Free market and meritocracy

Conservatives have for long opposed government regulation as stifling individual initiative and enterprise, and thereby causing inefficiencies, rent-seeking, and economic stagnation. Accordingly, as exemplified in the free-market focussed neo-liberal consensus and the recent Tea Party activism in the US, they advocate a very limited role for the government.

I will not go into a discussion on this. Suffice to say, the conservative argument is only part of the story. There is another dimension to the debate that is nowadays much less discussed and which poses a greater threat to economic growth than government per se. In fact, a more nuanced appreciation will lead us to the conclusion that government excesses may only be a symptom of the malaise, but not its underlying cause.

I am inclined to believe that the biggest danger facing societies and economies is the gradual sub-ordination of the institutional framework - social, economic, and political - that governs economic and political activities to the vested interests of those holding the reins of economic power. The power exterted by those at the top of the economic ladder inevitably permeates the institutional framework which determines the allocation of resources. Marx, after all, had a point.

This has several manifestations. A recent book by Charles Murray has sparked off an intense debate in the US about the divergence between the professional and working classes in white America over the last half century. In particular, it highlights how the various institutional elements in the society and economy favor the children of more well-off parents "to move seamlessly from their privileged upbringings to privileged careers" without a struggle. This stands in sharp contrast to the stiff entry-barriers and massive struggles that others face in even acessing their opportunities.

The biggest danger with such trends is the strong potential for elite capture of this institutional framework. As historians have documented, this would also involve using the government to protect and further their interests. An excellent recent illustration of this struggle is the attempt by the Koch Brothers to gain greater control in the activities of the libertarian Cato Institute in the face of strong opposition from the Cato Board.

The irony in this cannot be missed. At the back of Cato publications is written, "In order to maintain its independence, the Cato Institute accepts no government funding." However, now, reflective of the dangers posed by the power-elite, the biggest danger facing Cato is not government, but its own private benefactors. The Koch Brothers, who are major share holders in Cato Institute, want to increase their financial stake and thereby exert greater control in its activities. It is obvious that they want Cato to become unabashed promoters of their personal ideological prejudices, even at the cost of the institution's professional integrity.

In this context, Rajeev points to a brilliant old op-ed by Michael Young, who succinctly puts the issue in perspective,

It is good sense to appoint individual people to jobs on their merit. It is the opposite when those who are judged to have merit of a particular kind harden into a new social class without room in it for others. Ability of a conventional kind, which used to be distributed between the classes more or less at random, has become much more highly concentrated by the engine of education. The new class has the means at hand, and largely under its control, by which it reproduces itself...

So assured have the elite become that there is almost no block on the rewards they arrogate to themselves. The old restraints of the business world have been lifted and... all manner of new ways for people to feather their own nests have been invented and exploited.

Government and state machinery cuts both ways. They can be instruments to promote economic growth, enable access to opportunities, and reduce poverty. But they can also become the hand maiden of vested interests. Unfortunately, the dynamics of forces that drive the modern economy and governments are increasingly gravitating towards the latter. Most worryingly, the institutional checks and balances that existed to pre-empt such trends are being slowly chipped away.

I haven't yet read the recently released book, Why Nations Fail. But one of the central insights of Daron Acemoglu and James Robinson is that nations succeed, among other things, when their institutions of power are inclusive. In other words, they should not become "extractive institutions", where they become instruments to serve the interests of the elite. If this is happening in societies across the world, and there are compelling evidence, then aforementioned trends do not bode well.

Update 1 (22/3/2012)

Daron Acemoglu and James Robinson argue that the biggest concern with economic ienquality is that it brings along with it a reduction in equality of opportunity and generates political inequality,

Economic inequality will lead to greater political inequality, and those who are further empowered politically will use this to gain a greater economic advantage by stacking the cards in their favor and increasing economic inequality yet further -- a quintessential vicious circle... The wealthy have greater access to politicians and to media, and can communicate their point of view and interests - often masquerading as "national interest" - much more effectively than the rest of us. How else can we explain that what is on the political agenda for the last several decades has been cutting taxes on the wealthy while almost no attention is paid to problems afflicting the poor, such as our dysfunctional penal system condemning a huge number of Americans to languish in prisons for minor crimes?

