contingent not on birth but on ability. Like many others, I am given to believe that the communist utopia is not really a utopia. Even if somebody could magically get communism to work, I would not want to live in a scoiety where everyone has the same outcome, irrespective of ability. It seems natural to me - I won't be surprised if it was proven that this feeling is hardwired into us by evolutionary mechanisms. I do, however, believe that society should try its best to provide everyone with the same opportunity, irrespective of anything. This belief could be a result of evolution. It could also be one of the many 'anti-evolutionary' tendencies that we have developed over time.

Either way, a 1000 years ago the sentiment that station of birth should not ideally be a large component of success in later life wasn't a very common one. It is now. Is it then unimaginable that a 1000 years from now the prevailing sentiment of 'universal human rights' and utopia will include the communist idea of equal outcomes, not just equal opportunities? I had no answer to this question posed by a dormmate after I had summarily destroyed the rest of his commie arguments. It was a useless argument, for it was not debatable and also irrelevant from the perspective of policy-making, but it was a strong argument and one that gains immense relevance the moment we start connecting free market mechanisms to the natural and social evolution of human civilization and positing them as universal truths.

Communism may just be an ideology that came much before its time. It may make sense to qualify 'self-evident economic truths' with adjectives that are temporal instead of 'universal'.

5) Property rights, indeed the very definition of property, are the crux of every major philosphical point of difference in conflicting worldviews. Unless one wishes to indulge in humpty-dumptyism with the meaning of property rights, the deontological position on property is far from settled. I have never heard a convincing argument about the moral philosophy underlying the default heratibility of property. Nor have I ever read any convincing arguments about any given property distribution being considered moral in a non-contextual, universal sense. For this and similar other reasons, property rights have to be separated from other rights that seem to be analogous. The right to life must exist independent of property rights, and the right to free speech can also be evaluated in a framework that need not necessarily build upon property rights.

Random information - I am getting extremely enchanted by behavioural finance these days. Riskless arbitrage does not exist, or so my hedge fund trader friend informs me 2 weeks into the job. The insurance fund market is apparently so inefficient that one can safely claim that market mechanisms don't even seem to work.

I'm also getting enthused by the New Keynesians, not the least because Greg Mankiw is one himself. He can be safely added to Raghuram Rajan and Hernando De Soto in the list of economists I want to read extensively.

As you must have observed already, I am too much of a lazy bum to put up the requisite links. Sorry, but deal with it.

In which I resume

2007-12-28T22:47:00.000+05:30

1) I am often stunned by the enthusiasm with which perfectly sensible people make painfully insensible statements just because it follows analogously from some other strong rational argument. Ronald Coase is invoked by Falstaff here with these scarcely believable lines

"Third, this is an argument for defining boundaries, not for allocating costs. Remember Coase? To the extent that the presence of children in the public space represents a situation akin to the tragedy of the commons, who bears the cost will depend on how society allocates 'rights' over that space. And given the numerical majority of parents and the overall superstructure of parenting as a good, the chances are that those rights will go to parents, not to non-parents. All I'm suggesting here is that we make the allocation of those rights explicit, so that those of us who want to avoid children can do so. I'm perfectly willing to pay, say, 15-20% more on an air-ticket for the comfort of knowing that there won't be any children under 12 on the flight. I'd be happy if there were restaurants that kept children out, even if eating there meant I paid a premium. "

Poeple talk like that all the time in B-School. It is a common enough affliction for engineer kids who have just learnt economics. But there is an implicit understanding of the fact that things are being said in semi-jest, that even if one is being sincere with one's feelings, one understands the various reasons why it won't actually work. This, however, was being said in utmost earnestness.

There are numerous people in this country who would happily pay more than a 20% premium on the services that they avail to keep other groups/communities of people out. Is it very difficult to imagine that the baby/no-baby demarcation of boundaries is bound to be significantly less common a sentiment than a similar one based on caste or religion lines? (Yes I have replaced "avoid" with "keep out". No it is not meant to insinuate that the above paragraph or its author is exclusionary in nature. It is just to point out that the intention is irrelevant.) There is a reason why companies that offer services availed by a vast cross section of people have explicit non-discrimination policies - human notions of fairness aren't always fungible with money. That is the single greatest transaction cost which prevents a multitude of Coasian negotiations from acting out on their own.

