What do we learn from recent events?

Rakesh Mohan

The turmoil in global financial markets has set off fresh thinking on how financial regulation should be improved so as to avoid such crises.

RBI's monetary policy framework fell into place long ago, based on the knowledge of monetary economics that was prevalent at the time. Today, in mainstream monetary economics, a central bank which has notions of multiple objectives, non-transparency, etc. is seen as part of the problem and not part of the solution. So ordinarily, RBI people look at their shoelaces when there is any talk about a sound monetary policy framework.

Rakesh Mohan has mounted a spirited defence of the RBI intellectual framework, claiming that the difficulties seen in global finance are caused by the revolution in monetary policy of the last 30 years that gave us transparent central banks with predictable behaviour, low inflation and low inflation volatility. He says:

It may be ironic that the perceived success of central banks and increased credibility of monetary policy, giving rise to enhanced expectations with regard to stability in both inflation and interest rates, could have led to the mispricing of risk and hence enhanced risk taking. Yet another view is that more than success or failure of central banks, the repeated assurances of stability and guidance to markets about the future path of interest rates, coupled with the availability of ample liquidity was an invitation to markets to underprice risks. This view, consequently, puts the blame on those central banks who failed to give space to markets to assess risks by eschewing surprise elements in policy.

If he's right - if central banks can help matters by building in elements of surprise - it would amount to a major revolution in monetary economics. As Andrew Rose once said about a paper by Surjit Bhalla : `This is either a home run or it's totally wrong'.

Reading between the lines, the subliminal argument is that an RBI which is non-transparent and unpredictable, one that delivers high inflation and high inflation volatility should be kept safe from reform.

Alan Blinder

This is not the mainstream view amongst the top people in monetary economics. Alan Blinder and Fred Mishkin are remarkable thinkers, combining top quality knowledge of academics economics coupled with real-world experience in policy making. Alan Blinder offers his views in the New York Times on how financial regulation should be improved in the wake of the difficulties with sub-prime loans in the US housing market. His `fingers of blame' are:

1. You could blame households for reckless borrowing. But in all probability, such frailty in the thinking of individuals will recur, and you can't do anything about it.
2. Some lenders sold mortgage products that were plainly inappropriate for customers.
3. Bank regulators should have done more in protecting lending practices.
4. Investment bankers dreamed up and marketed complex products.
5. Credit rating agencies didn't get it right, and credit rating agencies suffer from serious underlying conflicts of interest.

Blinder summarises saying `we don't have to destroy the subprime market in order to save it', and no, he does not require a radical reshaping of monetary economics to accomodate recent events.

Fred Mishkin

And, Fred Mishkin reminds us of the analytical core of monetary economics:

1. Inflation is always and everywhere a monetary phenomenon
2. The benefits of price stability
3. No long-run tradeoff between unemployment and inflation
4. The crucial role of expectations
5. The Taylor principle [link]
6. The time-inconsistency problem
7. Central bank independence
8. Commitment to a nominal anchor
9. Financial frictions and the business cycle.

Putting it together

As Blinder and Mishkin suggest, learning from recent events does not require a counter-revolution in monetary economics, to undo the remarkable achievements of the last 30 years.

In my understanding, a monetary policy framework like the RBI recipe of non-transparency, unpredictability, multiple objectives, and eschewing plain English, etc. is not new. It has been tried for many decades by various central banks worldwide. We know what it does. It gives elevated GDP volatility, it exacerbates the business cycle. Roughly 30 years ago, the smart central banks of the world started moving away from that policy framework. This change in the monetary policy regime has yielded big payoffs.

In the task of preventing RBI reforms, the argument is often made that ideas on monetary economics have changed repeatedly in the last 100 years, hence all proposals for progress are mere fads. I find this to be a pretty anti-intellectual defence. Yes, we use computers today and we used calculators only 30 years ago, and there is a certainty that the devices we will use 30 years from now will be different from where we stand today. But that is no basis for suggesting that one should not change in response to changing ideas, that one should not stay at the frontiers of human knowledge. Just because people moved on from using calculators to using computers, it doesn't mean we should continue to use calculators today.

