Economic stress in Russia

by Ajay Shah.

The Russian economy has faced a series of adverse shocks after the invasion of Ukraine:

• Many de facto restrictions have emerged upon international trade,
• Many foreign companies have chosen to pull out or restrict activities in Russia, spanning non-financial and financial firms,
• Many individuals living in Russia have chosen to emigrate; these are likely to be high skill people.

We may think it is not hard for Russia to absorb these shocks. After all until 1991 it was the USSR, a land of central planning and autarky. We think they will just go back to those ways. However, the recent events are likely to impose substantial costs for the Russian economy.

Russia is no longer a centrally planned economy

It sounds funny, in today's world, to think of officials owning a target for exports, to think of officials making calculations about how much steel will be required in the light of what the five-year plan has envisaged for building railway lines. But that non-market mechanism for thinking and allocating resources did exist in the USSR (as it did in India).

That institutional capacity has been lost after 1991, and it cannot be quickly recreated. Now, Russia is a capitalist economy. The shocks will be dealt with by the price system in its usual ways.

Disruptions in the price system

Within the domain of the price system, trade and FDI have a deep influence upon the structure of production. Every modern economy involves millions of decisions about what to produce and how to produce. These decisions are made in a decentralised way, and millions of contracts are in place that govern the purchases and sales of each firm.

When 10% or 30% of these relationships are disrupted, it adds up to a storm in the economy. Yes, production can be reconfigured in a self-reliant way (and self-reliance will always induce greater poverty), but that takes time. There is a period of extremely volatile prices, of shortages, where every firm is cautiously waiting for the dust to settle before establishing a new set of self-reliant contracts. Millions of negotiations have to take place, to get a new set of production relationships going. There is a learning process where some contracts fall into place, and then prices change, and then once again some contracts are disrupted or renegotiated, and so on.

When the price system is humming, it is a marvel to behold, and when it is disrupted, getting back to normalcy (even the low level normalcy of self-reliance) is hard.

In the case of Russia, foreign goods and foreign technology are particularly important. They are an economy organised around selling natural resources and importing everything else. Hence, cutting off ties to the rest of the world will be particularly painful. Russia is more like Saudi Arabia and less like India in this regard.

Finance is the brain of the economy

Every real sector decision is shaped by finance. To get to the correct decisions in the real sector, we need finance to be operating correctly.

Russian finance is not operating correctly. The Moscow stock exchange was closed down on 25 February. For a month, the economy has not known stock prices. It is difficult for managers to make real sector decisions without the direction that stock prices provide. Conversely, the lack of observation of stock prices induces private decision makers to wait and see.

The credit market is also disrupted. Foreign banks have a position of about $120 billion (about 8 per cent of GDP) and are downgrading or exiting their role in the economy. Many borrower firms have a cashflow crisis owing to fluctuations in the economy, and would default on banks. A large scale banking crisis is likely. These fears, in turn, would hamper the ability of banks to fund real sector firms in rebuilding for a world of self-reliance.

The mind of the firm

In this thinking, it's important to go into the minds of the key persons of Russian firms. They are debating and thinking to themselves: Will I default on debt? What will happen when there is a default? What will input and output prices be a year from now? How can I put my skills to the best use in this environment, so as to buy locally and sell locally and make a profit? How do I address the departures of some of my employees? Should I leave? How much emotional and financial resource should I commit to overcoming this crisis? Do I just wait this out, and there will be a regime change, and we will go back to globalisation?

Many firms will choose to lie low and wait for the storm to end, as opposed to jumping to action in reconfiguring production for a new world of self-reliance. This inaction will increase the short term pain in the economy and increase the time required to get back to a humming economy.

The threat of emergency central planning

While Russia evolved into a market economy in the post-1991 period, in every society, when faced with a war and an economic crisis, there is a greater danger of central planning by the state. For an analogy, think of the behaviour of Indian officials when faced with Covid-19. In a crisis, there is a greater risk of abandoning the price system, of officials giving orders to firms. The lack of rule of law and constitutionalism in Russia implies that there is more of a free hand for officials to behave like this.

To the extent that central planning resurges in Russia, it will make things worse.

Conclusions

There are three levels of bad economic performance.

Economic performance is bad when there is self reliance.

It gets worse when we layer self reliance with central planning.

It is worst when the self reliance and central planning are brought in suddenly.

In steady state, Yes, it is possible to do self-reliance. We know that self-reliance will induce mis-allocation of resources and a low GDP, but it can be done. A sustained estrangement by Russia will taken them back to conditions reminiscent of the old USSR or the self-reliant India of old.

But getting to that (poor) state is itself a difficult task. In the short term, the Russian economy is in even worse shape than the mere self-reliance scenario.

The fact that the USSR was once the prime exponent of central planning and autarky does not mean that it is easy for today's Russia to readily go back to autarky and central planning. Russia now operates in the price system; the institutional capacity for central planning has atrophied and cannot be readily recreated. The sudden difficulties in trade, FDI, and finance, create a very difficult environment for every private firm. Self-reliant structures of production can indeed be created, and they will achieve a low level performance of the economy, but it will take years to get there, to reconstruct the complexity of the modern economy in a self-reliant way. In the short term, there will be a large scale economic collapse.

I have previously argued that freezing central bank assets is not that important. But the rest of the economic sanctions are an imposing barrier, that will likely induce an economic collapse, even without considering the direct cost of waging war.

I am grateful to Alex Etra and Josh Felman for useful discussions.

Retreat from private infrastructure projects

by Ajay Shah.

The case for private participation in infrastructure

Many years ago, most infrastructure in India was government owned. Policy thinkers strenuously argued for greater private participation, for the following reasons:

• Private ownership would give better hardware, as a private person cares about what is being built. It would also give better safekeeping of the assets, as a private person cares about his things.
• Private owners would strenuously push for adequate user charges, and act as a counterweight against the biases of the Indian political system in favour of low user charges and thus a burden upon the exchequer.
• If a project is unviable, the private sector will more clearly say so and walk away, in contrast with the government processes which will build infrastructure in respond to political pressures.
• Indian public finance would be better off when its balance sheet is freed from infrastructure assets, and these are instead held by listed utilities who issue debt and equity. It would become possible to bring the vast global capital to bear on these markets and deliver low cost financing.

For some years, private participation in infrastructure grew well, but things have changed sharply. Here are three key pictures. At each point in the time-series, we sum up the value of infrastructure projects in the CMIE Capex database that are classified as being `under implementation' by CMIE. The time series of the stock of `under implementation' projects changes from $t$ to $t+1$ because some old projects are commissioned, some are abandoned, and some new projects appear into the list.

Private infrastructure projects that are Under implementation in the CMIE Capex database

As the graph above shows, we got a huge increase from 2003 to 2011: a gain of roughly 10x in nominal rupees. By 2011, there was a stock of roughly Rs.25 trillion rupees of private infrastructure investment projects that were under implementation.

After  that, private infrastructure projects have receded substantially. We have a decline of Rs.5 trillion in nominal terms. If inflation were taken into account, that is a decline of another 25%.

How has government infrastructure investment activity fared?

Government infrastructure projects that are Under  implementation in the CMIE Capex database

This shows a picture of steady growth. In 2011, both private and government projects were at roughly Rs.25 trillion. From there, the private projects have dropped to Rs.20 trillion while the government has gone on to Rs.38 trillion. There is growth in the stock of government infrastructure investment projects under implementation, even after you take out the 25% increase in prices from 2011 till today.

It is quite a reversal for the long-held objective of having greater private participation in infrastructure.

What's the overall picture of infrastructure investment?

