## Monday, June 29, 2009

### A nuclear weapon going off in your city centre

On 13 December 2001, there was a terrorist attack on the Indian Parliament. In the following days, there was a dramatic escalation of tension, complete with nuclear sabre-rattling.

I was in North Block at the time. I could not help think that my GPS coordinates were on the shortlist of any plan for nuclear attack against India. Vaporisation is not that bad, once you get to think about it, but one does think about it.

I tried to look at the fledgling Nifty options market, to see whether there was something one could read in the implied volatility. Then I started thinking that nuclear war is a unique problem on the options market. There are really two kinds of players in this situation. The first is a person in Bombay/Delhi who expects to be vaporised in the event of nuclear war. For him, it's efficient to sell protection, getting cash for free while he's around with no cash outgo if things go wrong (thanks to vaporisation). This should generate a lot of supply of protection and generate apparently low implied vols. Then there are investors at a safe distance -- e.g. foreign investors -- who might like to buy options as protection. But they'd have to worry about whether NSCC would remain aloft across the nuclear war; though they would expect that the Indian government would ensure that NSCC would not default at a time like this. So if nuclear war was a serious threat, options would be cheap but foreign buyers would be skittish about credit risk.

It was interesting, thinking of the tree of states of nature and option payoffs, some of them labelled vaporisation', asking how to back out the probability of nuclear war from this information. Some of these thoughts came back to me today, when I saw this talk by Irwin Redlener. His big idea is that during the cold war, civil defence countermeasures against nuclear war were irrelevant, since nuclear war between superpowers would torch the sky and there would be no life on earth after that. But the genuine nuclear threats that we face today, such as a few Indian cities being targets, are qualitatively different. Civil defence countermeasures can help greatly reduce the toll, and there is something to live for because these small scale nuclear explosions do not imply the end of life on earth. He argues that modest efforts to prepare for this scenario could save a half million lives in the scenario of a modest 10 MT nuclear weapon targeted at a major city centre.

## Sunday, June 28, 2009

### Hedging using derivatives

There is a fascinating article in The Economist about how the world of derivatives has shaped up through the crisis.

I often encounter misconceptions about hedging. The one line that summarises the issue is this: The job of a hedging strategy is to combat extraneous economic exposure. Let me focus on currency exposure as an example, though the basic idea works in all aspects of hedging. A good currency hedge is one which neutralises the effect of currency fluctuations on the NPV of profit.

I have seen four major mistakes in the way people think about hedging:

1. Hedging seen as a way of eliminating currency risk in the translation of direct import/export proceeds. This is wrong because it's an incomplete picture of what happens to the profits of a company when the currency moves. A lot of finance practitioners are confused on this subject, particularly in India where RBI rules have had mistakes on these things for decades. (While RBI staff made mistakes, that was no reason for currency hedging consultants and such like to also make the same mistakes).
2. Hedging seen as a profit centre. This is wrong because the job of hedging is to eliminate exposure of the NPV of profit, not to make money. Suppose a company embarks on a currency hedging program. Half the time (ex-post) the hedge will appear to have made money and half the time (ex-post) the hedge will appear to have lost money. For a company which has very big currency exposure, ex-post, half the time there will be massive cash losses on the currency hedge. If top managers, directors or regulators do not understand this correctly, it's easy to jump into complaints about massive losses on derivatives trading'. This emphasises the importance of seeing a hedging strategy and the economic exposure in an encompassing way. A person who closes out one element of an overall hedging strategy because that's generated a lot of cash outflow in recent days is, well, wrong.
3. Hedging away the core sources of profit. A refinery is a bet on the crack spread', the gap between the price of crude oil and the price of petroleum products. The shareholder and owners of a refinery are inexorably speculators on the crack spread. If you don't believe that this spread will do well, don't build a refinery. For a refinery, this is core business risk, this is the source of profit. It is not an extraneous economic exposure. To try to hedge away this exposure is not correct.
4. Insecurities about imperfect hedges. Every now and then, a bright person complains that a proposed hedge has a substantial basis risk. The only perfect hedge is found in a Japanese garden. All realworld hedges are imperfect. The useful question is: Is an imperfect hedge better than no hedging?