Tailpiece: credit rating agencies

While I'm on this subject, I should also point you to a wealth of interesting material which has appeared on credit rating agencies. In addition to my earlier blog entries, look at:

1. Unsafe at any rating by Mark Gilbert
2. Rating firms' practices get rated
3. How and why credit rating agencies are not like other gatekeepers by Frank Partnoy, 2006.
4. Credit and blame, in The Economist
5. Rethinking the emphasis on credit rating agencies in Basle-II by Willem Buiter
6. Model revisions at Moody's

The new monetary economics

The Revolution in Monetary Policymaking Institutions by Alex Cukierman is useful fodder for thinking about reforms of the monetary policy framework in India.

Inflation is a stubborn problem

Ila Patnaik says that inflation continues to be a serious problem.

Convertibility + floating rates: sooner rather than later

Subir Gokarn has a piece in Business Standard about the great debates of exchange rate flexibility and convertibility, where he says:

... the rupee appreciated by about 10 per cent in a matter of months, the same magnitude of change it had experienced in the much longer period of five years. Not too many people complained about a 10 per cent change over five years, whereas lots of people screamed bloody murder at the appreciation between March and July 2007.

Until last weeks developments, it appeared that the RBI was reverting to the managed exchange rate approach, after having allowed a 10-12 per cent appreciation to take place. Last weeks surge, however, demonstrated that even this position may be untenable in a relatively stable global financial environment, in which India is among the more attractive investment destinations and looks likely to attract larger and larger capital inflows as more and more investors try not to lose out on the opportunity. If this trend continues, it will make no difference at what exchange rate appreciation is resisted. Further reserve accumulation and the monetary pressures that it exerts are inevitable.

The only sustainable exchange rate policy in this situation is a genuine float. This, in turn, can be accomplished only in an environment of full convertibility. For a market to function efficiently, all eligible participants should be able to trade without restriction; currently, the limits on outward investments by resident individuals, as generous as they may be, are a constraining factor on efficient price discovery.

But, this is easy to justify as an objective or target. What does cause concern is the speed of transition. As is quite clearly demonstrated by the contrast in the rate of rupee appreciation in the recent past, a gradual movement is quite palatable to all those who might be impacted by it, whereas a rapid adjustment of similar magnitude towards a market outcome (which, clearly, hasn't been reached yet) raises howls of protest, presumably because they have not been able to counter the effects of appreciation with offsetting increases in efficiency in the short time available.

If one accepts the inevitability of a market-determined exchange rate (whatever it may be), while also recognising that abrupt movements are disruptive and painful, finding the middle ground involves laying out a transition roadmap, which will allow us to achieve the objective in a reasonably short period of time, while also allowing affected interests to make the adjustments necessary to accommodate the change.

We do have a transition plan towards full convertibility, which visualises us achieving that state by 2011. Going by our recent experience with the increase in capital inflows, however, that is way too far into the future. However, whatever the timeframe that may be set, there are two key preconditions that need to be fulfilled. First, the financial system has to raise its levels of protection against the eventuality of sudden and sharp capital outflows. This requires both consolidation amongst sub-optimally sized institutions and sophisticated risk management systems. The latter are being steadily built up but the former is clearly not taking place at a rate that is consistent even with this very generous timeframe.

Second, the markets and instruments that investors and intermediaries need to hedge their exposures at as low a cost as possible need to be developed or, where they already exist, strengthened. Both these are processes involving continuous movement towards an end goal, which is itself constantly shifting, so they can never be deemed to be finished. Equally, however, there is some minimum threshold at which the benefits of a floating currency outweigh the risks; it is this threshold which needs to be targeted within a timeframe that is far shorter than seven or five or even four years.

...

So far, we have been looking at a floating rupee as the culmination of a long and elaborate process, which may never end. In todays global environment, we will be better off doing the reverse; accept a floating rupee as both inevitable and desirable and work backwards to satisfy some critical threshold conditions as quickly as possible

The outlook for Maharashtra and Gujarat

R. N. Bhaskar has written a three-part article in DNA about the decline of Maharashtra. This particularly caught my eye because I just noticed that in the CMIE Capex data, Maharashtra is at rank 10 amongst the 20 large states when ranked by the value of projects `under implementation' expressed on a per capita basis. I was very surprised when Maharashtra came out at the median and not around the top. The top five are Haryana, Orissa, Himachal Pradesh, Gujarat and Uttarakhand.

