Archive for March, 2008

Where are the customer’s yachts?

March 14, 2008

The more and more I read about this sub-prime crisis and recent developments in India’s financial sector, the more I think- where are the customer’s yachts?

For the uninitiated, ‘Where are the customer’s yachts?’is a title of a finance classic written by Fred Schwed in 1940. This website explains:

He noticed that all the stock brokers, investment advisors, and fund managers had yachts. Obviously there was money to be made on Wall Street! But how about the customers? Where were their yachts? Wasn’t the financial services industry supposed to help the customer get rich?

The purpose of the financial services industry, on Bay Street and Wall Street, is not to enrich the customer. The purpose is to extract fees from the customer. The sooner you, the customer, figure this out, the sooner you start asking the right questions, the sooner you will be on your way to buying your own yachtrather than someone else’s.

Stock brokers, investment advisors, financial planners, and fund managers don’t get to buy yachts because they are great investors who know better than you what companies to invest in. Ultimately, they get to buy yachts because they’re great salesmen, who have perfected the art and science of extracting trading fees, spreads, commissions, service charges, trailer fees, expense ratios, administration fees, you get the idea.

It is funny that this was written in 1940 and little has changed since then. One of the main reasons for the recent subprime crisis was the search for better yachts (read incentives).

Before Rajan made a case for this rising search for yachts, it was a fact known long ago and nothing seems to have changed since then. Moreover, the nature of derivative markets is such that the hedge fund managers will continue to have their yachts. There is little wonder why John Bogle criticises the financial sector despite being from the same.

There is a remarkable correlation how this is true across the world. The cities that have financial centres like NewYork, Tokyo, London, HongKong , Mumbai are also the costliest places in the world. So, the organisation has to make enough money to first, afford to have offices and second to pay the employees so that they can manage a living. And we all know both the factors are managed really well.

We keep saying markets are getting efficient but the reality is different. If the markets were getting efficient we would see little purpose in having investment managers. But what we see is the opposite. The search has gone beyond yachts and now we have ranches, private jets etc. Moreover, they can under-perform and offer to resign, atke the severence package and join another firm taking home a bigger set of incentives.

There is still a lot of money being made and that is why we see top paying jobs being created in the finance sector and new firms being launched. I wonder what the efficient market proponents have to say on this development.

Assorted Links

March 14, 2008

1. WSJ pointsto a report which says possibility of intervention to support falling USD are rising. It also pointsto a Myron Scholes solution to prop up banks.

2. Check out this blog on behavioral economics by Dan Ariely. Lots of food for thought.

3. MR on trade-offs and points that Adam Smith’s house is on sale

Dr Radhakrishnan report on agricultural indebtedness

March 13, 2008

The 60,000 crore debt waiver has been the most discussed topic after this Union Budget (after the issue over contingent liabilities).

There have been comments from all sections of the public (Shankar Acharya does a summary of the views).

The Finance Minister mentions in his speech of the Dr. R. Radhakrishnan report:

Sir, while I am confident that the schemes and measures that I have listed above will give a boost to the agriculture sector, the question that still looms large is what we should do about the indebtedness of farmers. Honourable members will recall that Government had appointed a Committee under Dr. R. Radhakrishna to examine all aspects of agricultural indebtedness. The Committee has since submitted its report and it is in the public domain. The Committee had made a number of recommendations but stopped short of recommending waiver of agricultural loans. However, Government is conscious of the dimensions of the problem and is sensitive to the difficulties of the farming community, especially the small and marginal farmers. Having carefully weighed the pros and cons of debt waiver and having taken into account the resource position, I place before this House a scheme of debt waiver and debt relief for farmers….

And then he suggests the proposal for debt waiver.

I am going through this report and on reading it I just ask one question- Have we progressed at all as a nation?

The same problems which must have been there at the time of independence (or even before) continue to exist. I have mentioned earlier over the crisis in the agri sector. I have even written a research paper on the subject which captures bulk of the reasons for indebtedness mentioned in the report.

However, I was not aware of several other issues like undernourishment has increased in farmers over the years (the ones who provide nourishment are undernourished) etc.

Most would criticise the political system in the country and say how the political parties have wasted resources in the country. I don’t really agree. The country as a whole has to share the blame. I had said this earlier as well.

Only in a country like India we see management graduates breaking records in salaries every year and have so many people die because of indebtedness.