The Economist article points out that with the upsurge in volatility, demand for derivatives has gone up, not down. Once most large firms of the world start doing balance-sheet scale hedging, derivatives positions will be much larger than they are today. The world needs bigger, not smaller, derivatives markets. We stumbled on our way to that world, and now have to figure out once again how we are going to get there.

In the world of OTC derivatives, firms face credit risk owing to contracts with banks and banks face credit risk owing to contracts with firms. In the good old days, these risks were mostly ignored, and OTC derivatives looked more attractive than exchange-traded derivatives (where posting collateral is unavoidable). Now, both sides are getting wary about what this involves. Banks have started charging higher prices for bearing this risk (either though a bigger price or through collateral requirement), and banks have started refusing to have exposures against certain firms. Both these phenomena should enlarge the footprint of exchange traded derivatives. All this flows logically but it was interesting seeing descriptions in the article about things actually shaping up this way.

### Diamonds and MIFC

Pallavi Aiyar has an article in Business Standard on Indian entrepreneuers and the Antwerp diamond trade. You might like to also see this. She ends the piece on an MIFC theme saying:

Many within Antwerp's Indian community share this prognosis. "In Israel, Muslims are not welcome, in Dubai, Westerners don't always have an easy time, in Hong Kong, it's primarily the Chinese, and in Mumbai, it's Indians," says Mihir Shah of Jayam NV. "India is simply not so open for foreigners to come and work and this is something essential to the diamond business."

Its lack of multiculturalism is not the only obstacle to the success of Mumbai's bid to replace Antwerp. It is also plagued by lax security, sluggish bureaucracy, lengthy red tape, in addition to lacking the infrastructure, physical and financial, to support the international diamond trade. The Bharat Diamond Bourse project, intended as a one-stop shop and dedicated custom house for the trade, has taken almost two decades to complete. Value added tax has to be paid - only to be returned, although only after the government has held on to it for a while. "In Mumbai, you still have to pay octroi, and it isn't possible to import or export goods on consignment," complains Jayam's Shah.

Antwerp's Gujarati traders are quick to voice their appreciation of a slew of helpful policies the Indian government has implemented in recent years, including the removal of duties on the import of polished diamonds. But when asked about Mumbai's prospects as a leading hub in the business, they smile uncomfortably and shake their heads.

While on the subject of Bombay, see Aakar Patel on how Bombay happened, and on Surat.

## Thursday, June 25, 2009

### Wages in banking

Early in the financial crisis, Raghuram Rajan put compensation issues into the centre of thinking about what has gone wrong. In recent weeks, in India, this dimension has come to life. P. Vaidyanathan Iyer had a story in Indian Express saying that RBI had blocked the compensation packages of the CEOs of three private banks: ING Vysya Bank, Axis Bank and Development Credit Bank. Something similar might be taking place with HDFC Bank also.

See Anita Bhoir in Mint on CEO compensation of private banks in India. In the case of Axis Bank, the compensation of the outgoing CEO (P. J. Nayak) in 2007-08 was Rs. 1.5 crore. This is a firm with a market value of Rs.25,000 crore today, which reported a net profit of Rs.1041 crore in that year. I would also reckon that of all Indian banks, Axis Bank is a cut apart in terms of the corporate governance culture, and the say that the outside board members have in the affairs of the firm.

I have an article in Financial Express today, where I say that concerns about ownership, governance and compensation are important components of the regulatory process in finance. But what is needed is a sophisticated analysis of the incentives that these three elements (in combination) induce. This requires a subtle understanding of economics and incentives. An approach of merely blocking high wages is one of giving in to the populist politics of envy. Conversely, improving compensation structures of PSUs requires not just shifting to a higher level of wages under an old-style wage formula, but a full rethink of the incentive implications of a wage formula.

See Alex Edmans and Xavier Gabaix on voxEU on designing the right mechanism for executive compensation, and we get a flavour of the kind of subtlety that RBI needs to bring into this. And, read Martin Wolf on the deeper problems of banking.

Also see: statement by Timothy Geithner on compensation on 10 June, a debate between Gary Becker and Richard Posner, and a blog post by Jayanth Varma.