Total infrastructure projects that are Under implementation in the CMIE Capex database

Putting the two together, there is broad stability from 2013 onwards (but a decline in real terms once you take out inflation). What has not been widely observed is the compositional change within this overall number: the private sector is losing ground and government infrastructure projects are gaining ground.

Implications

In my view, the original logic in favour of greater private participation in infrastructure remains. The private sector will use capital more effectively, deliver a better incremental capital-output ratio, and take care of assets better. Conversely, public sector domination of infrastructure investment is going to deliver reduced bang for the buck.

 

The great advantage of private-led infrastructure investment lay in the ability of the private sector to tap into the near-infinite resources of the global financial system. Public sector investment, in contrast, is constrained by the Indian fiscal situation. This generates a significant resource constraint for the public-led strategy.

 

The compositional shift in favour of public infrastructure projects is a weakness.

Where did we go wrong?

In the first wave of pushing private sector participation, we did not adequately understand that private participation in infrastructure requires complex institutional machinery. The government's role in infrastructure is in three parts: Planning, Contracting and Regulating. Clear structures needed to be established for each of these three pillars. Mechanisms were required for resolving disputes and protecting cashflows from user charges. We needed to keep our eye on the prize: the projects that come out of all the complexities of the early stage and make it into the listed space, as boring utilities who just collect user charges and do O&M. With the benefit of hindsight, we went  about private sector investment in infrastructure in a slipshod manner.

In the recent period, instead of fixing these institutional complexities, there has been an excessive willingness to give up on private sector participation and make do with muscular State-led investment. It feels like an entire generation of institutional memory, about the problems of public sector infrastructure investment, has been lost. We are now running a Chinese-style risk of large investments going in with low returns in terms of incremental GDP per unit investment.

What does socialism do to ethics

Marginal Revolution has a post about the moral effects of socialism. In this, we are pointed to a fascinating new paper. Ariely, Garcia-Rada, Hornuf, Mann have a new paper where they analyse the natural experiment of one Germany that was arbitrarily sub-divided into communist GDR and capitalist FRG. They find that people with a greater exposure to socialism are more likely to cheat.And, a paper by Al-Ubaydli et al on PLOS One in March 2013 finds that the framework of markets and trade increases trust in strangers.

I have heard similar concerns about low ethical standards in China as the outcome of many generations of communist rule.

Was it just a matter of stamping out religion? Is the causal chain composed of destroying organised religion that leads to cheating by individuals? This does not square with some other evidence. This paper by Gregory S. Paul in the Journal of Religion & Society finds that highly secular democracies consistently enjoy low rates of societal dysfunction.

In the comments on the Marginal Revolution post, mm says that P. J. ORourke says that he knew communism was not going to work when it managed to convert Germans into lazy workers.

These ideas resonate for us in India, with our experiences with the corruption and cheating that is associated with government-controlled resource allocation. There is a fundamental tension between socialism and our core aspirations like the rule of law, a Calvinist work ethic, and fairness and honesty in our dealings. What mechanisms might be at work in the corrosion of values under socialism? From my observation of India, I may conjecture:

1. When things are available through connections or the black market, this gives everyone incentives to engage in illegality, and to violate the rule of law. When storage is proscribed as `hoarding' and forecasting the future becomes `black marketing', people get used to the idea that illegal activities are to be pursued, and the people who are willing to engage in greater illegality get ahead in life.
2. In the parts of India where land reform took place, it became more acceptable to steal other people's stuff.
3. People became supplicants in front of a powerful State, and detested the bureaucrats and politicians who wielded discretionary power. This created pervasive hatred and disrespect for the State, an environment that was conducive to breaking laws more frequently.
4. When inequality is bemoaned and envy becomes fashionable, there is reduced incentive to engage in hard work as a tool to get ahead in life.
5. A big State employs more people, and employees of government and public sector companies tend to have a diluted work ethic.
6. There is a big gap between all the talk about poor people and the reality of the socialist State. This breeds cynicism about politics and government, and fewer wonderful people get involved in matters of the State.
7. When the political leadership allocates time and money to doing central planning and running welfare programs, this comes at the expense of time and money focused on catching crooks.

If we are able to retreat from an intrusive State, and build the rule of law for a narrow set of interventions that do public goods and address market failures, this will help create a new tone of flesh in the Republic. But the changes in behaviour that come with a socialist phase take many decades to get stamped out. We should change things from here on -- but we will live with the consequences of Indian socialism for a long time.

Hence, questions about ethics are going to be a key feature of the Indian story for years to come. I have written before on related themes: Indian capitalism is not doomed, and Ethics and entry barriers. There are now 40 posts on this blog with the label `ethics'.

Competence in policing

David Montgomery, Sari Horwitz and Marc Fisher have a great story in the Washington Post about how the police tracked down the murderers in Boston. Also see Spencer Ackerman in Wired magazine. On a similar theme, look back at the attack at Times Square in New York.

We in India fare dismally on this. Lacking competence in the police, we repeatedly engage in faulty tradeoffs in security, where police either infringe on the freedom of citizens or resort to brutality against innocent `suspects'. Every time the police quickly solve a case, I worry that they merely tortured some plausible sounding suspect.

Law and order is the most important and most basic public good. Dense urban congregations, which are the essence of modern creative capitalism, are only possible with very high levels of safety. The US is priority #1 for the bad guys, and has had two attacks in 12 years, both of which were followed by outstanding investigations. We in India suffer from thousands of attacks, most of which are never solved. This shows the low capabilities of our law enforcement crew.

We in India go wrong at three levels:

• Elections have degenerated into competitive subsidy programs; both politicians and voters have stopped focusing on performance of the government on public goods. Left-oriented intellectuals are complicit in this, with an emphasis on inequality and subsidies rather than on public goods. When voters are not focused on public goods, the accountability through elections does not generate feedback loops in favour of better public goods.
• In this environment, inadequate resources go into public goods, the most important of which is the criminal justice system.
• Within the criminal justice system, there is little accountability, and we are not seeing feedback loops through which the system is constantly reshaped (within existing budget constraints) towards better performance.

The recent wave of outrage on law and order should ideally help set a new course. See Law and order: Going from outrage to action. Mistreating women is not encoded in our culture or our DNA: it is endogenous to the incentives provided by the criminal justice system. The same Indians behave very differently towards women when placed in alternative criminal justice systems in other countries. If enough voters demand performance from politicians for better law and order, we will get a greater focus on it, in terms of:

• More top management time. E.g. how many hours per year does the PM work on law and order in Delhi versus how many hours does he spend on NREGA?
• More money. E.g. how much money do we put into law and order in Delhi versus how much money do we put into NREGA? 
• More and better people. E.g. how do we get the best and brightest civil servants out of relatively unproductive tasks (subsidies) and into the things that matter (public goods)? How do we increase the staff strength of government in public goods, while cutting the size of government on subsidies? How do we make careers in police, courts and jails more attractive, and careers in education, health and welfare programs less interesting?
• More analysis. How do we get more research papers on the criminal justice system, and fewer research papers on development economics?

Sugar: Letting the invisible hand work

by Apoorva Gupta.

The recent announcement that dismantled the levy and monthly release mechanisms, in the sugar industry, will make the industry more efficient and competitive. But much remains to be done. This is a good time to look at the government interventions in this industry, the implications of recent decisions, and the way forward.