Update:

1. I have done a research paper on the same.

Give Indian Cricket League its due

March 13, 2008

I had written a while back on Economics of Indian Premier league. I have also argued in a Mint articlehow BCCI has ensured maximum revenues without a ball being played. However, I have not written on one of the main reason why IPL was started.

It was basically because Indian Cricket League was started by Subhash Chandra, Essel (Zee TV) group chief.  Subhash Chandra created a revolution in Indian cable TV industry and tried to do the same for Cricket as well.

ICL was criticised from day one for being a rebel league and chided for being interested only in making money from Cricket. IPL is not a rebel league (as it has got endorsements from other boards) but we can argue about it being a big money spinner (read this Shahrukh Khan interview)

BCCI naturally didn’t like the fact that without consulting it, Zee launched ICL.  It led to a huge controversy with respective country boards banning their players from playing for their country. The Indian state-level players were banned from playing for their respective teams. Various cricket grounds which are run by respective state cricket associations were not allowed to give their grounds for exhibiting ICL matches. Further, BCCI barred a senior cricketer like Kapil Dev from getting pensions.

I missed the first edition of ICL (in 2007) but have been watching the second edition. I find nothing they are doing which can be called rebellion etc. They are playing pure cricket and some matches have been really very good.

  • It has also got players from all countries and some great ones as well (Brian Lara (who is injured this time), Damien Martyn, Inzamam ul Haq, Chris Cairns etc). With such super players around, it helps build the Indian team in future as youngsters get to to learn a lot.
  • It is also based on the Twenty-20 format and is pretty exciting. The teams are also similar.

    ICL IPL
    Chandigarh Lions Mohali
    Chennai Superstars Chennai Superkings
    Delhi Giants Delhi Daredevils
    Hyderabad Heroes Hyderabad
    Kolkata Tigers Kolkata Knight Riders
    Mumbai Champs Mumbai Indians
    Lahore Badshahs Bangalore Royal Challengers
    Ahmedabad Rockets Jaipur Royals
  • What it is also doing (which IPL is also doing but is at best limited) is it has given chance to some young Indian talent. These players have been playing Ranji Trophy and other domestic matches in the hope of playing for India someday. But, being a large country and inadequate coverage (it is improving now) of India’s domestic cricket season they more often than not miss out.
  • Plus, ICL gives all these players a chance to earn a decent living. We often get the news that the cricket boards of Pakistan, Sri Lanka, New Zealand, West Indies etc are not doing well and need financial support. And they often ask BCCi for help. So, how do you expect them to pay the players? So, ICL helps them get a decent iving which isn’t a bad thing at all. As incentives are too high so players have not minded defecting to ICL instead. This has led to a concern for a few teams like New Zealand not having enough players!

I don’t know why despite so many benefits the ICL has been banned. How can you stop a youngster from playing for the country if his performance is good?

Like we say in economics competition is good, so is the case here. It is a win-win situation for all.

The ICC has also so far not allowed IPL to become an official international tournament. ICC says it is a domestic tournament. Then why do the players agree to play as most complaint of overdose of cricket. It is easy to say it is the huge incentives at stake, nothing else.

All ICC, BCCI and other boards have to do is plan a schedule and let players decide which league they want to play for – ICL or IPL? And then like we see in Europe, let top teams from each league compete against each other to become the best team.

Indian cricket also missed a great opportunity to make India a cricket superpower (it already is one, could have made it stronger). By letting both the leagues work, India’s already powerful stature in the game would have grown further. Just like various football leagues shifted the the football power to Europe, similarly it could be the case for India. It is not very often that we see people from developed economies coming to a developing economy to earn a living. It changes the dynamics completely.

It is time authorities do a rethink on this issue and remove the ban on ICL. Let cricket thrive!!

Addendum (31/3/08):

The matches have been simply amazing, nail-biting stuff. All matches are beiung played in great spirit as well. There is one request from ICL authorities though- please do not repeat one advertisment time and time again between the breaks. They always repeat the Airtel ad which makes it very boring and irritating.

Assorted Links

March 13, 2008

1. MR points to a new journal on public choice theory. It also points to an example of financial inclusion.

2. WSJ Blog says Fed may run out of ammunition. Meanwhile it has an excellent joke:

Journalist: I keep expecting to get hit by a kitchen sink flying out of the Fed.

Fed watcher: Hold onto that sink. You’ll be able to repo it at the discount window.

