## Sunday, December 23, 2012

### Law and order: How to go from outrage to action

There is fresh rage on the bad state of law and order in India today. That rage is entirely appropriate.

My father was born in 1926 and experienced British rule. One of the high points of his life was participation in the freedom movement. He used to say to me with great regret that under British rule, the Shiv Sena would have never arisen. What has happened in India is a disgrace.

The interesting and important question is: How can the problems be solved?

Moral outrage does not lend itself to good policy analysis. As with the problem of corruption, the problem of law and order requires sophisticated thinking. Just as the young people who got enamoured by Baba Ramdev and Baba Hazare got nothing done in terms of combating corruption, we should worry about what comes next on law and order. Anger and outrage, coupled with low knowledge of political science and public economics, is a sure path to poor policy analysis. What matters is shifting from anger to analysis to action.

As an example, if laws are modified to prescribe draconian penalties for rape, then rapists are more likely to kill the victim. What is required is better quality implementation of the existing law.

What would it take to make the police and courts work better? The three ingredients that are required are incentives for politicians, resources and feedback loops.

### Incentives for politicans

The first issue is incentives for politicians. Politicians will deliver law and order if they think that this is what will get them re-elected. From Indira Gandhi's time onwards, politicians in India have felt that the way to win elections was to focus on welfare programs for the poor. As long as this is the case, the narrative that will dominate the Indian State is that of poverty, inequality, and welfare programs.

Economists distinguish between public goods and private goods. Public goods are defined to be those that are non-rival' (your consumption of safety does not reduce my consumption of safety) and non-excludable' (it is impossible to exclude a new born child from the environment of safety). The legitimate purpose of the State is to pursue public goods. All citizens gain from public goods, and all voters should respond to these benefits. The first and most important public good is safety, which requires building the army, the police and the courts.

The Indian State has, instead, gone off on the adventure of building welfare programs: of government giving private goods to marginal voters. The first priority of the Indian State is the themes of poverty, inequality and welfare programs. Politicians need to learn that this hurts. Sheila Dixit should realise that her top priority in Delhi is law and order.

There are undoubtedly problems in the leadership and management structure of the police. I believe that once politicians want law and order, this will drive them to recruit the leadership that is required, and undertake structural reforms, so as to get results. As an example, look at how the politicians broke with PWD and setup NHAI, or setup Delhi Metro. The question that matters is : Do politicians want law and order? From the 1960s onwards, the minds of politicians have been addled by welfare programs.

If Rs.X is spent as a gift on a few marginal voters, it makes a certain difference to winning elections. If that same money is spent on public goods -- e.g. better safety for all -- it should make a bigger difference to winning elections since more voters gain. The question is: Do politicans see this and act in response?

### Resources

The second issue is resources. India needs much more staffing in the police and the courts. This includes both technical staff (e.g. constables and judges) and support staff (e.g. clerical staff, operators of computer systems, etc).

Courts and police stations need to be high quality workplaces with air conditioning, computer systems, modern office equipment, canteens, web interfaces to the citizenry, lighting, toilets, and such like.

Policemen need to live in high quality housing. If policemen live in high quality housing and work in high quality offices, they will be more civilised both in terms of the quality of intake and in terms of how their behaviour evolves on the job. This will cost a lot of money. The State in India has very little money. To improve the police and courts will require cutting back on welfare programs.

As Robert Kaplan says, underdevelopment is where the police are more dangerous than the criminals. One element of this is the biases in recruitment. As an example, the police in Bombay tends to be male Maharashtraian and relatively low skill. This needs to evolve into a more sophisticated workforce, with gender, ethnic and religious diversity that reflects the cosmopolitan structure of the populace.

At present, in India, spending on police and courts (which are core public goods) is classified as non-plan expenditure' and is treated as a bad thing. Spending on private goods like welfare programs is classified as plan expenditure' and grows lavishly year after year. In the UPA period, plan expenditure has gone up by four times in 10 years. These priorities need to be reversed.