## Wednesday, June 24, 2009

### Addressing shortages of human capital in India

High end skills in India are in short supply in most areas, whether we think about university professors or financial regulators. One element of addressing these shortages is to recruit globally. I just saw the following news:

Adam Posen has been appointed an External Member of the Bank of England's Monetary Policy Committee (MPC) for a three-year term beginning September 1. The MPC, akin to the Federal Reserve Board of Governors in the United States, is the Bank of England's interest-rate setting body. Dr. Posen, a US citizen, was selected for the position through an open competitive process for external appointments, ahead of 49 other applicants from the United Kingdom and around the world.

1. Sunil Jain in Business Standard on building highways.
2. Gautam Bhardwaj in Business Standard on the New Pension System. Also see him in Economic Times on related issues.
3. Gautam Chikermane has an important piece in Hindustan Times on financial sector reforms in the area of insurance. Also see Monika Halan on this in Mint.
4. Ila Patnaik in Financial Express on the Goods and Services Tax.
5. The first action in financial sector reforms that's come from RBI in 2009.
6. Read Yashwant Sinha and Pratap Bhanu Mehta on the BJP's predicament.
8. Mahesh Vyas uses the CMIE Capex database to talk about what is going wrong with SEZs, in Business Standard. BS followed up with an edit on this subject.
9. Ila Patnaik in Financial Express on the revival of capital inflows into India.
10. Watch this video of a talk by Larry Summers.

## Tuesday, June 23, 2009

### The Internet changes everything: Economist in India edition

A few days ago I wrote a blog post about fears of inflation in the US and the UK in the wake of unconventional monetary policy and unusual fiscal policy. This got widely noticed thanks to links from RGE Monitor and Economists View. Today I ran a google search for the exact title and it shows 1,120 links to it (and google hasn't yet noticed Economists View). This shows a much bigger distribution of this content than the 3,200 odd people subscribing to this feed. Before the Internet, it was much harder for an economist in India to be part of the contemporary global discourse in this fashion.

### Measuring the consequences for developing countries, of open access to the literature

In the long-standing debate on the conflict between copyright-protected journals and open science, one unique dimension is the consequence of closed journals for knowledge in developing countries. Writing on voxeu, Patrick Gaule and Nicolas Maystre say:

Nonetheless, there is a problem of access to the scientific literature in developing countries. In Gaule (2009), we find, controlling for the quality and field of research, that the reference lists of Indian scientists are shorter, contain fewer references to expensive journals, and contain more references to open access journals than the reference lists of Swiss scientists. This corroborates anecdotal and survey evidence documenting the difficulties of Indian scientists in accessing the scientific literature.

The goal of open access advocates to have all scientific publications freely available to the world from the day of publication of goals is laudable. But in the short run, it is more important to make scientific publications freely available for developing countries, because this is where the problem really is. A number of programmes have been set up for this purpose, including by publishers, but they are inefficient and exclude middle-income countries which are the most active in science. Thanks to new software, it is technically straightforward to grant automatic journal access to all developing country users. This solution should be widely adopted, with not-for-profit publishers taking the lead.

I have repeatedly noticed that NBER handles this better than CEPR. NBER papers are open access in India (except if you're using a Reliance wireless modem, where their IP -> location mapping is getting it wrong) while CEPR papers are closed. This is something that CEPR should review.

The fact that NBER gives open access to Indian users while CEPR does not is a source of random variation which can be utilised for measurement of the consequence of open access, through the following steps. Construct a dataset of a random selection of NBER and CEPR papers which have broadly similar citation characteristics. Find out how often papers written by authors in India cite these. The difference will measure the consequence of open access in a developing country. At some point, one might hope that CEPR will change their policy. This will make possible a Mark II of this research, where it will become possible to identify the dynamics and steady state impact of opening up access.

## Sunday, June 21, 2009

### Public libraries in India

We don't have public libraries in India to speak of. Is a library a public good? While a book is clearly rival, it seems that a library is something that's non-rival and needn't be excludable.

