## Thursday, April 30, 2015

### 5 steps forward, 2 steps back

The Ministry of Finance had begun:

• Monetary policy framework agreement (MPFA)
• Shift government bond market regulation to SEBI
• Shift commodity futures regulation to SEBI
• Establish the Public Debt Management Agency
• Shift regulation-making power for non-debt flows (under Section 6 of FEMA) from RBI to MOF

Two  of these were rolled back today -- bond market regulation and PDMA. Here's a response by Ankur Bhardwaj in the Business Standard.

The lack of a bond market is going to weaken the monetary policy transmission, thus making it harder for the MPFA to work. The presence of debt management at RBI is a conflict of interest, which makes it harder for the MPFA to work. The reforms could have worked because they reinforce each other.

Now RBI will have excuses: lacking a monetary policy transmission, they were not able to do inflation targeting; owing to the problems of selling government bonds, they had to keep interest rates too low and SLR too high. The agent who has multiple objectives is accountable for none.

## Tuesday, April 28, 2015

### Can India leapfrog into decentralised energy?

India woke up to telecommunications through the reforms of the late 1990s: the power of DOT was curtailed, VSNL was privatised, private and foreign companies were permitted, new methods of working were permitted. At the time, wired lines were mainstream and wireless communications was novel. However, setting up wire lines in India is very hard. India leapfrogged, and jumped into the mobile revolution for both voice and data. The concept of not having a land line at home was exotic in the US when it was normal in India. In similar fashion, India was an early adopter of electronic order matching for financial trading, and of second generation pension reforms: these things became mainstream in the world after they were done in India.

Could similar leapfrogging take place in the field of electricity? An important milestone in this story will come about with the announcement by Tesla Motors on Thursday the 30th of April, 2015.

### The problem of electricity, worldwide

Electricity consumption fluctuates quite a bit within the day. More electricity is purchased when establishments are open (i.e. daytime), when it's too hot or too cold, and when humans are awake in the dark. The electricity system has to adjust its production to ensure that instantaneous consumption equals instantaneous generation.

If producers are inflexible and consumers are inflexible then generation will not equal consumption. The puzzle lies in creating mechanisms through which both sides adjust to the problems of the other in a way that minimises costs at a system level.

For producers, it is not easy to continually modify production to cater to changing demand. The two most important technologies -- coal and nuclear -- are most efficient in large scale plants which run round the clock. It may take as much as a day to switch off, or switch on, a plant. These plants are used to produce the base load': the amount of electricity that is required in the deep of the night. Other technologies and modified plant designs are required to achieve flexibility of production within the day. This flexibility comes at a cost. Suppose the lowest demand of the day is $L$ and the highest is $H$. For the electricity system as a whole, a given level of average production is costlier when $H/L$ is higher. The cheapest electricity system is one where $H/L=1$; this runs base load all the time.

Matters have been made more complicated by renewables. Solar energy is only available when it's light, while peak demand of the day is generally in the late evening. Electricity generation from windmills is variable. Further, the planning and despatch management of the grid is made complicated when there is small scale production taking place at thousands of locations, as opposed to the few big generation plants of the old days.

There are thus a large number of decisions: how to produce, how much to produce and when, how much to consume and when. Economic efficiency is achieved by putting a market in between buyers and sellers, where the price of spot electricity continuously fluctuates. The electricity industry, organised around this price, becomes a self-organising system where a large number of players make uncoordinated decisions about how much and when to consume, how to produce, and how much and when to produce. The price in this market is the summary statistic of the problem of electricity, worldwide' as articulated above. Here's an example (source) of the key patterns, from PJM Interconnect, the biggest power market of the world:

 Figure 1: Demand and price of electricity at the PJM Interconnection

The orange line shows consumption. This was lowest on Saturday night at around 70 GW. It peaked in the evening of Thursday at around 160 GW. This was $H/L> 2$! This gave huge fluctuations in the price, which is the blue line in the graph above. Base load production has no flexibility and was probably configured at 70 GW. When demand was 70 GW, the price was near zero, given the inelasticity of base load production. The price went all the way up to 450 \$/MWh at the Thursday peak. From the viewpoint of both consumers and producers, these massive price fluctuations beg the question: How can we do things differently in order to fare better? The question for consumers is: How can purchase of electricity from the grid be moved from peak time to off-peak time? The question for producers is: How can more production be achieved at peak time? ### Unique features in India All this is true of electricity worldwide. Turning to India, there are two key differences. The first issue is that ubiquitous and reliable electricity from the grid has not been achieved. The mains power supply in India is unreliable. The euphemism intermittent supply' is used in describing the electricity supplied by the grid in India. Households and firms are incurring significant expenses in dealing with intermittent supply (example). Intermittent power imposes costs including batteries, inverters, down time, burned out equipment, diesel generators, diesel, etc. Diesel generation seems to come at a cost of \$0.45/kWh. When power can be purchased from the grid, it isn't cheap, as a few buyers are cross-subsidising many others.

