Problem with variable pay

Slowdown in profit growth and decline in stock prices might lead to growing employee dissatisfaction under variable pay plans in the quarters ahead

Cafe Economics | Niranjan Rajadhyaksha

It has been estimated that about one-third to half of all American workers have part of their earnings tied to the overall performance of the firms that employ them, through profit sharing, direct ownership or stock options.

This particular tide is rising in India as well. In a recent survey of 540 locally owned, foreign-owned and joint venture companies conducted by consulting firm Hewitt Associates, 95% of the respondents said they had variable pay plans in 2007. The use of stock options, too, is growing, with most large companies listed on the stock exchange giving their employees the option to buy shares at a later date and at a predetermined price.

Tying an individual’s performance to the overall performance of a company seems a good idea. The interests of shareholders and employees are aligned. You really care whether the company prospers or goes down the tube. Some economists have shown that both employee productivity and company growth are higher when employees have a stake in the growth of the firm that employs them. There is some form of incentive compatibility.

But there are several problems as well, though they will tend to remain under the surface when profits are growing rapidly and stock prices are soaring. But I suspect that the coming slowdown in profit growth (which will hurt variable payments to employees) and the decline in stock prices (which will send stock options below their strike price, or under water) will lead to growing employee dissatisfaction in the quarters ahead.

Are company human resource departments ready for this?

There has been a lot of research by economists in recent years about the system of paying workers — either directly through variable pay or indirectly through stock ownership — based on company performance rather than the market price of labour. There is even a name for these arrangements: shared capitalism.

The first big problem in shared capitalism is what is called the free rider problem. Say you are one of the hundreds of employees who will get paid a large chunk of their salary in the form of variable pay. Individually, you have little direct impact on the overall performance of the company: You are a cog in the wheel. There is, thus, an incentive to take it easy in office; you hope the other cogs will work hard enough to help the company meet its goal. You are what economists call a free rider.

This would be less of a problem when the economy is booming. Companies find it relatively easy to meet their sales and profit targets, and so everybody walks away with an impressive stash of money. Free riders are less likely to be abhorred. But the mood could change in a downturn. The ant may ask why the grasshopper is getting the same variable pay deal as it is. There could be tensions in cubicle land.

The other problem is more personal. You have already bet your human capital on one company. Shared capitalism ensures that you are also betting large parts of your financial capital on the same company. It’s a poor diversification of risks—too many eggs have been placed in this one basket.

In a new paper published this month by the National Bureau of Economic Research, an American research outfit, three economists have examined issues of risk and the lack of diversification in shared capitalism. “Since shared capitalism, especially in the form of employee stock ownership and stock options, is an investment, we need to examine it from the critical perspective of risk,” write Joseph R. Blasi of Rutgers University, Douglas L. Kruse of Rutgets University and Harry M. Markowitz of the Rady School of Management in California. (Markowitz is a pioneer of the modern theory of portfolio choice, for which he won the Nobel Prize in economics in 1990.)

They ask whether risk is really “the Achilles heel of employee ownership”. There is little doubt that employees with stock ownership or options have put too much risk in one basket. But Blasi, Kruse and Markowitz show that a lot also depends on each individual’s view of risk and the culture of the companies they work in.

For example, risk-averse employees are less likely to respond to the incentives provided by stock options. Employees who feel they are underpaid are more likely to look at the payments from ownership as wage substitutes rather than added incentives.

And a lot also depends on workplace culture. “In the absence of empowerment, shared capitalism may easily be seen as nothing more than increased income risk, whereas empowerment creates a greater sense that one can affect workplace performance and rewards under shared capitalism.”

In other words: The success or failure of variable pay and stock option schemes depends on the context, both personal and organizational. This is something that Indian companies, too, will have to understand if the current headwinds continue to blow them off their path.

Your comments at welcome at cafeeconomics@livemint.com

Disclaimer :- The copyright for the articles published here lies with HT Media Ltd. The blogs are owned and maintained bylivemint.com. You may not copy, reproduce, republish, download, post, broadcast, transmit, make available to the public, or otherwise use livemint.com content in any way except for your own personal, non-commercial use. You also agree not to adapt, alter or create a derivative work from this content without prior written permission of HT Media Ltd. You are however, free to link to this page.

A new portfolio strategy

A sustained rise in the rupee could lead to a change in the way corporate profits are distributed in the country

Cafe Economics | Niranjan Rajadhyaksha

Infosys Technologies will announce its latest quarterly results on Thursday. Its senior managers will also tell us how they expect the company to perform in the coming quarters. The big question they will have to face from journalists and analysts: how will revenues and profits be affected by the relentless rise of the rupee?

The dilemmas faced by Infosys are not unique. It is well known that a host of export industries have been struggling to come to terms with the appreciation of the rupee this year.

A sustained rise in the rupee could lead to a change in the way corporate profits are distributed. And the economics underlying this shift could also give investors useful clues about how to structure their portfolios.

Usually, a strong currency brings down the cost of imports. I recently decided to buy annual subscriptions to two of my favourite foreign magazines, partly because they are now cheaper by more than 10%. Forget magazines. Everything, from crude oil to toothpastes, that lands at Indian ports will be cheaper than before in rupee terms.

Cheaper imports will put downward pressure on local variants. Companies will have to cut their listed prices to compete with imports that suddenly boast of lower prices.

Economists talk about the law of one price—or the fact that prices of goods tend to equalize across national borders. But not everything we buy is hostage to the law of one price. It is hardly likely that the cost of a haircut or a doctor’s consulting fee will drop because of a rise in the rupee’s value against the dollar. These are services that are not traded across national borders.

High transport and transactions costs make the markets for these non-tradable services resolutely domestic. You are hardly likely to catch a flight to New York to get a pedicure because it now costs you less in rupees.

What this means is that the price of tradables will drop but the price of non-tradables will remain steady (or rise) in a country with an appreciating currency. Cheaper iPods, but more pricey music concerts.

This is an axiomatic statement. A nation’s real exchange rate is the ratio of the price of non-tradables to the price of tradables. A drop in the latter is bound to push up the real exchange rate. That could be happening in India, though I have not seen any recent research on how the relative price of non-tradables could be going up.

What should investors make of this? Price pressures in toothpastes and rising prices on hospital fees could mean that profits of companies which make non-tradable goods and services have a better chance of surviving a strong rupee. (Of course, the best companies making stuff that can easily be traded can also deal with the rising rupee by being more productive, innovative and quality-conscious.)

China is already seeing a profit shift from tradables to non-tradables. In a new research report, Goldman Sachs analysts Hong Liang, Yu Song and Eva Yi say this about the appreciation of the Chinese yuan (CNY): “As the CNY appreciates, the prices of upstream products (or tradable goods) tend to decline relatively to the prices of downstream products (or non-tradable goods). In addition, more interestingly, such a shift in relative performance seems to also have taken place in the share of profit distribution between upstream versus downstream industries.”

I would not be surprised if something similar is happening in India as well. If you slice stock market returns over the past few quarters, you’ll see that investors have dumped companies dealing in tradable goods and services.

This is perhaps why automobile, pharmaceuticals, consumer goods and software companies have been relative underperformers.

And now take a look at the stars —retailing, banking, telecom and power, for example. These cannot be easily imported. Hence companies in these sectors are relatively less sensitive to a strong rupee. They are not passive price takers. Investors seem to have figured out how relative prices and profits have shifted (and will perhaps continue to shift) as the rupee strengthens.

If this trend continues—it may not —then it is only a matter of time before the grumbling about India’s de-industrialization becomes audible. Countries with strong currencies have usually seen their manufacturing companies under stress, especially those churning out low-value stuff.

The US went through this phase in the 1980s. So did Japan in the 1990s.

Indian companies, with low wages and low productivity, still have immense scope to control costs and remain competitive despite a strong rupee. But that fact alone will not be enough to silence the inevitable grumbling about how India is losing industrial strength when it should be building it.

One can almost see protectionists emerging out of the woodwork.

Your comments are welcome at cafeeconomics@livemint.com

Disclaimer :- The copyright for the articles published here lies with HT Media Ltd. The blogs are owned and maintained bylivemint.com. You may not copy, reproduce, republish, download, post, broadcast, transmit, make available to the public, or otherwise use livemint.com content in any way except for your own personal, non-commercial use. You also agree not to adapt, alter or create a derivative work from this content without prior written permission of HT Media Ltd. You are however, free to link to this page.

A band and its business

Radiohead’s experiment also tells us a lot about how trust is the bedrock of the modern market economy

Cafe Economics | Niranjan Rajadhyaksha

Rock music has no place in this column. The proprietor of Café Economics has quaint tastes in music, and is more comfortable listening to Talat Mahmood rather than the Rolling Stones. But this article is an exception to the rule. A rock band named Radiohead has stirred my interest, and of several other economic commentators, because of a daring move. The band has put its new album up on its website, from where fans can download at whatever price they choose.

That’s right: There is no fixed price for the music.