The other critical resource, other than money, is top management time. The simple question that I would ask Sheila Dixit or Manmohan Singh is: What fraction of your time do you devote to public goods? My fear is that the bulk of their time is spent worrying about welfare programs. When the top management is not focused on law and order, safety will degrade.

The lack of safety is a regressive tax: it hits the poor more than the rich. The rich are able to insulate themselves at a lower cost. When a policeman faces me on the street, he immediately speaks to me in a certain way once he sees that I come from the elite. Poor people are mistreated by both criminals and the police. Through this, the number of votes that should be affected by improved law and order is large. The people who care deeply about the poor, and would like to focus the Indian State upon problems of inequality and poverty, should ponder the consequences of what they have wrought.

### Feedback loops

In order to think about law and order, we need measurement. I used to think that the murder rate is high quality data. Over recent years, I have come to believe that in many parts of India, not all murder is reported to the police. In this case, we are at ground zero about the state of crime: we know nothing about how much crime is taking place out there.

What you measure is what you can manage. I had recently written a blog post about health, and the same issues apply here. Our first priority should be to setup crime victimisation surveys [link].

The most important outcome that I think matters is a question asked in a household survey of parents: Are you comfortable when your teenage daughter is out alone at 11 PM? That's it. That's the end goal. Civilisation is where parents are comfortable when their teenage daughters are out alone at 11 PM.

Once the CPI is measured, and measured well, RBI can be held accountable for delivering low and stable inflation. In similar fashion, the Bombay police can be held accountable once we get a graph updated every month about the crime rate in Bombay, supplemented by quarterly data from crime victimisation surveys. This would generate feedback loops whereby we can judge whether Sheila Dixit has improved law and order in Delhi on her watch.

When Sheila Dixit gets anxious about the lack of progress on publicly visible statistics about the state of law and order in Delhi, she will have the incentives to recruit high quality leadership for the Delhi police, and to resource them adequately, to get things done.

### Why are these good things not getting done?

This is the hardest question. I have three opinions about what has been going wrong.

The first lies in the incentives of politicans. Why do politicians pursue private goods for a few when they can instead spend money on doing public goods that benefit all? Why does democracy not push Indian politicans towards the centre? I think one element of the answer lies in first-past-the-post elections.

Today in India, winning elections does not require pleasing all voters; it only requires a base of 30% of the voters. This gives politicans a greater incentive to dole out goodies for the 30% and not work on public goods that please all voters. This reduces the prioritisation for public goods.

The second issue is that of urban governance. The defining challenge for India today is to make the cities work. But our constitutional structure is confused on the location of cities versus states. The feedback loop from the voters in Bombay do not drive improvements in governance in Bombay.
Delhi is unique in this respect in that it's the first city of India where the basic structure is correct. Sheila Dixit is the Mayor of Delhi. She is held accountable for making voters in Delhi happy. Voters in Delhi bother to vote in the Delhi elections. Hence, I am far more optimistic about the future of Delhi than I am with Bombay.

The third issue lies in the intelligensia. Western NGOs, aid agencies and the World Bank are focused on inequality, poverty and welfare programs. This generates incentives for individuals to focus on inequality, poverty and welfare programs, owing to the funding stream and career paths associated with western NGOs, aid agencies and the World Bank. These large funding sources and career paths have generated a distorted perspective in the Indian intelligensia. We need more minds in India who think in terms of first principles economics and political science, without the distortions that come from the worldview of development economics.

We blame politicians in India for being focused on welfare programs. But to some extent, they are influenced by the intelligensia. It is the job of the intelligensia to hold their feet in the fire, and hold politicians accountable for public goods. The politicians were too happy when, from the 1960s, the intellecturals proposed welfare programs, poverty action, socialism, etc.

## Friday, December 21, 2012

### Next big development in the global market for the rupee

The next interesting development after ICE trading of rupee futures: CME will launch rupee futures soon also. See CME follows ICE into rupee futures by Tom Osborn on Financial News.

ICE and CME are the world's top exchanges and they are serious rivals for the global rupee market. These recent developments add up to a substantial change in the outlook for the rupee as an internationally traded currency. The rupee will become more prominent as a globally traded and liquid market. And, ICE and CME are likely to do well, thus accelerating the decline of the onshore market.

