Thursday, July 29, 2010

Is the Keynesian concept of price stickiness valid at extremes?

The one major contribution of The General Theory of Unemployment, Interest & Money (John Maynard Keynes, 1936), if I have to choose one, was the concept of “price stickiness”. In effect, Keynes gave a reason why changes in money supply would change output and not prices, effectively rebutting the basic premise of the Quantity Theory of Money. Keynes stated that because prices don’t change as rapidly as potential changes in money supply, an increase in money supply would result in higher demand which would increase output to match this increase demand. This concept was been the bedrock of monetary policy in the post-WWII world getting diluted only by the shift towards  Chartalism in the 1970s. Recent events and attempts at stimulus, however, have relied largely on this concept and mark a resurgence of Keynesian thought.

Price stickiness also included wage stickiness following the logic that a unit of work was as much a product as say, a car or a soda, and an increase in aggregate demand would allow entrepreneurs to increase production by hiring more labor without increasing the unit cost of labor. This would continue till such time labor supply reached its limit, at which point, labor costs will start rising. The inverse was held to be true for a recessionary environment, when a fall in aggregate demand would result in entrepreneurs shedding labor, and such shedding of labor would not change the price of labor. However, this concept is now being challenged.

Tyler Cowen, in a recent blog post, admits his forecasts for some European economies was a lot worse than their actual performance. And he believes this is due to his assumption that wages in these economies were far more sticky than they actually are. Evidence that nominal & real wages are falling is available across the cross section of these economies which leads him to believe that downward inflexibility in wages isn’t just a function of the employee’s readiness to accept less, but also caused by the fact that most employers don’t like to cut wages of existing employees unless absolutely required. This can result in large wage cuts being more common and more acceptable than small ones.

This is an extremely significant observation with an intuitive real world ring. Just as, ceteris paribus, it is improbable that an employee would change jobs for a marginally higher salary, it is equally improbable that an employer would risk damaging employee morale when required wage reduction is small. However, in both cases, if the difference is substantial, it may be well worth the risk. After the 2008 crisis, aggregate demand dropped sharply accompanied by a sharp jump in unemployment. Demand remains subdued, as does job creation, and it is extremely likely that out-of-work skilled workers, and see no hope of getting back to work soon, may be willing to accept much lower pay than their own earlier pay, or the existing pay of workers they can replace.  If this difference is substantial, employers would either ask their existing workers to accept a lower salary or replace them, since their savings would be large enough to offset any cost associated with damaged employee morale and the like. And when job creation is slow, existing employees may accept such a reduction willingly.

But this would also mean that Keynes’ “stickiness” works only in the case of gradual changes in aggregate demand, which can be effectively countered by stimulus and not when the change is sudden, significant and long lasting. In the latter case, it is extremely likely that the loss of aggregate demand will not only be accompanied by increased joblessness, but by lower wages as well.

This also implies that government stimulus in the latter situation, unless it is of a magnitude and duration large enough to have a pronounced and lasting impact, would actually be a complete waste of money. And if it is of such a magnitude, it would distort labor costs by not allowing them to fall to a market clearing rate possibly casting the nation’s lack of competitiveness in stone.

Either way, it can’t be good.

Wednesday, July 28, 2010

RBI’s December inflation forecast @ 6% - I told you so!

I don’t like saying this, but I did tell you so… Way back in March, in this post, I had detailed the reasons why inflation would drop to 6% by December 2010.

The reasons hold and they still have nothing to do with monetary policy.

And about time too…

It seems the advisability of RBI’s dual role is being questioned again. In a very well written and eloquent column, Mr. A. K Bhattacharya details the reasons.

There is one reason which is missed out, though. And that is accountability. Over  the years, the RBI has proven itself to be an excellent bank regulator. However, it’s conduct of monetary policy has been, well, disastrous. As a result, the RBI has always been able to hide its monetary policy failures behind regulatory successes. The crises India has avoided in 1997 and 2008 have been regulatory victories more than anything else. A pragmatic regulatory environment did not allow banks to take unseemly risks, which protected both the financial & real economy when the bubble burst. But the conduct of monetary policy when these events are underway was bumbling at best. I have written about the 2008 episode here. It is also true that there have been periods of excellence. Dr. Jalan’s tenure was one such period and by all indications, Dr. Subbarao’s tenure promises to be another. But these have been the exception rather than the rule.