Similar experiments have been tried before, but perhaps never on this scale. Zodiac Grill, the upscale restaurant in Mumbai’s Taj Mahal hotel, did not have a price list at one point of time. Patrons paid what they thought the food was worth. I am told that net revenues did not suffer, since many overpaid.

And then there is the famous experiment recounted in Freakonomics, the wildly popular book by Stephen Dubner and Steven Levitt. Paul Feldman, an economist-turned-bagel delivery entrepreneur in Washington, DC, decided to leave his cash box in the offices where he delivered his bagels. That saved him time. He did not have to wait till his customers paid him and could, hence serve more companies.

There was a note on the cash box that asked customers to leave what they owed Feldman. You would think that he would end up with nothing, as cheapskates (or rational consumers —take your pick) helped themselves to a free bagel. That did not happen. Payments tended to average around 90 cents a bagel, enough to make it a profitable business.

A restaurant in Mumbai, a bagel man in Washington, DC and a rock band in London. Each has tried to shift the power to fix prices to the consumer, assuming that the price will not be zero. Each of them works on an honour system. The seller appeals to the buyer’s sense of honour to pay what he believes to be the true price of a good or service. The rock band’s experiment also tells us a lot about how trust is the bedrock of the modern market economy.

Not every use of the honour system is based on a payment. When you walk out of an international airport, you are allowed to choose whether to walk out of the green or red channel. There are random checks to discourage those who misuse the system, of course. But any such arrangement will not work unless the vast majority of users respect the honour system and do not abuse it.

Coming back to Radiohead. It is too early to say whether its gamble has really paid off. Downloads started on 10 October, so it’ll be many months before the big numbers can be totted up. But one can try to figure out what the rockers are up to. The ease with which music can be downloaded online, often for free, means that the traditional business model in the music industry is cracking. Musicians will no longer depend on CD sales for most of their income.

It is likely that most of the money earned by musicians will come from live concerts and merchandising. To charge premiums on these, it would be useful to have your music playing in as many homes and bars as possible so that your brand has instant recall. Flexible-price downloads help build up a large network of listeners. The larger the network you build, the larger your future income.

Radiohead’s move looks like a stroke of genius.

The new pricing model also throws some light on the nature of value and prices. Ever since the 1870s, most economists have accepted the fact that value is subjective. Each of us has a different sense of how much something is really worth. Some may believe a new Himesh Reshammiya CD is worth Rs5 while there could be others who are willing to put Rs500 on the counter to buy his nasal hits.

No amount of computer modelling and quantitative gimmicks can match the complexity and information-processing prowess of the market.

Radiohead’s great gamble may not work after all. Horror-story writer Stephen King tried something similar a couple of years ago. He started serializing a new book online, chapter-by-chapter. Readers could get the chapters for free, or pay King whatever they wanted to.

The experiment fizzled out. Actually, King had structured the deal in an interesting manner. A reader was downloading a chapter, reading it and then downloading the next chapter. So, the reader had an incentive to pay up. Reading half a novel is no fun. Novels are an indivisible product. Ideally, pricing should have peaked as the novel’s climax approached.

Radiohead’s unusual pricing strategy may or make not succeed. But we should not be surprised if many more such experiments crop up in the years ahead, especially on the Internet. It’s unlikely that you can choose your price for a car or a house, but flexible pricing can come into its own as far as digitized products are concerned.

Your comments are welcome at cafeeconomics@livemint.com

Disclaimer :- The copyright for the articles published here lies with HT Media Ltd. The blogs are owned and maintained bylivemint.com. You may not copy, reproduce, republish, download, post, broadcast, transmit, make available to the public, or otherwise use livemint.com content in any way except for your own personal, non-commercial use. You also agree not to adapt, alter or create a derivative work from this content without prior written permission of HT Media Ltd. You are however, free to link to this page.

The capital conundrum

The government needs to back RBI’s moves with a tighter fiscal policy to cool demand in the economy

Cafe Economics | Niranjan Rajadhyaksha

How should India respond to the flood of capital gushing into its economy?

The Reserve Bank of India (RBI) and the Securities and Exchange Board of India (Sebi) have, for better or worse, stepped knee-deep into the flood water and tried to control its flow. And have courted controversy in the bargain.

RBI has done either of two things, depending on the circumstances. It has tried to buy up the dollars and pump more money into the domestic economy. Or it has let the rupee appreciate. The first policy weakens it in the fight against inflation and the second could hurt export competitiveness. Sebi has tried to turn away one category of investors in the stock market—hedge funds and other shadowy investment pools that invest indirectly through offshore derivatives. This has shaken the stock market.

It is time the government, too, got into the act in a meaningful way—by slashing the fiscal deficit.

First: how big is the flood?

The finance minister says the inflows are “copious”, an adjective that has gained wide currency over the past 10 days. The International Monetary Fund (IMF) says in its new World Economic Outlook that the amount of private capital cumulatively flowing into India since 2002 is equal to 18.3% of its GDP, far more than the 6.9% in 1988-90 (in the run-up to the crisis of 1991) and the 3.2% in 1994 (the first big burst of foreign institutional investors activity in India).

How does this compare with other countries? It’s middling. Many in Europe’s north are dealing with capital inflows that are three to five times larger than ours, for every unit of GDP. In Asia, Vietnam has been getting cumulative inflows of 38.5% of its GDP. In that sense, India is by no way being soaked in foreign capital.

Between 1990 and 1996, Korea received cumulative capital flows equal to 18.9% of its GDP in the last year of that period. That did not protect it from the wave of capital outflows that wrecked East Asia and South-East Asia in 1997. The others affected were in deeper water: Indonesia (26.3%), Malaysia (79.1%) and Thailand (88.8%, between 1988 and 1996).

Any way you look at it, India does not seem to have had threateningly large capital inflows in the past five years. But this does not mean that Indian policymakers are mistaken in their flurry of discussion and policy. IMF has identified 109 episodes of “large net private capital inflows” since 1987; of these, 87 were completed by 2006. IMF says that “one-third of the completed episodes ended with a sudden stop or a currency crisis, suggesting that abrupt endings are not a rare phenomenon.”

Two further issues need to be looked into. First, what is the nature of these private capital flows? Are they predominantly long-term foreign direct investment or are they short-term speculative capital that can be withdrawn by hitting the enter key on a laptop in the Bahamas?

It is quite well-known that India has been more popular with portfolio investors than with corporate investors in the past decade or so, though the balance between the two is less skewed than before.

The other troublesome question is the state of the economy’s fundamentals. India needs to worry about two things: its current account deficit and its fiscal deficit.

The former puts India at greater risk of a sudden reversal of capital than those countries that have large trade and current account surpluses. “The consequences of large capital inflows are of particular concern to countries with substantial current account deficits...” says IMF.

Then there is the fiscal deficit. Capital inflows usually stoke up economic growth but put the overall economy to the risk of overheating—thus creating the conditions for eventual loss of investor confidence and capital outflows. The textbook way to deal with such a situation is either to run a tight monetary policy and/or a tight fiscal policy. RBI has been doing the first, as a result of which we have seen some deceleration in bank credit and consumer demand.

The government needs to back this with a tighter fiscal policy to cool final demand in the economy. The finance ministry is busy making self-congratulatory statements about how it will meet its fiscal targets this year and will eventually bring the revenue deficit down to zero by 2009.

But surely the government can do better. The bipartisan deal to bring India government finances back on track through the Fiscal Responsibility and Budget Management Act was hammered out at a time when economic growth and tax collections were sluggish. The subsequent economic boom has led to huge increases in tax collections, which ideally should have been used to slash the fiscal deficit, something that the Clinton administration did in the 1990s in the US. The Mumbai sisters have a huge battle on their hands. Isn’t it time the big brother in New Delhi entered the fray?

(Your comments are welcome at cafeeconomics@livemint.com)

Disclaimer :- The copyright for the articles published here lies with HT Media Ltd. The blogs are owned and maintained by livemint.com.

You may not copy, reproduce, republish, download, post, broadcast, transmit, make available to the public, or otherwise use livemint.com content in any way except for your own personal, non-commercial use. You also agree not to adapt, alter or create a derivative work from this content without prior written permission of HT Media Ltd. You are however, free to link to this page.

Look ma, no cash

Indian companies can use stock swaps for future global buys. But what about family control?

Cafe Economics | Niranjan Rajadhyaksha

The global acquisition bandwagon has stalled, ever since the international credit market stumbled into a crisis in August—a crisis that could worsen in the months ahead as estimates of loan losses mount. So, we now have nothing to match the headline-grabbing deals of early 2007: Tata Steel and Corus, Hindalco and Novelis, Suzlon Energy and Repower.

That’s not surprising. In July, Café Economics had asked whether it was time to end the leveraged buyout (LBO) revelry. “The entire LBO party has been fuelled by cheap money, because interest rates have been very low in recent years thanks to central banks across the world. In other words, LBOs have been an arbitrage between the credit markets and the market for corporate assets. You borrow from one to buy in another. The ground is now shifting below the feet of the party-goers, as borrowing costs in the credit markets have started inching up.”

