Friday, May 27, 2016

Asymmetric ignorance and monetary policy

Forward guidance has assumed a central role in monetary policy making in recent years as central banks try all possible means to stimulate economic growth. The forward guidance literature makes the distinction between Delphic guidance about public statements about “a forecast of macroeconomic performance and likely or intended monetary policy actions based on the policymaker’s potentially superior information about future macroeconomic fundamentals and its own policy goals,” and Odyssean guidance that involves clarifying ex-ante on the policymaker’s professed commitment. 

In this context, Ippei Fujiwara andYuichiro Waki argue that unlike Odyssean guidance, the Delphic guidance on private information available with central banks can be destabilising. Using a New Keynesian model, they find,
The underlying mechanism is simple and operates through the forward-looking, price-setting behaviour of sellers, i.e. the New Keynesian Phillips curve. Imagine that the sellers also receive some (private) information that is useful in predicting future cost-push shocks. Such information influences their inflation expectations and, therefore, the prices they set today. Their price-setting decisions become more susceptible to future cost-push shocks, and, everything else being equal, inflation becomes more volatile. Conveying news about shocks to the central bank’s loss function and shocks to the natural rate of interest has the same effect. In contrast to Odyssean forward guidance that helps stabilise inflation and the output gap, Delphic forward guidance can destabilise them in New Keynesian models.
A little asymmetric ignorance would help.

In this context, this GMO study by James Montier and Philip Pilkington assume relevance. They document very significant positive effect on equity prices over the past 30 years on FOMC meeting days after the meetings announcements. Their analysis found that since around 1985 the markets started to react significantly to FOMC days. Using a strategy of going long (buying) on the meeting days and zero on all other days of the year, over the years, they find
The authors write,
This means that we removed around 18 days a year in the 1960s, 14 days a year in the 1970s, and 8 days a year from 1981 onwards. During the period 1964 to 1983 there was absolutely no effect from removing these days. But, from 1985 onwards, removing fewer days began to have a major and increasing impact on the market. In fact, FOMC days account for 25% of the total real returns we have witnessed since 1984... the chance of this occurring randomly was only 0.0086% (that is, 86 out of 1 million).
Breaking down the effects over periods, they find that the average returns on FOMC days in the 2008-12 period were 29 times higher than the average on non-FOMC days!
In fact, the result was not, in a statistically significant manner, any different even when the Fed was tightening.
As the authors say, "it appears that the stock market reaction wasn’t driven by easing so much as it was by the fact that the FOMC was meeting at all!" Their monetary adjusted CAPE (cyclically adjusted price-to-earnings ratio), obtained by replacing the FOMC day returns with non-FOMC day average, leaves the markets significantly lower than today.

Thursday, May 26, 2016

Campaign finance fact of the day

Washington, too, is so deeply tied to the ambassadors of the capital markets—six of the 10 biggest individual political donors this year are hedge-fund barons—that even well-meaning politicians and regulators don’t see how deep the problems are.
I have blogged earlier about how the most corrosive effect of widening inequality may not be the inequality itself, but its effect in terms of how it enables capture of political decision making. The truism that "he who pays the piper calls the tune" is no different today than earlier.

The most telling example of this was the response in the US to the sub-prime mortgage crisis which left both financial institutions and homeowners fighting for survival. While the vast majority of the TARP was directed mainly at the financial institutions to save the TBTF institutions, the homeowners with negative equity were left with marginal assistance. It should not have been a surprising outcome given the grossly skewed participation in the discussions leading up to the finalization of TARP. The result,
A lack of real fiscal action on the part of politicians forced the Fed to pump $4.5 trillion in monetary stimulus into the economy after 2008. This shows just how broken the model is, since the central bank’s best efforts have resulted in record stock prices (which enrich mainly the wealthiest 10% of the population that owns more than 80% of all stocks) but also a lackluster 2% economy with almost no income growth.
It is in the political and social battleground that inequality wreaks its greatest damage. And it assumes even greater significance for India, which already has one of the highest and fastest rising net Gini index, since the antecedent social and other practices are likely to exacerbate the political capture problem.