As the independent conduct of monetary policy assumes greater importance, it cannot be conducted in the shadow of another activity, whether its banking regulation or government debt management.

If there ever was a time to break up the RBI, it is now.

Tuesday, July 27, 2010

The impressive Dr. Subbarao

The First Quarter Review of Monetary Policy 2010-2011, as its now called, is a landmark event. It marks a coming of age for the Governor, Dr. D. Subbarao in more ways that one. While signs of this have been apparent for some time now, with the Governor’s outspoken opposition to the establishment of a inter-regulatory dispute resolution authority by the MoF, this particular monetary policy statement is dramatic, to say the least.

At the heart of the reason why this judgment is possible is the manner in which the width of the LAF corridor has been reduced. It’s something I have been writing about for some time now like here, here, here and here. But normally, an RBI Governor would have found it suitable to just reduce the “corridor” without any specific mention of the reasons. But that would just be a lesser Governor than what Dr. Subbarao is transforming into. The following sentence left me astounded by its sheer simplicity and honesty.

“55. There is no unique way to determine the appropriate width of the policy interest rate corridor. But the guiding principles are: (i) it should be broad enough not to unduly incentivise market participants to place their surplus funds with the central bank; (ii) it should not be so broad that it gives scope for greater interest rate volatility to distort the policy signal. The challenge, therefore, is to strike the right balance.”

When one says that the corridor should not be so broad that it gives scope for greater interest rate volatility, sets up a Working Group to look into it, but reduces the width of the corridor pending the working group’s deliberations and conclusion, it can only mean that the corridor was actually perceived to be wider than desired. That it was a policy prescription which was not suitable anymore, if it ever was.

It takes a very self-assured RBI Governor to make that statement. And all indications are that unlike his predecessor, we now have one. 

Thursday, July 15, 2010

Developments since my last post

It’s been almost a week since my last post and for that i apologize to regular visitors. There have been some interesting developments since. Some good, others not so…
Firmly in the good category is the new symbol for the Indian Rupee.

Designed by D. Udaya Kumar, an alumnus of and assistant professor at IIT-Guwahati, the symbol is one all of us can be proud of. What good does it do? Well, its a “coming of age” event, one that will go a long way when we get to the point of having Capital Account Convertibility. Its my belief that the INR will be a reserve currency at some point, something that will change only if the world gives up the idea of having reserve currencies. The latter is a possibility, but since survival for the US depends on a continuation of the reserve currency system, a distant one.

In the irrelevant category, the Arms Act 1959 has been amended. There is a growing group of voters who believe that laws made by parliament should expire after 25 years. This will help each generation establish rules that suit the times. Currently, laws become irrelevant over a period of time but they can, are are, used by a corrupt police force to harass honest upright citizen. How many of us know that its necessary to obtain a license for each radio set we own? And yes, that includes the one in your car. 
The amendment to the Arms Act 1959 makes it more difficult for a person without antecedents to get a gun… legally. It took them all of 50 years to think of it… Awesome! 

In other developments, the Finance Ministry has succeeded in getting both the RBI & SEBI to knots their knickers. The June 18th ordinance issued by the government to settle the ULIP dispute supposedly includes a mechanism to govern warring regulators. The RBI has a problem with this as it would infringe on its independence, which if this article is to be believed, is not up to the mark anyway. From where I stand, in no country is the central bank more independent. The governor supposedly reports to the Ministry of Finance, but can choose to defy it if the fancy grips him. Remember YV Reddy and his famous wars with P Chidambaram? Even in the US, the Chairman of the Board of Governors of the Federal Reserve has to testify, under oath, to a bi-partisan committee of the Senate. The RBI’s position is already like that of an extra-constitutional body which isn’t accountable to the people at all. But that isn’t enough.