I have long noticed the theme of `finance follows trade'. Where international trade blossoms, there is a natural consumption of international financial services. Bhaskar rightly points out the edge that has developed with Gujarat in ports. He writes about the remarkable Mundra port. I have long been struck by the fact that Gujarat has roughly half of India's ports. Putting together the picture on roads, ports, and the possible freight corridor, this could give Gujarat a very good position on international trade.

So could Gujarat make a play for doing international financial services? The MIFC report is not deeply bound to Bombay: it focuses on getting the framework of financial and monetary policy in order, so that India can produce IFS. While Bombay has a natural edge, it doesn't have to be the case that an IFC takes root in Bombay. After all, only a few hundred years ago, Surat was a big commercial centre and Bombay was a barren island. :-) Bhaskar talks about the work that is going on at the outskirts of Ahmedabad to will a finance cluster named `GIFT' into existence. GIFT has a new website. Update: Some people in government seem to think similarly about the lack of binding to `M' in the MIFC report.

The US Fed rate cut

Three perspectives on the US Fed rate cut

Distress in financial firms

It is feared that many financial firms are facing the threat of bankruptcy. This naturally prompts calls for help from the financial sector (e.g., here's a particularly shrill version). Most observers understand that rescuing financial firms triggers off a `moral hazard'. If financial firms know that they will be rescued when they take high risk and things go wrong, this will encourage them to be complacent about risk. As an example, Indian Bank was rescued, and it is hard for PSU banks to be closed down. Hence, every CEO of a PSU bank sleeps easily, knowing that bankruptcy is not a threat.

Economy-wide consequences of large-scale failure of financial firms

Ben Bernanke is famous for unraveling the links between endemic bank failure in the US in the 1930s and the Great Depression; he understands this issue very well. This motivates a role for the central bank to play the role of a lender of last resort - to stand ready to lend unlimited amounts to a wide variety of financial firms in a crisis, against good collateral, at penal interest rates. There is merit in such efforts on the part of central banks worldwide. It is careful to draw the line between the lender of last resort function of a central bank and outright bailouts where `zombie firms' are kept alive. The former is fine, the latter induces moral hazard, and as recent events in the UK show, it's not easy to draw the line.

The core business of inflation targeting

The third perspectives focuses on the core business of central banks, which is setting the short-term interest rate. Perhaps the greatest achievement of 20th century macroeconomics was the understanding, towards the end of the century, of inflation targeting. When a central bank stabilises inflation, this exerts a tremendous calming influence upon the business cycle. But the key ingredient is credibility. For inflation targeting to work its magic, the public has to believe that the central bank is serious about inflation targeting, and that inflation will not stray significantly from the publicly announced target.

Deconstructing the US Fed rate cut

Central banks in mature market economies have spent decades building credentials as inflation hawks. From 1979 onwards, the US Federal Reserve has become a de facto inflation targeting central bank. The really difficult question about the present situation is: By cutting rates, is the Fed igniting inflation, and risking the loss of this hard-won credibility that has been build up by the two preceding Fed chairmen?

In my mind, an important difference between the Bank of England, as opposed to the US Fed, lies in de jure versus de facto inflation targeting. In the UK, decision makers have to worry less about the credibility of inflation targeting because it's written into the law. In the US, decision makers know that the law predates modern monetary economics. It's only by force of sheer will that Messrs. Volcker followed by Greenspan have shifted the country to inflation targeting.

Bernanke eloquently defends the de facto inflation targeting regime, saying that while the law asks for a pursuit of both low unemployment and low inflation, the only way to get low unemployment on a sustained basis is to do inflation targeting. He's right, of course, but many politicians might see this differently. As Greenspan has been emphasising in recent weeks, there are legitimate concerns about whether the US Fed will be able to hang on to this course in the years and decades to come [Mark Gilbert].