3. This postfrom  WSJ Blog tells me we would have some more data which will help us understand economic history of numerous countries. (The purpose of the post is actually completely different)

4. Rodrik says why foreign investors are given preferential treatment over domestic investors.

5. PSD Blog points to a new conference on partial credit guarantees

6. Ajay Shah on watching markets work.

First ICICI Bank, then L&T, what is next?

March 12, 2008

I am not really amazed by the recent developments in Indian financial markets-  losses in derivative markets. It started with ICICI Bank, then we had news of L&T and I wouldn’t be surprised if we hear more such cases.

The ICICI Bank press release says the bank had no direct and indirect exposure to the subprime markets in US but the losses have been due to widening of credit spreads. This has resulted in mark to market losses. It points to two losses:

1)  Credit derivatives: ICICI Bank and its overseas banking subsidiaries have an aggregate exposure of USD 2.2 billion in credit derivatives. As of January 31, 2008, the mark-to-market negative on this portfolio due to movement of credit spreads was about US$ 155 million of which USD 88 million had been provided for in the financial statements of the bank and its subsidiaries for the nine months ended December 31, 2007.

2. Fixed income portfolio: In addition, ICICI Bank and its overseas banking subsidiaries have fixed income investment portfolios which have a mark-to-market negative due to widening of credit spreads. As of January 31, 2008 this negative was about US$ 108 million of which US$ 101 million had been accounted for in the financial statements as of December 31, 2007. This includes mark-to-market on the available for sale portfolio which has been accounted for in the shareholders’ equity.

So total mark to market losses are $ 155 mn+ $ 108 mn= $ 263 million.

How about Larsen and Toubro? I couldn’t find anything on its website. However, disclosure is there in NSE (see the release on 10 March 2008) :

Larsen & Toubro Limited has vide its letter inter-alia stated, “We wish to clarify that during the year 2007-08, thre has been extreme volatility in the markets, especially in commodity prices. The Company has exposure in commodities and part of it is being hedged by it. As per the un-audited numbers, there could be a loss in commodity hedging of around Rs. 200 crore. The actual number will get crystalized on finalization of Accounts. We have reduced the exposures to a considerable extent. However, the Company maintains its guidance on order booking, sales and operating margins for the year with an emphasis on improvement in the operating margins.”

200 crores = $49 – $50 million.

Now, the possibility of this spreading to other companies has caught up with the media. BS says worse is to come.

This Mint story says there is 128 trillion of derivatives on Bank’s books. (I know it is wrong to compare financial stock with GDP but just to get some relative picture it is about 2.7 times the GDP!!) The story also says there is a possibility that companies have not understood these risks and have simply taken exposures.

I had pointed this long back when it was reported that one of ICICI Bank’s customers had complained that ICICI Bank had sold exotic stuff it was not aware of.

This will automatically lead the derivative sceptics to step in action and ask to ban these items. It is amazing how often the financial markets give these sceptics a chance. Mint edit says it will be wrong lesson to take forward this lesson and instead asks for better regulation and governance.

I wonder whether regulation and governance alone can help. The financial market players need to become more responsible. We keep on creating more and more derivatives (read this excellent John Bogle view) and fancy our chances of making monety by trading them. Most of these creators have a  basic education in finance which says you can’t predict markets. But still we keep on taking chances. In good times, they manage and in bad times they need to be managed. By the very nature, derivatives should help you in bad times but what you see is the opposite.

Another point is this rise in trend of other incomes of the companies (read this Bimal Jalan interview). Most companies have nowdays have fancy looking treasury departments/special entities that engage in trading and creating financial assets. There is no problem with this but why the euphoria over the treasury? The main task of a company is to generate profits from its mainstream business not trading financial assets.

We may get tied up with the media coverage over rising and falling growth but the real story is we have a long way to go. There is wide exclusion and deficit across sectors- financial, infrastructure, qualitative employment etc. The organisations should concentrate on them and not get carried away by these asset market movements.

Addendum:

This article from Business Standard explains how the above mentioned 128 trillion derivative book of banks could go for a toss.

Meanwhile market rumours have picked up. This news from ET says (look for Crash course at the end):

Kotak Mahindra Bank fell 9.5% on Monday following media reports of RBI audit looking into an overexposure to equity. But the truth, possibly is, that RBI is looking into small manageable hits in currency derivative books of some private banks. Clients of these banks who have bought derivatives are refusing to pay after an unexpected surge in euro and yen. According to the market grapevine, Kotak’s provisioning may be in the region of Rs 100 crore, some of which has already been accounted for in December.

