Archive for the ‘Economics – macro, micro etc’ Category

‘Consumerisation’ of banking in India: Cyclical or structural?

July 29, 2021

Rajeshwari Sengupta (IGIDR) and Harsh Vardhan (SP Jain) in this Ideas4India article show how Indian banking has become more consumerised over the years:

Over the past decade, India’s banking sector has undergone a transformation in terms of the proportion of credit extended to consumers and industry – with consumer credit now accounting for a larger share. In this post, Sengupta and Vardhan examine this change and contend that the next couple of years would be crucial in determining whether the ‘consumerisation’ of banking is a cyclical or structural phenomenon.

Banking in India appears to be at a crucial juncture. The next couple of years will decide if it goes back to being a lender to industry and businesses, or if it will continue to focus on consumer lending. If the ‘consumerisation’ of banking continues, it will have a profound impact on the economy in general and on the growth of industry in particular. For sustained economic growth, capital expenditure cycles will have to be revived. Indian companies will have to get back to investments and will need credit to do so. The preference of bankers to lend to consumers over industry, could create a credit shortfall, which may impede the investment cycle and ultimately harm economic growth.

Hmm..So will we need to go back to old model of establishing industrial banks/DFI to finance industry?

 

Tariffs and the Exchange Rate: Evidence from Trump’s Tweets

July 29, 2021

Dmitry Matveev and Francisco Ruge-Murcia in this Bank of Canada working paper:

US commercial policy during the presidency of Donald Trump led to renewed interest in the macroeconomic effects of trade tariffs. It has become common to use tariffs and other restrictions on international trade in an attempt to boost the domestic economy. One factor affecting the impact of tariffs is the response of local currency after tariffs are imposed. The effects of tariff changes can be eased or overturned if the local currency appreciates and prevents the relative prices of local and foreign goods from adjusting. 

The behaviour of the exchange rate following an increase in tariffs has not been fully evaluated empirically because of lack of data and challenges in methodology. Our assessment focuses on the recent renegotiation of the North American Free Trade Agreement (NAFTA).

During this period, a key source of news about tariffs was public communication by the US president—often in the form of tweets. We use the US president’s tweets to quantify how potential and actual tariffs on Canada and Mexico affect their bilateral exchange rates with the United States.

Our results show that the anticipation of higher tariffs on goods imported from Canada led on average to a 0.022 percent appreciation of the US dollar relative to the Canadian dollar within five minutes of the publication of a tweet. In the case of Mexico, the average effect was twice as large—a 0.049 percent appreciation of the US dollar. We find that these numbers are economically and statistically significant.

Interesting how Twitter is being used for economic research.

When the stadium goes silent: How crowds affect the performance of discriminated groups

July 28, 2021

Mauro Caselli, Paolo Falco and Gianpiero Mattera in this voxeu research show that when there are no spectators in football matches, African players do well:

Racism in football returned to the headlines recently following racial abuse of England players on social media after the final of the UEFA European Championship. How does the harassment of supporters affect discriminated athletes? Using the COVID-19 lockdown as a natural experiment, this column compares the performance of individual football players in the Italian Serie A with and without fans at the stadium. The evidence shows that players of African origin, who are most frequently targeted by racist abuse, perform better in the absence of supporters.

Our results fit a broader framework that stretches beyond the world of sports, whereby individuals who belong to historically discriminated groups perform worse than their peers when the task takes place in an environment in which discriminatory behaviour occurs manifestly. More generally, the analysis fits within an ever-growing literature documenting the role of racial discrimination in driving labour market disparities (e.g. Deschamps and De Sousa 2015, Lang and Spitzer 2020, Aizer et al. 2020, Bayer and Charles 2018). Furthermore, since the research shows that discriminated players do better in the absence of fans while no other groups do worse, the evidence suggests that racial harassment leads to an overall decrease in productivity and efficiency. The issue has also begun to attract the attention of the media and new statistics on the issue have circulated after the release of the working paper, corroborating the findings (e.g. The Economist 2021).

