Category: Public policy

23rd January 2009

Building a monetary and financial system for a free society

By Sanjeev Sabhlok, published in Freedom First, Mumbai, January 2009.

For a wealth-destroying event of the magnitude of the global financial crisis (GFC) to have taken place despite celebrated economists running Western economies tells us that ‘standard’ economics has failed at a most fundamental level, like theories which said the earth is flat. Instead, the ideas of thinkers like Ludwig von Mises and Friedrich Hayek (the economics Nobel prize winner of 1974) of the Austrian school of economics, who repeatedly warned about the dangers of state-induced distortions in money markets, have been fully vindicated.

Unfortunately, the economics taught today continues to ignore these great economists’ insights. Current economics is more inclined to side with Marx who dreamt of state-controlled credit in the hands of a national bank. It is time the world asks these ‘standard’ economists the blunt question: why must free societies have Marxian central banking?

Unfree financial markets
People exchange goods and services in the free market at a mutually agreed price. The unit and medium of exchange, money, is also created by these markets. For instance, notes issued by private banks in medieval Europe, being commitments to pay specified amounts of gold to the bearer of these notes, were readily accepted as money. This system of money creation and banking, based on the ‘gold standard’, arose spontaneously from freedom.

However, in 1694, the British government, in financial distress, found a convenient way to produce money from thin air by giving sole rights to produce money to the newly established (private) Bank of England, and receiving an advance of £1.2 million in return. This anti-competitive distortion of previously free money markets became very popular among later governments. Some enlightened governments did allow free banking for a while: for instance, in Sweden between 1830 and 1902. Indeed, this (Swedish) free banking episode eliminated booms and busts and dramatically reduced bank failures. But Sweden soon abandoned free banking because it demands great discipline from governments which would rather follow Robert Mugabe’s inflationary footsteps, instead.

The free market also ordinarily determines the price of money, which is the interest rate that this money commands in a competitive marketplace. This market-based interest rate perfectly matches the society’s time preference of consumption. But central banks are established exclusively to interfere with this free determination of interest rates by distorting money supply and fixing the price of money. Naturally consumers and entrepreneurs are confused in these economies.

We can see why Americans save so little and borrow so much. By deliberately preventing the time preference of society from being disclosed through the market, and by (often) forcing interest rates to fall below their market rate, people are motivated to consume more and save less. Sensible persons won’t save when their savings don’t earn much interest or even earn a negative interest after inflation and taxes. They would rather borrow at low interest rates and consume in excess. Americans are quite rational; it is their politicians and central bankers whose heads need a check up.

Betrayal of freedom
Like other socialist planners, central banks are prone to imagine that the solutions to the world’s problems lie inside their presumably super-intelligent but in reality deeply flawed and ill-informed brains (we are all similarly endowed: that is the basic truth about human frailty). Fatal conceit afflicts them as they try to ‘fine tune’ the economy by randomly tinkering with money supply and its price. Alan Greenspan (whom the great philosopher of freedom, Ayn Rand, erroneously considered as her disciple) wrote in the 1960s that the US Federal Reserve (Fed) had ‘nearly destroyed the economies of the world’ in the 1920s, and that ‘a free banking system stands as the protector of an economy’s stability and balanced growth’. This was, no doubt, good thinking.

But strange things happened between 1987 and 2006. As Chairman of the Fed, Greenspan changed colours. Not only did he not liberate the money markets, he kept interest rates artificially low, particularly between January 2001 and June 2004. Had he recalled the Austrian trade cycle theory (which Ayn Rand endorsed) he would have realized the great dangers of administering the price of money. His artificially low interest rates persuaded entrepreneurs worldwide to build things like houses and car factories in great excess, leading to the same over-investment that led to the roaring 20’s and thence to the Great Depression. Greenspan thus did exactly what he had earlier decried. Freedom was betrayed by the man once considered its great votary. It is now time to stop this stupidity of having a controlled product (money) in otherwise frees societies. Central banking, the illegitimate child of mercantilist monarchs and communist utopians, must be abolished. We must get free banking, instead: based on the gold standard.

US government’s socialist interventions
These massive failures of the Fed were greatly exacerbated by American welfare socialism. Nationalised Fannie Mae was created in 1938 to funnel federal funds into home loans, artificially boosting the demand for housing. It was (notionally) privatised in 1968 but remained guaranteed by the US government. Freddie Mac was later created in 1970 to allegedly provide Fannie Mae with competition. American welfare socialism worsened with Jimmy Carter’s 1977 Community Reinvestment Act which required all banks to give loans to people without income or on low income, over-riding good lending practices. Fannie May and Freddie Mac (FMFM) were thereafter ‘leaned upon’ by successive US governments to buy the sub-prime mortgages issued by banks. Then started what can only be (in polite terms) termed as government-supported fraud. FMFM started guaranteeing sub-prime loans issued by Bear Stearns and also directly sold such debt to foreigners.