Update:

1. As I feared, we are seeing more and more banks are accused of selling exotic derivative products to the manufacturers. Mint has an update where it says clients of 5 banks- Kotak Mahindra Bank, HDFC Bank, ICICI Bank, Yes Bank and Axis Bank have turned adversaries.

2. Satyajit Das interview in ET where he says all these developments are Naked Greed.

Assorted Links

March 12, 2008

1. WSJ Blog points to the recent  Fed statement where the Central banks have again pitched in to stem the liquidity crisis. Also Fed has expanded its Term Securities Lending Facility. It will now accept these securities for 28 days (it was a fortnight earlier) and will accept other securities.

It also points to Economists’ reactions. Here is Krugman’s  reaction.

2. Econbrowser says we expect too much from Monetary policy. As I have said earlier, this entire debate needs a new framework for monetary policy.

3. S&M has a good post on equity premium (Though the purpose of the post is not to discuss equity premium)

4. TTR is a contrarian, is well known. He lendshis support to the controversial debt waiver scheme. He also saysthere is no property bubble here. I think there very much is especially in metros. Why do economists make a broadcase for rising incomes in India. Incomes have risen but it is only limited to a certain section of population.

5. IE Blog points to the smartest Indian unknown entrepreneur

6. JRV points to lots of research on the sub-prime crisis.

Great Moderation revisited

March 11, 2008

I have written quite a few posts on the subject (here and here). It basically means that volatility in GDP and inflation has become lower over the years. Hence there is a huge research on the factors responsible for the same.

I had mentioned about the Bank of France symposiumon globalisation and monetary policy. I had covered Dr Reddy’s speech as well.

I went through this speech by Janet Yellen where she discusses a paper by Bill White on Great Moderation (GM).

White points to 4 possible reasons for GM- monetary policy, domsetic deregulation, global savings and globalisation. Yellen adds:

Because no single hypothesis adequately explains the full set of “stylized facts”, Bill advocates a global aggregate demand-aggregate supply approach in which all four explanations matter to inflation to varying degrees and at varying times. Demand-side factors, driven mainly by tighter domestic monetary policy, were central to the decline of inflation in the 1980s and 1990s. Supply-side factors, associated with both domestic deregulation and globalization, as well as lower aggregate demand associated with excess global saving, all have played a role in restraining inflation  more recently.

However, Yellen says she would add more importance to monetary policy and less to globalisation. Yellen provides a lot of references on the subject as well. 

Overall, a nice read.

Assorted Links

March 11, 2008

1. Krugman writes a great post analysing the subprime mess.  It is a must read.

2. WS Blog says analysts  say rate cuts would not be enough. I said the same long back. I said it is a valuation problem and the US authorities need to sort it.

3. Meanwhile, analysts also predict a 75 bps rate cut in the next Fed meeting on 18 March 2008.

4. MR points to the aggregate cost of trying to beat the stock market

5. Mankiw points to Fed vs ECB. He also points to the gains from trade. Is this true?

6. Rodrik points to a new webpage that lists all the papers on growth diagnostics framework.

7. PSD Blog points to an article which says “If Bill Gates had started Microsoft in a garage in Brazil, it would still be in the garage”!

8. Econbrowser says possibility of there being two recessions in Bush presidency looks quite good.

How about buying a house in Omaha instead of Mumbai?

March 10, 2008

There are a lot of blog posts and comments over annual treat for finance professionals- Warren Buffet’s letter to shareholders. It is one of the most awaited events.

This one is also full of anecdotes Buffetisms:

Some major financial institutions have, however, experienced staggering problems because they engaged in the “weakened lending practices” I described in last year’s letter. John Stumpf, CEO of Wells Fargo, aptly dissected the recent behavior of many lenders: “It is interesting that the industry has invented new ways to lose money when the old ways seemed to work just fine.”

You may recall a 2003 Silicon Valley bumper sticker that implored, “Please, God, Just One More Bubble.” Unfortunately, this wish was promptly granted, as just about all Americans came to believe that house prices would forever rise.

He explains the great, good and gruesome business

The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

Before he begins to explain how much he earned from his 4 lines of business (insurance, utilities, manufacturing and retail, finance and finance products), he writes:

The best anecdote I’ve heard during the current presidential campaign came from Mitt Romney, who asked his wife, Ann, “When we were young, did you ever in your wildest dreams think I might be president?” To which she replied, “Honey, you weren’t in my wildest dreams.”