Finally, it is worth pointing out that the results are particularly striking because they concern elite athletes, who are the best in their profession and typically enjoy high earnings as well as enviable social status. Further investigation would be necessary to test the impact of racism on the performance of athletes in lower-ranked leagues, and especially among youth, where one can imagine the impacts of discrimination being even more significant and harmful.

The conclusion of the study is that racism can do economic harm to the football industry. Football, like other sports, thrives on fans from all over the world seeking to watch and emulate extraordinary players who perform beyond the normal. When a significant share of players cannot express their full potential, the ‘beautiful game’ becomes less beautiful and less appealing.

Damning from so called developed world.

Reforming the US macroprudential regulatory architecture

July 28, 2021

US financial system may be neighbor’s envy especially before the 2008 crisis but its regulatory system is owner’s envy. It is a mess with multiple regulators and chaos. How US financial system grew despite such poor regulatory structure is something worth looking. There are some who will argue size is one thing but efficiency is another. US financial system grew in size tracking the economy but its efficiency has followed the regulatory system.

Kathryn Judge and Anil Kashyap in this voxeu article suggest a way forward to reform the macropru regulatory structure of US. The post is based on this yet another report on reforming the US system.

Let me work from home, or I will find another job

July 27, 2021

Jose Maria Barrero, Nicholas Bloom and Steven Davis in this interestung voxeu post point how the pandemic has impacted the work patterns in US (perhaps forever).

They show via a survey that employees prefer to work for home and will switch jobs if they are asked to return full-time to office:

 

Fundamentals vs. policies: Can the US dollar’s dominance in global trade be dented?

July 27, 2021

Georgios Georgiadis, Helena Le Mezo, Arnaud Mehl and Cédric Tille in this ECB working paper analyse what drives USD’s dominance in trade:

The US dollar plays a dominant role in the invoicing of international trade, albeit not an exclusive one as more than half of global trade is invoiced in other currencies. Of particular interest are the euro, with a large role, and the renminbi, with a rising role. These two currencies are well suited to contrast the roles of economic fundamentals and policies, as European policy makers have taken a neutral stance in contrast to the promotion of the international role of the renminbi by the Chinese authorities. We assess the drivers of invoicing using the most recent and comprehensive data set for 115 countries over 1999-2019.

We find that standard mechanisms that foster use of a large economy’s currency predicted by theory – i.e. strategic complementarities in price setting and integration in cross-border value chains – underpin use of the dollar and the euro for trade with the United States and the euro area. These mechanisms also support the role of the dollar, but not the euro, in trade between non-US and non-euro area countries, making the dollar the globally dominant invoicing currency. Fundamentals and policies have played a contrasted role for the use of the renminbi.

We find that China’s integration into global trade has further strengthened the dominant status of the dollar at the expense of the euro. At the same time, the establishment of currency swap lines by the People’s Bank of China has been associated with increases in renminbi invoicing, with an adverse effect on dollar use that is larger than for the euro.

 

U.S. Healthcare: A Story of Rising Market Power, Barriers to Entry, and Supply Constraints

July 27, 2021

Li Lin, Mico Mrkaic and Anke Weber in this IMF WP analyse US healthcare system:

Healthcare in the United States is the most expensive in the world, with real per capita spending growth averaging 4 percent since 1980. This paper examines the role of market power of U.S. healthcare providers and pharmaceutical companies. It finds that markups (the ability to charge prices above marginal costs) for publicly listed firms in the U.S. healthcare sector have almost doubled since the early 1980s and that they explain up to a quarter of average annual real per capita healthcare spending growth.

The paper also finds evidence that the Affordable Care Act and Medicaid expansion were successful in raising coverage and expanding care, but may have had the undesirable side-effect of leading to labor cost increases: Hourly wages for healthcare practitioners are estimated to have increased by 2 to 3 percent more in Medicaid expansion states over a five-year period, which could be an indication that the supply of medical services is relatively inelastic, even over a long time horizon, to the boost to demand created by the Medicaid expansion.

