India's most debt-ridden states

India's economy grew the slowest in a decade. The country's GDP growth in first quarter (April-June) slipped to 5.5 per cent from 8 per cent in the corresponding period in the last fiscal.

Meanwhile, the Reserve Bank of India has also sharply lowered this fiscal's economic growth projection to 5.8 per cent, from 6.5 per cent earlier, in view of global and domestic factors like poor investments and subdued demand.

The International Monetary Fund slashed India's 2012 (calendar year) economic growth forecast for India to 4.9 per cent from 6.1 per cent.

To add to the country's economic woes, the debt burden of India's states is also rising.

Maharashtra has the highest debt among all states in India.

Maharashtra's debt is higher than that of states like Uttar Pradesh, West Bengal, Andhra Pradesh and Tamil Nadu, according to the Reserve Bank of India.

Uttar Pradesh is the second most debt-ridden state, followed by West  Bengal.

The World Our Grandchildren Will Inherit

A superb research note from Daron Acemoglu. Well it is amazing to see him churn one paper after the other.

He talks about ten trends which have happened in the last 100 years.

• The rights revolution
• The sweep of technology
• Unrelenting growth
• Uneven growth
• The transformation of work and wages
• The health revolution
• Technology without borders
• Century of war, century of peace
• Counter-Enlightenment in politics
• The population explosion, resources and the environment

Out of the ten, it was rights revolution which was most important. But then all are linked:

The last century has been the age of political rights. Never in our history have so many people taken part in choosing their leaders and having a say in how their societies are governed. To be sure, this unparalleled expansion of civil and political rights remains incomplete. Yet it is profoundly significant, not only due to its transformative impact on the lives of billions, but also because so many other phenomena in recent history are connected to it. The rights revolution is intertwined with diverse trends such as the development of technology; sustained yet uneven economic growth; a general decline in war within recent decades; and a population explosion placing new pressures on our resources and environment.

These trends do not exist independently of one another. Understanding how they interrelate is an important step in any attempt to assess how they will continue. The framework I will use to interpret these trends borrows heavily from my work with James A. Robinson, but also augments it in a number of  important respects.  At the center of my interpretation is the idea that technological change is at the root of economic growth — but that political institutions shape the nature, pace, and spread of technological change. From ancient Rome to the Industrial Revolution and the dramatic economic transformations of the last century, history is littered with examples showing how the development, spread, and use of technology depend on institutions.

In this, I depart from the conventional wisdom in much of social science, which maintains a causal link running from technologies to institutions — and not the other way around, as I am arguing. A popular variant of this conventional wisdom is modernization theory, which posits an inexorable link from prosperity to democracy and political rights. Yet there is no more support for modernization theory in the data than there is for any other form of technological determinism. Globally, countries that have grown more rapidly since World War II, or since the beginning of the 20th century, are no more likely to become more democratic than those growing more slowly, for example.18 I will instead argue that institutional developments, caused by and causing the rights revolution, are the main drivers of the technological and economic changes we have experienced over the last century.

And now most would know hos the story unfolds. Whether you have inclusive or extractive political instis, you create a framework for all the other ten trends.

He then goes onto reflect whether the 10 trends will continue..

He reflects on how China manages to grow despite having extractive political instis:

The expansion of China’s economy over the last three decades is another example of growth produced by extractive institutions, but with a major difference. The onset of technology without borders has meant that the extent and pace of growth under extractive institutions can be greater today than it was in the 19th century, when Germany and Russia went through a process of catch-up. Though the two countries reached higher growth rates than the leading economies of the time, the U.S. and the U.K., their expansions ended quickly, and had been only made possible by deep-rooted changes in the structure of society — changes that ultimately destabilized and upended the regimes in those nations.

By contrast, China has been able to achieve rapid catch-up growth for over three decades, with much more limited threats to its extractive institutions, partly because the nature of technology has changed. In Germany and Russia at the end of the 19th century (or in Japan and South Korea during the second half of the 20th century) catch-up growth involved developing industries, building a domestic market,and undergoing a process of structural, social, and institutional changes — including rapid urbanization and the social and political demands coming with industrialization.

But unlike China, their growth wasn’t built on simply importing technology to produce goods for the world market. In contrast, today, instead of having to develop an entire industry, an emerging market economy can just house some of an industry’s tasks, such as assembly and operation. This has enabled China to grow rapidly by leveraging its cheap and abundant labor force, while also mollifying the internal demands for political changes that earlier societies undergoing catch-up growth had to contend with.

So, technology seems to have allowed China to prosper:

Here we therefore encounter a paradoxical consequence of the technological breakthroughs originating from inclusive institutions: they may aid the continuation of extractive institutions elsewhere in the world. The globalization of production that technology without borders has created may have fueled rapid Chinese growth, but in so doing it may have lessened domestic pressure for institutional changes. In fact, this paradox might be deeper. One phenomenon related to Chinese growth is the fifth trend, the transformation of work and wages, which has helped produce the inequality gap that has opened up within advanced economies.

