The optimist Central Bank of Canada

I came across this speech by David Longworth, Deputy Governor of the Bank of Canada which is very aptly titled as —  Work in Progress: The Bank of Canada’s Response to the Financial Turbulence.

The speech is a very neat summary of what BoC has done over the last one year. Why did the liquidity problem arise:

Now, it is important to note that the decline in the liquidity of bank-funding markets and the decline in the liquidity of asset markets in general are not unrelated. Indeed, there are theoretical reasons to believe that market liquidity and the funding liquidity of banks with trading operations are mutually reinforcing, thus leading to the possibility of a “liquidity spiral” in a downward or upward direction.

This possibility arises because first, the ability of traders to provide market liquidity depends on the amount of funding they have and, second, the amount of funding they have, through capital and margin loans, depends on market liquidity. This second linkage arises because, with mark-to-market accounting, asset-price movements affect capital and because, empirically, margins tend to rise when asset prices fall.

On a different note, I would add that the leverage of trading operations is strongly procyclical, falling when asset prices fall and rising when they rise.

Excellent. Somehow BoC’s statments on liquidity are the best (see this as well). What did they do to resolve the crisis? This explains all their work in sum.

the central bank should be prepared, if necessary, to take steps that go beyond adjusting the aggregate supply of reserves, including providing an increased volume of term funds, conducting operations against a broad range of collateral, and conducting operations with a broad range of counterparties

However, after all the explanation of why crisis happened and how BoC supported the markets, Longworth says:

Two conclusions can be drawn from how these problems played out in Canada. First, the financial system is sound, and the Canadian financial, non-financial, and household sectors are strong enough to deal with the problems we have seen in financial markets.

Really? Then why was all that support needed? Could they have done better if the Central Bank had not intervened? He himself points to a report which says:

The CGFS report suggests that central bank actions in response to the market turbulence have been effective in that they have “reduced, though not resolved,” tensions in short-term money markets, thereby mitigating the damage to the economy.

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The big Indian policy challenge- moving unskilled to skilled

I came across this superb interview of Arvind Subramanian of Peterson Institute.

He says why services picked up?

you had this sudden accident of the IT (information technology) thing picking up and India being particularly well-suited. The fact (is) that we developed high skill and neglected basic education. So the technology shock came along, (and) we had high skills and the services sector takes off.

This is pretty standard well-known stuff. However this was very interesting point:

What I am going to develop further is that in some ways this has gone one step further. If you look at FDI (foreign direct investment), the big China-India comparison is that China gets a lot of FDI, India gets very little. If you look at the exports of FDI, India exports a lot of FDI, more than China. It exports this FDI to not just poorer countries, but to the rich countries as well.

So to me what this suggests, of course, is two things. This skill we have is not just people, who can write code cheap, it’s also about managerial and entrepreneurial capital, which is now a world beater. This is kind of really striking. Generally, countries do this when they are at a much higher stage of development. This is the kind of upside, or triumphalist side of precocious India.

However, there is a downside to this:

 By definition if you develop based on a factor that is in limited supply, you don’t use a factor in relatively abundant supply, you get inequality. So the challenge for India is going to be how we provide opportunities for all these unskilled people. How we manage the challenge is one of the big challenges facing the Indian economy.

He says skilled labor is scarce compared  to unskilled and as growth goes to former, we have higher inequality. And this is the biggest challenge India faces.

He also says India needs to improve its public institutions ( I had reviewed his excellent paper on India’s institutions here), lagging states like Bihar and Rajasthan need to catch up etc.

I had highlighted similar issues in my paper here.

Assorted Links

1. US revised its Q2 GDP figures from 1.9% to 3.3%. Econbrowser discusses the surprise release as most expected a recession.  WSJ Blog points US GDP has been revised upwards but recession can still come.

2. I can’t understand this mania over recession. The focus should be on inflation.

3. WSJ Blog points India might better China over a longterm. It points 5 sectors that will get hit further

4. TTR points changing face of Indian bureaucracy. He is a true contrarian

5. IDB points to some solutions to improve Indian agriculture. I agree agriculture is important but unless we can migrate the huge surplus labour employed in agriculture to other productive sectors, we just can;t get this sector going.

6. IDB also points to an interesting study which shows peer group leads to higher saving

7. ACB has a fantastic post on inflation.

8. Macroblog has a very confusing post on inflation

9. PSD Blog points which country won more gold medals per capita- Mongolia

Get Nobel Prize ideas in a parking lot

It is amazing to find how all these Nobel laureates get ideas which lead to The Prize after all. I had pointed earlierhow Markowitz got a Nobel Prize idea after he got a tip from a stock-broker.

