Ajay Shah's blog

Macroeconomics: A reading list

2012-02-09T10:11:00.001+05:30

Economics is a rich and fascinating subject. But all too often, the teaching process forces young people in the field to look at the tail of the elephant, to think about macroeconomics as the game of solving dynamic models. There is actually much more going on. (On a related note, you might like to see Books that should be read before starting a Ph.D. in economics on this blog, 18 May 2011).

In this blog post, we walk through the evolution of the key ideas in historical order, and offer suggestions to interesting readings, which will help you see the fuller picture. Many of them are on your reading list, but some are not.

The old paradigm

Nobody tells it better than The age of uncertainty by John Kenneth Galbraith.

The old paradigm is now in the dustbin of history. But in order to comprehend the revolution in macroeconomics, it is rather useful to start from there. One encounters these arguments from time to time, so it's worth knowing about the furniture of that mind.

The revolution of modern macroeconomics

The starting point is a speech : The role of monetary policy by Milton Friedman, American Economic Review, 1968, which had enormous influence in arguing that the mainstream Keynesian paradigm was fatally flawed, and that it was not going to work as a guide to policy on a sustained basis. By the early 1970s, the empirical evidence was showing that Friedman was on the right track, which led to everything that followed. This speech is arguably the beginning of modern macroeconomics. At the same time, this was only an argument conducted in English, and not a model.

The next big milestone was the Lucas critique: Econometric policy evaluation: A critique by Robert Lucas, Carnegie-Rochester Conference Series on Public Policy, 1976. This devastated traditional macroeconomics. In addition, it's a remarkably elegant idea.

Lucas, Sargent and others mapped out a work program in a series of non-technical pieces, which were enormously influential. They set a generation of economists going to build a class of models that were rooted in the intuition of Friedman, 1968, and were invulnerable to the Lucas critique. You should read: Understanding business cycles by Robert Lucas, Carnegie-Rochester Conference Series on Public Policy, 1977; After Keynesian Macroeconomics by Lucas and Sargent, Federal Reserve Bank of Minneapolis Quarterly Review, 1978; Methods and problems in business cycle theory by Robert Lucas, Journal of Money, Credit and Banking, 1980.

As important as the Lucas Critique was Rules rather than discretion: The inconsistency of optimal plans by Kydland and Prescott. An accessible set of materials on this work is found in their 2004 Nobel Prize page.

This work came to fruition in the early 1990s in the form of the NK-DSGE model with a policy rule. Important tools got developed in a classical setting (the RBC model), and then Keynesian frictions were put in, to give the NK-DSGE model. It has many problems, but with this, the Lucas program did work out. Nice readings on the NK-DSGE model are The science of monetary policy: A new Keynesian perspective in the JEL by Clarida, Gali, Gertler (1999), and their Monetary policy rules and macroeconomic stability: Evidence and some theory in the QJE in 2000.

The new macroeconomics is nicely showcased in Technology, employment, and the business cycle: Do technology shocks explain aggregate fluctuations? by Jordi Gali in AER, 1999. This is a wonderful example of confronting empirics with theory, plus a fundamental (if highly controversial) contribution in the eternal quest for the sources of business fluctuations.

On the other side, there is a powerful critique of the micro-founded approach to macroeconomics: The scientific illusion of empirical macroeconomics by Larry Summers, Scandinavian Journal of Economics, 1992.

By the late 1990s, there was a lot of progress to report. There is a nice article: Thirty-Five Years of Model Building for Monetary Policy Evaluation: Breakthroughs, Dark Ages, and a Renaissance by John B. Taylor, Journal of Money, Credit and Banking, 2007. There is the best single book on monetary policy: Monetary Policy Strategy by Frederic S. Mishkin, 2007. And, there are two other nice articles: A stable international monetary system emerges: Inflation targeting is Bretton Woods, reversed by Andrew K. Rose, Journal of International Money and Finance, 2007, and How the World Achieved Consensus on Monetary Policy, by Marvin Goodfriend, Journal of Economic Perspectives, 2007.

The second stage

Once the basic plan was laid, important work emerged in connected fields. A critical issue that came to fore was the role of finance in macroeconomics. Agency costs, net worth, and business fluctuations by Bernanke and Gertler, AER 1989, is the most elegant illustration that financial structure matters for macroeconomics.

We close this off with a canonical reference about fiscal policy from a macro perspective. A good recent treatemnt is Activist fiscal policy to stabilise economic activity by Auerbach and Gale, from the 2009 Jackson Hole symposium.

Post-crisis revisionism?

On this, see Monetary policy and financial stability: Is inflation targeting passe? by Takatoshi Ito, July 2010.

Diluting the role of the IIT JEE

2012-02-05T23:44:00.000+05:30

The JEE used to serve India well

Many years ago, high school education in India worked in a twin track system: There were those who studied for the IIT JEE and there was everyone else who didn't. The former studied good books like Resnick/Halliday, which is a college level book elsewhere in the world, solved physics problems from Irodov, etc.

In contrast, studying for the 12th standard ("board examination") tended to emphasise rote memorisation, focusing on trivial questions where you had to plug numbers into a formula, emphasised accuracy of calculation and good handwriting. I vividly remember a textbook for 11th class physics used in Maharashtra, which said that Newton's second law did not apply for living things and powered vehicles. The thoughtful author must have wondered how a stationary cat started walking without the action of an external unbalanced force, and resolved the problem by limiting the footprint of Newton's second law. The less time that kids spend in studying for board examinations, the better.

I used to be optimistic that the footprint of the enhanced curriculum, and complexity of examination questions, lay far beyond the tiny number of people who entered IIT. Even if only 2,000 kids entered IIT, if 40,000 of them studied for the JEE, it gave them world class capabilities at high school. In each cohort, we got 40,000 people who were very good by world standards. In a country with pervasively low capabilities, it was very useful having this slice of high inequality of knowledge, for it gave a group of people who were able to learn modern technology, connect to globalisation, and create firms which generate a lot of high-paying jobs. It is fashionable to complain about inequality of knowledge, but given that you are in a LDC with a very low mean, would you really rather have very low variance??

With this old configuration, we also got a nice tool for inter-generational class mobility. The middle class got their kids into IIT, and almost all these graduated into upper class by the time they were 30.

More generally, a lot of countries have found that high stakes examinations are a good thing. High stakes examinations push the work ethic, grow the ability of young people to work hard in a sustained manner with high concentration, ensure foundations of mathematics and science, and encourage a meritocracy. They create a self-selected elite of young people who are not immersed in and defined by mass culture. All these are good things.

Problems of the JEE

I used to think like this for a long time. I have reluctantly been persuaded, over recent years, that the JEE isn't working so well.

Too many young people are studying for the examination and not the subject. The obsessive focus upon coaching classes is producing a one-dimensional personality which isn't so well suited to entering college. In the 1980s, the most interesting students in IIT were thinking people who read books, knew a lot about the world, and could also solve monkeys on pulleys. With brutal competition, and the coaching classes phenomenon, too often, all that's left today is the monkeys on pulleys. There is a certain kind of parent who is willing to have a child go live in Kota at age 15. This screened out many families from the race.

Economists know about this phenomenon in agency theory. High-powered incentives are a problem because the agent only focuses on the incentive and tends to cut corners (or worse) on everything that's not mentioned in the incentive contract. Andrade and Castro bring this generic idea in agency theory into the question of examinations, and find similar effects.

In the 1980s, there was substantial diversity of background, experiences and class amongst the students. This was a good thing, since students would then pick up the culture of people unlike them. In recent years, it appears that there is much greater homogeneity of background, experiences and class. The extent to which the person gets transformed in the four years has, as a consequence, gone down. When very few children of the elite go to IIT, this reduces access to the knowledge and networks of the elite for everyone who goes to IIT. This has reduced the ability of IIT to generate inter-generational class mobility.

Jishnu Das and Tristan Zajonc have found a nice bump in the upper tail of the distribution of skills in India. The pessimist sees this as being about class or caste: certain families bring up kids who know more. The optimist in me used to think this was the bunch studying for the IIT entrance. Also see Geniuses and economic development on the importance of the upper tail of the skills distribution.

It is increasingly difficult to be optimistic about how this is going. Narendra Karmarkar graduated from IITB in 1978, and went on to do truly important work in 1984. My optimism about the IITs peaked in 1984. Phenomena like Narendra Karmarkar should have scaled up manifold in the following years. This has not happened. In the 1980s, I used to think that by 2010, we'd have atleast one Nobel laureate from the IITs. That has not happened. This tells us that the IITs are not delivering on their early promise; things haven't worked out well in the following years. While the IITs suffer from many problems, I think the JEE is also a part of the problem.

One of the most disappointing features of the recent OECD PISA evidence was the absence of this bump in the upper tail. This new evidence shows a scary world of low inequality of skill, of a country with a terrible mean and no upper tail of an elite that can power the country out of mass poverty. I would conjecture two potential explanations for what has been found. One, it could be the case that this testing was done at age 15, at which time not much of the IIT JEE studying has as yet taken place; we're only picking up the victims of board examinations. Alternatively, it could be the case that studying for the IIT JEE is distorted by the coaching class phenomenon, and is not producing good knowledge.

But the solution being offered doesn't seem to be the right one

There are two views on how these problems can be solved. The first alternative is to shift away from admissions based on a high stakes examination. Universities in the US screen applicants on many parameters, so this is generally thought to be better. But when we look back in history, universities in the US used to focus primarily on academic performance only, until a glut of Jews showed up in Harvard. The shift to asking for `well rounded personalities' was a tool by the dominant anti-semetic elite to screen out Jewish kids who did not play football. So we should be cautious in respecting the undergraduate admissions process in the US. It is also important to remember that the quality of kids starting college in the US is quite weak by world standards. There are other countries (e.g. Japan) where large scale high-stakes examinations are used for university admissions, with much success.

I feel that the core problem that we have in India is just too few seats, which has generated a ridiculous extent of competition and distorted behaviour on the part of the kids. The solution lies in solving the policy problems in higher education, so that a large number of kids are taken into world class institutions every year. E.g. adding undergraduate programs at I I Sc, with recruitment through the JEE, was a move in the right direction. We need to grow the size of the entrant class in universities in India, that figure in the Times Higher Education Supplement ranking, by 25-fold. At present, we have only one university in that list - IIT Bombay.

Kapil Sibal is offering neither of the two solutions above: we are not being offered a modified admissions process based on looking at a fuller picture of the child, and we are not being offered a Japanese scale world of high stakes examinations with a lot of seats in world class universities. What we're being offered is a scaling down of the role of the IIT JEE. A greater role for the 12th standard examination is just a recipe to emphasise rote memorisation, focusing on trivial questions where you had to plug numbers into a formula, emphasising accuracy of calculation and good handwriting. This seems wrong to me.

You may like to also see: Education in India: A compact reading kit.

Girish Sant

2012-02-03T19:01:00.000+05:30

Girish Sant, at New Rajendra Nagar in New Delhi, 10 January 2002

Girish Sant died of a heart attack in a hotel in Delhi yesterday.