Major government controls

With an aim of offering farmers, firms, and consumers a fair deal, the government intervenes in production and distribution through various controls:

1. Minimum price for cane: Under the Sugarcane (Control) Order, 1966 (SCO), the Central government announces a `Fair and Remunerative Price' (FRP) to ensure a good return to farmers. The state governments announce a `State Advised Price'  (SAP) which has typically been higher than the FRP, thus making the FRP redundant. In 2010-11, the SAP was 47% higher than the FRP.
   
2. Cane Reservation Area: To guarantee continuous and sufficient supply of cane to all mills, the area from which a mill can procure cane is reserved. It is also obligatory for the farmer to sell all  produce to the mill in that area. The state has the power to reserve this area under the SCO.
   
3. Minimum Distance Criterion: The Central government, under the SCO, has set a requirement of a 15 km. minimum distance between two mills to ensure supply of cane to all. States are authorised to increase this limit with prior approval from the Center. Punjab, Haryana and Maharashtra have a minimum distance requirement of 25 km.
   
4. Levy Obligation: Under the Levy Sugar Supply (Control) Order, 1979, till recently, mills had to sell 10% of their produce to the government at a price lower than the market price, and this sugar was distributed through the public distribution system.
   
5. Monthly release mechanism: The central government dictated the amount of sugar a mill could release each month in the open market, under the Essential Commodities Act, 1955 and the SCO. This allowed the government to control the prices of sugar in the market. In 2012, the release orders became quarterly.
   
6. Trade Policy: To ensure national food security and contain price volatility, the government has historically used quantitative restrictions on export and import, depending on domestic and foreign conditions.
   
7. Controls on by-products of sugar manufacture: Molasses is used to produce alcohol which is used in the production of potable alcohol, chemicals and blending with petrol. States impose restrictions on the movement of molasses, and artificially reduce the price for the benefit of liquor barons. The Center has not yet released a clear policy on pricing of ethanol for blending in petrol. The state also imposes restrictions on open access sale of power generated from bagasse.
   
8. Compulsory jute packaging : The central government has made it compulsory for mills to pack 40% of the sugar produce in jute bags.

These controls add up to a comprehensive central planning system that blankets the sugar industry.

No one gains!

Each of these controls has created distortions.

#1: The minimum support price aims to ensure a fair price for cane to farmers, but on the contrary, it is the leading cause of accumulation of cane arrears (Rs 5495.04 crore for 2011-12 sugar season). The SAP is often not commensurate with the market price of sugar, making it hard for the mills to pay the farmers in time. Farmers shift to cultivation of a different crop because of delayed payments and this leads to shortages of cane. With lower production of sugar and higher market prices, the mills are able to reduce cane arrears and this incentivises the farmer to shift back to cane cultivation and the cycle is repeated. The graph below shows these fluctuations.

The figure above shows cyclicality in total production, total cane arrears and the average PBDIT of a balanced panel of 50 sugar companies observed in the CMIE Prowess database. There is a direct relationship between the production of sugar and the cane arrears, and an inverse relationship between total production and firm profit. This cycle is characteristic of the present restricted industry industry.  The price and supply of sugar are extremely volatile, even though consumption has been growing at a steady pace. The mills are often working under capacity and many small ones are shut down in the lean season since production is not economically viable. Farmers are burdened with delayed payments, and consumer welfare is reduced due to volatile prices.

#2 and #3: The cane reservation area and minimum distance requirement have fostered creation of monopolies. The farmer is obliged to sell his produce to a mill irrespective of its past payment record and cannot search for the best price for his produce. This gives monopoly power and artificial protection to firms, and helps inefficient firms to persist in the market. Currently, there are approximately 500 mills, some of which operate only in times when the cane is in surplus, produce as little as 500 tonnes of sugar in a year, and have a very low ratio of recovery of sugar from cane. Moreover, these controls do not allow high productivity firms to expand and achieve economies of scale, invest in increasing the acreage and sucrose content of cane.

#4 and #5: The levy obligation imposed a direct cost on mills to the tune of Rs.3000 crore in 2011-12. In 2011-12, the levy sugar price was Rs. 1904 per quintal, while the price of non-levy sugar was Rs. 2749 per quintal, excluding excise. The mills passed on these losses to consumers in the form of higher prices, and to farmers by delaying payments. The monthly release mechanism led to high inventory accumulation costs and made it hard for mills to manage cash flows. These two controls also incentivised mills to hoard inventory, increasing the administrative and litigation costs of implementing these controls.

#6: The abrupt and unanticipated trade barriers in the form of duties and outright bans, has not achieved the desired reduction in price volatility. Besides the dead weight loss of restricting trade, the unstable policy regarding export and import has reduced the ability of mills to foster long term contracts abroad.

#7 and #8: Mills lose money by selling molasses to liquor barons at an artificially low price. The unclear policy on ethanol pricing for oil marketing companies leads to unfulfilled contracts between sugar mills and OMCs and increases losses for both industries, since blending ethanol reduces the price of petrol for OMCs, and mills do not get revenues from the sale of molasses. The restriction on open sale of power generated from bagasse imposes an environmental cost. Compulsory packing in jute bags adds Rs 0.40 per kg of sugar. These policies, which try to develop one industry at the cost of another, eventually increase the cost for consumers and farmers.

Rangarajan Committee recommendations

The Rangarajan Committee was appointed to study the issues related to regulation of the sugar industry in early 2012. They recommended phased decontrol of the industry.

The recommendations include immediate removal of the levy obligation and monthly release mechanism, and phasing out of cane reservation area, minimum distance criterion and trade barriers over the next couple of years. Concerning cane pricing, the committee recommends that cane price should be a combination of FRP and a share in value of sugar. On international trade, they suggest that the current policy should be replaced by moderate duties not exceeding 5-10 percent. The need to deregulate the movement, pricing and quantitative restrictions on by-products of sugar, and abolish mandatory packaging or sugar in jute bags is also emphasised.

Recent decisions on decontrol

The Cabinet Committee on Economic Affairs has recently approved the removal of levy obligation and the monthly release mechanism (#4 and #5), as suggested by the Rangarajan Committee. The markets welcomed this decision, with a cumulative abnormal return of the CMIE COSPI Sugar Industry Index of 9% over the 2 days after the announcement. The spot price of sugar also spiked after the announcement. The market was over-exuberant at the partial decontrol of the industry and some of these gains have been reversed.

The implications of this partial decontrol are:

1. Impact on finances: The removal of levy implies a direct increase in profit for mills of about Rs.3000 crore since they no longer have to sell 10% of the produce at significantly low prices. With the freedom to release stock, the mills will have choices about selling in India and abroad. The mills facing financial problems can liquidate their inventory when needed.
   
2. Reduction in cane arrears: Mills with large cane arrears will now be able to release stock to make pending payments. But as elections come closer, there is a possibility that the SAP is increased and cane arrears accumulate. This will hurt the financial health of the firms.
   
3. Volatility in prices: If mills release too much stock to reduce cane arrears or due to sheer inexperience with a free market, prices might plummet. The strategic moves of mills, rather than decisions of politicians and bureaucrats, will determine prices.
   
4. Greater trading: Since cane is crushed seasonally and the mills have full freedom to release sugar, the trading on futures market will matter more. The futures market will become much more important in shaping decisions of everyone involved in sugar.
5. Survival of the best: Until now the government regulated the amount of sugar released in the market, and the firms had no experience in thinking strategically. Reaching a Bayesian equilibrium will involve learning by doing, and creative destruction in the industry. Mills will require building up financial depth and skills in hedging using futures. Large firms, which have diversified into production of power and alcohol, will have an upper hand.
   