Are free markets in information flows good for stability?

Chris Dillow has an interesting post where he compares the role played by information cascades in triggering off stock market sell-offs and riots. In this context, in a recent paper Klaus Adam and Albert Marcet show that even a very small information cascade can generate significant asset price volatility. Can the same model of information cascades be extended to explain rioting?

Extending the same logic to social and political systems, there could be a strong argument that the latest communication technologies and information dissemination channels, which remove information market frictions, reduce their stability. In the circumstances, a familiar debate, similar to that between advocates of laissez faire and those favoring a more nuanced acceptance of free-markets, appears inevitable.

Laissez faire advocates would welcome the proliferation of these technologies as contributing to increasing the efficiency of information flows. They would argue that it will help people make more informed decisions and thereby reduce distortions and prejudices that are commonplace in social, political and economic markets. Is this assessment correct? Is unrestricted information flows and social networking platforms an unqualified good? Do market failures in financial and economic systems carry any relevance for information markets?

There are a few observations on this.

1. Information markets are vulnerable to atleast some of the same failures that characterize financial markets. Mere availability of information does not guarantee efficiency in decision making. As is the case with financial markets, thanks to the cognitive biases of human beings, the manner in which the information is presented or made available has important bearing on their individual response.

2. Social and economic systems straddle a fine line between stability and chaos. Unrestricted information flows often end up unsettling the delicate balance in such systems and chaos ensues. Without going into the merits of whether the delicate balance was sub-optimal or inefficient, it is often the case that stability is the casualty when the information market is unshackled. This assumes importance since socio-political stability is critical for any economic growth and development. The instability that followed the break up of countries like Yugoslavia is an example of this.

3. This brings us to an issue of whether some form of information latency is desirable for social and political stability. For example, in a highly heterogeneous society, democracy and the formal norms of democratic governance cannot be readily transplanted without having in place several other institutionalized checks and balances. Conventional norms of majority rule can be destabilizing in these countries, as evidenced by the civil wars in the aftermath of democratic elections held in a few African countries in the nineties.

4. As information flows unhindered and the communication channels become more active, the probability of even small events upsetting the balance is greater. Even small, often insignificant information flows, as the work of Klaus Adam and Albert Marcet shows, have the potential to generate considerable instability. A sharp increase in the quantity and velocity of information flows, as is happening now, significantly increases the probability of such dynamics being triggered off. This increases the social or political riskiness associated with traditionally unstable societies. This also means that instability mitigating institutional systems assume much greater significance in these countries.

5. Always-on and many-to-many communication channels like social networking sites amplifies the impact of free information flows. In all respects, these channels are much more disruptive of stability that mere information flows. Further, their stability creating aspects, most often end up being crowded out by the stability disrupting aspect. After all, do we not more often come across examples of an information flood clarifying issues instead of complicating them?

None of this is an argument in favor of placing restrictions on information flows and social networking sites. Far from it. It is only a note of caution and a pointer to possible triggers that can upset the stability of social, political and economic systems. It therefore becomes important that such information technology developments be accompanied by policies that mitigate the market failures that arise out of them.

Parental education and income inequality in India

One of the most contentious ideological debates in public policy making is whether governments should seek to promote equality of opportunity or equality of outcomes. Over the years, public policies on various issues in India have been formulated with the specific objective of promoting equality of outcomes.

In this context, Ashish Singh has a nice paper which explores this debate by examining the relative contributions of individual effort and luck (or circumstances) towards the widening income inequality among households in India. He writes,

"This paper estimates the opportunity share of inequality in wage earnings as well as per capita household earnings for urban India and opportunity share of inequality in per capita household earnings as well as per capita household consumption expenditure for Rural India, for different age based cohorts for the year 2004‐05.
The estimates obtained are the lowest bound estimates and suggest that government’s redistributive policies should aim at reducing inequality of opportunity rather than aiming at reducing income inequality itself because inequality of opportunity is the cause which leads to income inequality which is an outcome."

