Eliminating Discretion: The Need for Rule Based Policies

Ever since Raghuram Rajan announced this Saturday that he would return to academia once his tenure as RBI governor expires in September, the media has been going, to use the scientific term, crazy.

“Why Rajan should stay”; “Why Rajan should go”; “Who will succeed Raghuram Rajan?”; someone even coined the cringe worthy term “Rexit” for the event. And in doing so, people forgot one very important thing. That we are focusing too much on the person, and too little on the system.

Sure, we should praise Dr Rajan for all his good work, and criticise him wherever he has gone wrong. But it is imperative that we understand the need for a robust system, an institution which is beyond politics. Most RBI governors have not been independent of political influence, and Raghuram Rajan is an odd man out. The RBI needs to be autonomous so that sound economic policy does not take a back seat in the face of populist pressures.

So, what do we need to ensure the autonomy of the RBI? The answer may lie in rule based policy making. This simply means that humans should have very little discretion in setting interest rates and the money supply, which should instead be based upon a rule; an ironclad mathematical equation that does not answer to any politician. This idea was first put forth many years ago by the Nobel Prize winning economist, Milton Friedman.

So how does it work exactly?

The idea is that we first set a mandate for the RBI. Should it worry only about inflation? Or should it worry about growth and job creation as well? Step two: once the mandate is set, we try to figure out how the money supply (controlled by RBI) and interest rates (partly controlled by the RBI) affect inflation, growth, job creation and anything else that might be part of the mandate.

For example, if the mandate is simply to prevent inflation, we can simply increase the money supply at a rate equal to the real GDP growth rate. If the quantity of money rises at the same rate as the quantity of goods and services, there can be no general price rise.

If the mandate includes focusing on growth as well, we can use the Taylor Rule, where we decide how much inflation we are willing to tolerate in order to stimulate growth.

Step three, we make a mathematical model (equation) out of our chosen rule. Then a government official can simply enter the desired level of inflation and growth into a computer, which will calculate and tell us what the money supply and interest rate should be to achieve that.

Sounds great! What are the hurdles to achieving this?

There are two main obstacles in the path to rule based policy making.

  1. Data deficiency: Although the mathematical equations are made purely by using theories, those theories need to be tested against real world observations. This is done by gathering loads of data and running statistical tests on the equations to test their validity. Unfortunately, we do not have the ability to gather reliable data in large enough quantities.

A greater part of our economy is in the informal sector, from which little data gets collected, and even then with dubious reliability. The government can help in this regard by helping firms and workers transition from the informal to the formal sector where data is collected in a standardised manner.

  1. Model building and transitioning: Even with the best economists and statisticians in India, it is doubtful that the RBI will get it’s mathematical model right on the first try. Any good policy is arrived at via trial and error. Thus in the initial phase there would be frequent, mostly small, changes to the model to reflect new insights into the workings of the economy. This might negatively affect price stability

But once the right model is discovered, our efforts will be rewarded with much needed price stability. We can enjoy the best of both worlds by way of little inflation and a high rate of economic growth.

What we can hope for

If rule based policy making is implemented, it will mean far less discretion in policy making either by politicians or the RBI governor. It will also mean policy continuity, as the government cannot easily change the rule once made, only the growth and inflation targets can be modified.

There have been concerns that another Pahlaj Nihalani, or Chetan Chauhan might be appointed RBI governor by Modi sarkar. If rule based policies become a reality, then investors, and economists like myself, can rest easy regardless of whether the government decides to appoint Dr Urjit Patel, or chooses Meghna Patel as RBI governor instead.

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To Preserve Species, Hunt them

It is almost every other day that we come across news of deforestation, or species becoming endangered and even extinct due to illegal poaching and destruction of habitat. This is followed by the usual drama of politicians “harshly condemning” such events and making “firm commitments” to stop it from happening using more “stringent laws”.