Catching and punishing those who make false or misleading claims about a product is a primary function of the government, but the US Office of Federal Housing Enterprise Oversight (charged with supervising FMFM) did nothing to block these falsehoods. Activities of a similar nature were also unfolding in the private marketplace in relation to financially engineered products. For instance, Credit Suisse Group Sellers misled markets about the risks of its securities by touting the AAA ratings it got (bought?) from Standard & Poor’s. Self-regulation dramatically failed in the financial sector.

In addition, urban planning laws in many parts of the USA prevented urban boundaries from expanding even though thousands of new housing loans had been issued. This caused house prices to skyrocket. All these bad policies, together with low interest rates, fuelled a major housing bubble which has now burst. The main lesson we can draw from the GFC is that economic booms and busts are always created by government interference, mismanagement, and incompetence; not when markets are free and held to account.

I fear that worse things may be in store for the USA, including the possible collapse of the US dollar by about 2018 given its massive unfunded social security and medicare obligations (the only way to save USA would be for other countries to follow even worse policies!). After destroying and socialising its financial system, the USA government has now started throwing its taxpayers’ money at failing companies. In a free society each business or company must take responsibility for its own decisions; if it becomes insolvent it must declare bankruptcy as part of its accountability. If any value is still left over, private investors will buy it out. Using taxpayer funds to bail out companies that no one wants to touch, amounts to theft of taxpayers’ hard-earned money. Also, by rewarding incompetents, it creates disincentives for prudential management.

Lessons for India
Despite being founded under the banner of liberty, America has never been completely free. But its badly regulated money and financial markets, coupled with its socialist response to the GFC, shows that it is no longer fit to talk about freedom. This makes it even more important for India to show the way.

India’s Reserve Bank should get out of the business of creating money and fixing the price of money. It should become an independent regulator of a private money and banking system. Its current functions should be unbundled: coins and notes should be issued only by private banks; the lender of last resort function should be performed by private insurance companies. Reforms on these lines will disclose the market’s true interest rate, and price risks transparently, thus enabling uninterrupted economic growth. Good fiscal policy would have to accompany such reforms, including policies to minimise inflation, but I’ll touch upon these related policies in a separate article.

The Freedom Team of India
India needs leaders urgently to take it to freedom. I’d like to request you to consider joining the Freedom Team (freedomteam.in) to lead India. The task is clearly becoming more urgent than ever before.

==============================ADDENDA=========

Addendum 13 June 2009. A sensible article by Paul Kelly in The Australian today. Fix it, Don’t Break it.

Addendum: ‘Recession is ‘cleansing’, Corbett says‘, 15 May 2009 by Nine MSN.

Addendum: Eight centuries of financial folly and counting, 23 April 2010. Public Sector Development Blog

Addendum: Copy of the entire article by Paul Kerin (“There should be less government intervention, not more”, published in The Australian, 14 Sept. 2009):

MANY claim that the global financial crisis has slain the most important economic theory of the last half-century — the efficient markets hypothesis (EMH) — and, therefore, that much more government intervention in financial markets is necessary.

In fact, the GFC didn’t even give the EMH a flesh wound. At least in Australia, there should be less intervention — not more.

Kevin Rudd blames the EMH for engendering the “belief in the superiority of unregulated financial markets” that he holds responsible for the GFC. Even my excellent MBS colleague Ian Harper — member of the 1997 Wallis Inquiry into Australia’s financial system — says the GFC had “blown efficient markets theory out the water”. Other doubters include ASIC chairman Tony D’Aloisio and Warren Buffett, justifiably the world’s most admired investor.

EMH critics either don’t understand what it is or (in Harper’s case) refer to one particular corollary, on which doubts are most defensible. In 1965, Eugene Fama — who fathered the EMH — defined an “efficient market” as one in which individual security prices “fully reflect all available information”.

Critics often cite economist Robert Shiller, author of the best-seller Irrational Exuberance, which was published just before the dotcom crash. Shiller agrees with the famous “Samuelson dictum” — that financial markets are micro-efficient, but may not be macro-efficient. That is, markets price individual securities well, but overall market levels may not reflect reality. Nobel Prize winner Paul Samuelson propounded his dictum in the midst of the dotcom boom and soon after the Asian financial crisis.