These findings suggest that promoting more competition in healthcare markets and reducing barriers to entry can help contain healthcare costs.

 

Market Power and Monetary Policy Transmission

July 27, 2021

Romain A Duval ; Davide Furceri ; Raphael Lee ; Marina M. Tavares in this IMF working paper:

We show that firms’ market power dampens the response of their output to monetary policy shocks, using firm-level data for the United States and a large cross-country firm-level dataset for 14 advanced economies. The estimated impact of a firm’s markup on its response to a monetary policy shock is large enough to materially affect monetary policy transmission. We also find some evidence that the role of markup in monetary policy transmission, while independent from other channels, is greater for firms whose characteristics — notably size and age — are likely to be associated with greater financial constraints. We rationalize these findings through a simple partial equilibrium model in which borrowing constraints amplify disproportionately low-markup firms’ responses to changes in interest rates.

30 years of India’s economics reforms: Mercatus Centre starts ‘The 1991 Project’

July 26, 2021

Mercatus Centre at George Mason University has started ‘The 1991 Project‘, on the 30 years of India’s reforms:

On July 24, 1991, amid economic crisis and political turmoil, a budget speech changed the course of Indian history.

After decades of socialist planning, India’s finance minister Manmohan Singh announced the country would embrace markets. It was a change that would lift a quarter of a billion people out of poverty in the decades that followed, and leave no part of Indians’ lives untouched.

Yet three-fifths of all Indians have been born since 1991. Having not experienced the crisis, nor the socialist regime that preceded it, they are unfamiliar with the dramatic impact of the 1991 liberalization and the lessons it holds for India’s future. On its 30th anniversary, we seek to revive the ideas and policies that can continue to foster economic growth in India.

Shruti Rajagopalan in the lead essay gives her perspective on the importance of reforms. In the end, she describes ‘The1991Project’:

The 1991 Project is an effort to kickstart a discourse on economic growth-centered reforms in India by focusing on economic ideas. In the coming months, our team will publish essays, data visualizations, oral histories, podcasts, and policy papers demystifying the Indian economy.

The project hopes to raise and answer many questions. Why does economic growth matter? How did socialist planning impoverish India? If socialism was so bad, why did India adopt it as an economic model? How did India switch from a command-and-control to a market economy? What is the political economy of institutional persistence and change? How can India achieve high rates of economic growth once again?

We, the contributors to the 1991 project, will discuss the Indian economy and life under socialism and after liberalization. We will cover the salient economic ideas over the past century and their impact on Indian policy. We will tell the stories of the madmen, and academic scribblers, and intellectuals, and technocrats who reformed India. We will discuss the way forward for India to strengthen institutions that can support a market economy. And most importantly, we will discuss policies that can enable economic growth.

 

Myths and Landmarks in US Business and Economic History

July 26, 2021

Eco historian Richard Vague has written a new book titled The Illustrated Business History of the United States.

Vague discusses the book in this INET podcast with Rob Johnson.  There is a transcript of the podcast as well.  He says one big myth in US business history is that companies grew in a free market/laissez faire manner:

(more…)

Macroprudential Limits on Mortgage Products: The Australian Experience

July 26, 2021

Nicholas Garvin, Alex Kearney and Corrine Rosé in this RBA paper evaluate impact of macroprudential policy on Australian banks:

The Australian Prudential Regulation Authority implemented 2 credit limits between 2014 and 2018. Unlike similar policies in other countries, these imposed limits on particular mortgage products – first investor mortgages, then interest-only (IO) mortgages. With prudential bank-level panel data, we empirically identify banks’ credit supply and interest rate responses and test for other effects of these policies.