The lack of easy money to fund overseas takeovers has had its expected effect. But this does not mean that Indian companies will have to stay away from global acquisitions till the loan party comes to life again.

Perhaps it is time to use another type of acquisition strategy—stock swaps, where an acquiring company uses its own shares as currency to take control of a target company. Each shareholder in the target is offered a certain amount of shares in the acquiring company in exchange for his original shares.

Here’s why this could work.

The past few months have seen a very significant shift in global valuations, as investors have come to believe that Asia is decoupling from the US. Emerging market stocks now attract better valuations than stocks in the rich countries, for perhaps the first time ever. A recent report in The Economic Times shows that the market valuation of ICICI Bank is now at par with that of Lehman Brothers, a Wall Street investment bank. State Bank of India has a higher value than Singapore’s DBS. In a few years, it is likely that many Indian companies will have market values that are more than their global competitors.

More generally, the MSCI index for emerging market stocks has a trailing price-earnings multiple that is 12% higher than that for developed markets. And this could widen. The Economist says that CLSA strategist Christopher Woods expects the forward price-earnings multiple of shares in emerging Asia to “peak at twice America’s”. Though the two sets of figures are not strictly comparable, you can get the general idea. Investors seem to be ready to pay far more for every dollar of profits in emerging markets, compared with what they will pay for American profits.

And given the fact that economic growth in our part of the world is most likely going to be far quicker than that in the US, Japan and Europe, it is not unrealistic to expect emerging market companies to play catch up with their rich-world peers. China has already caught up, though this is also because of its irrationally exuberant stock market. Petro China was briefly valued at a trillion dollars, making it the world’s most valuable company. And Industrial & Commercial Bank of China (ICBC) has a market value more than that of Bank of America.

It’s all about the price of acquisition currency. LBOs and cash deals had a good run over the past few years because of the low price of global credit. Stock swaps could be the next big thing because of the high price of emerging market shares. Companies that have higher valuations need to offer fewer of their shares in exchange during an acquisition. You get more for less.

But there is a problem. Business families control many emerging market groups. A stock swap will dilute their control, as the investor base widens. To the extent that control matters, business families in Asia (including India) have little incentive to go in for this variety of acquisitions.

Mittal Steel had used a combination of cash and stock offers to buy Arcelor in 2006. One reason this was possible is that the Mittal family owned 88% of Mittal Steel before the Arcelor acquisition. Their holding in ArcelorMittal, the new merged entity, is down to 49.4%, enough to maintain control.

There are undoubtedly many Indian companies where the controlling family owns a large chunk of the share capital—DLF, Wipro and TCS, for example. Then there are the cases such as ICICI Bank and HDFC, where ownership is widely distributed and the top management does not come from a “family”. But a majority of Indian companies do not fall into either of these categories, and will find it difficult to do large stock-swap mergers without putting management control under threat.

So how will Indian companies that have an acquisition opportunity respond—by going in for a stock-swap acquisition or preferring to maintain tight control? It’s an interesting choice.

Your comments are welcome at cafeeconomics@livemint.com

Retirement saving myths

The standard portfolio model is flawed because it ignores human capital, according to economist Joseph Stiglitz

Cafe Economics | Niranjan Rajadhyaksha

Most of the financial advice we get is hopelessly inadequate and simplistic—if not outright wrong.

Last week, I heard Joseph Stiglitz launch a typically blunt and brilliant attack on some of the sacred cows of the financial advisory business. The economics professor at Columbia University in the US and winner of the 2001 Nobel Prize in economics is popularly known as a trenchant critic of some aspects of globalization, though his academic work spans a wide range of economic issues, including financial ones.

“Long-term financial planning is a very complex task. Individuals cannot judge what they need to do and so they fall prey to wrong advice. This gives rise to fashionable rules of thumb,” said Stiglitz in a presentation at the Second European Colloquia organized by Pioneer Investments in Vienna at the end of November. (Disclosure: I was in Vienna as a guest of Pioneer Investments.)

The most common rule of thumb is that an individual should invest heavily in equities at a young age and then gradually move into bonds as the age of retirement nears. A popular and pseudo-scientific way of defining this rule is as follows: subtract your age from the number 100, and you get your ideal exposure to equities. For example, a 30-year-old should have 70% of his long-term savings in equities (100-30) while a 50-year-old should bring it down to 50%.

Neat, huh? But also wrong, said Stiglitz.

Most financial advice—and the economics that underlies it—is flawed. It assumes that an individual has only two types of capital: relatively safe fixed-income bonds and equities that are more risky but which also give more returns. The question is how long-term savings should be distributed between the two as we age.

“The standard portfolio model ignores other forms of individual capital,” said Stiglitz. One important form of this is human capital, which is usually calculated as the present value of all the future earnings an individual will earn over his working life.

Most of our value as economic animals resides in our ability to earn over our working lives—our human capital. According to some estimates, nearly 80% of an individual’s capital is human capital. This form of capital and its risk profile should ideally be considered while designing a good financial plan for retirement.

Human capital is usually more risky at a young age, points out Stiglitz. You are just starting off on your career and the future is uncertain. As you age and get settled into your chosen profession, the uncertainty about your ability to earn starts declining. Human capital gets less risky as you age.

Seen from this perspective, most financial plans are built on shaky foundations. A 25-year-old setting out down a fresh career path faces huge amounts of risk in his overall portfolio (financial and human), because his future earnings are uncertain. Ideally, his financial portfolio should have low risk to balance out the high risk in his human capital. He should be buying more bonds than he is usually advised to do. But the cookie-cutter financial advice that he gets is to put most of his savings into equities—and increase his overall risk.

The big question is whether human capital resembles a safe bond or risky equity. In a separate presentation, Stephen P. Zeldes, a professor of finance and economics at Columbia University, asked: “Is labour income stock-like or bond-like?” He suggested there are no easy answers here. Without disagreeing with Stiglitz, Zeldes said labour income has both characteristics, depending on the circumstances.

All this makes financial planning a complicated process. Besides, other factors such as which industry one is working in, the nature of one’s family responsibilities and home ownership also need to be thrown into the consideration. In a country such as India, for example, where a large part of the population is self-employed, labour income would tend to be risky.

Perhaps we are wrong in blindly assuming that we should cut our exposure to equities as we age. In fact, a well-settled professional with stable earnings perhaps has more reason to invest in equities than, say, a young entrepreneur in a technology start-up.

These are nuances that are often ignored, even in our grander debates on how pension fund money should be used in India.

One challenge before those involved in designing social security systems is how to balance freedom of choice and good guidance. Choice is important because an individual knows about his retirement needs than outsiders. But, as Stiglitz pointed out, individuals make rational decisions by learning from past experiences—their own and of others. That’s not possible for retirement planning. A person who realizes at 60 that he has not saved enough for his retirement cannot say: “I’ll do better next time.”

There is no second chance.

Your comments are welcome at cafeeconomics@livemint.com

Alfred Marshall in Bhiwani

Bhiwani seems to have a boxing ecosystem just as Bangalore has an innovation ecosystem or Mumbai once had a cricketing ecosystem

Cafe Economics | Niranjan Rajadhyaksha

The gutsy boxers of Bhiwani have perhaps never heard of Alfred Marshall. But I think that something the great economist wrote more than a hundred years ago, on why some activities tend to flourish in certain towns and regions, has echoes in the Bhiwani of today. And what Marshall and other subsequent economists have written about geographical specialization and clusters could help India cobble together a better strategy for the 2012 Olympics in London.

Online encyclopedia Wikipedia quite aptly describes Bhiwani as “the Kashi of boxing”. Three pugilists from the town — Akhil Kumar, Vijender Kumar and Jitendra Kumar — went through to the quarter finals while Vijender Kumar went on to win a bronze medal in the recently concluded Beijing Olympics. There has been a flood of newspaper reports since then on the vibrant boxing culture in Bhiwani.

Marshall was one of the first economists to ask why certain occupations and industries tend to cluster in a particular town: cutlery in the Sheffield and pottery in the Staffordshire of his times, for example. “When an industry has thus chosen a locality for itself, it is likely to stay there for long: So great are the advantages with people following the same skilled trade get from near neighbourhood to one another. The mysteries of the trade become no mysteries; but are as it were in the air, and children learn from many of them unconsciously.”

Boxing is clearly in the air in Bhiwani, in the sense Marshall wrote about. The town seems to have a boxing ecosystem just as Bangalore has an innovation ecosystem or Mumbai once had a cricketing ecosystem. And the success of the three fighters coming out of Bhiwani clubs shows that specialization works in sports as well as it does in business. Furthermore, just as certain towns are good at certain sports, it seems that entire countries too have core competencies in the sporting arena.

This simple fact should help Indian sports administrators and private charities design a sensible strategy for the next Olympics in London. And it should be based on doing what India seems to be good at.