The entire rationale for light regulation rests on financial market’s micro-efficiency, not macro-efficiency.

In 2005, Shiller concluded: “Substantial evidence vividly illustrates the truth in Samuelson’s dictum for the US stockmarket since 1926.” His key reason is that substantially more information is available on the drivers of individual firms’ cashflows (hence their intrinsic values) than on the overall market’s drivers (such as future macro-economic growth).

Even the world’s best-known EMH advocates recognise that macro-inefficiency may exist. Six months before the 2007 market peak, Burton Malkiel (author of A Random Walk Down Wall Street) questioned in The Wall Street Journal whether the market was exhibiting “irrational complacency”, given that macro-economic indicators were already slowing.

Critics also mock assumptions that they claim the EMH makes. Even the otherwise sensible Lindsay Tanner wrote: “The efficient markets theory and the assumption that people act rationally are under intellectual siege.” But Fama explained in 1965 that this and other assumptions — if true — were sufficient for the EMH to hold, but not necessary. Those assumptions probably don’t hold in the banana market either, but it works pretty well.

If critics cite any micro-inefficiency examples, they’re the usual suspects: the Dutch tulip and South Sea “bubbles”. The tulip case actually reflected a government-supported change in trading rules and a ban on short-selling. As tulip bulbs cannot be uprooted between October and May, the large price rises between November 1636 and February 1637 were on futures contracts, which obligated buyers to pay the contracted price for next season’s bulbs. But from November 1636, the Florists Guild had been moving to give buyers the right to avert this obligation by paying a small fee — and for this change to apply retrospectively to all contracts made from that time.

That is, the market knew that “futures” contracts may become “options” contracts from November. The likelihood of this happening kept rising until it was mandated in February 1637. As that likelihood rose, buyers willingly agreed to higher prices because they were less likely to have to pay them. The “crash” in February 1637 simply reflected the fact that, in any market, options trade at a small fraction of futures prices. “Tulipmania” claimants are comparing the prices of apples and bananas. Indeed, UCLA’s Earl Thompson concluded that “Tulipmania” was actually a “remarkable illustration of market efficiency”.

The South Sea fiasco didn’t reflect market inefficiency. Market prices can only reflect available information. Instead, it highlights the dangers in governments granting monopolies to private companies. After the crash, fraud by South Sea directors and corruption in the British Cabinet was exposed. The chancellor of the exchequer was jailed.

While macro-inefficiency may be possible, stockmarket crashes do not “prove” it. We often und
erestimate the impact that new information can have on estimated intrinsic values. The intrinsic value of a share paying $1 a year dividend with expected annual growth of 5 per cent and a 10 per cent cost of equity is $21. Suppose a “shock” (subprime crisis, say) raises investors’ risk premium by 1 per cent and makes them expect a 30 per cent dividend cut to 70c a share for the next three years, before 5 per cent annual dividend growth is restored. Rational investors would cut their estimated intrinsic value fall by 49 per cent — about how much our market dropped by.

While most EMH tests are of micro-efficiency, there is even some evidence supporting macro-efficiency. A 2008 study by Australian researchers Jae Kim and Abul Shamsuddin of sharemarket indices (like the Nikkei) before and after the Asian financial crisis found they were efficient in relatively developed markets, such as Hong Kong and Japan. Market efficiency was strongest in nations with business cultures and regulatory arrangements conducive to transparent corporate governance (such as good disclosure rules).

In questioning the EMH, D’Aloisio cited the collapse of various unlisted managed investment schemes and debenture issues. But no EMH advocate has ever claimed it applies to these over-the-counter products, for good reason. Investor prices (on both buy entry and exit) are set by issuers, not by a free, competitive, transparent market. In the latter, sophisticated investors and arbitrageurs work to keep security prices sensible; they cannot do so with the products D’Aloisio cites.

And D’Aloisio was wrong in claiming that the Wallis Inquiry said “there shouldn’t be capital requirements” on issuers of these products due to “the efficiency of the market”. The Wallis committee didn’t recommend capital requirements because they were unnecessary to protect financial system stability — those products, in total, represent too tiny a share of total financial assets to pose any significant systematic risk. Wallis instead emphasised the need for good disclosure requirements, which ASIC is now moving to strengthen.

The very best protection for retail investors is free, competitive, transparent securities markets, because prices are then most likely to reflect intrinsic values. Governments should certainly ensure transparency by mandating good disclosure and punishing rumour-mongering and insider trading. But interventions like short-selling bans actually inhibit market efficiency — putting retail investors at more risk, not less.