If the Ministry steps in to settle disputes that rage between these regulators, its a threat to these regulators. To those that have sacrificed market development and homogenization because they couldn’t see eye to eye. The ULIP controversy isn’t the only one. Debt  Market development has been on the back-burner forever because the RBI and SEBI cannot agree on who regulates what. SEBI believes that the Negotiated Dealing System, an order matching system for Government Securities, is an exchange and should come under its purview. The RBI believes it should regulate it since its a part of the Government Securities market. As a result, banks are allowed direct access to the market while mutual funds are excluded, or allowed indirect access. Petty differences like this stand on the way of even the government securities market becoming a homogeneous whole.  And we haven’t even scratched the surface with this.

In the face of this idiocy, someone has to step in. Since RBI, SEBI, IRDA & PFRDA all come under the Ministry of Finance, its only natural that it would. When children squabble, and this squabbling starts to vitiate the home environment, parents need to step in. Our regulators can either behave like adults or be treated like children. There is no other way out.

Internationally, economic policy mavens are still discussing issues discussed by Keynes & Hayek in 1932. And there is as much venom between the two sides as was then. All it tells me is that the profession hasn’t grown over the last 80 years or so. There are no new ideas, no new thoughts. Its the same old wine in the same old bottle. The funny part is, even though Keynesians believe they won the last round and central banks, which are Keynesian creations, have been conducting monetary policy along Keynesian lines over this time, reality points elsewhere. Central Banks have systematically sabotaged Keynes' proposed system to a point when it just stopped functioning (more of this in my next post). This isn’t a Keynesian failure. Its betrayal.

Sunday, July 11, 2010

Do you have the facts, Mr. Rajwade?

Mr. A.V. Rajwade is at it again. In his column, he argues that India’s exchange rate policy is braver than China’s while China’s policy is wiser. Whether a weak currency policy is wisdom or not is another matter altogether and having written about it enough, I’ll restrict this post to the facts and not opinion.

Mr. Rajwade says that India’s braver(and he doesn’t mean it as a compliment) because it allowed the exchange rate to appreciate by 6.5% in April 2007 and also when we allowed the rupee to appreciate 12% in “real terms”. The “real terms” he speaks about relies, no doubt, on REER. But leaving that aside as well, lets look at slightly long term data and not isolated instances of INR appreciation only.

In July 2008 China pegged its Yuan(CNY) to the US Dollar(INR) and ended this peg on June 21. 2010. Since India’s exchange rate was flexible through this period it would make a lot of sense to look at movement over this period and not just at intermittent movements within. On July 1 2008, the CNY traded at 6.8608 and the Indian Rupee (INR) at 43.23. On July 1 2010, they traded at 6.7810 & 46.65 respectively. Over this period of time the CNY appreciated by 1.16% whereas the INR depreciated by 7.91%.

Looking at these numbers over a longer period of time and specifically addressing the 2007 INR appreciation, on July 1 2005, the CNY traded at 8.2765 and the INR at 43.45. Given the 2010 traded rates above, over the last 5 years the CNY appreciated by 18.06% and the INR depreciated by 7.36%.

Bravery & wisdom are subjective judgments, but lets at least get the facts right.

Another rate hike, another missed opportunity

On a totally different note, when the RBI increased its Repo and Reverse Repo rates by 0.25% last Friday, it missed another opportunity to reduce what it calls the LAF “corridor”. With the Reverse Repo rate at 4.00%, a gap of 1.50% between it and the Repo rate isn’t a corridor. Its an expressway. It allows the RBI to conduct monetary policy in an underhanded manner like it did last month.

When liquidity tightened due to the 3G and Broadband spectrum payments, the overnight rate moved from the Reverse Repo rate of 3.75% to the Repo rate of 5.25% without any explicit monetary policy action or guidance.

So much for transparency…

Friday, July 2, 2010

The rise of hedonistic economics

Its been a while since my last post and its not because I’ve been busy otherwise. I’ve been working on a currency model that has the potential to resolve some of the global imbalances that exist. But like with any model, its throws up new problems and ultimately, one has to make a choice between the existing problems and new ones.