I was reading this Nobel Prize speechof Gary Becker (1992 winner) where he explain how he got one of the many ideas for which he got the prize while trying to park his car:

I began to think about crime in the 1960s after driving to Columbia University for an oral examination of a student in economic theory. I was late and had to decide quickly whether to put the car in a parking lot or risk getting a ticket for parking illegally on the street. I calculated the likelihood of getting a ticket, the size of the penalty, and the cost of putting the car in a lot. I decided it paid to take the risk and park on the street. (I did not get a ticket.)

As I walked the few blocks to the examination room, it occurred to me that the city authorities had probably gone through a similar analysis. The frequency of their inspection of parked vehicles and the size of the penalty imposed on violators should depend on their estimates of the type of calculations potential violators like me would make. Of course, the first question I put to the hapless student was to work out the optimal behavior of both the offenders and the police, something I had not yet done.

This led to building the rationality theory of crime:

In the 1950s and 1960s intellectual discussions of crime were dominated by the opinion that criminal behavior was caused by mental illness and social oppression, and that criminals were helpless “victims.” 

I was not sympathetic to the assumption that criminals had radically different motivations from everyone else. I explored instead the theoretical and empirical implications of the assumption that criminal behavior is rational, but again “rationality” did not necessarily imply narrow materialism. It recognized that many people are constrained by moral and ethical

However, police and jails would be unnecessary if such attitudes always prevailed. Rationality implied that some individuals become criminals because of the financial rewards from crime compared to legal work, taking account of the likelihood of apprehension and conviction, and the severity of punishment.

🙂

I was wondering what would Becker think if he walks into a parking lot in Mumbai? Why did he buy the car?? 

Assorted Links

1. WSJ Blog points to Fedspeak – Lockhart

2. ASB calculates the expenses and tracking errors of index funds in India….No wonder there are no takers with costs being so high. I also don’t understand why expenses are so high?

3. JRV points to his comments on Raghu Rajan’s Jackson Hole paper

4. IDB on branchless banking

5. ICB on IPOs 

6. PSD Blog points doing business might get easier in India

What drives corporate bond spreads?

Corporate Bond Spread is the difference between the yield of a corporate bond and a government bond. Just like we have the government bond yield curve we have a corporate bond yield curve and it tells us the spread at different maturities. (A yield curve is nothing but a graph that shows the yields at different maturities….you have bonds of various maturities – i1 year, 2 year, 10 year etc….if we plot the yields of each bond with the respective yield, we get a yield curve)

Now, the question which comes to mind is what determines the corporate bond spread? I mean suppose we see the difference in yields between one year corporare bond and government bond as 100 bps, can we say it is right? Or if it changes from say 80 bps to 100 bps, what drives the change?

This FRBSF paper explains the concept. First why is it important?

A thorough understanding of the primary factors determining the changes in corporate bond yields is important for proper risk management of corporate bond portfolios. It also is useful to the conduct of monetary policy since developments in the corporate bond market may provide a timely and forward-looking measure of the general business climate as opposed to statistical releases that are inherently backward looking.

The Theory behind the spread:

 The logic behind this supposition is that, in a world without distortion from factors such as transactions costs and taxes, the only rationale for credit spreads to exist would be to compensate for the probability of default and the size of the ensuing loss. Thus, the systematic components in corporate bond credit spreads should all be factors that reflect the financialconditions of firms in general.

What about the empirical analysis:

In practice, however, empirical researchers have only been able to explain less than half of the variation in credit spreads, and therein lies the credit spread puzzle.

For example, Duffie, Saita, and Wang (2007) present and estimate a dynamic model for the default probability of 2,770 U.S. industrial firms. They find that, in addition to a set of firm-specific factors, two market-based factors–the 3-month Treasury bill rate and the 12-month trailing return on the S&P 500 index–have significant explanatory power in predicting the default probability of the firms in their sample

Duffee (1998) finds that for most of the rating and maturity combinations considered, a little less than 20% of the variation in the average credit spread can be explained solely by the level and slope of the Treasury yield curve

Collin-Dufresne et al. (2001) study the credit spread changes for 688 different corporate bonds. They control for variables that affect the likelihood of a firm defaulting such as leverage ratio and asset volatility in addition to controlling for the effects of changes in short- and long-term Treasury bond yields and the return on the S&P 500 index. However, they are able to explain only about 25% of the variation in the credit spread changes across the 688 different bonds.

As the spread can’t be explained, the economists term it as a corporate bnd spread puzzle. The paper then looks at two factors that could explain the spread- taxes and liquidity. Read the note for details.

The conclusion is:

The studies reviewed here show that more than half of the variation in corporate bond credit spreads is not related to the financial health of the issuing firm, but rather reflects effects such as compensation for liquidity risk, which can vary over time, and to some extent the tax treatment of corporate bonds.

