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Aside

Larry Summers on the Future of Higher Education http://www.nytimes.com/2012/01/22/education/edlife/the-21st-century-education.html?pagewanted=1&_r=1 What You (Really) Need to Know By LAWRENCE H. SUMMERS Published: January 20, 2012 A PARADOX of American higher education is this: The expectations of leading universities do much to define … Continue reading

RBI’s blunt instrument against inflation

The Reserve Bank ofIndiahas raised its interest rates again this week in an effort to curb inflation that has seen double digit growth in recent months. This is another rate hike in the long series of rises started by the RBI in March 2010, yet inflation continues unabated. This is hardly surprising since the tool that the RBI has is a blunt instrument.

The tool – interest rates work to control inflation only if there is excess liquidity in the system that needs to be mopped up lest it power the increase in prices. In our case, the system is far more complex and controlling just one aspect has not proved to be very effective – in fact interest rates have risen so much that they are now an impediment to our much vaunted economic growth.

The forces that work on inflation are not just the supply (and demand) of money, which is what the Reserve Bank is trying to control by making it more expensive to borrow money. The supply and demand of real goods and services are equally more important determinants of the price levels. We, inIndiahave had the good fortune of high economic growth with rising income levels, which has spurred demand, both for essentials and luxuries. Our government is trying to build its version of a social security network via schemes like the NREGA among others. The resultant incomes are spent on food and other essentials while the supply of these has not kept pace. This will inevitably lead to inflationary pressures that the RBI’s tools cannot do anything about. Much has been written about the supply constraints in the agricultural sector, in infrastructure – all of which feed inflation and are beyond the purview of the RBI.

Systemic constraints remain too – much ifIndia’s money is not in the banking system at all. These markets do not even participate in the official monetary  system, so any tweaks by the RBI have little or no impact. At the same time, there is little or no resistance to the rise in prices from the public. Resistance does not always mean that people need to protest or form a mob, but does mean that they resist the higher prices by buying less, thus pressurizing the suppliers to reduce their prices. The RBI’s interest rate hike is not going to create this demand side pressure.  

Sadly, inflation often goes into a self sustaining cycle, where rises in prices are linked to rises in incomes. This happens both in the government and in many parts of the unorganized sector. The higher incomes support purchases, which in turn raises prices.

With the rise in interest rates, the RBI hopes that we will save more, borrow and spend less so that the money sloshing around in the economy is contained. But in this too, it is thwarted – for purchase decisions are based on expectations as much as current realities. Rising prices make people and businesses tend to hoard goods to save themselves from buying the same at higher prices later. This further restricts the supply of goods in the market – pushing prices further up.

The incentive to save due to higher interest rates has to be countered by a matching assurance that prices will not continue to rise – which is not possible by tweaking rates and money supply alone. Rising inflation in fact eats into the nominal interest rate (the stated rate), reducing its real effect on both borrowing and lending. In a system where people begin to believe that inflation is likely to rise faster than interest rates, it is smarter to borrow than to save, for the real (inflation adjusted) value of what will be returned is less than the paper value.

Unless the RBI can be seen to be totally in control of this process, reining in inflation with measured rises in rates – it has a tool that blunts itself by being used. This, it cannot do alone – without stamping down on the other causes of price rise, the Reserve Bank seems to be fighting a lone, losing battle.

The Reserve Bank ofIndiahas raised its interest rates again this week in an effort to curb inflation that has seen double digit growth in recent months. This is another rate hike in the long series of rises started by the RBI in March 2010, yet inflation continues unabated. This is hardly surprising since the tool that the RBI has is a blunt instrument.

The tool – interest rates work to control inflation only if there is excess liquidity in the system that needs to be mopped up lest it power the increase in prices. In our case, the system is far more complex and controlling just one aspect has not proved to be very effective – in fact interest rates have risen so much that they are now an impediment to our much vaunted economic growth.