Wednesday, May 25, 2016

The power of mild preferences

I have blogged earlier, pointing to the famous Schelling chessboard experiment, about how even mild preferences (among agents) can have surprisingly large macro-level general equilibrium effects. 

My examples focused on school choice and the use of vouchers - this on the dynamics associated with how school choice ends up enfeebling public systems and this on how voucher advocates confuse the merits of vouchers with the relative superiority of private schools. Intuitively school vouchers should be great - they enable choice and lets parents seek out the best schools, thereby fostering school competition and generating desirable outcomes all round. Surprisingly, the evidence from across the world (US, Chile, Colombia, Mexico, Sweden etc) in terms of improving learning outcomes (test scores), retention rates, and years of schooling is very mixed. In fact, in the most recent study from New Orleans (post-Katrina) reveals that it lowered learning outcomes. 

Now, Allison Shertzer and Randall Walsh examine neighborhood-level data to study segregation in US cities over the 20th century and comes to similar conclusions. They point to a similar trend contributing to the distinct US urban segregation pattern of white suburbanization and black core, 
Whites began resorting themselves away from black arrivals in the first decades of the 20th century, decades before the opening of the suburbs. Our analysis isolates the channel of white flight from institutional barriers that constrained where blacks could live in cities. We argue that accelerating white population departures in response to black arrivals at the neighbourhood level can explain up to 34% of the increase in segregation over the 1910s and 50% over the 1920s. Importantly, our analysis suggests that, while discriminatory institutions faced by blacks were clearly important, segregation may have emerged in US cities even in their absence simply as a consequence of market choices made by white families... Our results indicate that one exogenous black arrival was associated with 1.9 white departures in the 1910s and 3.4 white departures during the 1920s.
Their conclusion is very important,  
Policies that reduce barriers faced by blacks in the housing market may not prevent or reverse segregation as long as white households continue to resort themselves away from potential black neighbours.
But there may be one more wrinkle to this story. Such policies, whether in housing or schooling, is unlikely to directly achieve its desired objective of increased mixing among communities. But what if the desegregation contributes to attenuating preferences and making mixed habitations less unacceptable? What if it contributes to greater social integration? What if, over a long period of time, the general equilibrium effect in favor of social integration is greater than the similar effect towards segregation? 

Tuesday, May 24, 2016

Globalization and taxation

In recent times, amidst weak global economic prospects and rising protectionist sentiments, an intense debate about globalization has resurfaced. Peter Egger, Sergey Nigai, and Nora Strecker have a new paper which adds to the debate by raising the possibility that globalization may have had the effect of increasing the reliance of governments on less mobile middle-class tax bases. They examined a taxation database of 65 countries in the 1980-2007 period, and find significant effects as globalization gathered pace post-1994. 

Their narrative is simple. As economies open up and globalises, businesses and high-income individuals become footloose or to paraphrase Charles Tiebout, "vote with their feet". One way countries compete to retain and attract them is by lowering the corporate and marginal tax rates. In the process, among developed economies, on the average and when there is limited induced economic activity, tax revenues from these sources decline, forcing governments to rely more on the relatively immobile middle-class incomes. The authors write,
When goods and factors became relatively more footloose after 1994, evidence suggests that OECD governments found it more difficult to tax (arguably highly mobile) high-income earners. Moreover, in light of competition for such often high-skilled individuals, countries have further sought to decrease those individuals' personal income tax rates and compensated the foregone revenues by increasing taxes on individuals with middle incomes (and lower bargaining power than high-income earners)... under the threat of flight of high-skilled workers, governments reduced taxes for mobile high-income earners and increased them for the immobile middle- and upper-middle-income classes. 
Consider this. Middle-class income tax rates have increased by around two percentage points across 65 countries, whereas corporate and marginal tax rates have declined significantly. 
And, for the OECD countries, the burden has been carried by those at the middle, especially post-1994.
This effect is likely to get amplified as other technology-driven trends like e-commerce and remote working gains ground. The losers of globalization will perceive that their jobs are being taken by foreigners and their tax rates are rising. The widening inequality will exacerbate the discontent and generate more backlash against globalization.