I was intrigued by this article by Manoj Sharma which describes the rise of for-profit libraries in India which are using the Internet well. A library is certainly excludable. He describes two firms doing this -- friendsofbooks.com and bookmeabook.com.

I tried to look at both collections and they were not that impressive. It was perhaps too much to expect them to hold certain dry non-fiction books, so I looked for fiction.

bookmeabook had no Alan Furst, no Raymond Chandler.

friendsofbooks had one book by Alan Furst, and no Raymond Chandler.

So I guess this is a way to make progress on access to books, but so far, these offerings are not impressive.

## Saturday, June 20, 2009

### Fixing financial regulation in the US

The Obama administration has unveiled a proposal for modifying financial regulation in the US. I have a piece in Financial Express today responding to this. Also see Jayanth Varma, who wrote in Financial Express yesterday on it, and Avinash Persaud on voxEU.

## Saturday, June 13, 2009

### Unconventional monetary policy

Central banks worldwide have gone into unconventional monetary policy' owing to policy rates having hit the zero interest rate bound, and owing to the difficulties in finance which have impeded the monetary policy transmission. This has involved dramatic increases in money supply, purchases by central banks of government bonds and corporate bonds, and other unconventional things.

### Unusual expansion of debt

A critical part of the global fiscal response to the downturn has been massive fiscal stimuli, particularly in the OECD. Governments worldwide have seen a sharp escalation of debt/GDP ratios in recent years, through a combination of automatic stabilisers (reduced tax revenues, and more spending on welfare programs, in a downturn) and discretionary expenditures (fiscal stimuli and financial sector problems).

The UK DMO, which issued roughly 8 billion pounds of bonds in the year it was created, moved up to issuing 225 billion pounds this year. An IMF projection suggests that by 2014, G-20 advanced countries will have added 36 percentage points of GDP to their debt compared with end-2007 levels.

### The questions

This new mountain of debt, and the dramatic enlargement of money supply, is making some people nervous. A host of questions are now back to prominence:

• Will there be an upsurge of inflation?
• Do these recent actions amount to an abandonment of inflation targeting?
• How safe is it to buy a US or a UK long bond?

The graph superposes the three-month and ten-year interest rates in the US. While the short rate has gone to zero and roughly stayed there, the long rate has risen substantially through calendar 2009, going up from 2% to 4%. Can this be interpreted as a resurgence of fears about inflation?

Direct observation of inflationary expectations by comparing the prices of inflation-indexed and nominal bonds would have given a direct reading of how the bond market feels. Unfortunately, market efficiency on the market for inflation indexed bonds in the US has broken down and this information source has been snuffed out.

There is a distinct question that engages many people, which is an evaluation of the recent developments in macro policy. Should fiscal stimuli and unconventional monetary policy have been adopted? In the present discussion, we treat these as given, and ask about what comes next. Now that we are here, how might things unfold?

### Outright default vs. inflation

The ratings agencies focus on default in the technical sense of the word. Default takes place when a government reneges on the cashflows promised on its bonds.

