Smith, Ricardo and the FM

Will high food prices strangle growth? The differing views of Adam Smith and David Ricardo can shed light

Cafe Economics | Niranjan Rajadhyaksha

Is it time to revive a dusty debate that goes all the way back to the birth of modern economics? That old dispute could help us understand a contemporary issue: How will high food prices and volatile farm output affect economic growth in the long run?

That there are concerns on this score is evident. Global food prices have been on fire over the past year. Farm productivity is stagnant. Arable land is being lost to urban expansion and climate change. Food security of the poorest could be under threat.

In his Budget speech of 29 February, finance minister P. Chidambaram made several mentions of the risks from high food prices and the near-stagnation in agriculture. He noted that capital formation in agriculture has increased from a low of 10.2% of India’s gross domestic product (GDP) in 2003-04 to 12.5% in 2006-07. He also added that farm investment has to rise further to 16% of GDP if India is to sustain 4% growth in agricultural output. While Chidambaram seemed more concerned about the immediate impact of sluggish farm output on inflation, there should be longer-term concerns about the impact on economic growth as well.

The 18th century English economist, David Ricardo, believed that societies would be forced to cultivate increasingly less fertile land as demand for food expanded. Food prices would rise, pushing up wages and rents. This would leave a smaller part of the national income for profits. Low profits would make new investments unattractive to the capitalist class. Ricardo believed that the capitalist economy would eventually settle into a stationary state of zero growth.

Ricardo was proved wrong. The discovery of the Americas led to a sudden increase in the supply of high-quality land. Technical improvements increased farm productivity. Relative prices of food have fallen dramatically over the past century. But the Ricardian belief that an agricultural pinch would act as a constraint on economic growth got a fresh lease of life in the development debates of the 1950s.

The early development debates in the 1950s in India and elsewhere took a lot from Ricardo’s glum talk about constraints on growth. Our textbooks told us how India has to ration scarce savings, foreign exchange and food if it is to grow.

Prime Minister Manmohan Singh mentioned these issues in a speech he gave on 7 February 2007. “In the past it used to be said that India’s economic growth was being held back by a trinity of internal and external constraints—a foreign exchange constraint, a food and wage goods constraint and a savings constraint. Today, we can say with confidence that we have broken each of these constraints,” he said. He also added that India now faces a new set of constraints such as poor infrastructure and the shortage of skilled manpower.

Have we really broken the food and wage goods constraint? Perhaps. But what if we haven’t? Would India be condemned to low economic growth because food inflation will push up wages and compress profits? Not necessarily, if we go by the perspective of another old economist Adam Smith.

Smith came before Ricardo. His was the more optimistic view. This 17th century Scottish economist believed that the division of labour and specialization would spur innovation and growth. No stationary state for him.

In a recent blog post on economic history, Mark Koyama of Oxford University compared the two views of economic growth. “There are, broadly speaking, two different perspectives in economic history: a Ricardian/Malthusian perspective…emphasizes the significance of the constraints that bound pre-industrial economies… This view was certainly the dominant view amongst economic historians in the post-war period and it seems also to have dominated discussions in development—particularly the emphasis on importance natural resources, savings and population control and the comparative neglect of institutional considerations that typified the approach taken in the 1950s and the 1960s follows from a Ricardian paradigm,” writes Koyama. He earlier described “Smithian growth based upon falling transactions costs and increases in specialization and the division of labour.”

Coming back to our own day and age, the question then is: Will higher food prices be an inevitable Ricardian constraint that will damage long-term economic growth or will more reforms in agriculture and related industries such as retailing help spur growth through more specialization and falling transaction costs?

It perhaps seems a bit odd that what Smith and Ricardo wrote around 200 years ago should continue to be so relevant in the 21st century. But then great economics is like a great book. Every new generation finds fresh meanings and insights from the old classics.

So: Smith or Ricardo? Who’s your choice?

India on two propellers

Tax cuts and the impending civil service pay hikes could put a lot of money in people’s pockets, and spur consumption

Cafe Economics | Niranjan Rajadhyaksha

Equity markets usually hold a mirror to the real economy around them, other than during mad episodes of irrational exuberance. A quick look at the Bombay Stock Exchange’s benchmark index thus tells us a lot about how the Indian economy has changed over the past five years.