He says when thinking about technology we should  be aware that it could allow countries to prosper despite having extractive instis. But this cannot continue for a long time and it is just that technology has sort of allowed China to grow for such a long time despite not having the right framework for sustained growth..

An amazing essay… Connects so many dots..

"Mostly Economics"

The Devil Called 'Energy Subsidies'

FOR decades, governments from Egypt to Indonesia have subsidised the price of basic fuels. Such programmes often start with noble intentions—to keep down the cost of living for the poor or, in the case of oil-producing countries, to provide a visible example of the benefits of carbon wealth—but they have disastrous consequences, wrecking budgets, distorting economies, harming the environment and, on balance, hurting rather than helping the poor.

Emerging markets are not the only places that distort energy markets. America, for instance, suppresses prices by restricting exports. But subsidies are more significant in poorer countries. Of the $500 billion a year the IMF reckons they cost—the equivalent of four times all official foreign aid—half is spent by governments in the Middle East and north Africa, where, on average, it is worth about 20% of government revenues. The proceeds flow overwhelmingly to the car-driving urban elite. In the typical emerging economy the richest fifth of households hoover up 40% of the benefits of fuel subsidies; the poorest fifth get only 7%. But the poorest suffer disproportionately from the distortions that such intervention creates. Egypt spends seven times more on fuel subsidies than on health. Cheap fuel encourages the development of heavy industry rather than the job-rich light manufacturing that offers far more people a route out of poverty.

How to save $500 billion and the planet

For all these reasons the benefits of scrapping subsidies are immense. Emerging economies could easily compensate every poor person with a handout that was bigger than the benefits they got from cheap fuel and still save money. In the process, they would help the planet. According to the International Energy Agency, eliminating fossil-fuel subsidies would reduce global carbon emissions by 6% by 2020.

Some emerging-market governments are persuaded by these arguments, and are getting serious about reform (see article). Indonesia raised petrol prices by more than 40% last year, and the front-runner in the upcoming presidential election says he will consider a more comprehensive fuel-subsidy revamp. Iran has just begun the second phase of a big subsidy overhaul, raising the price of petrol, gas and electricity. Egypt’s new president is being pushed towards tackling energy subsidies by a gaping budget deficit. Morocco and Jordan have cut subsidies in the past couple of years. Even Kuwait announced this week that it plans to scrap diesel subsidies.

Yet the politics of reform are exceedingly difficult. Politicians are loth to antagonise the urban elite; insiders benefit (often corruptly) from cheap fuel; ordinary citizens do not believe they will be compensated. Many previous attempts to cut subsidies have been abandoned in the face of popular protests or rising global oil prices. Experience suggests that any attempt to cut subsidies needs to be accompanied by a public-education campaign to explain the costs and inequities of subsidies, to have a clear timetable for gradual price increases and to be supported by targeted transfers to counter the effect of higher fuel prices on poorer people.

Even with better politics and the best-laid plans, it would be a mistake to expect too much too fast. Entrenched subsidies anywhere are devilishly difficult to get rid of. If the oil price rises, so too will the pressure on emerging economies to “protect” their citizens from dearer fuel. But, for the moment, there seems to be a chance to accelerate reform. It is an opportunity not to be missed.

ECONOMIST

Does Europe face the prospect of a lost decade?

Christian Noyer of Banque De France asks this q in a recent speech.

He says lost decade could happen in Europe for two reasons (though adds it is not limited to Europe alone):

Questions about long-term growth are not limited to Europe. What we hear about our continent reflects a more general concern: the possibility of “secular stagnation” in advanced economies. Larry has launched this crucial debate. I don’t know whether he was thinking specifically about Europe, but, of course, this question is very relevant for us.

Secular stagnation rests on the assumption that the natural interest rate is negative. This may happen for two reasons:

• In the short run, we may have a downward shock on demand and an increase in savings resulting from the deleveraging process. I have just explained how we are currently addressing this issue.
• In the longer run, ageing and slower innovation may push up saving rates and bring down the return on capital. Therefore, the ultimate response to the risk of secular stagnation is to improve the return on investment, thus pushing the natural interest rate back into positive territory. Again, this is not only a European problem. But we do have difficulties in this regard. Structural reforms are not easy.

Many, however, are currently being implemented. Italy is abolishing its provinces, generating savings that will allow for a reduction in taxes and liberalising its labour market. France is on the same track and has reduced taxes on its labour costs as well as improving labour market flexibility.

   

He says opposite forces are hitting Europe:

Strangely, in the euro area, growth and inflation are moving in opposite directions. As growth accelerates, inflation keeps going down. This “disconnect” in the Philips curve is puzzling. We must look, then, at the broader picture. Euro area economies have attracted strong capital inflows over the recent months, with two opposite effects on financial conditions: first, easing through lower long-term interest rates. And, second, an appreciation of the euro exchange rate.