There are no easy solutions. A two-pronged response may be the only way forward. One, the losers will have to be compensated by way of a stronger social safety net complemented with re-skilling programs that equip them with occupational mobility. The corollary of this though is to increase tax rates on the winners so as finance the benefits for the losers. But this redistribution runs into the Tiebout problem.

This brings us to the second response, which is about international coordination on taxation policies to prevent a race to the bottom. More so at a time when the global economy is weak, investments anemic, and international trade stagnant, and income growth confined to the highest earners, any competitive tax reduction is most likely to be a zero-sum game for all countries put together. No country gains without hurting others. In other words, tax reduction merely increases arbitrage opportunities without any commensurate increase in productive efficiency and output. In the absence of some form of global coordination or restraint, economies will be encouraged to indulge in competitive tax reduction that would only increase the relative tax burden on the middle-class everywhere. 

Monday, May 23, 2016

Shaping expectations - taming inflation and corruption

Both inflation and corruption are a function of expectations. Further, both have high levels of hysteresis and the resultant tendency to get entrenched. Once internalized, dismantling requires vigorous efforts to reshape expectations. In the process, collateral damage is inevitable.

In an environment where inflation expectations were unhinged, India's central bank Governor Raghuram Rajan has sought to cement low inflation expectations through an extended period of monetary tightening, even at the cost of economic growth. It has been acclaimed by experts, who have hailed him as India's Paul Volcker. 

On a similar vein, in an environment where corruption in senior level postings had become pervasive, the Government of India's Department of Personnel and Training has sought to reshape expectations by adopting an extremely rigorous process of screening. Unsurprisingly, the multiple levels of due-diligence for integrity and efficiency have come at the cost of causing delays and leaving many posts vacant/unfilled for long periods. Senior level positions in banks and public sector units have remained unfilled for long periods. The same experts complain that the delays in filling up posts have caused administrative paralysis.    

While the jury is still out on whether inflation has been slain or not, it can be fairly confidently asserted that the expectations on personnel deployments have been favorably reshaped. But not if you have been following the mainstream media. Clearly what is sauce for the goose is not sauce for the gander!

Saturday, May 21, 2016

Weekend reading links

1. Excellent interactive in the Economist on incomes, annual economic growth, and inequality across several countries during the 1980-2015 period. China is already the second most unequal society in the world, after South Africa, even as its middle class has grown richer than Brazil's. In the 35 years, median income has growth at an annual average pace of nearly 12%, to just 3.5% in India. Assuming past growth rates, median incomes will catch up with the US in 10 years for South Korea, 25 years for China, 60 for Brazil, and 100 for India. 

2. Nice article on Venezuela. The decline has been stunning,
the government led first by Chavez and, since 2013, by Maduro, received over a trillion dollars in oil revenues over the last 17 years. It faced virtually no institutional constraints on how to spend that unprecedented bonanza... In the last two years Venezuela has experienced the kind of implosion that hardly ever occurs in a middle-income country like it outside of war.
3. Are debt-financed dividend payouts and share buybacks that boost stock prices a massive Ponzi scheme? Yes, says Rana Faroohar in her new book. ExxonMobil's ratings downgrade, first time since 1949 it is not AAA, has a lot to do with its stockpile of debt accumulated to finance share buybacks