The Fed has to worry about two scenarios. On one hand, the conditions in the housing market in the US are very bad, and these could tip the economy into a recession [Feldstein]. In this case, inflation will drop in the future, and a rate cut today is appropriate as part of running an inflation targeting monetary rule. Fred Mishkin has recently emphasised the importance of a monetary policy response before large output losses are visible owing to the housing crash. John Mauldin's newsletter has a good treatment of this. On the other hand, the US economy is extremely resilient, with a rapid switching of workers from one firm to another or one sector to another. The economy could be on its way to bouncing back, in which case the rate cut could endup igniting inflation. The essence of the decision of the US Fed lay in making a call between these two scenarios.

The trouble is that the best economic models of inflation are not very good in helping to choose between these two scenarios [Lucas]. Bernanke and Co. have made a call. Time will tell whether it was the right one. The early evidence suggests that the Fed decision has stoked inflationary expectations.

The key point about their thought process is that Ben Bernanke, and everyone else involved in the decision making, are very conscious of the hard-won post-1979 track record of the US Fed as being an inflation targeting central bank, despite an outdated legal framework. They would be loath to squander this credibility. In other words, if they have decided to cut rates, it must mean that in their judgment, things are really bad in the US economy.

Herein lies the conundrum. Financial markets seem to think that the rate cut is good news. But when we deconstruct the Fed decision, it seems to be predicated on a gloomy assessment.

Why is the equity market so optimistic?

Why is the equity market so optimistic when Bernanke and his colleagues, who are arguably the smartest and best-informed analysts of the world economy, are not? Do financial markets over-estimate the power of monetary policy.

Optimism about conquering the impending downturn is expressed through the analogy with the success of the US Fed in 2001. That success story should be tempered by three caveats:

1. When the 9/11 attacks took place, the Fed got a uniquely clear real-time signal about impending distress. On 12 September 2001, it was crystal clear that there was a problem. In contrast, in a normal times, no such clear data is available; a downturn is only known with a lag of many months owing to weaknesses of the statistical system.
2. After the 9/11 attacks, the downturn in the US was aggressively tackled with both monetary and fiscal policy. Not only were interest rates cut in the US; tax rates were also cut and the massive expenses of fighting two wars began. Monetary policy should not get all the credit for rescuing the economy.
3. Finally, as Nouriel Roubini emphasises, the aggressive easing of monetary policy in 2001 did not eliminate the downturn. There was a full half year of negative GDP growth in the US.

In other words, even with a modern inflation-targeting central bank, operating with supernormal information, with rare synchronisation with fiscal policy, the business cycle has not been conquered. Conditions in 2007 are surely less benign.

One difficulty lies in the demographic composition of participants in the financial markets. Inflation targeting by the world's key central banks has worked so well from 1979 onwards, that most people in financial markets have never experienced a serious recession. They may be prone to understating the business cycle.

Financial market participants are very effective at pricing and arbitrage involving one instrument at a time. But they seem to find it difficult to grapple with macroeconomic complexity, where there are many moving parts interacting in a complex way. From 2002 onwards, there has been a gulf between the perception of the economists and the markets on the `global imbalances', and particularly the co-dependence of China and the US. Many wise macroeconomists expected a complex adjustment process with many uncertainties. Financial market practitioners were sunny and optimistic. So far, the macroeconomists are ahead.

An Indian perspective

India is much more globalised these days; what happens in the US economy matters greatly to us [Ila Patnaik]. In India, RBI has weak credentials on fighting inflation. Every now and then, it surreptitiously sets about pumping liquidity into the local economy in chasing exchange rate targets, which ignites inflation.

If RBI continues to run a pegged exchange rate regime, it focuses on the clerical function of ensuring that the rupee-dollar rate does not move, and Bernanke is our central banker. When Bernanke cuts rates, capital is likely to flow into India and thus generate excessive liquidity here, thus igniting inflation. This is not in India's interests, given where India is in the business cycle. India does not have a problem of a housing market which is in deep distress; India's problem lies in having stubborn inflation that needs to be vanquished.

The most important task, in coming months, lies in insulating India from the US Fed's monetary policy. We need to establish Y V Reddy as our central banker and not Ben Bernanke. There are many uncertainties in how things will play out. Capital flows could surge into the country, in response to the falling dollar, or they could reverse themselves if there is a global flight to safety. In either case, RBI needs to refrain from trading in the currency market; it must not run a pegged exchange rate. If it is able to do this, then the currency market could actually be a shock absorber that will shield the economy from global fluctuations and US monetary policy.