It is also important to distinguish between macro-inefficiency in financial markets versus the real economy. Samuelson once said that the real economy’s business cycle “like herpes, has always been with us”. A Keynesian, he supports activist macro-economic policies to keep that disease in check — but not activism in financial markets. The Federal Reserve’s 1929 intervention to prick what it saw as a stockmarket bubble — and the Great Depression that followed — demonstrates the danger.

My big worry is that our Prime Minister will overreact. Rudd had advocated “constraining excessive expansion of derivatives markets” and a “fundamental regime change” to “social capitalism” — “a system of open markets, unambiguously regulated by an activist state”. Activism can be taken far too far.

Politicians may think markets overreact, but never look in the mirror. At least markets soon correct themselves. Politicians rarely do.

Paul Kerin is Professorial Fellow, Melbourne Business School

===
Here’s an excellent article: “Milton Friedman and the Case against Currency Monopoly” by Selgin, George; Cato Journal, Spring-Summer 2008, v. 28, iss. 2, pp. 287-301 (EconLit with Full Text)

http://bit.ly/c3bKdk – Crisis puts nails back in Keynesian coffin, by Michael Stutchbury, Economics editor From: The Australian June 15, 2010

http://www.theage.com.au/opinion/politics/fiscal-time-bomb-yet-to-explode-20100614-ya3c.html (Fiscal time bomb yet to explode, Tim Colebatch The Age, 15/6/2010)

http://www.theage.com.au/business/pm-accused-of-panic-in-global-crisis-20100622-yvtr.html It is never going to be easy to kill such panics. Considered infrastructure funding is hard, mindless throwing away of taxpayer funds is easy. This is an article with much useful information to add to fiscal policy debates.

See this blog post at Marginal Revolution: http://www.marginalrevolution.com/marginalrevolution/2010/09/on-austro-european-business-cycle-theory.html

http://cafehayek.com/2010/11/has-the-fed-been-a-failure.html. Research shows that “The Fed’s full history (1914 to present) has been characterized by more rather than fewer symptoms of monetary and macroeconomic instability than the decades leading to the Fed’s establishment”

http://cafehayek.com/2010/11/denationalize-money.html

A debate at: http://www.marginalrevolution.com/marginalrevolution/2010/11/xxxxxxxx.html

Housing: Too Good to be True: June 04, 2004 by Mark Thornton

The myth of deregulation being a cause of the GFC.

http://www.freebanking.org/2011/06/04/free-banking-and-classical-liberalism-a-potted-history/

How much did Fannie and Freddie cause the financial crisis?

http://catallaxyfiles.com/2011/11/03/a-nice-piece-on-one-of-the-causes-of-the-us-housing-debacle/ [A nice piece on one of the causes of the US housing debacle]

MURRAY AND BIER: Avoiding a lost decade: Obama on course to repeat Japan’s errors of the 1990s {one of the best articles on the subject}

Gary Becker says:

The widespread demand after the financial crisis for radical modifications to capitalism typically paid little attention to whether in fact proposed government substitutes would do better, rather than worse, than markets.
Government regulations and laws are obviously essential to any well-functioning economy. Still, when the performance of markets is compared systematically to government alternatives, markets usually come out looking pretty darn good.

Also see this blog post for a clear rebuttal of false claims by Steve Horwitz: https://www.sabhlokcity.com/2011/10/if-you-still-believe-that-capitalism-caused-the-financial-crisis-then-read-this/

Here’s a nice summary of what went wrong: http://catallaxyfiles.com/2011/10/28/politics-not-incompetence/

(The turning point was the spring and summer of 2004. Fannie and Freddie had kept their exposures low to loans made with little or no documentation (no-doc and low-doc loans), owing to their internal risk-management guidelines that limited such lending. In early 2004, however, senior management realized that the only way to meet the political mandates was to massively cut underwriting standards.)

