Category Archives: economics

Raghuram Rajan replies to my Pragati article

At least I like to believe that! A couple of weeks back I’d published this article in Pragati (published by the Takshashila Institution, where I work part time as Resident Quant) slamming recent decisions by the Reserve Bank of India to make two factor authentication compulsory and to limit the number of free ATM withdrawals from non-home banks.

My criticism for both these decisions was that they were designed to take money out of the banking system, which would result in a reduction of money supply, and subsequent increase in borrowing costs, thus slowing down India’s economic recovery. I had some other criticisms, too, such as it being none of the RBI’s business to mandate what was essentially a pricing decision between the RBI and the customer, and the perverse incentives the rule created for banks seeking to set up new ATMs.

Could it be that the above regulations are a move by the RBI to curtail money supply without necessarily doing the politically tricky task of raising interest rates?

If it is (and it is a very remote possibility), we should commend the RBI for what will then amount to be a sneaky decision. If not, it must be mentioned that though noble in thought, the two decisions are completely bereft of economic and financial reasoning.

I had written.

So an article published an hour back in Mint quotes Rajan on these two policies, where he defends them. On the two factor authentication issue, he is surprisingly defensive, offering nothing more than a statement that banks and companies need to follow the rules and not try to circumvent them in the name of innovation. Rajan then added that he is looking into permitting transactions up to  a certain limit that don’t need two factor authentication – something I had pointed out in my Pragati piece.

On the ATM issue, I (and other news organisations who I got my news from) seem to have got my information wrong. Apparently currently regulation exists that five ATM transactions per month from non-home banks are supposed to be free, and that is being cut down to three. Rajan clarifies (as reported in Mint today) that the new regulation only allows banks to charge customers beyond the first three transactions in a month, and they are not obliged to do so. He talked about the perverse incentives that the earlier regime (where banks were obliged to permit a number of free ATM transactions from non home banks) created.

My apologies for not reading the regulations correctly (of course a part of the blame has to go to the newspapers that reported it thus! :) ). I admit I should have checked from multiple sources on that one.

Coming to the point of the post, why do I think that Rajan is responding to my Pragati piece? You might argue that it might simply be a case of correlation-causation – that it might be coincidental that Rajan has spoken about two issues that I had highlighted in that post. However, there are two reasons as to why I believe that Rajan was responding to my post.

The first has to do with the combination of subjects. While the two regulations (ATM withdrawals and two factor authentication ) were widely reported in the media, I haven’t seen any piece apart from mine which addresses these two issues together (I must admit my perusal of Indian media has dropped nowadays given my Twitter and Facebook sabbatical). Given that Rajan has chosen to address these two issues today, it is likely that he is responding to my piece.

The second reason has to do with the timing. The Takshashila Institution sends out a weekly “dispatch” which is a summary of commentary written by its fellows and employees and associates. This is an emailer which contains links to these articles along with short snippets, and a number of fairly influential people (within the government and outside) are on the list of recipients. The latest edition of the Takshashila dispatch went out this morning, and it has a link to my Pragati piece. Now, while Rajan is not on the mailing list (to the best of my knowledge), it is likely that an influencer on the list with access to him brought it up today (it could even be the Mint journalist who has reported the story – that would still count as Rajan, albeit indirectly, responding to my piece). This reaffirms my belief that he was responding to my piece in his comments today!

You might think I’m deluded. So be it!

A culture of thinking and differentiated services

In a very interesting Op-Ed in Mint this morning, Anurag Behar argues against vocational training at the school level, arguing that the purpose of school education is to enable children to think, and that the ability to think is paramount in offering superior services.

He gives the example of a welder who understands basic geometry and the mechanics of metals, saying such a welder can offer superior services to one who has just been trained in welding. Thus, a welder who had been through school and thus understands the basics of geometry and mechanics can do a much better job as a welder than one that has just learnt how to weld.

Now, while this culture of thinking is important, another important pre-requisite is the culture of differentiated services. The question we need to ask is if the market here is mature enough to pay a premium for the welder who knows geometry and mechanics compared to an illiterate welder.