About the philosophical underpinnings for this conclusion and its policy implications, he writes,

"The main suggestion of an equal opportunity philosophy is that social and economic inequalities due to factors beyond the individual responsibility are inequitable and to be compensated by society; whereas inequalities due to personal responsibility are equitable and not to be compensated. Therefore, according to the opportunity egalitarian conception, to judge a country’s status as an egalitarian society, one has to distinguish, in a given distribution of outcomes, the inequalities due to personal responsibility as opposed to the inequalities due to non responsible factors or opportunities...

By trying to understand the causes and the components of the earnings inequality, we will be in a better position to suggest focused policies in terms of type and extent of redistribution and welfare measures required to reduce (and how much to reduce) the disparities in the society."

He calculates the share of income inequality in urban and rural areas due to inequality of opportunity arising out of differences in parental education for four cohorts of people in the age group 20-65 for their respective incomes for the year 2004-05.



The paper uses only parental education as circumstance to calculate variations in percapita wage and household incomes, and per capita consumption expenditures. It does not examine the impact of other circumstance factors like parental occupation, caste, religion, place of birth, etc, which are likely to contribute significantly towards income inequality.

Social enterprises in development

Here is my op-ed in today's Mint on social enterprises.

Income inequality and the role of luck

In his recent visit to India Warren Buffet again referred to the role of the "ovarian lottery" in deciding life outcomes. He pointed to his luck in having been conceived in the womb of an American women, born male, and into a family which was infused with the values of capitalism.

In this context, Chris Dillow has an excellent post which highlights the role of plain good luck in income inequality. He points to a paper by Daniel D. Schnitzlein who compared the earnings of siblings and found that that share of inequality in permanent earnings that can be attributed to family and community factors shared by brothers are 20%, 43% and 45% for Denmark, Germany and US respectively.

Chris Dillow argues that while inequalities that are a result of the individuals' free choices about how hard to work, save and study are acceptable, that arising from the luck of what type of family we are born into is not acceptable. He advocates taxation of those excessively lucky to normalize incomes and remove the inequality arising from their disporportionate good luck.

However, if the objective is to reduce inequality, mere taxation will not help. I have blogged earlier about the work of Lane Kenworthy, who has examined the impact of various government policies on inequality across the developed countries. He has found that contrary to conventional wisdom with its emphasis on progressive taxation system, inequality reduction is achieved more by government transfers and better quality public services, both of which require higher quantity of taxes.

The over-sized role of the "ovarian lottery" in determining life-time incomes is validated empirically by the persistence of inter-generational earnings divisions between people at different levels in the income ladder. In this context, Markus Jäntti, Bernt Bratsberg et al write about the low social mobility in the US,

"Mobility is lower in the US than in the UK, where it is lower again compared to the Nordic countries. Persistence is greatest in the tails of the distributions and tends to be particularly high in the upper tails: though in the US this is reversed with a particularly high likelihood that sons of the poorest fathers will remain in the lowest earnings quintile. This is a challenge to the popular notion of 'American exceptionalism'. The US also differs from the Nordic countries in its very low likelihood that sons of the highest earners will show downward 'long-distance' mobility into the lowest earnings quintile."

Talking about inequality, Joseph Stiglitz has an excellent article in Vanity Fair, where he describes the American democracy as that "of the 1%, by the 1%, for the 1%"! He points to the extreme polarization of income levels in the US - the upper 1 percent of Americans are now taking in nearly a quarter of the nation’s income every year, while the top 1 percent control 40% of wealth.

Outcome-based venture capital financing of social policy

Imagine this social policy experiment. Crimeland prison has among the highest prisoner recidivism rate (prisoners are convicted of another crime within one year of release) in Globonia. Then World Without Crime Foundation (WWCF) comes up with a proposal that commits to lower recidivism rate by atleast 50% (after adjusting for the national average decline) over three years. It would cost $50000 to implement the program over its three years.

So WWCF offers to finance the entire upfront investments in return for being given Prison Improvement Bonds. These Bonds would have 4 year maturity and would be redeemed with returns which are based on the percentage of reductions (over and above the promised 50% minimum) achieved with recidivism. However, if the experiment fails to yield the expected minimum returns, the investors get nothing and lose their principal.