ADDENDUM 18 June 2014

The Virginian 2 hours ago
I would fully endorse the Justice Department criminally pursuing the people who did the bad deeds. But, they instead have chosen to treat the banks as piñatas and a ready source of cash to fund U.S. government operations.
These large fines don’t do anything to the people who did the deeds – they just reinforce the belief that it’s a cost of doing business.
Instead, they wreak tremendous damage on stockholders, which are primarily American citizens, their pension funds and insurers.
Let’s not forget that most of the ‘bad deeds’ began by the exhortations of:
1) Barney Frank (a famous US Congressman who was the Chairman of the House Financial Services Committee), who pushed U.S. banks to loan money to poor people who couldn’t qualify for mortgages as part of his belief in social justice … and who famously said “I want to roll the dice a little bit more in this situation toward subsidized housing.”
2) the Federal Reserve, which pressured the banks to buy the companies that often did the bad deeds in order to save the U.S. financial system and, by extent, the world economy as the economic crisis deepened. (The most famous example is Bank Of America’s purchase of Countrywide, which actually made the bad loans BAC is being punished for.)
There is plenty of blame to go around … but, much of it is directly attributable to the U.S. Government Congress, both political parties, and our vaunted regulatory agencies which aggressively enforced the political clamor to make mortgage loans to poor people so they could own homes, regardless of their ability to repay).
Hypocrisy is an elemental part of the political process and we see it every day in our government. I just want it to finally be moderated here so that us stockholders can regain our savings and fund our retirements … and so that our banks are again willing to make the loans necessary to grow our economy.
Right now, the U.S. government is actively sabotaging all three of these necessary requirements through their extended bleeding of Bank America, Citigroup, JP Morgan, and other banks.

ADDENDUM

An alterantive view (which I don’t find persuasive): The housing bubble: Perceptions and reality – Scott Sumner. My comment:

This article is off the mark.
That the steep decline in the Fed funds rate in 2002-2004 set off a housing bubble is clearly vindicated by looking at this chart of house prices:
http://www.jparsons.net/housingbubble/us_home_prices_vs_rents.png
This bubble was purely created by loose monetary policy. That doesn’t mean everyone has to start defaulting in their payments immediately. It would be a mistake to default if your house price is increasing in value.
However, in the US, most mortgagees can walk out of their mortgage once the property goes below its purchase price. So AFTER the bubble burst (due to many factors – all bubbles burst sooner or later), the default rate THEN shot up. The buyers who had bought high, walked out, setting off a chain reaction, making it attractive even for those who could pay, to default.
The problem with Erdmann’s spurious argument is his assumption (2):
“2) As rates rose, low income households with unsustainable ARM mortgages couldn’t afford their mortgage payments. Delinquencies started to pile up.”
No one in his right mind said that. See my January 2009 article in which I refer to the HOUSING BUBBLE (not delinquencies) and a range of socialist policies as the driver of the GFC.
https://www.sabhlokcity.com/2009/01/building-a-monetary-and-financial-system-for-a-free-society/

Even a Harvard professor understands that government caused the Global Financial Crisis:

3rd January 2009

Property rights and land acquisition

The following article was published in Freedom First, December 2008. http://freedomteam.in/mag/

Sanjeev Sabhlok

This month I’d like to begin by exploring the concern a reader has raised about the urban governance model I had suggested in my November article. Noting that ‘elected representatives are equally corrupt and non-accountable’ and that ‘persons of integrity stand little chance of getting elected’, the reader thinks that the model I proposed won’t work, at least not before other things happen first, such as speedy trials of corrupt people.

It is true that a large number of interconnected reforms are needed in India. But to avoid getting lost in this complexity, I suggest that we look at each area in isolation and determine the best policy for that area. We want policy compatible with freedom; policy that will deliver accountability while being mindful of human nature. This set of best policies can then become a blueprint of reforms that we can aim to, together, deliver to India through political organisation.

The local governance model I proposed last month works without corruption in many parts of the world. Therefore I can’t see any major reason why it won’t work in India. Let us insist on local governments where council CEOs can be hired and fired by elected representatives. Separately, let us explore policies to expedite court trials of the corrupt. I will review the policies of justice in a separate article.

Origin of property

The defence of our property is critical to our continuing freedom. Freedom and justice are of one piece, and, as David Hume noted, ‘[t]he origin of justice explains that of property’. In each of our transactions we leave a memory of relevant accountabilities and attributions. Attribution, namely, who it is that owns a particular consequence, determines the ownership of property during and after a transaction. Some transactions leave a physical residue we call goods; others, being a service or intellectual property leave behind the memory of an experience or thought.

Socialist aversion to property

Socialists differ sharply from liberals in their conception of property. The socialists’ main aim is to achieve economic equality by robbing Peter to pay Paul. They aim to do this by abolishing private property and vesting it in the state. But even if they succeed in abolishing private property for an instant, new private property and inequality springs to life like a Houdini springing out of his cage. A pen, paint brush, or a good voice can generate untold wealth and upturn utopian socialist goals.

India’s initial Constitution was largely liberal and allowed for substantial property rights, but socialist Nehru soon enacted land ceiling legislation to confiscate lands above a certain size, and sheltered these illiberal laws under the Ninth Schedule of the Constitution. Later, through the 25th Constitutional amendment of 1971, Indira Gandhi removed the Constitutional requirement to compensate people for their land compulsorily acquired by government. An unspecified ‘amount’ was now deemed sufficient in lieu. State theft was thus fully institutionalised.

