Monday, December 28, 2009

Protectionism, recession, recovery: looking back and looking forward

In thinking of protectionism, the Great Depression, the Great Recession, and what might come next, here are two interesting angles.

Governments with their backs against the wall


Ideally, stabilisation using monetary and fiscal policy, alongside actions by the private sector, should restrain the decline in consumption, and yield conditions which are not too harsh for households. At the time of the Great Depression, much less was known of economics. Pegging the currency to gold meant giving up monetary policy autonomy; the US Fed succumbed to contractionary monetary policy once you take into account the closure of banks; the fiscal policy response at the time was miniscule.

It has been argued that the the Smoot-Hawley Tariff Act came about in the US in June 1930, at a point in time where the politicians were coming under enormous pressure to do something. After seven months of inaction by macro policy, with mounting difficulties in the economy, the politicians succumbed to protectionism. This appears to have been of decisive importance in sending the world down the destructive path of competitive trade barriers and cometitive devaluation. In the graph made famous by Barry Eichengreen and Kevin H. O'Rourke, at month 7 there was almost no decline in world trade. Douglas A. Irwin is worth reading on this.

Protectionism adversely impacts the recovery


Greg Mankiw and Scott Sumner point out one more channel through which Smoot-Hawley damaged prospects for the recovery was through the impact of protectionism on confidence.

The private sector saw protectionism as symbolising government backing away from responsible thinking in economics, and responded with a weakening of investment demand. This served to exacerbate the downturn.

Will this time be different?


The bulk of world GDP is now endowed with inflation targeting central banks. This ensures that monetary policy will be counter-cyclical: under bad business cycle conditions, inflation forecasts will drop below targets, and central banks will use every trick in their book to push inflation back up to target.

Fiscal policy has responded well this time around, thanks to better understanding of business cycles when compared with 1929. But there is little headroom to go further.

The world has as little ability to rein in some players engaging in competitive devaluation (e.g. China) today, as was the case in 1930. But with the bulk of world GDP being placed with inflation targeting central banks, the extent to which such tactics will be used will be relatively limited.

So far, we have had an upsurge of protectionism, but nothing on the scale of that seen from 1930 onwards. This could partly reflect the dramatic actions which governments have undertaken through monetary and fiscal policy, through which politicians have been able to reduce the domestic political difficulties that go along with business cycle downturns. But if, in coming months, the world economy remains mired in recession, then we could get fresh pressure to do something. In a recent voxEU post, Jeffrey Frieden points out that the path of adjustment of macroeconomic imbalances and currency distortions will involve political pain along the way, which could spillover into protectionism.

Some protectionist decisions could reflect bargaining tactics aimed at getting China to reduce or end their market manipulation of the currency market. But if there is an upsurge of protectionism beyond this, it will further damage the recovery by hurting investment, giving a spiral of bad economy -> protectionism -> reduced investment demand -> worse economy.

Saturday, December 26, 2009

Five questions on asset prices and monetary policy

Howard Davies was a deputy governor of the Bank of England, and the first head of the UK FSA. He is one of the world's leading thinkers on financial regulation and monetary policy, and one of the people who combines skills in both finance and monetary economics. In a recent article, he focuses on the five interesting questions about central banks and asset prices. Everyone interested in monetary policy today needs to ask themselves these five questions.

Q1: Should central banks target asset prices?


Davies points out that the consensus view is that central banks should remain focused on inflation targeting and not target asset prices.

However, pretty much everyone would agree that information from the world around us, about asset prices, is useful for forecasting inflation and output, and should be used in figuring out what values for output and inflation we put into our Taylor rules (whatever they might be).

So it seems that on this question, there is consensus: Asset prices are (and have always been) useful inputs in monetary policy formulation, but monetary policy should continue to do inflation targeting and not asset price targeting.


Q2: Should the measure of inflation targeted include an element of asset price, and particularly house price inflation?

Any reasonable CPI must have house rent in it, and through this, a boom in house prices and thus rents will get reflected in the CPI. This would give one more channel through which asset prices would directly influence a traditional inflation-targeting central bank.


Q3: Is it possible to identify serious asset price misalignments, and are they of legitimate concern to monetary policy-makers?

This is controversial territory. Some economists believe it is possible to ask central banks to make a call on when asset prices are misaligned.