Mandatory digression - Someday, a behavioural economist will prove more or less the same thing in far more rigorous terms. Last year's Nobel prize anyway went to mechanism design theorists and Daniel Kahneman has already won his for prospect theory and behavioural finance. I think that the Chicago school reign is in for a cold winter, unless Raghuram Rajan comes up with something spectacular. Digression ends.

There are exclusive children's spaces at restaurants. There are, however, none that are exclusively non-children. This should be some indicator of the fact that society does not deem it urgent to allocate the rights. I also wonder who is the " we" in the "we make the allocation of those rights explicit" bit. I have a feeling there's not enough of them. Else, we should have at least seen some serious flirtation with a business model based on avoiding babies in public spaces.

I genuinely wish that Coase had written and published more than he did in his lifetime. I have a feeling that he would have disapproved of a substantial amount of the polemic that uses him as a luanchpad.

2) Ramchandra Guha is unimpressive. His credentials as an ecological historian are impeccable but as a social historian, he is typically vague and superficial. In his recent lecture at the insti, he wheezed through what seemed like a laundry list of post-independence Indian history, rejoicing with every single anecdote of one or the other snooty western political journalist being proved wrong about India. And what were the assertions that India managed to falsify? Well, unbelievable as it may seem, back in those days some supposedly respected journalists and political commentators had pronounced every single Indian general election to be the last. Now I may have the benefit of historical hindsight, but if today someone was to predict that a country will never see another general election, even if that country is Pakistan, I would just have to call him an idiot. So India proved that these idiots were indeed idiots. I would have been surprised had it been otherwise. Guha, however, is thrilled to bits.

He also tried to obfuscate the considerable differences in the political outlook of Sardar Patel and Nehru by painting the canvas with suitably large brushes. (Weasel statemets like "both were committed to the concept of India as a secular, democratic nation") Worse, immediately after the talk had picked up a little in its third quarter, he went for a ridiculous gimmick with a 1000 buck note, and narrated two ridiculous incidents about the diversity of India. They were akin to the Italian coffeemaker, Brazilian beans, US cafe, Mexican worker etc. type e-mail forwards and that's all that can be said about them.

It was a talk that was obviously prepared with a western audience in mind, and that was the most underhwleming as well as disturbing thing about it.

3) Existential question - what is the threshold of the amount of time one can spend online/ with books/ with pseud music and poetry, etc. without becoming intellectually detached from the real world? I ask not for myself, but for a certain breed of people I see around me and in the cyber-world. It is surpriasing, it really is.

4) I wonder why they call those things 'graphic novels'. 'Comics' would do just as well. Was there enough discrimination to jusify the intorduction of a politically correct term?

While I Mug

2007-12-16T22:54:00.000+05:30

Heard in macroeco class

"Everything reminds Milton of the money supply. Everything reminds me of sex but I try to keep it out of my papers."

- Robert Solow

Unfortunately, he is no Milton Friedman. Hence, this just seems like a case of 'Look ma! I am so clever. I can think of metaphors and all.'

So long, until I am done with mugging for the term.

The only thing I will ever write about communal violence

2007-11-27T02:32:00.000+05:30

is that almost whichever way you look at it, it is quite pointless. Even if one was to evaluate it from a my-community-first 'strategic' perspective (and there are just so many things that are wrong with such an aproach - but let's stick to the logic within the layer), it would fall flat. For the simple reason that those that came at you were not the ones you will go for. And those you go for will not be the ones who will come back at you, in the given phase or later. You will satisfy only bloodlust, not vengeance. And your actions would become the tipping point for some of those that were yet undecided.

Besides, mob violence is one of the only two forms of violence that takes no courage.

From this week's finance and macroeco classes

2007-11-23T15:22:00.000+05:30

1) Libertarians with knowledge of the financial markets, it's question time. I'm guessing you know what circular trading is. Explain a ban on circular trading from the first principles of coercion and/or fraud. And if you do not support the ban, explain how you propose to solve the inefficiency in the markets resultant from circular trading.