:-) 

He goes on to criticize overstated reportings by public companies and defends sovereign wealth funds.

And finally, he says the annual meeting will be on May 3 2008. And the centre would have many avenues for shopping. What caught my eye is this

This year we will again showcase a Clayton home (featuring Acme brick, Shaw carpet, Johns Manville insulation, MiTek fasteners, Carefree awnings and NFM furniture). You will find that this 1,550- square-foot home, priced at $69,500, delivers exceptional value. And after you purchase the house, consider also acquiring the Forest River RV and pontoon boat on display nearby.

I just checked the website of the Clayton and came across some superb homes.

Well, now the main point. If you calculate the per square rate of this house it costs just about Rs. 1793.5 per sq ft! And that too with some basic furniture.

You wouldn’t get a house at these rates in Mumbai and would have to go really to far-0ff places. Like let us compare the ratesacross the 3 railway tracks . You wouldn’t get a house for this rate as far as Panvel (the last stop on Harbour Line) and might get one beyond Ambernath (on Central Line) and Virar (on Western Line).

So, those having a house in Mumbai and are looking to invest, Omaha could be a good option; prices are rock bottom in US and one can gain from appreciation over the years.

Moreover, it might also just bring some respite to the Mumbai property market. And address demand-supply problems which a visitors have commented on in this post.

Dr Reddy suggests new avenues for research

March 10, 2008

Bank of France organised a symposium on Globalisation, Inflation and Monetary Policy. It has got some of the best brains talking on an evergreen subject in monetary policy- the impact of globalisation on inflation (the summary is here). I would try and cover the speeches I have read in subsequent posts.

Dr. YV Reddy in his speech suggested few topics of research on the subject. Some I have shortened, some have been picked from his speech (in italics) 

1.  What has led to lower inflationary pressures- . globalisation of trade or globalisation of finance or both.

2. India and China, both have grown despite managed capital account and has also not led to adverse sentiments in financial markets. So should the research give more weight to macroeconomic fundamentals than capital account openness?

3. recent turbulence in financial markets/institutions and the importance of harmonised and coordinated response of public policies indicate the significance of countercyclical fiscal and monetary policies. Is it possible to argue that similar harmonisation between monetary policy and prudential policies would be of some value as part of counter cyclical measures?

4.  Regard to regulation and supervision over banks, it is useful to explore whether the special status of banks in the financial system and the need for active coordination among regulators / supervisors needs to be reaffirmed.

5. Shouldn’t regulation of financial markets be expanded as financial flows are becoming more global?

6. How should Central Bankers cooperate and coordinate in these times?

7. Finally, from a purely academic perspective, it may not be out of place to explore the issues concerning international policy coordination including the political economy considerations, in terms of interaction between governments and the financial sector, which may have been influenced by not only by the growing importance of finance but also the cross-border linkages in the financial flows.

All the seven are really good areas of research on this subject of globalisation and monetary policy. I will post on the topics as and when  if I come across some useful research on the same.

Assorted Links

March 10, 2008

1. TTR believes ICICI subprime losses are exaggerated.

2. WSJ Blog points to a lot of Fedspeak: Kohn, Mishkin, Hoenig, Yellen

3. Krugman explains what Bernanke is upto.

4. Mankiw asks what happened to inflation targeting? He also pointsto an article looking at similarity between ethanol and subprime mess.

5. Rodrik responds to the criticism against his article where he advocated political controls.

6. EPSA Blog points to a new book on development in  B’Desh.

7. Econbrowser asks has the recession started?

Can we limit hedge fund managers’ salaries?

March 7, 2008

This is a hot topic of discussion- limiting the huge salaries of investment managers. It was started by Raghuram Rajan and I had mentioned earlier we should see some research on this topic.

 I came across this excellent paper from Dean Foster and Peyton Young . Foster is a Statistics prof from Wharton and has taken a lot of interest in finance especially to show that it is not skill but good luck that leads to huge returns. I have pointed out to his superb paper on the same here

Now coming to the main paper. The abstract says it all:

This paper examines theoretical properties of incentive contracts in the hedge fund industry. We show that it is very difficult to structure incentive payments that distinguish between unskilled managers, who cannot generate excess market returns, and skilled managers who can deliver such returns. Under any incentive scheme that does not levy penalties for underperformance, managers with no investment skill can game the system so as to earn (in expectation) the same amount per dollar of funds under management as the most skilled managers. We consider various ways of eliminating this “piggyback effect,” such as forcing the manager to hold an equity stake or levying penalties for underperformance. The nature of the derivatives market means that none of these remedies can correct the problem entirely.