I am personally skeptical about the extent to which this is possible. It is always easy to look back, ex-post, and say that it was obvious that US house prices were way off in 2006. But how many of the people who say this today were shorting US housing then?

Making a call about asset price fluctuations is hard even for a well motivated hedge fund manager. It is doubly hard in the public sector given the peculiar combination of skills and incentives that are found within central banks. The people with real skill in these things are unlikely to choose to work in a central bank; years spent in a central bank do not hone skills at market timing; the public will be very irritated if a central bank calls wrong.

So overall, I'm skeptical about the extent to which central banks (past or future) can usefully make calls about when asset prices are out of whack.


Q4: Even if we can identify misalignments, and believe that some price adjustment is bound to occur, is it right to use interest rates to try to moderate the expansion?

Even if you knew that asset prices were grossly wrong, interest rates seem to be a very blunt tool, which inflict collateral damage all around the economy. Davies quotes Mervyn King who said two months ago: Diverting monetary policy from its goal of price stability risks making the economy less stable and the financial system no more so.


Q5: Should we try to find and use mechanisms other than interest rates to moderate extravagant credit expansion and associated asset price bubbles?

I think there is a good case for building some kinds of counter-cyclicality into financial regulation. But operationalising this is hard.

It should be feasible for financial regulators to have three manuals which govern boom times, normal times, and recessions. Full public disclosure of these three manuals is, of course essential, to avoid the usual issues of transparency and consistency. The question is: When would you flip from one manual to another?

Doing this based on asset prices runs into the difficulties articulated above. How is a civil servant to know when asset prices are in a boom or a bust?

Doing it based on business cycle conditions is more objective and feasible. It should be possible to setup indicators like Eurocoin which give low latency information about a coincident indicator. This could be used to drive rules about when we go into each of the three manuals. I personally think this would be useful.

Such efforts can be rationalised on the narrow ground that we seek to reduce the extent to which finance is a source of pro-cyclicality in the economy. If this is done right, it would reduce the amount of heavy lifting that monetary and fiscal policy have to do by way of stabilisation.

You don't have to have a `financial markets are irrational' view to support this. All you have to believe is that the existing structures of financial regulation are a source of pro-cyclicality. If that much is agreed, then there is a case for changing the framework of financial regulation so as to reduce the extent to which this is the case.

Wednesday, December 23, 2009

Interesting readings

Tuesday, December 22, 2009

Building the perfect GST

The 13th finance commission has released the report of the task force on the GST. Here are some responses:
There are three huge and complex projects which are afoot in India today, each of which is of critical importance in transforming the landscape. They are: the Goods and Services Tax (GST), the New Pension System (NPS) and the Unique Identification (UID).

A lot of what I know about pension economics comes from David Lindeman, and he often quoted Larry Thompson in saying that such reforms involve three dimensions of effort : policy, politics and administration. Each of the three has to work out right in order to obtain success. If any one of the three goes wrong, then the overall outcome is attenuated.

With the NPS, we have made enormous progress on the politics and policy, but are weak on implementation. The GST faces political difficulties and it is not clear that the policy thinking will be done right. But the moment these early stages are crossed, the brunt of the problem will become administration. With the UID, there seems to be political support (so far), and the challenges are of making the right moves on policy and administration.

Bringing Nandan Nilekani to run UIDAI is an important step forward because it shows a recognition that the administrative challenges of these systems are unlike business-as-usual in government. These are complex IT systems, and require a new kind of execution punch in terms of rolling out complex nationwide IT systems. Similar thinking needs to be brought to bear for NPS and GST also.

Till date, the best success of a large complex system of this nature is the TIN. That was a problem which was all administration - it did not involve complex problems of politics and policy. However, it has proved a certain model of how to get this done (by contracting-out to NSDL using a certain kind of contract structure).

On large complex IT systems and their impact on India, you might like to see: Improving governance using IT systems, page 122-148 in Documenting reforms: Case studies from India, edited by S. Narayan, Macmillan India, 2006.

Update (February 2011): IT strategy for GST.

Monday, December 21, 2009

How bad was industrial production in October?

by Radhika Pandey and Rudrani Bhattacharya.

This appeared in Financial Express today.

In India, many people look at year-on-year changes to track the state of the economy. This indicator has important weaknesses. It is the moving average of the change seen in the latest twelve months and is hence a sluggish indicator of the changes in the economy. In order to monitor current developments in the economy, it is preferable to look at month-on-month changes.