Intuitively it makes sense – an educated welder is likely to be more careful in his work and is likely to offer much superior quality. However, what I’m not so sure of is that the market in India is currently mature enough to recognize this increase in quality and thus pay a premium for such services. And unless the market matures to pay a premium for an educated welder, an educated person will choose a career other than being a welder and we will be only left with uneducated welders offering poor quality.

Derivatives trading in football players

I love it! It’s a dream come true!! It’s official!!!

Football clubs have finally wisened up to trading in derivatives on players’ contracts, it is apparent based on the transfer deadline news of yesterday. Alvaro Negredo has been loaned out by Manchester City to Valencia, but at the end of the year Valencia have an obligation to make the deal permanent. The same article mentions Fiorentina taking Micah Richards on loan, also from Manchester City. In this case, however, Fiorentina has the option to make the deal permanent after a year.

In fact, thinking about it, this kind of option trading in football contracts is not all that new. When Brendan Rodgers was initially appointed by Liverpool in 2012, he was given a three year deal, with the club having an option of extending it by a year (the deal has since been revised).

It’s all very interesting. I’ve constantly lamented that some of the great concepts in finance which are well applicable to everyday life are not applied to the extent that is required. Option valuation is one such concept, for example. I wrote to a friend just now asking why I should join a club he is exhorting me to join, given it’s not doing much now. His reply can be condensed to “option value”.

Option valuation is not the only thing. There is the concept of liquidity. A very commonly used concept within financial markets, it is surprisingly absent in general economic literature. For example, in finance it is a well understood concept that the more the number of active market participants the less is the transaction cost (measured as the bid-ask spread). The same concept can be used to analyze markets for taxis, housing, cooks (why a cook costs much more in Rajajinagar where demand is much lower than in Jayanagar), etc. You never see too many economists talking about it, though.

The problem might be that practitioners of financial economics concepts find finance too lucrative to apply their concepts elsewhere, while mainstream or left-leaning economists might find finance (especially complex derivative finance) abhorrent, and thus are loathe to borrow concepts from that (generally speculating)!

In terms of liquidity, though, things seem to be changing. My old friend Sangeet has been practically making a living over the last couple of years evangelizing the concept of liquidity, through his excellent blog on platform economics. Check out his recent post on Uber, for example. Platform economics is nothing but the economics of liquidity. The success of Sangeet’s blog shows that people are finally beginning to take the concept seriously. Still not mainstream economists, though!

In which I thulp the RBI

I’m still so pissed off with the Reserve Bank of India doing a Ramanamurthy that I’ve written a serious editorial in Pragati – the Indian National Interest Review (published by the Takshashila Institution). In this piece I take on measures by the RBI to limit ATM transactions and the thing on two factor authorization.

I claim that both these decisions are economically unsound and there is only possibly a farcical explanation for them:

There is perhaps only one idea (more a conspiracy theory) that possibly explains the above decisions from the RBI. Both these decisions, it might be noticed, help push up the usage of hard currency and decrease the levels of bank deposits. Less bank deposits means less money available for banks to lend out, which means that the cost of borrowing from a bank implicitly goes up. Could it be that the above regulations are a move by the RBI to curtail money supply without necessarily doing the politically tricky task of raising interest rates?

If it is (and it is a very remote possibility), we should commend the RBI for what will then amount to be a sneaky decision

Link

Market forces

This morning I refused to board an auto rickshaw since it had one of those old analogue metres. Most autos in Bangalore nowadays use digital metres, which is the regulation. Except a few like the one I saw in the morning.

Now, given that most autos have digital metres people have a choice to choose only such autos. I’m sure the driver I met this morning will realise soon enough that he’s not getting as much business as he can due to his old metre, and make the switch.

It’s similar with usage of metres. In some parts of Bangalore it’s the norm for auto rickshaws to ply by metre. In such areas any driver who tries to make a quick buck by negotiating a higher fare is likely to lose customers. When a customer knows that after letting go of an auto which asked for excess fare, he had a good chance of finding one that will go by the regulated fare, he is less likely to heed to the demand for excess fare.

You can think of this being a case of what Malcolm gladwell calls the tipping point – once markets have tipped to one side (let’s say using regulated fares for auto rides) there is positive reinforcement that leads to an overwhelming move in that direction.