In large parts of India, the grid has just not been built out. There are numerous places where it would be very costly to scale out the conventional grid. There are places in India where calculations show that a large diesel generator in a village has strengths over the centralised system. There are small towns in Uttar Pradesh where private persons have illegally installed large generators and are selling electricity through the (non-functioning) grid, in connivance with the local utility staff.

Global discussions of energy systems talk about base load and peak load. In India, the existing generation capacity is not adequate even at base load! The apparent $H/L$ in the data is wrong; demand at the peak is much greater than $H$ -- we just get power cuts. Every little addition to capacity helps. There has been a large scale policy failure on the main energy system. Perhaps more decentralised solutions can help solve problems by being more immune to the mistakes of policy makers.

The second interesting difference is high insolation with high predictability of sunlight.

Compare the insolation in Europe:

 Figure 2: Insolation in Europe

against that in India:

 Figure 3: Insolation in India

(source for these maps). Note that the deep blue for the European map is 800 kWh/m$^2$ while for the Indian map, the same deep blue is 1250 kWh/m$^2$. Arunachal Pradesh and Sikkim get more sunlight than Scotland.

### Innovations in renewables

Substantial technological progress is taking place in wind and in solar photovoltaics (SPV).

Wind energy is enjoying incremental gains through maturation of engineering, and also the gains from real time reconfiguration of systems using cheap CPUs and statistical analysis of historical data from sensors.

The price of crystalline silicon PV cells has dropped from \$77/watt in 1977 to \$0.77/watt in 2013: this is a decline at 13% per year, or a halving each 5 years, for 36 years. This is giving a huge surge in installed capacity (albeit a highly subsidised surge in most places).

For decades, renewables have been a part of science fiction. Now, for the first time, massive scale renewable generation has started happening. The present pace of installation is, indeed, the child of subsidy programs, but the calculations now yield reasonable values even without subsidies. If and when the world gets going with some kind of carbon taxation, that will generate a new government-induced push in favour of renewables, which could replace the existing subsidies in terms of reshaping incentives.

### Innovations in storage

Electricity generation using renewables is variable (wind) or peaks at the wrong times (solar). In addition, wind and solar production is naturally distributed; it is not amenable to a single 100 acre facility that makes 2000 MW. These problems hamper the use of renewables in the traditional centralised grid architecture. These problems would be solved if only we could have distributed storage.

What would a world with low cost storage look like? Imagine a group of houses who put PV on their roofs and run one or two small windmills. Imagine that these sources feed a local storage system. The renewable generation would take place all through the day. When electricity prices on the grid are at their intra-day peak, electricity would be drawn from the storage system.

For the centralised system, the cost of delivering electricity at a certain $(x,y,t)$ can be quite high: perhaps households at certain $(x,y,t)$ can sell electricity back to the grid.

This is the best of all worlds for everyone. The grid would get a reduced $H/L$ ratio and would be able to do what the grid does best -- highly efficient large-scale base load technologies. The grid would be able to deliver electricity to remote customers at lower cost. Consumers would be better off, as payments for expensive peak load electricity would be reduced.

This scenario requires low cost storage. For many years, we were stuck on the problem of storage. In recent years, important breakthroughs have come in scaling up lithium-ion batteries, which were traditionally very expensive and only used in portable electronics. Lithium Ion batteries have 2.3 times the storage per unit volume, and 3.1 times the storage per unit mass, when compared with the lead acid batteries being used with inverters in India today.