4. More news of the damage from weak global economic prospects comes from the woes of container shipping liners,
The industry... is suffering what could well turn out to be the deepest and longest downturn in its 60-year history. Container shipping lines have made a series of investments in new, giant vessels, and this glut of capacity has sent freight rates tumbling. The Shanghai Containerised Freight Index — one of the few public sources of information on what lines are charging to ship a container — last month reached the lowest level since its inception in 1998... Amid a slowing world economy, 2016 could be the fifth straight year of subpar expansion in trade.
The industry which has expanded aggressively into larger sized ships is now undergoing a phase of consolidation,
In the first quarter of 2016, Maersk generated $1,857 of revenue for each 40ft container it carried on its ships, 25 per cent less than one year earlier, and $203 below the average cost of moving each box.
5. Fascinating pictorial essay chronicles life in the United States since 1870 as told in Robert Gordon's excellent new book. Here's a description of 1870s life,
They ate pork. Lots and lots of pork — 131 pounds of it per person per year in 1870 (that number was half as much by 1929 and is around 55 pounds today). Unlike other meat-producing animals, pigs could live almost anywhere and could survive largely on food scraps. Their meat, easily salted or smoked, could be preserved in an era without refrigeration. Fresh vegetables were scarce; farmers emphasized crops that could be stored or preserved, like turnips, pumpkins, beans and potatoes, instead of leafy greens that would deteriorate quickly... Instead of a toilet, you used a chamber pot or an open window in the city, an outhouse with an open pit underneath in the country... Boston had 700 horses per square mile. The average horse produced 40 to 50 pounds of manure and a gallon of urine daily, which made the streets of major cities no pleasant place to be.
By today’s standards, entertainment options were limited. Total circulation of newspapers was 2.6 million in a country of 40 million people. There was no telephone, record player, movie or radio. Men could go to the local saloon to drink; women generally couldn’t. Vacations and weekends were not really a thing.  
Childbirth usually took place at home, and deaths were common both at birth and during early years from diseases like yellow fever, cholera and many others. There was no licensing of doctors, so quacks were common.
And what changed in the 1870-1920 period,
The most fundamental shift over those decades was that the American home became, in Mr. Gordon’s word, “networked.” Houses that were once dark and isolated were becoming intertwined. They were starting to be connected to electric grids, providing clean, bright light without emitting smoke. Urban water networks supplied clean water, and sewer systems removed waste without the pungent odors of chamber pots and outhouses. Telephones allowed people to converse with distant friends. These advances were enabled not just by technological innovation in plumbing and electricity, but also by urbanization. In 1870, 23 percent of the United States population lived in cities, which rose to 51 percent by 1920.
6. The consortium hired to reconstruct and operate a new terminal at LaGuardia for 35 years secured $2.5 bn of financing through a municipal bond offering which attracted considerable interest. The Baa3 rated (one notch above junk) 30-year 2046 bond was priced with a yield of 3.27% and a 5% coupon. A Bank of America Merrill Lynch index of triple-B-rated munis across multiple maturity dates yielded 2.88%. This is against 2.6% yield for 30 year US Treasuries. The consortium, LaGuardia Gateway Partners, includes airport operator Vantage Airport Group, construction company Skanska, and Meridiam Infrastructure, an investor and asset manager of infrastructure projects.  

Two observations. One, the very low rates and spread between the Treasuries and risky bonds, despite the near-junk nature of the muni, underscores the point that this is a truly unprecedented opportunity for governments to borrow and invest in improving infrastructure. Two, the consortium presents the ideal mixture of contractor, operator, and financier, a partnership with clearly defined roles and risk allocation which allows for seamless changes in shareholding patterns. In contrast, in countries like India, the concessionaires are invariably construction contractors who develop and then try to either sub-contract maintenance or exit by selling stakes. Apart from creating perverse incentives, such arrangements may, ironically enough, end up increasing life-cycle costs.  

7. How can rising cash reserves and debt burden subsist together? A new Moody's report shows that the US corporate cash reserves rose to $.17 trillion by end-2015, with $1.2 trillion held overseas. For the first time ever, the top five cash hoarders with $504 bn were tech companies - Apple ($216 bn, 93% held overseas), Microsoft, Alphabet, Cisco, and Oracle. 
The rising hoard is a reflection of two trends - tax arbitrage and avoidance, and weak economic expectations and the consequent reluctance to invest. In fact, the report points out that expenditures on things like new equipment declined 3% to $885 bn on the face of lower commodity prices.  