If, on the other hand, RBI focuses on the exchange rate, then we are in for an unpredictable ride where decisions made by Bernanke, based on concerns of US citizens, shapes the lives of Indian citizens.

Maintenance of Parents and Senior Citizens Bill

Writing in Business World, Ashok Desai says it's `just another Congress racket', that it's better to preserve a separation of family and State.

How states are faring on investment

Ila Patnaik summarises the CMIE Capex data on investment projects at hand in the states of India. The ranking, by the value of `under implementation' projects expressed per capita, is most interesting. It makes us think afresh, and challenge many preconceptions, about which states are doing well and which states aren't.

A surprising feature of the data is the remarkably poor showing of Maharashtra. This is a failure of the politicians. As Sunil Sethi says in Business Standard today:

In its edgy, manic way, Mumbai prided itself on being the more organised of Indian cities, devoted to the work ethic, the go-getting glamour capital of the country. This is no longer true. It is now more ramshackle than Kolkata, more inefficient than Delhi and, probably, neither as rich nor as inventive as Bangalore or Hyderabad. Its cosmopolitan ethos and egalitarian energy has been hobbled by provincial-minded politicians, sectarian ideology and pick-pocket capitalism.

The capital flows puzzle

I wrote a piece in Business Standard today: The capital flows puzzle. Coincidentally, on the same day, there was a front page story by Surabhi in Financial Express which says that the RBI proposes that convertibility should not be done for the next 10 years. I'm not sure they understand that India's globalisation is not entirely in their control.

Shanta Devarajan has started a blog.

Shanta Devarajan has started a blog.

The new EPFO investment guidelines

Ashish Aggarwal and Susan Thomas talk about the new EPFO investment guidelines in Economic Times today.

Paper on forecasting nifty volatility

Vipul and Joshy Jacob of IIM Lucknow have done a paper Forecasting performance of extreme-value volatility estimators in Jnl Futures Markets. As far as I can tell, there is no freely accessible PDF file of this article on the web. The abstract reads: This study evaluates the forecasting performance of extreme-value volatility estimators for the equity-based Nifty Index using two-scale realized volatility. This benchmark mitigates the effect of microstructure noise in the realized volatility. Extreme-value estimates with relatively simple forecasting methods provide substantially better short-term and long-term forecasts, compared to historical volatility. The higher efficiency of extreme-value estimators is primarily responsible for this improvement. The extent of possible improvement in forecasts is likely to be economically significant for applications like options pricing. By including extreme value estimators, the forecasting performance of generalized autoregressive conditional heteroscedasticity (GARCH) can also be improved.

Unregulated exchanges

A system of checks and balances

Financial regulation is not always a good thing. Regulation can be over-zealous. It is too easy for a safety-first mentality to set in, where a regulator who bans everything achieves great safety and soundness, without a whiff of scandal. As an example, if the initial margin of a futures market is 100% of the notional value of the position, the clearing corporation is surely safe, but then you've lost the futures market.

It is useful to have a system of checks and balances whereby the regulated market is forced to compete, to some extent, with an unregulated market. Atleast some customers should make the choice of whether they want to be in the unregulated market. This will put pressure on regulators to not be over-zealous.

The natural participants on unregulated markets are `big' customers who can generally be expected to look after themselves, so that governments do not need to step into markets to protect them on the grounds of investor protection. The role of the State can then drop down to contract enforcement. On this subject, you might like to see page 150-152 of the MIFC report.

Unregulated fund management

The great success story of this approach, of course, is the hedge fund: an unregulated fund management vehicle accessible only to rich people. Rich people have a choice between going to a regulated mutual fund vs. an unregulated hedge fund. If the government is adding value through regulation of mutual funds, rich people will use mutual funds; else hedge funds will gain favour. The remarkable success of hedge funds worldwide suggests, to me, that regulation of mutual funds has gone too far in terms of imposing restrictions.

Unregulated exchanges

A new frontier seems to be opening up in this debate: unregulated exchanges. In the US, the Commodity Futures Modernisation Act setup a light regulatory mechanism for exchanges where there are no retail customers. This paved the way for Internet websites that do trading, and injected a new level of competition into the exchange industry.

