The lowering of the US Federal Reserve’s benchmark interest rate by a further 25 basis points, juxtaposed with similar action taken by the Bank of England and European Central Bank’s infusion of liquidity, brings to fore the evolving role of central banks. Textbooks talk of monetary policy in the context of growth and inflation targets. However, the monetary authority has progressively become more responsible for the integrity of the system, which has a bearing on policy formulation. The question is how far it should go to protect the inefficient or failed elements of the system.
The official line taken by the US Fed when it lowered interest rates by 50 basis points earlier was that both GDP growth and inflation are quite satisfactory, but its own proclivity is towards growth. This time, it has said no such thing. But one could guess subprime concerns. The losses to be suffered by the financial system are estimated in a range of $200-400 billion. Estimates of both the OECD as well as The Economist indicate that while growth may be hit, an outright recession is ruled out. In fact, given that commodity prices are rising, inflation is the bigger concern today. Clearly, due to the present liquidity problem, the Fed has been lowering its rate and has held out $24 billion towards liquidity supply. Nothing really wrong in this, but it does provoke a debate on whether or not the central bank should come to the rescue of financial players in times of such crises.
To go back a bit into economic theory, Joseph Schumpeter had espoused “creative destruction”, wherein he emphasised that it is a natural law that as economies move along, crises are but natural and should be allowed to run their course. This will help eliminate inefficient players, and in turn, lead to catharsis that would leave the system better off. Note that the subprime case’s origins can be traced to banks and other mortgage houses lending recklessly to individuals and then securitising the loans. Such institutions that operate on flaky grounds, according to Schumpeter, must not be allowed to survive, and their failure will come to cleanse the system and set an example for others. The Asian crisis, for example, was mainly due to crony capitalism, and had lessons on credit assessment that makes Basle 2 norms all the more relevant. Prudential banking, everyone agrees, is important to economic stability.
Also, by helping save the situation, the Fed (and the Bank of England and European Central Bank) sets a precedent of standing by any financial organisation which bungles, especially so in case there is systemic risk posed to the Economy. In fact, Henry Paulson of the US Treasury has also spoken of repricing subprime mortgage loans, which benefits those who are less likely to comply, thus creating a perverse incentive not to worry about compliance. This results in a moral hazard, which is quite scary because if banks in India, for example, know that the Reserve Bank of India (RBI) will eventually cover them, then they would be that much more reckless in lending.
From the point of view of the protagonists of rescue missions by central banks, there are two compelling reasons for affirmative action. The first is that the financial system today is a very important part of the Economy and has deep implications for the real sector (and overall growth). The Asian economies took over five years to recover, and the other affected countries such as Brazil and Russia took even longer to recover from the slump. Lower US growth is serious business that the Fed cannot ignore.
The other reason is that in the world of globalisation, it is hard to escape the contagion effect. Indian stock Markets were hit when the subprime crisis erupted. It affected not just our banks but also the RBI’s policy stance. Funds were withdrawn from bank stocks across the world, causing market turbulence. Further, various countries’ monetary policies are getting aligned with one another, and given that the “decoupling” of the rest of the world from the US is still not a proven phenomenon, a recession in the US can affect others too. Recall that the Fed took the blame for the Great Depression of the 1930s, which explains why it must be proactive in such situations.
The result is that central banks have taken on a new inadvertent role of protecting inefficient entities—ironically, to protect the Economy. Further, as was the case with Northern Rock, the interests of deposit holders had to be protected. The UK’s regulator, the Financial Services Authority (FSA), was in charge, but the Bank of England had to come to the bank’s rescue to protect deposit holders.
This certainly calls for greater and more stringent financial supervision, either with a separate arm of the central bank or an independent authority which will in turn have to ensure that the rules are obeyed and be responsible for a bailout in times of crisis.
Thursday, December 20, 2007
Friday, December 14, 2007
The green currency : DNA 15th December 2007
Protecting the environment the fiscal way will reap benefits for consumers
The present concern about the environment is significant for three reasons. The first is that we are all progressively getting aware of the seriousness of the problem and accept that we need to do everything possible to control this degradation, as it is going to affect our future — and this may be just 20 to 30 years away. The second is that after the Kyoto Protocol took shape, it became possible to identify these polluters and companies are taking countervailing measures.
The third is that we have also made a neat business of this, wherein carbon credits are actually traded — the preservers of nature earn credits which can be traded with those who pollute the environment, thus making it a zero sum game. The game also mandates that those who do not stop their pollution must pay for it by purchasing these credits. This means that we are able to value these pollutants on a commercial scale.
If all this is true, the government can actively play a part in environment control through a system of taxes and incentives. The carbon credit system enables one to identify the level of pollution caused by an activity. If I am able to reduce the pollution caused by this activity and am able to prove it, then I earn some credits which can be traded with those who emit high pollutants. This means that all organised activity can actually be linked with emission levels, which can then be ‘capped and traded’ or, rather, taxed.
This tax would do two things. The first is that it will ensure that there is revenue for the government which will rise as long as society is willing to pay for it. The other is that any shortfall would automatically mean that pollution is under control as the polluting activity has been checked.