An equally important notion of default is unanticipated inflation. A person who bought a bond that pays $100 at a future date is short changed if, owing to unanticipated inflation, this nominal cashflow has reduced purchasing power. Unanticipated inflation is a soft option for governments faced with fiscal distress. Here is an example of an opinion piece by John Taylor in Financial Times which envisions an inflation scenario. ### Fiscal prudence vs. inflation Debt dynamics are benign in times of high GDP growth; but troublesome with low GDP growth. There is a benign scenario: Monetary and fiscal stimuli will do the trick, and GDP growth will quickly come back. Fairly large debt issuance is paid for by the increased tax revenues in a recovery. If there was confidence that (a) not doing a fiscal stimulus would yield a deep downturn and (b) doing a fiscal stimulus would considerably reduce the severity of this downturn, then a good chunk of the fiscal stimulus pays for itself. But what about a gloomy scenario? What if this is a long, shallow recession, with only an anaemic recovery? What if a fresh wave of poorly thought out over-regulation of the economy in general and finance in particular makes it hard for world GDP growth to get back to the above-4% range? Higher tax rates, required for fiscal adjustment, will increase deadweight cost and thus lower GDP growth. In this case, it's a scenario with the burden of a big debt/GDP ratio but a slow growth environment. The existing empirical evidence encourages us to expect this kind of scenario in the aftermath of a financial crisis. In that scenario, debt stability will require reduced government expenditure and higher taxation. Substantial fiscal corrections in the US and the UK will be required from 2010 onwards, assuming that the recovery commences by the end of 2009. The IMF estimates that the UK primary balance needs to improve by six percentage points of GDP, and for the US the estimate is roughly half as big. These are very large fiscal adjustments and they will be politically unpopular. Will governments bite the bullet and go down this route, or will they try to default in some fashion? In short: Will inflation in the US and the UK in 2011-2014 shape up to a scenario of 1981-84? How big is the risk to buyers of bonds in these difficult times? ### Does democracy induce an adequate check against inflation? In democracies, voters are averse to high inflation and that exerts a good check to rule out high inflation. In India, it often appears that inflation is a bigger priority for politicians than it is for the central bank, and politicians have exerted a healthy pressure in favour of lower inflation. However, from the viewpoint of the trust that a bondholder places in a long bond, even small changes in inflation - that might not bother voters so much - are material. A zero coupon bond that pays \$100 at a horizon of 30 years has a price drop from \$55 to \$41 (i.e. a drop in the bond price of 25%) if the interest rate goes up from 2% to 3%.

The most that inflation-averse voters can do is to create the enabling environment for legislation that holds central banks accountable for delivering on an inflation target. Short of this, public opinion and the processes of democracy do not, by themselves, give an adequate safeguard against small' movements in inflation from 2% to 3% that the public might not mind so much.

### Has the UK inflated away debt in the past?

It is useful to look back at the history of the UK for guidance on how things might work out. UK debt surged in the Napoleanic wars and in the first world war. The gold standard was in operation, so the inflation option was absent. Over the years, this debt was (largely) paid down.

Then came the debt associated with the second world war. Their debt/GDP ratio went from something like 40% to 140% of GDP. This was a period with fiat money, so inflation was a feasible option.

At the time, they did not have a clean separation of debt management, monetary policy and public finance. All three functions spilled over into each other. These conflicts of interest may have induced an inflationary bias. Unprecedented inflation came about. Large public debt was not the sole causal factor behind that outburst of inflation. But it was one factor influencing the minds of economic policy makers, encouraging them to view a little inflation benignly.

To summarise, while the UK has had three great episodes of building up debt when faced with a calamity (the Napoleanic wars and the two world wars) and while it brought down debt in the decades of peace which followed each of these, in one of these three episodes (where fiat money existed) it did use inflation to a significant extent.

### The inflation option in the current institutional setting in the UK

In the current institutional setting, the UK Bank of England is mandated by legislation to deliver on an inflation target. The UK Debt Management Office (DMO) does the work of investment banking for the government, that of selling bonds. The Bank of England does not share the goals of the DMO and does not worry about the task of selling bonds. It only focuses on the inflation target.

There are two ways to get an upsurge of inflation that would help reduce the burden of debt: the Treasury could instruct the Bank of England to target a higher inflation rate, or Parliament could modify the legislation so as to abandon inflation targeting.

To put this differently, a person who is shorting the long bond issued by the UK government with an expectation of a substantial upsurge in the long rate is, to some extent, a person who has the view that the Treasury will instruct the Bank of England to target a higher inflation rate, or that Parliament will modify the legislation so as to shift away from inflation targeting. Neither of these scenarios so far appears particularly likely. Hence, it seems that this institutional structure will deliver on the inflation target.

Can unconventional operating procedures of monetary policy be consistent with inflation targeting? If unconventional things (i.e. directly influencing corporate bond prices since the monetary policy transmission had broken down) had not been done, inflation would have dropped below target. The strategy remains getting to inflation of 2%; the tactical details about how this is achieved have changed. Similarly, the immense expansion of money supply is consistent with the fact that the money multiplier collapses in a financial panic. If reserve money had not been dramatically expanded, we'd have been in an environment like the Great Depression, with strong deflationary pressures, which is not consistent with achieving the inflation target. So the people who are worried about the framework of inflation targeting having broken down are perhaps worrying too much. The strategy has not changed; the tactics have.

### Inflation targeting has been the key element of the institutional apparatus

Unconventional monetary policy and unusual debt enlargement are raising concerns about inflation. Inflation targeting is particularly important in assuaging these fears.

With de jure inflation targeting as the overall framework, the central bank is able to go into unconventional terrain, while simultaneously reassuring the bond market that there is no risk of an explosion in inflation in the offing. If de jure inflation targeting were absent, the central bank would have to be more concerned about unhinging inflation expectations when it adopted unconventional tactics.

The same applies with unusual fiscal policy. When governments set forth to borrow on a large scale, if the bond market was uncomfortable about the possibility of inflation, the prices at which governments were able to borrow would have rapidly escalated. This would have limited the extent to which fiscal stimulus was possible and choked off the recovery. In other words, the cheap financing that governments have got, which has enabled fiscal stimuli, has been made possible in part by inflation targeting.

De jure inflation targeting gives the central bank credibility to temporarily do dramatic things that a central bank without this overall framework would stop short of doing. This reasoning is the opposite of what the critics of inflation targeting worry about -- that inflation targeting is too rigid and reduces the flexibility for coping with unusual events. Instead, inflation targeting as the medium term framework is precisely what gives the central bank credibility to do unusual things - i.e. obtain more flexibility on tactics - in the short term.

The immense enlargement of central bank balance sheets would be worrisome were it not for the fact that these are taking place under the overall strategy of inflation targeting. As the financial system comes back to life, as the money multiplier comes back to normal values, the intellectual framework of inflation targeting will shape the responses of the central banks. There will obviously be some mistakes in forecasting inflation, given that the parameter estimates in our models are driven by normal times. But one can expect an average error of zero in the sequencing through which unconventional monetary policy is withdrawn. And when mistakes are made, when de jure inflation targeting is in place, the bond market will know that these are mistakes of execution and not a change in strategy.

In summary, the fact that almost all OECD countries and many emerging markets have tied down monetary policy with either de jure or de facto inflation targeting is a critical difference of the institutional environment today, when compared with earlier business cycle downturns. It is the critical glue which has enabled unconventional monetary policy and unusual fiscal responses. The hard work done in preceding decades, of putting monetary policy on a sound footing and separating out the bond issuance of the government from monetary policy, has helped the world economy come out relatively lightly in this downturn.

### The perspective of a credit analyst who thinks inflation targeting will work

De jure inflation targeting in the UK is comforting to bond holders who might otherwise worry about being defrauded. But it is interesting to see that as a consequence, the present situation is more like the UK of 1815 or 1918: a government has built up debt; it faces a hard budget constraint; it does not have the choice of having an upsurge of inflation. The Treasury will be forced to make ends meet by spending less and taxing more - the alternative is that of reneging on the inflation target in the public eye -- something like going off the gold standard in the olden days -- and enduring the wrath of the bond market when that is done.

Hence, if you were narrowly focused on technical default on a bond, this is a more difficult environment for the government because a lever (inflation) that was used in the 1970s to stave off default is now unavailable. This is a scenario more like 1815 or 1918, where there was an upsurge of debt and the monetary regime gave no space to inflate it away (barring a drastic measure, that of going off the gold standard).

For a credit analyst narrowly focused on technical default of a bond and not concerned with defrauding bondholders through inflation, holding other things constant, a country with fiat money which lacks inflation targeting is safer than a country with fiat money and inflation targeting. A Zimbabwe can be counted on to pay on local currency bonds by printing money since its fiat money lacks the intricate institutional dance of inflation targeting.

### The inflation option in the US

The situation is a bit different in the US. There also, the central bank does not do investment banking for the government: this function is placed in the Treasury. But the central bank has not been tied down by law to deliver on an inflation target. As with the UK, a substantial fraction of bondholders are not US citizens; this raises a fear that decisions by the US government might inflict losses on them.

The lack of de jure inflation targeting raises greater uncertainty about what the central bank might do in the future. I can't see why the US Fed might like to help out the Treasury shed some debt by having an upsurge of inflation, and I do believe this is an unlikely scenario. But until the legal foundations of the central bank clearly require achieving an inflation target, there is some uncertainty about what might happen.

Reducing the US debt/GDP ratio using inflation to any significant extent would be a drastic option. Foreign bondholders would feel defrauded, and dump US government bonds and the dollar. The US long rate would skyrocket and the US dollar would crash. The crash in the dollar could possibly induce tightening of the short rate to cope with the inflationary consequences. The severity of this punishment helps stave off this scenario even if a successor to Ben Bernanke is not as clear-headed about inflation targeting as he is. Similar considerations apply to the time when (if) the UK government envisages a bigger inflation target or an abandonment of inflation targeting.

### Will interest rates go up because governments are issuing so much debt?

Suppose a government issues a lot of 10 year paper. Can this induce price pressure, giving lowered prices (i.e. higher interest rates for 10-year bonds)?

Suppose we live in a world where the bond market is working properly. In this case, the various points on the yield curve are linked up by arbitrage. Ultimately, all points on the yield curve are about expectations about movements of the short rate (i.e. the policy rate) in the future.

So given enough arbitrage capital, price pressure at the 10 year rate will result in a flurry of arbitrage opportunities and an arbitrage-free yield curve will be restored. Since policy rates are low and are likely to stay low for a while, an arbitrage-free curve will be one where rates further out on the yield curve would be pushed down.

In many places in the world, the financial system has broken down (or had broken down in the last few months) into a limits of arbitrage' trap. There is often not enough arbitrage capital chasing down these arbitrage opportunities. As an example, as mentioned above, liquidity in the bond market no longer supports accurate estimates of expected inflation based on bond market data. Hence, in these stressed times, excessive issuance by the government of (say) 10-year paper could possibly result in price pressure at the 10 year rate and create a kink in the yield curve.

So it seems that there are some question marks about the traditional reasoning about an arbitrage-free yield curve, with the long rate being tied down by expectations of the trajectory which the short rate is likely to trace out in coming years and by yield curve arbitrage. The one factor which is perhaps holding down the long rate is the simple flight to quality. A great deal of capital that had walked into risky assets during the great moderation has been spooked and portfolio managers have rediscovered the joys of government bond holdings. For a while, we're probably going to see bigger weightages on government bonds. I think this factor will significantly help provide the other side of the trade when governments are selling a lot of bonds. See Martin Wolf on this. The rise in the long rate should not necessarily be interpreted as signalling a sharp rise in inflation expectations.

### The two paths through which monetary policy gets distorted

Monetary policy today wants to drive down interest rates so as to push up aggregate demand and achieve the inflation target. Since yield curve arbitrage has broken down, this requires central banks to buy government bonds so as to drive up their price and drive down the interest rate. This is tantamount to monetisation of government debt.

Monetisation is often seen as something Truly Dangerous; it's the start of the slippery slope to the Weimar Republic. But it's important to be clear on means and ends.

With a well structured monetary policy regime that is targeting inflation, the central bank will periodically buy and sell government bonds. When it is buying government bonds, this will be tantamount to monetisation, and vice versa. As long as monetisation happens as a pure side effect of achieving the goals of monetary policy, this is not dangerous. When monetisation is done in order to achieve the goals of the Debt Management Office, this is where the slippery slide to Zimbabwe commences.

In similar fashion, a central bank can trade on the currency market in order to help achieve an inflation target. This is perfectly safe. This will lead to periodic increases or reductions in the net foreign assets of the central bank. As long as these are merely the side effects of a well structured monetary policy framework, this is safe.

In short, reserve money is the sum of net domestic assets (NDA) and net foreign assets (NFA). As long as NDA and NFA fluctuate as a side effect of a well structured monetary policy framework, this is safe. It is when NDA and NFA are distorted owing to the pursuit of other goals, that this becomes troublesome. The danger to NDA comes from the goals of the Debt Management Office which might influence the central bank to do monetisation, and the danger to NFA comes from exchange rate policy. This symmetry between NDA and NFA as sources of change in reserve money is not widely appreciated: people generally see that deficit financing by purchase of government bonds is bad because it distorts NDA, but fail to see that this is no different from a distorted NFA caused by purchase of foreign assets.