The next frontier in private exchanges is exchanges where professionals trade in shares of unlisted companies. See this blog entry by Roger Ehrenberg. I think there are a few different fascinating angles here.

At the simplest, one can think of this as a harmless pre-IPO trading mechanism. At present, before the IPO, transactions do take place. They are preceded by old-fashioned negotiation through human networks and face to face meetings. So it seems natural to ask: Can computer technology be applied to reduce the frictions of trading? Since the firms are unlisted, and the participants are private equity investors, it seems reasonable to think that this is entirely unregulated.

But there are other, deeper implications. Suppose this works well. Then unlisted firms could treat this as a legitimate alternative to going public! Some firms could think they're better off without the entire barrage of legal and regulatory complexity which comes from doing an IPO.

In the old world, the stark tradeoff given to firms was: Stay unlisted, you have full freedom and flexibility, but there is no liquidity, and valuations are terrible. Alternatively, the firm could get listed, gain liquidity and improve valuations, but then there was a barrage of regulatory constraints.

These private exchanges could mature into offering a third path: where no constraints are imposed, a little liquidity is obtained, and maybe valuations are not as bad as used to be the case without liquidity.

I personally believe in the virtues of the `package deal' of listing on public exchanges and large-scale direct shareholding by households, backed by rules about disclosure and corporate governance, which gives remarkable liquidity and market efficiency. I've spent half my life trying to help build that ecosystem.

But we should not assume that this `package deal' is good. A viable framework for trading shares of unlisted firms, without any of the legal and regulatory overheads that come from going IPO, would improve competition against this package deal, and induce greater checks and balances in the economy.

Paper on corporate governance in India

Rajesh Chakrabarti, William L. Megginson and Pradeep K. Yadav have a paper surveying the literature on corporate governance in India.

Paper on de facto exchange rate regimes

Exchange Rate Regime Analysis Using Structural Change Methods by Achim Zeileis, Ajay Shah, Ila Patnaik. The abstract reads:

Regression models for de facto currency regime classification are complemented by inferential techniques for tracking the stability of exchange rate regimes. Several structural change methods are adapted to these regressions: tools for assessing the stability of exchange rate regressions in historical data (testing), in incoming data (monitoring) and for determining the breakpoints of shifts in the exchange rate regime (dating). The tools are illustrated by investigating the Chinese exchange rate regime after China gave up on a fixed exchange rate to the US dollar in 2005 and to track the evolution of the Indian exchange rate regime since 1993.

Four slideshows on open economy macroeconomics

The NIPFP-DEA Program has four slideshows on open economy macroeconomics.

NIPFP-DEA Research Program on Capital Flows and their Consequences

National Institute for Public Finance and Policy and the Department of Economic Affairs, Ministry of Finance, have come together to create a NIPFP-DEA Research Program on Capital Flows and their Consequences. There is a website and a blog.

Don't focus exclusively on the mutual fund agents

In Indian Express today, Gautam Chikermane points out that the mutual funds are complicit in the game of high fees and expenses.

Review of `A demon of our own design' by Richard Bookstaber

This book review appeared in Business Standard today. While on this subject, you might like to also read this article which appeared in Wall Street Journal.

A demon of our own design: Markets, hedge funds, and the perils of financial innovation by Richard Bookstaber, 2007.

Modern finance is a relatively new creation. In my reckoning, "modern" finance only got started in the early 1970s, with the launch of currency futures trading at CME in 1972, the invention of the Black/Scholes option pricing formula in 1973 and the launch of stock options trading at CBOE in the same year. In India, the starting point of "modern" finance was the rise of equities trading at NSE in 1995.

Many people who spent their formative years away from these developments, or grew up being used to Indian-style financial repression, have a profound mistrust of finance. By and large, this "fear of finance" is merely a luddite fear of the unknown and a conservative instinct biased against change. Richard Bookstaber is in a unique position of knowing the new finance from the inside. Starting from an economics Ph.D. at MIT, where Robert Merton was on his committee, to a ring side view of the evolution of modern finance, he has a tremendous knowledge of this new world. He was directly involved in the two major crisis events of modern finance - the 1987 crash in the US and the failure of LTCM in 1998. Hence, a provocatively titled book about the difficulties of modern finance by him has credibility.