Take a look at how the top teams collected their Olympic medals. One would have thought that sporting superpowers such as the US, China and Russia would have had their medals evenly spread around all types of sports. That is not so.

The US picked up a total of 110 medals in Beijing. Sixty of them came from athletics and swimming (the latter no doubt helped by a man called Michael Phelps). Thirty-five of Russia’s 72 medals came from athletics, weightlifting and wrestling. Great Britain won 33 medals in cycling, sailing, rowing and kayaking; its grand total was 47. Australia won 20 of its 46 medals in swimming while it bagged five more in canoeing and kayaking. Thirteen of Japan’s 25 medals came from judo and wrestling.

China has its medals more evenly spread across various sporting pursuits, perhaps a reflection of its authoritarian and state-driven sporting set up that perhaps mirrors a similar economic programme where the government pushes the development of industries it thinks China should be strong in. But even China has stood out in a few disciplines such as shooting, diving and gymnastics.

Looking at the way various countries have won Olympic medals this year, there is a clear sense that what works in the world of economics seems to work in the world of sports as well. As more countries become participants in the “market” for Olympic medals, each individual country tends to focus on doing what it is best at. Or: Division of labour increases in tandem with the growth of the market. That we have known since the days of Adam Smith.

And it is perhaps the way forward for India as well — both the Indian Olympic Association and the various private foundations that are ready to fund sporting excellence.

The tricky question is how to identify what sports India is really good at. There is a centralized and managerial way of doing this: Identify a few fashionable or influential sports and say that India should have a dominant presence in them. This approach is close to what proponents of national industrial policy say: Let’s identify a few prestigious industries such as semiconductor manufacturing or car making and support them with money and subsidies.

The other approach is a more experimental and market-oriented one: watch where Indians are winning — either in global markets or sporting tournaments—and then ask what can be done to help those who are active in these areas. In other words, let the markets rather than bureaucrats pick the potential winners.

There are already some signs that are evident to even couch potatoes: India’s best medal chances were in shooting, wrestling, boxing and court games such as badminton and tennis. Let’s build on them.

Your comments are welcome at cafeeconomics@livemint.com

Escaping caste traps

An experiment by two economists shows people can lose out even when there is little overt caste discrimination

Cafe Economics | Niranjan Rajadhyaksha

A neat little experiment conducted by two economists in 2004 tells us a lot about a very contemporary debate —the persistence of caste traps. It is useful to revisit their experiment at a time when the reservations debate has flared up once again. This experiment suggests that caste is a deep-rooted problem that can persist despite laws banning discrimination as well as more specific interventions such as selective reservations.

Karla Hoff of the World Bank and Priyanka Pandey of Pennsylvania State University collected a group of 622 boys and girls at a junior high school in a village in Uttar Pradesh. They wanted to find out the effects of caste on performance. These students were in classes VI and VII. Half were from the so-called upper castes and the other half from the so-called lower castes.

The children were asked to solve a maze. Those who successfully completed the game were rewarded with money. So, there was a clear economic incentive to play the game for the benefit of the researchers. At first, the castes of the participating children were kept secret. There was very little difference between the success rates of children across castes during this part of the experiment.

Then the castes of the participating children were publicly announced during a second round of the experiment. The lower-caste children suddenly performed significantly worse during this round. The number of mazes that they successfully solved fell by a quarter.

The results of these trials show that people can continue to be victims of caste and racial stereotypes even when there is no legal discrimination in a society. We are aware of how biases affect the way people from certain castes are perceived. The problem here is different: Stereotypes become self-fulfilling. People tend to unconsciously behave in accordance with the way they are stereotyped. Similar experiments have been conducted in the US. One shows how the performance of black Americans taking the Graduate Record Examination (GRE) slipped when they filled questionnaires asking them to reveal their race.

Such experiments show that people tend to conform to stereotypes—and could lose out in life though there is little overt discrimination.

There are several reasons to be wary of jumping to any grand conclusions from the results of one experiment. First, the Hoff-Pandey trial was conducted in rural Uttar Pradesh, a region that has seen far less social reform, economic development and mobility than many other parts of India. So, it is an unrepresentative region in many ways. And the results cannot be used for national policy.

Second, the current debates on reservations in education are focused on the intermediate castes rather than the lower castes. Members of these castes have never suffered the brutal discrimination that the Dalits faced over the centuries. I doubt the caste factor would be so important in case the two groups of children solving the maze were from the “upper” and “intermediate” castes.

One solution is to create or support a “big push” to break the fetters of caste stereotypes. “Policies attempting to reduce inequalities need to be highly cognizant of the prevailing cultural norms. In the low-caste case, for example, simply giving supply-side incentives or reservations alone may not solve the problem. The tug of the prevailing norms can be stronger than material interests. The flip side of this logic produces a classic “big push” type of argument. If some small group of individuals who are typically discriminated against does manage to break the norms and succeed, the effect can be powerful. They can serve as role models for many others and remove at least the norm-induced barrier,” says Harvard economist Sendhil Mullainathan in a recent paper.

This happened in Maharashtra with the success of B.R. Ambedkar, who showed millions that there could be a life beyond the traditional demeaning jobs that others in his caste were condemned to. One example: Narendra Jadhav, who grew up in the slums of Mumbai, rose to become chief economist of the Reserve Bank of India and is now vice-chancellor of Pune University, writes in his autobiography how as a child his aim in life was to become a petty gangster. That was what his peers became. It was the Ambedkar movement that led Jadhav to the road to success. He, too, is now a role model for the next generation of Dalits.

Finally, hear what the World Bank says in its World Development Report 2006: “Discrimination and stereotyping have been found to lower the self-esteem, effort and performance of individuals in the groups discriminated against. This reduces their potential for individual growth and their ability to contribute to the economy.”

Caste is a tricky issue and there can be no easy answers. But, it is unfortunate that the debates all around us depend more on passion rather than fact. Meanwhile, cynical politicians such as Arjun Singh can play the divide-and- rule game.

Your comments are welcome at cafeeconomics@livemint.com

Prince and pauper

The extent of inequality in India seems to be stable, from Mughal India to our times

Cafe Economics | Niranjan Rajadhyaksha

It is common to hear the claim that inequality has increased because of economic reform and globalization. Most debates on this important issue end up as shouting matches. But is the claim really true?

Data I have seen this week show something eye-catching: The extent of inequality in India seems to have been remarkably stable over the centuries. The Mughal Empire collapsed. The British came and left. Independent India emerged from the pains of partition and now sees itself as an emerging superpower. Through this long cycle, the country seems to have maintained its level of equality/inequality.

First, let’s look at the immediate numbers. Mint reported last week that inequality in India had actually decreased between 1997 and 2005, going by the estimates published in the United Nations Development Programme’s human development reports. Inequality is usually measured with the Gini coefficient. A Gini of one means a country has perfect equality and a Gini of 100 indicates perfect inequality. India’s Gini coefficient has fallen from 37.8 in 1997 to 36.8 in 2005.

India is perhaps more equal today than it was around 10 years ago. That’s something that the critics of reforms have to deal with.

As with all such estimations, this one, too, can be questioned based on the quality of data and the definitions used. But that is not the point of this column. What struck me is that inequality in India has been surprisingly steady over the very long run. The data I will quote below are taken from an interesting new research paper, Measuring Ancient Inequality, by three economists—Branko Milanovic, Jeffrey G. Williamson and Peter H. Lindert. The original data that the three use is from economist Angus Maddison, whose work on world incomes since the dawn of history is incomparable. (A quick note: The main point of the Milanovic, Williamson and Lindert paper is quite different from the focus of this column.)

Let’s take an initial step back into history. The first official measure of inequality in independent India was in 1951, when the National Sample Survey field workers first went knocking on doors. The Gini then was 36, not too far from what it is today, according to the latest data. Inequality has stayed around that level through the ups and downs in the Indian economy over the next six decades and more.

But we could step even further back in time, all the way to the Mughal era. Naturally, data were scarce in those days. So, these are broad estimates. First stop: British India just before independence. The average Gini at that time was 48.9.

At first glance, it may seem that inequality dropped dramatically after the British left India. One possible reason is that the top British officials —from the viceroy to the judges to the district collectors—packed their bags. Maddison says that top British officials and businessmen made up just 0.06% of the total population of India, but they mopped up 5% of the national income. The Indian nobility and business class accounted for another 0.94% of the population and 9% of the national income. Thus, the 1% at the top of the income pyramid got 15% of total income.

However, Milanovic, Williamson and Lindert say that even without the British, the Gini would have been a high 45. Even so, there is a nine-point gap between inequality in 1947 and in 1951. The three economists offer four explanations. One, the 1947 Gini was based on incomes while the 1951 Gini was based on expenditure. So, is expenditure more equally distributed than income? Two, Maddison overestimated 1947 inequality. Three, he underestimated the incomes of India’s poor. Four, inequality did indeed drop after the British left and India became a free republic.