But politicians often ignore a fact widely known to economists; if there is demand, someone will supply it for a price. As long as there is a demand for ivory, tiger skin, and other animal parts, there will be poaching. As long as people demand more luxury apartments and more manufactured goods, land will be cleared for it. More government regulation is not the way to go if we want to save forests and the animals living in them.

So what can governments do?

They can accept the economic incentive for these activities instead of trying to outlaw it. There is a need to work with the forces of supply and demand rather than legislate them away. In other words, to preserve flora and fauna, they must sell off all the forests as private property for their owners, to do with as they please. Simultaneously, they must decriminalise the hunting of animals, and the trade in animal body parts.

Sounds paradoxical, doesn’t it? To understand better how privatisation will help conserve species and habitats, let us look at farms. Billions of chicken, sheep and other domestic animals are killed every year. Yet those species are in no danger of extinction. Why? Because they are private property of the farmer. Nobody but the farmer is allowed to kill his animals.

The farmer may choose to kill all his animals in one go and make more money now, but that would deprive him of future income. So the farmer thinks “I’ll kill only half my sheep now, and let the rest breed and multiply so I will have more income next year.” The farmer has an economic incentive to invest in his animals by providing living space and letting them grow.

Now come back to the jungle. Even if a poacher knows that tigers or rhinos will go extinct, he thinks “I would love to let these animals breed so that I can have more income next year. But if I don’t kill them now, some other fellow will. I will have nothing now, and nothing tomorrow as well.”

In economics, this is called the “tragedy of commons”. If everyone owns it, nobody owns it, and nobody has an incentive to preserve it. Privatisation provides the economic incentive. Take the elephants in South Africa, Zimbabwe and Botswana for example. Their elephant populations were earlier falling. But since they allowed sport hunting at game reserves, their elephant populations have been either growing or stable, but not falling.

In private hunting preserves, they have conservation practices so they have a steady supply of animals for hunters. In a year they might probably allow only 10% of the elephants to be hunted for example, depending on how many they have. And there are prices. So the rarest animals cost more, naturally. But it also depends on gender.

So if you want to kill a young female elephant, who will have babies in the future, you have to pay a lot more than you would to kill an old male elephant, since the herd size depends more on the number of females.

Interestingly, I found that it costs twice as much to kill a lion than it does for a lioness. Why? It turns out that if you kill a lioness, there is one less animal. But if you kill a lion, the next dominant lion of the pride will kill all the former leader’s cubs, which might otherwise have grown into trophy specimens for future hunters.

Or take the case of the scimitar horned oryx. It is believed that the sighting of an injured Scimitar Oryx was the origin of the unicorn myth. But I digress. The species is extinct in its native African wilderness. It is found now in captivity such as zoos and government run enclosures in very small numbers.

The one place where it has thrived is Texas, USA. There, the oryxes are kept on private hunting ranches. These are huge tracts of land which are planted with flora from Africa so that the animals feel at home. Each year people pay significant sums to enjoy an African hunting safari without having to travel to Africa. Thus the ranchers in the US and forest owners in Africa have an incentive to preserve their flora and fauna.

So what does this mean for species preservation?

Simply put, deep pocketed real estate tycoons or industrialists won’t be stopped by animal rights activists taking to the streets or a few people doing chipko andolan (tree hugging). They can only be stopped by other deep pocketed people; ones who will invest in forests for profit; ones who are willing to pay hefty sums for trophy hunting; people who will pay for a nice tiger skin rug, a fur coat, or beautifully carved ivory ornaments; they are the real hope for species and habitat preservation.

How the Government Taxes Itself

Just yesterday, I stumbled upon a news report so ridiculous that it might have been on Faking News or UnReal Times. Alas, it was not a work of fiction, but rather fact. It said that, since May 2, the Customs and Excise Department had held up a brand new MiG-29K at a Goa port, because the customs duty had not been paid by the Indian Air Force.

In other words, the Ministry of Defence had not paid a tax to the Ministry of Finance. It started earlier this year when the government decided to subject military equipment to customs duty, in order to “level the playing field” for Indian manufacturers. This has resulted in spare parts and engines for numerous aircraft being stuck at various ports till the dues of Rs 160 crore are paid by the Defence Ministry.

If the spare parts are not available, the planes cannot be serviced in a timely manner, reducing the life of the aircraft and increasing the chances of malfunctions and accidents. This problem is not limited to the Air Force and affects the Army and Navy as well. How are the soldiers supposed to guard our borders in such a situation? Does the Finance Ministry expect them to use paper planes, plastic models of battleships and remote controlled toy tanks?

And I have not even mentioned the adverse effect this will have on the quality of equipment manufactured by Indian firms because they’ll be insulated from competition. They will have less incentive to innovate and more incentive to make sub-standard gear for our soldiers. Tariffs and customs duties are bad in every sector since they result in higher prices and worse quality, but they will be especially devastating for the military. Our soldiers already use obsolete equipment and vehicles, as evidenced by exploding submarines and crashing aircraft. A tax on imports will only make things worse.

How do we fare in the civilian sphere? Not much better I’m afraid, owing to the infinite wisdom of our policy makers. Take the Central Industrial Security Force(CISF) which provides security to the airports (owned by the Ministry of Civil Aviation for most part), Delhi Metro and to other similar facilities. Even they are subject to tax. The CISF is a central police force under the Home Ministry, which has to pay tax to the Finance Ministry, because it renders services to other government departments.

Another example, from March this year, is when the Force One headquarters of Mumbai police commissionerate could not be handed over to the agency because property taxes had not been paid. Force One was set up to protect Mumbai from terror attacks post 26/11, but they can’t do their job because the BMC wants to collect taxes from the government of Maharashtra. Where are the commandos supposed to live and work? How can they protect the city if they do not even have basic housing facilities? Fortunately the Maharashtra government is considering a new law to exempt the police from property tax, but given how slow and inefficient the process of legislation is, I would not harbour any false hope.

What about the economic implications of all this nonsense? Let us revisit the first example of military equipment. Here are the steps involved:

Step 1: The Ministry of Finance allocates a certain budget to the Ministry of Defence.

Step 2: The Ministry of Defence buys military equipment from abroad.

Step 3: The Ministry of Finance charges a tax on that equipment, which was purchased using funds from the finance ministry itself.

Now think of all the resources wasted. Human resources, i.e. bureaucrats, waste a lot of time filing a ton of extra paperwork that is not needed. These highly educated bureaucrats could have done a much better job in the private sector and contributed to economic growth which is badly needed in India.

Think of all our tax money being wasted on paying these bureaucrats to process the paperwork. Enormous amounts of money which could have gone towards buying better equipment for soldiers, or building schools and hospitals, funding some other social programmes or simply giving a tax break to the poor, hard working citizen.

Think of the time that is unnecessarily wasted. In the absence of these inefficient regulations and procedures, the government would have been able to get things done more quickly and at a lower cost.

Government taxing itself is akin to me transferring money from my left pocket to my right pocket. Sure, I can do that, but it’s waste of my time and energy which I’d rather use more productively.

What is the solution to this mess?

There are a few basic measures the government can start with. The military (and ideally everyone else) should be exempt from customs and tariffs in the interests of economic efficiency. The airports should be privatised and the owners should have to pay for security, either private or provided by the CISF. Either way, the government should not be taxing its own agencies.

In conclusion I will just say this. The government has become too large, and one branch of the government often does not know what the others are doing and simply get in each other’s way. The only way out of this mess, that I can see, is to cut government down to size.

Can markets help deliver justice?

When the senior most judge of the country starts crying, you know the judicial system is in serious trouble. It is overburdened and understaffed, a perfect recipe for long delays in judgments.

This bothers me, not just as a citizen, but also as an economist. Because economists are obsessed with efficiency, and this is not efficient. And this led me to think “How can we use markets, the epitome of efficiency, to unburden the courts?

The answer to the problem may lie in arbitration. What is arbitration? Arbitration is when two parties to a dispute cannot arrive at an agreement, so they appoint a neutral third party, an arbitrator, to resolve their dispute. The parties mutually agree to go for an arbitration, and whatever decision the arbitrator makes is binding and final.

Take a simple example, of two siblings fighting over who gets to ride in the front seat of the car. They can’t reach a consensus, so they go to their parents to resolve their dispute, and whatever the parents decide is binding on them. In this case the parents are the arbitrators.

Has this been applied in real life? Yes, the Indian Arbitration and Conciliation Act of 1996 lays down the rules of how an arbitration can be done, with minimum intervention by the courts. Currently, however, it currently applies only to certain disputes between corporations, and does not cover matrimonial, anti-competition or commercial court matters.

But there is no good reason to limit the scope of the law in such a way. If a husband and wife have a dispute and want to see an arbitrator, they should be free to do so. And not just matrimonial cases but all civil disputes arising between individuals or corporations should be brought under the ambit of the Indian Arbitration and Reconciliation Act.

There are many benefits arbitration provides over a traditional court case

  1. The parties can, by mutual consent, choose their own arbitrator.

  1. The waiting period to begin proceedings is very short (no tareekh pe tareekh here).

  1. Since arbitrators are essentially private judges who are in it to make a profit, they generally take less time to resolve disputes than ordinary judges.

  1. We can appoint the right person for the right job. In a matrimonial case, the arbitrator can be a family counselor. In an anti-competition case, the parties could appoint an economist and an expert in the relevant industry. Ordinary judges, on the other hand, have all gone to law school and may not be the most appropriate people to deal with the matter at hand.

  1. Finally, there’s a lower cost to the taxpayer. If a case drags on too long in a regular court, there is some expense to the taxpayer; maintaining the court premises, salaries of the judge and other court personnel etc. This is not the case in an arbitration, where all costs are borne privately.

  1. Arbitrators are allowed, by law, to use their own procedures in their tribunals, subject to the parties’ agreement and provided they give both parties an equal opportunity to present their side of the story. This means that cases do not get hung on obscure legal technicalities as they do so often in the regular courts.

I am by no means suggesting that we replace the courts with private arbitration tribunals. On the contrary, arbitration tribunals can supplement the judiciary. There are numerous cases where both parties simply want a swift resolution, but they don’t get a court date for a long time. If we open their cases to arbitration, they will obviously be better off. But the biggest beneficiary will be the judicial system.

If the private sector, through arbitration, can take some of the burden from the judicial system, it will not only result in lesser workload for judges, but also faster dispensation of justice. Maybe then the Chief Justice will finally be able to smile again.

The Solution to Pollution? Privatise the Roads

There has been a lot of discussion about air pollution lately. Most of the focus has been on Delhi, and the government’s odd-even rule. People have supported it, and criticised it with equal passion. Critics have also suggested alternative solutions, such as improving public transport, having cycling lanes, and imposing a higher tax on new car sales.

All of these proposed solutions are ineffective at best, and will increase problems at worst. I shall briefly dwell on the problems with the proposed solutions, and then set forth my own alternative.

First, improving public transport. It will take a lot of resources, and time, and will, if history is any guide, be overcrowded.

Make cycling lanes. Okay, but apart from the fact that it is costly and time consuming, people won’t suddenly switch to cycles because there are cycling lanes. Office workers are in a rush, they won’t switch. Most people who have a car are used to the convenience and comfort that come with it, and will not be willing to give that up.

Higher taxes on new cars. This will make the problem even worse. Why? Because it will pay to keep older cars on the roads much longer. Old cars are less fuel efficient, meaning more polluting, and also less safe.

So what’s the alternative?

Privatise the roads and highways, and that will help reduce pollution. To understand why, we must go back to some basics. Okay so first of all, why is pollution bad? It’s bad because it damages the health of the people it comes in contact with.

Now, in an ideal world, where we knew exactly who has emitted the pollution and who was harmed by it, we would simply have the car owners directly compensate the victims. But we don’t know who was harmed and who did the harm. In such cases, what we do is impose a tax on the amount of pollution emitted, so the more you pollute, the more tax you pay.

“But”, you say, “each car contributes only a very tiny fraction, an infinitesimal amount of the total pollution”. That’s right. And that’s where my solution comes in.

You see, it is not cost effective for the government to check how much pollution each car emits. if we privatise the roads and highways, we could say to the highway owner, “Hey, you’re allowing millions of pollution emitting cars on your highway everyday, so you should pay a tax for all of that accumulated pollution.”

In effect we amalgamate the little teensy weensy bits of pollution, from millions of cars, into one big smoke cloud over the highway, which is a significant amount. And now we have to tax only one entity: the highway owner, instead of going after millions of drivers.

The highway owner will of course, try to reduce this cost we will impose on him. He will say to the car owners “Look, if you want to use my highway, you have to pay for it. And if you drive a big gas guzzling SUV, you’ll have to pay 10 times more than if you drive an environment friendly hybrid car, for example.”

This would make it in the self interest of the commuters to minimise the cost. Those buying new cars will go for more economical and fuel efficient cars, instead of bigger cars to be used as status symbols. A number of people will switch to public transport. And people will come up with all sorts of creative ways to reduce costs, up till the point where pollution is reduced to manageable levels.

Why this is better than other solutions

It’s cheaper, a lot cheaper. The only thing the government would have to pay for is installing air quality sensors in the city. These have to be installed regardless of whether my proposal is adopted or not. Everything else, be it overhauling public transport or building cycling lanes, is an added cost. Moreover, by selling off the roads to private owners, the government can raise enough revenue to reduce or eliminate other taxes for a few years.

It’s faster. The system could be set up within a month or two, as soon as the air quality sensors are in place. The private players would take maybe another month or two to set up their various payment systems, and probably organise it into a network for the commuter’s convenience. But private companies tend to be efficient, since they have a profit incentive.

It requires less monitoring. This one should be obvious. Instead of an entire police force standing around trying to catch an odd or even numbered car among hundreds of cars whizzing by, we just have to monitor the air quality in various areas. In areas with less air pollution, the tax rate charged would be lower, and in the areas with bad air quality, the tax would be higher.

Nobody can evade it. Every other regulation can be bypassed by creative people. Odd even rule? Get a second car. Higher taxes on new car sales? If a tax is imposed in Delhi, I can easily go to a showroom in one of the neighbouring states, buy a car from there, and drive it into Delhi. Tax evaded. Can the road owner evade tax? It’s a road, you can’t move it, you can’t hide it, hence no tax evasion.

Finally, a question that many people are bound to ask is “Why can’t the government charge people for using the roads on the basis of pollution emitted?”

It can, but it won’t be efficient. A private business person has the incentive to minimise cost and maximise profit. So a private road owner will try method A, then method B, then C and so on to keep increasing the profits and reducing the costs. The government does not do that. Bureaucrats are not spending their own money, so they don’t care about costs, and they don’t get to keep the revenue collected, so there is no incentive to experiment and increase efficiency like the free market does.

The Paradox of Mumbai

I had attended a discussion about the possibility of a bubble in Mumbai’s real estate market some time ago. The discussion forced me to think about a paradoxical situation that almost everyone has noticed. There is an excess of luxury apartments costing about Rs 3 crore on average. At the same time, Mumbai is home to Asia’s largest slum, simply because there is a shortage of affordable housing.

Since people are usually puzzled by how Mumbai has luxury apartment buildings and slums side by side, I will explain the cause and also give a solution to this problem.

Artificially low carrying costs

This is what lies at the root of this whole paradox. The property taxes in Mumbai are absurdly low, and complex to calculate. The tax should be linked only to the market price of land (the highest price which any particular piece of land will sell). Instead they have different methods of valuation depending on the age and type of construction and different tax rates for different uses of land. Under construction or vacant land is essentially undervalued which makes its price lower. Luxury apartments take four and a half years on average to sell because there aren’t enough buyers.

As Milton Friedman would say, the best way to create a shortage is to have a price lower than the market equilibrium. You think builders would make luxury apartments that they can’t sell if they had to pay high taxes for those four years? You bet they won’t.

Blame low interest rates

But the question remains that why builders construct such buildings when they can’t sell them. Apart from the fact that there are very low carrying costs, the bubble formed due to very low interest rates. Do not be fooled by the nominal interest rates charged by the banks on home loans. Look at the real interest rates. Going by the HPI (housing price index), from the year 2007 till 2014, the housing prices in Mumbai have risen by an average of about 20% year on year, higher than the interest rate charged by banks for a home loan.

As F A Hayek would say, blame low interest rates for any bubbles. It’s just inflation that’s driving the ones who invest in new projects of housing construction. As long as the real interest rates are so firmly in negative territory, people feel richer by buying a house, even if they have to borrow, since they feel that buying a house is an investment.

As the demand-and hence the price-increased, builders rushed to build more homes to satisfy the increased demand. But this demand was artificially created through low interest rates. It was just people borrowing money so they could own a second or a third home, not actually wanting to live there, but intending to sell it off later and make some quick cash. And that’s how we got an excess of luxury apartments.

Absurdities Abound

Then there are sizable areas of Mumbai where the tax is actually ZERO. Take the case of Aram Nagar. About 40 acres (that’s 1742400 square feet) of land having 367 bungalows (you do the math). The tax on those is absolutely zero, because technically it is land owned by MHADA, which charges rent from the users of this land. That “rent” works out to Rs 1200 per year per bungalow. There are many such areas in Mumbai which go tax free simply due to this convoluted arrangement.

Ironically enough, MHADA was created to improve the housing situation of low income families. It is, sadly, doing exactly the opposite.

The Solution

Property taxes need to be sufficiently high so as to deter wasteful usage of land, land-banking and the creation of real estate bubbles like the one that is currently nearing its peak. This will result in more open spaces (the lack of which we seem to constantly lament) and more affordable housing at the same time.

We simply cannot have spacious luxury apartments lying empty while people live in such deplorable conditions in the slums, and the only way to improve the situation is to have much higher taxes on land use.

Is government regulation of finite resources necessary?

I just read an insightful post by Abhijay on the economics of Harry Potter’s wizarding world. Essentially it has infinite resources, all created by magic, so there’s plenty for everyone. This concept set me thinking about our own world. People say resources are finite, that we are depleting them at alarming levels. Land, energy sources like fossil fuels, are scarce and need to be regulated, according to most people. I would like to disagree with this point of view.

Let us take the problem of land. We say land is fixed, and in a very narrow sense of land area it is. But we don’t think two dimensionally anymore. We build skyscrapers, and thus effectively increase the usable land. And it’s not limited only to residential uses. I came across this very interesting thing called vertical farming, where entire multistory towers are dedicated to growing farm produce.

Because of technology, the effective amount of resources available to us today is more, not less, compared to a hundred years ago.

Take the case of energy. How much solar energy did we have a hundred years ago? None. Because the technology had not been invented yet, it was useless to us. Even with oil, we have a phenomenon called reserve growth. The same spot over time turns out to have more reserves than initially expected. Then again, when these run out, no problem. We have developed, and are continuing to develop, various other sources of energy, of food, of any and every resource we might require.

As Abhijay rightly pointed out, today’s society would seem magical to a person from the last millennium. I would however, like to add, that the society a century from now, would probably appear miraculous to us, in that there will be many more people, enjoying a vastly better standard of living than we do now, but only if the markets are allowed to function without interference.