`Bandya', as he was known to friends, could have chosen any career when he stepped out of IIT in 1986. He chose the less travelled path of taking interest in the public policy, and applying himself to a combination of technical mastery and the dogged persistence that is essential to making a difference. He founded a think tank, Prayas, which has come together as a pretty unique organisation in the Indian landscape. The Indian development project desperately requires more people who combine his intellect with his commitment to fixing up the world.

I always thought of Bandya as a gentle giant. He combined a soft and understated personality with depth of knowledge. When I spoke with him, I was always running at 100% CPU utilisation.

On a more personal note, Bandya was a lead climber in the first ascent of Konkan Kada, and I was part of that team. That was a peak experience. We will miss him.

Battlefronts

2012-01-30T11:56:00.001+05:30

Freedom of speech is high on our minds in India today, with the problem rooted in laws about three fronts: obscenity, defamation and hate speech. While freedom of speech is an essential foundation of democracy, it is closely connected with other dimensions of freedom. Here are some fascinating episodes, in the liberal project of getting to personal freedom.

United States, 1644

Faramerz Dabholwala in the Guardian:

When the Massachusetts settler James Britton fell ill in the winter of 1644, he became gripped by a "fearful horror of conscience" that this was God's punishment on him for his past sins. So he publicly confessed that once, after a night of heavy drinking, he had tried (but failed) to have sex with a young bride, Mary Latham. Though she now lived far away, in Plymouth colony, the magistrates there were alerted. She was found, arrested and brought back, across the icy landscape, to stand trial in Boston. When, despite her denial that they had actually had sex, she was convicted of adultery, she broke down, confessed it was true, "proved very penitent, and had deep apprehension of the foulness of her sin ... and was willing to die in satisfaction to justice". On 21 March, a fortnight after her sentence, she was taken to the public scaffold. Britton was executed alongside her; he, too, "died very penitently". In the shadow of the gallows, Latham addressed the assembled crowds, exhorting other young women to be warned by her example, and again proclaiming her abhorrence and penitence for her terrible crime against God and society. Then she was hanged. She was 18 years old.

India, 2007

Vinod K. Jose in Caravan magazine:

...on the morning the poll was published, an angry mob of about 50 people attacked the Dinakaran office in Madurai, Azhagiri's home base. They threw petrol bombs and set the newsroom on fire; two journalists and a security guard were burned alive.

Pakistan, 2012

Declan Walsh in the New York Times:

One morning last week, television viewers in Pakistan were treated to a darkly comic sight: a posse of middle-class women roaming through a public park in Karachi, on the hunt for dating couples engaged in `immoral' behavior.

Panting breathlessly and trailed by a cameraman, the group of about 15 women chased after - sometimes at jogging pace - girls and boys sitting quietly on benches overlooking the Arabian Sea or strolling under the trees. The women peppered them with questions: What were they doing? Did their parents know? Were they engaged?

Some couples reacted with alarm, and tried to scuttle away. A few gave awkward answers. One couple claimed to be married. The show's host, Maya Khan, 31, demanded to see proof. ``So where is your marriage certificate'' she asked sternly.

India, 2012

Reportage in the Hindustan Times:

Over 50 Shiv Sena activists attacked the The Times of India building at south Mumbai on Saturday and damaged plants and furniture at the reception.

The men, who claimed to be supporters of former Sena MLA Anandrao Adsul, were protesting against a news report that appeared in Maharashtra Times, a Marathi daily. The report speculated that Adsul was on his way to join the Nationalist Congress Party. Adsul, who addressed the media later, has threatened to file a Rs 100-crore defamation suit in addition to a complaint with the State Election Commission and Press Council of India. "Such baseless allegations made without hearing my version won't be accepted," Adsul said. The Sena man was unapologetic about the incident. "My supporters went with a letter, but they were not allowed inside. So they reacted in anger."

India, 2012

Johnson T. A. in the Indian Express:

While she was being beaten up, Suvarna insisted that she would only marry Govindaraju and that it was she who wanted to meet him that day, Govindaraju told the police in a statement last week when he briefly emerged out of hiding. An enraged Davalana, according to the police complaint, directed his relatives to `hang this girl who is insistent on marrying a Madiga'.

Police investigators say they believe Suvarna probably died after the thrashing from her father at her relative's house but her body was dragged to Govindaraju's house and strung up on a rope to make it seem like a suicide in the lover's home.

Inflation targeting has come to the US

2012-01-27T10:18:00.002+05:30

Reportage by Robin Harding and Michael Mackenzie in the Financial Times:

The rate-setting Federal Open Market Committee predicted low interest rates until late 2014 and set a formal inflation objective of 2 per cent, reflecting chairman Ben Bernanke’s long-held goal of providing greater transparency.

The FOMC downgraded its estimate of growth in the coming quarters from “moderate” to “modest” and Mr Bernanke indicated that another monetary boost for the economy – most likely another round of quantitative easing, or QE3 – remained an option.

“We are prepared to take further steps in that direction if we see that the recovery is faltering or if inflation is not moving toward target,” Mr Bernanke said.

The Fed also published its first detailed forecasts of future interest rates.

...

Adopting the 2 per cent objective is a historic move that binds the whole FOMC to a defined goal that will endure after Mr Bernanke leaves. It means the FOMC can easily justify more easing if it wants to because its inflation forecast for 2014, of between 1.6 and 2 per cent, is below target.

The FOMC voted for Wednesday’s decision by 9-1. The only dissenter was Jeffrey Lacker, president of the Richmond Fed, who wanted to leave the late 2014 date out of the policy statement.

The US suffers from legacy legislation, which predates modern monetary economics, which places the burden upon the Fed of pursuing both price stability and low unemployment. The evolution of the US Fed has been led by human energy within the Fed. Starting from Paul Volcker, who took charge in August 1979, the US Fed has run a Taylor rule with a nice strong above-1 inflation coefficient. In a recent column in the Indian Express, Ila Patnaik tells us about Paul Volcker's story and how it matters to us. In effect, from Volcker's chairmanship onwards, the behaviour of the US Fed has been that of an inflation targeting central bank. This was the de facto reality. Everyone knew that the US Fed targets inflation at 2%. What is new now is that the Fed has put greater credibility behind this, by going closer to de jure inflation targeting.

A key dharma of good central banking is to say what you will do, and then do what you just said. By saying that there is an inflation target, there is now full alignment between the words and deeds of the US Fed.

The day will come when India will enact high quality legislation which puts monetary policy on a sound institutional foundation. But we should not accept mal-performance by RBI until that day. It is possible for RBI to do much better, when compared with the present, even though the present legislation is really badly written. The US Fed is a good example of how technical capabilities within the Fed, and not an external legislative mandate, have driven improvements in the functioning of the Fed. This sort of progression is what RBI can and should aspire to, and this does not require waiting for a high quality RBI Act.

Education in India: A compact reading kit

2012-01-24T21:38:00.001+05:30

With the first release of OECD PISA results for India, and with the release of one more year of Pratham data, there has been an upsurge in interest in education in India. The following set of materials are a useful reading kit to get a grip of the field.

Elementary education

Education in India at the crossroads, 24 January 2012.
Ila Patnaik in the Indian Express, 20 January 2012.
ASER 2011 report by Pratham. Article in the Indian Express on this by Rukmini Banerji.
Accountability in education by Jeff Hammer, 18 January 2012.
The first PISA results for India: The end of the beginning by Lant Pritchett, 5 January 2012.
The Right to Education Act: A critique by Parth Shah, 1 April 2010. Also see Raghuram Rajan and Abhijit Banerjee 20 February 2010.
Getting results on education and health expenditures of government, by Lant Pritchett and Jeff Hammer, 16 July 2009.
Ila Patnaik on the then draft Right to Education Bill, 13 January 2008.
The mess in education by me in the Business Standard, 28 February 2006.
The World Bank's WDR 2004: Making services work for poor people.
Rethinking elementary education by me in the Business Standard, 1 July 1998.

Higher education

The THES ranking of the top 400 universities of the world. The only win for India in this list is IIT Bombay (ranked in the 301-350 range).
The six ingredients for a great university, 5 January 2010. And, read Larry Summers in the New York Times on the key ingredients of the university of the future.
Andre Beteille on private and public education, 27 August 2008.
Pratap Bhanu Mehta in the Indian Express, 26 August 2008.
Don't play Arjun Singh's game by me in the Business Standard, 7 June 2006.

Education in India at the crossroads

2012-01-24T21:26:00.001+05:30

The debate

Roughly one decade ago, there was a strong debate in India about how we should tackle the problem of education. There were two views:

Intensification: On one side were those who felt that nothing was fundamentally wrong; all that was needed was more money. So we should just continue building more government schools and hiring more civil servants to act as school teachers, and we'll be fine.
Reform: On the other side were the reformers, who argued that the basic incentives in Indian education were wrong. Putting more money down a dysfunctional system was pointless.

The Intensifiers won this debate. An informal coalition of educationists (i.e. the incumbent education system) and leftists came together, supported by the World Bank, which pushed for mere enlargement of Indian education, without questioning the foundations.

All of us are involved in this story at many levels. At the simplest, we are the customers of the education establishment. We pay income tax and VAT and a few other taxes. On top of this, we pay the 2% education cess. In return for this, we get certain educational services. These influence our kids, and they influence all the young people that we encounter in this young country. Trillions of rupees have been spent, and more than a decade has gone by. It is time to assess the performance of this strategy.

Three blocks of evidence are now visible, which tell us that the Intensifiers were wrong. The old strategy, which was invigorated by a vast rise in spending, was the wrong one.

Evidence #1: OECD PISA results for India

This story is well told in a recent blog post by Lant Pritchett. Bottom line: The first internationally comparable measurement of what children learn has been done. The sample correctly includes urban and rural children; it correctly includes children going to private or public schools; there are no first order mistakes in what was done. It tells us that Indian education policy has failed miserably: the results have come out at the bottom of the world.

Evidence #2: ASER 2011 results

Pratham has been running surveys which measure characteristics of children and schools in rural India (only). Their latest survey results, for 2011 show the following facts.

First, rural kids learn less at public school. Here's a simple example of what the evidence shows. Surveyors ask kids in class III to recognise numbers upto 100. Here are the numbers, for the proportion of kids in class III who cannot recognise numbers upto 100:

In 2008, the failure rate with private schools was roughly 17 per cent. Government schools were much worse at over 30 per cent. A short three years later, conditions had deteriorated sharply in government schools. The failure rate had gone up to 40 per cent. Private schools had also worsened slightly, to a failure rate of 20 per cent. By 2011, a big gap had opened up between the two: private schools are failing to teach 20 per cent of the kids while government schools are failing with a full 40 per cent of their kids.

Parents in India face the choice between sending their children to a government school, which is free and serves a mid-day meal, versus sending them to a private school where they pay fees. Yet, an increasing fraction of parents choose to send their children to a private school, paying tuition fees from their own pockets, while government schools are free. The relationship between a parent and a private school is a transaction between consenting adults. The relationship between a parent and a government school involves all of us, because we are paying for it.