To get back to the metre example, when the fares increased a few months back traffic cops in Bangalore ran a drive where they checked for auto metres and fined those who had not made the switch by a particular date. Maybe that’s led to about 95% of the metres getting recalibrated. The beauty here is that market forces will take care of pushing this 95% to 100% and cops need not spend any more time and energy on enforcing this! Similarly if cops want to enforce usage of regulated  fares they would waste time by doing this drive in areas where most rides are by metre – the focus should be on tipping the other areas over!

To summarise, some parts of regulation gets enforced by sheer market forces, and regulators should not be wasting their energies there. Focus should instead be given to those areas where market failure is extreme – for that is where regulation has a role to play.

Why Keynes’s prediction has not come true

Writing in the 1930s economist John Maynard Keynes predicted at at the “time of our grandchildren” (figurative term since he himself had no kids) people would live a life of leisure and work for an average of fifteen hours a week. Yet, it’s been eighty years since and we still slog away, putting in anywhere between forty and sixty hours a week as we earn our living. And it doesn’t look like things are going to change soon

So why did this happen? I propose two reasons. When I quit my first job almost eight years ago within three months of joining I complained that the workload was way too high. I added that I didn’t need all the money that job paid me and wouldn’t mind taking up something that paid half the money and where I had to work only half the time. No such thing materialized and I slogged away, before going freelance two years back.

Now why does this little anecdote matter? I’m using this to show that the returns to work are not linear. If you were to plot the number of hours worked per week on the x axis and the total value added on the y axis you are likely to get a convex function. In other words the marginal benefit out of every additional hour you work per week is an increasing function of how much you’ve already worked.

The question is why this is so. One simple answer is that in jobs with a high degree of learning by working longer you end up learning faster. Then within the job you can have network effects where the work you do in one part of the job can help you do another part better (I constantly see this in my freelancing where I work on several projects at a time). If there is a steep learning curve it is easier for the firm to appoint one worker to work sixty hours a week than two to work thirty each – since the starting costs get saved. And so forth.

So this increasing returns to effort (in terms of the hours worked) is that the trade off between work and leisure gets resolved in favour of leisure only at a very high level of work – where you are working close to capacity and don’t want to risk burnout and want to maintain your sanity. Before that the increasing returns to effort means that you are likely to put off leisure in favour of “just a little more work”.

The question is if all jobs work this way, and why an economist as brilliant as Keynes didn’t see this concept of increasing returns to work. The answer is that increasing returns to work applies only to a certain kind of jobs – jobs that require a high level of skill and learning and which can be broadly classified as “knowledge jobs”.

Back in Keynes’s time such knowledge jobs were few – far fewer than they are today. Most workers were in jobs that didn’t require a high degree of skill or learning. In unskilled jobs or jobs that are physically demanding the expanding returns to effort part of the curve is extremely short. Once you have figured out the best way to bolt together two metal pieces doing more of this job is not going to make you much faster in bolting together two metal pieces.

Instead since it is physical after you’ve put in a certain number of hours in a day you begun to tire and become less efficient (notice this point occurs at a later stage for knowledge jobs). And the returns to hours curve starts flattening out much sooner. If you were to do the trade off with leisure using such a curve the equilibrium might occur much earlier than for knowledge work – perhaps at Keynes’s predicted value of fifteen hours per week.

Now even today while the proportion of non knowledge jobs is smaller than eighty years back the number of people doing such jobs is not small. So if the work-leisure equilibrium happens at fifteen hours a week why do people work longer?

The answer is that work-leisure is not the only equilibrium one is solving for. You also need to work enough to be able it fund your living. And it has happened that fifteen hours of non knowledge work pays nowhere close tO what is required to fund a reasonable living. For this reason non knowledge workers are forced to work much longer than their work-leisure equilibrium rule permits!

So why didn’t Keynes see this? I think what he missed was the boom in the knowledge economy in the postwar period. With the rise in the knowledge economy what you had was a set if jobs that had increasing returns to effort. Moreover these returns, on an hourly basis, were far larger than the returns on a non knowledge job. The boom in the knowledge economy meant that people working in such jobs impacted general prices and this forced the non knowledge workers to work longer!

