Thursday, November 08, 2012

World Bank's infuriating & inconsistent poverty data

The World Bank does some excellent development research, and really ought to be the first place you turn out for data on world poverty, inequality etc. As I've mentioned in an earlier post, however, its poverty and inequality data regarding India just do not add up. In that post I had to go through several hoops and construct complicated Lorenz curves to try and establish that things don't add up, but some latest figures will help establish my case much more simply.

Consider the numbers on this page :

The % of Indian population at or below the various consumption thresholds are :

< $1.25/day - 32.7%
< $2.00/day - 68.7%
< $2.50/day - 81.1%
< $4.00/day - 93.7%
< $5.00/day - 96.3%

If we convert cumulative percentages to the group specific percentages, we get:

$1.25/day - 32.7%
$1.25 to $2.00/day - 36.0%
$2.00 to $2.50/day - 12.4%
$2.50 to $4.00/day - 12.6%
$4.00 to $5.00/day - 2.6%

Now assume that everyone in the respective groups earns/consumes the upper limit of the group.

(This is 'boundary condition' assumption that overstates the actual consumption of each group because in reality people in a given group will have consumption ranging between the lower limit and the upper limit of the group.)

Given this assumption, the total annual consumption of all the five groups combined comes out as follows

< $1.25/day - 32.7% ------- $179 bilion
< $2.00/day - 68.7%------- $316 billion
< $2.50/day - 81.1%-------$136 billion
< $4.00/day - 93.7%-------$221 billion
< $5.00/day - 96.3%-------$57 billion

The total is $908 billion. Keep in mind that this is the upper possible limit, the actual consumption by these five groups will be much lower. All of these figures are at purchasing power parity (PPP).

The data is from 2010, when India's private final consumption was Rs. 45 trillion. However, the world bank poverty lines are based on 2005 prices, so we divide this number by 1.4 (the price level went up by 40% in India in those 5 years) to get the relevant consumption figure - Rs. 32 trillion. (All figures from 2010 and for price level changes from the Reserve Bank

At the then prevailing PPP rate of roughly $1 = Rs 20, this converts to total consumption figure of $1,600 billion. Which is to say, that the remaining 3.7% of India, the top 3.7% consumes atleast (1600-908)/1600 = 43% of India's total consumption! Not only is this figure unbelievable, the World Bank's own chart on consumption by quintile on the left of the same page ( refutes it directly. The top 20% of India consumes 42% of our total consumption, so the top 3.7% can't possibly consume more than 43%.

Again, remember that the $908 billion figure is most likely a gross overestimate, so the comparison is even more stark than the one I show. The World Bank data page contains an arithmetic absurdity, one more egregious than the now irrelevant Ryan-Romney tax plan.

So what gives, World Bank? This is simple stuff, there should be consistency checks for this kind of thing on your pages, no? Unless the RBI data is seriously incorrect (which I doubt, and plus, both RBI and World Bank get their macro data from the same source - MOSPI in India), I think my calculations hold.

My sense is, the $1.25/day figure of 32.7% is quite rigorous and alright - it corresponds to and roughly matches with India's national poverty estimates - the percentages estimated to be living under each subsequent threshold are severely overstated. There simply is no way that 96.3% of India's population lives below $5/day (2005 prices), which in today's prices and after PPP would mean something like Rs. 150/day.

Hopefully, once the 2011 round of price comparison and consumption surveys of the World Bank is collated, we will have a much better view.

Friday, October 12, 2012

Economics Nobel bleg

Tyler Cowen rounds up the chatter around the Eco Nobel. Here's WSJ, and here are the Thomson Reuters predictions. Northwestern has its own list too - it leans heavily towards the Industrial Organization & New Institutional Economics side of affairs. Both good, but rewarded in the recent past.

My contention is, if Jean Tirole and/or Oliver Hart are awarded, so will/should Bengt Holmstrom. Oliver Hart is a forerunner for the incomplete contracts view of the theory of the firm, Holmstrom has done masterful work on the disaggregation of the liquidity and the the connections between corporate finance & macroeconomic phenomena, culminating in what he calls the Liquidity-based Asset Pricing Model. This line of research is extremely promising, and yet to be fully exploited.

But if IO/NIE does not win, the prize really should go to Angus Deaton. Deaton is among the foremost authorities on consumption, inequality & poverty in developing countries, and a lot of his research focuses on India. If you wish to educate yourself on modern interpretations of the challenge of poverty & development in India, Deaton really is person you should listen to. His lack of an axe in the cacophonous debates on this helps- he seems to be intellectually compatible with both Surjit Bhalla & Jean Dreze, something that most Indian readers will find unbelievable.

The American finance gurus - Fama, Shiller, Thaler & Ross are all deserving, but I know who I'm rooting for.

Monday, October 08, 2012

A simple framework to think about business cycle macro

I think that my comparative advantage lies in curating and contextualising the insights of my intellectual superiors rather than coming up with new ones.  I like to believe that this is a useful skill in macroeconomics & monetary economics - where people tend to repeat, forget and and re-invent the same debates for a couple of hundred years, and where there is growing evidence that there really is very little new under the sun. The important stuff has probably already been said, debated, understood (and sadly, forgotten) multiple times over. However, there's still ample scope to organise and parse it in a relatively novel fashion.

To this end, I often find myself creating frameworks to organise things I read. The macro-cube still serves me well in organising the leading thinkers. Here's another framework - a much simpler one - to think about the leading theories of short and medium run, or business-cycle macro.

Money, Capital, Production, Prices. That's what business cycle macro is about. The money-capital connection is the 'financial axis' , roughly corresponding to the asset markets and the underlying real assets they represent claims to. The capital-production connection is the 'real axis', the connects the productive capacity of the economy with actual production (via, say, the Cobb-Douglas production function). The money-prices connection is the 'nominal axis', which explores the connection between the purely nominal variables in the economy, e.g. money and total spending, via, say the equation of exchange and QTM.  The production-prices connection connects the macroeconomy with the microeconomics of individual markets - the general equilibrium (GE), so to speak.

It's possible to organize a surprisingly wide array of macro thought along these lines. I will invoke this framework often enough in subsequent posts.

Wednesday, September 12, 2012

Monetary confusions abound

Macroeconomics, especially monetary economics, is hard. It is not hard like stochastic calculus is hard. It is hard at the level of intuition itself because of its connect-ALL-the-dots nature. The outmoded and narrow pedagogy that most of us are exposed to doesn't help. The charged politics of macro policy-making further blinkers analysis.

Of late, the economic discourse in India  has been increasingly critical of the incumbent UPA-2 government's macroeoconomic management. One of my frustrations with this discourse has been its failure to focus on what is truly important and truly wrong, while shooting critical arrows at random targets. The increase in the analytical content of public discourse, as well its right-ward shift is surely to be welcomed. However, the quality of the analysis hasn't necessarily been strong. Part of this is because of the inevitably charged politics. But I believe a more significant role is played by the fact that macro is, simply put, hard.

A good illustration is this article by R Jagannathan in FirstPost. He also links to an earlier piece by Latha Venkatesh, also in FirstPost. In what follows, I will basically critique these articles, using them to hopefully illustrate a few key monetary concepts. I wish to make it clear that I don't intend this as a personal criticism of either of them Mr. Jagannathan's writing performs the indispensable function of speaking truth to power - witness his dogged pursuit of the shady dealings behind K Abraham's removal from SEBI, for example. It's just that his article is a veritable goldmine for my purpose here.