Let’s stick to reason number one for now and assume that there is a nine-point gap between income inequality and expenditure inequality. And then take another leap into history, back to the era of the Mughals. Around 1750, the Mughal nobility and zamindars accounted for 1% of India’s population and 15% of the total income. That’s remarkably similar to what the top 1% of the population—British officials, British businessmen, Indian nobles and Indian businessmen—got in 1947. The Gini in 1750 was 43.7%, very close to the “non-British” Gini at the eve of independence.

This is astonishing. The data shows that the extent of India’s inequality has been remarkably similar over the centuries, be it in Mughal India, British India or independent India. Of course, there must have been ups and downs depending on the economic and political circumstances. But the overall picture has not changed much. Is this our “natural” rate of inequality?

That’s a sobering thought amid the noisy debates.

The entire paper on measuring ancient inequality can be read at www.nber.com.

Your comments are welcome at cafeeconomics@livemint.com

No longer a bottomless pit

Subsidies and rural employment generation schemes are politically attractive ways to help the poor, but they are usually wasteful and short-term fixes

Cafe Economics | Niranjan Rajadhyaksha

India’s farm economy will create no new jobs in the coming years — and that is good news.

The Planning Commission estimates in the 11th Plan that the number of workers in agriculture will stagnate between 2006-07 and 2011-12 — and then drop by around four million in the subsequent five years. This is perhaps the first time since data has been collected that Indian agriculture will no longer be the bottomless pit in which the unemployed and unemployable are hidden.

The actual economy rarely jumps through the hoops that planners hold in front of it and so the eventual pattern of employment may be quite different from these estimates. Yet, what the Planning Commission expects is truly extraordinary. If fewer people in absolute terms will be busy on the farm from now on, not just the economy but India as a country would have changed — becoming less agricultural and perhaps more urban.

Jobless growth is usually not welcome. It is only when new jobs are created that the benefits of economic growth filter down to more people. That is the true meaning of inclusive growth — the ability to provide quality jobs to as many people as possible. In fact, the phrase “inclusive growth” gained wide currency only at the beginning of this decade, when there were widespread fears that the rapid economic growth of the 1990s was not creating enough jobs or bringing down poverty fast enough. Subsidies and rural employment generation schemes are politically attractive ways to help the poor, but they are usually wasteful and short-term fixes. They do not eventually lead to truly inclusive growth.

Gainful employment is the only way out. An earlier instalment of this column had quoted Nobel Prize-winning economist Edmund Phelps as saying this: “High wages enable workers to solve various problems, participate in the economy and live with dignity.”

Agriculture has kept absorbing people. The problem is that new jobs created in agriculture amount to disguised unemployment. In other words, it is possible to produce the same amount of farm output by employing fewer workers. But there were few jobs outside agriculture and millions were trapped in low-productivity work in farms. Indian farms are family-owned, so family members who have no job opportunities outside end up toiling on the same patch of land that already employs too many people.

That is why jobless growth in agriculture should be welcome. The farm income pie will not keep getting cut into ever-smaller pieces; incomes would improve.

But, where are the alternative jobs — both for new entrants into the labour force and the four million or so who will leave their farms?

And this is where the Plan documents point to really interesting possibilities. The traditional answer is that people moving off the farm will eventually be absorbed in labour-intensive manufacturing. That is what happened across Asia, in countries such as Taiwan, South Korea, Thailand and Malaysia. Farm labour moved into the cities and export zones to work in factories that made toys, textiles, computer chips and the like for the export market. There are too many obstacles to the growth of such labour-intensive manufacturing in India, including labour laws that protect those with industrial jobs but harm prospective workers.

The Planning Commission says it expects an extra 11 million manufacturing jobs in the five years to March 2012. But that’s not where the story ends. Almost an equal number of new jobs will be created in the construction industry. Trade, hotels and restaurants will absorb an extra 17 million workers. And another nine million will find jobs in transport, storage and communication.

What this means is that we will be seeing radical change in the Indian workforce. Fewer people will be toiling away on farms in rural India. New workers will find employment in factories, but far more will be busy at construction sites, restaurants, retail outlets and warehouses.

Such work will not necessarily allow them to live better. A lot will depend on the details. A job in retail? Does that not mean standing at the check-out counter of a large department store or toiling away in a corner shop? Construction work? With an engineering company that invests in worker safety or some site that has never seen a hard hat? And what of proper labour contracts, decent wages and social security?

The Planning Commission has raised a very valid issue in the 11th Plan: what it calls the informalization of employment. Too many Indians will continue to have jobs in tiny and unorganized workplaces. The growth of the formal sector will hopefully lead to better working conditions and wages. That is something those opposed to modern retailing and the reform of land laws should understand.

Your comments are welcome at cafeeconomics@livemint.com

Dreaming of Swatantra

Modern India’s only stab at a successful liberal party started in August 1959; the Swatantra Party would have entered its 50th year this month, if it had survived as a national political force

Cafe Economics | Niranjan Rajadhyaksha

Nobel laureate Amartya Sen — who is not a free-market liberal — has spoken on how contemporary India needs a right-wing political party that is both secular and committed to an open economy. This is a good time to go back to the issue, for two reasons. First, we have seen how economic reforms were blocked by the Left to begin with and have now been hijacked by the crony capitalism of the Samajwadi Party. Second, modern India’s only stab at a successful liberal party started in August 1959; the Swatantra Party would have entered its 50th year this month, if it had survived as a national political force.

Fifteen years of high growth, thanks to economic reforms, should have created a strong political base for liberal party. It hasn’t. I am often surprised at how even people who have benefited from economic reforms still believe that the government should control prices to beat inflation or that companies are making too much profit at the cost of society. Is it any wonder that no party is ready to face the electorate with a free market agenda?

The interesting question is why this happens. The answer involves more than political failure. The nature of Indian society and capitalism are also part of the answer.

An interesting new research paper by Philippe Aghion of Harvard University, Yann Algan of the Paris School of Economics, Pierre Cahuc of the Ecole Polytechnique and Andrei Schleifer of Harvard University offers one set of clues. They have mapped the relationship between demands for regulation in a country and the level of distrust between its citizens.

What these four economists show from their study of rich nations is that people ask for more government regulation when they do not trust their fellow citizens. They have used a concept that has attracted a lot of attention over the past decade and more — social capital. Any economy needs physical capital (tools), financial capital (money) and human capital (skills) to grow. It also needs social capital (trust). Economist Kenneth Arrow once said that virtually “every commercial transaction has within itself an element of trust, certainly any transaction conducted over a period of time. It can be plausibly argued that much of economic backwardness in the world can be explained by the lack of mutual confidence.”

Aghion and his three fellow authors show in their July paper, Regulation and Distrust, that countries with low levels of trust in other persons, companies and political institutions are more likely to have more regulations on economic activity. But this regulation leads to low growth and corruption, as we know from our own experience of the licence permit raj. “What is perhaps most interesting about this finding…is that distrust generates demand for regulation even when people realize that the government is corrupt and ineffective; they prefer state control to unbridled production by uncivil firms,” say the economists.

The way companies earn profits does affect the popularity of capitalism. In a paper published in 2006, Rafael Di Tella of Harvard Business School and Robert MacCulloch of Imperial College ask: Why Doesn’t Capitalism Flow to Poor Countries? They say the most important factor is corruption, which cuts into the “moral legitimacy of capitalism”. Di Tella and MacCulloch add: “Existence of corrupt entrepreneurs hurts good entrepreneurs by reducing the general appeal of capitalism.”

These two pieces of research show that the popularity of a free market political party will depend on both the level of trust in a country and whether profits come from competitive markets or oligopolies protected by the state.

Economic historian Douglass C. North and his colleagues have given us what they call a conceptual framework to interpret human history. They say that societies emerge as “limited access orders”. Here, the political system is used to limit economic participation and impose social order. The lack of economic competition leads to excess profits that are used to limit violence and maintain political stability.

North says that some societies later evolve into “open access” orders. Here, there are few restrictions on economic and political participation, which is another way of saying that these societies have open economies and open political systems. Order is maintained through the competitive process.

There is a famous story about Margaret Thatcher. Soon after she became head of the Conservative Party in the UK, she is said to have reached into her briefcase and pulled out a copy of F.A. Hayek’s Constitution of Liberty, a book that explains with great clarity why liberal systems lead to freedom and prosperity. Interrupting the speaker, she is said to have banged the book down on the table and said: “This is what we believe.”

Is there any Indian politician who has similar convictions — and the guts to make them public?

Your comments are welcome at cafeeconomics@livemint.com

Our urge to splurge

New spending data from the government captures the vast changes in middle-class family budgets

Cafe Economics | Niranjan Rajadhyaksha

I was a bemused onlooker to a recent discussion between my wife and her partner in shopping crime. They were discussing family budgets. The main point was that while family incomes have increased almost beyond imagination over the last 10 years, spending has grown apace.

I am quite sure that’s also the experience of most Indian families which have benefited from the recent burst of economic growth. The bank balance doesn’t quite meet the targets set when we get our new salary deals and our annual bonuses.