6. Stability in acreage and cyclicality: The ability to manage cash flows would increase the security of payment to farmers, incentivising them to continue with cane cultivation. The mills and farmers (in the area reserved for them) might enter into contracts where the supply of cane is guaranteed, in return for timely payments. This can considerably reduce the amplitude of the sugar cycle and lead to an improvement in cane acreage.
   
7. Impact on the growth of sector: With a better balance sheet, mills will be able to invest more. The global perception of the industry is going to change from highly regulated to partially decontrolled and this might give greater foreign investment. The freedom to release stock in domestic and foreign markets (provided export policy is not binding) will increase the international presence of mills.

Next steps

Of the list of eight controls, the government has removed two. Most of the pending controls come under the purview of the state governments and decontrol of this industry is now largely their task.

#1: Reforming the regulation of price is essential to reduce cyclicality in cane production, which is a leading cause of cane arrears and low profitability. The recommendation of the Rangarajan Committee on pricing of cane suggests that the farmer will be better off as he is protected from uncertainty in the market due to a guaranteed FRP, and also encourages him to invest in increasing the yield of cane for he has a share in the value.

#2 and #3: Abolishing the minimum distance requirement and the cane reservation area will lead to competitive bidding for cane and farmers would be able choose the best price on offer across an array of choices [analogy]. The increased competition to acquire cane might encourage mills to enter into long term contracts with farmers and offer them other benefits such as timely payments irrespective of the phase of the cycle, make them shareholders, and also assist in increasing cane yield. The inefficient firms are likely to perish with more competition in the market, leading to a more consolidated industry.

#6: Removal of trade barriers is likely to make trade more stable, foster global relationships between firms and make Indian firms internationally competitive. In the recent past, imports were duty free and export release orders were removed, suggesting that the government is slowly liberalising trade.

#7 and #8: Decontrolling movement, pricing and allocation of molasses can contribute significantly to the reduction of cyclicality in the sugar industry. In years of a bumper stock, cane can be used to produce molasses directly and can be distributed to all players at competitive prices. This will also make the sector more profitable. Co-generation from bagasse can become a reliable source of power. Removing restriction on sugar packaging will lead to a direct cut in costs of manufacturing.

Conclusion

The government needs to hasten the process of adopting the Rangarajan Committee recommendations. The job of the government is to focus on public goods, such as improved road and rail networks for the transportation of a heavy and perishable good like cane, improved irrigation facilities to reduce the dependence on monsoons and improved information dissemination for price discovery. Market forces will furnish higher efficiency and growth in the system by ensuring the survival of the best firms, fostering mutually beneficial contracts between the farmers and mills, and stabilising the price of sugar for the consumers.

Acknowledgements

This article has greatly benefited from suggestions from Dr. K. P. Krishnan, Dr. Ajit Ranade and Dr. G. S. C. Rao.

Important work by cobrapost that illuminates high-powered incentives

The investigative journalism by cobrapost, their videos, and Monika Halan in Mint add up to an important story.

Most of us have enormous respect for the achievements of Axis Bank, HDFC Bank and ICICI Bank. But as Monika emphasises, there are also genuine problems there. We saw it first with the hard-driving mis-selling in recent years, particularly with ULIPs, and now we see it here, with staffpersons supporting illegal activities.

Ordinarily, a media outlet in India bringing such information out has to worry about brazen strong-arm tactics being deployed against them, such as filing of criminal cases. In this case, luckily, there is a certain decency about these three organisations which precludes such concerns. It is ironic that the Indian media vigorously reports on the misdeeds of civilised people, and tends to be silent about uncivilised people.

In India, most of us are reverential about the power of incentives. To make people work, we think, you have to have high powered incentives. We revere incentive packages, stock options, stock grants, which whip the staffperson into a frenzy of hard work.

Economists led this charge, starting with Jensen and Murphy, 1990. The notion that high powered incentives are a good thing came out of academia and went into the real world. But increasingly, it has become clear that there are problems. By 2004, Jensen and Murphy themselves were saying that we should be more circumspect about using high powered incentives.

A person facing high powered incentives tends to focus on one thing. There is an excessive pursuit of that one thing, and all other considerations tend to evaporate. Similarly, when there are quantitative goals alongside qualitative goals, high-powered incentives will generate a focus on quantitative goals and tend to crowd out qualitative goals. Employees of a bank that are given powerful incentives to hit targets for deposit growth (sacked if you don't, given a 100% bonus if you do) are more likely to try to pull in that deposit growth by hook or by crook. If the internal controls of an organisation are weak, then employees are likely to achieve their targets by dubious means.

For all of us in India, coming from a backdrop of socialism and State, it is natural to have extreme hostility to the absence of incentive for a civil servant to do his job. We have seen how private organisations have triumphed by giving employees more incentive. But it's easy for us to overdo this message. In many situations, I feel it's better to go from no incentive to low-powered incentives, but not all the way to high powered incentives.

These issues are widely discussed in the global debate. When we transplant these ideas into India, a big difference lies in the weak governance environment. Super-charged employees in private firms seem to be willing to break laws in their pursuit of profit. Since CEOs weigh the costs and benefits of unethical behaviour, we may argue that when, in a weak governance environment, the expected punishment is small, an increase in the gains from unethical behaviour (through high-powered incentives) results in reduced fairplay. 

This suggests two things. First, HR managers needs to be more sophisticated in how the objectives of an employee are defined. If we could be more nuanced in clarifying what the employee is to maximise, this could yield better results. The second issue is about internal controls. When internal controls are strong, they become a non-negotiable constraint within which growing sales or profit has to be done. Unfortunately, once the top managers of an organisation are really hard-driving, chasing growth and profitability, these kinds of niceties (of both kinds) tend to fall by the wayside.

One of the most important mechanisms through which we get high powered incentives is : an entrepreneur who manages a company with family members, and who has dominant shareholding. The one area where this gets us into the most trouble is: Finance. A series of papers that have analysed the Great Recession have found that financial firms where CEOs had more high powered incentives got into more trouble. I am a great advocate of less public sector and more private sector in finance, but we have to be cautious about high powered incentives e.g. those that go with dominant entrepreneurs in a family business.

A prominent example of this debate has been `financial market infrastructure institutions' (FMIIs), a category that comprises organisations like exchanges, depositories, clearing corporations, all of which produce public goods for the financial system. In all these areas, the organisation is unique in that, alongside the goal of maximising profit, there is a regulatory function. This tiny handful of firms is unique, when compared with essentially any other part of capitalism, in that some government functions of regulation and supervision are placed in private, profit-maximising hands. High powered incentives to produce profit or valuation will lead to a dilution or worse of regulatory and supervisory functions. If profit-seeking owners/managers of these organisations under-emphasise or abuse the regulatory and supervisory functions in the quest for profit, this has far-ranging externalities. Failures of regulation and supervision at exchanges have given macroeconomic crises in India in 1992 and 2001. Hence, even though the revenues and profits of these firms is truly tiny on the scale of the economy, this conflict of interest is an important issue for policy makers.

Similarly, there has been a vigorous debate about entry by private banks. As a working approximation, we have to assume that RBI supervision is less than perfect. In this case, I feel that we should be quite circumspect about banks led by entrepreneurs.

How to improve freedom of speech in India

Most of us in India understand that there is a huge problem with freedom of speech in India. India now ranks at the bottom of the world on freedom of speech. Here is some interesting discussion on such facts.

For a sense of the zeitgeist, see an editorial and Lawrence Liang in the Economic Times. R. Jagannathan on FirstPost reminds us that judges in India are not intellectuals who will lead the way on this.

Public shaming

There are two ways through which things are getting better. The first area of importance is public outrage. Even if India has laws that hinder free speech, we should all speak up and establish social norms in favour of free speech, where the use of existing laws that support attacks on freedom of speech is just not done.