Thus, using corporate bond spreads to derive conclusions about the general business climate requires a very demanding decomposition of credit spreads into their separate components. Moreover, while the research reviewed here has been able to contribute much to our understanding of the composition of credit spreads on corporate bonds, there are still some significant pieces missing before the credit spread puzzle can be declared solved.

 Good stuff!

Assorted Links

1. WSJ Blog summarises the various research on recent date releases on housing sector- the pace of declining slows

2. WSJ Blog points to an new World Bank report that says poverty was higher in 2005 than previously estimated.  It also points poverty might increase in US in 2008

3. ASB on the next RBI Governor

4. NEB is back. It pointsto a paper on why subprime crisis happened. It pointsto a new paper on Asian forex reserves

5. NB pointsto a Thaler interview

6. MacroBlog ponders over issues raised in Kansas Fed Symposium

7. Mankiw points volatility in stock markets is quite high

8. Fin Rounds points to the jargon you hear in economics conferences . 🙂

9. FCB updates info on CDS.

10. PSD Blog points to papers on impact of remittances on economies

11. DB Blog on insolvency laws

Blinder’s Dutch boy story retold

Kansas Fed Symposium papers have been put on the website. The conference going by its tradition has led to couple of superb papers. The paper which has led to most controversy is the one by Willem Buiter (a 141 page paper!!) and the discussion of the paper by Alan Blinder. Buiter thrashes Fed and Blinder defends it. I haven’t read Buiter’s paper (of course) and just read Blinder’s paper.

In this post, I would like to restate Blinder’s story of the Dutch Boy. Blinder’s version is:

One day a little Dutch boy was walking home when he noticed a small leak in a dike that protected the people in the surrounding town. He started to stick his finger in the hole, but then he remembered his moral hazard lesson. “The companies that built this dike did a terrible job,” the boy said. “They don’t deserve a bailout. And doing that would just encourage more shoddy construction. Besides, the dumb people who live here should never have built their homes on a floodplain.” The boy continued on his way home. Before he arrived, the dike burst and everyone for miles around drowned, including the little Dutch boy.

Perhaps, You’ve have heard Fed’s an alternative version of this story. In this kindler, gentler version, the little Dutch boy, somewhat desperate and very worried about the horrors of the flood, stuck his finger in the dike and held it there until help arrived. It was painful. The little Dutch boy would much rather have been somewhere else. But he did it anyway. And all the foolish people who live behind the dike were saved from the error of their ways.

Here is my version of the story:

The little Dutch boy, somewhat desperate and very worried about the horrors of the flood, stuck his finger in the dike and held it there until help arrived. 

Meanwhile as the help too time to arrive, he remembered and wondered why such dikes keep being built. He had heard stories of such dikes being made time and time again and someone finding it and sticking his finger. Sometime the dikes were quite weak and the finger didn’t work and drowned everybody despite the best effort.  He had also heard the persons who built the dikes did not usually suffer as they had received the money and were building dikes elsewhere or enjoying the pay-offs (building their own castles away from the dikes).  He had even heard that if the flow of water was very strong it could destroy other dikes as well leading to big deluge. This made him nervous and wanting to withdraw the finger.

Then he also remebered, the dikes that were stronger and the finger helped, the person was hailed as a hero. So he just stuck it on hoping his dike is stronger.

Despite all this confusion, he kept thinking why the dikes kept on being built in such a manner….. He then related the problem to his school and realised that whenever he (or orhers) was punished he did not make the same mistake (or atleast tried his best to aviod it). So why did the dike buuilders not get punshed enough not to repeat the mistake again?

While thinking all this, the dike turned out to be weaker than expected….

Bernanke gives a reality check on systemwide regulation

Bernanke in his speech at Kansas Fed Symposium raises number of issues on financial stability and regulation. It is a pretty good speech highlighting issues related to the subject.

First, Fed’s response to the crisis:

The Federal Reserve’s response to this crisis has consisted of three key elements. First, we eased monetary policy substantially, particularly after indications of economic weakness proliferated around the turn of the year.

The second element of our response has been to offer liquidity support to the financial markets through a variety of collateralized lending program

The third element of our strategy encompasses a range of activities and initiatives undertaken in our role as financial regulator and supervisor

As first two have been discussed at numerous forums, Bernanke focuses on third as that is also the topic of the conference.

An effective means of increasing the resilience of the financial system is to strengthen its infrastructure. For my purposes today, I want to construe “financial infrastructure” very broadly, to include not only the “hardware” components of that infrastructure–the physical systems on which market participants rely for the quick and accurate execution, clearing, and settlement of transactions–but also the associated “software,” including the statutory, regulatory, and contractual frameworks and the business practices that govern the actions and obligations of market participants on both sides of each transaction.