What my wife and her friend were talking about is backed by numbers—including a new set of data on savings and consumption trends in India, released a couple of weeks ago by the government statistics office. These numbers show that there have been vast changes in how India accumulates and spends money. Family budgets today are radically different from what they were at the end of the last century. And they will change even further in the years ahead.

First, consider savings behaviour. India as a whole now stashes away a far bigger proportion of its national income than ever before. But that’s because of a jump in corporate and government savings, rather than in household savings.

The gross financial savings of Indian families have risen from 13.9% of the gross domestic product in 2003-04 to an estimated 18.4% in 2006-07. But that’s what we collectively squirrel away before servicing our debt. Once that factor is taken into account—the money we have borrowed from banks to buy houses and consumer goods and (alas) overpriced initial public offerings as well—it’s clear that the net savings rate of Indian families has barely budged over the past four years.

But this doesn’t mean that the story on the spending side of the family financial ledger has been just one of uniformly climbing expenses: buying the same stuff we always did, only lots and lots more of it. In fact, how we spend our money has changed drastically over the past few years as incomes have increased.

We splurge a larger share of our incomes on mobile phones, eating out, transport and recreation—but surprisingly, not as much as we believe on education and health. We also eat differently, as even a cursory glance into our fridges and kitchens shows. And as far as indulgences go, tobacco is losing importance and what the bean counters call intoxicants have become more important in our lives.

There are hard numbers to back our individual experiences. New spending data captures the vast changes within middle-class family budgets in recent times.

The quick estimates of national income, consumption expenditure, saving and capital formation for 2006-07 were released by the Central Statistical Organization on 31 January. They show that total private final consumption expenditure—largely made up of household spending—increased at an annualized rate of 8.12% in the five years between 2002 and 2007. That’s at current prices. At constant prices, the rate at which private consumption spending has increased at 5.03%. The difference between the two rates of growth—3.09%—is a proxy for consumer price inflation.

But there have been deep changes within this overall trend. In 1999-2000, spending on food, beverages and tobacco accounted for 51.5% of the total spending by Indian families at current prices. That dropped to 42.7% in 2006-07. (The drop after taking inflation into account is less sharp). This means that we are spending a relatively smaller part of our incomes on food than before, which is quite natural in a country that is emerging from poverty.

There are signs of growing prosperity within this category as well. Consumer eating preferences have shifted from the traditional cereals, bread and oilseeds towards stuff such as fruit, milk, meat and even intoxicants. Spending on tea, coffee and cocoa has actually dropped in nominal terms—not quite in tune with our daily experience of umpteen cups of caffeine and crowded city cafés.

On the other hand, our expenditure on communication has exploded, increasing from 1.2% of spending in 1999-2000 to 2.7% in 2006-07 (at current prices), undoubtedly helped by the mobile telephony revolution and deflation in call charges. Indians now spend more on communications than they do on tobacco or hotels and restaurants. And even on education. It was not so at the beginning of this decade.

India is still a country with too much poverty. But there are signs of change. We see this in the broader data on average incomes, which have crossed $1,000 a year. But the consumer spending statistics also show how India is changing—from the daily struggle of getting food to the growing aspiration to eat better, send children to school, own a mobile phone and perhaps have a drink or two.

Your comments are welcome at cafeeconomics@livemint.com

Faster, higher, richer

Much has been said and written about how China will use the event to showcase its achievements over the past three decades, as it moved from being a Maoist cesspool to its current status as one of the world’s emerging superpowers

Cafe Economics | Niranjan Rajadhyaksha

he 2008 Olympics will open on Friday in Beijing in a burst of pomp and pageantry. Much has been said and written about how China will use the event to showcase its achievements over the past three decades, as it moved from being a Maoist cesspool to its current status as one of the world’s emerging superpowers. The famous Bird’s Nest stadium, the 36 other Olympic facilities, the gleaming new hotels, the super-fast trains from Beijing to Tianjin (where the football games will be played), the world’s biggest airport terminal in the capital city — each is meant to impress.

China is not unique in this respect. Japan did something similar when it hosted the 1964 Olympics in Tokyo. “The autumn of 1964, when the Olympics came to Tokyo, was to be the greatest ceremonial celebration of Japan’s peaceful, post-war democratic revival. No longer a defeated nation in disgrace, Japan was respectable now. After years of feverish construction, of highways and stadiums, hotels, sewers, overhead railways, and subway lines, Tokyo was ready to receive the world with a grand display of love, peace, and sports,” writes Ian Buruma in his 2003 book on the rise of Japan, Inventing Japan: From Empire to Economic Miracle.

Familiar, isn’t it?

Economic resurgence and hosting the Olympics seem to go hand in hand. There is a common feature between the Tokyo and Beijing Olympics — and indeed most of the Olympics held across the world in the postwar years. And this common feature could offer us some clues about when India will be ready to host its first Olympics.

Most countries have hosted their first post-war Olympics when their average incomes have moved into a tight band of between $4,000 and $8,000, calculated using 1990 purchasing power parity, or PPP, dollars. I have taken the incomes data from economic historian Angus Maddison’s monumental research into the world economy since the dawn of the christian era. The record suggests that India should try to host its first Olympics when its average income is somewhere in that range.

Consider two Asian countries that had just about emerged out of mass poverty when they hosted the Olympics, to tell the world that they have arrived. Japan had a per capita income of $5,668 in 1964. South Korea had a per capita income of $7,621 in 1988, the year the Games came to Seoul. Both had recorded around 15 years of astonishing growth by the time the world’s best athletes came to their capital cities to win medals and glory. In another part of the world, Mexico had a per capita income of $4,073 in 1968, a year marked by the slaughter of protesting students to ensure a peaceful Olympics and Black Power salutes on the victory stand. It was not economic success but political unrest that made those Games memorable, a risk that the Chinese are well aware of.

But the incomes rule is not restricted to emerging Asian and Latin American nations alone. Interestingly, even more developed nations had average incomes in the same range when they hosted their first post-war Olympics. Here are some of the relevant numbers: London in 1948 ($6,746), Helsinki in 1952 ($4,674), Melbourne in 1956 ($8,108), Rome in 1960 ($5,916) and Moscow in 1980 ($6,427). The exceptions are few, such as Munich in 1972 ($11,481), Montreal in 1976 ($14,902) and Atlanta in 1992 ($23,298). But when Hitler and his thugs tried to use the Berlin Olympics in 1936 to showcase their achievements, Germany had a per capita income of $4,451.

I am not suggesting any Iron Law of Olympic Bids. But it does appear that countries need strong economies to convince the International Olympic Committee that they can play host to the world’s best sportspeople and thousands of tourists. You need to be rich enough to do the job.

So, when will India be ready? India’s average income right now is around $3,000 in PPP. That is at current rates, and not in the 1990 dollars that I have used in the earlier examples. But a comparison with China today would suffice. Average Chinese PPP incomes will be around $5,500 this year.

How long will it take India to reach that level? Assuming current rates of economic growth and population growth, it will need at least another decade to reach there. In other words, India could think of bidding for the 2020 Games.

China will be showcasing more than its physical infrastructure in Beijing this year. It also wants to prove that it has the world’s best athletes. A quick tour of various online betting sites suggests that China is expected to win more medals this year than any other country. As far as winning medals goes, India is unlikely to emulate its northern neighbour by 2020.

Sad, but true.

Your comments are welcome at cafeeconomics@livemint.com

Price of global warming

Climate change sceptics are wrong for the same reason that financial models have been proved wrong of late

Cafe Economics | Niranjan Rajadhyaksha

The climate change debate is far from settled. Or at least that’s the impression one gets when visiting a new website called www.climatedebatedaily.com. The home page is split vertically down the middle, with global warming enthusiasts and sceptics ranged against one another. One recent academic article on the sceptical side of the fence says that the world should be concerned about global cooling rather than global warming.

So, should we sit back and wait to see what happens?

This is where I think the climate change sceptics get it all wrong. One of the most common arguments they put forward in defence of their scepticism seems convincing at first glance. They argue that forecasting the future of any complex system such as the climate (or the economy) is terribly difficult. The margin of error is huge—and hence we must take the predictions that regularly hit the newspaper with a pinch of salt.

But that’s just the point. Forecasters may be erring on both sides because of the uncertainty involved. The world may not heat as much as expected. Or it may heat many, many times more than what we have been told to expect.

“Although greater uncertainty means climate change might be less bad than we fear—for example, an ‘iris’ effect means increases in cloud cover may slow global warming—it also means it might be much worse,” writes Paul Klemperer, a professor of economics at Oxford University, in a recent article. He draws parallels between the financial models that failed last summer and the climate change debate. “Only last summer, hedge fund managers found their stock market models’ predictions were, in their own words, ‘25 standard deviations’ from the outcomes, just as the Nobel Prize-winning economists who advised LTCM believed the probability that the fund would lose more than half its money was way below a billionth (until, that is, they lost almost all their money).”