It’s not clear whether the overall effect is positive. While nominal conditions are more accommodating in euro area than in the US, real indicators point to a more restrictive stance. We may see a perverse feedback loop develop, with low inflation, increasing real rates, capital inflows and exchange rate appreciation mutually fuelling each other. The financial economy may be heading towards a bad equilibrium that would threaten the real economic recovery.

The situation called for an appropriate policy response and, as you know, the Governing Council has agreed last Thursday on a strong package of four significant measures

India just has an opposite problem. Despite slipping growth, inflation remains high.

What a mess we all are in…All basic macro conditions are all over the place.

From: Mostly Economics, Amol Gupta

From WPI to CPI - Is Calculation Important that Remedy to Price Situation in India?

Post Contributed by Vrusti, Sem IV, Institute of Law, Nirma University

Governor Raghuram Rajan-led Reserve Bank of India will start using consumer prices instead of wholesale prices as the inflation benchmark for valuing the Indian rupee against other currencies, a move that could make it less tolerant of appreciation by the rupee. The Indian rupee's value is set by the market, but the central bank tracks its relative value, known as the real effective exchange rate (REER), as a guidepost. Although the bank does not have a target exchange rate, it does intervene in the market to ease volatility.

Late on Friday, the central bank said in a statement that the consumer price index would now be used to arrive at the rupee's value on a REER basis. That is consistent with its move to make CPI the main inflation gauge, in a shift away from the wholesale price index. Annual CPI inflation in February was 8.10 percent, compared with 4.68 percent for the WPI. The switch to CPI means the rupee was overvalued by around 4 percent in March, based on what the central bank said was a REER of 104.20. A REER of 100 would mean the currency is fairly valued. 

Previously, the rupee was undervalued at a REER of 89.46 in March, based on the WPI inflation benchmark.

The rupee has risen 2.8 percent in 2014. It closed at 60.08 to the dollar on Friday. Rupee appreciation has prompted the central bank to buy dollars in the market, increasing India's foreign exchange reserves by $5 billion in the week ended March 28, the biggest weekly gain in 4 months.

RBI shifts to CPI-based Real Effective Exchange Rate

(PTI) Shifting focus to retail inflation, the Reserve Bank today said it will compute and release Real Effective Exchange Rate (REER) only on the basis of the Consumer Price Index (CPI) as the price index for India from this financial year. "REER index constructed using a CPI for both India and trade partner countries would ensure a higher degree of comparability of former's international competitiveness vis-à-vis trading partner countries," the RBI said in a release. REER indicates movements in exchange rates of the home currency against a basket of currencies of trade partner countries and is considered to be an indicator of international competitiveness.

Since October 2013, the RBI has started providing indicative projections of inflation in terms of the broader CPI-Combined.

"Thus, with greater focus on CPI inflation as primary objective of domestic monetary policy, it is pertinent to have an alternative index of REER based on CPI," RBI said. Till now, in the case of India, the RBI was providing the REER index using the Wholesale Price Index (WPI) for India and CPI for partner countries. The RBI today released a monthly series on CPI-based REER for both six-currency and 36-currency baskets for the period April 2004 to March 2014.

It said from this financial year, only the CPI-based REER would be compiled and released.

The Tale of the Gandhi Cap

A nice piece by M.S.S. Pandian of JNU in recent EPW edition.

He points how the humble Gandhi cap has made a comeback due to Anna movement and AAP surgence to power. But then given AAP’s performance, the rebirth time might be much smaller.

There are two interesting tales on Gandhi cap from history:

Let me share two Gandhi cap stories – both from Maha­rashtra, the home of Anna Hazare. In a prelude to the 1946 provincial election, B R Ambedkar visited Nagpur. Following his visit, a conference was organised to highlight the injustice faced by dalits. As Namdeo Nimgade, an Ambedkarite and a well-known agricultural scientist educated in the US, reminiscences in his autobiography, the dalit leader P N Rajbhoj told the audience, “The Congress Party is systematically trying to divide and rule the various Scheduled Caste groups… In recognition of their deceit, I declare that I will burn the sign of the Congress, the Gandhi cap.”

The gathering made a bonfire of their caps and Nimgade fanned the flames by throwing his father’s cap into the fire.

The election day too was eventful. It witnessed widespread caste violence. Nimgade tells us: “Several unfortunate individuals of all castes were trapped in the wrong place at the wrong time during the riots.”

One of them was an upper-caste man, Bhivapurkar Kosshti. He sought Nimgade’s help to survive the riot and bartered his cap for his life. Nimgade writes: “I felt sorry for him. I said, ‘Brother, if you wear your Gandhi topi here, you will not survive. Please give it to me.’ I took his Gandhi cap and escorted him to Baburao Meshram’s house and hid him there until the riot calmed down…”

From Nagpur, the scene shifts to Bombay, and the period from the 1940s to the 1950s. On the night of 20 November 1955, S K Patil, the president of the Bombay Pradesh Congress Committee, and Morarji Desai, the chief minister of Maharashtra, addressed a public meeting on the sprawling sands of Chowpatty beach. The gathering had no fewer than 1,50,000 people. The next day Bombay witnessed a general strike in demand of a united Maharashtra, egged on by both speakers who were arch enemies of the Samyukta Maharashtra movement.