The biggest blow to property rights was administered by the Janata Party, a rag-tag bunch of socialist factions, some of which have later formed the BJP. The Janata Party abolished the right to property through the 44th Constitutional amendment of 1978. In the past, Article 19(1)(f) had guaranteed Indians the right to acquire, hold and dispose of property. This was repealed. We therefore have no Constitutional property rights today. Property is merely a legal right revokable by simple majority in Parliament.

The utopian system of socialism always attracts the most evil people. Even as they have publicly pursued populist socialist policies to undermine property rights, our socialist politicians have exported unimaginable public wealth from India into their Swiss bank accounts. This fraud has been facilitated by not maintaining accurate and transparent land records. The free West, on the other hand, has developed technologies to strongly protect people’s titles in land, which has facilitated new investment and economic success.

Compulsory land acquisition and land re-zoning

The main reason we form a nation through a social contract is to maximise our security and freedom. National security is, in many ways, a precursor of freedom. Where national security so requires, we agree to exchange our property rights in a particular piece of land with comparable land elsewhere. So, for example, if I own land on top of a hill but the army needs to build a fort on it, then I agree to hand over my land in lieu of just compensation. Similar arguments apply to major roads such as the Golden Quadrilateral which can expedite troop movement in India during a crisis, or to roads in border areas.

But what about compulsory acquisition of land for ordinary economic infrastructure: things like small roads, local dams or sewers, or land for schools and universities? And what if a local government rezones our land from residential to non-residential, potentially reducing its value? Are such actions of elected governments compatible with our freedom? Yes – they are, provided a genuine public interest is met and just compensation paid.

Validation of the public interest can be done through local governments through public consultation including small referendums, in addition to the necessary declarations of public interest from the state or central governments. Compensation can then be determined by an expert panel headed by a retired High Court judge to ensure that not only taxpayers get good value out of this acquisition but the property rights of those whose land is being acquired or re-zoned are protected. The panel should, in the first instance, aim to acquire land only though voluntary consent.

Our current methods to determine compensation (‘amount’), being primarily based on figures from registered sales, are flawed since sale prices are under-reported in India to save stamp duty. In addition to this basic information, innovative ideas including those from experimental economics should be used to assess values. Economic modelling and experimental markets can assist in arriving at the optimal value proposition for everyone. In principle, if a net present value of Rs. 10 is created from the infrastructure, then up to Rs. 5 should be available for sharing with those whose land is being acquired, either as a one-off payment or a long-term annuity.

What about compulsory acquisition of land for purely private purposes – say, when Tatas want to build a factory in Singur? That is clearly out of bounds: coercive acquisition of land to benefit the shareholders of Tatas or for any other purely private purpose is repugnant to a free society. Game playing may well occur between Tatas and its competitors in consequence, potentially preventing the quick private acquisition of land, but that cannot be used as an excuse to use the state’s coercive powers. Markets must find their own solutions to competition.

Freedom Team of India

The above discussion has barely scratched the surface of property rights and policies to protect these rights. But I do hope that such discussions will sufficiently motivate you to consider joining the Freedom Team to deliver such policies to India (see http://freedomteam.in). The point to remember is that the policies of freedom won’t get adopted and implemented in India with out a major political battle to be fought by the liberals. Let us ‘Arise, awake, and stop not till the goal is reached’ (Vivekananda).

Contact Sanjeev at sabhlok AT yahoo DOT com

ADDENDUM

Knowledge problem’ of land debate by Vipin P Veetil LiveMint, 6 June 2011

3rd January 2009

India’s centralised approach to urbanization

The following article was published in Freedom First, November 2008. http://freedomteam.in/mag/

Sanjeev Sabhlok

The Freedom Team of India is trying to bring together 1500 like-minded liberals willing to contest elections as a coherent group from 2014 onwards. The Team aims to ultimately offer the Indian people a choice both of good candidates and good policy. As the Team continues to grow, albeit slowly, I want to start discussing issues which could inform the policies offered by the Team. I begin by looking at urban policy.

Productivity gains from urbanisation

In 1776 Adam Smith wrote about division of labour as the major driver of productivity in free societies. While the assembly lines seen in factories are a good example of this division of labour, specialisation is now an even more widespread part of modern life. Another driver of productivity, highlighted by Alexis de Tocqueville in 1835, is social capital arising from the vibrant associations and networks of like-minded people. Both these drivers of productivity require people to live close together, and thus form the motivation for urbanisation. The average Indian, however, has not yet benefited from these productivity-enhancing features, with only 28 per cent of Indians living in urban areas today, compared with 44 per cent of the Chinese, 78 per cent of the Americans, and 86 per cent of the Australians.