However, month on month changes are distorted by seasonal fluctuation. The solution lies in seasonal adjustment. The seasonally adjusted month on month changes provide more timely information about the state of the economy. Internationally, the standard procedure for examining and monitoring economic series uses seasonal adjustment.

The figure shows the familiar time-series of year-on-year growth of IIP. This shows that output in October 2009 was 10.3% bigger than the level of October 2008. This seems reassuring.

Far more informative is the time-series of month-on-month changes. Each of these values is the annualised month-on-month change in the seasonally adjusted IIP. The term applied is `SAAR change' which stands for the Seasonally Adjusted Annualised Rate of change. This shows an unhappy value of -5.12% for October 2009 (when compared with September 2009). The key strength of this approach is that we are discussing the change from September 2009 to October 2009, instead of the 12 changes from October 2008 till October 2009.

Is the picture so dismal? To answer this, we need to look into the non-economic factors which might influence this number. October 2009 was a month of festivities with fewer working day but enhanced purchases prior to Diwali. At the same time, Diwali does not occur in a fixed month every year. Hence, the simplest seasonal adjustment procedures will not remove these effects.

In the jargon of seasonal adjustment, Diwali is a `moving holiday'. It requires special care in seasonal adjustment. Hence, in our work on seasonal adjustment, we test for the impact of moving holidays such as Diwali and Id, and when these effects are statistically significant, we adjust for them. Through this procedure, we find that SAAR for IIP for October 2009 works out to +0.12%. In other words, correcting for Diwali yields a change from an estimate of -5.12% SAAR for October 2009 to an estimate of +0.12% SAAR.

The figure superposes the two time-series of SAAR IIP (without adjusting for Diwali) and SAAR IIP (with adjustment for Diwali). In most months, the two series are obviously identical. But in some months, the interpretation of the IIP data strongly requires care in treatment of Diwali as a moving holiday.

Many analysts warned about reading too much into the weak October 2009 IIP performance, on the grounds of a Diwali effect. We go from this broad but unspecific caution to a precise estimate of what happened to overall IIP and IIP-consumer goods in October 2009 when compared with September 2009, after adjusting for seasonality and Diwali. The result is a gloomy value of 0.12% SAAR for IIP in October 2009.

The biggest impact is visible on the IIP-consumer goods (figure above) which shows a pleasant value of 7.01% SAAR after the Diwali adjustment, while without this adjustment, there is a worrisome SAAR value of -25.07%.

The calculations reported here are updated every Monday at on the world wide web. For all series, Diwali effect testing is done, and wherever the impact is statistically significant, it is adjusted for. It proves to be significant for IIP, IIP (Manufacturing) and IIP (Consumer goods).

Sunday, December 20, 2009

The trading hours controversy

Shifting away from central planning


Traditionally, Indian socialism has involved government control of all aspects of financial products or processes. As an example, government specified the time of day at which trading starts and the time of day where it stops. The RBI committee process on currency futures and interest rate futures specified that trading must start at 9 AM and stop at 5 PM.

In most areas of the Indian economy, goverment no longer controls the economy in such fashion. The government does not specify what time a shop opens or closes. There was a time when the Indian government did not permit the use of aluminium for making cans of soft drinks. A large fraction of such meddling in the economy has been dismantled (though not in finance).

A few weeks ago, SEBI came out with a liberalised policy: Exchanges could open anytime afer 9 AM and stop trading anytime before 5 PM. If NSE or BSE opt for longer hours, securities firms will face the decision about the time at which the shop opens for business and the time at which it closes. Staying open longer will involve somewhat higher costs and in return will yield somewhat higher revenues. Each shop will make its own decision about choosing a starting and a closing time.


What do we gain?


If Indian markets to be open from 9 AM to 9 PM, there are two benefits. First, consumers should have maximal choice on when they can achieve their trading needs. Recall that internationally, many grocery stores choose to stay open for 24 hours a day.

Second, in the late evening in India, the ADR market opens in the US, and it is important to link up the closing Indian prices to the opening US prices.


How will exchanges and their members cope?


If securities firms have to stay open for 12 hours a day, this will require process modification, including multiple shifts for certain employees.

These changes might seem burdensome. But similar changes have taken place before. With floor trading at the BSE, trading only lasted for two hours a day; but when NSE came along, trading moved up to 5.5 hours a day. Members doing commodity trading are already running to almost midnight.