Given the low income of parents in India, their use of private schools is a striking indictment of what the Intensifiers have wrought:

At class II, the fraction of rural children in private school went up from 19 per cent (2007) to 23 per cent (2011). At class VII, this rose more slowly to levels slightly above 20 per cent.

Evidence #3: CMIE household survey

CMIE has data for the year ended March 2011 about the behaviour of 169,492 households, about their expenditure on school/college fees and tuition fees. Here's the picture for the quarter ended September 2011; all values as percent of overall expenditure:

Income class	School/college fees	Private tuition fees
Rich - I	4.79	0.66
Rich - II	3.79	0.51
High Middle Income - I	3.54	0.63
High Middle Income - II	3.12	0.65
High Middle Income - III	2.44	0.68
Middle Income - I	1.93	0.59
Middle Income - II	1.62	0.45
Lower Middle Income - I	1.38	0.49
Lower Middle Income - II	1.05	0.60
Poor - I	0.76	0.58
Poor - II	1.13	0.28
Overall	2.10	0.57

If parents chose to stay within public sector schools, their expenditure on fees would have been zero. The table shows that across all income groups of India, there is movement towards private provision of education, both by paying fees at schools and by paying for private tuition classes. These two elements add up to 2.67 per cent of overall expenses of households. (The CMIE household survey separately measures expenses on books, journals, stationary, additional professional education, education overseas, hobby classes and other education expenses. This helps us gain confidence in the extent to which the two fields in the table above narrowly pin down the feature of interest).

These decisions of well intentioned parents are the strongest indictment of education policy in India. The product being given out by the Intensifiers is such a terrible one, the parents of India are walking away from it even though it is free and the alternative is not and the parents are poor.

Implications

For more than a decade, the Intensifiers have controlled Indian education policy. They have said: Leave education to the education establishment, do nothing radical, just give us more money, we will deliver results. Now we know that they were wrong. They took the money, but failed to deliver the results.

Kapil Sibal has said that his ministry should not be held responsible for the stream of bad news that is coming out. To me, this seems to be dodging accountability. His ministry is responsible for Sarva Shiksha Abhiyaan, for the Right To Education Act, for blocking OECD PISA from being done in India, etc. The bureaucratic consensus of his ministry represents the education establishment.

The key phrase that needs to be emphasised today is accountability. If a contractor took money from you, and failed to deliver on building your house, you would sack him. (You would also take him to court, to recover the money that was paid to him, for services not delivered). In similar fashion, education is too important to be left to the educationists. We need to start over.

What is to be done

We need to start over in the field of education, with a fresh management team, one that is not a part of the status quo, one that is rooted in the worlds of incentives, public policy and public administration.
In 2004, we were told that in return for a tax rate increase of 2%, in the form of an education cess, we would obtain improvements in education. We now know that those improvements did not come about. Hence, that tax rate increase should go. (Even if sharp improvements in educational outcomes had been obtained, the education cess was a mistake in terms of basic public finance, and needs to go. Public expenditures on education should simply come out of general tax revenues; there is no need to have a cess.)
The flow of public money into the status quo needs to go down sharply. There is no reason to put money into something that fails to deliver the goods. First we must prove that a mechanism delivers results, and only after that should we put money into it. This is the common sense that a housewife would apply. She would not spent gigabucks on promises from people who have failed to deliver.
OECD PISA measurement needs to take place every year at every district. The production of this data is a public good that the government can and should do. It can be fully contracted out to private firms so as to avoid the problems of public sector production. Datasets about student characteristics and school characteristics should be released, covering every district and every year, so as to enable research.
Civil servant teachers, who have tenured (permanent) have no incentive to teach well, regardless of their qualifications or high income. We can't sack them, but what we need to do on a massive scale is to stop recruiting them. The existing stock can be reallocated to other civil servant functions where staff is in short supply. Through this, it would become possible to whittle away at the accumulated stock over the coming 20 years.

A fueling fable: Consumer protection issues with payments

2012-01-23T09:34:00.000+05:30

by Naman Pugalia and Viral Shah.

On 22nd December 2011, we purchased petrol worth Rs.100 from an Indian Oil fueling station in Bombay using an ICICI Bank debit card. The receipt suggested that we could have saved a fuel surcharge of 2.5% had we used an Indian Oil Citibank credit card. Upon seeing this message, we asked the cashier at the petrol pump if we would be charged 2.5% over and above the Rs.100 that we paid for the fuel. The cashier assured us that only Rs.100 would be debited from the account linked to the card. The chargeslip and the receipt were:

The chargeslip

The receipt

A couple of days later, we viewed the account statement online and found that the relevant transaction had been recorded. A full week later, we observed that an additional charge of Rs.11.03 had been
debited from the account for the same vendor. Not only was the entry unusual, the charge did not match the 2.5% figure which was mentioned on the transaction receipt:

The statement

We wrote to the bank asking them to explain the transaction. The bank explained that for fuel purchased at non-HPCL petrol pumps, a surcharge of 2.5% of the fuel cost or Rs.10 (whichever is higher) would be levied. A service tax would be levied additionally.

There is a consumer protection issue here. After the account had been debited, and up until we sought a clarification from the bank, we were not made aware of the surcharge. The chargeslip gave a false impression of the amount being paid.

Upon delving further, we find various websites where people have complained about this surcharge being confusing. Further investigation revealed an interesting combination of participants:

The surcharge on fuel is mentioned in the fine print in Terms and Conditions of a debit card.
The bank that deploys the POS machine (acquiring bank being Citibank in our example), at the end of day, surcharges the higher of 2.5% or Rs.10 and sends it to the customer's bank (issuer bank being ICICI Bank in this case).
The issuing bank then creates a separate debit in the customer's account for the surcharge
The acquiring bank shares much of this surcharge back to Oil Marketing Company (Indian Oil in this example).
Contrast this with typical debit card processing fees in India around 1.5%. In most cases, merchants will inform a customer before surcharging, and the value on the chargeslip is what the
customer pays.
Many banks apply these surcharges weeks or months after the transaction actually occurs, which helps ensure that most customers do not understand what is going on.

When paying for fuel in India with a debit card, the customer pays the surcharge by being misled, the Oil Marketing Company makes higher profits, the charge is administered in a non-transparent way, and is posted late when the customer may not even recall the transaction. Thus, Government owned companies and banks have created a perverse incentive, whereby customers prefer to use cash rather than pay electronically.

Author: Viral Shah

2012-01-23T09:14:00.004+05:30

A fueling fable: Consumer protection issues in payments, with Naman Pugalia, 23 January 2012.
Excitement in electronic payments, 18 January 2011.
Interpreting the 4th fastest supercomputer in the world, 19 November 2007.
Should IST be broken up into two? Should India do DST?, 23 August 2007.

Accountability in education

2012-01-18T22:42:00.001+05:30

by Jeff Hammer.

I was shocked by Lant Pritchett's note on the appalling performance of India's best two states on the international PISA assessment. Actually, I was not really shocked; I didn't expect anything else as I've been listening to Lant for years now. By the same token, I agree with Jishnu Das that we really don't know much about what works in education (other than that good teaching makes a difference) and that our bean-counting of inputs into education may be completely wrong headed. From conversations with him (also over years) I surmise that the only thing we really know about what leads to more learning is that it is correlated with how many years children stay in school. What that suggests, though, is that attention be directed towards the choice of parents and students to stay in school.

In my opinion people choose to do things if it is worth it to them. This is a common assumption for economists. While challengeable in some circumstances, does it make any sense to think that people send their children to school if they don't think it's worth it? If it is compulsory: sure. With compulsion, attention of policy makers and carefully watchful observers such as Pratham should be to make sure school is worth the year of children's attendance since people would not be able to decide for themselves. Until we see compulsory schooling enforced, though, years of education remain a family's choice and we have to understand how and why people make that choice.

Unless we think parents are utterly clueless about the value of education and totally incapable of telling if teachers are doing anything or their children are learning anything, the effectiveness of teaching and the amount of knowledge imparted must be a major factor in their decision as to whether school is worth it. Don't get me wrong, I've met dozens of educators and education officials in India who believe parents are, indeed, clueless and such decisions should be out of their hands. But they are the very people who gave us the PISA ratings and are indeed throwbacks to the License Raj where only bureaucrats were assumed to know anything. Further, with the explosion of private schools, even in rural areas, it is laughable to think that there are so many parents who value education so little. They are willing to forego free public education in order to pay for something more worthwhile.

Which brings us to accountability.

What could parents be looking at, that makes them think school is worth it? It must be based on performance: parents don't really see the inputs, they mostly just see their children learn. Or not learn as is the case. So how can they translate their concern for learning into actual learning? They have to be free to pick the educational context that they see is working for them or their neighbors. That's where accountability comes in.

A provider of any good or service is likely to be most accountable when their livelihood depends upon attracting customers. If what they provide is worth it, people will take the service, and the provider can make a living. If not, parents won't pay and teachers won't get paid. As of now, there is no mechanism to allow families to make that choice. There is no such compulsion for teachers to provide a service worth paying for. No doubt there are many teachers (probably most) who are doing the best they can regardless of how they are paid. But with over 24% absenteeism, large numbers of teachers observed to be doing anything but teaching, and many sub-contracting their position to under-qualified replacements at a fraction of government salaries, there is substantial room for improvement.

Further, if we are going to get more students (and, hence, teachers) into classrooms, the dedicated teachers may be the ones who are already on the job. People induced to enter the profession may not be as dedicated and, hence, need some other way to hold them accountable than internally felt professional ethics.

I am an educator (of sorts) but have no opinion about what the bottleneck in children's learning really is. Jishnu says the most successful headmasters all say different things (after good teachers - but then, don't we judge the goodness of teachers by whether their students actually learn? It's an output based judgment, too.) I know little of pedagogical theory. But I know just as little about the inner workings of most complex things I use -- computers and the Internet, water systems, bicycles. I can tell when they work and when they don't, though. Similarly, I know that my sons learned to read and write, become responsible citizens and to develop and exercise critical intellectual capacities (sometimes way too critical for my taste) even though I have no idea how they learned them. I did know that their teachers were in school almost every day and doing things that sounded like teaching to me. I did not have to be an expert on pedagogy to hold the schools completely accountable for my children's education.

I was also fortunate enough to be able to take (or threaten to take) them out of government schools if I thought otherwise. Funding for government schools (in the U.S.) follows enrollment, if not so directly and obviously as for private schools. So my threats about shifting my children out of government school directly mattered to their teachers.

There is no reason why Indian parents can't do the same. They, on average, may not have my education but after talking to hundreds of families in rural areas, tribal villages, urban slums and SC hamlets, I hear no less concern for their children's future than I have for mine and no less ability to tell if a teacher appears to be doing his job. They may be more capable than me since they are more likely to see the teachers themselves -- I needed to ask my children.

In many rich countries, the issue of vouchers to pay for schools is emotionally charged. Historically, free compulsory public education was a result of fights between church and State (even in Japan where `church' doesn't quite fit -- but religion and State does). Children were already attending school in high percentages and there was a fight for their hearts and minds. In rich countries currently, suggestions to provide vouchers instead of State-run schools re-kindle this old antagonism against religious instruction.