Tesla Motors is an American car company. They have established a very large scale contract with Panasonic to buy Lithium Ion batteries. Nobody quite knows, but their internal cost for Lithium Ion batteries is estimated to be between \$200/kWh and \$400/kWh. On Thursday (30 April 2015), they are likely to announce a 10 kWh battery for use in homes. It's cost is likely to between \$2000 and \$4000 for the battery part, yielding a somewhat higher price as there will also be a non-battery part. (It is not yet certain that the part they announce will be 10 kWh. There are many stories which suggest this will cost \$13,000, which are likely to be wrong). A 10 kWh battery can run for 10 hours at a load of 1000 Watts. Note that Tesla is only pushing innovations in manufacturing; they are not improving battery technology. Many others are on the chase for better battery technology. Stupendous progress has happened with batteries in the last 20 years. Only two years ago, this price/performance was quite out of reach. It is a whole new game, to get a Lithium-Ion battery at between \$200 to \$400 per kWh. Suddenly, all sorts of design possibilities open up. Further, this is only the beginning. Experts in this field in the US believe that when Lithium Ion batteries are below \$150/kWh, they will be fully ready for applications in the electricity industry in the US. These experts believe this number will be reached in 5 to 10 years.

The rise of storage links up to the rise of electric cars in two ways. First, electric cars are driving up demand for lithium-ion batteries and giving economies of scale in that industry. Second, a home which has an electric car has that battery! The present technology in electric cars -- Tesla's Model S -- has a 85 kWh battery, which is good capacity when compared with the requirements of a home.

Renewables have generated excitement among science geeks for a long time, but have disappointed in terms of their real world impact. Scientific progress in renewables, and in batteries, are coming together to the point of real world impact.

Storage is one method for coping with the intermittent generation from renewables. The other method is to make demand more flexible. As an example, a smart water heater or a smart air conditioner could do more when electricity is cheap, and vice versa. This would make consumption more price elastic.

### Leapfrogging in India?

The Indian environment with expensive and intermittent electricity from the grid is an ideal environment for renewables + batteries.

Distributed generation and distributed storage are seen as ambitious cutting edge technology in (say) Germany. Perhaps the natural use case for this is in India. In Germany, the grid works -- there is no problem with achieving high availability. In Germany, there isn't that much sun. In India, every customer of electricity suffers increased costs in getting up to high availability, and there is plentiful sunlight.

A weird thing that we do in India is to charge high prices for the biggest customers of electricity. For these customers, roof-top PV systems are already cheaper. Problems in the fuel supply have given a steep rise in base load prices, and have pushed the shift to renewables.