The 30-share Sensex is weighted by market capitalization, or how investors value the entire company on a given day. On Monday, there were only two pure-play consumer stocks included in the index—ITC Ltd and Hindustan Unilever Ltd. Their joint weight in the index was 6.85%. Five years ago, the situation was remarkably different. There were four consumer stocks in the Sensex—ITC Ltd, Hindustan Lever Ltd, Nestle India Ltd and Colgate Palmolive India Ltd. They jointly made up 22.75% of the index.

The trend in capital goods is a sharp contrast. Five years ago, the two capital goods companies in the index—Bharat Heavy Electricals Ltd (Bhel) and Larsen and Toubro Ltd—had a 3.72% weightage. On Monday, despite the sell-off in the two stocks over the past fortnight, the two heavy industry heavyweights made up 8.59% of the Sensex.

There have been several other changes in the benchmark index as well, but let’s focus on this one change for now—the changing balance between consumer and capital goods stocks. This change tells us something about how the Indian economy has evolved in recent years.

There has been a splendid investment boom over the past five years, as savings and investment rates have soared. The investment rate has shot up from 25.2% of gross domestic product (GDP) in 2002-03 to 35.9% in 2006-07. This sharp rise in investment spending has increased the demand for the machines that companies such as Bhel and Larsen and Toubro crank out every day from their factories. Consumption, too, has been growing. We Indians have not stopped using soap or smoking cigarettes, stuff that the consumer goods majors sell to us. But the relative importance of investment has increased and that of consumption has declined over the past five years.

The finance ministry’s new Economic Survey provides the numbers. During the five years of the 9th Plan, three quarters of the economic growth India clocked in those years came from government and private consumption. Investment contributed the other quarter. In the 10th Plan, the two were evenly balanced. Both were almost equally responsible for pushing the economy forward. But in the past few years, investment has been the more important engine. This year, consumption will contribute 52% of economic growth while investment will contribute 55.2%. (The trade deficit will account for the rest.)

Ever since the investment boom of the mid-1990s ended, the Indian economy resembled a plane flying with one engine. Consumption spending was by far the main propeller of economic growth. It held up the economy. The second engine started whirring around 2004. That’s one reason why the balance between consumer and capital goods stocks changed in the stock market over the past five years.

Is this about to change? In his new Budget announced last month, the finance minister has cut the effective rates of income tax. This is likely to put thousands of extra crores in the hands of taxpayers. P. Chidambaram told the Times of India in a post-Budget interview that he would like beneficiaries to save half their extra money and spend the other half.

Then there the impending civil service pay hikes once the recommendations of the 6th Pay Commission are accepted later this year. The annual hike in the Union government’s salary bill could be around Rs20,000 crore, or 0.4% of GDP. The state governments will have to match this payout to satisfy their own staff. Add another Rs20,000 crore. And what if there is a backlog of arrears to be paid? More spending?

In short, the tax cuts and the civil service pay hikes could prove to be an impetus to consumption spending in the coming year or two.

And what about investment? It is likely to steam ahead, but there is another low-probability possibility. There are some early signs of an investment slowdown. “The share of fixed capital formation in GDP has fallen from 33% in the first two quarters of 2007-08 to 31.6% in the third quarter. While not of great concern (it is in the range of this share in 2006-07), the drop needs to be monitored to see if a trend emerges,” say Axis Bank economists Saugata Bhattacharya and Rituparna Banerjee in a recent note.

Could India be headed for a consumption surge and an investment slowdown, mirroring the combination we saw in the late 1990s after there was a similar mix of tax cuts, civil service pay hikes and an investment slowdown?

It’s too early to tell. But if something like this does happen, watch how those consumer goods stocks could perform.

Computers or classrooms?

The role of the teacher is restricted to switching on the computers and allocating them to different batches of children

Cafe Economics | Niranjan Rajadhyaksha

Ever since fears erupted about a decade ago that the world could be divided into digital haves and have-nots, policymakers and do-gooders have assumed quite correctly that this digital divide needs to be bridged. The most obvious first step was to give children from poor families access to computers, in school and at home. From that followed ambitious programmes as One Laptop Per Child (OLPC), which is funded by some of the world’s best firms such as Google. Some visionaries even dream of an education system where the teacher is replaced by a computer programme.

Does this plug-and-study idea really work in poor neighbourhoods? Not necessarily, it seems.

True, the initial findings were encouraging. Many studies showed that poor kids improved their exam scores when they had access to computers. But more recent studies cast some doubts on the assumption that the academic performance of children from poor families improves with access to computers. In other words, plonking a computer in front of a kid does not necessarily do the trick.

In one recent study in Gujarat, Leigh Linden, an economist with Columbia University, and the MIT Jameel Poverty Action Lab evaluated how academic performance changed when computers were introduced in classrooms. The data was collected from schools in the slums of Ahmedabad and some other towns and villages in Gujarat that are run by Gyan Shala, an NGO. Children in these schools get one hour of computer time each day. The role of the teacher is restricted to switching on the computers and allocating them to different batches of children.

Linden found that a lot depends on how the computers are used — as complements or substitutes for the teacher and the regular curriculum. The programme of computerized learning does not work too well when it is used to substitute the teacher in the normal school day. Math scores actually dropped in schools that took this path. The “out-of-school” alternative — when students sat at the computers either before or after school — showed better, though modest, improvements in academic performance. Here, the learning software is a complement rather than a substitute for the usual curriculum. Further, Linden says the worst students benefited the most in this case.

The Gujarat study shows that merely providing computers in schools is not much of an answer. A lot depends on how they are used, when they are used, and who uses them.

Another study from across the world has an even more sobering lesson. Economists Ofer Malamud and Cristian Pop-Eleches turned their eyes on what happens when poor children in Romania get computers at home. As part of a programme, called Euro 200, some poor Romanian families were given euro 200 to buy computers for their children. Other families with similar income levels did not get this subsidy because of budget constraints. The two economists compared what happened in the two groups of families which were alike in almost every other respect.

There is much to be learnt: Kids with computers saw less television, but they also had less time for their homework. Grades dropped. “The lesson from Romania’s voucher experiment is not that computers aren’t useful learning tools, but that their usefulness relies on parents being around to assure they don’t simply become a very tempting distraction from the unpleasantness of trigonometry homework. But this is a crucial insight for those tasked with designing policies to bridge the digital divide,” writes Ray Fisman, in a June article for online magazine Slate, where Malamud and Pop-Eleches’ research was cited.

Does this mean that computers have no role in classrooms? Does this mean that the age-old talk and chalk teaching routine is irreplaceable? There is no need to draw such dark conclusions. (And these are dark conclusions, since schools do need reform. Peter Drucker once pointed out that our schools are the only social institutions around us that have not changed at all since the Industrial Revolution. Everything else — from governments to workplaces to families — has been radically transformed.)

The more limited point is that it’s not just an issue of lavish funding and putting computers in classrooms. The OLPC mission statement reflects this belief: “To eliminate poverty and create world peace by providing education to the poorest and most remote children on the planet by making them more active in their own learning, through collaborative and creative activities, connected to the Internet, with their own laptop, as a human right and cost free to them.”

In the Gujarat study, Linden draws attention to several more cost-effective ways to improve the academic performance of children from poor families — cash incentives for teachers, scholarships for girls and access to textbooks. And good libraries, too. Computers are part of the answer — but perhaps not the most important part.

It takes two to tango

The car is the economy. Both the government and the central bank have one steering wheel and one set of brakes at their disposal

Cafe Economics | Niranjan Rajadhyaksha

Most of us have been through driving school — and seen the exasperated driving instructor take over the mechanical reins of the car at some point or the other. It is his deft combinations of the clutch and brake that sees the car up a hill or through a crowded street.

Something similar occasionally takes place in the world of economic policy. The two drivers trying to steer the car up a hill are the government and the Reserve Bank of India (RBI). And they cannot decide how to do it.

The current debate on how inflation should be brought under control reminds me of an analogy used by economist Alan Blinder many years ago. Blinder asked his readers to consider the problem of designing a car in which student drivers will be taught to drive. This car will need two steering wheels and two sets of brakes — one for the teacher and one for the student. Blinder used this example to illustrate an issue that has great contemporary relevance: What should be the respective roles of the government’s fiscal policy and the central bank’s monetary policy in steering the economy?

The car is the economy. Both the government and the central bank have one steering wheel and one set of brakes at their disposal. How should they coordinate between themselves to keep the car on an agreed course? Should one agency have the right to override the other in times of disagreements? Should one brake a little harder because the other is accelerating too much? These issues tell us a lot about the current fight against high inflation.

The two Indian drivers seem to be working at cross-purposes right now. It is fairly well known that RBI has been worried about the long-term damage the high inflation can do to the economy. It is only recently that the finance ministry has come around to this view. Since late 2004, the central bank has been nudging up interest rates and reducing the ability of banks to create credit in a bid to cool down the economy. Matters have become worse over the past few weeks, as inflation has jumped above the 7% level. RBI announced an out-of-turn increase in the cash reserve ratio (CRR) on 17 April. And it has followed this up with the Tuesday decision to push CRR up by another 25 basis points, to 8.25%.

And what about the government? It, too, has ostensibly been fighting the inflation battle with “fiscal measures”. These have largely consisted of dropping the import duties on some agricultural and industrial commodities. But a far more effective fiscal measure goes unmentioned — the politically tough decision to slash the fiscal deficit. A sharp drop in the fiscal deficit will do a lot to curb effective demand and inflation.

But that’s not the case. India’s total fiscal deficit — which should ideally include the deficits of the Union government, its various off-budget liabilities and the combined deficits of the various state governments — is rising at a worrisome pace. It could perhaps be close to 10% of the gross domestic product, which is not too far away from the level that led to the financial crisis of 1991.

In short, the government has been stimulating demand even as RBI has been trying to curb it. So, we have the strange decision to cut tax rates and push through a pay hike for civil servants even as inflation is rising. To revert to Blinder’s motoring analogy, the two drivers have not been working in coordination.

Some conflict between a central bank and a government is perhaps inevitable — and history is littered with examples of such conflicts. It’s because of the nature of the tasks. In a presentation made in February, Bank of Thailand’s deputy governor Atchana Waiquamdee gave a fine overview of the issue of how and why monetary and fiscal policies can be coordinated. A central bank tries to fine-tune short-term interest rates in order to influence long-term rates. It also tries to manage demand and inflation expectations through various tools at its disposal. The hope is that low inflation will keep down long-term interest rates and help investments.

Fiscal policy does have a role in stabilizing the economy. But it also has to deal with issues such as fairness in income distribution within and between generations. Tax and spending policies also affect the incentives to work, save and invest. These help sustain growth. It would thus be unrealistic to expect the government and the central bank to work in perfect coordination at every point of time. That’s why most countries have a system of discussion between the two economic authorities.

Both RBI and the government need to share the burden of keeping inflation under control. That’s not happening right now, with the government running a fiscal policy that is too loose.

It’s clear: A deep cut in the fiscal deficit will be of great help in the war against resurgent inflation. Till that is done, interest rates cannot decline.

Lessons from credit crisis

First, this period marked the end of financial arrogance. Complicated derivatives dreamed up by investment banks and priced according to fancy models proved to be worthless

Cafe Economics | Niranjan Rajadhyaksha

American foreign policy chief Henry Kissinger had once asked Chinese leader Zhou Enlai what impact he thought the French Revolution had on the world. Zhou’s answer was memorable: “It is too early to tell.”

So it is with the global credit crisis. July 2007 was the final moment of calm before the storm that has shaken and stirred many boats. As with the French Revolution, initial attention was restricted to the body count. But later, fond beliefs on economics, finance and regulation will be shattered. What will these be? As Zhou would have said—it is too early to tell.

But there should be no doubt that there will be deep and significant lessons to be learnt. America in the 1930s, Japan in the 1990s and Asia in 1997— each financial crisis led to a whole new way of looking at economies and public policy. Here is a random list of some very preliminary lessons of the past 12 months, culled from the work of select economists and practitioners.

First, this period marked the end of financial arrogance. The fond hope that computer models could make the economy predictable ignored the fundamentally uncertain nature of the modern market economy. There is a world of difference between models and markets. Complicated derivatives dreamed up by investment banks and priced according to fancy models proved to be essentially worthless.

First, this period marked the end of financial arrogance. The fond hope that computer models could make the economy predictable ignored the fundamentally uncertain nature of the modern market economy. There is a world of difference between models and markets. Complicated derivatives dreamed up by investment banks and priced according to fancy models proved to be essentially worthless.

Nobel economist Edmund S. Phelps wrote in The Wall Street Journal in March that economists are mistaken in the belief that the economy is essentially predictable and understandable. He termed this “conceit in the financial industries and central banking” and added that “considering uncertain knowledge to be certain knowledge, (is) taking us in a hazardous direction”. Scathing stuff.

Rather than admit its mistakes, the financial industry pretended to be surprised by what happened. Goldman Sachs CFO David Viniar famously said in August 2007: “We were seeing things that were 25-standard deviation moves, several days in a row.” A 25-standard deviation event is a very, very rare one. How rare? As economist Brad de Long was quick to point out, “The universe isn’t old enough for even one sixteen-standard-deviation event to have ever happened.” We know for sure that financial crises happen more often than that.

Second, some of the basic assumptions about modern central banking have been overturned, especially the belief that central banks should have a single-minded focus on inflation, ignoring other parameters such as financial stability. “Under certain conditions, concentrating on year-to-year monetary stability, in the sense of keeping of a CPI inflation target, can lead you to follow policies that are inimical to financial stability in the long run,” wrote economist Axel Leijonhufvud in October 2007.

He said low inflation lulled the US Fed into keeping interest rates too low for too long. Alan Greenspan did not worry as long as inflation was low. He was not too concerned about what was happening in the financial system. But Leijonhufvud said US inflation was low thanks to cheap Chinese imports. So, the flood of money did not at first show in the inflation numbers; but it led to excessive risk taking in the financial sector. “Inflation targeting might mislead you into pursuing a policy that is actively damaging to financial stability,” he wrote.

Third, the lessons on financial sector regulation. The credit crisis has shown that the economic cycle is at the heart of financial instability. (Or is it the other way round?) Why did banks take so many risks? Charles Goodhart and Avinash Persaud have argued quite convincingly that the capital which banks need to put aside should not be a static number. Rather, it should change with the state of the economic cycle. They have proposed contra-cyclical charges—“capital charges that rise as the market price of risk falls as measured by financial market prices”. That would work as an automatic and built-in stabilizer.

There is another issue that regulators are struggling with—what should they regulate? Central banks have traditionally regulated institutions that accept deposits from the public, since financial crises usually started with runs on banks, as depositors lined up to withdraw their money. The bank topples over and pulls down the rest of the financial system.

But what happened at Bear Stearns changes all that. Bear Stearns did not accept deposits from the public. Yet, its collapse could have pulled down the entire US financial system. In an unprecedented move, the Fed helped arrange the firesale of a financial institution that does not take public deposits. At one stroke, a century and more of central banking convention was dumped. The so-called “boundaries of regulation” expanded. From here, it is not hard for regulators to argue that all financial creatures that could seek help from them should first come under the regulatory scan.

And the lessons will mount as the crisis deepens.

The Indian profit cycle

Indian companies have learnt their lessons from the gut-wrenching boom and bust cycle of the mid-1990s

Cafe Economics | Niranjan Rajadhyaksha

Indian companies have usually done better than the overall economy in the past 10 years. Will they continue to do so in the future as well?

The answer to this question matters a lot in these times of rising inflation and slowing growth. And it could also offer useful clues to equity investors who have been battered and bruised in the crash of 2008.
The record so far seems impressive: Every year since 1998, on average, the largest listed Indian companies have managed to increase their net profits around 11 percentage points faster than the nominal economic growth, which is measured as the gross domestic product, or GDP, at current prices. This result is based on profit data from 359 of the companies that comprise the BSE 500 stock index and for whom data going back to 1998-1999 is readily available.

What does this tell us?

To use a more contemporary word to describe the situation, it seems that companies have decoupled from the overall economy in the past decade or so. They managed to run ahead of the rest of the pack. But this is a mildly misleading conclusion, as I shall try to show later in this column, because the averages hide more than they reveal.

The stellar show by Indian companies in itself is not surprising. Indian companies have learnt their lessons from the gut-wrenching boom and bust cycle of the mid-1990s. The investment surge in the middle of the last decade of the 20th century led many companies to make expensive mistakes that were exposed when the global economy fell into trouble in 1998. New projects were launched based on overly optimistic demand forecasts, were funded with heavy doses of borrowing and were backed at a time when India was still a heavily protected economy. The subsequent pain was severe.

Since then, Indian companies have focused on getting the most of what they already have — through tighter working capital cycles, productivity drives on the shop floor and cutting debt from their balance sheets. Investments in new projects picked up again only around two years ago. This discipline paid off. So, even as sales went up and down, profit growth continued to be healthy.

That sort of explains the apparent decoupling of profits from the rest of the economy.

Going by the average difference between net profit growth and nominal GDP growth — of around 11 percentage points — it would seem that Indian companies are well placed to weather the coming slowdown. Here’s a quick back-of-the-envelope calculation. The Indian economy could grow at around 15% in nominal terms this year, with real GDP growth at 7.5% and inflation at 7.5%. If companies can outgrow this rate by the average 11 percentage points, then net profits of the largest listed companies could grow at around 26%. That would make the stock market — which trades at a forward price-earnings multiple of 13 — seem completely undervalued.

But the picture is actually far more complicated than the raw averages suggest. In fact, there is only a weak correlation (a correlation coefficient of 0.54, in case you are interested in such stuff) between net profit growth and nominal GDP growth since 1998-99. What’s more, the difference between the two fluctuates wildly. The standard deviation of the data is a hefty 11.23.

There have been years when company profits have grown several times more than nominal GDP growth; there have been years when the two have more or less marched in step with each other; and there has been one year when companies could not increase their net profits faster than the overall economy.

Here are a few random examples. In 2003-04, net profits of the 359 sample companies grew by 43.32%, while the economy grew at 12.5% at current prices. In 2002-03, profit growth of 10.62% was slightly more than nominal economic growth of 7.9%. And in 1999-2000, profits grew 1 percentage point slower than the underlying economy. What will happen over the next few years?

It is too early to say for sure. But I think that the days when companies could collectively increase their profits far faster than the growth in the economy in which they operate are over. There should usually be a far higher correlation between corporate performance and economic performance. We may even see a few years of underperformance very soon — which is not unusual — as the excesses of a boom are revealed.

There will be individual cases of exceptional companies that will beat the slowdown. But equity investors would be foolish to believe that Indian companies can keep increasing their profits at a rate that is far in excess of the country’s nominal GDP growth rate.

The past, as we all know, is not a perfect predictor of the future. The past 10 years have shown Indian companies at their productive best. But the next few years may be less impressive.

Winner’s curse in cricket

As in most other auctions, investors in the IPL business also seem to have misspent their money initially

The lives of millions of Indians have settled into a predictable pattern these days—escape from the workplace as early as possible, reach home and then settle down in front of the television to watch the Indian Premier League (IPL).

The cricket has been engrossing, the level of interest drummed up has confounded sceptics and we have seen some signs of other parts of the entertainment industry suffering because of the IPL mania. I actually drove past half-empty restaurants on Saturday night and a couple of high-profile new films have run before thin audiences. The IPL has been a grand success, at least till now.

But there is a dark spot as well. The millions that were coughed up by companies and film stars to buy team franchises and individual players during the high-profile auctions earlier this year took the cricketing world by storm. However, halfway through the first IPL season, there seems to be a very weak link between the money spent and actual performance on the turf. As in most other auctions, investors in the IPL business also seem to have misspent their money initially.

Take a look at the team rankings at this stage of the tournament. Rajasthan Royals have surprised most spectators by climbing to the top of the eight-team league. It is also the team that was bought at the lowest rate—Rs268 crore. In an ironic symmetry, the three teams at the bottom of the heap are the most expensive ones—Hyderabad Deccan Chargers (Rs428 crore), Mumbai Indians (Rs448 crore) and Bangalore Royal Challengers (Rs448 crore).

A similar pattern crops up when performance of the individual players is concerned. I am not sure how individual performances should be tallied in the Twenty20 (T20) format. Should you look at the average runs scored per innings by a batsman or his strike rate or some weighted average of the two? Does a bowler have to be judged by the number of wickets he takes or the average runs he gives in every over he bowls or some combination of the two? Proper metrics have not yet been developed.

But I took a look at the individual rankings on the official IPL website earlier this week. The Top 5 batsmen on Monday night were Gautam Gambhir, Virender Sehwag, Matthew Hayden, Brendan McCullam and Rohit Sharma. The Top 5 bowlers were Irfan Pathan, Ajit Agarkar, Sohail Tanvir, Zaheer Khan and Manpreet Gony. Some of them topped the auction price lists. But overall, not too many of the batsmen and bowlers with heart-stopping valuations feature prominently in these lists of personal performance. No Mahendra Singh Dhoni (though he has admittedly been a cool-headed captain) or Andrew Symonds or Sanath Jayasuriya there.

What’s up? Most auctions—be they for works of art or telecom licences— suffer from what economists describe as the winner’s curse. This is the tendency to get sucked into a bidding war. Bidders tend to get carried away and pay astronomical prices. Cooler heads could have bough the asset cheaper. Suppose Company A bids Rs10,000 crore for an oilfield, while Company B loses out by bidding only Rs7,000 crore. Now the winner could have bagged the oilfield by paying only a rupee more than the losing bid, but shelled out Rs3,000 crore extra. That is the winner’s curse.

The early days of the IPL suggest that there is a version of the winner’s curse at play here as well. There has been overbidding and payments that are far in excess of actual performance. Of course, it is too early for buyer’s regret to set in: a “what have I gone and done” moment that can afflict many successful bidders. T20 may be a quick shot of entertainment, but the IPL business model is for the long term.