The policies quickly reduced growth in the targeted type of credit while total mortgage growth remained steady. Banks met the limits by raising interest rates on targeted mortgage products and this lifted their income temporarily. The largest banks substituted into non-targeted mortgage products while smaller banks did not. Practical implementation difficulties slowed effects of the (first) investor policy, and led to some disproportionate bank responses, but had largely been overcome by the time the (second) IO policy was implemented.

Fintech and the digital transformation of financial services: implications for market structure and public policy

July 26, 2021

Erik Feyen, Jon Frost, Leonardo Gambacorta, Harish Natarajan and Matthew Saal in this BIS paper:

The digital transformation of financial services gives rise to a set of important policy issues regarding competition, regulatory perimeters and ensuring a level playing field. Potential outcomes regarding competition, concentration and market composition include a “barbell” outcome composed of a few large providers and many niche players. Authorities must coordinate across financial regulation, competition, and industry regulatory bodies to manage trade-offs between stability and integrity, competition and efficiency, and consumer protection and privacy.

Need to move from a country’s balance sheet to the One-Earth Balance Sheet

July 26, 2021

Andrew Sheng in this INET article writes on how we need to move away from thinking around national issues to earth issues:

Each sovereign country behaves today as if its monetary, fiscal or consumption policies operate in a silo, impacting its own citizens only. Since there is no global government or central bank, no one compiles a global monetary and fiscal accounting to see if what individual nations do is consistent with the Sustainable Development Goals for the planet as a whole. Citizens are not given a complete picture of what alternative policies are available that could help the planet as a whole.

But if we consider Earth as a living being, we can easily amend the current accounting measurement frameworks to take into consideration human interactions with nature. For example, suppose we create an extra “nature” sector for national and international economic accounting systems. We could keep records of how much it has “transacted” in terms of carbon emissions and capture, usage of natural resources, pollution and more.

There is much work to do to standardize concepts, frameworks and disclosure requirements. But the building blocks for the compilation of the One-Earth Balance Sheet, with the input of natural and social scientists and communities are broadly available and can be accelerated to create a common narrative on dealing with climate change and inclusivity.

Having a One-Earth perspective would allow more pluralistic debate over the costs and benefits of applying unilateral policies, such as carbon tariffs that shift the costs to exporting countries. If there is a shortage of funds to finance carbon-reducing investments, could these be funded by a globally agreed Tobin-tax on financial trading, which could cut short-term speculation for better resource allocation?

A One-Earth Balance Sheet would be able to identify where our largest imbalances are. Many are already obvious, such as social, income and wealth. But others, such as consumption behavior relating to pollution, carbon emissions and choke points (vulnerable links) in global networks and supply chains, have not yet been mapped adequately.

 

Is dollar or any other currency a meme?

July 23, 2021

Never really thought about currency as a meme! AS in they have value because government says so.

JP Koning in his super moneyness blog says that currencies are not memes. They drive their values from balance sheets of central banks and are subject to credit analysis. Whereas cryptocurrency analysis is just meme analysis:

“Currencies are not memes that only have value because governments say they do,” writes Brendan Greeley for the Financial Times. 

I agree with him.

The dollar-as-meme claim is often made by cryptocurrency enthusiasts. That this idea would emanate from the cryptocurrency community makes sense, since cryptocurrency prices are a purely meme-driven phenomenon. There is no cryptocurrency for which this is more apparent than Dogecoin, a cryptocurrency started as a joke and sustained by shiba inu gifs, but it applies equally to Doge’s older cousin, Bitcoin. The harder you meme the higher a cryptocurrency’s price, as the image at top suggests.

And so for cryptocurrency analysts, getting a good understanding of a given coin’s value is a matter of picking through its underlying memes and meme artists. 

But if cryptocurrency analysis is ultimately just meme analysis, what sort of analysis applies to dollars?

Dollars issued by banks are secured by the banks’ portfolio of loans, Greeley reminds us. And so they are subject to credit analysis, not meme analysis. An analyst appraises the quality of the bank’s investments in order to determine the soundness of the dollar IOUs the bank has issued.