In the US, the cost of power varies between 7 and 20 cents/kWh. In this environment, grid parity requires that Lithium Ion batteries achieve \$150/kWh. In India, the break even point is much higher. The announcement on Thursday may yield a price that is viable for many applications in India. At a campus scale in India, a small electricity system could be constructed with the following elements: • The roofs are covered with PV. • There are a few windmills. Large-scale adoption would require windmill designs which cater to aesthetic sense and not just technical efficiency. • It would make sense to add one diesel generator into the mix, with the advantage that it would run at top efficiency as it would only be used to feed the battery. (This is similar to the efficiencies of running the engine in a hybrid car). • The campus would buy electricity from the grid when it's available and when it's cheap, and use this to charge the battery. • Electricity from the grid, the renewables and the disel generator would feed the battery. • All consumption would happen from the battery. Users inside the campus would experience 100% uptime. • Electric cars and motorcycles could augment the battery capacity at the campus scale. • Cheap CPUs would give the intelligence required to seamlessly orchestrate this system, in real time, all the time. As an example, the picture below is a pretty windmill, 3m diameter and 5m high, which has a nameplate rating of 6500 watts. The output would vary with the wind, but under normal circumstances in India, we might get average production of 1500 watts from this.  Figure 4: A windmill with aesthetic qualities Sprinkling a few of these devices on a campus would be quite elegant. Here is another example, a device that is 1.5m wide, and costs 4000 Euro or Rs.260,000. A large number of installations of this nature would change the elasticity of demand for electricity. When there is peaking load, and the price of electricity is high, these installations would switch to using their batteries. This would reduce the$H/L$ratio and thus bring down the capital cost of the centralised electricity system. A related development is taking place with rural mobile towers in India. These must grapple with the problem of intermittent electricity, and are starting to do distributed electricity generation for surrounding households. They are also pushing into new storage technologies. ### Scenario 1: Hunky dory Scenario 1 is where all this happens. For this, five things have to happen: 1. Higher oil prices, ideally a carbon tax worldwide. 2. In industrial countries: continued government support for R&D and adoption of renewables and electric cars. 3. Continued worldwide scientific progress with batteries. 4. Sustained low interest rates, globally, for a long time. 5. Electricity policy in India which gives time-of-day pricing all the way to each household, and sets up an API through which a CPU at the household can query the price. Ideally, a mechanism for distributed producers to sell back to the grid at a cost which reflects the cost faced by the grid in delivering electricity at that location. If these five things happen, then we're pretty much on our way to a new world of distributed generation and distributed storage, in India and in the world outside. One interesting consequence of this scenario would be a sustained decline in crude oil prices. This would finally yield the outcome envisaged by Sheik Zaki Yamani who said in 1973: The stone age did not end because the world ran out of stones. ### Scenario 2: This shapes up as a mainstream technology for difficult areas only In an alternative scenario, these five things do not quite work out okay, and distributed generation + distributed storage do not shape up as the mainstream technology for every day use in the first world. However, this could still be compatible with the possibility that these are good technologies for a place like India where grid supply is untrusted and there is plenty of sunlight. ### An Indian public policy perspective The malleability of a late starter. In the US, where the grid is well established, these new developments threaten the business model of the existing electricity industry where vast investments are already in place [example]. In India, high availability grid power has not yet come about; the grid is far from meeting the requirements of the people. Hence, there is greater malleability and an opportunity to change course, in a direction that favours decentralisation and reduced carbon. Disrupting a broken system. If a lot of buyers in India defect from the excessive prices charged by the grid (owing to the cross subsidisation and theft), this will generate financial difficulties for the grid. As an example, see this submission in Maharashtra by the Prayas, Energy Group, and their response on the proposed amendments to the Electricity Act. Allocative decisions for the capital that goes into distributed energy. On the scale of the country, capital would shift from centralised production of electricity to distributed production + distributed storage. In the Indian public policy environment, it's always better to have self-interested households and firms making distributed choices about capital expenditures, rather than capital being placed in the hands of regulated firms. Industrial policy is not required. This article is not a call for industrial policy. We don't need to launch subsidy programs, or force car manufacturers to switch to electric, or force mobile phone towers to switch to renewables, etc. The Indian State has poor capacity on thinking and executing industrial policy. As a general principle, in public policy thinking in India, it's best to eschew industrial policy or planning, and just focus on getting the basics right. No industrial policy was required in getting to the ubiquitous water tanks on every roof in India -- it came from private choices responding to the failures of public policy on water. The invisible hand is amply at work. Indian car manufacturers exported 542,000 cars in 2014-15. Hence, these firms have ample incentive to figure out electric cars. Unreliable and expensive electricity is giving ample incentive to customers to find better solutions. Indian software services and IT product companies have ample incentive to tune into this space, and build the software end of this emerging global environment. New technological possibilities will be rapidly taken up. India should fix the grid. There are major economies of scale in making centralised electricity generation work. But we should see that we are coming at this from the opposite direction. In the West, we start from 100% centralised energy and will perhaps head towards 66% centralised energy. We in India may first overshoot to 40% centralised energy and then go up to 66% centralised energy through gradual improvements in public policy on centralised electricity. Compare and contrast this with how we see water tanks on roofs. These water tanks are the physical manifestation of the failure of public policy in the field of water. When sound water utilities come up, they will do centralised production of 24 hour water pressure, and the water tanks will go away. On one hand, the failures of public policy on electricity in India are exactly like the failures of public policy in water in India. Once it becomes possible to opt out of public systems to a greater extent, with generation and storage under the control of a campus, people will take to this. This will overshoot, going beyond what's technically sound. In the long run, when the policy frameworks on electricity become better, the share of centralised energy will go up. But there is good sense in distributed energy and it's not just a coping strategy. Even deep in the future, when policy failures are absent, there's a big role for distributed energy while there is no role for distributed water storage. For an analogy, the wireless revolution came first to Indian telecom. But now that this is established, we know that there laying fibre to the home is required in order to get good bandwidth. We will asymptotically endup converging on what's seen in the West, we'll just come at it from a different direction. India has yet to reap the efficiencies of centralised generation, transmission and distribution. We need to end subsidies and combat theft. This is the slow process of improving policy frameworks in electricity. The main point of this article is that along the difficult journey to this destination, we'll first have an upsurge of Sintex water tanks on roofs. Sound pricing rules are required. From an Indian public policy point of view, the key action point required is that moment to moment, supply and demand should clear, the spot price should fluctuate, buyers of electricity should be fully exposed to these fluctuating prices, and the spot price at all points of time should be made visible to each buyer through an API. This is not insuperably difficult. Even the present bad arrangement -- unpredictable grid outage where the price goes to$\infty\$ -- is actually pushing private persons in the right direction.