This experience has led me to believe that one of the best ways to protect the financial system against future systemic shocks, including the possible failure of a major counterparty, is by strengthening the financial infrastructure, including both the “hardware” and the “software” components

Financial regulation has always been scoffed at and this is dfficult to understand as regulation has been pretty effectivein other markets. Financial markets need better regualtion as information asymmetry is much higher here compared to other markets. Bernanke then discusses how to strengthen the finacnial infrastructure.

One suggestion which has emerged from the crisis is that regualtors need to look at systemwide risk and not just a  firm specific risk. So far, regulators just look at individual firms and act only if individual firms are in trouble.

The integration of financial markets imply though individually firms may be fine but when analyses from a systemwide perspective they could pose high risks. This has been suggested by BIS for quite some time now but has been ignored. In the subprime crisis it was felt that Banks were in good shape as they had adequate capital cushions but we still had a systemwide crisis. Hence the focus on systemwide implications (also called macroprudential regulations) is increasing.

Bernanke says:

Going forward, a critical question for regulators and supervisors is what their appropriate “field of vision” should be. Under our current system of safety-and-soundness regulation, supervisors often focus on the financial conditions of individual institutions in isolation. An alternative approach, which has been called systemwide or macroprudential oversight, would broaden the mandate of regulators and supervisors to encompass consideration of potential systemic risks and weaknesses as well.

At least informally, financial regulation and supervision in the United States already include some macroprudential elements. …..For example, following lengthy comment periods, in 2006, the federal banking supervisors issued formal guidance on underwriting and managing the risks of nontraditional mortgages, such as interest-only and negative amortization mortgages, as well as guidance warning banks against excessive concentrations in commercial real estate lending

And then he provides a reality check:

 Some caution is in order, however, as this more comprehensive approach would be technically demanding and possibly very costly both for the regulators and the firms they supervise. It would likely require at least periodic surveillance and information-gathering from a wide range of nonbank institutions. International regulatory coordination, already quite extensive, would need to be expanded further.

Macroprudential supervision also presents communication issues. For example, the expectations of the public and of financial market participants would have to be managed carefully, as such an approach would never eliminate financial crises entirely. Indeed, an expectation by financial market participants that financial crises will never occur would create its own form of moral hazard and encourage behavior that would make financial crises more, rather than less, likely.

This is pretty useful reality check by Bernanke. I had not really thought about the costs and difficulty associated with assessing systemwide risks. Though, regulation is needed we have a number of issues to be sorted out. This area of financial regulation requires urgent attention. 

For long we have discussed financial regulation from a design perspective – principles based vs rules based or single regulators vs multiple regulators. What is needed now is to understand it from a functional perspective and get the basics right. Otherwise, either we would stifle financial innovation (markets) or would have too many crisis.

Understanding India’s Political economy

One seldom comes across different papers on Indian economic system (IES). There are usual papers – India’s growth prospects, the need to reform India’s financial markets, the need for reforms etc. We still don’t know so much about Indian economic system- like labor markets, the legal system, property rights etc (for each we know we need to reform it). I am unaware of different papers on IES and would be great if the readers could point to a few.

I came across this superb paper by Sadiq Ahmed and Ashutosh Varshney on Indian political economy. It is a wonderful read and discusses the nuances of how political decisions are taken, what shapes these decisions, relation with economics etc.

The authors first discuss the growth trends growth composition, states performance, poverty etc in India. They then ask:

• How exactly does the policy process operate in India?
• How did the transformation in policies begin to come about in the 1980s and pick up momentum in 1991?
• Why was the economic strategy not changed earlier despite a long period of low growth?
• What role did leaders play in ushering change? How did they learn what was wrong and, more importantly, how to set things right?
• Why did they change some policies (investment, trade, exchange rate), but not others especially labor laws)?
• Why has growth rates of different states diverged so much in the second period?
• Finally, moving forward, inclusiveness is a critical issue, especially as urban-rural, interpersonal, and regional inequalities have grown. Are the decision makers thinking about inclusiveness?

The authors then seek answers and this is what makes a fascinating reading. I can’t discuss the entire paper….Wull just point to a few interesting points:

Surprising as it may seem, economic issues and policies have generally not made, or unmade, governments in India. On the whole, economics does not determine India’s election results. The sole exception is inflation.

Why should this be? Read this:

The concept of master narratives of politics also makes clear where economic policy belongs in India’s political space. Religion and caste have dominated mass politics in India; economic policy has basically been a contentious matter in elite politics (Varshney 2000a and 2007).

What are the key differences between mass politics and elite politics? The primary arena of mass politics is the street and the ballot box.

The major theaters of elite politics are the English language press, the Internet, university seminars, corporate conferences, and the corridors of power, where corporate executives, officials of the international financial institutions, foreign government representatives, and lobbies meet with the bureaucrats and politicians.