The meeting was torn asunder, as stones were pelted and the uproar drowned the voices of the speakers. Around 100 people were injured, and half of them sent to hospitals. The next day – the day of the general strike – anyone wearing a Gandhi cap, the sartorial hallmark of Morarji Desai, was attacked.

So clearly in the two examples, those wearing Gandhi cap became the targets of dislike and attack. So there were moments when the humble cap wearers had just the opposite experiences.

The first one is really interesting as Gandhi cap was seen as a symbol of Congress. How AAP made this its own symbol (because Congress forgot it) is an interesting tale..

Other Than Economics !

Sometimes I feel like rejecting all economics related stuff and get onto figuring technology. After all much depends on how the latter can generate economic growth and future opportunities. The action always has been in new emerging technologies and how they can change things..

Edward Jung (earlier at Microsoft and now at Intellectual Ventures) argues why it is time to look at new metrics for economic growth. The problem is much of economic activity is getting centred around digital technology but latter is not being measured properly in traditional indicators:

“If you can’t measure it, you can’t manage it.” That is the wisdom behind metrics like gross domestic product and other aggregate indicators that signal the health of national economies around the world. Policymakers and planners have used these numbers for decades to help them understand how to guide domestic economic growth.

But reliance on GDP and other traditional indicators may be sabotaging a keenly sought goal: the development of thriving innovation economies. Today, some vital parts of the information-technology sector barely register in the national accounts. While GDP measures the market value of all goods and services produced within a country, many stars of the digital age (think Wikipedia, Facebook, Twitter, Mozilla, Netscape, and so on) produce no goods and provide free services.

These same star players also tend to undercut the productivity of traditional businesses. Free navigation apps have shrunk sales for Garmin, the GPS pioneer that was once one of the fastest-growing companies in the United States. Skype is killing the international phone call “one minute at a time.”

These developments point to the need for new growth metrics that recognize new kinds of enterprise. And, because these metrics concern innovation, they should be forward-looking as well. Policymakers need to understand how to establish, manage, and thus measure the conditions that encourage innovators to flock to a region and forge a prosperous future there. Innovation metrics must capture the value of new ideas years before those ideas become profitable in traditionally measured ways.

He says FDI too is a wrong measure as it does not push home country to innovate:

The need for such metrics is especially urgent in the developing world. Emerging economies commonly use foreign direct investment (FDI) as a yardstick to measure progress. That metric makes sense in the early stages of development: poor economies need foreign capital to build factories, train workers, and put money in the pockets of ordinary citizens.

But foreign investment most often goes to low-risk, low-margin projects: iron foundries, cement plants, and so forth. Innovation, by contrast, is a high-risk, high-reward effort. Even big multinationals do not put a lot of money into a new idea at first. Tomorrow’s most disruptive innovation may have no effect on FDI or GDP today.

Thus, for countries like China, India, and Brazil that are trying to jump-start their domestic innovation cultures, FDI targets actually prevent government planners from reaching out to the people and companies that are most likely to take creative approaches to problems.

We need a change in thinking:

So what does valuable innovation look like, in terms of macroeconomic data, years before it gives rise to the next Google, Bayer, Porsche, or Alibaba? What numbers best characterize a thriving innovation ecosystem in its birth stages?

We already know some of the essential ingredients. They include top-level talent, serial entrepreneurs with good track records, start-ups backed by reputable capital, and breakthrough products protected by intellectual-property rights. Analysts at my company recently investigated whether these ingredients could be quantified. Our preliminary results suggest that they can.

hFor example, we learned that five of today’s most successful start-ups in the information-technology sector had two attributes in common by the end of their third year in business: they had filed more than one patent and been funded by more than one top venture-capital firm. In subsequent years, these five companies’ cumulative revenue was six times higher than that of start-ups chosen at random.

Economists could extend such analyses to develop a set of key performance indicators for young innovation economies. Governments could then use these innovation metrics to identify start-ups, talent, and products with the strongest potential for future success. This approach could be applied to any high-tech incubator project – within or beyond the developing world – that currently measures success only in dollars.

Some countries are trying to include technology into the traditional world:

Changing how we think about economic value will not be easy. Yet countries where GDP has been flagging – an ever-increasing cohort – might welcome new metrics that can show signs of real progress. And there is a growing awareness among policymakers and planners that virtual assets like creative talent and entrepreneurial skill make up an increasing portion of a country’s wealth.

The US Bureau of Economic Analysis acknowledged as much last summer when it changed the definition of GDP to represent better the contributions of intellectual property and research and development to productivity and economic vitality. Broader efforts to reform GDP, including initiatives sponsored by the Organization for Economic Cooperation and Development and the European Commission, seek to encompass sustainability, living standards, and other important aspects of a country’s wellbeing. Groups like the Institute for New Economic Thinking are championing the study of innovation economics to provide data and analyses for these efforts.