The market failure: externalities. Knowledge spillovers benefit society at large, and self-interest favours under-investment in knowledge. In the face of this market failure (i.e. positive externalities), perhaps the government can fund a few research labs [example] so as to grow skills in this emerging landscape. See Rangan Banerjee's article at page 38 of the December 2014 issue of Energy Next which talks about renewables R&D and manufacturing in India. It would help if there was a large number of pilot projects which aim to build towards campus-scale adoption, so as to have a precise sense of how well things work, solve local problems, and diffuse knowledge.

The gap in knowledge in India on batteries is large. But it is feasible for India to get into manufacturing power units, solar cells, etc. We need to study the steps taken by Japan and China to build up their capabilities in this field.

The importance of the cost of capital. Renewables involve high capital cost and near-zero running cost. The use case is critically about the cost of capital. Successful inflation targeting, and capital account openness, will give lower rates of return for equity and debt, which is required for the adoption of these technologies.

There is no market failure in energy conservation. When customers are given high prices of electricity, they have ample incentive to adopt energy-efficient technologies. India is in good shape on pricing in some areas (electricity, petrol) though not in some others (kerosene, LPG). Once the price of energy is correct, the next price that shapes adoption of energy efficient technology is the cost of capital. The failures of monetary policy and finance in India are giving a high cost of capital. Once these are solved, there is no market failure in the adoption of demand side innovations. Low interest rates and low required rates of return on equity will shift the private sector calculation in favour of energy efficient technology.

### Implications for the private sector

If this scenario unfolds as described in India, there will be a loss of momentum in centralised energy, and sharp growth in distributed production and storage of energy.

Perhaps we will get a surge in imports of Lithium Ion batteries and slow growth of lead-acid battery production in India.

### Acknowledgements

Brijesh Vyas helped me in understanding the issues and in getting the calculations right. He recommends that we read Linden's Handbook of batteries. I also thank Sanjay Arte, Ashwini Chitnis, Ashwin Gambhir, Sanjeev Gupta, Gopal Jain, Rajeev Kapoor and Anand Pai for useful discussions. All errors are, of course, mine.

## Tuesday, April 21, 2015

### The big changes in financial reform

Budget 2015 has been an important period for India's financial reforms. Indian Merchants Chamber, BSE and NIPFP had organised a meeting on these issues. From this show, here are two videos.

Yours truly:

and Ashish Chauhan:

## Friday, April 17, 2015

### The standard approach in public economics

The standard approach of conventional public economics is to emphasise that the market economy generally works well, barring a group of market failures. The job of government is to try to address these market failures. The standard checklist of market failures is:
1. Externalities -- e.g. a factory that pollutes.
2. Asymmetric information -- e.g. safety in food or medicines.
3. Market power -- e.g. firms that earn super-normal profit owing to weak competition, and
4. Public goods -- e.g. law and order.

In the standard approach we weigh market failures against the problems of obtaining effective State intervention. The barrier is public choice theory': the State is not benevolent. The citizen is the principal, the State is the agent, and there is a principal-agent problem. It is not easy to obtain performance when setting up real world arrangements that will sally forth, intervene in the working of the economy, and address market failures. This limits the class of situations where intervention may be appropriate. In a world with a perfect and benevolent State, we'd do a lot more in terms of going after market failures. In India, where State capacity is low, we are very selective and only do a few things.

### The end of asymmetric information?

Alex Tabarrok and Tyler Cowen look at the proliferation of methods to create, store and transmit information, and say that there is an increased class of situations where asymmetric information has been conquered, thus reducing the extent of market failures.

Improved access to information also reduces the public choice problem. More information about the activities of politicians and bureaucrats is available to the citizen, which reduces the principal-agent problem.