Negotiations, discussions, and bargaining are the typical forms of elite politics. Voting, agitations, protests, and demonstrations are the principal forms for mass politics; riots are also sometimes a key element. Only occasionally disrupted by mass agitations and protests, authoritarian polities are normally driven by elite politics.

This is so true. So how do mass politics decide when to oppose or let go of a policy?

Three factors are typically critical: (a) how many people are affected by the policy, (b) how organized they are, and (c) whether the effect is direct and short-run, or indirect and long-run. The more direct the effect of a policy, the more people are affected by it and the more organized they are, the greater the potential for mass politics. Underlying, long-run, and indirect links do not flourish in mass politics where the basic message has to be simple, intuitive, clearly demonstrable, and capable of arousing mass action.

This explains why only inflation is a matter of concern:

Within economic policy, following this reasoning, some issues are more likely to arouse mass contestation than others. For example, inflation, by affecting more or less everybody except those whose salaries are inflation indexed, quickly becomes part of mass politics. Privatization, a change in labor laws, withdrawal of agricultural subsidies, and reforming the reservation policy for small-scale industry also have similar properties. Either a large number of people are negatively affected in the short run (agriculture and small-scale industry), or those so affected, even when not in large numbers, are well organized in unions (privatization and labor laws).

And this also explains why certain reforms go through:

Contrariwise, stock markets directly affect the shareholders, whose numbers are not likely to be large, and who are also not likely to be organized, in a poor country. As a result, short of a financial collapse, stock market fluctuations and the developments in the capital markets rarely, if ever, arouse mass politics in less developed countries. Similarly, overhauling industrial investment rules— delicensing—concern primarily the investor, foreign and indigenous. Their numbers are also typically small. Since 1991, India’s reformers have achieved their greatest success in reforming capital markets and investment regimes.

if trade is a small part of the economy, as has been true of India and Brazil historically, changes in trade and exchange rate regimes remain peripheral to the mass concerns. In 1991, India’s trade/GDP  ratio was a mere 15 percent. Of late, this ratio has been rising rapidly, nearing 35–38 percent. Trade is likely to be a matter of mass contestation before long.

This is precisely the point I keep making. Max reforms have taken place in financial markets and the elites want more of it. There is hardly any movement in other reforms and duo make a good point why this is so….

The authors then go on and discuss the political economy in a timeline and the impact etc.

Overall A fantastic paper. Highly recommended.

Assorted Links

1. JRV points to the much discussed Buiter paper

2. WSJ Blog points to a Fed paper that supports usage of core inflation

3. IDB on NREGA and India’s Education gap

4. NB on why employers cut jobs not wages during recession

5. PSD Blog on creative capitalism.

Economics of Citation

I came across this fantastic paper from Christian Zimmermann et al. It evaluates why economists cite other economists in their papers. The abstract is:

In this paper, we study the citation decision of a scientific author. By citing a related work, authors can make their arguments more persuasive. We call this the correlation effect. But if authors cite other work, they may give the impression that they think the cited work is more competent than theirs. We call this the reputation effect. These two effects may be the main sources of citation bias. We empirically show that there is a citation bias in Economics by using data from RePEc. We also report how the citation bias differs across regions (U.S., Europe and Asia).

The authors find that correlation effect in particular is stronger than reputation effect 🙂

I had read about signalling being used to indicate quality of employment, policies etc. Now it is being used for citation as well.

Assorted Links

1. I have mentioned about the Kansas Fed Annual Symposium many times. Somehow, papers/ideas presented in this conference are very very good (for instance see this post here). WSJ Blog points to the papers discussed here – By Raghu Rajan and Willem Buiter

2. JRV points to the comparison between Benrnake’s speech last year at Kansas Annual Symposium and this year.

3. ACB points how views over moble phones were anything but true.

4. MR pointsto fantastic Hardford views on nudges. It also points to a new paper on benefots of trade

5. NB points where nudges is needs- DVD players

6. Econbrowser on recession

UBS appoints a chief communications officer

This Blog does not talk about appointments. However, this press release from UBS is a nice development:

UBS appoints new Chief Communication Officer

UBS appoints Michael Willi Chief Communication Officer. In his new role Michael Willi will report to the Group CEO and bear global responsibility for UBS corporate and brand communications. He will head up the areas of Communications Management, Media Relations, Internal Communications and Brand Management. Financial communications will now be part of the Group Chief Financial Officer function.

Read the last lines….financial communications will be a key responsibility of CFO.

Surely looking at the UBS shareholder report and the ongoing mess, a communications officer is welcome. What is needed is a person who can explain the developments in finance in plain English (read my post and research here). It is a much bigger task than creating all the fancy instruments. I hope Mr Willi takes some steps towards this matter. It will be a good idea if other firms also have a officer designated to take care of communications.

Another source of research dries

I am not feeling good after reading this Business Standard piece. TCA Srinivasan says he will not be writing – Okonomos anymore. Okonomos a weekly column written every Friday has been the only of its kind.

It provides a glimpse of some exciting research paper mostly in field of economics. I woke up to this column pretty late (in 2006) but have enjoyed it ever since. After TCA, it is only Niranjan Rajadhyaksha’s pieceswhere one gets to read about some research. I didn’t cover it much in this blog but I realised quite a few papers TCA pointed out, I had mentioned them in my blog already. This made me feel confident that I am perhaps reading right things.

I always felt we lack way behind in research but his column confirmed my apprehensions. He raises it again here:

When, back in 1998, I had mooted the idea of writing a weekly commentary on research in economics….The aim, originally, was to write only about Indian research. But after only a few weeks I ran into a problem: There just wasn’t enough of high quality research going on. The theoretical stuff from places like the Indian Statistical Institute and the Delhi School of Economics was good, no doubt, but hardly the sort of thing one could write about in a newspaper.

The empirical stuff was limited by the fact that there just wasn’t enough data around. The exception was the RBI and its publication, Occasional Papers. But that was mainly because the staff had the data. Sadly, it has become too occasional now. The website link was last updated in February and the last volume is dated Monsoon 2007.

I should also mention that of the nearly 600 Okos I wrote, I received less than 10 submissions from Indian economists. I finally had to conclude that the people for whom it was originally meant — economists — were not interested in reading about what other economists were saying. I would be remiss, though, if I did not mention that non-economists did find it useful.

 He drops some bombs as well:

One of the most striking things was the frequent assertion by the economists I met was that they didn’t read the business papers. This strange approach doesn’t seem to have changed much. Just two days ago, I met a university professor who said the same thing. I wondered about the point of the research they did. If, like their counterparts in the US and the rest of the west, they didn’t address live problems, what did they do then? And why?

That was not all. I also discovered how easy it was for very powerful interests, both vested and wannabes, to use naive but competent economists to further their cause. The whole “reform the financial sector now, at once, now, now now” campaign then fell into proper perspective.

So, they don;t even read business papers. There is a simple answer to his question. Well one only needs to go to the working papers of various universities and wonder how the papers help.

So how did the column survive?

It was in 2001, I think, that I discovered the NBER site.

I don’t need to say anything more as no words describe NBER.

I don;t know about others but I would surely miss this column which was a unique initiative. Good thing is it is going to continue.

I understand the column will continue, which is great news. Now I can sit back and let someone else bring me up-to-date on what’s going on in the confused world of economists. Better do a good job of it, lads.

Yeah, the successors have pretty high standards to follow.

We are all responsible for India’s Olympics woes

I am pretty late on this topic and it has been discussed quite a bit already (see this from Cowen). It is the hot topic- why do we do so poorly in Olympics despite having such a vast pool of resources? The usual blame comes on poor facilities, lack of funding, interventions etc.  I don’t really see it in this way. I agree these are factors but not the only ones. Infact we as a nation are responsible for this state of sports in the country.

Actually, this is a quadrennial question visited every 4 years at time of Olympics and forgotten after the event. We as a nation are obsessed only with one sport- Cricket and that is where it ends. The same media which blames poor facilities gives every other sport a very poor coverage. How many would know the captain of Indian Hockey Team (just a reminder Hockey is our national sport)? How many know India won the Asian Football Confederation cup? Media is surely to be blamed as one could see the interest in boxing, shooting and wrestling just rise to esoteric levels after the recent Indian performances. But I am sure it will all move to cricket after Olympics (despite such poor recent performances).

If state does not help, what prevents the private sector from supporting the players? As this Mint article shows Mittal Foundation and  joint effort by former All-England badminton champion Prakash Padukone and billiards great Geet Sethi, helpoed things. Infact, both Abhinav Bindra and Akhil Kumar (the boxer who lost in Quarter Finals) were beneficiaries as Mittal trust provides finances when both were fighting health problems. Indian industry has made rapid strides with record profits, acquisitions etc..surely they can help and finance a sport/sportsmen. But instead record money continues to flow in cricket. Let it flow in other sports as well. Before Indian Premier League, we had a Indian hockey league where similar club concept was made to make hockey popular. However, it didn’t receive the fanfare it deserved. It is irritating to see the corporate world line outside sportsmen houses after the medal wins. Why not before as well?