So we have the unique situation now that those people who can afford to work for only fifteen hours a week have no incentive to do so. On the other hand people who have an incentive to work no more than fifteen hours a week are forced to work longer because otherwise they cannot find their lives!!

Landmark mismanagement

Yesterday’s Landmark Quiz in Bangalore was a major waste of time. No, I’m not talking about the quality the quiz here – the prelims was among the better Landmark Quiz prelims I’ve sat through, and given that we just missed out on qualification for the finals (AJMd, as we say here in Bangalore) I didn’t sit through the finals though I was told the questions there too were pretty good.

I’m talking about the transaction costs of attending the quiz. The overall management of the event left much to be desired. First of all, we had to show up at the venue at 11:45 for a quiz that was supposed to start at 1:45 pm. Teams with confirmed seats were let in at around 12:30 and only around 1 o’clock were us “waitlisted” teams let in. There too, the organizers did a major show of letting in waitlisted teams, calling them in order and taking over half an hour to let everyone in.

The point is that even after all the waitlisted teams had been let in, there was plenty of room in the auditorium. This makes me wonder about the wisdom of waitlisting so many teams, and then making such a big show of letting people in. Given that the total turnout was much smaller than the hall capacity, things would have been much simpler if people had been simply left in, with volunteers only ensuring that the seating was efficient (without leaving gaps).

Before the quiz yesterday i started writing a blog post on how the quiz registration process was itself flawed, and gave incentive to people to register zombie teams because the option of registering a team came free. So while the hall had been theoretically filled up many days ago, most of these registrations were zombie registrations thus leading to a long wait list and thus calling people early. Given that the quiz doesn’t have an entry fee, I can’t currently think of a good way to price this option.

But reaching the venue early was not the only waste of time. The written prelims of the quiz finished around 3 pm, including calling out the correct answers. The results, however, weren’t announced till close to 6 o’clock. In the interim time period there was the finals for school students, but that still doesn’t explain why they had to wait until 6 o’clock to announce the results of the senior quiz.

The way I see it, it was sheer disrespect on the part of the organizers of the time of the participants. Yes, Landmark might be a much sought after quiz, rated among the best in the country. Yes, most people come there for the questions and not just to win – and so stay on to watch the finals even when they haven’t qualified (it is indeed commendable that Landmark quizzes have managed to be great spectator events while not dropping quality). Yes, many participants have traveled from other cities and so having traveled the cost of their time might be “cheap” – in that they have little else to do in the rest of the day.

Even taking into account all these, the wastage of 5 hours of each quizzer’s time (2 hours for early reporting; 3 hours gap between prelims and results announcement; 4 if you consider that watching the Junior finals wasn’t a waste of time) is not a done thing. Given the quiz’s unparalleled reputation it is unlikely that market forces are going to tell the organizers that they are wasting people’s time, but the message has to go through.

The Economics of Forts

I had first planned to write this post back in February 2012, when I visited the magnificent Kumbalgarh Fort in Southern Rajasthan (this was part of my bike ride around that state). However, I didn’t have a typing device handy, so I postponed the post, and it got postponed indefinitely until I visited the equally magnificent Chitradurga Fort in Karnataka recently.

The fort in Chitradurga is famous possibly because of the early 1970s Vishnuvardhan movie Naagarahaavu (cobra) which is set in that city. A lot of the action in the movie takes place in and around the fort, and there is a famous song which is picturized in the fort. The song goes back in history, too, to the battle between Nawab Hyder Ali of Mysore and Madakari Nayaka of Chitradurga back in the 1770s, when after multiple attempts Hyder Ali finally managed to capture the fort. The heroine of the song is one “Onake Obavva” who slays a number of Hyder Ali’s soldiers entering the fort through a small gap in the rocks using her pestle, until she is attacked from behind and killed.

The fort at Chitradurga is popularly known as the “yELu suttina kOTe” or “seven layered fort”. This is not entirely correct. The fort has seven “layers” of walls only on the front side. At  the back, where it is bordered by another hill, there are only two layers of walls. However, the terrain meant that the back was not easily approachable for invaders so most invasions happened through the front. In that sense, the name wasn’t so wrong.