It's a good article. I felt the case was a bit overstated. E.g. reputation measures on the Internet help people see more about you, and that's good in some settings (e.g. you know something about the Uber driver), but it's a small change in a vast gulf of lack of information. E.g. the authors say : Many public choice problems are really problems of asymmetric information. I don't agree. Yes, more information will help, but the principal-agent problem between citizen and State is vast and complicated. Merely monitoring some of the activities of civil servants better does not solve the public choice problem.
There is vast asymmetric information in the relationship between an employer and an employee in most complex work places, and nothing has changed which will make a dent to this. We can think of numerous other situations where the asymmetric information has not changed.

### More or less government intervention?

The flavour of the article is that with less asymmetric information, you'd need less State. Yes, that is true, but it's also the case that with less of a public choice problem, you could use more State. In thinking about public policy, we are constantly watching the market failure that's worth addressing versus our ability to construct a State apparatus that would actually deliver the goods in trying to address this market failure. The new age of improved information cuts both ways: it reduces the places where we might want a State intervention, and it increases the class of places where we could pull off a successful State intervention.

### A new kind of State intervention

In this new age of easy capture, storage and transmission of information, I have felt that there is a new kind of State intervention: one which rearranges the information set. The State can use its coercive power to force certain kind of information to be captured or released or transmitted. This is a beautiful intervention that directly addresses the root cause of the market failure, the lack of information.

As an example, in the old analysis of insurance, there were some good drivers and some bad drivers, but the insurance company did not know who fell into what category. There was adverse selection (bad drivers were more likely to sign up for insurance) which led to high prices of insurance and many good drivers got insurance which was not actuarially fair.

This is the standard description of the market failure, in the textbooks. We can now think of a new kind of State intervention: The government forces cars to be equipped with devices that measure how the person drives. This is an intervention that directly stabs at the asymmetric information.

Here is another example which nicely illustrates an information intervention. We have been working in the field of regulation of warehouses. There is an asymmetric information problem: I submit my goods for storage at the warehouse, but I don't know how much care will be exercised by the warehouseman. There are old style interventions which reduce this information asymmetry.
In some situations, we can directly attack the information asymmetry. As an example, consider frozen food. When you deposit 1000 kilograms of cheese into a cold storage, you worry that the warehouseman will not maintain the temperature at precisely 4 degrees. But now there are low cost devices that will measure the temperature every minute and thus tell you what your cheese experienced.

Now the customer and the warehouseman can enter into a private contract where the temperature of the cheese is monitored, and a set of payoffs calculated based on the extent to which the temperature of the cheese strays above 4 degrees. Good warehousemen would think: Why don't I release this information, so that prospective customers would trust me? The trouble is: this data could be tampered with, or data could be selectively released.

This suggests the design of a government intervention: The government could establish an inspection mechanism which ensures truthful release of comprehensive data about all transactions by the warehouse. This is a combination of the new age of devices (the data logger) plus a dose of State intervention (to ensure truthful and complete data release). We could also envision a valuable State intervention that standardises the XML files which are put out by all warehousemen, which would reduce the cost of processing this data for customers.

This is an example of what I call an information intervention', which rearranges the structure of information, and thus combats the market failure that's rooted in asymmetric information.

### How Finance SEZs can matter

I have a column in the Indian Express today on how Finance SEZs can matter.

## Thursday, April 09, 2015

### Brand names versus reality

Some people like a shirt if it's a good shirt. Some people are obsessed with the brand name on the shirt. To some extent, this could be rational: I know nothing about cars, but I've had good experiences with cars by Toyota in the past, so I have a bias in favour of cars by Toyota. And yet, why is it that in some places and some times, brand names matter more? The simplest idea seems to be one of exposure. If the stakes are very small, I'll go by a brand name, but if not, then it makes sense to see through the brand name to the underlying reality.

There is some evidence that consumers are more brand conscious in some places than in others. The Harris Poll, 2011, says that the following proportions of consumers believe that good brands translate to quality products (from Table 5):

CountryFraction that's brand conscious
China92
India89
Singapore75
U.S.65
Italy63
France53
Great Britain48
Germany47
Spain41

Similar problems are found in the academic version of the pursuit of brand names: connections with the top universities, and publications in the top journals. Research ought to be about following your curiosity, pursuing important questions, getting novel and persuasive answers, and doing research that matters. As I wrote in this post on Indian economics, the process of recruiting and promoting researchers in India has become centred on the filtering by North American editors and referees. This chase for external brand names is exerting a corrosive effect upon the Indian academic profession. Managers of research have absolved themselves of their responsibility to judge who is a good researcher. At too many places, it's turned into a stultifying chase for brand names.