India never had this fight nor this evolution of public provision. Our view of schooling here in India was imposed based on the final result of universal free education seen in rich countries without the history from which that final result evolved.

India needn't go through the phase of fighting over who gets to teach students who are already highly motivated to learn and have seen learning take place. If India wants to see all children educated, she can certainly pay for the cost of education (in fact, the job can be done for much less per student is presently spent) so that families don't have to. But the government doesn't have to provide it directly (though government schools should be free to compete for this money if it can). The fight is the State against society (families), not against the church.

What the State can do is make as much information known to parents as possible. What should children know after how many years of school? How do you know if your child is keeping up? How do you know what you're paying for is worth it? As of now, this information is certainly not given to parents. Maybe State run schools don't want parents to know (and, unfortunately, most Indian parents will not know about PISA). And as of now, there is nothing parents (particularly poor parents) can do about it anyway.

The new world of computers

2012-01-16T00:53:00.001+05:30

I read a beautiful article, Why software is eating the world by Marc Andreessen. It made me reflect on how the world of computers and networks has evolved over the last 20 years. It is comfortable for us to think that the world has only evolved in incremental ways. But as I look around me, it seems that the hard-driving pace of change on many fronts has added up to fundamental change, to places far away from the comfort zone of people of my vintage.

All the way till the 1980s, business computing was dominated by databases. The basic story was one of capturing data, storing it, and summoning it forth with queries.

At first, databases were the exclusive preserve of mainframes and minicomputer. The PC revolution made it possible for small databases to be held on the desktop. It's interesting to note that at first, we got PCs without networks. We evolved from databases stored on remote mainframes or minicomputers to databases stored on PCs. All the way into the late 1980s, it was quite a cool thing to have a standalone PC holding a database where certain queries could be executed.

The first wave of change, of the early 1990s, was networks in the form of TCP/IP (the universal communication protocol) and the Internet (the universal network). Now, suddenly, the data centre became more interesting. Instead of storing and manipulating data at the desktop, we could do so many better things by storing and manipulating data at a big central computer. The desktop diminished from being the location of data and computation to being the location of the user interaction.

Then came a series of surprises which have added up to a qualitative shift.

1. The network got ubiquitous

First, the Internet went everywhere for the road warrior armed with the laptop computer. Crashing prices of laptop computers and then netbooks meant that essentially everyone had one. So workers started spending much more time outside the office (with 100% connectivity).

Software had to adapt itself to reach out on an Internet scale. This killed off applications which worked on the scale of the LAN. The software that the busy road warrier used was the software that worked effortlessly on his laptop.

Today, 1 Mb/s wireless networks are common and 50 to 100 Mb/s offerings are on the anvil. This is relentlessly shifting the balance of convenience to mobility.

In a place like India, the low-end staff might not have netbooks and/or Internet on the go. So for certain very low-end applications, it might make sense to hug the desktop at the workplace. For any modestly well paid person, laptops / netbooks coupled with 3g or CDMA networks are the norm, and hence being tethered to the office network is quite limiting.

2. The user interfaces got better

In the 1980s, software came with fat manuals. Users actually sat down in training classes. A remarkable feature of the new world is how the manuals and training are gone. Software is incredibly capable but there are no manuals. Google maps or Amazon or Apple Mail are very powerful programs, but the fundamental assumption is that a reasonable person can just start tinkering with them and learn more as he goes.

The modern office worker gets no formal training in software all his life. The modern knowledge worker learns major tools (e.g. a programming language) and often puts in enormous effort for these. But for the rest, the ordinary flow of day to day life, where new software systems come up all the time, is done without formal training.

Once the modern office worker faces high quality UI design from google and such like, where there is zero training and zero marketing, it became much harder to accept training. Standards have changed; in the olden days, people would actually try to learn. Today, knowledge workers are willing to get training in programming languages (e.g. R or Stata) but not in applications. The MBAs are generally training-proof.

3. All of us got busy

There was a time when one purposedly went about the work day systematically doing certain things with certain software tools. Knowledge workers have become deluged with information and with stimuli. We have gone from being an information scarce economy to being an attention scarce economy.

Software and information systems are now competing for the attention of the user. The scarce resource is now the mind share of the user. This is linked to the problem of user interfaces. If something has a complicated user interface, and there are a hundred other tasks that need to be done, the user ignores the complicated thing. Software systems that don't fly immediately just die.

4. Peers determine where attention is directed

In a world where the knowledge worker is bombarded with hundreds of things every day, what does he do? He tends to direct his scarce time into the things that come well recommended. The recommendations of respected peers are supremely important in determining what a person does.

High powered sales compaigns have lost power. The person just asks his friends what they do. The impulses through the day coming into each person - over email, IM, twitter, social networks, etc. - are the de facto controllers of the persons' time.

Peers are thus the gatekeepers to the user. The stuff that is striking and remarkable gets noticed and pointed to friends. What gets pointed tends to get a high google pagerank.

The importance of high pressure sales dropped. Some of the most successful firms got by with negligible sales departments. Their stuff was intuitive and good, and got immediately picked up.

5. Network effects leading to user generated content

The old model was one of corporations producing information and users consuming information. In that power structure, the user was only a source of revenue.

In the new world, the critical story is about kicking off network effects. The systems that win are those that get better because of one more user interaction.

At the simplest, user interactions kick off impulses to peers which brings in more customers (viral marketing). But very soon, user interactions generate relevant data. Google watches what users click and uses that to improve search. Amazon tells you that the people who liked this book also liked that book. Amazon has user-generated content in terms of reviews.

Good systems create a warm and supportive environment in which users contribute bug fixes, feature suggestions. These systems ride the power of user eyeballs and brains to get better. The power structure has changed. IBM DB2 used to be designed in a temple and then went out to the helpess masses. Google's world is critically linked to the users at so many levels (a receptive environment for bug reports, feature requests, user generated content, and usage data being turned back into strengthening the system).

The bottom line: Successful designers found ways to harness every single user and user interaction to build the quality, the content and the footprint of the system. Stalinist structures, which disempowered the user and treated him only as a source of revenue, stand isolated and stagnant.

6. Loss of power of enterprise IT

In the old world, enterprise IT mattered more. Grave decisions were made by enterprise IT managers and then thousands of users fell in line. In the new world, users forge ahead with their laptops and tablets and mobile phones, exercising enormous autonomous choice about how they spend their time. Consumer considerations, and the loyalty of each individual user, are far more important than they used to be. The enterprise IT department is much less of a gatekeeper. In the olden days, hardware and software was sold to enterprise IT, which made decisions for everyone inside the organisation. In the new world, usage is won one user at a time, and it is contestable every day.

7. CPUs became too cheap to meter

In the old world, computation was something scarce. The money that went into building data centres was carefully weighed. System designers carefully did things that were parsimonious in the use of CPU.

With the rise of parallel computation, bringing 1000 CPUs into a problem became cheap. Successful designers were those that found ways to deploy incredibly large amounts of computer power to do things that delight users. Google and amazon are spending millions of clock cycles in the back end, thinking about how to handle the next move, as the mouse cursor moves! When faced with a choice between doing something nice that users will like, versus doing something that saves compute power, the former always won.

8. Unexpected revenue sources

Who would have imagined that an ad agency would become the most powerful author of operating systems for mobile phones in the world? When hardware got dramatically cheap, and the Internet generated access to eyeballs on an unimaginable scale, new revenue models came about which were surprisingly different from the way we used to think earlier.

Interesting readings

2012-01-16T00:32:00.001+05:30

A nice pair on UIDAI from the Economist: The magic number and Reform by numbers.

Trampling on the individual in India: Akshaya Mishra on Firstpost.

Devangshu Datta in the Business Standard.

Ila Patnaik, in the Indian Express looks at Italy and worries about India.

Kanika Datta in the Business Standard on the Bombay Club.

Authoritarian India at its worst.

Ila Patnaik in the Indian Express worries about the economic consequences of NREGA.

Ila Patnaik in the Indian Express on RBI's thinking about new entry by private banks.

A great article on India's energy-fiscal mess by Urjit Patel, a rare person who understands both.

Tamal Bandyopadhyay in Mint, and Ila Patnaik in the Indian Express, on RBI's use of capital controls to combat rupee depreciation.

In the Indian Express, Ila Patnaik reminds us to avoid adventurism in the use of reserves for buying natural resources.

Shahan Mufti has a great article in Business Week on the supply chain problems that the US faces in Afghanistan.

I have often worried that we are not as bright as we used to be. Mark Pagel has an argument about why that might be.

Fundamental progress on payments by Russ Jones. I'm not a lawyer, but it's a fair guess that Square will be banned in India.

I just re-read James Buchanan's 1986 Nobel prize speech.

Once the public goods of a strong statistical system are in place, the real challenge becomes the brainpower that is deployed into thinking about the data. In India, we don't have half decent maps data in the public domain. But once high quality maps data becomes freely available, things change. Seth Stevenson on Slate tells a story of a beautiful design for a humble problem: a map.

Where did we go wrong?

2012-01-13T22:23:00.001+05:30

It is a time for deep thinking about what has gone wrong in India. Here are a few excellent takes:

Anil Padmanabhan in the Mint.
Ila Patnaik in the Indian Express and in the Financial Express. Also see Liberalisation 2.0 by her.
Pratap Bhanu Mehta in the Business Standard.

As we watch many train wrecks in India unfold in slow motion, Timothy W. Ryback in the New York Times reminds us about that ineffable substance of the human soul ... that shapes individual decisions and ultimately determines the course of actions, both large and small, that constitute the chain of events we know as history.

The resource curse of land ownership

2012-01-12T23:57:00.001+05:30

Land ownership in pre-modern India

In India, 50 or 100 years ago, land was a defining feature of wealth. The stock of land generated a flow of income. The landless were low-paid agricultural labour. The landed gentry of rural India were the kings of their heap. They had power, prestige, position, prosperity.

In the eyes of many, the initial conditions of high inequality of land ownership were a key barrier that held India back. It was argued that a one-time bout of bloodshed was essential, to expropriate the rich, and to transfer land ownership into a more equitable distribution. In India, this capacity for State-inflicted bloodshed was present in some places only. In much of India, the unequal distribution of land ownership found in 1947 was left intact.

Fast forwarding into the present, there has been a sea change in the fortunes of the owners of agricultural land.

Agriculture is less important

Particularly after we escaped from the Hindu rate of growth (3.5%) in 1979, the share of agriculture in GDP has dropped sharply. In relative terms, the wealth created through firms in industry and services has dwarfed the wealth of the landed gentry. The richest man in India today is born of one who started out with no land. Government interventions continued to stifle agriculture, but shifted to a greater laissez faire approach in industry and services; this helped accelerate the decline of agriculture.