I'll tackle only one of his arguments in this post here, leaving the rest for later.

Ms. Venkatesh's article, which discusses the possible impact of a 1% cut (from 5% to 4%) in CRR in India, asserts that the money multiplier is between 4 and 5 in India. But it's all a little confusing because she's not talking about an injection of monetary base, which is what the money multiplier is supposed to work on. 'Liquidity' is being 'freed up' by a cut in CRR, and the monetary base is being held constant. Later she is more precise as she talks about the money multiplier as that which when multiplied by the liquidity freed up as a result of the CRR cut gives us the corresponding increase in deposits. It is tempting to assume that this is the same as the textbook money multiplier but this is not so. 

Let's call this the modified money multiplier (mmm). I'll skip the algebra but it's easy to show show that mmm = 1/(K+CRR) where K = currency/deposits is the currency drain ratio. [the traditional money multiplier mm = (1+K)/(K+CRR)]

We know that Ms Venkatesh is discussing a cut in CRR from 5% to 4%. The other variable is K - so what is K for India? Bank deposits currently stand at Rs. 70 trillion, currency is Rs. 11 trillion. K = C/D = 11/70 = 16%. So, mmm = 1/(0.16+0.04) = 5. Ms. Venkatesh seems correct about the size of the modified money multiplier.  

But if you back out from all these numbers a bit, what is driving the size of these multipliers? Even at 5% CRR is an order of magnitude lower than K. Multipliers are being driven almost entirely by K, the currency drain ratio. What does that behavioural quantity have to do with actual banking operations or CRRs or anything? Can it not change if the quantity of deposit grows a lot? A simple illustration through a banking system balance sheet with numbers will show my point.

What happens when CRR is cut?

Consider the following stylized balance sheet of the Indian banking system.


CRR is, as now, 5%. Consider the extreme case - what happens if the CRR legal requirements is completely removed? This frees up reserves of 5 units. Now the actual reserves will not go down to 0, because banks will want to have some for inventory-theoretic reasons. Let's say this 'desired' CRR (as opposed to a legally mandated CRR) is 1% of deposits. I have chosen 1% because that is about the % that banks keep innon-crisis times in countries where reserves are miniscule or not legally mandated - UK, New Zealand, Canada - actually keep. (Yes, there are such countries, and no they don't suffer from inflation on this count. We will soon see why).

So now we have free reserves of  5 units and a desired CRR of 1%. What happens to loans and deposits? They can in  theory jump five fold! After all, with reserves = 5, a desired reserve ratio of 1% will give deposits of 500. 

Fig. 2

A five-fold increase in deposits sounds crazy, right? Let's try another scenario. What if banks just purchase safe assets with the freshly freed up reserves ?

Fig. 3

So will deposits go to 500 or remain 100 or be something in between? The multiplier story thinks it may have the right answer. Deposits will go to 120, as the freed up reserves of 4 units will lead to increased deposits of 20 via a modified money multiplier of 5. If you keep the proportions of safe assets and loans constant, this is how the banking system's balance sheet may look like. 

Fig. 4

Now what if the economy with the banking system of Fig. 3 was to grow by 20% organically? It would end up with a banking system like this

Fig. 5

     Fig.5 and Fig.4 are very similar. Indeed, from a monetary perspective they're nearly identical. Shouldn't they represent the banking systems of two very similar economies? They do, and that's the problem with the argument as presented by Mr. Jagannthan and Ms. Venkatesh.

What I've gone through several hoops is to try and demonstrate that in the (modified) money multiplier story, if the CRR were to be completely removed, we should expect that the aggregate nominal economy- not just the quantity of bank deposits - is larger by about 20%. 

So why is growing the nominal economy  by 20% a problem? Even if you fear inflation and think that the entire 20% extra spending goes into prices (and nothing into quantities), sales and excise taxes collected by the government on the extra spending would by themselves close the fiscal deficit by 2% odd. Mr. Jagannathan doesn't realise this, but he seems to have uncovered a miracle way to close the fiscal gap that he's so worried about - government expenditures are largely salaries, so keep the path of government salaries as previously expected (government salaries are only revised once in 10 odd years and the yearly inlation adjustment is not built for a 20% increase) and remove CRR. If some part of the 20% goes into real GDP rather than prices, even better.

The miracle way sounds absurd, and it is. And that's because the modified money multiplier is absurd. Even at a seemingly text-bookish value of 5, it is absurd for the same reason that the situation in Fig. 2 is absurd. You cannot make an economy 'jump', not five-fold nor 20%. 

Fig. 3 is the most likely scenario of a post-CRR cut banking system. Dropping CRR increases the return banks make on their safe assets and thus increases bank profits and re-capitalizes them. That part of Mr. Jagannthan's story is correct. But it doesn't do too much for bank deposits, lending or nominal spending. CRR is used by RBI to manage liquidity stresses in atypical situations - ahead of an advance tax payment date, for example. Or, it's used as fiscal mechanisms to extract (or give back) profits from (to) the banking sector. But it's not a mechanism to influence bank lending or aggregate spending. For that the RBI uses, in line with central banks across the world, policy rates.

So if the modified money multiplier is incorrect, doesn't that cast doubt on the traditional money multiplier as well? It does, and that's why I referred to bad pedagogy as one of the reasons why deciphering macro can be hard. While the money multiplier is trivially true as an arithmetic identity, the direction of causality between deposits and reserves is far from obvious, and things depend more on price mechanisms and overall central bank targets than on any quantity mechanisms. While central bank guidance and policy can be forward looking and pro-active, its operations are mostly defensive or reactive. The CRR is an operational tool to manage near-term liquidity, not a policy tool for macroeconomic management. The reserves 'freed up' by cutting the CRR will somewhat increase lending on account of higher profitability for banks, but will mostly just have to be mopped up by the RBI, through open market or reverse repo operations.

 (Reverse repos are operations where banks 'lend' to RBI at interest - they essentially have a deposit at RBI that they promise to draw down at a certain date. Of course they can simply roll choose to roll the deposit over, thus in effect creating reserves that earn interest.

Indeed, if not for operational continuity and legacy reasons, the RBI could choose to drop the CRR to 0 tomorrow without changing the path and effect of monetary policy by much.

The RBI is monopolist on reserves. A monopolist can either set prices or quantities. As a setter of price (reverse repo rate), the RBI forgoes control of the quantity of reserves. The CRR is not a quantity control, it's simply a bank tax. Unless you believe that a tax rebate of ~0.3% of bank assets (7%  interest rate * 4% CRR) will encourage so much lending and spending that it will prop up the economy by 20%, you shouldn't talk about money multipliers for CRR cuts. Not if it's a 1% cut as discussed by Ms. Venkatesh, nor if it is removed completely as in my thought experiments.

Wednesday, August 29, 2012

Stray thoughts on PDS failure in India

Read this article this morning, and felt intensely despondent. 

The head-line is scare-mongering but the story is sobering. The real clincher comes when the author talks about how the PDS scam, morally reprehensible as it is, has barely made a dent in India's food stockpiles. India has excess food, but many of our people are still starving. India's hunger comes not from its scams and its corrupt politicians, it comes from the poverty of its citizens and the poverty of the ideas that make our governance framework.

Amartya Sen showed in the 80s that even in colonial India, famines were mostly a matter of income failures, not crop failures per se.