I could write this post about the design of the fort itself (and there is a lot to talk about it -from the rain water harvesting to feed the moats, to the L-shaped design of the gates to the attention to detail in the positions of the soldiers and guards, and arrangements for their camps, and so forth). However, I would prefer here to talk about the economics of building the fort.

The Nayakas of Chitradurga initially started off as a vassal state to Vijayanagara. When Vijayanagara fell in 1565 following defeat at the Battle of Talikota, Chitradurga and the Nayakas became independent. The Nayakas ruled for over 200 years until they were defeated by Hyder Ali in the 1770s. During that period they built this magnificent fort. The question that arises, however, is about how they were able to finance it.

Building a fort with seven layers is no joke. Stones had to be quarried, cut and raised to build each wall. Considerable engineering and architectural acumen also went into the design of the fort itself. It apparently took several generations for the fort to get completed. Considering that there was little economic activity in and around Chitradurga those days apart from agriculture, one can only suppose that the state that built the fort was extractive.

On a visit to Bikaner last February, someone pointed out to me about the quality of the craftsmanship that went into creating the stone carvings in the palace there. “You will never get such quality nowadays”, this person surmised. I agreed with him, and my reasoning was that nobody is willing to pay for such intricacies nowadays. It is only in an extractive state where the taxpayer has no control over the state’s finances that a ruler can spend thus to beautify his own residence rather than spending on the development of the state itself. Where there is a “large coalition” whose support the ruler draws to stay in power, he is forced to invest in projects that benefit this large coalition at the expense of those that just benefit himself.

Wandering through the Chitradurga Fort on Sunday, I thought the expenses on developing the fort could be justified as simply a “large defence budget”. However, the problem with this hypothesis is that a fort doesn’t really provide ‘national security’. What a fort instead does is to make the capital city strong and defensible, but this comes at the cost of securing the borders. People outside the fort are perfectly susceptible to plunder and pillage by the invading party. All the fort does is to protect the capital and the treasury, and thus the king.

The next time you see a magnificent palace or a fort, think of the economic conditions in the state that built it. Think of how the structure might have been financed, and if so much could be spent on a structure such as this what the total size of the royal budget might have been. Then imagine what the tax rates might have been if the royal family managed that large a budget, especially when the kingdom in question was a rather small one like the ones at Chitradurga or Kumbalgarh. Then decide if you would have wanted to live and do business in that age.

After two hundred years of solid resistance, the Chitradurga Fort finally fell to Hyder Ali, in the old fashioned way. Hyder Ali simply bribed some of Madakari Nayaka’s officers, and got them to switch sides. A path through the back that was normally used to supply milk and curd to the fort was discovered, and with the complicity of some of Madakari Nayaka’s officers, Hyder Ali invaded through this route. And the fort fell.

Radhakrishna, the tourist guide who showed us around the fort on Sunday put it best. “Of what use is two walls or seven walls”, he said, “if you can’t exercise control over your own officers?”

 

Gold: Currency or Commodity?

In today’s Hindu Business Line, S Gurumurthy of the Swadeshi Jagran Manch has an insightful article on the Indian affinity for gold. In this, he talks about gold being the preferred form of savings among the poor and mentions that the preferred form of financing for poor and/or rural households is the “gold loan” (loan issued keeping gold as collateral), often arranged by an informal moneylender. He argues that attempts to regulate gold imports are futile and what instead needs to be done is formalization and regulation of the gold loan industry.

The question one needs to answer when trying to regulate gold is whether it is a currency or a commodity. Or, to “segment along another axis”, whether it is a “conventional asset” or “financial asset”. The thing with “conventional assets” (as opposed to financial assets) is that demand decreases as price increases (most goods and services fall under this category). “Financial assets” on the other hand see the reverse relation – price increases are usually followed by an increase in demand.

Conventional wisdom which governs gold regulation in India (and elsewhere) is that it is a commodity, and a conventional asset. Gurumurthy’s argument is that it should rather be treated as a currency or a financial asset.

The concept of gold being a currency is not new. In fact, if you look at the way currencies were traditionally traded (by the “gold standard”) gold was a de facto currency. The gold standard can be described as gold being the only convertible currency, which could be converted to any national currency at a fixed rate. In the era of the gold standard, it can be argued that all international transactions were effectively priced in gold, and only notionally paid for by means of a national currency.