The plight of those who stayed back

Rural to urban migration has unleashed new forces on the role and status of the landed lords. Within rich families, high IQ children may be going off to the city to a greater extent, e.g. based on the filtration by competitive examinations where outcomes are correlated with IQ. To the extent that such a process has been afoot, it has given a selection bias where the low IQ children were the ones more likely to stay back in the `idiocy of rural life' (as Marx characterised it). Over a couple of generations, the interplay of nature and nurture can add up to substantial effects.

That there was an easy option - to live off the land - was a `resource curse' which afflicted the households who had land. In contrast, for landless households, there was no conflict of interest in moving to cities (other than the recently introduced NREG, which tries to perpetuate poverty by hindering rural to urban migration).

The power and status of the landed lords was now twice undermined. Their quick-witted cousins who established themselves in the cities were connected into capitalism and getting ahead. Families of the landless have tended to move to cities, connect into capitalism, and get ahead. The erstwhile lords have started looking nervously at both groups of escapees, wondering whether land ownership was such a nice initial condition.

In a fascinating recent article, Devesh Kapur, Chandra Bhan Prasad, Lant Pritchett and D. Shyam Babu gave us some insights into these changing social structures. In their survey data, in 2007, 98.3 per cent of Harijans were contracting-out the work of tilling their fields to their erstwhile lords, the upper-caste men who owned and operated tractors. The upper tail of the Indian income distribution has, in a few generations, been reduced to operators of agricultural equipment.

The importance of engaging with the market

A defining issue of modern times, for an individual, is a continued and deep engagement with the market. For insights into this idea, see this interview with Tom Sargent. The Ljungqvist/Sargent story matters even more in India, when compared with what has happened in the West. At 7 per cent GDP growth, every few years, far-reaching change comes about in technology and processes. Each individual builds knowledge and human networks by continually engaging with the market. If a person is cut off from engagement with capitalism for even a few years, this generates a lot of human capital depreciation. At that reduced human capital, the person has to either accept an offer at a much reduced wage, or stay unemployed (which further undermines human capital).

The Ljungqvist/Sargent story helps us understand the plight of adivasis in India, who have been away from the market economy, and are unable to plunge into it. It helps us understand the plight of the unemployed of Europe: the welfare state pays them dole to stay warm and well fed for many years of unemployment, but after this they are unable to come back into the labour market.

In this setting, consider the plight of a land owner, who has been living off the land, and has never engaged with modern India. Particularly in the post-1979 period, when India has experienced relatively rapid growth, each year of being a country hick owning land meant being further away from the skills required to participate in the contemporary Indian economy. The landed gentry of India lacks the skills to participate in the market economy. Income from the land, their resource curse, dulls their incentive to overcome the barriers. They are often too proud to accept low wage assignments which are the starting point through which the unskilled connect to capitalism. These problems have come together to give a unique vicious cycle of dis-engagement with modern India.

Sale of land in the outskirts of cities

At the edges of all cities, urbanisation is proceeding through developers buying land from the local landed rich and transforming it into the endless suburbs. In the short term, this has generated immense windfalls of wealth for the landed rich. But in some ways, this is a bit of a disaster for many of them. Lacking in knowledge about the market economy, they are scammed by insurance salesmen and such like. Much of this newfound wealth tends to get dissipated in a few years.

Urbanisation and land development throws open vast opportunities for trade and industry. But the erstwhile landed rich tend to be uniquely ill equipped at harnessing these opportunities. They tend to be too proud to work for someone else, and inadequately equipped to stake out on their own. They experience a brief blaze of glory when paid fabulous prices for their land, and then fade away into insignificance.

Some politicians have been moved to advocate special legal protections for the hapless rural rich who sell land to the modern sector. It's quite a turnabout within a few generations: from landed elite that oppress the others, to witless folk who need to be protected by special laws that inhibit the sale of land.

The curse of land

A few decades ago, the left-of-centre view dominated the thinking in India. It was felt that inequality of land was a major bottleneck that held India back. Many argued that the failure of Indian democracy to engage in a one-time bout of class warfare through `land reform' was a major mistake that was holding India back. It was argued that the Chinese path was the right one: to expropriate the landowners and then start a capitalist economy under conditions where everyone is equal.

With the benefit of hindsight, things look different. I think this story reiterates the dangers of social engineering. We are dealing with enormously complex systems that we only dimly understand. As far as possible, it is wise on our part to use the force of the State as little as we can, and to always avoid treading on fundamental human rights such as property rights.

Acknowledgments

I am grateful to K. P. Krishnan, Suyash Rai and Mihir Thaker for insightful conversations.

The first PISA results for India: The end of the beginning

2012-01-05T15:23:00.001+05:30

by Lant Pritchett.

Now this is not the end. It is not even the beginning
of the end. But it is, perhaps, the end of the beginning.
Winston Churchill, November 1942

The PISA 2009+ results are the end of the beginning. For the last decade there has been a debate. Some argued the levels of learning inside Indian elementary schools (primary and upper primary) are a national scandal and a threat to the future of India's society, polity, and economy. Others appeared to believe that the main, if not only, problem with Indian schools was that not enough children attend them and that with more money and more of the same, all would be well. The last five years saw a relentless accumulation of evidence about the crisis of learning. The establishment has tried to deny, deflect, and dismiss the evidence on learning. Eventually the Government of India agreed to participate in the PISA (Programme for International Student Assessment) - but only for two states, Tamil Nadu and Himachal Pradesh - and both sides agreed PISA was the litmus test. The PISA 2009+ results, which are both official and are beyond gain-saying are unspeakably bad. They confirm the worst of what anyone has been saying about the levels of learning in India elementary education.

In reading of the 74 regions participating in PISA 2009 or 2009+ these two states beat out only Kyrgyzstan.
In mathematics of the 74 regions participating the two states finished again, second and third to last, again beating only Kyrgyzstan.
In science the results were even worse, Himachal Pradesh came in dead last, behind Kyrgyzstan, while Tamil Nadu inched ahead to finish 72^nd of 74.

But just coming in last (if we can dismiss as a relevant comparator for India a tiny Central Asian state) does not convey the enormity of how bad these results were, as not only was India last, it was far, far, behind its aspirations, both at the bottom and at the top levels of performance.

PISA expresses the levels of performance in two ways, an overall index number and the fraction of students achieving various "levels" of achievement. The PISA index numbers for each subject are scaled so that the typical OECD student is at 500 and the standard deviation across OECD students is 100. The testing of thousands of students allows the results to present not only the average but also the worst (5^th percentile) and best (95^th percentile) students do in each country/region. PISA also classifies student performance into "levels" that represent different degrees of mastery of the material.

Table 1 compares India's performance to three groups of countries. The economic superstars have successfully completed the transition from poor to rich economies in just two generations - Singapore, Hong Kong, Korea (China's only results are just for the city of Shanghai, which are the highest scores of any region tested, but this is too a typical to really be comparable) and India aspires to their sustained success economically. The current super powers are represented by the USA and the OECD average reflects India's aspirations as a superpower. The rising powers are represented by the BRIC countries of Russia and Brazil which reflect the rise of the emerging markets.

Compared to the economic superstars India is almost unfathomably far behind. The TN/HP average 15 year old is over 200 points behind. If a typical grade gain is 40 points a year Indian eighth graders are at the level of Korea third graders in their mathematics mastery. In fact the average TN/HP child is 40 to 50 points behind the worst students in the economic superstars. Equally worrisome is that the best performers in TN/HP - the top 5 percent who India will need in science and technology to complete globally - were almost 100 points behind the average child in Singapore and 83 points behind the average Korean - and a staggering 250 points behind the best in the best.

As the current superpowers are behind the East Asian economic superstars in learning performance the distance to India is not quite as far, but still the average TN/HP child is right at the level of the worst OECD or American students (only 1.5 or 7.5 points ahead). Indians often deride America's schools but the average child placed in an American school would be among the weakest students. Indians might have believed, with President Obama, that American schools were under threat from India but the best TN/HP students are 24 points behind the average American 15 year old.

Even among other "developing" nations that make up the BRICs India lags - from Russia by almost as much as the USA and only for Brazil, which like the rest of Latin America is infamous for lagging education performance does India even come close - and then not even that close.

To put these results in perspective, in the USA there has been huge and continuous concern that has caused seismic shifts in the discourse about education driven, in part, by the fact that the USA is lagging the economic superstars like Korea. But the average US 15 year old is 59 points behind Koreans. TN/HP students are 41.5 points behind Brazil, and twice as far behind Russia (123.5 points) as the US is Korea, and almost four times further behind Singapore (217.5 vs 59) that the US is behind Korea. Yet so far this disastrous performance has yet to occasion a ripple in the education establishment.

Table 1: Comparing Indian (Tamil Nadu and Himachal Pradesh) students mastery of mathematics to economic superstars, current superpowers, and rising superpowers
Country/Region	5^th	mean	95^th	HP+TN average to comparator average	*HP+TN average* to comparator 5^th percentile**	HP+TN best (95^th) to comparator's average	HP+TN best (95^th) to comparator's 95^th
Country/Region	5^th	mean	95^th	Points TN/HP is behind (-)/ahead(+)
*Economic Superstars*
Singapore	383	562	725	-217.5	-38.5	-99	-262
Hong Kong	390	555	703	-210.5	-45.5	-92	-240
Korea	397	546	689	-201.5	-52.5	-83	-226
*Current Superpower*
OECD avg.	343	496	643	-151.5	1.5	-33	-180
USA	337	487	637	-142.5	7.5	-24	-174
*Rising Superpowers*
Russia	329	468	609	-123.5	15.5	-5	-146
Brazil	261	386	531	-41.5	83.5	77	-68
*Indian States*
Tamil Nadu	241	351	468
Himachal Pradesh	223	338	458
Average of TN and HP	232	344.5	463
Source: PISA 2009 Plus Results, Table B.3.1 for first three columns and author's calculations.

I have emphasised Mathematics because many believed math was an Indian strong suit. The results for reading and science are similarly bad. Table 2 shows science results in a different format, which shows the proportion of children in various categories of performance. There are three points:

"Below level 1" doesn't even have a description as it implies that so little proficiency is demonstrated it is impossible to distinguish from not knowing anything at all. In the USA, even with its socio-economic and racial inequalities and language inequalities and its failing inner city schools, only 4.2 percent are in this category. In HP 57.9 percent of 15 year olds in school cannot be distinguished from not having learned any science at all and in TN 43.6 percent all in this category - ten times as many as the USA.
PISA considers "level 2" as the minimum level that provides the science competencies that will enable them to participate actively in life situations related to science and technology. Since more than 80 percent of students in both HP and TN are level 1 or below this most students in these states have reached age 15 ill-equipped for the century they will face.
While a thin elite that competes for the few highly selective technical institutes are globally competitive, this is a tiny fraction of the population. The estimate of the fraction of TN or HP students at level 6 in science proficiency was zero. Their estimate of the fraction at level 5: also zero. Of course this does not mean there are not such students in these states, of course there are, just that from the samples available in the study the best estimate was so small as to be indistinguishable from zero.