We have tried to overcome income failures by legislating it. Public distribution and price controls. Never works. The aim should not be to control the price of rice to 2 Rs./kg. It should be to let the price rise to 20 Rs./kg - or whatever the price would be - but to ensure that everyone in the country has 20 Rs. to buy that kg of rice. This is not so difficult as it sounds - a country that is self-sufficient in foodgrains quantity-wise also has, by definition, enough income in the aggregate to pay for those foodgrains. The question to be asked is, why do some people not have enough money to buy that food? And the answer lies in cash transfers and re-distribution of wealth and income, not price controls and public distribution and ration shops.

There's a comment in that article that illustrates the follies of Indian governance, and governance in general, better than any economics lesson could. 

“If you can buy a Pepsi in every village in India, why can’t the government get us our rations?” asked Vaish, who lives in Satnapur. “The reason we don’t is because the government doesn’t want us to -- they all get a cut.”

The activist has asked the right question, but arrived at the wrong answer. Everyone in the chain of providing a Pepsi in a village also gets a cut. The salesman, the distributor, they all get a 'cut'. The cut is what they work for. And that system works beautifully. It makes a Pepsi reach the innermost villages in India. Yet, the cut system does not work with the government. Why?

We might think that PDS failures in India are about delivery mechanisms and supply chains, and this would be right, but only partially right. We can fix the supply chain to temporarily improve outcomes, but eventually, another scam like would happen, another supply chain failure will arise and we will rehash the old arguments again. There's something in the logic of the profit motive and free competition that no amount of good intentions will help us replicate. 

If someone wants a Pepsi somewhere in India, and can afford it, Pepsi will try to make sure that it reaches him. Pepsi doesn't bother about the problem of whether or not that person can afford it. That's where the government's domain liesNot in trying to make sure that Pepsi or food reaches the villager, but in trying to make sure that he can afford it. There is no way that a system of governance can replicate the alignment of incentives that the private system creates - Pepsi's very survival depends on being able to meet demand, better than others, at cheaper prices or higher qualities than others. It's survival is tested everyday in the market place. The government's survival is not tested in the same manner. No matter how well intentioned individual politicians and bureaucrats are, the system's incentives are just not aligned with the incentives of those that it propose to serve. One election every five years does not solve the problem, especially when you can win the election by simply being of the right caste.

Milton Friedman used to joke that if you put the government in charge of the Sahara, in five years there will be a shortage of sand. I always thought it was funny but trivial. Recent events have made me re-consider the wisdom of that statement, though in a somewhat revised form. In China, there's a huge unsold housing and inventory over-hang, even as poor and even middle class people can't afford the houses that do exist. In India, some poor people face starvation even as the country's stockpile of food grains grows. 

How are these fundamentally poor countries where the basic needs of good food and good shelter are not yet satiated facing over-supply, of any sort? We're used to thinking that poor countries are somehow supply-constrained, often due to government interference in production and distribution, as implied by the Friedman quote above. But it's not just that. Poor countries that are somehow managing to overcome the supply constraints through a mixture of public and private efforts are showing a different form of governance failure. Despite there being enough supply in the aggregate, there isn't enough demand, due to the skewed distribution of income and wealth - which itself is, in part, so skewed due to the multitude of government-imposed restrictions on production and distribution. 

In India, this inadequate demand does not manifest as inadequate demand, because at the false administered price of near-zero, the observed demand is potentially infinite. It manifests as an artificial supply shortage and scams, with grains being 'diverted' to more profitable avenues. Price controls and public distribution are dysfunctional, because they cannot help but be dysfunctional. One can best understand the current PDS failure in India by analysing it *as if* the price of the food grains were their true market prices, and we had a large mass of people unable to afford grains at those prices.

Like so many other things in governance and the political economy, it is a failure of bad ideas, not just vested interests. 

Wednesday, August 08, 2012

The macroeconomics and public finance of inflation in India - 5

(This is the final in a 5-part series that was earlier planned as one long post. If you haven't, you should read the earlier posts first. This tries to bring it all together.)

It's worthwhile to do a quick re-cap of the main stylized concepts that I have argued for earlier, before we try to tie them all up together.

1) A fiscal deficit does not directly lead to inflation. It has to be monetized or something wonky has to happen in the government bond markets.

2) To the extent that India has a fiscal deficit, the interest payments (though numerically smaller than the expenditure outlays) are what's driving the deficit at the margin. Interest payments look sustainable at current interest rates and growth rates. The Indian state is playing a commercially viable financial intermediary, creating a pool of assets at various maturities that services the savings demand of our households.

3) To the extent that India has a primary deficit that casts questions on sustainability of government finances, it results from being under-taxed, not over-spent.

4) Flagship spending schemes have a plethora of public-choice issues, but the pure macroeconomics behind them is quite simple and uncontroversial. The effects on inflation, if any, are best analysed through the lens of an AS/ Philips curve.

5) 1 and 4 imply that to have any shot at understanding inflation, it is imperative to look at the central bank's monetary regime, and its own evaluation of aggregate supply.

RBI's monetary regime

RBI officially tries to maintain inflation around 4% in the medium term, while maintaining growth prospects and allows the currency to float as per the market, while trying to reduce volatility in currency price. It's an admirable, if somewhat convoluted, set of macroeconomic stability goals. But the actual performance of the Indian inflation seems to fly in the face of what its central bank is trying to do. We have consistently overshot 4% and not just in the last couple of years. Atleast since 2005, inflation has been more than 6%. Yet, the RBI seems to have a relatively credible inflation-fighting stance, with most of its criticisms being directed at currency interventions or micro-management.

But even more surprising than the credibility is the fact that RBI itself seems to be wary of monetary tightening to actually try and achieve its goal to make inflation 4%. Ostensibly, this would not do much for inflation, but kill growth. Which is to say, RBI believes that the AS curve is horizontal on the downside. At the same time, it seems wary of monetary easing to actually try to boost growth, because this would only create inflation, not boost growth. Which is to say, RBI believes that the AS curve is vertical on the upside! This is RBI in its own conception, operating between a rock and a hard place, operating at that miraculous inflection point on the AS curve where it turns from being near-horizontal to near-vertical.

If you don't buy this story as it stands, that's because you shouldn't. One can indeed land at such a jarring discontinuity in the AS curve, but it has to be a matter of sheer fluke, rather than a series of fiscal failures that gradually led to the discontinuity. And if the central bank manages to optimize within this shoddy hand that the government has dealt it with, that will also be a matter of fluke, not effective monetary policy. One should expect to see either accelerating inflation, or growth in a downwards spiral with stable prices/inflation. Not both at the same time.

But what if RBI was, through design or default, optimizing something completely different. Not growth nor inflation, separately. A combination of the two, taken together, treated inseparably. What if it was targeting nominal income growth - that simple idea which has taken the popular macro/monetary discourse in the developed world by a storm.

The evidence would certainly suggest so. Nominal GDP at factor cost (GDP at market prices net of the indirect taxes and transfers of the government) has grown at a remarkably consistent rate in India. Over the past 6 years, the average growth has been 16% per annum, with a standard deviation of 1% (both logarithmic - all data calculated from national income accounts available with MOSPI). It's the nominal aggregate in India with the lowest coefficient of variation (mean divided by standard deviation). As far as macro-stabilization goes, this is what is being stabilized. Not the price level, whether measured through consumer prices or the GDP deflator. Not nominal GDP at market prices. Not real GDP. Nominal GDP, at factor cost.