## Thursday, December 20, 2012

### Trade misinvoicing as a channel for capital account openness

A recent literature has explored the effectiveness of capital controls (Klein, 2012, Yothin, Noy and Zheng, 2012, Patnaik and Shah, 2012). In a recent paper on trade flows, we find that unofficial capital flows through the channel of trade misinvoicing are an additional mechanism through which the effectiveness of capital controls is eroded.

In the 1970s and 80s, when the literature first identified capital flight through trade misinvoicing, many countries had significant restrictions on trade. Aizenman (2004) showed that in countries that have capital account restrictions, greater trade integration creates greater opportunities to shift capital through trade misinvoicing.

In a recent paper (Patnaik, Sen Gupta and Shah, 2012), we find that de jure capital account restrictions are correlated with higher levels of trade misinvoicing. After controlling for factors such as macroeconomic stability, corruption, currency overvaluation, and political instability, the openness of the capital account influences trade misinvoicing. For each increase in the Chinn-Ito index of de jure capital controls by 0.1, export misinvoicing goes up by 0.8 to 1.3 percent of exports. On the landing page above, we have released the full dataset so as to facilitate replication and downstream research.

Based on this evidence, trade misinvoicing should be viewed as a channel for de facto capital account openness. Over the 1980--2005 period, the average extent of misinvoicing-induced capital flows in developing countries works out to roughly 7.6 percent of GDP. This is a substantial number when compared with the objectives of macroeconomic policy.

The traditional literature on trade misinvoicing has focused on two broad motivations for misinvoicing. First, it emphasised high customs duties. When firms face high rates of customs duties, or VAT on imports, they have an incentive to understate the true value of imports. Second, misinvoicing was viewed as a method for achieving capital flight, which was, in turn, motivated by fears of expropriation alongside unsound economic policy and political instability.

An overvalued exchange rate, and high inflation, gives expectations of depreciation in the near future and stimulates capital flight. Research on the determinants of the large outflows of capital from Latin American countries in 1980s and Asian economies in late 1990s has identified explanatory variables such as macroeconomic instability, large budget deficits, low growth rates and the spread between foreign and domestic interest rates. These factors, as well as others such as corruption, political freedom, and accountability were significant in explaining capital flight from sub Saharan Africa.

By the logic of this traditional literature, when countries like India and China achieved high GDP growth and cut customs duties sharply, the motivation for misinvoicing should have subsided. We find that by and large, such a decline in misinvoicing is not visible. Hence, we pursue a new explanation: that misinvoicing is a tool for evading capital controls.

### Conventional estimates are likely to understate the phenomenon

The magnitude of trade misinvoicing is conventionally estimated by juxtaposing trade data from the importing and the exporting country. A firm interested in moving capital out of a country would underinvoice its exports, thus bringing reduced foreign exchange into the country. Similarly, overinvoicing of imports would allow the domestic importer to gain access to greater foreign exchange than required. Both these mechanisms leave domestic firms in control of hard currency assets overseas. Underinvoicing of imports, on the other hand, can result from an attempt to evade taxes on imports including customs duties and the Value Added Tax (VAT) on imports. These calculations are likely to understate the scale of misinvoicing on the current account for three reasons:

1. The overall misinvoicing of imports that is computed using macroeconomic data reflects a certain cancelling out between some firms who are engaged in underinvoicing of imports and other firms who are engaged in overinvoicing of imports. Similar considerations apply with misinvoicing of exports. To the extent that firms have heterogeneous goals, the measured misinvoicing is likely to understate the true scale of gross capital flows being achieved through misinvoicing in an economy.
2. Services trade offers substantial opportunities for misinvoicing given the lack of market benchmark prices for many services such as customised software. Many elements of services trade are not in conventional trade databases.
3. Intra-MNC trade offers opportunities for misinvoicing that would not be captured in our methodology. When the importer and the exporter are one firm, there will be no discrepancy in the data, even if the value of a product is overstated or understated.