I have never seen a model or an economic school of thought that solves all problems without creating new ones. If that were possible, we would all be in economic utopia. There are times when the Libertarian model seems to work better and times when substantial benefits are to be had by following Keynes, and these aren’t the only choices available. In the end, economic decision making boils down to making a choice between immediate problems and future problems. Its the difference between being hedonistic and ascetic.

If one looks at individual decisions as well, there are obvious differences to be seen. There are consumption-oriented individuals and savings-oriented individuals. Hedonistic & ascetic respectively. A nation’s orientation is derived from its citizens and consequently, there are nations which are either hedonistic or ascetic. With the demise of communism (or at least its’ most powerful manifestations) the economic war has now changed. The war is now between Hedonists and Ascetics.

The choice between the two isn’t purely economic in nature. A nation can be capitalistic and still be ascetic, with Germany being a prime example. It is also possible to be socialistic and hedonistic, with Greece leading the charge here. The choice is cultural and affects almost all aspects of life. But it is economics where this divide becomes the most apparent and Gross National Savings is an indicator one can look at to determine this.

As things stand, Greece has the lowest Gross National Savings (GNS) rate in the world. It is followed by Portugal, the US and the UK amongst others.  Data for Greece and Portugal isn’t easily available, but estimated savings for 2010 are 6% and 7.5% of GDP respectively. For the 10 year period 2000-2009, average GNS rate for the world has been close to 22.50%,, the US & UK have managed an average of just over 14.75%. The difference of close to 7.75% grew to over 9.50% in the case of the US and 8.9% for the UK over the last five years. These nations can very easily be classified as the most hedonistic in the world.

Looking at the Euro Area in general, the average GNS rate over the last 10 years has been close to 21.25%, lower than the global average by just over 1.25%. For Germany these numbers are 22% and 0.50% respectively. The Euro Area (with the exception of Greece & Portugal) along with Canada  are ascetic in absolute terms, but on the margin in relative terms.

Turning to the  Middle East, Asia and the Commonwealth of Independent States. Savings rates in these regions has always been higher than the global mean, averaging 35.50%, 31.85% & 28.90% respectively. These regions can be easily classified as ascetic, both in absolute and relative terms.

Net National Savings reinforce this point with Greece, Portugal and the US all in negative territory. The UK is marginally positive, but the recent budget with it’s much vaunted austerity measures may be the first step towards correcting this. Almost every other country in the world saves a portion of its Gross National Income for the future. Time series data for Net National Savings isn’t easily available as well for all nations, but occasional data indicates the above equally clearly.

All of us are born hedonists. As babies and children, we tend not to think about the future impact of our need for instant gratification. As we grow, we begin to worry about the future impact of our decisions and this is reflected in our actions, words and overall approach to life. Juxtaposing this to the global stage, it would be fair to conclude that today’s hedonistic nations are the children of the world. Like any child, they want their problems to go away now, regardless of whether this hurts their future. And now these children want the adults to follow their way of life. And are going to great lengths to ensure this.

The battleground for the recent war of words between New Keynesians like Paul Krugman, Mark Thoma, Martin Wolf etc) and “Austerians” (almost everyone else) seems to be continuation of the fiscal stimulus undertaken by most nations to tackle the recent crisis. But scratch the surface and one can clearly see that the war is, in effect, between Hedonists and Ascetics. New Keynesian economists believe that the only way out of the current mess the US finds itself in (unemployment @ 10%+) is to continue spending money the government doesn’t have in the hope that it’ll create enough jobs and pay for itself going forward. The fact that this kind of profligacy added to the intensity of the recent crisis is but a matter of detail. And the possibility that this may result in a bigger mess is something that they will face in the future. The battle cry is to make things better now, no matter how it hurts the future.

Much like a parent giving in to a child’s tantrums, the actions of global leaders are being guided by this noise. And as is normal, the adults will pay for this as well.

A version of this post appeared on my Business Standard Blog on July 1, 2010