Has the RBI been living a Sumnerian dream - stabilizing aggregate demand (net of fiscal stabilizers) and letting the supply side play itself out?  If yes, how? It could be by design - Subba Rao always strikes me as a remarkably well-clued man, but that's not enough. It could be by default, trying to stabilize some other key metric (like credit growth) and ending up stabilizing the nominal gross domestic income because of certain stable relationships in the Indian economy that haven't broken down as yet. I don't really know, but the implications are interesting.

For one, all inflation is stagflation. Or, more correctly, any increase in inflation will necessarily be seen as a decrease in growth. Just like the twin deficits, this is not a double whammy, but two sides of the same economic fact resulting from the central bank's monetary policy reaction function. Secondly, there are no inflation expectations driven independently by the central bank, but whatever we see is a result of the interplay between the private sector and the government. It's not the AS curve that has the strange kink, it is the AD curve.

This story flies in the face of what the RBI claims to do, but it explains the stylized facts. It is also consistent with the intuition of the standard narrative, when that intuition is suitably enhanced through the argument that expectations of inflation in India may be dependent on the fiscal stance, macro theory notwithstanding. We are so used to monetized deficits causing price rises that we continue to believe the same even though the fiscal regime in India has actually changed substantially, through design or default.

(Christopher Sims, last years's Nobel prize winner, has an explanation of how inflation expectations may be fiscal and how rate hikes by the central bank may be counter-productive in that scenario. His argument invokes the fiscal theory of the price level, which I don't quite agree with, and works through the nominal rates on government debt, which seems quite stable, so one doesn't have to take it at face value. However, just like Friedman's maxim and the sectoral financial balance approach, the Sims conception adds a dimension and mechanism in the operation of macroeconomic policy that we should keep in mind.)

With this in mind, what remains to be analysed is, if the AS curve becomes more steep, causing 'stagflation', what comes first - inflation expectations, or a supply crunch? And if there is a supply crunch, what is it?

Investment - the missing link

So what is the expectation of inflation in India? Recall the fact that 10 year g-secs trade at close to 8% yield. The current inflation is in excess of that. If the current inflation is expected to continue, savers are ok with negative real rates on their savings. In a capital deficient country like India, this seems rather absurd. If you think that this may be the result of financial suppression - of the central bank mandating banks and investors to hold a certain proportion of their assets as g-secs - consider the fact that when the SLR was recently cut from 24% to 23%, most banks were anyway sitting on 28%-29% of their assets as g-secs (plus gold).

There are two possibilities. Inflation expectations really are high, and real interest rates really are that low. If that is true, then the degree of risk aversion implied by that fact means that within the next 5 -10 years, India will see macroeconomic woes that will make our current predicament seem like a walk in the park. Then, we will know what a true stagflation is.

But if that is not the case, and real interest rates are positive, this means that the current inflation is perceived as transitory and inflation expectations in the medium term are actually tracking the RBI's target quite closely. If so, that would be a tremendous macroeconomic achievement by our central bank and fiscal authorities - we have adjusted to the new fiscal regime and RBI is able to stabilize current aggregate demand even while maintaining medium term price stability. So we should turn back our focus on the current supply bottleneck. And what could that bottleneck be.?

The most solid empirical evidence points to investment. This is especially important, because today's investment is tomorrow's capital. An investment bottleneck in the AS curve is most likely to persist from the short term to the medium term. Current inflation is most likely to be endogenized if it results from an investment shortfall. Even if we have somehow achieved macroeconomic Nirvana, an investment shortage can bring us back to our ugly past.

Note that this is not a particularly 'right-ist' view. Axel Leijonhufvud, whom I consider the foremost Keynesian, has done some excellent work exploring the micro-foundations that affect this crucial link between inflation and investment. His ain argument is that proper financial intermediation breaks down in high inflations, especially for longer term capital needs. His work focuses on monetary regimes that are substantially less stable than the RBI today and 'high inflations', for which India's 8%-10% does not really qualify. But it arguably holds even for the RBI's regime, if people are likely to go back to the old ways of thinking about our profligate government, and if our particular investment needs are especially long term.

India's and UPA's greatest failure on the fiscal front has been its utter failure to prevent the fall in investment - and indeed abetting the fall through some bone-headed moves.


So, in the end, if it all does come down to a fiscal failure, and it does come down to supply bottlenecks, and if it does come down to how inflation expectations in India may possibly be fiscal, just why have I spilt so much electronic ink? If the standard narrative is broadly true, why try to dismantle it before putting it back together again?

I think its important to come to the right conclusions, but it is also important to do so through the right analytical framework. It helps you focus your criticism, and it helps you see some successes where you may only have imagined macroeconomic failures. I hope I was able to clarify how it's investment, not government spending that we should focus our minds on. I hope I was able to demonstrate how the 10 year yield is an important variable to watch out for. And if my posts help clear the absolute clutter that one reads in the Indian print media in the name of macroeconomic and public finance analysis - stuff like negative returns on savings, twin deficits, stagflation, outcries against tax hikes - I would consider my job done.

The macroeconomic and public finance of inflation in India - 4

(Update : I was writing the original series as just one long post. But then, it got too long, so I have decided to split it up into multiple posts. If you haven't, you should read the earlier posts in the series first.)

(This is somewhat tangential to the main theme of inflation, but I just wanted to close the loop on taxes and fiscal deficit before tying it all up together)

Tax policy and the size of the government

As we saw earlier, if we admit the possibility that the redistributive cash transfers implied by NREGA are an ok policy by themselves, we're left with the corollary possibility that the fiscal deficit is a result of not raising ta rates, rather than the spending itself. To invoke Alfred Marshall, asking whether spending or taxes are responsible for the deficit is a bit like asking which blade of the scissor does the cutting. However, tax policy is the sine qua non of the political and commercial legitimacy of the state, and is hence a question as much of political philosophy as of economics. Ethical judgements are indispensable and I'm positing the view that the increased government spending for redistribution is perhaps ethical, so that what is truly 'unethical' (or unsustainable, coming back to the more grounded economics of the fiscal deficit) is the lack of corresponding  increase in taxes. 

This is where Chidambaram's exhortation to 'share the burden' with increased taxes is important. Predictably, he was hounded for first having emptied the treasury and then calling for higher taxes. But the higher taxes are unavoidable. If so, what could those taxes be? 

The economics literature on public finance and taxation is vast and varied. There seem to be some broad agreements on the design of optimal tax policy, though. Broad base, low rate. Tax consumption, or income, if you must. Avoid taxing capital. Definitely don't tax corporate income. Tax wealth in a lump-sum manner if you wish to redistribute. Tax luxury transactions. The arguments are many and hard to summarize, but Scott Sumner's post over at the Economist makes a cogent case for the mainstream theoretical position. 

Note that consumption taxes, which everyone seems to love when presented as VAT/GST, are basically the same as the sales and excise taxes decried as the taxes that all of us, including the domestic help, pay to 'feed the beast'. The big benefit is the simplified regime (which will tremendously slash supply chain costs across the country, for one). Consumption taxes are also great at acting as automatic fiscal stabilizers - though the farm loan waivers of 2008 are invoked very often, the bigger fiscal action taken that year to keep private consumption and production up in the face of a global recession was to lower sales and excise taxes substantially.

Some have argued that consumption taxes are regressive (esp. when thought of as a 'flat tax'), as the poor consume a higher proportion of their income than the rich. Some combination of a highly progressive wage income tax and luxury taxes should fix that. Capital income taxes are slightly more tricky, with the usual argument that they are double taxation being counter-balanced by arguments about euitable taxation between capital and labour. A more original argument comes from Earl Thompson, the UCLA economist, who argued that the biggest beneficiaries of national defence are capital-owners, and capital taxes thus exist to solve for the disproportionate consumption of that particular public good. 

In general, though, the broad thrust for tax policy remains clear. Get to the GST regime faster. Do all you can to eliminate corporate income tax. Get the income taxes right - broad-based, and hopefully low.

The implications for this for India are interesting. For one, a declining corporate tax would mean that all talk about eliminating personal income tax should be consigned to the bin. Secondly, a GST, while hugely beneficial in many ways, will not necessarily boost revenue by much as we already pay a bunch of sales and excise taxes. Big reforms that would be needed is to include farmer incomes in the income tax net AND a reduction in the income bracket that qualifies for 0% tax. Yes, there, I said it. Most of the public finance 'budget' analysis in India around personal income taxes is urban, elitist, ill-informed and simply back-ass-wards. While the need to include farmers into the income tax fold is widely recognised, increases in the minimum tax bracket are celebrated. The annual per capita income is around Rs. 70,000. The income exempted from taxes is upto Rs. 200,000! Even if we were to include farmer incomes, we'd still leave out more than 90% of population, and almost around 70% of income out of the tax bracket by default. A 10% income tax on half of that would boost tax revenues by 3.5%. Ok, less than that as taxes are contractionary, but we don't operate anywhere near the maxima on the Laffer curve, so a figure around 3% is a safe bet. Given that India's total tax receipts (state + centre) are about 17% of the GDP (And the primary deficit is less than 1%) this is substantial. 

And that figure, 17%, is itself worth mentioning. It's very low on the global scale, and among the lowest in emerging countries. While we may like to fret about our huge and inefficient government, we are among the least government-supplied states in the world, whether it's per-capita policemen, per-capita armed forces, per-capita diplomatic staff etc. If we want a proliferation of private schools, private hospitals, etc. then we have to recognise that these entail with them significant redistribution demands, which again raises the need for tax and spending. India is an under-taxed state, our government is under-funded. Its inefficiency in collecting even those revenues that it entitles itself is glaring, with obnoxious last-ditch attempts like delaying deserved refunds on tax paid earlier. 

Of course, all this makes the the inefficiency of the state and the dabbling in unnecessary enterprises all the more palpable. But what that also means is that at current margins, this is not the time to starve the beast. Lowering taxes to lower spending does not guarantee that wasteful spending will be reduced. If anything, an inefficient and perverse beast is likely to cut the justified spending just as much - if not more - as the wasteful spending. 

Improving the public-choice performance of the government is an activity that goes hand in hand with getting the size of the government right, and does not need to force it this way or that. The directional size of the Indian government currently needs to go up, with our without the need to close the fiscal deficit. In an inflationary environment, the scope to raise consumption taxes (which raise prices across the board) is low. What that should mean, is more income taxes and luxury taxes. I fear that what it would mean, unfortunately, is higher corporate taxes. 

Tuesday, August 07, 2012

The macroeconomics and public finance of inflation in India - 3

(Update : I was writing the original series as just one long post. But then, it got too long, so I have decided to split it up into multiple posts. If you haven't, you should read the earlier posts in the series first.)

The Macroeconomics of NREGA

The flagship spending scheme of the UPA government has been the NREGA. Put very simply, this scheme promises to pay Rs 120/day for 100 days to rural labour unable to find work, for doing public-related work. Though the Right to Food bill etc. have come under heavier fire, the NREGA is the one actually held responsible for the downward turn in public finances, for it's the only one which has been implemented for a substantial amount of time.

Now many people cry hoarse about anything that Sonia Gandhi/ Jean Dreze devise. But some have actually attempted some conceptual economic theorizing and predictions around NREGA. a case in point is Nitin Pai, here, about 4 year ago. Now Nitin actually calls his theorizing 'the microeconomics of NREGA', but he only achieves that by restricting his analysis to 'rural markets', an awkward category - nothing particularly micro about it. He then proceeds to talk about how rural markets may be uncompetitive because there are only a handful of shops, which reduces the act of production to the act of selling, and abstracts out of manufacturers and producers completely, and goes further into la-la land, moving sneakily from a steep supply curve to a vertical supply curve by saying that NREGA doesn't boost consumption at all, but only boost prices. I could have let that go simply as a matter of confused theorizing, but I am invoking it because Nitin has been an extremely vocal critic of NREGA on the inflation grounds, mocking Dreze/Sen all over his twitter timeline when inflation (broad-based, not even rural consumption specific) finally came about two years later (!), and because I believe his argument may still have some force, albeit in a macroeconomic sense.

What if Nitin had drawn his demand/supply curves as macro aggregate demand (AD) and aggregate supply (AS) curves? Then, what he would be saying is that the Aggregate Supply curve is steep. Recall that the AS curve is simply the expectations augmented Philips curve. (The original Philips curve was about inflation and employment, but as macroeconomists realised, the argument can be split up into inflation/growth and growth/employment). So Nitin is doing nothing but invoking Phelps-Friedman-Lucas circa 1970. The expectations augmented long run Philips curve is vertical. A pure income effect is a pure price effect.

Now, what if the AS curve is not vertical, simply steep? Then some output/ consumption can be increased by simply raising incomes. It's not clear why this increase is to be mocked away simply because most of the income has gone into prices. Say even 90% of the increase in nominal output is absorbed by prices. So? Why shouldn't we let inflation increase  by 9 percentage points, if that does mean growth increase by 1 percentage point? Why do we care about the level of prices? Why do we care about the rate of change of these prices? Why shouldn't we exploit the Philips curve until it becomes vertical?

There are two challenges to this - the first is the classical macro-theory challenge of an accelerating rate of inflation. Inflation expectations become endogenized fast, so that the risk of over-shooting the Philips curve is imminent and non-trivial. This is what RBI worries about when Subba Rao says that the non accelerating inflationary rate of growth in India has dropped to 7%.

The second is that inflation is a regressive tax with distributive consequences. I don't wish to dwell on this for long, but the macro literature that tries to prove this distributive consequence through consumption effects goes into several hoops, with the result critically dependent on the assumption of economies in scale in credit provision. The other way to get a distributive consequence would be to posit that poor people are more likely to have their assets is cash or other such nominally fixed holdings, and are thus losing real wealth faster. This is quite true, but consider the other effect of inflation - to lower the real value of nominal debts. To the extent that poor people are more likely to be in debt, an inflation tax is actually progressive. Further, inflation in India typically takes the form of food or fuel inflation. The former actually benefits most of our rural poor (Yes, I know, only 33% of the price of food reaches producers, but this is as true of the extra price as the original price. A poor supply chain is not a poor-er supply chain.). The latter is globally driven.

In all, the distributive consequences of inflation in India are unclear. The worst hit are the urban poor, who are neither food-producers, nor NREGA beneficiaries, nor in possession on inflation hedge assets. We need to look out for them, but they are not the only constituency in the calculus of macroeconomic policy.

With that is mind, let's analyse what NREGA does for inflation. In more recent times we have heard how NREGA has caused a shortfall in farm labour/ low-skilled industry labour, by giving people money for nothing (let's assume that the public works envisioned in NREGA are of absolutely zero value). 120 Rs/ day * 100 days = 12000 rupees. 12,000 rupees per annum is all it takes to make people give up the desire to earn money, apparently. I find it almost a perversion of empirical logic to posit that there is a shortage of unskilled labour in India, but let's say that there is. So what? What about the price system? there is a shortage at the current prices of unskilled labour. Why're we assuming current prices must continue?