It is easy to jump from here to a hasty conclusion that this is yet another case of markets gone wrong. Ban cricketing auctions. Ban forward markets in agriculture. Ban derivatives trading. One can almost expect parliamentarians spouting some more economic nonsense the next time they get a chance.

Markets are learning mechanisms. Information is transmitted through prices. And mistakes usually get minimized over time. I hazard a guess here. There will be fewer bidding mistakes the next time around. Bidders will learn from their mistakes and they will also have the benefit of examining the record of actual performances on the field. Perhaps there will be more interest in younger players. And good spinners?

“Experienced bidders avoid the winner’s curse by bidding cautiously… Laboratory experiments corroborate this: the subjects bid too high initially, but as they become more practiced, they tend to adjust and avoid overbidding. Alert winners are not cursed,” writes Stanford University economist John McMillan in his wonderful book, Reinventing the Bazaar: A Natural History of Markets.

Cricket auctions promise to be long and exciting game.

Your comments are welcome at cafeeconomics@livemint.com

Revolving door is jammed

Finally, there now seems to be agreement between New Delhi and Mumbai — high inflation will be a stubborn guest and monetary policy is the best way to control it

High inflation has rattled Indian policymakers — and rightly so.

Look at the sequence of events. First, finance minister P. Chidambaram admitted on Friday that India faces “difficult times”. Then finance secretary D. Subbarao said on Saturday that monetary policy would be the “first line of defence” against rising prices. And Reserve Bank of India (RBI) governor Y.V. Reddy suggested on Monday that there has been a flurry of activity over the weekend. He had a detailed meeting with his senior colleagues at the central bank on Friday, then called both the finance minister and the Prime Minister on Saturday, and added that he would also be consulting members of the technical advisory committee on monetary policy.

Reddy has been uncomfortable with inflation for many months. The finance ministry has been less worried. The finance minister himself did not seem to be too keen on higher interest rates till now. Overall, the government preferred to either underplay the inflationary pressures which were building up in the economy or play the blame game by attacking speculators in the commodity markets or profiteering steel and cement cartels.

Finally, there now seems to be agreement between New Delhi and Mumbai — high inflation will be a stubborn guest and monetary policy is the best way to control it.

But there is usually a collateral damage whenever interest rates are raised. The pace of economic expansion slows. I have earlier mentioned RBI’s research published in 2002 which showed India would have to sacrifice 2 percentage points of growth for every percentage point victory against inflation. The “sacrifice ratio” may or may not be that high, but some growth will have to be sacrificed to get inflation down.

There are ways to limiting collateral damage to growth. Monetary and fiscal policies should move in opposite directions: If you tighten one, then you loosen the other. So, a tighter monetary policy to attack inflation can be balanced with a looser fiscal policy to prevent demand from collapsing. And it works the other way round as well.

I remember what Massachusetts Institute of Technology economist Paul Krugman had told me in the course of an interview I did with him in 1998 for a business magazine. “If you take back demand through one policy, you should stimulate it through another. It’s like a revolving door,” he had said.

I had interviewed Krugman in the aftermath of the Asian financial crisis. The International Monetary Fund was under attack because it was insisting that the afflicted countries in Asia should cut government spending and push interest rates sky-high, in effect condemning them to deep recession. Krugman was then arguing that fiscal contraction should be offset with lower interest rates. Lower interest would lead to further speculative attacks on regional currencies; these could be prevented through capital controls.

The revolving door needs to be brought into play once again. University of California economist Barry Eichengreen reiterated the same point in an article published in Mint on Monday, on how Asian governments should attack inflation. “Tax cuts and increases in public spending on locally produced goods will limit the contraction in aggregate demand (because of higher interest rates),” he wrote.

India needs to walk through the revolving door. But there is one problem: The door is jammed. We already have a fiscal deficit that — if measured correctly — is at its highest level in more than a decade. It would be reckless to try and ramp up public spending right now, an invitation to an economic crisis. Compare this with the situation in China, where its government has a huge budget surplus that it can spend in times of trouble. In short, India does not have the space to use a looser fiscal policy to soften the blow from higher interest rates.

That brings us to a point that this column has repeated several times. The government wasted a great opportunity to knock India into fiscal shape. That would have been handy insurance against any trouble. But this government squandered the record taxes it collected, thanks to a five-year economic boom, on all sorts of well-meaning but wasteful schemes. We have seen three policies this year — the pay hike to the bureaucracy, the farm loan waiver and income-tax cuts — that will stoke demand and put further pressure on government finances.