As for central banks like the Fed, they are just special types of banks, says Greeley, and so the dollars they issue are also subject to credit analysis.  

The idea that the money issued by central banks—so-called fiat money—is subject to the same credit analysis as any other type of debt security is a point I’ve also made on this blog. There are certainly some odd features about Fed dollars or Bank of Japan yen, but ultimately they are just another form of credit.

More in the post…

What will the bank of the 21st century look like?

July 23, 2021

One of the biggest questions facing the scholars of money and banking is:  What will the bank of the 21st century look like?

Dennis Beau, First DG of Banque De France in this brief speech shares his perspective:

(more…)

India’s CBDC: RBI working towards a phased implementation strategy and examining use cases

July 23, 2021

RBI Deputy Governor T Rabi Shankar in a speech yesterday (22-Jul-2021) spoke on CBDC and RBI’s take on it.

Central Banks across the globe are engaged in exploring CBDCs and a few countries have also introduced proofs of concept / pilots on CBDC. The High Level Inter-Ministerial Committee (November 2017) constituted by Ministry of Finance, Government of India (GoI) to examine the policy and legal framework for regulation of virtual / crypto currencies had recommended the introduction of CBDCs as a digital form of fiat money in India. Like other central banks, RBI has also been exploring the pros and cons of introduction of CBDCs since quite some time.

Generally, countries have implemented specific purpose CBDCs in the wholesale and retail segments. Going forward, after studying the impact of these models, launch of general purpose CBDCs shall be evaluated. RBI is currently working towards a phased implementation strategy and examining use cases which could be implemented with little or no disruption. Some key issues under examination are – (i) the scope of CBDCs – whether they should be used in retail payments or also in wholesale payments; (ii) the underlying technology – whether it should be a distributed ledger or a centralized ledger, for instance, and whether the choice of technology should vary according to use cases; (iii) the validation mechanism – whether token based or account based, (iv) distribution architecture – whether direct issuance by the RBI or through banks; (v) degree of anonymity etc. However, conducting pilots in wholesale and retail segments may be a possibility in near future.

On legal matters:

Although CBDCs are conceptually no different from banknotes, introduction of CBDC would require an enabling legal framework since the current legal provisions are made keeping in mind currency in paper form. Under the Reserve Bank of India Act, 1934, the Bank is empowered to “…regulate the issue of bank notes and the keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage” (Preamble).

The Reserve Bank derives the necessary statutory powers from various sections of the RBI Act – with respect to denomination (Section 24), form of banknotes (Section 25), status as legal tender (Sec 26(1)) etc. There is a need to examine consequential amendments to other Acts like The Coinage Act, 2011, FEMA, 1999, Information Technology Act, 2000 etc.

Even though CBDCs will be a primarily technology driven product, it will be desirable to keep the legislation technology neutral to enable coverage of a variety of technology choices.

However, this bit on credit creation needs some updating:

CBDCs, depending on the extent of its use, can cause a reduction in the transaction demand for bank deposits. Since transactions in CBDCs reduce settlement risk as well, they reduce the liquidity needs for settlement of transactions (such as intra-day liquidity). In addition, by providing a genuinely risk-free alternative to bank deposits, they could cause a shift away from bank deposits which in turn might reduce the need for government guarantees on deposits (Dyson and Hodgson, 2016).

At the same time reduced disintermediation of banks carries its own risks. If banks begin to lose deposits over time, their ability for credit creation gets constrained. Since central banks cannot provide credit to the private sector, the impact on the role of bank credit needs to be well understood.

Plus, as banks lose significant volume of low-cost transaction deposits their interest margin might come under stress leading to an increase in cost of credit. Thus, potential costs of disintermediation mean it is important to design and implement CBDC in a way that makes the demand for CBDC, vis‑à‑vis bank deposits, manageable.