The paper explains how the hedge fund manager can structure the derivative contracts which will make him appear as a skilled fund manager but in reality he is unskilled or even an ‘outright con artist’. Foster had also explained the paper in an article which I covered here.

The main thought is:  

There are two separate problems that a properly designed incentive scheme needs to address. The first is how to align the interests of the manager and the investors more closely. The second is how to distinguish between skilled and unskilled managers. The former is the alignment problem whereas the second is the separation problem.The authors say structuring the incentives could take care of alignment problem but separation problem would remain.

They structure the incentives in three ways:

1) payments based on final returns
2) forcing the manager to have an equity stake
3) levying penalties for underperformance

And in all three the conclusion is the same- you can’t seperate the skilled from unkilled and latter can easily piggyback on former.

The conclusion is:

First, it is extremely difficult for investors to tell whether a given series of excess returns was generated by superior skill, by mere luck, or by duplicity. Second, because it is easy to fake excess returns and earn a lot of money in the process, mediocre managers and con artists could be attracted to the market. The situation is analogous to an automobile ‘lemons’ market with the added feature that ‘lemons’ can be manufactured at will .

Indeed, it is analogous to a car market with the following characteristics: i) every car is one of a kind; ii) the car’s engine is locked in a black box and no one can see how it works (it’s not protected under patent law); iii) anyone can cobble together a car that delivers apparently superior performance for a period of time and then breaks down completely.

In such a case one would expect the price of cars  both good and bad – to collapse, because buyers cannot tell the difference between them. A similar fate may await the hedge fund industry unless ways are found to make their functioning more transparent.

This is a superb paper and the findings can be applied in other types of investment business as well- mutual funds, pension funds etc. Though, the hedge funds are unregulated entities and the effect would be more for them. But still we can’t ignore the findings. 

Highly reccommended.

Assorted Links

March 7, 2008

1. TTR points that a code on banker’s pay is being developed.

2. Ajay Shah criticises India’s macroeconomic framework.

3. WSJ Blog points that recent Flow of Funds  data shows household balance sheets are  deteriorating.

4. WSJ Blog points to a new speech from Boston Fed president – Eric Rosengren.

5. Mankiw points real interest rates are now negative.

6. Fin Prof points to a new research that shows currency funds dont’ outperform benchmark.

7. DB Blog points to a new paper on institutions and development

Inequality in US and lessons for India

March 5, 2008

I came across this superb lecture (Thanks to Rodrik for the pointer) by Frank Levy (MIT prof) on income inequality in US and the role of institutions. The lecture is basically a short-version of the paperhe coauthored with Peter Temin.

The main idea is:

I want to talk tonight about the role of institutions in achieving a fair distribution of the gains from economic growth. In labor economics today, institutions do not receive much attention. Most attention is reserved for market forces like the impacts of technology and international trade. The work I will discuss tonight does not deny the importance of market forces. But I will argue that institutions – unions, the minimum wage, the tax system, accounting conventions and ultimately the tone set by the government – have the power to either moderate or reinforce the underlying market. I will describe how U.S. institutions abandoned a moderating role sometime after 1975, when market forces were already tending toward greater inequality. In my story, the inequality we see today reflects continued market pressures unhampered by institutional restraint.

He goes on to show how inequality has widened in US. He has an interesting take on the education inequality:

Finally, many people argue that today’s earnings problem is really an education problem – that the labor market is changing and we don’t have enough well educated workers. That is clearly a part of the story – in these figures, you can see the growing gap between college and high school graduates. But you also can see the problem goes deeper since, for example, the compensation of the average 40-year-old man with a bachelor’s degree is not growing in line with productivity. In other words, we can’t seriously talk about an education problem whose solution requires making everyone an MBA, a lawyer or a PhD.

We can see similar things happening in India with incomes accruing mostly to those with fancy degrees. The media generally reports one side of the story that  the son/daughter gets more salaries than his/her father who has much more experience. This is usually celebrated. The other side of the story is – rising inequality.