2) It is fashionable among a lot of theorists to assert that if you are philosophically on the wrong footing, no amount of mathematics will help you out. The example of P C Mahalanobis is given to substantiate this point. Now this assertion has typically been a little difficult to digest, expecially since I am given to romantically believe that mathematics is the only true philosophy. Turns out that in the case of India's five year plans and P C Mahalanobis, I may not have been very off the mark.

You see, the Indian government, pre-liberalization, was an almost entirely fiscal policy focussed administration. The guiding principle of our macroeconomic policy was apparently the IS/LM model. This is, in very general terms, a series of dynamic equilibriums of real national income with real interest rates. But, the interest rates were administered. We had neutered one of the two axes of the mathematical model that we used and yet we hoped to be correct. For decades, we were doing one of the mathematically stupidest things possible.

Resultant aphorism - faults of philosophy will manifest themselves as mathematical idiocies. One only needs to try harder.

Of strategy, ideology and incentives

2007-11-23T13:54:00.000+05:30

I congratulate Alan Krueger and Amit Varma for jointly coming up with the solution to the world's most pressing problem. It is clear that democracy in Pakistan is the Ram-Baan that will ensure world peace. I have learnt various new things through that masterpiece of an article. One, that the Taliban are terrorists. Two, that lawlessness and suppression of political expression are synonymous. Three, that logically, China should be a brilliant breeding ground for terrorists. Four, that Sri Lanka must have had a long history of the suppression of civil rights and curtialing freedom of the press. Five, and most insightful, that when people are denied political expression in their own country, their propensity to bomb some other country increases rapidly.

George Bush is obviously an idiot. He must realise that installing democracy in Pakistan is like the one act where incentives and ideological correctness so beautifully merge that a single, Pareto-optimal to boot, strategy becomes the natural result of thinking it through. I now suggest that the POTUS form a strategic group headed jointly by Mr Varma and Mr Krueger. This group should continue existing with the same leadership irrespective of the political affiliation of the POTUS. When the Democrats finally assume office, the Jagadguru shall provide support, but only from the outside.

In other news, we have also learnt last week that the current trouble in Nadigram and the subsequent riots in Calcutta are the natural result of property rights issues and contract violations, nevermind the fact that all acquisition activity stopped about a year ago as a fallout of the controvery over Singur.

I now support legislation that insists that people who wish to speak/write on political strategy have spent at least 10 years either in the vicinity of the geography they wish to speak of or kin the field that they wish to speak of. Those excued from this requirement under this legislation are bureaucrats and their babalog, and Avataram.

To understand why I support this legislation, please drop everything and rush to read the Greatbong on the violence in Bengal. It is the only blog post you should ever read on the issue.

Nilu's smartest move

2007-11-19T22:29:00.000+05:30

was to get Avataram to write for his new blog. Why do I say this? Read on.

This piece gets rave reviews here and here. Now blogger no. 1 unabashedly loves everything that Mint publishes but I was a little surprised to see Aadisht recommending the "Bangalore is Coasian" line. I read the piece, and wasn't interested at all. I tried to figure out why - one obvious reason is that one could replace Bangalore by Gurgaon in the article and it would still remain the same in its substantive claim. Or one could replace Bangalore by Nagpur and have no answers to why Nagpur doesn't fit the claims. The article reduced Bangalore to a syntactic tool, devoid of any semantic significance. It doesn't answer the fundamental "Why Bangalore?".

But I was still searching for THE reason I disliked the piece. Avataram provides the answer, in a short piece that explains the title of my post. Of course, this is it. ALL cities are Coasian, dammit all forms of organization are Coasian. In the memorable words of Prof. Datta, even marriage is an institution that minimizes transaction costs. Thus, an argument along the lines of 'outsourcing is Coasian, Bangalore is all about outsourcing and hence Bangalore is Coasian" is so superficial that it does not even begin to scrape any surface whatsoever.

Avataram also has this sagely advice from Wittgenstein's Tractacus to offer - one which I'll try to follow more often - “Wovon man nicht sprechen Kann daruber muss mann schweigen” - “Whereof one cannot speak, thereof one must remain silent”.

I'm convinced. Recursive Hypocrisy is so much better off with Avataram. Nilu has indeed made the smartest move he would ever make.

Two aphorisms and an observation

2007-11-11T13:14:00.000+05:30

Aphorism 1 : There are no infinite recursions, only incomplete base cases.

Aphorism 2: All economic activity tends to an equilibrium, yet the distance from the equilibrium is the primary economic incentive.

Observation : It is universally acknowledged that it is far easier to critique than to construct. Hence, one moves from the critique to the construction. Yet, one notices that the critique invites more attention than the construction. Now one could believe that this is in part due to the inherent unattractiveness of one's construction. But when one has read a bloody 180 page report, gone through the fine print of a diplomatic document, and spent considerable time and energy to develop the construction, a conceited view of reality makes a lot more sense. Hence, one assumes that the construction is so faultless that no one could possibly come up with a contrary viewpoint, and that people comment only when they have contrary viewpoints.

Of child labour, property and worldviews

2007-11-10T23:17:00.000+05:30

Blogger no. 1 writes about child labour - please go read. I have a small point to make. One of the reasons why people feel compelled to rescue children despite knowing that many of them start working by their own volition or that of their parents, is this - many children indeed start working due to poverty, but many of them are forced to stay on due to coercion. Even if one does not support the ban on child labour, one has to think about the conditions in which these children work and what can be done to improve them.

Second, and this is slightly more fundamental - poverty forces many parents to make their children work but many of these children do not want to work themselves. If we begin with the moral position that children below a certain age should not be working, does the parent have the right to send the child to work? Where does legitimate parental control end and coercion begin? And if we believe that the child's wish should be honoured, is this a strong argument in support of a welfare state and a safety net? There will definitely be inefficiencies and corruption in any such government initiative. Should the options then be evaluated by a cost-benefit analysis? Or is one of the two options significantly more correct from a first principles, moral point of view?

Apropos this, will any libertarian (or anyone, for that matter) explain to me what is the "moral position" on the distribution of property in the first place. I ask because any discussion on economic freedoms ultimately boils down to philosophical differences on property rights - what existing distribution of property can be accepted as correct and moral? Is there any moral basis for the heritability of property? Does it make sense to talk about economic freedom from a moral standpoint at all?

My worldview is this - the objectives of my ideal society are maximization of utility, liberty and equality of oportunity, in that order. I am right of centre, economically and politically, and a social liberal. I do not mind sitting on the fence on a lot of issues - it is a lot more honourable than it is usually made out to be. I try to work on certain first principles (which are close to the libertarian ideal), but I realize that given the constraints of a non-ideal reality, this is not always the best stand to take. I am wary of extreme positions. I admire balance - one of the biggest learnings from my short life has been that on either extreme of any world-view divide, one ends up contradicting oneself. I am a libertarian-centrist, so to speak. A consequentialist, a utilitarian.

Interpreting the Truth: The Nuclear Deal

2007-11-01T21:36:00.000+05:30

The nuclear deal with the US has disrupted public discourse multiple times in the recent past. It is amazing how our public discourse is typically filled with opinions flying left, right and centre – opinions that each one of us fits with our own world views – and the proverbial scratch on the surface reveals that not much exists beneath the surface at all. ‘Too much punditry, too little analysis’ is a description that characterizes the greater majority of our public debates, with even ‘informed’ analyses in reputed publications typically failing to connect all the dots.

There are broadly two axes along which the deal can be analysed - the first is energy economics and the second is strategy and foreign policy. I am convinced that the deal is favourable along both dimensions, but let’s look at the issues one by one.

First, the relevant facts – the duration of the deal is 40 years, and the proposed energy transfer in the period is about an installed capacity of 60,000 MW. Either party can terminate the deal with a notice period of 1 year in this interim 40 year period, and with a notice period of 6 months at the end of the deal. The objective of the deal is to “enable full civil nuclear cooperation with India covering aspects of the associated nuclear fuel cycle”. The resultant business is likely to be of the tune of $150 billion, of which the lion’s share is likely to go to American nuclear power companies.

So what are the implications for India’s energy scenario? To evaluate that, a look at our current position is necessary. We currently have an installed peak capacity of 160,000 MW, including captive generation sources. This implies a peak shortfall of 11.7% or about 21.2MW. (This is just the installed capacity, ignoring the severe T&D losses). The Integrated Energy Policy (IEP) report of the expert committee of Government of India, dated 9th August 2006, shows that even though the elasticity of per capita energy consumption per capita of GDP growth has been falling over the years and is less than 1 now (meaning that if x% is the annual increase in energy demand and y% is the annual increase in GDP, then x < y), the energy needs per capita are still likely to increase at a rate of 6%-7% p.a., averaged over the next 25 years. It estimates that in 2031-32, we will need an installed capacity of 800,000 MW. Where is this 800,000 MW going to come from? From “pursuing all possible fuel options”, in the words of the expert committee. The 800,000MW figure is inclusive of an estimated 63,000 MW of nuclear power, 150,000 MW of hydel power, and thermal power increase of 5.1% p.a. India’s uranium reserves are good enough for only about 10,000 MW, representing the limiting value for our PHWR reactors.

Opponents of the deal have continuously touted the figure of Rs. 11 crore / MW, the estimated costs of the nuclear power generated through imported fuel and reactors. This figure, they claim, is significantly higher than the Rs 7 crore / MW for power from indigenous nuclear sources, Rs 4 crore / MW for power from thermal sources, and the even lesser cost per Mw for hydel power. These figures are a little tricky. It is fair, for e.g., to ask why the relevant power figure for comparison was taken as 30,000 MW and not 53,000 MW (estimated requirement minus indigenous resources). Ventures with higher fixed costs (import of reactors, fuel etc.) become increasingly attractive for higher volumes. The long run marginal cost of producing 1 business unit (1 KWH) of energy through nuclear sources was estimated at about Rs 1.00 for nuclear energy and about Rs. 0.90 for thermal energy, (at 1984 prices) in a 1997 paper by Prof Y K Alagh. The comparison becomes favourable for nuclear power when the distance to which coal has to be transported exceeds a 1000 Km., due to the high transportation cost of coal.

According to the IEP report, Indian uranium is extracted from ore that has 0.1% useful content as opposed to the international standards of 12 -13%. This makes indigenous nuclear fuel 2-3 times costlier than imported fuel. With all these figures, it seems hard to accept the cost considerations that have been drawn for a capacity for 30,000 MW. The dissonance is futher magnified by the fact that the IEP report has suggested that India change its energy policy from “minimum initial cost purchase” to “minimum life cycle cost purchase”.

However, let us for a moment assume that comparison to be absolutely correct. Does that change things? Not really. The inherent assumption that we could use alternative sources to generate the 30,000 MW is itself flawed. The IEP report assumes 150,000 MW of hydel power, which is 100% of the known hydel power potential of India. It also assumes a constant growth of 5.1% p.a. for thermal power, which has been the current trend. India needs those 30,000 MW of nuclear power even after exploiting these alternative options to their reasonable maximum. The scenario that we are looking at, thus, is not one of high cost power vs. low cost power, but one of some power vs. no power. One is reminded of Homi Bhabha’s succinct remark that puts this situation in its proper perspective – “No power is costlier than no power”.

India’s mineable coal reserves are estimated to last another 45 years (at 5.1% growing usage p.a.) and known oil reserves are likely to last 23 years of production and 7 years of consumption. With increasing oil prices and depleting coal reserves all around the world, there seems to be no way except to go for nuclear power. The IEP report says that “Nuclear energy theoretically offers India the most potent means to long-term energy security”. It is true that energy security has to be achieved in the long term through indigenous sources, and that the indigenous thorium-based FBR program is theoretically the best way to achieve nuclear power security. However, to let go of the opportunity of imported uranium based power generation in the hope of an unmitigated success of the FBR program would be extremely damaging in the medium term, and implies continuing peak load power capacity shortfalls.

Next, we move on to the strategic and foreign policy implications. The opponents of the deal have raised four main considerations on this front, namely
1) The deal does not guarantee assured nuclear fuel supply, and only promises to “seek to amend domestic laws” to ensure the same.
2) The Hyde act is likely to prove a major bug-bear, and the necessity of “congruence” of Indian foreign policy with that of the US impinges upon our autonomy and will be interpreted as strictly as possible by the US.
3) In the event of a unilateral termination of the agreement by the US, we will be left with unusable nuclear reactors that will impose maintenance and safety costs for no benefits at all.
4) IAEA safeguards will continue in perpetuity even though the deal is terminable.