For these three reasons, conventional trade misinvoicing measures may understate the true extent of misinvoicing.

### Conclusion and implications

The evidence on misinvoicing suggests that studies on the effectiveness of capital controls should also take into account unofficial flows through the trade account as these may be further eroding the effectiveness of capital controls. For example, there is interest in the extent of capital flight from China. While capital flight through official channels can be observed directly on the capital account of the balance of payments, significant capital flight might take place through the current account. Since the trade account for China is large, it provides a channel for capital movements. The discussion on whether there is capital flight from China cannot be settled without an analysis of its trade account.

It is sometimes argued that developing countries should open the trade account but not the capital account. This evidence suggests that once trade openness is achieved, a substantial element of de facto capital openness follows.

## Tuesday, December 18, 2012

### 10th Conference of the NIPFP-DEA Research Program

As part of the NIPFP-DEA Research Program, we have been running a conference series in the fields of macroeconomics and finance. The 10th of these conferences was a joint effort with Journal of International Money and Finance: a subset of the papers will appear as a special issue on the Macroeconomic and financial policy challenges of China and India. The materials of the conference are up on the website.

## Friday, December 14, 2012

Ruminating over The Republic by Plato is the first step to thinking about politics and the State, and many angry young men that try to think about India do wrong by skimping on their intellectual foundations. Saugato Datta in Mint worries about similar problems in the domain of economics.

Ila Patnaik analyses the two kinds of criticisms of Aadhaar: (a) That a lot of money is being spent and this expenditure isn't justified and (b) That building Aadhaar will threaten civil liberties in India.

Trampling on the individual in India: Five ways Indian Internet users are fighting for free speech by Sruthi Gottipati on the India Ink blog on the New York Times website. Sec 66A: Curbs on free speech are part of Nehru family legacy by R. Vaidyanathan on FirstPost.

In thinking about Why is solving India's inflation crisis important?, see Does Inflation Harm Corporate Investment? Empirical Evidence from OECD Countries by Piotr Cizkowicz and Andrzej Rzonca.

Vivek Kaul has an excellent article in FirstPost about India's problems with ponzi schemes. Also see: Buying respectability. Ponzi schemes are one of the many consequences of the badly structured laws in Indian finance. We have created silos such as securities and banking, and existing agencies can wash their hands off what is going outside their jagirdari. The legal foundations must change in the ways proposed by FSLRC

In an interview with Akshai Jain on Tehelka, Arvind Panagariya says he isn't convinced the Indian child malnutrition data is horribly out of line.

Ila Patnaik on the role of FDI in non-tradeables as a essential element of competition policy, analogous to what trade does for tradeables.

Lant Pritchett and Shrayana Bhattacharya in the Indian Express on what cash transfers can do and what they cannot.

Evgeny Morozov has an amazingly well written article in the New Republic about new-age superficiality. Notes to self: One day I'm going to write such a hatchet job about a management guru or such like.

Joseph Sternberg has a great article on the things that went wrong when Bangladesh attempted industrial policy.

David Pogue of the New York Times is impressed at the new Samsung Chromebook . Hmm, \$250 is Rs.13,000 for a laptop that's 1.1 kg, it is nice.

Tunisia, Libya, Egypt, Syria?, and after that Lebanon?.

## Thursday, December 06, 2012

### International financial centres: Peering into the future

I did the SIGFIRM Quarterly Lecture at the University of California in Santa Cruz recently:

Also see: Mumbai as an International Financial Centre, a project led by Percy Mistry.

You may like to subscribe to the NIPFP MF channel on youtube.

## Tuesday, December 04, 2012

### The problems of the economics profession

Ronald Coase has an interesting new piece titled Saving economics from the economics profession. You may like to see What is wrong with Economics on this blog.

Last week, in the US, I heard that the number of Ph.D. graduates coming out vastly exceeds the number of academic job openings. Most economics Ph.Ds. are going to end up in non-academic jobs. In fields like Physics, the basic arithmetic became clear early on. Each academic in a research university produces 12 Ph.D. students, on average, over his or her life. In steady state, 11 of them have to go into non-academic lives. For some time, in Economics, this phenomenon was masked by the rise of business schools and schools of government, which recruited a lot of economists. With that transition largely behind us, the simple logic of 1-in-12 comes back to hit us.