Interestingly, the rising cash reserves have accompanied rising debt. Overall debt rose nearly $850 bn to $6.6 trillion by end-2015. In fact, over the past five years, while cash reserves increased by about $600 bn, debt obligations surged by $2.8 trillion. While the top tier firms too leveraged up, the increased indebtedness was concentrated in smaller and lower quality groups who took advantage of the record low borrowing costs.

8. Citylab points to stunning visualization of property price trends developed by Trulia of 100 largest US metros. The biggest increase was in San Francisco, where the percentage of million dollar homes rose by a staggering 37.8 percentage points from 19.6% to 57.4% of all houses in the 2012-16 period.
Some of the increases in the city neighborhoods have been jaw-dropping - in Westwood Park the percentage rose from 2.9% of homes to 96%!

9. Upshot puts New York's restrictive nature of zoning regulations in perspective by pointing to a study of 43000 buildings which found that 40% of buildings in Manhattan could not be built today. These restrictions include height, limits on residential and commercial space, limits on the number of dwelling units and parking lots, setback rule that mandates buildings to step back in order to rise (saw-tooth structure) etc.
Relaxation of zoning regulations is arguably one of the very few low hanging fruits in public policy space. It is also possibly the only way in which cities, especially in developing countries can avoid extreme gentrification and accommodate the millions of urban migrants.

10. Upshot reminds us about the critical role of luck in determining life outcomes,
According to a 2008 study, most children born in the summer tend to be among the youngest members of their class at school, which appears to explain why they are significantly less likely to hold leadership positions during high school and thus, another study indicates, less likely to land premium jobs later in life. Similarly, according to research published in the journal Economics Letters in 2012, the number of American chief executives who were born in June and July is almost one-third lower than would be expected on the basis of chance alone. Even the first letter of a person’s last name can explain significant achievement gaps. Assistant professors in the 10 top-ranked American economics departments, for instance, were more likely to be promoted to tenure the earlier the first letter of their last names fell in the alphabet, a 2006 study found. Researchers attributed this to the custom in economics of listing co-authors’ names alphabetically on papers, noting that no similar effect existed for professors in psychology, whose names are not listed alphabetically.
11. The growth dynamics of the newly constituted Bank Board Bureau (BBB) in India may be a teachable example of how institutions can go astray. The BBB was notified in February 2016 primarily to "recommend for selection of heads of financial institutions". The popular former Comptroller and Auditor General of India, Mr. Vinod Rai, was appointed its chairman.

After assuming charge, Mr. Rai has waxed on the bank bad assets resolution process, reassured that bank chiefs will not be questioned over the bad asset resolution decisions, and discussed consolidation of PSBs. I am confused. Is the BBB's mandate so wide enough to cover all these complex regulatory issues? If BBB, which advises on appointments, assumes a role in operational management, then isn't there a serious conflict of interest? If so, where do the BBB's role end and the banking regulator's begin?

Or is it a case of "Mission Creep" by BBB, a feature that, once the judiciary showed the way with its liberal interpretation of Public Interest Litigations (PILs), has come to characterize institutional development in India? The hyper-active media have obviously only been too eager to nudge a willing Mr. Rai into these transgressions.