In fact, metrics that help countries drive innovation could change our very understanding of economic growth. Governments want them, economies need them, and the global community will benefit from them. It is time for macroeconomics to measure up to the ambitions of twenty-first-century innovators.

Not sure whether flagging economies can be innovative.

But yes one gets the broad point. It is ironic that GDP includes things like financial activity which hardly count as real production but fails to incorporate technology which boosts much of it. Infact much of finance is now about technology these days..

I guess the broader question is always this – Why has economics developed into a way where we are pursuing so narrowly defined goals. I mean one did talk about things like technology and innovation earlier via likes of Schumpeter and so on.

Interesting viewpoint..

What Can We Learn From Honey Bees ? (Economics ?)

What a brilliant paper by Vesa Kanniainen of University of Helsinki, Tuula Lehtonen  of Finnish Beekeepers’ Association and Ilkka Mellin  of Aalto University.

      It tells you about so many things about economics using honeybees and their activity at the centre.       It tells you about economic systems, leadership, externalities (positive ones), work ethics and what       not:

For thousands of years, humans have known the value of honeybees in agriculture. Their pollination services are crucial for the mankind, the Global ecosystem and food production. The recently documented decline of the honeybee colonies in the world is alarming and may threaten the whole living nature. To develop a proper policy intervention, the economic analysis can be employed to develop Honeybee Economics. Such an endeavour reveals striking efficiencies of honeybee societies in terms of division of labor, the pleasure of work, career development, information sharing, and extreme altruism. A communist society, however, comes at a cost. Strict policing in management of the genetic interest conflicts is unavoidable in terms of workers’ dictatorship with a rather limited power allocated to the Monarch.

In our paper, the economy of honeybees is analyzed in terms of an implicit labor contract with a farmer. It is a two-output economy: the honeybees not only produce honey but are engaged in Pareto-efficient exchange with flowering plants including procurer and provision of pollination services. This benefits the whole nature. Markets for pollination services exist only in limited areas, for example in the Western United States. The missing market makes the pollination an externality. In their principal-agent relationship with the farmer, the working effort of honeybees appears a virtue in the spirit of the Calvinist Ethics. The industry is subject of substantial risks. The risk aversion creates a wedge between the expected market price and the production cost. The risks are reflected in volatility in the pollination services reducing the consumers’ welfare. Data on honey production, a complement to the pollution services, is used to examine the magnitude of risks and the potential cycles. Both the externality, the industry risks and the risk aversion speak for taxing consumers and subsidizing producers as the solution for the optimal tax problem.

Though the paper is on technical side. However, students could be given this paper in the class to work simultaneously on econ and math lessons. The paper moves interestingly from one aspect of honeybee economics to other ….I would love to be part of such a class and sort some math..

(excerpt from Amol Gupta's Article)

Independent Evaluation Office to assess impact of Indian Government’s Flagship Programmes

Planning Commission has set up a new office  – Independent Evaluation Office to assess impact of Government’s Flagship Programmes.

The Union Cabinet today approved the establishment of an Independent Evaluation Office (IEO) to undertake impartial and objective assessment of the various public programmes and improve the effectiveness of public interventions. This is in pursuance of the Presidential address to the Joint Session of both Houses of Parliament in June, 2009 to establish an Independent Evaluation Office at an arms’ distance from the Government to assess the outcomes and impact of the major flagship programmes of the Government of India.

The IEO will be an independent office attached to the Planning Commission under a Governing Board chaired by the Deputy Chairman, Planning Commission. It will be funded by the Planning Commission and will have, as its head, a full-time Director General (DG) in the rank and status of Member, Planning Commission. It will have full functional autonomy to discharge its functions. The IEO will also advise the Planning Commission and the implementing agencies in developing appropriate management systems consistent with the evaluation objectives.

The IEO will strengthen the existing evaluation process by drawing the best resources available from leading research organizations. The findings of the independent evaluation will be reported to the Government of India and also be placed in the public domain.

I was wondering what happens to this department of Planning Commission – Programme Evaluation Organisation. It has near same functions as well and has taken out decent reports as well. May be it is merged with this new office. But why this duplication?

Leaving the euro: What’s in the box?

Rumours of Eurozone break-up are mounting. This column argues that exiting a strong currency for a weak one poses almost unthinkable challenges, from the redenomination of contracts and the imposition of bank restrictions to the restructuring of external debt and limiting of capital mobility. Lessons from Argentina illustrate just how radical the changes would need to be.

The turmoil in Europe is not abating. True, some calm has returned to the markets after the initial storm, but tenacious misgivings about the euro project in general are growing, driven by disenchantment with the policy responses and a realisation of the magnitude of the problem.

Something that was unthinkable six months ago is happening today. There are, still few indeed, but undeniable mounting calls for euro exit – and not only from euro sceptics across the Atlantic (see Feldstein 2010, Financial Times 2010, and Baldwin 2010 for a summary of the debate on Vox.)