It is said that great minds discuss ideas, average minds discuss events, and small minds discuss people. The accessibility of a book flows inversely from this - stories of people are highly readable, recounting events is fun, heavy pages of ideas are least read. Bookstaber has done a wonderful blend of personal memoir, where he takes you close to many of the key players of these fascinating decades, accompanied by a treatment of the major events of the period both at the level of personalities as well as a larger picture. And every now and then, he plunges into a mini-essay of big ideas.

I think this is an excellent way to write a book. Particularly in India, where most of us have little firsthand experience with the great global world of modern finance, the book is particularly useful in giving a flavour of how this world works. I would recommend that all senior staff in financial firms and financial regulators read the book. I only have a slight complaint that such an intellectually oriented personal story is not what you expect based on the title of the book.

The main puzzle of the book consists of the question: If we have devoted so much trading technology and financial economics into building modern finance, why do financial markets occasionally seize up? Why does liquidity sometimes abruptly vanish; why do `market crises' happen? Will loading on more trading technology, more financial economics and more financial innovation solve the problem - or make it worse?

There is much merit in Bookstaber's explanations. A key feature of the problem lies in the (mis)behaviour of employees of institutional investors, who suffer from two kinds of problems. First, regulations often prevent them from doing rational things. Second, the difficulties of organisational structure often give them incentives to do the wrong things.

I was disappointed that the book did not link up more explicitly to the `limits of arbitrage' argument of Andrei Shleifer and Robert Vishy, which works out the consequences of inadequate arbitrage capital in the real world, and the analysis of `liquidity black holes' by Avinash Persaud and others. I would encourage the reader to follow through from this book to an examination of those two themes.

This intellectual framework contradicts the Indian public policy bias in favour of `institutional' investors and against arbitrage. The Indian public policy bias against arbitrage is positively harmful, and constitutes one of the biggest intellectual failures of policy making in India, one that doubtless reflects the fear of finance in the minds of many key policy makers. The public policy bias in favour of `institutional' investors needs to be tempered by an understanding of their limitations. The employees of institutional investors are prevented far more often, by regulations, from engaging in rational trades. And, the difficulties of organisational structure that generate incentives for doing wrong things are only a feature of large financial firms.

In my view, the two important ways to make progress - which are not adequately emphasised by Bookstaber - are to emphasise individual market participants and to emphasise hedge funds. Individuals and hedge funds have behaviour that is less distorted by regulations. And in both cases, organisational dynamics intrudes to a lesser extent.

Review of `Politics of Change - A ringside view' by N K Singh

This book review appeared in Business Standard a short while ago.

Politics of Change - A Ringside View by N K Singh Published by Penguin Viking and the Express Group Pages 254 Price 395

The book is a collection of sunday columns in Indian Express. They have been organised by subject. Even though I had read many of these pieces before, I found the book useful and interesting; the whole is better than the sum of the parts. Most of the chapters are valuable summaries of the state of the play in one area. As an example, chapter 8 - `Taking the French connection beyond wine and cheese' - is a compact policy note on what comes next in Indo-French relations. Given the slow pace of economic reform in India, the articles are not out of date when compared with the present state of play.

An entire section of five articles deals with the oft-neglected subject of migration. The author is a pioneer in placing a high importance on the issues connected with migration, along with a few other original thinkers such as Lant Pritchett who recently wrote a prominent book on the subject. The emphasis on migration reflects the enormous importance of this `invisible' pillar of globalisation: while most discussions about globalisation have focused on the free movement of ideas, goods, services and capital, one of the most far-reaching aspects of globalisation is the movements of people.

Thinking about migration in the Indian context has gone through three phases. Initially, this field was focused on the `brain drain', with India as a source of migrants who make up the vibrant NRI community worldwide. This negative perspective on the `brain drain' changed considerably in the second phase, as NRIs have become an increasingly important facet of India's engagement with the world after the economic reforms began. We now see that the child who leaves at age 21 becomes a pillar of strength,and a key mechanism for India to plug into globalisation, at age 41. Finally, a new twist lies in India's increasing import of high skill migrants from all over the world who are coming to some of the top jobs in Indian firms. India now needs a new focus on attracting the smartest people from the whole world, on making it easy for them to relocate and work in India, and go on to citizenship.