The forces that work on inflation are not just the supply (and demand) of money, which is what the Reserve Bank is trying to control by making it more expensive to borrow money. The supply and demand of real goods and services are equally more important determinants of the price levels. We, inIndiahave had the good fortune of high economic growth with rising income levels, which has spurred demand, both for essentials and luxuries. Our government is trying to build its version of a social security network via schemes like the NREGA among others. The resultant incomes are spent on food and other essentials while the supply of these has not kept pace. This will inevitably lead to inflationary pressures that the RBI’s tools cannot do anything about. Much has been written about the supply constraints in the agricultural sector, in infrastructure – all of which feed inflation and are beyond the purview of the RBI.

Systemic constraints remain too – much ifIndia’s money is not in the banking system at all. These markets do not even participate in the official monetary  system, so any tweaks by the RBI have little or no impact. At the same time, there is little or no resistance to the rise in prices from the public. Resistance does not always mean that people need to protest or form a mob, but does mean that they resist the higher prices by buying less, thus pressurizing the suppliers to reduce their prices. The RBI’s interest rate hike is not going to create this demand side pressure.  

Sadly, inflation often goes into a self sustaining cycle, where rises in prices are linked to rises in incomes. This happens both in the government and in many parts of the unorganized sector. The higher incomes support purchases, which in turn raises prices.

With the rise in interest rates, the RBI hopes that we will save more, borrow and spend less so that the money sloshing around in the economy is contained. But in this too, it is thwarted – for purchase decisions are based on expectations as much as current realities. Rising prices make people and businesses tend to hoard goods to save themselves from buying the same at higher prices later. This further restricts the supply of goods in the market – pushing prices further up.

The incentive to save due to higher interest rates has to be countered by a matching assurance that prices will not continue to rise – which is not possible by tweaking rates and money supply alone. Rising inflation in fact eats into the nominal interest rate (the stated rate), reducing its real effect on both borrowing and lending. In a system where people begin to believe that inflation is likely to rise faster than interest rates, it is smarter to borrow than to save, for the real (inflation adjusted) value of what will be returned is less than the paper value.

Unless the RBI can be seen to be totally in control of this process, reining in inflation with measured rises in rates – it has a tool that blunts itself by being used. This, it cannot do alone – without stamping down on the other causes of price rise, the Reserve Bank seems to be fighting a lone, losing battle.

Speculatively, Sticking my Neck Out

The big Double Dip is here, and we are for it. It will huff and puff, and we can only hope that we remembered to build our house with bricks, to reprise a folk tale for children. These tales are cautionary and contain much wisdom. And in the sprit of using metaphors and tales, and learning as much from them as from history, let us see what the future must logically, in one form or another, bring to us.

 

The recession this time has come from the failure of big businesses, and the misery is compounded by the fact that for many countries the coffers are empty. Fiscal deficits are at their highest, inflation is climbing and printing more money (or borrowing from the future) does not seem to be a particularly satisfactory solution to anything. The root of the problem has been borrowing too much when fundamentally, values were a fraction of the notional amounts transacted on financial assets.

 

The more fundamental issues are the lack of incentives to growth and production. While demographics clearly say that the size of the middle class will grow in the emerging markets (estimates by the World Bank say that 95% of the middle class will be in emerging markets by 2030), there is no indication of what will cause demand, and more importantly production to grow in the traditional markets such as the US, Europe and Japan.

 

It has always been human ingenuity that has found a way out of our troubles and this time too, we will have to have to find clever customized solutions to escape the economic trap that we find ourselves in. The solution we seek lies in innovation, where we seek new processes or products to create value in jaded economies that need renewal. But this time, the innovation may not be big innovation, very few firms have the funds for that. We are unlikely to see investments splashed on the offchance that the new market or product will take off. The risk profile of such innovation is likely to be different. And this is what I call the ‘Spirit of Dunkirk’, where famously a flotilla of assorted small boats and ships found a way to cut across the channel and rescue the troops besieged there. This is the spirit that will need to be revived – in business- to be able to revive economies.