A variation of the brand name problem is the great man syndrome'. A person scores wins in field X, and starts talking about field Y, and is able to command credibility on field Y even though the actual knowledge on that field is low.

A person is a set of brand names (where have I studied, what organisations I have worked in, what journals I have published in), a set of capabilities (character, values, ethics, knowledge) and a set of outcomes (what have I done in life). While it appears obvious that the capabilities and outcomes should matter more, some people care more about the brand names. Why is it that in some places and some times, brand names matter more?

In an ideal world, we start at a young person of age 21 and we know little about the things that matter -- emotional endurance, values, ethics, knowledge, character. So we judge the person by the brand names: "She is an NTS scholar so she must be very smart".  (I am showing my age; I believe KVPY is now the most elite club in India). As the person grows up, we can increasingly switch gears from the brand names to the person. What matters in the 20s is the brand names; in the 30s it's personality, and after that it's character.

#### Why might brand names matter disproportionately in India?

Let's use the notation B for the brand name, D for the data that we observe, j for our judgement about a person. We start with a very flat prior P(j); we know very little. Now we get the minimal information packet -- the brand name. Under Bayesian learning, we should P(j | B) = P(B | j) P(j) / P(B). Here we seem to do a lot of learning; if we were good Bayesians, P(B|j)/P(B) is a big number. And then we observe facts about the person D. We update P(j | D) = P(D | j) P(j) / P(D). Here, we seem to do little learning; if we were good Bayesians, P(D|j)/P(D) seems to be a small number.

What is going on? Some conjectures follow:

1. One could say: "This has nothing to do with India; this is just confirmation bias', a well known bug in human decision making. We are not rational Bayesian updaters, we overweight the prior and do not attach enough weight to the data. Get used to it, this problem is everywhere."  There is something to this argument. However, there is something going on e.g. people in China seems to care more about the brand name on clothes; people in India seem to care more about the brand names on the resume. Maybe humans are the same everywhere, but are there some features of the stochastic environment which make things different across space and time?
2. In the West, the environment is stable. Trend GDP growth is 2.5%, which yields a doubling every 27 years. From age 20 to age 60, a person experiences a change from 100 to 268. This is a relaxed pace of change where people get satisfied with doing a few small steps, and can comprehend what is going on. In India, we are in an environment of far more hectic change. Trend GDP growth is 6.5%, which yields a doubling every 11 years. From age 20 to age 60, a person experiences a change from 100 to 1241. This an environment of big decisions and big consequences; this is not a comfortable locale for the cautious climber of career ladders. It is far more difficult to figure out what is going on. This is a very noisy environment. Could this high volatility generate greater conservatism i.e. inadequate updating? E.g. in money management, great returns can be owing to dumb luck, and this can happen more in a high volatility environment. In a high volatility environment, a money manager who generated high returns is less likely to have intrinsic skill -- data about performance is less informative.
3. Inequality of knowledge could also be an issue. If I know nothing about cars, I will just fall back on brand names. When journalists know less, they will fall back on brand names -- they will think that the IIT guy must be right. If the seniors in decision making roles (who judge young people for promotions or appointments) know very little, there is a greater temptation to fall back on brand names and hire the IIT guy. Critical thinking on the part of person i about person j requires a low gap in knowledge between the two. A greater use of brand names may be inevitable in an environment of high inequality of knowledge. By this logic, the use of brand names in the world of business should be lower as the results (profit, measured in rupees) are visible for all to see.
4. Principal-Agent problems are at work. Nobody ever got fired for hiring the IIT guy. When faced with the prospect of failure, the Agent seeks deniability by purchasing the brand name.

#### What goes wrong in a brand-centric world

The IIT guy may feel he has arrived. He may work less hard. He may take less risk. He doesn't have to score wins; he just has to be good enough and make it into his next job.

In academics, the research trajectory of myriad researchers is distorted by chasing brand names. A lot of people would use their lives much better if only they would dig in and research reality. This misdirection of effort results in waste. Similar things can be said all across the labour market, but it's particularly bad in academics. In the non-academic part of the world, the brand names fade away more rapidly as the person grows up.