As Bank of England researchers (followed by other central banks) showed that banks first create credit which comes back as deposits. So banks are never really credit constrained and certainly not by deposits. The contraints are more on real economy side i.e. whether banks can identify are economic opportunities and so on.   Another constraint is regulations.

Ending shadow banking means ending modern central banking

July 22, 2021

Anantha Nageswaran in his GoldStandardSite blog quotes from this Prospect magazine article by Ann Pettifor.

Ann argues how central banks have allowed shadow banking to proliferate.

The vast “shadow banking” system, which has grown out of the same flawed monetary thinking, is another matter. Comprising pension funds, hedge funds, insurance companies and other investment vehicles, it now manages a $200 trillion stock of assets, dwarfing that $2 trillion cryptocurrency valuation, and also vastly exceeding the annual income (or GDP) of the world as a whole, estimated at $86 trillion. Being in the shadows, then, no longer means being on the margins.

Central bankers have permitted and sometimes encouraged this sector to expand beyond the regulatory frameworks of governments. But the real roots are deeper, lying in the great structural shift of pension privatisation. Between 1981 and 2014, 30 countries fully or partially privatised their public mandatory pensions. Coupled with cross-border capital mobility, the move to private retirement savings steadily generated vast cash pools for institutional investors.

Today one asset management firm, BlackRock, manages in excess of $8 trillion of the world’s savings. Such companies have outgrown the capacity of “main street” banks to provide services. No traditional commercial bank could absorb these sums; few governments are willing to guarantee individual accounts of more than $100,000. The new form of “banking” answered the need to accommodate the enormous sums of globalised capital.

Like pawnbrokers, who practised an earlier form of unregulated credit, shadow banks exchange the savings they hold for collateral. But instead of watches and wedding rings, they lend out on the strength of government bonds and other securities.

Replete with cash, they can provide “liquidity” on a vast scale to businesses or investors who need it. In return, the borrowers offer up a security—and write an IOU offering to repurchase it later, at a higher price. This markup is, in effect, the interest on the loan. These repurchase deals are struck in the “repo” markets which form the heart of the shadow banking system.

Note that this whole system avoids reliance on the social construct of credit, upheld by trust and enforced by law, which traditional banks had to work within. Instead, the system is one of deregulated exchange in which cash is simply one more commodity—no more regulated than any other.

She goes onto argue how QE programs of central banks have allowed shadowy banking to continue.

The reason why emergency injections of money are increasingly needed is that the shadow banking system is structurally prone to volatility and debt crises. The borrower’s promise to repurchase an asset at a higher price is relatively easy to uphold when the value of that asset remains stable. But the value of assets can rise or fall suddenly, which in this system can set in train self-amplifying feedback loops—with catastrophic consequences.

Anantha goes a step further that ending shadow banking will mean end of modern day central banking:

It clarifies a lot of things, actually. In other words, without QE, the shadow banking system will cease to exist. If it ceases to exist, then the real economy crashes. So, central bankers can assuage themselves by saying that by providing the liquidity that the leveraged shadow banking system needs, they are indirectly supporting the real economy or preventing the real economy from collapsing.

Her conclusion is quite appropriate:

Whenever the vast shadow banks wobble, there is the threat of a disastrous contraction of the credit for the real economy, which could bring everything crashing down. As long as the system is allowed to stand, there is no alternative to taxpayer-backed central banks rescuing private markets.

The only way to call time on QE, if that is what we truly want, is to deconstruct and then reconstruct, regulate and stabilise the whole financial system, so that the extraordinary privilege of credit creation is always balanced by a responsibility not to take undue risks. And if footloose capital responds by skipping across borders and away from oversight, then we may also need to look at controls on that front too. Only then will the world stand any chance of kicking the QE habit, address those dangerous imbalances and finally escape this grim shadowland of money.