The rural labourer takes a non-zero risk that he will not have a job when he scampers off to make some money-for-nothing in NREGA. So his reservation wage has not been raised by the full 12,000. What businesses/ farms are these that cannot pay their unskilled labour about Rs. 5000-10000 more per annum, and still be profitable? What fundamental right do these businesses have to exist? These owners - whether of farms or businesses- have to bid up wages to get their labour back, or get out. This will increase the inflationary pressure, yes, but as we saw it is not immediately clear what the big dangers of inflation are. (Notice that this inflationary pressure is not added on top of the NREGA pressure - it is another mechanism through which NREGA creates inflationary pressure, a proper macro one at that and one that lends itself more suitably to analysis through AS/ Philips curves).

Note that what I'm saying is not particularly 'leftist'. Here is Tyler Cowen, a self-described libertarian, talking about how the way to improve the condition of workers is to increase the utility of unemployment. And this is in a developed country, organized workers environment. We're talking about unskilled farm labour in NREGA, people at the very edge of decent existence.

Raise the utility of unemployment to workers.  This could be a guaranteed annual income, better unemployment insurance, more food stamps, whatever.  Call it the welfare state.  Improving the welfare state will improve worker bargaining across virtually all workplace dimensions and in the longer run limit the scope of all the employer depredations.

We’re back to the point that what helps is to give people cash, or something cash-like, including when it comes to the dimensions of workplace quality.  It is also a huge help to institute policies which will raise rather than lower worker productivity

NREGA, shorn of public works, is a cash transfer, pure and simple. There was a time when cash transfers were supposed to be the right way of implementing redistribution, especially by those on the right. So why the outcry when the cash transfer was finally enacted?

For one, we distrust our delivery mechanisms, we suspect leakages. Massive government programs are massive opportunities for rent-seeking. This is right reason to dislike NREGA. But this has nothing to do with  inflation. For another, we distrust the upward creep in the size of the government that redistribution entails, so that we would like indirect subsidies cut first before cash transfers are enacted. This has merit, but again it is a public-choice issue, not a macroeconomic issue. And third, we may simply believe that we were at the right level of redistribution as it were. So anything further shifts the balance. You could say that, and I would have no argument to offer because then we would have widely different priors, to the point that we'd talk past each other.

But if we don't believe that, then we have to analyse NREGA's macroeconomics as the macroeconomics of  a just redistributive cash transfer. And then the corollary observations follow - NREGA increases the fiscal deficit only when it is not backed by an equivalent increase in tax receipts. It is you and I, salaried income city dwellers, that are causing the fiscal deficit. And then, we have to go back to the questions raised in part 1 and part 2 of the series - how does this fiscal deficit translate into inflation when it is not money-financed, and when government bonds are showing no spikes in interest rates?

The macroeconomics and public finance of inflation in India - 2

(Update : I was writing the original series as just one long post. But then, it got too long, so I have decided to split it up into multiple posts. If you haven't, you should read the earlier posts in the series first.)

Fiscal deficit

A fiscal deficit is simply the excess of government spending over its revenues. Spending minus taxes. G-T, national income accounts wise. G-T is +ve when the government runs a deficit, -ve when it runs a surplus. Begin with the identity that Y (income) = C (consumption) + I (investment) + G (goverment spending) + NX (exports minus imports) (1). Private sector savings (S) are private sector disposable income not consumed. S = Y-T-C  (2).

Combining (1) and (2) gives S = I + G - T + NX. Or, (S-I) = (G-T) + NX. This rather simplistic identity goes by the name of the sectoral financial balances approach, with Wynne Godley being its foremost exponent. The macroeconomic world has been split up into three seemingly autonomous sectors - government, private and foreign. It is scarcely believable, but playing around with this identity seems to give some heterodox theorists additional analytical edge and real-world relevance over mainstream macro-theory. Witness, for example, Martin Wolf. How in the world does a definition add insight?

Well, here it is. S-I is the net private sector surplus. G-T is the fiscal deficit. NX is the net foreign sector surplus. At a given level of NX, a private sector surplus is necessarily matched by a fiscal deficit. Read that carefully, again. A private sector surplus is matched by a government deficit. Ceteris paribus, an increase in government deficits increases the private sector surplus. A decrease in government deficits crashes the private surplus. The government (and net exports) creates financial wealth for the private sector. Most importantly, if your NX is -ve, i.e., you have a current account deficit, you cannot possibly have a private sector surplus unless the government runs a deficit. Read that again too. A government deficit is almost a foregone conclusion if you want to invest sustainably (through domestic savings) in the face of current account deficit.

Now let's back out a bit. This can't possibly be true. Private sector wealth should not be positively related to government deficits. All our received wisdom says otherwise. And yet, there it, a mathematical equation, the last thing in the world which can be jaundiced by ideology. So what's going on? Obviously, ceteris is not paribus.

The equation is true at all levels of Y, I, C etc. It says nothing about the evolution of those quantities over time. Arguments against government spending and deficits must have some implicit behavioural assumptions that affect the course of these quantities over time. G-T creates S-I, sure. But does it boost S (good) or crash I (bad) ? Does it hold NX constant, or does something happen to crash NX while G was increasing? The equation does not say. Ultimately, what that equation reveals depends on other equations implicit in your mental model. But just as in the Friedman quote on inflation, even if not particularly edifying when taken literally, the sectoral financial balances approach gives us pause. It makes us understand that one plausible role of the state is that of a financial intermediary, that deficits may be helping the private sector achieve its desired levels of savings and investment.

So again, what does all this arcane theory of government finances have to do with India's current woes?

For one, let's get out of the mode of 'twin deficits'. Even the RBI governor mentions this in his speech, but while it's an ok phenomenon to invoke when analysing currency price movements, it does not add much value to a discourse on overall macroeconomic stability and performance. A country with a current account deficit will almost always have a twin deficit.

Second, recall that the fiscal deficit is typically split up into two parts - the primary deficit, and interest payments. The primary deficit is the main measure of the sustainability of a government's revenue balance - e.g. do our taxes cover for the salary payments of our armed forces? Interest payments are on the outstanding government debt. They are nominally fixed. They will spike only if g-sec investors believe that the government is running a ponzi scheme, and thus each roll-over of government debt will imply a worsening fiscal situation. Otherwise, any inflation only helps to bring the fiscal balance under control, by reducing the real value of government debt payments.

Now, India's total public debt (state + central) is 68% of GDP. The average maturity of that debt is 10 years. The benchmark 10 year g-sec yields 8% p.a. 8% of 68% is 5.4%. (All figures from here). The interest payments of the Indian state are thus 5.4% of GDP. India's total fiscal deficit is 5.9%. India's primary deficit is thus 5.9% - 5.4% = 0.5%. Round that up to 1%, and read that slowly again. India's fiscal deficit is being driven by its interest payments. Of course, there's also a primary deficit, so that reducing the interest payments themselves unilaterally by simply not rolling over the debt is not immediately feasible. But go back to the concept of the state as a financial intermediary. The Indian state is taking on debt mostly to pay interest on debt. That sounds like a Ponzi scheme! So what exactly is the government doing here?