 

Innovation and Entrepreneurship are the twin tools that are going to be necessary to power the recovery. These will necessarily have to operate in tandem, possibly starting at a very small scale to be able to convert the nooks and crannies of opportunity into value. It would be foolish to assume that the spirit of Dunkirk was only about the smart little boats. This time too, the twin tools of enterprise and innovation will need support from either governments, or large enterprise and venture capital. The initial idea, the pilot testing and the proof of concept will, of necessity now need to be in segregated risk pockets. Once they have cleared the intial hurdles, the game changes to that of proven opportunity and valuation. This is where true scaleable value creation can be achieved. This, when aggregated will power the growth engine for the future. Failing this, there are few other means that can power growth in these economies.

 

The recession has, and again will be quite tough on enterprises that do not deliver clearly defined value to its consumer base. These will have to perforce learn to be lean mean entities in these years of want. At the end of the down-cycled, we can expect many of them to emerge fitter than when they went into it. This of course will necessarily mean that there will be many that do not survive the lean years, even if their intentions were noble and processes well designed. The market is a cruel mistress, and she favours only those that can reward her well. It is the enterprises that can find ways of wooing the markets and retaining the best people that will survive in the next few years.

 

Others, to carry on with the metaphor, may need to seek partners to be safer or more useful. Many larger enterprises will play safe to survive and will most likely buy innovative units with growth potential rather than invest in growing them in-house. Smaller and medium sized enterprises are likely to seek the shelter of mergers to be able to withstand the vicissitudes of the market – which if not done well may lead to a further shake out and failures.

 

If there was a business that I would bet on in the next few years, it would be mergers and acquisitions – both advisory and financial. Those who know how to wind up companies and allocate their assets to others will also certainly do well. This sounds morbid, but it is undeniable, that the medium enterprises that need rapid growth to stabilize will find little support from the markets, at least not at the pace that they may need in their businesses.

 

So where would that leave us at the end of the recession. Large companies, lean and mean in their core operations, possibly bloated due to scaled up acquisitions. A few tight and sturdy survivors in the mid-sized markets. Some poised for growth, others relieved to have survived the storm just seeking to remain in safe proven waters. And a host of small innovative enterprises (for this is what governments would have encouraged) poised for growth and ready to prove their worth to potential new investors.

Back with a bang?

Green shoots notwithstanding, I begin to wonder if we have the collective strength to lever ourselves out of this mess. The experts have certainly started speaking of a recovery. Goldman Sachs has shown us again – that they have whatever it takes to survive ups and downs. The questions being asked now are about the shape of the recovery.

Certainly not the bang that we all hoped for. Sharp downturn, sharp upturn ‘V’ shaped recovery, it is not. Paul Krugman in an interview today spoke of a ‘W’ shaped recovery – where we see things get a bit worse before they get better. This is probably more realistic than the previous prediction of a long slow ‘U’ shaped recovery pattern.  Just a little reminder – the letter is a combined letter – made of a ‘double U’ (not a combined V), the recovery too is likely to be the same.

There are signs of demand picking up in some sectors. Among other things that are seen as leading indicators such as real estate and gold, I tend to watch shipping rates. These have finally seen a bit of an upturn indicating a modest increase in international trade, albeit one way. The summer sales in the UK have been better than was feared. Demand data across the world sends mixed signals. China seems to be holding its end up. Investments are still largely government led – therefore a series of promises. Hope again rests on the BRIC countries.

For once, contrary to my instincts, I beleive that the answers to this tangle lies in the small picture. It is the time when we will have to depend on micro-projects, micro-finance and micro-entreprenuers to seize every mico-opportunity. This does not exclude the big players – but it does mean that they need to be able to spot the small gaps and opportunities that they would have ignored in better times. We live in times when we cannot afford to miss the smallest opportunity.

It is time for the Dunkirk strategy again. A flotilla of little ships to the rescue. And we survive to fight another day.

Anti protectionism

 

Our biggest fear today should not be  ‘how long will the recession last?’

What we should fear is protectionism as these are like many other indulgences – feel great in the short term but are harmful in the longer run and for the larger self. A bit like chocolate and alcohol, they are addictive too, and can lead to greater evils – in this case jingoism. Unfortunately, protectionism is a popular story, easily sold while the logic of comparative advantage across countries needs better PR. It will take much juggling and manouvering to get public opinion and policy makers to actively and publicly support what must be done.