Turning to institutional structures, there are three chapters on the planning commission, which clearly draw upon the experiences of the author as member of the planning commission. They relate nicely to the recent M. Govinda Rao vs. Kirit Parikh debate on the relevance of the planning commission in the market economy, which has been taking place on the pages of Business Standard. There is a good piece on reforms of the Ministry of Finance, one which unfortunately does not seem to have utilised the Kelkar report on reorganisation of MoF (a report which has not been released into the public domain).

A series of excellent chapters at the end come to grips with the problems of Bihar. It is hard to see a robust future for the Republic of India without addressing the fundamental State failure in poverty traps such as Bihar. The chapters reflect the extensive experience, and continued engagement, of the author with the problems of Bihar. They serve a valuable role by virtue of both helping to put Bihar on the agenda of the intelligensia, and of shedding light on the unique problems of Bihar. There are also useful pieces on other states - in particular a devastatingly accurate essay titled "The economically illiterate populism of manifestos" about Maharashtra.

The language is readable, and occasionally rises above the ordinary. As an example, the article `When sacred cows block the intersection' has this text about PSUs in the field of infrastructure: These public companies are the sacred cows in the middle of a busy intersection. They cannot be hurried or bothered but at the same time, they are risky customers, unreliable carriers and threatening competitors that clog the flow

N K Singh is a past master at the art of navigating complex political and bureacratic avenues through which fundamental economic reform gets done. The reader anticipates a flavour of that gritty detail of how things actually get done in reading the book. Unfortunately, the author has kept too many of his cards close to his chest. Too often, the book is at the level of lofty ideas and does not descend into the real world aspects of rival constituencies, fractious coalition politics and internecine bureacratic warfare. This book is worth reading, but we will all await the memoirs with great interest!

Dark skies, Ladakh

I noticed a fascinating article The Dark Side by David Owen, in New Yorker magazine, which incited me to look for and find the International Dark-Sky Park program. On a related note, see this article by H. T. Goranson. It struck me that Ladakh fits the bill as being a place with an incredibly clear and dark sky. The `Bortle Dark Sky Scale', measures the darkness of the sky but googling didn't yield the value for Ladakh.

The role of think tanks

Robert J. Samuelson has an interesting opinion piece in The Washington Post about the role of think tanks in the US setting, and a proposal for a book project that addresses a live issue (the challenges of ageing) in the US. A deep flaw of the intellectual landscape in India is that if you picked one topic, it isn't easy to find six good quality authors to debate it.

Paper on insider ownership and firm value in India

A key insight in the corporate governance literature concerns the relationship between insider ownership and firm value: "too little" insider ownership hurts the alignment of interests and "too much" insider ownership generates a lack of threat of takeover. In thinking about the Indian setting, I have generally worried that there is too little threat of takeover in India, so the complacence might set in pretty early in the game.

On this subject, I came across Insider Ownership and Firm Value by Manoj Pant and Manoranjan Pattanayak [pdf]. The abstract reads: This paper examines the effect of insider ownership on corporate value in India for the period of 2000-01 to 2003-04, using 1,833 Bombay Stock Exchange listed firms by investigating the relationship between insider’s equity holding and firm value. While the “convergence of interest” or “monitoring” hypothesis predicts a positive relationship, the “entrenchment” hypothesis predicts a negative one. This paper also provides evidence that the relationship between insider shareholding and firm value is not linear in nature and documents a significant non-monotonic relationship between the two. Tobin’s Q first increases, then declines and finally rises as ownership by insiders rises. It also confirms that foreign promoter / collaborator shareholding has a significant positive impact on firm value.

They don't seem to have been aware of a good paper on the same subject by Ekta Selarka in 2005; if someone can post a comment with a URL for this PDF, that'll help.

How to organise financial firms

In recent days, there has been much discussion about holding companies in finance. I wrote an article in Business Standard of 5 September titled How to organise financial firms. This draws on page 143-147 of the MIFC report.