The government is creating a pool of credit-risk-free financial assets at all maturities of the term structure. The government is creating the way in which you and I are able to park our funds in 2 year, 5 years, 10 year fixed deposits. It is creating the source of income for closed end mutual funds. It is running a Ponzi scheme, albeit one that is perfectly sustainable as long as the expected growth of the economy is in excess of the interest rate on government securities. This is state as a financial intermediary, as what Perry Mehrling calls a social mutual fund.

Now you may wonder - how in the world did a bunch of poorly incentivized bureaucrats and people like Palanappian Chidambaram come up with such a fantastic, commercially viable role of the state. I don't want to push the point, but the answer perhaps lies in Hayekian spontaneous order. We don't have to be well meaning and in possession of a master blue-print to organically stumble upon beneficial arrangements, and beneficial arrangements need not be restricted to 'the market'. Perhaps we copied the advanced states. Perhaps some regulator just gave in to some market pressure for kick-back and asked for a new and improved term structure of government debt. Who knows.

The point to remember is - fret about the fiscal deficits yes, but recognise the fact that most of them arise not from profligate 'spending', but from the state playing a financial intermediary. Arguments challenging the viability of latter will take a very different form than those that challenge the viability of the former. For one, the key variable to look at is not inflation, but interest on benchmark 10-year government debt. And that particular metric has stayed put at around 8%.

The macroeconomics and public finance of inflation in India - 1

(This is a data-free 'concept' post. The only data invoked are stylized facts. Ideally I would have wanted to work through the data and present it before writing this, but that may have delayed it too much, and made the post far too long. So I thought, let's get my analytical mental model out first.)

(Update : I was writing the original series as just one long post. But then, it got too long, so I have decided to split it up into multiple posts. If you haven't, you should read the earlier posts in the series first.)

The Indian economy has not been doing well for the past year or so. The currency has spiralled downwards vs. the dollar (and other currencies), growth projections have been revised downwards, and the central bank has very publicly warned that the rate of non-inflationary (should actually be called non-accelerating inflationary) growth has been substantially impacted by, inter alia, supply constraints, commodity prices and fiscal pressures. India is facing stagflation, with stagnation being re-defined as simply a drop in the growth rate.

There is a standard narrative that underlies most explanations of what's happening. The UPA government, prodded and misguided by Sonia Gandhi and the NAC, has spent way beyond its means. Fuel subsidies, NREGA, Right to Food etc. are all manifestations of this. Fiscal discipline has been thrown to the dogs, and now we're bearing the consequences.

The standard narrative is intuitively true, almost trivially so. It seems obvious that a profligate government causes inflation and impedes growth. That is how most banana republics have conducted macroeconomic policy in modern history. That is how India got its high inflation of the 70s and the 80s, resulting finally into a balance of payments (BoP) crisis in 1991. And that is how we have landed in the mess that we have.

There is just one small catch. The standard narrative is at odds with received macro-economic theory, both orthodox and heterodox. Let me explain.


Most intermediate textbook treatments of inflation will identify  three 'causes' of inflation : cost-push, demand-pull and monetary. The first operates through the supply side e.g. a bad monsoon will push food prices up. The second through the demand side, and the third through central bank (in)competence. This rather sterile slicing and dicing is easy prey to the Milton Friedman challenge : supply-side and demand-side inflations are about relative prices, which do not necessitate an increase in the overall price level. Inflation is everywhere and always a monetary phenomenon.

Don Patinkin, a Chicago-trained macroeconomist who created the post-1950 monetary economics orthodoxy - followed by monetarists and Keynesians alike - in his magnum opus Money, Interest & Prices, used to quip that this was not a particularly edifying formulation. Since the price level is the inverse of the purchasing power of money, he likened it to the banality that the price of potatoes is a potato phenomenon. Epic as that take-down is, it's useful to retain uncle Milty's maxim for analytical purposes. We will see why.

At heart of the Patinkin-Friedman debate is a fundamental disagreement over the interpretation of the quantity theory of money (QTM), which has been the orthodox right-of-centre neoclassical position on money and the price level since David Hume. QTM states that the long run level of prices depends on the level of the money supply, formalized in the equation of exchange MV = PY, with V and Y held constant, or more properly, fully anticipated, so that M is proportional to P. As Milton Friedman also said, in the two hundred years since Hume we have moved one derivative beyond him, so that we now believe that delta M (changes in money supply) is proportional to delta P (inflation). The Patinkin-Friedman disagreement is about whether the causality in the equation of exchange must be established through other means (Patinkin) or whether it could be taken as obvious - delta M causes delta P (Friedman).

To infer causality from (or impose causality onto) an equation that's always true is an ill-disguised sleight of mind, so I tend to go with Patinkin. However, the Friedman conception has an important insight to offer.If you believe in the autonomy/free-will of the central bank, and if you believe in the special character of money - both fairly uncontroversial positions - you must ask yourself, what was the central bank doing? If you're investigating inflation, you must pause and ask - what is the central bank's reaction function? If there is something, a bad crop, a technological change, a profligate government, anything really,  that puts upward pressure on some prices, does it follow that the economy must experience an increase in absolute prices? Moving one derivative beyond, if there is unanticipated inflationary pressure somewhere, must the overall inflation rate of the economy increase?

So what does all this arcane monetary theory have to do with India's fiscal deficits and inflation? Well, simply this - by the orthodox theory, for fiscal deficits to cause inflation, those deficits have to be monetized. The central bank has to bank-roll the government. That's what banana republics do. That's what India and RBI used to do. However, in line with most of the world, India's fiscal deficits have been bond-financed for quite some time now. When the sovereign credit is commercially bought and sold and commented upon, fiscal profligacy should simply result in an increased interest rate on government securities (G-Secs). Broad-based inflation does not directly follow.

There's a  heterodox left-of-centre challenge to this orthodoxy - Neo-Chartalism - which fiscal deficits are even more benign. Governments, as monopoly issuers of their own currency, never run the risk of 'default' on domestically held debt, so real interest rates don't spike. Monetary quantities are endogenously determined in the macroeconomic system and thus not really of separate interest, and while fiscal deficits may cause inflation, this is a soft constraint that only really matters when the interest rate on government debt starts approaching the growth rate of the economy. At 15% (nominal) annual GDP growth and 8% (nominal) yield on government debt, India is not even close.

So regardless of what you believe about the fiscal profligacy of the Indian government, and whether you choose to side with the orthodoxy or the heterodoxy, it does not necessarily follow that there must be inflation.

Monday, July 09, 2012

What I want to blog about

I've spent quite some time in the past few months trying to come to terms, intellectually, with the economic situation that (primarily) the developed economies find themselves in. The GFC of 2007-2012 has been  an absolutely salutory one in at least one respect - the quality of the macroeconomic discourse has substantially widened, if not necessarily improved. There has scarcely been a better time to teach yourself some macro - and trust me when I say that you can absolutely teach yourself some macro. It is hard, it is time-consuming, but is very rewarding. And it's a field where the experts often enough do not seem to know much more than a determined autodidact.

Blogs are, of course, an important part in the widening of this discourse. The Economist has frequently noted    the tremendous impact of blogs. But they are only part of the picture. There is a lot of talking past on blogs, and not enough sustained construction or critique. The other leg on which I've tried to expand my horizons has been to try and read large parts of the oeuvres of some of the more comprehensive macroeconomists and historians of macroeconomic and monetary thought. Axel Leijonhufvud, David Laidler, Willem Buiter, James Tobin, Perry Mehrling.