The players also need to understand they need to pull performances and then only private money, media, fans etc follow. However, what you get to see is disappointing performances and that too from favorites. No performance is repeated. Rajyavardhan Rathore got us silver in Athens which made shooting popular and we had maximum medal hopes in Beijing-2008. However, barring Bindra hardly anyone could even qualify for the final events. Likewise, Karnam Malleswari raised hopes in weightlifting when she won a bronze in Sydney 2000. But again because of poor performances later on, we hardly see anything happening. And surely these athletes would be looking at performances from countries where facilities are hardly going to be any better (Ethiopia etc). The Indian athletes should realise they are the chosen one to represent the country and should give it their best shot. One inspired performance is all it takes.

This is where China is really good. Looking at these Olympics, all their favorites have won and have infact broken records. They not only maintained their previous wins but have ensured they enter new fields like swimming etc. The athletes are not just physically superior but mentally as well. Imagine the pressure on them performing in front of their home crowd which has set such high standards. But still they don’t buckle and instead deliver. Looking at the recent India medals all have come (barring Vijendra at Boxing) when least attention was on them. Whenever the nation looked up to a medal performance, it was thorough disappointment.

How about the general public? Apart from watching the other sports, we need to push children in sports as well. You come across so many people who give up sports careers as there isn;t any hope if you are a sportsman.

The state of Indian sports is a chicken and egg situation. The players blame facilities/lack of funds for poor performance, private sector blames poor performance for lack of interest, public blames poor performance/media coverage etc and the circle simply goes on and on. It is time when we all act in it together. If I am asked,  private sector support surely should help make things better.

I hope Beijing 2008 provides the turning point.

Financial Sector and its growing excesses

While leading economists discuss about the future of financial regulation in Lindau, Germany (see this WSJ Blog post for various viewpoints), the concerns over financial sector excesses continue.

I had pointed earlier to a superb lecture on Inequality in US by Frank Levy where he said:

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.

I had covered the concerns from various angles financial innnovation, my views on modern finance and then this one on political economy of finance where I pointed to a comment from Liz Warren (Harvard Law Professor)

The consumer financial services industry has been the single biggest contributor in the 2000 election cycle, in the 2002 election cycle, and they’re on target to do it again in the 2004 election cycle. George W. Bush’s single biggest contributor to his [2000] presidential campaign was MBNA, the second biggest credit card issuer in the country.

And now I came across this superb lecture from Kemal Dervis, Administrator of the United Nations Development Programme. (I came to know about the lecture from this superb Dr Virmani presentation). The lecture is on developments in World Economy and Mr Dervis touches on financial sector as well.

It seems clear that the last two decades have been characterized by rapid and accelerating world growth, with the trend interrupted three times: around 1997, around 2001 and now again around 2008, although we do not know yet how serious this interruption will be. These recent interruptions are not associated with wars or periods of trade disintegration. Instead all three of them have been caused by financial sector difficulties of a more or less global nature.

The causes..irrational exuberance

In all three cases it was a certain “irrational exuberance” in the financial sector that led to the shock. The Asian crisis was caused by excessive private capital flows to the emerging markets with very open capital accounts and excessive appreciation of assets in or relating to these emerging markets.

The dot com crisis was caused by a similar type of exuberance, but this time focused on the new high-tech and start up enterprises linked to the information technology revolution, mostly in the United States. When the bubble burst the crash was quite severe in that sector.

In the ongoing crisis we have seen enough irrational exuberance (call it greed). What about the policy responses?

Moreover, as had been the case with the Asian crisis, there was a vigorous policy response in the form of greatly expansionary fiscal and monetary policies in the United States. The fiscal balance changed from a 2.4 percent of GDP surplus in 2000 to a smaller surplus of 1.3 percent in 2001 and deficit of 1.5 percent in 2002 and almost 3.5 percent in 2003 (US CBO 2008). The federal funds rate set by the US Federal Reserve was lowered from 6 percent in early January of 2001 to 3.75 percent in late  une of 2001 to 1.25 percent by November of 2002 and further to 1 percent by June of 2003.

It is important to note whereas Asian policies are always criticised, the developed world is no better. As I always say, in times of crisis all policymakers act in a similar way with monetary easing and fiscal stimulus. However, in developed we call this “prudent policies” and for others it is called “careless polices”. The latter are called careless as no lessons are learnt (moral hazard) …we don’t see any lessons learnt in former as well. Above all by cutting interest rates, they lead to huge inflows in emerging economies.

Back to finance

Over this period capitalism in the rich countries has increasingly changed its nature from one where the lead sector was manufacturing, to one where the role of traditional industries has declined, the share of services has increased and the financial sector is playing a leading role. Figure 4 presents a rather amazing picture. In the early 1980s the share of the financial sector in both, corporate value-added and profits in the American economy, was about 5 to 6 percent. The share of financials in value added has steadily increased and has reached about 8 percent in 2006-2007. The share of profits, however, climbed to reach an extraordinary 40 percent and more!