As an example, Vodafone embarked on legal bullying against one person, but backed away when faced with outrage.

A splendid example of this push back is IIPM. Recent events (link, link) should make IIPM regret having gone down this route. Speaking for me, I have not accepted and will not accept invitations from IIPM for speaking or writing in their publications, and I will be quite circumspect about resumes that carry the name IIPM. (This is my standard operating procedure for left tail organisations in India). If enough of us do this, it will establish deterrence.

Outrage matters. We should be naming and shaming the offenders and maintaining a hall of shame.

Fixing the laws

The real problem is the laws. Modifications are required -- large and small. We need to shift away from proscribing defamation, obscenity, blasphemy to a stance of supporting freedom of expression. Restrictions on freedom implemented through government control on the Internet need to give way to accepting freedom of the Internet. What is new in recent months is that the outrage has bubbled up to the point where many people are saying Let's go fix the laws:

• An excellent television conversation between Shashi Tharoor and Karan Thapar.
• Pratap Bhanu Mehta in the Indian Express talks about the unusual response of Omar Abdullah and a delicious quotation from Manish Tewari.
• Suketu Mehta in the New York Times says that we must fix the Constitution.
• Jay Panda, Lok Sabha MP, has begun working on private members bills that will fix the laws.

Small modifications of the laws will constitute elements such as: shifting defamation from criminal to civil liability, and having a provision where costs are always paid to the defendant if the accusation does not hold. Fundamental change will constitute fixing the Constitution.

Conclusion

Capitalism and freedom reinforce each other. Both require the ability to think (freedom of speech, freedom of thought) and the ability to act (to vote, to transact, to conduct business, to live). Achieving freedom requires pushing on both fronts -- on establishing a vibrant and open `marketplace for ideas' and on establishing freedom to act.

IIPM reminds us that apart from being a question of high ideas, this is a question of simple consumer protection. When a person thinks of getting a degree, he should have full information about the choices, and IIPM is trying to block that information. Similarly, consumer protection requires that for any publicly visible financial product or service, there should be an unrestricted marketplace of ideas, otherwise the ability of consumers to make wise choices is impaired.

In the best of times, liberal democracies suffer from too little criticism. If we are to make progress on dealing with the problems of corruption and runaway governments, the most important channel is high quality, pointed, trenchant criticism. The present laws are grossly out of touch with the principle of freedom of speech. We need to go fix that: first as a matter of social custom, and then as a matter of law. It appears that there is some movement on both fronts.

Activism and wonkery are the yin and yang

The first element of achieving change is a dissatisfied public that is able to speak up. In places like China, freedom of speech is circumscribed and it is not that easy to express dissatisfaction with the way things are going. In India also, freedom of speech is under attack, and particularly when it comes to our problems of crony capitalism, the threats that we face are dire. But in some other fields -- e.g. the protests against the events in Delhi -- there are no real barriers to speaking out.

When does democratic outrage genuinely change the republic?

Everyone is against rape. Shouldn't our outrage about rape immediately yield a world where women are safe? Unfortunately, the safety of women comes from the functioning of the complex machinery of laws, police, lawyers, judges, courts. To fix the problem, we have to modify this machinery.

The workings of government are a vast clanking machinery with many moving parts. When you see something going wrong in the outcomes, it isn't always easy to diagnose the problems of objectives, accountability, and organisation structure that are inducing the problem, and envisioning the change that is required in order to solve the problem. The protester is saying I'm mad because the car does not work. But it takes a skilled engineer to understand why the car does not work and how to fix it.

Sometimes, I see activists who are revulsed at the workings of the dark satanic mills; who emphasise the protesting and downplay the fixing. There is sometimes a mix of frustration and reverse snobbery in play. I think that at its best, democratic society needs both: the activism (that puts a searchlight on things going wrong in society) and the wonkery (that actually gets things done). I respect the work of activists: What is in the searchlight of the public debate is where we have a chance to break free from the tyranny of the status quo. But there is no escape from getting engaged in the plumbing, from figuring out how it works, and coming up with fully articulated blueprints for change.

In a blog post about Occupy Wall Street, Paul Krugman says:

It would probably be helpful if protesters could agree on at least a few main policy changes they would like to see enacted. But we shouldn't make too much of the lack of specifics. It's clear what kinds of things the Occupy Wall Street demonstrators want, and it's really the job of policy intellectuals and politicians to fill in the details.

This emphasises a two-part process: a democratic process throws up an opportunity for change, after which the quality of the change that is obtained depends on the capabilities of the policy intellectuals and politicians.

While voice is a precondition, it is not enough. The Anna Hazare movement set out to conquer corruption and achieved nothing. A great deal of energy was expended, and it generated plenty of television footage, but it came to nought.

A related example: a while ago, there was a public outcry about insecticides in soft drinks. I think the activists got it wrong : the really important target should be the low quality of drinking water, and not corporations peddling soft drinks. We did not have the policy intellectuals and politicians who could think about reforming water and sanitation, who could harness the outrage and get a meaningful reform program going. Hence, that episode has failed to alleviate the insecticide in India's drinking water.

Example: London's Great Smog of 1952

The Great Smog of China by Clarissa Sebag-Montefiore in the New York Times tells a great story. In 1952, London was hit by a terrible bout of air pollution, termed `The Great Smog of 1952'. 4000 people died. As she says: Most Londoners who lived through the Great Smog thought it was simply an especially foggy period until the undertakers ran out of coffins and the florists sold out of funeral flowers. This led to a `Clean Air Act' of 1956.

Look at the Clean Air Act of 1956. It takes a great deal of thinking to go from outrage at 4000 dead, to figuring out how to draft this. There are hundreds of decisions in the 15,389 words of the law, all of which have complex implications in terms of public administration, incentives for private households and firms, and so on. It isn't about setting up a death penalty for emitting smoke: it is about finding the smallest possible intervention that will get the job done, and one that is feasible given the implementation constraints of government.

Example: India and airports

Circa 2002, the airports were a disgrace. There was a public outcry. The government reacted. Today Bombay and Delhi have decent airports. Why did this work so well?

1. The outcome - a high quality airport - is visible and measurable and monitorable. In other fields -- e.g. criminal justice system -- it is much harder to know where you stand, which reduces accountability.
2. MPs and ministers use the airport. In contrast, with the criminal justice system, they have opted out of public systems. In a problem like corruption, many might actually want the status quo to continue.
3. Airports are relatively cheap and easy: All you had to do was to offend the employees of AAI. The government wrote contracts with GMR/GVK, and the passengers are footing the bill in terms of paying user charges every time they fly. There was no tradeoff between pushing airports and pushing welfare programs.

Under these circumstances it was possible for the political leadership to achieve airports, and make some in the elite (and themselves) happy, at no cost to their conventional focus on welfare programs and at no cost to anyone other than a few unhappy employees of AAI (who did not even lose their jobs).

There was the difficult problem of building regulatory capacity at AERA. The leadership in AERA of the early years did things better than most infrastructure or financial regulation in some respects. My personal experiences with AERA in recent months have left me enormously impressed at the capabilities in the organisation. But at the same time, the problem that they face is a relatively simple one. To use Pratap Bhanu Mehta's delicious phrase, building airports in Bombay and Delhi was not a wicked problem.

Example: London's Big Stink of 1858

Going much further back into time, London went through the `Big Stink of 1858', where the Thames was clogged with human waste. In the summer of 1858, within 18 days, Parliament drafted and enacted legislation that, in time, made the Thames one of the cleanest rivers of the world.