I feel the profession is not doing enough to prepare the 11-of-12 economics Ph.D. students for a life in the real world. I am a sunny optimist on the importance of economics in the real world. Whether it is Google or a hedge fund or a consulting firm: I think a good economist has a lot to say. But what we do to Ph.D. students is pretty bad. The skills required to succeed in academic economics seem to be precisely unlike the skills required to engage with the world. I feel that fairness to the students requires turning this upside down. We should be primarily training Ph.D. students to gear up to be useful in the real world, for only a tiny fraction of them will go back into academics.

Academic economics in India suffers from one additional layer of trouble: the legacy of development economics. India has moved on. Only 15% of Indian GDP is agriculture; the labour force is moving away from agriculture; only 20% of India is below the poverty line. This implies that development economics is of little use in thinking about India. Whether it is P. Chidambaram or Mukesh Ambani, the decision makers of India are not too interested in development economics.

The early days of physics shows us a nice three-step story. First, the datasets fell into place, with Tycho Brahe. Then came the empirical regularities, with Kepler. Once Kepler's laws were firmly established as hard facts of the data, you could curiously ask: Why might this be the case? And this gave us theory, in the hands of Newton. In economics, and particularly with economics in India, we are struggling with the first phase. We barely observe the economy.

When the physicists did not observe the world, the frontier lay in observation (Tycho Brahe), and not in the guys doing angels on pinheads. But in economics, in the early years, in the absence of data, the field got dominated by mathematicians analysing artificial worlds, the bulk of which was angels on pinheads exercises. Instead of looking at the world, we looked at blackboards and made up assumptions. Research papers got written by looking at other research papers, rather than looking at the world.

I am optimistic about where we will go from here, for the computer revolution is finally giving us datasets where there is high quality observation of the economy. E.g. retail stores are capturing scanner code data, financial exchanges see every order, massive databases of census or tax authorities are being prised open, google trends data is available, satellites measure illumination at night and give us estimates for the GDP of each square kilometre of the country every night, etc. The future of economics lies in data science. Just as astronomers are drowning in the data coming out of telescopes, we in economics will shake our heads in wonder, as we find our way around immense treasures of large datasets of high quality.

Yet, at present, most economists and economics Ph.D. students are focused on theory, or the old perspective where economics is seen as a part of axiomatic mathematics and not as an observational science. For most people in economics, there is a certain willingness to accept bad data and bad econometrics since all this is (in any case) just an excuse to get on with the thing that really matters, the model. Matters are made worse, in India, by the typical Western referee who does not ask questions about data quality. This gives the economist in India zero incentive to be careful about measurement, and gives us an equilibrium replete with garbage-in-garbage-out.

I don't want to overstate the problem. Things have changed enormously when compared with the 1970s and 1980s, when economics was almost entirely dominated by theory. Today, the most important work in the profession is applied. Applied papers get more citations. The ship is turning. But as Ronald Coase is saying, it's still far from where it needs to be.

Academic economics is a self-sustaining system, on the strength of the tuition fees paid by a large number of undergraduates who register for these course. There is relatively little pressure to change. The impetus for change will come from four directions:

1. While wages for a small number of the superstars of the profession are sky high, most academic economists are not paid that well and are not experiencing real wage growth. This gives an incentive for some to engage with the world through consulting. Their work will matter.
2. As Larry Summers has emphasised, a strength of the business school and the school of government (and the think tank) is that they engage with reality. They have incentives to look at the field with new eyes. The work done in these places will matter.
3. The 11 of 12 freshly minted Ph.D.s who show up in the real world and puzzle over it matter a great deal. For the vast majority of them, the Economics Ph.D. will recede in their minds like a bad dream. A small fraction of them will do stuff that matters.
4. The people with skills in data science will do unexpectedly cool things with the new datasets where we observe the economy. This stuff will matter.