David Leonhardt points to a real-world experiment with such bonds in Britain. The British Government has initiated a program at Her Majesty’s Prison Peterborough, where 60% of the prisoners are convicted of another crime within one year of release. A nonprofit group named Social Finance has raised about $8 million from investors and is implementing, in collaboration with the prison authorities, a program to help former prisoners find work, stay healthy and the like. Some 3000 prisoners are being covered under this, which started last year.

Investors will get their money back starting in 2014 — with interest — if the recidivism rate falls at least 7.5%, relative to a control group. If the rate falls 10%, the investors will receive the sort of return that the stock market historically delivers.

They form part of the emerging category of social policy financing - social impact bonds. It has also been called payment-by-performance by the British government officials. Non-profit groups like foundations pay the initial money for a new program and also oversee it, with government approval. The government will reimburse them several years later, possibly with a bonus — but only if agreed-upon benchmarks show that the program is working. If it falls short, taxpayers owe nothing. It is hoped that success with a few initial interventions could help build a mainstream social investment market that attracts financial institutions and retail investors.



The British government is also planning to raise about £5m to develop a further package of two or three more social impact bonds. These bonds could fund programmes reducing the number of children going into care, working with children in pupil referral units, diverting persistent women offenders from prison, and developing more effective drug rehabilitation projects. Schemes to tackle long-term health problems in the community, such as diabetes and asthma, could also produce big savings in acute hospital bills.

In the US, David Leonhardt also reports that the Obama administration is set to shortly propose seven pilot programs, costing up to $100 million, along these lines. The financing mechanism will be described as pay-for-success bonds. They are set to broadly focus on increase kindergarten readiness among low-income children; increase college completion rates; reduce criminal offenses and incarceration rates among minority youth; raise the future earnings of laid-off workers; reduce hospital readmissions among patients with chronic illness etc.

What are the advantages with such social policy venture capital funds? One, most importantly, it will bring in a culture of outcome evaluation into social policy spending. Two, governments can hedge against the downside risk of the intervention failing. It will ensure much greater bang for the buck with social policy spending. Three, the hedging against downside risks also makes it easier for governments to embrace innovative programs that would otherwise have not found the light of day for risk aversion and status quo bias.

Four, Governments strapped for cash would not need to cough-up resources upfront, especially for programs whose returns are likely to show-up only after a few years. They would need to make payments only on the successful implementation of the intervention. Five, non-government agencies, non-profit and for-profit, get the platform (with all the attendant logistical support) of government agencies to experiment on their initiatives. This would marry the professional expertise and commitment of the non-government agencies with the existing government systems. Six, it will enable more effective utilization of non-government funds. Today, much of these funds are frittered away on piecemeal interventions that have little policy value.

However, there are several formidable challenges that need to be surmounted before this approach can achieve its desired objective. Which interventions to select? Which outcomes to measure, with what parameter, and how do we benchmark them? What should be the baseline and expected outcome scores? What should be the appropriate control group?

There is the possibility of external agencies being entrusted perfectly doable projects and walking away with assured returns. Ensuring the selection of parameters that, with a reasonable degree of accuracy, measures outcomes is a difficult task and one that can be very easily subverted. Both the baseline calculation and the final outcome fixation should be done with adequate care and after rigorous due diligence. The final outcome should be adjusted for changes that would have taken place even without the intervention. In the absence of clear definition of the target population, the external agency will have an incentive to cherry-pick and present a distorted picture of its achevements. Finally, the control group should be selected with appropriate care so as to be representative with the treatment.

In fact, the details of such initiatives should be arrived at only through a rigorous professional exercise carried out by competent agencies, and devoid of political and anecdotal judgements. On a note of caution, atleast for the initial set of such financing interventions, it may be better to leave out economic cost-benefit analysis (and focus on the financial benefits by way of budgetary savings) from calculations of return on investment. It may be advisable to focus on interventions (or outcome measurement parameters) where the benefits are more easily quantifiable by comparison with a relevant control group. Further, decentralized interventions are more likely to succeed, at least in the initail stages, with such financing programs.