Levy looks at what led to this rising inequality in US and he says it is mainly because of lack of institutions. The abstract of the main paper says:

… the income distribution in each period was strongly shaped by a set of economic institutions. The early postwar years were dominated by unions, a negotiating framework set in the Treaty of Detroit, progressive taxes, and a high minimum wage – all parts of a general government effort to broadly distribute the gains from growth. More recent years have been characterized by reversals in all these dimensions in an institutional pattern known as the Washington Consensus.

What should be done to reduce inequality in US? The answer is a no-brainer- get the institutions back. Though there is no clarity w.r.t to type of institutions. All the paper says is:

Only a reorientation of government policy can restore the general prosperity of the postwar boom, can recreate a more equitable distribution of productivity gains where a rising tidelifts all boats. The precise form of this reorientation is not yet clear.

The authors also have pointed out an interesting thing: most of the gains have actually accrued to the financial sector.

When we say that the top one percent of tax filers now receive something over 17 percent of all taxable income, it will not surprise you that a significant fraction of that top 1 percent comes from the financial sector.

This reminded me of what John Bogle keeps saying in his speeches – the excesses in the financial sector. So many things are linked in economics. It also partly looks at the compensation issues in the financial sector which Raghu Rajan has pointed.

In India, also we need to do similar type of studies. What is driving the inequality in then country. Unlike US, the % of have-nots are expected to be much larger in India. So, if we want to address inclusive growth we may need to take a relook at our labor market institutions.

Assorted Links

March 5, 2008

1. WSJ Blog points to  2 new speeches from Fed. It also points to a new paper from Rogoff et al which says movement in currencies can be used to predict movement in commodities (we would usually think it to be opposite)

2. TTR on Centre’s subsidy bill

3. EPSA Blog on climate change and poor. A very interesting post.

4. Econbrowser says it isn’t about housing anymore. The decline is being seen in auto, gasoline, ISM all are declining. (I am so confused by US economy)

5. MR points to a new blog- Odd numbers blog.

Interest Rate Future Report

March 4, 2008

RBI has released Interest Rate Future report . This is a very important missing component of India’s Financial Markets. The derivative market in equity segment has been quite active. It is time that we have an active derivatives market in debt segment as well.

The press release informs:

Interest Rate Futures (IRF) were introduced in India in June 2003. In the context of continued financial market developments, the Annual Policy Statement of April 2007 had proposed to set up a Working Group under the aegis of the Technical Advisory Committee on Money, Foreign Exchange and Government Securities Markets. Accordingly, on August 9, 2007, the  Technical Advisory Committee constituted a Working Group on Interest Rate Futures (Chairman: Shri V K Sharma, Executive Director, RBI) to review the experience gained with IRF with particular reference to product design issues and make recommendations for activating the instrument.

Assorted Links

March 4, 2008

1. WSJ Blog points Paulson says Economy to grow, more slowly. What does it mean?

2. WSJ also points to a speech from Philadelphia Fed President, Charles Possner. He says turnaround in mid year.

3. Jeff Frankel points to geopolitical implications if USD looses its numero-uno position in world currency markets. He also has some interesting investment advice- invest in Munis.

4. Rodrik points Kennedy School of Government has been renamed as Harvard Kennedy School.

5. Fin Prof points to the annual treat- letter from Buffet to its shareholders.

Impact of sixth pay commission on fiscal

March 3, 2008

This is one of the most important questions being asked  in the Indian economy- What is going to be the impact of sixth pay commission on India’s fiscal deficit.

I was reading the recent speech by Dr. Rakesh Mohan (Deputy Governor, RBI) , where some analysis has been done. He compares the payout in fifth pay commission (implemented in 1997-98) and the sixth pay commission. See this table for details.