There are essentially two major sources of pollution. The first is the industry where manufacturing causes emission of noxious substances which damages the environment. Prima facie, these activities can be identified and the tax rate can be fixed proportional to the emissions on a progressive scale. Production of fertilisers, plastics, cement, glass, oil and so on can be ranked and taxed accordingly. Power companies could also be forced to move over to more environment friendly fuels that can be used to lower pollution levels. Non-adherence would mean a tax, which may or may not be passed on to the consumer. Considering that the tariff rates for power are partly administered, these companies may choose safer environmental friendly fuels, as carrying the costs would mean losses.
The tax can also cover individuals. At a micro level, individuals are responsible for pollution by activities performed either directly or indirectly. Vehicular pollution is high and would attract a differential tax on the fuel used be it petrol or diesel or CNG. This, by itself, may encourage drivers to shift over to a medium which lets out the least pollution like CNG over petrol and diesel. In fact, subsidies could be given on use of pollution reducing kits.
Another big indirect pollutant is air travel. The aviation industry has been identified as being one of the biggest destroyers of the ozone layer. To discourage such travel or make people more aware of this effect, a flat surcharge on every ticket can be levied by the government which will ensure that all those who contribute to the pollution also pay for it. Government action will actually penalise the polluters while adding to its own revenue.
There will still be a large unorganised set of polluters which will be difficult to track, but models can be built on reducing this by providing incentives instead for doing something that lowers environmental degradation. Simple rules like construction of public amenities and provision of dustbins can be linked with tax benefits for a community in the form of, say, a cheaper water supply.
Today environment control norms are harsher on developed countries, most of which have agreed to adhere to the Kyoto norms. It has been accepted that these countries, in their processes of industrialisation, have added substantially to environmental degradation levels and hence need to atone for it. But developing countries, which are getting increasingly more industrialised, also need to shoulder this burden and need to use a blend of taxation and subsidies to address the problem, and thereby probably earn net revenue.
The present concern about the environment is significant for three reasons. The first is that we are all progressively getting aware of the seriousness of the problem and accept that we need to do everything possible to control this degradation, as it is going to affect our future — and this may be just 20 to 30 years away. The second is that after the Kyoto Protocol took shape, it became possible to identify these polluters and companies are taking countervailing measures.
The third is that we have also made a neat business of this, wherein carbon credits are actually traded — the preservers of nature earn credits which can be traded with those who pollute the environment, thus making it a zero sum game. The game also mandates that those who do not stop their pollution must pay for it by purchasing these credits. This means that we are able to value these pollutants on a commercial scale.
If all this is true, the government can actively play a part in environment control through a system of taxes and incentives. The carbon credit system enables one to identify the level of pollution caused by an activity. If I am able to reduce the pollution caused by this activity and am able to prove it, then I earn some credits which can be traded with those who emit high pollutants. This means that all organised activity can actually be linked with emission levels, which can then be ‘capped and traded’ or, rather, taxed.
This tax would do two things. The first is that it will ensure that there is revenue for the government which will rise as long as society is willing to pay for it. The other is that any shortfall would automatically mean that pollution is under control as the polluting activity has been checked.
There are essentially two major sources of pollution. The first is the industry where manufacturing causes emission of noxious substances which damages the environment. Prima facie, these activities can be identified and the tax rate can be fixed proportional to the emissions on a progressive scale. Production of fertilisers, plastics, cement, glass, oil and so on can be ranked and taxed accordingly. Power companies could also be forced to move over to more environment friendly fuels that can be used to lower pollution levels. Non-adherence would mean a tax, which may or may not be passed on to the consumer. Considering that the tariff rates for power are partly administered, these companies may choose safer environmental friendly fuels, as carrying the costs would mean losses.
The tax can also cover individuals. At a micro level, individuals are responsible for pollution by activities performed either directly or indirectly. Vehicular pollution is high and would attract a differential tax on the fuel used be it petrol or diesel or CNG. This, by itself, may encourage drivers to shift over to a medium which lets out the least pollution like CNG over petrol and diesel. In fact, subsidies could be given on use of pollution reducing kits.
Another big indirect pollutant is air travel. The aviation industry has been identified as being one of the biggest destroyers of the ozone layer. To discourage such travel or make people more aware of this effect, a flat surcharge on every ticket can be levied by the government which will ensure that all those who contribute to the pollution also pay for it. Government action will actually penalise the polluters while adding to its own revenue.
There will still be a large unorganised set of polluters which will be difficult to track, but models can be built on reducing this by providing incentives instead for doing something that lowers environmental degradation. Simple rules like construction of public amenities and provision of dustbins can be linked with tax benefits for a community in the form of, say, a cheaper water supply.
Today environment control norms are harsher on developed countries, most of which have agreed to adhere to the Kyoto norms. It has been accepted that these countries, in their processes of industrialisation, have added substantially to environmental degradation levels and hence need to atone for it. But developing countries, which are getting increasingly more industrialised, also need to shoulder this burden and need to use a blend of taxation and subsidies to address the problem, and thereby probably earn net revenue.
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