But, on their own, central banks will be afraid to do the job of deconstructing and reconstructing. It is a political project because, in reality, it would amount to cutting both shadow banking and central banking to size. That is why central bankers would resist it actually. Ending the last forty years of financialisation will also end central banking as it has evolved in the last forty years. Central bankers will go back to operating in the shadows, if shadow banking were to be ended!

Will politicians be up to the task? I doubt.

The risk is that, in doing so, the ‘House of cards’ aka ‘the real economy’ will collapse. No one wants it on their watch. If the world of shadow banking has to end, it will happen through exogenous shocks. Both QE (i.e., modern central banking) and the world of shadow banking have to collapse from being unable to bear the sheer weight that they have grown into.

Hmm..worth thinking about..

Global reflation?

July 21, 2021

BIS Bulletin on rising inflation across countries:

  • Inflation has risen in many countries. In conjunction with a rebound in GDP growth and evidence of significant bottlenecks in some sectors, this has prompted concerns that the low inflation era of recent decades could be nearing its end.
  • A closer look at the data reveals that the pickup in inflation can be ascribed largely to base effects, increases in the prices of a small number of pandemic-affected items and higher energy prices. A common thread through these causes is that their effect on inflation is likely to be temporary.
  • A more persistent increase in inflation would likely require a material pickup in labour costs and an unmooring of inflation expectations. However, wage growth remains contained and the medium-term inflation expectations of professional forecasters and financial markets show little sign of de-anchoring. These developments are consistent with medium-term inflation moving towards central bank targets.

Moving from a poor economy to a rich one: The role of migrant job tasks

July 21, 2021

Prof Eran Yashiv of Tel Aviv University in this voxeu research shows what happens to a migrant moving from a poor economy to a rich economy:

How market design can help solve problem of water allocation

July 21, 2021

Nice article by Paul Milgrom and Silvia Console Battilana:

Misallocation of scarce resources too often deprives users of them even as others waste their supply. Well-designed markets can overcome such problems by enabling voluntary transactions that allow existing users to retain their allotments while enabling higher-value uses.

Market design will also play a critical role in solving the problem of water allocation. Many of the world’s existing rights to fresh water – both surface water and groundwater – have already been granted and grandfathered in complex ways to cities, farmers, and industrial users. In some cases, each individual trade of these rights requires governmental approval; other jurisdictions prohibit such trading entirely.

These restrictions and historical rules have led to highly inefficient allocations. Water may be unavailable to towns that require more of it as they grow, even when those urban and residential uses are a hundred times more valuable than the rural ones they would supplant. Certain industrial firms whose rights are based on historical use may have an incentive to overuse water, even during droughts, to retain their rights to future allotments. Where trading of rights is limited or prohibited, poor price signals make it difficult even to assess which uses are most valuable. And water demand will increase and shift as climate change continues to upend historical usage patterns.

The success of the US radio spectrum auction points to a solution. Instead of revoking incumbents’ spectrum rights unilaterally, Congress redefined them in a way that made trading them possible and simple, and then allowed TV broadcasters to decide for themselves whether to continue their previous uses or decline to participate. The rights that were sold were then reconfigured to be suitable for new uses and efficient trading, while those that were unsold remained fit for existing purposes.

A similar reorganization of water rights could protect existing users not wishing to sell, while creating tradeable rights for others that would allow water to flow to its most valuable use. Any attempt to compel all current users to participate will likely be thwarted by legal and political opposition, but a fully voluntary market styled on the same principles as the one for radio spectrum could accommodate resisters while drastically improving the allocation of water rights. Moreover, policymakers could use a portion of the value freed by any reallocation to offset inequities – for example, by granting credits to rural towns or small agricultural producers so that they receive the water resources they need.

Allocating water efficiently and fairly will require innovation, collaboration, and regulation. In this and other domains, market design puts practical economic theory in the service of establishing rights and introducing effective rules and algorithms. That way, we can accommodate diverse market participants, harness new technologies, and maximize the public good.


%d bloggers like this: