By Claus Vistesen, on February 13th, 2012
I have been enjoying myself in the Austrian Alps last week and hence the lower output. Here is my look though, of a number of notable news stories and contributions.
Global Liquidity
Benoît Cœuré, Member of the Executive Board of the ECB has penned a speech (and argument) on global (excess) liquidity. Izabella likes it and I agree with her that it is a good piece. I am not sure though that it is that much different than the Savings Glut argument put forward by Bernanke, but I may be missing the fine print (i.e. need to read it more carefully). The biggest problem I have is that he assumes that the lack of safe government (i.e. AAA rated assets) is cyclical and due to market failure or other “temporary” factors. Izabella interprets it as follows,
What’s the solution to this vicious liquidity circle? Simple, says Cœuré. The euro area needs to regain its role as a global supplier of safe assets. Something which could be achieved by a) ensuring that Eurozone countries have become fiscally sound and b) diverting excess liquidity from other zones back into “programme countries” by way of the IMF.
I disagree. The failure of euro zone economies and indeed large parts of the OECD edifice in general to provide “safe haven” assets is deeply structural and tied to population ageing. Unfortunately, there is little prospect that the euro zone economies will be able to supply AAA rated securities for a long time and herin lies the rub. Of course, if we are talking euro bonds, but then again. I will believe it when I see it.
Japan and the currency wars
A recent Bloomberg article suggested that Japan has been “secretly” selling JPY to try to stem the tide and force through depreciation of the Yen.
Japan used so-called stealth intervention in November as the government sought to stem yen gains that hammered earnings at makers of exports ranging from cars to electronics.Finance Ministry data released today showed Japan conducted 1.02 trillion yen ($13.3 billion) worth of unannounced intervention during the first four days of November, after selling a record 8.07 trillion yen on Oct. 31, when the yen climbed to a post World War II high of 75.35 against the dollar. The currency’s strength has eroded profits at exporters such as Sharp Corp. and Honda Motor Co., just as faltering global growth undermines demand.
Open market operations to sell domestic currency are so old school. Didn’t they get the memo in Japan? In a world where all major central banks are either at or very close to the zero bound, it is central bank balance sheet expansion (quantitative easing) that matters. On this note, both Japan and the Fed are being left decisively behind by the ECB and BOE (at least in the past six months). Of course, even the usage of “standard” measures in Japan is being contested and as long as this is the case, the Yen will continue to strengthen.
Don’t bet on deflation with the current team of global central bankers
Elsewhere, I am wondering where all the deflation, let alone disinflation, is. I am a sworn deflationist and I believe in the main thesis of the deleveraging/depression/deflation crowd. However, I have the utmost respect for the inflationist bias of global central banks and with the current batch of policy makers at the helm, deflation is a very remote risk.
The latest data show that inflation in China recently quickened as well as producer prices in the UK increased in the week that the BOE announced another round of QE. Of course, this is not all clear cut. Chinese real M1 (YoY) recently moved into negative territory for the first time since 1996 and in the UK, it is noteworthy that core inflation (ex food, beverages, tobacco and petroleum) came in noticeably lower in January.
I will change my views on the basis of changing data, but I am beginning to think that the bout of global headline disinflation we are expecting as a result of the global slowdown will reverse itself much, much quicker than many (including me) have expected. Arguably, we still need decisive easing in emerging markets and QE3 from the Fed, but it is more a matter of when and not if this happens and as such, global central bankers remain fully committed to creating inflation.
The main problem so far for those arguing for strong central bank action (including me) is the absence of nominal growth in output in excess of consistently rising headline inflation. Could this be a result of doing too little, perhaps, but at the moment stagflation remains the best way to describe our current economic situation and thus inflation in all forms is a drag on growth. Should the genie finally come out of the bottle in the form of consistent wage increases central bankers may find that they got more than they bargained for even if the alternative is equally painful.
The Greek experiment is about to end
Greece remains the main talking point and also the only thing that appears to prevent equity markets ripping to new highs. Greece is bankrupt and while I understand that the patience of the rescue committee will run out at some point, I am astounded that anyone expects this hideous experiment to end well. Greece will see its fifth year of contraction this year and for what? A membership of a currency union that does not work anyway?
We are told by the Troika, the EU and the IMF that failure to reach a deal would be catastrophic and thus that Greece has no way out but to take the medicine. However, Greece has a real choice and the stronger she is pushed the more obvious the end result is. Internal devaluation and decades of austerity don’t work; not in Greece and not elsewhere. This remains the KEY issue that the euro area politicians and the ECB have not understood. The social fabrics of society won’t stand the pressure and strain. Textbooks tell us that the cure is simple when you can’t devalue, but practical experience have now shown otherwise.
I am neither on the Greeks’ nor the IMF/Troika’s side, but I simply point out the obvious destiny of current events; failure! Even if Greece manages to appease its creditors with austerity, the end result in terms of Greek macroeconomic balances is still unsustainable and thus the underlying problems will not have been solved.
The ECB and the IMF will likely face significant drawdowns on their Greek bondholdings regardless of whether they use such drawdowns as ”carrot” for Greece to push through austerity measures. This is what the establishment has not yet understood.
MF Global investigation fails to uncover illegal activity?
Megan McArdle has an amazing article suggesting that the investigation on the failure of MF Global is finding it difficult to uncover anything illegal.
Megan quotes a piece from Reuters (no link available)
Lawyers and people familiar with the MF Global investigation of the firm that was run by former Goldman Sachs head Jon Corzine say that even though the hunt is still on to find out whether or not officials at MF Global intended to pilfer customer money in a desperate bid to keep the brokerage from failing, the trail at this point is growing cold.
This seems very odd to me even if I have not followed the aftermath in detail. I completely agree with the sentiment expressed by Megan.
I don’t understand how this could be true. To be clear, I am not saying that it couldn’t be true-only that I don’t understand how such a thing could have happened. There is more than a billion dollars missing from supposedly segregated client accounts. I understand that it was chaotic, but what kind of chaos causes you to accidentally move money out of money that any moderately sophisticated compliance system should have automatically flagged for approval?
While my professional responsibilities are confined to the smooth running of a macro research product I sit in an office, and work, with asset managers and ever since the failure of MF global I would imagine that their general level of concern has increased. This is understandable. If your main counterparty as an asset manager (i.e. your prime broker) essentially decides to steal your deposits and/or allocate them to losing trades against the principle of segregated accounts, it really does not matter what you do. No matter the tightness of the shop run on the asset managers’ end, he will face significant and perhaps even fatal losses.
Obviously counterparty risk is as old as finance itself and any decent asset manager today will deal with more than one broker and even have a strategy on how to manage counterparty risk. Ultimately though, mutual trust between asset managers and their prime brokers is a commodity which has been severely impaired by the MF Global failure and this is an issue for all players in financial markets.
Dealing with vintage data in economic forecasts using instrument variables (wonkish!)
A recent note from the George Washington University points to an interesting study from Warwick University on the forecasting of data vintages in the context of US output and inflation forecasts. The problem is as follows;
Consider a simple benchmark autoregressive model that a forecaster might use to forecast an economic variable yt. In order to estimate the parameters to be used for the forecast, typically the forecaster will obtain the most recently updated data on yt (i.e. the vintage of yt available at that time) and estimate the model using those data. However, the data in this single time series may in fact be coming from different data generating processes. The data some time back in the series have gone through monthly revisions, annual revisions, and perhaps several benchmark revisions. The most recent data, however, have been only “lightly revised,” as Clements and Galvão term it. Therefore, Clements and Galvão argue that the data in a single vintage are of“different maturities.” Forecasters may want to forecast future revisions to data as well as exploit any forecast ability of data revisions to improve forecasts of future observations. In their article, Clements and Galvão suggest that a multiple-vintage vector autoregressive model (VAR) is a useful approach for forecasters working with data subject torevisions. This comment discusses the importance of taking revisions into consideration and compares the multiple-vintage VAR approach of Clements and Galvão to a state-space approach.
This is a significant issue but remember; if the following holds, we need not worry too much about it.
If the revisions are unpredictable and the early data are efficient estimates of future data, then we may not need to be concerned about the different vintages.
Most economists assume that the statement above is true and simply force through their model. Being a great believer in practical usability when it comes to empirical economics, I would argue that in most cases this will not cause too many problems in most cases. However, a growing body of evidence suggest two important issues to consider. Firstly, revisions are predictable and thus provide important ex-ante information which should be incorporated into the the forecast. Secondly, even if revisions are unpredictable, the manner in which data is revised may itself provide important information on future data readings.
I agree, but the problem is potentially much more severe. Another issue then concerns that situation where you try to forecast Y(t) as a function of X(t) where both variables may be subject to revisions. Normally, we would solve this issue by restricting X(t) to variables where revisions are minimal (or absent alltogether). One way to do this is to use market based data (market prices, closing values of securities etc) which are, by definition, not revised. However, in the context of the e.g the classical leading indicators framework pioneered by Geoffrey H Moore, this issue re-emerges X(t) is cast in the form of real economic variables (themselves potentially subject to revision).
We have replicated and refined many of the LEIs described by Moore et al and applied it to various economic data series with specific fitting of a time series regression in each case. However, such an approach may still suffer from vintage data issues (as described above. One solution that I been thinking about is to imagine two forms of right hand variables. X(t, economic) and X(t, market based); if the latter is unrevised it might be possible to find an instrument for X(t, economic) (final revision!) using a variation of X(t, market based). This would, in my opinion, constitute an elegant way to solve the issue of data revisions in your explanatory variables.
In practice, you could also try to replace Y(t, economic) with Y(t, market based), but this is probably too a-theoretical and ad-hoc.
By Simon Grey, on February 10th, 2012
If Beijing’s intervention into the Chinese economy justifies U.S.-government ‘retaliation’ to ‘correct’ market distortions created by those interventions, shouldn’t the still-significant lingering negative consequences of Beijing’s interventions into the Chinese economy from 1949-1978 be considered? Shouldn’t Beijing’s artificial destruction, during the middle decades of the 20th century, of production efficiencies in Chinese factories be weighed against Beijing’s artificial creation, in the early decades of the 21st century, of such efficiencies?
In short, the answer is no.
Boudreaux, in asking the question, implicitly accepts the validity of the state and of citizenship. He must also accept that the state must act in the best interest of its citizens. While the government should seek to redress the negative effects that its citizens face as a result of foreign market intervention, it has no responsibility to address the negative effects that non-citizens face as a result of foreign intervention. China is not the US, and Chinese aren’t Americans. As such, the US government has no obligation to concern itself with addressing negative economic outcomes faced by the Chinese people that arose as a result of the Chinese government’s economic policy.
By Ajay Shah, on February 7th, 2012
The JEE used to serve India well
Many years ago, high school education in India worked in a twin track system: There were those who studied for the IIT JEE and there was everyone else who didn’t. The former studied good books (e.g. Resnick/Halliday (which is a college level book elsewhere in the world), solved physics problems from Irodov, etc.
In contrast, studying for the 12th standard (”board examination”) tended to emphasise rote memorisation, focusing on trivial questions where you had to plug numbers into a formula, emphasised accuracy of calculation and good handwriting. I vividly remember a textbook for 11th class physics used in Maharashtra, which said that Newton’s second law did not apply for living things and powered vehicles. The thoughtful author must have wondered how a stationary cat started walking without the action of an external unbalanced force, and resolved the problem by limiting the footprint of Newton’s second law. The less time that kids spend in studying for board examinations, the better.
I used to be optimistic that the footprint of the enhanced curriculum, and complexity of examination questions, lay far beyond the tiny number of people who entered IIT. Even if only 2,000 kids entered IIT, if 40,000 of them studied for the JEE, it gave them world class capabilities at high school. In each cohort, we got 40,000 people who were very good by world standards. In a country with pervasively low capabilities, it was very useful having this slice of high inequality of knowledge, for it gave a group of people who were able to learn modern technology, connect to globalisation, and create firms which generate a lot of high-paying jobs. It is fashionable to complain about inequality of knowledge, but given that you are in a LDC with a very low mean, would you really rather have very low variance??
With this old configuration, we also got a nice tool for inter-generational class mobility. The middle class got their kids into IIT, and almost all these graduated into upper class by the time they were 30.
More generally, a lot of countries have found that high stakes examinations are a good thing. High stakes examinations push the work ethic, grow the ability of young people to work hard in a sustained manner with high concentration, ensure foundations of mathematics and science, and encourage a meritocracy. They create a self-selected elite of young people who are not immersed in and defined by mass culture. All these are good things.
Problems of the JEE
I used to think like this for a long time. I have reluctantly been persuaded, over recent years, that the JEE isn’t working so well.
Too many young people are studying for the examination and not the subject. The obsessive focus upon coaching classes is producing a one-dimensional personality which isn’t so well suited to entering college. In the 1980s, the most interesting students in IIT were thinking people who read books, knew a lot about the world, and could also solve monkeys on pulleys. With brutal competition, and the coaching classes phenomenon, too often, all that’s left today is the monkeys on pulleys. There is a certain kind of parent who is willing to have a child go live in Kota at age 15. This screened out many families from the race.
Economists know about this phenomenon in agency theory. High-powered incentives are a problem because the agent only focuses on the incentive and tends to cut corners (or worse) on everything that’s not mentioned in the incentive contract. Andrade and Castro bring this generic idea in agency theory into the question of examinations, and find similar effects.
In the 1980s, there was substantial diversity of background, experiences and class amongst the students. This was a good thing, since students would then pick up the culture of people unlike them. In recent years, it appears that there is much greater homogeneity of background, experiences and class. The extent to which the person gets transformed in the four years has, as a consequence, gone down. When very few children of the elite go to IIT, this reduces access to the knowledge and networks of the elite for everyone who goes to IIT. This has reduced the ability of IIT to generate inter-generational class mobility.
Jishnu Das and Tristan Zajonc have found a nice bump in the upper tail of the distribution of skills in India. The pessimist sees this as being about class or caste: certain families bring up kids who know more. The optimist in me used to think this was the bunch studying for the IIT entrance. Also see Geniuses and economic development on the importance of the upper tail of the skills distribution.
It is increasingly difficult to be optimistic about how this is going. Narendra Karmarkar graduated from IITB in 1978, and went on to do truly important work in 1984. My optimism about the IITs peaked in 1984. This should have scaled up manifold in the following years. It has not. In the 1980s, I used to think that by 2010, we’d have atleast one Nobel laureate from the IITs. That has not happened. This tells us that the IITs are not delivering on their early promise; things haven’t worked out well in the following years. I think the JEE is a part of the problem.
One of the most disappointing features of the recent OECD PISA evidence was the absence of this bump in the upper tail. This new evidence shows a scary world of low inequality of skill, of a country with a terrible mean and no upper tail of an elite that can power the country out of mass poverty. I would conjecture two potential explanations for what has been found. One, it could be the case that this testing was done at age 15, at which time not much of the IIT JEE studying has as yet taken place. Alternatively, it could be the case that studying for the IIT JEE is not producing good knowledge.
But the solution being offered doesn’t seem to be the right one
There are two views on how these problems can be solved. The first alternative is to shift away from admissions based on a high stakes examination. Universities in the US screen applicants on many parameters, so this is generally thought to be better. But when we look back in history, universities in the US used to focus primarily on academic performance only, until a glut of Jews showed up in Harvard. The shift to asking for `well rounded personalities’ was a tool by the dominant anti-semetic elite to screen out Jewish kids who did not play football. So we should be cautious in respecting the undergraduate admissions process in the US. It is also important to remember that the quality of kids starting college in the US is quite weak by world standards. There are other countries (e.g. Japan) where large scale high-stakes examinations are used for university admissions, with much success.
I feel that the core problem that we have in India is just too few seats, which has generated a ridiculous extent of competition and distorted behaviour on the part of the kids. The solution lies in solving the policy problems in higher education, so that a large number of kids are taken into world class institutions every year. E.g. adding undergraduate programs at I I Sc, with recruitment through the JEE, was a move in the right direction. We need to grow the size of the entrant class in universities in India, that figure in the Times Higher Education Supplement ranking, by 10-fold. At present, we have only one university in that list – IIT Bombay. Kapil Sibal is offering neither of the two solutions above: we are not being offered a modified admissions process based on looking at a fuller picture of the child, and we are not being offered a Japanese scale world of high stakes examinations with a lot of seats in world class universities. What we’re being offered is a scaling down of the role of the IIT JEE. A greater role for the 12th standard examination is just a recipe to emphasise rote memorisation, focusing on trivial questions where you had to plug numbers into a formula, emphasising accuracy of calculation and good handwriting. This seems wrong to me.
 
By Ajay Shah, on February 2nd, 2012
On 22nd December 2011, we purchased petrol worth Rs.100 from an Indian Oil fueling station in Bombay using an ICICI Bank debit card. The receipt suggested that we could have saved a fuel surcharge of 2.5% had we used an Indian Oil Citibank credit card. Upon seeing this message, we asked the cashier at the petrol pump if we would be charged 2.5% over and above the Rs.100 that we paid for the fuel. The cashier assured us that only Rs.100 would be debited from the account linked to the card. The chargeslip and the receipt were:
 |
| The chargeslip |
 |
| The receipt |
A couple of days later, we viewed the account statement online and found that the relevant transaction had been recorded. A full week later, we observed that an additional charge of Rs.11.03 had been
debited from the account for the same vendor. Not only was the entry unusual, the charge did not match the 2.5% figure which was mentioned on the transaction receipt:
 |
| The statement |
We wrote to the bank asking them to explain the transaction. The bank explained that for fuel purchased at non-HPCL petrol pumps, a surcharge of 2.5% of the fuel cost or Rs.10 (whichever is higher) would be levied. A service tax would be levied additionally.
There is a consumer protection issue here. After the account had been debited, and up until we sought a clarification from the bank, we were not made aware of the surcharge. The chargeslip gave a false impression of the amount being paid.
Upon delving further, we find various websites where people have complained about this surcharge being confusing. Further investigation revealed an interesting combination of participants:
- The surcharge on fuel is mentioned in the fine print in Terms and Conditions of a debit card.
- The bank that deploys the POS machine (acquiring bank being Citibank in our example), at the end of day, surcharges the higher of 2.5% or Rs.10 and sends it to the customer’s bank (issuer bank being ICICI Bank in this case).
- The issuing bank then creates a separate debit in the customer’s account for the surcharge
- The acquiring bank shares much of this surcharge back to Oil Marketing Company (Indian Oil in this example).
- Contrast this with typical debit card processing fees in India around 1.5%. In most cases, merchants will inform a customer before surcharging, and the value on the chargeslip is what the
customer pays.
- Many banks apply these surcharges weeks or months after the transaction actually occurs, which helps ensure that most customers do not understand what is going on.
When paying for fuel in India with a debit card, the customer pays the surcharge by being misled, the Oil Marketing Company makes higher profits, the charge is administered in a non-transparent way, and is posted late when the customer may not even recall the
transaction. Thus, Government owned companies and banks have created a perverse incentive, whereby customers prefer to use cash rather than pay electronically.
By Ajay Shah, on January 26th, 2012
The debate
Roughly one decade ago, there was a strong debate in India about how we should tackle the problem of education. There were two
views:
- Intensification
- On one side were those who felt that nothing was fundamentally wrong; all that was needed was more money. So we should just continue building more government schools and hiring more civil servants to act as school teachers, and we’ll be fine.
- Reform
- On the other side were the reformers, who argued that the basic incentives in Indian education were wrong. Putting more money down a dysfunctional system was pointless.
The Intensifiers won this debate. An informal coalition of educationists (i.e. the incumbent education system) and leftists came
together, supported by the World Bank, which pushed for mere enlargement of Indian education, without questioning the foundations.
All of us are involved in this story at many levels. At the simplest, we are the customers of the education establishment. We pay income tax and VAT and a few other taxes. On top of this, we pay the 2% education cess. In return for this, we get certain educational
services. These influence our kids, and they influence all the young people that we encounter in this young country. Trillions of rupees have been spent, and more than a decade has gone by. It is time to assess the performance of this strategy.
Three blocks of evidence are now visible, which tell us that the Intensifiers were wrong. The old strategy, which was invigorated by a
vast rise in spending, was the wrong one.
Evidence #1: OECD PISA results for India
This story is well told in a recent blog post by Lant Pritchett. Bottom line: The first internationally comparable measurement of what children learn has been done. The sample correctly includes urban and rural children; it correctly includes children going to private or public schools; there are no first order mistakes in what was done. It tells us that Indian education policy has failed miserably: the results have come out at the bottom of the world.
Evidence #2: ASER 2011 results
Pratham has been running surveys which measure characteristics of children and schools in rural India (only). Their latest survey results, for 2011 show the following facts.First, rural kids learn less at public school. Here’s a simple example of what the evidence shows. Surveyors ask kids in class III to recognise numbers upto 100. Here are the numbers, for the proportion of kids in class III who cannot recognise numbers upto 100:
In 2008, the failure rate with private schools was roughly 17 per cent. Government schools were much worse at over 30 per cent. A short three years later, conditions had deteriorated sharply in government schools. The failure rate had gone up to 40 per cent. Private schools had also worsened slightly, to a failure rate of 20 per cent. By 2011, a big gap had opened up between the two: private schools are failing to teach 20 per cent of the kids while government schools are failing with a full 40 per cent of their kids.
Parents in India face the choice between sending their children to a government school, which is free and serves a mid-day meal, versus sending them to a private school where they pay fees. Yet, an increasing fraction of parents choose to send their children to a private school, paying tuition fees from their own pockets, while government schools are free. The relationship between a parent and a private school is a transaction between consenting adults. The relationship between a parent and a government school involves all of us, because we are paying for it.
Given the low income of parents in India, their use of private schools is a striking indictment of what the Intensifiers have wrought:
At class II, the fraction of rural children in private school went up from 19 per cent (2007) to 23 per cent (2011). At class VII, this
rose more slowly to levels slightly above 20 per cent.
Evidence #3: CMIE household survey
CMIE has data for the year ended March 2011 about the behaviour of 169,492 households, about their expenditure on school/college fees and tuition fees. Here’s the picture for the quarter ended September 2011; all values as percent of overall expenditure:
| Income class |
School/college fees |
Private tuition fees |
| Rich – I |
4.79 |
0.66 |
| Rich – II |
3.79 |
0.51 |
| High Middle Income – I |
3.54 |
0.63 |
| High Middle Income – II |
3.12 |
0.65 |
| High Middle Income – III |
2.44 |
0.68 |
| Middle Income – I |
1.93 |
0.59 |
| Middle Income – II |
1.62 |
0.45 |
| Lower Middle Income – I |
1.38 |
0.49 |
| Lower Middle Income – II |
1.05 |
0.60 |
| Poor – I |
0.76 |
0.58 |
| Poor – II |
1.13 |
0.28 |
| Overall |
2.10 |
0.57 |
If parents chose to stay within public sector schools, their expenditure on fees would have been zero. The table shows that across
all income groups of India, there is movement towards private provision of education, both by paying fees at schools and by paying
for private tuition classes. These two elements add up to 2.67 per cent of overall expenses of households. (The CMIE household survey separately measures expenses on books, journals, stationary, additional professional education, education overseas, hobby classes and other education expenses. This helps us gain confidence in the extent to which the two fields in the table above narrowly pin down the feature of interest).
These decisions of well intentioned parents are the strongest indictment of education policy in India. The product being given out
by the Intensifiers is such a terrible one, the parents of India are walking away from it even though it is free and the alternative is
not and the parents are poor.
Implications
For more than a decade, the Intensifiers have controlled Indian education policy. They have said: Leave education to the education
establishment, do nothing radical, just give us more money, we will deliver results. Now we know that they were wrong. They took the money, but failed to deliver the results.
Kapil Sibal has said that his ministry should not be held responsible for the stream of bad news that is coming out. This seems to me to be dodging accountability. His ministry is responsible for Sarva Shiksha Abhiyaan, for the Right To Education Act, for blocking OECD PISA from being done in India, etc. The bureaucratic consensus of his ministry represents the education establishment.
This brings us to accountability. If a contractor took money from you, and failed to deliver on building your house, you would sack
him. (You would also take him to court, to recover the money that was paid to him, for services not delivered). In similar fashion,
education is too important to be left to the educationists. We need to start over.
What is to be done
- We need to start over in the field of education, with a fresh management team, one that is not a part of the status quo, one that is rooted in the worlds of incentives, public policy and public administration.
- The flow of public money into the status quo needs to go down sharply. There is no reason to put money into something that fails to deliver the goods. First we must prove that a mechanism delivers results, and only after that should we put money into
it. This is the common sense that a housewife would apply. She would not spent gigabucks on promises from people who have failed to deliver.
- OECD PISA measurement needs to take place every year at every district.
- The education cess was always a mistake and needs to go. Public expenditures on education should always have come out of general tax revenues; there is no need to have a cess.
- Civil servant teachers, who have tenured (permanent) have no incentive to teach well, regardless of their qualifications or high income. We can’t sack them, but what we need to do on a massive scale is to stop recruiting them. The existing stock can be reallocated to other civil servant functions where staff is in short supply. Through this, it would become possible to whittle away at the accumulated stock over the coming 20 years.
By Claus Vistesen, on January 23rd, 2012
Global stock markets are up about 10% since the beginning of the year, volatility has collapsed, US economic data continue to defy even the mild slowdown proponents and the ECB seems to have backstopped the European banking system.
Yes, my dear reader. This is how quickly you move from away from the apocalyptic abyss and back to normal. My base case is that we are close to excess complacency in equity markets and a sell off is overdue, but it is exactly also under these circumstances (where smart money start to hedge) that the market may deliver one final run up to get everyone and the postman in before hosing everyone.
In the short term, one of the only remaining stumbling block in the form of the ongoing default proceedings in Greece seem to be no match for the ongoing positive animal spirit of the equity market. Only a week ago, we got news that talks in Greece had stalled, but most recently we have been reassured that talks are back on track.
The main niggle on the first occasion appeared to be what kind of interest rate that investors would get on their new bonds and thus, ultimately, the loss of face value currently said to be 50% but also, by some, claimed to be as high 62.5%. Another issue would be whether Greece would pass legislation that forces investors to participate in the debt swap if a majority of investors agree to the PSI terms. This was specifically being discussed in the context of a particular group of investors holding both CDS contracts and the underlying bond and who would maximize their payout on the former by forcing through a hard default.
None of the terms seems have changed massively in the past week, but time is running out with March the 20th set as the final deadline as this is when Greece would otherwise have to make a payment of 4.5 billion-euro ($18.7 billion) on maturing debt. The general consensus is that if no agreement is reached, this date would mark the hard default. The reason for the optimism is then that we are very close to full surrender in the form of a 90% participation rate of creditors and, we are told, it is only a matter of time before the final 10% agrees.
The details reported so far are as follows;
Quote Bloomberg (21 Jan 2012)
The parties are near an initial agreement under which old bonds would be swapped for new 30-year securities carrying a coupon that would begin at 3.1 percent, reach 3.9 percent and go as high as 4.75 percent, Athens-based newspaper Proto Thema reported on its website yesterday, without saying where it got the information.
The desired macroeconomic outcome of all this is obviously well advertised. In 2020, Greece is supposed to have a government debt to GDP ratio of 120% and presumingly some form of growth that would allow this level of debt to stay stationary or perhaps even decline over time.
Let me be clear absolutely clear here. Within any conceivably realistic macroeconomic model, there is no way that Greece can reach a stable debt level with moderate growth under these conditions. Under the interest rate scenario noted above (let us with a average interest rate of 3.8% on the new debt) the nominal interest rate would still be substantially higher than the growth rate of the economy. The only way, the nominal debt level could then be kept stationary is by forcing the fiscal balance into surplus. However, the problem is that this affects the denominator in the debt/GDP calculation by sucking out demand (growth) from an economy already structurally impaired (within a currency union and all that).
The implications are clear. The promises of stability that the PSI currently holds (even if it comes with considerable pledges of IMF money) are bound to disappoint.
First act of several to come
First of all, let us be clear. Despite, politicians’ mortal fright to use the D-word and the media’s acceptance of this fact on the basis that CDS contracts are not activated under the PSI, this is a stone wall default. Anyone, who bothered to take merely a scant look at the history of sovereign defaults will see that the current Greek situation fits well within all the models. Indeed, the proposition that this is not a default because CDS contracts are not activated is ludicrous since in the vast majority of sovereign defaults, the debtor country begins negotiations with creditors well before the actual default is forced upon it. The fact that insurance contracts bought to protect a creditor involved in such negotiations have now been rendered useless says more about the nature of the our modern financial system than it does about the definition of a sovereign default.
Hence, we come to the real nature of this game.
The deal which now seems to be close to completed by no means closes proceedings. It is very likely in my opinion that private creditors who are currently the only ones being forced to take a haircut to seniority of the IMF and the ECB will face a near 100% loss on their holdings. The argument here is simple. Given the amount of debt held by the ECB and the IMF and the fact that these two institutions are senior debt holders the debt held by private creditors become something else than actual bonds. It becomes equity, i.e. the tranche which takes the first (and often complete) loss in the event of a default.
Of course, once we reach this point the issue of CDS contracts will rear its head yet again since if a 50-60% haircut can be considered voluntary anything beyond this becomes very difficult to characterize as such. Any rating agency would find it difficult not to classify further losses as a default and thus begins the fun in earnest. And then comes the ECB and IMF’s share. It will be politically dynamite if the ECB had to print on the liability side to cover losses on the asset side on Greek sovereign debt [1].
Finally, Greece only represents the starter here. Any deal agreed on in Greece will be ardently watched in Ireland and Portugal who will feel they are entitled to the same deal with their private creditors.
Most tragedies have several acts, twists and turns. Investors should expect no less from the one currently being played out in the European sovereign debt markets.
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[1] – In practice the ECB could do nothing and see its balance sheet shrink with the amount lost on the asset side (i.e. reduce lending to the banking system (delevering) with the amount lost on the bonds). However, it is likely that it would “need” to credit reserves with the amount lost on Greek bonds (hence printing money). Mind you, only a central bank could do this as it is free to increase the assets of the banking system by creating its own liabilities.
By Claus Vistesen, on January 18th, 2012
Edward Hugh has a brilliant analysis of recent events in the eurozone and especially how banks are leveraging the liquidity provided by the ECB to “cleanse” their balance sheet of bad assets and essentially exchanging these for freshly minted euro deposits at the ECB. I think we should be very clear what is going on here; this is essentially a covert recapitalisation of the European banking system and the ECB is in every sense of the word acting as a lender of last resort.
Here is the relevant part;
Another area where the transfer of liquidity doesn’t show up as a change in aggregate excess liquidity is when banks offload their wholesale liabilities to other EuroArea banks and refund via the ECB. Here again, if they do it smartly, they can even earn a bit of “quasi carry” in the process, by buying back their debt at well below face value from those who are anxious to exit the periphery, and then refinancing at the ECB without writing down the underlying asset. This could be termed a liability “write down”, and again the procedure earns the bank a nice bit of income which can subsequently be used to help the recapitalisation process.