Let’s deal with the last consideration first, because the first three are closely inter-linked. What exactly are the IAEA safeguards that we have to adopt? Simply that any reprocessing performed on the nuclear fuel imported through this deal will be in a newly created reprocessing facility that will be open for IAEA inspection (typically, these inspections are inventory checks of weapons-grade nuclear materials). Any reprocessing done in this facility will be open for IAEA inspection. But do these safeguards extend to all reprocessing performed in India’s reactors? Not at all. It is perfectly possible for India to strike similar deals with other NSG nations and reprocess the fuel obtained through those deals at separate facilities with separate safeguards. Even if the US is likely to put pressure on most NSG nations to have similar safeguards, the option of Russia remains perfectly tenable.

The first three considerations all become relevant only in the event that the US goes ahead with a unilateral termination of the deal. Since large US business houses are going to have a stake in the profits generated by the deal, their pressure and lobbying is going to act as a deterrent to the possibility of this scenario. More significantly, the information and technology transfer is going to aid India on the path of creation of indigenous reactors that can process higher grade uranium that can be imported from non-US NSG countries. This acts as a genuine buffer to the shock of a unilateral termination.

Interestingly, this is what Article 5.6(b) of the deal reads like
(i) The US is willing to incorporate assurances regarding fuel supply …. which would be submitted to the US Congress
(ii) The US will join India in seeking to negotiate with the IAEA for India-specific fuel supply agreement.
(iii) The US will support an Indian effort to develop a strategic reserve of nuclear fuel to guard against any disruption of supply over the lifetime of India’s reactors
(iv) If despite these arrangement a disruption…occurs, the US and India would jointly convene a group of friendly supplier countries to include countries such as Russia, France and the UK to pursue such measures as would restore the fuel supply to India.

The language is ambiguous, but not by diplomatic standards. Please find me another instance where India has been able to negotiate a deal with a superior power with such major concessions. Is it at all possible for the US to guarantee fuel supply in contravention of its domestic laws? Can the UPA, for example, promise the US that the deal will definitely go through?

And what about the Hyde act? Without delving into legalese, the essence of the matter is that the act is definitely restrictive, but as explained by Dr. G Balachandran of the IDSA, four prominent exemptions have been granted to India. The first one was the exemption of the requirement of IAEA fullscope safeguards. The second was an exemption that made sure that India’s detonation of a nuclear device after the passage of the Atomic Energy Act (1978) of the US does not hinder the deal. The third waived the sanction on exports to India. The fourth exemption ensures that India’s unsafeguarded nuclear activities that are independent of the nuclear transfers as part of the deal cannot be invoked as a reason for termination. The Hyde act remains an issue of contention, but seems like one that has to be negotiated with, rather than something that can be made a reason to ditch the deal.

The arguments in favour of the deal are many, the detractions few. It would be a great loss to India if the left succeeds in its attempts to stall the deal.

I'm still alive

2007-11-01T01:19:00.000+05:30

and kicking.

Just to stay in the game, a couple of mini-fisks, of bloggers whom I otherwise look up to.

1) Ravikiran, theorising about Indian democracy, says (among other things)

"
If we are honest with ourselves, we will have to admit that no one has a clue about which way the Indian voters vote, and once they have voted, the process of translating the votes to seats makes it pretty much impossible to draw a causal chain between the intention of the voter and the “Popular Will” as expressed via the seat position in the legislature.

If pollsters and pundits cannot call an election a month in advance, it is very likely that those in the government will be unable to take a guess as to which policies will win them the next election five years away. If democracy means that rulers govern according to the will of the people, then India’s democracy is broken.
"

Now this statement rests on the assumptions that
1) Politicians are not significantly more competent in knowing the popular mind than pollsters, and do not understand the votes to seats translation better than the average citizen.
2) Policy making and implementation in the government are a fucntion of five-year (or similar medium term) strategies of political parties, strategies optimized to give them votes.