Despite this background of gold being a currency, however, in India it is regulated as a commodity. Take for example, the customs duty on gold. Drawing an analogy, think of what would happen if a “15% customs duty” were imposed on US Dollars. In other words, every time I converted my US dollars into Indian Rupees, I would have to pay 15% of the value of the transaction to the government as “customs duty”. You might say that is absurd. However, that is exactly what is happening with the customs duty on gold, with the result that gold has started being imported via illegal channels.

The problem with gold is that world over it now behaves like a commodity (after the abolition of the gold standard). In India, however, it behaves more like a currency. Because it internationally behaves like a commodity, standard modern economics treats it as one, and the Indian regulations also treat it such. However, given that gold is (I agree with Gurumurthy) more of a currency than a commodity in India, none of these regulations have worked.

It is time regulators started thinking of gold as a currency and financial asset.

 

Cartels, good and bad

This post is about two professional cartels in India, and why one is better than the other. The “better” cartel is the Institute of Chartered Accountants of India (ICAI). The “worse” is the Medical Council of India (MCI). As the names suggest, they regulate the profession of chartered accountants and doctors respectively. And the way the former works is better than the latter.

First of all, let me convince you that these two are cartels. The basic concept is that in order to practice as a Chartered Accountant in India, you need certification from the ICAI. And who does the ICAI consist of? Other CAs. So it is nothing but a trade guild, which tries to control who gets to join the guild. It is a similar case with the MCI and doctors. Doctors trying to control who else can be doctors. As the more perceptive of you might have figured out, it is in the interest of both these guilds to not admit too many new members, since that would lead to supply of their profession to a level that significantly affects profit margins for the incumbents.

Now that we have established why these two are cartels, and that they both have an interest in restricting membership, let us see how they go about the process.

The ICAI follows what can be described as “exit level testing”. There are no restrictions on anyone wanting to be a CA – all you need is a high school (12th standard) degree with mathematics as one of your subjects. They have three levels of examination – “basic”, “intermediate” and “final”, and one needs to clear all of these in order to become a member of the guild. And how does the guild control membership? By making these examinations super-tough, so that only a select few pass these exams every year. There are several “CA institutes” who train students for these examinations. And there is no restriction (AFAIK) on anyone opening one such institute.

The MCI does it differently. Anyone with a recognized degree in medicine is automatically a member of the MCI. They regulate the numbers instead by controlling the number of medical colleges, so that only a select few can even aspire to get into the MCI. More importantly, the entry to medical colleges is not strictly on “merit” – colleges are free to allocate a certain portion of the seats on discretion, and they do so based on recommendations, donations, etc. I’m not really saying any of this is wrong. Just describing the situation as it is. However, when you combine this with the fact that an entry into a medical college guarantees membership of the MCI (provided you pass your college exams, which shouldn’t be too hard), it effectively means that you can buy your way into the MCI.

Actually, thinking about it, this option of creating additional membership of the MCI “upon payment” is a masterstroke by that guild. The concept is that when people pay large sums of money to gain entry, they are not going to be in a hurry to look to slash profit margins (key here is the fact that the amount of work a doctor can do is constrained by his/her time, so doctors cannot play  the “volume game”). So the pricing of these seats ensure additional revenue for the MCI and their constituent colleges, while not compromising on the members’ margins.

Note, however, that it is not possible to buy your way into the ICAI. Yes, aspiring members who seeks to buy their way in might buy “training” and “apprenticeship” under the best CAs who are members of the cartel, but still, to get a membership they need to pass the examination, which is not easy at all. Contrast this with the MCI where either money or the right connections get you straight in.

I’m not saying that the ICAI is a wonderful guild. Cases such as the Price Waterhouse – Satyam case or the Deloitte-FTIL case have shown that the profession is deeply flawed, and doesn’t regulate itself adequately. All I’m saying that the entry criteria it uses, as opposed to the one used by the MCI, ensures a higher quality in terms of the ability of its members.

As for me, I’m happy that I’m involved in a profession (or professions) that don’t need any certification or guild membership.