Before we examine how urban areas can be managed to cope with increased urbanisation, we should ask whether it is feasible for a country like India to live predominantly in cities? How is it possible, we wonder, to feed a huge urban population?

The answer is that a relatively small population should be able to produce all the food we need after we reform our agricultural policies. Such reforms should lead to increased mechanisation and productivity. Since agricultural reforms will require a separate discussion, let us, for the moment, assume that it is possible to increase agricultural productivity to feed up to 600 million additional urban dwellers. In addition, let us assume the existence of good education and health policies with the result that rural migrants to urban areas stand a real chance of being productive. We also assume incremental and organic growth of urbanisation, not a forced approach.

Local governance at the heart of urban reform

We all know that today, even with our extremely low levels of urbanisation, our urban areas are in a bad shape. My sister owns an IT company in Delhi and travels all over the city daily. She was complaining the other day to me that it now takes her two hours to cover the distance which took her an hour ten years ago. Such congestion not only hurts businesses but also reduces social capital as it becomes increasingly difficult for people to associate with each other.

So how can we start improving our urban areas? We need to increase urban infrastructure and improve the urban environment while avoiding the congestion which can quickly reduce the gains from urbanisation. Three principles can inform the governance arrangements for urban reform: good incentives, accountability, and subsidiarity.

The principle of subsidiariaty says that ‘a central authority should have a subsidiary function, performing only those tasks which cannot be performed effectively at a more immediate or local level’. This tells us that state governments must stay out of urban management, which is a local matter. This should be in the hands of local councils that service, say, about two lakh people each. For instance, New York has 51 councils and Melbourne has 28. So Delhi should have 60 councils. Instead, we have mega-municipalities which have little or no local representation and are far removed from ground realities.

For the states to create the third tier of government at the urban or rural level it was not really necessary to amend the Constitution. But with the 74th amendment there can now be no excuse for the states to avoid creating such a third tier. Unfortunately, the states still refuse to do so. Instead, tenured generalist bureaucrats without the foggiest idea of good policy and without any accountability to anyone, are charged today with ‘managing’ our cities using their exaggerated notions of personal wisdom and perspicacity, with no participation from the citizens.

This needs to change. The state governments must create a framework of laws for the local councils to implement. This framework should link urban and rural councils and reduce the dichotomy between these two. The framework must delegate key functions like land planning and zoning, land acquisition, local (third tier) roads and parks, libraries, community halls, and waste disposal to the councils. Food and other inspections should also be dealt with by councils. The state can retain the role of coordinating the records of land use and ownership.

To fund these services, the councils should be empowered to raise land taxes and rates, and to recover unpaid dues from recalcitrant residents. Councils which want to attract wealthier residents will then provide better infrastructure by charging higher rates. Since all the infrastructure needs of urban areas cannot be funded through rates and taxes, the councils should be empowered to issue long-term bonds to fund these needs. Citizens will then be free to pick the council that best suits their budget and preferences. The competition between councils will generally keep the rates low and the services high.

It is important for the councils to have sufficient representation. The ratio of representatives to citizens must be in line with international best practice. For instance, Delhi should have 300-600 elected councillors including 60-odd mayors. Of course, these political representatives would need to be held to account through elections held every three years. In addition, the state government would need to retain a judiciously exercised power to dismiss corrupt councils and order new elections.

To ensure a clear line of sight of accountability, elected councillors would have to be fully empowered to hire the chief executives of their councils on a performance-based contract at market rates, and to fire them for non-performance. This contract should be based on an understanding of the principal-agent problem and the use of the right incentives. These chief executives, in turn, would need to be empowered to hire (and fire) the best professional land planners, environmental scientists and landscaping specialists. This approach, followed in many developed countries, achieves the best results for the community.

Coordination issues, and migration

How will the councils in large cities coordinate their diverse plans? The association of councils will be able to coordinate most issues, including long term plans for the relevant city. The state government can help if asked to. These professionally managed councils will also be able to manage the migrations from rural areas effectively. Since new migrants generate wealth, the councils will likely complete for new migrants by providing relevant infrastructure to make best use of the new migrants’ talents.

In brief, this model of responsive and accountable decentralised government, based on the principles of freedom, will lead India to dramatically better cities and ensure that it can meet the forthcoming challenge of mega-urbanisation and wealth creation.

* * *
As usual, before closing this write-up, I would like to urge you to consider leading
India. Consider joining the Freedom Team (freedomteam.in). Write to me.