That's a remarkable story. As an illustration of the firepower amongst the policy intellectuals: they had Michael Faraday working on the problem! We don't have a Michael Faraday in our midst; we have yet to match the capabilities of the UK circa 1858.

Some areas are harder than others

Drawing on work by Lant Pritchett and Michael Woolcock, we should apply three tests to understand when doing something in government is hard: (a) Does a public service have a large number of transactions? (b) Do front line workers have discretion? (c) Are the stakes high?

When these three problems come together, building sound public systems is extremely hard. As an example of this thinking, financial regulation is hard while monetary policy is easy. By these three tests, building a criminal justice system is truly hard.

How do good countries grapple with the problem of constructing a criminal justice system? As an example, the John Jay College of Criminal Justice, at the City University of New York, works in this field. It has over 1000 academics working on this one field! In this one field, they have placed more than 2x the number of academics across all fields at IIT Bombay.

There are thus two reasons why making progress on the criminal justice system is hard. Unlike the airports example, these are difficult areas: Large number of transactions, front line civil servants have discretion, and the stakes are high. And unlike the partial success of the equity market reforms, we in India have not laid the foundations in terms of analysis of problems, consensus-building, and construction of key individuals that can play leadership roles in the change.

Example: India's stock market reforms

Financial regulation is a wickedly hard problem. There are a large number of transactions, front-line workers have discretion, and the stakes are sky-high. If all regulation and supervision were done in government, it would be truly hard to make things work, particularly in India.

Hence, there is a neat two-part separation of the work. The exchange is a unique private body that does regulation and supervision. In the bad old days, the exchanges in Bombay and Calcutta were riven with conflicts of interest and did not do a good job of supervision. This gave us stock market crises in 1992 and 2001, which had large-scale consequences for the country. Calcutta Stock Exchange was a small player in 2001, but the problems there were big enough to matter to everyone.

There was an outcry. This led to a dramatic program for change. A new governance model was put into place at NSE and BSE, where there is a three-way separation between shareholders, managers and trading members. The managers, who perform quasi-State functions in supervision, have no shareholding nor stock options. It worked.

Why did it work? It is important to look back into time. Right from the 1980s, ideas for reform had been tossed about. The G. S. Patel Committee, in 1984, had many of the key ideas of the following 20 years in its report. A little noticed feature of the G. S. Patel Committee report is in the preface, where the research support of a R. H. Patil from IDBI is acknowledged. Many of the names that figure in the story of the Indian stock market in the following 20 years were part of the G. S. Patel Committee; as an example R. H. Patil was the founding CEO of NSE.

As a consequence, in 1992, when the crisis came, there were people and ideas in the system that were ready to respond. The knowledge and consensus that was available then carried us half the way.

Through the 1990s, there was a process of analysis and thinking about policy alternatives. There was a view on how change should proceed, and the conservatives were able to stall it. In the listless years from 1996 to 2001, a lot of hard work got done on fully thinking through the next batch of reforms. When, in 2001, the next crisis came, the Ministry of Finance was able to access well-developed ideas and people that drove the next batch of change.

From the viewpoint of politicians, all change is risky. Fear of the unknown feeds into inertia: Why suffer a political cost for sure, offending the status quo, for a reform that might not work? We improve the probability of a reform being attempted when two properties hold: (a) We have a fully articulated blueprint for change, which is backed by high quality thinking and evidence, and (b) People who can staff the reform effort are available.

From 1980 to 2000, the committee process created a working consensus on what was needed to be done, took new ideas from heretical to mainstream, and built individuals who went on to play leadership roles in achieving the change.

That's the good part. And yet, in some ways, this has started turning into a failure story of sorts. After 2001, when the big changes fell into place, the policy community stopped focusing on the stock market. It was felt this is a solved problem. There was a lack of institutional memory about what had gone wrong in 1992 and 2001. The three-way separation between shareholding, management and securities firms was not remembered, and has been undone. We are going back to dangerous times.

Why has the wonkery been so weak in India?

Why are the policy intellectuals and politicians of India so weak on the questions that matter for India's future? There are two elements of an explanation. The first is money.

In India, we spend roughly 1% of GDP on research in four fields : defence, nuclear engineering, the space program and agriculture. But all these fields are of second order importance when compared with the main story of India's future, which is at the intersection of politics, economics, law, ethics and philosophy. In these areas, we are spending 0.001% of GDP. This ratio of 1000:1 of expenditure between these areas is inappropriate. As a consequence, we are failing to grow the intellectuals and university departments in these fields.

This matters for the wonkery. It also matters for the activism. If we could do better on the education that millions of people get in college, we could have a much more thinking citizenry which could be much more effective in mass political action. Our failures on universities are limiting the feedback loop through which growth should feed higher education and should feed back into better politics.

The second problem is development economics. What little is there of the social sciences and humanities in India matters less than it should, owing to the development economics worldview. Everyone outraged about violence in India should ask why the policy wonks of India are so interested in health, education and welfare programs, and so disengaged with the most basic public good of all, law and order. Why have economists thought the private goods of primary health centres are more important than the public goods of policing and courts?

To some extent, the two problems are related. India has offered little by way of career paths in studying India, and getting engaged in the project of building the republic. The development economics establishment, in contrast, offers a full career path: with Western aid agencies, NGOs, the World Bank, academic development economics, and much nourishment from a socialist government. This gives strong incentives for people to focus on poverty, inequality and welfare programs. This has enfeebled the wonks, for the big questions that India now faces are not poverty, inequality or welfare programs.

Conclusion

As Sunil Khilnani says, the most important task for each of us in India is to get involved in politics, in the sense of taking interest in how the State functions and undertaking actions small and large that will prod it towards better functioning. We have traditionally felt that the greatest threat that we face is that of an apathetic citizenry.

It now appears that we have a more active and participatory demos and this is a great thing. We are seeing profound changes in the world of activism. New technologies are reducing the cost of mobilisation. Millions of people have joined the conversation. We find that they care about core public goods and corruption. The voice of the people is negating the socialist claim of all these years, that what people care most about is garibi hatao and inequality. These are great developments.

But while this is a necessary element for a well functioning republic, it is not sufficient. The surge of policy involvement by citizenry is not getting translated into action on a commensurate scale. The constraint is the weakness of the elite. We lack the policy intellectuals and politicians who are able to pursue wicked problems, diagnose what is going wrong, and articulate a tangible program for change.

The policy intellectuals and politicians are missing in action on the questions that matter. The bulk of the existing policy establishment is focused on poverty, inequality and welfare programs. As Shekhar Gupta has emphasised, the ruling ideology among most politicians is ossified in the thought process of the 1970s. India has moved on, but our political ideologies haven't.

Intellectuals are the yeast that make a society rise. Our under-development in intellectual capacity limits our ability to translate a moment -- like the anti corruption movement -- into change. In addition, there is a danger that an irate public that is weak on political philosophy will settle for cartoonish solutions like Lok Pal or Naxalism or a death penalty for rape.

The wonkery is intellectually bankrupt today. The policy intellectuals and politicians who are able to reshape themselves to fit the needs of India from 2013 to 2038 will matter. A greater conversation between the two cultures will also matter greatly, with each cross-fertilising the other. Activism and wonkery are the yin and yang that must work together to build the republic.

Acknowledgements

This post grew out of email discussions with Joshua Felman.

Law and order: How to go from outrage to action

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

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

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

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

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

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

Incentives for politicans

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

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

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

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

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

Resources

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

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

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

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

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

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

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

Feedback loops

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

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

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

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

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

Why are these good things not getting done?