12. Finally, Ananth links to Michael Lewis's review of Mervyn King's new book. Lewis describes the central idea of the book on regulation of banks, the King Rule,
Deposits and short-term loans to banks simply need to be separated from other bank assets. Against all of these boring assets, banks would be required to hold government bonds or reserves at the central bank in cash... The riskier assets from which banks stand most to gain (and lose) would then be vetted by the central bank, in advance of any crisis, to determine what it would be willing to lend against them in a pinch if posted as collateral... The banks would decide, before any crisis, which of their risky assets they would be willing to pledge to -- basically, pawn with -- the central bank. The riskier the asset, the less the central bank would be willing to lend against it. Any asset so complicated that it couldn’t be explained satisfactorily to the central bank in three 15-minute presentations wouldn’t be eligible as collateral. Everyone would know, if any given bank ever required a loan from the central bank, the size of the loan the central bank would be willing to extend. The central bank would go from being the lender of last resort to what King calls the pawnbroker for all seasons.
It would also have a handy, simple rule to determine if any given bank is solvent: the difference between its “effective liquid assets” and its “effective liquid liabilities.” The effective liquid assets would consist of the securities the bank held against its deposits (government bonds, cash), plus the collateral value of its riskier bets as judged by the central bank. The effective liquid liabilities would be the money that could run from the bank at short notice -- deposits and loans of less than one year made to the bank. The rule -- call it the King Rule -- would be that a bank’s effective liquid assets must exceed its effective liquid liabilities. If they don’t, the bank is insolvent, and its deposits would be moved without any panic or trouble to a bank that isn’t.
This is certainly going to generate much discussion in the days ahead. A few quick observations. Clearly, depositors are ring-fenced off and that takes bank runs off the table. Fundamentally, this is substantively the same as directly mandating higher capital reserves, though framed very differently. Is the framing, in terms of informing the creditors and shareholders their 'haircuts' upfront, likely to be more acceptable? Most importantly, the critical issue here would be the normal time price-discovery with riskier assets. It assumes that central banks can more accurately assess the real value, especially when they become stressed, of these assets than the financial institutions themselves. Further, it also assumes that the central banks can avoid the cognitive bias and environmental pressures that force banks to systematically under-estimate and underprice risks during good times. In fact, it assumes that the 'pawnbroking price' would be a more accurate signal than even those of rating agencies. 

Friday, May 20, 2016

Chasing chimera - credit rating for infrastructure projects

The Business Standard informs that six credit rating agencies are working together on a new rating system for infrastructure projects that is a more accurate signal of its credit-worthiness. It writes,
The new ratings system will look at variable risk factors in public-private partnership projects to assess their viability. The new ratings will differentiate between credit rating of contractor versus the project.
Unfortunately, I am afraid that like with all such search for simple solutions to complex problems, this too is unlikely to work. The fundamental premise is that the reckless lending and borrowing of the last decade with the attendant current banking sector woes could have been avoided with better signalling. In other words, the rating agencies and their ratings could have made up for the banker's failure in accurately assessing project risks. Alternatively, the banks could have outsourced the due-diligence activity to rating agencies. 

It is facile to assume that such ratings can be a substitute for painstaking and rigorous due-diligence by lenders. For a start, it assumes that it is possible to make accurate ex-ante assessments of project risks and betrays an ignorance of the manner in which those risks surface. No type of ex-ante ratings, concluded even before the financial closure, could have been any more reliable in predicting the construction delays and cost over-runs. The commercial risks are project specific, readily identified, and amenable to being assessed with greater certainty than construction risks. Emergent market risks are in any case uncertain by their very nature. Such risk assessments and environment surveillance is extremely costly and require competence that goes far beyond those available with rating agencies. There is simply no substitute for building good risk due-diligence institutional competence in lenders. It just cannot be outsourced.   

As to differentiating between the contractor and the project, it is a first order distinction between corporate finance and project finance. In case of the former, the contractor's rating assumes significance, whereas in the latter, the project gets rated. It cannot be helped if the lenders relied on the wrong rating!

It does little to address the fundamental problem with the prevailing ratings model - the conflict of interest arising out of the rating agencies being paid by their clients. Further, recent experiences with rating agencies give us no reason to repose such faith in their ability and intent to make reliable assessments about project risks.  

Finally, experience from across the world and across history provide ample evidence that financial markets cannot be insulated from credit risks at all times even with measures that mitigate information asymmetry. It has been a feature of these markets that they lose their discipline when credit is plentiful and financiers indulge in risky lending. This would be all the more likely in the context of countries like India, with its massive capital investment requirements and large available shelf of infrastructure projects, and intense pressure on governments to get them rolling.  

A more reliable assessment of the project risks is to use the concept of "optimism bias" that countries like Australia and UK have used to calibrate project risks. As I have blogged earlier, this can be extended to discount the delays associated with individual contractors as well as nature of projects. This may be a more relevant information for creditors, contractors, as well as governments in assessing project risks. And it does not require any rating agency, but can be consolidated and maintained by an institution like the envisaged P3 Institute.