The government seems to have completely misread the economic situation, loosening fiscal policy when we were on the cusp of high inflation. The next government will not have the freedom to spend when the economic slowdown starts pinching a year later.

It’s not the end of the “India story”. The rise in savings and investment rates, the efficiency that has come with economic reforms and globalization and the fact that we have a young population in the midst of an ageing world are long-term advantages.

But there will be intermittent problems. Are we prepared for the one that could be just around the corner?

The rebirth of distance

The past two decades have seen the rise of a global economy that is almost seamlessly linked across thousands of miles


Sometime in the late 1990s, the tag line in an advertisement for a failed telecom venture magically morphed into a popular mantra for globalization: Geography is history, it evocatively said.

There is enough truth in this neat little phrase for it to be taken seriously. The past two decades have seen the rise of a global economy that is almost seamlessly linked across thousands of miles. Distances did not matter too much. This allowed companies to scour the world in their relentless search for low costs.

Global supply chains were born. Management gurus and economists usually roll out a long list of factors that helped this process — reforms in emerging markets, global trade deals, new business models that shattered integrated companies and much else.

There is one other factor that most people forget to mention when they discuss the success of globalization: low transport costs. It makes sense to make components in Korea, assemble them in China, and then ship them to consumers in the US only if the costs of moving widgets across the world are a minor part of overall production costs.

The inexorable climb in oil prices has rattled this pillar of globalization. The cost of shipping stuff across the oceans has shot up. By some estimates, the cost of sending a tonne of soya bean from South America to China is almost the same as the cost of procuring it from farmers. Suddenly, it looks as if geography is not quite history; distance matters.

Earlier this month, three of the world’s largest mining companies signed deals with Chinese and Japanese steel makers for the supply of iron ore. Distance was a big factor in these negotiations. A lot depended on whether the ore was being sent from Brazil (by Vale) or from Australia (by Rio Tinto and BHP Billiton).

The Australian miners managed to negotiate higher price increases for their iron ore because it costs less to ship it from their mines to China. They basically got the Chinese to share the “freight advantage” that Australian ore has over that shipped from Brazil. The spurt in global shipping costs has shattered the traditional rule that there would be one global price for iron ore. Prices depend on distance.

The big question, then, is what does all this mean for globalization? The Wall Street Journal had reported earlier this month that rising transport costs are forcing some US companies to bring production back to North America. Jeff Rubin and Benjamin Tal, two economists with CIBC World Markets, have written a much-cited report that asks whether soaring transport costs will reverse globalization.

“Globalization is reversible. Higher energy prices are impacting transport costs at an unprecedented rate. So much so that the cost of moving goods, not the cost of tariffs, is the largest barrier to global trade today… The explosion in global transport costs has effectively offset all the trade liberalization of the last three decades. Not only does this suggest a major slowdown in the growth of world trade, but also a fundamental realignment in trade patterns,” they wrote in a 27 May report.

The regular talk about the threats to globalization hovers around the usual suspects, from the Doha deadlock to the wave of rising protectionism in the West. Few have bothered about rising transport costs till now. Rubin and Tal estimate that, at current prices, transport costs are equivalent to a 9% import tariff. And, lest we forget, the link between globalization and transport costs is an old one. The drop in haulage costs allowed minerals and food to be shipped in cheaply to Europe and helped the first round of globalization at the end of the 19th century.

A lot will depend on what is being moved. Trade in low-value items that are moved across great distances will be hit the most. More valuable goods will be less affected by rising transport costs. And the movement of voice and data beamed across wires and satellites will not suffer at all; the Indian outsourcing industry is safe from this particular quake.

What follows for the rest of this column is more of a thought experiment. Let us ask ourselves a few questions.

One, will trade and supply chains be reconfigured along regional rather than global lines? And where should India look to: West Asia or East Asia?

Two, is the debate on how currencies should be priced to promote exports a bit irrelevant at this juncture?

Three, if global trade has helped bring down prices, then will the rollback of globalization because of high transport costs push up inflation and interest rates?

Far out stuff? Perhaps. It is clearly too early to conclude that the rise in fuel and transport costs will be the death knell of Globalization Ver 2.0. But what if oil goes to $200 a barrel? And what about $250? A lot of tradable stuff may suddenly become non-tradable. This is an eventuality worth speculating about. Both companies and policymakers would do well to be alive to the possibility.