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

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

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

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

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

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

Acknowledgments

I am grateful to Pradnya and Nandu Saravade who helped me think about all this.

The IRR of UIDAI is over 50 per cent in real terms

We have released a cost-benefit analysis of the UID system. In one line, the result of the calculations, under fairly conservative assumptions, is that the IRR of building the system is 53% in real terms. Hence, building UIDAI is a pretty good use of public money.

Through this page, you can access a short and accessible explanation, a video presentation, and the full PDF paper. We have also released the spreadsheet used in our calculations, so that others can modify the assumptions or other numerical values, and obtain alternative answers.

This is true in the Indian case. Is it true in general? I feel the answer depends on (a) The scale of expenditure on subsidy programs and (b) The extent to which present implementation systems suffer from the kinds of leakages that UID readily addresses (multiple payments to one person, payments to ghosts). If a country has small welfare programs, that would undermine the case for UIDAI. If a country is doing a pretty good job of paying out subsidies through conventional procedures, that would undermine the case for UIDAI.

I should like to call you all by name

• China: Worse than you ever imagined by Ian Johnson in the New York Review of Books.
• Totalitarianism, Famine and Us by Samuel Moyn in the Nation.
• Stalin's cannibals by Ron Rosenbaum, on Slate.
• The worst of the madness by Anne Applebaum in the New York Review of Books.
• Stalin and Hitler: Mass murder by starvation by Timothy Snyder in the New York Review of Books.
• Kakfa in Beijing by John Garnaut and Sanghee Liu in Foreign Policy.
• Bloc heads by Louis Menand in the New Yorker magazine.
• Yegor Gaidar's story about the dying days of the USSR is fascinating. This is not going to be the endgame of the PRC.
• Requiem, by Anna Akhmatova.

Government equity infusions into PSU banks

Harsh Vardhan's excellent blog post on this subject made me think further about the questions.

Finance policy makers in India are often proud of the fact that India has avoided a large systemic crisis in which substantial fiscal resources have been put into rescuing financial firms. I think this optimism is overstated. If we look back into the last 20 years, there has been a steady process of government money going into financial firms. On one hand, we have big events like UTI or IFCI or Indian Bank where large sums of public money were put into financial firms. Equally important is the regular flow of government money into PS Banks.

India is in the midst of a business cycle slowdown. This has come after the biggest-ever credit boom in India's history: in 2007, year-on-year growth of non-food credit was nudging 35%. As we know well, a boom in credit is followed by a boom in NPAs when a downturn comes about. We may well be at the cusp of an upsurge of NPAs. In this case, the pressure on capital in PS banks is going to be acute. If government thoughtlessly continues on the path of putting public money into PS banks then it would involve large sums of money.

As Harsh remarks, the striking feature of this annual resource flow is the way it has become commonplace. Nobody even notices this any more. In a time where government does not put equity capital into any other PSUs, the scale at which this is taking place is quite remarkable.

When the government builds a highway, the cost-benefit analysis is straightforward. Do we want to spend Rs.5000 crore in order to get a 1000 kilometre highway? A tangible result -- the highway -- is the fruit of the fiscal labour. In contrast, capital infusions into PS banks are not animated by a clear goal. What are we doing? Why is this wise? What is the cost benefit analysis? Are there other mechanisms through which the same objectives can be obtained at a lower cost? As the approach paper of the FSLRC has emphasised, perhaps the most important element of the public policy process that we require in India is clarity on objectives, and a clear demonstration that the proposed policy initiative is the best way to achieve the objective. I would classify the annual fiscal transfers to PS banks as part of the larger problem, that the edifice of Indian financial economic policy has been grounded in inadequate analysis. I am almost certain that 1000 kilometres of highway is a better use of public money than putting it into the equity capital of a PSU.

Once objectives are articulated, it becomes possible to measure the extent to which those objectives are being achieved. Evidence can be brought to bear about the extent to which the claimed objectives are being pursued. As an example, Shawn Cole did a beautiful paper which demonstrates the extent to which PS banks are a tool for rigging elections in India [journal link, ungated pdf]. If this is what PS banks do, are we better off if PS bank assets would decline, as a fraction of GDP?

Harsh's calculations treat one key number -- 1.1% return on assets for Indian banks as a whole -- as a given. If this number is given, the average Indian bank is not generating enough retained earnings to support growth, and then there is an inexorable need for fresh equity capital. I would attenuate this discussion in two dimensions:

• A key feature of a world where banks are required to have equity capital is that not all banks get this equity capital. Some banks do well, they build up their balance sheets, they have good prospects and are able to raise equity capital, and they are able to grow. Alongside them, weaker banks fail to grow. This is perfectly appropriate and a desirable feature of the system: a healthy banking system must be one where only some banks are able to grow. The fact that a bank with the average ROA requires capital for growth does not mean that we should be putting public money into all banks that require capital for growth. Many, many banks in India do not deserve to grow and hanging tough is the right way to deal with them. Growth is not a birthright: a bank must do well, and pass the market test, and thus earn the right to grow.
• There are many elements of banking policy which are driving down the return on assets. Easing these constraints is a better path for policy rather than putting in public money.

Banks in India are facing a combination of swelling NPAs, and difficulties in finding capital to grow. It is not fair for private banks to face competition from PS banks that get equity capital for free. I am reminded of Kingfisher. As long as Kingfisher was around, with an artificially low cost of capital, this exerted downward pressure on air fares, and hurt all healthy airlines. The exit of Kingfisher was of essence in bringing the rest of the industry back to health. This is the story of Japan's `zombie firms': when failed firms were kept alive using public money for capital infusions, this infected healthy firms. Percy Mistry famously pointed out that Indian finance suffers from the presence of `zombie banks', who only walk the world on the life support of public money. This is a deeper consequence of easy access to capital for public sector companies that we in India should be worrying about.

Harsh is undoubtedly right in suggesting that government should be willing to accept a reduced shareholding in PS banks while retaining control under the Bank Nationalisation Acts. But this leaves the residual question: if PS banks have a low ROA, the share price that this can support is low, if investors see no possibility of true privatisation in the years to come. The amount of equity capital which will come by going down this route is limited. The real story has got to be to ask PS banks to demonstrate that their claim on public money is backed by a good possibility of using capital better than NHAI.

Suppose we suggest that the government should be stingy in giving equity capital to PS banks. In the short term, the partial equilibrium analysis suggests that this will hold back the growth of banks and thus the size of Indian banking. We should bring two different perspectives to this. First, the very absence of free capital for PS banks will increase the profitability and thus equity capital access for private and foreign banks. The overall impact for India will thus be attenuated. In addition, it's easy for government to have entry of 20 new private banks. Suppose each is asked to bring in Rs.500 crore as equity capital. Using the rough 20x leverage that's found in Indian banking, this gives us new bank assets of 2% of GDP or Rs.2 trillion.

The widget illusion

The Economist runs a discussion forum titled The Economist By Invitation. In this, they recently setup a discussion about an opinion piece by Dani Rodrik about the future of manufacturing-led growth in emerging markets. I wrote a response there which is reproduced here.

The role of manufactures

I agree with a small element of Dani Rodrik's argument, but mostly for different reasons. Rodrik says:

Except for a handful of small countries that benefited from natural-resource bonanzas, all of the successful economies of the last six decades owe their growth to rapid industrialization.

I have seen this kind of thinking among some policy makers in India also: that industrialisation is somehow special and good when compared with services. I would question this proposition, that I term `the widget illusion'. What matters to a country is having sophisticated firms that have a high marginal product of labour. We should not care whether this happens in services or in manufacturing. If anything, the opportunity to do it is perhaps better in services.