In short, the uncertainty about the future course of global temperatures means that it is sensible to buy some insurance against 25 standard deviation climatic outcomes.

How? There are no easy answers to the problem of climate change, which could be the biggest externality the world economy has ever faced. As with the design of most economic policies, the trick is to identify the trade-offs and incentives involved. Economists need to be part of the solution.

The Indian government seems to have got the point. There has been some criticism of the fact that the 13th finance commission has been asked to look at “the need to manage ecology, environment and climate change consistent with sustainable development”. That’s not the job of a finance commission, which traditionally tries to figure out how tax revenues should be shared between the Centre and states. But, the new finance commission could help frame the Indian debate on what economic policies are needed to mitigate the effects of climate change. And that will be a big step forward.

The International Monetary Fund (IMF), too, has jumped into the fray in its new World Economic Outlook (WEO) that has been released this month. It seems like a strange decision at first glance. Shouldn’t IMF leave the climate change issue to scientists and focus more on the global economic slowdown and the spurt in inflation? But climate change could be a huge risk to the global economy.

WEO also has a box on the possible impact of an abrupt climate shock on an illustrative South Asian country that is heavily dependent on agriculture. Think India. There are several possibilities. The dislocations to agriculture and industry will pull down productivity as farmland is lost, industry is relocated and labour is retrained. Foreign demand for this country’s products will be hit “due to reduced competitiveness of the new industries in which the country is forced to specialize”.

The government will be forced to respond through a higher deficit and lower interest rates. These will reduce national savings and increase the current account deficit. The deterioration in the country’s economic performance will drive up risk perceptions and borrowing costs. These higher interest rates will squeeze investment and improve the current account balance.

The questions pile up. By how much should the price of carbon be increased to bring down emissions over the long run? How should the burden of cleaning up be shared between our generation and the coming generations? What part of the task should be left to private markets and what part should be tackled directly by government policy? How should the bill be shared between the rich countries that have been responsible for most of the carbon pumped into the atmosphere till now and the developing countries that will be the world’s biggest polluters in the future?

Economic reasoning needs to supplement climate change forecasting.

Your comments are welcome at cafeeconomics@livemint.com

India needs new fiscal pact

The deficit number that will be announced in the new Budget this week should be consumed with a pinch of salt

Cafe Economics | Niranjan Rajadhyaksha

Finance minister P. Chidambaram will stand in front of the nation on 29 February and deliver what could be the final Budget of this government. He will almost certainly announce that the government has met the fiscal deficit target that was announced a year ago. He is also likely to say that the government is on course to meet the deficit targets imposed upon it by the Fiscal Responsibility and Budget Management (FRBM) Act of 2003.

But the official deficit number will be misleading. The official Budget numbers will look impressive because of strong revenue growth rather than spending discipline. But the government has been running a parallel deficit that has been kept out of its books through accounting fudges. If we add these off-budget liabilities—including oil and food bonds worth close to 1% of gross domestic product, or GDP, that have been sold to offset the losses on fuel and food subsidies—to the official Budget figures, then the government’s finances will not seem as impressive as claimed by the finance ministry.

Several economists have already pointed this out. The International Monetary Fund (IMF) says in its latest staff report on India that if off-budget bond issuance and the deficits of state governments are added to the official government numbers, then India’s fiscal deficit is around 7.25% of GDP. That’s intolerably high. “Overall fiscal consolidation has…stalled. (The) general government deficit has hovered at just over 7% of GDP since 2004-05.”

The fiscal gains of the past few years are, thus, part illusion.

Even if one ignores the excursions into smart accounting, India’s fiscal record is not as impressive as it seems at first glance. True, the fiscal deficit for 2007-08 is far lower than what it was at the beginning of this decade. But India’s fiscal deficit is still far higher than the budget gap in most other emerging markets. China, for example, has a small budget surplus.

This government has frittered away a wonderful opportunity to put its finances in order and get rid of our most persistent macroeconomic problem. India has witnessed an economic boom that is unmatched in its history. Tax collections have soared. But so have expenditures. Other countries— notably the US in the 1990s—used strong economic growth to set their financial houses in order. We haven’t.

The recent record suggests that the Indian government—irrespective of the party in power—is incapable of being fiscally disciplined in even the most benign economic circumstances.

The only instances in the recent past when there have been serious attempts to control deficits were in the early 1990s and the early years of this decade. In the early 1990s, the stiff conditions attached to the IMF loan forced the government to slash its deficit. And then in the early years of this decade, the National Democratic Alliance government agreed to tie its own hands by passing the FRBM Act in 2003.

Other countries have also used fiscal responsibility laws to curb government profligacy. New Zealand introduced a Fiscal Responsibility Act in 1994. In the US, after the failure of the Gramm-Rudman-Hollings Act during the Reagan era, the Budget Enforcement Act of 1990 paved the way for a bipartisan push to balance the budget there. The European Union’s Growth and Stability Pact of 1997 is another exemplar legislation.

The most practical way to avoid such fiscal stress is to tie the government down with binding constraints. FRBM has been a welcome piece of legislation. In its original form, this law expected the Union government to bring down its fiscal deficit down to 3% of GDP and wipe out its revenue deficit by this year. The government later pushed the deadline to 2009.

Despite the burgeoning off-budget liabilities, there is little doubt that FRBM did help prevent worse fiscal excesses. The problem is that the FRBM law has given numerical targets till 2009—and targets that were impressive at a time when the deficit was close to 6% of GDP and economic growth was sluggish. But these targets now look quite modest.

And there are no numerical targets for the years beyond 2009. Given the economic boom and strong growth in tax collections, India now needs a fresh set of stiff and binding deficit reduction targets. Or a new fiscal pact that will force the government to further cut its deficit over the next five years.

High deficits are not an economist’s irrelevant obsession. The Reserve Bank of India (RBI) is under immense pressure to cut interest rates, despite resurgent inflation. But what the central bank’s critics often do not say is that India cannot run a slack monetary policy when it also has such a loose fiscal policy. One of the two policy screws has to be tightened at this juncture—to keep effective demand and inflation under control.

In other words, the high government deficit restricts RBI’s ability to cut interest rates

Your comments are welcome at cafeeconomics@livemint.com

A menu of dilemmas

Governments will have to negotiate many tough choices in their battle against rapidly rising food prices

Cafe Economics | Niranjan Rajadhyaksha

The images from the global food crisis are grim. A smouldering slum in Haiti after food riots there. Thai farmers protecting rice farms from looters. Winding queues outside provision stores in the Philippines. Soldiers guarding grain supplies in Africa. World Bank president Robert Zoellick says that the near doubling of food prices over the past three years could push 100 million people deeper into poverty. Finance minister P. Chidambaram has said that the diversion of crops to make biofuels rather than feed people is a crime against humanity.

Tough words. The food crisis could be a temporary scare that will wither away with the next harvest. Or, it could be the first section on the road to a bigger humanitarian calamity. Either way, what has happened in these past few months should ideally be a wake-up call for a world that did not pay too much attention to agriculture over the past couple of decades.

There will be several policy dilemmas to deal with in the months ahead. Here, I will outline a few.

First, whom should the government protect: farmers or consumers? High food prices are good news for those who are net sellers of the stuff. Their relative incomes would rise. But higher prices of food will feed inflation expectations in the rest of the economy and could lead to spiralling demands for wage hikes in the industrial and services sector. Interest rates would rise. Higher wages and borrowing costs will eat into corporate profits.

Second, what should be done to boost farm output? The current rush to ban exports of some types of food and cut import duties on others is a temporary fix. The only viable long-term solution is to increase farm productivity and output. But artificially suppressing food prices will be a disincentive for farmers to work harder and take more risks. So, there is an inevitable tension between the short-term and long-term measures needed to tackle food shortages.

Third, if price controls and fiscal measures to keep down food prices will harm incentives to increase farm output, what should the government do to protect poor consumers? The only viable strategy right now is to let the food subsidy rise. This means the government buys food from farmers at market rates and sells it through the public distribution system at low prices. The difference will be met through the budget. But then there is also the task of keeping the fiscal deficit under control. I think a higher food subsidy should be balanced with deep cuts in other subsidies. That’ll be a political minefield.

Fourth, who will come up with the money and technology needed to boost long-term farm output—the private sector or the government? It is unlikely that debt-ridden farmers will have either the money or the appetite to take large risks at this point of time. The government needs to step in. But how? Till around the mid-1980s, public investment accounted for a majority of the total government spending on agriculture. Since then, subsidies have become the more important intervention. By the early years of this decade, public investment was a little more than 1% of gross domestic product (GDP) while subsidies were more than 6% of GDP. The government needs to figure out ways to reverse the balance between the two—spending far more money on rural infrastructure rather than subsidies.

Fifth, what role can global trade play? The Doha round of trade talks has made little progress in breaking down trade barriers on agriculture. We are now seeing opportunistic cuts in import duties as countries try to ship in cheaper food. But then there are also bans on exports as countries try to keep food within national borders. Yet, there is still the broader issue of what can happen to the liberalization of global trade in agriculture.