While faint exit pleads could be heard in Germany, as a way to avoid bearing the cost of the bailout, the louder calls are coming from the economies under pressure and looking to regain competitiveness, with Greece in front of a potentially larger number of countries willing or forced to give up the single-currency project.

Switching from a strong to a weak currency

But the process of launching a new, weaker, national currency to substitute a stronger one as legal tender is, to be sure, a very complex one. What do we know about this process? Eichengreen (2007) provides an analysis of this event but when it comes to hard facts the answer is simple. We know virtually nothing.

Indeed, it is unclear whether those toying with this type of solution have analysed the preconditions and consequences of such a move since there is not much precedent for an episode of this kind in recent economic history.

Abandoning a battered currency in favour of a stronger one (“dollarisation” in the jargon) has been more frequent, and is probably easier in comparison (see for example Levy Yeyati and Sturzenegger 2002).Creating or reintroducing a national currency with the deliberate intention to weaken it relative to the existing one (and to all other world currencies, for that matter) is an altogether different and much more complicated endeavour, particularly if this has to be done in times of distress and mistrust of domestic policies.

Argentina 2002

The closest, although certainly not identical, precedent to this course of action is Argentine’s exit from a currency board arrangement to float a weakening peso in 2002, an event that has important common aspects with the case in point. While still far, in many respects, from a “new drachma” or a “new peseta”, the episode nonetheless offers some interesting pointers as to what the whole affair involves.

At the risk of generalising and omitting, the Argentine lessons can be summarised under four categories. If a country is willing to seriously entertain the idea of introducing a new, weaker, currency (which for simplicity we could call the peso), it needs to be willing to deal with:

• the “peso-ification” of contracts,
• the imposition of heavy restrictions to commercial bank operations,
• an external debt restructuring, and
• the use of capital and exchange controls – at least temporarily.

Crucially, all of these four types of tribulations, which come on top of the potential inflationary consequences that follow any normal devaluation, need to be tackled jointly and up front, as they are likely to be anticipated by agents and markets.

Exit costs can only grow larger if the decision process is protracted and marred by improvisation and half-baked patches.

a brief discussion on why these four issues are an almost inescapable consequence of leaving the strong currency may be listed as below:

Peso-ification or redenomination of contracts

The new currency needs to create its own transactional demand and requires a legal framework that makes it the sole legal tender and unit of account. This requires the forced redenomination of all contracts in the economy. Regarding prices and wages – as well as other flows of funds – the redenomination may not create very serious disruptions.

The redenomination of accumulated stocks, however, particularly those arising from domestic financial contracts, becomes an extremely thorny issue.

• On the one hand, if the new currency succeeds in achieving a real devaluation (i.e., this if the pass-through of the nominal devaluation to inflation is reasonably low), the forced peso-ification of financial contracts results in heavy and asymmetrical balance sheet effects.

In particular, the losses experienced by domestic euro debtors would more than offset the gains from a more competitive economy and make the whole euro exit strategy self defeating (see Frankel 2005).

• On the other hand, the peso-ification of bank deposits and credits could have a massive redistributive impact (benefiting net bank debtors and hurting net deposit holders) and could bring up violent social and political reactions.

It would also immediately trigger a bank run, as depositors run to protect their savings by switching them back into hard currency. Indeed a bank run may be unavoidable and precede the exit, as the Argentine case illustrates.

The Argentinean bank run started in early 2001, nine months before the abandonment of the currency board arrangement. This is because the mere expectation of an exit is enough to fuel a deposit run, as well as a credit crunch, in anticipation of the inevitable peso-ification (see Levy Yeyati et al. 2010).

A deposit freeze

To counter the deposit run and to avoid massive bank failures until the economy is out of the woods, a temporary deposit freeze would be needed. Crucially, to minimise the damage, the freeze needs to be selective, excluding sight and savings deposits needed for everyday transactions.

Argentina, again, is a good example – albeit negative. The gate dropping on all deposit withdrawals in November 2001 (the so-called “corralito”) was a misguided choice that caused a liquidity crunch that only contributed to the downward spiral in economic activity and market sentiment.

This misguided policy was the immediate cause of the government collapse. By contrast, the deposit restructuring in January 2002, that peso-ified and froze only term deposits, slowed down the run thereby preserving the payments system.

Needless to say, these options were (as they always are) desperate measures to cope with a terminal crisis, and suffered from many shortcomings that are inevitable when policy is made in a crisis. But even the most careful preparations may not prevent the financial panic surrounding an anticipated conversion.

An external debt restructuring

This is the flipside of the peso-ification of domestic financial contracts. External debt under international law cannot be redenominated by the government but, following the peso-ification of state revenues and expenditures, it becomes very difficult to service on its original terms. Therefore international debt relief could come through a negotiated debt exchange.

Importantly, however, such a restructuring is not restricted to the sovereign. Corporate euro debtors would suffer the same balance-sheet shock and, with the government unable to fund a bailout, would be forced to renegotiate their liabilities.

In Argentina that was a painful and protracted but essentially successful process. Firms restructured their debts under the umbrella provided by the combination of sovereign default and capital controls that inhibited debt servicing abroad. In this way, bankruptcies were avoided but the access to international markets by the corporate sector remained impaired for many years. Besides this distinction, however, the main lesson from the Argentine experience is that it is unrealistic to conceive a euro exit without a debt default.

Capital and exchange-rate controls

Euros (and other reserve currencies) will be precious in the event of a euro exit. Financial uncertainty fuels capital flight just at the time when the country needs to fund a narrowing but still sizeable current-account deficit. This scarcity of euros will probably be exacerbated by a loss of access to international capital markets.

As a result, traditional restrictive measures such as the obligation to surrender export proceeds to the central bank, often coupled with capital outflow and exchange-rate controls, are necessary. All of these measures were launched in Argentina in early 2002 and contributed to stabilise the transition.

In fact, it may not be possible to enforce the redenomination of contracts nor the deposit freeze without capital controls; without them all settlements would immediately move abroad.

Again, the lesson here is that conceiving a euro exit while maintaining full convertibility is probably wishful thinking.

The euro difference: Harder than a currency board arrangement

Argentina’s abandonment of its hard peg has some similarities but also marked differences with the current situation regarding euro exit. Leaving the currency board arrangement was actually simpler than the introduction of a new currency in that the currency board arrangement never eliminated the use of the local currency for transaction purposes, the basis of the demand for money.

In Argentina, the devaluation caught people with pesos in their wallets, and the need for liquidity supported a steady demand for pesos all through the first quarter of 2002 when it depreciated by 300% (see De la Torre et al. 2003). By contrast, a “new drachma” or a “new peseta” would need to create from scratch a demand for a currency born weaker by design. Could it work?

Everything is possible but, as noted, there are no real precedents and, just judging from the costs involved in redistributing wealth through the redenomination of contracts, imposing bank restrictions, restructuring external debt, and limiting capital mobility, it is certainly not the easiest way out.

References

Baldwin, Richard (2010), “A re-cap of Vox columns on the Eurozone crisis”, VoxEU.org, 10 May.

De la Torre, Augusto, Eduardo Levy Yeyati, and Sergio Schmukler (2003), “Living and Dying with Hard Pegs”, Economia, 43-107.

Eichengreen, Barry (2007), "Eurozone breakup would trigger the mother of all financial crises", VoxEU.org, 17 November.

Feldstein, Martin (2010), “Let Greece Take a Holiday from the Eurozone”, Financial Times, 17 February.

Financial Times, “Dis-membering the euro”, 14 July, Lex.

Frankel, Jeffrey (2005), “Contractionary Currency Crashes in Developing Countries”, IMF Staff Papers,52(2).

Levy Yeyati, Eduardo, Maria Soledad Martinez Peria, and Sergio Schmukler (2010), “Market Discipline under Macroeconomic Risk”, Journal of Money, Credit, and Banking.

Levy Yeyati, Eduardo, and Federico Sturzenegger (2002) (eds.), Dollarization: Debates and Policy Alternatives, MIT Press.

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Foreign Aid: Beneficial or not?

Jagdish Bhagwati has written a fascinating historical review of foreign aid. Zambian born Goldman Sachs economist Dambisa Moyo has recently criticized aid severely. She has said aid does not get any desired benefits for Africa and only goes into the purses of the politicians. What is worse is that there are hardly any suggestions from any African leaders on what should be done. The suggestions mostly come from Western economists/policymakers who are usually not aware of the local situation.

Bhagwati reviews the broad economic rationale behind aid and how it was seen as beneficial. Foreign aid is based on two principles- moral duty and should yield beneficial results. The second principle has never rally worked which has weakened the first one as well. The early works of  Gunnar Myrdal, Paul Rosenstein-Rodan and Arthur Lewis led to some support for foreign aid. This led to rich countries  being asked to fix a target for giving s1% of aid every year.
 Bhagwati tracks where did 1% come from? Arthur Lewis had a student working in a French colony who said French spent 1% of GNP on the colony. The same was explained by Lewis to a UK MP and the term caought on.

Bhagwati also explaisn how Rosenstein-Rodan got this aid idea popular within US congress. It was the time of Cold war and aid was seen as a way to prevent communism from spreading to the world. Soviets had helped Egypt construct a dam and this was used as a way to show USSR ideas are gaining grounds. So obviously it caught on with US congress!!!

As Cold War became over, Aid was seen as something that would help the developed countries. As poor become more developed because of aid, they would demand more goods and services from developed and would lead latter to grow as well. This was superfluous as spending the same amount in developed countries itself would lead to more prosperity. Another idea was aid would lower illegal immigration. Bhagwati says this was also not right as illiegal immigration would actually increase as people will have more money to bribe on the borders.