In response to the global slowdown, governments have responded, albeit slowly to the symptons. They are curing the fever, not the disease. Most governments – at least the larger ones seem to have come up with the formula – protect your economic borders, give cash (ish) handouts and tax the future incomes of the nation.  How, but how can this be right? Why is this any different from the retail profligacy of the past few years? Is there virtue in the aggregation of unsustainable debt? Or is the securitisation of possible future streams of taxable incomes any different from what the banks have done?

While in an earlier blogpost I had argued that the government must – and indeed is the only entity that can – pump money into the economies to stimulate demand, I must say I am apalled at the way it is being done. Cash handouts at the retail level, incentives to buy houses and cars, subsidised interest rates…how is any of this sustainable. Or, to rephrase – is this the best use of the money (future taxes) to stimulate demand?

Given the mess we are in, governments and central banks will certainly have to dance the fiscal and monetary dance. There will be a series of  expensive stimulus packages followed by severe cutbacks and taxes. It is up to each sovereign government to decide the beat and the rhythm of this dance. This much is certain. What is interesting is what comes next in the decision tree.

The key question today really is – what should the money be spent on? Should governments use the money to close their borders (almost) and seek to stimulate local demand and local production? However populist this measure may be, it should be obvious to all that this is a very expensive way of doing things. To coin a soundbyte: a global problem cannot have a local solution.

Or should they, as I think they should, invest in the long term needs of the country. Investment in infrastructure, education, skills, productivity, innovation, research – all of these, among others will be the determinants of future success. Spending on these will also release funds into the economy. With good PR and public education campaigns (again, income for some), these investments can serve the dual purpose of riding out the storm and preparing for the good times ahead, while holding the rudder steady.

Will politicians have the guts to invest in the future rather than pretend to protect the present and steal from the future?

What are governments’working towards?

 

 

Niranjan Rajadhyakshya’s blogpost in Mint and the comments on that led me to respond with this:

 

“There is no doubt that governments have a larger role to play in the downturn, and their greatest contribution will be in filling the investment gaps left by the receeding private investors. I beleive that they will also have to support the gap in demand for services for a while too, while the economy finds its new rhythm and balance.

This is an opportunity for the governments to focus on re-examining their systems – physical, regulatory and at the policy making level. The recent frenzied pace had governments rushing to keep pace with the demand for each of these services,and the slowdown gives them an opportunity to do just that. The tools they use to do so must have the twin targets of supporting investments and creating demand while re-inventing these systems. The ultimate goal of course being sustainable long term (high) rates of growth (at least till we climb Maslow’s mountain!)

This begs the next two questions: ‘What needs to be done?’ and ‘How do you know it is working?’ Here I have to agree with myself and other commentators – Direct targets for fiscal policy can really only be set in terms of inputs. The results (phal) of these policies are based on complex inter-relationships, unpredictable and very difficult to measure. The correlation of any stimuli to growth may be measurable, the causality truly is not. Intermediate targets such as jobs, health (delivery numbers), education and skills initiatives are great examples of the categories of targets that can be measured. (The underlying assumption here being that there is a direct causal relationship between these measures and the goal – growth/living standards/happiness).

To add my tuppence and answer the original question at the very begining of your post: Should there be an explicit variable that they should target. Yes,it has to be explicit. They will be measured by other economies, by the press, by the people and if they are to be honest about their progress, they must let us know what they are working towards.

I add another question: Can it be a single variable? I think not. I think they (or some of us!) will have to work to creating a composite that is like a ‘balanced scorecard’ and I know that there are others like me who would love to take this forward.”

 

 

My question here is: What should this scorecard contain?  What are governments really working towards?

Of economists

How can you tell an economist apart from a normal person? Well, they answer every question with the words. ” It depends..”

True…economics is a behavioural science. You cannot expect a single answer as in physics or mathematics. Every issue is complex and will naturally have multiple solution sets. Honest economists will try to estimate the chances of each of these solutions. Economists in lobby groups, political parties or in need of funding will have to chose the path that is economically beneficial to them. If I were to read the opinions of and economist and beleive them without researching their affiliations, I would be a fool.

 

 

In response to: http://indianeconomy.org/2009/01/17/can-we-trust-economists/