Contact Sanjeev at sabhlok AT yahoo DOT com

16th September 2007

My Times of India Article of 30 July 2007 on the bureaucracy

Hi, The TOI posted an edited version of my article on the bureaucracy on 30 July under the title, 'Reform the Bureaucracy'. Below is the original article I sent to TOI.

A new bureaucracy for India

We face an inexplicable dichotomy in India between the performance of our public and private sector. While Indian business performance is often second to none, the results of India’s public sector are poor beyond description. Delivering simple things like water, electricity, roads, and education is well beyond our capacity.

This is unacceptable, and an explanation is in order.

I suggest that the blame for our poor public sector performance can be laid on the way our bureaucracy is structured, and on the incentives it faces. I base this conclusion not solely on academic comparisons, but also on the learning acquired by working for 18 years in the IAS and for 7 years in one the very finest bureaucracies in the world, in the state of Victoria in Australia.

When I started off at the middle rung of the Victorian bureaucracy in 2001, one of the most unexpected observations I made was that the performance of senior Australian bureaucrats was significantly better than anything I had experienced in India. No IAS officer knows more in the relevant subject area, can think as well and as strategically, or lead a team of professionals better, than his or her Australian counterpart. Australia also constantly benchmarks against the world’s best. Being just a little better than Bihar is not considered sufficient.

In my book, Breaking Free of Nehru, now available freely on the internet, I have proposed a plan by which India can, without significant disruption to existing service-delivery, acquire a new bureaucracy. The solution hinges on transforming the quality of our Secretaries, and the incentives facing them. The change needs to begin at the top.

The principles driving this plan are:

abolition of tenure at senior levels;
open market recruitment for each position;
contestability of policy advice to political leaders;
market competitiveness of remuneration;
extensive delegation of responsibility; and
provision of access to the latest technology, information and training.

The validity of these principles can be readily seen by thinking of how a good national cricket team is built.

If our cricket team was not to be selected based strictly on players’ track record, and if non-performers were not to be ruthlessly weeded out, we know that the team would stand no chance on the world stage. An Indian cricket team built on the principles that apply to our bureaucracy would have Pataudi as its captain and Sachin its 19th man, waiting patiently for a turn at the crease. And every Australian school team would soundly thrash this ‘national’ team!

It is true that merit is taken into account at the entry point of the IAS. But merit is not a one-off measure. Shouldn’t a secretary to the government be a person with a track record of world-best performance? Shouldn’t the person be a subject- matter genius, a management guru? A great leader? What has writing a good essay in an examination at age 21 to do with these competencies?

Second, we do not prune our officers for performance and integrity. The legal protections provided to IAS officers are such that even when caught taking bribes, they cannot be punished, let alone demoted for non-performance. With our society thus signalling their invincibility, these officers increasingly become indolent, arrogant and incompetent, and yet, advance without resistance into the position of India’s secretary to government.

While Indian tax payers support this ineffective bureaucracy, thinking perhaps that there is no alternative, advanced countries have used the findings of agency and public choice theory to design systems that reward expertise, leadership, and good performance; and ruthlessly punish bad performance. In doing so, they have transformed their public servants into dynamic agents of change and excellence.

I suggest that we need to begin the desperately needed change by making a fundamental shift in accountability, ensuring that the bureaucracy becomes merely one of the many potential service providers to Ministers. This can be done by Ministers contractually appointing world-renowned subject-matter specialists who are committed to delivering their party’s policy platform, as their advisers. No file would then go to a Minister without these advisers having had a look.

Ministers would then appoint their secretary through an open (preferably global) market competition ? in the first instance, on a two year ‘hire-and-fire’ performance based contract ? paying a salary comparable with what senior MNC executives get in India. Secretaries would similarly appoint their joint secretaries. To ensure continuity, leadership change would need to stop at this point in the first phase. No government employee would lose monetarily for two years while the restructure is embedded.

Each of the newly appointed secretaries would then implement a two-year strategic process to restructure the bureaucracy into ten departments: freedom, defence, justice, external affairs, public finance, physical infrastructure, social infrastructure, commerce, social capital and community, and sustainability. This would involve significant training and redundancy planning.

A Public Administration Act would underpin the restructured, new bureaucracy. Positions requiring significant judgment and leadership skills would be brought under a three-year performance-based contract. Upon the Act coming into force, Constitutional provisions on civil services would be repealed.

By no means am I trying to suggest that this reform will be a panacea for India’s chronic misgovernance. Our political and electoral systems need fundamental reforms, too. But we must begin somewhere, and changing our bureaucratic leadership will, at this stage, make the most difference.