All this frustrated Lewis and he said in jest that development econs should hand over iad to Madison Avenue. And this became true after 20 years as we have rockstars, concerts asking to give aid!
Bhagwati also looks at the fame Harrod Domer model which justified aid. The model says there are two ways for a country to grow. One, how much it saves and invests. Two, how much returns it got from investments. The broad idea for foreign aid was it would supplement domestic savings and help in growth. Then as an add on, the domestic savings will also increase over a period of time. However, the recepiuent countries politicians were smart and realized shortfalls in domestic savings would be taken care of. And actually domestic savings went down!!

Overall, the foreign aid failed to pick up. Every year targets are missed.
 Bhagwati adds China and India did not grow based on foreign aid but based on reforms. Development basically comes down to how the citizens and poliymakers make proper choices and reform their economies. Foreign aid is unlikely to help.
 A great article by Bhagwati. In just about 5 pages, explains so much about foreign aid and its basics.

Posted in Academic research & research papers, Economics - macro, micro etc, Economist, Financial Markets/ Finance, Growth and development, Policy

'Seeing is Believing'.. For the AAM AADMI

How Government can restore the faith of citizens (using a behavioral nudge)..

A billion dollar (or trillion?) dollar question facing most citizens across the world. And this is perhaps the oldest research question which remains relevant today and likely to remain in future as well. Michael Blanding at HBSWK summarise the findings of this recent research by HBS profs -Michael Norton and Ryan Buell.

What research says is something really simple and intuitive — Seeing is believing. So unless people see that the govt is working for them, they are always going to feel nothing is working. So, for a government to demonstrate its efforts it needs to show people that something is going on. What is interesting in the research is how they come about these results:

In a previous research, Buell and Norton had experimented with customer satisfaction in travel and dating websites. They found that when these sites visually showed the effort being exerted by the site during searches or transactions, customers were more likely to be satisfied while waiting for results. “There is a strange human tendency to value effort independent of outcome,” says Norton. “If you appear to be working hard and sweating, people will assume you are doing a good job.”

Buell and Norton put that into practice by partnering with an organization called Code for America, which describes itself as the “Peace Corps for Geeks.” Its coders take publicly available data and use technology to visualize the work of government for the public in accessible ways. In Boston, for example, the group worked with the Mayor’s Office of New Urban Mechanics to release data on public works requests for repairs such as potholes, graffiti, and broken streetlights.

Using a cell phone application developed by the mayor’s office, citizens can request service by snapping a photo of the problem and uploading it to the city accompanied by GPS data of its location. These service requests are then visualized on Code for America’s Daily Brief website, which Buell and Norton used in their experiment.

The researchers worked with the organization to pilot several versions of the website, each with different visualizations of this data, in order to test its influence on citizens.

In their first website, they just show the basic details of the requests, In second version they also show the location of the site using a map. The second approach had much better response from the viewers who thought the government is working for them:

In the first iteration of the website, the researchers included only the number of open requests for repairs, along with the number of requests opened and closed the previous day, in order to show that government was actively responding to requests. In the second condition, they included pins on a map showing the location of these issues; when users clicked on a pin, a window opened showing a photo of the problem along with its description and location.

Buell and Norton found that when shown the second version of the website, users were much more impressed with the work that government was doing—and much more favorable about the efficacy of government overall.

“There’s a big difference between providing people with information about what’s being done and allowing them to see it for themselves,” says Buell. “Moving from the ‘base case’ where we just show statistics to a transparent version of the website that shows the problems that are being addressed, significantly improves attitudes towards government and government service.”

When asked if “Government often does a better job than given credit for,” only 34 percent of people agreed after viewing the first case; but some 57 percent agreed after the second case. Seeing the visual evidence of government working had broader implications as well. When participants were asked, “In general, is the government’s effect on your life positive or negative?” 76 percent said “positive” after viewing the first case—but a full 91 percent gave that answer after viewing the second.

This is really bit of a behavioral nudge using pictures, visual tools etc to show performance.

Infact, there is a catch. It is not as if one can be transparent with everything. In the third edition, the authors also added on the map the total number if sites where there was a problem. So you had two kinds of pins – one showing all the problem sites and two those in which work was completed. As latter usually is a smaller number, this led to people having lower ratings!

Those results, however, suggest that effort by itself is not enough; it must also be coupled with a positive outcome. Norton compares it to results in their online dating research in which users were more satisfied when they saw the website working hard for them during searching-but only if they ended with attractive or average looking people at the end of the search. “If they received less attractive people, they were actually angrier,” says Norton. “They could blame themselves, but of course no one ever did.”

In the same way, citizens may be happier with their government if they see it working hard on their behalf-but only if they see it actually accomplishing what it sets out to do. “The sweet spot,” says Buell, “is where you are working hard, but also getting things done.” Even Thoreau would have to look kindly on government then.

Nice bit..

Though, this can work for governments that are actually working but people not getting it. In most cases, the governments hardly work so the answer to the eternal question remains as elusive as ever..

(Adopted from Mostly Economics Blog)