In the US, it seems that the price paid for a brand name education is hard to justify in terms of the improvements that flow in a causal sense from that education.

One bizarre thing that I often see is an exaggerated cynicism. It's claimed that we're all clueless and ignorant and wrong. This is elaborately packaged as humility -- let's be careful to not think that thinking helps. The hidden subtext is: "Thinking is pointless, so let's just leave it to the IIT guy". By deprecating logic, we hand it over to the brand name.

#### Finding underpriced assets

The pervasive obsession with brand names has left undiscovered assets for me. I take effort to see the person rather than the brand name, and find hidden geniuses who are shunned by a brand-conscious establishment. Many heroes of the Macro/Finance Group at NIPFP fit this description. In this security selection' process, it is relatively easy to shrug aside the brand names, but it is harder to look beyond personality and peer into character.

I find some of the most impressive people in leadership roles in India are those who got there without brand names. This may be similar to what's being conjectured about women CEOs: It is so hard for a woman to become a CEO, she's got to be really good.

## Monday, April 06, 2015

### Financial reforms -- a meeting at the BSE tomorrow

Indian Merchants Chamber, BSE and NIPFP have organised a meeting at 4:30 PM tomorrow.

### Making monetary policy more potent

Tamal Bandyopadhyay in Mint, and MC Govardhana Rangan in the Economic Times, worry about the lack of effectiveness of monetary policy.

RBI officials have hinted at taking `tough actions' if banks do not respond to changes in the policy rate by RBI. This seems to be a bit odd to me. In a well functioning economy, changes in the policy rate should propagate out through a market process and not central planning. If that market process is not working out okay, this calls for reforms of the underlying problems and not more central planning.

There are three components of the monetary policy transmission:

1. The bond market: When the central bank changes the policy rate, the entire yield curve changes through yield curve arbitrage. This propagates all through the Bond-Currency-Derivatives Nexus. It impacts upon the exchange rate as currencies and bonds are tightly interlinked. It impacts upon the corporate bond market at all maturities as the corporate bond market is priced off the risk yield curve.
2. The banking system: When the central bank changes the policy rate, competition between banks forces changes in lending and borrowing rates.
3. The exchange rate: When the central bank changes the policy rate, this impacts upon capital flows and particularly debt flows. This changes the exchange rate. E.g. when we cut rates, less money comes in, which gives a rupee depreciation, which is expansionary.

These three channels rely on a sensible financial system. The first requires a bond market embedded in the Bond-Currency-Derivatives Nexus. The second requires a banking system. The third requires openness to debt flows and a flexible exchange rate. In India today, we have difficulties on all four counts:

• RBI has failed on bond market development for 25 years. This has damaged the monetary policy transmission through the Bond-Currency-Derivatives Nexus.
• RBI gives out two banking licenses every decade, and blocks foreign banks, so there is a lack of competition in banking. This has damaged the monetary policy transmission through the banking system: changes in the policy rate do not impact upon the rates at which banks borrow and  lend.
• RBI has blocked debt capital flows. This has damaged the monetary policy transmission through the exchange rate.
• RBI has emphasised exchange rate objectives. This has damaged the monetary policy transmission through the exchange rate. Things have become much worse on this count after 2013.

These four elements of RBI strategy have made RBI ineffective as a central bank. The journey to a strong and effective RBI lies in changing course on these four questions.

These four elements of RBI strategy are the barriers to make inflation targeting work. It is one thing to sign a Monetary Policy Framework Agreement, it is another to actually succeed in delivering the goods. Until the quality of economic thinking at RBI improves, we will ricochet from failure to failure.

It is important to see the triad of the recent reforms as tightly interconnected. Setting up the PDMA is important as it takes away a key conflict of interest, and leaves RBI free to focus on the inflation objective. Shifting bond market regulation to SEBI is important as it gives RBI the monetary policy transmission. These two moves are integral to inflation targeting. The people who argue against these reforms are those who are perpetuating a weak and ineffective RBI. The Ministry of Finance has been kind to RBI by doing three things, as opposed to only doing the Agreement.

The RBI is now 80 years old and faces existential questions. All these years, RBI staff could mumble some mumbo jumbo, and get away with it, as most people could not understand the mistakes in thinking. Now RBI is accountable for delivering on CPI inflation, where the target and the performance are three simple numbers. This is a whole new game. If financial sector reforms are now not undertaken, failure will be visible in public.