Take the Portuguese Bank BPI (the country’s fourth largest), which is making public tender offers to buy back its debt. If all concerned tender their bonds to BPI, BPI will pay something short of €1.5bn cash to investors. Mortgages which were previously sitting in one of their SPVs will return to their balance sheet, and ECB money will now be on the other side financing them allowing significant profits (and capital) to be reported. In this particular tender the smallest discount is 35% and the largest is 65%. Investors may initially balk at the offer, since they will nurse a heavy loss (equal, naturally, to BPI´s profit) but ultimately they will probably be only too happy to be able to walk away from Portugal, and with some cash in their pocket to boot.
Iberian banks were already aware of the benefits of this kind of restructuring during the 2009-2010 liquidity wave, and went about quietly repurchasing their bonds (bank capital, securitizations, senior bonds) on a selective and private basis at a discount. Much of their reported profits in those years in fact came from either the ECB carry trade or this kind of transaction. So when we read that another Portuguese bank – Banco Espirito Santo – has just had €1 billion of debt guaranteed by the Portuguese state (a sovereign which can’t itself go to the markets) it isn’t hard to imagine that the process going on in the background is something similar to that seen in the BPI case, and that the debt is being guaranteed so it can go over to the ECB to be posted as collateral.
The National Bank of Greece has been doing something similar. They recently offered to buy back some €1.5 billion in covered bonds and preferred securities,offering 70% of face value for the covered bonds and 45% for the preferred hybrids. As the bank itself says, “The purpose of the offers is to generate core Tier 1 capital for the group and to strengthen the quality of its capital base….The offers would generate a gain for the group.”
And Italian banks would seem to be doing something similar, since they issued around €40 billion in government backed bonds specifically to take to the ECB. The bonds are held by the banks themselves and stay on their books to maturity, their only purpose being to provide collateral for use at the ECB. In fact Italian banks took something like €116 billion from the LTRO, or almost 25% of the total. Perhaps this is why Unicredit CEO Federico Ghizzoni and other European top bankers met ECB officials in Frankfurt back in November, to discuss new rules for collateral.
In Spain securitised mortgages sitting on the balance sheets of the bank-ownedFondos de Titulizacion de Activos could also be recycled in this way (here’s a complete list, although note that these Funds are regulated by Spain’s CNMV and not the Bank of Spain, which is why their presence is relatively unknown and people are able to accurately say that the central bank has been very strict on SIVs, since they weren’t their responsibility).
That something like this may be happening, with the ECB “buying into” public and private Euro Periphery debt while investors are discretely getting out is suggested by this report in Bloomberg:
The euro is losing the relationship with riskier assets that underpinned the currency in 2011 as the deepening sovereign debt crisis reduces the creditworthiness of even the biggest economies in the region. The 17-nation currency has fallen 8.7 percent against the dollar since October, while the Standard & Poor’s 500 Index has gained 3.4 percent, and the correlation between the two dropped to 58 percent from a record 91 percent in November, according to data compiled by Bloomberg. The euro had moved almost in lockstep with investments linked to growth, including stocks and the Australian dollar, since January 2011.
This decoupling is taking place as European Central Bank President Mario Draghi cuts interest rates and promises banks unlimited cash for three years to rein in soaring borrowing costs for governments… Strategists also anticipate more losses as the US economy improves while the euro zone shrinks, driving international investors away from the region’s assets.
So if the first two objectives were to help the struggling sovereigns, and enable the commercial banks to refinance their debt, then to some extent these objectives have been met. But what about the third objective, moving credit on the periphery to get the real economy moving again? Well, here the ECB’s measures are likely to have far less effect, and indeed what effect they do have may be in some way a mixed blessing, since the banks seem far more worried about demonstrating they have an adequate level of core capital than they are about participating in solutions to real economy problems.
While I would, in general, be hesitant in taking anything from Zero Hedge at full face value I think the following story on Unicredit adds flavor to this by providing further evidence on the points Edward mentions above.
The story is clearly speculative but gets backing from Edward’s accout above. The following seems to be a part of the general process which in itself is, in my view, absolutely mad.
Banks in weak countries have been issuing debt, getting a government guarantee, and then posting them as collateral at the ECB. There are examples of this for Greek banks for sure, but my understanding is it has also been occurring in Portugal and Ireland. It is the only way banks in Greece (and the other countries) can raise money.
The article then goes on to make this more alarming point (but really does not have evidence to back it up) that it appears that about €40 billion of the first LTRO was done by Italian banks (Unicredit?) that issued bonds to themselves and got a government guarantee, and then posted this asset as collateral for liquidity through the LTRO.
So, here is how I understand it.
Unicredit issues a 3m bill and gets a government guarantee so that whoever chooses to buy this bill knows that it will be backed by the sovereign (after all, this is still better than the bank even if the two are joined by the hip). The only problem is that it is being issued to itself with a permanent guarantee from the government.
From an accounting perspective this must be close to illegal in any meaningfully lawful jurisdiction, but I defer to experts here of course. The issue here is not then that the sovereign is guaranteeing a liability of a bank, we have seen this plenty of times and it is indeed the only way that some financials can issue debt, but rather that the bond never gets marketed to third party buyers.
It is absolutely astonishing that this 3m bill is then being posted as collateral at the ECB. But you must understand that it has to be posted as such as far as I can see since you can’t hold your own liabilities. So, the banks posts a bond issued to itself and posts it at the ECB and get freshly minted fresh euros credited to its bank account at the ECB. After the process, Unicredit still has the bond as a liability but instead of the same bond on the asset side (which is impossible) it has a deposit asset with the ECB.
If this is true, and the ECB is agreeing to this I must admit that it amounts to a serious bout of banking follies in the European banking industry.
By Rok Spruk, on January 16th, 2012
Recent debacle at the summit of Brussels in the midst of the political intervention of the EU leaders to facilitate the institutional agreement between the European countries towards the formation of the European fiscal union has caused not only a long-standing dissolution of the “core countries” of the Eurozone and the UK but, more importantly, a non-solvable puzzle on the end scenario of the European debt crisis that pervaded both the eurozone and the countries outside it ever since the beginning of the 2008/2009 financial crisis. The anatomy of the European debt crisis is a multifaceted process that is heavily interrelated with the economic principles of the process of European integration and the unintended consequences that erupted in the recent debt crisis.
The introduction of Maastricht criteria that stipulated fiscal prudence by obliging EU member states to adhere to the level of public debt below 60 percent of the GDP and low fiscal deficit boosted the expectations of stable macroeconomic environment, partly sustained by the European Central Bank which, since its inception in 1999, successfully maintained price stability. Despite an enviable achievement in the stabilization of inflation expectations, the EU Treaty did not stipulate stringent fiscal rules in case of the breach of treaty obligations on behalf of EU member states, neither has European Growth and Stability Pact (EGSP) provided selective mechanisms that would hinge on the EU member state in case Maastricht criteria were not fulfilled. On the other hand, the gradual enlargement of the European union did not finalize in the economic union characterized by the realization of four basic freedoms.
In 1977, Portugal and Spain were acceded into the European Union. Four years late, Greece was admitted as the 12th member of the European community. Over time, the EU grew from an integrated area of 15 Western European countries into a conglomerate of nations that did not impinge of the full-fledged liberalization of the internal market in 1988 but, moreover, has evolved into the spiral that accelerated the community toward the political union. In the mean time, member states of the Eurozone have continuously breached the rules laid out by Maastricht treaty. In bearing the fiscal consequences of the reunification, Germany repeatedly breached the Maastricht criteria both in public debt and fiscal deficit which postponed the introduction of the Euro, following a large shock from gigantic fiscal transfers from high-income West Germany into low-income East German regions. In a similar manner, until 2005, France did not manage to reduce the debt-to-GDP ratio under the 60 percent threshold stipulated by the Maastricht criteria.
Nevertheless, peripheral countries such as Spain and Portugal entered the Eurozone at an overvalued exchange rate relative to German mark before the introduction of the common currency. In the following years, these countries, notably Spain, accumulated significant current account surpluses resulted from the inflows of direct investment from the core countries such as Germany and France. These surpluses were, of course, artificial in the sense that the downward convergence of interest rates in the peripheral countries stimulated the over-leveraging of the financial sector which triggered a balloon in the housing sector.
For years, Italy and Greece have repeatedly breached the Maastricht treaty in the fiscal sense. Prior to adjoining the European Monetary Union, Greece repeatedly experienced volatile inflation rates and default on its external obligations and subsequent Drachma depreciation. Italy’s macroeconomic stabilization hinged on the discretion of government spending which, after excessive rises under various transition governments, cumulated in one of the highest debt ratios within the EMU. How could EMU countries, despite a stringent set of rules delineated by the Treaty of Maastricht, pursued discretionary fiscal policies and jeopardized the macroeconomic stability of the national economies and the Eurozone? Prior to the onset of the financial crisis by the end of 2007, little was known on the perils of excessively leveraged balance sheets which investment banks used to seek high rates of return on high-yield and relatively risky peripheral regions. Until 2007, the exposure of major German investment to over-leveraged financial sector in countries such as Spain and Greece generated sizeable spillover effect. Before the onset of the financial crisis, Spain enjoyed sizeable current account deficit resulted from excessively high and robust overall investment. In 2007, Spain’s investment-to-GDP ratio (31 percent) was roughly comparable to developing Asia. In such highly volatile environment where economic growth departed from its long-run fundamentals, even small-scale macroeconomic shocks can result in a substantial loss of economic activity, notwithstanding the spillovers in the banking system and labor market.
The asymmetry in political structures and underlying macroeconomic fundamentals across member countries casts significant doubt in the long-term stability of the Eurozone as an area with common monetary policy. The necessary condition for the inception of common monetary policy does not hinge on the political initiatives that pervaded the process of European integration but on the careful consideration whether adjoining countries adhere to the macroeconomic criteria as denoted by the Maastricht Treaty. The failure to adhere to the contours of fiscal prudence and budgetary discipline by the major EU member states, with few notable exceptions such as the Netherlands, Austria and Finland, lies at heart of the underlying reasons why significant asymmetry and non-coordination in fiscal policy resulted in the adoption of dispersed economic policies whereas the adverse outcomes were not foreseen neither by the politicians neither by policy advisers and academics. To a large extent, as the recent debt crisis has succinctly demonstrated, the ultimate goal of the European monetary integration was the build-up of political union. But whereas European politicians were preoccupied with all-embracing design of the EU as unitary political union, they forgot to acknowledge that political union would require the full convergence of economic policies including the integration of the labor market which hardly any political initiative within the EU deemed feasible.
The non-coordination of fiscal policymakers was highly evident in the division of member states on the core countries and EU periphery. Considering the peripherical countries, Italy, Spain, Portugal and Greece repeatedly proved ill-disciplined in managing the levels of public debt and the magnitude of the budgetary imbalance. Portugal is often the case in point. Prior to the introduction of the Euro, Portugal experienced unprecedented economic boom. Between 1995 and 2001, economic growth averaged 4 percent per annum and the unemployment rate reduced from 7 percent to 4 percent by the end of 2001. At the same time, nominal wages grew rapidly without the necessary productivity growth compensating for the increase unit labor cost. Alongside the overheating of economic activity, driven by construction boom, current account deficits increased significantly, lowering domestic savings rate. After the country experienced a mild recession in 2003 when domestic output decreased by 1 percent on the annual basis, the slowing of artificial economic growth driven by the Euro boom, turned from temporary into permanent. In the period 2002-2010, growth of domestic output averaged at the level of no more than 1 percent per annum with stagnating productivity and significant pressure on nominal wages. Since the size of the labor cost is the major deterrent on growth, the cure for Portuguese ailing economy is the structural adjustment in the public sector such as the reduction of public debt by generating substantial primary fiscal surpluses and the lowering of government spending. Similarly, the experience of Greece, Spain and Italy suggests the evolution of the same pattern evolving over time although Italy has been known as low-growing economy during the boom time.
However, fiscal policymakers in peripheral countries repeatedly produced ill-conceived fiscal mismanagement of public finances. In 2008, the level of budgetary deficit in Greece exceeded 13 percent of the GDP whereas the country has not adhered to Maastricht criteria ever since the introduction of the Euro. After the depreciation, the net debt as percent of GDP in Greece reached 85 percent of GDP and increased to 110 percent of GDP by the end of 2008. As IMF’s recent forecasts suggest, by 2012, Greece’s public net debt could reach 175 percent of GDP. The failure to adhere to the common set of principles as delegated by the Maastricht treaty and EU Stability and Growth Pact in the peripheral countries stemmed largely from the mismanagement of public finances and structural rigidity of the public sector with resulting increases in the burden of the labor cost. In addition, the adoption of extraordinary measures embedded in the public sector such as very low effective retirement age and substantial bonuses for civil servants exacerbated the burden of the public debt with unforeseen net financial liabilities of governments which have not mitigated the persistent burden of public debt that grew substantially over time in the EU periphery.
A natural question is whether the exclusion of peripheral countries from the Eurozone might be feasible and whether Greece’s default on external obligations might help overcome country’s mountainous strain on public debt. First, the re-adoption of domestic currencies is hardly a solution to overcome the intricacies of debt crisis. If Greece re-introduced drachma, external obligations would be strained by a painful and enduring bank run since investors would withdraw the deposits from the portfolio and invest it into safer holding with less volatility and uncertainty ahead. Another argument in favor of Greece exiting the Eurozone is that a devaluation of drachma would boost inflationary expectations and consequently reduce the burden of the public debt but given junk score on government bonds, a rather immediate bank run would follow the devaluation of drachma rather than macroeconomic stabilization. In addition, when Greece’s domestic output is growing far below the long-term potential, inflationary expectations is not a feasible tool to revive the economy from deflationary trap with 16 percent unemployment Moreover, the only feasible and meaningful short-term strategy to boost growth is the reduction of the size of the public sector including the privatization of inefficient state-owned enterprises to generate substantial fiscal surpluses since this is the only plausible measure to tackle the increasing burden of the public debt. As the history of financial crises suggests, the eruptions of banking crises occurred mostly when governments rested on currency devaluations as the ultimate tool to reduce the burden of external debt. In addition, if Greece defaulted on its external obligations, CDS spreads could indicate a snowball effect where Spain, Portugal and possibly Italy could follow the same track.
The question is whether non-coordination between European fiscal policies helped facilitate over-leveraged financial sectors which asked for the bailout by central governments in the wake of the 2008/2009 financial crisis. Over-leveraged financial sectors were attributed to the determinants of various extent. Some argued that over-leveraging is the outcome of innovative financial engineering where fancy mathematicians and physicists applied VaR models to calculate the probability of losses in the portfolio distribution of returns whereas the financial derivative schemes developed by advanced and complex mathematical models were so complicated that nobody, sometimes even mathematicians themselves, could understand sensibly. On the other hand, the monetary policy perspective of over-leveraged financial sectors has been rather overlooked in policy discussions since periodically low interest rates encourage excessive risk-taking which further facilitated the construction of portfolios with excessively volatile returns that increasingly relied on VaR assumptions whilst fundamentally ignoring the instability of returns from over-leveraged investments. But a more intriguing question pertaining to the banking perspective of financial crises is whether more prudent financial regulation as envisaged from recent stress tests by European Banking Authority can be achieved by raising capital adequacy standards. Unfortunately, the history of Basel accords demonstrates that the banking sector has been prone to search alternative channels to avoid raising capital adequacy ratios through innovative accounting tricks whereas neither Basel I and II envisaged the adverse outcomes from excessive risk-taking. As stress tests indicated, capital adequacy ratios should be increased substantially but, moreover, the regulatory framework should not only build on increasing criteria on Tier I capital and common equity but also on the safeguard despositary insurance of contingent liabilities to mitigate liquidity risk that led to the systemic crisis.
The solution to revive the Eurozone economy and revive it from a decade of flawed political imperatives should not exclude multiple options. The focal point of the Eurozone’s recovery from debt crisis should be to help peripheral countries establishment fiscal prudence, discipline and soundness of the public finances. In fact, the recovery from the debt crisis will endure for more than a decade. The structural adjustment does not rest on the ability of the EU to provide financial assistance to peripheral countries but on the principled and coordinated action to reform inefficient public sectors which are at the heart of the debt spiral since years of generous entitlements to civil servants have tremendously raised the net present value of public debt to the point that peripheral countries are on the brink of default on its external obligations. Without generating substantial fiscal surpluses, there is no feasibility and no realistic scenario under which public debt level would be brought under the control in the near-term perspective. Hence, recent discussions of the consequences of debt crisis in Europe have simply overlooked the importance of growth-enhancing measures as the real cure for growing debt-to-GDP ratio where the measures do not apply to peripheral countries only.
First, in the wake of fiscal insolvency of public pension systems, effective retirement age should be raised substantially for men and women alike. The studies have shown that under the increase in effective retirement age to 65 years, long-term fiscal obligations would reduce and consequently an important step towards long-term macroeconomic stability would be achieved. Nearly every European country is facing low-fertility trap followed from increased affluence and generous early-retirement policies from 1970s onward. Consequently, European government have amounted a mountain of net financial liabilities that exceeded the size of GDP by several times, respectively. Decreasing the size of net liabilities to contemporary and future generations of retirees, requires a robust increase in effective retirement age. Higher retirement age threshold would substantially increase working-age population by encouraging labor market participation among the elderly. Current levels of effective retirement age are unsustainable in the long-run since a growing burden of pension obligations can seriously threaten the stability of the public finance and increase the probability of fiscal insolvency.
Second, European countries suffer from low productivity growth. In some countries, such as Italy productivity growth has remained stagnant over the course of recent two decades while elsewhere productivity growth is to slow to compensate for the increase in nominal wage rates. The evidence, in fact, overwhelmingly suggested that high tax rates are the prime obstacle to greater labor market participation, particularly among the elderly who face high implicit tax rates on work. In particular, to facilitate the channels of productivity growth, marginal tax rates should be decreased substantially. At current levels, marginal tax rates restrain labor supply significantly. In the Netherlands, the top marginal income tax rates reached 52 percent in 2011 which is a serious hinder on the working activity. In this respect, bold tax reforms should be complemented with more flexible labor markets which remain saddled with employment regulations and distort labor supply incentives. Less regulated labor market to supplement greater labor force participation, especially among women, elderly and the youth is vital to enhance productivity growth since living standards by the end of the day are determined by productivity improvements.
Ultimately and most importantly, peripheral countries should be given a free choice whether to withdraw from the EMU since recent financial crisis has shown that Eurozone is a suboptimal currency area which emerged from non-cooperative fiscal policies among its member states that caused adverse outcomes and asymmetric adjustment where macroeconomic stabilization outcomes are mutually exclusive among member states. Asymmetry adjustment that currently threatens the existence and stability of Eurozone lies at the heart of Eurozone’s debt crisis. As a general matter, economic policies have failed to recognize that structural measures in the labor market and fiscal policy regime could facilitate growth enhancement and provide the necessary impetus to stabilization of crisis-impeded monetary union. Recent suggestions by France and Germany for EU member states to form a fiscal union have led to sustained resistance from the UK which dissolved from the fiscal pact. The ultimate grain of truth in the fiscal union is that a monetary union necessarily requires the coordination of fiscal policies to prevent adverse and asymmetric policy outcomes within the union. The fateful conclusion from recent EU debt crisis is that without the integration of the labor market on the EU level, the monetary integration cannot exist in coherence with asymmetric fiscal policies. In the future, stricter adherence to budgetary discipline will be necessary through budgetary authority. In this respect, countries that fail to adhere to Maastricht criteria and deviate from the fiscal discipline either marginally or substantially should be condemned and pay for their actions of fiscal imprudence by withdrawing from the monetary union.
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By Ajay Shah, on January 13th, 2012
Land ownership in pre-modern India
In India, 50 or 100 years ago, land was a defining feature of wealth. The stock of land generated a flow of income. The landless were low-paid agricultural labour. The landed gentry of rural India were the kings of their heap. They had power, prestige, position, prosperity.
In the eyes of many, the initial conditions of high inequality of land ownership were a key barrier that held India back. It was argued
that a one-time bout of bloodshed was essential, to expropriate the rich, and to transfer land ownership in a more equitable fashion. In India, this capacity for State-inflicted bloodshed was present in some places only. In much of India, the unequal distribution of land ownership found in 1947 was left intact.
Fast forwarding into the present, there has been a sea change in the fortunes of the owners of agricultural land.
Agriculture is less important
Particularly after we escaped from the Hindu rate of growth (3.5%) in 1979, the share of agriculture in GDP has dropped sharply. In
relative terms, the wealth created through firms in industry and services has dwarfed the wealth of the landed gentry. The richest man in India is born of one who started out with no land. Government interventions continued to stifle agriculture, but shifted to a
greater laissez faire approach in industry and services; this helped accelerate the decline of agriculture.
The plight of those who stayed back
Rural to urban migration has unleashed new forces on the role and status of the landed lords. Within rich families, high IQ children may be going off to the city to a greater extent, e.g. based on the filtration by competitive examinations where outcomes are correlated with IQ. To the extent that such a process has been afoot, it has given a selection bias where the low IQ children were the ones more likely to stay back in the `idiocy of rural life’ (as Marx characterised it).
That there was an easy option – to live off the land – was a `resource curse’ which afflicted the households who had land. In
contrast, for landless households, there was no conflict of interest in moving to cities (other than the recently introduced NREG, which tries to perpetuate poverty by hindering rural to urban migration).
The power and status of the landed lords was now twice undermined. Their quick-witted cousins who established themselves in
the cities were connected into capitalism and getting ahead. Families of the landless have tended to move to cities and connect into
capitalism and get ahead. The erstwhile lords have started looking nervously at both groups of escapees, wondering whether land ownership was such a nice initial condition.
In a fascinating recent article, Devesh Kapur, Chandra Bhan Prasad, Lant Pritchett and D. Shyam Babu gave us some insights into these changing social structures. In their survey data, in 2007, 98.3 per cent of Harijans were contracting-out the work of tilling their fields to their erstwhile lords, the upper-caste men who owned and operated tractors. The upper tail of the Indian income distribution has, in a few generations, been reduced to operators of agricultural equipment.
The importance of engaging with the market
A defining issue of modern times, for an individual, is a continued and deep engagement with the market. For insights into this idea, see this interview with Tom Sargent. The Ljungqvist/Sargent story matters even more in India, when compared with what has happened in the West. At 7 per cent GDP growth, every few years, far-reaching change comes about in technology and processes. Each individual builds knowledge and human networks by continually engaging with the market. If a person is cut off from engagement with capitalism for even a few years, this generates a lot of damage to the human capital. At that reduced human
capital, the person has to either accept an offer at a much reduced wage, or stay unemployed (which further undermines human capital).
In this setting, consider the plight of a land owner, who has been living off the land, and has never engaged with modern India. Particularly in the post-1979 period, when India has experienced relatively rapid growth, each year of being a country hick owning land meant being further away from the skills required to participate in the contemporary Indian economy.
We see the plight of adivasis in India, who have been away from the market economy, and are unable to plunge into it. We see the plight of the unemployed of Europe: the welfare state pays them dole to stay warm and well fed for many years of unemployment, but after this they are unable to come back into the labour market.
We see a similar problem with the landed gentry of India. They lack the skills to participate in the market economy. Income from the land, their resource curse, dulls their incentive to overcome the barriers. They are often too proud to accept low wage assignments
which are the starting point through which the unskilled connect to capitalism. These problems have come together to give a unique vicious cycle of dis-engagement with modern India that now afflicts the rural landed gentry.
Sale of land in the outskirts of cities
At the edges of all cities, urbanisation is proceeding through developers buying land from the local landed rich and transforming it
into the endless suburbs. In the short term, this has generated immense windfalls of wealth for the landed rich. But in some ways,
this is a bit of a disaster for many of them. Lacking in knowledge about the market economy, they are scammed by insurance salesmen and such like. Much of this newfound wealth tends to get dissipated in a few years.
Urbanisation and land development throws open vast opportunities for trade and industry. But the erstwhile landed rich tend to be
uniquely ill equipped at harnessing these opportunities. They tend to be too proud to work for someone else, and inadequately equipped to stake out on their own. They experience a brief blaze of glory when paid fabulous prices for their land, and then fade away into insignificance.
Some politicians have been moved to advocate special legal protections for the hapless rural rich who sell land to the modern
sector. It’s quite a turnabout within a few generations: from landed elite that oppress the others, to witless folk who need to be
protected by special laws that inhibit the sale of land.
The curse of land
A few decades ago, the left-of-centre view dominated the thinking in India. It was felt that inequality of land was a major bottleneck
that held India back. Many argued that the failure of Indian democracy to engage in a one-time bout of class warfare was a major mistake that was holding India back. It was argued that the Chinese path was the right one: to expropriate the landowners and then start a capitalist economy where everyone is equal.
With the benefit of hindsight, things look different. I think this story reiterates the dangers of social engineering. We are dealing
with enormously complex systems that we only dimly understand. As far as possible, it is wise on our part to use the force of the State as little as we can, and to always avoid treading on fundamental human rights such as property rights.
Acknowledgments
I am grateful to K. P. Krishnan , Suyash Rai and Mihir Thaker and for insightful conversations.
By Ethan Zuckerman, on January 10th, 2012
A few days back, I wrote a post about the Occupy Nigeria movement. As with many of my posts, my main goal was to research the issue and get a better understanding of what was going on and what I thought about it. The post has generated a good deal of feedback, some of it quite confrontational, some skeptical, some helpful in helping me understand the situation better. I’m particularly grateful for the last two types of feedback, as I feel like I understand the situation better than when I wrote the first post.
In my first post, I argued that removing the fuel subsidy is ultimately the right thing for Nigeria to do, as it is riddled with corruption, offers massive benefits to a few companies fortunate enough to have been awarded import contracts, and dominates the government budget at the expense of critical infrastructure projects. What I hadn’t understood fully is that the protests aren’t against removal of the subsidy per se, but about a lack of trust in government. As Nicholas Ibekwe, one of the organizers of the Occupy Nigeria protests in London explains, “Most organizers of the protest believe that removal of subsidy is not a bad thing. And I share that sentiment as well. However, the removal of subsidy in Nigeria is not about economics, it is mostly about trust, corruption and timing. The Nigerian government has not given the ordinary Nigerian reason to trust it.”
Put more simply by Chude Jideonwo on YNaija, “This is good policy badly executed, not because of timing necessarily as because of trust.” In the long run, Nigeria needs to eliminate a fuel subsidy that buys imported fuel – it makes very little economic sense for a nation to produce raw petroleum, export it to countries that refine it and subsidize its reimportation. It would make much more sense for the Nigerian government to help rebuild the nation’s refineries so the oil could be processed locally.
The problem is that, as Ibekwe and Jideonwo both explain, people don’t trust the Jonathan government to repurpose the subsidy to build infrastructure. Many of the arguments against subsidy removal focus on overspending in the Nigerian government, particularly on salaries and benefits to elected officials. The assumption – not without some justification – is that any savings from the subsidy will line the pockets of politicians at the expense of ordinary Nigerians.
Based on the feedback I’ve gotten from Nigerian friends, there’s no doubt that the subsidy removal was implemented poorly. Removing the subsidy in one fell swoop may have been designed to minimize opportunities for dissent (as each step of a gradual increase might invite protest), but it maximizes harm to the ordinary Nigerians who are struggling to cope with cost increases. The removal of the subsidy during the Christmas season had the additional complication of stranding some Nigerians in their home villages without sufficient funds to pay for transport home. And, as the commentators I quote above have pointed out, the Jonathan government simply doesn’t enjoy enough popular support and trust to have implemented these changes so unilaterally.
Alex Thurston at Sahel Blog argues against two arguments he sees me making in the piece. The first argument he sees me making is that removal of the subsidy is a good thing. I don’t think that’s what my argument was, precisely – I think removing the subsidy, ultimately, is something Nigeria needs to do. But as I’ve conceded here, I agree the move was made badly, without sufficient consideration of the harms to ordinary Nigerians, and I hope it will be rolled back and implemented in a more careful, considered way.
The second argument Thurston disagrees with is my contention that a protest against the subsidy is reactionary. Here I think he and I genuinely disagree. Thurston suggests that removal of the subsidy favors the 1% over the 99%, and suggests that because the World Bank and IMF would like to see the subsidy removed, the interests of the powerful favor subsidy removal. I don’t think it’s especially fair to equate the oft-maligned IMF and World Bank with the globally rich and powerful. There are lots of smart economists – including Nigerian Finance Minister Ngozi Okonjo-Iweala, former Managing Director of the World Bank – who are looking for solutions to Nigeria’s long-term economic woes, and who see removing the subsidy as a step towards economic reform.
There’s no doubt that removal of the subsidy is hurting the 99% in the short term. But poor and middle-class Nigerians were experiencing a great deal of economic misery before removal of the subsidy. In the long term, one way or another, Nigeria needs a functioning infrastructure, a working power grid, better roads and rail, better health care and education. In the long term, some of these services need to come from the government… and the government will gain legitimacy by providing services that people want and need, beyond cheap fuel.
Thurston and the Occupy protesters seem to be arguing that the government can’t and won’t provide those services, and therefore we should focus on the short term: maintaining a large subsidy on the import of foreign petroleum products. That mistrust of government’s ability to provide any services sounds more like the Tea Party than the Occupy movement to me. I’m not saying that the protesters are wrong in their mistrust of Jonathan’s government. I am saying that a government taking steps towards modifying a budget to provide essential goods and services appears more progressive than supporting a massive subsidy.
In US terms, this argument sounds like a very typical right-wing argument: we can’t trust the bloated, lazy government to produce public goods, so we should have very low taxes and rely on the private sector for any goods and services. In practical terms, removal of a fuel subsidy is a tax increase. It’s a badly implemented tax increase and it affects people who are ill able to afford it. But the goal is a progressive one, so long as you accept the notion that Ngozi Okonjo-Iweala and Jonathan are genuinely trying to build infrastructure and help the economy recover. If you don’t trust their motives, obviously, you won’t see this move as anything other than an opportunity for more corruption.
Do I think the subsidy removal was a good idea? I think it’s an admirable goal in the long run, but was badly implemented and should be rolled back and implemented gradually in closer consultation with a variety of non-government groups. Do I support the Occupy Nigeria movement? Yes, inasmuch as I think it’s great to see organized, peaceful, popular opposition to corruption in Nigeria. But I am deeply worried that the movement is focused on rolling back a change that, in the long run, is intended to correct some of the major problems of the Nigerian economy. Do I still think the movement is reactionary? Yes, in the literal sense that protesters are trying to roll back a change made by government, and more figuratively, because the movement questions the ability of the government to create positive change for the people. I hope the movement will become a broader anti-corruption movement, which I would see as less reactionary, more progressive and more in line with global Occupy movements.
Do I expect that this post will reduce the amount of angry email I’ve recently received? Probably not.  As several correspondents have pointed out, passions are understandably running very high around these issues. It’s hard to both critique and support a movement, but I think the issues here are complicated enough that it’s worth trying to do both simultaneously.
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