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!

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. 

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.

World Bank Poverty Stats

I have been doing some comparisons and calculations ever since the World Bank came out with this release. http://web.worldbank.org/WBSITE/EXTERNAL/NEWS/0,,contentMDK:23130032~pagePK:64257043~piPK:437376~theSitePK:4607,00.html

Though the $1.25/day (@2005 PPP rates) is the 'line' of absolute poverty, I'm somewhat more interested in the $2/day line. The release itself mentions that the progress on this (still fairly modest) indicator has been markedly less successful – but the absolute percentages and numbers are still quite shocking.

For instance in 2010, by World Bank's estimates, 32.7% of India's population was below $1.25/day and 68.7% below $2/day. While the first figure is understandable (though certainly not an acceptable state of affairs), the second figure is truly staggering. http://data.worldbank.org/indicator/SI.POV.2DAY/countries/IN?display=graph

In 2005 PPP terms, $1 was equal to Rs. 11.4 in rural areas and Rs. 17.2 in urban areas. This roughly corresponds to a weighted average of Rs. 16, nationally, given the urban-rural size of economy splits. http://www.worldbank.org.in/WBSITE/EXTERNAL/COUNTRIES/SOUTHASIAEXT/INDIAEXTN/0,,contentMDK:21880725~pagePK:141137~piPK:141127~theSitePK:295584,00.html

$2/day then, means Rs.32/day, again at 2005 prices. Total consumer price inflation in India between 2005 and 2010 was 53%, so this now converts to Rs.49/day at 2010 prices.

http://data.worldbank.org/indicator/FP.CPI.TOTL.ZG/countries.

This is, of course, consumption. Income would be somewhat higher – say by 25% (implying a savings rate of 20%, fairly optimistic for a person living at that level of income)? So, Rs. 61/day then. Or, Rs. 22,000/annum, rounded to the nearest thousand. Now this is where my disbelief kicks in. India's per capita income in 2010 was Rs 55,000 (again, rounded to the nearest thousand). So, by the World bank's estimates, a full 69% of the Indian population earns less than 40% of the national mean?!

I tried to do a simple stress test this figure – using the World Bank's Gini figures. The intuition is simple, given poverty headcount ratios and per capita incomes, one can create lower bounds on the Gini coefficient of a country. See this link for how the Gini coefficient is calculated. http://en.wikipedia.org/wiki/Lorenz_curve

In this instance, the stat claims that 69% of India earns less than (an average of) Rs. 22000/ annum. Let's say they all have an income of 22,000 per annum (thus understating inequality and the Gini). Then the other side of this divide (31%) has an average income of Rs 128,000/annum (to make an average of Rs 55,000 per annum). Let's say they all earn thsi same average income. So now, we have divided everyone in India in two separate sets, with perfect equality within each of the sets.

This division implies that the bottom 69% of India earns (at most) 28% of India's income and the top 31% earns (at least) 72% of India's income. This is an extremely simplistic piece-wise linear representation of the population-income Lorenz Curve, but it provides an implied lower bound of the Gini. The area under the curve (with coordinates of (0,0), (0.69, 0.28) and (1,1)) is 0.295, implying a Gini of ((0.5-0.295)/0.5) = 41%. To reiterate, this is just the lower bound. The World Bank Gini coefficient for India in 2010, however, is just 37.

If you separate the population into four distinct sets - at the world bank lines of $1/day (17% of India's population below this), $1.25/day (33% below this) and $2/day (69% below this), you get a lower bound on the Gini of 51!

Now I understand that these are based on very rough calculations and assumptions, but given that I am only trying to establish a lower bound with fairly conservative assumptions (about the savings rate, about intra-population equal distribution of income within the two separate populations identified), the 69% figure doesn't seem to pass the 'smell test'.

If India's poverty stats are indeed correct, then we'd be almost as unequal as Brazil and much more unequal than China. But India's inequality stats belie that. Which of these numbers is incorrect? My hypothesis suggests the $2/day figure of 69% is over-stated, but there could be other reasons.

Incidentally, I've mailed the World Bank about this. Let's see if they get the time to reply.

The 2011 Economics Nobel - Christopher Sims

(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

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

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

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

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

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

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

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

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

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?