Institution building in monetary policy is essentially about getting these extraneous influences (selling bonds for the government and the pursuit of exchange rate policy) out of the objectives of the central bank. These risks are not present in the US or the UK, which have a pretty sound inflation targeting framework, where neither central bank cares about the goals of bond issuance of the government or about the exchange rate. These risks are present in places like India, where the pursuit of these extraneous goals has repeatedly distorted monetary policy, where fiscal/financial/monetary institution building has not yet taken place.

### A one-time increase in the targeted inflation rate?

The operating procedures of monetary policy that work fine with ordinary interest rates have run into trouble once interest rates hit the zero lower bound. These are admittedly rare scenarios; ordinary operating procedures might work for many decades before hitting a scenario like this. At the same time, we are all keenly aware of the problems that have arisen once interest rates went to zero.
What is wrong with unconventional monetary policy? First, we do not have the foundations of economic knowledge required to guide us on what to do when placed in unconventional territory. E.g. the DSGE models used by central banks are lost when the policy tools become quantitative easing' (whatever that means). Second, it is very hard for financial markets to comprehend what is being done, which undermines the effectiveness of monetary policy. Central banks must say what you do, and do what you say'. This clarity is unavoidably hampered when in unconventional zone. Thirdly, there is the risk of loss of independence owing to these unconventional actions. Individual firms/industries are gainers or losers of these operating procedures, and politicians will demand oversight.

In this crisis, it looks like there have been situations where achieving an inflation target of 2% required a policy rate of -5%, which is impossible. One way to reduce the extent to which the zero lower bound is hit is: to raise the level of the inflation target. Roughly speaking, if 7% inflation had been targeted, then in a crisis like this one, the policy rate would have gone to zero but negative rates would not have been desired by the central bank.

We might not need to go as far as 7%, but this crisis has certainly changed my mind on the desirable inflation target; instead of 2-3% maybe something like 4% is better.

If a country with an existing inflation target (e.g. the UK) announces that the target inflation will go up from (say) 2% to 3%, this would induce massive losses for the bondholders. The only fair way to do this would be to simultaneously compensate bondholders for this loss that they suffered.

### Also see

Willem Buiter Fiscal Implications of the Global Economic and Financial Crisis, released by the fiscal affairs department of the IMF on 9 June.

### Acknowledgements

My thinking on this was improved through conversations with Joydeep Mukherji, Charlie Bean, Anand Pai, Josh Felman, Percy Mistry, Roberto Zagha, Russell Green, Ila Patnaik, Paul Levine and Econlogic.

## Thursday, June 11, 2009

### The joy of economics

Two interesting readings. First, on the life of the economic policy team in the US today. From an Indian point of view, it makes you think about the lack of comparable intellectual firepower. And another, on using economics in the realworld. Generally, when we think of direct engineering applications of economics, we think of finance, but this is in a new setting: google.

## Tuesday, June 02, 2009

### The recipe for building high quality universities

With the removal of Arjun Singh from the Ministry of HRD, there is a prospect of genuine change in Indian higher education. The importance of this has been written about extensively. As an example, see Shekhar Gupta in Indian Express.

While most of us agree that India needs better universities, there is less clarity on how to set about achieving better universities. In Indian Express today, Ila Patnaik draws on the knowledge of a new NBER working paper titled The Governance and Performance of Research Universities: Evidence from Europe and the U.S. by Philippe Aghion, Mathias Dewatripont, Caroline M. Hoxby, Andreu Mas-Colell and Andre Sapir. This carries the discussion forward by identifying specific elements of the design of the institutional environment which will induce high quality universities.

A quick summary of the five ingredients which matter:

1. No government approval required for budget; budget-making happens at the university and university alone.
2. Reduced government role in the core funding of the university.
3. High inequality of wages: two academics of the same seniority and rank should get different wages.
4. Full flexibility in recruitment of students.
5. A big role for competitive processes for gaining funding for research.

## Monday, June 01, 2009

### Evolution of exchange traded derivatives

I have an article in Financial Express looking back at how exchange-traded derivatives in India have changed.