At the end of the day, the rate of return on financial assets on average and over the long term, must reflect the rate on return in the real economy. That rate of return can be higher than the growth rate, but it cannot be expected to be multiple times the real growth rate of GDP. If real growth in an economy is 3 percent, which is the maximum rate at which most analysts say potential output can grow in the most advanced economies, than it is simply not reasonable to insist on 12 or 15 percent profit rates.

Yeah 40%. So out of every $ 100 of profits, 40 go to the finance sector in US. He also suggests that financial sector is important but what we see is short termism in the financial transactions:

Many believe that this much increased role of the financial sector works in favour of greater efficiency, by forcing out lethargic managers, encouraging a relentless search for greater productivity and profits, and allowing a constant restructuring and adjustment that increases flexibility and innovation throughout the economy. All this may be quite true but the pre-eminence of the financial sector also imparts a greater amount of “short-termism” to the system with immediate profits a more important driver than long term considerations.

So what do we do? Regulation

To avoid this constant repetition of the same scenario, it would seem to be highly desirable to regulate and supervise the financial sector in such a way that incentives become more symmetric, so that losses also have serious personal financial consequences for those whose decisions cause them, and that rewards are tied to long term success, rather than quick short term gains. This requires a degree of intrusive public policy that is not necessary in other sectors and will be resisted.

Finally, a superb food for thought

The fact, however, is that the financial sector can never be a purely private affair. It is at the heart of the modern market economy and plays an organizing role that is a public good. Its failure affects the whole economy and all citizens. The public policy maker cannot let the financial sector fail in a systemic manner and has to, in one way or another, rescue it. It is important and fair, therefore, that it is regulated in a way that encourages responsibility, a longer term horizon and an evaluation of risk by its managers, that is not truncated by the unavoidable need for the socialization of large losses.

Great speech, with lots of insights. Highly recommended.

Assorted Links

1. TTR points on creating world class universities in India. Also read his post on RBI proposes and finance ministry disposes

2. WSJ Blog points nobel laureates discussing financial regulation. Cowen reflects on the discussion and says one of the ideas as the worst – setting a commission to vet fin products

3. PSD Blog points a great time to gamble

4. DB BLog on superb construction norms in Singapore.

5. NB points to first Nudge grant

6. Econbroswer on speculation in oil futures markets. It also compares various inflation measures used in US.

Is there a differnece between policies in emerging and developed economies?

It is pretty fancy to talk about the differences between emerging economies (EE) and developed economies (DE). We often get to hear the speeches from policymakers of emerging markets talking about how certain frameworks don’t apply/need to be modified to their countries. However, with the recent crisis, one wonders whether any of the differences still apply?

I came across this speech from Dr Bandid Nijathaworn, Deputy Governor of the Bank of Thailand. He says there are two differences between DE and EE.

For emerging markets, there are two stylized facts that are unique to its policy setting. The first is the greater income and consumption volatility that have been observed in emerging markets, both in terms of the level and in terms of growth relative to developed economies. And the second is the fact that economic agents in emerging markets face greater limitations in the ability to smooth consumption in response to shocks.

These two factors lead to different policies. Then he goes on to talk about the different policies needed to manage these two shocks in emerging economies. You can easily replace the problems he associates with emerging economies as problems in developed economies and ask what is this comparison all about?

This point is well taken. I agree EE and DE are different. However, it can’t really be said that the institutions and frameworks in DE are superior to EE as recent crisis has shown. The policymakers have found to be short on every aspect – financial supervision, monetary policy etc. Some might say, the crisis could have been worse if the institutions in DE were like EE. I wonder how much worse? The policies have created a global tremor and it is being seen as the worst crisis since Great Depression in 1929.

I would think it is best to have policies which suit your own country/economy and not ape or compare with the other developed economies.

Assorted Links

1/2.  WSJ Blog points out of 7 OECD countries, US has grown fastest.

1. A new blog to understand taxes in India – Indian Tax Guide

2. ACB points a change in ICICI derivatives strategy. It also points to the next big idea – The Gridlock Economy

3. Krugman on eco humor

4. CB points who will grow faster India or China?

5. Fin Prof on hedging in jet fuel prices

6. Lusardi says in US financial illiteracy is pretty high. Read the second question she asks and read my paper on the subject

7. PSD Blog points to a paper which says:

[T]he aid system has generated the same negative shocks to per capita income…in developing countries, and with more frequency, as the two World Wars and the Great Depression generated in developed countries.

8. DB Blog points Poland to become a business friendly country

9. ASB says we should provide certifications as a means to building human capital. Point well taken but the industry hardly values these certificates. He mentions he has met people who took NSE’s NCFM examination and had successful careers in finance. I am not sure what success  means here. To have a successful career, the industry values branded degrees and not certificates. I have seen a lot of people not getting promotions, salary hikes etc despite being superbly talented. Why? they didn’t have the degrees.