Both are wholly unreasonable assumptions. Pollsters survey people, extrapolate data and make predictions on that basis. The sample sizes are typically so small as compared to the size of the elctorate that statistically the interval of confidence should prevent you from making any estimates. However, the TV demands a number. Hence, the pollster quotes a mean, neglecting the variance. Political parties have teams of workers working at multiple levels - they do not need to understand the scientific model or the mean or the variance for their data is far more representative and most parties know what is going to happen in the election, irrespective of what they may claim on TV. Plus, a Brahman+Dalit combine in the Up sweeping the legislature elctions there was pretty much predicted by everyone, wasn't it?

Anyone who has any close relative working in the steel frame will tell you why assumption no. 2 is false. On a daily basis, the work of the government is largely independent of the strategy of the party. The issues and stands that highlight the ideological(?) differences in the parties and become controversial are largely tactical in nature, and far lesser bearing on policy formulation and implementation.

2) Shruti Rajgopalan talks about how the market itself corrects market failures far better than governments, even in the case of public goods. The crux of the matter - people used to crowd in to listen to tour guides in Prague, even those people who hadn't really paid for their services. This is a nuisance because it is free-riding, and it can even cause legitimate tourists to miss the guide's detailing due to crowding. To solve the problem, tour guides now use small microphones and headphones are given to the touring group, thus preventing the free-riders from listening in.

Shruti believes that this is a wonderful example of a market corecting a market failure, and shows us the following dystopian situation as the government's possible solution

"How would the government deal with this problem? They would regulate the number of tourists each guide can have in a group. Furthermore they would regulate the distance each group must maintain and each individual must maintain from the groups. Then they would issue licenses to guides and have Tourist Inspectors for enforcing the regulations and ensuring the correct distance is maintained."

Oh dear god.

She calls the tourist guide's service a public good because it is "non-exclusive" and rival.

"It is difficult to exclude other tourists who are also at the monuments and the consumption may be rival as those who paid for the guide get crowded out"

Three points

1) Excuse my pedantism, but the term is non-excludable, and not non-exclusive(trust me, there's a significant difference)
2) A non-excludable, rival good is called a common property resource, not a public good.
3) The fact that a tour guide finds it difficult to physically exclude the non-paying tourists does NOT mean that his services are non-excludable. He is charging a fee for his services, and can easily deny his service to anyone. This by definition implies that his service is excludable. The problem, thus, is one of logistics (the fact that denying the service is physically difficult), and not economics and market failures(where denying the service is practically impossible, for example fishing in a sea).

The tour guide's service is in fact rival and excludable, a pure private good if there ever was one. It is a smart solution to a problem of business logistics, and not a romantic success of the market against its own shortcomings (atleast not in the free market vs government context that Shruti tries to provide her text).

I am now convinced of two things. One, ideological extremism, of any form whatsoever, is such an over-riding factor that it can totally impinge upon reason. Centrism is pretty much the only way out. Two, very few people have truly internalised what they learnt in their microeconomics course. People choose convenient bastardizations of a sound theory to criticise at will. I am reminded of Prof Deodhar's remark to us about trying to avoid the abuse of terms like moral hazard and adverse selection.

p.s : Some problem with blogger. Wll put up the links to their respective posts a little later.

Of Thought & Articulation

2007-10-09T03:47:00.000+05:30

So the last post spoke about how the first great in a field is not its greatest exponent ever, and how many people frequently confuse the two. It's amusing to know the other things that people often confuse.

Yours truly is an eternal optimist. I am even optimistic about Indian politics, so I don't think I need to further explain my case. However, it appears that some of my classmates have no hesitation in calling me a pessimist. On deeper thought and exploration, it turns out that this is so because I am generally hard to please, especially with respect to the level of CP (class participation, usually semi-sensical things uttered by MBA students who are in peretual GD mode) in class. Ok people, let's clear this - cynical and critical are not synonyms.

Similarly, abstract and absurd are not the same. What is abstract need not be absurd. What is absurd need not be abstract. The proof of the first part is recursively contained in itself. For the proof of the second part, let's think of an absurdity that is definite - "The sun will rise in the west tomorrow" - for e.g.

Q.E.D and all that jazz.