Table 2: Comparison of science proficiency in Tamil Nadu and Himachal Pradesh to India's aspirations
Country/Region	Below level 1	Level 1 ¹	Level 5 ⁵	Level 6 ⁶
Singapore	2.8	8.7	15.3	4.6
Hong Kong	1.4	5.2	14.2	2
Korea	1.1	5.2	10.5	1.1
OECD avg.	5	13	7.4	1.2
USA	4.2	13.9	7.9	1.3
Russia	5.5	16.5	3.9	0.4
Brazil	19.7	34.5	0.6	0
Tamil Nadu	43.6	40.9	0^a	0^a
Himachal Pradesh	57.9	30.9	0^a	0^a
Source: PISA 2009 Plus Results. Description of levels Table 3.2, percentages Table B.3.4. 1) At Level 1, students have such a limited scientific knowledge that it can only be applied to a few, familiar situations. They can present scientific explanations that are obvious and follow explicitly from given evidence. 5) At Level 5, students can identify the scientific components of many complex life situations, apply both scientific concepts and knowledge about science to these situations, and can compare, select and evaluate appropriate scientific evidence for responding to life situations. Students at this level can use well-developed inquiry abilities, link knowledge appropriately and bring critical insights to situations. They can construct explanations based on evidence and arguments based on their critical analysis. 6) At Level 6, students can consistently identify, explain and apply scientific knowledge and knowledge about science in a variety of complex life situations. They can link different information sources and explanations and use evidence from those sources to justify decisions. They clearly and consistently demonstrate advanced scientific thinking and reasoning, and they demonstrate willingness to use their scientific understanding in support of solutions to unfamiliar scientific and technological situations. Students at this level can use scientific knowledge and develop arguments in support of recommendations and decisions that centre on personal, social or global situations. a) In Table B.3.4 these are reported as blank but the estimated percentages in below 1 to level 4 sum to exactly 100 percent. Obviously this not imply that there are exactly zero students in all of these two states meeting these levels but that with the sample sizes assess students of 1616 in HP and 3210 in TN there was insufficient information to create a non-zero estimate.

These results on PISA 2009+, while tragic for what they imply for Indian youth and perhaps shocking to newcomers to this subject, come as no surprise to those who have been working on basic education in India:

Das and Zajonc (2008) used results from Orissa and Rajasthan to create indices on mathematics performance similar to those of TIMSS (Trends in Mathematics and Science Study) and found these states near the bottom of the global rankings.
Educational Initiatives carried out an 18 state study using sophisticated testing instruments and found levels of performance on TIMSS comparable items that were stunningly lower. For instance on the open ended question "Write a fraction larger than 2/7" less than 30 percent of Indian students in standard 8 could answer correctly compared to more than 70 percent internationally.
The APRest study led by Karthik Muralidharan and Venkatesh Sundararaman in rural AP asked the same questions of students in grades 2 to 5 and found very slow rates of learning progress.
The results year after year from the ASER [2010 2009] study supported by Pratham find that significant fractions of students in Standard 8 cannot master even Standard 2 curricular basics. In rural areas nationwide a third of children in grade 8 could not do a simple division problem and almost 20 percent could not read a level 2 text. The 2011 results, due out in a few weeks will show continued stagnation or even retrogress in learning.
Numerous studies by MIT's JPAL, World Bank, NCAER/University of Maryland and other researchers found levels of performance that were shockingly low compared to curricular expectations.

These PISA 2009+ results are the end of the beginning. The debate is over. No one can still deny there is a deep crisis in the ability of the existing education system to produce child learning. India's education system is undermining India's legitimate aspirations to be at the global forefront as a prosperous economy, as a global great power, as an emulated polity, and as a fair and just society. As the beginning ends, the question now is: what is to be done?

Uncomfortable times in real estate in store?

2011-12-24T18:06:00.001+05:30

Patrick Chovanec has a fascinating article in Foreign Affairs, titled China's Real Estate Bubble May Have Just Popped. This is interesting and important from two points of view.

First, bad news for China is bad news for the world economy. We are already in a bleak environment, with difficulties in Europe, Japan, the US, and India. It will not be pretty if China runs into trouble as well. I am reminded of the feeling of carefully watching real estate in the United States in 2006, with a sense that the future of the world economy was going to turn on how it turned out.

Second, it made me think about real estate in India. As with China, one often sees buyers of real estate in India have the notion that this is a safe financial asset. This is a questionable proposition. Real estate is perhaps not an asset class with a positive expected return in the first place; and it is certainly not a convenient asset class with features like liquidity, transparency, diversification and easy formation of low-volatility diversified portfolios. I find it hard to explain the prominence of real estate in the portfolios of even educated people in India.

In the article, Chovanec says:

For more than a decade, they have bet on longer-term demand trends by buying up multiple units -- often dozens at a time -- which they then leave empty with the belief that prices will rise. Estimates of such idle holdings range anywhere from 10 million to 65 million homes; no one really knows the exact number, but the visual impression created by vast `ghost' districts, filled with row upon row of uninhabited villas and apartment complexes, leaves one with a sense of investments with, literally, nothing inside.

This has not happened in India. So in this sense, the situation in India is not as dire. But his second key message seems uncomfortably close:

As 2011 progressed, developers scrambled for new lines of financing to keep their overstocked inventories. They first relied on bank loans (until they were cut off), then high-yield bonds in Hong Kong (until the market soured), then private investment vehicles (sponsored by banks as an end run around lending constraints), and finally, in some cases, loan sharks. By the end of last summer, many Chinese developers had run out of options and were forced to begin liquidating inventory. Hence, the price slashing: 30, 40, and even 50 percent discounts.

Part of this looks familiar. There is a lot of leverage in Indian real estate development and speculation. Real estate speculators and developers are finding themselves in a bit of a scramble hunting for credit. One hears about very high interest rates being paid by developers. Other sources of financing are also weak. This reminds me of the dark days before the global crisis, when borrowing by real estate companies was the canary in the coal mine.

If business cycle conditions and financial conditions worsen, the problems of borrowing by real estate developers and speculators will get worse. How might this turn out? Perhaps the borrowers will merely get uncomfortable. Or, a few firms could really get into trouble, and start liquidating inventory. That would have substantial repercussions.

Suppose there is a situation where there are many people who have speculative positions in real estate, but significant selling of inventory has not yet begun. The longs would then be nervously looking at each other, wondering who would be the first one to sell, to take a better price and exit his position. The ones who sell late would get an inferior price. In such a situation, conditions could change sharply in a short time.

On a longer horizon, I would, of course, be delighted if real estate prices are lower. This would help shift the supply function of labour, reduce the cost of setting up new businesses, etc. But that's more about the long-term policy changes, which would remove barriers for converting land into built-up housing, while rising vertically into the sky with FSI in Indian cities ranging from 5 to 25.

The most-read posts on this blog

2011-12-17T03:09:00.000+05:30

Google started maintaining data about blogs from May 2009 onwards. In this data, I find the most read posts were:

The Right to Education Act: A critique, by Parth Shah
What in the world is happening to the rupee?
The rupee: Frequently asked questions
When and where do great feats of architecture come about?
Guide to the Eurozone crisis, by Percy Mistry
The US sells chopsticks to China, by Jim Hanson
Household financial choice of the hapless households of India
Don't like the SKS valuation? Compete, don't complain, by Bindu Ananth and Nachiket Mor.

RBI reaches for capital controls

2011-12-15T21:51:00.001+05:30

By and large, I have felt that RBI has done a pretty good job of the exchange rate. They doubled currency flexibility twice, in 2004 and 2007. In 2009, they shifted to a floating rate. There were two problems:

They continue to sometimes do tiny blocks of trading on the currency market. In a market of $70 billion a day, a small scale of trading (e.g. $1 billion a month) is irrelevant, so why bother doing it? This has been pointless, but it has done no damage.
They have failed to correctly communicate to the market that the exchange rate is now a float. I cannot recall an RBI governor who used the phase "floating exchange rate". Many economic agents seem to have got the following message: You're on your own for small fluctuations, but if there are big movements, RBI will block them. This was mis-communication. The people who hedged against small movements but not against large ones, as a consequence of RBI, have now got burned. This is going to further increase the cost of RBI to gain credibility in the years to come, to come to a point where its words are respected.

Barring these two issues, I have felt that RBI has done a pretty good job of the exchange rate. Until now.

RBI has just announced a batch of capital controls against the currency market. This is a mistake:

When there is turbulence on the currency market, you want greater activity on the currency derivatives market - which is where people protect themselves from currency risk - not less. Recall how the Greek default really damaged the Italians because on that day, the owner of an Italian government bond was told that maybe his CDS would malfunction if an Italian default came about. It was not good for Italy for economic agents to have a reduced ability to manage this risk.
This will merely shift business to alternative venues - the offshore market and the onshore currency futures market. To the extent that shifting to these venues is tedious or infeasible (e.g. FIIs are banned from the onshore currency futures market and don't have that choice), economic agents will be averse to holding India risk. This is bad for asset prices in India at a particularly difficult time.
In a climate of pessimism about economic policy, it is important to send out a message, through action and non-action every day, that RBI (and more generally the Indian economic policy establishment) possesses top quality knowledge and decision-capabilities in economics and finance. This action of RBI reinforces the gloom about economic policy capabilities in India.

In April, Ila Patnaik and I released a paper titled Did the Indian capital controls work as a tool of macroeconomic policy? Our answer was largely in the negative. RBI's actions of today are likely to shape up as yet another episode of this larger theme. It might make things worse for the rupee, for Nifty, etc.; to this extent these decisions would not be irrelevant.

Financial regulation should be focused on the problems of consumer protection, micro-prudential regulation, market integrity and systemic risk. It should not be used as a tool for short-term macroeconomic policy. If this is done, it damages market liquidity and yields a less capable financial market. This further damages the limited monetary policy transmission that RBI possesses.

Be skeptical. Be very skeptical.

2011-12-13T15:20:00.000+05:30

Mistake upon mistake

In recent months, we've had a few slip-ups by the official statistical system in India:

Yesterday's IIP release was preceded by a mistake. Mint says: On Monday, the government was guilty of a similar error in its factory output data. Till it corrected the number pertaining to capital goods output, analysts were left scrambling for explanations as to how this had grown 25.5% while overall factory growth had shrunk 5.1%. (The answer: it hadn’t, and had actually shrunk by 25.5%).
On 9 December, we discovered there were important mistakes in the exports data.
In December 2010, RBI modified the numbers that it releases about its trading on the currency market.
In September 2010, there was a mistake in the quarterly GDP data released by CSO.

What is going wrong?

These examples are part of a larger theme, of problems of the official statistical system. The Indian statistical system is afflicted by three levels of problems:

The first level is conceptual problems and analytical errors. As an example, the weights of the WPI basket are wrong; the estimation methods used in the IIP are likely to be wrong, etc. Quarterly GDP measurement does not have a demand side (which requires a quarterly household survey, which the government does not know how to do).
The second level is the lack of rugged IT systems. The production of statistics requires high quality enterprise IT systems. The government does not have the ability or incentive to roll these out. As an example, the September 2010 mistake in quarterly GDP data seems to have come about because quarterly GDP data is produced in a spreadsheet. As with all usage of spreadsheets, this is highly error prone. The hallmark of a reliably executed process is the absence of spreadsheets.
The third level is the problems of truant front-line staff. In a country which is not able to get civil servants to show up at school to teach, it is not surprising that front-line staff of statistical agencies are untrustworthy in going out into the field and filling out survey forms. More generally, the statistical system is a set of public goods produced by civil servants, who are unresponsive about the needs of users, or the unhappiness of users, either on flaws about what is done or about the gaps in what is not done.