  • The liability of the Central Government as a result of implementing the FPC award was estimated at Rs.18,500 crore up to the end of February 1998.
  • The impact was spread over the period from 1997-98 to 2000-01, rather than being a mere one off impact in 1997-98 .
  • The proportion of wages, salaries and pensions of the Central Government, as a proportion of GDP, which had increased from 2.7 per cent in 1996-97 to 3.3 per cent for three years up to 2000-01, tapered-off back to about 2.7 per cent by 2003-04.
  • Thus, the impact of the FPC approximately amounted to about 0.6 per cent of GDP per annum over a four-year period – a cumulative impact of 2.4 per cent – for the Central Government.
  • In respect of the State Governments, in the absence of budgetary data on salary expenditure, the impact of FPC can be ascertained from its proxy taken as the non-plan revenue expenditure in social, economic and administrative services.
  • The impact was visible from the year 1999-2000 when the proxy indicator as a proportion to GDP rose from 6.6 per cent in 1998-99 to 7.0 per cent in 1999-2000 and 7.2 per cent in 2000-01, before declining back to 6.7 per cent in 2001-02. Thus, the impact of FPC for the States amounted to approximately 0.4-0.6 per cent of GDP (a cumulative impact of 1.0 per cent over the two-year period).
  • The combined impact of the Centre and States, thus, approximated to around 1.0 per cent of GDP (a cumulative impact of 3.4 per cent).
  • In order to absorb the impact of FPC, the Government envisaged to bear it through a combination of additional resource mobilisation and expenditure reducing measures. However, as alluded to above, there was a decline in the tax-GDP ratio in the late 1990s, which exacerbated impact on the Government finances. 
  • Looking forward, assuming that the scale of the impact of the SPC to be similar to FPC in proportionate terms, the pressures on expenditures may amount to about 1.0 per cent of GDP per annum for the Centre and States combined, spread over a 3-4 year period.

This means it would add about 1% to the total expenditure for the 3-4 years when it is implemented. This is a pretty big figure. But the situation isn’t as bad as it was in the time of FPC.

Unlike the prevailing situation during the FPC, the SPC implementation would be undertaken when the economy is witnessing high tax buoyancy – the tax-GDP ratio of the Centre has increased by 2.6 percentage points to 11.3 per cent in 2006-07(RE) from 8.8 per cent in 2002-03.

It all depends on tax revenues. If they decline, there could be a problem.

Addendum:

BS reports that according to Finance Secretary D Subbarao, 6th pay commission expenditure would be within 0.4% of GDP. Here is an interview of the Finance Secretary on the same.

Do we see similar housing demand in Mumbai?

March 3, 2008

Bob Shiller (of Yale) has written a wonderful articleexplaining the recent Housing Bubbles. Shiller is an expert on matters pertaining to housing markets. He applies the principles of psychology really well to understand the developments in financial and other asset markets.

What struck me was the way in which the concept can be applied to understand housing markets worldwide.

 The failure to recognize the housing bubble is the core reason for the collapsing house of cards we are seeing in financial markets in the United States and around the world. If people do not see any risk, and see only the prospect of outsized investment returns, they will pursue those returns with disregard for the risks.

Were all these people stupid? It can’t be. We have to consider the possibility that perfectly rational people can get caught up in a bubble. In this connection, it is helpful to refer to an important bit of economic theory about herd behavior.

Precisely. We have to consider the fact that even rational people can make poor decisions. Then he points to a paper which helps us understand the process:

Three economists, Sushil Bikhchandani, David Hirshleifer and Ivo Welch, in a classic 1992 article, defined what they call “information cascades” that can lead people into serious error. They found that these cascades can affect even perfectly rational people and cause bubblelike phenomena. Why? Ultimately, people sometimes need to rely on the judgment of others, and therein lies the problem. The theory provides a framework for understanding the real estate turbulence we are now observing.

Mr. Bikhchandani and his co-authors present this example: Suppose that a group of individuals must make an important decision, based on useful but incomplete information. Each one of them has received some information relevant to the decision, but the information is incomplete and “noisy” and does not always point to the right conclusion.

The main issue he tries to address is that best people in the business are bound to have incomplete information. So they rely on others who also have incomplete information leading to a cascade of poor decisions and what the authors call as “wrong collective action”. The finding is quite surprising:

Mr. Bikhchandani and his co-authors worked out this rational herding story carefully, and their results show that the probability of the cascade leading to an incorrect assumption is 37 percent. In other words, more than one-third of the time, rational individuals, each given information that is 60 percent accurate, will reach the wrong collective conclusion.

37% !! That is a big number. So, even if we assume rationality, there are bound to be huge errors.

The same concept can be applied to the other asset markets even in other parts of the world.

Like, we continue to see the housing prices rise (and rise and rise) in Mumbai. I have explained previously the demand curve has actually become an upward sloping curve with hardly any effect of rising prices showing on demand. The main reasons given are pretty rational ones- increase in demand for housing due to rising incomes, migration etc.

Though, I am sure large part of the rise is also because of the information cascade effect explained above. Just because someone else has bought, the other person feels it is the right time. And if he is a leader in the peer group/family, the cascade effect is bound to be larger.

Addendum:

I couldn’t find the original paper, but here is a similar kind of research paper from the same authors. It looks like an updated version as well.


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