Tarana-e-Watan, slight reprise

2007-10-09T02:26:00.000+05:30

Reference to Context : this

Gaurav asserts that a lout, a thief who believes strongly in the idea of India and stands up for Vande Matram is a better Indian than an impeccable, polished, law-abiding citizen who doesn't care too much about the nation. In the dictator's world, a nation is nothing but an idea, and thus anyone who refuses to believe in the idea is actually detrimental to the national identity. The second half of his post is largely something that one agrees with. But this initial assertion has to be rebutted.

A nation is indeed an idea. But ideas have no independent existence - they are solely dependent on the people who hold them. The idea is glorious, nay, even credible only if the people who believe in it are taken care of. A nation is an idea, but it is not just an idea. One could speak of the common culture, food, geography, language, etc. but in a nation like India, these are so distinct and numerous that they are superficial and inadequate proxies. There is exactly one concrete marker of a nation, and that is its current constituents. India is a lot of things to a lot of people, but to me it is primarily the people who inhabit the nation today, and more pertinently, the people who identify themselves as Indians. The strength of their belief in the idea of India is of low consequence to me.

One could argue that the individual's safety is dependent upon the group's, as Gaurav does. Or one could argue that the group's safety is nothing but the safety of each one of it's individual members. This top-down vs bottom-up approach to individuals and groups can be discussed ad infinitum. I believe there is one critical aspect that such a discussion ignores. An individual and his/her freedom are well defined, and often, static entities. A group is only a template. A nation is a group, so is a gender, so is a religion, a caste, a state, an ethnicity, an instiution, and even a dorm within an insitution. An individual, as Amartya Sen beautifully explains in the first few pages of Idenity and Violence, is at the very least an intersection of these various groups. I am an Indian, a Hindu, a Bihari etc. Which one group's safety is most important for my safety? What is the correct level of granularity at which it becomes undesirable to express one's allegiance to a group virulently? Every group has contributed to my identity - which ones have the right to demand a compromise on my freedom? What is the priority order of these groups in their claims on my freedom?

One could also argue that status quo dictates that believing in a strong nation has near universal acceptance, and hence a nation has the first claim. That would be an argument hard to beat on the basis of current data. But to argue that it is this aspect of the status quo that needs to be perpetuated would take either a leap of faith, or a rational justification on some grounds. Would it be possible to evaluate essentially irrational choices on the basis of utilitarian grounds?

I am a liberal, and I am a nationalist. India has the first claim on my freedom. But there is no rational reason for this choice. I would be hard pressed to explain why it is not Hinduism, my religion, or Bihar, my native place, or Gujarat, my state of domicile, or the Kayasthas, my caste, or indeed, the entire male 'brotherhood' of the world. If one regards the ' I do not want to sing Vande Matram ' Indian as a threat to the idea of India, should one also regard the ' I do not want to sit for the Satyanarayan Pooja ' Hindu as a threat to the idea of Hindusim?

A nation is not just an idea, it is primarily the people who identify with the allegiance to the idea. The thief, when he commits a crime against an individual in the nation, an act that the nation does not permt him to commit, betrays the nation. No amount of symbolic respect to the nation's idea absolves him of this betrayal. To me as well, there is no dilemma. The man disrespectful of the Indian flag but respectful of her citizens is a far better Indian than the Vande Matram loving lout. One does not disrespect a nation only by disrespecting the flag. When one spits where one is not supposed to, one disrespects the nation too. Somebody else, a fellow country man, will have to come and clean it. It would be rather fraudulent then, to claim that one's respect for the national anthem makes up for the lack of respect for another Indian's dignity, and a lack of respect for the conditions required for the country's efficiency.

It amuses me that the dictator proudly proclaims to be a Hindutva Fascist. It would be interesting to know if he also subscribes to the following descriptions - Male Chauvinist, and Kayastha Supremacist. Reverse snobbery is the easiest game to play.

p.s - People who are wondering about the obvious Jimi Hendrix reference in the title of the post must know that I'm not exactly the man's greatest fan. I mean, sure, he was great, revolutionary blah blah. But to claim that he was the greatest guitarist ever! One might as well say that W G Grace was the greatest batsman ever. First great != greatest.

p.p.s - Which is not to say that he wasn't great either. If you are not a fan of his rendition of All Along The Watchtower, you haven't the foggiest idea about hard rock guitar.

p.p.p.s - With reference to the last line of the p.s, yes I am a computer engineer by training.