The rash of mistakes that we're seeing, lately, are merely a reflection of #2 (the lack of rugged enterprise IT systems). But there is much more going on which holds back the usefulness of official statistics.

How to make progress?

Government officials in this field have pinned a lot of hope on the implementation of the report of the statistical commission (headed by C. Rangarajan, 2001). I am personally not optimistic about this. The report seems to emphasise an incremental agenda of building the statistical system, emphasising the interests of the incumbents. In any case, it's been a decade after 2001, and it's important to ask fresh questions about what is going wrong and why.

What is required is a ground-up rethink about the statistical system, from first principles, so as to address the three difficulties above. As an example, most of the civil servants processing data in a labour-intensive manner are not required if a good quality enterprise IT system is put into place (and it is hence not surprising that the incumbents are un-enthusiastic about business process transformation). The revolution of computers and telecommunications needs to be brought into this field, just as it has done in so many others. This does not require large sums of money; it requires superior public administration.

What should users of data do?

Turning to the users of official statistics, most economists attach enormous prestige to phrases like GDP, IIP, CPI, etc. But in India, we cannot unthinkingly use some numbers just because they come with the label `GDP' from some government agency. We have to always skeptically ask first principles questions about how the data is generated. All too often, the standard Indian government data is useless.

Global financial firms who now operate in India have brought a certain cookie-cutter mentality. They produce a major report about each release of quarterly GDP for all countries that they write research reports about. Hence, once they started having such analyst coverage of India, they have started writing a report about quarterly GDP. Such a mechanical approach is a waste of resources. The quarterly GDP data is mostly uninformative.

In the class of government data that I know of, I feel the CPI is reasonably okay. The WPI is a fairly useful database about prices but useless as a price index. The quarterly GDP data, IIP, NSSO, ASI are untrustworthy.

Decision makers in government and in the private sector need to struggle with these issues, carefully thinking about what statistics are allowed to influence their decision processes.

Academic users of data need to be much more careful about avoiding garbage-in-garbage-out (GIGO). With a large number of academic papers that work with Indian data, I stop reading the paper after I have read the data description; I know the data is rubbish, so the paper will not change my mind, so I should not bother reading it. A good referee blocks papers which are GIGO. But even if the referee in a faraway place thinks that quarterly GDP in India is well measured, the researcher should ponder whether there are better uses of his time - are there projects which can be more meaningful and genuinely answer important questions, over and beyond merely getting past a referee?

Finding out more

For more on this subject, you might like to look at the label `statistical system' on this blog.

Interesting readings

2011-12-12T01:43:00.001+05:30

China's Pakistan Conundrum by Evan A. Feigenbaum, in Foreign Affairs.

The most important task of government is the public goods of law and order: laws, courts and judiciary. The first step towards strengthening these lies in sound measurement. Writing in Pragati, Sushant K. Singh has an excellent article on the problems of measurement of crime in India.

An independent judiciary by Ruma Pal.

Devesh Kapur, in the Business Standard, on the HR crisis in the Indian State.

Shyam Saran in the Business Standard on a more sensible approach that we should bring to intra-South-Asia logistics.

The lack of freedom of speech in India: Karan Singh Tyagi in the Hindu.

Amit Rai writes in the Times of India about the mistakes of the legal actions following the AMRI fire.

Mobis Philipose in Mint on how charges by exchanges have made a difference to the currency futures market.

Every advocate of a big spending Indian government should ponder this article about Greece by Landon Thomas in the New York Times.

Dreze and Sen on what India does right and wrong. We may not agree with most of this, but they are smart people and it's worth reading.

Hard times at UTI: Anirudh Laskar and Vyas Mohan in Mint, and Niladri Bhattacharya and N. Sundaresha Subramanian in Business Standard.

Air India and Maharashtra PSUs remind us, in interesting ways, about why government should not be in business.

Martin Feldstein explains what went wrong with the Euro.

Look at profiles of Mario Monti, who will try to fix Italy, and Loukas Papadimos, who will try to fix Greece. I guess that every now and then, the professional politicians foul up big time, and then bring in the economists to clean up. It reminds me of a perspective by C. B Bhave on urban governance in India: when things are going well, the politicians want an accomodating civil servant; when the city goes to hell, they want a tough competent one. Also see Greece and Italy Seek a Solution From Technocrats by Rachel Donadio in the New York Times.

Charles Moore looks back at the story of Maggie Thatcher, who ended Britain's long decline in the 20th century.

Read Larry Summers in the Financial Times on the problem of inequality and three things that need to be done about it.

Two important platforms for modern web development were Flash and HTML5. It now looks like Flash is dying. Looks like Steve Jobs was right on one more thing.

Business cycle conditions in India: It's mostly cycle, not trend

2011-12-10T22:46:00.001+05:30

There is a lot of gloom in India today about the broad-based failure of the UPA strategy of combining left-of-centre populism, fiscal profligacy, theft, and a lack of interest in the foundations of India's growth. We learn from history that we learn nothing from history; India has clearly learned very little from its escape from the Hindu rate of growth. The moment we got a little bit of growth, the old style socialism and theft reared up again. In one of the many pessimistic articles of this theme, Shekhar Gupta in the Indian Express says:

What is the Hindu Rate of Growth two decades after reform? It certainly can’t be the 2-3 per cent of India’s socialist Brezhnev decades. The new Hindu Rate of Growth is 6 per cent, and on all evidence, from macroeconomic data to the empty billboards of Mumbai, we are headed there next year.

In thinking about GDP growth, it's always useful to think about both growth and fluctuations. Growth is about the underlying trend growth rate. In the olden days, this was all you needed to worry about. The economy trundled along at roughly the trend growth rate (the Hindu rate of growth of 3.5 per cent), being kicked up or down by good or bad monsoons. In that period, macroeconomics in India required thinking in completely different ways, when compared with standard Western textbooks.

But from the early 1990s onwards, India changed. The market-oriented reforms, which began with the Janata Party in 1977 and gathered momentum in the 1980s, had started creating a market economy. And every market economy in the world experiences business cycle fluctuations. So, in addition to the trend, we got a cycle about the trend. There were good periods and bad periods, and the story running in there was much like that found in mainstream Western textbooks, with a prominent role being played by profitability, inventories and investment by firms.

From this viewpoint, it's useful to decompose two elements of what we are seeing after 2009. On one hand, trend growth has been influenced by decisions of the UPA. Any perceptive observer also tends to rage at the lost opportunities, of policy decisions that should have been taken, which would have accelerated trend growth. But the second big story is that of fluctuations. Corporate investment is a major driver of business cycle fluctuations in India, and there has been a certain deceleration in this. This may have set off a downturn.

The bulk of the drama that we're now seeing, and what will play out in 2012, is business cycle fluctuations. This is about fluctuations, not the trend. When trend growth is 7 per cent, the fluctuations make GDP growth range from 4 per cent to 10 per cent. Even if trend growth does not change by even a bit, business cycle fluctuations can take us from a high of 10 per cent to a low of 4 per cent, which is a huge swing of 6 percentage points.

Many elements of economic policy are pro-cyclical: when times are good, they make things better and when times are bad, they make things worse. The financial system tends to suffer from pro-cyclicality: when times are good, bankers lend exuberantly (thus expanding the boom) and when times are bad, bankers tend to be cautious (thus accentuating the bust). It is important to look for a framework for stabilisation, of tools that will counteract business cycle fluctuations. India has crossed one major milestone, in getting to a floating exchange rate. The floating exchange rate is stabilising, in and of itself. In addition, it opens up the possibility of stabilising monetary policy.

As of today, by and large, I think of both fiscal policy and monetary policy as being part of the problem and not part of the solution. While floating the exchange rate (decisions from 2007 to 2009) opened up the possibility of sound monetary policy, the logical next step did not materialise. As of yet, we do not have a sound monetary policy regime. We're going to require far-reaching surgery to laws and institutions, in order to craft frameworks for fiscal policy and monetary policy that do stabilisation. Until these changes are made, Indian GDP growth will have the high volatility that is characteristically found in countries with weak institutions.

A lot of our work in the Macro/Finance group at NIPFP is rooted in this conceptual framework. In particular, you might like to see two relatively non-technical articles: New issues in macroeconomic policy and Stabilising the Indian business cycle.

Talk by Thomas Laubach on inflation expectations, inflation targeting, monetary policy

2011-12-02T22:52:00.001+05:30

Thomas Laubach will do a talk titled Inflation: Expectations, Targets and the Institutional Framework for Monetary Policy at the NIPFP auditorium at 3:30 PM on December 9 (Friday). He is Professor at Goethe University in Germany. All are welcome.

The rupee: Frequently asked questions

2011-12-01T23:56:00.001+05:30

q: How big is the market for the rupee?

The rupee is now a big market. Summing across both spot and derivatives, perhaps $30 billion a day of onshore trading and $40 billion of offshore trading takes place. Both these markets are tightly linked by arbitrage. In other words, for all practical purposes, it's like NSE and BSE which are a single market unified by arbitrage. If you place a small order to buy 100 shares on either NSE or BSE, you get essentially the same price, and arbitrageurs are constantly at work equalising the price across both markets. It is a similar state of affairs between the onshore and the offshore rupee. Both markets are tightly integrated by arbitrage.

The offshore market for the rupee, and a large part of the onshore market, is OTC trading. Hence, the efficiencies of algorithmic trading and algorithmic arbitrage cannot be brought to bear on onshore/offshore arbitrage. So the arbitrage is done by manual labour. Still, it gets done. Both markets are tightly linked and show the same price. We should think of them as one market. It's one big market, it is one of the big currencies of the world, it's roughly $70 billion a day.

q: How might RBI do manipulation of this market?

If RBI wants to hit the market with orders big enough to make a difference, they have to be ready to do fairly big orders and to be able to do it on a sustained basis. As a rough thumb-rule, I might say that in order to make a material difference to a market with daily volume of $70 billion, they have to be in the market with atleast $2 to $3 billion a day.

q: What would go wrong if they tried this?

Three things would go wrong.

First, foreign exchange reserves are $275 billion. If RBI sells off $2.75 billion a day, the reserves would be quickly gone.

Second, when RBI sells dollars and buys rupees, this sucks liquidity out of the market. The side effect of selling dollars would be a sharp rise in domestic interest rates. In other words, monetary policy would get hijacked by currency policy. This would not be wise. Monetary policy should be focused on delivering low and stable inflation: it should have no ulterior motives. We have to make a choice: Do we want to use up the power of monetary policy to achieve domestic goals, or do we want to use up the power of monetary policy to achieve currency policy goals?