India is a good example of a country which embarked on its catchup by connecting into globalisation late: from 1991 onwards. It was probably the last country in the world to shed autarkic policies. This has given a remarkable growth acceleration. Sustained growth of 7 per cent is pretty good by world standards. These achievements have been significantly driven by services production in India within global supply chains (whether within production facilities owned by global MNCs who are operating in India, or contracted-out by global MNCs to Indian firms). If your null hypothesis was that industrialisation is essential to growth, then you would not have predicted what happened in India, where manufacturing was hobbled by an array of policy mistakes.

This illustrates the limitations of manufacturing-focused thinking, which seems a bit out of date in today's world economy where most output is services. Agriculture and manufacturing have wilted away in the consumption of the global representative agent: to succeed in the world economy today requires prime attention upon services.

Rodrik says:

Consider India, which demonstrates the limitations of relying on services rather than industry in the early stages of development. The country has developed remarkable strengths in IT services, such as software and call centers. But the bulk of the Indian labor force lacks the skills and education to be absorbed into such sectors. In East Asia, unskilled workers were put to work in urban factories, making several times what they earned in the countryside. In India, they remain on the land or move to petty services where their productivity is not much higher.

As Rodrik points out, there are important gaps between the skills of the great unwashed masses in India versus China, where elementary technical training reached a larger mass of humans. In addition, China did better on core economic policy choices about (a) Removing protectionism; (b) Removing barriers to FDI; (c) Building hard infrastructure; (d) Labour law and (e) Rationalising taxation.

What policy advice would flow from this? India should not have have made these six mistakes in economic policy (low training for the masses, protectionism, barriers to FDI, weak investments into infrastructure, labour law and mistakes in tax policy). At the same time, this does not recommend a bias in favour of manufacturing. It is hard to discern a meaningful choice about emphasising services versus manufacturing in Indian economic policy. Participation in all global production is good. Governments should remove all barriers that inhibit global integration whether in goods or in services - e.g. the six mistakes in Indian policy sketched above.

A paragraph earlier, Rodrik says:

To be sure, some modern service activities are capable of productivity convergence as well. But most high-productivity services require a wide array of skills and institutional capabilities that developing economies accumulate only gradually. A poor country can easily compete with Sweden in a wide range of manufactures; but it takes many decades, if not centuries, to catch up with Sweden's institutions.

I would point out the contradiction: "A poor country can easily compete with Sweden in .. manufactures" but earlier it was asserted that the gaps in Indian skills inhibited India's ability to compete with Sweden in manufactures.

Doing things that push skills and institutional capabilities

I would go further to say that it is good to go after fields which require a wide array of skills and institutional capabilities.

I am reminded of Ricardo Hausmann's `Good Cholesterol' argument about financial globalisation as opposed to mere FDI. When a poor country operates in an institutional vacuum, foreign investors are uncomfortable, and the only thing that can happen is FDI. To obtain financial flows, the country has to build institutions: laws, regulators, property rights, and so on. This is a good thing! A country that gets to FDI and gets stuck there should ponder what is going wrong. In similar fashion, no country aspires to have low-wage production; every country wants to understand the secret sauce through which a part of the labour force can earn high wages by world standards.

As a country rises out of poverty, it is essential to build up skills and institutional capabilities. If policy makers hinder services and/or favour manufacturing, there is a greater chance of being stuck in low skills and low institutional capabilities. I am not proposing industrial policy in favour of services. I am only proposing the absence of industrial policy; we should avoid a `widget illusion' and foster more global integration without trying to push towards one industry or another.

In India, with 7 per cent growth, GDP doubles every decade. As a thumb-rule, I feel that a comprehensive transformation of skills and institutions is required across each doubling of GDP, which is roughly each decade for India. A country that is stuck in low-skill manufacturing will find it difficult to achieve the reinvention of this `soft infrastructure' of the mind. If policy makers tried to push a country towards doing low end grunge work, it would be harder to obtain these repeated transformations of institutions and the furniture of the mind, which would lead to growth decelerations.

As an example, in the article New wave of deft robots is changing global industry, John Markoff says:

Foxconn has not disclosed how many workers will be displaced or when. But its chairman, Terry Gou, has publicly endorsed a growing use of robots. Speaking of his more than one million employees worldwide, he said in January, according to the official Xinhua news agency: ``As human beings are also animals, to manage one million animals gives me a headache.''

The project of economic development requires sophisticated interactions between firms and workers. The laws, human rights and management practices that are required when dealing with humans are different from those required when running a firm with `one million animals'. I would hence argue that it is limiting for a country to focus on the political, legal and institutional requirements to produce a la Foxconn. It is better to confront the complexities of high skill, high wage production, and to build the environment for this to happen: in the political and legal system, in management practices of firms, and in the power structure embedded in a conversation between two citizens who are co-workers within a firm. Services production is a valuable learning ground where the complex management practices that involve high skill humans can be learned.

The new world of manufacturing

Rodrik correctly points out that manufacturing has become more sophisticated in recent years. This has some fascinating dimensions:

• The rapid improvements in capabilities and declining costs of robots.
• The rise of open source design coupled with 3-d printers. If a 3-d printer in the US fabricates a part close to its usage in an assembly line, while the labour-intensive design work ("services") that controls the 3-d printer is done in India, does this entail manufacturing or services work in India?
• The world economy is likely to be in a low interest rate environment for a long time, which will encourage capital intensity worldwide (robots, 3-d printers), thus blunting the value of low wages.

Momentous changes are afoot, which challenge our traditional notions of manufacturing versus services. To some extent, we are even seeing some manufacturing go back to the US.

Things that might `go wrong'

Finally, Rodrik talks about reduced willingness in the West to tolerate unfair tactics like the Chinese exchange rate regime. I would generally consider this to be a good thing, both for developing countries and for the world. In any case, the Asian `Bretton Woods II' episode seems to be subsiding. As an example of the disenchantment with exchange rate distortions: From 2004 to 2007, India debated exchange rate rigidity, and walked away from it. The links between undistorted exchange rates and growth have not been adequately emphasised in the discourse. A developing country builds up inferior skills and institutional capabilities by exporting under a subsidised exchange rate: it is better to force firms to confront the market price and achieve the productivity required to participate in globalisation when facing an undistorted price vector.

He worries about a rise in protectionism in the West, but we have to admit that the 2008-2012 experience has been pretty good in this regard: by and large the West has not succumbed into protectionism. In 2008, all of us worried about Smoot-Hawley. Today, things seem to be be going well.

Conclusion

In summary, I would argue that we should avoid a `widget illusion'. There is nothing special about manufacturing or industrialisation: as long as people in India get high wage jobs, this is good. Getting there requries deep integration into the world economy, which includes policy battlefronts such as:

• Openness to the Internet
• Use of English
• Inbound and outbound FDI
• The array of cross-border financial services that are the enablers of complex globalised production of both goods and services
• Globalisation-compatible tax policy on both trade and finance
• The absence of either protectionism or mercantalism
• Fostering high quality human skills, and
• Infrastructure.

To the extent that globalised production of goods and services happens in areas which involve high skills and complex institutional development, this is a bonus, since any high growth country needs a rapid pace of reinvention of laws and institutions.

Most of this is the old orthodoxy. Policy makers worldwide are generally focused on these issues, as they should be. From the 1960s onwards, dirigisme has generally subsided, with the twilight of policies like fixed exchange rates, industrial policy, capital controls, protectionism, etc. These key lessons remain intact in the 21st century.