World Bank’s Zoellick said in a recent speech: “If ever there is a time to cut distorting agricultural subsidies and open markets for food imports, it must be now. If not now, when?” The entire premise of the trade talks was that agricultural subsidies in Europe and the US were artificially keeping down the global price of food and other farm commodities such as cotton. Open trade would push up their prices and help millions of impoverished Asian and African farmers.

“Wouldn’t the removal of these distorting policies raise world prices in agriculture even further? And, in fact, aren’t these price effects the main channel through which agricultural trade liberalization in the North is supposed to benefit the South?” asks Harvard University economist Dani Rodrik on his blog.

With food inflation a growing threat, the unexpected policy lesson is that the subsidies that the European and US governments give to their farmers are keeping the price of food down globally. So, in effect, these are subsidies that are paid by taxpayers in rich countries to help urban consumers in poor countries.

Are our trade negotiators barking up the wrong tree by asking the rich nations to cut the subsidies they give to their farmers?

Your comments are welcome at ­cafeeconomics@livemint.com

Escaping caste traps

An experiment by two economists shows people can lose out even when there is little overt caste discrimination

Cafe Economics | Niranjan Rajadhyaksha

A neat little experiment conducted by two economists in 2004 tells us a lot about a very contemporary debate —the persistence of caste traps. It is useful to revisit their experiment at a time when the reservations debate has flared up once again. This experiment suggests that caste is a deep-rooted problem that can persist despite laws banning discrimination as well as more specific interventions such as selective reservations.

Karla Hoff of the World Bank and Priyanka Pandey of Pennsylvania State University collected a group of 622 boys and girls at a junior high school in a village in Uttar Pradesh. They wanted to find out the effects of caste on performance. These students were in classes VI and VII. Half were from the so-called upper castes and the other half from the so-called lower castes.

The children were asked to solve a maze. Those who successfully completed the game were rewarded with money. So, there was a clear economic incentive to play the game for the benefit of the researchers. At first, the castes of the participating children were kept secret. There was very little difference between the success rates of children across castes during this part of the experiment.

Then the castes of the participating children were publicly announced during a second round of the experiment. The lower-caste children suddenly performed significantly worse during this round. The number of mazes that they successfully solved fell by a quarter.

The results of these trials show that people can continue to be victims of caste and racial stereotypes even when there is no legal discrimination in a society. We are aware of how biases affect the way people from certain castes are perceived. The problem here is different: Stereotypes become self-fulfilling. People tend to unconsciously behave in accordance with the way they are stereotyped. Similar experiments have been conducted in the US. One shows how the performance of black Americans taking the Graduate Record Examination (GRE) slipped when they filled questionnaires asking them to reveal their race.

Such experiments show that people tend to conform to stereotypes—and could lose out in life though there is little overt discrimination.

There are several reasons to be wary of jumping to any grand conclusions from the results of one experiment. First, the Hoff-Pandey trial was conducted in rural Uttar Pradesh, a region that has seen far less social reform, economic development and mobility than many other parts of India. So, it is an unrepresentative region in many ways. And the results cannot be used for national policy.

Second, the current debates on reservations in education are focused on the intermediate castes rather than the lower castes. Members of these castes have never suffered the brutal discrimination that the Dalits faced over the centuries. I doubt the caste factor would be so important in case the two groups of children solving the maze were from the “upper” and “intermediate” castes.

One solution is to create or support a “big push” to break the fetters of caste stereotypes. “Policies attempting to reduce inequalities need to be highly cognizant of the prevailing cultural norms. In the low-caste case, for example, simply giving supply-side incentives or reservations alone may not solve the problem. The tug of the prevailing norms can be stronger than material interests. The flip side of this logic produces a classic “big push” type of argument. If some small group of individuals who are typically discriminated against does manage to break the norms and succeed, the effect can be powerful. They can serve as role models for many others and remove at least the norm-induced barrier,” says Harvard economist Sendhil Mullainathan in a recent paper.

This happened in Maharashtra with the success of B.R. Ambedkar, who showed millions that there could be a life beyond the traditional demeaning jobs that others in his caste were condemned to. One example: Narendra Jadhav, who grew up in the slums of Mumbai, rose to become chief economist of the Reserve Bank of India and is now vice-chancellor of Pune University, writes in his autobiography how as a child his aim in life was to become a petty gangster. That was what his peers became. It was the Ambedkar movement that led Jadhav to the road to success. He, too, is now a role model for the next generation of Dalits.

Finally, hear what the World Bank says in its World Development Report 2006: “Discrimination and stereotyping have been found to lower the self-esteem, effort and performance of individuals in the groups discriminated against. This reduces their potential for individual growth and their ability to contribute to the economy.”

Caste is a tricky issue and there can be no easy answers. But, it is unfortunate that the debates all around us depend more on passion rather than fact. Meanwhile, cynical politicians such as Arjun Singh can play the divide-and- rule game.

Your comments are welcome at cafeeconomics@livemint.com

Finders and seekers

Innovation has many dimensions

Cafe Economics | Niranjan Rajadhyaksha

This year marks the 125th anniversary of the patron economist of innovation. Joseph Schumpeter was born on 8 February 1883 — and his work on innovation and the role of the entrepreneur continues to be a beacon to economists, businessmen, management consultants and venture capitalists. Economist Lawrence Summers has said that the 21st century will be the century of Schumpeter.

It is usually believed that true innovation emerges out of the tinkering of smart people in labs, garages and university dorms. Think of Larry Page, Sergey Brin and Google. But there is also the structured innovation that comes from large companies. Think of the team of engineers at Tata Motors who designed the Nano. We usually tend to underplay the importance of the corporate innovation, especially if it is part of a slow-burn process of incremental advance.

Schumpeter often wrote later in his life that large companies, too, could be hotbeds of innovation. “By the mid-20th century”, writes his biographer Thomas K. McCraw, (Schumpeter) was arguing that innovation “within the shells of existing corporations offers a much more convenient access to the entrepreneurial functions that existed in the world of owner-managed firms”. In other words, it isn’t necessary to start your own firm to satisfy your entrepreneurial urges; you can do it within the innards of a large company.

Innovation has many dimensions. One of the most fascinating research programmes that I have come across in recent years is that of David Galenson, a professor of economics at the University of Chicago. In a series of papers that he has published over the past decade, Galenson has identified two types of innovators — the conceptual innovators and the experimental innovators.

Galenson says that the conceptual innovators are the finders. They make bold leaps and challenge the existing way of looking at the world and doing things. This group mostly does its best work at an early age. The experimental innovators are seekers who gradually reach their goal, taking one step at a time. Their best work usually gets done later in life.

Galenson derives his insights by studying artistic achievement. He has recently published two new papers for the National Bureau of Economic Research (NBER) in the US. Take the movies — and two directors born in 1930. Jean-Luc Godard changed the grammar of cinema when he was in his 30s, but declined later. Clint Eastwood did not pick up the director’s megaphone till he was past the age of 40; and his best directorial work has come in his 60s. Godard directed Breathless when he was 30 while Eastwood made Letters From Iwo Jima at the age of 76. Galenson says that Godard was a conceptual innovator while Eastwood is an experimental innovator.

Cinema is just one arena where Galenson has picked his insights. The same patterns of innovation can be seen in other arts such as architecture, poetry, painting and novel writing. So Pablo Picasso was a conceptual innovator. Paul Cezanne was an experimental innovator. Among poets, T.S. Eliot was in the first category while Robert Frost was in the second. Among novelists, Ernest Hemmingway produced his best work at an early age while William Faulkner gave us his classics later in his life. “The elegant and sophisticated poetry of Cummings, Eliot, Pound, and Wilbur grew primarily out of imagination and study of literary history, and was formulated conceptually, while Bishop, Frost, Lowell, Moore, Stevens, and Williams produced poetry rooted in real speech and experience, drawing on the observed reality of their daily lives to innovate experimentally,” wrote Galenson in a 2003 article.

Galenson’s insights can be adapted to the world of business and innovation. Some businessmen strike like lightning at a young age. Others gradually come into their own later in their life. It is fair to say that Bill Gates was at his best in the early years of Microsoft. Sam Walton changed the retailing industry only much after he had moved into middle age. His innovations took place at a glacial pace, and were not the result of one inspired idea but gradual learning born out of experience. Steve Jobs seems to have magically transcended the divide.

Other economists too have tried to understand the interplay between drastic and incremental innovation. One group, for instance, believes that upstream firms usually produce drastic innovations while downstream firms tend to use these drastic innovations to produce their own incremental innovation.

Coming back to Galenson’s two categories of innovators, perhaps the distinction between the seekers and finders extends to national innovation systems as well. Would it be correct to say that the US is a nation of seekers while Japan is a nation of finders? And what about India? And Indian industry? Are we more finders or seekers? I invite readers to write in with their answers to these questions.