Third, suppose you and I saw a market price of Rs.45 per dollar, which is created by RBI and not a market reality. We would know that in time, the truth will out, that the price will go back to Rs.52 a dollar. The rational trading strategy for each of us would be: To sell any and every domestic asset, and shift money out of the country. This would trigger off an asset price collapse in India. We would take the money out, and wait for the distortion of the currency market to end. At that point (perhaps Rs.52 a dollar, perhaps worse) we would bring the money back to India and buy back our assets. We might make two returns here: first, on the move of the INR/USD from 45 to 52 (or worse) and the second, on the gain from the drop in asset prices.

q: Isn't it hard to take money out of India in this fashion?

It's easier than we think. Remember September 2008? The mythology in our heads was: we in India are crouching safely behind a wall of capital controls. In truth, the wall wasn't there.

q: But until recently, RBI used to give us a pegged INR/USD exchange rate! What changed?

In late 2003, RBI ran out of bonds for sterilisation. Associated with that, there was a first structural break in the rupee exchange rate regime, with a doubling of volatility. A short while later, in March 2007, there was another structural break, with another doubling of volatility. From April 2009 onwards, RBI's trading in the market has gone to roughly zero. RBI stopped managing the exchange rate a while ago.

The exchange rate is the most important price of the economy. The decontrol of this exchange rate is the biggest achievement of the UPA in economic reforms. The credit for this goes to Y. V. Reddy and Rakesh Mohan (who took the first two steps of doubling exchange rate flexibility twice) and to Dr. Subbarao (who got out of trading on the currency market, which did remarkably little to INR/USD volatility).

q: Why did nobody tell me that something changed in the exchange rate regime?

RBI should be talking more transparently about what is going on. But they are not transparent about what they do. Even though hundreds of millions of people are affected by their trading on the currency market (or the lack thereof), the manual which governs their currency trading at any point in time (i.e., the documentation of the prevailing exchange rate regime) is not transparently disclosed to the people of India. We have to decipher what is going on by statistically analysing exchange rate data.

The dates of structural break of the exchange rate regime are extremely important dates in thinking about what was going on in macroeconomics and international finance. Any time one is using data about exchange rates, interest rates, etc., it is important to work within one segment of the prevailing exchange rate regime at a time. It is wrong to pool data across many years. All users of data need to be careful in this regard.

q: So what might happen to the rupee next? Is there a `law of gravity' which will pull it back to erstwhile values of Rs.45 or Rs.50?

When you don't manipulate a financial market, the price time-series comes out to something close to a random walk. In the ideal random walk, all changes are permanent. The random walk never forgets; there is no law of gravity which takes it back to recent values. Your best estimator of what it will be tomorrow is: what you see today.

In order to get a sense of what will come next, go through the following steps. First, go to INR/USD options trading at NSE, and pluck out the implied volatility for the four at-the-money options. I just did that, and the values are: 10.43, 10.32, 10.33 and 10.08. Calculate the average of these four numbers. With the above four values, the average is: 10.3. (This is a quick and dirty method; here is one which is much better).

This tells a very important thing: The options market believes that in the future, the volatility of the INR/USD rate will be 10.3 per cent per year.

In order to re-express this as uncertainty per month, we divide by sqrt(12). This gives the volatility for a month as : 3% per month.

Roughly speaking, the 95% confidence interval for what might happen over a month, then, runs from -6% to +6% (this is twice the standard deviation, which we just worked out was 3% per month).

The INR/USD is now Rs.51.62. By the above calculation, we can be 95% certain that one month from today, it will lie somewhere between 48.5 and 54.7.

These trivial calculations have been done by equity market participants for the longest time. It is a standard and trivial idea: To read the implied volatility off the Nifty options market, and to do such calculations to get a sense of what might come next with Nifty. But on the currency market, this is relatively novel. Only recently have we got a nice currency options market, and only recently have we got to a genuine market. Now these skills can be brought to bear on the currency market. It's a brave new world, one in which the operations of financial derivatives markets (Nifty options, INR/USD options) produces forward-looking and timely information about the economy (implied volatility).

q: What changed in imports and exports which gave us the big recent move of the rupee?

The current account (goods, services, and then some) adds up to a mere buying and selling of $4 billion a day. The bulk of currency trading is about the capital account. The currency is a financial object; the exchange rate is defined by financial considerations and not by current account considerations.

q: What happens to the Indian economy when the rupee depreciates?

This has been the source of a great deal of confusion and it's important to think straight about this. There are three important effects in play:

Some people had borrowed in dollars, and left it unhedged since they were speculating that the INR would appreciate. They have got burned. That's okay - in a market economy, many people place bets about future fluctuations of financial prices, and half the time the speculator loses money. (If the rupee had not depreciated sharply, these speculators would have been truly joyous).
When the rupee depreciates, imports become costlier and India's exports become more competitive. So exports (X) gradually start going up and imports (M) gradually start going down. The net gain in X-M is increased demand in the local economy. In this fashion, INR depreciation is good for aggregate demand (and conversely INR appreciation pulls back demand). However, we have to bear in mind that these effects are small and take place with long lags.
Many things in India are tradeable. It is important to focus on the things that are tradeable and not just on the things that are imported. As an example, there are many transactions between a domestic producer of steel and a domestic buyer of steel. The buyer and seller are both in India. But the price at which they transact is the world price of steel (which is quoted in dollars) multiplied by the INR/USD exchange rate. This situation is called `import parity pricing'. Through this, the domestic prices of tradeables goes up when the rupee depreciates.

q: What is the impact of costlier tradeables for RBI?

RBI's job is to fight inflation. RBI must work to deliver year-on-year CPI inflation (a.k.a. `headline inflation') of four to five per cent. When tradeables become costlier, domestic CPI inflation goes up. So the rupee depreciation has made RBI's job harder. RBI will have to respond by hiking interest rates. (Note that one impact of higher interest rates will be that more capital will come into India, which will tend to yield a rupee appreciation; import parity pricing has created a new channel through which RBI rate hikes combat inflation).

q: What is the impact of costlier tradeables for business cycle conditions in India?

As the example above about steel suggests, the price realisation of all tradeables companies goes up when the rupee depreciates. Costs change by less by revenues (since many costs are not tradeables), and profitability goes up.

Firm profitability has dropped sharply in 2011. My prediction is that firms producing tradeables will show better profitability in Oct-Nov-Dec 2011 when compared with the previous quarter, thanks to the rupee depreciation.

This is great news for business cycle conditions. Profitability goes up, which yields more cash for investment by financially constrained firms. And, when profitability is higher, more investment projects look viable.

q: In the bottom line, what is the link between the rupee and India's business cycle stabilisation?

If RBI tried to peg the exchange rate, the lever of monetary policy would get used up to deliver the target exchange rate. By not trading on the currency market, the lever of monetary policy is now available. A pretty good use for this lever is to deliver low and stable CPI inflation. If this is done, then an RBI focused on inflation would help stabilise the economy by cutting rates when CPI inflation drops below 4% and hiking rates when CPI inflation goes above 5%.

But floating the exchange rate also yields stabilisation purely in and of itself. In bad times, capital leaves India, the rupee depreciates. This gives higher profitability in tradeables firms and bolsters investment. Conversely, when times are good, more capital comes into India, the INR appreciates, which crimps profitability of tradeables firms. The floating exchange rate exerts a stabilising influence upon the economy: purely by doing nothing on the currency market, RBI has unleashed this new force of stabilisation which will help India.

q: What should RBI do next?

RBI should do as they have done, i.e. avoided trading on the currency market.

RBI should keep driving up the short-term interest rate until point-on-point seasonally adjusted CPI inflation shows a decline and goes into the target zone of 4-5 per cent. After this hangs in there for a year, `headline inflation' (y-o-y growth of CPI) will be in the target zone.

q: What do other countries do?

When we look at countries with good governance, the mainstream strategy seen worldwide is an open capital account and a central bank that delivers on an inflation target. By and large, this goes with a floating exchange rate. Trading on the currency market interferes with achieving price stability and has hence been dispensed with, by most good countries. Japan and Switzerland come to mind as exceptions to this broad regularity.

IGIDR Emerging Markets Finance conference

2011-11-29T16:15:00.001+05:30

Link.

Taxing investors to pay NGOs

2011-11-25T17:42:00.001+05:30

In India, NGOs are fashionable. It is almost never wrong, in the Indian discourse, to give more money and more functions to NGOs.

Many people have worried about the extent to which NGOs are being used to supplant failing State machinery. This may seem expedient, but no country every became a developed country on the back of NGOs. There is no alternative to fixing the core mechanisms of the State.

In recent days, two pro-NGO policy elements seem to be in the pipeline:

A new Companies Bill seems to require that 2% of profit be spent on corporate social responsibility (CSR).
SEBI decided to force listed companies, starting with the top 100 firms, to describe measures taken by them along the key principles enunciated in the ‘National voluntary guidelines on social, environmental and economic responsibilities of business,' framed by the Ministry of Corporate Affairs (MCA).

When the government grabs 2% of the profit of a company, and hands it out to any purpose (no matter how good or bad), that is called expropriation. The fact that it satisfies some bleeding hearts does not change the fact that it is expropriation. In a good country, property rights would be fundamental, and the Supreme Court would block such expropriation.

The job of a corporation is to efficiently organise production, and send dividends back to shareholders. It is the individual, the shareholder, who has to then make a call about whether he would like to give money to charitable causes or not. We do wrong by expropriating this money even before it reaches the individual.

For an analogy, it is Bill Gates' birthright to gift away his own money, in his capacity as an individual. And I really admire the intelligence with which the Bill and Melinda Gates Foundation works. But Bill Gates (or the government or anyone else) has no right to expropriate money belonging to shareholders, through charitable initiatives by Microsoft.

We do wrong by placing the burden of charitable works upon the corporation. Corporations should not be organised to be do-gooders. They should be organised to obey laws, have high ethical standards and then power India's way out of poverty by efficiently organising production. Anything that corporations do, other than focusing on efficient production, is a distraction from the main trajectory of India's growth and development.

When a country is run by bleeding hearts, things start going wrong. If such a tax is enacted, it reduces the post-tax return on capital that Indian firms generate. Foreign investors and domestic investors have choices about where to invest. They will demand that firms only invest in a smaller set of high-return projects, which are competitive on the rate of return by global standards, even after being taxed. In other words, many projects will not be undertaken. This can't be good for India.

To make progress in India, we need to be hard headed. We should not let the urge to do good crowd out intelligence and analysis. We are falling into this trap too often.

One key element that I blame is the Indian college education. We fail to teach political science, we have too many people who have not read The Republic, so we get trouble like Anna Hazare. We fail to teach economics, so we get Sarva Shiksha Abhiyaan and the education cess. Given the absence of a positive strategy for what India should be doing, in the mainstream, we are willing to turn away from the hard work of fixing the State, and feel satisfied by funding some do-gooding NGOs.

Intellectuals are the yeast that make a society rise. India is a big mighty youthful stagnant dough, waiting for a pinch of yeast.