In the next few posts (I don't know how many) - which I hope to write without large time lags - I will try to present my distillation of whatever I have gleaned over the last few months. There may (or may not) be original insight, but I propose to build upon the discussions raised by a few people that I consider truly indispensable to the discourse - people who are more knowledgeable, more original and more creative thinkers than I am. I will try to integrate the seemingly multiple themes that keep popping up into a few overarching frameworks, hopefully figuring out along the way which of the disparate ideas can be assimilated into a consistent whole and which are truly at loggerheads with each other. 

Specifically, I wish to cover, apart from the above mentioned distinguished gentlemen, at least :

1) Ashwin Parameswaran - on cronyism,  reviving Schumpeter, the question of which monetary policy , banking reform and much more.
2) Steve Randy Waldman - on helicopter drops, negative interest rates and more.
3) Izabella Kaminska - on negative carry, post-scarcity and more. 
4) David Glasner - on monetary theory and the history of monetary thought.
5) Rajiv Sethi - On multiple equilibrium, disequilibrium and the under-discussed contingencies of monetary policy.  
6) The extremely diverse Tyler Cowen, whose eclecticism is sometimes diluted by his enigmatic style and seemingly deliberate vagueness.  
7) Some market monetarist/ monetary disequilbrium mish mash of Nick Rowe, Scott Sumner & others.
8) Some theorists of the monetary microstructure 
9) Some modern interpreters of Keynes and capitalism

I have the basic ideas, but I don't yet have a 'plan of attack'. When that crystallizes, I shall launch headlong. So if you are interested in macro and money, watch this space!

Thursday, April 26, 2012

The value of money - the price level

Nothing I read on the internet is as confusing and simultaneously as all-consuming as discussions on monetary theory and banking. I plan to discuss this at some length later on, but a short one on the most recent discussion - where does the 'value' of fiat money (created out of nothing that exists currently by central banks, governments) come from.

For more involved discussions, you can read Nick Rowe, David Glasner, Mike Sproul (reviving the Real Bills doctrine, which seems to me like a tautology in the general case), the standard neo-classical theory since Hume or any number of chartalists. At the moment, I'm just wondering about the circularity of it all. To give an example, witness this section from a completely unrelated post at the NY Times :

The 1,000 shillings note exchanged for roughly $0.13 when Gen. Muhammad Aideed employed a printing firm to reproduce the note in 1996. As the number of notes in circulation grew, the exchange value fell to just $0.03, which is the cost of producing an additional note. Since the exchange value equals the cost of production, forgers can no longer profit by increasing the supply. Today, the Somali shilling is a commodity money. Its supply is governed by the cost of ink and paper required to produce a note. From Letters.

Now notice the number of questions this seemingly simple paragraph begs. If the value of Somali shillings (as denominated in US dollars - this is crucial) fell so much, why did the cost of forging/ printing a new note (as denominated in US dollars) not fall in lockstep? Notice that the argument applies equivalently to the Somali authorities as to the forgerers - this is the same as saying that the seigniorage power of the Somali government is now zero.

This paragraph makes sense only if one was to assume two things - that the global price (or at least the price relevant for printing the Somali shilling) of ink and paper is fixed or sticky in terms of the US dollar, and that the US dollar is the relevant unit of account for the act of printing Somali money. Which is to say, that the Somali currency has also been dollarized, not just commoditized. The argument wouldn't hold equivalently if all the forgery/ printing were to happen through locally produced paper and ink that were not traded in contracts denominated in dollars.

All this is to say that talking about the value of anything without first defining a unit of account is incoherent (also why I think the real bill doctrine is a tautology). And the unit of account does not need to be the same for all trades - it usually would simply be whatever is the most common/ commonly accepted medium of exchange. And then we're back to square one. This is also why I've never quite understood why the price of coffee or restaurant meals should have shot up in the Weimar hyperinflation, or why there should ever be hyperinflation in a localized system. The story goes that a cup of coffee worth 5000 Marks when ordered would be worth 8000 Marks by the time the bill arrived. If coffee was locally produced (the coffee, not the beans), locally consumed, by local people who on the average would have nothing to do with international markets, why should  the depreciation of the Deutsche Mark in dollar terms affect the local price of coffee denominated in Marks?

It would all make sense if one was to talk in terms of self-fulfilling expectations - the cup of coffee became more expensive because the seller no longer trusted the value of 5000 marks, whatever that is, to be 5000 marks. He now expected it to be 8000 marks, so he hiked the price of coffee and the mark depreciated with respect to coffee. The underlying theory of the price level is that people in general have some 'sticky' expectations of relative prices, some expectation of an absolute unit of account (the local currency, gold, dollar, whatever), and then those prices that  fluctuate with respect to the unit of account may (or may not) take the other prices along with them. All of which is very confusing. 

Thursday, March 29, 2012

How to Parse like Krugman

Adam Posen, external member of the Monetary Policy Committee in the Bank of England has a great new speech analyzing why the post-recession recovery in the UK has been slower than the US.

Krugman links to it here, concluding "It's the austerity, stupid."

What Adam Posen actually writes in conclusion :

Monetary policy and its effectiveness were not the source of difference, nor was business optimism (especially since forecasts for UK growth, not just the MPC’s, surprised on the downside). Credit was more poorly allocated in the UK, producing less investment for a given pound of credit or financing issued. The spillovers of risk from the euro area on the UK financial system, inherently much less of a problem for the US financial system, also distorted the cost of capital and risk taking behaviour.


Deleveraging by households was not a major factor, given the comparable state of US and UK balance sheets.


Fiscal policy, however, played an important role as well. Cumulatively, the UK
government tightened fiscal policy by 3% more than the US government did – taking local governments and automatic stabilizers into account – and this had a material impact on consumption. This was particularly the case because a large chunk of the fiscal consolidation in 2010 and in 2011 took the form of a VAT increase, which has a high multiplier for households. The fact that British real incomes were hit harder than American households’ incomes by energy price increases could be ascribed in large part to the past depreciation of Sterling, which also hit real incomes directly. All combined, these factors significantly dampened consumption growth in the UK, with knock on effects on investment and stockbuilding.


Going forward, most of these factors causing the difference between UK and US behaviour will recede. Inflation is only a temporary difference, and the national rates are now converging on their long-run targets. On official forecasts, fiscal policy is likely to remain more contractionary in the UK than the US for a couple of years to come, but the difference will shrink significantly from both ends over the next couple of years. Monetary policy is continuing to support recovery of investment in both economies, and must continue to do so. A longer-term troubling difference is in the apparent relative inefficiency of the British domestic finance system in allocating capital to businesses. While some of that should recede when the banks build up their capital buffers, and if and when euro area risks themselves recede, there remains a clear structural agenda for the UK to deal with in its financial system.

Poor allocation of credit, austerity and currency depreciation. With poor allocation of credit being the only major threat going forward. Note that the fiscal austerity here is a tax increase, not a reduction in subsidies/ transfers as one is likely to assume.

The British banking sector is highly oligopolistic, and as Ashwin Parameswaran would say, almost all assets that it owns which could be monetized are probably already monetized. It is highly plausible that it does a worse job of allocating credit. Posen's speech also brings to light a fundamental truth for energy/commodity importing nations - the effects of monetary easing (rates/ currency) through the wage/price/credit channel may be eroded by the income effect of prices of imports.

In conclusion, it's not just the austerity. Don't be stupid - read Posen, not Krugman.