Securities firms and exchanges will need to change their process design to achieve longer hours. If a securities firm has to trade from 9 to 9, this will require two shifts. The first shift will probably come to work at 8 AM, and stay till 3 PM, while a second shift will probably come to work at 3 PM and stay till 10 PM. Some firms will find that this does not make sense for them and they will choose to only keep their shop open for shorter hours.

The operation of securities markets in India is held back by infirmities of the payment system. A shift to longer trading hours will encounter frictions owing to problems with payments.

At first, clumsy solutions will be found because of problems of the payments system. But at the same time, when the industry demands more from the payments system, we set ourselves on the course for deeper surgery of the payments system. In this 21st century, we can and should have a payments system which processes 100,000 messages per second and runs for 24 hours a day. When the industry complains enough about the infirmities of what is in place, the existing payments system will be questioned, which could ultimately lead to improvements in the payments infrastructure.


A messy situation?

NSE and BSE have gone through a series of announcements. First, BSE said they would start at 9:45. Then NSE said they would start at 9 AM. Then both said they would think about this after the holidays.

These activities seem messy and confusing in the public eye. These tactical details are an inherent part of the market economy. When government control is withdrawn, and a license-permit raj is scaled down, we go from a tranquil and stable environment -- the silence of a graveyard -- to a dynamic environment where firms are thinking and reacting. This should be welcome.


Doing more on moving away from central planning


SEBI needs to move forward on many fronts in terms of getting away from government control of product features. There is no reason to restrict exchanges to the zone from 9 to 5. Similarly, many other product features on the derivatives market need to be decontrolled: what underlyings to use, whether cash settlement or physical settlement, the expiry dates, the contract sizes, etc. Government control of these product features is as legitimate as government control over the design of a bicycle.

There is a difference between regulation and control. The role of government is to specify pollution standards for cars and to require seat belts or airbags. It is not to design cars.

An upsurge in inflation?

There is a lot of concern about inflation. Most of it is based on perusing the following numbers of the year-on-year changes in price indexes:

WPI Food
WPI fruits,vegs
True inflation in India is somewhere between the CPI-IW (which overstates the importance of food) and the WPI (which overstates the importance of tradeables and thus the exchange rate). YOY CPI changes are stubbornly above 10\%, and the yoy WPI inflation seems to have risen in each of the above three changes.

However, the year-on-year growth is the summation of the changes of the last 12 months. To get a sense of what is going on in the recent period, and to not be confused by ancient information, it is essential to look at month-on-month changes. This requires seasonal adjustment.

At, we have a program of regular release of this data, which includes month-on-month changes expressed as `seasonally adjusted annualised rates' (SAAR). This shows:

WPI Food
WPI fruits,vegs

This shows a rather different picture. We have food inflation, particularly with fruits and vegetables, given that we've just had a bad monsoon. But the overall WPI Food inflation contained one big jump in July and has slowed down after that.

The CPI(IW) gives a lot of weight to food. Hence, it showed a big value in July. After that, it has reported softer values.

The WPI itself was showing values around 10% in July and August, but gave values near 5% in September and October.

This, then, seems to be a relatively benign inflationary environment to me, particularly from the viewpoint of monetary policy. Monetary policy should not take interest in food prices in connection with a monsoon failure, because the time horizon over which monetary policy acts is long - perhaps between 9 and 18 months. By this time, conditions in WPI Food will have been reshaped by many new harvests.

Friday, December 18, 2009

Difficult times in Andhra Pradesh

Andhra Pradesh was once seen as a state with good governance by Indian standards. In recent years, the problems seen with Satyam, attempts to harass Nimesh Kampani, etc. have led many to question the quality of governance in Andhra Pradesh. Today, John Elliott has an important article in the Financial Times on the difficulties of Andhra Pradesh.

I took a look at the CMIE data on investment projects outstanding to measure the share in the investment projects at hand in India. I found that the action was strongest in state-wise data for projects which were `Announced' (and not `under implementation'). The two states with the biggest decline in the share in India were West Bengal and Andhra Pradesh:

Andhra Pradesh West Bengal
Jun '08 7.46 8.00
Sep '08 6.43 7.31
Dec '08 7.15 8.19
Mar '09 6.20 6.48
Jun '09 6.29 5.71
Sep '09 5.43 5.56

For Andhra Pradesh, the decline over this period was 2.03 percentage points and for West Bengal, the decline was 2.44 percentage points. These are the two biggest declines across all the states in this period.

All these values are a far cry from the biggest share of Andhra Pradesh ever seen -- which was 18.53% in December 2001, when Chandrababu Naidu was chief minister. For a comparison, the peak share seen for West Bengal was 8.25%, which was in March 2008, when the CPI(M) was still a part of the UPA; we can vividly see the decline from that point to 5.56% in the latest data. The full time-series for all states are here.

Tuesday, December 15, 2009

Getting to a liberal trade regime

I wrote two columns on trade liberalisation in Financial Express:
Also see:

Monday, December 14, 2009

Consequences of exposure to violence

Marginal Revolution pointed me to a paper by Edward Miguel, Sebastian Saiegh, and Shanker Satyanath (of UCB, UCSD, NYU) titled Civil war exposure and violence. Their key result is: Football players from countries which have experienced civil wars are more violent on the field (after controlling for a host of things). This supports the idea that exposure to violence coarsens human sensibilities.

The authors mention the World Values Survey, and I dug out a small table out of this about responses to the proposition: Using violence for political goals is not justified. Here is what we see for 1995:

Strongly agree
I picked Russia because they have suffered terrible violence through the combination of World War II and Communism. We see a difference in "Strongly agree" but not much of a difference in "do not agree" (i.e. the residual category).

I have often wondered about these issues in the context of India's story. In the period after the fall of the Mughal empire, many parts of India experienced extreme violence. But the last big war that was fought in India was 1858. After this, there have only been wars at the border; these wars have not brought violence and barbarism to civilians. We were incredibly lucky to have been the lab for Gandhiji's revolutionary idea, of political change without violence. So we have had 151 years without war. But the roots of India's sustained peace today lie not just in Gandhiji and the nature of the freedom movement, but deeper in history to the peace that has reigned from 1858 onwards. If anything, the puzzle in India is about how badly law and order has fared, given such benign initial conditions.

Going by the argument of Miguel et al, this sustained peace would have helped shift mores towards reduced violence. I feel that when peace is established, and for many generations the incentives guide young men towards participating in the market economy, this exerts a civilising force.

The great bursts of violence that we have had have been like Partition (1947), Delhi (1984), Punjab (1984-1990) and Gujarat (2002). (I'm curious: What other big episodes would you classify alongside these?) Each of these would scar an entire generation near that location. Time heals, but the clock takes 25 years after one such episode of large-scale violence. Part of what has worked better for South India is that there has been less violence there all the way from 1858 onwards.

This perspective tells us something about places like Iraq or Afghanistan or Pakistan. It is not enough to bring about peace; what is of critical importance is to have sustained decades under conditions of peace. This would yield the incidence of non-violent behaviour and trust capital which might help in graduating to the double helix of capitalism and freedom.

Tuesday, December 01, 2009

Interesting readings

  • T. N. Ninan in Business Standard on the decline of Bombay. I think of the establishment of ISB in Hyderabad as an important lost opportunity, and a prominent contribution of the Shiv Sena to India's backwardness. ISB near Hyderabad is an impressive achievement, but it's a shadow of what it would be if it were on the outskirts of Bombay.
  • G. N. Bajpai, Mr. Bhave's predecessor's predecessor, argues in favour of legislation that defines the role of HLCC and makes it more effective. (This was an opinion piece in the Economic Times).
  • Replace EPFO with NPS by Dhirendra Kumar.
  • Writing in Financial Express, Ramkishen Rajan worries about the analytical foundations of the supposed hierarchy of desirability of various types of capital flows.
  • Viral Acharya in Financial Express.
  • In India, the phrase `industrial policy' is considered acceptable in polite company, while in the international discourse, people get embarassed when they propose it. Michael Boskin has a column on the return of industrial policy from its grave.
  • Roger Bate, writing in The American is skeptical about the possibilities for the Indian drugs industry.
  • A 1000 word precis summarising what we know about economic development, by Daren Acemoglu. Also see this piece by Lisa Chauvet and Paul Collier on voxEU.
  • A paean to Timothy Geithner, by David Brooks, in the New York Times.
  • The open source approach to maps: See this and this. You might like to see my blog post and FE article on the subject of map databases in India.
  • David Edmonds has a great story about Levon Aronian, the man who aspires to unseat Vishwanathan Anand from the world #1 slot, and the remarkable place of chess in Armenia.